NOVEMBER 9, 2015 VOLUME 22 NUMBER 41
[Note: this article was originally written in 2015. Since then, the estate tax numbers have significantly increased. The structure we explain may still be valid, but not necessarily the numbers.]
Here’s a challenging problem for lawyers who focus on estate planning: how can we explain federal estate tax “portability” to clients in a way that helps them figure out how the concept applies to them? After five years of experience with the idea, you might expect us (collectively) to be better at this.
When Congress introduced the idea of estate tax portability in 2010, it was partly to simplify estate tax planning. In the decades before that development estate planners regularly found themselves explaining the idea of a “bypass” trust — although some favored “credit shelter” or “exemption equivalent” or “A/B” or “decedent’s” rather than “bypass.”
The bypass trust idea was not all that complicated, but it was not intuitive. First, it was only important for married couples. Second, it was much more important for couples with a taxable estate — though that included a lot more people twenty years ago than it does today. For married couples worth more than the estate tax exemption amount, though, the bypass trust was almost universal.
Here’s the basic idea: when one spouse dies, his or her share of assets subject to the estate tax — up to the amount of the estate tax exemption in place at the time of death — could be put into a trust that was treated as taxable. Since the amount going into the trust would be less than the tax limit, the amount of tax would be $0. That money would then not be taxed in the surviving spouse’s estate when she or he later died. It was fairly easy to double the estate tax exemption amount, in most cases, using the bypass trust.
Now “portability” makes that planning moot — or it seems like it might, anyway. When a spouse dies under the new rules, any unused estate tax exemption equivalent figure is passed on to his or her surviving spouse. It’s brilliantly simple in concept, but a little harder to apply in the real world (as it turns out).
Let’s consider an imaginary couple under the new portability rules. We’ll call them Dick and Jane, and they are worth a total of $8 million. Their estate plans simply leave everything to each other. When Dick dies in 2016, his $4 million (we’re going to keep Dick and Jane simple — they own every single asset jointly, with a 50/50 interest) simply passes to Jane outright. It won’t matter, for our purposes, whether that happens by his will, by the operation of joint tenancy, or by the terms of their trust or trusts.
Dick has used none of his $5.45 million estate tax exemption equivalent (that’s the new number for next year, if you didn’t already know it). Jane inherits his $4 million AND his $5.45 million in unused exemption amount. If her estate grows before her death, she still won’t owe any estate tax — even though she will be worth more than the $5 million adjusted-for-inflation figure in the year of her death.
Under the old rules, Dick and Jane would have needed to pay someone to prepare their bypass trust plan, Jane would need to actually divide the trust assets on Dick’s death, and Jane would need to give accounting information to Dick and Jane’s children for the rest of her life, while also filing separate income tax returns for the bypass trust. What a nuisance — and good riddance.
But wait. There are still times when the bypass trust is important to consider. Why? Because there are some limitations in the use of portability. Those limitations include:
- The need to file an estate tax return. Jane can’t elect the portability option after Dick’s death unless she files a federal estate tax return — it’s a nuisance and an expense. She’ll need to get at least some valuation information for all their assets, even though no tax will be due.
- State estate taxes. Arizona doesn’t apply an estate tax, and if Dick and Jane lived here, Jane decides to stay, and they own no assets in other states, then Jane won’t much care about state estate taxes. But what if she plans on moving, or they own a summer cottage in a state with an estate tax, or there is some other reason to worry about state taxes? Sometimes the bypass trust might be a better option.
- Future changes in the law. It seems unlikely that estate tax levels will drop below the current $5 million plus. But then it seemed unlikely that they would go up to $5 million, too — and yet they did. Future tax rates might change, or portability might even be done away with. The bypass trust option locks in Dick’s estate tax status as against those possible changes.
- Generation-skipping tax. If Dick and Jane intend to leave the bulk of their estate to grandchildren rather than children, or in trust for children and ultimately to grandchildren, they might want to rethink relying on portability. Why? Because the $5.45 million (in 2016) generation-skipping tax exemption does not have a portability feature. It’s unlikely to affect Dick and Jane, but it might — if they really plan on leaving much of their estates to the grandkids (and that could change over time, as the children age and gain wealth during the rest of Jane’s life).
- Assurance of inheritance. Are both Dick and Jane completely comfortable with the surviving spouse’s ability to decide to leave most or all of their combined wealth to someone outside the family? If Dick simply leaves everything to Jane, he’s trusting that she won’t have a second family, or a big interest in a charity that Dick doesn’t actually care for, or a good friend who ends up receiving some or all of their wealth. Maybe Dick and Jane aren’t worried about this problem, but maybe they are — at least a little bit.
- Growing wealth. Jane likely won’t add another $2 million or more to her wealth after Dick’s death — but she might. If she does, that could subject assets to the estate tax, and creating a bypass trust could have possibly avoided that eventuality.
Portability is a great boon to couples with straightforward estate plans and estates well under twice the taxable level. But it’s not a panacea, and it just makes the explanation process more complicated for us when we talk with couples about their estate planning. We hope this outline of the issues helps speed up that process.