Understanding the Death Tax
Planning for death is morbid. Unfortunately, the alternative -not planning at all -may be financially detrimental to our children, or other beneficiaries. Therefore, it's instrumental to try and understand the complicated nature and rules surrounding the New York and Federal estate tax ("death tax"). This article will provide a brief explanation and some very basic concepts in connection with estate taxes.
The first basic concept to understand about the New York and Federal estate tax is the marital deduction. The marital deduction means that a surviving spouse does not pay any estate taxes upon the first spouse's death. The tax is deferred until the death of the surviving spouse. The public policy behind this law is clear -surviving spouses should not be forced to sell their homes or other assets (in the case of illiquid estates) to pay the estate tax.
Next, we must distinguish between state and Federal estate taxes. In New York, a deceased domiciliary may pass up to $1,000,000 to his or her beneficiaries tax free- this is referred to as the estate tax exemption or exclusion. So, if a New York resident passes away with $1,000,000 in his name, his or estate is not taxed and the beneficiary receives the property tax-free. However, if a New York resident passes away leaving more than $1,000,000, his or her estate is taxed at a tax rate capped at 16%. Please note that New York does not have a gift tax (no taxes on gifts made during a persons lifetime). As made permanent by the American Taxpayers Relief Act of 2013 ("ATRA"), the federal estate tax exemption is $5,250,000. The federal estate and gift tax is unified so that lifetime gifts reduce the available federal exemption to the extent made. The federal tax rate is capped at 39.6%.
Another significant difference between the New York and federal estate tax is that the federal estate tax exemption is portable. The New York estate tax exemption is not portable. Portability means that if one spouse passed away not using up the entire $5,250,000 the surviving spouse can make use of the deceased spouse's unused portion. Therefore, a Husband and Wife can pass up to $10.5 million to their heirs without paying a federal estate tax. Let's illustrate with a simple example:
Husband has $5,250,000 and Wife has $5,250,000. Husband passes away first leaving everything to his Wife and and therefore does not use any of his $5.25 million exclusion (because all passed to his wife). When the Wife passes away at a later date she leaves behind $10,500,000 to her children without paying any federal estate taxes (the $5.25 million she inherited from her husband and the $5.25 million she owned). However, if they were New York residents, the children would owe a state estate tax of $1,680,000 (16% of $10.5 million).
Let's also take a look at an example to illustrate that New York does not have portability:
Husband has $1,000,000 and Wife has $1,000,000. Husband passes away first leaving everything to his Wife. Wife then passes away and leaves behind $2,000,000 to her children. The Wife's estate must pay the New York estate tax on the $2 million because the estate is larger than $1 million and the Husband's unused exemption lapsed at his death.
If the Husband and Wife in either example engaged in estate planning with a knowledgeable attorney, they could have achieved better results. In our first example, the couple would have been well advised to create a "credit shelter trust" in their Wills. This type of a trust preserves the exemption (as does portability) however various other advantages including the reduction in the New York estate tax paid would be gained (there would be less in New York estate taxes paid because the tax is progressive). A credit shelter trust typically provides that the surviving spouse has the right to use the property (in case of real estate) and the right to income and support from the trust property but upon the surviving spouse's death passes to the children, or other beneficiaries. The property in the trust also has creditor protection and protection of the assets from a potential future spouse (in the event the surviving spouse remarries). The couple from our second example would have avoided the New York estate tax entirely had they employed this planning strategy. This is so because the Husband's credit shelter trust would have been funded with his $1 million instead of disappearing along with his death. Therefore the Wife would pass away with only her own $1 million and the children receive $2 million tax free.