Pay New York a little to avoid paying the United States a lot
Last summer, one of our clients in his mid-forties died unexpectedly, before we were able to finish helping him with his wealth transfer planning. He was a New York resident and was survived by his wife and two young children.
The decedent's combined family assets had a value of approximately $17.5 million. Most of the assets were titled in the decedent's name. The assets were comprised predominately of a single, highly appreciated equity position, homes and rental real estate holdings. Several of the properties had mortgages in excess of fair market value. The decedent had substantial passive loss carry-forwards associated with the rental properties.
The decedent's will created a credit shelter trust equal to his unused estate tax exclusion, with the residuary passing outright to his surviving spouse. At the time of the decedent's death, there was no estate tax exclusion and New York hadn't yet provided guidance on how to interpret such funding clauses. Towards the end of 2010, New York amended Estate Planning and Trust Law Section 2-1.13, which instructed executors to interpret these types of estate plans as if it were Dec. 31, 2009 (that is, as if there was a $3.5 million estate tax exemption).
The decedent's estate would have obtained the greatest estate tax planning benefit if the decedent's personal representatives elected out of the estate tax regime and the spouse disclaimed a significant portion of the estate over the credit shelter amount. However, the income tax planning benefits from the estate tax/basis step-up regime were significant, and the estate tax could be avoided entirely by utilizing the marital deduction.
The surviving spouse was, understandably, very concerned about having sufficient assets for her family's living needs. She was a permissible beneficiary of the credit shelter trust but wouldn't have had access to additional amounts that she disclaimed. She was ultimately willing to disclaim about $3 million above the credit shelter amount.
Our income tax analysis of the situation involved several competing considerations. First, the $4.3 million of available basis adjustment under the carryover basis regime would have covered only half of the appreciation in the equity position. Second, there was a desire to diversify the position as quickly as possible.
Third, with respect to the real estate, the passive loss carryovers were significant to the overall equation. Under Internal Revenue Code Section 469(g)(2), passive loss carryforwards in excess of the basis step-up associated with related property may be used on a decedent's final income tax return. Because the real estate had actually declined in value, the passive losses were fully available under either election and were used to offset ordinary income from a Roth individual retirement account conversion the decedent had made prior to death.
After we revised a great deal of our analysis to reflect the changes in New York and federal law, we advised the decedent's representatives that subjecting the estate to the estate tax in exchange for a basis step-up provided the best overall result. The surviving spouse was then able to use her increased gift tax exclusion in 2011 to fund the desired $3 million transfer to a trust for the children.
Because New York maintains its estate tax exemption at $1 million, the $5 million credit shelter bequest created a New York estate tax of $391,600. But because there's no New York gift tax, the additional $3 million transfer to the children created no additional New York tax. Overall, the substantial income tax savings related to the diversification of the concentrated equity position and the use of the passive losses far exceeded the incremental New York estate tax.
Carl C. Fiore is a director in the New York City office of WTAS LLC, a tax consulting firm with offices throughout the United States