Don't Underestimate State Estate TaxesMarch 2015
Today’s federal estate tax exemption is generous by historical standards. However, families residing in any of the 19 states, and the District of Columbia that levy state estate or inheritance tax should not be complacent. Fiduciary Trust’s Elisa Shevlin Rizzo examines the potential impact of state estate taxes on an inheritance.
Q. What is the difference between federal and state estate and gift taxes?
Elisa: While there has been a lot of discussion about federal estate taxes over the past 10 years, state estate taxes have often fallen under the radar. At the federal level, each of us may transfer—either during lifetime or at death—up to $5.45 million in 2016 (adjusted annually for inflation) free from federal gift and/or estate tax. Any amount over the federal exemption is taxed at a maximum 40% federal estate tax rate.
Many states impose separate state estate, gift and/or inheritance taxes on assets transferred during lifetime or at death. Until 2005, most states simply received a share of the federal estate tax in the form of an estate tax credit (also called a “pick-up tax”), so no additional burden was felt by most families. However, under the 2001 tax act, the state estate tax credit was slowly phased out and was replaced with a less valuable estate tax deduction. As a result, many states lost an important revenue source. In response, a number of states “decoupled” from the federal system and enacted their own separate transfer tax systems. Today, 19 states including New York, New Jersey, Connecticut, Maine and Rhode Island, plus the District of Columbia levy state estate or inheritance taxes and the rates can be as high as 20%.
Q. What impact can state estate taxes have on an inheritance?
Elisa: State estate taxes can have a meaningful impact on an inheritance, particularly when the family expects that no tax will be due at the death of the first spouse. While the federal exemption is quite high, states will often tax much smaller estates. For example, New Jersey only exempts the first $675,000 from state estate and inheritance tax. Other state estate tax exemptions range from $1.5 million in Rhode Island to $4 million in Illinois.
To put this into dollar terms, consider that a New Yorker who dies in 2016 with a $5.45 million estate will owe no federal estate tax, but will owe $444,800 in New York state estate tax. Residents of Maryland, Massachusetts, Minnesota and Washington, D.C. face similar costs.
Q. Can families living in states without estate tax be affected?
Elisa: Absolutely. Residents of states that do not impose a state estate tax should not be complacent. First, if an individual owns property in a state with an estate tax, such as a vacation home, the family may be subject to a non-resident estate tax.
Second, tax laws can and do change. Within the last few years, some states including Illinois, Delaware and Hawaii have re-enacted or made permanent their separate state estate tax laws. Other states have modified their existing laws, either by increasing (Rhode Island) or reducing (Connecticut) the amount that can pass free from state estate taxes. Rates may also change—for example, Washington recently raised the top four estate tax rates by 1%, bringing the highest marginal rate to 20% on taxable estates in excess of $9 million.
Q. Since state and federal estate tax exemption levels differ, how can families best make use of both exemptions?
Elisa: For many families, maximizing the use of the federal exemption through the use of a credit shelter trust (CST) funded with the then-available federal exemption amount remains a priority, even if such a plan would require that a state estate tax be paid at the death of the first spouse.
Others may wish to avoid or minimize state estate taxes at the first spouse’s death. In that case, there are several planning options which may involve the use of qualified disclaimers, limiting the CST to the state estate exemption, planning for the “gap” amount between the state and federal estate tax exemptions with the use of marital trusts and/or maximizing the use of any state Qualified Terminable Interest Property (QTIP) elections. We recommend that our clients speak with their Fiduciary Trust representative or estate planning attorney to determine the most appropriate strategy for their particular situation.
Q. Can married couples combine their individual exemption amounts?
Elisa: Yes and no. Federal law allows for “portability” of federal estate and gift tax exemptions between spouses. In simple terms, if an individual dies without having used his or her full federal estate tax exemption, the unused exemption can be used at a later date by his or her surviving spouse, provided certain elections are made on the decedent’s estate tax return.
That said, portability does not apply to state estate, gift or inheritance taxes, nor does it apply to the federal generation-skipping transfer (GST) tax exemption. While portability may simplify estate planning at the federal level, it may result in a substantially higher state estate tax bill at the first spouse’s death plus additional taxes on distributions to grandchildren at a later date if one’s GST tax exemption is not preserved.
Q. Can lifetime gifts help to reduce state estate taxes?
Elisa: Yes, lifetime gifting is a great option for individuals seeking to reduce their overall estate tax bill. Since Connecticut is the only state that imposes a state gift tax, most people can reduce their state estate tax bill by making lifetime gifts. In most cases, assets transferred during life will not incur a state level gift tax and will not be subject to state estate tax at the donor’s death. Of course, we recommend that our clients consult with their attorney or other advisors before making substantial lifetime gifts.
This communication is intended solely to provide general information. The information and opinions stated are as of November 2015, and may change without notice. The information and opinions do not represent a complete analysis of every material fact. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods. IRS Circular 230 Notice: Pursuant to relevant U.S. Treasury regulations, we inform you that any tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein
FIDUCIARY TRUST FORUM
Elisa Shevlin Rizzo
Managing Director and Trust Counsel
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