Portability of Unused Estate and Gift Tax Exclusion Between Spouses

Editor: Kevin D. Anderson, CPA, J.D.

Estates, Trusts & Gifts

One of the essential elements in the equation for the computation of both the federal gift and estate tax is the reduction of the tax due by the amount of the estate or gift tax on the applicable exclusion amount (also known as the unified credit). For a married couple, because of the unlimited marital deduction available for property passing between U.S. citizen spouses, a significant amount of estate planning revolves around not wasting the applicable exclusion amount of the first spouse to die. Generally, this planning involves establishing and funding an irrevocable trust upon the death of the first spouse so as to fully utilize the applicable exclusion amount of the first spouse to die.

Because of changes to the tax law under the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2011, P.L. 111-312, a surviving spouse, assuming an election is made by the executor of the deceased spouse’s estate, will be able to increase his or her applicable exclusion amount by the amount of the unused exclusion amount of the deceased spouse (dying after 2010). This new ability to increase the surviving spouse’s applicable exclusion amount by the unused exclusion amount of the deceased spouse has been described by estate planners as the “portability of unused exclusion between spouses.”

The act accomplishes this change by redefining the term “applicable exclusion amount” to include the sum of the basic exclusion amount and the deceased spousal unused exclusion amount. The basic exclusion amount is defined to be $5 million and may be adjusted for inflation in the case of any decedent dying in a calendar year after 2011. The deceased spousal unused exclusion amount means the lesser of:

• The basic exclusion amount; or
• The excess of the basic exclusion amount of the last deceased spouse of the surviving spouse over the amount with respect to which the tentative tax is determined under Sec. 2001(b)(1) on the estate of the deceased spouse (in other words, the unused basic exclusion amount of the last deceased spouse).

The application of these new rules is probably best explained through examples.

Example 1—No prior taxable gifts and 100% marital deduction: Husband 1 (H1) dies in 2011 with a gross estate of $5 million and leaves the entire estate to Wife 1 (W1). W1 is a U.S. citizen. Because H1’s estate passed entirely to his spouse, the unlimited marital deduction will reduce his taxable estate to zero, resulting in no use of the applicable exclusion amount. See Exhibit 1.

The $5 million increase in the applicable exclusion of W1 can be used to compute W1’s subsequent gift tax or estate tax. Prior to the act, H1’s unused applicable exclusion would have been lost.

Election Required

In order for the surviving spouse to be able to increase his or her applicable exclusion by the amount of the deceased spouse’s unused exclusion amount, the executor of the deceased spouse’s estate must make an election on a timely filed estate tax return on which the amount of the unused exclusion amount is computed. The election, once made, is irrevocable.

The statute expressly states that no election may be made if the estate tax return is filed after the due date, including extensions, for filing the return. The need to timely file an estate tax return to make the election is unfortunate. This requirement would appear to be a trap for the unwary. Often, the estate of the first spouse to die will be less than the amount required to file an estate tax return. Nevertheless, the executor will be required to file a timely estate tax return to make the required election so that the decedent’s unused exclusion amount will become portable.

Statute of Limitation

Despite the running of the statute of limitation on the decedent’s estate tax return or gift tax return(s) with respect to the computation of the deceased spousal unused exclusion amount, the IRS may examine the returns of the deceased spouse to determine the amount of the deceased spousal unused exclusion for purposes of computing the surviving spouse’s applicable exclusion amount.

Example 2—Prior taxable gifts: The facts are the same as in Example 1, except H1 made taxable gifts in 2010 of $1 million (illustrating the concept of “using” the applicable exclusion amount by making taxable gifts during one’s lifetime). By making the $1 million of taxable gifts in 2010, H1 reduced the deceased spousal unused exclusion amount by that $1 million. Therefore, the applicable exclusion amount available for W1 is $9 million, or $1 million less than was available in Example 1. See Exhibit 2.

Example 3—Remarriage and death of second spouse: The facts are the same as in Example 1, except W1 remarries, to Husband 2 (H2). H2 makes taxable gifts during 2011 of $5 million. In 2012, H2 dies with no taxable estate and is survived by W1. W1 now has an applicable exclusion amount equal to $5 million. This result occurs because the incremental increase in her applicable exclusion amount for the deceased spousal unused exclusion amount is based on the exclusion amount of her last deceased spouse. This is true even though the executor of H2’s estate makes no election with respect to portability. See Exhibit 3.

This example illustrates the design of the statute to allow the adjustments to the basic exclusion amount of the surviving spouse to be limited to the unused exclusion amount of the last spouse to die. Upon the death of H2, the previous increase in exclusion from the death of H1 is lost. For gift tax purposes, the applicable exclusion amount is determined based on the applicable exclusion available for estate tax purposes as if W1 died on the last day of the year. Thus, since H2 died during 2012, W1’s applicable exclusion amount for gift tax purposes for all of 2012 was $5 million.

Example 4—Remarriage and death of surviving spouse: The facts are the same as in Example 3, except that W1 dies in 2012 and is survived by H2. Remember that at the time of her death, W1 had an applicable exclusion amount of $10 million per Example 1. Assume W1 had a gross estate of $6 million, all of which was left to her children from her marriage to H1. H2 will have an applicable exclusion amount of $5 million. There will be no increase in his exclusion amount because W1’s taxable estate exceeded $5 million. In effect, H2 cannot benefit from H1’s unused exclusion. See Exhibit 4.

This example illustrates that a surviving spouse may take advantage of only the basic exclusion amount of his or her deceased spouse and not any incremental increase in a deceased spouse’s exclusion amount resulting from the death of a prior spouse of the deceased spouse. An example (Example 3) contained in the Joint Committee Report explaining the portability provisions incorrectly allows the exclusion amount of a prior deceased spouse to affect the amount of the available deceased spousal unused exclusion amount (Joint Committee on Taxation, Technical Explanation of the Revenue Provisions Contained in the “Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010” (JCX-55-10), p. 53 (December 10, 2010)). Based on a plain reading of the statute, this result is not possible because the definition of the “deceased spousal unused exclusion amount” in this situation will be determined by the basic exclusion amount of the deceased spouse ($5 million) reduced by his or her adjusted taxable gifts and taxable estate.

No Portability for GST Tax

The act revises the tax law so that the portability of the applicable exclusion amount specifically does not apply for purposes of the generation-skipping transfer (GST) tax exemption. Therefore, any unused GST tax exemption at the death of the first spouse will be lost, regardless of any portability election made with respect to the deceased spouse’s unused exclusion amount.

Regulations

The act provides that Treasury shall prescribe such regulations as may be necessary or appropriate to carry out the portability provisions.

Sunset

The portability of the applicable exclusion amount will expire after 2012. Therefore, absent further legislation to extend the applicability of the portability provisions, a spouse dying after 2012 must use his or her applicable exclusion amount or it will be lost.

Planning

Despite the availability of portability of the applicable exclusion amount between spouses, for those couples who engage in estate planning with anticipated joint estates in excess of the applicable exclusion amount, it is expected that their estate planning documents will continue, similar to those estate plans prior to the act, to contain dispositive provisions funding an irrevocable trust upon the death of the first spouse. The reasons for continuing to provide for the so-called bypass or credit shelter trusts would include the following:

• It is uncertain whether the portability provisions will be continued after 2012;
• Unlike the basic exclusion amount, the deceased spousal unused exclusion amount does not adjust for inflation. However, accumulated income and future appreciation within a bypass trust will be excluded from the gross estate upon the death of the second spouse;
• The GST tax exemption amount is not portable; therefore, in order to take advantage of the generation-skipping tax exemption of the first spouse to die, it is advantageous to continue to fund a bypass trust.
• There are also nontax advantages of funding an irrevocable trust, including asset protection and management of trust assets.

One of the advantages of relying on the portability provisions, however, will be the step-up in basis in all the assets of the second spouse to die. The assets held in a bypass or credit shelter trust would not be entitled to such a basis adjustment. If the portability provisions are extended beyond 2012, and given the likelihood of increased income tax rates, the step-up in basis aspect of relying on portability of the applicable exclusion amount might become more of a determinative factor.

Another benefit of portability is a lessened concern that a “poor spouse” might be the first spouse to die. For these purposes, the poor spouse would be a spouse having an estate of less than the basic exclusion amount. Prior to the act, without planning, if the poor spouse died first, some portion of the applicable exclusion amount would be lost. Assuming that the poor spouse’s executor makes the required election on a timely filed estate tax return, due to portability the applicable exclusion will no longer be lost.

Conclusion

A surviving spouse no longer has to be concerned about the loss of the applicable exclusion amount of the first spouse to die, if that spouse dies after 2010. The unused applicable exclusion amount will be added to the surviving spouse’s basic exclusion amount. The increased applicable exclusion amount can be applied against future gift taxes and estate taxes of the surviving spouse. To take advantage of this increased applicable exclusion amount, however, it is essential that the executor of the deceased spouse’s estate file a timely estate tax return electing into the portability provisions. The return making the election must be filed even though the size of the deceased spouse’s estate is insufficient to require the filing of an estate tax return. Because of the lack of portability with respect to the GST tax exemption and the lack of certainty about the extension of the portability provisions beyond 2012, it is anticipated that most estate planners will continue to advise clients to establish bypass or credit shelter trusts as part of the dispositive provisions of their estate plans.

EditorNotes

Kevin Anderson is a partner, National Tax Services, with BDO USA, LLP, in Bethesda, MD.

For additional information about these items, contact Mr. Anderson at (301) 634-0222 or kdanderson@bdo.com.