Ka Wai Ola - Office of Hawaiian Affairs, Volume 5, Number 10, 1 ʻOkakopa 1988 — Some Inevitable Taxes [ARTICLE+ILLUSTRATION]

Some Inevitable Taxes

Ta.\cs and Yon

By Lowell L. Kalapa, Director Tax Foundation of Hawaii

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Although we often hear advice on how we ean reduce the amount of ineome taxes we have to pay to the federal and state government, we often overlook one tax that we all may have to pay. This tax is the one imposed on the property we leave behind

after we die. While we don't like to think about the inevitable passing, estate taxes are somethingthat must be dealt with, like it or not. While situations and circumstances differ, let's look at the federal and state death taxes and leam a little bit about them. For many years, the State of Hawaii had both an inheritance and an estate tax. The difference between the two is that the inheritance tax was imposed on the beneficiary or the person who received a gift of property from the estate of the deceased. On the other hand, an estate tax was imposed on the entire estate of the deceased.

In fact, Hawaii had a form of inheritance tax as far back as 1892 although an inheritance tax law was not formally adopted until 1905. The first tax exempted members of the immediate family from any inheritance tax while imposing a tax of $5 for every $100 of property for other beneficiaries. The 1905 law continued to recognize the relationship of immediate family members and imposed a 2% tax on any bequest in excess of $1,000 to an immediate family member while another had to pay a rate of 5 percent on anything in excess of $500.

While various changes were made to the amounts subject to inheritance taxes, it is significant to note that in 1931, Hawaii added an estate tax. The estate tax amounted to a recapture on any difference between the Hawaii inheritance tax and the credit the federal estate tax allowed for state death taxes. Basically, the Hawaii death taxes remained the same until the Congress undertook a massive overhaul of this tax. The Eeonomie Recovery Tax Act of 1981 updated the federal law in recognition that both inflation and time had made the schedule of federal exemptions and rates very out-of-date. In 1982 the state legislature looked at the federal law and thought they could merely amend the state inheritance tax and grant parity with the federal law. In a year's time they realized that there was still a disparity in benefits between the state and federal law.

As a result, the 1983 legislature undertook a complete re-write of the state inheritance tax law, doing away with the inheritance tax and adopting only an estate tax. The state law now is simply a matter of calculating what the federal credit allowed for state death taxes and paying that to the state tax department. If no federal tax is due, then there is no state estate tax due.

So the real focus on taxes as a result of a death is at the federal level. Since its ineephon, the federal estate tax has been designed largely to capture great amounts of wealth that pass from one generation to another. Generally, the rates under the federal estate tax recognized small transfers of property by imposing lower tax rates with the rates graduated so that at the high end, the rates took a substantial portion of the transfer. For nearly 40 years prior to 1976, the federal estate tax rates started from a low of 3 percent of the first $5,000 transferred to a high of 77 percent of any estate greater than $10 million. There was a separate gift tax rate schedule whieh was imposed on gifts made during a person's lifetime and these rates ran from 2.25 percent on gifts of $5,000 or

less to a high of 57.75 percent on gifts greater than $10 million. In 1976, the estate and gift tax schedules were combined and the rates were set at 18 percent on *transfers of less than $ 10,000 and 70 percent of any transfers greater than $5 million. While this schedule sounds worse than what it replaced, it should be noted that along with this new rate schedule eame a tax credit such that the first $175,000 of an estate would be exempt from the tax. Thus, the philosophy of imposing the tax largely on substantial amounts of wealth continued.

The Eeonomie Tax Reform Act of 1981, better known as ERTA, completely revamped the federal estate tax. One of the biggest changes was to exempt any and all transfers between spouses from the estate tax. Thus, property transferred to a surviving spouse escapes the estate tax. Further, a substantial tax credit was phased in over a period of years such that estates of persons dying after 1987 will escape the tax if the value of the estate is less than $600,000. Before anyone runs out and plans to transfer their assets or estate to their spouse upon death, there are some pitfalls that should be avoided. For example, it might seem all right to do that at the time of death, but what happens when the surviving spouse passes away? Should the estate at the time of death of the first spouse be worth $400,000 whieh represents one half of all the property the eouple owned jointly for a total ownership of $800,000, transferring the first spouse's interest to the surviving spouse would merely delay the day of doom for the federal estate tax.

Under the current tax law, the first spouse's estate would be entirely exempt since it is less than $600,000. If the $400,000 of assets be transferred to the surviving spouse, upon that spouse's death, the estate would be worth a minimum of $800,000 of whieh at least $200,000 would be subject to the federal estate tax. If on the other hand, the first spouse gives his share to his children or grandchildren, the likelihood of ever being exposed to the federal estate tax would be minimized. The surviving spouse's estate would not be increased by her spouse's half and at the minimum would be worth less than the $600,000 exempted by the federal estate tax law.

The surviving spouse may also wish to reduce the size of her estate by giving away part of it over a period of time. Under the federal law, annual gifts of $10,000 or less may be made and excluded from estate and gift taxes. This exclusion applies to eaeh gift per recipient. Thus, if the surviving spouse in the above example had two children and four grandchildren, up to $60,000 could be given per year with no more than $10,000 being given to eaeh child or grandchild. These numbers are all staggering and you may not think that the estate tax could apply to you. This is a very eommon misconception. Estate planners, lawyers and tax practitioners all suggest that people should sit down and take an account of what they own. Real property, such as your home, is a major contributor to the value of an estate.

Too often people overlook the real market value of their house and lot. Or for that matter many Hawaiians who still retain their ancestral lands or ahupua'a do not recognize the value that may be assigned to the property upon the owner's death. That shack at the beach may be just that, a shack, but the value of the property will be assessed as if it were sold even if you have no thoughts of selling it. If there is anything you should do when you are pau reading this eolumn, it should be to take an aecounting of what property you may leave behind should you pass away. Not only are there legal problems, but in the long run there may be substantial tax consequences.