When Texas pipeline billionaire Dan Duncan died in March of this year, and again when George Steinbrenner died, much was made of the fact that the heirs of both men might inherit their riches free of the federal estate tax, because a one-year repeal is currently in effect. Here, paraphrased, are some of the many different responses which followed: “Hooray! The government should not get one cent of their hard-earned money;” “They paid tax on the money once: the death tax is a double tax!” “The government established the free society which allowed them to earn their money and should be allowed to tax it;” and “The idea of vast inherited wealth is intrinsically in conflict with the ideals of a democratic society.”
Clearly the estate tax strikes deep emotional and philosophical chords in our citizenry, but what is it, exactly? And what will it mean if it comes back in 2011, as it most probably will? There is much misinformation circulated about this tax. Herewith, an attempt to clear the air as Congress prepares to “fix” the estate tax problem.
First, the event taxed is the transfer of wealth. The tax is paid by the executor, from the assets of the estate, and its burden falls on the beneficiaries, not those who may have earned the money. It is computed on the fair market value of the decedent’s taxable estate on the date of death, or if lower, the value six months later.
The “taxable” estate is the gross estate after deducting property passing to a spouse or to charity, and debts and expenses. In 2009, estates valued up to $3,500,000 after these deductions enjoyed an exemption from the tax. That meant that with properly drawn wills, a married couple could pass twice that amount—$7,000,000—to their children, estate tax-free. It is fair to say then, that the tax only affects those who enjoy “wealth” in the common sense of the term.
Moreover, as of 2009, if the gross estate did not exceed the exemption, the executor did not have to file a return at all. In 2007, only about 1.5% of all U.S. estates (which in that year were subject to a much lower $2,000,000 exemption) had to file the return, and less than half of those returns showed a tax due after deductions.
The gross estate is the value of every economic interest owned by an individual. Taxpayers will go to great lengths to disguise wealth by changing its form in order to avoid the tax. The tax code catches most interests, but one can still avoid the tax by giving up the legal ability to control or enjoy certain aspects of the property. Trusts, partnerships and other entities are often used to achieve these ends. Granted, when property does not escape taxation, the rate is high, 45%. However, even at that rate (which has dropped from 55%), the tax has not really cut into the amounts owned by the very wealthiest individuals and families. After 93 years of continuous estate taxation, the wealthiest 1% own about 34% of U.S. total wealth, a percentage that has been rising. So it is fairly difficult to make the case that the tax is significantly redistributionist.
Is it a double tax? Well, partially. To the extent that a person’s wealth at death consists of accumulated after-tax income, this is true. But insofar as wealth is growth on assets such as real estate and stocks, which have been acquired and held for investment, the gain has often not been subject to tax before death. Further, under the capital gains tax regime in effect before the estate tax was repealed, heirs were not ever subject to gains tax on the growth before death. So the estate tax was the government’s only crack at taxing such gain. By the way, such is not the case under the 2010 repeal, which, if it were extended by Congress, would replace lost estate tax revenue by taxing the capital gains on inherited assets sold by the heirs in some estates.
Does the tax force the sale of small businesses, as is often claimed? In many cases, the government will lend the estate the money to pay the tax at highly advantageous rates for terms of up to 15 years. When one looks behind the stories of heirs who were “forced” to sell the family business, one rarely finds that the estate tax was the sole, or even primary, cause. On the other hand, it is true that estates consisting primarily of large holdings of real estate may be at risk, and persons with such estates should plan their transfers accordingly. Business owners should plan well in advance as well, so as not to leave their heirs scrambling for liquidity.
Finally, as with all taxes, citizens are well within their rights to avoid, if not evade, the estate tax. Families affected by the tax are usually those with means to understand and avoid it. Massachusetts and Rhode Island did not repeal their state estate taxes, and the federal estate tax will probably be resurrected, or maybe even made retroactive to 2010. Sophisticated legal counsel is the best choice when evaluating the options available to avoid or minimize estate taxes. You can’t take it with you, so fair tax or “heir tax,” it is a tax to think about and plan for now.