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Fixing the Estate Tax Situation

Written by Nickel - 16 Comments

Fixing the Estate Tax Situation

As you’ve likely heard by now, President Obama has agreed to extend the Bush era tax cuts for all taxpayers for the next two years. What you may not have heard is that this sweeping agreement also includes a fix for the looming estate tax situation.

What situation? Well… In case you weren’t aware, the estate tax disappeared for 2010, and was set to come back with a vengeance next month with the estate tax exemption dropping from $3.5M in 2009 to $1M in 2011, and the top estate tax rates jumping from 45% to 55%.

Well, that was then… Now it’s looking like the estate tax exemption will be increased to $5M and the top rate will be reduced to 35%. While the timing of this change isn’t clear, I’m assuming that they’re hoping to have it in place by January 1st.

What do you think? Does this agreement go far enough? Too far? Personally, I’ve never really been a fan of the estate tax even though it doesn’t impact the vast majority of people. I am, however, a bit surprised at how far the proposal goes. This goes well beyond restoring the status quo.

Published on December 7th, 2010
Modified on December 9th, 2010 - 16 Comments
Filed under: Planning, Taxes

About the author: is the founder and editor-in-chief of this site. He's a thirty-something family man who has been writing about personal finance since 2005, and guess what? He's on Twitter!

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16 Responses to “Fixing the Estate Tax Situation”

  1. 1
    Jeff Says:

    I’m split on it. The majority of millionaires in this country got their money through hard work and risk. My parents came to this country unable to speak English and now my father is a partner in a small business that generates millions of dollars in gross profit a year. I’m not thrilled with the thought of his hard earned money being taxed(again) upon his death. But I see the necessity of generating revenue for the state, politics about spending aside, and I really shouldn’t rely on his money to get by. Doesn’t mean I don’t want it someday though.

    Side question: Is the exemption per person? As in does a married couple get to give 10M tax free?

  2. 2
    Nickel Says:

    Jeff: Yes and no. It’s per person, but if one spouse dies first and the assets flow to the second, then it will all pass through #2 when that individual dies. It can actually be quite complex depending on how you have things set up.

  3. 3
    Steve Says:

    The estate tax and the step-up in basis go hand in hand. Maybe the step-up in basis is no longer needed, in today’s era of electronic records. But to step-up without imposing any tax is too generous to those who are lucky enough to inherit large assets. Even a $5 million exception is a lot; that’s enough money for multiple families to live a comfortable lifestyle in perpetuity.

  4. 4
    John Says:

    I’d be curious to see if there are any economic models on this, but I would guess that the inheritance tax is probably one of the least disruptive ways possible for the government to collect revenue without adversely affecting the economy.

    Let’s take an extreme case and pretend that the inheritance tax rate goes to 100% next year, with no exemption. Since anyone with an estate can no longer pass it on, their choices are either let the government take 100% of their assets or spend the money in their lifetime. Obviously, the only decision that makes any sense in this context is to spend as much of the money as possible prior to death.

    In general taxes slow economic growth, but in this case it seems like a high inheritance tax rate would have a very stimulative effect on the economy. Even if there is some work avoidance (i.e., why should I work as hard if I won’t get to pass it on anyway), it seems like this would be easily outweighed by the “forced-spending” effects of the tax.

    Thoughts?

  5. 5
    Patrick Says:

    Being from a farming community this estate is looked at differently by people in the Mid West than on either coast.

    Farm land has gone up in value and is only as valuable as the ability for the farmer to generate cash in future years by growing and selling crops. Now, what does this have to do with the estate tax? Well according to the bank most of the farmers in my area are worth anywhere from $500k to $5 million in assets but almost none of them have anywhere near that kind of money on hand.

    If they die and pass on the farm the potential tax would be 35% of $5 million or about $1,750,000. Now, the only way the person inheriting the farm could possibly pay this tax would be to sell either parts or the entire farm. Now, on top of having to pay the inheritance tax the farmer will be hit with a capital gains tax.

  6. 6
    Barry Says:

    While I agree with the comments here, I must point out an often over-looked reason for the estate tax: to prevent wealth from being concentrated in the hands of a few.

    You can argue this happens anyway, but that’s besides the point. By taxing very large estates, the government helps break up aristocracy and the concentration of wealth.

  7. 7
    Kevin @ Thousandaire.com Says:

    I think the estate tax is necessary. If you have over $5 million, then your beneficiaries are getting enough. The government needs to generate income somehow, and keeping it from being concentrated on the rich is a great way to do it.

  8. 8
    Kevin R. Says:

    A subject near and dear to my heart, as of recently, with another bereavement. Now my mom’s estate is between the old and the new exemption. Currently the advise of the accountant is list beneficiaries on the annuity and other cash assets (so they’ll go directly to the individual instead of going into the estate) and start gifting (up to $11K per individual per year) to get around the current taxes. Back in ’90’s the way around all this was to form trusts and place most assets into the trust. Congress has whittled down that loop hole over the years, although trust do have some benefits (such as protection of biological children in case of remarriage). Best to ask for professional advice on these matters at points of life changes (marriage, children, retirement, bereavement – I think it would be a little morbid to keep up with the year to year, unless professionally).

    There does always seem to be large loopholes, that one can drive a truck through, for those who keep up with money matters on an ongoing basis. My parents formed the trust after the death of Chief Justice Burger and the Washington Post financial section ridiculed how behind the times his estate planning had been to be caught with such a tax burden. My dad was a child of the depression, so squirreled away cash in every conceivable vessel, but lived within very modest means, so there was no concept of the size of the estate until his passing. The laws seem to catch those with wealth but for whom their wealth is of lesser importance not to keep up with all the latest nuances of the laws.

  9. 9
    Kevin R. Says:

    The trouble with ‘breaking up concentration of wealth’ argument is that there always seem to be loopholes, some large enough to drive a truck through. However, the loopholes do seem to be dynamic in nature.

    My family has recently gone through a bereavement, no trouble this year but the value is over the new amount. The advice of the estate lawyer’s accountant is to list beneficiaries on the annuities and other assets (which will keep them out of the [future] estate, going directly to individuals), to begin to gift (IRS current is $11K per individual per year).

    My parents formed a trust in the ’90’s, because at the time of Chief Justice Burger’s death the Washington Post financial section ran several pieces at how outdated his estate planning was to be hit by all the taxes. My dad was child of the Depression, so we grew up frugally (first new car was when he was 45, a Chevy) but squirreled away cash in every conceivable vessel – we had no idea until the accounting of the estate size (not over the old exemption, but much more than the new). The moral question seems clouded when wealth is less important it’s easily taxed, but if more a focus in an individual thinking, then the current strategies and loopholes are known.

    Putting the question out there without answer, I think it’s prudent for folks to pay a professional at major life changes (marriage, children, retirement, bereavement) because the field does seem ever changing.

  10. 10
    BG Says:

    The point of the estate tax, is to finally tax wealth that had NEVER been taxed.

    Think of people like Warren Buffet, who have built massive wealth through stock purchases. He has not paid a single cent in tax on the growth of his hoard. If he were to sell his stocks, then he would pay a tax — but the man never sells.

    The transfer of estate ownership should be taxed as it were ’sold’, and then the remaining value of the estate (that is past to the heirs) should be taxed as if it were their income that year.

    Every single financial transaction is taxed in this fashion, why should massive hoards that are passed down through generations be immune?

  11. 11
    Evan Says:

    @Patrick
    Everyday, literally everyday I go to work, I am attempting to plan for the future estate taxes of the very wealthy. There are ways to plan for it, but the future decedent has to be willing to look into them, which leads us directly to Kevin’s point about planning.

    There are some great articles comparing public figures who planned and didn’t plan. Maybe FCN will let me do a guest post on them but a classic comparison is Jackie O who paid 1mil on a 50mil estate while Joe Robbie’s family had to sell the Dolphins in a fire sale to pay the estate taxes!

    @Kevin,
    It is actually 13K/donee this year. If your estate attorney or CPA is telling you 11k it is time to get a younger advisor lol

    @BG,
    That is how they do it up in Canada – there is no “estate” tax, per se, but it is treated as a capital gains payment

  12. 12
    jim Says:

    I think the $5m exemption and 35% rate is just fine.

  13. 13
    jim Says:

    Patrick, There is a thing called the Qualified Family Owned Business Interest exemption that gave an extra deduction for small business/farm assets passing from one generation to another. So theres already exception in place to help the VERY rare situation where a multi-million dollar estate has low liquidity and is a family run operation. There is also a ’special-use valuation’ rule that allows farms to value assets below market value. So theres already rules in place to help the handful of multi-million dollar farms out there that don’t have piles of cash on hand.

    “Now, on top of having to pay the inheritance tax the farmer will be hit with a capital gains tax.”

    Normally you do not have to pay capital gains on the full value of an inherited asset. The cost basis is adjusted to current market value.

    THis year in 2010 the rules are flipped. Theere is no tax but your cost basis is $0. So while there is not estate tax you have to pay capital gains on the entire value if and only if you sell the asset. That won’t hurt farms in your example at all, they’d be totally tax free in 2010 if they don’t sell.

  14. 14
    Brian Says:

    It’s somewhat inaccurate the reason for the estate tax is to tax wealth that’s never been taxed, although in many instances that may be the effect. However, if I am someone who (perhaps unwisely) holds $10M in money market deposit accounts, I will have already paid taxes on any wealth in those accounts, so an estate tax would indeed be a straight up tax on wealth.

    If it’s truly supposed to be a capital gains tax payable at death, they should just make it so, with appropriate exemptions to account for illiquidity situations. It might potentially be a fairer approach, as it wouldn’t favor one asset allocation over another (e.g., the person in my example above wouldn’t, in a sense, be double taxed).

    That being said, I can also see the problem with large concentrations of dynastic wealth.

    I suppose the $5M exemption is appropriate, despite the fact if done right, spouses could pass on $10M with virtually no income tax liability during lifetime and zero estate tax liability at death, while heirs enjoy a step-up in basis of assets. I really wish I had a rich grandfather right now.

  15. 15
    Michael Harr @ TodayForward Says:

    @Jeff – With a basic A/B Marital Trust (aka credit shelter), the new law will allow a married couple who does a little paperwork to shelter up to $10 million without paying taxes.

    @John – The revenue generated via estate tax is quite small relative to other tax receipts. The tax exists more for the preservation of our democratic capitalist institution than as a mechanism for bolstering tax roles. In addition, anyone that can afford a decent attorney can generally pass on their estate with a small fraction of the estate tax rate. Even when it was 55%, it was commonplace to see estates transfer 90% or more of their value to beneficiaries. This includes estates with hundreds of millions of dollars in them.

    As for taxing money twice, it’s a simple redistribution method that is setup to prevent the wealthiest families from continuing to amass multi-generational fortunes to the exclusion of the general population. A study of the Medici family (the original capitalists) had estimated they would have owned the entire world – and that was many years ago.

    @Kevin R – Careful how you structure ownership and beneficiaries on annuities. This is one of the most common areas where people put together a great estate plan that blows up because ownership and bene’s are wrong. I’d even pay the attorneys’ staffers to help you work through it.

    @BG – The reason capital investments aren’t taxes on a year to year basis and only when they are sold is there is no cash and the capital is at work. In the instance of a private company that raises capital through a stock offering, do you think anyone would invest if they had to pay taxes on any gains immediately? Where would the cash come from? A forced sale of stock? Most stock investments are made with the intent of holding for longer periods of time to reap the rewards generated by the business with taxes being paid from the proceeds of the sale. Taxing before cash is available…not so good.

    The estate tax actually INCREASES the tax rate that Warren would hypothetically pay (since he’s giving it all away). Without estate taxes, he would pay the then current capital gains rate which is currently 20% lower than the upcoming estate tax rate. As someone mentioned earlier, loopholes abound, so even if he didn’t want to give his estate away, he could likely avoid most of them anyway (see literature on Sam Walton’s estate).

    Actually, nevermind…I misread your comments.

    @Jim – Glad you hit on that. The other issue you have at death is depreciation recapture in valuing the estate and accounting for IRD. That’s a real pain in the backside.

  16. 16
    Darwin's Money Says:

    The estate tax is something I really struggle with (where I stand). On one hand, it’s money that’s already been taxed once when earned – and now the government is usurping hard-earned family income a second time just to redistribute it. On the other hand, should anyone rightfully be inheriting billions of dollars without being subject to tax – what happened to meritocracy?

    Finally, we’re in a boatload of debt and the government has to get serious about looking at revenue sources and curtailing entitlement spending or the bond market will demand it of us by way of a true crisis and hyperinflation.

    So, fundamentally speaking, I’m opposed to it, but the pragmatist in me says we need it – and I’m surprised Obama went as high as a $5 Million threshold.

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