Taxation & Estate Planning

The QTIP, Part 2

By Joel A. Schoenmeyer

Let me add a little bit of a wrinkle to the discussion in my last post, by introducing the concept of the state estate tax. This is extremely relevant to the new Illinois QTIP statute.

Yes, most states (including Illinois) have an estate tax. But, in the past, this tax was hard to spot. Why? Because, on the federal estate tax return, you would get something called a "state death tax credit" (essentially, a credit for state estate taxes paid). And most states (again, including Illinois) had what was known as a "pick-up tax" or "sponge tax," meaning that their estate tax was equal to the state death tax credit. That made the state estate tax look almost invisible. If you owe a federal estate tax of $6 million, that's what you pay in total, but instead of all $6 million going to the federal government, a portion (equal to the state death tax credit) goes to Illinois.

Then things got even trickier. In 2001, legislation was passed raising the (federal) exemption amount over time. (Allow me to sound old: when I started practicing law, in 1996, the exemption amount was $600,000. In 2001 it was $675,000. Now it's $3.5 million.) That meant less estate tax revenue for the states with a sponge tax. To makes matters even worse, the state death tax credit was phased out. These two changes meant much less estate tax revenue for most states, so most of them hit upon a solution: change their estate tax from a pick-up tax to a real, bona fide estate tax.

That's what Illinois did, but the state set its exemption amount (also called the "exclusion amount") at $2 million instead of $3.5 million. You can imagine the problem that that causes -- most estate plans are drafted to minimize the federal estate tax. So, as I explained previously, if you are married and have a $5 million estate, it's easy to pay no estate tax upon your death:

$3.5 million to family trust (no estate tax on this, ever, because it equals the exemption amount)
$1.5 million to marital trust (no estate tax on this because of marital deduction; will be taxable in surviving spouse's estate)

But if you set up your trusts like this, then you will owe Illinois estate tax, since $3.5 million exceeds the Illinois exclusion amount.

Next time: the Illinois QTIP.

Full post as published by Death and Taxes Blog on October 27, 2009 (boomark / email).