Do You Understand Portability of the Estate Tax Exemption?

On December 17, 2010, President Obama signed the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 ("TRUIRJCA" for short) into law. As part of this law, significant modifications were made to the rules governing federal estate taxes, gift taxes and generation skipping transfer taxes. In addition, TRUIRJCA introduced for the first time the concept of "portability" of the federal estate tax exemption between married couples for the 2011 and 2012 tax years.

Then, on January 2, 2013, President Obama signed the American Taxpayer Relief Act ("ATRA" for short) into law. Under the provisions of ATRA, portability of the estate tax exemption between married couples has been made permanent for 2013 and future years. So what does "portability" of the estate tax exemption mean?

Definition of Portability of the Estate Tax Exemption

In simple terms, portability of the federal estate tax exemption between married couples means that if the first spouse dies and the value of the estate does not require the use all of the deceased spouse's federal exemption from estate taxes, then the amount of the exemption that was not used for the deceased spouse's estate may be transferred to the surviving spouse's exemption so that he or she can use the deceased spouse's unused exemption plus his or her own exemption when the surviving spouse later dies.

Note that with regard to state estate taxes, currently only Hawaii offers portability at the state level, and Maryland will begin offering portability of its state estate tax exemption beginning in 2019.

Examples of Portability of the Estate Tax Exemption

Some examples using numbers should help to illustrate the concept of portability of the federal estate tax exemption between spouses:

Result Without Portability

Assume Bob and Sue are married and have all of their assets jointly titled and their net worth is $8,000,000, Bob dies first and the federal estate tax exemption is $5,340,000 on the date of his death, and portability of the estate tax exemption between spouses is not in effect:

1. Under these facts, when Bob dies his estate will not need to use any of his $5,340,000 estate tax exemption since all of the assets are jointly titled and the unlimited marital deduction will allow Bob's share of the joint assets to be automatically transferred to Sue by right of survivorship without incurring any federal estate taxes.
2. Assume that at the time of Sue's later death the federal estate tax exemption is still $5,340,000, the estate tax rate is 40%, and Sue's estate is still worth $8,000,000.
3. With Bob's $5,340,000 estate tax exemption completely wasted, when Sue later dies she can only pass on $5,340,000 free from federal estate taxes. Thus, Sue's estate will owe about $1,064,000 in estate taxes after her death:

$8,000,000 estate - $5,340,000 exemption = $2,660,000 taxable estate
$2,660,000 taxable estate x 40% estate tax rate = $1,064,000

Result With Portability

Assume Bob and Sue are married and have all of their assets jointly titled and their net worth is $8,000,000, Bob dies first and the federal estate tax exemption is $5,340,000 on the date of Bob's death, and portability of the estate tax exemption between spouses is in effect:

$8,000,000 estate - $10,680,000 exemption = $0 taxable estate

1. As above, when Bob dies his estate will not need to use any of his $5,340,000 estate tax exemption since all of the assets are jointly titled and the unlimited marital deduction allows for the automatic transfer of Bob's share of the joint assets to Sue by right of survivorship and without incurring any federal estate taxes.
2. Assume that at the time of Sue's later death the federal estate tax exemption is still $5,340,000, the estate tax rate is 40%, and Sue's estate is still worth $8,000,000.
3. Enter portability of the estate tax exemption - Using the concept of portability of the estate tax exemption between spouses, under these facts Bob's unused $5,340,000 estate tax exemption will be added to Sue's $5,340,000 exemption, in turn giving Sue a $10,500,000 exemption.
4. Since Sue has "inherited" Bob's unused estate tax exemption and she can pass on $10,680,000 free from federal estate taxes at the time of her death, Sue's $8,000,000 estate will not owe any federal estate taxes at all:
5. Thus, portability of the estate tax exemption will save the heirs of Bob and Sue about $1,064,000 in estate taxes.
6. Note that Sue will not automatically "inherit" Bob's unused exemption; instead, she must timely file IRS Form 706, United States Estate and Generation Skipping Transfer) Tax Return, in order to make an affirmative election to add Bob's unused exemption to her exemption. See Rev. Proc. 2014-18 for special rules that apply to the estates of married decedents who died after December 31, 2010, and on or before December 31, 2013.

Comparing Portability With the AB Trust System

Prior to the enactment of portability, the only way that married couples could pass on two times the estate tax exemption to their heirs was to use the AB Trust system.  With portability, however, dividing the deceased spouse's estate between the A Trust and B Trust is no longer necessary.