NEW JERSEY’S SIMPLIFIED TAX SYSTEM COULD BE COSTLY

Could the method that an estate utilizes to report tax to the State of New Jersey result in different amounts of taxes being owed? Maybe, maybe not. Two years after a revision to the tax law, the question remains unsettled among estate tax planners.

On July 1, 2002, New Jersey revised its estate tax law (“July 2002 law”). The State’s revision of its tax law was in reaction to the federal 2001 tax relief act (“tax relief act”). The effects of the July 2002 law continue to serve as a source of debate among estate tax planners to this day.

Under the July 2002 law, New Jersey estate tax is imposed on every estate that would have been subject to federal estate under the provisions of the Internal Revenue Code as it existed on December 31, 2001. In short, a New Jersey resident’s estate will pay New Jersey estate tax if the taxable estate is greater than $675,000.

Prior to July 2002, New Jersey estate tax was only owed if an estate was subject to federal estate tax. New Jersey changed its estate tax law due to the tax relief act, which would have substantially reduced the number of estates subject to federal estate tax and, concurrently, the amount of New Jersey estate tax that our State would collect.

Under the tax relief act, the credit against federal estate tax was raised substantially – from the $675,000 that existed in 2001 to a high of $3,500,000 in 2009, with the federal estate tax being repealed in its entirety in 2010. By freezing the credit at $675,000 – New Jersey has ensured itself a tax-base for years to come.

The rub in the New Jersey estate tax is this – an estate may owe more estate tax based solely on the method the estate employs to report the tax.

Because of the new law, the New Jersey Division of Taxation created new methodologies for estates to use in reporting New Jersey estate tax. There are two methods: the “706 method” and the “simplified method.”

The 706 method refers to the form number of a federal estate tax return. A federal estate tax return is a form number 706. (Most of us are aware of IRS form number; for instance, personal income tax is reported on a form 1040.)

Under the form 706 method, the estate files a year 2001 form 706, that is, the form 706 as it existed in 2001. In addition, the estate files a New Jersey form IT-Estate (which is an inheritance tax-estate return).

If the estate employs the simplified method, the estate files a New Jersey Inheritance Tax return and a form IT – Estate.

In cases where the estate is subject to federal estate tax – which would mean that the estate is valued at more than $1,500,000, the current credit against federal estate tax – the estate must use the 706 method; however, if the estate is valued at between $675,000 and $1,500,000, it can choose either method.

The thing is, for those estates that can choose which method to employ, the method chosen can actually result in different amounts of tax being owed. That’s a bit odd. To think that the same estate will pay more tax based upon the tax return that it uses to file – as opposed to the value of the estate – is weird, to say the least.

Here’s how a difference in tax could occur: Under federal law, a person can gift $1,000,000 during her lifetime without paying gift tax. In addition, a person can give $11,000 a year to an unlimited number of people without reducing her $1,000,000 lifetime credit against gift tax; this is called the “annual exclusion.”

Assume that a person (let’s call her “Mrs. Jones”) gifted $11,000 to her five children one year before she dies. Let’s further assume that when Mrs. Jones died, she had assets of $800,000 remaining in her name.

If the executor of Mrs. Jones’s estate choose to use the 706 method for reporting the New Jersey estate tax – since Mrs. Jones’s estate exceeds $675,000, the executor may file using either method – the five $11,000 gifts would not be brought back into her estate for purposes of New Jersey estate tax; accordingly, the value of her estate that would be subject to tax (assuming no deduction, which is unrealistic) would be $800,000.

On the other hand, if the executor utilized the simplified method for reporting the estate tax, the five $11,000 gifts would be brought back into the estate, meaning that the taxable estate would be $855,000.

Why? Because if the simplified method is used, the estate must file a New Jersey Inheritance Tax return, and the inheritance tax return brings gifts above $500 back into the estate, if the gift is made within three years of death.

Same estate, different tax, depending on which method is used. When I called the Division of Taxation that was the answer I received. Yet, when I reviewed the Inheritance Tax return, I noticed that on the first page of the return, it asks if the estate plus “taxable gifts” (e.g., gifts above $11,000) exceeds $675,000. In my opinion, this question might be the saving Grace for the simplified method. Even if the estate does exceed $675,000 on the Inheritance Tax return, if the excess is due to non-taxable gifts (e.g., $11,000 gifts), the estate might avoid New Jersey estate tax.

My advice, get a lawyer who can make the argument for you. You might be in for a fight.