(Published in the New Hampshire Bar News, March 2011)
The 2010 Tax Relief, Unemployment Reauthorization, and Job Creation Act of 2010 (2010 TRA) introduces an interesting new concept - "portability" - to the estate and gift tax regime. In theory, portability of a deceased spouse’s estate and gift tax exemption should obviate the need for a first-to-die spouse to use a credit shelter trust (a CST, also referred to as a bypass trust or family trust) and other practices to preserve the first-to-die spouse’s estate tax exemption. To paraphrase Mark Twain, however, reports of the death of the credit shelter trust are greatly exaggerated. Despite portability, there remain many tax and non-tax reasons to use CST. A CST and other traditional planning techniques should and will remain an integral part of many estate plans.
Before The 2010 TRA
Most clients understand that (provided your spouse is a US citizen) you can transfer unlimited assets to your spouse, either through lifetime or testamentary transfers, tax free. Assets included in the decedent’s taxable estate above the exclusion amount (not passing to a spouse or to charity) were taxed; under the old rules, and without a CST and proper asset allocation, the first-to-die spouse’s exclusion amount was often "wasted."
Estate planners used CSTs, in part, to prevent such waste by funding them with assets up to the exclusion amount. Upon the death of the first spouse, the CST usually distributes income and principal to the surviving spouse or other family members while the surviving spouse is alive and passes on the remainder to beneficiaries when the surviving spouse dies. Assets in the CST are not included in the survivor’s taxable estate, and are not subject to the second spouse’s estate tax.
The New (and Temporary?) Portability Rules
Under the 2010 TRA, individuals who die in 2011 or 2012 will have a "basic exclusion amount" (defined below) of $5 million (indexed beginning in 2012 and reduced if they made certain gifts during lifetime). If an individual’s taxable estate does not use the entire $5 million basic exclusion amount, the unused portion can be "ported" to their surviving spouse. Thus, the unused exclusion is "portable."
On its face, portability seems to imply that our clients no longer need CSTs. After all, if the surviving spouse can utilize all of the deceased spouse’s unused exclusion, why worry about (and spend money establishing) a CST?
Specifically, Sections 302(a) and 303(a) of the TRA accomplish portability by amending the language of the IRC (Internal Revenue Code) (I.R.C. § 2010(c)(2), redefining the "applicable exclusion amount." Now an individual’s applicable exclusion amount is the sum of her "basic exclusion amount" ($5 million, indexed for inflation beginning in 2012) and her "deceased spousal unused exclusion amount." The TRA defines the deceased spousal unused exclusion amount (DSUEA) as the unused deceased spouse’s basic exclusion amount. See I.R.C. 2010(c)(2) as amended by TRA §303(a)(4).
Moreover, The TRA essentially "reunified" the gift tax applicable exclusion amount with the estate tax applicable exclusion amount. (See I.R.C. § 2505(a)(1) as amended (incorporating the I.R.C. § 2010(c) estate tax definition as applied to gifts). Beginning in 2011, a surviving spouse can use her DSUEA to make inter vivos gifts as well as transfers at death.
In simpler words, a surviving spouse may use the DSUEA in addition to her own basic exclusion amount for taxable transfers made during life or at death.
The following example describes how the new portability provisions may work:
Illustration 1: Assume that Husband 1 dies in 2011, having made taxable transfers of $3 million and having no taxable estate. An election (see below) is made on Husband 1’s estate tax return to permit Wife to use Husband 1’s `DSUEA`. 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 DSUEA from Husband 1), which she may use for lifetime gifts or for transfers at death. (The Joint Committee on Taxation Report (Joint Committee on Taxation Technical Explanation of the Revenue Provisions contained in the `TRA`, Scheduled for Consideration by the United States Senate, 52 n.57, Dec. 10, 2011).
Notice that the Illustration mentions "an election." In order for a surviving spouse to capture the DSUEA, the executor for the deceased spouse must timely file an estate tax return (presumably IRS Form 706) on which the unused exclusion amount is computed and make an irrevocable election to "port" the amount to the surviving spouse. (See I.R.C. 2010(c)(5)(A) as amended.) This is true even if the estate would otherwise not have to file. Even surviving spouses with modest assets should consider electing to capture the DSUEA. The surviving spouse may acquire unanticipated wealth, or may remarry a wealthy spouse.
What happens if Wife remarries and the second spouse predeceases her? She can only use the most recent DSUEA. (See I.R.C. § 2010(c) as amended.) Her unused DSUEA from her first spouse is wasted.
There is some confusion regarding specific portability provisions. Stay tuned. The TRA directs the Secretary of the Treasury to adopt regulations implementing the portability provisions.
Does My Client Still Need a CST?
Yes. Because the provisions of the TRA, including portability, sunset after 2012. Couples should not rely solely on portability and forego CST, asset equalization and other planning techniques.
Moreover, even if portability remains after 2012, there are still many reasons for each spouse to plan to use as much of the applicable exclusion amount as possible. For example: Appreciation on property placed in a CST is excluded from the estate of the second-to-die spouse, unlike appreciation on that same property if passed directly to that spouse. The DSUEA is not indexed for inflation. Asset appreciation could result in an otherwise avoidable tax.
The DSUEA may be lost upon remarriage.
Fifteen states and the District of Columbia still have their own estate taxes, many with exemptions of $1 million or less.
The Generation Skipping Transfer tax exemption is not portable. (See I.R.C. § 2631(c) as amended.)
Capturing the DSUEA requires the time and expense (and audit risk) of filing an estate tax return.
Electing the DSUEA keeps the IRS Statute of Limitations open on the first-to-die spouse’s estate. In addition, CSTs are not all about taxes. A spouse can use a CST to: protect assets from spendthrifts; protect assets from creditors; provide assets to children of previous marriages; promote family harmony; and provide for the professional management of assets.
While it may be an improvement, portability is no substitute for proper planning. No, in spite of the new portability options, Credit Shelter Trusts (and other traditional estate and gift planning tools) are not "dead." Far from it.
Christopher Paul is an associate with McLane, Graf, Raulerson & Middleton’s Trust and Estate Department.