At the end of 2012, the entire country watched as major changes were made to income tax laws with the adoption of the American Taxpayer Relief Act of 2012 (ATRA). The act also made significant changes in estate tax laws.
Estate Tax Portability
One important change is that the estate tax portability law is now permanent. Estate tax portability means that the unused portion of the first-to-die spouse’s estate tax exemption passes to the surviving spouse. The current estate tax exemption is $5.43 million ($5 million with adjustments for inflation). This means that a married couple’s total estate tax exemption is currently $10.86 million ($10.86 million in 2015). For example, a husband dies with $2 million in separate assets. He has $3.43 million remaining in his estate tax exemption, which passes to his wife, giving her a total of $8.86 million in estate tax exemption. Without portability, the husband’s remaining exemption might have been forfeited if the couple had not implemented special tax planning techniques as part of their estate plans.
How Do You Claim the Portability?
This is where married couples and estate executors can get into trouble. The estate tax portability rule is not automatic. In order to claim the remainder of the first-to-die spouse’s estate tax exemption, the surviving spouse or the deceased spouse’s estate personal representative must file an estate tax return soon after the death, usually within nine months.
If this filing deadline is missed, then the couple will not get the benefit of estate tax portability. Missing the estate tax filing deadline can result in hundreds of thousands of unnecessary and avoidable estate taxes.
In a recent report in The Wall Street Journal, estate planning experts expressed concern that personal representatives of small estates may be unaware of the estate tax return filing requirement and may believe that an estate tax return is unnecessary if the deceased spouse’s assets fall under the $5.43 million exemption amount. To preserve portability, however, the estate tax return must be filed after the first spouse’s death. Alternatively, married couples can utilize a special trust, referred to as a “credit shelter trust” or “bypass trust” to prevent forfeiture of their individual exemptions. This planning technique must be undertaken when both spouses are still alive.
The Consequences of Failing to File an Estate Tax Return
As a simple example, consider a husband and wife who have a total of $7.5 million in assets, $6 million in a business the husband owns and the remaining $1.5 million owned by the wife. Upon the wife’s death, the estate’s personal representative files a timely estate tax return and the wife’s remaining $3.93 million in estate tax exemptions passes to the husband. When the husband dies, his entire $6 million business passes to his heirs tax free, even though his personal estate tax exemption is only $5.43 million. If portability is not claimed, then approximately $500,000 of the husband’s business will be taxed (the current rate is 40 percent). The husband’s heirs would be required to pay approximately $200,000 in estate taxes which could have been avoided if the wife’s estate personal representative had filed an estate tax return within the time limit.
Even if both spouses together have assets under the current $5.43 million exemption, it is still a good idea to file an estate tax return after the death of the first spouse. Filing the estate tax return and preserving the portability benefit protects the surviving spouse’s heirs in the event the surviving spouse receives a windfall during his or her lifetime that raises his or her assets above the $5.43 million exemption level.