To Port . . . or Not to Port?
By Kimberly S. Coogan, Carrie M. Buddingh and Derek M. Johnson
The “portability” of a deceased spouse’s unused (federal estate tax) exclusion (“DSUE”) is a welcome, long-overdue state
tax election available to married couples. Portability gives the surviving spouse an alternative to using the predeceased spouse’s federal estate tax exclusion amount on the first death. Perhaps proper planning was not completed prior to the first death, or circumstances exist under which it is advantageous to defer inclusion of the assets to the surviving spouse’s estate. This article will explore the concept of portability, how to calculate it, how it affects the estate planning process and its relation to Illinois’ estate tax laws, and how to elect it.1
Portability: When Did It Begin, What Is It, And How Is It Calculated? On December 17, 2010, the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (the “2010 Act”) created the portability election.2 The portability election allows the estate of a surviving spouse to not only utilize its own federal estate tax exclusion amount3, but also that amount of the federal estate tax exclusion amount not previously used by the estate of the predeceased spouse.4 Under the 2010 Act, the portability election was temporary, and was set to expire on December 31, 2012.5 On January 2, 2013, the American Taxpayer Relief Act of 2012 made portability permanent.6 Portability is available to the estates of married decedents who pass away on or after January 1, 2011.7 On June 16, 2015, the Department of the Treasury issued its final regulations, which took effect on June 12, 2015, containing the requirements for electing portability and calculating the DSUE amount.8 Please note that the final regulations are only applicable to descendants who passed away on or after June 12, 2015.9 For estates of descendants who died on or after January 1, 2011 through June 11, 2015, the previously released temporary regulations are still applicable.10
The DSUE amount is the lesser of: (i) the basic exclusion amount in effect in the year of the deceased spouse’s death11; or (ii) the deceased spouse’s applicable exclusion amount12, less the sum of the deceased spouse’s taxable estate and adjusted taxable gifts.13 The taxable estate is the deceased spouse’s gross estate, as determined under Sections 2031-2046 of the Internal Revenue Code (“Code”), less the deductions available under Code §§ 2053-2058.14 The adjusted taxable gifts equal the total amount of taxable gifts, as determined under Code §2503,made by the deceased spouse after December 31, 1976, less the amount on which any gift tax was paid for the calendar year of the gifts.15 However, the adjusted taxable gifts do not include gifts that were included in the deceased spouse’s gross estate.16
The estate of a surviving spouse may utilize the DSUE amount available from the surviving spouse’s “last deceased spouse” only.17 The “last deceased spouse” is the most recently deceased individual who, at that individual’s death, was married to the surviving spouse.18 E.g., if a surviving spouse remarries, the second spouse predeceases the surviving spouse, and the surviving spouse passes away, then the estate of the surviving spouse cannot utilize any DSUE amount from the surviving spouse’s first deceased spouse. However, if a surviving spouse remarries and predeceases his or her second spouse, or they divorce, then the surviving spouse’s estate may only use the DSUE amount of the surviving spouse’s first (i.e., most recently deceased) spouse.19 Finally, if the surviving spouse applies the DSUE amount of his or her first spouse to lifetime gifts, and the second spouse later dies, then the DSUE amount available on the death of the surviving spouse is the sum of the unused DSUE amount from his or her last (second) deceased spouse and the DSUE amount from his or her first deceased spouse that was applied to lifetime taxable gifts.20
Planning and Drafting Considerations with Portability. A married couple has retained you to prepare their estate planning documents. Now you’re faced with determining the optimal formula to allocate the estate between a marital deduction (“A”) trust (or outright distribution), and an estate tax exclusion (“B”) trust upon the first death. With portability, do we have to worry about funding a B trust on the first death?
You’ll need to take into consideration several factors, such as: What is the total value of the clients’ estate? Is there potential Illinois estate tax? What portion of the estate do tax-deferred assets comprise? Are there highly-appreciated assets? What is the age of each of the clients? What are the ages of their children/dependents? What is the expected rate of growth or depletion of the estate after one or both deaths? Are they expected to maintain Illinois residency?21
If the clients’ total estate is less than (and not expected to exceed) the Illinois estate tax exclusion amount22, then you might safely decide not to use any estate tax exclusion on the first death. If, however, the estate is expected to exceed the surviving spouse’s exclusion amount, you’ll need to plan to use the predeceased spouse’s exclusion. Assume that your clients are domiciled in Illinois, and the plan will utilize at least that amount of exclusion needed to minimize Illinois estate tax on the second death, including making an Illinois qualified terminable interest property (“QTIP”) election23 when appropriate. Regardless of the size of the estate, you’ll want to authorize the Executor (and the Trustee to direct the Executor) to make tax elections after the clients’ deaths.
Planning in advance for the surviving spouse to make a qualified disclaimer24 of property otherwise passing to him or her under the estate tax unlimited marital deduction25 is perhaps the most flexible approach. The documents may provide that, upon the first death, everything will pass to the surviving spouse, but that any disclaimed portion of the estate will pass to a B trust for the benefit of the surviving spouse. This approach allows the survivor to decide within nine (9) months26 after he spouse’s death whether to make a disclaimer, based on how much, if any, of the exclusion amount should be utilized on the first death. Based on an analysis of the factors listed above, the surviving spouse should disclaim that amount of the predeceased spouse’s estate that can be anticipated to minimize the overall estate tax payable on the second death. It may be that after the disclaimer, there is no need to file a DSUE election because the surviving spouse’s estate is not anticipated to exceed his or her own federal exclusion amount. On the other hand, the client will need to make an informed decision as to whether to file a DSUE election to hedge against potential future events.
For those clients with larger estates, perhaps it is a foregone conclusion that the estate will be taxable, and the exclusion amounts must be fully utilized on each death. Such cases call for more traditional A-B trust plans. The next decision will be: Which allocation formula should be utilized?
Prior to the Illinois estate tax coming into the law in 2003,27 the typical allocation formula directed an amount up to the deceased spouse’s federal exclusion amount to the B trust. If the estate is expected to exceed the federal exclusion amount, this may be the best course (but consider income tax basis step-up strategies). Using this formula, the B trust must be “QTIP-able,” in order to elect an Illinois QTIP over a portion of the B trust equal to the amount by which the B trust exceeds the decedent’s Illinois exclusion amount. We will use the term “QTIP-able” to mean that the trust is eligible for the Illinois or federal QTIP election.28
If the predeceased spouse’s estate is not expected to exceed the survivor’s Illinois exclusion amount, you may want your formula to require the B trust to be funded with only that portion of the predeceased’s estate that may pass free of both federal and state estate tax. In this scenario, depending on other non-tax considerations, the A trust may be QTIP-able or may be a general power of appointment trust, or the marital portion may be distributed outright to the survivor. A portability election may be made for the unused federal exclusion. However, be aware that, if the estate is expected to appreciate in value, the DSUE amount is frozen upon the first death. This is in contrast to the non-QTIP B trust, which is 100% exempt from estate taxation in the surviving spouse’s estate, regardless of appreciation of the B trust assets.
Consider a single-trust plan with a B trust only, making the B trust QTIP-able; the trustee may elect after the first death to make a federal or state QTIP election for part, none, or all of the B trust, filing a portability election for any unused federal exclusion. This may allow for income tax planning. If the estate includes appreciated assets for which a cost basis step-up might be desirable on the second death, those assets may be allocated to a QTIP trust on the first death and a portability election filed.
Of course, there are those clients who may have a potentially taxable estate, but a significant portion of one spouse’s estate comprises qualified, tax-deferred assets. This may be a case in which electing portability is the best option. Circumstances at the time of the first death must be considered, and the documents must be designed with flexibility for post-mortem planning. The qualified plan beneficiary designations will be a critical component of the estate plan. The B trust in this case should include “stretch” provisions qualifying the B trust for “look-through” treatment for purposes of determining the amount of the required minimum distributions that must be made from a qualified account payable to the B trust. The beneficiary designations for the qualified plan owner’s accounts should name the spouse as the primary beneficiary, and the B trust as the secondary beneficiary. This allows the surviving spouse to decide after the qualified plan owner’s death to (a) roll over the plan into a spousal IRA, and make a portability election; or (b) disclaim part or all of the account, thereby causing part or all to become payable to the B trust, utilizing the predeceased spouse’s exclusion amounts. Factors to be considered include the age and life expectancy (actual and per IRS tables) of the surviving spouse (i.e., the difference in income taxes between RMDs using a spousal rollover and the somewhat accelerated RMDs with the B trust as beneficiary); the anticipated value of the surviving spouse’s estate; the state estate tax rates and exclusion amount in effect at that time; the income tax rates in effect at that time; and the surviving spouse’s income tax bracket.
Electing Portability. While making a portability election appears to be a relatively simple process, it actually can be very technical. So how does one elect portability? The executor of the deceased spouse’s estate must timely file a complete and properly prepared estate tax return on which the DSUE amount is calculated.29 Simple, right? Perhaps not. The final portability regulations released by the Treasury Department and the IRS on June 16, 2015 have defined what “timely” and “complete and properly” prepared means.30
The deadline for a timely filed estate tax return is nine months after the decedent’s date of death31 or the last day of an extension if an extension was obtained.32 However, this rule only applies to those estates that are required to file an estate tax return.33 This includes estates of U.S. citizens or residents with a gross estate over the basic exclusion amount in effect under section 2010(c) of the Code.34 Those estates may apply for an automatic six-month extension of its filing deadline.35 For estates under the required threshold filing solely to elect portability, the automatic six-month extension is not available.36
Previously, the Treasury Department and the IRS released temporary regulations that automatically granted an extension of time for filing a return for estates of individuals who died on or between January 1, 2011 and December 31, 2013.37
Those temporary regulations were not made permanent in the final portability regulations. Thus, for estates that do not meet the required filing threshold who wish to elect portability for individuals who died after December 31, 2014, the executor must file an estate tax return within nine months of the decedent’s date of death. If the executor fails to file the return by the deadline, he or she may still seek relief under Regulation section 301.9100-3 and make the portability election via a private letter ruling.38 In general, under Regulation section 301.9100, relief is granted if the taxpayer establishes to the satisfaction of the Commissioner that the taxpayer acted: (i) reasonably; (ii) in good faith; and (iii) grant of relief will not prejudice the interests of the government. However, the cost of a private letter ruling may make seeking relief under this regulation cost prohibitive (the filing fee alone is $10,000!). Obviously, the preferred route would be simply adhering to the nine-month deadline.
While the definition of “timely” has been clarified and limited under the final portability regulations, the definition of “complete and proper” has become broader. A complete and properly-prepared estate tax return lists the fair market value of the decedent’s assets as of his or her date of death or alternate valuation date along with supplemental documentation evidencing such values.39 For example, if a decedent owned a home as of his date of death, then the executor would need to obtain an appraisal of the property and attach it to the decedent’s estate tax return in order for it to be considered complete and proper. Depending on the decedent’s assets as of his or her date of death, obtaining the value for all of the assets and the corresponding supplemental documentation can become rather costly.
The temporary and final portability regulations include a special rule applicable to estates under the filing threshold that allows the executor to estimate the value of the assets in certain circumstances.40 This special rule only applies to those assets which will pass under the marital deduction41 or charitable deduction42.43 However, this special rule does not apply to those assets for which a valuation is required under certain specific Code sections.44 When estimating the value of an asset pursuant to this special rule, the executor must exercise due diligence to estimate the fair market value of the asset.45 The executor will need to consult the Table of Estimated Values listed in the Instructions for Form 706 and report the corresponding estimated amount on lines 10 and 23 of the return.46
A word of caution when preparing an estate tax return for an Illinois decedent: the exemption equivalent for Illinois estate tax purposes is $4.0M. Thus and per the Illinois Attorney General’s 2015 Important Notice Regarding Illinois Estate Tax and Fact Sheet, the executor will need to prepare and file the Illinois Estate Tax Return (Form 700), along with a Federal Form 706, or an equivalent with substantially the same information, for tentative taxable estates with adjusted taxable gifts between $4.0M and the basic exclusion amount47 even though the estate does not meet the federal filing threshold.
The Federal Form 706 filed with the Illinois Estate Tax Return must include all schedules and required supplemental documentation (e.g. appraisals) that would be required for a federal taxable estate.48 Thus, using estimated values under the special rule would not be acceptable in such cases. In addition, the return will need to be completed and filed within nine months of the decedent’s date of death in order to elect portability.
While portability is a welcome addition to the estate tax toolkit, be aware of the potential pitfalls of portability in estate planning. It should be seen as a safety net; or a planning tool to be used only after careful consideration. Be sure to study the Code and applicable Regulations in filing for the election, as there are some traps for the unwary.
1. This article assumes the surviving spouse is a U.S. citizen. A DSUE amount elected by a non-citizen surviving spouse is subject to adjustment (Regs. § 20-2010(c)(4)) (not within the scope of this article).
2. Pub. L. No. 111-312, § 303.
3. I.R.C. § 2010.
4. I.R.C. § 2010(c)(4).
5. Pub. L. No. 111-312, §§ 101(a), 304; Pub. L. No. 107-16, § 901(a).
6. Pub. L. No. 112-240, § 101(a).
7. I.R.C. § 2010(c)(4); 80 Fed. Reg. 34,279 (June 16, 2015).
8. 80 Fed.Reg. 34,279 (June 16, 2015).
9. 80 Fed.Reg. 34,279 (June 16, 2015).
11. Treas. Reg. §§ 20.2010-1(d)(4), 20.2010-2(c)(1). Beginning January 1, 2011, the basic exclusion amount was $5.0M. I.R.C. § 2010(c)(3)(A); it is adjusted annually for inflation. I.R.C. § 2010(c)(3)(B). For decedents dying in 2016, the basic exclusion is $5.45M. Rev. Proc. 2015-53.
12. The “applicable” exclusion amount is the sum of the basic exclusion amount and, in the case of a surviving spouse, the DSUE. I.R.C. § 2010(c)(2).
13. I.R.C. §§ 2503 and 2504.
14. I.R.C. § 2051.
15. I.R.C. § 2001(b); Treas. Reg. § 20.2010-2(c)(2).
16. I.R.C. § 2001(b).
17. Treas. Reg. § 20.2010-3(a)(1)(i).
18. Treas. Reg. § 20.2010-1(d)(5).
19. Treas. Reg. § 20.2010-3(a)(3).
20. Treas. Reg. § 20.2010-3(b)(1).
21. H.B. 3522, 99th Gen. Assem., Reg. Sess. (Ill.2015) introduced in February 2015, proposes aligning the Illinois estate tax law with the federal law, i.e. matching the federal exclusion amount, and including portability.
22. 35 ILCS 405/2(b) and 405/3.
23. 35 ILCS 405/2(b-1). Discussion beyond the scope of this article.
24. I.R.C. § 2518(b) and 755 ILCS 5/2-7.
25. I.R.C. § 2056.
26. I.R.C. § 2518(b)(2).
27. 35 ILCS 405. 28. I.R.C. § 2056(b)(7).
29. I.R.C. § 2010(c)(5)(A).
30. 80 Fed.Reg. 34,279 (June 16, 2015).
31. I.R.C. § 6075(a).
32. Treas. Reg. § 301.9100-2.
33. I.R.C. § 6075(a).
34. I.R.C. § 6018(a).
35. Treas. Reg. § 301.9100-2.
36. 80 Fed.Reg. 34,279 (June 16, 2015).
37. Rev. Proc. 2014-18.
38. Treas. Reg. § 20.2010-2(a)(1).
39. Instructions for Form 706.
40. Treas. Reg. § 20.2010-2(a)(7)(ii).
41. I.R.C. §§ 2056 and 2056A.
42. I.R.C. § 2055.
43. Treas. Reg. § 20.2010-2(a)(7)(ii)(A).
44. Treas. Reg. § 20.2010-2(a)(7)(ii)(A)(2).
45. Treas. Reg. § 20.2010-2(a)(7)(ii)(B).
46. Treas. Reg. § 20.2010-2(a)(7)(ii)(B).
Kimberly S. Coogan, Carrie M. Buddingh and Derek M. Johnson are attorneys with Bellock & Coogan, Ltd., in Oak Brook, IL. Kimberly is a founding partner of the firm and a Certified Public Accountant. She graduated from the University of Illinois, U-C with an Accounting degree and received her J.D. with honors from Chicago-Kent College of Law. Carrie, who was recently named a partner of the firm, graduated from the University of Iowa with a bachelor’s degree in Political Science and a minor in Business Administration before earning her J.D. from The John Marshall Law School in Chicago. Derek graduated with distinction from the University of Wisconsin-Madison with a bachelor’s degree in Anthropology before earning his J.D. with honors from Chicago-Kent College of Law.