Federal estate tax uncertainty breeds state estate tax uncertainty.
Larry Richman's client was certain that his parents'
estate planning needs were minimal. "Their net worth is a little less
than $2 million," the client said, referring to the amount that's
exempt from federal death tax through 2008. "Can you just do a simple
will?" the client asked Richman, who is a partner and chair of the
private wealth services practice group at Chicago law firm Neal, Gerber
& Eisenberg LLP.
Then Richman learned the couple lived in New York, one of several states that currently exempts less from estate tax than the feds do (see Figure 1). "In order for their property to pass to the children without any state estate tax, we had to create a state credit-shelter trust," says Richman. Without it, the couple might have needlessly paid thousands of dollars in New York tax at the death of the survivor.
State death tax planning has grown in complexity and significance since Washington passed the Economic Growth and Tax Relief Reconciliation Act of 2001. "Today there is a lot of variation between state laws, whereas pre-EGTRRA there was something approaching uniformity," observes Bruno Graziano, a senior analyst at CCH, the business-information provider in Riverwoods, Ill.
A big part of the reason is that prior federal law had encouraged more than three dozen states to peg their estate tax to a federal tax credit for state death taxes paid. But EGTRRA abolished the credit which, long story short, meant curtains for those states' estate tax unless they altered their laws. Some have. Others have done nothing-their taxes are now history-yet their levies would resurrect if EGTRRA sunsets as scheduled on December 31, 2010, according to Graziano. That would reinstate the federal credit for state death taxes, which in turn would automatically revive this group's estate tax (see Figure 2). Of course, that's a pretty big "if." Call it trickle-down uncertainty.
Against this backdrop, advisors need to do a few things. First, get familiar with the rules everywhere clients hold property, bearing in mind that besides estate tax, some jurisdictions levy a separate inheritance tax. "To help clients accomplish their goals, it's vital that you understand the law and its implications and then educate clients," says Cory Schauer, a vice president in Mellon Financial's private wealth management group.
For instance, says Tom Kelley, a Baltimore-based senior financial planner with Wilmington Trust, "A $1.8 million estate could owe $85,000 or more in state taxes. An estate that size needs to plan for that."
Another critical step is reviewing existing plans, Schauer says. See how they'll play out under the law in effect now as well as in the foreseeable future. Advisors should also contemplate the following issues, each of which has gained salience in EGTRRA's wake.
Diversity among state death taxes ups the ante in choosing where to live. "If you have a $30 million estate in New York, where the top rate is 16%, you could owe $4 million or $5 million in tax, whereas a state like Florida currently has no tax. Some of my clients have actually moved there for that reason, among others," says Manhattan estate planning attorney Gideon Rothschild, a partner at Moses & Singer LLP.
An issue with out-of-state property is whether the other state imposes a death tax. If so, your client's property could be subject to it, although there is an escape hatch for real estate. You could put it into an entity like Richman did for a Florida client who had a summer home on the Jersey shore.
"In many states, an interest in a limited liability company or partnership is considered intangible personal property that a nonresident isn't taxed on, rather than taxable real estate," says Richman. In his client's case, the adult children contributed money in return for a small general-partner interest. "My client is the limited partner," Richman says, noting that there are no valuation discounts involved with this strategy.
But be careful. "The Massachusetts Department of Revenue has said they will look through the entity and consider the asset to be real estate, although it isn't clear whether they can actually do that," says Charles "Skip" Fox IV, a partner in the Charlottesville, Va., office of law firm McGuireWoods LLP, who maintains a comprehensive chart of state death tax rules for the American College of Trust and Estate Counsel. "You never know what a state revenue department might try to do," Fox says.
Where the state exemption is lower than the federal (which rises to $3.5 million in 2009), clients with a net worth falling roughly between the two can really benefit from advice, says attorney Todd Steinberg, a Greenberg Traurig shareholder in Tysons Corner, Va. "A lot of creative planning can be done for estates between about $1 million and $5 million."
Take lifetime gifting. Unlike the IRS, many states won't count gifts, including deathbed transfers, as part of the estate, Steinberg says. "In Maryland, a client with $1.5 million could give family $500,000 to get down to the state threshold for tax," he says. You'd have to watch for adverse federal gift tax consequences, of course.
A major planning challenge for couples is how to fund the credit-shelter and marital trusts. Traditional estate planning places the federally exempt amount in the credit-shelter trust at the first death, so that the exemption shields those assets from federal tax. The decedent's remaining property typically pours into a trust for the spouse, which defers any federal tax until she passes.
But when the state exempts less than the IRS, the traditional approach triggers state tax at the first death. Consider a $4.6 million Maryland couple. Say the first death occurred earlier this year and the estate planning documents direct $2 million (i.e., the federal exemption) to the credit-shelter trust. Since Maryland exempts just $1 million, it would tax the trust's second million.
Can that be avoided? Yes, although sometimes it isn't worth it. Here's the planning dilemma: Should you fund the credit-shelter trust with the federal exemption and pay state tax at the first death? Or is it better to fund it with the state exemption to avoid the state tax, even though that could enlarge the survivor's estate and potentially increase her federal estate tax by more than the state tax saved?
Unfortunately, the answer varies depending on a host of factors that aren't knowable up front. A chief one is the relationship between the federal exemption at the second death and the second-to-die's net worth. Figure 3 displays some possibilities.
Faced with such uncertainty, a wise approach is to create a flexible plan that defers the funding decision until the first death, when the planning picture might be less hazy.
Minimizing State Tax At The First Death, Or Not
One solution is a state QTIP (qualified terminable interest property) election, says Wilmington Trust's Kelley. The catch is, not all states allow this tax election. Where it is available, the election allows the first-to-die's executor to carve out a portion of the credit-shelter trust so that it's not considered part of the decedent's estate for state death tax purposes. For the couple above, electing $1 million of state credit-shelter trust assets would reduce the husband's Maryland estate from $2 million to $1 million and eliminate state tax. "With a state QTIP, a couple may be able to pay both federal and state estate taxes at the second death. It maximizes deferral," Kelley says.
A federal QTIP election is another path to flexibility. Everything could be left to a marital QTIP trust, Rothschild explains. Then at the first death, the executor uses the election to move the optimal amount of assets to the credit-shelter trust. With this arrangement, the spouse benefits from the decedent's entire estate.
When the client wants to benefit someone besides the survivor, a slight variation known as the Clayton QTIP can be useful, Rothschild says. By leaving everything to this type of trust, "the portion of the estate that the executor puts in the credit-shelter trust can benefit anyone, whether that's the children and spouse, or maybe just the children from a first marriage," Rothschild says.
Perhaps the least favored alternative is a qualified disclaimer, a tool heirs employ to refuse bequeathed assets. By leaving everything to the spouse, she can decide (with your help) how much should go to the credit-shelter trust and then disclaim that amount to the trust.
But the disclaimer must be made within nine months-scant time for a distraught survivor to make big decisions, Steinberg cautions. And in the interim, the survivor could unwittingly do something with the assets that forfeits the ability to disclaim them.