Fall 2003 Newsletter
LIFETIME TRANSFERS RESULT IN VIRGINIA ESTATE TAX SAVINGS DUE TO PHASE OUT OF STATE DEATH TAX CREDIT
by Erin Sheehey Downs
The decoupling of the Virginia estate tax from the federal state death tax credit as a result of the Economic Growth Tax Relief and Reconciliation Act of 2001 ("EGTRRA") provides a significant opportunity for tax savings through lifetime giving. The tax savings is the result of simple mathematics. The state death tax credit, upon which the Virginia estate tax is based, applies only to the taxable estate and does not apply to adjusted taxable gifts. Therefore, lifetime transfers that are completed gifts will not be subject to Virginia estate taxes. This tax savings opportunity should not be overlooked, especially for the terminally ill client who will not be able to benefit from future tax reform or repeal. This article explains and illustrates the reduction of overall estate taxes through lifetime gifts.
The Decoupling of the Virginia Estate Tax from the Federal Estate Tax System
Current Virginia law provides that the amount of the Virginia estate tax shall be no less than the amount of the federal death tax credit as it existed in 1978.1 The EGTRRA decreases and then eliminates the allowable credit for state death taxes over a four year period.2 In 2002, the credit was reduced by 25%. This reduction is 50% in 2003 and increases to 75% in 2004. In 2005, the credit is eliminated and replaced with a deduction for state estate or inheritance taxes paid.3 The deduction continues until the scheduled repeal of the federal estate tax in 201 0.
On April 3, 2003, the Virginia Assembly sustained Governor Warner's veto of legislation that would have "coupled" the Virginia estate tax to the federal estate tax system. If that legislation had passed, Virginia's estate tax would have been exactly equal to the amount of the federal death tax credit, so as the credit decreased and then disappeared as a result of the 2001 Tax Act, Virginia's estate tax would have also decreased and then disappeared. Instead, the Virginia estate tax remains at 100% of the computed state death tax credit.
Tax Savings Through Lifetime Transfers
The additional estate taxes resulting from the decreasing federal credit and the anchored Virginia estate tax can be saved if the client makes lifetime gifts because the state death tax credit, upon which the Virginia estate tax is based, applies only to the taxable estate and not to adjusted taxable gifts. This strategy is successful in Virginia because there is no state gift tax and no gift in contemplation of death rules. The following example illustrates the mathematics that result in the tax savings.
Assume that Client is not married. Her total current assets are $5,000,000. The beneficiaries of her estate are her children. If Client makes gifts of $3,000,000 and dies in 2003, the gifts result in estate savings of $146,000. If her death occurs in 2004, the tax savings increase to $219,000. Assuming the same facts, except that Client's current assets are $25,000,000 and the amount of her lifetime gifts is $12,500,000, the estate tax savings are $1,000,000 if she dies in 2003 and $1,500,000 if she dies in 2004. The tax calculation for 2003, as well as the percentage savings for 2003-2009, are shown in Exhibit A.
Note that lifetime gifts result in an increase in the federal estate and gift tax liability. It is the reduction in the Virginia estate tax that causes the total tax savings. Since the federal taxes are increased, the gifts are not a red flag for an IRS audit. The risk of audit by the Virginia Department of Taxation is typically less than the risk of a federal audit. Even if there is an audit, there is no exposure if the gifts are in fact completed before the client dies.
Of course, one disadvantage of making lifetime gifts and incurring a current federal gift tax liability is that if the federal estate tax is repealed, federal gift taxes have been paid unnecessarily. This lifetime gifting strategy is therefore recommended for amounts in excess of the $1,000,000 gift tax exemption amount only when it is apparent that the client will not survive estate tax repeal or reform.
A gift of the $1,000,000 federal estate tax exemption amount will not result in a current gift tax liability. Such a gift will result in estate tax savings, the amount of which depends on the value of the client's estate. If a client's estate will be taxed in the top marginal Virginia estate tax bracket, applicable to taxable estates in excess of $10,100,000, a gift of $1,000,000 will result in Virginia estate tax savings of $80,000 if the client dies in 2003 and $120,000 of savings if the client dies in 2004.
Planning for Gifts During Incapacity
It is advisable to ensure that an agent or trustee has the authority to make these gifts in the event that the client becomes incapacitated prior to death. Then, if the client becomes ill and it is apparent that he will not recover, gifting can be accomplished and tax savings realized.
Gifting for Clients with Appreciated Assets
Highly appreciated assets should not be used to fund the gifts, if possible. The donee will have a carryover basis in appreciated property, and will incur capital gains taxes when the gifted property is sold. The client could borrow the cash to make the gifts, pledging an investment portfolio or other appreciated property as collateral. Then when the client dies and the basis of the appreciated property is stepped up to fair market value, the appreciated property can be sold with little or no tax cost to payoff the loan.
Change in Domicile to Save Taxes
A number of states have a tax that is tied to the federal death tax credit. When the state death tax credit is eliminated in 2005, these states will no longer have an estate tax. A change in domicile for a Virginia resident to one of these other states will result in significant estate tax savings for the client. Many wealthy Virginians already have residences in other states and spend a significant amount of time residing in those other homes. Those clients should give serious consideration to a possible change in domicile.
Every Virginia estate planning attorney should plan for the possibility of lifetime gifts in order to minimize estate taxes. As illustrated above, the tax savings can be substantial. Unlike other estate planning strategies, there is little audit risk to this lifetime giving strategy. So long as the gifts are complete before the client's death, the tax savings are realized. Future legislation in Virginia may also provide some estate tax relief. In the meantime, Virginians should keep all of their options open, including a possible change in domicile.
Erin Sheehey Downs is a shareholder with the law firm of Jones, King & Downs, P. C. in Bristol, Virginia. Ms. Downs received her B.S. and J.D. degrees from William and Mary ·in 1984 and 1987 respectively. Prior to joining her firm, Ms. Downs was associated with the firm of Christian & Barton in Richmond and served as Trust Counsel for Crestar Bank. She focuses her practice on estate planning, trust and estate administration and fiduciary litigation. Ms. Downs gratefully acknowledges the efforts of her partner, Nell King Bieger,for her prior work on this issue and for her editing contributions.
1 Va. Code § 58.1-901.
2 I.R.C. § 201 1(b)(2).
3 I.R.C. §§ 2011 (t), 2058.