State Estate Taxes: Windfall Gold in Expiring Tax Cuts

As Congress delays action on extending the 2001-03 tax cuts, state revenue officers may be secretly hoping for continued legislative paralysis. Why? Because the federal estate tax, repealed for this year, will be back in January —and many states are in line for a windfall if the levy returns to its pre-2001 form. It’s not that states want to tax estates per se, but they wouldn’t mind getting some easy revenue.

Until 2001, every state had a “pick-up” tax that piggybacked on the federal levy. Estates could claim a credit of up to 16 percent of their federal tax for estate taxes paid to states, so it was no surprise that states typically set their estate taxes at that maximum 16 percent rate. It was “free” money—the state got the tax revenue but estates paid nothing extra.

The 2001 tax act that phased down and eventually repealed the estate tax for this year didn’t just raise the tax threshold and cut the rate. It also replaced the credit with a deduction starting in 2005. As a result, states that relied on pick-up taxes tied to the repealed federal credit lost their windfall. Some passed new laws to decouple their taxes from the credit. A few enacted new taxes. But this year only 15 states and the District of Columbia will collect any estate taxes. (Five more levy inheritance taxes on heirs and two—Maryland and New Jersey—impose both.)

But nearly all of the 30 states that have no estate or inheritance tax in 2010 stand to collect estate taxes again if Congress allows the federal tax to return to its 2000 form in January. Since those states never changed their estate tax laws, the resurrection of the credit would also automatically resuscitate the pick-up taxes.

From the states’ perspective, what’s not to like? Without having to take the politically risky step of raising taxes, a few billion dollars will flow into depleted state accounts. And governors can blame it all on Congress.