Portability Is One Benefit Of Marriage But Its Not The Best Move For Every Couple

Written by Jacque Mingle

Posted on Jul 31, 2013

In the estate planning world, there has been a lot of buzz lately about portability.  The New Year’s Day fiscal cliff bill changed the law to allow married couples to make their federal estate/gift tax exemption amount “portable,” hence the new option known as “portability.”

Before we can talk about portability, you first need to know that the federal estate tax exemption amount is $5.25 million for those who die in 2013.  This means that if you die this year, you can up pass up to $5.25 million upon your death to any persons and/or organizations without paying any federal estate tax (assuming you haven’t made any large gifts during your lifetime).  Any assets over the $5.25 million exemption amount that do not pass to charity or a surviving spouse will be subject to a 40% transfer tax rate.   So what is portability?  It applies only to married couples.  So, if you’re not married and you don’t intend to get married any time soon, you can probably stop reading here.  If you are married and have significant assets, you’ll probably want to read on.  Portability allows couples, upon the death of the first spouse, to transfer the deceased spouse’s unused exemption amount to the surviving spouse.  Then the surviving spouse may use the first spouse’s unused exemption amount to make gifts during lifetime and at death.

An example may help describe the concept.  Harry and Willa are a married couple who have a combined estate of $8 million.  Harry dies first in 2013, leaving all of his assets to Willa.  If Willa makes the portability election on Harry’s federal estate tax return, then she will receive his $5.25 million exemption (Note: he didn’t use any of his exemption because everything passed to Willa, and there is an unlimited marital deduction for amounts passing to a spouse).  After Harry’s death, Willa will have an $8 million estate and a combined exemption of $10.5 million (because she carried forward Harry’s $5.25 million in exemption that he did not use, plus she has her own $5.25 million.)  The result: Willa can apply her $10.5 million exemption against gifts made during her lifetime or her estate upon death.

Before portability, married couples with a taxable estate typically created a “bypass trust” or “credit shelter trust” upon the death of the first spouse.  The idea was to fund the bypass trust with the first spouse’s exemption amount (which was only $600,000 a little over a decade ago).  This technique was also referred to an “A/B” trust structure, and the objective was to make full use of the first spouse’s exemption amount.  Upon the death of the second spouse, the bypass trust, including any appreciation of assets, avoided estate tax.  Now that we have portability, this A/B trust structure that was common for so many years is not needed to make full use of the first spouse’s exemption amount.

Does this mean that everyone should rely on portability and can forget about the old-fashioned approach?  No, definitely not.  Portability may be appropriate for many couples, but it’s certainly not for everyone.

Let’s discuss the two primary benefits of portability.  First and foremost, it’s simple.  You don’t have to create a bypass trust to take advantage of the first spouse’s exemption amount.  So you don’t have to create a trust during your lifetime to shelter assets from the estate tax, you don’t have to fund a bypass trust upon the first death, and you don’t have to file a fiduciary income tax return for the bypass trust each year until the surviving spouse’s death.  With portability, if a married couple’s estate is less than the combined exemption amount ($10.5 million), the first spouse can simply direct that all assets pass to the surviving spouse.  The surviving spouse then files an estate tax return for the first spouse’s estate and elects portability, meaning he or she gets to carry forward the first spouse’s unused exemption amount.

The second primary benefit of electing portability relates to income taxes.  To explain this benefit, you need to know what basis means.  In general, your basis is the amount you paid for the asset.  The capital gains tax is based on the gain in the price of an asset from its original cost.  For example, if you paid $1,000 for company stock (this would be your basis), and you sold it for $1,500 (this would be your sale price), then you would have to pay capital gains tax on the $500 gain on your investment.   The higher your basis, the lower your capital gains tax.

Okay,  back to portability.  If a couple elects portability, the assets get two basis adjustments – once upon the death of the first spouse and another  upon the death of the surviving spouse.  If you do not elect portability, the assets in the bypass trust do not get a step-up in basis upon the surviving spouse’s death.

There are, however, ways to draft a trust to make getting a step-up in basis an option and achieve  the same  income tax benefit that you get with portability.  Now for  the disadvantages of portability.  First, there is no inflation adjustment for the first spouse’s unused exemption amount, which could create an estate tax problem if the assets appreciate between the death of the first and second spouse.  Second, you have to file an estate tax return upon the first spouse’s death to elect portability, even if a return is otherwise not required.  So, it’s not automatic.  You have to make the election on the first spouse’s estate tax return.  Third, a surviving spouse may only use the unused exemption amount of his or her last predeceased spouse.  In other words, you can only use it for the spouse who died most recently.  Finally, Congress could change the rules that apply to portability, or Congress could eliminate portability altogether.

Although portability is an option for married couples and may be completely appropriate for many people, here are some reasons that you might want to talk to an estate planning attorney about trust planning:

• Multigenerational planning.  If you wish to leave assets to future generations, you should not rely on portability because the federal generation-skipping tax (GST) exemption is not portable.
• Blended families.  Couples who have children from a previous marriage typically like the assurance that the assets in the bypass trust will be preserved for their children.  This is because the bypass trust is available to the surviving spouse during his or her lifetime, but any remaining assets are generally set up to pass to the children of the spouse who died first.  Therefore, the irrevocable Bypass/Credit Shelter Trust can have a very important non-tax benefit to protect the ultimate beneficiaries of the first spouse to die.  If a married couple relies solely on portability, the survivor could legally leave everything to his or her family, or even to a new spouse.
• Avoiding probate.  Many wish to avoid the costs and delays associated with a probate administration
• Minor beneficiaries.  Many couples have concerns about leaving their estate to minor beneficiaries who are too young to responsibly manage the assets or may be less motivated to be contributing members of society if given assets outright.
• Beneficiaries with special needs.  If you have a beneficiary with special needs, you do not want your estate assets to interfere with the beneficiary’s government benefits.
• Beneficiaries with drug/alcohol dependency problems.  If you have a beneficiary with dependency issues, you may want to include incentive provisions to encourage positive behaviors rather than give the assets outright and take the risk that the beneficiary will spend it all supporting his or her addiction.
• Asset protection.   By leaving assets in a certain type of trust for beneficiaries, you protect the assets from the beneficiary’s creditors.

In closing, portability offers a simple estate planning option for married couples, but it is not appropriate for everyone and should  be relied upon only after consultation with an estate planning lawyer.  Portability doesn’t change the fact that you should still consult an estate planner to make sure that your plan meets all of your goals in a tax efficient manner.