Deceased Spouse Estate Tax Exemption Portability (DSUEA) – Friend or Foe?

Along with other temporary estate and gift tax changes in 2011 and 2012, Congress made a deceased spouse’s unused estate tax exemption portable. At first glance, this sounds like a good thing. However, most married couples would be better off just pretending that this so-called benefit doesn’t exist. Here is why.

The acronym for this latest gift of uncertainty bestowed upon us from Washington is DSUEA – Deceased Spousal Unused Exclusion Amount. The idea is that a married couple, each with a 5 million dollar estate tax exemption, should be able to pass any unused exemption on to the surviving spouse to be used to shelter the surviving spouse’s estate from federal estate tax. It certainly sounds good in theory, but in reality it can be a trap for the unwary.

The requirements for DSUEA are (1) married at time of death, (2) death occurs after December 31, 2010, (3) the transfer of DSUEA is made to a surviving spouse, (4) the election to transfer the DSUEA is made on a timely filed estate tax return and (5) the DSUEA of the last deceased spouse eliminates any DSUEA previously transferred to the surviving deceased spouse. That last requirement is the first of many subtle traps.

To make this trap a little more obvious, let’s assume that the year is 2013 and the exemption from federal estate tax is 1 million dollars per individual, or 2 million dollars total for a married couple. Dick and Jane, a married couple with three adult children, have 2 million dollars in net assets and decide to skip any estate tax planning trusts because the unused exemption of the first spouse to die can be transferred to the survivor. Dick dies leaving his 1 million dollar estate to Jane, outright. Jane then remarries her high school sweetheart, Steve, who is also widowed and has three adult children. Being thoughtful, Jane and Steve agree to leave their respective estates to their respective children. Then, Steve dies with an estate valued at 1 million dollars. Jane dies a year later without Dick’s DSUEA because the last spouse to die was Steve – not Dick. Steve did not have any DSUEA because he gave his entire 1 million dollar estate to his children using up Steve’s entire exemption. Dick’s DSUEA was wiped out by Steve’s death – the last deceased spouse. Assuming an approximate estate tax rate of 50%, Jane’s estate pays about $500,000.00 in estate tax.

This is just one of many reasons why most individuals should not rely on estate tax exemption portability as a replacement for estate tax and trust planning. There are many other reasons. For example, portability of DSUEA is temporary and expires at the end of 2012. Credit shelter trusts protect the deceased spouse’s appreciating assets from estate tax on that appreciation. Credit shelter trusts also have a built in asset protection feature protecting the deceased spouse’s assets from the surviving spouse’s creditors which may include a new spouse.

Estate tax exemption portability is not a replacement for estate planning. While there are certainly some benefits and planning opportunities with DSUEA, there are significant risks in assuming that the portability of the exemption will result in the avoidance of estate tax in the future.