Exercise Caution with Portability and Second Marriages

Traditional planning required the first spouse to die to leave property in a credit shelter, or family, trust in order to use the applicable exclusion from estate tax and keep the property sheltered from estate tax in that generation. Now, a spouse has an option of leaving property just for his or her spouse, take advantage of the marital deduction, and elect to have the applicable exclusion transfer to the surviving spouse. The surviving spouse will have more property in his or her estate, but also have both that spouse’s own exclusion and part or all of the predeceased spouse’s applicable exclusion (called the DSUE amount in the Code).  With a current exclusion of $12,920,000, the surviving spouse could conceivably have as much as $25,840,000 of property sheltered from estate tax.

Since portability was enacted as part of the Tax Relief Act of 2010, it also has taken the pressure off of couples to formulate an estate plan around a primary goal of suing as much exclusion as possible at the first death. By eliminating the “use it or lose it” aspect of planning with the applicable exclusion, portability allows a couple to set aside property in a non-marital trust at the first death, but not cause use of the exclusion to drive other planning decisions. This is particularly important for couples with large amounts in IRAs, who wish to leave the IRAs directly to the surviving spouse because of the income tax advantages. For a more detailed examination of portability and marital deduction planning, click on the attached link.

Despite its advantages, portability is not always recommended. The family’s attorney and family office advisers should exercise particular caution in a marriage where there are children from a prior marriage, or other non-standard family situations. Here, portability remains a dangerous choice. The estate planning attorney needs to consider whether leaving an executor with discretion to use portability is even appropriate, and if it is, who the executor should be and how the estate tax burden should be allocated.

The problem with portability in non-standard families is that it allows the surviving spouse to use the DSUE amount personally, rather than for the beneficiaries of the first spouse to die. In effect, electing portability is like leaving assets outright to that surviving spouse. The regulations provide that, for a testate decedent, only the executor can make the portability election. In these situations, the executor probably should not be a beneficiary under the estate plan, and/or should be directed as to a portability election.

For example, if the estate is not large enough to independently require the filing of an estate tax return, an executor who is a child of a prior marriage may choose not to incur the expense of filing an estate tax return solely to make the portability election for the second spouse. Rather than have the parties disagree over the need for a return, or over covering the cost of its preparation, it is better to have the estate plan direct whether an estate tax return should be filed to elect portability, and, if so, who is responsible for the cost of the preparation and filing.

Often, in a complex family structure where a client has children from a prior marriage, a QTIP trust is used for the surviving spouse, with the trust assets eventually passing to the client’s descendants. However, when a QTIP trust is combined with portability, the client’s estate plan may not operate as intended.

Example: John marries Mary several years after his wife, Janet dies. John has three children from his marriage to Janet. John bequeaths most of his estate to a QTIP trust for Mary, remainder to his children. He names Mary as executor. At John’s death, Mary elects QTIP treatment for the trust and portability. She then makes gifts of her own assets to her family using John’s DSUE amount. Mary dies with an estate equal to her basic exclusion amount, which she also leaves to her family. The QTIP trust pays estate tax, and John’s children receive no benefit from John’s exclusion amount.

Even if Mary did not make gifts to her family, assuming that her estate was large enough to absorb most of her applicable exclusion amount (including the DSUE), the QTIP trust would have to contribute to pay the estate taxes attributed to it, unless the estate plan waives reimbursement. Code Section 2207A requires reimbursement on a marginal not proportionate basis. Thus, the QTIP trust could bear most or all of the estate tax at the second spouse’s death, while the second spouse’s personal assets are sheltered in part by the deceased spouse’s DSUE amount. In cases such as these, the more prudent course of action may be to use traditional credit shelter/marital deduction planning. If there is DSUE amount available, then the estate plan should direct whether it will be used and how the tax burden on the QTIP trust is handled.

These issues also could be addressed in a prenuptial or postnuptial agreement. For example, the parties could agree to permit the surviving spouse to have the use of any DSUE amount of the first spouse to die in return for an agreement that the surviving spouse would waive the right of reimbursement for tax due as a result of the inclusion of the QTIP trust in the surviving spouse’s estate (or at least for that portion of the QTIP trust equal to the DSUE amount).