Are you wondering what the Federal Estate Tax is and how it impacts the U.S.? Well, the good news is that most people won’t have to worry, as only 0.2% of Americans will owe Estate Tax, according to statistics of the Joint Committee on Taxation.
However, it’s helpful to understand what it is, where it came from, and how it works.
Here are 11 facts you should know about the Federal Estate Tax.
#1 What the Federal Estate Tax is
“There are two major forms of federal taxes: income taxes and estate taxes,” says Enrolled Agent Steven J. Weil, Ph.D., President of RMS Accounting.
The IRS defines the Estate Tax as the tax on your right to transfer property at the time of your death. So, if you pass away and are not survived by a spouse who is a U.S. citizen, everything you leave to your heirs will be subject to the estate tax regulations.
This applies if you are a U.S. citizen, a resident of the U.S. at the time of your death, or a nonresident who owns property in the U.S. (and is in the country at the time of death). You’re only required to file the IRS form (Form 706) for the Federal Estate Tax if your “Gross Estate” and lifetime taxable gifts exceed the threshold for the given year, both of which will be explained further in fact #3.
Assets with the potential to appreciate in value can be transferred to certain trusts that can help avoid Estate Tax on that increase in dollar value.”
According to the Joint Committee on Taxation [JXC 17-17], the estate and gift tax rates start at 18% for the first $10,000 of transfers considered taxable and go up to 40% for taxable transfers exceeding $1,000,000.
#2 The Federal Estate Tax is controversial
The first introduction of the Estate Tax was in 1916, and it included many of the features it has today. Estate tax rates rose during World War I and had a top tax rate that reached 77% from 1941-1976.
Many loopholes were found and utilized by taxpayers during these years, which resulted in a new tax bill being written in 1976. It established the estate tax system we have today. The unified credits were added, allowing many estates to pass on a set amount of tax-free assets to their heirs.
There have been a few times that Congress has been close to voting on a permanent repeal of the Estate Tax. In fact, it was abolished altogether in 2010, for that year only. Supporters of the tax say that it safeguards the U.S. against the concentration of wealth in the hands of a small minority, which they claim ensures a healthier democracy.
Critics say that this tax results in double taxation because a portion of the estate is earned income. They also claim that the tax reduces savings and economic growth by stifling wealth builders. Lastly, they say the tax burdens families who have built businesses and wealth that they want to pass on to the next generation.
Despite the controversy, the Estate Tax lives and has been in place for about a century now (aside from 2010).
#3 How Federal Estate Tax is calculated
“The Estate Tax is calculated by determining the fair market value of the items in the estate, subtracting any allowable deductions, adding the amount of lifetime taxable gifts, and then subtracting the available unified credit. The remaining total is the taxable estate.,” explains Joshua Zimmelman, President at Westwood Tax & Consulting.
According to the IRS, the “Gross estate” includes everything a person owns or has interests in at the time of death, including cash, securities, real estate, annuities, interest, trusts, certain life insurance proceeds, and other assets.
Deductions can include items such as mortgages and other debts, property that passes on to surviving spouses, charitable deductions, losses during estate administration, funeral costs, and estate administration expenses.
The value of the lifetime taxable gifts is calculated by adding up all of the gifts a person has given that exceed the annual exclusion limit for the year in which they were given. For example, in 2017, the limit is $14,000. If you gift one person $114,000 this year, $100,000 of that will be taxable.
Taxes are not paid on the gifts each year, but during the settling of the estate at the time of death. Zimmelman says, “Every taxpayer is entitled to a unified credit, which is the amount exempted from the Estate Tax based on the tax for all lifetime gifts and property transfers. Only the amount that exceeds the unified credit is due as tax.”
The unified credit is an amount that increases each year due to inflation and is set at $5.49 million for 2017.
Here’s an example of the estate tax calculation:
Gross estate worth: $6 million
Deductions: $2 million
Lifetime taxable gifts: $500,000
$6,000,000 -$2,000,000 + $500,000=$4,500,000
Unified credit: $5.49 million
Taxes owed: $0.
The $5.49 million unified credit covers the taxable estate worth so that no tax would be owed.
If your net assets and lifetime taxable gifts amount to over $5.49 million, you would be required to file the Estate Tax form; the difference between the total and the unified credit would be taxed.
#4 Heirs are not taxed on their inheritance
Some people wonder who pays the Federal Estate Tax when it does apply. Do the heirs have to pay it on their inheritances? Cameron R. Kelly of Stillwater Estate & Business Planning says, “In general, there is no tax on inheritance. This is confusing for some clients, who believe that their heirs get taxed on the receipt of property.”
He explains, “The Estate Tax taxes the decedent’s estate. Very few states have an inheritance tax, and most often beneficiaries will not pay tax. Similarly, the money received by the beneficiaries is not generally considered income, and therefore, is not subject to the income tax.”
So, to keep things clear, the government is taking the taxes owed from the decedent’s estate before it’s distributed to the heirs.”
#5 Most people won’t owe federal estate tax
An estate tax return is only required if the combined gross assets and taxable gifts exceed the set exclusion limits, and this doesn’t happen often (99.8% of the Americans don’t pay Estate Tax).
“If you have a relatively small and simple estate (no joint property, no special deductions, small amounts of easily valued assets) then you probably won’t have to file an estate tax return or pay an Estate Tax.” says Zimmelman.
Even for those who would owe federal estate taxes, Ted D. Snow, CFP(r), MBA at Snow Financial Group says, “People generally won’t have to pay if they set up properly drafted wills and trusts, gifting strategies, and other annual tactics to ensure a tax is not levied on their estate.”
Kelly notes that, while federal estate taxes won’t apply to many people, the rules relating to transfer tax will. He says, “For example, a gift of more than $14k in 2017 needs to be reported to the IRS on a gift tax return.”
#6 Family-owned farms are minimally impacted
There has been concern over how estate taxes will impact smaller family-owned farms that are over the tax exclusion threshold. According to the United States Department of Agriculture (USDA), in 2016, only 0.4% of farm-operator estates ended up owing estate taxes. The impact has steadily decreased as the exemption amount has increased, notably since 2001.
#7 Taxable estates owe an average of 17% of their estate’s value
It may be shocking to see that tax rates on estates can currently reach as high as 40%. However, the Tax Policy Center reports that, in 2017, the average taxable estate only owed 17% of their total value in taxes. How can they owe less than the minimum tax rate?
Tax is only due on the part of the estate that exceeds the exemption level, which results in an average effective rate far below the top statutory rate.
Here’s an example. If your estate is worth $10,000,000, you have $3,000,000 in deductions, and you have no lifetime taxable gifts, your taxable estate in 2017 would be $1,510,000 (after deducting the $5,490,000 million unified credit).
If you apply the 40% tax, because it’s over $1 million, you would pay $604,000 in Estate Tax. The $604,000 due in taxes is around 6% of the total estate amount of $10 million.
#8 Unrealized capital gains hold a large share of the biggest estates
According to the Federal Reserve Board, the average share of unrealized capital gains in estates increases with the size of the estate. It starts at 13% for estates smaller than $2 million and goes up to 55% for estates larger than $100 million.
Capital gains are never quantified until an asset is sold. So, if it’s held until death and passed to an heir, it would never be taxed if it wasn’t for the Estate Tax, which calculates the fair market value of all assets. This was one of the reasons for the establishment of the Estate Tax back in 1916.
#9 Certain trusts can help you reduce estate taxes
There are workarounds for unrealized capital gains if you plan ahead. Allie Petrova, Managing Partner of Petrova Law, says, “Assets with the potential to appreciate in value can be transferred to certain trusts that can help avoid Estate Tax on that increase in dollar value.”
She explains, “Good examples of qualifying trusts are grantor retained annuity trusts (GRATs) and intentionally defective grantor trusts. No estate tax would apply to capital gains once the assets are in a qualifying trust until the assets are sold or exchanged, or the gains are otherwise realized. Assets that are great candidates include business interests, marketable securities, an art collection, or real property.”
A GRAT is an irrevocable trust set for a specified period. It works by allowing an individual to move money or assets from their estate into the trust, which is designed to repay the estate the original amount plus interest as set by the Treasury. If the investment rises in value past the rate set by the Treasury, all profits can go to an heir, tax-free.
An intentionally defective grantor trust is another irrevocable trust that gives you the ability to transfer assets away from your estate and only pay income tax on them.
#10 You can use gifts to save on estate taxes
As Snow mentioned above, you can use gifting strategies to lower taxes that are levied on your estate.
Weil explains, “Gifts can be used to save on estate taxes. If you know your overall net worth will exceed the limit at death, you can make use of the $14,000 annual gift exclusion to reduce your estate and therefore save on taxes down the road. If you have a large estate, the savings can amount to upwards of 40 cents on every dollar you give away.”
The laws pertaining to gifting allow you to give a set amount of money (or assets equivalent to that amount of money) per person, per year without any tax consequences. You could gift money or assets to as many people as you’d like and it will be tax-free, as long as you stay under the annual exclusion limit.
Zimmelman also points out that you don’t have to file a gift tax return if you’re directly paying someone’s educational costs or medical expenses.
#11 An estate plan is beneficial whether you owe Estate Tax or not
Lastly, even if you don’t owe estate taxes, it’s still a good idea to make an estate plan.
“There are many reasons to ensure you have an estate plan in place whether or not you will be subject to the Estate Tax,” says Rebecca Pavese, CPA, financial planner, and portfolio manager with Palisades Hudson Financial Group,
She adds, “A plan will ensure that you provide the desired support and financial security for your family, it will help preserve assets for future generations, it ensures you take an active look at how your assets will pass to your heirs, and allows you to confirm or change the intended beneficiary.”
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