You can take it with you: Death-tax break extends beyond the grave

Wealthy individuals in the U.S. will find it easier to cut their estate-tax bill as a result of a provision for using their deceased spouses' exemption credit. Everybody has a gift and estate-tax exemption of up to $5 million this year and next. For people who died after Dec. 31, 2010, any unused portion of that can now be passed by the estate to the surviving spouse, according to tax legislation enacted by Congress in December. Before that law, couples set up specialized trusts and had to be sure their assets were divided up in a certain way. “It's something that can help someone caught dying before they did any planning, but certainly shouldn't be something you count on,” according to John Olivieri, a partner in the private clients group in the New York office of White & Case LLP. The $5 million exemption covers gifts made while alive as well as after death. For example, if a married man died this year and left his $2 million estate to his children and had made a $1 million lifetime gift, he would have a $2 million exemption that was unused. The portability provision would allow his widow to take advantage of that $2 million exemption and add that to her $5 million exemption, and give away up to $7 million free of federal gift and estate taxes if she dies before 2013. There are 3,300 estates in the U.S. that would owe federal estate taxes under the current threshold of $5 million, according to estimates from the Tax Policy Center, a joint venture of the Urban Institute and Brookings Institution, two Washington research groups. Bypass Trusts Portability will expire and the estate tax will switch to a top rate of 55 percent instead of 35 percent and the exemption will fall to $1 million as of Jan. 1, 2013, unless Congress acts. The deficit reduction legislation enacted Aug. 2 calls for reducing the deficit by at least $2.1 trillion over 10 years. Before this year, taxpayers would prepare wills that included so-called bypass or credit-shelter trusts to preserve exemption amounts when they died, and passed the rest of their assets to their surviving spouses upon death. Gifts to spouses who are U.S. citizens during life or upon death generally aren't taxed under the Internal Revenue Service's rules. Upon the death of one spouse, couples would put up to the exemption amount in a trust, which would be structured to allow distributions to the surviving spouse, Olivieri said. When the second spouse died, the assets in the trust would pass tax-free to the heirs because they're outside the estate. ‘Safety Valve' “Portability is a safety valve for married couples that didn't have wills that utilized the exemptions,” said Marco Svagna, a certified public accountant at New York-based Berdon LLP, who advises clients with net worth of $100,000 to more than $1 billion. Having a will that includes a bypass trust and other tax- planning strategies could cost up to $10,000, Olivieri said. “Portability is meant to address the perceived problem that although there is an estate-tax exemption, unless you do some level of sophisticated planning, a married couple could lose the benefit of one exemption,” Olivieri said. Passing all assets to spouses upon death and using the portability provision rather than forming bypass trusts is best suited for taxpayers who have estates worth about $7 million or less, with the main assets being real estate and retirement plans, said Linda Hirschson, a trusts and estates lawyer at Greenberg Traurig LLP in New York. That's because they might not want put those assets in a trust, since they need to live in the house and may want to easily access the money in the retirement account, she said. Taxpayers with estates worth more than $10 million should continue to use bypass trusts, she said. Lower Portable Amounts Wealthy taxpayers should beware of undoing bypass trusts and relying on portability because it may not be extended by Congress, said Carlyn McCaffrey, a partner in the law firm McDermott Will & Emery LLP where she is co-head of the New York private client group. Even if it is extended, the carryover amount may change if the tax thresholds are altered, Olivieri said. That's because the legislation says the portable amount is the lesser of the unused exemption amount of the first spouse to die or the exemption amount at the time of the second spouse's death. That means if the threshold switches to $1 million in 2013 and the surviving spouse in the above example dies that year, her estate would only be able to use $1 million under portability instead of $2 million from her deceased spouse. Trusts can also protect assets from creditors and election rights of spouses, said McCaffrey. And they ensure that assets, as well as their appreciation, are outside of the estate, she said. Give Gifts One strategy to preserve portability, if it expires, is to give the unused exemption amount away as a gift before 2013, according to McCaffrey. In the above example where the wife gets $2 million carried over from her husband, she could make a gift of that amount this year or next year, and may still be able to preserve her individual exemption amount. It's unclear whether surviving spouses can use their inherited exemptions first, so a better way to preserve portability in the above example would be for the wife to give away the full $7 million before she dies, Olivieri said. To take advantage of a deceased spouse's unused exemption amount, the executor of the estate must fill out an estate-tax form to preserve the exemption for the surviving spouse, even if estate taxes aren't owed, said Svagna of Berdon. Estate-tax returns must be filed within nine months after death, and six- month extensions are generally granted. Beware of Remarrying Widow or widowers who remarry should remember that portability only applies to the last deceased spouse, said White & Case's Olivieri. If the wife with the $2 million unused exemption carried over from her husband were to remarry someone who died this year or next, and who had used all of his exemption amount through gifts during his life and upon death totaling $5 million, she would only have her individual $5 million exemption. If she died before he did, she would maintain the $2 million unused exemption, said Olivieri. Taxpayers should keep in mind that states generally don't allow for portability of unused state estate-tax exemptions and states may have lower thresholds than the federal government, said Hirschson of Greenberg Traurig. In New York, the limit is $1 million and in New Jersey, it's $675,000.