To Port or Not to Port: Is Filing for Portability Right for You?

Prior to 2010, the concept of portability as a tax strategy simply did not exist. Any amount of a lifetime exemption that went unused by an estate was purely lost. However, in 2010 Congress passed the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act (“the Act”), which introduced the ability to “port” unused exemption amounts between a married couple.

When enacted, portability was originally set to expire in 2013, but it was made permanent that year and can only be changed if the law is repealed. As a permanent tax planning consideration for married couples, it can have a significant impact on your situation, maybe more than you think.

What is Portability?

Portability was designed to minimize the impact of estate taxes by allowing a surviving spouse to use the remaining lifetime exemption of a deceased spouse, referred to as the deceased spouse’s unused exemption (DSUE). Married individuals can now each protect up to $12.92 million in 2023 from gift and estate tax, even if they do not have an updated estate plan or “credit shelter trust” provisions. Looking ahead, the lifetime exemption amount is scheduled to decrease to approximately $6 million in 2026, so plan accordingly as we approach anticipated changes in estate tax law.

As you consider portability, it’s important to note that it is an election. That means that the transfer is not automatic but rather can only be transferred by completing the election on Form 706 Estate Tax Return. Traditionally, the form must be filed in a completed manner and filed within nine months after death (with a six-month extension option), even if the exemption amount is not subject to tax and falls under the lifetime threshold. There are special exceptions for filing late if only filing for portability, as long as it is filed with five years of the date of death. Filing Form 706 and electing portability will preserve the remaining exemption amount. Understanding the temporary relief provided by the IRS for non-spouse beneficiaries, such as the waiver of required minimum distributions in 2023, adds another layer to the intricate landscape of estate planning.

Benefits of Portability

There are a number of advantages to electing portability in your estate plan. The most obvious is the significant tax benefits that accompany this option. Let’s say a couple, John and Jane, are married with jointly titled assets and a net worth of $17 million. John passed away last year in 2022 when the federal estate tax exemption was $12.06 million, but Jane did not elect portability of the estate tax exemption after John’s passing. John’s estate is not subject to federal taxation since their assets are titled jointly and his portion of the assets automatically transfer to his wife Jane under the unlimited marital deduction by right of survivorship.

If Jane passes away in 2023 with a $12.92 million exemption rate and the same net worth of $17 million, Jane has a remaining $4.08 million in assets subject to the 40% estate tax rate. Since Jane did not elect portability and file Form 706, John’s exemption amount is gone. Jane’s estate will now owe $1.63 million in estate taxes after she passes away, handing down $15.37 million to their heirs.

If John and Jane had elected portability, Jane would have been able to use John’s $12.06 exemption amount together with her $12.92 exemption amount, totaling $24.98 million, and avoid paying estate tax on their $17 million in assets, handing down their total net worth to their heirs.

Downsides of Portability

While portability is beaming with tax benefits, there are noteworthy drawbacks that should be considered before restructuring an existing estate plan. For example, if a surviving spouse remarries, the IRS imposed a “last deceased spouse rule,” which means the surviving spouse forfeits the first spouse’s unused exemption in the event the second spouse passes away. In that case, portability would need to be re-elected within the second marriage. There are, however, strategies to protect the first spouse’s unused exemption through gift giving or marital portability agreements.

In addition, if assets appreciate more than expected or Congress lowers the exemption amount, portability may not fully protect a taxpayer from paying estate tax owed if exemption thresholds or asset values change.

Portability vs. Credit Shelter Trust

If you’re looking for another planning strategy to help solve the disadvantages associated with portability, there’s another option to consider. Before portability took shape in 2010, married couples implemented a “credit shelter trust” (or “bypass trust”) as the gold standard to preserve federal exemption amounts, and many of our clients continue to use them today. These trusts can be used as a more sophisticated approach to overcome some of the downsides of portability and imbue more control over where assets are allocated after death.

Here’s how it works: When assets are placed in a credit shelter trust upon a married individual’s death, their entire estate (or as outlined in the trust agreement) is frozen for future beneficiaries for estate tax purposes. The sole purpose is to preserve the deceased spouse’s available exemption against the estate tax and “shelter” any increase in value from tax. This means that any future appreciation on those assets bypasses the surviving spouse’s estate. If a married couple only depends on portability, future appreciation will be included in the spouse’s estate, whereby potentially triggering estate tax if total assets exceed the exemption threshold at the time of passing. The main downside to this option is that the assets inside the credit trust will not get a step-up in basis upon the second death. So, any appreciation, while not included in the estate, will have income taxes due upon any sale of assets.

Beyond leveraging exemption amounts and minimizing estate taxes, a credit shelter trust also solves a number of other issues, including:

• Generation-skipping transfer (GST) tax exemption: Since the GST exemption is not portable, a credit shelter trust is necessary to weave in bypass planning. You may also consider a dynasty trust, a trust that is set up to provide for multiple generations without incurring estate and gift taxes at each generation.
• Remarriage protection: If a surviving spouse remarries, a credit shelter trust will protect the inheritance of the deceased spouse’s children and ensure that they are cared for. It can put spending restrictions on the surviving spouse and how s/he allocates money from the trust in the new marriage. In addition, the trust can prevent the loss of estate tax exemption benefits should the surviving spouse’s new spouse pass away. As mentioned above, portability only applies to the most recently deceased spouse.
• Preserving assets: In most cases, a credit shelter trust is exempt from claims by the surviving spouse’s creditors or financial mismanagement. So, taking the time to create a well-crafted trust will ensure that your assets are secure for future generations and shielded from anyone outside of whom the trust is intended.
• State taxes: In all but two states (Hawaii and Maryland), portability is not recognized for state estate taxes. So, even if portability suits your federal estate planning needs, taxpayers will need to consider trust planning to preserve state exemption amounts. (Note that at this time, Arizona does not have a state estate tax).

Now is an ideal time to develop a well-designed trust plan, review current estate plans, and evaluate tax implications of planned asset transfers in the current tax landscape, with a lens focused on the future.

Please contact an R&A advisor to discuss your situation. R&A offers a range of both simple and sophisticated estate planning strategies to match your needs.