The Two Estate Taxes

There are two estate taxes authorized by federal law.

Republicans want to repeal the one that generates $1,000,000 revenue per return with tax owing and is paid by only 30,300 estates per year. It leaves heirs $2,000,000 of assets tax free and never taxes more than 46% of the entire estate. This tax closely approximates an income tax on inheritances.

The other estate tax, which no one talks about, generates $1,000 of revenue from each of about 400,000 estates per year, seizes virtually all of the property in the estate, and applies only to those with less than about $36,000 a year of income and no assets more substantial than a modest home (usually with well under $200,000 of equity) and car, in their final years.

The Well Known Estate Tax

The key thing to understand about the estate tax is that it is a tax on the people who actually earned the money in name only and for convenience purposes only. They don't actually feel the bite of the tax, because they are dead. If gifts and inheritances were income for tax purposes (they are excluded by Internal Revenue Code Section 102), the administrative burden would be immense, and excluding de minimus gifts and inheritances keeps administrative costs down while keeping much of the revenue from the tax in place, but the tax impact would be similar to that of the existing estate tax.

In practice, it is a tax in lieu of an income tax on someone who has done nothing to earn it. Likewise, the charitable deduction makes sense because if the distribution had been treated as income rather than a gift, it wouldn't have been taxed anyway. The only people who pay estate taxes are dead people, and they are very rarely (and never of necessity) paid by surviving spouses.

The gift and estate tax does protect transfers that remain within the family unit. Neither transfers to a spouse (with an exception for non-citizen spouses and certain elaborate types of transfers), nor transfers to minor children for support, are taxable gifts. But, when you have adult children (as is the case 99.5% of the time in taxable estates), with their own households, the "this has already been taxed" argument doesn't hold water.

Why should someone who receives $40,000,000 from an uncle as an inheritance (which would be tax free if the estate tax is abolished) be treated any differently from someone who wins a $40,000,000 Powerball jackpot, or that same person who worked for 40 years in the uncle's business and received $40,000,000 of stock options or deferred compensation? These heirs, by definition, have done nothing to earn a multi-million dollar inheritance. They may be personally nicer people than Paris Hilton, but the incidence of the tax is born overwhelmingly by members of her social class -- inheritors of vast wealth. The Paris Hilton example reminds us that other heirs, like her, have done nothing to deserve their inheritance other than winning the DNA lottery.

The government deserves these funds because the money received by people who luck into large inheritances should not be treated more favorably taxwise than funds of people who actually earn their money. It is a matter of tax equity.

Effective Estate Tax Rates Are Often Lower Than The Highest Ordinary Income Tax Rate

You can reasonably argue that the current top rate should be harmonized with the current top income tax rate (this discrepency is largely a historical accident as top rates for ordinary income were amended without changing estate tax rates). But, it is also true that the top estate tax rate is somewhat deceptive.

The estate tax rate is 46% on amounts in excess of $2,000,000 of net worth at death (reduced by taxable gifts made during life, the estate and gift tax are partially unified). But, any capital gains taxes which have accured but not been paid in a decedent's property because an asset has not yet been sold are forgiven at death. Thus, the net estate tax rate on capital gains which are part of an estate at death is really 31% (the capital gains tax rate tops out at 15%).

Calculated on a comparable basis (income and estate taxes are "tax inclusive" while gift taxes are "tax exclusive", i.e. taxed only on the after tax amount of the gift) the top gift tax rate is about 32%, but does not involve capital gains tax forgiveness (gifts have a "carryover basis", causing the recipient to remain liable on any accured capital gains taxes).

The top ordinary income tax rate, of course, is 35%. So,inheritances of capital gains present in an estate, net of the income tax forgiveness to the decedent involved, are actually taxed at less than ordinary income tax rates to the heirs. And, capital gains make up a disproportionately large share of estate taxable estates (particularly if you view the first $2,000,000 as coming first from property value not derived from capital gains). Many large estates, if not most, consist largely of appreciation in real estate and business ownership interests like corporate stock. It is very hard to get an estate heavily exposed to the estate tax from interest income and earned income alone -- CEOs typically spend the bulk of their salary (typically little more than $1,000,000) and perks and live primarily off appreciation in stock and stock options which can be tax free if held until death.

In smaller estates, the $2,000,000 of tax free transfers reduces the effective rates. A married couple with an $8,000,000 net worth and only the very most basic estate plan (an revocable trust with a credit shelter trust provision) would be taxed at an effective rate of 23% on that estate, for example. The same couple, with a $12,000,000 net worth, would be taxed at an effective rate of less than 31%. The effective tax rate exceed the top ordinary income tax rate of 35% only for married couples with a net worth in excess of $16.7 million after only the most basic estate planning (the proper documents cost about $2,000). In a typical two child family (the wealthy are not known for their fertility), this means that the tax in lieu of income tax born by the heirs will exceed ordinary income tax rates only for heirs receiving more than $8.3 million of unearned inheritance each, about twenty times the point where the 35% marginal rate for ordinary income taxes, much of which typically comes from earned income, begins.

Also, in larger estates containing closely held businesses, almost anyone with reasonable tax counsel can obtain a quite artificial 35% or more minority interest valuation discount (even if the heir ultimately obtains a majority interest) due to a lack of a consistency requirement between the gift tax and estate tax. This produces a roughly 31% tax rate on the portion of that asset that is not due to appreciation, and a roughly 20% tax rate on the portion of that asset that is due to a capital gain, net of the capital gains taxes that would otherwise be due.

Basically, the heirs who actually end up paying a tax rate (net of income taxes which accrued during the decedent's life but were not paid) in excess of the 35% ordinary income tax rate are those who inherit very large pensions or 401(k)s. But it is rare that these make up a large share of the large taxable estates facing more than a 35% effective tax rate after the $2,000,000 exemption, because even with very good stock picks, historical limits of about $15,000 of contributions to those accounts per year typically leave the largest in the single digit millions in value. Those whose wealth exists primarily in the form of publicly held stocks and bonds also have a hard time avoiding paying estate taxes (valuation discounts are not available to them), but typically these assets are in the form of stock inherited from founders of publicly held corporations and are typically predominantly made up of never taxed capital gains appreciation (discussed above). Also, the arguments for preserving closely held businesses from estate tax bites don't follow when a business is publicly held. In a publicly held business, it doesn't really matter who owns the shares, which have almost exclusively economic value, rather than control value.

The inequities of the current estate tax system vis a vis current income tax rates could easily be resolved by (1) setting both the estate tax rate and the gift tax rate at 35% on a tax inclusive basis, (2) giving inheritances of capital gains at death either a carry over basis (as currently proposed) or alternately making death a deemed sale of capital assets (to reduce the paperwork impact of having to keep track of purchase price data for many decades or even more than a century), in either case with an exclusion for small estates, rather than forgiving all capital gains taxes due at death, at a revenue loss of tens of billions of dollars per year, overwhelmingly from taxable estates, and (3) statutorily shutting down tax loopholes like the minority interest discount for closely held businesses (without regard to actual ownership percentages of the donor or recipient), and the exclusion of insurance proceeds based upon who owns the policy, regardless of who the insured is or who paid for the policy.

Modest Inheritances Are Excluded, Resulting In Reasonable Collection Costs For a Meaningful Amount of Government Revenue

To keep the cost of administering the estate tax down, and reduce the burden of the tax on people who are merely upper middle class, rather than rich, the estate tax has generous exemptions. About 98% of probate estates don't even have to file federal estate tax returns.

Current federal estate tax exemptions of $4,000,000 per married couple, plus $12,000 per person per year of gifts during life, plus discounts for closely held businesses and further discounts for real estate owned by a closely held business worth more for development than for use in an active business, protect all family homes worth less than Michael Jackson's compound. Any business meaningfully taxed by this regime is stretching the definition of "small business" and is in any case entitled to long term favorable interest rate financing from the IRS on the estate tax bill. Estate tax critics have yet to identify a single family farm lost to the estate tax. The typical case where estate taxes are even an issue for a farm involve a several thousand acre ranching operation next to a ski resort that has caused real estate values in the area to surge from almost worthless to Aspen and Vail like heights, or a large farm that benefits from newly discovered valuable oil and gas resources (a la the Beverly Hill Billies).

The revenues are significant, comparable to the entire excise tax collections or customs duty collections of the U.S. government. Contrary to critics claims, the tax isn't terribly expensive to collect (since so few returns are involved) and could be made far cheaper to collect and plan for, if the law remained stable. Part of the compliance costs of the existing law is that the law changes every year and that no one is really sure what the law will look like in 2011, since no one really believes that the provisions on the books (which reduce the exemption to $1,000,000 per person and increase the highest tax rate to 55% plus a 5% bubble rate) will b e allowed to come into effect, but few believe that estate tax repeal will really happen either, given current budget pressures.

If a few of the loopholes that make possible some of the most expensive estate planning options were eliminated, and a few tweaks were made to mimic the effects of common estate planning techniques without involving an attorney to actually draft the documents in cases involving married couples, collection and compliance costs could be reduced further still. For example, allowing a surviving spouse to inherit the $2,000,000 estate tax exclusion amount of a a deceased spouse would reduce the number of families who need to draft any documents to reduce their estate taxes by 75% or more. Changes in the rules governing when life insurance is included in a taxable estate could, in combination with a rule allowing inheritance of estate tax exclusion amounts, probably reduce that number of families who need to draft any estate tax oriented planning documents by 85%-90% from current levels.

The Less Well Known Estate Tax

The death tax people should really be concerned about is the Medicaid estate recovery program. It impacts only elderly people who couldn't afford nursing home care in their final years without liquidating their homes and cars and spouse's businesses, and results in many more farm and small business liquidations than the estate tax. Basically, only the middle middle class and working class are affected. The estate recovery program allows the government to recover any assets owned by a decedent, either in a probate estate or as a result of a Medicaid lien applied to exempt real estate, up to the extent of the value of the care provided by the program to the beneficiary, which is not protected by an exemption for a surviving spouse. Like the estate tax, it usually comes due at a second death.

There are about 8,000,000 Medicaid nursing home beneficiaries at any given time. About 400,000 estates of Medicaid nursing home beneficiaries face estate recovery actions each year (based on data from Massachusetts on collection rates and national beneficiary numbers, as Massachusetts has 33,000 Medicaid nursing home beneficiaries at any given time and about 1,600 estate recoveries per year). In contrast, only 62,000 federal estate tax returns were filed in 2004, of which tax was due on fewer than 30,300. The Medicaid number will be larger, and the estate tax number will be smaller in 2006, due to an aging population increasing Medicaid enrollments, and increased estate tax exemptions reducing estate tax filings, in 2006. Yet, the estate recovery program produces far less revenue. Nationwide, the estate recovery program recovers only about $362 million a year, about 1% of the collections of the estate tax and only about 0.8% of Medicaid nursing home spending. The average estate tax return where an estate tax is due produces about $1,000,000 in federal revenues. The average Medicaid estate tax recovery results in about $1,000 of revenue, although the bite is harsher in a significant minority of case that not infrequently result in the loss of homes and farms.

There is a death tax which should be abolished in this country, but it is not the federal estate tax, it is the Medicaid estate recovery program. Medicaid nursing home coverage should be a social program made available as a gift to eligible beneficiaries, not a disguised government loan which results in a bad debt 99.2% of the time, which is what the current program is, in effect.