A Skeleton Return And Portability

 

The amount for 2025 is $13.99 million.

This is the lifetime exclusion amount for combined gift and estate taxes. You can give away or die with assets up to this amount and owe neither gift nor estate tax. This amount is per person, so – if married – you and your spouse have a combined $27.98 million.

Next year that amount resets to $15 million, or $30 million for a married couple.

Let’s say it: most of us do not need to sweat. This is a high-end issue, and congrats if it impacts you.

What I want to talk about is the portability of the lifetime exclusion amount.

Tax practice brings its own acronyms and (call it) slang.

Here is one: DSUE, pronounced Dee-Sue and referring to the transfer of the lifetime exclusion amount from the first spouse-to-die to the second.

Let’s use a quick example to clarify what we are talking about. 

• Mr. and Mrs. CTG have been married for years.
• They have not filed gift tax returns in the past, either because they have not made gifts or gifts made have been below the annual gift exclusion. The exclusion amount for 2025 is $19,000, for example, so only a hefty gift would be reportable.
• Mr. and Mrs. CTG have a combined net worth of $20 million.
• For simplicity, let’s assume that all CTG marital assets are owned jointly.

 At a net worth of $20 million, one might be concerned about the estate tax.

Except for one thing: we said that all assets are owned jointly.

Let’s say that Mr. CTG passes away in 2026 when the lifetime exclusion amount is $15 million. His share of the joint estate is $10 million ($20 million times ½), well within the safety zone. There is no estate tax due.

Let’s go further. Let’s say that Mrs. CTG dies later in 2026.

Her net worth would be $20 million ($10 million - her half - and $10 million from Mr. CTG).

Could she have an estate tax issue?

First impression: yes, she could. She exceeded the lifetime exclusion amount by $5 million ($20 million minus $15 million).

In income tax we are used to numbers being combined when filing as married-filing-jointly. This is estate tax, though. That MFJ concept … does not apply so neatly here.

We can even create our own tax headache by having the first-to-die leave all assets to the surviving spouse.

And there is the point of the DSUE: whatever lifetime exclusion amount the first-to-die doesn’t use can be transferred to the surviving spouse. In our example, $5 million ($15 million minus $10 million) could be transferred. If Mrs. CTG dies shortly after Mr. CTG, her combined exclusion amount would be $20 million (her $15 million and $5 million from Mr. CTG). Since combined assets were $20 million, there would be no estate tax due. It’s not quite the simplicity of married-filing-jointly, but it gets us there.

Moving that $5 million from Mr. CTG to Mrs. CTG is called “portability,” and there are rules one must follow.

The main rule?

          A complete and properly prepared estate return must be filed.

Practitioners who work in this area know how burdensome a complete and properly prepared estate tax return can be. The return requires full disclosure of assets and liabilities, including descriptions and values, not to mention documentation to support the same. Here are a few examples:

•  Do you own stock? If yes, then each stock position must be valued at the date of death (or six months later, an alternative we will skip for this discussion). How do you do this? Perhaps your broker can help. If not, there is specialized software available.
•  Do you own 401(k)s or IRAs? If so, one needs to know who the beneficiaries are.
•  Do you own a business? If so, you will need a valuation.
•  Do you own real estate? If so, you will need an appraiser.

Let’s be blunt: there are enough headaches here that someone could (understandably) pass on filing that first-to-die estate tax return.

Fortunately, the IRS realized this and allowed a special rule when filing an estate tax return solely for DSUE portability.

Yes, we see the usual tax gobbledygook, but the IRS is spotting us a break when preparing the Form 706. 

• You can use (good faith) estimates. You do not have to hire appraisers and valuation specialists, for example.
• However, the special rule only applies if all property goes to the surviving spouse (the marital deduction), to charity (the charitable deduction), or a combination of the two.

Can you fail the special rule?

Yeppers.

Let’s look at the Rowland case.

Fay Rowland passed away in April 2016. She did not have a taxable estate.

The surviving spouse (Billy Rowland) passed away in January 2018. He did have a taxable estate.

Note the fact pattern: they will want to transfer Faye’s unused lifetime exemption (that is, the DSUE) to Billy, because he is in a taxable situation.

Fay’s Trust Agreement (effectively functioning as a will) instructed the following:

• 20% to a foundation
• 25% to Billy
• The remainder to her grandchildren

Fay filed an estate tax return reporting everything under the special rule: showing zero for individual assets but a total for all combined assets.

Billy’s estate return reported a DSUE (from Fay) of $3.7 million.

The IRS bounced Billy’s DSUE.

Off to Tax Court they went.

The Court agreed with the IRS.

Why?

Take a look at the special rule again.

• Assets passing to Billy qualify as a marital deduction.
• Assets passing to the foundation qualify as a charitable deduction.
• Assets passing to the grandchildren …. do not qualify for the special rule.

Fay’s estate tax return showed all assets as qualifying for the special rule. This was incorrect. The return should have included detailed reporting for assets passing to the grandchildren, with simplified reporting for the assets passing to Billy or the foundation.

Fay did not file a complete and properly prepared estate return.

The failure to do so meant no DSUE to port to Billy.

Considering that the estate tax rate reaches 40%, this is real money.

What do I think?

I have seen several DSUE returns over the last year and a half. Some have been straightforward, with all assets qualifying for the special rule. We still had to identify assets and obtain estimated values, but it was not the same amount of work as a full Form 706.

COMMENT: Practitioners sometimes refer to this special-rule Form 706 as a “skeleton” return. Skeleton refers to one providing just enough information on which to drape a portability election.

Then we had returns with a combination of assets, some qualifying for the special rule and others not. This is a hybrid return: nonqualifying assets are reported in the usual detail, while assets qualifying for the special rule are more lightly reported.

Fay’s estate tax return should have used that hybrid reporting.

Our case this time was Estate of Billy S Bowland v Commissioner, T.C. Memo 2025-76.

Blowing An Estate Tax Deduction

 

Let’s talk about the Estate of Martin W. Griffin.

Martin Griffin (Martin) was married to Maria Creel.

Martin created a revocable trust known as the Martin W. Griffin Trust.

COMMENT: A revocable trust means that the settlor (Martin in this case) can undo the trust. When that happens, the trust is disregarded and Martin and his revocable trust are considered the same person for tax purposes. The classic revocable trust is a “living trust,” which has no effect until one dies. Its purpose is not tax-driven at all and is instead to avoid probate.

Martin next created the MCC Irrevocable Trust.

COMMENT: Irrevocable means that Martin cannot undo the trust. He might be able to tweak a thing or two at the edges, but he cannot do away with the trust itself.

The Irrevocable Trust had the following language in the trust agreement:

The trust shall distribute the sum of Two Million Dollars ($2,000,000) to the trustee then serving …. for the benefit of Maria C. Creel. From this bequest, the trustee … shall pay to Maria C. Creel a monthly distribution, as determined by Maria and Trustee to be a reasonable amount, not to exceed $9,000 ….”

You see the word “Estate” in the case name. The issue in this case is estate tax, and it involves passing assets at death to one’s surviving spouse. There are two general ways to do this:

·       You simply transfer the asset to the surviving spouse.

An example here is a principal residence. The deed is in both spouse’s names. When you die, the house transfers directly to her (I am assuming you are the husband). She can then do what she wants: she can keep the house, sell the house, rent it or whatever. She has unfettered control over the house.

·       You transfer a right – but not all the rights – to the asset.

Let’s stay with the above example. You instead transfer a life estate to your wife. Upon her death the house goes to your children from your first marriage. She no longer has unfettered control over the asset. She cannot sell the house, for example. She has some – but not all – incidents of ownership.

The reason this is important is that the estate tax will allow you to deduct category (1) assets from your taxable estate, but category (2) assets have to go through an additional hoop to get there.

Here is the relevant Code section:

26 U.S. Code § 2056 - Bequests, etc., to surviving spouse

(7) Election with respect to life estate for surviving spouse  

(A) In general In the case of qualified terminable interest property—  

(i) for purposes of subsection (a), such property shall be treated as passing to the surviving spouse, and

(ii) for purposes of paragraph (1)(A), no part of such property shall be treated as passing to any person other than the surviving spouse.  

(B) Qualified terminable interest property defined For purposes of this paragraph—  

(i)In general The term “qualified terminable interest property” means property—

(I) which passes from the decedent,

(II) in which the surviving spouse has a qualifying income interest for life, and

(III) to which an election under this paragraph applies.

Section 2056 addresses the hoops we are talking about. If you are transferring less than total and unfettered rights to an asset, you want to make sure that you are transferring enough to qualify the asset as “qualified terminable interest property.” If you do, you get a subtraction for estate tax purposes. If you do not, there is no subtraction. 

It takes a lot to get to an estate tax in 2025 (given the lifetime exemption), but – if you do – the rate ramps to 40% rather quickly.  

Back to Martin.  

The Irrevocable Trust transferred enough to qualify as qualified terminable interest property.

Here is the Court:

The $2 million bequest is not QTIP. It is terminable interest property that does not qualify for the marital deduction and is includible in the estate.”

Huh? What happened?

Go back to (B)(iii) above:

(III) to which an election under this paragraph applies.

How do you make the election?

You include the asset on Schedule M of Form 706 (that is, the estate tax return):

That’s it. It is not complicated, but it must be done. The Code requires it.

Someone missed this while preparing Martin W Griffin’s estate tax return.

Yep, I expect a malpractice suit.