As we approach the end of 2019, I am reminded that this was supposed to have been the year in which New York’s estate tax exclusion amount was to have become the same as the federal estate tax exclusion amount.[i] As things turned out, it didn’t come close, but that wasn’t Albany’s fault, not by a long shot – at least not this time. The Feds were to blame, and how could anyone reasonably have foreseen the 2017 tax legislation?
Looking back on the year, however, it is not difficult to identify a couple of New York’s uniquely home-grown contributions to its reputation as a place that many business owners would like to avoid, or from which they would like to escape.
Before we examine these local products, we should give the Feds their due.
Recent Federal Activity
As you probably recall, among the changes made by the 2017 Tax Cuts and Jobs Act,[ii] the one that immediately caught the attention of “more mature” business owners was the doubling of the federal estate and gift tax exclusion amount for decedents dying, and for gifts made,[iii] after December 31, 2017 and before January 1, 2026.[iv]
This increase was accomplished by doubling the “basic exclusion amount” from $5 million to $10 million for 2018, before taking into account the prescribed inflation adjustments;[v] once indexed for inflation, this generated an exclusion amount of $11.2 million per U.S. individual in 2018 and $11.4 million in 2019. As a result of recently announced inflation adjustments, the exclusion for 2020 will be increased to $11.58 million.[vi]
Thus, in 2020 – only a few weeks from now – a married U.S. couple that has not made any taxable gifts in prior years may pass along to the “objects of their bounty” property with a total fair market value of $23.16 million, by way of either lifetime or testamentary transfers, without incurring gift or estate tax, as the case may be.[vii]
What’s more, because a surviving U.S. spouse may utilize a predeceasing spouse’s unused federal exclusion amount to make tax-free gifts or testamentary transfers (“portability”), a married couple should be able to fully utilize their combined federal exclusion.[viii]
However, given the temporary nature of the increased exclusion amount provided by the Act – it reverts to pre-2018 levels, adjusted for inflation, for lifetime or testamentary transfers made after December 31, 2025 – many advisers questioned whether the cumulative, or unitary, nature of the gift and estate tax computations,[ix] coupled with the differences between the exclusion amounts in effect (i) at the time of a taxpayer’s death and (ii) at the time of any lifetime gifts made by the taxpayer, would result in inconsistent tax treatment of gifts made after 2017 and testamentary transfers made after 2025.[x]
Fortunately, the IRS proposed regulations to address these concerns just over one year ago[xi] and, last week, these regulations (with some modifications) were issued in final form.[xii]
With the publication of these final regulations, an individual business owner should be confident that their estate will not be inappropriately taxed by reason of their having made lifetime gifts that take advantage of the increased federal exclusion amount before its scheduled expiration date of December 31, 2025.
As an additional incentive to making such gifts, the owner need only consider the estate and wealth tax proposals being discussed by so many of the Democratic presidential hopefuls for 2020.[xiii]
But what about a business owner who is domiciled in New York?
Don’t Forget New York
New York eliminated its gift tax for transfers made after December 31, 1999.
What’s more, before the passage of the Act, New York was in the process of “catching up” to the federal estate tax exclusion amount.
Specifically, the New York estate tax exclusion amount, which was $1.0 million through March 31, 2014, was steadily increased to approximately $2.06 million for the 12-month period ending March 31, 2015, then to $3.125 million for the next 12-month period, ending March 31, 2016, and then to approximately $4.188 million for the period ending March 31, 2017; from April 1, 2017 to December 31, 2018, the New York exclusion amount was set at $5.25 million.[xiv]
As of January 1, 2019, the New York estate tax exclusion amount was poised to become the same as the basic federal exclusion amount of $5.0 million,[xv] adjusted annually for inflation.
Thus, if a New York decedent had died during the April 1, 2017-to-December 31, 2017 period, the New York exclusion amount was $5.25 million, while the federal exclusion was $5.49 million.
As a result of the Act, however, the federal exclusion amount[xvi] diverges greatly from the New York amount after 2017. In the case of a New York decedent dying during 2018, the New York exclusion amount remained $5.25 million, but the federal amount was increased to $11.2 million.
For testamentary transfers made during 2019, the New York exclusion amount is $5.74 million per individual,[xvii] while the federal amount has been $11.4 million.
Finally, for a decedent passing during 2020, the New York exclusion amount is scheduled to be $5.85 million,[xviii] whereas the federal exclusion will be $11.58 million.
The New York Traps
Based on the foregoing, it appears that a New York business owner would be well-advised to start making gifts of their equity in the business so as to reduce their New York taxable estate.[xix]
This appears to be a conceptually sound approach. After all, there is no New York gift tax, and the increased federal exclusion amount may shelter a significant portion of such gifts from federal gift tax liability.[xx]
However, there are two factors, or traps, that conspire against the effectiveness of this strategy.
The first operates to deny more affluent New York business owners the benefit of New York’s increased exclusion amount. It does so by phasing out the exclusion amount when a decedent’s taxable estate exceeds the exclusion amount. What’s more, the phase-out occurs over a very narrow band of value, so that the benefit of the exclusion amount is eliminated entirely when the taxable estate is greater than 105-percent of the exclusion amount. At that point, the owner’s entire taxable estate becomes taxable, not just the part that exceeds the exclusion amount.[xxi]
This is what has been described as New York’s “estate tax cliff.” When the cliff applies, the decedent’s taxable estate is taxed according to New York’s graduated estate tax rates, beginning at 3.06-percent for the first $500,000, and then continuing upward, with the excess over $10.1 million being taxed at 16-percent.[xxii]
The second trap is intended to prevent a taxpayer, like the owner of a closely held business, from circumventing the New York estate tax by making gifts that reduce the taxable estate below the exclusion amount. Not only does this provision ensure the application of the New York tax to the estates of many resident decedents, it also increases the likelihood that New York’s “cliff” rule will apply to these estates, thereby generating a greater tax liability.
Summary of Recent N.Y. Estate Tax Legislation
Since the passage of the Act, New York has made it abundantly clear that it will neither match the federal estate tax exclusion amount, nor adopt the federal rule on portability between spouses.[xxiii]
However, that does not mean New York has been inactive on the estate tax front – on the contrary.[xxiv]
In April of 2019,[xxv] New York retroactively reinstated a provision[xxvi] by which a resident decedent’s New York gross estate will be increased by the amount of any taxable gift[xxvii] made by the decedent during the three-year period ending on the decedent’s date of death,[xxviii] provided the property transferred is not otherwise included in the decedent’s federal gross estate,[xxix] and provided the decedent dies before January 1, 2026.[xxx]
In other words, the requirement to add back taxable gifts has been extended to apply to estates of decedents dying on or after January 16, 2019 and before January 1, 2026.
That being said, the following gift transfers are not subject to the reinstated “claw-back” or inclusion rule:
- Gifts made when the decedent was not a resident of New York;
- Gifts made before April 1, 2014;
- Gifts made between January 1, 2019 and January 15, 2019;
- Gifts of real property or tangible personal property having an actual situs outside New York at the time the gift was made.[xxxi]
Planning Under the Mismatched Rules
As we approach the year 2020, tax advisors who represent business owners domiciled in New York should take stock of the basic federal and New York estate tax rules within which they will be operating:
- Federal Rules
- The combined gift and estate tax exclusion amount will be $11.58 million per individual;[xxxii]
- This increased basic exclusion amount will remain through 2025;
- The top federal estate (and gift) tax rate of 40-percent will apply to that portion of a taxable estate (or gift) in excess of $1.0 million;
- A surviving spouse may utilize the unused exclusion amount of their predeceased spouse;
- New York Rules
- The estate tax exclusion amount will be $5.74 million per individual;
- New York has no gift tax;
- New York will include in the estate of a New York decedent dying before 2026 the sum of any taxable gifts made by the decedent during the three-year period ending with their date of death;
- The benefit of the exclusion amount is completely lost for a New York taxable estate that exceeds 105-percent of the exclusion amount;
- The top New York estate tax rate of 16-percent will apply to that portion of a taxable estate in excess of $10.1 million;
- There is no portability of the unused exclusion amount from the estate of a deceased spouse to the surviving spouse – if a predeceasing spouse fails to utilize their entire exclusion amount, it will be lost.
In light of the fact that New York’s estate tax exclusion amount will be much lower than the federal exclusion amount, at least for the foreseeable future, a business owner who is domiciled in New York, and who is serious about reducing their total estate tax liability and maximizing the amount of wealth that will pass to their family, cannot simply plan for the federal estate tax and ignore New York.[xxxiii]
Depending upon who owns the business, both the owner and their spouse may consider making gifts, or splitting gifts,[xxxiv] of equity in the business in order to reduce both their federal and New York gross estates.
The owner may also want to consider making a gift of stock to their spouse in an amount sufficient to allow the spouse to fully utilize their New York exclusion amount.[xxxv]
Of course, the owner will have to survive for three years following a taxable gift if they hope to avoid New York’s claw-back rule and the inclusion of the gifted property in their New York estate. Because one never knows when Thanatos[xxxvi] will come for us, the owner may want to formulate and implement a gift plan sooner rather than later.
If the owner is concerned about giving away too much, this plan may include the use of SLATs[xxxvii] for the benefit of the owner’s spouse and/or children. This may assure the owner of continued access to the gifted property, “vicariously” through their spouse.[xxxviii]
In addition to outright gifts, this plan may also include transactions that are treated as sales – rather than as taxable gifts – for purposes of the gift tax. Thus, the owner’s sale of an equity interest in their business to a grantor trust[xxxix] in exchange for a promissory note may freeze the value of the property sold at the principal amount of the note, while shifting the appreciation in the property to the trust and away from the grantor-owner, which may keep the owner’s estate below the 105-percent threshold amount.
If there is any concern about a gift resulting from what may, in hindsight, turn out to be a bargain sale, a “Wandry”-like adjustment clause may be used to eliminate the risk of an inadvertent gift.[xl] A transfer to a GRAT may serve the same purpose.[xli]
Revisit Wills and Revocable/Living Trusts
Although gifts and other lifetime transfers are effective vehicles for planning for one’s estate – as well as for addressing the differences between the New York and federal estate tax rules – there are some individuals who find it extremely difficult to part with their property or to otherwise compromise their control, especially over their business.[xlii]
Those business owners, and their advisers, cannot lose sight of the fact that estate planning does not have to end with their demise. This is certainly true when planning for the use of the New York exclusion amount. For example, someone’s will may provide for the funding of a trust with an amount equal to the federal exclusion amount. Because the federal exclusion amount is so much greater than the New York exclusion, this provision may expose this individual’s estate to New York estate tax.[xliii]
It may be advisable to revise the terms of this testamentary trust so that it qualifies for the marital deduction as a QTIP trust;[xliv] in this way, a partial QTIP election may be made for the portion of the trust that exceeds the New York exclusion amount. Alternatively, perhaps the will should be drafted so as to allow the surviving spouse to timely disclaim[xlv] property that would thereby fund a testamentary trust up to the New York exclusion amount.
Escape from NY[xlvi]
In extreme cases, a New York business owner may try to abandon their New York domicile and establish a new domicile in a state that does not impose an estate tax.[xlvii]
However, changing a taxpayer’s domicile is easier said than done, especially where the New York business has not yet been sold and, more difficult still, where the owner remains active in its management.
In light of the foregoing, it will behoove the business owner who is domiciled in New York to meet with their advisers for the purpose of considering how their estate plan – including their will and/or revocable trust, and any gift or other transfers that may become a part of such plan[xlviii] – may impact their New York estate tax situation.
[i] OK, some of you might view the year-end differently. I can’t account for your lapses, like “I thought the Knicks would be more competitive by this point in the year,” or “Only two and one-half months before pitchers and catchers.” Seriously? Then there are those of you who enjoy the excesses of holiday shopping, and who actually look forward to New Year’s Eve. And you believe that I need help? C’mon.
[ii] P.L. 115-97; the “Act”.
[iii] Don’t forget the GST tax.
[iv] IRC Sec. 2010(c)(3).
[v] Beginning with 2012.
[vi] Rev. Proc. 2019-44.
[vii] In general, if such gifts had been made, but not in excess of the individual’s exclusion amount at the time of the gifts, the individual’s ability to make additional gifts without incurring gift tax liability would be determined by subtracting from the new exclusion amount the fair market value of those earlier taxable gifts based upon the fair market value of the properties transferred at the time of such gifts. The same principle applies – taking into account lifetime gifts – in determining how much value a decedent may pass without incurring estate tax. (You die only once.)
[viii] IRC Sec. 2010(c)(2) and (4).
[ix] Taxable gift transfers that do not exceed a taxpayer’s exclusion amount are not subject to gift tax. However, any part of the taxpayer’s exclusion amount that is used during their life to offset taxable gifts reduces the exclusion amount that remains available at their death to offset the value of their taxable estate.
[xii] T.D. 9884. The regulations apply to gifts made after 2017 and to decedents dying after 2025.
[xiii] Query whether the 2020 election results will accelerate the sunset of the increased exclusion amount into 2021, rather than as scheduled, in 2026?
[xiv] See TSB-M-14(6)M.
[xv] See P.L. 111-312, Sec. 302, and P.L. 112-240, Sec. 101.
[xvi] Effective for gifts and deaths after December 31, 2017.
[xvii] $11.48 million per couple, assuming both individuals utilize their respective exclusion amounts.
[xviii] $11.70 million per couple.
[xix] A gift of property removes the property, the income generated by the property, and the appreciation in the value of the property.
[xx] Especially if one considers the valuation of an equity interest that represents a minority stake in a closely held business.
[xxi] Contrary to the federal rule, which taxes only the excess.
[xxii] Only the states of Washington and Nebraska have a higher top marginal rate, while several others match New York at 16%. https://taxfoundation.org/state-estate-tax-state-inheritance-tax-2019/
[xxiii] Stated differently, although New York is not into portability, it definitely enjoys decoupling, at least when it comes to the federal rules.
[xxiv] See TSB-M-19(1)E.
[xxv] New York Fiscal Year 2020 Budget.
[xxvi] This provision was introduced in 2014, and had expired at the end of 2018. The reinstatement begins for gifts made on or after January 16, 2019.
[xxvii] Within the meaning of IRC Sec. 2503, even if “sheltered” by the federal exclusion amount.
[xxviii] This is derived from the old federal rule under which transfers made “in anticipation of death” were brought back into a decedent’s gross estate. Today, the three-year inclusion rules under IRC Sec. 2035 operate very differently.
[xxix] For example, by virtue of a retained interest in the gifted property under IRC Sec. 2036.
[xxx] Thus, New York’s three-year “claw-back” applies for the period of the increased federal basic exclusion amount.
[xxxi] Part F of Chapter 59 of the Laws of 2019; Tax Law § 954(a)(3).
[xxxii] Of course, 2020 is also a presidential election year. Much may depend upon the outcome, including the size of the federal exclusion.
[xxxiii] We are assuming, for our purposes, that the business will represent the most valuable asset of the estate, and will constitute most of the estate.
[xxxiv] IRC Sec. 2513. Splitting gifts allows one spouse to actually make the gift transfer, while charging one-half of the amount of the transfer against the consenting spouse’s exclusion amount.
[xxxv] Credit shelter planning for the predeceasing spouse is alive and well in New York.
As always, consider a shareholders’ agreement and recapitalizing into voting and nonvoting equity interests.
[xxxvi] The ancient Hellenic god of non-violent death. Best not to contemplate the other.
[xxxvii] Spousal limited (or lifetime) access trusts.
[xxxviii] Rather than through a “retained” interest that would cause the transferred property to be included in the transferor’s gross estate. Careful of reciprocal trusts.
[xxxix] https://www.taxlawforchb.com/2016/03/estate-planning-sales-to-grantor-trusts-not-dead-yet/ .
[xl] https://www.taxlawforchb.com/2014/02/wandrying-about-defined-value-clauses/ .
[xli] IRC Sec. 2702; Reg. Sec. 25.2702-3.
[xlii] Of course, there is no substitute for succession planning within the business. In any situation involving at least two owners, a buy-sell agreement should also be seriously considered.
[xliii] By funding it with an amount in excess of the New York exclusion.
[xliv] IRC Sec. 2056(b)(7).
[xlv] IRC Sec. 2518.
[xlvi] Do you remember this movie from the early ‘80s, with Kurt Russell, Adrienne Barbeau, Lee Van Cleef, and Donald Pleasance?
[xlvii] There are plenty of choices: https://taxfoundation.org/state-estate-tax-state-inheritance-tax-2019/ .
[xlviii] In other words, their plan for disposing of their assets among their family and perhaps others.