For many residents, federal and state tax law changes merit additional planning to reduce total taxes and confirm the dispositive plan under the estate plan instruments.

With the passing of the Economic Growth and Tax Relief Reconciliation Act of 2001, there is the much-touted one-year “repeal” of federal estate tax. In less than a year, on January 1, 2010, there will be a suspension of the levy of federal estate tax unless there is federal legislation in 2009 to change this result. Perhaps more importantly, under the 2001 Act, the federal estate tax exemption amount has been increasing, along with a phase-out of the state death tax credit upon which the state “pick-up” tax is based. Please refer to the 2009 edition of the Federal Estate, Gift, and GST Tax Rates & Exemptions for a summary of current and historic rates.

The changes that commenced in 2001 to the exemptions for the federal estate tax and state death tax credit have caused many potential issues for state governments. Prior to 2001, most of the 50 states and the District of Columbia have been “pick-up tax” states, meaning the state took the maximum share of the gross federal estate tax payable to it under Section 2011 of the Internal Revenue Code. As long as the state estate tax was no more than the federal limit, whatever amount paid to the state was credited against the federal estate tax. Thus, many states simply assessed an estate tax at the maximum state estate tax credit allowable under federal law. After 2001, the phase-out of the state death tax credit has given rise to states de-coupling from the federal system in an attempt to stave off the loss of revenue that is being diverted to the federal government.

In some instances, the highest estate tax rate, which under prior law was 55 percent, may be exceeded as a result of states enacting an additional state estate tax payable at a decedent’s death. In a recent count, 23 states, including Connecticut, Illinois, Indiana, Iowa, Kansas, Kentucky, Maine, Maryland, Massachusetts, Minnesota, New Jersey, Nebraska, New York, North Carolina, Ohio, Oklahoma, Oregon, Pennsylvania, Rhode Island, Tennessee, Vermont, Virginia and Washington, as well as the District of Columbia, have de-coupled from the federal system by amending their statutes to prevent the phase-out of their state estate tax revenue, or the state has put in place an inheritance tax not linked to the federal credit for state death taxes. These state estate tax regimes alter how some estate plan formulas divide up the estate. Existing formulas may not fully capture the benefit of the increased federal exemption.

For example, on January 1, 2009, the federal estate tax exemption increased from $2 million to $3.5 million. Unfortunately, the Illinois estate tax exemption remained at $2 million. The consequences of this mismatch depend on the type of formula in the estate plan. McDermott On the Subject “2009 Changes to Federal and Illinois Estate Taxes Warrant Estate Plan Review” summarizes the potential consequences of this mismatch.

The state exemptions amounts vary along with how the state estate tax is calculated. For states that have exemption amounts as low as $675,000, the potential for additional planning to reduce state estate taxes is at least as great as the need to reassess existing wills and revocable trust to ensure compliance with current goals and objectives.

What You Should Do

If you are a resident of, or own real property in, any of the 23 mentioned states or the District of Columbia, you should review your estate plan to determine the extent of the state estate tax interplay on your existing plan, and consider updating your plan and documents to take full advantage of opportunities currently available.