When Congress passed the American Taxpayer Relief Act (ATRA 2013), there were two permanent changes made in the estate tax law that have significantly impacted the way that many families plan their estates.
The first permanent change was the increase to $5 million of the Federal Tax exemption (with annual increases for inflation). The 2014 exemption amount is $5.34 million for the estates of people who die this year. Since less than one percent of all estates are valued at more than $5 million, most families do not have and do not expect to ever accumulate a taxable estate.
The second permanent change to the estate tax law was a provision that allows the unused portion of a deceased spouse’s exemption amount (called DSUEA) to be transferred or “ported” to the surviving spouse, effectively doubling the amount of exemption available to the surviving spouse, in most cases. In
order for the surviving spouse to claim the DSUEA, the surviving spouse must file a federal estate tax return Form 706 for the deceased spouse and elect to receive the unused exemption amount.
The following three examples demonstrate how portability works. Along with the examples are four potential pitfalls that may arise when trying to take advantage of the portability of a DSUEA.
John and Jane Jenson have an estate worth $8 million. John dies in 2014 and leaves $1 million to his children from a prior marriage and the remainder of his estate to Jane. The bequest to John’s children will not be subject to estate taxes because John has a $5.34 million exemption to cover the bequest. Jane can also file a federal estate tax return Form 706 and elect to receive the unused portion of John’s exemption, which would be $4.34 million. When Jane passes away, she will have her own exemption (currently worth $5.34 million), plus John’s unused exemption, giving her a total available exemption of $9.78 million.
Pitfall: DSUEA must be elected by filing a federal estate tax return. The surviving spouse MUST file a complete federal estate tax return for the estate of the deceased spouse and make the DSUEA election, even if a federal estate tax return is not otherwise required. This means that a surviving spouse and the spouse’s advisors must be proactive in the months following the death of the first spouse to determine whether to make the election and then to prepare a return.
Tyler and Tina Thompson have an estate valued at $2 million. Upon Tyler’s death, Tina does not file a federal estate tax return to elect Tyler’s DSUEA, because the estate is well below the $5.34 million exemption amount. Five years later, Tina receives an unexpected inheritance of $8 million from her
rich uncle. Tina now has a $10 million estate and just one exemption amount valued at $5.34 million, indexed to inflation. If she had elected Tyler’s DSUEA, she could have sheltered the entire amount from estate taxes on her death.
Pitfall: The estate of the surviving spouse may grow faster than expected. The surviving spouse may not think that it is necessary to utilize the DSUEA upon the death of the first spouse, only to learn many years later that the estate has grown into a taxable estate faster than anticipated.
Hubby One and Wife One have an estate valued at $10.5 million. Hubby One dies in 2014 and leaves everything to Wife One. Wife One files an estate tax return and elects Hubby One’s DSUEA, giving her a total exemption of $10.78 million. Wife One marries Hubby Two. Hubby Two has an estate valued at $5.34 million, and he leaves that entire amount to his children when he dies. Wife One can only elect to receive the DSUEA of the last deceased spouse and Hubby Two had no DSUEA to give her because he used it all in the bequests to his children. Wife One effectively loses the DSUEA of Hubby One, and she now has $5.34 million of assets subject to a 40% taxation rate that were previously protected by the Hubby One DSUEA.
There is a taxpayer-friendly rule that may allow Wife One a way out of her dilemma. IRS regulations provide that Wife One can use Hubby One’s DSUEA to make gifts prior to the death of Hubby Two, thereby possibly avoiding the forfeiture of Hubby One’s DSUEA if Hubby Two dies.
Pitfall: Only the last deceased spouse’s DSUEA amount is portable. This means that a surviving spouse who remarries may lose the DSEUA of the first spouse, if the surviving spouse survives a second spouse.
Pitfall: DSUEA does not apply to the GST exemptions of a deceased spouse. The ATRA 2013 increased the Generation-Skipping Transfer (GST) Tax exemption to $5.34 million and indexed it to inflation. That means that the estate tax exemption and the GST tax exemption are the same. But the GST tax exemption is not portable and may not be elected by the surviving spouse. If the first spouse to die does not take advantage of the GST tax exemption (by leaving assets in a GST tax-exempt trust, for instance) the GST tax exemption is wasted or lost.
So what does portability mean to you? Most of our married clients who have estates of $2 million or
more provide that upon the death of the first spouse, the share belonging to the deceased spouse will be directed to a Family Trust to ensure that it is not subject to estate taxes at the second death. The Family
Trust also provides bloodline protection for the children, asset protection for the surviving spouse, and
divorce protection if the surviving spouse remarries. But some clients who do not expect their estates to
ever exceed $10 million are now opting to leave everything to the surviving spouse, rather than creating
the Family Trust, and allowing the surviving spouse to elect portability to protect the estate from federal
taxes. If you think it is time to review your estate plan because of changes in the tax law or other changes in your life, give us a call.