One of the most important aspects of the 2012 Tax Act1 for estate-planning professionals is that it made portability permanent (to the extent anything emanating from Washington can be said to be “permanent”).2 The term “portability” is shorthand among estate planners for the ability of a predeceased spouse’s executor to transmit to the surviving spouse the predeceased spouse’s deceased spousal unused exclusion amount (DSUEA). As a result, measured by 2020 numbers, spouses with an aggregate net worth of up to $23.16 million, without having to reallocate ownership of assets between them before either of them has died, would be able to transfer all of their assets to any one or more persons, whether through judiciously timed gifts during life or testamentary transfers at death, and pay no federal gift or estate tax.
Among the significant limitations of portability are: (1) the DSUEA, unlike the basic exclusion amount, isn’t adjusted for inflation; and (2) any income and appreciation accruing after the predeceased spouse’s death aren’t sheltered by the DSUEA. That said, a major advantage of portability is that all assets that, at the death of the first spouse to die, would’ve passed under that spouse’s estate plan, in the absence of portability, to a credit shelter trust (CST) using the traditional approach, instead pass to the surviving spouse and will be included in the surviving spouse’s estate at his subsequent death—thereby generating a step-up in basis of the assets to their then fair market value3 and minimizing future capital gains taxes when they’re sold4—perhaps without subjecting the surviving spouse’s estate to estate tax liability.
Portability vs. CST
If portability is used in place of the traditional CST model, and if the surviving spouse doesn’t have a taxable estate (for example, because the spouses’ combined net worth was relatively modest to start with or due to poor investment results and/or consumption by the surviving spouse), the beneficiaries will save, at some point in the future when they decide to sell inherited assets, 20% in federal capital gains tax they would’ve paid on the spread between the basis immediately before the surviving spouse’s death and the sale price had a CST disposition been implemented. In this case, using portability is obviously the better course of action. A basis step-up with respect to the assets that had composed both spouses’ estates is secured at no tax cost.
If portability is used in place of the traditional CST model, and if the surviving spouse ends up with a taxable estate (for example, due to positive investment results and/or reduction in the basic exclusion amount during the surviving spouse’s life): (1) the amount of the estate exceeding the surviving spouse’s applicable exclusion amount5 will generate an immediate federal estate tax burden of 40%; and (2) the beneficiaries will save, at some point in the future when they decide to sell inherited assets, 20% in federal capital gains tax they would’ve paid on the spread between the basis immediately before the surviving spouse’s death and the sale price had a CST disposition been implemented. Whether portability turns out to be advantageous in this case depends on: (1) the amount of federal estate tax payable; (2) the amount of federal capital gains tax saved; and (3) how far in the future federal capital gains tax would’ve been paid if a CST plan had been used.
CST vs. Portability
For the most part, the opposite results may be expected if a CST approach is used. For purposes of this portion of the analysis, it’s assumed that the dispositive provisions of the CST confer on the surviving spouse a “formula” testamentary general power of appointment (GPA), that is, a general power that comes into existence at the surviving spouse’s death only to the extent its existence doesn’t generate federal estate tax.
If a traditional CST is implemented instead of portability, and if the surviving spouse doesn’t have a taxable estate, the beneficiaries will save, at some point in the future when they decide to sell assets received from the CST, 20% in federal capital gains tax they would’ve paid on the spread between the basis immediately before the surviving spouse’s death and the sale price but only to the extent the formula testamentary GPA comes into existence at the surviving spouse’s death. The smaller the size of the surviving spouse’s estate, the larger the amount of the CST’s assets to which the formula testamentary GPA would apply—thereby generating a basis step-up. If the value of the surviving spouse’s estate is equal to the surviving spouse’s basic exclusion amount, the formula testamentary GPA will be irrelevant. Whether the loss of basis step-up resulting from not using portability turns out to be seriously detrimental depends on: (1) the amount of federal capital gains tax that could’ve been saved; (2) how far in the future federal capital gains tax would’ve been saved; and (3) the amount of federal estate tax saved by using a CST. If the value of the surviving spouse’s estate is zero or close to zero, the formula testamentary GPA will deliver essentially the same tax result as portability (albeit only because, in this circumstance, the predeceased spouse’s basic exclusion amount isn’t used because it’s not needed).
If a traditional CST is implemented instead of portability, and if the surviving spouse does have a taxable estate: (1) the amount of the estate exceeding the surviving spouse’s basic exclusion amount will generate an immediate federal estate tax burden of 40%; and (2) the formula testamentary GPA will be irrelevant. Whether sacrificing basis step-up (which could’ve been secured by using portability) is offset by excluding the value of the CST’s assets from the surviving spouse’s taxable estate depends on: (1) the extent of net investment return generated by those assets inside the CST during the surviving spouse’s life; (2) the amount of federal capital gains tax that could’ve been saved; (3) how far in the future federal capital gains tax would’ve been saved; and (4) the amount of federal estate tax due.
Pick Your Poison
The portability option will be compelling in those cases in which it’s virtually certain that the combined estates of both spouses will have insufficient value to generate federal estate tax liability at the death of the surviving spouse.
The portability option may be attractive in those cases in which it’s expected that: (1) the combined estates of both spouses won’t generate significant federal estate tax liability at the death of the surviving spouse; and (2) the estate of the surviving spouse will contain highly appreciated assets.
The CST with formula testamentary GPA option may be attractive in those cases in which it’s expected that the resulting federal estate tax savings on the increase in value of the CST’s assets during the surviving spouse’s life will offset the present value, at the surviving spouse’s death, of the amount of federal capital gains tax that could’ve been saved had portability been used.
It’s a metaphysical impossibility to achieve both basis step-up at the surviving spouse’s death of all assets that had composed both spouses’ estates plus exclusion from the value of the surviving spouse’s gross estate of all net investment return during the surviving spouse’s life generated by assets that were, or could’ve been, funneled into a CST at the death of the first spouse to die.
Endnotes
1. American Taxpayer Relief Act of 2012 (P.L. 112-240, H.R. 8, 126 Stat. 2313, enacted Jan. 2, 2013).
2. Portability was introduced into the law by Section 302(a)(1) of the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (P.L. 111-312, H.R. 4853, 124 Stat. 3296, enacted Dec. 17, 2010), amending Internal Revenue Code Section 2010(c).
3. IRC Section 1014(a).
4. It’s assumed that the value of assets will increase with the passage of time—a usually safe, but not rock-solid in all cases, assumption. Also worthy of note is that the value of assets only very rarely increases in a linear fashion.
5. Section 2010(c)(2).