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You have most likely heard about the potential for either a repeal of the federal estate tax or a large increase in the amount that can be sheltered from the federal estate tax. Either of these possibilities causes many to think that their estate plans are in great shape and that they are home free as far as avoiding estate taxes. But for those who reside or own real estate in Maryland or the District of Columbia, changes in local estate taxes have added complexity and potentially greater taxes. This article explains these changes and reviews a few important rules to consider for planning. In 2001 federal legislation raised the federal estate tax exemption in stages from the then-existing level of $675,000, which meant that anyone with an estate valued at less than this amount was not subject to the tax. The exemption increased to $1.5 million in 2005, goes up to $2 million for 2006-2008, and is scheduled to increase to $3.5 million in 2009. Under the current legislation there will be no federal estate tax in 2010, and the exemption will be reduced to $1 million in 2011 and thereafter. Traditionally, most states’ estate tax exemptions mirrored the federal exemption levels. As a general rule, tax planning for the federal estate tax exemption also produced good estate tax planning for state estate tax purposes. Plans to defer or minimize the federal estate tax liability usually deferred or minimized state estate tax liabilities, as well. Under this scenario, where the state estate tax exemption mirrored the federal exemption, the state tax system was considered “coupled” with the federal tax system. Under coupled estate tax systems, increases in the federal estate tax exemption automatically resulted in similar increases in the state exemption. The 2001 federal estate tax legislation, however, effectively eliminated state estate taxes in a majority of states. (This occurred because the states based their estate tax on a credit, and the new federal legislation replaced the credit with a deduction.) Consequently, a number of states — including Delaware, Florida, and California — that had not altered their old state estate tax laws, no longer have a state estate tax. STATES DECOUPLING In response to the revenue shortfall states experienced as a result of the 2001 federal estate tax legislation, some states, including Virginia, adopted new state estate tax exemptions that mirror the federal exemption. Another approach that Maryland, the District, and other states took was to “decouple” their respective estate tax exemption from the federal levels. Maryland and Washington currently have estate tax exemptions of only $1 million, and both exemptions are not scheduled to increase with the federal exemption. Particularly for those married couples subject to Maryland or D.C. estate taxes, the traditional approach of minimizing or deferring federal estate taxes may now result in paying large and sometimes unnecessary state estate taxes due from the estate of the first spouse to die. For residents or real property owners in Maryland, the District, and approximately 15 other states that have also decoupled, estate planning now must include planning for state estate taxes. Fortunately, there are options by which this tax liability can be deferred or avoided altogether. Yet there also are other situations where the additional tax exposure still represents the best planning alternative. Suffice it to say that each case must be considered independently. BYPASSING TAXES To illustrate the effects of decoupling, consider this example: Assume that a spouse dies in 2006 with an estate plan that provides for the creation of a traditional estate tax savings trust, frequently known as a “bypass” trust. Because any amounts passing to a surviving spouse are deductible on an unlimited basis, a bypass trust allows each spouse to fully use his or her individual estate tax exemption. By using the bypass trust, a couple can essentially double the amount that passes free of estate tax on the survivor’s death. The will or revocable trust document that establishes the bypass trust has traditionally funded that trust with an amount equal to the federal estate tax exemption (currently, $2 million) of the first spouse to die. Although there would be no federal estate tax liability in this situation with the full funding of the bypass trust, if the decedent was a resident of Maryland or the District, a Maryland or D.C. estate tax liability of as much as $99,600 could result. This state estate tax liability will increase again in 2009 as the federal exemption is increased. Yet paying state estate tax upon the first spouse’s death may still represent good planning. Again, it depends on the circumstances. The payment of these Maryland or D.C. estate taxes — resulting from fully funding the bypass trust to avoid federal estate taxes — removes an additional $1 million (plus the growth on that amount) from the taxable estate of the surviving spouse. Paying $99,600 of state estate taxes upon the first spouse’s death has the potential for saving approximately $460,000 in federal estate taxes (plus 46 percent tax on the amount of growth on that $1 million). Further, that $1 million is removed from the state estate tax system in the surviving spouse’s estate. In determining whether an estate plan should pay Maryland or D.C. estate taxes after the first spouse’s death, one must consider several factors. The first thing to look at is the currently projected amount of federal estate taxes, if any, and the currently projected total of state estate taxes, if any, that will be due upon the surviving spouse’s death. One also would need to estimate, however imperfectly, future tax rates and exemptions for both federal and state estate taxes. Finally, there’s the question of whether the surviving spouse would be willing to pay Maryland or D.C. estate tax at the time of his or her spouse’s death, notwithstanding the expectations of some future tax savings. PENDING BILLS Some of these questions are difficult, if not impossible, to answer. It is likely that Congress in the next few years will enact legislation altering the amount that passes free of federal estate tax and adjusting the tax rates that apply to taxable estates. Congress may even abolish the federal estate tax altogether, and it is certainly possible that Maryland or the District may change its estate laws. Currently, for example, two bills are before the Maryland Legislature’s Ways and Means Committee that would alter the Maryland estate tax: •

Maryland House Bill 138, the Maryland Estate Tax-Family Home Protection Act, allows for a state-only QTIP (qualified terminable interest property) election. • Maryland House Bill 154, the Maryland Estate Tax-Federal Credit and Deduction for State Death Taxes and Unified Credit Effective Exemption Amount, recouples the Maryland estate tax to the federal estate tax. With such complexities surrounding estate taxes, a surviving spouse may be unwilling to pay a state estate tax that may or may not bring future tax benefits. As a very general rule, people with large estates for which it is likely that federal estate taxes will be due upon the surviving spouse’s death should consider fully funding the bypass trust upon the first spouse’s death. For those who fund the bypass trust up to the amount that passes free of the federal estate tax, a Maryland or D.C. estate tax will be due upon the first spouse’s death. Although it is usually advisable to defer the payment of any taxes, currently paying a Maryland or D.C. estate tax of approximately $99,600 is preferable to paying the federal estate tax, albeit later, of approximately $460,000. For smaller estates, for which federal estate taxes may not be due from the surviving spouse’s estate, it is often advisable to fund the bypass trust only up to the amount that passes free of the Maryland or D.C. estate tax. BUILDING FLEXIBILITY There are several techniques to build flexibility into estate plans. These have the common goal of deferring such decision-making until the first spouse’s death so that the frequently changing tax law can be assessed at that time to ensure the optimal solution. One such technique is to leave all the assets outright to the surviving spouse, but to allow that spouse to “disclaim” some amount of assets to fund the bypass trust. Under this type of disclaimer, a decision about what value, if any, to subject to state estate taxes can be deferred until shortly after the first spouse’s death. The disadvantage, however, is that the surviving spouse must follow certain rigid rules to make a qualified disclaimer. Another technique used to build flexibility into an estate plan that does not require disclaimers is the use of a QTIP trust. This trust may also provide protection against creditors for beneficiaries. This trust can elect to qualify (or not to qualify) for the federal estate tax marital deduction. By not electing marital-deduction treatment on some or all of the assets in the QTIP trust, those assets can be used to consume the estate’s federal estate tax exemption, and thereby are not taxable in the estate of the surviving spouse. One benefit of this approach is that the executor has up to 15 months from the death of the first spouse to die to determine whether state estate taxes should be paid and, if so, what amount should be paid. In sum, although the changes to the federal estate tax that began in 2001 were designed in part to simplify tax laws, the changes have had the opposite effect in Maryland and the District. Thus, particularly for couples in Maryland and the District, a good estate plan drafted a few years ago may or may not still be the best approach. It is, therefore, important that couples review their estate plan to see if state decoupling has in any way undermined their original intent or their long-term goals.


Marianne Kayan is an associate in the Bethesda, Md., firm of Paley Rothman, where she concentrates on estate planning, tax law, and commercial transactions.

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