What is the Estate Tax and How Does it Work?

Ruder Ware

Earlier this month, I provided a very brief overview of the estate tax in a vlog.  You can view the vlog here. In this blog post, I’ll expand on estate tax basics.

What is the estate tax?  At its foundation, the estate tax is a tax imposed on the transfer of property upon death.  It is distinct from other taxes imposed on the transfer of property, including the gift tax, the generation-skipping transfer tax, and in some states, the inheritance tax.  For purposes of this blog post, I’ll focus on the estate tax, but make sure that you subscribe to our content here if you’d like to learn more about these other transfer taxes in the future.

Wisconsin law technically imposes an estate tax equal to the state death tax credit computed on the federal estate tax return.  However, the federal government phased out the state death tax credit beginning in 2001, and it was eliminated by 2005.  In response to the federal government’s phase-out of the state death tax credit, Wisconsin implemented a temporary state estate tax that was independent of the federal estate tax (i.e., the computation was not reliant upon the state death tax credit).  Wisconsin’s temporary state estate tax sunsetted on December 31, 2007, meaning that the estate tax equal to the state death tax credit became effective again.  In effect, Wisconsin repealed its state estate tax, since there is no state death tax credit.

The federal government continues to impose an estate tax.  Here’s how it works.  Upon your death, you can transfer a certain amount of assets without paying any estate tax.  This amount is called the estate tax exemption.  In 2017, the federal government set the estate tax exemption at $10 million, as adjusted for inflation on an annual basis through 2025.  In 2021, the estate tax exemption amount is $11.7 million.  Under current law, this amount will continue to be adjusted annually through 2025, after which the estate tax exemption reverts to the pre-2017 amount of $5 million, as adjusted for inflation on an annual basis.

The federal gift and estate tax exemptions are “unified,” meaning lifetime gifts will reduce the amount you can transfer upon your death without paying estate tax.  This reduction is dollar-for-dollar.  For this purpose, lifetime gifts do not include annual exclusion gifts, which are gifts you can make without reducing your gift and estate tax exemptions.  In 2021, the annual exclusion gift amount is $15,000 per person.  So, if you make a $16,000 gift in 2021, $15,000 of the gift will be sheltered as an annual exclusion gift, and $1,000 of the gift will reduce your gift and estate tax exemptions.

Upon your death, your remaining estate tax exemption is calculated by reducing the current estate tax exemption by the value of your lifetime gifts.  For example, if you die in 2021, your estate tax exemption is $11.7 million.  If you made lifetime gifts worth $11 million, your remaining estate tax exemption is $700,000.

If you transfer assets in excess of your remaining estate tax exemption, your estate will be subject to a 40% estate tax on every dollar over your remaining exemption.  So, if your remaining estate tax exemption is $700,000, and you transfer $1,700,000 upon your death, the value of your transfers exceeds your exemption by $1,000,000.  Your estate will pay estate tax equal to 40% of $1,000,000, which is $400,000.

Please keep in mind that this explanation of the estate tax is very simplified.  Depending on your unique circumstances, there may be nuances to the estate tax laws as applied to you.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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