New Gifting Incentives: Return of the Deathbed Transfer

Several odd complications in the way the federal and Minnesota estate tax systems interact are creating new incentives for Minnesota residents to make large lifetime gifts; even if those gifts are made only moments before death.

by Andy Kremer

Mere moments before his death, King Edward the Confessor conveyed his entire kingdom — previously promised to his cousin William — to his chief minister, Harold Godwinson.  Or so the story goes; the manner of his conveyance and the ambiguous language he used (“I commend my wife and all my kingdom to your care”) left substantial doubt about the King’s true dying wishes and blemished the legitimacy of Godwinson’s subsequent reign.

The law has historically disfavored deathbed transfers because of the inherent questions they raise about testamentary capacity and undue influence.  Estate planning attorneys (being on average a conservative lot) also generally prefer to operate a little more deliberately with their planning recommendations.

Fortunately, state and federal lawmakers have largely cooperated in discouraging last-minute estate maneuvering by eliminating many of the tax incentives for doing so.  One example of such a legislative disincentive lies in the gift tax system itself, which some believe was enacted solely to shore up a rather obvious loophole in the estate tax.  (“If I give everything away while I’m alive, there will be nothing left in my estate to tax”).  Although lifetime gifting still has an advantage over testamentary gifts because of the tax-exclusive way in which the gift tax is calculated, a donor must live an additional three years beyond the date of a gift in order to benefit from this advantage.1 Since the enactment of the Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA”), however, several odd complications in the way the federal and Minnesota estate tax systems interact are creating new incentives for Minnesota residents2 to make large lifetime gifts; even if those gifts are made only moments before death.

Opportunity for Married Couples

One of the EGTRRA’s more broadly publicized estate tax provisions was an increase in the amount a decedent can transfer at death without incurring an estate tax (commonly referred to as the unified credit exemption). While the act increased this amount dramatically for federal estate tax purposes, and will continue to do so as shown in Table 1, the amount that can be transferred free of Minnesota estate tax remains substantially lower. Prior to EGTRRA, the federal and Minnesota exemption amounts were identical.

Beginning in 2002, the different exemption amounts created a $33,200 tax problem for Minnesota couples whose estate plans included standard credit shelter planning.  Standard credit shelter planning is an estate planning strategy for married couples; it involves placing assets, out of the estate of the first spouse to die and in an amount equal to the unified credit exemption, into a credit shelter trust (commonly “family trust” or “B Trust”).  Remaining assets are left outright or in trust for the surviving spouse.

Most estate plans that were drafted before the EGTRRA provided for the credit share to be funded with an amount equal to the federal unified credit exemption; which, beginning in 2002, exceeds the maximum that a Minnesota resident can leave to nonspouse beneficiaries without incurring a state estate tax. As the gap between the maximum federal exemption and the maximum Minnesota exemption continues to grow, the tax burden payable on the death of the first member of a married couple with traditional estate planning will also grow. For deaths in 2004 and 2005, a fully funded credit share will generate a $64,400 Minnesota tax.

Practitioner Response

The easiest solution to the Minnesota exemption “gap” may simply be to change trust-funding clauses so that they limit the credit share to the lesser Minnesota exemption amount.  This will ensure that the deceased spouse’s Minnesota exemption amount will be sheltered and eliminate any estate tax liability on the first death.  However, there is a drawback: the $650,000 difference between the current Minnesota exemption of $850,000 which is sheltered and the current federal exemption of $1.5 million that could have been sheltered may be subject to both federal and Minnesota tax on the second death at combined effective rates as high as 60 percent.  In other words, $64,400 saved now may cost $390,000 later.

The practical problem faced by estate-planning practitioners and their clients is in the uncertainty of the future liability.  The estate tax may be permanently repealed before the surviving spouse’s death, or the exemption amount may be increased. The surviving spouse may spend enough annually on gifts, medical expenses, or travel to reduce the remaining estate below her exemption, or decide to leave the difference to charity. While paying a relatively small tax now may seem like a tempting investment when compared to the potential future liability, the number of variables affecting that future liability can make for an uncomfortable choice.

Fortunately, clients probably don’t have to decide right away whether their wills should direct full or partial credit share funding.  A number of creative planning techniques, including disclaimer funding clauses, partial QTIP elections or Clayton QTIP trusts,3 have been developed by estate planning practitioners to defer the need to make a decision until after the first death. These techniques are an excellent way to help clients make solid plans for the future while preserving flexibility where appropriate. By the time a decision becomes necessary for most clients, the options and consequences will perhaps be clearer or a legislative solution will have been provided.4

In the meantime, lifetime gifting may present a partial solution.  Minnesota does not impose a gift tax.  Likewise, lifetime taxable gifts are not counted as part of a decedent’s taxable base for Minnesota estate tax purposes as they are for federal (though they are counted against the $850,000 Minnesota exemption).  Table 2 illustrates the effect a $1 million gift5would have on a hypothetical estate worth $2 million (assuming standard credit shelter planning). The first column illustrates the tax computation for traditional Minnesota estates facing the “gap” problem.  Although the combined effects of the marital deduction and the unified credit eliminate any federal tax liability, a Minnesota liability of $64,400 remains because the federal taxable estate of $1.5 million exceeds the Minnesota maximum of $850,000.  The second column assumes the same hypothetical estate, except here the decedent made a gift of $1 million shortly before death.  The federal computation is the same, since although the initial estate is $1 million less as a result of the gift, lifetime taxable gifts are added back for computational purposes. Note, however, that they do not get added back to the taxable base for Minnesota purposes.  As a result, the total Minnesota tax is only $10,000 as compared to $64,400.  The same result is obtained for deaths occurring in 2005.  In 2006 the same $1 million gift would decrease the Minnesota estate tax liability from $99,600 to $33,200.

The result in these cases is the same regardless of when the gift is made; whether three years before death or moments before.  Thus, while on the one hand this example may simply emphasize the importance of lifetime gifting as a means of minimizing estate taxes, it may also prove a useful late-life strategy for those smaller estates where aggressive lifetime gifting wasn’t as practical. In the case of the late-life planning scenario, the $1 million lifetime gift could presumably be made to an inter vivos trust identical in terms to the $500,000 credit trust that will be established at death.6  After death, the inter vivos and testamentary credit trusts could likely be merged for administrative convenience.

Opportunity for Singles

Prior to the EGTRRA, the federal estate tax laws allowed an estate to claim a dollar-for-dollar credit on its federal return for any state death taxes owed up to a certain percentage of the total tax (depending on the size of the estate). Many states, including Minnesota, simply responded with a “sponge tax,” which picked up in state taxes the maximum amount the federal government would allow as a credit against federal tax. Therefore, under prior law, the imposition of an estate tax at the state level did not affect the total taxes payable; only who they were paid to, since any taxes paid to Minnesota reduced an estate’s federal tax liability dollar-for-dollar.

The EGTRRA began phasing out the state death tax credit between 2002 and 2004, and will eventually replace it with a state tax deduction beginning in 2005.  The result of these changes is a “decoupled” state and federal estate tax system where strategic planning transactions designed to decrease the Minnesota estate tax burden will no longer be completely offset by increases in the amount owed the federal government. As mentioned above, lifetime gifts do not factor into the computation of Minnesota estate taxes other than to determine whether the exemption threshold has been exceeded.  Significant savings opportunities exist, therefore, in making large lifetime gifts; even if made shortly before death.

The example in Table 3 illustrates the benefit a $1.5 million lifetime gift would have on an otherwise taxable estate of $2 million. This example differs from the first in that we are assuming the decedent is unmarried and no marital deduction is available.  As shown in the first column, the combined federal and state estate tax liability on a $2 million estate (assuming 2004 rates) is $299,700.   The second column starts with the same $2 million estate as reduced by a $1.5 million gift shortly before death, generating a gift tax of $210,000.  Note that the starting number in the second column has been reduced only by the lifetime gift and not by the gift tax payable on the gift. This is because the illustration assumes the gift was made shortly before death and the three-year rule applies to pull the gift taxes paid back into the tax base for computational purposes. As is shown, the reduction in Minnesota estate tax (as partially offset by a smaller federal credit for state death taxes) saves a total of $67,200 in transfer taxes. Larger estates can achieve similar results from large gifts made shortly before death, though the savings on a percentage basis will be closer to 12 percent.

Basis Step-up

Both of the above examples can be implemented with little disruption to existing estate plans or administrative difficulty.  However, a potential disadvantage may be the loss of the income tax basis adjustment applicable to property received from a decedent. If the property to be gifted has appreciated substantially, the potential capital gains tax payable by the transferee may exceed the expected estate tax savings. 

Factors to consider in comparing the potential capital gains tax with the estate tax savings include: (1) the possible basis step-up for gift taxes paid on the transfer of appreciated securities,7 (2) whether the donor would be better off selling the assets and gifting cash (thereby removing the income tax cost from his or her gross estate), (3) whether the donor has a capital loss carryforward that could be used to offset gains, or (4) whether appreciated securities could be used as collateral on a loan to make gifts of cash.  It’s possible, in light of the large number of variables, that a gift of even highly appreciated securities could yield sufficient estate tax savings to offset the income tax cost.  However in all likelihood, gifts of cash or unappreciated assets will produce the best results.

Final Thoughts

The decoupled Minnesota estate tax system is offering new opportunities for estate tax savings.  From a practical point of view, however, deathbed-planning will often be a difficult and sensitive subject to broach with clients who may be coping with terminal illness or anticipating the loss of a family member.  For this reason, it may be beneficial to discuss these opportunities with clients while they are still healthy.  By establishing a framework now through which future estate-planning decisions can be made and ensuring that designated family members will have the authority to make them, significant tax savings can be harvested with a minimal amount of anxiety regarding a sensitive subject.

NOTES
1 IRC Section 2035(b)

2 The District of Columbia and 17 states have decoupled from the federal estate tax, including Illinois, Kansas, Maine, Maryland, Massachusetts, Minnesota, Nebraska, New Jersey, New York, North Carolina, Ohio, Oregon, Rhode Island, Vermont, Virginia, Washington, Wisconsin (Center on Budget and Policy Priorities).

3. For two excellent discussions on the various techniques, see Terry Slye, “Minnesota / Federal Estate Tax Decoupling Issues: ‘Breaking Up is Hard to Do,” 30th Annual Probate and Trust Law Section Conference, MSBA CLE, and Larry K. Houk, “The Latest Developments in Estate Tax Planning,” 49th Annual MNCPA Tax Conference.

4 See H.F. No. 3159 (04/01/04)

5 Although the unified credit exemption amount continues to increase for federal estate tax purposes, for gift tax purposes it remains frozen at $1 million (IRC Section 2505)

6 Care should be taken here to ensure that none of the trust’s terms would constitute a retained interest under Section 2036 or other estate tax provision.

7 Section 1015(d)(6)

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ANDY KREMER is an attorney and CPA with Boulay, Heutmaker, Zibell & Co, PLLP.  He focuses his practice on tax and estate planning issues for individuals. He can be reached at akremer@bhz.com