Estate tax exemption “portability”

In news coverage of the debate over estate taxes, you may have heard something along the lines of “In 2009 the federal estate tax exemption was $3.5 million, or $7 million for married couples.” Strictly speaking, that was not quite accurate. Yes, with some basic estate planning and given certain assumptions about who owns what and who dies first, married couples could achieve a doubling in the value of the federal estate tax exemption. But without that estate planning, a couple would most likely would lose one of their exemptions.

That has changed now. For deaths in 2011 and 2012, when the exemption from federal estate tax has been boosted to $5 million, a surviving spouse may inherit “unused” estate tax exclusion amounts. All that is required is the filing of an estate tax return with an election by the executor authorizing the surviving spouse to take the unused exclusion into account.

Example. Sam and Janet have a $6 million estate, which we’ll assume is entirely in Sam’s name. Assume that Sam died in 2009, leaving everything to Janet. At her death in 2011, Janet’s $6 million estate will have the benefit of her $5 million exemption, so only $1 million will be taxed. The estate tax will come to $350,000.

Now make one change, Sam’s will created two trusts of $3 million each. One was “taxed” in his estate, but it was sheltered by the $3.5 million exemption available in 2009. That trust will not be included in Janet’s estate at her later death. The second trust avoided taxation at Sam’s death thanks to the marital deduction. It will be exposed to tax at Janet’s 2011 death, but the $5 million exemption will cover that.

Next, make a different change. Sam dies in 2011, not 2009, leaving everything to Janet. If his executor so elects, Janet will be entitled to both her own and Sam’s exemption amount, potentially $10 million, even without the use of trusts.

The new marriage penalty. The new law prevents piling up estate tax exemptions through a series of marriages. It achieves this by limiting the unused exclusion amount to that from the most recently deceased spouse.

To continue our example, let’s say that Janet remarries after Sam’s death. Her new husband, Jeff, leaves $5 million to his heirs at his death, perhaps the children of his first marriage. He has used up his own federal estate tax exclusion, and Janet’s estate once again faces estate tax on $1 million.

With complexities such as these, the demand for estate planning is not likely to diminish. If Sam already has a two-trust plan in his will, he should consider sticking with that approach. Portability is scheduled to expire at the end of 2012.

(February 2011)