What is Portability of the Estate Tax Exemption?

On December 17, 2010, President Obama signed the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 into law. A big part of this new law is modification of the federal estate tax rules, including offering "portability" of the federal estate tax exemption between spouses for the 2011 and 2012 tax years. But what does "portability" of the estate tax exemption mean?

Definition of Portability of the Estate Tax Exemption

In simple terms portability of the federal estate tax exemption between married couples means that if the first spouse dies and doesn't use up all of his or her federal exemption from estate taxes, then the exemption that the deceased spouse didn't use will be transferred to the surviving spouse's exemption so that he or she can use the deceased spouse's unused exemption plus his or her own exemption when the surviving spouse later dies.

Examples of Portability of the Estate Tax Exemption

Some examples using numbers should help to illustrate the concept of portability of the federal estate tax exemption between spouses:

Result Without Portability

Assume Bob and Sue are married and have all of their assets jointly titled and their net worth is $8,000,000, Bob dies first and the federal estate tax exemption is $5,000,000 on the date of his death, and there isn't portability of the estate tax exemption between spouses:

1. Under these facts, when Bob dies his estate won't need to use any of his $5,000,000 estate tax exemption since all of the assets are jointly titled and the unlimited marital deduction allows Bob to transfer his share of the joint assets to Sue without incurring any federal estate taxes.
2. Assume that at the time of Sue's later death the federal estate tax exemption is still $5,000,000, the estate tax rate is 35%, and Sue's estate is still worth $8,000,000.
3. With Bob's $5,000,000 estate tax exemption completely wasted, when Sue later dies she can only pass on $5,000,000 free from federal estate taxes. Thus, Sue's estate will owe about $1,050,000 in estate taxes after her death:

$8,000,000 estate - $5,000,000 exemption = $3,000,000 taxable estate

$3,000,000 taxable estate x 35% estate tax rate = $1,050,000

Result With Portability

Assume Bob and Sue are married and have all of their assets jointly titled and their net worth is $8,000,000, Bob dies first and the federal estate tax exemption is $5,000,000 on the date of Bob's death, and there is portability of the estate tax exemption between spouses:

1. As above, when Bob dies his estate won't need to use any of his $5,000,000 estate tax exemption since all of the assets are jointly titled and the unlimited marital deduction allows Bob to transfer his share of the joint assets to Sue without incurring any federal estate taxes.
2. Assume that at the time of Sue's later death the federal estate tax exemption is still $5,000,000, the estate tax rate is 35%, and Sue's estate is still worth $8,000,000.
3. Enter portability of the estate tax exemption - With full portability of the estate tax exemption between spouses, under these facts Bob's unused $5,000,000 estate tax exemption will be added to Sue's $5,000,000 exemption, in turn giving Sue a $10,000,000 exemption.
4. Since Sue has "inherited" Bob's unused estate tax exemption and she can pass on $10,000,000 free from federal estate taxes at the time of her death, Sue's $8,000,000 estate won't owe any estate taxes at all:

$8,000,000 estate - $10,000,000 exemption = $0 taxable estate

5. Thus, portability of the estate tax exemption will save the heirs of Bob and Sue $1,050,000 in estate taxes.

Of course, these examples illustrate how portability of the estate tax exemption between spouses really works in the same way that the AB Trust system works but without the need for setting up AB Trusts.