Recent Release of Rev. Proc. 2022-32 and Its Potential Impact on Surviving Spouse’s Future Federal Estate and Gift Tax Liability
Effective July 8, 2022, the IRS published Revenue Procedure 2022-32 to extend the period for certain estates of decedents who are survived by spouses to make a “portability” election under Section 2010(c)(5)(A) of the Internal Revenue Code. Those who qualify will now be able to elect portability of a Deceased Spousal’s Unused Exclusion (“DSUE”) amount up to five years after the decedent spouse’s date of death, which is a significant increase in the extension of time to elect from the prior law.
With this extension, certain surviving spouses will now have the opportunity, with the increased exemption from their decedent spouse’s DSUE amount to apply to the surviving spouse’s subsequent transfers during life or at death, to avoid/reduce federal gift and estate tax liability upon their own death. This benefit will become increasingly valuable if the federal lifetime exemption amounts are dramatically reduced, as current envisioned and further discussed below.
In order to more fully understand the implications of this Revenue Procedure, let us first examine what is the federal lifetime exemption, portability and the DSUE amount.
During 2022, every U.S. person has a $12.06M lifetime exemption that applies to federal gift and estate taxes. This exemption permits every U.S. taxpayer to transfer up to the exemption amount, during life (in the form of gifts) or at death (in the form of bequests through a Will or other transfers at death), or some combination thereof, without incurring any federal gift/estate tax.[1] If the transfers exceed this amount, then the excess (i.e., amount above $12.06M) is subject to federal gift/estate tax, at a progressive tax rate that goes up to 40%.
Under current law, the federal lifetime exemption is scheduled to be substantially reduced to $5M (inflation adjusted), starting on January 1, 2026. In addition, President Biden has, to date, unsuccessfully proposed legislation that would have reduced the lifetime exemption amount to $3.5M (and sought to increase the highest federal gift/estate tax rate to 45% from 40%), but this proposed legislation may return. This is one of the reasons why this issue may take on a more important role going forward.
Transfers between U.S. spouses[2] do not count towards the current $12.06M lifetime exemption amount as there is an unlimited marital deduction that allows transfers, free from federal gift and estate tax, between U.S. spouses during life or at death. Moreover, for married couples, since 2010, if a spouse dies with an unused portion of his or her lifetime estate and gift exemption (DSUE) amount (i.e., if the first spouse dies with a taxable estate that is less than the then-in-effect lifetime exemption amount), this remainder amount can be transferred (“portability”) to the surviving spouse, thus increasing the surviving spouse’s lifetime exemption amount, and enabling the surviving spouse to pass a greater amount free of gift/estate tax.
However, this is where foot faults arise since portability is not automatic upon a spouse’s death. Instead, a federal estate tax return (Form 706) must be timely filed by the decedent spouse’s estate to claim portability for the surviving spouse so that the surviving spouse can receive the DSUE amount. This filing is easily missed because a significant majority of estates do not owe federal estate taxes and do not otherwise have a Form 706 reporting requirement. Stated differently, in order to elect portability, it is often necessary that an estate tax return be prepared and filed for an estate that is not technically required to file such a return.
The following example shows how portability works:
Example 1. Spouse 1 passes away on March 1, 2022 with a taxable estate of $1,000,000 left to her children. This amount is less than Spouse 1’s $12,060,000 estate tax exemption in 2022 and thus there is no federal estate tax owed upon the death of Spouse 1. Absent a desire to elect portability, there would be no need to prepare and file a Form 706 upon Spouse 1’s death. However, failure to do so would result in a missed opportunity, as Spouse 1’s estate had $11,060,000 of unused exemption (DSUE) that can be transferred to Spouse 2. Thus, it would be prudent for the representative of Spouse 1’s estate to file a Form 706 and make the portability election as Spouse 2’s (surviving spouse) available lifetime exemption amount will then be increased by the DSUE amount, such that Spouse 2 then has an exemption of $23,120,000 ($11,060,000 of DSUE plus $12,060,000 of Spouse 2’s own exemption amount). Spouse 2 then passes away on December 1, 2022, with a taxable estate of $20,000,000. In the example described, no federal estate tax will be owed upon Spouse 2’s death as the taxable estate is less than the $23,120,000 exemption. In summary, Spouse 2 did not have any Federal estate tax liability because of the portability election.
This new Revenue Procedure extends the time to make the portability election filing to on or before the fifth-year anniversary after the first spouse’s date of death. This rule is retroactive in that it allows estates of decedent spouses who passed away less than five years ago to make the portability election if a Form 706 has not already been filed by the decedent spouse’s estate.
In order to qualify for the new portability election procedure, the decedent must meet the following requirements: (1) have been survived by a spouse; (2) passed away after December 31, 2010; (3) have been a U.S. citizen or U.S. resident on the date of death; (4) not otherwise been required to file a Form 706 (the estate did not owe federal estate tax); and (5) not have previously filed a Form 706 for his or her estate.
All that is required to make the election under this new procedure is to: (1) file a properly completed Form 706 on or before the fifth annual anniversary of the decedent’s date of death; (2) make the portability election on the Form 706; and (3) state on the Form 706 that the return is “FILED PURSUANT TO REV. PROC. 2022-32 TO ELECT PORTABILITY UNDER § 2010(c)(5)(a).”
This example shows the benefit of the DSUE amount if the surviving spouse dies after January 1, 2026 based on current law expectations:
Example 2. Spouse 1 died on February 1, 2019 and did not use any of her available Federal estate tax exemption of $11,400,000, the lifetime exemption amount in effect in 2019. Spouse 1’s estate was not required to file a Form 706 as no federal estate tax was due, such that one was never filed. On July 1, 2026, Spouse 2 (surviving spouse) passes away with a taxable estate of $8M and a federal lifetime exemption of $5M (inflation adjusted) based on the anticipated January 1, 2026 law change, so assume that this exemption amount is $6M based on inflation. Without portability, Spouse 2 has a federal estate tax liability of ~$800,000 (40% tax rate on $2M that exceeds $6M).[3]
Instead, if pursuant to this Revenue Procedure, the portability election is filed on or before February 1, 2024 (fifth anniversary of Spouse 1 death), Spouse 2’s Federal estate tax exemption at Spouse 2’s death would have been $17,400,000 ($6M plus $11,400,000 (DSUE)) and Spouse 2 would owe no Federal estate tax liability.
While there is a cost to the Form 706 tax return preparation and filing, this cost is likely justified by the potential federal gift/estate tax savings arising out of filing a portability election. If a Form 706 was not filed for the first deceased spouse who has died within the last five years and has a DSUE amount, then this new portability election procedure should be considered.[4]
[1] There is also currently an annual federal gift tax exclusion of up to $16,000 per individual ($32,000 when combined with a spouse) with no gift tax consequences, which is separate and does not count towards the federal lifetime exemption amount.
[2] Transfers to a spouse who is not a U.S. citizen will not enjoy the benefit of the unlimited marital deduction. While outside the scope of this article, it is important for couples who are not both U.S. citizens to consult with their attorney to ensure that inter-marital transfers do not run afoul of these rules.
[3] As noted previously, the Federal gift/estate tax is a progressive tax rate, so not every taxable dollar that exceeds the exemption amount is subject to the highest 40% tax rate, such that this is an approximate number.
[4] The Revenue Procedure also notes that the extended filing period could also apply to situations, which qualify under the Revenue Procedure, where federal gift/estate tax has already been paid by the surviving spouse/surviving spouse’s estate in connection with gift(s), during life or after death, by the surviving spouse that exceeded the federal lifetime exemption amount but did not exceed the exemption amount plus the DSUE amount. Depending on the applicable statute of limitations and the factual circumstances, the surviving spouse/estate of the surviving spouse may be able to potentially claim a refund by filing the portability election based upon the Revenue Procedure’s extended five year deadline.
