When a client asks what amounts a given estate plan might cost or save, and a reliable approximation would require some complex math, you don't have to say "Let me get back to you on that," say Amy Albert and Austin Bramwell of Milbank LLP.
To the dismay of many young lawyers, estate planning inevitably requires some math — and it can get tricky. For example, see the annuities valuation formula at Reg. §25.2512-5(d)(2)(v)(A)(1)(i) Figure 1. A century ago, in Edwards v. Slocum, Supreme Court Justice Oliver Wendell Holmes, Jr., sardonically warned (quoting the Second Circuit's decision) that "algebraic formulae are not lightly to be imputed to legislators." Not long after, perhaps piqued by the Court's insult, Congress passed legislation effectively requiring algebraic formulae to compute estate tax in some cases. To quote Reg. §20.2055-3(a)(2): "[T]he computation becomes highly complicated."
Trust and estate lawyers, like most other professionals, can spend their entire careers oblivious to the math they had learned in high school. Quite often, when a client asks what amounts a given plan might cost or save, the only possible response in the moment is "Let me get back to you on that."
We would like to make that a less frequent occurrence. This article provides some useful mental shortcuts or heuristics that even the most math-averse planners can use to quickly give clients reliable ballpark answers that will help them round the bases without delay.
Math Shortcuts
(1) The effective gift tax rate isn't 40% but rather is about 30% if the donor survives three years.
As a starting consideration, both the estate tax and the gift tax, despite being nominally progressive as set forth in I.R.C. §2001(c) and §2502(a), are imposed at an effective flat rate of 40% (exceptions apply for transfers by nonresident noncitizen donors or decedents) on amounts exceeding the gift and estate tax exemption, which exceeds the highest bracket threshold many times over. However, while the estate tax is imposed on the taxable estate, including the portion used to pay estate tax, the gift tax is imposed only on the amount of the gift. In tax jargon, the estate tax is computed on a "tax-inclusive" basis while the gift tax is "tax-exclusive." The difference makes the gift tax cheaper.
Example: Suppose that a client who has used up all of his lifetime gift tax exemption (which for 2024 is $13.61 million) makes a $10 million gift. The gift tax is 40% of that amount, or $4 million. Thus, the total expenditure by the client (gift plus gift tax) is $14 million. The effective tax rate, therefore, is $4 million / $14 million = 28.57% (for heuristic purposes, round to 30%).
By contrast, if the client dies with $14 million, 40% or $5.6 million will go to taxes. The gift saves $1.6 million of tax.
Proof: To put it algebraicly:
Gift tax rate = 0.4
Let x = amount of a gift
Gift tax on gift = 0.4x
Gift plus gift tax = x + 0.4x = 1.4x
Effective rate = gift tax / (amount of gift + gift tax) = 0.4x / 1.4x = 0.4 / 1.4 = 0.2857
Caveat: The lower gift tax rate is eliminated if the donor dies within three years of the gift. In that case, the gift tax is included in the donor's gross estate under §2035(b). In the example above, if the donor dies within three years of making a $10 million gift, the estate tax on the $4 million of gift tax is $1.6 million. The total taxes are thus $5.6 million ($4 million of gift tax plus $1.6 million of estate tax on the gift tax), which is 40% of the sum of the $10 million gift and $4 million of gift tax — i.e., the same amount of tax that would be imposed if the donor had done nothing and died with $14 million.
(2) To compare the cost of paying estate tax on a certain amount versus giving it away during life and paying gift tax, subtract 30% from the amount.
The quick calculation is the same as for (1). Subtracting 30% is just a way of approximating gift tax in a way that compares it to an estate tax on the same amount.
Example: Suppose a client has used up all of his gift tax exemption. If he dies with $10 million in his taxable estate, the estate tax will be $4 million, or 40% of $10 million. If instead he uses the $10 million to make a gift and pay gift tax, he would make a gift of about $7 million — i.e., $10 million less 30% of $10 million — and pay about $3 million of gift tax.
Nota bene: More precisely, the amount of that gift tax is $2.8 million. The 30% rule just quickly gets you in the ballpark.
The actual amount: The "correct" amount of a gift that, combined with gift tax, uses up exactly $10 million of wealth, is $7,142,857.14, computed as follows:
Let x = the amount of the gift
Gift tax = 0.4x
x + 0.4x = 10,000,000
1.4x = 10,000,000
1.4x/1.4 = 10,000,000/1.4
x = 10,000,000/1.4 = $7,142,857.14
More generally, to compare estate tax and gift tax, you can give away 71.43% of a given amount and use the balance to pay gift tax. By contrast, if you die holding the same amount, the beneficiaries will only receive 60%; the balance must be used to pay estate tax.
(3) In a state with a 16% estate tax rate, the effective combined federal and state estate tax rate is about 50%.
State death taxes are deducted from the federal taxable estate under §2058. Thus, the net cost of state death taxes is less than the amount of state death taxes actually paid because the state death taxes reduce the federal estate tax.
Example: Suppose that a decedent, having used up his federal estate tax exemption amount, dies with $50 million in a state with a 16% flat estate tax rate. The state estate tax is $50 million × 16% = $8 million. The $8 million in state death tax is subtracted from the federal taxable estate, so that the federal taxable estate is $50 million – $8 million = $42 million. The 40% federal estate tax on $42 million is $16.8 million. Thus, the combined federal and state estate taxes are $16.8 million + $8 million = $24.8 million. That's an effective rate of 49.6% (round to 50%), or $24.8 million divided by $50 million.
For those who want the proof:
State estate tax rate = 0.16
Let x = taxable estate before the state death tax deduction
State estate tax = 0.16x
Federal taxable estate = x – 0.16x = 0.84x
Federal estate tax = 0.4 × 0.84x = 0.336x
State plus federal estate tax = 0.16x + 0.336x = 0.496x
Combined estate tax rate = 0.496x / x = 0.496
An even more precise formula is that the combined estate tax rate = 40% + 60% × (state estate tax rate).
Caveat 1: Most if not all states with estate taxes have an exemption amount and a progressive bracket structure, with the 16% top rate reached (for historic reasons) at $10,100,000. Thus, the 49.6% rate is most accurate with very large estates. For smaller estates, 49.6% is less accurate. For example, the estate tax on a $10.1 million New York taxable estate is $1,082,800, which is an average rate of only about 10.7%.
Historically, the $10,100,000 threshold came from now-repealed §2011, All states had "pick-up" taxes that used up the state death tax credit, which was designed as an increasing percentage of the "adjusted taxable estate," with the percentage topping out at 16% for adjusted taxable estates of $10,040,000, which was equivalent to a $10,100,000 taxable estate
Caveat 2: Not all states with estate taxes have a maximum rate of 16%. Maine's, for example, tops out at 12%. Using the formula 40% + 60% × (state estate tax rate), the combined estate tax rate in that case is 47.2%, after disregarding (for simplicity) progressive rates and any exemption amount.
(4) If a state has 16% estate tax rate and adds gifts made before death into the state taxable estate, that amounts to an additional 6.4% of estate tax.
Some states add gifts before death into the taxable estate for estate tax purposes. New York, for example, adds gifts made within three years of death. Unfortunately, §2058 does not allow a deduction for state death taxes unless the state death tax is "in respect of any property included in the gross estate." Thus, a gift by a New Yorker made within three years of death can actually cause an artificial increase in federal estate tax.
Example: A New York domiciliary has $50 million of assets and has used up all of his federal gift and estate tax exemption. If he does nothing, the combined federal and New York estate tax will be about 49.6%, as we have seen, or $24.8 million (assuming, for simplicity, a flat New York estate tax rate of 16%). By contrast, if he makes a $10 million gift but dies less than three years later, the total taxes will be $25,440,000, determined as follows:
Gift tax (federal) on $10 million: $4 million Remaining assets at death: $50 million – ($10 million + $4 million) = $36 million
Gross estate: $36 million + $4 million = $40 million New York taxable estate: $40 million + $10 million = $50 million
New York estate tax: $50 million × 16% = $8 million
Deductible portion of New York estate tax = $40 million × 16% = $6.4 million
Federal taxable estate: $40 million – $6.4 million = $33.6 million
Total taxes (gift tax + NY estate tax + federal estate tax):
$4 million + $8 million + $13.44 million = $25.44 million
The $10 million gift caused total wealth transfer taxes to increase by $640,000, or 6.4% of the amount of the gift.
Show me the algebra:
State estate tax rate = 0.16
Let x = amount of the gift
State estate tax on the gift = 0.16x
Reduction of federal state death tax deduction = 0.16x
Federal tax cost of reduced deduction = 0.4 × 0.16x = 0.064x
Rate = 0.064x / x = 0.064
Caveat: If the gift appreciates in value, the artificially increased rate may be more than offset by savings from the appreciation escaping both federal and state estate tax.
Comment: It may be possible to achieve the best of both worlds — i.e., make a gift during one's lifetime in order to avoid state estate tax and avoid the risk of an artificially increased tax at death if dying within three years — by granting the donor a contingent special power of appointment over the initial corpus. A description of this type of planning is beyond the scope of this article.
Originally published by Bloomberg Tax
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