The phaseout of the federal state death tax credit.

• Author: Godfrey, Howard
• Position: Part 2

Many states are changing estate and inheritance tax rules in response to the phase-out of the Federal credit for state death taxes, the increased unified credit and lower Federal rates. Part two of this article focuses on state law changes in effect for 2004 and beyond

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Death tax revenues of many states are declining as a result of the phaseout of the Federal state death tax credit (SDTC) and the credit for state generation-skipping transfer (GST) taxes. Some states are changing their estate or inheritance tax laws to avoid or reduce the effect of Federal changes. Part 1 of this article, in the February 2004 issue, summarized the Federal changes affecting the SDTC and state death tax revenues. Part II, below, focuses on the changes being made or proposed at the state level in response to the Federal phaseout.

State Revenue Reduction

Sec. 2011 allows a state death tax credit on the Federal estate return, limited to the excess of the gross estate tax liability, over the unified credit under Sec. 2010. As explained in Part I, a change that reduces the gross estate tax liability or increases the unified credit effectively reduces the limit on the SDTC. Thus, death tax revenues of states with death taxes tied to the amount of the Federal credit are being reduced, because of (1) a reduction in the top Federal estate tax rates, (2) an increase in the unified credit and (3) the phaseout of the Federal SDTC and state GST taxes.

Pre-EGTRRA Changes

Congress had scheduled increases in the unified credit starting in 1998. Several states also made changes before 2001, enabling them to avoid the effect of the Economic Growth and Tax Revenue Reconciliation Act of 2001 (EGTRRA). For example, Kansas imposed a death tax equal to the credit that would have been allowed under Federal law as it existed on Dec. 31, 1997. (16) Thus, Kansas avoided the effect of the increases in the Federal unified credit that became effective in 1998, and is not affected by the EGTRRA. New York bases its state death tax on the credit computed under the 1998 Internal Revenue Code (IRC). (17) (In this article, some state law is described as having an "IRC reference date" of a given year.)

In contrast, some states began eliminating death taxes prior to the EGTRRA. For example, Montana repealed its inheritance tax in 2000; (18) Louisiana's inheritance tax rates are being reduced each year. For deaths occurring after 2004, the Louisiana rates are reduced by 80%; the tax is eliminated for deaths occurring after June 30, 2004, when certain actions are taken. (19)

Connecticut has a succession tax and an estate tax. The succession tax was scheduled to be repealed in 2006, but the General Assembly has delayed the repeal. (20)

Administrative Policy

In some cases, the state revenue department interprets the state death tax law to be consistent with Federal law. For example, until this year, the Oregon estate tax law bad an IRC reference date of 1997, but the tax was not collected unless an estate filed and paid Federal estate taxes. Thus, Oregon law was not tied to the state death tax phaseout; however, by administrative practice, the state has been treated as being effectively connected to the Federal credit. (21) On Sept. 24, 2003, the Governor of Oregon signed a hill that conforms the state's estate tax to changes in the IRC through January 2000. (22)

Constitutional Limits

Some state constitutions prohibit the levying of a death tax in excess of the amount allowed as a credit on the Federal estate tax return. For example, the Nevada Constitution provides:

The legislature may provide by law for the taxation of estates taxed by the United States, but only to the extent of any credit allowed by Federal law for the payment of the state tax and only for the purpose of education, to be divided between the common schools and the state university for their support and maintenance. The combined amount of these Federal and state taxes may not exceed the estate tax which would be imposed by Federal law alone. (23)

States with such constitutional limits cannot adjust their tax systems to maintain their current levels of death tax collections.

State Tax Systems

The post-EGTRRA law is generally described as coupled (pure pickup), decoupled, fixed, separate or none. Example 1 below shows examples of pick-up tax systems, Exhibit 2 on p. 150 contains examples of combination approaches and Exhibit 3 on p. 151 has information on the current state systems.

Pick-Up Taxes

Before the EGTRRA, (24) some form of pick-up estate tax was used by all states and the District of Columbia, including pure pick-up taxes, fixed taxes and sponge taxes. Before the EGTRRA, 25 states had pure pick-up GST taxes; two had GST taxes with a fixed IRC reference date.

A "pure pick-up tax" is a single estate tax equal to the SDTC allowed on the Federal estate tax return, when the decedent's property is located entirely in one state. If the decedent's property is located in more than one state, the affected states share the credit based on the relative amounts of property in each state. Some variations in state pick-up death taxes are illustrated in Exhibit 1. Taxes in the three groups of state death tax structures shown in Exhibit 1 (A, B and C) are often called pick-up taxes. However, those described in Group A are pure pick-up taxes, because the state death tax equals the Federal SDTC.

Coupled Tax

In this article, a "coupled tax" describes a tax in effect after the EGTRRA with the characteristics of a pure pick up. A coupled tax imposes a state death tax equal to the available Federal credit and disappears as the Federal credit disappears. Connecticut is an example of a state with an inheritance tax and a state GST tax equal to the amount allowed as a Federal credit under the IRC in effect on the date of the decedent's death. (25) Connecticut death taxes are coupled taxes. Arizona imposes an estate tax equal to the Federal credit and has updated its IRC reference date to Jan. 1, 2003; thus, the Arizona estate tax is also a coupled tax. (26)

As explained in Part I of this article, a fully coupled state will be affected by three changes at the Federal level: (1) lower rates, (2) larger applicable exemption amount (AEA) (which dictates a larger unified credit) and (3) phaseout of the Federal SDTC and the credit for state GST taxes. Exhibit 3 identifies 26 states with estate tax laws coupled with the Federal estate tax. Twenty-seven states had either pick-up GST taxes or GST taxes with a pre EGTRRA IRC reference date (there are only 24 such states after the EGTRRA (Illinois and Nebraska have decoupled their GST taxes and Kansas has repealed its GST tax)).

When the Federal SDTC is completely phased out in 2005, a coupled state will no longer have a state death tax. Of course, a separate inheritance tax not coupled with the Federal law will continue to generate revenue. Likewise, a state pick-up GST tax...