As noted above, the marital deduction will only postpone the estate tax to the death of the second spouse to die. It will not reduce the couple’s estate tax. What’s more, use of the marital deduction for the entire estate effectively wastes the exemption of the first spouse to die. Therefore, many married individuals who have or will have taxable estates will take advantage of both the estate tax exemption and the unlimited marital deduction in a coordinated fashion by transferring property in a special type of trust, often called a bypass trust. These trusts, which are used to take full advantage of a deceased spouse’s remaining estate tax exemption, typically provide income and discretionary distributions of principal to the deceased’s surviving spouse. The amount that goes into these trusts is typically determined by a formula that puts the maximum possible amount into the trust without generating federal estate tax in the deceased spouse’s estate. Assets in excess of the remaining exemption either pass to the surviving spouse outright or remain in a form of trust that will qualify for the estate tax marital deduction. The advantage of the bypass trust is that its assets will not be included in the surviving spouse’s estate at his or her death, regardless of the amount in the trust at that time.
Portability. If a spouse passes away during 2017, the surviving spouse can add to his or her own exemption whatever amount of the exemption—up to $5.49 million if death occurred in 2017—the deceased had not used during his or her lifetime. In order to take advantage of this option, an election must be made with a timely filed estate tax return for the deceased spouse, even though the estate of the deceased spouse many not be large enough to require the filing of an estate tax return.
A surviving spouse will be able to use the deceased spouse’s unused exemption for lifetime transfers as well as his or her own at death. However, portability is not allowed for the GST tax exemption, so a surviving spouse would not be able to use the unused GST exemption of the deceased spouse.
Prior to the availability of portability, the only way to avoid wasting the exemption of the first spouse to die was to use the bypass trust structure described above.
Under the portability rules, there would still be no tax due on the death of the first spouse to die. However, the deceased’s exemption would not be “wasted.” Instead, any of the deceased’s unused exemption carries over to the surviving spouse. While the portability rules provide relief in the ability to use a deceased’s unused exemption, the funding of a bypass trust should continue to be considered in an estate plan. First, the funding of a bypass trust at the death of the first spouse removes the exemption equivalent amount and the associated future appreciation from the surviving spouse’s estate. Second, the traditional benefits of using a trust, such as creditor protection, should be considered as well as the possibility of the surviving spouse remarrying and the potential inability to use the first deceased spouse’s unused exemption amount. Third, the bypass trust may be needed to assure that the children of a deceased spouse’s prior marriage are not disinherited by the surviving “new” spouse. Finally, portability is not allowed for GST tax exemptions, so a surviving spouse would not be able to use the unused GST tax exemption of the deceased spouse.
The following examples explain how an estate or gift tax exemption can be transferred from a deceased spouse to a surviving spouse.
Example 1. Assume that Husband 1 dies in 2017, having made taxable transfers of $3 million and having no taxable estate. An election is made on Husband 1’s estate tax return to permit his Wife to use Husband 1’s deceased spousal unused exclusion amount. As of Husband 1’s death, the Wife has made no taxable gifts. Thereafter, Wife’s applicable exclusion amount is $7.98 million (her $5.49 million basic exclusion amount plus $2.49 million deceased spousal unused exclusion amount from Husband 1), which she may use for lifetime gifts or for transfers at death.
Example 2. Assume the same facts as in Example 1, except that Wife subsequently marries Husband 2. Husband 2 also predeceases Wife, having made $4 million in taxable transfers and having no taxable estate. An election is made on Husband 2’s estate tax return to permit Wife to use Husband 2’s deceased spousal unused exclusion amount. Although the combined amount of unused exclusion of Husband 1 and Husband 2 is $3.98 million ($2.49 million for Husband 1 and $1.49 million for Husband 2), only Husband 2’s $1.49 million unused exclusion is available for use by Wife, because the deceased spousal unused exclusion amount is limited to the lesser of the basic exclusion amount ($5.49 million) or the unused exclusion of the last deceased spouse of the surviving spouse (here, Husband 2’s $1.49 million unused exclusion). Thereafter the Wife’s applicable exclusion amount is $6.98 million (her $5.49 million basic exclusion amount plus $1.49 million deceased spousal unused exclusion amount from Husband 2), which she may use for lifetime gifts or for transfers at death.
Example 3. Assume the same facts as in Examples 1 and 2, except that Wife predeceases Husband 2. Following Husband 1’s death, Wife’s applicable exclusion amount is $7.98 million (her $5.49 million basic exclusion amount plus $2.49 million deceased spousal unused exclusion amount from Husband 1). Wife made no taxable transfers and has a taxable estate of $3 million. An election is made on Wife’s estate tax return to permit Husband 2 to use Wife’s deceased spousal unused exclusion amount, which is $4.98 million (Wife’s $7.98 million applicable exclusion amount less her $3 million taxable estate). Husband 2’s applicable exclusion amount is increased by $4.98 million (i.e., the amount of deceased spousal unused exclusion amount of Wife).
State death tax considerations. Many states impose some kind of inheritance or estate tax. In some states, the estate tax is simply the amount of the federal credit for state death taxes. However, since the federal state death tax credit had been eliminated for decedents dying in 2005 through 2009, there would be no state estate tax. To avoid this result, many states enacted estate taxes that are not tied to the federal credit. In addition, some states revised their tax laws to set their estate tax exemption at an amount that is less than the federal estate tax exemption. Furthermore, some states do not allow an unlimited marital deduction, as the federal government does. Consequently, in many states it is possible to have a taxable estate for state estate tax purposes but not for federal purposes. In these states, state death tax considerations may influence how your estate plan should be structured.
Foreign death tax credit. A credit is allowed against the federal estate tax for any death taxes actually paid to a foreign country, Puerto Rico, or the Virgin Islands on property that is also subject to the federal estate tax. The credit is limited to the U.S. tax attributable to the property taxed by the foreign country. An estate and gift tax treaty with the foreign country imposing the tax may also provide benefits.
Credit for tax on prior transfers. Under certain circumstances a credit is allowed against the federal estate tax for part or all of any estate tax paid on property transferred to the present decedent from a prior estate if such transfer occurred within 10 years of the death of the present decedent.
