The Most Misunderstood Tax - The Estate Tax
The poor unloved estate tax. It gets no respect and I don’t understand why. Flexo at Consumerism Commentary posted an article about Warren Buffett’s recent testimony before Congress on the subject. Buffett urged the Senators not to repeal the estate tax. I agree wholeheartedly (and not just because doing so puts me on Warren Buffett’s team).
Estate tax explained
The estate tax has to be the most maligned, misunderstood part of the IRS code. Critics call it the ‘death tax’ in an effort to generate popular support for its repeal. But the phrase ‘death tax’ is way misleading.
‘Death tax’ is misleading because virtually no one in America has to pay the estate tax. According to the IRS’s own data, in 2005 less than 1% of estates pay any taxes at all. The more proper term for this tax is the inheritance tax.
The estate tax is applicable when an individual leaves assets in excess of $2M (going up to $3.5M in 2009). Almost no one in the U.S. leaves that kind of money when they die.
Losing the family farm or small business
‘But what about the small business or family farm owner?’ people will ask. This classic line of attack on the estate tax goes something like this. When an owner of a family farm dies, his or her heirs will have to sell the farm just to pay the taxes on it. They’ll lose the farm!
This, in a word, is crap. The American Farm Bureau, a pro-repeal, pro-farm lobbying organization has never found a single example of this happening. Not one. Maybe a reason is because few farms reach the $2.0M threshold and of those that do, most have 
liquid assets available to pay the tax. Or maybe it’s that if the heirs agree to actually work the farm for 10 years, they get a $4.1M pass.
The family farm big enough to be heavily taxed by the estate tax is a myth.
So what about small businesses? Here again, hardly any are big enough to be affected by the tax. Only 4% of small businesses are bigger than $3.5M.
Some more objections punctured
- It’s double taxation. It’s not double taxation. Think about it - the gains in small businesses and family farms are unrealized gains. They’ve not yet been taxed.
- The tax rates are unreasonable. It’s true that the top estate tax rate is 48%. The problem with this line of thinking, though, is that marginal rates don’t mean very much. If you’re in the 25% tax bracket, does it mean all of your income is taxed at 25%? No, it doesn’t (see this great explanation of effective tax rates from NCN). So even if an estate does pay estate tax, the true percentage paid is much, much lower than 48%. In fact, according to the latest IRS data available, of those estates having to pay any tax, the percentage paid averaged 20%.
- It punishes success. I disagree. What it does is tax those most able to pay. It’s probably the most progressive tax in the IRS code. It only punishes success in the same way capital gains tax punishes stock market success - if you make money, you have to pay a small percentage in taxes. As Flexo says, “File this under the category of ‘problems I’d like to have one day.’”
- It will discourage investment (especially in small businesses). Let’s get real. I’d be willing to bet the estate tax consequences have never entered the mind of an entrepreneur considering starting a business. It simply makes no sense that someone would forgo gaining personal wealth because at some future time, their estate will be taxed.
No repeal
It simply boggles my mind that someone other than the handful of people actually subject to this tax would be in favor of its repeal. The estate tax brings in real revenue. When it is temporarily repealed in 2010, the federal budget will lose $56B.
There are only three ways to plug a $56B hole in a budget. You can
- raise other taxes,
- cut services,
- or borrow the money
Borrowing the money just worsens the already criminally large deficit being left to future generations to clean up. Raising other taxes must, by definition, affect more people (read you and me) than the estate tax. Or we could cut government programs - who’d like to suggest one?
If you’re in favor of the estate tax, you must either be in favor of higher deficits, higher taxes, or cutting government services.
The simple fact is the estate tax provides money for the nation from those in the best position to provide it. Incidentally, those are the very people who received so much from that nation.
Our tax system is far from perfect (or even good). But repealing arguably the most progressive tax in the code is insane.
Sources:
November 16th, 2007 at 9:44 am
[…] Update: On Advanced Personal Finance, KMC explains why the estate tax is the most misunderstood tax. […]
November 16th, 2007 at 10:47 am
Thanks for posting these details. It’s really enlightening. The argument against the estate tax preys on emotions without the facts for support. I didn’t realize before that there were no incidences of families losing their farms. You would think from the vehement arguments that the tax has caused the death of American agriculture.
November 16th, 2007 at 11:40 am
I’m with Flexo, thanks for posting. The farms part is particularly good. Someone needs to give those talking points out to a few senators.
November 16th, 2007 at 11:45 am
The estate tax *on its own* isn’t that onerous. But remember, it acts in concert with other taxes. On an estate of, for example, $2.2M in a tax-deferred account, a non-spousal beneficiary can *easily* pay more than half of the *entire amount* in taxes.
You pay estate tax on the entire estate *including the pre-tax value of tax-deferred assets*! Then you pay income tax on the remaining money. Some plans will not let a non-spousal beneficiary roll tax-deferred assets into another tax-deferred vehicle.
I went through this process several years ago (the estate tax was on assets over $1.5M then). My relative was a very hard-working middle-class person who saved diligently and paid his taxes. He deferred taxes at a marginal rate of about 25%, with no state taxes. After his death, his beneficiaries watched as the tax code, between income tax and estate tax, took more than 50% of his modest estate.
The estate tax doesn’t look that bad to many of us because we always assume it impacts “the other guy”. You know the saying.. Any government that robs Peter to pay Paul can always count on the support of Paul.
November 16th, 2007 at 11:53 am
I should give a more concrete example. Let’s say you inherit $3M in a tax-deferred non-qualified account and you live in a state with a 10% income tax.
You pay:
48% of $1M ($480,000). Then you pay 35% federal 10% state on the $3M ($1.35M), *$1M of which was already taxed at 48%!*
So on an estate of $3M, you just paid $1.83M in taxes, between the estate tax and income tax. Now let’s say that you inherit $10M tax-deferred. You pay $3.84M in estate tax and $4.5M in income tax, for a total of $8.34M in taxes. That’s right boys and girls. That extra $7M that your parents saved is worth only $490,000 after the government gets its take.
You’ll get back a small portion of that thanks to the “Income in Respect of a Decedent” deduction, but that’s a fairly small portion. And of course I’m using round numbers. The 45% federal state is marginal, but on $3M you reach that marginal rate pretty quickly.
November 16th, 2007 at 1:17 pm
I knew this post was bound to attract at least one of these examples…
@anonymous - First, I’m sorry that your relative’s heirs had to pay a lot of money in taxes. Paying taxes sucks. But it seems from your examples that the critical piece is the ‘tax deferred’ part. Unless I’m misunderstanding, you’re saying this money had never been taxed. Well, now it has to be.
I’m by no means a tax attorney and I’m not qualified to dissect your examples (hell, I barely followed some parts). Specific examples aren’t of as much interest to me as the basic point.
My central point remains that the estate tax taxes those most able to pay it. It is progressive. I’m sorry if your family is in the 0.5% of Americans that pay it.
November 16th, 2007 at 2:25 pm
How can you simultaneously imply (1) hardly anyone is affected by it and (2) if you oppose it you have to come up with $56B?
Obviously someone is paying the $56B.
Besides, per the Fool http://www.fool.com/taxes/2001/taxes010706.htm , when the estate tax is repealed in 2010 it’s replaced with a carryover-basis, so the money is taxed eventually anyway.
November 16th, 2007 at 3:21 pm
@visitorus - I’m not implying it. I’m stating it.
0.5% of estates face some taxation according to 2005 IRS data.
The budget gap caused by the estate tax’s temporary elimination in 2010 is estimated by the Joint Committee on Taxation to be $56B.
Someone is paying it. About 18,000 people annually pay some estate tax (rather, their estates do). That’s out of the 2.5M people who die every year in America.
November 17th, 2007 at 1:04 pm
“Or we could cut government programs - who’d like to suggest one?”
Hmm, not counting the war (660billion and counting!), what about the $10 billion in annual farm subsidies to mostly large corporate farms? Or reining in some of the billions in earmarks added to spending bills every year. Improve overall government efficiency, etc.
If you wanted to go more controversial, think of the savings and tax revenue if marijuana were *gasp* legalized and taxed.
I’m not actually against the estate tax, just the view (by the government and the public) that there is a certain amount of tax revenue the government is somehow entitled to, and that anything that reduces that amount needs to be counteracted by an increase elsewhere, rather than actually having the government *spend less money*!
Also, the numbers seem a bit strange to me. 18,000 estates/year paying the tax and a $56 billion revenue loss means each estate is paying about $3.1 million on average. That would mean an average estate of $6.5 million based on the top 48% rate, or an average estate of $15.5million based on the 20% “real” average rate. With only about 1 million households surpassing the $5million level, that means almost 2% of these wealthy people are dying annually, compared to a national average death rate of .8%. Is the government killing them for the tax revenue, or am I making some error in my understanding?
November 19th, 2007 at 9:07 am
[…] Personal Finance presents The Most Misunderstood Tax - The Estate Tax — Some enlightening detail about how the estate tax really works. Unfortunately, I am […]
November 19th, 2007 at 11:24 am
You’re absolutely right that in my example the money in the estate was tax deferred. The point is that the estate tax is assessed against the *pre-tax* portion of the estate, not the post-tax portion.
It’s really tough to explain how shocking that is, until you see it for yourself. Let’s say your parent is in the 25% marginal bracket, and contributes $1 to his retirement plan, then dies. Assuming his estate already hit the $2M point that $1 of tax deferred money is likely to be taxed down to about $.12. Now let’s say that he pays taxes up front rather than deferring. Now after death that $1 is worth $.39. I guess we can just consider that extra $.27 the punishment for tax deferral.
The gist is that the estate tax, in concert with the income tax on tax-deferred savings, is effectively a “confiscatory” tax. In other words, it takes *everything*. This isn’t one of those “paying taxes sucks, but we all do it” kinds of things. This is the government taking pretty much *everything*.
And if that’s something that you support, then that’s OK. But in the interest of calling a spade a spade, hopefully those who support the estate tax will acknowledge that they support taking all of one’s belongs after he dies.
November 19th, 2007 at 10:52 pm
I don’t necessarily agree with it all, but it was well thought out and well presented.
Best Wishes,
D4L
November 20th, 2007 at 5:51 pm
To second Flaxo’s point above, the pro-repeal movement is so desperate to find an actual farmer to serve as their talking point they’ve taken their search public: http://ipdw.org/farmer
according to the site, “the winning candidate, if any is found (fingers crossed), will serve as the repeal movement’s new spokesperson. Winners will be featured in brochures, TV ads, and other campaign materials to abolish the Estate Tax. In addition, qualifying candidates will receive a gift bag filled with items from the 18 wealthy families funding the “movement” to repeal the Estate Tax, including a jug of wine from the Gallo Estates, a candy bar from the Mars family, and something kind of nice, but plastic, from the Wal-Mart heirs.”
November 20th, 2007 at 6:35 pm
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November 30th, 2007 at 11:05 am