Turning Back
the Clock:
New Jersey's "Decoupled" Estate Tax Law
By Andrew J. DeMaio, Esq.
Jim was puzzled. Seated in the spacious conference room of their lawyer's office, he and his wife Eileen were discussing updates to their wills. But something didn't sound right.
"I thought you just told us that the federal estate tax exemption was increased from $675,000 to 1 million dollars."
"That's right," came the reply.
"And there's no New Jersey inheritance tax on our estates because everything is passing to each other, then to the kids?"
"Right again."
"But now you're saying that the exemption is only $675,000 in New Jersey because of this new law." The look on Jim's face betrayed his confusion.
"Look, I know it sounds complicated. And it is. But it makes sense if you understand the background."
"OK," Jim sighed, "Fill us in." It was going to be a long afternoon.
It is a scene that is being played out repeatedly in many New Jersey law
offices these days. Faced with the most severe budget crunch in recent memory
and blindsided by revenue-robbing federal tax law changes made last year,
the New Jersey legislature, following the lead of several other states, has
responded by revising its own estate tax laws. The result, for consumers,
is an increasingly complicated patchwork of federal and state tax law. The
new law will wreak havoc on many estate plans carefully drafted under prior
law. Any will or trust with estate tax planning provisions should be reviewed,
and possibly revised, in light of the recent enactment.
Background
The federal estate tax is a tax on the transfer of wealth. It is imposed on the value of the estate at death. Deductions are allowed for assets passing to the decedent's surviving spouse or to charity. More importantly for our purposes, a credit is allowed for death taxes (inheritance taxes or estate taxes) imposed by state governments. The maximum amount of this "state death tax credit" depends on the size of the estate, but it can be as much as 16% of the adjusted taxable estate. Subject to this upper limit, it's a dollar for dollar credit -- for every dollar of state death tax imposed, a dollar credit is allowed against federal estate tax.
That means that states can enact a "painless" death tax. Up to the allowable credit amount, any estate tax imposed by the state doesn't cost the taxpayer anything in the long run because a full credit is allowed against federal tax. Even states that don't have an inheritance tax, seizing this opportunity, impose a tax equal to the amount of the federal credit. This kind of tax is referred to as a "sponge tax" or "pickup tax".
The situation has been a blissful one for the tax departments of New Jersey and other state governments. In effect, they collect a cut of the federal estate tax revenue, incurring few administrative costs in the process. Estates file with New Jersey a simple one-page form that lists the federal credit allowed, and are required to submit a copy of the federal estate tax return (Form 706) as proof of the amount of the credit. The responsibility to audit the voluminous Form 706 rests with the IRS. If any changes are made after audit, the updated federal return must be filed with New Jersey.
Then came the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), signed by President Bush on June 7, 2001. It provides for increases in the federal estate tax exemption (the new exemption is $1 million for decedents dying in 2002), and for the temporary repeal of the federal estate tax in 2010. The EGTRRA provision that threw down the gauntlet for New Jersey and other states, however, is the phaseout of the state death tax credit. EGTRRA provides that the credit allowed by Uncle Sam for state death taxes will be eliminated over 4 years. In 2005 and thereafter, only a deduction, and not a credit, will be allowed for death taxes paid to a state government. Without a federal credit, the revenue from state sponge taxes will simply disappear.
With this change, the line had been drawn in the sand. States could no longer rely on a steady stream of income from death taxes, courtesy of the folks in Washington. Estimates of revenue loss began to appear. Some states would lose up to 2% of their annual revenues. At the same time, many states, including New Jersey, were facing a severe budget crunch. The federal estate tax changes would make the situation worse. According to Governor McGreevey's 2003 Budget Highlights, "[i]f New Jersey does not address recent federal changes to the estate tax law, and allows the estate tax to expire, the State will lose $72 million in estate tax revenues in fiscal year 2003 and nearly $700 million over the next five years."
The New Law
New Jersey's response came July 1, 2002, in the form of Chapter 31 of the New Jersey Public Laws of 2002. We will refer to it in this article as "Chapter 31".
Chapter 31 provides that beginning January 1, 2002, the New Jersey estate tax shall be calculated on the basis of the federal estate tax laws that were in effect on December 31, 2001. On that date, the federal estate tax exemption was still $675,000, and the phaseout of the state death tax credit had not yet begun. Thus, Chapter 31 "turns back the clock", preserving the favorable state of affairs that existed prior to EGTRRA. At first glance, it appears to be a simple and elegant solution. On closer examination, however, snags become evident.
For example, Chapter 31 imposes New Jersey estate tax on any estate valued at greater than $675,000. But estates of under $1 million are not required to file a federal estate tax return in 2002. If no federal return is due, how will New Jersey calculate and verify the amount of the death tax credit that would have been allowed under the pre-EGTRRA federal law? The new law addresses the problem by requiring that the executor file with New Jersey a federal estate tax return "in the form in which such return would have been required to be filed with the federal government under the ...federal Internal Revenue Code... in effect on December 31, 2001". Thus, executors of New Jersey estates worth between $675,000 and $1 million, who are not required to file Form 706 with the IRS, must nevertheless prepare that form and file it -- with the State of New Jersey. To properly prepare such a return, the executor must obtain written appraisals of real estate, family businesses and other hard-to-value assets. He or she must calculate and claim deductions for marital and charitable bequests and for administrative expenses in accordance the federal law. The federal estate tax return also requires a reconciliation of any taxable gifts made during the decedent's lifetime. Estates that are large enough to require a federal estate tax return must, under Chapter 31, file with New Jersey two versions of Form 706 -- the real one as filed with IRS, and a historical one reflecting the federal law as it existed in 2001.
And how will the State of New Jersey verify the information reported on these historical estate tax returns? In the past, the State could rely on the IRS to audit the returns. It simply took into account any adjustments that resulted from the federal audit. That approach is no longer available when the filing of a federal return is not required. And how will New Jersey courts resolve disputes over such filings? Any lawsuit challenging an assessment of tax under the new law will, in effect, require the New Jersey courts to interpret and apply federal estate tax law -- not the current federal estate tax law, but the law that was in effect on December 31, 2001.
Chapter 31 anticipates this problem by permitting a "simplified tax system" to be devised by the Director of the New Jersey Division of Taxation to "produce a liability similar to the liability" determined by applying the pre-EGTRRA federal law. However, that simplified procedure is optional. It may be elected by the "person or corporation liable for the payment of the tax" imposed by Chapter 31.1
The new tax imposed by Chapter 31, according to section 2 of the law, "shall remain a lien on all property of the decedent as of the date of the decedent's death until paid. No property owned by the decedent as of the date of the decedent's death may be transferred without the written consent of the director [of the Division of Taxation], or pursuant to such rules as the director may prescribe." A similar lien for the payment of New Jersey inheritance tax attaches to estate assets. Procedures for the expedited issuance of inheritance tax waivers make the transfer of property after death manageable. In the case of the inheritance tax, the absence of tax is established by proving the relationship between the decedent and the beneficiary or beneficiaries. Transfers to a spouse, children or grandchildren, for example, are exempt. Proving that no lien attaches under Chapter 31 will necessarily be more complex. Until regulations are issued and forms are promulgated by the Division of Taxation, there appears to be no way to remove the lien on the estates of decedents dying on or after January 1, 2002.
How Much Tax?
The estate of a person dying in 2002 with assets valued between $675,000 and $1 million pays tax in the amount of the state death tax credit that would have been allowed under pre-EGTRRA law. For an estate of exactly $1 million, the amount of tax is $33,200. The computation is more complex for 2002 estates valued at over $1 million. Those estates are required to pay federal estate tax, and enjoy a partial credit for death taxes paid to New Jersey.
In 2004, the federal estate tax exemption is scheduled to increase to $1.5 million. That change will expand the range of estates that are free of federal tax, but owe tax under Chapter 31. An estate of $1.5 million will owe $64,400 of New Jersey estate tax.
In 2006, when the federal exemption jumps to $2 million, an estate of that value will be free of federal estate tax, but will be liable for $99,600 of New Jersey tax under Chapter 31.
In 2009, the federal exemption is scheduled to increase to $3.5 million. An estate of that size will, however, pay New Jersey tax of $229,200. In 2004 and after, federal law will allow a deduction, not a credit, for any death taxes payable to a state government.
Implications for Planning
The enactment of Chapter 31 has serious implications for nearly every estate plan. Under the new law, many of the tax-related formulas contained in existing wills and trusts will produce unintended results.
For example, a common estate tax planning strategy for married couples is to provide for the creation of a "credit shelter trust", also known as a "bypass trust", on the death of the first spouse to die. The amount that is sheltered by the first spouse's federal estate tax exemption is placed into the trust, protecting it from taxation on the second death and assuring that both spouses' exemptions will be used. Before the enactment of Chapter 31, this type of plan resulted in no federal or state death tax on the first spouse's death. Chapter 31, however, imposes a New Jersey estate tax of at least $33,200 on the first spouse's death. The tax on the first death can be avoided by limiting to $675,000 the amount passing to the bypass trust. However, imposing that limitation may result in a higher tax on the second spouse's death.
How much should be placed in the bypass trust? Should its size be limited to $675,000, with a view toward preventing the imposition of tax on the first death? Or should the trust be funded to the full extent of the increasing federal exemption ($1 million to $3.5 million)? A few examples will help to illustrate some of the complex considerations that enter into estate tax planning under Chapter 31. 2
Example 1 - The $1.5 million estate
Husband and Wife have a combined estate of $1,500,000. The value of Husband's assets is $1 million; Wife owns $ 500,000. Husband dies first, in 2002. Wife dies later in 2002. Are they better off if the bypass trust created on Husband's death is funded with $675,000, or with $1 million? If $1 million passes to the trust, there is no federal estate tax, but a New Jersey estate tax of $33,200 is payable. On Wife's death, her estate is only $500,000, which is free of both federal and New Jersey tax. Thus, the total tax is $33,200.
If, on the other hand, only $675,000 passes to the trust on Husband's death, there is no tax at that time. Wife's estate consists of her $500,000 plus $325,000 received from Husband's estate. The total of $825,000 is not subject to federal estate tax, but generates a New Jersey estate tax of $24,000.
In this example, limiting the amount passing to the trust appears to be the preferable strategy. Not only is the total amount of tax lower, but it is deferred until the second death.
Example 2 - The $2 million estate
Husband and Wife each own assets worth $1 million, for a total of $2 million. As in Example 1 above, on Husband's death in 2002, his entire $1 million estate passes to the bypass trust, incurring a New Jersey estate tax of $33,200. On Wife's death, her $1 million estate also incurs a New Jersey tax of $33,200, for a total of $66,400.
If only $675,000 passes to the bypass trust, no tax is due on the first death, but federal estate tax of $85,150 and New Jersey tax of $53,200 are due, for a total of $138,350. In this case, fully funding the trust with $1 million produces the lower tax.
Example 3 - The $4 million estate
Husband and Wife each own assets worth $2 million, for a total of $4 million. On husband's death, if $1 million passes to the bypass trust, there is New Jersey tax of $33,200. On Wife's subsequent death, federal tax of $793,500 and New Jersey tax of $136,500 are due, for a total of $930,000. If only $675,000 is placed in the trust on Husband's death, there will be no tax on the first death. But on Wife's subsequent death, the total tax imposed will be $1,092,500 ($933,200 federal tax and $159,300 New Jersey tax). Once again, fully funding the bypass trust reduces the overall tax.
These examples may seem to suggest that larger estates should fund the bypass trust to the full extent of the available federal exemption, even if it means paying New Jersey tax at the first death. However, the analysis is not that simple. In the Examples, we have assumed that both Husband and Wife die in 2002. However, if there is an interval of time between the two deaths, intervening events could lessen or eliminate the tax due on the second death. For example, scheduled increases in the federal estate tax exemption could take effect, or the repeal of that tax could be made permanent by future Congressional action. Or Chapter 31 could be revised, repealed or declared unconstitutional. 3
Chapter 31, EGTRRA and the prospect of amendments to both, create an extremely fluid environment for estate planning. One strategy for dealing with the uncertainty is to build as much flexibility as possible into the estate plan. Qualified disclaimers can be employed to permit the surviving spouse, shortly after the death of the first spouse to die, to fine tune the planning based on facts available at that time, but that are not known when the plan is devised. A Qualified Terminable Interest Property (QTIP) trust arrangement can place the decision in the hands of the executor of the estate of the first spouse to die.
Final Thoughts
If your will or living trust incorporates estate tax planning, it should be reviewed in light of the new law. Many estate plans are more severely affected by Chapter 31 than by EGTRRA, the federal law that spawned it. No single solution is right for every estate plan. Any adjustments should be based on a careful consideration of your particular facts and circumstances.
End Notes
1 The alternative tax system is, in the opinion of the author, a less than perfect solution to the dilemma created by reliance on historical federal law. Unless the optional system produces, in all cases, a tax that is significantly less than the death tax credit under pre-EGTRRA law, the executor of an estate between $675,000 and $ 1 million will potentially face criticism for making an election that results in more tax than necessary. In order to determine whether the simplified system produces more or less tax, the executor may well need to obtain the valuations, calculate the deductions and prepare at least a preliminary version of the pre-EGTRRA Form 706. It is not even clear that the election lies with the estate's executor alone. N.J.S 54:38-1a, as amended by Chapter 31, places the election in the hands of the "person or corporation liable for the payment of the tax". N.J.S. 54:38-6, however, provides that "all administrators, executors, trustees, grantees, donees and vendees, shall be personally liable for any and all such taxes until paid..." Must the executor obtain the consent of all such persons before making the decision? What if they fail to agree?
2 The examples are taken from Wilcox, "Wisconsin's New Estate Tax", 74 Wisconsin Lawyer No. 12, December 2001, available on the Web at http://www.wisbar.org/wislawmag/2001/12/wilcox.html. Wisconsin's decoupling legislation is temporary, but in some other respects resembles Chapter 31. The Wilcox article contains a thoughtful analysis of the Wisconsin legislation.
3 Some analysts believe Chapter 31 may violate the New Jersey Constitution because it bases the imposition of tax on a body of federal law. This may be an improper delegation of legislative authority, or may violate Article IV, Section VII, Clause 5 of the New Jersey Constitution, which prohibits the incorporation of a law by reference.