Myth busting: portability does not eliminate need for good trust-based planning, but it does change it

There seems to be a myth circulating on the Internet created by changes in the estate taxation rules from the American Tax Relief Act of 2012 (“ATRA”): that because of “portability,” there is no longer a need for the “traditional” A-B Trust planning. Although I agree with that statement for some couples, there are many groups of people for whom this advice is woefully inadequate. (Sorry in advance — this is long and kind of dense. If you don’t want to read the details, my point is that good estate planning by a competent planner is as important now as ever.)

First, what the heck am I talking about? (I’m going to try to simplify this down to make the point, so if you are an expert in this area, cut me some slack!) When someone dies and their property is inherited by someone else, the feds might want to take a share as an estate tax. Inheritance by someone’s spouse is always tax-free, but inheritance by anyone else isn’t necessarily. Each person has his or her own “exemption” amount, which allows that person to bequeath property to a non-spouse tax-free up to the amount of the exemption. Think of it as a “coupon” to save on your estate taxes. Beyond the exemption amount, the inherited property is heavily taxed (currently 40%). Before ATRA, the exemption was a “use it or lose it” exemption: if the first spouse to die passed everything to the surviving spouse, the first spouse’s exemption wasn’t used and was thus lost. In the “coupon” analogy, each person gets a coupon, and that coupon couldn’t be given to anyone else.

So the “traditional” strategy to limit the amount of estate taxes paid was to use an A-B Trust plan for the first spouse to die. In this system, (again, I’m simplifying here) the first-to-die spouse’s property was split into two shares: one share in the amount of the exemption was passed (tax-free) to someone other than the spouse (like the kids) and the second share (everything else) was passed to the spouse tax-free (because transfers to spouses are always tax-free). In this way, the first-to-die spouse’s coupon was used up, saving taxes on that portion. Ultimately, when the second spouse died, he or she would use his or her coupon to save taxes on a remainder of the estate. Two coupons = better tax savings.

ATRA on its face eliminated the need for this sort of planning, by creating a rule that, in effect, says you can give your unused coupon to your spouse when you die. (Actually, the surviving spouse needs to take the coupon by filing a form with the IRS.) So now the first-to-die spouse can leave everything to the other spouse, including his unused coupon, and the second spouse can use both coupons at her death. Everything seems so simple and straightforward. This new rule (called “portability”) has been touted as the greatest thing since sliced bread when it comes to estate planning, because theoretically it made everything so much simpler.

I submit that the opposite is true — if anything, portability has created more options and more questions to answer, which actually increases the complexity of estate planning. Let me illustrate:

One problem with portability is that the surviving spouse can’t save more than one extra coupon. In other words, if the surviving spouse remarries, she essentially has to tear up her first spouse’s coupon as part of the wedding ceremony. One wasted coupon = potentially more estate taxes. So that would suggest that we stick with the traditional A-B plan. If we use up that first coupon instead of giving it to the surviving spouse, the survivor can’t accidentally misplace it or run it through the document shredder. Great — so back to the A-B plan. But wait! One big problem with the A-B plan has become much more of an issue as a result of other recent changes to the estate tax law: the “step-up in basis problem!” (Cue dramatic music.)

(For those who aren’t big fans of the tax code, when you sell an asset, you pay taxes on the amount you received minus the “basis” of the property. Usually this is what you paid to buy the asset, but a higher basis is better because it saves you income tax.)

See, when assets are inherited, they receive what we call a “step-up in basis.” The IRS just assigns a new basis as the value of the asset on the date of the person’s death. So even if mom and dad paid $12,000 for the house back in 1967 and it’s now worth $1.2 million, if the kids inherit the house, they get it with a new stepped-up basis of $1.2 million. Sweet deal. The problem with traditional A-B trusts is that, by saving on estate taxes, some of the property misses out on a second step-up in basis at the death of the second spouse, costing on income taxes. It used to be that the estate tax exemption was so small that no one really worried about this problem, but it has grown to be a big one, especially given that we might have been able to have the best of both worlds if we didn’t use the A-B Trust. So maybe we shouldn’t be using A-B Trusts after all? Should we just leave property to our spouse outright and then to our kids?

No! That solution doesn’t work either for many couples. Trusts do the following:

  1. Keep the property from being transferred out of the family line through remarriage, scam, or skulduggery.
  2. Protect assets from creditors, including divorcing spouses.
  3. Can manipulate how income is taken, to minimize income taxation.
  4. Potentially allow some property to appreciate tax-free, avoiding additional taxation.
  5. Allow for better planning involving the Generation-Skipping Transfer Tax (The what? That’s for a future post I fear.)
  6. Allow for planning around disability or need for government benefits (like Medicaid/Medicare).
  7. Might help in a simultaneous death situation.

Okay, so maybe I’ve proved my point — portability does not simplify estate planning by providing clear answers. Instead, it raises a bunch of questions. The answer to these questions (since you asked) is not to throw your hands in the air and ignore the issue altogether. Instead, estate planners are getting creative with their strategies to get the best benefits from trusts (protection from creditors, protection in future marriage, protection against loss of coupon), while giving maximum future flexibility for figuring out the tax details down the road (using disclaimers, powers of appointment, and other estate planning tools). So the answer, as it so commonly is on this blog, is that you should talk to a competent professional who can give you specific advise to help you navigate this mess.

Thanks for “simplifying” things, Congress!

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