In December 2010, Congress passed the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010. TRA 2010 extended the provisions of several previously enacted pieces of legislation that were set to expire after 2010, including the Economic Growth and Tax Relief Reconciliation Act of 2001, or EGTRRA. In addition, TRA 2010 also made a number of significant changes to the tax laws. Several of these changes have caused a number of people to call into question the need to utilize estate planning, an idea that could prove to be detrimental for many individuals if they do not carefully think through the issues.
One of the fundamental building blocks of a married couple’s estate plan has been the use of what is known as an A-B trust. Section 2010 of the Internal Revenue Code grants to every individual an “applicable exclusion amount.” This is the maximum amount that one may transfer to a nonspouse free of tax via gifts or through their estate. An A-B trust takes advantage of the applicable exclusion amount by funding a credit shelter trust with the unused portion of a deceased individual’s applicable exclusion. The remaining funds can either pass outright to the surviving spouse or to a trust for his or her benefit. This plan results in no estate tax being incurred at the death of the first spouse while maximizing the amount that the couple transfers tax free.
Prior to TRA 2010, A-B trusts were necessary because the applicable exclusion amount had a “use it or lose it” aspect to it, i.e., any unused amount vanished if it was not used by the individual to whom it belonged. TRA 2010 has called into question the need for the A-B trust because, for the first time in history, any unused applicable exclusion amount can be transferred to a surviving spouse through what is known as portability. Additionally, the applicable exclusion amount has been increased to $5 million per individual. This combination of provisions has caused many couples to arrive at the conclusion that they do not need to employ estate planning because one can now simply pass his or her assets outright to the surviving spouse, who will then possess the ability to transfer an estate worth $10 million free of tax. While this line of thought may seem reasonable at first, there are many reasons that the use of a credit shelter trust is still important, and a failure to utilize this tool may prove costly.
Though the driving force behind utilizing an A-B trust is to maximize the use of the applicable exclusion when portability is unavailable, trusts have a number of other benefits. For example, assets held in trust are protected from the creditors of the trust’s beneficiaries and such a transfer locks in a decedent’s disposition of his or her estate. The usefulness of these benefits can be seen in the following example:
Consider a surviving spouse who remarries. If assets are passed outright to the surviving spouse, the new spouse may be able to grab those assets in the event of a divorce or through use of the elective share, two situations where assets may not go to the deceased individual’s descendants. Additionally, notwithstanding the wishes of the deceased spouse, if a transfer is made outright to a surviving spouse, that spouse can do whatever he or she wishes with those assets, including giving those assets to his or her new spouse.
Another example of the advantages of these two benefits working together can be seen in the context of medical assistance eligibility. If assets are transferred outright to a spouse who may need nursing home care, he or she will need to spend down those assets to receive medical assistance, thus preventing any of those assets from passing to children. A well-drafted trust can help to avoid both of these situations and ensure that a decedent’s estate remains protected and passes according to his or her wishes.
Another advantage of using a credit shelter trust is that once assets are placed in trust, they can appreciate in value without incurring additional estate tax, thus allowing for more value to pass to future generations free of the estate tax. If assets are transferred outright to a spouse, any appreciation of those assets will increase the value of the combined marital estate, which may be subject to tax.
The potential benefit of this, and one drawback of portability, can be demonstrated when comparing the use of a trust to a couple who chooses to rely upon portability because their combined estate is less than twice the applicable exclusion. Under TRA 2010, the applicable exclusion available to a surviving spouse is the combination of the surviving spouse’s applicable exclusion amount in effect at his or her death and the unused portion of the deceased spouse’s applicable exclusion amount. This means that there is no certainty as to what exclusion a surviving spouse may have at his or her death. If the applicable exclusion amount decreases after the death of the first spouse, the surviving spouse will not, as anticipated, have double the deceased spouse’s exclusion to use at his or her death.
This could prove problematic if the assets transferred outright to a surviving spouse appreciate in value post-death. For example, assume a married couple has a combined estate worth $6 million when the husband passes away in 2012, leaving his estate outright to his wife. Barring an act of Congress, in 2013 the applicable exclusion amount is slated to be reduced to $1 million. Assume further that the wife passes away in 2013 and that the value of the combined estate has appreciated in value to $7 million. This means that the wife will only have an applicable exclusion of $6 million, thus subjecting $1 million to estate tax. By relying upon portability, the couple has incurred additional estate taxes on the appreciation of the husband’s assets. Had the husband’s exemption been used at his death in conjunction with a trust, the wife’s estate could have avoided paying some, if not all, of this additional tax because at least a portion of the appreciation in value would have been sheltered from estate tax.
Even if one were to ignore the benefits derived from the use of a trust, there are a number of pitfalls that may result from reliance on portability. For example, portability only applies if the executor of the deceased spouse’s estate makes an affirmative election to allow for the surviving spouse to utilize the unused applicable exclusion amount. The election is made on the federal estate tax return. It is not inconceivable that an executor might forget to file a return if the estate were not subject to tax. This would result in a loss of the deceased spouse’s applicable exclusion amount and could result in an increase in the estate taxes incurred at the death of the surviving spouse.
An additional reason to avoid reliance on portability is that a surviving spouse may only use the unused exclusion of his or her last spouse. This means that if portability is relied upon and a surviving spouse remarries, he or she may have thrown away the deceased spouse’s exclusion that could have otherwise been used to transfer assets free of estate tax.
One aspect of estate planning that most individuals do not consider, but is still of importance, is the generation-skipping transfer tax. Generally speaking, this is a tax imposed on transfers made to individuals who are more than one generation below the transferor. Like the estate and gift tax, there is an exclusion amount that allows transfers to be exempt from this tax. However, unlike the estate and gift tax, Congress has not provided for the portability of the GST applicable exclusion. This means that anyone having an inclination to pass wealth to generations beyond his or her children will need to utilize the GST, something that cannot be done with an outright transfer to a spouse.
Up until this point, this article has ignored one large elephant in the room: the sunset provision of TRA 2010.
TRA 2010 provides that Section 901 of EGTRRA applies to the estate tax provisions of TRA 2010. Section 901, as amended by TRA 2010, states that the provisions of the two acts shall not apply after Dec. 31, 2012. It further states that the provisions of these acts shall be treated as if they had never been enacted after 2012. A strict reading of the two acts means that, absent further legislation, it will be as though portability never existed and a deceased spouse’s applicable exclusion may not be available for surviving spouses to utilize post-2012.
To summarize, while simply relying on portability to simplify one’s estate plan may seem enticing, and in some cases may be advisable, it may not be the best method to transfer wealth. The determination as to whether or not to rely on portability is one that should be made on a case-by-case basis and probably one that should be considered with the assistance of a professional.
Peter J. Bietz is an associate with High Swartz in Norristown, where he focuses his practice on estate planning, business transactions and tax-related matters. He is a graduate of Boston University School of Law and earned an LL.M. in taxation from Villanova University School of Law in 2009. He can be reached at email@example.com. •