Learning About Portability

TO OUR ESTATE PLANNING, TRUST, AND CHARITABLE CLIENTS ~ This is an extended version of an article summarized in our 2013 newsletter on new estate planning options available in 2013.

New Gift and Estate Tax Options Available in 2013

The American Taxpayer Relief Act offers new options for estate planning. Like many things in life, though, complexity comes at an administrative cost and requires trade-offs. Below, we’ve identified four key estate planning goals. The key to making the most of the new law is to understand your family’s goals and priorities so that your plan will be implemented properly and achieve your main objectives.

The good news is that your existing plan may work just fine under the new law. But you may find that you can simplify your existing trust or take advantage of new opportunities with some of the provisions of the new law. Here’s an overview. Call me if you’d like us to review your plan and make specific recommendations for your family.

Reviewing Your Plan

Now is a good time to review your main estate planning goals to determine whether your existing plan is still right for your family.

  • Do you want to minimize the potential estate tax at the second death?
  • Do you want to minimize the potential capital gains taxes paid by your heirs?
  • Do you want to minimize administrative complexity for the surviving spouse?
  • Do you want to control assets after the first spouse dies?
Minimizing Estate Taxes: Unified Credit Trust

Until now, traditional estate planning for married couples often focused on reducing the taxable estate of the family as a whole. Before 2013, the way to do this was to create an irrevocable Unified Credit Trust (or Bypass Trust) at the death of the first spouse. The survivor would be the lifetime beneficiary of this trust (children could also be included), but the assets would not be taxed at the survivor’s death, even if they appreciated. Many of our clients have this type of trust.

This type of planning reduced the taxable estate of the survivor, but it came with a built-in capital gains tax disadvantage: assets held in the Unified Credit Trust would not get a step up in basis at the survivor’s death. At the death of the first spouse, community property assets get a step up in basis to the fair market value of those assets at the date of the first spouse’s death. As a result, the heirs would pay less, or no, estate tax, but if they sold the assets held in the Unified Credit Trust at the survivor’s death, they would have to pay capital gains on the appreciation those assets had enjoyed since the funding of the Unified Credit Trust (when the first spouse died). If only a few years pass between the first and second death, this may not result in significantly higher capital gains taxes. However, if many years pass between the first and second death, this appreciation could be significant. In that scenario, the heirs would pay capital gains on this rise in value, but, no estate taxes on the appreciated assets.

For many families, traditional estate plans with this structure still makes sense. The estate tax rate, currently forty percent (40%), is almost double that of the long-term capital gains tax rate, currently 23.8% for the top bracket, including the 3.8% medicare tax for earners above a certain threshold. So, if reducing the estate tax is your most important goal, funding a Unified Credit Bypass Trust makes sense, even if your heirs will pay some capital gains taxes as a result.

Minimizing Capital Gains Taxes: Portability

The new law offers families whose primary concern is not reducing the estate tax, but rather minimizing capital gains taxes, a new way to achieve that goal. For families that are unlikely to have taxable estates, but do have assets that are likely to appreciate significantly, such as a house in the Bay Area, minimizing capital gains is a worthy goal—after all, their heirs are not likely to have to pay an estate tax, but they may be selling assets that have appreciated significantly.

Here’s how it works. Instead of funding a Unified Credit Trust to reduce the taxable estate of the survivor, this kind of plan simply leaves the deceased spouse’s assets to the survivor, either outright or in an irrevocable trust (but not a Unified Credit Trust). When the survivor dies, all of the family’s assets are in the survivor’s taxable estate, but, if the survivor files an estate tax return within 9 months of the deceased spouse’s death, he or she can elect to use the estate tax exemption not used by the deceased spouse. This is called portability, and it was introduced in 2011, but was only in effect until the end of 2012. Now, though, it’s a permanent feature of the estate tax.

Portability allows both spouse’s exemptions to be used by the survivor at his or her death. Using 2013 exemption amounts, that would mean a couple could pass up to $10.5 million free of estate tax. And, all of the assets held by the survivor at death will receive a second step up in basis.

Portability is an attractive option, but it’s not a magic solution for everyone. First, if a surviving spouse remarries, they will lose their first spouse’s exemption. Second, portability is not automatic; it requires that the survivor file an estate tax return within 9 months of the first spouse’s death, or file a request for an automatic six month extension. If you miss the deadline, it’s too late. Third, filing an estate tax return is not a trivial project, it requires compiling detailed records on the value of the assets owned by the deceased spouse and costs several thousand dollars to prepare. Fourth, if assets appreciate more than expected after the first spouse dies, the survivor could still have a taxable estate at death.

Minimizing Administrative Complexity

Estate planning works best when the plan that you’ve designed for your family is implemented properly. But life has a way of intruding into the pristine pages of your plan. Grief is a powerful emotion and even the most organized, competent person can find themselves lost in the details. We work with many families who find themselves dealing with the details years after there’s been a death, not months. One of the biggest advantages of a ‘traditional’ estate plan with a Unified Credit Trust is that it can be implemented whenever the surviving spouse is ready to work with us and their accountant to fund the trust and move ahead with the plan. It’s better, of course, not to wait too long, but it’s not catastrophic if you do wait awhile.

In contrast, planning that relies on portability also requires the survivor to be proactive. An estate tax return (or a request for a six month extension) must be filed within 9 months of the first death. . If the survivor misses that deadline, it means that all of the assets will be taxed at the survivor’s death, and only one exemption can be applied to those assets, not two.

If you are a procrastinator, or someone easily overwhelmed by financial tasks, portability-based planning may not be a good idea for you.

Controlling Assets After the First Death

Many families find that taxes aren’t the primary concern when determining the structure of their estate plan. For those concerned about second (or third) marriages, it can be critical to design a plan that controls what happens to assets after the first spouse dies. This was true prior to the new tax law, but now that the exemption level is set at $5 million and indexed for inflation, fewer families will be subject to the estate tax than ever before.

Traditional planning using a Unified Credit Trust is one way to control assets. The terms of the Unified Credit Trust become irrevocable upon the first death, which protects the assets placed there from second marriages or new families. This plan comes with all the advantages and disadvantages discussed above: it protects against the estate tax, it allows assets to appreciate outside of the survivor’s taxable estate, but assets will not receive a second step up at the survivor’s death.

However, if you would like to control assets after the first death, but also get a second step up in basis for appreciated assets, the new law now allows you to structure an estate plan to do just that. Instead of placing assets in a Unified Credit Trust, your plan can allocate the assets of the first spouse to die to a Marital Deduction Trust instead. Assets placed there will still be available for the survivor’s use and will still be in a trust that becomes irrevocable at the first death. However, unlike a Unified Credit Trust, assets held in the Marital Deduction Trust will be subject to estate tax in the survivor’s estate and will receive a second step up in basis. This plan comes with all the advantages and disadvantages of portability discussed above: it requires the survivor to file a timely estate tax return, appreciating assets are part of the survivor’s taxable estate, but all assets held in the Marital Deduction Trust will receive a second step up at the survivor’s death.

Providing Flexibility After Death

One of the most frustrating things about estate planning is that you have to make decisions about the future with imperfect information. The new law is only as ‘permanent’ as any other piece of legislation. And, of course, none of us know when we will die or what assets we will own at that time. It may well be that whatever plan you’ve got, when the first spouse dies, adjustments need to be made.

Luckily, after one spouse dies, the survivor has the option of accepting gifts or “disclaiming” (refusing to accept) all or part of the gifts. By including alternatives for disclaimed gifts in your estate planning documents, you can let the survivor take another look at your assets and the estate tax exemptions, and then decide whether it makes sense to accept the gifts as described or allow an alternative to take effect. While not a perfect solution, disclaiming is a great way to take a fresh look at the relative tax advantages offered by the approaches outlined above.

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Federal Tax Notice: To comply with Treasury Regulations, we inform you that any tax advice contained in this newsletter is not intended or written to be used, and cannot be used, by any person or entity for the purpose of (i) avoiding tax-related penalties that may be imposed under the Internal Revenue Code, or (ii) promoting, marketing, or recommending to another party any tax-related matter addressed in this newsletter.