Sample Academy FYI

FROM STEVE LEIMBERG ESTATE PLANNING E-NEWSLETTER

State death tax decoupling legislation introduces new uncertainty to the estate planning process. In some states, state death tax is imposed on estates that are too small to be subject to federal tax. In those states, planners for married couples face a difficult choice. Maximizing the available federal estate tax exemptions may incur state estate tax on the first spouse’s death. Disclaimers and QTIP trusts can be used to build flexibility into the planning process.

FACTS:

EGTRRA’s phaseout of the state death tax credit has triggered a rash of estate tax “decoupling” laws from state legislatures. According to the Center on Budget and Policy Priorities, eleven states have enacted decoupling legislation. The laws of another five states are effectively decoupled, because they tie the amount of the state “pickup” or “sponge” tax to pre-EGTRRA law, and did so even before EGTRRA was passed.

Although no two decoupling laws are alike, a few patterns have emerged.

Decoupled from Phaseout of the Credit Only. Some states, such as Maryland, ignore EGTRRA’s phaseout of the state death tax credit. But the exemption still follows federal law. Thus, states that are exempt from federal estate tax (e.g. estates of under $ 1 million in 2002) are also free from state tax.

Decoupled from Credit Phaseout and from Exemption. A few states not only ignore the phaseout of the credit, but also freeze the amount of the exemption for state purposes at $675,000, the level that was in effect in 2001. New Jersey is an example.

Exemption Follows TRA 1997. Other states allow, for state death tax purposes, the estate tax exemption that would have been allowed under the Taxpayer Relief Act of 1997: $700,000 in 2002 and 2003, $850,000 in 2004, $950,000 in 2005, and $1 million in 2006 and beyond. Massachusetts appears to follow this pattern.

Full conformity with federal law. In states that have not decoupled, the state tax equals the allowable federal credit, which will diminish and eventually disappear in 2005. In Florida, Nevada and Alabama, this result is compelled by state constitution. THE SAME IS TRUE IN CALIFORNIA.

COMMENTS:

In states that have decoupled the exemption as well as the credit, the threshold for imposition of state death taxes is lower than for federal estate tax. Planners in those states face unprecedented challenges. A very common planning strategy for married couples, the use of a credit shelter (bypass) trust, comes unraveled under the new laws. Existing formulas in many estate plans will result in the imposition of an unexpected state estate tax on the first spouse’s death.

For example, assume that the will or revocable trust of a New Jersey resident contains a formula placing the full amount of the federal estate tax exemption into a credit shelter trust. On the first spouse’s death in 2002, $1 million will pass into the trust. Under New Jersey’s decoupling legislation, the estate will be required to pay New Jersey estate tax of $33,200. To avoid that tax in future cases, a planner may draft wills and revocable trusts so that only $675,000 passes to the bypass trust. However, that strategy is likely to increase the amount of federal estate tax due on the second spouse’s death. In other words, limiting the funding to $675,000 results in wastage of the balance of the available federal exemption.

Whether to fully fund the credit shelter trust with a goal of minimizing federal estate tax, or to limit the size of the trust to the amount that avoids state death tax on the first death is, in states with decoupling legislation, the newest dilemma facing drafters of wills and trusts. It is a question that has no easily discernible, “correct” answer. Whether the overall tax burden will be less when the trust is fully funded with the federal exemption or when funding is limited to the lower state death tax exemption depends on factors such as the rate of growth (or shrinkage) of asset values, the longevity of the surviving spouse, and the future of the federal estate tax.

In the face of this uncertainty, planners are using strategies that preserve flexibility and allow the level of funding to be determined at the first spouse’s death, rather than be fixed when the plan is drafted.

USING A DISCLAIMER TO PRESERVE FLEXIBILITY

As the estate tax exemption has risen in recent years, planners of many small and mid-sized estates have avoided the use of a formula altogether. In lieu of a formula, the will or trust provides that the credit shelter trust is funded by means of a disclaimer by the surviving spouse. This leaves to the survivor the determination of how much will pass to the trust (or whether the trust will be funded at all).

DAP 4.1 CONTAINS A DISCLAIMER TRUST FORT HIS TYPE OF PLANNING.

Another approach is to draft a formula that places the amount of the state death tax exemption (for example, $675,000) into the bypass trust and leaves the balance of the estate to the surviving spouse outright. Any assets disclaimed by the surviving spouse pass to the credit shelter trust, or to a separate trust that has terms similar to that trust. Based on the facts known at the first spouse’s death, the survivor can decide whether to opt for limited funding of the trust or to fund it with the full amount of the federal estate tax exemption then in effect. As discussed a bove, a decision to limit the amount passing to the credit shelter trust limits the potential federal estate tax savings achieved by the trust, and thus may increase the total (federal and state) estate tax burden imposed on both estates.

USING A QTIP TRUST

Other approaches use the QTIP trust concept to ensure flexibility. For example, the credit shelter trust can be drafted so that it potentially qualifies as a QTIP trust. If the full amount of the federal exemption passes to the credit shelter trust, the executor can elect to qualify part of the trust for the marital deduction in order to avoid state estate tax on the first death.

Alternatively, the plan can provide for the creation of a separate QTIP trust to hold the difference between the federal exemption and the state exemption. This, too, places in the executor’s hands the decision whether to avoid state tax by qualifying the difference between the federal exemption and the state exemption for the marital deduction.

As with the disclaimer-based plan, there is a tradeoff between state death tax savings and potentially higher federal estate tax. The “cost” of the QTIP election in the first spouse’s estate is inclusion of the elected assets in the survivor’s estate under Code section 2044. The executor who avoids state death tax by qualifying all assets above the state death tax exemption for the marital deduction increases the potential federal estate tax on the second spouse’s estate.

THESE ARE ALL BASICALLY VARIATIONS OF THE CLAYTON TRUST OPTIONS UNDER DAP 4.1

Some states permit the QTIP election to be made for state estate tax purposes, even if a federal QTIP election is not made. In those states, a “state only” QTIP election can avoid the imposition of state death tax on the first estate without causing inclusion of the assets in the second spouse’s estate for federal estate tax purposes. In other states, however, a “state only” QTIP is not permitted. The election that is made for federal purposes is effective for state death tax purposes as well. New Jersey officials have tentatively advised that a “state only” QTIP election will not be permitted under New Jersey’s decoupling legislation.

DAP 4.1 PROVIDES FOR A SIMILAR OPTION UNDER THE STATE QTIP FAMILY TRUST LANGUAGE AT THE END OF ARTICLE EIGHT (OF THE MJ RLT)

REV. PROC. 2001-38

Rev. Proc. 2001-38 pronounced that certain QTIP elections will be disregarded for estate tax purposes. Specifically, the Rev. Proc. states that QTIP elections that are not necessary to eliminate federal estate tax on the first spouse’s death will be ignored in determining the amount included in the surviving spouse’s estate under Code section 2044.

Example: Husband’s gross estate is worth $1.5 million. Husband’s will leaves $1 million to Wife and the balance of his estate to a QTIP trust. Husband’s executor makes a QTIP election for the trust. That election is ill-advised. It is not needed to eliminate tax in Husband’s estate, since the balance of the estate qualifies for the marital deduction. Yet it will cause inclusion of the QTIP trust in Wife’s estate on her subsequent death, potentially increasing the estate tax on her estate. In effect, by making the election the executor has wasted Husband’s estate tax exemption. Rev. Proc. 2001-38 says that on Wife’s subsequent death, IRS will disregard the ill-advised election and will not insist on inclusion of the QTIP trust assets in Wife’s estate.

At first blush, it may appear that Rev. Proc. 2001-38 gives planners and their clients an opportunity to obtain the benefit of a marital deduction in the first spouse’s estate without the accompanying tax burden in the surviving spouse’s estate.

Example: Husband’s will contains a formula bequest of $675,000 to a credit shelter trust. The will provides that the difference between the federal estate tax exemption and the lower state death tax exemption passes to a QTIP trust. The residuary estate passes to the surviving spouse. Husband, a New Jersey resident, dies in 2002. After Husband’s death, the QTIP trust is funded with the difference between the New Jersey exemption ($675,000) and the $1 million federal exemption. In order to avoid state death tax, the executor of Husband’s estate elects to qualify the QTIP trust for the marital deduction. Wife dies in 2004. Her executor does not include the QTIP trust in her gross estate. Instead, the executor claims relief under Rev. Proc. 2001-38, pointing out that the QTIP election in Husband’s estate was not necessary to reduce Husband’s federal estate tax to zero.

By using Rev. Proc. 2001-38, is the family able to “have its cake and eat it too.”? Does the Rev. Proc. mean that the QTIP election can be used to avoid state death tax on the first death, while the QTIP trust is still excluded from the surviving spouse’s estate? Probably not. When a taxpayer obtains relief under the Rev. Proc., the QTIP election is disregarded for all purposes, including for purposes of the marital deduction in the first spouse’s estate. Reversing the marital deduction may not incur any federal estate tax in the first estate. But without that deduction, state estate tax would have been imposed. State tax authorities, upon learning of an application for relief under the Rev. Proc., will likely assert a claim for tax in the first spouse’s estate, along with interest and any other additions to tax.

INTERESTING IDEA, BUT THE STATE AND FEDERAL GOVERNMENTS WOULD NOT ALLOW THIS 2001 REV. PROC. TO BOTH MAXIMIZE FEDERAL ESTATE TAX SAVINGS AND AVOID A STATE DEATH TAX AT BOTH FIRST AND SECOND DEATH.

IN ADDITION TO THE ABOVE, STEVE AND I HAVE RECENTLY ADDED LANGUAGE TO THE MJ AND MS TRUSTS THAT ALLOW THE SPECIAL CO-TRUSTEE TO DISREGARD THE STATED FUNDING FORMULA IN ORDER TO OVER- OR UNDER-FUND THE FAMILY TRUST AT FIRST DEATH TO ACHIEVE THE GREATEST OVER TAX SAVINGS FROM BOTH FEDERAL AND STATE DEATH TAXES. THIS WILL OFTEN TIMES MEAN PAYING A SMALL STATE DEATH TAX AT FIRST DEATH IN ORDER TO ACHIEVE THE GREATEST OVERALL ESTATE TAX SAVINGS.

WHAT IS THAT OLD CHINESE PROVERB ABOUT LIVING IN INTERESTING TIMES?