Portability Offers New Opportunities for Tax Savings in Estate Planning
By James Siegel
In 2013, the estate tax and gift tax rates increased to 40% and the federal estate and gift tax exemption amounts were frozen at $5 million per person (adjusted for inflation) as a result of the American Tax Payer Relief Act of 2012. The 2015 estate tax exemption amount is now $5.43 million per person and the 2015 gift tax annual exclusion amount is $14,000. Other recent tax law changes include the increase of the highest federal income tax rate to 39.6% (plus an additional 3.8% net investment tax on passive income) and the increase of the highest California state income rate to 13.3%. These changes, especially the increase in the estate, gift, and income tax rates pose a serious concern for individuals and couples with significant estates. Traditionally, when an individual passes away, property with a value up to the estate tax exemption amount (less any lifetime gifts) will pass estate tax free and all of the property in the estate receives a tax basis adjustment to the fair market value as of the date of death. Any assets above the exemption amount are taxable (i.e. 40% estate tax rate). In contrast, if the entire exemption is not used by the estate, it is lost, even if the property passes on to a surviving spouse. The good news is that a new legal concept was recently added to the federal estate tax law that can lessen the burden of estate and gift taxes on spouses, as well as provide some planning opportunities to minimize income taxes. This new legal concept is “portability.” Essentially, “portability” allows a surviving spouse to use the deceased spouse’s unused estate tax exemption amount upon his or her death or during his or her lifetime. This new concept has a significant impact on the type and design of trusts several of our clients are electing to create to protect their assets and their families.
Portability Expands Estate Planning Opportunities
Traditionally, married couples had to create an irrevocable Bypass Trust upon the first death in order to maximize the estate tax exemptions available to each spouse and minimize estate tax. Now, using portability, married couples do not have to create a Bypass Trust and can still get the same estate tax benefits. There may, however, be important non-tax reasons for still creating an irrevocable trust upon the first death, but trusts can now be designed to include both the non-tax benefits of an irrevocable trust for a spouse and take advantage of portability planning. Portability also offers income tax planning opportunities by taking advantage of the basis adjustment discussed above not only at the first death but also at the death of the surviving spouse.
Many estate plans created before the availability of portability provide that on the death of the first spouse, the deceased spouse’s separate property and one-half interest in community property is required to be held in a “Bypass Trust” for the benefit of the surviving spouse for his or her lifetime. Typically, following the death of the surviving spouse, the balance of the Bypass Trust passes to the remainder beneficiaries as designated by the deceased spouse. This trust design is desirable because it allows the deceased spouse to ensure that his or her property passes to the desired designees (i.e. children of a prior marriage) rather than other individuals identified by the surviving spouse. Bypass Trusts are also utilized because the deceased spouse’s estate tax exemption amount can be allocated to the Bypass Trust assets, meaning that the value of the Bypass Trust is not subject to estate tax upon the death of the surviving spouse. The main disadvantage is that the assets in the Bypass Trusts do not get a second adjustment in their income tax basis to fair market value upon the death of the surviving spouse. This means that although any appreciation of the assets between the death of the first spouse and the death of the second spouse escape estate tax upon the surviving spouse’s death, the appreciation (built-in-gain) may be subject to income tax upon a later sale of the assets. Using portability, it is now possible to structure a trust in such as way so that the full estate tax exemption of the deceased spouse is available to the surviving spouse (during the surviving spouse’s lifetime or upon the surviving spouse’s death) to not only minimize estate tax similar to as if a traditional Bypass Trust were created, but also allow for the income tax basis of the assets to be adjusted to fair market value a second time upon the surviving spouse’s death, thus eliminating the built-in-gain. This is a significant benefit as we see the increase in both Federal and California income tax rates.
“Income Tax Basis”
“Income tax basis” is an important tax concept when you are considering income, gift or estate taxes. The income tax basis of an asset is typically the cost of the property at the time it was purchased. This tax basis is important to know and understand because it will affect how much tax is paid when ownership of an asset is transferred through a sale, a gift, or through an estate. The tax basis for an asset can be adjusted to account for improvements or depreciation but tax law requires payment of taxes for any appreciation in value.
Important Considerations when Using Portability
It is important to note that this planning to completely eliminate estate tax is only possible if the spouses’ combined estates do not exceed the combined remaining estate tax exemptions at the time of the surviving spouse’s death. As in the traditional Bypass Trust planning, any asset values exceeding the combined estate tax exemptions would still be subject to estate tax. However, the income tax planning opportunities are available regardless of the size of the estate. As stated above, this new portability planning can be accomplished by either passing assets directly to the surviving spouse, thus eliminating the need to create an irrevocable Bypass Trust, or by creating an irrevocable trust for the benefit of a surviving spouse if there are non-tax reasons to do so. The non-tax benefits of creating the irrevocable trust include ensuring that the deceased spouse can still control the ultimate disposition of assets to his or her intended beneficiaries and/or providing creditor protection for the surviving spouse. Portability ultimately provides the surviving spouse with greater estate, gift, and income tax planning opportunities and flexibility.
Practical Concerns with Portability and Estate Planning
Portability must be elected following the first death and there are various deadlines for filing a portability election so it is important that a surviving spouse consult with his or her legal advisor as soon as possible following the first death. There are some disadvantages to electing portability, namely that portability only preserves the deceased spouse’s exemption amount as of his or her date of death and this amount will not be indexed for inflation. Remarriage on the part of the surviving spouse can also negatively affect the election of portability if the new spouse predeceases the surviving spouse. Effective estate planning for couples requires taking a comprehensive look at both the individual assets of the couple, as well as the assets they have acquired together and the goals they have for their estate and family. It also requires an in-depth understanding of current tax and estate planning laws. Effective estate planning requires consideration of and responsiveness to changes in estate law and tax law. As a result, we recommend reviewing and revising (if necessary) your estate plan with your attorney at least every five years. With the new changes in the law, if you haven’t had a chance to schedule an appointment with your estate planning attorney in the past six months, we encourage you to reach out today and get an appointment scheduled. Let’s discuss how portability may affect your plans and how we can protect your hard earned assets.  The income tax basis adjustment does not apply to certain retirement accounts and other deferred income.