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When tax exemptions carry over : Portability explained

Some people will tell you that the American Taxpayer’s Relief Act of 2012 (ATRA) has made estate planning easy and foolproof for the vast majority of people, i.e. the 99%. They believe that a tool dubbed portability — I’ll explain how it works in a second — eliminated the need for complicated bypass trusts. Well, not quite. Portability, as I will show today, has its advantages. But in certain situations it can also work against people’s interests. (More about that next time.)

So what does portability do? Bottom line, it allows the transfer of the gift and estate tax exemption (which is currently set at $5.43 million for each individual and rises annually with inflation) from one spouse to another; a surviving spouse can claim the deceased spouse’s exemption in addition to his or her own. Before the ATRA became a law, this was not possible. Back then, if the first spouse died without having used all of his or her exemption for gifts, then the remainder simply evaporated. The second spouse had her or his own exemption, but that was it.

To make things more clear, consider this hypothetical case: Kay dies, leaving Jim with assets worth $6 million that pass to him tax free because of another exemption called the marital deduction. During her lifetime, Kay already claimed $2 million in exemptions for gifts she made, but the balance of $3.43 million has not been used. Thanks to portability, Jim can now use what’s left of Kay’s exemption on top of his own $5.43 million, meaning he can give away or bequeath assets worth $8.86 million without taxes coming due. (A note of caution here: Portability is not automatic. Rather, the executor of the deceased person’s estate must file an estate tax return, Internal Revenue Service Form 706, to elect it. The IRS must receive the form within nine months of the first spouse’s death.)

Portability certainly has its advantages, the main one being that the deceased spouse’s assets are reevaluated at the point of his or her death. This step-up in tax basis reduces the amount of capital gains tax that will be levied if the assets are later sold. Portability also works well for property that is hard to manage from within a bypass trust, such as IRAs and principal residences. So are bypass trusts obsolete for the 99%? I’d say no. Check back in two weeks for details!

 

By Kevin J. Moore