The 2001 Tax Act set the stage for phasing out the estate tax by increasing the exemption amount until 2010 when estate taxes would be eliminated entirely. The sunset provision of the law causes estate taxation to revert to 2001 laws with a $1,000,000 per individual exemption and a top tax rate of 55%.
These law changes are creating problems for state legislatures around the country that count on state death taxes for revenue. This revenue source has been tied to the Federal Estate Tax codes in most cases. With the elimination of the Federal tax, states are looking at the unhappy prospect of falling revenues.
The type of state death tax and how it is levied varies from state to state. Death taxes are imposed on the transfer of wealth at the time of death or in anticipation of death. States typically levy an inheritance tax and/or an estate tax. Those who receive the inheritance pay an inheritance tax. The estate that gives or transfers assets pays an estate tax.
The inheritance tax is the oldest and most common form of death tax. It is strictly a State tax since the Federal system does not tax inheritances. The tax is usually graduated and reduced by a number of exemptions. Typical exemptions include the relationship of the giver and the heir, exemptions for bequests to charitable organizations, and exemptions for property on which a tax has been paid.
States like South Dakota, for example, place a higher tax on property left to distant family or non-relative heirs, giving a tax break to property kept within a family. Tax rates vary widely among the states: Indiana’s, for example, starts at 1% and graduates to 10% for amounts in excess of $1.5 million. Pennsylvania taxes inheritances to family members at 6% and non-family heirs at 15%.
Rates vary from state to state. Indiana taxes lineal descendants at rates varying from 1% on inheritances of up to $25,000 to 10% on amounts of $1.5 million or more. In Pennsylvania, however, they are taxed at a 6% rate and non relatives are taxed at a 15% rate, regardless of the amount of inheritance.
Estate taxes differ from an inheritance tax in that the rates are imposed on the estate as a whole without regard to the relationship of the beneficiary to the donor. Again specific exemptions apply; the most common being the single specific exemption applying to the entire estate, removing it from the tax base. In 2005 that Federal exemption amount is $1.5 million, increasing to $3.5 million by 2009.
Again there is a large variance in state rates. It’s cheaper to die in Ohio where the maximum state estate tax is 7% vs. New York where the maximum is 21%.
California and Washington operate under a different tax structure. Federal statutes allow taxpayers a credit based on state taxes paid. Essentially this allows states to "pickup" taxes that would have been paid to the Federal government anyway. This does not increase the amount paid by the taxpayer, since the state is simply taking from the Federal pocket. As a result, all state inheritance and estate taxes operate as pickup taxes as well.
Expect laws on the state level to continue to evolve. This will impact our transitory baby boomers who are now migrating away from states where they worked and raised families to states where they expect to retire. Wills and trusts done in one state may not work as well in states with different laws.
One thing is certain, even if Congress does away with the Federal Estate Tax, States will see opportunities for raising revenues by imposing new inheritance and estate taxes.
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