Title: “The Federal Portability Series”

 

Source: The Prosperity Law Blog Part 1 | Part 2
Word Count: 991 (part 1), 1,421 (part 2)
Notes: This is a 2-part blog on request of the client, merged together into this one project.

"federal portability"This week, I need to bring an issue to light which many people do not know about. The topic of discussion is Federal Portability, which relates to estate tax exemptions. While it’s not as important as it once was, the exemption status and rules should still be considered. New estate tax thresholds have changed the federal portability rules. Let me first explain what federal portability is and you can be more informed to judge for yourself and your family if it’s beneficial.

Federal Portability

Let me briefly explain that portability is the ability to transfer estate tax exemptions from one spouse’s estate to the other, provided that the deceased spouse’s estate doesn’t require all the exemptions. (i.e. Take a typical married couple. If the first spouse (husband) dies and the value of his estate doesn’t require all his federal exemption from estate taxes exemptions, then the unused exemptions can pass to his wife’s exemptions so she can use all available exemptions (his leftovers and her original exemptions)). The main goal is to protect against from paying estate taxes.

The topic of portability came to light through former President Barack Obama. During his first term in 2010, he signed into law the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act or “TRUIRJCA.” This allowed for some changes to take place in the 2011 and 2012 tax years. I believe TRUIRJCA was an experiment of sorts. Three years later in 2013, President Obama signed into law the American Taxpayer Relief Act or “ATRA.” Under ATRA, portability between spouses was made permanent starting 2013 and moving forward. Interestingly enough, a few states stand out as of late:

  • Only Hawaii offers portability at the state level.
  • Maryland will begin offering portability of its state estate tax exemption in 2019.

Real World Examples

The best way to illustrate how the federal portability law affects a married couple is to run through a few examples. The first will illustrate an estate process without portability and the second adds portability.

Example 1: Without Federal Portability

Paul and Helen are married and all their assets are jointly titled. Their combined net worth is an even $8,000,000 for argument’s sake. Paul falls ill and dies within a year of diagnosis. On his death date, the federal estate tax exemption is $5,340,000. Keep in mind: portability of the estate tax exemption between Paul and Helen is NOT IN effect.

In this scenario, when Paul dies, his estate will not need to use any of his $5,340,000 estate tax exemption since all the assets are jointly titled. Additionally, a concept known as the unlimited marital deduction will allow Paul’s share of the joint assets to be automatically transferred to Helen by right of survivorship without incurring any federal estate taxes. The unlimited marital deduction definition simplified is that married couples can make unlimited transfers of property without incurring taxes, either during their lifetimes or after their deaths.

Assuming at the time of Helen’s death, the federal estate tax exemption is still $5,340,000. The estate tax rate is 40%, and now Helen’s estate is still worth $8,000,000.

Now, Paul’s estate tax exemption of $5,340,000 is gone. Helen can only pass on $5,340,000 free from federal estate taxes. Thus, Helen’s estate will owe $1,064,000 in estate taxes after her death. Here’s the math broken down:

An $8,000,000 estate minus the $5,340,000 exemption equals a $2,660,000 taxable estate.
A $2,660,000 taxable estate times the 40% estate tax rate equals $1,064,000. ($1,064,000 in taxes owed from the estate).

Example 2: With Federal Portability

Paul and Helen are married and all their assets are jointly titled. Their combined net worth is an even $8,000,000 for argument’s sake. Paul falls ill and dies within a year of diagnosis. On his death date, the federal estate tax exemption is $5,340,000. (Now 11 million and 22 million, but these figures have a ______ rule 2026.)

Assume Paul and Helen are married and have all of their assets jointly titled and their net worth is $8,000,000, Paul dies first and the federal estate tax exemption is $5,340,000 on the date of Paul’s death, and portability of the estate tax exemption between spouses is IN effect.

Their $8,000,000 estate with the $10,680,000 exemption = $0 taxable estate. The case for portability is simple and clear; it can tremendously help avoid taxes. Here’s how this is possible …

This occurs because Paul will not need to use any of his $5,340,000 worth of estate tax exemptions. Their assets are jointly titled, the unlimited marital deduction allows for the automatic transfer of Paul’s share of the joint assets to Helen by right of survivorship and (without incurring any federal estate taxes). Nothing has changed here.

At the time of Helen’s death, the federal estate tax exemption is still $5,340,000, the estate tax rate is 40%, and Helen’s estate is still worth $8,000,000. It’s the same facts as before. Now … enter the portability of the estate tax exemption. Under ATRA, Paul’s unused $5,340,000 estate tax exemption will be added to Helen’s $5,340,000 exemption, which gives Helen a $10,500,000 exemption. ***

Since Helen has been given Paul’s unused estate tax exemption and she can pass on $10,680,000 free from federal estate taxes at the time of her death, Helen’s $8,000,000 estate will not owe any federal estate taxes at all. Therefore, the portability of the estate tax exemption will save Paul and Helen’s beneficiaries about $1,064,000 in estate taxes.

Nota Bene
*** While we don’t live in a world where good is just handed to people, it’s there with a bit of diligence and work. With that being said, Helen won’t automatically inherit her late husband’s exemptions, just like that. She would need to file a Form 706 (United States Estate and Generation-Skipping Transfer) with the IRS. Having that on record will allow the portability law to work fluently and protect the joint estate from paying out excessive taxes upon the death of both spouses.

"federal portability"Last week, I brought the topic of federal portability to light. Even though it’s not much of a critical issue now, I am still going to blog about it. It’s more of a back-burner issue, but it does need to be on your stove—on your radar. For all my Massachusetts clients and those living here, this blog will help you understand more about federal portability. Incidentally, most states in America, including Massachusetts do not follow the federal portability code. Because Massachusetts applies the federal rules in effect as of 2000, the laws Obama signed, such as TRUIRJCA—the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act—and ATRA—the American Taxpayer Relief Act—do not apply. What are Massachusetts spouses left to do to protect themselves and their estates?

Comparing Portability Vs. The A-B Trust System

Prior to President Obama bringing portability into creation, married couples could pass two times the estate tax exemption to their heirs. This was only possible through a solution called the A-B trust system. Typically, assets were split between the two trusts in the system, Trust A and Trust B. Each spouse had his or her own trust in the pair. When the first spouse died, the assets and exemptions would pass onto the second trust. Once the second spouse died, all assets would be distributed to the beneficiaries.

If you peruse my blog, you’ll see trusts are not an uncommon topic. I’ve covered many common trusts such as special needs trusts, charitable trusts, revocable trusts for your children and now credit shelter trusts. Credit shelter trusts are utilized in most states (including Massachusetts) to reduce and very possibly eliminate estate taxes. They make maximum use of the unified credit for estate taxes—also known as the lifetime exemption. Each individual is allowed a once-in-a- lifetime exemption from estate and gift taxes. The trust itself is best suited for Massachusetts married couples whose estate worth is higher than the amount exempt from estate tax.

(If you do additional research on this topic, understanding the nomenclature is important to keep things straight. “A Trusts” are also known as “Marital Trusts,” “Marital Deduction Trusts, ”or “QTIP Trusts.” On the other hand, “B Trusts” are also called “Bypass Trusts,” “Credit Shelter Trusts,” or “Family Trusts.”)

Now, with portability available on the federal level, dividing the deceased spouse’s estate between the A Trust and B Trust is no longer necessary. In Massachusetts, this is still necessary and the principle holds a lot of water. Without our state recognizing federal portability, we must find a workaround. The option of federal portability is out, meaning the only viable solution is the old-fashioned A-B trust system. The bottom line is that the A-B trust approach allows spouses to take full advantage of all Massachusetts exemptions. Even though it’s not part of federal law under ATRA, credit shelter trusts are as strong in terms of protection.

The Problem With Estate Taxes

Massachusetts is an interesting state in that it does not recognize the federal rule on the estate tax. Massachusetts only follows Massachusetts’ estate tax laws. Estate tax laws apply to estates larger than $1,000,000; this is the threshold.

A married person can leave any assets to his or her spouse, free of estate taxes and without using any estate tax credit. This leaves the estate in a vulnerable spot once the first spouse dies. If portability is not in effect, there’s a chance the second spouse’s estate will be worth more than the exempted amount. If this is the case, the second spouse’s estate will incur estate tax. At the same time, the first spouse’s estate tax credit has been entirely wasted.

The A-B trust system was created to remove the vulnerability of the estates in regard to estate tax. All bypass trusts are very flexible in that they can be revocable or irrevocable as well as living or testamentary. More often than not, the bypass trust creates a single living trust that is revocable and progresses forward from that stage based on the wishes of the grantor.

The A-B Trust System Solution

In an ideal family situation and upon the death of the first spouse, the single living trust is transformed. The death creates a separate, irrevocable “bypass” trust with the deceased spouse’s share of the trust’s assets. The surviving spouse is the beneficiary of this trust, while the children are beneficiaries of the remaining interest. The irrevocable trust is funded to the extent of the first spouse’s exemption. Thus, the amount in the irrevocable trust is not subject to estate taxes upon the first spouse’s death. In this instance, the trust takes full advantage of the first spouse’s estate tax credit.

At the same time, special language exists in the first irrevocable trust to prevent assets in the said trust from being included in the taxable estate of the beneficiary. This involves giving the second spouse limited control over the trust’s assets. Therefore, assets in the irrevocable trust bypass the estate tax that would be normally be assessed (in the vulnerable state) when the second spouse dies.

A Real World (Average) Example

This scenario DOES NOT have credit shelter trust in place: Picture a husband and wife. Thomas and Ashley have a combined net worth of $1,500,000. We’ll assume Thomas dies first and leaves everything to Ashley. Due to the unlimited marital deduction, there’s no tax due from

Thomas’ estate. Now assume Ashley dies without spending the $1,500,000. That lump sum is now included in her taxable estate. Because the maximum threshold for the estate tax is $1,000,000 as mentioned above, she is $500,000 over and now owes an estate tax of 12.8% or $64,000.

This scenario DOES have a credit shelter trust in place: Picture a husband and wife. Thomas and Ashley have a combined net worth of $1,500,000. They divide their assets equally down the middle and hold them in separate revocable trusts with estate tax planning provisions. We are assuming still that Thomas dies first and leaves his assets in a credit shelter trust. His half of the assets are far below the $1,000,000 threshold. Therefore, there’s no estate tax due. Thomas’ credit shelter trust is now available for Ashley, but the value is not added to her taxable estate when she dies. At the time of Ashley’s death, her taxable estate consists of the $750,000 in her revocable trust, which is also under the threshold. Therefore, no estate tax is due.

A Real World (Larger) Example

I want to add in a second example for anyone reading with estates larger than the standard threshold. This scenario DOES NOT have credit shelter trust in place: Jim and Pam have a $3,000,000 combined net worth. Again, we’ll assume Jim dies, leaving everything to Pam. Again, there’s no tax due from Jim’s death because of the unlimited marital deduction. Again, assume Pam dies with $3,000,000 in her taxable estate, she is now over the threshold by $2,000,000, and owes a Massachusetts estate tax of approximately $182,000 (still 12.8%).

This scenario DOES have a credit shelter trust in place: Jim and Pam have a $3,000,000 combined net worth. They divide their assets equally and hold them in revocable trusts with estate tax planning provisions. Assume that when Jim dies first, he leaves $1,000,000 in the credit shelter portion of the trust, and the remaining $500,000 in the marital deduction portion of the trust. Because of the marital deduction, his taxable estate is only $1,000,000, and not over the state threshold. Note that both trusts are available for Pam’s benefit. Upon Pam’s death, her estate consists of the $1,500,000 in her own trust, and $500,000 in the marital trust, for a total estate of $2,000,000. Pam is surely over the threshold by $1,000,000 and owes a Massachusetts estate tax of approximately $100,000. Still, in this scenario, she is saving $82,000 in taxes.

By now, I’ve covered a slew of blogs on charitable trusts as well as credit shelter trusts to circumvent Massachusetts’ avoidance of the ATRA law. Trusts can be simple or complex animals to tame depending on the circumstances. There are plenty of potential downsides—and objections—due to family matters, specific circumstances, and various sizes of estates. There are not manageable or protectable, but I will tell you that all details need to be brought to the table. All the details need to be ironed out to ensure your wishes are met within the unforeseen future.

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