SUCCESSFUL MARITAL DEDUCTION PLANNING

Mid-Atlantic Fellows Institute

Barbara A. SloanMcLaughlin & Stern, LLP

New York, New York

August 18, 2019

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TABLE OF CONTENTS

I. INTRODUCTION. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1A. Nothing Could Be Simpler and More Treacherous. . . . . . . . . . . . . . . . 1B. One of the Great Misnomers. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1C. Scope of the Outline.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

II. REQUIREMENTS FOR THE MARITAL DEDUCTION. . . . . . . . . . . . . . . . . . . . . . 2A. In General.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2B. Passing from the Decedent.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3C. To the Surviving Spouse. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4D. Includible in the Client’s Estate. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5E. Exceptions under Section 2056(b) of the Code - Terminable Interest

Property. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51. General Rule. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52. Qualifying Bequests of Terminable Interest Property

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

III. TRADITIONAL MARITAL DEDUCTION/CREDIT SHELTER PLANNING. . . . 19A. The Classic Marital Deduction/Credit Shelter Plan.. . . . . . . . . . . . . . 19

1. In General.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 192. Formula Bequests.. . . . . . . . . . . . . . . . . . . . . . . . . . . . 203. Methods of Structuring Marital Deduction/Credit

Shelter Planning. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20B. Marital Deduction Funding Methods.. . . . . . . . . . . . . . . . . . . . . . . . . 21C. Pecuniary Formulas. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22

1. Preresiduary Credit Shelter . . . . . . . . . . . . . . . . . . . . . 222. Preresiduary Marital.. . . . . . . . . . . . . . . . . . . . . . . . . . 23

D. Fractional Share Formula.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24E. How to Select a Funding Method and Structure. . . . . . . . . . . . . . . . . 24

IV. NEED TO INCORPORATE FLEXIBILITY INTO MARITALDEDUCTION/CREDIT SHELTER PLANNING. . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

A. Higher Applicable Exclusion Amount.. . . . . . . . . . . . . . . . . . . . . . . . 25B. State Death Taxes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

1. States that Do Not Impose an Estate Tax.. . . . . . . . . . 262. States that Impose an Estate Tax. . . . . . . . . . . . . . . . . 26

C. Status of State Death Taxes in the Mid-Atlantic Region. . . . . . . . . . . 27

V. METHODS FOR INCORPORATING FLEXIBILITY INTO MARITALDEDUCTION/CREDIT SHELTER PLANNING. . . . . . . . . . . . . . . . . . . . . . . . . . . . 29

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A. Building Flexibility into the Estate Plan. . . . . . . . . . . . . . . . . . . . . . . 291. Disclaimers.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 292. Partial QTIP Elections.. . . . . . . . . . . . . . . . . . . . . . . . 343. Clayton (or Contingent Income) Trusts.. . . . . . . . . . . 36

VI. TAILORING THE USE OF FLEXIBILITY TECHNIQUES. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40

A. Use Flexibility Techniques in Combination. . . . . . . . . . . . . . . . . . . . 40B. Combinations of Techniques Can Achieve Tax Savings and Ease

Tensions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40

VII. PORTABILITY. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41A. No Longer New. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41B. Simplification?.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42C. Transfer of Exclusion Amount.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42

VIII. HOW PORTABILITY WORKS. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43A. Requirements in the Code. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43B. Regulations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43

1. Making the Election. . . . . . . . . . . . . . . . . . . . . . . . . . . 432. Computing the DSUE Amount. . . . . . . . . . . . . . . . . . 463. When the DSUE Amount Can be Used. . . . . . . . . . . . 494. Definition of Last Deceased Spouse. . . . . . . . . . . . . . 505. Ordering Rule and Effect in the Case of Multiple

Deceased Spouses. . . . . . . . . . . . . . . . . . . . . . . . . . . . 506. Authority to Examine Returns of Deceased Spouses

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52

IX. ADVANTAGES OF PORTABILITY. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52A. No Separation of Assets.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53B. No Loss of Basis Adjustment.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53C. No Trust Required. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53D. Avoids Planning with “Difficult” Assets. . . . . . . . . . . . . . . . . . . . . . . 53E. Planning Opportunities in States with State Death Taxes. . . . . . . . . . 53

X. DISADVANTAGES OF PORTABILITY.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54A. Future Growth. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54B. Loss of DSUE Amount. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55C. Unexpected State Estate Tax. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55D. Complex Family Structures. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55E. GST Exemption. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61

XI. APPLICATION OF PORTABILITY RULES. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62

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A. Married Couples with Modest Wealth. . . . . . . . . . . . . . . . . . . . . . . . . 62B. The More Wealthy/Less Wealthy Couple. . . . . . . . . . . . . . . . . . . . . . 63C. Planning with Difficult Assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64D. Portability Planning for Wealthy Clients. . . . . . . . . . . . . . . . . . . . . . . 65

XII. PORTABILITY AS A POST-MORTEM DECISION. . . . . . . . . . . . . . . . . . . . . . . . 67A. The Need for Flexibility.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67B. Effect of Portability. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67

1. The Effect of Portability on Disclaimers. . . . . . . . . . . 672. The Effect of Portability on Partial QTIP Elections. . 693. The Effect of Portability on Clayton Elections. . . . . . 70

XIII. CONCLUSION. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70

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SUCCESSFUL MARITAL DEDUCTION PLANNING

I. INTRODUCTION

A. Nothing Could Be Simpler and More Treacherous.

1. From an estate tax perspective, the marital deduction is simply amechanism to permit the surviving spouse to have the benefit of acouple’s assets until the death of the survivor of them, in recognitionof the couple’s combined estateS as their economic unit. From a gifttax perspective, it permits transfers between spouses to occur withouttransfer tax consequences, again in recognition of the couple’s assetsas their economic unit.

2. A number of fairly technical rules apply to limit the applicability ofthis hugely generous estate tax deduction, and failure to abide by themcan have disastrous consequences.

B. One of the Great Misnomers.

1. The marital deduction is one of the greater misnomers in the estate andgift tax usage: it is the marital deferral, not deduction, because itmerely defers the estate tax until the death of the survivor of a maritalcouple. Unlike a charitable deduction for example, which, once taken,eliminates the transfer tax on that transfer, the marital deduction willapply to tax the assets of the first spouse to die (to the extent they arenot spent) transferred to the estate of the survivor of them, at thesurvivor’s death.

2. Successful marital deduction planning includes planning for the use ofthe client’s available applicable exclusion amount, which when1

Prior to the Tax Relief, Unemployment Insurance Reauthorization, and1

Job Creation Act of 2010 (“TRUIRJCA” or the “2010 Act”), § 2010(c) of the InternalRevenue Code of 1986, as amended (the “Code” or “IRC”), defined the applicableexclusion amount as a specific dollar amount stated in the section. As amended byTRUIRJCA, § 2010(c) now uses the term “basic exclusion amount” to refer to thespecific dollar amount that can be sheltered from estate tax. The term “applicableexclusion amount” now refers to the sum of the basic exclusion amount and, in the caseof a surviving spouse, any deceased spousal unused exclusion amount, as defined in

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combined with the use of the marital deduction, may reduce the estatetax in the estate of the first to die to zero, while preserving the benefitof transferring assets that will not be subject to estate tax in the estateof the survivor.

C. Scope of the Outline.

1. Entire treatises have been devoted to the breadth of the topic of themarital deduction. This outline will focus primarily on the estate taxmarital deduction.

2. Some topics that bridge the span of the marital deduction topic withother areas of estate, gift and generation-skipping tax planning havebeen left to others to cover. For example, this outline does not addressmarital deduction issues related to planning with retirement assets orthe applicability of the marital deduction to the terms of a separationagreement in a divorce.

3. Finally, a substantial portion of the outline is devoted to planning withportability because, although it is a statutory technique, few provisionsare included in the estate planning documents of a taxpayer whocontemplates incorporating it into her estate plan; it truly is the silentpartner of estate planning.

II. REQUIREMENTS FOR THE MARITAL DEDUCTION

A. In General.

1. Section 2056(a) of the Code provides that, except as limited bysubsection (b), the value of a decedent’s estate is reduced by the valueof property passing from the decedent to her surviving spouse if theproperty is included in the value of the decedent’s gross estate forestate tax purposes.

§ 2010(c)(4). For persons other than surviving spouses, the basic exclusion amount andthe applicable exclusion amount are identical. The Tax Cuts and Jobs Act (P.L. 115-97)signed by the President (December 22, 2017) (the “2017 Act”) increased the applicableexclusion to $11,000,000, indexed for inflation, currently $11,400,000. Absent a changein the law, the exclusion amount will remain at that level, adjusted annually for inflation,through 2025, after which it will return to the prior $5 million, adjusted annually forinflation as though it had never been changed.

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2. A lot is packed into the few short lines that provide the most importantdeduction available to a married couple. Each requirement is reviewedbelow.

B. Passing from the Decedent.

1. This requirement is not complex; the decedent must have been thesource of the property passing to the surviving spouse.

2. However, in cases where an estate is contested in some way, if asettlement ensues, the property may not be treated as having passedfrom the decedent.

a. Whenever a settlement agreement modifies the terms of abequest otherwise passing to a surviving spouse, care must betaken to ensure that the modification is the bona fide resolutionof enforceable rights in the estate among beneficiaries. For2

example, if a decedent’s Will failed to include the provisionsfor the surviving spouse required under a premarital agreement,a resolution of the surviving spouse’s claim filed against theestate would qualify for the requirement that the propertypassed from the decedent. Alternatively, a consensualagreement among beneficiaries to permit a portion of thebequests passing to the children to instead pass to the survivingspouse would not meet the requirement. Many gray areas mayoccur when beneficiaries, including a surviving spouse, argueabout an estate and it is the lawyer’s task to be sure that theresolution of the disagreement carries adequate evidence of abona fide controversy of rights in the estate.

b. A second pitfall is to be certain that, even when the controversyover the estate is bona fide, the terms of the share passing tothe surviving spouse under the settlement agreement meet theother requirements for the marital deduction. For example, ifin the example above, the agreement provides that thesurviving spouse’s share would be held in trust for his life andthen pass to the other beneficiaries, if the terms of the trust donot meet the requirements for a trust eligible for the maritaldeduction, then even if the bequest is treated as passing fromthe decedent, it is treated as passing in a manner that does notqualify for the marital deduction, discussed further below.

Reg. § 20.2056(c)-2(d)(2).2

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C. To the Surviving Spouse.

1. Again, although this may seem like a simple requirement (indeed muchsimpler now that same sex marriages qualify for the maritaldeduction), the wise attorney assumes nothing.

2. A client’s marital status should not be taken for granted and isdetermined at the moment of death.

a. A client’s marriage may not be respected under the law. Consider the possibility that a disgruntled beneficiary advisesthe Internal Revenue Service (“Service”) that the decedent’smarriage of many many years was not legal because thedecedent never legally divorced her prior husband. Althoughthe Service will not raise the issue of the validity of a marriageon its own, once advised of an issue, they do indeed follow up3

and raise the issue on audit of the estate tax return.

b. Although direct inquiries into the validity of a client’s marriagemay be viewed as inappropriate or even rude, a good practiceis to routinely request copies of significant documents fromyour client’s past, including settlement agreements, prenuptialagreements, buy sell agreements, the estate tax returns ofpredeceased spouses, etc., even if obtaining them requiressubstantial follow up on your part. All of these documents canaffect the availability of the marital deduction in your client’sestate.

c. Even if the decedent’s marriage is valid, a surviving spousemust be a US citizen in order for a bequest to or for his benefitto qualify for the marital deduction, unless the bequest qualifiesfor the special exception under § 2056A of the Code thatrequires the bequest to be held in a Qualified Domestic Trust(“QDOT”). 4

(1) As the name implies, the QDOT includes provisionsthat ensure the value protected from estate tax by themarital deduction at the decedent’s death will be subject

See Rev. Rul. 67-442, 1967-2 C.B. 65.3

IRC § 2056(d). 4

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to US estate tax at the death of the foreign survivingspouse, discussed further below.

(2) Unlike most requirements, citizenship of the survivingspouse is not determined until the date the QDOTelection must be made (no more than one year after thedue date for the estate tax return, with extensions),permitting a non-US citizen spouse to avoid the use of aQDOT if the spouse becomes a US citizen by that date.5

D. Includible in the Client’s Estate.

1. As § 2056(a) states expressly, “estate” in this case refers to the client’sestate for federal estate tax purposes, not for probate purposes.

2. Non-probate property passing to the surviving spouse by jointownership, from insurance policies includible in the client’s estate,from retirement plans of which the decedent was the participant areeligible for the marital deduciton.

3. In addition, property passing to the surviving spouse as the result of thedecedent’s exercise of a general power of appointment is eligible forthe marital deduction even though the decedent was not the actualsource of the property.

4. Property that was transferred by the decedent during life that isincludible in the decedent’s estate and passes to the surviving spousewill also qualify for the marital deduction. Includible property in aGRAT, QPRT, or an irrevocable life insurance trust to which a policywas transferred within three years of the decedent’s death can qualifyfor the marital deduction if the surviving spouse’s interest in theproperty meets the other requirements for the marital deduction,discussed below.

E. Exceptions under Section 2056(b) of the Code - Terminable Interest Property.

1. General Rule. No marital deduction is allowed for non-deductibleterminable interest property. The definition of non-deductible

Reg. § 20.2056A-1(a)(1)(iii). Generally, an estate tax return must be filed5

within 15 months of the decedent’s death (includes one automatic six month extension),giving the surviving spouse 27 months in which to become a citizen.

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terminable interest property is convoluted and introduces the conceptthat some terminable interest property is deductible.

a. Terminable interest property is an interest in property that forsome reason (the passage of time or the occurrence or non-occurrence of an event) will terminate. Two classic exampleswould be (i) a patent or royalty interest which is an interestprotected under law only for a specified period of time or (ii)an interest passing to a surviving spouse that terminates andpasses to children if the surviving spouse remarries.

b. To be non-deductible, an interest must be terminable and eitherbe purchased by the decedent’s executor at her direction or passto or for the benefit of someone other than the surviving spouseat the termination of the surviving spouse’s interest. A lifeestate in property to a surviving spouse with the remainder tochildren is a classic example of a non-deductible terminableinterest.

c. A deductible terminable interest is an interest in propertyowned by a decedent that was terminable in the hands of thedecedent (in other words, that is all the decedent ever owned inthe property), because it does not pass to someone other thanthe surviving spouse at the decedent’s death. If a decedentbequeaths her interest in a royalty stream to her survivingspouse, the interest will terminate at some point, possiblybefore the surviving spouse dies, but the spouse is given all thatthe decedent had to give and thus the interest qualifies as adeductible terminable interest.

d. While these examples may seem clear and discrete, this is anarea in which issues are easy to miss and in a large estate, thefailure to qualify a bequest for the marital deduction couldresult in an enormous amount of tax.

(1) Clearly, under the general rule, bequests in trust for thesurviving spouse do not qualify for the maritaldeduction. However, several types of otherwisenondeductible bequests to trusts can qualify for themarital deduction if they meet specific requirements,discussed below.

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(2) Of some help is the boilerplate provision included inwell drafted wills that the marital bequest cannot be6

funded with assets that do not qualify for the maritaldeduction if other assets that do qualify are available. This provision addresses the requirement of§ 2056(b)(2) of the Code that if the estate includes anasset that does not qualify for the marital deduction butcould be used to fund it, the value of the maritaldeduction is reduced by the value of the asset. For anyestate where you did not draft the Will (!) that includesnon-deductible property, be sure to check for thisprovision.

2. Qualifying Bequests of Terminable Interest Property.

a. Estate Trust. Any bequest in trust for the benefit of a survivingspouse that holds property otherwise qualifying for the maritaldeduction will be eligible for the marital deduction if, at thedeath of the surviving spouse the trust terminates and pays tothe estate of the surviving spouse.

(1) This type of bequest actually does not fall within theterminable interest rules at all because the trust propertydoes not pass to a third party at the death of thesurviving spouse.

(2) For this reason, the terms of the trust during thesurviving spouse’s life time may vary broadly,including terms that do not permit any distributions ofany kind to the surviving spouse during his life.

(3) All of the trust property will be included in thesurviving spouse’s probate estate.

(4) For a trust to qualify as an estate trust, the survivingspouse is not permitted to hold a testamentary power ofappointment because the Service has taken the positionthat the potential beneficiaries of the power ofappointment would be third parties to whom propertypasses at the termination of the interest of the surviving

References to wills apply equally to revocable trusts and any other6

testamentary substitutes.

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spouse, thus making the trust property non-deductibleterminable interest property.7

b. General Power of Appointment Trust.

(1) Under § 2056(b)(5) of the Code, a specific exception iscarved out for bequests of an interest to or for thebenefit of a surviving spouse of otherwise non-deductible terminable interest property. The purpose of this exception is to permit the property to be held intrust but also to make the benefits of the trust propertyaccrue sufficiently to the surviving spouse to warrantthe tax benefit of the marital deduction. The result ofthe requirements to the exception is that, even thoughthe property is held in trust for the benefit of thesurviving spouse, the surviving spouse will be taxedsimilarly as if the trust property were owned by thesurviving spouse.

(2) The requirements to meet the exception are:

(a) All trust income must be distributed to thesurviving spouse at least annually for life.

(b) No one other than the surviving spouse can be abeneficiary of the trust during the life of thesurviving spouse.

(c) The surviving spouse must have a general powerof appointment over the trust property thatpermits the surviving spouse to appoint the trustassets to himself or to his estate.

(3) The “ all income” requirement and the “no otherbeneficiary” requirements are clear in meaning, but mayinadvertently be violated by inclusion of provisions theclient has requested (e.g., a direction not to distribute allincome if the spouse remarries or a direction to pay theeducation expenses of the children). In addition, theService has made clear that “income” is satisfied by themeaning of income under § 643(b), including income

Rev. Rul. 75-128, 1975-1 C.B. 308.7

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under an appropriate unitrust election. One finalrequirement is that income accrued but unpaid at thesurviving spouse’s death must be required to be paid tothe surviving spouse’s estate or be subject to a generalpower of appointment.

(4) To qualify the trust for the marital deduction, thegeneral power of appointment must meet furtherrequirements.

(a) Although the definition of a general power ofappointment under § 2041 includes a power toappoint to the taxpayer, her creditors, her estateor the creditors of her estate, in order to satisfythe § 2056(b)(5) requirement, the power must beexercisable in favor of the spouse or his estate. A power to appoint in favor of the creditors ofthe spouse’s estate would cause inclusion of thetrust in the spouse’s estate but would not qualifythe trust for the marital deduction in thedecedent’s estate.

(b) In addition, the power may not include anysubstantive restrictions or contingencies on thesurviving spouse’s ability to exercise the power. It must be exercisable in any event without theconsent of anyone else.

(c) Although an inter vivos general power ofappointment may meet the requirements for themarital deduction, inclusion of a testamentarypower provides a reliable method of ensuringthe requirement is met. Certainly, both typesmay be included if the client would like for thesurviving spouse to be able to make transfers ofthe property in the trust during his life.

(d) Finally, to avoid a trustee’s ability to limitincome to the surviving spouse throughinvestment in (or continuing to hold) non-income producing property, the spouse musthave the right to require the trustee to invest inincome producing property.

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i) Care should be give to this issue in ageneral power of appointment trust inwhich a large percentage of its assetsmay be an interest in a family businessfor which the decedent would not wantthe surviving spouse to have the powerto force a sale.

ii) Planning for an appropriate buy-sellagreement applicable to the decedent’sestate and planning for a method to fundit may be the best course of action toavoid this result, if possible.

iii) Of course, so long as the family businessproduces a reasonable rate of return, thisshould not be an issue.

c. Qualified Terminable Interest Property Trust.

(1) Qualified terminable interest property (“QTIP”) trustswere created under § 2056(b)(7) specifically to addressthe dilemma that a married testator, particularly onewith children from a prior marriage, faced: should sheprovide for her surviving spouse - who then might notleave the testator’s property to the testator’s children athis death - or should she provide for her children fromthe prior marriage to be sure they would receive herproperty - leaving the surviving spouse withoutmaximum financial security. 8

(2) Since both types of trusts for surviving spouses thatqualified for the marital deduction (estate trusts andgeneral power of appointment trusts) required that thesurviving spouse have control over the ultimatedisposition of the trust property, Congress created aspecial category of trusts as an exception to theterminable interest property rule that permitted propertyto be held in trust for the surviving spouse during hislife with a remainder interest in the trust passing to the

See, e.g., H. Rep. No. 97-201, 97 Cong., 1 Sess., at 159-60.8 th st

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decedent’s children or other objects of her bounty. If atrust meets the requirements for a QTIP trust, thebequest to the trust that creates a terminable interest inthe surviving spouse will qualify for the maritaldeduction.

(3) The legislative difficulty with a trust designed in thisfashion was that the surviving spouse may not have anyinterest in the trust that requires its value to be includedin his estate at his death, permitting the trust to escapeestate taxation altogether at the death of the survivingspouse. To address the need to tax the trust property inthe surviving spouse’s estate without giving thesurviving spouse a power to dispose of the trust assets,the value of the trust is required to be included in thesurviving spouse’s estate under § 2044 if a maritaldeduction for the trust was elected to be taken in thedecedent’s estate.

(4) The requirements for a QTIP trust are similar to thoseof a general power of appointment trust to be sure thatthe surviving spouse has sufficient interests in the trustto warrant the marital deduction.

(a) The property must pass from the decedent.

(b) All of the income must be paid to the survivingspouse at least annually for his life. In addition,the spouse must have the right to make non-income producing property productive. 9

(c) No one, with or without the consent of thesurviving spouse, can receive a distribution fromthe trust other than the surviving spouse duringthe surviving spouse’s lifetime.10

Treas. Reg. §§ 20.2056(b)-7(d)(2) and 20.2056(b)-5(f)(4).9

Treas. Reg. §§ 20.2056(b)-7(d)(1) and 20.2056(b)-7(d)(6).10

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(d) An irrevocable election to qualify the trust forQTIP treatment must be made by the executoron the estate tax return.11

(5) QTIP treatment provides a number of advantages notavailable to other forms of marital bequests.

(a) Partial QTIP Election.

i) QTIP trusts offer an opportunity notavailable to any other form of maritalbequest: an executor may elect toqualify only a portion of the bequest formarital deduction treatment. The electedpart must be a fractional or percentileshare of the trust. The balance remainsin trust for the surviving spouse, but issubject to estate tax in the estate of thefirst spouse to die (unless protected fromtax by the first spouse’s applicablecredit) and not in the estate of thesurviving spouse.

ii) The advantage of this flexibility is that itpermits an executor to determine howlarge a marital deduction to take withoutchanging the value of the assets passingfrom the estate for the survivingspouse’s benefit.

iii) The executor can make an election thatminimizes the marital deduction andtakes full advantage of the decedent’sapplicable credit amount to protect thenon-elected portion of the marital trustfrom estate tax, which may require

IRC § 2056(b)(7)(B)(v). To reduce the number of returns on which the11

executor mistakenly failed to “check the box” on Schedule M of Form 706, the IRS hasadministratively reversed the presumption of the election, and a trust which qualifies as“QTIP-able” listed on Schedule M for which a marital deduction is taken qualifies as aQTIP trust “unless the executor specifically identifies the trust (all or a fractional portionor percentage). . . to be excluded from the election.” See Form 706, Schedule M.

N0032553.1 12

payment of some state estate tax incertain states.

iv) Alternatively, the executor can alsodecide whether it may be moreadvantageous to elect QTIP treatment forthe entire trust, not use any of thedecedent’s applicable exclusion amountto protect the trust from estate tax, andtake advantage of portibility.

v) Finally, the executor can decide to makea partial election to have the maritaldeduction apply only to the amount ofassets in the QTIP trust in excess of theamount that can pass free of state estatetax in states that impose a death tax.

(b) Reimbursement for Estate Taxes Paid by theSurviving Spouse’s Estate

i) As noted above, the value of the QTIPtrust will be included in the value of thesurviving spouse’s estate for estate taxpurposes.

ii) Under § 2207A of the Code, thesurviving spouse’s estate has a right ofreimbursement from the QTIP trust forthe amount of the estate tax due from thesurviving spouse’s estate at the highestmarginal rate (if tax brackets were toapply) as a result of the inclusion of theQTIP trust in his estate. Since thebeneficiaries of the QTIP trust may notbe the same as the beneficiaries of thesurviving spouse’s estate, this provisionprevents the surviving spouse’sbeneficiaries from being required to payany estate tax on assets that they will notreceive.

N0032553.1 13

iii) This right of reimbursement may bewaived in the will of the survivingspouse, but the waiver is effective only ifit specifically refers to the right ofreimbursement.

iv) Note that failure to exercise the right ofreimbursement if it is not waived willresult in a taxable gift by thebeneficiaries of the survivng spouse’sestate to the beneficiaries of the QTIPtrust.12

(c) Reverse QTIP Election.

i) Without digressing too deeply intogeneration-skipping transfer (“GST”) taxissues, the general rule is that thetransferor of a testamentary trust forGST tax purposes is the person in whoseestate the trust was most recently subjectto estate tax. It is the GST exemption ofthe transferor that may be allocated to atransfer to protect it from GST tax.

ii) This means that the surviving spouse athis death will be the transferor for GSTtax purposes of assets in marital trustscreated for his benefit since they arerequired to be included in the estate ofthe surviving spouse, thus potentiallywasting GST exemption of the decedent.

iii) If the decedent’s available GSTexemption exceeds the amount of thedecedent’s remaining applicableexclusion amount, the decedent is13

Reg. § 20.2207A-1(a)(2).12

A bequest to or for the benefit of grandchildren can be made using the13

decedent’s available applicable exclusion amount without attracting estate tax in the

N0032553.1 14

confronted with the choice of whether toleave the maximum amount of her assetsfor the benefit of her spouse or to takeadvantage of her ability to protect someof her assets for the benefit of hergrandchildren without estate taxation inthe hands of her children.

iv) To permit the decedent to transfer herassets to a QTIP trust for the benefit ofher surviving spouse and also permit thedecedent to use her GST exemption toprotect the remainder of the trust for thebenefit of grandchildren, a specialelection is available that permits thedecedent’s executor to cause thedecedent to be treated as the transferorand to allocate her GST exemption to theQTIP trust. 14

a) If the total value of the assetspassing to the QTIP trust exceedsthe value of the decedent’s GSTexemption available to beallocated to the QTIP trust, topreserve efficient GST planning,two QTIP trusts must be createdand the reverse QTIP electionmade for only one of them.15

b) The surviving spouse may thenuse his available GST exemptionto protect the non-exempt QTIP

decedent’s estate. Even though the amount of the decedent’s applicable exclusionamount and GST exemption initially are equal, rarely has the decedent used GSTexemption for every gift she has made and she no longer has equal amounts of themremaining by the time of her death.

IRC 2652(a)(3).14

As with all GST exemption allocations, this division should be made on a15

formula basis.

N0032553.1 15

trust or other assets for thebenefit of grandchildren.

c) In the event that two QTIPs arecreated, one exempt from GSTtax and one not, the decedent’swill should include twoprovisions.

1) A direction that thedistributions of principalto the surviving spouse bemade first from the non-exempt QTIP trust and

2) A direction that estatetaxes payable from theQTIP trusts at the deathof the surviving spouse bepaid first from the non-exempt trust and, only ifit is insufficient to coverall of the tax, then fromthe exempt trust.

(6) It is significant to note that if a trust includes a generalpower of appointment that qualifies under § 2056(b(5),the trust will be protected from estate tax by the maritaldeduction, but it will be treated as a general power ofappointment trust, regardless of whether a QTIPelection is made. Thus care must be taken when givingthe surviving spouse rights of withdrawal during lifeand powers of appointment at death to ensure that theadvantages of QTIP treatment are available.

d. Qualified Domestic Trust.

(1) A QDOT for the benefit of the decedent’s non-USspouse may be created under the decedent’s Will or, forproperty bequeathed or otherwise passing directly to thesurviving non-citizen spouse, the surviving spouse may

N0032553.1 16

create a QDOT for his own benefit and transfer theinterests received from the decedent to the QDOT.16

(2) The election to treat a qualifying trust as a QDOT mustbe made on a timely filed estate tax return (includingextensions) or on the first return filed no more than oneyear after the due date (including extensions).17

(3) The requirements for a QDOT include the requirementsfor an estate trust, general power of appointment trust ora QTIP trust with added requirements.

(a) At least one trustee must be a US citizen ordomestic corporation;

(b) No distribution (other than a distribution ofincome which must be required unless an estatetrust is used) may be made from the trust unlessa US trustee has the right to withhold the estatetax due from the distribution.

(c) Separate requirements apply depending on thesize of the trust. If a surviving spouse is thebeneficiary of multiple QDOTs all funded by thesame spouse, the values of these trusts must beaggregated to determine the applicability of thedifferent requirements based on size. QDOTscreated in relation to a different spouse are notincluded.

i) If the trust will not have a value inexcess of $2 million, the trust instrumentmust prohibit investment of more than35% of the trust assets in off-shore realestate.

Reg. § 20.2056A-2(b)(2) and § 20.2056A-4(b)(1). Note that if the16

surviving spouse created the QDOT for his own benefit, the trust will be a grantor trustfor income tax purposes. In addition, to avoid a gift to the remaindermen upon thecreation of the QDOT, the surviving spouse should be given a special power ofappointment over the remainder.

IRC § 2056A(d).17

N0032553.1 17

ii) If the trust value will exceed $2 million,the trust must either:

a) have at least one trustee that is aqualifying US bank or trustcompany or

b) furnish a bond or letter of creditequal to 65% of the value of thetrust corpus.

iii) For purposes of determining the $2million threshold and the 65% bond orletter of credit security requirement, upto two personal residences (one of whichis the principal residence) and includingfurnishings, but not to exceed $600,000,may be excluded.18

(4) Taxation of QDOT’s.

(a) Although all marital deductions are conceptuallydeferrals of estate tax, a QDOT is treated as adeferral of the decedent’s actual estate tax untildistributions (other than income as required) aremade from the trust. It is as though, oncedistributed, that amount did not qualify for themarital deduction in the decedent’s estate.

(b) The tax is due:

i) When the surviving spouse dies,19

ii) When distributions of principal are madeto the surviving spouse, except20

Reg. 20.2056A-2(d)(1)(iv).18

IRC § 2056A(b)(1)(B).19

IRC § 2056A(b)(1)(A).20

N0032553.1 18

distributions of corpus on account ofhardship, or21

iii) In the event that the trust’s status as aQDOT fails.22

(c) The payment of estate tax from the QDOT istreated as a distribution to the surviving spousein the year in which it is paid, unfortunatelytriggering a potentially endless series of annualdistributions for a distribution made during thelife of the surviving spouse.

(d) In the event that the surviving spouse becomes aUS citizen, the QDOT tax rules no longerapply and, if the terms of the trust permit, the23

trustee may distribute the trust to the survivingspouse without imposition of the decedent’sestate tax. The trustee is required to report thatthe surviving spouse became a US citizen.

III. TRADITIONAL MARITAL DEDUCTION/CREDIT SHELTER PLANNING

A. The Classic Marital Deduction/Credit Shelter Plan.

1. In General.

a. To review, in its classic form the marital deduction/creditshelter plan carves out the amount of the client’s availableapplicable exclusion amount and bequeaths it to a trust for thebenefit of her surviving spouse and children.

IRC § 2056A(b)(3)(B). Distributions are permitted for immediate and21

substantial financial needs for the health, education maintenance or support of thesurviving spouse or anyone the surviving spouse is legally obligated to support to theextent that other resources are not reasonably available. These distributions must bereported to permit audit.

IRC § 2056A(b)(4).22

IRC § 2056A(b)(12).23

N0032553.1 19

b. The credit shelter trust can be structured in a variety of ways,the most flexible of which permits discretionary distributionsof income and principal among the surviving spouse andchildren, and, at the death of the surviving spouse, passes to thecouple’s issue, either per stirpes or pursuant to the survivingspouse’s exercise of a special testamentary power ofappointment.

c. The balance of the estate passes to or for the benefit of thesurviving spouse in a manner that qualifies for the maritaldeduction (e.g., an outright bequest or a bequest to a QTIPtrust). 24

d. At the death of the first spouse to die, no federal estate tax isdue because a portion of the estate is protected by theapplicable exclusion amount and the balance is protected by themarital deduction. At the death of the surviving spouse, thecredit shelter trust is not includible in the surviving spouse’sestate (assuming he has no rights in the trust that would make itincludible in his estate) and the surviving spouse’s availableapplicable exclusion amount protects as much as possible ofthe surviving spouse’s assets and, if a marital trust was used,the marital trust. Thus, the children receive the benefit of bothspouses’ applicable exclusion amounts.

2. Formula Bequests.

a. Since a client may have used some or all of her applicableexclusion amount making taxable gifts during her life, it maybe impossible to know how much of it she will have at the timeof her death, especially since the amount of the applicableexclusion amount is now indexed for inflation, and since thelaw relating to the estate tax has begun to change with suchfrequency.

b. Given such unpredictability, if a credit shelter bequest isincluded in the estate plan, it is prudent to express this bequestas a formula, rather than an exact number.

3. Methods of Structuring Marital Deduction/Credit Shelter Planning.

See IRC § 2056(b)(7).24

N0032553.1 20

a. Preresiduary (pecuniary) credit shelter trust with the residue tothe spouse or a marital trust;

b. Preresiduary (pecuniary) marital bequest (outright or to amarital trust) with the residue to a credit shelter trust; or

c. Fractional Share with division of the residue into two fractionalshares, one of which is the size of the decedent’s availableapplicable exclusion amount which passes to a credit sheltertrust and the other of which is the balance which passes to thespouse or a marital trust.

B. Marital Deduction Funding Methods.

1. While the marital deduction/credit shelter plan appears simple on itsface, it actually involves complex issues related to limiting the amountthat can pass to the credit shelter trust. Congress and the Service havelong been concerned that when a transfer tax benefit, through adeduction, credit, or exemption, is available, the value of the propertyprotected by the benefit should not exceed the amount Congressintended. Estate planners, on the other hand, want to wring everypossible drop of advantage they can from every tax benefit availablefor their clients.

2. As a result of the delay that occurs during the administration of anestate, assets usually are not worth the same value when the estate planis funded as they were when the decedent died. If a credit shelter trustis funded with appreciated assets and a marital share is funded withslow-growing or depreciating assets, two benefits occur. The creditshelter trust protects more than its pro rata share of the total increase inthe decedent’s assets and the amount includible in the survivingspouse’s estate is minimized. A number of rules apply to maritaldeduction funding to limit this leveraging.

3. As a result, in designing a credit shelter/marital deduction plan, severaldecisions must be made: whether to use a pecuniary formula or afractional share formula, whether to pay state estate tax and the type25

of funding to use once that choice is made.

As discussed below, because many state estate tax laws are “decoupled”25

from the federal estate tax law, funding a preresiduary bequest with the largest amount that

can pass free of federal estate tax may result in a state estate tax liability.

N0032553.1 21

C. Pecuniary Formulas.

1. Preresiduary Credit Shelter (also known as reverse pecuniary marital): This is a preresiduary formula bequest of a non-marital pecuniaryamount (e.g., the amount permitted to pass free of federal estate tax byreason of the applicable credit amount). This type of formula can befunded in two ways:

a. True worth funding, which is satisfied with assets valued atdate of distribution. This approach permits the maximum “pickand choose” flexibility and is definitely the simplest toadminister.

(1) True worth funding freezes the value of the pecuniarycredit shelter amount which moves appreciation to theresiduary marital if the estate increases in value andpreserves the credit shelter amount if the estatedecreases in value.

(2) However, one of the most significant disadvantages ofthis approach is that it requires recognition of gain orloss upon funding. A second related disadvantage isthat this technique requires revaluation of the assets atthe time of distribution.

b. Fairly representative funding, which is satisfied with assetsvalued at their federal estate tax value (or cost if acquired afterdeath), but selected on a basis that fairly represents the netappreciation and depreciation in all of the assets available tofund the bequest from the valuation date to date of funding.

(1) Fairly representative funding permits substantially lessflexibility in selecting assets to fund the bequest.

(2) The primary advantage of this approach is that no gainis subject to capital gains tax on funding.

(3) This approach may overfund or underfund the creditshelter bequest because the assets used to satisfy thebequest are not likely to have the same value as thepecuniary bequest. This approach also requiresrevaluation of all assets.

N0032553.1 22

2. Preresiduary Marital: This is a preresiduary formula pecuniary maritaldeduction bequest (e.g., the smallest amount necessary to reduce thefederal estate tax to zero after taking the applicable credit amount intoaccount). Like the preresiduary credit shelter bequest, this bequest canbe funded in several ways:

a. True worth funding, which is funded using date of distributionvalues.

(1) This approach has the same advantages anddisadvantages that apply to true worth funding of apreresiduary credit shelter trust.

(2) The main difference is that any appreciation which hasoccurred will accrue to the residuary credit shelter trust. Alternatively, if assets decline in value, the value of themarital bequest is preserved.

b. Fairly representative funding, which is satisfied with assetswhich are fairly representative of appreciation and depreciationin all assets available to fund the bequest using federal estatetax values (or cost if acquired after death).

(1) Like preresiduary credit shelter bequests funded usingvalues that are fairly representative of changes in estatetax values, gain is not subject to capital gains tax.

(2) This method risks over- or underfunding of the maritalbequest and requires the assets to be revalued whenfunding.

c. Minimum worth funding, which is funded with assets using thelesser of federal estate tax or date of distribution values.

(1) Minimum worth funding risks overfunding the maritalbequest with the attendant risk that the residuary creditshelter trust might be bankrupted.

(2) This approach should not be used in conjunction withGST tax exemption allocation because it will require

N0032553.1 23

use of date of distribution values as the denominator ofthe applicable fraction.26

D. Fractional Share Formula.

1. The concept underlying a fractional share formula is entirely differentthan that underlying a pecuniary formula bequest. Instead of “carvingout” pieces and leaving an undefined residuary amount, it divides theestate into two or more portions which are defined in terms of fractionsof the estate.

a. The numerator of the fraction is similarly worded to apecuniary bequest.

b. The denominator is the value of the assets available to fund theshare.

2. The common approach to funding a fractional share formula is todivide each and every asset of the estate into the required shares, basedon the fraction allocable to each share.

3. This approach does not require the recognition of gain or loss or therevaluation of assets when funding the bequests.

4. However, it has several major disadvantages:

a. No pick and choose flexibility.

b. It requires a pro rata division of every asset. If a non pro ratadistribution is made, a taxable exchange among beneficiaries islikely to result, which would generate gain or loss recognition.

c. It is difficult to administer. For example, each time adistribution is made to one beneficiary and not to others or if anasset is revalued on audit, the fractions will need to be adjustedand the assets will need to be revalued.

E. How to Select a Funding Method and Structure.

See IRC § 2642(a)(2).26

N0032553.1 24

1. Generally, the factors involved in choosing which funding method touse are not materially affected by changes in the estate tax rate or theamount of the applicable exclusion. Instead, they are most affected bywhether the assets appreciate or depreciate post-death. Since estateplanners usually do not know when their clients will die, much lesswhether the markets will be rising or falling at the time, the choice offunding method is best picked based on which will be the mostconvenient to administer.

2. However, where the true worth funding method is used, it is usuallypreferable for the smaller of the credit shelter amount and the maritalbequest to be the preresiduary bequest to minimize recognition of anycapital gain on funding and to minimize the risk of a bankruptresiduary estate.

3. For example, in smaller estates, now that the federal applicableexclusion amount is over $11 million, many estates that were designedto have a fully funded preresiduary credit shelter trust may havebankrupt residuaries. As a result of the volatility of the applicableexclusion amount, good drafting may suggest adding a provisiondirecting that the credit shelter trust be treated as the residue if theresidue is bankrupt.

IV. NEED TO INCORPORATE FLEXIBILITY INTO MARITALDEDUCTION/CREDIT SHELTER PLANNING

A. Higher Applicable Exclusion Amount.

The increase in the estate tax basic exclusion amount from $675,000 in 2001to the current $11,400,000 has had a huge influence on wealth transferplanning, particularly for clients who are not in the ultra high net worthcategory. In many cases, for various reasons, these clients may choose not toutilize the entire available exclusion amount of the first spouse to die.

B. State Death Taxes. The phaseout and repeal in 2001 of the § 2011 state death tax credit by theEconomic Growth and Tax Relief Reconciliation Act (“EGTRRA”) has27

created substantial planning issues in states that continue to impose some form

P.L. 107-16.27

N0032553.1 25

of death tax. Because full use of the federal applicable exclusion amount in28

states that impose some form of state death tax may require payment of statedeath tax, many estate planners in these states have chosen to draft theirclients’ wills using flexible techniques that permit deferral of the decision ofwhether full use of the federal applicable exclusion amount in the estate of thefirst spouse to die will be advantageous. Portability now creates yet anotherchoice to consider under these circumstances.

1. States that Do Not Impose an Estate Tax.

a. Needless to say, in states that do not impose an estate tax, theanalysis of whether or not to use the full amount of the federalapplicable exclusion amount and whether to elect to useportability in a particular situation is simpler because theconsequences of the state estate tax do not need to beconsidered.

b. BUT, in the event that the client also has property in otherstates, the laws of each of these states must be considered. Ifany of them impose an estate tax, the effect of the tax may besignificantly more substantial than might be expected.

2. States that Impose an Estate Tax.

a. In states where the amount that can pass free of state estate taxis lower than the federal applicable exclusion amount, thengenerally a formula is used to fund the credit shelter amountthat refers to “the amount that can pass free of federal and state

See, e.g., New York Tax Law, §§ 951-952. Historically, New York28

required that the amount of New York estate tax be calculated using the now repealedstate death tax credit under § 2011 using an applicable exclusion amount of $1,000,000. However, as of April 1, 2014, New York amended its estate tax law to reach a result verysimilar to that required under § 2011 prior to the 2017 Act, gradually increasing theexclusion amount up to the then federal amount: $2,062,500 for decedents dying afterApril 1, 2014; $3,125,000 for decedents dying after April 1, 2015; $4,187,500 fordecedents dying after April 1, 2016; $5,250,000 for decedents dying after April 1,2017and before January 1, 2019; and thereafter to what would have been the federal applicableexclusion amount had the 2017 Act not been enacted, with cost of living adjustments (currently $5,740,000). See 2014-15 New York State Executive Budget Revenue ArticleVII Legislation, Part X.

N0032553.1 26

estate tax.” This preserves the use of the amount that can29

pass free of state estate tax without requiring the payment ofstate estate tax on the difference between the state “exclusionamount” and the federal applicable exclusion amount. Thengenerally, a flexibility technique is incorporated into the estateplan, like disclaimers, QTIPs or Clayton Trusts, to allow apost-mortem decision about what to do with the balance of thefederal applicable exclusion amount. Some states permit astate QTIP election that protects this amount from state estatetax with the marital deduction even while it is protected fromfederal estate tax by the applicable exclusion amount.

b. In states that have an “exclusion amount” equal to the federalapplicable exclusion amount (or that permit portability of thestate exclusion amount), the state estate tax likely will notaffect the use of the full federal applicable exclusion amountand of portability.

C. Status of State Death Taxes in the Mid-Atlantic Region.

1. The states in the Mid-Atlantic region of ACTEC are New York, NewJersey, Pennsylvania, Delaware, Maryland and the District ofColumbia and they include a number of different approaches to statedeath taxes, indicating the amazing complexity now applicable intaking state death taxes into account.

2. New York.

a. New York uses the $5 million, indexed for inflation, that wasthe amount of the federal applicable exclusion before theincrease in the 2017 act. Currently, New York’s applicableexclusion amount is $5.74 million. If the federal law is notchanged and the $11 million exclusion amount expires at theend of 2025, the New York exclusion amount will be equal tothe then federal applicable exclusion amount.

b. In the event that the decedent’s estate exceeds the amount of

the New York exclusion amount by more than five percent, theNew York exclusion amount is eliminated and the full NewYork taxable estate is subject to estate tax.

Note that when planning for death taxes in a state that has an inheritance29

tax, this analysis may need further refinement.

N0032553.1 27

c. New York estate tax rates are similar to the rates on therepealed federal state death tax credit table, but are setindependently and do not reference the table.

d. Although New York does not have a gift tax per se, gifts madewithin three years of a New York decedent’s death are pulledback into the decedent’s estate for New York estate taxpurposes. This has the unfortunate effect of making the30

amount of New York estate tax imposed on these gifts notdeductible on the federal estate tax return under § 2058 of theCode because the amount of the gifts is not included in thefederal gross estate. This law is currently scheduled to expirein 2026.

3. New Jersey.

a. New Jersey has no estate tax.

b. New Jersey still has an inheritance tax that is imposed based onthe relationship between the decedent and the beneficiary. Notax is imposed on transfers to spouses, registered domesticpartners, parents, children and grandchildren. Various ratesapply to other categories of beneficiaries based on the totalamount of the transfers to that beneficiary.

4. Pennsylvania.

a. Pennsylvania does not have an estate tax.

b. Pennsylvania imposes an inheritance tax with rates rising to15%, based on the degree of relationship to the decedent. Transfers to spouses are exempt from inheritance tax.

5. Delaware. – imposes no death taxes.

6. Maryland.

Pursuant to § 954(a)(3) of NY Tax Law originally enacted as part of the30

2014-15 New York State Executive Budget Revenue Article VII Legislation, Part X, theNew York gross estate includes the value of gifts made by a New York resident afterMarch 31, 2014 and within three years of death. Originally sunsetting in January 2019,this provision has been extended until December 31, 2025.

N0032553.1 28

a. As of January 1, 2019, Maryland has a fixed exclusion amountof $5 million, not indexed for inflation. The estate tax is stillcalculated based on the state death tax credit that was finallyphased out of federal law at the end of 2004 and caps at 16%of the difference between the taxable estate and the $5 millionexemption.

b. Maryland recognizes portability and permits the decedent’sunused exemption to be transferred to the surviving spouse.

c. Maryland imposes an inheritance tax on beneficiaries otherthan spouses, lineal descendants including step-children andtheir descendants, parents, siblings, and grandparents.

d. Maryland’s inheritance tax can apply to gifts made incontemplation of death.

7. District of Columbia.

a. District of Columbia has an estate tax based on the repealedfederal state death tax credit table with an exemption of$5,681,760, indexed for inflation.

b. District of Columbia has no inheritance tax and no gift tax.

V. METHODS FOR INCORPORATING FLEXIBILITY INTO MARITALDEDUCTION/CREDIT SHELTER PLANNING

A. Building Flexibility into the Estate Plan.

Although tentative decisions about funding or not funding a credit shelter trustat the first death can be made at the time that the clients execute their wills,such decisions almost always can more prudently be made after the firstspouse’s death, based on up-to-date information regarding the family’spersonal and financial circumstances, along with knowledge of the actual taxlaws that apply.

1. Disclaimers.

N0032553.1 29

Although disclaimers have long been used to “fix up” an estate planfollowing a decedent’s death, since the enactment of EGTRRA the useof disclaimers as a planning technique has become commonplace.

a. In General.

Disclaimers are utilized to permit all or part of a bequest orother disposition to pass as though the designated beneficiaryhad predeceased the decedent. From a tax perspective, thispermits the transfer of the disclaimed assets to someone otherthan the initial beneficiary without imposition of gift tax on thedisclaiming beneficiary. To obtain this benefit, both state lawrequirements and federal law requirements must be met.31

b. Requirements of Section 2518 of the Code. 32

In order for a disclaimer to be a qualified disclaimer for federaltransfer tax purposes, five requirements must be met:

(1) The disclaimant must not have accepted the benefits ofthe property to be disclaimed.

(2) The refusal must be in writing.

(3) The disclaimer must be delivered to the transferor, legalrepresentative or holder of title of the property to bedisclaimed within nine months after the later of creationof the interest -- in most cases death of the testator -- orage 21.

(4) Except in the case of the decedent’s spouse, thedisclaimed interest must pass to someone other than thedisclaimant.

Be aware of possible additional requirements under state law for a31

disclaimer to be effective for state law purposes. See, e.g., New York’s requirements for“renunciations” in EPTL 2-1.11.

For a complete discussion of the requirements of § 2518, see Mary F.32

Radford, The Use of Disclaimers: Navigating the Interplay between Federal and StateLaw, Georgia Federal Tax Conference (Summer 2003).

N0032553.1 30

(5) The disclaimant must not have the power to direct towhom the disclaimed property will pass. The propertymust simply pass as it would have if the disclaimanthad not been alive at the time of the transfer to thedisclaimant, or, assuming state law permits, the testatormay direct in her will to whom the property will pass ifit is disclaimed.33

(a) This means that the disclaimant cannot:

i) serve as the sole trustee of a trust towhich the disclaimed property will passif the trustee holds any discretionarypowers. Note that a trustee power tomake distributions to a beneficiary thatis limited by an ascertainable standardwill not be problematic for a disclaimantto hold following her disclaimer. 34

ii) serve as a trustee or director of afoundation to which the disclaimedproperty will pass, unless some kind offirewall is created around the disclaimedassets to be sure the disclaimant does notparticipate in any decision of whichcharities will receive the income orprincipal of the disclaimed property.

iii) hold a special power of appointment (ifthe disclaimant is the surviving spouse)

See, e.g., under New York law, EPTL § 2-1.11(e), which provides33

“[u]nless the creator of the disposition has otherwise provided, the filing of arenunciation, as provided in this section, has the same effect with respect to therenounced interest as though the renouncing person had predeceased the creator or thedecedent or, if the renounced interest is a future estate, as though the renouncing personhad died at the time of filing or just prior to its becoming an estate in possession,whichever is earlier in time, and shall have the effect of accelerating the possession andenjoyment of subsequent interests, but shall have no effect upon the vesting of a futureestate which by the terms of the disposition is limited upon a preceding estate other thanthe renounced interest.” (Emphasis added).

Treas. Reg. § 25.2518-2(e)(1)(i). 34

N0032553.1 31

over the credit shelter trust property thathas been disclaimed into the trust by thesurviving spouse.

(6) Caution: a disclaimer may be effective under state lawto transfer property away from the disclaimant, but notmeet the requirements for a federal qualified disclaimer. In this case, the disclaimant will be treated as havingmade a gift to the recipient of the disclaimed propertyfor federal transfer tax purposes.

c. Example of Credit Shelter Disclaimer Planning.

The surviving spouse can disclaim all or a portion of hisinterest in the marital trust created for his benefit, and if thewill so provides and state law permits direction of thedisclaimed property under the will, the property can thereby beshifted to the credit shelter trust. The spouse can continue to bethe income beneficiary of that trust, but cannot retain anypower of appointment over the trust. (Note: An otherwisedisqualifying special power of appointment can be disclaimed.)

d. Partial Disclaimers.

Treasury Reg. § 25.2518-3 allows disclaimers of partialinterests in property, including, inter alia, powers ofappointment, undivided fractional interests and pecuniaryamounts.

e. Successive Disclaimers.

In order to ensure that a disclaimer is qualified and that no partof the disclaimed interest passes to the disclaimant (if thedisclaimant is not the spouse), it may be necessary for thedisclaimant to disclaim several successive interests under thewill and ultimately under intestacy. 35

See, e.g., PLR 200846003 (7/30/08) (under convoluted facts,35

determination that children’s disclaimer of their interest in decedent’s IRA was notqualified because, upon their disclaimer, IRA was instead paid to Trust 1 of whichdecedent’s spouse was income beneficiary and, at spouse’s death, was to be paid to Trust2, which then paid out to decedent’s children, which interests the children had notdisclaimed).

N0032553.1 32

f. Rules to Live By.

(1) Never disclaim until it is certain to whom the propertywill pass after the disclaimer. Assume nothing!

(2) Estate plans based on post-mortem disclaimers requirethat the client’s family be educated about therequirements for a disclaimer and the “no acceptance ofbenefits” rule.

g. Simple Credit Shelter Trust Disclaimer.

(1) The following scenario illustrates a typical use of adisclaimer to effectuate a flexible maritaldeduction/credit shelter estate plan:

(a) The client, who has an estate valued at$20,000,000, currently has a standard creditshelter-based will, that is to say, the applicableexclusion amount passes to a discretionary trustfor spouse and issue, with the balance outrightto spouse, protected from estate tax by themarital deduction.

(b) Leaving the entire estate to the client’s spouse,with a provision in the will that, in the event hedisclaims any portion of his bequest, thedisclaimed amount passes into the credit sheltertrust, is a far more flexible plan. Following theclient’s death, her spouse can decide whatpercentage, if any, should pass to the creditshelter trust based on the tax law and thefinancial circumstances applicable at the time.

(2) Note that utilizing a disclaimer trust approach willprevent the client from giving her surviving spouse aspecial power of appointment or other control over theultimate disposition of the trust.

(3) Note also that this sort of disclaimer planning isprobably inappropriate when the client’s survivingspouse and children may not have a unity of interest.

N0032553.1 33

h. Complex Credit Shelter Trust Disclaimer.

Consider whether a plan for successive disclaimers by asurviving spouse may be designed under the will to provideseveral alternatives for the disposition of the disclaimedproperty. For example, the will could provide that theresiduary passes outright to the spouse or, to the extent hedisclaims this bequest, to a QTIP trust, or, to the extent hedisclaims his interest in the QTIP trust, to a credit shelter trust. The spouse could then decide how much of the bequest to himhe would like to own directly, how much he would like toprotect from creditors by permitting it to pass to the QTIPtrust, how much he would like to pass to a credit shelter trust36

for his benefit and that of the children (reducing the DSUE thatotherwise passes to him), and, assuming he is the executor ofthe estate, by making the portability election, the amount ofDSUE he would like to use making gifts.

2. Partial QTIP Elections.

a. Just as the division between the marital share and the creditshelter share may be defined by formula, it is advantageous tomake the partial QTIP election by formula. In this event, if37

values of assets in the estate are adjusted on audit, the sharepassing to the marital deduction portion of the trust for thebenefit of the surviving spouse will self-adjust to obtain thedesired tax result.

b. If a partial QTIP election is made, good practice suggeststaking advantage of the provision in the regulations that

For a discussion of state law issues in protecting disclaimed property from36

the claims of creditors, see Kevin A. White, A Clash of Expectations: Debtors’Disclaimers of Property in Advance of Bankruptcy, 60 Wash. & Lee L. Rev. 1049, 1054(2003).

The formula should be expressed as a fraction of the total value of the37

trust, e.g., “the numerator of the fraction is the amount of deduction necessary to reducethe Federal estate tax to zero (taking into account final estate tax values) and thedenominator of the fraction is the final estate tax value of the residuary trust (taking intoaccount any specific bequests or liabilities of the estate paid out of the residuary estate).”Treas. Reg. § 20.2056(b)-7(h), Example 7.

N0032553.1 34

permits the marital trust to be divided into two identical trustsif authorized by the instrument or governing law: one whichqualifies for the estate tax marital deduction and one whichdoes not. This division facilitates accounting for the separate38

shares of the marital trust in the event distributions fromprincipal are made only from the portion of the trust that isincludible in the surviving spouse’s estate. To ensure theavailability of this alternative, whenever a QTIP trust isincluded in the estate plan, the will should include a provisionauthorizing division of the trust if a partial QTIP election ismade.

c. Partial QTIP elections also permit planning to take advantageof the credit for tax paid on prior transfers - the “PTP credit” -under § 2013. If, at the death of the first spouse to die, itappears likely that the surviving spouse may die within a shorttime after the first spouse or if he in fact does die shortly afterthe first spouse to die, the executor can elect to qualify asmaller portion of the marital trust for QTIP treatment,intentionally pay federal estate tax in the estate of the firstspouse to die, and take advantage of the PTP credit under§ 2013 for the actuarially determined value of the survivingspouse’s interest in the nonqualified portion of the marital trust,even though the trust is not includible in the surviving spouse’sestate.

(1) For this reason, it is generally prudent to put the estatetax return on extension when a QTIP trust is utilized sothat the executor has 15 months, rather than only ninemonths, to determine whether this credit will beavailable in the estate of the surviving spouse.

(2) The full amount of the credit is allowed if the survivingspouse dies within two years of the first spouse to die. Thereafter, the credit is reduced by 20% every twoyears, until it is exhausted at the end of ten years.

(3) Note that the value of the surviving spouse’s interest isdetermined under § 7520 of the Code which prohibitsuse of the valuation tables if the surviving spouse wasterminally ill at the death of the first spouse.

Treas. Reg. § 20.2056(b)-7(b)(2)(ii)(A). 38

N0032553.1 35

d. The primary disadvantage of estate plans relying on partialQTIP elections is that all of the income from the non-electedtrust must be distributed to the surviving spouse, therebyincreasing his taxable estate and subjecting that income toestate tax before it passes to the children. Also, there can be nodiscretion to make distributions to children and other familymembers.

e. The primary reasons to use a QTIP trust as the planning vehicleare:

(1) The assets will be held in trust regardless of whether theelection is made, to be preserved for ultimatedistribution to the beneficiaries chosen by the decedent.

(2) The decision regarding the QTIP election (which willeffectively also decide to what extent portability will beexercised) will be made by the executor, who may be ina better position than the surviving spouse to make themost prudent decision based on an objective analysis.

3. Clayton (or Contingent Income) Trusts.39

a. These trusts, in many ways, utilize and combine the advantagesof disclaimer credit shelter trusts and partial QTIP trusts.

b. Clayton trusts, named after the case, Estate of Clayton v.Comm’r., are hybrid trusts that include a set of trust terms that40

meet the requirements for QTIP treatment if a QTIP election ismade and a set of trust terms that permit beneficiaries otherthan the surviving spouse to be included if and to the extentthat the QTIP election is not made.

(1) Initially, the government was hostile to the concept of a

trust designed to make the requirement that all of the

For a more thorough discussion of Clayton elections, see Barbara A.39

Sloan, Funding Formulas Fail on Flexibility: Variations on Traditional MaritalDeduction/Credit Shelter Planning, U. Miami Heckerling Inst. on Est. Planning, Ch. 9(2004).

976 F.2d 1486 (5 Cir. 1992).40 th

N0032553.1 36

income be paid to the surviving spouse contingent onwhether the QTIP election was made.41

(2) Ultimately, the government abandoned its position andreissued Treas. Reg. § 20.2056(b)-7(d)(3) to providethat an income interest that is contingent on the electionof the executor will not fail to be a qualifying incomeinterest for purposes of the marital deduction.

(3) The non-marital alternative of the Clayton trust does notneed to require that all of the income from the trust bedistributed to the surviving spouse, can permit thesurviving spouse to have a special power ofappointment over the trust property and can includeincome beneficiaries other than the surviving spouse. Indeed, the surviving spouse need not be a beneficiaryat all of the non-marital portion of the Clayton trust.

c. Terminology.

(1) Clayton Trust. For purposes of this outline, a “Claytontrust” refers to the entire mutable entity of a QTIP-abletrust which, to the extent that a QTIP election is notmade, becomes a trust containing provisions that woulddisqualify it as a QTIP trust.

(a) Marital component. This component of the trustprovides that if the spouse survives the testator,the spouse will have a mandatory incomeinterest and no one other than the survivingspouse will have the right to receive anythingfrom the trust during the surviving spouse’slifetime (including through the exercise of apower of appointment). This QTIP-ablecomponent of the Clayton trust may or may not

In TAM 8631005, the Service ruled that a marital deduction was available41

where the surviving spouse served as executor for an estate which included a QTIP-abletrust which poured over to a non-QTIP-able trust, because the election was in the handsof the surviving spouse. However, this position was reversed in subsequent rulings andaudits and Treas. Reg. § 20.2056(b)-7(d)(3) took the position that such a trust did notqualify for the marital deduction.

N0032553.1 37

provide that the surviving spouse can receivedistributions of principal.

(b) Non-marital or family component. This secondtrust usually benefits the children and may ormay not include the surviving spouse as abeneficiary. During the period when a QTIPelection could but might not be made, thiscomponent of the Clayton trust has as muchviability as the marital component.

(c) Either the marital or non-marital component of aClayton trust may never actually becomeoperational, depending on the election that theexecutor makes. Alternatively, in the case of apartial QTIP election, they will both be funded.

(2) Clayton election. The only formal election involved ina Clayton trust is the QTIP election which, to the extentmade, eliminates the non-marital component of theClayton trust. The “election” which gives life to thenon-marital component of a Clayton trust is actually theabsence of a QTIP election and, in that sense, is not anaffirmative act. The term, “Clayton election,” actuallyrefers to the decision not to QTIP and the filing of thereturn without the QTIP election.

d. The interesting challenge presented in drafting a Clayton trustis that it is created upon the nonoccurrence of an event. Whilethe making of a QTIP election itself is irrevocable, thenonelection cannot always be said to have occurred with thesame definiteness.

(1) The issue raised here is that under Treasury Regulations§§ 20.2056(b)-7(b)(4) and (5), a QTIP election may bemade or modified on a return until the final due date forthe return, including extensions actually granted, or onthe first late return.

(2) To trigger the funding of the non-marital component ofthe Clayton trust, the drafting language can refer to afailure or refusal of the executor to elect the maritaldeduction for some portion (or all) of the marital trust

N0032553.1 38

under § 2056(b)(7)(B)(ii)(V) on the last federal estatetax return filed for the estate on or before the due dateof the return, including extensions, or if a timely returnis not filed, the first estate tax return filed by theexecutor after the due date. Since this leaves the timeperiod open indefinitely if no return is filed, makinguncertain who the beneficiaries will be, one alternativeis to provide in the will that if the Clayton election isnot made within a specified period of time, thatalternative ends and thereafter only a partial QTIPelection may be made.

(3) It is possible that a surviving spouse who serves as thesole executor of the estate may have adverse gift taxconsequences as a result of his power to direct propertyaway from himself without actually meeting thequalified disclaimer requirements. Until guidance isissued, it may be prudent not to name the survivingspouse as the sole executor of an estate that includes aClayton trust and to provide that an independentexecutor will make the decision regarding the QTIPelection. In most cases a co-executor could beappointed who would have no responsibility other thanmaking or not making the QTIP election.

e. Advantages of Clayton Trusts.

(1) Clayton trust planning has almost all of the advantagesof traditional partial QTIP planning:

(a) The executor has fifteen months instead of onlynine months to make his decision.

(b) The surviving spouse can have a special powerof appointment over the non-marital trust.

(c) Control is in the hands of the executor, whoshould not be the surviving spouse and so can bea disinterested independent party.

(d) There is no danger that the plan will bejeopardized by accidental acceptance of benefits

N0032553.1 39

by the surviving spouse of assets which wereintended to be disclaimed.

(e) Income need not be distributed to the survivingspouse from the non-marital portion, thusavoiding unnecessarily enlarging his estate.

(f) The non-marital component can be structured asa sprinkling credit shelter trust, just as withdisclaimer credit shelter trusts, and can be heldfor the benefit of the surviving spouse and thedecedent’s children, with discretionary incomeand principal distributions to any of them.

f. Disadvantages.

(1) Just as with a partial QTIP election, the assets must bedivided between the two trusts on a fractional sharebasis.

(2) If the two spouses die within a short period of time ofeach other, the estate of the surviving spouse will notqualify for the credit for previously taxed propertyunder § 2013 of the Code. This is because a Claytontrust which does not require that the income from thenon-marital portion be distributed to the survivingspouse (or which permits distributions to other people)does not give the surviving spouse an interest in thetrust which is capable of being valued actuarially.

VI. TAILORING THE USE OF FLEXIBILITY TECHNIQUES

A. Use Flexibility Techniques in Combination.

Given that each of these techniques has advantages and disadvantages,depending on the size of the estate and the client’s tolerance for complexity, itmay make sense to combine some of the techniques. One combination thatalways exists is, of course, the possibility of making a portability election inany estate where the decedent has some applicable exclusion amount.

B. Combinations of Techniques Can Achieve Tax Savings and Ease Tensions.

N0032553.1 40

1. One of the primary issues in determining which of these techniques touse is its appropriateness for the client’s family structure and thepersonalities involved. Although it is tempting to design estate plansthat simply maximize tax planning results, a significant portion of thejob of a successful estate planner is also to factor in how the partieswho survive the decedent will react to the plan and to build inprovisions to account for these reactions.

2. If, for example, there is any concern that the client’s spouse maychoose not to disclaim an outright bequest to a credit shelter trust -because he does not want his assets encumbered in trust, for example -the will can leave an outright specific bequest to the spouse so that hereceives some assets directly and leave the balance of the estate to aQTIP trust. The will can provide that if the spouse disclaims anyportion of the QTIP, it will pass to a credit shelter trust (withoutspecial power of appointment, of course). If the spouse then fails todisclaim (less likely since he will be choosing between holding hisbequest in trust no matter what), the executor (if she is not the spouse)still has the fall back position of making a partial QTIP election to takeadvantage of the client’s unused applicable exclusion amount.

3. A plan such as this allows the spouse to feel involved in the post-mortem planning for the decedent’s estate without leaving all of thecontrol in his hands if that is not appropriate, for example, because thedecedent’s children are from a prior marriage. Although a similarresult could have been obtained by making an outright bequest to thespouse and then giving the executor the option of making a Claytonelection, assuming the surviving spouse is not the executor (to avoidpotential adverse gift tax consequences if for no other reason), thesurviving spouse would have not been a participant in these decisions.

VII. PORTABILITY

A. No Longer New.

Now that portability, which permits the unused applicable exclusion amountof a deceased spouse to be transferred to the surviving spouse for use in hisestate planning, has been around for a few years as a permanent part of our42

IRC § 2010(c). Section 2010 of the Code remains titled “Unified Credit42

Against Estate Tax” even though the text of the section no longer refers to the unifiedcredit and instead refers to the “applicable credit amount” and the “applicable exclusion

N0032553.1 41

estate planning tool kit, it is important to know not just how to use it, but43

also when to use it, when not to use it, and when the decision should be made. It simplifies estate planning in many estates, particularly those that aresmaller, and creates potential substantial estate tax savings in many largerestates, particularly in decoupled states.

B. Simplification?

Portability has the enticing look of simplification. It was designed to simplifythe estates of couples with combined estates greater than one basic exclusionamount and less than two times the basic exclusion amount. For 30 years,these couples, if they visited estate planners, had been creating estate planswhere, by combining two separate bequests for the benefit of the survivingspouse, one using the applicable exclusion amount and the other the unlimitedmarital deduction, the applicable exclusion amount of the first spouse to diecould be preserved for the benefit of the testator’s descendants and no taxwould be due until the death of the surviving spouse. This technique of usinga combination of a marital deduction bequest with a credit shelter trust hadbeen the backbone of their estate planning. The concept of using portability ofthe deceased spouse’s unused applicable exclusion (“DSUE”) amount in lieuof a credit shelter trust is simple on its face, but, like many things, becomesmore complex as rules to implement it are developed.

C. Transfer of Exclusion Amount.

In December 2010 as a part of TRUIRJCA, Congress authorized a taxpayerdying in 2011 or thereafter to allow any of her unused applicable exclusionamount to be transferred to her surviving spouse without the need for a creditshelter trust to preserve the use of the credit at the death of the survivingspouse. This change represents a breakthrough in planning, particularly for44

those taxpayers with combined estates that total an amount greater than one

amount.” Note that the term “applicable credit amount” refers to the actual amount oftentative tax that would be payable if the tax base were equal to the applicable exclusionamount. All references in this outline to sections are references to sections of the Code,unless otherwise indicated.

Section 101(a)(2), P.L. 112-240.43

Specifically, Congress amended § 2010(c) of the Code to add, inter alia,44

subsection (2) that provides that “the applicable exclusion amount is the sum of (A) thebasic exclusion amount and (B) in the case of a surviving spouse, the deceased spousalunused exclusion amount.” P.L. 111-312, § 303(a).

N0032553.1 42

applicable exclusion amount, but less than two - what may be referred to asthe “wealthy middle class.” And, even for those of our married clients whofully used their applicable exclusion amounts making gifts in 2011 and 2012,portability will continue to be of interest since the applicable exclusionamount has, for the moment, increased substantially in size and is indexed forinflation.

VIII. HOW PORTABILITY WORKS

A. Requirements in the Code.

1. In § 2010(c) of the Code, in addition to authorizing portability of theapplicable exclusion amount and providing the definitions of thecomponents of portability, Congress provided that in order to takeadvantage of portability, the executor of the estate of the deceasedspouse must file an estate tax return on which the amount of the DSUEis calculated and an election to permit the surviving spouse to use theDSUE amount is made.

2. Congress also provided that the details of how portability would workwould be developed by Treasury in legislative regulations.

B. Regulations.

1. Making the Election.

a. By Executor on Timely-Filed Return.

As required by the Code, the executor is required to make theportability election on a timely-filed estate tax return. 45

(1) The filing of a complete and properly prepared timelyreturn will constitute a making of the election if there isa surviving spouse. The executor may affirmatively optout of portability when filing the Form 706.46

(2) The last-filed timely-filed return is determinative ofwhether the election was made and that decision is

Treas. Reg. §§ 20.2010-2(a) (flush language) and (a)(6)(i).45

Treas. Reg. § 20.2010-2(a)(2).46

N0032553.1 43

irrevocable thereafter. The regulations do not provide47

a procedure for making a protective portability electionor for relief to make a late portability election, althoughthe regulations make clear that an extension of time toelect portability may be available under §§ 301.9100-1and 301.9100-3 to an estate that otherwise is notrequired to file a return because the value of the grossestate does not exceed the basic exclusion amount.48

b. No Executor.

In the event that no executor is appointed for an estate, anyperson in actual or constructive possession of the decedent’sproperty (a “non-appointed executor”) may file the estate taxreturn and make the election for portability to apply to thedecedent’s DSUE amount or not. 49

(1) A significant distinction regarding a portability electionmade by a non-appointed executor is that, unlike onemade by an appointed executor, it cannot be supersededby a contrary election made by a different non-appointed executor.

(2) This means that in the case where there is no appointedexecutor, a race to the mailbox with the Form 706 maydetermine whether or not an election will be made.

c. Complete and Properly-Prepared Return.

The regulations reiterate the requirement that theelection is made by filing a “complete and properly-prepared” estate tax return. However, for estates not50

Treas. Reg. § 20.2010-2(a)(4).47

Treas. Reg. § 20.2010-2(a)(1). See Rev. Proc. 2017-34 which allows an48

estate otherwise not required to file a federal estate tax return a simplified method toobtain an extension of time to file a return to make the portability election for the twoyear period following the decedent’s death.

Treas. Reg. § 20.2010-2(a)(6)(ii).49

Treas. Reg. §§ 20.2010-2(a)(2) and (7)(i).50

N0032553.1 44

otherwise required to file a return, a special rule appliesto make completion of the return less expensive andless burdensome.

(1) For smaller estates, executors are not required to reportthe value of certain transfers that qualify for the maritalor charitable deduction and may, exercising duediligence, estimate the total fair market value of thegross estate. The regulations explain that the51

instructions for Form 706 provide dollar ranges for theexecutor to use in identifying the executor’s bestestimate of the value of the estate.52

(2) With respect to marital and charitable deductionproperty included in the gross estate, the executor mustprovide only a description of the property, who theowner of the property was, and/or who the beneficiaryof the property is, along with information sufficient toestablish the estate’s right to the marital or charitablededuction.53

(3) As a result, the only assets requiring the usualprocedure for determination of value on a Form 706 arethose not qualifying for the marital or charitablededuction.

d. Opting Out of Portability.

Although several post-mortem decisions may affect whetherthe decedent has a DSUE amount (e.g., QTIP elections anddisclaimers), it is possible, particularly in some dysfunctionalfamilies, that even though the decedent has a DSUE amount,the executor does not wish to elect portability. In order for theportability election not to apply to the decedent’s DSUEamount, if a return is required to be filed, the executor muststate affirmatively on a timely-filed return that the estate is not

Treas. Reg. § 20.2010-2(a)(7)(ii).51

Treas. Reg. § 20.2010-2(a)(7)(ii)(B).52

Treas. Reg. §§ 20.2010-2(a)(7)(ii)(A) and (B).53

N0032553.1 45

electing portability. If no return is required to be filed and the54

executor in fact does not file a return, then, as always, the lackof a timely filed return will prevent the application ofportability.

e. Nonresident Non-Citizens.

No portability election is available for nonresident decedentswho were not US citizens at the time of their deaths. In55

addition, a nonresident surviving spouse who is not a UScitizen at the time of making a gift or at the time of her deathmay not take into account any DSUE amount of a deceasedspouse, except as may be allowed under an applicable treatyobligation of the United States. 56

2. Computing the DSUE Amount.

a. Where Calculated.

(1) In order to meet the requirements to elect portabilitytreatment on an estate tax return, the executor mustinclude a calculation of the DSUE amount on thereturn. 57

(2) Even if it appears that there is no DSUE amount, thereturn should still include the calculation of a zeroDSUE amount in order to preserve portability in theevent that an adjustment to the taxable estate results in aDSUE.

b. How Calculated.

(1) In order to calculate the DSUE amount, it is necessaryto understand several terms defined in the Code:

Treas. Reg. § 20.2010-2(a)(3).54

Treas. Reg. § 20.2010-2(a)(5).55

Treas. Reg. §§ 25.2505-2(f) and 20.2010-3(e).56

Treas. Reg. § 20.2010-2(b)(1).57

N0032553.1 46

(a) Each individual has a “basic exclusion amount”defined as $11 million plus any cost of livingadjustment determined to be applicable,currently $11,400,000.

(b) The “applicable exclusion amount” is the sumof the basic exclusion amount and, in the case ofa taxpayer who is a surviving spouse, the DSUEamount.58

(2) Definition of DSUE Amount.

(a) Treas. Reg. § 20.2010-2(c)(1) provides:

“General rule. Subject to paragraphs (c)(2)through (4) of this section, the DSUE amount ofa decedent with a surviving spouse is the lesserof the following amounts–

(i) The basic exclusion amount in effect in theyear of the death of the decedent; or

(ii) The excess of–

(A) The decedent’s applicable exclusionamount; over

(B) The sum of the amount of the taxable estateand the amount of the adjusted taxable gifts ofthe decedent, which together is the amount onwhich the tentative tax on the decedent’s estateis determined under § 2001(b)(1).”

(b) The regulations clarify that the first reference to“basic exclusion amount” in the code sectionmeans the basic exclusion amount in effect inthe year of the death of the decedent whoseDSUE is being computed. This appears to be59

a determination by Treasury and the Service

§ 2010(c)(2).58

Treas. Reg. § 20.2010-2(c)(1)(i).59

N0032553.1 47

that, in the event the basic exclusion amount isreduced in future years, the amount of theDSUE nonetheless is determined based on thebasic exclusion amount in effect at the time ofthe decedent’s death.

(3) In addition, to avoid using exclusion for amounts onwhich gift tax was actually paid, solely for purposes ofcomputing the DSUE amount, the amount of thedecedent’s adjusted taxable gifts is reduced by theamount of any gifts on which gift tax was paid.60

(4) Example: Decedent, while alive, makes a total of $2.5million of gifts in 2002, when the applicable exclusionamount for gift tax purposes was $1 million. Decedent pays gift tax on $1.5 million of gifts. In 2019, Decedentdies with an estate of $2 million. Her DSUE iscalculated as the lesser of $11.4 million (the basicexclusion amount at the time of her death) or the excessof $11.4 million over $3 million ($1 million of adjustedtaxable gifts and $2 million in her estate) or $8.4million. For the purposes of this calculation only, the$1.5 million of gifts on which Decedent paid gift tax isnot included in her adjusted taxable gifts.

c. Special Rule when Property Passes to Qualified Domestic Trust(“QDOT”).

(1) Although the DSUE amount is calculated on thedecedent’s federal estate tax return, in the case of adecedent who has left property to a QDOT, this amountis tentative, subject to reduction for any tax due ondistributions made from the QDOT or any other taxableevent that could occur with respect to the QDOT.61

(2) At the termination of the QDOT, the decedent’s actualDSUE amount can be determined because all potentialestate tax deferred by the use of the QDOT will then bedue under § 2056A and the amount of the decedent’s

Treas. Reg. § 20.2010-2(c)(2).60

Treas. Reg. § 20.2010-2(c)(4).61

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applicable exclusion amount that will be necessary toreduce that tax can be finally determined. The62

surviving spouse will have access to the decedent’sDSUE only after the QDOT ends, either during thesurviving spouse’s life or at her death.63

(3) Example: Decedent, a US citizen, while alive, makes ataxable gift of $1 million in 2002 when the applicableexclusion amount for gift tax purposes is $1 million. Decedent dies in 2019 when the basic exclusion amountis $11.4 million owning assets of $10 million. Surviving spouse is a US resident, but not a US citizen. Decedent’s will leaves $9.5 million to a QDOT forsurviving spouse and decedent’s executor makes theQDOT election and elects portability on her estate taxreturn. Decedent’s estate receives a marital deductionof $9.5 million and Decedent’s DSUE amount iscalculated to be the lesser of $11.4 million or the excessof $11.4 million over $1 million in gifts and $500,000taxable estate or $9.9 million. Later in 2019, survivingspouse dies without having taken any distributions ofprincipal from the QDOT or having any other taxableevents under § 2056A occur. At the time of survivingspouse’s death, the value of the QDOT is $9.6 million. Decedent’s DSUE amount is adjusted to cover the$9.6 million in the QDOT in addition to the $500,000taxable estate and $1 million in gifts, leaving a DSUEamount of $300,000 available to surviving spouse’sestate to protect his assets from estate tax.

3. When the DSUE Amount Can be Used.

The regulations provide that a DSUE amount can be used bythe surviving spouse at any time following the decedent’sdeath, assuming the portability election is made on the Form706 filed for the decedent and that the decedent is the last

Treas. Reg. §20.2010-3(c)(3).62

See Treas. Reg. § 25.2505-2(d)(3).63

N0032553.1 49

deceased spouse of the surviving spouse at the time of thetransfer by the surviving spouse.64

4. Definition of Last Deceased Spouse.

a. The regulations define last deceased spouse as “the mostrecently deceased individual who, at that individual’s deathafter December 31, 2010, was married to the survivingspouse.”65

b. The identity of the last deceased spouse of a surviving spouseis unchanged by her marriage to a new spouse or by hersubsequent divorce from the new spouse. Needless to say,however, if the new spouse dies, he becomes the last deceasedspouse of the surviving spouse.66

c. The most recent spouse who has died is the last deceasedspouse of the surviving spouse, regardless of whetherportability was elected in his estate.67

5. Ordering Rule and Effect in the Case of Multiple Deceased Spouses.

a. When a surviving spouse makes a taxable gift, the DSUEamount from her last deceased spouse will be applied againstthe amount of the surviving spouse’s taxable gifts for thatcalendar year, prior to the application of the surviving spouse’sown basic exclusion amount.68

b. The DSUE amount available to the surviving spouse at anygiven moment in time during her life or to her estate at herdeath includes the DSUE amount of the surviving spouse’s last

Treas. Reg. §§ 20.2010-3(a)(1) and 25.2505-2(a)(1).64

Treas. Reg. § 20.2010-1(d)(5).65

Treas. Reg. §§ 20.2010-3(a)(3) and 25.2505-2(a)(3).66

Treas. Reg. §§ 20.2010-3(a)(2) and 25.2505-2(a)(2).67

Treas. Reg. § 25.2505-2(b).68

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deceased spouse and any DSUE amount she actually applied totaxable gifts even if that DSUE amount was from a decedentwho is no longer the surviving spouse’s last deceased spouse. 69

(1) This means, for example, that a surviving spouse whohas survived the deaths of several spouses may use theDSUE amount from each of them before the death ofhis next spouse, assuming a portability election wasmade for each of them.

(2) However, the DSUE amounts of the deceased spousescannot be aggregated and all used at once.

(3) At the death of the next spouse, any remaining DSUEamount left from a prior deceased spouse may no longerbe used by the surviving spouse.

c. Example: Decedent, while alive, makes gifts of $1 million in2002 when the gift tax applicable exclusion amount is$1 million. Decedent dies in January, 2018, with an estate of$2 million which she leaves entirely to her surviving spouse. Her executor makes a portability election on her estate taxreturn and calculates her DSUE amount to be $10.18 million. In May of 2018, surviving spouse remarries and in June makesgifts of $2 million to his children. Tragically, in September,2018, surviving spouse’s second spouse dies, having used$1.5 million of her applicable exclusion amount making gifts toher sister. She leaves the balance of her estate to survivingspouse. Second spouse’s executor makes a portability electionand properly calculates her DSUE amount to be $9.68 million. At that point, Surviving spouse’s applicable exclusion amountis his own basic exclusion amount of $11.18 million which hehas not used yet, $2 million of his first spouse’s DSUE whichhe used making gifts to his children, and $9.68 million ofDSUE amount from his second spouse, for a total $22.86million. Although he forfeited the remaining $8.18 million ofDSUE amount available from his first spouse when his secondspouse died, he is still better off for having received his secondspouse’s DSUE. Surviving spouse now marries his thirdspouse and makes additional gifts to his children of $7 million. Third spouse dies in November, 2018, without having used any

Treas. Reg. §§ 25.2505-2(c) and 20.2010-3(b).69

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of her applicable exclusion amount. She leaves her estate tosurviving spouse and her executor elects portability treatmenton her estate tax return. Surviving spouse now has anapplicable exclusion amount of his own $11.18 million, the $2million he used from his first spouse, the $7 million he usedfrom his second spouse, and the $11.18 million DSUE amounthe just received from his third spouse, or $31.36 million. InJanuary of 2019, surviving spouse has an applicable exclusionamount of $31.58 because his basic exclusion amountincreased to $11.4, but the DSUE from his third wife is notincreased. Note, however, that $9 million of the DSUE amountfunctions to offset surviving spouse’s taxable gifts of $9million, which will be included in his estate tax base asadjusted taxable gifts.

6. Authority to Examine Returns of Deceased Spouses.

a. For purposes of determining the DSUE amount included in theapplicable exclusion amount of the surviving spouse, theService may examine any tax returns of each of the survivingspouse’s deceased spouses whose DSUE amount is claimed tobe included in the surviving spouse’s applicable exclusionamount, regardless of whether the period of limitations onassessment has expired for the return. 70

b. The Service may adjust or eliminate the DSUE amountreported on a return, but may not assess additional tax on thatreturn if the period of limitations for assessment for that returnhas expired.71

IX. ADVANTAGES OF PORTABILITY

Aside from its most obvious advantage of simplification by permitting taxpayers toavoid the need to create trusts in order to utilize their exclusion amounts, portabilityoffers other advantages.

Treas. Reg. §§ 20.2010-2(d), 20.2010-3(d) and 25.2505-2(e).70

Treas. Reg. §§ 20,2010-3(d) and 25.2505-2(e).71

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A. No Separation of Assets.

Many taxpayers have crafted marriages in which all of their wealth is jointlyowned, and they feel this is a significant component of their relationship witheach other. When told they should separate their assets to permit moreefficient tax planning, they may do it, but not happily, even when usingtechniques designed to give them more comfort (e.g., using separate revocabletrusts where both spouses are co-trustees of each trust). Portability obviatesthe need for separating assets. All assets can remain jointly owned, and forsome clients, this will be a substantial benefit.

B. No Loss of Basis Adjustment.

Portability may also resolve one of the few disadvantages of credit sheltertrusts - the loss of basis adjustment under § 1014 at the death of the secondspouse to die. Because the surviving spouse can own all of the assets directly,these assets can all receive a basis adjustment at his death which can be avaluable benefit. Of course, this advantage also holds if the surviving spouseis the beneficiary of a QTIP trust.

C. No Trust Required.

Although many estate planners are big believers in trusts and the manyadvantages that they offer, many of our clients see the use of trusts as a botherthat adds unnecessary complexity to their estate plans. Again, portability canbe the solution for these clients, permitting the simple “I love you” wills thatmost of them think will be sufficient for their needs.

D. Avoids Planning with “Difficult” Assets.

Another difficulty that portability can address is that of taking full advantageof the applicable exclusion amount in the estate of the first spouse to die whenthe couple’s assets are composed primarily of assets that are difficult to use tofund a credit shelter trust, such as retirement plans. Portability avoids wastingapplicable exclusion amount when attempting to fund the credit shelter trustwith “difficult” assets.

E. Planning Opportunities in States with State Death Taxes.

In states that have a state death tax but no gift tax, portability will permit thesurviving spouse to use the DSUE amount of the first spouse to die to makegifts that escape state transfer taxation altogether. Since in these states full useof the decedent’s applicable exclusion amount to fund a credit shelter trust

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generally necessitates payment of some state estate tax, this can be a bigadvantage. And since the regulations provide such a favorable ordering rule,allowing the DSUE amount to be used for gifts prior to using the donor’s basicexclusion amount, this technique permits the maximum benefit to be derived72

from the DSUE. Although gifting assets by the survivor does mean that thebeneficiary loses out on an adjustment in basis at the death of the survivingspouse, this disadvantage is no worse than the result obtained through the useof a credit shelter trust, which we have all been living with for years. On theplus side, the gift can be to an intentionally defective grantor trust.73

X. DISADVANTAGES OF PORTABILITY

A. Future Growth.

1. By giving assets directly to the surviving spouse, rather than wrappingthem in a credit shelter trust, the future growth in the assets is notinside the protective wrapper, but instead is subject to estate tax at thedeath of the surviving spouse. This is one of the first disadvantagesestate planners mention in thinking of portability and can besignificant, particularly in the case of young clients.

2. Generally, this will not be a significant issue where the clients’ networth is modest. However, when the clients are young, it may bedifficult to predict the extent to which their estates will increase overthe years.

3. A partial offset not to be overlooked, however, is the fact that theassets will receive an adjustment in basis at the death of the secondspouse. The adjustment may or may not be significant depending onthe nature of the assets and the applicable state income and estate taxregimes. In some states, avoidance of income taxation of capital gain

Treas. Reg. § 25.2505-2(b).72

An intentionally defective grantor trust is one over which the grantor has73

been given so much control or has retained so great an interest that the trust is subject tothe income tax grantor trust rules. The grantor’s retained control or interest is structuredin such a way that the trust is disregarded for income tax purposes, but not for estate taxpurposes, and all of the income and deductions associated with the trust are taxed directlyto the grantor. Furthermore, purchase and sale transactions between the grantor and thegrantor trust do not result in gain or loss recognition. Rev. Rul. 85-13, 1985-1 C.B. 184. See IRC §§ 671-679 for the grantor trust rules.

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may be as valuable as avoidance of estate taxation, making the loss ofan adjustment in basis at the death of the surviving spouse asexpensive as payment of estate tax on the assets. Note that it willlikely be the income tax regimes applicable to the family's children thatwill be the most relevant.

B. Loss of DSUE Amount.

1. A risk with portability is that the surviving spouse will lose some or allof the DSUE amount if he remarries and the second spouse, who has asmaller or no basic exclusion amount, also predeceases him. TheDSUE amount is not cumulative unless used making gifts prior to thedeath of the succeeding spouse.

2. By contrast, the surviving spouse's remarriage does not impact thebenefits of a credit shelter trust and the surviving spouse canaccumulate multiple credit shelter trusts.

C. Unexpected State Estate Tax.

1. Assume clients are living in a state that does not impose a state estatetax and they rely on portability of the entire basic exclusion amount ofthe first spouse to die because no tax, federal or state, is due at thedeath of the first spouse to die. Then assume that the surviving spousemoves nearer to grandchildren in a state that does impose an estate tax. The assets inherited by the surviving spouse that could have beenprotected from state estate tax in a credit shelter trust established at thedeath of the first spouse to die will all be subject to state estate tax atthe death of the surviving spouse.

2. This circumstance and the one prior to it (loss of DSUE amount) createimponderables in estate planning. The best an estate planner can do isask the right questions, advise the client of the potential risks andbenefits, let the client make the decisions, and hope for the best.

D. Complex Family Structures.

1. Perhaps an even more troubling disadvantage of portability is that itdoes not work well in many complex family structures, and in manycases, this disadvantage has no “work around.”

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2. The first issue involves selection of the executor for the first spouse todie. The regulations clearly provide that, for a testate decedent, onlythe executor can make the portability election. 74

a. Several situations may occur where this can raise an issue. First, if the estate is not large enough to independently requirethe filing of an estate tax return under § 6018, the executor maychoose not to incur the expense and trouble of filing an estatetax return solely for the purpose of making the portabilityelection, particularly if the spouse is a second spouse and theexecutor is a child of the decedent’s first marriage.

(1) Unfortunately, the author is already aware ofcircumstances in which an executor has suggested thatthe children of the decedent’s first marriage shouldshare in some of the benefit of the portability election(should receive a payment from the surviving secondspouse) in order to obtain the executor’s agreement tofile an estate tax return.

(2) Even in less egregious cases, the executor may requirethe surviving spouse to cover the expenses of filing thereturn since he will be receiving the benefit of theelection. These costs may be treated as including thecost of gathering information regarding the assets andtheir value, in addition to the actual preparation of thereturn, even though some of the costs likely would havebeen incurred even if a return had not been filed.

b. As a caution, in cases such as these, we may serve our clientsbest by asking if they would like to include language in the willdirecting whether an estate tax return should be filed if nototherwise required if there is a DSUE amount and if so,directing the source of funds to be used to cover the cost of thepreparation and filing.

3. An even more difficult situation may be posed by a family structure inwhich each spouse has children from a prior marriage and assets inexcess of the basic exclusion amount. Typically, in a complex familystructure where a client has children from a prior marriage, we, asplanners, rely on QTIP trusts to obtain the marital deduction and allow

Treas. Reg. § 20.2010-2(a)(6).74

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the surviving spouse to receive the economic benefit of the deceasedclient’s assets while ensuring that at the death of the surviving spouse,the client’s assets pass to the client’s descendants (or whomever theclient chooses). QTIP trusts were designed to address these complexfamily structures, work well and give the clients (and us) comfort thatthe surviving spouse and the children from the prior marriage areadequately protected. However, different results may follow where aQTIP trust is combined with portability, and this combination mayactually defeat the client’s goals.

a. In this case, if the decedent were to bequeath all of her assets toa QTIP trust for the benefit of her second spouse, with theremainder to her children, and permit her second spouse toserve as executor, he would likely elect QTIP treatment for thetrust and elect portability for the DSUE amount.

(1) If the surviving second spouse then were to make giftsto his children of his first marriage of his applicableexclusion amount (including the DSUE amount fromthe decedent), at his death there would be no credit leftand the decedent’s children would be required to pay allof the tax generated by the inclusion of the QTIP in theestate of the surviving second spouse, even though thedecedent’s DSUE amount had protected gifts of thesurviving second spouse’s assets to his children fromtax.

(2) Even if the surviving second spouse did not make giftsof the applicable exclusion amount to his children,assuming that at his death his estate were large enoughto absorb his entire applicable exclusion amount,nothing would require him to exonerate the QTIP trustfrom its statutory tax contribution.

Example: Frieda is married to Harvey. Both are married forthe second time with children from prior marriages. Friedadies first early in 2018 with an estate of $8 million which sheleaves in a QTIP trust for Harvey with the remainder to herchildren. Harvey, as her executor, elects QTIP treatment andportability. Harvey has separate assets of $16 million. At hisdeath late in 2018, shortly after filing Frieda's estate tax return,he has a taxable estate of $24 million. He has an applicableexclusion amount of $22.36 million. Everything above that is

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taxed at 40% resulting in estate tax of $656,000. Because§ 2207A requires reimbursement from the QTIP at themarginal rate, the $656,000 of tax will all be payable from theQTIP, and Frieda's children will receive $7.344 million. All ofthe benefit of Harvey's applicable exclusion, including Frieda'sDSUE amount, goes to Harvey's children. This is on top of thefact that Harvey also got all of the income from Frieda's QTIP.

b. Even in cases where the combined assets of a married coupleare less than their combined applicable exclusion amounts, useof portability may be contraindicated and traditional creditshelter planning may be the more p rudent course of action.

Example: John is 55 years old with three children. Jane, John'sfirst wife, died in 2008 and John has married Sally who has nochildren, but does have nieces and nephews she favors. Johnhas assets of about $8 million, as does Sally. John has said (infront of Sally) that he wants all of his separately owned assetsto pass to his children whether or not Sally survives him. Sallyis willing for her separately owned assets to go to a trust forJohn if she predeceases, but she wants the remainder to go toher nieces and nephews. If Sally leaves her assets in a QTIPtrust for John and permits him, as her executor, to electportability of her $11.4 million exclusion amount, it is not hardto imagine that, if John lives to his life expectancy (aboutanother 30 years), the combined value of his assets and theassets in the QTIP trust may exceed the value of his applicableexclusion amount even though his basic exclusion amount isindexed for inflation because Sally's DSUE amount is notindexed. Assuming (1) the tax laws do not substantiallychange in the next 30 years, (2) John does not remarry awoman who also dies - thus potentially losing Sally's DSUEamount, and (3) John, in his will, does not exonerate the QTIPtrust from paying its required reimbursement for estate tax, atJohn's death, estate tax will be due and the QTIP trust will berequired to pay the marginal estate tax due on its value. John'schildren will get the benefit of Sally's DSUE amount andSally's nieces and nephews will receive their share reduced byestate taxes.

c. In cases such as these, the more prudent course of action wouldbe to say that portability may not be appropriate for this family

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structure and caution your clients to go forward with traditionalcredit shelter/marital deduction planning.

(1) It is true that in some cases, placing assets in a creditshelter trust where they will not receive an adjustmentin basis at the death of the surviving spouse, rather thanin a QTIP trust where they will, may actually cost taxdollars rather than saving them due to the range of stateestate and income tax laws.

(2) However, given the number of uncertain variables (howlong the surviving spouse will live, changes in the taxlaws, which state income tax law will apply to thebeneficiaries at the time they wish to sell inheritedassets, rates of inflation and rates of return), the onlyway to be sure that the applicable exclusion amount ofthe first spouse to die benefits her beneficiaries is tolock its use in with a credit shelter trust at the time ofher death. Any excess amount can pass to the survivingspouse as DSUE so that it is not wasted.

d. At a minimum, these issues do require some discussion withyour client about her preferences and a careful selection of theparty to serve as executor – perhaps coupled with a direction inthe will as to what elections the executor should make.

e. These issues could also be addressed in a prenuptial orpostnuptial agreement. For example, the parties could agree topermit the surviving spouse to have the use of any remainingexclusion amount not used by the first spouse to die on lifetimegifts, in return for an agreement that the surviving spousewould waive the right of reimbursement for estate tax due as aresult of the inclusion of the QTIP trust benefitting the childrenof the first spouse to die in the surviving spouse’s estate.

f. For clients who are already married and (1) do not have aprenuptial agreement or do not have a provision addressing theuse of the DSUE in their prenuptial agreements, and (2) live ina state where postnuptial agreements are not effective or theclients prefer not to negotiate a postnuptial agreement, theremay be another option. In these cases, consider whether thetestator can unilaterally address the issue by including aprovision in her will that directs her executor to make the QTIP

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election for a trust created under her will only upon receiving abinding agreement executed by the surviving spouse agreeingto waive in his will the right of reimbursement from the QTIPtrust.

Example: Returning to Frieda and Harvey, Frieda created an$8 million QTIP for Harvey, who had $16 million of his own. At Harvey's death, if his Will exonerates Frieda's QTIP fromreimbursement for estate tax under § 2207A, then all ofFrieda's $8 million will go to her children. Harvey's childrenwill get the benefit of Frieda's $3.18 million of unused DSUEamount (in effect, $8 million of her DSUE amount is protectingthe QTIP), and all of Harvey's basic exclusion amount.

BUT, consider the following example:

Example: Flora and Herbert are on their second marriages,each with children from a prior marriage. Flora dies first inFebruary of 2019 with an estate of $20 million which sheleaves to a QTIP for Herbert. Flora's Will has a provisionpermitting her executor to make a portability election if Herbertagrees to exonerate the QTIP from reimbursement under§ 2207A. Herbert agrees to exonerate the entire QTIP. AtHerbert's death a few months later, he has separate assets of$12.4 million, making his taxable estate $32.4 millionincluding the $20 million QTIP. He has an applicableexclusion of $22.8 million, leaving $10 million subject to tax at40% ($4 million). His $12.4 million estate will pay the entire$4 million of tax and the entire $20 million in the QTIP willpass to Flora’s children. If, instead, Flora’s will had created acredit shelter trust of $11.4 million with the remainder to herchildren and Herbert had not waived his right of reimbursementfor estate tax from the QTIP trust, the QTIP trust would havebeen funded with $8.6 million for which it would havereimbursed the estate $3.448 million in tax, leaving Herbert’sestate to pay only $560,000 in tax from Herbert’s assets. Herbert’s children would have received the full benefit ofHerbert’s applicable exclusion amount and paid tax on theexcess and Flora’s children would have received the fullbenefit of her applicable exclusion amount and paid tax on theexcess. Exoneration of the entire QTIP trust can over-compensate the QTIP beneficiaries.

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(1) Under circumstances such as Flora and Herbert's,consider segregating the QTIP into two shares: oneequal in value to the DSUE amount and one equal to thebalance and exonerate only the first QTIP from the rightof reimbursement for taxes.

(2) A final point to consider in using the exonerationtechnique to preserve benefits from the DSUE amountfor the beneficiaries of the first to die is the importanceof a solvent surviving spouse. The surviving spouse'sestate may have huge adjusted taxable gifts madeimmediately before death, and not many assetsremaining in the estate. In this case, there might not beenough left in the estate to pay the tax due on the QTIP. Even in cases of well-meaning surviving spouses, thesedeathbed gifts may have been made by a child of thesurviving spouse under a power of attorney.

E. GST Exemption.

1. A final disadvantage of using portability is that the GST tax exemptionis not portable. The use of portability for the client’s applicableexclusion amount may cause the client’s GST tax exemption amountto be wasted, or, at best, make its use inefficient.

2. Under current law, the amount of the GST tax exemption and theamount of the basic exclusion amount are equal. Assuming thedecedent’s remaining applicable exclusion amount is being transferredto the surviving spouse through a portability election, the only way thedecedent can take advantage of her remaining GST exemption is tomake a bequest for the benefit of grandchildren using a reverse QTIPtrust.75

3. In conjunction with making the portability election, if the executorwere to make a reverse QTIP election to allocate the decedent’sremaining GST tax exemption to a trust for the surviving spouse withher grandchildren or more remote descendants as the ultimateremaindermen, this would result in an inefficient use of GST taxexemption. First, the value of the assets in the trust would notappreciate as quickly as would be desirable because all of the incomeof the trust would be required to be distributed to the surviving spouse.

§ 2642(a)(3).75

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In addition, if the reverse QTIP trust is the only QTIP trust created inthe estate of the first spouse to die, or, in the worst case, if the regularQTIP is not obligated to pay the estate tax due on the reverse QTIPtrust, the estate tax due at the death of the surviving spouse might haveto be paid from the GST tax exempt assets in the trust. This willclearly reduce the effectiveness of the GST exemption allocation.

XI. APPLICATION OF PORTABILITY RULES

The concept of portability is most useful in three particular situations: (1) where thecombined estate of a married couple is taxable but does not exceed twice the amountof the basic exclusion amount; (2) where the bulk of value in the combined estate of amarried couple is in assets that are hard to use to fund a credit shelter trust; and (3) forwealthy couples.

A. Married Couples with Modest Wealth.

1. The Ideal Couple.

Married couples with combined estates of greater than one basicexclusion amount but less than two times the basic exclusion amountare generally the taxpayers for whom portability was implemented. These individuals (with the help of their estate planners) have beencreating credit shelter trusts in their documents because, although theirseparate estates were not taxable, their combined estates potentiallywould be taxable at the death of the survivor of them. Generally, hadit not been for tax planning, the vast majority of these taxpayers wouldnot have created trusts for their spouses and would instead have beenhappy with simple “I love you” wills.

a. Now, using portability, the first spouse can simply leave all ofher assets to her surviving spouse, with the knowledge that hercredit will still be of use in protecting her assets from tax at thedeath of her spouse.

b. The simplest example might be a couple where each of themhas $6 million of assets. At the death of the first spouse, sheleaves all of her assets to her spouse who, after her executorelects portability on her estate tax return, then has an applicableexclusion amount of $22.8 million. This exceeds the amountof the couple’s combined wealth by a nice margin, andassuming they are not too young, is likely to be sufficient to

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protect all of their assets from tax at the death of the survivor,even permitting some growth in the assets.

c. Note, however, that if they reside in a state that imposes a deathtax, additional state death tax will be due at the death of thesurviving spouse since any state death tax exemption of thefirst spouse will have been wasted.

d. For this reason, for clients residing in states that continue toimpose a death tax, a credit shelter trust in the amount that canpass free of state estate tax will still be a prudent course.

2. But What about the Growth?

A more troubling example might be a couple where each of them has alittle over $10 million of assets. In this case, if it were likely that thevalue of the assets would increase, a credit shelter trust in the estate ofthe first spouse to die would protect any future appreciation of theamount of the credit shelter trust from tax. Note, however, in statesthat impose a death tax, state tax is likely to be due at the death of thefirst spouse on the amount in the credit shelter trust that exceeds theamount that can pass free of state estate tax. In addition, theappreciation in the value of the assets between the two deaths willqualify for a § 1014 basis adjustment if owned directly by thesurviving spouse or by a QTIP trust, which would not be the case if acredit shelter trust were to be used. Estates in this range can poseconundrums and it may be difficult to determine whether portability inexcess of the amount that can pass free of state estate tax is the bestchoice for these clients.

B. The More Wealthy/Less Wealthy Couple.

On the other hand, if the two spouses do not have assets of equalvalue, but instead have most of the wealth in the hands of one spouse,portability can permit them to take full advantage of the applicableexclusion amount, regardless of who is the first to die.

1. If the less wealthy spouse is the first to die and his executor electsportability, then the more wealthy spouse will have the maximumamount of exemption available to protect her assets from tax at herdeath. Again, this is subject to the caveat that it may be prudent to besure the less wealthy spouse can take advantage of the amount that canpass free of state estate tax, if any.

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2. Alternatively, if the more wealthy spouse is the first to die, she canleave all of her assets either outright or in a QTIP trust for the lesswealthy spouse, have her executor elect portability and at the death ofthe second spouse, the less wealthy spouse will have all of the assetsincludible in his estate and will have both exclusion amounts availableto him.

3. This eliminates the need for the couple to retitle assets in order to fullyuse each of their applicable exclusion amounts, an exercise that oftendistorted a couple’s otherwise preferred financial structure.

C. Planning with Difficult Assets.

Regardless of the size of a couple’s combined estate, there are some assets thatmay represent a substantial portion of the value of the couple’s assets but thatare difficult to use to fund a credit shelter trust. A couple of examples arepresented below.

1. IRD Assets.

Retirement plans can be used to fund credit shelter trusts, but evenwhen done properly, it is very easy to end up with a trust that isinefficiently funded because a big chunk of it is required to beexpended for income tax. The same is true of other deferredcompensation plans.

2. Residences.

In some cases, the clients’ home is their most valuable asset, but it maybe laden with issues that make it a poor candidate to use to fund acredit shelter trust.

a. For example, the client may want to continue to takedeductions generated by the real estate taxes and the homemortgage on her personal income tax return.

b. If there is a mortgage, there may not be any cash in the trustwith which to make the mortgage payments, and asking thebeneficiary to pay those expenses may raise issues aboutwhether the beneficiary has become a grantor of the trust bymaking principal payments on the mortgage.

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c. If the house is owned in part by the credit shelter trust and inpart by the surviving spouse, keeping track of each paymentand the allocation of every expense will be bothersome and canbe expensive.

d. In addition, if it is necessary to transfer the home to either spouse to be sure that spouse has sufficient assets to fund acredit shelter trust and the “wrong” one dies first, there may nothave been any adjustment in the basis of the residence if thesurviving spouse would like to sell the property.

D. Portability Planning for Wealthy Clients.

1. As noted above, the clear intent in passing a law permitting portabilityof the applicable exclusion amount of the first spouse to die was tosimplify the estates of couples who otherwise would not create trustsfor each other at their deaths. However, as is often the case, the folkswho can use this technique to hit the ball out of the park are thewealthy, particularly those living in states that impose a death tax.

2. An inter vivos defective grantor trust created by the surviving spousecan be used in place of a credit shelter trust created at the death of thedecedent.

a. Instead of creating a credit shelter trust for the amount that canpass free of federal estate tax, the will of the first spouse to diecould leave the balance of the client’s estate to her spouse(perhaps with a disclaimer option into the credit shelter trust incase the tax laws change again). Assuming that her executorelects portability and that gifts are not subject to state transfertax, this sets the stage for excellent estate planning.

b. The surviving spouse then makes a gift of the DSUE amount toan intentionally defective grantor trust for the benefit of theirdescendants. If the surviving spouse also wishes to use thebalance of his applicable exclusion amount, he could make agift of up to $22.8 million (depending on their availableapplicable exclusion amounts) to a defective grantor trust onwhich he will be required to pay all of the income taxes withoutany state or federal transfer tax consequence. If he chooses to76

use his GST tax exemption, he can divide the gift into two

See Rev. Rul. 2004-64, 2004-27 I.R.B. 7.76

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parts: a trust that is GST tax exempt for grandchildren using hisGST exemption and the balance to a trust for children. 77

c. This result is far more efficient than disclaiming into a creditshelter trust.

(1) If a traditional credit shelter trust is created at thedecedent’s death, the trust (or its beneficiaries) will paythe income tax on trust income. Unlike the creditshelter trust, the assets in the defective grantor trust willnot be diminished by payment of income tax and willcompound at a much higher rate. This advantage of adefective grantor trust is such a powerful estateplanning benefit, it may outweigh other considerations.

(2) Moreover, in a state that imposes a state death tax,using the full amount of the decedent’s applicableexclusion amount to fund a credit shelter trust likelywould require payment of some state estate tax in orderto take full advantage of the federal credit. Thedefective grantor trust can be fully funded with theamount of the federal applicable exclusion amountwithout payment of any transfer tax.

d. Although an adjustment in basis is not necessarily available ineither case, the credit shelter trust or defective grantor trust, inthe case of the latter it is possible the assets could receive anadjustment in basis if the surviving spouse swaps them out forcash or unappreciated assets shortly prior to death. Undercurrent law, this transaction would avoid any recognition ofgain by the grantor or the trust and permit the trust assets toreceive a basis equal to their fair market value at the death ofthe surviving spouse.

3. This plan works for the wealthy since they can afford to make gifts ofthis size and pay the income tax on income they do not receive. Thedifficulty with this plan for clients of more moderate size is that thesurviving spouse, who is the grantor, should not also be a beneficiaryof the trust. To use this technique, even if the only amount gifted is

To avoid wasting the GST exemption of the first spouse to die, a reverse77

QTIP election could be made in her estate to utilize her available GST exemption. Seediscussion below.

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the amount of the DSUE, the surviving spouse must have adequateassets to be able to live without the benefit of the gifted assets. Someplanners have suggested that including the grantor/spouse as abeneficiary might be successful in states that protect self-settled trustsfrom creditors, but the results of this do not seem reliably predictableat this time.

4. Although the focus above is on states with an estate tax but no gift tax,many of the benefits of this technique also work well in the absence ofa state estate tax.

XII. PORTABILITY AS A POST-MORTEM DECISION

Because of the number of factors and fact-specific considerations to be taken intoaccount, the decision on whether to utilize portability likely will need to be a post-mortem decision. As should be obvious from the analysis of the factors above, inmost estates the surviving spouse will need to review his circumstances and make adecision about the best course of action, both economically for the family and forhimself.

A. The Need for Flexibility.

In order to permit the decision to use portability to be made post-mortem, itwill be necessary to incorporate one of the three standard flexibility techniquesinto the estate planning documents to preserve the ability to use the applicableexclusion amount of the first spouse to die in the event that portability is notelected. Generally, marital planning at death focuses on techniques fordividing the testator’s estate between the use of the testator’s remainingapplicable exclusion amount and a marital bequest, usually with the goal ofpaying no estate tax at the death of the first spouse to die. Even for clientswho have fully used their applicable exclusion amounts during life, it isnevertheless prudent to include a flexibility technique described below thatwill allow use of any applicable exclusion amount the client may unexpectedlyhave at death. Although a portability election will now preserve anyunexpected applicable exclusion amount of the first spouse to die bytransferring it to the surviving spouse, as noted below, it may not be the bestalternative in some cases.

B. Effect of Portability.

1. The Effect of Portability on Disclaimers.

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a. Prior to the enactment of portability, a surviving spouse’sdecision not to disclaim, for example to avoid the imposition ofstate estate tax, would have had the effect of wasting the firstspouse’s applicable exclusion amount, which would generallyresult in a greater estate tax liability at the surviving spouse’sdeath. With the availability of portability, however, if thesurviving spouse chooses not to disclaim, he will “inherit” thedecedent’s DSUE amount, which he can use to make lifetimegifts, or save and use at his own death (unless he becomes asurviving spouse of a later deceased spouse). The decisionwhether or not to disclaim – essentially a decision whether ornot to use portability – will involve a sophisticated analysis ofthe advantages and disadvantages of using portability, asdescribed in detail above.

b. Portability may also address two of the thorny problemsassociated with disclaimers.

(1) A primary difficulty with disclaiming is that clientsoften do not realize the significance of their actions anddo things that constitute the acceptance of the propertythey plan to disclaim. Thereafter, those assets generallycannot be disclaimed, although a partial disclaimermay, under certain circumstances, still be possible. Even clients who have been educated during the estateplanning process about not accepting benefits of theassets still take actions which prevent a qualifieddisclaimer. For couples who engage in disclaimercredit shelter trust planning, it is imperative that thesurviving spouse seek legal assistance in administeringthe deceased spouse’s estate as quickly as possible andnot take any action with regard to assets owned by thedeceased spouse or jointly with the deceased spouseuntil he has done so.

(2) A second issue in disclaiming (which can get fairlytechnical but should not be overlooked) is that apecuniary disclaimer, that is, a disclaimer of a specificamount, likely will cause capital gain to be recognizedon the assets transferred as a result of the disclaimer.

(a) Use of formula disclaimers is often advisable inorder to ensure that the credit shelter amount is

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not over- or underfunded in the event that assetsare revalued on audit or later discovered.

(b) Since disclaimers to a credit shelter trust may bepecuniary disclaimers even if they are made byformula, it is generally good practice not todelay too long in making the decision todisclaim, particularly in a rising market.

(c) In addition, a sometimes overlookedrequirement for a pecuniary disclaimer is thatthe disclaimed amount and any incomeattributable to such amount immediately mustbe segregated from other estate assets followingthe disclaimer.78

(3) A portability election is not affected by the actions ofthe surviving spouse with respect to the decedent’sassets and does not require the recognition of gain onthe amount of the DSUE nor the segregation of thedisclaimed assets.

2. The Effect of Portability on Partial QTIP Elections.

a. Portability is not as effective a solution to the issues raised bypartial QTIP elections as it is in addressing disclaimer issues. Certainly the executor can make a full QTIP election and allowthe decedent’s applicable exclusion amount to pass to thesurviving spouse to use for gifting during life. If the survivingspouse promptly gifts assets with a value equal to the DSUEamount, all of the income from the assets that would otherwiseincrease the value of his estate will be transferred to his donees. However, this alternative raises two issues that do not arise if apartial QTIP election is made:

(1) To take advantage of this alternative, the survivingspouse must have assets sufficient to support himselfwithout the benefit of the income from the gifted assetsand

Treas. Reg. § 25.2518-3(c).78

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(2) The surviving spouse might gift the assets to his ownchoice of beneficiaries and not the beneficiaries the firstspouse to die would have selected.

b. For these reasons, the use of portability as an alternative topartial QTIP elections may not be appropriate.

3. The Effect of Portability on Clayton Elections.

a. As with a partial QTIP election, the decision whether and towhat extent to elect Clayton treatment will to a large extent bedriven by the executor’s determination whether and to whatextent to utilize portability.

b. Again, if the reason a Clayton structure has been selected isbecause the decedent has children from a prior marriage and isinterested in protecting their bequests, then portability likelywill not be a viable alternative to Clayton trust planning.

XIII. CONCLUSION

A. To sum up, marital deduction/credit shelter planning is not simple. Althoughthe need to incorporate flexibility techniques into clients’ estate plans began inan effort to address the ever changing estate tax laws applicable since 2001,now, even though the current estate tax law is temporarily more stable, the useof flexibility techniques in clients’ estate plans has never been more important.

B. Care to preserve the benefit of the marital deduction is the most basic ofconsiderations, requiring attention not only to the terms of the disposition forthe benefit of the surviving spouse, but also to the nature of the assetsthemselves and who the key players in the estate plan will be.

C. The importance of incorporating planning for state death taxes also cannot beoverstated, even in states that currently do not have a state death tax. Clientmobility and assets located in “foreign” states can provide very unpleasantresults.

D. Portability adds an interesting element to testamentary planning because, otherthan possibly providing in the will that the executor should make the electionif the decedent has a DSUE amount, there are no provisions included in thewill directing how it will or will not be implemented. It is the silent partner oftestamentary estate planning.

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E. It appears it is absolutely necessary to continue to incorporate flexibilitytechniques into marital deduction/credit shelter estate plans and to draft topermit the decision on whether or not to use portability to be a post-mortemdecision.

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