How the Estate Tax Works

The estate tax was designed to make sure the federal government got its piece of the country's largest estates -- but who pays?
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From its inception in 1916, the federal estate tax in the United States has been used to generate tax revenue from the transfer of wealth between deceased family members and their descendants. The tax is calculated as a percentage of the total value of the estate's assets (cash, investments, real estate and more) minus a variety of deductions, including charitable contributions. In 2012, the top estate tax rate is 35 percent. Dubbed the "death tax," the estate tax has been the target of sharp criticism from tax reform proponents for decades.

This tax is nothing new. The ancient Egyptians were the first to tax the transfer of wealth upon death circa 700 B.C., and about 2,000 years ago Roman Emperor Caesar Augustus taxed the inheritance of money by all but immediate family members [source: Jacobson, et al]. In the United States, the first estate and inheritance taxes were temporary measures to raise revenue during wartime. (For more information on the difference between the two, take a look at How Inheritance Tax Works.) The first was the Stamp Act of 1797, which taxed wills and distributions of "legacies" to raise money to fight an undeclared naval war with France. Similar revenue-raising measures were employed during the Civil War and the Spanish-American War, but all were quickly repealed once the wars were over [source: Jacobson, et al].

The late 19th and early 20th centuries saw the rise of the super-wealthy -- industrial magnates and tax-dodging "holding companies" that threatened to consolidate the wealth of the nation in the hands of a powerful few. Led by trust-busting progressives like President Theodore Roosevelt, the government pushed through tax measures to distribute the wealth more fairly. The 16th Amendment to the Constitution, passed in 1913, established the first federal income tax. And in 1916, Congress approved the first federal estate tax on estates valued over $50,000 [source: Jacobson, et al].

From the beginning, the estate tax has always been reserved for a slim minority of American estates. For the 2011 tax year, an estimated 3,300 estates will owe estate taxes, representing 0.1 percent of all deaths in America [source: CBPP]. The other 99.9 percent of deaths will result in no estate tax at all. That's because 99.9 percent of American estates are valued at less than $5 million, and under 2012 tax law, only the value of an estate that exceeds $5 million is taxed. If your estate is worth $5 million or less, you don't pay a cent.

So who exactly are the 0.1 percent of Americans that pay the estate tax? We'll take a closer look on the next page.