Estate Tax and Inheritance Tax

What It Means

The property that people accumulate during their lives is often something they wish to leave to their children, grandchildren, or other relatives at the time of their death. The accumulated property—a house, land, money, or other wealth—is known as the person’s estate. In the United States, if the value of an estate reaches a certain amount, the government charges a tax on the right to transfer the property to descendents. This tax is the estate tax. It is charged as a percentage of the total value of all the property owned by the deceased person.

The U.S. federal government imposes the estate tax on an entire estate before it is distributed to those people inheriting it and regardless of how it is distributed. A different federal tax, called the inheritance tax, is a tax on the portion of an estate an individual receives, when and if he or she chooses to take on its ownership. It is charged after portions of the estate are transferred to each heir (a person who inherits the property of a deceased person). The inheritance tax is calculated as a percentage of the amount that the heir receives.

In addition to the federal-level estate tax, 24 U.S. states impose estate or inheritance taxes, and these state-level taxes bring in a total of approximately $4.5 billion a year. States use most of this money to pay for education, health care, and public safety.

When Did It Begin

In the United States the federal government has imposed either inheritance or estate taxes for many years. During both the Civil War (1861–65) and the Spanish-American War (1898), the inheritance tax was one of the ways the government raised money to pay for military expenses. The states individually developed inheritance taxes; in 1826 Pennsylvania became the first state to impose a state-level inheritance tax.

In 1916, when the U.S. government faced the high costs of engaging in World War I (1914–18), Congress needed to find the money to pay for waging the war. It recognized that the tax system at the time, which relied heavily on a consumption tax (a type of sales tax), put the most financial burden on the citizens least able to pay it (because for the wealthy it would seem a negligible amount, but for the poor it would be a more significant portion of their income). Congress believed that the larger portion of the revenue that the government needed should come from those with more income and inherited wealth. Because an estate tax would be easier to collect than an inheritance tax, and because many states already imposed inheritance taxes, Congress instituted an estate tax. Various changes have been made to the federal estate tax since then, but the principals of it have remained the same.

More Detailed Information

Estate taxes can seem complex, but in fact the way they are generally calculated is similar to the way personal income taxes are calculated every year. As with income tax, certain deductions and credits apply, reducing the amount of tax that will ultimately be owed. A deduction is an amount subtracted from the value of the estate (and is therefore not taxed), and a credit is an amount directly subtracted from the tax owed. After the deductions are taken from the total amount of the estate, the tax is figured as a percentage of the remaining amount. Any credits are then subtracted from the tax.

Allowable deductions from a taxable estate include funeral expenses, debts owed at the time of death, and the costs of settling the estate. In addition, if the deceased person leaves property to governmental, charitable, scientific, educational, or veteran organizations, the value of that property may also be deducted from the value of the estate (in other words, it is not taxed). When a deceased person has owned property jointly with a husband or wife, or inherited property from a husband or wife, that property is not subject to an estate or inheritance tax. This is referred to as the marital deduction.

Knowing that their estates will be heavily taxed by the government leads many people to give some or all of their estates to nonprofit or charitable organizations, both at death and during their lifetime. In effect, the estate tax encourages charitable donations because they significantly reduce the tax on large estates.

As of 2007 the first $2 million of an entire estate was exempt from taxation (that is, not taxed), and this amount (called an exemption) was scheduled to increase to $3.5 million in 2009. Estates over this amount were taxed 45 percent. An estate with a value under this amount was not subject to the estate tax.

Inheritance taxes are the responsibility of the heir (who is called the beneficiary). Determining how much inheritance tax must be paid on a certain estate or part of an estate depends on the date of death of the person leaving the estate to heirs and the relationship of the heir to the deceased person. If the heir is a distant relative or friend, the tax rate is much higher than if he or she is a close family relative, such as a child, grandchild, or sibling. For example, as of 2007 the state of Pennsylvania, for dates of death on or after June 1, 2000, charged a 4.5 percent tax on transfers of property to direct descendents (sons, daughters, and grandchildren), a 12 percent tax on transfers to siblings (sisters and brothers), and a 15 percent tax on transfers to other heirs, such as nieces, nephews, other extended family members, and friends. Consider a Pennsylvania estate valued at $50 million that was divided so that a son was to receive half of it, a sister was to receive a quarter of it, and a nephew was to receive a quarter of it. If there were no exemptions or deductions, the state of Pennsylvania would charge inheritance taxes of $1,125,000 (4.5 percent of $25 million) to the son, $1.5 million to the sister (12 percent of $12.5 million), and $1,875,000 (15 percent of $12.5 million) to the nephew.

Recent Trends

In 2001 Congress passed the Economic Growth and Tax Relief Reconciliation Act, a law that significantly impacts the federal estate tax. As a result of this law, the federal government began to reduce the estate-tax rate in 2002. The rate dropped from 55 percent to 50 percent in 2002, and then by 1 percentage point each year until it reached 45 percent in 2007. Finally, the federal estate tax would be eliminated entirely in 2010.

The Economic Growth and Tax Relief Reconciliation Act also substantially increased the amount that individuals could pass to their heirs without having federal estate taxes imposed on it. The exemption for 2002 was $1 million, and it was set to increase gradually to $3.5 million in 2009. The full repeal (official cancellation) of the estate-tax law would take effect in 2010. The law, however, contained a “sunset” provision, which means that the estate-tax laws in effect before 2001 would be reinstated in 2011 if Congress did not pass an additional law calling for an entirely new estate-tax plan.