Understanding the State Estate Tax Exemption Trap

The District of Columbia and 13 states impose their own separate estate tax in addition to the federal estate tax. They include Connecticut, Hawaii, Illinois, Maine, Maryland, Massachusetts, Minnesota, New Jersey, New York, Oregon, Rhode Island, Vermont, and Washington.

There's a significant "gap" between the value of the federal estate tax exemption and the value of the state estate tax exemption in many of these states. The gap can result in a state estate tax being due when the first spouse dies even though no federal estate tax will be due until after the second spouse's death.

What Is the State Estate Tax Exemption Gap?

The state estate tax exemption gap refers to the difference between a state's estate tax exemption and the federal estate tax exemption. The 2021 Maine exemption was only $5.87 million in 2021, while the 2021 federal estate tax exemption was $11.7 million, and it increased to $12.06 million in 2022. This leaves a "gap" of $5,830,000 between the two exemptions in tax year 2021, increasing to $6,190,000 in 2022 if the state doesn't increase its exemption by that time.

The estate tax exemption was only $1 million in Massachusetts, so the gap was a whopping $10,700,000 in 2021, increasing to $11,060,000 in 2022.

The result of this "gap" in estate tax exemptions is a much larger taxable estate at the state level than at the federal level. The tax on each estate must be calculated and paid twice (and for two separate amounts), once at the state tax level and again at the federal level.

How Can the Gap Affect an Estate Plan?

Married couples who live in the District of Columbia or a state with its own estate tax may have a problem when the first spouse dies.

The typical estate plan for married couples will include AB trusts, which are designed to maximize the use of the federal estate tax exemptions of both spouses. AB trust planning allows married couples to pass on $11.7 million free from federal estate taxes in 2021 and $12.06 million in 2022 when it's properly structured.

The problem for married couples who live in one of these states is that AB trust planning has nothing to do with minimizing state estate taxes. This problem is exacerbated by the introduction of "portability of the federal estate tax exemption" between married couples for deaths that occur in 2011 or later years.

An Example of the Gap and an AB trust

The first $11,700,000 of the deceased spouse's estate would go into the B trust if the estate plan of a Massachusetts couple was written years ago to solely maximize the use of both spouses' federal estate tax exemptions and one of the spouses died in 2021. This might have been the case in 1997 when the federal estate tax exemption was only $600,000.

But the Massachusetts estate tax exemption is only $1,000,000, so $10,700,000 of the B trust will be subject to Massachusetts estate taxes. This will definitely be a surprise to the surviving spouse who was told years ago when the estate plan was drafted that estate taxes would only be due and payable after both spouses are gone.

What if the estate plan of the Massachusetts couple does not include AB trust planning because the couple wants to rely on portability of the federal estate tax exemption? Assuming that the surviving spouse takes all steps necessary to elect portability, the couple will be able to pass on $23,400,000 free from federal estate taxes in 2021.

But what about the Massachusetts estate taxes? the couple will only be able to pass on $1,000,000 free from Massachusetts estate taxes by foregoing any type of state estate tax planning.

ABC Trusts Can Be Used to Plan for State Taxes

Fortunately, there are ways you can plan for both state and federal estate taxes in some of these states that will defer the payment of all estate taxes until after the second spouse's death. Spouses can use an "ABC trust" system instead of typical AB trust planning in Illinois, Maine, Maryland, Massachusetts, Rhode Island, and Washington.

Married couples will still have to include AB trust planning in their estate plans in states where ABC trust planning isn't possible. The surviving spouse must choose between paying a state estate tax after the first spouse's death or under-funding the B trust and making the portability election. This would allow both state and federal estate taxes to be deferred until after the surviving spouse's death.

AB or ABC trust planning is necessary for married couples in order to maximize use of the state estate tax exemption of each spouse in most of the states that collect a state estate tax. Only Hawaii and Maryland recognize portability of their state estate tax exemptions.

NOTE: The information contained in this article is not tax or legal advice, and it is not a substitute for such advice. State and federal laws change frequently, and the information in this article may not reflect your own state’s laws or changes to the law. Please consult with an accountant or an attorney for personal tax or legal advice.