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The federal government collects the vast majority of its revenues by taxing individuals and businesses on their earnings. However, the government also has a number of smaller sources of revenues; two of those — estate and gift taxes — are levied on the transfer of assets. While those two areas of the tax code are relatively small in dollar terms, they can generate a significant amount of attention and even controversy in the broader conversation about wealth. Estate taxes are levied on assets transferred at death and gift taxes are levied on assets transferred while the donor is living. This piece will provide an overview of how the estate tax works, its interaction with the gift tax, and their contribution to government revenues.
What is the Federal Estate Tax and How Does it Work?
The estate tax affects only very large estates that transfer assets above a certain amount to heirs other than a surviving spouse. The underlying principle of the estate tax is that many large estates consist mostly of unrealized – and therefore, untaxed – assets, like capital gains. Simply put, an unrealized gain is when an asset increases in value, but the owner has yet to sell it. Assets covered under the estate tax include land and real estate, financial investments, collectibles, and furnishings. The tax is based on the value of those assets, which is defined as what those assets would sell for at the time of the transfer.
The Internal Revenue Service exempts a significant portion of any estate’s value. That exemption amount, currently set at $11.58 million for 2020, is known as the filing threshold and is indexed for inflation.
To illustrate how the estate tax works, consider the example of a person leaving behind an estate with a value of $15 million. If that estate were transferred to a spouse, there would be no tax liability; otherwise, the estate would be taxed on the amount above the $11.58 million threshold. That would leave $3.42 million subject to a 40 percent tax, resulting in a tax liability of $1.37 million. As another example, if an estate worth $10 million were left behind, it would have no estate tax liability, regardless of who the beneficiary was, because the value of the estate would be entirely below the threshold.
What is the Gift Tax?
Gift taxes prevent individuals from avoiding the estate tax by transferring assets before death. The annual gift exclusion allows a donor to transfer up to $15,000 per recipient before owing a gift tax. Gifts received are not taxable income. Married couples can gift up to $30,000 and gifts between couples are exempted. A donor can defer the taxes on gifts in excess of $15,000 and have it reduce the exemption for the estate tax at the time of death.
Trends in Federal Estate and Gift Taxes
A number of policy changes, including those in the Tax Cuts and Jobs Act (TCJA), have resulted in fewer estates paying taxes. The Tax Policy Center (TPC) estimated that in 2017, over 11,000 estates filed tax returns of which half were taxable. In 2018, after the enactment of TCJA, TPC estimated that only 4,000 estates filed tax returns and 1,900 were taxable. Because the tax primarily affects very wealthy taxpayers, the top 10 percent of earners paid more than 90 percent of estate taxes in 2018, with nearly 40 percent paid by the top 0.1 percent of earners.
Over time, estate and gift taxes have declined as a share of federal revenues, falling from an average of 2.0 percent in the 1970s to less than 0.5 percent in 2019. In 2019, the federal government collected $17 billion in such taxes.
The trends in estate and gift taxes are largely dependent on two factors, the tax rate and filing threshold, both of which have varied greatly over the past two decades. Gradual increases to the filing threshold coupled with lowered tax rates have resulted in reduced revenues from the estate tax. For example, from 2000 to 2009, the filing threshold increased from $0.7 million to $3.5 million while the tax rate declined from 55 percent to 45 percent. The estate tax was repealed entirely in 2010, leaving only gift taxes in effect that year at a lower tax rate.
In 2011, estate taxes were re-established and the top tax rate was set at 35 percent. The filing threshold was set at $5 million and included the lifetime gift exemption — formerly a separate threshold for assets transferred while living. In 2012, the top tax rate increased to 40 percent. In 2017, the TCJA doubled the filing threshold to $11.2 million for singles and $22.4 million for married couples, but only for 2018 through 2025. After 2025, the filing threshold will return to prior levels and continue to be adjusted for inflation.
State Taxation of Estates
Thirteen jurisdictions also impose state-level estate taxes, with rates and filing thresholds that are both generally less than half of the federal levels. The rate is lowest in Connecticut and Maine at 12 percent and it is highest in Washington and Hawaii at 20 percent. Estates with a value of less than $1 million are not subject to taxes in any jurisdiction.
Conclusion
Despite declining as a share of total receipts, taxes on the transfer of assets remain a high profile source of federal revenues. Largely due to the filing threshold, the estate tax affects only a few — but the wealthiest — estate holders.