Over the last decade, there has been increased scrutiny on the widening gap of economic inequality. Between the Occupy Wall Street movement in 2011 and discussions of a wealth tax taking place in the most recent presidential debates, there has been consistent concern about the taxation of those at the top of the economic food chain.
One such tax that some have referenced, and which recently garnered political consideration in California, is the estate tax.
Those in favor of an estate tax suggest that it is fair and reasonable to tax money whenever it changes hands. They consider it a similar transaction as paying taxes when you earn wages from your employer, receive a large gift, or make a transaction at a cash register. Thus, proponents of the estate tax suggest that you should pay taxes when you receive a significant inheritance.
However, those on the other side of the aisle refer to the estate tax as a “death tax”. Opponents to the tax argue that the income was already taxed when earned; therefore, the deceased’s children, other relatives, or charitable causes, should not have to pay additional taxes.
The estate tax has long been a controversial tax. So what is it exactly? What is its status on the federal level? How does it impact you at a state level?
What is estate tax?
The estate tax is a tax on your right to transfer property at your death. It applies to the deceased’s gross estate, which generally includes all of their assets, both financial (e.g., stocks, bonds, and mutual funds) and real (e.g., homes, land, and other tangible property). It also includes their share of jointly owned assets and proceeds from life insurance policies they owned.
The total tax is calculated based on the gross estate’s fair market value, rather than what the deceased originally paid for their assets. In addition, if appropriate, the state in which the deceased was living at the time of their death is the one to levy the tax.
As of 2020, the estate tax exists almost exclusively at the federal level. However, 12 states and Washington D.C. also levy an estate tax.
How is the estate tax different from gift and generation-skipping transfer taxes?
It is common for people to group the estate tax, gift tax, and generation-skipping transfer (GST) together. However, each term refers to a disparate tax. Here is a simple way to tell each of them apart:
- The estate tax applies to the transfer of property at death.
- The gift tax applies to transfers made while a person is living.
- The generation-skipping transfer tax is an additional tax on a transfer of property that skips a generation.
Congress enacted both the gift tax and GST tax in order to close some loopholes for wealthy individuals and families. For example, the gift tax intends to prevent donors from avoiding estate tax by transferring their wealth before they died.
Similarly, the government instituted the GST tax in 1976 to inhibit families from avoiding the estate tax for one or more generations by making gifts or bequests directly to grandchildren or great-grandchildren. The GST tax effectively imposes a second layer of tax on wealth transfers to recipients who are two or more generations younger than the donor.
How is the estate tax different from an inheritance tax?
As of 2020, the federal government does not impose an inheritance tax and only six states choose to collect one. Here are how the two differentiate:
- Estate tax is based on the net value of all property and assets owned by an individual at the time of their death. The estate pays for the tax.
- Inheritance tax is calculated with the value of individual bequests received from a deceased person’s estate. The beneficiaries cover the tax.
Maryland remains the only state with both an estate and inheritance tax. The other five states imposing an inheritance tax are Iowa, Kentucky, Nebraska, New Jersey and Pennsylvania.
Transfers to surviving spouses are completely exempt from the inheritance tax in each of the six states. In addition, four of those states – Iowa, Kentucky, Maryland and New Jersey – also exempt transfers to surviving children and grandchildren.
Typically, the law requires more distant heirs, such as siblings, nieces, nephews, and friends, to pay the tax. The tax rate tends to escalate as the degree of kinship decreases.
What are federal regulations on estate tax?
The federal estate tax works in the following ways:
- Upon the death of the individual, the estate executor must file a federal estate tax return within nine months. However, this is only necessary if the gross estate exceeds the exemption amount (see below).
- The gross estate generally includes all of the decedent’s assets, including cash, stocks, investments, real estate, business interests, and more.
- The estate tax (as well as the gift tax) allows for an unlimited deduction for transfers to a surviving spouse, to charity, and to support a minor child. Estates may also deduct debt, funeral expenses, legal and administrative fees, charitable bequests, and estate taxes paid to states. The taxable estate equals the gross estate less these deductions.
- As part of the Tax Cuts and Jobs Act (TCJA), the federal exclusion amount doubled to $11.58 million for individuals ($23.16 million for married couples) as of 2020. Therefore, estate tax is only due if the gross estate exceeds this threshold. Please note that the $11.58 million threshold applies exclusively to the federal estate tax. Some states have their own, significantly lower, estate tax thresholds.
- Special provisions reduce the tax, or spread payments over time, for family-owned farms and closely held businesses. Estates that satisfy certain conditions may use a special-use formula to reduce the taxable value of their real estate, often by 40 to 70%.
- Inheritances are not taxable income to the recipient under the income tax.
- Inherited assets receive a basis step up to the value at the time of death, meaning that unrealized capital gains on assets held until death are never subject to income tax.
How does California treat estate tax?
At one point, all states had an estate tax. The federal estate tax return offered a credit toward state-level estate taxes and states based their own tax rates on this federal credit. However, this changed in the early 2000s when federal tax law amendments eliminated the credit. As a result, many states repealed their estate taxes.
Some states continue to apply estate tax. However, California is not one of them. However, that does not come from a lack of trying.
In March 2019, California State Senator Scott Weiner put forth Senate Bill (SB) 378 to levy a state estate tax as early as January 1, 2021. The bill proposed a California tax of 40% applied to estates larger than $3.5 million for an individual ($7 million for a married couple). To avoid double taxation by the state and federal government, SB 378 allowed the California version to phase out once the value of the deceased resident’s estate reached the federal threshold.
However, the bill never reached the floor of the California legislature. Even if the bill did receive enough passing votes and a signature from Governor Gavin Newsom, the ultimate decision would have been up to California voters by way of ballot in November 2020.
The estate tax may not affect a majority of households in California, but an awareness of the tax landscape and different estate and inheritance taxes is valuable.
Our tax team at Squar Milner brings a wealth of knowledge and expertise in working with individuals to optimize their tax planning over time. Between our team’s extensive background in estate planning as well as our expertise in State and Local Tax, we will work closely with you to ensure that you meet your future goals for you and your family.
Disclaimer: This material has been prepared for informational purposes only, and is not intended to substitute for obtaining accounting, tax, or financial advice from a professional tax planner or financial planner. All information is provided “as is,” with no guarantee of completeness, accuracy, timeliness or of the results obtained from the use of this information.