Estate tax (United States)

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The estate tax in the United States is a tax assessed against the estate of a deceased person, before property (real estate, stocks and bonds, business interests, etc.) is transferred to heirs or assigns according to terms of a will or state intestacy laws. 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, assesses a tax on transfers of property during a person's life; it 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 assess 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 affects popular opinion.[1] Recently, the term "Paris Hilton tax" has been used among proponents of the tax because it would affect high income individuals, such as millionaire socialite heiress Paris Hilton.

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.

Contents 1 Federal estate tax 1.1 The "gross estate" 1.2 Deductions, the taxable estate, and the tentative tax 1.3 Unified credit, the exemption equivalent, and the tax 1.4 Requirements for filing return and paying tax 1.5 Exemptions and tax rates 2 Inheritance tax at the state level 3 Tax Avoidance 4 Debate 4.1 Arguments against 4.2 Arguments in favor 4.3 The "Death Tax" neologism 4.4 Effects of the debate 5 IRS audits 6 Related taxes 7 Further reading 8 External links

[edit] Federal estate tax

The Federal estate tax is imposed "on the transfer of the taxable estate of every decedent who is a citizen or resident of the United States." See 26 U.S.C. § 2001(a).

[edit] 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" defined at 26 U.S.C. § 2031 and 26 U.S.C. § 2033, 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 courtesy" (see 26 U.S.C. § 2034);

• 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 (see 26 U.S.C. § 2035);

• the value of certain property transferred by the decedent before death for which the decedent retained a "life estate," or retained certain "powers" (see 26 U.S.C. § 2036);

• the value of certain property in which the recipient could, through ownership, have possession or enjoyment only by surviving the decedent (see 26 U.S.C. § 2037(a)(1));

• 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 (see 26 U.S.C. § 2037(a)(2));

• the value of certain property transferred by the decedent before death where the transfer was revocable (see 26 U.S.C. § 2038);

• the value of certain annuities (see 26 U.S.C. § 2039);

• the value of certain jointly owned property (see 26 U.S.C. § 2040);

• the value of certain "powers of appointment" (see 26 U.S.C. § 2041);

• the amount of proceeds of certain life insurance policies (see 26 U.S.C. § 2042).

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.

[edit] Deductions, the taxable estate, and the tentative tax

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 (see 26 U.S.C. § 2053);

• Certain charitable contributions (see 26 U.S.C. § 2055);

• Certain items of property left to the surviving spouse (see 26 U.S.C. § 2056).

• Gift taxes already paid on retained interests of nonqualified intervivos gifts.

After subtracting the deduction amounts from the gross estate amount to arrive at the "taxable estate" amount, the tax rate is imposed on the value of the "taxable estate" to compute the tentative tax.

[edit] Unified credit, the exemption equivalent, and the tax

However, the law then provides for a credit against the tentative tax. The credit may be thought of as providing, in effect, for an "exemption equivalent" or exempted value with respect to the value of the property. For a person dying during 2005, an estate with a value less than $1,500,000 would not pay a federal estate tax and most likely would not have to file a federal estate tax return. The applicable exclusion amount increases to $2,000,000 for decedents dying in the years 2006, 2007 and 2008. The amount increases to $3,500,000 for 2009. According to the Economic Growth and Tax Relief Reconciliation Act of 2001, the federal estate tax disappears for the year 2010, but the tax returns in 2011 at the 2001 level. 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. In addition, to the extent that the gift tax exemption is used during lifetime, a dollar for dollar reduction in the estate tax exemption equivalent occurs. Past gifts from the estate that were subject to gift tax must be included in a grand recalculation of the credit, the estate value, and the estate/gift tax due -- making this a nontrivial calculation. Special cases can lead to surprising tax obligations.

For taxable estates valued not greater than $10,000 the tax liability is 18% of the estate.

For taxable estates below the next threshold value of $20,000 the tax is $1,800 plus 20% of the excess over $10,000.

For taxable estates below the next threshold value of $40,000 the tax is $3,800 plus 22% of the excess over $20,000.

For taxable estates below the next threshold value of $60,000 the tax is $8,200 plus 24% of the excess over $40,000.

For taxable estates below the next threshold value of $80,000 the tax is $13,000 plus 26% of the excess over $60,000.

For taxable estates below the next threshold value of $100,000 the tax is $18,200 plus 28% of the excess over $80,000.

For taxable estates below the next threshold value of $150,000 the tax is $23,800 plus 30% of the excess over $100,000.

For taxable estates below the next threshold value of $250,000 the tax is $38,800 plus 32% of the excess over $150,000.

For taxable estates below the next threshold value of $500,000 the tax is $70,800 plus 34% of the excess over $250,000.

For taxable estates below the next threshold value of $750,000 the tax is $155,800 plus 37% of the excess over $500,000.

For taxable estates below the next threshold value of $1,000,000 the tax is $248,300 plus 39% of the excess over $750,000.

For taxable estates below the next threshold value of $1,250,000 the tax is $345,800 plus 39% of the excess over $1,000,000.

For deaths in 2002 and 2003 the applicable equivalent exclusion amount was a million dollars so that the unified credit for those years was $345,800.

[edit] 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 or other person responsible for administering the estate. 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.

[edit] Exemptions and tax rates

[edit] 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.

[edit] 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 technniques. 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 create a living trust in a way to combine the tax exemption limits for a husband and wife. The various 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. This is important for those who's primary wealth is in a business they own, or real estate, or stocks, as the estate tax could force 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.

[edit] Debate

The propriety of the estate tax has been debated extensively.

[edit] 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 unfortunate 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. [2]

Moreover, not all taxpayers have equal access to (or trust in) estate planning services; an aging farm or business owner (perhaps a Depression survivor) might not understand the consequences of leaving inheritance issues to surviving family members, or even of intestacy. A policy that creates an uneven tax burden, even when due to ignorance or inaction, can raise the appearance of unfairness.

Opponents also argue that the Federal estate tax rate is effectively higher as a percentage of the amount actually transferred to heirs. For example, an estate worth $3.5 million paid $940,000 federal estate tax in order to transfer $1,280,000 to each heir, suggesting an effective transfer tax rate of 36.7%. Similarly, at the limit, the top federal tax rate of 50% on the estate value would imply a transfer tax rate of 100% of the amount transferred to heirs. (For non-cash assets such as real estate or securities, market fluctuations after death can lead to tax/asset mismatches and a higher effective rate of taxation for heirs; this affected some estates valued during the economic downturn in 2001-2002.) The high effective transfer tax rate has prompted many wealthy benefactors to make sizable gifts during their lifetime, paying a gift tax on the amount transferred, rather than allow the whole amount to be taxed at the estate level.

Some argue that the estate tax creates a potential for double and triple taxation, that is, taxation on assets which have already been taxed. Double taxation occurs on earned income, and by imposing capital gains tax on the returns after earned income is reinvested in new ventures, stocks, bonds,and savings. However, the capital gains on those reinvested proceeds have never been taxed in the first place, because the income tax system does not recognize income until the asset (here a share of stock) is sold or transferred. Without the estate tax, the alternative is to treat the transfer of ownership of the stock at death as a sale and impose the capital gains tax then. In this manner, the estate tax would not be seen as an additional tax, but the first tax upon the unrealized capital gains.

[edit] 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.

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.

Proponents further argue that the estate tax serves to encourage charitable giving, one way in which individuals can avoid paying the tax. A 2004 report by the Congressional Budget Office found that eliminating the estate tax would reduce charitable giving by 6-12 percent.

Another argument in favor of the estate tax relates to comparative incentives. Proponents argue that the estate tax is a better source of revenue than the income tax, which is said to directly disincentivize work. While all taxes have this effect to a degree, some argue that the Estate Tax is less of a disincentive since it does not tax money that the earner spends, but merely that which he or she wishes to give away for non-charitable purposes. Moreover, some argue that allowing the rich to bequeath unlimited wealth on future generations will disincentivize hard work in those future generations.

Proponents of the estate tax tend to object to characterizations that it operates as a double or triple taxation. They either note that such 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.

Some proponents of the estate tax also point to historical precedent for limiting inheritance. This is cited for the proposition that unlimited inheritance tends to destabilize societies, as well as that current generational transfers of wealth are greater than they have been historically.

[edit] The "Death Tax" neologism

Many opponents of the estate tax refer to it as the "death tax" in their public discourse, as a death must occur before any tax on the deceased's assets can be realized.

The term was popularized in a famous memorandum written by Republican pollster Frank Luntz. He recommended that the party use the term "death tax" when referring to the estate tax, writing that the term "death tax" "kindled voter resentment in a way that 'inheritance tax' and 'estate tax' do not" [3].

Linguist George Lakoff alleges in his book Don't Think of an Elephant! Know Your Values and Frame the Debate that this is a deliberate and carefully calculated propaganda tactic. Lakoff claims that the phrase "death tax" and similar neologisms are a method of psychologically framing the debate in favor of repealing the estate tax, because the human mind immediately and automatically produces unpleasant images of an evil tax collector appearing to rummage through the valuables of a newly bereaved family whenever the words "death tax" are heard or read. Lakoff says that pervasive public use of the phrase induces even some proponents of the estate tax to repeat it and thus unwittingly spread the Republicans' desired frame to others.

[edit] 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 Senate, and it failed to pass.

[edit] IRS audits

In 2000, the Internal Revenue Service (IRS) said that 85 percent of large taxable gifts it audited shortchanged the government. Between 2001 and 2006, officials at both the IRS and the Treasury told Congress that cheating among the highest-income Americans is a major and growing problem.

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.[4]

[edit] 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 of their assets during their lifetime.

There are two levels of exemption from the gift tax. First, transfers of up to (as of 2006) $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, and a married couple can make gifts up to twice that amount, 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 (or, as the IRS puts it, "the unified credit against taxable gifts [is] $345,800 (exempting $1 million from tax)". [5]

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 this strategy is based on how long it can continue as obviously it cannot continue past death).

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.

[edit] Further reading

• Ian Shapiro and Michael J. Graetz, Death By A Thousand Cuts: The Fight Over Taxing Inherited Wealth, Princeton University Press (February, 2005), hardcoveer, 372 pages, ISBN 0-691-12293-8
• William H. Gates, Sr. and Chuck Collins, with forword by former Federal Reserve Chairman Paul Volcker, Wealth and Our Commonwealth: Why America Should Tax Accumulated Fortunes, Beacon Press (2003)

[edit] External links

• IRS publication 950, Introduction to Estate and Gift Taxes, revised September 2004
• "Estate Tax Pyramid Scheme", a June 2006 article by former US Secretary of Labor Robert Bernard Reich arguing for the estate tax.
• "Tax Breaks for Rich Murderers", a June 2005 article from the London Review of Books by David Runciman
• Deathtax.com an anti-inheritance tax campaign by a Seattle family-owned newspaper
• Gross Estate and Net Estate Tax on Farms and Businesses in 2004, from the Tax Policy Center website
• ...Ads exaggerate what the tax costs farmers, small businesses..., a June 2005 article from FactCheck
• Myth: Death tax repeal only benefits the wealthy Heritage Foundation
• Death tax deception Article from Dollars & Sense magazine
• Sterling Harwood, "Is Inheritance Immoral?" in Louis P. Pojman, Political Philosophy (McGraw Hill, 2002). www.sterlingharwood.com.
• David Runciman, London Review of Books, 2 June 2005, "Tax Breaks for Rich Murderers"
• Myth: Death tax repeal only benefits the wealthy Heritage Foundation
• Wiki Legal Comment, Night of the Living Dead: Why Death Tax Won’t Stay Dead, Wiki Legal Journal This article is part of a study to determine if a wiki community can produce high quality legal research, Nov. 18, 2006 (this comment explores the various proposals Congress has considered with a special emphasis on the interaction of estate tax on state revenue and philanthropy.).