As the federal estate tax exemption climbs, and as the 2010 repeal approaches, many families and their advisors are relieved that $2 million to $7 million of assets can be inherited federal estate tax-free. However, residents of most states must still plan for looming, and often substantial, state death taxes.
In 2000, most states imposed an estate tax to the extent of the state death tax credit under §2011 of the Internal Revenue Code (the “Code”). Their estate tax systems were “coupled” with the Code and “picked-up” an estate tax to the extent of the §2011 credit.
Until 2001, the typical estate plan of a married couple with a federal taxable estate provided for the estate of the first deceased spouse to be divided into two shares. One share (the “Credit Shelter Trust”) would be funded with an amount equal to the applicable federal estate tax exemption. The balance of the deceased spouse’s estate would fund the “Marital Deduction Trust” which qualified for the marital deduction, usually achieved by making a “QTIP election.” As a result of this estate planning technique, both federal and state estate taxes would be deferred until the death of the surviving spouse.
Married Maine resident (a “pick-up” state) died in 2000 with a gross estate of $3,000,000. Decedent’s Revocable Trust provided for his estate to be divided into two shares: a Credit Shelter Trust equal to the applicable federal estate tax exemption at the time of his death ($675,000) and a Marital Deduction Trust equal to the balance of his estate ($2,325,000). This formula would result in no estate tax liability at the first spouse’s death and would fully “fund” his federal estate tax exemption.
The Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA”) changed the federal estate tax system significantly: the applicable federal exemption was increased; the maximum federal estate tax rate was decreased; and the §2011 state death tax credit was gradually phased out and replaced with a deduction under §2058 for state estate taxes paid.
The repeal of the §2011 credit pulled the rug out from under the “pick-up” states. They were left with two choices: do nothing, and allow the state’s death tax to evaporate with the repeal of the §2011 credit, or respond with legislation to “de-couple” from the federal estate tax system. About one-third of the “pick-up” states have eliminated their states’ death tax. Several others have separated entirely from the federal estate tax system and have enacted their own independent inheritance or estate tax. The remaining “pick-up” states have “de-coupled” from the federal estate tax, but are “coupled” with a pre-EGTRRA version of the Code.
Most estate plans drafted prior to 2001 provide for maximum estate tax deferral based on a “coupled” state-federal estate tax system. Such estate plans may no longer provide the desired estate tax deferral because of the new state death tax laws.
Married New Jersey resident dies in 2008 with a gross estate of $3,000,000. His Revocable Trust directs his estate to be divided into two shares: the Credit Shelter Trust would be funded with the applicable federal estate tax exemption ($2,000,000) and the Marital Deduction Trust would be funded with the balance of the estate ($1,000,000). New Jersey “de-coupled” in 2002 and limited its applicable exemption to $675,000. The estate tax liability would be $99,600.
Credit Shelter Trust Planning
A state death tax liability may be looming for older estate plans which have not been updated since EGTRRA. Estate plans of a married couple may be amended so upon the death of the first spouse, decedent’s estate is divided into three shares. The first share (the “Credit Shelter Trust”) is equal to the applicable state estate tax exemption and will not be subject to any estate taxes. The second share (the “State QTIP Trust”) is funded with an amount equal to the difference between the deceased spouse’s state exemption and federal exemption and will be subject to the state’s death tax upon surviving spouse’s death. The third share (the “Federal QTIP Trust”) is funded with the balance of decedent’s estate and will be subject to both federal and state estate taxes upon surviving spouse’s death. Complete estate tax deferral is possible by making a state-only QTIP election to the State QTIP Trust, thereby qualifying it for the marital deduction for state estate tax purposes. Both federal and state QTIP elections will be made for the Federal QTIP Trust.
Married Rhode Island resident dies in 2008 with a taxable estate of $3,000,000. Pursuant to his updated Revocable Trust, Decedent’s estate would be divided into the following three shares: the Credit Shelter Trust would be funded with $675,000, an amount equal to the Rhode Island estate tax exemption, the Rhode Island QTIP Trust would be funded with $1,325,000, an amount equal to the difference between the applicable federal estate tax exemption ($2,000,000) and the Rhode Island exemption; and the Federal QTIP Trust would be funded with $1,000,000, the balance of Decedent’s estate.
Some states permit estates to make a state-only QTIP election. However, not all states permit an independent state QTIP election to be made when a federal QTIP election has not been. For residents of these states, the decision must be made whether to pay state estate taxes at the first spouse’s death or defer estate taxes until the surviving spouse’s death. The drawback to complete deferral is the increase in the size of the surviving spouse’s taxable estate for federal estate tax purposes.
A married New York resident dies in 2009 with a taxable estate of $5,000,000. Pursuant to her pre-EGTRRA Revocable Trust, Decedent’s estate would be divided into two shares: the Credit Shelter Trust would be funded with $3,500,000, an amount equal to the available federal estate tax exemption; and the Marital Deduction Trust would be funded with $1,500,000, the balance of her estate. Federal and New York QTIP elections would be made for the Marital Deduction Trust. Since New York has “de-coupled” and frozen its estate tax exemption at $1,000,000, the New York estate tax liability would be $229,200.
Assume the same facts as above, except Decedent’s estate plan has been amended since EGTRRA. The Credit Shelter Trust would be funded with an amount equal to the lesser of the federal estate tax exemption or the New York estate tax exemption at the time of Decedent’s death, $1,000,000. The balance of Decedent’s estate would fund the Marital Deduction Trust, $4,000,000. Federal and New York QTIP elections would be made for the Marital Deduction Trust. At the time of Decedent’s death, the applicable federal estate tax exemption is $3,500,000. $2,500,000 of this exemption would be unused. Depending on the size of the surviving spouse’s taxable estate when he dies, this may be up to an additional federal estate tax of $1,125,000, significantly higher than the estate tax liability at the first death in Example 4.
Planning for the Patchwork State Estate Tax
A significant state death tax liability may arise as a result of a decedent having assets in multiple states. The estate tax rules of many states assume that all states are based on the §2011 state death tax credit. For example, the Massachusetts estate tax applicable to its residents is based on the decedent’s federal gross estate, i.e., all of decedent’s property, no matter where located. The Massachusetts estate tax liability is decreased by death taxes paid to other jurisdictions. What if decedent has property in a state in which there is no death tax?
Widowed Massachusetts resident dies in 2008 with a $3,000,000 taxable estate consisting of a $1,000,000 Miami condominium and $2,000,000 Massachusetts property. Massachusetts “de-coupled” in July 2002 and froze its estate tax exemption at $1,000,000 beginning in 2006. Florida does not have a state death tax. For Massachusetts estate tax purposes, the Miami condominium is included in Decedent’s gross estate. The Massachusetts estate tax would be $182,000, although the tax on Massachusetts property would be $99,600.
Widowed Florida resident dies in 2008 with a $3,000,000 taxable estate consisting of a $2,000,000 Boston condominium and $1,000,000 Florida property. Decedent does not own the condominium outright; she owns it as the sole member of a Limited Liability Company (“LLC”), used for holding title because it is rental property. The Massachusetts estate tax applicable to non-residents applies to Massachusetts real estate; it does not apply to intangible personal property, such as a membership interest in an LLC. There is no state death tax liability.
Advisors cannot assume that because a client does not have a federal taxable estate, state death taxes are not relevant, especially as states feel the “pinch” from the post-EGTRRA drop in revenue. A careful analysis is necessary to determine the proper plan to minimize, defer or pay state death taxes. Such analysis should also consider both the applicable estate taxes of the client’s domicile and the estate taxes of all states in which the client may own property.
Richard P. Breed, III is a shareholder and co-founder of Tarlow, Breed, Hart & Rodgers P.C. of Boston, which was established in 1991. He concentrates his practice in the field of estate and business planning and advises owners and their families on the complexities of estate planning and administration, taxation and corporate law.
Jennifer Civitella Hilario has been an associate with Tarlow, Breed, Hart & Rodgers P.C. since 2006. She concentrates on estate planning, tax planning and estate administration.