An account of everything an individual owned or had interest in on the date of their death is included in the tax on the transfer of their property. This is called the estate tax. This includes cash and securities, real estate, insurance, trusts, annuities, business interests, and other assets. The tax is based on the fair market value of these assets (less certain exclusions), generally as of the day the decedent died.
An inflation-adjusted lifetime exclusion prevents smaller estates from being taxed. This exclusion is $5,450,000 for 2016, but it is adjusted (reduced) by the value of untaxed gifts that the decedent gave in excess of the annual gift exemption (currently $14,000) over his or her lifetime. Thus, if the value of all the decedent’s property is less than the adjusted exclusion amount, there would be no estate tax and, generally, no need to file an estate tax return. However, filing an estate tax return when it otherwise wouldn’t be needed may be beneficial to the surviving spouse when the decedent was married.
When a decedent is survived by a spouse and the decedent’s estate is worth less than the adjusted lifetime exclusion, the estate of the decedent may elect to pass any of the decedent’s unused lifetime exclusion to the surviving spouse. Considering that estate tax rates currently range from 18 to 40 percent, this can be very beneficial if the estate of the surviving spouse could exceed the adjusted lifetime exclusion when he or she subsequently passes.
Example – A husband with an estate valued at $2 million died in 2014, having made prior taxable gifts of $1 million. Even though there was no estate tax return filing requirement, the decedent’s spouse filed one to claim the election to pass the decedent’s unused lifetime exclusion to his spouse. The husband’s unused exclusion amount was $2.34 million, which is the 2014 estate tax exemption of $5.34 million minus the $1 million in prior taxable gifts and the $2 million value of his estate. His spouse can then add his unused exclusion to her own. Assuming that the spouse has made no taxable gifts, if she passes in 2016, her estate’s exclusion amount for 2016 would be $7.79 million (her $5.45 million basic exclusion amount plus $2.34 million of her spouse’s unused exclusion amount).
For the surviving spouse (or his or her estate) to claim the deceased spouse’s unused exclusion amount, the estate of the first spouse to die must make an election, referred to as the portability election, by filing a timely estate tax return. The estate tax return must include a computation of the unused exclusion amount. This is true even if the value of the estate is not enough to require an estate tax return to be filed.
This presents a quandary for the executor (or other representative of the estate, often the surviving spouse), who must decide whether it is worth the cost of having an estate tax return prepared and filed when there is no requirement to do so outside of making the portability election (as estate tax returns are quite complicated and expensive).
When making this decision, an executor needs to carefully consider the likelihood of the surviving spouse’s estate exceeding the adjusted lifetime exclusion amount. Another factor to consider is that Congress has changed both the lifetime exclusion amount and the estate tax rates in the past; as this topic seems to be a constant subject of discussion in Washington, there are no guarantees that the exemption will remain at its current level. If the executor is not the surviving spouse, he or she will ideally consult with the widow(er) on the decision, but this is not required. This could pose a problem if there is animosity between the executor and the surviving spouse. To avoid this situation, if someone other than the spouse is the executor of the estate for the first spouse to die, it is a good idea to include language in the couple’s wills or trusts that will require the executor to make the portability election.
If you have questions related to this election, the lifetime exclusion, the annual gift tax exemption, or estate planning in general, please give Dagley & Co. a call.
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