Estate Tax Exemption Portability

Currently, on account of the enactment of the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (the “2010 Tax Act”), the Federal estate tax exemption is $5.12 million, or twice that for a married couple.

It was and is common practice for a married person to provide if his or her surviving spouse survives to have his or her estate to be divided into two broad portions. One part is made equal to the estate tax exemption. That part is exempted from estate tax when that spouse dies on account of the so-called unified or applicable estate tax credit (which may be translated into a dollar exemption of $5.12 million). That part may be placed into a trust of which the surviving spouse is a beneficiary but need not be included in the gross estate of the survivor. Typically, that trust is called the “credit shelter trust” (because it is protected from type by reason of the unified credit), “estate tax exemption trust” or a “bypass trust” (because it “passes by” the estate of the surviving spouse for estate tax purposes).

The second part of the estate of the surviving spouse usually passes to or in a marital deduction trust for the surviving spouse and avoids estate tax when the first spouse dies by reason of the estate tax marital deduction. The property that passes to or in trust for the surviving spouse under the protection of the estate tax marital deduction is included in the gross estate of the survivor (unless consumed, given away or dissipated before the survivor dies). (In some cases, this second part of the estate is also divided by directing an amount equal to the otherwise unused generation skipping transfer tax (GST) exemption of the first spouse to die to pass into a separate qualified terminable interest property (QTIP) trust described in Section 2056(b)(7) of the Internal Revenue Code (Code). A QTIP trust qualifies for the estate tax marital deduction only by affirmative election.

As mentioned, the 2010 Tax Act increased the Federal estate tax exemption to $5.12 million for this year. That Tax Act also made other changes to the Code including adopting a “portability” system under which the surviving spouse may “inherit” any unused estate tax exemption of the first spouse to die, by an affirmative election on the United States estate tax return of the spouse dying first, and use it to protect the survivor’s later gifts from gift tax or his or her estate at death from Federal estate tax.

But under the 2010 Tax Act, the Federal estate tax exemption is scheduled to decline to and remain at $1 million at the end of this year. Moreover, under that act, portability will disappear. However, many think that Federal legislation will be enacted that will increase the Federal exemption to at least $3.5 million and make portability permanent.

Under Revenue Procedure 2001-38, 2001-1 CB 1335, the IRS ruled that the estate of the surviving spouse is permitted to “undue” or “reverse” any QTIP election made in the estate of the first spouse to die which was unnecessary to reduce the Federal estate tax marital deduction. In other words, if the spouse dying first directed the amount by which his or her Federal estate tax exemption exceeded the amount needed to eliminate Federal estate taxes back into the marital deduction trust, then over-funding the QTIP trust can be undone so that no part of the over-funded amount will be included in the survivor’s gross estate.

If both portability and Rev. Proc. 2001-38 are available, two additional considerations need to be taken into account. The first is that all appreciation with respect to the assets excluded from the estate of the surviving spouse, by reason of enacting the revenue procedure, occurring after the death of the first spouse to die up to the death of the survivor on those assets, would be excluded from the gross estate of the survivor. In contrast, in the case of portability, all appreciation on the assets passing to the surviving spouse with respect to the ported amount of Federal estate tax exemption would be included in the survivor’s gross estate. The second is that, in the case of portability, the property inherited by the surviving spouse will receive automatic change in income tax basis pursuant to Section 1014 of the Code. On the other hand, if revenue procedure is invoked, the basis of that property will not be adjusted at the survivor’s death.