Estate Tax Law and Legal Definition
Estate tax is imposed on the transfer of property based upon the net value of a decedent's estate. Congress has approved a schedule that increases the amount an individual can leave to heirs tax-free to $1.5 million in 2004 and eventually to $3.5 million in 2009. In 2010, it will supposedly be repealed altogether. In some states, the tax is imposed on the receipt of the property by the heirs, rather than the decedent's transfer, and is called an inheritance tax. Estate taxes are a form of transfer tax because it is based on the transfer of title to property, rather than the property itself.
While you are alive, you can gift up to $11,000 to an individual recipient each year without owing any federal gift tax or using up any of your $1 million gift tax exemption or any of your separate estate tax exemption. If you are married, the annual tax-free gift limit is $22,000 per recipient if you and your spouse make joint gifts. While still alive, you can also give away an unlimited amount as long as the money goes directly to an educational institution for tuition or to a medical service provider to pay for uninsured expenses.
Estate taxes are taxes levied on the value of an estate when it is passed to heirs upon the death of its owner. Estate taxes are often informally referred to as death taxes or a death tax. The entire value of an estate is not taxed which is why most Americans never have to pay estate taxes. Calculating the taxable portion of an estate is a complicated task usually taken on by the executor of an estate, a person named in the decedent's will.
In the simplest terms, the taxable value of an estate is the gross value of all assets within the estate upon the death of its owner, plus life insurance proceeds, minus outstanding liabilities and the cost of settling the estate. From the resulting value allowable deductions can be made and a well-planned estate is able to minimize the tax owed through the proper applications of these deductions. When an estate includes the assets from a family farm and/or a family business, higher deductions are available.
Many estates, upon the death of one spouse, will transfer, tax free, all assets to the surviving spouse, so long as he or she is a U.S. citizen. The question of estate taxes is, in this way, postponed only to arise again upon the death of the surviving spouse.
Recent changes in tax law have reduced the small number of estates subject to federal estate taxes. In fact, in 2006 less than 1 percent of all U.S. estates will be liable for federal estate taxes, leaving 99 percent able, if necessary, to pass on all of their assets to heirs on a federal tax-free basis. State taxes on inherited property are another subject. Each state assesses its own estate tax.
ESTATE TAX HISTORY
Many experiments with transfer taxes were undertaken before the Federal government enacted the Revenue Act of 1916, which introduced the modern-day income tax and also contained an estate tax with many features of today's system. The act was signed into law during a period of buildup to World War I. This was a time of growing budget deficits. There was also a general concern about the risks posed to a democracy by large concentrations of wealth, the era of the robber baron being very much in the lifetime of those governing at the time.
The estate tax rose almost immediately as the U.S. entered World War I. It continued rising thereafter and reached a top rate of 77 percent for the largest estates during the depression of the 1930s. The rates and the sizes of the estates affected by those rates fluctuated throughout much of the century. During the late 1960s and early 1970s tax reformers were focused on trying to close the many tax loopholes that had evolved over time. These efforts culminated in a 1976 tax bill that rewrote estate taxation, and established the system we had for the rest of the 20th century.
CURRENT TAX RATES
In 2001 the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) was enacted. This act introduced tax reductions across the board and in particular a phased reduction of the estate and gift tax. The new law increases estate tax exemption levels also called unified credits. The exemption level provides all Americans with the ability to pass on to their heirs the first X number of dollars in their estate, X being the government established exemption amount for that year. EGTRRA calls for an increase in the exemption rate every two years—from 1 million in 2003 to 3.5 million in 2009. Then, in 2010, the estate tax is completely abolished for one year. EGTRRA also gradually reduces the top marginal federal estate tax rate to a low of 45 percent in 2009. It is the "sunset" provision of the act which is most striking. In 2011, unless Congress votes to repeal the tax altogether, or establish new tax rates, estate and gift laws will revert to their pre-EGTRRA form. The very unusual single-year abolition of federal estate taxes in 2010 has led to many jokes along the lines of the one in the title of a 2006 Money magazine article: "Could You Please Die Sometime in 2010?"
This law has been highly controversial and there is much uncertainly surrounding what will happen with estate and gift taxes after 2010. Congress was scheduled to vote on a permanent repeal of the estate tax in 2005 but the measure was tabled in the wake of devastating hurricanes that hit along the Gulf Coast in the summer. Although no legislation has been passed as of early 2006 to address the post-2010 period, most analysts believe that EGTRRA will not be allowed to "sunset" and that some new legislation will be enacted before the end of 2010. Writing in the Virginia Tax Review in 2002, Karen C. Burke described the situation this way: "Virtually no one expects to see the estate tax in its current form spring back into force in 2011. Instead, the 2001 Act is best viewed as an unstable truce between two contending political camps: on one hand, the root-and-branch tax-cutters who are determined to abolish the estate tax permanently, in several strokes if the goal cannot be achieved all at once; and on the other hand, skeptics who concede the need for estate tax reform but balk at outright repeal. Both camps have introduced bills staking out their respective positions, and the outcome of the battle over the future of the estate tax remains uncertain."
ARGUMENTS FOR AND AGAINST THE ESTATE TAX
The vast majority of Americans never have to pay estate taxes. This may be hard to believe based on the vehemence with which the subject is debated. The positions taken in favor of and against an estate tax tend to rest upon deeply held beliefs. How somebody answers the following questions is a sure predictor of where that person stands on the questions of estate taxation: Do the country's richest citizens owe an extra debt to society? Do they have, in Theodore Roosevelt's words, a "peculiar obligation" to those less fortunate?
Supporters of the Estate Tax
Estate tax supporters would tend to answer the questions posed in the affirmative.
Perhaps the principal argument in support of an estate tax is that it helps to make the tax burden on Americans more progressive. Proponents of an estate tax argue that such a tax serves to safeguard against the concentration of wealth and political power in the hands of a tiny minority. This in turn, they suggest, is essential for a healthy democracy. There is an underlying assumption implicit in the support of an estate tax and it involves an understanding about what is in the common good and that, as the old French saying goes, "noblesse oblige" (or nobility obliges).
The maintenance of a vibrant economy is aided by many commonly funded goods—a national infrastructure of roads, waterways, airports, and the like; an educational system open to all; an effective system of public safety and security; a just legal and political system, among others. Those who are most fortunate benefit particularly from these systems, and institutions according to estate tax proponents. They should, consequently, be willing to pay a fair share towards their maintenance—nobility obliges.
Critics of the Estate Tax
Estate tax opponents would tend to answer the questions posed in the negative.
Critics of the estate tax list three primary objectives to the taxing of accumulated wealth. First, they argue that this form of tax ends up double taxing earned income since at least a portion of any estate is made up of earned income. Second, opponents of an estate tax claim that it has a chilling effect on savings rates and on economic growth by stifling society's proven wealth builders and job creators. Third, those who wish to repeal the estate tax often state that this tax is a particular burden to family businesses and farms and makes it more difficult to pass on these assets to the next generation who can continue the businesses.
Paul J. Gessing, Director of Government Affairs for the National Taxpayers Union, explains the fundamental objection to an estate tax this way: "While the economic case against the death tax is persuasive enough, the moral case is even more powerful. Because it taxes virtue—living frugally and accumulating wealth—the tax wastes the talent of able people, both those engaged in enforcing the tax and the probably even greater number engaged in devising arrangements to escape the tax."
Complicating the debate about whether to modify the existing estate tax or repeal it all together is the stark reality of a budget deficit that has grown in every year since 2000 and is forecast by the Congressional Budget Office to continue annually for the next ten years. A repeal of the estate tax would exacerbate these annual budget deficits by reducing tax revenues by $20 billion to $60 billion a year.
ESTATE TAX PAYMENT OPTIONS
Usually, taxes on an estate are due nine months after the death of the estate holder. However, estates involving farms and closely held businesses have the option of making installment payments instead. These installment payments may be spread out over as many as 14 years and in the first five years, only interest is due. Interest charged on the taxes due from these business-related estates is set by the IRS at 4 percent. This permits a business to more easily absorb the cost of estate taxes. The deferred payment plan is jeopardized if the business is broken up or sold during the repayment period. A failure to meet the installment payment schedule too may jeopardize the deferred payment plan.
Managing a business includes taking steps to minimize the tax liability as much as possible. For family-owned closely-held businesses this planning may include planning around the estate taxes that may be due upon the death of one of its principals. Proper business and estate planning can usually prevent any unexpected or onerous tax burdens.
One step that many companies take in preparing for an expected estate tax bill is to buy life insurance on the owner or owners. The policy should be owned by the company or a life-insurance trust and the proceeds should be kept out of the deceased owner's taxable estate. Planning ahead is very important in this process since many techniques for reducing tax liability require time to implement. The use of "gifting" is one such technique. This involves the annual gift giving that is tax-free as long as it doesn't exceed $12,000 per recipient. The gifts can be in the form of stock or other assets.
Transferring ownership of a business through buy-sell agreements, partnerships, trusts, or outright gifts is a key component in many of the planning strategies available to minimize or eliminate estate tax liability. Business experts caution that taking such steps may be even more important—and also even more complicated—when a small business is owned by two or more family members, since the business can potentially be hit with estate taxes every time one of the owners passes away.
The formation of a family limited trust is another way in which to minimize potential estate tax liability. In the most basic terms, a family limited partnership allows the business to be transferred to the next generation at considerably less than its full value. This reduces the size of the estate and thus the amount of federal taxes owed. Other trusts may also be formed for use in a comprehensive plan but the use of trusts is complicated and is best handled by financial planning experts.
Because of the need for outside expertise, the job of tax planning, and in particular estate tax planning is a costly one. The expense of such planning is, in fact, one of the arguments used by those who wish to see the estate tax repealed. But, as is true with most business activities, one must deal with the realities of the environment in which one does business. Until the uncertainty surrounding the future of the estate tax is clarified by Congress, family-owned businesses are wise to make thorough and prudent plans for succession, plans that include measures to minimize the potential for estate tax liability.
SEE ALSO Family Limited Partnerships; Retirement Planning; Succession Plans
Congressional Budget Office. The Budget and Economic Outlook: Fiscal Years 2005 to 2014. Available from http://www.cbo.gov/showdoc.cfm?index=4985&sequence=0 Retrieved on 1 March 2006.
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Gessing, Paul J. Open Letter to Representative Cox. National Taxpayers Union. Available from http://www.ntu.org/main/letters_detail.php?letter_id=235 4 January 2005.
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