Portability of Estate Tax Exemptions: General Rules

We waited a long time, many would say too long, for estate tax legislation, and when it arrived in December, 2010, it provided some surprises. Perhaps the most significant surprise is the addition of portability of estate and gift tax exemptions between spouses, which had been included in prior bills but was not anticipated to be part of the compromise package. This post will discuss the general rules of portability.

General Rule. For decedents dying in 2011 and 2012, the personal representative can elect to transfer the deceased spouse’s unused exemption to his or her surviving spouse. When the surviving spouse later dies or makes a lifetime gift, the surviving spouse will have his or her own exemption ($5,000,000 in 2011 and 2012) plus the unused exemption of his or her deceased spouse to offset the estate or gift tax. Thus, for the first time, unused exemptions can be transferred between spouses.

Election. The election is made by the personal representative of the deceased spouse’s estate on a timely filed estate tax return (including extensions). Once made, the election is irrevocable. The election actually puts the personal representative in a difficult position. For estates that are not otherwise required to file an estate tax return, the personal representative will need to determine whether it is worthwhile to incur the costs to prepare an estate tax return in order to make the election. Moreover, for estates of all sizes, the transfer of the exemption may not benefit all beneficiaries. Some beneficiaries might object to the estate incurring that additional cost or demand that it be borne by only those beneficiaries who may benefit from it. This new election should be addressed in preparing wills in 2011 and 2012. Generally, the personal representative may be given the authority to elect to transfer the unused exemption regardless of the costs to do so and even if such election favors only some beneficiaries. Further, the personal representative may be released from any liability for making, or choosing not to make, such election.

Statute of Limitations. The election to transfer the unused exemption will keep open the statute of limitations period for the IRS to determine the actual amount of the deceased spouse’s unused exemption. Therefore, planners must consider how this open ended limitations period could affect the surviving spouse. For example, the IRS could examine the deceased spouse’s return many years down the road to contest the value of property passing to children. If the values are increased and, in turn, the unused exemption is reduced, gifts made by the surviving spouse could inadvertently incur gift tax. There is also an interesting relationship to the limitations period for the surviving spouse’s gift tax return, which is not open ended. If an IRS adjustment causes a gift tax in a closed year of the surviving spouse, presumably the IRS would not be able to collect such tax from the surviving spouse.

Limitations on Transfer. To avoid serial marriages for tax reasons, only the unused exemption of the last deceased spouse is counted. This seemingly simple rule adds quite a lot of complexity to these rules. Lets walk through some of the possible scenarios.

What if the surviving spouse, lets call her Anna Nicole, remarried after the death of her first husband, lets call him J. Howard, and also survived spouse number two, lets call him Larry? The unused exemption from J. Howard disappears and is replaced by the unused exemption, if any, from Larry.

But what if Anna Nicole used J. Howard’s unused exemption before Larry died by making gifts? There does not appear to be any prohibition against Anna Nicole using J. Howard’s unused exemption. This seems to be true even if Anna Nicole would have lost some of this unused exemption on Larry’s death (which happens if Larry’s unused exemption that replaces J. Howard’s is lower).

What if Anna Nicole remarried and then died before Larry? Larry cannot get J. Howard’s exemption held by Anna Nicole because Larry can only get unused exemption from Anna Nicole, his last deceased spouse.

What if Larry made gifts during Anna Nicole’s lifetime and Anna Nicole joined in those gifts so that they were treated as half made by her? Larry can effectively use J. Howard’s exemption held by Anna Nicole through these split gifts, but Larry may have to pay gift tax to do so. It is not clear whether J. Howard’s exemption held by Anna Nicole is used before Anna Nicole’s own exemption or whether there is some pro rata reduction of exemptions. Being a cynic, my money’s on the IRS issuing guidance that requires Anna Nicole to use her own exemption before J. Howard’s.

Recapture. This is a highly technical issue the mechanics of which are only interesting to the most devout tax practitioners, but it is important and should be noted that the surviving spouse’s estate tax may be calculated to effectively recapture gifts sheltered by a predeceased spouse’s unused exemption. We await guidance from the IRS on this issue.

GST Tax. The transfer of exemptions between spouses applies for gift and estate tax purposes, but not for generation-skipping transfer (GST) tax purposes. In other words, the deceased spouse’s unused GST tax exemption is not transferable.

Indexed for Inflation. The surviving spouse’s own exemption is indexed for inflation, but the exemption from the deceased spouse is not indexed for inflation.

Surviving Spouse’s Return. The deceased spouse’s exemption is not counted for purposes of determining whether the surviving spouse is required to file an estate tax return.