New Exemption Portability Rule Not a Panacea

The Federal Tax Relief Act that became law on December 17, 2010 contains a surprising new provision that is designed to help married couples fully utilize both of their lifetime exemptions from gift and estate taxes. An examination of the procedural steps necessary to take advantage of the measure demonstrates that it is not foolproof and should be thought of as a backstop rather than an exemption-saving panacea. In 2011 and 2012, the lifetime exemption amount is $5 million. Certain types of gifts are always exempt from the federal gift and estate taxes. The lifetime exemption amount allows an individual to give, in addition to gifts that are always exempt, $5 million in assets during life or at death without incurring any gift or estate tax liability.

When a married person dies during 2011 or 2012, any portion of the spouse's $5 million exemption that he or she did not use may be used by the surviving spouse’s estate to reduce or eliminate the surviving spouse's estate tax liability. If the first spouse to die uses none of his or her exemption, the entire $10 million may be used by the surviving spouse. Note, however, that the executor of the first spouse to die is not permitted to use any of the surviving spouse's exemption – the exemption amount for the first spouse is set at $5 million.

To illustrate how this exemption transfer works, assume that the first spouse to die, “A” passes away in 2011 or 2012 and that A made gifts worth $1 million during life, thereby using $1 million of his $5 million exemption. He dies with an estate of $2 million, and therefore uses $2 million more of his $5 million exemption to transfer his entire estate free of estate tax. The part of the $5 million exemption not used by A, $2 million, can be transferred by his or her executor to the surviving spouse, “B.” When B dies, assets equal in value to the exemption amount available to B under then-current law will pass to B’s heirs free of estate tax, and because A’s unused exemption amount was transferred by A’s executor to B, up to $2 million in additional assets will also pass to B’s heirs free of estate tax.

To take advantage of this exemption "portability," the executor for the estate of the first spouse to die must make an election on an estate tax return to transfer the decedent's unused exemption to the surviving spouse. The return must be filed even if the filing of an estate tax return would otherwise not be required. If the executor is not aware of the need to make the election, or if the executor misses the IRS estate tax filing deadline and has not been granted an extension, the ability to transfer the deceased spouse's unused exemption amount is lost. A failure by the executor to make the election and to file it on time could mean a seven-figure loss for the surviving spouse. For example, if the deceased spouse did not use $3 million of his $5 million exemption, a failure to transfer the $3 million remaining exemption to the surviving spouse would result in estate tax liability of $1,050,000 for the surviving spouse's estate if the surviving spouse's assets exceeded the value of her remaining exemption amount plus $3 million.

There are several reasons that an executor might fail or choose not to make the election to transfer the deceased spouse’s remaining exemption, including indifference toward the surviving spouse or even a desire to spite or “get even with” the surviving spouse. This might occur, for example, if the executor is a child of a prior marriage who feels that his or her parent was too generous with surviving spouse to the detriment of the child.

Married couples who allow this potentially costly matter to ride on the reliability and decision making of an executor are taking a serious and unnecessary risk. Credit shelter trusts will continue to be an essential component of proper estate planning for the well-to-do married couple.

The Gift and Estate Taxes in 2011 and 2012

On December 17, 2010 President Obama signed H.R. 4853, the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010. The most sweeping tax legislation to be enacted in nearly a decade significantly alters the gift and estate taxes. One of the most extraordinary aspects of the new law is a provision that allows an individual to give away $5 million during the individual's lifetime completely free of federal gift tax. To understand the momentousness of this exemption amount, consider that from the time the gift tax was first introduced in 1924 until now, the most a person could give away during life without owing federal gift tax was $1 million. The Tax Relief Act of 2010 is set to expire at the end of 2012, meaning that the extremely wealthy have been granted a two-year window of opportunity to pass unprecedented amounts of wealth to children, grandchildren, and others completely gift tax-free.

Certain types of gifts, such as gifts to spouses and to charities, and gifts within annual allowances set by law are always exempt from the gift tax. The $5 million exemption is an allowance available to exempt gifts that don't fall within these always-exempt categories. In 2012 the $5 million amount may be adjusted to include a cost-of-living increase.

The $5 million exemption provided for in the Tax Relief Act of 2010 is a unified gift and estate tax exemption amount, meaning that the exemption may be used at death to the extent it is not as used during life. For example, if a person who dies while the Act is in effect made gifts of $2 million during life, then $3 million of the person’s exemption amount would remain at death, allowing $3 million to pass to the decedent's beneficiaries free of federal estate tax.

A dramatic new provision of the Tax Act helps married couples fully utilize both of their $5 million exemptions. If a married person dies during 2011 or 2012, any portion of the spouse's $5 million exemption that is not used to reduce his or her taxable estate may be used by the surviving spouse to reduce the surviving spouse's taxable estate. In the past, any portion of the estate tax exemption amount that was unused by the estate of the first spouse to die was simply lost and was not available to the surviving spouse.

The Tax Relief Act expires at the end of 2012 when Congress will once again be called upon to devise a more permanent gift and estate tax system. Because of the various, constantly changing political and economic ingredients that impact congressional decision-making, it is impossible to say at this point what the gift and estate tax system will look like in 2013 and beyond.

Eyes on the Estate Planning Prize

Estate planning is not simply about the transfer of assets at death. At best, estate planning is also about providing maximum quality of life for the estate planning client. All too often, estate planning attorneys serving wealthy clients focus exclusively on preservation of wealth for succeeding generations and on the reduction of gift and estate taxes. These goals are accomplished essentially by giving assets away during life. Though wealth preservation and optimum tax planning are critical elements of a good estate plan, leading estate planning attorneys agree that the tax tail should not wag the dog. A plan that fosters the client's comfort and peace of mind throughout the remainder of his or her lifetime is the estate planner's ultimate goal. The plan itself should not implicitly pressure the client to live monastically in order to preserve wealth for future generations. Well-to-do clients may choose a lifestyle well below their means, but their choice should not be swayed by the recommendations of the estate planning attorney. I believe clients should be encouraged to live the lifestyle they have earned.

This is not to say that living life to the fullest and preserving wealth for loved ones are mutually exclusive goals. A qualified estate planning attorney can suggest multiple strategies for achieving both objectives splendidly. The estate planning prize goes to the attorney who places the human element first, who understands that his or her job is to develop a plan that will minimize taxes but that will also provide for the client's maximum comfort, security, and happiness.