Portability: Planning with the New Estate Planning Paradigm

By: Martin M. Shenkman, Esq.

 

 

Introduction

 

TRA Creates new Planning Concept

 

Until recently, “portable” referred to that old portable barbeque grill you took to the Jets tailgate parties. Unfortunately, when Jet’s fans who are tax attorneys think “portability” now, something different comes to mind.

 

The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (“TRA”), Public Law number, P.L. 111-312, was signed into law by the President on December 17, 2010. The substantial increases in the now unified gift, estate and GST exemption, coupled with a new concept that has been dubbed “portability,” a low 35% rate, and other changes makes the TRA the most sweeping estate tax change in many decades. Considerable uncertainty remains in light of the sunset of so many of the TRA provisions at the end of 2010. The sunset also affects the topic of this monograph, portability.  While the TRA doesn’t use the term “portability,” that is the term used in the Joint Committee report, and the one that has become the moniker for the new provision this monograph will focus on. No. JCX-55-10; 12/10/2010.

 

Why Portability Shouldn’t Be Ignored

 

So, even if portability were the cats meow, a two year meow doesn’t mean much in the planning world. And, as will be explored below, there are more twists and turns in the portability rules than on a roller coaster at Cedar Point. So, why should anyone care about portability?

 

• Many consumers have been left with the false impression from media reports that if they’re married they don’t have to concern themselves with estate tax if their estate is under $10 million. While this might be wrong from many perspectives, this misconception must be addressed or otherwise intelligent and wealthy consumers will simply not take the steps that most practitioners believe advisable to protect themselves. This false sense of security has had some consumers (even some pretty smart financial reporters) making statements like: “Gee now I can get rid of my life insurance and that complicated bypass trust.” Not exactly Jeopardy championship material here! Educating clients about the limitations of portability remains a critically important reason why portability cannot be ignored.
• It makes great cocktail reception conversation – what an ice breaker!
• Congress may in fact make portability permanent in 2013 and if planning is not addressed now, and a client does not (or cannot, perhaps due to incompetency) update his or her documents, a potentially valuable opportunity would be lost.
• For some situations portability is superior to more traditional bypass trust planning, so perhaps it should not be ignored even though it has plenty of faults.
• Competency is not assured. If a client executes documents today and implements a plan taking what is viewed as a conservative or optimal approach in light of portability’s ephemeral, if it becomes a permanent estate planning fixture in 2013, the testator may not be assured of having adequate competency to revise the documents or planning to address it. But unfortunately, given the myriad of complexities the TRA has created will testators bear the complexity and cost of plans and documents that contemplate all these scenarios? Likely not.

 

Prior Law Bypass Trust, Asset Title and Other Complexities

 

Under the estate tax rules that applied in 2009 and prior years, a married couple had to engage in rather complicated estate tax planning to claim their entire family exemption. In 2009, this was $3.5 million per person, or $7 million for a couple. It was less in prior years. If planning were not properly addressed, all assets on the death of the first spouse to die would pass to the surviving spouse. While there would be no tax on the first death, assets would be doubled up in the surviving spouse’s estate and subject to a greater estate tax. To avoid the negative estate tax consequence, the couple would have to divide assets between them so that whoever died first would have sufficient assets to fund a bypass trust (also referred to as an applicable exclusion or credit shelter trust) on the first death with an amount equal to the estate tax exemption. The assets in the bypass trust (including all of their appreciation) would not be subject to estate tax at the second spouse’s death.  The result of these rules is that many taxpayers who incurred the expense and made the effort to properly plan their estates could have avoided estate tax. But taxpayers who did not receive sufficient advice, would leave their estates vulnerable to the estate tax. The need for this type of planning, and the means to prevent unsuspecting taxpayers from being ensnared by the estate tax, was to provide a mechanism to enable the surviving spouse to benefit from the deceased spouse’s unused estate tax exclusion. Such a mechanism has been provided for the first time in the TRA.

 

Bypass trust planning, and their interrelationship with the portability considerations, are discussed in greater depth in the planning section at the end of this article.

Overview of Portability

TRA to the Rescue: Portability

 

So does the new portability paradigm avoid complexity?  It does to some degree, but not as much as many taxpayers may believe. As with so many “tax simplifications” (think about the automatic allocation of GST exemption as an example), the simplification cure can be worse than the tax complexity for which it was prescribed. Tax simplification is like the old adage: “The cure is worse than the disease.”

 

The unfortunate reality is that for many taxpayers the steps and decisions involved with portability may be quite complex. In many situations, relying on the simplification portability is intended to provide will prove very detrimental. Assets held in a traditional bypass trust on the death of the first spouse could appreciate without limit and not be subject to estate tax in the surviving spouse’s estate. If instead of a bypass trust, the client opted for the cheaper “I love you will” leaving all of his or her estate to the surviving spouse outright, then portability might come to the rescue to protect the assets up to the amount of the portable exclusion. The incremental benefit is that the assets included in the surviving spouse’s estate will receive a step up in basis on the last-to-die spouse’s death. The assets in the bypass trust will not.

Definitions

 

The portability rules include several new definitions, which although explained elsewhere in this article are noted here:

 

• Basic Exclusion Amount. In 2011 and 2012 this amount will be $5 million based on the TRA relief. TRA Sec. 303(a)(3)(A). The exclusion had previously been called the "applicable exclusion amount." In 2009 this amount was $3.5 million. In 2013 absent yet another change in the law this amount will be $1 million. Under TRA, a new building block was required to address the concept of portability of a deceased spouse’s unused exclusion to the surviving spouse. TRA’s new math/definitions are: [Basic Exclusion Amount + Portable Amount = New Applicable Exclusion Amount]. IRC Sec. 10201(c)(4)(B)(i). This reference appears to limit the amount that is portable to the basic exclusion amount in existence when used not when the last deceased spouse died. Therefore, if later legislative changes reduce the basic exclusion amount the DESUA then available would also appear to be reduced.
• Applicable Exclusion Amount. This term from prior law has been redefined to encompass the new estate tax concept of portability allowing the surviving spouse in certain situations to use the remaining basic exclusion amount from his or her previously deceased spouse. TRA Sec. 303(a)(2). It is: [Your Basic Exclusion Amount + Portable Amount from your Last Deceased Spouse = New Applicable Exclusion Amount]. Consider some of the surprising affects of this definitional change. A power of attorney that permitted gifts up to the applicable exclusion amount, does that now mean $5 or $10M instead of perhaps the $1M when signed?
• Deceased Spouse Unused Exclusion. TRA created a new concept called portability which endeavors to simplify the estate tax system by avoiding the need for families to undertake complex planning to maximize the use of both spouses’ exclusions. Under prior law, the couple might have divided assets 50/50 and had each will include a bypass trust to benefit the surviving spouse, while still avoiding inclusion of those assets in the surviving spouse’s estate. Under TRA, if your spouse dies with none of this planning on your later death, you may be able to utilize your prior deceased spouse’s unused estate tax exclusion. Portability is not simple, nor does it assure the intended result. TRA Sec. 303(a)(3)(A)(4).

Reporting and Other Requirements

 

The portability benefits will only be available for those dying after 2010. This benefit was not made retroactive to the beginning of the 2010 year as were other TRA changes. Thus, for some taxpayers, holding on until after the last stanza of Auld Lang Syne was concluded was an affirmative tax planning step.

 

Section 303(a)(5) of the 2010 TRA: (5) Special Rules.—(A) Election Required.— A deceased spousal unused exclusion amount may not be taken into account by a surviving spouse under paragraph (2) unless the executor of the estate of the deceased spouse files an estate tax return on which such amount is computed and makes an election on such return that such amount may be so taken into account. Such election, once made, shall be irrevocable. No election may be made under this subparagraph if such return is filed after the time prescribed by law (including extensions) for filing such return. (B) Examination of Prior Returns After Expiration of Period of Limitations With Respect to Deceased Spousal Unused Exclusion Amount.—Notwithstanding any period of limitation in section 6501, after the time has expired under section 6501 within which a tax may be assessed under chapter 11 or 12 with respect to a deceased spousal unused exclusion amount, the Secretary may examine a return of the deceased spouse to make determinations with respect to such amount for purposes of carrying out this subsection.

 

To use the “portable” exclusion the first-to-die spouse’s estate must file an estate tax return no matter how small the estate is. The Joint Committee Report states: “A deceased spousal unused exclusion amount is available to a surviving spouse only if an election is made on a timely filed estate tax return (including extensions) of the predeceased spouse on which such amount is computed, regardless of whether the estate of the predeceased spouse otherwise is required to file an estate tax return.”

 

How many decedents’ with estates that appear to be safely within the limits of the avoiding tax would willingly incur the expense and cost of filing a return? Will this become the same trap for the unwary that not having a bypass trust had been in prior years that led up to the call for portability? Will more moderate net worth, or less sophisticated taxpayers, fall into the same trap they did with bypass trusts?

 

The statute of limitations on auditing the estate tax return electing portability is subject to special rules. The Joint Committee Report provided: “In addition, notwithstanding the statute of limitations for assessing estate or gift tax with respect to a predeceased spouse, the Secretary of the Treasury may examine the return of a predeceased spouse for purposes of determining the deceased spousal unused exclusion amount available for use by the surviving spouse. The Secretary of the Treasury shall prescribe regulations as may be appropriate and necessary to carry out the rules described in this paragraph.” How will executors view this non-ending statute of limitations for an audit? Fortunately, the endless statute of limitations applies only for the purpose of determining the proper amount of the deceased spousal unused exclusion amount that the surviving spouse can use. IRC Sec. 2010(c)(5)(B). What kind of receipt and release would be necessary for such an executor to protect that type of decision?

 

Perhaps the IRS will see fit to provide a simplified estate tax filing to preserve portability, but even that will often be overlooked. For decedents residing in states with a state estate tax, a rather comprehensive return will be needed in any event so perhaps for those decedents the filing will not create any significant incremental burdens.

 

Planning Note: This filing requirement provides a window into the “logic” of government tax law writers. Follow the bouncing ball: The old rules were deemed unfair. If the taxpayer didn’t seek out an estate planning attorney who understood what a bypass trust was, that family would have lost out on the exclusion. So that wasn’t quite fair. So let’s enact a law called portability to obviate that unfairness. Great. Keep your eye on the ball because this is somewhat like the three shell game on a street corner. Can you find the ball? Because the law pre-portability lead to unfair results, Congress enacted a law that requires that the probate attorney for the estate file an estate tax return to secure the benefit of the exclusion. So if the taxpayer didn’t know to hire an estate attorney to draft a bypass trust, how will his or her heirs know to hire a probate attorney to make the necessary filing? So which shell is the ball under?

 

Statutory Language and “Last Deceased Spouse”

 

The 2010 TRA’s portability provision is effective for estates of decedents dying after December 31, 2010.

 

Section 303(a)(3)(A)(4) of the 2010 TRA: “Deceased spousal unused exclusion amount.—For purposes of this subsection, with respect to a surviving spouse of a deceased spouse dying after December 31, 2010, the term “deceased spousal unused exclusion amount” means the lesser of— (A) the basic exclusion amount, or (B) the excess of— (i) the basic exclusion amount of the last such deceased spouse of such surviving spouse, over  (ii) the amount with respect to which the tentative tax is determined under section 2001(b)(1) on the estate of such deceased spouse.”

 

The phrase “basic exclusion amount of the last such deceased spouse” implies that the first-to-die spouse’s exclusion is not inflation adjusted as suggested earlier. Furthermore, the phrase “last such deceased spouse” has a special impact (different from previous portability legislative proposals. The phrase implies that if Husband 1 is married to Wife 1 and Husband 1 dies, Wife 1 would be able to utilize Husband 1’s remaining exclusion. However, what if Wife 1 remarries Husband 2? Would Wife 1’s estate only be entitled to utilize the remaining exclusion from Husband 2. While remarriage might be viewed as reasonably cutting off the right to use the prior spouse’s exclusion, this does not appear to be the manner in which the law operates.

 

Thus, this new law provides that the unused exemption is only available from the "last such deceased spouse." The terminology that has become popular for this is “Deceased Spouse’s Unused Exclusion Amount” or “DSUEA.” IRC Sec. 2010(c)(4). This means that if the surviving Wife 1 remarries Husband 2, she may still use the unused exemption from Husband 1 because Husband 1 still remains her "last deceased spouse" so long as Husband 2 is alive.  When Husband 2 dies, then Wife 1 could only use Husband 2’s unused exemption, and Wife 1 could no longer use Husband 1's unused exemption (if any). Although it seems somewhat odd that being married to a new spouse with a new exemption would still mandate the use of the last spouse’s exemption that seems to be the case.

 

The concept of a “DSUEA,” and the last deceased spouse, was incorporated into the law to prevent the concept of a serial spouse accumulating unused exclusions from many prior spouses. However, the abuse Congress sought to restrict can still be achieved to a degree, as illustrated below.

 

Privity on Use of Deceased Spouse Exclusion

 

The use of the exclusion appears also to require marriage in that a spouse of a surviving spouse cannot use that surviving spouse’s prior deceased spouse’s unused exclusion if the surviving spouse dies before the taxpayer in question.

 

Example: Wife 1 is married to Husband 1. Husband 1 dies. Wife 1 could use Husband 1’s unused exclusion. Wife 1 remarries to Husband 2. If Wife 1 dies, Husband 2 can use Wife 1’s unused exclusion. However, Husband 2 cannot use the unused exclusion of Wife 1’s former deceased spouse, Husband 1.

 

The conclusion is not certain at present. For example, would it matter if Wife 1’s executor used the predeceased spouse’s unused exclusion of Husband 1 to avoid any tax in Wife 1’s estate and then sought to file an estate tax return permitting Husband 2 to utilize Wife 1’s own exclusion (which perhaps was undiminished as a result of her use of Husband 1’s theretofore unused exclusion)?

 

These rules make the likelihood of a particular prior deceased spouse’s exclusion being used somewhat precarious as it will depend on remarriage, longevity of the new spouse, the new spouse’s exclusion, and as discussed below the filing of an estate tax return many will undoubtedly overlook. Portability seems to bring to estate planning about the same quantum of simplicity that the GST automatic allocation rules created!

 

Examples of Portability Rules from Joint Committee Report

The Joint Committee Report included the following examples of the application of the portability rules:

 

Example 1.- Assume that Husband 1 dies in 2011, having made taxable transfers of $3 million and having no taxable estate. An election is made on Husband 1's estate tax return to permit Wife to use Husband 1's deceased spousal unused exclusion amount. As of Husband 1's death, Wife has made no taxable gifts. Thereafter, Wife's applicable exclusion amount is $7 million (her $5 million basic exclusion amount plus $2 million deceased spousal unused exclusion amount from Husband 1), which she may use for lifetime gifts or for transfers at death.

 

Example 2.- Assume the same facts as in Example 1, except that Wife subsequently marries Husband 2. Husband 2 also predeceases Wife, having made $4 million in taxable transfers and having no taxable estate. An election is made on Husband 2's estate tax return to permit Wife to use Husband 2's deceased spousal unused exclusion amount. Although the combined amount of unused exclusion of Husband 1 and Husband 2 is $3 million ($2 million for Husband 1 and $1 million for Husband 2), only Husband 2's $1 million unused exclusion is available for use by Wife, because the deceased spousal unused exclusion amount is limited to the lesser of the basic exclusion amount ($5 million) or the unused exclusion of the last deceased spouse of the surviving spouse (here, Husband 2's $1 million unused exclusion). Thereafter, Wife's applicable exclusion amount is $6 million (her $5 million basic exclusion amount plus $1 million deceased spousal unused exclusion amount from Husband 2), which she may use for lifetime gifts or for transfers at death.

 

Example 3.- Assume the same facts as in Examples 1 and 2, except that Wife predeceases Husband 2. Following Husband 1's death, Wife's applicable exclusion amount is $7 million (her $5 million basic exclusion amount plus $2 million deceased spousal unused exclusion amount from Husband 1). Wife made no taxable transfers and has a taxable estate of $3 million. An election is made on Wife's estate tax return to permit Husband 2 to use Wife's deceased spousal unused exclusion amount, which is $4 million (Wife's $7 million applicable exclusion amount less her $3 million taxable estate). Under the provision, Husband 2's applicable exclusion amount is increased by $4 million, i.e., the amount of deceased spousal unused exclusion amount of Wife.

Gift and GST Implications of Portability

Gifts Generally

 

If a surviving spouse can use her previously deceased spouse’s unused exclusion on her estate, why should she not also be able to use that exclusion to protect gifts she makes from gift tax? Since the gift and estate tax are fully unified in 2011 and 2012 that result should be reasonable. It appears to in fact be the case. TRA Sec. 303(b)(1). This may not be an easy proposition as discussed above. The Joint Committee Report states: “A surviving spouse may use the predeceased spousal carryover amount in addition to such surviving spouse's own $5 million exclusion for taxable transfers made during life or at death.”

 

Given the shortcomings of portability, clients should be advised to evaluate the relative merits of gifts rather than relying on portability. If the assets can be given to an irrevocable trust before death, the assets can grow outside of either spouse’s estate. This could compare favorably to the alternative of relying on using a portable exemption. The gift transfer could also have GST exemption allocated, something that the portable exemption cannot.

 

Planning note: If a client’s spouse dies in 2011 or 2012 consideration should be given to gifting any portability exemption amount before the end of 2012 to avoid the elimination of that portable amount in the event 2013 results in an elimination of portability.

Gifts – Ordering Rules

 

Will there be an ordering rule? Will the surviving spouse have to utilize his or her unified exemption before using the exemption of the last deceased spouse? Ordering rules could have a significant impact on the usefulness of inter-vivos gift planning to take advantage of a last deceased spouse’s exemption prior to a remarriage that could jeopardize it. If there is no ordering rule, or any rule adopted permits the use firs of the exemption of the prior deceased spouse it might be advisable in many, perhaps most, remarriage situations to have the surviving spouse utilize the last deceased spouse’s exemption prior to a remarriage by a transfer to a self settled asset protection trust at minimum. In this way, the portable exemption from the prior spouse will be locked in against any risk of the new spouse dying thereby wiping out the exemption of the prior spouse. If the survivor is not generally desirous of making a large gift, the use of the self settled domestic asset protection trust might suffice by assuring him or her of access to the funds in the discretion of the trustee, while securing the tax benefit.

 

GST Tax and Portability

 

For many clients, the decision to use trusts or not might be simplified by the introduction of GST tax considerations. The portability provisions are designed to eliminate the need for the “mere wealthy” to have to incur the cost and complexity of dividing title to assets and having a bypass trust. But for those who are the more than “mere wealthy,” portability was not extended to GST tax. See Joint Committee Report footnote 56. Thus, for those estates wishing to take advantage of the GST exemption of the first spouse to die, a trust will have to be created in any event. As noted in an earlier discussion, if compound interest is the Eighth Wonder of the World, compounding inside a dynasty trust that is GST exempt is the Eighth Wonder of the World with whipped cream on top. Unless the portability benefit is extended to encompass GST, any family unit with potentially more than a $5 million estate should carefully evaluate the loss of GST benefits. If any significant wealth can be held onto through the generations, the GST benefits of trust planning on the first death could prove quite valuable over time.

 

Portability Rules Illustrated

If Henry VIII had Portability

 

The wives of Henry VIII, in order, were: Catherine of Aragon, Anne Boleyn, Jane Seymour, Anne of Cleves, Catherine Howard, and Catherine Parr.

The famous rhyme tells what befell each of the above wives. The analysis indicating impact on portability was actually developed in more recent times.

Divorced beheaded died
Divorced beheaded survived.

 

• Catherine of Aragon was divorced so Henry VIII obtained no benefit of her unused exclusion. Portability scorecard -0-.
• Anne Boleyn was beheaded so presumably, but for potential application of the slayer statute, Henry VIII could have benefited from her unused exclusion. But since he later married Jane Seymour who died, he would have had to have used Anne Boleyn’s exclusion for gift purposes. Portability scorecard $5M.
• Jane Seymour died. So her death cut off Henry VIII’s use of Anne Boleyn’s exclusion, but being a wily kinda guy, we’ll assume he used it for gift purposes. Portability scorecard $10M.
• Anne of Cleves divorced Henry so Henry VIII obtained no benefit of her unused exclusion. Portability scorecard stays at $10M.
• Catherine Howard was beheaded so presumably, but for potential application of the slayer statute, Henry VIII could have benefited from her unused exclusion. But since his prior deceased spouse Jane Seymour had died, we will continue to assume that he used Jane Seymour’s exclusion for gift purposes. So Catherine Howard should become the last deceased spouse. Portability scorecard $15M.
• Catherine Parr appears to have survived (or the old rhyme ended before her) so that Catherine Howard remains the last predeceased spouse. But Catherine Parr has her own exclusion that she could use before death so that effectively Henry VIII’s portability scorecard can count her $5M for the family fisc. Portability scorecard $20M.

 

Well folks, one seminar participant, Barry Dickman, Esq. of Hackensack, NJ, so enjoyed the Henry the VIIIth analysis of portability that he provided a bit more historical perspective that we would be remiss in not sharing:

 

“I enjoyed your discussion of the new estate tax law at last week’s seminar, and found it quite useful.  I just wanted to fill in the blanks in your Henry VIII example. Catherine Parr did survive Henry and inherited his estate.  He was probably the richest man in England; I remember the guide at Hampton Court saying he owned something like 25 castles. Catherine soon got married again, to Thomas Seymour, the brother of her predecessor, Jane Seymour, but died within a year as a result of childbirth.  I have seen her tomb, at Sudely Castle in the Cotswolds, but oddly her epitaph didn’t mention her estate tax exclusion.  Since her husband was eventually executed for treason and the historians lost track of her son, I don’t know what happened to her estate, but I’m guessing it was seized by Queen Elizabeth, and that she didn’t pay any estate taxes...”

And Don’t Forget Herman’s Hermits

 

For homework, please analyze Herman’s Hermits song from a portability perspective:

I'm Henry the eighth I am

 Henry the eighth I am, I am

 I got married to the widow next door

 She's been married seven times before…

 

Planning Implications of Portability

Portability By Year

There is much confusion about the rules and application of portability. Perhaps a summary of the implications by year, with some “guesses” as to future outcomes, might provide a better framework for understanding its application:

 

• 2010 – Does not apply.
• 2011 – Applies without indexing so that the maximum “Basic Exclusion Amount” that might qualify for portability is $5 million.
• 2012 – Applies with inflation indexing so that the maximum “Basic Exclusion Amount” that might qualify for portability is $5 million, increased to reflect inflation since 2010 (not since 2011).
• 2013 and later years – The law as it presently stands provides for a sunset of the rules so that in 2013 the gift and estate exemption reverts to the $1 million pre-EGTRAA amount and portability disappears. Here are some of the possibilities that might occur in 2013 with respect to portability:
• The law reverts as presently written and portability disappears as a mere two year historical footnote. Few practitioners believe this likely.
• Congress is indecisive for a period of time so that similar to 2010 when estate planners were guessing and flip-flopping on options, there may be a similar such period. So regardless of what the eventual outcome of the law is, given the risk of this and the problems it creates, it would suggest that drafting wills and other dispositive instruments presently should incorporate optional bypass trust type language to avoid the uncertainty. Many practitioners fear that periods of unknowns, flip-flopping, and uncertainty all define the “new normal” of estate planning.
• $3.5 to $5 million exclusion and a 35% to 45% rate. If the estate tax remains with an exclusion in the ranges indicated it would seem likely that portability will remain a permanent fixture in the law and that it could then be more affirmatively relied upon for the limited circumstances where reliance might appear warranted.
• Repeal of the estate tax. The impact on portability and related planning will all depend on what might replace the estate tax. If, for example, a capital gains tax on death were substituted, assets held in a bypass trust might avoid that tax on the second death. All remains uncertain.
• If portability is extended in 2013 and later years the extension might be just that, an extension. If the political winds result in merely a two year extension of the 2011-2012 rules, planning reliance on portability will remain in appropriate and portability will remain primarily a response to “oops” planning for clients that did not title assets properly or fund bypass trusts.
• If Congress extends or makes permanent (however that term is defined in terms of Congressional tax legislation) the 2011-2012 rules, what happens if the exemption (“Basic Exclusion Amount”) is lowered to something less that $5 million? Will that reduce the amount that is portable from a last  deceased spouse that died in 2011 when the portable exemption was $5 million to a new lower number?

Recordkeeping to Maximize Portability Benefits

 

Given the rules discussed above, there are a number of steps practitioners should take to protect clients’ interests in portable exemption amounts:

• Estate tax returns making the portability election, along with all supporting documentation should be saved indefinitely because of the unlimited statute of limitations.
• When a client has the benefit of a last deceased spouse’s unused exemption amount that amount and its use should be tracked to document how much was used and when. The “when” is vital in the event of the demise of a later spouse.
• Use of GST exemption will have to be monitored carefully since it will differ since GST is not portable.
• When practitioners are preparing gift tax returns they should expressly inquire as to whether any DSUEAs exist and document the existence or lack of any.
• If ordering rules are created they will have to be monitored and tracked.
• It may be advisable to attach a schedule to any gift tax return listing the source of all prior DSUEAs and their use to assure that the records are available and not lost. Since the prior gift tax returns will have to be attached to a future estate tax return of the surviving spouse these records might prove helpful.

Evaluating Portability and Options Under Selected Scenarios

The portable exemption as discussed above is not indexed for inflation, but this phrase is a somewhat unclear and should be explained more carefully so that its impact on planning can be evaluated. The Basic Exclusion Amount  is indexed from 2012 and in future years (in 2012 retroactively back to 2010). But once the first spouse to die (the “last deceased spouse”) has died, the amount of that deceased spouse’s portable exemption is fixed at that time. Thus, at least in theory, inflation in assets up until the first spouse’s death should be addressed by inflation indexing of the exclusion amount. However, any inflation in the value of assets after the death of the first spouse cannot be protected by this inflation adjustment. This, in many instances, will be a significant factor favoring the use of a bypass trust.  Perhaps one way to address this in a flexible manner is illustrated as follows.

 

Example: Husband age 85 and Wife age 72, each with a $4 million estate and domiciled in a state without an estate tax, complete estate planning documents. It is anticipated that Wife will outlive husband by many years and the use of a bypass trust in Husband’s estate is warranted. In this manner if Husband is the first spouse to die Husband’s assets can grow for many years in the bypass trust and the growth will be outside of Wife’s estate. What if Wife unexpectedly predeceases Husband? Should Wife’s will mirror Husbands with a bypass trust? Perhaps the better approach as it would be anticipated that Husband may not outlive wife for many years that Wife’s will provide for an outright bequest to Husband, but if Husband disclaims then pass the assets into a bypass trust. In that way, should the unexpected occur, Husband can evaluate whether significant post death appreciation is likely to be an issue or not. In the case of his survival, it may not be.

This seems a bit like Goldilocks and the three bears trying to figure out which porridge is just right. For this fairytale state estate tax is ignored.

 

• Porridge No. 1 – Survivors Estate Under $10 Million: If the estate of the surviving spouse is less than the aggregate of the surviving spouse’s exclusion as inflation indexed plus the first-to-die spouse’s non-inflation indexed exclusion, it would be advantageous from purely a federal tax perspective to use the outright bequest to the surviving spouse. This would provide the maximum basis step up on second death for all assets and avoid any federal estate tax cost (ignoring state estate tax issues, protections afforded by trusts, etc.). In this scenario, the bypass trust porridge would be too hot.
• Porridge No. 2 – Appreciation Pushes 1^st To Die Spouses Assets Above $5 Million: If the assets that could have been bequeathed to a bypass trust on the first death appreciate at a rate such that the aggregate of the bypass-able assets and the surviving spouse’s assets would exceed the first-to-die spouse’s exclusion (applied to the bypass trust) and the survivor’s exclusion, then it would be advantageous to fund the bypass trust to remove that excess appreciation from the surviving spouse’s estate and avoid the estate tax on the second spouse’s death. In this scenario, the bypass trust porridge would be just right.
• Porridge No. 3 – Income Tax Costs Exceed Estate Tax Costs: Since the estate tax rate is now only 35 percent if the surviving spouse resided in a state with no estate tax but with a high income tax rate, when combined with the federal income tax rate applicable on the surviving spouse’s death exceeded the estate tax on the portion of the estate that exceeded the available estate tax exemption, the second basis step up might be more valuable in terms of income tax savings than the savings in estate tax afforded by the bypass trust. In this scenario, the bypass trust porridge would be too cold.

 

To Fund or Not To Fund – A Bypass Trust

 

The decision as to whether to fund a bypass trust, with the complexities just described, will have to be made without the benefit of hindsight. Thus, the determination as to whether to fund a bypass trust might consider a myriad of factors, including but not limited to:

• Which assets might be available to fund the bypass trust and how difficult might they be to transfer into the bypass trust.
• Are there assets that are not possible to transfer to the bypass trust but which might be protected by portability (e.g, professional practice).
• What is the anticipated appreciation potential of the assets involved.
• Anticipated inflation increase in the surviving spouse’s exclusion.
• Life expectancy of the surviving spouse.
• Likelihood of the surviving spouse remarrying a new spouse who dies before the surviving spouse

 

Many more considerations will have to be evaluated to make the optimal decision. But in many instances, instead of going through this analysis, the use of appropriate trusts on the death of the first spouse will probably prove the safer bet and well worth the cost involved. Similarly, non-married partners will likely find trusts the way to go.

 

Planning Note: While a theoretical case can be made for circumstances when intentionally not funding a bypass trust is preferable, the only way to quantify that analysis would be to model the possible outcomes of the decisions. This would include forecasting future income and estate tax rates, growth in assets, state income and estate tax consequences, and other imponderables. The torrent of recent and often irrational and unexpected tax laws have proven that projecting future tax consequences is not art or science but more an exercise in futility. The safer and more conservative answer in most instances, considering the myriad of nontax benefits of using a trust, is to fund a trust on the first spouse’s death. The reality will unfortunately be that most taxpayers with estates well under the $5 or $10 million thresholds will be reluctant to incur the incremental cost of planning for this, and the operational cost of maintaining a trust after the first spouse dies. That will prove for many a costly mistake.

 

Non-Reciprocal Inter-Vivos Bypass Trusts

 

Some practitioners are recommending that taxpayers fund reciprocal bypass trusts using much of their available $5 million gift exemption amount. The rationale for this type of planning is that the growth in the assets so transferred will be outside their estates. If the exemption amount is reduced in 2013 or later years, the leverage of growth on the $5 million will continue outside the estate. If a bypass type structure is utilized then each spouse and the descendants or other agreed beneficiaries can all be benefited. If this type of planning is pursued, caution must be given to the risks posed by the reciprocal trust doctrine. The IRS might challenge such an arrangement as if the husband established a trust for the wife, while the wife established an identical trust for the husband, and then “un-cross” the reciprocal trusts causing inclusion in the respective estates. See U.S. v. Grace, 395 316 (1969); PLR 9643013; PLR 200426008.

 

If this type of planning is pursued incorporate differences into each of the trusts to lessen the risk of this type of challenge. Several, not one, difference should be created. The more significant in aggregate, the better to avoid the reciprocal trust doctrine. The trusts should be drafted pursuant to different plans. Separate memorandum or portions of a memorandum dealing with each trust separately may support this.  The husband and wife should not be in the same economic position following the establishment of the two trusts (e.g. husband is a beneficiary of wife’s trust, and wife is a beneficiary of husband’s trust).  The trusts should not be interrelated. o Give one spouse a “5 and 5” power under one trust, but don’t include a “5 and 5” power under the second trust (this may be viewed as an immaterial difference). Include an inter-vivos special power of appointment (SPA) under one trust but not another. Endeavor to make this a meaningful power (e.g., more than just reallocating assets between the same group of children or grandchildren).  Include a testamentary special power of appointment (SPA) under one trust but not another. Include a martial savings clause in one trust but not the other. Each trust should have different vesting options. For example, one trust could mandate distributions at specified ages and the other trust could you meaningfully different ages, or if state law permits, the second trust could be a perpetual dynasty trust.  Use different distribution standards in each trust. For example, one trust could distribute solely based on an ascertainable standard, and the other trust could use a broader comfort and welfare or totally discretionary standard with an independent trustee. Add different beneficiaries to one of the trusts, but not the other. Note that if husband creates a trust for wife and their first child, and wife creates a trust for husband and their second child, this could still be unraveled under a reciprocal gift analysis. See Sather 251 F.3d 1168 (8th Cir. 2001); See Schuler, 282 F.3d 575 (8th Cir. 2002).  Use different trustees for each trust. If neither spouse is a trustee or co-trustee and you have different trustees for each trust this could be a very significant factor. Use different time periods for each trust if feasible. Have the trusts signed at different times. Each trust can hold different assets.

The Portability Bypass Combo

 

Well, Subway isn’t the only place you might find a combo sandwich. Estate planners might just find that the determination as to whether a particular estate should use portability or a bypass trust comes squarely down on the side of use both! The two concepts can mesh quite well.

 

Example: Decedent died in 2011 survived by Spouse. Decedent’s estate consists of an IRA worth $1.5 million, a ½ interests in a house owned as tenants in common worth $600,000 and a brokerage account worth $2 million. Decedent’s will provides for an outright marital to the surviving Spouse and if a disclaimer is exercised the assets will pass to a bypass trust. Spouse reviews the situation and believes that there is some risk that the estate tax exclusion amount will decline in 2013, and that even at a $5 million level that an estate tax might be due as a result of inflation. Spouse disclaims the interest in the house and brokerage account, but not the IRA, which is simply rolled over. So the bypass trust is funded, via disclaimer, with $2.6 million in assets. An estate tax return electing portability is filed. On the later death of Spouse, the $2.6 million plus all appreciation on it is excluded from her estate. Her applicable exclusion amount will consist of her own $5 million Basic Exclusion Amount (inflation indexed) plus her last deceased spouse’s unused exclusion amount of $2.4 million [$5 million in 2011 reduced by the $2.6 million used on the funding of Decedent’s bypass trust], or $7.6 million (ignoring inflation indexing of Spouse’s exclusion).

Step Up In Basis with Portability and Not a Bypass Trust

 

One of the significant issues to evaluate in determining whether funding a bypass trust or relying on portability is preferable (leaving aside the uncertainty and other potentially deal breaker issues governing portability) is how to evaluate the trade off of using a bypass trust and preserving unified credit amount, versus the opportunity for a step up in the income tax basis of those assets if they were instead included in the surviving spouse’s estate and he/she as surviving spouse relied on portability. The difficulty of this decision is considerable.

• If capital gains tax rates rise, which many believe is inevitable especially for higher income taxpayers, the trade-off of preserving the exemption versus garnering the basis step up, may way in favor of sacrificing a possible estate tax benefit for an income tax savings.
• If the client resides in a state with a state estate tax the state estate tax when combined with a 35% federal estate tax might clearly way in favor of choosing to secure the estate tax benefit with a bypass trust rather than the increased exemption.
• If the client resides in a state with a state estate tax the state estate tax, but who is unlikely to trigger a federal estate tax, might have to weigh the state estate tax against the combined federal and state capital gains tax increase that might be realized in the future by sacrificing the greater basis step up which portability might provide.
• If the client resides in a state with a state estate tax the potential for the client relocated to a state without an estate tax prior to death may be another factor to consider.

 

Is a Disclaimer Bypass the Way to Go

 

Some practitioners are recommending the use of a disclaimer bypass trust for clients whose net worth appears to be under the federal exemption amounts (non-married $5 million and married $10 million. This approach does in fact provide more flexibility in that the taxpayers can defer any decision until the death of the first spouse at which time there may be more certainty.

 

Can you Bypass and Get a Step Up in Basis on the 2^nd Death

Is there another option so that the taxpayers can have their bypass cake and eat it too? Is it possible to fund the bypass trust but somehow trigger the inclusion of those assets in the surviving spouse’s estate to obtain a step up in income tax basis on the survivor’s death if that proves to be the better result. If the combined estate proves to be under the federal estate tax exemption amount (ignoring state estate taxes and other considerations) the step up may not have a negative estate tax consequence.

 

Power to Distribute: One approach to accomplish this is to have an independent trustee the right to make principal distributions to the surviving spouse. If bypass trust assets are distributed to the surviving spouse before his or her death, they will be included in his or her estate and qualify for a step up. While this approach can provide some theoretically advantageous tax results it does not come without considerable risks. What if the surviving spouse remarries, undertakes an aggressive gift program to persons other than the intended heirs, is sued, and so on. What if the power is not exercised in time? Might this trigger a second state estate tax when the surviving spouse dies? Will a spendthrift clause prevent this distribution?

Power of Appointment: Another approach might be to designate an independent person and provide that person with the authority to grant the surviving spouse a general power of appointment over the bypass trust to the surviving spouse to cause inclusion of those assets in the surviving spouse’s estate for purposes of achieving an income tax basis step up to the date of death values. This approach might have some theoretical appeal, but who would accept this role? What could be done to protect the person exercising, or not exercising, the power from being sued by a disgruntled would-be heir? What if the power is not exercised in time? Might this trigger a second state estate tax when the surviving spouse dies?

Delaware Tax Trap: While complicated and subject to several practical issues, it might be feasible to intentionally trigger the Delaware tax trap thereby causing estate tax inclusion in the estate of the surviving spouse and thereby obtaining a desired basis step up for assets in the bypass trust. IRC Sec. 2041(a)(3).  This approach could provide a significant degree of flexibility in a taxpayer’s planning. If the estate tax exemption is large enough, the taxpayer may want estate tax inclusion to qualify bypass trust assets for a step up in tax basis on death by forcing inclusion in the estate. If the appropriate power of appointment in included to trigger estate inclusion it may provide a “second look” to ascertain whether estate tax inclusion and step up in basis or estate tax exclusion and lower basis.

 

For this approach to succeed a rule against perpetuities savings clause that might commonly be included in a trust may have to be removed as it may prevent the Delaware Tax Trap technique form working in the fashion desired post-TRA 2010. In a state like New Jersey, which has statutorily eliminated the rule against perpetuities, will this type of application of the Delaware Tax Trap work in the desired manner?

The general rule concerning powers of appointment is that if a taxpayer has a special power of appointment, in contrast to a general power of appointment, holding that power will not cause estate tax inclusion. There is one exception to this general rule that may result in the inclusion in the gross estate of the value of property subject to a post-1942 non-general power of appointment. However, the application of this special rule will demined on restrictions of local property law. IRC Sec. 2041(a)(3) requires that there be included in the gross estate the value of property with respect to which the decedent by will, or otherwise in a testamentary fashion as indicated by Sections 2035, 2036 or 2037, exercised a post-1942 power of appointment, by creating another power of appointment, that meets certain conditions. For the Delaware Tax Trap to be triggered, state law must permit the new power to be exercised in a manner that can postpone the vesting of the estate or interest in property or suspend ownership for a period ascertainable without regard to the date of creation of the first power. The rationale for this rule was to prevent taxpayers from extending a trust in perpetuity without an estate tax being triggered through exercise of successive non-general powers. Could die and give child a limited power of appointment. Under Delaware law when an heir created a new trust and gave a beneficiary of that trust a power of appointment, under the common law rule against perpetuities, the power had to relate back to the grantor’s original creation of the power. Delaware law now provides that it looks to lives in being at death of child, not parent. This could be exercised, if the 2042 backstop were not enacted seriatim to continually avoid estate tax. 2041(a)(3) prevents this end-run around the estate tax by providing that if power a of appointment can be exercised without regard to rule against perpetuities, an estate or gift tax is imposed.

Relying on the Delaware tax trap is not without risk. A decedent's exercised a non-general power of appointment to create a power of appointment in each of decedent’s children. The power given to the children enabled them to each appoint property at that child's death among decedent's descendants living at the time of the child’s death. The IRS held that this did not postpone or suspend vesting of the trust assets beyond the perpetuities period.  Therefore, this did not result in inclusion of the trust assets in decedent's estate. PLR 201029011, 4/12/10.

Another case also illustrated the difficulties of attempting to trigger the Delaware Tax Trap. In the case, the decedent exercised special power of appointment over property, by transferring the property to a testamentary trust under her will. The taxpayer created a second special power of appointment over the property, exercisable by her husband. The court held that this wasn't includable in her gross estate under IRC Sec. 2041(a)(3). This arrangement may have triggered the Delaware Tax Trap and caused estate inclusion if the second power could have been exercised in a manner that would postpone the vesting of any interest in property, or suspend the absolute ownership or the power of appointment over the property, for a period determined without reference to the date on which the power was first created. Estate of Murphy, 71 TC 671, 01/29/1979.

 

State Level QTIP Election

Planning at this wealth level if the client lives in a state with a state estate tax (death tax) they could still face significant state estate tax. So it may be worth planning for the state tax. Using a state level QTIP election may be useful in states that permit this approach, but not all do.

 

QTIPs versus Portability

 

There may be some instances in which the client refuses to transfer asset to the non-wealthy spouse, even in an inter-vivos martial trust (e.g., inter-vivos qualified terminable interest property, “QTIP”, trust). In such instances the possibility of portability may be all that can be relied upon.

Prenuptial Agreements and Portability

The considerable tax benefits of portability, if made permanent, will have tremendous planning implications for blended families.

 

Planning Note: It will become de rigueur in negotiating prenuptial agreements for second and later spouses to obtain confirmation of the remaining portable estate tax exclusion.  This representation should specifically address whether any prior taxable gifts were made, whether gift tax returns were filed (and if so copies should be attached as an exhibit), and whether any audits of those returns occurred.

 

Might Internet marriage want ads soon tout exclusion availability?

 

“Handsome and pleasant male age 89 available for marriage. No assets, but full estate exclusion portable and available. Corroboration from major law firm available for review.” 

 

Should pre-marital due diligence include a review of all prior gift tax returns to ascertain if the adequate disclosure rules were met and the statute indeed tolled? If the items reported on a gift tax return were reported with sufficient specificity and disclosures then the period during which the IRS can audit that return will run out (toll). When the audit period has expired, the IRS cannot revisit the returns and audit them. Thus, just as on American Idol, you may be “safe.”

 

Perhaps for open gift tax return years (i.e., returns for periods that the IRS can still audit the returns), the prenuptial agreement should provide a readjustment of the negotiated financial arrangements if the audit of those returns depletes the remaining exclusion of the spouse being represented.

 

Matrimonial counsel should also carefully evaluate having an estate planner transfer assets to an irrevocable trust for the client prior to marriage. Since it appears that portability of estate exclusion can be applied to inter-vivos gifts by the surviving spouse as well, this may secure the benefit of that exclusion without the risks discussed above. This may not be a simple task if the surviving spouse has to use her own exclusion (basic exclusion amount) first, or simultaneously.

Retirement Assets and Portability

 

Retirement assets can be quite a challenge in planning to fund a bypass trust. Portability can be a tremendous benefit to clients with large IRAs endeavoring to minimize estate taxes and still securing simplicity and preferable IRA treatment.

 

From a purely income tax perspective (which is not always consistent with personal goals) leaving an IRA outright to a spouse is generally the preferred approach. This provides the surviving spouse the most tax flexibility and benefit. The surviving spouse can rollover the deceased spouse’s IRA into his or her own IRA. Thus, if the surviving spouse is under the age for which required minimum distributions are required he or she can continue to defer the IRA until that time. The surviving spouse can name new designated beneficiaries for the rollover IRA. The surviving spouse might even opt to convert some or all of her IRA to a Roth IRA. But unlike past tax law, so long as the portability option exists, securing these income tax benefits may not have to come at the sacrifice of estate tax benefits. The increased $5 million exemption solves the entire issue for many clients, because their aggregate estate will no longer be subject to federal estate tax. But for clients whose estate increases beyond this level, portability may be a great answer.

 

If portability becomes permanent, then the complexities and tax inefficiencies involved in funding a bypass trust with retirement plan assets can be avoided. If a bypass trust were named beneficiary of the IRA the assets would have to be paid out over the life expectancy of the oldest beneficiary, typically the surviving spouse. But if the testator had named an elderly relative or older sibling as a beneficiary of the bypass trust, even a worse income tax deferral result would be realized.

 

To maximize flexibility in this uncertain tax world, many advisers recommend the disclaimer approach. The client can bequeath all assets outright to his or her surviving spouse, who then, with the wisdom and judgment of hindsight can disclaim just the right amount to fund a bypass trust.

 

Example: Husband and Wife reside in New York, which has a $1 million state estate tax exclusion. Husband’s estate consists of a house valued at $2 million, a $3 million IRA, and $1 million brokerage account. The house and brokerage account are owned jointly and Wife obtains title automatically by operation of law upon Husband’s death. The IRA lists Wife as the primary beneficiary. Under Pre-TRA Wife would have to disclaim as the primary beneficiary of Husband’s IRA. If Wife disclaimed then the IRA would pass to a bypass trust under Husband’s will.

 

Assume that Wife survives Husband, but based on the current 2011 $5 million exclusion, Wife determines not to disclaim any of Husband’s IRA to fund a bypass trust under Husband’s will. Her reasoning is that the aggregate estate is only $6 million, not much more than the $5 million exclusion. She anticipates spending down the estate over time to meet living expenses. If in fact her assumption proves correct, there will be no federal estate tax, although there will be a moderate New York estate tax on her eventual death. However, more sound reasoning might suggest another approach. The estate may be valued at $6 million only because housing and security values are currently at depressed levels. If markets recover, the estate will almost assuredly exceed the $5 million exclusion even with a spend down. This will result in a federal and state estate tax. Post TRA, however, portability may enable Wife to avoid any federal estate tax.

 

Portability is not a cure all. Even if all the requirements (e.g., filing requirements) are met, state estate tax is not avoided because state law does not permit (yet?) portability. On this basis, Wife could at least disclaim $1 million of assets to remove those assets, and future growth in those assets, from her potentially taxable estate. At the $1 million threshold, she will reduce state estate tax on her death. Wife will also be able to reduce the federal estate tax.

 

Portability, Bypass Trusts and Related Planning Post 2010 – New Jersey Illustration

 

New Jersey Planning Consideration/Objective

 

One objective for planning for New Jersey estates is to endeavor to minimize New Jersey estate tax, with consideration to the federal estate tax impact, all while maintaining some flexibility on the death of the first spouse. One goal is, to the extent feasible, to provide the flexibility to pay none, or only some, New Jersey estate tax on the death of the first spouse. If the Credit Shelter Trust provided for under the client’s will can qualify for the estate tax marital deduction (i.e., it is QTIP’able) then assets bequeathed to that trust may avoid New Jersey tax on the first spouse’s death on values above the $675,000 New Jersey exclusion amount.

 

If a bypass trust is funded to the full federal exemption amount of $5 million a New Jersey estate tax of $391,600 would be due in 2011. If there is an inflation increase in 2012 the $5 million, and the New Jersey estate tax will increase.

 

Consistency Requirement

 

The state of New Jersey requires consistency with the federal reporting positions taken by the same estate. The perspective of the New Jersey tax authorities is that if the federal government mandates that the estate file a return, that similar reporting position must then be taken on the New Jersey estate tax return. 

 

The New Jersey rule of consistency rule starts from the premise that you cannot have a QTIP election for New Jersey purposes unless you make a QTIP election on a consistent basis on the federal estate tax return. A letter from the State of New Jersey, Department of Revenue, Division of Taxation, to a New Jersey attorney addressed important aspects of the New Jersey consistency requirement. The letter was a response to an inquiry as to the New Jersey position if an estate that was under the federal estate tax filing threshold requirement so that no federal return was filed. The State of New Jersey permitted a New Jersey QTIP election for New Jersey only when a Form 706 is not required to be filed and is not in fact filed. Making a New Jersey QTIP election if no federal return was required to be filed was not deemed by the state of New Jersey to violate the New Jersey consistency requirement even though technically no federal QTIP election was filed. The TRA 2010 changes the situation rather substantially.

 

Another letter from Fred M. Wagner of the State of New Jersey, Department of Revenue, Division of Taxation, was issued on January 27, 2011 outlining the state’s position concerning QTIP elections for decedents who died in 2010. “…it has been the Division’s policy that in an estate where a Federal estate tax return is not required to be filed, the estate representative may for New Jersey estate tax purposes make a QTIP election in accordance with the provisions of the Internal Revenue Code in effect on December 31, 2001 and the terms of the decedent’s will or other controlling document. In those cases where a federal estate tax return is not filed and not required to be filed and the estate representative determines to make a QTIP election for New Jersey estate tax purposes, the property for which the QTIP election is made is includable in the estate of the surviving spouse…”

 

Consistency and Portability

 

After TRA 2010 the estate of the first to die spouse should generally, arguably always, file an election to have portability apply to preserve the benefit of the first to die spouse’s federal exemption for the surviving spouse “just in case.” But to elect portability, the estate must file a federal estate tax return. What implication might the New Jersey policy of consistency have to this federal return? According to New Jersey if federal law requires filing a return to make an election for portability, then New Jersey may maintain that to avoid New Jersey estate tax on the death of the first spouse, the estate may have to treat the excess over the New Jersey estate tax as a marital deduction, e.g. making a QTIP type election.

 

Another letter from Fred M. Wagner of the State of New Jersey, Department of Revenue, Division of Taxation, was issued on January 31, 2011 outlining the state’s position concerning QTIP elections for decedents subject to portability. The letter stated: “In cases where the estate representative under the provisions of the 2010 Tax Relief Act files a Federal estate tax return for an estate valued at $5 million or less in order to compute the DSUEA and elects to make it available in the surviving spouses’ estate the same QITP election reflected thereon must be made for New Jersey estate tax purpose. If the estate representative determines not to elect to claim as marital deduction for QTIP property on the Federal return, eh or she may not elect to do so for New Jersey estate tax purposes.”

 

Post-TRA the requirement to elect portability on the federal estate tax return of the first spouse to die essentially requires that a federal return be filed by almost every estate. Even if the estate may not be required to file a return based on its size being under $5 million, it may have to in order to elect portability. If such a return is filed then the New Jersey consistency rule would apply and require comparable treatment on the New Jersey estate tax return to the federal return. If the portability Form 706 is filed, then it would appear that a New Jersey QTIP treatment cannot then be elected since no QTIP treatment would exist on the federal portability election return.

 

Why is this so relevant? It may prevent what effectively could be a New Jersey state only QTIP election for assets of the first to die spouse above the $675,000 New Jersey exemption but below the $5 million federal exemption. Prior to the enactment of portability, for example in 2009, an estate of under $3.5 million could fund a $675,000 bypass trust and a $2,825,000 New Jersey QTIP trust and not file a federal return. Following portability a federal return is required to be filed to elect portability and the $2,825,000 must be declared. Since on a federal return this amount would likely be treated as a family share and not a marital share, consistent treatment will be required by the State of New Jersey. If this trust has to qualify for a federal QTIP election then it would result in requiring a payment of income to surviving spouse out of this trust and making a federal an election. If the federal election is not made then New Jersey tax will be incurred on the first spouse’s death on this $2,825,000 excess. Some New Jersey practitioners believe that this result is arguably incorrect and should be challenged.

 

Portability thus may have a substantial and costly indirect impact on decedents domiciled in New Jersey.

 

Example

 

First Spouse dies with a $2 million estate. The entire estate is bequeathed to a trust for Surviving Spouse. At the death if First Spouse, the trustee of the trust for the Surviving Spouse can divide the trust into two shares and make a New Jersey QTIP election for the $1,325,000. The other share of the trust would contain the $675,000 amount that can pass free of New Jersey estate tax. The QTIP share would not be subject to New Jersey estate taxes on the death of First Spouse. On the later death of Surviving Spouse the balance in the QTIP share may be taxable for New Jersey purposes, but the couple would have successfully deferred New Jersey estate tax on the death of First Spouse. What if Surviving Spouse changes her domicile to Florida after the death of First Spouse? New Jersey may loose jurisdiction over the QTIP share so that what was initially intended as only a deferral of New Jersey estate tax on the death of First Spouse might ultimately enable the family to entirely avoid New Jersey estate tax. 

 

Inheritance Tax

 

New Jersey’s death tax system is even more complex in that New Jersey also has an inheritance tax that applies to Class B and C beneficiaries. If the $675,000 bypass trust solely benefits the surviving spouse then no inheritance tax would apply to the funding of that trust. However, if the bypass trust is a spray or pot trust that is designed to benefit both a surviving spouse and nieces and nephews, the New Jersey inheritance tax needs to be considered. If the inheritance tax exceeds the New Jersey estate tax, then the larger inheritance tax will be due by the estate. This could result in a 15% toll charge on the funding of the bypass trust.

 

Applying the New Jersey Rules

 

There are a myriad of factors to evaluate in endeavoring to determine how to plan for an estate under the new portability paradigm under any particular state’s laws. The following discussion takes a broad view of not only the portability issues, but the interplay of many of the related decisions, applying the New Jersey estate tax as an illustration. Many, but not all of the concepts illustrated should provide guidance as to planning under many other scenarios, even in some different states. One bottom line conclusion of the discussion following is that the enactment of portability only complicates the calculus.

 

Age: If the client is elderly, perhaps over 80, in contrast to being middle age perhaps in their 50s, the benefits of incurring a New Jersey estate tax on the first spouse’s death will differ significantly. The elderly couple may view incurring a New Jersey estate tax as a toll charge to potentially save a federal tax, or to fund a family trust with more flexibility. If the ages and/or health of each spouse is such that they would not anticipate a significant number of years between the first and second death this may be prudent.

 

Net Worth Under Federal Exemption Generally: Consider whether the couple’s aggregate wealth is in excess of the federal exemption amount, or if it is likely to be. If the client is securely under the federal exemption amount (but can anyone predict that with both economic uncertainty and a 2013 sunset?), but taxable for the state of New Jersey, than various planning options should be evaluated.

 

Formula Approach No. 1 -- Small Estates Rely on Two New Jersey Exemptions: One technique used for New Jersey planning, as illustrated above, is to fund a bypass or family trust on the first spouse’s death for the $675,000 New Jersey exemption amount, and use the surviving spouse’s $675,000 New Jersey exemption amount on the second death to pass an aggregate of $1.3 million to their heirs New Jersey estate tax free. The bypass trust could have the surviving spouse receive mandatory income distributions, have the right to be a trustee if properly drafted, provide the right to access principal if limited to a health, education maintenance and support (“HEMS”)  standard, and hold a right to invade principal to the greater of $5,000/year or 5% of principal (the so called “5 and 5 power”), and also provide the surviving spouse a special or limited power of appointment to allocate the trust corpus among children or other heirs as to how assets would be distributed.

 

With states with a low decoupled exemption amount, funding a bypass trust up to the state estate tax exemption amount will be warranted in many situations.

 

Approach No. 2 -- Disclaimer Approach: Another commonly used approach is to provide for a disclaimer mechanism. All assets are bequeathed out right to the surviving spouse and if he or she disclaims the assets are then pass into a bypass trust. The disclaimer must comport with applicable state law. In New Jersey there is no time requirement but federal law under IRC Sec. 2518 has a nine month deadline. Thus, in many instances regardless of state law, the limiting factor may prove to be the federal disclaimer statute. If multiple states are involved issues as to which state law governs. The simplest approach might be to endeavor to meet the requirements of both states to avoid any issue.

 

While disclaimer planning clearly provides for more flexibility at the first death the experience of many practitioners is that it is too often not utilized. If the credit shelter trust is not warranted on the first death, the surviving spouse can forgo it and simply accept the assets outright. Even if the disclaimer trust technique is used, the surviving spouse can still serve as the trustee and be granted the powers discussed above, but without the right to reallocate (i.e., the special power of appointment). 

 

Consider risks and issues of relying on disclaimers. How realistic is the likelihood of the surviving spouse giving up any measure of control over assets?  A critical issue in the success of any disclaimer is the requirement that the disclaimant not have accepted any benefit from the property disclaimed. There has been some leniency afforded in this regard which may be invaluable in endeavoring to salvage a disclaimer planning opportunity. In Revenue Ruling 2005-36 and PLR 200503024 the IRS permitted what can perhaps be described as a modified acceptance. This might prove helpful to address issues of a surviving spouse having had some “acceptance” of the benefit from a particular asset, and then determining that she wants to disclaim her interests in that asset.  Revenue Ruling 2005-36 dealt with an IRA from which surviving spouse took a distribution.  The IRS held that the mere taking if the required minimum distribution (“RMD”) is not deemed to be full acceptance, but rather a partial acceptance as to the distribution taken, and the income earned on it. In PLR 200502034 the decedent had established a joint bank account between husband and wife. The wife, as the surviving spouse, had directed her broker to buy and sell assets and distribute monies. Then the wife decided she wanted to disclaim. The disclaimer disclaimed all rights that could be disclaimed and set up separate accounts. One account segregated all untainted assets. The other account contained all the tainted assets. The IRS held that non-tainted portion could in fact be disclaimed.

 

Young Married Couples: For younger clients there is a greater likelihood of remarriage so that in many if not most instances the disclaimer approach will be inadvisable as it will not provide any protection for the family assets for the children.

 

Approach No. 3 -- Clayton Contingent QTIP Trust Approach:  The formula approach endeavors to determine how much should be allocated as between the family (bypass) and marital share. The disclaimer approach empowers the surviving spouse to determine after the fact how much should be transferred to the family (bypass) share. The Clayton approach empowers the executor (personal administrator) to instead make that determination with the benefit of hindsight after the death of the first spouse. Under the Clayton approach the will provides that the portion that is transferred into the marital or QTIP trust share is what the executor determines. Estate of Clayton v. Commr., 97 T.C. 327 (1994). That portion would qualify for the unlimited estate tax marital deduction. Treas. Reg. Sec. 20.2056(b)-7(d)(3)(ii). The remainder of the assets which the executor does not direct into the marital QITP share are transferred to the family or bypass trust share.

 

An independent fiduciary, not the surviving spouse, should make this decision. According to some commentators this raises a potential gift tax issue. If the surviving spouse had the power to effectively direct assets into a bypass trust that does not require payment of income to her each year, and the QTIP where the assets would have remained but for the election, would require income be paid to her as surviving spouse each year, the shift of the income interest could constitute a gift. Other commentators suggest an opposing theory that if the surviving spouse made this election as executor she would be doing so in a fiduciary capacity so that it would not constitute a transfer by gift of her income interest. So if the Clayton approach is used, the safest means to craft the provision, would be to name someone independent to hold the power. The use of an independent fiduciary, however, makes the decision to use this approach potentially nettlesome. Few clients would really be comfortable providing this level of responsibility to an independent person. Also, how comfortable will the third party be having the right to make these decisions? 

 

With the tremendous uncertainty as to how the federal estate tax law will exist after 2012 (e.g., what will the exemption amount be and will portability be made permanent), and some uncertainty as to how any state, and New Jersey in this illustration, will react, the Clayton contingent QTIP approach affords potentially several significant benefits. Because the determination of the funding of the marital share is dependent upon the executor’s QTIP election, if the estate tax return is properly extended, the final decision can be deferred for 15 months from the date of death. Not only does this compare favorably with the nine month time frame for a qualified disclaimer, but the 15 months might conceivably afford sufficient time to have a better knowledge (or at least guesstimate) of what will happen to the estate tax in 2013 (e.g., whether portability will become permanent, etc.). Time is a key ingredient to flexibility which is so important given the tax uncertainty that continues.

 

One drawback to vesting the fiduciary with the power to designate the portion of the QTIP that would qualify for the marital deduction was that the surviving spouse had to have a QTIP-like payment of income annually even from the trust for which QTIP treatment is not elected. This effectively required that income be paid over and over to the surviving spouse ever year even if the surviving spouse does not need the income. This would add to size of surviving spouse’s estate. So in the Clayton case the attorney argued that if the executor does not elect QTIP treatment for a portion of the assets, those assets would transfer into a discretionary trust that provided for distributions to grandchildren, i.e., a trust with dispositive provisions akin to a bypass trust. The court held that would be valid for marital deduction purposes. The court held this type of mechanism would not jeopardize the marital deduction.

 

Conclusion

 

Once you master all of these nuances of portability, you might feel a tad like becoming the Yoda of carryover basis (since the carryover basis rules may only apply to a handful of wealthy people who died in 2010). Being all-knowing about carryover basis and fifty cents will get you a cup of coffee at best. Even if you are all-knowing about the complexities of portability, the portability rule only applies during a small window of application for people dying after 2010 and before 2013, or more simply in 2011 and 2012. Unless Congress extends the rules when we revisit this in 2013, portability will disappear from the tax law.