State estate and gift tax provisions.

An important element of minimizing the death tax burden involves pre-mortem planning. Federal estate tax planning, however, covers only part of the potential tax liability experienced at death. Each state imposes a death tax, and many of these taxes differ from the Federal transfer tax structure. Therefore, an effective estate plan must incorporate all of the relevant state tax provisions. (Note: The Federal unified tax system and the gift and death tax systems of the various states all allow for certain amounts to be transferred free of transfer tax; these nontaxable transfers are not considered in this discussion. Therefore, unless otherwise noted, all references to lifetime gifts or transfers at death are to taxable transfers, i.e., amounts transferred in excess of any applicable Federal or state tax exemptions.)

While state estate and gift taxes are a significant consideration in estate planning, they are not the only transfer costs that may be incurred as a result of lifetime or at-death transfers. Other such costs include sales/use taxes and other fees imposed by the various states associated with the transfer of title to property. Such additional costs are beyond the scope of this discussion, but should be considered in estate planning.

State Death Tax Systems

There are three basic state death tax systems currently in use: piggy-back, estate and inheritance. Thirty-one states have adopted the so-called "piggy-back" death tax method Under this method, the state assesses a tax equal to the maximum allowable state tax credit on the Federal estate tax return. The maximum state tax credit is progressive and effectively ranges from 0.8% on taxable estates in excess of $100,000 to 16% for taxable estates in excess of $11 million.

Example 1: A decedent from a piggy-back state leaves a net taxable estate of $1,000,000. The tentative Federal estate tax is $345,800, minus the Federal estate tax transfer credit of $192,800, for a net tax of $153,000. To calculate the maximum allowable state death tax credit, the $1,000,000 net taxable estate is reduced by $60,000 (Sec. 2011) to $940,000. From the state tax credit table (Sec. 2011), the allowable credit on $940,000 is $33,200 [calculated as $27,600 on the first $840,000 plus $5,600 (5.6% of the $100,000 excess over $840,000)]. The resulting Federal estate tax inability is $119,800 ($153,000 -- $33,200). A piggy-back state would assess a tax on the decedent's estate of $33,200. As a result, there is no net increase in the decedent's overall tax burden.

Four states (Mississippi, New York, Ohio and Oklahoma) use an estate death tax system, which is a levy on the right to transfer property imposed on the decedent's estate. Fifteen states (Delaware, Indiana, Iowa, Kansas, Kentucky, Louisiana, Maryland, Montana, Nebraska, New Hampshire, New Jersey, North Carolina, Pennsylvania, South Dakota end Tennessee) impose an inheritance tax system, which is a levy on the right to receive property imposed on the heirs. Inheritance tax states typically impose higher tax rates on property transferred to individuals who are less closely related (by marriage or blood) to the decedent; additionally, the total inheritance tax payable can be significantly affected by the number of heirs.

In addition, all 19 states with an estate or inheritance tax impose an additional tax called a pick-up tax. These states employ their own rules for calculating the state death tax liability. This tax liability may be more or less than the allowable state tax credit on the Federal estate tax return. When the state tax liability is less than the maximum allowable state tax credit, a pickup tax is imposed by the state equal to the difference, thereby causing the state tax liability to equal the maximum allowable state tax credit. However, when the calculated state tax liability exceeds the Federal maximum allowable state tax credit, no adjustment is made to lower the total state tax liability. Therefore, the state tax liability could equal or exceed the total amount allowable as a credit on the Federal estate tax return.

A state gift tax is also levied in six states (Connecticut, Delaware, Louisiana, New York, North Carolina and Tennessee), usually on gifts over a specified exemption value to nonspouses. These gift tax systems apply only to taxable lifetime transfers, in contrast to the Federal unified transfer tax system, which applies to lifetime gifts and at-death transfers.

Basic State Tax Provisions

The due date for the filing and payment of the Federal estate tax may differ from the state due date. State due dates vary between six and 18 months after the date of death.

The piggy-back states follow the Federal rates and deductions, as discussed. If no tax is due at the Federal level, no tax is paid to the state. Once a transfer above $600,000 in net taxable value occurs, the state credit disallowed by the exemption equivalent immediately becomes due to the extent of the total tax.

Example 2: A net taxable estate of $642,424 results in a Federal tax of $15,697 and an allowable state credit of $15,697. Thus, net taxable estates valued between $600,000 and $642,424 pay taxes only to the state; above $642,424, the Federal government starts collecting its share of estate tax.

In the inheritance tax states (which impose tax rates depending on the relationship of the heir to the decedent), there are a wide range of rates and exemptions. The tax classes vary in terms of heirs, rates and number of classes. Only Delaware and Maryland tax direct transfers to the surviving spouse; Delaware taxes spousal inheritances over a $70,000 exemption, while Maryland taxes spousal transfers of nonreal property without the right of survivorship in excess of $100,000. Iowa and South Dakota have the greatest number of tax classes (six). The inheritance tax exemptions range from no exemption to an exemption for the total transfer to the respective class.

Among the estate tax states, the tax rates range from a low of 0.5% in Oklahoma (which has two separate tax classes) to a maximum of 21% in New York. The exemptions for estate tax states range from $0 in Oklahoma to $600,000 in Massachusetts and Mississippi; Ohio and New York offer estate tax credits of $500, rather than exemptions.

State Gifting and Special-Use Valuation

Gifting and special-use valuation provisions vary not only among death tax systems, but also among the states within a category. The Federal treatment of gifts flows through to the 31 piggyback states, to the extent that any taxable gifts are included in the Federal taxable estate. This is because the state tax liability in piggy-back states is directly related to the amount of the Federal taxable estate, as discussed earlier. However, other states pull gifts within six months to three years of death back into the decedent's estate. These gifts may be deemed in contemplation of death; however, in some states, an established gifting program may avoid this treatment if the estate can show that the plan was implemented well before the decedent's death. Additionally, many states do not take into account the Federal annual gift exclusions when recapturing gifts; for example, Pennsylvania allows only a $3,000 exemption for each gift made within one year of death.

Five of the states that impose a gift tax--Connecticut, Delaware, Louisiana, New York and North Carolina--follow the Federal annual exclusions, including the provisions for split gifts. New York imposes the gift tax at the same rate as its estate tax, while Connecticut and Delaware tax gifts at rates between 1% and 6%. Louisiana has a $30,000 specific lifetime exemption and North Carolina has a $100,000 lifetime exemption for transfers to class 1 donees. North Carolina taxes gifts at the same rate as the inheritance tax, while Louisiana imposes gift tax rates from 2% to 3%. Tennessee, the other state imposing a gift tax, incorporates an additional tax class for gifts; the Tennessee gift tax rates range from 5.5% to 16%, allow the annual exclusion only to class 1 heirs, and permit a $5,000 total exemption for class 2 donees for gifts exceeding $3,000.

Special-use valuation provisions also vary among the states. The 31 piggyback states typically follow the Federal provisions, but other states have unique rules. Indiana, North Carolina and Oklahoma (among others) disallow special-use valuation. Kentucky, Mississippi and Ohio have maximum gross estate value reductions of $500,000 and recapture periods of five, 15 and four years, respectively. South Dakota has a special inheritance tax class for farm and forest heirs; class 6, with lower marginal rates, applies to heirs not in class 1 or 2 who engaged in business or farming with the decedent for at least 10 out of 15 years prior to death.

Although New Jersey does not allow special-use valuation, it values forest land according to comparable forest land sales and requires a recalculation of the estate tax if the land's use is changed. Louisiana has no provisions for special-use valuation, but accepts the Federal valuation. Maryland values forest land according to its most recent real property assessment for property tax purposes and allows a 15-year tax recapture. Pennsylvania has a seven-year recapture period, and Virginia (a piggy-back state) has special provisions extending the recapture period to 15 years.

Many of the other inheritance and estate tax states have laws similar to the Federal special-use valuation provisions. Although special-use valuation may not be fully used by some states, the Federal provisions will pass through to a state with a pick-up tax.

State Deferral and Extension Provisions

Deferral and extension of death tax payments on the state level do not always follow the Federal provisions. Generally, states may apply their own interest rates to extensions, grant additional extensions or limit the total extensions. All states, except Kentucky and Montana, allow filing extensions; however, 12 states do not allow extensions to pay the death taxes.

The interest rate on extensions to pay varies from 0% to 15%. Six states (Alabama, Arizona, Missouri, Nevada, Ohio and South Carolina) follow the applicable Federal rate for extensions. (Many of the states have variable interest rates, similar to the Federal.)Virginia adds 2% to the applicable Federal interest rate. Louisiana and Massachusetts charge no interest for extensions; Vermont charges no interest on hardship extensions (not to exceed five years). Wyoming charges no interest on extensions and does not charge interest or penalties for late payments (which suggests that heirs have no economic incentive to pay the tax). States also vary in the length of time allowed for extensions of time to file and pay; while Alabama and Maine allow 10 years, Texas allows only four years.

Installment payments rarely follow the Federal model. Nine states (Georgia, Indiana, Iowa, Michigan, Nebraska, North Dakota, Oregon, South Dakota and Vermont) do not allow installments. Arkansas, Missouri, Montana, Nevada and New York allow installment payments at the favorable Federal 4% interest rate. Illinois charges 6% for installments. Arizona allows installment payments if the state tax exceeds $50,000. Many other states that allow extensions do not give a special interest rate for installments. Additionally, California, Delaware, New Hampshire, North Carolina, Rhode Island and Tennessee allow installment plans negotiated between the estate and the state taxing authority. Finally, a 5% discount for prompt payment of the state tax is allowed by Indiana, Kentucky, Montana and Pennsylvania, if payment is made within 12 months, nine months, 18 months and three months of the decedent's date of death, respectively

In addition to the general Federal provisions, New York has some unique state transfer tax provisions. It allows a $250,000 principal residence deduction, and an Agricultural Exemption Credit (not to exceed $15,000) for property used in the trade or business of farming. The qualified property is the same as that eligible for special-use valuation treatment for Federal tax purposes.

Conclusion

The Federal estate tax is quite complex and must be thoroughly understood in order to conduct effective estate planning. Some state death tax systems are equally complex, and many Federal provisions do not carry over to the state systems. The three death tax systems--piggy-back, estate and inheritance--have widely varying characteristics with which an estate planner should be familiar. Even the piggyback states (which generally follow the Internal Revenue Code) include some differing provisions. Thus, estate planners should be aware of the differences in Federal and state death taxes. Effective estate planning must include consideration of both Federal and state death taxes if an estate plan is going to meet the goals of efficient ongoing operation of the estate's assets and minimization of the total death tax burden. Furthermore, estate plans must be continually updated to reflect changes in the estate and Federal and state transfer tax laws.

From Daniel M. Peters, Graduate Research Assistant, Department of Forestry, Dr. Harry L. Haney, Jr., Garland Gray Professor of Forestry and Extension Specialist, Department of Forestry, and Dr. Debra S. Callihan, CPA, Assistant Professor of Accounting, Department of Accounting, Virginia Polytechnic Institute and State University, Blacksburg, Va.

Editor's Note: Ms. Manos-McHenry chairs the AICPA Tax Division State and Local Taxation Committee.

For more information about this article, contact Dr. Callihan at [phone] or Dr. Haney at [phone].

Authors' note: The research for this article was supported in part with funds provided by the Project on Forest Resource Law and Economics, Southern Research Station, New Orleans, La.

The information contained herein was correct as of May 1996.