One of the common features of proposals to reform the Federal estate tax is the idea that married couples should not need complicated estate planning, involving one or more trusts, to make full use of their estate tax exemption amounts.  But Marc S. Bekerman points out that “exemption portability” may not eliminate common needs for trusts and raise a number of new potential problems.

Here’s the current situation: Every person is entitled to an exemption of $3.5 million in calculating the Federal estate taxes owed at his or her death.  But when a surviving spouse inherits most of the deceased person’s estate–without special estate planning–estate taxes are avoided for another reason:  the unlimited marital deduction.  Since the estate tax exemption and the marital deduction both result in avoiding estate taxes, why does it matter which one applies?  Because when the estate tax exemption applies, the assets can pass to future generations without estate taxes.  When the marital deduction applies instead, estate taxes must eventually be paid when the surviving spouse dies.  Of course, the surviving spouse’s estate tax exemption will apply at that time, but the estate tax exemption of the first spouse to die–that is, the ability to pass up to $3.5 million in value to future generations–goes unused unless estate planning steps are taken to make sure it gets used.  In most cases, this means creating one or more family trusts to “shelter” the estate tax exemption amount (they are often called shelter or bypass trusts).  The surviving spouse is usually the initial beneficiary of the family trust, but trust property (again, up to $3.5 million) can be held for children and grandchildren, all estate tax free.  Wouldn’t it be great to have the same effect without needing the complicated estate planning and multiple trusts?  Maybe.

Enter exemption portability.  This idea was discussed in the Wall Street Journal article I previously discussed (Estate Tax Update).   While there remain many details about exemption portability to be worked out, the general idea is for a surviving spouse to use the unused estate tax exemption amount of the first spouse to die.  No more need to shelter the estate tax exemption amount.  The surviving spouse can just add the unused exemption amount to his or her own.  If the surviving spouse inherited all of the property of the first spouse to die, which is the intention of most married couples, then both exemption amounts ($7 million in the aggregate, at today’s level) would be available at the death of the surviving spouse.  There would be no need to hold a large portion of the first spouse’s estate in a trust, which limits the surviving spouse’s access to the funds.  Even if a wealthy couple does no estate planning prior to the death of the first spouse (it happens too often), it’s possible to fully utilize the first spouse’s exemption amount when the surviving spouse dies. 

Exemption portability might be a good thing for most folks, but it does not rule out thorough estate planning entirely.  As Marc S. Bekerman points out, there are at least two reasons why family trusts will still have a role a in the estate planning for most couples:

1.  A family trust can ensure that part of the estate of the first spouse to die remains for surviving generations.  If the survivng spouse remarries, he or she may leave part or all of his or her estate (including inheritances from the first spouse) to a second spouse or children and grandchildren from the second marriage. 

2.  A family, shelter trust freezes the value of the first spouse’s estate to which the estate tax exemption applies, so that future appreciation in the trust assets pass to the next generation free of estat taxes.  On the other hand, if the estate tax exemption is not used at the the death of the first spouse and carries over to the death of the surviving spouse (there is no “freezing” event), the appreciation in value is subject to estate taxes upon the death of the surviving spouse.  Granted, the surviving spouse would have two exemption amounts to apply towards the appreciated value of the estate, but the appreciation in value may easily exceed the unused portion of the first spouse’s exemption amount.

In addition, Marc S. Bekerman notes that there are a number of significant questions about how exemption portability might work in practice, including:

1.  What happens to portability when a surviving spouse remarries?  If a surviving spouse “inherits” the unused exemption amount of his or her first spouse and then dies without using all of the combined exemption amount, does the remaining exemption amount pass to the surviving second spouse?  This seems beyond the orginal intention, but a distinct possibility.

2.  How will a surviving spouse (or rather, the executor of his or her estate) proof the amount of the unused exemption amount inherited from the first spouse to die?  Will this require the filing of an estate tax return in every estate, regardless of size, because there is no way to know if the unused exemption amount will be needed by the surviving spouse?  This would be an extra burden that does not exist in most estate administrations.

Whether or not exemption portability because a reality, you can be sure that there will still be situations that require careful estate planning and perhaps one or two trusts.

What are your thoughts on exemption portability or any other proposed changes to the Federal estate tax?  Share them in the Comments.