Warning: This article is very long.
It feels weird to write a post in favor of taxes, but hear me out. After my last post about ways to avoid the estate tax, some friends indicated that the estate tax should be abolished altogether. While I’m no fan of taxes, they are a certainty of life, and I believe the estate tax reforms over the last 12 years have been a great success.
Let me begin by explaining the current estate tax system, and how it’s evolved over the last 12 years.
Current Estate Tax System
Rates and Thresholds
Just like income taxes, there is a federal estate tax, and a Massachusetts estate tax. Currently, the federal estate tax is a flat 40% of anything over $5.25 million (the calculations are a bit more complicated, but this is basically how it works). For example, if you die with $6.25 million, you’re $1 million over he limit, and will owe $400,000. Massachusetts taxes estates over $1 million, a much lower threshold, but the rates are also lower, on a scale from 0 to 16%. A $5 million estate would owe a Massachusetts estate tax of $391,600, which is an effective rate of 7.8%. That same estate would owe no federal estate tax, because it’s under 5.25 million.
Treatment of Married Couples
While the rates described above are for individuals, married couples can essentially double their threshold, and defer any remaining estate tax to the death of the second spouse. For the federal estate tax, this can be done with almost no planning, due to new “portability” rules. In Massachusetts, achieving this favored treatment usually requires some advanced estate planning, which is fairly common. Here is an article about estate tax planning for married couples.
Evolution Over Time
The current estate tax rates are fairly low, and the thresholds fairly high, but this wasn’t always the case. In 2001, the federal estate tax was up to 55% on the value of the estate over $675,000. From 2001 to the present, the estate tax went through a series of periodic changes. Essentially, the rates went down and the thresholds went up until we reached our current $5.25 million/40% system. Strangely enough, there was no federal estate tax in 2010.
While the federal estate tax underwent massive changes, the Massachusetts rates remained the same.
Capital Gains Avoidance
Typically, if you buy and asset, then sell it later for a profit, you will owe a tax on the increase. This is called a capital gain, and is taxed at rates slightly to significantly lower than normal earned income. To calculate the gain you subtract your purchase price (cost basis) from your sale price. If you paid $15 (basis) and sell for $25, your gain is $10. Therefore, even though there are favorable tax rates for capital gains, it can still be expensive to sell highly appreciated property.
Fortunately, there is a provision in the Internal Revenue Code that states that any asset included in calculating the value of a persons estate for estate tax purposes receives a “step up” in cost basis for income tax purposes, upon the death of the owner. For example, if you buy a house in 1980 for $50,00o, and it is worth $300,000 upon your death in 2013, then your next of kin would owe no capital gains tax when they sell it for fair market value in 2013, because of the step up in basis. If there were no estate tax, then there would be a capital gain of $250,000, which would likely result in an income tax liability of $37,500 (assuming a 15% capital gains rate). This is a huge benefit, and undercuts the impact of the estate tax for many taxpayers.
The Hypothetical $5 Million Estate
Let’s take a look at a hypothetical estate worth $5 million. Assume that the pre-step up basis in the estate’s assets is $2.5 million. We know that there will be no federal estate tax due, because it’s under the $5.25 million threshold. We also know, from above, that the Massachusetts estate tax will be $391,600. Assuming a capital gain rate of 15% (it’s probably going to be higher due to the Obamacare surtax), there would have been an income tax of $375,000 if no estate tax were in effect (($5M value -$2.5M basis) x 15% rate). Of course, the heirs could always hang onto the property instead of selling it, but the gain would be realized eventually.
So the estate tax due was $391,600, and the capital gain savings was $375,000. That’s a net tax liability of $16,600, which is only 0.3% of the $ 5 million estate. Even without considering the capital gains treatment, the effective rate is only 7.8%. This is a drop in the bucket, especially compared with the 2001 estate tax system.
Now let’s consider the merits of the estate tax in comparison to other common taxes.
Comparison to Other Taxes
I posit that the estate tax is economically and morally superior to other types of taxes.
Estate Tax vs. Income Tax
The federal and Massachusetts income tax systems are truly marvels to behold. While simple in concept, intended to skim off a portion of each taxpayer’s income, they are replete with rules, regulations, loopholes and perverse calculations. When you boil it down, you’ve essentially got a graduated tax on earned and unearned income, so that the most income you have the higher your rate, and the more taxes you pay.
The Mitt Romneys of the world make their money from buying and selling investments, and therefore pay lower capital gains rates on their income. Other fortunate folks have significant unearned income, for which they are taxed. But for the vast majority of taxpayers, the income tax is a tax on their earned income. It is a tax on their paycheck. It reduces the reward for their labor. This has major negative macroeconomic implications.
Of course everyone expects to send some money to our friends at the IRS and DOR. When a teenage kid gets his first paycheck for bagging groceries, and sees that $10 a week goes towards taxes, he’s probably not going to quit and go home. But that same kid may respond differently ten years later, when he’s beginning a professional career, and he’s in a 38% tax bracket (or ten years after that, when he’s a self-employed consultant in a 45% bracket).
A little aside about income tax brackets: Your bracket determines your “marginal rate,” which is the percentage of taxes that you pay on each additional dollar earned. Brackets are graduated, so that you pay a lower rate on the first dollar earned, than you do on the last dollar earned. While FICA and self employment taxes are technically different from the “income tax,” they are taxes on income, and should be considered in calculating your marginal rate, at least in the context of personal/family finance. Therefore, a Massachusetts resident earning from $36,250 to $87,850 per year is in a 25% federal income tax bracket, and pays a 5.25% Massachusetts income tax rate, and 7.65% FICA rate. That’s a combined marginal rate of 37.9%. So if this person receives a $1,000 raise, then $379 dollars goes towards taxes. The FICA rate is doubled for self-employed taxpayers.
As you can see, with rates approaching, and even exceeding 50%, income taxes provide a huge disincentive to further one’s career. And with higher rates for the self-employed, they make building a successful business nearly impossible. One might find it easier to just bag groceries. The ripple effect through the economy is dramatic.
The estate tax system, on the other hand, taxes wealth at the moment of its transfer via inheritance, not at the moment of its payment as compensation. If you work harder and earn more money, you will have the full benefit of that money during your lifetime. If you save that money, then you may increase the estate taxes payable upon your death. But it is the persons inheriting your wealth that will lose the benefit of that money, and they never had control over it to begin with. So unlike the income tax, the estate tax does not disincentivize work. Conversely, if a wealthy person’s heirs know that they’ll lose part of their inheritance to estate taxes, then that may actually encourage them to work harder to earn their own wealth.
Furthermore, from an ethical standpoint, it is more justifiable for government actors to take money that you did not earn, than to take money for which you actually worked.
Estate Tax vs. Sales Tax
The second most visible tax that most of us pay is the sales tax. In Massachusetts we pay a tax of 6.25% of the price of most goods that we purchase. Therefore, the sales tax increases the cost of most items. These higher prices discourage consumer spending spending. And because consumer spending stimulates the economy, the sales tax has a significant negative macroeconomic effect.
This negative economic effect is directed mostly at the middle class. Wealthy people are not going to forgo making a purchase because of the extra 6.25% tax. Poor people do not have the money to spend on discretionary purchases to begin with. However, the middle class has a limited discretionary budget, so the sales tax will cause them to spend less (or drive to New Hampshire).
While the sales does discourage discretionary spending by the middle class, it does not discourage spending on the household necessities that everyone needs, regardless of class. This causes the regressive application of the sales tax. Taxes can be either progressive, meaning that richer people pay higher rates, or regressive, meaning that poorer people pay higher rates. A tax could also be flat, meaning that everyone pays the same rate, regardless of wealth. The sales tax doesn’t have brackets; it’s the same 6.25% for everyone. While this may seem like a flat tax, it is regressive in application.
The sales tax is regressive, because poorer people spend a higher proportion of their money on necessary household goods. Without considering luxury purchases, most families have the same expenses for essentials. A family of four making $300,000 per year, and a family of four making $40,000 per year, each spend the same amount of money on toilet paper, or dish soap, or laundry detergent. Therefore, each family pays the same sales tax on these goods. However, that sales tax represents a much higher percentage of the poorer family’s income than the richer family’s income.
Regressive taxes are particularly burdensome in today’s economy, where 76% of Americans are living paycheck-to-paycheck.
Looking at both the discouragement of spending, and the regressive nature of the sales tax, the estate tax stands in sharp contrast. The estate tax actually encourages spending, because money spent during life is no longer part of the taxable estate at death. Furthermore, the estate tax is the ultimate progressive tax. It only kicks in for Massachusetts residents with over $1 million, and the rates stay relatively low until the federal threshold of $5.25 million. The vast majority of individuals will never have to pay an estate tax, and only the very wealthy will pay a significantly high percentage of their wealth towards estate taxes.
Effect on Small Businesses
Critics of the estate tax often cite the “devastating effect on family businesses” as justification for its repeal. In actuality, however, the estate tax does not devastate family businesses. The first step in engaging in this discussion is to define the term family business. Sure there are a few families that have $100 million businesses. Even after a 50% estate tax, these families will still walk away with over $50 million. They aren’t the sympathetic characters that we’re referring to.
Instead, let’s define “family business” as a company worth between $1 million and $20 million. By the time a business gets to $20 million, the ownership has usually spread out to include more people, so that the entire value will not be included in one owner’s taxable estate. Often time a business owner will sell their business to a public company, or private equity firm, before it gets that large. Still, let’s take a look at the hypothetical $20 million family business.
The Hypothetical $20 Million Family Business
First of all, no one is likely to build a $20 million business without the support of a loving spouse. So assume that the business owner is married (it is a family business after all). Well, the unlimited marital deduction for both federal and Massachusetts estate taxes ensures that estate taxes need not be paid until the second spouse dies. Furthermore, portability rules dictate that the couple can pass $10.5 million free from federal estate taxes. Simple marital estate planning can double the Massachusetts threshold to $2 million. These results requires a fairly simple amount of estate planning.
Based on a $20 million estate, the Massachusetts estate tax will be around $2.5 million. This state level estate tax is deductible from the federal gross estate, which results in a federal tax liability of around $2.8 million. I won’t bore you with all of the calculations, because they are a bit complicated, but you can see that the total estate tax liability is around $5.3 million, which is 26.5% of the estate.
Under the 2001 estate tax system, the estate tax would be substantially higher. The calculations were a bit different back then, but even using the marital planning described above, the total estate tax due would be around $10.26 million, or 51.3%.
Paying the Tax
The challenge for our family is to come up with $5.3 million of cash to pay the tax. Well, they’ve got a business worth $20 million, so they probably have some liquid assets lying around as well. If those liquid assets are not enough, they could borrow money from a bank, using the business as collateral, in order to pay the tax. They could then repay the loan over a period of years, using excess cash flow from the business. With today’s low interest rates, this option could make sense even if there was an extra $5 million lying around. Suppose they couldn’t get a bank to loan them the money. Well, the Internal Revenue Code has special provisions that allow business owners to pay their estate tax in annual installments.
Of course, the best way to deal with this estate tax liability is to plan for it in advance. The only time that the estate tax devastates a family business is when that family fails to properly plan for the succession of their business. This brings us to the last topic.
Easily Avoided with Estate Planning
The best aspect of our current estate tax system is that the taxes can be so easily reduced or avoided. With a fairly simple level of estate planning, the family in our example above was able to reduce the tax on a $20 million estate to only $5.3 million.
With more sophisticated planning, they could reduce this tax even more. For example, an annual gifting program to the next of kin could easily pass on $2 million worth of business stock over a ten year period. The gifts could be of non-voting stock, with valuation discounts, so that ownership and control of the business can be addressed separately. The gifts could be made in trust to protect the beneficiaries from their own financial woes.
Interest rate arbitrage strategies, using grantor retained annuity trusts (GRATs), or installment sales to intentionally defective grantor trusts (IDGTs), can pass wealth outside of the estate.
Those with the intelligence to build a $20 million business must also understand their own mortality. Allocating a small amount of the business’s profits to pay premiums on life insurance policies would provide liquidity at the moment of death, which could cover estate taxes.
Perhaps there was a college or university that set the family on the path to success, or perhaps the family’s faith was instrumental in building their business. Charitable gifts are deductible from the estate and lower estate taxes.
Sure, all of these techniques require the guidance of a competent estate planning professional. But the return on investment for this advice is immense. Legal fees are relatively small compared with the millions of dollars saved by proper planning.
Then vs. Now
Under the 2001 rates, estate planning could only go so far in reducing estate taxes on large estates. Now, under the 2013 system, estate tax rates are much lower, and the thresholds are much higher. This results in lower overall taxes for everyone, which helps family businesses. It also makes the estate tax more progressive, and contains the impact to those who can truly afford it.
My Professional Pledge
While this article lays out my beliefs on the propriety of our current estate tax system, it is my duty to explain this system to my clients, and to reduce or eliminate their future estate taxes. Many people never plan for estate taxes, and those are exactly the people that should be paying them. When a client comes to me, it is my goal to ensure that they do everything within the law, and within their comfort level, to pay as little an estate tax as possible.
In our complicated world, people have many competing interests, and taxes are only one of them. My goal is to review a client’s situation holistically, taking many factors into consideration, taxes included, to craft the plan that is best for them.
If you found this article informative, and would like to discuss how these topics impact you or your family, please contact me to schedule a consultation. My office is in Danvers, Massachusetts. I would love to hear from you.