Portability of the Estate and Gift Tax Exemption

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The estate and gift tax imposes a tax on assets an individual owns at death and assets gifted during life in excess of the exemption amount.  Gifts and estates in excess of the exemption amount were subject to a federal tax ranging from 35-45%.  The exemption amount has fluctuated dramatically in the last decade making estate planning difficult as we generally do not know the exemption amount for the year in which death occurs.  Also, the exemption amount was personal meaning it could not be transferred between spouses and was a use it or lose it proposition.

Congress passed the American Taxpayer Relief Act of 2012 on January 1, 2013.  The exemption from estate tax was increased to $5 million, indexed for inflation.  The lifetime exemption from gift taxes was also increased to $5 million and fully integrated with the estate tax.  To the extent that a person uses part of their gift tax exemption during life, it reduces the estate tax exemption available at death.  The estate tax rate is 40% on estates exceeding the exemption.  The 2013 law also makes permanent the portability of the exemption amount between spouses.  Portability allows for the surviving spouse to use the unused estate tax exemption of a deceased spouse.

President Donald J. Trump signed the Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018 on December 22, 2017.  The new law provides for a doubling of the exemption from estate and gift taxes to $11.2 million.

These two changes, a dramatic increase in the exemption amount coupled with the ability to use a spouse’s unused exemption, have resulted in a change in estate planning techniques.  The pre 2013 estate tax regime was a use it or lose it proposition meaning that if we did not use the first spouse’s exemption amount upon the first spouse’s death, we would lose the ability to use it in the future.  The vast majority of estate plans drafted prior to the new law are referred to as A-B trusts which require the mandatory funding of a bypass trust upon the death of the first spouse.

When the first spouse died we would take half of the assets and transfer them into the bypass trust.  This administration upon the death of the first spouse was required in order to be able use the exemption of the deceased spouse.  The administration would require us obtain a Tax ID number, set up bank accounts and transfer property into the bypass trust.  The bypass trust must be irrevocable so the surviving spouse could not change its terms.  Also, the bypass trust would have to file its own tax return each year.  The surviving spouse also must be prepared to account to the future beneficiaries of the bypass trust if requested.

Most estate planning attorneys no longer automatically include the bypass trust in their trusts.   The new law makes the portability of the exemption between spouses permanent.  We now make funding of the bypass trust optional.  I generally draft my trusts to provide that everything passes to the surviving spouse upon the death of the first spouse but that the surviving spouse has the option of disclaiming property to a disclaimer trust which would operate as a bypass trust.  Effectively, we are simply making the funding of a bypass trust optional, rather than mandatory.  One important thing to note is that the disclaimer must be made within nine months of the date of death or the ability to fund the disclaimer trust terminates.

The majority of my clients request that I update their trusts to remove the mandatory bypass and replace with the optional disclaimer trust format.  We still use the mandatory funding of a bypass trust at times, particularly in the case of second marriage where one of the parties may have prior children.

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