In 2012, Congress passed the American Taxpayer Relief Act. That Act, in addition to implementing the $5,000,000 federal estate tax exemption amount per person (adjusted for inflation which, as of 2017, results in an exemption per person) also implemented new so-called “portability” rules. Under the portability rules, if a decedent passes away without utilizing the entire $5,490,000 federal estate tax exemption amount, any “unused” exemption may be “ported” or transferred to the decedent’s surviving spouse if certain conditions are met (such as filing a federal estate tax return for the decedent).
Marital Deduction Increases Portability and Allows Second Basis “Step Up”
Where a decedent’s assets pass to a surviving spouse and the decedent obtains a marital deduction, the amount of the marital deduction may increase the amount of the decedent’s unused federal estate tax exemption amount that may be transferred to the surviving spouse (since assets qualifying for the marital deduction do not absorb any of the federal estate tax exemption). Although outright distributions to a surviving spouse qualify for the marital deduction, certain trust arrangements may also qualify for the marital deduction if an election is made. Under this rule, if a decedent leaves assets in trust for the benefit of the decedent’s spouse, income from the trust must be paid annually to the spouse, the assets held in the trust must be made productive upon demand of the surviving spouse, and an election (a so-called “QTIP” election) is made on the decedent’s federal estate tax return, then the value of the assets passing to the QTIP trust qualify for the marital deduction. Therefore, the property held in the QTIP trust may increase the decedent’s unused federal estate tax exemption. Another consequence of this QTIP election is that the assets in the QTIP trust remaining upon the surviving spouse’s death are included in the surviving spouse’s estate for federal estate tax purposes and, as a result, also obtain a step-up (or step-down) in income tax basis upon the surviving spouse’s death (thereby lowering potential income taxes to the beneficiaries upon a subsequent sale of the assets previously held in trust). This may be referred to as a “double” step-up since the assets obtain a step-up in basis on the first spouse’s death, then again on the second spouse’s death.
Portability Provides Some Optionality When Making QTIP Elections
With the new portability rule and the high federal estate tax exemptions, many married clients may want to have assets pass in trust for the benefit of the surviving spouse (for non-tax reasons, such as asset protection), allow maximum portability of the estate tax exemption, and allow the assets to obtain a second step-up in basis on the surviving spouse’s death. For example, if a decedent has assets worth $3,000,000 (and his surviving spouse has assets of $5,000,000), his estate plan may provide that all of his assets (all $3,000,000) will be held in trust for the benefit of the surviving spouse. Prior to portability, the decedent’s executor would generally not make a QTIP election but utilize $3,000,000 of the decedent’s federal estate tax exemption with the trust arrangement because the decedent’s federal estate tax exemption amount, if any, must have been used at his death or would simply be lost (and, if a marital deduction were made, the surviving spouse’s estate would risk a federal estate tax since her assets plus the QTIP trust’s assets would exceed her single $5,490,000 exemption). Upon the surviving spouse’s death, without a QTIP election, the assets held in the decedent’s trust would not obtain a step-up in tax basis. However, under current law, the decedent may want his executor to have the option to cause the trust to make a QTIP election rather than utilizing $3,000,000 of his federal estate tax exemption. In such a case, the decedent’s entire $5,490,000 federal estate tax exemption is transferred to the surviving spouse (meaning the spouse would have up to $10,980,000 of exemption to utilize at her death, enough to shield $8,000,000 of estimated assets) and because a QTIP election was made, the trust will also obtain a potential step-up in income tax basis upon the surviving spouse’s death. In other words, all $8,000,000 would obtain a step up in tax basis on the surviving spouse’s death, no federal estate taxes would be owed, and the $3,000,000 would be protected in trust for the surviving spouse’s life.
Rev. Proc. 2001-38 Clarifies the Availability of QTIP Elections for Portability
Practitioners, however, have been wondering whether a QTIP election in an example such as this where the election is not needed to bring the estate tax to $0 on the first spouse’s death (since the decedent’s total estate is less than the decedent’s federal estate tax exemption) was valid. Under a prior Revenue Procedure, Rev. Proc. 2001-38, if an estate makes a QTIP election that was wholly unnecessary to eliminate the Federal estate tax, the surviving spouse, or the surviving spouse’s estate, could seek relief disregarding the QTIP election. Thus, the existence of this Revenue Procedure caused a concern as to whether a QTIP election not needed for a $0 estate tax was perfectly acceptable, void, or voidable. Under recently issued Rev. Proc. 2016-49, the IRS has indicated that it will not treat an unnecessary QTIP election as void if the executor made a portability election. Therefore, QTIP elections may be used for portability purposes and to enhance both estate and income tax planning. In addition, such elections may be useful in states with a state estate tax where the state exemption amount is lower than the federal estate tax exemption amount and that doesn’t allow a separate state-only QTIP election (but only follows the federal rule). In such cases, an estate may make a valid Federal QTIP election to obtain both portability and a marital deduction for state estate tax purposes.