New Estate Tax Law Can Trap the Unwary

EDITOR'S NOTE: This article was originally published in the April 2011 issue of Kiplinger's Retirement Report. To subscribe, click here.

What a relief. Now that the federal estate-tax exemption is a record-high $5 million, owners of estates worth less no longer need to worry about leaving heirs with a tax bill. Or so you thought.

But think again: It may be time to see your lawyer for an estate-plan tune-up. Even if your estate falls well below the new federal limits, you could be snared by estate taxes imposed by your state. And if your current documents include certain kinds of trusts, you could unintentionally leave your spouse or children in bad shape.

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Under the new law, you can leave up to $5 million to your heirs free of federal estate tax. Married couples can pass as much as $10 million tax-free to heirs. (A spouse can leave unlimited assets tax-free to his or her spouse.) Estates that exceed the exemption amounts will be taxed at a flat rate of 35%.

But these provisions are temporary, applying only for this year and next. If Congress and President Obama don't reach a deal by the end of 2012, the estate tax will revert to its pre-Bush levels, when estates larger than $1 million were taxed at a rate of 55%. Although that's unlikely, you must make sure your estate plans hold up no matter what Congress does. "You can choose to wait and see, but that could turn into wait and pay," says Martin Shenkman, an estate lawyer in Paramus, N.J.

Besides the higher exemption amount, the new law includes a provision that's designed to simplify estate planning for many couples. The new "portability" feature allows a surviving spouse to take the unused portion of the late spouse's estate-tax exemption. For example, say a husband and wife each has $5 million. He leaves everything to her, using none of his exemption. When she dies, the portability provision enables her to leave $10 million tax-free to her heirs. Without portability, her heirs would benefit from just her $5 million exemption; the husband's $5 million exemption would be wasted.

Congress intended that the portability provision would reduce the need for many couples to set up bypass trusts, also known as credit shelter trusts. With a bypass trust, the first spouse to die leaves assets to the trust worth up to the federal exemption amount, with the balance going tax-free to the surviving spouse. The trust is earmarked to the kids, but typically the survivor can tap trust income for living expenses. When the second spouse dies, the kids get the money in the trust tax-free, and the survivor can leave his or her own assets up to the exemption amount to the children or other heirs tax-free.

Despite the higher exemption and the portability feature, couples can still trip over tax land mines. One reason is that many existing trusts are funded by a formula that automatically funds the trust up to the federal estate-tax exemption limit.

Let's say a husband created a trust years ago when the federal exemption was $1 million. If he dies in 2011 or 2012 with a $5 million estate, the entire amount will go into the trust -- with the surviving spouse getting nothing of her own.

Even if you set up a trust today, you need to be careful because of the uncertainty over the estate tax's future. Perhaps you have a $7 million estate and you want to create a bypass trust to preserve part of your estate for your children from your first marriage. You intend for the trust to hold the federal exemption amount of $5 million for your kids when you die, and for the balance to go to your second spouse.

If you die by the end of 2012, your kids will get their full inheritance. But what if you die in 2013 when the estate-tax exemption may be back to $1 million? If your trust is funded by a formula, your children will get $1 million and your second spouse will get an unintended windfall. "You should never use a tax-driven formula provision where the inheritance turns on the timing of death and state of the law," says Jonathan Blattmachr, an estate lawyer at Milbank Tweed Hadley and McCloy.

To prevent that from happening, Blattmachr says, you should rewrite the trust to clearly state your intentions. "Your instructions should reflect your choices no matter if the exemption is $1 million or $5 million or there is no estate tax at all," he says.

Another potential problem involves state estate taxes. The District of Columbia and 17 states impose their own estate levies. That means your heirs could be stuck with state estate taxes even if they don't owe federal estate tax.

Consider the estate tax in New York, which imposes a levy on estates worth more than $1 million. An estate worth $5 million would pay no federal tax, but would owe $391,600 in state estate taxes, says Sanford Schlesinger, an estate lawyer at Schlesinger, Gannon and Lazetera, in New York City. In Connecticut, with a $3.5 million exemption, beneficiaries of a $5 million estate would be on the hook for $121,800 in estate levies, he says. Schlesinger says that in many states, there may be certain trusts that can save or defer the payment of state taxes. There is no portability for state estate taxes.

The Unintended Consequences of Portability

Even portability can be a problem, according to a number of estate lawyers. "Portability will be a disaster," says Schlesinger. For one thing, he says, both spouses would have to die in 2011 or 2012 for portability to be certain to work.

Take a married couple who has $9 million. Because their estate is less than $10 million, they decide to forgo a bypass trust. The husband dies in 2011, and the entire estate goes to his wife. If she dies in 2012 and the estate is still $9 million, the kids get the estate tax-free.

But what if the wife instead dies in 2013 with a $9 million estate? If Congress does not extend portability, the kids will pay big time. Assuming the exemption remains $5 million, the heirs will pay estate tax on $4 million. The kids would owe nothing if the couple had protected the husband's $5 million exemption amount in a bypass trust.

Congress could make portability permanent, but couples could still be at risk. Shenkman offers this scenario: Each spouse has $5 million, and the couple decides not to bother with a bypass trust. The husband dies. His assets grow to $7 million. At the wife's death, the heirs will get $10 million tax-free, but pay federal tax of $700,000 on the excess $2 million. If the husband had placed his assets into a bypass trust, the $2 million growth would have been protected from estate tax.