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Policy Basics: The Estate Tax

March 23, 2015

A long-standing part of the tax system, the federal estate tax is a tax on property (cash, real estate, stock, or other assets) transferred from deceased persons to their heirs. Roughly 2 of every 1,000 estates have to pay any estate tax, largely because of its generous exemption levels. Because it affects only the very wealthiest estates, the estate tax is the most progressive part of the tax code.  In addition to the federal estate tax, taxes on inherited wealth are also a traditional and common revenue source for states.

The tax is levied only on the portion of an estate’s value that exceeds the exemption level, minus deductions, such as for charitable giving. 
Taxable estates owed 16.6 percent of their value in tax, on average, in 2013, the latest year for which estimates are available.  

The estate tax also serves as a backstop to the capital gains tax: without the estate tax, the increase in the value of unsold assets that had appreciated over time would never be subject to taxation.

Estate Tax Has Weakened Considerably Since 2001

policybasics-estatetax_rev3-23-15-t1.pngLegislation enacted in 2001 gradually phased out the estate tax by raising the exemption level and reducing the rate, leading to the tax’s temporary repeal in 2010. The tax was scheduled to return in 2011 under pre-2001 rules (an individual exemption of $1 million and a top rate of 55 percent), but policymakers instead permanently extended it in much weaker form.

Under current law, the exemption level is $5.43 million per person for 2015, indexed for inflation, and the top statutory rate is 40 percent. The estate tax will generate about $246 billion over 2016-2025 under current law, according to the Congressional Budget Office.  The President’s 2016 budget proposes returning to the 2009 estate tax parameters with an exemption level permanently at $3.5 million per person ($7 million per couple) and the top rate at 45 percent, which would raise an additional $138 billion over 2016-2025.

Effective Tax Rate Modest Under Current Rules

As noted, taxable estates owed 16.6 percent of their value in tax in 2013, on average (see Figure 1). This “effective rate” is much less than the top marginal rate of 40 percent for three reasons:

  • policybasics-estatetax_rev3-23-15-f1.pngThe tax is applied only to the value of the estate that exceeds the exemption level. For example, at the current exemption level, an estate worth $6 million would owe taxes on at most $570,000, for a maximum effective tax rate of less than 4 percent.
  • The tax contains a number of provisions that reduce estates’ tax liability, many of them originally designed to protect farmers and small businesses. 
  • Many wealthy estates use complex estate planning methods to exploit loopholes that reduce their tax liability and allow them to pass on significant portions of their estates tax-free.

Backstop to Capital Gains Tax

Usually, capital gains are taxed when the asset is sold or disposed of and the gain is “realized.” But if a person holds an asset that grows in value until his or her death, that “unrealized” capital gain is forgiven, and neither the heir of the estate nor the deceased person is taxed on it.  These unrealized capital gains account for a significant proportion of the assets held by large estates — ranging from 32 percent for estates worth between $5 million and $10 million to as much as about 55 percent of the value of estates worth more than $100 million (see pie chart).  Thus, without the estate tax, a large portion of these estates would never be taxed.

Small Businesses and Farms

policybasics-estatetax_rev3-23-15-f2.pngSome worry that the estate tax could threaten family-owned small businesses and farms.  However, analysis by the Urban-Brookings Tax Policy Center (TPC) finds that in 2013, only roughly 20 small business and farm estates owed any estate tax.  Furthermore, TPC estimates those few estates owed just 4.9 percent of their value in tax, on average.  In addition, special estate tax provisions allow the few taxable estates that may have any issues paying the tax immediately to pay spread payments over a 15-year period (at low interest rates).

Economic Evidence

Opponents of the estate tax argue that the tax hurts the economy.  However, evidence shows the estate tax is economically sound because it likely has little or no impact on wealthy donors’ savings and encourages heirs to work. 

Thus the estate tax is an economically efficient way to raise revenue that supports public services and lowers deficits without imposing burdens on low- and moderate-income Americans.  It is plays an important role in our revenue system, particularly given our long-term budget challenges.

For more, see “Ten Facts You Should Know About the Federal Estate Tax.”