Estate Tax Basics

If your estate is large enough, it will face federal estate taxes before it is distributed to your heirs. In addition, some states also have state "death taxes" which have to be paid.

The Federal estate tax came into being in 1916 and originally concerned only the very wealthy. It came about for two reasons. First, it was anticipated that the U.S. would become involved in World War I, and wars are expensive. Hence, increased tax revenues would be necessary. Second, and probably more importantly, there was a prevailing social opinion that inherited wealth was the greatest social evil. While everyone admired the "self-made" millionaire, few people had positive opinions about those who became wealthy through inheritance from their parents. Over the years, the estate tax and the associated gift tax were modified a number of times. In 1976 the tax rates were made the same.

Basically, all U.S. citizens have a Uniform Tax Credit (UTC). This credit fulfils the first $196,800 in taxes and allowed an estate with a net value of $600,000 to pass tax free to the intended heirs. The amount in excess of the net $600,000 was taxed. All of this changed in 2000 when a new tax law was passed. Under the new law, the UTC increases each year until 2010 when the estate tax is formally ended. Maybe. One provision of the law, a "sunset" provision, requires that the law be voted on a second time in 2010. If this vote fails, then estate taxes will go back to how they were in 1999. Most estate planners see this as likely in view of approaching financial needs of both Social Security and Medi-Care.

As a result of this, dual estate planning strategies must be considered. One strategy is if the law is extended, the other is if the law is not reconfirmed. Thanks Congress.

How the Tax Work: The Net Taxable Estate must be determined. The Gross Taxable Estate is all that a person owns. From this are subtracted:

  1. Debts of the estate and estate owner
  2. Income taxes due the year of the owner's death
  3. "Final Expenses" including medical, funeral, and legal costs
  4. A state death tax allowance
  5. Unlimited gifts to IRS-recognized charities

After subtracting these the Net Taxable Estate is determined. This number is indexed to the IRS tax table revealing the Gross Estate Tax. From the Gross Estate Tax is subtracted the Uniform Tax Credit for the year of the death of the owner. This yields the tax which is due. The UTC will change over the next several years as thus:

  • Year UTC Actual Tax Credit
  • 200-01 $675,000 $211,300
  • 2002-3 $700,000 $229,800
  • 2004 $850,000 $287,300
  • 2005 $950,000 $326,300
  • 2006 $1,000,000 $345,800

There are two often overlooked surprises in estate plannng. First, many estates may be large today, yet be fully sheltered by the UTC. However, inflation over the years may cause the estate to "grow" into taxability. If the annual inflation rate is 3%, after 10 years the estate will have become one-third larger. Second, life insurance death benefits are fully taxable for estate tax purposes (IRC 2042). Hence, a large but assumedly untaxable estate may face taxes because the owners both have large life insurance policies and inflation has increased the size of the estate. If you are a non-U.S. citizen, but a legal U.S. resident, you need specialized planning because you will not have the advantage of a full UTC. For alien residents, the UTC is much smaller.

The size of an estate can also be greatly changed if the estate owners receive an inheritance, as well.

What to do? Congress can be unpredictable, particularly looking many years ahead. In addition, tax laws are easily changed. An estate plan should have the maximum of flexibility and should also plan for the worst case scenario. In other words, despite tax law changes, assume that the law of 1999 will return and plan for that.

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