Posts Tagged ‘portability’

Weighing Estate Tax “Portability” Against the Bypass Trust

NOVEMBER 9, 2015 VOLUME 22 NUMBER 41

Here’s a challenging problem for lawyers who focus on estate planning: how can we explain federal estate tax “portability” to clients in a way that helps them figure out how the concept applies to them? After five years of experience with the idea, you might expect us (collectively) to be better at this.

When Congress introduced the idea of estate tax portability in 2010, it was partly to simplify estate tax planning. In the decades before that development estate planners regularly found themselves explaining the idea of a “bypass” trust — although some favored “credit shelter” or “exemption equivalent” or “A/B” or “decedent’s” rather than “bypass.”

The bypass trust idea was not all that complicated, but it was not intuitive. First, it was only important for married couples. Second, it was much more important for couples with a taxable estate — though that included a lot more people twenty years ago than it does today. For married couples worth more than the estate tax exemption amount, though, the bypass trust was almost universal.

Here’s the basic idea: when one spouse dies, his or her share of assets subject to the estate tax — up to the amount of the estate tax exemption in place at the time of death — could be put into a trust that was treated as taxable. Since the amount going into the trust would be less than the tax limit, the amount of tax would be $0. That money would then not be taxed in the surviving spouse’s estate when she or he later died. It was fairly easy to double the estate tax exemption amount, in most cases, using the bypass trust.

Now “portability” makes that planning moot — or it seems like it might, anyway. When a spouse dies under the new rules, any unused estate tax exemption equivalent figure is passed on to his or her surviving spouse. It’s brilliantly simple in concept, but a little harder to apply in the real world (as it turns out).

Let’s consider an imaginary couple under the new portability rules. We’ll call them Dick and Jane, and they are worth a total of $8 million. Their estate plans simply leave everything to each other. When Dick dies in 2016, his $4 million (we’re going to keep Dick and Jane simple — they own every single asset jointly, with a 50/50 interest) simply passes to Jane outright. It won’t matter, for our purposes, whether that happens by his will, by the operation of joint tenancy, or by the terms of their trust or trusts.

Dick has used none of his $5.45 million estate tax exemption equivalent (that’s the new number for next year, if you didn’t already know it). Jane inherits his $4 million AND his $5.45 million in unused exemption amount. If her estate grows before her death, she still won’t owe any estate tax — even though she will be worth more than the $5 million adjusted-for-inflation figure in the year of her death.

Under the old rules, Dick and Jane would have needed to pay someone to prepare their bypass trust plan, Jane would need to actually divide the trust assets on Dick’s death, and Jane would need to give accounting information to Dick and Jane’s children for the rest of her life, while also filing separate income tax returns for the bypass trust. What a nuisance — and good riddance.

But wait. There are still times when the bypass trust is important to consider. Why? Because there are some limitations in the use of portability. Those limitations include:

  • The need to file an estate tax return. Jane can’t elect the portability option after Dick’s death unless she files a federal estate tax return — it’s a nuisance and an expense. She’ll need to get at least some valuation information for all their assets, even though no tax will be due.
  • State estate taxes. Arizona doesn’t apply an estate tax, and if Dick and Jane lived here, Jane decides to stay, and they own no assets in other states, then Jane won’t much care about state estate taxes. But what if she plans on moving, or they own a summer cottage in a state with an estate tax, or there is some other reason to worry about state taxes? Sometimes the bypass trust might be a better option.
  • Future changes in the law. It seems unlikely that estate tax levels will drop below the current $5 million plus. But then it seemed unlikely that they would go up to $5 million, too — and yet they did. Future tax rates might change, or portability might even be done away with. The bypass trust option locks in Dick’s estate tax status as against those possible changes.
  • Generation-skipping tax. If Dick and Jane intend to leave the bulk of their estate to grandchildren rather than children, or in trust for children and ultimately to grandchildren, they might want to rethink relying on portability. Why? Because the $5.45 million (in 2016) generation-skipping tax exemption does not have a portability feature. It’s unlikely to affect Dick and Jane, but it might — if they really plan on leaving much of their estates to the grandkids (and that could change over time, as the children age and gain wealth during the rest of Jane’s life).
  • Assurance of inheritance. Are both Dick and Jane completely comfortable with the surviving spouse’s ability to decide to leave most or all of their combined wealth to someone outside the family? If Dick simply leaves everything to Jane, he’s trusting that she won’t have a second family, or a big interest in a charity that Dick doesn’t actually care for, or a good friend who ends up receiving some or all of their wealth. Maybe Dick and Jane aren’t worried about this problem, but maybe they are — at least a little bit.
  • Growing wealth. Jane likely won’t add another $2 million or more to her wealth after Dick’s death — but she might. If she does, that could subject assets to the estate tax, and creating a bypass trust could have possibly avoided that eventuality.

Portability is a great boon to couples with straightforward estate plans and estates well under twice the taxable level. But it’s not a panacea, and it just makes the explanation process more complicated for us when we talk with couples about their estate planning. We hope this outline of the issues helps speed up that process.

Bypass Trusts, Disclaimer Trusts and Portability in Estate Planning

MAY 6, 2013 VOLUME 20 NUMBER 18
Last week we wrote about questions we often hear from our clients in the wake of big changes to the federal estate tax structure. Almost immediately we heard from a reader asking about portability and disclaimer trusts; our reader suggested we try to explain the two concepts and how they are related. It’s a good idea.

First, a caveat: if you are not married OR if you are married but you and your spouse are “worth” less than about $5 million, then your interest in this topic is probably academic. That doesn’t mean you shouldn’t read on, but only that the explanation won’t affect you much — except perhaps to alert you if you have a more-complicated estate plan than you need.

Let’s start, as we often do, with a brief explanation of the classic A/B trust setup that prevailed in estate planning for married couples for nearly three decades. In an environment where estate taxes kicked in at the relatively low level of $600,000 of net worth, many couples had estate plans that created an irrevocable trust (sometimes called the “bypass” or “decedent’s” trust) on the first death. That typically allowed the surviving spouse to get the benefit of the money left to the trust, but not include it in her (or his) estate — thereby effectively doubling the $600,000 exemption amount to a total of as much as $1.2 million.

Of course, over the last decade the exemption amount rose from $600,000 to $3.5 million and then settled at $5 million (plus an annual increase for inflation). That meant that only couples with estates  of $5 million would need to create the two-trust setup, and that their estates would be covered up to a total of over $10 million with fairly simple estate planning.

But the other change made by the 2010 tax law (and made permanent effective this year) makes it harder to explain the planning options. That change is usually called “portability.” Here’s how it works:

Each spouse in a married couple has an exemption amount of $5 million (plus the inflation adjustment effective the year of that spouse’s death). If, say, the husband dies in 2013, with a $5.25 million exemption amount, but leaves his entire estate outright to his wife — she inherits his estate PLUS his exemption amount. She immediately has a $10.5 million exemption amount, and it goes up (or at least “her” half does) next year for inflation. No irrevocable trust needed. No fancy estate planning required. No legal fees, no accounting or tax preparation until the surviving spouse dies.

That’s a great outcome. It should save money for most married couples, and it is much easier to understand (and execute) than the two-trust solution. The hardest thing to understand about portability might just be its formal name: DSUEA (“Deceased Spousal Unused Exclusion Amount”).

There are, though, a number of wrinkles that well-informed planners need to appreciate. Note that these wrinkles do not mean that you should not rely on the portability arrangement. Most people will not be affected by them.

Generation-skipping tax. The generation-skipping tax exemption is a flat $5.25 million this year (it is also indexed for inflation). if you and your spouse are worth more than about $5 million AND you plan on leaving your assets to grandchildren, or in trusts for your children lasting past their deaths, then you might not want to rely on the portability arrangement.

Filing an estate tax return. The portability of the exemption amount is not automatic. The surviving spouse can only keep the deceased spouse’s exemption amount IF a federal estate tax return is filed. Say what? In order to get this benefit you have to file a return that almost no one else has to file, and to incur the expense of valuing assets (which would not have to be done otherwise)? Yes.

State estate taxes may not work the same way. Arizona, as we keep reminding clients, does not have a state estate tax. But a number of other states still do, and they will apply even to Arizona residents if they own real estate in one of those states. So portability may not be enough in cases where there are significant out-of-state assets.

Remarriage can cause loss of the portability exemption. Let’s sketch out a story. Martha’s husband David died in 2011, leaving his $2 million estate to Martha. She filed a federal estate tax return and claimed David’s $5 million unused estate tax exemption. In 2013, she has $10.25 million in exemption equivalent amount (David’s $5 million plus her $5.25 million). Note that she inherited more exemption amount from David than she inherited of actual estate value.

This year Martha’s wealthy parents died, leaving her their estate; she is now worth $8 million. She remarries. Her new husband, Hal, is a wealthy and very generous man; he has previously given his children a total of $5 million in gifts.

Does this story seem absurdly fanciful? Do you wish you had these problems? Do you want to tell Martha she shouldn’t have married Hal? Because if Hal dies, Martha “loses” David’s unused estate tax exemption, and gets Hal’s instead — and that could mean estate tax on a couple million of her estate. On the other hand, if Martha dies Hal inherits her unused exemption (the exact amount depends on who she leaves her estate to), making it possible for him to give several millions of dollars more to his children with no gift or estate tax consequences.

Can you just imagine the prenuptial agreement? And aren’t you glad that the estate tax system has been simplified?

The truth is, of course, that it has been simplified — vastly simplified, in fact, for individuals and couples worth less than about $5 million. That means most of us — about a quarter of one percent of American households are worth more than $5 million, according to some calculations.

What does all this say about disclaimer trusts? As we reported last week, having a back-up trust for your spouse might make sense in at least some circumstances, and one way to do that would be to give the surviving spouse the power to fund the trust by disclaiming the ability to inherit outright. But we predict that disclaimer trusts will be implemented infrequently.

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