Portability of the Estate and Gift Tax Exemption

I recently listened to a podcast from The American College of Trust and Estate Counsel outlining the ten key estate and trust developments from 2021. (link) The issues identified were wide-ranging, some dealing specifically with Trust and Estate practitioners, but others had general applicability. I want to highlight one of them to you and use it to explain a key estate tax provision.

The issue highlighted in the podcast was the IRS is now charging a fee to get an estate closing letter. The IRS issues a closing letter after accepting the decedent’s estate tax return (IRS Form 706). Not every estate is required to file an estate tax return. Rather, those exceeding the exemption threshold must file the return ($12.06M in 2022 but is slated to decrease by about ½ in 2026).

The IRS set the fee at $67. Given that for every $1M over the threshold, an estate would be paying approximately $400K in taxes, a charge of $67 seems to be a bush league move by the IRS to send a letter they are statutorily obligated to send anyway. Not that I, or likely anyone else, is crying for these estates over $67, but it may affect a lot of more modest estates below the threshold. The Form 706 estate tax return serves a second purpose for these estates. Whether you owe taxes or not, filing the return is how you preserve the decedent’s estate tax exemption for the second spouse. This is called portability.

Simply stated, portability provides for the combining of spouses’ estate and gift tax exemption. Starting in 2010, a surviving spouse could be credited with the unused portion of their late spouse’s estate tax exemption. The result is that upon the second spouse’s death, their estate can claim both their exemption plus the unused exemption of the deceased spouse.

But portability is not automatic. The deceased spouse’s estate has to file a federal estate tax return electing to allow the surviving spouse to claim the unused exemption. The estate tax return is due within nine months of the deceased spouse’s death, and failing to file the return and making the election forfeits portability, and such forfeiture may not be appealed or reinstated.

What does this mean in practice? The easiest way to visualize the process is to look at a simple scenario. Let’s say a couple had a combined estate valued at $15M. Husband dies in 2022, with his half of the combined estate valued at $7.5M. He leaves this entirely to his wife.

He has used none of his exemption because transfers between spouses are exempt from estate taxes even without the individual exemption. Therefore when the wife dies, she gets to add $12.06M to whatever her estate tax exemption is in the year of her death. Let’s assume she dies in 2025 and the inflation-adjusted estate tax exemption in that year is $13.5M. With portability, the wife’s estate of $15M pays no estate tax upon her death because her combined exemption is $25.56M. But without portability, her estate will owe approximately $600K in estate taxes (40% of the $1.5M above the exemption).

This scenario is even more illustrative if she were to die in 2026. Under the current tax code, the exemption amount reverts to the pre-2018 exemption of $5M adjusted for inflation since 2010. For illustration’s sake, let us assume the 2026 exemption is $7.5M. Therefore, with her husband’s unused exemption, she has a total estate tax exemption of $19.56M ($7.5M plus $12.06M), but without it, she’s limited to $7.5M. Her estate still owes nothing in estate tax with portability, but the estate now owes approximately $3M without it.

While the current exemption largely limits taxes to significant estates, Congress sets the exemption. As recently as 2002, the exemption was only $1M with no inflation adjustment. There is nothing to prevent Congress from adjusting the exemption downward. During the recent Build Back Better debates, they intended to do just that by moving to 2022 the reversion of the enhanced exemption to the pre-2018 level.

The lesson from this is just because an estate does not owe estate taxes, the executor should think carefully before deciding not to file a return. It is impossible to know the value of any future estate tax exemption with certainty. The decision to forgo portability is a key one in many estates and one that is permanent. Avoiding paying $67 to the IRS to get your closing letter should not be a factor. Unless there is no chance that the portability feature will be unneeded by the surviving spouse, an executor’s failure to file a Form 706 and preserve the portability of the exemption is arguably a breach of fiduciary duty. Whether the breach results in damages remains unknown until the second spouse’s death.