Tennessee Inheritance Tax Repealed – It’s Time for an Estate Planning Review
January 26, 2016 | Sherrard Roe Voigt & Harbison Blog I Carla Lovell
Prior to 2016, Tennessee imposed a separate inheritance tax and had an exemption from that tax that was less than the federal estate tax exemption. As of January 1, 2016, Tennessee’s inheritance tax is fully repealed. The federal estate tax exemption is $5,450,000 for 2016 and is indexed for inflation. Assets in excess of the federal exemption are taxed at 40%.
Federal law also allows the unused estate tax exemption of the first spouse to die to carry over to the second spouse. This concept is known as “portability.” If the first spouse leaves his or her entire estate outright to the survivor, no exemption will be used because the entire estate is eligible for the estate tax marital deduction. The surviving spouse will then have a double federal exemption, although the carry over amount from the first spouse will not continue to benefit from inflation indexing. Portability does not apply to the federal generation-skipping transfer tax exemption so it will still be lost to the extent it isn’t used at the first death.
For a couple with combined assets up to the federal exemption amount, planning and documents can now be simpler. For many years, minimizing estate taxes has involved by-pass trust planning (also known as a “Family Trust” or “Credit Shelter Trust”). A Family Trust was funded when the first spouse died and was sheltered by the first to die’s estate tax exemption. The Family Trust was excluded from the estate of the survivor so that the survivor would have full use of his or her own estate tax exemption. When the Tennessee inheritance tax exemption was less than the federal exemption, the Family Trust may have been divided between a Family Trust and a Tennessee Marital Trust to defer the payment of Tennessee inheritance tax on the Family Trust assets in excess of the Tennessee exemption.
By-pass trust planning required that spouses hold assets in separate names, avoid ownership as joint tenants with right of survivorship, and balance their estates so that no matter which spouse died first, assets would be available to fund the Family Trust. For estates where the combined assets of both spouses will be less than the federal exemption, this strategy is no longer needed to save estate taxes. Spouses can now leave property outright to each other, and can hold assets jointly, so that at the first death title passes directly to the survivor by operation of law.
Simplicity is appealing and will be appropriate for many couples. However, there are nontax reasons why trusts will still be useful in certain situations. It remains important to use trusts to hold assets for the benefit of a minor, disabled, or financially immature beneficiary. A trust may also be used to provide asset protection for mature beneficiaries who may be in high risk professions or businesses. By-pass trust planning remains necessary to take full advantage of the federal generation-skipping transfer tax exemption. Where spouses are providing for each other, even if both spouses are currently fully capable, there is a risk that the survivor may suffer a loss of capacity and become a victim of undue influence or financial scams. A trust may provide a helpful defense against these risks.
A trust may also be useful to assure that the assets will ultimately pass to the children after the second death. This is particularly important in a second marriage situation where the children of the first to die are not also the children of the surviving spouse. A trust may also be used to ensure that the assets of the first to die will pass to the children if the survivor remarries.
While trusts may be useful for various nontax planning purposes, there are costs associated with administering a trust. These costs may include trustee’s fees, accounting fees for trust tax returns, the potential cost of paying income taxes on trust income at higher marginal rates, and the loss of the step-up in cost basis in the trust assets at the second death. If a trust avoids substantial estate taxes or is needed to protect a minor or disabled beneficiary, the justification for the trust is compelling. If estate taxes are not an issue, the burdens of holding the assets in trust must be weighed against the nontax benefits.
For larger estates, or estates where there have been significant taxable gifts, estate planning will continue to be complex and will need to involve the tools we’ve used in the past to minimize the adverse impact of the 40% federal estate tax. These tools include using family trusts, marital trusts, generation-skipping trusts, and charitable bequests or trusts to maximize the use of available exemptions and deductions.
The repeal of the Tennessee inheritance tax creates planning opportunities that may help families who are administering existing Family Trusts that were created upon the death of a deceased spouse or a trust for a child that was created after a parent’s death. As mentioned above, while there may have been nontax reasons for creating the trust, if the primary purpose was to keep the assets out of the estate of the surviving spouse or child or if the nontax reasons are now irrelevant, the trust may no longer be needed in light of the higher federal estate tax exemption. Depending upon the size of the estate of the surviving spouse or child, the assets may now be included in the estate of the surviving spouse or child without triggering federal estate tax. If the assets are included in the second estate, the income tax basis of the assets will be stepped up to fair market value at the second death. This would eliminate unrealized capital gains on the assets that were held in the trust at the second death.
It is sometimes feasible to terminate a trust and distribute the trust assets to the surviving spouse or the child. A termination may be followed by the transfer of the assets to a Tennessee asset protection trust (also known as a “Tennessee Investment Services Trust”) for a better tax result combined with continued creditor protection. Alternatively, it may be possible to modify the trust to achieve a better tax result without actual termination of the trust. Under Tennessee law, the termination or modification of a trust whose grantor is deceased, even if approved by all qualified beneficiaries, must be approved by the local probate court.
Each trust is different, and determining the feasibility of termination requires a close review of the trust’s terms and the family situation. Some questions to be asked are: Who are the beneficiaries of the trust and how must the trust assets be distributed if the trust is terminated? How burdensome is the administration of the trust, and are income taxes a consideration? How much unrealized gain is trapped inside the trust and if the trust is terminated, would the spouse’s or child’s estate be subject to federal estate tax? Is there a continued need for the asset protection or investment management afforded by the trust? Are the beneficiaries who will receive the assets at the death of the surviving spouse or child the same as the remainder beneficiaries of the trust? Do all of the qualified beneficiaries approve a termination?
The repeal of the Tennessee inheritance tax and the increased federal exemption should trigger a review of many estate plans, especially those containing by-pass trust planning. Now is also a good time to review existing Family Trusts to see if they still meet the needs of the family. In addition, it is always wise to review the designation of fiduciaries from time to time to make sure that the individuals named as executors, trustees, and agents under powers of attorney are still willing and able to undertake the duties of their position.
Carla Lovell is a tax attorney concentrating in the areas of Trusts & Estates and Taxation.
