In light of indeterminate tax consequences, a flexible estate plan may be a married couple's best option.

BY ALVIN M. CHESLOW

Recent changes in federal and New Jersey law have placed estate planners in a taxing dilemma; a New Jersey resident’s estate may be exempt from federal estate tax but subject to New Jersey estate tax.

For wealthy married persons, an estate plan may be drafted that exempts the estate of the first spouse to die from both federal and New Jersey estate taxes. But this strategy may ultimately lead to a greater tax liability for the estates of both spouses.

As explained below, disclaimer provisions included in married couples’ estate plans can provide the flexibility needed to minimize the combined tax burden their estates may incur.

The Economic Growth and Tax Relief Reconciliation Act of 2001 was enacted on June 6, 2001. The 2001 Tax Act reformed existing estate, gift and generation skipping transfer taxes, increased available exemptions, decreased tax rates and for a one year period (2010) entirely eliminated estate and generation skipping transfer taxes (the tax returns with a $1,000,000 exemption in 2011).

The 2001 Tax Act also provided for the reduction and eventual elimination of the state death tax credit. The credit is reduced from 2001 levels by 25 percent in 2002, 50 percent in 2003 and 75 percent in 2004, and is entirely eliminated in 2005, when the credit is replaced with a deduction.

Projections indicate the 2001 Tax Act would cause New Jersey to lose significant tax revenue. The New Jersey Office of Legislative Services (OLS) estimated that in the 2001 fiscal year approximately 45 percent of state receipts labeled inheritance taxes were actually attributable to estate tax collections, with the balance derived from inheritance taxation.

The OLS further estimated total inheritance tax collections at $500 million in fiscal year 2002 and $530 million in fiscal year 2003. Based on these estimates the OLS projected a loss of estate tax collections of approximately $60 million in fiscal year 2003, $120 million in fiscal year 2004, $180 million in fiscal year 2005 and $240 million in fiscal year 2006 and thereafter.

In an effort to neutralize the effect of the 2001 Tax Act on its estate tax collections, New Jersey enacted legislation on July 1, 2002, amending existing tax law. N.J.S.54:38-1 et seq. For persons dying on or after January 1, 2002, New Jersey estate tax would be based upon the maximum allowable state death tax credit as of December 31, 2001, without regard to later federal estate tax law revisions.

This change meant that taxable estates in excess of $675,000 would be subject to New Jersey estate tax regardless of federal exemption levels. For example, in 2004 an unmarried New Jersey resident will be able to leave a $1.5 million taxable estate to children free of federal estate tax. However, the same estate will be subject to New Jersey estate tax in the amount of $64,400.

Married persons may plan to eliminate the New Jersey estate tax upon the death of the first spouse, although that approach may prove costly in the long-term. The following fact patterns are illustrative.

Two New Jersey couples, each with $3 million of assets, want to implement new estate plans. Assets are divided evenly between the spouses, each having an estate of $1.5 million. The spouses want to provide for each other and eventually leave assets to children of their marriage while minimizing estate taxes.

Couple one adopts a plan that establishes, upon the death of the first spouse, a nonmarital trust is funded with $675,000, the amount that can pass as exempt from both federal and New Jersey estate tax. Remaining assets are

left to the surviving spouse. In a non-marital trust, assets are set aside for the lifetime benefit of the surviving spouse with restricted access to principal — the restrictions allow the trust principal to be excluded from the estate of the surviving spouse and thus be considered "non-marital." Upon the death of the second spouse, all assets pass to the couple’s children.

Couple two chooses to fund a non-marital trust upon the death of the first spouse with the maximum amount that can pass free of federal estate tax in the year of the death of that spouse by reason of the applicable credit amount, with any balance left to the surviving spouse. Upon the death of the second spouse, couple two’s assets pass to the children of the marriage.

In each case the first spouse dies in 2004 and the second spouse in 2007. Upon the death of couple one’s first spouse, the survivor will not owe either federal or New Jersey estate tax. A non-marital trust will be funded with $675,000 and the first spouse’s remaining assets, $825,000, will be distributed to the second spouse and added to his or her estate. Upon the death of couple one’s second spouse, their children will owe federal estate tax of $146,250 and New Jersey estate tax of $124,000, for a total tax liability of $270,250.

In the case of couple two, upon the death of the first spouse a nonmarital trust is funded with the entire $1.5 million of assets that comprised the first spouse’s estate. No federal estate tax will be due. However, since the amount distributable to the nonmarital trust will exceed the allowable $675,000 New Jersey estate tax exemption, New Jersey estate tax in the amount of $64,400 will be assessed. Upon the death of couple two’s second spouse there still will be no federal estate tax liability, the children of that couple only owing an additional $64,400 of New Jersey estate tax.

Accordingly, the total estate tax liability for the estates of couple two, consisting entirely of New Jersey estate tax, would be $128,800, while the federal and New Jersey estate tax assessment against the estates of couple one would total $270,250.

In many situations, payment of some New Jersey estate tax upon the first death will eventually lead to an overall Federal and New Jersey estate tax savings for the combined estates of a married couple. But this may not always be the case.

Examples where a married couple with sizeable estates should plan not to pay New Jersey estate tax upon the death of the first spouse would include but not be limited to the following: (a) where the surviving spouse is considering relocation to a state with a different estate tax statute; (b) where one spouse suffers an early untimely death; or (c) where there is a significant age disparity between the spouses.

In the latter situations, where it is likely that one spouse will outlive the other by many years, it may be possible for the surviving spouse by superior investment experience to recoup the projected eventual tax cost from the plan designed to eliminate New Jersey estate tax from the estate of the first spouse.

In addition, it is certainly possible that Federal and New Jersey estate tax laws will undergo further revisions in coming years. Amendments might include raising exemption levels or even outright repeal of one or both of these taxes. Such changes could make one regret the early payment of New Jersey estate tax which, had the taxpayer chosen to wait, might have been eliminated.

In light of the indeterminate estate tax consequences occasioned by the 2001 and 2002 changes in federal and New Jersey estate tax law, there would be little reason to recommend an estate plan for married persons with set formulas for the funding of the nonmarital trust and the marital bequest. Instead, a more flexible approach should be considered.

An appropriate plan might include wills with disclaimer provisions, in which assets are left to the surviving spouse but subject to the right of disclaimer, with the disclaimed assets to pass to a nonmarital trust. The disclaimer format would avoid locking the couple into a decision at the time they execute their estate plan, in the hope that at a later date they would be better able to decide whether New Jersey estate tax should be paid upon the death of the first spouse or deferred until the death of the second spouse. Provided that the Internal Revenue Code (Section 2518) and New Jersey (N.J.S.3B:9-l, et seq.), disclaimer rules are adhered to, the surviving spouse would have up to nine months from the date of death of the first spouse within which to make the decision.

A disclaimer may not afford a perfect method to address the problem of the uncertain Federal and New Jersey estate tax consequences resulting from recent law changes. It may be inappropriate to include a disclaimer in documents for individuals in complex marital situations (e.g. second marriages where one or both of the spouses have children from prior marriages). However, for persons in long-term primary marriages with substantial assets the disclaimer may be the best device available to solve an estate tax conundrum.