Practitioners in all decoupled states must be careful
A recent decision out of New Jersey — Estate of Stevenson v. Director, Division of Taxation1 — illustrates a novel issue arising under the decoupled estate tax systems adopted by many states: the potential imposition of state death taxes on federal taxes that are never paid!
In Stevenson, the residuary estate actually passed to the surviving spouse at the decedent's death in 2005. Nonetheless, in determining the decoupled New Jersey estate tax due, a court reduced the marital deduction by the amount equal to a hypothetical federal estate tax payable from the residue determined by applying the Internal Revenue Code in effect in 2001.2
Practitioners are now faced with the need to plan both for death taxes that get paid and for theoretical taxes that arise under the decoupled estate tax statutes of several states. Fortunately, tax clause language can be added to wills to avoid this startling and unintended result.
The attorney for the taxpayer is still stunned by the decision in Stevenson. “Since when do we tax funds [that] actually go to the spouse? When did N.J. get the power to redefine the marital deduction?” asked Richard T. DeCou in an email discussing the case. A partner in the Morristown, N.J., firm of Capehart & Scatchard, P.A., DeCou added: “I would not hesitate to take the issue all the way up if I had sufficient dollars at stake and a client willing to continue. It's just plain wrong.”
The opinion by New Jersey Tax Court Judge Gail Menyuk provides that the facts were undisputed and the matter was ripe for summary judgment. It immediately summarizes the tax clause in question without quoting the actual language used in the will, failing to set forth a critical undisputed fact.3
Judge Menyuk describes the clause as follows: “The will directed that all estate, inheritance, and other death taxes, federal or state, imposed with respect to property passing under the will or otherwise, be paid out of the residuary estate, without contribution, reimbursement or apportionment.”4 But by failing to set forth the will's actual language, the decision deprives practitioners of critical guidance on how to avoid its result.
The judge does set forth the mechanics of the statute and the competing computations of the tax.
The taxpayer5 argued that the New Jersey estate tax is computed on the basis of the federal estate tax actually imposed. Because the taxable estate was less than the federal exemption amount of $1.5 million in 2005, no federal estate tax reduced the residue. After initially paying New Jersey a larger amount, the taxpayer filed for a refund, claiming taxes due of only $53,239.6
The state argued that the statute requires the tax to be computed as the federal estate tax would have been imposed in 2001, when the exemption amount was only $675,000. Pursuant to the tax clause in question, the phantom federal estate tax then is allocated to the residue of the estate, where it reduces the marital deduction and causes a tax on tax, required to be determined through use of an algebraic formula. The hypothetical federal estate tax prior to the Internal Revenue Code Section 2011 credit was $423,308.45, wiping out the residue and resulting in New Jersey claiming a tax due of $77,689.35.7
Judge Menyuk's opinion extensively addresses arguments of tax policy regarding the preservation of the marital deduction and the construction of tax statutes. She criticizes the taxpayer's arguments as inappropriate and cites legislative history extensively set forth in the New Jersey Tax Court's 2008 decision of Oberhand v. Director,8 a decision subsequently affirmed by the New Jersey Supreme Court. In Oberhand, the courts refused to apply the decoupled estate retroactively on the legislative doctrine of “manifest injustice.”
Late in the Stevenson opinion, Judge Menyuk returns to consider the tax clause. She dismisses summarily the taxpayer's argument that the tax clause does not apply to imaginary taxes.9 The judge does not attempt to address the difference between taxes actually imposed and taxes made up for purposes of decoupling. Instead the judge, apparently being critical, comments on the lack of any attempt to reform the will. She then adopts the state's position and mechanically applies the New Jersey estate tax to impose it on dollars actually passing to the surviving spouse, depriving the estate of the benefit of the marital deduction for New Jersey purposes.
What Went Wrong?
Judge Menyuk's cursory treatment of the tax allocation clause is most unfortunate and should raise an alarm around the country. Typically, practitioners use the tax allocation clause to express and realize the intent of their clients to avoid a result such as the finding in Stevenson.
The prospect of a client intending to allocate a hypothetical estate tax against assets otherwise qualifying for the marital deduction, creating a tax on a phantom tax, is beyond the experience of tax practitioners. No client or professional could reasonably have anticipated this result, necessarily creating an ambiguity in the will to be resolved.
Judge Menyuk's opinion unexpectedly poses the question: Does the tax apportionment clause apply only to taxes that are actually paid, or did the testator intend it to also apply to hypothetical taxes for the purpose of increasing the overall tax burdens?
Estate of Stevenson presents unusual facts supporting the mechanical approach adopted by the state. As described in the opinion, the will created a common two-share estate plan, with a credit shelter portion equal to the maximum amount that can pass free of federal estate taxes to the decedent's children, and the residue passing to the surviving spouse.10
Significantly, the bulk of the assets circumvented the terms of the will as non-probate property. The decedent's estate totaled $1,752,258. Of that amount, $1,272,377 was held in a brokerage account passing directly to the decedent's children pursuant to what Judge Menyuk describes as a “transfer on death” agreement. The residue, passing to the surviving spouse, was $405,849.11
Because of the non-probate assets, the credit shelter trust was not funded and could not be reduced by any allocation of estate taxes, real or hypothetical. Rather, the only assets passing under the will and subject to the tax clause were the marital deduction assets.
Hence, the residue became subject to Judge Menyuk's extraordinary, mechanical application of both the tax statute and the estate tax clause to cause the hypothetical federal estate tax to increase the decoupled New Jersey estate tax.
From the perspective of practice in New Jersey, the Stevenson decision is disappointing. New Jersey has a very strong tradition of construing wills to resolve ambiguities or even reform a document pursuant to the doctrine of probable intent, dating from the seminal case of Fidelity Union Trust Co. v. Robert12 in 1962, and set forth in statute at N.J.S.A. 3B:3-33.1. The doctrine considers:
- the language of the will taken as a whole;
- the extrinsic circumstances; and
- the impulses common to human nature.
Because the only controversy involving the estate, that is to say the scope of the tax clause and the computation of the estate tax, was before the New Jersey Tax Court, the construction or reformation of the will pursuant to the doctrine of probable intent was properly before it. The judge clearly avoided and did not address construction or reformation as a basis for relief to the taxpayer. She did not recite the language of the will in her opinion, so that it could be considered as a whole. By proceeding on a summary basis, the judge failed to conduct a plenary hearing appropriate to marshalling the extrinsic evidence relevant to determining the meaning of the tax clause. Finally, she failed to apply well-known case law favorable to the taxpayer recognizing impulse common to human nature to benefit a surviving spouse and to reduce and minimize tax burdens, including In re Estate of Ericson13 and In re Estate of Branigan.14 In short, the judge failed to consider the probable intent analysis to construe the will in a manner favorable to the taxpayer.15
In more common circumstances, the Stevenson tax on phantom tax result should not occur. Typically, probate assets will be at least adequate to fund the credit shelter trust in an amount necessary to pay the phantom federal estate tax on the exemption amount.
By way of example, the phantom federal estate tax on a credit shelter disposition equal to the full $3.5 million exemption is $1,345,250 less the state death tax credit of $229,200 (that is to say, the decoupled New Jersey tax). To avoid the Stevenson result when the full exemption amount is used, the net assets passing under the credit shelter disposition of the will have to equal at least $1.35 million.
The planning process for a married couple includes a review of the assets and advice regarding the allocation of the assets between the spouses, in addition to the preparation of the wills or revocable trusts and other dispositive documents. The asset review provides one opportunity to avoid the Stevenson result. Many formula credit shelter clauses also will reduce the bequest for charges to principal that are not deductible for federal estate tax purposes providing another opportunity to avoid Stevenson.
But planning is inherently uncertain. As the nuclear family changes, it becomes even more uncertain, as illustrated by the Stevenson case, when the exemption amount was relied upon to shelter non-probate assets passing to children of the decedent's prior marriage. The planning clearly worked for federal estate tax purposes, but it had previously unknown state death tax consequences. Consider the further uncertainties of not knowing when death will occur, what specific assets may be worth at death, or even the state of the decedent's domicile at death. Even when the Stevenson issue is anticipated and addressed through asset allocation and re-titling, the problem may arise time and again.
The tax allocation clause provides the most practical opportunity to avoid the Stevenson result.
Common tax clause patterns allocate estate taxes to the credit shelter portion if the spouse survives, avoiding the tax on tax issue. Even if a tax clause allocates the burden to a marital share passing as the residue, the actual operation of the formula may reduce the credit shelter portion.
The Stevenson opinion emphatically demonstrates that, practitioners everywhere should revise tax clauses set forth in wills16 under decoupled estate tax systems.
First, any state death taxes deductible under IRC Section 2058 should be allocated to the residue, because the deduction will avoid the tax on tax issue with respect to state death taxes for purposes of the federal estate tax actually imposed. Because IRC Section 2058 did not allow any such deductions in 2001, this allocation will not be effective under the hypothetical federal tax computation for decoupled state tax purposes, and the state death taxes will get allocated under the subsequent provisions of the tax clause.
Second, the balance of estate taxes payable then needs to be allocated. At the death of the first spouse to die, the balance should be allocated first to the credit shelter property passing under the will. Under the hypothetical federal tax computation for decoupled state tax purposes, this allocation will include the state death taxes.
Third, to the extent that the credit shelter share passing under the will is inadequate, the balance of the taxes should be allocated to the property causing the tax, passing either under the will or outside of the will, taking into account any deductions allowed in determining the tax.
Pursuant to this clause, any non-probate property causing an estate tax will bear the tax to the extent that the credit shelter bequest under the will is inadequate.
Finally, to the extent that the non-probate assets are inadequate to pay the taxes, they should then be allocated to residue, that is to say, the marital share.
Tax allocation clauses commonly have an opening provision directing the payment of estate taxes pursuant to one of two options. One option to is pay all estate taxes on property passing as a result of the decedent's death, whether or not the property passes under the will. The other is to direct the payment of taxes only on property passing under the will.
The second option clearly avoids the Stevenson result. The first option creates potential for additional confusion even if language is added to avoid the Stevenson result, because it allocates taxes away from non-probate property. Avoiding the Stevenson result also requires the introductory language to allow for this third option: the partial allocation of estate taxes to non-probate property.
I've created some sample tax clause language that may be used to avoid the Estate of Stevenson result in states having decoupled estate tax systems. (See “Bulletproof Your Wills,” p. 12.) It might be a good idea to use it, just as a precaution.
While Estate of Stevenson presents unusual facts, it also illustrates the aggressive position that state tax authorities may take to increase revenues from decoupled state estate taxes. Practitioners everywhere should be aware of the potential problem, and revise tax clauses to avoid the unanticipated, unfair result of the Stevenson decision.
In re Estate of Stevenson, 23 N.J. Tax 583 (2008).
The decoupled New Jersey estate tax is set forth at N.J.S.A. 54:38-1 et seq., allowing an exemption of only $675,000. Specifically, at N.J.S.A. 54:38-1.a (2)(a), it imposes the tax “Upon the transfer of the estate of every resident decedent dying after December 31, 2001 which would have been subject to an estate tax payable to the United States under the provisions of the federal Internal Revenue Code of 1986, in effect on December 31, 2001.”
Stevenson, supra note 1, at p. 585.
Represented by Richard T. DeCou of Capehart & Scratchard in Mt. Laurel, N.J.
Stevenson, supra note 1, at p, 586.
Oberhand v. Director, Div. of Taxation, 23 N.J. Tax at pp. 589-90. The New Jersey Supreme Court decision is at Oberhand v. Director, 193 N.J. 558 (2008).
Stevenson, supra note 1, at p. 595.
Ibid., at pp. 585-86.
Ibid., at p. 588.
Fidelity Union Trust Co. v. Robert, 36 N.J. 561 (1962).
In re Estate of Ericson, 74 N.J. 300 (1977).
In re Estate of Branigan, 129 N.J. 324 (1992).
Should the issue arise again, New Jersey practitioners have available the probable intent argument left unaddressed by the Stevenson decision to avoid the Stevenson result.
For brevity, this article will address only tax clauses in wills. The same principles apply to estate planning done through revocable trust agreements.
Joseph C. Mahon is a partner in the Princeton, N.J., office of Cooper Levenson
Bulletproof Your Wills
Here's some sample tax clause language that may shield your clients' estates from a Stevenson-like problem
This is just an example of the kind of tax clause language that may be used to avoid the Estate of Stevenson result in states with decoupled estate tax systems. The language to avoid the Stevenson result is in italics. The assumption is that the credit shelter bequest is pre-residuary, and the residue passes to the spouse so as to qualify for the marital deduction:
“Estate Tax Allocation. My Executors shall pay any and all estate, inheritance and other death taxes and duties, including any interest and penalties thereon imposed by reason of my death by the United States of America, or any State or local entity thereof (but not any tax, interest and penalties imposed under Chapter 13 of Subtitle B of the Internal Revenue Code (the “generation skipping transfer tax”) or any similar state statute), apportioned to the property passing under this Will to the extent provided herein, in respect of property required to be included in my gross estate for the purposes of such taxes, whether passing under this Will or otherwise, other than i) any property which is subject to such taxes as a result of Section 2044 of the Internal Revenue Code or any similar state statute; ii) any property passing under any irrevocable trust created by me during my lifetime; iii) or any property over which I have a general power of appointment within the meaning of Section 2041 of the Internal Revenue Code created by a person other than me that I have not exercised. I authorize my Executors, in their absolute discretion, to pay or to decline to pay any such taxes, and interest and penalties thereon, imposed by any foreign government or subdivision thereof.
“If my spouse survives me, I direct that any such taxes and interest and penalties thereon so paid shall be allocated and apportioned in the following order:
“(1) any such taxes and interest and penalties for which a deduction is allowed under Section 2058 of the Internal Revenue Code shall be apportioned to and paid out of my residuary estate; and
“(2) the balance of such taxes and interest and penalties shall be apportioned to and paid out of that property of my estate which shall be allocable to the trust created under Article/Section ________(credit shelter) of this Will; and, if and to the extent the same is insufficient, then
“(3) the balance of such taxes, interest and penalties on property that does not pass as part of the trust created under Article/Section ________(credit shelter) hereof or my residuary estate and that does not qualify for any deduction for Federal estate tax purposes shall be apportioned to and paid out of such property (whether or not passing under this Will); or, if and to the extent the same is insufficient, then
“(4) the balance of such taxes, interest and penalties shall be apportioned to and paid out of my residuary estate.”
The third paragraph also could be drawn more simply to apportion the estate taxes to non-probate property once the credit shelter trust is exhausted, as follows:
“(3) the balance of such taxes, interest and penalties on property that does not pass under this Will and that does not qualify for any deduction for Federal estate tax purposes shall be apportioned to and paid out of such property; or, if and to the extent the same is insufficient, then ….”
Because wills are construed to give effect to the decedent's intention, a provision also may be added to set forth the client's intention to avoid the Stevenson result. Here is one example:
“My intention to allocate and apportion all such taxes, interest and penalties that are not allowed as a deduction in determining such taxes to property that does not qualify for the marital or any other deduction for purposes of determining such taxes, and I direct that this section be construed and that such taxes, interest and penalties be allocated to preserve all such deductions to the greatest extent practical and to minimize the imposition of such taxes on my estate.”
— Joseph C. Mahon