"De-coupling" May "De-plete" Your Assets

(UPDATED to address Illinois Public Act 96-0789)

Estate tax is imposed on the value of a decedent's (i.e., the deceased's) "gross estate". A person's gross estate is made up of all the assets owned as of the date of death. Currently, the maximum estate tax rate imposed at the Federal level is 45%. Illinois also imposes a separate, additional estate tax at the maximum rate of 16%. When combined, and after factoring in the Federal deduction for any Illinois estate taxes paid, the maximum rate is roughly 54%.

Both the State of Illinois and Federal government provide for exemptions from their respective estate taxes for gross estates that total less than a certain threshold. If the gross estate is less than the exemption amount, no estate tax is due.
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Traditionally, the state of Illinois and the Federal government have had the same applicable exemption amount—in other words, Illinois estate tax exemptions were “coupled” with Federal estate tax exemptions. For example, in 2008 both Illinois' and the Federal government's exemption amounts were $2.0 million. Thus, so long as a decedent's gross estate was less than $2.0 million, no estate tax would be due.
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However, in 2009 Illinois' applicable exemption remains limited to $2.0 million while the Federal applicable exemption has increased to $3.5 million. This is referred to as "de-coupling", and could result in an state-level estate tax of over $200,000.

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TRADITIONAL ESTATE PLANS MAY NOT BE SUFFICIENT

In a traditional living trust for a married couple, upon the death of the "first-to-die" spouse, the decedent's estate is divided into two separate trusts: (1) the “Family Trust”; and (2) the “Marital Trust”. Upon the first spouse’s death, the Family trust is funded first with the applicable Federal exemption amount and all property is designed to pass estate tax-free. The Family Trust is held for the benefit of the surviving spouse and children. The Marital Trust is funded with the excess amount over the exemption, and is for the benefit of the surviving spouse only. Because the Marital Trust is solely for the benefit of the surviving spouse, all property that passes in the Marital Trust qualifies for the marital deduction. The Executor would make a QTIP election with respect to the Marital Trust and any potential tax would be postponed until the second spouse’s death. Therefore, traditionally, upon the death of the first-to-die spouse, no tax would be incurred.
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With the inception of de-coupling, however, state level taxes may nonetheless be imposed on the first spouse’s death unless specific provisions are included. In particular, if the Family Trust is funded with the applicable Federal exemption amount ($3.5 million), although no Federal tax would be due, Illinois would impose estate tax on the $1.5 million excess over Illinois’ $2 million exemption. This could result in tax liability in excess of $200,000.
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HOW TO ADDRESS THE PROBLEM

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To deal with the potential state-level tax, trusts can be drafted (or existing trusts can be amended) to allow the Executor of the estate to make a marital deduction (i.e., QTIP election) with respect to a portion of the Family Trust for Illinois purposes only.  As of September 8, 2009, Illinois law (Public Act 96-0789) specifically sanctions a QTIP election for state purposes only.  In practical terms, upon the death of the first-to-die spouse, the Family Trust would be fully funded with $3.5 million and qualify for the Federal estate tax exemption amount. The Executor would then make an election as to the assets worth $1.5 million in the Family Trust to qualify for the marital deduction for Illinois purposes only. This allows maximization of both the Federal and Illinois exemptions without subjecting assets to either Federal or Illinois estate tax on the death of the first spouse.