'Zombie' Estate Taxes Appear Dead for Good

The fiscal cliff deal seems to have made it all but impossible for about 25 states to collect estate taxes, barring new laws.
by | January 21, 2013

State officials across the country anxiously watched Washington as 2012 neared its end, fearing that congressional inaction would plunge the country off the so-called fiscal cliff through a combination of automatic tax increases and spending decreases.

That didn’t happen. Federal lawmakers reached a compromise that raised tax rates for highest earners and delayed automatic federal spending cuts to March 1 (as of press time, the outcome of that process was unclear). One of the biggest fears of state leaders -- a cap on the tax exemption for municipal bonds -- didn’t go through either. But the deal did make changes to federal tax laws that will impact states.

As a result of the deal, states will no longer be able to take advantage of a federal policy that once offered federal tax credits for estate taxes paid at the state level. The policy -- which all 50 states took advantage of -- allowed states to levy estate taxes without really impacting residents’ bottom lines, since the money was subsequently taken off their federal tax bill. In 2001, as part of the Bush tax cuts, the credits were scrapped.

Those tax cuts were scheduled to expire at the end of 2012, and with their expiration, the credit would have been restored.  Any hopes of seeing the credit making a comeback were dashed as part of the fiscal cliff deal, making it the second time the credit was poised to make a comeback but failed to do so (Bush tax cuts were extended n 2010 for two years).

As a result of the 2001 change, there are 25 states that have “zombie” estate taxes on the books that are linked to the federal credit but don’t actually collect anything, says Norton Francis, senior research association at the Urban Institute. Why does that matter? If Congress had allowed the status quo to be restored, those states would have collected around $3 billion in new revenue, according to Francis.

The uncertain status of the credit meant some of those “zombie” estate tax states had projected to collect that revenue again, even if it was never that likely they’d come back. California projected $45 million in new estate tax revenue to help balance its budget for the 2012-2013 fiscal year, and Wisconsin's executive budget office included that revenue in a recent budget forecast, according to Francis. But at this point, it seems the tax is as good as dead -- for real this time.

 The deal also has other state tax implications.

 •    Twenty-four states and D.C. have earned income tax credits, which are generally a percentage of the federal EIC, which was just extended for another five years.

 •    Six states could be poised to lose some tax revenue since they allow residents to deduct their federal taxes from their taxable state income. With the top federal tax rates increasing, that would mean less money for those states.

 •    Five states use federal taxable income as the starting point for their own state taxes. Limits on personal exemptions -- that were lifted as part of the Bush tax cuts -- now come into play again, meaning taxpayers in that handful of states would now owe more.

 •    Congress fixed the alternative minimum tax by permanently indexing it to inflation. That ensures that large numbers of taxpayers who aren’t top earners won’t be subject to the AM  and can continue to deduct state income taxes from federal returns. That’s essentially a subsidy for states.

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