In December 2010, the federal government passed a law that made several significant changes to the estate, gift and generation skipping transfer (GST) tax law effective January 1, 2011.  These include increasing the federal estate and gift tax exemption to $5M and a provision commonly referred to as Portability. At first glance Portability seems to offer a huge benefit to married couples wealthy enough to worry about federal estate taxes.  However, like may “good” things, this one may not be as good as it first appears.

Portability refers to the surviving spouse’s ability to use the amount of his or her deceased spouse’s unused federal estate and gift tax exemption to shelter the gifts made during lifetime and bequests at death by the surviving spouse from Federal estate and gift tax. It would appear that a couple with combined assets of less than $10M could have a simple will which leaves everything to the surviving spouse and the surviving spouse would not have to be concerned about his or her heirs paying federal estate tax and that their combined $10M would shelter bequests at the surviving spouse’s death so no federal estate tax would be due.  Before Portability, the only way to get this result and utilize the federal estate tax exemption of both spouses was to create an Exemption Trust (also commonly referred to an Exemption Trust , “B” Trust, a Shelter Trust, a Family Trust, or Exemption Trust) under a will or trust which could be fully funded at the death of the first spouse. Portability would appear to greatly simplify or eliminate the need for more advanced estate planning and the use of the Exemption Trust.

While many couples may want to rely on Portability for their estate tax planning, there are a number of reasons why this may not be desirable.  First, portability is scheduled to expire on December 31, 2012. That means you or your spouse would have to die before the end of 2012 to take advantage of it benefits. And even if portability is extended beyond 2012, its utility is still limited.

Portability is not automatic. In order to preserve the deceased spouse’s unutilized exemption, the executor of the deceased spouse’s estate must make an election on a timely filed federal estate tax return (9 months after death or 15 months if an extension was requested and granted). Estates that would not otherwise need to file a federal estate tax return (those with a gross estate under the federal estate tax exemption), will now need to file. The executor of every estate, no matter how small, will need to strongly consider filing a federal estate tax return to preserve the decedent’s unutilized exemption or risk being held liable for the failure to do so.

Portability only applies to the last deceased spouse of an individual.  If the surviving spouse remarries and his or her second spouse also dies, the surviving spouse is limited to the unused exemption of the second spouse.

Portability does not apply to GST Taxes.  Portability applies only to the estate and gift tax exemption and not to the generation skipping tax exemption.  Couples who want to benefit grandchildren and subsequent generations at the death of the second spouse cannot rely on portability to shelter the assets from GST tax.

Portability does not apply to State Estate Taxes. Many states have a State Estate Tax with exemptions that do not mirror amount of the federal estate tax exemption. Individuals that live in a state with an estate tax or who own property in a state that has an estate tax could be at risk if they rely on Portability alone. For example, New Jersey and New York have state estate taxes with exemption of $675,000 and $1M, respectively, and they do not recognize portability. (Pennsylvania does not have an estate tax.). However, there is a complex interplay of the federal estate tax law and some of the states’ estate tax law, which requires careful analysis before it can be determined which approach will provide the greatest overall tax savings as your estate passes to future generations.

Portability does not provide any creditor protection for the surviving spouse. Assets that pass outright to the surviving spouse are subject to the claims of his or her creditors.

Exemption Trust vs. Portability.

For many of my clients, the biggest shortcoming of Portability is the loss of asset protection. Members of the medical community are very aware of and rightfully concerned about creditors’ claims and the need for asset protection planning. An Exemption Trust can provide asset protection for the surviving spouse and future trust beneficiaries. An Exemption Trust can take many forms.  Often times, the surviving spouse is entitled to all of the income and principal in accordance with a defined standard. The Exemption Trust utilizes some or all of the deceased spouse’s federal estate and GST exemptions so the assets remaining in the trust will pass to the remainder beneficiaries, i.e. children and grandchildren, free from federal estate tax and generation skipping transfer taxes. Through a properly drafted Exemption Trust, the assets in the trust will never be subject to the creditors of any beneficiary.

Advantages of an Exemption Trust.
• No federal estate tax return is needed unless the gross taxable estate of the deceased spouse exceeds the federal estate tax exemption at the time of his or her death.
• Assets placed in an Exemption Trust, including the growth on those assets, will never be subject to federal estate or GST tax.
• The exemption of the deceased spouse is not lost if the surviving spouse remarries, no matter how many times.
• An Exemption Trust preserves the state estate tax of the deceased spouse.
• An Exemption Trust provides Asset protection for the surviving spouse and subsequent generations of trust beneficiaries.

Portability may answer the estate planning needs of some people.  It is surely better than the federal estate tax law without Portability.  However, people should not be lulled into complacency.  In light of the limitations, Portability should not be relied upon in the place of prudent estate planning.