Douglas A. Turner, P.C.

Hurray! The federal estate tax exemption is 1.5 million this year. Hurray! A married couple with a tax planning estate plan can shelter up to 3 million from federal estate tax. Hurray! The federal exemption will go even higher in the year 2009. But … what about STATE estate tax? Oops! Well, listen up and save some money.

The term of art is decoupling. It is technical. It is hard to understand. But, it is pretty darn important these days.

First, you have to understand state estate tax. Colorado, for example, has an estate tax. However, it is transparent to the taxpayer. The Colorado estate tax does not increase the total amount of estate tax paid upon death. It is deducted directly from the federal estate tax. The federal estate tax regulations provide a direct credit for a specific amount of state estate tax paid. This is called a sponge tax because the state sucks up whatever the federal government allows as a credit. That is exactly what Colorado does. Colorado collects whatever the federal government allows without increasing the total estate tax payable.

Last time I checked, about 30 to 40 states had this kind of sponge tax. I think the exact number was 37. Anyway, guess what? Remember that federal law responsible for the increasing federal estate tax exemption? Well, that same law did away with the credit given for state estate tax paid. As of January 1, 2005, the credit is no more. This a one-two blow to states using a sponge tax. First, the increasing federal exemption reduces estate tax revenue because a sponge tax state “couples” its rates to the federal rates. Second, the federal credit is no more. After 2004, any state using the “sponge” is left with no estate tax revenue. Nada! Zip!

As a result, many states are decoupling from the federal estate tax exemption rates. While the federal exemption is now at 1.5 million and rising (for now), states are setting lower exemption limits. This is a problem because most husband-wife tax planning wills and trusts in sponge tax states assume a coupled federal/state rate. The funding clause used in the estate plan directs the maximum amount allowed under federal law to the tax planning trust (the Family Trust/Bypass Trust/Credit Shelter Trust). As states decouple, those estate plans may generate state estate tax upon death. If the deceased has assets over the state estate tax exemption limit, state estate tax will be generated.

For now, Colorado has not decoupled. However, many other states have decoupled and more are considering decoupling. And, a Colorado resident with real property in a decoupled state may have estate tax to pay.

So, what should a person do? Well, it is probably a good idea to see your estate planning lawyer and modify your estate plan. With a revised estate plan, a married couple can take full advantage of the entire federal estate tax exemption without triggering state estate tax. It can be done, but it is certainly a more complex plan. In the mean time, keep a close eye on the Colorado legislature. Colorado may be the next state that decouples from the federal estate tax system.