Federal Tax Relief Federal Taxes Paid by Estates, Because Act Alters Federal Estate Tax Law the Pick-Up Tax Reduces, Dollar in Three Major Respects

DIVISION OF LEGISLATIVE SERVICES V I R G I N I A L E G I S L A T I V E ISSUE BRIEF N U M B E R 2 3 J U N E 2 0 0 1

owed is the “unified credit,” a all of the other states’ laws in Federal Tax single credit applicable to both one major respect. Section estate and gift taxes. (For 58.1-901 of the Code of Virginia Relief Act purposes of this article, the states that the amount of the gift tax aspects will not be federal credit shall not “be less than the federal credit allowable DAVID A. ROSENBERG discussed). Currently, this by § 2011 of the Internal Rev- MARK J. VUCCI credit effectively exempts the enue Code as it existed on SENIOR ATTORNEYS first $675,000 of the taxable estate. In other words, no January 1, 1978” (Emphasis federal estate tax is owed on added). The other states (except taxable estates worth for New York and Washington) On June 7, 2001, President $675,000 or less. The amount accept the amount of the federal Bush signed into law the of this unified credit (prior to credit as it exists in federal law Economic Growth and Tax the new federal law discussed at the time of the decedent’s Relief Reconciliation Act of below) was scheduled to gradu- death. (The importance of this 2001, which generally will ally increase to $1 million by difference is discussed in the become effective on January 1, 2006. section of this article titled 2002. This article discusses “Impact on Virginia.”) certain effects that the Act will Virginia have on the Commonwealth’s In the fiscal year ending estate tax and individual June 30, 2000, the Common- income tax. Virginia’s estate tax oper- wealth collected $150.1 million ates to impose a tax in an in estate taxes. amount that equals the maximum amount of the federal Estate Tax credit. This state tax, referred New Federal Law to as a “pick-up” tax, has Current Law never increased the total The new federal Tax Relief Federal taxes paid by estates, because Act alters federal estate tax law the pick-up tax reduces, dollar in three major respects. for dollar, the amount of Federal estate tax laws federal estate taxes due. In 1. It reduces the amount of the provide taxpayers with a credit other words, if Virginia did not federal credit (i.e., pick-up against federal estate taxes collect the tax, the federal tax) beginning January 1, owed in the amount of state government would. 2002, by 25 percent each estate taxes paid, not to exceed year until it no longer exists certain maximum amounts. Not surprisingly, all states, on and after January 1, These maximum amounts are as well as the District of 2005. Beginning January 1, calculated according to a Columbia, impose a pick-up 2005, the credit is replaced formula that increases the tax. Virginia, 37 other states, by a deduction that reduces amounts according to the size and the District of Columbia the value of the estate of the taxable estate. In no impose the pick-up tax as the subject to the federal estate event, however, can the only state death tax. The tax in an amount equal to all amount of this credit exceed other 12 states impose the state death taxes actually the amount of federal estate pick-up tax in addition to a paid. taxes owed. separate state estate tax or inheritance tax. 2. It increases the exclusion In this regard, one of the amount used to compute the major determinants in the Virginia’s estate tax law, unified credit to $1 million amount of federal estate taxes however, differs from almost Issue Brief 2 Number 23 June 2001

in 2002 and gradually Virginia ties Virginia’s Taxation is in the process of increases the credit appli- definition of the amount of calculating an estimate of cable to estate taxes to $3.5 the federal credit for pur- the amount of this reduc- million by 2009. poses of determining the tion. amount of Virginia estate 3. It completely repeals federal taxes, to the maximum ■ Repeal of the federal estate estate taxes in 2010. amount of such credit as tax — The triggering event provided under the federal for the imposition of the law as it existed on January Virginia estate tax is the The federal Act provides that 1, 1978. Accordingly, con- “transfer of the taxable all of these changes will sunset trary to the results in most estate.” Section 58.1-901 of in 2011 unless reenacted by other states, reductions to the Code of Virginia states Congress. the credit under the new that “‘taxable estate’ means federal law will not reduce ‘taxable estate’ as defined in Impact on Virginia the credit as currently § 2051 of the United States defined by Virginia, and Internal Revenue Code of The three major changes to thus will not reduce the 1954, as amended or re- federal estate tax laws will amount of tax imposed by numbered, or the successor affect Virginia estate taxes as the Commonwealth. provision of the laws of the follows. United States.” Unlike the Under such circum- Virginia definition of “fed- ■ Reduction of federal credit stances, however , the eral credit,” which has a — Under current Virginia Commonwealth’s estate tax “fixed” conformity date with law, the gradual reduction of no longer would be a pure federal law of 1978, the the federal credit beginning “pick-up” tax. That is, to the Virginia definition of “tax- January 1, 2002, and its extent the amount of able estate” changes as the elimination on January 1, Virginia’s estate tax ex- federal law changes (“rolling 2005, will not affect ceeds the new reduced conformity”). Accordingly, Virginia’s estate tax rev- federal credit, it will consti- when the federal estate tax enues. As mentioned, § tute an amount that other- is repealed in 2010 there 58.1-901 of the Code of wise would not have been will no longer be any “tax- paid to the federal govern- able estate.” As a result, ment. This situation has under current Virginia law, not occurred previously in 2010 there will be no because the federal credit “transfer of the taxable formula has remained the estate,” and therefore no same since 1978. Thus, if imposition and collection of the General Assembly the Virginia estate tax. wishes to phase out Virginia’s estate tax on the Of course, all of these results same schedule as that for will be negated beginning in Virginia Legislative Issue Brief is the federal credit, then 2011 unless Congress repeals an occasional publication of the legislative action is re- or extends the 2011 sunset Division of Legislative Services, quired. date. an agency of the General Assembly of Virginia. ■ Increase in unified credit — The gradual increase in the E.M. Miller, Jr., Director credit to $3.5 million by Individual Income Tax R.J. Austin, Manager, Special Projects 2009 will reduce Virginia’s K.C. Patterson, Editor estate tax revenues more Virginia is one of 35 states For information contact: than they would have been that, in one form or another, reduced under the current conforms its individual income Special Projects Division of Legislative Services schedule that would gradu- tax laws to federal individual 910 Capitol Street, 2nd Floor ally have increased the income tax laws. This means Richmond, VA 23219 credit to $1 million by 2006. that (i) Virginia applies the (804) 786-3591 The Virginia Department of federal definition of “income” http://dls.state.va.us/ Issue Brief 3 Number 23 June 2001 and other terms in administer- ried persons) may deduct up to 2002, by allowing the interest ing its individual income tax $2,000 in qualified higher educa- deduction for any year in which laws; and (ii) the starting point tion expenses. This deduction interest is paid on a qualified for calculating Virginia indi- ends in taxable year 2005. education loan and by changing vidual income tax is the income the adjusted gross income ceil- amount (federal adjusted gross Qualified higher education ing from $55,000 or less to $65,000 income) reported on the expenses include tuition and fees or less ($130,000 for married per- taxpayer’s federal income tax required for the enrollment or sons). return. Thus, any changes to attendance of the taxpayer, the federal adjusted gross income taxpayer’s spouse, and in certain III. Expansion of the Tax- provided for under the Tax cases the taxpayer’s dependent Relief Act will also impact for courses of instruction at an Exempt Status of Virginia’s individual income tax institution of higher education Education IRAs revenues. (an accredited post-secondary educational institution). The term Current Federal Law Many provisions of the Tax does not include student activity Relief Act operate to reduce fees, athletic fees, insurance ex- federal adjusted gross income. penses, meal expenses, room and Education Individual Retire- Following is a discussion of board, and other expenses unre- ment Accounts (education IRAs) several of these provisions, lated to an individual’s academic are tax-exempt under federal income tax law. An education IRA which are expected to signifi- course of instruction. cantly reduce federal individual is a trust created exclusively to pay the qualified post-secondary income tax revenues. These II. Expansion of Deduction for provisions taken as a whole (or educational expenses of the ben- perhaps even individually) may Interest on Education Loans eficiary of the trust designated by also have a significant negative the person making contributions impact on Virginia’s individual Current Federal Law to the trust. income tax revenues. Contributions to the trust are Federal income tax laws cur- invested. Unlike the trust itself, I. New Deduction for Qualified rently provide a deduction for in- earnings from investment of the Higher Education Expenses terest paid during the taxable year contributions are generally in- on qualified education loans. In cluded in federal adjusted gross Under the Tax Relief Act, tax- computing federal adjusted gross income at the time they are dis- payers are allowed a new deduc- income, individuals with an ad- tributed (this is similar to the tax tion for qualified higher educa- justed gross income of $55,000 or treatment for other earnings, tion expenses paid in a taxable less ($75,000 or less in the case of such as interest on bank savings year. In computing federal ad- married persons) may deduct up accounts). However, earnings of justed gross income, individuals to $2,500 in interest paid on quali- an education IRA are excluded with an adjusted gross income of fied education loans. A qualified from federal adjusted gross in- $65,000 or less ($130,000 or less education loan generally is any come if, in the year of distribu- in the case of married persons) indebtedness incurred on behalf tion, the total amount distributed will be able to deduct up to $3,000 of the taxpayer, the taxpayer’s from the education IRA (contribu- in each of taxable years 2002 and spouse, or the taxpayer’s depen- tions plus earnings) is less than 2003 for qualified higher educa- dent to pay the cost of attendance the post-secondary educational tion expenses. In each of taxable at an institution of higher educa- expenses of the beneficiary. years 2004 and 2005, individuals tion (an accredited post-second- with an adjusted gross income of ary educational institution). The Qualified educational ex- $65,000 or less ($130,000 or less deduction is allowed only during penses for which an education in the case of married persons) the first five years of repayment IRA may be established include may deduct up to $4,000 in quali- of the qualified education loan. tuition, fees, books, supplies, fied higher education expenses, equipment, and room and board. and individuals with an adjusted New Federal Law The maximum amount that can gross income greater than be contributed on behalf of each $65,000 but less than $80,000 The Tax Relief Act expands beneficiary is limited to $500 per (greater than $130,000 but less the potential use of the current year, and contributions may not than $160,000 in the case of mar- deduction beginning January 1, be made on behalf of persons 18 Issue Brief 4 Number 23 June 2001 and older. Furthermore, only in- increase in the usage of educa- V. Increase in Allowable dividuals with an adjusted gross tion IRAs means that more Contributions to Traditional income of $110,000 or less earnings on IRA contributions Individual Retirement ($160,000 or less in the case of will be permanently excluded married persons) can contribute from federal adjusted gross Accounts and Tax-Deferred to an education IRA. income and therefore from the Retirement Plans Virginia individual income tax New Federal Law base. Current Federal Law

Under the Tax Relief Act, Federal income tax laws along with qualified post-sec- IV. Extension of the provide certain tax preferences ondary educational expenses, Exclusion for Educational to encourage taxpayers to qualified elementary and sec- Assistance Provided contribute to individual retire- ondary school expenses may ment savings plans such as also be paid using tax-free by Employers IRAs and tax-deferred retire- distributions from an education ment savings plans. These IRA. Qualified elementary and Current Federal Law preferences include allowable secondary school expenses deductions for contributions (in include tuition, fees, academic Under present law, the first computing federal adjusted tutoring, special need services, $5,250 of educational assis- gross income) and the deferral books, supplies, and other tance provided to an employee of income tax on certain salary equipment incurred in connec- by his employer (generally, and other compensation that is tion with the attendance of the payment of the employee’s contributed to a retirement beneficiary at a public, private, tuition, fees, books, supplies, savings plan. or religious school providing and equipment for a course of elementary or secondary educa- instruction) is excluded from Individuals may contribute tion (grades kindergarten the employee’s federal adjusted up to $2,000 a year to a tradi- through 12). The term also gross income. The educational tional (excluding Roth and includes computer technology, assistance must be related to a education IRAs) IRA. The computer equipment, and written plan of the employer annual contribution limit is Internet access and related that provides educational $4,000 for married persons. services to be used by the assistance to his employees. The amount contributed to a beneficiary during any of the The $5,250 exclusion does not traditional IRA may be deducted years the beneficiary is in apply to educational assistance by the taxpayer in computing school. for graduate level courses. federal adjusted gross income. Moreover, the exclusion is set The Tax Relief Act also to expire on December 31, 2001. In addition, taxpayers may increases the maximum defer federal income tax on amount that can be contributed salary and other compensation on behalf of each beneficiary New Federal Law that is used to make contribu- from $500 per year to $2,000 tions to § 401 (k) plans (em- per year. Finally, the adjusted The Tax Relief Act makes ployer matching contribution gross income ceiling applicable the exclusion permanent and plans) or § 457 plans (state and to married persons is increased applicable to educational assis- local government deferred from $160,000 or less to tance for both graduate level compensation plans). In these $220,000 or less. and undergraduate courses. cases, the federal income tax is This will allow employees a deferred until the time the The practical effect of these permanent and expanded contributions and earnings are changes, which are effective exclusion for educational withdrawn from these retire- beginning January 1, 2002, is assistance provided by their ment savings plans. Both the to expand the use of education employers, which is otherwise contributions and any earnings IRAs in paying for certain taxable income. are subject to federal income educational expenses. An taxes when withdrawn. The deferral of federal income tax on Issue Brief 5 Number 23 June 2001 such compensation also results decrease in the TABLE 2 in a deferral of Virginia indi- amount of income vidual income tax, as such reported as federal Maximum Annual Contribution compensation is generally adjusted gross in- to § 401 (k) and § 457 Plans* included in federal adjusted come will result in gross income at the time of a decrease in Vir- Maximum Annual withdrawal (i. e., when the ginia individual Tax Year Contribution taxpayer is ready to retire). income tax revenues. 2002 $11,000 The maximum that a taxpayer may contribute per year The Tax Relief 2003 $12,000 to a § 457 plan is the lesser of Act also increases 2004 $13,000 $8,500 or 33.3 percent of his the maximum 2005 $14,000 compensation. The maximum yearly contribu- annual contribution allowed to a tion to § 401 (k) and 2006 $15,000 § 401 (k) plan is $10,500. § 457 plans, as 2007 and $15,000** shown in Table 2. beyond New Federal Law Thus, taxpay- *These are general maximum limits for each individual ers will be allowed ** The $15,000 is indexed in $500 increments for inflation. The Tax Relief Act increases to defer federal the maximum yearly contribu- income taxes on more of their known as itemized deductions tion to a traditional IRA and salary and compensation. This and are subtracted from federal allows a higher maximum also means that the Virginia adjusted gross income. Item- contribution for persons 50 and individual income tax would be ized deductions reduce the older, as shown in Table 1. deferred to a later date on such amount of an individual‘s salary and compensation. income that is subject to federal These new limits increase the income taxes. amount that may be deducted for traditional IRA contributions in VI. Increase in the While itemized deductions do computing federal adjusted gross Maximum Amount of not factor into federal adjusted income. As discussed above, any Itemized Deductions gross income (the starting point in determining Virginia indi- Current vidual income tax), the TABLE 1 Federal Law Commonwealth’s income tax Maximum Annual Contribution laws allow Virginia citizens an income tax deduction equal to for Traditional IRAs* Federal income tax laws either a standard amount or the amount reported as itemized Tax Year Under Age 50 50 and older provide for deductions from federal deductions on the individual’s 2002 $3,000 $3,500 adjusted gross federal income tax return. (The income for an standard deduction for Virginia 2003 $3,000 $3,500 individual’s individual income tax purposes 2004 $3,000 $3,500 unreimbursed is $3,000 for individuals and $5,000 for married persons.) 2005 $4,000 $4,500 expenses, includ- ing Thus, any change in federal law 2006 $4,000 $5,000 unreimbursed affecting itemized deductions 2007 $4,000 $5,000 medical ex- will also impact Virginia’s penses, mortgage individual income tax rev- 2008 $5,000 $6,000 interest, state enues. 2009 and $5,000** $6,000*** and local taxes, beyond charitable contri- New Federal Law butions, and certain employee *These are general maximum limits for each individual expenses. These The Tax Relief Act allows ** The $5,000 is indexed in $500 increments for inflation. certain taxpayers an increase *** The $6,000 is indexed in $500 increments for inflation. deductions are Issue Brief 6 Number 23 June 2001 in the amount of itemized deductions that they currently can claim on their federal income tax return. This is TABLE 3 accomplished by repealing the Reductions in Allowable current overall limitation on Itemized Deductions the amount of itemized deductions that may be claimed on a Required federal income tax return. Current federal law provides Tax Year Reduction that the amount of otherwise 2001 - 2005 3%* allowable itemized deductions is reduced by three percent of the 2006 & 2007 2% amount of an individual’s 2008 & 2009 1% federal adjusted gross income Repealed in excess of $66,475 ($132,950 2010 and in the case of married persons). beyond The Tax Relief Act repeals this required reduction over a five *No change from current law. year-period beginning in 2006, as shown in Table 3.

Repealing the overall limita- Summary enues. The Department of tion on itemized deductions will Taxation will be developing a allow certain taxpayers to claim The Economic Growth and fiscal impact statement on the more in itemized deductions on Tax Relief Reconciliation Act of specific state revenue implica- both their federal and Virginia 2001 contains several provi- tions resulting from the new individual income tax returns. sions that could significantly federal tax legislation. This This will tend to decrease both impact Virginia’s estate and information will be reported as federal and Virginia individual individual income tax rev- soon as it is available. income tax revenues. Summary of Fiscal Impacts on Virginia Economic Growth and Tax Relief Reconciliation Act of 2001

2000-02 (Current) Biennium: Small $1.4 million 2002-04 (Next) Biennium: Larger $83.3 million

Fiscal Impact ($millions)

Item 2002 2003 2004 2005 2006

Eliminate limit on itemized deduction 0 0 0 0 -7.4 Benefits for children 0 -0.1 -2.5 -2.5 -2.6 Education provisions 0 -14.7 -21.7 -27.5 -37.8 Estate tax 0 -8.6 -11.5 -16.1 -15.0 Pension and IRA -1.4 -8.7 -15.5 -20.7 -27.5

Total -1.4 -32.1 -51.2 -66.8 -90.3

Source: Virginia Department of Taxation