Vermont Estate Tax: To Decouple or Not?

Article written by John C. Newman, Esq.
Posted on Jul 01, 2011

by John C. Newman, Esq. and Ron R. Morgan, Esq.

In a major departure from current tax policy, the Vermont legislature is considering a bill to impose the Vermont estate tax on some estates where currently no federal estate tax would be due. Under present law, estates valued at $3.5 million or less are not subject to Vermont or federal estate tax. Under the proposed law, Vermont estates valued at more than $2 million would be subject to the Vermont estate tax, applied retroactively to the estates of decedent’s dying after December 31, 2008. Attorneys Ron Morgan and John Newman have recently presented testimony before the Ways and Means Committee of the Vermont House or Representatives, outlining some of the problems with implementing such legislation and describing the potential impact of the change on current Vermont estate plans.

House Ways & Means Committee

Written Testimony of John C. Newman & Ron Morgan, Kenlan Schwiebert

Rutland, Vermont–February 11, 2009

  1. The relevant provisions are Sections 18-21 of the Miscellaneous Tax Bill.
  2. The bill provides: For decedents dying on or after January 1, 2009, if a federal estate tax

    return would have been required under the provisions of the Internal Revenue Code as in effect on January 1, 2008, the estate tax shall be calculated as provided in this section except that the applicable credit amount used to calculate the tax shall be the amount in effect as of January 1, 2008. Section 18. The applicable credit (exempt) amount in effect on January 1, 2008, was $2 million. IRC Section 2010 (c).

  3. If a federal estate tax return is not required (because the gross estate is less than the

    federal exempt amount of $3.5 million), but a Vermont return is required (because the gross estate is greater than $2 million), then a "pro forma" federal estate tax return must be prepared and filed with the Vermont estate tax return. Section 20.

  4. The Vermont estate tax is calculated based upon the amount of the federal taxable estate.

    Form E-1 (rev. 12-08). Currently, the federal taxable estate of the first spouse of a married couple to die is typically zero, because there is an unlimited marital deduction for assets passing to the surviving spouse, which reduces the taxable estate to zero. IRC Section 2056. However, it is common for attorneys in Vermont and elsewhere to design estate plans that will fully utilize the federal exempt amount of the first spouse to die by having assets pass into a so-called “bypass trust” for the benefit of the surviving spouse and the decedent’s children. The assets in the bypass trust do not qualify for the marital deduction and are therefore included in the decedent’s taxable estate; however, no estate tax is due because the value of the assets passing into the bypass trust does not exceed the federal exempt amount. A properly drafted bypass trust is not includible in the taxable estate of the surviving spouse. We have included below a diagram of our standard estate plan as it worked with the $2 million federal exemption equivalency.

  5. The bill imposes the Vermont estate tax on taxable estates greater than $2 million for

    decedents dying on or after January 1, 2009. Under current law, the federal exempt amount in 2009 is $3.5 million. For decedents dying in 2009 with a typical bypass trust plan, this means that the federal taxable estate of such decedents will be $3.5 million and, therefore, exempt from tax under federal law. However, since the taxable estate of such decedents will be greater than $2 million, a Vermont estate tax of $230,000 estate will be due. Such a tax unfairly penalizes taxpayer couples who have engaged in estate planning, compared with those who do not (because married couples without estate plans typically own all of their assets jointly or leave all of their assets to the surviving spouse and therefore there is no taxable estate upon the death of the first spouse to die). More importantly, in many cases such a tax could seriously reduce or eliminate the liquid assets available to the surviving spouse for their support, possibly forcing the sale of assets at a loss, or even the sale of the personal residence.

  6. There is a minor complication in the foregoing analysis. Schedule A of Form E-1

    indicates that the Vermont estate tax liability is the lesser of the federal estate tax or the calculated Vermont estate tax. In the foregoing example, if Schedule A is modified to conform to the proposed new law, the federal tax liability would be calculated as if a $2 million exemption applied, even if the actual federal exempt amount were $3.5 million (as it is today). For some estates in excess of $2 million but substantially less than $3.5 million, the Vermont tax liability would be limited. Under the new legislation, however, the fully funded bypass trusts would bear the full brunt of the Vermont estate tax, and the federal tax would be zero up to the $3.5 million exemption.

  7. Massachusetts, which has a lower exempt amount than the federal exemption, addresses

    the foregoing problem by allowing the trustee of a bypass trust to make an election to treat a portion of the trust assets as qualifying for the marital deduction for state estate tax purposes, so that no Massachusetts estate tax is due upon the death of the first spouse. This election is sometimes referred to as a "State QTIP" election (See, "Massachusetts Department of Revenue Directive 03-2, Issues Arising from Decoupling the Massachusetts Estate Tax from the Federal Estate Tax.”). Unfortunately, the election: (i) is not statutory, only a matter of administrative discretion (meaning reversible), and (ii) only applies to certain types of trusts (all income payable to the surviving spouse at least annually, no other beneficiary during the lifetime of the surviving spouse). If the Vermont bill were to allow a state QTIP election for qualifying trusts, many Vermont taxpayers would likely have to amend their trust agreements to comply, placing a heavy burden on taxpayers since the effective date of the law is January 1, 2009. Such a provision would also be difficult to administer, since a portion of the assets in the bypass trust would then become subject to Vermont estate tax upon the death of the surviving spouse, requiring an allocation and segregation of assets for that purpose.

  8. "Decoupling" of the state estate tax from the federal estate tax in a manner that is fair

    and equitable to all Vermont taxpayers is a complex undertaking. For example, the US Congress is considering a portable credit that could be used by either member of a married couple so that they could avoid the use of trusts in taking advantage of the full federal estate tax credit in the estate of the first spouse to die. Such a transferable credit, if allowed by the new Vermont legislation, might solve the problem posed by the bill. We believe further study is needed in order to draft an effective, fair, and administrable law. The current uncertainty at the federal level regarding the future of the estate tax regime makes this undertaking even more difficult. Ideally, it would be best to wait until the Congress finally acts to permanently reform federal estate tax law. Unfortunately, the possibility that the estate tax may he allowed to be repealed for one year in 2010, only to return in full force in 2011 based upon the law as it existed before the 2001 Act, with a $1 million exemption and a 50%+ top rate, makes such an approach rather challenging.

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