State death taxes have been overshadowed by the attention that the federal estate tax has gotten. Statistically, estate tax affects a relatively small percentage (1 percent to 2 percent) of all estates settled, but most estates are within reach of the death taxes that states levy. That’s why state death-tax planning should be an important component of the overall estate-planning process, and you should understand the death-tax laws in the states where you practice. Ignoring them can lead to expensive consequences that can undermine your client’s otherwise well-designed estate plan.
Every state has some form of estate or inheritance tax. Estates that are too small to trigger the federal tax can easily rack up thousands of dollars in state death taxes and probate costs. With the reduction of federal estate taxes, state death taxes are increasing. Many states are imposing new estate taxes to make up for the revenue lost from the discontinued federal state-tax credit. Some states also have expensive and lengthy probate systems that apply to an increasing number of estates.
Beneficiary classes and tax rates
In most states, estate beneficiaries are divided into classes based on their relationship to the decedent. The closest relatives are subject to the least amount of tax and the largest exemption. If property passes to someone other than a surviving spouse, the effect of these taxes can be significant.
Many states are imposing new estate taxes to make up for the revenue lost from the discontinued federal state-tax credit.
There are two types of death-tax rates states use: a flat percentage rate and a graduated percentage rate. In states with a flat rate, the value of the whole share passing to a beneficiary is taxed at the same percentage rate. The flat rate may vary according to the beneficiary’s degree of blood relationship to the decedent. In states with graduated rates, a beneficiary’s inheritance is broken down into brackets similar to the federal gift and estate- and income-tax rate schedules. The lowest bracket is taxed at the lowest percentage rate, with each additional bracket taxed at an increasing rate.
The concern increases greatly if the decedent owned property in more than one state. Each state involved may claim a right to tax the transfer of that property or the entire estate.
Types of state taxes
There are different kinds of estate taxes that states may levy. One is a state inheritance tax, which is based on the beneficiary’s right to inherit property from an estate, and on the value of the property each beneficiary receives. It is generally levied at a graduated rate. The rate typically depends on the beneficiary’s relationship to the deceased. Currently, fewer than one-third of the states impose an inheritance tax. Another allowable tax is a state estate tax, which is similar to the federal estate tax; it is a tax on the decedent’s right to transfer or pass property to his heirs.
Credit estate taxes
EGTRRA (Economic Growth and Tax Relief Reconciliation Act of 2001) made some significant changes to state death taxation. Prior to 2005, all states used credit estate taxes to capture the maximum amount of taxes equal to the allowable credit against the federal estate tax for state death taxes the estate paid. If the state death tax was less than the federal estate-tax credit allowed for state death taxes, the state assessed the difference and collected at least as much as the federal estate-tax credit amount.
Estates that are too small to trigger the federal tax can easily rack up thousands of dollars in state death taxes.
For example, assume that for a federally adjusted taxable estate of $840,000, the federal government allowed a tax credit of $27,600 for state taxes. If the state tax amounted to only $25,000, the state collected the remaining $2,600 allowed by the federal credit under the state credit estate-tax provisions.
EGTRRA eliminated the state death-tax credit at the beginning of 2005, and it was replaced with a deduction for the amount of state death taxes paid. As you can imagine, this has had a negative effect on states’ revenue. Consequently, many states have enacted laws to prevent future death-tax revenue losses by decoupling from the post-EGTRRA federal estate-tax system.
Although arrangements vary from state to state, the simplest form of decoupling is when a state uses the full federal credit available prior to the 2001 changes. Those states have frozen the amount of the state death-tax credit that was allowed before EGTRRA for state death-tax purposes.
For more information on estate taxes and estate-tax planning, be sure to check out The American College’s course: LUTC 271 Foundations of Estate Planning.
Glenn E. Stevick Jr., CLU, ChFC, LUTCF, a member of Tri-County AIFA (N.J.), is an LUTC author and editor, and assistant professor of insurance at The American College. Contact him at glenn.stevick@TheAmericanCollege.edu.