Until recently lawyers routinely cautioned their clients that the estate tax exemption is something that belongs to each of us personally and can't be shared. That meant spouses risked losing one of their tax-free opportunities by leaving everything to each other in what are called "I love you wills."
But the federal estate tax system signed into law by President Obama on Dec. 17 changes that with a wonderful new break for married couples. Starting in 2011 widows and widowers can add to their own estate tax exemption the unused exemption of the spouse who died most recently. This provision, plus an increase in the exemption amount to $5 million per person, enables married couples together to transfer as much as $10 million tax-free to their children or other heirs, either by making lifetime gifts or through estate plans.
Portability, as tax geeks call it, is an extremely positive development that can simplify planning for many people. But for others it raises tough choices about whether to abandon more complex estate planning tools that may have other advantages. To further complicate matters, portability only applies to deaths in 2011 and 2012. So until Congress makes it permanent, there's a risk that it will expire before most folks can take advantage of it.
For now, perhaps the greatest benefit of the new provision is for people who didn't plan, and as a result previously would have fallen into a very common trap for the unwary. For example, had it existed in 2009, portability would have made a huge difference for the family of a wealthy Texan who died that year.
This fellow tried to save a few bucks by using a form he copied from a library book to write his own will (not a good idea) and left everything--a cool $7 million--to his wife. There was no estate tax due at that point because assets left to a citizen spouse or to charity generally aren't subject to the tax. But anything left when she died, less her own exemption amount, would have been taxable as part of her estate. Although Texas has no estate tax, the husband had forfeited what was then a $3.5 million federal estate tax exemption.
Since portability only applies to deaths after Dec. 31, 2010, it doesn't help the Texan's family.To fix the problem after the husband died, William Wollard, a lawyer with his own practice in McKinney, Texas, recommended the wife disclaim (or turn down) the entire exemption amount, allowing it to pass under state law to the couple's three adult sons. That meant she no longer has access to the money. But in the future, with portability, others like her will have another option: to add the husband's unused exemption amount to her own, retaining control of the funds until her death.
There are two other ways for couples to each use their full federal estate tax exemption amount, and they both still work. One is to leave assets outright to people other than a spouse--for example, to children. The other, more popular strategy is to use a bypass trust.
Here's how these trusts (also called family trusts) work: When the first spouse dies, the trust is funded with up to the exemption amount. The trust distributes income and principal to the survivor or other family members (usually the couple's children) while the surviving spouse is alive, then passes on whatever is left to family. Funds in the bypass trust are covered by the exemption amount and are not taxed when the first spouse dies. Nor are they considered part of the survivor's estate, so they are not subject to tax when she dies.
Now that portability makes it unnecessary in most cases for spouses to use a bypass trust solely to preserve the federal exemption amount, is this planning device defunct? Not by a long shot. Still, it's never been for everyone, and far fewer people may need it now than in the past. Whether you're one of them depends on various factors, including your net worth, family relationships, investment outlook and tolerance for complexity. Here are some reasons to use, or not use, a bypass trust.
You want to protect the inheritance from creditors.
Preserving resources for your heirs goes beyond sound investment and money management. You also need to guard against the possibility that, sometime in the future, the objects of your bounty could lose assets to their own creditors. They may include everyone from disgruntled spouses and ex-spouses to people who win lawsuits against your family.
Leaving assets to heirs in a family trust, rather than outright, is an excellent means of sheltering family assets from creditors. For many people this is the main reason to set up trusts and to leave assets permanently in this legal wrapper.
Among the many people who might benefit from this asset protection tool are those whose work could generate lawsuits: entrepreneurs, doctors, lawyers, accountants and other professionals; construction contractors and real estate developers; executors and trustees; and directors of public companies. Keep in mind that in tough economic times, people find reasons to sue. It's prudent to ensure your family is not an easy target.
Your spouse might remarry after your death.
This raises a couple of additional concerns. One involves your children if they don't get along with the evil stepmother or stepfather. Picture this: your surviving spouse commingles everything with this great-unknown quantity and your kids get completely cut out. Stranger things have happened. With a bypass trust, you can avoid that result.
Another issue is that under the new law, remarriage cuts off the surviving spouse's ability to use the exemption amount of his or her first spouse, if the new spouse dies first. For example, let's say Harry has an unused exemption amount of $5 million when he dies next year. His widow Sally adds that to her own $5 million exemption amount. Then she remarries to Joe. If his unused exemption is less than Harry's (or if he has no unused exemption at all) Sally is out of luck if she survives him and leaves behind more than $5 million. In this example, using a bypass trust would preserve Harry's exemption amount just as in the days before portability. (Note that if Sally dies before Joe, her estate can still use Harry's unused $5 million exemption and can pass on up to $10 million, but Joe can't carry over more than $5 million from Sally.)
Your spouse might strike it rich.
Putting the funds in trust, rather than leaving them outright, ensures that neither the assets nor any appreciation on them will be considered part of your spouse's estate. A bypass trust reduces the possibility that by time your spouse dies his or her net worth will be more than the exemption amount.
What you lose by using a bypass trust in this scenario is potential income tax benefits down the line. Had the assets been left outright to the surviving spouse and included in her estate, they would get an adjustment in basis to their value at the date of her death, which minimizes the capital gains tax heirs must pay when they are sold--assuming they have increased in value in the years between the two deaths. In contrast, the basis on assets that went into the bypass trust when the first spouse died will not have changed since then.
You have grandchildren (or might someday).
Portability does not apply to the $5 million exemption from generation-skipping transfer tax. This is the 35% levy that applies, on top of estate or gift tax, to assets given to grandchildren and more remote generations (or to trusts for their benefit). So if you don't want to lose the exemption, you must use it, either by making lifetime gifts or by factoring it into your estate plan. There are various ways to do this. One is to include grandchildren as beneficiaries of a bypass trust and to apply at least part of your exemption to that trust.
Your plan already includes a bypass trust.
Given the potential benefits this trust affords, carefully weigh the pros and cons before you revamp your plan and ditch it. But if you haven't revised your documents in a number of years, do make sure they still reflect your intent about how much money is destined for one of these trusts.
Instead of naming a specific sum that will go into a trust, many documents refer to an amount up to the exemption or express the sum as a percentage of whatever the limit happens to be when the person dies. Skim your will and living trust for phrases like "that portion," "that fraction" or "that amount" (without specifying how much). These formula clauses are signs of lawyers trying to take maximum advantage of the estate tax exemption, which kept increasing. In the past, that was a good standard practice. But it's possible that given the current $5 million exemption, less money would now go to your spouse than you would like, or too much would go to your grandchildren. Consult your lawyer about whether amendments may be necessary.
One alternative, in a stable first marriage, is to leave everything to your spouse outright, but give him or her the right to disclaim all or part of the inheritance and have it go into a bypass trust. Be aware, though, that when it comes to disclaimers, the world of estate planning lawyers is divided into two camps: those who like the flexibility a disclaimer affords, and those who joke about the five-word lie spouses routinely tell each other: "Honey, I promise to disclaim."
You live in a state that has an estate tax or own property in one of these states.
Currently 13 states and the District of Columbia have separate estate taxes, and most have exemptions of $1 million or less. Hawaii and North Carolina are two exceptions--they will match the $5 million federal exemption for 2010. None, as of now, have any portability provisions. With tax rates running as high as 16%, married couples in states with a tax may still want to fund bypass trusts, up to the state exemption amount, in order to preserve the first spouse's exemption.
Most of your assets are in joint ownership.
This issue has always made bypass trusts cumbersome, especially for couples of moderate wealth, since the trust must be funded with your own assets.
The ideal assets to put into the trust are cash, bonds or marketable securities held in your own name. But for many people, their homes and retirement accounts are their most valuable assets, or the only ones available to fund a bypass trust. Each presents its own challenges because of special rules that apply.
If you use retirement assets to fund a bypass trust, you may lose certain income tax benefits. Therefore, you need to weigh the potential estate tax savings against the income tax cost.
Using a home to fund a bypass trust is also an imperfect solution. The way to do this with a jointly owned home is for the surviving spouse to disclaim the one-half interest in the property he has inherited. That part of the house then becomes a bypass trust asset, although the spouse could buy it out of the trust and replace it with cash, either all at once or over time.
There are a number of drawbacks to this approach. Unless the spouse is a trustee of the bypass trust, you take away the survivor's sense of ownership. Depending on the arrangement, the trust may need to share the cost of maintenance and repairs, it can't deduct property taxes, and if the house is sold, a valuable income tax break could be lost.
Given the complications and disadvantages of funding a bypass trust with a home or with retirement assets, you will want to look for alternatives. If you don't have any, you might decide to forgo the bypass trust and buy second-to-die life insurance, which covers both members of a couple and pays off only when both of them have died. The proceeds can be used to pay the federal and state estate taxes, if any are owed.
You want to avoid administrative pitfalls.
There's a big one lurking with portability: The executor handling the estate of the spouse who dies first needs to transfer the unused exemption to the survivor, who can then use it to make lifetime gifts or pass assets through his or her estate. This must be done by filing an estate tax return when the first spouse dies, even if no tax is due.
This return is due nine months after death with a six-month extension allowed. Spouses ought to file it even if they're not wealthy today, because someday, who knows? But if the executor doesn't file the return or misses the deadline, the surviving spouse loses the right to use her late spouse's remaining exemption.
You don't trust Congress.
Along with all the other estate tax goodies in the new law, portability is set to expire on Dec. 31, 2012. If Congress doesn't act before then, not only could we lose portability, but the exemption amount will revert to $1 million and the rate will increase to 55% from the current 35%.
If that looks even remotely possible as 2012 draws to a close, widows and widowers who carried over an unused exemption could suddenly feel like Cinderella rushing to get home from the ball before the stroke of midnight. Unless they make lifetime gifts to use up the carried-over exemptions, they risk losing everything they gained through the 2010 tax law.
Uncertainty about what's ahead is enough to make a financial advice wonk's imagination run wild. But as a practical matter, Congress is likely to extend portability; the provision just makes it easier to accomplish something that many couples have been doing anyway.
What to do in the meantime? Howard M. Zaritsky, a Rapidan, Va., estate planning expert who advises other lawyers in the field, says he's telling practitioners not to base estate plans on portability until it becomes permanent. He says "Congress has shown a propensity for surprising us with both bad decisions and good ones, and you just cannot plan on Congress doing the expected or the right thing."
