“Portability” is an estate tax relief provision for married individuals which was made a permanent part of the Federal estate tax statutes in 2013.
The portability law provides that if a married individual dies and does not utilize all of his Federal estate tax exemption, then his surviving spouse may add her deceased spouse’s unused exemption amount to her own. (For ease of presentation, let’s assume that the husband is the first spouse to die, although be assured the same concepts apply if the wife dies first.) An individual’s estate tax exemption may be unused because his estate is not large enough to fully utilize the recently-expanded exemption amount, or because he left everything to his wife (a gift which qualifies for the marital deduction, so does not use exemption). In the latter case, portability can apply even in very large estates.
In order to “port” unused exemption to the surviving wife, the husband’s executor must file a Federal Estate Tax Return (Form 706) for his estate, due nine months after the husband’s death, unless extended. This is a complex return to assemble and prepare, and essentially discloses all assets owned by the husband at the time of his death, as well as all outstanding liabilities. If this return is not timely filed, portability is lost. Think of it as claiming a “carry-forward” type tax benefit.
Prior to portability, the primary method of preserving the husband’s estate tax exemption was to incorporate a bypass trust in the husband’s Last Will. The bypass trust was then funded following the husband’s death, with assets in his estate equal in value to his remaining exemption amount. While the bypass trust would benefit the wife for her lifetime, it would not be taxed as a part of her estate when she later died. If the husband’s estate was not large enough to fully fund his bypass trust, then his unused exemption would be lost, whereas with portability the unused portion can be added to the surviving wife’s exemption.
These days, many married taxpayers have opted to simplify their Wills for good reason. There are certain advantages to relying on portability to preserve the husband’s unused estate tax exemption, primary among them being simplicity. Under the portability regime, all of the husband’s estate can be left outright to the surviving wife, foregoing the need for a bypass trust and its attendant administrative requirements. Additionally, with assets passing from husband to wife, these assets are eligible for a basis adjustment at the husband’s death and again at the wife’s death. This is especially important with appreciating assets. By contrast, assets held in a bypass trust are not included as a part of the wife’s estate, and therefore are only eligible for a basis adjustment at the husband’s death. Thus, relying on portability could save capital gains tax on assets sold after the wife’s death. Farner & Perrin, L.L.P., encourages our married clients to actively review whether they still wish to incorporate a bypass trust at the first death, a decision that could save ongoing costs associated with trust administration, and could have potential income tax benefits as well.
On the other hand, there are definite disadvantages to relying on portability and foregoing the use of a bypass trust, and these must be weighed against the advantages. First, there is always the risk that the surviving wife could change her Will following the husband’s death, and that his children may not receive what the husband had intended to leave to them. This might be more of a risk in a blended family, but also could occur if the surviving wife remarries and leaves the assets to her new husband. A bypass trust better assures that the husband’s children receive his remaining assets following the wife’s later death, because his Last Will controls the disposition of the bypass trust assets when the wife dies. Also, one limitation of the new portability law is that it allows a surviving wife to port only her most recent husband’s unused exemption. So, if a widow remarries and then her second husband predeceases her also, she will lose the exemption that she “ported” from her first husband’s estate.
There are also two subtle tax nuances that may favor the use of the bypass trust over portability. If a bypass trust is used, the estate tax exemption amount is measured at the husband’s death and may appreciate by the time of the wife’s death, to the extent the trust assets grow. In other words, the bypass trust is initially funded with the amount of exempt property, which can then appreciate during the wife’s lifetime and still be fully excluded from her estate at her death. Whereas, any unused exemption “ported” from a deceased husband does not grow during the surviving wife’s lifetime. Instead, it remains fixed as of the husband’s death; to wit, the amount ported when the husband dies will be the amount that the wife adds to her exemption when she dies, say 15 years later (assuming no remarriage). This can be an especially important advantage to using a bypass trust in estates where significant appreciation in assets is expected over time.
Secondly, while the surviving wife can port her husband’s unused estate tax exemption, she cannot port his unused generation-skipping tax (GST) exemption. This can be significant where the estate plan includes lifetime trusts for children, with grandchildren as the ultimate beneficiaries. In such a case, if a couple relies on portability and foregoes the bypass trust option, their family will be limited in how much can be funded into these “GST exempt” trusts, based on the GST exemption available only at the wife’s death (in other words, the husband’s GST exemption will be wasted). By contrast, amounts funded into a bypass trust at the husband’s death can be made “GST exempt” by application of the husband’s GST exemption. The effect of this is generally to double the amount that can later avoid estate tax, at the children’s deaths.
Many observers of the national debate over Federal finances ponder whether Congress may reduce the estate tax exemption in the future. If that were to happen, the bypass trust and its potential to “grow” the exemption may be important to consider.
As with most tax issues, each case is unique and must be analyzed given its particulars, with an appreciation that the “tax tail” should not wag the dog.