A Fix for the Estate Tax Exemption

Congress considers a good idea

By Kaye A. Thomas
Posted June 18, 2008

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Federal transfer tax rules offer a complete exemption for transfers between spouses (assuming the spouse is a U.S. citizen). Yet leaving your entire estate to your spouse can be a colossal blunder. The reason is that the estate tax provides each person with a credit that acts as an exemption for transfers up to a certain dollar amount, currently set at $2,000,000. Leaving everything to your spouse wastes your exemption amount.

Example: You leave $3,000,000 of your $5,000,000 estate to your spouse and $2,000,000 to your children. No estate tax applies to this transfer: your exemption amount covers the transfer to the children, and transfers to your spouse are exempt. If your spouse dies and leaves $3,000,000 to the children, another $2,000,000 exemption amount is available, and the estate tax applies to $1,000,000.

If you leave everything to your spouse, the $5,000,000 transfer is once again free of estate tax. If your spouse dies and leaves $5,000,000 to the children, though, the estate tax applies to $3,000,000, the amount in excess of the $2,000,000 exemption. Leaving everything to your spouse causes the estate tax to apply to an additional $2,000,000.

There's another way the estate tax exemption can be wasted. If total wealth is $5,000,000, but 90% is in the hands of one spouse, the death of the other spouse (holding $500,000) would waste $1,500,000 of the $2,000,000 exemption that might otherwise be used to transfer wealth to the younger generation.

There are ways to deal with these problems. In the first case, $2,000,000 of the estate can go into a trust designed to use the first spouse's exemption amount, provide lifetime benefits to the surviving spouse, and go to the children without further application of the estate tax on the death of the second spouse. In the second case, the solution may be to transfer some of the wealth from one spouse to another so that each holds wealth at least equal to the exemption amount. Planning of this kind is grist for the estate planning mill that occupies so many lawyers and finance professionals.

Much of this planning is contrary to the basic wishes of the parties involved, however. In many cases, the desire is simply for one spouse to leave everything to the other, and let the second spouse leave everything for the children. Pre-death transfers may not be desirable, and may incur unnecessary expenses. Establishing the trusts required to make full use of the estate tax exemption amount involves further expense, and there are costs involved in maintaining the trusts.

A great idea

These problems would go away  if Congress changed the law to allow the transfer of any unused portion of the estate tax exemption amount from one spouse to another at the death of the first to die. Congress is considering such a proposal now. It's too early to say the proposal will definitely become law in the near future, but Congress appears to be moving in the direction of making this welcome change.

The possibility of this legislation should not deter you from taking appropriate estate planning steps in the meantime. It's always difficult to predict when politics will derail even a popular and relatively uncontroversial piece of legislation.

You might think the lawyers who earn fees helping set up trusts and handle asset transfers would oppose a change that would eliminate the need for these arrangements. On the contrary, they prefer to spend their time more productively. A legislative proposal to create portability for the estate tax exemption received unanimous support from the Transfer Tax Study Committee of the American Counsel of Trust and Estate Counsel, and the chair of that committee testified in favor of that proposal at a recent hearing of the Senate Finance Committee, calling it an idea whose time has come.

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