Estate Taxes: What You Need to Know to Protect Your Family and Your Business
If there are only two certainties in this world, then the point where they intersect is in the estate tax, which taxes estates upon the death of their owners. A popular stump subject on campaign trails, the estate tax is often misunderstood as a death tax, a term that is, at best, misleading.
For business owners, there is understandable concern about whether or not the estate tax will dismantle their companies and their legacies, leaving little to nothing for their children to inherit.
Understanding the history and application of the estate tax should help business owners to know what to expect, as well as to alleviate certain fears.
One Hundred Years and Counting
Estate taxes have a long history. A ten-percent tax on property transferred at death existed in ancient Egypt. Emperor Caesar Augustus imposed the Vicesina Hereditatium during his reign, an estate and gift tax for wealthy Romans. Even in America, the estate tax has existed nearly as long as the country itself.
The Stamp Tax Act of 1797, the Revenue Act of 1862, and the War Revenue Act of 1898 were all forms of estate tax legislation. In these cases, the tax was introduced and later repealed or allowed to phase out, as the main purpose of these laws was filling the federal coffers in times of war.
The modern estate tax, by comparison, is built upon the Revenue Act of 1916. Extending from the federal income tax, the Revenue Act sought not merely to increase the U.S. war chest but also to ensure that the American elite paid a fair share of the nation's tax burden.
Previous to federal income taxes and the Revenue Act, the federal government primarily raised funds through tariffs and real estate taxes, burdens felt most acutely by farmers. As the industrial revolution forever altered the economic landscape, the fortunes of industrialists lay mostly untaxed.
The estate tax has endured much tinkering in the hundred-odd years since the Revenue Act of 1916, but it has remained a fundamental element of American economic policy.
How Estate Tax Works
The U.S. federal estate tax is actually composed of three separate components: taxes on estates, taxes on gifts made during life (inter vivos gifts), and taxes on generation-skipping transfers (GST). The latter two taxes were added after 1916 as wealthy individuals sought measures by which they could pass on their estates tax-free (such as simply turning over an estate before death).
Estate tax: Nine months after an individual's death, a federal tax return must be filed by the estate's executor. If the value of the estate exceeds $5.43 million, taxes are owed. An estate includes financial assets, tangible property, and jointly held assets such as life insurance proceeds.
Unlimited deductions are allowed for transfers to surviving spouses, as well as to charities. Other deductions include funeral expenses, financial debts, legal fees, and estate taxes themselves.
The estate tax itself is levied upon the value above $5.43 million. For example, if an estate after deductions is valued at $6 million, then the tax is applied to only $567,000.
The estate tax rate is 40%.
Gift tax: There is a lifetime exemption per donor of $5.43 million (the same exemption as the estate tax). Any gift from one individual to another above this limit is taxed at 40%.
In addition to the lifetime exemption, donors may gift $14,000 per year without incurring any tax burden. A married couple with one child could gift their child a total of $28,000 per year without paying any tax.
Generation-skipping trust tax (GST): A GST is a transfer of assets to an individual's grandchildren (or great-grandchildren) after the individual's death. GST taxes are set at the same rates as gift taxes, and operate in the same fashion.
Common Misconceptions
As the estate tax has become a regular part of political platform debates, many misconceptions about the so-called death tax have entered national discussions. In an effort to clarify the effects of the estate tax, the Center on Budget and Policy Priorities composed a report: Ten Facts You Should Know About the Federal Estate Tax. The following misconceptions are addressed in that report.
The estate tax affects a large part of the country. In reality, 99.8 percent of estates are entirely unaffected by the estate tax, as they fall below the $5.43 million cut-off mark. For every 1,000 deaths in America, only two individuals will end up paying estate taxes.
The estate tax takes half of the estate value. It is true that the peak statutory tax rate is 40%, but actual tax payments are far below that level. According to the Tax Policy Center, the average effective tax rate is 16.6%. Because estates can exempt $5.43 million and take advantage of numerous other deductions, few if any estates ever pay even half the statutory rate.
The estate tax hurts farmers and small businesses. A 2013 analysis by the Tax Policy Center determined that only 20 small business and small farm estates owed any estate tax that year. These estates were defined as estates with half their value in a small business or farm and with assets of less than $5 million. Those 20 estates paid an average effective tax rate of 4.9%.
Repealing the estate tax will lead to savings and investment. A report by the Congressional Research Service found inconclusive results on this matter, noting that a repeal would lead some individuals to save more and others to save less. The report did, however, note that a repeal of the estate tax would almost certainly lead to greater levels of government borrowing (to make up for the missing revenue), thus soaking up capital that would otherwise be available for investment.
