The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 authorized portability of the federal estate and gift tax exemption for married couples. This means that if one spouse dies without having used his or her entire exemption, the survivor may use it.

Portability has been widely hailed as a great estate planning benefit. The benefit is that the first spouse to die can leave everything to the survivor rather than having to create a credit shelter trust. 

Our view is that the benefit of portability is overrated; furthermore, it creates a trap for the unwary. We are not advising any of our married clients to plan on using portability.

The foremost reason that we do not favor portability is because the statute that created it also required the law to expire on December 31, 2012. President Obama and many members of Congress have indicated that they would like to extend portability beyond this sunset date; however, we have learned that it is foolhardy to plan on the assumption that future tax laws will be consistent with sensible statements made by politicians. 

Even if portability is made “permanent” by future legislation, there are many pitfalls to using portability. First, there is no inflation adjustment. For example, assume a married man dies this year and leaves his entire $5 million estate to his wife. When the wife dies, she will be able to use her husband’s unused exemption, but without any adjustment for inflation. If the husband had placed the $5 million in a credit shelter trust instead of transferring it to his wife, appreciation of the value of the trust during his wife’s remaining lifetime would have also escaped estate taxes.

The Tennessee inheritance tax exemption is not portable. If you fail to use the exemption in the estate of the first spouse to die, it will be lost forever. This will result in higher Tennessee inheritance taxes for the survivor’s estate.

Those who plan to establish trusts that last for the lifetimes of their children and beyond, are concerned about generation-skipping transfer tax exemption. The GST exemption is not portable. However, if the first to die establishes a trust and allocates GST exemption to the trust, the trust will be exempt from generation-skipping taxes for up to 360 years.

In order to claim portability, the estate of the first spouse to die must file a timely federal estate tax return. I predict that a lot of surviving spouses who are not otherwise required to file an estate tax return will fail to file timely returns in order to claim portability. 

There are numerous portability issues associated with the remarriage of the surviving spouse. It will likely take years for regulations and court cases to fully flesh out these issues. All things considered, we recommend that you disregard portability as a planning tool, at least until the law is made permanent.

The Tennessee legislature has enacted the Tennessee Community Property Trust Act of 2010. If the Governor signs the bill, the new law will allow resident and nonresident married couples to convert their property to community property by transferring the property to a new type of trust known as a Tennessee Community Property Trust. Alaska is the only other state that allows residents of common law states to voluntarily convert some of their assets to community property.

There are three types of benefits that a Tennessee Community Property Trust will provide. First, community property is a property ownership system that provides for equal ownership of property by husband and wife, including a sharing in the appreciation and income from the property. Some couples may find this equality and sharing arrangement to be a preferred form of property ownership.

Second, community property receives a significant federal income tax advantage. At the death of the first spouse to die, both spouses’ interests in the community property will be eligible to receive a basis increase (not to exceed fair market value), up to a maximum increase of $4,300,000 in 2010, and a full basis adjustment to the fair market value of the property for deaths in 2011 and later years. As a result, there will be no capital gains tax payable if the first spouse dies in 2011 or later and the property is sold for its value after the first spouse’s death. Further, the increased basis will allow for increased depreciation deductions for business and investment depreciable property. If the property had been jointly-owned by the husband and wife in a common law state such as Tennessee, only one-half of the property would receive such an adjustment in basis.

Assume that in 1983 John and Martha Brown paid $200,000 for a farm that is worth $600,000 at the time of John’s death in 2011. Federal tax law allows Martha to increase the income tax basis of John’s half of the farm to $300,000 (one-half of the fair market value of the entire farm). Martha’s basis for her half of the farm will remain at $100,000 (one-half of the original purchase price). Thus, Martha’s total basis in the farm will be $400,000. When Martha sells the farm for $600,000, she will realize a capital gain of $200,000 and pay a federal capital gains tax of $40,000. Federal tax law would allow Martha to increase the basis of the farm to $600,000 if the farm had been held in a Community Property Trust. Thus, when Martha sells the property, she will not pay any capital gains tax.

The third advantage of a Tennessee Community Property Trust is the division of assets owned by the trust for purposes of  funding a credit shelter trust upon the death of the first spouse and obtaining fractional interest discounts upon the death of the surviving spouse. Funding the credit shelter trust and obtaining fractional interest discounts will reduce Federal estate tax and Tennessee inheritance tax upon the death of the surviving spouse. These same advantages can be obtained by converting ownership to tenancy-in-common; however, tenancy-in-common will not allow the favorable income tax advantage discussed above.

A Community Property Trust has the following requirements:
(1) It must declare that the trust is a Tennessee Community Property Trust and contain certain language that gives notice of the consequences of the trust;
(2) At least one trustee must be Tennessee resident or a Tennessee bank or trust company; and
(3) It must be signed by both spouses.

If the spouses divorce, the trust will terminate and the trustee must distribute one-half of the trust assets to each spouse. When property is distributed from a community property trust, it will no longer constitute community property. The equal division of the trust assets upon divorce may be different than the division that would have occurred if assets had not been transferred to the trust.

A debt incurred by only one spouse before or during marriage may be satisfied from that spouse’s one-half share of a community property trust and a debt incurred by both spouses during marriage may be satisfied from all of the trust assets. Thus, a Tennessee Community Property Trust has inferior creditor protection to tenancy by the entirety ownership, and should not be utilized by couples with potential creditor problems.

The new law will become effective July 1, 2010. I expect that Tennesseans will establish a lot of these trusts in July of 2010, similar to the wave of Tennessee Investment Services Trusts that were established in July of 2007 when the Tennessee Investment Services Trust Act became effective. It will take longer for Tennessee banks and trust companies to market the advantages of this opportunity to nonresidents. The advantages will be greater for nonresidents who live in states that impose income taxes on capital gains and rental income.
 

The simplest estate plan for a married couple is for them to own everything jointly, with the result that everything will be owned by the survivor after the death of the first spouse to die. Unfortunately, the Federal estate tax and Tennessee inheritance tax laws penalize couples for taking the simple approach if their combined assets exceed $1 million in value. This is because the survivor’s estate will exceed the available exemptions from federal and Tennessee inheritance tax.

A better tax plan is for the couple to each own separate assets or to own assets as tenants-in-common. If the first spouse to die owns a tenancy-in-common interest in real estate or a brokerage account, the decedent’s Will can transfer these assets to a credit shelter trust for the primary benefit of the survivor. The credit shelter trust will not be subject to tax upon the subsequent death of the survivor.

The first spouse to die must own assets that can be transferred to the credit shelter trust. For Tennessee residents, this is not possible with assets that are owned jointly with a spouse, unless the form of ownership is specifically designated as tenancy-in-common. As in most states, there is a presumption in Tennessee that property held jointly by a husband and wife is held as tenants-by-entirety, rather than as tenants-in-common. This means that the assets will not be available to fund a credit shelter trust upon the death of the survivor.

In the Estate of Oscar Goldberg, the failure to change ownership of real estate to tenancy-in-common resulted in litigation with the IRS and unnecessary estate taxes of almost $400,000. When it comes to estate planning, simplicity may carry a high price tag for your children.
 

Over the course of my career, I have worked with several clients who knew they had but a few months to live due to inoperable cancer. As a general rule, these clients have been mentally sharp when I have worked with them.

The knowledge that death will occur in the near future causes the client to be keenly focused on making sure their estate planning affairs are in order. It is basic to make sure that the client has incapacity documents such as a living will, health care power of attorney, and a financial power of attorney.

There are numerous financial matters to be considered. Perhaps ownership of assets can be changed to avoid probate or to provide tax benefits. Should gifts be made to children and grandchildren? Should a revocable trust be utilized in order to avoid probate? Beneficiary designations on assets such as retirement accounts and life insurance policies should be verified.

One married client changed the ownership of the house into his name and changed the beneficiary of his life insurance policy to his estate. These steps will provide his estate with enough assets to fund a credit shelter trust. The credit shelter trust will save substantial estate and inheritance taxes upon the subsequent death of his wife.

The estate planning steps outlined above would be equally effective for any client nearing the end of his or her life. Unfortunately, a lot of terminal illnesses incapacitate the client to the point that he or she is not able to accomplish them. The only “good” thing about terminal cancer is that it generally gives the client adequate time to get their affairs in order and to say their good-byes.