The phaseout of the federal state death tax credit.

• Author: Godfrey, Howard
• Position: Part 1

EXECUTIVE SUMMARY

* 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.

Terminology

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...