Let me first explain the history of the Hawaii inheritance tax and the Hawaii estate tax.  An estate tax is a tax on the property of someone who has died.  The federal death tax is an estate tax. An inheritance tax is a tax on property that is inherited by each beneficiary or heir.  When I first became an attorney in 1976, there was a Hawaii inheritance tax.  I remember preparing Hawaii inheritance tax returns.  Then Hawaii adopted The Estate and Transfer Tax Reform Act of 1983.  When this law was adopted, the Hawaii death tax became an estate tax.  Hawaii’s estate tax was called a “pick-up tax.”  It allowed the State of Hawaii to pick up (or collect) for itself part of the estate tax which the federal government could collect.  The amount that Hawaii could collect was the maximum amount that the federal government allowed as a credit for state death taxes against the federal estate tax.  Later, the federal government passed the Economic Growth and Tax Reconciliation Act of 2001.    This tax act phased out the state death tax credit at the rate of 25% a year starting in 2002.  This meant that the amount of the federal death tax which Hawaii got to keep was reduced each year, until it became zero.  Since 2005, there has been no Hawaii death tax, until now.

The new Hawaii estate tax law is poorly written.  It would be difficult for someone to understand the new law without doing some tax research and without knowing the history of the federal estate tax and the Hawaii estate tax.  When you first read the new law, it sounds like the tax only affects nonresidents who are not citizens of the United States.  After researching the federal and state tax laws referred to, you realize that the new law affects Hawaii residents and citizens as well.

It appears that under the new law, there will be no Hawaii estate tax to pay unless you die with a taxable estate of more than $3,600,000.  Although the new law allows a $3,500,000 tax free amount, when you actually calculate the tax, another $100,000 is tax free, for a total of $3,600,000.   For the first $50,000 over $3,600,000, the tax rate is only .8%.  For those who die with a taxable estate of more than $10,100,000 the tax rate goes as high as 16%.

If a married person with an A-B trust with more than $3,600,000 dies in 2010, since there is no federal estate tax this year, the entire estate would go into the B trust, and nothing would go into the A trust (the marital trust). Everything going into the B trust in excess of $3,600,000 would be subject to the new Hawaii estate tax.  Some or all of that tax could be avoided by changing the trust to cause some assets to go into the A trust.  In 2011 or later years, under current law only $1,000,000 will be exempt from the federal estate tax but $3,600,000 will be exempt from the Hawaii estate tax.  Depending on the size of the estate, there may be tax savings by arranging the estate plan so that some tax is paid when the first spouse dies, instead of deferring all taxes until the second spouse dies.   Anyone with assets large enough to be taxed should have their estate plan reviewed to see if any changes are warranted as a result of the new Hawaii estate tax or the reduction in 2011 of the federal tax free amount to only $1,000,000.

There is no federal estate tax this year.  Since the State of Hawaii has no inheritance tax, Hawaii residents can die this year with any amount of assets and pay no death taxes at all.  This is only for the year 2010.  For someone dying in 2011 or later years, any assets not inherited by a spouse or a charitable organization will be taxed, starting at a tax rate of 41% from the first dollar over 1 million, and going up as high as 55% for amounts over 3 million dollars.

The strange law this year and next year is a result of the 2001 tax act.  The 2001 tax act was supposed to get rid of the estate tax.  The 2001 tax act provided that the amount exempt from estate taxes would be $1,000,000 in 2002 and 2003, $1,500,000 in 2004 and 2005, $2,000,000 in 2006, 2007 and 2008, $3,500,000 in 2009, with no estate tax at all in 2010.  However, the bill that passed Congress contained a “sunset clause.”  The sunset clause provided that unless Congress in the future voted to extend the law, this new tax law would expire after December 31, 2010.  Like Cinderella’s beautiful carriage turning back into a pumpkin, just after midnight on December 31, 2010, the tax law will go back to what it was in 2001, which was that only 1 million dollars is exempt from the estate tax.  Therefore, there is no estate tax, but only for this year.  Remember, however, that Congress and the President can change the law again at any time.

Another important change is in the law regarding the stepped up basis.  (See my October 2009 Estate Planning Insights column about the stepped up basis.  You can find a copy in my blog at www.okuralaw.com.)  The usual stepped up basis rules do not apply in 2010, but will again apply starting January 1, 2011.  The 2010 basis rules are called the “Modified Carry-over Basis” rules.  If a person dies in 2010, the tax basis in the property will be the lower of the basis before the person died, or the fair market value at date of death.  However, the executor can increase the basis of assets owned at death up to the lesser of fair market value or 1.3 million dollars, plus up to the lesser of fair market value or 3 million dollars for property passing to a surviving spouse.  To qualify for the increase in basis, the property has to be in the name of the person who dies, or in her revocable living trust.  Although some experts differ on this issue, it is my opinion that property in which a person dies in 2010 with a life estate will not get a step up in basis.

Another important tax change in 2010 is with Roth IRA conversions.  Using a Roth IRA is a wonderful way to invest.  Although you do not get a tax deduction when you put money into the Roth IRA, it grows tax free, and you can take it out tax free.  You do not have to start taking distributions at age 70 ½.  You can leave part or all of it to children or grandchildren, who can take it out over their entire life, totally tax free!  The law has not allowed Roth IRAs for single persons earning more than $110,000 a year or married couples earning more than $160,000 a year.  However, in 2010, regardless of large income, a person may be able to convert a traditional IRA, 401(k) plan, profit sharing plan, 403(b) plan, 457 plan or even an inherited 401(k) into a Roth IRA.  Income tax must be paid on the conversion, and it could be a huge tax, but thereafter the Roth IRA and its profits are tax free forever.  It is possible to set up a Roth IRA to invest in real estate, private corporations and LLC’s, etc. and there are techniques for legally reducing the taxes payable upon conversion.

© OKURA & ASSOCIATES, 2010

There are some proposed new rules and laws which would affect estate planning.  First, let’s review the current estate tax law.  The estate tax is a federal tax.  At this time there is no Hawaii estate tax or inheritance tax.  As a result of the 2001 tax act, the current estate tax law is very strange.  A person can die in 2009 with up to $3,500,000 of assets without any estate tax.  For amounts over $3,500,000, the estate tax rate is 45%.  In 2010 there is no estate tax at all.  Bill Gates could die in 2010 with 50 billion dollars of assets and pay no death tax!  In 2011 a person can die with only $1,000,000 tax free.  For amounts over $1,000,000, the estate tax rate starts at 41% and goes up to 55% for amounts over $3,000,000.

This strange law was created by Congress in 2001.  At that time, a person could die with $1,000,000 of assets tax free.  The 2001 tax act pretended to get rid of the estate tax.  It gradually increased the amount of assets with which a person could die tax free.  The tax free amount was increased to $1,500,000 for persons dying in 2004 and 2005, $2,000,000 for 2006 through 2008, $3,500,000 for 2009, and then in 2010, there would be no estate tax at all.  However, the bill that passed Congress had a “sunset clause.”  It provided that unless Congress acted to extend the law, this new law would disappear at midnight on December 31, 2010, and on January 1, 2011, we would return to the law which was in effect in 2001 before the 2001 tax act was passed.  Some of the nation’s top estate and gift tax scholars believe that Congress never did intend to get rid of the estate tax.  Congress just pretended they would get rid of the tax, to win political points.

At the end of March 2009, Senate Finance Committee Chairman Max Baucus (D- Montana) made an important announcement.  He announced proposed legislation to be called “The Taxpayer Certainty and Relief Act of 2009.”  The word “certainty” in the title is to reassure the public that we will finally know for certain what the estate tax law is going to be.  The major proposal of the bill is to make permanent the 2009 estate tax, gift tax and generation skipping tax laws.  This means that the bill proposes to keep $3,500,000 as the amount exempt from estate taxes in 2010, 2011 and beyond.  The bill also proposes to index the amount of exemption for inflation.  This means that the amount exempt from estate taxes would increase as the cost of living goes up.  The bill proposes other changes, both in estate tax laws and in income tax laws.  After the details of the proposal are available, I will give you a more complete report on this important bill.  I believe there is a very high probability that Congress will pass changes to the estate tax laws this year.  The reason I believe this is that I don’t think they would want wealthy people to die in 2010 without being taxed.

The Deficit Reduction Act of 2005 was the most sweeping change in 13 years of laws relating to Medicaid for nursing homes.  It was signed into law by President Bush on February 8, 2006.  The State of Hawaii is so slow in implementing it that the new law is still not being followed in Hawaii.  On March 23, 2009, the Department of Human Services finally held a public hearing on proposed changes to the Hawaii Administrative Rules based on the Deficit Reduction Act.  However, when I read the proposed rules, I did not find any rules showing the most important changes made by the federal law.  Therefore, until further notice, we can still get nursing home residents qualified for Medicaid under the less strict older law, which is still being followed in Hawaii.

© OKURA & ASSOCIATES, 2009