RAMIFICATION FOR ESTATE PLANNERS OF THE PHASE OUT OF THE FEDERAL STATE DEATH TAX CREDIT: BOOM, BUST OR UNKNOWN? Charles D. Fox IV Schiff Hardin & Waite Chicago, Illinois Robert C. Pomeroy Susan L. Abbott Laurie L. O Donnell Goodwin Procter LLP Boston, Massachusetts I. Introduction One somewhat neglected aspect of the 2001 Tax Act, which is having a significant impact on the revenues of many states, is the phase-out of the state death tax credit. Some states have addressed or are addressing this and others have not. The 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 a 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. Phase-Out of State Death Tax Credit. 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 in respect of 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 IRC 2011(b) to the taxable estate was reduced to 75% of that amount in 2002, 50% of that amount in 2003, and 25% of that amount in 2004. The state death tax credit will not apply to estates of decedents dying after December 31, 2004. 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 subject to any maximum amount allowable, other than the amount of state death taxes actually paid. Impact on State Revenues. According to the Conference Committee report on the 2001 Tax Act, the impact of the repeal of the estate and GST taxes will be a loss of federal revenue of $161 billion over a ten year period. One area that has received little discussion is the impact of the repeal of the estate tax on the individual states. 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 Copyright 2003, Charles D. Fox IV, Robert C. Pomeroy, Susan L. Abbott and Laurie L. O Donnell. All rights reserved.
for amounts actually paid in state death taxes up to the amount of the credit. The states will quickly feel the impact of this revenue loss. One commentator has estimated the repeal of the state death tax credit will cost the states $100 billion of revenue in the next ten years. 1 For some states, the revenue derived from the state death tax credit is a significant part of the annual state budget. In New York, Florida, and Connecticut, it is over 2.5%. Most states will face a 1 to 2% reduction in revenue at a time when state budgets are already stretched thin. 2 II. Impact of Phase-Out of Federal State Death Tax Credit on the States Actual Impact Values. The actual impact of the elimination of the state death tax credit will vary from state to state. Approximately one-half of the states will not automatically eliminate their state death taxes in 2005. Some 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. 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 Tennessee. 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 as to the threshold at which the supplemental estate tax will be imposed. 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 Tax Act law to prevent the revenue loss. The states that have decoupled are: Maine (decoupled through 2004), Maryland, Massachusetts, Minnesota, Nebraska, New Jersey, North Carolina, Pennsylvania, Rhode Island, Vermont and Wisconsin (decoupled through 2007). In the other one-half of the states, all state death taxes, unless action is taken, will be eliminated as of January 1, 2005. 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. 3 Federal Revenues Diminish Little Between Now and 2009. The overall effect of the 2001 Tax Act on federal estate tax revenues is that federal revenues do not decrease significantly between now and 2009. 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. Essentially, as of 2001, 39% of the 55% estate tax rate on taxable estates in excess of $10 million went to the federal government and 16% went to the states. The federal rate declined to 38% in 2002 (with the states receiving 12%). In 2003 the federal government will receive 41% and the states will 1 Jonathan Blattmachr, Wealth Transfer Tax Repeal: Some Thoughts on Policy and Planning, Trusts and Estates, February, 2001, at p. 49. 2 Elizabeth McNichol, Many States Are Decoupling From the Federal Estate Tax Act, Center on Budget and Policy Priorities, Washington, D.C., revised December 6, 2002. 3 The ACTEC Website includes a chart, which is regularly updated, which 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
receive 8%. In 2004 the federal government will receive 44% and the states will receive 4%. Starting in 2005, the federal rate is the total rate and will vary from 45% to 47%. Comparison of Federal and State Shares Year Total Rate Federal Share State Share 2001 55% 39% 16% 2002 50% 38% 12% 2003 49% 41% 8% 2004 48% 44% 4% 2005 47% 47% 0% 2006 46% 46% 0% 2007-2009 45% 45% 0% Ron Aucutt has estimated that a decedent with a $10 million estate who lives in a state with only a pick up tax will not see federal taxes decrease by more than 7% from the level of federal taxes in 2001. 4 Total Death Taxes Paid by Resident of Decoupled 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 $10 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 State Death Tax Credit Additional Tax to New York State Federal Tax Rate Combined Federal and New York State Tax Rate* 2002 12% 4% 50% 54% 2003 8% 8% 49% 57% 2004 4% 12% 48% 60% 2005 0% 16% 47% 55.48% 2006 0% 16% 46% 54.64% 2007 0% 16% 45% 53.80% 2008 0% 16% 45% 53.80% 2009 0% 16% 45% 53.80% 2010 0% 16% 0% 16% 2011 16% 0% 55% 55% * Taking into account the deduction for state estate taxes for decedents dying after December 31, 2004. Different Approaches Taken by Decoupled States. States which have decoupled take different approaches as to when a state death tax will be imposed. If a state recognizes the scheduled increases in the federal applicable exclusion amount between 2002 and 2009 provided by the 2001 Tax Act, no state tax will be imposed on an estate 4 Ron Aucutt, Still Debating the Prospects for Estate Tax Repeal, 28 Estate Planning, p. 383 (August 2001). 3
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. EXAMPLE: Decedent dies in 2006 with a $2 million taxable estate. The state has decoupled its state death tax, but preserved the increases in the applicable exclusion amount provided in the 2001 Tax Act. As a result, no state death tax is imposed on this estate. States recognizing the scheduled increases in the federal applicable exclusion amount in the 2001 Tax Act are Maryland and Vermont. If a state does not recognize the increases in the applicable exclusion amount provided in the 2001 Tax Act, there may be a state tax on a taxable estate that is less than the federal Applicable Exclusion Amount. EXAMPLE: Decedent dies in 2006 with a $2 million estate. The state has decoupled its state death tax and does not recognize the increases in the applicable exclusion amount provided in the 2001 Tax Act. The threshold in 2006 for state death taxes in that state is $1 million. Thus, although federal tax is not owed, state death tax will be owed. Further complicating the picture, some decoupled states will recognize the scheduled increases in the federal applicable exclusion amount under pre-2001 Tax Act law. The pre-2001 Tax Act scheduled increases in the applicable exclusion amount were: Year Pre-2001 Tax Act Applicable Exclusion Amount 2003 $700,000 2004 $850,000 2005 $950,000 2006 $1,000,000 Decoupled states that will follow the pre-2001 Tax Act scheduled increases in the federal applicable exclusion amount are: Kansas Maine Massachusetts Minnesota North Carolina Pennsylvania Washington 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: State Amount District of Columbia $675,000 Nebraska $1,000,000 New Jersey $675,000 New York $1,000,000 4
Rhode Island $675,000 Wisconsin $675,000 Illinois on May 30, 2003 passed legislation that ties the Illinois state death tax to the federal state death tax credit on December 31, 2001. Illinois tax will be paid only if the assets of an estate exceed the federal applicable inclusion amount through 2008. 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 2010. 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 2004. Both Alabama and Mississippi have statutes keyed to amounts allowed as either a credit or deduction. (AL ST 40-15-2; MS ST 27-9-5) Since the deduction for state death taxes beginning in 2005 is unlimited, if these statutes are applied literally in 2005-2009, the state death tax would equal the value of the entire estate. 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 $10,000 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 that 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. III. Planning Considerations Effect on Planning for Deathtime Transfers. For clients domiciled in states which have an estate tax based upon the pre-egtrra 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 $1,000,000; in others (e.g., Massachusetts, New Jersey, 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 QTIP elections.) Even clients domiciled in states which 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. Analysis of the Impact on Existing 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 impacted by the decoupling of a state s estate tax from the state death tax credit, it becomes important to examine the impact of that decoupling and consider whether changes 5