Sharon L. Klein
Sharon L. Klein (Handout)

On March 31, 2014, the New York State Legislature passed the Executive Budget for 2014-2015, bringing with it substantial changes to trusts and estates law in New York.

Estate Tax Exclusion Increases

The new law increases the New York estate tax exclusion amount, which was $1 million. The exclusion amount is $2,062,500 for individuals dying on or after April 1, 2014, and before April 1, 2015. The exclusion amount increases to $3.125 million in 2016, and to $4,187,500 in 2017. It then increases to $5.25 million for individuals dying on or after April 1, 2017, and before Jan. 1, 2019.

After Jan. 1, 2019, the basic exclusion amount will be indexed for inflation with a cost-of-living adjustment pegged from 2010. That should link the state exclusion amount to the federal exclusion amount in effect in 2019, and going forward. For 2014, the federal exclusion amount is $5.34 million, and projected to be $5.9 million in 2019 ($5 million, indexed for inflation since 2010).

Although the governor had originally proposed reducing the top estate tax rate from 16 percent to 10 percent, the rate reduction was eliminated from the final version of the budget bill, and the top rate remains 16 percent. Interestingly, the estate tax rate schedule is stated as applying to individuals dying between April 1, 2014, and March 31, 2015. There is no rate schedule for individuals dying after March 31, 2015. This may have the effect of eliminating the estate tax for those outside the expressed window of application, potentially signaling that the intent was to force the rate schedule to be revisited as part of next year’s budget bill negotiations.

Beware the Estate Tax Cliff

Governor Andrew Cuomo had criticized the New York estate tax for having tax rates among the highest in the country, with exemption levels among the lowest. He advocated reform of what he called the “move to die” tax by increasing the tax threshold and reducing the tax rates to put New York in line with other states. However, far from the governor’s January press release objective to “restore fairness and eliminate the incentive for older middle-class and wealthy New Yorkers to leave the State,” the increase in the New York estate tax exclusion amount fully benefits only those estates equal to or below the New York exclusion amount in effect on the date of death. This has a cliff effect:

• New York taxable estates that are less than or equal to the New York estate tax exclusion amount will pay no tax;

• New York taxable estates that are between 100 percent and 105 percent of the exclusion amount will rapidly lose the benefit of the exclusion due to a phase-out computation; and

• New York taxable estates that exceed 105 percent of the basic exclusion amount will lose the benefit of the exclusion amount entirely.

As a result, if a resident decedent’s taxable estate exceeds the basic exclusion amount by more than 5 percent, the entire taxable estate will be subject to New York estate tax. Due to modifications to the new bracket structure, if an estate does exceed 105 percent of the New York exclusion amount and is fully subject to New York estate tax, the estate tax owed will be the same amount that was owed under prior law. Accordingly, once the New York estate tax exclusion is linked to the federal exclusion in 2019, the final impact will be to exempt from New York tax those estates that are less than or equal to the federal exclusion amount. Under prior law, only estates under $1 million were exempt from New York tax. The end result is that there is no change to the estate tax consequences for estates under $1 million (not taxable under prior or current law) and estates that exceed the New York exclusion amount by 105 percent (same tax payable under prior and current law).

The cliff effect, however, can be very dramatic: For example, assume an individual dies on May 1, 2017, when the New York basic exclusion amount is $5.25 million. If that individual’s New York taxable estate was $5,512,500 (which exceeds the basic exclusion amount by $262,500 and is 105 percent of $5,250,000) the estate would pay New York estate tax of $452,300. If that individual had died with an estate valued at $5.25 million, however, the estate would have owed no New York tax. There is a New York estate tax differential of over $450,000 (or a marginal New York estate tax rate of over 170 percent) on the additional New York taxable estate of $262,500 in excess of the basic exclusion amount of $5.25 million: an arguably confiscatory result. Ironically, reducing the taxable estate with a $262,500 charitable bequest would result in a tax saving of $452,300: The tax saving is greater than the amount of the bequest by pushing the estate value down to the exclusion level.

Planning regarding how married individuals can each use his or her New York exclusion amount to potentially avoid this cliff result in both estates might merit close consideration. For example, if the first spouse to die leaves everything to the survivor, that might push the survivor’s estate into the cliff zone. Structuring the estate plan to take advantage of the exclusion amount at the first death, so for example each estate is under the cliff threshold, could potentially result in substantial estate tax savings.

Gift Add-Back

The original budget bill included a proposal to increase the New York gross estate of a deceased resident by the amount of any taxable gift made on or after April 1, 2014, if the decedent was a New York resident at the time the gift was made. In other words, although a current gift tax was not proposed, the value of taxable gifts made during lifetime was to be added back at death to increase the size of the estate, potentially subjecting those amounts to New York estate tax at a maximum rate of 16 percent. The stated intent behind the change was to close a loophole by preventing deathbed gifts from escaping the estate tax: A deathbed gift would not be subject to gift tax in New York since New York does not impose a gift tax, and the gifted assets would reduce the size of the estate for the purposes of computing the New York estate tax.

Although the add-back for taxable gifts remains in the final budget, its application has been significantly narrowed: The add-back applies only to gifts made within three years of death. Additionally, this three-year look-back applies only to gifts made on or after April 1, 2014, and before Jan. 1, 2019.

Specifically, the New York gross estate of a resident decedent will be increased by the amount of any taxable gift under Internal Revenue Code Section 2503 not otherwise included in the decedent’s federal gross estate, made during the three-year period ending on the decedent’s date of death, but not including any gift made: (1) when the decedent was not a resident of New York state; (2) before April 1, 2014; or (3) on or after Jan. 1, 2019.

The way the proposal is currently drafted, there appears to be a lack of parity with the estate tax regime: Gifts by a New York resident of out-of-state real property or tangible personal property are not specifically excluded from the proposed add-back, but out-of-state real and tangible property are specifically excluded from the New York gross estate for New York estate tax purposes. A clarification may be necessary to confirm parity.

Note also that, although New York estate taxes are generally deductible against the federal estate tax liability, the estate tax attributable to the gift add-back does not seem to be deductible. The result is that gifts added back will potentially be subject to the full maximum 16 percent estate tax rate, without any offsetting federal deduction.

‘Loophole’ Closed

Pursuant to New York Tax Law Section 601(c), an income tax is imposed on the income of a “resident trust.” A resident trust includes a trust created by a New York decedent, an irrevocable trust created by a New York domiciliary or a trust that became irrevocable while the creator was a New York domiciliary.

However, under Section 605(b)(3)(D) of the Tax Law, a resident trust will not be subject to tax if three conditions are satisfied:

1. All trustees are domiciled outside of New York;

2. The entire corpus of the trust, including real and tangible property, is located outside of New York; and

3. All income and gains of the trust are derived from sources outside of New York.

Intangible property is considered located in New York if one or more trustees are domiciled in New York. Accordingly, a New York resident trust with no trustees in New York, no assets in New York and no New York source income would not be subject to New York income tax. Often, New York tax liability at the trust level could be eliminated merely by appointing a non-New York trustee.

The Section 605(b)(3)(D) exception to the taxation of resident trusts originated from the decision in Mercantile-Safe Deposit & Trust Company v. Murphy.1 In the Mercantile case, the New York Court of Appeals held that it was unconstitutional for New York to tax a trust created by a New York resident that had an out-of-state trustee and was administered out of state, even though the primary beneficiary was a New York resident.

Instead of imposing a tax at the trust level, the new law taxes distributions of accumulated trust income to New York beneficiaries of exempt resident trusts. These “throwback” rules are perceived as a constitutionally permissible mechanism to tax accumulated income that is distributed to New York resident trust beneficiaries: The tax is imposed on the resident beneficiary and not the trust.

Changes are also made with respect to the taxation of incomplete gift, non-grantor trusts (so-called DINGs if created in Delaware or NINGs if created in Nevada). Transfers to these trusts were structured to be incomplete for gift tax purposes so no gift tax was payable, but the trusts were designed to be separate taxpayers for income tax purposes. The goal was for a New York resident to structure the trust so it was not subject to state income taxation by establishing it in a jurisdiction that did not impose an income tax on the trust. If appreciated property transferred to an exempt resident trust was sold, it might not have been subject to New York income tax that otherwise would have been payable had the New York resident grantor sold the property himself.

Under the new law, ING trusts will be decoupled from federal income tax treatment and treated as grantor trusts for New York purposes. Accordingly, the income and gains of the ING trust will be includible in the income of the New York grantor, although the trust will remain a separate taxpayer for federal purposes.

According to a memorandum issued by the governor in support of the budget, in general, from an income tax perspective, income that is earned by a trust may be included in the income of the grantor, the trust, or the beneficiaries of the trust. Under the Tax Law, however, the accumulated income (i.e. the income of a trust that is not distributed to a beneficiary) of several types of trusts is not subject to any New York tax at the grantor level, the trust level, or the beneficiary level. These categories of trusts include:

(1) non-resident trusts (i.e. a trust whose grantor is not domiciled in New York at the time the trust became irrevocable);

(2) exempt resident trusts (i.e. trusts that are exempt from New York income taxation because three conditions in Tax Law §605(b)(3)(D) are satisfied: there are no New York trustees, assets or source income); and

(3) incomplete gift, non-grantor or “ING” trusts (i.e. certain trusts that are specifically structured (i) so that the settlor’s transfer of property to the trust is an incomplete gift and (ii) to avoid grantor trust status under Sections 671 through 678 of the Internal Revenue Code).

The new law will (1) tax New York beneficiaries of exempt resident trusts on the accumulated income of the trusts when the income is distributed to the beneficiary and (2) include the income of an ING trust established by a New York resident in the current income of its grantor.

The original budget bill proposal extended the accumulation tax to New York beneficiaries of both non-resident trusts and exempt resident trusts, but the final budget language limits the tax to accumulation distributions from exempt resident trusts.

Other modifications made in the final budget language facilitate the administration and operation of the new law: The new tax applies only to (1) distributions of income accumulated in taxable years after Jan. 1, 2014, and (2) accumulation distributions of undistributed net income or “UNI,” a limitation used in federal law.2 Additionally, distributions of income are not taxable if accumulated by a trust prior to (a) the birth of a beneficiary, (b) the beneficiary turning 21 or (c) the beneficiary first becoming a resident of the state.

The law also provides a credit for exempt resident trust beneficiaries for taxes paid to other jurisdictions and requires exempt resident trusts to file information returns, including the identity of the resident beneficiary and the amount of the accumulation distribution.

The law is effective immediately and applicable to tax years beginning on or after Jan. 1, 2014. To mitigate transition issues, however, the section excludes from tax: (1) distributions of accumulated income by exempt resident trusts (except ING trusts) made before June 1, 2014; and (2) income earned by ING trusts that are liquidated on or before June 1, 2014.

GST Tax Repealed

New York’s generation-skipping transfer tax was enacted in 1999 but was not a major source of revenue. On average, fewer than 50 GST tax returns were filed and the tax generated less than $500,000 annually. The new law repeals this tax.

Portability Absent

“Portability” refers to the ability of a surviving spouse to utilize the federal unused gift and estate tax exclusion of the first spouse to die ($5.34 million for 2014). Portability has been permitted for federal purposes since 2011. Although several organizations, including the New York City Bar Association, had advocated for state-level portability to match the federal regime and facilitate planning, portability is absent from the budget legislation.

Sharon L. Klein is managing director of family office services and wealth strategies at Wilmington Trust, N.A. and chair of the Trusts, Estates and Surrogate’s Court Committee of the New York City Bar.

Endnotes:

1. Mercantile-Safe Deposit & Trust Company v. Murphy, 19 A.D.2d 765, 242 N.Y.S.2d 26 (1963), aff’d 15 N.Y.2d 579, 255 N.Y.S.2d 96, 203 N.E.2d 490 (1964).

2. See Internal Revenue Code Section 665(a).