As if the uncertain fate of the federal estate tax hasn't caused enough confusion, the revenue-starved states are taking steps of their own that further muddy the waters, and in some cases set up traps for the unwary.
Such a trap is now set for District of Columbia residents.
In an emergency measure last summer, the city enacted an estate tax with rules that are different from the federal levy. The result is that married couples who use a fairly standard estate-planning technique to eliminate federal taxes at the death of the first spouse can now end up with the widow owing as much as $30,000 in D.C. tax, lawyers here say.
The situation is an outgrowth of a provision in the big 2001 federal tax cut. That measure phases out the federal estate tax, first progressively increasing the amount of assets that can go untaxed and then repealing the tax altogether in 2010. Of course, the whole thing "sunsets" in 2011, unless Congress does something, but that's another story.
Along with the changes in the tax, lawmakers also phased out a special credit that had been available for estate taxes paid to states and the District. This credit allowed states to impose their own estate tax, which would then be subtracted from the federal tax bill. The state tax therefore actually costs a person's estate nothing. Since this was so painless, most states imposed a tax that went up to the federal credit limit and stopped. This was often called a "pickup" tax because it simply picked up the credit amount for the state.
But when the credit began to disappear, states quickly realized that their pickup taxes would pick up less and less, so they have begun to "decouple" their taxes from the federal one.
But when the D.C. Council did this, it applied its new tax to estate assets greater than $675,000, unless left to a surviving spouse. Such spousal bequests are untaxed.
The $675,000 was the amount that was untaxed at the federal level at the beginning of 2001. But under the new federal law, the untaxed amount has risen to $1 million, and it will go higher in subsequent years.
The issue now for married couples in the District involves the use of what are sometimes called credit-preservation trusts or A-B trusts, which are used to allow both spouses to pass on the maximum possible amount of assets tax-free.
Under federal law, each spouse can bequeath a certain amount, currently $1 million, to anyone tax-free and an unlimited amount to a surviving spouse tax-free. With planning, this means that a couple can leave a total of $2 million between them tax-free. But if the first to die simply leaves everything to the survivor, the first $1 million exemption is lost, and the total exemption available at the second spouse's death is $1 million.
To preserve each spouse's $1 million, lawyers commonly set up two trusts for each spouse: one, the A trust, to receive the exempt amount, and the other, or B trust, to get whatever's left. At the first death, $1 million goes into that spouse's A trust, and the remainder to the B trust, which is written to qualify for the marital exemption.
Typically, the trust documents are worded to say that the A trust gets the tax-free amount, whatever it is. Specifying a figure would mean rewriting the documents every time the amount changed.
When the federal and state taxes are in sync, which they used to be, and this wording was used, there was no tax, state or federal, at the first death.
But now, with the D.C. exemption amount lower than the federal, estate plans drawn this way will cause up to $375,000 -- the difference between D.C.'s $675,000 limit and the federal $1 million -- to be subject to D.C. tax.
"We've been telling people that on the first death there's no tax," said Calvin H. Cobb III of Craighill, Mayfield, Fenwick, Cromelin & Cobb in the District. But now "that's untrue."
With life insurance and current house prices, $675,000 is not the vast sum it once was, "so it's not necessarily rich people" who will feel the tax, he said.
Cobb added that D.C. residents can rewrite their wills, but those who don't, or the survivors of those who have already died, may be stuck. He said he favors some kind of transition rule that, for example, would allow the survivor the option of choosing to fund the A trust only up to $675,000 and pay no tax, or to fund it fully and pay the tax.
Virginia and Maryland have kept their exemption in line with the federal one, so some city residents who have learned of the new D.C. law are moving away, said William E. Davis, an lawyer with Ross, Marsh & Foster in the District.
Single taxpayers and widows/widowers who leave estates between $675,000 and $1 million would also have to pay taxes if they were residents of the District but would not if they had lived in Maryland or Virginia.
"I think this legislation is going to be counterproductive. Even before [the 2001 law] the estate tax exemption was scheduled to increase up to $1 million, and D.C. presumably would have gone along," Davis said. Now, D.C. estates "are in worse shape than they were before," he said.
"We have residents who are in higher tax brackets and they conceivably are going to move across the District line, and not only are we going to lose that [income] tax base, we are not going to get the estate tax," he added. "I have clients right now looking for a place in Maryland."
Readers may be aware that, in another effort to boost electronic filing of tax returns, the Internal Revenue Service announced last week that it has "partnered" with more than a dozen tax-preparation services to provide free online tax-return preparation and e-filing this year. The list, with links, is displayed on the IRS's Web site, www.irs.gov.
Free filing should make electronic transmission of returns more appealing. But a note of caution is in order. The IRS's partners are allowed to set their own eligibility criteria for free filing. So some sites have income limits, other age, others state of residence. In fact, taxpayers under 45 with adjusted gross incomes between about $33,000 and $100,000 who don't live in one of five states, aren't in the military and don't use Form 1040EZ may not be able to find a free site.
And it's worth checking criteria carefully. If you aren't eligible, the preparer may well try to get you as a paying customer, something you may or may not want. Terry Lutes, director of electronic tax administration at the IRS, said the preparers are not allowed to make you buy something as a condition of obtaining free e-filing, but they can try to sell you things if they wish.
Among the things they can offer, but not require, are "refund anticipation" loans. Such loans, marketed as a way of getting your refund quickly, have been widely criticized for their high costs. IRS officials noted that any e-filer who has a bank account and authorizes direct deposit can get a refund in as few as 10 days.
The IRS has scheduled a public hearing for April 19 in Washington on the proposed rules covering cash-balance pension plans. . . . President Bush signed legislation last week retroactively reauthorizing the national flood insurance program; Congress went home last year without extending the program.