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An Overview of Estate Tax Portability Provisions

Estate tax returnThe IRS on Sept. 29 issued Notice 2011-82 to alert executors of 2011 estates of the need to file a Form 706 to make the election to transfer a decedent’s unused $5 million estate and gift tax exclusion to the surviving spouse. In particular, for the executor of a 2011 estate to make a portability (i.e., deceased spouse unused exclusion amount) election, the executor is required to file a timely Form 706 for the decedent's estate, even if the estate is not otherwise obligated to file a Form 706. If a timely return is not filed, any excess exclusion amount is lost forever and is unavailable at the death of the surviving spouse. To avoid falling into this trap, practitioners should discuss with their clients the benefit of filing the federal estate tax return for the first spouse, even if no tax is due. Over the next few weeks and months, it is very important to file extensions (Form 4768) or Form 706 for early 2011 deaths within the nine-month deadline (starting Oct. 3, 2011).

2011 Deaths and Form 706 and Portability

If you prefer, you can read the entire transcript after the jump or download this and other audio webcasts from the Personal Financial Planning Section on AICPA.org.

Robert S. Keebler, CPA, MST, DEP, Partner, Keebler & Associates, LLP. Bob is a 2007 recipient of the prestigious Distinguished Estate Planners award from the National Association of Estate Planning counsels. From 2003 to 2006, Bob was named by CPA Magazine as one of the top 100 most influential practitioners in the United States. He is the past Editor-in-Chief of CCH's magazine, Journal of Retirement Planning and a member of CCH's Financial and Estate Planning Advisory Board. His practice includes family wealth transfer and preservation planning, charitable giving, retirement distribution planning, and estate administration. 

This audio webcast was originally recorded Nov. 15, 2011.

Transcript: 

On behalf of the AICPA's Personal Financial Planning Division, this is Bob Keebler to discuss IRS Form 706 in 2011 and '12, including portability issues.  Welcome.

Today we're going to go through filing federal estate tax returns in 2011/12, in particular talk about the issues associated with portability.  And this is a very big thing for CPAs, because what's happening here is the IRS is taking the position you actually have to file a 706 to utilize portability.  So we're going to go through this.  We'll talk about some of the basics, and then we'll get into this in considerable depth.

First of all, just a matter of background.  Remember, in 2010, there was no estate tax.  You could elect out of the estate tax.  That's the first thing that we want to be cognizant of.  Second thing, in 2010 there was no generation-skipping transfer tax, even though you had a $5 million exemption if you made gifts and you want to allocate GST exemption.

Fast-forward to 2011.  In 2011 and '12, everyone has a $5 million exemption for the gift, estate and GST.  Now, in that excuse me is going to grow slightly for estate and for GST purposes to $5,120,000, almost irrelevant to today's conversation.  The estate tax rate in '11 and '12 will be 35%.  Part of the bill that was signed by the President on December 17, 2010, introduced the concept of portability.  Portability is a concept that says that if I die today and my wife, through you, her CPA, files an estate tax return, she is going to be able to capture my $5 million exemption, giving her a $10 million exemption.

Now, one of the caveats with this is if my wife lives another 40 years and her exemption grows by inflation from 5 million to 15 million, the exemption that I ported to her is frozen in time, never changes.  It's going to stay at exactly, precisely $5 million.  That's the first problem here.

Now, the second problem, absent action by Washington, portability disappears on January 1st, 2013.  Third problem with portability, portability only applies for gift and estate tax purposes.  Portability does not apply for GST purposes.  Portability does not help you with creditor protection.  Portability does not prevent your spouse -- a lady dies, she leaves property to her husband, he remarries and he leaves all of their -- his first wife's property and his property to a second wife.  It doesn't prevent any of that.  So these are the things that you have to counsel your clients on.

Now, again, portability disappears in 2013 unless it's extended by Congress.  The Green Book says portability should be made permanent.  We don't know what's going to happen.

Now, to understand portability, we need to go through some definitions.  The first definition is the basic exclusion amount.  In 2011 and '12, the basic exclusion amount will be 5 million, and that's based on the TRA relief.  Now, this has previously been called the applicable exclusion.  Now it's called the BEA, basic exclusion amount.  Again, and that is $5 million, but in 2013 that goes back to a million dollars.  Now, that is 12 and a half months from now, so we have a serious issue that we have to face into.  Congress is very dysfunctional, and there's no doubt about that, and no one would argue that.  At the end of the day we could go back to the million-dollar exemption, and if that happens, that means that you're going to have your work cut out for you.  If that happens, it's possible that portability would actually disappear.  Okay?  So portability could actually disappear.

Now, so BEA is your basic exclusion amount.  I have 5 million, you have 5 million.  That's what BEA is.  If you take your basic exclusion amount and you add in your portable amount that you received from your spouse, that gives you your applicable exclusion, or $10 million.  Bottom line is, no matter what you call it, you have 5 million.  If your wife dies or your husband dies and you receive his or her 5 million, you're up to $10 million, okay?  Remember, that portable amount is not adjusted for inflation.  The basic exclusion amount is adjusted for inflation.

Now, the term from prior law had been redefined to encompass this concept of portability, basically allowing the surviving spouse in certain situations to use the remaining basic exclusion amount from his or her previously deceased spouse.  And that's kind of where we are.  Now, we do not know a lot of things about this whole concept.  We do not know if we make gifts.  For example, if I gift -- or I die and I leave my 5 million exclusion to my wife and she dies later, we know she has 10 million.  But what if she makes a gift?  If she makes a gift of 10 million, we know that she can use my exclusion plus hers, okay?  But what does she use first?  What if she only makes a gift of $4,999,000?  Has she burned up all of her exclusion, or has she just burned up my exclusion?  There's no ordering rules right now.  There are no ordering rules right now.

Now, the one concept which I'm going to come back to a couple more times is, to capture this, to actually port the exemption from me to my wife when I die, you have to file a federal estate tax return.  Now, if you've already missed that because of a January or February or perhaps March death this year, the government may be open to giving us some relief.  If you have that situation, e-mail me, and I'll talk to you about what I've heard privately on that.  And again, I -- But they are open.  They recognize that they didn't have the rules out there, and they have to find some way to give us some relief.

Now, the tax reform -- tax dictionary deceased spousal unused exclusion amount, that everyone is calling DSUEA, and TRA created a concept called portability, and what portability does, it tries to make things fair.  We understand that.  But absolutely, DSUEA is the amount that you ported from one spouse to another, okay?  Remember, portability is not simple.  It doesn't always get us the intended result.

One of the concepts with portability is last deceased spouse.  So on my death, if my last deceased spouse had not used his or her exclusion, and we've been -- they filed an estate tax return, I'm going to get to use her exemption, okay?  I mean, that's the bottom line.  Now, one of the problems is -- and we'll go through some examples -- when you have a lady, her husband dies, that's the first step.  So now she's a widow and she remarries.  From her first husband, she had a $5 million exemption that transferred over, that ported over.  She has a $10 million exemption.  But now she remarries Mr. X, and Mr. X dies before her.  But Mr. X leaves everything to his children, burning up his entire 5 million.  But because he's her last spouse, the 5 million that transferred from her first spouse completely disappears.  This will be a major issue when you're helping with prenuptial agreements for older folks that you're going to have to look at.  So you're going to have to look at that.

Now, TRA tax indexing.  Remember, the basic exclusion amount -- my own personal exemptions indexed for inflation, the amount, the transfer that ported from my wife, is not indexed for inflation.

Now, the executor is considered to have elected to allow the surviving spouses to transfer the surviving -- to the surviving spouse the decedent's unused exclusion if you file a federal estate tax return.  You have to file a complete and timely federal estate tax return.  I think eventually where we're going to get to is the government may give some relief in the short run to let you fix these things.  But if you haven't filed a complete federal estate tax return, eventually you're not going to be able to seek any relief.  Remember, this Statutory Guideline 9100 relief wouldn't be available, because that is a regulatory relief, not a statutory relief.

Now, very important.  You may represent some people that choose not to allow the surviving spouse to take into account for transfer tax purposes decedent's unused exclusion.  In other words, I die, and my children despise my second wife, okay?  And so you have a gentleman that's married.  His first wife died, he's remarried, his children despise his second wife, and they decide they're not going to file an estate tax return, or they attach a statement to the 706 indicating the decedent's not making the election to transfer the portability amount, or they write on the top of the return in pen, "No election under Section 2010(5)" across the top of that return.  And they make that whole -- they throw away the whole portability election.  Okay, now that would be -- There would be probably no point to that, but they could do that if they felt that was the right thing to do.

Now, portability issues.  If the filing of a 706 is not otherwise required for the decedent's estate -- you're under 5 million -- not filing a timely and complete 706 effectively prohibits the surviving spouse from using the exemption.  What's going on here is, you just need to file the 706.  So for everyone that dies, you're going to have to ask yourself the reasonable question, should we grab portability?  Should we file a 706 to grab portability?

Now, you represent this lady, she's 86 years old, her husband just died, her net worth is 400,000, and his net worth that transferred directly to their children is 400,000.  You know the exemption's going to be at least a million.  You might not want to file an estate tax return.  You may not want to go through the cost of that.

On the other hand, you represent her granddaughter, who is a 36-year-old neurosurgeon whose husband just died in a tragic accident.  You would probably, no matter how little money that young couple had, you would probably want to file a 706 to try to transfer the $5 million exemption from the young man that died to his wife, where she would then have a $10 million exemption.

Now, there's a concept out here.  So we want to understand, you have to file the estate tax return to make this happen.  The government estimated that based on the $5 million exemption, only about 6 or 7,000 estate tax returns would ever be filed.  Now, if you look into the fact that for many, many people you're going to want to take portability, that number completely changes, okay?  So that completely changes, and that's something that I think is a great practice opportunity for many of you.  You're going to have to take a real hard look at how can you make that work in your practice, okay?  So the issue becomes how can you really make that work in your practice?

Now, let's go into the concept of last deceased spouse.  This is a tricky concept, so you're going to have to pay very close attention to this, especially if you're helping with prenuptial agreements.  Surviving wife 1 marries husband 2.  She is still allowed to use the unused exemption from her husband because husband 1 still remains as her last deceased spouse.  So as long as husband 2 is alive, she's good.  But when husband 2 dies, wife 1 loses husband 1's exemption, and then it would succeed to husband 2's exemption.  But if husband 2 has left everything to his children, everything -- his wife would no longer have any exemption remaining, any portable exemption remaining.  This is a trap, and if you're representing people on prenuptial agreements, take a good look at this.

Okay, so basically we want to understand that the use of exemption requires marriage.  If wife -- In my prior example, wife 1 is married to husband 1.  Husband 1 dies.  Wife 1 can use husband 1's unused exclusion -- that makes sense, there's privity.  At one point in time they were married.  Wife 1 marries husband 2.  Now wife 1 dies.  Husband 2 can use wife 1's unused exclusion amount, her personal unused exclusion amount.  However, he cannot -- husband 2 cannot use the unused exclusion of wife 1's former spouse, husband 1.  That would disappear.

So let's talk about big picture, here, impact on different types of clients.  First of all, this is very appropriate for moderate-wealth clients.  Very wealthy clients are always going to want to use their bypass trust.  Clients in states like New York, where you have only a million-dollar exemption, are probably still going to want to use their bypass trust.  We have to watch out for inflation.  We have to remember, 2013 could really bring back the million-dollar exclusion.

Now, if we go back to the million-dollar exclusion, portability disappears.  We do not know what's going to happen to people that died in '11 and '12 that elected portability.  It would be very unfair to say that, you know, my wife died, I took the assets thinking I had portability.  I didn't disclaim them like we were going to, and then I do not get any portability.  So I think clearly that's going to be a subject of great litigation in years to come unless Congress makes that fair.  So we want to be very careful.  You want to remain flexible.

Do not forget, portability doesn't do anything from an asset protection or remarriage protection, okay?  And basically, let's say that husband died, his wife is a physician.  There's no way she's going to want to take his property.  She's going to want to get that property into some type of bypass trust where she has really strong asset protection.

Now, few clients are really going to care.  Only 5,600 estate tax returns will be required in 2011 and '12.  But that doesn't include clients that are going to file just for the sake of portability, and if someone refuses to file a return to grab portability, you're going to want to have them sign off just so that you're not in trouble later, okay?  And moderate-wealth clients are going to have to consider all the pros and cons of portability planning.  If you have IRAs, that's going to change everything.  Right now we're representing two different estates where husband died, couples -- surviving spouse in her 80s, bottom line is, I'm telling these ladies, forget portability.  Portability might disappear.  Let's fund the bypass trust.

And, again, this creates -- Portability is seemingly designed to lower planning costs and lower complexity.  I'm not so sure it does that, okay?  Because it's certainly going to make estate administrations much more complicated.

Bottom line, anyone that dies, you -- even if you're only doing your income tax return, you need to brief them on this portability, because I am not sure that every lawyer and every CPA in the country right now knows you have to file an estate tax return to grab portability, and undoubtedly there are CPAs and lawyers out there helping with estate administrations and doing the tax work after someone dies, and they may not be attuned to this, how specific this require is.  And the fact that you can't go back and do it later, okay?

Now, again, asset protection, portability does not -- physicians and other mid-wealth clients are going to have to worry about asset protection.  They are going to have to fund a bypass trust.  No state estate tax.  Again, if you're in a state like Wisconsin, where there's no incremental state estate tax, no big deal.  But if you're in a state like up in the upper Northeast part of the United States, where there seems to be extra state taxes layered in, you're going to have to worry about how do you reduce state tax in addition to federal tax.

Portability.  If portability sticks, it is going to mean that large IRA accounts you have a lot more flexibility in.  From an income tax perspective, what you're doing with portability is great, because now I die.  My wife can roll over my IRA.  She doesn't have to worry about estate tax until she gets the $10 million.  She can let that IRA grow and grow and grow on a tax-deferred basis.  That may be a much better result than funding the bypass trust with an IRA.  So from an income tax perspective, the spousal rollover is almost always more powerful.

Now, portability malpractice traps.  Again, the election to file for the unused estate tax exemption must be made on a timely filed estate tax return.  Absolutely no election can be made on a late return.  The government will probably give us some relief for 2011, but probably not beyond that.

Now, here's the scary part.  The statute of limitations remains open for the decedent spouse's estate tax return until the statute lapses on the surviving spouse's state tax return.  Let me bottom-line this for you.  I die today, my wife lives 50 years to age 100, and she dies at 100.  My estate tax return from today, believe it or not, is still open.  So my estate tax return for today filed -- wasn't filed -- it was filed timely -- is going to be open 50 years from now, and you're going to have -- somebody's going to have to defend that, probably no one on this phone call, but someone is going to have to defend that estate tax return.  And you're going to have to make sure you have plenty of evidence as far as valuations on anything that could be difficult to value.

So if the IRS audits the deceased spouse's estate tax return, they can reduce the amount of the unified credit that was transferred.  And that is very, very important.  That is very, very important, and you need to be on top of that and make sure you're doing a great job of filing these things.

Now, the other thing that was pointed out to me in one of my classes, and it seems like a small thing, but it's really not, is I would make sure you're keeping a paper copy of that, not an electronic copy of that, because down the road whoever's helping with this estate may not be able to open an electronic file.  It may be such a different media down the road.

Okay, now, remember, 2010, we had no estate tax.  We had a $5 million GST exemption.  2011 and '12, we have a $5 million GST exemption, 35% rate.  Portability does not apply for GST purposes, okay?  So unlike a surviving spouse's ability to utilize the predeceased spouse's unified credit for gift and estate tax purposes, this doesn't shift over for GST.  That creates a very big problem, because most of your wealthy clients are going to want to have property transferred at the first death into a trust that's exempt for both children and grandchildren.

Now, a couple of what we'll call bookkeeping or record-keeping issues, estate tax returns, making the portability election, along with all the supporting documentation should be saved indefinitely, because of the unlimited statute of limitations.  You want to track any last deceased spouse's unused exemption amount, and it's used to document how much was used and when.  The use of GST exemptions has to be monitored carefully because, again, it's going to differ from the estate tax and gift tax exemptions because portability's not available.

When you're preparing gift tax returns on a going-forward, if somebody's spouse has died, you're going to have to look into whether you have any of the DSUEA, and you're going to have to determine the ordering rules.  Right now, we do not know that if somebody died in January of 2011, you filed to take portability, and then a gift is made in December of 2011, is the surviving spouse using her exemption or the amount that transferred over from her husband?  Again, the ordering rules are not out there yet.  If ordering rules are created, they're going to have to be carefully tracked and monitored.

Now, it may also be advisable to attach a schedule to any gift tax return listing the source of all prior DSUEA amounts and to basically provide records that are available, make this as simple as possible.

Now, when you look at the 706 by schedule, nothing has really changed.  The biggest thing you're going to have to pay attention to is if you do not want to transfer the portable amount, you're going to have to make a specific election not to transfer that portable amount.  Otherwise it's automatic.

Now, from a retirement planning standpoint, again, portability is a great thing, because it allows my wife to take my IRA, roll it into her own name and not have to worry about the estate tax.  Once we get past 2013 and we know what the rule is going forward, this will be the way -- this will change the face of estate planning for IRAs for married couples.  In the meantime, proceed like you have in the past, try to fund the bypass trust at a person's death, do not get caught up in this notion that portability is sure, a certain thing.

Again, for the two estates we're representing for people in their 80s, we pretty much ignored portability.  I mean, we'll file the returns.  We'll take whatever portability is left.  But we're pushing everything we can into the bypass trust.

Now, let's say I died and I was worth $3.8 million.  I die today.  You would file an estate tax return for me.  Even if the 3.8 went into the bypass trust, you would still file an estate tax return for me, and what you would do is you would then -- everything that I didn't put in the bypass trust would transfer over to my spouse.  So everything that I didn't put in the bypass trust would transfer over to my spouse.  That would create an incredible opportunity.

Now, we fund to the bypass trust, but now my wife's exemption would be her 5 million plus whatever I ported over, and that's exactly what you're going to want to do.  If clients do not want to file the 706 because of the cost, you need to protect yourself, protect the lawyer that you're working with on the estate administration and get the client to sign off on that, get the heirs to sign off that they're throwing away that DSUEA amount.

So we've covered a lot of ground today.  This is a very interesting topic.  I think what you should really look at is, think about the best way for each client.  And remember that funding the bypass trust is going to make sense with or without portability for three reasons:  One, you can allocate GST exemption to the bypass trust.  You cannot -- GST exemption does not transfer for portability purposes.  Two, if that bypass trust -- if I die today and my bypass trust grows from 5 million to $20 million by the time my wife dies, that entire 20 million is excluded from her estate.  On the other hand, if we -- my wife just took my exemption amount, my 5 million, and that grew to 20 million in her estate, 15 million would be subject to estate tax, only 5 million would be exempted.  And finally, remember what the credit shelter trust does for you.  It provides you with spendthrift protection, creditor protection, divorce protection, investment management and, of course, the estate planning we've been talking about.

There's a lot here.  Portability is a very big issue.  We have a number of other podcasts out on our website you may want to listen to, and I just want to thank you very much for being here today.  There is a lot we covered.  And just to review, you need to file a 706 to make all this work.  So you're going to have to file a 706 to make this work.

So again, thank you for being with us today.  Keep up with the latest news and resources to help you navigate issues such as these in your practice.  Be sure to read the AICPA PFS News, which is delivered to PFP Section members weekly via e-mail.  For regular updates on legislative, regulatory news, visit AICPA.org/PFP/advocacy.

On behalf of the AICPA, this has been Bob Keebler, and thank you for joining us today.

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