Last month’s article provided an overview of tax considerations that arise when death and taxes intersect: the deceased’s final income tax return; inheritance tax (none in New York); fiduciary income tax (if the estate generates taxable income); and estate tax. Now, we will consider in more depth the New York estate tax and the more than 100% marginal tax rate that can be imposed. No, that is not a typographical error! The marginal tax rate can exceed 100%.
The applicable or basic exclusion amount. In 2018, each individual is allowed to pass up to $11.18 million free of federal estate tax and, for persons dying between 4/1/2017 and 12/13/2018, up to $5.25 million free of New York estate tax. This tax benefit is sometimes referred to as the applicable or basic exclusion amount. It can be passed through lifetime gifting in excess of the annual exclusion amount (currently $15,000 per person per year), through assets that pass at death, or through a combination of the two. These tax benefits are in addition to unlimited transfers between spouses and unlimited charitable deductions. While the federal system allows any of the exclusion amount that was not used at the first spouse’s death to be transferred (“ported”) and remain available for the second spouse, New York does not provide this flexibility.
The New York estate tax system works by providing a “credit” up to the amount of tax that would have been imposed on an estate of the basic exclusion amount, e.g., $5.25 million. If the exclusion amount is exceeded by up to 5% ($262,500 in 2018, so a total estate of $5,512,500) the credit is reduced. If the exclusion amount is exceeded by more than 5%, the credit is eliminated and the entire estate is subject to New York estate tax. The estate tax rate is stepped from 5 to 16%. For example, an estate of $5.55 million, which exceeds the exclusion amount by $300,000, in 2017 would have resulted in a New York estate tax of $456,800 – meaning $156,800 more was due in tax than the amount by which the exclusion was exceeded. Thus, if an individual or a couple has (combined) assets in excess of $5.25 million that would be included in the taxable estate, New York estate tax planning is advisable.
The taxable estate. The “taxable estate” is much larger than the assets that pass pursuant to the deceased’s Last Will and Testament. It includes any assets in which the deceased had an ownership interest, including those that pass by non-probate means such as through joint ownership or beneficiary designation. Business interests such as a fractional interest in a partnership, shares in a closely held corporation, membership interest in an LLC, or keyperson insurance owned on a business partner are all included in the taxable estate.
Assets that the deceased previously sold or transferred but retained some ties, such as by keeping life estate in real property or the right to receive income, are included at their full value (not just the value of the life estate). The taxable estate even includes assets in which the deceased no longer had an ownership interest – gifts the deceased made within one year (federal) or three years (New York) of passing are “pulled back” into the taxable estate.
There are multiple tax planning strategies that can be implemented, singularly or in conjunction.
- Do nothing. After considering and weighing the options, some people decide to not take steps to minimize estate tax.
- Make gifts to remove assets from the taxable estate. Annual exclusion gifts ($15,000.00 per person per year in 2018) are not included in the taxable estate nor, after one year (federal) or three years (NY), are gifts in excess of that amount. To reduce my taxable estate, I could start systematically making gifts each year to my children, grandchildren, great-grandchildren…. The possibilities are endless!
- Divide ownership of assets between spouses. Since under New York law each spouse has an exclusion amount, ownership of assets could be adjusted and equalized between the couple so that regardless of the order of death, there would be assets available to take advantage of the deceased’s exclusion. For example, if the couple had $6 million of assets but all the assets were in Spouse 1’s name, if Spouse 2 passed away first there would be no assets in Spouse 2’s taxable estate and no assets available to use Spouse 2’s exclusion while Spouse 1’s taxable estate would exceed Spouse 1’s exclusion. Instead, if $1 million of assets were transferred to Spouse 2’s name, neither spouse would have a taxable estate upon death. Keep in mind, however, that if Spouse 2 then leaves all the assets to Spouse 1, all the assets will still be included in Spouse 1’s taxable estate and the division of ownership will have effectively been undone; if Spouse 1’s assets are not reduced before death (through spending or gifting), Spouse 1’s taxable estate will nonetheless exceed the exclusion amount.
The inability or inadvisability of transferring or re-titling some business interests or retirement accounts can limit the extent to which asset ownership can be equalized, making other strategies necessary.
- Establish a “credit shelter trust” in your Last Will and Testament. If at the first spouse’s passing the surviving spouse thinks he or she will have a taxable estate upon his or her death, the surviving spouse may elect to “disclaim” some of his or her inheritance. Disclaimer usually causes assets to pass as though the person disclaiming had predeceased the decedent; frequently, this means the assets pass to children. As part of your Last Will and Testament, a trust can be established to instead hold any assets that are disclaimed. The terms of the trust may provide that the trust assets can be used for the surviving spouse’s benefit but, since the assets are owned by the trust rather than by the surviving spouse, the assets will not be part of the surviving spouse’s taxable estate upon his or her death.
A credit shelter trust could be funded with an amount or formula set forth in the Last Will and Testament, but my general preference is for the trust to be funded with any amounts the surviving spouse disclaims in order to afford the most flexibility in terms of waiting to see both what future tax laws may be and what the couple’s future financial picture may be. Many older wills, drafted when the estate tax threshold was lower and therefore more likely to create negative tax consequences, contain rigid funding language that can have unintended practical consequences by limiting a surviving spouse’s access to assets and should be periodically reviewed.
- Include a flexible charitable bequest in your Last Will and Testament. A bequest to a charity generates an estate tax deduction, thereby reducing the amount of the taxable estate. Since it can literally be less expensive to give assets away than to pay the New York estate tax, a charitable bequest can be included in your Last Will and Testament, to be funded only to the extent that the estate would otherwise be subject to New York estate tax. Of course, charitable bequests not dependent on the value of the estate could also be included! The Northern New York Community Foundation and countless other charities and foundations enable immeasurable good to be done in our local communities.
Business interests, profit sharing plans, stock options, and keyperson insurance can quickly increase the value of the taxable estate, resulting in astonishing tax consequences. Although this article provides general information, you should consult with your attorney and/or tax accountant for advice on your particular situation.