This is a question that has arisen in my practice numerous times this year since “Portability” became permanent when the American Taxpayer Relief Act (ATRA) was signed in January 2013. And I’m sorry, but–the answer is “Maybe”.
The Way It Was
The majority of my clients want the surviving spouse to continue to be able to use all of the couple’s assets after the first spouse dies. In the not so distant past, when the Estate Tax Exemption (Exemption) was $600,000 (increasing to $1 million over a period of years), and estate tax rates were up to 55%, this was a real problem. If clients with $2 million in assets provided for all assets to pass outright to the survivor, then when the survivor died owning the whole $2 million, there could be $500,000 of estate taxes to pay. As a result, the vast majority of my clients who are married couples have an estate plan that creates a “Bypass Trust” when the first spouse dies, to bypass estate taxes. The Bypass Trust will hold the deceased spouse’s assets, and use the deceased spouse’s Exemption. The survivor is the beneficiary of the Bypass Trust but the assets in the Bypass Trust are not taxed when the survivor dies. This allows the survivor to use all the assets during his or her lifetime, and to use the Exemption of both spouses; this approach essentially doubles the amount that can pass free of Estate Tax.
There has always been a potential downside to the use of the Bypass Trust, and that is: while the assets in the Bypass Trust escape Estate Tax at the death of the survivor, they also do not receive a new ”stepped up” income tax basis at that time. Because the Estate Tax was taxed at up to 55% versus capital gains at 20% (plus California capital gain taxes around 9+%), it was almost always better to avoid the Estate Tax and forgo the “stepped up” basis at the death of the survivor. With the current Estate Tax rate of 40%, and California capital gain tax rates bumped up to 13.3%, this is not such an easy choice now.
Now, we have Portability. This means that if the Exemption is not used when the first spouse dies, the survivor can use it at his or her death; or even during his or her lifetime. So, it is possible for the married couple to have a simple estate plan that leaves everything outright to the survivor, and still use the Exemptions of both spouses.
The Exemption is now $5.25 Million, so a married couple can leave $10.5 million to their beneficiaries without paying any estate taxes.
What to Do?
With the increased Exemption, most couples will not need to plan for avoiding estate tax; and so the Bypass Trust may be unnecessary for those clients for tax planning. It would seem that the simplest thing to do would be just to leave everything outright to the survivor. No separate trusts. No record keeping. The assets all receive a new basis when the survivor dies.
However, there are a number of reasons it may make sense for clients not to leave assets outright to the surviving spouse:
- Assets left in the Bypass Trust for the spouse will be protected from the survivor’s creditors.
- Assets left in the Bypass Trust for the spouse cannot be given away to a new spouse or others; the assets will pass only to those people chosen by the deceased spouse.
- In order to take advantage of Portability it is necessary to file a Federal Estate Tax Return at the death of the first spouse. If the deceased spouse has under $5.25 Million, it is not otherwise necessary to file such a return to allow the assets in the Bypass Trust to pass free of estate tax at the death of the survivor.
If a Bypass Trust would be desirable because of one of the above concerns, there is still the issue of the loss of the step up in basis on those assets when the survivor dies. However, it is possible to draft the Bypass Trust to allow the assets to obtain the step up in basis.
If you have a Bypass Trust type plan in your documents now, and if you don’t need it for estate tax purposes (because your combined estate is under $5.25 million), I recommend that you consider amending your plan. You can either leave the assets outright to the survivor, or allow the assets in the Bypass Trust to obtain a step up in basis on the death of the surviving spouse.
- If the couple’s estate is large, close to or over the $10.5 million, there could be additional estate taxes to pay at the death of the survivor if Portability is relied upon rather than creating a Bypass Trust. Why? Because although the assets in the Bypass Trust, including all appreciation in value after the death of the first spouse, pass free of estate tax when the survivor dies, all of that appreciation will be taxed at the survivor’s death if the survivor instead owns the assets outright.
- Portability is not available to the surviving spouse if the surviving spouse is not a U.S. citizen.
- Portability of the unified credit of the first spouse is not available if the survivor remarries and his or her second spouse dies.
The Bottom Line: While Portability has the potential for reducing capital gains taxes after the survivor’s death, and “simplifying” an estate plan, there are enormous risks that should be discussed with an estate planning attorney before proceeding.
If you wish to read further on this subject, check out the Forbes article: “A Married Couple’s Guide to Estate Planning.”