The points discussed in this article are intended for general background information and are not intended to constitute legal advice for any particular person or situation.
On January 1, 2013, Congress enacted the American Taxpayer Relief Act of 2012. Part of the law concerns the estate tax and the gift tax. Since 2001, the amount of the exclusion from estate taxes rose from $1 million for persons dying in the year 2001 to $3.5 million for persons dying in the year 2009. For the year 2010, the estate tax was eliminated, and in 2011 and 2012 the estate tax exclusion increased to $5 million with the amount of the exemption indexed for inflation. The gift tax exclusion also increased to $5 million. If Congress had not acted before December 31, 2012, then the estate tax exclusion would have reverted to its 2001 level of $1 million.
As a result of the new law, the exclusion from estate tax is $5 million, indexed for inflation. The lifetime exclusion from gift taxes is also $5 million and is fully integrated with the estate tax. For estates over $5 million, the estate tax rate has increased to approximately 40%. Another key feature of the law is the adoption of “portability.” Portability is the concept of allowing the surviving spouse to use the unused portion of the estate tax exclusion of a deceased spouse.
Since 1981, a key concept of the Internal Revenue Code was to provide married couples with an unlimited marital deduction. In other words, upon the death of the first spouse, an unlimited amount of assets could be transferred to the surviving spouse free of estate taxes. However, the entire remaining estate would be taxed after the death of the second spouse. Simply stated, Congress enacted the limited marital deduction in order to treat married couples as a unit and wait until the second death to impose the estate tax. The problem with the estate tax statutes prior to 2013 was that the lifetime exclusion, which could have benefited the couples’ children, was lost after the death of the first spouse to die unless an AB Trust was utilized by the married couple.
For many years, a common estate planning technique used by attorneys was an AB Trust to reduce estate taxes. Here is a simple example of how the AB Trust operated. Assume that a married couple had an estate of $2 million, and assume that the estate tax exemption in the year of the first spouse to die is $1 million. If husband dies first and leaves his $1 million share (1⁄2 of the entire estate) to his surviving wife, then the surviving wife now has a total of $2 million of assets in her estate when she eventually becomes deceased. In this example, there was no tax after the death of husband, due to the unlimited marital deduction for assets flowing from husband to wife. However, upon the death of wife, the entire estate of $2 million, less the amount of the wife’s estate tax exclusion of $1 million, results in a taxable estate of $1 million. The result is that $1 million dollars of assets is subject to estate tax at about the 40% tax rate. That is a huge amount of estate taxes for the children to pay from the estate.
Now lets assume the couple had an AB Trust. Upon the death of husband, the Declaration of Trust states that a sum of money equal to the estate tax exemption in the year of death is set aside in a Bypass Trust (sometimes referred to as the ‘B’ Trust). The remainder of the estate is placed in the Survivor’s Trust (sometimes referred to as the ‘A’ Trust) for the use of wife, the surviving spouse. The ‘B’ Trust must be worded as an irrevocable trust and can allow the surviving spouse to have the income from the Bypass Trust and the right to invade the principal of the Bypass Trust if necessary for her health, support, maintenance, and education expenses, so that the assets of the exemption trust will not be included in the wife’s taxable estate at her death. (IRS Code §2041). Hence, in our example, upon the death of husband, $1 million would be placed into the ‘B’ Trust, and wife would have complete control over the ‘A’ Trust, which would hold the other 1⁄2 of the estate. There would be no estate tax payable on the first death, because of the use of husband’s lifetime exclusion. On the death of wife, only the assets of Trust A are subject to estate tax. The wife’s 1⁄2 of the estate, $1 million, qualifies for the lifetime exemption. Hence, there is no estate tax on the death of husband and no estate tax on the death of wife. A tremendous savings in estate tax results when the combined estates of husband and wife exceed the amount of the exclusion amount.
Now let us look at the new law. The principle of portability would at first glance make it appear that it is no longer necessary for a married couple to create an AB Trust, since the concept of portability allows the surviving spouse to use the unused portion of the deceased spouse’s estate tax exclusion. The executor of the first spouse to die files an estate tax return and elects to pass the unused portion of the estate tax exclusion to the surviving spouse. There will likely be an unused estate tax exclusion, because upon the death of the first spouse, he will likely leave his estate to the surviving spouse and make use of the unlimited marital deduction.
However, portability did not make the estate planning process easier, it actually presents married couples with a choice between two different methods of dealing with their estate and the anticipated estate taxes.
First, the most a married couple will be able to shield from estate taxes is the decedent’s exclusion and the survivor’s exclusion, which is likely to be $5 million each, plus inflation adjustments. If the couple owns assets that are likely to greatly appreciate in value, perhaps valuable real estate or stock in a successful business, and if the couple had instead used an AB Trust, then the assets in the exemption trust could greatly appreciate in value between the first death and the second death, and all of the assets in the exemption trust would have completely escaped federal estate taxes when those assets pass to the children after the death of the second spouse.
Next, income taxes must be considered. If assets of a decedent are administered, then the assets receive a “step up” in tax basis. The advantage of portability is that the assets are “administered” on the death of the first spouse when, after the death of the first spouse, an estate tax return is filed and portability is elected. The assets are administered again upon the death of the second spouse, when the assets are distributed, presumably to the couple’s children. Therefore, the children receive the assets of their parents’ estate with a step up in tax basis to current values. If the children then sell those assets, which may have appreciated greatly over many years during the lifetime of the parents, there may be no capital gains tax.
On the other hand, if the couple had made use of an AB Trust, the assets that were left in the exemption trust do not receive a step up in basis on the death of the second spouse, and, hence, for example, if the exemption trust held real estate assets that had appreciated greatly over many years, upon the death of the second spouse, then when those assets were distributed to the children, the children would have assets that may have a current high fair market value, but have a very low tax basis. Hence, a capital gains tax would result if and when the children sold those assets, even though the transfer of the assets would escape estate taxes.
Another advantage of the AB Trust arrangement is that the assets in the ‘B’ Trust are held in an irrevocable trust and hence are likely protected from the creditors of the surviving spouse. The AB Trust arrangement may also allow a couple to lock in the provisions of the exemption trust upon the death of the first spouse, so that the second spouse cannot change the beneficiaries of the exemption trust, as might be the case where the couple has children from different relationships. Often the spouses wish to enter an arrangement whereby after the first death the surviving spouse cannot change the plan of distribution.
Many practitioners believe that couples with estates greater than $10 million should continue to use an AB Trust as an estate planning method, because the ability to shield appreciated assets in the exemption trust from estate taxes may be more important than the loss that might result from the inability to take advantage of the step up in basis. Many practitioners believe married couples whose estates are not likely to reach $10 million will benefit from the principle of portability because of the advantage of obtaining a step up in tax basis in view of the fact there is likely not to be any estate tax on the death of either spouse.
The best method of dealing with the dilemma may very well be to include provisions in a trust to allow the trustee an election, upon the death of the first spouse to die, to either create a traditional AB Trust with the marital estate, or to forego the division of the estate into a separate Survivor’s Trust and Exemption Bypass Trust and instead elect principles of portability, depending upon the trustee’s determination of which result might be of overall benefit to the intended beneficiaries considering the nature and value of the assets held by the married couple, the likelihood that assets in an exemption trust might greatly appreciate between the death of the first spouse and the second spouse, and the wishes of the married couple concerning locking in the identities of beneficiaries to prevent the surviving spouse from altering the intended plan of distribution after the death of the first spouse.