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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.

Nearly half of all states are expected to levy some form of separate state inheritance or estate tax law changes. Some states have constitutional limits on their ability to raise revenue from estate taxes. As a result, some will be able to raise their death taxes and others will be able to brag about the fact that they didnt. In the end, this is likely to add to the list of tax competitions that already exist between the states. People who are significantly impacted will begin to pay attention to which states do or do not impose certain taxes and vote with their feet by moving.

This is not a new phenomenon, but it is the reversal of a trend begun in the 1980s when states began dropping their separate death taxes because of the flight of wealthy residents to locations that were perceived to have lower tax burdens.

The structure of state death taxes will take various forms. A recent review of state activity indicates that 25 states will allow their estate tax to sunset with the federal credit. Twelve others now impose an inheritance tax. To retain estate tax revenue some states have simply “decoupled” from the federal system. In this case, decoupling means that the calculation of state death tax is independent of the federal tax structure. The form of the decoupling varies. Some states will simply ignore the impact of EGTRRA and impose the tax that would have been imposed prior to 2001.

The exemption amount (currently $1 million at the federal level) is another variable. At the low end, Oregons exemption is reported to only be $600,000; Rhode Islands, $675,000. This, in turn, makes for some interesting challenges for “marital deduction formula” planning designed to minimize death taxes for a couple. What does this means to producers? Here are some proactive steps Id advise them to take:

1. Learn about your local state rules and the other states where you do business. A resource on this topic can be found with your state department of revenue Web site. If the data is meaningful, inform your clients–this can be a very confusing issue and good advice, as usual, is important. If nothing else, these changes give a producer a good reason to see clients and reexamine their estate plans. Does your clients formula marital deduction consider state death tax implications?

2. Keep up-to-date. Producers need to keep their eyes open because there will be continuing changes coming out. As the governors continue to negotiate with their legislatures, death taxes will certainly be part of the discussion.

3. Make sure you structure your clients life insurance plans to make the most sense considering both state and federal issues. This includes reviewing the ownership and beneficiary designation of the policy. In larger estates, an irrevocable trust established by the insured is often the owner and beneficiary of the coverage. When the insured dies, the executor of the estate can use the proceeds of the policy to buy assets from the estate. This generates cash to pay federal and/or state death taxes. In essence, the power of life insurance is used to keep a lifetime of assets intact.

There is no doubt that the ongoing fallout from EGTRRA will continue for a long time. Federal and state legislators will continue to use the estate tax as a political football. This offers both opportunities and pitfalls for financial planners. It promises to be a wild and adventurous ride for all of us in the financial services industry. So, stay tuned.

is second vice president and tax attorney in the Hartford, Conn., office of with Lincoln Financial Distributors Inc., a broker/dealer that is the wholesaling distribution organization of Lincoln Financial Group.


Reproduced from National Underwriter Edition, July 14, 2003. Copyright 2003 by The National Underwriter Company in the serial publication. All rights reserved. Copyright in this article as an independent work may be held by the author.