Estate Taxes

The federal government taxes large gratuitous transfers, which are transfers to recipients, usually referred to as beneficiaries, who provided little or no consideration for the transferred property. Gratuitous transfers can either be gifts given while the donor was still alive or transferred from his estate after his death. Inter vivos gifts may be subject to gift tax and the donor's estate property may be subject to estate tax and both transfers can be subject to a generation-skipping transfer tax.

The estate tax was 1^st enacted in 1916, not as a revenue generator, but as a tax to prevent the accumulation of wealth in the upper echelons of society, when the richest 1% owned 50% of America's wealth, which many people have argued is a threat to democracy. By 1976, high estate and gift taxes have reduced their proportion of wealth to 20%. However, generous exemptions on the estate tax plus other tax loopholes allowed the wealthy to accumulate more and more wealth so that in 2010, the wealthiest 1% segment owned 1/3 of America's wealth, while 80% of the poorest Americans, those in the lowest 4 quintiles, owned just 16% — in other words, the wealthiest 1% owned twice as much as 80% of Americans. Furthermore, income from gifts, inheritance, or life insurance is not subject to income taxes; hence, it is the least taxed form of income, even though the recipients do nothing for the income.

The general term death taxes usually refers to both estate and inheritance taxes. An inheritance tax is distinguished from an estate tax in that it is assessed on the donees receiving the gifts rather than the estate. Although the federal government does not impose an inheritance tax, many states do. Another distinguishing feature of the inheritance tax is that the rate often depends on the relationship between the decedent and the beneficiary – the closer the relationship, the lower the tax.

Under the Tax Reform Act of 1976, the gift and estate taxes were considered as a whole, with the same rates and exemption or credit amounts applying to both. When an inter vivos gift was made, the donor did not have to pay for the tax in that year, but the amount was charged against his estate. The 2001 Economic Growth and Tax Relief Reconciliation Act (2001 Tax Act) created different exemption amounts for the gift and estate taxes, starting in 2004, and, in 2010, the gift tax will be 35% while there will be no estate tax. After 2010, both taxes will be reset to their 2002 levels.

The Tax Reform Act of 1986 created a generation-skipping transfer tax that imposed additional tax on any transfers to beneficiaries more than one generation removed from the decedent—grandchildren and their descendents. So, for example, if the decedent gives his child a life estate in his property with the property going to his grandchild when this child dies, then a generation-skipping transfer tax is imposed upon the property when the child dies. The generation-skipping transfer tax is equal to the highest estate tax rate for the estate after exemptions and exclusions are deducted. Although the 2001 Tax Act repealed the generation-skipping transfer tax and estate tax for 2010, both are scheduled to return in 2011, allowing only $1,000,000 worth of property to transfer tax-free.

Unified Transfer Tax Credit

The law provides a unified tax credit that allows a certain amount of property—the exemption amount (aka exemption equivalent)—to be passed free of estate or gift tax. Although most people think of the tax-free amount as being an exemption, the IRS actually calculates the exemption by granting a tax credit equivalent to the exemption. For instance, in 2003, the tax credit was $345,800 that allowed $1,000,000 of property to be transferred tax-free.

The credit is described as unified because it is a lifetime credit that applies to gift, estate, and generation-skipping taxes. Each application of the credit during the taxpayer's lifetime reduces the credit.

For 2009, the unified tax credit for gifts is limited to $345,800, which allows an exemption of $1,000,000 for gifts. For estates, the unified credit is $1,455,800, which exempts $3,500,000 of estate property from taxes. Note that, although the 2 credits are differing amounts, they are still unified, in that any gift tax credit used will reduce the credit for the estate tax. Hence, if a taxpayer uses the $345,800 credit for gifts during his lifetime, then his estate credit will be reduced to $1,110,000, allowing only $2,500,000 worth of property to pass tax-free. The unified tax credit has been increased to $5 million and applies to gift, estate, and generation-skipping taxes for tax years 2011 - 2012.

Calculating the Estate Tax

The federal estate tax is imposed on the decedent's taxable estate which is equal to the decedent's gross estate less deductions.

Taxable Estate = Gross Estate – Deductions

After the tentative tax is calculated based on the taxable estate, any credits—including the unified transfer tax credit—are subtracted to determine the payable tax.

Since the federal estate tax is a graduated, cumulative  tax with a rate that depends on the size of the gross estate, the value of all post-1976 lifetime gifts that were above the annual gift tax exclusion for the year of the gift is added to the estate, including any gift taxes that were paid during the decedent's lifetime. This determines the size of the estate and the applicable tax rate. Although paid gift taxes are added to the estate to determine the applicable tax rate, the estate can deduct the gift taxes paid so that taxes are not paid twice on any gift.

In 2010, there will be no estate tax and the top rate for the gift tax will be the top marginal rate on income — 35%. In 2011, unless Congress changes the law, both gift and estate taxes (including the generation-skipping transfer tax) will reset to their 2002 levels, with a top rate of 55% with an unified exemption of $1,000,000 on both taxes.

The gross estate includes property in the probate estate, nonprobate property, and any transfers where the decedent retained sufficient control or power over the property.

The estate tax is assessed on the fair market value of the property at the time of death; thus, the beneficiaries of the estate receive the property with the tax basis being equal to the assessed value of the property in the estate. This is often referred to as a stepped-up basis, because real estate and financial instruments do generally go up in value.

Deductions include charitable gifts, debts, loans, and mortgages, funeral expenses, state death taxes, and the marital deduction. In broad outline, the estate tax is calculated thus:

1. Determine the taxable estate, by taking the decedent's gross estate, which is the value of all property that the decedent owned or had a beneficial interest in, or retained control over at the time of death and certain transfers made within 3 years of the decedent's death, minus various deductions, such as death related expenses, debts, charitable deductions, state death taxes, and the marital deduction.
2. Apply the tax rate on the decedent's taxable estate.
3. Determine estate tax liability by deducting any credits, including the unified tax credit, with the result being the estate tax due.

Estate Tax = Taxable Estate x Tax Rate - Credits

The personal representative of the estate is liable for the tax. If there is an estate tax due, then the personal representative of the estate must file Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return with the Internal Revenue Service no later than 9 months after the death of the decedent. However, the personal representative can file Form 4768 to automatically extend the time to file by 6 months.