Federal Gift and Estate Taxation

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The Estate Tax

When a U.S. citizen or resident dies, he or she may be subject to the federal estate tax. The estate tax, for persons dying in 2004, applies to individuals with a net worth, broadly defined, in excess of $1,500,000. This cutoff will continue to increase until 2009 under current law. In 2010, the estate tax will be repealed under current law. In 2011, the estate tax will be restored with a cut off of $1,000,000 under current law.

The current estate tax rate applies only to assets of a deceased person (according to the broad definition and reduced by a number of deductions) in excess of the cutoff. Estate tax rates start at 37%. The rates increase gradually with the size of the estate. The top rate in 2004 is 48%. The top rate will decline one percentage point a year through 2009 under current law. In 2011, when the estate tax is returned, the top rate will be restored to 55%.

Assets transferred to a U.S. citizens spouse at death are not subject to the estate tax. Neither are assets transferred to charities, which are defined more broadly for estate tax purposes than they are for income tax deduction purposes.

Certain exclusions apply for family owned business assets. Many assets, such as shares in closely held companies and real estate using in a closely held business or subject to a conservation easement, are valued on an especially favorable basis for estate tax purposes. Only a small percentage of all estate subject to estate taxation have active operating family owned businesses.

Numerous strategies exist to reduce estate taxes. Most seek to secure low valuations for assets and to make maximal use of available exclusions and deduction and credits. In practice, estate planning can usually permit a couple with $5,000,000 or so of assets prior to estate planning, to avoid all estate taxes after engaging in tax planning with sufficient lead time. Estate planning can reduce the estate tax burden on larger estates, but in very large estate of the $10,000,000 or more level (which account for the vast majority of all estate taxes collected), it is almost impossible to avoid all estate taxes without making very large charitable gifts. Many large bequests have a substantial tax motivation.

No one expects the estate tax to be fully reinstated in 2011 as proposed by current law, but there is not a consensus on permanently repealling the estate tax either. This has produced a great deal of uncertainty for tax planners. Conventional wisdom holds that compromise legislation will keep the estate tax in place but significant increase the cutoffs that apply before one has to pay them.

Gift Taxes

The gift tax exists primarily to prevent people from making gifts during life in order to circumvent the estate tax.

Basically, gift taxes are due on large gifts made to someone other than a U.S. citizen spouse or a charity, during life. However, taxable gifts first reduce the value of the assets that can pass free of estate taxes at an individual's death, before any actual tax must be paid. Often large gifts are made during life in an effort to reduce future estate taxes. This is done because many assets are likely to increase in value between the time of the gift and the donor's death (leveraging the lifetime exclusion from gift and estate taxes), because some gift tax exemptions are "use it or lose it", and because when actual gift taxes are paid as a result of making a gift the effective tax rate is about a third lower than the rate if the gift was held until death because the gift tax values a gift on an "after gift tax" basis, while the estate tax values an inheritance on a "before estate tax" basis.

Gifts of a "present interest in property" to a single individual from a single donor in an aggregate annual amount of $11,000 or less, are not taxable gifts and don't count towards the lifetime limit on gifts. Direct payments of tuition for anyone, direct payments of medical expenses for anyone, and payments made to fulfill a legal obligation of support or a legal tax obligation of the donor (whether or not ordered by a court) also do not count as gifts for gift tax purposes.

Generation Skipping Transfer Taxes

Gifts made from a parent to a living child's children, or to anyone else in that generation determined by the tax rules, are subject to the generation skipping transfer tax. This tax basically tried to reduce the tax incentive to gift directly to grandchildren (and thus paying estate taxes once) rather than giving an inherantance first to a child (and paying estate taxes at that stage) and then having the child in turn leave the assets to the child's children (and thus paying estate taxes again at that stage). This applies only to gifts to grandchildren well in excess of $1,500,000 in a lifetime and involve quite technical and complicated rules.

State Gift and Estate Taxation

Until recently, most states had what is known as a "pickup tax". In other words, they used a provision of the federal estate tax laws that allow states to take a percentage of federal tax receipts. The state share has been reduced with recent changes in the law, so many states are now passing or considering passing their own seperate estate taxes to make up for the revenue shortfall.

Analysis and Reform Proposals

In General

The federal gift and estate tax is the most progressive tax in the tax system. It falls mostly on "dumb money". No one who earned the money pays the tax during their lives. It is basically a tax on heirs who receive large sums of money they have done nothing to earn, in lieu of an income tax on those funds. It is similar to the income tax imposed upon lottery proceeds.

This tax has virtually no impact on middle class families. It imposes a substantial compliance cost burden on upper middle class families who must pay lawyers to understand the tax and take full advantage of loopholes under the law, but results in very few actual tax payments by upper middle class families. This is a tax paid overwhelmingly by those so rich that they simply cannot avoid it, and even then, it operates far more as an incentive to make charitable contributiosn than as an actual source of governmental revenue.

Most Democrats favor closing loopholes in the estate tax and increasing the cutoffs so that the tax poses less of a tax planning burden and impacts fewer taxpayers. These changed do not signficantly reduce (and may even increase) revenues from the tax, but the change from a $600,000 cutoff to a $1,500,000 cutoff for estate taxation has already reduced the number of taxpayers subject to estate taxes by 75%-90%, while having only a modest impact on estate tax revenues.

The American Bar Association Report

The American Bar Asociation report on the transfer tax system has the following preface:

[The Report] provides expert analysis of the changes enacted by the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA or Act) regarding federal wealth transfer taxes. The Report does not consider policy questions having to do with the economic effects of a wealth transfer tax system as compared to other systems of taxation. It also does not consider policy questions having to do with whether redistribution of wealth is an appropriate goal of a tax system. The central concern of the Report is to assess—on the basis of simplicity, compliance, and consistency of enforcement—the temporary repeal of the estate and generation-skipping transfer (GST) taxes, the phaseout period, the continuation of the gift tax after repeal, the modified carryover basis rule, and the alternatives to federal wealth transfer tax repeal.

The Report is designed to provide diverse views and perspectives on a wide range of issues concerning the current federal wealth transfer tax system and the changes the EGTRRA makes to that system. With most issues it identifies, the Report suggests options that Congress might consider, but it does not make specific recommendations for regulatory or legislative action. . . .

The Report consists of four parts and two appendixes. Part I considers issues that pertain to the phaseout period of the estate and GST taxes and their reinstatement in 2011. Part II addresses issues arising from Congress’s retention of the gift tax for the purpose of protecting the integrity of the income tax system upon reduction and ultimate repeal of the estate and GST taxes. Part III discusses issues that will arise upon implementation of the modified carryover basis rule that takes effect upon repeal of the estate and GST taxes. Part IV and Appendix A shift attention away from the EGTRRA and consider alternatives to repeal of the estate and GST tax laws. Part IV identifies issues arising under the current estate, gift, and GST tax laws and suggests alternative ways of resolving those issues within a wealth transfer tax system. As part of its discussion, Part IV indicates alternative approaches that Congress might want to adopt during the phaseout of the estate and GST taxes. Appendix A evaluates alternatives to the current wealth transfer tax system and to the repeal of the estate and GST tax laws accompanied by a modified carryover basis rule.

Repeal of the Estate Tax

In his first term, George W. Bush passed a bill that would temporarily repeal the Estate Tax; however, there is a concerted effort to make that change permanent. Public Citizen reported that that 18 families worth a total of $185.5 billion have financed and coordinated a 10-year effort to repeal the estate tax, a move that would collectively net them a windfall of $71.6 billion.

From their press release: "The report profiles the families and their businesses, which include the families behind Wal-Mart, Gallo wine, Campbell’s soup, and Mars Inc., maker of M&Ms. Collectively, the list includes the first- and third-largest privately held companies in the United States, the richest family in Alabama and the world’s largest retailer.

In a massive public relations campaign, the families have also misled the country by giving the mistaken impression that the estate tax affects most Americans. In particular, they have used small businesses and family farms as poster children for repeal, saying that the estate tax destroys both of these groups. But just more than one-fourth of one percent of all estates will owe any estate taxes in 2006. And the American Farm Bureau, a member of the anti-estate tax coalition, was unable when asked by The New York Times to cite a single example of a family being forced to sell its farm because of estate tax liability."

Rhetoric

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