Increased Estate Tax Exemption and De-Coupling of Federal and State Estate Taxes May Create Results You Did Not Intend

Strong Incentives to Review Your Estate Plan

Effective January 1, 2004, the federal estate tax exemption will increase from $1,000,000 to $1,500,000, representing a significant step in the increased exemptions that are to be phased in through 2009 under the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). While these increased exemptions will provide much-needed relief by reducing or eliminating the federal estate tax payable by families of modest wealth, they also pose new challenges for estate planners and their clients.

Many Wills and Revocable Trust Agreements drafted prior to the enactment of EGTRRA contain a “credit shelter trust” or “bypass trust” preceded by a formula clause providing that the trust is to be funded with the largest amount that can pass free of federal estate tax. Such trusts are intended to make certain that each spouse makes use of his or her exemption and thus provide considerable estate tax savings.  The credit shelter or bypass trust benefits the client’s spouse and/or children during the spouse’s lifetime, and at the time of the surviving spouse’s death, bypasses his or her estate and becomes distributable to the children free of estate tax. 

These formula clauses contained in Wills or Revocable Trusts executed prior to the enactment of EGTRRA may now direct a significantly greater portion of a decedent’s estate into the bypass trust, and perhaps a smaller portion to the marital share, which solely benefits the surviving spouse. Particularly in cases where someone other than the surviving spouse is the primary beneficiary of the bypass trust or in cases where the bypass trust will receive a testator’s entire estate, the formula clause may well produce a result that is inconsistent with the testator’s intentions.  Thus, it is important that individuals have their Wills or Revocable Trust Agreements reviewed to determine whether they have a bypass trust or other provision funded by a formula clause and whether, in light of their present holdings, the portion of their estate allocated to such trust is consistent with their present wishes.

Another problem has arisen with respect to a concept known as “de-coupling.”  Although the federal estate tax exemption increases to 1,500,000 in 2004 and is scheduled to increase incrementally to $3,500,000 by 2009, many states that are strapped for revenue have not similarly increased their exemptions for estate, inheritance or succession taxes. This means that a Will or Revocable Trust Agreement establishing a bypass trust funded with the maximum amount that can pass free of federal estate taxes may result in an immediate state death tax due on the difference between the federal and state exemptions at the time of the first spouse’s death.  For example, in the state of New York, the estate tax attributable to de-coupling ranges from $64,400 in 2004 to $229,200 in 2009.

There are a number of alternative approaches to dealing with the de-coupling problem, including the use of disclaimer trusts, divisible qualified terminable interest property (QTIP) trusts and limiting the formula funding clause to the lesser of the federal and applicable state exemptions. The approach which best meets a particular client’s objectives must be assessed on a case-by-case basis, taking into account considerations including age, assets and family structure.