In the always exciting world of estate planning, one issue that has been getting a good deal of press over the last year and a half is the generous increase in the federal estate tax exemption that was effected by the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act (“TRA 2010”). Pursuant to that law, signed by President Obama on December 17, 2010, the federal estate tax exemption was dramatically increased to $5,000,000 per individual for 2011. Additionally, TRA 2010 introduced the “portability” mechanism into federal estate taxation, whereby the unused exemption of one spouse may be “transported” to the surviving spouse. Under the new scheme, the executor—by making an election on the decedent’s estate tax return—can insure that the unused portion of the first spouse’s exemption remains available to the surviving spouse to stack on top of his/her exemption. If the first spouse does not use any of his/her exemption, the surviving spouse can—under current law—combine both exemptions to protect an estate worth up to $10,240,000.
So far so good. The problem is that states have not kept up with the generosity of the federal government. New York’s exemption, for example, is only $1,000,000, and New Jersey’s is only $675,000. This difference between the federal and estate exemptions has created what is referred to as the “decoupling problem.” In other words, an individual dying in New York and having a total taxable estate worth more than $1,000,000 might completely escape federal estate taxes and yet still be subject to New York estate taxes. This is not an insignificant amount of exposure: New York estate tax rates range from approximately 5% at the low end to 16% for estates of $10,040,000 and above. And once the $1,000,000 threshold is exceeded, the New York estate tax is on the entire estate—all the way up from dollar #1.
Many existing wills fail to address the decoupling problem. Instead, attorneys have—until this time—been focusing on using all of the federal exemption (which was previously lower) to protect as much of the marital estate as possible from federal estate taxes. To do so, attorneys had developed a strategy whereby they shifted some of the estate into a credit shelter trust so that they could simultaneously expose that money to federal taxation and protect it with the federal exemption. In this way, the money in the credit shelter trust could pass to the next generation free of taxation.
To see how this would work, imagine that the couple has a combined net worth of $6,000,000, that there is a federal exemption of $3,500,000, and that there is no portability. Without a credit shelter trust, the entire estate of the first spouse to die would be protected by the unlimited marital deduction: the problem is that the second spouse would have to pay the estate tax bill for the entire estate. In this example, the second spouse would then have a $6,000,000 estate with only one $3,500,000 exemption to protect it—leaving $2,500,000 to be taxed. The better strategy would have been to fund a credit shelter trust with $3,500,000, leaving the remaining $2,500,000 to go to the spouse under the marital deduction. Upon the death of the second spouse, only $2,500,000 would be potentially taxable, and this would in turn would be protected by the second spouse’s $3,500,000 federal exemption.
Many wills still use this strategy. In fact, many wills contain a boilerplate provision mandating that the executor fund the credit shelter trust to the full extent of the federal exemption. But let’s see how that would operate under current law. Upon the death of the first spouse, the credit shelter trust would be funded to the full amount of $5,120,000, leaving $880,000 for the spouse to pass under the marital deduction. The problem is that any amount in the credit shelter trust would be outside of the marital deduction, and though there would be no federal tax problem (because the exemption in 2012 is $5,120,000), there would be a substantial New York estate tax problem, because only $1,000,000 would be exempted, and $4,120,000 would be left exposed to New York estate taxes.
It is possible to address the decoupling problem. Strategies to get around it include strategic gifting, re-drafting the will to account for the New York exemption, and taking advantage of other opportunities offered by the New York State estate tax laws.
 For 2012, the federal exemption has been adjusted for inflation to $5,210,000. However, to get the full exemptions, both spouses would have to die during 2012.
 As of this writing, Governor Christie of New Jersey has proposed—in his budget for 2013—an increase in the New Jersey exemption to $1,000,000.
 Typically, the spouse would get the income from the assets of the credit shelter trust, while the next generation would get the principal.