New proposals have been introduced in the 108th Congress to reduce or eliminate the federal estate tax.
One variation would eliminate the tax for 2009 with an estimated revenue loss to the federal government of about $40 billion. The concept is not new, but is a variation to the budget and tax plans being debated by Congress this year. Whatever the outcome to the federal rules, there is a counter-trend your clients should be aware of at the state level.
The stage was set for a renewed tax competition among states when President Bush signed the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) into law in June 2001. That legislation included a phase-out, starting in 2002, of the state death tax credit allowed against the federal estate tax.
Until recently, many states structured their estate tax to exactly equal the federal credita practice commonly referred to as a “sponge” or “pick-up” tax. States have relied on death tax revenue for a long time. In 1926 the maximum credit was 80%. More recently the maximum credit was 16%. Absent new state legislation, this federal law will eventually eliminate this source of state revenue after 2004. It is the various state reactions to these rules that will create renewed competition.
Tax Bracket BINGO
By reducing the credit, certain death tax revenue was shifted to the federal government from the states. Here is an example: The old 55% estate tax rate was effectively split into two buckets: 39% for the federal government and 16% for a state.
Under EGTRRA, once the credit is fully phased-out in 2005, the credit is transformed into an estate tax deduction (but only if a state imposes a death tax). That year the top federal rate is scheduled to be 47%. So in a state that only has had the “sponge tax,” the federal government would collect 47% at the top margin with nothing going to a state. The result would be that the federal governments share of the revenue increases with the top marginal tax rate going from 39% to 47%. The impact is contrary to the public perception that the federal death tax is being phased out because of rate reductions and an increasing exemption.
Impact on State Budgets
Its no secret that most states today are faced with significant deficits and the elimination of the state death tax revenue can have an increasingly important impact on budget planning. The phase-out rule has been estimated to cost states a total of $23 billion over the next five years.
Budget deficits are prohibited in most states. They can result in cutbacks, layoffs and tax increases. The tax changes can take many forms. A recent survey found many states modifying their cigarette and alcohol tax programs. State sales tax rate increases or base expansion is possible in at least six states, while four states have increases in the personal income tax under consideration, according to the National Conference of State Legislatures. And changes to the way state governments deal with the death of a resident are already under way.