Portability and the New Permanency of Tax Laws

The uncertainty of the last two years was put to rest on January 2, 2013 when President Obama signed into law the “American Taxpayer Relief Act of 2012” (ATRA). The new law saved us from the “Fiscal Cliff” and forestalled significant tax increases for most taxpayers and across-the-board budget cuts. The impact of ATRA is far-reaching and affects all taxpayers (individuals, businesses, estates and trusts) and types of tax (income, capital gains, alternative minimum tax, business, estate, gift and generation-skipping transfer tax). ATRA makes “permanent” the Bush-era tax provisions with minor modifications. The new tax brackets, rates, exemptions and patches do not sunset and will not change unless Congress enacts new legislation that expressly makes a change. Here is a quick look at some of the recent changes.

As of January 1, 2011, the estate, GST and gift tax rate was 35 percent with a unified $5 million exemption. Under ATRA, as of January 1, 2013, the estate, GST and gift tax rate increases from 35 to 40 percent. The unified exemption remains at $5 million (indexed for inflation). In addition, the portability of the exemption to a surviving spouse is preserved under the new law. The exemption amount is indexed for inflation, allowing individuals to acquire additional exemption each year.

Gifting

Annual exclusion gifts are not affected by ATRA. The annual exclusion amount is indexed for inflation, and thus, for 2013, a taxpayer may give up to $14,000 annually to an unlimited number of individuals without using any of the taxpayer’s exemption (and without paying any gift tax). Payments made directly to an educational institution for tuition costs or to a medical care provider for medical costs (including medical insurance) are also excluded from gift tax.

There are leveraging benefits to lifetime gifts, as all future appreciation on such gifts will escape gift and estate tax. Also, lifetime gifts benefit from the tax exclusive nature of the gift tax versus the tax inclusive nature of the estate tax. The gift tax is based only on the amount transferred, and the funds used to pay the gift tax are also removed from the taxpayer’s estate. If the donor waits until death, the funds used to pay the estate tax will be included in the taxable estate. For individuals who have used the $5.12 million of gift tax exemption that was available in 2012, approximately $130,000 of new gift tax exemption is available in 2013.

In prior discussions, President Obama proposed a minimum 10-year term on Grantor Retained Annuity Trusts (GRATs) and would have prohibited zeroed out GRATs (GRATs designed to incur no gift tax exposure). Those limitations are absent from ATRA. Consequently, short-term zeroed out GRATs are still valuable avenues for transferring wealth, especially with the Section 7520 rate remaining low (only 1 percent for January 2013).

All of these factors continue to make lifetime gifts very attractive for those able to make gifts and retain a comfortable standard of living.

Estate Tax

For 2013, the estate tax rate is 40 percent and the maximum estate tax exemption is $5.25 million (less any exemption used during the decedent’s lifetime). The new law did not reinstate the state death tax credit. ATRA continues to allow estates to take a deduction for state death taxes paid. This does not provide a dollar for dollar reduction at the federal level. In fact, for those states imposing an estate tax (e.g., New York and New Jersey), full utilization of the federal estate and GST exemption at the first spouse’s death can be expensive. In such states significant state death taxes may be due when the first spouse dies. In states that do not impose a gift tax, the state death tax impact does not apply lifetime gifts – another example of the advantage of lifetime gifts. We encourage all clients to review their wills and other estate planning documents to make sure these documents still reflect their intentions in light of the increased exemption amounts and new portability rules.
Generation-Skipping Transfer (GST)

As of January 1, 2013, the GST tax rate is 40 percent with a GST exemption of $5.25 million. However, portability does not apply to the GST exemption. Therefore, it remains important for married couples to carefully divide their assets in order to maximize use of their individual GST exemptions. Some interest groups were lobbying to limit the duration of a GST Trust to 90 years. This lobbying effort was unsuccessful. GST Trusts may last as long as permitted under state law. (In some states, including Pennsylvania and New Jersey, there is no limitation on the duration of perpetual trusts.)

Portability

An important component of ATRA is that it “permanently” provides for portability of the estate and gift tax exemption (although not for the GST 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 his or her estate does not require the use all of his or her 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.

This means that married couples can take advantage of a combined “total” of $10.5 million in gift and estate tax exemptions, regardless of the way assets may be titled. Under this new rule, a surviving spouse may use any exemption amount not used by the first spouse to die (plus all prior deceased spouses’ unused exemption amounts). The formula for portability pulled from mondaq.com is:

$5.25 million exemption of first spouse to die
Less exemption used by first spouse for lifetime gifts
Less exemption used by first spouse for gifts at death
Plus any unused exemption of any prior deceased spouse of the first to die

= Unused exemption of first spouse

Plus $5.25 million exemption of surviving spouse
Less exemption already used by surviving spouse for lifetime gifts

= Balance of exemption available for surviving spouse to use for
lifetime gifts or gifts at death

For individuals in states that have decoupled from the federal estate tax (e.g., New York and New Jersey), portability may provide more flexibility and planning opportunities to close the gap between a state’s exemption amount and the federal exemption amount. Special attention must be given to this option, however, due to portability only applying to the estate exemption, not the GST exemption.

Here is a detailed example from about.com on how portability effects transfers 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 $5,250,000 on the date of his death, and portability of the estate tax exemption between spouses is not in effect:

Under these facts, when Bob dies his estate will not need to use any of his $5,250,000 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.

Assume that at the time of Sue’s later death the federal estate tax exemption is still $5,250,000, the estate tax rate is 40%, and Sue’s estate is still worth $8,000,000. With Bob’s $5,250,000 estate tax exemption completely wasted, when Sue later dies she can only pass on $5,250,000 free from federal estate taxes. Thus, Sue’s estate will owe about $1,100,000 in estate taxes after her death:

$8,000,000 estate – $5,250,000 exemption = $2,750,000 taxable estate

$2,750,000 taxable estate x 40% estate tax rate = $1,100,000

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 $5,250,000 on the date of Bob’s death, and portability of the estate tax exemption between spouses is in effect:

As above, when Bob dies his estate will not need to use any of his $5,250,000 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.

Assume that at the time of Sue’s later death the federal estate tax exemption is still $5,250,000, the estate tax rate is 40%, and Sue’s estate is still worth $8,000,000. 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 $5,250,000 estate tax exemption will be added to Sue’s $5,250,000 exemption, in turn giving Sue a $10,500,000 exemption.

Since Sue has “inherited” Bob’s unused estate tax exemption and she can pass on $10,500,000 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:

$8,000,000 estate – $10,500,000 exemption = $0 taxable estate

Thus, portability of the estate tax exemption will save the heirs of Bob and Sue about $1,100,000 in estate taxes. 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.

If you have any questions or concerns about how the new tax laws may effect you, call one of Maya Murphy’s experienced tax law attorneys located in Westport Connecticut today for a free consultation at 203-221-3100.