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Recent Changes in Portability of Estate Tax Exemption

How will the recent changes to portability affect you? Read here for planning insights from our expert.

By Philip Herzberg, CFP

Established as permanent with the legislative passage of the American Taxpayer Relief Act of 2012 (ATRA), portability can play an integral role in ultimately helping you and your spouse avoid or reduce estate and income taxes.

Philip Herzberg, CFP®, CDFA®, CTFA, AEP® is a Lead Financial Advisor at Team Hewins, a wealth management firm with offices in South Florida and the San Francisco Bay Area.

Philip Herzberg

Portability Background

The federal gift and estate tax exclusion as of 2022 is $12.06 million per individual ($24.12 million for married couples) and increases in 2023 to $12.92 million per individual ($25.84 million for married couples). This means that a married couple in 2022 should be able to collectively give $24.12 million, during life or at death, to their children or other intended non-spousal beneficiaries, without incurring estate or gift tax. Gifts in excess of the exemptions are subject to estate or gift tax at a 40% rate.

Portability, which is only available to married couples, is a way of transferring the amount of the gift and estate tax exemption that a deceased spouse did not use to the surviving spouse. A married couple can appropriately choose between portability and a bypass trust to effectively use both of their applicable exclusions to protect their family from estate taxes. The upshot is that a married couple can leverage the federal exemption portability provision to shield as much as $24.12 million of net worth in 2022.

The portability option only applies when the deceased spouse’s taxable estate is less than his or her remaining estate tax exclusion. This planning occurs when the individual’s remaining estate is less than the exclusion or when part or all of the individual’s assets pass to the surviving spouse or charity, reducing the taxable estate to less than the exclusion amount.

Prior to 2011, the first-to-die spouse needed to use such spouse’s exemptions in their entirety during life or at death to ensure they were not wasted. This exemption was frequently used by fully funding a “credit shelter” trust (also known as a “bypass,” “family,” or “exemption” trust) under the first-to-die spouse’s will or revocable living trust. Assets placed in the trust are generally held apart from the estate of the surviving spouse, so they may pass tax-free to the remaining beneficiaries at the death of the surviving spouse.

IRS Extends Late Portability Election

The Internal Revenue Service (IRS) issued a new revenue procedure on July 8, 2022, that enables a deceased person’s estate to elect portability of their unused estate and gift tax exemption for up to five years after death. You may be able to file an IRS Form 706, the U.S. Estate and Generation-Skipping Transfer (GST) tax return, to transfer the unused estate tax exclusion to yourself if your spouse passed away less than five years ago. The bottom line is that this portability has enabled more flexible estate planning where the first-to-die spouse’s exemption is not necessarily wasted, even if all or most assets were passed outright to the surviving spouse (or in a marital trust) without using any exemption.

Here is some guidance on how the recent changes to the portability of the estate tax exemption may impact you:

Filing with Portability

You do not automatically inherit your spouse’s unused exemption. To claim the benefit of portability of the exemption, you must file IRS Form 706 to make the election to add the unused exemption to your own, even if the estate does not owe a tax.

Previously, this return had to be filed within two years of a person’s date of death, assuming a federal estate tax return was not required sooner. The IRS decided to extend the filing time because many estates kept missing this window.

Notably, the estate tax return must be complete and properly prepared. For smaller estates, a special rule allows executors to avoid reporting specific values for certain marital or charitable deduction property. Rather, they provide a good faith estimate of the total value of such property on the estate tax return.

Planning Insight: If your spouse’s estate in 2022 were worth $4 million, that would leave an unused exemption of $8.06 million, which you could add to your own $12.06 million exemption, should you ever need it. You must file an estate tax return for your spouse and complete the section of Form 706 currently entitled “Portability of Deceased Spousal Unused Exclusion (DSUE)” with a computation of this amount. The surviving spouse also will need to keep copies of this 706 form in an identified folder for heirs and successor trustees to eventually know the amount of DSUE that was transferred.

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Estate Planning Techniques to Follow Over Solely Relying on Portability

Using a credit shelter trust and other traditional estate planning techniques may be more appropriate for some folks than relying on portability. Both tax and non-tax factors should be considered when determining whether portability is suitable for you.

Portability only carries over the exclusion in effect at the date of death. The credit shelter trust exempts assets and any appreciation on those assets from estate taxes. All growth in the value of assets in the credit shelter trust bypasses the surviving spouse’s estate and will not be subject to federal estate and possibly state estate taxes at the surviving spouse’s death.

Planning Insight: If your spouse’s estate in 2022 were worth $11 million, with portability, the survivor will get exactly $1.06 million of unused exclusion to add to your survivor’s taxable estate. If those assets have grown to $35 million, then the exclusion will not provide significant protection against an estate tax. However, if $11 million of assets are placed in the credit shelter trust and then grow to $35 million, the trust assets may all be free from estate tax.

Be mindful that portability is unavailable in most states that levy their own state estate taxes. Also, portability does not apply to the Generation-Skipping Transfer (GST) tax exemption. If a married couple wishes to create a dynasty trust for the benefit of their heirs, the portability election should not be made, as it can result in the loss of the deceased spouse’s unused GST tax exemption.

Another potential advantage of utilizing a credit shelter trust over electing portability is that the DSUE amount could be lost if the surviving spouse is likely to remarry. The first spouse to die can control where the assets remaining in the trust are distributed after the surviving spouse’s death rather than depending on the surviving spouse to carry out the desires of the first spouse to die. Should the surviving spouse remarry, the predeceasing spouse’s assets will pass to the descendants of the deceased spouse rather than to the new spouse or to the children of the new marriage.

Planning Insight: If the assets are left in a credit shelter trust, the trust may be drafted to protect the assets from the surviving spouse’s creditors or the surviving spouse’s mismanagement or substance abuse. Review your asset protection strategies, particularly those intended to shield you from potential creditors in legal judgments, with an estate planning attorney who is well-versed with the laws in the state where you live and where your trust is located.

Advantages to Electing Portability

Portability may allow for potentially better income tax planning if it is important for you to receive another step-up in basis on the surviving spouse’s death. Assets that are included in the surviving spouse’s estate at death will receive a step-up in income tax basis for a second time, while assets in a bypass trust are stepped up only once at the death of the first spouse.

For families with sizable wealth, the ability to claim the DSUE through filing an estate tax return, now extended for up to five years after death, could result in substantial tax savings. Under current law, the higher 2022 exemptions ($12.06 million per individual with inflation adjustments through 2025) will “sunset” or expire on December 31, 2025. Consequently, the exemption will be reduced by about half to an inflation-adjusted $6 million for any individual passing away in 2026 or later. Even though many families might not have an estate tax problem under current law with the elevated exemptions, they very well may pay estate tax if the second spouse dies after the exemptions are cut in half. In this scenario, claiming the first-to-die spouse’s DSUE could ensure that you owe no estate tax, or at a minimum, you save significant money on estate taxes.

Planning Insight: Portability may also be easier than creating and administering a credit shelter trust. Income tax returns must be filed for the trust to obtain the benefits of a CST. If the assets that are used to fund the trust are complex, this filing can be cumbersome and costly.

Portability Benefits for Retirement Accounts and Substantial Assets

It is worthwhile to contemplate electing portability if you own $10 million of retirement plan and IRA assets, while your spouse has $400,000 and cannot fund a credit shelter trust. Since the ownership of these retirement accounts cannot be transferred or split between two spouses while living, a spouse can be designated as the primary beneficiary of those retirement assets and use portability as a preferred approach for efficient income tax deferral. Portability also preserves optimal “stretch” potential for IRA assets for surviving spouses, who can facilitate rollovers to their own IRAs.

Planning Insight: Another advantage of portability is that it makes planning easier when you have a huge indivisible asset, such as a residence that would be challenging to administer in a trust. Think about leaving this very large asset outright to your surviving spouse and relying on portability to maximally use DSUE at the surviving spouse’s subsequent death. Verify that this portability decision is made in accordance with the married couple’s wishes and future family goals.

It may not be to your benefit to skip filing Form 706 for estate taxes, especially if you are a high-net-worth family with interests in harder-to-value assets, such as certain types of businesses. You may make the mistake of not filing an estate tax return since you think the first spouse’s wealth is below the threshold. If the IRS questions the estate valuation letter, it may block the second spouse from fully leveraging portability.

Seek the guidance of a qualified estate planning attorney, in tandem with a CERTIFIED FINANCIAL PLANNER™ professional, to help you determine if Form 706 should be filed for estate taxes and how the recent changes to portability may affect you.

About the author: Philip Herzberg

Philip Herzberg, CFP®, CDFA®, CTFA, AEP®, is a lead financial advisor at Team Hewins, LLC, a wealth management firm with offices in South Florida and the San Francisco Bay Area.

Team Hewins, LLC (“Team Hewins”) is an SEC-registered investment adviser; however, such registration does not imply a certain level of skill or training, and no inference to the contrary should be made. We provide this information with the understanding that we are not engaged in rendering legal, accounting, or tax services. We recommend that all investors seek out the services of competent professionals in any of the aforementioned areas. Certain information provided herein is based on third-party sources, which information, although believed to be accurate, has not been independently verified by Team Hewins. Team Hewins assumes no liability for errors and omissions in the information contained herein.

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