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Since the beginning of 2011, clients who pass away and leave their assets to their spouse have been able to bequeath not only their property, but also their unused estate tax exemption. As a result, bypass trusts are no longer necessary to preserve the estate tax exemption of the first spouse to die. Unfortunately, though, the portability of the estate tax exemption is only temporary, and is scheduled to expire at the end of the year. Recently, though, the Treasury put forth Proposed and Temporary Regulations, intended to clear up some areas of confusion around portability, and invite public comments to further press towards Final Regulations. While the regulations bring some welcome clarification - and a few positive changes for planners as well - the fact that the Treasury went through the trouble of working on regulations also suggests that they, too, expect portability to ultimately become permanent. While most planners aren't counting on the change yet, the new regulations do provide a good opportunity to better understand the details of portability and how it may play out in the future.

The inspiration for today's blog post was the recent Treasury release of proposed regulations regarding the portability of a deceased spousal unused exclusion amount (DSUEA) under IRC Section 2010. In addition to clarifying several uncertainties from the original law, the new regulations also create some favorable new planning opportunities... at least, if portability is ultimately made permanent.

Understanding Portability

The Tax Relief Act of 2010 included a provision that allows the unused portion of a deceased spouse's estate and gift tax exemption to be transferred to the surviving spouse. This new "portability" of the unused exemption was implemented by adjusting the formulas for calculating the estate tax exemption. While under the prior rules, everyone was eligible for an applicable exclusion amount, under the new rules the applicable exclusion amount is expanded into two parts. The first part is called the "basic exclusion amount" and corresponds to what was previously the entire applicable exclusion ($5,120,000 for 2012, which ties to the unified credit of $1,772,800). However, a taxpayer's total applicable exclusion amount is now the sum of the basic amount, and the so-called "Deceased Spousal Unused Exclusion Amount" (DSUEA). The DSUEA is the exclusion amount inherited from a deceased spouse to the extent it wasn't utilized.

Thus, for example, a surviving spouse's exemption could include a basic exclusion amount of $5.12M, and a DSUEA of $5.12M (unused from his/her deceased spouse), leading to a total exemption to $10.24 million! Notably, the carryover of the unused exemption applies for both estate and gift tax purposes, but not generation-skipping taxes.

Estates must file a timely estate tax return (even if not otherwise obligated to do so) in order to make a portability election and report the amount of the unused exemption that remains from the decedent as a carryover to the surviving spouse.

To prevent abuse (either deliberate or simply by circumstance), the determination of the DSUEA is calculated with respect to the last deceased spouse (who passed away after December 31, 2010, when the rules took effect). Thus, in the event of multiple marriages and a widow/widower with multiple deceased spouses, the deceased spousal unused exclusion amount is only calculated and applied with respect to the most recent deceased spouse, not the cumulative value from all prior spouses.

The new portability rules applies for decedents who pass away after 2010 (when the rules took effect) and before 2013 (when the rules lapse); in other words, portability currently applies only to those decedents who pass away in 2011 and 2012... at least, until/unless it is extended further by Congress.

Changes Under The New Regulations

Under the newly proposed regulations from the Treasury, several notable changes occur to the portability rules, providing both some administrative ease and relief, and also proactive planning opportunities.

While the new rules reiterate that it is necessary to file an estate tax return to take advantage of portability, and that the deadline is still the due date for the estate tax return (plus extensions), one notable relief is that the Form 706 may simply include an "estimated value" for property, to the nearest $250,000, if the entire amount is being left to a spouse or charity (such that the value, whatever it would be, is being offset by a marital or charitable deduction anyway) and the estate is under the $5.12 million exemption. This eliminates the need (and cost) to get detailed and accurate valuations/appraisals for all property in the estate. Notably, though, the exception applies only if all property is going to the spouse or charity; if there's a split between multiple parties, such as 50% to spouse and 50% to children, then accurate valuation is needed, to ensure the proper split of the total value of the estate.

If an estate tax return is filed, the portability election will be assumed to have been made, unless the executor explicitly opts out of portability (although there appears to be little reason to ever do so). The good news is that this means portability will happen automatically when the return is filed, eliminating the risk that the executor files the return but forgets to make a portability election. However, the bad news in the regulations is that portability only applies if the executor files the estate tax return; as a result, if the executor fails to do so (or chooses not to do so due to cost), the surviving spouse cannot override the executor's decision. Expect to see Wills become more detailed regarding whether the executor is required to file an estate tax return or not, just to ensure portability of the exemption.

The new regulations also clarify that the DSUEA is available to the surviving spouse immediately after the decedent passes away, even if the estate tax return has not yet been filed (as long as it ultimately is filed in a timely manner). In addition, the new rules also indicate that if a surviving spouse makes a gift, the gift is deemed to have come first from the DSUEA, preserving the individual's own lifetime estate tax exemption. This is important, because it eliminates the risk of a gift/estate tax "clawback" if a spouse used a DSUEA through gifting and then later "lost" it by remarrying and outliving a second spouse (where the death of the second spouse overwrites the DSUEA from the first deceased spouse). On the other hand, some surviving spouses in the future may begin to take advantage of the favorable ordering rules to proactively gift after inheriting a DSUEA, either to preserve it in case of a future remarriage with a subsequent spouse death, or to even gift when a spouse is on his/her deathbed to preserve the prior DSUEA just before it is overwritten by a more recent deceased spouse.

Prospective Planning For Portability

Unfortunately, prospective planning for portability is still limited, due to the fact that portability itself is scheduled to lapse at the end of 2012. As a result, technically the new proposed regulations will be a moot point after the end of the year, unless Congress acts. And in point of fact, the Proposed Regulations are technically still only proposed, and may be further modified after their 90-day comment period ends (although they were also issued simultaneously as Temporary Regulations, which means they are actually in force in current form now, until/unless modified further).

Nonetheless, there is a strong likelihood that portability will ultimately be made permanent. It has generally been viewed positively from both sides of the Congressional aisle (as neither party thought it was 'fair' that Americans should be required to go through the trouble of bypass trust planning just to take advantage of the estate tax exemption for a married couple). The extension of portability is also included in the so-called Treasury Green Book, which outlooks the coming year's budget from the White House. And the decision of the Treasury itself to go through the trouble of issuing substantive regulations suggests that they believe portability has a strong likelihood of persisting. 

Although portability makes a bypass trust a moot point for many couples, as long as portability is temporary, clients will probably not eschew bypass trusts entirely; even at the extreme, most clients are simply increasing the flexibility of their estate plans, but not changing them entirely. Nonetheless, taking the necessary steps to ensure that portability will be available if it is extended is prudent - most notably, by filing a Federal estate tax return for clients who die this year, even if their estates are below the exemption amount, just to ensure that portability for the surviving spouse is available if the rules are extended in the future. 

So what do you think? Are you incorporating portability into your planning, or adopting a wait-and-see approach? Have you been encouraging estate tax returns for any clients who passed away to preserve portability, just in case? Will you be more proactive with gifting in light of the favorable ordering rules for surviving spouses? 

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Michael E. Kitces

I write about financial planning strategies and practice management ideas, and have created several businesses to help people implement them.

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