Estate tax could also bite the middle-class

For most of the 20th century, Minnesota assessed an inheritance tax, collecting taxes from people who received inheritances upon someone's death. But in 1979, that tax was repealed and replaced by the estate tax, which is paid by the deceased's estate.

Minnesota's estate tax is projected to raise about $170 million a year -- a small fraction of state revenue. It hits a small percentage of residents, typically among the most affluent. But middle-class couples can be making an expensive mistake if they assume the tax can't possibly apply to them.

"The estate tax at the Minnesota level kicks in for estates over $1 million, and it's not very difficult for a middle-class family to reach that threshold," said Scott Nelson, an attorney and chair of the Minnesota State Bar Association.

Critics of Minnesota's estate tax say it could drive wealthy residents to other states that don't tax assets passed on to children and other heirs. But it also can bite middle class Minnesotans who don't feel like millionaires - but in the eyes of the law, could be.

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"The estate tax at the Minnesota level kicks in for estates over $1 million, and it's not very difficult for a middle-class family to reach that threshold."

Nelson said many people don't realize the range of assets tax law considers part of an estate. Among them are life insurance proceeds.

"When you add in the death benefit on life insurance and the retirement accounts and the equity in the home, you can easily get to the million dollar threshold," he said.

While the vast majority of residents don't trigger Minnesota's estate tax, many may be closer to the threshold than they realize.

Say a husband dies with $400,000 in life insurance, perhaps another $400,000 in retirement savings. With that money added to the surviving spouse's assets, the surviving spouse may be closing in on millionaire status.

There is no tax problem yet, but there could be one when the husband's widow dies.

"When the first spouse dies, everything can pass to the surviving spouse free of estate tax," said Shannon Enright an estate planning attorney in Stillwater, Minn. "But upon the second death, that's where couples run into trouble."

Problems arise when a spouse gives everything to the surviving spouse, leaving that person with an estate that can continue growing to more than $1 million. Minnesota generally only allows $1 million from an estate to pass untaxed to children and anyone else who is not a surviving spouse. Anything above $1 million is usually taxed, unless certain farm and small business property is involved.

Estates worth more than $1 million are typically taxed at rates of 10 to 15 percent. A state analyst estimates that the tax hit on an estate of $1.3 million likely would in the range of $40,000 to $50,000.

Even if the estate were to pass to young children, the government could be there to collect taxes, no matter how young the children are or how much it costs to raise them.

The federal government estimates that it can cost a white-collar professional couple about $300,000 to raise one child to age 18. On top of that, there's the cost of college.

But Enright said a will or other estate planning instrument can take advantage of the fact that a $1 million exemption is available to each spouse.

"By putting a plan in place before that first spouse dies, you can make sure both $1 million exemption amounts gets used," she said. "So, you essentially have $2 million as a couple, instead of $1 million."

Enright said a trust that reduces or even eliminates estate taxes can be included in a will or other estate planning tool. The whole package would probably cost $1,000 to $5,000 in legal fees. But Enright said that's a bargain compared to paying estate taxes.

Minnesota recently added provisions designed to tax parts of an estate given away in someone's final three years of life.

In a recent appearance on MPR's Daily Circuit show, House tax committee chair Ann Lenczewski defended the move as making the wealthy pay their fair share.

"This is a progressive tax, based on the ability to pay," said Lenczewski, DFL-Bloomington.

But former Republican state legislator King Banaian and other estate tax critics say Minnesota is adding to the tax when Congress is making it easier to escape the federal estate tax.

"The real issue is increasing complexity and compliance costs takes people away doing things that actually create wealth for society," he said.

As long as lawyers can help clients avoid taxes, they'll inevitably have a lively business doing that.