What are the general rules of "portability" of a spouse's unused estate and/or gift tax exemption?

Upon the death of the first spouse (Decedent), an election can be made to elect to carry over to the surviving spouse (Survivor) the Deceased Spouse’s Unused Exclusion Amount (DSUEA). The DSUEA was made a permanent provision in Federal estate tax law in 2013. The concept of allowing the Survivor to use a DSUEA from the prior Decedent is commonly referred to as portability. This is a significant change in the Federal estate and gift tax laws permitting portability of estate and gift tax exemptions between spouses.

The General Rules of Portability

General Rule. For decedents dying in 2013 and thereafter, the personal representative can elect to transfer the deceased spouse’s unused exemption to his or her surviving spouse. When the surviving spouse later dies or makes a lifetime gift, the surviving spouse will have his or her own exemption ($5,250,000 in 2013) plus the unused exemption of his or her deceased spouse to offset the estate or gift tax. Thus, unused exemptions can be transferred between spouses, and portability allows married couples to transfer $5,250,000 apiece ($10.5 million together) tax-free.

Election. The election is made by the personal representative of the deceased spouse’s estate on a timely filed Federal estate tax return (IRS Form 706) nine months from the date of death, with an additional six-month extension available, even if no estate tax is due. Once made, the election is irrevocable. The election requires the personal representative to make an affirmative decision whether to file a Form 706. For estates that are not otherwise required to file a Federal estate tax return, the personal representative will need to determine whether the benefits outweigh the costs to prepare a 706 in order to make the election.

This election should be addressed in preparing wills and trusts in 2013 and thereafter. Generally, the personal representative may be given the authority to elect to transfer the unused exemption regardless of the costs to do so and even if such election favors only some beneficiaries. Further, the personal representative may be released from any liability for making, or choosing not to make, such election.

Statute of Limitations. The election to transfer the unused exemption via portability will keep the statute of limitations period open for the IRS to determine the actual amount of the deceased spouse’s unused exemption. Therefore, planners must consider how this open-ended limitations period could affect the surviving spouse. For example, the IRS could examine the deceased spouse’s return many years down the road to contest the value of property passing to children. If the values are increased and, in turn, the unused exemption is reduced, gifts made by the surviving spouse could inadvertently incur a gift tax. Interestingly, the limitations period for the surviving spouse’s Federal gift tax return is not open ended. If an IRS adjustment causes a gift tax in a closed year of the surviving spouse, presumably the IRS would not be able to collect such tax from the surviving spouse.

Remarriage. If the Survivor remarries and the Survivor dies before the Survivor’s new spouse, the Survivor still gets the benefit of the DSUEA from the Decedent plus the Survivor’s Exclusion that is available on the Survivor’s death.

Recapture. This is a highly technical issue in which the surviving spouse's estate tax may be calculated to effectively recapture gifts sheltered by a predeceased spouse’s unused exemption.

GST Tax. The transfer of exemptions between spouses applies for gift and estate tax purposes but not for generation-skipping transfer (GST) tax purposes. In other words, the deceased spouse’s unused GST tax exemption is not transferable.

Indexed for Inflation. The surviving spouse’s own exemption is indexed for inflation, but the exemption from the deceased spouse is not indexed for inflation.

Surviving Spouse’s Return. The deceased spouse’s exemption is not counted for purposes of determining whether the surviving spouse is required to file an estate tax return.

Credit Shelter Trusts. While portability is very helpful for estate and gift tax tax planning, commonly used Credit Shelter Trusts have the advantage of sheltering appreciation and could also be helpful in situations where you want to protect assets from creditors, use your GST tax exemption, or benefit children from a previous marriage. A Credit Shelter Trust does not, however, receive a step-up in basis at the time of the surviving spouse’s death.