Estate planning with portability in mind, part II.

• Author: Law, Lester B.
• Position: TAX LAW

This is the second part of a two-part article: Part one, published in last month's issue of The Florida Bar Journal, discussed the factors to consider in portability planning and addressed some of the ambiguities with the new law. Part two addresses strategies when planning with portability in mind.

Given the wide range of client circumstances (e.g., marital status, age, wealth, family issues, health, etc.), our aim is to provide a framework for analysis where portability is a factor.

Traditional Plan Versus Basic Portability Plan

In part one, we compared the traditional plan with the basic portability plan. The traditional plan (illustrated in Figure 1, next page) provides that each spouse has a pour-over will with a revocable trust incorporating by-pass (or credit shelter) and marital trust planning. (1) By comparison, the basic portability plan (illustrated in Figure 2, next page) provides that the couple has "I Love You" wills (i.e., where they leave everything outright to the surviving spouse).

Applying various assumptions, we use the traditional and basic portability plans as a basis to illustrate the pros and cons of portability planning. As shown below, there are times when neither plan is a good fit. In such instances, enhancements can be made to either or both plans to help achieve a better result for the client.

The Estate Tax Versus Income Tax: A New Analysis

Before moving forward, it is important to understand that portability introduces a new tax analysis--planners must now compare the potential income tax detriment to the estate tax detriment under both plans. The following example illustrates this issue:

* Example One--Assume that this is H and W's (2) first and only marriage. H and W have always resided in Florida (a noncommunity property state). 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. (3) Their descendants will survive both H and W. H dies in 2012. W, who does not remarry, dies in 2021 (i.e., nine 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 Ws 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 (4) will increase (5) from $5.12 million in 2012 to $6 million in 2021, (6) and the transfer tax rate will be a flat 35 percent 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.

Let's look at what happens if the value of their net worth grows to $10 million from the time of H's death to W's death. (7)

> The Estate Tax Analysis--Under the traditional plan, H's $4 million would fund the by-pass trust. If W makes the portability election, (8) H's deceased spousal unused exemption amount (DSUEA) (9) of $1.12 million (10) will be ported to W. When W dies, her applicable exclusion amount (AEA) (11) would be $7.12 million (i.e., her assumed basic exclusion amount (BEA) of $6 million in 2021 and H's DSUEA 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, (12) which is well below her $7.12 million AEA.

Under the basic portability plan, H would leave his entire estate to W, which would qualify for the marital deduction under IRC [section] 2056. Accordingly, H uses none of his AEA, and ports his entire DSUEA (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 AEA would be $11.12 million (i.e., the sum of her assumed $6 million BEA and $5.12 million DSUEA).

Both the traditional plan and the basic portability plan yield the same estate tax result. The tax analysis, however, does not end there--we should consider income taxes, too.

> The Income Tax Analysis--Under the traditional plan, H's by-pass trust was funded with $4 million. When W died, we assumed that it grew to $5 million. Remember, because 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 percent, then there is a future potential tax of $200,000.

Under the basic portability plan, because all of the assets were owned by W at death, they were included in her gross estate. Therefore, under IRC [section] 1014, the assets' bases were adjusted upward to $10 million. This results in no unrealized gain and no potential future capital gain tax.

Thus, the basic portability plan yields a "better" result, at least from the income tax perspective.

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* Example One Estate Tax and Income Tax Summary--The chart on the following page summarizes the results under the different plans and illustrates how portability injects a new dimension in transfer tax planning.

It should be noted that if the asset values decrease over time, then there is a preserved capital loss in the by-pass trust. Thus, one should always look at both possibilities (i.e., asset value increase and decrease). Now let's look at another example and examine what happens if there is a greater increase in...