By Daniel B. Evans
This article describes the "decoupling" and "recoupling" of the Pennsylvania estate tax from the federal estate tax credit for state death taxes and the issues raised by decoupling by reason of the uniformity clause of the Pennsylvania Constitution.
Before the enactment of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), every state (and the District of Columbia) imposed a tax of at least as much as would be equal to the credit against the federal estate tax allowed for state death taxes under I.R.C. section 2011. (For Pennsylvania, which already had an inheritance tax, the "estate tax" was the excess, if any, of the allowable credit over the inheritance tax already imposed.) This "credit tax" (or "slack tax" or "sponge tax") added nothing to the tax burdens on estates, because if the money had not been paid to the state it would have been paid to the federal government. However, it has been a significant source of revenue for the states.
EGTRRA began the repeal of the federal estate tax by phasing out and repealing the state death tax credit, which is reduced by 25% in 2002 and 50% in 2003, and will be reduced by 75% in 2004, and replaced with a deduction for state death taxes in 2005. According to a May 2002 report of the National Conference of State Legislatures, the annual loss of revenue from the repeal of the state death tax credit will range from $1 million per year (Idaho) to $1.55 billion (California). Faced with these revenue losses, several states have acted to "decouple" their death taxes from the phase-out of the state death tax credit under EGTRRA.
The Pennsylvania legislature is among the legislatures unwilling to accept the reduction in revenues, and the Pennsylvania legislature enacted H.B. 1848 in 2002, which Gov. Schweiker signed into law on June 29, 2002, as Act No. 89 of 2002.
Section 28 of Act 89 amended section 2102 of the Pennsylvania Inheritance and Estate Tax Act (Article XXI of the Tax Reform Code of 1971; 72 P.S. §9101), to add a declaration that all references to the Internal Revenue Code of 1986 are references to the Code "as amended to June 1, 2001." That date is critical, because EGTRRA was signed into law on June 7, 2001. This change, together with conforming changes to section 2117 of IETA (such as changing "is" to "would be") means that the calculation of the Pennsylvania estate tax must now be based on the federal estate tax as it existed before EGRRTA, effective for the estates of decedent's dying after June 30, 2002. See section 34(5) of the Act.
Because the entire Internal Revenue Code is "frozen" as of June 1, 2001, and not just section 2011, the unified credit applicable exclusion amount is also determined under pre-EGTRRA law, so in 2003 the Pennsylvania estate tax applies to estates in excess of $700,000, not $1,000,000. (Because the Pennsylvania inheritance tax will normally exceed the state death credit for a $700,000 or $1,000,000 estate, the difference in the unified credit should only affect those estates will significant assets that are included in the taxable estate for federal estate tax purposes but are not subject to Pennsylvania inheritance tax, such as life insurarance and some retirement benefits. But for a $1,000,000 taxable estate consisting entirely of life insurance proceeds, the "credit tax" under pre-EGTRRA section 2011 would be $33,200.) Death tax calculations could become particularly burdensome after 2004 because estates in Pennsylvania would need to perform three separate determinations: the Pennsylvania inheritance tax, the federal estate tax under EGTRRA (including a deduction for the Pennsylvania taxes paid), and the federal taxable estate and state death tax credit under pre-EGTRRA law (which doesn’t allow a deduction for state death taxes, but would still allow a deduction for qualified family-owned business interests under section 2057). (New Jersey has also “decoupled” its estate tax, and the New Jersey Department of Revenue will apparently require two separate federal estate tax returns, one based on pre-EGTRRA law and one based on post-EGTRRA law.)
Section 28 of Act 89 also changed IETA section 2145 to require a Pennsylvania estate tax return 10 months after the decedent's death, instead of one month after the federal return is filed, and requires either the federal return or a return prescribed by the Pa. Department of Revenue. Those changes are necessary because there can now be a Pennsylvania estate tax even though the estate not large enough to require a federal estate tax return.
But is the "decoupled" estate tax consitutional in Pennsylvania?
Article VIII, section 1, of the Pennsylvania Constitution states that "All taxes shall be uniform, upon the same class of subjects, within the territorial limits of the authority levying the tax, and shall be levied and collected under general laws." Unlike the federal constitution (where the requirement of uniformity is geographical, not quantitative, and progressive tax rates are allowed), the Pennsylvania requirement of uniformity has been held to be a requirement that, once a tax is imposed on a subject, the exact same rate of tax must apply to all instances of the subject.
In holding that a $5,000 exemption from inheritance tax was unconstitutional, the Supreme Court stated:
"A pretended classification that is based solely on a difference in quantity of precisely the same kind of property is necessarily unjust, arbitrary and illegal. For example, a division of personal property into three classes with the view of imposing a different tax rate on each, -- class 1, consisting of personal property exceeding in value the sum of one hundred thousand dollars ($100,000), class 2, consisting of personal property exceeding in value twenty thousand dollars ($20,000) and not exceeding one hundred thousand dollars ($100,000), and class 3, consisting of personal property not exceeding in value twenty thousand dollars ($20,000) -- would be so manifestly arbitrary and illegal that no one would attempt to justify it." Estate of Cope, 191 Pa. 1, 22, 43 A. 79 (1899).
The unconstitutionality of progressive rates was confirmed by the Supreme Court in Kelley v. Kalodner, 320 Pa. 180, 181 A. 598 (1935).
As recently as 1971, the Supreme Court held that Pennsylvania could not impose an income tax based on "taxable income" as defined under the Internal Revenue Code, because the numerous deductions allowed by the federal government (such as mortgage interest, medical expenses, and other personal costs) violated the uniformity clause. Amidon v. Kane, 444 Pa. 38, 279 A.2d 53 (1971).
Judged by these standards, the state death tax credit under section 2011 is hopelessly non-uniform. The credit is calculated from a table of progressive rates, and there is no credit until the tentative tax exceeds the unified credit. So in 2003, the first $700,000 of the estate is exempt from tax (under pre-2001 law) and the taxable estate in excess of $700,000 is taxed at progressive rates from 4.8% up to 16%.
The following chart shows the Pennsylvania estate tax (according to Act 89) payable for different sized taxable estates in the year 2003, the marginal rate of tax for that estate, and the average rate of tax for the estate.
| Taxable Estate | Tax | Marginal Rate | Average Rate |
|---|---|---|---|
| $700,000 | $0 | 0% | 0% |
| $750,000 | $18,500 | 4.80% | 2.47% |
| $850,000 | $25,200 | 4.80% | 2.96% |
| $950,000 | $30,400 | 5.60% | 3.20% |
| $1,000,000 | $33,200 | 5.60% | 3.32% |
| $2,000,000 | $99,600 | 7.20% | 4.98% |
| $3,000,000 | $182,000 | 8.80% | 6.07% |
| $5,000,000 | $391,600 | 11.20% | 7.83% |
| $7,000,000 | $638,000 | 12.80% | 9.11% |
| $10,000,000 | $1,067,600 | 15.20% | 10.68% |
There were challenges to the Pennsylvania estate tax as soon as it was enacted in the 1930s, but those challenges failed because, until Act 89, the Pennsylvania estate tax did not actually cost the estate anything.
"It is unnecessary to continue the discussion along this line [regarding uniformity], however, for none of the points of attack against the Act of 1927, made by appellants are involved in this case, since, as before said, appellants are in no wise injured by any provision of that statute; indeed, so far as the main feature of this act is concerned, it is difficult to perceive how it can harm anyone taking estates or having an interest in estates taxed thereunder, because, in each instance, if the additional tax created by the act was not paid to the Commonwealth, the same amount would have to be paid to the national government, and when paid to the Commonwealth, the amount in question is allowed by the national government to the estate making the payment. As this court said in Gentile v. P. & R. Ry. Co., supra, it is of no moment to complainant whether the amount to be paid goes to one person or another, so long as his liability is not prejudicially altered; the same principle applies here." Knowles's Estate, 295 Pa. 571, 590, 145 A. 797 (1929).
However, because the Pennsylvania estate tax is now being calculated differently than the federal state death tax credit, many estates are being called upon to pay more in estate tax than the credit actually allowed. The following chart shows the additional tax payable (and not allowed as a credit) for different sized estates for years from 2002 through 2006 under Act 89:
| Taxable Estate | 2002 | 2003 | 2004 | 2005 | 2006+ |
|---|---|---|---|---|---|
| $750,000 | $18,500 | $18,500 | 0 | 0 | 0 |
| $850,000 | $25,200 | $25,200 | 0 | 0 | 0 |
| $950,000 | $30,400 | $30,400 | $30,400 | 0 | 0 |
| $1,000,000 | $33,200 | $33,200 | $33,200 | $19,500 | 0 |
| $2,000,000 | $24,900 | $49,800 | $74,700 | $99,600 | $99,600 |
| $3,000,000 | $45,500 | $91,000 | $136,500 | $182,000 | $182,000 |
| $5,000,000 | $97,900 | $195,800 | $293,700 | $391,600 | $391,600 |
| $7,000,000 | $159,500 | $319,000 | $478,500 | $638,000 | $638,000 |
| $10,000,000 | $266,900 | $533,800 | $800,700 | $1,067,600 | $1,067,600 |
Since the enactment of Act 89, estates are being called upon to pay a tax that is more than the credit allowed by the federal government. Therefore, and however indirectly that tax may be defined, Pennsylvania is still attempting to collect a tax that is not uniform.
A court challenge to the "decoupled" Pennsylvania estate tax was filed by the firm of Heckscher, Teillon, Terrill, and Sager, P.C., in the Pa. Commonwealth Court. Estate of Frances H. O'Dell v. Dept. of Revenue, 713 MD 2003, filed 10/16/2003.
In its prayer for relief, the petition in O'Dell asks both for a declaration that the estate is not obligated to pay the additional estate tax resulting from the "decoupling" of Act 89 of 2002 and for a refund of all estate tax already paid (and allowed as a credit by the IRS).
So, if the courts had declared the amended (and "decoupled") estate tax to be unconstitutional, the Commonwealth ran the risk of losing not just the extra tax revenues in excess of the state death tax credit, but the state death credit as well.
The litigation over the constitutionality of the decoupled estate tax became moot on 12/23/2003, because on that day Governor Rendell signed H.B. 200, making it Act No. 46 of 2003.
Act 46 retroactively amended the Pennsylvania estate tax by deleting the definition of "federal estate tax" that was added by Act 89 of 2002 (which defined the federal estate tax as of 6/1/2001 and eliminated the phase-out of the state death tax credit that has been occuring under federal law under EGTRRA of 2001).
So the Pennsylvania estate tax is now once again equal to the federal estate tax credit for state death taxes (and will be phased out along with the phase-out of the credit). And the change applies to the estates of decedents dying after 6/30/2002, which is when the amendment that "de-coupled" the tax took effect, which means that the litigation over the constitutionality of the "de-coupled" estate tax is now moot.
See sections 24 and 33(17) of H.B. 200, pages 79 and 94 of Printer's No. 3160.
Copyright 2003 Daniel B. Evans. All rights reserved. Not legal advice.