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Banking & Finance Law Report

Federal Estate Tax and Portability

Posted in Estate Planning And Use Taxation

As a part of the tax changes enacted by Congress in late 2010, the concept of "portability" was introduced into the estate tax law. The implications of this change will be of interest to professionals, business owners and executives.  Careful consideration must be given to the results of estate plans that incorporate this change in the law.

Under portability, when the first spouse dies, his or her estate can elect to transfer any federal estate tax credit (currently equal to the tax on $5,000,000 but scheduled to fall to $1,000,000 under current law) of the deceased spouse to the surviving spouse. Portability permits one spouse to leave all of his or her property to the other spouse without the use of a credit shelter trust and still avoid tax on an amount equal to twice the credit at the second spouse’s death. Under prior law, most married persons with estates equal to the amount of the credit equivalent created a trust to hold the portion of their estate equal to the credit in order to avoid losing their credits. This trust, known as a credit shelter trust, does not qualify for the marital deduct and, thus, is not subject to federal estate tax in the second spouse’s estate.

To take advantage of portability, it is necessary that the estate of the deceased spouse file a federal estate tax return, Form 706, within nine months of the date of death. Failure to timely file the form will result in the loss of portability.

Relying on portability, however, may not produce the best result.

First, Congress may change the law and eliminate portability. Estate plans relying on portability would then be ineffective.

Second, even if portability remains in the law, there are still advantages to having a credit shelter trust in place.  Consider the following example based on an estate tax credit of $1,000,000 and 55% estate tax (the law after December 31, 2012 unless Congress and the President act).

Without Credit Shelter Trust

Spouse 1 dies with an estate of $1,000,000.  Spouse 2′s assets at that date are valued at $1,000,000 as well.  The proper filing is made as described above.  The $1,000,000 passes federal estate tax free to spouse 2.  Between the dates of Spouse 1′s death and Spouse 2′s death, the $2,000,000 of assets now owned by Spouse 2 appreciates by 50% to $3,000,000.  Spouse 2 would have a total exemption of $2,000,000, leaving $1,000,000 to be taxed at 55%, producing a federal estate tax of $550,000.

With Credit Shelter Trust

Spouse 1 dies with an estate of $1,000,000.  Spouse 2′s assets at that date are valued at $1,000,000 as well.  Spouse 1 has a credit shelter trust.  The $1,000,000 passes tax free to that trust.  Between the dates of Spouse 1′s death and Spouse 2′s death, the $1,000,000 now owned by Spouse 2 appreciates by 50% giving that spouse $1,500,000.  The $1,000,000 in the credit shelter trust also appreciates to $1,500,000.  No portion of the credit shelter trust’s assets will be subject to tax at Spouse 2′s death because that spouse does not own those assets.  Spouse 2 would have a total exemption of $1,000,000, leaving $500,000 to be taxed at 55%, producing a tax of $275,000.

As you can see, in this example the credit shelter trust produces substantially less tax than the portability planning.  While portability is a safety net for decedent’s who have failed to do the proper planning, the use of credit shelter trusts will still be beneficial for many taxpayers.