What Spouses Need to Know About Portability of the Estate Tax Exemption

Many people have heard that the “portabili- ty” rule essen- tially doubles the lifetime estate and gift tax exemption for married couples, but most people don’t know important details about how the rule works. Before portability was created in 2010, the lifetime estate and gift tax exemption was a use-it-or-lose-it benefit.

When one spouse’s estate wasn’t valuable enough to use all of his or her lifetime exemption, the excess exempt amount was lost. That was a big problem when most of the couple’s assets were in the name of one spouse and the spouse who owned fewer assets passed away first.

The spouse with most of the assets might inherit the other spouse’s assets but have only one estate tax exemption to shelter the entire joint estate from taxes. Estate planners devoted a lot of time to rearranging the ownership of assets to minimize lost lifetime exemptions and payment of estate taxes. Now, any unused lifetime estate and gift tax credit of the first spouse to pass away can be transferred to the surviving spouse, who can add it to his or her exemption. Estate plan- ners call this portability or portable credits, though the terms aren’t used in the tax code.

Understanding how portability works is important for people with estates that could be taxable. Many people should pay attention to the rule now, because there is talk of re- ducing the lifetime estate and gift tax exemption, and the current exemp- tion is scheduled to be cut in half after 2025 if Congress doesn’t act.

Consider Max and Rosie Profits with a net worth of $20 million, $15 million in Max’s name and $5 mil- lion in Rosie’s name. Rosie passes away first, in 2022. The lifetime estate and gift tax exemption 2022 is $12.06 million. Rosie’s estate is exempt from estate taxes. In addition, her unused estate tax exemption of $7.06 million can be transferred to Max. His estate will have both his own exemption of $12.06 million plus Rosie’s unused $7.06 million exemption, for a total of exemption of $19.12 million.

Here’s one of the tricks to portabili- ty: Max’s exempt amount is increased for inflation each year he lives after 2022, but Rosie’s unused amount that carried over to Max is fixed at $7.06 million. It isn’t increased for inflation no matter how many more years Max lives.

In addition, portability isn’t auto- matic. To secure the portability of the first spouse’s unused exemption, the estate executor must file an estate tax return, even if the estate is ex- empt from filing a return because no tax is due. The return must be filed within nine months of the date of the first spouse’s death or 15 months if a six-month extension is obtained. If an estate tax return is filed but doesn’t mention transfer of the unused credit, it is treated as though the executor elected to transfer the unused credit.

If the executor fails to file a return or misses the deadline, there is no portability and the unused exemp- tion can be lost. The executor can ask the IRS to allow the portability election to be made after the dead- line, but that will take time and cost money.

The executor, when filing the return, can elect not to allow porta- bility if, for some reason, you wanted that, or the executor decides that’s best. It’s important that executors know to file an estate tax return, even when one is not required, for an unused exemption to be transferred to the surviving spouse.

When the surviving spouse had more than one deceased spouse over his or her lifetime, only the exemption of the last deceased spouse can be used. Here’s how that rule works. In this example, I do away with inflation indexing to keep things simple and use the uninflated exempt amount of $10 million. Rosie Profits dies, leaving her surviving husband, Max.

Rosie had a previous husband who passed away and his estate used only $3 million of his exemption. So, Rosie has a $17 million exemption (her $10 million exemption amount plus the unused $7 million exclusion amount from her first husband). Rosie didn’t make any taxable gifts during her lifetime and has a taxable estate of $3 million. She has a $14 million unused exemp- tion amount. Rosie’s estate elects to let Max use Rosie’s unused exclusion amount. But Rosie’s estate can’t transfer to Max, her second spouse, the unused exemption amount from her first spouse.

So, Max won’t receive a $14 million exemption transfer from Rosie. He’ll receive only her personal exemption amount, $10 million, mi- nus the value of her estate. That gives Max a $7 million exemption transfer from Rosie. A price of portability is the estate of the first spouse to pass away can be audited any time until the audit period for the second spouse to pass away has closed.