Portability: Saving Estate (and Income) Taxes For Your Kids

By Liza Hanks
Liza Hanks

It's not often that estate planning experiences a fundamental shift in focus. But in January of 2013, Congress passed a revision to the estate and gift tax law that did just that. The new law presents an opportunity for many of people to both simplify their estates and to save their children significant money with respect to capital gains taxes--which in California, including federal capital gains, the new Obamacare surtax, and state taxes) amounts to close to 33% for those with income of more than $350,000. Anyone who lives in Silicon Valley and has an estate plan drafted prior to 2010 needs to take another look at that plan. Here's why:

How Portability Works

Portability allows a surviving spouse to use a deceased spouse's unused federal exemption from the estate tax. A widow, for example, whose husband died with a $3 million estate in 2015, who leaves everything to her, can request the use of his unused $5.43 million federal estate tax exemption at her death. As a result, she will be able to pass $5.43 million dollars worth of assets to her children, plus whatever exemption is available to her (it is $5 million as of 2010 indexed to inflation so will continue to increase).

Currently that widow would be able to pass $10.86 million to her children at her death. The primary benefit of portability is that all of the widow's assets will pass to her children with a stepped-up basis to the date of death value. If her biggest asset was an appreciating house, those children would greatly benefit from such planning because they would owe no capital gains taxes upon the sale of that house if they sell it shortly after her death. If the widow's total estate is less than $10.86 million, no estate taxes would be due either.

Compare to a Credit/Survivor's Trust Plan

Prior to 2010, the only way that a couple could combine these exemptions was through the use of a Credit/Survivor's Trust estate plan, which many of our clients currently have. These estate plans divide up the assets held in a family trust into two subtrusts at the first death: A Credit Trust, that holds the decedent's assets (up to the federal estate tax exemption available to that decedent) and a Survivor's Trust. The good news is that these plans will continue to work and are appropriate for many families. But these kind of estate plans are designed to minimize the potential estate tax due at the second death, they do not minimize capital gain taxes, and, for families with an estate below $10.86 million (many, even here in Silicon Valley), estate tax avoidance is not going to benefit them as much as income tax planning. The reason this is the case is that assets held in the Credit Trust, while not part of the survivor's taxable estate, will not receive a step up in basis to the date of death value at the second death. It's true that these assets will not be subject to estate tax, but if the family doesn't have a taxable estate, that's not a benefit, right?

To use the example above, had the widow put half of her house into a Credit Trust, and survived her husband by ten years, at her death, when the children went to sell that house, they would owe capital gains on the increase in value between the first and second death on the half of the house held in the Credit Trust. The half of the house held in the Survivor's Trust would receive a step-up in basis. For houses that sell in the millions, this is significant.

Portability's Drawbacks

While it does offer significant advantages, there are four drawbacks to portability and clients need to consider all of them before restructuring an existing plan.

Portability is not automatic. The survivor must elect portability by filing an estate tax return within nine months of the spouse’s death. There is an automatic six-month extension available, but that, too, must be requested by the nine month deadline. If you miss the deadline, you can’t use portability.

Portability does not protect you if Congress lowers the exemption after the first spouse has died. Families relying on portability to reduce their estate taxes may have an unexpected estate tax bill if Congress lowers the exemption amounts applicable to the survivor’s estate.

Portability does not protect your estate if your assets appreciate more than you were expecting in the future. All of the assets held by the surviving spouse will be subject to estate tax at the survivor’s death, so, if assets appreciate during the survivor’s lifetime, the survivor’s estate may be taxable after all.

Portability does not survive re-marriage. If the survivor remarries he or she loses the portability of the first spouse’s unused exemption.

Which Plan is Right for Which Client?

While it is not possible to really address the intricacies of which plan is right for which client in a short newsletter, in general, here are some of the things that I discuss with my clients:

Which tax do you think your children are more likely to have to pay?
If you don't think your estate is going to exceed $10 million, focus on minimizing capital gains taxes.

How risk tolerant are you?
If you are worried that Congress may lower the exemption in the future, and want to minimize the possibility of paying estate tax in the future, a Credit Trust may make sense.

How rapidly are your assets appreciating?
If a couple wants to get appreciating assets out of the estate of the surviving spouse, a Credit Trust can make sense.

How proactive do you think the Surviving Spouse is going to be?
For couples that don't like lawyers, don't like paperwork, don't like filing tax returns, and generally procrastinate, an approach based on portability could backfire because it requires that a survivor be proactive and actually file a timely estate tax return requesting portability. If they don't file, they don't get to use the unused exemption of the deceased spouse.

How important is it to control what happens if you die first?
For couples in second marriages, or those with concerns about remarriage, there are benefits to dividing assets after the first death into two trusts. This kind of plan can also make use of portability, but it is an important issue to consider.

Which plan is better?There is no rule of thumb to follow when considering which type of estate planning should be adopted by a couple, because so much depends on the type of assets involved, what the couple owns at the first and second death, how those assets appreciate, what Congress does in the interim, and so on. Estate planning is always a situation where we make big decisions with imperfect information. But it's still worthwhile to try and forecast likely scenarios and, most importantly, for families to focus on their goals, both tax and non-tax driven.

Portability means that planning is more complicated now. It's not a slam dunk that a Credit/Survivor's Trust plan makes the most sense for most married couples and it definitely provides many clients with a significant incentive to revisit their plans and reconsider what matters to them most. Feel free to contact me if you want to have your plan reviewed or have questions about portability. You can email me at lhanks@fmwlaw.com or call me at 650/327-0088. You can also download my book, The Family's Guide to Wills and Estate Planning, for free.