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was entirely repealed.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: fewer 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.
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