Who Pays Federal Estate Tax?

If you’re an executor, the odds are very good that you won’t have to worry about filing a federal estate tax return (IRS Form 706). In fact, it’s estimated that for deaths in 2011, more than 99.6% percent of estates will NOT owe federal estate tax. (Or, as Warren Buffett put it, “You would have to attend 200 funerals to be at one at which the decedent's estate owed a tax.”)

The reason: Only the largest estates are subject to this tax. For deaths in 2011, the individual estate tax exemption is $5 million; for 2012 deaths, $5.12 million. Married couples can share their individual amounts in any way lets them avoid the most tax.

In other words, any person can give away or leave $5 million in taxable gifts without paying any federal estate tax. And many gifts are not taxable, including property given or left to a spouse or to a tax-exempt charity.

The Way It Used to Be

It wasn’t always that way. Although the tax has never affected most families, back in 1977, about 10.5% of estates paid some estate tax.

The modern federal estate tax was instituted in 1916, to help pay for the expenses the United States incurred in World War I. The first exemption amount was $50,000.

The Federal Estate Tax Rate

The federal estate tax rate, now the lowest since 1932, still sounds terribly high: 45%. But because so much money ($5 million per person) is exempt from the tax, the actual rate is much lower.  In 2009, the average effective tax rate (the amount of tax paid as a percentage of the entire estate) was 19.4%, according to the Tax Policy Center. Even for estates above $20 million, the effective rate was only 22.4%. Because the exemption is now larger, the rate is even lower now.

What an Estate Tax Does

Obviously, an estate tax brings in a lot of sorely needed revenue.  Eliminating the estate tax, as many Republicans have proposed, would cost about $500 billion over the next decade, according to an estimate from the Congressional Joint Committee on Taxation. Keeping the exemption at its 2009 level of $3.5 million per person (an early Obama proposal) and indexing it to inflation would cut that loss of revenue by about half.

The estate tax also gives the government an opportunity to tax income that has never been taxed. Most of the big fortunes being transferred from one generation to the next contain a sizeable proportion of unrealized capital gains. That wealth has never been taxed.

Finally, an estate tax that affects only the wealthiest families also serves to reduce, at least to some extent, the concentration of wealth among the few.  The income inequality trend intensified between 1979 and 2007, according to a Congressional Budget Office study.  During that period, for the one percent of the population with the highest income, average after-tax household income grew by 275%. For the 20% of the population with the lowest income, it grew 18%.

The top 1% also own a staggering 40% of the country’s wealth. Most Americans don’t know that, according to a recent survey by professors from Duke and Harvard, who questioned people and found that most people overestimated the amount of wealth owned by the poor and underestimated the amount owned by the rich.

Many wealthy families have spent a lot of money lobbying against the estate tax. Others, including Bill Gates, Sr. and Warren Buffett, have applauded the tax. Buffett testified before Congress that "dynastic wealth, the enemy of meritocracy, is on the rise. …. A progressive and meaningful estate tax is needed to curb the movement of a democracy toward plutocracy."