Should the Death Tax Die?

Most discussions of the estate tax, better known as the death tax, ignore the green monster in the room. Obviously, envy is involved.

Since a legislative compromise in 2013, the death tax is 40% on the amount of the estate over $5 million dollars. The $5 million is indexed for inflation and is currently about $5.4 million. You can’t get out of death tax by giving your money away to your children before you die. In that case there is a gift tax. The gift tax and the death tax share the same $5 million limit. There is no gift tax or death tax for transfers of money between spouses. By proper structuring of their estates, a married couple can leave up to $10 million (indexed for inflation) without death tax to their children, or anyone else for that matter. In addition you can give up to $14,000 in any year (also indexed for inflation), to anyone, without it being deducted from your $5 million lifetime allowance. A married couple can give away $28,000 each year to as many people as they please.

You might think that you can evade death taxes by leaving the country and renouncing U.S. citizenship. In that case there is the exit tax, a substantial tax, too complicated to explain here, but probably less than the death tax.

There are a multitude of schemes for avoiding the death tax. Most of these schemes may reduce the tax by about 30%. For example is there a type of trust called a defective trust. If you gift property to a trust that belongs to your children, it is considered a gift to your children. But if the trust has certain “defects” you remain liable for the income tax on the earnings of the trust, even though you never receive those earnings. Originally the government made these rules to prevent moving income to family members with lower tax brackets. The advantage from an estate tax view is that the trust can grow income tax free because you, not the trust, are paying the taxes. Effectively the taxes you pay the government are a tax-free gift to your children. Taking the defective trust idea one step further, you can set up a defective trust that pays back its principal and income to you over a period of years. Anything left in the trust at the end, if anything, belongs to your children gift tax-free. The periodic payments are calculated so that the trust will zero out if the earning of the trust are equal to a special interest rate prescribed by the government -- currently about 2%, because interest rates are historically low. The trust is considered a zero dollar gift, for gift tax purposes. But if the trust earns more than 2% something is left at the end and this is a gift tax-free gift to the children. However, if you die before the trust matures, or the trust doesn’t earn enough, it doesn’t work.

Many tax schemes amount to feeding your assets a poison pill so that they are worth less and thus can be transferred with less gift or death tax. For example, the assets can be placed in a partnership structure that would be unattractive to a potential buyer, thus reducing the market value. Working against this is the general rule that manipulations that have no other purpose than to reduce taxes are disallowed. Thus there must be a supposed business purpose in any scheme. If the IRS should become more hostile to these schemes, the schemes might lose effectiveness.

There are special interests, other than the U.S. government, that benefit from the death tax. These are lawyers, accountants, insurance businesses, and charitable institutions. Insurance is often purchased to pay death taxes. Charitable institutions benefit because bequests to charity escape the tax. You won’t catch these special interests openly supporting the death tax, because their clients and donors are the same rich people that hate the tax. The death and gift taxes are very minor contributors to government revenue, perhaps 1%.

The evidence that the death tax damps economic activity is extensive. Businesses accumulate cash in anticipation of the tax and businesses are drained of cash after the death of the owner. Vigorous growing businesses stop growing and concentrate on accumulating cash to pay an amount equal to 67% of the value of the business. The cash is taxed too, so it works out that a business worth $100 million would have to accumulate $67 million in cash to pay the 40% tax. Given that the main operator of the business may have died and that the business may be stripped of its liquid assets and must often sell off assets and borrow money, it is not surprising that growing businesses may be turned into shrinking or failing businesses.

Capital is a necessary element of capitalism. Every business needs equipment, working capital, and money to finance new ventures, research, and expansion. The most vital and fastest growing businesses are often owned by one or more individuals. If the business is successful, these individuals may be very wealthy, but the wealth is usually not liquid wealth easily turned into the cash needed to pay death taxes.

Many developed countries have no death tax at all, and only 3 developed countries have a higher death tax rate than the U.S.

The defenders of the death tax cite high-minded justifications such as fairness and the terrible injustice involved in parents giving property to their children when other children born to poor parents don’t get anything. They suggest that armies of spoiled children will become exceptional loafers because they have unjustly inherited money. They cite left-wing billionaires who loudly preach the virtues of the death tax. Of course, those billionaires are free to give their money to the government even if the death tax is abolished.

The death tax is not extremely popular. A poll shows that 60 or 70 percent of adults oppose it. The advocates of the death tax reply that people oppose the death tax because they don’t fully understand that it only applies to rich people. And rich people are not considered a persecuted minority?

America was settled by puritans. The puritan gene and culture is widespread. When a mom and pop bakery is fined $135,000 because they refused to make a cake for a gay wedding, it is obvious that puritanism is involved, and it is not the bakers who are the puritans. H.L. Mencken defined puritanism as “The haunting fear that someone, somewhere, may be happy.” The government, in many ways, large and small, works to ameliorate this haunting fear. The death tax is one more way.

Most discussions of the estate tax, better known as the death tax, ignore the green monster in the room. Obviously, envy is involved.

Since a legislative compromise in 2013, the death tax is 40% on the amount of the estate over $5 million dollars. The $5 million is indexed for inflation and is currently about $5.4 million. You can’t get out of death tax by giving your money away to your children before you die. In that case there is a gift tax. The gift tax and the death tax share the same $5 million limit. There is no gift tax or death tax for transfers of money between spouses. By proper structuring of their estates, a married couple can leave up to $10 million (indexed for inflation) without death tax to their children, or anyone else for that matter. In addition you can give up to $14,000 in any year (also indexed for inflation), to anyone, without it being deducted from your $5 million lifetime allowance. A married couple can give away $28,000 each year to as many people as they please.

You might think that you can evade death taxes by leaving the country and renouncing U.S. citizenship. In that case there is the exit tax, a substantial tax, too complicated to explain here, but probably less than the death tax.

There are a multitude of schemes for avoiding the death tax. Most of these schemes may reduce the tax by about 30%. For example is there a type of trust called a defective trust. If you gift property to a trust that belongs to your children, it is considered a gift to your children. But if the trust has certain “defects” you remain liable for the income tax on the earnings of the trust, even though you never receive those earnings. Originally the government made these rules to prevent moving income to family members with lower tax brackets. The advantage from an estate tax view is that the trust can grow income tax free because you, not the trust, are paying the taxes. Effectively the taxes you pay the government are a tax-free gift to your children. Taking the defective trust idea one step further, you can set up a defective trust that pays back its principal and income to you over a period of years. Anything left in the trust at the end, if anything, belongs to your children gift tax-free. The periodic payments are calculated so that the trust will zero out if the earning of the trust are equal to a special interest rate prescribed by the government -- currently about 2%, because interest rates are historically low. The trust is considered a zero dollar gift, for gift tax purposes. But if the trust earns more than 2% something is left at the end and this is a gift tax-free gift to the children. However, if you die before the trust matures, or the trust doesn’t earn enough, it doesn’t work.

Many tax schemes amount to feeding your assets a poison pill so that they are worth less and thus can be transferred with less gift or death tax. For example, the assets can be placed in a partnership structure that would be unattractive to a potential buyer, thus reducing the market value. Working against this is the general rule that manipulations that have no other purpose than to reduce taxes are disallowed. Thus there must be a supposed business purpose in any scheme. If the IRS should become more hostile to these schemes, the schemes might lose effectiveness.

There are special interests, other than the U.S. government, that benefit from the death tax. These are lawyers, accountants, insurance businesses, and charitable institutions. Insurance is often purchased to pay death taxes. Charitable institutions benefit because bequests to charity escape the tax. You won’t catch these special interests openly supporting the death tax, because their clients and donors are the same rich people that hate the tax. The death and gift taxes are very minor contributors to government revenue, perhaps 1%.

The evidence that the death tax damps economic activity is extensive. Businesses accumulate cash in anticipation of the tax and businesses are drained of cash after the death of the owner. Vigorous growing businesses stop growing and concentrate on accumulating cash to pay an amount equal to 67% of the value of the business. The cash is taxed too, so it works out that a business worth $100 million would have to accumulate $67 million in cash to pay the 40% tax. Given that the main operator of the business may have died and that the business may be stripped of its liquid assets and must often sell off assets and borrow money, it is not surprising that growing businesses may be turned into shrinking or failing businesses.

Capital is a necessary element of capitalism. Every business needs equipment, working capital, and money to finance new ventures, research, and expansion. The most vital and fastest growing businesses are often owned by one or more individuals. If the business is successful, these individuals may be very wealthy, but the wealth is usually not liquid wealth easily turned into the cash needed to pay death taxes.

Many developed countries have no death tax at all, and only 3 developed countries have a higher death tax rate than the U.S.

The defenders of the death tax cite high-minded justifications such as fairness and the terrible injustice involved in parents giving property to their children when other children born to poor parents don’t get anything. They suggest that armies of spoiled children will become exceptional loafers because they have unjustly inherited money. They cite left-wing billionaires who loudly preach the virtues of the death tax. Of course, those billionaires are free to give their money to the government even if the death tax is abolished.

The death tax is not extremely popular. A poll shows that 60 or 70 percent of adults oppose it. The advocates of the death tax reply that people oppose the death tax because they don’t fully understand that it only applies to rich people. And rich people are not considered a persecuted minority?

America was settled by puritans. The puritan gene and culture is widespread. When a mom and pop bakery is fined $135,000 because they refused to make a cake for a gay wedding, it is obvious that puritanism is involved, and it is not the bakers who are the puritans. H.L. Mencken defined puritanism as “The haunting fear that someone, somewhere, may be happy.” The government, in many ways, large and small, works to ameliorate this haunting fear. The death tax is one more way.