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April 3, 2015
Repealing the Federal Credit for State Estate Taxes Was Bad Policy
by Claire Arritola

Full Text Published by Tax Analysts®

This article first appeared in the August 11, 2014 edition of StateTax Notes.

"But in the world nothing can be said to be certain except death and taxes."1

I. Introduction

Like death itself, taxation is an area of the law that leaves no person untouched. Not every area of the law is as all encompassing. One may never have the misfortune of being a party in a medical malpractice suit or a criminal prosecution, but everyone will face taxation throughout their lives. Similarly, death spares no one; it may be feared and perhaps delayed, but it inevitably arrives.

These two eventualities converge in the area of the law referred to as wealth transfer taxation -- an area of tax law that is often feared, neglected, or deemed unimportant. While it is true that federal wealth transfer taxes generally account for less than 1 percent of federal tax revenue (they once accounted for 10 percent),2 those taxes could still be a significant source of revenue for state governments.

This article will discuss the various categories of state wealth transfer taxes and the impact of the federal repeal of the federal state estate tax credit. To understand state reactions to the wealth transfer tax credit repeal, it is helpful to understand the status of the federal wealth transfer tax law, and how the federal government came to repeal the state estate tax credit. In recent years, the repeal has shaped the wealth transfer taxation policies of most states. The repeal of the credit was arguably bad tax policy and has potentially harmed the states as well as taxpayers. The effects on the states have included diminished state tax revenue, increased taxpayer burden, and potential double taxation for some taxpayers. However, through the repeal of the credit and the continual weakening of federal wealth transfer taxes, states have had an opportunity to shape tax policy that may be beneficial to their particular needs. The paper will also propose possible approaches to the issues created by the repeal of that credit.

II. What Are Wealth Transfer Taxes?

A. Overview

Wealth transfer taxes consist of estate taxes, inheritance taxes, and gift taxes.3 The estate and inheritance taxes focus on taxing the transfer of property on a person's death.4 The federal estate tax, which was enacted in 1916, is found in IRC section 2001.5 The estate pays the tax on its taxable estate, which, in simplified terms, consists of a fair market value accounting of all the property of the decedent at the time of death, including "cash, securities, real estate, insurance, trusts, annuities, and business interests." Some deductions are allowed, such as debts of the decedent, administrative expenses, and funeral expenses. The value of lifetime taxable gifts is also added to the taxable estate to come up with the estate tax base.

The federal estate tax applies to estates that, after the accounting and computations described above, are valued in 2014 at more than $5.34 million (the unified credit exemption equivalent amount). Essentially, only the wealthy pay federal estate taxes.6 The level, however, at which state estate taxes begin to apply varies greatly. Practitioners and estate planners must be knowledgeable of the law in the state in which the decedent dies and owns property.

For inheritance taxes, an individual receiving a transfer from a testate or intestate decedent pays the inheritance tax, as opposed to the estate itself.7 There is no federal inheritance tax, but several states levy the tax. Both estate and inheritance taxes provide incentives for potential taxpayers to transfer property during their lives (that is, to make inter vivos transfers or gifts), rather than retain their wealth until death.8

The third type of wealth transfer tax is the gift tax, which is intended to deter tax avoidance through inter vivos wealth transfers. The federal gift tax, found in IRC section 2501, is integrated with the federal estate tax.9 In addition to the federal scheme, several states create additional complexity by having either gift taxes or inheritance taxes that apply specifically to gifts made in contemplation of death.

There are considerable differences among the federal wealth transfer taxes and the state wealth transfer taxes.10 One must be wary of which taxes will apply in a given situation; each individual or decedent faces unique requirements and tax burdens depending on the state. That complexity, however, did not always exist, as will be seen below.

B. History of State Wealth Transfer Taxes and the Federal Estate
Tax Credit on State-Level Taxes

State wealth transfer taxes are not new -- Pennsylvania imposed an estate tax in 1826.11 By 1916, when the federal estate tax was passed, 34 states had enacted similar taxes. By 1924 there was competition among the states to attract wealthy individuals who would contribute to the economy. Some states already had wealth transfer taxes in place, but other states, such as Florida, did not. States looking to attract the wealthy took steps such as placing prohibitions on estate taxes in their state constitution. Between 1924 and 1926, the states engaged in vigorous debates on that subject and participated in three national conventions meant to address the competition among the states. Most of the discussions centered on how rogue states, primarily Florida, were the source of that problem.12 In 1924 Congress stepped in with a solution for the states: It enacted the estate tax credit for state-level taxes, a dollar-for-dollar reduction on the federal estate tax return for state estate taxes paid by that estate. There was a credit available for "estate, inheritance, legacy, or succession taxes actually paid to any state," but the credit was not to exceed 25 percent of the federal estate tax. By 1926 Congress increased the maximum credit to 80 percent of the otherwise payable federal estate tax. Eventually, all states enacted estate taxes to take advantage of the credit.13

C. The Credit and Its Effects

Generally, an estate tax credit reduces a person's estate tax liability dollar for dollar.14 The federal credit eliminated the impact of state estate taxes up to the amount of the credit.15 That enabled states to generate revenue without having to impose an extra tax burden on their citizens -- essentially a transfer of funds from the federal government to the state governments. The credit has also increased uniformity because states structured their estate taxes around the value of the credit. Thereafter, states adopted a pickup tax16 that allowed them to impose a tax to take advantage of the federal credit.17 Through that mechanism, the problem of competition among states was largely eliminated.18

To understand the importance and impact of the credit and its repeal, one must understand the difference between pure pickup taxes and frozen pickup taxes.19 A pure pickup tax was tied directly to the federal credit and tracked any changes, while frozen pickup taxes were tied to the IRC at a specific point in time and would not change if there was a change in the federal estate tax law. By 2001, 38 states imposed some form of a pickup tax, while another 13 states had both a pickup tax and either a separate estate tax or inheritance tax.20 During the early history of the credit, many states retained separate inheritance taxes, but as the year 2000 grew closer, most states decided to forsake those separate taxes and use the pickup estate tax as their only death tax. In fact, between 1976 and 2000, 31 states had eliminated their traditional state estate taxes in favor of the pickup tax.21

D. Elimination of the Federal Credit

The federal credit for state-level taxes was arguably intended to be a temporary fix to interstate competition and last only as long as it took for holdouts like Florida to enact their own estate taxes. However, the states' reaction to the credit, and the enactment of pickup taxes, created a rather unanticipated problem for the federal government. The state estate taxes in states with pickup taxes tied to the credit would remain in force only as long as the federal credit existed. Not wanting to harm state finances, Congress and the federal government were reluctant to eliminate the credit. But 80 years later, in 2001, with an executive branch administration that wanted to eliminate the federal estate tax, everything began to change.22 That change may have been largely detrimental to the states and their resident taxpayers.

The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) repealed the credit.23 That process began with the credit being phased out by 25 percent each year, and eliminated it completely after 2004. By extension, EGTRRA effectively repealed the pure pickup state estate taxes that were tied to the federal credit.24 EGTRRA also added IRC section 2058, which created a deduction for estates that have paid state estate taxes and is meant to replace the IRC section 2011 credit.25 EGTRRA provisions were slated to sunset in 2010, but Congress extended them through the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010.26 Later, the Taxpayer Relief Act of 201227 amended EGTRRA so that the repeal of the federal credit was made permanent.28

III. State Responses to the Credit Repeal

A. General Overview

Since the 2001 repeal of the federal credit, states have experimented with different estate and inheritance tax options.29 Many states eliminated their estate taxes after EGTRRA.30 One source notes that since 2001 more than half the states have repealed their estate or inheritance taxes or let them expire with the federal credit.31 The states with pure pickup taxes had the option of doing nothing and allowing the taxes to expire; 23 states allowed that to happen, including Florida, which is discussed in more detail below.32 The alternative was to repeal the pickup taxes through legislation -- an action taken by Arizona, Kansas, Nebraska, Ohio, and Oklahoma.33 An outright repeal had the benefit of increasing certainty and predictability for budgeting purposes.34 Without a repeal of a pure pickup tax statute, if the federal credit were to return, the state would immediately resume collecting estate taxes, but it may have lost its ability to do so. A repeal of the state pickup tax would guard against that possibility.

Another potential course of action was to decouple the state statute from the federal code and enact new state estate taxes.35 These measures were designed to prevent revenue loss created by the federal repeal.36 Most states that followed this path have enacted statutes that mirror pre-EGTRRA levels of estate taxation.37 Maryland is an example of a state that took this route.38

States that had stand-alone estate and inheritance taxes have kept them in place. Interestingly, states with inheritance taxes often vary liability depending on the status of the heir.39 In those jurisdictions, transfers to persons closer to the deceased, such as spouses and children, are subject to a lower tax rate than transfers to more distant relatives. An example of this type of scheme is found in Kentucky. Under its system, the inheritance tax "is a tax on the right to receive property from a decedent's estate, both tax and exemptions are based on the relationship of the beneficiary to the decedent." Three separate classes of beneficiaries receive different tax treatment: Parents, children, and siblings are not assessed an inheritance tax, while nieces, nephews, and aunts pay a 4 to 16 percent inheritance tax with a $1,000 exemption. More distant relatives pay a higher rate and receive a lower exemption.40

Some states impose a decoupled estate tax or have stand-alone taxes.41 On the other hand, 25 states elected to do nothing in response to the repeal of the credit.42 Some states impose inheritance taxes that were always independent of the credit. These states are Indiana, Iowa, Kansas, Kentucky, Nebraska, New Jersey, New Mexico, Oregon, South Dakota, West Virginia, and Wisconsin.

B. A Closer Look at Three Courses of Action

    1. Florida: The Do-Nothing Model
Before the repeal of the tax credit, Florida had a pickup estate tax that was tied to the federal credit.43 When the credit was phased out, so was Florida's pickup statute. The state did not respond to the repeal. Further, it has not demonstrated an intent to decouple from the federal statute and impose a stand-alone tax. Florida has lost $800 million of annual revenue as a result. Despite that loss, the state and prominent politicians are taking this opportunity to make the state more attractive to retirees.44 In essence, Florida is back to its pre-1926 rogue state status, except that it is being joined by many other states that have also opted to do nothing following the federal repeal.45 It should be noted that Florida's state constitution bars an estate or inheritance tax, which makes decoupling from the federal credit and creating a stand-alone tax impossible without a constitutional amendment.

    2. Arizona: Repeal of Estate Taxes
During the time of the credit, Arizona had an estate tax that equaled the amount of the credit. In 2006 Arizona repealed its estate tax in response to the elimination of the credit. In the past, Arizona was collecting nearly $100 million from the estate tax; however, no estate taxes have been collected since 2006. Kansas, Nebraska, Ohio, and Oklahoma followed a similar course.46

    3. Maryland: Decoupling and Stand-Alone Taxes
States in this category either have stand-alone taxes that are completely independent of the IRC or have laws that reference the pre-EGTRRA IRC. In 2002 Maryland began decoupling from the federal law regarding the credit.47 In 2004 Maryland further decoupled from the federal system. It now imposes a tax on taxable estates valued at more than $1 million. These changes will cause increases in the "total tax due from an estate."48 Maryland also imposes a stand-alone inheritance tax, which has a narrower base.49

IV. Repealing the Credit Was Bad Policy

A. Components of Good Tax Policy

The main goal of taxation is to raise the revenue state and local governments require to provide vital services for their citizens. There are many considerations when determining what constitutes good tax policy.50 Those considerations include "the burden placed on individuals by the tax system," the effect on commerce and industry, and political ramifications.51 For some, it is important that the tax burden be proportionate to a taxpayer's ability to pay or that some segments of the public should be responsible for paying for the government services from which they benefit. Other commentators focus on the effect that a tax will have on the economy or whether difficult political decisions will interfere with raising revenue. The subject of wealth transfer taxes can be evaluated using these criteria. It appears that the elimination of the credit has harmed the states as well as taxpayers.

B. Policy Arguments in Support of State Wealth Transfer Taxes

Repealing the credit was arguably poor tax policy because it has led many states to repeal their wealth transfer taxes. Those taxes were valuable because they raised revenue and because they served an important role in bringing progressivity52 and balance to the state tax schemes.

There are several reasons why the decline of state wealth transfer taxes is unfortunate. First, wealth transfer taxes can make a state's overall tax scheme more progressive.53 It can be beneficial for states to levy those types of taxes to offset the regressive54 taxes that often provide much of state revenue, such as sales taxes.55 The estate tax is levied only on those estates that are most able to pay, and statistics have shown that only a small percentage of estates ever face an estate tax.56

Also, the wealthy disproportionately benefit from many state government protections such as the protection of property rights.57 The rich have more property to protect and therefore benefit greatly from the legal and physical protections paid for with taxes. It is only fair that those who benefit most pay more, as was argued by President Theodore Roosevelt when he said that "the man of great wealth owes a particular obligation to the State because he derives special advantages from the mere existence of government." Also, the protection of the property rights can spur economic growth and industry as the public services provided by state governments, such as healthcare, education, and infrastructure, allow businesses to grow and continue to employ individuals, thus expanding the economy of states.

In addition to the equity, tax burden, and economic impact concerns, the repeal of the credit has had a serious effect on state tax revenue. It varies by state, but statistics show that "the repeal of the state death tax credit could potentially cost states $5 billion to $9 billion in annual revenues."58

For state politicians to replace this revenue by imposing an estate or inheritance tax is politically risky. If the history of the credit is any indicator, most politicians are not willing to increase taxes.59 As a result, many states lack the revenue they desperately need. Also, estate and inheritance taxes are likely to be increasingly relevant as baby boomers begin to die in significant numbers, leaving behind their significant wealth.60 That is a lost opportunity to raise revenue in a fashion that many see as equitable because the burden falls on those most able to pay.

Another effect of the credit repeal is an increased planning and compliance burden for taxpayers as well as the states that would have relied on the future revenue stream of those taxes.61 Estate planners must be very careful because the estate may have both a federal tax burden and a state burden -- or estates may not be subject to federal estate tax but may be subject to state taxes. Estate planners must be more vigilant under the new regime. The repeal of the credit has significantly decreased or eliminated the uniformity that existed among the states for the 80 years of the credit's existence.

The repeal of that credit has also created a potential double taxation problem for some taxpayers, because the estate of a decedent may be subject to taxation at the state level and then again at the federal level. It should be noted that the federal deduction now allowed for state estate taxes will ameliorate that problem, but it will not eliminate it completely. The deduction provides relief only to the extent of the marginal rate62 times the deducted amount. On the other hand, the credit is a dollar-for-dollar reduction of the tax.

The elimination of the credit has also rekindled competition among the states for wealthy retirees.63 Such competition leads to problems (for example, taxpayer flight), as was the case before the enactment of the credit. That competition may be even fiercer as the retiree community increasingly consists of baby boomers who are numerous, politically and financially powerful, and mobile. Baby boomers contribute to the economy and represent a potential revenue source in the form of property, sales, and income taxes.

On the other hand, the credit repeal has given states an opportunity to shape or tailor wealth transfer taxes in a way that will be best suited for their citizens and for raising revenue. The repeal has further allowed states to experiment with alternative schemes, which may be valuable for both the states and the democratic process because it encourages citizens to participate. Also from the perspective of the federal government and its own fiscal difficulties, the phaseout of the credit was a way to reduce the total cost of EGTRRA. This was supported strongly by federal lawmakers because it "would raise federal revenue without increasing federal rates."64 The federal government has its own considerations in creating its own budget; however, removing that credit from the states in a short period has been arguably dislocating and detrimental.

V. Potential Solutions

The credit repeal became permanent after January 1, 2013. There are ways the states may reduce the negative consequences of the repeal. First, states may organize to lobby Congress to reinstate the credit.65 It should be noted that the states did lobby Congress in opposition of the repeal in 2001 but were unsuccessful because of the late start of their efforts. Both the National Conference of State Legislatures and the National Governors Association can provide meaningful statistics about the high cost of the repeal, especially for states that are dealing with large deficits.

This solution may be difficult to implement. However, states should emphasize that federal aid to states in this area has had a long and successful history.66 The success has come in the form of reduced interstate competition and equitable and helpful distribution of revenue to states.

Another potential solution would be the creation of model estate tax legislation. That would help return state uniformity to the wealth transfer taxes and would further reduce competition among adopting states. There are many bureaucratic barriers to creating model legislation, however. First, it would be difficult to get states to agree on the content and form of that legislation. Second, it would be time consuming and would likely take several years with an uncertain result. Finally, depending on the state, enactment of model legislation might require a popular vote. Despite those practical limitations, states should consider these options, with model legislation being the solution of last resort. The Multistate Tax Commission is another organization that could help lobby Congress for either the reinstatement of the credit or the passage of model legislation. The MTC has a standing uniformity committee to assist states in developing model regulations, statutes, and policy guidelines.

VI. Conclusion

Tax scholars such as Jeffrey A. Cooper, professor of law at the Quinnipiac University School of Law, have pointed to the historical reasons for the state estate tax credit. The reasons for enacting the credit 80 years ago may be instructive regarding its repeal.67 While family and social structures have changed, and past justifications may or may not be applicable, it is important to note the mobile nature of today's society and the ease with which the aging population can relocate. That may exacerbate interstate competition for rich retirees. Ideally, the federal tax law should provide neutrality68 and discourage jurisdiction shopping when it comes to estate and inheritance taxes by reinstating the credit. Further, the federal tax law assists in the avoidance of double taxation with the foreign tax credit of IRC section 901.69 Why should it not do it with the states?

Elected state officials should pay more attention to the need to find uniformity regarding estate taxes. Whether that is done through the adoption of model legislation or by persuading Congress to reinstate the credit is a matter for another debate.


1 Letter from Benjamin Franklin to Jean-Baptiste Leroy, 1789.

2 Jennifer Bird-Pollan, "Unseating Privilege: Rawls, Equality of Opportunity, and Wealth Transfer Taxation," SSRN (Mar. 26, 2014).

3 See "Key Elements: Wealth Transfer Taxes," The Tax Policy Briefing Book 302 (2012).

4 IRS "Estate Tax" (2014).

5 Patrick R. Thiessen, "The Death of the State Death Tax Credit: Can It Be Resuscitated?" Marq. Elder's Advisor (2009), at 309.

6 See Chye-Ching Huang and Nathaniel Frentz, "Myths and Realities About the Estate Tax," Center on Budget and Policy Priorities (2013) (noting that only 0.14 percent of estates pay an estate tax).

7 See "Estate and Inheritance Taxes," Institute on Taxation and Economic Policy (Aug. 2012).

8 "Estate and Gift Tax: An Overview," Cornell University Law School, Legal Information Institute (2014).

9 See id. Integrating the two taxes prevents large estates from shielding themselves from taxation through gifts.

10 Supra note 7.

11 Supra note 5.

12 Id.

13 See Revenue Act of 1924, section 301(b); see also Jeffrey A. Cooper, "Interstate Competition and State Death Taxes: A Modern Crisis in Historical Perspective," 33 Pepp. L. Rev. 835, 881 (2006).

14 "Income Tax Issues: What Is the Difference Between Tax Deductions and Tax Credits?" The Tax Policy Briefing Book 90 (2012).

15 See Cooper, supra note 13.

16 The pickup tax is a tax imposed by one jurisdiction, which is equal to a credit granted by a second jurisdiction.

17 Michel G. Kaplan, "Will the Disappearing State Death Tax Credit Deliver a Knock-Out Punch to the Tennessee Inheritance Tax?" Tenn. B.J., 28, 29 (2003).

18 Cooper, supra note 13.

19 Supra note 5.

20 Cooper, supra note 13.

21 Id.

22 Id.

23 Supra note 5.

24 Cooper, supra note 13.

25 Supra note 5.

26 Chris Edwards, "Tax Policy Under President Bush," Fraser Forum (2006); H.R. 4853.

27 H.R. 8.

28 "Congress Passes 2012 Taxpayer Relief Act and Averts Fiscal Cliff Tax Consequences," Halt Buzas & Powell Ltd. (2014).

29 Supra note 5.

30 Joel Michael, "State Responses to the 2001 Federal Estate Tax Changes," Minnesota House of Representatives, Research Department (Feb. 2004).

31 Supra note 5.

32 Id.

33 Norton Francis, "Back From the Dead: State Estate Taxes After the Fiscal Cliff," Tax Policy Center (Nov. 14, 2012).

34 Id. at 12.

35 Supra note 5.

36 Id.

37 "Taxation, Deductions and Credits, Federal Estate Tax Credit Absorbed or Decoupled (Regulations)," Thomson Reuters (Sept. 2013).

38 Supra note 33.

39 Supra note 7.

40 Id.

41 Id. These states are Connecticut, Delaware, Hawaii, Illinois, Maine, Maryland, Massachusetts, Minnesota, New Jersey, New York, North Carolina, Oregon, Rhode Island, Vermont, Washington, and the District of Columbia.

42 Supra note 33. These states are Alabama, Alaska, Arkansas, California, Colorado, Florida, Georgia, Idaho, Louisiana, Michigan, Mississippi, Missouri, Montana, Nevada, New Hampshire, New Mexico, North Dakota, South Carolina, South Dakota, Texas, Utah, Virginia, West Virginia, Wisconsin, and Wyoming.

43 Cooper, supra note 13.

44 Id.

45 Supra note 33 (stating that there are 25 states that are in a similar position).

46 Id.

47 Id. at 10.

48 Maryland Comptroller, "What You Need to Know About Maryland's Estate Tax" (undated).

49 Supra note 33.

50 See David Brunori, State Tax Policy: A Political Perspective 11 (3d ed. 2011).

51 Id. at 12.

52 Leo P. Martinez, "'To Lay and Collect Taxes': The Constitutional Case for Progressive Taxation," 18 Yale L. & Pol'y Rev. 111 (1999).

53 Supra note 6.

54 See Meredith R. Conway, "Money, It's a Crime. Share It Fairly, but Don't Take a Slice of My Pie!: The Legislative Case for the Progressive Income Tax," 39 J. Legis. 119, 123 (2013).

55 Supra note 6.

56 Id. at 1.

57 Id. at 7.

58 Cooper, supra note 13.

59 Id.

60 Supra note 5.

61 Jeffrey A. Cooper et al., "State Estate Taxes After EGTRRA: A Long Day's Journey Into Night," 17 Quinnipiac Prob. L.J. 317, 333 (2004).

62 The marginal rate is the tax rate that applies on the last incremental dollar of the tax base. See "Policy Basics: Marginal and Average Tax Rates," CBPP (Apr. 15, 2013).

63 Supra note 5, at 326.

64 Supra note 33.

65 Supra note 5.

66 Joshua S. Rubenstein, "Impact on States of Federal Estate Tax 'Repeal,'" ACTECJ (Winter 2002).

67 Id.

68 See Brunori, supra note 50 (explaining that neutrality is described as the concept that "taxes should have as little effect on market decisions as possible").

69 "Part 4: Examining Process, Section 10. Foreign Tax Credit," IRS.


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