THE STATE OF STATE INCOME, GIFT, ESTATE AND INHERITANCE TAXES AND IMPACT ON YOUR INVESTMENT STRATEGY

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1 WEALTH MANAGEMENT THE STATE OF STATE INCOME, GIFT, ESTATE AND INHERITANCE TAXES AND IMPACT ON YOUR INVESTMENT STRATEGY Benjamin Franklin famously observed that there were only two things that were certain in life: death and taxes. When viewed as a function of state residency, however, while death is most definitely certain taxes are somewhat less so. This article offers a brief summary of Tennessee income, gift and inheritance taxes tax, an overview of these taxes in other states across the country and concludes with a look at both the requirements for, obligations of and possible advantages to changing your residency for tax purposes. Tax advisors have long admonished clients not to let the tail wag the dog when it comes to tax planning. Stated otherwise, while tax considerations play an important role in many decisions, they should rarely be the decisive factor. Take, for example, your choice of residency. A great many Tennesseans live in Tennessee not so much by choice, but rather because they were born here and regard the state as their home. Others may have been born elsewhere, but moved to Tennessee as a result of a job offer, a transfer, to be closer to family or perhaps even the desire to live in a warmer climate, and have also come to regard Tennessee as their home. The terms domicile and residency are used somewhat interchangeably for tax purposes, but they each have a slightly different meaning. A taxpayer s domicile or tax home is the state in which he or she resided with the intent to remain indefinitely. A taxpayer s residence is any state in which he or she resided for a specified period of time. Domicile is more significant for gift, estate and inheritance taxes; residency has somewhat more significance for income tax purposes. Thus a taxpayer may be domiciled in one state but be treated as a resident of another state for income tax purposes. Such a taxpayer would be potentially liable for income, gift, estate or inheritance taxes in the state of his or her domicile and income taxes in the state in which he or she was deemed to be a resident. This, of course, is less than ideal tax planning.

2 Courts tend to look at both a taxpayer s subjective intent as well as certain objective evidence of domicile. Taxing authorities, however, focus on specific objective factors when a question of domicile arises. There is no one factor that conclusively establishes domicile, but the following are benchmark indicators of a taxpayer s domicile: Physical presence in the state for at least 6 months and 1 day Filing a Declaration of Domicile Permanent mailing address Register to vote and actually vote in elections Automobile registration and driver's license Residence claimed for automotive and homeowner s insurance purposes Location of primary care and other physicians Location of primary bank accounts Utility and other bills Filing income tax returns Location of Will, Power of Attorney and Living Will/Health Care Directive The rules for determining domicile and/or residency vary widely from state to state. For example, if a taxpayer lives in Maryland for at least six months out of a calendar year and either maintains a home in Maryland or lives in Maryland as of the last day of the year, then he or she is considered a Maryland resident for tax purposes. In neighboring Virginia, however, the law is a much simpler: a taxpayer is considered a resident if they live in Virginia for at least 183 days during the year. Some states effectively require taxpayers to produce evidence establishing where they were for each day of the period of residency in question. In short, establishing a change of domicile or residency is serious business. STATE INCOME TAXES Tennessee is frequently listed along with Alaska, Florida, Nevada, New Hampshire, South Dakota, Texas, Washington and Wyoming as one nine states that does not have an income tax. Technically speaking this is true. But Tennessee taxpayers are well aware of the fact that Tennessee does impose a tax

3 on certain interest and dividend income so the claim that Tennessee does not have an income tax may ring somewhat hollow to them. The Tennessee Hall Income Tax of 6% that applies to all taxable dividend and interest income was adopted in A taxpayer whose legal domicile is in Tennessee and whose taxable interest and dividend income exceeded $1,250 ($2,500 if married, filing jointly) during the tax year is required to file a return, as is any person who moved into or out of Tennessee during the year and whose taxable interest and dividend income during the period of Tennessee residency exceeded the $1,250 ($2,500 if married, filing jointly) filing threshold. A non Tennessee domiciliary who maintains a residence in Tennessee for more than six months of the year is also required to file a return if he or she has taxable interest and dividend income that exceeds $1,250 ($2,500 if married, filing jointly). Military personnel and fulltime students having legal domicile in another state are not required to file. A person who is legally blind or a quadriplegic is exempt from the tax, as is any person 65 years of age or older having a total annual income derived from any and all sources of $16,200 or less ($27,000 or less for joint filers). Tennessee does not tax IRA distributions, pension plan distributions or Social Security income. Let s consider the case of Mr. and Mrs. Holmes, both of whom have been Tennessee residents since birth. Mr. Holmes retired in 2000 after selling his very successful small business and promptly purchased a vacation home in Florida. His three children and ten grandchildren all live in Tennessee, so it comes as no surprise that Mr. and Mrs. Holmes consider Tennessee their home and have no desire to become Florida residents. As the years go by, however, it seems that Mr. and Mrs. Holmes are spending more and more time in Florida. In fact, the Holmes winter home in Florida is now their primary residence from Labor Day through the end of April.

4 If the Holmes have roughly $200,000 of taxable dividend and interest income each year, they will pay an annual Hall income tax of about $11,850. In fact, they ve been paying the Hall tax for so long that they never give it a second thought. But last year, when they received their tax return, it included a note from their accountant asking them if they have ever considered becoming Florida residents. As noted above, the Holmes think of themselves as Tennesseans (and hate the dreaded Gators), but they suddenly recognized that they actually spend about eight months a year in Florida. If they were to change their residence to Florida a change would require very little for them they will no longer have to pay almost $12,000 in Hall tax. Over ten years the savings will approach $120,000, and Mr. and Mrs. Holmes both agree that kind of savings is worth considering. But they are curious about the other tax consequences that would flow from a change of residence, specifically gift, estate and inheritance taxes. STATE GIFT AND INHERITANCE TAX Tennessee is the only state that maintains its own gift and inheritance tax system. Indeed, under current law the vast majority of states have neither a gift nor an estate or inheritance tax, and those that do rely almost entirely on federal gift and estate tax law. Tennessee gift and inheritance tax system is relatively straightforward, employing the following rate system for both gift and inheritance tax purposes: Class A Class B Amount Transferred Tax rate Amount Transferred Tax Rate Less than $40, % Less than $50, % $40,000 $240, % $50,000 $100, % $240,000 $440, % $100,000 $150, % More than $440, % $150,000 $200, % More than $200, % For gift tax purposes Tennessee classifies the recipient of the gift as either a Class A or Class B beneficiary and taxes the gift based upon the class of the donee. Class A beneficiaries include the husband, wife, son, daughter, lineal ancestor,

5 lineal descendant, brother, sister, son in law, daughter in law, or stepchild of the donor everyone else is a Class B beneficiary. There are some notable exclusions from the Class A list. For example, unless the donor has no children or grandchildren, his nieces and nephews are Class B beneficiaries. Similarly, in laws and step children are Class A beneficiaries only as to one generation. As a result, gifts to the spouse of grandchild or to a step grandchild are gifts to Class B beneficiaries (and much more expensive to make). The tax rates for gifts to Class B beneficiaries are clearly much higher than those for Class A beneficiaries. In addition, while Class A beneficiaries qualify for the federal annual exclusion amount (currently $13,000 per person per donee), Class B beneficiaries are limited to an exclusion equal to the greater of $3,000 per donee or $5,000 meaning that gifts that are tax free for federal purposes often result in (unexpected) Tennessee gift tax. For inheritance tax purposes the identity of the recipient is irrelevant the estate is taxed as if every beneficiary was a Class A. In contrast to Tennessee, Florida has no gift, estate or inheritance tax. With this information in hand, let's return to Mr. and Mrs. Holmes. The Holmes have an estate valued at approximately $10MM, which includes their home in Tennessee and their home in Florida, each of which is valued at $1MM. In addition, Mr. and Mrs. Holmes regard their niece, Katie as if she were their own daughter. Katie s parents died in a car accident when she was young and she was raised in the Holmes home. The Holmes traditionally make annual exclusion gifts to all of their children and Katie, a total of $104,000 annually. The gifts are tax free as to their children, but the gift to Katie results in $1,155 in Tennessee gift tax. While the Holmes would not be subject to any federal estate tax at their death, their Tennessee estate plan suggests that they should expect approximately $748,400 in Tennessee inheritance tax. So what should the Holmes do? The tax consequences of changing residency are fairly compelling for the Holmes: they would save $11,850 in annual Hall income tax, $1,155 in annual Tennessee

6 gift tax and $748,400 in Tennessee inheritance taxes (under current law) by becoming Florida residents. Inasmuch as the Holmes already spend eight months a year in Florida, they have already overcome arguably the biggest hurdle to changing their tax home. A declaration of domicile, to be filed in the courthouse closest to their Florida home, attests to their intent to treat Florida as their domicile. With new Florida drivers licenses, automobile and voter registration, the Holmes should be treated as Florida residents for all tax purposes. INVESTMENT STRATEGY While the overriding investment concern should always revolve around the risk/reward trade off and how a particular investment fits within the existing portfolio, taxation of returns is an important secondary consideration. In most cases, investors understand the basic Federal System of Taxation as it relates to their investments. Some returns are considered income and taxed at the individual s personal tax rate, and other returns are considered appreciation. Appreciation is taxed in the year in which the gain is realized (sold) and is either short or long term depending on how long it has been held (more or less than 1 year). Short term gains are taxed at the individual s personal tax rate, and long term gains are currently taxed at 15%. Less attention seems to be paid by investors to the way a particular state s tax system would figure into the investment decisions. Investment Planning related to the Tennessee Hall Income Tax often revolves around trying to select investments that grow through appreciation rather than income or dividends. To the extent a client needs fixed income for diversification (as opposed to current income), there are a couple of strategies that can be employed Hold Fixed Income in Tax Deferred Accounts: Once they decide on their asset allocation, many investors implement that allocation throughout all of their investments. Let s consider a client who allocates their money 60% to equities and 40% to fixed income. The amount allocated to fixed income is not there because of income needs but rather to reduce volatility / risk. Let s assume the client has a portfolio worth $1,000,000 in total and $500,000 of that is in an IRA

7 and $500,000 is taxable money. Conventional thinking would be to invest each account $300,000 to equities and $200,000 to fixed income. However, you could get to the same overall allocation of 60%/40% by putting $400,000 to fixed and $100,000 to equity within the IRA and doing exactly the opposite with the money in the taxable account. The upside to this is almost all of the income from the fixed income portion is within the IRA and would not be subject currently to state or federal tax a great result! Buy State Specific Municipal Bonds: Let s consider a scenario where a person wants more fixed income than their IRA is worth. That person could purchase bonds issued by various entities and municipalities in their state of residency that are exempted from that state s tax. These type bonds are also exempt from federal taxes. Being exempt from both of these taxes increase the yield significantly. In Tennessee, this tax exemption can be worth over 40%. In others words, a 2% tax free yield would be equivalent to a 3.34% taxable yield. In the old days (3 years ago), most investors would have 100% of their municipal bonds from the state in which they resided to maximize this tax benefit. However, our thinking is that a municipal bond portfolio does need some state and geographic diversification within the securities held for credit/default reasons. One only needs to think of a portfolio that would only hold California or Illinois bonds to understand that thinking! We have often said, It is not what you gross but what you net that is important. State taxes are an important consideration when you think about your net. CONCLUSION Changing residency for tax purposes is a BIG deal and it should not be undertaken lightly. Merely wanting to change or intending to change residency generally will not work you have to actually do the things that residents of your new state would customarily do. For taxpayers with multiple residences, however, sometimes the changes required are rather minor, arguably even simple to make. And as illustrated by Mr. and Mrs. Holmes, the tax benefits can be dramatic.

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