The phaseout of the federal state death tax credit.
* Many stats have pick-up death taxes tied directly to the maximum SDTC.
* A change that reduces the gross Federal estate tax liability or increase the unified credit reduces the limit on the SDTC.
* The SDTC is being phased out this year; in 2005, a deduction will take its place.
Federal estate tax reductions and the state death tax credit phaseout are having an adverse effect on state death tax revenue. This two-part article summarizes these changes in Federal law, explains how they affect state death taxes and reviews the states' responses.
According to the Spring 2002 issue of the IRS Statistics of Income Bulletin, approximately 102,000 Federal estate tax returns were filed in 2000, with about half of them reporting taxable estates; the net Federal tax liabilities totaled about $25 billion. (1) These returns had an average estate tax liability before credits of close to $1 million. State death tax credits (SDTCs) totaling about $6.5 billion were claimed on 57,587 returns, for an average SDTC of close to $113,000 per return. Nearly 500 of those returns showed generation skipping transfer (GST) tax totaling about $158 million, for an average of about $330,000 per return. (2)
Section 501 of the Economic Growth and Tax Revenue Reconciliation Act of 2001 (EGTRRA) set in motion the phaseout of the Federal estate tax between 2003 and 2010. After complete phaseout, EGTRRA Section 901 provides that the estate tax will reappear in 2011 in its previous form. (3) In addition, the phaseout of the Federal SDTC will he complete after 2004; these changes affect the states' death tax revenues. Some states are changing their estate or inheritance tax laws to preserve some of their tax revenues.
This two-part article explains how recent changes in the Federal estate and gift tax law affect the SDTC and revenue, and the actions states are taking in response to those changes. Part 1, below, summarizes the current Federal law's effect on the SDTC. Part II, in the March 2004 issue, will summarize the changes being made or proposed at the state level, including a comprehensive chart with information on all of the states' estate, inheritance and GST taxes after the EGTRRA.
Sec. 2011(a) provides at credit for any estate, inheritance, legacy or succession tax paid to a state or the District of Columbia (death taxes). An "estate" tax is imposed on the right to transfer property at death. (4) An estate tax rate is not based on the relationship of the beneficiaries, nor is the tax base reduced to take into account the fact that Federal estate tax and state death taxes will diminish the amount available for beneficiaries.
"Inheritance" and "succession" both generally mean the receipt of property as a result of the previous owner's death; these terms are often used interchangeably, (5) An inheritance or succession tax is a tax on the right of succession to property, and is a tax on what the transferee receives. (6) The tax rate for an inheritance or succession tax generally varies to some extent, depending oil the relationship of the beneficiary. A deduction for Federal estate taxes may be allowed in computing the amount of property to be inherited, resulting in a reduction in the inheritance or succession tax. The term "legacy tax" also refers to a death tax. (The distinction between estate taxes and inheritance taxes is not always recognized; in this article, the applicable term is used, even if the state uses another term.)
Effect of Federal Changes on State Revenues
The Federal estate tax is changing in several ways that result in a reduction in the allowable SDTC and in tax revenues for "pick-up" states.
1. The top estate tax rates are being reduced.
2. The "applicable exclusion amount" (AEA) for the unified credit against estate tax is increasing.
3. The amount of the SDTC computed from the applicable table is being phased out and replaced by a deduction for the state death tax paid.
4. Ultimately, the Federal estate tax is eliminated for one year, before being reinstated.
The Federal government has consistently shared Federal estate tax revenue with the states, by allowing a Federal credit for state death (estate or inheritance) taxes paid. (7) When a state imposes an estate tax equal to the maximum credit allowed on the Federal return, the state tax does not create a burden for its taxpayers. The payment to the state results in a corresponding reduction in Federal taxes.
At the Federal level, Sec. 2601 imposes a tax on GSTs at the highest estate tax rate. Sec. 2604 allows a credit against this tax for payment of a state GST tax, limited to 5% of the Federal GST tax paid.
The Federal state tax credits have been a strong incentive for states to adopt an estate or inheritance tax, at least equal to the maximum Federal credit for those taxes. In fact, all states and the District of Columbia had some form of "pick-up" taxes for the Federal estate tax before the EGTRRA's passage; some also had "pick-up" taxes for the Federal GST tax. (8)
A state death tax is called a "pickup" tax when it is tied directly to the maximum Federal credit for state death tax. (9) As explained in Part II of this article, there are various forms of pick-up taxes at the state level. Some are equal to the available Federal credit, while others require payment of an amount at least equal to the available Federal credit, and possibly more.
Combination of Inheritance and Estate Tax
When a state has both an estate and inheritance tax, a state credit is often allowed against the state estate tax for the inheritance tax paid. Generally, the state has a goal of ensuring that the total state death taxes are sufficient to fully absorb the available Federal credit for state death taxes. Of course, the state death taxes may exceed the Federal credit.
Pennsylvania imposes an estate tax based on the Federal credit allowed by the Code, as amended to June 1, 2001. The estate tax is reduced by the inheritance tax paid) (10) Pennsylvania's inheritance tax applies to all property transfers. It is imposed at a flat 4.5% rate for assets transferred to parents, grandparents or lineal descendants (children, grandchildren and stepchildren), 12% for assets transferred to brothers and sisters and 15% for assets transferred to all others; however, there is no tax for assets passed to a spouse. (11) The top Pennsylvania inheritance rate, 15%, is less than the top rate of 16% used to compute the Federal SDTC. The estate tax assures that Pennsylvania receives the full amount of death taxes qualifying for the Federal credit for large estates. Thus, this estate tax is called a "pick-up" tax or "sponge" tax.
Current Federal Estate and Gift Tax Regime
Exhibit 1, at right, illustrates the basic process far computing the Federal estate tax with a SDTC. The 2004 Federal estate and gift tax rates are listed in Exhibit 2 at right. Exhibit 3, on p. 99, shows the currently scheduled reductions to the top rates each year through 2007.
The gross estate includes all property owned by the decedent at death. Deductions are allowed for charitable bequests, property passing to the surviving spouse (marital deduction) and certain expenses, debts and losses. Current Federal tax law provides for a deduction for state death taxes starting in 2005. (12)
The taxable estate is computed by subtracting allowable deductions from the gross estate. Assuming the decedent made no taxable gifts, the estate tax is computed by applying the rates to the taxable estate. If the decedent made taxable gifts, they are added to the taxable estate to arrive at the tax base on which the estate tax is computed. In the latter case, a credit is allowed for gift taxes paid on such gifts.
Many policy experts think a gift tax is necessary to have an effective estate tax. Without a gift tax, taxpayers are more likely to give away their property before death to avoid the estate tax.
The Federal gift tax is unified with the estate tax, in that the same tax rates are used to compute both taxes (transfer taxes). In computing the gift tax, Sec. 2503(b) permits an annual exclusion of $11,000 for gifts to each individual (adjusted for inflation). Secs. 2522 and 2523 allow deductions for gifts to charity and property transferred to a spouse in the computation of taxable gifts.
Unified Credit and Tax Rate Changes
Since 1976, there has been a unified credit against the estate and gift tax. The amount of the unified credit is related to the AEA (the amount of taxable estate or taxable gifts to be shielded from the transfer tax). Exhibit 3 lists the scheduled changes in the maximum Federal estate tax rates, the AEA and the unified credit through 2009.
In Exhibit 1, the unified credit amount is $555,800, which is the amount of tax on the AEA of $1.5 million for 2004 (see Exhibit 2). In a state with a pick-up tax, the state death tax on this estate would be $66,774, assuming all property is located in the applicable state. (13) A SDTC is allowed in 2004 for 25% of $66,774. Thus, the estate tax liability is zero, despite the fact that the amount of the taxable estate is $1,537,097, because the estate incurred $66,774 in state taxes.
Federal Gift Tax Changes
The same unified transfer tax rates are used for both taxable estates and taxable gifts until 2010, when the estate tax is scheduled to expire. At that time, a revised set of gift tax rates goes into effect, with a maximum 35% rate. (14) Exhibit 3 shows how the estate tax unified credit is scheduled to increase in coming years. However, the gift tax unified credit remains constant at $345,800, which shields up to $1 million in taxable gifts from gift tax. (15) Of course, such taxable gilts enter into the computation of the Federal estate tax, so use of the credit for taxable gifts reduces the taxable estate (before adding gifts to arrive at the tax base) that can be shielded from tax by the unified credit.
Computation and Phaseout of SDTC
Exhibit 4, at left, contains a partial list of the SDTC rates from the table in Sec. 2011(b)(1). The Federal SDTC computed from the table is limited to the Federal estate tax, less the unified credit. A change that reduces the gross estate tax liability or increases the unified credit reduces the limit on the SDTC. In addition, the Federal SDTC from the table is reduced by 75% in 2004; it will be eliminated in 2005. Similarly, the Federal GST tax credit for state GST taxes under Sec. 2604 will be eliminated for deaths occurring after 2004.
In Exhibit 1, the SDTC is allowed because the Federal estate tax exceeds the unified credit. However, if the taxable estate were $1.5 million, none of the SDTC would be allowed because, under Sec. 2010(c), the unified credit covers all Federal estate tax on a taxable estate of $1.5 million. (The SDTC calculation using the rates in Exhibit 4 would have yielded $64,400, reduced by 75% under Sec. 2011(b)(2), for a death occurring in 2004.)
Starting in 2005, the SDTC is replaced by a deduction for state death taxes paid under Sec. 2053(d). The Federal tax law currently has no limit on the deduction of state death tax paid after 2004.
Part I of this two-part article described how the SDTC and revenue are affected by the EGTRRA, such as the reduction of the top Federal estate tax rates, increase in the unified credit and the phaseout of the Federal SDTC. Part II, in the March 2004 issue, will discuss actual and proposed changes to state estate and inheritance tax laws in response to the Federal changes.
Exhibit 1. Estate tax illustration Changes that will Basic computations 2004 reduce the SDTC Estate tax (no gifts made) Gross estate (Secs. 2031-33) $1,537,097 Charitable bequests (Sec. 2055(a)) Marital deduction (Sec. 2056(a)) Expenses, debts, losses (Secs. 2053-2054) State death tax (Sec. 2058) (after 2004) Total deductions $ 0 Taxable estate (Sec. 2051) $1,537,097 Estate tax (Sec. 2001) 1. Declining estate (see rates in Exhibit 2 below) $ 572,494 tax rates Unified credit (Sec. 2010(a)) $ (555,800) 2. Increasing unified credit SDTC (Sec. 2011) $ (16,694) 3. Phaseout of the SDTC Other credits (Secs. 2011 et. seq.) Total credits $ (572,494) Federal estate tax due $ 0 Note: Under Sec. 2011(b)(2), the SDTC is 25% of the amount from the state death tax credit table. Exhibit 2: Partial Federal estate tax rate table for deaths in 2004 (Sec. 2001(c)) A B C D Tax base equal to Tax base Tax on amount Tax on excess or greater than less than in column A over column A (%) 0 $10,000 $0 18% $10,000 $20,000 $51,800 20% Skipped $750,000 $1 million $5,248,300 39% $1 million $1.25 million $5,345,800 41% $1.25 million $1.5 million $5,448,300 43% $1.5 million $2 million $5,555,800 45% $2 million $2.5 million $5,780,800 48% Note: The top rates will be reduced to 45% by 2007; see Exhibit 3 on p. 99. Exhibit 3: Top estate tax rate, AEA and unified credit Year Top tax rate AEA Unified credit 2004 48% $1.5 million $555,800 2005 47% $1.5 million $555,800 2006 46% $2 million $780,800 2007 45% $2 million $780,800 2008 45% $2 million $780,800 2009 45% $3.5 million $1,445,800 Tax rates are in Sec. 2001(c)(2); AEA is in Sec. 2010(c). Exhibit 4: Partial table for computation of maximum SDTC (Sec. 2011(b)) A B C D ATI * equal to ATI Credit on amount Credit on excess or more than less than in Col. A over Col. A (%) 0 $40,000 -- None $40,000 $90,000 -- 0.80% $90,000 $140,000 $400 1.60% $140,000 $240,000 $1,200 2.40% $240,000 $440,000 $3,600 3.20% $440,000 $640,000 $10,000 4.00% $640,000 $840,000 $18,000 4.80% $840,000 $1,040,000 $27,600 5.60% $1,040,000 $1,540,000 $38,800 6.40% $1,540,000 $2,040,000 $70,800 7.20% $2,040,000 $2,540,000 $106,800 8.00% Skipped $10,040,000 -- $1,082,800 16.00% * ATI is the adjusted taxable estate (i.e., taxable estate less $60,000).
Editor's note: Dr. Godfrey is Co Chair of the SDTC Task Force of the AICPA Tax Division's Trust, Estate. and Gift Tax Technical Resource Panel (TRP).
Author's 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).
(1) See Johnson and Mikow. IRS Statistics of Income Bulletin (Spring 2002), p. 167.
(2) Id. at p. 168
(3) The Federal gift tax was modified, but not eliminated: see EGTRRA Section 511(d). For background on the EGTRRA changes, see Sawyers and Whitlock. "Estates, Trusts & Gifts: Post-EGTRRA Planning and Analysis." 32 The Tax Adviser 822 (December 2001)
(4) See Hoffman, Smith and Willis, West's Federal Taxation: Individual Income Taxes (South-Western/Thompson, 2002), p. 1-11.
(5) An inheritance or succession tax is defined as: "A tax on the right to receive property from a decedent at death and is usually graduated by the size of the share of the particular beneficiary and his/her relationship to the decedent...."; see Hower, Wills, Trusts and Estate Administration (West, 1979) p. 924.
(6) See Hoffman, et al, note 4 supra, at p. 17..3.
(7) See Duncan, "State Responses to Estate Tax Changes Enacted as Part of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA)," Tax Notes, Doc. No. 2002 26344 (11/26/02).
(8) See id.
(9) The Maryland Court of Appeals described the Maryland pick-up tax as follows: "The structure of the Maryland estate tax is referred to as a 'pick-up' tax. This means that, if the federal credit for state death taxes allowable by the Internal Revenue Code exceeds the Maryland inheritance tax, an estate must pay Maryland estate tax to pick up the difference between the credit and the state inheritance tax. Stated more succinctly, the inheritance tax is deducted front the federal estate tax credit to determine the amount of Maryland estate tax. By providing for full use of the federal credit for state death taxes, the Maryland estate tax statute shifts taxes that would otherwise be paid to the federal government to the state treasury." Register of Wills for Baltimore Cty v. Jeffrey A. Arroswsmith, 365 Md. 237 (2001), fn. 6. citing Comptroller of the Currency v. Mary Jameson, 332 Md. 723 (1993).
(10) Pa. Stat. Ann. [section] 9117.
(11) Pa. Stat. Ann. [section] 9116.
(12) See Sec. 2053(d). as amended, for transfers after 2004.
(13) If property is located in several states, the state death tax is often prorated based on the percentage of property located in each state.
(14) See Sec. 2502(a), as amended, for transfers after 2009.
(15) EGTRRA Section 901 provides that the EGTRRA provisions do not apply in the estate and gift tax area for transfers after 2010. Obviously, this sunset provision adds uncertainty to the planning process.
Howard Godfrey, Ph.D., CPA
Professor of Accounting
University of North Carolina-Charlotte
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|Title Annotation:||part 1|
|Publication:||The Tax Adviser|
|Date:||Feb 1, 2004|
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