As we have indicated in previous newsletters, the Maine Legislature has been grappling with the problem of what to do about the Maine estate tax since the federal government adopted a tax reform bill in 2001 which phased out a uniformly calculated estate tax that was shared between the federal government and participating states like Maine. In 2003 the Maine Legislature “froze” the credit that would have been allowed under pre-2001 federal law as the Maine tax for deaths in 2003 and 2004. That state law has just been extended permanently, and Maine now joins the ranks of a growing number of states which have “decoupled” their estate tax systems from the new federal estate tax system.

The Maine system relies on prior federal law and taxes estates that are at a much lower threshold than would be taxed under the new federal system. For example, the federal exclusion amount for 2004 is $1.5 million, but the Maine exemption for 2004 is only $850,000. The effect of these changes is that a Maine estate tax may be due even if there is no federal tax due or no federal filing requirement. Many traditional estate plans for Maine residents drafted to optimize tax benefits under federal law will now result in the payment of a Maine estate tax even if there is a surviving spouse. Although payment of a relatively small Maine estate tax on the death of the first spouse to die may be appropriate in some cases, clients should be aware of what their plan will do and be comfortable with the results.

Because the original Maine changes were only for a two year period, many clients decided to wait and see whether Maine would enact further changes. Now that the Legislature has decided that Maine will continue to have an estate tax that is “decoupled” from the new federal system, clients should consider the impact of this development on their own plans, and determine whether revisions are now appropriate. Below is a table that illustrates the difference between the federal exemption amount (known as the “applicable exclusion amount”) and the Maine exemption amount for estates that do not include taxable gifts. It also shows the amount of Maine tax that would be due on the death of an individual who has a typical estate plan directing the maximum federal exclusion amount to a credit shelter trust and distributing the balance to the surviving spouse.

The calculation and application of the new Maine estate tax is quite complex. Please click here for an explanation of how the Maine Estate Tax is calculated. Perhaps the clearest way to examine the impact of this new tax is by example. It is important to note that the impact varies greatly depending upon the size of the estate and the year of death. This makes planning difficult because there are so many variables; and the likely future of the federal estate tax itself, a critical component in the equation, is also uncertain at this time.

Before Maine decoupled from the federal system, a typical estate plan for a married couple with assets over the federal exclusion amount provided for the use of a credit shelter trust to hold assets having a total value equal to the federal exclusion (currently $1.5 million), with the balance of the decedent’s estate passing to the surviving spouse and/or a marital trust. This type of plan (a “federal plan”) served to avoid all state and federal estate taxes on the death of the first to die and kept all assets in the credit shelter trust out of the estate of the surviving spouse for estate tax purposes. It had a positive impact for a couple with a total estate value slightly over the federal filing threshold and also for those significantly over that threshold.

For example, under the previous system, if John and Abigail had a $5 million combined estate and John died in 2004 owning $3.5 million of that estate, he would have left the federal exclusion amount ($1.5 million) to a credit shelter trust for the benefit of his family, and the remaining $2 million to his wife.² There would have been no state or federal estate tax due on John’s death. On Abigail’s subsequent death, her taxable estate would be worth $3.5 million (the $2 million she inherited from John, and $1.5 million of her own, assuming no appreciation), which would be reduced by her federal exclusion amount ( $1.5 million in 2004 and 2005; $2 million in 2006 – 2008; and $3.5 million in 2009) to determine the state and federal estate tax liability of her estate. The assets in John’s credit shelter trust (initially $1.5 million but possibly much more by the time of his wife’s later death) would pass free of all estate taxes to the remainder beneficiaries of his trust. Similarly, if George and Martha had a combined estate of $2 million, and George passed away in 2004 owning $1 million of that estate, his entire separate estate would have passed to his credit shelter trust, and there would have been no tax at all under the previous system. Upon Martha’s later death, her entire estate ($1 million of her own assets, assuming no appreciation) would be covered by her exemption and there would be no state or federal estate tax due at the death of either.

Unfortunately, under the current Maine estate tax system, this type of plan no longer works to avoid a state tax on the death of the first to die. Because Maine now calculates its estate tax under the prior federal law and has lowered its threshold for taxable estates, both John’s and George’s taxable estates in the examples above would be over the $850,000 Maine threshold and would owe a Maine tax. John’s estate plan would generate a Maine tax of $64,400 and George’s would generate a Maine tax of $33,200. Over the next several years, as the federal exclusion amount continues to increase, a typical “federal plan” (which funds the credit shelter trust by as much as the federal exclusion amount, as in the examples above, and leaves the balance to the surviving spouse) could lead to a significant Maine estate tax liability upon the death of the first spouse to die if he or she has a separate estate worth more than the Maine exemption amount³.

In essence, clients now have a choice: avoid all estate taxes upon the death of the first spouse to die by underutilizing his or her federal exclusion, or pay a Maine estate tax at that first death in order to fully utilize both available federal exclusions. By paying a Maine estate tax at the first death, the estate of the first spouse to die can fully fund a credit shelter trust, thereby sheltering more assets from taxation on the death of the surviving spouse and potentially reducing the total estate tax burden on the survivor’s death. Although clients may avoid a Maine estate tax on the first death by choosing to fund the credit shelter trust with the lower Maine exemption amount instead of the higher federal exclusion amount, they might add more than is appropriate to the estate of the survivor and ultimately expose those additional assets to an unnecessary high federal tax rate (and a state tax) at the survivor’s death. But will there even be a federal estate tax at the survivor’s death? And if there is such a tax, how high will the federal exclusion amount be in 2010, or 2015, or 2020; and what will be the applicable tax rate in effect in those years? At this point in time, unfortunately, no one has an answer to these questions, which makes planning under these circumstances a challenge.

Returning to our example of Abigail and John with a $5 million combined estate, a “federal plan,” and John passing away in 2004 with full funding of his credit shelter trust, the Maine estate tax on John’s estate would be $64,400; but the total estate tax payable on Abigail’s subsequent death with an estate of $3.5 million (assuming no other assets, no appreciation in value, and no further tax law changes) would vary depending on the year of her death, as illustrated below:

If John’s estate plan had called for funding the credit shelter trust with the Maine exemption amount (rather than the federal exclusion amount), there would have been no federal or Maine estate tax liability at his death. But the “cost” of eliminating the Maine estate tax liability would be John’s inability to use his entire federal exclusion ($1.5 million in 2004). Had John funded his credit shelter trust with the Maine exemption amount ($850,000), Abigail’s estate would be $4,150,000 (rather than $3.5 million) for both federal and Maine estate tax purposes. Upon her subsequent death (assuming no other assets, no appreciation in value, and no further tax law changes), her estate would be liable for the following estate taxes depending on the year of her death:

The result for John and Abigail seems fairly clear: under current federal law and the new Maine law, their ultimate beneficiaries, after the death of the survivor, are better off with a “federal plan” and paying a relatively small Maine estate tax on the death of the first to die. The following table compares the total tax burden under the different plans for years 2004 through 2009:

The comparison of federal and Maine plans for George and Martha, however, yields very different results. When the combined estate is in the $2 million range, the calculations are much closer and vary a great deal based on the year of death for each spouse. If George were to die in 2004 owning half of the estate, and Martha were to die later but before 2006, a Maine plan would generate a lower aggregate tax than a federal plan; but if Martha were to die after 2005 (again, assuming no other assets, no appreciation in value, and no further tax law changes), a federal plan would generate the more favorable overall result. The following table compares the results of the total state and federal estate tax on the estates of George and Martha, assuming George’s death in 2004, depending upon when Martha later dies:

To add even more confusion to the analysis, if we were to change our facts and increase the combined estate from $2 million to $2.5 million, and George were to die in 2004 (survived by Martha) owning $1.5 million of that total, the use of a federal plan (and payment of a Maine estate tax by George’s estate) would always yield a smaller aggregate tax liability for the two estates (utilizing the same assumptions as above), no matter when Martha later died during this period. But were George to die in 2006 instead, the results would be quite different. At that point, under a Maine formula, Martha’s estate would never have a federal tax, and thus the Maine formula is probably the better choice. The discussion above illustrates the complexity of the planning process, especially for couples who are slightly over the Maine filing threshold with a significant amount of separate property owned by each. Given the many variables involved, and the uncertain fate of future estate tax reform, carefully drafted flexibility in estate planning documents will be essential to allow appropriate choices to be made at the proper time without incurring unnecessary or premature payment of tax.

Existing estate plans should be reviewed to make certain that each client is comfortable with the choices made in his or her plan. If a client’s estate is slightly higher than the federal exclusion amount right now, then the use of a Maine formula with an appropriate disclaimer provision should be considered. If a client’s estate is significantly over the filing thresholds (say $5 million or more) a federal plan may continue to be appropriate. This would mean, however, that a Maine tax would be due at the first death in order to reduce or eliminate estate taxes at the survivor’s death; and it is quite possible the federal estate tax may have been repealed, or exclusion amounts increased significantly, by the time of that second death. Given the uncertainties about future estate tax developments, a hybrid plan that is based on a Maine formula but allows more to flow to a credit shelter trust by disclaimer may be the most appropriate and flexible choice for many situations. Such a hybrid disclaimer plan postpones the decision about how large the credit shelter trust will be until after the first death has occurred.

There are some additional planning techniques that can minimize the effects of the Maine changes. As we noted in a previous Client Alert, clients may decide to change their domicile to a state that has a more favorable estate tax structure. The estate tax systems in New Hampshire, Florida and Arizona, for example, remain linked to the current federal law. Those states will have no estate tax after this year unless they change their estate tax laws, which appears to be unlikely, at least in Florida and Arizona. Maine Revenue Services has become very aggressive in pursuing former Maine taxpayers who claim to have changed their domicile to another state; so if you make the decision to do this, it will be important that you attend carefully to the details, given the level of scrutiny and hostility your decision may prompt. Moreover, simply changing your domicile will not completely eliminate the Maine estate tax if you continue to own Maine real estate. Maine levies an estate tax equal to the proportion by which the value of the Maine property in an estate is related to the entire estate, even if the real estate is owned jointly or passes to a surviving spouse. Returning to the example above, if John (with an estate valued at $3.5 million) died in 2004 domiciled in Florida, with a “federal” estate plan but owning real estate in Maine valued at $1 million, his estate would be liable for a Maine estate tax of $18,400 (1/3.5 times $64,400). Had John been domiciled in Maine, his Maine estate tax would have totaled the full $64,400. Accordingly, changing his domicile would have saved John’s estate $46,000 in 2004, but would not have eliminated the Maine tax completely. There are some techniques which may mitigate this result, depending on the type of real estate, and those strategies can be explored in appropriate situations.

Another technique to lower the impact of the Maine estate tax is to make lifetime gifts in excess of the annual exclusion (currently $11,000) so long as such gifts do not generate any gift tax. Again, this will not eliminate the Maine estate tax (even if it brings the taxable estate below the filing threshold, as previously thought), but it can serve to reduce its impact. Had John in our example above made a lifetime gift of $650,000 (i.e. the “gap” between the federal and Maine exemption amounts), and if he had a federal plan at the time of his death in 2004, then his estate would have no federal estate tax liability but would owe a Maine estate tax of $25,200. Again, without the lifetime gift, John’s estate would have been liable for a Maine tax of $64,400. The gift, in essence, would have saved the estate $39,200 in taxes. The potential tax savings will increase with the size of the gift. Had John’s lifetime gift totaled $1 million instead of $650,000, the Maine tax would be further reduced to $10,000, saving his estate $54,400 in taxes. Since federal gift taxes are due once a donor exceeds an aggregate of $1 million of taxable gifts over a lifetime, this will place a natural cap on the amount of such gifts for most situations.

Estate tax “reform” seems to be a work in process at both the state and federal levels. We anticipate further developments and changes in the years ahead, but cannot predict with any confidence what those changes might be. In such an environment of uncertainty, it becomes increasingly important to incorporate as much flexibility as feasible into one’s estate plan. A possible change of domicile, or a program of planned gifts, or utilization of other tax-favored techniques may also make sense depending upon one’s particular circumstances. If you would like our assistance in reviewing your current estate plan in light of these developments, or if you would like to discuss in more detail the information contained in this newsletter, please contact us at your convenience.

^{1. Although it is counterintuitive, the Maine tax on an estate of a given size will not necessarily vary from year to year, even with an increasing Maine exemption and filing threshold. For a fuller explanation of this seemingly odd result, see our discussion on Calculating the Maine Estate Tax in the separate explanation below.}

^{2. All examples in this article assume an outright marital bequest. Bequests in trust for the benefit of a surviving spouse create certain nuances concerning elections. Explaining this clearly would require additional material that would make our example more confusing and, we believe, less helpful.}

^{3. It should be noted that some states, including Massachusetts, have adopted a state-only marital deduction election that could eliminate the tax generated because of this “gap” between the state and federal exemptions. The new Maine statute does not address this issue, and we do not know if Maine will ultimately allow a similar election. We will keep clients informed of any developments in this regard.}

^{4. These state figures are correct! See Footnote 1 and our discussion about how the Maine tax is computed.}

Another development in this year’s session of the Legislature was the enactment of L.D. 1579, which recognizes “Domestic Partners” and “Domestic Partnerships” for certain purposes under Maine law. The term “Domestic Partner” is defined as “one of two unmarried adults who are domiciled together under long-term arrangements that evidence a commitment to remain responsible indefinitely for each other’s welfare.” The new law provides for the formation of a Domestic Partner Registry and sets forth the requirements for how Domestic Partners may become Registered Domestic Partners. It also provides for termination of a Registered Domestic Partnership. To become Registered Domestic Partners, domestic partners must jointly file with the Registry a declaration under oath which satisfies the criteria set forth in the new law. Under the new law, a surviving Registered Domestic Partner is given the same rights as a surviving spouse to a share of an intestate decedent’s estate, and the same priority as a surviving spouse for appointment as the Personal Representative of such an estate. A decedent is “intestate” if he or she died without a will. The new law also provides a Registered Domestic Partner with the same priority as a spouse (1) for appointment as guardian and/or conservator of an incapacitated person, and (2) with regard to the disposition of a decedent’s remains. These new provisions are effective as of July 30, 2004.

Disclaimer: Nothing in this Client Alert should be taken as legal advice for any individual case or situation. The information in these articles is intended to be general in nature and should not be relied upon for any specific set of circumstances. You should consult with an experienced attorney before applying the information in this Client Alert to your own situation.

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