The Fall and Rise of
Washington State Estate Tax

Washington State taxpayers collectively held their breath earlier this year as the court case, Estate of Hemphill, made its way to the Supreme Court of Washington for review. On February 3, 2005 the Court ruled, unanimously and decisively, in favor of the taxpayer in the class action lawsuit against the State of Washington Department of Revenue. Their ruling deemed the current estate tax invalid. Estates of individuals dying after December 31, 2001 that paid Washington estate tax in excess of the federal estate tax credit are not only entitled to refunds of this excess, but also interest on those refunds. It appeared that the estate gods smiled on us, and Washington State taxpayers were off scot-free!

But the estate gods are a fickle bunch. No sooner had Washington taxpayers brought out the party supplies did the rain start. On May 17, 2005 Governor Gregoire signed into law a new estate tax. The new tax is meant as a replacement of the previous tax, without mirroring it too closely. The tax draws on language that establishes this tax as a "stand-alone" tax, separate in nature from our federal estate tax. Doing so increases the likelihood that this tax will stand up to the Court scrutiny that brought down its predecessor. That being said, our new law incorporates many of the same provisions of the federal estate tax written in the Internal Revenue Code as of January 1, 2005.

Who does this tax affect? According to the Department of Revenue website, approximately 200 estates will be affected in 2005, 210 in 2006 and 220 in 2007. This represents about onehalf of one percent of all deaths. The tax is expected to generate about $100 million per year, increasing slowly over time, to benefit the Education Legacy Trust Fund. On evaluation of these facts, one might find it curious how the Department came to their estimate for affected estates!

Specifically, the tax affects Washington State residents and anyone owning real property in Washington State who died on or after May 17, 2005 with a taxable estate of more than $1.5 million in 2005, or $2 million in 2006. However, these threshold amounts are deducted from the taxable value of the estate, and tax is due only on the remaining amount. The tax rates range from 10% to 19%, with the highest bracket being reached at a taxable estate of $9 million. Washington estate tax paid is deductible as an expense on your federal estate tax return, effectively reducing the Washington State rate to between 5.5% to 10.5%.

The unlimited marital deduction available for federal estate tax purposes should also be available at the state level for assets passing directly to one’s spouse. This deduction allows married clients to continue deferral of estate taxes until the second passing, regardless of the value of their taxable estate for Washington State estate tax purposes.

Despite the gloom and doom, opportunities still exist!

One very glaring difference written into the Washington State estate tax is the calculation with regard to lifetime gifting. The federal estate tax essentially pulls your lifetime gifts back into the calculation, not to be taxed, but to rearrange the tax bracket at which you are taxed. Washington State has no gift tax, and the tax calculation omits the "bump up" to the applicable brackets. This makes gifting up to your lifetime gift exemption ($1 million) much more attractive.

On a cautionary note, Washington taxpayers should reevaluate the entity structure for which out-of-state assets are held. Holding out-of-state property in LLCs and Revocable Living Trusts has been popular for both estate and income taxation as well as asset protection purposes. However, the Washington estate tax effects of these two structures are very different. While holding out-of-state assets inside of a living trust may help you escape potentially costly out-of-state probate, it also will escape taxation of estate tax in the state of Washington. However, if the same out-of-state property were held in an LLC structure, the Washington estate tax would apply to the extent of the decedent’s ownership interest.

Most Washington residents would never call any other state home. (I could be one of these!) But for snowbirds splitting time between states this may be a good time to consider whether you are most effectively claiming your residency based on income and estate taxes. A change in residency from Washington State would be most relevant for those splitting time in states that have no estate tax, and for taxpayers past their earning prime. If you are able to claim residency in a state that generates their funding from income taxation rather than estate taxation your overall taxation may be less. Of course, there are many factors to take into account before changing residency, including some significant non-tax motivators.

They say the only constant is change. It is important to remember that the federal tax exemptions will continue to change and increase, ultimately leading to the scheduled federal estate tax disappearance in 2010. However, the Washington State estate tax is set to remain in effect. At least for now...

If you have additional questions on the new Washington estate tax or on estate planning in general, please feel free to give Berntson Porter a call. We would love to discuss how this tax will apply to your individual situation.

Reneé Hawkes, Manager of the Estate & Wealth Management Department, rhawkes@bpcpa.com at (425) 454-7990 or (800) 876-6931.