In 2011 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, North Carolina, Ohio, Oregon, Rhode Island, Tennessee, Vermont and Washington. In the majority of these states there is a "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.
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 2011 federal estate tax exemption is $5,000,000, the 2011 Washington exemption is only $2,000,000, which leaves a "gap" of $3,000,000 between the two exemptions. In Tennessee the 2011 estate tax exemption is only $1,000,000, so the gap is a whopping $4,000,000.
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 $10,000,000 free from federal estate taxes in 2010, 2011 and 2012. 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 2012.
For example, if the estate plan of a Tennessee couple was written many years ago to solely maximize the use of both spouses' federal estate tax exemptions (such as when the federal estate tax exemption was on $600,000) and one of the spouses dies in 2011, then the first $5,000,000 of the estate of the deceased spouse will go into the B Trust. But since the Tennessee estate tax exemption is only $1,000,000, $4,000,000 of the B Trust will be subject to Tennessee 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 Tennessee 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 and both spouses die in 2011 or 2012, then the couple will be able to pass on $10,000,000 free from federal estate taxes. But what about Tennessee estate taxes? By foregoing any type of state estate tax planning, the couple will only be able to pass on $1,000,000 free from Tennessee 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. 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.
