by Richard T. DeCou, Esq.
Tax Planning Complexity
In our recent Alert to you we reported that, retroactive to 1/1/02, New Jersey has frozen its estate tax at 12/31/01 levels, refusing to accept the recent changes in the federal estate tax. Whereas the exemption from the federal estate tax increased from $675,000 to $1,000,000 on 1/1/02 (with future increases scheduled), the New Jersey exemption remains at $675,000. A $1,000,000 estate, exempt from the federal estate tax, would generate a $33,200 New Jersey estate tax, unless left to the surviving spouse. Secondly, the federal estate tax would phase out the “credit for state death taxes” paid (which formerly defined the amount of the New Jersey estate tax), and replace it with a deduction. New Jersey will continue to claim an estate tax equal to the full amount of the credit, ignoring its phase out and replacement in the calculation of the federal estate tax. Overall, the sum total of the federal and New Jersey estate taxes will go up.
This uncoupling of the New Jersey estate tax from the federal estate tax introduces even greater complexity to planning. To give an example:
Assume Husband and Wife are married, and each has $1 million in his or her own name.
Before New Jersey made its retroactive change, upon Husband’s death, he would direct his $1 million to a “by-pass” trust designed to benefit Wife, and at the same time to exclude Husband’s $1 million from Wife’s later estate. Husband’s $1 million estate does not exceed the “applicable exclusion” (or exemption) from the federal estate tax, so there would be no federal estate tax. Until now, New Jersey would follow the same applicable exclusion, so there would be no New Jersey estate tax either. At Wife’s later death, the same analysis would apply. With a $1 million exemption in each of two estates, their $2 million would pass to the children free of estate tax.
After New Jersey’s retroactive freeze at the $675,000 level, Husband’s estate will pay $33,200 of New Jersey estate tax on the $1 million which Husband did not leave to Wife (because it went into the by-pass trust). Wife’s estate will also pay $33,200 on the $1 million that she leaves to the children at her later death.
Suppose instead of putting $1 million into the by-pass trust, Husband puts in only $675,000, and gives the other $325,000 to Wife? There would be no federal or New Jersey estate taxes at Husband’s death. But Wife now has $1,325,000. If she dies before 1/1/04, her estate pays New Jersey estate taxes of $53,200 and federal estate taxes of $94,850 (death in 2002) or $108,150 (death in 2003). If she dies on 1/1/04, when the federal exemption increases to $1,500,000, she pays no federal estate tax. So the process of saving $33,200 at Husband’s death results in additional estate taxes in Wife’s estate of $114,850, $128,150, or $20,000, depending on the year of Wife’s later death. (Should Wife buy life insurance to cover the risk in 2002 and 2003?)
If Wife were terminally ill, and knew that she would not survive to 1/1/04, perhaps she could “disclaim” the extra $325,000, causing it to go back into the by-pass trust. By so doing she would choose to have Husband’s estate pay the $33,200 to New Jersey, instead of her estate having to pay an extra $20,000 to New Jersey plus $94,850 or $108,150 to IRS. But such disclaimer cannot be made more than 9 months after Husband’s death, nor if Wife “accepts” what Husband has left for her.
We lawyers could make the by-pass trust in the form of a QTIP trust. Husband’s executor would have the right to elect how much of this QTIP trust would qualify for the marital deduction and how much would not so qualify. The part not so qualified would operate as a by-pass trust. Instead of relying upon Wife to put $325,000 back into a by-pass trust by disclaimer, the QTIP trust would be a full $1,000,000, and the executor would decide whether it would be used as a by-pass trust for $675,000 or $1,000,000. But here again, the decision must be made on the federal estate tax return, 9 months after death.
The QTIP trust looks attractive, more attractive than relying upon the uncertainties of disclaimer. Surviving spouses are reluctant to disclaim because they feel insecure after the loss of their spouse. Often the technical requirements for disclaimer cannot be met, or the deadline passes, or the property is inadvertently accepted. Property which reaches the by-pass trust by disclaimer cannot be subject of a “limited power of appointment” whereby the surviving spouse can control who will receive the trust property after her death. Such control is often desirable and useful if years pass and circumstances change between the dates of death of Husband and Wife.
However, Wife does not want Husband’s funds in a trust (QTIP or whatever) unless the trust will save estate taxes for the benefit of their children. The applicable exclusion/exemption from federal estate tax is scheduled to increase to $1.5 million on 1/12/04 and to $2.0 million on 1/1/06. She is planning to live beyond 1/1/06. So why not receive Husband’s $1 million, add it to her own $1 million; the $2 million won’t produce any federal estate tax in 2006. The New Jersey estate tax is $66,400 on two estates of $1 million each, compared to $99,600 on one estate of $2 million. To Wife, it may be worth the extra $33,200 (paid at her death) to not have to bother with the paperwork and restrictions of a trust. (Should Wife buy life insurance in case she is wrong about her surviving to 2006?)
So what should we lawyers advise Husband and Wife to do? Can we really give them firm advice, or are we reduced to providing what-if scenarios such as this, and letting them choose? Will they understand what we have said? Can it be made understandable to the ordinary person? Will they want to pay anyone to produce these what-if scenarios which are then thrown in front of them without any reliable means of choosing among them? Few of us can predict the year of our death. Few of us believe that federal estate tax law beyond 1/1/04 will remain unchanged, because repeal in 2010 followed by reinstatement in 2011 is obviously absurd.
Given the changing and unpredictable framework, should we not maintain a strong preference for avoiding taxes here and now, and deferring possible taxes into the future? Avoid the $33,200 tax in Husband’s estate, despite the risk of paying several times that amount in Wife’s later estate — unless Wife’s mortality risk prior to 1/1/04 dictates otherwise. But we must still try to explain the tax choices and risks, the mortality tables, and so forth. Thus, estate planning has become more expensive, at least for married persons with combined estates exceeding $675,000.
Many other states are doing what New Jersey has just done. Pennsylvania has also enacted a statute tying its death taxes to 2001 levels, but with some differences compared to New Jersey’s. Thus far Florida has chosen to stay aligned with the federal credit for state death taxes, so for most persons it is once again cheaper to die domiciled in Florida. There are and will be many variations from state to state. If you move from one state to another, it will warrant a review of your will.
Existing Wills — Married Couples Need to Reconsider
If you are one of those married couples with more than $675,000 in combined estates (roughly net assets, plus proceeds of life insurance, plus pensions), you may need to reconsider your will.
In many cases your will provides for a by-pass trust (a non-marital trust, often called the “residuary” or “family” trust). Until now, because the federal and state estate taxes worked in tandem, the amount allocated to the by-pass trust was tied to the “applicable exclusion,” “unified credit,” or similar term expressing the amount which is exempt from the federal estate tax. For example, it may be expressed as an amount or fraction remaining after a marital share which reduces federal estate tax to the lowest possible amount.
With the decoupling of the New Jersey estate tax from the federal estate tax, the existing formula in your will may not produce the result which you are seeking. It is likely that there will be some New Jersey estate tax at the time of the first death, and that tax will reduce the funds left for the surviving spouse. Many people will not want that result and will choose to postpone all death taxes, even if postponement may cause the overall taxes in two estates to increase.
Those of you who have selected a stand-by by-pass trust, to be utilized only if the surviving spouse chooses to disclaim, probably do not need to rewrite your wills. If that form still suits your desires, the surviving spouse can regulate the amount which goes into the by-pass trust. He/she may simply disclaim less. In many cases, disclaimers and stand-by by-pass trusts are used when estate size is only slightly above the exemption level, and the disclaimed amount will be less than the full exemption amount; that is, only what is needed to keep the surviving spouse’s estate below the exemption level.
Those of you who utilize a QTIP trust intended to encompass both the marital and non-marital shares (not intended simply to control the marital share) may also continue to find that form appropriate. However, the great majority of our clients have preferred separate marital and non-marital shares, with little or no restriction on spouse’s access to the marital share.
And recall our earlier alert informing you that the rising “applicable exclusion” from the federal estate tax, in cases where assets have not been divided equally between husband and wife during lifetime, may leave the surviving spouse poorer than intended. That is because many formulas for determining the non-marital share of the decedent’s estate are based upon the increasing applicable exclusion, leaving a decreasing share to the surviving spouse.
Whatever the form of will which you have selected previously, you should take the time and trouble to rethink the relationship between the goal of providing for your surviving spouse and the goal of minimizing death taxes.
New Jersey Estate Tax Lien.
Mercifully, the New Jersey Division of Taxation has adopted a policy with respect to its estate tax lien which is substantially similar to its inheritance tax lien. That is:
Only half of New Jersey bank accounts, and all of New Jersey securities, are “frozen” as security for payment of the estate tax. All other assets may be freely sold or transferred. (The statute seemed to require a different interpretation, but practicality seems to have prevailed, at least temporarily.)
Even frozen securities may be sold, so long as the custodial institution retains custody of the proceeds. Also, the proceeds of frozen accounts or securities may be used to pay the New Jersey estate tax.
Should frozen assets still be needed in order to pay taxes and administration expenses, application may be made to the Inheritance Tax Bureau for permission.
The L-8 and L-9 forms have been revised. In addition to certifying that the entire estate or account passes to beneficiaries exempt from the inheritance tax, the executor must now also certify (in order to lift the estate tax lien) that “the decedent’s taxable estate plus adjusted taxable gifts for federal estate tax purposes under the provisions of the Internal Revenue Code in effect on December 31, 2001, may not exceed $675,000.” “May” is intended to mean “does” in this context, it seems. Happily, the Bureau will accept the executor’s word, at least for releasing the lien. Happily, it will accept “taxable” (roughly “net”) assets, instead of gross assets, up to $675,000.
It could be a lot worse. Nevertheless it may take considerable time in some estates to determine if the L-8 and L-9 requirement is met. The executor should have a sufficient inventory of the assets and liabilities to be able to support any certification that the estate is exempt from the estate tax.
For those unwilling to abide the inconvenience of dealing with the estate tax lien, there seem to be some easy methods of avoidance. As with the inheritance tax lien, present policy does not extend the lien to bank accounts out of state, nor to securities in companies not chartered in New Jersey. Similarly, New Jersey accounts or securities, if held by a corporation, partnership, LLC or trust, are free of the lien. Of these, the revocable trust appears to be the most convenient choice. Those of us who have thought the revocable trust to be of limited utility in New Jersey must now re-evaluate.
Should you have questions regarding this publication or will, estate or trust related matters, please contact Capehart & Scatchard, PA.
