The past decade has been a tumultuous one for the world of state estate taxes. What had been a rather stable structure for decades, with the Federal credit for state estate taxes paid that allowed states to create a “sponge tax” to absorb the maximum Federal credit, was brought to an end with the Economic Growth and Tax Relief Reconciliation Act of 2001, and in the years that followed the system was phased out and replaced with a state estate tax deduction instead. As a result, states faced the possibility that their estate tax revenue would drop to zero, which is in fact what happened for all states by 2005 that did not “decouple” from the Federal system to create their own state estate tax, often with their own exemptions.
Yet the reality is that for the remainder of that decade, states had continued to rely upon the Federal $1,000,000 gift tax exemption threshold to effectively “backstop” their state estate tax systems; after all, without any gift tax system, the estate tax doesn’t really work, as people simply gift the money away before they die to avoid paying the tax at death. In turn, a new wave of state estate tax “disruption” occurred at the end of 2010 when the fiscal cliff legislation “reunified” the Federal gift and estate tax systems, bringing up the Federal gift tax exemption from $1,000,000 to an inflation-indexed $5M+ level, removing in the process the Federal gift tax support structure for the states that still had a gift tax.
As a result, in today’s environment the states remaining with a state estate tax find themselves in an untenable position; most have an estate tax but no gift tax, which just invites citizens to either give away the money before they pass away, or relocate and change their residency to another state to another the tax (which causes the state loses income, property, and other tax revenue as well!). To fix the problem, states are increasingly compelled to come up with a solution: either enact gift taxes themselves to backstop the system (and then hire auditors to oversee and enforce the system); repeal the estate tax; or “recouple” the state back to the Federal system, to once again rely on the Federal tax structure and the IRS to backstop the states. Ultimately, it remains to be seen which path the states will pursue, but the likelihood for legislation is increasing – some states are considering proposals already – which means the time window is quickly closing for anyone who actually wishes to take advantage of the state estate tax “loophole” that still exists today!
The Great Decoupling Of State Estate Taxes
For most of its history, the Federal estate tax system has included a provision that allowed a Federal estate tax credit for any state estate taxes that were paid. A mechanism for avoiding double-taxation, the credit ensured that any Federal estate tax obligations would only be for the excess above the liability at the state level.
For instance, if the state estate tax was $100,000 and the Federal estate tax was $400,000, then a $100,000 credit would be applied at the Federal level, reducing the obligation to only $300,000. The net result – the total taxes owed remain at $400,000 (the Federal estate tax amount), but the actual taxes paid will be $100,000 to the state and the remaining $300,000 to the Federal government.
Of course, this would theoretically provide an incentive for states to just increase their state estate tax all the way up to the Federal level – thereby capturing all of the Federal estate tax without actually increasing what citizens would owe in total – so the Federal system under IRC Section 2011 put a cap in place, with a maximum tax rate of 16% on estates just over $10M of net worth.
Nonetheless, states took advantage of the available credit to the extent they could; for many decades, every state had a “sponge” estate tax that, by statute, applied a state-level tax that was exactly equal to the maximum amount allowed as a credit under the Federal system. This essentially made the Federal estate tax system a Federal-state “partnership” of sorts, as states had free reign to gather a portion of the Federal estate tax without actually increasing anyone’s total tax obligations, as all of the state estate tax was effectively “carved out” of the Federal obligation due to the available credit.
This all changed, however, with the Economic Growth and Tax Relief Reconciliation Act of 2001 – the first of the so-called “Bush tax cuts” – which phased out the Federal estate tax credit system from 2002 to 2004 and replaced it with a state estate tax deduction instead, beginning in 2005. As a result, states that calculated their estate tax based on the maximum Federal credit amount suddenly found their estate tax revenue reduced to $0, as the credit was phased out. At that time, about half the states simply allowed their state estate taxes to remain at $0, or outright repealed their state estate tax recognizing that their estate tax laws were no longer generating revenue anyway.
The other half of the states “decoupled” from the Federal system, by choosing to apply their own state estate tax regardless of whether a Federal estate tax credit would be available. However, for simplicity’s sake – and likely, the ease of passing the law expeditiously – most states determined their “new” state estate tax by simply freezing the state estate tax system as it had existed in 2002 when the phaseout of the Federal credit began. While a few states chose different thresholds or tax rates, this meant that most “decoupled” states would keep a $1,000,000 state estate tax exemption amount (in effect in 2002), and a top tax rate of 16% (the old maximum rate from the original Federal credit system), with an exemption that remained flat going forward even as the Federal estate tax exemption continued to rise.
The Second Decoupling Of State Estate Taxes
For the remainder of the last decade, the state estate tax system was relatively stable. By the middle of the decade, most states had decided whether they were going to decouple from the Federal system and apply their own state estate tax with their own exemption, or simply allow their estate tax revenue to wind down as the Federal credit was phased out. From that point forward, the states that had a tax collected it, and those that didn’t, didn’t.
At the end of 2010, however, a new change occurred: as a part of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act (also known as the first “fiscal cliff” legislation), the Federal gift tax exemption, which had remained at the $1,000,000 threshold from 2002 until 2010, was increased to $5M (the new estate tax exemption amount in 2011), and indexed for inflation, thereby “reunifying” the Federal gift and estate tax exemptions. An important unintended consequence of reunifying the Federal gift and estate tax exemptions was that it indirectly resulted in a second decoupling – the decoupling of the state estate tax exemption from the Federal gift tax exemption.
To understand why this is important, it’s necessary to reflect on the original purpose of a gift tax. Notwithstanding its name, the real purpose of a gift tax is not really to generate tax revenue by taxing gifts; it’s just to ensure that people can’t avoid the estate tax at death by gifting while they are alive. After all, having an estate tax without a gift tax would be a tax that’s easy to dodge – just make sure you give the money away right before you die, even if it’s on your deathbed, and the estate tax would never be paid. By applying a gift tax, the incentive to give money away before death is eliminated, and as a result most people simply hold their assets until they die and deal with the estate tax at that time. In other words, the primary goal of a gift tax isn’t really to generate a lot of tax revenue on gifts, it’s merely to backstop the estate tax.
Accordingly, this is actually what the Federal gift tax exemption of $1,000,000 was doing for all the states that decoupled and applied their own state estate tax from 2002 until 2010. Historically, virtually no states had ever had a state gift tax; it wasn’t necessary, given that most states merely had a “sponge tax” that was based on the Federal system anyway, and the Federal system already had its own unified gift and estate tax system. Even after the Federal exemption was raised and states decoupled, the remaining unification of the Federal gift and state estate tax exemptions (most commonly at $1,000,000) ensured that the states still had a gift tax backstop.
But when the fiscal cliff legislation reunified the Federal gift and estate tax systems, it decoupled the Federal gift system backstopping the states. As a result, states suddenly faced the worst possible scenario: now it really had become possible to entirely dodge the state estate tax by simply giving the money away before death (at least, for anyone who was above the $1,000,000 state estate tax exemption and below the Federal $5M inflation-indexed threshold). For instance, an elderly individual with $3M of net worth simply had to give away $2.01M at any time before death; the gift wouldn’t be taxable at the state level (no state gift tax), nor at the Federal level (below the Federal $5M inflation-indexed exemption), and the remaining estate would now be only $990k, leaving a value below the state estate tax exemption and eliminating the need to even file a state estate tax return. The net result: state estate taxes could be vanished away with just a little proactive planning and gifting!
Closing The State Estate Tax Loophole – Enact Gift Taxes, Repeal, Or Recouple
As it stands now, the current situation with state estate taxes is simply untenable – for those with estates above the state threshold but below the Federal limits, the tax may be entirely avoided by simply giving the money away before death, which means state estate taxes disproportionately strike those who die “unexpectedly” without the opportunity to gift, and those who simply aren’t aware of the gifting opportunity.
One solution to this is to simply pass a state gift tax, yet as it stands now only 2 states have a gift tax: Connecticut (which has had a gift tax since decoupling in 2005), and Minnesota (passed a gift tax in 2013 for gifts that occur after 6/30/2013). Another solution is to craft what’s called a “gift-in-contemplation-of-death” rule, which essentially states that if a gift occurs shortly before death, it will still be drawn back into the estate for state estate tax purposes; however, only 8 states have a gift-in-contemplation-of-death rule, and for most of them it’s to protect an inheritance tax, not an actual state estate tax. And either way, having a gift tax – or a gift-in-contemplation-of-death rule – requires the state to write rules and regulations to apply the rules, and a team of audits to investigate and enforce the rules, which isn’t necessarily appealing for a lot of deficit-bound states right now.
For states that don’t want to impose and pursue a more aggressive gift tax regime on their citizens, the opposite extreme would simply be to repeal their state estate taxes altogether. Repeal is obviously the “simplest” – states could decide to simply stop pursuing a relatively inefficient state estate tax and let it go, either on the principles of challenging enforcement, or perhaps out of concern that if their “death tax” remains that citizens (especially retirees) may choose to relocate out of state in their later years to avoid the danger of being subject to the tax; after all, an estate tax generally only applies in the state in which you pass away, and for a married couple that utilizes the unlimited marital deduction, it’s usually the state that the last spouse passes away, which makes “change of residence” a remarkably effective (and legal) state estate tax avoidance tool given that more than half the states have no such tax at all. Although repeal would obviously have a “cost” to the state in terms of foregone revenue, the state might try/hope to make some of it back by retaining the income taxes, property taxes, and other taxes that continue to be paid by those who choose to remain in the state and don’t relocate to avoid estate taxes. This is already the path that’s been pursued by North Carolina (estate tax repealed in July 2013, retroactive to January 1st of that year) and also Ohio (repealed on June 30, 2011, for deaths occurring in 2013 and beyond). Tennessee passed a law in 2012 that will repeal their estate tax gradually over several years, ultimately eliminating it in 2016 (and their gift tax was repealed immediately in 2012). Indiana also repealed their inheritance tax for those dying in 2013 and beyond.
The mid-point compromise between full-scale gift taxes and total repeal is for states to choose to “recouple” to the Federal system instead, adopting the unified Federal gift and estate tax exemptions (which have risen to $5.34M for 2014) but apply the state’s own tax rate (which may be higher or lower than the currently common maximum rate of 16%). The advantage for states of recoupling is that they can return to an environment where their estate tax is backstopped by a (Federal) gift tax, without any significant obligations to hire auditors and enforce the gift tax; in addition, since anyone above the thresholds would already have to file a Federal estate tax return, the states can ‘rely’ on the IRS to audit and enforce proper valuation rules and fight against any abuses of the system… and then simply apply their own tax rate to whatever the taxable estate applies for the Federal return. This solution would also allow the state to retain some estate tax revenue as well, and perhaps reduce the number of citizens who might try to relocate just to avoid the tax. In point of fact, this recoupling approach is already being considered in 2014 for New York State, Hawaii coupled their exemption to the Federal threshold back in 2012, and Delaware already maintains an exemption at the Federal levels. The chart below provides a summary of the landscape (as of the time this article was written) for the 20 states that still maintain a state estate or inheritance tax:
|State|| Estate Tax
|Inheritance Tax||Gift Tax||Gifts-in-contemplation-of-death rules|
|Dist. Columbia||Yes ($1,000,000)||No||No||No|
|New Jersey||Yes ($675,000)||Yes||No||Yes|
|New York||Yes ($1,000,000)||No||No||No|
|Rhode Island||Yes ($921,655)||No||No||No|
Sources: Survey of State Estate, Inheritance, & Gift Taxes, Information Brief, Research Department, Minnesota House of Representatives, State Estate Tax & Exemption Charts (About.com), State Inheritance Tax Charts (About.com)
Ultimately, it remains to be seen exactly how states will proceed to close the “loophole” that has emerged since the Federal gift tax exemption decoupled from the common $1,000,000 state estate tax threshold in 2011, but now that the current levels – and the repeal of the Federal estate tax credit – are permanent law under the American Taxpayer Relief Act, the pressure is building for states to decide how to close their lack-of-a-gift-tax loophole. On the other hand, that also means the time window is quickly closing for those clients who wish to take advantage of the current state estate tax “loophole” to do so soon, before the laws are changed to eliminate the opportunity altogether!
Have you seen an increase in the focus on state estate taxes in your planning with clients? Do you have any clients impacted by the “gap” of states that have an estate or inheritance tax but no gift tax? Are you doing any additional planning with clients before the “loophole” closes?