Are Death Taxes Still an Issue?

There have been well-publicized changes in the federal estate tax system, beginning with the new law that took effect July 1, 2001. The $600,000 federal exemption has been gradually increased to $1.5 million beginning January 1, 2004. However, much less publicized have been the significant changes in state death taxes. As we will see, many states have �decoupled� from federal law, meaning estates which owe little or no estate taxes may still be subject to state death taxes.

In order to understand the significance of this decoupling, a short history lesson is in order. Prior to 2002, whenever an estate owed federal estate tax, the IRS allowed the estate to claim a tax credit for state death taxes actually paid up to a maximum amount. There was a table whereby the estate could calculate the maximum amount of this dollar-for-dollar credit.

For example, let�s say that Mr. Johnson�s estate owed a federal estate tax of $100,000 before any credits. According to the table, the maximum credit allowed for state death taxes was $16,000, and Mr. Johnson�s heirs actually paid state inheritance taxes of $10,000. So the estate could deduct the $10,000 from the $100,000 in federal estate taxes and submit only $90,000 to the IRS. But what about the remaining $6,000 Johnson�s estate could have taken as a credit had the state imposed higher death taxes? For many years prior to 2002, all 50 states had so-called �pick-up� tax laws. If you had any unused state death tax credit, the law said kindly remit it to the state taxing authorities and take the full credit. For 75% of the states, this pick-up tax was their only state death tax. Even states like Florida which have no inheritance taxes nevertheless had a pick-up state death tax. After all, such a tax was merely shifting revenue from the federal government to the state government. The net death taxes, adding both state and federal together, would be the same.

Under a new federal law enacted in 2001, the credit for state death taxes will be reduced to zero by 2005. The obvious effect of eliminating the credit for state death taxes is dramatic. States will no longer collect any pick-up tax at all. Congress had assumed that if the federal government wanted to phase out death taxes the states would want to do likewise. It turned out, however, that many states wanted to keep some form of death tax in order to raise revenue. Accordingly, many states decided to �decouple� their death tax from the federal credit and to enact some other form of state death tax. As a result, for the first time ever, some estates may incur state death tax liability even without having any federal estate tax liability whatsoever. Some states that have fully decoupled, like New Jersey and Rhode Island, have essentially enacted a $675,000 exemption, which was the federal exemption in 2001. Other states like Florida and California have not decoupled at all, thereby allowing their pick-up taxes to be phased out beginning in 2005.

Maryland and other states have partially decoupled. Maryland continues to follow the federal exemption increases, which eliminate the death tax for most estates. But for those estates subject to federal estate taxes, Maryland imposes a tax equal to the maximum state death tax credit that was allowed prior to the change in federal law. Since there will be no credit for these taxes off the federal estate taxes, the net effect is that many clients will pay higher overall death taxes. In addition, clients could have an added tax burden if they own real property in other states, especially if those states have fully decoupled. Real property is subject to state death taxes in the state where the property is located.

These changes in tax law make professional tax planning even more important. The tax cost of not planning may have just gone up!