PLANNING TO AVOID STATE DEATH TAXES

Article by Thomas D. Begley Jr.

Prior to July 1, 2002, the New Jersey estate tax was a “sponge” or “pick up” tax that was essentially based on the federal estate tax.  On July 1, 2002, the tax was decoupled from the federal estate tax.  The New Jersey estate tax is now imposed upon the transfer of an estate that would have been subject to federal estate tax under the Internal Revenue Code in effect on December 31, 2001.  Essentially, this means that if a decedent’s estate exceeds $675,000, a New Jersey estate tax return must be filed within nine months of the date of death and any tax due must be paid within nine months.  The tax rate is graduated and tops out at 16%.  The tax can be significant.  For example, on an estate of $2,040,000, the tax is $106,800.

There are three main options to avoid the New Jersey estate tax.  The first option is to change residence to a state that does not have death taxes.  Twenty states have either an estate tax, an inheritance tax, or both.  These include:  Connecticut, Delaware, District of Columbia, Hawaii, Illinois, Iowa, Kentucky, Maine, Maryland, Massachusetts, Minnesota, Nebraska, New Jersey, New York, Oregon, Pennsylvania, Rhode Island, Tennessee, Vermont, and Washington.  There are limited options to residents of those states to avoid such taxes.  For many individuals, this is easier said than done.  Many seniors are reluctant to move away from children and grandchildren and some seniors have children with special needs and the seniors feel compelled to live nearby.  The second option is to make inter vivos gifts to children, other heirs, or charities to reduce the size of the individual’s estate, or even to bring the individual below the state death tax exemption.  The third option for married couples is to utilize a Spousal Lifetime Access Trust.

Spousal Lifetime Access Trust

Purpose

The purpose of a Spousal Lifetime Access Trust (SLAT) is to avoid or reduce state death taxes.  The concept was originally used to avoid or reduce federal estate taxes, but with the increase of the federal estate tax exemption, this is no longer an issue for most people.  Of the 20 states that have either a state estate or inheritance tax, only one, Connecticut, has a gift tax.  The idea is to make lifetime gifts to an irrevocable trust that would then be excluded from the estate of the donor upon death.

Design

The SLAT must be an irrevocable trust.  Essentially, the SLAT is a by-pass trust funded during the donor’s lifetime.  The difference is that typically, a bypass trust is funded on death, while the SLAT is funded during lifetime either using the state gift tax exemption in Connecticut or without regard to state gift taxes in those states that do not have a gift tax.  The SLAT is designed to provide for payment of income and principal to the spouse and, if desired, to descendants as well. Distributions can be at the trustee’s discretion, but normally distributions would be in accordance with the HEMS standard.  The idea is to make the funds in the SLAT available to the non-donor spouse and descendants without including them in the estate of the donor.  Not only the assets, but also any income produced by the assets would be excluded from the donor’s estate.

The beneficiary/spouse may be a trustee of the trust for his or her benefit, but prudence would dictate a co-trustee other than the donor.

When to Use

Normally, a SLAT would be appropriate for an older couple facing a significant state death tax.  For example, if a husband is in poor health and there is no need for the healthy spouse to fund a SLAT in reverse.

Reciprocal Trust Doctrine

Under the “Reciprocal Trust” doctrine, if an individual creates a trust for another person who creates an identical (reciprocal) trust for the first party, then courts “uncross” the trusts and treat the situation as though each person created a trust for his or her own benefit.  In order to avoid the application of the Reciprocal Trust doctrine, the following strategies might be considered:

  1. Trust.  Only have one spouse establish a trust for the other.
  2. Separate Trustees.  Have each spouse create a separate trust, but use different trustees or have different rights or establish the two trusts at different times.  It should be noted that there is no “safe harbor” to follow with respect to reciprocal trusts.

In conclusion, a Spousal Lifetime Access Trust is a tool to be used in the right situations that can effect significant New Jersey estate tax savings for clients and their families.

 

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