ESTATE PLANNING UPDATE
The Federal Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) repeals the federal estate tax effective in 2010 for one year. Between 2002 and 2010, EGTRRA also reduces the estate tax rates somewhat and increases the exemption level for the federal estate tax. See previous Estate Planning Update on The 2001 Tax Act at www.moneylawoffices.com. In addition, EGTRRA provides that the amount of state death tax credit that may be taken against the federal estate tax is reduced by 25 percent for deaths occurring in 2002, 50 percent for deaths in 2003, 75 percent for deaths in 2004, and by 100 percent for deaths occurring in 2005 and thereafter. Beginning in 2005, a deduction is allowed for state death taxes paid in computing the taxable estate for federal purposes which will complete the transition from a state death tax credit to a deduction. Thus, under EGTRRA the federal credit for state death taxes was reduced incrementally beginning in 2002 by 25 percent in each year until fully repealed in 2005. This changed the relationship between state and federal estate taxes.
Pre-EGTRRA State Death Taxes
Since its enactment in 1926, all states and the District of Columbia have taken steps to coordinate their state death taxes in some fashion with the state death tax credit. Prior to the enactment of EGTRRA in 2001, 37 states (including New Hampshire, Maine, Massachusetts, and Florida) relied solely on a "pick-up tax" or "sponge tax" in which the state estate tax was simply an amount equal to the maximum amount of state death tax credit allowed under federal law where states would "soak up" tax dollars that would otherwise have passed to the federal government.
Beginning in 2005, the federal government will not share any estate tax revenue with any sponge tax state. The effect of the phase-out is to transfer revenue from states to the federal government during the period of the phase-out. As a result, states using a pure sponge tax would get no state estate tax revenue in 2005 and thereafter. That is why more than 15 states – including Maine and Massachusetts as set forth below – have decoupled their state estate tax laws from the federal estate tax laws in order to raise lost state tax revenue. This update presents the results of state legislative action taken to offset the impact of EGTRRA on state death taxes.
Post-EGTRRA Legislative Action
Since the enactment of EGTRRA, several states have taken legislative action to offset all or a part of the impact of the death tax credit phase-out. This includes nine states (including Maine and Massachusetts) that took legislative action to preserve their pick-up tax. In most cases, the legislative change was accomplished simply by conforming the state law references to the state death tax credit to the federal law at some point prior to the passage of EGTRRA. In broad terms, states have come up with some general responses to the changes under EGTRRA. The first is to ignore the phase out of the percentage reduction in the state death tax credit. The second is to ignore the increased exemption amounts. Another approach, as seen in Maine and Massachusetts, is a combination of both.
I. New Hampshire - Repeal of NH Legacy and Succession Tax
New Hampshire has not decoupled, and absent legislation to the contrary, its estate tax will be phased out by EGTRRA in 2005 and thereafter. However, New Hampshire has repealed its separate state inheritance tax effective in 2003. Siblings and others previously covered by New Hampshire’s state inheritance tax no longer will have to pay 18 cents per inherited dollar. Effective January 1, 2003, the New Hampshire Legacy and Succession Tax, which took 18% of any inheritance left to all but children, grandchildren, stepchildren, and spouses, was repealed. The tax will apply to estates of those who died before January 1, 2003.
II. Massachusetts - New Massachusetts State Estate Tax
The Commonwealth has decoupled and enacted a new estate tax which will now require the payment of state estate taxes even if there is no federal estate tax liability if your estate exceeds $700,000 effective in 2003; $850,000 in 2004; $950,000 in 2005 and $1,000,000 in 2006 through 2010. The legislation keeps the Massachusetts estate tax equal to the amount of the state death tax credit under Internal Revenue Code Section 2011 as in effect on December 31, 2000, notwithstanding federal legislation that is phasing out the federal estate tax. The new law, for persons dying after January 1, 2003, may increase the overall death taxes paid by an estate, versus what it otherwise would have had to pay under the old law.
III. Maine - New Maine State Estate Tax
The Maine state budget enacted in March, 2003, for calendar years 2003 and 2004, reduces the estate tax unified credit amount and resets the state death tax credit calculation to their pre-EGTRRA levels. The reduced unified credit amount (from $345,800 to $229,800 in 2003; from $555,800 to $287,300 in 2004) lowers the threshold of taxability and increases the upper tax limit for estates with Maine property. As a result, estates of 2003 decedents worth more than $700,000 are taxable to Maine while only those in excess of $1 million are taxable at the federal level. For estates of 2004 decedents, those worth more than $850,000 will be taxable to Maine while only those in excess of $1.5 million will be taxed at the federal level. In general, since the Maine estate tax is limited by the amount to which the federal gross estate tax exceeds the unified credit, lowering the unified credit amount raises the Maine estate tax limit. Also, the federal reduction (50% in 2003, 75% in 2004) in the state death tax credit is ignored for purposes of calculating the tax due to Maine.
Florida has not decoupled, and absent legislation to the contrary, its estate tax will be phased out by EGTRRA in 2005 and thereafter. Moreover, the Florida state constitution can be interpreted to mean that in order for Florida to decouple its state estate tax from the federal estate tax there would need to be a constitutional amendment to the Florida state constitution. If the Florida state estate tax phases out and no new Florida estate tax takes it place, then some clients may consider moving and changing domicile to Florida to save taxes.
Uncertain Impact On Planning
When the decreased exemption is factored into the equation, along with the fact that real estate values have increased in recent years, clients may face an estate tax where they did not before. A potential divergence between federal and state calculations of death tax credits could mean that many estates will have to file state estate tax returns even when no federal return is required.
What To Do Now
The difference between state and federal exemptions and tax computations will give rise to more planning needs. The new state laws will likely result in more gift and estate planning. For example, lifetime gifts could reduce state taxes, which are computed on taxable estates only, while federal estate taxes are based on taxable estates and adjusted taxable gifts. We are encouraging clients to have their estate plans reviewed and updated with flexible provisions, particularly for those Maine and Massachusetts clients who previously established an estate plan under the old state laws. There is no uniform solution and each case will involve many decisions such as whether, for example, married couples and single persons should amend their wills and revocable living trusts, revisit a more aggressive giving program, or maybe even change their state of domicile. Clients who did their estate planning before these new state laws decoupled the state and federal systems, need to review their documents and likely update them so that no federal or state estate tax is owed upon the death of the first spouse to die. EGTRRA, having introduced uncertainty and complexity in planning at the federal level, has now indirectly achieved the same at the state level. If you would like to discuss any of these changes and revisit your estate plan (which probably is a good idea anyway, particularly if you live in Maine or Massaxchusetts), please call us for an appointment.