Delaware Enacts Estate Tax Effective July 1, 2009

July 6, 2009

In a surprising and quick development, and in an apparent response to budgetary concerns, the Delaware Legislature passed and the governor signed legislation reinstating the Delaware Estate Tax for decedents dying on or after July 1, 2009. Delaware has not had a separate state death tax since the phase-out of the federal state death tax credit in 2005. The new Delaware Estate Tax is tied to the federal state death tax credit as it existed on January 1, 2001 and, apparently, will apply to estates of $3.5 million or more. Non-residents will be taxed on the pro-rata portion of their estates that are subject to tax in Delaware. The legislation also provides that the IRC § 2058 deduction for state death taxes will not be taken into account in calculating the Delaware Estate Tax, which has the effect of increasing the amount of the Delaware tax. The legislation, H.B. 291, was introduced in the Delaware House of Representatives on June 29 and passed the same day by a vote of 25 to 16. The legislation passed the Senate the next day by a vote of 14 to 6 and was signed by the governor on July 1, 2009.

Ongoing Fallout from 2001 Federal Legislation

The phase-out of the federal state death credit is one of the enduring legacies of the Economic Growth and Tax Relief Reconciliation Act of 2001 (“2001 Tax Act”) that has profoundly affected estate planning. Beginning in 2002, the federal state death tax credit, which was previously allowed with respect to estate, inheritance, legacy, or succession taxes paid to any state or the District of Columba, was reduced incrementally from 2002 to 2004 and then eliminated for decedents dying after December 31, 2004. As a result, a form of dollar-for-dollar revenue sharing between the federal government and the states was eliminated. Since January 1, 2005, IRC § 2058 has instead permitted a deduction for the full amount of state death taxes paid.

After the elimination of the federal state death tax credit in 2005, approximately half of the states retained some form of a state death tax. The responses of those states retaining a death tax varied from state to state. Some states, such as New York, Oregon and the District of Columbia, prior to the enactment of the 2001 Tax Act, had tied their state death taxes to the federal state death tax credit as it existed in a year prior to 2002. Accordingly, these states’ death taxes automatically remained in effect. Other states retroactively tied their state death taxes to pre-2001 Tax Act state death tax credit, or they simply decoupled from the federal system altogether in order to prevent revenue loss. Some states, such as Connecticut, Washington and Kansas, implemented independent state estate tax regimes that are unconnected to the state death tax credit. Still other states like Indiana, Iowa, Kentucky and Tennessee lost their estate taxes after the federal state death tax credit was eliminated, but continued to maintain a state inheritance tax. Finally, other states that had a separate state death tax have repealed their tax, such as Virginia, or allowed it to expire, such as Wisconsin.

One challenging aspect of the change was that many states had thresholds for their respective state death taxes that were lower than the federal applicable exclusion amount. For some states, such as New Jersey and Rhode Island, the state threshold of $675,000 was lower than the $1 million federal applicable exclusion amount starting in 2002. For other states, such as Massachusetts and New York, the federal and state amounts were equal at $1 million in 2002 to 2003, but then separated in 2005 when the federal applicable exclusion amount increased to $1.5 million. Illinois has a $2 million threshold, so its threshold was equal to the federal threshold until 2009.

Responses in Other States

Earlier this year, in Vermont, the state legislature on June 2, 2009 overrode the governor’s veto of H. 442, which reduced the threshold for Vermont’s estate tax to $2 million, retroactively to January 1, 2009. Previously, the threshold for the Vermont estate tax tracked the federal applicable exclusion amount which increased to $3.5 million on January 1, 2009.

In other states, legislation was introduced but failed to gain sufficient support to get out of committee. For example, this year in Virginia, three bills were introduced to create a new death tax, exempting the estates of families and businesses valued at under $5 million, while imposing a tax as high as 16% on estates valued over that amount. This was estimated to generate over $100 million per year in new revenue for the Virginia government. These three bills all failed in committee either in the House of Delegates or the Senate so neither the full House nor full Senate considered these pieces of legislation.

In Kansas, H.B. 2047 was introduced on January 21, 2009 to permanently extend the stand-alone Kansas Estate Tax which is scheduled to expire as of January 1, 2010. This was apparently viewed as a way to increase state revenue in a time of declining revenue.

In New Hampshire, two bills were introduced in 2009. House Bill 543 would have established an inheritance tax on collateral heirs while House Bill 691 would have created an 8% estate tax and a threshold for New Hampshire estate tax of $2 million.

Impact of Economic Challenges

The current economic challenges facing the country, resulting in large budget deficits in most states, may encourage states that have state death taxes to increase them, and it may encourage states that do not have state death taxes to consider enacting them. This appears to have influenced the recent action in Delaware and the action earlier this year in Vermont.

On the other hand, many states have seen their current budget problems temporarily solved or delayed by the anticipated infusion of federal stimulus money. But states that face new budget shortfalls when the federal stimulus funds are no longer available may once again look at a state death tax as a means to increase revenue. As a result, the area of state death taxes, which has been subject to considerable changes since 2002, will likely continue to see more changes.

McGuireWoods’ Fiduciary Advisory Services

Our Fiduciary Advisory Services team monitors developments in the states with respect to state death taxes. A summary can be found in the regularly updated State Death Tax Chart.