Portability and the New Paradigm
The newest feature on the estate planning landscape is portability. A full discussion of the planning implications of portability is beyond the scope of this outline and there are resources publicly available that cover the subject in a comprehensive manner. In the context of the “new paradigm” in estate planning discussed above, portability, at least in theory, can provide additional capacity for the surviving spouse’s estate to benefit from a “step-up” in basis with little or no transfer tax costs.
In traditional by-pass trust planning, upon the death an individual who has a surviving spouse, assets of the estate equal in value to the decedent’s unused Applicable Exclusion Amount fund a trust (typically for the benefit of the surviving spouse and, perhaps, descendants). The trust is structured to avoid estate tax inclusion at the surviving spouse’s estate. The marital deduction portion is funded with any assets in excess of the unused Applicable Exclusion Amount. The by-pass trust avoids estate tax inclusion at the surviving spouse’s estate. From an income tax standpoint, however, the assets in the by-pass trust do not receive a “step-up” in basis upon the death of the surviving spouse. Furthermore, while the assets remain in the by-pass trust, any undistributed taxable income above $12,150 of taxable income will be subject to the highest income tax rates at the trust level.
In portability planning, the decedent’s estate would typically pass to the surviving spouse under the marital deduction, and the DSUE Amount would be added to the surviving spouse’s Applicable Exclusion Amount. Because all of the assets passing from the decedent to the surviving spouse in addition to the spouse’s own asset will be subject to estate taxes at his or her death, the assets will receive a “step-up” in basis. Additional income tax benefits might be achieved if the assets that would otherwise have funded the by-pass trust are taxed to the surviving spouse, possibly benefiting from being taxed a lower marginal income tax bracket. In addition, if the by-pass trust would have been subject to a high state income tax burden (for example, California), having the assets taxed to a surviving spouse who moves to a low or no income tax state would provide additional income tax savings over traditional by-pass trust planning.
Of course, there are other considerations, including creditor protection and “next spouse” issues, which would favor by-pass trust planning. However, from a tax standpoint, the trade-off is the potential estate tax savings of traditional by-pass trust planning against the potential income tax savings of portability planning. Because the DSUE Amount does not grow with the cost-of-living index, very large estates ($20 million or above, for example) will benefit more with traditional by-pass trust planning because all of the assets, including any appreciation after the decedent’s death, will pass free of transfer taxes. On the other hand, smaller but still significant estates (up to perhaps $7 million, for example) should consider portability as an option because the combined exclusions, the DSUE Amount frozen at $5.25 million and the surviving spouse’s Applicable Exclusion Amount of $5.25 million but growing with the cost-of-living index, is likely to allow the assets to pass at the surviving spouse’s death with a full step-up in basis with little or no transfer tax costs (unless the assets are subject to significant state death taxes at that time).
In evaluating the income tax savings of portability planning, planners will want to consider that even for very large estates, the surviving spouse has the option of using the DSUE Amount by making a taxable gift to an IDGT. The temporary Treasury Regulations make clear that the DSUE Amount is applied against a surviving spouse’s taxable gift first before reducing the surviving spouse’s Applicable Exclusion Amount (referred to as the basic exclusion amount). The IDGT would provide the same estate tax benefits as the by-pass trust would have, but importantly the assets would be taxed to the surviving spouse as a grantor trust thus allowing the trust assets to appreciate out of the surviving spouse’s estate without being burdened by income taxes. If the assets appreciate, then this essentially solves the problem of the DSUE Amount being frozen in value. Moreover, if the IDGT provides for a power to exchange assets of equivalent value with the surviving spouse, the surviving spouse can exchange high basis assets for low basis assets of the IDGT prior to death and essentially effectuate a “step-up” in basis for the assets in the IDGT. The ability to swap or exchange assets with an IDGT is discussed in more detail below.
Portability planning is slightly less appealing to couples in community property states because, as discussed below, all community property gets a “step-up” in basis on the first spouse’s death. Thus, the need for additional transfer tax exclusion in order to benefit from a subsequent “step-up” in basis is less crucial. This is not true, however, for assets that are depreciable (commercial real property) or depletable (mineral interests). As discussed below, these types of assets will receive a “step-up” in basis but over time, the basis of the asset will be reduced by the ongoing depreciation deductions. As such, even in community property states, if there are significant depreciable or depletable assets, portability should be considered.
 See Franklin, Law and Karibjanian, Portability – The Game Changer, ABA-RPTE Section (January 2013) (http://meetings.abanet.org/webupload/commupload/RP512500/otherlinks_files/TheGameChanger-3-12-13v11.pdf)
 See Rev. Proc. 2013-35, Section 3.
 Treas. Reg. § 25.2505-2T(d).
 See Rev. Rul. 2004-64, 2004-27 I.R.B. 7.
 § 675(4)(C) and
 See Rev. Rul. 85-13, 1985-1 C.B. 184 and PLR 9535026