What are the estate and gift taxes?
The estate tax (also known as the “death tax” by those opposed to it) is a tax on the transfer of property at death. This is different from an inheritance tax. An estate tax is paid by the estate of the deceased (that is, the person giving the property). The inheritance tax is paid by the beneficiary. This distinction can be important if the two parties have different tax rates.
Example: Frank has a son named Sam. Frank’s total estate is worth $1M. In Frank’s will he leaves all his property to Sam. He has used all of his lifetime exemption (described below).
- Scenario 1: An estate tax of 40% – Frank’s estate pays $400,000 and the remaining estate of $600,000 goes to Sam.
- Scenario 2: No estate tax, but inherited property is taxed as regular income. Sam is in the 28% tax bracket (we’ll ignore the fact that $1M moves Sam into a different tax bracket) – Frank’s estate pays the entire $1M to Sam. Sam pays his normal 28% income tax on the money, resulting in Sam paying $280K in taxes. Sam has $720K remaining.
For the rest of this article I’ll just refer to the estate tax, as this is what we have here in the US.
Once you have an estate or inheritance tax you also need to have a gift tax. If you had an estate tax but no estate tax then people could just give away all their assets tax-free during their lifetimes. Maybe you’d work out a deal with your heirs – I’ll give you all my money when I’m 60 and you take care of me the rest of my life. Using this method you could just gift all your assets during your lifetime and never be subject to the estate tax. This would result in an unfair situation where only those people who die unexpected would be subject to the estate tax.
Annual gift exclusion
Each year you can make an tax-free gifts of up to $14,000 to an unlimited number of people. This is called the annual gift exclusion. In 2016 person A can make a tax-free gift of $14,000 to person B and Person A can make a tax-free gift of $14,000 to person C. If he wanted to, Person A could make gifts of $14,000 to 100 different people, allowing him to transfer $1.4M completely tax-free.
My wife and I have 2 kids. If we wanted to transfer wealth to our kids we could do the following:
- I give $14,000 to our daughter
- I give $14,000 to our son
- My wife gives $14,000 to our daughter
- My wife gives $14,000 to our son
Each transfer is for $14,000 and is therefore covered by the annual exclusion. In total, my wife and I could transfer $56,000 to our kids per year, completely tax-free.
Note that the annual gift exclusion applies to gifts and gift taxes, but NOT to estate taxes. That is, there is no $14,000 exemption for transfers at your death.
Unified estate and gift tax
Here in the US we have a unified gift and estate tax. Each person has, as of 2016, a lifetime exemption of $5.45M. That means that, over the course of your life and at your death, you can transfer a total of $5.45M without paying any federal taxes. This is in addition to the yearly gift exemption. The lifetime exemption is indexed annually for inflation.
Any gift or estate transfer beyond the lifetime exemption is taxed at the 40% gift and estate tax. Note that the person making the gift pays the gift tax, NOT the recipient.
There is also an unlimited spousal exemption. This means that you can leave you spouse any amount of money and it will transfer tax-free.
Portability of the lifetime exemption
It used to be the case that upon a person’s death their lifetime exemption would die with them. Let’s say that my wife and I have a $10M estate. I die and leave everything to her. My portion of the estate goes to her under the unlimited spousal exemption so no taxes are incurred. However, under the old rules, that also meant that my lifetime exemption would disappear and she would then be able to transfer only $5.45M tax-free upon her death.
The rules changed in 2011, and now the exemption is portable. If I die then my wife inherits any of my unused exemption. If I have used none of my exemption then she will have a total exemption of her exemption plus my unused exemption, or $5.45M + $5.45M = $10.9M. Thus, she could leave almost $11M to our kids without paying any taxes.
Examples
Here are some examples of how all of this works in practice:
Example 1: Assume I’m single and have not used any of my lifetime exemption. When my daughter turns 18 I give her $1M. $14,000 of that will be covered by the annual gift exclusion. The remaining $986,000 will count towards my lifetime exemption. I will still have a $4,464,000 ($5,450,000 lifetime exemption – $986,000 used this year) exemption to use for future gifts or to reduce my estate taxes.
Example 2: Assume I’m single and over the course of my life I’ve used $3M of my lifetime gift exemption. I have $5.45 – $3M = $2.45M of my lifetime exemption left. At my death my estate is worth $5M. $2.45M of my estate is tax-free (my remaining lifetime exemption). The remaining $5M – $2.45M = $2.55M is taxable. This amount is taxed at 40%, which means my estate will pay $1,02M in estate taxes. My heirs will receive the remaining $5M – $1.02M = $3.98M.
Example 3: Assume I’m single and have not used any of my lifetime exemption. This year I give $3M to my son and $3M to my daughter. The total amount of taxable gift is the gift to each child, minus the annual gift exemption for each child, minus my remaining lifetime exemption. This works out to $522,000 ($3M + $3M – $14,000 – $14,000 – $5.45M). $522,000 is taxed at 40%, resulting in $208,800 in gift taxes. Again, note that the person making the gift is responsible for the gift taxes. My children both receive the full $3M gift and I pay $208,800 in gift taxes. I have used all of my lifetime exemption so any additional gift beyond the annual exemption will be taxed at 40%, as will my entire estate at my death.
Example 4: Assume I’m married and have not used any of my lifetime exemption. I’m worth $1B. Upon my death I leave everything to my wife. Because of the unlimited spousal exemption she receives all of the money tax-free. Note – she could then remarry the pool boy and leave everything tax-free to him. The pool boy could then remarry and leave everything tax-free to his new spouse. In this way the unlimited spousal deduction can be used for an unlimited number of tax-free transfers.
Example 5: Assume that I’m single and have not used any of my lifetime exemption. I die and my estate is worth $2M. Because this amount is below the lifetime exemption, all of my assets go to my heirs tax-free.
Example 6: Assume that I’m single and have used ALL of my lifetime exemption. I die and my estate is worth $2M. All of this is taxed at 40%. My estate pays $800,000 in estate taxes and the remaining $1.2M goes to my heirs.
Basic tax planning
The reality is that, despite the protests about how unfair the estate tax is, it affects virtually nobody. Under the current estate tax only about .2% of Americans who die in 2017 (about 5,200 people) will have taxable estates. These people are obviously the richest of the rich. Repealing the estate tax will ONLY help the top 1%.
However, if you’re worried about being hit by the estate tax the easiest way to avoid it is to maximize your use of the annual gift exemption.
Example 7: My wife and I have 2 kids (a son and a daughter). Both of our kids are married. Each year we make the following gifts:
- I give $14,000 to our son
- I give $14,000 to our son’s spouse
- I give $14,000 to our daughter
- I give $14,000 to our daughter’s spouse
- My wife gives $14,000 to our son
- My wife gives $14,000 to our son’s spouse
- My wife gives $14,000 to our daughter
- My wife gives $14,000 to our daughter’s spouse
We can give away 8 * $14,000 = $112,000 per year without incurring any taxes or using any of our lifetime exemption. That’s a significant amount of wealth transfer. If this is done for 10 years you’d transfer $1.12M.
Another way to make your wealth transfer as productive as possible is to transfer assets that are expected to grow in value. Let’s say you own $14k in stock that you expect to grow to $100k in 10 years. If you give it to your heirs now it will fall under the annual gift exclusion. If you wait for 10 years to give away the stock you’ll need over 7 years to give it all away using the annual exemption.
Arguments for and against the estate tax
I understand the arguments against the estate tax. People work hard to create wealth – why should the government take any of it? If you want to leave all of your money to your children (or your pets) you should be allowed to, right? Opponents of the estate tax usually argue that it hurts small businesses. If you have a business worth $20M and you want to pass it on to your heirs you’re going to have to pay a lot of estate taxes to do so. Let’s say that between you and your spouse you have $10M in lifetime exemption remaining. That means the remaining $10M of your estate is subject to the estate tax, resulting in $4M in taxes. If your estate doesn’t have $4M in cash available to pay the taxes then you might need to liquidate the business to pay the estate taxes.
This is a compelling argument, but the reality is that, again, it affects very few estate. Those estates can plan for this eventuality by starting to transfer money out of the estate each year using the annual exemption. Another planning methodology is to purchase life insurance on yourself, with the proceeds payable to your estate. If you buy a $4M policy then the life insurance proceeds will cover the estate taxes, allowing you to transfer the business to your selected heirs.
The other issue with this scenario is that a business worth $20M is hardly a small business. I’m not sure there is a populist movement in the US towards protecting the families worth >$20M who don’t want to pay estate taxes.
I’m generally in favor of the estate tax. First, I’m not a fan of passing unlimited wealth to the next generation. I don’t think it’s very good for people to receive that much wealth, and ultimately allowing the unlimited transfer of wealth from one generation to another will create a new aristocracy in the US. Just because somebody wins the ovarian lottery and is born into the Walton or Buffett or Gates family doesn’t mean they should live a life of luxury and excess.
I liked Warren Buffett’s stance on this. He said he wanted to leave enough money to his children so they could do anything, but not enough so they could do nothing.
Conclusion
The good news is that the estate tax might not be an issue for much longer, as both the Republican controlled Congress and President-Elect Trump have said they want to repeal the estate tax. I haven’t seen any statements about repealing the gift tax – it would seem strange to have a gift tax but not an estate tax, as that would just incentive people to hold on to their wealth until they die, even if the money could be better used by less wealthy family members.
What do you think about the estate and gift taxes? Are they fair?