United States: Planning For The $5-$10 Million Couple: Portability Or Credit Shelter?

Background

In 2009, each individual had a $3.5 million estate tax exemption. If a married individual had assets over $3.5 million, without careful planning, those assets in excess of $3.5 million would fall subject to a 45% estate tax. Careful planning often included retitling assets between spouses and utilizing a credit shelter trust (typically, a trust for the benefit of the surviving spouse and children created to hold assets equal to the remaining exemption of the first spouse to die). Additionally, if the first spouse to die did not utilize his or her exemption, whatever remained of his or her unused exemption at death was lost forever.

Example 1: Harold and Wilma (married) have a combined estate of $7 million. Harold and Wilma each have a Will leaving their entire estate outright to the surviving spouse. Wilma dies on January 1, 2009. At Wilma's death, Wilma's entire estate passes to Harold's estate tax free. Harold dies on December 31, 2009. At Harold's death, $3.5 million of Harold's estate ($7 million less his $3.5 million exemption) is subject to estate tax at 45% resulting in a $1,575,000 estate tax bill. Sadly, this result could have been avoided by Harold and Wilma retitling the assets so that each owned assets valued at $3.5 million and revising their Wills incorporate credit shelter trusts. If Harold and Wilma had done this, their estates would not have owed estate taxes.

To help couples like Harold and Wilma who did not plan, in 2010, Congress introduced the concept of "portability" as part of the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (the "2010 Act"). The 2010 Act sunset in 2012, but Congress made portability permanent in early 2013 as a part of the American Taxpayer Relief Act of 2012 (the "2012 Act"), which also permanently fixed the estate tax rate at 40%. The 2012 Act also permanently fixed the estate tax exemption amount at $5 million, indexed annually for inflation. In 2016, the estate tax exemption is $5.45 million.

Note that the 2012 Act also fixed the individual generation-skipping transfer tax exemption amount (an extra level of tax that applies to gifts and bequests made to grandchildren and other individuals significantly younger than the donor) at $5 million, indexed annually for inflation. In 2016, the generation-skipping tax exemption is $5.45 million.

Portability

Portability is the ability of a surviving spouse to utilize a deceased spouse's unused lifetime estate tax exemption ("DSUE"). In other words, if a married couple fails to properly plan prior to the first death, the surviving spouse still has the ability to utilize the deceased spouse's unused estate tax exemption.

Example 2: Same facts as Example 1 except that Wilma dies on January 1, 2016, and Harold dies on December 31, 2016. At Harold's death, he is able to use his $5.45 million exemption, and he is also able to use Wilma's unused $5.45 million exemption. As a result, neither estate will owe estate taxes.

Relying on portability (leaving everything outright to the surviving spouse or to a marital trust) has advantages, including, primarily, simplicity. Another advantage to relying on portability, especially in this age of rising income tax rates, is the fact that the basis of assets left outright or in a marital trust for the surviving spouse will be stepped up to the fair market value of those assets on the death of the surviving spouse.

Example 3: Henry and Wendy (married) have a combined estate of $10 million, consisting of assets that are all titled in Henry's name. Henry and Wendy have Wills that leave all of their assets outright to the surviving spouse. Henry dies on March 1, 2016. At Henry's death, no estate taxes are owed. Wendy dies ten years later on March 1, 2026 at a time when the assets have appreciated at a rate of 12% per year to $31,058,482 and the estate tax exemption is $7 million. At Wendy's death, she can use her $7 million exemption and Henry's DSUE amount of $5.45 million with the result that $7,443,393 of estate taxes is due (($31,058,482-$12.45 million)*(40%)). If the assets are sold immediately following Wendy's death, no income taxes will be due because the basis in each of those assets was stepped up to the fair market value on the date of Wendy's death.

However, relying solely on portability also comes with several disadvantages, including the fact that the DSUE amount is not indexed for inflation. Additionally, relying on portability can also be risky. For a surviving spouse to take advantage of his or her deceased spouse's DSUE, the decease spouse's estate must have filed an estate tax return. This is an often overlooked requirement of portability. Additionally, if the surviving spouse remarries, the DSUE amount could be lost if the new spouse predeceases the surviving spouse. Finally, portability only applies to an individual's estate tax exemption amount. It does not apply to an individual's generation-skipping tax exemption amount.

Continued Use of The Credit Shelter Trust

While the relevance of the credit shelter trust has been a hot topic for the past three years, the estate planning community has come to the conclusion that, while the credit shelter trust is not the gold standard that it was prior to 2010, it is still a handy tool in an estate planner's toolbox.

The credit shelter trust shields the assets (including appreciation) from estate tax on the surviving spouse's death, but does not allow for a basis step-up on those assets on the surviving spouse's death. In other words, the decision whether or not to utilize a credit shelter trust or rely on portability is primarily a question of whether it would be cheaper to pay estate taxes or income taxes, which primarily depends on a couple's assets. A couple with total combined assets close to $5 million and whose children intend to sell the assets following both spouses' deaths might benefit more from portability. However, a couple with appreciating assets may benefit more from the credit shelter trust primarily because, as stated above, the DSUE amount is not indexed for inflation.

Example 4: Same facts as Example 3 except that Henry and Wendy's Wills utilize the credit shelter trust by leaving an amount of assets equal to their estate tax exemption to a trust for the benefit of the surviving spouse and children and the remaining assets outright to the surviving spouse. At Wendy's death, the credit shelter will own assets equal to $16,926,873 ($5.45 million assuming a growth rate of 12%). Wendy will own $14,131,609 of assets ($10 million less $5.45 million, assuming a growth rate of 12%). At Wendy's death, her estate will owe $2,852,644 of estate taxes. If the assets are sold immediately following Wendy's death, income taxes of $2,295,375 will be due on the assets in the credit shelter trust (($16,926,873 -$5,450,000)*(20% capital gains tax rate)). This totals $5,148,019 in taxes. Utilizing a credit shelter trust has saved Henry and Wendy total taxes of $2,295,375 ($7,443,393-$5,148,018).

Finally, as previously stated, portability does not apply to the generation-skipping tax exemption. Therefore, a couple who wishes to provide significant benefits to their grandchildren may benefit more from the use of the credit shelter trust because the deceased spouse's remaining generation-skipping tax exemption amount can be applied to the credit shelter trust.

Planning Notes

Unfortunately, since estate planners cannot predict the future, the key to a successful estate plan for couples in the $5-$10 million net worth range is flexibility. Often, this translates into incorporating techniques that allow couples to defer decision making until the death of the first spouse.

For example, if the spouses would prefer to leave assets to each other outright, planners may want to include a standby credit shelter trust (a "disclaimer trust") so that, at the death of the first spouse, the surviving spouse and his or her advisors can decide whether the surviving spouse should accept the assets outright, or, instead, place assets in a credit shelter trust.

For the couple that elects to utilize the credit shelter in their Wills, many planners are now including a provision that allows the trustee to grant the surviving spouse a "general power of appointment" over the credit shelter trust assets so that those assets will be included in the surviving spouse's estate at death. If needed, this will allow the assets in the credit shelter trust to receive a step up in basis.

If the spouses would prefer to leave assets to each other in marital trusts, which do not utilize the deceased spouse's estate tax exemption amount, the Will could include a provision so that, at the death of the first spouse, the surviving spouse and his or her advisors could choose to have some of those assets pour into a credit shelter trust (a "Clayton QTIP").

Finally, while the generation-skipping tax exemption amount is not portable, the "reverse QTIP" election is available to utilize the deceased spouse's unused generation-skipping tax amount for those couples choosing to leave all of their assets to each other in marital trusts.

Closing Thoughts

Portability, while allowing more estate planning flexibility, does create an additional level of complexity for those couples with a $5-$10 million net worth that makes planning more important than ever.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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