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Virginia Gov. Mark Warner recently vetoed legislation that would have eliminated Virginia’s estate tax, leaving his state with an ongoing problem now faced by all 50 states and the District of Columbia: how to respond to changes in the state death tax credit against the federal death tax. Perhaps this sounds ho-hum. But it will hit home when some estates end up paying more in total death tax as a result of the “repeal” of the federal death tax than they would have paid without the repeal. Not to mention that the federal decision to forgo estate taxes threatens to cut revenues for some states if they don’t act. In June 2001, President George W. Bush signed the Economic Growth Tax Relief and Reconciliation Act (EGTRRA), which, among its many tax relief provisions, vastly changed the nature of the state death tax credit. Prior to EGTRRA, many states, including Virginia, and the District taxed only those decedents’ estates that were also taxed at the federal level. (Some states, like Maryland, might collect an inheritance tax on smaller estates.) The system worked rather neatly. The taxpayer — the personal representative of the decedent’s estate — calculated the taxable estate, which would be the gross estate minus deductions such as the costs of administering the estate, the decedent’s debts, the marital and charitable deductions, and so on. If the taxable estate exceeded the filing level ($675,000 in 2001), the tax was calculated under Internal Revenue Code Section 2001. Although that section by its terms addressed only the federal tax, it was usually the case that the entire death tax to be paid to the feds andthe state could be calculated under that single section. Why? Because another section of the Internal Revenue Code set forth a credit against the federal tax. Section 2011 provided that a certain amount of estate (or inheritance) tax paid to a state could be subtracted from the amount due to the feds. Section 2011 set a ceiling on the allowable credit. Maryland, Virginia, and the District, among others, adopted that ceiling as a cap on the amount of estate tax they would assess against an estate. There were wrinkles, of course. For example, Maryland’s tax on receipts of inheritances by individuals other than close family members might be assessed even where the taxable estate did not exceed the federal filing level. (But if the estate did have to pay an estate tax, the inheritance taxes were deductible from the estate tax.) Another wrinkle: Where the decedent owned assets in more than one state, it was necessary to determine how the state credit would be divided up. But on the whole, the system worked quite well, and it had the benefit of being stable. A TEMPORARY DEMISE Then EGTRRA came along and upset the apple cart. Congress lowered the top estate tax bracket in steps from 55 percent to 45 percent. Then it jumped the level at which a taxable estate would owe an estate tax from $675,000 in 2001 to $1 million in 2002 and 2003, rising after that to $1.5 million in 2004 and 2005, $2 million in 2006 to 2008, and $3.5 million in 2009, all leading up to a single year in which the estate tax system does not apply at the federal level — 2010. The difficulties these rapid jumps create for estate planning professionals can well be imagined. (So, in what year do you plan to die, Mrs. Jones?) The scheduled sunset of EGTRRA also creates planning headaches. Unless one of numerous proposals on Capitol Hill passes, the old law will apply again in 2011 and later. Under pre-EGTRRA law, federal tax would then be imposed on taxable estates above $1 million. (Mrs. Jones, please try not to live past 2010.) The problems didn’t end with estate planning, however. What was hidden in the law was that the revenue the feds appeared to lose in one part of EGTRRA was partially recaptured through a change in the state death tax credit. EVOLVING CREDIT As noted, the state death tax had previously been credited against the federal tax, usually leaving the same overall amount of tax due as calculated for the feds alone. Some of that money went to the Internal Revenue Service, and some went to the state treasurer. But now, the credit is being phased out, 25 percent per year, reaching zero in 2005. For example, a 2003 decedent’s taxable estate of $2 million will create a federal tax of $435,000. The maximum state credit provided in I.R.C. Section 2011 is $99,600. Under the old system, a state tax of $99,600 would be subtracted from the federal tax owed, leaving a total federal and state tax payable of $435,000. But under EGTRRA in 2003, only 50 percent of $99,600 can be credited against the federal tax. Thus, the total tax bill for the estate could be nearly $485,000. How will states respond to this steady elimination of the credit? Some states, including Maryland and Virginia, and the District are “anchored,” in that the calculation of the state death tax is tied to the maximum amount calculated under Section 2011. Their estate tax revenues will not be hurt directly, but their taxpayers will not get to offset their federal tax by what they pay the state. Other states (including Maryland until recently) calculate their estate tax based on the amount of the actual credit given against the federal tax. Absent changes in their laws, these states face a steady reduction in the amount of estate tax they can collect, down to zero in 2005. In the years 2005 through 2009, the death taxes paid to the states will shift from being a credit against federal estate tax to a deduction from the federal taxable estate. (This requires a circular calculation that only a math geek — like some of us estate planners — can enjoy. The size of the taxable estate can’t be determined until all the deductions are known, but the deduction for state death taxes can’t be known until the size of the taxable estate is determined.) WHAT WILL STATES DO? Of course, states must now decide not only whether they want to (or can) continue to anchor their estate taxes in the Internal Revenue Code, but also whether they can live with the rising level of the federal tax-free estate. If a state’s death tax revenue is mostly generated from taxable estates in the lower ranges — say, $675,000 to $1.5 million — it makes quite a difference to that state whether it taxes only estates that are taxed federally, because starting in 2004 there will be no federal tax on a taxable estate of $1.5 million or less. The District has decided, for now, to freeze the tax-free estate at $675,000. That is, a taxable estate of $675,001 will create a tax for D.C. purposes even though it doesn’t for federal purposes. Other states have adopted $700,000 or $1 million as their filing floor. Some states are still floating with the federal amount. In any case, EGTRRA has required all states to determine the federal law’s effect on their laws, then to decide whether to set their own anchors or float with the feds, and then, if they choose to anchor, whether to adopt a filing level lower than the federal filing level. In so doing, the states have had to dust off vocabulary and concepts that had been shelved for decades in which they collected state estate tax based on the federal model. Indeed, it took a few tries before the District’s new forms accurately reflected the intention of the D.C. Council. An early form called for a tax of $18,000 on the first dollar over the filing floor. Determining state taxes where a decedent’s assets are taxable in more than one state will also be a whole new ballgame. For example, D.C. law calls for a credit against D.C. tax for estate tax paid in another state if a federal credit is allowed for that state’s tax. After 2005, there will be no federal credit because the credit will become a deduction. Taxes could thus be owed in both the District and another state on the same assets. In the District, the estate tax is about 1 percent of tax revenues. That’s not a whole lot, but the staff once needed to collect it was small, since they had only to review the federal tax return and a one-page cover sheet to decide what was due. After EGTRRA, maintaining even that level of revenue may well cost more. The federal government’s creeping abandonment of the estate tax promises to remain costly for the states. They face a difficult decision whether to overhaul their estate tax systems or get tossed around by the federal system. The uniformity on which estate planners could once rely and the stability of federal law on which states could once rely are now gone. Virginia A. McArthur is the principal of a two-lawyer estates and trusts boutique practicing in Washington, D.C., Maryland, and Virginia. She has served on and chaired the Steering Committee of the D.C. Bar’s Section on Estates, Trusts and Probate Law; is immediate past president of the Washington, D.C., Estate Planning Council; and is a fellow of the American College of Trust and Estate Counsel. She co-authored the bookWills, Trusts and Estates, with Nicholas Ward and August Zinsser III (Bar Association of D.C., 1993); an update is now in progress with a new publisher, Matthew Bender. McArthur can be reached at [email protected].

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