Portability: a game changer

Thursday, 01 May 2014
Louis A Mezzullo reviews the US provisions relating to ‘portability’ between spouses of the unused applicable exclusion amount.

The American Taxpayer Relief Act of 2012 (ATRA) made two changes to the gift and estate tax provisions that have significantly altered how estate planners advise their clients.

First, ATRA made permanent (to the extent any legislation can be considered permanent) the USD5 million applicable exclusion amount and generation-skipping transfer (GST) tax exemption, which will be indexed for cost-of-living increases (USD5,340,000 in 2014). The effect of the much greater exemption means less than 0.2 per cent of decedents will have estate tax exposure. Second, ATRA made permanent so-called ‘portability’, which is the ability of the estate of a deceased spouse to elect to have the unused applicable exclusion amount of the last deceased spouse be available to the surviving spouse for both gift and estate tax purposes.

Pre-2011

Prior to the advent of portability for decedents dying in 2011, the common estate plan that a married couple would adopt if their combined wealth exceeded or was expected to exceed the applicable exclusion amount, which was USD3.5 million in 2009, was to create two trusts at the death of the first spouse to die: a marital trust and a bypass or credit shelter trust. The amount of the deceased spouse’s unused exclusion would pass to the bypass trust and the balance to the marital trust, which was designed to qualify for the unlimited marital deduction. Under such a plan, there would be no estate tax at the death of the first spouse to die and the unused exclusion of the first spouse to die would be preserved in the bypass trust, which was designed not to be included in the surviving spouse’s estate. In order to ensure that, at the death of the first spouse, their estate had sufficient assets to use their exclusion, transfers between spouses were often necessary.

Post-2011

With portability, it is no longer necessary to set up a bypass trust at the death of the first spouse to die in order to take advantage of the deceased spouse’s unused exclusion amount.

For example, assume that the applicable exclusion amount is USD5 million, for the sake of simplicity. Assume that, when the husband dies, his unused applicable exclusion amount (referred to in the regulations as the DSUE amount, which stands for ‘deceased spousal unused exclusion’ amount) is USD4 million, because he made a taxable gift during his lifetime of USD1 million that used USD1 million of his applicable exclusion amount. The wife now has an applicable exclusion amount of USD9 million: her own USD5 million applicable exclusion, plus her deceased husband’s unused USD4 million exclusion. Consequently, the wife could make a taxable gift of USD9 million without incurring any gift tax.

However, if the wife remarried and her new husband dies before she dies and has used his entire USD5 million applicable exclusion amount, the wife will not have a DSUE amount, because it is the last deceased spouse’s unused exclusion amount that a surviving spouse is entitled to use.

Bypass trusts

Nevertheless, there will still be reasons for setting up a bypass trust at the death of the first spouse to die. Using a bypass trust will exclude from the survivor’s estate any increase in the value of the assets in the bypass trust, plus income on the assets. Because portability does not apply to the GST tax exemption, using a bypass trust is one way to use the unused GST tax exemption of the first spouse to die and preserve the assets for the surviving spouse. Even though a bypass trust has been established by a deceased former spouse, the surviving spouse could remarry and then have the benefit of the new spouse’s unused exclusion amount. Finally, a bypass trust may be necessary to use a state’s estate tax exemption.

Using a bypass trust also provides the traditional benefits of an irrevocable trust, including: protection from creditors; protection from the rights of future spouses; professional management; and preserving assets for children of the deceased spouse’s prior marriage. However, all of these objectives can be accomplished with a qualified terminable interest property (QTIP) trust. Although any increase in value of the assets in the QTIP will be subject to estate tax at the surviving spouse’s death, the assets will have a new basis for income tax purposes equal to their fair market value.

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Louis A Mezzullo

Louis A Mezzullo is a Consultant Partner at Withers Bergman LLP.

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