Stanley - Beware of state death taxes

With all the talk about tax cuts and repeal of the federal estate tax, you may have overlooked what amounts to a tax increase. This increase takes the form of a decrease in a credit against federal estate taxes, so it is more subtle than an outright tax rate hike but it can be just as costly. Costly enough that you may need to consider the impact on your estate plan and the amount of cash you'll need to settle your estate.

EGTRRA 2001

You may be thinking that estate taxes are a thing of the past -- wasn't the federal estate tax repealed a couple of years ago? Actually, the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of 2001 reduced federal estate tax rates and increased the federal estate tax exemption, but only repealed the federal estate tax for those who die in 2010.

Beginning in 2011, the estate tax returns with a vengeance to its 2001 status, unless Congress acts before then to make the repeal permanent. Many believe that increased federal deficits make permanent repeal of the federal estate tax unlikely in the foreseeable future.

In addition to the federal estate tax, most states impose an inheritance or estate tax.

However, to avoid the potential for "double taxation," a credit was historically allowed in computing federal estate taxes. The credit reduced federal estate taxes dollar for dollar for state death taxes paid. For example, an estate that owed $50,000 in federal estate taxes and $20,000 in state inheritance taxes would typically pay no more than $50,000 total. A credit for the state death taxes of $20,000 was applied against the federal tax bill to reduce it to only $30,000.

But, here's where that new tax increase comes in.

Under EGTRRA 2001, the state death tax credit allowed in computing federal estate taxes was reduced by 25 percent in 2002. The credit was decreased another 25 percent in each of 2003 and 2004 and repealed entirely in 2005. Once the state death tax credit is eliminated, an estate with $50,000 in federal estate taxes and $20,000 in state death taxes could end up paying $70,000 in combined state and federal taxes, not just the $50,000 that would have been payable in the past.

Impact on state revenues

Prior to EGTRRA 2001, 37 states plus the District of Columbia made their state death tax equal to the federal credit. In these "sponge states," if the maximum allowable state death tax credit was $400,000 on a $5 million estate, the state required payment of $400,000 in state death taxes. Of course, the $400,000 paid to the state reduced federal taxes of approximately $2.5 million by $400,000.

When Congress repealed the state death credit in 2001, it expected state death taxes in sponge tax states to decrease as well. After all, if no federal credit was allowable, no state taxes would be payable in these states.

But, things have changed a lot since the spring of 2001 when EGTRRA was enacted.

Already the "sponge" states have seen a minimum 50 percent reduction in state death tax revenue as the state death tax credit has been cut in half from its 2001 level. By 2005, when the state death tax credit is eliminated, the sponge states could potentially lose all of their death tax revenue at a time when many of them are facing their worst fiscal crises of the last half-century.

To prevent the revenue loss, 11 of the 37 sponge tax states have passed legislation to make their state death taxes equal to the pre-EGTRRA federal credit.

The combined effect of the repeal of the federal state death tax credit and reinstatement of pre-EGTRRA death tax amounts in certain sponge tax states is a hidden tax increase. In the example of the $5 million estate, the increase could be as much $400,000.

What should you do?

If you live in a state that imposes state death taxes, you need to visit with your tax or legal adviser about the effect of the state death tax credit repeal on your estate plan. If you live in a state where the amount of death taxes are already independent of the federal estate tax credit or in one of the 11 sponge tax states that have reinstated death taxes to pre-EGTRRA levels, you could be looking at an increase in the amount of overall death taxes you owe -- unless you are fortunate enough to die in 2010.

If your overall state and federal death tax bill has increased, chances are that your estate will be faced with an increased liquidity need. State and federal death taxes are, generally, payable promptly within a few months of death. If your estate consists largely of illiquid assets such as real estate or an interest in a closely-held business, a tax sale could compound problems by resulting in loss of asset value.

This is why it is a good idea to meet not only with your tax or legal adviser, but also with a licensed financial professional. Life insurance, is considered by many to be the best vehicle for helping to address the liquidity shortfall created by death taxes. Properly arranged, the life insurance is not itself subject to death taxes and is even income tax free.

Sharon Stanley is a representative of The Prudential Insurance Co. of America in Cape Girardeau. (334-2603 )