| Share

Beware the Portability Election


Estates Less Than $5 Million May Need to File an Estate Tax Return

By Donita M. Joseph, CPA, MBT
The 2010 Tax Relief Act, enacted Dec. 17, 2010, amended Internal Revenue Code Sec. 2010(c), which allows the surviving spouse of a decedent who dies after Dec. 31, 2010, to use the deceased spousal unused exclusion amount (DSUEA) in addition to the surviving spouse’s own basic exclusion amount (the amount that can be transferred at death free of federal estate tax) when making gifts and upon death.

The ability to transfer the DSUEA to the surviving spouse is referred to as “portability.” Because of portability, the need for spouses to retitle property and create trusts solely to take advantage of each spouse’s basic exclusion amount is eliminated [Notice 2011-82, 2011-42 IRB 516-IRC sec(s). 2101]. The basic exclusion amount is $5 million in 2011, to be adjusted annually for inflation after 2011 [IRC Sec. 2010(c)(3)]. With inflation, the 2012 basic exclusion amount is $5,120,000 [Rev. Proc. 2011-52, 2011-45 IRB, 10/20/2011].

The DSUEA is the lesser of:
  • The basic exclusion amount ($5 million, indexed for inflation), or
  • The excess of the basic exclusion amount of the last deceased spouse over that deceased spouse’s taxable estate plus taxable gifts [IRC Sec. 2010(c)(4)].

The idea behind this law is to keep taxpayers from being forced to use a credit shelter trust (also commonly referred to as a bypass trust or exemption trust) to utilize the basic exclusion amount. Many taxpayers do not have trusts in place when they die, and to many it seemed inequitable that these individuals could not use the exclusion amount. Though this election is available for decedents dying in 2011 and 2012, the use of the credit shelter trust is still the preferred method for preserving the basic exclusion amount.

In addition, the provisions of this law generally sunset for tax years beginning after Dec. 31, 2012. As written, the law only applies to married decedents dying in 2011 and 2012, and the DSUEA will not be available by a surviving spouse after 2012. However, many commentators think that it’s likely there will be new legislation to extend this benefit, and a recommendation to make the law permanent was included in President Barack Obama’s 2012 budget.

Why is This Important to Your Clients?
A surviving spouse may use the DSUEA, in addition to the surviving spouse’s own $5 million exclusion, for taxable transfers made during life (in other words, gifts) or at death. This can be accomplished without setting up a credit shelter trust or incurring many of the expenses related to sophisticated estate planning techniques. The following examples found in the Joint Committee on Taxation Report (JCX-55-10) illustrate the results of making the portability election:

Example 1: Assume that Husband 1 dies in 2011, having made taxable transfers of $3 million and having no taxable estate. An election is made on Husband 1’s estate tax return to permit Wife to use Husband 1’s deceased spousal unused exclusion amount. As of Husband 1’s death, Wife has made no taxable gifts. Thereafter, Wife’s applicable exclusion amount is $7 million (her $5 million basic exclusion amount, plus $2 million deceased spousal unused exclusion amount from Husband 1), which she may use for lifetime gifts or for transfers at death.

Example 2: Assume the same facts as in Example 1, except that Wife subsequently marries Husband 2. Husband 2 also predeceases Wife, having made $4 million in taxable transfers and having no taxable estate. An election is made on Husband 2’s estate tax return to permit Wife to use Husband 2’s deceased spousal unused exclusion amount. Although the combined amount of unused exclusion of Husband 1 and Husband 2 is $3 million ($2 million for Husband 1 and $1 million for Husband 2), only Husband 2’s $1 million unused exclusion is available for use by Wife. This is because the deceased spousal unused exclusion amount is limited to the lesser of the basic exclusion amount ($5 million) or the unused exclusion of the last deceased spouse of the surviving spouse, which is Husband 2’s $1 million unused exclusion in this example. Thereafter, Wife’s applicable exclusion amount is $6 million (her $5 million basic exclusion amount, plus $1 million deceased spousal unused exclusion amount from Husband 2), which she may use for lifetime gifts or for transfers at death.

It’s important to note that had Wife not married Husband 2, her applicable exclusion amount would have been
$7 million (her $5 million basic exclusion amount, plus the $2 million DSUEA from Husband 1). From a tax standpoint (notwithstanding the romantic standpoint), one of the things to consider when marrying after the death of the first spouse is the effect on the surviving spouse’s applicable exclusion amount.

Example 3 below found in the report does not seem to agree with IRC Sec. 2010.

Example 3: Assume the same facts as in examples 1 and 2, except that Wife predeceases Husband 2. Following Husband 1’s death, Wife’s applicable exclusion amount is $7 million (her $5 million basic exclusion amount, plus $2 million deceased spousal unused exclusion amount from Husband 1). Wife made no taxable transfers and has a taxable estate of $3 million. An election is made on Wife’s estate tax return to permit Husband 2 to use Wife’s deceased spousal unused exclusion amount, which is $4 million (Wife’s $7 million applicable exclusion amount, less her $3 million taxable estate). Under the provision, Husband 2’s applicable exclusion amount is increased by $4 million—the amount of deceased spousal unused exclusion amount of Wife.

Here, Husband 2 receives the benefit of Wife’s $5 million basic exclusion amount and the unused exclusion amount of $2 million from Husband 1. If Wife had not been married before, Husband 2 would have benefited only from Wife’s unused exclusion amount, which would have been $2 million (Wife’s $5 million applicable exclusion amount, less her $3 million taxable estate).

Sec. 2010 seems to say that $2 million is the correct answer because the DSUEA of the surviving spouse is the excess of the basic exclusion amount less $3 million, not the applicable exclusion amount less her $3 million estate. This is another legal area that needs to be clarified. It is possible that the law will be corrected to agree with the example in the report, but we do not yet know.

Keep in mind that there is a potential for a DSUEA in small, medium and large estates depending on the facts involved. A large estate could end up with a DSUEA where a substantial portion of the estate is gifted to charity. In each case, the numbers will need to be run to determine the potential DSUEA amount. If Page 1, line 5 of Form 706 is less than the basic exclusion amount for the decedent’s year of death, there could be a DSUEA.

How is the Portability Election Made?
IRS Notice 2011-82, issued Sept. 9, 2011, alerts executors of the estate of a decedent dying after Dec. 31, 2010, of the requirement to file a Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, on a timely filed return (including extensions) to elect to allow the decedent’s surviving spouse to take advantage of the deceased spouse’s unused exclusion amount.

The executor is required to file a Form 706 for the decedent’s estate, even if the executor is not otherwise obligated to file a Form 706, for example, because the estate is too small. The estate of such a decedent will be considered to have made a portability election if a Form 706 is timely filed in accordance with the form’s instructions.

For decedents who died in early 2011, the date may have already passed to file an extension of time to file the estate tax return. However, there is a procedure under Treas. Reg. Sec. 20.6081-1(c) that permits an estate, upon showing good cause, to apply for a six-month extension to file. This section provides that Form 4768 should be filed sufficiently early to permit the IRS time to consider the matter and reply before what otherwise would be the due date of the return.

The instructions to Form 4768 provide that if the estate has not filed an application for automatic extension, and the time for filing such application has passed, the estate should file Form 4768 as soon as possible. CPAs are encouraged to consider requesting a six-month extension to file the estate tax return if they missed filing the Form 706 on time and would like to try to obtain the benefit of the portability election for the surviving spouse.

How Does an Estate Opt Out of the Election?
Estates filing a Form 706 that choose not to make a portability election must:
  1. Attach a statement to Form 706 indicating that the estate is not making the election under Sec. 2010(c)(5), and
  2. Enter “No Election Under Sec. 2010(c)(5)” at the top of the first page of Form 706.

Miscellaneous Items of Note
  • If the predeceased spouse is a nonresident noncitizen of the United States, portability does not apply, even if the surviving spouse is a U.S. citizen.
  • Portability does not apply to the GST exemption.
  • Since portability is a provision of federal law, it may not apply in some states that have an estate or inheritance tax. Note that California does not.

It’s not known what effect a future reduction in the estate tax basic exclusion amount will have on lifetime gifts. For example, if the client gives $5 million today and pays no gift tax, what happens if the exclusion drops to $3.5 million, or even $1 million?

Some commentators have discussed a “clawback,” which would result in the client having to pay additional estate or gift tax on the portion of the prior gift that is in excess of the lowered exclusion amount. Other commentators believe it is unlikely a clawback will come into play, and even if it does, the benefits of making the gift may still outweigh the risk of having to pay tax in a clawback situation.

Things to Consider
There is no easy way to determine whether the DSUEA election should be made. Considerations include:
  • Age of the surviving spouse. If the surviving spouse is young, there is more time for the estate to grow.
  • Size of the survivor’s estate and potential for growth.
  • Potential of survivor marrying well.
  • Potential of survivor inheriting substantial wealth.
  • Potential of survivor winning the lottery.
  • Filing a Form 706 as a hedge against the unknown.
  • Fees required to be paid for the preparation of the Form 706. Clients may balk.
  • Estate containing any hard-to-value assets or valuation discounts. The executor may not want to make the election in this case because, if the election is made, the statute of limitations on the decedent’s Form 706 stays open until after the death of the surviving spouse.

Why Utilizing Trusts is Still a Good Idea
There are several reasons why it is still a good idea to utilize trusts in estate planning, even though the portability election is available:
  • Maximizing each spouse’s GST tax exemption since portability does not apply to GST;
  • Providing creditor protection;
  • Placing assets in the credit shelter trust, so that future appreciation of those assets will not be included in the estate of the surviving spouse;
  • Being able to distribute income and principal to children as well as to a surviving spouse out of a credit shelter trust; and
  • Retaining control of the assets at the survivor’s death.

What This Means to CPAs and the Potential Liability
CPAs should consider filing federal estate tax returns for all decedents who have a surviving spouse. No one knows what the financial situation of the surviving spouse will be when they die. If the election is not made, and the surviving spouse has a taxable estate that could have been avoided if the election had been made, there are potential grounds for a lawsuit against the executor who did not make the election and the advisers, be they CPAs or attorneys, involved.

If the executor does not want to file a Form 706 to make the election, the CPA would be well-advised to have documentation in the file indicating that the election was discussed and the executor chose not to make the election.

In the case of blended families (i.e. when a child of the decedent is named executor and the surviving spouse
is not the birth mother of the child), the executor may opt not to file Form 706 (when not otherwise required) and not make the portability election just to get back at the surviving spouse.

It is not known whether the executor could be compelled to make the election. This is another area of the law that needs to be clarified.

Because of the requirement to file Form 706 to make the election, even if an estate is not otherwise required to file a Form 706, for example, because the gross estate is less than the $5 million, there may be an increase in the number of estate tax returns being filed. This, of course, means more work for CPAs who practice in this area. There has been some talk about creating a simplified version of the Form 706—perhaps a Form 706-EZ?—just for making this election, but some, including the IRS, are concerned that such a form may not contain enough information about the estate to be able to accurately calculate the DSUEA. Stay tuned for developments.

Because this law is so new and many practitioners are not familiar with it, there will probably be many missed opportunities to make the portability election. When asked by the AICPA Trust, Estate and Gift Tax Technical Resource Panel members, IRS representatives indicated that there is no relief for a missed filing of the Form 706 to make the portability election. Careful consideration should be given in each case where a client dies leaving a surviving spouse. Thinking that “the estate is less than $5 million so there is no need to file” will get many practitioners in trouble. CPAs should discuss the DSUEA and portability election with their clients and if, in light of all the facts, it is decided not to make the election, have documentation to memorialize the discussion and decision.
Donita M. Joseph, CPA, MBT is chair of the CalCPA Estate Planning Committee and a partner at Windes & McClaughry Accountancy Corporation.