Portability Election Could Trigger Estate Tax Return Avalanche

A simple oversight could cost your clients as much as $1.75 million in estate tax exposure. If your client dies in 2011 or 2012 and their estate doesn't take affirmative action to elect the applicable exclusion portability on an estate tax return, their beneficiaries could permanently lose the benefit of the Deceased Spousal Unused Exclusion Amount, which was enacted as part of the two-year estate tax makeover in the Tax Relief Act of 2010.

DSUEA Basics

The Deceased Spousal (or alternatively "Spouse" or "Spouse's") Unused Exclusion Amount (DSUEA) is a big deal because it allows married couples to fully utilize both spouses' exclusion amounts without having to resort to an A-B trust arrangement—which can have an adverse effect on beneficiaries' basis in assets they receive from the B trust after the second spouse's death.

Now, if the first-spouse-to-die's ("first spouse") estate does not fully utilize that spouse's exclusion amount, the second-spouse-to-die's ("second spouse") estate can add the first spouse's unused exclusion amount to the second-spouse's exclusion amount, increasing the amount of property that can pass to the beneficiaries' estate tax-free upon the second spouse's death.

The effect of the DSUEA is to allow the second spouse to shield up to $10 million from estate tax without the use of a credit shelter trust.

Unanswered Questions

As great as the DSUEA is for your high-net-worth clients, it is anew concept, and the IRS is only now getting around to issuing guidance on how the DSUEA works. Two of the big unanswered questions are as follows:

Does the DSUEA need to be elected by the estate of the first spouse? Or does the DSUEA automatically extend the first spouse's unused exclusion amount to the second spouse?
Can the first spouse's estate elect against the DSUEA? And if so, what is the procedure to elect against the DSUEA?

The IRS issued guidance last week answering these two questions and posing a few more that will be answered in future guidance. (See Notice 2011-82 and IR-2011-97.)

Electing the DSUEA

Estate tax returns for estates that will be affected by the new estate tax were due as early as October 3 of this year, so the IRS's guidance is going to be too late for some estates. The portability provisions of the Tax Relief Act are available to estates of decedents dying after Dec. 31, 2010 and before Jan. 1, 2013.

The essence of the IRS' guidance on portability is that portability must be elected. If one of your clients dies after Dec. 31, 2010 leaving a surviving spouse behind, the deceased spouse's estate must make a timely portability election. If they don't make the election, the second spouse's estate could, depending on the circumstances, face an additional tax bill of $1,750,000!

Estate tax returns generally are due nine months after the decedent's death, but estates have the option of paying the estimated correct amount of estate tax due and requesting a six-month extension prior to the return's due date.

The executor of an estate that wants to elect portability of the first spouse's unused exclusion amount must elect portability by filing Form 706, U.S. Estate (and Generation-Skipping Transfer) Tax Return, even if the estate is not otherwise required to file an estate tax return. An estate tax return is strictly required for estates of decedents dying in 2011 and 2012 only if the value of the gross estate (plus taxable gifts) exceeds $5 million. But estates that are not required to file a return will probably want to take that extra step to preserve portability for the second spouse's estate. A lot can happen between the two spouses' deaths.

Electing Against the DSUEA

Executors of estates of decedents dying after Dec. 31, 2010 that do not want the portability provisions of the Tax Relief Act to apply to them have two potential options. First, if the estate is not required to file an estate tax return, the estate will be deemed to have elected against portability if it does not file a return. If, on the other hand, the estate is required to file an estate tax return, the estate will need to follow the forthcoming instructions on soon-to-be amended Form 706 to elect against portability.

Conclusion

If one of your clients dies in 2011 or 2012 leaving a surviving spouse behind, it will almost always be advisable to file an estate tax return, regardless of whether a return is otherwise required. If, for instance, a couple has a combined estate of $2 million and one of the spouses dies in 2011 at the age of 55, no estate tax return would be required (unless, of course, the decedent spouse made $5 million in gifts during his or her lifetime).

If the second spouse dies when the exclusion amount is still $5 million and the estate is $2 million or less, there's no need to use the DSUEA to reduce the second spouse's estate tax liability.

On the other hand, if $2 million left with the surviving spouse grows at an average rate of 6% and he or she survives to age 80, the surviving spouse's estate could be north of $8.5 million. The second spouse, then, has a relatively big estate tax problem without the DSUEA. On the other hand, with the DSUEA, the second spouse's estate will have zero estate tax liability. In this case, failing to file an estate tax return on the death of the first spouse could cost the second spouse's beneficiaries over $1 million in estate tax liability!

It is very important to note that portability must be elected by filing an estate tax return—on time. If one of your clients dies after Dec. 31, 2010 leaving a surviving spouse, and the estate's representative indicates that an estate tax return is not being filed, it may be time for a second opinion.

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See also The Law Professor's blog at AdvisorFYI.