June 26, 2017

Extended Portability of Estate Tax Exemptions

There is nothing more terrifying to a young attorney than making a clerical error that ends up wasting a lot of the senior partners’ billable time. This is a difficult risk to manage, as every case has its own set of issues and deadlines, many of which the firm may be liable for if not handled properly. The one that got me as a young associate attorney was a missed estate tax deadline. Thankfully for me, so many attorneys across the country made the same error (and continue to do so), that the IRS has provided a “do-over” for all estates of individuals who have passed away since 2011. With the new IRS rules now in place, this error never would have happened.

First, a little background on the estate tax exemption. While individuals may leave unlimited assets to their spouses at death with no estate tax assessed, the federal government and many state governments assess a tax on assets transferred to non-spouses when an individual dies. This tax is assessed on all of a decedent’s assets above a certain threshold, called the federal estate tax exemption. This exemption is $5.49 million for people who pass away in 2017 and is indexed each year for inflation. The states that levy an estate tax each have their own respective exemption amounts.

The federal estate tax exemption is applied to every individual, not to married couples jointly, which creates the following problem: if the first spouse to die leaves everything to the surviving spouse, then the entirety of the bequest falls under the unlimited spousal deduction and, as a result, the estate tax exemption of the first spouse goes unused.

Generations of estate planning attorneys have prepared bypass/exemption trusts whose sole purpose was to capture the first spouse’s exemption by creating a series of trusts at the first spouse’s death. Congress sought to simplify things in late 2010, creating a system by which spouses could “port” (transfer) their deceased spouse’s unused federal estate tax exemption amount and add it to their own. This system is called “portability” and it was made permanent in 2013.

Portability simplifies some parts of the estate transfer process, as it is no longer necessary for a family to prepare elaborate trust documents in order to capture the enormous tax benefit of the estate tax exemption. However, the portability process had a wrinkle: in order to preserve the first spouse’s exemption, the family needs to file a federal estate tax return upon the death of the first spouse. This was an important provision of the “simplified” portability process, as prior to the advent of portability, there was no need for an estate to file a tax return if assets were below the exemption amount.

As an associate attorney practicing the year portability was enacted, I once failed to file a federal estate tax return upon the death of a first spouse. Part of this mistake was a systemic one, as there were no internal systems to flag these cases – ones where a return would never have been filed prior to the advent of the new portability rule. When we realized the mistake (and I washed a little bit of egg off of my face), we wrote the IRS seeking forgiveness for what was most likely a meaningless error. Given the small amount of assets left to the surviving spouse, it was extremely unlikely the surviving spouse would accumulate assets in excess of the federal estate tax exemption over the remainder of her life, but a return needed to be filed nonetheless. The good news is that so many estates made the same mistake that the IRS has issued a series of rulings that allow estates to file a federal return after the filing deadline, if the sole purpose of filing is to preserve the unused exemption by electing portability.

The IRS recently extended this flexibility even further. Executors now have two years to file a federal return to elect portability, rather than the standard nine months allowed for estates filing for traditional purposes. Through the end of 2017, the IRS is also allowing taxpayers to file a return in order to elect portability for anyone who died since 2011.  If you have a friend or family member who has passed away over the last five years, and who was married at the time of his or her death, you may want to check with your estate planning attorney to see if filing a federal estate tax return to elect portability is the right move.