Paul O. Dillon, Attorney at Law

Why Your Trusts Need to Be Reviewed for Potential Tax Issues

You’ve undoubtedly seen the headlines about the end of the generous federal estate and gift tax exemptions coming at the end of 2025. Nevertheless, most Americans don’t have estates worth $13,610,000 or $27 million for couples. A recent article, “Is there a tax trap in your trust?” from Los Angeles Daily News, says we should be more concerned with an income tax issue for trusts, especially if they were created years ago.

Trusts created before 2010 commonly contained a trust provision to divide the trust in two upon the death of the first spouse. There were two reasons to split the trust. One was to be sure the surviving spouse didn’t change the named beneficiaries and leave the assets in the trust to someone else, like a new spouse.

The second reason was so each spouse’s estate tax exemption could be used. The use of both spouses’ exemptions mattered more way back then because the exemption was far lower than today: $1 million in 2002.

After 2010, if a married couple had a trust worth $5 million and their trust left everything to each other, the surviving spouse could inherit the trust and then change beneficiaries, disinheriting any offspring from a prior marriage. Even if they didn’t do this, when the second spouse died, there would be an estate tax on the estate's value over the second spouse’s tax exemption.

The A/B Trust solved the problem. The “B” part of the trust was an irrevocable trust and owned the deceased spouse’s share of assets and used the decedent spouse’s estate tax exemption. In 2010, the Tax Relief, Unemployment Reauthorization and Job Creation Act of 2010 became law, and the portability of the estate tax exemption for the first spouse to die was established. The surviving spouse had the option to file an election to preserve the deceased spouse’s estate tax exemption to be applied upon their own death.

The Tax Cuts and Jobs Act came along and raised the estate tax exemption from $5,490,000 to $11,180,000 in 2018. With increases for inflation, most married couples today don’t concern themselves with both spouse’s exemption amounts. However, a new issue must be considered and discussed with your estate planning attorney, especially if you live in a community property state.

When the first spouse dies, all the jointly owned assets receive a step-up in income tax basis in community property states (but only a step-up on the half attributed to the decedent spouse in separate property states). If you purchased an asset for $100, your basis is $100. If you sold it for $1,000, you’d have a profit or gain of $900. However, if the stock was worth $1,000 when the first spouse died, the new basis is $1,000 in a community property state. The beneficiary can sell the stock for $1,000 with no gain. When the second spouse dies, there’s another step-up on income tax basis. However, assets in a “B” trust—those of the first spouse to die—don’t receive another step-up in basis.

The result could be a significant capital gain when the assets are sold, especially if a lot of time has passed since the first spouse's death. If your trust hasn’t been reviewed or revised in a long time, you may want to update your trust, so the share of the first spouse to die goes instead into a marital trust.

A marital trust is drafted to protect contingent beneficiaries, typically the children from the marriage with the first spouse. It also serves to include assets in the surviving spouse’s estate, so the assets get that second step-up in basis.

This is an example of how changes in tax laws require trusts and estate plans to be reviewed by estate planning attorneys. Tax laws change, and personal situations do, too. You may have had a great plan when it was created. However, if your estate plan hasn’t been reviewed or updated in a while, it’s time to make an appointment with an experienced estate planning attorney.

Reference: Los Angeles Daily News (Oct. 20, 2024) “Is there a tax trap in your trust?”

Who Should Pay Taxes on Trust Income?

Irrevocable trusts include language directing how taxes on income should be paid. This falls into two general kinds of taxes, according to a recent article from Kiplinger, “Should You or the Trust Pay a Trust’s Income Taxes?” The first category includes transfer taxes, typically in the form of gift and estate taxes and generation-skipping transfer taxes, which are less common. The second category includes income taxes, such as earned income taxes and income taxes on investments, as well as capital gains taxes, best described as income taxes on property appreciation following the sale or exchange of property.

Who is responsible for paying these taxes? Rental income from real estate, profits from trust investments, appreciation income from selling property and distributions of assets from the trust are all taxable. Trust income is reported on either the trust’s income tax returns or on the tax return of either the trust maker or the beneficiary. The trust income tax return pays taxes at trust tax rates, while the beneficiary will pay taxes at individual tax rates.

While it seems intuitive to opt for the trust to pay the taxes, trust tax rates are often far higher than individual tax rates.

Trust tax rates are higher because an irrevocable trust has only hundreds of dollars of standard deductions. Irrevocable trusts pay the highest federal taxes after a few thousand dollars of income. Unless the trust maker is already paying taxes in the highest tax brackets, it’s almost always less costly for the taxes to be paid by the trust maker.

When speaking with your estate planning attorney about how to structure an irrevocable trust, the conversation will include how the irrevocable trust’s tax responsibilities will be managed. When the trust is being created, examine your budget to ensure the taxes will be manageable.

The language in the trust is known as “grantor trust status,” permitting the trust maker or another person to pay trust income taxes.

When an irrevocable trust is treated as a grantor trust, the trust maker is treated as the owner of the trust’s income or principal and must include any items about trust income, deductions and credits on their personal tax filing. This is required even though income remains in the trust.

Making matters more complicated, in some cases, having trust income tax grantor powers may mean the trust is included in the trust maker's taxable estate. Estate taxes are different from trust taxes. If the grantor has the power to revoke or amend the trust, it may also be considered part of the grantor’s taxable estate, as opposed to a true irrevocable trust outside of their estate.

Creating and planning trusts should only be done with the help of an experienced estate planning attorney, as there are many nuances to be considered.

Reference: Kiplinger (July 1, 2024) “Should You or the Trust Pay a Trust’s Income Taxes?”

Estate Planning has Begun for Exemptions Expirations

The high lifetime estate and gift tax exemptions gave extremely wealthy Americans terrific tax breaks. In 2024, exemptions are currently at $13.61 million per person and $27.22 million for married couples.  However, the end of these levels means that taxpayers with wealth of a much lower magnitude will need to prepare, according to a recent article from Forbes, “Wealthy Families: Consider These Planning Ideas Before ‘The Sunset.’”

Some state estate taxes are tied to federal estate taxes, so people of modest wealth should check with their estate planning attorney to be sure they are properly situated before the law changes. In addition, several strategies can be considered and applied to many tax brackets.

Charitable Giving. Instead of making a gift through a trust, you might consider donating cash to a charity. Under the 2017 law, the deductions for direct cash contributions jumped from 50% of AGI to 60%, including gifts to Donor-Advised Funds (DAFs). When the exemptions end, the limit will return to 50%, so if you are charitably inclined, making a cash gift now is a good idea.

Strategic Gifting. Assets depressed in value may have tax value as gifts. You might gift them to a beneficiary or a trust, so their appreciation may occur after they have been removed from your taxable estate. This creates two wins: the depressed assets will use less of your lifetime estate and gift tax exemption, and their future growth and possible increase in value will take place outside of the taxable estate.

“Substitution Powers” Assets. If you have transferred assets to grantor trusts with retained “substitution powers," consider moving low-basis assets out of trusts at a lower current value in exchange for higher-basis assets of equivalent value. This strategy could lessen capital gains on the lower-basis assets by returning them to the taxable estate and benefit from the step-up in basis at death. Talk with your estate planning attorney about how this might work for you.

Business Owner Planning. The Qualified Business Income (QBI) tax deduction created by the Tax Cuts and Jobs Act allows select pass-through entities, like sole proprietorships, partnerships, and S-corp owners, to deduct as much as 20% of business income. There are income thresholds and other limits to consider. However, this tax deduction ends on December 31, 2025. Accelerating income now could be of great value for business owners who qualify.

Basic Income Tax Planning. Income tax brackets will return to their levels before the TCJA law was enacted. The top bracket may increase to 39.6%, so you may not want to defer income. Middle tax brackets are also expected to expand.

Alternative Minimum Tax and Incentive Stock Options. The exemption amount for the AMT increased under the TCJ. However, this will also return to previous levels, making more taxpayers vulnerable to the AMT. One workaround is to exercise incentive stock options, which aren’t considered income for regular tax purposes but are considered income for AMT taxes. The AMT could be due in the year of exercise. If you can exercise before 2026, it could be a tax-savvy move.

Estate Planning Strategies. Planning needs to be flexible, since there is no way to know if Congress will or won’t act to renew TCJA. It may seem like there’s time to make any necessary changes. However, it takes time to create and execute a plan, which is why wealthy families are acting now to protect their assets.

Reference: Forbes (March 6, 2024) “Wealthy Families: Consider These Planning Ideas Before ‘The Sunset’”

Do I Pay Taxes on Wedding Gifts?

A generous gift for a child’s wedding doesn’t necessarily cause a tax problem unless your lifetime gifts are over the lifetime exclusion limit, which is extremely high right now. A recent article from Yahoo! Finance, “Do I Need to Worry About the Gift Tax If I Pay $60,000 Toward My Daughter’s Wedding?” says most Americans won’t have to worry about the gift tax.

In 2024, the lifetime exclusion is $13.61 million per person and $27.22 million for a married couple. Unless you’ve gone above and beyond these limits, you can make as many gifts as you like to anyone you choose without worrying or paying the 18% to 40% federal gift tax.

But there’s one thing to remember: if you make a gift over the annual gift limit, which is $18,000 per person in 2024 or $36,000 for a married couple, you need to send the IRS Form 709. The form should be submitted even if no gift taxes are due. It’s a simple and smart move.

How do gift taxes work? The federal gift tax doesn’t come into play often. Most gifts are tax-free simply because of the size of both the annual and lifetime gift exclusions. You can gift freely if you keep the limit in mind.

The lifetime exclusion for gift and estate taxes is so high right now that few Americans need to worry about it. If you are generously minded, you may gift $13.61 million (individual) and $27.22 million (married couple). The lifetime exclusion is just as it sounds: the number of gifts you may give during your life or as part of your federal estate.

If you are charitable-minded, you may make many contributions. There are no gift taxes levied on charitable donations, gifts to spouses or dependents, or gifts to political parties. As long as you pay directly to the institutions, there are no taxes on college tuition or healthcare expenses.

If you have a wedding coming up and are concerned about gift taxes, you can pay the vendors directly rather than giving money directly to the happy couple.

There are some strategies to manage the gift tax. One would be to split your $60,000 gift between your daughter and her fiancé. Both gifts would be under the 2024 $36,000 per person exclusion, assuming you are married, so there would not be a gift tax.

Another tactic is to spread the gift out over a few years. Let’s say you’re a single parent. You could gift your daughter and her fiancé $15,000 each this year and next, keeping you below the $18,000 annual gift tax exclusion.

If you’ve already given a gift of $60,000 to your daughter and made gifts over and above the $13.61 million lifetime exclusion, speak with your estate planning attorney to determine where you fall in the gift tax brackets and how much you’ll need to pay.

The easiest way to avoid gift taxes is to pay the vendors directly, but this depends on your overall situation. For instance, where is the money coming from—tax-deferred accounts or investment accounts? It would be wise to talk with your estate planning attorney before making a large gift.

Reference: Yahoo! Finance (March 14, 2024) “Do I Need to Worry About the Gift Tax If I Pay $60,000 Toward My Daughter’s Wedding?”

Will New IRS Memo End the Decanting of Irrevocable Trusts?

The term “irrevocable trust” is not quite what it seems, says a recent article from The National Law Review, “Is CCA 202352018 the Death of Irrevocable Trust Decantings?” There are several mechanisms by which irrevocable trusts can be modified. Generally, they can be modified in one or two ways, depending on the state’s laws. In some states, an irrevocable trust can be modified with the consent of the beneficiaries and the trustees. Some states also require the consent of the settlor if they are living. This is referred to as a “non-judicial modification.”

In other states, an irrevocable trust can be modified by a decanting, a process where an authorized trustee exercises their independent discretion to “pour” over the property of the trust to a new trust with different terms—hence the term decanting.

However, the IRS’ Chief Council Advice Memorandum (CCA 202352018) (the “CCA”) may be the end of irrevocable trust decantings as they have been used for years. It’s all about the taxes.

Estate planning attorneys have been concerned that using a non-judicial modification to make changes with the beneficiaries' consent, such as removing a beneficiary, shifting beneficial interests, or diluting a beneficiary’s interest, might be considered a taxable gift by the beneficiaries. The concern wasn’t present for decantings, since they are effectuated by the independent act of an authorized trustee, who doesn’t have a beneficial interest in the trust without the beneficiaries' consent - until the CCA.

The CCA Memorandum reviewed a case where, in the first year, an irrevocable inter vivos trust is established for the benefit of a Child and the Child’s descendants, and the trustee may distribute income and principal for the benefit of the child according to the trustee’s discretion. When the Child dies, the remainder will be distributed to the Child’s issue per stirpes.

In year two, when the Child has no living grandchildren or remote descendants, the trustee petitions the state court to modify the terms of the trust. The Child and Child’s issue consent to the modification. Later that year, the State Court grants the petition and issues an order modifying the trust to provide a trustee of the Trust with the power to reimburse the grantor for any income taxes. The grantor pays due to the inclusion of the Trust’s income in the grantor’s taxable income.

The Chief Counsel finds the modification of the irrevocable trust with the consent of the beneficiaries may constitute a taxable gift from the beneficiaries. However, the CCA goes on to say, “[t]he result would be the same if the modification was pursuant to a state statute that provides beneficiaries with a right to notice and a right to object to the modification and a beneficiary fails to exercise their right to object.”

This additional comment from the Chief Counsel is seen as foreshadowing the IRS’ position concerning decanting, and it may prove problematic. Most states currently authorizing trust decanting by statute require the trustee to provide the beneficiaries with notice of the decanting and provide that unless the beneficiaries consent to an earlier effective date, the decanting is only effective after a period of time elapses following the beneficiaries’ receipt of the notice.

It remains to be seen whether this comment from the Chief Counsel will foreclose all possible options for decanting. Decantings are permitted by law in various states, and many estate planning attorneys include provisions in their irrevocable trusts allowing the trustee to decant the trust under the terms of the trust, using the language of an “internal decanting provision.”

Whether the IRS will issue further guidance on the intersection of decantings and gift tax implications remains to be seen. If you are exploring the possibility of modifying an irrevocable trust, it is always best to speak with an estate planning attorney to review options and possible risks.

Reference: The National Law Review (Feb. 29, 2024) “Is CCA 202352018 the Death of Irrevocable Trust Decantings?”

When Should Gift Tax Return Be Filed?

Gift tax returns may be the most misunderstood and overlooked part of estate planning. The first mistake people make, according to the article “Know The Most Misunderstood Part Of Estate Plans: Gift Tax Returns” from Forbes, is not knowing when they do or don’t have to file a gift tax return. Even if a gift you make is tax-free, you might have to file a return anyway. And there are times when you aren’t required to file a gift tax return, but it’s still a good idea to do so.

The gift tax return is IRS Form 709, which can be downloaded from the IRS website at no cost.

In most cases, the IRS can’t take action on an incorrect gift tax return once more than three years have passed since it was originally filed. There are exceptions for fraudulent returns or if a return is either missing information or substantially misstates information.

However, there’s no statute of limitations if you fail to file a gift tax return, and the IRS can raise questions about the transaction at any time. This includes coming after your heirs or your estate after you’ve passed. At that time, your heirs or executor may not have the evidence to prove you complied with the tax law. The IRS would be within its rights to assess not only the gift tax but also penalties and interest for all the years from the date of the gift tax filing to the current date.

For this reason alone, it’s a good idea to file a gift tax return if there’s even the slightest question of whether it’s necessary.

Form 709 has a section for reporting “non-gift transactions.” Some estate planning attorneys recommend taking advantage of this to start the statute of limitations clock ticking and prevent the IRS from recharacterizing your gift years later as a taxable gift.

Consider this especially when you sell assets to a trust or shift assets from one irrevocable trust to another, known as “decanting” a trust. Consider also filing a gift tax return for a non-gift if you take advantage of the generation-skipping transfer tax exemption through a trust.

Another common mistake is not realizing that certain actions are considered gifts by the IRS, whether in the general sense or not. Let’s say you sell an asset to your children at less than market value. The difference between the selling price and the market value is a gift. So is forgiving or making a loan at a below-market interest rate.

If parents pay bills for adult children, this might be considered a gift if the gifts are valuable or if you also make significant gifts of money or property to the same person in the same year.

A gift tax issue the IRS pays close attention to is valuation. There’s not much question about the value of a publicly traded security, but for many other assets, there’s a lot of room to question the correct value, and the gift tax is based on the asset value at the time the gift is made.

While spouses may make unlimited gifts to each other tax-free, there are times when gifts between spouses must be reported. One time is when the gift is defined in the tax code as a “terminable interest.” Another time is if one spouse is not a U.S. citizen. Gifts to that spouse from the other spouse exceeding a certain amount during the year must be reported on IRS Form 709.

It’s always a good idea to check with your estate planning attorney about when a gift tax return should be filed to protect yourself and your heirs.

Reference: Forbes (Feb. 16, 2024) “Know The Most Misunderstood Part Of Estate Plans: Gift Tax Returns”

What are the Federal and Gift Tax Exemptions for 2024?

Unless Congress acts, regulations that elevated exemptions will expire at the end of 2025, and the exemption will be cut by about half, says the article “Take Advantage Of Increased Gift And Estate Tax Exclusions in 2024” from mondaq.

Those whom the gift and estate tax may impact should speak with their estate planning attorney about using this historically high exemption. Many estate planning strategies can be used to transfer wealth and take advantage of these exemptions efficiently.

In November 2023, the IRS announced increases for gift and estate tax exemptions in 2024, including an increase in the federal gift, estate, and GST (Generation Skipping Tax) exemption and the annual exclusion from gift tax. These changes became effective on January 1, 2024.

The gift and estate tax exemption has increased to $13,610,000 per individual in 2024. Married couples can transfer up to $27,220,000 since both partners may utilize the exemption. This marks a substantial increase of $690,000 per person ($1,380,000 per married couple) from the prior year.

Generally, gift and estate taxes may be due if a person’s total wealth transfer during their lifetime and at their death exceeds the gift and estate tax exemption.

The GST tax exemption increased to $13,610,000 per person in 2024. This tax may be triggered by transfers to or in trust for family members more than one generation younger than the donor. It might also be triggered by gifts to unrelated individuals who are 37.5 years younger than the donor.

The annual gift tax exclusion increased to $18,000 per donor, per gift recipient, and $36,000 per married couple splitting gifts. The annual gift tax exclusion permits individuals to make gifts to any amount of people tax-free every year without being counted against their lifetime gift and estate tax exemption.

An experienced estate planning attorney will explain the time-sensitive opportunities presented by the increases in 2024 in conjunction with the current (yet temporary) exemptions.

Now is the time to consider funding trusts with assets expected to have high growth potential, using a portion of the gift tax exemption while removing future appreciation from the estate.

Reference: mondaq (Dec. 21, 2023) “Take Advantage Of Increased Gift And Estate Tax Exclusions in 2024”

Should You Gift Kids Inheritance Now, or After You’ve Passed?

This is a genuine dilemma facing millions of parents and grandparents as they prepare to pass an enormous amount of wealth—$73 trillion—to the next generation. There are pros and cons to both approaches, according to the article, “Give the Kids Their Inheritance Now or Make Them Wait? 3 Things to Keep in Mind,” from Barron’s.

Giving too much too early could put parents in an economic bind in their later years. Therefore, this needs to be considered in light of today’s longer life spans. However, if you can afford to make a generous gift and your children could use the money now for a good purpose, it’s hard to justify making them wait.

How much to give is as critical as when to make the gift. The predominant concern is if you give your children too much, they won’t be motivated to earn their own wealth, or other family members will resent the gift. Estate planning attorneys and financial advisors routinely speak with families about these issues. These conversations always consider the values they want to instill in their children.

In some cases, parental support can help a child while working at an entry-level (i.e., low paying) job in their dream career. Covering the cost of rent for a few years can offer young adults a support net until they achieve financial stability.

This is very different than paying the expenses of a young adult with no career goal whose primary focus is a robust social life.

Anyone can make a yearly gift to any other person of up to $17,000 tax-free, or $34,000 per couple, but there are ways to make gifts without triggering gift taxes. Direct tuition payments to schools are tax-free. Unlike putting money into a 529 account, there is no limit to how much can be paid directly to a college or university. Parents and grandparents could also help with a downpayment on a child’s home without paying gift taxes.

Gifts don’t have to be large to have an impact. Some parents and grandparents give their children or grandchildren a small amount to start saving for retirement. A gift of a few thousand dollars during their 20s can grow into a nice sum over many decades. If the recipient has earned income, you can contribute to their IRA or Roth IRA accounts.

If assets are limited, consider giving personal possessions, such as jewelry or family heirlooms, to younger generations. You’ll get to see them enjoy their gifts, without putting your own financial situation at risk.

Whenever the decision is made to make these gifts, families should talk about their values and intentions around money.

If there are concerns about children losing an incentive to work because of the family’s wealth, a spendthrift trust might pass wealth along while controlling its distribution.

Remember that today’s generous federal estate tax rules are set to expire in 2026. Currently, individuals can gift up to about $13 million ($26 million for couples) tax-free in their estate plans. If the exemptions expire, this amount will be cut by approximately half.

Reference: Barron’s (Nov. 4, 2023) “Give the Kids Their Inheritance Now or Make Them Wait? 3 Things to Keep in Mind”

Estate Planning Myths Debunked

Estate planning is intimidating to people who think it’s only for the wealthy or don’t want to consider their own mortality. However, not addressing estate planning can cause families to suffer everything from the expense of estate battles to fractured families. A recent article from Forbes, “10 Estate Planning Myths You Shouldn’t Believe,” addresses the most common myths.

Estate planning is for the wealthy. Many articles focus on strategies to avoid paying the federal estate tax, which is only an issue if your estate is worth more than $12.92 million. However, estate planning is also about three things: planning for your finances to be taken care of if you’re incapacitated, making sure your health care decisions are carried out the way you want even if you aren’t able to communicate your wishes and making sure that your children and other heirs are cared for when you die. Estate planning is for anyone who may become seriously ill or die, which means everyone.

You’re too young for estate planning. The news is filled with stories of celebrities who die unexpectedly before creating a will. We never know when we may need estate planning.

If you die without a will, the state will get your assets. If you die without a will, each state applies intestacy laws to determine who inherits your property. You or your family may not like how the law distributes property. However, there won’t be anything they can do about it. Even if you don’t care about your property, if you have minor children, you need a will to determine who would be the guardian of your children if both parents die. Otherwise, the court will decide for you.

You don’t have to worry about probate if you have a will. This is wishful thinking, as probate can be long and expensive, especially if more than one court decides about your assets. While a will gives the court guidance on your wishes, it doesn’t avoid probate entirely. A will becomes public information that can be easily contested in court. If you own property in more than one state, each property may have to go through probate in its respective state.

You can draft these documents without an attorney. Yes, there are many forms online, and your hospital may have forms available for Health Care Proxy. However, you may be creating more problems than you solve by doing so. There are nuances in health care decisions not addressed by standard forms. Wills and trusts need the guidance of an experienced estate planning attorney to ensure that the documents align with state laws and accurately reflect your wishes.

No one needs an estate planning lawyer. There may be complicating issues in your life you are unaware of. An experienced estate planning attorney needs to review any estate planning documents to prevent problems for you and your family. Estate planning practitioners are accustomed to families coming for help after a do-it-yourself estate plan has gone wrong.

To avoid probate, you need a trust. Jointly owned property generally passes to the other owner without going through probate, as do assets with beneficiary designations, including life insurance, annuities and retirement plans, like 401(k)s and IRAs. Each state has its own rules for titling property to facilitate the transfer when a joint owner dies.

Trusts avoid estate taxes. If you’re worried about having a taxable estate, talk with an experienced estate planning attorney. Certain trusts can be part of a strategy to reduce and sometimes eliminate estate taxes.

You don’t have to worry about the estate tax. You may not need to worry about the federal estate tax, but some states have their own estate tax with far lower thresholds. Add in the value of your home, life insurance proceeds and retirement accounts. Then, talk with an estate planning attorney.

You’ll have to pay a gift tax if you give someone more than $17,000 annually. If you give an individual more than $17,000 in a single year, you reduce your federal lifetime gift and estate tax exclusion amount. You must start paying a gift tax only after you use up the entire exclusion. You still have to file a gift tax return and keep track of how much you’ve reduced your lifetime exclusion amount, so to avoid the hassle, you may want to stay within the $17,000 annual amount.

There are many misconceptions about estate planning, all of which can be cleared up with an appointment with an experienced estate planning attorney. This is one part of your life where a skilled professional can make a big difference for you and your family.

Reference: Forbes (Oct. 2, 2023) “10 Estate Planning Myths You Shouldn’t Believe”

How Does Portability Work in a Second Marriage Estate Plan?

Despite its advantages, portability isn’t always the solution, even as it’s been used to take the pressure off couples to focus on using as much estate and gift tax exclusion as possible after the first spouse’s death. According to a recent article from Wealth Management, “Portability and Second Marriages,” portability might be a mistake.

The couple and their estate planning attorney need to consider whether leaving the executor with the discretion to use portability is appropriate, and if it is, who the executor should be and how the estate tax burden should be allocated.

The problem with portability in nonstandard families is this: it allows the surviving spouse to use the DSUE (Deceased Spouse’s Unused Exemption) amount personally, instead of requiring it be used for the beneficiaries of the first spouse to die. It’s almost like leaving assets outright to the surviving spouse. In the case of a testate decedent, Treasury regulations provide that only the executor may make the portability elections. The executor should probably not be also a beneficiary and should not be responsible for making the portability election.

Let’s say the estate isn’t large enough to require an estate tax return filing. If the executor is a child from a prior marriage, they may not choose to incur the expense of filing an estate tax return solely to make the portability election for the second spouse. Instead of having the family involved in a disagreement over the need for a return or determining who will pay for its preparation, a better option is to have the estate plan direct whether an estate tax return should be filed to elect portability and if this is done, establish who is responsible for the cost of the preparation and filing.

In complex families with children from a prior marriage, a Qualified Terminable Interest Property (QTIP) trust is used for the surviving spouse, with the trust assets eventually passing to the client’s descendants. However, if the QTIP trust is combined with portability, the estate plan may not operate as intended.

Here’s an example. Ted marries Alba several years after his first wife, Janine dies. Ted has three children from his marriage to Janine. He bequeaths most of his estate to a QTIP trust for Alba and the remainder to his children, naming Alba his executor. At Ted’s death, Alba elects QTIP treatment for the trust and portability. She then makes gifts of her assets to her family using Ted’s DSUE amount. Alba dies with an estate equal to her basic exclusion amount, which she also leaves to her family. The QTIP trust pays estate tax, and Ted’s children receive no benefit from Ted’s exclusion amount.

Even if Alba didn’t make gifts to her family, assuming her estate was large enough to absorb most of her applicable exclusion amount (including the DSUE), the QTIP trust would have to contribute to pay the estate taxes attributed to it unless the estate plan waives reimbursement. Thus, the QTIP trust could bear most or all of the estate tax at the death of the second spouse, while the second spouse’s personal assets are sheltered in part by the deceased spouse’s DSUE amount.

In cases like this, the prudent course of action may be to use traditional credit shelter/marital deduction planning. If there’s a DSUE amount available, the estate plan could direct whether it will be used and how the tax burden on the QTIP trust is handled.

An experienced estate planning attorney will look at the family’s situation holistically and evaluate which strategies are most appropriate to distribute the property per the parent’s wishes to minimize taxes and ensure that the estate plan achieves its goals.

Reference: Wealth Management (June 21, 2023) “Portability and Second Marriages”