Starting January 1, 2009, changes to the exemptions for the federal estate tax and the Illinois estate tax will alter how some estate plan formulas for married taxpayers divide up the estate. Existing formulas may not fully capture the benefit of the increased federal exemption.
On January 1, 2009, the federal estate tax exemption increases from $2 million to $3.5 million. State death taxes aside, this means that in the estate plan of the first spouse to die, ideally the estate plan formula would allocate $3.5 million to a “family trust” for the benefit of the spouse and children, and the balance to a “marital trust” for the surviving spouse. The $3.5 million would not be taxed in either spouse’s estate, regardless of how large the family trust is at the survivor’s later death. Likewise, the marital trust would not be taxed in the decedent’s estate, but it would be subject to estate tax at the survivor’s later death. Under this formula, federal estate tax is deferred until the death of the second spouse to die and maximum use is made of each spouse’s federal estate tax exemption, thereby minimizing the federal estate tax on the passage of funds to the next generation.
Unfortunately, the Illinois estate tax exemption will stay at $2 million. The consequences of the mismatch between Illinois’ $2 million exemption and the federal $3.5 million exemption depend on the type of formula in the estate plan. Consider the following two examples.
Under older estate plans, at the death of the first spouse to die, the formula will fund the family trust with the largest amount that will produce no federal or state estate tax. Starting in 2009, for an Illinois decedent, that would mean no more than $2 million. Even though another $1.5 million could be allocated without the imposition of federal estate tax, any amount over $2 million would incur Illinois estate tax, so the balance of the estate would pass under this formula to the marital trust. While this allocation would result in no federal or Illinois estate tax at the death of the first spouse to die, it would “waste” $1.5 million of the decedent’s exemption. The consequence of this is felt at the surviving spouse’s later death. It is then that this $1.5 million—or the amount it may have grown to in the time between the deaths of the spouses—is subjected to federal and state estate tax.
Under an estate plan with an updated formula, the allocation would be the first $2 million to the family trust, the next $1.5 million to a “contingent” marital trust and the balance to the “regular” marital trust. The executor has the option to leave the allocation “as is,” in which case the estate tax result is the same as in the first example under the old formula—no federal or Illinois estate tax at the first death, but a “waste” of $1.5 million of federal estate tax exemption. Alternatively, the executor can elect to let the “contingent” marital trust fall into the family trust. Under that option, the estate realizes the full benefit of the $3.5 million federal estate tax exemption. However, the cost to achieve that result and the potential benefits of exempting that amount and any appreciation on it from estate tax at the survivor’s death is $229,200 in Illinois estate tax, which would come out of the marital trust. In many estates, it will make sense to pay the approximately 15 percent Illinois estate tax in order to reap the future benefit of the additional $1.5 million in federal exemption. This is so because, in present value dollars, that $1.5 million of exemption is worth $675,000 in savings at today’s marginal federal estate tax rate of 45 percent.
For persons who have not used the $1 million federal gift tax exemption, use of that exemption currently to create a trust for family members, gift-tax free, will reduce the $229,200 Illinois estate tax by $90,400. The reason is that taxable gifts (even those covered by the federal gift tax exemption) generally are not counted for purposes of figuring the Illinois estate tax.
What You Should Do
If you are a married Illinois resident and your estate plan has the old formula, you should consider having it updated so your estate has the option of using your full federal exemption. If your estate plan has the new formula, no change is required. If you have not used your $1 million federal gift tax exemption, you should consider doing so, not only for the potential $90,400 Illinois estate tax savings, but because the sooner that exemption is deployed in a trust that will not be included in your estate, the more value you can pass on without transfer tax to your descendants.