By Cowles Liipfert

For married taxpayers with total assets of several million dollars or more, it is important to consider whether the estate tax exclusion of the first spouse to die should be utilized to minimize federal estate taxes upon the death of the surviving spouse.

Anything which a decedent leaves outright to his or her surviving spouse will qualify for the deceased spouse’s estate tax marital deduction and will pass to the spouse, tax-free.  However, that property will become part of the surviving spouse’s taxable estate and will therefore be subject to potential transfer tax (gift tax/estate tax) for the surviving spouse, unless a portability election is made on a federal estate tax return for the deceased spouse.

A portability election is made in Part 6 of the deceased spouse’s federal estate tax return, unless the surviving spouse intentionally opts out of portability under Section A of Part 6. 

Until 2011 the only way to take advantage of the estate tax exclusion of the first spouse to die was to leave assets in a manner which would not qualify for the deceased spouse’s marital deduction and thereby would use the deceased spouse’s estate tax exclusion, instead of his or her marital deduction, to avoid or reduce estate tax at the first death.  That is, using the exclusion at the first spouse’s death was a “use it or lose it” proposition.  If the first spouse to die did not provide for a portion of his or her estate to be set aside in a manner which did not qualify for the marital deduction, then his or her estate tax exclusion would be lost forever and could not later be used to reduce federal estate taxes at the death of the surviving spouse.

Let us assume that a deceased spouse in 2010 had a taxable estate of $6 million, and that the estate tax exclusion was $3.5 million at that time.  Estate taxes at the first death could have been completely avoided if the deceased spouse left at least $2.5 million to the surviving spouse in a manner which qualified for the estate tax marital deduction, in which case up to $3.5 million in value could be set aside at the first death which would not be subject to estate tax at the surviving spouse’s death.  Thus, only $2.5 million would become part of the taxable estate of the surviving spouse.

Often the first priority of a deceased spouse is to provide for the surviving spouse, in which case the $3.5 million share (under the above fact situation) which was intended not to qualify for the estate tax marital deduction was often left in trust for the surviving spouse’s lifetime benefit, but the terms of the trust would keep the assets from being included in the taxable estate of the surviving spouse.  The undistributed trust assets would remain outside the surviving spouse’s taxable estate and would pass to the secondary beneficiaries after the surviving spouse’s death, free of estate tax.

Prior to 2011, when the law was changed, a common method used to minimize estate taxes at the surviving spouse’s death, was a “shelter credit” trust created by the deceased spouse, sometimes called a “family” trust (which is a friendlier-sounding name).  A trust funded at the first spouse’s death, could make income and/or discretionary principal distributions to or for the benefit of the surviving spouse for life, but upon the death of the surviving spouse, the trust assets would pass on to the remainder beneficiaries, often the deceased spouse’s children and grandchildren, free of federal estate tax. 

Starting in 2011, however, a different set of rules became applicable.  After that date it became possible for the deceased spouse’s unused exclusion at the time of his or her death to be preserved, even if assets were left outright to the surviving spouse.  If the deceased spouse’s exclusion was preserved, the exclusion could be used for gifts subsequently made by the surviving spouse, or on the surviving spouse’s estate tax return.  

If you have estate planning documents which were executed before 2011 which include a shelter credit trust (a “family trust”) for the surviving spouse, you are advised to review these documents with your estate planning attorney, to see that such a trust is still appropriate for you, especially with the higher threshold for estate taxes likely to be available at your death.

The federal and gift tax exclusion has been increased substantially since 2011 on two occasions, first to $5 million indexed for inflation, then to $10 million indexed for inflation.  The latter was under The Tax Cuts and Jobs Act of 2017, which is scheduled to expire in 2026, but which could be reduced at an earlier date by act of Congress.

If a deceased spouse does not utilize the opportunity in his or her estate planning documents to preserve some or all of his or her estate tax exclusion, the surviving spouse now has the option of filing a federal estate tax return and electing the portability option to preserve the Deceased Spousal Unused Exclusion (DSUE) on that return, which allows the surviving spouse to apply the deceased spouse’s DSUE against any gift and estate tax liability of the surviving spouse, including future lifetime gifts and transfers upon the death of the surviving spouse.

In order to take advantage of the portability of the deceased spouse’s DSUE, the personal representative of the deceased spouse’s estate must file a federal estate tax return (Form 706) in a timely manner, on which the DSUE is computed, and must elect to claim a DSUE portability election.  That election may be made in Part 6 of the federal estate tax return.  Once made, that election is irrevocable.

Estate tax returns are due nine months after the date of death, but a six-month extension is available, if requested on or before the original due date of the return. 

Sometimes a personal representative fails to file a federal estate tax return claiming the portability election in a timely manner.  If so, Rev. Proc. 2017-34 provides a fairly simple procedure for relief in certain circumstances.  If the personal representative, after the return’s due date, wants to file an estate tax return to claim portability, he or she may be allowed to do so under that Revenue Procedure, but only if all the following requirements are met: (1) The decedent must have died after 12/31/2010, and must have been a U.S. citizen who was survived by his or her spouse; (2) The personal representative must not have been required to file a federal estate tax return (other than to claim portability); (3) An estate tax return must not have been filed before the filing date for the return; and (4) The personal representative must include the following statement at the top of Form 706: FILED PURSUANT TO REV. PROC. 2017-34 TO ELECT PORTABILITY UNDER SECTION 2010(a)(5)(A).

This method of filing for relief is available only if filed within two years from the date of death, and only if all the requirements listed above have been met.  If those requirements have not been met, the personal representative may request a private letter ruling from the IRS, which is more cumbersome and expensive procedure, but which may provide relief. 

ADDITIONAL OBSERVATIONS:

1. Please note that the DSUE does not apply to generation-skipping-tax. The deceased spouse’s GST exemption is lost if not used by the deceased spouse.
2. Also please note that, although the exemption for gift and estate tax for the surviving spouse is indexed for inflation, the DSUE amount for the deceased spouse’s exclusion is frozen as of the deceased spouse’s date of death, and is not indexed for inflation which occurs after the deceased spouse’s death.
3. If the surviving spouse makes taxable lifetime gifts after the death of the first spouse to die, and if a portability election has been made after the first spouse’s death, the DSUE of the deceased spouse is first applied to those gifts, before the surviving spouse’s gift tax exclusion is used.

On page 1 of Form 709, U.S. Gift Tax Return, Item #19 asks whether the surviving spouse has applied for a DSUE exemption from a predeceased spouse to a gift or gifts reported on the surviving spouse’s gift tax returns; if so, the surviving spouse is instructed to complete Schedule C on the Form 709.   

• If a surviving spouse has more than one deceased spouse who made DSUE elections, the exemption of the last predeceased spouse at the time of the gift shall be applied first, if available. That is, the DSUE of more than one predeceased spouse, if applicable, may be applied in succession, starting with the most recently-deceased spouse.
• There is a limit on the total DSUE amount which can be applied for a surviving spouse, however. The total DSUE amount claimed by a surviving spouse or by his or her estate cannot exceed the overall exclusion set out for gifts or estates for a single individual.

There are a number of factors which should be considered when determining whether or not to use portability at the first spouse’s death, both in pre-death planning and after the death of the first spouse to die, including: (a) the size of the combined estates of both spouses; (b) the age of the surviving spouse; (c) the surviving spouse’s ability to manage assets, and his or her spending habits and needs; (d) protecting the eventual inheritances of the children and grandchildren; (e) other likely inheritances by the surviving spouse; and (f) the possibility of remarriage by the surviving spouse.

If considering whether to make a portability election after the first spouse’s death, the safest approach – based on the theory that one never knows what will happen – would be to have the surviving spouse make a portability election, no matter what the circumstances, but the cost of preparing an estate tax return and making the election is often impractical, given the financial situation of the surviving spouse. Each case and each family financial situation is different, so we recommend that you review your circumstances with an experienced estate planning attorney, both while both spouses are living and again after the death of the predeceased spouse, to decide what’s best for you.