Here we are four months into 2010 and there has been no change to the gift and estate tax law.  Most observers were surprised that a patch to continue the law as it stood in 2009 was not enacted.  Now there is talk of such a patch or even a new law that would accomplish it retroactively.  But the first truly rich American has died, a multi-billionaire who was number 74 on the world wealth rankings.  His estate has plenty of money to spend fighting any retroactive tax law as well as a lot of money to be saved if it prevails.  But what if nothing happens?

As a refresher, if the estate tax law of 2001 is allowed to expire then everyone’s estate can pass $1,000,000 free of federal estate tax. Above that, the estate is taxed on a rising bracket scheme until the top bracket of 55 percent is reached.  There is a surtax on estates over $10 million until the benefits of bracketing are gone and the estate is taxed at a flat 55 percent.  Also, the state tax paid is allowed as a credit, not just a deduction.  There is a table that shows what the IRS will accept as state death tax credit. It starts after $60 thousand and moves up in brackets until it reaches 16 percent.  This is the ultimate in revenue sharing because what you pay to your state is reduced dollar for dollar from your federal estate tax.  It was phased out in the four years following 2001 but would reappear if the current law is allowed to reach “sunset”.

Every state used that table as part of or all of their estate tax assessment.  It was called the state estate tax, or the slack tax, or the pickup tax.  When it was phased out, some states (the “time machine” states) adjusted their laws to levy tax as if the IRS law in effect before 2001 was still in effect.  Others, the “philosophical” group, just shrugged, apparently saying, “Easy come, easy go.”  Pennsylvania tried the “time machine” approach, but bracketed tax violates the state constitution, so it begrudgingly had to join the “philosophical” group.  While the state estate tax was always unconstitutional in Pennsylvania, it was never challenged in court because no one was injured by it (except maybe the IRS) and so there was no cause of action.  When credit for it started vanishing from the IRS credit list, a cause of action was created and thus the trip to the back of the “philosophical” line for Pennsylvania.

If sunset occurs, the states are ready to enjoy the benefit again.  Since U.S. Senators and Congressmen are well aware of their state’s financial problems, it seems they all have a motive to allow the “sun to set”.  But the federal government needs money too, so wouldn’t this cause an income problem for the U.S. Treasury?

The answer is yes and no, but mostly no.  Consider what Pennsylvania and the IRS collect on an estate under the 2009 regime and again under the 2011 sunset rules.  Assume the decedent is the second of a couple to die. There is almost never any tax for the first to die thanks to the unlimited spousal exemptions in both the federal and state tax law.  Assume all the estate will go to children or parents, for whom the state inheritance rate is 4.5 percent.

With an estate of $6 million, both the state and the US would end up with about twice as much income.  At $10 million, the state does about 2.4 times better, while the U.S. still does better but only by a factor of 1.37.  At $30 million, the factors are 3.16 and 1.05.  At $40 million, the factors are 3.26 and 1.01.  At a net estate of $44,337,107, the factors are 3.29 and 1.0.  The IRS actually takes in the same dollar amount.  Above this level, the state factor keeps getting better, but with a limit, while the IRS factor drops below 1.0.  At $250 million, the factors are 3.51 and 0.92.  At $1 billion, the factors are not much different, being 3.54 and 0.91.

Both taxing authorities improve their income in the ten million dollar range.  The state continues to improve until it collects about three and a half times more in the billion dollar range.  The IRS drops to break even at about $44 million and collects less than before above that amount but never dropping below 90 percent of what it had collected.  Estates pay more, since 55 percent is more than 45 percent.  But, more of the revenue stays in the state, which is a motive that could leave us seeing the sun set in 2011.