Glenn Henkel’s most recent article, Changes to the New Jersey Tax Laws Warrant Immediate Attention!, originally appeared in the Philadelphia Estate Planning Council’s Winter Newsletter Vol. XXVI, No. 2., posted on January 12, 2017. Mr. Henkel is currently a member of the Board of Directors of the Philadelphia Estate Planning Council, a highly recognized interdisciplinary organization for professionals involved in estate planning, providing its members with opportunities to enhance their skills and expand their network through programs and interaction.
On October 14th, New Jersey Governor Chris Christie signed legislation raising the state’s gas tax to help replenish the state’s expired transportation trust fund. As a tradeoff, the law takes steps to encourage residents to remain in the state after retirement. First, it phases out the estate tax, effective January 1, 2018, and that will have a profound impact on the manner that our New Jersey clients will plan for their estates. Second, there is an enhanced retirement income exclusion that is phased in between now and 2020. This article will discuss estate planning issues for New Jersey residents and it will also highlight several issues that planners will need to know.
While the major highlight in this new legislation is the repeal of the estate tax after 2018, since it is really a “phase out,” there is always the potential that the tax may not, in fact disappear. Moreover, the New Jersey inheritance tax is retained (a significant trap for unwary). The rules for 2017 decedents allow a $2 million exemption per decedent, including a change in the manner that the tax is computed. The way the law is drafted allows an easy fix to retain the tax if the state later decides to keep the 2017 tax format. The current tax law is a “cliff,” meaning that the tax applies on all estates subject to tax but the new law provides a “credit” reducing the tax even on larger estates. The other provision is the enhanced pension exclusion that looks good, but it may not apply to some of our clients. Consider that the New Jersey estate tax repeal together with the other changes in the transportation trust fund law creates an unfunded hole in the New Jersey budget of more than a billion in 2018. Before client’s hurry home to New Jersey, they should look into the details.
Under the new law, the New Jersey estate tax will be phased out for decedents passing after January 1, 2018. Presently the exemption of $675,000 is the lowest in the country and the exemption will increase to $2 million for decedents who pass away after January 1, 2017. What does this mean for those living in New Jersey? What changes to planning and documents might be advisable to consider for New Jersey domiciliaries? Will it bring back former New Jersey residents who “changed” their domicile to a no-tax state? For many, it has been the INCOME tax that has caused clients to leave from New Jersey (maybe climate too). Because the current law only allows a meager $20,000 pension exclusion (married filing joint), the new law adds an increased pension exclusion that is likewise phased in and makes New Jersey more competitive regionally.
The newly adopted pension exclusion increases the thresholds from $20,000 in 2016 to $40,000 in 2017, $60,000 in 2018, $80,000 in 2019 and to $100,000 for 2020 and thereafter (all married filing jointly). For single taxpayers, the current $15,000 exclusion goes to $30,000 (2017), $45,000 (2018), $60,000 (2019) and $75,000 (2020). However, this benefit is provided only to taxpayers who are below the gross income threshold. Even a mere $1 of gross income over the exemption, denies the taxpayer of the benefit. Under current law, the pension exclusion is denied if the persons New Jersey taxable income is more than $100,000. Thus, while the law is a step in the right direction, it is not that attractive to high net worth individual.
For the estate tax, New Jersey law provides that there are no estate tax changes for 2016 decedents (leaving in place the $675,000 exemption threshold based upon the 2001 provisions in IRC Section 2011) and there is no tax for 2018 decedents. For 2017 decedents, the tax is imposed based upon the prior I.R.C. Section 2011 “credit” rate chart as it existed in 2001 that is now incorporated into the statute, but the computed tax is reduced by a “credit” of $99,600, the tax that would have been imposed on a $2,000,000 estate.
Whether the State will be financially able to forgo the estate tax revenues in 2018 and thereafter remains to be seen, but that will be an issue for a future legislature and a future Governor. The lost revenue effects even just for the estate tax repeal are huge, almost $500 million in fiscal 2020 and more than $500 million fiscal 2021 and fiscal 2022. As mentioned, the 2017 tax computation could be a precursor to future rules so they are worth study.
The new New Jersey tax computation for 2017 decedents is keyed to the definition of “taxable estate” contained in Internal Revenue Code Section 2051. That reference has raised an interesting interpretive question. When the existing New Jersey tax was keyed to the 2001 tax code, there was no deduction for state estate tax. (IRC Section 2058 that allows a state estate tax deduction is only effective for decedents passing after 2005). Now, because of the reference to the current tax code, the state tax to be paid is a deduction in arriving at the tax- thus, there is a circular computation to arrive at the tax. Maybe this will be fixed in a technical correction. However, as of now, the computation is a “circular,” meaning you deduct the tax against the tax and need a computer or algebraic formula to determine the amount owed. The allowance of a deduction could also raise questions about taxes paid to other jurisdictions where an estate could attempt to claim both a credit for tax paid and a deduction.
One major benefit is that this definition of the tax base in IRC Section 2051 starts with the “gross estate” less deductions, which is before adding back prior gifts made. As a result, like it was for the pre-2017 rules, gifting still reduces the estate and thereby, using a gifting strategy reduces the estate tax. Before gifting however, advisors should make sure that the assets being given away do not result in a higher income tax cost. When assets are gifted, the donee receives “carryover” income tax basis rather than the “step up” that can occur at death. It is usually not a good idea to save estate tax at a cost of and increased income tax, unless the tax is lower (analysis is needed before the gift) or the asset will not be sold (e.g., a vacation home or a family business). Another consideration with gifting is that under the old rules, the gifts escaped estate tax. However, there was still a tax on the assets remaining in the estate, so there would be some tax due. To avoid any tax at all, a donor had to gift all the way down to a retained asset base of just $100,000. Now, because of the “credit” on the first, $2,000,000, a retained asset base of $2,000,000 will escape the tax entirely. This is a great opportunity for deathbed planning however, while there is generally no “3-year” rule for estate tax, there remains a rule for inheritance tax that will impose an inheritance tax on all gift within three years of passing.
Another benefit to the new system is that the pre-2017 “simplified method” of computing the estate tax will be repealed. This approach was not “simple” and often resulted in more tax than under the usual so called “706 method” named after the federal tax return Form 706.
In the end, the New Jersey estate tax change is welcome relief, but for clients with estate above the $2 million exemption amount, prudence would suggest that they retain their existing plans. With the potential that the Trump administration will repeal or modify the federal estate tax, many clients will be eager for simplification to their planning however, let’s not act too quickly for our New Jersey residents. If an estate is below the $2 million sum, then perhaps the simplification may be useful. However, for many others, immediate changes may not be warranted.
Another key factor to consider is that New Jersey also imposes an inheritance tax. The New Jersey inheritance tax is not repealed as a result of this effort. The New Jersey inheritance tax does not generally apply to transfers to a spouse, child, or grandchild who are referred to “Class A” beneficiaries. Unfortunately, the New Jersey Inheritance tax subjects transfers to siblings, and children in law at a rate of 11% (on an amount over $25,000) known as Class “C” beneficiaries. This rate rises on transfer above $1.1 million reaching a high of 16%. Others non relatives are taxed at a 15% rate (16% over $700,000). While a “step child” is a preferred “Class A” beneficiary, the transfer to a “Step grandchild” causes a 15% tax. The New Jersey inheritance tax remains a costly trap for unsuspecting taxpayers. As noted above, unlike the rules for the New Jersey estate tax, in inheritance tax carries with it a three-year inclusion of gifts in the tax base.
Many of the questions in a spousal estate tax planning structure relate to the plan in place from the passing of a first spouse until the passing of the survivor. A common approach taken in wills (or revocable trusts when used as the primary dispositive document), is to incorporate a ‘credit shelter trust’ and a marital disposition (either outright or in trust). The purpose of the credit shelter trust was generally to make assets available to the surviving spouse but to avoid them being included (or taxed) in the surviving spouse’s estate for estate tax purposes. In other words, this technique to limit the tax seeks to allow the heirs to inherit assets tax free sheltered by the exemption of both parents.
In New Jersey, some families would employ a state exemption level credit shelter trust of $675,000, a “gap” trust funded with the difference between the federal exemption and the New Jersey exemption (then $675,000). The excess above the federal exemption would be bequeathed to a “Qualified Terminable Interest Trust” or “QTIP” as defined in IRC Section 2056(b)(7) or other marital deduction qualifying bequest. The estate, post-death, could then determine how to characterize the gap trust. For smaller estates some practitioners may have relied on outright bequests and the provision of a credit shelter trust that is created by a “disclaimer” by the surviving spouse. While that type of dispositive scheme might appear not to require any modification that may be too superficial of an analysis. Practitioners must evaluate the plan in light of the recent legislative developments made, pending or anticipated. Because of the pending changes happening over time, a plan for a 90 year old client might differ from the plan for a 60 year old client. However, it may be beneficial to review existing documents, particularly those with tax driven formula clauses as tax thresholds change.
With the repeal of the New Jersey estate tax (or possible federal repeal), a “Disclaimer Trust” plan may become the default planning approach for moderate wealth taxpayers. If spouses have been married for a long time and the children are “common children” of the marriage, such that it could be anticipated that a surviving spouse would not be expected to disinherit the children of the predeceasing spouse, then a disclaimer trust may provide the greatest opportunity for flexibility. Disclaimer trusts, however, are not effective in achieving non-tax planning objectives.
A disclaimer trust estate plan would devise the entire estate to the surviving spouse. If the inheritance is “disclaimed’ by the survivor, the will or revocable trust can direct the inheritance to a trust for the spouse as permitted by I.R.C. § 2518. By granting a surviving spouse this option, the surviving spouse can choose whether funding the trust with the estate is appropriate based upon a variety of circumstances at that time, such as (1) the size of the combined estates at the first death; (2) the applicable federal/state estate tax exemption; (3) the likelihood that the surviving spouse will reside in a state with a state estate tax (4) will a trust provide opportunities for income tax planning and “basis” shifting. While all of these uncertainties may remain at the death of the first spouse, this flexible plan is premised on the assumption that we may know more at that time than when the wills and estate plan were drafted.
Another issue to consider is that since the federal American Taxpayer Relief Act of 2012 (signed January 1, 2013) the federal government has permitted “portability” of the federal estate tax exemption. Portability was designed with an eye toward eliminating the need for the complexity of traditional “by-pass/credit shelter/family trust” planning used to shelter tax by preserving the estate tax exemption of each spouse of a married couple. In general terms, “portability” of estate tax exemption allows one spouse to inherit the assets of their deceased spouse – which used none of the exemption permitted for non-marital and non-charitable transfers and also and inherit the unused exemption. The technical term for this “unused” exemption is the “Deceased Spouse Unused Exemption” or “DSUE.” In the context of planning for New Jersey domiciliaries, assuming the estate tax remains, the state does not allow for “portability” of exemptions.
Procedurally, the administration of a New Jersey has always been hampered by the process that protects the State collection of the tax. In New Jersey, there is a lien for estate tax on the estate of a decedent. The executor/personal representative could always access half of the funds without discharging the lien (known as a “blanket waiver”) but the balance of the estate could be released only on receipt of clearance from the New Jersey Division of Taxation. The Division would issue “inheritance and estate tax waiver” forms that prove the tax has been paid and the institution holding funds would require these “waivers” to make final release of the estate assets. For estates where no tax is due, a “Self-executing waiver” process could be used. These are the forms L-8 (for cash/stocks/bonds/intangibles) or form L-9 for real estate. Under new procedures, the “self-executing waiver” process will be updated to apply only where the estate is less than $2,000,000. However, there may be a delay in spreading the word since many institutions are aware of the pre-2017 $675,000 threshold. In other words, there may be some time before institutions will be aware to use the new rules.
Finally, another trap for unwary is that in 2015, the federal “Surface Transportation and Veterans’ Health Care Choice Improvement Act of 2015” (H.R. 3236) relaxed filing due dates for federal tax returns placed on extension. For federal taxes, a fiduciary can get a 5 ½ month extension on income tax returns (Form1041) from April 15 until September 30. At present that rule will not apply for New Jersey purposes (Pennsylvania too). Thus, while federal tax returns can be extended to September 30 the New Jersey return will still be due Sept 15 (if extended).
In sum, the ever-changing tax landscape will cause our New Jersey clients to review their estate planning documents. For a change, the news from Trenton is good news, but before changes are implemented, advisors should carefully consider the fine print. Compound this with possible federal tax changes and clients will undoubtedly want to eliminate tax planning in favor of simplicity. Simplicity may be appropriate for some, but not all, clients and estate planners will need to be ready to figure out which ones can or should change and which ones should not change. Be careful out there!
Glenn A. Henkel is a shareholder in the firm and earned his J.D. degree at Rutgers University School of Law, where he graduated with honors and was awarded the Prentice Hall Award for outstanding performance in the area of taxation. He earned his LL.M. in Taxation at New York University. Mr. Henkel’s particular areas of expertise include complex estate planning, tax-exempt organizations and Probate, Trust and Estate Law.