Beware The State Estate Tax Trap

Thursday, May 8, 2014 - 14:09

There has been considerable talk over the past five years about the substantial changes in the federal estate tax that were made permanent at the end of 2012, with the exemption increased to $5 million plus adjustments for inflation and portability between spouses. However, relatively little attention has been paid to the separate taxes that are collected at the state level in some 19 states[1] and the District of Columbia. As many fewer estates are affected by the federal estate tax, state estate taxes take on considerably more importance.

In the good old days, most states (but not all) had a “pick up” or “sponge” tax whereby the state accepted a death tax equal to the formula amount the federal tax laws permitted as a credit against the federal estate tax. For larger estates that paid federal tax, the state tax mattered little because it reduced the federal tax dollar for dollar. No more. As part of the Bush-era tax changes, the federal credit for state death taxes was phased out over three years ending in 2004 and replaced by a deduction. In most states, such as Florida and California, this meant the complete elimination of the state estate tax. Other states, such as New York, New Jersey and Connecticut, amended their statutes to maintain their separate estate taxes and “decoupled” from the federal system.

State estate tax laws have been in a constant state of flux. Mounting budgetary pressures in some states create an incentive to add an estate tax. In other states, there is pressure to reduce or eliminate the estate tax by increasing the exemption, lowering the rate or outright repeal. It is common for a state to enact the tax, then repeal it or substantially modify it within a couple of years. 

So, how do the state estate taxes work? Each state has its own exemption, which may or may not equal the federal exemption, and each state has its own rates, often based on the rates used to calculate the old federal-state-death-tax credit. New Jersey has the most onerous tax. It has an estate tax exemption of only $675,000, with graduated rates up to 16 percent. Estates under the exemption will pay no tax. However, once an estate exceeds $675,000, it “falls off a cliff,” and the estate is taxed on all property in excess of $60,000! (New York has something similar, but the exemption is larger.) Typically transfers to spouses and charities are tax free.

Some states also have an inheritance tax (Iowa, Kentucky, Pennsylvania, Maryland and New Jersey). Two of those states have an inheritance tax in addition to the estate tax (Maryland and New Jersey). The fundamental difference between the two is that the estate tax is based on the value of the entire estate passing at death. The inheritance tax is determined by who inherits the property. Transfers to spouses and children, and sometimes other lineal descendants, are typically free of inheritance tax or taxed at very low rates. Transfers to collateral relatives and third parties are taxed at higher rates.

States generally apply the same rules as are used for federal estate tax purposes, both as to what assets are taxed and how they are valued. Thus, real estate located within the state, cash, securities, IRAs and other retirement benefits, personalty and certain property deemed to be owned by the decedent (such as property given away during the decedent’s lifetime as to which he or she has retained certain rights or powers) are all subject to estate tax. A state estate tax return will have to be filed if the decedent’s gross estate exceeds the state’s applicable exemption amount, even if there is no tax to be paid (for example, if the bulk of the estate goes to a spouse or charity). State returns are normally due at the same time a federal estate tax return would be due – nine months after the date of the decedent’s death, plus extensions, although there are exceptions (Connecticut, for example). 

The disparities between the federal and state estate tax rules and the possibility of being taxed in two or more states with markedly different systems of taxation create complexity and traps for the unwary, and require careful individual planning and discussion with the client.

If you are a domiciliary of a state that does not have a state estate or inheritance tax, you may nonetheless be exposed to state estate tax if you own real property or tangible personal property in a state that does have the tax. You would then pay a fraction of the state estate tax based on the ratio that the real or tangible property located in the state with the tax bears to the entire estate. The classic scenario would be a Florida resident who owns a valuable vacation home in, say, New York or New Jersey. Conversely, if you live in a state with an estate tax like New York but own real or tangible property in a tax-free state like Nevada, you would get the benefit of your home state not taxing the property located elsewhere.

The federal estate tax contains a portability provision that permits a surviving spouse to make use of the unused federal estate tax exemption from a predeceased spouse. If a couple does not do the classic bypass/marital deduction planning,[2] the predeceased spouse's exemption need not be lost. However, the states do not have portability provisions, and a state exemption that is unused (for example, because everything goes to a surviving spouse) will be lost forever, resulting in increased taxes at the death of the surviving spouse.

Even if a couple does the classic planning, the lower exemption in most states with an estate tax can result in a potentially big tax bill up front. For example, a bypass trust in the amount of $5,340,000 (the amount of the 2014 federal estate tax exemption) will result in a tax of more than $430,000 if the decedent resides in New York or New Jersey. And because there is no federal tax, the state tax is not deductible. There may be some advantages to paying this tax up front, especially for larger estates, but it can be a nasty surprise for a couple who thought they were planning for a tax-free estate when the first spouse dies.

Validly contracted same-sex marriages are now recognized for federal estate tax purposes, and transfers between same-sex spouses can be made free of federal estate tax. (It is not a coincidence that the Windsor case, which resulted in the Supreme Court overturning parts of the Defense of Marriage Act, involved the disparate treatment of same-sex spouses for federal estate tax purposes.) However, only some states recognize same-sex marriages, and, thus, a benefit available at the federal level may not be available in calculating state death taxes, resulting in some very large tax bills even for relatively modest estates.

So what can be done to minimize the state estate tax bite? Here are some strategies:

  • Set up a bypass trust in the amount of the state exemption, and qualify all other assets for the marital deduction. This might be coupled with a provision allowing disclaimers into the bypass trust to allow the surviving spouse a “second look” at the planning after the first spouse dies. If you wish to separately set aside an additional bypass trust to hold the balance between the state and federal exemptions, some states will allow you to qualify that trust for the marital deduction even if it is not so qualified for federal purposes. This permits the deferral of the state tax until the death of the survivor.
  • Change your domicile to a state without an estate tax (one reason so many in the Northeast move to Florida). This can be a major undertaking, however (and the worthy subject of a future article). It requires careful planning and discussion with your tax and legal advisors.
  • Make lifetime gifts, in trust or otherwise, to reduce the value of your taxable estate, if possible, to the amount of the state estate tax exemption. Currently, only one state, Connecticut, has a gift tax, although New York will tax gifts made within three years of death.
  • Purchase a life insurance policy that “replaces” the wealth lost to estate taxes, and put it in a life insurance trust so that the policy is not itself subject to estate tax.
  • Consider putting any real and tangible personal property located outside the state of your domicile, but in a state with an estate tax, in an entity such as a limited liability company, which in many states will convert the property to intangible personal property that has a situs in your tax-free state of domicile.
  • Seek expert advice.

These are but a few options, and the most important of them is the last: seek good advice from qualified estate planners to help minimize your exposure to state estate taxes.


 

[1] Connecticut, Delaware, Hawaii, Illinois, Iowa, Kentucky, Maine, Maryland, Massachusetts, Minnesota, Nebraska, New Jersey,  New York, Oregon, Pennsylvania, Rhode Island, Tennessee, Vermont and Washington.

[2] A typical plan would create a bypass or credit shelter trust to make use of the first-to-die’s exemption amount with the balance of the estate eligible for the marital deduction and passing tax-free to the survivor.

 

Carolyn R. Caufield and Christina M. Mason are Partners in Kelley Drye’s Private Clients practice and Co-chairs of the Nonprofit Organizations practice, both resident in the firm’s New York office. Ms. Caufield is also Co-chair of the Private Clients practice group and focuses her practice on trusts and estates, closely held businesses, valuation issues for estate and gift tax matters, fiduciary income tax and disputed matters involving fiduciaries. She represents numerous private individuals of substantial means in connection with estate and tax planning matters, including advice regarding lifetime giving and gift structuring, charitable giving, planning for disability and/or incompetence, and planning using trusts, especially as part of multigenerational estate planning. Ms. Caufield represents and advises owners of closely held businesses on estate and financial planning, including advice regarding valuation issues. She also has represented numerous individual and corporate fiduciaries in contested probate and judicial accounting proceedings; federal and New York estate tax and gift tax valuation proceedings; and proceedings involving federal and New York income taxation of estates, trusts and beneficiaries.

Ms. Mason focuses her practice on trusts and estates, tax, estate planning, and private foundations and other charitable organizations, as well as residential real estate transactions. She provides the full range of estate and tax planning services for an entrepreneurial and international clientele, advising on matters such as the valuation of businesses and other assets; disposition of retirement benefits and insurance policies; charitable giving; lifetime gifts; and family limited partnerships, GRATs, and will and trust provisions to maximize applicable tax credits and exemptions. She administers trusts and estates, including income tax planning for distributions; valuation of assets; sales of real estate, jewelry and works of art; and preparation of estate, gift and income tax returns. She represents individuals and fiduciaries in estate and gift tax audits before the Internal Revenue Service. Ms. Mason advises foundations and other charities on a full complement of issues, including with respect to governance, investments, and corporate and tax law.

 
Please email the authors at ccaufield@kelleydrye.com or cmason@kelleydrye.com with questions about this article.