The Federal Estate Tax: A Brief History

In many ways, the United States inherited the model for the federal estate tax from the British.  In feudal England, the monarch owned all of the real property and granted use of real estate to his nobles during their lifetime (life estate).  When the nobleman died, his heir could continue to use the land upon payment of an estate tax to the sovereign.  These death taxes provided needed income to the Crown to pay for war debts.   In default of heirs, the estate reverted to the Crown (escheat).  The statute Quia Emptores passed in 1290 finally granted the right to of an individual to hold an estate in land in fee simple (freehold) and to sell it (alienation), but it left the matter of the estate tax in the hands of the Crown.

The original Thirteen Colonies were the result of real estate grants and licences from the British Crown founded on the principles of Quia Emptores.  Whether New York still retained vestiges of Quia Emptores in its real estate law was  the subject of debate in the 19th century.  The court in De Peyster v. Michael, 6 NY 467 (1852), held that Quia Emptores had never been in effect in the colonies, meaning that land was not freely alienable in New York.  Seven years later, in Van Rensselaer v. Hays, 19 NY 68 (1859), the court in that case held that Quia Emptores had always been in effect in New York.  The question was settled in New York State Constitution Article 1 §12 which states "all lands within this state are declared allodial, so that, subject only to liability to escheat, the entire and absolute property is vested in the owners, according to the nature of their respective estates."  In a prior post, I have addressed the issue of the possibility of an estate escheating to the State when an individual dies without a Will (intestate). 

In 1765 the British Crown had imposed the Stamp Act specifically on the American colonies, the purpose of which was to help defray the military expenses, mainly troop salaries,  for the recently-fought Seven Year's War with France.  Among the provisions of the Stamp Act was a requirement that legal documents, such as Wills, be produced on special stamped paper produced in London and containing a revenue stamp.  Thus any colonist wishing to make a Will had to pay a tax.  Colonial discontent with taxes such as these would lead to the Revolutionary War.

Ironically the new government did not abandon this practice of enacting a tax on Wills to raise money to pay for military debts.  In an article published in the Journal of Business & Economics Research,  Eddie Metrejean and Cheryl Metrejean demonstrate an historical pattern whereby federal inheritance taxes began to be enacted to pay for wartime expenses.  Just a few years after the Revolution, the new Congress passed the Stamp Act of 1797 establishing a tax on Wills related to the transfer of property after death, once again to pay for a war in 1794 (albeit undeclared) with France.  But the law was quickly abolished before it could take effect.

The issue of an inheritance tax would not arise again until the Civil War.  A wartime inheritance tax was passed as part of the Revenue Act of 1862 affecting only the northern states, whose purpose was to raise over $1 million from estates valued at over $1000.  After the war, the inheritance tax was abolished by the Revenue Act of 1870.  Another short-lived inheritance tax was passed in 1898 to raise revenue for the Spanish-American War.  It was repealed in 1902.

Congress passed its first permanent estate tax with the Revenue Act of 1916, three years after the passage of the 16th Amendment and the institution of the federal income tax.  The constitutionality of new federal estate tax was challenged in New York Trust Co. v. Eisner, 256 U.S. 345 (1921), and in an opinion delivered by Oliver Wendell Holmes the Supreme Court held that the new law posed no "unconstitutional interference with the rights of the states to regulate descent and distribution" (256 U.S. 345, 348 (1921).

In order to close the loophole in the tax that allowed people to escape the inheritance tax by giving away their property, Congress passed a gift tax in 1932 that was declared constitutional by the Supreme Court in Heiner v. Donnan, 285 U.S. 312 (1932).  In 1948, the marital deduction became law, allowing property to pass to one's spouse without paying any estate tax.

The most significant changes to the federal estate tax occurred with the Tax Reform Act of 1976.  The Act enacted the following changes:

• a single unified rate structure for transfers of property at death;
• a single unified rate structure for lifetime property transfers;
• a unified exemption from taxes for certain transfers made either during one's lifetime or at death;
• a generation-skipping tax, taxing the transfer at the unified rate of the "skipped" generation if the beneficiary was two or more generations younger than the donor.

There have been other significant additions to the law.  In 1980, the "stepped-up" basis restored to the pre-1976 provisions, giving the beneficiaries a significant break in the amount of capital gains they would pay on transferred property that they later sold. 

In 1981, the martial deduction became unlimited, but with a catch.  With proper estate planning, the surviving spouse can escape paying any estate tax.  Without estate planning, the surviving spouse is left with a much larger estate on which the estate tax will be imposed.

In 2001 President Bush signed into law the Economic Growth and Tax Relief Reconciliation Act of 2001.  The law repealed the federal estate, gift, and generation-skipping taxes after 2009, meaning that anyone dying during 2010 is able to pass on his or her estate free of any federal estate, gift, or generation-skipping taxes.  However, state inheritance taxes may still be in effect.  But the 2001 law contained an expiration date:  all of the provisions of the 2001 law are set to expire on December 31, 2010.  Should Congress not act, then the pre-2001 estate tax will automatically reappear in 2011.

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What is the Difference between an Heir and a Beneficiary?

In everyday life, you will often hear people speak about their hope for an inheritance from a family member or relative.  However, this commonplace use of the term "inheritance" often masks a misunderstanding of the law and can lead to unintended consequences when misplaced assumptions are not addressed.  Today we are going to examine exactly what the term "inheritance" means from a legal standpoint, and how having a Will takes uncertainty out of the equation.

What defines an "heir"?  Strictly speaking, one is not an "heir" of a living person.  That is because the exact identity of an "heir" is determined at the time of the decedent's death.  The determination is made by the laws of the jurisdiction, and not by the decedent.  An "heir," then, is a legal creation and its terms are defined by a State.  One becomes an heir by virtue of satisfying the definition in a statute.  In New York, that statute is EPTL § 4-1.1. That is because New York  has an interest in the smooth transfer of property from one generation to the next.  As such, an "heir" is the statutory recipient of property from a decedent who dies without a Will (intestate).  The State is also the final "heir" in most statutory schemes.  If there are no statutory heir, then the property will go to the State (escheat).  In New York, a person who inherits property under intestate succession is called a distributee.

New York also has a "laughing heir" statute (EPTL §4-1.1(6)).  A "laughing heir" is someone entitled to inherit by law who is so remotely connected to the deceased that he or she would not feel any sorrow at hearing of the death.  To prevent this occurrence, New York cuts off heirs at the grandchildren of the deceased:  "For the purposes of this subparagraph, issue of grandparents shall not include issue more remote than grandchildren of such grandparents."  No one more remote, such as a great-grandchild, may inherit.  After that, the property of the deceased escheats to the State.

When a person dies without a Will, New York uses as its default an intestate distribution system called per capita ("each head") at each generation.  In this system, each person is weighed equally.  By virtue of their presence on the family tree, no one can be disinherited.  The first thing we have to do is determine the number of surviving distributees. To illustrate: Beth is a single person who dies without a Will.  She had two sons named Luke and Dick, and a daughter named Nancy.  Luke had two children, Bill and Jane, and Nancy had one child named Jim, and Dick had two children named Sandy and Sam.

At the time of Beth's death, Luke had already predeceased her.  Had Luke been alive, he, Nancy and Dick would have each received 1/3 of the estate.  Because Luke has already died, Nancy and Dick each receive their 1/3 share, and Luke's children divided what would have been their father's share equally between them.  So Nancy receives 1/3, Dick receives 1/3 , and Bill and Jane each receive 1/6.   

Depending upon your family situation, the New York default system of distribution may not suit your needs.  In that case, you may want to draft a Will stipulating that you want your estate distributed per stirpes ("by each branch") to give you more control over the outcome.  In New York, a person who receives under a Will is called a beneficiary.  Let's say that you want your great-grandchild to receive something from your estate.  Drafting a Will eliminates the "laughing heir" statute and allows you to leave something to your great-grandchildren.  A Will also allows you to distribute your estate to a class of beneficiaries, such as "to all my children" or "to all of my grandchildren" to cover any issue born or adopted after the execution the Will (pretermitted child).  The class closes at the time of the death of the testator.

Finally, instead of having your estate possibly escheat to the State, you can name a person unrelated to you or a charity as a beneficiary of your residuary estate.  Your property can then be used in a way that is consistent with your life and beliefs.  You should seek the advice on an attorney in drafting a Will so that your wishes are reflected in the resulting document.

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