What You Need To Know About The Phase-Out Of The Federal S tate Death Tax C redit (With C hecklist)

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1 What You Need To Know About The Phase-Out Of The Federal S tate Death Tax C redit (With C hecklist) C harles D. Fox IV, RobertC. Pomeroy, SusanL. Abbott, and Laurie L. O Donnell Charles D. Fox IV is a partner in S chiff Hardin & Waite, LLP, Chicago, Illinois. Robert C. Pomeroy, S usan L. Abbott, and Laurie L. O Donnell are partners in Goodwin Procter LLP Boston, Massachusetts. A complete set of the course materials from which this outline was drawn may be purchased from ALI-ABA. Cal CLE-NEWS and ask for S J All section references are to the Internal Revenue Code ( Code ), unless otherwise indicated. ACTEC refers to the American Association of E state Counsel; EGTRRA, to the Economic Growth and T ax Relief Reconciliation Act of 2001, Pub. L. No , S tat. 38; GS T, to generation-skipping transfer tax; and QT IP, to qualified terminable interest property. A. Introduction 1. The phase-out of the state death tax credit is a somewhat neglected aspect of the 2001 T ax Act, but it is having a significant effect on the revenues of many states. S ome states have dealt with or are dealing with this problem, while others have taken no action. T he actions taken or not taken by each state may have serious consequences for clients or customers who fail to review and possibly amend their planning documents in light of any change in their state s death taxes. Moreover, given the current budget problems faced by many states, many states are likely to take some action if they have not already done so. 2. Beginning in 2002, the state death tax credit, which is allowed with respect to estate, inheritance, legacy, or succession taxes actually paid to any state or the District of Columbia for any property included in the gross estate (up to a maximum amount, which varies with the value of the taxable estate) was reduced. The amount of the credit that would have been allowed by the application of the schedule and section (b)(2)(b) to the taxable estate was reduced to 75 percent of that amount in 2002, 50 percent of that amount in 2003, and 25 percent of that amount in The state death tax credit will not apply to estates of decedents dying after December 31, Instead, after December 31, 2004, a deduction will be allowed from the value of the gross estate for the amount of any estate, inheritance, legacy, or succession taxes actually paid to any state or the District of Columbia, in respect of any property included in the gross estate. Unlike the state death tax credit, the deduction for state death taxes will not be subj ect to any maximum amount allowable, other than the

2 amount of state death taxes actually paid. 3. EffectO nstate Revenues. According to the Conference Committee report on the 2001 T ax Act, the effect of the repeal of the estate and GS T taxes will be a loss of federal revenue of $ 1 61 billion over a 1 0-year period. One subj ect that has received little discussion is the effect of the repeal of the estate tax on the individual states. a. Nearly every state imposes a death tax equal to the state death tax credit. That credit reduces the federal estate tax on a dollar-for-dollar basis for amounts actually paid in state death taxes up to the amount of the credit. The states will quickly feel the effect of this revenue loss. Two commentators have estimated the repeal of the state death tax credit will cost the states in excess of $ 1 00 billion of revenue in the next 1 0 years. J onathan G. Blattmachr and Mitchell M. Gans, WealthTransferTaxRepeal: Some Thoughts onpolicy and Planning, 1 40 T r. and E st. 49, 60 (February 2001 ). b. For some states, the revenue derived from the state death tax credit is an important part of the annual state budget. In New York, Florida, and C onnecticut, it is over 2.5 percent. Most states will face a one to two percent reduction in revenue at a time when state budgets are already stretched thin. E lizabeth McNichol, Many S tates Are Decoupling From the Federal Estate Tax Act, C enter on Budget and Policy Priorities, Washington, D.C., revised December 6, B. Effect O f Phase-Out O f Federal State Death Tax Credit O n The States 1. ActualEffectO nvalues. T he actual effect of the elimination of the state death tax credit will vary from state to state. a. Approximately one-half of the states will not automatically eliminate their state death taxes in i. S ome states previously tied their state death taxes to the federal state death tax credit as it was in effect in a particular year. These states include: Kansas, New York, Oregon, Virginia, Washington, and the District of Columbia. ii. In some states, the state estate tax will be eliminated, but not the independent inheritance taxes. These states include Connecticut (inheritance tax scheduled to be phased out in 2006), Indiana, Iowa, Kentucky, Louisiana (inheritance tax scheduled to be phased out in 2004), and T ennessee. Ohio has a free-standing estate tax and a supplemental estate tax tied to the federal state death tax credit. There is considerable ambiguity in Ohio on the threshold at which the supplemental estate tax will be imposed. iii. In other states, the legislatures have acted since the 2001 Tax Act to decouple the state death tax from the federal system or to tie it to pre-2001 T ax Act law to prevent the revenue loss. The states that have decoupled are: Maine (decoupled through 2004), Maryland, Massachusetts, Minnesota, Nebraska, New J ersey, North C arolina, Oregon, Rhode Island, Vermont, and Wisconsin (decoupled through 2007). Interestingly, in December 2003, Pennsylvania, which passed decoupling legislation in 2001, passed recoupling legislation. T his will permit the phase-out of the Pennsylvania estate tax in The recoupling legislation does not affect the Pennsylvania inheritance tax, which is independent of the federal state death tax credit.

3 b. In the other one-half of the states, all state death taxes, unless action is taken, will be eliminated as of J anuary 1, Three states, California, Florida, and Nevada, have constitutional prohibitions against an independent state death tax or otherwise will require a popular vote to impose such a tax. The ACTEC Web site includes a chart, which is regularly updated, that shows the current law in each state and the status of any legislation addressing the phase-out of the state death tax credit. A copy of the chart is attached. 2. FederalRevenues DiminishLittle BetweenNowAnd T he overall effect of the 2001 T ax Act on federal estate tax revenues is that federal revenues do not decrease significantly between now and This is accomplished at the cost of substantial decreases in state death tax revenues because of the phase-out of the state death tax credit. a. Essentially, as of 2001, 39 percent of the 55 percent estate tax rate on taxable estates in excess of $ 1 0 million went to the federal government and 1 6 percent went to the states. The federal rate declined to 38 percent in 2002 (with the states receiving 1 2 percent). In 2003 the federal government will receive 41 percent and the states will receive eight percent. In 2004 the federal government will receive 44 percent and the states will receive four percent. S tarting in 2005, the federal rate is the total rate and will vary from 45 percent to 47 percent. Comparison of Federal and S tate S hares Year Total Rate Federal S hare S tate S hare % 39% 1 6% % 38% 1 2% % 41 % 8% % 44% 4% % 47% 0% % 46% 0% % 45% 0% b. Ron Aucutt has estimated that a decedent with a $ 1 0 million estate who lives in a state with only a pick-up tax will not see federal taxes decrease by more than seven percent from the level of federal taxes in Ronald D. Aucutt, StillDebating the Prospects forestate TaxRepeal, 28 E st. Plan. 383 (Aug ). 3. TotalDeathTaxes Paid By ResidentO fdecoupled State. It has been estimated that the total federal and state estate tax will actually go up on the portion of a taxable estate that exceeds $1 0 million in a state which continues to impose a tax at the pre-2001 tax levels. The following chart shows what is anticipated to happen in New York. New York Example Federal S tate Additional Tax Federal Combined Federal Death Tax to New York S tate Tax Rate and New York S tate Tax Rate* % 4% 50% 54% % 8% 49% 57% % 1 2% 48% 60% % 1 6% 47% 55.48% % 1 6% 46% 54.64%

4 2007 0% 1 6% 45% 53.80% % 1 6% 45% 53.80% % 1 6% 45% 53.80% % 1 6% 0% 1 6% % 0% 55% 55% * Taking into account the deduction for state estate taxes for decedents dying after December 31, DifferentApproaches Takenby Decoupled States. S tates that have decoupled take different approaches on when a state death tax will be imposed. a. If a state recognizes the scheduled increases in the federal applicable exclusion amount between 2002 and 2009 provided by the 2001 T ax Act, no state tax will be imposed on an estate equal to the applicable exclusion amount, even if a state is decoupled from the federal system and bases its state death tax on a pre-2002 federal state death tax credit. b. S tates recognizing the scheduled increases in the federal applicable exclusion amount in the 2001 T ax Act are Maryland and Vermont. c. If a state does not recognize the increases in the applicable exclusion amount provided in the 2001 T ax Act, there may be a state tax on a taxable estate that is less than the federal applicable exclusion amount. d. Further complicating the picture, some decoupled states will recognize the scheduled increases in the federal applicable exclusion amount under pre-2001 T ax Act law. The pre-2001 T ax Act scheduled increases in the applicable exclusion amount were: Year Pre-2001 Tax Act Applicable Exclusion Amount 2003 $700, $850, $950, $1,000,000 e. Decoupled states that will follow the pre-2001 T ax Act scheduled increases in the federal applicable exclusion amount are: Kansas, Maine, Massachusetts, Minnesota, North C arolina, Oregon, and Washington. f. Other states have frozen the applicable exclusion amount for state death tax purposes at a fixed amount. Decoupled states that have frozen the exclusion amount at a set sum are: S tate Amount District of Columbia $ 675,000 Nebraska $1,000,000 New J ersey $675,000 New York $ 1,000,000 Rhode Island $ 675,000 Wisconsin $675,000 g. Illinois on May 30, 2003, passed legislation that ties the Illinois state death tax to the federal state death tax credit on December 31, Illinois tax will be paid only if the assets of an estate exceed the federal applicable inclusion amount through However, in 2009, when the federal applicable exclusion amount increases to $ 3.5 million, Illinois tax will be assessed on estates exceeding $ 2 million. Illinois specifically recouples in

5 h. Two states, possibly, face an almost comical situation if their legislatures fail to make changes in their state death tax systems between now and the end of Both Alabama and Mississippi have statutes keyed to amounts allowed as either a credit or deduction. Ala. Code ; Miss. Code Ann S ince the deduction for state death taxes beginning in 2005 is unlimited, if these statutes are applied literally in , the state death tax would equal the value of the entire estate. i. Other states, such as New York, could impose a tax larger than the value of property in New York on non-residents because of the formulas used to apportion tax between the state of residence and New York. At the 2003 ACTEC Annual Meeting, one fellow cited an example involving New York, whose Revenue Department interprets the New York law to permit New York to take whatever state death tax credit is unused by other states. As a result, a Massachusetts decedent with a large estate in Massachusetts and a $ 1 0,000 timeshare condominium in New York is facing a New York death tax bill of $250,000. However, the New York Revenue Department has recently announced that it will apply a rule so the New York tax will be based on a pro rata share of its tax relative to the percentage of estate assets in New York. C. Planning Considerations 1. EffectO nplanning ForDeathtime Transfers. For clients domiciled in states that have an estate tax based on the pre-e GTRRA state death tax credit, the full funding of the federal applicable exclusion amount may now result in the incurrence of a state death tax. In some states (e.g., New York and Nebraska) this will happen only when the federal applicable exclusion amount exceeds $1 million; in others (e.g., Massachusetts, New J ersey, Pennsylvania, and the District of Columbia), this will be immediately true. It is possible that some states may allow a separate QTIP election to be made for state death tax purposes, independent of the federal QTIP election. (The taxing authorities of at least three states Massachusetts, Rhode Island, and Washington are permitting state-only QT IP elections.) Even clients domiciled in states that continue to assess a tax based solely on the state death tax credit in effect at the time of a decedent s death need to be concerned. If those clients own property in a state which has decoupled its estate tax from the state death tax credit, their marital deduction funding formulas may produce some unexpected and undesired results. 2. Analysis O fthe EffectO nexisting Documents. Many clients have existing documents wherein the size of the marital deduction gift is determined by a formula. For those clients who will be affected by the decoupling of a state s estate tax from the state death tax credit, it becomes important to examine the effect of that decoupling and consider whether changes should be made to their estate plans. A discussion of some of the more common formulas follows: 3. Minimum TotalTax. Many estate plans have language that provides for the funding of the marital deduction if required to produce the maximum reduction in all estate (and possibly inheritance) taxes.