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Understanding the State Estate Tax Exemption Trap

Don't Ignore State Estate Taxes

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NOTE: State laws change frequently and the following information may not reflect recent changes in the laws. For current tax or legal advice, please consult with an accountant or an attorney since the information contained in this article is not tax or legal advice and is not a substitute for tax or legal advice.

In 2013 the District of Columbia and the following states impose their own separate estate tax in addition to the federal tax - Connecticut, Delaware, Hawaii, Illinois, Maine, Maryland, Massachusetts, Minnesota, New Jersey, New York, Oregon, Rhode Island, Tennessee, Vermont and Washington. In the majority of these states there is a significant "gap" between the value of the federal estate tax exemption and the value of the state estate tax exemption which for married couples can cause a state estate tax to be due when the first spouse dies even though no federal estate tax will be due until after the second spouse's death.

For a chart showing past and present state estate tax information, please refer to the State Estate Tax and Exemption Chart.

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. For example, while the 2013 federal estate tax exemption is $5,250,000, the 2013 Washington exemption is only $2,000,000, which leaves a "gap" of $3,250,000 between the two exemptions. In New York the 2013 estate tax exemption is only $1,000,000, so the gap is a whopping $4,250,000.

How Can the State Estate Tax Exemption Gap Affect an Estate Plan?

Married couples who live in the District of Columbia or one of the states listed above may have a state estate tax problem when the first spouse dies. Why? Because 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. If properly structured, AB Trust planning allows married couples to pass on $10,500,000 free from federal estate taxes in 2013. But the problem for married couples who live in D.C. or one of the states listed above 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.

For example, if the estate plan of a New York couple was written many years ago to solely maximize the use of both spouses' federal estate tax exemptions (such as in 1997, when the federal estate tax exemption was only $600,000) and one of the spouses dies in 2013, then the first $5,250,000 of the estate of the deceased spouse will go into the B Trust. But since the New York estate tax exemption is only $1,000,000, $4,250,000 of the B Trust will be subject to New York 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 New York couple does not include AB Trust planning because the couple wants to rely on portability of the federal estate tax exemption? Then, assuming that the surviving spouse takes all steps necessary to elect portability, then the couple will be able to pass on $10,500,000 (if both die in 2013) free from federal estate taxes. But what about New York estate taxes? By foregoing any type of state estate tax planning, the couple will only be able to pass on a measly $1,000,000 free from New York estate taxes.

ABC Trusts Can Be Used to Plan for State Estate Taxes in Some States

So what can married couples who live in one of the states where they will be subject to the state estate tax exemption gap do? Fortunately in some of these states there are ways to plan for both state and federal estate taxes in such a way that will defer the payment of all estate taxes until after the second spouse's death by using an "ABC Trust" system instead of typical AB Trust planning. These states include Illinois, Maine, Maryland, Massachusetts, Ohio (through 2012, since Ohio's estate tax was repealed on January 1, 2013), Oregon, Rhode Island, Tennessee and Washington. It may also be possible to use ABC Trust planning in Vermont, but please consult with a Vermont estate planning attorney to be sure.

But what about states where ABC Trust planning is not possible? Then in these states married couples will still need to include AB Trust planning in their estate plans and then the surviving spouse will need to choose between paying a state estate tax after the first spouse's death or under funding the B Trust and making the portability election so that both state and federal estate taxes will be deferred until after the surviving spouse's death.

Finally, note that in any state that collects a state estate tax AB Trust planning or ABC Trust planning is necessary for married couples in order to maximize use of the state estate tax exemption of each spouse since to date none of the states that collect a state estate tax have adopted portability of the state estate tax exemption.

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