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Illinois Estate Tax 2009 Update

The last major federal estate tax legislation was enacted in 2001. The 2001 Tax Act (aka EGTTRA) purported to phase-in full repeal of the federal estate tax over a 9-year period by increasing the federal estate tax exemption amount to $1 million in 2002; $1.5 million in 2004; $2 million in 2006; $3.5 million in 2009; and full estate tax repeal in 2010. To keep the official projected cost of the legislation suppressed, a “sunset” provision was included which boomerangs the estate tax back in 2011 reverting to the $1 million exemption. Additionally, to keep projected federal revenue losses minimized, and of course to further complicate matters, the 2001 law also phased out the “credit for state death taxes”, ending in 2005. Prior to the 2001 Tax Act, the credit for state death tax allowed states to automatically share in a portion of the overall estate tax bill, without assessing their own separate tax or increasing the overall tax bill. This was a fairly significant source of revenue for many states (actually for individual counties), including Illinois. Faced with this looming loss of revenue, individual states, on a state-by-state basis, had to choose whether to forgo this source of revenue or to “decouple” from the federal estate tax system and assess some version of a new, additional state estate tax. Many states have done just that, including Illinois.

In 2003, Illinois amended its estate tax laws in a couple of respects. First, it provided that after completion of the full phase-out of the credit for state death taxes in 2005, Illinois would assess an add-on tax for estates subject to federal estate tax calculated as if the repeal of the state death tax credit had never happened. Second, Illinois agreed to recognize and match the rising federal exemptions, BUT – and this is the key here – only up to a maximum exemption of $2 million. However, as noted earlier, way back in 2001 the Tax Act scheduled an increase in the federal estate tax exemption to $3.5 million for 2009. This disjuncture and mismatch of the federal/state exemptions has now been realized.

With all of this in mind, there are critical ramifications of a $3.5 million federal estate tax exemption coupled with a $2 million Illinois estate tax exemption for many existing estate plans. Under the terms of most traditional estate tax planning documents for married couples, each living trust contains a formula funding clause under which an amount up to, but not exceeding, the federal exemption amount is placed into a separate trust (the “Credit Shelter” aka “Family Trust” aka “B Trust”) that is included in the taxable estate of the first to die but excluded from the survivor’s taxable estate. In 2008, this meant that the credit shelter trust was funded with up to $2 million in assets. Since both the Federal and Illinois estate tax exemptions equal $2 million for 2008, no tax would be incurred, the maximum amount would be sheltered from both Federal and Illinois estate tax and the plan would be implemented as designed. Fast forward to 2009. For a 2009 decedent, the credit shelter trust will be funded with up to $3.5 million in assets because the trust funding formula is pegged to the federal exemption which will be $3.5 million in 2009. A $3.5 million credit shelter trust triggers $0 Federal estate tax in 2009, but it triggers Illinois estate tax on the difference between the value of the credit shelter trust (up to $3.5 million) and the Illinois estate tax exemption (which will be $2 million). This leaves a possible 2009 Illinois taxable estate of $1.5 million. The Illinois estate tax due on a $1.5 million taxable estate in 2009 is $229,200.

The good news in 2009 is that a larger amount of your estate ($3.5 million plus the future growth on this) escapes estate taxation forever. The bad news is that the cost of this future benefit is $229,200 due immediately out of the surviving spouse’s pocket. If you’re like most people, you don’t want to pay estate tax any earlier than is absolutely necessary. This is understandable. The question you probably have at this point is whether there is any way around this. The answer is yes. The solution is to ensure that the funding formula in your will or trust is crafted in a way that redirects the amount by which the Federal exemption exceeds the Illinois (or other state) exemption into a separate trust that allows your executor to choose whether to subject the separate trust to Federal and/or Illinois estate tax. If avoiding Illinois estate tax is more advantageous than fully funding the credit shelter trust, your executor can elect to qualify the trust as a “QTIP” Trust and qualify it for the martial deduction such that no tax is paid at the first death. If, on the other hand, the benefit of a larger credit shelter trust outweighs the burden of paying state estate tax, then your executor can opt out of QTIP (tax-free marital deduction) treatment. Better yet, your executor may be able to elect the best of both worlds – that is, a larger credit shelter trust ($3.5 million) and no state estate tax at the first death. This would be achieved by electing QTIP treatment for Illinois purposes only, but opting out of QTIP treatment for Federal estate tax purposes. At the moment, this does not appear to be an available option because Illinois has not enacted regulations that would enable a “state-only” QTIP election (as many other states have done). However, it is possible that enabling legislation or regulations may be enacted that would allow for this in 2009 and beyond. As of January, 2009, legislation has been proposed and is pending that would allow an Illinois-only QTIP election. In any case, a funding formula that directs excess exemption resulting from the disjuncture into this separate trust that is QTIP-eligible gives your executor added flexibility and avoids the automatic triggering of significant state estate tax at the first death under outdated funding formulae.

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