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The Will & The Way, May 2011 – a publication of the Estate Planning & Fiduciary Law Section of the North Carolina Bar Association (NCBA)

The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (“Act”) has enabled – at least for the next two years – a married couple to make lifetime or death transfers of up to $10 million of assets without incurring estate and gift taxes. Before 2011, a surviving spouse could not take into account the unused applicable exclusion amount of the deceased spouse. Effective after 2010, the Act’s new “portability” provisions now enable the transfer of the deceased spouse’s unused applicable exclusion amount to the surviving spouse. This article is an overview of portability based on the new Internal Revenue Code (“Code”) provisions1, the Joint Committee on Taxation Technical Explanation2, and some of the professional commentary3 on the subject to date. Treasury Regulations are forthcoming.

Applicability

Effective for transfers at death or lifetime gifts made after December 31, 2010, portability is available only to U.S. citizen or resident decedents or donors who are married on the date of death. Nothing requires a spouse to be married for a minimum period of time. Significantly, portability does not apply to generation-skipping transfers, as there is no provision allowing the transfer of any unused generation-skipping tax exemption to a surviving spouse. Congress applied the EGTRRA sunset provision to the transfer tax modifications in the Act, so the portability provisions will expire after Dec. 31, 2012.

Applicable Exclusion Amount

The Act amended the Code’s definition of applicable exclusion amount. Code section 2010(c)(2) redefines the applicable exclusion amount as the sum of the “basic exclusion amount” (“BEA”) and, in the case of a surviving spouse, the “deceased spousal unused exclusion amount” (“DSUEA”). The BEA is $5 million for 2011, subject to future cost-of-living adjustment in $10,000 increment(s). Code section 2010(c)(4) defines the DSUEA as the lesser of:

(i) the BEA, or

(ii) the excess of the BEA of the “last such deceased spouse” of the surviving spouse over “the amount with respect to which the tentative [estate] tax is determined under [Code] section 2001(b)(1)” on the deceased spouse’s estate.

Generally speaking, the amount in (ii) above is the deceased spouse’s taxable estate plus adjusted taxable gifts. The following example is based on the first example in the Joint Committee Technical Explanation.

Example 1. Hal and Willa are married. Hal made taxable lifetime gifts of $3 million and dies in 2011 with no taxable estate. Hal’s applicable exclusion amount under Code section 2010(c)(2) is his basic exclusion amount: $5 million. The executor of Hal’s estate elects on a timely-filed estate tax return to allow the DSUEA to be taken into account in determining Willa’s applicable exclusion amount. The DSUEA is $2 million, i.e., the lesser of $5 million (Hal’s BEA) or $2 million [$5 million (Hal’s BEA) – $3 million (amount used to determine tentative estate tax)]. Therefore, under Code section 2010(c)(2), Willa’s applicable exclusion amount is $7 million, i.e., $5 million (Willa’s BEA) plus $2 million (the DSUEA). Willa may consume her $7 million applicable exclusion amount by making lifetime gifts or by transfers at death.

The Election

Code section 2010(c)(5)(A) describes the election. The surviving spouse cannot use the DSUEA unless the executor of the deceased spouse’s estate makes an irrevocable election on a timely-filed estate tax return. Significantly, even after the Code section 6501 limitations period for the imposition of estate or gift tax expires with respect to the deceased spouse, the IRS may examine the deceased spouse’s estate tax return to determine the DSUEA that can be used by the surviving spouse.

Preparers of (i) any gift tax returns in subsequent years for the surviving spouse, and (ii) the surviving spouse’s estate tax return will need information about the DSUEA election on the first-to-die spouse’s estate tax return. Furthermore, preparers will need to track separately the applicable exclusion amount for estate and gift tax purposes and that for generation-skipping transfer tax purposes.

Effect of Remarriage

Recall that Code section 2010(c)(4) generally defines the DSUEA as the lesser of the BEA or the remaining unused exclusion amount of the last deceased spouse. This means that only the last deceased spouse’s unused exclusion amount can be used by the surviving spouse. So if the surviving spouse remarries and the new spouse dies before the surviving spouse, then the twice-widowed surviving spouse must use the DSUEA of the latter deceased spouse. Here are two examples based on the examples in the Joint Committee Technical Explanation:

Example 2. Hal and Willa are married. Hal dies. The executor of Hal’s estate elects on a timely-filed estate tax return to transfer the DSUEA ($2 million) to Willa. Willa later marries Hank. Then Hank dies. The executor of Hank’s estate elects on a timely-filed estate tax return to transfer the DSUEA ($1 million) to Willa. Willa is limited to the DSUEA from Hank ($1 million) because Hank is the “last such deceased spouse” of Willa. Willa’s applicable exclusion amount is $6 million (her $5 million BEA plus the $1 million DSUEA from Hank).

The Joint Committee Technical Explanation states that the last deceased spouse limitation “applies whether or not the last deceased spouse has any unused exclusion or the last deceased spouse’s estate makes a timely election.” This means that if a surviving spouse remarries and the second spouse dies, then the deceased first spouse’s DSUEA will be lost. Perhaps the forthcoming Treasury Regulations will address issues raised by the surviving spouse’s remarriage. For example, what happens if after Hal’s death (but before Willa’s remarriage to and survival of second husband Hank) Willa made lifetime gifts that consumed her own BEA plus the DSUEA from her first husband Hal? Upon Willa’s death (after second husband Hank’s death), would the reduction in Willa’s applicable exclusion amount on account of the Hank’s lower DSUEA result in estate tax liability for a portion of the lifetime gifts previously made by Willa?

Example 3. Hal and Willa are married. Hal dies. The executor of Hal’s estate elects on a timely-filed estate tax return to transfer the DSUEA ($2 million) to Willa. With an applicable exclusion amount of $7 million ($5 million + $2 million), Willa later marries Hank. Willa then dies with a taxable estate of $3 million, leaving her second husband Hank as the surviving spouse. The executor of Willa’s estate elects on a timely-filed estate tax return to transfer the DSUEA ($2 million) to surviving spouse Hank. Code section 2010(c)(4)(B) limits the DSUEA to the lesser of the BEA or Willa’s unused basic exclusion amount, not Willa’s applicable exclusion amount. Accordingly, the DSUEA from Willa to Hank would be $2 million ($5million – $3 million), not $4 million as stated in Example 3 in the Joint Committee Technical Explanation

Several practitioners have mentioned a possible trend: Will portability encourage wealthy, unmarried individuals to marry poor, sick individuals so that the robust DSUEAs of the latter can be utilized by the former?

Planning Considerations

Some believe that portability was intended to simplify estate planning for married couples by eliminating the need for credit shelter trusts; however, practitioners appear to agree that the credit shelter trust is still appropriate to remove assets and future appreciation from the surviving spouse’s estate or to meet non-tax goals such as beneficiary asset protection or control over the beneficiaries of the decedent’s assets.

As stated previously, the DSUEA is not adjusted for inflation after a spouse dies. This may be an important consideration if one spouse is significantly younger than the other spouse, as a frozen DSUEA would lose value over a younger surviving spouse’s remaining lifetime on account of inflation. A credit shelter trust funded with the then applicable exclusion amount (to which GST exemption may be allocated) removes all future appreciation from the estate of the surviving spouse. On the other hand, if all assets instead pass to the surviving spouse, and portability remains in effect at the surviving spouse’s death, then it would allow for basis step-up for all BEA and DSUEA assets passing at the surviving spouse’s death.

Drafting Considerations

Portability has forced practitioners to consider the following questions: To what extent should a testator’s will address the portability election, if at all? Should a testator’s will be drafted to require the executor to make the election or to consult with the surviving spouse? Should the estate incur the cost of the election if an estate tax return is not otherwise required? Can a premarital agreement require the election? What happens if the executor fails to make the election? n

Mr. and Mrs. Cella are shareholders with Manning, Fulton & Skinner, P.A., in Raleigh.

End Notes

1. Section 303 of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, H.R. 4853, P.L. 111-312, enacted December 17, 2010.

2. Joint Committee on Taxation, Technical Explanation of the Revenue Provisions Contained in the “Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010” Scheduled for Consideration by the United States Senate (JCX-55-10), Dec. 10, 2010.

3. LISI Estate Planning Newsletter #1738 (Dec. 21, 2010) at http://www.leimbergservices.com; 45th Annual Heckerling Institute on Estate Planning, Supplemental Program Materials (2011).

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