The Phaseout of the Federal State Death Tax Credit (Part II)

Many states are changing estate and inheritance tax rules in response to the phaseout of the Federal credit for state death taxes, the increased unified credit and lower Federal rates. Part two of this article focuses on state law changes in effect for 2004 and beyond.

Howard Godfrey, Ph.D., CPA
Professor of Accounting
University of North CarolinaCharlotte
Charlotte, NC

Editors note: Dr. Godfrey is Co-Chair of the SDTC Task Force of the AICPA Tax Divisions Trust, Estate, and Gift Tax Technical Resource Panel (TRP).

Authors note: The author expresses appreciation to the other Task Force members for their research and editorial assistance: Brian T. Whitlock (Co-Chair), Evelyn M. Capassakis (TRP Chair), Roby Sawyers (TRP Vice Chair), Robert A. Blume, Barbara A. Bond, Carol Ann Cantrell, Mary Delman, Barbara A. Jones, Robert L. Perez, Robert M. Pielech, Steven A. Thorne, Russell Sanders and Eileen Sherr (AICPA Technical Manager).
 

For more information about this article, contact Dr. Godfrey at hgodfrey@email.uncc.edu.
  

Executive Summary

• Several states decoupled from the Federal estate tax before the EGTRRA, enabling them to avoid its effect; some states eliminated death taxes entirely.

• In general, pure pick-up taxes coupled with the Federal SDTC will disappear in 2005, unless they are tied to the credit as in effect for a prior year.

• When the Federal SDTC is replaced by a deduction, the focus on reporting and collection of state death taxes will shift to the states.

Death tax revenues of many states are declining as a result of the phaseout of the Federal state death tax credit (SDTC) and the credit for state generation-skipping transfer (GST) taxes. Some states are changing their estate or inheritance tax laws to avoid or reduce the effect of Federal changes. Part I of this article, in the February 2004 issue, summarized the Federal changes affecting the SDTC and state death tax revenues. Part II, below, focuses on the changes being made or proposed at the state level in response to the Federal phaseout.

Sec. 2011 allows a state death tax credit on the Federal estate return, limited to the excess of the gross estate tax liability over the unified credit under Sec. 2010. As explained in Part I, a change that reduces the gross estate tax liability or increases the unified credit effectively reduces the limit on the SDTC. Thus, death tax revenues of states with death taxes tied to the amount of the Federal credit are being reduced, because of (1) a reduction in the top Federal estate tax rates, (2) an increase in the unified credit and (3) the phaseout of the Federal SDTC and state GST taxes.

Congress had scheduled increases in the unified credit starting in 1998. Several states also made changes before 2001, enabling them to avoid the effect of the Economic Growth and Tax Revenue Reconciliation Act of 2001 (EGTRRA). For example, Kansas imposed a death tax equal to the credit that would have been allowed under Federal law as it existed on Dec. 31, 1997.¹⁶ Thus, Kansas avoided the effect of the increases in the Federal unified credit that became effective in 1998, and is not affected by the EGTRRA. New York bases its state death tax on the credit computed under the 1998 Internal Revenue Code (IRC).¹⁷ (In this article, some state law is described as having an IRC reference date of a given year.)

In contrast, some states began eliminating death taxes prior to the EGTRRA. For example, Montana repealed its inheritance tax in 2000;¹⁸ Louisianas inheritance tax rates are being reduced each year. For deaths occurring after 2004, the Louisiana rates are reduced by 80%; the tax is eliminated for deaths occurring after June 30, 2004, when certain actions are taken.¹⁹

Connecticut has a succession tax and an estate tax. The succession tax was scheduled to be repealed in 2006, but the General Assembly has delayed the repeal.²⁰

Administrative Policy

In some cases, the state revenue department interprets the state death tax law to be consistent with Federal law. For example, until this year, the Oregon estate tax law had an IRC reference date of 1997, but the tax was not collected unless an estate filed and paid Federal estate taxes. Thus, Oregon law was not tied to the state death tax phaseout; however, by administrative practice, the state has been treated as being effectively connected to the Federal credit.²¹ On Sept. 24, 2003, the Governor of Oregon signed a bill that conforms the states estate tax to changes in the IRC through January 2000.²²

Constitutional Limits

Some state constitutions prohibit the levying of a death tax in excess of the amount allowed as a credit on the Federal estate tax return. For example, the Nevada Constitution provides:

The legislature may provide by law for the taxation of estates taxed by the United States, but only to the extent of any credit allowed by Federal law for the payment of the state tax and only for the purpose of education, to be divided between the common schools and the state university for their support and maintenance. The combined amount of these Federal and state taxes may not exceed the estate tax which would be imposed by Federal law alone.²³

States with such constitutional limits cannot adjust their tax systems to maintain their current levels of death tax collections.

The post-EGTRRA law is generally described as coupled (pure pickup), decoupled, fixed, separate or none. Example 1 below shows examples of pick-up tax systems, Exhibit 2  contains examples of combination approaches and Exhibit 3 has information on the current state systems.

Pick-Up Taxes

Before the EGTRRA,²⁴ some form of pick-up estate tax was used by all states and the District of Columbia, including pure pick-up taxes, fixed taxes and sponge taxes. Before the EGTRRA, 25 states had pure pick-up GST taxes; two had GST taxes with a fixed IRC reference date.

A pure pick-up tax is a single estate tax equal to the SDTC allowed on the Federal estate tax return, when the decedents property is located entirely in one state. If the decedents property is located in more than one state, the affected states share the credit based on the relative amounts of property in each state. Some variations in state pick-up death taxes are illustrated in Exhibit 1. Taxes in the three groups of state death tax structures shown in Exhibit 1 (A, B and C) are often called pick-up taxes. However, those described in Group A are pure pick-up taxes, because the state death tax equals the Federal SDTC.

Coupled Tax

In this article, a coupled tax describes a tax in effect after the EGTRRA with the characteristics of a pure pick-up. A coupled tax imposes a state death tax equal to the available Federal credit and disappears as the Federal credit disappears. Connecticut is an example of a state with an inheritance tax and a state GST tax equal to the amount allowed as a Federal credit under the IRC in effect on the date of the decedents death.²⁵ Connecticut death taxes are coupled taxes. Arizona imposes an estate tax equal to the Federal credit and has updated its IRC reference date to Jan. 1, 2003; thus, the Arizona estate tax is also a coupled tax.²⁶

As explained in Part I of this article, a fully coupled state will be affected by three changes at the Federal level: (1) lower rates, (2) larger applicable exemption amount (AEA) (which dictates a larger unified credit) and (3) phaseout of the Federal SDTC and the credit for state GST taxes. Exhibit 3 identifies 26 states with estate tax laws coupled with the Federal estate tax. Twenty-seven states had either pick-up GST taxes or GST taxes with a pre-EGTRRA IRC reference date (there are only 24 such states after the EGTRRA (Illinois and Nebraska have decoupled their GST taxes and Kansas has repealed its GST tax)).

When the Federal SDTC is completely phased out in 2005, a coupled state will no longer have a state death tax. Of course, a separate inheritance tax not coupled with the Federal law will continue to generate revenue. Likewise, a state pick-up GST tax that remains fully coupled with Federal law will disappear after 2004, when the Federal GST tax credit for payment of a state GST tax expires.

Sponge Tax

In this article, sponge tax is used to describe taxes in Groups B and C of Exhibit 1. A sponge tax soaks up sufficient additional tax to fully use the Federal credit. Tennessee describes its sponge tax as follows:

The purpose of the Tennessee estate tax is to supplement the inheritance tax to assure the state secures a total tax at least equal to the State Death Tax Credit allowed by the Federal government on the Federal Estate Tax Return pursuant to I.R.C. Section 2011. If the State Death Tax Credit exceeds the inheritance tax, the difference is the Tennessee Estate Tax.²⁷

After the EGTRRA, sponge tax applies to a tax that supplements another estate or inheritance tax as needed to assure full benefit of the Federal credit; it will be phased out as the Federal credit is phased out, unless it has a fixed IRC reference date. Exhibit 3 shows that after the EGTRRA, there are seven states with sponge taxes.

Fixed Tax

In this article, an estate tax equal to the Federal credit using an IRC reference date in a prior year is referred to as a Fixed tax, with the month and year reference date indicated in parenthesis. For example, Minnesotas estate tax is equal to the Federal credit with an IRC reference date of Dec. 31, 2000.²⁸ In Exhibit 3, the Minnesota estate tax is listed as Fixed (Dec. 00). A death tax law of this type can only be coupled if the state updates the IRC reference date.

Separate Taxes

Before the EGTRRA, 13 states had a separate inheritance tax not tied to the Federal SDTC, in addition to an estate tax that functioned as a sponge tax: Connecticut, Indiana, Iowa, Kansas, Kentucky, Louisiana, Maryland, Nebraska, New Hampshire, New Jersey, Oklahoma, Pennsylvania and Tennessee. In addition, Ohio had two estate taxes, with the second one serving as a sponge tax.

Decoupled States

Before the EGTRRA, some states had decoupled as to the scheduled increases in the Federal unified credit, to avoid a decrease in state death taxes tied to the Federal credit. The EGTRRA accelerated the rate of decrease in the Federal estate tax. Some states took action to shield estate and inheritance tax collections from the EGTRRAs effect, by choosing a pre-2002 IRC reference date. For example, the Massachusetts estate tax, for dates of death occurring after 2002, is computed with an IRC reference date of Dec. 31, 2000. The Massachusetts tax is listed as Fixed (Dec. 00) in Exhibit 3.²⁹ The Massachusetts tax will be at least as much as the current Federal credit available and possibly more, because the allowable SDTC would have been as high or higher under prior Federal law.

Exhibit 3, Column 4, shows that 18 states have death tax systems that are either decoupled from the Federal law, or have an old IRC reference date. Those states are identified as Decoupled or Fixed. Two states have decoupled the state GST tax; three states have the GST tax with an old IRC reference date.

Interpreting, for state law purposes, fixed IRC reference dates in a state law can be a challenge. California recently passed a bill that updated the IRC reference date in the state tax law to 2001. However, the bill specifically excluded the estate tax and the GST tax from its provisions.³⁰ The California death taxes are coupled, because the applicable state sections make no reference to a specific IRC reference date.³¹

Partial Decoupling

Maryland and Rhode Island illustrate contrasting ways of using fixed IRC reference dates. As seen in Exhibit 2, the Maryland estate tax is decoupled; the state is decoupled from the phaseout of the Federal SDTC. However, the EGTRRA reduction in tax rates and increases in the unified credit apply for Maryland estate tax purposes.³² In Rhode Island, if death occurs on or after Jan. 1, 2002, the death tax equals the maximum SDTC allowed by Sec. 2011 as in effect on Jan. 1, 2001, provided, however, that any scheduled increase in the unified credit provided in Sec. 2010 in effect on Jan. 1, 2001, or thereafter shall not apply.³³ Maryland and Rhode Island are effectively using two different IRC reference dates (pre- and post-EGTRRA dates). They are classified as decoupled in Exhibit 3, because they do not use a single IRC reference date.

State Computations

A state with a pure pick-up tax is not concerned about the detailed computations for gross estate, taxable estate, etc., when all of a decedents property is located within the state. The pick-up tax is determined solely by reference to the credit shown on the Federal estate tax return. When the decedent owned property in more than one state, it is necessary to pro-rate the Federal credit to the applicable states using a formula that takes into account the percentage of property owned in each. That computation may be based on an allocation formula that takes into account the gross estate on the Federal estate tax return and the gross assets located in the different states.

When a state decouples from the Federal credit, it is necessary to compute gross estate, taxable estate, etc., and report such amounts on the state return. If the state fixes its estate tax to an older version of the IRC (i.e., pre-EGTRRA), such computations will need to be based on the old IRC, except when the state adopts a special rule inconsistent with the IRC. After the Federal credit is replaced by a state death tax deduction, some states may have to establish an independent system for computing the state death tax.

Deduction Replaces Credit

The current Federal SDTC provides a convenient way for states to collect a pure pick-up death tax without imposing a tax burden on its citizens, because there is a corresponding reduction in the payment to the Federal government. When a deduction at the Federal level replaces the credit in 2005, a state death tax will be only partially offset by Federal death tax savings. The Federal tax savings will equal the state death tax, multiplied by the marginal Federal tax rate.

Alabama law³⁴ provides that the state estate tax equals the maximum amount allowed as a credit or deduction on the Federal return. Conceivably, this law could be interpreted to require a 100% state estate tax rate, because the Federal law places no limit on the deduction for estate taxes after 2004. However, the state Department of Revenue  interprets this to mean that the state death tax is limited to the allowable credit.

State Gift Tax Laws

Only four states impose a gift tax; those taxes were imposed before the EGTRRA. Those states are Connecticut,³⁵ Louisiana.³⁶ North Carolina³⁷ and Tennessee.³⁸ Wisconsin eliminated its gift tax in 1992. New York repealed its gift tax effective Jan. 1, 2000.³⁹

There appears to be limited coupling of state gift taxes with the IRC. For example, the North Carolina gift tax is coupled with changes in the Federal annual gift tax exclusion.⁴⁰ Some states have a gift tax that applies to gifts in contemplation of death. Because there is no Federal credit for state gift taxes, the affect of Federal changes are not expected to affect state gift taxes significantly. States that do not have gift taxes provide an incentive for their citizens to make lifetime gifts to avoid the state estate or inheritance tax.

State Filing Requirements

Many pick-up states have set their estate tax filing requirement equal to the Federal requirement, because no state death tax was due unless a Federal return was required. States with pre-EGTRRA IRC reference dates will have lower filing thresholds than those applicable to the Federal estate tax.

State Collections

In the past, the Federal government was the predominant collector of death taxes. States have shared Federal revenues to some extent through the SDTC; some states have imposed separate estate or inheritance taxes. The scheduled elimination of the Federal estate tax after 2010 does not eliminate the need for death tax planning, because many states are set to continue collecting state death taxes beyond that date.