Portability and the Federal Estate Tax:
Flexibility in Uncertain Times
As a presidential candidate, Donald Trump campaigned on a plan to overhaul the United States tax code, including a repeal of the Federal Estate Tax. Now that Mr. Trump has become President of the United States, the future of the Federal Estate Tax is very uncertain. The below article will provide a very basic overview of the Federal Estate Tax as it currently exists in the law and explain in basic terms how a feature of the law called portability may be beneficial to estates of married couples.
The Federal Estate Tax was first implemented in 1916 as a tax on the total amount of wealth an individual possessed at the time of his or her death. Since the tax was originally designed as a tax on the wealthy, it excludes a certain amount of wealth from its calculation (the “exclusion amount”). In general, the amount of Federal Estate Tax due is calculated by determining the value of the decedent’s property as of his or her death (the “total gross estate”). The total gross estate includes all the decedent’s worldwide property, including individually-owned property, life insurance, jointly-owned property, and property that does not pass through the probate process. Once the total gross estate is calculated, any applicable deductions are subtracted, leaving the net taxable estate. The exclusion amount is then subtracted from the net taxable estate, and the tax is applied on the excess.
Because the Federal Estate Tax is part of the U.S. Tax Code, it is subject to change by Congress. Over the years, both the rate of estate tax and the exclusion amount have fluctuated greatly. For example, when the Federal Estate Tax was first implemented in 1916, the maximum rate of tax was 10% and the exclusion amount was $50,000.00. From 1942-1976, the maximum rate of tax reached an all-time high of 77%, with an exclusion amount of $60,000.00. More recently, the exclusion amount in 2001 was $675,000.00 with a maximum tax rate of 55%, and in 2009 the exclusion amount was $3.5 million with a maximum tax rate of 45%. At present, the maximum tax rate for 2017 is 40%, and the exclusion amount for an individual is $5.49 million.
Given the current high exclusion amount, relatively few estates actually pay Federal Estate Tax. For tax year 2015, fewer than five thousand estates actually paid Federal Estate Tax; the approximately $17 billion generated comprised less than 1% of all federal revenue. More than a third of the revenue generated by the Federal Estate Tax is tax year 2015 was paid by less than three hundred estates valued at $50 million or more.
These statistics show why the Federal Estate Tax is often subject to so much Congressional wrangling: some see the Federal Estate Tax as an unnecessary tax that does not actually generate significant federal revenue, while others see it as a necessary tax on the rich, who can afford to pay it. Therefore, even if the Federal Estate Tax is successfully repealed under the current presidential administration, it may very well be brought back at some point in the future.
Given the uncertain future of the Federal Estate Tax, one estate planning technique that married couples may utilize is a feature called portability. Portability was first signed into the estate tax law by President Barack Obama in 2010, and was made a permanent part of the estate tax law in 2013. Portability allows for the surviving spouse to preserve the unused portion of the deceased spouse’s estate tax exclusion (commonly called the deceased spouse’s unused exemption and abbreviated as “DSUE”) and add that DSUE to the available exclusion at the surviving spouse’s death. This means that the second spouse to die is able to increase the amount of exclusion available to his or her estate, thereby reducing or eliminating the amount of Federal Estate Tax that must be paid at his or her death.
A few very basic examples will illustrate this point. Suppose that Spouse 1 and Spouse 2 are a married couple. Spouse 1 died in 2014 with a net taxable estate of $3 million. In 2014, the exclusion amount was $5.34 million, so Spouse 1 does not need to pay any Federal Estate Tax and has a DSUE of $2.34 million. Spouse 2 properly elects for portability. Spouse 2 then dies in 2017 with a net taxable estate of $7 million. Because Spouse 2 properly elected for portability, Spouse 2 can add the DSUE of $2.34 million to his or her 2017 exclusion of $5.49 million, for a total exclusion amount of $7.83 million. Therefore, Spouse 2’s estate does not have to pay any Federal Estate Tax.
Again using the above example, suppose Spouse 2 did not elect portability at Spouse 1’s death. That would mean that Spouse 2 would only have an exclusion of $5.49 million, and so $1.51 million of Spouse 2’s estate would be subject to Federal Estate Tax at a rate of 40%.
The only way to properly elect for portability is by preparing and filing a Federal Estate Tax Return (IRS Form 706) at the death of the first spouse. Form 706 is due within nine (9) months of the date of death; however, one six (6) month extension may be requested if necessary.
Many clients may think that it is not necessary to elect for portability at the first spouse’s death because the surviving spouse’s estate is not even close to the current exclusion amount, or they feel that the Federal Estate Tax may be repealed entirely under the new administration. However, it is always possible that the exclusion amount could decrease significantly from its current high amount, or that the Federal Estate Tax could be reinstated by a future administration. While portability itself is subject to change or repeal, the law as currently in effect would allow for flexibility given the uncertain future of the Federal Estate Tax. It is therefore important for a surviving spouse to seek legal counsel upon the death of his or her spouse to discuss the complexities of estate administration and the various taxes involved, including whether or not filing for portability may be beneficial.