[Editor’s Note: This is a guest post from a regular reader and an attorney who wishes to remain anonymous. I love guest posts where I learn something new, and this is one of those. Lots of pearls here, although the article is a bit long. The pearls are all in the first half, and the second half contains excellent examples illustrating them. I have no financial relationship with the author. The usual caveats apply. He is an attorney, but not your attorney. This article, like the rest of this website, is for general informational purposes. The author would like me to point out that he is not an estate planning expert and is not providing legal or other advice with respect to the tax or other planning considerations of any individual reader.]

I’m a BigLaw partner in my early fifties, contemplating retirement in the near-term.  As part of our retirement preparation, my wife and I recently have taken a close look at estate planning considerations and, with the assistance of an estate planning attorney, have revamped our estate plan.  While I’m certainly not an estate planning expert, I used this process to educate myself regarding how the federal estate tax could potentially apply to us and the pros and cons of various estate planning approaches.  The last few years have brought significant changes to the federal estate tax regime, including a substantial increase in the individual estate tax exemption amount, as well as the addition of a “portability” feature that allows a surviving spouse to take advantage of the unused portion of the exemption amount of the spouse who dies first.  The changes have caused many doctors and other highly compensated professionals to conclude that the federal estate tax is now completely “irrelevant” to them and applies only to the extremely wealthy.  In reality, however, the changes in law have not made things quite that simple.

The Old Estate Tax Regime-Prevalence of A/B Trusts

Not that long ago, the federal estate tax was a real issue that impacted even people of relatively moderate wealth.  Going  back 10 years to 2006, the individual exemption amount was only $2 million.  After including life insurance proceeds and other assets, a significant number of doctors and other high-income professionals faced potential estate tax liability upon their deaths.  Although a spouse had an unlimited exemption for anything he or she left to the surviving spouse, the deceased spouse’s unused $2 million exemption amount could not be transferred to the surviving spouse; in other words, it was not “portable” to the surviving spouse.  For example, assume that a couple had combined assets of $2.5 million and that those assets were owned 50/50 by each spouse, meaning that each spouse owned assets worth $1.25 million; this was well less than the $2 million exemption for each spouse.  However, if one spouse died and left his or her $1.25 million of assets to the surviving spouse, then the surviving spouse would own more than the $2 million exemption amount and there could be federal estate taxes owed on the second spouse’s death.

Because of this result, historically it was very common to employ so-called “A/B trusts” or “credit shelter trusts” to attempt to minimize the potential tax.  In the example above, at the death of the first spouse, the deceased spouse’s $1.25 million might go into the A/B trust, where the income (and principal, if needed by the surviving spouse) would be available to the surviving spouse during that spouse’s lifetime and then pass to the trust beneficiaries (usually the couple’s children) at the death of the second spouse.  In that scenario, the $1.25 million that went into the trust when the first spouse died did not trigger any federal estate tax because it was less than the $2 million exemption, and when the second spouse later passed away (assuming that he or she continued to have assets of $1.25 million at that time) no estate tax would be owed because such surviving spouse’s total estate also was less than the $2 million exemption amount.

The New Estate Tax Regime-Much Larger Exemptions and Portability

Traditional estate tax planning was turned on its head in many ways in 2013, when a change in law increased the individual estate tax exemption to more than $5 million, with the amount being automatically indexed for inflation in future years, This was combined with the addition of portability to the surviving spouse of any unused exemption amount from the first spouse to die.  Because of increases for inflation, a spouse passing away in 2016 could pass $5.45 million to anyone without triggering any tax, and to the extent that spouse left everything to the surviving spouse the portability feature could permit the second spouse, upon his or her subsequent death, to potentially take advantage of the first spouse’s $5.45 million exemption in addition to the second spouse’s own exemption, allowing the couple to pass more than $10 million of assets without incurring federal estate tax.

Does the New Estate Tax Regime Mean that a Couple Can Simply Ignore The Federal Estate Tax as Long as The Couple Does Not Have More than $10 Million in Assets?  Not quite so Fast!

As my wife and I began to consider our estate plan as part of our plan for a potential retirement, I saw quite a few articles, posts and other statements from fairly knowledgeable people essentially saying that the federal estate tax is now “dead” or “irrelevant” to anyone other than the very wealthy (those with more than $10 of combined assets, if married).  As I continued my research, however, I found that these conclusions are, at best, an oversimplification.   The increase in the personal exemption is very helpful, but the advantages of portability are not as straight-forward as might be assumed.

  • Portability is Not Automatic and Will Not Apply for the Vast Majority of People.   Portability does not apply unless the personal representative of the first spouse to die actually files a federal estate tax return.  Although a “simplified” version of the return can be used if being filed purely for portability purposes where no estate tax is owed, this still costs some money and is a hassle.  In fact, depending on the type of assets in the deceased spouse’s estate, appraisals and other mechanics could be necessary.  The evidence shows that the vast majority of estates simply are not filing these estate tax returns and therefore are foregoing the benefit of portability.  According to the IRS, only 11,931 federal estate tax returns were filed in 2014, with the number of deaths in the US for a typical year number in the millions (more than 2.5 million in 2014, according to the CDC).  That amounts to returns filed, and the preservation of portability if the deceased was married, for less than half of one percent of all Americans dying in a typical year.  Wills and estates attorneys with whom I’ve spoken have told me that they have a very hard time convincing the surviving spouse (who is usually the executor of the deceased spouse’s estate) to go to the trouble and expense of filing an estate tax return when no tax is owed and the surviving spouse sees this as perhaps speculative and unnecessary; these attorneys are having to be very careful to protect themselves by documenting that they have given adequate notice to the executors/surviving spouses the potential impact of failing to file the estate tax return.
  • The Portability Amount Available to the Surviving Spouse is Uncertain.   Unlike an A/B trust scenario, where the deceased spouse’s assets are out of the estate upon death, when relying on portability the amount of the exemption available for the surviving spouse is entirely dependent on what the exemption/portability amounts are at the time of the surviving spouse’s death.  Since the current law was put in place, the Obama administration already has proposed lowering the individual exemption amount, and there can be no certainty that portability will not be legislatively done away with all together by the time the second spouse dies.   Also, even if the deceased spouse’s executor files an estate tax return to preserve portability, the surviving spouse only gets to look to his or her most recently deceased spouse when determining the portability amount.  So, if the surviving spouse remarries and the new spouse passes away during the surviving spouse’s life, the surviving spouse will only be able to use the amount of the exemption not already used up by the last spouse.  The new spouse might have children from a prior marriage and may use up some or all of his or her exemption amount leaving assets to those children.
  • The Portability Amounts Is Not Indexed for Inflation After the First Spouse’s Death.  Although under current law the exemption amount increases automatically each year with inflation,  the same is not true for the portability amount passed along to the surviving spouse.  That amount is “locked in” on the date of the first spouse’s death, thereby diminishing the portability benefit in real terms each year until the surviving spouse’s death.   If the first spouse died at age 60, for example, and the surviving spouse lived another 30 years,  the portability amount in real terms could be only a fraction of what it was worth on the date of the first spouse’s death.

Examples Involving Two Couples

The examples below highlight the differing estate planning considerations that may apply for couples at different asset levels – but both examples involve couples with assets substantially less than the $10.9 million current joint exemption amount.  For purposes of the illustrations, I assumed that one spouse dies at age 60 and that the other spouse lives an additional 30 years.   If the timing of the second spouse’s death is in close proximity to the death of the first spouse, then the highlighted issues are much less significant.  I intentionally assume a long period between the deaths of each spouse to highlight the potential issues that may result.   I assume that the husband is the one dying early, as that is statistically more likely.

Couple A – $4 million in total assets.

Couple A has $4 million in assets (divided 50/50 between spouses) when Husband dies at age 60 shortly after his retirement.  Wife lives 30 more years.  At first blush, it would appear that there would be no potential federal estate tax issue for Couple A if Husband simply leaves his entire $2 million of assets to Wife, as their combined assets are less than even the individual exemption applicable to one spouse.  If Husband’s executor fails to file a federal estate tax return, however, there will be no portability.  This means that Wife now has $4 million in assets and a $5.45 million exemption amount.  Assuming that the law doesn’t change, the exemption amount will increase with inflation.   Assuming that Wife invests in a balanced portfolio and lives off the $4 million, withdrawing 4% per year and increasing withdrawals for inflation, an “average” outcome historically would have her asset level in real terms increase to around $8 million, which obviously would exceed the exemption amount ($5.45 million adjusted in real dollars), with a 40% estate tax rate applying to the excess, for a total bill to Uncle Sam of over $1 million in today’s dollars.  Wife could perhaps give money away during her lifetime to get her assets below the exemption amount, subject to annual gift limits that are imposed, but the point is that the estate tax is not simply “irrelevant” for Couple A.

This estate tax also could be avoided if Husband’s executor (who likely is Wife) files an estate tax return to preserve portability.  In that case in the above example, the assets at Wife’s death would be below the combined exemption amounts and no federal estate tax would be owed.  This assumes, of course, that the law doesn’t change to eliminate portability or to change Wife’s exemption amount.  This also assumes that Wife does not remarry, or that if she does, either her new spouse outlives her or her new spouse does not “use up” his exemption amount if he dies before Wife does.  Even with these uncertainties, however, it seems reasonable that Couple A might decide to avoid the traditional A/B trust approach and simply rely on portability.  That avoids the additional complexity of having to document and administer an A/B trust, and it also has other benefits.  When Wife dies, Couple A’s heirs will get a stepped-up basis for federal income tax purposes in all of her assets, so they would not incur federal income tax if they sold those assets immediately.  In contrast, if Husband had transferred his assets into an A/B trust, the amount transferred into the trust does not get a stepped-up basis when Wife dies, as it does not belong to Wife and is not part of her estate.  Given that federal estate tax seems unlikely for Couple A, relying on portability might be a sensible plan.

Couple B – $8 million in total assets.

Couple B has $8  million in assets (divided 50/50 between spouses) when Husband dies at age 60 shortly after his retirement.  Wife lives 30 more years.  If Husband leaves his entire $4 million of assets to Wife, and if Wife invests in a balanced portfolio and follows the 4% rule as Couple A did, an “average” outcome historically would have Wife dying with very significant wealth of around $16 million in real dollars.  If Husband’s executor filed an estate tax return so that the couple could take advantage of portability, under current law Husband’s portable exemption amount available for Wife in real dollars would be substantially less than the current $5.45 million amount provided under law, as Husband’s exemption amount would be locked-in at his death and would not be indexed for inflation.  Assuming a 3% inflation rate over the 30 year period, the Husband’s exemption amount at Wife’s death would only be about 41% of the amount at Husband’s death, or about $2.23 million.  Assuming a $16 million estate in current dollars,  this would mean under current law that there would be a 40% estate tax on about $8.3 million of Couple B’s estate, or more than $3.3 million owed to the federal government.  Utilizing an A/B trust wouldn’t completely solve the estate tax problem, as the assumed $16 million estate would still result in a federal estate tax of around $2 million, but obviously it would help.

The numbers likely are overestimated for most couples, as it is unlikely that there will be a 30 year gap in dates of death for the spouses, but the point remains that a couple with $8 million or so in assets at around age 60 has a good chance of having a federal estate tax issue even if Wife does not live a full 30 years after Husband’s death.  This issue will be exacerbated if Couple B merely relies on portability, rather than utilizing an A/B trust.  Although utilizing an A/B trust will mean that Couple B’s heirs will not get a stepped-up basis in the A/B trust’s assets for federal income tax purposes, that result might easily be outweighed by avoiding the 40% federal estate tax on additional amounts.  The heirs may not need to sell everything right away and trigger capital gains tax; in fact, they might live off the assets utilizing the 4% rule or something like it and only sell assets gradually over time.  In addition, under current law the income tax rate on capital gains is substantially lower than the 40% federal estate tax rate.   A couple with assets in the neighborhood of $8 million clearly needs to do some estate tax planning, including potentially giving away assets, subject to annual limits, during their lifetimes.  They can’t simply assume that the federal estate tax is “irrelevant” for them.

Our Own Circumstances

In our own case, we have assets that raise issues similar to what Couple B would face.  In addition to that, we are contemplating my retirement while in our early fifties.  This means that there may be a very significant amount of time before the death of the last spouse, providing the opportunity for our assets to appreciate a great deal in real terms.  This possibility is enhanced by our expected withdrawal strategy in retirement.  We have a very flexible budget, with no debt and significant international travel planned, which can be delayed if needed; so our spending can rise or fall as dictated by the performance of our portfolio.  Based on that, we plan to spend no more than 4% of our current portfolio balance each year – this is NOT the same as starting with 4% and automatically increasing spending for inflation each year.  This kind of flexible withdrawal strategy significantly enhances the likelihood that we may increase our assets, in real dollar terms, very substantially before the death of the surviving spouse.  We are planning to have a good chance of preserving and growing our assets for the benefit of our heirs. Given our situation, we have decided to employ a traditional A/B trust, rather than relying on portability.  After considering various assumptions and possibilities, this approach when combined with other “giving during life” strategies, seems more likely to minimize federal estate tax and the overall tax bill for our heirs.

In addition to the tax considerations, the existence of the A/B trust provides asset preservation and other protections.  If one of us were to die at a fairly young age, it seems unreasonable to expect that the surviving spouse will never remarry over coming decades.  Such a remarriage, however, could have significant effects on our estate plan.  We happen to live in a community property state; if one of us leaves everything to the surviving spouse and that spouse remarries, the “presumption” is that all property of the new spouses is community property, meaning that the new spouse would be presumed to own half of my wife’s assets.  This presumption can be negated by carefully keeping everything separate, but the wills and estates lawyers with whom I’ve spoken say that keeping things sufficiently separate is unusual absent a separate trust that can be clearly traced.  Even minor “intermingling” of assets may subject all assets to status as community property.  Even in non-community property states, if a spouse who brought assets from a first marriage dies before the new spouse, the new spouse may have the statutory right to a so-called “elective share” of the deceased spouse’s estate even if not left anything through the will of the deceased spouse.  Finally, there are many sad examples of a widow/widower being influenced by a new spouse to leave the new spouse the assets that the deceased spouse assumed would go to the initial children.  There are many families with very hard feelings (and even histories of litigation) in cases where the first-to-die spouse assumed there was no chance that the surviving spouse would not leave their mutual assets to their children.  The effects of age, time and possible diminished capacities have to be considered.

If the couple wants a trust for non-tax reasons and wishes to rely on portability, rather than an A/B estate tax trust, the traditional answer is a so-called QTIP trust (that stands for Qualified Terminable Interest Property trust).  The point here is that QTIP trust must provide that 100% of  the income (and potentially principal, if needed) may be used by the surviving spouse during that spouse’s life but that the remaining assets go to the children on that spouse’s death.  If those requirements and certain bells and whistles are complied with, the property in that trust can be considered property of the surviving spouse (and included in the surviving spouse’s estate) upon the death of the surviving spouse.  The benefit of the QTIP trust, where the estate is not large enough to have estate tax issues, is that when the surviving spouse dies, the children get a fully stepped-up basis in the trust assets for federal income tax purposes because those assets are treated for tax purposes as having been owned by the surviving spouse.  Unfortunately, there currently is some uncertainty as to whether this basis step-up from a QTIP trust is permissible if the first spouse to die didn’t have an estate at least as large as the individual estate tax exemption (currently $5.45 million).  If the deceased spouse’s estate was smaller than that, then the deceased spouse didn’t need the spousal exemption (he or she could have given all his or her assets to anyone, even other than a spouse, without triggering any estate tax).  Practitioners are hoping that the IRS will clarify this soon.   With such clarification, hopefully spouses who are unlikely to have estate tax issues but who want the non-tax benefits of a trust will be able to utilize the QTIP trust while preserving portability and achieving a step-up in basis upon the second spouse’s death.

Conclusion

While the changes in the federal estate tax laws in the past few years have been helpful in potentially eliminating federal estate tax in many cases where it might have been due under previous law, it is not the case that couples can simply ignore estate tax implications if they have less than $10 million of assets.  Even couples with moderate levels of wealth may need to take steps to preserve portability of the exemption from the first spouse to die, and there are numerous other estate tax considerations that may be applicable depending on the level of wealth and assumptions regarding survival of the last-to-die spouse.  In any event, there may be non-tax considerations that may cause a couple to consider a trust as an estate planning tool.  For couples with even moderate levels of wealth, consulting an estate planning specialist may be well worth the time and modest expense.

[Editor’s Note: I had to laugh at the author’s description of a $5-15M+ estate as “moderate” as I’m sure many readers will not view that level of wealth as moderate at all. It reminds me that pretty much all Americans consider themselves “middle class.” (1% considers themselves upper class, and 10% considers themselves lower class.) Nevertheless, the main points made are excellent and were new to me and perhaps may even save my heirs millions of dollars, so I’m grateful for the article. Also, bear in mind the article doesn’t even mention state estate taxes, so if you live in a state where that applies, you have even more need for a visit with an estate planning attorney.]

Do you have an A/B trust or are you relying on portability? What’s your take on the QTIP step-up in basis issue? Did you know about the requirement to file an estate tax return when the first spouse dies? What about the “lock-in” of the first spouse’s exemption amount? What percentage of docs do you think will have to worry about any of this? Comment below!