Summer 2004: DB&M Reports to Clients

In our September 2002 Report, we noted that the Tax Act of 2001 could cause unexpected consequences for persons who fail to restructure their estate plans in light of the new law. Under the new Act, formula clauses in Wills that automatically adjust with the phased-in increases in the Federal estate tax exemption between 2001 and 2009 could reduce or eliminate the amount of assets passing outright to or for the benefit of a surviving spouse. This Report highlights yet another dilemma created by the new Act - one that arises from the "decoupling" of the Federal and state exemptions.

As noted in the last Report, the Federal estate tax exemption increased from $1,000,000 to $1,500,000 in 2004, while the New York estate tax exemption remains at $1,000,000. As a result of this "decoupling" of the exemptions in New York and a number of other jurisdictions (such as New Jersey and Virginia), a portion of a person's assets (i.e., an amount equal to the difference, or $500,000) could be subject to the state estate tax. One estate plan most likely to be negatively affected by this decoupling is a plan widely used by married couples that first incorporates formula language to create a "Credit Shelter Trust" (or "by pass trust") designed to hold property equal to the maximum Federal exemption for the benefit of descendants (or for the spouse and descendants, in the Trustee's discretion). Then, the plan typically provides for a spousal bequest of the balance of the estate assets, either outright or in trust, thereby reducing any estate taxes payable at the death of the first spouse to zero.

This familiar plan continues to be effective to produce a zero taxable estate for Federal purposes, since it fully utilizes the Federal estate tax exemption to fund the Credit Shelter Trust and allows the Marital Deduction to shield the balance of the assets passing to the spouse. However, this plan could result in a state estate tax if Federal and state regimes have been decoupled. For example, New York estate tax would be imposed on the additional $500,000 in excess of the maximum $1,000,000 state exemption, resulting in a tax of $64,400. This situation becomes more onerous over time. With the Federal estate tax exemption scheduled to increase to $2,000,000 for years 2006, 2007, and 2008 and to $3,500,000 in 2009, the New York estate tax liability (computed with an exemption still fixed at $1,000,000) would be $99,600 for the years 2006-2008 and $229,200 in 2009.

The dilemma faced by planners is whether to aim to eliminate the state estate tax occasioned by the Federal and state exemptions no longer being in sync. This may not always be an easy choice, because if a current state estate tax is paid, there could be a significant decrease in Federal and state estate tax payable at the subsequent death of the surviving spouse. Decision-making may involve taking into account a variety of factors, including the health, domicile and likely needs of the surviving spouse, as well as the nature of the assets and the lingering question of whether the Federal estate tax will in fact be permanently repealed in 2010.

To avoid a state estate tax at the death of the first spouse under these circumstances, married couples have various solutions to consider. They could revise their Wills to include greater flexibility by (i) granting broader discretion to the Executor in taking advantage of the available tax elections, (ii) changing the formula language to limit the amount of assets passing to the Credit Shelter Trust so that it does not exceed the applicable state exemption of $1,000,000, or (iii) making express provision for a "qualified disclaimer" by the spouse. In addition, a lifetime gift-giving plan could be utilized to avoid the state tax under certain circumstances. Given the uncertainties, most situations will involve a commitment to a regular review of the overall estate plan in light of changing tax laws, family circumstances, and asset values.

To briefly summarize some of the potential methods for reducing or avoiding the state estate tax at the death of the first spouse:

Granting Broader Discretion. A Will can be drawn to grant the authority to an independent Executor to determine the amount qualifying for the Marital Deduction for the spouse's benefit. One method has become known as a Clayton Qualified Terminable Interest Property Trust (a/k/a "Clayton Q-TIP"). The Executor can then take into account the circumstances prevailing at the time and decide whether or not it is preferable to incur the additional state estate tax and protect more asset value from estate tax at the subsequent death of the second spouse.

Limiting Formula Language. The Will could simply limit the Credit Shelter Trust to the dollar amount of the current state exemption. Alternatively, formula language in the Will can limit it to the amount of the state exemption prevailing at death. In New York, this would result in a Credit Shelter Trust of $1,000,000 at the present time, but could accommodate a future legislative change in the applicable state exemption amount. This would assure a zero estate tax at the death of the first spouse, as had been intended before the Federal and state exemptions were decoupled.

A Second Look With a Disclaimer Will. Building flexibility into an estate plan so that the surviving spouse can take a "second look" may be a more desirable approach for some situations. This can be accomplished if the Will of the first spouse to die transfers his or her assets outright to the surviving spouse, and also provides that any amount the surviving spouse "disclaims" (or declines to accept) within the permissible nine-month period after death will be placed in a Credit Shelter Trust for other beneficiaries. Such a "disclaimer" would permit the surviving spouse to determine whether the scheduled increases in the Federal estate tax exemption might cause too much of the decedent's estate to be placed in trust for the surviving spouse. This method gives the surviving spouse a "second look" at both the prevailing tax laws and his or her own financial needs before making a determination.

Lifetime Gifts. Gifts during lifetime can be made in an appropriate situation to use the difference between the amounts of the Federal and state exemptions without any adverse estate tax consequences. See "Yes, You Should Make Gifts" in our February, 2004 Report.

Regular Review: Current Circumstances, Assets and the Credit Shelter. Spouses should be committed to periodically reviewing the way in which their assets are divided between themselves to determine whether each has in fact enough assets to take advantage of the increased estate tax exemption amounts. Then, there is the separate question of whether a formula clause that references the expanding Federal estate tax exemption may inadvertently place too much in a Credit Shelter Trust, thus creating a state death tax liability due to the decoupling or, in certain situations, reducing the amount of assets available for the surviving spouse. All persons utilizing a formula that references the Federal estate tax exemption (or the separate Generation-Skipping Tax exemption) should review those provisions in light of current circumstances to see if they are still comfortable with the automatically expanding formula. A watchful eye must also be trained on the other scheduled changes in the Federal and state transfer tax rules.

Many estate plans may need to be modified to either take full advantage of the recent changes in the tax laws or avoid some unintended consequences. If you would like more information, please contact our Estates, Trusts and Private Clients practice group, or sign our guest book at www.dunnington.com and type "Estate Planning Information." We will be happy to discuss these planning options with you at your convenience.

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Joseph Michaels IV is the principal draftsman of this issue of Estate and Tax Planning with assistance from associate Emilie M. Baser.