Bridging the Tennessee Gap: Differences in Federal Estate Tax and Tennessee Inheritance Taxes  

By Keith Burroughs
keith@bcnattorneys.us

OVERVIEW

For individuals who are residents of Tennessee, or who own real estate or other property situated in Tennessee, there are two potential death taxes of which to be aware. Nearly everybody is aware of the Federal Estate Tax, but the State of Tennessee also has a death tax referred to as the Tennessee Inheritance Tax. Not all estates are subject to these death taxes, as both taxing schemes exempt a significant amount of property from taxation. Prior to 2002, and for a period of several years, Tennessee and the Federal government exempted the same amount of property from death taxes. For example, in 2001, the Federal Estate Tax allowed the first $675,000 of property in one’s estate to pass free of Federal Estate Taxes, and likewise, the Tennessee Inheritance Tax exempted the first $675,000 of assets from taxes.

In 2002, new federal tax legislation significantly increased the Federal Estate Tax credit allowing for much larger amounts to be exempted from Federal Estate Taxes. Tennessee, however, did not to change its taxing scheme. Thus, since 2002 and continuing, there is a difference in the amount of one’s estate that can be exempted for Federal Estate Taxes and the amount that is exempt from Tennessee Inheritance Tax. This difference is often referred to as the “Tennessee Gap.”

In 2002, an individual could pass $1,000,000 dollars of assets of his or her estate free of Federal Estate Taxes, but could only pass $700,000 of those assets free of Tennessee Inheritance Taxes. This Tennessee Gap has widened since 2002, and continues to widen over the next several years. Presently, the Federal Estate Tax allows $1,500,000 of assets to pass free of Federal Estate Taxes, but the Tennessee Inheritance Tax exempts only $850,000. Clearly, the Tennessee Gap is widening.

The Tennessee Gap is significant to Tennessee residents and other individuals owning property in Tennessee because estate planning documents that do not specifically plan for the Tennessee Gap can have the inadvertent effect of triggering and or accelerating Tennessee Inheritance Taxes. This is especially significant for married couples.

IMPACT OF TENNESSEE GAP

As alluded to above, the significance of the Tennessee Gap is the potential of inadvertently triggering Tennessee Inheritance Taxes. This is especially significant for individuals and married couples who have existing documents that establish so-called “credit shelter” or “by-pass” trusts designed to shelter property from a surviving spouse’s estate. The same concern applies to individuals who leave all assets in excess of the Federal Estate Tax exemption to charity, with the exempt portion passing to children or other family members. For years, it was common for estate planning documents to allow the credit shelter or by-pass trust to be funded with estate assets up to the maximum amount that could pass free of Federal Estate Taxes. Such language did not impact Tennessee residents, as the Tennessee Inheritance Tax exemption amounts mirrored the amounts exempted under the Federal Estate Taxing scheme. Presently, such planning would trigger Tennessee Inheritance Taxes at the individual’s death. For example, assume a Tennessee resident dies in 2004 with estate planning documents providing that a credit shelter trust is established to hold the maximum amount of property that can pass free of Federal Estate Taxes. Under this scenario, the credit shelter trust would be funded up to $1,500,000 of assets, but because the Tennessee Inheritance Tax exemption is currently $850,000, Tennessee Inheritance Taxes could be assessed on $650,000 ($1,500,000 less $850,000 = $650,000).

The planning needed to address the Tennessee Gap is technical and goes beyond the scope of this article. Suffice to say that planning for the Tennessee Gap can involve limiting the credit shelter trust or the by-pass trust up to the maximum amount that can pass free of Federal Estate Taxes and Tennessee Inheritance Taxes. This ensures that the credit shelter trust is not over funded for Tennessee purposes, resulting in Tennessee Inheritance Taxes. Further, a “Gap” trust is often needed, as there may be differing marital deduction elections taken for federal and Tennessee purposes. Because the Tennessee Gap continues to widen, the amount of Tennessee Inheritance Taxes which can be triggered correspondingly increases each calendar year.

WHO NEEDS TO PLAN FOR THE TENNESSEE GAP?

Certainly, any Tennessee resident or any non-resident owning property situated in Tennessee should consult with his or her legal counsel regarding the Tennessee Gap. Despite the need for all of the aforementioned individuals to assess potential Tennessee Gap issues, there are two (2) sets of individuals who are immediate candidates to plan for the Tennessee Gap. First are married couples in Tennessee who executed estate planning documents prior to 2002. Because the Tennessee Gap came into existence during 2002, it is very possible that married couples who executed estate planning documents during 2001 or earlier, have documents which have not planned for the Tennessee Gap. Of course, it is also possible that estate planning documents prepared during 2002 or more recently did not plan for the Tennessee Gap. There are many existing estate plans among Tennessee residents that are set up to fund the credit shelter trust or by-pass trust up to the maximum amount that can pass free of Federal Estate Taxes that left unchecked can have the unforseen impact of triggering Tennessee Inheritance Taxes at death.

Finally, the other set of candidates for immediate estate planning review are Tennessee residents who have migrated to Tennessee from another state. Certainly, individuals who have recently moved to Tennessee, which is the case for many retirees in this area, have estate planning documents executed in other states. Obviously, such documents are not Tennessee specific and likely will not have planned for the Tennessee Gap.  In other words, the estate planning previously done for such residents may have been appropriately drafted for Michigan, Florida, Ohio or other states, but could have significant tax problems for Tennessee purposes.

CONCLUSION

Any Tennessee resident or individual with property situated in Tennessee should consult with his or her legal representative regarding the Tennessee Gap. This is especially significant for (i) married couples in general, (ii) married couples who have had estate planning documents prepared prior to 2002, and (iii) Tennessee residents who have moved here from another state. As the Tennessee Gap widens, the potential Tennessee Inheritance Tax liability correspondingly increases. In 2006, an individual can pass $2,000,000 free of Federal Estate Taxes, but can pass only $1,000,000 free of Tennessee Inheritance Taxes. This means the Tennessee Gap will be $1,000,000 in 2006. The effect of the federal tax legislation beginning in 2002 brightened the Federal Estate Tax liability situation for many individuals. However, an unforseen impact was the potential for increased Tennessee Inheritance Taxes as a result of the gap between the two taxing schemes. Unfortunately, many individuals will inadvertently fall into this gap without proper estate planning.