After the publication of Estate Planning Newsletter #2387 (“Ten Common Portability Mistakes and What You Need to Know to Avoid Them”), we were contacted by several astute LISI members about our conclusion concerning the availability of an automatic six-month extension for smaller estates that are not required to file a Form 706. Keith Schiller and Wendy Greenberg have posted their own thoughtful response on this issue in Estate Planning Newsletter #2392 titled “FLASH: Contention That Extension of Time under Form 4878 is Available for Estate Tax Returns Filed Solely for Portability Election Purposes.”

We regret any confusion this contention may have caused LISI members, and also regret that one of our co-authors, Ed Morrow, was mistakenly not given an opportunity to review this later added section of the newsletter prior to its submission. We thank several well respected commentators for sharing their thoughts and also letters from the American Bar Association’s Real Property, Probate and Trust Section to the Treasury Department on this issue.

This revised newsletter takes into account the many comments and suggestions with respect to whether and how to obtain an extension to file a Form 706 for estates electing portability that would not have otherwise been required to file a federal Estate Tax Return.  The authors thank Howard Zaritsky, and many others, for their recent comments on this topic.

Ed Morrow agrees with Keith Schiller and Wendy Greenberg that estates electing portability are entitled to an automatic six-month extension if Form 4768 is timely filed, and that ambiguous language in the preamble to the regulations should not taint the clearer language of the regulations and instructions. The other authors feel that this result is still unclear, because of the language used by the Internal Revenue Service in Treasury Regulation 20.2010.  Out of an abundance of caution, and based on the advice of other well known commentators, we believe it best for any small estate wishing to extend an estate tax return to clearly state a legitimate reason for the filing of an extension on Form 4768.

This should disarm any potential argument that the IRS might use to deny an extension.  Those who would still have concerns may feel safest filing the estate tax return within the nine-month period without relying on an extension.

Our revised newsletter is being republished to address our changes in thought on this issue.

Most planners are familiar with portability and how it works to enable a surviving spouse to make use of the unused estate and gift tax exclusion of the first dying spouse. Nevertheless, in addition to a number of math and tax misconceptions, the impact of new regulations released this summer leave room for the vast majority of estate planners to refine and improve their knowledge and protocols for both the technical and practical aspects of portability. In many cases, a review of some “facts of life” mathematics will be the most important and eye opening processes that a conscientious estate planner can go through to improve results and decrease the risk of desirable tax and other results for clients. Making decisions without running the numbers will, in many situations, be closely akin to flying in the dark without a gyroscope.

The purpose of this newsletter is to allow well-versed planners and those who have recently reviewed the basics of portability to come up to speed more efficiently, while also considering common implications of portability decision-making, with a strong dose of reality. We will highlight some of the common mistakes planners make when it comes to electing portability, as well as some misguided assumptions that may or may not make sense in a number of areas.

Alan S. Gassman, J.D., LL.M., Edwin P. Morrow, III, J.D., LL.M., Kenneth J. Crotty, J.D., LL.M., Christopher Denicolo, J.D., LL.M., Seaver Brown, J.D., MBA and Brandon Ketron, J.D., CPA, provide members with their commentary on ten common portability mistakes and what advisors need to know to avoid them.

Alan S. Gassman J.D., LL.M., practices law in Clearwater, Florida with Christopher Denicolo, J.D., LL.M. and Kenneth J. Crotty, J.D., LL.M. They publish numerous articles and books in publications such as BNA Tax & Accounting, Estate Planning, Trusts and Estates, Interactive Legal and their own Haddon Hall Publishing.  Mr. Gassman and the below authors have written “The Legal Guide to NFA Firearms and Gun Trusts,” which is now available on Amazon, and also as a publication of Interactive Legal. The Alan Gassman Channel at Interactive Legal has recently opened, and features many books and resources, including the above book and many Florida and Federal based materials, forms and resources.  Alan is also co Chairman of the Florida Bar annual Wealth Protection Conference which will take place in Miami Florida on April 14^thand 15^th this year as an advanced program and will feature many well-known authorities, including Barry Engle, Denis Kleinfeld, Howard Fisher, Jerry Hesch and more.  His e-mail address is agassman@gassmanpa.com

Edwin P. Morrow III, J.D., LL.M. (tax), CFP®, is a board certified specialist in estate planning and trust law through the Ohio State Bar Association and Director of Wealth Transfer Planning and Tax Strategies for Key Private Bank’s Family Wealth Advisory Group. One of his previous LISI newsletters, a white paper discussing redesigning trusts for more optimal income tax planning (The Optimal Basis Increase Trust, Estate Planning Newsletter #2080), has been updated and is available at the following link http://ssrn.com/abstract=2436964. 

Seaver Brown is a law clerk at Gassman, Crotty & Denicolo, P.A. in Clearwater, Florida.  He graduated with his Juris Doctorate from Florida Coastal School of Law, and obtained his Masters in Business Administration from Jacksonville University. He attended the University of South Carolina where he played football and graduated with a degree in Business Administration. 

                                               

Brandon Ketron has just finished his law school program at Stetson University College of Law, and is a licensed CPA in the State of Virginia. He attended Roanoke College where he graduated cum laude with a degree in Business Administration and a concentration in both Accounting and Finance. Brandon will pursue an LL.M. in Taxation at the University of Florida and then practice in the areas of Estate Planning, Tax, and Corporate and Business Law.  

Here is Alan, Ed, Ken, Chris, Seaver and Brandon’s commentary:

EXECUTIVE SUMMARY:

Most planners are familiar with portability and how it works to enable a surviving spouse to make use of the unused estate and gift tax exclusion of the first dying spouse.   Nevertheless, in addition to a number of math and tax misconceptions, the impact of new regulations released this summer leave room for the vast majority of estate planners to refine and improve their knowledge and protocols for both the technical and practical aspects of portability.  In many cases, a review of some “facts of life” mathematics will be the most important and eye opening processes that a conscientious estate planner can go through to improve results and decrease the risk of undesirable tax and other results for clients.  Making decisions without running the numbers will, in many situations, be closely akin to flying in the dark without a gyroscope.

The purpose of this newsletter is to allow well-versed planners and those who have recently reviewed the basics of portability to come up to speed more efficiently, while also considering common implications of portability decision-making, with a strong dose of reality. We will highlight some of the common mistakes planners make when it comes to electing portability, as well as some misguided assumptions that may or may not make sense in a number of areas. 

It is the authors’ belief that the decision-making and advice given in this area is often flawed.  Many practitioners conclude that it would be best for the vast majority of middle aged married Americans with a net worth less than $11,000,000 to leave everything outright to the surviving spouse or possibly a QTIP Trust and rely upon portability.  Moreover, there is a further assumption that portability is the only appropriate vehicle for receiving stepped-up income tax basis on the surviving spouse’s death. Neither assumption is correct. There are also inaccurate assumptions with respect to the after income tax results of having a full IRA rollover versus the use of Accumulation or Conduit Trusts, which are discussed below.

We have grouped these common errors into ten separate categories, with titles and introductions that can alert the reader as to the content and main emphasis for future reference.  

FACTS:

                                                                            

Most American families will never have a surviving spouse whose net worth exceeds $5,450,000, plus future inflation adjustments, so making a portability allowance election after the death of the first dying spouse is often a precaution, as opposed to a requirement.[1]  Most planners and clients have a general understanding of how portability works, but do not fully appreciate the many pitfalls and misconceptions that this article will address.

The authors are aware of five primary reasons that a fiduciary might opt out of portability when filing an estate tax return, or not file an estate tax return altogether to take advantage of the Deceased Spouse’s Unused Exemption (“DSUE”) amount.

1.       To be mean-spirited or vindictive. The threat of opting out may be used as a negotiating tactic by executors and family members adverse to the surviving spouse, even if the surviving spouse agrees to pay the costs of filing. This may occur when a surviving spouse with separate children makes either an elective share election, demands homestead entitlement, or makes other demands or claims that are not considered to be “fair or intended” by the children of the first dying spouse who may control the estate. Oftentimes, the first dying spouse will have made changes to his or her estate plan that were not to the liking of the children. Under such circumstances, the surviving spouse will be better poised and protected if there is a written and binding agreement in place to require that the portability allowance be facilitated. 

This brings to mind the “Failure to Require The Election As  Legal Obligation of the Successor and Assigns of the Decedent” Mistake. While many practitioners require the executor of the estate to make the portability allowance election by language in the Last Will and Testament, oftentimes there is no estate to be opened, which may occur if the children of the first dying spouse see this coming and cause all assets to pass by survivorship, pay on death accounts or otherwise.  Placing the language in the Revocable Living Trusts of the clients would be a good back stop strategy, but a written agreement that is binding on the successors and assigns of the first dying spouse, coupled with requiring the election under each spouse’s Will and Revocable Living Trust would be the safest approach. 

2.       To provide a lower profile for basis or other sensitive tax or other issues. Aggressive, non-spousal beneficiaries, who wish to assume aggressively-high date of death fair market values for income tax basis purposes may prefer not to have the higher levels of scrutiny and documentation that may result from preparing and filing an estate tax return.[2]  While the new basis consistency rules under §1014(f) will not apply to beneficiaries when estate tax returns are not required, reported values still establish a presumption and may prevent executors and potentially other beneficiaries from claiming a higher value for basis purposes later. 

 

In addition, there may be “hidden assets” or prior gifts that would have to be disclosed on the estate tax return under penalties of perjury that fiduciaries and beneficiaries may not want to have to disclose to a surviving spouse or others, such as collectibles and precious coins or metals that a decedent has asked one or more family members to hold, and then own after the decedent’s death, in secrecy from other beneficiaries and third parties.  These assets may make no difference from a tax liability or reporting threshold standpoint, but may nevertheless be personal and have a confidential existence that may have been important to the decedent and recipients, for reasons known to them.

 

3.       The executor may not want to risk having to work with or against the IRS decades later if the surviving spouse’s death opens up questions about the first to die spouse’s DSUE amount.  Should part of the estate be set aside for possible expenses and obligations that may become applicable many years up the road when a portability election estate tax return has been filed?

 

4.       Many are simply unable or unwilling to accept professional advice and to act upon it, for whatever reason.  It is therefore useful to consider appointment of trust companies or professional fiduciaries, or to at least give the surviving spouse the ability to require that a professional or trust company fiduciary be added as a co-executor, even if this may be at the expense of the surviving spouse.

  

5.       Receiving bad advice.   Many taxpayers simply receive bad advice and do not realize that doing nothing can be very harmful to the family of the surviving spouse.  Layman are well advised to get advice in writing from a qualified tax professional, and to double check by second opinion if there is any doubt. An agreement between the spouses may specify that a board certified or otherwise credentialed professional must be involved to some extent in decision making and giving advice after the death of the first dying spouse

 

 

With the above as a backdrop, we can now investigate what common mistakes occur, which often cause one or more of the above actions or inactions.  Many of these mistakes deal with misconceptions of professionals, so please think through these carefully to determine how they may apply to you and your clients.

COMMENT:

MISTAKE NUMBER ONE:   FAILURE TO FILE AN ESTATE RETURN ON TIME OR ACCIDENTAL OR INTENTIONAL ELECTION OUT OF PORTABILITY IN A TIMELY FILED RETURN. 

While the IRS has done a very good job of simplifying the process of making the portability election, [3] we predict that a great many taxpayers and advisors will still be tripped up under the new portability election rules.  For the purposes of the making the portability election, relief may be available for small estates that do not file a timely election which is not available for large estates.

By “small estates,” we mean estates that are not required to file a federal estate tax return (Form 706) due to the deceased spouse’s gross estate being below the $5,450,000 applicable exclusion amount (for decedents dying in 2016), which may be lower if the decedent made taxable gifts during the decedent’s lifetime.  “Large estates” mean estates that are required to file a federal estate tax return due to the value of the decedent’s gross estate exceeding the applicable exclusion amount. 

Large and small estates can timely file an estate tax return (i.e., within 9 months following the decedent’s death).  Large estates can file a Form 4768 before such 9 month deadline to receive an automatic six-month extension to file an estate tax return.  Small estates may also apparently file a Form 4768 before such 9 month deadline to receive an extension to file an estate tax return, but because of the language used in the new Regulations, which could conceivably be read to mean that such an extension must be affirmatively “granted” by the Internal Revenue Service for small estates, some prominent planners, including Howard Zaritsky, have suggested that the Form 4768 include a satisfactory reason for extension request by describing why the estate was not able to file the return within the nine month deadline, to be certain that the return, once filed, will be accepted.  This possible distinction regarding small estates is a result of the language used by the Internal Revenue Service, and is explained in greater detail below.  The authors have received comments from very well versed authorities advising that the extension will be automatic, and that there is no need to be concerned, but not everyone shares this opinion.   We regret and apologize that an earlier version of this letter concluded that careful practitioners should file the Form 706 within the 9 months because a Form 4768 filing might not be sufficient.  We expect that the Service will clarify the Regulations in the future.  Large and small estates also may obtain an automatic six-month extension to amend an estate tax return that has been filed within nine months of the decedent’s death to correct errors in the return that had been timely filed.  It is therefore essential that advisors be well-versed on when and if an estate tax return is required to be filed, and what needs to be included in the estate tax return to support a portability “election” when portability is desired.

As further discussed below, in addition to the filing requirements and extensions available to estates, the new basis consistency rules put a heavier burden on those who are required to file federal estate tax returns.  They must provide appropriate appraisals or other documentation to confirm values of assets that receive a stepped-up basis on the death of a decedent, because the estate tax return’s stated values may be binding for income tax purposes required for calculation of depreciation, and capital gains or losses when such assets are later sold.  Families should therefore be apprised early on in the post first death process of the possible need to file a return and to conduct appropriate due diligence and to acquire appropriate valuation verification documentation and appraisals, when needed, to comply with these rules. 

There is confusion among many practitioners as to when an estate tax return is required to be filed, especially when there are assets of uncertain value, or previous gifts and debts that reduce net worth under the filing guidelines, so a review of these rules and a summary of how the 9100 relief and Portability Election rules work is as follows:

 

·    Regardless of the size of a decedent’s gross taxable estate, in order for a surviving spouse to use their deceased spouse’s unused exclusion (DSUE) amount, the decedent’s estate must file a federal estate tax return (Form 706).

·    For large and small estates, the Form 706 is due 9 months after the decedent’s date of death, or 15 months after the decedent’s date of death, if an extension of time for filing has been obtained by timely filing a Form 4768.

·   Requests for an automatic six-month extension under Regulation 20.6081-1(b) are automatically granted for large estates if a Form 4768 is filed before the 9-month due date of the Form 706.  The key point here is that to get 20.6081-1(b) automatic relief, a large estate must timely file the Form 4768 before the 9^th month anniversary of the decedent’s death.

     Recently we have been contacted by several astute LISI members about our conclusion concerning the availability of an automatic six-month extension for smaller estates that are not required to file a Form 706 in the Estate Planning Newsletter #2387 “Ten Common Portability Mistakes and What You Need To Know To Avoid Them Keith Schiller and Wendy Greenberg have posted their own thoughtful response on this issue in Estate Planning Newsletter #2392 titled “FLASH: Contention That Extension of Time under Form 4878 is Available for Estate Tax Returns Filed Solely for Portability Election Purposes.”

 

We regret any confusion this contention may have caused LISI members, and also regret that one of our co-authors, Ed Morrow, was mistakenly not given an opportunity to review this later added section of the newsletter prior to its submission. We thank several well respected commentators for sharing their thoughts and also letters from the American Bar Association’s Real Property, Probate and Trust Section to the Treasury Department on this issue.

 

This revised newsletter takes into account the many comments and suggestions with respect to whether and how to obtain an extension to file a Form 706 for estates electing portability that would not have otherwise been required to file a Federal Estate Tax Return.  The authors thank Howard Zaritsky, and many others, for their recent comments on this topic.

 

Ed Morrow agrees with Keith Schiller and Wendy Greenberg that estates electing portability are entitled to an automatic six-month extension if Form 4768 is timely filed, and that ambiguous language in the preamble to the regulations should not taint the clearer language of the regulations and instructions. The other authors feel that this result is still unclear, because of the language used by the Internal Revenue Service in Treasury Regulation 20.2010.  Out of an abundance of caution, and based on the advice of other well known commentators, we believe it best for any small estate wishing to extend an estate tax return to clearly state a legitimate reason for the filing of an extension on Form 4768.

 

This should disarm any potential argument that the IRS might use to deny an extension.  Those who would still have concerns may feel safest filing the estate tax return within the nine-month period without relying on an extension.

 

The reason for this concern is that the Summary of Comments and Explanation of Revisions published on June 29, 2015, in the Internal Revenue Bulletin 2015-26 stated that the 2012 Temporary Regulations required “every estate electing portability of a decedent’s DSUE amount to file an estate tax return within nine months of the decedent’s date of death, unless an extension of time for filing has been granted.”  The use of the word “granted” seems to imply that the extension is not automatic, but is instead discretionary.  The BNA Estates, Gifts and Trusts Portfolio 844-4th on Estate Tax supports this proposition by stating at Section II(B)(1)(a)(1) that an estate electing portability must file an estate tax return within nine months of the decedent’s death, unless the IRS has granted the estate an extension to file.

The language of the first three sentences of the Final Regulation 20.2010-2(a)(1) is essentially identical to the language that had been in Temporary Regulation Section 20.2010-2T(a)(1).  Although both of the Regulations state that the due date for electing portability is the later of “nine months after the decedent’s date of death or the last day of the period covered by an extension (if an extension of time for filing has been obtained),” the reference to the extension being “granted” in the Summary of Comments and Explanation of Revisions suggests that if such an extension is obtained it is not automatic.  The use of the word “granted” may be read by the IRS to mean that it only need provide an extension upon the showing of good cause, similar to extensions granted under Treasury Regulation 20.6091-1(c), although IRS personnel have apparently assured representatives of the ABA Real Property, Probate and Trust Law Section that no showing of good cause should be needed.  

·   An executor of a small estate must look for relief under Regulation 301.9100 to elect Portability if a Form 706 is not timely filed (within 9 months after the decedent’s death, or 15 months if a 6-month extension is obtained).

·   Unfortunately, if a small estate does not timely file a Form 706 after the decedent’s death, relief under Section 9100-2 will not be available.  Section 9100-2 only provides an automatic six-month extension to make certain elections if the applicable return is timely filed.  As the IRS notes in the final regulations, “the portability election is deemed to be made by the timely filing of a complete and properly prepared estate tax return.”  As a result, if the Form 706 is not timely filed and then corrected within the six-month period following the unextended due date of the return, then relief under Section 9100-2 will not be available.

·   Discretionary extensions to the deadline for filing a Form 706 are available pursuant to Section 9100-3 where a small estate’s estate tax return has not been timely filed after the decedent’s death.  The Section 9100-3 rule is only available to small estates.  Unlike the Section 9100-2 relief extension, there is no requirement to have timely filed an estate tax return.  To qualify for such “discretionary relief” under Section 9100-3, however, the Taxpayer must prove that (1) they acted reasonably and in good faith, and (2) that the granting of such extension will not prejudice the interests of the government.  The relief afforded under Section 9100-3 requires the taxpayer to make a private letter ruling request, and the costs of such relief will be material and will vary based upon income as noted in Appendix A of Revenue Procedure 2016-1.  This is in addition to any legal and/or accounting fees an estate may incur when preparing the relief request.

Now, let’s explore the effect on portability when the 9-month deadline is missed in three scenarios: (1) when no return is required to be filed; (2) when a return is required to be filed, but it is still within the time frame of a six-month extension; and (3) when a return is required to be filed but it is past the due date, or the extended due date if extended.  

The final regulations provide that an extension of time to elect portability will not be granted under § 301.9100-3 to any (large) estate that is required to file an estate tax return (because the value of the gross estate equals or exceeds the threshold amount described in § 6018), but may be granted under the rules set forth in §301.9100-3 to (small) estates with a gross estate value below that threshold amount and thus not otherwise required to file an estate tax return.[4]

 

Therefore, the filing threshold is absolutely crucial for determining when a Form 706 must be filed. When filing is not required, a late filed Form 706 electing for portability to apply may be permitted if the taxpayer can prove that (1) they acted reasonably and in good faith, and (2) that the granting of such extension will not prejudice the interests of the government, as described above.  In most cases, reasonable cause can be established if the family can show that there was reliance upon one or more tax advisors who did not properly advise the family of deadlines or the effect of or need for filing. 

In three recent Private Letter Rulings 2015-44017, 44003, and 44001, the estates of three decedents requested relief under Treasury Regulation Section 301.9100-3 because they had all failed to timely file an estate tax return following the decedent’s death.[5] The facts of each Private Letter Ruling were fairly similar, in that they each involved decedents who had died on or after January 1, 2011,[6] with gross estates being less than the applicable exclusion amount for that year. 

Treasury Regulation Section 301.9100-3 provides the discretionary standards that the IRS will apply to determine whether or not they grant an extension of time to make a portability election. Pursuant to Section 301.9100-3, the taxpayer must provide evidence that they acted reasonably and in good faith, and that the interests of the government will not be prejudiced by granting such relief.[7] Subsection (b)(1) of Section 301.9100-3 provides a list of when the IRS may deem a taxpayer to have acted reasonably and in good faith.[8]  Subsection (b)(3) provides instances when such a taxpayer will not be deemed to have acted reasonably or in good faith.[9]

The IRS granted all three of these estates a 120-day extension to file an estate tax return so as to make a portability election to take into account the DSUE amount.  Certainly a great many more PLR’s of this nature will follow.  

Anyone representing a surviving spouse who, for any of the reasons set forth below, may want to have a portability allowance will want to recommend that there be an estate tax return prepared and filed for the first dying spouse, and that the return be reviewed before it is filed to ensure that the estate did not elect out of portability, and properly enumerated and valued the assets not qualifying for the estate tax and charitable deductions.

The return should be carefully prepared, and the backup documentation on ownership and value should be carefully preserved since the IRS will have until the statute of limitations runs on the estate of the surviving spouse to audit the return of the first dying spouse as to the portability allowance.  If the estate of the surviving spouse is not required to file an estate tax return, then the statute of limitations may never run. 

To provide further detail on estate tax return considerations for families considering use of the portability allowance, a deeper dive into the estate tax return filing requirements, portability implications, and common errors is provided in the footnote below.[10]

The following scenarios illustrate how large estate or small estates can extend the time in which to make a portability election.[11]  The examples, which assume the 2016 exemption amount of $5,450,000, are as follows: 

John Doe never made any lifetime gifts beyond charitable gifts and annual exclusion amounts not exceeding $14,000 per child to his children.  He dies in 2016.  He has a gross estate of $6 million, part of which is a $1 million home with a mortgage of $600,000 remaining.  His net estate after the debt eligible to be deducted under IRC §2053 is $5,400,000, which is below the $5,450,000 applicable exclusion amount for the year he died – his estate will owe no estate tax. However, his estate is required to file a Form 706 pursuant to IRC §6018.

If John Doe made a $2,000,000 lifetime gift beyond annual exclusion amounts, and died with a $4,000,000 gross estate with a similar debt, the result would be the same – the filing threshold under IRC §6018 is adjusted for the gift, so there is still a requirement to file a Form 706, even when there is no estate tax due.

By contrast, let’s explore the difference between recourse and nonrecourse debt and assume that John paid off his home mortgage, but has a rental property worth $1,000,000, subject to debt of $600,000.  If the loan is recourse, the result is exactly the same as above.  However, if the loan is non-recourse, the net amount of $400,000 is all that will be included in the gross estate, not $1,000,000 with a $600,000 deduction.[12]  Non-recourse debt is debt against the property itself in which the decedent has no personal liability. Therefore, no Form 706 is required.  There is some uncertainty about how nonrecourse debt is accounted for under a new law passed this year for basis adjustments under IRC §1014(f).[13]

MISTAKE NUMBER TWO: WRONGFULLY ASSUMING THAT NO ESTATE TAX PLANNING WILL BE NEEDED.

 A more profound error is an assumption on the part of a married couple, and often their planners, that they will not have an estate tax issue. In these cases, the married couple and their planners will fail to properly plan for the use of Credit Shelter Trusts, Gifting Trusts, installment sales and other widely available techniques and strategies.

LISI Estate Planning Newsletter #2061, entitled “The 28 Million Dollar Mistake,” described a couple who had $5,250,000 of investment assets thirty years before the death of the surviving spouse.[14]  We calculated the surviving spouses’ estate tax liability on the investments, assuming they grew at 10.98%[15], without taking into account savings that could result from ongoing income.  The end result, at the life expectancy of the surviving spouse, was an estate valued at $96,663,144 with an estate tax of $31,527,059, when there would have only been a $3,242,857 estate tax had a Credit Shelter Trust (also known as a Bypass or Family Trust) been used on the first death.  The authors have found that there is no substitute for simply running the numbers to see what possible results can apply under various scenarios.

This can be exacerbated by the possibility that a surviving spouse might move to a state that imposes estate or inheritance taxes, and even worse that these states may have the tax apply beginning at much lower thresholds than those under the Federal system.  How many planners ask a surviving spouse if they plan on moving to live with their children in a state with high estate or inheritance taxes like Oregon, Washington, Maine, Connecticut, Delaware, New York or New Jersey? Since most states do not have an analogous portability provision, failure to utilize the exemption at the first spouse’s death may lead to a significantly increased state death taxes. We have seen one family absolutely bar an elderly gentleman from moving from Florida to live near his children up north because it would have cost the family too much in taxes if he had died after moving.

A fairly easy rule of thumb that can be used in the conference room is the Rule of 72, where we can approximate a doubling of value by using the result of 72 divided by the assumed rate of return.  Thus, at a 7.2% net rate of return, investments can be expected to double in value every 10 years. However, if we assume inflation at 3%, the credit exemption amount can be expected to double in value only every 36 years, or said another way, can be expected to increase in value by only 34% every 10 years, as shown below in these tables that might appropriately be kept in conference rooms for discussion with clients and advisors.  

Year	3%	7.2%	10%
0	$1,000,000	$1,000,000	$1,000,000
1	$1,030,000	$1,072,000	$1,100,000
5	$1,159,274	$1,415,709	$1,610,510
10	$1,343,916	$2,004,231	$2,593,742
15	$1,557,967	$2,837,408	$4,177,248
20	$1,806,111	$4,016,943	$6,727,500
25	$2,093,778	$5,686,822	$10,834,706
30	$2,427,262	$8,050,884	$17,449,402
35	$2,813,862	$11,397,707	$28,102,437

Year	3%	7.2%	10%
0	$3,000,000	$3,000,000	$3,000,000
1	$3,090,000	$3,216,000	$3,300,000
5	$3,477,822	$4,247,126	$4,831,530
10	$4,031,749	$6,012,694	$7,781,227
15	$4,673,902	$8,512,224	$12,531,745
20	$5,418,334	$12,050,830	$20,182,500
25	$6,281,334	$17,060,466	$32,504,118
30	$7,281,787	$24,152,652	$52,348,207
35	$8,441,587	$34,193,121	$84,307,311

Year	3%	7.2%	10%
0	$5,000,000	$5,000,000	$5,000,000
1	$5,150,000	$5,360,000	$5,500,000
5	$5,796,370	$7,078,544	$8,052,550
10	$6,719,582	$10,021,157	$12,968,712
15	$7,789,837	$14,187,040	$20,886,241
20	$9,030,556	$20,084,717	$33,637,500
25	$10,468,890	$28,434,110	$54,173,530
30	$12,136,312	$40,254,419	$87,247,011
35	$14,069,312	$56,988,535	$140,512,184

Factoring in continued earnings and saving rates, and potential windfalls from businesses and inheritances that are received directly, as opposed to in a protective Trust, it is easy to see that many American families will pay millions of dollars in federal estate taxes if proper planning is not implemented.  For many families, portability provides a panacea that will result in more estate taxes being paid than would have been the case without portability, most notably because of the errors described in this article.

It is worth mentioning that some clients will conclude that they do not want to gift assets because they worry that they may run out of wealth to support themselves, but at the same time are rightly concerned about federal estate tax.  Often the concern is that the wife will live much longer than the husband and that with an asset growth rate of 8% or more will have a large estate tax, while an asset growth rate of 3% could result in running out of assets.  We have found that such clients may prefer to have the husband fund a reasonably sized Irrevocable Trust for the wife and his descendants with a Spousal Lifetime Access Trust (“SLAT”) that will use a small portion of the husband’s exemption, and can grow income tax free by reason of being disregarded for income tax purposes during the husband’s lifetime.  The husband may even be includable as a beneficiary by Trust Protectors if the Trust is funded in an Asset Protection Trust (“APT”) jurisdiction, and the husband’s net worth goes below a certain specified level that is less than expected to occur.   If 20% to 30% of a couple’s investment assets are held in this manner, then they can be estate tax proof, and also have enhanced creditor protection, and protection of the family assets if the surviving spouse remarries. 

MISTAKE NUMBER THREE: LOSING THE PORTABILITY ALLOWANCE BECAUSE OF REMARRIAGE TO A NEW SPOUSE WHO MAY DIE FIRST.

While almost every article and discussion about the portability allowance has described how the DSUE amount can be lost or may change if the surviving spouse remarries and survives a subsequent spouse, very few commentators have emphasized the profound psychological and practical impact that DSUE amounts can have on subsequent relationships, and the prospects of pursuing a happy and fulfilling life by remarrying.

This can work an extreme injustice upon a widow who would have the benefits of a new spouse who can provide her with both financial and emotional support, when she learns that the marriage can cause her children to incur over $2,000,000 of federal estate tax (up to 40% of up to $5.43 million as adjusted portability amount) at the time of her death.  That is one heck of a wedding present from the children! People already carry enough guilt when they have lost a spouse, and have done their best to live appropriately in our modern society.  Is this a burden that planners want to take credit for having imposed on a widow in the name of simplification, and allowing for a stepped-up basis on the surviving spouse’s death that will be of no economic benefit to the widow at all?

Assume the example of a self-sufficient 50-year-old widow, who has a net worth of $2,500,000 after receiving all common assets on the death of her husband.  Following his death, she continues to live responsibly, supporting herself from additional earnings, a lifetime pension, and social security benefits. Assume further that in fifteen years, at age 65, her net worth has grown at an annualized average rate of 7.2% to $7,500,000.

 

At this point she meets the new Mr. Right who proposes that the two of them marry. He seems to be everything she has been missing since losing her first husband fifteen years before, especially compared to some of the gentlemen that she has attempted to date in the interim.

She is also pleased that he has a net worth that exceeds hers, and will conscientiously leave his assets to his four children, one of which has special needs. The other three children are all teachers with a very close relationship to their father, and are very supportive of his decision to marry. Despite all of this, he agrees to support his new wife during the marriage.

Unfortunately, her tax advisors nix the deal, explaining that it will cost her an estimated $2,000,000 in federal estate tax when she dies, given the expected growth of her estate, and her life expectancy.

Compare that to a situation where her first husband could have left $1,125,000 into a Credit Shelter Trust that would have grown to $2,500,000 in ten years, and $3,125,000 in fifteen years. Under this scenario, her remaining personal net worth would have been $4,375,000 when she met Mr. Right at age 65. Through the use of discount gifting and other planning she could have avoided all estate tax exposure, and could have walked the aisle with no trepidation to better enjoy and find fulfillment and financial security in her remaining years with her new Prince Charming.

Going back to whoever planned (or failed to plan) the estate before her first husband died, the concern over a loss of stepped-up basis on half of the marital assets placed in a Credit Shelter Trust on the first death could have been reduced by simply granting a formula power of appointment, or giving an independent fiduciary or Trust Protector the power to give the surviving spouse the right to appoint appreciated assets to creditors of her estate.  The result is that a stepped-up basis could be received on the most appreciated assets in the Credit Shelter Trust at the time of her death, to the extent that her estate tax exemption would be sufficient to allow her personal assets and a portion of the assets in the Credit Shelter Trust to pass estate tax-free. Such power of appointment language should be in Credit Shelter Trusts for clients now living, and can be implanted into Credit Shelter Trusts already in existence by court order, Trust Protectors, or an agreement between all beneficiaries, based upon applicable state law.

For example, if planners would have included a formula based power of appointment in the Credit Shelter Trust, highly appreciated stock in the Credit Shelter Trust could be included in the widow’s gross estate to the extent that it would not exceed her applicable exclusion amount.  This would allow the beneficiaries to receive a step-up in basis.  Additionally, the formula power of appointment can allow for built-in loss property to avoid a step down in basis since it will not be subject to the power or appointment granted to the widow, resulting in significant tax savings.  Too many planners are missing the opportunity to facilitate this. [16]

                  

MISTAKE NUMBER FOUR:  LOSS OF THE ABILITY TO SHARE DSUE AMOUNTS WITH A SUBSEQUENT SPOUSE AND HIS OR HER FAMILY.

 

Gift splitting ability is of great value in the auction of love, when a potential wealthy new spouse would prefer to split gifts and, in effect, subsidize gifting to the wealthier spouse’s descendants, who may be preferred over the children of the first marriage for any number of reasons. Unless the surviving spouse is an estate tax attorney, you can easily imagine the conversation that might occur many years after the whole concept of portability might be explained: “Honey, I’d like to give some of my separate property to my kids, can you just sign this tax form so I don’t have to pay $2 million in gift tax?  It won’t cost you anything.”  Spouses regularly sign joint income tax returns without fully exploring or understanding the ramifications and it’s unlikely a Form 709 will be viewed all that differently.

 

Loss of the DSUE amount by gift splitting (or being predeceased by a second spouse) also reduces the exemption allowance available to the surviving spouse, who might otherwise be given general powers of appointment under Irrevocable Trusts that might exist or be established for the purpose of providing a stepped-up date of death fair market value basis when the surviving spouse dies.

MISTAKE NUMBER FIVE: CRITICISM OF THE “OUTRIGHT TO SPOUSE AND ALLOW DISCLAIMER TO CREDIT SHELTER TRUST” ARRANGEMENT.

A great many planners have determined that it is best for many of their clients to have estate plans that provide outright devises to the surviving spouse, with the spouse having the ability to disclaim the devise within nine months of the decedent’s death, resulting in the funding of a Credit Shelter Trust that will benefit the surviving spouse without being subject to federal estate tax on the spouse’s death. This gives the surviving spouse nine months after the death of the first dying spouse to decide whether, or to what degree to rely on portability, or to facilitate funding of a Credit Shelter Trust that might be converted to a Clayton QTIP Trust, as further discussed below.  

          The authors have three primary problems with respect to this strategy:

1.       Emotionally Challenged Surviving Spouses Must Face Difficult Decisions. It is well known that surviving spouses are often disoriented after the death of their spouse. Even more concerning, they may not receive or accept sound advice, and may take actions that preclude a qualified disclaimer, and in some cases simply do not disclaim when they should. The default effect of not making a decision is more often the wrong result.  It is better to have the more likely result apply if no decision is made, as described below. In addition, accepting control, use or income of or from property that would be disclaimed can foreclose the ability to have a valid disclaimer for estate tax planning purposes, and state law may not permit a disclaimer if the surviving spouse is insolvent. 

 

2.       Must Also Disclaim Powers of Appointment. Such a disclaimer will not be effective for federal estate tax purposes unless the surviving spouse also disclaims any power of appointment or other right to direct how the Credit Shelter Trust assets will pass on said spouse’s subsequent death, unless it is very specifically drafted.[17]  This makes it less likely that the spouse will disclaim, and also deprives the family of flexibility and personal accountability, which is disadvantageous to the surviving spouse and most descendants.

3.       Must Wonder For Years to Come If They Made the Right Decision.  Even after the decision is made, surviving spouses will often ruminate and feel guilt and doubt over whether they have made the right decision.

MISTAKE NUMBER SIX: NOT USING THE CLAYTON QTIP ARRANGEMENT TO SAFEGUARD ASSETS AND MAKE USE OF THE FIRST DYING SPOUSE’S GST EXEMPTION.

Many planners are mistakenly not using Clayton QTIP language and providing for assets to pass into a Credit Shelter Trust that can become a Clayton QTIP. The authors strongly prefer having the disposition of assets of the first dying spouse to a Credit Shelter Trust that the surviving spouse, or one or more fiduciaries may retroactively elect to convert to a QTIP Trust within nine months of the decedent’s date of death (and, unlike qualified disclaimers, an extension can be granted to allow another six months, for a total of fifteen from date of death). An election that permits different terms for the Trust, depending on whether or not the election is made, is known as a Clayton QTIP election.[18]

A Clayton QTIP Trust can qualify for the Federal Estate Tax Marital Deduction, while protecting the Trust assets (but not the income) from potential future creditors, spouses, and potential improvidence.  Further, the surviving spouse will have the right to receive all income, will be required to be the sole lifetime beneficiary, and may direct how the Trust assets pass on such spouse’s subsequent death by retaining powers of appointment that can be provided in the Trust documents.

An independent fiduciary can be appointed to have the power to direct that some or all of the Trust assets be paid outright to the surviving spouse, and it is not necessary that this occur within nine months of the decedent spouse’s date of death.

The Clayton QTIP Trust also has another very important advantage – it allows for use of the deceased spouse’s GST exemption, so that for deaths occurring in 2016 up to $5,450,000 can pass to the Trust, without being considered as owned by the children and grandchildren for federal estate tax purposes when they die. 

It can be a huge mistake for an affluent or potentially affluent family to lose the GST exemption of the first dying spouse by having an outright disposition to a surviving spouse. Especially, if instead, the mechanisms and desire to fund a QTIP Trust are not available to the surviving spouse.

Example – Upon the death of husband (first dying spouse), assume that assets are left to his wife in a Clayton QTIP Trust.  The executor can use the Clayton QTIP election to determine how much of the Trust should qualify for the marital deduction, and how much should pass into a Bypass/Credit Shelter Trust.  The assets will pass to a Credit Shelter Trust to the extent that the QTIP election is NOT made, which may pass to another Trust or to other beneficiaries without jeopardizing the marital deduction, while the remaining assets will pass to a QTIP Trust for the wife, giving the executor the flexibility to determine the appropriate amount. 

As discussed above, the advantage here is that the husband has a $5,450,000 generation skipping tax exemption that enables that amount in assets to be placed into the Clayton QTIP Trust on the husband’s death (after any needed disclaimer and the Clayton QTIP Trust election have been made) and if that $5,450,000 grows to $12,000,000 before the wife dies it can pass to a Trust that can benefit the children without being subject to federal estate tax at the children’s level.[19]

MISTAKE NUMBER SEVEN: ASSUMING THE IRS WILL NOT DENY CLAYTON QTIP TREATMENT WHEN IT IS NOT NECESSARY TO AVOID ESTATE TAX ON THE FIRST SPOUSE’S DEATH.

 

The next mistake is assuming that the IRS will allow the Clayton QTIP Trust to work as intended, when in fact there is perhaps a 3% or greater chance that the IRS will try to use Revenue Procedure 2001-38 to prevent assets that pass to a Marital Deduction Trust from qualifying for the marital deduction when not needed to avoid estate tax.  This will reduce the portability allowance by the amount passing to the Marital Deduction Trust. While the vast majority of commentators and estate tax professionals expect that the IRS will not take this position, the law is not so certain, and for reasons described below it will be much safer to use only partial Clayton or other QTIP marital deduction elections, as opposed to full marital deducti