Deborah L. Jacobs, Forbes Staff, writes on finance for baby boomers said: The New Year’s Day fiscal cliff bill, which ended an 11-year period of uncertainty about estate tax exemptions and rates, also made permanent a wonderful break for widows and widowers that was set to expire after a two-year introductory period. Starting for deaths in 2011, and now going forward, widows and widowers can add any unused exclusion of the spouse who died most recently to their own $5.12 million tax-free amount. This enables them together to transfer up to $10.24 million tax-free. It also eliminates the need in many cases for the tax-planning gyrations that lawyers routinely recommended to preserve each spouse’s estate tax exemption amount.
Portability, as tax geeks call it (though that term does not actually appear in the American Taxpayer Relief Tax Act Of 2012 or ATRA), doesn’t change the fact that you can give an unlimited amount to your spouse, during life or through your estate plan (provided she or he is a U.S. citizen) with no tax applied–this is the unlimited marital deduction. But until portability became part of the law, without proper planning, when the second spouse died anything above the exempt amount not going to charity would be taxed. In other words, the first spouse’s exemption would be lost. Bypass trusts (also called family trusts or credit-shelter trusts) addressed that problem.
Here’s how these trusts work: When the first spouse dies, the trust is funded with up to the tax-free exemption amount. The trust distributes income and principal to the survivor or other family members (usually the couple’s children) while the surviving spouse is alive, then passes on whatever is left to family. Funds in the bypass trust are covered by the exemption amount and are not taxed when the first spouse dies. Nor are they considered part of the survivor’s estate, so they are not subject to tax when she dies.
All this is still true, but portability makes it unnecessary for spouses to use bypass trusts solely to preserve the federal exemption amount. As with any new process there is a shakeout period, though. Here are answers to some frequently asked questions: Does this provision help me if my spouse died years ago? No. It applies only to deaths after Dec. 31, 2010.
Does portability apply to lifetime gifts as well as assets that pass through an estate plan? Yes. The lifetime gift tax exclusion and the estate tax exclusion are expressed as a total amount – currently $5.12 million per person – and it is possible to use this exclusion (sometimes called the “unified credit”) to transfer assets at either stage or a combination of the two. If you exceed the limit, you (or your heirs) will owe tax of up to 40%.
The IRS expects you to keep a running tally and report these gifts so it will know how much has already been used up when you die. For example, if you have used $1 million of the exclusion to make taxable lifetime gifts, the unused exclusion when you die will be $4.12 million, rather than $5.12 million.
Couples can share the basic exclusion during life (this process is called gift-splitting) and give more to the kids now, tax-free. But of course this also reduces how much of the tax-free amount will be available when they die, either for their own use or to be carried over by the survivor.
Does portability apply to same-sex married couples? No, and there’s no equivalent of the marital deduction for them either. That’s because the federal Defense of Marriage Act of 1996 defines marriage as a “legal union between one man and one woman,” and spouse as “a person of the opposite sex who is a husband or a wife.” (See my FORBES magazine article, Same-Sex Couples Face A Raft Of Planning Issues, and Wendy Goffe’s guest post, “Will The Supreme Court Legalize Same-Sex Marriage This Term?”)
Does portability apply if the surviving spouse is not a U.S. citizen?No, and the marital deduction is much more limited.
Is portability automatic? No. The executor handling the estate of the spouse who died will need to transfer the unused exemption to the survivor, who can then use it to make lifetime gifts or pass assets through his or her estate.
The prerequisite is filing an estate tax return when the first spouse dies, even if no tax is due. This return is due nine months after death with a six-month extension allowed. If the executor doesn’t file the return or misses the deadline, the spouse loses the right to portability. Spouses should file it even if they’re not wealthy today, because someday, who knows?
One would hope that the Internal Revenue Service will develop a short form for the purpose. Meanwhile, see my post, “How To Get The Latest Tax Break Without Spending A Bundle On Legal Fees.”
Is the amount that’s portable adjusted for inflation? No, but the surviving spouse’s own exemption amount is. For 2012, it is $5.12 million. So far the IRS has not published an inflation-adjusted estate tax exclusion amount for 2013.
What happens if you remarry? That depends on who dies first – you or your new spouse. For example, let’s say Harry had an unused exemption amount of $2 million when he died in 2012 (say, because he left $3.12 million to his children outright). His widow Sally has a $5.12 million exemption amount of her own. As the executor of Harry’s estate, Sally files a return, transferring Harry’s unused exemption, so that she will then be able to pass $7.12 million tax-free (her own $5.12 million exemption plus Harry’s $2 million unused exemption). Then she marries Joe.
If Joe dies before Sally, she can no longer use Harry’s unused exemption amount – only Joe’s. If Joe’s unused exemption is less than Harry’s (or if he has no unused exemption at all), Sally is out of luck. On the other hand, what if Sally dies first? She came into the marriage with a $7.12 million exemption amount, including the $2 million unused exemption from Harry. Assume she leaves $3 million to the children she and Harry had together. In that case, Joe can use the remaining $4.12 million exemption, along with his own. However, under the law the amount carried over can never be more than $5.12 million.
Can I use my exclusion instead to provide for children from a previous marriage? Yes. You can do this with just part of your exclusion amount — or the whole thing – by leaving assets to them outright or in a bypass trust.
Does portability also apply to the exemption from generation-skipping transfer tax? No. This tax applies, on top of estate or gift tax, to assets given to grandchildren (or to trusts for their benefit). Although there is no portability at death, for transfers during life married couples can combine each of their exemptions to give away a total of $10.24 million without incurring the tax.
Do I still need a bypass trust? The trust has the advantage of sheltering appreciation and could also be helpful in situations where you want to protect assets from creditors, use your generation-skipping transfer tax exemption, or benefit children from a previous marriage.
If you live in a state that has an estate tax, factor that into your analysis, too. Currently 22 states and the District of Columbia have a separate estate tax, and none have portability provisions. By funding a bypass trust up to the state exemption amount ($1 million or less in most states that have this tax), you shelter the first spouse’s exemption from state estate tax. See Ashlea Ebeling‘s post, “Where Not To Die In 2012: A Guide To State Death Taxes.” Still, in many cases, where couples have combined estates of $10.24 million or less, they might prefer to avoid the expense and inconvenience of a trust and simply leave everything outright to each other in what is called an “I love you will.”
When outright bequests to the surviving spouse make sense for estate tax reasons, there may also be income tax benefits down the line. When the second spouse dies, these assets, included in her estate, get an adjustment in basis to their date of death value, which minimizes the capital gains tax heirs must pay when they are sold. In contrast, the basis on assets that went into the bypass trust when the first spouse died will not have changed since then.
Is this a subject that should be covered in prenuptial agreements?Macabre as it may sound, inheritances often are the subject of prenups, especially when there are children from a previous marriage. And wills often specify the funds from which estate taxes should be paid (for instance, it’s not tax efficient use retirement assets for this purpose). So while this is certainly a new topic, if it concerns you, it’s something you should address.
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