The federal estate tax is collected on the transfer of a person's assets to heirs and beneficiaries after death.
The total tax due is calculated by adding up the fair market values of all the decedent's assets as of his date of death, although the executor or administrator of the estate can elect to have everything valued on an alternate date six months later instead.
Using the six-month alternate valuation date can be beneficial if an estate is expected to lose value over six months so its estate tax would be calculated on less.
Credits and allowable estate tax deductions are subtracted from the total value of the assets. These can include the bequests made to charity, paying off mortgages and the decedent's other debts, and costs and fees incurred in settling the estate.
The remaining balance over a certain threshold, referred to as the estate tax exemption, is taxed at a percentage of value. An estate valued at $10,000 more than the 2019 federal estate tax exemption is taxed at a rate of 18%, while an estate that exceeds the exemption amount by $1 million or more is taxed at 40%.
A Little History
The estate tax exemption was initially indexed for inflation under the provisions of the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (TRUIRJCA). This Act also set the top estate tax rate at 35%.
These provisions were supposed to remain in place until December 31, 2012, at which time the federal estate tax laws were intended to revert back to those that were in effect in 2001. This meant that the federal estate tax exemption would drop all the way down to $1 million, and the tax rate would jump to 55% on January 1, 2013.
Then Congress and President Barrack Obama acted in the early days of 2013 to pass the American Taxpayer Relief Act (ATRA). This Act made permanent the changes to the rules governing estate taxes, gift taxes, and generation-skipping transfer taxes that were previously implemented under TRUIRJCA.
Then came the Tax Cuts and Jobs Act (TCJA) in 2018. The TCJA doubled the exemption, which was already indexed for inflation to increase marginally each year to keep pace with inflation.
Who Is Subject to the Federal Estate Tax?
The estates of each and every U.S. citizen are subject to the federal estate tax, but very few estates actually have to actually pay it because of the exemption. The Internal Revenue Code effectively gives each U.S. citizen this "coupon" to apply against the value of their estates.
The exemption was $3.5 million in 2009, increasing to $5 million in 2010 and 2011. It went up to $5.12 million in 2012, then to $5.25 million in 2013. By 2014, it was up to $5.34 million, then it increased again to $5.43 million in 2015 and to $5.45 million in 2016 before reaching $5.49 million in 2017.
The exemption hiked up to $11.18 million in 2018, increasing to $11.4 million in 2019 and $11.58 million in 2020.
This means that only estates whose values exceed $11.58 million after deductions are made and credits are taken are subject to the federal estate tax on the balance.
An estate will pass to its heirs and beneficiaries free from federal estate taxes if its net value after being reduced by allowable estate tax credits and deductions does not exceed $11.58 million in 2020.
The Unlimited Marital Deduction
One of the most significant deductions for the estate of a married decedent is the unlimited marital deduction.
Remember, the estate tax is based on an estate's value after all available deductions and credits have whittled it down. The unlimited marital deduction allows a decedent to take a deduction for everything transferred to the surviving spouse at death.
An estate could escape taxation entirely in this circumstance, simply because a decedent was married and left everything he owned to his spouse.
Marital assets would be subject to the estate tax when the surviving spouse dies unless that spouse has remarried and again passes the property to the current spouse, but this would effectively mean disinheriting the couple's children, if any.
Estate Tax "Portability"
The Internal Revenue Code also provides for portability of the estate tax exemption between married couples. This provision was first introduced under the TRUIRJCA and was then made permanent.
The portability provision allows the estate of one spouse to shift any unused federal estate tax exemption to the surviving spouse for use at the time of the surviving spouse's own death.
For example, Joe might have left an estate worth $10 million. After applying the 2019 estate tax exemption of $11.4 million, $1.4 million of the exemption would be left over. Joe's spouse Mary can accept that remaining $1.4 million exemption from Joe's estate and add it to her own exemption.
Now Mary can shelter $12.8 million of her estate, or $1.4 million more than whatever the estate tax exemption is at the time of her death.
A federal estate tax return must be filed if the executor of the estate wants to give the portability bump to the surviving spouse, even if the decedent's estate doesn't owe a tax because its value doesn't exceed the exemption amount. The estate tax return would simply indicate that the portability option is being exercised, alerting the IRS to this fact.
What Happens When an Estate Is Taxable?
An estate must file a federal estate tax return, Form 706, the United States Estate (and Generation-Skipping Transfer) Tax Return, when a gross estate exceeds the federal estate tax exemption for the year of the decedent's death.
Form 706 must be filed with the IRS within nine months of the decedent's date of death. The estate tax payment is due at the same time Form 706 is due.
An automatic extension can be applied for using Form 4768, Application for Extension of Tie to File a Return and/or Pay U.S. Estate (and Generation-Skipping Transfer) Taxes, but the payment itself will begin accruing interest after the nine-month deadline.
The Estate Tax Is Not an Inheritance Tax
Estate and inheritance taxes are two quite separate things, but they're often confused—maybe because they're lumped together under the ignominious name "death taxes."
The estate tax is based on the value of a decedent's entire estate after deductions, credits, and the estate tax exemption are subtracted and applied. It's payable by the estate.
An inheritance tax is payable by the beneficiary who receives property from the estate and is based on only the value of those particular assets. The beneficiary is responsible for paying this tax, although some people include provisions in their wills to have the estate take care of this burden for them.
The federal government doesn't impose an inheritance tax, but six states do as of 2020: Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania. The tax rate is typically based on how closely related the beneficiary is to the decedent, and the closer the better. Spouses are almost invariably exempt.