Estate tax portability: weighing the drawbacks

The American Taxpayer Relief Act of 2012 permanently established the concept of portability: availing a surviving spouse of a deceased spouse's lifetime exemptions for estate and gift taxes. In general, that was greeted with hosannas by estate planners and their clients, who found life much simpler, and discovered new ways to transfer assets among family members without cumbersome and expensive trusts.

But now, three years into the era of portability, many planners are recognizing potential drawbacks to this tactic. Why would client not want to take advantage of portability? Here are some of the most common reasons:

• Trusts that people used to use offer a certain number of "safe harbors" that portability does not. For example, all future appreciation in the value of assets in a bypass trust is sheltered from estate tax in the surviving spouse's estate, which is not true of assets that pass to a surviving spouse via portability. A trust may be a better choice if the client is seeking asset protection to make certain that the proceeds from the estate last not just the lifetime of the surviving spouse but can also provide for the next generation.

• There are still good uses for a bypass trust.  Traditional trust planning works especially well for couples whose combined wealth is likely to exceed their lifetime exemptions before the death of the surviving spouse. By putting the current exemption limit of $5.34 million into a trust rather than relying on portability, for example, the appreciation on that amount can be shielded from estate tax.

• Portability does not apply to state estate taxes. Don't let a client think he or she is safe from the federal estate tax by making use of portability — only to be blindsided by a state estate tax.

• If a surviving spouse remarries, and that person's new spouse dies before the surviving spouse, the unused basic exclusion amount that had carried over from the first spouse is lost. In other words, a widow can't have exemptions from two different husbands. If she inherits an exemption after her first husband's death, then marries a second husband who also dies, she can get the exemption from the second husband but has permanently lost the one from the first husband.

• An executor has some leeway in the portability decisions, which can be a problem if there is bad blood between the survivors (for example, if the executor is a child from the decedent's first marriage and is dealing with portability for his parent's second spouse). The executor may in such cases choose to ignore the portability opportunity. One can put a provision in a will or trust agreement requiring a portability election if there's a possibility of a conflict arising.

• Portability doesn't apply to the generation-skipping transfer tax exemption. That is the amount that a person can transfer to a trust that is sheltered from transfer tax in that person's descendants' estates. If a couple fails to fully fund a bypass trust upon the first spouse's death, this could reduce their ability to shelter assets in their children's and grandchildren's estates via the Generation-Skipping Transfer Tax exemption.

• IRS Form 706, which deals with federal estate tax, must be filed to secure portability. If the client refuses to authorize the filing of Form 706, either through ignorance or a desire to save time or money, portability would be lost. As the AICPA points out, portability is elective, not automatic, and every proper document must be filed to have it proceed correctly.

• Finally, portability might be repealed by a future Congress. The estate tax has been constantly tinkered with, so there's always the chance of the same thing happening to portability. It's an unlikely scenario, but one your clients should be aware of. Forewarned is forearmed.