& Priest LLC
129 Church Street
New Haven, CT
2011 TAX ALERT - CONNECTICUT
Preface: this is essentially the same alert posted when 2009 arrived! One big change: "Portability" of estate tax exemption
January 1, 2011. Happy New Year! Amazingly, the White House and the Republicans reached a tax "compromise" that Congressional Democrats had virtually no choice but to ratify. The result is that the federal estate tax exemption has reset not to $1 million, but to $5 million per person -- with the ability to give any unused exemption to a surviving spouse (known as "portability") -- and a return of the step-up in basis. The re-set is retroactive to January 1, 2010, but estates of those dying in 2010 have the opportunity to elect not to have the estate tax apply and instead opt for the adjusted "carryover basis" with a limited ability to "allocate" a capital gains tax exemption to sales proceeds of assets "acquired from a decedent" during 2010.
Paradoxically, this good news at the federal level may have unintended negative tax consequences for your estate -- assuming that the recession has left you with more than $3.5 million between you. The problem is the disconnect between the federal and state exemptions. Although the federal exemption is now $5 million -- $10 million for a couple -- the Connecticut exemption is now $3.5 million with no increased exemption for couples unless appropriate tax planning shelters assets at the first death from being taxed at the second. This disconnect could result in about $121,800 in Connecticut estate tax, payable 6 months after the first of you dies.
An estate plan (particularly one prepared before 2005) often includes trusts designed to minimize taxes, by "sheltering" assets from the federal estate tax payable when the second of you dies. These trusts may be in your wills, or revocable trust agreements. Although no tax is due when you leave your assets to your U.S. citizen spouse, doing so used to expose them to federal estate tax at the time of your spouse's later death -- with amounts in excess of the federal exemption taxed at 35% and amounts in excess of the state exemption taxed at 5-16%. This approach is still the way state estate taxes are applied: assets that pass to your surviving spouse will be taxed at his/her death. For this reason, your will or revocable trust agreement may include a trust or "Fund" established when the first of you dies, whether it is called a "credit shelter trust," a "bypass trust," "fund A," or some other name. Assets owned by the first person to die pass into trust at that person's death and thus escape tax at the time of the second person's death.
So far, so good. But your documents -- especially if written before 2005 -- may describe what goes into the trust as "the largest amount that may pass free of federal estate tax," or something similar. As of 1/1/11, that amount is $5 million -- more than the amount that can pass free of Connecticut estate tax. If, therefore, you own more than $3.5 million in your sole name that does not pass to your spouse by beneficiary designation and you die first, more than $3.5 million may pass to the trust. Result = tax. If you have $5 million, everything will pass into the trust, with a resulting tax of approximately $121,800.
What to do? There are three ways to solve the problem -- and I leave aside the fourth possibility, that you will spend everything on long-term care costs or bad investments decisions, leaving nothing to worry about. The three choices:
Each of you should try to keep no more than $3.5 million separate, in order to shelter that amount in your trust if you are the first to die. To rearrange assets may be the best choice when you have combined assets of $7 million but your holdings are lopsided, with one person currently owning more than $3.5 million.
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