Ohio Repealed Its Estate Tax This Year

Ohio repealed its estate tax effective January 1, 2013. (See also here).  Prior to repeal, in 2012, the state level estate tax was 6% on the portion of estates greater than $338,333 but less than $500,000, and 7% on the balance, exclusive of any amount passing to a surviving spouse.  This was not a "pickup tax" of the kind once in effect, in which states were effectively allowed to take a share of federal estate tax collections.  Prior to its repeal, Ohio's estate tax was one of the highest for estates smaller than the federal threshold.

In contrast, in 2012 and 2013 the federal estate tax was imposed on estates over $5,000,000 (plus an inflation adjustment), exclusive of any amount passing to a surviving spouse, at a rate which was 35% in 2012 and is 40% in 2013.  When I started practicing law, the federal estate tax threshold was $600,000. 

In both cases, with proper planning, the amount that can be passed to heirs tax free with only the most minimal of lifetime or testamentary trust arrangements (no longer required in most cases at the federal level), can be roughly doubled for married couples before engaging in any really involved estate planning.

(Of course, it is more complicated than that, but the numbers do reflect a very meaningful difference.)

State Inheritance and Estate Taxes in General

State estate and/or inheritance taxes are found in every Mid-Atlantic and New England state except Vermont.  North Carolina, Tennessee and Kentucky are the only Southern or border states with estate or inheritance taxes.  In the Midwest, Indiana, Illinois, Iowa, Minnesota and Nebraska have them.  In the West, Washington, Oregon and Hawaii have estate taxes.

Details vary.  At both the state and federal levels, inheritance and estate tax rates tend to be on the same order of magnitude as income tax rates for upper middle class to wealthy taxpayers.  State level estate and inheritance taxes frequently impact more estates than the federal estate tax.

The federal estate tax has a quite high threshold of taxation at the moment that excludes from any estate taxation even many multimillion dollar estate of quite affluent upper middle class or even marginally rich decedents, and its current tax rate is quite a bit lower than a top 55% marginal rate with a 60% bubble rate to make up for the benefits of lower rates for much of the early part of my career as a trusts and estates attorney (I also practice in other areas).

An estate tax is formally imposed on the deceased person's assets and collected by the executor.  Whether or not a tax is imposed, and the rate of tax if it is imposed, is typically based on the wealth of the decedent rather than the sized of the inheritance received by an individual.  Estate taxes are usually best views as a tax in lieu of an income tax on heirs consolidated for adminitrative convenience outside the income tax system.  The consolidation of the tax at the decedent's level also makes the decisions someone makes about who to leave their estate to less tax driven (apart from the incentives not to disinherit a surviving spouse). 

Estate taxes also provide a rough justice way to make up for capital gains tax revenues forgone at death by an income tax law that eliminates capital gains taxes on the difference between the purchase price of the asset with certain adjustments and its fair market value on the date of death that would otherwise have had to have been paid by the heirs when the asset was ultimately sold (the rule that applies to lifetime gifts of appreciated assets).

In contrast, an inheritance tax is formally imposed on the person receiving the inheritance.  Inheritance taxes are typically based on how much benefit an individual receives and are lighter on small bequests.  Inheritance taxes also often vary based on the nature of the relationship between the heir and the decedent with closer family typically taxed at lower rates than more distant relations.

Inheritance taxes tend to have much less generous complete exclusions from taxation than estate taxes which tend to focus only on larger estates.  Even Ohio's comparatively very low cutoff prior to 2013 excluded the vast majority of decedent's estate, something that is often not the case with inheritance taxes particularly in the case of an unconventional scheme of distribution to unrelated or distantly related people.  Nebraska, Iowa, Indiana, Kentucky, Tennessee, Pennsylvania, Maryland and New Jersey have inheritance taxes.  Maryland and New Jersey have both estate taxes and inheritance taxes.

Inheritance taxes more close track the tax in lieu of an income tax concept that drives both estate and inheritance taxation, but tend to be viewed as less elegant and more old fashioned approaches from a good government or statutory drafting quality perspective.

Some state estate taxes parallel the federal estate tax and thus require little or no additional planning despite increasing the tax burden on heirs, while many state level estate or inheritance taxes are very different, driving up the costs of compliance in estate planning as two very different sets of rules must be considered simultaneously.

Many states with state inheritance or estate taxes also have more onerous probate court proceedings.

The Invisible Middle Class Estate Tax

Also, every state, or at least almost every state, in order to be eligible for Medicaid funds under federal Medicaid regulations as a result of a 1993 law, has established a Medicaid estate recovery system that seeks to recover Medicaid expenditures (mostly or entirely for nursing home care) from the probate estates of (and via Medicaid liens on real estate during life) from Medicaid beneficiaries.  The basics of the program are summed up in a 2005 white paper.  The current law is basically the same, in broad strokes, as it was in 2005.

According to a 2007 follow up study by the AARP as of that time:

Fifty of the 51 states (including the District of Columbia) have a Medicaid estate recovery program. As of this writing, Michigan had no program, and Georgia was in the process of implementing one. New Mexico reported an inactive program. . . .

Amounts collected through estate recovery represent between 0.01% and 2.09% of total state long-term care Medicaid expenditures, with only six states above 1%. The average proportion has remained constant at 0.61% (FY 2005), compared with 0.63% (FY 2003) two years earlier, as reported in the 2005 study. The amount recovered nationally in FY 2005 was $411,133,981—almost $81 million more than in FY 2003. The average state recovery was $8,061,451, compared with $6,477,206 in FY 2003.

Administrative collection costs to impliment this program have a public sector cost of about 10%-20% of revenues generated.  Of course, this omits the burden this program places on modest income families with fragile elders in nursing homes who subsequently pass with a modest estate in order to plan for and comply with the requirements of the program for hundreds of thousands of families every year.  If the private sector compliance burden is more than even a modest $350 per family, the transaction costs associated with the program are about 50% of the revenue generated.

Some states, however, choose to make collections in these cases a higher priority than others, so in some states the probability that the state will bring recovery claims is a near certainty, while in others, only seemingly egregious cases or just unlikely scapegoats are targeted for recovery actions.

The main battle on this front is between the children of middle class homeowners who receive Medicaid nursing home assistance and have no surviving spouse and Medicaid seeking reimbursement out of the house which was not a disqualifying asset during the receipient's life.  (Medicaid is rarely able to recover from an estate if there is a surviving spouse.)

Retired or nearly retired children who are heirs to a modest middle class house and nothing more are much more likely to lose their inheritance to government coffers than heirs to estates of several million dollars.

The Medicaid estate recovery program affects vastly more people than any federal or state estate tax, produces very modest revenues to state at the cost of high enforcement costs, and drives a lot of legal expenses of middle class and working class families seeking to pass on home equity to their children despite parents who needed nursing home care that they couldn't afford while keeping their homes.

Upper middle class and wealthy families, who typically have long term care insurance and/or significant financial assets, generally don't qualify for Medicaid nursing home coverage and often don't make a serious attempt to engage in the kind of planning that would make it possible to qualify for Medicaid nursing home coverage, because the amounts of money at stake aren't worth the hoops one would have to go through to obtain it. 

This is probably the main reason while the issue isn't a priority for law makers.  Empirically, law makers are very responsive to the concerns of the upper middle class and affluent, but not so attuned to middle class and working class concerns, even if much greater in the number of people affected.  More affluent people are more politically active, contribute to campaigns more often, volunteer more for politicians, are more reliable voters, and are more aware of what their elected officials are doing.  Politics are a luxury that few less affluent people can afford in terms of time and effort, or money for campaign contributions.

UPDATE:  This is a bit stale information from a May 9, 2006 post at this blog but provides some useful specificity by quantifying the issues.  Due to changes in the law since then, far fewer people are subject to federal estate taxes and the revenue generated by them is perhaps half as great.  But, the basic magnitude of the numbers in both cases is similar and the Medicaid nursing home care figures are probably not all that different in 2012 to what they were in 2006.  If anything, more people are subject to its provisions because fewer can afford nursing home care.

There are about 8,000,000 Medicaid nursing home beneficiaries at any given time. About 400,000 estates of Medicaid nursing home beneficiaries face estate recovery actions each year (based on data from Massachusetts on collection rates and national beneficiary numbers, as Massachusetts has 33,000 Medicaid nursing home beneficiaries at any given time and about 1,600 estate recoveries per year).  

In contrast, only 62,000 federal estate tax returns were filed in 2004, of which tax was due on fewer than 30,300. The Medicaid number will be larger, and the estate tax number will be smaller in 2006, due to an aging population increasing Medicaid enrollments, and increased estate tax exemptions reducing estate tax filings, in 2006.  

Yet, the estate recovery program produces far less revenue. Nationwide, the estate recovery program recovers only about $362 million a year, about 1% of the collections of the estate tax and only about 0.8% of Medicaid nursing home spending. The average estate tax return where an estate tax is due produces about $1,000,000 in federal revenues. The average Medicaid estate tax recovery results in about $1,000 of revenue, although the bite is harsher in a significant minority of case that not infrequently result in the loss of homes and farms.

Ending the Medicaid nursing home estate recovery program should be an area where Democrats and Republicans can agree.