What’s new?

On May 26, 2004, Maryland Governor Robert Ehrlich signed a new revenue bill that included, among many other fiscal initiatives, substantial changes to the Maryland estate tax system. For estates of decedents dying after December 31, 2003, the new law retroactively freezes the Maryland estate tax exemption at $1 million.

Who will be impacted?

Those estate plans for married couples that were designed to minimize federal estate taxes by utilizing a bypass trust concept could actually produce as much as $64,400 of Maryland estate tax upon the death of the first spouse if death occurs in 2004 or 2005.This tax could be as much as $99,600 in 2006 and $229,200 in 2009.

Decoupling from the applicable exclusion amount

- The new Maryland law decouples the Maryland estate tax from the federal tax and limits the Maryland estate tax exemption to $1 million.
- The tax rate is extremely regressive. As a result of a complex calculation formula, approximately the first $94,000 over the $1 million exemption is taxed at 41%. Tax rates for amounts in excess of roughly $1,094,000 range between a more reasonable 5.6% and 16%.
- The change is retroactively applicable to estates of decedents who died on or after Jan.1, 2004. Maryland estate tax still survives repeal of the federal estate tax in 2010.

What clients should do

- Married couples who utilize a formula type provision to eliminate the federal estate tax upon the first spouse’s death through bypass trust planning should consider amending their current estate documents to minimize state death taxes potentially due at the first death. The decision may boil down to whether it is preferable to save state estate tax upon the first death at the expense of potentially higher federal estate taxes upon the second death.
- Since the estate tax law varies among the states, individuals who hold real property in other states should recognize that different jurisdictions may levy state estate taxes, even if the individual died a resident of Maryland.

Two common scenarios to consider

1. The Unnecessarily Fully Funded Bypass Trust.
Take a couple with combined assets of $2.1 million whose wills direct “the largest amount that can pass free of federal estate tax” to fund the bypass trust. Currently, the bypass trust will receive $1.5 million and the estate of the first spouse will pay $64,400 in Maryland Estate Tax. A better idea may be to limit the funding of the bypass trust to $1 million and defer all future taxes, if any, until the death of the second spouse.

2. Accidentally Under Funded Bypass Trust.
Now take a couple with combined assets of $8 million whose wills direct “the largest amount that can pass free of all estate taxes” to be paid into the bypass trust. Currently, the bypass trust will receive only $1 million, thereby exposing an additional $500,000 to federal estate tax (at a tax rate upwards of 45%) upon the second spouse’s death, only to avoid exposing the same sum to Maryland’s Estate Tax in the first spouse’s estate (at a tax rate of about 6%). This could result in as much as $191,000 in excess taxes to be due. Since Maryland does not have a gift tax, a better idea may be to make a lifetime gift of $500,000 to non-spouse beneficiaries.

Also be aware that the State Comptroller’s office will now require the filing of a Maryland Estate Tax return for some estates that are exempt from federal estate tax.

The rationale behind the changes

From its original enactment in 1929, Maryland’s Estate Tax (as in most other states) was coupled to the federal estate tax. The federal estate tax allowed a dollar for dollar credit for state death taxes paid. As such, states were able to levy an estate tax that imposed no net or increased burden on estates. The tax simply redirected revenues in the amount of the credit from the federal government to the states. The state estate tax was referred to as a “pickup” or “sponge” tax.

In 2001, new federal tax legislation provided for generous increases in the applicable exclusion amount with the intent to phase out the federal estate tax by 2010.To help pay for the cost of the estate tax repeal, the tax law phases out the state death tax credit by 2005. For federal purposes estates will now only be able to take a deduction, not subject to any dollar limit, for death taxes paid to any state.

The federal government’s repeal of the credit for state death taxes changes the landscape for state estate taxes considerably. To replace this lost revenue, Maryland, like many other states, has responded to the repeal by rewriting its estate tax laws. Fourteen other states besides Maryland have frozen the exclusion amount at a set sum. The chart below provides a summary of those states and the exemption amounts.

Conclusion

The present estate tax law is unstable and imposes considerable pressure on the states to make up the revenue lost by the phase out of the state death tax credit. Flexibility in current plans may be the key to minimize future tax liabilities.

EXEMPTION LIMIT STATES
(AS OF SEPTEMBER 2004)
State Exemption Recognized
Connecticut $ 1,000,000
District of Columbia $ 1,000,000
Illinois $ 2,000,000 *
Kansas $ 850,000 **
Maine $ 850,000 **
Maryland $ 1,000,000
Massachusetts $ 850,000 **
Minnesota $ 850,000 **
Nebraska $ 1,000,000
New Jersey $ 675,000
New York $ 1,000,000
Oregon $ 850,000 **
Rhode Island $ 675,000
Washington $ 850,000 **
Wisconsin $ 675,000

* No more than $2 million
** Increasing to $950,000 in 2005 and to $1 million in 2006

The information contained herein has been prepared from sources believed to be reliable but is not guaranteed by us and is not a complete summary or statement of all available data, nor is it considered an offer to buy or sell any securities referred to herein.