New Jersey Estate Tax Changes And Divorce Affecting Group Life Insurance

by Richard T. DeCou, Esq.

There are two recent developments affecting estate planning for New Jersey residents:

1. New Jersey Estate Tax Changes.

Last year’s federal estate tax decreases seemed to cause decreases in the New Jersey tax as well, but New Jersey has now declined to go along. As part of the McGreevy tax package, the New Jersey estate tax is frozen at December 31, 2001 levels. (P.L. 2002, Chapter 31, approved July 1, 2002.) This means that the New Jersey estate tax will not decrease as the federal estate tax decreases over this and future years. The New Jersey estate tax is known as a “sponge” or “pick-up” tax. That is because it soaks up the “credit for state death taxes” which is allowed against the federal estate tax. This credit is a revenue-sharing device in the federal estate tax. The amount payable to IRS may be reduced by the credit, but only if the credit amount is paid to the state. Naturally, the state accepted this offer and enacted a tax to utilize this credit, since there is often little or no New Jersey inheritance tax in the typical estate plan (because assets are transferred to exempt beneficiaries, such as a spouse and children). The 2001 Federal Tax Act made two changes which threatened to reduce revenues from the New Jersey estate tax. First, it increased the exemption level, by increasing the “applicable exclusion” from $675,000 to $1,000,000 on January 1, 2002, with additional increases scheduled for future years. Estates below these numbers would pay no federal estate tax, and, under previous law, no New Jersey estate tax. New Jersey has now frozen its exemption level at $675,000, so that an $800,000 estate will pay a New Jersey estate tax despite the fact that no federal estate tax is due.

The second change in the 2001 Federal Tax Act was to phase out the state death tax credit, and to convert it to a deduction. The phase-out was 25% per year over 4 years, after which the New Jersey tax would become a deduction rather than a credit. A dollar of credit would reduce the federal tax by a dollar, or by 75%, 50%, or 25% of a dollar during phase-out. A deduction will reduce the federal estate tax by, for instance, 45% for an estate in the 45% bracket.

The estate taxes on $1.25 million are/were as follows:

a. In 2001 (federal exemption – $675,000; New Jersey exemption – $675,000):

b. In 2002, if NJ had not passed this law. (with 25% reduction in the credit) (federal exemption – $1,000,000; New Jersey exemption – $1,000,000):

c. In 2002, if New Jersey had not passed this law, and if Congress had not reduced credit by 25% (federal exemption – $1,000,000; New Jersey exemption – $1,000,000):

d. In 2002, as a result of this New Jersey law (federal exemption – $1,000,000; New Jersey exemption – $675,000):

You can see that by phasing out the credit (compare examples b and c), Congress intended to take $12,100 from New Jersey so as to reduce its own revenue loss. New Jersey has refused to accept the loss. So the $12,100 must be paid by the taxpayer to New Jersey. You are not getting what Congress said you would get (at New Jersey expense). We will let you decide whether Congress or New Jersey should be blamed.

The New Jersey Act now requires the preparation of a federal estate tax return equivalent in those cases when no federal estate tax return would otherwise be required. New Jersey will apply its own appraisal techniques to businesses and real estate.

The most disturbing part of the New Jersey act is this: No property owned by the decedent as of the date of the decedent’s death may be transferred without the written consent of the director, or pursuant to such rules as the director may prescribe.

This is to enforce “a lien on all property of the decedent” until the tax is paid. Previously, the New Jersey estate tax was not a lien. While the New Jersey inheritance tax was always a lien, the tax has not applied to spouses or lineal descendants since 1988 and the lien is easily lifted if all beneficiaries are exempt from tax. Unfortunate nephews, nieces and others still subject to the inheritance tax lien must suffer their New Jersey stocks being frozen and half of New Jersey bank accounts being frozen until the tax is paid and the lien waiver received. If this new language means what it seems to mean, then in any economic downturn, widows and orphans must watch the value of their now frozen securities and other assets fall until the always-understaffed personnel in Trenton get around to reviewing the estate tax return. This is usually about a year or more after death. This problem extends to “all property of the decedent,” making it much broader and harsher than the inheritance tax lien. Placing securities with a Philadelphia broker does not appear to solve the problem, as the brokerage firm probably does business in New Jersey, subjecting it to New Jersey penalties. Hopefully, the Division of Taxation will issue rules less harsh than our interpretation.

2. Estate of Zienowicz v. Metropolitan Life Ins. Co. et als., 2002 U.S. Dist. Lexis 10573 (D.N.J., June 13, 2002).

Zienowicz named his spouse as beneficiary of his employer’s group life insurance policy. Subsequently, he and his spouse divorced, and later he died without having changed his beneficiary designation. This New Jersey case held that the insurance should be paid to his former spouse, as provided by the beneficiary designation, disregarding contrary language in the divorce decree.

Prior to Estate of Zienowicz, a 1999 case had upset established insurance law by holding that divorce served to revoke the designation of the former spouse as beneficiary. John Hancock Mutual Life Ins. Co. v. Timbo, 67 F.Supp. 2d 413 (D.N.J. 1999). Notwithstanding this precedent, the Zienowicz court refused to follow it, adopting instead what it conceded is the minority position among the federal courts of appeal, that plan administrators may not consider documents external to the plan. Its reasoning was that employer group life insurance is a “welfare benefit” governed by federal law, ERISA. ERISA expresses “the strong interest in the uniform, simple administration of ERISA plans” by requiring and allowing plan administrators to rely only upon plan documents in their possession. Whatever one may think of that policy, it is disturbing that the court felt obliged to go further by stating that the language in the divorce decree stating “Each party shall be the sole owner of their respective retirement and employment benefits,” would be ineffective, even if the plan administrator could consider it, because it failed to “specifically identif[y] the benefits being waived.” This and citation to similarly stringent language from other jurisdictions leaves one wondering what exactly would satisfy this court. The contrast between the clerical exactitude required here, and the “probable intent” doctrine applicable to the interpretation of wills in New Jersey, is very striking.

Absent further case law in this area, divorced individuals should take care to execute new beneficiary designations after divorce and obtain a qualified domestic relations order (QDRO) or an explicit signed waiver from the former spouse, on forms provided by the employer, and take care to see that the QDRO or waiver is filed with the administrator of the employer plan. Anything short of this risks seeing the benefit paid to the former spouse.

Should you have questions regarding this publication or will, estate or trust related matters, please contact Capehart & Scatchard, PA.