A Death Sentence for the Federal Estate Tax? States Watching Closely

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Tax Policy

President Donald Trump's tax reform proposal calls for repealing the federal “death tax.” In this article, Day Pitney's Angela Titus McEwan and Stacey Valentine Fielding discuss how repealing federal death taxes will affect the states.

Angela C. Titus McEwan Stacey Valentine Fielding

By Angela C. Titus McEwan and Stacey Valentine Fielding

Angela C. Titus McEwan and Stacey Valentine Fielding are attorneys with the law firm Day Pitney LLP.

Much has been written about President Trump's promise to eliminate the estate tax, including his not having offered up anything substantive as of yet. Although the Trump Administration ranks tax reform as one if its highest priorities, rather than state a detailed proposal, the President has offered vague objectives and goals to overturn a tax code he critiques as overly complicated, confusing and burdensome. While his intention to simplify, deregulate and otherwise reform the tax code is clear, what's less clear is what Trump tax reform would actually look like. Equally intriguing is what, if anything, the impact of this uncertainty will be to estate tax at a local level and how ultimately a repeal will impact state revenues.

The Federal Scheme and Its Impact on States

The federal estate tax has taken many shapes since its enactment in the early 1900's. Sweeping changes occurred with the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of 2001, which marked the beginning of the end for states whose estate tax revenues were purely a function of state death tax credits offered at the federal level. With EGTRRA, credits disappeared as temporary estate tax repeal approached, and so did state estate tax revenues tied to them. As a direct result of the changes occurring on the federal level, states began implementing their own estate tax laws. Some enacted wholly separate schemes while others still linked theirs to aspects of the federal code, typically as it existed before the federal law changed. Ultimately, “permanency” of the federal estate tax came with the American Taxpayer Relief Act (ATRA) in 2013, which while it kept the federal estate tax in place, increased individual exemptions substantially. By then, states that had elected to keep an estate tax had, for the most part, put their own laws into place.

The permanency of a law is as good as the government enacting it. With a new President or Congress, things can change. The most recent proposal by President Trump consists of a two page document containing a single bullet point that reads “Repeal the death tax.” The talk is generally about the estate tax, but intertwined and running consecutively with it are the gift tax, the generation-skipping transfer (GST) tax, and the “stepped-up” basis commonly relied upon to eliminate capital gains upon death. With this proposal, theories abound as to whether “repeal the death tax” includes all of these items or otherwise. For instance, during his campaign, President Trump suggested implementing a capital gains tax at death as an “alternative” to the estate tax, which would be similar to the system presently existing in Canada. Should “repeal the death tax” affect basis for income tax purposes, perhaps the largest impact to the states of the federal estate tax change would be upon those states whose income taxes are still tied to federal law.

Death Tax at the State Level

States face bigger problems than what the federal government will do to its estate tax. States with onerous tax laws, estate or otherwise, are facing outmigration by their residents. Historically, retiring generations have sought the climate of a state imposing no death tax or income tax on retirement. Recent surveys suggest that Millennials are following suit, leaving states with high income or real estate taxes that they cannot afford to pay. Ultimately, a state's overall tax scheme will impact its relationship with its residents.

At the state level, death taxes are on their way out. This trend began with the elimination of the state death tax credit and has continued regardless of changes that have occurred to the federal estate tax since then. The vast majority of states has repealed the death taxes entirely, leaving only the District of Columbia and 14 states with an estate tax (soon to be 13 states when New Jersey's estate tax is eliminated in 2018). Not surprisingly, of those states still carrying an estate tax on their books, their schemes vary in structure and application. In general terms, three states - Connecticut, Oregon and Washington - have an estate tax wholly independent of the federal estate tax scheme. The remaining eleven jurisdictions, including Delaware, Maine, Maryland, Minnesota, New Jersey, New York, Rhode Island, Hawaii, Illinois, Vermont and the District of Columbia, link their estate tax to some aspect of the federal law, such as an exemption equivalent to the state death tax credit existing when EGTRRA came to be.

Aside from estate tax, only six states still carry an inheritance tax, including Iowa, Kentucky, Maryland, Nebraska, New Jersey and Pennsylvania. In these states, transfers to certain individuals, depending upon their relationship to the decedent, will be taxed at different rates that are dependent upon that degree of relationship. Some variations, aside from the rate of tax, include what beneficiaries or assets are exempt from such tax and the extent to which gifts made prior to death will still be clawed back for inheritance taxation.

Conclusion

If the federal tax changes result in a full repeal of the estate tax, the impact among states is virtually non-existent. Unless change results in giving something back to the states, the states will continue to independently evaluate generating revenue to fill their budgets, in ways that may not rely on death taxes. Personal factors, including the loss of citizens or businesses desiring to escape income, estate, or real estate taxes, will continue unless states take matters into their own hands. This is a task having nothing to do with the status of the federal estate tax, which will follow a citizen wherever he or she may go. Residents retaining domicile in a state maintaining a death tax would be well advised to include flexibility in their estate plans to accommodate future changes.

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