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Introduction

In the past, all 50 states, as well as the District of Columbia, imposed a tax (a "state death tax") on the estate of a decedent. The federal government also imposes a tax on the estate of a decedent. At one time, the federal government allowed a credit for state death taxes paid (the "state death tax credit") to help offset the burden of double taxation. However, in 2001, President Bush signed the Economic Growth and Tax Relief Reconciliation Act ("the 2001 Tax Act) into law. Among other things, the 2001 Tax Act phased out the state death tax credit, fully repealing it in 2005, and replacing it with a deduction.

The "Credit Estate Tax" Dilemma

Prior to 2005, all states imposed a death tax in an amount that was at least equal to the federal state death tax credit, and some states imposed death taxes that exceeded this credit. Most states and the District of Columbia imposed only a state death tax that absorbed the state death tax credit (this type of tax is called a "credit estate tax," "sponge tax," or "pickup tax"). That is, the state imposed a tax equal to the state death tax credit that was allowed on the decedent's federal estate tax return. The remaining states imposed death taxes that were not directly linked to the state death tax credit. This type of tax is either an "estate tax" or "inheritance tax." In these states, if the estate/inheritance tax amount exceeded the state death tax credit, then that was the amount of tax collected by the state. If the estate/inheritance tax amount was less than the state death tax credit, the state would collect the estate/inheritance tax and also impose a tax equal to the difference so that the state would still collect the full state death tax credit amount.

States that tied their estate tax revenue to the federal state death tax credit faced a dilemma. The repeal of the state death tax credit meant that these states would collect less money (while the federal government would collect more). And, with the full repeal of the federal credit in 2005, the estate tax of some jurisdictions was eliminated entirely.

Technical Note: Inheritance tax is imposed on the heirs of an estate and typically treats the transfer of assets to lineal and non-lineal heirs differently as to rates and exemptions. In contrast, estate tax is levied on the value of a person's estate before it is passed on to the heirs.

Pre-2001 Tax Act

Between 1926 and 2005, estates were entitled to a dollar-for-dollar federal estate tax credit (subject to a cap) for any state death taxes paid by the estate. Over those years, the states structured their own death taxes to coordinate with the federal state death tax credit. The states shared in the tax revenue imposed by the IRS, and there was no additional net burden to the estate. Many states completely eliminated their separate death tax schemes, having no need to impose their own; other states modified their separate tax scheme to work in tandem with the federal tax system. By the time the 2001 Tax Act was passed, 37 states and the District of Columbia had only a credit estate tax in place.

Example(s): John died in 2001. His taxable estate was valued at $2 million. The maximum state death tax credit allowable to his estate was $99,600 (assume no other variables) and the federal estate tax payable was $460,650, computed as follows:

Taxable estate

$2,000,000

Less $60,000

$60,000

Adjusted taxable estate

$1,940,000

Estate tax on taxable estate

$780,800

Less unified credit (applicable exclusion amount) for 2001

$220,550

Estate tax before state death tax credit

$560,250

Less state death tax credit

$99,600

Net federal estate tax payable

$460,650

Example(s): John lived in a state that imposed a credit estate tax only. John's estate paid $99,600 in death taxes to the state and $460,650 to the IRS. The total tax paid by John's estate was $560,250. If John's state had not imposed a state death tax, John's estate would have still owed $560,250 in total because John's estate would have been unable to take the state death tax credit. In that case though, the entire amount would be payable to the IRS and not divided between the IRS and the state.

Technical Note: The amount of the state death tax credit was found using the chart provided by Internal Revenue Code (IRC) Sec. 2011. The state death tax credit was limited based on the size of the estate and a set of graduated rates.

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Post 2001 Tax Act

The 2001 Tax Act phased in a repeal of federal estate taxes. The applicable exclusion amount (i.e., the amount of property effectively exempt from tax) increased gradually until it reached $3.5 million in 2009, and the highest estate tax rate decreased gradually until it reaches 45 percent in 2009. Full repeal was scheduled for 2010, but at the eleventh hour, Congress enacted a two-year band-aid. This band-aid reinstated the estate tax for 2010 with a top tax rate of 35 percent and an applicable exclusion amount of $5 million. The estates of persons who died in 2010, however, can opt out of the estate tax. If an estate elects to opt out, property in those estates will receive a modified carryover basis, and not a step-up in basis. The band-aid also provided that for 2011 and 2012, the top tax rate would be 35 percent, and the applicable exclusion amount would be $5 million (indexed for inflation in 2012). The 2012 Tax Act permanently extended the $5 million (as indexed for inflation) applicable exclusion amount, but increased the top tax rate to 40 percent starting in 2013. The Tax Cuts and Jobs Act doubled the gift and estate tax basic exclusion amount to about $11.2 million in 2018 (indexed annually for inflation). After 2025, the exclusion is scheduled to revert to its pre-2018 level and be cut by about one-half. The 2001 Tax Act also phased out the state death tax credit, reducing the credit by 25 percent in 2002, 50 percent in 2003, and 75 percent in 2004, and fully repealing the credit in 2005. This effectively shifted some of the burden of the estate tax repeal to the states.

Example(s): Assume the same facts as above, except that John died in 2002.

Taxable estate

$2,000,000

Less $60,000

$60,000

Adjusted taxable estate

$1,940,000

Estate tax on taxable estate

$780,800

Less unified credit (applicable exclusion amount) for 2002

$345,800

Estate tax before state death tax credit

$435,000

Less state death tax credit ($99,600 x 0.75)

$74,700

Net federal estate tax payable

$360,300

Example(s): In this example, John's estate paid only $74,700 in death taxes to the state and $360,300 to the IRS. The total tax paid by John's estate was $435,000. The state gets 25 percent less in 2002 than it did in 2001. The IRS also collects less because the applicable exclusion amount had increased.

Technical Note: The state death tax credit was replaced by a deduction in 2005. A tax credit differs from a deduction in that the credit is subtracted from the tax itself (in the case of the state death tax credit, subject to limitation), while a deduction is subtracted from the gross estate, resulting only in a reduction to the amount of property that is subject to tax.

How the States Have Reacted

Decoupling

Several states derived significant revenues from state death taxes; the potential lost revenue for the states was estimated to total billions of dollars. It's not surprising then to find that since the enactment of 2001 Tax Act, many states that faced losing revenues have revised their tax laws to unlink ("decouple") them from the federal system.

Several states have enacted legislation to decouple their state death tax from the state death tax credit (seven states and the District of Columbia decoupled automatically without further legislation). States that decoupled now generally impose a tax based upon the state death tax credit allowable under federal law in existence prior to the 2001 Tax Act. So, for instance, the decedent in the second example above would owe the state $99,600 even though his estate could only take a credit on its federal return of $74,700.

Making More Estates Subject To Tax

Some credit estate tax states have also changed their tax laws to impact a greater number of estates by lowering or freezing their exemption amounts. Under the old regime, because these state tax systems mirrored the federal tax system, if an estate wasn't large enough to owe federal estate tax, then it would also owe no state tax. By keeping threshold amounts from rising to match the federal system, some estates that will not owe federal tax will find that state taxes may still have to be paid. For example, assume a state enacted legislation to keep its exemption at $675,000. So, in 2020, while an estate valued at $11,580,000 is exempt from federal tax, it will still be subject to state tax.

Other Action and No Action

Some states have enacted stand-alone inheritance or estate taxes to replace their credit estate tax. The rest of the states that have not decoupled have seen the elimination of their death taxes for the estates of persons dying on or after January 1, 2005.

What Should Individuals Do In This Changing Tax Environment?

In General

Even though the combined amount of state and federal estate taxes may be lower, individuals who live in states that have decoupled could end up paying more in state tax. Moreover some estates could be subject to state taxes even if their assets are exempt from federal taxes.

Married Couples Using Credit Shelter Trust May Need To Revise Estate Plan

Many married couples use a credit shelter trust to minimize estate taxes. Many estate plans created prior to the 2001 Tax Act provide that the maximum amount of the estate that can pass free of federal estate taxes should be allocated to the credit shelter trust. This way, the applicable exclusion amount of the first spouse to die will be fully utilized. The remaining assets would pass free of tax to the surviving spouse under the unlimited marital deduction.

Making that allocation post-2001 Tax Act may mean that there will be death taxes payable to the state at the death of the first spouse to the extent the federal exemption amount exceeds the state exemption amount. This result can be avoided by revising the estate plan to provide that only amounts that can pass free of both federal and state estate tax be allocated to the credit shelter trust.

Caution: This may not be the best result for all estates. Because the federal estate tax rates are generally higher than state death tax rates, some couples may choose to pay death taxes to the state at the death of the first spouse and enjoy greater savings of federal estate tax at the death of the surviving spouse.

Persons who employ this technique, or are otherwise concerned about this change in the tax environment, should consult a qualified estate planning attorney to discuss what changes to documents, if any, are appropriate.

 

 

This material was prepared by Broadridge Investor Communication Solutions, Inc., and does not necessarily represent the views of The Retirement Group or FSC Financial Corp. This information should not be construed as investment advice. Neither the named Representatives nor Broker/Dealer gives tax or legal advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. The publisher is not engaged in rendering legal, accounting or other professional services. If other expert assistance is needed, the reader is advised to engage the services of a competent professional. Please consult your Financial Advisor for further information or call 800-900-5867.

 

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