Estate Planning with Portability in Decoupled States

Volume 27 No. 3

By

Lisa M. Rico is a principal in the Needham, Massachusetts, firm of Shea, Diamond & Rico LLP and the co-vice-chair of the Trust and Estate Division’s Business Planning Group.

If a couple relies solely on portability for their estate plan, the couple will lose the benefit of using the first deceased spouse’s state exclusion/threshold amount. There are now over 20 different state estate tax regimes. When planning for married couples in those states, the states’ estate tax laws must be carefully reviewed and a careful analysis made to determine whether portability will be detrimental or helpful.

Before the enactment of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), Pub. L. No. 107-16, 115 Stat. 38, most states’ estate tax was tied to the federal state death tax credit (often referred to as a “pick up tax”). Pick up tax (also known as “sponge tax” or “soak up tax”) states imposed an estate tax equal to the federal state death tax credit. By 2005, EGTRRA replaced the state death tax credit under § 2011 of the Internal Revenue Code of 1986, as amended (IRC) with the federal state death tax deduction under IRC § 2058. The replacement of the state death tax credit with a state death tax deduction effectively eliminated the estate tax in states with a pick up tax. Many of those states, because of the state’s own revenue concerns, “decoupled” from the federal estate tax and enacted their own estate tax.

State Death Tax Regimes

At least 12 decoupled states and the District of Columbia are modified pick up states. Modified pick up states impose a state estate tax based on the state death tax credit under IRC § 2011 as it would have been in effect on a certain date (usually before the enactment of EGTRRA) and assuming certain threshold amounts (for example, $1 million, $3.5 million, $5.25 million, or such other amount as determined by the state’s legislature). Massachusetts is an example of a state that is now a modified pick up state. For Massachusetts decedents or nonresidents with real estate or tangible personal property located in Massachusetts, dying on or after January 1, 2003, Massachusetts imposes an estate tax equal to the state death tax credit in effect under the IRC as of December 31, 2000, for estates over $1 million. Mass. Gen. Laws ch. 65C, § 2A. Other decoupled modified pick up states and the state’s 2013 threshold amount include: Delaware, $5.25 million (Del. Code Ann. tit. 30, § 1502(c)); District of Columbia, $1 million (D.C. Code Ann. §§ 47-3702, 47-3701); Hawaii, $5.25 million (Haw. Rev. Stat. §§ 236D-3, 236D-2); Illinois, $4 million (35 Ill. Comp. Stat. 405/2); Maine, $2 million (Me. Rev. Stat. tit. 36, § 4062); Maryland, $1 million (Md. Code Ann., Tax–Gen. § 7-309); Minnesota, $1 million (Minn. Stat. §§ 291.005, 291.03); New Jersey, $675,000 (N.J. Stat. Ann. § 54:38-1); New York, $1 million (N.Y. Tax Law § 951); North Carolina, $5.25 million (N.C. Gen. Stat. § 105-32.2); Rhode Island, $910,725 (R.I. Gen. Laws § 44-22-1.1); and Vermont, $2.75 million (Vt. Stat. Ann. tit. 32, §§ 7402(8), 7442a, 7475).

Three states have their own separate estate tax. The separate estate tax is a tax not based on the pre-EGTRRA estate tax. The states with their own estate tax set their own definitions of taxable estate, estate tax rates, and exclusion/threshold amounts. Some decoupled states have an exclusion amount (in other words, the amount of the estate that exceeds the exclusion amount is subject to the state’s estate tax). Other states, including modified pick up tax states, have a threshold amount; generally once the threshold amount is exceeded, the state’s estate tax is imposed on the entire taxable estate. For example, Connecticut has its own estate tax with a $2 million exclusion amount and estate tax rates ranging from 7.2% to 12%. Conn. Gen. Stat. § 12-391. The other two states and the state’s exclusion/threshold amount are Oregon, $1 million (Or. Rev. Stat. § 118.010), and Washington, $2 million (Wash. Rev. Code § 83.100.040).

At least eight states impose an inheritance tax. An inheritance tax is imposed on the transferee of property. The tax may be imposed on lineal heirs (for example, parents, spouse, children, and grandchildren), collateral heirs (for example, aunts, uncles, cousins, and other next of kin), and unrelated persons. The persons subject to an inheritance tax, the rates, and the threshold amounts vary from state to state. Inheritance tax states include Indiana (Ind. Code § 6-4.1-2-1), Iowa (Iowa Code § 450), Kentucky (Ky. Rev. Stat. ch. 140), Maryland (Md. Code Ann., Tax–Gen. §§ 7-202, 7-203), Nebraska (Neb. Rev. Stat. § 77-2001), New Jersey (N.J. Stat. Ann. § 54:34-1), Pennsylvania (Pa. Stat. Ann. tit. 72, § 9106), and Tennessee (Tenn. Code § 67-8-303).

Traditional Marital Deduction Planning for Married Couples

Estate plans for married couples in states with a pick up tax often were designed to take advantage of the federal estate tax applicable exclusion amount as well as the state’s exclusion/threshold amount through the use of a bypass or credit shelter trust. In the typical credit shelter trust plan, on the death of the first spouse to die, an amount equal to the federal applicable exclusion amount would pass into a credit shelter trust. The remaining assets would be either distributed outright to the surviving spouse or transferred into a trust (qualifying for the marital deduction) for the surviving spouse’s benefit. The value of the deceased spouse’s taxable estate would not be subject to an estate tax because of the federal and state unlimited marital deductions and exclusion/threshold amounts. Subsequently, on the surviving spouse’s death the amount in the credit shelter trust would not be included in the surviving spouse’s estate because it was already “taxed” on the first spouse’s death. Under this technique, the estates of the deceased spouse and the surviving spouse were able to take advantage of the federal applicable exclusion amount and the state exclusion amount.

Marital Deduction Planning in Decoupled States

Post-EGTRRA, in a decoupled environment, states with lower exemption amounts than the federal applicable exclusion amount made estate tax planning more challenging. In many states, a married couple had to choose between (1) using all of the deceased spouse’s federal applicable exclusion amount, in which case the deceased spouse’s estate would pay a state estate tax, or (2) limiting the use of the deceased spouse’s federal applicable exclusion amount to the state’s exclusion/threshold amount to defer all taxes to the death of the surviving spouse, but potentially creating a larger federal estate tax on the surviving spouse’s death.

In states with a lower exclusion/threshold amount than the federal exclusion, but that allowed a separate QTIP election (in other words, the state’s QTIP election was not required to be the same as the federal QTIP election), the credit shelter technique still allowed the couple to defer both federal and state estate taxes to the surviving spouse’s death while being able to use the deceased spouse’s federal applicable exclusion and state exclusion/threshold amount. Massachusetts is an example of a state that permits a separate state QTIP election. Mass. Dep’t of Revenue, Estate Tax Issues Arising from Decoupling the Massachusetts Estate Tax from the Federal Estate Tax, DOR Dir. 03-02 (Feb. 19, 2003). To illustrate the benefit of a separate state QTIP election, assume a married Massachusetts resident dies with an estate of $10 million (and had made no prior taxable gifts). The decedent’s estate plan provided for the funding of three trusts: (1) a credit shelter trust with $1 million, which would use a portion of the deceased spouse’s federal applicable exclusion amount and the full Massachusetts threshold amount; (2) a state QTIP trust with $4.25 million, which is the difference between the federal applicable exclusion amount and the state threshold amount, over which a Massachusetts state (but no federal) QTIP election would be made, thereby using the deceased spouse’s remaining federal applicable exclusion amount; and (3) a federal and state QTIP trust with the remaining $4.75 million, for which federal and Massachusetts QTIP elections would be made. Because Massachusetts allows a separate state QTIP election, the spouses are able to use fully their federal applicable exclusion amounts and Massachusetts threshold amounts and defer both federal and Massachusetts estate taxes until the death of the surviving spouse. Other states that allow for a separate QTIP election include Indiana (Ind. Code § 6-4.1-3-7), Illinois (35 Ill. Comp. Stat. 405/2(b-1)), Kentucky (by administrative pronouncement), Maine (Me. Rev. Stat. tit. 36, § 4062), Maryland (Md. Code Ann., Tax–Gen. § 7-309), Ohio (Ohio Rev. Code Ann. § 5731.15(B)), Oregon (Or. Rev. Stat. §§ 118.013, 118.016), Pennsylvania (Pa. Stat. Ann. tit. 72, § 9113), Rhode Island (R.I. Div. of Taxation Declaratory Rulings, Rul. Req. No. 2003-03 (Apr. 16, 2003)), Tennessee (Tenn. Code §§ 67-8-304 (10)(A), 67-8-315(a)(6)), and Washington (Wash. Rev. Code § 83.100.047). New York allows for a limited separate QTIP election when no federal estate tax return is required to be filed. Office of Tax Policy Analysis, Qualified Terminal Interest Property (QTIP) Election for New York State Purposes When No Federal Return Is Required, Tech. Mem. TSB-M-10(1)M (Mar. 16, 2010), www.tax.ny.gov/pdf/memos/estate_&_gift/m10_1m.pdf.

Some states such as New York do not permit a QTIP election separate from the federal QTIP election, except in certain limited circumstances. If the decedent in the above example died a resident of New York instead of Massachusetts, the New York couple must decide whether to use fully the federal applicable exclusion amount or to defer New York state estate taxes until the surviving spouse’s death. If the couple had the same plan as the Massachusetts couple described in the paragraph above, the deceased spouse’s estate would incur a New York estate tax of $420,800 because the estate would not be able to make a separate New York state QTIP election for the state QTIP trust. If the deceased spouse’s estate made a federal and state QTIP election for the state QTIP trust, then on the death of the surviving spouse both the state QTIP and the federal and state QTIP trusts (with an approximate value of $9 million assuming no appreciation or depreciation) would be included in the surviving spouse’s estate for federal estate tax purposes, thereby wasting $4.25 million of the deceased spouse’s federal applicable exclusion amount.

Portability

On December 17, 2010, President Obama signed into law the Tax Relief, Unemployment Reauthorization, and Job Creation Act of 2010 (TRA 2010), Pub. L. No. 111-312, 124 Stat. 3296, which, among other significant tax-related provisions, extended the so-called Bush-era tax cuts enacted under EGTRRA, increased the applicable exclusion amounts for estate and gift tax purposes, increased the generation-skipping transfer tax exemption, and enacted a new system of portability for federal gift and estate tax purposes. Portability refers to the ability of the executor of the deceased spouse’s estate irrevocably to elect to transfer that spouse’s unused applicable exclusion amount (the “deceased spousal unused exclusion amount” or DSUEA) to the surviving spouse. IRC § 2010(c)(4). The American Taxpayer Relief Act of 2012 (ATRA), Pub. L. No. 112-240, 126 Stat. 2313, enacted into law on January 2, 2013, made permanent the estate, gift, and generation-skipping transfer tax laws enacted under TRA 2010, including portability.

Portability in Decoupled States

Although portability is available for estates of decedents for federal estate and gift tax purposes, currently no states allow portability of a deceased spouse’s state exclusion/threshold amount to the surviving spouse. In fact, New York’s Office of Tax Policy Analysis issued Tech. Mem. TSB-M-11(9)M, Supplemental Information on New York State Estate Tax Filing Requirements Related to the Federal 2010 Tax Relief Act, dated July 29, 2011, www.tax.ny.gov/pdf/memos/estate_&_gift/m11_9m.pdf, stating that there is no portability of the New York state estate tax exemption. In many states with a state estate tax, if spouses want to simplify their estate plans by leaving everything to the surviving spouse and opting for portability, the deceased spouse’s estate will not be able to take advantage of the state’s estate tax exclusion/threshold amount. This will increase the amount of state estate taxes incurred by the surviving spouse’s estate.

For example, assume a Massachusetts couple had a combined estate of $2 million and, for simplicity, established estate plans that left everything to the surviving spouse. On the death of the first spouse, all of the assets of the deceased spouse pass to the surviving spouse, and the deceased spouse’s executor makes the portability election for federal estate tax purposes. There is no federal or Massachusetts estate tax because of the unlimited marital deductions. But, on the death of the surviving spouse, the surviving spouse’s estate would be $2 million, which would be subject to a Massachusetts estate tax of $99,600. The price for taking advantage of portability in this situation was $99,600 in Massachusetts estate taxes. In states with a higher exemption rate, this additional estate tax incurred would likely be higher. If the couple had used traditional marital deduction planning, the couple could eliminate all Massachusetts estate taxes. On the deceased spouse’s death, the deceased spouse’s estate would fund a credit shelter trust with the Massachusetts threshold amount, thereby resulting in no Massachusetts estate tax. On the death of the surviving spouse, the surviving spouse’s estate would include only $1 million, which would not be subject to a Massachusetts estate tax. Therefore, in decoupled states planning with portability can be disadvantageous and result in the surviving spouse’s estate’s paying a larger state estate tax or an estate tax that could have been avoided.

As explained above, taking full advantage of portability on the death of the first spouse can result in losing the ability to use one spouse’s state death tax exclusion/threshold amount. In states that do not allow a separate QTIP election, however, portability may provide an opportunity for the estate of the first spouse to die. By using the deceased spouse’s state exclusion/threshold amount and portability, spouses in a state that does not allow for a separate QTIP election can reduce their overall state estate taxes and not increase the surviving spouse’s federal estate tax.

In states similar to New York that do not allow for a separate QTIP election, the technique would be for the deceased spouse’s estate to make a larger federal QTIP election to eliminate all federal and state estate taxes on that estate, then make a portability election for the difference between the federal applicable exclusion amount and the state’s threshold amount. For example, if a New York married resident died with an estate of $10 million (and made no prior taxable gifts) and the couple wanted to defer taxes until the death of the surviving spouse, the deceased spouse’s executor can use portability to defer the New York estate tax while preserving the deceased spouse’s unused applicable exclusion amount. The plan would provide for the funding of two trusts on the deceased spouse’s death: (1) a credit shelter trust with $1 million, using part of the deceased spouse’s federal applicable exclusion amount exemption and the full New York threshold amount; and (2) a federal and state QTIP trust with $9 million, for which federal and New York state QTIP elections would be made. The deceased spouse’s executor would then make a portability election on the federal estate tax return to transfer the spouse’s DSUEA to the surviving spouse.

What if, in the above example, the deceased spouse’s estate were below the federal applicable exclusion? The estate would not be required to file a federal estate tax return. If we take New York as an example again, if the executor of the estate decides to file a federal estate tax return to make a portability election, but does not make a federal QTIP election, the executor cannot make a New York state QTIP election. The New York State Department of Taxation and Finance issued Tech. Mem. TSB-M-11(9)M, which provides that even if a federal estate tax return is filed solely for the purpose of electing portability, the same QTIP election reflected on the federal estate tax return must be made for New York estate tax purposes. Accordingly, if a QTIP election is not made on the federal estate tax return, a QTIP election cannot be made for New York estate tax purposes. If no federal estate tax return is filed at all, then a separate New York state QTIP election is allowed.

Assume the deceased spouse had a $5 million estate. If the estate files a federal estate tax return to make a $4 million QTIP election and a portability election to defer the New York estate tax, will the QTIP election be respected for federal and New York estate tax purposes? In Rev. Proc. 2001-38, 2001-1 C.B. 1335, the IRS determined that because the estate of the deceased spouse did not need a federal QTIP election to reduce the federal estate tax liability to zero, the federal QTIP election would be treated as null and void. PLR 201131011. If the QTIP election is treated as null and void for federal estate purposes, will it also be treated as null and void for New York state QTIP purposes? There is no clear answer to this question. New York or any other state that does not allow a separate QTIP election could determine that, because the federal QTIP election was actually made, that it would be valid, but there is no guidance on this issue. In fact, each state that does not allow a separate state QTIP election may come to a different conclusion on this issue.

Another alternative in this situation would be to rely on Rev. Proc. 2001-38. Instead of making a federal QTIP election and a portability election, the executor of the deceased spouse’s estate just makes the federal QTIP election and relies on Rev. Proc. 2001-38 to have the federal QTIP election disregarded in the estate of the surviving spouse. In that case, the deceased spouse’s federal applicable exclusion amount would be applied to the trust for which the QTIP election was made. There is still, however, the question of how the states that do not allow a separate QTIP election would treat the state’s QTIP election if the federal QTIP election is disregarded by the IRS. See Mitchell M. Gans & Jonathan G. Blattmachr, Decoupling, Portability and Rev. Proc. 2001-38, LISI Est. Plan. Newsl. No. 1965 (May 21, 2012), www.leimbergservices.com, for an in-depth discussion of this planning technique.

Portability provides estate planners with a tool when planning a married couple’s estate. There are a number of reasons, however, why portability should not be the primary tool for planning a married couple’s estate, including, but not limited to, the potential waste of a decoupled state’s exclusion/threshold amount, the limited time for which portability is available, and the uncertainty of what will happen if it does not become a permanent part of our transfer tax system. If the couple relies solely on portability, the couple will lose the benefit of using the deceased spouse’s state exclusion/threshold amount. In some situations, using portability as part of the plan can help avoid a state estate tax in a decoupled estate. There are now over 20 different state estate tax regimes. When planning for married couples in those states, the states’ estate tax laws must be carefully reviewed to determine whether portability will be detrimental or helpful.

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