How Does Estate Tax Differ from Inheritance Tax?

Both estate tax and inheritance tax are forms of taxes that may be levied on the transfer of assets after a person's death. However, they differ in terms of who is responsible for paying the tax, the taxable event, and the calculation of the tax. Understanding these differences is essential for proper estate planning and minimizing tax burdens for the heirs.

Key Differences Between Estate Tax and Inheritance Tax:

Taxable Event:

• Estate Tax: An estate tax is levied on the total value of a deceased person’s estate before the assets are distributed to the heirs or beneficiaries. It is a tax on the estate itself.
• Inheritance Tax: An inheritance tax is imposed on the value of the assets received by the heirs or beneficiaries. It is a tax on the individual inheritance received by the beneficiary from the deceased.

Who is Liable to Pay the Tax?

• Estate Tax: The estate of the deceased is responsible for paying the estate tax. The tax is calculated based on the total value of the assets owned by the deceased at the time of death.
• Inheritance Tax: The heirs or beneficiaries who receive the inheritance are liable to pay the inheritance tax. The tax is paid by the individual who inherits the assets, not the estate.

Tax Rate and Exemptions:

• Estate Tax: The tax rate on the estate tax is typically applied to the gross value of the estate. This includes the value of all assets owned by the deceased, such as real estate, investments, and personal belongings. Certain exemptions or deductions may apply, such as for spouses or charitable donations.
• Inheritance Tax: The tax rate on the inheritance tax depends on the value of the inheritance received and the relationship of the beneficiary to the deceased. Close relatives (such as spouses or children) often benefit from lower tax rates or higher exemptions. For example, children might pay a lower inheritance tax rate than distant relatives.

Calculation of Tax:

• Estate Tax: The estate tax is calculated based on the total value of the estate (all assets owned by the deceased), after subtracting any debts, funeral expenses, and allowable deductions. The remaining value is subject to estate tax at the prescribed rate.
• Inheritance Tax: The inheritance tax is calculated based on the value of the assets each beneficiary inherits. The tax amount will depend on the relationship between the deceased and the beneficiary and the value of the inheritance. The closer the relationship, the lower the inheritance tax rate.

Jurisdiction:

• Estate Tax: Estate taxes are less common today but still apply in some countries or regions. For example, the United States has a federal estate tax, but many other countries have abolished estate taxes.
• Inheritance Tax: Inheritance taxes are more common and apply in various countries, such as the United Kingdom, France, and some states in the United States. These taxes vary by jurisdiction, and the rates may differ depending on the relationship of the beneficiary to the deceased.

Impact of Double Taxation:

• Estate Tax: Since the estate tax is levied on the total estate, there is usually no risk of double taxation for the heirs, as the tax is paid before the assets are distributed.
• Inheritance Tax: There could be a potential for double taxation if the inherited assets are also subject to tax in the country where the estate was located. However, some countries have agreements in place to prevent double taxation, such as Double Taxation Avoidance Agreements (DTTAs).

Countries that Apply Estate Tax vs. Inheritance Tax:

Estate Tax:

Countries like the United States, Japan, and South Korea have an estate tax in place. In these jurisdictions, the estate tax is imposed before the distribution of assets to heirs.

Inheritance Tax:

Countries like the UK, Belgium, Germany, and certain states in the US impose inheritance taxes. In these jurisdictions, the beneficiaries of the estate are responsible for paying the inheritance tax based on what they inherit.

Example:

Example 1: Estate Tax in the United States

Mr. John passes away, leaving a property, bank accounts, and investments. The total value of his estate is $10 million. Before his assets are distributed, the estate is subject to an estate tax of 40%. The estate is responsible for paying $4 million in estate taxes before the heirs inherit the remaining assets.

Example 2: Inheritance Tax in the United Kingdom

Mrs. Sarah inherits £500,000 from her late aunt. The inheritance tax rate for close relatives is 40%. Mrs. Sarah will pay £200,000 in inheritance tax on the inherited amount.

Conclusion:

The key difference between estate tax and inheritance tax lies in who is responsible for paying the tax. Estate tax is paid by the deceased person’s estate before assets are transferred to the heirs, while inheritance tax is paid by the heirs or beneficiaries based on the value of the inheritance they receive. Each tax type has its own tax rates, exemptions, and deductions, and the applicable rules depend on the jurisdiction in which the estate is being administered. Estate planning can help manage and minimize both types of taxes, depending on the applicable tax laws.