Planning for ‘Portability’ of the Estate Tax Exemption

With new laws come a greater need for informed opinion

by Russell E. Towers JD, CLU, ChFC

The American Taxpayer Relief Act of 2012 (ATRA) permanently enacted the concept of “portability” of any unused estate tax exemption which may now be carried over the first death to the second death of a married couple.

Technically, this is known as the “Deceased Spousal Unused Exclusion” (DSUE) and must be formally elected on the Form 706 U.S. Estate Tax return of the first spouse to die. The estate tax exemption in 2015 is currently $5,430,000 and it is also permanently indexed up each year for inflation.

Prior to the enactment of ATRA, if the estate tax exemption was not used on the first death, it was not available at the second death. Since the Economic Recovery Tax Act of 1981 (ERTA), the common planning technique to assure that this exemption was not “wasted” at the first death was the Marital-Credit Shelter Trust, commonly known as the A-B Marital-Family Trust or A-B Marital / By-Pass Trust.

The credit shelter portion (B) was typically allocated an amount of property equal to the estate tax exemption then available (ranging from $600,000 to the current $5,430,000) with the remainder of the estate allocated to the marital portion (A) via the unlimited marital deduction. This widely used A-B technique would result in $0 estate taxes at the first death and defer all estate taxes to the second death.

Asking the portability question

After 2012, one important question for estate planning is whether or not “portability” should be elected at the first death. After all, electing “portability” could mean that a surviving spouse could have double the estate tax exemption at the second death (currently $5,430,000 x 2 = $10,860,000). The need for splitting the estate into “marital” and “credit shelter” portions at the first death would be eliminated. Or would it?

Planning on a case by case basis may still involve a marital-credit shelter A-B split at the first death for a number of reasons. In these cases, the survivor may NOT want to elect portability so that the deceased’s estate tax exemption can be used at the first death:

• At what age did the first spouse die? If the first spouse died in their 60s or 70s, a surviving spouse may have a life expectancy of 15-25 years or more. Even for a first death in the early 80s, a surviving spouse may live 10 years or more. The question of future asset appreciation from the first death to the second death against a current 40% estate tax rate needs to be taken into account.

• Was the marriage a second marriage for the couple? In this case, children from the first marriage need to be considered, possibly as remainder beneficiaries a special trust known as a Q-TIP Marital-Credit Shelter trust. In a Q-TIP trust the second spouse has only a limited income interest in the trust with the trust principal preserved for children from the first marriage.

• Splitting the estate into a marital-credit shelter plan at the first death can protect the credit shelter portion ($5.43 million) from subsequent marriages by the survivor.

• Splitting the estate into a marital-credit shelter plan at the first death can protect the credit shelter portion ($5.43 million) against creditors of the surviving spouse.

Let’s take a look at a hypothetical case example where we compare a electing “portability” of the estate tax exemption versus NOT electing “portability” and using a Credit Shelter / By-Pass trust instead at the first death.

Case Study Example

Mr. and Mrs. Johnson are each 67 years old and have a combined estate of $16,000,000. They are Florida residents and have no state death taxes to worry about. However, federal estate taxes are a concern. They want to make sure that their 3 adult children receive the maximum inheritance.

A conservative growth rate for the estate is assumed to be 4%. Their estate planning advisors have informed them that federal estate taxes can be deferred to the death of the survivor with certain planning techniques. These techniques may or may not involve utilizing “portability” of the estate tax exemption at the first death.

It is assumed that the estate tax exemption will be indexed into the future at a 2% rate. Based on these assumptions, does it make sense to elect “portability” if Mr. Johnson died unexpectedly today and Mrs. Johnson died at her life expectancy, which is age 85 (18 years)?

I. $16,000,000 Estate Electing “Portability” Growing at 4% for 18 Years

• $16,000,000 Estate in 2015 ………. 100% estate tax marital deduction (Growth at 4% for 18 Years)

• $32,000,000 Estate of Survivor
in 2033 Minus
$13,190,000 Exemption …………..……“Portable” current exemption of $5.43 million + $7.76 million indexed exemption of survivor (2%)
= $18,810,000 …………………………. Taxable estate at 2nd death in 2033
40% ……………………………………… Estate tax rate

= $7,524,000 …………………………… Federal estate tax at 2nd death in 2033

• $24,476,000 ……………………….. Net inheritance to heirs in 2033

II. $16,000,000 Estate NOT Electing “Portability” Growing at 4% for 18 Years Marital-Credit Shelter A-B Plan at First Death

Marital Portion (A)

• $16,000,000 Estate in 2015 ………………“Portability” is NOT elected

Minus $5,430,000 Exemption ……………. Credit shelter (B) portion at 1st death

= $10,570,000 …………………………….. Marital deduction (A) portion (Growth at 4% for 18 Years)

• $21,413,000 Estate of Survivor
in 2033 Minus
$7,760,000 Exemption ……………………. Indexed exemption of survivor (2%)

= $13,653,000 …………………………… Taxable estate at 2nd death in 2033
40% ………………………………………. Estate tax rate
= $5,461,000 …………………………….. Federal estate tax at 2nd death in 2033

• $15,952,000 ………………………………Net inheritance from A portion in 2033

Credit Shelter “By-Pass” Portion (B)

• $5,430,000 ……………………………… Credit shelter (B) portion in 2015
(Growth at 4% for 18 Years)

• $11,000,000 Value of Credit Shelter Portion in 2033
(Not included in estate of survivor)

• $11,000,000 ……………………………. Net inheritance from B portion in 2033
$15,952,000 …………………………………. Net inheritance from Marital Portion (A) in 2033
+ $11,000,000 ………………………………. Net inheritance from Credit Shelter Portion (B) in 2033
= $26,952,000 ……………. Total net inheritance to heirs in 2033

Case Study Example Summary of Electing “Portability” versus NOT Electing “Portability at 1st Death

• $24,476,000 …. Net inheritance to heirs by electing “portability”

• $26,952,000 …. Net inheritance to heirs by NOT electing “portability”

• $2,476,000 …… Net increased inheritance to heirs by NOT electing “portability” at 1st death

What can we conclude from the hypothetical electing “portability” versus not electing “portability” example above? We can generally conclude that if the estate is expected to grow at a modest rate between the first and second death of a married couple, that it may make sense NOT to elect “portability” at the first death.

This is especially true if the survivor has 10 or more years of life expectancy after the death of the first spouse. By NOT electing “portability”, the common and well-known marital-credit shelter A-B plan can be implemented at the first death instead.

The growth on the B portion “by-pass” amount will not be included in the estate of the survivor. The projected estate tax free growth on the B portion is important considering that this growth will avoid the 40% federal estate tax rate at the death of the survivor. This contrasts with electing “portability” at the first death with an unlimited marital deduction for the surviving spouse.

The growth of the estate will not avoid the 40% federal estate tax rate at the surviving spouse’s death if “portability” was elected. With this information, the married couple can make an informed decision about whether or not “portability” should be elected at the first death. Then, they can decide how much life insurance may be needed to offset projected estate taxes at the second death.

This insurance would probably be some form of survivorship life owned by an Irrevocable Life Insurance Trust (ILIT). The death proceeds would be income tax and estate tax free and allow the heirs to inherit upwards of 100% of the estate value without any shrinkage. ♦