71 J. Kan. Bar Assn. 10, 19-32 (2002). 2002 Kansas Death Tax Legislation: An Emperor in Need of Clothes.

• Author: By Timothy P. O'Sullivan and Stewart T. Weaver

Kansas Bar Journals

Volume 71.

71 J. Kan. Bar Assn. 10, 19-32 (2002).

2002 Kansas Death Tax Legislation: An Emperor in Need of Clothes

Kansas Bar Journal71 J. Kan. Bar Ass'n, November/December 2002, 19-32 (2002)2002 Kansas Death Tax Legislation: An Emperor in Need of ClothesTimothy P. O'Sullivan and Stewart T. Weaver, 2002 Kansas Death Tax Legislation: An Emperor in Need of Clothes, J. Kan. Bar Ass'n, November/December 2002, 19-32By Timothy P. O'Sullivan and Stewart T. WeaverI. Introduction

The 2002 Kansas Legislature failed to pass legislation proposed by the Estate Tax Advisory Committee to the Judicial Council. That legislation would have conformed the Kansas Estate Tax Act with the estate tax applicable exclusion amounts enacted at the Federal level under the 2001 Economic Growth and Tax Relief Reconciliation Act ("EGTRRA"). The Kansas Legislature did, however, pass into law an ill-conceived new "inheritance tax."

These acts of omission and commission have thrown Kansas death taxes into a state of turmoil without precedent. The former problem affects decedents dying on or after Jan. 1, 2002, and the latter problem affects decedents dying on or after the effective date of the new "inheritance tax," which is June 6, 2002. The goal of this article is to alert practitioners of the immediate import of the resulting problems and suggest planning strategies to mollify their impact.

2. Nonconformity Problem

   In 1998, the Kansas Legislature enacted into law legislation proposed and supported by the Kansas Bar Association, which repealed the Kansas Inheritance Tax Act. In place of the Kansas Inheritance Tax Act, the Kansas Legislature enacted the Kansas Estate Tax Act ("the Act"), found at K.S.A. 79-15,100 et seq. Essentially, the Act retained in the law a Kansas death tax equal to the amount of the state death tax credit permitted under Section 2011 of the Internal Revenue Code against an actual Federal estate tax liability (after considering the Federal unified credit and applicable deductions) imposed under Section 2001. This tax is often referred to as the "pick-up" tax, as it "picks up" the Federal state death tax credit. Because the "pick-up" tax has been a "dollar for dollar" credit against the Federal estate tax liability otherwise owing, payment of the Kansas estate tax did not add to the total death tax liability of Kansas decedents or nonKansas decedents owning Kansas property. This, revenue sharing and "death tax neutral" aspect of the "pick-up," tax was intended by Congress when it enacted the first state death tax credit in 1924. Predictably, it resulted in all states imposing a death tax at least equal to the amount of the "pick-up" tax in order to secure additional revenue. Prior to the trend over the past two decades in which most states repealed their separate estate or inheritance tax, a substantial majority of states, including Kansas, also had separate death taxes (either an inheritance or estate tax) in addition to the "pick-up" tax.

   The tax neutrality feature of the "pick-up" tax ended for decedents dying on or after Jan. 1, 2002. EGTRRA provides for substantially increased estate tax applicable exclusion amounts for decedents dying on or after Jan. 1, 2002, and in subsequent years, from the applicable exclusion amounts, which would have been otherwise applicable under prior law. However, as a result of specific wording in the Act the dramatically increased applicable exclusion amounts under EGTRRA are not likely to result in a commensurate reduction in the amount of death taxes owing to the state of Kansas under the Act. The Kansas Revisor of Statutes Office, when it drafted the provisions of the Act in 1998 retaining the "pick-up" tax, chose not to include provisions which would have "floated" the amount of the "pick-up" tax with the state death tax credit and filing exemptions under Federal law applicable at the time of a decedent's death. Rather, the Act specifically references the provisions of the Internal Revenue Code as they existed on Dec. 31, 1997 ("prior Federal law"), the law in effect when the Act was enacted. The Revisor's office determined that the "float" alternative would have violated the Kansas Constitution and constituted an impermissible delegation of Kansas legislative authority to the Federal government.[1] As a consequence, the Act does not consider the scheduled increases in the applicable exclusion amount enacted under EGTRRA. Such increases include a $1.0 million applicable exclusion amount for decedents dying on or after January 1, 2002, with scheduled increases in subsequent years to $3.5 million in 2009, a one year repeal in 2010, and a reversion to prior Federal law in subsequent years. Thus, until the year 2011, taxable estates (after giving effect to all allowable deductions under prior Federal law) in excess of the applicable exclusion amount under prior Federal law ($700,000 in 2002) will nonetheless remain liable for the "pick-up" tax assessed under the Kansas Estate Tax Act, notwithstanding the fact there may be no actual Federal estate tax liability under EGTRRA against which the "pick-up" tax may be credited.

   The position of the Kansas Department of Revenue (the Department) is consistent with this interpretation. On June 27th, 2002, the Department issued Notice 02-01.[2] The Notice states that "under current law, the Kansas estate tax will not be affected by the recent changes to Federal law."[3] Therefore, assuming no prior taxable gifts, a taxable estate of $1.0 million with respect to a decedent dying in 2002 would have no Federal estate tax liability. However, it would be liable for the Kansas "pick-up" tax of $33,200, the applicable state death tax credit on a $1.0 million taxable estate under prior Federal law. This represents an approximate 11 percent Kansas "pick up" tax rate on the $300,000 difference between the $700,000 applicable exclusion amount under prior Federal law and the $1.0 million applicable exclusion amount under EGTRRA. The amount of "pick-up" tax imposed by the nonconformity of the Act with current Federal law under EGTRRA will increase dramatically in future years due to the Federal applicable exclusion amount increases under EGTRRA in subsequent years being much greater than those that would have occurred under prior Federal law. For example, the "pick-up" tax liability for a decedent dying in 2004 will be almost double that of a decedent dying in 2002, $64,400, an approximate 10 percent Kansas "pick-up" tax rate on the difference between the EGTRRA applicable exclusion amount of $1.5 million and the applicable exclusion amount under prior Federal law of $850,000.

   Practitioners should take immediate notice of the potentially adverse death tax consequence this nonconformity may cause and pay particular attention to the marital deduction formula clause used in drafting testamentary instruments for married individuals subject to Federal estate taxation. Depending upon the precise language of the formula clause, and assuming no prior taxable gifts, existing formula clauses would fund the "bypass" amount in the estate of a decedent dying in 2002 with either the sum of $700,000 (if such clause minimizes exposure to both Federal estate tax and Kansas death taxes) or $1.0 million (if the formula clause is designed to minimize exposure to Federal estate tax while maximizing the benefit of the applicable exclusion amount). Because such formula clauses are typically designed to take full advantage of the applicable exclusion amount and any additional amounts where the additional estate tax beyond the applicable credit would be offset by the state death tax credit and total death taxes owing would not be thereby increased, it would be expected that a substantial majority of existing formula clauses literally fall, or would be interpreted to fall, in the latter category. That is, most existing formula clauses were not designed to address the unanticipated nonconformity problem of there being a "pick-up" tax liability in situations where there was no Federal estate tax liability.

   With respect to formula clauses which would fund the "bypass" amount with the full applicable exclusion amount under current law, the problem of nonconformity would be compounded if the provisions of the testamentary instrument place the burden of payment of the "pick-up" tax on the marital portion rather than the "bypass" amount. This would lower the amount of the marital deduction (under a circular formula), thereby possibly subjecting the estate-to-estate taxes and additional "pick-up" taxes, as the increased taxable estate resulting from the decreased marital estate tax deduction would be in excess of the current applicable exclusion amount. If the testamentary instrument is silent as to the apportionment of the "pick-up" tax, provisions of the Kansas Estate Tax Apportionment Act would not allocate the tax against any amounts qualifying for the marital estate tax deduction,[4] thereby avoiding any increased estate or "pick-up" taxation beyond that incurred on the "bypass" amount.

   It may be desirable during this period of nonconformity to revise formula clauses which would fund the "bypass" amount with the applicable exclusion amount under current Federal law in order to limit such amount to the lesser of the two amounts, i.e., the maximum amount which incurs the minimum amount of both Federal estate tax and Kansas "pick-up" tax liability. This modified formula clause would...