Simple Explanation of the Federal Estate Tax

Simple Explanation of the Federal Estate Tax

On a daily basis I have to turn complicated tax issues into a simple discussion.  A discussion that I have to discuss/teach very often is the Federal Estate Tax.  Before we discuss the easy way to determine your Federal Estate Tax bill some caveats:

  • The calculations below are commonly referred to as “Napkin Math.”  Meaning, it is simplified and thus can be done on the back of a napkin.  We are not using exact numbers, exact deductions, exact credits, etc.  Rather, I am providing tools to understand what the Federal Estate Tax actually is, and how it affects people.
  • Second, I am not dealing with State Estate Taxes (Yeah bet you didn’t know that your state may have one!).  There are 18 states with separate Estate Taxes, known as Decoupled States.  We will talk about them in another post.
  • Third, this post is not meant to start a fight about the Estate tax (or when used as political rhetoric – Death Tax), but rather educate how the current system works.
  • The number we we come up with – is due and owing within 9 months from date of death, in cash.  The government has no interest in property – leads to a huge amount of liquidity issues that we will discuss in a different post (again, this a generality, the government allows farms and small businesses to extend their payment).
  • Before completing your 706 form – also unofficially known as your LAST TAX  RETURN EVER – speak with a qualified attorney or CPA (but from my experience, most CPAs know very little about this area).

Phew, with all those caveats out of the way lets get down to “work”!

Calculating your Estate Taxes

First we need a person’s Gross Estate, i.e. everything they own.  If it is owned jointly then we will use one-half of that value (this may be different in community property states but there are only 9 of you and no where near my state so I am going to ignore you guys for now).  Also when we take the gross estate – we have to minus an liabilities owed on that asset.  Once we have that Gross Estate we then minus the Credit Shelter Amount.  The Credit Shelter Amount is (simply put) a coupon that the government gives you; it allows you to pass that amount of assets to a non-marital U.S. Citizen beneficiary.  This year a decedent can pass $2,000,000 tax free; in 2009 that number is $3,500,000, in 2010 it is unlimited; and then in 2011 we are back down to $1,000,000.

After we minus the Credit Shelter Amount, we have the Taxable Estate.  We then minus any assets given to a spouse (Marital Deduction) or given to a charity (Charitable Deduction).  This Taxable Estate is then multiplied by 50%, remember, we are using napkin math!  The number you come up with is your Net Taxes owed.

THAT’S IT FOLKS – How do I do all this on the back of napkin?  It is this easy:

Assets

-Credit Shelter Amount

-Marital Deduction

-Charitable Deduction

Taxable Estate

X50%

THIS IS THE AMOUNT OWED TO THE U.S. GOVERNMENT

Example:

We have Mr. Chauvinistic – He owns EVERYTHING in his family.  His assets include $10,000,000 Taxable Portfolio (i.e. not qualified money), and a home worth $4,000,000 (no mortgage – remember napkin math).  So lets get to it.

(Assets) $14,000,000

- (Credit Shelter Amount) $2,000,000

- (Marital Deduction) Everything goes to the Wife

- (Charitable Deduction)ZERO

(Taxable Estate) 0

X50%               0

What happened here? He left $14,000,000 but owed no taxes?  Simple – his Marital Deduction covered everything!  However, now Mrs. Chauvinistic dies

(Assets) $14,000,000 (ignore growth for now)

-Credit Shelter Amount$2,000,000 (she dies this year after the heart break of losing her husband

-Marital DeductionZERO

-Charitable DeductionZERO

Taxable Estate$12,000,000

X50%  $6,000,000

This family loses both parents and now has to pay the U.S. Government $6,000,000.  I have talked about how to reduce this amount (here) and will continue to do so in future posts.

P.S. Lets look what happens to the same numbers 2011:

Assets$14,000,000 (ignore growth for now)

-Credit Shelter Amount $1,000,000 (she dies this year after the heart break of losing her husband)

-Marital DeductionZERO

-Charitable DeductionZERO

Taxable Estate$13,000,000

X50%                           $6,500,000

AN EXTRA $500K!

Any questions or comments?!

8 Responses to Simple Explanation of the Federal Estate Tax

  1. It makes no sense to pay taxes on money and assets that you already paid income taxes on.

    Besides, many argue the purpose of the estate tax is to prevent small groups from accumulating extraordinary wealth and passing it from generation to generation. This doesn’t work. How much estate tax do you think the Kennedy’s have ever paid.

  2. Gov’t Tax Sales,

    I agree that the idea behind an estate tax is wrong, that being said, it generates too much money (think tens of billions) but only affects the top 2% of the country…it is way too perfect for politicans to let go of. Hell, even the ancient Romans had one.

    Your second point is VERY interesting. Jackie O when she died with an estate valued at about $50mil or so she paid $1mil in tax BECAUSE SHE PLANNED FOR IT (See my quote by Judge Learned Hand…yes, that is his real name). Compare that to the owner of the Miami Dolphins in the mid 90’s, he died NO PLANNING he owed over $500mil and the team had to be sold by his heirs.

    So for some it does work!

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