Bequests and Inheritances

Enacted in 1916, the federal estate tax has gone through many changes over the years. Marginal tax rates have ranged from 1 percent to as high as 77 percent. There have been limits on how much can be transferred to spouses and others, and there have been changes in the ways estates are valued. This section briefly describes the major components of the federal estate tax as it existed through most of the twentieth century. Note that the Economic Growth and Tax Relief Reconciliation Act of 2001 includes gradual reductions in the estate tax, with complete elimination in 2010.

Table 3 shows the amount of tax collected from estates of different sizes. The progressive nature of the estate tax is quite evident here. Nearly half of the estates had a value of less than $1 million, and these estates paid 3.5 percent of the tax due that year. At the other extreme, a small portion (approximately 0.5 percent) of estates had a value above $20 million, and paid 23.8 percent of the total tax.

The federal estate tax has several objectives, the foremost being to raise revenue for the federal government. While the portion of federal revenues derived from the estate tax has generally been fairly small (typically less than 2 percent), it did exceed 5 percent in several Depression era years and approached 10 percent in 1936. Opponents of the estate tax have argued that this small contribution to federal revenues is not sufficient to prevent its elimination.

A second objective of the estate tax is to complement the income tax system to ensure all income is taxed. Much wealth is held in capital gains, which are not considered income until realized (i.e., when the underlying asset is sold). When a person holding an asset that has appreciated dies, no income taxes are paid on the appreciation. When the asset is transferred to another individual, the basis on which capital gains taxes will have to be paid becomes the then current value of the asset—usually much higher than the price paid by the original owner. The new owner will have to pay capital gains taxes only on the increase in value that occurs after he or she receives the asset. By collecting estate taxes on the value of the transferred asset, the estate tax complements the income tax and ensures that all capital gains are taxed. Without the estate tax, owners of capital assets would have to keep track of the original purchase price, regardless of who made the purchase and how long ago the purchase occurred.

A third objective is to reduce concentrations of wealth. Some view large inheritances as contrary to a major value of American society: equal opportunity for all. They see estate taxation as a way of "leveling the playing field." The values in Table 2 suggest that estate taxes do little to reduce familial wealth concentrations. However, it is possible that the difference between bequests received by lower- and higher-income individuals would be even greater in the absence of the estate tax.

A fourth objective is to reduce competition between states for wealthy individuals. Some states could seek to encourage wealthy people to move there by advertising their low (or nonexistent) estate tax rates. The federal estate tax ensures that decedents' estates will be taxed similarly regardless of their state of residence. While some differences between state estate tax laws exist, almost all of them are smoothed out by the structure of the federal estate tax. (See "Tax Credits," below.)

Determining estate taxes. To figure the tax due on an estate, one must first calculate the value of the estate. This includes the value of real estate holdings, stocks, bonds, pensions, businesses, cash, and proceeds from life insurance policies owned by the decedent. Often decedents have transferred assets to others prior to death. Some assets must be included in the calculation of a decedent's estate if they were transferred to others within three years preceding death.

Assets can be valued at the date of death or six months after death. This allowance recognizes that it can take a considerable amount of time to settle an estate and the value of the estate may decrease in that time. There is also a method of valuing property used in a closely held farm or business. Such property sometimes would have a greater value under a different use than under its current use. For example, a five-hundred-acre farm may have a certain value as farmland, but a much higher market value if sold for residential property. Rather than forcing the estate to consider the value of the land as residential, it can be valued as farmland. Certain restrictions apply to using this "special use" valuation, and there is a maximum as to how much of the market value can be excluded from the estate. In 1995, 456 estates used the "special use" valuation, for a reduction of $171 million in gross estate value.

Once the gross estate value has been determined, a number of deductions are allowed. The largest of these is bequests to the spouse. Initially this deduction was limited to a fraction of the gross estate, but this limit was removed in 1982. Recognition that estate taxes would be paid at the death of the surviving spouse made limiting the spousal deduction unnecessary. Other allowable deductions include charitable bequests, debts of the decedent (e.g., mortgages and medical debts), and expenses incurred by the estate (e.g., funeral expenses and attorney's fees). Table 1 gives 1999 values for these deductions.

Tax credits. Initially, the first $50,000 of an estate was exempt from taxation—similar to the standard deduction allowed for personal income taxes. The exemption amount was increased periodically (and decreased in 1932) until 1977, when it was repealed and replaced with a credit. This credit, called the "unified credit," is by far the largest credit provided for in the estate tax, reducing estate tax liability by roughly $18.5 billion in 1999. Since this credit eliminates all estate tax liability for most estates, it is often more convenient to speak in terms of the amount of an estate it effectively exempts from taxation. For example, in 1999 the unified credit amount was $211,300. An estate valued at exactly $650,000 (after deductions) would have had an initial liability tax of exactly $211,300. Applying the unified credit (i.e., reducing tax liability by the amount of the credit) leaves a final liability of $0. The initial tax liability on estates smaller than $650,000 is less than $211,000, so the unified credit eliminates all tax liability for these estates. For larger estates the unified credit effectively eliminates the tax that would be due on the first $650,000 of the estate. Under the Economic Growth and Tax Relief Reconciliation Act of 2001, the effective exemption rises to $3.5 million in 2009. This credit gets its name from the fact that it unifies the exemptions for the estate, gift, and generation-skipping transfers taxes.

The state death tax credit is the other major credit allowed under the estate tax. This credit provides a one dollar reduction in federal estate taxes due for each dollar of state estate taxes paid. The credit is capped at an amount that varies with the size of the taxable estate. Most states simply charge estate taxes equal to the maximum allowable federal credit amount. In fact, there is little incentive for states to do otherwise. States that charge a smaller amount do not save their constituents any money; they only allow them a smaller credit against their federal estate taxes— in effect letting the federal government collect tax revenues the state could have collected. States that charge a larger amount are providing a disincentive for wealthy people to live in their state. In 1999, the state death tax credit reduced federal estate taxes by approximately $6.0 billion.