November 2013 Volume 5, No. 3 This estate planning edition of Currents is by Tiffany N. Apel, Esq., an estate planning associate of the firm. Please contact Tiffany N. Apel at TApel@clarktrev.com or others lawyers in the Clark & Trevithick estate planning practice to inquire about the subject of this issue. Portability-Enabled & Traditional Trusts: A Comparative Analysis of Estate Planning for Married Couples Estates This article provides a general overview of the concept of portability in estate planning for married couples. It compares traditional trusts to portability-enabled trusts, bringing to light key advantages and disadvantages of both. The best choice for a particular couple depends on a variety of factors that may vary from one situation to the next. 1. INTRODUCTION: What is Portability? A. History The 2012 American Taxpayer Relief Act ( The Act ) made permanent the concept of portability, which allows a surviving spouse 1 to apply, or port, his or her deceased spouse s unused federal unified gift and estate tax exemption 2 to the surviving spouse to use against future gift or estate taxes. Prior to portability, living trusts 3 were constructed in such a way that required separate subsidiary trusts for each spouse s estate tax exemption. After The Act, however, living trusts may be more simply constructed, as the surviving spouse can utilize the entire unused exemption amount of the deceased spouse at his or her discretion without necessarily creating a so-called Bypass Trust (sometimes known as Credit Shelter Trust or Exemption Trust ). There are several important implications of constructing a portability-enabled trust. This article explores some of the more significant advantages and disadvantages of each. B. Traditional Trust Planning Below is a schematic diagram of a Traditional Family Trust. In a Traditional Family Trust, two sub-trusts are necessarily created after the death of the first spouse to die ( deceased spouse ): Survivor s Trust and Bypass Trust. As illustrated below, the Survivor s Trust is funded (assets and properties transferred to) with one-half of the community property ( CP ) and 100% of the surviving spouse s separate property ( SP ) held in the living trust estate. The Bypass Trust is funded with the lesser of the Traditional Family Trust Joint Lifetimes FAMILY 2013 Trust 1/2 CP + Survivor s SP 1/2 CP + Decedent s SP 1st Death Survivor s Trust QTIP Trust Bypass Trust 2nd Death Beneficiaries 1 Continued on next page.
available estate and gift tax exemption amount of the deceased spouse, or one-half of the deceased spouse s CP, plus his or her SP. If the estate is large enough such that one-half the CP and all of the deceased spouse s SP exceeds the available estate and gift tax exemption, then a third sub-trust, the QTIP 4 Trust, is also created and funded with the balance. Of these three sub-trusts, the Bypass Trust and QTIP Trust are irrevocable. The Survivor s Trust is revocable. C. Trust Planning with Portability There are two general approaches to drafting a portability-enabled trust: (1) Revocable Family Trust with Disclaimer and (2) Revocable Family Trust with a QTIP. 1. Revocable Family Trust with Disclaimer The structure of a portability-enabled trust that provides the option of the Bypass Trust is similar to the Traditional Family Trust in that, during the married couple s joint lifetimes, all assets are held in a revocable living trust. The settlors are usually the trustees and always the income and principal beneficiaries. The big difference, however, is that upon the first spouse s death, assets are not automatically divided and allocated between two different subsidiary trusts. Rather, all assets can be funded into a single Survivor s Trust, thereby giving the surviving spouse complete control and flexibility. Alternatively, the surviving spouse can choose to disclaim 5 all or part of the allocation of the deceased spouse s assets, thereby causing them to pass into a Bypass Trust, which only has the surviving spouse as the beneficiary. There are two key differences between this model and the Traditional Family Trust. First, in this model, funding of the Bypass Trust is discretionary, not mandatory. Second, under the Traditional Family Trust, the deceased spouse s share passes automatically to an irrevocable Bypass Trust and if the trust estate is large enough, to an irrevocable QTIP Trust. This structure effectively locks in the deceased spouse s share such that all assets allocated to the Bypass Trust or the QTIP Trust at the death of the surviving spouse passes to the persons named by the deceased spouse. By contrast, in a portability-enabled Revocable Family Trust with Disclaimer, the deceased spouse s share combines with the surviving spouse s share thereby making the disposition of the deceased spouse s assets freely amendable by the surviving spouse. Family Trust with Disclaimer Joint Lifetimes FAMILY 2013 Trust 1st Death 100% CP + 100% SP Survivor s Trust (portability eligible) Optional Disclaimer Bypass Trust 2nd Death Beneficiaries 2 Continued on next page.
2. Revocable Family Trust with a QTIP Like the two aforementioned trust approaches, in a Revocable Family Trust with a QTIP, during the married couple s joint lifetime, all assets are held in a revocable living trust whereby the settlors are usually the trustees and always the income and principal beneficiaries. However, upon the deceased spouse s death, one-half the CP and all of the surviving spouse s SP are funded into a Surviving Spouse s Trust and one-half the CP and all the deceased spouse s SP are funded into a QTIP Trust. Like the Family Trust with Disclaimer, the surviving spouse also has the option to disclaim assets of the QTIP Trust, thereby creating a third trust the Bypass Trust, or make a partial QTIP election. 6 This structure is effectively the same as the traditional family trust, but for the fact that the Bypass Trust or Non-Qualifying QTIP Trust becomes optional as opposed to mandatory. By making it optional, the survivor can choose whether to use the deceased spouse s exemption at the deceased spouse s death or port it to a later date. Another difference is that the QTIP Trust is irrevocable, protecting the deceased spouse s disposition from change. Further, with a QTIP Trust, the surviving spouse could have up to 15 months after the deceased spouse s death to decide on whether or not to make a partial QTIP election and/or claim portability, while a disclaimer must be made within nine months. Also, with a Qualifying QTIP there is a new income tax basis at the surviving spouse s death. If needed, this QTIP Trust arrangement also allows for allocation of the GST exemption by making a reverse QTIP election. This is a variation on disclaiming to a Bypass Trust, by first making a partial QTIP election. Family Trust with QTIP Joint Lifetimes FAMILY 2013 Trust 1/2 CP + Survivor s SP 1/2 CP + Decedent s SP 1st Death Survivor s Trust QTIP Trust Optional Disclaimer Bypass Trust 2nd Death Non-Marital GST Exempt Marital GST Exempt Beneficiaries 2. A COMPARATIVE ANALYSIS: Traditional Trusts vs. Portability Enabled Trusts A. The Advantages of Portability Four significant advantages of electing portability, as opposed to using a traditionally structured trust, include (1) simplicity, (2) flexibility, (3) a second step-up in basis and (4) full use of residence capital gains tax exclusion (by allocating to the Survivor s Trust). 1. Simplicity Electing portability offers administrative simplicity in that all assets are transferred together into one sub-trust, typically called a Survivor s Trust. This sub-trust is revocable, meaning the surviving spouse controls the beneficiary designation of all assets. Such unfettered access and control eliminates the complication of allocating assets to multiple sub-trusts, which can be particularly challenging in the case of illiquid assets. Furthermore, there are no irrevocable sub-trusts, 3 Continued on next page.
which eliminates the administrative burden of filing for tax identification numbers, annual tax returns specific to the sub-trust, and separate accounting for the sub-trusts. 2. Flexibility If portability is elected, the surviving spouse has the flexibility to decide when to use the deceased spouse s unused estate and gift tax exemption amount. For lifetime gifting purposes, the surviving spouse can use the exemption immediately by making a disclaimer or a partial QTIP election, or at any future time, provided the laws on portability have not changed. Portability is lost when a surviving spouse remarries, if the new spouse dies before the surviving spouse used the deceased spouse s unused exemption. Comparatively, in a traditional family trust, that decision to use the deceased spouse s unused exemption is made at the time the living trust is initially created and is determined under a QTIP marital deduction formula in the trust instrument. The surviving spouse has no flexibility; the sub-trusts must be created, assets must be divided and allocated, and annual tax returns must be filed for the irrevocable trusts. 3. Second Step-Up in Basis Electing portability allows the surviving spouse to keep all assets in a Survivor s Trust or a Qualifying QTIP Trust, which keeps the assets treated as part of the surviving spouse s estate. Thus, there is a second step-up 7 in basis for all assets in the trusts at the surviving spouse s death. Comparatively, under a traditional trust structure, the assets funded to a Bypass Trust are automatically excluded from the surviving spouse s estate and thus do not receive a second stepup in basis. Consequently, in electing portability, there is a step-up in basis for potentially more appreciating assets than would be eligible under the traditional family trust. 4. Full Use of Residence Capital Gains Tax Exclusion In the case of the traditional trust, there are circumstances in which the residence may be allocated in part to a Bypass Trust. When this occurs, the surviving spouse will not be able to use the full amount of the residence capital gains tax exclusion. 8 However, if portability is elected, the entire residence can remain in the Survivor s Trust, and thus be treated as part of the surviving spouse s estate, allowing eligibility for the entire residence capital gains tax exclusion amount. In this circumstance, portability can save the surviving spouse up to $250,000 in tax exclusion from capital gains tax if the residence is sold and has a capital gain. B. The Disadvantages of Portability On the other hand, electing portability has notable disadvantages, such as: 1. Risk of Losing Exemption In not using the decedent spouse s unused exemption immediately, the surviving spouse assumes the risk that the exemption may be lost in its entirety upon remarriage (if the new spouse dies before the surviving spouse) or with a future law change. 2. Taxable Appreciation When portability is elected, the appreciation realized between the deceased and surviving spouses deaths is taxable with respect to the entire estate. Comparatively, in a traditional family trust, post-death appreciation on assets and income held in a Bypass Trust is not subject to estate tax at the death of the surviving spouse. 3. No Asset Protection for Surviving Spouse Given the premise that portability enabled trusts maintain their revocability, all assets in the estate are accessible to creditors of the surviving spouse, unless those assets are disclaimed to an irrevocable trust such as a QTIP Trust or Bypass Trust. 4. Filing Requirement Even if no federal estate tax is due on the deceased spouse s death, in order to claim the portability election, the surviving spouse must prepare and file IRS Form 706 within 9 months (or 15 months if extension is timely filed), of the deceased spouse s death. 5. Portability is Not Indexed The exemption amount which can be ported is conclusively determined at the time of the deceased spouse s death and not adjusted for subsequent inflation. Thus, while the assets on which the estate tax need be paid may be appreciating in value, the amount of the available exemption ported from the deceased spouse is not. Additionally, assets in a Bypass Trust are excluded from the surviving spouse s estate no matter how much they appreciate. Therefore, in some circumstances it may be advantageous to use the ported exemption through lifetime gifting so to maximize the amount of exemption applied to the assets likely to appreciate. 6. Distribution Susceptible to Change In addition to tax planning concerns, portability-enabled trusts also require that attention be given to familial relationships. Because portability often empowers a surviving spouse to alter the final distribution of the couple s assets, the distribution that the deceased spouse expected, may change at the direction of the 4 Continued on next page.
surviving spouse. This is particularly relevant in families including children of previous marriages, as a surviving spouse may be inclined to redistribute assets favorable to the surviving spouse s children at the expense of the deceased spouse s children. Thus, giving the surviving spouse this unrestricted control may come at the expense of a distribution contrary to the expectations and wishes of the deceased spouse. C. A Comparative Analysis Given the advantages and disadvantages of each approach, the estate or tax planning professional must balance financial and familial concerns to determine which avenue is best for each couple. Consider Net Worth and Composition of Net Worth In determining whether or not to recommend a portabilityenabled trust, an analysis must be conducted on the client s net worth and the composition of that net worth. For example, if a client has a substantial net worth that will undoubtedly yield significant estate taxes, and that net worth is primarily based in real estate, then the portability-enabled trust which allows for a second step-up in real property basis is extremely advantageous. The particular situation and the specific numbers must be analyzed to determine if a second step-up in basis is greater than the tax savings of excluding assets from appreciation. As previously explained, a taxpayer who elects portability can gain a second step-up in basis on up to $5.25M 9 worth of assets. However, that same taxpayer then foregoes the benefit of excluding from estate tax the appreciation of up to $5.25M of assets. Thus, to determine which is more advantageous, the numbers must be crunched and the specific situation must be considered (i.e., consider the expected amount of appreciation, the anticipated time between deaths of spouse, etc.) Family History In addition to the extremely important tax consequences of choosing one structure over another, it is equally important to consider family social dynamics. In stratified families containing children of previous marriages, the social dynamic can play a significant role in the spouse s decision to elect portability. Specifically, if a spouse wishes to ensure the beneficiaries of his or her portion of the estate, then the spouse must elect a traditional trust or a portability-enabled Revocable Family Trust with a QTIP Trust where that spouse s assets will be irrevocably distributed to the beneficiaries of his or her choosing. Only if one spouse has ultimate trust in the other spouse, can they proceed with a portability-enabled trust. The monetary and social considerations are extremely complex, and no one formula can be ascertained for all families. All estate plans must be individually tailored to the particularities of each family s concerns and desires. Portability, if well understood, has the power to furnish families with tax savings and administrative efficiencies not previously available under the traditionally structured trusts. 1 Under Rev. Rul. 2013-17, the terms spouse, husband and wife, husband and wife include, for federal income tax purposes, an individual married to a person of the same sex if the individuals are lawfully married under state law. Thus, references to a spouse, husband, or wife in this article also apply to same-sex couples if lawfully married under state law, even if not residing in that state at death. 2 For the purposes of this article, reference to the exemption amount is specific to 2013, where the unified estate and gift tax exemption is $5,250,000 per person thus, $10,500,000 in the aggregate for a married couple. This is an inflation-indexed figure adjusted from year to year. 3 Living trusts are created during the settlors joint lifetimes as compared with testamentary trusts established under wills after death. Testamentary trusts may also incorporate portability. 4 QTIP means Qualified Terminable Interest Property eligible for the federal estate tax marital deduction. QTIP assets are held in a QTIP Trust. 5 For federal estate and gift tax purposes, a disclaimer must be made by the surviving spouse within nine months after the deceased spouse s death. 6 A QTIP Trust is an irrevocable trust where the surviving spouse mandatorily gets all the net income and is the sole beneficiary. The surviving spouse, as trustee, may choose to elect this marital deduction for some or all of the property allocated to the QTIP Trust. If a partial election is made, then that property will be allocated to the Qualifying QTIP Trust and get a new step-up in basis at the death of the surviving spouse. The balance of the property will be allocated to the Non-Qualifying QTIP and use up some or all of the deceased spouse s lifetime exemption. The partial election is distinguished from the reverse QTIP election made for generation-skipping transfer tax exemption allocation purposes (see text, infra). 7 Technically, there is a new basis equal to the value at the surviving spouse s death. If the value is greater than when the first spouse dies, this is called a step-up in basis. If the value is less, this is a step-down in basis. 8 The principal residence capital gains exclusion is currently $250,000. You are eligible for the exclusion if you have owned and used your home as your main home for a period aggregating at least two years out of the five years prior to its date of sale. Generally, you are not eligible for the exclusion if you excluded the gain from the sale of another home during the two-year period prior to the sale of your home. 9 Technically, there is a new basis equal to the value at the surviving spouse s death. If the value is greater than when the first spouse dies, this is called a step-up in basis. If the value is less, this is a step-down in basis. 5
Contact Us If you have any questions about this article, please do not hesitate to contact us. Telephone: (213) 629-5700 Website: www.clarktrev.com Email: TApel@ClarkTrev.com. Currents is intended to be educational only. It is designed to provide our clients and friends with the discussion of current topics and legal authorities as applied to those topics. Currents is not intended to constitute legal advice or provide any opinion about the application of such legal authorities to a particular circumstance, set of facts or situation. In addition, that you have received transmission of Currents does not create any relationship of attorney and client between Clark & Trevithick, PLC and you. Clark & Trevithick, PLC is a full service law firm representing clients throughout California and western states for more than three decades. Our practice includes specialization in federal and state taxation law and tax reporting compliance, as well as estate planning for owners of closely-held businesses and other high net worth individuals. We also counsel on the sale of closely-held businesses. We develop methods for transferring wealth to surviving spouses and descendants by the most efficient and tax-advantaged methods available. Our practice profile also includes corporate, real estate, litigation, creditors rights and remedies, white collar crime and employment law matters. CIRCULAR 230 DISCLOSURE TO COMPLY WITH INTERNAL REVENUE SERVICE REQUIREMENTS, PLEASE BE ADVISED THAT ANY TAX ADVICE CONTAINED IN THIS EDITION OF CURRENTS IS NOT INTENDED OR WRITTEN TO BE USED, AND CANNOT BE USED, BY THE RECIPIENT TO AVOID ANY FEDERAL TAX PENALTY THAT MAY BE IMPOSED UPON THE RECIPIENT, OR TO PROMOTE, MARKET OR RECOMMEND TO ANY OTHER PERSON OR ENTITY, ANY REFERENCED ENTITY, INVESTMENT PLAN OR ARRANGEMENT. FOR MORE INFORMATION, PLEASE GO TO WWW.CLARKTREV.COM. 2013 Clark & Trevithick. All Rights Reserved. Unless otherwise indicated, all materials are copyrighted by Clark & Trevithick. The reproduction, modification or distribution of these materials is strictly prohibited without prior written permission. 6