Portability: A Planning Game Changer

As part of the series “Planning After ATRA: The CPA’s Guide to Financial and Estate Planning,” Steven G. Siegel presented the Web seminar, “Portability: A Planning Game-Changer, But Not as Simple as It Appears,” in September 2013. Planner sat down with Steven to find out more about portability and to discover what CPA financial planners need to know about this topic. Be sure to read to the end of the interview for a complete listing of related Web seminars and information on the Advanced Personal Financial Planning Conference in January 2014.

Planner: Thanks for sitting down with us to talk about portability. Some of our readers may not be intimately familiar with what portability is, so tell us what it’s all about.
Steven Siegel: Portability allows the estate of a decedent who is survived by a spouse to transfer the decedent’s unused federal transfer tax exclusion to the surviving spouse. The surviving spouse can then use the deceased spouse’s unused exclusion amount (DSUE) to address the survivor’s transfers during life and at death.

The American Taxpayer Relief Act of 2012 (ATRA) makes permanent portability between spouses. In fact, ATRA provides that the basic exclusion amount is $5 million for 2011, indexed for inflation annually thereafter. The 2013 basic exclusion amount is $5.25 million. The 2014 basic exclusion amount will be $5.34 million.

Planner: What is portability intended to accomplish and how is it applied?
Steven: By preserving the unused portion of the deceased spouse’s exclusion, portability is designed to simplify estate planning for many married couples and create fairness between those who plan their estates and those who do not. Portability eliminates the need for many married couples to retitle their assets or to create complex “credit shelter bypass trusts” to fully use the transfer tax exclusion.

Portability rules affect the unused exclusion amount of a deceased spouse who dies after December 31, 2010, and this amount is available in addition to the surviving spouse’s own applicable exclusion amount. However, it is important to recognize that portability applies only to the unused exclusion of the last deceased spouse.

When a surviving spouse is predeceased by more than once spouse, the amount of available DSUE is limited to the lesser of the basic exclusion amount or the unused exclusion amount of the last deceased spouse. If the last deceased spouse has no unused exclusion available, the surviving spouse gets no benefit from portability. If a spouse has DSUE from a predeceased spouse and remarries, the DSUE is not lost unless the new spouse dies. Then, that deceased spouse’s available DSUE, if any, is ported to the surviving spouse and the DSUE from a previous deceased spouse is lost. Planning suggests using the DSUE of a deceased spouse sooner rather than later if a remarriage might take place. The good news here is that the surviving spouse is deemed to use the DSUE received from the last deceased spouse before using any of the surviving spouse’s own applicable exclusion.

Planner: What other points should we know about portability?
Steven: There are several. First, portability is elective, not automatic. For a surviving spouse to use the DSUE, an election must be made on a timely filed federal estate tax return. Federal Form 706 must be filed for the estate of the predeceased spouse regardless of the size of the estate or whether the estate is otherwise required to file an estate tax return. Form 706 is due nine months after a decedent’s date of death, and an automatic six-month extension can be obtained using Form 4768. Note that there are no special boxes to check, or statements to make, on Form 706 to make the portability election, but not filing Form 706 in a timely manner will effectively prevent the portability election. To date, the IRS has not issued any guidance that would allow late elections to be made.

Second, representatives of smaller estates may think this election is unnecessary, assuming the surviving spouse’s estate would never reach the level of the DSUE plus the surviving spouse’s own basic exclusion amount. Representatives and survivors may be reluctant to incur the cost of preparing the Form 706. However, it is suggested that taking this position is incorrect.

What if the spouse receives a financial windfall after the first spouse dies—either through good luck (for example, lottery winner, jackpot winner, inheritance from a wealthy relative)—or by bad luck (being severely injured in an accident)? What if the surviving spouse remarries a wealthy person? If the representatives of the first decedent spouse elected portability, the additional exclusion would be available to the surviving spouse. Failing to make a portability election may well expose the legal representative of the decedent’s estate and the estate’s advisors to a potentially significant liability risk if the surviving spouse’s estate turns out to be taxable. The tax could have been avoided or mitigated by a portability election.

Planner: How do you determine the DSUE?
Steven: There are three methods:

  • Starting point. DSUE is the lesser of the basic applicable exclusion amount, or the excess of the basic exclusion amount of the surviving spouse’s last deceased spouse over the amount of the tentative tax on the deceased spouse’s estate.
  • Remarriage. If the surviving spouse remarries, the DSUE will still be available to the surviving spouse as long as his or her new spouse is living. A surviving spouse who remarries is advised to use the DSUE quickly or risk losing it on the death of the new spouse.
  • Order of Transfers. Specific rules govern the use of DSUEs when used with taxable gifts, remarriage after the death of a spouse, and remarriage and divorces. Keep in mind that the DSUE received by the surviving spouse is used first, and is only lost when there is another deceased spouse who now becomes the “last” deceased spouse, replacing the previously deceased spouse in that status.

Planners should also note that the IRS is given an unlimited statute of limitations to examine the return of a predeceased spouse to determine the correct DSUE amount for portability by a surviving spouse. As a result, executors should preserve the relevant records for an extended period of time until after the death of the surviving spouse. Regulations allow the DSUE amount reported on an earlier Form 706 to be adjusted or eliminated after the normal three-year statute of limitations period, but additional tax on the earlier Form 706 can be assessed only within the normal statute of limitations period.

The temporary regulations confirm that if an executor or administrator is appointed for the estate of the deceased spouse, then only that fiduciary and not the surviving spouse may file a Form 706 to elect or opt out of portability. Questions or difficulties may come up if there is no appointed executor. In such cases, a surviving spouse may be well advised to commence a probate proceeding and obtain appointment of an executor to control the process going forward, as well as file Form 706 to gain the benefit of the portability election. 

However, beware the “angry” executor! If the executor of the first spouse to die is resentful of the surviving spouse, he or she (the angry stepchild?) may choose to ignore the portability opportunity to deny the additional tax saving in the future estate of the surviving spouse. This can be done by either failing to file Form 706 for the deceased spouse’s estate, or filing form 706 and checking a box electing out of portability. It may be wise to insert language in a prenuptial agreement requiring the executor of at least the estate of the “poorer” spouse to elect portability if that spouse is the first to die.

Planner: What other information should we know about Form 706?
Steven: Form 706 can certainly be complicated. An estate tax return prepared in accordance with applicable requirements is considered to be a “complete and properly-prepared” return that satisfies the portability election requirements. However, there are special rules in place for preparing Form 706 for smaller estates not otherwise required to file Form 706. Beginning with the Form 706 for deaths in 2012, the form’s instructions describe a simplified procedure for completing the form. For example, executors do not have to report the precise value of certain assets that qualify for the marital or charitable tax deduction. Appraisals of properties need not be filed. Executors may also estimate the total value of the gross estate based on a “determination made in good faith and with due diligence,” and then round that number upward by $250,000.

The revised Form 706 for deaths in 2012 and thereafter now provides a seven-step calculation to show the DSUE amount being portable from the deceased spouse to the surviving spouse.  Part 6 of Form 706 has been revised to address portability issues, and the form and its instructions reflect simplified reporting and permitted estimates of values. This simplified approach does raise questions about how to file Form 706 when a reverse qualified terminable interest property election is desired by wealthy clients for generation-skipping tax planning purposes. The IRS recommends using the standard rules in this case for preparing Form 706 with respect to the marital deduction and generation-skipping tax issues, and the simplified method for the balance of the return.

Planners also should be aware of the new Form 709 gift tax return filing provisions, beginning with the Form 709 for 2012. Form 709 now includes a new Schedule C, DSUE Amount. Assuming the executor of the last deceased spouse of a surviving spouse elected portability, the surviving spouse can use the DSUE of that spouse as an additional gift tax exclusion. If a taxable gift is made, the DSUE amount received from the last deceased spouse is applied before the surviving spouse’s basic exclusion amount.

Planner: Portability seems to be something all of us should think about for our clients, but what are some of its pros and cons?
Steven: Portability isn’t black and white, but is best looked at in terms of these five areas:

  1. Simplification. Portability simplifies estate planning and often eliminates the need for married people to divide their assets and hold them in separate names. Portability provides a stepped-up basis for the assets left to a surviving spouse, suggesting the possibility of reduced future income tax if the inherited assets are sold. It may eliminate the need for bypass trusts and can help when assets pass to a spouse outside of a will or revocable trust.
  2. Retirement Rollover. Portability can help when a decedent has a large retirement plan. It also helps when there are concerns about whether to leave the plan to a surviving spouse to take advantage of the spousal rollover opportunity, featuring favorable income tax liability deferral, and generous distribution rules favoring the surviving spouse’s beneficiaries. The increased exclusion and portability option allows large plans to be left outright to spouses, while retaining the spousal rollover as a planning option. Using a retirement plan to fund a credit shelter trust will be less necessary with portability now available.
  3. State-Oriented Planning. States that decoupled from the federal estate tax system must be taken into account in planning. Good planning here suggests foregoing the full portability election at the first death and instead creating a bypass trust funded with an amount equal to the state death tax exclusion of the state where the decedent resided. This will enable the estates of both spouses to take advantage of the state death tax exclusion, rather than only benefitting from the survivor’s exclusion if portability is used. Having two state death tax exclusions rather than one will benefit the heirs of the spouses. This suggestion is not necessary when the decedent resided in a state that did not have an independent death tax.
  4. Is simple better? The intentional rejection of a bypass trust can be positive or negative. Avoiding the use of a trust gives the surviving spouse control over the inherited property. This may please the survivor, but it raises issues of not providing asset protection from the spouse’s creditors and risking the spouse’s possible lack of management skills.  If the spouse remarries, all of the decedent’s property could be left to the new spouse. If the spouses had a “blended family” (children of prior marriages of husband and wife), portability does not provide any protection for an inheritance by the children of the first spouse to die. They could be completely left out as heirs. When portability is used, all appreciated property is taxable at the death of the surviving spouse—and because portability is not indexed for inflation, there may be limited opportunity to address appreciation or inflation. Where the decedent’s property has strong appreciation potential, this should be considered, as the surviving spouse could end up with a taxable estate that a credit shelter trust could avoid. Conversely, where there is little risk of the surviving spouse having a taxable estate, using portability is favored, since the value of property included in the survivor’s estate receives a basis step-up at the survivor’s death, suggesting that heirs can avoid potentially significant future income tax liability.
  5. The dilemma. Portability is neither indexed for inflation nor does it apply to a decedent’s unused GST exemption. What portability does provide is a second step up in basis (at the death of the surviving spouse) of the assets of the first decedent spouse. This higher income tax basis may benefit the heirs of the spouses if assets are sold; advisers should compare the advantages on a case-by-case basis. Planning might suggest here using a QTIP trust for the surviving spouse to combine the benefits of portability with the asset protection of a trust—and the safeguarding of the inheritance left by the first decedent spouse to that spouse’s chosen beneficiaries.

There is no doubt that portability can be an estate planning game-changer for many clients. Portability, however, is more complex than it may at first seem and should be applied on a case-by-case basis.