A few years ago, Congress changed the estate tax laws and introduced the concept of estate tax “portability.” This has had a significant impact on estate planning by married couples.
The idea behind portability was to simplify the estate planning process. Previously, in order to take advantage of each spouse’s maximum estate tax exemption, property had to either be left to someone other than the surviving spouse or to a bypass trust.
The bypass trust had other names: “credit shelter,” “exemption equivalent” or “A/B” trust, among others. Without a bypass trust or equivalent, the estate tax exemption of the first spouse to die could be lost forever. With the estate tax exemption currently set at $5.45 million, the loss of these tax benefits could cost a family more than $2 million.
For lawyers, the bypass trust was not that complicated, but to clients it always seemed difficult to grasp. In fact, the prior law favored those married couples who hired lawyers to set up these types of trusts, while those couples who did not properly plan their estate could get hit with this excessive tax.
Here’s how it works: when one spouse dies, his or her share of assets subject to the estate tax — up to the amount of the estate tax exemption in place at the time of death — could be put into a bypass trust that was treated as taxable.
Since the amount going into the trust would be less than the tax limit, the amount of tax due would be $0. That money would then not be taxed in the surviving spouse’s estate when she or he later died. It was fairly easy to double the estate tax exemption amount, in most cases, using the bypass trust.
Under the portability rules, when a spouse dies, any unused estate tax exemption amount may be passed on to his or her surviving spouse. In order to realize the benefit, the transfer of the first spouse’s exemption to the surviving spouse’s estate tax return must be filed — and portability must be elected. This must be done even if there is no other reason to file an estate tax return and even if no estate tax is due.
By leaving the assets to a bypass trust, you have more control over where your assets go when the surviving spouse dies and provide income to your surviving spouse and/or other family members during the surviving spouse’s lifetime. If assets are left outright to a surviving spouse and he or she remarries, those assets could end up in the hands of the second spouse or family. While many families don’t worry about this, perhaps they should.
There are other reasons why a bypass trust works better for many families than relying on portability, including if grandchildren are part of your estate plan or if the surviving spouse’s assets appreciate significantly after the death of the first spouse.
So, while portability might be a good solution for some couples with relatively straightforward estate plans, it is not a panacea. For many, the bypass trust still lives and remains a viable estate-planning tool.