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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Prenuptial Agreements and Property: Getting Clear about Title

In January 2010, the New York Times published an article in the real estate section about the growing number of unmarried couples purchasing real estate together (“Come Buy With Me and Be My Love“).   While the attraction may be low mortgage rates or the ability to buy a more desirable property that the current housing market has placed within an unmarried couple’s reach,  the couple in consultation with their attorneys should give care and thought to such issues as to how the property will be titled, how the property will be treated in each party’s Will, how payments and tax issues will be apportioned, and whether a new deed will be drafted and recorded in the event that the couple marries.

For an unmarried couple wishing to purchase real estate together, a prenuptial agreement can resolve these issues before the purchase is made.  Domestic Relations Law (DRL) 236[B](3) recognizes provisions in prenups “for the ownership, division or distribution of separate and marital property.”  As we shall see, the way in which a property is titled has some serious repercussions.

To simplify this discussion, I have divided ownership types by whether or not they have a right of survivorship, meaning that the surviving tenant will become the owner of the entire property without Probate.  The surviving tenant’s claim on the property will be first in line over any other claims on the property. 

There are two ways to title property to ensure the right of survivorship.  The first is available only to married couples:  tenancy by the entirety.   For married couples in New York, this is the default title.  It affords certain rights not available to unmarried couples.  Tenancy by the entirety presupposes that in marriage the two become one.  The law views the couple as a single unit.  Each spouse owns an undivided 100% of the property.   Neither spouse can sell or diminish the 100% share that each owns without the consent of the other.  Should a creditor obtain a lien on one spouse’s interest in the property, the lien will only survive if the debtor spouse is the surviving spouse.  Otherwise, the lien is extinguished with the death of the debtor spouse.  Moreover, the property cannot be reached in a bankruptcy proceeding. 

Joint tenancy with right of survivorship provides some of the same protections for an unmarried couple.  Each person owns an undivided 100% interest.  However, one party may transfer or put a lien on his/her interest without the knowledge or consent of the other joint tenant, thereby severing the joint tenancy and making the property a tenancy in common.  Moreover, the interest of each joint tenant can be attached by creditors or in bankruptcy.  When attachment takes place, the property can be sold to recover against the debt, and the proceeds of the sale will be divided between the unencumbered party and the bankruptcy trustee.

When a joint tenant transfers his/her interest to a third party, the joint tenancy with right of survivorship is severed and the parties become tenants in common with no right of survivorship.  Why is this important?  First, it can be done without the knowledge or consent of the other party.  Secondly, it can undo the estate planning that the other party has done, particularly if there is every expectation by the non-suspecting party that the property will pass outside Probate to the surviving party.

Tenants in common have no right of survivorship.  When one tenant in common dies, their property rights pass according to their wishes in their Will, or by the applicable rules of intestacy if they die without a Will.  Each tenant in common enjoys full possession of the property and may not be excluded without compensation.  Tenants in common need not have equal shares, and more than two persons may own the property together.  A tenancy in common affords no protection from creditors or the bankruptcy court.  One joint tenant can transfer his/her ownership rights to a third party without the consent of the other, effectively giving the other co-tenant a new “roommate.”  That third party will now be in possession with the remaining original co-tenant.  The only remedy that the remaining original remaining co-tenant has is to demand a sale of the property and a division of the proceeds.

With a prenuptial agreement, the couple can clearly designate how the property will be titled.  In addition, they can agree to apportion payments based on a percentage of each other’s earnings, reviewable on a yearly basis.  Since each party will be filing taxes separately until the marriage, the prenuptial agreement can spell out the pro rata percentage that can be used for deductions on the IRS’s Schedule A.

Finally, the prenuptial agreement can spell out if and how the unmarried couple will re-title the property as a tenancy by the entirety in the event of a marriage.  Will the property become marital property, or will it remain separate property?  Being up-front about one’s intentions can spare both parties much anxiety and grief, and also bring clarity to each party’s estate planning.

If you would like to discuss your own personal situation with me, you can get a free 30-minute consultation simply by filling out this contact form.   I will get back to you promptly.

I invite you to join my list of subscribers to this blog by clicking on “Sign me up!”  under Email Subscription on the left-hand side of the page so that you can receive a notification when the next installment has been published.  Thank you.