State Estate and Inheritance Taxes

Background: Decades ago Michigan imposed an inheritance tax. In 1993 it converted its inheritance tax to a state estate tax with the repeal of the Michigan Inheritance Tax. [MCL 205.301-205.256] but with one exception. The Michigan inheritance tax is still in effect but only for those individuals who inherit assets from a person who died on or before September 30,1983.

Michigan then imposed a state estate tax to replace its repealed inheritance tax. Michigan’s state estate tax was what was informally called a ‘pick-up transfer tax’ in that its state estate tax was equal to the amount collected on the federal estate state tax credit that the IRS then allowed, i.e., money that would have been paid as a federal estate tax was instead paid to Michigan.  However, in 2005 Congress eliminated the state estate tax credit for federal estate tax reporting purposes. The result was with no state tax credit available, there was no state estate tax revenue. Accordingly, since that time,  Michigan has not collected any state estate taxes.

Other State Transfer Taxes: While Michigan does not collect any inheritance or state estate taxes (other than the limited exception described above) about 17 states do impose either an inheritance or a state estate tax in additional to any federal estate taxes owed. With the change with the current federal administration and the concomitant drop in federal grants and federal support for many state welfare programs administered by the states, many states are taking a second-look at ways to replace those lost federal revenues. That trend is reflected with many states either adopting ‘millionaire’ surtaxes or imposing various forms of  ‘wealth taxes’ on billionaires. Other states look to either reinstitute their inheritance or state estate tax regimes or by cut back on state’s estate exemption amounts.

Inheritance Tax Regimes: Five states impose a state inheritance tax. Kentucky (0-16%); Maryland (0-10%); Nebraska (0-15%); New Jersey (0-16%); and (Pennsylvania (0-15%.) Most of these inheritance tax regimes exempt the inheritance tax for transfers to a surviving spouse or the decedent’s children or grandchildren.

State Estate Tax Regimes: The states that impose a state estate tax are Connecticut, D.C., Hawaii, Illinois, Maine, Maryland, Massachusetts, Minnesota, New York, Oregon, Rhode Island, Vermont, and Georgia. Making the exposure to state estate taxes even more challenging is that each state uses its own applicable exemption amount for its state estate tax liability, with only Connecticut adopting the federal government’s current $15 million applicable exemption amount per person. [Some examples are Illinois’ exemption is $4.0 million; Minnesota’s exemption is $3.0 million; and Hawaii’s exemption is $5.49 million.] Adding to the confusion is that two states (D.C. and Vermont) do not allow a state qualified terminal interest property (QTIP) option to defer state estate taxes until the surviving spouse’s death.

State inheritance and state estate taxes are in flux in the on-going search for state tax revenues. If f individuals own assets outside of Michigan and in any of these 18 states, it pays to take a look at whether the other states where the property is located may be subject to an inheritance or state estate tax regime, or possible changes that would increase the exposure to pay any ‘state death taxes.’

Interesting Twists: The presence of a state imposed inheritance tax, or a state estate tax can also impact state income taxes that might be owed by a recipient. One example is New Jersey. New Jersey imposes a state income tax that ranges from 1.4% to 10.75%. Contributions to traditional IRAs are not deductible for New Jersey income tax reporting purposes, but they are treated as previously taxed contributions- loosely translated, contributions to a traditional IRA for New Jersey income tax purposes are treated as an increase in that IRA’s tax basis. As noted above, New Jersey also imposes a state inheritance tax. New Jersey takes the administrative position (it is not in any of its statutes) that inherited IRA assets that are subject to the New Jersey inheritance tax are treated as previously taxed contributions. Consequently, an inherited IRA receives a basis adjustment for state income tax reporting purposes attributable to any state inheritance taxes paid with respect to the inherited IRA, the same way as if the inheritance tax payment was a contribution to the IRA that was not deductible, i.e., and after-tax contribution to the traditional IRA. While an interesting position to take, it can also complicate estate administration.[Recall that inheritance taxes are paid by the recipient, not the decedent’s estate or trust.] Inheritance taxes can also create challenges when it comes to estate administration.

Example: Ned, a New Jersey resident, dies leaving his assets to a discretionary Trust for the benefit of his daughter Deborah, for her lifetime. On Deborah’s death the Trust continues to provide for Deborah’s descendants, if any. If there are no then-living descendants, the Trust’s assets continue in trust for Ned’s siblings, or if none are then living, each sibling’s share then passes to the deceased sibling’s descendants. Deborah is a Class A individual under the New Jersey inheritance laws, so no inheritance tax will be due. However, at the time of Ned’s death the trustee does not know how much, if anything, will be distributed from the Trust to Deborah, or to Deborah’s descendants free from any inheritance tax (since Deborah’s descendants are also Class A individuals who can inherit without any inheritance tax.) Nor will the trustee know when or how much will be distributed to Ned’s siblings, who are Class C individuals; a Class C individual has a $25,000 exemption with inheritance tax rates above $25,000 ranging from 11% to $1.1 million,  and 13% from $1.1 million to $1.4 million. A descendant of a deceased sibling (Ned’s nephews or nieces)  is a Class D individual, and under the state’s inheritance tax regime, he/she is exempt from inheritance tax on the first $500, but anything above $500 inherited is taxed at 15% on the first $700,000 and 16% on any amount inherited above $700,000. Any New Jersey inheritance tax is deferred until these contingencies are resolved. Any inheritance tax is due to be paid to the state 8 months after Ned’s death. If an estate is opened for Ned, the Personal Representative will probably want to close the estate as quickly as possible. As such, the Personal Representative of Ned’s estate will likely propose some compromise tax payment based on the facts, circumstances and ages of Deborah and her issue. Whether the New Jersey Division of Taxation agrees with the Personal Representative’s proposal is anyone’s guess.

Conclusion: Tax laws are always changing. State taxation often responds to what is going on (or not) at the federal level. Most states find it easier to either add surtaxes on the uber-wealthy to generate revenues, or to tweak their inheritance or estate tax regimes to tax ‘unexpected’ wealth when it passes from a decedent to more remote heirs.

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