Why should we be concerned about estate tax if our estate is less than $12.06 million?
If gridlock continues for legislation effecting taxation, then the exemption drops to approximately $6 million on January 1, 2026 ($5,490,000 indexed for inflation) under current law. President Biden sought to further reduce the exemption to $3.5 million. No one knows what the long-term future may bring.
In the event of a death, we should consider taking advantage of the current $12.06 million exemption. Note that this exemption is a “use it or lose it” planning alternative. Without proper planning, a married couple can and often does lose one of the two (2) lifetime exemptions available for a married couple.
For most families, an overall estate plan will leave all or a substantial amount for the surviving spouse. Assets left to a surviving spouse qualify for an “unlimited marital deduction.” The terms “unlimited” and “deduction” would seem to be a good thing. However, this can trigger higher taxes. If there is no taxable estate on the death of the first spouse because all costs go to the surviving spouse and qualify for the martial deduction, then the deceased spouse’s exemption is lost. The family’s available estate tax exemption was effectively reduced from $24.12 million to $12.06 million due to poor planning.
Existing law provides a tool to prevent the loss of an estate tax exemption as described above. Existing tax law allows a deceased spouse to transfer any unused portion of his or her exemption to the spouse if the decedent was married. This tool is referred to generally as “portability”. Sadly, many families are unaware of this opportunity and fail to take advantage of this important tool or planning alternative.
For example, let’s consider a family (husband, wife, kids) with a $10 million estate which is community property. That is, one-half (1/2) is owned by each spouse. If husband dies today, your initial thought is that we don’t have to worry about estate tax. There is a $12.06 million exemption for Husband and another $12.06 million for wife. That is a combined exemption of $24.12 million. The estate is only $10 million.
However, if wife lives to at least January 1, 2026 (and we all hope that she does), then the family may have an estate tax liability of $1,600,000. This must be paid in full in cash 9 months from the date of death with certain regular limited exceptions. This may trigger the need to sell assets to pay the tax. Such a sale may result in a lower sale price. This is without regard to any future appreciation in the assets from husband's death in 2022 to wife’s death in 2026.
How can that be? The estate tax exemption fell to approximately $6,000,000 on January 1, 2026. Wife will hold an estate worth $10 million (without regard to future appreciation). The taxable estate after the exemption is $4 million. With an estate tax rate of 40%, that triggers an estate tax liability in the amount of $1,600,000. This amount, without certain very limited exceptions, must be paid in full in cash 9 months after his death.
In order to prevent the loss of husband’s $12.06 million exemption, a portability election may be made on a timely filed estate tax return for his death. This filing “ports” or transfers his entire lifetime exemption of $12.06 million to the wife’s estate. The family just saved $1,400,000 in estate tax that would otherwise be due.
The only “downside” to filing for the portability election is the cost of filing the required estate tax return (IRS Form 706). A portability only estate tax return can be filed up to two (2) years from the date of death. The valuation rules are relaxed for the filing of an estate tax return solely for the sale of portability. Nevertheless, there is a cost to the filing which will typically rise in relation to the value, complexity of the estate and the number and type of assets held. With the potential for a reduction in the estate tax exemption a portability election may be considered as a form of insurance to protect the family from an unexpected estate tax liability. Consideration should be given upon the death of a married person with a total estate of $2 million, or $3 million.
Consideration should also be made to provide for portability pre and post marital agreements. In the event of a divorce or separation, even a well-crafted and thought out estate plan may still trigger an estate tax liability. A provision providing the right to make a portability election in the event of a marital separation may be of substantial benefit to the surviving spouse.