The Changing State and Federal Estate Tax Systems:Estate Tax Planning Now Can Mean Big Tax Savings Later
The Changing State and Federal Estate Tax Systems:
Estate Tax Planning Now Can Mean Big Tax Savings Later
Oregon Lodging Association’s "Lodging News"
November 2005
In 2001, Congress passed the Economic Growth and Tax Relief Reconciliation Act of 2001 (the "2001 Act") which contained the highly touted repeal of the federal estate tax by the year 2010. Unfortunately, the repeal is short-lived and the 2001 Act contains what is known as a "sunset" provision whereby in 2011 the amount of an estate that will be excluded from federal estate tax will return to the level existing in 2001 Ð $1,000,000. For the remainder of 2005, the exclusion amount is $1,500,000. For the years 2006, 2007 and 2008, the amount increases to $2,000,000. In 2009, the amount moves up to $3,500,000.
As you can see, the federal estate tax is in flux, which causes a great deal of uncertainty, and heightens the need for sound and flexible planning of your estate. Such planning is even more crucial for Oregon residents given the so-called "Oregon Inheritance Tax Disconnect," which refers to the Oregon Legislature’s decision to disconnect Oregon’s inheritance tax system from the federal estate tax system creating a significant risk of incurring inheritance taxes that could otherwise be deferred if steps are not taken to plan accordingly.
Recognizing that the 2001 Act failed to provide long-term certainty, Congress has been considering various options, ranging from permanent exclusion levels of anywhere between $3,000,000 - $5,000,000, to permanent repeal of the estate tax in its entirety. In fact, the United States House of Representatives passed a bill providing for a permanent repeal of the federal estate tax. Republicans have been pushing hard for a vote on this bill in the Senate where it will be much more difficult to pass due to the Senate’s rules; however, Senate republicans have reportedly reached a back up compromise with democrats to set the exclusion as high as $5,000,000. All sides were getting ready for a thorough debate of the issue when Hurricane Katrina hit forcing this issue onto the back burner for the indefinite future.
In the meantime, at the end of 2003, the Oregon Legislature decided to disconnect the Oregon inheritance tax system from the federal estate tax system. Oregon has set its inheritance tax exclusion amount at $950,000 in 2005, increasing to $1,000,000 in 2006 and thereafter. In addition to the obvious result that Oregon taxpayers will be subject to Oregon inheritance taxes for every dollar in their estate in excess of $1,000,000 in 2006 (as opposed to the federal level of $2,000,000 in 2006), the problem with this disconnect is that it can result in the need to pay state inheritance taxes in instances where such taxes would normally be deferred when taking advantage of certain tax planning tools. An example will help to illustrate the problem.
Assume that you are married with two grown children and that your estate has a net value of $4,000,000. Under both state and federal law, you are allowed to leave an unlimited amount of money and assets to a surviving spouse without paying any state inheritance or federal estate tax when the first spouse dies; however, if the first spouse leaves everything to the surviving spouse outright, and the joint estate is fairly large, then your surviving spouse, upon his or her death, will likely incur a larger amount in federal and state inheritance taxes than necessary. Such "unnecessary" taxes could be as high as $1,000,000 - $2,000,000, or more. To avoid this, a common estate planning tool is to include a Bypass Trust in your will. Pursuant to provisions that would be included in your will, the Bypass Trust would be funded with assets from the deceased spouse’s estate. In 2006, the Bypass Trust could be funded with assets and cash of up to $2,000,000 to maximize the benefits of the federal estate tax exclusion.
Before the Oregon Legislature disconnected Oregon from the federal estate tax system, funding the Bypass Trust with this amount would also have the result of maximizing the tax benefits under the Oregon inheritance tax system by using fairly standard provisions that would allow the surviving spouse to receive optional payments of income and principal from the Bypass Trust under certain conditions. With the passage of the disconnect by the Oregon Legislature, obtaining the benefits discussed above required additional tax planning provisions to be drafted into a will to provide for the establishment of an Oregon Qualified Terminable Interest Property ("QTIP") Trust. This Oregon QTIP Trust, which would apply only to the amount of the Bypass Trust representing the difference between the Oregon exclusion level and the federal exclusion level ($1,000,000 in 2006), requires a mandatory distribution of all trust income to the surviving spouse. This is contrasted with common Bypass Trust provisions which do not require mandatory distributions of income. Although the Oregon Legislature recently passed legislation to provide some relief for current estate plans that do not currently include the proper Oregon QTIP Trust provisions referenced above, the better practice is to review your current estate plan and to revise it as necessary.
Fully explaining the intricacies of the federal estate tax system and the Oregon inheritance tax system is impossible in a short article. The point is that both federal estate and state inheritance tax laws in this area are continually changing resulting in the need to undertake careful estate tax planning and to establish a sound and flexible estate plan. We highly encourage you to consider the size of your estate currently, where you think it might be in the coming years, and the tax planning tools currently in place. By taking a few simple steps now, you can greatly reduce the amount of estate taxes that you and your spouse will have to pay in the future by as much as $1,000,000, and likely more.