Author: Gavin Morrissey, JD, LLM

The past decade has been witness to several changes in the laws governing the taxation of estates. With the passage of the Economic Growth and Tax Relief Reconciliation Act in 2001, the estate tax rate began a gradual decline from 55 percent in 2001 to 45 percent in 2009, while the estate tax exemption increased from $675,000 to $3.5 million over the same period. Estate planning professionals were taken by surprise in 2010 when the estate tax was completely repealed only to be reinstated with the passage of the most recent legislation, known in its abbreviated form as the Tax Relief Act of 2010.

Due to expire on December 31, 2012, the Tax Relief Act further reduced the federal estate tax rate to 35 percent and raised the estate tax exemption to $5 million per individual. The act also provided a provision (referred to as “portability”) that allows a surviving spouse to assume the unused portion of a deceased spouse’s $5 million estate tax exemption. Under current law, a couple can effectively shelter $10 million from federal estate taxes with little planning. The Tax Policy Center estimates that this latest piece of legislation will result in 99.9 percent of estates avoiding taxation.

For most clients, the estate tax has become nothing more than fodder for politicians to use as a rallying cry to increase tax revenues from wealthy families or to rail against as an assault upon small business owners and farmers. This perception may be true; however, the attention being paid to the federal estate tax system has given some clients a false sense of security against a continuing threat to their estates: state death taxes.

THE BIGGER ISSUE
Understanding that most clients, under current law, do not have an incentive to plan for federal estate taxation, it is important that advisors explore their clients’ exposure to the possibility of state death taxes. Many Commonwealth advisors have clients who reside in various states, and, at the time of this writing, Washington, D.C. and 22 states impose some form of an estate tax, an inheritance tax, or both (see Table 1).

To clarify the differences, an estate tax is imposed upon the value of the estate, and the estate assumes the tax liability. An inheritance tax, however, is imposed upon the value of property received, and the tax liability, therefore, is the responsibility of the beneficiary. To further complicate matters, many states impose different taxation depending upon the recipient classes of the estate beneficiaries. For example, a recipient class that includes a spouse and/or children may incur little or no tax liability, whereas a recipient class that includes an uncle, an aunt, a niece, or a nephew that receives the same property may be subject to taxation.

PLANNING CONSIDERATIONS
Although the average top tax rate at the state level tends to be about half of the current 35-percent federal estate tax rate, the average exemption amount also tends to be significantly lower than the current $5 million available at the federal level.

Suppose the federal estate tax rate was reduced to 15 percent but the exemption also decreased to $1 million? Undoubtedly, this development would create a sudden estate planning need for a significant number of your clients. This scenario is a reality for many who live in states that impose death taxes; however, a great number of those clients have not adequately prepared to address this issue. While 15 percent may not be as onerous as 35 percent, imagine the impact of a 15-percent tax upon an estate consisting primarily of a family business or other illiquid assets. Fortunately, there are steps that can be taken to minimize the impact of state death taxes on the value of an estate that passes to heirs.

Consult an attorney. First, ensure that your clients have visited with an attorney to provide proper estate planning documents based upon their current situation. Significant changes in your clients’ lives should trigger a review of their estate planning needs. Clients typically understand that a birth, death, marriage, or divorce would create a need to review and update their estate plans, but they sometimes ignore the effect of relocation to another state. Every state has different laws to be considered.

If you have clients who reside in or plan to relocate to any of the states in Table 1, be sure those clients have their estate plans reviewed to determine if additional tax planning is necessary. At a minimum, bypass provisions should be in place to ensure that the exemption amount of a deceased spouse can be fully utilized upon his or her death.

Consider making lifetime gifts. Once the documents are in order, clients can take additional steps to further reduce the impact of potential state death taxes. One of the most simple and efficient ways to transfer wealth out of a taxable estate is by making lifetime gifts.¹ These gifts can be further enhanced when ownership interests in an entity such as a family limited partnership or an LLC are transferred because a valuation discount may apply to the gift due to a minority interest and lack of marketability. This strategy can be particularly useful when a family business is a significant portion of the estate’s value.

Also consider gifts to purchase life insurance. The policy can be owned in trust outside of the taxable estate to provide heirs with liquidity to meet the tax liability imposed by state death taxes.

For the right client, charitable gifts are another excellent method for minimizing the impact of state death taxes. Not only does a gift to charity reduce the taxable estate, but the donor typically will also receive an income tax deduction for gifts made during his or her lifetime.

DON’T STOP THE ESTATE PLANNING
The federal estate tax is less of a concern to your clients than ever before, but that doesn’t mean that the estate planning can stop. State death taxes continue to be a factor, and many clients don’t realize the liability they may face. Because state laws vary, it is of utmost importance that your clients seek the advice of an attorney licensed to practice in the state where they reside.

1. A handful of states impose a gift tax upon lifetime transfers. Please consult with an attorney licensed in the client’s state of residence before making any gifts.

Commonwealth Financial Network® does not offer legal or tax advice.

Gavin Morrissey is the director of advanced planning. He is available at x9719 or at gmorrissey@commonwealth.com.