The Tennessean ran an article this morning about the impact that Tennessee’s state inheritance tax (mentioned as estate tax in the article although this isn’t accurate) has upon the residency of the very wealthy.
To summarize the substance of the article it discusses a very uncommon tactic, in my experience, of changing the client’s residency in order to avoid payment of any inheritance taxes on their estate. Tennessee is the only southern state in which there is any kind of taxation of either the privilege of passing money or the privilege of receiving money at the death of the grantor. Because of the fact that we are the only state in the south with such a taxation structure it does present an opportunity for clients to run across the border, establish new residency and avoid the payment of death taxes in Tennessee. Now, what you have to remember is that such a tactic will not eliminate the obligation to pay federal estate taxes (currently estates over $5,120,000 are taxed at an effective rate of 35%), just Tennessee inheritance taxes (currently estates over $1,000,000 are taxed at a laddered rate that tops out at 9.5%). So the question raised by this article is whether uprooting the family (often after retirement or a liquidity event) outweighs the potential tax obligation that the family will face in Tennessee.
Well, the one issue that should be discussed first is the need to engage in advanced planning. This planning should occur significantly earlier in life than most high net worth individuals care to begin. This is due to the ability to transfer wealth through planning techniques when the underlying asset has a lower value. For example, if the test case in this article had began transferring minority, non-voting interests in his company to trusts for the benefit of his children when the company was worth $5,000,000 (still a Tennessee taxable estate) he could have reaped great benefits at this point in his life. This would have allowed the increase or appreciation of the transferred interest to be placed outside of his estate and into the hands of the next generation. So, if he had transferred 20% of the company when the value was $5,000,000 (an effective $500,000 transfer that could be maximized further through the use of accounting discounts) all of the appreciation related to that amount would have been removed. When the company increases by more than $15,000,000 over the next several years his estate (assuming this is his sole asset) has been reduced from $20,000,000 to $16,500,000 due to the appreciation he removed through the earlier gift. In Tennessee that would be an approximate tax savings of $250,000 (there would have been a small gift tax burden on the transfer of the $500,000 gift, but that can also be minimized through planning).
However, a plan of this sort required a willingness by the client to forego some ownership interest in the company that has been built. Often this is the most difficult issue facing a family. When is the proper time to bring the next generation up to the helm of the ship? My advice is to always bring them up sooner than you think because life is too unpredictable. They need to have experience in watching how the company is run. The client needs an opportunity to watch how their children will run the company. One of the best ways to get children actively interested in learning to run the company is to give them a little skin in the game. That is where the gifting of a minority interest comes in to provide that extra incentive to really commit themselves to the project.
Moving on from estate reduction planning through the use of gifting, there are also alternative ways to minimize the Tennessee inheritance tax. One thing to remember is that, through a properly structured tax planning will, there will be no tax due, either to the Federal government or Tennessee government on the death of the first spouse. The taxes will be deferred to the second death. So, the second death is really the main issue for the families to address. This further reduces the need for intact families to pick up roots and move out of state while both spouses are living. Further, the use of life insurance (which can be a double edged sword if people aren’t properly advised as to the potential taxation of life insurance) can mitigate or eliminate all tax burdens for a family at a greatly reduced cost to the family (essentially just the cost of preparing the necessary trust instrument and paying annual premiums). The statement in the article that “plane tickets are only $500” so it isn’t that hard to come back into town is true. However, a family that does not want to live the life of a “nomad” may prefer to put that travel money towards a well planned life insurance policy to help offset the tax burden for the family.
In summary, I think this article does raise an issue that is discussed with most planning clients. There is disparity between Tennessee and the surrounding states on this issue. The question is what is the family willing to give up in order to avoid a 9.5% tax? Proper advanced planning can make such extreme action unnecessary.
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