The IRS just came out with their final rulings on how portability is to be used for the federal estate tax exemption.  That statement alone probably makes no sense to half of my readers, so let me take a step back and explain.

Currently there is a $5.43 million exemption to the federal estate tax.  This means that you only have to pay tax on anything that exceeds that amount.  The IRS says that if you don’t use all of your exemption when you die, your surviving spouse can ‘port’ it over to her and add it to her exemption amount.

A simple example is you and your spouse have $5 million each.  Upon your death, you give $3 million to your spouse and give the remaining $2 million of your assets to your kids.  Your spouse gets the $3 million estate tax free as there is an unlimited marital deduction (doesn’t matter how much you give to your spouse, it’s tax free).  The kids also get the $2 million tax free as that’s less than the max exemption of $5.43 million.  Your wife can then port over the remaining $3.43 million of your unused exemption to her to add to whatever her exemption is at the time of her death.  Sounds easy, but if you are at all familiar with the IRS, you know that nothing they do or say is easy.

In order for the surviving spouse to elect portability, he or she must file a federal estate tax return; even if there is no tax due.  Understand that this is over a 30 page, confusing document that must be filled out.  There was talk about a short form for those with non-taxable estates, but that never happened.  So now you will probably incur the time and expense of an accountant or tax attorney.

Even if the surviving spouse is way below the estate tax exemption threshold, it may be the prudent thing to file within the allowed 9 months after the death and elect it anyway.  If you don’t and then win the lottery, get a legal settlement or inheritance, or if the estate tax threshold drops, you may regret not shielding the extra dollars from estate tax.

To add insult to injury, if the deceased had an estate that had to go through Surrogate’s Court so that a fiduciary was appointed, only the fiduciary can file the tax return.  This may or may not be the spouse as many people nominate their children, accountant, or attorney as not to burden their spouse.  The surviving spouse has no power to force the fiduciary to file the tax return and cannot file it herself.

Another problem is that electing to port over the exemption may not be advantageous for the more affluent couples.  Using the example above, let’s say that you left all of your $5 million to your spouse.  She now has $10 million in assets and a $10 million exemption after porting over your $5 million.  In 10 years her estate has now grown to $12 million and the exemption has risen to $6 million.  But that’s only her exemption.  The amount that was ported over does not change, so there’s only an $11 million exemption leaving $1million taxable at a 40% tax rate.

If, instead, you gave your $5 million to your children (preferably through some sort of a trust for them), your spouse would still have her original $5 million.  Following above, the assets now grow to $12 million ($6 million in the trust and $6 million of the spouse’s).  And, as above, the exemption has also grown to $6 million.  The surviving spouse, now deceased, can pass the rest of the entire estate tax free to the children, saving $400,000 in taxes.

Lastly, you must remember that portability is only for federal estate taxes.  New York also has an estate tax with an exemption currently at approximately $3.1 million.  But there is no portability in New York.  If you don’t use your exemption, you lose it.  So, the examples above would be disastrous in New York, as the marital deduction is overused and the exemptions are underused.

One way to avoid the problems and pitfalls of using the portability option is to use credit shelter or disclaimer credit shelter trusts instead.   Of course, if you don’t like trusts, you can just leave the maximum exemption amount directly to your heirs outright, but then your surviving spouse would not be able to have any access to any of the assets given to them.  To fully understand the ins and outs of these trusts, you need to speak to a qualified estate planning attorney.