How is the federal estate tax calculated?

The federal estate tax is imposed upon the total value of every deceased person’s taxable estate, which is generally the fair market value of all the property that a person owns or has the right to control at the time of death. Basically, everything that a person owns is taxable, although it may not actually be taxed.

Even though the federal estate tax is imposed against everything that is owned, it is only calculated against the “taxable estate” or the value of all property that remains after the subtraction of all allowable deductions.

Allowable deductions include the deceased’s debts, funeral expenses, the costs of estate administration, and the value of any gifts made to qualified charitable organizations. All property that passes to a surviving spouse who is a U.S. citizen is also deducted from the gross estate before the federal estate tax is determined.

The IRS provides the following definitions at its website, as well as much more detail and official publications at its official site.

Gross Estate
Your gross estate includes the value of all property in which you had an interest at the time of death. Your gross estate also will include the following.

1) Life insurance proceeds payable to your estate or, if you owned the policy, to your heirs, 2) The value of certain annuities payable to your estate or your heirs, 3) The value of certain property you transferred within 3 years before your death, 4) Trusts or other interests established by you or others in which you have certain powers.

Taxable Estate
The allowable deductions used in determining your taxable estate include:

1) Funeral expenses paid out of your estate,2) Debts you owed at the time of death, and 3) The marital deduction (generally, the value of the property that passes from your estate to your surviving spouse).

Determination of Tax
The year of a person’s death determines the appropriate estate tax rate, along with the appropriate unified credit amount. These two values are used to determine the taxes that are owed against the value of the taxable estate.

Tax Calculation – The Unified Credit
As a tax credit, the unified credit can only be applied when there is an actual amount of tax that is owed. When tax is owed, the unified credit is used to reduce or eliminate the amount of federal estate tax that must be paid.

Rather than calculate the amount of federal estate tax that is owed against the entire taxable estate, the applicable exclusion amount can simply be subtracted from the taxable estate prior to calculating the taxes. When using this method, the taxes are only calculated against the amount of the taxable estate that exceeds the applicable exclusion amount, if any. 

Taxable Estate Greater Than the Applicable Exclusion
Where the taxable estate is greater than the applicable exclusion amount, Federal estate tax will be owed against the value of the taxable estate that is greater than the applicable exclusion amount.

Using 2008 as an example shows that this calculation can be easily performed as follows:

Taxable Estate Greater Than App. Exclusion Amount
Taxable Estate $3,000,000
Minus Applicable Exclusion Amount (2008) -$2,000,000
Amount Subject to Estate Tax $1,000,000
Multiplied by Tax Rate x 45%
Estate Tax Actually Owed $450,000

Taxable Estate Less Than the Applicable Exclusion
Because it is a tax credit, any amount of the unified credit that is not applied to taxes which are actually owing will be lost.

As previously shown, the estate of every person dying in 2008 receives a unified credit of $780,800. However, those who owe an amount of estate tax less than $780,800 will not receive cash back from the IRS for the amount of unused amount of credit.

The example below shows the result of a taxable estate that is less than the allowed credit: The amount of the taxable estate that is subject to the tax is merely reduced to zero.

In these circumstances, the deceased does not receive payment for the amount of credit that is not used. The unified credit is also personal, which prevents any portion that is not used by an estate from being transferred for use by any other person’s estate.

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