IRS Form 706 is commonly known as an “Estate Tax Return.” It is not well-known even by most accountants and is rarely filed. But estate planning lawyers will swear by them!
So what’s the deal? Why are they so elusive to some, and yet so important to file according to others?
Usually, there is a HUGE advantage in filing a Form 706 after the death of the first spouse, and it has to do with something related to the estate tax, called “portability.”
While the federal estate tax is well beyond the scope of this article, for our purposes here, you should know that the estate tax is a tax levied when an individual dies leaving behind a certain amount of wealth. In 2020, for example, the estate tax kicks in if someone dies leaving behind more than $11.58 million. Any amount above the limit is taxed substantially, usually 40-45%. (For a more detailed overview of the estate tax, read our article, “What is the Federal Estate Tax?“)
Let me go over a simple example to best illustrate the value of the Form 706.
Let’s say Husband (H) is married to Wife (W) and they have 2 kids. Let’s also assume that H and W own $8 million worth of assets. Let’s also assume H and W are US citizens. H dies in 2020 in a year where the federal estate tax exemption is $11.58 million. W sees the family accountant who tells W that no 706 is needed to be filed, because H and W only had $8 million and they under the estate tax exemption. This makes sense to W, so she does not file a 706.
In 2030, W suddenly dies, leaving behind an estate worth $10 million. Let’s imagine that in 2030, the federal estate tax exemption was only $6 million. Now, because W left behind $10 million, her estate is subject to estate tax because she died with $4 million above the exemption. This $4 million is subjected to a 40-45% tax (depending on current law at the time).
Could this tax have been avoided had a 706 been filed?
Yes!
Let’s imagine W went to her estate planning lawyer instead after H died in 2020. Let’s imagine the attorney convinced her to file a 706. Now what would have happened in 2030 when she died?
In 2030, Wife would have been subject to the estate tax exemption in that year ($6 million) but she also would be able to apply the exemption from 2020 ($11.58 million) when H died (because she filed the 706). (We say Husband’s exemption is “portable,” because it has transferred from Husband over to Wife. Portability is not automatic at death; instead, you need to apply for it via a Form 706).
This means, in 2030, Wife would be able to leave behind $17.58 million tax-free. Because she died in 2030 with $10 million, there would be no estate tax.
Therefore, filing for your deceased spouse’s unused exemption is critical, because if you don’t file for it in a timely manner, you will lose their exemption amount forever.