Should You File An Estate Tax Return?

Introduction

When the first of two spouses dies the survivor can safeguard the estate tax exemption that the deceased spouse’s estate did not use. The unused exemption is called the Deceased Spouse Unused Exemption or “DSUE.” The concept of passing on that exemption is called “portability.” The whole point of this is to “simplify” the estate tax system. “Simplify” is in quotes since anyone who has grappled with any aspect of our tax system knows that it is rare at best that anything in the tax Code is ever simple. To understand how portability simplified the system you need to understand what happened before portability existed. Before portability if say the husband died and wanted to protect his estate tax exemption he would bequeath assets to a trust for his wife (and often for his wife and all descendants). That would use or safeguard his exemption, permit the surviving spouse to benefit (which is often the personal goal), and avoid the assets being included in the surviving spouse’s estate. One problem with that was that it required hiring an attorney with the sophistication to draft a will (or revocable trust) that included this type of trust, dividing assets between spouses, then on death that trust had to be funded (a step that was often overlooked), and then the trust had to be administered and an annual income tax return for the trust filed. That was complicated, costly and a step that was often missed. So, Congress enacted portability so that could all be avoided. Yet portability, despite all the good intent, requires filing an estate tax return and involves a decision process and awareness that few lay people are aware of, and which many either don’t understand or fail to appreciate the benefits of.

You secure your late spouse’s exemption you must make an election on a timely-filed estate tax return. That means the cost of filing an estate tax return. Further, if you do file for the DSUE the time period during which the IRS can audit (called the “statute of limitations”) remains open for the decedent spouse’s estate tax return until the statute of limitations has run on your (i.e., the surviving spouse’s) estate tax return. That could be a long time.

Consider how complex and costly it can be to file an estate tax return the law permits your personal representative to not report the value of certain property that qualifies for the marital or charitable deduction (since those would not be subject to estate tax in any event). Also, to use this special rule the executor must exercise due diligence to estimate the fair market value of the assets included in the deceased spouse’s gross estate and report the values under penalty of perjury to the IRS. In reality, many CPAs have found these rules sufficiently nettlesome, that they just try to get actual values. Also, you need values to support the basis adjustment of the deceased spouse’s income tax basis on the property to the fair market value at death. Since that can have important income tax implications, and because the potential impact of different valuations on beneficiaries, many CPAs or other tax preparers (e.g., the attorney handling the estate) opt to get real numbers.

So, the law was really complicated before portability. Congress tried to simplify the rules especially to help smaller estates, but created a host of new complications and traps.

What’s the bottom line? There is incredible uncertainty over estate taxes. For example, will the next election bring a different administration that might reduce the exemption to $1 million? Who knows.

Here are a few thoughts:

1. There is no way to predict the future of the estate tax so why not play it safe and lock in the exemption on the death of the first spouse. If you’re the executor and you don’t file might you get sued in the future if that was the wrong decision?
2. For income tax basis purposes you need back up of what the fair value of assets were on the first death so, if you are gathering all that data anyhow, why not file?
3. Depending on the dispositive plan it may be necessary to have proper values of the assets involved.
4. Beneficiaries may want the information regardless of the above.
5. Getting precise information on assets may be helpful to fulfilling your obligations as a personal administrator (executor) or successor trustee under the deceased spouse’s revocable trust.

So, likely many more surviving spouses should file an estate tax return to secure their deceased spouse’s unused exemption. Many don’t simply to save money. Cost is clearly a significant consideration but it is not the only one.

Why Bother Filing?
A common belief that many taxpayers exhibit is “Why file and incur the cost since the total estate is so much less than one exemption?” The answer to that question can be analyzed with a few more questions like:

• In what year will you die?
• What will the estate tax exemption be in the year you die, but before you answer that evaluate whether between now and the date you die a democratic administration may sweep Washington and enact an exemption as low as a $3.5 million or perhaps even $2 million?
• How much will your estate (including that of your late spouse) grow before you die?
• Will you win a lottery, realize an unexpected inheritance, ore receive a windfall?

Mom Can Just Gift Assets to Us
There is no shortage of ideas how to avoid the expense of filing an estate tax return to secure the exemption of your spouse that passed. Another one of these “ideas” goes like this. “Dad died. So, mom can just gift assets to us so she wont have a taxable estate.” First, read the “what-if” questions above. These same uncertainties may apply to your family as well. It is not clear what the idea behind the surviving spouse making gifts is, but here are a few thoughts:

• Why gift assets away, what if mom needs them? Can you predict what health insurance, Medicare or Medicaid might pay for if and when mom get’s sick? If she gives away assets how will she be protected? The common answer to that is “I’ll take care of mom!” That is pretty half-baked. First, and most important, should mom have to count on you if she needs her own money? Also, how do you wont’ spend it, get sued or divorced, and lose most of the money?
• Gifting assets to children (or other heirs) directly is probably a mistake. Those assets should be given in a trust. If you want to minimize costs and hassles create a simple trust for each child and name that child (assuming they are responsible enough) as the only trustee of their own trust. That gives each child substantial control over the use of their funds, and generally speaking does not make them answer to anyone. But that approach could provide invaluable protection for the inherited or gifted assets if you are ever sued or divorce.
• If mom gifts the assets equally to say three kids what if one or two of the kids want to help out mom and one ore more kids won’t? That could be devastating for family relationships.

A Better Option

Have a CPA file an estate tax return for the first spouse to die. If the assets come outright to the surviving spouse he or she can gift assets into a trust that can protect the assets, protect heirs, and assure the surviving spouse access. With the potential cost of several of the uncertain future developments it just doesn’t make a lot of sense to save a few bucks now for risk and problems later. You might turn out to be right and perhaps the filing could prove unnecessary. But if you are proven wrong it could be too late and dramatically more costly then the saving in professional fees.