With the federal estate tax exemption at an all-time high, residents of most U.S. states do not have to worry about an estate tax. Unfortunately, some Minnesota residents do not have that luxury. Minnesota is one of twelve states with a state estate tax and out of those states, Minnesota has the fifth lowest estate tax exemption ($3 million per person in 2023). Unlike the federal estate tax, there is no portability for Minnesota estates. As such, without some planning, if a Minnesota couple has more than $3 million, they could be subject to the Minnesota estate tax. If you and your spouse fall under this category, consider estate planning to minimize or avoid the Minnesota estate tax.
In order to understand the Minnesota estate tax, it is important to understand the federal estate tax and the federal gift tax. An individual’s “taxable estate” is calculated by taking their gross estate (i.e., everything owned by the individual as of the date of death) and subtracting applicable deductions. Deductions to the gross estate may be taken for the following: funeral costs, expenses of administration, claims against the estate and unpaid mortgages or other debts; losses from casualty or theft during the administration of the estate; the marital deduction; the charitable deduction; and the amount of any state estate taxes actually paid. After an individual’s taxable estate is determined, the value of any federally taxable gifts (i.e., gifts in excess of the annual exclusion amount ($17,000 in 2023, or twice that amount if a spouse joins in the gift), excluding payments made directly for tuition or qualifying medical expenses), is added to the taxable estate. A person is taxed at the federal level on any portion of their taxable estate that exceeds the federal estate tax exemption. In 2023, the federal estate exemption is $12.92 million for individuals and $25.84 million for married couples. The federal estate tax rate is currently 40% in the year 2023. Unlike the federal exemption amount, which is indexed for inflation, the tax rate stays the same from year to year. Note, however, that the federal estate tax exemption is currently scheduled to be cut in half, in the year 2026, unless Congress acts before them.
The Minnesota estate tax is applied to individuals with taxable estates that exceed the $3 million Minnesota estate tax exemption. Unlike the federal estate tax exemption, Minnesota’s exemption is not indexed for inflation. Minnesota is a little nicer, though, in that the Minnesota estate tax rate is lower, ranging from 13% up to 16%, depending on the size of the estate. In addition to the much lower estate tax exemption, there are other key differences between the Minnesota estate tax and the federal estate tax. Unlike the federal estate tax exemption, the Minnesota estate tax exemption is not “portable” between spouses. This means that if all of a deceased spouse’s property goes outright to the surviving spouse and no further action is taken, the deceased spouse’s Minnesota estate tax exemption is lost. Because there is currently no Minnesota gift tax, lifetime gifts do not reduce the Minnesota estate tax exemption. However, under the “Three-Year Rule,” the value of federally taxable gifts made within three years of a person’s death are “clawed back” to the person’s estate for purposes of determining Minnesota estate tax.
The main estate planning tools to limit Minnesota’s estate tax include the use of credit shelter trusts, disclaimers, and QTIP trusts. A brief overview of these estate planning tools is provided below.
A credit shelter trust, also known as a “Bypass Trust,” “Family Trust” or “B Trust,” is an irrevocable trust designed to shelter assets from estate taxes. Estate planning with a credit shelter trust is typically accomplished through the so-called “A/B Trust,” with the A trust being a marital deduction trust and the B trust being a credit shelter trust. Under a traditional A/B Trust plan, the assets of the first spouse to die are divided into two trusts. Assets with a value equal to the Minnesota estate tax exemption are allocated to a credit shelter trust and the balance of the deceased spouse’s estate is allocated to a marital deduction trust. Mandatory funding of the credit shelter trust prevents the deceased spouse’s Minnesota estate tax exemption from being lost. However, there is typically little flexibility in determining the amount to be put into the credit shelter trust. Depending on the distribution provisions of the credit shelter trust, the size of each spouse’s estate, and how assets are allocated between spouses, A/B Trust planning may effectively disinherit the surviving spouse.
A disclaimer is a refusal to accept a property interest or a gift. The most common disclaimer for estate planning is a planned disclaimer by a surviving spouse when a “disclaimer trust” is created to hold the assets disclaimed and provide income to the surviving spouse. This allows a surviving spouse to refuse to accept the testamentary gift from the deceased spouse, causing the disclaimed interest to pass as though the disclaimant were not alive and died before the deceased spouse. Disclaimer trust planning offers flexibility because the surviving spouse can consider the estate tax laws at the first spouse’s death and make informed decisions that best fit their needs regardless of the tax implications. These decisions include the following: whether to make a disclaimer at all; the amount to be disclaimed; and the choice of assets to be disclaimed. However, if the surviving spouse does not disclaim within 9 months of the deceased spouse’s death, and if the surviving spouse is not careful with how they handle the assets to be disclaimed, the opportunity to disclaim may be lost.
A qualified terminable interest property (“QTIP”) trust is a trust that qualifies for the unlimited marital deduction. In order to qualify for the marital deduction, the trust must meet the following requirements: the surviving spouse must be the only beneficiary of the trust during their lifetime; the terms of the trust must grant the surviving spouse a “qualifying income interest for life;” and the terms of the trust must grant the surviving spouse the power to direct the trustee to convert non-income producing assets to income producing assets. Under QTIP trust planning, the residue of the deceased spouse’s estate (the portion not being used to fund the credit shelter trust) passes to a QTIP trust for the surviving spouse. Although the trust balance (i.e., principal) typically remains protected until the surviving spouse also passes away, the trustee of a QTIP trust can be given the discretion to distribute principal to the surviving spouse for the health, education, maintenance, and support of the surviving spouse. A QTIP trust allows a deceased spouse to control the ultimate disposition of the QTIP trust assets, while still ensuring that the assets within the QTIP trust are eligible for the marital deduction at the deceased spouse’s death. At the death of the surviving spouse, the assets of the QTIP trust are distributed pursuant to the terms of the trust agreement. For this reason, QTIP trusts are often considered best suited for blended families as they protect against the surviving spouse favoring their own children over those of the deceased spouse.
Together with or separately from the above estate planning strategies, Minnesota residents may also use gifts to limit Minnesota’s estate tax. As previously mentioned, there is no state gift tax in Minnesota. As such, a simple solution to reduce the size of one’s taxable estate is to make annual gifts to one’s beneficiaries. Keep in mind, however, that federally taxable gifts made within three years of one’s death are pulled back into the Minnesota taxable estate. You should also keep in mind that capital gains may offset any potential Minnesota estate tax savings. When a person makes a gift, the recipient of that gift has the same income tax basis in the gift that the gift-giver had. So, if you make a gift of an asset with a low-cost basis, there is no step-up basis at the gift-giver’s death, resulting in the beneficiaries paying capital gains tax when those assets are later sold. Considering how Minnesota’s estate tax rate starts at 13%, considering how the federal capital gains tax rate can be 0%, 15%, or 20% (depending on the income of the individual selling the asset), and considering how Minnesota taxes capital gains as “ordinary income,” you have to crunch some numbers to determine whether getting the step up in basis is more important than reducing the size of your Minnesota taxable estate through gifting.
If you are married and the combined value of your estate and your spouse’s estate exceeds $3 million, you may want to consult with an attorney to see if the Minnesota estate tax can be minimized or avoided entirely. The best estate plan for you will be the one that is tailored to your situation. The sooner an estate plan is created, the more options you may have to reduce your taxable estate.
Joseph Heck is an attorney at Fryberger Law Firm. He can be reached at Fryberger’s Cloquet office at (218) 879-3363.
The material in this article is for informational purposes only and not for the purpose of providing legal advice. You should contact your attorney to obtain advice with respect to any particular issue or problem.
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