Definitions

Estate tax (United States)

Estate tax in the United States

The estate tax in the United States is a tax imposed on the transfer of the "taxable estate" of a deceased person, whether such property is transferred via a will or according to the state laws of intestacy. The estate tax is one part of the Unified Gift and Estate Tax system in the United States. The other part of the system, the gift tax, imposes a tax on transfers of property during a person's life; the gift tax prevents avoidance of the estate tax should a person want to give away his/her estate just before dying.

In addition to the federal government, many states also impose an estate tax, with the state version called either an estate tax or an inheritance tax. Since the 1990s, the term "death tax" has been widely used by those who want to eliminate the estate tax, because the terminology used in discussing a political issue can affect popular opinion.

If an asset is left to a spouse or a charitable organization, the tax usually does not apply. The tax is imposed on other transfers of property made as an incident of the death of the owner, such as a transfer of property from an intestate estate or trust, or the payment of certain life insurance benefits or financial account sums to beneficiaries.

Federal estate tax

The Federal estate tax is imposed "on the transfer of the taxable estate of every decedent who is citizen or resident of the United States. The starting point in the calculation is the "gross estate." Certain deductions (subtractions) from the "gross estate" amount are allowed in arriving at a smaller amount called the "taxable estate."

The "gross estate"

The "gross estate" for Federal estate tax purposes often includes more property than that included in the "probate estate" under the property laws of the state in which the decedent lived at the time of death. The starting point for the calculation of the estate tax is the value of the "gross estate, as modified by certain other statutory provisions. The gross estate (before the modifications) may be considered to be the value of all the property interests of the decedent at the time of death. To these interests are added the following property interests generally not owned by the decedent at the time of death:

  • the value of property to the extent of an interest held by the surviving spouse as a "dower or curtesy;
  • the value of certain items of property in which the decedent had, at any time, made a transfer during the three years immediately preceding the date of death (i.e., even if the property was no longer owned by the decedent on the date of death), other than certain gifts, and other than property sold for full value;
  • the value of certain property transferred by the decedent before death for which the decedent retained a "life estate", or retained certain "powers;
  • the value of certain property in which the recipient could, through ownership, have possession or enjoyment only by surviving the decedent;
  • the value of certain property in which the decedent retained a "reversionary interest", the value of which exceeded five percent of the value of the property;
  • the value of certain property transferred by the decedent before death where the transfer was revocable;
  • the value of certain annuities;
  • the value of certain jointly owned property, such as assets passing by operation of law or survivorship, i.e. joint tenants with rights of survivorship or tenants by the entirety, with special rules for assets owned jointly by spouses.;
  • the value of certain "powers of appointment;
  • the amount of proceeds of certain life insurance policies.

The above list of modifications is not comprehensive.

As noted above, life insurance benefits may be included in the gross estate (even though the proceeds arguably were not "owned" by the decedent and were never received by the decedent). Life insurance proceeds are generally included in the gross estate if the benefits are payable to the estate, or if the decedent was the owner of the life insurance policy or had any "incidents of ownership" over the life insurance policy (such as the power to change the beneficiary designation). Similarly, bank accounts or other financial instruments which are "payable on death" or "transfer on death" are usually included in the taxable estate, even though such assets are not subject to the probate process under state law.

Deductions and the taxable estate

Once the value of the "gross estate" is determined, the law provides for various "deductions" (in Part IV of Subchapter A of Chapter 11 of Subtitle B of the Internal Revenue Code) in arriving at the value of the "taxable estate." Deductions include but are not limited to:

  • Funeral expenses, administration expenses, and claims against the estate;
  • Certain charitable contributions;
  • Certain items of property left to the surviving spouse.
  • Beginning in 2005, inheritance or estate taxes paid to states or the District of Columbia.

Of these deductions, the most important is the deduction for property passing to (or in certain kinds of trust for) the surviving spouse, because it can eliminate any federal estate tax for a married decedent. However, this unlimited deduction does not apply if the surviving spouse (not the decedent) is not a U.S. citizen. A special trust called a Qualified Domestic Trust or QDOT must be used to obtain an unlimited marital deduction for otherwise disqualified spouses;.

Tentative tax

The tentative tax base is the sum of the taxable estate and the "adjusted taxable gifts" (i.e., taxable gifts made after 1976) and the tentative tax is then calculated by applying the following tax rates:

For amounts not greater than $10,000, the tax liability is 18% of the amount.

For amounts over $10,000 but not over $20,000, the tentative tax is $1,800 plus 20% of the excess over $10,000.

For amounts over $20,000 but not over $40,000, the tentative tax is $3,800 plus 22% of the excess over $20,000.

For amounts over $40,000 but not over $60,000, the tentative tax is $8,200 plus 24% of the excess over $40,000.

For amounts over $60,000 but not over $80,000, the tentative tax is $13,000 plus 26% of the excess over $60,000.

For amounts over $80,000 but not over $100,000, the tentative tax is $18,200 plus 28% of the excess over $80,000.

For amounts over $100,000 but not over $150,000, the tentative tax is $23,800 plus 30% of the excess over $100,000.

For amounts over $150,000 but not over $250,000, the tentative tax is $38,800 plus 32% of the excess over $150,000.

For amounts over $250,000 but not over $500,000, the tentative tax is $70,800 plus 34% of the excess over $250,000.

For amounts over $500,000 but not over $750,000, the tentative tax is $155,800 plus 37% of the excess over $500,000.

For amounts over $750,000 but not over $1,000,000, the tentative tax is $248,300 plus 39% of the excess over $750,000.

For amounts over $1,000,000 but not over $1,250,000, the tentative tax is $345,800 plus 41% of the excess over $1,000,000.

For amounts over $1,250,000 but not over $1,500,000, the tentative tax is $448,300 plus 43% of the excess over $1,250,000.

For amounts over $1,500,000, the tentative tax is $555,800 plus 45% of the excess over $1,500,000.

For years before 2007, additional tax brackets applied for amounts over $2,000,000 with marginal rates of up to 55%.

The tentative tax is reduced by gift tax that would have been paid on the adjusted taxable gifts, based on the rates in effect on the date of death (which means that the reduction is not necessarily equal to the gift tax actually paid on those gifts).

Although the above tax table looks like a system of progressive tax rates, there is a unified credit against the tentative tax which effectively eliminates any tax on the first $2,000,000 of the estate (or the first $2,000,000 on a combination of taxable gifts during lifetime and a taxable estate at death), so the federal estate tax is effectively a flat tax of 45% once the unified credit exclusion amount has been exhausted.

Credits against tax

There are several credits against the tentative tax, the most important of which is a "unified credit" which can be thought of as providing for an "exemption equivalent" or exempted value with respect to the sum of the taxable estate and the taxable gifts during lifetime.

For a person dying during 2006, 2007, or 2008, the "applicable exclusion amount" is $2,000,000, so if the sum of the taxable estate plus the "adjusted taxable gifts" made during lifetime equals $2,000,000 or less, there is no federal estate tax to pay. According to the Economic Growth and Tax Relief Reconciliation Act of 2001, the applicable exclusion will increase to $3,500,000 in 2009, the estate tax is repealed in 2010, but then the act "sunsets" in 2011 and the estate tax reappears with an applicable exclusion amount of only $1,000,000 (unless Congress acts before then).

Do not confuse the estate tax credit or exemption equivalent with the federal gift tax credit or exemption equivalent. The gift tax exemption is frozen at $1,000,000 and does not increase, as does the estate tax exemption.

If the estate includes property that was inherited from someone else within the preceding 10 years, and there was estate tax paid on that property, there may also be a credit for property previously taxed.

Before 2005, there was also a credit for non-federal estate taxes, but that credit was phased out by the Economic Growth and Tax Relief Reconciliation Act of 2001.

Requirements for filing return and paying tax

For estates larger than the current federally exempted amount, any estate tax due is paid by the executor, other person responsible for administering the estate, or the person in possession of the decedent's property. That person is also responsible for filing a Form 706 return with the Internal Revenue Service. The return must contain detailed information as to the valuations of the estate assets and the exemptions claimed, to ensure that the correct amount of tax is paid. The deadline for filing the Form 706 is 9 months from the date of the decedent's death. This deadline may be extended for an additional 6 months, but the estimated estate taxes which are due must still be paid by the 9 month deadline.

Exemptions and tax rates

Year Exclusion
Amount
Max/Top
tax rate
2001 $675,000 55%
2002 $1 million 50%
2003 $1 million 49%
2004 $1.5 million 48%
2005 $1.5 million 47%
2006 $2 million 46%
2007 $2 million 45%
2008 $2 million 45%
2009 $3.5 million 45%
2010 repealed 0%
2011 $1 million 55%

As noted above, a certain amount of each estate is exempted from taxation by the federal government. Below is a table of the amount of exemption by year an estate would expect. Estates above these amounts would be subject to estate tax, but only for the amount above the exemption.

For example, assume an estate of $3.5 million in 2006. There are two beneficiaries who will each receive equal shares of the estate. The maximum allowable credit is $2 million for that year, so the taxable value is therefore $1.5 million. Since it is 2006, the tax rate on that $1.5 million is 46%, so the total taxes paid would be $690,000. Each beneficiary will receive $1,000,000 of untaxed inheritance and $405,000 from the taxable portion of their inheritance for a total of $1,405,000. This means that they would have paid (or, more precisely, the estate would have paid) a taxable rate of 19.7%.

As shown, the 2001 tax act will repeal the estate tax for one year—2010—and then readjust it in 2011 to the year 2002 exemption level with a 2001 top rate.

Inheritance tax at the state level

Many U.S. states also impose their own estate or inheritance taxes (see Ohio estate tax for an example). Some states "piggyback" on the federal estate tax law in regard to estates subject to tax (i.e., if the estate is exempt from federal taxation, it is also exempt from state taxation). Some states' estate taxes, however, operate independently of federal law, so it is possible for an estate to be subject to state tax while exempt from federal tax.

Tax avoidance

Estate tax rates and complexity have driven a vast array of support services to assist clients with a perceived eligibility for the estate tax to develop tax avoidance techniques. Many insurance companies maintain a network of life insurance agents, all providing financial planning services, guided to avoid paying estate taxes. Brokerage and financial planning firms also use estate planning, including estate tax avoidance, as a marketing technique. Many law firms also specialize in estate planning, tax avoidance, and minimization of estate taxes.

The first technique many use is to combine the tax exemption limits for a husband and wife either through a will or create a living trust. Many, but not all, other techniques do not really avoid the estate tax, rather they provide an efficient and leveraged way to have liquidity to pay for the tax at the time of death. It is very important for those whose primary wealth is in a business they own, or real estate, or stocks, to seek professional advice or they may run the risk of the estate tax forcing their heirs to sell these things at an inopportune time. In one popular scheme, an irrevocable life insurance trust, the parents give their kids (within the allowed yearly gift tax limit) money to buy life insurance on the parents in an irrevocable life insurance trust. Structured in this way, life insurance is free of estate tax. However, if the parents have a very high net worth and the life insurance policy would be inadequate in size due to the limits in premiums, a charitable remainder trust may be used. This is where a large asset is flagged to be donated to a charity, sold, and invested. The investment income buys life insurance but the principal goes to the charity when the parents die. Meanwhile the children get the full amount as well in life insurance proceeds. This is a large reason for many charitable gifts, and proponents of the estate tax argue the tax should be maintained to encourage this form of charity.

Debate

Arguments in favor

Proponents of the estate tax argue that it serves to prevent the perpetuation of wealth, free of tax, in wealthy families and that it is necessary to a system of progressive taxation. Proponents point out that the estate tax affects only estates of considerable size (presently, over $2 million USD, and over $4 million USD for couples) and provides numerous credits (including the unified credit) that allow a significant portion of even large estates to escape taxation. Regarding the tax's effect on farmers, proponents counter that this criticism is misguided as there is an exemption built into the law that is specifically designed for family-owned farms. Proponents note that abolishing the estate tax will result in tens of billions of dollars being lost annually from the federal budget.

Furthermore, supporters argue that many large fortunes do not represent taxed income or savings, that wealth is not being taxed but merely the transfer of that wealth, and that many large fortunes represent unrealized capital gains which (because of a step up in basis at the time of death) will never be taxed as capital gains under the federal income tax. Winston Churchill argued that estate taxes are “a certain corrective against the development of a race of idle rich”. Research suggests that the more wealth that is inherited by old people, the more likely they are to leave the labour market

Proponents of the estate tax tend to object to characterizations that it operates as a double or triple taxation. Proponents point out that many of the earnings that are subject to the estate tax were never taxed because they were "unrealized" gains. Others note that double and triple taxation is common (through income, property, and sales taxes, for instance) or argue that the estate tax should be seen as a single tax on the inheritors of large estates.

Supporters of the estate tax also point to longstanding historical precedent for limiting inheritance, and note that current generational transfers of wealth are greater than they have been historically. In ancient times, funeral rites for lords and chieftains involved significant wealth expenditure on sacrifices to religious deities, feasting, and ceremonies. The well-to-do were literally buried or burned along with most of their wealth. These traditions may have been imposed by religious edict but they served a real purpose, which was to prevent accumulation of great disparities of wealth, which tended to destabilize societies and lead to social imbalance, eventual revolution, or disruption of functioning economic systems. This economic safety valve is now partially imposed via the estate tax, which strips excess wealth from the recently dead and diverts it back to the society as a whole.

Proponents also note that the arguments of estate tax opponents are occasionally disingenuous. For example, while opponents point to family farmers and small business owners in an effort to demonstrate the unfairness or overreach of the tax, proponents note that nearly all family farmers and small business owners are exempt from or are not subject to the estate tax.

Two of the world's wealthiest men, Warren Buffett, CEO of Berkshire Hathaway, and the father of founder of Microsoft Bill Gates, William H. Gates, Sr., favor the estate tax.

Arguments against

One argument against the estate tax is that the tax obligation in itself can assume a disproportionate role in planning, possibly overshadowing more fundamental decisions about the underlying assets. In certain cases, this is claimed to create an undue burden. For example, pending estate taxes could become an artificial disincentive to further investment in an otherwise viable business – increasing the appeal of tax- or investment-reducing alternatives such as liquidation, downsizing, divestiture, or retirement. This could be especially true when an estate's value is about to surpass the exemption equivalent amount. Older individuals owning farms or small businesses, when weighing ongoing investment risks and marginal rates of return in light of tax factors, may see less value in maintaining these taxable enterprises. They may instead decide to reduce risk and preserve capital, by shifting resources, liquidating assets, and using tax avoidance techniques such as insurance policies, gift transfers, trusts, and tax free investments.

Another argument is simply that when applied to realty, it is yet another tax on items that have already been taxed. Private real estate is taxed when it is purchased, it is taxed annually based on its value, and then it is taxed again when it is passed on as an inheritance.

Another argument against the estate tax is a moral one. Proponents continually offer that the inheritor of wealth doesn't deserve it because, simply, he or she did not earn it directly. While it may be true that the receiver of wealth may not have a direct moral claim to that wealth, those opposed to the estate tax would argue that logically, neither does anyone else. The moral argument would further assert that the rights to that wealth lie with the deceased person, the person who earned it originally and who paid taxes on it continually while living. The rights lie with the deceased to dispose of his or her wealth as he or she sees fit, whether that disposition be in the form of a charitable gift, a check to the government, or a gift to a chosen heir. (Rand, 1967) The moral argument would logically assert that anyone claiming that an heir does not deserve inherited wealth could certainly not claim a right to use the power of government to confiscate that wealth on behalf of unknown others who most certainly would not deserve the wealth by that same line of thinking.

Opponents also point out that many attempts at validating the estate tax assume the superiority of socialist/collectivist economic models. For example, proponents of the tax commonly argue that "excess wealth" should be stripped from the recently deceased without offering a definition of what "excess wealth" could possibly mean and why it would be undesirable if procured through the honest effort of a productive life. Such statements exhibit a predilection for collectivist principles that opponents of the death tax have long opposed on moral grounds.

Estate value
(Millions)

Number of
returns

Average tax
(in thousands)

Effective
tax rate

 
$0.0 - $1.0
0
$0
0.0%
$1.0 - $2.0
190
$26
1.6%
$2.0 - $3.5
60
$190
7.5%
$3.5 - $5.0
40
$449
12.0%
$5.0 - $10
80
$1,322
19.3%
$10. - $20.
50
$2,832
22.9%
$20. +
30
$23,442
22.2%
All
440
$2,238
19.9%
Previous Tax Foundation research has found the estate tax acts as a strong disincentive toward entrepreneurship. A 1994 study found that the estate tax’s 55 percent rate at the time had roughly the same disincentive effect as doubling an entrepreneur’s top effective marginal income tax rate. The estate tax has also been found to impose a large compliance burden on the U.S. economy. Some past economic studies have estimated the compliance costs of the federal estate tax to be roughly equal to the amount of revenue raised—nearly five times more costly per dollar of revenue than the federal income tax—making it one of the nation’s most inefficient revenue sources. See The Economics of Federal Estate Taxes

The "Death Tax" neologism

Many opponents of the estate tax refer to it as the "death tax" in their public discourse partly because a death must occur before any tax on the deceased's assets can be realized and also because the tax rate is determined by the value of the deceased's assets rather than the amount each inheritor receives. Neither the number of inheritors nor the size of each inheritor's portion factors into the calculations for rate of the Estate Tax.

The term was coined in the Gingrich period by Jack Faris of the National Federation of Independent Business. It has been widely but inaccurately attributed to Republican pollster Frank Luntz. In a memo, Luntz wrote that the term "death tax" "kindled voter resentment in a way that 'inheritance tax' and 'estate tax' do not"

Progressive linguist George Lakoff alleges the phrase is a deliberate and carefully calculated neologism which is used as a propaganda tactic to aid in the repeal of estate taxes. However the use of "death tax" rather than "estate tax" in the wording of questions in the 2002 National Election Survey increased support for estate tax repeal by only a few percentage points.

Effects of the debate

Congress has passed tax laws that have changed the estate tax. Since 2003, the top rate has been lowered from 49% by one percentage point per year; in 2006 the top rate was 46%. If the US Congress makes no changes to US tax law, the top rate will continue to drop by one percentage point per year until 2009 when the top rate is scheduled to be 45%; in 2010 all estates will be taxed at 0%; and in 2011 the estate tax will return at a top rate of 55%. Most experts expect that Congress will change the tax law before then. If the estate tax is eliminated, then unrealized capital gains would be subject to capital gains tax in order to justify the step up in basis in the hands of the new owner.

Legislation to extend raising the unified credit (beyond year 2010) of the estate tax has passed the House of Representatives. It also passed in the Senate in June, 2006. Later when the conference committee added it to a bill to increase the minimum wage, the combined bill failed to garner 60 votes to invoke cloture in the United States Senate, and it failed to pass.

IRS audits

In July 2006, the IRS confirmed that it planned to cut the jobs of 157 of the agency’s 345 estate tax lawyers, plus 17 support personnel, by October 1, 2006. Kevin Brown, an IRS deputy commissioner, said that he had ordered the staff cuts because far fewer people were obliged to pay estate taxes than in the past.

Estate tax lawyers are the most productive tax law enforcement personnel at the I.R.S., according to Brown. For each hour they work, they find an average of $2,200 of taxes that people owe the government.

Related taxes

The federal government also imposes a gift tax, assessed in a manner similar to the estate tax. One purpose is to prevent a person from avoiding paying estate tax by giving away all his or her assets before death.

There are two levels of exemption from the gift tax. First, transfers of up to (as of 2008) $12,000 per person per year are not subject to the tax. An individual can make gifts up to this amount to as many people as they wish each year. A married couple can pool their individual gift exemptions to make gifts worth up to $24,000 per person per year without incurring any gift tax. Second, there is a credit that essentially negates the tax on gifts until a total of $1,000,000 has been given by one person to another.

If an individual or couple makes gifts of more than the limit, gift tax is incurred. The individual or couple has the option of paying the gift taxes that year, or to use some of the "unified credit" that would otherwise reduce the estate tax. In some situations it may be advisable to pay the tax in advance to reduce the size of the estate.

But in many instances, an estate planning strategy is to give the maximum amount possible to as many people as possible to reduce the size of the estate, the effectiveness of which depends on the lifespan of the transferor.

Furthermore, transfers (whether by bequest, gift, or inheritance) in excess of $1 million may be subject to a generation-skipping transfer tax if certain other criteria are met.

See also

Notes

Further reading

  • Cost and Consequences of the Federal Estate Tax, A Joint Economic Committee Study, http://www.house.gov/jec/publications/109/05-01-06estatetax.pdf
  • Ian Shapiro and Michael J. Graetz, Death By A Thousand Cuts: The Fight Over Taxing Inherited Wealth, Princeton University Press (February, 2005), hardcover, 372 pages, ISBN 0-691-12293-8
  • William H. Gates, Sr. and Chuck Collins, with foreword by former Federal Reserve Chairman Paul Volcker, Wealth and Our Commonwealth: Why America Should Tax Accumulated Fortunes, Beacon Press (2003)

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