American Bar Association

Portability - Part One The Estate and Gift Tax Committee in coordination with other committees of the Income and Transfer Tax Planning Group of the Real Property Trust & Estate Law Section of the American Bar Association prepared this paper on portability as enacted in the Tax Relief, Unemployment Reauthorization, and Job Creation Act of 2010. The members of the Income and Transfer Tax Planning Group responsible for this paper are: Carol A. Cantrell (Chair, Individual and Fiduciary Income Tax Committee, Houston, TX, ccantrell@cctaxlaw.com), Tiffany B. Carmona (Member, Estate & Gift Tax Committee, Chicago, IL, carmona@bessemer.com), Tracy Blake DeVlieger (Co-Vice-Chair, Estate & Gift Tax Committee, Radnor, PA, td@gsw-llp.com), Richard S. Franklin (Co-Chair, Estate & Gift Tax Committee, Washington, DC, rfranklin@mcarthurlaw.com), George D. Karibjanian, (Chair of the Portability Subcommittee of the Estate & Gift Taxes Committee of the ABA Tax Section, Boca Raton, FL, gkaribianian@proskauer.com), Marianne R. Kayan (Co-Vice-Chair, International Tax Planning Committee, Washington, DC, marianne.kayan@ey.com), Lester B. Law (Vice-Chair, Estate & Gift Committee, Naples, FL, lester.law@ustrust.com), Anne Kelley Russell (Member, Hilton Head, SC, akrussell@mcnair.net), and Ashley Weyenberg (Member, Washington, DC, ashley.weyenberg@ey.com). If you have any questions or comments on this paper, please send them to any of the authors.

This paper has many hyperlinks (colored in blue) to other materials. An electronic version of this paper, with working hyperlinks, will be posted on the Estate and Gift Tax Committee’s webpage.

Important Disclaimers and Disclosures This paper has not been approved by the House of Delegates or the Board of Governors of the American Bar Association and should not be construed as representing the position of the American Bar Association. These materials are for education purposes and are not designed or intended to provide financial, tax, legal, accounting, or other professional advice. The reader is cautioned that changes in law may be applicable, that these materials only provide a general discussion, that critical information may be omitted, and that any ideas, concepts or strategies discussed herein may not be suitable for any particular individual. Any forms and sample language provided are for discussion purposes only. Any examples are for illustration purposes only.

The opinions of Carol Cantrell, Tracy Blake DeVlieger, Richard S. Franklin, George D. Karibjanian, Marianne R. Kayan, Anne Kelley Russell, and Ashley Weyenberg expressed herein are their own and do not necessarily reflect that of their respective firms, their partners, co-shareholders, and co-owners.

The opinions of Lester B. Law expressed herein are his own and do not necessarily reflect that of U.S. Trust Bank of America Private Wealth Management, Bank of America, N.A., Bank of America Corporation, any of its subsidiaries and/or affiliates. U.S. Trust, Bank of America Private Wealth Management operates through Bank of America, N.A. and other subsidiaries of Bank of America Corporation. Bank of America, N.A., Member FDIC.

The opinions of Tiffany B. Carmona expressed herein are her own and do not necessarily reflect those of Bessemer Trust.

To ensure compliance with IRS requirements, please be advised that any discussion of U.S. tax matters contained in or attached to these materials is not intended or written to be used, and cannot be used, for the purposes of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing, or recommending to another party any transaction or matter discussed herein.

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American Bar Association ............................................................................................................................. i

Important Disclaimers and Disclosures ........................................................................................................ i

Portability ..................................................................................................................................................... 1

Part One ....................................................................................................................................................... 1

I. Introduction ......................................................................................................................................... 1

A. Misconceptions ................................................................................................................................ 1 1. Simplicity Complication ............................................................................................................... 1 2. It’s Safe to Rely on Traditional By-Pass Trust Planning and Ignore Portability ........................... 2 3. No GST Exemption Portability Eliminates Utility ......................................................................... 2 4. No State Death Tax Portability Eliminates Utility of Portability with Gap Planning .................... 2 5. Portability Will Greatly Increase Estate Tax Return Filings ......................................................... 2 6. Portability Will Lead to Less Estate Planning ............................................................................... 2

B. Terms Used in this Paper ................................................................................................................. 2 1. Applicable Credit Amount ........................................................................................................... 2 2. Applicable Exclusion Amount ...................................................................................................... 3 3. Basic Exclusion Amount ............................................................................................................... 3 4. By-Pass Trust ................................................................................................................................ 3 5. Deceased Spouse ......................................................................................................................... 3 6. Deceased Spousal Unused Exclusion Amount ............................................................................. 3 7. Gift Tax Credit .............................................................................................................................. 4 8. Inherited Exclusion Amount ........................................................................................................ 4 9. Last Deceased Spouse Rule ......................................................................................................... 4 10. Internal Revenue Code ................................................................................................................ 4 11. Regulations .................................................................................................................................. 4 12. “section” ...................................................................................................................................... 4

C. Suggested Sources of Information on Portability ............................................................................ 4 1. 2011 Form 706 & Instructions ..................................................................................................... 4 2. Notice 2011-82 ............................................................................................................................ 5 3. ABA RPTE EG Comments ............................................................................................................. 5 4. ACTEC Comments ........................................................................................................................ 5 5. New York City Bar Comments ...................................................................................................... 5 6. Florida Bar Comments ................................................................................................................. 5 7. Estate and Gift Committee’s Summary of the Tax Relief, Unemployment Reauthorization, and Job Creation Act of 2010 ...................................................................................................................... 5 8. ACTEC’s Eight Recommendations to Improve Implementation of Existing Tax Laws ................. 5 9. Steve Akers’ Latest Outlines Covering Portability ....................................................................... 5

II. Why Learn Portability? ........................................................................................................................ 6

III. History of Portability ............................................................................................................................ 7

IV. Rules of Portability Under TRA 2010 ................................................................................................... 9

A. Portability for Estate Tax Purposes: Section 2010(c) ...................................................................... 9 1. Essential Concept of Portability ................................................................................................... 9

a. First Limitation ....................................................................................................................... 10 b. Second Limitation .................................................................................................................. 10

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2. Portability for Non-Resident Non-Citizens ................................................................................ 11 B. Portability for Gift Tax Purposes: Section 2505 ............................................................................ 12 C. GST Tax ........................................................................................................................................... 12 D. Joint Committee Examples ............................................................................................................ 12

1. JCT’s Example 1 .......................................................................................................................... 13 2. JCT’s Example 2 .......................................................................................................................... 13 3. JCT’s Example 3 .......................................................................................................................... 14

a. Analyzing JCT’s Example 3 – Without the Errata Statement ................................................. 14 b. Analyzing JCT’s Errata Statement........................................................................................... 15 c. Ordering Rules for Using Inherited Exclusion Amount .......................................................... 15 d. Anecdotal Information about the JCT’s Example 3 and Errata Statement ............................ 16

E. Remarriage of Surviving Spouse .................................................................................................... 17 1. Last Deceased Spouse Rule ....................................................................................................... 17 2. Lifetime Gift Use of Inherited Exclusion Amount and Remarriage ........................................... 18

a. End of Year Assumption – An Anomaly ................................................................................. 18 b. The Portability “Clawback” or “Recapture” ........................................................................... 25

3. What if the Joint Committee on Taxation’s (JCT’s) Suggested Change to Section 2010(c)(4)(B)(i) is Implemented? ....................................................................................................... 26

F. Incentives and Risks Under Portability Rules ................................................................................. 28 G. Portability Election ......................................................................................................................... 28

1. Surviving Spouse is a Prerequisite to Election ........................................................................... 28 2. Election Required ...................................................................................................................... 28

a. Requirements of Valid Portability Election ............................................................................ 29 (I) Estate Tax Return Required ............................................................................................... 29 (II) Timely Filing Requirement ................................................................................................. 30 (III) Complete Estate Tax Return Requirement ........................................................................ 31 (IV) Compute the Inherited Exclusion Amount ........................................................................ 32 (V) Elect Portability .................................................................................................................. 32

b. Always Make the Election – Almost Always .......................................................................... 33 c. Authorization Language in Will/Revocable Trust .................................................................. 33 d. Election Out of Portability ...................................................................................................... 33 e. Upon the Surviving Spouse’s Death ....................................................................................... 34

3. Statutes of Limitation ................................................................................................................ 35

V. Awaiting Regulatory Guidance .......................................................................................................... 35

A. In General ....................................................................................................................................... 35 B. Notice 2011-82 ............................................................................................................................... 35

1. Treasury’s Request .................................................................................................................... 35 2. Summary of Comments in Response ......................................................................................... 35

a. The Amount and Use of the Inherited Exclusion Amount ..................................................... 36 (I) Calculating the Gift Tax Credit (as a Result of the Inherited Exclusion Amount) .............. 36 (II) Possible Portability Recapture ........................................................................................... 37 (III) Clarification on the Use of the Inherited Exclusion Amount of Non-Resident Non-Citizen Aliens .......................................................................................................................................... 37 (IV) Portability and QDOTs........................................................................................................ 37 (V) Use of the Inherited Exclusion Amount – Its Hierarchy ..................................................... 38 (VI) Effect of Divorce on the Inherited Exclusion Amount ....................................................... 38 (VII) Other Estate Tax Credits .................................................................................................... 38

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b. Logistical Issues – Electing Portability .................................................................................... 38 (I) Election Requirement ........................................................................................................ 38 (II) Required To File An Estate Tax Return ............................................................................... 39 (III) Form to Provide Guidance on Inherited Exclusion Amount Calculation ........................... 39 (IV) Provide Regulation Section 301.9100 Relief ...................................................................... 39 (V) Amended Returns .............................................................................................................. 39 (VI) Relief for Faulty Election .................................................................................................... 39 (VII) Protective Elections ........................................................................................................... 39 (VIII) Effect of Spousal Agreement ............................................................................................. 40 (IX) Who is an Executor for purposes of making the Election? ................................................ 40 (X) Form 706 EZ ....................................................................................................................... 40 (XI) Refusal of Personal Representative to Make Election, but Desire of Surviving Spouse to Make the Election ...................................................................................................................... 40

c. Scope of the IRS’ Review of Estate Tax Return of Deceased Spouse(s) ................................. 40 C. Issues Not Raised But Need Answers ............................................................................................. 40

1. What Happens When a New Spouse Dies on December 31 and a Gift is Made in that Year? . 40

VI. Sunset Provisions ............................................................................................................................... 41

VII. Conclusion.......................................................................................................................................... 41

VIII. Portability Planning Teasers .............................................................................................................. 41

A. Is Traditional By-Pass Trust Still Good Planning? ........................................................................... 41 1. Modest Growth ......................................................................................................................... 41

a. The Estate Tax Analysis .......................................................................................................... 42 b. The Income Tax Analysis ........................................................................................................ 42

2. More Significant Growth ........................................................................................................... 43 a. The Estate Tax Analysis .......................................................................................................... 43 b. The Income Tax Analysis ........................................................................................................ 43

3. Preliminary Conclusion About the Estate and Income Tax Issues ............................................. 43 B. Rev. Proc. 2001-38 and QTIP Elections .......................................................................................... 44 C. GST Planning .................................................................................................................................. 46

1. Inter Vivos Transfers .................................................................................................................. 46 2. Inter Vivos QTIP Trust Utilizing the “Reverse QTIP Election” .................................................... 46

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Portability This paper is Part One of a two part paper. Part One covers the background of portability (including its history and enactment), reasons to learn about portability, a critical analysis of the law, an analysis of the examples provided by the Joint Committee on Taxation, a summary of the comments provided to the Treasury pursuant to Notice 2011-82, suggestions for regulatory and statutory changes, and some suggested changes to other related rules. Part Two will be distributed at the ABA’s RPTE Spring Meeting (May 3 - 6, 2012) in New York, NY. Part Two will focus on estate planning with portability. Topics covered will include, a discussion of the tension between the estate and income tax, a discussion of the factors to consider when deciding whether to take advantage of the portability provisions, planning ideas for maximizing the benefits of portability with existing plans and new plans, innovative ideas and current thinking about how to use portability and not lose the benefits of the GST exemption, and how to plan with portability for clients who live in states with a separate state estate taxes. In the event that Treasury issues regulatory guidance in the interium, we will also cover that. In section VIII below are several teasers as to Part Two.

Part One On December 17, 2010, President Barack Obama signed into law the Tax Relief, Unemployment Reauthorization, and Job Creation Act of 2010 (TRA 2010),1 which enacted a new system of portability of exclusion amounts for gift and estate tax purposes. Part One of this paper provides a historical perspective on portability, details the statutory structure of portability, summarizes the unclear or unknown issues, and summarizes areas where regulatory guidance is anticipated. Part Two explores the planning implications of portability.

I. Introduction Portability establishes a new system for using the available lifetime gift and estate tax exemptions. Essentially, if a deceased spouse’s estate tax exclusion amount is not fully used, the unused balance can be used by the surviving spouse against gifts and testamentary transfers. Portability may be helpful to some and not to others. Some may not use portability – it’s optional. Like many tax laws, it is more complex than it appears. In general, the advent of portability is favorable to taxpayers.

A. Misconceptions There are many misconceptions regarding portability.

1. Simplicity Complication Portability has been billed as simplifying estate planning by avoiding the need for complicated trusts or rearranging assets between spouses:

“Without this portability provision, spouses are often required to retitle assets into each spouse’s separate name and create complex trusts in order to allow the first spouse to die to take full advantage of his or her exclusion. Depending upon the nature of the couple’s assets, such a division may not be possible. Such a division also has significant consequences under property law and often is not consistent with the way in which the married couple would prefer to handle their financial affairs. Portability would obviate the need for such burdensome planning.”

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1 P.L. 111-312 (Dec. 17, 2010).

2 General Explanations of the Administration’s Fiscal Year 2012 Revenue Proposals, Department of the Treasury, p. 123

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In some situations that may be true, however, in many situations the overlay of portability complicates estate planning.

2. It’s Safe to Rely on Traditional By-Pass Trust Planning and Ignore Portability

In Part Two, we explain that simply relying on traditional by-pass trust planning may disadvantage clients and subject the attorney to criticism. The availability of portability increases the pressure to obtain optimal estate and income tax results. This creates more complexity, analysis and risk.

3. No GST Exemption Portability Eliminates Utility Another misconception is that portability planning has little utility because the generation-skipping transfer (“GST”) tax exemption is not portable. As we explain in Part Two, portability planning can be used without wasting the deceased spouse’s GST exemption; the planning approaches are not mutually exclusive.

4. No State Death Tax Portability Eliminates Utility of Portability with Gap Planning

If portability is fully used in states that have a separate estate tax, the deceased spouse’s estate will fail to take advantage of the state’s exemption amount thereby perhaps resulting in a larger overall estate tax on the death of the surviving spouse. However, in states that do not permit a state only QTIP, portability provides tax minimization opportunities that otherwise would not exist. We discuss this in Part Two in detail.

5. Portability Will Greatly Increase Estate Tax Return Filings With the increase in the basic exclusion amount, the number of estate tax return that are required to be filed will decrease because a smaller number of estates will meet or exceed the statutory filing threshold. Not every portability-qualifying estate will elect portability. It remains to be seen whether the number of estate tax returns will increase dramatically solely as a result of electing portability.

6. Portability Will Lead to Less Estate Planning While portability will simplify estate planning for some couples, in many cases it could lead to more complicated planning in an effort to obtain a second basis adjustment when the surviving spouse dies. Additionally, marital (and divorce) planning may be more complicated. We will discuss some of these issues in Part Two.

B. Terms Used in this Paper 1. Applicable Credit Amount

The applicable credit amount3 is the amount of tentative tax equal to the applicable exclusion amount.4 Thus, when the applicable exclusion amount (defined below) is equal to $5 million, the applicable credit amount is $1,730,800. In 2012, the applicable exclusion amount increased to $5.12 million (i.e., the

(February 2011), sometimes referred to as the “2012 Greenbook”. The website link is: http://www.treasury.gov/resource-center/tax-policy/Documents/Final%20Greenbook%20Feb%202012.pdf 3 Section 2010(c)(1).

4 Section 2505(a) refers to the applicable credit amount under Section 2010(c) to define the credit allowed against the gift tax.

As discussed below, for 2010 the applicable credit amount for gift tax purposes is limited to the tax on an applicable exclusion amount of $1 million. For 2010, Section 2631(c) refers to the applicable exclusion amount under Section 2010(c) to define the GST exemption amount. For 2011 and thereafter it refers to the basic exclusion amount to eliminate the portability feature for GST exemption purposes that is built into the term applicable exclusion amount starting in 2011.

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first year of indexing for inflation)5 and the applicable credit amount is $1,772,800, which is 35% of the adjustment amount for inflation.6

2. Applicable Exclusion Amount As of January 1, 2011, the applicable exclusion amount

7 is the sum of the basic exclusion amount

(defined below) and the Deceased Spousal Unused Exclusion Amount.8 For brevity, we will sometimes

use the acronym “AEA” to mean the applicable exclusion amount.

3. Basic Exclusion Amount For 2011, the basic exclusion amount was $5 million.9 For 2012, this amount has been indexed for

inflation (rounded to the nearest multiple of $10,000)10

and is $5,120,000.11

For brevity, we will sometimes use the acronym “BEA”.

We recognize the basic exclusion amount has been increased to $5,120,000 for 2012. For simplicity purposes, however, we will refer to the unadjusted amount of $5 million and use that amount in our discussion and examples, unless otherwise specifically provided.

4. By-Pass Trust We use the term “by-pass trust” interchangeably with the term "credit shelter trust," in each case to refer to a trust that is generally created upon the first spouse’s death, which is not subject to federal estate tax by virtue of the deceased spouse’s applicable exclusion amount and which benefits the surviving spouse (and perhaps others, such as descendants) but is not subject to federal estate tax in the surviving spouse’s estate.

5. Deceased Spouse We use the term “deceased spouse” to mean the first spouse to die, unless the context indicates otherwise.

6. Deceased Spousal Unused Exclusion Amount With respect to the surviving spouse of a deceased spouse dying after December 31, 2010, the term deceased spousal unused exclusion amount12 (defined below as the "inherited exclusion amount") means the lesser of (A) the basic exclusion amount of the surviving spouse at his or her death,13 or (B) the excess of (i) the basic exclusion amount of the last deceased spouse of the such surviving spouse,14

5 Rev. Proc. 2011-52, §3.29. The website link is: http://www.irs.gov/pub/irs-drop/rp-11-52.pdf

6 For a list of the applicable credit amounts (or the unified credit as it was called in earlier versions of the law), from 1977 to

date, see IRS Publication 950 at: http://www.irs.gov/publications/p950/ar02.html 7 Section 2010(c)(2).

8 The “deceased spousal unused exemption amount” is referred to by many as “DSUEA”, but we have opted for the simplified

term “inherited exclusion amount”. 9 Section 2010(c)(3)(A).

10 Section 2010(c)(3)(B) provides that the basic exclusion amount will be adjusted for any inflation increases. It should be

noted that if there is deflation, such amount is not adjusted downwards. 11

Rev. Proc. 2011-52, §3.29. The website link is: http://www.irs.gov/pub/irs-drop/rp-11-52.pdf 12

Section 2010(c)(4). 13

Section 2010(c)(4)(A) uses the term “ basic exclusion amount”. The term, if not modified by some other term, means the basic exclusion amount of the particular decedent for which one is calculating such decedent’s applicable credit amount. This term in § 2010(c)(4)(A) should not be confused with the term “the basic exclusion amount of the last such deceased spouse of such surviving spouse” which is used in § 2010(c)(4)(B)(i). The latter term (i.e., “ the basic exclusion amount of the last such deceased spouse of such surviving spouse”) relates to the basic exclusion amount of the last deceased spouse as such amount existed at the time such deceased spouse’s death. 14

Section 2010(c)(4)(B)(i). See also, supra Note 13.

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over (ii) the amount with respect to which the tentative tax is determined under Section 2001(b)(1) on the estate of such deceased spouse.15

7. Gift Tax Credit Section 2505 is titled “unified credit against gift tax”; we will use the term “gift tax credit” to mean such credit.

8. Inherited Exclusion Amount We use the term “inherited exclusion amount” rather than the acronym “DSUEA” to mean the deceased spousal unused exclusion amount.

9. Last Deceased Spouse Rule We use the phrase “Last Deceased Spouse Rule” to refer to the limitation in Section 2010(c)(4)(B)(i) which provides that the surviving spouse may only use the inherited exclusion amount from his or her last deceased spouse.

Example 1: H1 and W were married. H1 dies. At that point in time, H1 is W’s last deceased spouse. Subsequently, W marries H2. At the time of W’s marriage to H2, H1 continues to be W’s last deceased spouse. Should H2 predeceases W, then H2 steps into the shoes of H1 and becomes W’s last deceased spouse.

16 Upon W’s death, she may only use H2’s inherited

exclusion amount; any inherited exclusion amount that she received from H1 is lost.

As discussed below, the Last Deceased Spouse Rule creates several technical issues that are discussed throughout this paper.

10. Internal Revenue Code References to “Section” are to the Internal Revenue Code of 1986, as amended.

11. Regulations References to “Regulations” are to the Treasury Regulations, generally issued under a Section of the Internal Revenue Code.

12. “section” We will use the term “section” to mean a section of this paper. The term “Section” with a capital “S” is reserved for reference to the Code or Regulations.

C. Suggested Sources of Information on Portability 1. 2011 Form 706 & Instructions

United States Estate (and Generation-Skipping Transfer) Tax Return (a "Form 706") for decedents dying after December 31, 2010 and before January 1, 2012 (2011 Form 706), 17and the Instructions for 2011 Form 70618. The 2011 Form 706 and Instructions for 2011 Form 706 explain how to make the portability election.

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Section 2010(c)(4)(B)(ii). 16

This example is based on Example 2 on page 555 of the General Explanation of the Tax Legislation Enacted in the 111th

Congress, which was prepared by the staff of the Joint Committee on Taxation (“JCT”) on March 2011, which is commonly referred to as the JCS-2-11. The website link is: http://www.JCT.gov/publications.html?func=startdown&id=3775 17

The website link is: http://www.irs.gov/pub/irs-pdf/f706.pdf 18

The website link is: http://www.irs.gov/pub/irs-pdf/i706.pdf

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2. Notice 2011-82 Notice 2011-82, Guidance on Electing Portability of Deceased Spousal Unused Exclusion Amount (Notice 2011-82)19 provides guidance on making the portability election. This Notice also requested comments by October 31, 2011, in advance of the Treasury issuing more comprehensive regulatory guidance under Section 2010(c).

3. ABA RPTE EG Comments In response to Notice 2011-82, the American Bar Association’s Section of Real Property, Trust & Estate Law, Income and Transfer Tax Group, Estate and Gift Tax Committee – sent a letter titled “Regulatory Comments Concerning Portability” on October 31, 2011 (ABA RPTE EG Comments).20

4. ACTEC Comments In response to Notice 2011-82, the American Council of Trust and Estate Counsel provided comments to the Internal Revenue Service on October 28, 2011 (ACTEC Comments).21

5. New York City Bar Comments In response to Notice 2011-82, the Joint Subcommittee of the Trusts, Estates and Surrogate’s Courts Committee and the Estate and Gift Tax Committee of the New York City Bar Association provided comments to the Internal Revenue Service on October 31, 2011 (NY City Bar Comments).22

6. Florida Bar Comments In response to Notice 2011-82, the Real Property Probate and Trust Law (“RPPTL”) Section of the Florida

Bar also responded on by sending a letter on November 7, 2011 (Florida Bar Response).23

7. Estate and Gift Committee’s Summary of the Tax Relief, Unemployment Reauthorization, and Job Creation Act of 2010

The Estate and Gift Tax Committee of the Real Property Trust & Estate Law Section of the American Bar Association prepared a paper last year summarizing TRA 2010 (2011 E&G Committee Summary of TRA 2010).24

8. ACTEC’s Eight Recommendations to Improve Implementation of Existing Tax Laws

On November 2, 2011, ACTEC submitted to Congress eight recommendations to improve the existing tax laws (ACTEC’s Eight Recommendations).25

9. Steve Akers’ Latest Outlines Covering Portability Steve Akers has authored two excellent papers, Estate Planning Current Developments, December 2011, and Estate Planning Effects and Strategies Under the Tax Relief … Act of 2010, July 2011, which

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IR-2011-97, Sept. 29, 2011. The website link is: http://www.irs.gov/pub/irs-drop/n-2011-82.pdf 20

The website link is: http://meetings.abanet.org/webupload/commupload/RP509000/newsletterpubs/PortabilityABARPTEEGCommittee.pdf 21

The website link is: http://www.actec.org/Documents/misc/Radford_Comments_Notice_2011-82.pdf 22

The website link is: http://www2.nycbar.org/pdf/report/uploads/20072196-CommentstoIRSregardingNotice2011-82.pdf 23

The letter from the Real Property Probate and Trust Law (“RPPTL”) Section of the Florida Bar is incorporated in their agenda for the Executive Council meeting held on December 3, 2011 on pages 748 through 753. The website link is: http://www.rpptl.org/Content/PDFs/Marco_Island_AGENDA_12_02_11.pdf 24

The paper was written within weeks of the passage of the new law, and has been updated from time to time. The website link to the latest version is: http://www.americanbar.org/content/dam/aba/migrated/2011_build/real_property_trust_estate/summary_tax_relief_act_2010.authcheckdam.pdf 25

The website link is: http://www.actec.org/public/Governmental_Relations/Radford_Comments_11_02_11.asp

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provide thoughtful insights on many of the issues presented here. Steve has generously allowed these papers to be posted on the ABA’s RPTE website for your use and convenience.

II. Why Learn Portability? There is a common concern that because the portability provisions will expire without further action by

Congress at the end of this year (i.e., December 31, 2012),26

there is no point to devoting time to study its ramifications. We are convinced that taking time to learn this subject will be well spent:

Because there is a good chance that portability will become a permanent fixture of the federal estate and gift tax system. Portability is commonly thought of as a popular and noncontroversial middle-class-taxpayer-friendly provision, which appears to have support from both sides of the Congressional aisle.

Because the Obama Administration’s Fiscal Year 2012 budget proposes to permanently extend portability.27

Because the recently introduced Sensible Estate Tax Act of 201128 included a specific portability extender.

Because as explained below in section III - History of Portability, the concept of portability received significant consideration and analysis before its current enactment.

Because the Internal Revenue Service (sometimes referred to as the “IRS” or the “Service”) previously requested and received extensive formal commentary on the topic and is currently in the process of issuing regulatory guidance on portability.

Because the efforts of the Government to study, enact and administratively regulate portability would be wasted if the provision is not made permanent.

Because portability provides a logically consistent extension of existing tax policy and provisions favoring the mutuality of benefits between spouses, e.g., unlimited gift tax and unlimited estate tax marital deductions, gift-splitting, joint filing of returns, etc.

Because failure to plan with portability in mind could be detrimental to clients. For example, we are obligated to over the simplicity of portability as an alternative to the complexity formula fractional and pecuniary clauses.

Because the estate's beneficiaries may have to pay more overall taxes if they receive inadequate or incomplete advice from the estate planning attorney or advisor.

Because failure to plan with portability in mind for your clients could be risky to the practitioner.29

Because despite this unstable planning environment, portability is the current law and estate planning professionals are responsible for understanding its ramifications when presenting it as a planning option.

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Section 304 of TRA 2010 provides that the portability provision shall sunset in the same manner as all of the other provisions under the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). 27

See page 123 and 124 of the 2012 Greenbook. The website link is: http://www.treasury.gov/resource-center/tax-policy/Documents/Final%20Greenbook%20Feb%202012.pdf 28

H.R. 3467 (112th

Congress 2011-2012). The website link is: http://www.gpo.gov/fdsys/pkg/BILLS-112hr3467ih/pdf/BILLS-112hr3467ih.pdf 29

See, Keebler and Shenkman, Ten Portability Malpractice Traps Practitioners Should Consider, LISI Estate Planning Newsletter #1880 (October 18, 2011) at http://www.leimbergservices.com. This article alerts the practitioner of the potential malpractice issues, in the event he or she is not advising his clients (not just fiduciaries of estates) of the portability provision.

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Because if the planner continues to simply create by-pass trust estate plans, the planner may provide an inferior result to the client’s beneficiaries by failing to consider the larger goal of saving total taxes (i.e., estate and income taxes). This is because portability introduces a new tension between the estate and income taxes, and in certain situations there could be an income tax detriment associated with traditional by-pass trust planning as opposed to planning with portability in mind. Portability increases the pressure on attaining a better income tax result, thereby complicating estate planning.

Because there are solutions that would preserve the option to elect portability if it appears to be viable upon the deceased spouse’s death or to use a traditional by-pass trust if that appears to be the best solution at the time.

Because portability provides additional implications and planning considerations for impending marriages: 1) for inclusion in prenuptial agreements, and 2) for where a surviving spouse contemplates remarriage.

Because the portability election is irrevocable, with little or no curing options on a late filing basis.

Because, even if your clients never choose to use this planning option, a future client—beneficiary, surviving spouse, executor or otherwise—may seek advice regarding the impact of elections previously made in the administration of estates in which they have a vested interest or a fiduciary obligation to understand.

Because we believe that the new system of portability creates opportunities for estate planners to offer innovative strategies to clients.

Because estate planners are on the precipice of a great increase in professional time that will be devoted to planning for the potential and actual operation of portable exclusion amounts.

Because there will be a heightened expectation and obligation for professionals to thoroughly discuss and document decisions relating to the portability election and the use of the inherited exclusion amounts and the documentation of such decisions on gift and estate tax returns.

Because attorneys who have devoted the time to becoming conversant and knowledgeable about portability will be positioned to benefit their clients and themselves.

Because being on the cutting edge of planning maybe financially rewarding to the practitioner.

III. History of Portability In 2004, the Task Force on Federal Wealth Transfer Taxes, which included representatives from RPTE, the ABA Section of Taxation, the American College of Tax Counsel, the American College of Trusts and Estates Counsel (“ACTEC”), the American Bankers Association and the American Institute of Certified Public Accountants, published a Report on Reform of Federal Wealth Transfer Taxes (the “Task Force Report”). The Task Force Report proposed the limited “portability” of federal transfer tax exclusions between spouses, whereby the executor of a deceased spouse’s estate may convey unused federal transfer tax exclusion to the surviving spouse. Working from the fundamental premise that the federal wealth transfer tax should not unfairly disadvantage married couples who decline to engage in

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sophisticated by-pass trust planning or whose assets do not lend themselves to appropriate allocation, the Task Force Report proposed five solutions: (1) allow the surviving spouse a portable federal estate tax exemption;30 (2) allow the surviving spouse a portable federal gift tax exemption;31 (3) limit portability of these exemptions in the event of remarriage of the surviving spouse;32 (4) allow the surviving spouse a portable federal generation skipping transfer (“GST”) tax exemption; and (5) allow the surviving spouse the benefit of portable lower federal transfer tax rate brackets unused by the deceased spouse.

The Task Force Report’s recommendations sparked various legislative proposals, and a degree of consensus emerged for the proposition that portability promotes the federal tax policies of simplifying estate planning for the middle class and treating married individuals as a single economic unit, consistent with the provisions of the Code allowing gift-splitting, the unlimited marital gift and estate tax deductions, and the filing of “married filing jointly” income tax returns.

One such legislative proposal was embodied in section 102 of HR 5970, the Estate Tax and Extension of

Tax Relief Act of 2006 (HR 5970 (109th Cong.)) (the “2006 Bill”),33

which provided that the unified

credit34

of a surviving spouse could be increased by the unused unified credits of each deceased spouse. Under this proposal, the applicable exclusion amount of a surviving spouse would be comprised of the surviving spouse’s own “basic exclusion amount” augmented by the “aggregate deceased spousal unused exclusion amount” of all of such surviving spouse's deceased spouses. The aggregate deceased spousal unused exclusion amount would be computed by adding the unused exclusion amount of each deceased spouse. The aggregate deceased spousal unused exclusion amount could never exceed the surviving spouse’s basic exclusion amount, and, as a precondition to the use of any deceased spouse’s exclusion, such deceased spouse’s executor must have made an irrevocable election on a timely-filed estate tax return. Also, the statute of limitations with respect to the estate tax return of each deceased spouse would not apply to preclude examination of that return for purposes of determining the amount of the unused exclusion. The 2006 Bill passed the House but did not survive a cloture vote in the Senate.

On April 2, 2008, the Joint Committee on Taxation published a report titled, Taxation of Wealth

Transfers Within a Family: A Discussion of Selected Areas for Possible Reform (JCX-23-08).35

JCX-23-08 highlighted the possibility that portability legislation could create opportunities for better tax results than would be available with by-pass trust planning and suggested Congress consider limiting the amount of exclusion that could be "ported" to a surviving spouse to the lesser of (1) the combined value of the couple’s assets at the death of the deceased spouse and (2) the unused exclusion amount of the deceased spouse.36 Addressing the multiple marriage situations, JCX-23-08 noted that earlier

30

The applicable federal estate tax exclusion amount under Section 2010(c) ranged from $1 million to $3.5 million in the years 2002 to 2009. 31

The applicable gift tax credit under Section 2505(a) for the years 2002 to 2010 was based on an exclusion of $1 million reduced by credit allowed against prior lifetime gifts. 32

The Task Force considered restricting the exclusion portable to a subsequent spouse to the surviving spouse’s own unused exclusion to prevent accumulation of multiple ported exclusion amounts if the surviving spouse outlives another spouse. See Task Force Report at 100 -101. 33

2006 Bill. The website link is: http://www.govtrack.us/congress/billtext.xpd?bill=h109-5970 34

Although the term “unified credit” is no longer used in the current Code, it is a term still used by planners today to mean the applicable credit amount. 35

The website link is: http://www.JCT.gov/publications.html?func=startdown&id=1317 36

This was intended to address the situation where a couple had fewer total assets than the maximum individual exclusion amount at the time of the decedent spouse’s death, but the assets appreciated greatly during the surviving spouse’s remaining lifetime. In this case, by allowing the surviving spouse to apply the decedent spouse’s maximum individual exclusion as well as

9

proposals (such as the 2006 Bill) would have capped the maximum amount of portable exclusion from all predeceased spouses at twice the exclusion in effect at the surviving spouse’s death. Further, JCX-23-08 expressed policy concerns as to whether a surviving spouse who survives his/her first spouse and predeceases his / her second spouse should be able to port to the second spouse the unused exclusion derived in part from the first spouse’s unused exclusion. Like the 2006 Bill, JCX-23-08 also recommended a filing requirement and an open statute of limitations for determining the unused exclusion.

The day after JCX-23-08 was published, Shirley L. Kovar, Chair of the Transfer Tax Study Committee of ACTEC, testified in favor of portability before the Senate Finance Committee.37 Many of Ms. Kovar’s remarks were supported by a legislative proposal approved by ACTEC’s Board of Regents on March 10,

2008. The ACTEC proposal,38

like the 2006 Bill, would have allowed a surviving spouse to aggregate the unused exclusions from more than one deceased spouse, but capped the available unused spousal exclusion at twice the amount of a single exclusion. Kovar noted such a rule would prevent “abuse by a surviving spouse who would marry a series of ill paupers in order to accumulate their unused [exclusions].”39 The ACTEC Proposal differed from the 2006 Bill and JCX-23-08 in that it would not have required an election to port unused exclusion to the surviving spouse, on the rationale that the election is both a trap for the unwary and unnecessary because the election can be assumed to have been desired. Further, unlike the 2006 Bill and JCX-23-08, ACTEC proposed that portability should also apply to the GST tax exemption. The ACTEC Proposal made no direct recommendation as to whether a first deceased spouse’s exclusion should be portable to the second spouse of the surviving spouse, but noted that “a privity requirement would adversely affect very few spouses and … most spouses would find privity to be a natural and acceptable requirement.”40

Thus, it was after years of debate and anticipation that TRA 2010 codified the concept of portability, drawing heavily from the structure of section 102 of the 2006 Bill.

IV. Rules of Portability Under TRA 2010 A. Portability for Estate Tax Purposes: Section 2010(c)

1. Essential Concept of Portability TRA 2010 amends Section 2010 to provide that the applicable exclusion amount for the surviving spouse of a deceased spouse dying after December 31, 2010 is the sum of the surviving spouse’s basic exclusion amount and, if the deceased spouse’s executor so irrevocably elected on a timely-filed return (even if a return is not otherwise required to be filed), the deceased spouse’s unused exclusion amount

her own current maximum exclusion, the surviving spouse could shelter total assets in excess of what the couple could have otherwise excluded from transfer taxes. 37

Outside the Box on Estate Tax Reform: Reviewing Ideas to Simplify Planning, Hearing Before the Senate Fin. Comm. on Portability of the Estate, Gift and Generation-Skipping [Transfer] Tax, 110th Cong. (2008). The website link is: http://finance.senate.gov/imo/media/doc/040308sktest.pdf 38

Id. See Preliminary Remarks, where Ms. Kovar states: “ … the legislative proposal that appears as Exhibit A to my written testimony was prepared by ACTEC's Transfer Tax Study Committee and was unanimously approved by ACTEC's Board of Regents on March 10, 2008. Accordingly, when I speak in support of that proposal, I am authorized to speak on behalf of ACTEC, as well.”

39 Id, at 124 (testimony of Shirley L. Kovar).

40 Id, at 126.

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(i.e., inherited exclusion amount).41 The applicable exclusion amount for a decedent who is not a surviving spouse is the same as his or her own basic exclusion amount.

Example 2: W, who dies in 2011, made $1 million of lifetime taxable gifts and died with a taxable estate of $3 million. W leaves her entire estate to a by-pass trust for H. The inherited exclusion amount available for H is $1 million ($5 million – ($3 million + $1 million)). The inherited exclusion amount would be added to H’s basic exclusion amount ($5 million) to obtain H’s applicable exclusion amount of $6 million for 2011 ($1 million + $5 million). In 2012, H’s applicable exclusion amount will be increased as a result of the inflation adjustment to his 2012 basic exclusion amount.

Under Section 2010(c)(4), the inherited exclusion amount of a surviving spouse is equal to the lesser of (1) the basic exclusion amount applicable to the estate of the surviving spouse (the “first limitation”) and (2) the excess of the basic exclusion amount42 applicable to the surviving spouse’s last deceased spouse’s estate over the amount of such deceased spouse’s taxable estate plus adjusted taxable gifts (the “second limitation”).43

a. First Limitation The first limitation ensures that inherited exclusion amount cannot exceed the basic exclusion amount at the time of the surviving spouse’s death.44 Therefore, if the basic exclusion amount decreases by the time of the surviving spouse’s death, the lower basic exclusion amount would be used to calculate the first limitation on the inherited exclusion amount.

Example 3: H has $1 million in H’s personal name; W has $6 million in W’s name and they have no joint assets. H dies in 2011, having made no taxable gifts during his lifetime. H leaves his estate to a by-pass trust for W who dies in 2012. Assume that the basic exclusion amount has been reduced in 2012 to $3.5 million (i.e., reduced by legislative change). W’s inherited exclusion amount is the lesser of (a) $3.5 million (i.e., the basic exclusion amount); or (b) $4 million (i.e., the $5 million basic exclusion amount at the time of H’s death less H’s $1 million taxable estate). Thus, W’s inherited exclusion amount is $3.5 million.

The basic exclusion amount of the surviving spouse adjusts for inflation and might also be increased or decreased by subsequent legislation for years after 2012.

b. Second Limitation In contrast, the “second limitation” is based on the deceased spouse’s actual historic basic exclusion amount at the time of the deceased spouse’s death, which is fixed and not indexed for inflation for the period of time between the decedent spouse’s death and the surviving spouse’s death. Simply put, the second limitation is fixed at the time the deceased spouse’s death.

41

Section 2010(c)(2). As a result of the requirement that the executor of the deceased spouse timely-file an estate tax return allowing the surviving spouse’s use of the unused exemption amount, it may be impossible for the estate of a surviving spouse to cure any defects which arose during the administration of the deceased spouse’s estate. 42

House Bill 3467 proposed on November 17, 2011 includes a provision which would replace “basic exclusion amount” with “applicable exclusion amount” in Section 2010(c)(4)(B). SENSIBLE ESTATE TAX ACT OF 2011, H.R. 3467, 112th Cong. § 2(d) (1st Sess. 2011). 43

Section 2010(c)(4), referencing the computation of tentative tax under Section 2001(b). 44

Section 2010(c)(4)(A).

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Example 4: H has $3.5 million in H’s personal name; W has $6 million in W’s name and they have no joint assets. H dies in 2011, having made no taxable gifts during his lifetime. H leaves all of his assets in a by-pass trust for W. W dies in 2012, when the basic exclusion amount is $5.12 million. W’s inherited exclusion amount is the lesser of (a) $5.12 million (i.e., W's basic exclusion amount); or (b) $1.5 million (i.e., the $5 million basic exclusion amount at the time of H’s death over his taxable estate). In this case, the inherited exclusion amount is $1.5 million, which was the inherited exclusion amount from 2011 and which is not adjusted for inflation in 2012.

Within the concept of the “second limitation” is the concept of the Last Deceased Spouse, which we discuss in detail below in section E.1 beginning on page 17.

2. Portability for Non-Resident Non-Citizens The unified credit45 of a non-resident non-citizen of the United States (“non-resident non-citizen”) is not governed by Section 2010, instead it is governed by Section 2102. Accordingly, a non-resident non-citizen does not have an applicable exclusion amount or a basic exclusion amount. At first blush, it would seem that non-resident non-citizens can neither give nor receive an inherited exclusion amount. However, there is an argument that the existence of tax treaty may cause a different result.

Specifically, the Code provides a non-resident non-citizen with a $13,000 unified credit ($60,000 estate tax exemption amount)46 but also provides that a higher credit will be allowed to a non-resident non-citizen to the extent a treaty obligation of the United States so requires.47 For example, the Canada-United States estate tax treaty provides that a non-resident non-citizen “shall be allowed a unified credit” equal to the greater of $13,000 and the amount that bears the same ratio to a United States citizen’s Section 2010(c) credit amount as the value of the non-resident non-citizen’s gross estate situated in the United States bears to the value of the non-resident non-citizen’s total gross estate wherever situated.48 The applicable credit amount for a United States citizen (or resident) is now arguably comprised of the basic exclusion amount augmented by any inherited exclusion amount. Because the inherited exclusion amount is tied to the applicable credit amount, a non-resident non-citizen surviving spouse may possibly be able to include the inherited exclusion amount of a predeceased citizen spouse in his or her applicable credit amount if a Form 706 is filed to elect portability.

Note, however, that a United States citizen surviving spouse would have a more difficult time justifying an inherited exclusion amount derived from a non-resident non-citizen spouse —which is at the most a $60,000 exemption—because the Canada-United States estate tax treaty does not operate to define the rights of the United States citizen spouse. Further, even if it was possible to claim an inherited exclusion amount under a treaty, the portability rules do not operate to afford a non-resident non-citizen’s estate the opportunity to elect to preserve the unused exclusion amount. More specifically, Section 2010(c)(5)(A), which provides the estate tax filing requirement for the portability election, applies to United States citizens and residents and does not cover non-resident non-citizens. Additionally, Notice 2011-82 provides that a portability election can be made only on a Form 706.”49 Non-resident non-citizens file a Form 706-NA. As such, the proper conclusion seems to be that a United

45

Section 2102(b) uses the term “unified credit” and not “applicable exclusion amount” or “applicable credit amount”. 46

Section 2102(b)(1) 47

Section 2102(b)(3)(A). 48

Paragraph 2 of Article XXIX B of the Canada-United States Tax Convention (1980). 49

Notice 2011-82, page 2.

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States citizen surviving spouse will not receive any inherited exclusion amount from a non-resident non-citizen spouse.

B. Portability for Gift Tax Purposes: Section 2505 TRA 2010 reunified the gift and estate taxes. Specifically, section 2505(a)(1) was amended to provide that the gift tax credit available to a citizen (or resident) is the “applicable credit amount in effect under section 2010(c) which would apply if the donor died as of the end of the calendar year” reduced by amounts allowed as credits for gifts in prior periods.50 Therefore, a surviving spouse is permitted to use the inherited exclusion amount of the deceased spouse to make lifetime gifts.

C. GST Tax TRA 2010 does not make the unused GST tax exemption of a deceased spouse portable to a surviving spouse. This is clear in that the GST exemption for any calendar year under section 2631(c) is limited to

“the basic exclusion amount under section 2010(c) for such calendar year.”51 However, we will discuss in Part Two, portability can be used without wasting the GST exemption – i.e., they are not mutually exclusive.

D. Joint Committee Examples The Staff of the Joint Committee on Taxation (“JCT”) provided three examples in the Technical Explanation of the Revenue Provisions Contained in the “Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010” Scheduled for Consideration by the United States

Senate on December 10, 2010 (i.e., 7 days before TRA 2010 was signed) (JCX-55-10). 52 The portability provisions are found on pages 51 – 53, inclusive. To avoid confusion with the examples used in this paper, the JCT’s three examples are labeled as: JCT’s Example 1, JCT’s Example 2 and JCT’s Example 3.

In March of 2011 in JCX-20-11, the JCT issued Errata – General Explanation of Tax Legislation Enacted in the 111th Congress (the “Errata Statement”), where it explained a possible technical error in Section 2010(c)(4)(B)(i) which affects the JCT’s Example 3.53

50

Section 2505(a) provides that the donor is allowed a credit against the gift tax (imposed under Section 2501). Section 2505(a)(1) provides that this gift tax credit is to be calculated based upon the applicable exclusion credit determined under Section 2010. There are two points that are important. First, there is an “end-of-year convention” that is to be applied in determining the credit; second, to determine the credit, the donor is deemed to have died at the end of the year (even though it is irrelevant if the donor died in the year of the gift or survived). Literally, Section 2505(a)(1) states that to determine the gift tax credit, use the section 2010(c) estate tax credit as “if the donor died as of the end of the calendar year.” To calculate the gift tax credit, the donor is really calculating his or her estate tax credit (i.e., the applicable credit amount) as if he or she died at the end of the year of the gift. The applicable credit amount is calculated by reference to the decedent’s (in this case, donor’s) basic exclusion amount and inherited exclusion amount at the time of the presumed death (which in this provision is the end of the year of the gift). Since the gift tax credit is based on the applicable exclusion credit. Which in turn is based on the inherited exclusion amount, the surviving spouse can use the inherited exclusion amount during life. This is not intuitive from the statute. See, Staff of J. Comm. on Tax'n, 111th Cong., “Technical Explanation of the Revenue Provisions Contained in the ‘Tax Relief, Unemployment Insurance Reauthorization, And Job Creation Act Of 2010’ Scheduled for Consideration by the United States Senate” 52-53 (J. Comm. Print 2010); See also, infra section IV.D.1 - JCT Example 1 on page 13. 51

Additionally, this is buttressed by the JCT’s comments in Note 1581 of JCS-02-11, where they state, “The [portability] provision does not allow a surviving spouse to use the unused generation-skipping transfer tax exemption of a predeceased spouse.” 52

The website link is: http://www.JCT.gov/publications.html?func=showdown&id=3716 53

The JCT copied everything from JCX-55-10 and JCX-20-11 and inserted them into the General Explanation of Tax Legislation Enacted in the 111

th Congress (JCS-2-11). The information from JCX-55-10 is now found on pages 554 -556 of JCS-2-11, and

the Errata Statement is found on the second printed page (which is unnumbered) of JCS-2-11.

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1. JCT’s Example 1 The JCT’s Example 1 illustrates (1) the calculation of the inherited exclusion amount after the death of the deceased spouse; (2) the requirement that there must be a surviving spouse; and (3) the requirement that an election must be made on the deceased spouse’s estate tax return.

“Example 1. − Assume that Husband 1 dies in 2011, 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 Wife to use Husband 1’s deceased spousal unused exclusion amount. As of Husband 1’s death, Wife has made no taxable gifts. Thereafter, Wife’s applicable exclusion amount is $7 million (her $5 million basic exclusion amount plus $2 million deceased spousal unused exclusion amount from Husband 1), which she may use for lifetime gifts or for transfers at death.”

Note that the example only states what Wife’s applicable exclusion amount will be at the time of Husband 1’s death; it fails to indicate that the basic exclusion amount would increase with inflation. Specifically, it says “Thereafter Wife’s applicable exclusion amount will be $7 million … which she may use for lifetime gifts or for transfers at death.” If Wife dies in 2012, her applicable exclusion amount would be $7.12 million, because her basic exclusion amount would have increased from $5 million to $5.12 million.

2. JCT’s Example 2 JCT’s Example 2 is designed primarily to illustrate the Last Deceased Spouse Rule.

“Example 2. − Assume the same facts as in [JCT’s] 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 million ($2 million for Husband 1 and $1 million for Husband 2), only Husband 2’s $1 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 million) or the unused exclusion of the last deceased spouse of the surviving spouse (here, Husband 2’s $1 million unused exclusion). Thereafter, Wife’s applicable exclusion amount is $6 million (her $5 million basic exclusion amount plus $1 million deceased spousal unused exclusion amount from Husband 2), which she may use for lifetime gifts or for transfers at death.”

The example illustrates the possibility that a surviving spouse could lose inherited exclusion amount from a first spouse if a second spouse predeceases her. The new statute and the Joint Committee’s example reflect that the only inherited exclusion amount available would be that of the last deceased spouse of the surviving spouse. In the JCT’s Example 2, the inherited exclusion amount from Husband 1 would effectively disappear and the new inherited exclusion amount from Husband 2 would replace Husband 1’s inherited exclusion amount.

The example assumes that all events transpire in 2011 (Husband 1’s BEA was $5 million and Husband 2’s BEA was also $5 million, and no reference is made to inflationary adjustments). Further, the JCT indicates that Wife’s “applicable exclusion amount is $6 million”. Again, that applicable exclusion amount is only calculated at the time of Husband 1’s death; by 2012, the cost-of-living adjustment that increases the basic exclusion amount from $5 million in 2011 to $5.12 million in 2012, so Wife’s applicable exclusion amount would increase to $6.12 million.

The JCT’s Example 2 also assumes that the executor of Husband 2’s estate makes an election to permit Wife to use Husband 2’s inherited exclusion amount. This begs the question of what happens if Husband 2’s executor does not make the election. Would Wife continue to retain the benefit of

14

Husband 1’s inherited exclusion amount? [Probably not, because in footnote 57 the JCT says “The last deceased spouse limitation applies whether or not the last deceased’s spouse has any unused exclusion or the last deceased spouse’s estate makes a timely election.”] Or, would Wife be left with no inherited exclusion amount at all? [Probably, because H2 would be the last deceased spouse.]

3. JCT’s Example 3 The JCT’s Example 3 reads as follows:

Example 3. − Assume the same facts as in [JCT’s] Examples 1 and 2, except that Wife predeceases Husband 2. Following Husband 1’s death, Wife’s applicable exclusion amount is $7 million (her $5 million basic exclusion amount plus $2 million deceased spousal unused exemption 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 exemption amount, which is $4 million (Wife’s $7 million applicable exclusion amount less her $3 million taxable estate). Under the provision, Husband 2’s applicable exclusion amount is increased by $4 million, i.e., the amount of deceased spousal unused exemption amount of Wife. [highlight added]

The Errata Statement relates to the JCT’s Example 3, so we include it here to, as follows:

1. On page 555, add the following footnote 1582A to the word “amount” in the next to last sentence in example 3:

The provision adds new section 2010(c)(4), which generally defines “deceased spousal unused exclusion amount” of a surviving spouse as the lesser of (a) the basic exclusion amount, or (b) the excess of (i) the basic exclusion amount of the last deceased spouse of such surviving spouse, over (ii) the amount with respect to which the tentative tax is determined under section 2001(b)(1) on the estate of such deceased spouse. A technical correction may be necessary to replace the reference to the basic exclusion amount of the last deceased spouse of the surviving spouse with a reference to the applicable exclusion amount of such last deceased spouse, so that the statute reflects intent. Applicable exclusion amount is defined in section 2010(c)(2), as amended by the provision.

The JCT’s Example 3 (as modified by the Errata Statement) has caused much confusion because it appears to improperly interpret the statute (as it is currently written), and the Errata Statement does not correct the example to comport with the current statute, rather it states how the current statute was “intended” to be drafted. Additionally, under the statute, it is unclear how the inherited exclusion amount is to be allocated by the surviving spouse if such spouse makes gifts during life.

a. Analyzing JCT’s Example 3 – Without the Errata Statement What is important to understand is that remarriage does not affect an individual’s inherited exclusion amount; rather the combination of (a) marriage to a new spouse, and (b) the new spouse predeceasing the original surviving spouse, causes the inherited exclusion amount from the first deceased spouse to disappear (and is replaced by the second deceased spouse’s inherited exclusion amount, if any). In the JCT’s Example 3, Wife’s inherited exclusion amount was unaffected by remarriage or her death before Husband 2.

The confusion is not with regard to the calculation of Wife’s applicable exclusion amount; it is with regard to the calculation of Husband 2’s applicable exclusion amount. Husband 2’s AEA under Section 2010(c)(2) is the combination of (A) his BEA of $5 million, and (B) where there is a deceased spouse, the inherited exclusion amount. Under Section 2010(c)(4), the inherited exclusion amount is currently defined as the lesser of (A) Husband 2’s BEA ($5 million) or (B) the excess of Wife’s BEA (which was $5 million in 2011) over her taxable estate of $3 million (per the facts). Thus, it would be the lesser of (A)

15

$5 million and (B) $2 million, which yields $2 million. So, the inherited exclusion amount that Husband 2 receives from Wife is $2 million. When added to Husband 2’s BEA of $5 million, his AEA is $7 million. So, why did the JCT conclude that Husband 2’s AEA was $9 million?

The JCT’s Example 3 says,

“… An election is made on Wife’s estate tax return to permit Husband 2 to use Wife’s deceased spousal unused exemption amount, which is $4 million (Wife’s $7 million applicable exclusion amount less her $3 million taxable estate)…”

The example says that to calculate the inherited exclusion amount, one would use Wife’s applicable exclusion amount and reduce that amount by the tentative estate tax base. Section 2010(c)(4)(B)(i) uses the term basic exclusion amount (and not applicable exclusion amount). It is true that Wife’s applicable exclusion amount is $7 million at her death and is to be used in determining Wife’s estate tax exposure (if any); however, that amount is not to be used in calculating any inherited exclusion amount that may be ported to Husband 2.

b. Analyzing JCT’s Errata Statement The Errata Statement provides as follows:

“1. On page 555, add the following footnote 1582A to the word “amount” in the next to last sentence in example 3:

The provision adds new section 2010(c)(4), which generally defines “deceased spousal unused exclusion amount” of a surviving spouse as the lesser of (a) the basic exclusion amount, or (b) the excess of (i) the basic exclusion amount of the last deceased spouse of such surviving spouse, over (ii) the amount with respect to which the tentative tax is determined under section 2001(b)(1) on the estate of such deceased spouse. A technical correction may be necessary to replace the reference to the basic exclusion amount of the last deceased spouse of the surviving spouse with a reference to the applicable exclusion amount of such last deceased spouse, so that the statute reflects intent. Applicable exclusion amount is defined in section 2010(c)(2), as amended by the provision.”

If the suggested technical correction is made, it appears that in determining Husband 2’s inherited exclusion amount, the JCT’s Example 3 will be correct.54 However, it leaves us in a quandary. What does the planner take away from that example? If the example is inconsistent with the current statute, then can we rely on it for any purpose? Opinions vary on this.

c. Ordering Rules for Using Inherited Exclusion Amount Some have commented that the JCT’s Example 3 provides an “ordering rule” for the use of the inherited exclusion amount. Ignoring the Errata Statement, one could reason as follows and conclude that, based on JCT's Example 3, Husband 2 is entitled to the $4 million of inherited exclusion amount. Wife’s taxable estate of $3 million “first” utilized Husband 1’s inherited exclusion amount of $2 million (see result in the JCT’s Example 1), and thus, the remaining $1 million would be used against the Wife’s $5 million basic exclusion amount, resulting in a $4 million inherited exclusion amount for Husband 2.

54

Even though it may correct how to calculate H2’s inherited exclusion amount, as we discuss in section IV.E.3 on page 26, the suggested fix in the Errata Statement does not resolve the potential portability recapture (discussed in section IV.E.2.b on page 24) that results from the Last Decease Spouse Rule.

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Wife’s Taxable Estate $3,000,000 Less: Wife’s inherited exclusion amount

from Husband 1 -$2,000,000

Remaining Taxable Estate $1,000,000

Wife’s basic exclusion amount $5,000,000 Less: Remaining Taxable Estate -$1,000,000

Inherited Exclusion Amount (ported to Husband 2) $4,000,000

The JCT’s Example 3 raises the intriguing possibility that, if Wife dies first, the estate of Husband 2 may gain the benefit of the inherited exclusion amount of Husband 1. This “first-in, first-out” interpretation is not authorized under the terms of the statute. The interpretation raises the issue of “privity” that is discussed in section IV.D.3.d, below.

d. Anecdotal Information about the JCT’s Example 3 and Errata Statement

In the history of the enactment of the portability provision (as discussed above), we note that Congress expressed several concerns with portability as to, (a) privity, and (b) the “black widow” issue. The issue of privity is simply whether a surviving spouse can use the deceased spouse’s inherited exclusion amount (received from a predeceased spouse of the deceased spouse). This is best explained by analyzing the privity issue that was first addressed in JCX-23-08. The JCT stated the issue as follows:

“To highlight another issue, assume that the estate tax exemption amount is $5 million and that Husband 1 dies with no taxable estate and having made no taxable gifts, such that his entire $5 million exemption is available for Wife, in addition to her own exemption. Therefore, Wife has $5 million for her use for purposes of making lifetime gifts or bequests. Further assume that Wife remarries and predeceases Husband 2. From a policy perspective, one may question whether the amount of unused exemption passed from Husband 1 to Wife should be available to Husband 2 following Wife’s death. As noted above, the House-passed bills

[55] cap the amount of exemption a person may receive

from all predeceased spouses at $5 million (the basic exclusion amount under such bills when fully phased in), such that in this situation, Husband 2 could benefit from only $5 million of Wife’s $10 million unused exemption. But the bills do not differentiate between a decedent’s own exemption and ported exemption for this purpose. So, for example, if Wife had made taxable gifts prior to Husband 1’s death and had only $2 million of her own exemption remaining, and subsequently received $5 million of unused exemption from Husband 1 (for a total of $7 million), she could still pass $5 million of unused exemption to Husband 2 at her death, even though a portion of this amount originally had been the exemption of Husband 1. The Congress could craft a rule to address this issue, but such a rule would raise additional administrability issues. Such a rule, for example, would make relevant at the death of Husband 2 the amount of unused exemption passed from Husband 1 to Wife at Husband 1’s death. As an alternative, one simply could provide that unused exemption received from Husband 1 expires if Wife remarries.”

55

The “House-passed bills” referred to were HR 5638 (109th Cong.) and the 2006 Bill. The website link for HR 5638 (109th

Cong.) is: http://www.gpo.gov/fdsys/pkg/BILLS-109hr5638ih/pdf/BILLS-109hr5638ih.pdf

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Effectively, what is currently Section 2010(c)(4)(B)(i), when originally proposed in HR 5638 (109th Cong.) (as Section 2010(c)(4) and (c)(5)), used the term “applicable credit amount” of the deceased spouse (and did not limit the inherited exclusion amount (or deceased spousal unused exclusion amounts)56 to the last deceased spouse). In reviewing the same provision in 2006 Bill, it too used the “applicable exclusion amount” (and not the basic exclusion amount) of the deceased spouse. Thus, originally, there was no concern about privity in those versions of the proposed bills, however, at some point in time between 2009 and TRA 2010, the concept of the “last deceased spouse” was introduced into the computation of the inherited exclusion amount. This, as we will see in section IV.E.1, may cause some anomalous results.

Interestingly, the JCT used examples in JCX-23-08; its example 3 in that 2008 report stated as follows:

“Example 3.−Assume the same facts as in Example 2, except that Wife predeceases Husband 2 in a year in which the basic exclusion amount is assumed for purposes of this example to be $5 million. Husband 2 had no prior spouses. An election is made on Wife’s estate tax return to permit Husband 2 to use Wife’s deceased spousal unused exclusion amount. Wife made no taxable gifts and has a taxable estate of $3 million. Under the provision, Husband 2’s applicable exclusion amount is increased by $4 million, i.e., the amount of the deceased spousal unused exclusion amount from Wife (computed as Wife’s $7 million applicable exclusion amount less her $3 million taxable estate).”

The JCT’s examples 1 and 2 in JCX-23-08 were similar to the JCT’s examples 1 and 2 in JCS-2-11 (which we call in this paper, JCT’s Example 1 and JCT’s Example 2). The result in JCX-23-08 is correct based upon the two House-passed bills that they referred to, since those bills used the term “applicable exclusion amount” in determining the inherited exclusion amount; whereas the result in JCT’s Example 3 (as provided in JCS-2-11) is inconsistent with the statute as enacted, which uses the term “basic exclusion amount” and not “applicable exclusion amount”. Taking the Errata Statement and this legislative history into consideration helps to understand the JCT’s comment and examples.

The so-called “black widow” issue was also discussed in JCX-23-08. The JCT indicated that “[p]ortability of unused exemption presents additional policy and complexity issues in multiple marriage situations.” Specifically, the JCT indicated that Congress was concerned that an individual would marry a number of persons to obtain additional unused exemption amounts. The JCT indicated that the House-passed bills (i.e., HR 5638 (109th Cong.) and 2006 Bill) addressed the issue by “capping” the maximum amount that an individual can port by limiting the ported amount to the basic exclusion amount at the time of the decedent’s death. That provision in the earlier proposed bills survived in TRA 2010, and is currently in our statute as Section2010(c)(4)(A). We called this the “first-limitation” in our discussion above.

E. Remarriage of Surviving Spouse 1. Last Deceased Spouse Rule

The operation of the rules becomes somewhat hairy if the surviving spouse remarries and the new spouse predeceases such surviving spouse, thus introducing the “Last Deceased Spouse Rule”.

The second limitation on the inherited exclusion amount is defined by reference to the “last” deceased spouse.57 In its explanation of the statute in JCS-2-11, the JCT explains that if a surviving spouse has more than one deceased spouse, the surviving spouse’s estate may only use the most recently deceased spouse’s inherited exclusion amount. Indeed, JCS-2-11 confirms that the “last” deceased

56

In HR 5638 (109th

Cong.), proposed Section 2010(c)(4)(B) used the term “deceased spousal unused exclusion amounts of the surviving spouse” [emphasis added]. 57

Section 2010(c)(4)(B)(i).

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spouse restriction applies without regard to whether (1) the estate of the last deceased spouse filed an election to port the decedent’s inherited exclusion amount to the surviving spouse, or (2) the last deceased spouse actually had any unused spousal exclusion amount.58 Therefore, any inherited exclusion amount derived from a first deceased spouse is lost to the extent it is not utilized before the surviving spouse is widowed again, regardless of whether such second deceased spouse has any unused applicable exclusion amount or if such second deceased spouse’s executor elects portability.

The following examples based on the JCT’s Examples 159 and 2,60 explain the rule:

Example 5: H1 and W are married. H1 dies. Portability is elected and $2 million of inherited exclusion amount ports W. W subsequently marries H2. H2 predeceases W. H2’s personal representative elects portability and $1 million inherited exclusion amount ports to W.

In this example, H1’s $2 million inherited exclusion amount is lost and replaced with H2’s $1 million inherited exclusion amount.

Example 6: Same as Example 5, except that portability is not elected by H1’s personal representative.

In this case, nothing would have ported from H1 to W, but when H2 dies, H2’s $1 million inherited exclusion amount would port to W.

Example 7: Same as Example 5, except that portability is not elected by H2’s personal representative. Recall that H1’s $2 million inherited exclusion amount ported to W upon H1’s death.

In this case, W would have no inherited exclusion amount because, as to W, her last deceased spouse was H2, not H1; therefore, H1’s ported amount is lost, and so is H2’s (for failure to make a timely election).

2. Lifetime Gift Use of Inherited Exclusion Amount and Remarriage a. End of Year Assumption – An Anomaly

The ‘end of year’ convention is a gift tax rule; it is not an estate taxes provision. When the ‘end of year’ provision and the Last Deceased Spouse rule collide, unexpected results occur.

Example 8: H1 and W are married. H1 dies in 2011. The portability election is made resulting in an inherited exclusion amount of $3 million. W remarries H2 in 2012. W then makes $8.12 million in gifts to her children. W dies in 2013 leaving the balance of her estate to her children. Thereafter in 2013, H2 dies leaving his $20 million estate to his children.

58

JCS-2-11, at 554 n. 1582. 59

See section IV.D.1 on page 13. 60

See section IV.D.2 on page 13.

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Example 8 Estate Tax Calculation

Gift Tax Calculation Asset

W's assets at H1's death 12,120,000

W's taxable gifts in 2012 8,120,000 -8,120,000

W's gift tax calculated under Section 2501 using the tables under Section 2502 2,822,800

W's gift tax credit under section 2505 -2,822,800

Gift tax liability 0

Assets owned by W at death 4,000,000

Add back gift tax paid within 3 years of death under section 2035 0

W's gross estate 4,000,000

Add back taxable gifts 8,120,000

Subtotal 12,120,000

Tentative tax 4,222,800

Less gift tax paid on taxable gifts 0

Less Applicable Credit Amount -2,822,800

Estate tax Liability -1,400,000

Net to Children 10,720,000

Total Tax Liability 1,400,000

Total Assets (reconciliation) 12,120,000

This example illustrates that marriage after the death of H1 does not change the W’s gift or estate tax result, which is based on inherited exclusion from H1.

Example 9: Let’s assume the same facts from Example 8, except H2 dies in January 2012, leaving his $20 million estate to his children. In March 2012, W makes an $8.12 million taxable gift to her children. In May 2012 W dies, leaving her estate to her children.

Example 9 Estate Tax Calculation

Gift Tax Calculation Asset

W's assets at H1's death 12,120,000

W's taxable gifts in 2012 8,120,000 -8,120,000

W's gift tax calculated under Section 2501 using the tables under Section 2502 2,822,800

W's gift tax credit under section 2505 -1,722,800

Gift tax liability -1,050,000

Assets owned by W at death 2,950,000

Add back gift tax paid within 3 years of death under section 2035 1,050,000

W's gross estate 4,000,000

Add back taxable gifts 8,120,000

Subtotal 12,120,000

Tentative tax 4,222,800

Less gift tax paid on taxable gifts -1,050,000

Less Applicable Credit Amount -1,722,800

Estate tax Liability -1,400,000

Net to Children 9,670,000

Total Tax Liability 2,450,000

Total Assets (reconciliation) 12,120,000

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H2 becomes W’s last deceased spouse, so the last deceased spouse rule applies at the time of the gift (and since that precedes W’s death, it applies to the estate too). The results are as follows:

In this case, as a result of the Last Deceased Spouse Rule, W lost H1’s $3 million of inherited exclusion amount. This happened before the time of the gift, thus, the gift tax credit was reduced. In fact, it does not matter when H2 dies in 2012 for gift tax purposes. As we will see in the following two examples, since W is deemed to die at the end of the year, if H2 dies in 2012 he will always have been deemed to predecease W. QUERY: What happens if H2 dies on December 31?

The gift tax result of this case is that when H2 becomes the Last Deceased Spouse for gift tax purpose W’s applicable exclusion amount is only $5.12 (i.e., her basic exclusion amount) instead of $8.12 million; thus, $3 million will be taxed at 35%, which equals to $1.05 million.

The estate tax result in this case is computed as follows. First, as a result of the gift and the tax payment, when W dies, she has $2.95 million in cash (which is part of her gross estate). Under Section 2035, the gift tax payment of $1.05 million has to be added back to the gross estate (i.e., gift tax paid within 3 years of death). And, we would add the taxable gift of $8.12 million. This means that $12.12 million is subject to estate tax. The tentative tax liability is $4,222,800. Recall that in calculating the estate tax liability Section 2010(b)(2) provides that the tentative tax on the sum of the taxable estate and adjusted taxable gifts, is reduced by any gift tax paid, which in this case was $1.05 million. Since H2 died before W died, the Last Deceased Spouse Rule also applies for determining the inherited exclusion amount. Since H2 did not have any inherited exclusion amount to port to W, she only has her basic exclusion amount to use to calculate her applicable exclusion amount, and thus her applicable credit amount. Her applicable credit amount would be $1,772,800. Thus, the estate tax was $1.4 million. This $1.4 million estate tax translates to a 35% tax on $4 million.

The total tax liability of $2.45 million was comprised of a gift tax of $1.05 million (tax on $3 million) and an estate tax of $1.4 million (tax on $4 million). This makes sense, since W had a total estate of $12.12 million and an applicable exclusion amount of $5.12 million, thus $7 million was taxed at 35%, equaling $2.45 million.

Example 10: Let’s assume the same facts from Example 8, except W makes an $8.12 million gift in January 2012. H2 then dies in March 2012, leaving his $20 million estate to his children. In May 2012 W dies, leaving the balance of her estate to her children.

The result of this is H2 becomes W’s last deceased spouse, so the last deceased spouse rule applies at the time of the gift (and since that precedes W’s death, it applies to the estate too). The results are as follows:

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Example 10 Estate Tax Calculation

Gift Tax Calculation Asset

W's assets at H1's death 12,120,000

W's taxable gifts in 2012 8,120,000 -8,120,000

W's gift tax calculated under Section 2501 using the tables under Section 2502 2,822,800

W's gift tax credit under section 2505 -1,722,800

Gift tax liability -1,050,000

Assets owned by W at death 2,950,000

Add back gift tax paid within 3 years of death under section 2035 1,050,000

W's gross estate 4,000,000

Add back taxable gifts 8,120,000

Subtotal 12,120,000

Tentative tax 4,222,800

Less gift tax paid on taxable gifts -1,050,000

Less Applicable Credit Amount -1,722,800

Estate tax Liability -1,400,000

Net to Children 9,670,000

Total Tax Liability 2,450,000

Total Assets (reconciliation) 12,120,000

The results of this example are identical to that of the prior example. It illustrates that H2’s death still can affect the amount of gift tax due and payable because of the end of year convention. Thus, in this case, as a result of the end of year convention and the Last Deceased Spouse Rule, W lost H1’s $3 million of inherited exclusion amount.

Example 11: Let’s assume the same facts from Example 8, except W makes an $8.12 million gift in January 2012. W then dies in March 2012, leaving the balance of her estate to her children. Then, in May 2012, H2 dies leaving his $20 million estate to his children.

In this case, H2 dies after W, but before year end. Before looking at the results, let’s remember in the prior two examples, the total tax was $2.450 million. In this case, surprisingly, the total tax is $1.05 million (i.e., the tax on $3 million), as follows

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Example 11 Estate Tax Calculation

Gift Tax Calculation Asset

W's assets at H1's death 12,120,000

W's taxable gifts in 2012 8,120,000 -8,120,000

W's gift tax calculated under Section 2501 using the tables under Section 2502 2,822,800

W's gift tax credit under section 2505 -1,722,800

Gift tax liability -1,050,000

Assets owned by W at death 2,950,000

Add back gift tax paid within 3 years of death under section 2035 1,050,000

W's gross estate 4,000,000

Add back taxable gifts 8,120,000

Subtotal 12,120,000

Tentative tax 4,222,800

Less gift tax paid on taxable gifts -1,050,000

Less Applicable Credit Amount -2,822,800

Estate tax Liability -350,000

Net to Children 10,720,000

Total Tax Liability 1,400,000

Total Assets (reconciliation) 12,120,000

In this case W makes a taxable gift before H2 dies. Thus, at the time of the gift, W believes that she still has H1’s inherited exclusion amount of $3 million; thus, her applicable exclusion amount is $8.12 million (totally covering her gift, and not having to pay any gift tax). Then W dies. In this case, W’s personal representative probably still believes that the Last Deceased Spouse Rule would not apply because H2 survived W. However, when H2 dies later in that year (i.e., in 2012), H2 is now the last deceased spouse – but only for gift tax purposes. This is because under section 2505, for gift tax credit purposes, W is deemed to die on December 31 in the year of the gift (i.e., December 31, 2012), thus, as to W, H2 is predeceased. However, the end of year convention is inapplicable to the estate tax, so as to W, H2 is not the last deceased spouse, rather H1 is.

For gift tax purposes, W made a taxable gift of $8.12 million, triggering a Section 2501 gift tax of $2,822,800. The gift tax credit under Section 2505 will treat H2 as W’s last deceased spouse, because of the end of year convention (i.e., H2 died in 2012). Recall that H2 did not port any inherited exclusion amount to W, thus, W’s applicable exclusion amount is her basic exclusion amount. Therefore, her applicable credit amount is $1,772,800. Accordingly, the gift tax liability is $1.05 million (i.e., 35% tax on $3 million).

The taxable estate for estate tax purposes is the combination of the remaining assets after the gift and payment of gift taxes, which is $2.95 million, plus the add-back of the gift tax paid within three years under Section 2035. Thus, the taxable estate is $4 million. This taxable estate is added to the taxable gifts of $8.12 million, yielding a subtotal of $12.12 million. The tentative estate tax is $4,222,800, however, as with before, under section 2001(b)(2) the $4,222,800 is reduced by the gift tax paid of $1.05 million. Thus, the net amount of estate tax calculated under Section 2001 is $3,172,800. The Section 2001 estate tax is reduced by W’s applicable exclusion amount. In this case, recall that H2 actually survived W. Since there is no end of year convention for estate tax, W’s applicable credit amount is based on W’s applicable exclusion amount, which is her $5.12 million basic exclusion amount and her $3 million inherited exclusion amount from H1 (W’s last deceased spouse at the time of her death). In this case the credit equivalent for $8.12 million is $2,822,800. Thus, the $3,172,800 Section 2001 estate tax amount is reduced by the credit, leaving an estate tax liability of $350,000. The total gift and estate tax is $1.4 million. This is the same result as if H2 had survived the end of the year. The difference is that if H2 dies in 2012, there is a gift tax of $1.05 million and an estate tax of $350,000,

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totaling $1.4 million; whereas if H2 had survived there would have been just an estate tax of $1.4 million. It is a peculiar result – an anomaly.

Example 12: Let’s change the facts a little and assume when H1 dies, he leaves no inherited exclusion amount to W, because he had taxable gifts in his life. W marries H2 in January 2012. In March 2012, W makes a gift of $8.12 million to her children. In May 2012 W dies. In June 2012 H2 dies, he has a taxable estate of $2 million. Can he make an election, because for gift tax purposes W is deemed to survive him?

QUERY: Can H2’s executor make a portability election for gift tax purposes? In this case when H2 dies, he is actually not survived by a spouse. But, for gift tax credit purposes, the end of year convention would deem it as if W survived to December 31, 2012. The result shown below assumes that H2’s executor cannot make an election, under the theory that the election can only be made if there is a surviving spouse at the time of H2’s death.

Example 12 Estate Tax Calculation

Gift Tax Calculation Asset

W's assets at H1's death 12,120,000

W's taxable gifts in 2012 8,120,000 -8,120,000

W's gift tax calculated under Section 2501 using the tables under Section 2502 2,822,800

W's gift tax credit under section 2505 -1,722,800

Gift tax liability -1,050,000

Assets owned by W at death 2,950,000

Add back gift tax paid within 3 years of death under section 2035 1,050,000

W's gross estate 4,000,000

Add back taxable gifts 8,120,000

Subtotal 12,120,000

Tentative tax 4,222,800

Less gift tax paid on taxable gifts -1,050,000

Less Applicable Credit Amount -1,772,800

Estate tax Liability -1,400,000

Net to Children 9,670,000

Total Tax Liability 2,450,000

Total Assets (reconciliation) 12,120,000

This also has an odd result. For gift tax purposes, technically, H1 is no longer W’s last deceased spouse; rather, if W is deemed to have died on December 31, 2012, then H2 is the last deceased spouse for gift tax purposes. If H2’s executor could not make an election, thus, he could not port any exclusion, even though he would have had $3 million inherited exclusion amount to port, if he could have made the election. Recall that the statute and the JCT’s comments indicate that it is irrelevant if the last deceased spouse did not make the election; that person is still the last deceased spouse. Therefore, in this case H2’s exclusion is wasted. Meanwhile, W’s taxable gift of $8.12 million uses only her basic exclusion amount of $5.12 million, leaving a taxable gift of $3 million, and a tax of $1.05 million.

With respect to W’s estate tax calculation, she is again taxed on $12.12 million, which equates to a $4,222,800 tentative estate tax. This is reduced by the credit for gift tax paid of $1.05 million and the credit equivalent of $1,772,800 on a basic exclusion amount of $5.12 million. The net of this is that there is an estate tax of $1.4 million (which equates to $4 million being taxed at 35%).

In looking at both taxes, they total $2.45 million, which is a 35% tax on $7 million. In this case, that appears to be the correct result, notwithstanding the end of year convention. However, it still leaves

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the intriguing question whether one can elect portability to benefit a recently predeceased spouse for the purpose of gift taxes?

In the prior example, we saw that the “year-end convention” caused the Last Deceased Spouse Rule to cause a gift tax to occur, but under those facts, it reduced the estate tax, so the total tax payment was the same. But, what happens if the year-end convention causes a gift tax and there would have been no estate tax. In other words, the taxpayer could be worse off making a taxable gift.61

Example 13: H1 and W are married. They have made no taxable gifts through H1’s date of death. In January 2011, H1 dies and leaves his entire estate outright to W in 2011. Portability is elected. In February 2011, W marries H2. In March 2011, W makes a taxable gift of $6 million to her children. In April 2011 W dies and leaves the rest of her estate, being $3 million, to her children. On December 30, 2011, H2 dies, leaving his $20 million to his children.

This series of transactions illustrates that, because H2 died in the same year as W made a gift, that W will suffer a gift tax; whereas, had she not made the gift, there would be no gift or estate tax.

Example 13 Estate Tax Calculation

Gift Tax Calculation Asset

W's assets at H1's death 9,000,000

W's taxable gifts in 2012 6,000,000 -6,000,000

W's gift tax calculated under Section 2501 using the tables under Section 2502 2,080,800

W's gift tax credit under section 2505 -1,730,800

Gift tax liability -350,000

Assets owned by W at death 2,650,000

Add back gift tax paid within 3 years of death under section 2035 350,000

W's gross estate 3,000,000

Add back taxable gifts 6,000,000

Subtotal 9,000,000

Tentative tax 3,130,800

Less gift tax paid on taxable gifts ## -350,000

Less Applicable Credit Amount ## -3,480,000

Estate tax Liability ## 0

Net to Children 8,650,000

Total Tax Liability 350,000

Total Assets (reconciliation) 9,000,000

## The credit cannot exceed the tax

When W made the $6 million taxable gift, she probably believed that she had sufficient exclusion amounts between her late husband, H1, and herself. Each had a BEA of $5 million (jointly $10 million) and their total assets were $9 million. Unfortunately, the end of year convention would treat H2 as predeceasing W for gift tax purposes. Thus, W’s gift tax under Section 2502 is $2,080,800. W’s gift tax credit would be the equivalent of a credit for her $5 million basic exclusion amount, which is $1,730,800. Thus, there would be a gift tax of $350,000 (i.e., the tax on $1 million).

When W dies, her gross estate would be 3 million, and her adjusted taxable gifts would be $6 million, totaling to $9 million. The tentative tax on $9 million would be $3,130,800. She would receive an offset

61

Traditionally, planners advise on making taxable gifts in taxable estates, the theory being that the gift tax is tax exclusive where as the estate tax is tax inclusive, thus, it’s better to make a taxable transfer and pay a gift tax. Clearly, the 3-year rule under Section 2035 minimizes the advantage for ‘death-bed’ transfers.

25

for the gift tax paid of $350,000, reducing the tax under Section 2001 to $2,780,800. Her applicable credit amount would be the credit equivalent of a $10 million applicable exclusion amount. Recall, at the time of W’s death, H2 had not died, thus H1 was W’s last deceased spouse. Thus, she not only had her $5 million basic exclusion amount, but she had H1’s $5 million inherited exclusion amount, too. The applicable credit amount would be $3,480,800, which exceeds the estate tax. Accordingly, she would have no estate tax liability.

W’s estate, however, paid a total tax of $350,000. Had W died, not having made any gifts, she would have paid no gift tax and no estate tax. Thus, the Section 2505 end of year convention, combined with the Last Deceased Spouse Rule, yields an unfair, and most likely, unintended consequence. Perhaps Congress and Treasury will look at this closer and resolve it properly for the taxpayer.

b. The Portability “Clawback” or “Recapture” As we saw above, the Last Deceased Spouse Rule mandates a surviving spouse to lose a prior deceased spouse’s inherited exclusion amount and replace it with a more recent deceased spouse’s inherited exclusion amount (if any). The rule applies only if (a) the surviving spouse married a new spouse, and (b) such new spouse predeceases such surviving spouse. What happens if the new spouse (H2) dies leaving a smaller inherited exclusion amount?

Example 14: H1 dies in 2011, never having made a taxable gift. H1’s entire estate passes to W. Portability is elected. In 2011, W makes a gift of $10 million to her children, and she does not remarry in 2011. After making the gift, W has $6 million in her own name.

At the time of the gift, W was able to make a $10 million taxable gift without suffering a gift tax liability. If the facts change, then it is possible that we can trigger a new type of ‘clawback’ or ‘recapture’, which we call “Portability Recapture” in this paper.62 Portability Recapture occurs when a surviving spouse makes taxable gifts (either in one year or over a period of time) and his or her applicable credit amount is reduced below the amount of such taxable gifts in a future year. We do not believe that Portability Recapture could happen during life, but it is possible at the death of the donor. The reduction of the applicable exclusion amount (and correlatively the applicable credit amount) occurs as a result of: (a) legislative change (i.e., Congress lowering the basic exclusion amount);63 or the Last Deceased Spouse Rule taking effect.

Example 15: Assume the same facts as in Example 14; except W marries H2 in 2012. Later in 2012 H2 dies. H2 leaves his entire $20 million estate to his children (from a prior marriage). H2 has nothing to ported to W.

In this example, when H2 dies, he becomes W’s last deceased spouse and H1 is no longer W’s last deceased spouse.64 Accordingly, at the time of H2’s death, W’s applicable exclusion amount is reduced to her $5.12 million basic exclusion amount (because she had no inherited exclusion amount from H2). But, recall, in 2011, W gave away $10 million when her gift tax credit amount was $3,480,800 (which translated to an applicable exclusion amount of $10 million).

62

We call this “Portability Recapture” to distinguish this with the general ‘clawback’ issue that arises under TRA 2010. The clawback issue of general application under TRA 2010 is discussed at Section VII(a) of 2011 E&G Committee Summary of TRA 2010, Notes 48 and 49. If a new spouse dies in the same year of the gift, there will be no clawback, because for gift tax purposes, the “end-of-year” convention would properly calculate the amount of the gift tax and concurrent gift tax credit. 63

It should be noted that the “inflation adjustment” provision under Section 2010(c)(3)(B) would have no negative effect. The reason for this is that inflation adjustment only requires upward adjustments under Section 1(f)(3). 64

In Part Two we will discuss some planning considerations to mitigate the effect of this result.

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What’s the effect of H2’s death on the prior gifts? If W made a small taxable gift of $10,000 in 2012, would that then trigger a gift tax liability in excess of the tax on that $10,000? Section 2502(a)(1)(A) provides that the tentative tax on the aggregate sum of the taxable gifts of 2011 and prior years would be the tax assessed on $10,010,000, or $3,484,300. Then Section 2502(a)(1)(A) is to be reduced by the Section 2505(a)(1)(B) tentative tax on the sum of prior taxable gifts (of $10 million) of $3,480,800. Thus, the difference would be $3,500 (as anticipated).

We also need to calculate the gift tax credit. Under Section 2505, that credit is determined by reference to the applicable credit amount under Section 2010, reduced by the allowable credits for prior years. This is where the issues arise. The credit under Section 2010 for 2012 (i.e., the year of the gift) is a credit equivalent to W’s basic exclusion amount. Recall that with H2’s death, we use his inherited exclusion amount which was zero ($0). Thus, the credit for 2010 is $1,772,800 (i.e., the credit equivalent for $5.12 million). This credit has to be “reduced by” the amounts used in prior years (applying the new rate table). The credit used in prior years was a credit equivalent of $10 million, which was $3,480,800. The combination of these two amounts yields a negative amount (i.e., $1,708,000 (i.e., 35% of the difference between $10 million applicable exclusion amount of 2011, and the $5.12 million applicable exclusion amount of 2012.) Does the “negative credit” cause us to pay a gift tax of $1.708 million for 2012? Could we rely on the words “reduced by” and say that you cannot reduce below zero? If this is the case, then an argument can be made that there is no Portability Recapture in the gift tax context.

The potential recapture occurs when W dies. Using the same example, assume that W dies five years later with a $10 million estate. Also assume that the estate taxes as they exist today are the same and that W’s basic exclusion amount is $6 million at the time of her death. She has no inherited exclusion amount, as a result of H2’s death. Her taxable estate would be $10 million, to which the $10,010,000 of taxable gifts are added, reaching a total of $20,010,000. She would have a $3,500 gift tax paid credit. The estate tax under Section 2001 would be $6,980,800. From this amount, W can reduce the tax with her applicable credit amount of $2,080,800 (i.e., the credit attributable to a $6 million BEA). Her estate’s resulting estate tax liability would be $4.9 million.

Dividing the $4.9 million estate tax liability by the 35% estate tax rate equals $14 million. Thus, $14 million is subject to estate tax. Does this make sense? At W’s death, her taxable estate (line 3 of the Form 706) is $10 million. The estate tax as a percentage of her taxable estate exceeds the maximum rate of 35%. She should only have been subject to an estate tax on $10 million; however, because of the Last Deceased Spouse Rule, Portability Recapture traps an additional $4 million and subjects it to tax. Again, we hope that Congress and/or Treasury will address this unusual and unintended situation.

3. What if the Joint Committee on Taxation’s (JCT’s) Suggested Change to Section 2010(c)(4)(B)(i) is Implemented?

The Errata Statement states that Section 2010(c)(4)(B)(i) should be read to say:

“ (i) the applicable exclusion amount of the last such deceased spouse of such surviving spouse, over … “ [emphasis added]

The JCT’s position is that the current statute does not reflect Congressional intent and that the term basic exclusion amount should be changed to applicable exclusion amount (the “JCT Fix”). As discussed above, at the time of the writing of this paper, Senators Rangel (D-NY) and McDermott (D-NJ) have proposed H.R. 3467 (the “Sensible Estate Tax Act of 2011”) which includes the suggested technical correction to Section 2010(c)(3)(B).65

65

See, Section 2(d) of H.R. 3467 (112th

Cong.), Sensible Estate Tax Act of 2011. The website link is: http://www.gpo.gov/fdsys/pkg/BILLS-112hr3467ih/pdf/BILLS-112hr3467ih.pdf

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If the JCT Fix becomes law, it may avoid only a part of the Portability Recapture issue, but would not completely eliminate the possibility of Portability Recapture. The better solution may be to use the approach utilized in the in the prior House bills (discussed in sectionD.3.d on page 16).66 Let’s first examine why the approach under H.R. 3467 may not be the solution.

Example 16: H1 and W are married. Neither H1 nor W has ever made any taxable gifts. H1 dies in 2011 leaving his entire estate to W outright. Portability is elected. W makes a taxable gift of $10 million to her children on December 30, 2011. W marries H2 in 2012. H2 dies leaving his entire $20 million to his children so W receives no inherited exclusion amount.

At the time of H2’s death, W’s applicable exclusion amount would be $5.12 million. When W dies, assuming she does not remarry, her applicable exclusion amount would be limited to her basic exclusion amount at the time of her death.

The suggested statutory change does not fix the problem. The proposed statute would only provide for W to receive the inherited exclusion amount from her “last deceased spouse”, who was H2, and since H2 left W nothing, W is still subject to Portability Recapture on part of the $10 million gift when she dies (unless the BEA exceeds $10 million or she remarries and inherits an inherited exclusion amount from what would be a third (or fourth, etc.) last deceased spouse – an unlikely situation.

The sole purpose for the JCT Fix is to make the JCT’s Example 3 correct. Recall, the JCT’s Example 3’s facts were that W died before H2 – our facts are the inverse order of death (i.e., H2 dies before W). The JCT’s Example 3 was trying to calculate H2’s applicable exclusion amount. The JCT’s Example 3 did not focus on the Portability Recapture.

One solution is removing the Last Deceased Spouse Rule from Section 2010(c)(4)(B)(i) and using the language in the 2008 versions of the portability bills in its place. Those 2008 versions provided that with respect to a particular decedent the inherited exclusion amount would effectively be the largest amount from any predeceased spouse that resulted by taking such predeceased spouse’s applicable exclusion amount and reducing it by the taxable estate amount.67 Thus, if that approach became law, under the prior example, W would continue to use the inherited exclusion amount received from H1, since it would be the largest available to W. The proposed statute would allow W to use “any” inherited exclusion amount received from any deceased spouse.

66

See Note 55, supra. 67

For instance, under HR 5638 (109th

Cong.), the statutory language provided as follows: “(4) AGGREGATE DECEASED SPOUSAL UNUSED EXCLUSION AMOUNT.— For purposes of this subsection, the term ‘aggregate deceased spousal unused exclusion amount’ means the lesser of— (A) the basic exclusion amount, or (B) the sum of the deceased spousal unused exclusion amounts of the surviving spouse. (5) DECEASED SPOUSAL UNUSED EXCLUSION AMOUNT.—For purposes of this subsection, the term ‘deceased spousal unused exclusion amount’ means, with respect to the surviving spouse of any deceased spouse dying after December 31, 2009, the excess (if any) of— (A) the applicable exclusion amount of the deceased spouse, over (B) the amount with respect to which the tentative tax is determined under section 2001(b)(1) on the estate of such deceased spouse.”

In reading this once-proposed statute, one can see that there is no use of the “last deceased spouse” rule, rather, it appears that one would use the greatest amount provided under the statute for any deceased spouse.

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F. Incentives and Risks Under Portability Rules For a variety of reasons, there is an incentive for the surviving spouse to consider using the inherited exclusion amount received from a deceased spouse through lifetime gifting as soon as practicable. Doing so ensures that the inherited exclusion amount received from the first deceased spouse will not be lost if the surviving spouse remarries and is widowed again. Prompt use of the first spouse’s inherited exclusion amount also protects against erosion of the value of that spouse’s inherited exclusion amount by inflation or a statutory reduction in the basic exclusion amount and may save state estate tax in some cases.

On the other hand, prompt gifting to lock in the benefit of the inherited exclusion amount is not without risks, the most significant of which is the possibility of Portability Recapture or “general clawback”. Use of an inherited exclusion amount to maximize sheltering of the Federal gift tax dramatically increases the possibility that a recapture of tax (described above) might occur. In this event, lifetime gifts not subject to gift tax could later become subject to estate tax. The Portability Recapture issue is different than the general clawback issue because it potentially applies under current law even if the basic exclusion amount is not statutorily reduced.68

Notwithstanding the risk of Portability Recapture or the general clawback, the availability of inherited exclusion amount for lifetime gifting may generate tremendous tax savings by placing appreciation and income earned on gifted assets outside the taxable estate. Of course, the donor must be mindful of possible loss of benefit due to potential depreciation of the donated asset. This risk has always been present (before portability) and it continues – perhaps more so in light of the recent economic environment. Thus, this risk must not be ignored.

G. Portability Election 1. Surviving Spouse is a Prerequisite to Election

The first and most obvious element for a valid election is that the deceased spouse must be survived by a surviving spouse. Therefore, the matter of electing portability is of no concern for a decedent who is not a party to a marriage recognized for Federal estate and gift taxes at the time of death.

2. Election Required A surviving spouse may receive an inherited exclusion amount from a deceased spouse only if such spouse’s executor irrevocably so elects on a Form 706 filed within the time prescribed by law, including extensions.69 Section 2010(c)(5)(A) provides as follows:

“Election required. A Deceased Spousal Unused Exclusion Amount may not be taken into account by a surviving spouse under paragraph (2) unless the executor of the estate of the deceased spouse files an estate tax return on which such amount is computed and makes an election on such return that such amount may be so taken into account. Such election, once made, shall be irrevocable. No election may be made under this subparagraph if such return is filed after the time prescribed by law (including extensions) for filing such return.”

JCX-55-10 confirms that the election must be made in this manner even if the deceased spouse’s estate would not otherwise be required to file a Form 706. On page 1 of the Instructions for 2011 Form 706, the IRS also confirms that the Form 706 must be timely filed “even if there will be no tax due on the return.” Correspondingly, page 12 of the Instructions for 2011 Form 706, in reference to Part 4, Line 4,

68

See also, Akers, Estate Planning Current Developments, December 2011, at 54-55. 69

Section 2010(c)(5)(A).

29

provides that if Form 706 is not otherwise required, the failure to file a timely and complete estate tax return will prevent the surviving spouse from using any of the decedent’s unused exclusion.70

For purposes of the election, the term “executor” is defined in Regulation Section 20.2203-1:

“The term ‘executor’ means the executor or administrator of the decedent's estate. However, if there is no executor or administrator appointed, qualified and acting within the United States, the term means any person in actual or constructive possession of any property of the decedent. The term ‘person in actual or constructive possession of any property of the decedent’ includes, among others, the decedent's agents and representatives; safe-deposit companies, warehouse companies, and other custodians of property in this country; brokers holding, as collateral, securities belonging to the decedent; and debtors of the decedent in this country.”

71

a. Requirements of Valid Portability Election To take advantage of portability, three steps are required:

File a timely Form 706;

Compute the inherited exclusion amount; and

Elect portability. Notice 2011-82 and the Instructions for 2011 Form 706 provide that the portability election is made by filing a “timely and complete” Form 706 prepared in accordance with the instructions. In effect, the executor is treated as having elected to allow the surviving spouse to receive the inherited exclusion amount reflected by the entries on the Form 706.72 Important for this purpose will be identifying the surviving spouse (see the instruction to Part 4, Line 3) and using less than the decedent’s entire applicable credit amount.

(I) Estate Tax Return Required The estate tax return requirement is mandated by statute and presumably reflects Congressional policy. The filing requirement has been justified on the basis of administrative workability, in that the value of the inherited exclusion amount may be difficult or impossible to determine at the death of the surviving spouse without a timely filing and computation at the time of the deceased spouse’s death.

The Service cannot by regulation or administratively eliminate this requirement. There have been proposals submitted to Congress asking that it eliminate the Form 706 filing requirement. For example, ACTEC’s Eight Recommendations suggested that Congress allow the portability election to be made on a schedule attached to the decedent’s final income tax return (i.e., as an option to filing a Form 706, when such return is not otherwise needed).

A great deal of angst has been expressed about the requirement to file a Form 706 to make the election. Most of the concern relates to the administrative cost for the decedent’s estate and the burden on the government with respect to the expected flood of Forms 706 that would be filed for no purpose other than to make the portability election. In Notice 2011-82 even the Government stated:

“Treasury Department and the Service anticipate a significant increase in the number of Forms 706 that will be filed by estates of decedents dying after December 31, 2010, and that many of those returns will be filed by the estates of decedents whose gross estate have a value below the applicable exclusion amount.”

70

But see, Note 97, infra, and accompanying text. 71

See generally, Gopman and McCawley, 832 T.M., Estate Tax Payments and Liabilities, X.A. 72

See Form 706 at http://www.irs.gov/pub/irs-pdf/f706.pdf, Instructions at http://www.irs.gov/pub/irs-pdf/i706.pdf and Notice 2011-82 at http://www.irs.gov/pub/irs-drop/n-2011-82.pdf.

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Some of the regulatory comments sought a more simplified filing regime. For example, the ACTEC Comments suggested that the return requirement should be satisfied if Parts 1, 2, and 4 to the Form 706 were completed, without any additional parts, schedules or attachments.

Whether this expected onslaught of Forms 706 filed solely for the portability election will materialize remains to be seen. To be sure, careful practitioners will advise making the election when it is available. But, remember, the possible universe of decedents’ estates needing to make the election only include those decedents with surviving spouses. Moreover, the fiduciaries of very small estates are not likely to choose to incur the cost. When the value of the couples’ combined estate is well under $1 million (i.e., the pre-Bush estate tax exclusion amount), electing portability will not likely be at the forefront of concerns, if the spouses or fiduciaries are even advised of this arcane portability election point. Sure, the surviving spouse may win the lottery or remarry a very wealthy individual in which events the inherited exclusion amounts would have utility, but in the real world clients make decisions based on realistic probabilities. The probabilities of winning the lottery or finding a rich “Prince Charming” are not likely to drive many actions carrying an upfront economic cost to pursue, such as filing a Form 706.

While the Service cannot eliminate the filing requirement, the 2011 Form 706 and Instructions for 2011 Form 706 distill the statutory requirements so that by filing a “timely and complete” Form 706 in accordance with the instructions, the executor is treated as having elected portability.73 The Service sought to set forth an elective approach that could be accomplished with a minimum of steps and little complication. In Notice 2011-82, the Service indicated that the election is made without requiring an affirmative statement, checking a box or otherwise affirmatively electing on the Form 706.

Time and expense will be incurred with filing Forms 706 simply for purposes of making the portability election. Yet in many cases, the actual time and expense may be minimal. Suppose for example that the deceased spouse owned a home worth $400,000 as tenants by the entireties with the surviving spouse, a $50,000 IRA with the surviving spouse as beneficiary and a joint checking account of $3,000 with the surviving spouse. Realistically, filing a Form 706 for this deceased spouse could be done with minimal effort by the surviving spouse as the person in possession of the property.

(II) Timely Filing Requirement The portability election must be made on a timely filed Form 706, including extensions. Section 2010(c)(5) specifically states that the election is unavailable after the time prescribed for filing has passed.

A great deal of caution is warranted because relief under Section 301.9100 of the Regulations is apparently unavailable in the event of a missed election. In general, taxpayers are able to seek discretionary relief under Regulations section 301.9100-3 to make certain regulatory elections on a late-filed return when the taxpayer acted reasonably and in good faith, and the grant of relief will not prejudice the interests of the government. The IRS’s view is that it may not grant a request for an extension if the time for filing the election is governed by statute, as is the case with the portability election. The IRS's authority to grant discretionary extensions applies only to requests for extensions of time fixed by regulations or other published guidance.74

73

See Form 706 at http://www.irs.gov/pub/irs-pdf/f706.pdf, Instructions at http://www.irs.gov/pub/irs-pdf/i706.pdf and Notice 2011-82 at http://www.irs.gov/pub/irs-drop/n-2011-82.pdf. 74

For example, in PLRs 200314012 and 9641023, the IRS refused the ruled that it may not grant a request for an extension beyond the six-month period allowed automatically by Regulations section 301.9100-2 because the time for filing a gift tax QTIP election is expressly prescribed by Section 2523(f)(4). See also PLR 201109012 (revoking PLR 201025021 which had allowed 9100 relief for late QTIP elections on Form 709 for inter vivos QTIP trusts).

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Notwithstanding the foregoing, the six-month period allowed automatically by Regulations section 301.9100-2 should be available. Under Regulations Section 301.9100-2(b), an automatic six month extension of time (from the due date of a return excluding extensions) to make a regulatory or statutory election, such as the portability election, is available if corrective action is taken within that six-month period. The theory is that the IRS could have granted the six-month extension of time for filing the return (i.e., the extension is regulatory or administrative in nature)75 and therefore the relief should be available during this window.

The ABA RPTE EG Comments requested that the IRS clarify (in future Regulations) whether, and the extent to which, relief will be available under Regulations Section 301.9100 for a late filing, as well as how an amended return would affect a portability election.76 The ABA RPTE EG Comments ask for lenient relief provisions to correct any inaccuracies, failed elections, without imposing penalties where the taxpayer has acted in good faith.

On March 5, 2012, the IRS issued Notice 2012-2177 which grants to “qualifying estates” up to a 6-month extension for filing a Form 706. The extension is granted when the executor of such qualifying estate failed to file the usual 6-month extension (i.e., Form 4768) within the 9-month period from the decedent’s date of death. For those qualifying estates to take advantage of this Notice, the executor must file both the Form 4768 and the Form 706 within 15 months from the date of death.

For purpose of this notice, a “qualifying estate” is defined as: an “estate of a decedent (1) whose date of death is after December 31, 2010, and before July 1, 2011, (2) who is survived by a spouse, and (3) whose gross estate78 does not exceed the $5,000,000 basic exclusion amount for 2011.”

This may seem like it is tax payer friendly, and to some extent, it is. However, as noted before, there is an argument from a purely statutory standpoint, there is no requirement to file an estate tax return if the estate is below the filing threshold. Accordingly, this extension merely restates the IRS’ position that a return must be filed “timely”, when, arguably, technically there is no time requirement.79

(III) Complete Estate Tax Return Requirement The Instructions for the Form 706 refer to a timely and “complete” return in accordance with the instructions. The ABA RPTE TE Comments requested guidance on what is meant by “complete.”80 Presumably, the standards set forth in Beard v. Commissioner81 determine whether a filing is sufficient to constitute an “estate tax return” for making the portability election. These standards are:

The document contains sufficient data to calculate the tax liability;

The document purports to be a return;

The document is a reasonable attempt to satisfy the requirements of the tax law; and

The taxpayer executed the document/return under penalty of perjury.82

75

Section 6081 (the IRS may grant an extension of time to file any return of up to six months). 76

ABA RPTE EG Comments, § V.H.i. 77

Notice 2012-21, IRB 2012-10, March 5, 2012. The website link is at: http://www.irs.gov/irb/2012-10_IRB/ar08.html 78

We believe the IRS meant the “gross estate” including prior taxable gifts (post 1976). 79

See, Note 97, infra. (I think the note was 94, so with the addition of these three footnotes, it should be note 97) 80

Id. at § V.H.iii. 81

82 T.C. 766, 777 (1984). 82

See generally, Zeier v. U.S., 94-2 USTC 60,177 (USDC Dist. of Montana 1994)(statute of limitations for filing refund claim did not begin with initial tentative 706 filing as claimed by the IRS, where initial filing contained insufficient information to

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(IV) Compute the Inherited Exclusion Amount The current version of the 2011 Form 706 does not satisfy the second requirement of computing the inherited exclusion amount, because it does not contain any provision regarding the calculation of the inherited exclusion amount from the deceased spouse. Section 2010(c)(5)(A), as enacted, requires, the executor of the “last deceased spouse,” the one making the portability election, to compute the inherited exclusion amount. Notice 2011-82 provides that, until such time as the Service revises the 2011 Form 706 to provide for the computation of the inherited exclusion amount, merely filing the Form 706 as discussed above will be deemed to contain the computation.

The Form 706 should be revised to provide for this step or the Regulations should clarify that the foundational data is sufficient. Without detailing the precise calculation method, many practitioners will be unsure of how to compute the inherited exclusion amount. Surviving spouses and their advisors will likely benefit from this computation being completed at the outset. This will provide a basis to track future inter vivos and testamentary use of the inherited exclusion amounts. The ABA RPTE EG Comments suggested that the Service develop a universal inherited exclusion amount schedule for use in preparing estate and gift tax returns. The suggestion is that Part 1 of this schedule could provide for the computation of the inherited exclusion amount, Part 2 for use in filing the surviving spouse’s gift tax returns and tracking the inter vivos use of the inherited exclusion amount, and Part 3 for use in filing the surviving spouse’s Form 706. The schedule would provide any needed process for converting the exclusion to a unified credit equivalent (i.e., which could then be inserted on the appropriate line of the estate or gift tax form), and accounting for any changes in estate tax rates or in the BEA that impact the inherited exclusion amount.83

Note that there is a statutory disconnect with regard to computing the inherited exclusion amount upon the deceased spouse’s death. Section 2010(c)(4) defines the inherited exclusion amount as the lesser of the (i) BEA (i.e., the BEA at the time the surviving spouse makes a transfer by gift or testamentary disposition) or (ii) the excess of the BEA of the last deceased spouse over the tentative estate tax on the estate of such deceased spouse. By definition, to do this calculation, information is needed that only can be known at the time of the surviving spouse’s transfer (i.e., the BEA at that time). Yet, under Section 2010(c)(5), the executor of the deceased spouse in the election process is required to compute the amount of the inherited exclusion amount. Presumably, the intended computation was of the amount set forth in Section 2010(c)(4)(B), which is a determinable number upon the deceased spouse’s death and would be fixed in time at that point. Otherwise, the computation upon the deceased spouse’s death of the inherited exclusion amount is tentative and would necessarily change if the BEA changes when determined upon the time or times of the surviving spouse’s transfers.

(V) Elect Portability The last statutory requirement is to make the election for portability. The Instructions for 2011 Form 706 do not indicate that there will be any specific affirmation with respect to the election. Notice 2011-82 confirms that completing the Form 706, in accordance with the instructions, constitutes making the portability election. While simple in design, the method set forth in Notice 2011-82 may seem unsatisfying to some. For example, by comparison to the QTIP election, the affirmative step of listing the property on Schedule M, on the lines under “QTIP property:” beginning at line A1 is necessary. To satisfy their desire for certainty by affirmatively stating the intention of making the election, some preparers may consider attaching a rider that memorializes the intended election:

calculate the tax, but rather the statute of limitations began after filing the complete 706 return). 83

See ABA RPTE EG Comments, § V.G.iii.

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“The executor of the Estate of Paul hereby elects, pursuant to Sections 2010(c)(4) and (c)(5), to port the decedent’s unused exclusion amount of $5,000,000 for use by the decedent’s surviving spouse, Mary.”

This may assist any individual reviewing the return in the future that the portability election was intended. Alternatively, this indication of intention could be covered in a letter or memorandum to the executor.

b. Always Make the Election – Almost Always The inherited exclusion amount represents a potentially valuable property right. Assuming a current 2012 basic exclusion amount of $5.12 million, it translates to an estate tax credit of $1,772,800 (i.e., a dollar-for-dollar reduction of taxes up to that amount). Generally, the practitioner representing the executor should “always” advise making the election any time there is a surviving spouse. Given the importance of this election, this advice and the client’s decision should be documented in writing.

The advice to “always make the election” generally makes sense in first marriages. However, in subsequent (i.e., 2nd, 3rd, 4th, etc.) marriage, there are other factors that must be considered, such as the authority of the IRS to examine the return of the electing deceased spouse “to make determinations with respect to” the inherited exclusion amount. The last deceased spouse’s executor and/or surviving beneficiaries may not want any increased burden of establishing and maintaining valuation records for an extended period, even though there should be no risk of further estate tax liability in that estate. If the last deceased spouse’s beneficiaries are the only takers of the estate, and the surviving spouse is not a beneficiary, the burden of the tax filing is borne by them, and there may be no benefit to them to justify the election. Suffice to say, in those situations, there may be non-tax reasons not to make the election.

c. Authorization Language in Will/Revocable Trust Consider authorizing the portability election in all Wills and Revocable Trusts – Sample Language:

Wills: “My Personal Representative may make the portability election under Section 2010(c)(5)(A) of the Code for any portion of my basic exclusion amount that would otherwise be unused, even if it appears unclear that my spouse or my spouse’s estate could benefit from such exclusion, and pay all expenses associated with making such election as an expense of administration.”

Revocable Trusts: “The Trustee may make the portability election under Section 2010(c)(5)(A) of the Code for any portion of my basic exclusion amount

84 that would otherwise be unused, even if it appears unclear that my

spouse or my spouse’s estate could benefit from such exclusion, and pay all expenses associated with making such election as an expense of administration.”

d. Election Out of Portability The approach of the instructions for the 2011 Form 706 and Notice 2011-82 that if sufficient information is provided to permit the calculation of the inherited exclusion amount, the portability election should be presumed unless the executor manifests a contrary intent. In order to irrevocably elect not to allow portability, the Notice and Instructions provide three options: (1) not filing a Form 706 if it is not otherwise required; (2) attaching a statement to the Form 706 indicating that the estate is not making the election under Section 2010(c)(5); or (3) entering “No Election under Section 2010(c)(5)” across the top of page 1 of the Form 706.

84

If the words “basic exclusion amount” in Section 2010(c)(4)(B)(i) are changed to “applicable exclusion amount”, those words should be changed here, too.

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e. Upon the Surviving Spouse’s Death Page 13 of the Instructions for 2011 Form 706, Part 4 – Line 3 instructs the executor as follows:

“Enter the marital status of the decedent at the time of death by checking the appropriate box and providing the requested information. If the decedent had more than one marriage in his or her lifetime, on the Explanation line provide the name and SSN of each former spouse, the date(s) of the marriage ended, and specify whether the marriage ended by annulment, divorce decree, or death of spouse (to the extent the information was not already provided above). Also, if the prior marriage ended in death and the predeceased spouse died after December 31, 2010, indicate on the Explanation line whether the executor of the estate of the predeceased spouse elected to allow the decedent to use the deceased spouse’s unused exclusion amount. If the executor of the predeceased spouse’s estate made the election, attach to the return the predeceased spouse’s Form 706 and a calculation of the Deceased Spousal Unused Exclusion Amount (DSUE amount). For more information, see Section 2010(c)(4).”

Therefore, on the surviving spouse’s Form 706, the marital status of the surviving spouse at the time of the surviving spouse’s death must be reported. If the surviving spouse is married at the time of his or her death, then the first box would be checked under Part 4, Line 3, and the surviving spouse’s name and SSN would be listed on Line 4a and 4b. If the surviving spouse died a widow or widower, the second box under Line 3 would be checked and deceased spouse’s information would be shown to the right of that check box.

If the surviving spouse had marriages other than the one that exists at the time of the surviving spouse’s death, then information regarding such prior spouses must also be shown. This part is new for the 2011 Form 706. This addresses the possible situation that the surviving spouse remarried after the death of the deceased spouse from whom the surviving spouse has some inherited exclusion amount available for use.

Example 17: H1 and W are married. H1 dies. Portability is elected and $2 million of inherited exclusion amount ports to W. Later W marries H2. W predeceases H2. The first box is checked on Part 4, Line 3, and H2’s name and SSN would be listed on Line 4a and 4b. H1’s name, SSN, and date of death would be provided on the Explanation line under Part 4, Line 3, as well as reporting that H1’s executor made the portability election. H1’s Form 706 would also need to be attached to W’s Form 706, as well as a calculation of the inherited exclusion amount.

The predeceased spouse’s Form 706 must be attached to the surviving spouse’s Form 706. Must the predeceased spouse’s entire Form 706 be attached with all schedules and accompanying documentation? The ABA RPTE EG Comments suggested that simply attaching of pages 1 and 2 of the predeceased spouse’s Form 706 would be more precise in instruction and would be less likely to inundate the Service with useless paper. The thought is that, especially if the assessment statute of limitations is closed, the sole reason for a review of the predeceased spouse’s Form 706 is to determine he inherited exclusion amount, as detailed below, so pages 1 and 2 would provide the Service with the information needed. Furthermore, the Service presumably has access in its own records to the full copy of the predeceased spouse’s Form 706 if more information is needed (or it could be requested the full form from the executor of the surviving spouse’s estate).

Lastly, the executor for the surviving spouse must calculate the inherited exclusion amount and attach that calculation to the surviving spouse’s Form 706. As mentioned above in section IV.G.2.a(VI), it will be helpful for the IRS to provide the precise calculation method.

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3. Statutes of Limitation To properly elect portability, the executor of a deceased spouse is required to calculate the deceased spouse's inherited exclusion amount. Section 2010(c)(5)(A). The IRS though, is not required to accept the executor's computation. Section 2010(c)(5)(B). Therefore, notwithstanding the expiration of the statute of limitations set forth in Section 6501 on an estate or gift tax assessment for a deceased spouse, the IRS may continue to examine the deceased spouse’s estate tax return or gift tax returns for purposes of determining the inherited exclusion amount available to the surviving spouse.85 Presumably though, with respect to the surviving spouse claiming inherited exclusion amount, the period of examination of the deceased spouse’s return does not extend beyond the Section 6501 audit period for the surviving spouse's estate tax return.

V. Awaiting Regulatory Guidance A. In General

Section 2010(c)(6) grants the Treasury broad the authority to “prescribe such regulations as may be necessary or appropriate to carry out this subsection”. Portability is listed as Item 7 under the “Gifts and Estates and Trusts” Section of the Treasury’s 2011 – 2012 Priority Guidance Plan.86 With the issuance of the 2010 Form 706 and Instructions to such form, as well as other notices and information on the 2010 return having been published, we believe that portability guidance is a high priority for the Treasury. We had hoped proposed regulations would have been issued by the time of the writing of this paper; however, they have not. Members of the various committees of the ABA-RPTE’s, Income and Transfer Tax Planning Group will review the proposed regulations when they are published, and anticipate commenting on the same.

B. Notice 2011-82 1. Treasury’s Request

As we have discussed above, there are many portability questions that remain unanswered (notwithstanding the guidance from the existing authorities, cited herein). Fortunately, the Service issued Notice 2011-82,87 for which the following is requested:

“Comments are invited on the following specific issues, which have been identified for consideration in proposed regulations to be issued under section 2010(c):

1. The determination in various circumstances of the deceased spousal unused exclusion amount and the applicable exclusion amount;

2. The order in which exclusions are deemed to be used;

3. The effect of the last predeceasing spouse limitation described in section 2010(c)(4)(B)(i);

4. The scope of the Service’s right to examine a return of the first spouse to die without regard to any period of limitation in section 6501; and

5. Any additional issues that should be considered for inclusion in the proposed regulations”

2. Summary of Comments in Response In response, a number of organizations, including ABA’s RPTE section, ACTEC, New York City Bar and the Florida Bar commented on the same. The following summarizes the issues presented and suggested

85

Section 2501 and Section 2010(c)(5)(B). 86

Dep’t of Treas. 2011-2012 Priority Guidance Plan, Sept. 2, 2011. The website link is: http://www.irs.gov/pub/irs-utl/2011-2012_pgp.pdf 87

Notice 2011-82, IR-2011-97, Sept. 29, 2011.

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solutions to Treasury.88 The comments could be grouped into three broad categories: (a) the amount and the use of the inherited exclusion amount; (b) the logistical issues of electing and living with portability; and (c) the scope of the review of the Form 706 for the deceased spouse.

a. The Amount and Use of the Inherited Exclusion Amount The comments encompassing the computation and use of the inherited exclusion amount are intertwined with statutory construction (or gaps in the statute), together with regulatory interpretation of the calculation of the inherited exclusion amount in the JCT’s Example 3.

As discussed above in section IV.D.3 beginning on page 14, the JCT’s Example 3 improperly calculates the inherited exclusion amount to port to Husband 2 (based on the current statute). Clarification was requested on the Service’s approach on how to calculate the inherited exclusion amount. Additionally, there was a request that the Regulations would provide relief for anyone relying on the JCT’s Example 3.

It is not entirely clear whether the correction lies in the hands of Treasury or Congress; however, notwithstanding the apparent statutory mandate, a suggestion was made that under case law Treasury may have the authority to issue Regulations that could give guidance based on legislative intent.89

(I) Calculating the Gift Tax Credit (as a Result of the Inherited Exclusion Amount) (i) “as if” – ‘End of Year’ Convention under Section

2505(a) Under Section 2505(a) the gift tax credit is calculated “as if” the donor died at the end of the year. The comments raise the issue is that there can be events that take place after the gift is made (unrelated to the gift and out of the control of the donor) that could affect the amount of the gift tax credit. Specifically, as we discuss in the Portability Recapture section of this paper,90 it is possible for the donor spouse to make a gift, relying on a deceased spouse’s inherited exclusion amount, and the amount of such inherited exclusion amount to be reduced either legislatively or as a result of a death of the donor spouse’s new spouse. The commentators requested clarification and examples illustrating the rule’s operation.

(ii) Gift Tax Paid on Gifts In cases where a gift has been made in earlier years and a gift tax has been paid, Section 2010(c)(4)91 does not appear to adjust for those gifts in future years when the basic exclusion amount may be increased as a result of inflation. A suggested regulatory clarification would be to provide that in calculating the tentative tax under Section 2010(c)(4)(B)(ii) the language would be interpreted to take into consideration the effect of gift taxes paid. The ACTEC Comments illuminate the issue with the following example:92

88

Some of the issues may be outside of the Treasury’s authority (e.g., the Last Deceased Spouse Rule may be one such area, though the ACTEC Comments resolve otherwise). If they are not within Treasury’s regulatory authority, hopefully, Treasury can work with Congress to provide guidance and a suggested legislative change, if necessary. Currently, the ABA’s RPTE and Tax Sections have been gathering input to the hope of providing a paper to Congress on tax legislative issues. One of the topics is portability. 89

This theory was presented in both the ACTEC Comments and the ABA RPTE EG Comments. Although statutory clarification is the best route, absent such clarification, the suggested theory is based on the case of Chevron U.S.A v. Natural Resources Defense Council, inc., 467 US 83 (1984). 90

See section IV.E.2.b, beginning on page 24. 91

The gift tax credit is found in Section 2505. That gift tax credit is computed by reference to the estate tax credit in Section 2010. Therefore, in discussing the gift tax credit, quite often reference is made to a provision in Section 2010. 92

ACTEC Comments, p 10 -11.

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“Example. In 2008, the applicable exclusion amount for gift taxes is $1 million, and H makes a $4 million taxable gift, utilizing his entire applicable exclusion amount and paying a $1,335,000 gift tax. H dies in 2011, survived by W, who is a U.S. citizen. H has a taxable estate of $1 million and the 2008 taxable gift is the only gift he has ever made. The DSUEA available to W should be $3 million (H’s $5 million basic exclusion amount - $1 million lifetime use of applicable exclusion amount - $1 million taxable estate), but Section 2010(c)(4)(B)(ii) could be read as requiring that the DSUEA available to W is reduced by H’s entire $4 million adjusted taxable gift, including the portion for which no applicable exclusion amount was available and therefore gift taxes were paid.”

ACTEC proposes that Section 2010(c)(4)(B)(ii) should be construed to only take into consideration those gifts on which a gift tax had not been paid. With respect to the above example, the $3 million of taxable gifts that generated gift taxes payable would not enter into the calculation of the inherited exclusion amount.

(II) Possible Portability Recapture As discussed above, the commentators discussed the Portability Recapture (as well as the general clawback) issues presented in TRA 2010 and how it is entirely possible for Portability Recapture to occur either from legislative change, reducing the basic exclusion amount or from the Last Deceased Spouse Rule.

The commentators indicated that it is especially relevant in the case of lifetime gifts, that could cause recapture and inadvertent results that could trap the unwary. There was a suggestion for Treasury to provide examples to illustrate the tax ramifications that could result in the event of Portability Recapture. Some commentators proposed changes that would prevent the occurrence of Portability Recapture.

A suggestion was made that if the exclusion were used during life, even if other events changed the applicable exclusion amount, no additional gift or estate tax should be incurred. For instance, one proposal suggested that

“Code § 2505(a)(1) should be interpreted such that each gift is separately evaluated to determine the amount of one’s applicable exclusion amount at the time of such gift. Even though it is presumed that the donor died at the end of the year, an intervening subsequent spouse’s death should be ignored with regard to the gift and use of a prior spouse’s DSUEA.”

93

(III) Clarification on the Use of the Inherited Exclusion Amount of Non-Resident Non-Citizen Aliens

The statute appears to be unclear whether a U.S. resident / citizen may receive an inherited exclusion amount from a non-resident / non-citizen spouse.94

(IV) Portability and QDOTs In order for property transferred at death to a non-citizen spouse to qualify for the estate tax marital deduction, the property must be placed in or assigned to a QDOT.95 That said, a gap in the law seems to exist with respect to whether a non-citizen spouse may receive the inherited exclusion amount of a deceased spouse when a QDOT is used to make transfers to the surviving spouse. Since the marital deduction plays such an integral role in planning for married individuals, helpful guidance from the Service would include resolution of the following: 1) whether inherited exclusion amounts can be

93

See, Note 8 of the ABA RPTE EG Comments, p. 7. 94

See our discussion above in section IV.A.2 on page 11, above. 95

Sections 2056(d) and 2056A.

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applied against QDOT tax imposed on distributions from a QDOT during the life of the surviving spouse and on the remaining principal in the QDOT at the surviving spouses death; and 2) whether the executor of a deceased spouse may elect partially portability to cover QDOT tax--thereby allowing the surviving spouse to use some of the inherited exclusion amount during life or offset any US estate tax at death.

In addition, if the Service determines a non-resident non-citizen is unable to receive an inherited exclusion amount, it would be helpful to receive guidance as to whether the result would change if the surviving spouse later becomes a citizen. Helpful guidance would detail the continuity between the QDOT rules and the portability rules. Specifically, the QDOT rules allow the general marital deduction rules of Section 2056 to apply if a resident, surviving spouse subsequently becomes a US citizen.96 Theoretically, the portability rules would allow the same or similar result

(V) Use of the Inherited Exclusion Amount – Its Hierarchy Important to planning is the use of an individual’s applicable exclusion amount. It is unclear how a donor’s applicable exclusion amount is used during life, when such applicable exclusion amount is comprised of the donor’s basic exclusion amount and the inherited exclusion amount. This is the “ordering rule” described above in section IV.D.3.c (i.e., which is applied first: the inherited exclusion amount, the basic exclusion amount, or both applied at the same time - pro rata (or some other manner). It is clear that the statute is silent regarding this point; perhaps Treasury could promulgate a Regulation that gives guidance nonetheless.

Suggestions included interpreting the current statute in the same manner that the JCT originally interpreted it when it first issued the JCT’s Example 3 (i.e., as if the words applicable exclusion amount had originally been drafted in Section 2010(c)(4)(B)(i) (instead of basic exclusion amount)). Using the applicable exclusion amount would eliminate the ordering rule. The reason for this is that the applicable exclusion amount is the sum of the basic exclusion amount and the inherited exclusion amount. Thus, when the applicable exclusion amount is utilized, the basic exclusion amount and the inherited exclusion amount are applied simultaneously, eliminating the need to keep track of the hierarchical use of the basic exclusion amount or the inherited exclusion amount.

(VI) Effect of Divorce on the Inherited Exclusion Amount A comment was made that Treasury should clarify that if a spouse marries after the death of a former spouse, and that newly married spouse divorces the new spouse, that the new spouse is disregarded for purposes of determining the surviving spouse’s inherited exclusion amount.

(VII) Other Estate Tax Credits The Code does not explicitly state whether the inherited exclusion amount is calculated before or after taking into consideration other estate tax credits (e.g., credit for tax on prior transfers (i.e., Section 2013) or the foreign death tax credit). There is a request for clarification, and a recommendation that the credit should be calculated irrespective of the other credits (i.e., to achieve the largest amount of credit possible).

b. Logistical Issues – Electing Portability (I) Election Requirement

Some of the issues posed in the comments were somewhat resolved when the IRS published the 2011 Form 706 and Instructions for 2011 Form 706. However, it would be preferable to have regulatory guidance, instead of attempting to glean a rule from the Instructions for 2011 Form 706.

96

Section 2056A.

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The rule requires that the taxpayer file a time and complete Form 706, compute the inherited exclusion amount and elect portability on such form. The current Instructions for 2011 Form 706 only require the filing of such form. Additionally, there is no requirement for an affirmative election and that there is no requirement for calculation of the inherited exclusion amount. The commentators would prefer that there be clarification of this issue in the Regulations (i.e., that the mere filing of a Form 706 is sufficient to meet the statutory guidelines).

(II) Required To File An Estate Tax Return There appears to be a gap in the statute on the mandate that the Form 706 be filed “timely” to elect portability. If an estate is required to file the Form 706 based on the size of the gross estate, because the gross estate (plus aggregate taxable gifts) by definition exceeds the decedent’s basic exclusion amount, then the portability election must be made within 9 months of the date of death (or as late as 15 months from the date of death, if an extension is timely filed). The statute is silent on the filing deadline when an estate is not required to file a return. If the deceased spouse is not required to file a Form 706, the statute does not mandate that a Form 706 be filed.97 It is important to note that the IRS’ position in Notice 2011-82 and Notice 2012-21 is that to elect portability, regardless of whether the estate was required to file a Form 706; the estate must timely file a Form 706 as if it were required to file such a return (i.e., within 9 months or the extended 15 month period). Regulations clarifying this issue would be helpful.

(III) Form to Provide Guidance on Inherited Exclusion Amount Calculation

The commentators thought that the Service should provide forms to assist the preparer on the calculation of the inherited exclusion amount for both the estate and gift tax returns. Recall, in the current 2011 Form 706 and its accompanying instructions, determining the amount of the inherited exclusion amount is not required (even though it is a statutory requirement).

(IV) Provide Regulation Section 301.9100 Relief It does not appear that Regulation Section 301.9100-3 relief would be possible if an election is not timely made; however, there was a request that, in light of the uncertainties and the complications with this new law, some sort of relief should be given to the taxpayer.

(V) Amended Returns There was a request that the Service provide guidance on the affect that amended returns would have on the portability election. Would amending a return “undo” an election? What if there is a requirement in a future year to “determine the amount?” If the amount was incorrect and the personal representative amended the return, would the return have been timely filed?

(VI) Relief for Faulty Election If, in the future, there is a requirement that an “election” must be made somewhere on the Form 706, what if the election is not made (e.g., a box is not checked). Would there be a method by with relief could be granted in this circumstance?

(VII) Protective Elections

97

See, Law, Portability Election: There May Be No Due Date for Smaller Estates, LISI Estate Planning Newsletter #1885 (November 1, 2011) at http://www.leimbergservices.com. In that article, the author states the conclusion as follows:

“Code §2010(c)(5) requires that the portability election must be made on an estate tax return within ‘the time prescribed by law (including extensions)’. If no estate tax return is required to be filed, under Code §§ 6018 and 6078, there is “no time prescribed by law”, and, under Code §§ 6018, 6075 and 6081, and Treasury Regulations §20.6081-1(b) there is also no ‘time prescribed by law (including extensions)’ … ”

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Guidance was sought on how a protective election could be made.

(VIII) Effect of Spousal Agreement Guidance was sought on the effect of spousal agreements for mandating the survivor to make an election.

(IX) Who is an Executor for purposes of making the Election? Guidance was sought on whether the same rules under Section 2203 would apply if there was no “executor” of an estate.

(X) Form 706 EZ The commentators asked the Service to consider whether a less complicated estate tax return (which we call a “Form 706 EZ”) could be used in certain circumstance (e.g., smaller less complicated estates) to elect portability?

(XI) Refusal of Personal Representative to Make Election, but Desire of Surviving Spouse to Make the Election

Situations may arise, generally non-first marriage situations (e.g., 2nd, 3rd, 4th, etc. marriages) where the personal representative of the first spouse’s estate refuses to make an election98 but the survivor may want to make an election; guidance was requested on how the survivor can somehow make the election.99

c. Scope of the IRS’ Review of Estate Tax Return of Deceased Spouse(s)

Section 2010(c)(5) provides for the extension of time for the examination of the deceased spouse’s Form 706, with respect to determining the inherited exclusion amount.

There were a couple of issues that the commentators felt should be clarified. First, we should be assured that the period of examination of the deceased spouse’s return does not extend beyond the Section 6501 audit period for the surviving spouse’s estate tax return. Second, the nature and extent of the IRS authority to examine the deceased spouse’s Form 706 is unclear. It seems that the legislative intent is to allow scrutiny of valuations at the time they become material to the collection of a tax in the surviving spouse’s estate, and that there is no intent or attempt to open the deceased spouse’s estate to liability. The scope of review should be confined to the purpose intended. For instance, does this authority mean that the deceased spouse’s gift tax returns also remain open for this examination? Clarification was requested to confirm that the Service could not use this authority as a ‘back door” for any other type of examination or assessment affecting any taxpayer other than the surviving spouse’s estate. Specifically, one commentator requested that the IRS "confirm and illustrate that such an examination cannot be used to assess an estate tax deficiency with respect to the estate of such predeceased spouse after the limitations period of Section 6501 has expired”.100

C. Issues Not Raised But Need Answers 1. What Happens When a New Spouse Dies on December 31 and a Gift is

Made in that Year? An interesting question is what happens when a new spouse dies on December 31 of a year when a gift is made. Typically, the end of year convention under Section 2505 would cause a spouse who dies anytime within the year as a predeceased spouse for gift tax purposes. But, if the spouse dies on the

98

If the beneficiaries, of that deceased spouse’s estate, receive no benefit from the surviving spouse’s estate, there is an expense borne by those beneficiaries with no benefit. 99

In Part Two, there will be a discussion on planning suggestions to potentially avoid the issue upon the death of a spouse. 100

ACTEC Comments, p 14.

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last day of the year and the donor spouse (who is now a surviving spouse (at least twice over)) is deemed to die on the last day of the year, has the new spouse become a “Last Deceased Spouse” for the gift tax credit purposes?

VI. Sunset Provisions TRA 2010 sunsets at the end of 2012, which means that without further action by Congress, the portability provisions will be unavailable in 2013 and beyond. Therefore, if the surviving spouse survives 2012, the inherited exclusion amount from a deceased spouse will be lost (to the extent it has not been used for lifetime gifting during 2011 or 2012).

The Obama administration’s Fiscal Year 2012 Revenue Proposals (published by the Department of Treasury on February 15, 2011) and Fiscal Year 2013 Revenue Proposal (February 13, 2012) would make portability a permanent fixture of the transfer tax system.101

VII. Conclusion Portability is a taxpayer-beneficial provision. In this Part One, we discussed the historical perspectives, gave a laundry list or reasons why one should study the new provision, dispelled with a few myths about portability, discussed portability’s provisions and the filing requirements, illuminated a few significant issues that currently exist, summarized the various comments by the ABA’s RPTE section and others in response to Notice 2011-82, and raised a number of issues and offered some solutions that Treasury and perhaps Congress will address. With this new law comes a new paradigm in planning. In Part Two, we will discuss the portability planning factors, analyze the tension between the income and estate tax that now exists (in light of portability) and provide suggested planning solutions for those who wish to plan with portability in mind. Below are several Part Two teasers.

VIII. Portability Planning Teasers A. Is Traditional By-Pass Trust Still Good Planning?

Portability introduces a new tax analysis - planners must now compare the potential income tax detriment of the traditional by-pass trust plan to the estate tax detriment of a simple “I Love You” will plan.

1. Modest Growth The following example illustrates this issue and assumes modest growth in the asset values:

101

See General Explanations of the Administration’s Fiscal Year 2012 Revenue Proposals, February 15, 2011 (TNT). The website link is: http://www.treasury.gov/resource-center/tax-policy/Documents/Final%20Greenbook%20Feb%202012.pdf; General Explanations of the Administration’s Fiscal Year 2013 Revenue Proposals, February 13, 2012 (TNT). The website link is: http://www.treasury.gov/resource-center/tax-policy/Documents/General-Explanations-FY2013.pdf.

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Example 18: H and W are married only once to each other. H and W have always resided in Florida (a non-community property state with no state death tax). H is 73 years old; W is 68 years old. They are receptive to any form of asset ownership and are willing to shift ownership, provided there are no adverse income tax consequences.

102 Their descendants will survive both H

and W. H dies in 2012. W, who does not remarry, dies in 2021 (i.e., 9 years later). A corporate fiduciary will act in all fiduciary capacities (i.e., as personal representative and successor trustees) upon H and W’s deaths. When H dies, his assets will pass to W (in trust or otherwise). Upon W’s death, the net assets will be distributed to the descendants (in trust or otherwise). H and W make no lifetime taxable gifts. The estate, gift and GST tax laws, as they exist today, will continue through W’s year of death, where the basic exclusion amount will increase from $5.12 million in 2012 to $6 million in 2021,

103 and

the transfer tax rate will be a flat 35% over any applicable exclusion amount. At the time of H’s death, the couple’s combined net worth was $8 million; each having $4 million in their individual names.

If the value of their net worth grows to $10 million from the time of H’s death to W’s death,104 the following results occur:

a. The Estate Tax Analysis Under a traditional by-pass trust plan, H’s $4 million would fund the by-pass trust. If portability is elected, H’s inherited exclusion amount will be $1.12 million will be ported to W. When W dies, her Applicable Exclusion Amount would be $7.12 million (i.e., her assumed BEA of $6 million in 2021 and H’s ported inherited exclusion amount of $1.12 million). At W’s death her estate would not be subject to estate tax, because her gross estate will only include the $4 million of assets in her name that grew to $5 million, which is well below her $7.12 million Applicable Exclusion Amount.

Under a simple will plan, H would leave his entire estate to W which would qualify for the marital deduction. Accordingly, H uses none of his BEA, and ports his entire BEA (of $5.12 million) to W. When W dies, there will be no estate tax, because her gross estate would be $10 million and her Applicable Exclusion Amount would be $11.12 million (i.e., the sum of her assumed $6 million BEA and $5.12 million inherited exclusion amount).

Both the by-pass trust plan and the simple will plan yield the same estate tax result. The tax analysis, however, does not end there – we should consider income taxes, too.

b. The Income Tax Analysis Under the by-pass trust plan, H’s by-pass trust was funded with $4 million. When W died, we assumed that it grew to $5 million. Since the assets were in a by-pass trust, they were not included in W’s gross estate, and therefore were not afforded the basis adjustment upon W’s death. Accordingly, there is an unrealized gain of $1 million encumbering those by-pass trust assets (that will be triggered when sold). If we assume that the gain would be a capital gain and the income tax rate for capital gains is 20%, then there is a future potential tax of $200,000.

Under the simple will plan, since all of the assets were owned by W at death, they were included in her gross estate. Therefore, under Code § 1014, the assets’ bases were adjusted upwards to $10 million.

102

Section 1041 provides that asset ownership can be shifted from one spouse to the other without tax consequence for most assets. The major exception is IRAs and other forms of deferred compensation. 103

This equates to roughly a 2% cost-of-living adjustment. 104

This growth equates to roughly 2.5% compounded annually.

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This results in no unrealized gain and no potential future capital gain tax. Thus, the simple will plan yields a “better” result, at least from the income tax perspective.

If the asset values decrease over time, then there is a preserved capital loss in the by-pass trust. Thus, planners should always look at both possibilities (i.e., asset value increase and decrease).

2. More Significant Growth What happens if there is a greater increase in value of the assets from H’s to W’s death? The following example better demonstrates the tension between the estate and income tax.

Example 19: Assume the same facts as Example 18, except that the assets increase in value from $8 million at H’s death to $16.24 million at W’s death.

a. The Estate Tax Analysis Under the by-pass trust plan, the results at H’s death would be the same as in the prior example (i.e., a $4 million by-pass trust is funded and H’s inherited exclusion amount of $1.12 million is ported to W). However, at W’s death there will be an estate tax because W’s gross estate will now be $8.12 million (i.e., her $4 million would have appreciated to that amount). W’s Applicable Exclusion Amount is $7.12 million, thus, she would have a taxable estate of $1 million. At a 35% estate tax rate, the estate tax liability would be $350,000.

Under the simple will plan, the result at H’s death would be the same as in the prior example (i.e., H’s $5.12 million inherited exclusion amount would be ported to W). When W later dies, her estate would be liable for estate taxes. In this case, her gross estate would be $16.24 million, while her Applicable Exclusion Amount would be $11.12 million, resulting in $5.12 million being taxed at 35%, which equates to a $1.792 million estate tax.

b. The Income Tax Analysis Under the by-pass trust plan, H’s by-pass trust was funded with $4 million. When W died, we assumed that it grew to $8.12 million. Thus, there is an unrealized gain of $4.12 million, which would result in a potential capital gain tax of $824,000 when the assets are sold (assuming the same 20% capital gain rate).

Under the simple will plan, all of H’s assets pass to W and are included in her gross estate. Thus, upon death W’s assets received a basis adjustment to $16.24 million, resulting in no unrealized gain and no income tax.

When the investment return increases, relying on portability yields a less beneficial tax result. Even if the potential income tax on the unrealized gain would be paid immediately upon W’s death, the total estate and income taxes would only be $1.174 million under the by-pass trust plan, compared with $1.792 million under the simple will plan. Thus, in this case, from an estate and income tax perspective, the simple will plan appears to be inferior to the by-pass trust plan.

3. Preliminary Conclusion About the Estate and Income Tax Issues It appears that the same three factors that one generally is concerned with in transfer planning in general are also relevant in portability planning: (1) time; (2) taxes; and (3) investment rate of return. Changes in any of these factors affect what the optimal plan ought to be – or, with hindsight, what the optimal plan ought to have been.

The example above is over-simplified to illustrate the dichotomy of the income and estate tax issue. For instance, the example assumed all growth was subject to capital gains tax, whereas, often times ordinary income tax rates are applied to part of the growth (i.e., the ordinary income component on taxable interest, for instance). Clearly rate differentials between individual and trust income tax rates should be analyzed, realistic costs for preparing and filing income tax returns should be considered, and other administrative costs should also be taken into account. Part Two of this paper will addresses these points in greater detail, as well as other factors that may impact planning decisions and how

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creating flexibility in planning can help to achieve potentially better results when working in an environment of unknown variables.

B. Rev. Proc. 2001-38 and QTIP Elections Revenue Procedure 2001-38105 is important to understand in the context of portability planning. Initially, consider this procedure in its context prior to the advent of portability. The IRS issued the revenue procedure in response to numerous requests for relief in situations in which the estate made an unnecessary QTIP election. For example, the procedure is designed to provide relief if a QTIP election is made for an estate having a value less than the applicable exclusion amount under Section 2010. In such as case, the election is unnecessary because no estate tax would be imposed without the election. The procedure notes that in some cases QTIP elections were mistakenly made for by-pass trusts.106 Remember, a QTIP election once made is irrevocable and it carries tax implications for the surviving spouse: (i) a QTIP election causes the trust to be included in the surviving spouse’s estate under Section 2044, (ii) in the event the surviving spouse disposes of any part of the income interest during his or her lifetime, a Section 2519 transfer would occur, and (iii) the surviving spouse becomes the transferor of the QTIP property for GST purposes, unless the reverse QTIP election is made.

The procedure applies to QTIP elections under Section 2056(b)(7) where the election was not necessary to reduce the estate tax liability to zero, based on final estate tax values. Rev. Proc. 2001-38 specifically does not apply to protective elections; or where a partial QTIP election was needed to reduce estate tax liability to zero and the executor made the election with respect to more property than was necessary; or to elections that are stated in terms of a formula designed to reduce the estate tax to zero. For example, if the executor made 50% QTIP election, when a 35% election would have zeroed out estate taxes, the procedure offers no relief.

If the QTIP election is within the scope of the procedure the election will be ignored for federal estate, gift and GST tax purposes, and the property will not be subject to transfer tax in the surviving spouse’s estate. The ruling makes a blanket statement that “In the case of a QTIP election within the scope of this revenue procedure, the Service will disregard the election and treat it as null and void for purposes of sections 2044(a), 2056(b)(7), 2519(a), and 2652.” Then the Service sets forth a procedure to follow in establishing whether an election is within the scope of the revenue procedure:

To establish that an election is within the scope of this revenue procedure, the taxpayer must produce sufficient evidence to that effect. For example, the taxpayer may produce a copy of the estate tax return filed by the predeceased spouse's estate establishing that the election was not necessary to reduce the estate tax liability to zero, based on values as finally determined for federal estate tax purposes. Such information, including an explanation of why the election should be treated as void under this revenue procedure, should be submitted either with the Form 706 filed for the surviving spouse's estate, or with a request for a private letter ruling submitted at any time prior to filing that Form 706.

Rev. Proc. 2001-38 does not state whether the Service could an ignore election within the scope of the procedure on its own accord or whether this procedure’s relief is solely within the control of the taxpayer. This is the crux of the issue as concerns portability.

105

Rev. Proc. 2001-38, 2001-1 C.B. 1335 (06/11/2001). 106

See PLR 2011120001 (3/25/2011)(erroneous QTIP election for by-pass trust ruled void).

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Example 20: Suppose H1 dies leaving his entire $4 million estate to a QTIP trust for W. H1 has made no taxable gifts. H1’s BEA is $5 million. The QTIP election is made and the portability election is made. Therefore, the QTIP trust is within the scope of Rev. Proc. 2001-38. The question is whether H1’s entire $5 million exclusion is ported.

If the QTIP trust in the example appreciates to $5 million before the surviving spouse dies, then the surviving spouse’s estate may wish to provide the information to show the QTIP election was within the scope of the procedure – i.e., voiding the QTIP election – and have the effect of a by-pass trust. In this permutation, $1 million of inherited exclusion is preserved as compared to having a $5 million dollar inclusion under Section 2044 with $5 million of inherited exclusion amount.107 It seems that this permutation is within the scope of the relief the Service sought to provide by the procedure. The fact that $1 million of inherited exclusion is ported is a natural result flowing from having used less than all of the $5 million BEA upon H1’s death.

On the other hand, if the QTIP trust in the example goes down in value to $3 million before the surviving spouse dies, then keeping the QTIP election in play and relying on portability may be better. In this permutation, surviving spouse would have $5 million of inherited exclusion and only $3 million in the QTIP trust to be included under Section 2044, thereby preserving $2 million of inherited exclusion as compared to just having $1 million of inherited exclusion if the QTIP election is void – i.e., the QTIP trust is in effect treated as a by-pass trust. This is the permutation that arguably the Service did not agree to accept by the relief granted under the procedure. It is unlikely the Service could have foreseen this benefit to keeping a QTIP election within the scope of the procedure in effect. Therefore, the concern is that Service would declare the QTIP election is void on its own accord.

Noted authority, Howard M. Zaritsky summed up the analysis as follows:

[A] similar issue was raised by the regs. under Section 2040. The regs, which still apply to property owned jointly with a right of survivorship between the decedent and someone other than the decedent's spouse, state:

‘The entire value of jointly held property is included in a decedent's gross estate unless the executor submits facts sufficient to show that property was not acquired entirely with consideration furnished by the decedent, or was acquired by the decedent and the other joint owner or owners by gift, bequest, devise, or inheritance.’ Regs. Sec. 20.2040-1(a)(2) (flush language at end).

Practitioners tried to argue that this allowed the executor of the first co-owner's estate to decide whether or not to include the entire property in the estate (and obtain the basis increase), merely by declining to show contribution by the surviving co-owner. They had a slight problem, because the Code itself states that inclusion occurred except to the extent that it ‘may be shown to have originally belonged to such other person . . . .’

Some courts held that the entire property was includible unless the executor showed contribution by the survivor. See, e.g., Rule v. United States, 105 Ct.Cl. 176, 191, 63 F.Supp. 351, 359-60 (1945); Estate of Saunders, 14 T.C. 534, 541 (1950); Tuck v. United States, 282 F.2d 405, 409-10 (9 Cir. 1960); English v. United States, 270 F.2d 876, 879-80 (7 Cir. 1959). The Tax Court also stated that: ‘Where the Commissioner determines that the entire value of jointly held property is includable in the gross estate, the taxpayer has the burden of

107

If the QTIP election is void, the $1 million of appreciation would not be eliminated by the step-up in basis rule as a result of inclusion in the surviving spouse’s estate under Section 2044.

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proving such determination invalid.’ Estate of Sylvester v. Comm'r, T.C. Memo. 1977-439, citing Estate of Peabody v. Comm'r, 41 B.T.A. 1 (1940).

In Madden v. Comm'r, 52 T.C. 845 (1969) and Estate of Fleming v. Comm'r, T.C. Memo. 1974-377, however, the Tax Court appears to have accepted that either party could prove the contribution by the surviving co-owner.

This walk down Memory Lane may not mean much, but it suggests that the IRS has some history of dealing with situations in which they try and put the burden of raising a particular issue on the executor, and then decide that they will raise it themselves in appropriate cases.

Therefore, while I believe one can reasonably read Rev. Proc. 2001-38 to require the triggering action of the surviving spouse's executor in order to void the first estate's QTIP election, the better analysis is that the IRS can itself decide to make this decision.

108

For planning purposes, it may not be wise to establish a QTIP trust and make an election within the scope of Rev. Proc. 2001-38 to enable the portability election. Rather than using a QTIP trust, one might use a general power of appointment marital trust or an outright disposition to the surviving spouse. If using a QTIP trust is important for control purposes or GST planning purposes, focus on QTIP elections that are outside the scope of the revenue procedure. For example, the ruling only applies to estate tax QTIP elections. Gift tax QTIP elections are beyond the scope of the ruling. Also, for example, a testamentary QTIP trust having a size in excess of the deceased spouse’s applicable exclusion amount would be outside the scope of the procedure, since without the QTIP election an estate tax would result. Part Two of this paper will explore these planning issues in further detail.

C. GST Planning Portability does not extend to the deceased spouse’s GST exemption. The following discusses one alternative to utilize the GST exemption of the deceased spouse in a portability driven plan.109

1. Inter Vivos Transfers Since spouses cannot port the GST exemption at death, consider plans by which GST exemption is utilized during life as a means to effect a virtual portability of the GST exemption at death.

2. Inter Vivos QTIP Trust Utilizing the “Reverse QTIP Election” Pursuant to Section 2652(a)(3), in the case of a QTIP Trust for which a marital deduction is allowed for estate tax purposes (under Section 2056(b)(7)) or for gift tax purposes (under Section 2523(f)), the estate or the donor, as the case may be, may elect for GST purposes to treat all of the property in such trust as if the QTIP election had not been made (the “Reverse QTIP Election”). While the trust qualifies for the marital deduction and is includible in the spouse’s gross estate, for GST purposes, the decedent/donor is deemed to remain as the transferor and therefore his or her GST exemption is applied against such property.

QTIP trusts utilizing a Reverse QTIP Election can be implemented in a portability-driven estate plan in the following way (assume for all purposes that (a) portability is in effect, and (b) the maximum basic exclusion amount at all times is $5 million).

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Mr. Zaritsky is quoted with permission. 109

Many commentators have advocated for Congress to implement portability for GST purposes. This analysis assumes the current law under which there is no such portability.

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Example 21: H, who has $10 million in individual assets, is married to W, who has no assets. H creates an inter vivos QTIP trust and transfers $5 million into such trust. On his gift tax return reporting the taxable gift, in addition to the QTIP election, H effects the Reverse QTIP Election. H dies with his remaining $5 million, which he leaves outright to W and qualifies for the Federal estate tax marital deduction. H’s executors elect portability and W receives $5 million in inherited exclusion amount from H.

As a result of the QTIP election, no part of H’s applicable exclusion amount is utilized on the gift and the entire amount will be taxed in W’s estate upon her death (and, ordinarily, W would become the transferor of the property for GST purposes). The Reverse QTIP Election causes H to be the transferor for GST purposes; thus, even though the property will not be taxed for estate tax purposes until W’s death, for GST purposes, the taxable transfer occurs upon the gift and H becomes transferor for GST purposes of the $5 million.

Upon W’s death, she has a gross estate of $10 million, $5 million of which is disposed of under her planning documents and against which she allocates her $5 million GST exemption; the remaining $5 million of her gross estate in the QTIP trust is already GST exempt on account of the H’s Reverse QTIP Election. W’s estate does not owe any Federal estate taxes because she has an Applicable Exclusion Amount of $10 million, comprised of her $5 million BEA and the $5 million inherited exclusion amount received from H.

Why implement this type of plan? One reason is to obtain the step-up in basis for income tax purposes upon W’s death on all assets. Another reason is that the couple could live in a state with a separate state estate tax. Funding a by-pass trust with $5 million (and allocating GST exemption to such trust) upon the first spouse’s death could cost approximately $450,000 in state death taxes. This inter vivos QTIP trust/portability plan could be used to avoid state death taxes upon the deceased spouse’s death, but preserve the use of both spouses’ GST exemptions and obtain a full basis step-up upon the surviving spouse’s death for all of their aggregate assets. Part Two of this paper will explore such GST planning ideas in further detail, as well as other uses of inter vivos QTIPs in relation to using the applicable credit amounts of both spouses.

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Appendix A

Selected Sections of the Internal Revenue Code In effect for 2012 (as of January 2012)

Section 2001 – Imposition of rate of tax (a) Imposition. A tax is hereby imposed on the transfer of the taxable estate of every decedent who is a citizen or resident of the United States. (b) Computation of tax. The tax imposed by this section shall be the amount equal to the excess (if any) of—

(1) a tentative tax computed under subsection (c) on the sum of— (A) the amount of the taxable estate, and (B) the amount of the adjusted taxable gifts, over

(2) the aggregate amount of tax which would have been payable under chapter 12 with respect to gifts made by the decedent after December 31, 1976, if the modifications described in subsection (g) had been applicable at the time of such gifts.

For purposes of paragraph (1)(B), the term “adjusted taxable gifts” means the total amount of the taxable gifts (within the meaning of section 2503) made by the decedent after December 31, 1976, other than gifts which are includible in the gross estate of the decedent. (c) Rate schedule.

If the amount with respect to which the tentative tax to be computed is: The Tentative tax is:

Not over $10,000 18% of such amount

Over $10,000 but not over $20,000 $1,800, plus 20% of the excess of such amount over $10,000

Over $20,000 but not over $40,000 $3,800, plus 22% of the excess of such amount over $20,000

Over $40,000 but not over $60,000 $8,200, plus 24% of the excess of such amount over $40,000

Over $60,000 but not over $80,000 $13,000, plus 26% of the excess of such amount over $60,000

Over $80,000 but not over $100,000 $18,200, plus 28% of the excess of such amount over $80,000

Over $100,000 but not over $150,000 $23,800, plus 30% of the excess of such amount over $100,000

Over $150,000 but not over $250,000 $38,800, plus 32% of the excess of such amount over $150,000

Over $250,000 but not over $500,000 $70,800, plus 34% of the excess of such amount over $250,000

Over $500,000 $155,800, plus 35% of the excess of such amount over $500,000

(2) Repealed.

… (g) Modifications to gift tax payable to reflect different tax rates. For purposes of applying subsection (b)(2) with respect to 1 or more gifts, the rates of tax under subsection (c) in effect at the decedent's death shall, in lieu of the rates of tax in effect at the time of such gifts, be used both to compute—

(1) the tax imposed by chapter 12 with respect to such gifts, and (2) the credit allowed against such tax under section 2505, including in computing—

(A) the applicable credit amount under section 2505(a)(1), and

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(B) the sum of the amounts allowed as a credit for all preceding periods under section 2505(a)(2). Section 2010 - Unified credit against estate tax. (a) General rule. A credit of the applicable credit amount shall be allowed to the estate of every decedent against the tax imposed by section 2001. (b) Adjustment to credit for certain gifts made before 1977. The amount of the credit allowable under subsection (a) shall be reduced by an amount equal to 20 percent of the aggregate amount allowed as a specific exemption under section 2521 (as in effect before its repeal by the Tax Reform Act of 1976) with respect to gifts made by the decedent after September 8, 1976. (c) Applicable credit amount.

(1) In general. For purposes of this section, the applicable credit amount is the amount of the tentative tax which would be determined under section 2001(c) if the amount with respect to which such tentative tax is to be computed were equal to the applicable exclusion amount. (2) Applicable exclusion amount. For purposes of this subsection, the applicable exclusion amount is the sum of—

(A) the basic exclusion amount, and (B) in the case of a surviving spouse, the deceased spousal unused exclusion amount.

(3) Basic exclusion amount. (A) In general. For purposes of this subsection, the basic exclusion amount is $5,000,000. (B) Inflation adjustment. In the case of any decedent dying in a calendar year after 2011, the dollar amount in subparagraph (A) shall be increased by an amount equal to—

(i) such dollar amount, multiplied by (ii) the cost-of-living adjustment determined under section 1(f)(3) for such calendar year by substituting “calendar year 2010” for “calendar year 1992” in subparagraph (B) thereof.

If any amount as adjusted under the preceding sentence is not a multiple of $10,000, such amount shall be rounded to the nearest multiple of $10,000. (4) Deceased spousal unused exclusion amount. For purposes of this subsection, with respect to a surviving spouse of a deceased spouse dying after December 31, 2010, the term “deceased spousal unused exclusion amount” means the lesser of—

(A) the basic exclusion amount, or (B) the excess of—

(i) the basic exclusion amount of the last such deceased spouse of such surviving spouse, over (ii) the amount with respect to which the tentative tax is determined under section 2001(b)(1) on the estate of such deceased spouse.

(5) Special rules. (A) Election required. A deceased spousal unused exclusion amount may not be taken into account by a surviving spouse under paragraph (2) unless the executor of the estate of the deceased spouse files an estate tax return on which such amount is computed and makes an election on such return that such amount may be so taken into account. Such election, once made, shall be irrevocable. No election may be made under this subparagraph if such return is filed after the time prescribed by law (including extensions) for filing such return. (B) Examination of prior returns after expiration of period of limitations with respect to deceased spousal unused exclusion amount. Notwithstanding any period of limitation in section 6501, after the time has expired under section 6501 within which a tax may be assessed under chapter 11 or 12 with respect to a deceased spousal unused exclusion amount, the Secretary may examine a return of the deceased spouse to make determinations with respect to such amount for purposes of carrying out this subsection.

(6) Regulations. The Secretary shall prescribe such regulations as may be necessary or appropriate to carry out this subsection.

(d) Limitation based on amount of tax. The amount of the credit allowed by subsection (a) shall not exceed the amount of the tax imposed by section 2001.

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§ 2501 Imposition of tax. (a) Taxable transfers.

(1) General rule. A tax, computed as provided in section 2502, is hereby imposed for each calendar year on the transfer of property by gift during such calendar year by any individual, resident or nonresident.

… § 2502 Rate of tax. (a) Computation of tax. The tax imposed by section 2501 for each calendar year shall be an amount equal to the excess of—

(1) a tentative tax, computed under section 2001(c), on the aggregate sum of the taxable gifts for such calendar year and for each of the preceding calendar periods, over (2) a tentative tax, computed under such section, on the aggregate sum of the taxable gifts for each of the preceding calendar periods.

… § 2505 Unified credit against gift tax. (a) General rule. In the case of a citizen or resident of the United States, there shall be allowed as a credit against the tax imposed by section 2501 for each calendar year an amount equal to—

(1) the applicable credit amount in effect under section 2010(c) which would apply if the donor died as of the end of the calendar year, reduced by (2) the sum of the amounts allowable as a credit to the individual under this section for all preceding calendar periods. For purposes of applying paragraph (2) for any calendar year, the rates of tax in effect under section 2502(a)(2) for such calendar year shall, in lieu of the rates of tax in effect for preceding calendar periods, be used in determining the amounts allowable as a credit under this section for all preceding calendar periods.

(b) Adjustment to credit for certain gifts made before 1977. The amount allowable under subsection (a) shall be reduced by an amount equal to 20 percent of the aggregate amount allowed as a specific exemption under section 2521 (as in effect before its repeal by the Tax Reform Act of 1976) with respect to gifts made by the individual after September 8, 1976. (c) Limitation based on amount of tax. The amount of the credit allowed under subsection (a) for any calendar year shall not exceed the amount of the tax imposed by section 2501 for such calendar year.