Decoupling of state death taxes.
Prior to the Economic and Tax Relief Act of 2001 (EGTRRA), the majority of states imposed a state death tax that was equal in amount to the allowable state death tax credit under federal law (known as a pick-up or sponge tax). Other states, that maintained an independent state death tax system, imposed a tax at least equal to the state death tax credit (i.e., the tax imposed was the greater of the state death tax credit or the separately computed state tax). Under this system of revenue-sharing, all states imposed a tax at least equal to the federal credit. For example, in 2001 the maximum federal estate tax of 55 percent was effectively split into two parts, with 39 percent paid to the federal government and 16 percent paid to the state government (lesser percentages were provided in a table for taxable estates under $10,100,000).
Under EGTRRA, the state death tax credit is: (1) reduced by 25 percent in 2002, 50 percent in 2003, and 75 percent in 2004; (2) eliminated and replaced with a deduction from 2005 to 2009 (a deduction provides less than half the benefit of a credit); and (3) scheduled to return in 2011, as it existed in 2001 (per EGTRRA's sunset provisions). Elimination of the state death tax credit from 2005 to 2009 effectively repeals the state inheritance tax in those states that levied a tax exactly equal to the state death tax credit. Threatened with the loss of significant revenue, many states have responded by "decoupling" from the federal estate tax. These new laws designed to recoup lost revenues can take a number of different forms, to include:
(1) Decoupling as to the tax rate but not the exempt amount. For example, in the chart on page 29, no state tax would be imposed on the $3,500,000 going to the family trust (state exemption is equal to federal exemption), but upon the second death the amount in excess of $3,500,000 would be subject to a maximum tax of 16 percent.
(2) Decoupling as to both the tax rate and the exempt amount. For example, assume a pick-up state decouples by imposing a tax based on the law immediately prior to EGTRRA 2001 (i.e., $675,000 is exempt and the top rate is 16 percent). In the chart on page 29, placing $3,500,000 in the family trust to take full advantage of the federal unified credit would expose $2,825,000 to state death taxes (3,500,000--675,000 = 2,825,000). However, placing only $675,000 in the family trust to avoid state death taxes upon the first death would expose $2,825,000 to federal estate taxes upon the surviving spouse's death (i.e., the full unified credit was not used upon the first death).
To cope with the lack of uniformity from state to state and the uncertainty of the federal estate tax under EGTRRA, additional flexibility should be added to estate plans (e.g., post mortem planning with disclaimers, see page 406). See also the planning pointers on pages 5-7 and the discussion of post mortem planning on 493.