Both at the planning stage and at the death of the first spouse, an estate planner must consider what role, if any, the ability to use the estate tax exemption of the first to die should play.1 An estate may be so large that the deceased spouse’s exemption should be used to create a credit shelter trust that will allow assets to appreciate and accumulate outside the surviving spouse’s estate.
On the other hand, an estate planner may choose to forego the use of a credit shelter trust, assuming that a deceased spousal unused exclusion (DSUE) election will be made to carry over the surviving spouse’s unused federal estate tax exemption of the deceased spouse. In this event, we assume that there’s little chance that the combined estate on the death of the surviving spouse will exceed the DSUE amount plus the surviving spouse’s inflation-adjusted estate tax exemption.2 In the smallest estates, an estate planner may even forgo both a credit shelter trust and the DSUE election.
Accordingly, at the death of the first spouse, the survivor must decide whether to make the DSUE election by filing a federal estate tax return. Unfortunately, analyzing these issues and making an appropriate recommendation to a client may be more of an art than a science. With the passage of time and the accumulation of anecdotal experience, each estate planner will likely develop a personal philosophy, taking into account multiple factors before making the ultimate DSUE coin flip. In today’s environment, it’s important for an estate-planning professional to consider and prioritize the principal factors that will drive the decision to make or forego the DSUE election. (See “When to Pass,” p. 18, for a list of characteristics that support skipping the DSUE election and “When to Elect,” p. 20, for a list of characteristics that support making the election.) In this article, we’re making assumptions based on our experience, along with assumptions common to many risk management analyses. (For information on using the DSUE election with a qualified terminable interest property trust, see “Portability + QTIP,” by Charles A. Granstaff, in this issue, p. 22.)
Size of Total Estate
The starting point for determining whether to file an estate tax return to preserve a decedent’s DSUE is the size of the couple’s combined taxable estate. The larger the estate, the more likely it could grow to exceed the surviving spouse’s inflation-adjusted estate tax exemption. Whether this growth occurs depends on so many factors that one despairs of calculating the result. Still, the size of the combined estate of the deceased spouse and the surviving spouse is transparently the springboard of any consideration of the DSUE election. The larger the combined estate, the closer the surviving spouse may be to an ultimate payment of estate tax at the survivor’s death.
Age of Surviving Spouse
Next to the size of the spouses’ combined estate, the age of the surviving spouse is perhaps the second most significant factor in the DSUE election consideration. A younger surviving spouse will, actuarially speaking, have more time to accumulate and compound wealth. Thus, the younger the surviving spouse, the more likely it is that significant growth could occur. This scenario assumes that growth on the surviving spouse’s assets exceeds the survivor’s spending. It’s also relevant if the surviving spouse is employed and still accumulating assets.3
A surviving spouse who’s retired or not otherwise actively employed, whose spending equals her income and whose combined assets (both her own and the assets of her deceased spouse) are about half of the survivor’s available estate tax exemption might be a candidate for taking a pass on making the DSUE election. She may choose to roll the estate tax dice with a reasonable chance of a favorable result.
A surviving spouse in good health, with good genes, a reasonable exercise regime, sensible eating habits and other healthy proclivities is, generally, more likely to have a significant period of compounded investment growth and may be more likely to face a taxable estate at her death. The contrary is generally true for a surviving spouse who’s in poor health and lacks healthy lifestyle habits. An unhealthy surviving spouse has an actuarially shorter life expectancy than a healthy spouse and, therefore, is less likely to see significantly compounded investment growth. In terms of estate tax exposure, she may be closer to “what you see is what you get.”
Long-term Care Insurance
If the surviving spouse has adequate, inflation-adjusted long-term care (LTC) insurance, her estate has a better chance of holding its value if there’s an LTC event. The premiums themselves will reduce the assets of the taxable estate, but probably not as much as a lengthy LTC period.
Paradoxically, if the surviving spouse is subject to estate tax, the tax provides a 40 percent discount for LTC expenses paid, and the assets that are saved by the LTC benefits are subject to the estate tax.4 Still, if the LTC policy pays more in benefits than the compounded cost of the premiums paid, the savings are welcome even if reduced by the estate tax. It’s better to have an asset reduced by the estate tax than to have no asset at all. Accordingly, adequate LTC coverage, despite the cost of the annual premium, tends to preserve an estate and might contribute to a decision to make the DSUE election.
If a portion of the current taxable estate is either term insurance or other underwater insurance that’s likely to terminate before the client dies, then the portion of the otherwise taxable estate that’s attributable to the insurance should be discounted in the DSUE election consideration. One of the reasons term insurance premiums are so reasonable compared to permanent insurance is that the beneficiary of the policy death proceeds has a smaller probability of collecting them. The true estate-planning question should be: Is such insurance needed, or is it a competitive fixed income investment?
If the insurance is viable, then it should be counted towards the value of the surviving spouse’s estate to determine if her assets will exceed her available estate tax exemption. If not, then the estate planner should discount this asset when considering the survivor’s ultimate estate tax exposure.
How Are Assets Invested?
An extremely conservative asset allocation, such as 20 percent stocks, 80 percent fixed income, while very protective of principal, decreases growth and may reduce the exposure to the estate tax at the surviving spouse’s death. A more heavily weighted equity portfolio increases the chance for growth and estate tax exposure but simultaneously creates a greater risk of investment loss. Still, a higher equity investment component increases the chance of growth leading to the estate tax. Private equity investments that could hit it big create both investment risk, and if successful, risk of estate tax exposure. And, while equities are an investment guess, the surviving spouse or the survivor’s investment advisor may be a good guesser; if so, then the risk of an estate tax is greater.
Annuities or Defined Benefit Pensions
If a large part of the surviving spouse’s expenses are covered by annuities (either defined benefit pension plan payments or non-qualified annuities that have actually been annuitized as compared to deferred annuities), then it may be more likely that the surviving spouse’s other investment assets will grow.5 If a large part of the survivor’s assets are covered by lifetime annuity payments, it would also be appropriate to have a riskier asset allocation on other assets, which might create more appreciation and exposure to an estate tax in the surviving spouse’s estate.
IRAs and Other Qualified Plan Benefits
While qualified plans and IRA benefits look good on a balance sheet and grow tax-deferred at an impressive rate, they’re reduced by income taxes when funds are withdrawn; hence, they diminish more quickly than an after-tax investment portfolio. Moreover, unless the accounts are Roth IRAs, qualified plan and IRA distributions must begin at age 701/2, causing the accounts to be reduced by income taxes. Non-qualified (non-IRA) annuities also have a required annuity starting date, but current industry practice allows these starting dates to be extended well beyond most actuarial life expectancies.6
Admittedly, circumstances could exist in which the survivor’s retirement accounts are so large that aggressive asset allocation and tax deferral would cause exposure to estate tax despite income taxes and required minimum distributions (RMDs). But on the whole, especially if the client or the client’s spouse experiences the actuarially expected (or better) longevity, the tax-deferred assets won’t exhibit the same compounded asset growth of a non-qualified, taxable investment account. This result is so because the RMDs, and the resulting payment of income taxes thereon, will cause the base level of the invested assets on which appreciation depends to erode.
Spender or Saver?
Even if somewhat subjective, the surviving spouse’s spending habits and needs, both perceived and real, are relevant factors in determining whether to make the DSUE election. While some estates will support luxurious summer and winter homes, plus country clubs at both locations, as well as extensive art collections and large charitable contributions, others won’t. Savers, who accumulate assets in all cases, are more likely to pay estate taxes than spenders, whose estates may decrease or grow more slowly.
Support of Children
For most parents, their biggest pay increase is when the children are off the payroll. While helping children in emergencies is often part of parenting, enabling children to become lifetime dependents is an unfortunate phenomenon many of us have observed. If the surviving spouse has dependent adult children, this is a negative factor in asset accumulation. A surviving spouse who has an estate moderately under the estate tax exemption level and who has adult children who are still on the payroll is less likely to be subject to the estate tax. Children with special needs whose care must be supplemented are a legitimate claim on their parent’s assets, but a fact that, nonetheless, slows estate appreciation.
Inheritances or Other Windfalls
If a surviving spouse is likely to receive a significant inheritance unprotected from estate tax by upstream generation-skipping transfer tax planning, the extra exemption ported from a deceased spouse could come in handy.
If a surviving spouse makes the DSUE election, remarries and subsequently dies, she can use a portion of her own applicable exclusion amount to exempt assets passing to the children of her first marriage, while transferring her remaining basic exclusion amount and any unused DSUE to her second spouse.7 The maximum amount that can be carried over, however, is limited to the amount of the then-current estate tax exemption.8
Moreover, an impecunious surviving spouse with both a full DSUE amount and her own basic exclusion amount could bring significant estate and gift tax saving opportunities to a second spouse with deep estate tax exposure. The augmented applicable exclusion amount that the surviving spouse brings to the second marriage could enable the second, wealthier spouse to transfer up to $10.68 million of his own assets to the surviving spouse, thereby allowing her to use these assets to make gifts to his children using her DSUE amount and basic exclusion amount.9 To be successful, this strategy requires that the gifts to the surviving spouse from her wealthier second spouse are unconditional, and the surviving spouse has established dominion and control over the gifted property in her own right prior to making the subsequent gifts to the second spouse’s children. Her ability to make these gifts, however, would be reduced to the extent the surviving spouse has assets from her first marriage that she would like to pass to the children of her first marriage on her death. In this manner, preserving the DSUE amount could provide estate and gift tax benefits in a remarriage situation.
While hardly something the couple is likely to talk about while falling in love, and certainly not the main foundation for a happy second marriage, the DSUE amount is an economic piece on the matrimonial chessboard and an appropriate subject to discuss with regard to any pre-marital agreement.
In an analysis of a client’s exposure to estate tax, debt is a double-edged sword. It magnifies potential appreciation, but to the extent the debt-financed investment is speculative, it also increases the magnitude of the loss. Moreover, to a certain extent, the interest paid on the debt, or the indebtedness itself, can impede the growth potential of a debt-financed investment. If the asset is a home run candidate, prudence would indicate a DSUE election, regardless of the odds of success. There’s another sort of debt, however, especially in an estate not clearly subject to the estate tax, which is more insidious. A mortgage on a primary residence or a vacation home (or on both), whether an obligation incurred at the purchase of the property or later home equity line of credit borrowing, particularly for a retired surviving spouse, would generally be a negative factor in a growth of the DSUE election analysis.
Undoubtedly, the most conservative approach is to have a surviving spouse elect the DSUE; one never knows what the future holds.
An accountant recently observed that filing an estate tax return and making the DSUE election was a $3,500 (name your own DSUE return flat fee) insurance premium to buy $5.34 million of estate tax protection. At that rate, it’s certainly cheaper than the premium for an equivalent policy held by an irrevocable life insurance trust.10
If the estate planner is only a little wrong, say $100,000 over the surviving spouse’s estate tax exemption, the damage is heavy, that is, the survivor’s estate would be left with a $40,000 estate tax bill. In our limited experience with surviving spouses after the advent of the DSUE, we’ve experienced clients (perhaps already discouraged with estate settlement fees to date) questioning the need to file the estate tax return only to make the DSUE election. Admittedly, there will be clients whose economic circumstances require a financial miracle to be subject to the estate tax. But equally as clear, the estate-planning professional’s letter to the surviving spouse should state that economic miracles do happen (there are white swans as well as black ones), and if lightning strikes, it could be costly unless a DSUE election is made.
A full and fair written explanation of the unpredictability of the future and the cost of being wrong, possibly combined with the most conservative advice, which is to make the DSUE election in most, if not all cases, is likely to be the approach many estate planners take. In this context, the estate planner is much like the doctor who receives a call from his patient with chest pains, and the patient asks if he should go to the emergency room. There’s no real upside to telling the patient to stay home, and there’s much to lose if the advice is wrong. The patient should go to the emergency room. We submit that the answer to the surviving spouse’s question, “Should I file to take advantage of the DSUE election?” should probably be much the same.
1. Internal Revenue Code Section 2010(c)(4). IRC Section 2010(c) allows a surviving spouse to make use of a deceased spouse’s unused exclusion (DSUE) amount by making an election to transfer such amount to the surviving spouse on a timely filed federal estate tax return.
2. Section 2010(c)(3). The current applicable exclusion amount per person is $5.34 million. This amount is increased each calendar year for inflation.
3. The DSUE amount itself isn’t indexed for inflation, so this fact may become even more critical in the DSUE analysis in circumstances in which the growing estate of a younger surviving spouse could out match the inflation adjustments provided by the IRC.
4. IRC Section 2033.
5. If pension income or annuity income covers most or all of the survivor’s daily living expenses, then there’s less need to tap into the survivor’s other investment assets. And, left alone for long periods of time, the effects of compounding interest on the survivor’s investment assets can be most gratifying and could attract an estate tax.
6. While the IRC doesn’t provide a maximum age when the income tax deferral of the non-qualified annuity must end and an annuitization must begin, annuity policies have traditionally chosen an age based on the identity of the annuitant when payments must commence. These ages, especially when optional extensions are considered, typically exceeded 100. On the death of the annuitant, however, IRC Section 72(s) adopts required minimum distributions that mirror those of individual retirement accounts and qualified plans under IRC Sec-
7. Temporary Regulations Section 20.2010-3T(a).
8. Temp. Regs. Section 20.2010-2T(c).
9. Temp. Regs. Section 25.2505-2T(b). A surviving spouse with a DSUE amount who makes taxable gifts is deemed to use the DSUE amount before her own applicable exclusion amount. Moreover, Temp. Regs. Section 25.2505-2T(a)(3) provides that a surviving spouse’s DSUE amount isn’t lost by simply remarrying a second spouse.
10. According to Highland Capital Brokerage in Milwaukee, an annual premium of $37,849.08 payable to age 115 would be needed to purchase a joint life insurance policy with a death benefit of $2,136,000 ($5.34 million—40 percent estate tax rate), if both spouses (age 70) are insurable at preferred non-tobacco rates.