Big Red Car here.
So I was listening in on The Boss’s recent meeting with a lawyer over lunch the other day. Nice salad at the new Austin Java on Windsor in west Austin.
So here is what I learned. The Boss does not like the estate tax and calls it an odious and confiscatory invasion of personal wealth. Completely unfair.
Damn, Boss, you are going to have to come out of your shell a bit. Tell us what you really mean.
History of the Estate Tax
The estate tax was originally a tax levied by the King based on the notion that he really owned all the assets in his kingdom and was only letting you use them during your lifetime. An concept that does not play well today.
In the United States, it has historically been a temporary tax levied to fund wars and then cancelled thereafter.
The modern estate tax has its roots in the Revenue Act of 1916 which imposed a 1% levy on estates in excess of $50,000 — $11,000,00 today when adjusted for inflation.
This levy was used to finance World War I but the government forget to terminate the tax when the war ended.
Today the moral justification for an estate tax is the notion that there is something inherently bad about a family accumulating the fruits of the labor of its forebears to be used in the manner they desire. This is after all all about property and wealth. And the creator of the wealth — after tax wealth, mind you — doing what she sees fit to do with her own property.
Hard Earned Money
Say for example that you have been saving your money and now have a nice little nest egg of $100,000 which you decide to invest in a rent house. This money is, of course, money upon which you have already paid ordinary income taxes and payroll taxes as it is “earned” income. You may have paid as high as 35% in income taxes. You worked hard to make this money.
The Lovely Little Rent House
Now you find a lovely little rent house and buy it. You put some sweat equity into your rent house — Hell, you’ve been watching those renovation and home flipping shows and you can paint a wall as well as the next person — and then you get a tenant. The tenant pays you rent. The real estate market has recovered and you decide to sell the rent house.
You paid $100,000 for the rent house. You put $10,000 plus plenty of your own work into the house.
You sell the rent house for $210,000 with the rent paying tenant in place.
Your profit is $210,000 – ($100,000 + $10,000) = $100,000.
You pay $15,000 in capital gains taxes — at the now current “Bush era” capital gains tax rate of 15%. You pocket $85,000 in real cash. You recover nothing for your sweat equity which is arguably subsumed in the profit that you have received.
An Untimely Demise
Now unfortunately, you fall ill and the next week you die. The funeral is lovely and you are much revered by your loved ones and your favorite nephew, Little Jimmy. Some truly touching testimonials at your funeral. You were a real mensch.
You worked hard, made a fair amount of money and had an estate of sufficient size that you will have to pay a bit of estate tax. For our example, we will assume that the entire amount of the $85,000 in profits from the sale of your rent house is included in the portion of your estate that is subject to estate taxes.
Your estate — the portion in excess of the exemption — is taxed at a rate of 35%. Remember that you are now dead, your death is the event which has triggered the taxes. Your death is a taxable event.
Your estate has $185,000 in it — your original $100,000 savings plus your $85,000 profit.
Your estate tax liability is $64,750 ($185,000 x 35% = $64,750).
Little Jimmy and the Numbers
Little Jimmy, an accountant, puts a pencil to paper to follow the money to see how Uncle Sam and the Infernal Revenue Service have treated you.
So, Little Jimmy determines that you had to earn approximately $153,846 to be able to save $100,000 in after tax dollars. This $100,000 in after tax dollars was your investment in the rent house. You paid approximately $54,000 in taxes on your ordinary income.
Then you invested the $100,000 in after tax dollars in the rent house. When you sold the rent house, you paid $15,000 in capital gains taxes.
When you died, you had to pay taxes of $64,750 in estate taxes.
From earning $153,846 you have now paid $53,846 in ordinary income taxes, $15,000 in capital gains and $64,750 in estate taxes. This is a total of $133,596.
You now have a total of $120,250. Remember, you started with $100,000 in after tax funds. Your starting funds were $100,000 (after tax funds from earnings of $153,846 less income tax of $53,846 = $100,000).
You made $100,000 on the sale of the lovely little rent house.
From this $200,000, you then paid incremental taxes of $15,000 for the lovely little rent house capital gain and $64,750 for the estate tax. Now your heirs have a total of $120,250.
Little Jimmy’s Recap
You earned $154,846 and netted after tax cash of $100,000. This was your savings.
You bought a rent house for $100,000, put $10,000 into it, sold it for $210,000 making a $100,000 profit and paid $15,000 in capital gains taxes.
You died and left an estate subject to a 35% estate tax rate. You had $185,000 subject to the estate tax and paid $64,750.
Your heirs received a total of $120,250 for all of your hard work.
The government and the IRS got $133,596.
The future is even worse as the administration wants to:
- Raise your income tax rate from 35% to 39% and add in approximately 5% in new Obamacare taxes.
- Raise your capital gains rate to approximately 28%.
- Raise your estate tax rate to 55%.
I am going to close for the day because The Boss is going to lunch at Green Mesquite Barbecue and he does not like being late for the Q.
More later but you can see where this is going. You like the direction things are going? Tell me about it.
Be kind to yourselves.