The word “portability” in an estate tax context refers to the ability to transfer a deceased spouse’s unused gift and estate tax “exemption” (technically known as the “basic exclusion amount” or the “BEA”) to the surviving spouse. Each person’s BEA totals $5,340,000 in 2014. This is applied on a cumulative basis to shelter any lifetime gifts and gifts at death from gift and estate tax.
As an example of how portability works, assume that Bob and Mary own assets totaling $7,000,000, all titled in their joint names. On the first death, everything passes automatically to the surviving spouse because of the joint ownership. Assets passing outright to a surviving spouse qualify for an unlimited estate tax marital deduction, so no portion of the first decedent’s BEA need be applied to his or her estate. By taking advantage of portability, the BEA of the first spouse to die is added to the surviving spouse’s BEA (the combined total is known as the “applicable exclusion amount”, or “AEA”), giving him or her $10,680,000 of estate tax shelter. This would be more than enough to protect the entire $7,000,000 from tax, even though the $7,000,000 would have exceeded the $5,340,000 BEA possessed by the surviving spouse alone (and would have attracted a 40% tax on the excess).
When portability was added to the estate tax in 2010, it represented a radical change in the law. In less than 20 years, the gift and estate tax BEA has risen from $600,000 to its present $5,340,000. Until 2010, the rule was “use it or lose it”. In other words, in our example above, the fact that the estate of the first spouse to die needed no exemption to avoid estate tax did not benefit the surviving spouse, and on the surviving spouse’s death (assuming no change in asset values) the tax bill on the $7,000,000 would be $664,000 (i.e. $7,000,000 – $5,340,000 x 40%).
For wealthier couples, prior to portability the standard estate planning approach to minimizing the estate tax burden involved two steps. First, the couple was advised to divide their assets so that each spouse had assets worth at least the amount of the BEA. Said another way, the couple was counseled that neither should have assets worth more than the BEA unless and until the other spouse also had assets equal to the amount of the BEA. The second step was to create a separate “by-passing” trust for each spouse so that on the first death, the decedent’s assets (at least up to the BEA) would be held in trust for the surviving spouse, rather than passing outright to the survivor. Because the trust did not qualify for the estate tax marital deduction, each spouse’s estate was able to apply the decedent’s gift and estate tax BEA to shelter his or her assets from estate tax.
Although the estate tax saving made this planning worthwhile, it was not without its disadvantages. First, the couple had to review the value and ownership of their assets periodically to assure that neither of them had assets worth more than the BEA if the other’s assets didn’t reach that level. Second, the assets passing to the by-passing trust on the first death had to be kept separate from the survivor’s other assets. Third, the by-passing trust had to file separate tax returns (federal and state) during the surviving spouse’s lifetime.
In many situations, portability makes all of this unnecessary. As described above, if all of the assets pass outright to the surviving spouse, both spouse’s BEAs will be available to shelter their combined wealth from estate tax. Even if their combined wealth exceeds their combined BEAs (i.e. $10,680,000 in 2014), transferring everything to the surviving spouse doesn’t result in any increase in the tax bill on the surviving spouse’s death.
In light of the absence of any estate tax saving, many couples opt for a much simpler joint trust as the centerpiece of their planning. They can hold their assets in this trust during their lifetimes to avoid the need for any probate proceedings on death, or in the event of a lifetime disability. Because the joint trust is the tax equivalent of joint property, no extra tax returns are necessary, even after one spouse dies. The surviving spouse has complete control of all assets.
Despite the significant advantages offered by portability, there are several reasons why clients might intentionally disregard portability as a planning tool. Our next post will address those issues.