Of Death and Decoupling

Since the early 1980s, the will for married people has changed very little, but beginning next year, couples will be well advised to revisit those estate documents. In 2005 a provision of the 2001 Tax Act kicks in, reforming the way federal and state tax authorities treat estates. This event has significant implications for the structuring of married peoples' finances. In the current environment,

Since the early 1980s, the “standard” will for married people has changed very little, but beginning next year, couples will be well advised to revisit those estate documents.

In 2005 a provision of the 2001 Tax Act kicks in, reforming the way federal and state tax authorities treat estates. This event has significant implications for the structuring of married peoples' finances.

In the current environment, a “standard” estate plan for a married couple features a will that divides a deceased spouse's estate into two parts. The first part, consisting of assets equal in value to the maximum federal estate-tax exemption amount, gets held in a “credit shelter” trust. The remaining second part of the estate passes outright to the surviving spouse (or to a marital deduction trust for that spouse).

This brand of estate plan is sometimes referred to as a “credit shelter/marital will.” It is designed to ensure that a married couple enjoys the benefit of sheltering two estate-tax exemptions at death instead of only one.

Historically, since the state estate-tax exemption amount was equal to the federal estate-tax exemption amount, this standard estate plan would result in no federal or state estate taxes paid at the death of the first spouse.

In light of the provision set to kick in next year, though, in many states this plan may now result in a significant state estate tax, because of a phenomenon known as “decoupling.” The adverse effects of decoupling can be avoided, but only through appropriate revisions to the client's will.

What is Decoupling?

The federal estate tax as it existed prior to the 2001 Tax Act provided for an estate tax revenue-sharing arrangement between the federal government and the states. Under that arrangement, the federal government allowed a credit against the federal estate tax for state estate taxes. (This is known as the “state death-tax credit.”)

The amount of the state death-tax credit was established by a table in the federal estate tax-return instructions. Rather than create and enforce a complicated inheritance tax system, many states simply charged a tax exactly equal to the credit allowed in this table. These state taxes are sometimes referred to as “sponge taxes” or “soak-up taxes” because they soak up whatever credit is available against the federal estate tax.

Beginning in 2005, the 2001 Tax Act eliminates the state death-tax credit. For a state that charges a tax exactly equal to the state death-tax credit, the elimination of the state death-tax credit effectively repeals that state's inheritance tax. Many states have responded to the elimination of the state death-tax credit by establishing their own separate state estate taxes. (Estate-planning lawyers refer to this separation of the federal and state estate-tax systems as the “decoupling” of these systems.)

In general, the amount that can pass, free from state tax, in decoupled states ranges from $675,000 to $1,000,000, which is less than the new $1,500,000 federal estate-tax exemption. As a result, many estates using the standard credit shelter/marital estate plan will now owe state estate tax even though they are exempt from federal estate tax, as shown in the following example.

Assume a married New York resident dies with an estate of $3,000,000 in 2004 when the federal estate-tax exemption is $1,500,000. New York is a decoupled state, and its state estate-tax exemption is only $1,000,000. Under the standard credit shelter/marital estate plan the credit shelter trust would be funded with $1,500,000. The balance of the estate, $1,500,000, would pass to the surviving spouse. No federal estate tax would be due, but a New York tax of approximately $64,000 would be due.

If the New York resident died in 2006, when the federal exemption is $2,000,000 rather than $1,500,000 (but the New York exemption is still only $1,000,000), the New York tax would increase to over $99,000.

How to Deal

These adverse results can be avoided, but only if the clients change their wills to provide for the credit shelter trust to be funded with only that amount that will produce neither a federal nor a state estate tax. (In the above example, this amount would be only $1,000,000.)

Of course, though reducing the size of the credit shelter trust is effective to shelter assets from the state estate tax at the death of the first spouse, the drawback is that a smaller credit shelter trust means a smaller amount will pass tax-free to the client's children when the surviving spouse dies.

For clients who want to leave all of their options open, more sophisticated planning can provide for the surviving spouse or the executor of the client's estate to decide to add the extra $500,000 to the credit shelter trust at the time of the client's death.

Decoupling affects estate planning for virtually every affluent married couple. Addressing the problem requires the couple to take action and revise their wills. A proactive advisor can add value by raising this issue with the client and suggesting that the client speak with a qualified estate-planning attorney to make the necessary changes in the client's will that will solve the problem and leave planning options open for the client's family at the client's death.

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