Q: My grandmother is worth a couple of million dollars. She has 2 kids and 8 grandkids. What is the estate tax likely to leave us with?
Stacie, Athens GA
A: That answer depends on when your grandmother dies, and what Congress decides to do with an estate tax law that is very much up in the air. It's important, though, to distinguish between a tax on estates, and a capital gains tax on assets that heirs receive.
To learn more about how heirs pay taxes on items they receive, read my article on inheriting property.
Most estates don't pay their own level of tax before distributing what is left to heirs. As a result, someone dying is not a taxable event. When an heir sells that property, though, there may be a capital gain (though as the above article details, the heir may benefit from "step up in basis" rules).
But what about those estates large enough to trigger a death tax? This area of tax policy has seen more turmoil than any other over the last decade, and will continue to do so until Congress sets some permanency here.
As part of the 2001 Bush tax cut (EGTRRA), the top marginal tax rate on estates is scheduled to decline from 55% in 2001 all the way to 0% in 2010. Simultaneously, the exemption amount (below which no death tax is owed) was scheduled to rise from $675,000 to $3,500,000 in 2009. In 2010, there would be no tax on estates.
In case she dies this year, your grandmother would have an estate tax exemption of $2,000,000 and a top marginal death tax rate of 45% (though the exemption would seem to cancel out the value of her estate entirely, assuming it was not reduced over the years by any gifts from her--more on that later).
However, that same tax cut was forced to "sunset" for budgetary reasons. As a result, the law as currently written has the 2001 death tax levels coming back for anyone dying after January 1, 2011. In that year, the top marginal rate would be 55%, and the exemption level would plummet back down to only $1,000,000.
No one reasonably expects Congress to let current law take place. One compromise that has been discussed is raising the exemption level to $5 million singles/$10 million couples (meaning most estates would owe no tax), and having a lower tax rate (15 and 30 percent have been thrown around). It remains to be seen what Congress will do.
There are several other issues interacting with the death tax:
1. Step-up in basis. As you read in the article above on inheriting property, heirs benefit from something called the "step-up in basis." As part of current law, this basis step-up is repealed the same year the death tax is. It is replaced with a $1.3 million basis exemption on capital gains. In 2011, the step-up returns along with the 2001 death tax levels.
Most compromises Congress has discussed include a retention of the step-up in basis. This makes practical sense, as the alternative is heirs trying to establish the actual cost basis of Grandma's Coca-Cola shares that split and paid dividends over 60 years. The step-up simply deems the basis to be the greater of the fair market value of the asset at death or the original cost basis.
Congress tried repealing the step up in basis in the 1970s, but there was a revolt. There is no reason to think that another wouldn't happen this time, even with the $1.3 million exemption.
2. State tax interaction. Many states have begun to eliminate their death taxes (Virginia being the latest). One reason is that EGTRRA de-coupled state and federal death taxes. State death taxes used to be a credit against federal death taxes. They are now simply a deduction, and therefore have more sting.
3. Gift tax interaction. Suppose your Grandmother wanted to begin to divest her estate prior to her death. Tax rules limit how quickly she can do this. Any gifts to any person in excess of $12,000 per year begin to reduce her death tax exemption amount (whatever that may be). For example, suppose she gave $500,000 of such gifts and she died this year. Her exemption amount would be reduced from $2 million to $1.5 million. The good news is, her estate should be that much smaller, as well.
One good strategy to use here would be to write a series of $12,000 checks every year to everyone in her family she intends to be an heir. This will reduce her taxable estate without reducing her death tax exemption.
4. Spousal inheritance. Any estate left to a U.S. citizen-spouse does not owe death tax. So maybe she ought to get married!
5. Charitable tricks. Any amounts left to charity are a deduction against taxable estate income. So, if she leaves her estate to charity, she won't owe any tax.
6. Life insurance. Proceeds from life insurance contracts are not taxable to the life insurance beneficiary. So, if she liquidated her estate and purchased a life insurance contract, the proceeds upon death would not be taxable to the beneficiaries (formerly her heirs).
This is an extremely complicated area of the tax code, and it should not be left even to professional tax advisers like me. I've only touched on the 30,000-feet level of this, and I'm willing to bet some sharp-eyed readers will see that I've gotten a detail or two wrong and left some important things out. That's why it's important that any family anticipating an estate of good size (maybe more than $1 million or so) should be working with an estate planning specialist.
Once Congress puts a probable $5 million or so exemption into law, only a few hundred families will have to worry. Until that day, though, if your family has been diligent and saved money over the generations, it pays to have some expertise on your side.