Wealth Transfer Taxes: How do the estate, gift, and generation-skipping transfer taxes work?
The United States has taxed the estates of deceased persons since 1916. In 1976 Congress linked taxes on estates, gifts made during life (inter vivos gifts), and generation-skipping transfers (GST). The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) cut all three taxes sharply but only through 2010. The act gradually phased out the estate and GST taxes and repealed both entirely for 2010, leaving only the gift tax (at a reduced rate) in that year. The Tax Relief, Un-employment Insurance Reauthorization, and Job Creation Act of 2010 set a single rate of 35 percent and a $5 million exemption (indexed for inflation after 2011) for 2011 and 2012. Unless Congress acts to extend the 2010 law, all three taxes will revert to their pre-2001 parameters in 2013.
- The executor of an estate must file a federal estate tax return within nine months of a person’s death if that person’s gross estate exceeds the exempt amount ($5 million in 2011).
- The estate tax applies to a decedent’s gross estate, which generally includes all of the decedent’s assets, both financial (such as stocks, bonds, and mutual funds) and real (homes, land, and other tangible property). It also includes his or her share of jointly owned assets and life insurance proceeds from policies owned by the decedent.
- The estate tax allows an unlimited deduction for transfers to a surviving spouse and to charity. Estates may also deduct debts, funeral expenses, legal and administrative fees, and estate taxes paid to states. The taxable estate equals the gross estate less these deductions.
- A credit then effectively exempts a large portion of the estate: in 2011, the effective exemption is $5 million (see table). Any value of the estate over $5 million faces a tax rate of 35 percent.
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- After 2011, the estate tax returns to an effective exemption of $1 million and tax rates ranging from 41 to 55 percent, with some estates subject to a 5 percent surtax.
- Special provisions reduce the tax or spread out payment over time for family-owned farms and closely-held businesses. Such estates that satisfy certain conditions may use a special-use for-mula to reduce the taxable value of their real estate, often by 40 to 70 percent. Estates where farms or businesses make up at least 35 percent of gross estate may pay the tax in installments over fourteen years at reduced interest rates, with only interest due during the first five years.
- Congress enacted the gift tax in 1932 to prevent donors from avoiding the estate tax by transfer-ring their wealth to heirs before they die.
- The gift tax provides a lifetime exemption of $1 million per donor, temporarily increased to $5 million for gifts made in 2011 and 2012. Beyond that exemption, donors must pay gift tax equal to 41 percent of the first $500,000 and 45 percent of any excess (the tax rate is reduced to 35 percent in 2011 and 2012).
- An additional amount each year is also exempted from both the tax and the lifetime exemption. This exemption, $13,000 in 2011, is indexed for inflation in $1,000 increments and is granted separately for each recipient. Thus, for example, a married couple with three children could give their children a total of $78,000 each year ($13,000 from each parent to each child) without ow-ing tax or counting toward the lifetime exemption.
- Regardless of their size, neither inheritances nor gifts received count as taxable income to the recipient.
- Congress enacted the GST tax in 1976 to prevent families from avoiding the estate tax for one or more generations by making gifts or bequests directly to grandchildren or great-grandchildren rather than passing them through each generation. The GST tax effectively imposes a second layer of tax (using the exemption and the top tax rate under the estate tax) on wealth transfers to recipients who are two or more generations younger than the donor.