by Lester B. Law and Andrew T. Huber
This is the second part of a two-part article: Part one, published in last month’s issue of The Florida Bar Journal, discussed the factors to consider in portability planning and addressed some of the ambiguities with the new law. Part two addresses strategies when planning with portability in mind.
Given the wide range of client circumstances (e.g., marital status, age, wealth, family issues, health, etc.), our aim is to provide a framework for analysis where portability is a factor.
Traditional Plan Versus Basic Portability Plan
In part one, we compared the traditional plan with the basic portability plan. The traditional plan (illustrated in Figure 1) provides that each spouse has a pour-over will with a revocable trust incorporating by-pass (or credit shelter) and marital trust planning.1 By comparison, the basic portability plan (illustrated in Figure 2) provides that the couple has “I Love You” wills (i.e., where they leave everything outright to the surviving spouse).
Applying various assumptions, we use the traditional and basic portability plans as a basis to illustrate the pros and cons of portability planning. As shown below, there are times when neither plan is a good fit. In such instances, enhancements can be made to either or both plans to help achieve a better result for the client.
The Estate Tax Versus Income Tax: A New Analysis
Before moving forward, it is important to understand that portability introduces a new tax analysis — planners must now compare the potential income tax detriment to the estate tax detriment under both plans. The following example illustrates this issue:
• Example One — Assume that this is H and W’s2 first and only marriage. H and W have always resided in Florida (a noncommunity property state). H is 73 years old; W is 68 years old. They are receptive to any form of asset ownership and are willing to shift ownership, provided there are no adverse income tax consequences.3 Their descendants will survive both H and W. H dies in 2012. W, who does not remarry, dies in 2021 (i.e., nine years later). A corporate fiduciary will act in all fiduciary capacities (i.e., as personal representative and successor trustees) upon H and W’s deaths. When H dies, his assets will pass to W (in trust or otherwise). Upon W’s death, the net assets will be distributed to the descendants (in trust or otherwise). H and W make no lifetime taxable gifts. The estate, gift, and GST tax laws, as they exist today, will continue through W’s year of death, where the basic exclusion amount4 will increase5 from $5.12 million in 2012 to $6 million in 2021,6 and the transfer tax rate will be a flat 35 percent over any applicable exclusion amount. At the time of H’s death, the couple’s combined net worth was $8 million, each having $4 million in their individual names.
Let’s look at what happens if the value of their net worth grows to $10 million from the time of H’s death to W’s death.7
† The Estate Tax Analysis — Under the traditional plan, H’s $4 million would fund the by-pass trust. If W makes the portability election,8 H’s deceased spousal unused exemption amount (DSUEA)9 of $1.12 million10 will be ported to W. When W dies, her applicable exclusion amount (AEA)11 would be $7.12 million (i.e., her assumed basic exclusion amount (BEA) of $6 million in 2021 and H’s DSUEA of $1.12 million). At W’s death, her estate would not be subject to estate tax because her gross estate will only include the $4 million of assets in her name that grew to $5 million,12 which is well below her $7.12 million AEA.
Under the basic portability plan, H would leave his entire estate to W, which would qualify for the marital deduction under IRC §2056. Accordingly, H uses none of his AEA, and ports his entire DSUEA (of $5.12 million) to W. When W dies, there will be no estate tax, because her gross estate would be $10 million and her AEA would be $11.12 million (i.e., the sum of her assumed $6 million BEA and $5.12 million DSUEA).
Both the traditional plan and the basic portability plan yield the same estate tax result. The tax analysis, however, does not end there — we should consider income taxes, too.
† The Income Tax Analysis — Under the traditional plan, H’s by-pass trust was funded with $4 million. When W died, we assumed that it grew to $5 million. Remember, because the assets were in a by-pass trust, they were not included in W’s gross estate and, therefore, were not afforded the basis adjustment upon W’s death. Accordingly, there is an unrealized gain of $1 million encumbering those by-pass trust assets (that will be triggered when sold). If we assume that the gain would be a capital gain and the income tax rate for capital gains is 20 percent, then there is a future potential tax of $200,000.
Under the basic portability plan, because all of the assets were owned by W at death, they were included in her gross estate. Therefore, under IRC §1014, the assets’ bases were adjusted upward to $10 million. This results in no unrealized gain and no potential future capital gain tax.
Thus, the basic portability plan yields a “better” result, at least from the income tax perspective.
• Example One Estate Tax and Income Tax Summary — The chart on the following page summarizes the results under the different plans and illustrates how portability injects a new dimension in transfer tax planning.
It should be noted that if the asset values decrease over time, then there is a preserved capital loss in the by-pass trust. Thus, one should always look at both possibilities (i.e., asset value increase and decrease). Now let’s look at another example and examine what happens if there is a greater increase in value of the assets from H’s to W’s death.
• Example Two — Let’s assume the same facts as example one, except that the assets increase in value from $8 million at H’s death to $16.24 million at W’s death (instead of $10 million, as in the previous example).
†The Estate Tax Analysis — Under the traditional plan, the results at H’s death would be the same as in example one (i.e., a $4 million by-pass trust is funded, and H’s DSUEA of $1.12 million is ported to W). However, at W’s death there will be an estate tax because W’s gross estate will now be $8.12 million (i.e., her $4 million would have appreciated to that amount). Recall that her AEA was $7.12 million; thus, she would have a taxable estate of $1 million. At a 35 percent estate tax rate, the estate tax liability would be $350,000.
Under the basic portability plan, the result at H’s death would be the same as in example one (i.e., H’s $5.12 million DSUEA would be ported to W). When W later dies, her estate would be liable for estate taxes. In this case, her gross estate would be $16.24 million, while her AEA would be $11.12 million, resulting in $5.12 million being taxed at 35 percent, which equates to a $1.792 million estate tax.
† The Income Tax Analysis — Under the traditional plan, H’s by-pass trust was funded with $4 million. When W died, we assumed that it grew to $8.12 million. Thus, there is an unrealized gain of $4.12 million, which would result in a potential capital gain tax of $824,000 when the assets are sold (assuming the same 20 percent capital gain rate).
Under the basic portability plan, all of H’s assets pass to W and are included in her gross estate. Thus, upon death, W’s assets received a basis adjustment to $16.24 million, resulting in no unrealized gain and no income tax.
† Example Two’s Estate Tax and Income Tax Summary — The chart on the following page summarizes the results and illustrates how portability introduces yet another new tax dimension.
As we illustrate, when the investment return increases,13 relying on portability yields a less beneficial tax result. Even if we assume that the potential income tax on the unrealized gain would be paid immediately upon W’s death, the total estate and income taxes would only be $1.174 million under the traditional plan, compared with $1.792 million under the basic portability plan. Thus, in this case, from an estate and income tax perspective, the basic portability plan appears to be inferior to the traditional plan.
†Preliminary Conclusion about the Estate and Income Tax Issues — It appears that the same three factors that one generally is concerned with in transfer planning in general are also relevant in portability planning in particular. Those factors are 1) time, 2) taxes,14 and 3) investment rate of return. Changes in any of these factors affect what the optimal plan ought to be — or, with hindsight, what the optimal plan ought to have been. The remainder of this article addresses how flexibility in planning can help to achieve potentially better results when working in an environment of unknown variables.
Planning Considerations: Add Flexibility
Having explored the play between income and estate taxes, we now offer some strategies to help navigate through the planning process.
• Example Three — Let’s assume the same facts in example one above, except we will not know W’s life expectancy or the value of the assets at W’s death.
When faced with these facts at the time of planning, one should explore not only the value, but also the nature and tax characteristics of the assets that H and W own. Let’s assume that H owns $3 million in marketable securities (in a non-tax deferred account), the homestead is valued at $1 million, and W owns $4 million in marketable securities (in a non-tax deferred account).
If the client has an existing traditional plan, consider modifying the by-pass trust to allow an independent trustee to make discretionary distributions to W during her life.15 Two main objectives are satisfied by modifying the plan in this manner: 1) The potential wasting of W’s applicable exclusion amount (AEA) is reduced or eliminated; and 2) the basis of distributed assets will be stepped-up upon W’s death.16 Of course, these assets are included in W’s gross estate and will receive a basis step-up upon her death.
If, on the other hand, the clients do not have a traditional plan, but have all assets in joint names (e.g., as TBE), then perhaps one could utilize a basic portability plan and modify it slightly by adding disclaimer trusts to the plan. H and W’s wills would be drafted so that if assets are disclaimed, they will pass into a by-pass type trust (the disclaimer portability plan — see Figure 3). As in the modified traditional plan, we would give an independent trustee (or trust protector) the power to make discretionary distributions to avoid wasting any of W’s AEA and getting the benefit of a step-up in basis upon W’s death. Thus, at H’s death, W could first disclaim17 H’s interest in the joint property, so half of the assets would pass to H’s probate estate. Subsequently, W could disclaim any interest in H’s probate estate so that it would pass to a disclaimer trust for W’s benefit.18
Although neither solution is ideal, it is important to keep in mind that even with uncertainty, one can adjust or modify existing plans to take advantage (or at least, not lose the benefit) of a particular type of plan.
• Example Four — Let’s assume the same facts as example one, except that H and W’s combined net worth is $4 million (instead of $8 million), and it is anticipated that because of consumption and conservative investing, W’s net worth will remain about the same (i.e., $4 million) at the time of her later death. Let’s also assume that H and W have done no estate planning, and their assets are owned as follows: H has $1.5 million IRA and $500,000 of marketable securities in his individual name; W has $1.5 million of marketable securities in her individual name; and H and W own their $500,000 homestead as tenants by the entireties (TBE). Recall that H is 73 years and W is 68 years of age; thus, H is withdrawing required minimum distributions (RMDs) from his IRA.
In this case, where we assume that the assets will not appreciate over time, the basic portability plan appears to be the better route for planning (compared to the traditional plan). The reason for this is even if the surviving spouse does not make the portability election,19 and if the tax laws stay the same, W’s applicable exclusion amount would likely exceed her gross estate; therefore, there will be no estate tax liability. However, with the uncertainty of the tax laws (at this time), the planner should consider modifying the basic portability plan to the disclaimer portability plan.
In addition to having the disclaimer portability plan, H and W must also look at title to assets and other legal documents that may affect ownership, such as the IRA beneficiary designation form. In example four, the clients may want to consider retitling all of the marketable securities (not in the IRA) as TBE property (to obtain a bit more asset protection from third-party creditors), and to facilitate the easy transition of assets from one spouse to the other at death. With regard to the homestead, the planner would keep the homestead in H and W’s names as TBE property, too. Finally, the planner should consider having the spouse as the primary beneficiary and the disclaimer trust as a contingent beneficiary of the IRA, if necessary.20
Planning for Nontax Considerations
We noted that in certain circumstance, from a tax perspective, a particular plan may be more suitable. However, we intentionally assumed away nontax factors that, in real life, may affect the plan. The following summarizes two important nontax issues and appropriate planning strategies.
• “Second” Marriages — There are two aspects that we wish to discuss regarding second marriages:21 The first is the case in which H and W are contemplating marriage, and this will be the second marriage for one or both. The second is the case in which one or both of the spouses are concerned that the survivor may remarry (and change the estate plan after remarriage).
Where H and W are contemplating marriage, and it is a second marriage for either or both of the spouses, quite often the use of a prenuptial plan is recommended, especially where at least one of the spouses is wealthier than the other.22 In this case, the estate planner should be involved in the planning aspects of that agreement (even if he or she is not the primary drafting attorney). If the surviving spouse becomes the personal representative of the estate of the first-to-die, the agreement should provide that portability should be elected, if it is desirable taking all beneficiaries into consideration. Frankly, this may put the spouse at odds with the remainder beneficiaries. With that being the case, we recommend selection of a corporate trustee or another independent person who would make the election if appropriate.
Other issues to consider include the possible loss of one’s DSUEA if the new spouse were to die. This happens because of the so-called “last deceased spouse” rule that we discussed in part one.23
• Example Five — Assume H and W held their entire $10 million in joint names as TBE. As a result of H’s death in 2011, the personal representative properly elected portability and preserved H’s DSUEA of $5 million. Let’s assume that W is contemplating marriage to H2, who also has a net worth $10 million. H2 and W want to leave nothing to each other at death, and instead leave their respective estates to their respective descendants
Should H2 predecease W, as a result of the last deceased spouse rule, H’s $5 million DSUEA would be lost.
One method to compensate for the potential loss of DSUEA is to use life insurance. Life insurance can make up for both a) the estimated amount of estate taxes due as a result of the loss of H’s DSUEA if H2 predeceases W, and b) the cost of purchasing such life insurance. To be fair, both parties should contribute equally to all of the premiums. To accomplish this, H2 and W would each create separate irrevocable life insurance trusts (ILITs) and contribute funds so each ILIT insures the life of the respective grantor. The policy in H2’s ILIT would provide a death benefit to cover the lost DSUEA and the cost of insurance. The policy in W’s ILIT would be used to cover the cost of the premium payments. The goal would be to purchase sufficient insurance to cover all of the costs and to draft the documents to ensure that the parties are roughly made whole.
The other major nontax concern in the portability area is that H and W are married, yet they have concerns about the survivor remarrying. If this is the case, one may wish to consider a traditional plan, instead of the basic portability plan. Alternatively, if they wish to take advantage of portability because they anticipate that upon the second of them to die they will not have an estate tax liability, and they want to take advantage of the step up in basis upon the death of the surviving spouse, perhaps they can make the by-pass trust a “QTIPable” trust, and possibly elect QTIP24 treatment for the by-pass trust, if it is desirable and possible upon the first spouse’s death.25 In this situation, the moneyed spouse would have a QTIPable trust, and at such spouse’s death, QTIP and portability elections would be made. Upon the second spouse’s death, the assets will pass according to the terms of the QTIP trust. Since the QTIP trust is included in the second spouse’s estate, the assets therein will receive an income tax basis adjustment.
† Asset Protection After Death of the First Spouse to Die — To accomplish some level of asset protection planning while both spouses are alive and remain married, they could hold all of their assets jointly as tenants by the entireties (TBE). This naturally leads one to consider using a basic portability plan. However, upon the first spouse’s death, the assets are unprotected (unless protected otherwise, e.g., Florida homestead and inherited IRAs). To attempt to mitigate or reduce creditor exposure, two possible options should be considered.
First, H and W could use a disclaimer portability plan, giving the survivor the option to decide whether to receive assets in his or her own name, or disclaim the TBE assets at the first death and have such assets eventually pass to an asset-protected trust. This will protect the disclaimed assets (i.e., approximately half of the assets) (this assumes at the time of the first death and continuing through the administration phase, there are no creditors as to H and/or W). The survivor could possibly use a self-settled trust in a jurisdiction that allows for asset protection (e.g., Delaware or Alaska) for the remaining assets.26 Alternatively, one may wish to utilize a traditional plan, and have the assets fund the by-pass trust after death of the first spouse to die. Much of the planning would depend upon the particular client circumstances.27 Suffice to say, if asset protection planning is the primary consideration, then one should first plan with protection in mind, and inject other features (e.g., portability planning) into the plan as appropriate.
We view portability as a gift from Congress. However, as with any beneficial provision, appropriate and thoughtful planning is necessary. The estate planner should keep portability planning at the forefront (and not as a back-up plan).28 This is true even though no one knows whether portability will remain a mainstay in our estate and gift tax laws or even whether some of the perceived ambiguities with the current statute will be remedied.
We understand that many clients do not welcome change. However, we feel that the planner should bring the portability opportunity to the client, explain the benefits and burdens, allow the client to choose the course of action, and document the analysis and choice.q
1 By-pass (or credit shelter) and marital trust planning contemplate that upon the first to die, the by-pass or credit shelter trust will be funded with the applicable exclusion amount, as such term is defined in Internal Revenue Code §2010(c)(2) (AEA) and the balance of assets (if any) will fund a marital trust. We contemplate that both trusts will be held for the benefit of the surviving spouse for life, with the remainder passing to the surviving descendants. Henceforth, all references to the Internal Revenue Code shall be to the Internal Revenue Code of 1986, as such Code may have been amended (“Code” or “IRC”). Generally, references to “sections,” “§§,” “section,” or “§” shall be references to the particular section or sections of the Code, unless otherwise provided.
2 We use H for husband and W for wife for purposes of brevity in this article.
3 I.R.C. §1041 provides that asset ownership can be shifted from one spouse to the other without tax consequence for most assets. The major exceptions are IRAs and other forms of deferred compensation.
4 In 2011, the basic exclusion amount (or BEA) was $5 million. I.R.C. §2010(c)(3)(A).
5 The 2011 basic exclusion amount of $5 million is indexed for inflation. See I.R.C. §2010(c)(3)(B). As reported in Rev. Proc. 2011-52, the basic exclusion was inflation-adjusted to $5.12 million for 2012.
6 This equates to roughly a two percent cost-of-living adjustment.
7 This growth equals roughly 2.5 percent compounded annually.
8 We assume that any portability election is timely and properly made for the balance of this article.
9 I.R.C. §2010(c)(4).
10 This is the difference between the 2012 exemption of $5.12 million and a $4 million gross estate.
11 I.R.C. §2010(c)(2) defines the AEA as the sum of the BEA (basic exclusion amount) and DSUEA.
12 The assets in the by-pass trust would not be part of W’s gross estate.
13 In example one, the compounded rate of return is roughly 2.5 percent; whereas, in example two, such rate of return was roughly 8.2 percent.
14 The authors have simplified the analysis by only taking capital gains taxes into account. We acknowledge that there may be rate differentials between individual and trust income tax rates, for instance. We also acknowledge the administrative costs of preparing and filing income tax returns.
15 Alternatively (or in addition to that modification), the trust could have a trust protector who is empowered to distribute assets to W before her death on a discretionary basis.
16 Discretionary distributions of appreciated assets to a beneficiary that are not in satisfaction of a pecuniary amount do not trigger income tax to the trust. I.R.C. §663.
17 We assume that the disclaimer (and any other disclaimer discussed herein) would be a qualified disclaimer under I.R.C. §2518.
18 The planner should be mindful that there are certain limits for disclaimer trusts (e.g., the surviving spouse would not have a power of appointment). These concerns should be considered in the planning process.
19 The authors do not wish to imply that the fiduciaries of H’s estate should not make the portability election; to the contrary, aside from the administrative cost of making the election, we see little downside to making the election. Thus, we think it the better course of action to make the election. We note, however, under I.R.C. §2010(c)(5), the statute of limitations for H’s estate would remain open if the election is made. However, in general, that “downside” should have little or no impact in the decision-making process.
20 If the BEA is decreased to $1 million, giving W the opportunity to disclaim the IRA increases the post-mortem flexibility in H’s estate. It would be unlikely that W would disclaim the IRA; however, we believe it is better planning to allow for all possible options.
21 We use the term “second marriage” to mean a second, third, fourth, etc., marriage of either spouse.
22 The authors suggest recommending prenuptial agreements for first marriages as well.
23 I.R.C. §2010(c)(4)(B) provides that the surviving spouse can only use the DSUEA of such spouse’s last deceased spouse.
24 When referring to a “QTIPable trust” or a “QTIP” election, the authors refer to a qualified terminable interest property trust as contemplated under I.R.C. §2056(b)(7).
25 The planner should be mindful of Rev. Proc. 2001-38, which potentially voids a QTIP election if the estate that is left to a QTIP trust is less than the remaining applicable exclusion amount (AEA). The theory is that QTIP elections not necessary for eliminating the federal estate tax on the estate of the first-to-die are unnecessary and will be ignored. Thus, this strategy may not be viable if H’s gross estate is less than his AEA. The authors hope that Treasury addresses this in light of portability. For a more detailed discussion on this issue, see Richard S. Franklin & Molly B. F. Walls, State Death Tax Planning, Trusts & Estates 32 (Sep. 2011).
26 Cf. Gideon Rothschild, Douglas J. Blattmachr, Mitchell M. Gans & Jonathan G. Blattmachr, IRS Rules Self-settled Alaska Trust Will Not Be in Grantor’s Estate, 37 Est. Plan. (Jan 2010).
27 It is beyond the scope of this article to go into depth about asset-protection planning.
28 We do not mean to convey that one may not try to rely on portability if a plan is not adequate because of changed circumstances or improper planning. We acknowledge that portability may be used to “save” some of the potential lost tax benefits of inadequate plans. However, we wish to advocate that it is better to initially plan with portability, instead of relying on it to fix inadequate plans.
Lester B. Law is a managing director and member of the National Wealth Strategies Group at U.S. Trust in Naples. He is board certified by The Florida Bar in wills, trusts, and estates law. He is an active member in The Florida Bar RPPTL’s Trust Law, Estate and Gift Tax Law, IRA, and Insurance committees. He is also a vice chair of the Estate and Gift Tax Subcommittee for the ABA’s RPTE’s Income and Transfer Tax Group.
Andrew Huber is a senior vice president and wealth strategist at U.S. Trust in Palm Beach. He received his J.D. from the University of Miami School of Law and LL.M. (tax) from the University of Florida College of Law. He is also a director for The Florida Bar’s Tax Section, where he currently serves as co-chair of the education division.
The examples in this article are for illustration purposes only. The opinions of the authors expressed herein are their own and do not necessarily reflect that of U.S. Trust Bank of America Private Wealth Management, Bank of America, N.A., Bank of America Corporation, any of its subsidiaries, and/or affiliates.
This column is submitted on behalf of the Tax Section, Domenick R. Lioce, chair, and Michael D. Miller and Benjamin Jablow, editors.