Estate Tax Portability

The estate tax “portability” provision, which was a part of the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010, allows a surviving spouse to benefit from the unused exclusion from their spouse’s estate. A recent IRS notice provides guidance with respect to an estate where the deceased has died before July 1, 2011.

The portability provision all but eliminates the need for spouses to retitle property, create trusts or use other estate planning maneuvers to solely protect property from incurring additional tax liability after the death of a spouse.

Each individual has a basic exclusion amount that can be transferred free of federal gift and estate taxes. The basic exclusion amount in 2011 was $5 million and, adjusted for inflation, the 2012 basic exclusion amount is $5.12 million. The portability provision allows individuals the opportunity to later use the remaining amount from a deceased spouse’s unused exclusion amount (“DSUEA”), in addition to their own exclusion when making gifts as well as upon death.

This ability to transfer the DSUEA to the surviving spouse is referred to as “portability.” Portability applies only to married decedents in 2011 and 2012. Under current law, portability will not be available for use by a surviving spouse after 2012 if the existing law expires. However, as part of President Obama’s proposed fiscal year 2013 budget there was a provision to make this provision permanent.

The following is an example of how portability could benefit a spouse:

Assume that an individual’s husband died in 2012, having made no taxable gifts and having a $3 million taxable estate. The husband’s estate files the estate tax return, which permits his wife to use his DSUEA. As of her husband’s death, the wife has made no taxable gifts. Thereafter assuming the estate tax provisions are made permanent, she does not have to pay taxes on the first $7.24 million of her assets (her $5.12 million basic exclusion amount plus $2.12 million DSUEA from her husband), which she may use for lifetime gifts or for transfers at death.

The DSUEA is available to a surviving spouse only if an election is made by the deceased spouse’s executor on a timely filed estate tax return (Form 706). Generally, the executor must file a Form 706 within nine months of the decedent’s death, plus any applicable extensions. The estate tax return must be filed even if not legally required, in order to obtain the portability benefits.

Because of the late release of the 2011 Form 706 and related instructions, public and professional practitioners had concerns over the specifics of the new portability rules. In response to those concerns, the IRS issued Notice 2012-21 (“Notice”), which provides certain estates with the ability to obtain a retroactive extension to file Form 706 to preserve portability.

Pursuant to this Notice, the IRS grants the executor of a “qualifying estate” a six-month extension (until 15 months after the deceased spouse’s date of death) to file Form 706. The Notice generally defines a qualifying estate as the estate of a decedent:

• Whose date of death is after December 31, 2010, and before July 1, 2011;

• Who is survived by a spouse; and

• Whose gross estate does not exceed the $5,000,000 basic exclusion amount for 2011.

Filing an estate tax return and making the DSUEA election is not an easy decision. There are many items to consider, including:

• Age of the surviving spouse – the younger a surviving spouse, the more time there is for the survivor’s estate to grow

• Whether portability will be extended beyond 2012

• Size of the survivor’s estate and potential for growth

• Potential of survivor’s estate to increase because of gifts, inheritance, and unexpected growth in inherited assets

• Potential generational skipping possibilities in estate plans

• Fees required to be paid for the preparation of the estate tax return (which is not otherwise required to be filed)

The Notice gives executors an extended time frame to make the election and weigh the pros and cons of making such an election. However, in most cases preservation of the DSUEA is the only way to protect the marital estate from future taxes even though we are uncertain whether or not the increased exemption or portability will extend beyond 2012.