After the Portability Election: Must a Surviving Spouse File Form 706?
Considering and anticipating downstream obligations
Table of Contents
Background
Previously, we covered in cursory fashion some of the rules relating to elective estate tax return filings on Form 706 along with a broader video series on the portability election itself.
As a refresher, what is portability? It is an election available to the estate of a deceased spouse, through which that deceased spouse’s unused estate tax basic exclusion amount (the “DSUE”) may be preserved for use by the surviving spouse as applicable credit against gift and estate taxes. It does not, however, preserve any unused GST exemption.
Portability can come with some surprises. For one, it leaves open the limitations period for determining the value of assets in the gross estate of the deceased spouse to the extent such assets affect the DSUE amount under Treas. Reg. 20.2010-3(d). And under Treas. Reg. 25.2505-2(b), if the surviving spouse makes lifetime taxable gifts, the DSUE must be used first to offset gift tax on such gifts before using the surviving spouse’s basic exclusion amount.
However, this also raises an interesting question. How does the porting of DSUE affect a surviving spouse’s obligation to file Form 706 at death?
General Filing Requirements
IRC Section 6018 sets forth the filing thresholds for Form 706. Paraphrased, these filing thresholds are:
Gross estate in excess of the basic exclusion amount (currently $13,990,000); or
Sum of (1) lifetime taxable gifts, and (2) gross estate, in excess of the basic exclusion amount.
Interestingly, this filing threshold is based on the basic exclusion amount and not the applicable exclusion amount. Why does this matter? Under IRC Section 2010(c)(2), the applicable exclusion amount is defined as the sum of (1) the basic exclusion amount and (2) in the case of a surviving spouse, any DSUE.
What this means is that the DSUE itself does not increase the filing threshold for a surviving spouse. As we will discuss, this has trickle-down effects.
Gross Estate
For a spouse with DSUE, it is often the case that significant marital gifts have generated the DSUE. These transfers may have been direct (as probate or nonprobate transfers), or they may be in QTIP-elected trusts which get included in the surviving spouse’s gross estate (at date-of-death or AVD FMV) under IRC Section 2044. So while the surviving spouse may not have significant assets of their own, trust assets and other lifetime transfers may come into play.
Often, planning to reduce estate tax involves making lifetime gifts. Prudent planning also means deferring some or all estate tax until the death of the surviving spouse. Using annual exclusion gifts (for a surviving spouse’s individually-owned assets), valuation discounts, and retained and split interest transfers to name a few, this deferred estate tax liability can be reduced or even eliminated.
And, in the case of a spouse with DSUE, this creates a larger applicable credit against estate tax. The DSUE is not subject to inflation, but also is not subject to the sunset of the basic exclusion amount. Depending on the size of the DSUE, even if the sunset occurs, estate tax may be eliminated at the surviving spouse’s death.
However, none of this means that a surviving spouse’s obligation to file Form 706 is eliminated. If the sunset occurs (reducing the basic exclusion by one-half), it will further reduce this filing threshold for a surviving spouse as well. Long story short, the pegging of the filing threshold to the basic exclusion amount limits the utility of DSUE to reduction of estate and gift taxes and does not reduce the administrative burdens of both spouse’s estates. Not only must the estate of the first spouse to die file a 706 to make a portability election, but the election itself increases the likelihood of filing by the surviving spouse.
What if, however, the surviving spouse makes significant lifetime gifts? This is where we must line up these gifts next to the available basic exclusion amount and GST exemption. And, as we will see below, the DSUE does not do us any favors.
Taxable Gifts
Under IRC Section 2001(b), the estate tax base generally consists of the sum of (1) the taxable estate, consisting of the gross estate (valued at date of death or at the AVD) net of deductions, and (2) the decedent’s lifetime adjusted taxable gifts (valued at date of completion of the gift(s)). The “adjustment” to taxable gifts usually focuses on the possibility that lifetime transfers with certain retained interests get pulled back into the gross estate under Code Sections such as 2035-2038, or 2042 to name a few, in which case the value of the included assets changes from date-of-gift to date-of-death/FMV.
This differs a bit from the filing thresholds mentioned above, which focus on the sum of the gross estate and adjusted taxable gifts. Generally, deductions that zero out the estate tax will not relieve a decedent’s estate from the obligation to file Form 706 if the pre-deduction gross estate (and, if any, adjusted taxable gifts) exceed the basic exclusion amount. It also means that lifetime use of basic exclusion amount does not reduce this filing threshold, as it gets applied in full to the estate tax base as described above (as part of the current unified nature of the gift and estate taxes).
This adjusted taxable gifts figure has more of a spotlight when we consider the effects of the DSUE. There is an ordering rule as mentioned above, under which lifetime gifts by the surviving spouse use DSUE first (as applicable credit against gift tax) before the basic exclusion is used. In some cases, this may mean that the surviving spouse never actually uses their basic exclusion amount.
Yet, if lifetime gifts use up the DSUE, the date-of-gift value of these adjusted taxable gifts will count in determining whether the surviving spouse exceeds the filing threshold – even if no basic exclusion amount is actually used! It could be the case that the surviving spouse has a gross estate well under the basic exclusion, but significant taxable gifts that used up DSUE without actually dipping into basic exclusion. Yet, these DSUE gifts get factored into the filing threshold under IRC Section 6018.
Considered together, the outcome is an increased possibility that a surviving spouse making significant lifetime gifts will need to file Form 706 at death. This is exacerbated by the facts that (1) DSUE does not increase the filing threshold, yet (2) DSUE gets applied to lifetime gifts first.
GST Tax
Recall, again, that a portability election does not preserve a deceased spouse’s unused GST exemption. This increases the chance that a surviving spouse may exhaust their own GST exemption for lifetime transfers and/or transfers at death. In such a case, filing Form 706 at death may become necessary to allocate the surviving spouse’s GST exemption in a manner that avoids or defers GST tax instead of relying on automatic allocation rules.
This possibility may be exacerbated by annual exclusion gifts by the surviving spouse (before or after the death of the first spouse to die) involving Crummey powers. Depending on the structure of such powers, GST exemption of the surviving spouse may have to be allocated to such powers.
So, while it is natural to assume that annual exclusion gifts can deplete the gross estate while not adding to adjusted taxable gifts (which themselves use DSUE or basic exclusion amount), this wrinkle of GST tax may necessitate filing a 706 at the surviving spouse’s death.
Methods to Avoid Filing
Given these issues, what can we do for a surviving spouse who might have significant DSUE (thus avoiding estate tax, even post-sunset) to reduce the chance that Form 706 must be filed at death?
First, as mentioned above, strategic use of annual exclusions – preferably direct gifts that don’t burn GST exemption – can be helpful since these do not increase adjusted taxable gifts.
Second, there are other ways to deplete the estate without adding to adjusted taxable gifts. Basic spending and consumption are obvious examples, but another possibility is payment of income tax on behalf of a grantor trust (which is not a gift per Rev. Rul. 2004-64). Gift tax paid more than three years prior to death can also deplete the gross estate in a tax-favored manner, but note that a surviving spouse will never actually pay gift tax unless or until both the DSUE and basic exclusion amounts are exhausted. It may be possible, however, to pay GST tax for direct skips in a similarly tax-advantaged manner and while the GST tax itself gets added to the value for gift tax purposes, the DSUE can be leveraged.
Third, note that lifetime gifts that qualify for the marital deduction (if the surviving spouse remarries) or the charitable deduction do not get added to adjusted taxable gifts and thus may also reduce the possibility of filing. This is especially important when compared to transfers at death, since the use of marital or charitable deductions against estate tax don’t reduce the filing threshold (due to the use of the gross estate instead of the taxable estate).
Finally, it is important to remain conscious of the value of all assets that might get included in the gross estate. This includes not just the surviving spouse’s personally-owned assets, but also QTIP-elected assets, assets subject to a general power of appointment in the surviving spouse, and lifetime transfers by the surviving spouse which are or may be subject to retained interests or powers under IRC Sections 2035-2038 or 2042.
On that note, when we consider the gross estate, it may be possible to push the gross estate (and adjusted taxable gifts) below the filing threshold through the use of valuation discounts. These discounts could apply even where, for example, a surviving spouse is a co-owner with a QTIP marital trust or credit shelter trust. But, reliance on valuation discounts should be approached with caution. When we consider the possibility of estate tax by the surviving spouse’s estate, the IRS has an incentive to challenge values. And, if it turns out that a challenge by the IRS pushes the gross estate and/or adjusted taxable gifts over the filing threshold, there may be a penalty for failure to file Form 706.
And, in all cases, note that having assets available for lifetime gifts may be a challenge – especially where QTIP trusts are involved. It may be possible to make taxable gifts of QTIP-elected assets by leveraging IRC Section 2519, but these gifts have been subject to challenges by the IRS this year in the Anenberg and McDougall cases. And while QTIP trusts could be depleted by distributions to a surviving spouse, the distributed assets are still subject to gross estate inclusion for the surviving spouse both before and after under IRC Section 2044.