Under the estate tax rules that applied in 2009 and prior years, a married couple had to engage in rather complicated estate tax planning to claim their entire family exemption. In 2009, this was $3.5 million per person, or $7 million for a couple. It was less in prior years. If planning were not properly addressed, all assets on the death of the first spouse to die would pass to the surviving spouse. While there would be no tax on the first death, assets would be doubled up in the surviving spouse's estate and subject to a greater estate tax. To avoid the negative estate tax consequence, the couple would have to divide assets between them so that whoever died first would have sufficient assets to fund a bypass trust (also referred to as an applicable exclusion or credit shelter trust) on the first death with an amount equal to the estate tax exemption. The assets in the bypass trust (including all of their appreciation) would not be subject to estate tax at the second spouse's death. The result of these rules is that many taxpayers who incurred the expense and made the effort to properly plan their estates could have avoided estate tax. But taxpayers who did not receive sufficient advice, would leave their estates vulnerable to the estate tax. The need for this type of planning, and the means to prevent unsuspecting taxpayers from being ensnared by the estate tax, was to provide a mechanism to enable the surviving spouse to benefit from the deceased spouse's unused estate tax exclusion. Such a mechanism has been provided for the first time in the TRA.
So does the new portability paradigm avoid complexity? To some degree, but not as much as many taxpayers may believe. As with so many "tax simplifications" (think about the automatic allocation of GST exemption as an example), the simplification cure can be worse than the tax complexity for which it was prescribed. It's like the old adage: "The cure is worse than the disease."
The unfortunate reality is that for many taxpayers the steps and decisions involved with portability may be quite complex. In many situations, relying on the simplification portability is intended to provide, will prove very detrimental. Assets held in a traditional bypass trust on the death of the first spouse, could appreciate without limit and not be subject to estate tax in the surviving spouse's estate. If instead of a bypass trust, the client opted for the cheaper "I love you will" leaving all of his or her estate to the surviving spouse outright, then portability might come to the rescue to protect the assets up to the amount of the portable exclusion. The incremental benefit is that the assets included in the surviving spouse's estate will receive a step up in basis on the last-to-die spouse's death. The assets in the bypass trust will not.
The decision as to whether to fund a bypass trust, with the complexities just described, will have to be made without the benefit of hindsight. Thus, the determination as to which assets might fund the bypass trust, the life expectancy of the surviving spouse, the likelihood of the surviving spouse remarrying a new spouse who dies before the surviving spouse, the appreciation potential of the assets used to fund the bypass trust, the inflation increase in the surviving spouse's exclusion, and many more considerations will have to be evaluated to make the optimal decision. But in many instances, instead of going through this analysis, the use of appropriate trusts on the death of the first spouse will probably prove the safer bet and well worth the cost involved. Similarly, non-married partners will likely find trusts the way to go.
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