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What is the Estate Tax Cliff?

That doesn’t sound fun, what is it and what does it mean for you? This is an often-overlooked issue and one that can cause significant headaches for your heirs if it is not addressed. We often hear from wealthy clients “After the Trump Tax cuts, I don’t have to worry about paying estate tax.” This may be true, but for many of our clients, it is far from reality. The New York estate tax exemption is a fraction of what is available in the Federal System. The New York approach to estate tax contains a feature that can result in a tax liability double or even triple the amount in excess of the exemption ceiling, an estate that exceeds the New York exemption amount by $250,000 can end up with a tax liability of $490,000. Effective tax rates in this zone can be in excess of 200%. Our team at BakerAvenue takes a proactive approach to address this potential liability that can result in substantial tax savings.

When people speak about the estate tax, they are typically referring to the Federal Government’s rules regarding assets that are passed at death. This is distinct from an inheritance tax. In other words, the deceased is responsible for the tax liability as opposed to the person inheriting these assets. Depending on your state residency you may also owe estate tax at the State level. These tax liabilities can be overlooked as many people are only concerned with Federal Estate tax liability.

There are two key concepts regarding estate tax liability, the exemption amount, and portability.

The Estate Tax exemption refers to the amount of assets that are excluded from any calculation of potential tax. If there is a $1 million exemption and you have a net worth of $2 million, the exemption excludes the first million from tax while any amount over $1 million is taxable. In this example, the estate would have a tax based on $1 million, the value above the exemption amount at the time of death. Every individual has their own personal exemption.

Portability is the concept of “sharing” an individual’s personal exemption with their spouse. Effectively this doubles the exemption amount for a married couple. It is important to note portability is a feature of the Federal estate tax system some states do not offer portability of exemptions.

The Federal estate tax system has been revised several times over the last 20 years. Prior to 2001 tax cuts implemented during the Bush administration, the exemption amount was $675,000. In addition, there was no concept of portability. The top marginal rate for estate tax at this time was 55%. Over the next 20 years, the amounts have changed greatly.

Source: How the Federal Estate Tax Exemption Changed From 1997 to Today

    Now about that dreaded cliff, there are a few basics you should know.

    1. Are you a New York state resident? We often hear “I spend the winter in Florida, so I don’t have anything to worry about it”. Unfortunately, this view can lead to unpleasant surprises for many people. The State of New York is widely regarded as having an aggressive approach to determining who is a resident. We have seen clients battling the state about their status so it is important to clarify a few terms.

    Resident - You are a New York State resident for income tax purposes if:

    • your domicile is New York State or
    • your domicile is not New York State but you maintain a permanent place of abode in New York State for more than 11 months of the year and spend 184 days or more in New York State during the tax year. Note: Any part of a day is a day for this purpose.

    Domicile - In general, your domicile is:

    • the place you intend to have as your permanent home
    • where your permanent home is located
    • the place you intend to return to after being away (as on vacation, business assignments, educational leave, or military assignment).

    You can only have one domicile. Your New York domicile does not change until you can demonstrate that you have abandoned your New York domicile and established a new domicile outside New York State.

    Permanent place of abode

    In general, a permanent place of abode is a residence (a building or structure where a person can live) that:

    • you permanently maintain, whether you own it or not; and
    • is suitable for year-round use.

    A permanent place of abode usually includes a residence your spouse owns or leases for several years.

    2. Do you own a home or other real estate? Do you have a 401k/IRA? Are you a business owner? If you answered yes to any of these questions, you may have a hidden estate tax liability. At BakerAvenue we have worked with many of our clients to address tax challenges.

    The New York State estate tax systems operate differently than the Federal estate tax system. The biggest difference being the aforementioned “Cliff.” New York state law has decoupled from the Federal system when the 2017 Trump Tax legislation was passed, formerly the Tax Cuts and Job Act of 2017 (TCJA). New York state has an exemption amount of $5.85 million for 2020. This amount is roughly 50% lower than the Federal exemption. In addition, New York State does not recognize the concept of portability, effectively reducing the Estate tax exemption by 75% compared to the Federal system. The difference is sizable, but perhaps the most important difference is New York’s approach to determine what the estate tax is based on. This factor is drastically different and why it is called the “Cliff”.

    The Federal system (and many others) completely excludes the value of deceased assets below the exemption amount. A single person has an exemption amount of $11.58 million. The taxable amount is calculated on a person’s asset-based minus the exemption amount. The tax base for an estate of $15 million is $3.42 million ($15 million - $11.58 million). The State of New York includes the ENTIRE estate for any deceased whose assets are about 105% of the exemption amount. The current (2020) New York State estate tax exemption is $5.85 million. If your net worth is currently below this amount there is no tax liability. New York starts to phase in the estate at levels above this amount.

    Source: NYS Department of Taxation and Finance, BakerAvenue

      The reality of sizable tax liability can cause many people to panic. The good news is there are a number of steps and techniques that can be implemented to help you manage this liability. Solutions can range from family-oriented, charitable methods to mitigate and sometimes eliminate this liability. The key is proper planning and the sooner you plan, the more likely it is to be effective. If you would like help with these transitions, contact us. BakerAvenue has worked with numerous clients to address these concerns and welcome conversations around this issue.

      Additional Resources:

      The opinions expressed in this commentary are those of the author and may not necessarily reflect those held by Baker Avenue Asset Management LP. This is for general information only and is not intended to provide specific investment advice or recommendations for any individual. All information is believed to be factual and up-to-date as of this writing and is subject to change. Before purchasing any investment, a prospective investor should consult with its own investment, accounting, legal and tax advisers to evaluate independently the risks, consequences and suitability of any investment.

      Any suggestion of cause and effect or of the predictability of economic or investment cycles is unintentional. Past performance is never a guarantee of future performance. Baker Avenue Asset Management LP may currently own or have previously owned a specific stock or company referenced, and a list of our past holdings can be found at the SEC website. Click to view full disclosures.