A surviving spouse can get a big federal estate tax break if the deceased spouse didn’t use up his or her individual estate tax exemption. Thanks to the "portability rule," the survivor can use what’s left. That gives the couple a total exemption of more than $23.4 million.
The couple can split their total exemption between them in any way that provides the greatest tax benefit. Depending on the date of the deaths, the total exemption amount may exceed $22 million. Portability became available in 2011, when the exempt amount was $5 million; that number was indexed for inflation and went up each year. With the passage of the Tax Cuts and Jobs Act of 2017, it's $11.7 million per person for deaths in 2021.
For example, say a man dies in 2018 and leaves $10 million to his widow; no estate tax is owed, because property left to a spouse is tax-free. The widow dies in 2021, leaving $13 million (her own $3 million plus the $10 million she inherited from her husband) to their children. Her estate won’t owe any estate tax, even though the estate is over the $11.7 million exemption amount, because the estate can use the husband’s unused exemption.
To take advantage of this provision, a federal estate tax return (IRS Form 706) must be filed after the first spouse’s death—even though no estate tax will be paid then. The return is due nine months after the death.
Congress added this feature to the estate tax because of a perceived unfairness in the old system: Couples (especially when estate tax was imposed on smaller estates, so that some not-so-wealthy people were subject to it) sometimes ended up owing estate tax simply because they didn’t get good tax and legal advice.
What happened was that couples often didn’t do any tax planning, because they knew that no tax was due when property is left to the surviving spouse. So when the first spouse died and left everything to the survivor, there was no federal estate tax bill. But suddenly the surviving spouse owning everything that the couple had previously owned, essentially doubling the size of her estate. If that pushed the size of the estate over the estate tax threshold, a big estate tax bill could come when the second spouse died and left property to the couple’s children.
There was, however, a fairly straightforward way around this problem. While both spouses were still alive, they could create a “bypass trust.” When the first spouse died, his share of the couple’s property went into the trust; this used up his estate tax exemption. The surviving spouse had the right to the income from the trust property, and could even use the principal under certain circumstances, but didn’t own the trust property outright. When the surviving spouse died, her half of the property went to the children; because the amount was under the estate tax threshold, no tax was due. The trust property went to the children, too, and because it had already been subject to tax at the first spouse’s death, no tax was due on that transfer either.
Many couples created these bypass (also called AB) trusts to make sure they wouldn’t owe estate tax, and it saved their families many thousands of dollars. But couples who weren’t savvy enough to take advantage of this tax-saving strategy ended up leaving their families big tax bills. It just didn’t seem fair.
Federal estate taxes (and their state counterparts) are very complicated. If you’re dealing with such a large estate that you’re concerned about these taxes, get advice from a probate lawyer or accountant who is experienced with preparing and filing estate tax returns.