For wealthy individuals, there are a number of factors to consider in determining the best state in which to be domiciled at death for tax purposes. Of course, which state is ideal for an individual is specific to each situation and hinges on many variables, such as that individual’s net worth, marital status and sexual orientation. Traditionally, one of the most significant of these factors has been whether the state imposes an estate tax. When combined with the federal estate tax, the highest marginal estate tax rates approach 50 percent. Making matters worse, some states limit the ability of executors to defer the state-level tax until the death of the surviving spouse by electing to treat certain property as qualified terminable interest property (QTIP).
While so much (unexpectedly) stayed the same in 2013, it was still a year of change for estate planning, and new factors must be considered in determining the best jurisdiction for wealthy families. The federal government gave us both permanent portability and the recognition of same-sex marriages, and now the states must determine if they’ll follow. Whether these developments impact a family depends on each family’s unique circumstances.
State Estate Tax
No one, except the very wealthy, will incur federal estate tax in 2014, as the exemption amount climbs to $5.34 million, but many estates not subject to federal estate tax will pay state estate tax. State estate or inheritance taxes often kick in at much lower thresholds than the federal estate tax. Currently, there are 31 states that impose no state estate tax.1 In recent years, several states have abolished their estate taxes, including Indiana, Kansas, North Carolina, Ohio and Oklahoma. Tennessee is scheduled to follow suit in 2016. Currently, 19 states and the District of Columbia continue to levy some form of estate tax or inheritance tax, of which 12 jurisdictions charge a so-called “pick-up estate tax.” The others impose either a stand-alone estate or inheritance tax.
Pick-up estate tax. In 2001, the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) phased out the federal state death tax credit. Prior to EGTRRA, states based their estate taxes on this credit. After EGTRRA, many states decoupled their estate taxes from the federal estate tax and continued to impose a pick-up estate tax (also known as a “sponge tax”) based on a prior version of the Internal Revenue Code. For example, New York charges an estate tax based on the federal state death tax credit in effect on July 22, 1998, which means that the threshold for New York estate tax is a mere $1 million.2
Only two jurisdictions have pegged their exemptions to the federal estate tax exemption: Delaware and Hawaii.3 The 10 others that impose a pick-up estate tax use lower thresholds than the federal exemption: Illinois ($4 million); Vermont ($2.75 million); Maine ($2 million); D.C., Maryland, Massachusetts, Minnesota and New York ($1 million); Rhode Island ($910,725); and New Jersey ($675,000).4 The cost of a state estate tax can be substantial, even when an estate isn’t subject to any federal tax. For example, a $5 million Massachusetts estate will pay no federal estate tax, but will owe the Commonwealth of Massachusetts $391,600.
Stand-alone estate tax. A few states—Connecticut, Oregon and Washington—have left the federal estate tax credit behind and impose independent estate taxes. The structures of these taxes are very similar to the federal estate tax, meaning that there’s an exemption amount, and tax is imposed above that threshold at a graduated rate schedule. Washington has decided to increase its exemption amount by the consumer price index beginning in 2014, similar to the federal exemption.
Inheritance tax. Several states charge an inheritance tax, and in limited cases, this tax is imposed in addition to another form of estate tax. Generally, inheritance tax is levied only on certain testamentary transfers based on the recipient of the bequest (for example, transfers to individuals other than a surviving spouse, grandparents, parents, lineal descendants and their spouses and siblings), and the amount of the tax may vary based on the recipient of the property. Iowa, Kentucky, Maryland, Nebraska, New Jersey, Pennsylvania and Tennessee impose inheritance tax at varying levels on transfers to certain beneficiaries (see “Cross-Country Trip,” p. 47).
Separate State QTIP Election
Most states that charge an estate tax no longer match the federal exemption amount. Thus, for wealthy married decedents, making a separate state QTIP election will help to achieve tax efficiency. While portability may also be a solution to this problem in some cases, without a separate election, decedents may be forced to incur state estate tax on the death of the first spouse to die or waste a portion of their federal estate tax exemption. For example, in Massachusetts, where a separate state QTIP election is allowed, the estate plan of a married individual will usually be designed to create three testamentary trusts: (1) a credit shelter trust to hold the $1 million that’s exempt from both state and federal estate taxes; (2) a marital trust to hold the difference between the Massachusetts exemption amount of $1 million and the federal exemption amount of $5.34 million (that is, $4.34 million in 2014), for which a Massachusetts-only QTIP election will be made; and (3) a marital trust to hold any assets over $5.34 million, which would be a QTIP trust for both state and federal purposes. The Massachusetts-only QTIP trust won’t be subject to federal estate tax on the death of the surviving spouse—only Massachusetts estate tax will be imposed—allowing any appreciation to escape federal estate tax.
Some states, however, like Connecticut and New York, don’t allow for a state QTIP election that’s inconsistent with the federal election. The Connecticut estate tax return provides: “If any marital deduction is elected for federal estate tax purposes, the same amount must also be elected for Connecticut estate tax purposes.”5 New York has a similar requirement. In 2011, the New York State Department of Taxation and Finance elaborated that whenever an estate tax return is filed for federal purposes, “the amounts used to compute the gross estate and any elections reported on the federal return are binding for New York State estate tax purposes.”6 Even when a federal return is filed only for purposes of electing portability, the QTIP election must be consistent on the federal and state estate tax return. Making no QTIP election for federal purposes on a Form 709 bars an election for New York purposes. Connecticut provides a bit more flexibility than New York and allows a QTIP election solely for Connecticut estate tax purposes if no election was made for federal estate tax purposes.7
Portability of the federal estate tax exemption may help individuals who engage in planning in states like Connecticut and New York.8 Instead of wasting a portion of the federal exemption or opting to pay state estate tax on first death, now, married taxpayers may plan to QTIP all estate property in excess of the state exemption amount and use portability to preserve the remaining federal exemption for later use by the surviving spouse. For example, in New York, where the exemption amount is $1 million, the executor of a $10 million estate could elect to treat $9 million as a QTIP (all property in excess of $1 million), and the deceased spousal unused exclusion (DSUE) amount of $4.34 million could be preserved for use by the surviving spouse.9
There are possible limitations to this approach for estates that don’t owe federal estate tax—those falling between the federal exemption amount and the lower state exemption amount. Revenue Procedure 2001-38 provides relief to taxpayers who make an unnecessary QTIP election, such as one with respect to a credit shelter trust or an estate below the exemption amount.10 If the QTIP election isn’t necessary to reduce the estate tax liability to zero, the IRS will treat it as null and void. However, the application of this revenue procedure is limited, and it won’t apply to: (1) situations in which a partial QTIP election was required to reduce the estate tax liability and the executor made the election with respect to more trust property than was necessary to reduce the estate tax liability to zero; (2) elections stated in terms of a formula designed to reduce the estate tax to zero; and (3) protective elections.11
In situations in which a QTIP election is necessary (that is, the estate would otherwise owe federal estate tax) and the executor elects to treat more property than necessary as QTIP for federal purposes, Rev. Proc. 2001-38 doesn’t apply. Therefore, relying on a larger QTIP election and portability may be a good planning tool for federally taxable estates.
Where no federal QTIP election is necessary to reduce the federal estate tax to zero (that is, the gross estate is below the exemption amount), the election may be null and void under Rev. Proc. 2001-38. While no federal estate tax would be triggered, the result in a state like New York, which follows the federal return, is unclear. If the New York QTIP election were also nullified, then New York estate tax would be due—not the intended result.12 It’s still unclear whether reliance on portability will work in this situation.13
State Estate Tax Portability
On Jan. 1, 2013, the American Taxpayer Relief Act of 2012 made federal portability permanent.14 Several states have begun contemplating portability of their state estate tax exemptions. For married residents of states that have estate taxes but don’t have portability, it may only make sense for estates to use portability of the federal exemption to the extent it exceeds the state exemption. The state exemption amount would still have to be used on the death of the first spouse to die or forfeited altogether. State portability would allow more flexibility and more extensive use of federal portability if it happens to make sense.
Hawaii appears to be the only jurisdiction currently allowing portability of the state exemption amount. On July 5, 2012, the governor of Hawaii signed The Estate and Generation-Skipping Transfer Tax Reform Act, conforming the Hawaii estate tax system as closely as possible to the IRC.15 The Form M-6, Hawaii’s estate tax return, takes the DSUE amount into consideration in determining the Hawaii net taxable estate.16 Vermont has gone as far as introducing legislation to make its $2.75 million exemption portable to the surviving spouse.17 Now, the other jurisdictions with their own estate taxes will have to analyze the potential revenue impact of state portability and determine whether they’ll follow Congress’ lead.
Recognition of Same-Sex Marriages
On June 26, 2013, the Supreme Court issued an opinion, in United States v.Windsor, holding Section 3 of the Defense of Marriage Act unconstitutional and defining marriage to include same-sex couples for federal purposes.18 This landmark decision triggered federal tax benefits for same-sex married couples. Importantly, married same-sex couples may now take advantage of the federal estate tax marital deduction, which means that the estate of the first spouse to die won’t be forced to incur an estate tax. The decision brings federal tax treatment of these estates into alignment with many states, like Massachusetts, the first state to recognize same-sex marriage in 2003.19 Married same-sex couples in Massachusetts no longer have to complete state and federal versions of tax returns making different elections resulting in different tax treatment of their marriages. For the 16 states (plus the District of Columbia) that recognize same-sex marriages, Windsor has made tax reporting simpler and liberated the surviving spouse from the burden of federal estate tax.
Windsor also creates a new disconnect—the federal tax system now views married same-sex couples differently from the states that don’t recognize these marriages. For wealthy same-sex couples, lack of state recognition of their marriages could result in the payment of state estate tax on the death of the first spouse, especially since state exemption amounts are often lower than the federal estate tax exemption. However, Windsor also creates a dynamic and fast-changing landscape for same-sex couples.
State recognition of marriage, and the tax benefits that come with it, is evolving quickly. Two states—Hawaii and Illinois—have passed legislation recognizing same-sex marriage only in the past few months. According to the Human Rights Campaign, nearly 40 percent of the U.S. population lives in jurisdictions that recognize same-sex marriage.20 For wealthy same-sex couples, how states will treat same-sex marriages will be a significant concern and will impact their estate planning and tax bills. (For more information about the same-sex marriage issue, see “Ding Dong, Is DOMA Dead?” by Joshua M. Rubenstein and Jason J. Smith, in this issue, p. 40.)
Determining the best or worst state in which to be domiciled at death is driven by many non-tax motivations. Analyzing the cost of the estate tax burden is only one element of the choice, and the factors discussed above must be examined on an individual basis. At the end of the day, reducing estate tax may not be compelling enough to instigate a move away from friends or family, but if one is already spending time in two states, tax savings could convince your client to spend a couple more days here or there, especially if that state has warm weather in the winter months.
—Brown Brothers Harriman & Co. and its affiliates do not provide tax, legal or investment advice and this communication cannot be used to avoid tax penalties. This material is intended for general information purposes only and does not take into account the particular investment objectives, financial situation, or needs of individual clients. Clients should consult with their legal or tax advisor before taking any action relating to the subject matter of this material.
1. Alabama, Alaska, Arizona, Arkansas, California, Colorado, Florida, Georgia, Idaho, Indiana, Kansas, Louisiana, Michigan, Mississippi, Missouri, Montana, Nevada, New Hampshire, New Mexico, North Carolina, North Dakota, Ohio, Oklahoma, South Carolina, South Dakota, Texas, Utah, Virginia, West Virginia, Wisconsin and Wyoming.
2. N.Y. Tax Section 951.
3. Delaware Code Section 1501(3)(c).
4. Rhode Island’s exemption increases with the consumer price index.
5. 2012 Form CT-706/709, Connecticut Estate and Gift Tax Return and Instructions, p. 3.
6. Technical Memorandum TSB-M-11(9)M (July 29, 2011).
7. Supra note 5.
8. Internal Revenue Code Section 2010(c)(2)(b).
9. IRC Section 2010(c)(4).
10. Revenue Procedure 2001-38, 2001-1 C.B. 1335 (June 11, 2001).
12. Supra note 6.
13. The ABA-RPTE Portability Regulation Comments asked Treasury to re-evaluate Rev. Proc. 2011-38 in light of portability.
14. Pub.L. 112–240, H.R. 8, 126 Stat. 2313, enacted Jan. 2, 2013.
15. Act 220 (H.B. 2328 ), Laws 2012, effective Jan. 25, 2012.
16. 2012 Hawaii Form M-6, line 8.
17. An Act Relating to Ensuring the Portability of a Deceased Spouse’s Estate Tax Exemption, VT House Bill 399.
18. United States v. Windsor, 133 S.Ct. 2675 (2013).
19. Goodridge et al. v. The Department of Public Health, 798 N.E.2d 941(Mass. 2003).
20. Carolyn Simon, associate director of Digital Media, Human Rights Campaign, “Reflecting on 10 Years Since the Goodridge Decision Brought Marriage Equality to Massachusetts,” www.hrc.org/blog/entry/reflecting-on-10-years-since-the-goodridge-decision-brought-marriage-equali (Nov. 18, 2013).