IRS Clarifys Estate Rules - Portability for a spouse

Saturday/Sunday, October 8 - 9, 2011 I B9 -1
IRS Clarifies Estate Rules
BY LAURA SAUNDERS

The Internal Revenue Service last week clarified a provision of the estate tax affecting people who die in 2011 and 2012.

The good news: The paperwork process is now clearer for surviving spouses. But the new rules could pose problems for some.

Last December, Congress reinstated the estate tax after allowing it to lapse in 2010, and raised the amount of assets exempt from the tax to $5 million per individual or $10 million per married couple.

Included was a provision on "portability," which allows a surviving spouse in effect to roll over the unused portion of a deceased spouse's exemption. The IRS said last week that to preserve the spouse's exemption, executors must file an estate-tax return listing assets and their values, even if the total is very small.

Say Harry's wife, Jane, died this year. Jane's assets totaled $1.5 million, so $3.5 million of her exemption went unused. Harry's assets total about $6 million and include a large individual retirement account and an interest in a business owned by his extended family.

Under the new rules, Jane's executor can file an estate-tax return listing her assets and their values as of the date of death. That automatically preserves her remaining $3.5 million for use at Harry's death, putting him below the estate-tax threshold.

Estate-tax returns are due nine months after death. With that date looming for people who died in January, estate planners welcomed the IRS's guidance. A six-month filing extension is available, with interest due on any tax owed.

The portability provision, long advocated by many estate-law experts, allows new post-death planning. From 1981 until Congress changed the law last year, married couples faced a dilemma: If they left everything to each other outright, then the first to die would, in effect, lose the use of his or her estate-tax exemption. In 2009, when the exemption was $3.5 million, this meant that instead of shielding $7 million from estate tax, the surviving spouse could shield only $3.5 million.

The way around this problem involved setting up special trusts, but taxpayers needed to be willing both to plan and to pay higher legal fees—insurmountable hurdles, in some cases. In others, planning was complicated by a large, indivisible asset such as an IRA or a business.

Some planners say the new requirement poses a problem, in that advisers usually don't file a federal return if the estate is worth less than the exemption amount. "But under these rules, even small estates have to file a return if they want to preserve any unused exemption," says Beth Kaufman, a tax attorney with Caplin & Drysdale in Washington." Not only could advisers miss the IRS's guidance and fail to file, but those estates that do file will owe professional fees for any needed appraisals (say, of a house).

The provision also provides spiteful executors with an opportunity. "If the executor is a child who dislikes his step-mother or step-siblings, he or she might opt out of the portability that would save tax when the stepmother dies," says Ron Aucutt, an estate attorney with McGuire Woods in Washington.

For example, say John dies and leaves an estate of $4 million. His executor, Jack, the son from his first marriage, dislikes John's second wife, Sonia, and her two children by him. If Jack opts out of portability on John's remaining $1 million exemption and Sonia dies with an estate of $6 million, then her estate might well owe tax it wouldn't otherwise have.

More guidance also is needed on how the surviving spouse would use the remaining exemption to make a tax-free gift of assets to heirs while alive, as well as what happens to it if the surviving spouse remarries.

The biggest drawback, however, is that portable exemptions expire when the current estate- and gift-tax exemptions do, at the end of 2012. Some believe portability is likely to be renewed if the current exemptions are renewed, but there isn't any guarantee.

Experts say it is too early to predict what will happen to the estate tax in 2013. Michael Graetz, a former Treasury official who is now a professor at Columbia University Law School, offers this possibility: "The $5 million exemption will not go down, but the estate tax might be repealed entirely. In that case, there would be great pressure to replace it with a tax on the heirs who receive assets."