Expensive Gaps in Estate Tax Planning

Posted By: Manish C. Bhatia


> In an effective estate plan, both federal and state estate taxes must be considered.

> Flexibility is essential to allow the trustee to maximize the available exemptions or defer estate tax liability for as long as possible.

> Understanding the costs and benefits of each available estate planning technique is the key to an estate plan that accurately reflects your intentions.

There are numerous pitfalls that can occur in estate planning documents, ranging from personal, such as not reflecting the intentions of the grantor accurately, to technical, such as failing to address or utilize all available tax exemptions. While a trust does allow for great flexibility, a trustee is obligated to abide by the terms of the trust document. Therefore, any flexibility or authority the grantor wishes to allow the trustee must be drafted into the trust document properly.

Federal vs. State Estate Tax

As a result of the Tax Cuts and Jobs Act (the “Act”), which was signed into law on December 22, 2017, the federal estate and gift tax exemption increased from $5.49 million in 2017 to $11.2 million per person in 2018. The increased estate tax exemption under the Act is indexed for inflation until January 1, 2026, when it will return to 2017 levels. Meanwhile, the Illinois estate tax exemption remains at $4 million in 2018.

With these drastic fluctuations in the federal exemption amount and the difference between state and federal estate tax exemptions being as large as it has ever been, proper planning and drafting for maximizing both estate tax exemptions becomes more important than ever. In order for an estate plan to be as flexible as is necessary in the current environment, the trustee must be granted the authority to account for variables that cannot be known until the date of death, when certain decisions must be made. Failing to address such variables can be a very expensive oversight for the beneficiaries of the estate.

State-Specific Planning

One scenario in which an oversight may result in a significant cost to the estate is when form documents with non-state specific tax provisions are erroneously used for estate tax planning purposes. Not only do states implement their own estate tax exemptions and rates, but many have unique formulas for determining the tax itself as well as credits and exemptions available to the estate.

A second issue arises when specific exemption amounts are stated in the documents themselves. Since the estate tax exemptions available depends on the decedent’s state of residence at the time of death as well as the year of death, flexible tax formulas are critical to an effective estate plan.

QTIP Planning

Many states, including Illinois, provide for a complex planning technique that allows the estate of a deceased spouse to defer state estate tax liability until the death of the surviving spouse by utilizing a Qualified Terminable Interest Property (“QTIP”) trust. This technique can provide significant flexibility and tax-deferral savings to the family but must be drafted and implemented correctly in order to comply with state requirements.

The cost of either failing to allow for the utilization of the QTIP trust or improper drafting can be significant. One common pitfall is that an individual passes away with an outdated trust that was prepared before the state decoupled from the federal estate tax (creating their own, lower state estate tax exemption) and failed to update the trust accordingly. If the trust document does not authorize the trustee to utilize the QTIP technique, then the trust will likely pass any amount up to the federal exemption to the Family Trust (or bypass trust) and will owe state estate tax on the amount above the state exemption. In Illinois, this could be up to $7.2 million in assets being subjected to Illinois estate tax that could have otherwise been deferred until the death of the surviving spouse.

Planning Opportunities

A proper estate plan provides many opportunities to maximize the available exemptions and minimize tax liability. First, planning for the lowest applicable exemption is important in order to incur the least amount of estate tax, whether federal, or state, that is possible. For example, many families may be informed that the federal exemption is $11.2 million per person and mistakenly believe that estate tax is not a concern, overlooking their state estate tax exposure. While state tax rates are lower than the top federal rate of 40%, it can nonetheless place a significant burden on the estate.

Second, planning for the likelihood that exemptions will increase or decrease by the time of the grantor’s death is crucial to an effective estate plan. Such flexibility allows the trustee to maximize the available exemptions or defer tax liability for as long as possible.

Third, reducing the size of the taxable estate through available gifting techniques can significantly reduce an individual or family’s estate tax liability at both state and federal levels. Due to certain exemptions expiring at the end of each year or as old laws sunset or new legislation passes, planning early can result in significant tax savings.

Finally, short-cutting estate planning is rarely a good idea. Whether it is through joint ownership of accounts, beneficiary designations or relying on portability as an estate tax planning substitute, such techniques can have many unintended consequences that often result in greater legal or tax liabilities to the beneficiaries. Thus, it is always preferable to obtain proper legal advice that is specific to your legal and financial situations and understanding the costs and benefits of each available estate planning technique.