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Portability and Re-Marriage—A Match Made in IRS Heaven

As a result of the enactment of the American Taxpayer Relief Act of 2012, portability was made permanent in the transfer tax system. But what is portability and how does it affect individuals who remarry?

The Federal government, and many states impose an estate tax which is calculated on the value of your assets when you die.  As a rule, the first $5,450,000 (2016 exemption) is excluded for Federal Estate tax purposes, however, if you are a resident of New York State, the current exemption amount is $4,187,500. This is a cumulative lifetime exemption, however taxable gifts made during your lifetime utilize part of this exemption.  Upon death, the remaining exemption is essentially applied to the remaining estate. Transfers to spouses, either by gift or at death, are not subject to estate or gift tax due to the unlimited marital deduction.

Under prior law, it was important to set up a credit shelter trust on the first spouse upon death in order to utilize their exemption.   (Leaving everything to the first spouse essentially squandered the first exemption on the first spouse's death.)  This credit shelter trust would provide income to the current spouse during their lifetime with the remainder going to the children upon the death of the second spouse.  The balance of this credit shelter trust would then pass outside of the estate of the second spouse and would not be taxed.
If you follow proper compliance procedures, you can port the exemption of the first spouse to the second spouse without utilizing a credit shelter trust on the death of the first spouse.

The exemption ported is known as the “Deceased Spouse Unused Exemption” or DSUE.  A surviving spouse can utilize the DSUE of the LAST deceased spouse through gifting or on the surviving spouse's estate tax return.  For example, if the first spouse did not use their exemption and the entire $5,450,000 was available then, upon death, the second spouse would have a $10,900,000 exemption available for their estate.

The DSUE can also be utilized by the surviving spouse through gifting during their lifetime. Taxable gifts made by the surviving spouse, should first be applied against the DSUE before utilizing their own remaining exemption.  This becomes very important in a second marriage.  The DSUE is that of the LAST deceased spouse, therefore, if the surviving spouse was to remarry and not utilize the DSUE through gifting, and the new spouse was to die, the only available exemption to the surviving spouse would be that of the LAST deceased spouse.

Here is an example:

John was married to Mary who died in 2016. The executor for Mary's estate properly filed an estate tax return indicating $4,000,000 in remaining exemptions to carry over to John. John subsequently got married to Susan.  Susan utilized all of her exemption through gifting to her children from her first marriage. Susan subsequently dies.  There is no DSUE from Susan's estate to be utilized by John.  Mary's DSUE is gone.

There is a simple solution to this problem if John was willing to do some gifting. John can make taxable gifts to anyone other than his current wife and utilize Mary's exemption.  But it is important that this is done as soon as possible, in case of the unfortunate demise of Susan.

There is no limitation on the number of re-marriages or uses of last deceased spouse's unused exemption.  The new spouse's DSUE becomes a negotiation tool for pre-nuptial agreements.

Portability election requires the filing of a return for the estate of the first deceased spouse, even if that estate is too small to require filing otherwise.  It must be elected on a timely filed return including extensions.  If not filed timely, a private letter ruling request may be required, which is expensive to obtain but is typically easily approved.

Testamentary trusts are still very important as portability only applies to Federal Estate tax.  It does not apply to Generation Skipping tax (GST) and may not apply to State estate tax.  (It is currently not available for NYS Estate tax.) 

This is best explained through an example:

John & Mary had two children (Aidan and Emma). Mary's will provides for the creation of a trust, which gives income to John during his lifetime with the residuary after John's death to stay in two separate trusts for each of their children.  Aidan and Emma's individual trusts are ultimately distributed to their children upon the death of Aidan or Emma.  Without application of the GST exemption, this trust would be subject to GST tax upon distribution to Aidan and Emma's children. 

Mary's estate consists of:
50% interest in 1st Street LLC (owning real estate) $ 5,000,000
Brokerage account     1,000,000
IRA      2,000,000
Joint assets with John    3,500,000
                                                 
The executors choose to fund the testamentary trust with 50% interest in the LLC and $450,000 in cash from the brokerage account.  They elect to apply Mary's entire GST exemption to this trust ($5,450,000),  which will then have what's known as a “zero inclusion ratio”. Distributions from this trust to the grandchildren will be exempt from GST tax.

Utilization of testamentary trusts may also remove growth from the second spouse's estate as seen in this example:
Rather than elect to carry forward Mary's exemption as a DSUE, Mary's will allows this trust to qualify as a credit shelter trust, fully utilizing her exemption on her estate tax return.  Upon John's death 10 years later, the value of the 50% LLC interest has grown to $15,000,000.   Had a credit shelter trust not been used, this entire $15,000,000 would be included in John's estate, utilizing Mary's DSUE of $5,450,000. Therefore the growth of the asset would not escape estate taxation.

There are additional decisions relating to the use of the applicable State exemption which may provide for use of a lesser exemption in Mary's estate.

The many intricacies of portability have changed the face of estate planning for good. Because each person's estate plan is unique, no one plan fits all and the use of portability to tailor that plan is no longer a secondary but a primary tool that needs to be considered at the onset of planning.

If you have any further questions regarding portability and its use in your estate plan, contact Lisa Rispoli, Partner, Trust & Estates Practice Leader of Grassi & Co., at lrispoli@grassicpas.com.