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When buying real estate, the old saying goes, the three most important factors are location, location, and location.
Estate planning is heading in that direction too. As the federal estate tax is being eliminated for most of us (and with full repeal a possibility), state taxes are not. In fact, states are increasing their death taxes.
The state in which you die may be the single largest factor in determining your estate tax liability. Forget complex wills, trusts, and family limited partnerships. For most of us, the most effective tax planning tool will be the Mayflower moving van.
There is an irony about this. The possible repeal of the federal estate tax has increased, not reduced, the complexity of estate planning. The new estate tax battles are at the state level, not the federal level. There is only one federal estate tax system to deal with, but fifty different state death taxes.
Background The federal estate tax phase out has two components.
First, the federal estate tax exemption is increasing rapidly. This exemption had been $600,000 for many years. It is 1.5 million dollars now; it will be 2 million dollars in 2006, 3.5 million dollars in 2009, and then unlimited in 2010.
Second, the federal estate tax credit for state death taxes is being phased out and will be eliminated in 2005. It will be replaced by a federal estate tax deduction. This is somewhat technical, but the effect is this: The money collected by states from the estate tax will be dramatically reduced.
Response By the States The loss of estate taxes caused a firestorm of protest, hand wringing, and "the end of civilization as we know it" whining from the state capitals. The states will lose tax revenue (i.e., "money") unless they respond.
Each state deals with the estate tax in its own way. Some states impose a separate, stand alone, estate tax. Some impose a "sop" or "sponge" tax equal to the state credit allowed on the federal return. Some impose an "inheritance" tax, which is a direct tax on the heirs who inherit property. Others impose a combination of these taxes.
The new buzz word is "decoupling." If a state "decouples" from the federal estate tax template, that state is not allowing its own estate tax exemption to rise with the federal exemption. A state that "decouples" is grabbing estate taxes that would otherwise slip away.
Here in New York, the estate tax exemption is frozen at 1 million dollars. So, a New York resident who dies in 2004 with an estate of 1.5 million dollars will pay no federal tax, but New York estate tax on $500,000.
States in the sunbelt, such as South Carolina, Florida, and Georgia, have not decoupled, so their allure to retirees is increasing. North Carolina tracks the federal exemption but imposes a tax equal to the "old" credit for state death taxes.
Getting Information on Decoupling The best way to find out about a particular state's estate tax is on the internet. But, be careful. Just as you tell your kids not to date anybody they meet in an internet chat room, don't believe everything you find on the internet when you go to Google and search "decouple." I got 106,000 hits, most of them useless.
The best sources for information are the websites of the states' tax departments. I have found these sites to be current and very helpful. Unless you get your information there, assume that what you get from anyplace else is wrong.
Why Decoupling is Insidious "Decoupling" adds a new dimension to estate planning. In the past, we advised married clients that the federal estate tax is paid, if at all, at the second death, never the first. That's still true.
But decoupling throws in a monkey wrench. At the death of the first spouse, there may be a hefty state estate tax bill. Since wills of our married clients with credit shelter or disclaimer trusts contemplate full trust funding at the first death, the price may be a substantial state estate tax.
The Full Circle The states' responses to the federal estate tax repeal brings us full circle to where we were years ago. It's déjà vu all over again. In the dark and distant 1970s and early1980s, we would advise clients on the tax advantages of changing tax residency from the high tax states (i.e., New York) to the low estate tax states in the sunbelt (i.e., Florida, South Carolina, and Georgia). We're back there again. Let's all practice saying "Y'all."
What Can a State Tax at Death? It is critical to know what is subject to estate tax by any state. The federal government (our friends in Washington) imposes federal estate taxes on the worldwide assets of a deceased US citizen. If you owned the two robots looking for water and life on Mars, the IRS would tax them at your death.
By contrast, the states are limited by the Constitution. A state can tax a resident decedent's worldwide assets at death, just like Uncle Sam. A state can tax a non-resident only on the tangible personal property and real estate within that state.
If a resident of New York owned a hunting lodge in Alaska, at his death New York imposes its estate tax on everything the decedent owned, including intangibles (such as cash, stocks, bonds, mutual funds, and partnership interests) and his worldwide property (the hunting lodge in Alaska). But, Alaska can impose its estate tax only on the real estate located in Alaska (the hunting lodge) and the tangible personal property in Alaska (furniture and fishing rods in the lodge). Alaska cannot impose its estate tax on the decedent's intangibles, such as his stock portfolio.
Planning for the Future State death taxes are no longer an afterthought in the estate planning process. New planning techniques are emerging to address the shifting new rules.
The difficulty with many of the suggested techniques is that the planner has to know a lot about the estate and gift tax laws of many states. If the client has assets in more than one state, the problems multiply. Each state has its own quirks.
- There is some uncertainty on the calculation of the estate tax imposed on non-residents of New York who own property---especially real estate--in New York. Many non-residents are putting their New York real estate into LLCs, thereby converting "real estate" into an "intangible," and skirting the New York estate tax.
- Deathbed gifts of real estate located in a state other than the state of residency may avoid some state estate tax (but not the federal tax). That depends on the state gift tax laws.
- New trusts are emerging. For example, use a credit shelter trust limited to the state exemption amount. Then, layer a "gap" QTIP trust to cover the excess of the state's exemption and the federal exemption.
If a client changes residency to a new state, that means advising the client on more than just the estate tax laws. You then become involved in:
- Residency requirements in the new state for homestead and personal residence tax breaks.
- Terminating estate and income exposure in the "old" state.
- Income tax in the new state on retirement income, social security benefits, and sale of out of state real estate.
- The rights of surviving spouses for elective shares at death. Is the new state a community property state?
- Taxation on personal property, such as boats, airplanes, and automobiles.
- Qualification for health care benefits and nursing home benefits under Medicare, Medicaid, and private insurance plans. Will that long term care policy apply in the new state?
- Rules for probate, common law marriage, property ownership, gifts taxes, titling of assets, status of living trusts, and settlement costs in the new state.
Clients with any state estate tax exposure, especially clients with assets in more than one state, must assess their geographic options. Restructuring of asset ownership, or moving to a tax friendly state, may save tens or hundreds of thousands of dollars.
The Pilgrims got on the Mayflower to flee oppression. Almost 400 years later, many of us may be calling upon Mayflower to flee oppressive taxation.
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