Estate Tax Changes

Prior Law

New York is an expensive place to die. Unlike most states, it imposes an estate tax on the estates of residents who die owning assets worth $1 million or more. Its estate tax rates begin at 3.06 percent and increase to 16 percent. The New York estate tax is deductible against the federal estate tax, so the actual tax rate may be lower, as discussed below. Until the 2014 legislation, New York’s $1 million exemption amount was much lower than the federal estate tax exemption amount of $5,340,000, which is adjusted annually for inflation.

New York does not have a state gift tax. Before the 2014 tax law amendments, a New Yorker’s lifetime gifts were not taken into account in determining his or her estate tax.

The New Law

Calculation of Estate Tax

New York’s new estate tax law gradually increases the estate tax exemption until it reaches the federal level in 2019. As of April 1, 2014, the exemption amount was increased to $2,056,000. No New York estate tax will be imposed on the estate of a New Yorker unless the value of the estate exceeds the applicable exemption amount. The chart below shows how the exemption will increase during the next five years and the size of the estate tax reduction caused by the increase.

The new exemptions will do nothing for the estates of wealthier New Yorkers, those whose estates exceed the exemption amount by more than 105 percent.  They will lose 100 percent of the benefit of the exemption and will be fully subject to the New York estate tax amount.  The loss of exemption is caused by the phase-out provision of the new law.  It reduces the exemption amount for New York taxable estates that are between 100 percent and 105 percent of the exemption amount and eliminates it entirely if the New York taxable estate exceeds 105 percent of the basic exemption amount.

The phase-out can create an estate tax bracket as high as 252 percent for some New Yorkers.  For example, the estate of a New Yorker who dies between April 1, 2017, and April 1, 2019, with a taxable estate of $5.25 million will pay no New York estate tax.  If her taxable estate were worth $100 more, the tax on the additional $100 would be $252.  At a level of $478,168 above the exemption amount, the tax rate on the excess will be approximately 100 percent.  Well-advised New Yorkers will likely want to add a formula clause to their wills or revocable trust agreements that will create a charitable gift of any excess that would attract a New York estate tax of at least 100 percent.

No Portability of Exemption

Federal estate tax law, under certain circumstances, permits a surviving spouse to use the deceased spouse’s unused exemption.  This feature of federal law is generally referred to as portability.  Portability permits a married couple to adopt a simplified estate plan that gives outright the entire estate of the first spouse to die to the survivor, without loss of the deceased spouse’s exemption.  The survivor will be able to use it during life or at death.

This simple approach could be a costly one for a New Yorker because New York law does not permit portability of the New York exemption between spouses.  Unless the surviving spouse is willing to make lifetime gifts equal to the deceased spouse’s exemption amount, gifts that would likely deprive him or her of control over and possibly the use of the gifted assets, the estate of the survivor could be subject to a significant New York estate tax, even if there is no federal tax.

For example, suppose Spouse A dies in 2018 with assets worth $5.25 million and leaves them outright to Spouse B, who also has assets worth $5.25 million.  Then suppose that Spouse B dies prior to April 2019 with assets worth $10.5 million.  There will be no federal tax on Spouse B’s estate because Spouse B will be able to use Spouse A’s unused exemption.  The New York tax on Spouse B’s estate will be $1,146,800.  This tax would have been avoided if Spouse A had left Spouse A’s estate in trust for Spouse B.

The lack of portability can cause a similar problem for spouses with unequal assets.  Suppose Spouse A in the prior example had no assets, but Spouse B had assets worth $10.5 million.  The arithmetic is the same.  When Spouse B dies with $10.5 million worth of assets, there will be no federal estate tax, but the New York estate tax will be $1,146,800.  The only current means of preventing this New York tax is a gift of $5,250,000 worth of assets by Spouse B to Spouse A during Spouse A’s lifetime, which in turn could be left in trust for Spouse B on Spouse A’s death.

Effect of Gifts Made Within Three Years of Death

The new law also changes the effect some lifetime gifts will have on the calculation of a New Yorker’s estate tax.  Under prior law, deathbed gifts were often used as a method of reducing New York estate taxes.  Because New York does not impose a gift tax, these gifts could be made free of New York tax.  Under the new law, the value of the estate of a New York resident will be increased by the amount of any taxable gift made after April 1, 2014, and before January 1, 2019, in the three years prior to her death.  The value of gifts made at a time when the decedent was not a resident of New York will not be taken into account, regardless of when these gifts are made.

This change creates a potential trap for New Yorkers.  Generally, the estate of a New York resident is not taxed on the value of real property or tangible personal property located outside of New York.  There is no such limitation imposed on the three-year gift inclusion rule.  It apparently applies to the value of all three-year gifts, regardless of the nature and situs of the property.  The New Yorker who makes a three-year gift of non-New York real estate or tangible personal property will be causing an increase to her estate tax that would not have occurred if she had not made the gift.

A similar change applicable to the estates of non-residents of New York creates another anomaly.  Non-residents are subject to estate tax only on their real property and tangible personal property located within New York.  The three-year gift rule expands the scope of the tax to the value of any intangible personal property employed in a business, trade or profession carried on in New York, but only if this kind of property is the subject of a gift within three years of death.

The additional tax caused by three-year gifts may be particularly costly.  In most cases, the New York estate tax burden is lightened by the deductibility of the amount of the tax from the federal taxable estate.  The deduction has the effect of reducing a tax that can be as high as 16 percent to 9.6 percent after reducing it by the federal estate tax savings.  Unfortunately, the federal deduction is permitted only for state estate taxes paid “in respect of any property included in the gross estate.”  Because gifts made within three years of a decedent’s death are not included in his or her gross estate, the additional New York taxes they cause are not likely to be deductible for federal purposes.

New York’s Generation-Skipping Transfer Tax Repealed

New York was one of the few states to impose a generation-skipping transfer tax on certain trusts created by New York residents or funded with New York real or tangible personal property.  This produces a tax as high as 2.75 percent on the death of a child of the trust’s creator if the property passed to the child’s children.  This tax was repealed by the recent New York legislation.

Changes to the Income Tax Treatment of Certain Trusts

Exempt Resident Trusts

New York law treats all trusts funded by a New York domiciliary as residents of New York.  These trusts face annual reporting requirements and, unless they have no New York trustees, no tangible personal property or real estate in New York and no New York source income, will be required to pay New York income taxes on their undistributed income.  There is no way for a trust to lose its resident status no matter how long ago it severed all ties with New York; if it satisfies the three requirements in the preceding sentence though, it will avoid New York taxation.  A trust that satisfies these requirements is often referred to as an Exempt New York Resident Trust.

Under prior law, distributions made to a New York resident from a trust, regardless of its residency, of income accumulated in a prior year was not subject to New York income tax.  The new law will tax New York resident beneficiaries of Exempt New York Resident Trusts on the trust’s income accumulated after January 1, 2014, when such accumulated income is distributed to the beneficiary.  Distributions to New York resident beneficiaries of income accumulated in a taxable year before January 1, 2014, in a year before the first year the beneficiary became a resident of New York or in a year before the resident attained age 21 will not be subject to New York income tax.

Although this new tax on distributions of accumulated income may result in additional New York tax revenue, it is unlikely to discourage trustees of New York resident trusts from continuing to administer their trusts in a manner that satisfies the exemption requirements.  The exemption will continue to produce the advantage of deferral.  Additionally, the New York tax will be avoided completely if distributions of accumulated income are made to non-residents of New York.

ING Trusts

The new law also closes what some believe was a loophole in the New York taxation of certain incomplete gift, non-grantor trusts (known as ING trusts).  These trusts were typically set up by New Yorkers to avoid New York income taxation on their investment income.  Transfers to an ING trust were believed to be exempt from gift tax.  So long as the individual who created and funded an ING trust remains a resident of New York, the new law will subject her to income tax on the income generated by her ING trust.  It accomplishes this result by treating ING trusts that are New York resident trusts as so-called “grantor trusts” and including the income of the trust, less any trust deductions, in the grantor’s income for New York income tax purposes.  This change is applicable to tax years beginning on or after January 1, 2014, but does not apply to the income of an ING trust that is liquidated on or before June 1, 2014.  The change does not apply to trusts a New York resident established and funded before becoming a New York domiciliary because these trusts are not New York resident trusts.

The liquidation of a New Yorker’s New York resident ING trusts on or before June 1, 2014, is likely to make good tax sense.  By doing so she will avoid New York tax on the trust’s income for the first five months of 2014.  If the New Yorker is planning to move out of New York to another state that imposes an income tax, it may, however, be prudent to retain the trust.  If the New Yorker moved to Connecticut, for example, unless Connecticut changes its tax law, the income from the ING trust will escape Connecticut income tax.  Recreating the ING trust after moving to Connecticut would not produce the same tax savings.  The savings would not be achievable because Connecticut’s system of trust taxation taxes trust income if the trust was created by a Connecticut resident and has Connecticut beneficiaries.

Review of New York Estate Plans

The recent changes to New York’s estate tax law and the manner in which it taxes trust income could impact the estate plans of many of our clients who are New York residents.