Neil Armstrong’s first words from the moon were heard all over Earth: “That’s one small step for man, one giant leap for mankind.” Most today know these words from memory. There is no phrase or moment more memorable or significant in space exploration.
In the field of estate and gift taxation, there may be no single number of greater significance than the unified credit or exemption amount, the amount a taxpayer may pass at death free of estate or gift tax. And when it comes to estate planning, utilizing and planning with this credit/exemption amount is arguably the most common technique to reduce ultimate tax burden. Last fall, Nelson Hunt posted on a recent considerable change in the wealth transfer tax arena, the portability of this exemption amount between spouses. Portability has been described as a small step for Congress, but a giant leap for surviving spouses whose spouse died without properly utilizing the exemption amount.
This past summer, the Treasury and IRS through temporary regulations clarified many of the issues under the current portability regime in the Code and beyond. This is a two part post that piggybacks off Nelson Hunt’s two posts last fall (see https://thehotchpot.wordpress.com/tag/portability/). Please reference Hunt’s posts for an exceptional description of what is portability, how portability works, and some of the basic policy concerns. This two part post examines some of the major updates to portability that happened this past summer and considers some additional policy concerns.
Tax Relief Act of 2010 modified Code section 2010 to include a provision for portability of the amount of the unused federal estate tax exemption at the death of the first spouse, the Deceased Spousal Unused Exclusion (DSUE) amount. The DSUE amount is defined in section 2010(c)(4) as
“the lesser of—
(A) the basic exclusion amount, or
(B) the excess of—
(i) the basic exclusion amount of the last such deceased spouse of such surviving spouse, over
(ii) the amount with respect to which the tentative tax is determined under section 2001(b)(1) on the estate of such deceased spouse.”
From the statute and beyond, the defined terms of “applicable exclusion amount,” “basic exclusion amount,” and “last deceased spouse” are central to the existing portability regime, specifically in the application. This past summer the Treasury and IRS issued Temporary and Proposed Regulations §§ 20.2001-2T, 20.2010-1T, 20.2010-2T, 20.2010-3T, 25.2505-1T, 25.2505-2T. The regulations clarified and defined these terms to mean:
- Applicable exclusion amount: the sum of the basic exclusion amount, and in the case of a surviving spouse, the DSUE amount.
- Basic exclusion amount: the amount of taxable transfers that is exempted from estate or gift taxation, as the case may be, through application of the unified credit. The amount is determined in the year of the death of the decedent whose DSUE amount is being computed. In 2011 and 2012, this amount is $5 million, with an inflation adjustment which will be ignored in this post.
- Last deceased spouse: the most recently deceased individual who was married to the surviving spouse at that individual’s death. Neither remarriage nor divorce from a subsequent spouse will sever a last deceased spouse relationship.
These long awaited regulations also clarified several other aspects portability that had been left wide open since enactment of portability in December 2010, including:
- How to utilize portability
- How to make the election
- When to make the election
- Who must make the election
- How to opt out of portability
Let’s consider two issues, arguably the most controversial, from the regulation’s guidance. Both issues involve remarriage and the potential issue of using multiple spousal exemption amounts.
Portability in Action – The Joint Committee on Taxation (JCT) Technical Explanation
The JCT technical explanation, which was published in December 2010, provides three examples of how portability works. The first and second examples are straightforward applications. But the third example, now clarified with reinforcing regulations, provides a quirk when applying the current statutory language under section 2010 as drafted.
Example 2: Husband 1 dies in 2011 having made taxable transfers of $3 million and elects to permit Wife to use his DSUE amount of $2 million. Wife subsequently marries Husband 2 who also predeceases Wife. Husband 2’s estate makes an election to permit Wife to use his DSUE amount of $1 million. Is Wife allowed to a combined $3 million DSUE amount or limited to Husband 2’s $1 million DSUE amount?
The JCT states the available DSUE amount is the lesser of the basic exclusion amount or the unused exclusion amount of the last deceased spouse of the surviving spouse, here Husband 2. Wife is left with an applicable exclusion amount of $6 million, thereby losing a net $1 million DSUE amount as a consequence of her marriage to Husband 2. However, if Husband 2’s DSUE amount had been greater than Husband 1’s, Wife would have increased her applicable exclusion amount.
Example 3: The facts are the same as in Example 2, except Wife predeceases Husband 2. Wife has a taxable estate of $3 million. Wife’s executor elects to permit Husband 2 to use her DSUE amount, which is calculated at $4 million.
The JCT states as a result, Husband 2’s applicable exclusion amount is $9 million. Consequently, Husband 2 benefited from Husband 1’s DSUE amount because Husband 1’s election increased Wife’s applicable exclusion amount by $2 million to $7 million.
But is Example 3 supported by the Code under section 2010? The Tax Relief Act of 2010 expressly rejects this “aggregate” definition. Recall from above that the Code in section 2010(c)(4) defines the DSUE amount as the “lesser of the basic exclusion amount, or the excess of the basic exclusion amount of the last such deceased spouse of such surviving spouse” over the amount with respect to which the section 2001(b)(1) tentative tax is determined.
Whereas the results of the JCT’s interpretation in Example 3 permit the stacking of the DSUE amount by calculating it from Wife’s applicable exclusion amount, the Tax Relief Act of 2010—reflected in the current statutory language of section 2010(c)(4)—leads to different results. This statutory language limits the surviving spouse to a maximum DSUE amount of the basic exclusion amount of the last deceased spouse, not the applicable exclusion amount. Considering the terms defined earlier in this article, applicable exclusion amount and basic exclusion amount, the distinction in these terms is critical to see that the result differs. Under the statute, if Husband 1 ported a $2 million exclusion amount to Wife, her applicable exclusion amount would be $7 million. If Wife married Husband 2 and then died with a taxable estate of $3 million, there would be $4 million of credit remaining.
Put another way, the JCT’s application in Example 3 allows porting the full $4 million amount to Husband 2. The current statutory language, however, limits the ported amount to $2 million. The current statutory language ignores Wife’s DSUE amount (derived from Husband 1) when calculating Husband 2’s applicable exclusion amount because the tentative tax is applied to the basic exclusion amount of Wife, rather than her applicable exclusion amount. Thus it appears that the statute does not support the JCT’s result in Example 3.
The JCT in March 2003, just a few months after publishing example 3, stated that the reference in section 2010(c)(4)(B) to the “basic exclusion amount” is an error:
The provision adds new section 2010(c)(4), which generally defines [DSUE] amount of a surviving spouse as the lesser of (a) the basic exclusion amount, or (b) the excess of (i) the basic exclusion amount of the last deceased spouse of such surviving spouse, over (ii) the amount with respect to which the tentative tax is determined under section 2001(b)(1) on the estate of such deceased spouse. A technical correction may be necessary to replace the reference to the basic exclusion amount of the last deceased spouse of the surviving spouse with a reference to the applicable exclusion amount of such last deceased spouse, so that the statute reflects intent.
The JCT’s response makes clear the need to replace “basic exclusion amount” under section 2010(c)(4)(B)(i) with “applicable exclusion amount.” For over a year, since March 2003, many practitioners were boggled by the JCT’s response and did not know which position to take.
This past summer, the Treasury and Service finally shed light on this very controversial example of portability application in the regulations. They agree with the JCT’s March 2011 response to Example 3 in the JCT’s technical explanation rather than the Code’s application to Example 3 in the JCT’s technical explanation. Temporary Regulation § 20.2010-2T(c)(1)(ii)(A) makes clear that basic exclusion amount under section 2010(c)(4)(B)(i) should be replaced with applicable exclusion amount. The Treasury and Service carefully considered this issue and provided their reasoning:
Construing the language of section 2010(c)(4)(B)(i) as referring to the same number described in section 2010(c)(4)(A) would lead to an illogical result because it would effectively render the use of “basic exclusion amount” in section 2010(c)(4)(A) meaningless. Specifically, the basic exclusion amount (the amount referenced in section 2010(c)(4)(A)) cannot be less than that same number reduced by another number (the amount referenced in section 2010(c)(4)(B)). Under such an interpretation, the basic exclusion amount referenced in section 2010(c)(4)(A) could not limit or impact the DSUE amount, and thus it would serve no purpose as written. Based on the principle that a statute should not be construed in a manner that renders a provision of that statute superfluous and consistent with the indicia of legislative intent reflected . . . Treasury and the IRS have determined that the reference in section 2010(c)(4)(B)(i) to the basic exclusion amount is properly interpreted to mean the applicable exclusion amount.
It took a while, but it seems this issue has been finally clarified. However, the result leads to further policy concerns which will be considered in the next part of this post.
Application of Portability to the Gift Tax
The Tax Relief Act of 2010 modified section 2505(a) to include “the applicable credit amount in effect under section 2010(c), which would apply if the donor died by the end of the calendar year.” Thus, the surviving spouse is permitted to use the DSUE amount of his or her predeceased spouse as a credit against lifetime taxable transfers (gifts).
There are certain special rules created to modify or clarify issues in the general rules of portability for application to lifetime transfers. For example, the “last deceased spouse” definition, which is defined above in this post, creates issues when remarriage is involved and lifetime transfers are made by the surviving spouse between the death of the first spouse and death of the next spouse. The first question to consider: If a surviving spouse makes lifetime transfers after the death of a spouse and elects portability, should the predeceased spouse’s DSUE amount apply to lifetime transfers before the surviving spouse uses his or her own basic exclusion amount?
A special “ordering” rule applies if a surviving spouse has multiple predeceased spouses and applies the DSUE amount of any predeceased spouse to lifetime transfers made by the surviving spouse before the surviving spouse’s own basic exclusion amount. Therefore, there is no recapture of previously gifted amounts made by using the DSUE amount of a prior last deceased spouse, and when the surviving spouse makes a gift; the DSUE amount of the last deceased spouse is applied before the surviving spouse’s own exclusion amount. Thus, the DSUE amount available to a surviving spouse (or a surviving spouse’s estate) includes both (1) the DSUE amount of the surviving spouse’s last deceased spouse and (2) any DSUE amount actually applied to taxable gifts made by the surviving spouse during the surviving spouse’s life to the extent the DSUE amount so applied was from a decedent who is no longer the last deceased spouse. This taxpayer-favorable ordering rule makes it possible for a surviving spouse to take advantage of the DSUE amount of the last deceased spouse as long as the DSUE amount was received from the surviving spouse’s last deceased spouse at the time of the transfer.
In other words, a surviving spouse may use the DSUE amount of a predeceased spouse against gift tax liability, as long as the DSUE amount is from the surviving spouse’s last deceased spouse as determined at the time of the transfer. There is no corrective adjustment or increase in gift or estate tax liability for gifts made by the surviving spouse using the last deceased spouse’s DSUE amount, even if the surviving spouse remarries and survives a subsequent spouse (who would then become the last deceased spouse of the surviving spouse). Consider an example:
In 2002, having made no prior taxable gifts, Husband 1 makes a taxable gift valued at $1 million and reports the gift on a timely-filed gift tax return. Because the amount of the gift is equal to the applicable exclusion amount for that year ($1 million), and Husband 1 utilizes this exclusion amount, the gift tax liability is zero. Husband 1 dies on January 15, 2011, survived by Wife. Husband 1’s taxable estate is $1 million. Husband 1’s executor properly elects portability of Husband 1’s DSUE amount. The executor of Husband 1’s estate computes Husband 1’s DSUE amount to be $3 million—the lesser of the [$5 million] basic exclusion amount in 2011, or the excess of Husband 1’s [$5 million] applicable exclusion amount over the sum of the [$1 million] taxable estate and the [$1 million] amount of adjusted taxable gifts.
On December 31, 2011, Wife makes taxable gifts to her children valued at $2 million. Wife reports the gifts on a timely-filed gift tax return. At the time of the gift, under the ordering rule in Temporary Regulation § 25.2505-2T(b), Wife is considered to have applied $2 million of Husband 1’s DSUE amount to the 2011 taxable gifts before her own exclusion amount; therefore, under Temporary Regulation § 25.2505-2T(c), Wife owes no gift tax. Wife is considered to have an applicable exclusion amount remaining in the amount of $6 million—$1 million of Husband 1’s remaining DSUE amount plus Wife’s own $5 million basic exclusion amount.
After the death of Husband 1, Wife marries Husband 2. Husband 2 dies on June 30, 2012, and Husband 2’s executor properly elects portability of Husband 2’s DSUE amount, which is properly computed on Husband 2’s estate tax return to be $2 million. The DSUE amount to be included in determining the applicable exclusion amount available to Wife for gifts during the second half of 2012 is $4 million, determined by adding the $2 million DSUE amount of Husband 2 and the $2 million DSUE amount of Husband 1 that was applied by Wife to Wife’s 2011 taxable gifts. Thus, Wife’s applicable exclusion amount during the balance of 2012 is $9 million—$5 million from her basic exclusion amount, plus the $4 million DSUE amount. Further, if Wife dies in October 2012 and makes no gifts in 2012, Wife’s applicable exclusion amount for estate tax purposes is the same $9 million.
The result of this ordering rule has caused much concern. These policy concerns will be considered in the next part of this post.
After considering these specific issues, it is easy to question the goal of simplicity intended by Congress and others when enacting portability. While the portability provisions are complex, the mechanics and application of portability in the Code have proved even more difficult. The next part of this post will consider some additional policy concerns that these issues [and others] raise. For a more in depth discussion of these issues and for the citations to all statements made, see my article The Portability Pill: Examining the Trial Stages of Federal Estate and Gift Tax Spousal Portability, will be published in the ABA Real Property, Trust and Estate Law Journal, volume 47, issue two, in November.
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