Married Couples: Have Estate Tax Law Changes Made Your Estate Plan Outdated?

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If it’s been a while since you and your spouse signed your Wills or Trusts or last updated your estate plan, it may be time for an update to address changes in your family, assets, desired distributions, or choice of Executors/Trustees, and also to address changes in federal estate tax law. This post discusses how updating your estate plan in light of two key provisions of current federal estate tax law and the potential repeal of the federal estate tax could streamline estate management for the surviving spouse and also reduce income taxes following the survivor’s death.

Two key provisions of current federal estate tax law are:

  • The federal estate and gift tax exemption, or the amount each person can pass free of federal estate and gift tax, is $5.49 million in 2017 (amounts over  the exemption are subject to tax at a 40% rate).
  • Portability, which went into effect in 2011, allows the estate tax exemption of the first deceased spouse to be transferred to the surviving spouse for the survivor to use in addition to his or her personal exemption, for a total exemption of up to 2 x $5.49 million = $10.98 million.

Prior to 2010, when the federal estate tax exemption was much lower (it was $600,000 during most of the 1990’s and increased over the first decade of the 2000’s) and not transferrable between spouses, lawyers frequently prepared Wills and Trusts for spouses that automatically funded a ‘bypass’ trust at the first spouse’s death with an amount up to the deceased spouse’s estate tax exemption. The bypass trust assets would typically be available for the surviving spouse’s benefit but would not be subject to estate tax at the survivor’s death (the assets would bypass the survivor’s estate for tax purposes).

Under current law, with the $5.49 million estate tax exemption and portability, a married couple with a combined estate of up to $10.98 million, less the value any lifetime taxable gifts either spouse has made, can avoid federal estate tax without funding a bypass trust at the first spouse’s death. The estate tax marital deduction allows the first deceased spouse to transfer an unlimited amount of assets outright to the survivor (if the survivor is a U.S. citizen) free of estate tax and without using any estate tax exemption. Portability allows the estate tax exemption of the first deceased spouse to be transferred to the survivor for the survivor to use in addition to the survivor’s personal exemption, resulting in the survivor having an estate tax exemption of up to $10.98 million.

To transfer the first deceased spouse’s estate tax exemption to the survivor, the first deceased spouse’s estate needs to make a portability election by filing a federal estate tax return within nine months of the death of the first spouse. However under a 2017 IRS ruling, if the first spouse died or dies after 2010 and the nine-month portability deadline was or is missed, the estate of the first deceased spouse has until the later of two years following the first spouse’s death or January 2, 2018 to file an estate tax return to make a portability election for the survivor’s benefit, but only if the estate of the first deceased spouse was/is under the estate tax exemption in effect the year of the first spouse’s death.

Also, Congressional Republicans’ proposed overhaul of the Internal Revenue Code released November 2, 2017 would raise each person’s estate tax exemption to $11.2 million in 2018 and repeal the estate tax in 2024, and passing these provisions into law is possible since Republicans control both houses of Congress and the Presidency. A repeal of the estate tax could eliminate the need to fund a bypass trust regardless of the value of your estate.

Bypass trusts can protect assets from the surviving spouse’s creditors and can also preserve assets for subsequent beneficiaries (such as children from a prior marriage) following the survivor’s death. Also, spouses who live in or who own real estate in states that have a state estate tax (and no portability provisions) might need bypass trusts to reduce state estate tax. Virginia has no estate tax but Washington, D.C., Maryland and some other states do have an estate tax.

Funding a bypass trust can also preserve the federal generation-skipping transfer (GST) tax exemption of the first deceased spouse and allow assets in the bypass trust to pass following the survivor’s death to beneficiaries (or trusts with beneficiaries) who are two or more generations below free of GST tax. The GST tax applies in addition to estate tax and each person has a $5.49 million GST tax exemption, however the first deceased spouse’s GST tax exemption cannot be transferred to the survivor through portability.

If your current Wills or Trusts fund a bypass trust at the first spouse’s death solely to reduce federal estate tax at the survivor’s death (and not for another reason such as creditor protection, asset preservation or to reduce state estate tax or federal GST tax), this bypass trust may no longer be needed in light of the $5.49 million federal estate tax exemption and portability, and it also may not be needed if the estate tax is repealed. If your bypass trust is no longer needed, then updating your Wills or Trusts to allow assets to pass outright to the survivor instead of into the bypass trust could provide two significant benefits- reduced administrative burden for the survivor and reduced income tax liability following the survivor’s death.

Benefit #1: Avoid Administrative Burden of an Ongoing Trust

If your current Wills or Trusts fund a bypass trust at the first spouse’s death solely to reduce federal estate tax at the survivor’s death, then the surviving spouse is likely named as Trustee of the bypass trust so the survivor and not another individual or entity will control the trust assets. As Trustee, the survivor would need to file annual trust income tax returns and maintain trust records, and these tasks can be burdensome. Updating your Wills or Trusts to allow all assets for the survivor to pass to him or her outright instead of into the bypass trust could make it easier for the survivor to manage your estate.

Benefit #2: Income Tax Savings

If assets that the first deceased spouse leaves to the survivor appreciate substantially between the spouses’ deaths, a significant amount of income tax could be saved when the assets are sold following the survivor’s death if the survivor owned these assets outright at death and these assets were not in a bypass trust at the survivor’s death.

If the first deceased spouse owned stocks in a non-retirement brokerage account worth $1,000,000 at death and left these stocks to the surviving spouse outright, and these stocks subsequently appreciated and were worth $1,300,000 at the survivor’s death, no income tax would be owed on the sale of these stocks for $1,300,000 following the survivor’s death because the income tax basis for the stocks would be ‘stepped up’ to the market value at the survivor’s death, resulting in no capital gain income on the sale. Congressional Republicans’ proposed overhaul of the Internal Revenue Code released November 2, 2017 retains the income tax basis step-up for assets a decedent owns at death.

If the first deceased spouse left the same stocks mentioned above in a bypass trust for the survivor’s benefit and these stocks were sold for $1,300,000 following the survivor’s death, the income tax basis for these stocks would be the market value at the death of the first spouse, $1,000,000 (assuming dividends had not been reinvested) and the sale would generate $300,000 in capital gain income. A Virginia resident in the 15% federal capital gains bracket and the 5% (rounded) Virginia bracket who inherited and sold these stocks would owe $300,000 x 0.20 = $60,000 in income tax. Unlike assets the surviving spouse owns outright at death, assets in a bypass trust at the survivor’s death do not receive an income tax basis step-up.

Disclaimer Provisions for Increased Flexibility

If spouses’ combined estate exceeds or might exceed both spouses’ estate tax exemptions (currently, $10.98 million), funding a bypass trust at the first spouse’s death could provide more estate tax protection than relying on portability because all assets in a bypass trust plus appreciation in these assets following the death of the first spouse are shielded from estate tax at the survivor’s death, whereas a portability election only shields a fixed sum (the estate tax exemption of the first spouse to die) from estate tax but not appreciation in assets beyond this amount.

Spouses can provide through disclaimer provisions in their Wills or Trusts that all assets pass outright to the survivor, however to the extent the survivor disclaims (refuses to accept) the outright distribution of assets, assets pass to a bypass trust for the survivor’s benefit. Disclaimer provisions allow the survivor to accept assets outright if a bypass trust is not needed for estate tax protection, but also allow the survivor to fund a bypass trust if, based the value of the spouses’ assets and the estate tax law in effect at the death of the first spouse, a funded bypass trust would potentially provide additional estate tax protection.

Conclusion

If your current Wills or Trusts require that assets pass into a bypass trust for the surviving spouse solely to reduce federal estate tax at the survivor’s death, this trust may no longer be needed because of the $5.49 million exemption and portability, and it also may no longer be needed if the federal estate tax is repealed. If the bypass trust is no longer needed, updating your Wills or Trusts to allow assets to pass outright to the survivor instead of into the bypass trust (while if desired, retaining the option to fund the bypass trust through disclaimer provisions) could streamline estate management for the survivor and potentially generate income tax savings following the survivor’s death.