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Portability Rule Clarified

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Jonathan Kinney
BKK Wills, Trusts and Estates Newsletter
November 2011

In early October 2011, the Internal Revenue Service ("IRS") issued regulations establishing formal requirements for a surviving spouse to preserve the unused portion of their spouse’s estate tax "exemption." The IRS declared that in order to preserve the spouse’s exemption, the executor of the deceased spouse must file an estate tax return listing assets and their values if the portability election is to be preserved. Under current law (effective at least through December 31, 2012), the amount of assets exempt from the estate tax is $5 million per person or $10 million per married couple.

The portability provision, which was added to the tax code last December, allows a surviving spouse to preserve the unused portion of their deceased spouse’s estate tax "exemption." The effect of the IRS ruling is that executors will be inclined to file an estate tax return to preserve the portability expenses even when the total assets of the deceased are below the current $5 million "exemption" amount.

By way of example, John and Susan have a total estate of $8 million. $2 million is in John’s name, $4 million is held jointly and $2 million is in Susan’s name. If John were to pass away this year, only $2 million of his $5 million "exemption" would be used, so in effect $3 million of his "exemption" is unused. To preserve this $3million "exemption," Susan must make sure the executors file an estate tax return listing her deceased husband’s assets and their value at the date of death (even though his estate is tax free). If the estate fails to fi le the return, the portability "exemption" is lost. In Susan’s case, that could be very costly since even assuming John did not give any of his estate to her (which may or not be accurate), her estate on death would be $6 million (the $4 million in joint assets plus the $2 million in her name). That would result in an estate tax on $1 million. If John left everything to his wife outright, then her estate would be $8 million, but only $5 million would be covered by the "exemption," so $3 million would be taxable.

Obviously John and Susan could set up revocable trusts, which would achieve the same purpose as the portability provisions. The portability provision was put into effect to cover situations where married couples with assets over $5 million did not have a full estate plan.

To some extent, this does not resolve the current predicament in estate and gift tax law (i.e., that the current estate and gift tax exemptions are set to expire at the end of 2012). While most estate tax commentators believe that the portability provision is likely to be renewed, there isn’t any guarantee; so, it may be more important to fi le the estate tax return if the current "exemption" amounts are reduced at the end of 2012. In the meantime, the best course of action is to file the estate tax return if it is at all likely that the spouse might need the additional "exemption" amount that the portability provision provides.