Portability Permits Doubling the Estate Tax Exemption for Surviving Spouses
In 2012, Congress instituted portability under which the surviving spouse’s may add the unused portion of a deceased spouse’s unified credit to her own unified credit. Here’s how it works: Let’s say that Jack and Betty Sprat are married. Jack dies and his estate is $2 million. That means that he won’t use $3.49 million of his $5.49 million (in 2017) unified credit ($5.49 million – $2 million = $3.49 million). If Betty elects portability, then her estate will be able to give away $9 million ($5.49 million + $3.49 million = $8.9 million) tax free. In order to do this, Betty must file a federal tax return for Jack even though he owes no federal estate tax and make the portability election on the return. She must do this within nine months of Jack’s death. (In fact, if Jack gave his entire estate to Betty, he would not have used any of his unified credit since the gifts would qualify for the marital deduction, meaning that in electing portability Betty would be able to give away $11 million tax free at death.)
Some estate tax professionals advise all of their clients to elect portability just in case. We had a client whose situation shows why this might be advisable. His wife died. Her estate and his together were well below $5.49 million (or whatever the threshold was that year). However, he owned a substantial number of shares in a start-up company. At the time of his wife’s death, the prospects for the company were quite poor and he thought the stock was worthless. Fortunately for him, lightening struck and all of the sudden the stock was worth millions. This occurred shortly after portability was enacted and it wasn’t clear how to elect portability. In addition, he did not do so within nine months of his wife’s death since at that time he thought the stock had no value. Fortunately, given the confusion for taxpayers and tax advisors at the time, the IRS extended the filing deadline and our client was able to elect portability.
Portability was enacted in part to protect married taxpayers who had not done estate tax planning but actually goes much further. In traditional planning, spouses separate their estates more or less in half and create trusts to shelter each half of their assets so that they will not be counted in the surviving spouse’s estate. Let’s assume, for example that Jack and Betty Sprat have $6 million between them that they separated into two $3 million shares. When Jack dies first (since husbands usually die first), his $3 million goes into trust for Betty’s benefit. Usually these trusts provide that Betty will receive all of the income the $3 million earns and additional distributions as needed for her health, education, maintenance and support in her customary standard of living, though there are a number of choices in how the trust is structured. The $3 million in the Jack’s trust will not be counted in the Betty’s taxable estate when she dies, even if it is invested and continues to grow in value. Without this planning, if Betty died with $6 million, her estate would be subject to taxes on the excess over $5.49 million, and a high rate of 40 percent.
Now, if Betty were to elect portability at Jack’s death, there’d be no tax at her death because $6 million is well below $11 million, even with not tax planning. As you can see, portability actually provides more tax protection than traditional estate tax planning which would protect only the $3 million Jack left in trust. If we add this to Betty’s $5.49 million unified credit, they could together shelter $8.49 million, a substantial amount but less than $11 million under portability. In addition, with portability Betty can totally control all her assets without having to deal with the formalities of a separate trust.
Be aware of the trap for the unwary. In order to elect portability, the surviving spouse must file a federal estate tax return for the deceased spouse, even though he may not have a taxable estate and no estate tax return would normally be necessary. This return, and the portability election, must be made within nine months from the date of the deceased spouse’s death.