For decades, estate planning has been dominated by a desire to avoid a confiscatory federal estate tax. In 1976, the amount a decedent could pass tax-free to non-charitable heirs was only $60,000. By the early 1980s it had increased to $175,000. These relatively small exemption amounts meant even middle class Americans had to design their estates to avoid the federal estate tax.
The Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”) effectively began to take the middle class out of the federal transfer tax system by the adoption of a series of reforms, including a $10,000 annual exclusion, an unlimited marital deduction and a phased-in unified tax credit equivalent to a $600,000 exemption. The Taxpayer Relief Act of 1997 provided for a phased-in increase in the exemption to $1 million by 2006. The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) provided for even higher tax-free transfers (e.g., $2 million beginning in 2006).
While permanent elimination of the federal estate tax is highly unlikely, significant estate tax exemptions will probably remain for the foreseeable future, reducing the tax confiscation many clients had anticipated at their death. It is generally expected that any tax bill in 2005 will provide for higher estate tax exemptions in lieu of an elimination of the estate tax.
These changes mean that fewer Americans than any time in recent history will be subject to a federal estate tax. By one estimate, in 2006, less than 1% of all decedent estates will owe a federal estate tax. For the vast majority of Americans, estate planning will no longer be driven by the avoidance of a federal transfer tax. Instead, personal and family concerns and other tax issues will drive the estate planning process.
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In the years to come, avoidance of state and federal income taxes and state estate taxes will become the prime tax planning motivations.
Prior to EGTRRA, 38 states used the maximum federal state estate tax credit as their state estate tax. Effectively, these states took a portion of the federal estate tax using the federal credit. As a part of EGTRRA, Congress replaced the federal state death tax credit with a federal estate tax deduction. The elimination has resulted in states creating new state estate taxes that are “decoupled” from the federal estate tax. Even if Congress restored the federal state death credit, many states will be reluctant to reduce their tax revenue by adopting the higher federal exemptions.
The changes wrought by EGTRRA are creating significant changes in the state tax rules governing estates. Among the results of these changes are:
o Some states will adopt exemptions that are lower than the higher federal exemptions, creating a state estate tax when no federal estate tax is due.
o Some states will freeze their state death tax as the pre-2001 federal credit, resulting in a top effective state tax rate of 16% (i.e., the top rate for the old federal state death tax credit).
o Some states may adopt inheritance taxes, with the tax rate being determined by the relationship of the decedent to the heir (i.e., the more remote the heir, the higher the tax rate).
o Like the federal government did in 1924, more states will adopt a state gift tax to stop the loss of transfer tax revenue through lifetime gifts. As of Dec. 31, 2003, only Connecticut, Louisiana, North Carolina and Tennessee have a state gift tax.
o The lack of uniformity in state death taxes will add significant complexity to estate plans. For example, if a person owns property in more than one state, the avoidance of the cost and estate taxes of ancillary probate will become a greater part of the estate plan.