Back from the Cliff: The Federal Estate Tax

After months of playing chicken, Congress and the President came together to address certain aspects of the changes in taxes and spending that have been referred to as the “Fiscal Cliff”.  As a result, on January 2, 2013, the President signed the American Taxpayer Relief Act into law.  There will still be more political gamesmanship in the ensuing year, but we have a little more clarity on the Federal Estate Tax laws. 

As background, in 2001, the federal estate tax (the tax at death on what a person owned) levied a 55% maximum tax on estates above $1 million.  Estates below that amount did not pay a federal estate tax (though most states have some form of death tax).  In May of 2001, Congress passed sweeping legislation that among other things gradually reduced and then eliminated the estate tax.  By 2009, the highest estate tax rate had been reduced to 45%, and it applied only to estates over $3.5 million.  Under the same 2001 law, in 2010, the estate tax was entirely repealed.  But then in 2011, the law was scheduled to return the tax to the same levels that were in effect in 2001:  a 55% maximum rate and a tax that applies to any estate over $1 million.

Why enact laws that expire or change in the future?  It is the politicians of 2001 forcing the politicians of 2010 to make decisions, and create issues that can form the basis for election year politics.  It worked.  In 2010, to avoid a return to 2001 levels, Congress voted a two year “patch” on the issue – a lower maximum rate of 35% was adopted, and the exemption level of $5 million was created for people dying in 2011-2012.  And then after 2012, the rates and exemption amount would automatically revert back to the 2001 levels.  This was the “cliff” for the federal estate tax.  The automatic expiration would result in a situation no one wanted, and then each party could blame the other one for failing to do anything about it.  Taxes would rise – but no politician would have to stand up in public and say he voted for it.  Because it happened automatically.  The politicians would get the best of both worlds – more tax revenues without having to take a public stand, and the ability to blame their opponent for the result. 

With the 2013 Act, they seem to have put an end to the periodic gamesmanship, at least with respect to the Federal Estate Tax.  Here is where we end up:

Unified Gift and Estate Tax:  First, the Estate Tax and the Gift Tax are unified.  You have $5 million in tax exemptions to use over the course of your life – whether you are giving away money each year, or waiting till you die to distribute your estate.  You can give away $5 million this year tax free if you wish – and you will not have to pay any gift tax.  When you die, though, you will have used up your lifetime exemption of $5 million, and so the value in your estate will be taxed at applicable rates.

Exemption Indexed for Inflation:  The $5 million lifetime exemption amount will be indexed for inflation, so that there is not an effective tax increase as inflation makes future dollars worth less than present dollars.  The exemption will grow and keep pace with inflation. 

Annual Gift Tax Exclusion:  Annual gifts of $14,000 or less to an individual have no gift tax consequences.  These gifts are not taxable, and do no use up any of the lifetime exemption amount.  You can make as many $14,000 gifts as you wish, as long as each one is made to a separate person.  If you make a gift of $15,000 to any one person, then the first $14,000 is excluded, but the $1,000 excess would then begin to use up your lifetime exemption.  How does the government know this?  For gifts of more than $14,000 in a given year, you are required to file a gift tax return that shows how much of the lifetime exemption you used, and how much remains.  Over the course of a lifetime, these gift tax forms should provide a paper trail of your gift giving, and your usage of your lifetime exemption amount.

Maximum Rate:  When you calculate and pay your federal estate tax, you do so based on a graduated series of rates.  The new maximum rate that will be payable at the highest levels is now 40% of the net estate, up from the 2010 maximum rate of 35%, but down from the 2001 maximum rate of 55%. 

Portability:  A husband and a wife each have a $5 million lifetime exemption.  Under 2001 law, if one spouse died having not used the whole amount of their exemption, then it was lost to them.  Estate planners then bridged this gap, by writing will clauses that provided for dispositions that would use up the exemption before disposing of the balance of the estate.  The 2010 Congress recognized that this result was uneven and therefore unfair; and so introduced the concept of portability to the lifetime exemption process.  If one spouse died with an unused portion of their lifetime exemption, the surviving spouse could then make use of any unused amount, in addition to their own lifetime exemption.  The 2013 Act makes “portability” a permanent part of the Estate Tax. 

GST Tax:  The accretion of wealth in a family is taxed at each generation through the Federal Estate Tax and Gift Tax.  With just an Estate Tax and Gift Tax in place, the well to do could provide for their children during life, and then leave the bulk of their estates to grandchildren and great-grandchildren, effectively skipping the tax on large fortunes for a generation or two.  In response to this type of estate planning, the Congress in 1976 adopted the Federal generation skipping transfer tax (GST), which applies to wealth transfers that skip persons and pass the wealth to grandchildren or more remote descendants or unrelated individuals who are more than 37.5 years younger than the donor; and certain trusts that effectively do the same thing.  The 2013 Act retains this tax, and incorporates the indexed $5 million lifetime exemption into the provisions with respect to generation skipping transfers.

In Summary:  The federal Estate Tax applies to very few estates:  less than 2 out of every 1,000 people who die owe any federal estate tax.  (Though remember that states may have their own estate and inheritance tax impositions).  It is a tax that falls squarely on the rich, as by almost anyone’s definition, those who die owning more than $5 million in assets are in that category.  According to the Congressional Budget Office, these taxes on transfers – gift, estate, generation skipping – “have historically made up a relatively small share of total federal revenues—accounting for 1 percent to 2 percent of total revenues in most of the past 60 years.”  So, while the Estate Tax contributes to the overall tax revenue, it is not a panacea to our budget issues.  Doubling or tripling the rate would not raise the revenues needed to close the ongoing budget gap.  In order to raise significantly more revenue with the Estate Tax, the tax would have to reach deep into much smaller estates, middle class estates.  That result would be unpopular on both sides of the aisle.  They are going to have to look other places to raise the levels of revenue that they need to close the budget gaps.

We still need some combination of more revenues and less expenses in order to avoid creating larger and larger budget deficits.  That Fiscal Cliff still looms ahead.  However, it looks like for now, the federal Estate Tax has been taken out of the game of politics, and put on a more certain footing.   That is good news for estate planners.  The last few years have been difficult for planning, with automatic expirations scheduled and changes in the law expected, but uncertain and unknown.  Now we know what the rules are likely to be for the foreseeable future.   The new football in the game will be income tax rates, deductions, exemptions and credits, on the revenue side, and Medicaid and Medicare, Social Security, and the defense budget on the spending side.  Planning for possible future income tax consequences is impossible right now – other than there is a general acceptance that rates will be higher across the board.  But for the first time in years, the federal Estate Tax is out of the game.