States Continue to React to the Economic Growth & Tax Relief Reconciliation Act of 2001

In June 2001, President Bush signed the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) into law. This legislation began a phase-out of the federal estate tax in 2002 with a one-year repeal in 2010. As a result, many states will lose some or all of their estate tax revenues because EGTRRA reduces (in 2003 and 2004) and then effectively repeals most state "sponge" or "pickup" taxes after 2004.

Having relied on estate and inheritance taxes for a portion of their revenues, states have begun to respond to this change in the federal law. These responses require a careful review of tax plans created for married couples.

If a person is married and has an estate plan that includes estate tax planning, it probably includes a Bypass Trust, sometimes called a Credit Shelter or Family Trust. The purpose of the trust is to allow an estate to take full advantage of the estate tax exemption allowed each taxpayer at death. Typically, the trust was written so that an amount equal to the current federal estate and gift tax exemption unused for lifetime gifts automatically went into the trust when the first spouse died. This allowed the exemption amount to pass estate tax free to beneficiaries, usually the children, on the second death. The language is included in a will or in a separate trust document.

For example, Sam and Sue have a $2 million estate. This is a second marriage for Sam and all of the assets are in Sam’s name. If Sam dies first during 2003, up to $1 million will be placed in a Credit Shelter Trust for his heirs (including Sue) and will utilize his $1 million federal exemption. The balance of the funds will be placed in a Marital Trust and will be exempt from taxation because the executor or trustee will be able to take advantage of the unlimited marital deduction. The Marital Trust also may include a QTIP (Qualified Terminable Interest Property) provision providing for minimum income distributions to Sue during her life. When Sue dies with $1 million in her Marital Trust, it will also pass free of estate taxes.

For many years, a majority of the states adopted estate tax legislation that claimed the federal credit allowed against federal estate taxes. This was called the "sponge tax" or "pickup tax" as states essentially were taking the part of the federal estate tax at the state level that would have otherwise gone to the federal government.

Now that the federal government has changed the rules, many states are not inclined to give up the ability to tax estates.

As a result, they have "decoupled" their state estate tax system from the federal regime. In other words, they are taxing more than the federal government was rebating to them, which previously was the case in only several states.

For taxpayers, this now requires a careful look at trust language so that full advantage can be taken of the state and federal law in order to avoid the maximum amount of estate taxes.

For instance, in Massachusetts, a state that has chosen to decouple, the grantor of a trust with $2 million may elect to split it into three parts at death: $700,000 (the state exemption for 2003) in a State Credit Shelter Trust; $300,000 (the balance of the federal exemption) in a Federal Credit Shelter Trust; and $1 million in the Marital Trust.

In this instance, only $300,000 in the Federal Credit Shelter Trust will be subject to Massachusetts’ estate tax on the first death and $300,000 in the Marital Trust will be subject to that tax on the second death (assuming both deaths occur in 2003).

Another option for the same Massachusetts client would be to fund the Credit Shelter Trust at the federal exemption ($1 million in 2003) and pay about $35,000 in state estate taxes on the first death, but have future appreciation of assets protected from any state or federal estate taxes. This may be an effective planning technique if the surviving spouse is much younger than the decedent or if a significant amount of appreciation is expected (for instance with stocks that are expected to increase in equity value).

In smaller estates, it may make sense to fund the Credit Shelter Trust at the state exemption level only. Let’s assume this same Massachusetts client has had losses in the stock market and has an estate of only $1,400,000. If he funds the Credit Shelter Trust with $700,000 and the Marital Trust also with $700,000, there will be no state or federal estate tax on the first death. If, on the second death, the assets have appreciated to $1 million in each trust, there may be no state or federal estate tax because Massachusetts is increasing its exemption to $1 million and the federal government is increasing its exemption to $3.5 million.

The following jurisdictions have kept the sponge tax at this writing: Alaska, California, Colorado, Connecticut, Delaware, Georgia, Hawaii, Idaho, Indiana, Kentucky, Louisiana, Michigan, Mississippi, Missouri, Montana, New Hampshire, New Mexico, North Dakota, Puerto Rico, South Carolina, South Dakota, Texas, Utah, Virgin Islands, West Virginia and Wyoming.

A number of jurisdictions are in full conformity with the federal tax law, in some cases by state constitutional mandates. These include: Alabama, Florida and Nevada.

Other states have decoupled and have varying forms of estate tax thresholds. For instance, the District of Columbia, Rhode Island and Washington have set their exemption at $675,000.

Additional states have decoupled, including: Arizona, Arkansas, Illinois, Iowa, Kansas, Maine, Minnesota, Nebraska, New Jersey, New York, North Carolina, Ohio, Oregon, Pennsylvania, Vermont and Wisconsin.

Maryland ignores the phase-out of the state death tax credit, but otherwise follows federal exemption levels.

Until recently, Illinois charged the amount of estate tax that the federal law gave as a credit to the state of the decedent’s residence, the so-called "pick-up tax." As a result there was no additional charge to the estate, merely a division between the two governments. However, since the 2001 Tax Act reduced the share of the states, Illinois has decided to join the states that have "decoupled" their tax and imposed an estate tax of their own. The new law in Illinois is effective for persons dying on or after January 1, 2003. This means that in cases where there will be a federal tax, there now will be an additional Illinois tax.

In Oklahoma, no decoupling is necessary because a separate estate tax avoids the revenue loss from the federal government. Virginia has passed its own estate tax phase-out legislation.

It is important to review the language in Bypass or Credit Shelter Trust plans because many documents do not have state-specific language. Often, the language will include a provision to allow funding with an amount equal to the current federal estate tax exemption. Sometimes the language will require funding the trust to a level that will reduce state and federal taxes to the maximum level, which could be confusing, or conflicting language in decoupled states.

Also confusing is the fact that the federal government has passed estate tax reform in two different versions with some states utilizing tax schedules based on the first reform not the second. For instance, Massachusetts will phase up its state credit at the former federal exemption rates for a maximum amount of $1 million while the federal rate will go up to a maximum amount of $3.5 million. Illinois will use the current federal exemption only until 2009.

Under IRC §2010 as it existed before the current law under EGTRRA, the applicable exclusion amount was scheduled to increase according to this schedule:

2002 - $700,000
2004 - $850,000
2005 - $950,000
2006 - $1,000,000

At present, IRC §2010 as amended by EGTRRA, the applicable exclusion amount will increase according to this schedule:

2002 - $1,000,000
2004 - $1,500,000
2006 - $2,000,000
2009 - $3,500,000

Surviving spouses face obstacles with the scheduled increases in the estate tax exemption that began in 2002. Currently $1 million, the exempt amount will rise to $1.5 million in 2004, $2 million in 2006, and $3.5 million in 2009. While good news for some, it may drastically reduce, even eliminate, the widow or widower’s share of the deceased spouse’s estate.

Take, for example, Frank and Tillie Scott. They own their home jointly and Frank has stock, bonds and cash of $1.5 million. He has a typical living trust that at his death leaves "the largest amount not subject to the federal estate tax," or words to that effect, to a "Family Trust" for Tillie and their children and the balance of his assets to Tillie.

Result: If Frank dies during 2003, Tillie would get only $500,000 of his $1.5 million cash and securities. If he dies after 2003, Tillie may get none of it.

Obviously, as the exemption increases or Frank’s estate falls in value, Tillie’s share shrinks or disappears. And if the estate tax is repealed, Tillie could be completely disinherited unless Frank changes his plan. A similar problem may exist if Frank creates a trust for his children and grandchildren based on his available, generation-skipping transfer tax exemption.

For many, the estate tax trap is not a problem. The survivor may be the primary beneficiary of the Family Trust with the right to the income and principal for health and support. He or she may also have extensive control of that trust by being the trustee. The survivor may have adequate assets of his or her own or that will pass directly from the other spouse, such as IRAs, life insurance or jointly held property. However, inevitably some new widows and widowers will have an unhappy surprise: their late spouse’s estate bypasses them due to changes in the tax law.

There are several ways to protect the surviving spouse. One is to guarantee the survivor a certain amount or percent of the other spouse’s estate. Another is to transfer some assets now to the spouse with the smaller estate. Still another is to leave everything to the survivor in which case he or she can "disclaim" whatever amount makes sense at the death of the first to die. However, documents may need to be modified and assets re-titled while both spouses are living to make these alternatives available.

While leaving too much to the Family Trust may shortchange the survivor, owning too much of the couple’s assets may result in unnecessary tax at the survivor’s death. Suppose, for example, that both Tillie and Frank die in 2003 and Tillie dies first. Frank’s estate is $1.5 million and, without a marital deduction, will pay about $225,000 in estate tax. But if Tillie owns $500,000 of the $1.5 million and leaves it in trust for Frank instead of outright to him, neither estate will owe any tax.

One option to avoid the new dichotomy in the tax system is for clients to become more aggressive about changing residency; and for many this means changing residency to states such as Florida, which has no state income tax or estate tax.

Filing a Florida Declaration of Domicile is the first step. Be prepared to take additional steps if you have not already done so to show that Florida is your primary home. This should include: paying Florida tangible and intangible property taxes; filing for a Florida homestead exemption; obtaining a Florida operator’s license and relinquishing old licenses; acquiring Florida license plates and relinquishing old license plates; and registering to vote in Florida and then actually voting there.

There are also less obvious steps that should be considered, such as filing non-resident income tax returns in your former state; filing with the IRS Center for Florida in Atlanta, Georgia; transferring safe deposit box contents to Florida; opening a Florida bank account; changing credit cards to a Florida address; signing a new Florida Will; referring to a Florida residence in all trusts and other legal documents; and affiliating with Florida organizations and considering disaffiliation with ones in the former state of residency.

Also consider having family gatherings and social activities in Florida rather than in your former state of residence; affiliating with a church or temple in Florida; changing the address on your passports; and investing in Florida. See: Fla. Stat. § 322.03(1). Fla. Stat. § 322.04(1)(c), Fla. Stat. § 322.031(1); Fla. Stat. §§ 320.37, 320.38.; and Fla.Stat. §§ 320.37, 320.38.

There are additional planning considerations besides relocating. For instance, in some states, such as Rhode Island, there is no gift tax and the federal government allows gifts each year of $11,000 per person without a gift tax. Also, the federal gift tax exemption is now $1 million and is no longer part of a unified credit estate tax system that began in 1986 and ended last year. Therefore, a person with a $1 million estate in Rhode Island in 2002 would have no estate tax, but would have a Rhode Island tax of $33,200 if he or she died this year. If that person gives $325,000 over time, however, there would be no federal gift tax if the gifts were limited to $11,000. If done in one year, a federal gift tax return would have to be filed, but there would still be no gift tax because of the $1 million gift tax exclusion.