The Tax Relief, Unemployment Insurance Reauthorization and Job Creations Act of 2010 introduced for the first time the concept of portability of the federal estate tax exclusion between spouses. When enacted, it was meant to apply only to estates of decedents dying before January 1, 2013. However, now portability is permanent — and it can have more of an impact than couples may think on their financial situation upon a spouse’s death.
The basic exclusion amount is the amount a person can pass to their heirs tax-free through lifetime gifting or at death. (Note that the exclusion is also commonly referred to as the estate exemption). Prior to portability, individuals often would need trusts and had to closely monitor the value of assets in each spouse’s individual name and/or trusts to ensure they took maximum advantage of their combined exclusions. The portability election now makes it much easier for a married couple to help protect more of their hard earned money from being taxed.
Currently the exclusion is $11.4 million and is scheduled to remain at this high level until 2025. Many taxpayers believe that if an individual dies with assets under this amount, there is no need to file an estate tax return (Form 706). While it is true that a return may not be required, an executor needs to seriously consider the future benefit of filing a return. Doing so allows for an election to transfer the Deceased Spousal Unused Election Amount (DSUE) to the surviving spouse. This portability election increases the total exclusion available to the surviving spouse by the amount of the deceased spouse’s unused exclusion. If you don’t file the 706 at the first death, you cannot elect to port over this remaining amount.
Assume a husband and wife each have $11 million of exclusion available. The husband dies with $3 million of assets in his estate, which he is leaving to the couple’s children. Because the $3 million is less than the $11 million, no federal estate taxes are actually due and no return is required. However, if the husband’s estate files an estate tax return and makes the election to transfer the DSUE, the wife’s exclusion is increased by $8 million. Now the wife’s estate has $19 million available to transfer to the heirs free of federal estate tax.
You may say, ‘that all sounds great, but there is no way my spouse and I will ever have over $22.8 million.’ That may be true, but the current exclusion is scheduled to revert back to the pre-2017 amount ($5 million adjusted for inflation) on January 1, 2026. This should amount to roughly $6 million after the expected inflation adjustments. Also the exclusion has been raised and lowered by Congress many times in the past and could be scaled back again any time.
Again, assume a husband and wife each have an $11 million exclusion. The couple has done no estate planning. The husband has a $3 million IRA, his wife is the beneficiary, and they hold their remaining $6 million estate jointly. He dies with a $6 million estate ($3 million IRA plus half of the joint assets), which will all pass to the surviving spouse. Since transfers to spouses are free from estate tax, the settling of the husband’s estate will not use up any of his $11 million exemption, and no federal estate tax filing is required.
The surviving spouse now has the entire $9 million of assets in her estate. Now assume that in 2021 Congress lowers the exclusion to $5 million (keeping the tax rate at the current 40%). The wife dies in 2021. Her estate will owe $1.8 million in estate taxes ($9 million less $5 million times 40%). However, if the husband’s estate had filed an estate tax return and made the election to transfer the DSUE, the wife’s exemption would be $16 million (the DSUE of $11 million plus her exemption of $5 million), and no estate tax would be due.
An added benefit of the portability election is a “relaxing,” if you will, of the diligence and complexity couples need to maintain with regard to each spouse’s estate value to ensure no exclusion is wasted. Before portability, the couple in Example #2 would most likely have established living trusts to hold their assets, and would have balanced assets between the trusts to ensure each could use up all or a large portion of the exclusion if they were to die first. They may have been able to avoid the estate tax at the death of the surviving spouse without filing an estate tax return; however, this strategy would have required legal documents, valuation monitoring, and possible transfers back and forth during lives to maintain optimal estate values for each of them on an ongoing basis. There would also be ongoing income tax compliance after the first death for the irrevocable trusts that would remain after the estate closing.
One final important factor to consider is that under recently finalized IRS regulations, there will be no reduction or claw back of any transferred exclusion should the basic exclusion amount be reduced sometime in the future.
Surviving spouses should seriously consider the potential advantages of filing Form 706 to make the portability election. Normally, Form 706 is due nine months from the date of death with a six month automatic extension available. However, if the 706 is filed only to elect portability, it can be filed anytime on or before the second anniversary of decedent’s death.
The passing of a spouse is a difficult time and requires the assistance of your advisory team. Discuss the portability election with your tax team now to determine if this strategy is right for you.
Contact Michael Boncher at mboncher@cohenco.com or a member of your service team to discuss this topic further
Cohen & Co is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.