A provision in the tax law, which had been effective only in 2011 and 2012, is now permanent. A surviving spouse may now inherit his or her predeceased spouse’s unused estate tax exemption.

This change was intended to make estate planning easier and, in fact, in some family situations it does. However, in other cases the pros and cons of utilizing this new provision must be weighed before engaging in estate planning.

A traditional estate plan for a married couple consists of dividing the estate of the spouse who dies first (the “deceased spouse”) into two parts; one part takes advantage of the estate tax exemption (now over $5 million for federal estate tax purposes) and the other part takes advantage of the marital deduction. The estate tax exemption part is often held in trust for the benefit of the surviving spouse (often called the “credit shelter trust”). The credit shelter trust is designed so that its assets will not be part of the estate tax base when the surviving spouse passes away. The surviving spouse then uses his or her own estate exemption to protect the surviving spouse’s own assets from estate tax. Thus both spouses’ exemptions are employed to avoid estate tax. If instead of creating a credit shelter trust those assets pass directly to the surviving spouse, then all of the inherited assets will be included in the surviving spouse’s estate tax base when he or she dies and the deceased spouse’s exemption will be “lost.”

Impact of Portability
The law now allows a surviving spouse to use the estate tax exemption that his or her deceased spouse did not use. This is referred to as “portability.” Rather than creating a credit shelter trust for the benefit of the surviving spouse, the deceased spouse can give everything outright to the surviving spouse. No tax will be due at the death of the deceased spouse due to the estate tax marital deduction. The surviving spouse will then have the benefit of the deceased spouse’s estate tax exemption—as well as his or her own exemption—to protect lifetime gifts from gift tax or to protect assets at the time of his or her death from estate tax.

Taking Advantage of Portability – Pros and Cons
Portability eliminates the need to establish a credit shelter trust in some situations. Complex wills that often contain formula clauses—designed to optimize use of the exemption and the marital deduction—are no longer necessary. In addition to simplicity, the reasons to take advantage of portability include the following:

  • Assets in a credit shelter trust will not receive a second income tax basis step up on the death of the surviving spouse, while assets in the surviving spouse’s estate will. 
  • If the only available assets to fund a credit shelter trust are assets which constitute “income in respect of a decedent,” such as deferred compensation or IRAs, then the income tax liability on those assets will reduce the value of the assets passing to a credit shelter trust. Taking advantage of portability may then be advisable.
  • The value of the credit shelter trust may decrease over the surviving spouse’s lifetime, either due to market performance or the surviving spouse’s needs. The portability amount remains constant. In such cases, portability may be advisable.
  • From an asset protection perspective, all of the couple’s assets can be put in the name of the less exposed spouse; the more exposed spouse can still port his or her exemption to the less exposed spouse.

However, there are strong reasons for each spouse to use his or her exclusion by creating a credit shelter trust. These reasons include the following:

  • Portability only applies to the federal estate tax exemption. There are states, such as New York and New Jersey, which impose a separate state estate tax.

Thus, a married couple may wish to create a credit shelter trust in order to avoid the loss of the deceased spouse’s state estate tax exemption.