Federal and Connecticut Estate Tax Tension: Two Big Reasons to Add a Trust to Your Estate Plan


Federal and Connecticut Estate Tax Tension: Two Big Reasons to Add a Trust to Your Estate Plan

By Paul T. Czepiga, CzepigaDalyPope LLC

Connecticut residents are exposed to both a federal estate tax and a Connecticut estate tax if their net worth at death exceed a certain level.

Unfortunately, the net worth level at which these taxes apply, and how they apply, is different for the federal estate tax and for the Connecticut estate tax. (Watch Paul spell it out in this video.)

Here is a quick walk through of how these taxes work and the tension that is created by having two different thresholds:

The federal estate tax threshold is $5.49 million (it is indexed for inflation and will likely increase each year). This means that each taxpayer is given a $5.49 million exemption from the federal estate tax. So if you die with a net worth less than this amount, your estate is not subject to the federal estate tax and is not required to file a federal estate tax return. This amount is indexed annually for inflation. If you are exposed to the federal estate taxes the rate is a flat 40%.

What about gift tax?

Yes, there is also a federal gift tax, and that also has a $5.49 million exemption. But you only get ONE exemption for federal estate and gift tax. If you make lots of big gifts during your lifetime, you will “use up” part of your exemption and have that much less exemption left when you die that you could otherwise have used to protect the assets you still own at your death.

You do not have a choice about paying gift tax now and “saving” the exemption for when you die. Gifts automatically soak up the exemption first.

Big gifts are those in excess of $14,000 to any one person in any given year. The $14,000 is indexed for inflation and rounded to the nearest $1,000 (it does not increase each year).

Property between spouses

Property passing between spouses during life or at death is not taxed for gift tax or estate tax purposes. This is known as the unlimited marital deduction.

For example, if your spouse dies with a $7.0 million gross estate and leaves you $4.0 million, your spouse gets a $4.0 million deduction, leaving them with a $3.0 million net taxable estate from their gross taxable estate.

The $3.0 million net taxable estate would itself be shielded from the federal estate tax because of the $5.49 million exemption. The $2.49 million of remaining exemption is portable for married couples—a new feature that came into being in 2012. This means that you, as surviving spouse, would have your own $5.49 million exemption and the remaining $2.49 million of your predeceased spouse’s exemption, for a total exemption of $7.98 million.

Connecticut taxes

Connecticut, like the federal government, also has an estate tax and a gift tax (Connecticut is the only state with a gift tax – lucky us!).

The Connecticut estate and gift tax works almost identically to the federal estate and gift tax with a few major exceptions.

1. The Connecticut estate and gift tax exemption only $2.0 million per person and it is NOT portable—the first spouse to die either uses their $2.0 million exemption or it is lost forever.

2. The Connecticut exemption is not indexed for inflation.

3. The rates for gifts or bequests go from 7.2% to 12%, unlike the federal flat rate of 40%.

Property passing between spouses during life or at death is not taxed for gift tax or estate tax purposes. This is known as the unlimited marital deduction and is identical to the federal scheme.

UNLESS YOUR ESTATE PLAN IS CAREFULLY DRAFTED, THIS FEDERAL AND STATE LAW CAN CAUSE A PROBLEM

Problem #1
Assume Joe has $3 million and his wife has $2 million.

Joe dies first and has an outdated estate plan that, in typical fashion, says leave in a trust for his spouse the largest amount that he can shield from federal estate by use of his exemption. This would be $5.49 million, but Joe has only $3 million of assets so his entire estate passes into a trust for his spouse. This type of trust normally does not qualify for the martial deduction, but there won’t be any federal estate tax due because Joe’s $3.0 million net taxable estate is fully protected by his federal estate tax exemption.

But what of Connecticut’s estate tax. Joe has a $3.0 million net taxable estate, but he only has a $2 million Connecticut estate tax exemption. The excess over the $2.0 million Connecticut exemption ($1 million) that passes into the trust for his spouse will be taxed to Joe’s estate by Connecticut at 7.2%, or a cost of $72,000. Oops?!

Problem #2
Assume the same facts as above, but Joe’s estate plan says something to the effect of: Gee, my wife’s and my estates combined are $5.0 million, and between us, due to the portable nature of the federal estate tax exemption, I can just leave my entire estate outright to my wife and she, at her death, will have available to her both mine and her $5.49 million federal estate tax exemptions—a total shield of $10.98 million.

Joe dies and leaves his entire estate to his wife and she later dies with the $5.0 million.

Result: No federal estate tax at either death, but when she dies with $5.0 million and only a $2.0 million Connecticut estate tax exemption, her estate will owe roughly $216,000 of Connecticut estate tax. She only has her $2.0 million exemption—unlike the federal scheme, Joe’s wife does not get the benefit of Joe’s unused Connecticut exemption.

Is there a solution?

Yes. It involves a trip to the attorney’s office to get the documents redrafted to factor in the use of one or more types of trusts that will allow all of the husband’s assets to be made available to the surviving spouse in a manner that delays or reduces the Connecticut estate tax.