The Tax Cuts and Jobs Act (TCJA) completely rewrites sections of the tax code for individuals and businesses. Under the TCJA, the federal gift and estate tax exemption doubles from $5 million to $10 million, indexed for inflation to $11.18 million in 2018.
Somewhat lost in the clamor is the fact that the new law preserves the “portability” provision for married couples. Portability allows your estate to elect to permit your surviving spouse to use any of your available estate tax exemption that is unused at your death.
The long and winding road
In addition to the unlimited marital deduction that shelters asset transfers between spouses from federal estate tax, the $11.18 million gift and estate tax exemption covers asset transfers to other heirs, such as your children and grandchildren. (See the sidebar “Don’t skip the generation-skipping transfer tax.”)
It doesn’t seem possible, but at the turn of the century the exemption was a mere $675,000 before being hiked to $1 million. Subsequently, the Economic Growth and Tax Relief Reconciliation Act of 2001 gradually increased the exemption to $3.5 million, while reducing the top estate tax rate from 55% to 35%, among other changes.
After a one-year estate tax moratorium in 2010, the Tax Relief Act (TRA) of 2010 reinstated the estate tax with a generous $5 million exemption, indexed for inflation, and a top 35% tax rate. The American Taxpayer Relief Act (ATRA) of 2012 made these changes permanent, with the exception of increasing the top rate to 40%.
Along the way, the unified gift and estate tax exemption was severed and then reunified, as they remain under current law. Thus, any amounts used to cover lifetime gifts erode the remaining estate tax shelter.
Most important, for the first time, the TRA authorized portability of the estate tax exemption, which was then permanently preserved by ATRA. Under the portability provision, the executor of the estate of the first spouse to die can elect to have the “deceased spousal unused exclusion” (DSUE) transferred to the estate of the surviving spouse.
How DSUE works
A good way to explain the DSUE is to look at a hypothetical example. Let’s say that Kevin and Debbie, who have two children, each own $5 million individually and $10 million jointly with rights of survivorship, for a total of $20 million. Under their wills, all assets pass first to the surviving spouse and then to the children.
If Debbie dies in early 2018, the $5 million in assets she leaves to Kevin is exempt from estate tax because of the unlimited marital deduction. Thus, her entire $11.18 million exemption is unused. However, if the election is made upon her death, Kevin’s estate can later use the $11.18 million of the DSUE from Debbie, plus the exemption for the year in which Kevin dies, to shelter the remaining $8.8 million from tax, with plenty to spare for some appreciation in value.
What would have happened without the portability provision? For simplicity, let’s say that Kevin dies later in 2018. Without being able to benefit from the unused portion of Debbie’s exemption, the $11.18 million exemption for Kevin in 2018 leaves the $8.8 million subject to estate tax. At the 40% rate, the federal estate tax bill would amount to a whopping $3.52 million.
Although techniques such as a traditional bypass trust may be used to avoid or reduce estate tax liability, this example demonstrates the potential impact of the portability election. It also emphasizes the need for advance planning.
Other points of interest
Be aware that this discussion factors in only federal estate taxes. State estate taxes may also have a significant impact, particularly in some states where the estate tax exemption isn’t tied to the federal exemption.
Also, keep in mind that, absent further legislation, the exemption amount is slated to revert to pre-2018 levels after 2025. Portability continues, although, for those whose estates will no longer be fully sheltered, additional planning should be considered.
Furthermore, portability isn’t always the best option. All relevant factors should be considered, including nontax reasons that might affect the distribution of assets under a will or living trust. For instance, a person may want to divide assets in other ways if matters are complicated by a divorce, a second marriage or unusual circumstances. Your estate tax advisor can help you decide if portability is right for your estate plan.
If you leave assets to your grandchildren or even younger heirs, either through your will or living trust, the transfer is subject to the generation-skipping transfer (GST) tax. This is separate from regular federal estate tax.
Fortunately, your estate is protected by the GST tax exemption. This exemption, which is the same figure as the estate tax exemption, is indexed to $11.18 million in 2018 under the Tax Cuts and Jobs Act. The GST tax rate is 40%.
But there’s a potential pitfall for individuals. Unlike the estate tax exemption, there’s no portability with the GST tax exemption. Each estate stands on its own. To avoid problems, ensure that the GST tax exemption is properly allocated when making transfers to heirs two or more generations below you.