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2011 Federal Estate and Gift Planning - State Estate Tax Update - Part 3

 

Section 3: State Estate Tax Update

The federal estate tax rate has been decreasing since 2001 from a top rate of 55% to 45% in 2009.  The federal estate tax rate then went to 0% for 2010 and was re-instated at 35% for 2010 (if elected), 2011, and 2012.  Even though the federal rate has decreased, the tax revenues generated did not significantly decrease until the total tax repeal in 2010. 

The way Congress achieved no estate tax revenue loss was due to the substantial decreases in state death tax revenues because of the phase-out of the state death tax credit.  The credit used to give the decedent’s resident state a percentage of the total estate tax paid.  This credit was replaced by an estate tax deduction, with phase out percentages.  As the chart below shows, even though the federal estate tax rate was decreasing, the percentage still going to the federal government was even more than when the federal estate tax rates were higher.  It was the share of the estate tax that historically went to the states that dramatically decreased, thus decreasing the state credit against federal tax and resulting in a net increase in federal tax collected. It has been estimated that the elimination of the state death tax credit will cost states $100 billion in lost revenue in the years 2002 to 2011.

As shown below, in 2001 when the top Federal estate tax rate was 55%, the federal share was only 39% because the state received the state tax credit of 16%.  In 2009 when the total federal rate was 45%, the federal share was the full 45% while the state share was 0 %. 

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%

States were confronted with a choice to either allow their tax revenue to be gradually eliminated or take legislative action to counter the decrease.  The legislative response varied from state to state and can be grouped into 3 categories; (1) states with no estate tax, (2) states that have “decoupled” from the federal credit (IRC section 2011), and (3) states that have imposed their own separate estate/inheritance tax system.

For the states cited in 1 through 5 below, due to state-specific laws it is required that tax professionals be very knowledgeable about the applicable rules in the resident state of their clients.

1. States with No Estate Tax.  In about one-half of the states, all state death taxes were eliminated as of January 1, 2005 when the IRC section 2011 credit for state death taxes was replaced with a deduction.

 A. The majority of these states still use a pick-up tax system tied to the IRC section 2011 credit for state death taxes.  No legislative action was necessary to “repeal” state death taxes; it happened automatically as a result of the 2001 tax Act (EGTRRA) changes in federal law. 

B. California, Florida, Nevada, and Pennsylvania. These states have constitutional prohibitions against an independent state estate tax or otherwise will require a popular vote to impose such a tax.

2.  States with a Decoupled Estate Tax.  A majority of the states that took action in response to EGTRRA "decoupled" their estate taxes from the phase-out of the IRC section 2011 credit or tied them to the pre-EGTRRA version of the statute, with levels of exemption ranging from $675,000 to $3,500,000. The states that have decoupled are Illinois, Maine, Maryland, Massachusetts, Minnesota, Nebraska, New Jersey, North Carolina, Rhode Island, Vermont and Wisconsin (decoupled through 2007).  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 included Kansas, New York, Oregon, Virginia, and the District of Columbia.  Kansas subsequently enacted a stand-alone estate tax for 2007 to 2009 and Virginia repealed its estate tax effective July 1, 2007.

The following chart shows the separate state estate exclusion amount on current law.  Residents of these states (among others) may pay estate tax of asset values over these exclusion amounts even though no federal estate tax due.

State

Amount

District of Columbia

$1,000,000

Maryland

$1,000,000

Nebraska

$1,000,000

New Jersey

   $675,000

New York

$1,000,000

Rhode Island

   $850,000

Wisconsin

   $675,000

   

3.  States with Separate Estate/Inheritance Tax Systems. Connecticut, Hawaii, Rhode Island, and Washington have enacted stand-alone estate tax systems.

States are continuing to look at the estate tax as a way to raise additional revenue.  The following represent some recent legislative enactments and pronouncements:

A.    Connecticut  For the estate of a decedent dying on or after January 1, 2010, the estate will not be subject to a separate Connecticut estate tax unless the amount of the estate's Connecticut taxable estate exceeds $3,500,000 (an increase from $2,000,000 under prior law).  Beginning for the estates of decedents dying after July 1, 2009, the Connecticut estate tax is payable six months after the decedent's date of death.  The Connecticut estate tax is not affected by the repeal of the federal estate tax.  See CONN. GEN. STAT. section 12-391(c) ("in the event of repeal of the federal estate tax, then all references to the Internal Revenue Code...shall mean the Internal Revenue Code as in force on the day prior to the effective date of such repeal").  According to a Special Notice issued by the Connecticut Department of Revenue Services on March 8, 2010, regardless of the federal estate tax, estates of decedents dying during 2010 for which the amount of the Connecticut taxable estate exceeds $3,500,000 will be required to submit a Connecticut estate tax return along with a pro forma Form 706.

Think of the problems that this six month payable schedule can cause.  Many Connecticut estates may use out of state lawyers or accountants to prepare the federal and Connecticut returns and they may not be aware of this short payable date.

B.  Delaware  H.B. 291 was introduced and passed in the Delaware House of Representatives on June 29, 2009, and passed the Senate on June 30, 2009.  The Governor signed the bill on July 1, 2009, which reinstated a separate Delaware estate tax.  The tax is based on the amount of IRC section 2011 credit for state death taxes allowable as of January 1, 2001 and adopts the $3,500,000 threshold for taxable estates effective in 2009 federal law.

C. New York  On March 16, 2010, the New York State Department of Taxation and Finance (the Office of Tax Policy Analysis, Taxpayer Guidance Division) issued a notice permitting a separate New York state QTIP election when no federal estate tax return is filed (either because of repeal, or when the value of the gross estate is below federal filing thresholds).  In such a case, the estate must file a pro forma Form 706 with the New York return. See TSB-M-10(1)(M). New York State Assembly Bill A9710, which was introduced on January 19, 2010 and signed by the governor on August 11, 2010, clarified that New York will recognize an exclusion amount of $1,000,000 for New York State death tax purposes, subject to a state-only QTIP election when no federal estate tax return is required to be filed (either because of federal estate tax repeal or the value of the decedent's estate does not require filing a federal estate tax return).

4.    State Treatment of Federal QTIP Elections

Many estate plans leave a decedent's entire estate to a trust that qualifies for QTIP treatment and then leave it to the executor to elect QTIP treatment for a portion of the trust.  Assuming some form of EGTRRA applies and the decedent is a resident of a decoupled state and ties its estate tax to the pre-EGTRRA state death tax credit in some manner or does not recognize the increase in exclusion amounts provided by EGTRRA, the executor will have to decide between (i) electing QTIP treatment for more than the amount required to eliminate the federal estate tax in order to save state estate taxes and (ii) limiting the election to the elimination of only the federal estate tax in order to save taxes in the second estate. 

5.   Disclaimer PlanningRather than utilizing marital formula allocations, some estate plans leave everything to the surviving spouse in a form that will qualify for the marital deduction and provide for a credit shelter trust to receive whatever portion of the estate that the spouse decides to disclaim.  If a form of EGTRRA is extended, this type of document may require the surviving spouse to decide between the avoidance of state estate taxes in the first estate and the possible saving of taxes in his or her own estate, much in the same way that the executor does with a QTIP election.  The disclaimer-based plan is inferior to the use of a QTIP in a couple of respects.

  • First, the disclaimer must be made within 9 months of death but by extending the estate tax return, the executor has 15 months to make a QTIP election
  • Second, the spouse cannot have powers of appointment of property disclaimed in a credit shelter trust.  Property added to credit shelter trust pursuant to certain types of QTIP’s is not so limited.

6.    Lifetime Gifts to Reduce State Estate Taxes

An alternative in many states for reducing the state estate tax is to make a large gift.  Most decoupled states do not impose a gift tax.  This means that residents of decoupled states can achieve significant tax savings by making lifetime gifts, including gifts made shortly before death ("deathbed" gifts).

7.    Residency and Domicile Considerations

  • A client living in a state which has decoupled its estate tax from the state death tax credit may want to consider moving to a state in which the state death tax has been phased out.
  • Factors to consider when determining whether such a move would be appropriate include whether the client already has contacts with that other state, the size of the client's estate and the client's willingness to make the lifestyle changes related to such a relocation simply to save state estate taxes.
  • If a client decides to move to a new state, it will be important for him or her to take appropriate measures ensuring that his or her domicile change will be respected for estate tax purposes.

Observation: The application of state estate tax is a constantly changing environment.  Current budget constraints will add to this uncertainty causing states to take a close look at their current position and what changes can be made to generate additional revenues

Section 1: 2011 Federal Estate and Gift Planning - Tax Act Provisions and Planning
Section 2: 2011 Federal Estate and Gift Planning - Selected Planning Vehicles for 2011
Section 3: 2011 Federal Estate and Gift Planning - State Estate Tax Update 


This article cites many topics discussed at the 2011 Heckerling Institute, and 2011 and 2012 estate and trust and wealth planning opportunities. If you wish to discuss these topics or other tax planning issues, please contact the article’s authors Marie Arrigo, Partner and Barbara Taibi, Director.

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