Burying the "death" tax
Virginia is among a minority of states taxing inherited wealth. Will it kill off the tax in 2006?

by Dena Sloan
Virginia Business
December 2005

Even with the wave of hurricanes that have pounded Florida, the Sunshine State remains an appealing place to call home for wealthy Vir-ginians. The balmy weather is an obvious draw. Plus, it’s cheaper to pass on an inheritance. Florida doesn’t impose an estate tax or an individual income tax for that matter — a strong incentive for some Virginians to establish legal residency. Indeed, some high-worth executives have already made the move for tax purposes.

For some, the exodus started after President George Bush’s 2001 tax cut. Following the reform — which called for a gradual phase out of the estate tax through 2010 and its revival in 2011 unless there’s a permanent repeal — changes wiped out credits against federal estate tax bills. Consequently, amounts paid by inheritors in state estate bills couldn’t be shaved off the amount owed to Uncle Sam. So some states went ahead and repealed the hated “death” tax, leaving only about 20 states that still impose a levy on inherited wealth, including Virginia.

Hopes are running high that 2006 might be the year Virginia puts the estate tax to rest. Republicans passed a bill to repeal the tax in 2003, but Democratic Gov. Mark R. Warner vetoed it, and the GOP couldn’t find enough votes to override the veto. Come January’s General Assembly session, things might play out differently. Newly elected Democratic Gov. Timothy M. Kaine supports phasing out the tax as the federal estate tax is eliminated so that small family farms can more easily be passed on to the next generation.

Steve Horton, a lobbyist with McGuireWoods Consulting, has pushed for the tax’s repeal since the first bill was introduced in 2002. “It’s very encouraging the level of support we’ve gotten. For the first time … it looks like we’ll have a governor who’s not going to support continuing the death tax,” he says.

Currently the estate tax is levied on estates valued at $1.5 million or more. Spouses are exempted from paying the tax. Of the 2,078 Virginia estate tax returns filed during fiscal 2004 (when the exemption limit was $1 million), 1,018 reported liability. Estates of $1.5 million and more made up about one-third of all those with an estate tax liability. They generated almost $123 million in state revenue, about 82 percent of a total collection of $150 million in estate taxes.

Overall, the estate tax brings in about 1.4 percent of the General Fund taxes collected by the state’s tax department. Nationally, the figure is the same, 1.4 percent of total federal receipts. However, with the aging of the baby boomers, this small stream of income has the potential to become a tidal wave as one of the country’s largest demographic groups dies off.

Virginia’s estate tax rates have remained the same since 1980, but the Economic Growth and Tax Relief Reconciliation Act of 2001 changed the way Virginians are taxed. John P. Josephs Jr., senior tax policy analyst at the Virginia Department of Taxation, says the decedent’s estate in every state used to receive a dollar-for-dollar credit against its federal estate tax bills for the amount it paid in state estate tax, up to a set limit. So if an estate in Virginia owed $50,000 to the federal government and $10,000 to Virginia, the executor could deduct the $10,000 from the $50,000 bill. Virginia and many other states set up their system so that each state’s tax qualified for the federal credit and did not increase an estate’s tax bills, explains Josephs.

When the Bush tax cuts took effect in 2002, estates began receiving only a partial credit for their state estate tax bills. By 2005, that credit was switched to a deduction. Now, instead of that $10,000 being shaved off the $50,000 bill, it is deducted from the total value of the estate being taxed. As a result, estates of people who die in states with estate taxes wind up paying more than the estates of those who die in states without the tax. And when an individual’s estate is worth a couple million dollars, that difference can cost inheritors big bucks.

“With the cost of dying in Virginia going up,” says Richmond lawyer Lou Mezzullo, wealthy clients who already have second homes in Florida and other states without an estate tax, are changing their legal residences. “...It's easy to do by spending more time in that state,” explains Mezzullo, a partner with McGuireWoods LLP. Florida is especially popular, he adds, and a “more than insignificant” number of his high net worth clients have opted to become Floridians for tax purposes.

But not everyone can pick up and move to shield inheritors from paying estate taxes. Robert Hall’s family has been farming about 2,000 acres in Virginia’s Northern Neck for more than 100 years. The corn and soybean farmer estimates his family members have paid millions of dollars in estate tax bills as relatives die and pass on their land to family members. Some of the land fronts a local river, driving up the property’s value. “I might be a millionaire, but I can't live like a millionaire,” says Hall.

Arguments regarding the estate tax have remained the same for years. Opponents say it unfairly taxes assets twice, discourages saving, and forces owners of farms and small businesses to sell their assets. Supporters claim that it’s a progressive way to raise needed revenue from those with the greatest ability to pay, and encourages charitable giving. In Virginia, the tax affects very few family farms and small businesses, according to the state’s tax department.

The initiative to ban the tax in Virginia began in 2002 after Virginia Beach Republican Del. Bob Tata got a letter from a retired constituent who suggested its repeal. Tata has submitted the same legislation every year since, and each time it’s been struck down. The political climate, however, appears to be shifting. Some of the Democratic senators who supported Warner’s 2003 veto now say they would vote to abolish the tax, citing a stronger state economy. Virginia expects to end the fiscal year with a $544 million surplus. Members of the House and Senate say they’ll reintroduce bills to eliminate the tax.

Although tax opponents will likely find more support in the governor’s office, they still need to get their measures through the Senate Finance Committee and its powerful chairman, Sen. John Chichester, a fiscal conservative from Northumberland County. Chichester supports the principle of abolishing the estate tax but says that it’s premature to decide how he would vote on such a bill. “I’m never sure what my vote is going to be on any bills before I see them.”

Even if state lawmakers banish the tax, some estate planning professionals say it won’t dramatically change the way they handle clients’ finances. Estates will still be subject to the federal tax for the next couple years, so financial professionals will continue using trusts and other vehicles to minimize tax liability.

Though the 2001 tax cuts have caused complications, they saved some beneficiaries from paying any taxes. The legislation has gradually raised the exemption limit on inherited wealth from $675,000 before 2001 to $2 million in 2006 and $3.5 million by 2009. For a married couple that does proper planning, an amount double the exemption can be passed tax-free to beneficiaries, says Tom Nolan, a lawyer with Virginia Estate Plans PLC in Charlottesville.

Rising exemption limits can simplify some customers’ financial plans, says lawyer Farhad Aghdami of the Richmond office of Williams Mullen. That’s because they enable professionals to unravel complicated trusts and other structures originally set up to protect assets from taxation. With less time spent figuring out how to avoid and minimize taxes, there’s more opportunity to work with clients on specific needs and requests. “We're getting a lot more descriptive of how and when assets are distributed to beneficiaries,” Aghdami says. “That’s really been a lot of fun.”

A lingering question is the uncertainty of what will happen to the federal estate tax. Unless Congress repeals it, the tax is scheduled to return in full force in 2011 with the original exemption limit of $1 million and a top statutory rate of 55 percent. Despite talk in Republican circles of permanent repeal, the mounting costs of the war in Iraq and Gulf Coast hurricane recovery could scuttle those plans.

If the federal tax is eliminated, Virginia’s tax would probably disappear, too, since the state tax is linked to the value of the estate taxed by the feds. In view of all the uncertainty, Charlottesville lawyer Nolan says it’s better to plan with the expectation that the levy will be around for a while. That way if Virginia does kill off the inheritance tax, it will come as an unexpected gift from a distant relative — sweet, but not something that can be counted on.