No Federal Estate Tax, but What About Your State?

As a reminder, we in MA have a $1,000,000 estate tax. Our trusts and wills account for this. If you have any questions, always feel free to email or call the office.


By: Paul Sullivan
The New York Times

The first quarter is nearly over, and the federal government has made no move to reinstitute the estate tax. So dying today seems free, right?

There is just one problem: If you live in one of 20 states with a state estate tax, you could find your existing estate tax plans causing more harm than good.

State estate taxes are not new. They had just been a secondary element in the course of figuring out the much higher federal estate tax.

Now, the issue is sorting through wills written to maximize the old federal exemption from estate taxes — $3.5 million in 2009. In states with their own estate taxes, some of these provisions could distribute money and incur taxes in ways the deceased never expected — or maybe not if the federal estate tax is reinstated. As Jerry Weihs, director of advanced planning at Sun Life Financial, said: “We’re in a state of ambiguity.”

AUTOMATIC MISTAKES The biggest issue with the state estate taxes is wills that contain so-called formula clauses. Many wills were redrafted in the last decade to take into account the increasing federal estate tax exemption. Instead of rewriting the will every few years, clauses were put in to reflect the rising exemption amount.

Two commonly worded clauses for estates that left money in trusts could cause problems. “If the clause says you leave the applicable exclusion to your kids and the rest to a second spouse, that could now mean leaving nothing to your children since there is no applicable exclusion in 2010,” said Sharon Klein, head of wealth advisory at Lazard Wealth Management. “The other issue is if you leave the maximum that could pass free of federal tax to your children and the rest to a second wife, then it is skewed toward the kids, and the wife is disinherited.”

So far 12 states have introduced legislation to remedy this, but the proposals vary. New York, for example, looks at the intent of the will on Dec. 31, 2009, but this applies only if there is a surviving spouse. A formula clause that splits assets between nieces and charity will not function as intended. Florida’s solution could be even more contentious: it allows a judge to interpret the intent of the deceased, if a trustee or a beneficiary challenges the will.

UNEXPECTED TAXES A formula clause can also cause another costly problem. If it was written to send as much money as possible free of federal estate taxes to a credit shelter trust, the estate could pay an unexpected amount in state estate taxes.

That is because estate plans were often written so that the maximum amount that would not incur federal estate taxes would be passed to one set of heirs and the rest to a surviving spouse tax-free. In New York, which has a $1 million state exemption, the estate would have paid $229,200 in state estate taxes on the difference between the New York exemption level and the $3.5 million federal exemption.

Today, the entire estate could pass free of federal taxes. This could lead to an unexpectedly high state tax bill, said Stephen Akers, associate fiduciary counsel at Bessemer Trust. He said the tax on a $25 million estate in New York would be $3,466,800.

“In retrospect, it could be wise to pay that,” Mr. Akers said. “You might be able to avoid the federal estate tax on that much money.” But that is a big if, and it depends on whether Congress decides to make a new estate tax retroactive.

MARRIAGE PROBLEMS The absence of a federal estate tax also raises the question of whether an estate can finance a qualified terminal interest property (QTIP) trust. Such trusts hold assets left to a surviving spouse free of tax until the second spouse dies. The glitch is that a QTIP trust was typically selected when filing the federal estate tax return.

Mr. Akers said several states like Connecticut, Massachusetts and Pennsylvania have a state QTIP election and others are working on it.

In theory, people living in these states could end up far ahead of where they otherwise would have been, he said. If someone left his estate in a state QTIP trust, the surviving spouse would not have to pay estate taxes on it when she died. This is because the estate tax for the surviving spouse comes into play only if a marital deduction is allowed when the first spouse dies. Since there is no federal estate tax return to file, the marital deduction is not an option now.

Mr. Akers said this had not been tested, but it was a better option than leaving assets outright to a spouse, which would certainly be taxed when the spouse died.

Ms. Klein said she was advising clients to set up QTIP trusts, where allowed, as a hedge. By filing extensions to the estate tax returns, you could have up to 15 months to make the election, at which point the estate tax landscape should be clearer.

SNOWBIRD TRAP More jarring to retirees who escape to Florida in the winter may be a bill under debate in that state’s legislature. It proposes to tax property owned by non-Florida residents who are residents of states with state estate taxes.

This is a radical change for Florida, which has long enticed wealthy residents because it had no income or estate taxes. The proposal, on the surface, is a battle between states: Florida wants its cut of any estate tax collected by another state on Florida property. (As proposed, people who live in states without an estate tax will be exempt.) But where it would affect nonresidents is in the legal costs to make sure Florida gets its cut.

And there are also immediate costs of Congressional inaction: changing your will to reflect your state estate tax is not free. “There are going to be significant expenses for what may well be a temporary situation,” Mr. Weihs said.