Inheritance tax

From Wikicpa

Inheritance tax, also known in some countries as a death tax and as an estate tax within the U.S, is a form of tax imposed upon the transfer of the property of the estate of a deceased person that is left to a living person or organization.

Supporters of the inheritance tax argue that it is not a death tax per se, but simply a tax on a transfer of wealth (though it only is implemented upon the death of the estate owner). Opponents argue that the tax is applied to the full estate, and not merely the amount transferred, which arguably increases the effective transfer tax rate. In the United States, the tax is imposed only on the "taxable estate," which is generally less than the value of the full estate.

If an asset is left to a spouse or a charitable organization, some countries do not apply the tax. The tax is also imposed on other transfers of property made as an incident of the death of the owner, such as a transfer of property from an intestate estate or trust, or the payment of certain life insurance benefits or financial account sums to beneficiaries.

Contents 1 Federal estate tax 1.1 The "gross estate" 1.2 Deductions, the taxable estate, and the tentative tax 1.3 Tax credit, the exemption equivalent, and the tax 1.4 Requirements for filing return and paying tax 1.5 Exemptions and tax rates 2 Debate 2.1 Arguments against 2.2 Arguments in favor 2.3 Effects of the debate 3 Related taxes 4 Further reading 5 Also see 6 External links

Federal estate tax

The Federal estate tax is imposed "on the transfer of the taxable estate of every decedent who is a citizen or resident of the United States.

The "gross estate"

The "gross estate" for Federal estate tax purposes often includes more property than that included in the "probate estate" under the property laws of the state in which the decedent lived at the time of death. The starting point for the calculation of the estate tax is the value of the "gross estate" defined at, as modified by certain other statutory provisions. The gross estate (before the modifications) may be considered to be the value of all the property interests of the decedent at the time of death. To these interests are added the following property interests generally not owned by the decedent at the time of death:

• the value of property to the extent of an interest held by the surviving spouse as a "dower or curtesy" ;

• the value of certain items of property in which the decedent had, at any time, made a transfer during the three years immediately preceding the date of death (i.e., even if the property was no longer owned by the decedent on the date of death), other than certain gifts, and other than property sold for full value;

• the value of certain property transferred by the decedent before death for which the decedent retained a "life estate," or retained certain "powers";

• the value of certain property in which the recipient could, through ownership, have possession or enjoyment only by surviving the decedent

• the value of certain property in which the decedent retained a "reversionary interest," the value of which exceeded five percent of the value of the property;

• the value of certain property transferred by the debtor before death where the transfer was revocable;

• the value of certain annuities;

• the value of certain jointly owned property;

• the value of certain "powers of appointment";

• the amount of proceeds of certain life insurance policies.

The above list of modifications is not comprehensive.

As noted above, life insurance benefits may be included in the gross estate (even though the proceeds arguably were not "owned" by the decedent and were never received by the decedent). Life insurance proceeds are generally included in the gross estate if the benefits are payable to the estate, or if the decedent was the owner of the life insurance policy or had any "incidents of ownership" over the life insurance policy (such as the power to change the beneficiary designation). Similarly, bank accounts or other financial instruments which are "payable on death" or "transfer on death" are usually included in the taxable estate, even though such assets are not subject to the probate process under state law.

Deductions, the taxable estate, and the tentative tax

Once the value of the "gross estate" is determined, the law provides for various "deductions" (in Part IV of Subchapter A of Chapter 11 of Subtitle B of the Internal Revenue Code) in arriving at the value of the "taxable estate." Deductions include but are not limited to:

• Funeral expenses, administration expenses, and claims against the estate  ;

• Certain charitable contributions;

• Certain items of property left to the surviving spouse.

After subtracting the deduction amounts from the gross estate amount to arrive at the "taxable estate" amount, the tax rate is imposed on the value of the "taxable estate" to compute the tentative tax.

Tax credit, the exemption equivalent, and the tax

However, the law then provides for a credit against the tentative tax. The credit may be thought of as providing, in effect, for an "exemption equivalent" or exempted value with respect to the value of the property. For a person dying during 2005, an estate with a value less than $1,500,000 would not pay a federal estate tax and most likely would not have to file a federal estate tax return. The applicable exclusion amount increases to $2,000,000 for decedents dying in the years 2006, 2007 and 2008. The amount increases to $3,500,000 for 2009. According to the Econonic Growth and Tax Relief Reconciliation Act of 2001, the federal estate tax disappears for the year 2010, but the tax returns in 2011 at the 2001 level. Note that this credit is a "unified gift/estate tax credit" that deals with both estate and gift taxes. Past gifts from the estate that were subject to gift tax must be included in a grand recalculation of the credit, the estate value, and the estate/gift tax due. Special cases can lead to surprising tax obligations.

Requirements for filing return and paying tax

For estates larger than the current federally exempted amount, any estate tax due is paid by the executor or other person responsible for administering the estate. That person is also responsible for filing a Form 706 return with the Internal Revenue Service. The return must contain detailed information as to the valuations of the estate assets and the exemptions claimed, to ensure that the correct amount of tax is paid.

Exemptions and tax rates

Debate

The propriety of the estate tax has been debated extensively.

Arguments against

An argument against the estate tax is the disincentive to invest in an estate that is nearing an exemption limit. Many farms, small businesses, and private investors simply stop investing in taxable enterprise, preferring to shift their resources to tax avoidance schemes within insurance policies, gift transfers, and tax free investments, rather than the farms and businesses that built their wealth to begin with. By moving investment away from personal choice to a tax favored status, the inheritance tax effectively limits the value of a small business and creates incentives to abandon profitable enterprise in favor of politically popular causes.

Moreover, not all taxpayers have equal access to (or trust in) such estate planning services; an aging farm or business owner (perhaps a Depression survivor) might not understand the consequences of leaving inheritance issues to surviving family members, or even of intestacy. A policy that creates an uneven tax burden, even when due to ignorance or inaction, can raise the appearance of unfairness.

Opponents also argue that the Federal estate tax rate is effectively higher as a percentage of the amount actually transferred to heirs. For example, an estate worth $3.5 million paid $940,000 federal estate tax in order to transfer $1,280,000 to each heir, suggesting an effective transfer tax rate of 36.7%. Similarly, at the limit, the top federal tax rate of 50% on the estate value would imply a transfer tax rate of 100% of the amount transferred to heirs. (For non-cash assets such as real estate or securities, market fluctuations after death can lead to tax/asset mismatches and a higher effective rate of taxation for heirs; this affected some estates valued during the economic downturn in 2001-2002.) The high effective transfer tax rate has prompted many wealthy benefactors to make sizable gifts during their lifetime, paying a gift tax on the amount transferred, rather than allow the whole amount to be taxed at the estate level.

Some argue that the estate tax creates a potential for double and triple taxation, that is, taxation on assets which have already been taxed. Double taxation occurs on earned income, and by imposing capital gains tax on the returns after earned income is reinvested in new ventures, stocks, bonds,and savings. The estate tax would then add an additional tax upon the two previous taxes netting a triple taxation of earned income.

The debate sometimes revolves around which estates are affected by current law. The effects of the law on small business owners and family-owned farms (entities which, conservatives argue, are hardest hit by the estate tax) was studied in an analysis undertaken by the Tax Policy Center. A study of the 18,800 taxable estates taxed in 2004 found 7,090 which had any farm or business income. Of those, there were 440 estates in which half or more of its assets were the value of farms and/or businesses. The effective tax rate on the 440 estates studied in detail never averaged more than 23%.

Arguments in favor

Proponents of the estate tax argue that it serves to prevent the perpetuation of wealth, free of tax, in wealthy families and that it is necessary to a system of progressive taxation]. Proponents point out that the estate tax only affects estates of considerable size (presently, over $2 million USD, and over $4 million USD for couples) and provides numerous credits (including the unified credit) that allow a significant portion of even large estates to escape taxation. Regarding the tax's effect on farmers, proponents counter that this criticism is misguided as there is an exemption built into the law that is specifically designed for family-owned farms.

Furthermore, supporters argue that many large fortunes do not represent taxed income or savings, that wealth is not being taxed but merely the transfer of that wealth, and that many large fortunes represent unrealized capital gains which with a step up in basis, will never be taxed as capital gains under the federal income tax.

Proponents further argue that the estate tax serves to encourage charitable giving, one way in which individuals can avoid paying the tax. A 2004 report by the Congressional Budget Office found that eliminating the estate tax would reduce charitable giving by 6-12 percent.

Another argument in favor of the estate tax relates to comparative incentives. Proponents argue that the estate tax is a better source of revenue than the income tax, which is said to directly disincentivize work. While all taxes have this effect to a degree, some argue that the Estate Tax is less of a disincentive since it does not tax money that the earner spends, but merely that which he or she wishes to give away for non-charitable purposes. Moreover, some argue that allowing the rich to bequeath unlimited wealth on future generations will disincentivize hard work in those future generations.

Proponents of the estate tax tend to object to characterizations that it operates as a double or triple taxation. They either note that such double and triple taxation is common (through income, property, and sales taxes, for instance), or argue that the estate tax should be seen as a single tax on the inheritors of large estates.

Some proponents of the estate also tax point to historical precedent for limiting inheritance. This is cited for the proposition that unlimited inheritance tends to destabilize societies, as well as that current generational transfers of wealth are greater than they have been historically.

Effects of the debate

Many of its opponents refer to the estate tax as the "death tax" and have called for its abolition. In response, Congress has passed tax laws that have changed the estate tax. Since 2003, the top rate has been lowered from 50% by one percentage point per year; in 2006 the top rate was 48%. If the US Congress makes no changes to US tax law, the top rate will continue to drop by one percentage point per year until 2009 when the top rate is scheduled to be 45%; in 2010 all estates will be taxed at 0%; and in 2011 the estate tax will return at a top rate of 50%. Most experts expect that Congress will change the tax law before then. Legislation to extend the abolition of the estate tax indefinitely has passed the House of Representatives three times. It secured a majority of 57 to 41 in the Senate in June, 2006, but failed to receive the 60 votes necessary to avoid a Democratic filibuster. In response, a compromise bill which would lower rates and increase exemptions passed the House of Representatives on June 22, 2006. Its fate in the Senate is uncertain.

Related taxes

The US also imposes a gift tax, assessed in a manner similar to the estate tax. One obvious purpose is to prevent a person from easily avoiding paying estate tax by giving away all of their assets during their lifetime. However, an exemption is available for transfers of up to (as of 2006) $12,000 per person per year. An individual can make gifts up to this amount to as many people as they wish each year, and a married couple can make gifts up to twice that amount, without incurring gift tax.

If an individual or couple makes gifts of more than the limit, gift tax is incurred. The individual or couple has the option of paying the gift taxes that year, or to use some of the "unified credit" that would otherwise reduce the estate tax. In some situations it may be advisable to pay the tax in advance to reduce the size of the estate.

But in many instances, an estate planning strategy is to give the maximum amount possible to as many people as possible to reduce the size of the estate (the effectiveness of this strategy is based on how long it can continue as obviously it cannot continue past death).

Furthermore, transfers (whether by bequest, gift, or inheritance) in excess of $1 million may be subject to a generation-skipping transfer tax if certain other criteria are met.

Further reading

• Ian Shapiro and Michael J. Graetz, Death By A Thousand Cuts: The Fight Over Taxing Inherited Wealth, Princeton University Press (February, 2005), hardcoveer, 372 pages, ISBN 0691122938
• William H. Gates, Sr. and Chuck Collins, with forward by former Federal Reserve Chairman Paul Volcker, Wealth and Our Commonwealth: Why America Should Tax Accumulated Fortunes, Beacon Press (2003)

Also see

Decedent's final return

External links

• wikipedia.org
• ...Ads exaggerate what the tax costs farmers, small businesses..., a June 2005 article from FactCheck.org
• Myth: Death tax repeal only benefits the wealthy