The Estate Tax Chaos
In recent years the federal estate tax has emerged as a
controversial political issue. Opponents of the tax have sought to reduce or
eliminate it, arguing in part that it places an unfair burden on family farms
and small businesses. Supporters of the estate tax believe that redistribution
of wealth is necessary to preserve the institution of democracy thereby
creating a striated society. Recent tax law changes has fueled the debate and
added to the uncertainty and confusion for everyone including taxpayers, estate
planners, attorneys and accountants.
How the Estate Tax Works
An estate is the total property owned
by a person following their death, and the federal estate tax is a tax levied
on this property. The tax is calculated as a percentage of the estate’s market
value, but because of deductions and exemptions, in 2002 only about 1.17
percent of estates had to pay.
Of the various deductions and exemptions, one of the most important is the
Unified Credit, which automatically exempts a certain value of every estate
from the tax. This exemption is currently $2 million, which means only the
value of an estate in excess of this amount is subject to the tax.
Other deductions and exemptions include, but are not limited to the following:
- The
marital deduction, which exempts the value of the estate that passes to
the surviving spouse. When used with a bypass trust this effectively doubles the value of an estate that is tax exempt.
- The
special use valuation of land, which allows farm and real property used in
a business to be valued at its actual use, instead of its market value.
Reduction in value is capped at $940,000 in 2007.
- Deductions for funeral
expenses, charity, and debts owed by the deceased.
Once all deductions and exemptions
have been applied, the remaining taxable value of the estate is taxed at the
maximum estate tax rate, which in 2006 was 46 percent. Both this rate and the
exemption provided by the Unified Credit are changing as a result of the
Economic Growth and the Tax Relief Reconciliation Act (EGTRRA) of 2001. Under
this Act the Unified Credit exemption is scheduled to increase to $3.5 million
in 2009, and in 2010 the federal estate tax is scheduled to be entirely eliminated.
If no changes to the law are made however, in 2011 the tax will be reinstated
with a higher tax rate and a lower exemption. Table 1 summarizes these changes.
Table 2 illustrates how scheduled
changes to the estate tax rate and exemption amount will affect estates of
different values. Note that in this table it is assumed no deductions are made
and that only the automatic exemption provided by the Unified Credit is used.
Possible Consequences of the Chaos
As real estate values escalate, especially in California,
it can erode the liquidity of one’s assets. Farmers, ranchers, and small
business owners many times have the bulk of their assets tied up in their
business endeavors. Most are hard working Americans that plan to pass on the
fruits of their labor to future generations.
Some ideologically desire their children and grandchildren to enjoy a
certain way of life. Unfortunately, there may be scant few liquid assets after
all the other bills are paid from the estate. The heirs may have little choice
but to liquidate a good portion of the assets in order to pay the estate taxes.
More unsettling is the total uncertainty of whether this can be avoided. As one
can see from the above tables the estate tax is an illusive unpredictable risk
looming over these taxpayer’s heads. Proponents of the estate tax claim only a
very small percentage of taxpayers are actually forced to liquidate. This is of
small comfort to those that find the family legacy up on the auction block!
Conclusion
So how does one deal with the chaos of estate taxes? First and foremost
carefully estate tax planning with your estate planning attorney and tax
accountant is critical. Estate planning will generally include strategies for
removing assets, especially those highly illiquid assets, from the estate. The
plan will need to be flexible enough to navigate the minefield of the estate
tax law. Despite whether you believe that the estate tax should be abolished or
not, you must now recognize that the estate tax system is broken. It is in serious
need of reform. I encourage you to contact your Congressmen and/or State Representatives
to express these concerns. Family farms, small businesses and ranches are a way
of life in