Patricia M. Annino
Portability vs. credit shelter trust: Which should your clients use?

Clients need to consider the pluses and minuses of both options when making estate planning decisions.

March 17, 2014
by Patricia M. Annino, J.D.

The American Taxpayer Relief Act of 2012 (ATRA), P.L. 112-240, made permanent the concept of portability, a game-changing concept that allows a deceased spouse’s unused federal gift and estate tax exemption to be used by the surviving spouse. Portability of the deceased spousal unused exclusion amount is important for all married clients—regardless of their net worth.

When making estate planning decisions, clients need to consider whether to (1) rely on portability; (2) implement the traditional credit shelter trust; or (3) use a hybrid approach where the credit shelter trust is drafted and established but not currently funded. Postmortem mechanisms also would need to be in place so that the decision of whether to fund the credit shelter trust can be made by the surviving spouse within nine months of the spouse’s death.

Portability applies to the federal gift and estate tax exclusion, but not to the federal generation-skipping tax exclusion. To obtain portability, a federal estate tax return (Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return) must be filed, even if one is not required for any other reason, and the portability election must be made by the nine-month deadline. (Editor’s note: In Rev. Proc. 2014-18, the IRS recently provided estates of decedents who died in 2011, 2012, and 2013 a simplified method to obtain an extension of time to make a portability election.) Here’s a look at what practitioners should consider when advising clients on these options.

Benefits of portability

Portability is simple—there’s no need to retitle assets. With portability, the assets are stepped up in basis at the death of the first spouse, and are stepped up in basis again at the death of the surviving spouse. (This is in contrast to using a credit shelter trust, in which case the assets are stepped up at the death of the first spouse but not at the death of the second spouse.) Portability works well for a client who has a significant retirement planning asset. If the asset is paid to the surviving spouse, the estate tax exclusion of the first spouse can be used without a credit shelter trust. Designating a credit shelter trust as the beneficiary of a retirement planning asset can be cumbersome and, because of the technical rules and tax returns, costly and difficult to administer.

Downside to portability

Portability is not available for the generation-skipping tax exemption—so if intergenerational planning is part of the overall plan, portability will not work. In addition, there is always the risk that the tax law will change and the exemption will decrease. And if the client lives in a state that has a state estate tax, portability applies only at the federal level, not the state estate tax level. Other downsides to portability arise when there is a blended family or concerns about asset protection, remarriage, or the management of assets by the surviving spouse. In this case, a bypass trust at the first death may be a better choice than portability.

Benefits of a credit shelter trust

If the credit shelter trust is funded at the death of the first spouse, any appreciation between the death of the first spouse and the surviving spouse is excluded from the surviving spouse’s estate. A credit shelter trust provides a certain level of asset protection, as most credit shelter trusts have spendthrift provisions that preclude the assets in the trust from being attached by the trust beneficiaries (which is, of course, not true for most other assets that pass to the surviving spouse through portability).

In a credit shelter trust, the trustee has a fiduciary duty to protect and preserve the trust assets. Therefore, when there is a need to control the use or disposition of a trust’s assets, a credit shelter trust is superior to portability. If intergenerational planning is important, then the credit shelter trust is a better option, as it allows for the use of the generation-skipping tax exclusion of the first spouse to die. If state estate taxes are an issue, a credit shelter trust can shelter the state estate tax exemption (and any appreciation in the value of those assets between the death of the first and second spouse) from the surviving spouse’s taxable estate.

Downsides to the credit shelter trust

To obtain the benefits of a credit shelter trust, the trust must file its own income tax returns. If the asset is complicated, such as a retirement planning asset, this filing can be cumbersome and expensive. Another downside is that the income tax bases of the assets in a credit shelter trust are stepped up once—at the death of the first spouse, and unlike with portability, not also stepped up at the death of the second spouse.

Which is the right strategy?

No one solution is right for every client. Each strategy should be evaluated for both new clients and those who have already done estate planning. If a client has a funded credit shelter trust, planners should consider reevaluating that choice to determine whether it is still the right solution.

Planners also should review the client’s assets to determine the consequences of using portability or a credit shelter trust. They need to consider the income tax basis, whether the asset is likely to appreciate, whether generational planning is important to the family, and whether the client lives in or owns real estate in a state that has a state estate tax.

If it is not clear which is the right choice, it is possible to make that decision within nine months after the date of death of the first client. That waiting period is possible as long as the assets are positioned so that if the surviving spouse chooses not to take or disclaim an asset that he or she would otherwise be entitled to by portability, it will pass by the terms of that disclaimer into the credit shelter trust of the first spouse to die.

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Patricia M. Annino, J.D., LL.M., is a nationally recognized authority on estate planning and taxation who chairs the Estate Planning practice at Prince Lobel Tye LLP in Boston.

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