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Visibility on State Estate Tax Clouded

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By Lowell L. Kalapa

Last week we looked at the changes made by Congress to the federal estate tax law and some of the ramifications the repeal of that law holds for taxpayers. What those changes hold for state government is the focus of this week’s discussion.
Since 1983, Hawaii’s death tax or inheritance tax has been linked to the federal estate tax with what is known as the “pick-up” tax. After years of having its own version of an inheritance tax which focused the tax on the beneficiaries of an estate, Hawaii, following in the footsteps of nearly thirty other states, adopted the pick-up tax approach.
Under the federal estate tax law, there is a provision that allows an estate to claim a credit for state death taxes based on the size of the estate. The credit, as a percent of the estate, ranges from 0.8% to 16%. Since the federal law allows this amount as a credit against the federal liability, states like Hawaii chose to make this credit the amount that it would take in state death taxes. Lawmakers thought that this was not only fair since the credit was being allowed by federal law to reduce the federal liability, but it also eliminated any additional paperwork in filing a state estate tax return. Thus, the term “pick-up” tax refers to the fact that the state merely “picks-up” the amount recognized as state death taxes.
However, the newly enacted federal legislation will begin to phase-out the state tax credit over the next four years, reducing the amount of the credit by a quarter each year. Then in 2005, the state death tax credit will be repealed and replaced with a provision that will allow for any state death taxes actually paid to a state government to be deducted.
Thus, it would appear that state officials may consider reenacting a state death tax as soon as the next session of the legislature. What it will look like is anyone’s guess, but there are some details to consider in adopting a new state death tax.
First, the political pressure to not adopt a state death tax will come to bear, especially in light of the fact that the federal estate tax is scheduled to be repealed in 2010. Taxpayers will ask why should the state tax the property of a decedent’s estate if the federal government no longer taxes the estate. On the other hand, state officials may argue that since the federal law will be in effect another five years beyond the repeal of the federal state death tax credit, Hawaii might as well take advantage of the allowable deduction for state taxes. And since the federal law will allow for a deduction of state death taxes Hawaii should reenact a state death tax.
While that might arguably be a good point, one has to question how that would comport with the fact that in getting rid of the federal estate tax, the basis of the inherited property is not “stepped-up” and thus any gains from the time the property was acquired by the decedent will be subject to the capital gains tax. In what would be a trade off at the federal level might end up to be a double taxation of the same property if the state imposes a state death tax and also adopts the unadjusted basis of inherited property.
And what will a state inheritance tax look like? While many people don’t like to think about it, the inheritance tax – be it at the state or federal level – is one tax everyone will have to deal with and pay. Settling an estate is a chore in and of itself, adding a tax to calculate and pay makes the tax that much more daunting.
Some practitioners argue that Hawaii should conform to the federal law, especially when it comes to keeping records on the basis of property. If Hawaii does not conform to the new basis rules, accountants and lawyers argue, then the taxpayer will have the trauma of maintaining two different sets of records, one for the federal law and the other for the state law.
That latter argument certainly makes sense, but what about conforming to what the federal officials are doing to the federal “death tax?” If taxpayers are going to be in lock-step with the rules for determining the basis of property that passes because of the death of the owner, then it seems that Hawaii should also mirror the actions of the federal law on the death tax.
That is not to say that the repeal of the federal estate tax was the best thing for taxpayers. No, it is just saying that what works for valuing property should also work for the taxation of the property at the time it passes from the decedent to the beneficiary. To do otherwise creates a double tax situation.

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