The increase in the amount exempt from federal estate tax to $5 million per taxpayer (plus inflation adjustments) has been a game changer for estate planners. Nearly as important, when it comes to estate plans for married couples, is the advent of the portability of the estate tax exemption, the Deceased Spouse’s Unused Exemption (DSUE). By simply filing an estate tax return at the death of a spouse, even if no estate tax is due, the estate tax exemption for the surviving spouse may roughly double. Such a filing is not required, but it would be a good precaution to take. The future course of the family fortune as well as the federal transfer tax regime are difficult to predict, so any step that could save substantial tax dollars in the future should at least be considered.
But this is a brand new planning area with which we are becoming familiar. Lawyers Alan Gassman, Ed Morrow, Ken Crotty, Christopher Denicolo, Seaver Brown and Brandon Ketron have prepared “Ten Common Portability Mistakes and What You Need to Know to Avoid Them” as a guide [LISI Estate Planning Newsletter #2395 (February 29, 2016)]. Here are just four errors they highlighted to keep in mind.
Accidental election out of portability
Failure to file an estate tax return for the first spouse to die will forfeit the DSUE for the survivor. The estate tax return must be filed within nine months of death, but a six-month extension may be granted. Timely filing Form 4768 will gain an estate an automatic six-month extension.
Estates smaller than the statutory threshold for filing may apply for a discretionary extension of time even beyond the normal 15-month period. Many recent Private Letter Rulings have granted an additional 120 days for filing [see Private Letter Rulings 201610013 and 201608010, for example].
Given the relative newness of portability, we may expect many more such private rulings in the coming years. Eventually, more and more executors will recognize the need to file the estate tax return even when no taxes are owed.
Assuming that no estate tax planning will be needed
If total family wealth is about $5 million, a couple may assume that a single federal exemption amount will be sufficient to shield the family fortune from the federal estate tax. Thus, they might decide to forego planning for the portability election as not worth the expense of hiring a professional to file an otherwise unnecessary estate tax return.
There are two potential defects with this plan. First, the amount exempt from federal estate tax could be sharply reduced in the future—both of the Democratic candidates for President this year have endorsed
Second, the surviving spouse may live for decades, and may not consume all of the income from that $5 million. If asset appreciation plus savings comes to just 7.2% annually, the family fortune will grow to $10 million in ten years, $20 million in 20 years. At a 10% growth rate, it could reach $40 million in 22 years. Inflation adjustments to the exempt amount are unlikely to keep up with that.
Losing the DSUE through remarriage
A surviving spouse may have a DSUE only from his or her most recently deceased spouse. Assume, for example, that widow with $8 million in assets has a $5 million DSUE through her late husband. She remarries a widower who has $10 million, and through a prenuptial agreement they waive their marital rights to each other’s assets. The second husband dies, leaving his entire estate to his descendants, using up his estate tax exemption. The widow’s DSUE from her first husband will be extinguished at that moment. Her heirs now may be exposed to substantial
It is entirely possible that when she consulted her lawyers about the pre-nup, they might have recommended against the marriage at all, considering the tax consequences. The authors suggest consideration of a credit shelter or bypass trust to mitigate this potential problem.
Not maximizing the DSUE with an irrevocable life insurance trust
Assume that Husband and Wife have a $5 million joint estate, and they each have $2 million life insurance policies. At Husband’s death, his assets and the insurance proceeds pass into a credit shelter trust. That will use up $4.5 million of his exemption, leaving Wife a $950,000 DSUE. She has her own exemption amount, which will be inflation indexed, and the DSUE, which is not.
The better alternative may be to have the life insurance owned by an irrevocable life insurance trust. In that situation, the insurance proceeds may be excluded from Husband’s estate, leaving Wife a much larger DSUE.
The advent of portability, coupled with larger exemptions, has allowed much greater flexibility in estate planning. However, that is not quite the same as simplicity. There remains a wealth of considerations for clients and their advisors to weigh as they find the best way forward in a challenging environment.
© 2016 M.A. Co. All rights reserved.