The federal estate tax and the exemption

In short

A friend of mine once said the estate tax is the one tax a person pays only by not being around to complain. He was half joking, and half right. If you are holding a large estate, the federal rules give each person a big exemption, set by law at the current figure, which the official source publishes each year this year. Anything above that amount is taxed at rates that top out at the current figure, which the official source publishes each year. Married couples can often combine their two exemptions, but only if the surviving spouse files the right form. Gifts made during life count against the same exemption, so the two are really one bucket. Take a little time to learn how the bucket works, and your heirs may be spared a hard surprise.

The whole of it

What it is

I once watched an old rancher walk his land with his grown children. He pointed at every fence post and said, "Somebody will have to answer for all this someday." He was talking about work, but he could just as well have meant the tax bill.

The federal estate tax is a tax on the right to pass property to other people when a person dies. It applies to the total value of what the person owned and controlled at death. That includes homes, land, bank accounts, stocks, a share of a family business, life insurance the person owned, and more. The Internal Revenue Code, in Chapter 11 of Title 26, sets out the tax. The IRS runs it, and the form that reports it is Form 706.

Most families never owe a dime. The law gives each person a large exemption, which is a slice of value that passes tax free. The tax only bites on the part of an estate above that slice. For a family worth tens of millions, that part can be big, so the rules deserve a careful look.

How it works

You have probably heard the phrase "unified credit." It sounds fancy, but the idea is plain. The law treats the tax on gifts and the tax on estates as one system. A person gets one lifetime allowance. Spend some of it on gifts while alive, and less is left at death.

Here is the path a dollar takes. First, the estate adds up everything the person owned at death. Second, the estate subtracts certain items. These include debts, funeral costs, charitable gifts, and anything left to a surviving spouse who is a U.S. citizen. Third, the estate adds back the taxable gifts the person made over a lifetime. Fourth, the estate applies the tax rate schedule to that total. Fifth, the estate subtracts the credit that matches the exemption. What remains is the tax due.

The tax rate on the top slice is the current figure, which the official source publishes each year. That rate applies only to value above the exemption, not to the whole estate. This point trips up a lot of good people.

Two features matter most to wealthy families. The first is the marital deduction. A person can leave unlimited value to a U.S. citizen spouse with no estate tax at that time. The tax is not erased, though. It is pushed off until the second spouse dies.

The second feature is portability. When the first spouse dies, any exemption left unused can pass to the survivor. The executor must elect this by filing Form 706 on time, even if no tax is owed. Skip the form and the unused exemption is lost. Miss it, and a family can leave millions of protected value on the table.

One more piece is the step up in basis. Basis is the starting value used to figure a gain when an asset is sold. Property that passes at death generally gets a new basis equal to its value on the date of death. That can wipe out years of built up gain for the heirs. Gifts made during life usually carry over the giver's old basis instead. This tradeoff sits at the heart of much estate planning.

The numbers, and where to find yours

Numbers in this area change, so it helps to know where the official ones live. The basic exclusion amount is the current figure, which the official source publishes each year, and the IRS publishes it each year in its estate and gift tax information. The top rate is the current figure, which the official source publishes each year. The annual gift exclusion is the current figure, which the official source publishes each year. A gift under that size to any one person in a year generally does not use up any of the lifetime exemption. Most gifts of that size also need no gift tax return, though gifts of a future interest are treated differently, and the Form 709 instructions explain when a return is required.

Look for your own numbers in three places. Your net worth statement shows what you own. Your insurance policies show who owns them and who gets paid. Your deeds and account titles show how each asset is held. The IRS instructions for Form 706 walk through each line.

Some states add their own estate or inheritance tax, often with a much lower threshold than the federal one. Check your own state's revenue department. A family can owe nothing to Washington and still owe something at home.

A worked example

Let me tell you about a couple I will call Harold and Ruth Whitfield. They are made up, but their numbers are plain and checkable. Harold dies first. At his death, the couple owns $30,000,000 in total, and Harold's half is $15,000,000.

Suppose Harold leaves everything to Ruth. The marital deduction covers all of it, so the tax at his death is $0. But Harold's own exemption goes unused unless his executor files Form 706 and elects portability. Say the executor does. Then Ruth can add Harold's unused exemption to her own.

Now Ruth lives on for years. For this story, say the exemption is a round $13,000,000 per person, a figure chosen only to keep the math easy. When Ruth dies, her estate is $30,000,000. With portability, she has $13,000,000 of her own plus $13,000,000 from Harold, which is $26,000,000 in all.

The taxable amount is $30,000,000 minus $26,000,000, or $4,000,000. At a flat 40 percent for this simple example, the tax is $4,000,000 times 0.40, which is $1,600,000.

Now picture the same family with no portability election. Ruth has only her own $13,000,000. The taxable amount is $30,000,000 minus $13,000,000, or $17,000,000. At 40 percent, the tax is $17,000,000 times 0.40, which is $6,800,000. The missed form costs $6,800,000 minus $1,600,000, or $5,200,000. One filing, a $5,200,000 gap.

The real tax uses a graduated schedule, so the true bill would differ a bit. The point still holds. The paperwork matters as much as the math.

Where it goes wrong

A neighbor of mine lost a father last year and told me the hardest part was not the grief. It was the scramble over deadlines. Estate taxes punish a late scramble.

The first trap is the portability form. The executor must file Form 706 to claim it, and the IRS sets a time limit. Check the current instructions for the exact window and any relief rules.

The second trap is valuation. A family business, a ranch, or a stake in a private company has no daily price. The estate must value it, and the IRS can challenge the number. A weak appraisal invites a fight. Cheap fixes here cost dearly.

The third trap is liquidity. The estate tax is due in cash, generally within nine months of death, unless the executor gets an extension. An estate rich in land and poor in cash can be forced into a hasty sale. Some provisions allow payment over time for closely held businesses, but the rules are strict.

The fourth trap is forgetting that gifts count. A person who gives away large sums during life uses up the same exemption. The donor must file Form 709 to report gifts over the annual exclusion, even when no tax is due.

The fifth trap is old paperwork. A will or trust written years ago may point at an exemption number that has since changed. Language tied to a fixed dollar amount can send assets to the wrong place. Dust off those documents.

One last caution. A spouse who is not a U.S. citizen is treated differently. The unlimited marital deduction does not apply the same way, and special trusts are required. Citizenship status changes the whole plan.

Questions to answer before you leave this page

Do you know the total value of everything you own and control, including life insurance you own and shares in a family business? Have you written down who is named on each account, deed, and policy? If you are married, does your family know that the surviving spouse must file Form 706 to keep any unused exemption? Have you counted the lifetime gifts you have already made, and did anyone file Form 709 for them? Does your estate hold enough cash to pay a tax bill due within about nine months, or would assets have to be sold in a hurry? Does your state add its own estate or inheritance tax, and where is its threshold set? When was your will last read by someone who knows today's rules, and does it name a dollar amount that may now be out of date?