The Many Lives Of The Death Tax

Wealthy estates could end up paying a lot as several states get aggressive

You might think the estate tax is going to its grave. But while the federal government is slated to phase out its "death tax" by 2010, 18 states plus the District of Columbia have opted to retain it within their borders. They join a handful of others with separate inheritance taxes -- imposed on the heirs rather than the estates. As a result, the estates of wealthy residents of these states could still wind up paying thousands of dollars in taxes.

For some taxpayers, this amounts to "a huge tax increase," says Laurie Hall, head of private client practice at Boston law firm Palmer & Dodge LLP. Consider the situation in New York. In 2004, New Yorkers will be able to leave heirs $1.5 million without paying Uncle Sam a dime. But because New York's estate-tax exclusion is $1 million, someone with a $1.5 million taxable estate will owe the state $64,400, says Blanche Lark Christerson, a director at Deutsche Bank Private Wealth Management (DB ). In 2009, the federal exemption rises to $3.5 million. But a $3.5 million taxable estate will owe New York $229,200, Christensen says. "The states are taking away a significant amount of the benefit of the reduction in federal estate taxes," says Hall.

The states are imposing these taxes in part to replace revenues lost by the declining federal estate tax. Unbeknownst to most taxpayers, Uncle Sam effectively shares its estate-tax revenue with the states. Starting in 2002, though, the feds began reducing the states' allocation, which will fall to zero in 2005.

The new state levies take many forms. Some states, including New Jersey and New York, are freezing estate-tax exclusions. In 2004, for example, New Jersey's exclusion will remain at $675,000, even as the Federal government allows taxpayers to shelter $1.5 million. (One caveat: Smaller estates which pass to heirs aside from spouses, children, and parents could still be liable for a separate inheritance tax.)

Other states, such as Vermont, are conforming to the federal government's estate-tax exclusion -- which is rising from $1 million in 2003 to $3.5 million in 2009. But if your estate exceeds those limits, watch out. A growing number of states are now forcing taxpayers to pay a state levy of up to 16% on top of the federal government's tax of up to 49% -- the maximum for 2003. For the next two years, a partial credit will reduce that burden to some extent.

Still other states have adopted different approaches. Massachusetts is allowing its estate-tax exclusion to rise but to thresholds below the federal limits. In 2003, Massachusetts taxpayers can shield $700,000 from state estate tax. That's scheduled to rise to $850,000 in 2004, $950,000 in 2005, and $1 million in 2006 -- where it is slated to stay, says Hall. Illinois, meanwhile, is following the federal limits. But it will freeze its exclusion at $2 million starting in 2009, says Carol Harrington, a partner at McDermott, Will & Emery in Chicago.

Some help is on the way. Starting in 2005, the Internal Revenue Service will let estates deduct state taxes from their federal returns. In 2005, this will effectively reduce the total tax bite such that those in the top state estate-tax bracket -- which kicks in at $10.04 million -- will pay only 8.5% instead of 16%, says Leonard Adler of JPMorgan Private Bank (JPM ) in Palm Beach, Fla.

DEFENSIVE STRATEGIES

Taxpayers can take some defensive steps. The most dramatic move: Relocate to a state with no estate tax, such as Florida or California. Another tactic is for spouses to change their wills to give their children or other heirs the maximum they can protect from state estate tax when the first spouse dies. In the case of a New York resident, for example, that would translate into a bequest of $1 million in 2004. Still, that means the New Yorker won't use $500,000 of the $1.5 million federal estate tax exclusion. If the surviving spouse dies before the federal tax expires in 2010 and has an estate that's above the federal exemption threshold, that $500,000 could be taxed by the IRS at rates of up to 49%.

Another approach is to put that $500,000 into a "contingent marital trust." That way, says Harrington, the executor can decide whether to pay or defer state estate taxes, depending on factors including the survivor's needs and the outlook for tax rates at the time. The best advice: Consult with a knowledgeable attorney or tax adviser.

By Anne Tergesen

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