Estate Tax Planning: Portability, Bypass and QTIP Trusts Explained

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What is portability?

In simple terms, portability means that when the first spouse dies, if the value of his or her taxable estate plus adjusted taxable gifts is less than his or her federal exemption from estate taxes, the surviving spouse can take (or “port”) the unused exemption amount and use it, in addition to the surviving spouse’s own exemption, to make lifetime of testamentary gifts.

Example:

  1. John Doe passes away in 2024, when the federal exemption from estate taxes is $13.61 million.
  2. The value of John’s taxable estate and adjusted taxable gifts is $6 million.
  3. This means that John has not used $7.61 million ($13.61 million exemption – $6 million estate value) of his federal estate tax exemption.
  4. Jane Doe, his surviving spouse, has her own federal exemption of $13.61 million.
  5. Under the portability rule, Jane can add John’s unused $7.61 million exemption to her own, giving her a total exemption of $21.22 million ($13.61 million + $7.61 million).
  6. If Jane’s estate is worth $18 million at her death, she can pass on the entire amount to her heirs without incurring any federal estate taxes, because her available exemption is $21.22 million.

What is the Deceased Spousal Unused Exemption Amount (DSUEA) and when do you know how much it is?

Referring back to the above example, item 3, the DSUEA is $7.61 million, the difference between that year’s exemption amount and the value of his estate. You know the exact amount of the DSUEA after the deceased spouse’s estate has been calculated and the federal estate tax return has been filed and processed. The DSUEA amount is subject to change if the estate undergoes additional review or audit by the IRS.

Is portability automatic?

No. Estates that do not exceed the filing threshold ($13.61 million in 2024) do not need to file an estate tax return [IRS]. Those which do exceed the filing threshold must file within 9 months. However, even if you are not required to file an estate tax return, you must do so if you want to make the portability election.

Previously, the window for filing a portability election, which allows a surviving spouse to apply their deceased spouse’s unused estate tax exemption to their own, was limited to two years after the decedent’s death. Effective from July 8, 2022, this deadline has been extended to five years after the decedent’s death.

What is the impact of inflation on the value of the DSUEA?

The IRS adjusts the basic exclusion amount (in 2024 $13.61 million) each year; because of inflation adjustments, it goes up. The DSUEA, however, is only determined once after the deceased spouse’s estate has been calculated and the federal estate tax return has been filed and processed. It stays the same.
If the survivor wants to make good use of the DSUEA, he or she should do so sooner rather than later by making lifetime gifts. Every year waiting leads to a further erosion of the value of the DSUEA: While the dollar amount is the same, the purchasing power (‘value’) of the gifts that can be made without incurring gift or estate taxes continues to decline.

What happens if the surviving spouse remarries?

The key consideration for a surviving spouse who remarries is that they can only apply the DSUEA from their last deceased spouse towards their own exemption amount. Therefore, strategic estate planning is essential, especially when considering remarriage after having received a DSUEA. For example, the new husband may have already used up most of the basic exemption amount by making large gifts to his children from his first marriage. Should he die first, the surviving spouse has only his much-reduced DSUEA to work with.

If someone has carried over a DSUEA from a previous spouse and then enters into a new marriage, it might be prudent for them to utilize the DSUEA from the earlier spouse by giving gifts during their lifetime. By doing so, they ensure that the DSUEA from the former spouse is utilized before the death of a later spouse. This strategy could enable an individual who outlives more than one spouse to effectively apply several DSUEAs over time.

Did portability make the use of a bypass trust obsolete?

The short answer is No. A bypass trust, also known as a credit shelter trust or family trust, is a type of trust that allows couples to minimize estate taxes by “bypassing” the surviving spouse’s estate. When the first spouse dies, assets up to the estate tax exemption limit are placed into the trust. The surviving spouse can benefit from the trust during their lifetime, but the assets in the trust are not included in their estate upon death. This allows the couple to effectively use both spouses’ estate tax exemptions, reducing the taxable estate when the surviving spouse dies.

Congress has presented portability as an option to mimic the effects of bypass trust arrangements so that people who did not avail themselves of sophisticated estate planning would not be left behind. At a basic level, this appears to be the case. The purpose of portability is to permit the surviving spouse to apply the unused exemption of their deceased spouse, thereby preventing the exemption from being forfeited. Bypass trust planning achieved this goal before portability was established.  Still, there are certain goals only a bypass trust can accomplish.

What are the advantages of a bypass trust compared to using only portability?

Preventing Reduction of Sheltered Amount: Using a bypass trust ensures that the deceased spouse’s Applicable Exclusion Amount (AEA) is preserved, regardless of future changes in estate tax laws or if the surviving spouse remarries and loses the DSUEA from the first spouse.

Sheltering Appreciation: The Basic Exclusion Amount (BEA) increases with inflation, but the DSUEA does not. Therefore, to protect the value of an estate against inflation, including future appreciation, a bypass trust is recommended.

Planning for Blended Families: In blended families where there is a desire to control the ultimate distribution of assets to one’s own children, rather than to the surviving spouse’s heirs, a bypass trust is preferable to portability, as it allows for more control over the final disposition of assets.

Generation-Skipping Planning: Portability does not extend to the generation-skipping tax (GST) exemption, meaning it’s lost if assets are passed directly to a surviving spouse. By using a bypass or QTIP trust (these are very different strategies, see below), the deceased spouse’s GST exemption can be applied, potentially allowing assets to pass to grandchildren free of GST.

Non-Citizen Spouse: Portability is not suitable for couples where one spouse is not a U.S. citizen because gifts and bequests to a non-citizen spouse do not qualify for the unlimited marital deduction. Traditional planning methods, such as a QDOT (Qualified Domestic Trust), are necessary to avoid estate taxes at the time of the first spouse’s death.

What are the benefits of portability as opposed to relying only on a bypass trust?

Basis Adjustment at Second Death: Portability can result in a step-up in basis for the assets included in the surviving spouse’s estate, as per Internal Revenue Code section 1014. This is beneficial if the assets have appreciated during the surviving spouse’s lifetime, especially for depreciable property, which could then have a new depreciation base or avoid depreciation recapture on a sale after death. If the estate’s value is less than the combined AEA and DSUEA, this step-up in basis occurs without incurring estate taxes.

Retirement Benefit Planning: Portability eliminates the difficult choice between using a deceased spouse’s AEA and the income tax advantages of a spousal rollover for IRAs or defined contribution plans. The surviving spouse can now execute a spousal rollover and still utilize the deceased spouse’s AEA by transferring the DSUEA.

S Corporation Planning: Before portability, planning for S corporation shares in an estate required the use of specific types of trusts that qualify as S corporation shareholders, such as QSSTs or ESBTs, each with its disadvantages. Portability allows for the deceased spouse’s shares to be transferred directly to the surviving spouse or to a revocable trust, which is treated as a grantor trust, thus using the DSUEA and avoiding the complexities and tax issues of QSSTs or ESBTs.

Can we combine the benefits of portability and bypass trusts?

The section describes how portability can be combined with Qualified Terminable Interest Property (QTIP) trust planning to gain certain advantages in estate planning. Traditionally, the marital deduction allows assets to be passed to the surviving spouse tax-free upon the death of the first spouse, but this typically requires giving the surviving spouse outright ownership of the assets. QTIP trusts utilize this benefit without requiring the transfer of outright ownership, maintaining the assets within a trust structure.

QTIP Trusts for Basis Adjustment: A QTIP trust offers an alternative to a bypass trust for managing assets after one spouse’s death. A QTIP trust enables the deceased spouse’s assets to qualify for the marital deduction—to recap, this is the tax provision allowing unlimited, tax-free transfers of assets to the surviving spouse. This strategy prevents the assets from using up the deceased’s estate tax exemption limit (AEA, in 2024 $13.61 million) upon the first spouse’s death. It’s important to note, however, that while taxes are deferred at the first death, estate taxes may be due upon the second spouse’s death, when the assets are finally transferred out of the trust.

The key advantage of a QTIP trust is in its handling of assets for tax purposes. The assets placed in a QTIP trust are counted as part of the surviving spouse’s estate. Upon the death of the surviving spouse, these assets are reassessed to their current market value, which often results in a basis adjustment. This adjustment can significantly reduce capital gains tax if the assets have appreciated over time. Importantly, this mechanism allows for the strategic use of both spouses’ exemption amounts to minimize taxes and maximize the value passed on to heirs.

In contrast, assets held in a simple bypass or credit shelter trust do not benefit from the same basis adjustment mechanism upon the death of the surviving spouse. This type of trust is structured to utilize the deceased spouse’s estate tax exemption without the assets being transferred directly to the surviving spouse, thereby bypassing the surviving spouse’s estate. As a result, these assets are not reassessed for their market value at the time of the surviving spouse’s death. The basis of the assets remains as it was at the time of the first spouse’s death, without any adjustment for appreciation during the surviving spouse’s lifetime. Consequently, when the ultimate beneficiaries sell these assets, they may face higher capital gains taxes due to the lack of a step-up in basis.

Creditor Protection: A QTIP trust can offer comparable creditor protection to a bypass trust if it includes a spendthrift clause, except regarding the income that must be distributed annually to the surviving spouse.

Generation-Skipping Transfer (GST) Tax Planning: A QTIP trust can be used to allocate the deceased spouse’s GST exemption to the trust’s assets by making a reverse QTIP election, which is not exclusively possible with a bypass trust.

Blended Family Planning: QTIP trusts provide a way to ensure that after the surviving spouse’s death, the trust assets go to the beneficiaries chosen by the deceased spouse, which is particularly useful in blended family situations.

Clayton QTIP Trust: This is a variation of the QTIP trust that provides additional flexibility. The fiduciary can decide after the death of the spouse whether to treat the trust as QTIP or allow it to pass directly to descendants, depending on what is most advantageous at the time.

Overall, QTIP trusts, when combined with portability, can offer flexible and advantageous estate planning options, particularly in complex family situations and for maximizing tax benefits. However, careful consideration and planning are needed to navigate potential challenges and ensure the trust’s intentions are realized.

What are the take-home points?

Portability should not be viewed merely as a procedural matter following a spouse’s death; it significantly influences current and future marital estate planning. It provides an alternative approach that can enhance the flexibility of married couples’ estate plans. Nonetheless, as highlighted in this blog post, portability introduces various challenges and complexities, increasing the responsibility of estate planners to ensure portability is used effectively and aligns with the deceased spouse’s intentions. It requires careful drafting of estate documents to preserve options for the surviving spouse and beneficiaries. Additionally, portability raises considerations for lifetime gift strategies, particularly when a surviving spouse possesses a substantial DSUEA from a previous spouse, which may exceed any future DSUEA. Estate planners must meticulously consider portability in each case, tailoring their guidance to the unique needs and situations of each married couple they assist.

Further Reading (an older article, excellent, hard to find): Portability: The Basics and Beyond [PermaLink]

What is a qualified terminable interest property (QTIP) trust?

Portability and the Unlimited Marital Deduction – Explained Step by Step

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