The Estate Tax 101

My copy of the federal code & regulations on the estate tax. Yeah, I had to cut some stuff out for this article.

With big changes in the estate tax coming in January, there has been a lot of buzz about the issue. Naturally, people can get confused and have questions regarding this less than simple tax. Since I spent 15 weeks studying just the estate and gift tax, I figured I would at least give a brief introduction to what exactly the estate tax is, how it works, and what (some of) the changes will be. All of course from the perspective of family farms.

Keep in mind though, I’ve watered stuff down. This is a fairly complex topic and I just want to give the basics of how it works. (See picture.)

The estate tax works hand in hand with the gift tax. Essentially, any time there is a large transfer of wealth from one generation to the next, these two gifts are meant to step in and allow the government to take its share. The gift tax occurs during life and the estate tax at death.

We look at the entire estate by the deceased, including any gifts made during lifetime. Each individual (mom and dad), right now, are allowed to transfer up to $5million (be that in money, land, houses, cars, whatever form) through gifts or at death without facing any type of tax. We refer to this as the part of the estate that can be “sheltered.” Anything over and above $5million is taxed on a graduated scale between 18 – 35%.  (Example: First $10,000 is at 18%, between $10,000 and $20,000 is at 22%, anything between $20,000 and $40,000 is at 24%….) The highest tax is for any amount over $5,500,000.

How about an example?

Let’s say Pop has an estate worth $7million. He transfers $1million to his friend Dave a couple years before he dies. At death, he transfers the remaining $6million to his three kids. Without getting too complicated, Pop will be allowed to “shelter” $5million of the estate. That leaves $2million to be taxed. Since that amount falls well within the highest bracket, it will be taxed at $155,800, plus 35% of the excess amount over $500,00. (Remember: it is a graduated tax, so smaller amounts are taxed at a lower amount, hence the seemingly random $155,800.) So, Pop’s estate owes $155,800 + ($1.5million * 35%), or $680,800.

Now property is normally valued at fair market value, or in this case its “highest and best use.” However, there is a special provision for land used as agriculture. In a normal, regular time, land would probably be worth more as a shopping mall than as a corn field. Therefore, as long as certain requirements are met (Jr. plans on keeping it and farming, etc.), the agricultural land will be valued at its current farm value.

That was great when ag land was worth $1400 an acre. Iowa just set a record for land selling at $21,000 an acre. Here in Michigan, it is a little more sane at $5,000 an acre. Important though that you can see how the ag valuation might not really benefit farmers right now if the value of ag land is so high. The land would probably be best just valued at its fair market value.

So, now that we have the basics down, what the heck is everyone going on about in regards to January?

In January, the current estate tax rates will lapse and the former rates will go into effect. These former rates are sort of the “default” for when Congress and the President fail to act. Most importantly, the amount of money “sheltered” will go down to $1million. That means any part of the estate valued over $1million will be subject to the estate tax (or gift tax if it occurs during life).

The rates of taxation will also go up. It will still be graduated, but the highest bracket (for any part of the estate over $500,000 over the sheltered amount) will be taxed at 55%.

Another example.

Let’s say Pop still has that estate worth $7million. He gives $1million to his friend Dave as a gift and the rest passes to his kids at death. Now, instead of only $2million being subject to the tax, $6million will be subject to the tax. After that first $500,000 that is taxed at a lower bracket is taken out, $5.5million will be taxed at 55%. That means the estate will be taxed $3,025,000, plus the tax on the first $500,000 over $1million (I don’t have that graduated number right now, but I don’t think I need it for the exercise.)

Can you imagine any family farm being taxed over $3million on mom and dad’s death? Most farm assets are in the form of land and equipment. Farms are generally considered “cash poor.” Unless the kids are wealthy enough to pony up the cash to pay the estate tax, the farm would have to be sold off piecemeal in order to satisfy the federal government.

Which is why it is so utterly important that Congress acts prior to January 1st.

Otherwise, there are a whole lot of family farms in the government’s cross-hairs.