State Estate Taxes: Planning for Uncertainty November 24, 2015 by Kevin Duncan of Fiduciary Trust Company International

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1 State Estate Taxes: Planning for Uncertainty November 24, 2015 by Kevin Duncan of Fiduciary Trust Company International Introduction Prior to 2001 most states imposed an estate tax based upon the Internal Revenue Code Section 2011 Credit for State Death Taxes. The Economic Growth and Tax Relief Reconciliation Act of 2001 ( EGTRRA ) repealed the credit effective for 2005, which effectively repealed any state estate tax that was tied to the credit. The states legislative response to EGTRRA was divided. Many states took no action and allowed their estate tax to become dormant. However, states eager to prevent the repeal of their estate tax, enacted legislation to decouple their estate tax by freezing the state death tax credit in effect prior to the enactment of EGTRRA. Some states went as far as to create stand-alone estate taxes with rates and exemption amounts unrelated to the federal credit for state death taxes. The American Tax Payer Relief Act of 2012 ( ATRA ) made permanent the EGTRRA repeal of the state death tax credit. In the years following the passage of ATRA, we have seen a flurry of legislation from the states fine tuning their estate/inheritance taxes. The trend among the states has been to lower the estate tax burden on its residents by either repealing the estate tax all together or by increasing exemption amounts. This trend is not universal, however, and states like Massachusetts and New Jersey have not increased their estate tax exemptions or lowered rates since initially decoupling. Each passing year has brought new legislation. In 2014, New York, Maryland and Minnesota enacted significant changes to their estate tax. 1 And 2015 has likewise seen three jurisdictions, Maine, New York and Washington D.C. passing legislation amending their estate tax system. Whether this legislative activity will continue into 2016 and beyond remains to be seen. The following article will review the list of legislative developments affecting state estate taxes in 2015 and review planning opportunities that can be utilized to reduce the state estate tax burden regardless of the legislative changes enacted by the states. 2015State Legislative Enactments 1. Washington D.C. On June 24, 2014, the Council of the District of Columbia approved the Fiscal Year 2015 Budget Support Act of 2015 ( 2015 Act ). The bill became effective on February 25, 2015 after the 30-day Congressional review period expired. The 2015 Act sets forth a list of tax reform proposals, enumerated in order of priority, which will be implemented if D.C. meets or exceeds certain revenue goals for fiscal year 2015 and beyond. Included among the proposals are two provisions to raise the D.C. estate tax exemption amount. The first provision would double the estate tax threshold from the current $1 million to $2 million and the second provision would raise the threshold to equal the federal exemption amount. In terms of priority, the provisions are listed 6th and 13th respectively. The proposals would have been effective for individuals dying on or after January 1, 2016, if certain revenue goals were met in the quarterly revenue estimates issued in February However, the revenue estimates were below expectations and the goals were not achieved. Despite the failure to meet revenue expectations in the February estimates, D.C. passed the Fiscal Year 2016 Budget Act ( 2016 Act ) which gave D.C. a second bite at the tax reform apple. Under the 2016 Act, the Tax Reform proposals passed in the 2015 Act would be implemented, in order of priority, if the September 2015 Revenue estimates for FY exceeded the estimates from the February report. On September 30th, 2015, the Office of the Chief Financial Officer issued the September 2015 Revenue estimates, which exceeded the February estimates. The excess revenue was sufficient to implement the first four tax reform proposals from the 2015 Act which included: 1) Reducing the rate on the new individual income tax middle bracket of $40,000 60,000 from 7.0% to 6.75%; 2) Creating a new individual income tax bracket of $350,000 to $1,000,000 at 8.75%; 3) Reducing unincorporated and incorporated business franchise tax from 9.4% to 9.2%; 3 4) Reducing the new individual income tax middle bracket of 40,000 to $60,000 from 6.75% to 6.5% 2 Page 1, 2018 Advisor Perspectives, Inc. All rights reserved.

2 Unfortunately, the revenue was not sufficient to increase the D.C. estate tax exemption. However, the exemption provisions increase in priority to number two and nine, respectively, and may be implemented if there is excess revenue in the February 2016 quarterly revenue estimates. The 2016 Act also includes a provision amending the estate tax rates. The rates were amended by the 2015 Act but omitted a tax rate for amounts in excess of $1 million but less than $2 million. The 2016 Act remedies this omission by imposing a 6.4% rate of tax on amounts above $1 million but not over $1.5 million and a 7.2% rate on amounts over $1.5 million but not more than $2 million. The rates are effective for individuals dying on or after January 1, 2016 and are not dependent upon D.C. achieving budgetary revenue targets. 2. Maine On June 30th, 2015, the Maine House and Senate overrode Governor Paul LePage s veto to enact budget legislation for fiscal years 2016 and The enacted budget bill includes a provision to increase Maine s estate tax exemption amount from the current $2 4 million to an amount equal to the federal exemption amount, effective for individuals dying on or after January 1, New York New York did not make substantive changes to its estate tax in 2015, but did pass several clarifications to the sweeping legislative changes passed in The clarifications included a provision to make the tax tables permanent. The tables were slated to expire for individuals dying after March 31, The legislation also clarified that the New York Taxable Estate would not include gifts of real or tangible property located outside of New York State at the time the gift was made and that taxable gifts made after January 1, 2019 will not be included in a decedent s New York Taxable Estate. The clarifications are effective retroactively to April 1, Planning for State Estate Taxes By de-coupling estate taxes and enacting exemption amounts that differ from the federal exemption, states have made addressing estate planning all the more complicated. Combine these changes with the introduction of federal portability and the increased federal income and capital gain taxes and planners have a myriad of complications to consider when drafting estate plans. Choosing the right estate plan depends on a thorough evaluation of a family s facts and circumstances, as well as weighing current needs versus future expectations. Planners must consider the characteristics of the family s assets, future investment returns, portability, generationskipping transfer taxes, spending habits, changed circumstances and state and federal income taxes. To further compound the difficulty, estate plans are rarely drafted when a client s future circumstances are known. After all an estate plan is designed to take effect at some uncertain point in the future, not the moment it is executed. Thus, the theme for planning for state estate taxes must be flexibility. The following are planning techniques that maintain flexibility in estate plans and allow decisions to be made after death. 1. Gap Trust Planning for Married Couples 5 Before states began to decouple their estate taxes from the federal credit for state death taxes, the basic estate plan for married couples was comparatively simple. At the first spouse s death, two trusts would be created. The first, a credit shelter trust, was funded with the decedent s remaining federal estate tax exemption and the balance of the decedent s property would pass to a second trust designed to qualify for a full marital deduction thereby eliminating estate taxes at the first death. Because the federal exemption and state exemption were effectively unified, the two-trust plan would not generate state estate taxes at the first death. Now, however, there is a gap between the state and federal exemption amounts in the majority of states and rigid funding clauses that direct executors to fund a credit shelter trust up to the federal exemption amount upon the first spouse s death can generate significant state level estate taxes taxes that are altogether avoidable by incorporating Gap trusts into your planning. Gap trust planning is designed to account for the discrepancy between the state and federal exemption amounts and allows executors to elect whether to incur state estate taxes at the first spouse s death by fully funding a credit shelter up to the decedent s federal exemption amount or to avoid state estate taxes by funding a credit shelter trust with the lesser state exemption amount. Gap trust planning requires the creation of three separate trusts: The State Credit Shelter trust is funded up to the state exemption amount. The trust will be sheltered from all federal and state estate taxes and can be drafted to provide income and principal to the surviving spouse and descendants. The Gap trust is funded with an amount in excess of the state exemption amount but below the federal exemption. The Gap trust would be drafted to qualify for a marital deduction if the executor makes a state and/or federal Qualified Terminable Interest Property ( QTIP ) election over the property. Page 2, 2018 Advisor Perspectives, Inc. All rights reserved.

3 Finally the balance of decedent s property would be allocated to the marital trust over which the executor would make both a state and federal QTIP election to qualify the trust for the marital deduction and minimize state and federal taxes upon the first spouse s death. With Gap trust planning the executor has the discretion to avoid state estate taxes by making a state only QTIP election, if available, or 6 a federal QTIP election to qualify the Gap trust for a full marital deduction. If a state QTIP election is available, the executor can make the state election to shield the Gap trust from state taxes but make no corresponding election on the federal return. The election will shield the Gap trust from state estate taxes at the first spouse s death and no federal tax would be owed as the trust is below the decedent s federal exemption amount. The beneficiary would receive support from each of the three trusts without a loss in value due to the payment of state estate taxes. This may be especially important in estates where the surviving spouse will access the trusts as their sole means of support. At the surviving spouse s death the Gap trust would be included in the taxable estate for state, but not federal, purposes. If the value of the surviving spouse s taxable estate, plus the state QTIP property, exceeds the surviving spouse s state exemption amount, a state tax would be owed at the second spouse s death. The state QTIP property and associated appreciation would not, however, be included in the decedent s estate for federal purposes because a federal QTIP election has not been made. In states that do not recognize a separate state QTIP election, the election made on a federal return will apply for purposes of filing the state return. Thus, executors will be tasked with a difficult decision. If a federal return is filed, the executor must decide whether to make the federal QTIP election over the Gap trust. By making the election, the executor will avoid state and federal estate taxes at the first 8 death but will subject the Gap trust and all future appreciation to both state and federal tax at the second spouse s death. By making the QTIP election, the decedent will have unused federal exemption amount which can be transferred to the surviving spouse via federal portability rules. The decedent s unused exemption amount could be used to shelter a portion of the Gap trust at the surviving spouse s death. However, portability is not indexed for inflation and will not increase during the surviving spouse s lifetime. Thus, the appreciation in the Gap trust will not be sheltered by portability which could result in a significant federal estate tax bill depending upon the rate of appreciation and the length of the trust. The executor must therefore give special consideration to the expected growth of the Gap trust before making an election in states that do not recognize separate state QTIP elections. The overall tax burden may outweigh the state estate tax savings realized at the first spouse s death. States that require parity of the state and federal QTIP election may not be as advantageous as jurisdictions allowing state-only QTIP elections but the incorporation of Gap trust planning should not be overlooked in these jurisdictions. Gap trust planning can still yield significant tax benefits for clients of moderate wealth, especially if they reside in a jurisdiction with gradually increasing exemption amounts. This is perhaps best illustrated by New York, which does not allow a separate tax QTIP election unless a federal return is not filed but which the exemption amount is increasing over the next three years. Consider the following examples: Married couple H and W. W is the primary breadwinner with a net worth of $7,000,000, while H has a net worth of $1,000,000. W dies in 2015 and under the terms of the will the executor is required to fund a credit shelter trust up to federal exemption amount of $5,430,000 with the balance of $1,570,000 to pass to a QTIP trust. This arrangement yields no federal taxes, but approximately $442,400 in New York estate taxes, at H s death. H dies in 2018 with a taxable estate of $1,000,000 plus a QTIP trust of $1,570,000. H s taxable estate is below the state and federal exemption amounts, thus no further tax is owed. Total tax paid: $442,400 Same example, except W s will directs the executor to fund the credit shelter trust up to the state exemption amount and provides the executor discretion to make a QTIP election over the balance. At W s death after April 1, 2015, the credit shelter trust is funded with the New York exemption of $3,125,000 and the executor makes a state and federal QTIP election over the balance of $3,875,000 for state and federal purposes. This results in no state or federal tax due at the first death. H subsequently dies in 2018 with a taxable estate of $1,000,000 plus the QTIP trust of $3,875,000 for a New York and federal taxable estate of $4,875,000. By 2018 the New York estate tax exemption is slated to rise to $5,250,000. Since H s taxable estate plus the QTIP trust are below both the state and federal exemption amounts, no estate tax is payable at the surviving spouse s death. Tax Savings: $442, Clayton Trusts 7 Clayton Trusts, named after the case approving their use, are another way to improve flexibility and allow the executor to determine 9 whether to avoid state estate taxes at the first spouse s death. With a Clayton Trust, the will or revocable trust would allocate the decedent s estate entirely to a QTIP trust. The executor would then make a state or federal QTIP election over all or a part of the trust. Any assets over which the executor did not make an election would then pass to a separate credit shelter trust. The executor can then decide to incur state estate tax based upon the state and federal QTIP election made over the QTIP trust. A Clayton-style provision can be incorporated into Gap trust planning as well. Under Gap trust planning the Gap trust is drafted to qualify for the marital deduction by making a QTIP election, which requires that the surviving spouse to be the sole beneficiary and all income must be paid out to the spouse, at least annually. If the executor decides not to make a QTIP election over the Gap trust, having the spouse as sole beneficiary and paying out all income annually may limit the growth potential of the trust. Planners can utilize a Page 3, 2018 Advisor Perspectives, Inc. All rights reserved.

4 Clayton provision to provide that if the executor does not make a state or federal QTIP election over the Gap trust, then the trust should be combined with and administered in accordance with the provision of the credit shelter trust. The credit shelter would typically provide for payments to beneficiaries other than surviving spouse and can allow the trustee to accumulate and reinvest income, thereby increasing the potential appreciation and growth of the credit shelter trust. 3. Disclaimer Planning Disclaimer planning is similar to the Gap Trust, except the decision to incur state estate taxes will be held by the surviving spouse. Under disclaimer planning, the decedent s assets are left either outright or preferably in a QTIP trust for the surviving spouse. The surviving spouse could then make a qualified disclaimer under IRC 2518 of his or her interest in the QTIP trust, which would pass under the terms of the Will or Revocable trust to a credit shelter trust for the benefit of the spouse and his or her descendants. The spouse could choose whether to disclaim the state or federal exemption amount and thus incur or avoid state estate taxes accordingly. This structure provides similar flexibility to the Gap trusts to determine the amount of state estate taxes generated on the first death, if any. 4. Lifetime Gifting Residents of states that impose state estate taxes can engage in lifetime planning to minimize their state estate tax exposure by gifting assets during life. With the exception of Connecticut, no state imposes a separate gift tax on assets transferred during life. Thus, resident taxpayers can make lifetime transfers to beneficiaries in trust, or otherwise. The transfer itself will not be subject to state gift tax, and the assets plus appreciation will not be included in the decedent s taxable estate for state tax purposes. For individuals who are able to utilize the federal exemption to make lifetime transfers, this can be one of the most powerful techniques available to minimize state estate taxes. To maximize the taxable benefits of lifetime gifting consider funding lifetime trusts with substitution powers. This allows taxpayers to substitute high-basis assets for low-basis assets held in the trust prior to death. Assuming the substituted assets are included in the decedent s taxable estate at death, the low-basis assets will receive a full step up in basis thus erasing the built-in gains. It is important to note that while states may not impose a gift tax, gifts made during life may have an effect on whether a state estate tax is required to be filed. Most states combine a decedent s gross estate with their adjusted taxable gifts in determining the decedent s need to file a return. The adjusted taxable gifts made by a decedent may push a decedent over the filing threshold thus subjecting assets in the gross estate to state estate tax, but the gifted assets themselves will not be subject to tax. a. Gifts In Contemplation of Death Some states have taken affirmative steps to minimize the utility of lifetime gifts by imposing a claw-back on gifts made within a certain time period of death. These gifts are included in the decedent s taxable estate and subject to state level estate taxes. Unfortunately, little can be done to avoid the claw-back rules once a gift has been completed other than surviving the claw-back period; but making the gift may nevertheless be advantageous. Claw-back rules include only the value of the initial gift, and not the subsequent appreciation in the decedent s taxable estate. Therefore, any appreciation would escape state estate tax and only the value of the original gift would be taxed. 5. Change of Domicile While changing domicile to a jurisdiction that does not impose a state estate tax may be the simplest solution to propose to clients, its execution may be the most difficult. While a thorough discussion of the change of domicile rules is beyond the scope of this article, a successful change of domicile often requires a clean break from the home state. The client that sells the family home in New York for the warmer winds of Florida leaving behind nothing more than a forwarding address is ideal, but not always encountered. Often clients move into a second home in the new jurisdiction, while maintaining real property in the original state and splitting time between the two. Continued presence inside the original state may cause the original jurisdiction to treat the decedent as a resident. To ensure a successful change in domicile, clients must minimize their contacts with their original state and demonstrate a true intent to be domiciled in their new jurisdiction. 6. Non-Resident Estate Tax Although an individual resides in a jurisdiction that does not impose a state estate tax, he or she may own real property in a state that does. In order to avoid paying state estate taxes on this property, an individual can convert the property to an intangible by placing the property into a limited liability company ( LLC ) or partnership. Intangible assets are typically treated as located in the state in which the decedent was domiciled at death and not the state in which the assets owned by the LLC are physically located. Thus real property can be contributed to an LLC owned by a non-resident in order to avoid state estate tax. a. Beware Look-Through Laws Page 4, 2018 Advisor Perspectives, Inc. All rights reserved.

5 States have taken steps to limit a non-resident s ability to convert real property into intangible ownership in order to avoid state estate taxes. For example, Minnesota passed legislation in 2013 that treats real property held in an LLC or trust owned by a non-resident as located within Minnesota for estate tax purposes. The New York Department of Revenue has similarly issued multiple advisory opinions that requires pass-through entities to have a business purposes in order for the asset to be treated as an intangible. 10 As an alternative to placing the asset inside an LLC, consider selling the asset to an irrevocable trust that is outside the owner s estate. The owner could continue to rent the real estate, at full fair market value rent, and, if the trust is structured as a grantor trust for income tax purposes, there would be no income tax gain on the sale. This revised structure may avoid state look-through rules. Conclusion State estate taxes are still finding their footing and over the coming years we may see additional legislative activity. For every change enacted there are multiple bills introduced that never see the light of day. State legislatures can move with surprising efficiency and enacted legislation can be quickly repealed or changed. Minnesota s recent legislative changes are an excellent example. In 2013 Minnesota enacted a separate gift tax, only to repeal it in The gift tax didn t survive a second legislation season. The fact is, nothing is certain with state death taxes. But building flexibility into estate planning documents and utilizing lifetime gifting strategies to reduce a decedent s gross estate can keep clients above the fray See, Md. Code Ann. Tax-Gen 7-309, 7-304; Minn. Stat , ; N.Y. Tax Law 952, 954. Vol. 62 D.C. Reg. pg. 3601(March 27, 2015) September 2015 Revenue Estimates, Office of the Chief Financial Officer, Government of the District of Columbia; available at, Me. Rev. Stat. Ann. Tit N.Y. Laws 59; New York Department of Taxation and Finance, Technical Memorandum, TSB-M-15(3)M (July 24, 2015) Delaware, Illinois, Hawaii, Kentucky, Maryland, Massachusetts, Minnesota, Oregon, Rhode Island, Tennessee and Washington all allow an executor to make a state-only QTIP election regardless of the election made on the federal return. 7 Connecticut and Maine allow a separate state QTIP election only if a federal election is not made. New York and New Jersey allow a separate QTIP election only if a federal return is not filed. Washington, D.C. and Vermont do not recognize a separate state QTIP election. 8 See Rev. Proc , which allows an executor to request the IRS to treat as null and void a federal QTIP election that is not necessary to reduce federal estate taxes. However, treatment of the election as null and void under Rev. Proc may cause state taxing authorities to treat the election as null and void for state purposes thus subjecting the Gap trust to taxation at the first death Estate of Clayton v. Comm., 976 F2d 1486, 70 AFTR 2d (CA-5, 1992) New York Department of Taxation and Finance Advisory Opinion, TSB-A-08(1)M (October 24, 2008) and TSB-A-15(1)(M)(May 29, 2015); Minn. Laws 150 Fiduciary Trust Company International Page 5, 2018 Advisor Perspectives, Inc. All rights reserved.