The 2001 Economic Growth and Tax Relief Reconciliation Act (EGTRRA) has seriously affected estate planning in jurisdictions throughout the country. Not only has the phase-out of the state death tax credit created situations in which combined state and federal estate taxes may actually rise, but the increase in the federal credit for estate tax also has complicated the formula for marital and credit shelter trusts.
Before EGTRRA, most states had a sponge tax that allowed a state to collect the maximum federal credit on taxable estates. While states received revenue on taxable estates, local estate taxes had little impact on planning. EGTRRA changed all this, primarily by phasing out the credit between 2002 to 2004 and replacing it with a deduction. In effect, sponge-tax states can't collect estate taxes after 2004.
The District of Columbia and 17 states responded by decoupling their estate taxes from the feds so that they could maintain the amount of taxes they gleaned from estates; state taxes are now imposed at the same rate as the phased-out credit. For clients, decoupling effectively increases their combined state and federal estate taxes.
For example, if a decedent dies in a decoupled state in 2004, the top federal estate tax rate is 48 percent, while the top state tax is 16 percent Because only 25 percent of the federal state death tax credit will be available, the estate will receive a 4 percent federal credit that does not completely offset the state taxes, making the effective federal rate 44 percent. But that 44 percent must be combined with the 16 percent state tax rate, meaning the executor of a large enough estate will face a top combined state and federal estate tax rate of 60 percent: 12 percent more than the 48 percent tax in a state that has not decoupled and 5 percent more than the top rate before EGTRRA was passed.
If the same person dies in 2005, the top federal rate will be 47 percent and the top state rate will remain 16 percent. Then a deduction, but no credit will be available, so the estate will receive a federal deduction worth 7.52 percent, making the effective federal rate 39.48 percent. That means, after 2004, the top combined state and federal estate tax rate will be 55.48 percent, 8.48 percent higher than in a non-decoupled state and again higher, albeit marginally, than pre-EGTRRA rates.
Yet higher tax rates are only one problem in decoupled states. Another is that many of these states have not linked the value of assets exempt from state estate taxes to the increased estate tax credits enacted by EGTRRA. The District of Columbia, New Jersey, Rhode Island and Wisconsin all have set their exclusions at $675,000; New York and Nebraska have frozen theirs at $1 million. Kansas, Maine, Massachusetts, Minnesota, North Carolina and Washington have linked their exemption amounts to the scheduled increases in the federal credit before EGTRRA's enactment.
The net effect: Estates in these jurisdictions may owe state estate taxes even if they are exempt from federal estate taxes. For instance, a Massachusetts estate worth $1.5 million will be exempt from federal estate taxes in 2004 — but it'll still be subject to state estate taxes, because the available state exclusion is only $850,000.
This difference between federal and state exclusions does more than complicate estate administration; it also creates potential problems for credit shelter and marital trusts. An executor might fund a bypass trust with less money than the decedent planned to avoid federal and state estate taxes. For instance, if the provisions governing the creation of a testamentary credit shelter trust include minimum taxation language, a trust established in 2004 by a Maine decedent could be funded with only $850,000. By the same token, funding a bypass trust to the federal applicable exclusion exclusion limit may inadvertently trigger state taxes that were not anticipated in the original estate plan. If the Maine trust were created with provisions that allowed the full use of the available federal credit, the estate would have to pay Maine estate taxes.
EGTRRA also affects how to fund a qualified terminal interest property (QTIP) trust. A minimum total tax formula may divert a portion of the first spouse's federal exclusion to a QTIP trust at the expense of the bypass trust. If the second spouse's estate is sufficiently large, those diverted assets could eventually be subject to higher federal and state estate taxes. Massachusetts, Rhode Island and Washington have tried to provide a solution to this dilemma by instituting state QTIP trusts. In these states, an executor can fund a bypass trust with the full federal and state exemption, fund a second trust with the difference between the federal and state exclusion, under a state QTIP election, then fund a QTIP trust with the remaining assets in the estate. This solution eliminates the imposition of any state or federal estate tax on the first spouse's estate, but also effectively increases the second spouse's estate, because that spouse must receive the income from the state QTIP trust.
Even residents of states whose taxes are still tied to the feds have to be careful if their estates include property located in a decoupled state. That decoupled state may impose taxes (on a limited pro-rata basis) if the federal and decoupled state exclusions differ. For example, if a decedent resided in a decoupled state, but held tangible property in Massachusetts, that state would levy a pro-rata estate tax if taxable distributions exceeded $850,000 even if those distributions did not exceed the $1.5 million federal exclusion amount. And if the decedent's estate planning instruments contained a testamentary trust governed by minimum tax provisions, that trust would be funded with $650,000 — less than the available federal exclusion — even though any Massachusetts taxes on the estate would be minimal.
Practitioners may address many of the EGTRRA-created issues by drafting flexible provisions and using such techniques as qualified disclaimers. For example, testamentary instruments may combine minimum total tax provisions with disclaimer powers that allow a surviving spouse to disclaim a portion of his bequest to a credit shelter trust in order to avoid under-funding bypass trusts. Another solution might be to allow an estate's executor to elect the funding amount for a QTIP trust. Clayton QTIP trusts serve this purpose admirably by deferring funding decisions until a testator's death, so these trusts may become more popular in decoupled states. But whatever solutions estate planners choose, they must recognize that EGTRRA has created a situation in which domicile considerations and careful vigilance will be the norm for some time to come.
“The Rosebud Egg,” an 1895 gift to Empress Alexandra Feodorovna, is trimmed with rows of diamonds, gold laurel swags and Cupid's arrows.