Wealth, Mobility, Inheritance And The Estate Tax

Studies | Taxes

No. 235
Thursday, June 01, 2000
by Bruce Bartlett


Estate Planning

Figure IV - Share of Estate Tax Revenue by Size of Estate%2C 1997

Because of legal estate planning techniques, much less of the tax actually falls on the wealthy than is commonly believed. In 1997, more than 50 percent of all estate tax revenue came from estates under $5 million. [See Figure IV.] The effective estate tax rate actually falls for estates above $20 million.53 [See Figure V.] A recent study estimates that two-thirds of the wealth of the nation's richest families go untaxed.54

Methods of Avoidance. The reason for this disparity is that careful estate planning can virtually eliminate the tax. At the simplest level, individuals can give away up to $10,000 per year per person free of gift tax. This means that a husband and wife with two married children, each with two children of their own, could give up to $160,000 per year to their offspring free of tax. Also, there is a large deduction for gifts made to spouses, whose estates may be taxed separately. Thus for most married couples, the estate tax only applies to estates larger than $1.35 million. Beyond that, there are a number of increasingly complex methods for reducing the burden of the estate tax. They include life insurance trusts, qualified personal residence trusts, charitable remainder trusts, charitable lead trusts and generation-skipping trusts.55

"More than half of all estate tax revenue comes from estates under $5 million."

So effective are these methods of avoiding estate taxes that it has been argued that the estate tax essentially is a voluntary tax. In the words of economist George Cooper: "The fact that any substantial amount of tax is now being collected can be attributed only to taxpayer indifference to avoidance opportunities or a lack of aggressiveness on the part of estate planners in exploiting the loopholes that exist."56 Economists Henry Aaron and Alicia Munnell put it even more bluntly. In their view, estate taxes aren't even taxes at all, but "penalties imposed on those who neglect to plan ahead or who retain unskilled estate planners."57

Incentives to Avoid Estate Taxes. However, the ability to exploit existing tax-avoidance techniques is not uniform across estates. Those with the largest estates generally have the greatest ability to engage in estate planning. This is because many estate planning techniques are costly and require long lead times to implement. Families with long histories of wealth are more likely to be familiar with them. Thus a disproportionate burden of the estate tax often falls on those with recently acquired, modest wealth: farmers, small businessmen and the like. In many cases their incomes may not have been very high and they died not even realizing that they were "rich."

Figure V - Estate Taxes as a Share of Gross Estate%2C 1997

"The effective estate tax rate annually falls for estates above $20 million, thanks to careful estate planning."

Another reason why those with larger estates are more likely to engage in complex estate planning is, of course, that they pay higher tax rates on their assets. Consequently, research shows that during periods when estate tax rates were rising, revenue from the estate tax fell as the incentive to engage in estate planning increased. Conversely, lower estate tax rates increased estate tax revenue, because it was no longer as profitable to engage in such planning.58

It should be emphasized that estate planning is costly, not just in terms of lawyers' fees and the like, but also because assets placed in trust may not earn as high a rate of return as they would under the original owner's control.59

Effects on Small Business. The impact of the estate tax on small businesses can be devastating. According to a recent survey:60

  • Fifty-one percent of family businesses would have significant difficulty surviving in the event of a principal owner's death, due to the estate tax.
  • Another 14 percent of businesses said it would be impossible for them to survive.
  • Only 10 percent said the estate tax would have no effect.

This same survey found that:

  • Forty-one percent of businesses said they would have to borrow against equity to pay the estate tax.
  • Thirty percent said they would have to sell all or part of the business.
  • Eighty-one percent of family businesses reported having taken steps to minimize the estate tax bite, including purchasing life insurance, making lifetime gifts of stock, putting the business into trust or other arrangements.

Academic research has also looked at the impact of the estate tax on small businesses. According to one study, its main effect is on business liquidity. Since most small businesses are undercapitalized to begin with, the estate tax can literally suck the life blood out of a business. Increasing the ability of entrepreneurs to leave an inheritance can greatly increase the chances of a small firms' survival.61 Other research found that the estate tax encourages small business owners to sell out or merge with large firms.62

"Fifty-one percent of family businesses would have difficulty surviving the death of the principal owner, due to the estate tax."

The latest research reinforces these findings. A survey of family businesses in New York found that they had spent $125,000 each in estate planning. These include attorneys' fees, insurance premiums and other expenses designed to mitigate the effects of the estate tax.63 In a review of the data from this survey, Douglas Holtz-Eakin concluded that the estate tax has a much greater distortionary effect on entrepreneurs than previously thought.64 It causes them to cut back on labor, investment and risk-taking.

Other Effects. The impact of estate planning goes beyond the estate tax and reaches the income tax as well. For example, under a charitable remainder trust one donates assets to a tax-exempt institution but retains income from the assets until death. Not only are the assets fully shielded from the estate tax, but the charitable donation reduces one's income taxes as well. Because of such interactions between the estate tax and the income tax, Douglas Bernheim estimated that lost income tax revenue may offset all of the revenue from the estate tax.65 It should also be noted that lawyers' and accountants' fees for estate planning can, in many cases, be deducted from one's income taxes, which is another way in which the estate tax reduces income tax revenues.


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