Bridging the Gap
The widening gulf between federal and state estate tax exemptions demands new planning strategies.
In 2012, the federal estate and gift tax exemption increases to $5,120,000, the highest it has ever been. In and of itself, the increased exemption is good news for taxpayers with substantial estates. However, for those who live (or own property) in states that impose their own estate tax (see chart below) — the increased federal exemption may create problems. The issue is the gap between federal and state exemptions, because the amounts that states exempt from taxation tend to be much lower (generally $1 million but even lower in some cases) than the federal exemption. For instance, if you live in New York and your federal estate tax liability is eliminated by the $5,120,000 exemption, that could still leave $4,120,000 of your estate subject to state estate tax, because New York recognizes only a $1 million exemption. The same would be true for other states like Massachusetts and Maryland. “The bottom line is that traditional estate planning methods may need to be reconsidered to make sure they are still appropriate,” says Mitchell A. Drossman, national director of Wealth Planning Strategies at U.S. Trust.
How the Gap Happened
After 2001, federal exemption amounts began to increase — first from $675,000 to $1 million, and then to $1.5 million (2004), $2 million (2006), $3.5 million (2009), $5 million (2010) and finally to $5,120,000 in 2012. As a result of these changes, as well as a phaseout of the federal credit for state estate tax, the estate tax in many states was reduced or eliminated. Some states, however, continue to impose estate tax, and in many of these states, the estate tax exemption is significantly lower than the federal exemption. That has created a “gap” of wealth exempt from federal estate tax but potentially exposed to state estate tax.
Applicable to 2012 deaths (as of February 15, 2012) Click to expand
One important wrinkle here is that the gap may be short-lived. The federal estate tax exemption is scheduled to revert to $1 million beginning in 2013, and that could bring it back in line with exemptions in many states. “But scheduled sunsets are no certainty if recent history is any guide, and particularly since it’s an election year,” says Drossman. “It’s something to keep an eye on, and if and when changes occur, we’ll adapt our approach. For this year at least, and perhaps longer, the federal estate tax exemption stands at $5,120,000, so we’re planning accordingly.”
Gap Planning Strategies
For those who reside in states that impose an estate tax, Drossman believes it makes sense to divide the federal exemption into two parts — the “exempt share” (the portion that is exempt from both federal and state tax) and the “gap share” (the amount that’s subject to state tax). In New York, for example, the exempt share is $1 million and the gap share is $4,120,000.
Planning for the exempt share typically involves directing it to a trust — known as a bypass trust — that would avoid federal and state tax in both spouses’ estates. “The full amount in this bypass trust would eventually pass to the spouses’ beneficiaries free of both federal and state taxes,” Drossman explains.
In planning for the gap share, the goal is generally to subject it to the least possible estate tax in both spouses’ estates. That might involve the use of a bypass trust, an outright disposition to the spouse, a disposition in trust for the spouse or a lifetime gift.
The amounts that states exempt from taxation tend to be much lower than the federal exemption
“Placing the gap share into a traditional bypass trust would avoid federal tax in both spouses’ estates,” says Drossman. In the first spouse’s estate, the full amount would be shielded from tax by the federal exemption, and it wouldn’t be included in the second spouse’s estate because it would be owned by the bypass trust and not by the spouse.
“For state estate tax purposes, however, such a disposition would be subject to tax in the first spouse’s estate because it exceeds the state exemption,” he says. In New York, for example, the $4,120,000 gap share ($5,120,000 federal exemption minus the $1 million New York exemption) would be subject to estate tax of $405,200, or approximately 10% of the gap share. While in some cases that may be the best choice, alternative dispositions of the gap share could sometimes produce better results.
Outright to Spouse or Federal QTIP Trust
“Alternatively, the gap share can be left outright to the surviving spouse or in a qualified terminable interest property trust, commonly known as a QTIP trust,” says Steven Lavner, a member of the National Wealth Planning Strategies Group of U.S. Trust. QTIP trusts provide income for the surviving spouse and also control the disposition of the property after that spouse’s death. Both an outright disposition and a QTIP trust would generally qualify for the marital deduction — which normally lets spouses inherit an unlimited amount from each other without federal or state estate tax liability — and would defer any estate tax on the gap share until the death of the surviving spouse, Lavner explains. However, such dispositions would then be subject to federal and state tax in the second estate. “Assuming a federal rate of 35% and an additional state rate of 16% (which is deductible for federal purposes), this is significantly greater than the tax on the bypass trust alternative,” says Lavner.
Traditional estate planning methods may need to be reconsidered to make sure that they are still appropriate
In analyzing the outright or QTIP trust alternative, there is one further complication. For 2011 and 2012, the federal estate tax law allows for what is known as “portability,” which lets any unused federal estate exemption of the first spouse to die to be transferred to the surviving spouse. (Unless a new law extends portability, it will end after 2012.) If the gap share is left outright or in a QTIP trust for the surviving spouse, and portability is elected, that would significantly reduce the federal estate tax in the second estate. However, even with portability, any income and appreciation on the gap share would still be subject to federal estate tax in the second estate, and portability wouldn’t affect the state tax in the second estate. “While portability certainly reduces the tax due in the case of an outright disposition or QTIP trust, those alternatives may still not be as tax-efficient as a disposition to a bypass trust,” Lavner explains.
State QTIP Trust
“In some states, it is permissible to make a QTIP election for state estate tax purposes only,” says Drossman. “In these cases, a disposition of the gap share to a state QTIP trust would avoid federal and state tax in the first spouse’s estate. There would be no federal tax because of the federal exemption, and there would be no state tax because of the marital deduction. In the second estate, there would be no federal tax on the gap share or any appreciation, because there was no federal QTIP election, but any income paid to the surviving spouse would be subject to estate tax. And because there was a state QTIP election, such a disposition would be subject to state tax in the second estate.” However, Drossman notes, state tax in the second estate might be avoided if the surviving spouse moved to a state that didn’t impose estate taxes.
The Lifetime Gift
All of these alternatives involve a “testamentary” disposition of the gap share — that is, gap share assets are transferred at the time of the first spouse’s death, often according to the terms of a will. “None of them avoids federal and state estate tax in both spouses’ estates,” says Lavner. “But in some cases, a lifetime gift of the gap share might achieve that goal.”
Like the testamentary bypass trust alternative, a gift made during a donor’s lifetime would avoid federal tax in both estates. Unlike the testamentary alternative, however, a lifetime gift of the gap share may also avoid almost all state tax in both estates, assuming there is no state gift tax (most states that impose estate taxes do not impose a gift tax). “Although this alternative could yield a much better tax result, it would require making an earlier, lifetime gift to a beneficiary,” he says, “and that might not be right for everyone.”
No One-Size Solution
“Each gap planning strategy has advantages and disadvantages, and each involves making certain tradeoffs,” Drossman concludes. “These strategies can often be quite complex, so if you’re considering putting together an estate plan, or you already have one that hasn’t been reviewed recently, I recommend getting together with your advisor and looking at all of the alternatives, from both tax and practical standpoints, and in the context of your own specific situation — and then choosing the best approach for you.”
Any information presented about tax considerations affecting client financial transactions or arrangements is not intended as tax advice and should not be relied upon for the purpose of avoiding any tax penalties. Neither U.S. Trust, Merrill Lynch, and its representatives nor its financial advisors provide tax, accounting or legal advice. Clients should review any planned financial transactions or arrangements that may have tax, accounting or legal implications with their personal professional advisors.
Always consult with your independent attorney, tax advisor, investment manager, and insurance agent for final recommendations and before changing or implementing any financial, tax, or estate planning strategy.