A $3.8 Million Estate in a State With a $2 Million Exemption
Harold, 74, was widowed two years ago when his wife Eleanor died. Everything passed to him by joint title and beneficiary designation, and no Form 706 was ever filed. Harold now owns a $1.4 million brokerage account with a $300,000 cost basis, a $900,000 traditional IRA, a $700,000 residence, a $500,000 vacation home, and $300,000 of cash. His state imposes its own estate tax with a $2 million exemption and graduated rates reaching 16%; the federal exclusion is roughly $14 million per person. Harold's beneficiaries are his two adult children and a nine-year-old grandson with Down syndrome, to whom he wants to leave $500,000. He is in good health, insurable, and has no charitable intent beyond a modest bequest to his church. He asks whether the failure to file a federal return for Eleanor's estate cost the family anything, and how to keep the state from taking a large share.
1. Did the failure to file a Form 706 for Eleanor's estate cost the family anything? Explain portability, the deadline that applies, and whether filing now is worthwhile.
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Eleanor's estate passed entirely to Harold through the unlimited marital deduction, so no federal tax was due and no return was legally required unless the executor wanted to elect portability. Skipping it has two consequences.
First, Harold lost Eleanor's unused exclusion, the DSUE. Under Rev. Proc. 2022-32 he can still fix this: a portability-only Form 706 may be filed up to five years after death, so a death in 2023 can be covered through 2028. The return is simpler than a full 706 but still requires a complete asset schedule and appraisal support.
Second, and more important: even with a perfect portability election, Harold's $3.8 million estate is far below the roughly $14 million federal exclusion, so federal estate tax is not his problem. His problem is the state's $2 million exemption. Portability is a federal concept; most states do not offer a state-level DSUE, so Eleanor's unused state exemption is simply gone.
Recommendation: file the late portability election as inexpensive insurance against future exclusion changes and asset growth, but do not let it distract from the state planning, which is where the actual dollars are.
2. Estimate the state estate tax exposure and rank the planning levers available to reduce it, explaining the basis tradeoff in each.
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Rough exposure first: $3.8 million less the $2 million state exemption leaves about $1.8 million taxable. At graduated rates reaching 16%, the state bill could run $150,000-$200,000 - payable in cash within nine months of death.
Levers, in order of value:
Basis discipline. The $1.4 million brokerage account has only $300,000 of basis. Do not gift that account; hold it for the step-up at death under IRC 1014, which eliminates $1.1 million of built-in gain. Gift cash and high-basis assets instead.
Annual exclusion gifts. At $19,000 per recipient, Harold can move $38,000 a year to his children and more through the grandchildren, slowly shrinking the state estate with no gift tax and no return.
Charitable bequest. The church bequest is deductible for state estate tax as well as federal. A charitable remainder trust funded with low-basis stock would remove the stock from the estate, defer the capital gain, pay Harold income for life, and produce a deduction now.
Life insurance. A policy owned by an existing or new irrevocable trust delivers tax-free cash to the children to pay the state tax without forcing a sale of the vacation home.
Review annually - many state exemptions are not indexed for inflation.
3. How should the $500,000 for the grandson with Down syndrome be structured? Address the trust type, the trustee choice, and any IRA-specific issue.
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An outright $500,000 inheritance would be the worst outcome. Assets in the grandchild's name count as resources for SSI (the limit is $2,000) and can disqualify him from Medicaid-funded services; a court-appointed guardian would control the money, and it would be spent on things public benefits already cover.
The tool is a third-party supplemental needs trust, funded at Harold's death, with a discretionary trustee, a spendthrift clause, and language stating that the trust supplements rather than replaces public benefits. Because Harold funds it with his own money - no assets of the grandchild go in - the remainder at the grandchild's death can pass to the other heirs; the Medicaid payback rule that applies to first-party special needs trusts does not apply here. Do not name the daughter as sole trustee if her own finances are shaky; a sibling co-trustee or a corporate trustee is safer.
The IRA is the subtle part. If Harold names the trust as beneficiary, the trust must qualify as a see-through trust; the grandchild may qualify as an eligible designated beneficiary because of his disability, which would allow payments over his life expectancy rather than the ten-year rule. That result depends entirely on trust drafting and documentation, so confirm with estate counsel before signing.