Legislation enacted a few years ago (finally) set a $5 million estate tax exemption for 2011 and indexed it for inflation each year thereafter. This means that the exemption grows as costs rise. For 2015, the exemption is $5.43 million. Assets exceeding the exemption amount are subject to a hefty 40% federal tax, as well as estate or inheritance taxes (sometimes both) imposed by 19 states and the District of Columbia. With state rates as high as 16%, some estates could be subject to tax rates exceeding 50%. Ouch! Of course, there is no limit to the amount that can be transferred from one spouse to another, either during one’s life or upon death.
But there was also another important change that didn’t receive much public attention at all, even though it can dramatically reduce the estate tax burden for many couples. When someone dies, provisions made permanent in 2012 allow the surviving spouse’s estate to essentially “inherit” the unused portion of the decedent’s estate tax exemption. This option, known as a Deceased Spousal Unused Exclusion (DSUE), can be a particularly helpful estate-planning consideration when one spouse is expected to outlive the other by many years, as well as for couples with uneven asset holdings or poorly-constructed estate planning structures. The DSUE election may reduce the need to create credit shelter or bypass trusts solely to take advantage of each spouse’s federal estate tax exclusion amount (there may be other reasons for creating such trusts, however, such as to avoid state-level taxation). It can also serve as a corrective buffer when well-intentioned mistakes have been made in estate planning that are discovered only after the first spouse has passed away.
Here’s the catch: In order to make the election, an estate tax return needs to be filed – even if the deceased spouse’s taxable estate is below the basic exclusion amount. The return, filed on Form 706, must be filed timely (including extensions)—generally within 9 months of date of death (15 months including extensions). If there is any concern that a surviving spouse’s assets, including inherited assets, may grow to the point that they exceed the exclusion level, it is important that the decedent’s personal representative consider filing an estate tax return that makes a protective DSUE election.
What’s the downside? There are some. The executor’s option of making or not making the DSUE election can fuel existing family conflicts, just as these kinds of conflicts can present problems at all levels of estate planning. Selection of an executor that will carry out the decedent’s wishes is crucial.
Consider for a moment the appointment of an executor that was devoted to his/her parent but is hostile to the surviving spouse or their heirs (think stepchildren, half-siblings, or conflicts between family members). Such an appointment could result in an estate tax return being filed for the specific purpose of denying the DSUE to the surviving spouse, which would essentially subject more of the surviving spouse’s estate to taxation. For example, if the decedent’s son or daughter is executor of the estate and they aren’t exactly fond of their surviving stepmother, they could file an estate tax return that doesn’t make the DSUE election, thereby denying the surviving spouse the opportunity to benefit from the decedent’s unused exclusion.
Perhaps the biggest drawback may be that the DSUE election extends the statute of limitations, giving the IRS more time to challenge the decedent’s estate tax return. Normally, there is a three-year statute of limitations for the IRS to challenge an estate tax return. The DSUE election essentially extends that to three years beyond the due date for the surviving spouse’s estate tax return. That’s right – making the election extends the statute of limitations to an unknown date in the future, long after both spouses have passed away.
But what happens when the surviving spouse remarries? That’s the subject of my next post.