I. Introduction

A number of important changes to New York estate, trust and gift tax law were recently enacted. Briefly, (i) the New York estate tax exemption will reach parity with the federal exemption by 2019; (ii) the federal estate tax concept of “portability” will not be extended to New York; (iii) gifts made within three years of death will be brought back into the decedent’s estate; (iv) “throwback” rules, similar to those applicable to foreign trusts, will apply to accumulation distributions by resident trusts exempt from tax by reason of having no New York trustees, no New York property, and no New York source income; (v) intentional out-of-state non-grantor trusts will be deemed grantor trusts for New York income tax purposes; and (vi) the generation-skipping tax has been repealed.

II. Estate Tax Exemption

The estate tax of New York became “uncoupled” from the federal regime in 2001 after EGTRRA. Accordingly, as the federal estate tax exemption has risen over the years to what is now $5.34 million in 2014 (the exemption is indexed for inflation) the New York exemption has been stationary at $1 million. Under the new law, the New York exemption will increase, in phases, to the federal level by 2019.
The new estate tax exemption has a strange twist: While the exemption amount will become more generous, the transgression of exceeding the exemption amount by even as little as five percent will cause the entire estate to become subject to estate tax.
For example, if a new York New York decedent dies in 2018 with taxable estate of $5.5125 million, which is only five percent more than what the New York exemption amount is projected to be at that time, the entire estate will become subject to estate tax, and estate tax liability of $430,050 will arise. This translates to an effective tax rate of 164 percent on the $262,500 excess arising from the difference between the taxable estate and the exemption amount.

In this situation, it would be preferable to make a charitable gift rather than incur an estate tax of over 100 percent on the incremental $262,500. Another technique to avoid this adverse result might be to implement a formula clause in testamentary instruments. Formula clauses have seen a steady rehabilitation in federal courts since the early holding of Com’r v. Procter, 142 F.2d 824 (4th Cir. 1944) which invalided formula clauses.
The Legislature, in enacting the new exemption limitations, might be of the philosophy that New York should not impose estate tax on estates not subject to federal estate tax, but that persons of means should not expect that largesse to extend to estates whose value exceeds the federal exemption. It is also possible that the puzzling tax result is simply the result of a drafting error.
Regardless of the reason for the unusual “clawback” feature of the new estate tax exemption, the Legislature has so determined the appropriateness of the tax, and individuals planning their estates should exercising prudence in avoiding this tax, which could be a trap for the unwary.

III. Federal Portability a Nonstarter in New York

States imposing an estate tax have been reluctant to extend the federal concept of “portability” of the federal exemption to their own states. New York is no exception. Thus, the failure by an estate to utilize the growing New York estate exemption will result in a permanent loss of the exemption at the death of the first spouse. The lack of portability at the New York level has increased the number of factors to consider when planning an estate. In a few years, the New York exemption will exceed $5 million. Leaving everything to the surviving spouse will still result in no federal or New York estate tax in the estate of the first spouse by reason of the unlimited marital deduction. However, while the federal exemption for the estate of the second spouse will be about $10 million, the New York exemption will be only $5 million. The maximum New York estate tax rate is 16 percent. Failing to shelter an estate of the first spouse of $5 million could result in nearly $1 million of estate tax in the estate of the second spouse.

Credit shelter trusts for the benefit of the surviving spouse or outright gifts to non-spouses (i.e., those not qualifying for the marital deduction) are simple yet effective methods available to wealthy spouses who do not wish to waste a New York exemption. QTIP elections can also be of some help, but New York now has strict rules concerning inconsistent federal and state QTIP elections, so caution is in order when planning involves such elections.
When the New York exemption amount was only $1 million, New York estate tax was a consideration, but not an overriding consideration in estate planning. Now, with the New York exemption set to approach the federal exemption in only a few years, New York state estate planning has become essential for persons with estates large enough to utilize federal portability.
Prior income tax assumptions also need to be reexamined in light of the new law. To achieve the maximum basis step-up at the death of the second spouse, it was previously advantageous for the first spouse to leave everything except $1 million to the second spouse. No additional New York estate tax would arise, since everything in excess of $1 million would have been subject to New York estate tax anyway. However, in a few years when the New York exemption reaches $5 million, the objective of achieving a full basis step up at the death of the surviving spouse must be weighed against the loss of the New York estate tax exemption. At times, it might still make sense to not utilize the New York estate tax exemption at the death of the first spouse if assets are expected to appreciate substantially after the death of the first spouse and before the death of the second spouse.

Under federal law, a QTIP election is made on the federal estate tax return. To further complicate matters, under the new legislation (which apparently codifies to some extent the policy of the Department of Taxation previously announced) if no federal estate tax return is required, an independent QTIP election may be made on the New York estate tax return. However, no separate QTIP election is permitted where a federal estate tax return is not otherwise required, but is filed for the purpose of electing portability (which can only be made on an estate tax return).

IV.  Clawback of Certain Gifts

For the five-year period from April 1, 2014 until January 1, 2019, gifts made by New York residents will be drawn back into the decedent’s estate. Although under federal law, some gifts (in which the donor retained “strings”) made within three years of death are included in the federal estate, outright gifts are not. Therefore, outright gifts made by a New York resident within three years of death will increase the New York taxable estate, but not the federal taxable estate. Under federal law, state estate taxes paid are allowed as a deduction in arriving at the federal taxable estate, but only if the gifted property was includable in the federal estate. Since outright gifts will not be includible in the federal estate, no deduction for federal estate tax purposes will be available.
It is unclear why the Legislature chose to “sunset” the recapture rule on December 31, 2018. However, given the five-year life expectancy of the rule, the Legislature has ample time to re-extend the provision.

V. Grantors Taxable on Nongrantor Trust Income

Nothing under the doctrine of Federalism requires New York to structure its income tax regime in the same manner as does Washington. Nevertheless, the federal regime is generally a model for many states and federal tax law is paramount. New York has signaled its intention not to follow federal tax law in the income tax treatment of certain grantor trusts.
Last year, the IRS announced in PLR 201310002 that certain trusts established by New York residents in Nevada or Delaware were not “grantor” trusts under federal tax law. Since these non-grantor trusts operated outside the orbit of New York income tax, New York grantors were not taxed on income earned by these trusts. These trusts were established in jurisdictions such as Delaware and Nevada where the trust income is not subject to any state income tax.
This result frustrated the Department of Taxation, since hundreds of millions of dollars in income tax revenues were being lost annually. To change this result, New York enacted a provision which treats the grantor as the tax owner of these trusts for New York income tax purposes, even though the grantor is not treated as the tax owner under the Internal Revenue Code.
Although the legislation does not appear to be unconstitutional, one wonders whether New York is exercising good tax policy in “carving out” exceptions to federal tax law in such an important area. Understandably, Albany was unhappy with PLR 201310002. However, New York residents depend upon the consistency of federal and state tax law. Divergent tax criteria concerning what constitutes a grantor trust under New York and federal law may spawn confusion and create impediments to effective tax planning. Those affected, most of whom are affluent, might decide to leave New York, precipitating the problem the statute sought to avoid.

VI. Resident Trusts Subject to Throwback

In Taylor v. NYS Tax Commission, 445 N.Y.S.2d 648 (3rd Dept. 1981), a New York domiciliary created a trust consisting of Florida property. Neither the trustees nor the beneficiaries were New York residents. The Appellate Division held that under the 14th Amendment

[a] state may not impose tax on an entity unless that state has a sufficient nexus with the entity, thus providing a basis for jurisdiction.

Following Taylor, New York codified an exception to the imposition of income tax imposed on New York “resident” trusts where (i) no trustees resided in New York; (ii) no property (corpus) was situated in New York; and (iii) where the trust had no New York source income. (A New York “resident” trust is a trust created under the will of a New York domiciliary or a trust created by a New York domiciliary at the time the trust was funded.) As a result of this exception, it was sometimes prudent for New York residents to implement New York resident trusts in Nevada or Delaware. New York would not trust income from such trusts except to the extent income was currently distributed to New York beneficiaries. If the trust accumulated income, beneficiaries would have no income to report. The accumulated income, when later distributed, to the extent it exceeded the distributable net income (DNI) of the trust, would forever escape income tax in New York.

To change this result, principles of federal taxation of foreign non-grantor trusts were imported. Now, beneficiaries receiving “accumulation distributions” will be taxed on those distributions, even if they exceed trust DNI. However, a credit will be allowed for (i) taxes paid to New York in prior years on accumulated income and (ii) taxes paid to other states.  Under the new law, trusts meeting the three exceptions, “exempt” trusts, will now be subject to reporting requirements for years in which accumulation distributions are made. The law became effective for accumulation distributions after June 1, 2014. (See Taxation of Foreign Nongrantor Trusts: Throwback Rule, Tax News & Comment, August 2014)

VII. Generation Skipping Transfer Tax Repealed

New York has repealed the generation-skipping tax, which applied to only a few dozen New York estates in recent years.