On March 21, Minnesota made multiple gift tax and estate tax revisions. Those include:

• Retroactively repealing the Minnesota gift tax that had been imposed since July 1, 2013
• Modifying the Minnesota estate tax rates
• Increasing the Minnesota estate tax exemption over the next five years

The new tax exemptions are as follows:

In lieu of a gift tax, Minnesota will now include gifts made within three years of death in determining the amount subject to estate tax. As before, assets passing to a spouse or to charity will not incur estate tax.

FEDERAL LAW CHANGES RECAP

For 2013, the federal government permanently set the amount an individual can pass free of estate tax at $5 million, with an annual increase for cost of living changes. For 2014, the estate tax exemption is $5,340,000. It also set the maximum estate tax rate at 40%, and added a new feature, allowing unused estate tax exemption to be used by a surviving spouse – a concept called “portability” of exemption. As before, assets owned at death receive a new income tax basis equal to their value at death.

ESTATE TAX VERSUS CAPITAL GAIN TAX: A COMPLICATED QUANDARY

While assets owned at death receive a new income tax basis equal to their value at death (potentially eliminating capital gains tax), the value of the assets are subject to estate tax (unless sheltered by exemptions or deductions). With the combined federal and state estate tax rates substantially higher than capital gains tax rates (historically at times as much as 40% difference in rates), avoiding estate tax whenever possible, at the cost of the capital gains tax incurred upon sale, nearly always made sense.

Before portability, common estate planning techniques ensured that married couples used both spouse’s estate tax exemptions – at the first death and at the second death – to maximize the estate tax savings. At the first death, a common approach was to direct the amount that can pass free of estate tax into a trust for the surviving spouse’s benefit, avoiding estate tax upon the surviving spouse’s death.

A tax trade-off might occur if the trust assets increased in value during the surviving spouse’s lifetime, and if liquated would incur capital gains tax. While the trust would be exempt from estate tax, it would carry a capital gains tax to be recognized by heirs at a later time, when sold.

With recent changes in the law, including the ability to use both spouses’ federal exemptions at the second death with portability (and adjusting income tax basis on all assets at the second death), and the comparison of current capital gains rates to estate tax rates, the decision to save estate tax in exchange for incurring a potential capital gains tax is not always clear.

This trade-off analysis is complicated further with Minnesota not following the federal “portability” rule, and Minnesota estate tax rates substantially lower than the state and federal capital gain tax rates – it is possible that foregoing the use of the Minnesota estate tax exemption at the first death (and incurring more Minnesota estate tax as a result) would be preferable to paying capital gains tax, if assets appreciate substantially after the first death.

With the increased federal exemption, decreased federal estate tax rate, federal portability and updated Minnesota estate tax for married couples, there is no longer a clear answer to the question: “How do we minimize taxes at death?” Taking a more flexible approach to planning – one that allows your family to elect between different planning options upon the death of one spouse – might serve your family better than mandating a plan to reduce estate taxes only.

This issue can arise for an estate of any size, but particularly impacts estates under $10 million in value.