Pitfalls of ‘portability’: Estate tax law gives spouses extra protection, but has drawbacks [Lawyers USA]

The new estate tax "portability" provision, which allows surviving spouses to benefit from the unused exclusion from their spouse's estate, was a welcome part of the federal tax law enacted late last year for estate planning attorneys and their clients.

The provision eliminates the need for spouses to retitle property, create trusts or use other estate planning maneuvers to protect property from incurring additional tax liability after the death of a spouse

"Having portability in the law is more equitable ..., even though it may cut down on my work a bit," said Jeramie J. Fortenberry of Fortenberry Legal, a Gulfport, Miss.-based boutique law firm focused on probate and estate planning.

But the portability rule is not a cure-all for married couples planning their estates. The short-term law has some drawbacks that necessitate the continued use of other estate planning tools in many cases.

"I think of portability as a fallback," Fortenberry said.

Short-term solution

The portability election allows the estates of married taxpayers to pass along the unused part of their exclusion amount, up to $5 million, to their surviving spouse. The new rule was part of the tax law enacted last December, just days before the estate tax was to reset to its highest levels since the 1990s.

The measure was lauded by tax lawyers, who had long urged Congress to adopt portability provisions for the federal estate and gift tax laws. But attorneys warn that there are pitfalls for unwary surviving spouses. The biggest problem is that the law is only effective until the end of 2012, and therefore only applicable to spouses who die before the end of next year.

After years of uncertainly over the future of the estate tax, the passage of such a short-term solution is causing some lawyers to proceed as if portability were not an option.

"For the majority of my clients, I tell them to ignore portability," said Christl Denecke, an estate planning attorney based in Mountain View, Calif. "Even if they are very elderly, we can't make a plan based on the possibility that the client will die within two years. There are a very few cases where a client may be terminally ill and you can guess, but even then you don't know."

Another problem with the new rule is that portability is not automatic. The law requires the estate of a deceased spouse to file an estate tax return to pass along his or her unused exclusion amount to the surviving spouse. This requirement can be a surprise to some, especially where the spouse otherwise would not have had to file a tax return.

An additional drawback of the portability provision, Fortenberry said, is that it is not indexed for inflation.

"The amount of the exclusion stays the same," he said. Even if portability is extended beyond next year, "over time, that means you are actually losing money, and it may make sense to take that money and put it in a credit shelter trust" that is indexed for inflation.

Long-term complications

Even where the portability option is available and a client elects to use it, there could be problems down the road, particularly when surviving spouses remarry.

If the second spouse then dies first, the surviving spouse will lose the exemption from his or her first husband or wife because the portability provision only applies to the last deceased spouse.

"There are a good number of elderly people who are getting remarried," Denecke noted.

Without the use of other estate tax planning tools, the loss of portability can quickly complicate estate administration, especially in cases where there are significant assets and children from the first marriage.

"It can get really complicated," said Denecke. She advises anyone contemplating remarriage to consider setting up trusts to avoid problems later.

The future of portability is as uncertain as the future of the estate tax. While the issue was not particularly controversial during the congressional debate over estate tax reform, it could fall by the wayside if another standoff between Washington lawmakers results in the estate tax law lapsing again.

"We are in a period of uncertainty," Fortenberry said. "I ... learned not to make any guesses about what Congress will do" after lawmakers allowed the estate tax to lapse entirely in 2010.

"You just never know," Denecke agreed. "When I plan for my clients I plan for [congressional] gridlock."