Minimize Estate Taxes With Portability | Baker, Burton & Lundy

Minimize Estate Taxes With Portability

Overview of Federal Gift and Estate Tax Exemptions

As of 2021, the unified gift and estate exemption amount is $11,700,000 per person.  This means that each person may give up to $11.7 million of assets estate tax-free.  Any amount in excess of this exemption is currently taxed at 40%.  Using a simple example, let us assume that at the time of X’s death, the exemption is still $11.7.  If X’s estate is valued at $15 million then the estate will owe $1.32 in estate taxes (40% of $3.3).

What is Portability?

Portability, an estate planning tool available only to married couples, is the ability of a surviving spouse to receive or “port over” the unused estate tax exemption from the deceased spouse.  For example, if the deceased spouse died in 2021 and did not use all of his/her $11.7 exemption during lifetime (such as by transferring property), then the surviving spouse can port over the deceased spouse’s unused exemption and add it to the available exemption the surviving spouse has.  In essence, this gives a family a second bite at the apple if no planning was done.  (This is because prior to portability, if no effective planning was done, the first person’s estate tax exemption disappeared, and no benefit was derived from it.)

Do I have to change my current estate plan in any way to take advantage of portability?

If your existing estate plan is in the form of an A-B Trust, a review would definitely be in order.

How does an A-B trust work?

Prior to 2011, married couples used the traditional A-B trust in their estate plans.

Upon the death of one spouse, the assets held in the joint trust are divided between the A Trust (aka “Survivor’s” Trust) and the B Trust (aka Bypass Trust, Exemption Trust, Residuary Trust, Credit Shelter Trust, Decedent’s Trust, etc).

The B Trust, which is an irrevocable trust, was funded with assets from the joint trust because assets held in the B Trust preserved the deceased spouse’s estate tax exemption.

Assets in the B Trust are not subject to estate taxes, irrespective of how much the assets in the B Trust grew in value before the surviving spouse died.

Since the B Trust was irrevocable, it gave the first spouse to die the knowledge that whatever was not used by the surviving spouse would go to their children at the surviving spouse’s death.  In other words, the assets could not be re-directed elsewhere by the surviving spouse.

An additional advantage of the B Trust was to provide creditor protection for the surviving spouse.  If the surviving spouse went bankrupt, the survivor’s assets could be lost, but the B Trust assets would be protected.

What was the drawback to using the B Trust?

When the second spouse died, the B Trust assets did not get a second step-up in basis.  (Learn more in the right hand column.)  To the extent the B Trust assets had appreciated since the first spouse’s death, this could create taxable income at the time of a sale.

How does portability minimize the need for a B Trust?

Since portability entered the scene, we no longer need to use a B Trust to save the deceased spouse’s estate tax exemption.  Instead, the deceased spouse’s unused estate tax exemption can be “ported” over to the surviving spouse, who can put that into his/her back pocket to use when the surviving spouse dies.

A “C” Trust, also known as the “QTIP” Trust, is now often used rather than the traditional B Trust.

The QTIP Trust has several benefits.  First, a QTIP Trust does not use any estate tax exemption.

If a spouse were to die this year and a QTIP Trust were in place, the surviving spouse can port over as much as $11.7 million in estate tax exemption.  If the current estate tax exemption is reduced in the future (and it is already scheduled to be reduced to $5 million in 2026), the surviving spouse can retain the deceased spouse’s $11.7 million, or whatever amount of the $11.7 million is unused at the time of his/her death.  As a result of portability, 98% of our clients can eliminate estate taxes.

Like the B Trust, the QTIP Trust protects the surviving spouse from creditors, and provides protection for the children.

Most importantly, unlike assets held in the B Trust, assets held in the QTIP Trust get a second step up-in basis when the surviving spouse dies.  This can be very valuable for the children or grandchildren who inherit from the QTIP trust.

Takeaway

Married couples who want to minimize capital gains taxes for their children should consider updating their estate plans to take advantage of portability and the QTIP Trust.

Please Note: This document does not constitute legal advice. Please consult an attorney for legal advice on what to do in a particular situation.

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Insight

What is a “Step-up in Basis”?

When property is inherited, the cost basis of the property is adjusted to the current market value of the property. This is called a “Basis Adjustment”.  With California’s historically booming real estate market, this often results in a “step-up” in basis rather than a “step-down.”  Getting a step-up in basis is tremendously valuable because it minimizes (or sometimes eliminates) the beneficiary’s capital gains tax liability.

If title is properly held as community property, married couples in California get a “double step-up in basis.”  This means that that there is a step-up in basis on the entire value of the property at the first spouse’s death, and a second step-up in basis on the entire value of the property at the second spouse’s death.

Mary Korkodian, Estate Planning Attorney