The new Maryland estate tax

By Jennifer A. Pratt, Esq.,
and Sarah Barr Kahl, Esq., CPA

Before Maryland law changed again in May, Maryland taxpayers could not have their cake and eat it too. Now they can.

Many married couples utilize an estate plan that sets aside an amount that would be exempt from federal estate tax in a credit shelter trust for the primary benefit of their children. The exempt amount is based on the remaining applicable exclusion amount of the first spouse to die. The remaining balance of the estate is put in a trust for which a federal QTIP election is made to qualify for the federal estate tax marital deduction. When the federal and state estate taxes were linked, no federal or state estate tax would be owed on the first death.

After the federal government began to phase out the credit for state death taxes and increase the applicable exclusion amount, eating away at state estate tax revenue, Maryland fully de-coupled from the federal system, first by collecting the pre-phase-out credit amount and then by limiting the applicable exclusion amount for Maryland estate tax purposes to $1 million.

Meanwhile, the applicable exclusion amount for federal purposes has increased to $2 million in 2006 and is scheduled to increase to $3.5 million in 2009. This increasing applicable exclusion left married couples with a catch-22 situation: fund the credit shelter trust with the full federal exemption on the first death and pay some Maryland tax (almost $100,000 in 2006) or fund the credit shelter trust with $1 million and pay no tax on the first death, but waste federal exemption.

Estate planners played a few guessing games. Were the combined estates large enough to be subject to federal tax on the second death? Would the surviving spouse be competent enough to make a choice by making a partial QTIP election or possibly disclaiming some property? What if the estate tax was repealed?

After much outcry, the legislature approved, and Gov. Ehrlich signed in May, a bill allowing a state-only QTIP election. Married couples can now fully fund their federal exemptions while deferring Maryland estate tax by making a special election on the Maryland estate tax return of the first spouse to die.

The new Maryland law provides that on a timely filed Maryland estate tax return of the first spouse to die, a state QTIP election may be made to reduce the taxable estate to below $1 million. This results in no Maryland estate tax upon the first spouse's death. The state-elected QTIP amount must be included in the surviving spouse's Maryland gross estate, and Maryland estate taxes will be paid at that time.

Now, Marylanders with federal taxable estates greater than $1 million may elect a state QTIP over the difference between the federal applicable exclusion amount and the $1 million state exemption amount to defer Maryland estate taxes until the death of the surviving spouse. This new law expressly allows inconsistent elections to be made on the federal and Maryland estate tax returns, so a federal QTIP election would typically not be made over the same amount.

Now that seems easy enough ... or does it?

The new law provides little guidance as to what will qualify for the Maryland QTIP. The only criteria appears to be that the trust would qualify for a federal QTIP and that the Maryland QTIP election is made on a timely filed Maryland estate tax return. This leaves questions with respect to the administration the state QTIP. For instance, if taxes are paid out of a federal QTIP trust, that portion of the taxes paid do not qualify of the federal marital deduction. Is the same true for the Maryland marital deduction?

Is a "Clayton" QTIP possible under the Maryland state marital deduction system? A Clayton QTIP provides that 100 percent of the decedent’s wealth is eligible to pass into the QTIP marital trust, but only to the extent that the personal representative in fact makes the QTIP election. To the extent that the election is not made, the non-elected property passes in another fashion, typically to a credit shelter trust in which the surviving spouse has no economic benefit, or at most a right to receive a spray distribution of income and principal for “ascertainable standards.”

For now, many practitioners may be assuming that what is permissible for federal estate tax purposes will be permissible for state estate tax purposes and, conversely, what is prohibited for federal purposes will be prohibited for Maryland purposes. Only time will tell if those assumptions are correct.

This is an interesting time to be planning and practicing in Maryland. The good news is that most married Marylanders with taxable estates greater than $1 million can defer the taxes until the death of the surviving spouse, so that no taxes need be paid on the first death, provided that the proper elections are made on the federal and state estate tax returns.

Sarah Kahl is a CPA and an associate in the Tax and Wealth Management Group at Venable LLP.

Jennifer A. Pratt, Esq., is an associate with Venable LLP. She assists clients with estate planning, charitable giving, and business continuity planning while minimizing estate, gift and generation-skipping transfer tax exposure.

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