Estate Tax

The estate tax is a federal tax levied on the transfer of wealth from a deceased person to their heirs and beneficiaries. It applies to the total value of the estate (assets minus debts), and is among the most complex and avoidable taxes in the US code. High-net-worth individuals employ sophisticated planning strategies to minimize estate tax exposure, including gifts, trusts, and charitable donations.

Federal rates and the exemption cliff

The federal estate tax rate is a flat 40% on the portion of the estate exceeding the exemption. In 2025, a single person can pass $13.61 million to heirs tax-free (the exemption). A married couple can pass $27.22 million. Above that threshold, the 40% rate applies.

Example: A widow with a $50 million estate in 2025:

• Exemption: $13.61 million (tax-free).
• Taxable estate: $50M − $13.61M = $36.39 million.
• Estate tax: $36.39M × 40% = $14.556 million owed to the IRS.

The heirs receive $50M − $14.556M = $35.444 million.

However, the current exemption is temporary. The Tax Cuts and Jobs Act (2017) doubled exemptions but included a “sunset” in 2026. Unless Congress acts, the exemption reverts to roughly $7 million (indexed for inflation) on January 1, 2026. This creates a massive planning window: wealthy individuals who can move wealth or die before 2026 benefit from the higher exemption. Those dying after 2026 face a much lower exemption and potential 40% taxation on assets the current law allows to pass tax-free. High-net-worth advisors have labeled 2026 “the year of the reckoning,” driving frenzied estate planning before the exemption drops.

State estate taxes: the hidden wedge

In addition to federal tax, 15 states and the District of Columbia impose their own estate taxes. Some states tie their exemption to the federal exemption (exemption coupling), while others have lower exemptions. A few states impose “decoupling,” maintaining a fixed state exemption (e.g., $1 million in some states, $5 million in others) regardless of federal changes.

Massachusetts: $1 million exemption; 16% top rate. A wealthy Massachusetts resident with a $50 million estate pays federal estate tax on $50M − $13.61M = $36.39M at 40%, plus state tax on $50M − $1M = $49M at up to 16%. Combined, the tax burden is enormous.

New York: $6.94 million exemption (2025); decoupled from federal. An estate above this hits 3.06–16% depending on excess amounts.

California, Texas, Florida: No state estate tax. These have become migration destinations for wealthy individuals in high-tax states, though the IRS scrutinizes last-residence changes.

For high-net-worth individuals, state planning (including relocation, domicile changes, and trust situs) is as important as federal planning.

The lifetime exemption and gift tax coordination

The estate tax exemption is unified with the gift tax exemption. Each person has a combined “lifetime exemption” of $13.61M (2025). Using the exemption for gifts during life reduces the exemption available to shield the estate at death.

This creates a strategic choice:

Strategy 1: Preserve exemption for death. Give gifts within the annual exclusion ($18,000 per recipient in 2024) without using lifetime exemption. At death, the full exemption shields the estate.

Strategy 2: Use exemption for gifts. Make large gifts now using the lifetime exemption, transferring wealth tax-free. This removes future appreciation from the taxable estate. If the gifted assets appreciate significantly, this saves estate tax on the appreciation.

Example: A parent with $20M in cash and a $5M startup (expected to grow to $50M).

Option A: Give the startup to children now (gift tax using $5M of lifetime exemption). At death, the startup is outside the estate, now worth $50M; the remaining estate $20M is within the remaining exemption. Total wealth transferred: $70M, estate tax: $0.

Option B: Keep the startup; give the $18K annual exclusion gifts. At death, the $20M estate is within exemption; the $50M startup triggers: ($50M − $13.61M remaining) × 40% = $14.556M tax. Only $70M − $14.556M = $55.444M to heirs.

The lifetime exemption gift strategy is often optimal when expecting appreciation, but requires legal documentation and triggers filing requirements (Form 709 if exceeding annual exclusion).

Trusts and estate planning vehicles

Revocable living trust. During life, the grantor (creator) retains control and can modify the trust. At death, the trust avoids probate by transferring assets directly to named beneficiaries without court supervision. A revocable trust does not reduce estate tax (the IRS includes revocable trust assets in the taxable estate), but it streamlines administration and provides privacy.

Irrevocable life insurance trust (ILIT). The grantor transfers life insurance to an irrevocable trust owned by others. At death, the insurance proceeds are held in the trust, outside the taxable estate. This can save 40% of the insurance payout. Common for wealthy individuals: $5M term policy outside the estate saves $2M in taxes.

Grantor-retained annuity trust (GRAT). The grantor retains an annuity income for a term (2–10 years), and remainder passes to beneficiaries. If the trust’s assets appreciate above a discount rate, the appreciation passes tax-free. Favored by wealthy individuals with volatile assets; used to shelter stock appreciation in growth companies.

Qualified personal residence trust (QPRT). The grantor retains the right to live in a house for a term, then passes ownership to children. The current value for gift tax is discounted because the children’s interest is deferred. At the end of the term, if the grantor dies, the house is outside the estate.

Dynasty trust. In states allowing perpetual trusts (Alaska, South Dakota, Nevada, others), wealth can be placed in trust for multiple generations, sheltered from estate tax at each generation with proper planning. Ultra-wealthy families ($50M+) use dynasty trusts to preserve wealth indefinitely.

Charitable donations and deductions

Charitable contribution deduction. The estate tax is reduced by contributions to qualified charities (100% deduction). A $50M estate donating $10M to charity faces tax on $40M instead. This incentivizes philanthropy by wealthy individuals.

Charitable remainder trust (CRT). The grantor transfers assets to a trust, receives an income for life, and the remainder goes to charity. The grantor gets a deduction for the present value of the charity’s remainder interest, reducing taxable estate. This is useful for illiquid assets (real estate, art): the owner avoids capital gains tax on a sale and receives income, with a tax deduction.

Charitable lead trust (CLT). Opposite of CRT: the trust pays income to a charity for a term, then remainder goes to children. The grantor deducts the present value of the charity’s income interest, reducing estate/gift tax on the remainder passing to heirs.

Portability and the “dead spouse unused exemption”

A feature added in 2010 is portability: if the first spouse dies, the surviving spouse can use the deceased spouse’s unused exemption. This is called the Deceased Spousal Unused Exemption (DSUE).

Example: In 2025, a married couple has $30M in assets (in the first spouse’s name). The first spouse dies with a properly drafted will. The exemption is $13.61M; $16.39M of assets trigger estate tax at 40% ($6.556M tax). However, the surviving spouse can claim the deceased spouse’s unused exemption ($13.61M) on their own estate. When the survivor dies, the combined estate uses both exemptions ($27.22M), sheltering much more wealth.

Portability requires an estate tax return (Form 706) to be filed even if no tax is owed, to preserve the DSUE. Failing to file forfeits the benefit — a costly mistake.

Strategies to minimize estate tax

Annual exclusion gifting. Gift $18,000/year to each child (or more to the spouse, per unlimited marital deduction). Over a decade, a parent can remove $1.8M+ from the taxable estate per child with no tax or exemption use.

Discounting for control and marketability. Values of illiquid assets (private business interests, real estate, art) can be discounted 20–35% for lack of control or liquidity. A parent can give a family partnership interest to children at a discount; the discounted value counts for gift/estate tax, but the children’s value grows without additional tax.

Family limited partnerships (FLPs). Parents place assets (real estate, securities) in a partnership, retaining the general partnership (control) while distributing limited partnership units to children. The units are discounted for lack of control; the units can be given away or put in trust, removing appreciation from the taxable estate.

Annual gifts to spouses and step-ups. A married couple can gift to each other unlimited amounts (marital deduction). Also, assets inherited from a spouse receive a full step-up in basis, so heirs avoid capital gains tax on appreciation up to death. This is a powerful incentive to hold appreciated assets until death rather than sell (which triggers immediate capital gains tax).

Tax avoidance and IRS scrutiny

Aggressive estate planning strategies (discounting schemes, artificial partnerships, leveraged GRATs) attract IRS scrutiny. The IRS can value assets differently, disregard partnerships created for tax avoidance, or challenge the discount applied.

Recent regulations have targeted several strategies:

• Grantor-retained trusts with short terms. If a GRAT is too short or too leveraged, the IRS may challenge it.
• Valuation discounts. If a discount is unsupported (e.g., a real estate partnership claiming 50% discount for control lack when the property is income-producing and liquid), the IRS can increase the value.
• Transfers with retained interests. If a grantor transfers assets but retains control/use, the IRS includes the assets in the taxable estate anyway.

Proper documentation, professional appraisals, and conservative structuring protect against these challenges.

2026 sunset and planning urgency

The exemption is set to drop to ~$7M on January 1, 2026 (indexed for inflation, so possibly $6.7–7.2M depending on adjustments). This creates unprecedented planning pressure:

• A $50M estate with current exemption $13.61M faces no federal tax. With 2026 exemption $7M, the estate faces $17.16M tax (40% on $42.9M).
• Families are rushing to use the exemption in 2025 via large gifts or trust funding before the drop.
• Congress may extend or modify the exemption, but assuming no action, the sunset is real.

Advisors recommend completed-gift planning before year-end 2025: fund irrevocable trusts with large gifts to lock in the current exemption, even if it means reduced lifetime access to capital.

Relationship to income tax and basis

Estate tax and income tax interact in subtle ways. The step-up in basis at death means heirs avoid capital gains tax on appreciation up to death, but this triggers estate tax. Some proposals would repeal the step-up and replace it with a carryover basis, reducing estate tax but increasing income tax on heirs selling appreciated assets.