Decoupling. No, I am not going to discuss divorce, or trains, or what happens after love bugs hit your windshield. To an estates and trusts attorney, “decoupling” has a much more ominous meaning. Estate taxes — state estate taxes.
As you know by now, federal legislation enacted in 2001 phases out the federal estate tax, which results in one-year repeal in 2010. We will not talk about what happens in 2011 and later – I do not own a crystal ball. The same federal legislation also repealed the federal estate tax credit to which most state estate taxes were tied. That repeal was on a much faster road and has already happened as of January 1, 2005.
By way of background information, before the 2001 law, most states received a portion of the estate taxes assessed by the federal government. Under this revenue sharing arrangement, the federal government allowed a “state death tax credit” to the states. A tax table in the Internal Revenue Code established the amount of the credit. The credit was called a “sponge tax” or a “pick-up tax.” Many states simply assessed this tax rather than create their own separate inheritance tax systems. The tax was easy to collect and did not cost much to implement because it piggybacked on the federal system. If a decedent dies owing property in more than one state, the state death tax credit was shared – usually based on the relative value of the property located each state. Florida was one of those sponge tax states. It was a simple way of generating revenue for the states.
All that ended on January 1, 2005. Congress repealed the state death tax credit. For a state like Florida, that meant the elimination of the state estate tax and a halt in revenue from that source – end of story. However, other states did not choose to let that revenue out of their coffers. Many have chosen to decouple. This means that a growing number of states have now enacted legislation to establish their own estate tax systems. As a result, many estates may owe stateestate tax even though those same estates are exempt from federal estate tax.
Well, you say, I reside in Florida. I am not a snowbird. It would take a constitutional amendment to impose a Florida estate tax. We may amend the Florida Constitution to protect pigs, but we voters will never pass a Florida estate tax. I am safe. What does decoupling have to do with me? Sorry, but it may have a lot to do with you if you die owning property in a decoupled state.
Consider the estate of Ernie Chips. You may recall Erniefrom the article I wrote a couple of years ago about the new Principal and Income Act and Ernie’s issues dealing with his brother’s trust. Well, Ernie’s woes have continued. In 2005, Ernie died. He was a Floridaresident. He left an estate of $4,000,000, consisting of his Florida assets of $3,200,000 and a vacation home in upstate New York worth $800,000. Ernie is survived by his wife, Clara, and his children.
Ernie was a conscientious father and husband. He dutifully consulted with his Florida estate-planning attorney who drew up a standard marital/credit shelter trust plan in 1998. The plan was designed with a formula clause that eliminated estate taxes in Ernie’s estate using both his current federal estate tax exemption and the marital deduction allowed for assets passing to his wife. After Ernie died, his credit shelter trust was funded with his federal estate tax exempt amount of $1,500,000. The credit shelter trust provides income and principal benefits for Clara and the children. When Clara dies, the trust balance passes outright to their children free from federal estate tax. The balance of Ernie’s estate passed to Clara free from federal estate tax via the unlimited marital deduction. There was no federal estate tax due. Florida received no state estate tax because the federal credit has been repealed. However, surprise, New York is owed $12,880 in state estate tax. What happened here?
New York is one of at least 17 states that have decoupled from the federal estate tax system. Unfortunately, not all of these states have decoupled in the same manner. New York happens to link its new estate tax system to the federal system that was in place before the 2001 federal tax law was enacted. The New York estate tax exemption is now limited to $1,000,000. On the other hand, New Jersey, decoupled with an exemption of $675,000, but that tax only applies to New Jersey residents. New Jersey also has a separate New Jersey inheritance tax for residence and non-residents. These are not the only variations on the new state estate tax laws that have popped up throughout the country.
Here is how changes in the state estate tax laws have affected the taxability of Ernie Chip’s estate. Ernieowned a New York asset worth $800,000, which is less than the New York $1,000,000 estate tax exemption; however, his estate plan funded his credit shelter trust with $1,500,000. By grinding through the numbers, we find that the decoupled New York estate tax law assesses an estate tax of $12,800 for the New York property. This is because Ernie’s estate plan left assets that were not protected by either the New York estate tax exemption of $1,000,000 or the federal marital deduction. New York imposes this tax even though Ernieis a Florida resident. Unfortunately, it is possible that New York estate tax will be due again at Clara’s death if she still owns the property.
What could Ernie have done to prevent this tax? ShouldErnie have given away the New York property before he died? Would it help if Ernie had devised the New Yorkvacation home specifically to Clara? What if Ernie andClara had owned the New York property in their joint names? Should Ernie have changed his estate plan to provide for only a $1,000,000 credit shelter trust? There are many ideas floating out there on how to deal with state estate taxes caused by decoupling.
Are you an Ernie? Do you own property located in other states? If you do, your estate may be obligated to pay state estate taxes at your death. You need to review your estate plan with a qualified estate-planning attorney. There may be ways you can minimize or eliminate those state taxes. Over the next few years, estate taxes are a moving target at both the federal and state levels. Estate taxes are not dead and they will not die even if the federal estate tax is repealed.