Repeal estate tax that sets trap for unwary

Friday, March 3, 2006

Two years ago, the General Assembly set out a tax trap for the unwary that could cost some Maryland families more than $100,000. The intended targets for this trap were the so-called wealthy whose estates were small enough that the federal estate tax did not apply, but large enough to attract the attention of our legislators.

Some background is in order. At the federal level, the estate tax was originally imposed on the estate of a deceased individual in order to redistribute wealth by imposing a tax as high as 90 percent on the estate of a deceased. Over the past 20 years or so, the inequities of the federal estate tax came into focus. Families with small businesses or farms were often forced to sell those assets to pay the estate tax, sometimes at a loss because the estate tax had to be paid within nine months of the date of death.

In 1981, a tax credit was adopted that could provide some relief by allowing up to $600,000 to be protected from the estate tax, a tax that was as high as 55 percent of the taxable estate at that time. Maryland, as in many states, followed along by designing an estate tax that would come into effect only if the federal estate tax was applied.

This new approach provided some logical planning alternatives. Maryland married couples with estates in excess of $600,000 set up estate plans that allowed each spouse to use the tax credit so that up to $1.2 million could be protected from the estate tax, whether federal or state. Because a taxable estate included home equity, life insurance proceeds and retirement accounts, more and more married couples adopted estate plans to take full advantage of their tax credits.

In 2001, the federal estate tax went through a significant overhaul. In the 20 years since the last major revision of the estate tax laws, inflation and prosperity had marginalized the amount that could be protected by the tax credit. This meant that more and more voters were being required to pay what could only be considered a confiscatory tax. Therefore, Congress increased the tax credit so that $1 million could be immediately protected in 2001.

In 2004, the amount protected from the estate tax went up to $1.5 million, and in 2006, this amount went to $2 million. In 2009, the tax credit will protect $3.5 million. In 2010, the federal estate tax is temporarily repealed for one year because in 2011, the 2001 amendment expires, returning the amount that can be protected to $1 million.

In this environment of ever-increasing tax credits at the federal level, and ever increasing revenue shortfalls at the state level, the General Assembly blinked. Instead of following federal policy, Maryland decided to ‘‘de-couple” the state estate tax from the federal estate tax. In 2004, the amount that could be protected from the Maryland estate tax was reduced to just $1 million. This change allowed the estate tax revenue stream to be protected.

The tax trap created by this change affects primarily married couples who previously took steps to plan their estates by incorporating established planning techniques into their estate plans to take maximum advantage of the federal tax credit.

In order to take advantage of each spouse’s tax credit, it is necessary to purposefully trigger the tax upon the death of the first spouse in order to use the tax credit. If the tax is not triggered, the tax credit for the first spouse to die is wasted. Many couples reorganized and retitled their assets so that upon the death of the first spouse, some portion of their estate is deliberately taxed. When the Maryland tax was applied only when the federal tax was applied, this system worked very well.

With the change in 2004, if the taxable estate of the first spouse to die exceeds $1 million, but is less than $2 million, there is no federal estate tax, but there is a Maryland estate tax of up to $140,000. This tax must be paid even though one spouse still survives.

It is possible that a surviving spouse could take steps to reduce the taxable estate of the first spouse to die to $1 million and avoid the Maryland estate tax. By taking this step, however, the surviving spouse would be exposing much more of the marital estate to the federal estate tax upon the death of second spouse to die. This increase could be as high as $450,000. The tax trap is thus sprung. And for many families, there is no awareness of this trap until after the death of the first spouse.

The General Assembly is considering the repeal of the 2004 change because of this inherent unfairness of trapping Maryland families. This repeal should be strongly encouraged.

If the purpose of an estate tax is to redistribute wealth, Maryland should follow the public policy established at the federal level. If the purpose is really to raise revenue, then there should be a more honest and forthright way to set a tax without trapping the unwary citizens of Maryland.

Michael W. Davis is a partner in the Columbia, law firm of Davis, Agnor, Rapaport & Skalny. He served on the Howard County Commission on Aging for the past 10 years and on the Elder Law Council of the Maryland State Bar Association since 1993. He also was a founding member of the Maryland⁄D.C. Chapter of the National Academy of Elder Law Attorneys.