“Death Tax” Basics

As of this newsletter, we are still awaiting the promised tax reform bill from President Trump.  While the details of the unfinished tax bill are still unknown, what is known from the one page summary that has been released is that it will seek, among many other changes, to permanently repeal the so-called “death tax.” While the term “death tax” has gained popularity in recent years, there actually is no tax by that name.  What is typically meant by that phrase is the estate tax.  As discussed below, it also sometimes refers to the inheritance tax. The estate tax is a tax imposed on a person’s estate after their death if it exceeds a certain size.  That size has varied much over the past 20 years.  For many years prior to 1997, estates that exceeded $600,000 were subject to the estate taxes.  For married couples, with proper planning, that amount could be doubled to $1.2 million.  Starting in 1997 and continuing through 2013, there have been four major tax laws that affected the estate tax: one under President Clinton, one under President Bush and two under President Obama.  As a result, as of 2017, the amount that can pass free of estate taxes has increased to a whopping $5.49 million which, again, with proper planning can be doubled to $10.9 million for married couples. The official tax rate on the amounts over the exemption is 40%.  And remember, this is before the Trump bill has been enacted. So, if you are concerned about estate taxes and wondering how they may apply to you, here are some facts that you should be aware of. Less than one percent of estates are required to pay estate taxes According to the Joint Committee on Taxation, 99.8% of all Americans are not required to pay any estate taxes upon their death. That equates to only 2 out of every 1,000 Americans. The reason is the above-mentioned federal estate tax exemption of $5.49 million for each individual. As noted, married couples, with proper planning, can double that exemption. The effective tax rate is around sixteen percent For those very few estates that owe estate taxes each year, the effective tax rate, on average, is 16.6 percent according to some reports. Sixteen percent is far less than the maximum statutory rate of 40 percent. This is quite contrary to the misconception that estate taxes consume almost half of an estate’s value. Tax-saving strategies make it easy for some estates to avoid taxes There are various tax-saving strategies that can be used to help estates avoid tax. For example, some estates use Grantor Retained Annuity Trusts (GRATs), which are designed to repay the estate the initial amount plus interest, usually over two years. If the investment increases in value any gain goes to an heir tax-free.  Otherwise, the full amount goes back to the estate. Only a few family-owned farms and businesses owe estate taxes According to most reports, roughly 20 small business and/or farm nationwide were required to pay estate tax in 2013. A small business or farm is one with more than half its value in a farm or business and valued at less than $5 million.  Of those 20 estates, the tax rate averaged at roughly less than 5 percent of their value. The largest estates typically include “unrealized” capital gains that were never taxed Capital gains tax is owed on the appreciation of assets, such as real estate, stock, or an art collection, only when the owner “realizes” or actually receives the gain, which is usually when the asset is sold. Consequently, the increase in the value of an asset is never subject to income tax as long as the owner holds on to the asset. These unrealized capital gains account for a substantial portion of the assets held by large estates. California Estate Tax and California Inheritance Tax have been eliminated As of January 1, 2005, California no longer imposes a separate estate tax at the state level. Therefore, the only estate tax liability California residents need to be concerned with is on the federal level. However, there are 17 states who still impose estate tax on the state level. An estate tax taxes the estate of a deceased person.  An inheritance tax taxes the amounts that a person inherits. It is sometimes also referred to as a “death tax.” California had an inheritance tax until 1982 at which time it was repealed. Only a handful of states, mostly back East, impose an inheritance tax. More about the federal estate tax exemption Due to recent legislation, the tax exemption is now “portable,” meaning that the surviving spouse of a decedent can take advantage of any unused portion of their deceased spouse’s exemption.  The unused portion of the exemption is then added to the surviving spouse’s own exemption.  For example, if only $2,000,000 of the wife’s $5,490,000 exemption is used, then the surviving husband can elect to add the husband’s remaining $3,490,000 exemption to his exemption.  This will allow him to pass on up to $8,980,000, tax-free. A timely election following the death of the first spouse is needed to preserve the “portability” option. Using the marital deduction Married couples can give a gift of an unlimited amount to their spouse. The value of the property gifted to the surviving spouse is deducted from the deceased spouse’s estate. If all assets go to the surviving spouse, then no estate taxes are imposed based on the “marital deduction.” A married couple can essentially protect $10.9 million from federal estate and gift taxes.  This is commonly referred to as the lifetime credit. If you have questions regarding estate taxes, or any other estate planning needs, please contact us (916) 437-3500.