$3.5 Million Federal Estate Tax Exemption for 2009 Could Mean Higher State Death Taxes


The federal estate tax exemption increases from $2 million to $3.5 million for deaths occurring in 2009. But for taxpayers who do not plan properly, this could mean an increase in state death taxes. Why?

The Tax Act passed in 2001 replaced the federal state death tax credit with a deduction, starting in 2005. As a result, many states that imposed a death tax equal to the federal credit decoupled their tax systems from the federal tax system, and began to impose a stand-alone death tax. Many states now only allow an exemption of $1 million (the amount of the federal exemption in 2001, when the Tax Act was passed) or less.

Many married couples have an estate plan designed to postpone estate taxes until the death of the second spouse. For example, an amount equal to the federal exemption passes free of federal estate tax to children (or first to a trust for the benefit of the surviving spouse). The balance of the estate passes to the surviving spouse free of federal estate tax under the unlimited marital deduction. This formula works as long as the federal exemption is the same as the exemption allowed by the state in which the decedent lived. However, if the federal exemption is greater than the state exemption, the difference may become subject to state death taxes. With the federal exemption amount increasing in 2009, more married couples may be vulnerable to higher state death taxation.