New Tax Laws - Separate New Jersey Estate Tax

New Jersey distinguishes its estate tax from the federal estate tax for deaths after January 1, 2002

Summary:

Due to a recent change in the New Jersey tax laws, estates which are exempt from federal estate tax may be subject to a separate New Jersey estate tax.  Sophisticated and simple estate tax planning techniques used prior to the enactment of this new law may cause an unintended New Jersey estate tax upon a person’s death.  Anyone who has invested in an estate plan should take this opportunity to revisit their plan – tax laws have changed; your financial and family circumstances may have changed as well.  Failure to act now could result in greater and/or unnecessary taxation upon death.

Background of the New Jersey Estate Tax:

For many years, New Jersey has had both an inheritance tax and an estate tax. Each of these taxes is independent of the other.  Until now, when planning for or administering an estate, most people have only concerned themselves with the New Jersey inheritance tax because the New Jersey estate tax had no economic impact on New Jersey residents. 

The New Jersey inheritance tax is based on who inherits assets.  There is no inheritance tax on amounts left to a spouse, parent, or lineal descendent (“Class A Beneficiaries”).  Amounts left to any person other than a Class A Beneficiary are subject to an inheritance tax of up to 16%.  The actual amount of the inheritance tax is calculated by multiplying the amount of assets left to a person, by the tax rate for that person’s class.

The New Jersey estate tax is a tax on a person’s total assets, less certain deductions, at the time of death.  Prior to the enactment of Chapter 31 of the New Jersey Public Laws of 2002 on July 1, 2002 (the “New Law”), the New Jersey estate tax had no effect on the total tax assessed at death.  This was because the federal estate tax gave a credit for taxes paid to any State for state inheritance or state estate tax, subject to certain limitations (the “State Death Tax Credit”).  Prior to the New Law, New Jersey’s estate tax was essentially equal to the State Death Tax Credit.   Accordingly, the New Jersey estate tax did not increase the overall tax liability of an estate; instead, once the federal estate tax was calculated, two checks were written that totaled the federal estate tax – one to New Jersey for an amount equal to the State Death Tax Credit[1], and the other to the IRS for the difference between the total federal estate tax and the State Death Tax Credit.

This all changed at the federal level with the enactment of the Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA”).  Under EGTRRA, the State Death Tax Credit phases out over a 4 year period, and is then replaced with a deduction.  Prior to the New Law, New Jersey’s estate tax was equal to the State Death Tax Credit: as a consequence, as the State Death Tax Credit goes down, New Jersey’s tax revenues go down.

New Jersey has decided not to quietly accept a federal tax change that will reduce and eventually eliminate a significant revenue stream (estimated by Governor McGreevey to be a loss of revenue of nearly $700 million over the next 5 years).  Instead, via the New Law, New Jersey has essentially frozen its anticipated estate tax revenue stream as it existed on December 31, 2001.  At that time, any estate of less than $675,000 did not owe any federal estate tax, and thus did not owe any New Jersey estate tax.  Under the New Law, if less than $675,000 is passing to a person other than a spouse or charity, there will not be any federal or New Jersey estate tax.  However, if more than $675,000 is passing to someone other than a spouse or charity, a New Jersey estate tax may be assessed even though the estate is exempt from federal estate tax (the federal estate tax exemption is currently $1,000,000, and is scheduled to increase dramatically over the next 8 years, until it is eliminated, subject to re-enactment - see chart below).

How might the New Law affect your estate plan?

Estate tax planning is now a concern for any person, or couples, whose assets are in excess of $675,000.[2]  In order to address this concern, your estate plan must be flexible enough to account for shifting tax laws.  Our staff of skilled attorneys and paralegals is ready to prepare a custom review of your estate plan so you will know exactly how the New Law will affect you.

Estate Tax Planning:

Many people are under the impression that if they live long enough, the estate tax will simply go away.  Unfortunately, the issue is more complex then that.  Under the current law, the federal exemption from estate taxes is scheduled to increase until 2010, disappear in 2010, and then be reinstated with a $1,000,000 exemption in 2011. [3] (See the chart below).   

Under the New Law, as the federal exemption increases, so does the New Jersey estate tax.  If a person has the largest estate possible without being subject to federal estate tax, the New Jersey estate tax would increase as follows, irrespective of whether or not there is any federal estate tax:

Note that there is no cap on the New Jersey estate tax.  As your assets increase, so does the New Jersey estate tax.  Under the federal estate tax laws in existence as of December 31, 2001, the State Death Tax Credit, upon which the New Jersey estate tax is based, ranged up to 16% of the entire taxable estate.  Accordingly, the New Jersey estate tax may be as much as 16% of the taxable estate, regardless of any federal estate tax liabilities.

By-Pass Trust Planning for Married Couples:

Prior to the New Law, a common estate planning technique for couples was to (i) create a trust (known as a Family Fund, Credit Shelter Trust, or By-Pass Trust, but referred to in this article as a “By-Pass Trust”), which was funded with the maximum federal exemption, and (ii) have the balance of the estate pass to the surviving spouse, either outright or in a marital trust (or “QTIP” trust).  If this type of plan is not reviewed, upon the death of the first spouse a large check could be due to New Jersey, even though no federal estate tax is due.  How should you plan? In order to answer this question, we must examine and compare the tax impact on the family if the New Jersey estate tax is paid or avoided on the death of the first spouse.

Smaller Taxable Estates:

Assume that the year is 2001 and husband (H) has $1 million in assets, and wife (W) has $300,000.  Under the By-Pass Trust technique described above, upon H’s death in 2001, an amount equal to his exemption from federal estate taxes ($675,000 in 2001) would be used to fund the By-Pass Trust.  The By- Pass Trust would not be an asset of W for estate tax purposes.  The balance of H’s assets, $325,000, would pass to W, either outright or in trust.  There would be no federal or New Jersey estate tax due because any assets in excess of the federal estate tax exemption amount ($675,000 in 2001) pass to the spouse, which is a deduction for both federal and New Jersey estate tax purposes.  If W also died in 2001, there would be no estate tax due at her death because W’s total assets of $625,000 ($300,000 of her own assets, plus $325,000 received from her husband) would be less than W’s exemption from federal estate taxes of $675,000. 

Now assume everything is the same as the example above, except that the year is now 2002.  A very different result occurs.   The federal exemption in 2002 is $1 million, so the By-Pass Trust created under H’s Will is funded with $1 million dollars.  While there is still no federal estate tax upon the H’s death, there is now a New Jersey estate tax of $33,200 assessed at H’s death.[4]  Under this scenario, the New Jersey estate tax could have been avoided if the By-Pass Trust was funded with only $675,000, the maximum exemption from estate taxes in New Jersey under the New Law.

Larger Taxable Estates:

Funding the By-Pass with $675,000 instead of the full federal exemption then available will not always reduce the overall estate tax due when passing funds to the next generation.  For larger estates, the total tax bill might be less if the New Jersey estate tax were paid when the first spouse died. 

For example, assume the year is 2002 and H and W each have $1 million of assets, for a total of $2 million.  If H dies in 2002 and funds the By-Pass Trust with only $675,000, then (i) no federal or New Jersey estate tax will be due, and (ii) $325,000 will pass to W.  However, if W also dies in 2002, her estate is $1,325,000, and taxable under both the federal and New Jersey estate tax.  The total tax due at W’s death will be $148,050 (a federal estate tax of $94,850 and a New Jersey estate tax of $53,200).

In comparison, if H funds the By-Pass Trust with $1 million, no federal estate tax will be due (because the amount passing to the By-Pass Trust is equal to H’s exemption from federal estate taxes), but a New Jersey estate tax of $33,200 will be due.  Upon W’s death, she now has only $1,000,000 of assets (the By-Pass Trust being excluded from her taxable estate).  Again, there will be no federal estate taxes, but a New Jersey estate tax of $33,200 will be assessed.  The total tax paid by the couple under this scenario is $66,400, a savings of $81,650 from the first scenario.

These examples are gross oversimplifications, since many other factors need to be weighed when determining whether or not it make sense to pay a New Jersey estate tax at the first death, such as total assets, growth and mortality assumptions, and whether there will even be a federal estate tax.  Your goal should be to allow us to develop an estate plan for you that is flexible enough to address as many of these factors as possible.

Incorporating the New Law into your Estate Plan:

The only certainty in the tax code is change; your estate plan must be flexible enough to deal with anticipated changes.  Your estate plan is an investment – we have the skills and expertise to bring that investment up to date in a cost-effective manner.  Please contact Henry H. Fein, Esq., Managing Shareholder, Deirdre R. Wheatley-Liss, Esq., Shareholder, or any other member of our Corporate, Tax, Trusts and Estates, and Elder Law Department at 973-538-4700 to discuss the best way to update your estate plan to provide for as much flexibility as possible.  

How might the New Law affect the administration of an estate when a person dies?

The process of administering any estate in excess of $675,000 will be much more complex under the New Law.  Unfortunately, it is not yet entirely clear what all the complexities will be as the Director of the New Jersey Division of Taxation has not issued all the regulations and forms necessary to fully implement the New Law.  We do know that the following additional layers of filings and paperwork will exist when administering an estate in New Jersey.

Filing a Federal Form 706 with the New Jersey Division of Taxation:

In order to calculate the appropriate New Jersey estate tax under the New Law, a federal estate tax return, Form 706, prepared under the federal laws in existence as of December 31, 2001 (the “2001 Law”) must be filed with the New Jersey Division of Taxation within 10 months from the date of death.[5]  This means that an estate of less than the federal exemption amount in the year of death, but more than the federal exemption amount under the 2001 Law (for example, an estate between $675,000 and $1 million in 2002), must prepare and file a Form 706 under the 2001 Law for New Jersey estate tax purposes, even though it would not be required to file a Form 706 for federal estate tax purposes.  For estates greater than the federal exemption, at least two returns must be prepared: a Form 706 for the year of death, to be filed with the IRS; and a Form 706 under the 2001 Law, to be filed with the New Jersey Division of Taxation.

Estate Tax Lien and Waiver:

The New Law also provides for an automatic tax lien on all assets of the decedent until the New Jersey estate tax is paid or a waiver is issued.  This may make it very difficult to administer an estate as no assets can be sold or distributed without the lien being waived by the Division of Taxation.  More importantly, no procedures have been established as of the date of this newsletter to obtain a waiver of the lien from the New Jersey Division of Taxation.  

Other Notable Changes in the Legal Landscape

Dormant Assets will Escheat to the State after 3 years:

The State of New Jersey has the power to take possession of, or “escheat”, assets that are deemed unclaimed and abandoned.  Under Chapter 35 of the New Jersey Public Laws of 2002 (signed into law on July 2, 2002), the categories of unclaimed, or “escheatable”, assets has been expanded, and the time period of inactivity before an asset can be deemed abandoned has been reduced to as little as 3 years.  A more in-depth article will be placed on our website at www.feinsuch.com.  We suggest you go to the unclaimed property site at the New Jersey Division of Taxation (http://www.state.nj.us/treasury/taxation/ ) and use the Unclaimed Property button to search for any escheated property of yours or a family member – you never know what you might find!

Business Tax Reform Act:

Under Chapter 40 of the New Jersey Public Laws of 2002 (signed into law on July 2, 2002), the Corporation Business Tax Act has been revised and updated to include, among other things: new filing fees for certain returns, an increase of the corporate minimum tax from $200 to $500, a $150 tax per member of each multi-member LLC or partnership, and a $150 per professional tax for any professional corporation. We invite you to visit our website at www.feinsuch.com to view a more in-depth article covering the Business Tax Act.

This Article is a service of the Corporate, Tax, Trust and Estates Department of Fein, Such, Kahn & Shepard, P.C.  It does not constitute legal advice nor create an attorney-client relationship.  For more information contact either Henry H. Fein at hfein@feinsuch.com or Deirdre R. Wheatley-Liss at dwheatley@feinsuch.com.

© 2002, Fein, Such, Kahn & Shepard, P.C., all rights reserved.  Permission is granted to reproduce and redistribute this article so long as (i) the entire article, including all headings and the copyright notice, are included in the reproduction, and (ii) no fee or other charge is imposed.