Using the DSUE to Exempt Family Business Interests From the Estate Tax

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The Tax Cuts and Jobs Act (TCJA) increased the federal estate tax exemption, which is currently $11.58 million per person. This increased exemption amount is due to sunset in 2026 and revert to the base amount of $5 million.

Generally, an individual is not required to file a Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, unless the decedent's estate valuation exceeds the exemption amount in the year of the decedent's death. For instance, an estate of $5 million would not be required to file a federal estate tax return if the decedent died in 2020. But, a federal estate tax return should be considered in connection with the right of portability.

Since the American Taxpayer Relief Act of 2012, portability has allowed a deceased spouse's unused exemption (DSUE) to transfer to the surviving spouse. In order to elect portability of the DSUE, the deceased spouse's estate must file a federal estate tax return and make the election. In the example above, although the $5 million estate is not large enough to trigger a mandatory federal estate tax return, the decedent's estate should consider filing a Form 706 to port the DSUE.

Why the DSUE Matters

This election option has increased importance today because the increased exemption period sunsets in 2026. If the first spouse dies before the exemption sunsets, a portability election for the DSUE will lock in the exemption at the time of the first spouse's death. This is beneficial because $11.58 million of exemption can be transferred to the surviving spouse who may survive to 2026 when the exemption reverts to the base amount of $5 million.

If the first spouse dies during this increased exemption period (before 2026), the DSUE in the year of the first spouse's death will not be reduced when the exemption sunsets. This is because the regulations to the Internal Revenue Code confirm that the DSUE is the lesser of the basic exclusion amount or the unused portion of the first spouse's applicable exclusion amount in the year of the first spouse's death. This ensures that a DSUE amount elected during the increased basic exemption amount period will not be reduced when the increased basic exemption amount sunsets in 2026.

For example, suppose an individual runs a family business worth $10 million and dies in 2020, with her interest in the family business transferring to her spouse using the unlimited marital deduction. A federal estate tax return is not required because the estate does not exceed the $11.58 million exemption, but a return is filed to elect portability of the DSUE. The surviving spouse dies after 2025 when the exemption reverts to $5 million and the family business has increased to $15 million. The surviving spouse has $5 million of his own exemption and $11.58 million of DSUE, shielding the entire value of the family business from the estate tax.

IRS Examples on Portability

The following are helpful examples from section 20.2010-1(c)(2)(iii) and (iv) of the regulations to the Internal Revenue Code (paragraph breaks added for optimal clarity):

Example 3. Individual B's predeceased spouse, C, died before 2026, at a time when the basic exclusion amount was $11.4 million. C had made no taxable gifts and had no taxable estate. C's executor elected, pursuant to § 20.2010-2, to allow B to take into account C's $11.4 million DSUE amount. B made no taxable gifts and did not remarry.

The basic exclusion amount on B's date of death is $6.8 million. Because the total of the amounts allowable as a credit in computing the gift tax payable on B's post-1976 gifts attributable to the basic exclusion amount (zero) is less than the credit based on the basic exclusion amount allowable on B's date of death, this paragraph (c) does not apply.

The credit to be applied for purposes of computing B's estate tax is based on B's $18.2 million applicable exclusion amount, consisting of the $6.8 million basic exclusion amount on B's date of death plus the $11.4 million DSUE amount, subject to the limitation of section 2010(d).

Example 4. Assume the facts are the same as in Example 3 of paragraph (c)(2)(iii) of this section except that, after C's death and before 2026, B makes taxable gifts of $14 million in a year when the basic exclusion amount is $12 million. B is considered to apply the DSUE amount to the gifts before applying B's basic exclusion amount. The amount allowable as a credit in computing the gift tax payable on B's post-1976 gifts for that year ($5,545,800) is the tax on $14 million, consisting of $11.4 million in DSUE amount and $2.6 million in basic exclusion amount.

This basic exclusion amount is 18.6 percent of the $14 million exclusion amount allocable to those gifts, with the result that $1,031,519 (0.186 × $5,545,800) of the amount allowable as a credit for that year in computing gift tax payable is based solely on the basic exclusion amount. The amount allowable as a credit based solely on the basic exclusion amount for purposes of computing B's estate tax ($2,665,800) is the tax on the $6.8 million basic exclusion amount on B's date of death.

Because the portion of the credit allowable in computing the gift tax payable on B's post-1976 gifts based solely on the basic exclusion amount ($1,031,519) is less than the credit based solely on the basic exclusion amount ($2,665,800) allowable on B's date of death, this paragraph (c) does not apply.

The credit to be applied for purposes of computing B's estate tax is based on B's $18.2 million applicable exclusion amount, consisting of the $6.8 million basic exclusion amount on B's date of death plus the $11.4 million DSUE amount, subject to the limitation of section 2010(d).

These regulations confirm that there will be no reduction or claw back of the DSUE if the exemption is reduced in the future. Because there will be no reduction or claw back, a federal estate tax return should be considered at the first spouse's death to elect portability of the DSUE.

Individuals with family business interests should consider transferring these interests to the surviving spouse using the unlimited marital deduction and electing portability for the DSUE. Under the current Internal Revenue Code, this election locks in the increased exemption for the surviving spouse even if the exemption is reduced in the future.

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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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