Estate and Gift Taxes

On this page: Taxation

Background

The federal estate tax was enacted in 1916 in an effort to raise revenues, reduce the concentration of wealth, and increase economic equality by preventing the wealthy from passing all of their assets to subsequent generations. The estate tax is one of the most progressive elements of the federal tax system. Taxes must be paid on the amount of the estate that exceeds a certain threshold. The value of the threshold was set fairly high. Thus the tax has affected a small share of all estates through the years. For example, in 2001 only 2.3 percent of estates paid any tax.

Although some people were concerned about the burden of the estate tax on small family-owned businesses and farms, a study by the Congressional Budget Office concluded that the estate tax applied to only about 2 percent of family farms and businesses, and found that most of these have sufficient liquid assets to pay the tax.

The estate tax repeal was a major element of the tax cuts that were enacted in 2001. The tax structure went through a large number of changes almost annually between 2001 and 2013. Finally the American Taxpayer Relief Act of 2012 (“the Act”) established a 40 percent maximum estate tax rate and $5 million exemption (indexed for inflation). The Act also allows for “portability,” which gives taxpayers greater flexibility in shielding assets from the tax. As a result of these changes the estates of less than 0.2 percent of deceased individuals are projected to be subject to the tax through 2022.

Many states also impose estate taxes or other forms of taxes on assets transferred at death. Prior to 2001 these taxes were offset dollar for dollar by the federal credit against federal estate taxes. As a result state taxes did not increase taxpayer liability, making the estate tax a so-called “painless” source of revenue for states. Thus prior to 2001 all states and the District of Columbia imposed one or more forms of this tax.

The 2001 tax legislation repealed the credit and replaced it with a deduction for estate taxes paid to any state or the District of Columbia. Because of this change, state taxes increased tax liability of estates or heirs. In response a number of states eliminated their estate or related taxes. By 2014 only 20 states had estate taxes or other taxes related to asset transfers at death. Inflation-adjusted state revenue from this source dropped by one-half between 2001 and 2013.

An income tax provision related to taxation of inherited assets often comes up in estate tax discussions. A “stepped-up basis” for inherited assets reduces capital gains taxes (see this chapter’s section Capital Gains and Dividends). A capital gain occurs when an investor sells an asset for more than its purchase price (or “basis”). Inherited assets receive a basis equal to fair-market value at the time of the original purchaser’s death (hence “stepped-up”), not the actual acquisition price. Thus appreciation in the asset’s value that has occurred between purchase and death goes untaxed. One rationale for the estate tax is to ensure that unrealized gains are taxed at some point. Because the great majority of heirs are not subject to the estate tax yet benefit from stepped-up basis valuation, most heirs avoid income tax on inherited unrealized capital gains.

Estate and Gift Taxes: Policy

Rationale

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Policymakers should retain estate and inheritance taxes as important components of our tax structure because they help reduce the concentration of wealth in society and prevent large amounts of capital income from escaping tax entirely. In the absence of an estate tax, capital gains should be indexed to inflation and taxed at death.

Incidence

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Federal and state estate and inheritance taxes should affect only the largest transfers, and surviving spouses, domestic partners, and family farms and businesses should be protected from excessive burdens. Heirs should have some protection against the need to liquidate assets to pay taxes