Congress recently made permanent the “portability” of a predeceasing spouse’s unused estate tax exemption (currently, $5.25 million per spouse).

On one hand, portability creates a potential tax planning opportunity:

  • Before portability, a Bypass Trust created at the first death was the sole method of insulating assets from inclusion in the survivor’s taxable estate.  Assets in a Bypass Trust, however, are ineligible to receive a step-up income tax basis at the survivor’s death.  Thus, all capital appreciation on Bypass Trust assets is subject to capital gains tax.

  • With portability, the survivor “inherits” the predeceasing spouse’s unused exemption.  Couples may therefore forgo a Bypass Trust (at least to the extent assets are not expected to exceed the combined exemption at the survivor’s death).  In doing so, couples can potentially avoid the estate tax and enjoy a step-up basis on all assets.

On the other hand, relying solely on portability has major risks:

  • The entire “inherited” exemption is completely forfeited if: 
    • The survivor remarries, or
    • The executor of the predeceasing spouse’s estate fails to file a simplified estate tax return
  • The failure to establish a Bypass Trust:
    • Bestows the survivor unlimited control over all assets which [i] allows the survivor to transfer the predeceasing spouse’s assets to anyone, and [ii] risks mismanagement of the assets;

    • Does not preserve the predeceasing spouse’s generation-skipping transfer (“GST”) tax exemption (which is not portable) and therefore fails to exclude assets the taxable estates of children and grandchildren;

    • Does not remove growth on the inherited assets (e.g. income and appreciation) from the survivor’s taxable estate; and

    • Exposes assets to the survivor’s creditors (and new spouse).

The bottom line: portability has the potential to reduce income taxes, but there are enormous risks that need to be discussed with an attorney before proceeding.

If you have any questions, please contact Jonathon Morrison at jmorrison@carr-mcclellan.com or at (650) 342-9600.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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