Closing an Estate Tax Loophole?

By Tom Yamachika, President, Tax Foundation Hawaii

One of the bills our legislature sent up to Gov. Ige to be signed, which is almost certain to become law because the Department of Taxation sponsored it, is one to close an estate tax “loophole.” The issue isn’t as simple as it might seem, however.

First, some background. An estate tax is imposed when a person dies. The Federal Government imposes it when a decedent owned more than $5.45 million at death. The federal tax rate brackets start from 18% and go to 40%. Only fifteen U.S. states have an estate tax, and Hawaii is one of them. Our law generally conforms to federal law, but our tax rates go from 10% to 15.7%. (Six states impose an inheritance tax, which is similar except that the tax falls upon the heirs; of these, two states also have an estate tax.)

For a person’s estate to have an estate tax liability, the estate is usually substantial, and may include assets in more than one place. For a person who doesn’t reside here, we tax assets that are located, or “sitused,” in Hawaii. For a person who does reside here, we tax all property in the federal taxable estate, but give credit for estate or inheritance taxes paid to other states.

What happens if there is an entity, like a corporation or a LLC, that owns property? Because an entity doesn’t die, the estate tax isn’t imposed on the entity. But entities have owners. Corporations have stockholders, for example. So, the estate tax reaches the value of those ownership interests, such as corporate stock. So far, so good; an individual can’t beat the estate tax by throwing property into an entity. But an individual can use an entity to “situs shift.” Suppose the individual lives in Ohio and the entity owns valuable real property in Hawaii. The entity is not subject to Hawaii estate tax, and neither is the individual, because the shares of stock are generally sitused to the individual’s place of residence. Lo and behold, Ohio doesn’t have an estate tax, so this estate will not be taxed in any state! This is the loophole the bill addresses.

The bill says that if the entity is a single member LLC that has not elected to be taxed as a corporation, then the estate owning the LLC will need to pay estate tax in Hawaii the same as if the decedent owned the Hawaii property directly.

But wait. The bill doesn’t plug the loophole completely. In the situation just described, Hawaii estate tax can be avoided regardless of the type of entity, while the fix only works if the entity owning the Hawaii assets is a single member LLC disregarded for income tax purposes. Thus, if the entity is a partnership, a LLC with more than one owner, or a LLC that has opted to be taxed as a corporation (perhaps a S corporation), the fix doesn't apply and the loophole remains.

Furthermore, how does the Department think it would be able to implement and enforce this law if it is enacted? The Department might be able to find out about a nonresident decedent who owned Hawaii property if there is a Hawaii ancillary probate, which would be needed to distribute Hawaii realty and other Hawaii assets, but how would it even find out about an LLC that owns Hawaii property and has a recently deceased owner? Even if the Department can keep an eye on all the Hawaii properties owned by LLCs, how could it watch their owners? In theory, LLCs that do business in Hawaii, wherever organized, need to register with the Department of Commerce and Consumer Affairs, but the registration form does not require the LLC to state who the owners are, just that a list of the owners will be kept on file at the company’s principal office.

In all, this bill seems like a knee-jerk reaction to a perceived problem. If this situs-shifting anomaly is a loophole that needs closing, it’s very doubtful whether this bill will accomplish it. Well, we can see what happens.