Portability was added to the estate planning landscape by the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (2010 Tax Act).1 The provision seemingly simplifies estate planning, since it permits a decedent to transfer her entire estate to her surviving spouse free of federal estate tax by operation of the marital deduction without fear of wasting her federal estate tax exemption.2

Portability, however, raises a number of concerns, such as its continued usefulness in light of its scheduled sunset, the inability to port the generation-skipping transfer (GST) tax exemption, and the unavailability of portability for state estate tax purposes.3

With the issuance of Notice 2011-82, the Internal Revenue Service clarified some of the issues left unanswered by the statute. In June 2012, the IRS issued temporary and proposed regulations (the regulations) that go far in resolving the outstanding issues, largely to the benefit of the taxpayer. In addition, the Obama Administration, in its Fiscal Year 2013 Revenue Proposals, has proposed making portability permanent.

In light of the foregoing, it is incumbent upon the personal representatives of estates of decedents dying in 2011 and 2012 and their surviving spouses to consider whether—and, if so, to what extent—to take advantage of portability, especially in light of the current favorable transfer tax environment.

Defining Unused Exclusion

Section 2010(c)(2) of the Internal Revenue Code4 defines a surviving spouse’s applicable exclusion amount as equaling the sum of (i) the “basic exclusion amount” and (ii) the “deceased spousal unused exclusion amount” (DSUEA5), if any. The basic exclusion amount is defined in §2010(c)(3) as $5 million, adjusted for inflation ($5.12 million in 2012). The DSUEA, as defined in §2010(c)(4), is interpreted in the regulations as being the unused portion of the last decedent’s applicable exclusion amount to the extent it does not exceed such decedent’s basic exclusion amount in effect at his death (taking into account the decedent’s taxable estate and adjusted taxable gifts).6 The preamble to the regulations notes that although §2010(c)(4)(B)(i) refers to the “basic exclusion amount” in order for that provision to have meaning, the regulations interpret that term as meaning the decedent’s applicable exclusion amount.7

One question that arose regarding the computation of the DSUEA was whether to take into account a taxable gift made by the deceased spouse for which gift taxes were paid because there was an insufficient exclusion amount available in the year the gift was made. The regulations clarify that amounts on which gift taxes were paid are to be excluded from adjusted taxable gifts in computing the DSUEA.8

Procedure

The portability election must be made by the executor, or if there is none, by the person in actual or constructive possession of any property of the decedent.9 It is made by filing a complete and properly prepared Form 706, the U.S. Estate (and Generation-Skipping Transfer) Tax Return, whether or not the return is otherwise required.10 If an estate tax return is required in any event, the executor can opt out of this automatic election by making an affirmative statement to that effect on or attached to the return.11

The election is deemed irrevocable as of the due date for the return (including extensions).12 For estates that are not otherwise required to file a return, the return will be considered timely if it is filed by the date that it would have been due had a return been required.13

The DSUEA is effective as of the decedent’s date of death. Therefore, the surviving spouse is permitted to make gifts prior to the actual filing of the Form 706 electing portability.14

Proper Documentation

A “complete and properly prepared” return is one that is in accordance with the Form 706 instructions and otherwise meets the normal requirements for an estate tax return.15 The return must document the fact that the deceased spouse’s taxable estate (that is, after application of any marital, charitable or other available deductions) was less than her basic exclusion amount.16 Until such time as the IRS releases a new Form 706 that provides for the computation of the DSUEA,17 consistent with Notice 2011-82, a complete and properly prepared return will be considered sufficient documentation of the DSUEA.18

For estates that are not otherwise required to file, the regulations provide some measure of relief from the burden of valuing the assets reported on the return. For such estates, the executor only need report an estimated value for property that qualifies for the marital and charitable deduction, along with the description, ownership and beneficiary of such property and the information necessary to establish the right of the estate to the marital or charitable deduction.19 The regulations require the executor to exercise due diligence in estimating the fair market value of the gross estate, including the property to which this special rule applies.20 Until a final revised estate tax return is released, the executor must include a statement with the estate tax return signed under penalties of perjury giving his best estimate of the total gross estate, rounded to the nearest $250,000.

An estate will not benefit from this special rule in the following circumstances: (i) if the value of the marital or charitable deduction property impacts on the determination of the value of the interest passing from the decedent to another beneficiary; (ii) the value of the marital or charitable property impacts on the estate’s eligibility under any other provision of the Internal Revenue Code;21 (iii) less than the entire value of an interest in property is eligible for the marital or charitable deduction; or (iv) a partial disclaimer or partial qualified terminable interest property (QTIP) election is made with respect to marital or charitable deduction property.22

Ordering of the DSUEA

The DSUEA is limited to the unused exemption amount of a surviving spouse’s “last deceased spouse.” This provision generated some uncertainty in the context of remarriages and multiple pre-deceased spouses. The regulations address this issue.

The “last deceased spouse” is defined as the most recently deceased individual who, at the individual’s death, was married to the surviving spouse.23 The subsequent marriage of the surviving spouse does not unseat a last deceased spouse; it only will change if and when the new spouse predeceases the surviving spouse. Accordingly, the DSUEA from that predeceased spouse will be available to the surviving spouse as long as her new spouse is living.24 Conversely, if the new spouse predeceases the surviving spouse, she can use that spouse’s DSUEA, if any, even if she already used the DSUEA inherited from the prior deceased spouse.25 For example, a surviving spouse inherits a $5 million DSUEA from her deceased spouse and applies it against $5 million of gifts. The surviving spouse remarries but is predeceased by her new husband who also leaves a DSUEA of $5 million. The surviving spouse will be able to use that $5 million DSUEA as well.

The regulations provide, in a rule favorable to taxpayers, that a surviving spouse will be deemed to use the inherited DSUEA before her own basic exclusion amount.26 Therefore, if a surviving spouse remarries and then predeceases her new husband, she may have a DSUEA to pass on to him.

Authority to Examine Return

Section 2010(c)(5) gives the IRS authority to examine returns of a decedent to determine the allowable DSUEA, notwithstanding that the applicable statute of limitations may have run (e.g., by the time of the surviving spouse’s death). Under the regulations, the scope of any such examination is limited to the adjustment or elimination of the DSUEA and does not extend to assessing additional tax with respect to such deceased spouse’s return.27

2012 Planning for DSUEAs

In light of the scheduled expiration of portability at the end of 2012, the benefit of the election must be weighed against any additional costs for so electing, especially if a federal return would not otherwise be required.28 If a federal estate tax return is required, there should be little cost differential for effecting a portability election. The same is true in a state like New York, where, if a state return is required, a pro-forma Form 706 must be submitted with it. There will be some added cost, however, associated with the time required to analyze the impact and necessity of a portability election and to document the decision.29

Also, in light of the pending sunset of portability, a surviving spouse who has inherited DSUEAs in 2011 or 2012 should consider using them before the end of the year. Unless portability is extended, the DSUEA will cease to be available to offset her gifts and her taxable estate in 2013 and thereafter.

If the surviving spouse is financially able and willing, she can make gifts in 2012 and thereby benefit from her inherited DSUEA, without necessarily using up any of her own basic exclusion amount.30 Of course, in light of the potential reversion to a $1 million applicable exemption, it may make sense for her to use her $5.12 million exemption as well.31

Pros and Cons

In a typical estate plan for a married couple domiciled in New York32 whose combined estates are likely to exceed the applicable exemption amount, a non-marital trust (the family trust) is created that will be funded with the maximum amount that can pass free of both federal and state estate tax (e.g., $1 million), which trust could be for the benefit of the surviving spouse and possibly other beneficiaries, such as descendants. The balance of the estate then will pass to the surviving spouse either outright or in a trust that can qualify for the marital deduction (the marital share). With such a plan, prior to portability, the balance of the deceased spouse’s exemption usually would be wasted.

In some instances, however, it may be preferable to preserve the decedent’s exemption by funding the family trust with the full amount that will pass free of federal estate tax, albeit not free of state estate tax (a fully funded family trust). Although a state estate tax will be incurred upon the first spouse’s death, an increased amount (which amount could include the appreciation in and income on the trust property) will be protected from estate tax on the surviving spouse’s death.

As long as portability exists, it no longer may be necessary to incur the upfront state estate tax in order to preserve the deceased spouse’s exclusion amount in excess of $1 million. Instead, such excess will convert to a DSUEA, available to the surviving spouse to apply against lifetime gifts or offset her estate. By relying on portability instead of a fully funded family trust, however, since portability does not apply to the GST exemption, the deceased spouse’s GST exemption still may be wasted. Also, unless the surviving spouse makes gifts soon after the first spouse’s death, any appreciation and income on the inherited property could be subject to transfer taxes, which would not be the case with a fully funded family trust. Nevertheless, depending upon the size of the surviving spouse’s estate and her inclinations, reliance on portability may be the best solution.

As suggested above, portability gives the estate planner an additional tool for conserving gift and estate taxes. Whether it makes sense to rely on it will depend upon the facts and circumstances at the time of the first spouse’s death. Based on the foregoing, coupled with the uncertain future of portability, it is advisable to incorporate into testamentary documents as much flexibility as possible. Such flexibility can be achieved by drafting for disclaimers, for partial QTIP elections as well as for portability.

Linda Hirschson is a shareholder and chair of the estate planning group at Greenberg Traurig in New York. Shifra Herzberg is an associate in the group.

Endnotes:

1. §303(a), Pub. Law 111-312, amending IRC §2010(c).

2. The portability election, however, is not available to the estates of non-resident alien decedents. Treas. Reg. 20.2010-2T(a)(5); Treas. Reg. 25.2505-2T(f). Note, too, for property passing to a non-citizen surviving spouse in a qualified domestic trust, the surviving spouse only can use the unused exemption for gifts in the year of the surviving spouse’s death or at the surviving spouse’s death. Treas. Reg. 20.2010-2T(c)(4); Treas. Reg. 25.2505-2T(d)(2).

3. See TSB-M-11(9)M, indicating portability does not apply to the New York state estate tax.

4. Hereafter, all section references are to the Internal Revenue Code of 1986, as amended, unless otherwise indicated.

5. The regulations use the term “DSUE amount.”

6. Treas. Reg. 20.2010-1T(d)(4).

7. Preamble at 13-14.

8. Treas. Reg. 20.2010-2T(c)(2).

9. Id. at 20.2010-2T(a)(6).

10. Id. at 20.2010-2T(a)(2).

11. Id. at 20.2010-2T(a)(3).

12. Id. at 20.2010-2T(a)(4). Query whether an estate that filed an estate tax return that did not reflect any available DSUEA will be deemed to have elected portability if the values on the return are later adjusted such that a DSUEA becomes available.

13. Id. at 20.2010-2T(a)(1).

14. Id. at 20.2010-3T(c); id. at 25.2505-2T(d). This is particularly relevant for decedent’s dying at the end of 2012, where the estate tax return won’t be filed until 2013, at which time portability may no longer exist.

15. See id. at §§20.6018-2, 20.6018-3, and 20.6018-4. Id. at §20.2010-2T(a)(7).

16. Id. at 20.2010-2T(b).

17. On Aug. 16, 2012, the IRS released a draft Form 706 which covers portability.

18. Executors that file pursuant to this transitional rule will not be required to file a supplemental return incorporating the DSUEA calculation. Treas. Reg. 20.2010-2T(b)(2).

19. Id. at §20.2010-2T(a)(7)(ii).

20. Id.

21. Including, without limitation, §§2032, 2032A and 6166.

22. See examples at Treas. Reg. §20.2010-2T(a)(7)(ii)(C).

23. Id. at §20.2010-1T(d)(5), 20.2010-3T(a); see also id. at 25.2505-2T(a).

24. Id. at 20.2010-3T(a)(3), 25.2505-2T(a)(3). If the surviving spouse remarries and then divorces the new spouse, she can still use the DSUEA of the prior deceased spouse.

25. Id. at 20.2010-3T(b), 25.2505-2T(c).

26. Id. at 25.2505-2T(b).

27. Id. at 20.2010-2T(d), 25.2505-2T(e).

28. This additional cost may be mitigated to some degree by the special rule for marital and charitable deduction property, if applicable.

29. In New York, the federal QTIP election is binding for New York estate tax purposes even where a federal return is filed solely to take advantage of portability. TSB-M-11(9)M. Query if there is any detriment to the fiduciary making a QTIP election on the federal return so as to preserve it for New York State purposes.

30. Note that New York does not levy a gift tax and the gifted property should be out of her estate for New York estate tax purposes.

31. In deciding whether or not to do so, the surviving spouse and her advisors also need to consider the possible loss of a step-up in basis with respect to the gifted property. There may be various techniques available to enable the donor’s estate to take advantage of the step-up in basis, but they are beyond the scope of this article.

32. The same analysis may be applicable to other states that are de-coupled from the federal estate tax.