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The Hunt for Estate Tax Allocation

Adam S. Bernick, Esq. on 10/21/2014

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Well known conservative/libertarian author Tom Clancy, who passed this life approximately a year ago in October 2013, would be appalled to discover that his estate is mired in litigation involving "death" taxes.  Yet, currently before the Orphans' Court in Baltimore, Maryland, is ligation involving his widow and adult children from a prior marriage revolving around the allocation of estate taxes. 

On September 8, 2014, Mr. Clancy´s widow filed in the Register of Wills of Baltimore Maryland/Orphans´ Court (Estate Number 000000101962) an action for a Declaratory Judgment and Removal, with a principal goal of shifting millions of dollars in state and federal estate taxes from having to be paid from her share of his estate to having to be paid from the share passing to Mr. Clancy´s adult children. In an estate consisting of an interest in the Baltimore Orioles, a WWII tank, guns, and other miscellaneous property totaling in the tens of millions of dollars, not to mention property passing outside of the estate, the importance of allocating the state and federal inheritance taxes among the shares of Mr. Clancy´s estate affect not just the net proceeds passing to the individual beneficiaries, but what will have to be sold to pay the taxes. One does not have to be a millionaire for allocation of estate taxes to impact an estate.

Unknown to many individuals is Pennsylvania´s imposition of a state inheritance tax on all assets (excluding certain assets, such as life insurance, or an IRA of someone who dies before age 59 ½). 72 Pa. C.S. § 9101 et. seq. Unlike many states and the federal government, which set minimum wealth requirements for estates to be subject to estate or inheritance tax, Pennsylvania imposes no such minimum. 72 Pa. C.S. § 9106 et. seq. If one dies with a net estate of $50,000 after paying for the funeral and other costs and debts, the Pennsylvania Department of Revenue (DPR) will subject the balance to inheritance tax. Whether the asset passes via the probate process or non-probate (including joint accounts, ITF accounts, POD accounts, revocable trust, etc...) DPR may subject it to inheritance tax. 72 Pa. C.S. §§ 9111, 9126 et. seq.

Currently, for an individual who died in 2014, Pennsylvania does not impose a tax on transfers to spouses, but transfers to descendants and ancestors of the decedent are taxed at 4.5% of the net asset transferred, 12% for siblings, and 15% for other individuals. Qualified charities and certain governmental entities are also exempt from inheritance tax. 72 Pa. C.S. §§ 9116 et. seq.

Absent clear language in the will of the testator specifically allocating the inheritance tax, the inheritance tax on assets passing as a specific devise or bequest are paid from the residue of the testator´s estate. 20 Pa. C.S. §§ 2514(15); 9144. Likewise, absent clear language in the will or trust specifically allocating from where the inheritance tax is paid, the inheritance tax on property passing outside of the will is to be paid by the individual receiving the property. 20 Pa. C.S. § 9144(f).

Many wills and estate documents, such as revocable trusts, contain standard default language directing that all inheritance and estate taxes are to be paid from the residue of the estate, without any allocation between probate and non-probate property, or any specific allocation among beneficiaries. Based on Pennsylvania law, then, under such a scenario, it is possible that the testator´s intended primary beneficiary may have their share reduced to pay inheritance tax on shares passing to more distant relatives.

Hypothetically, if testator created a standard will that specifically bequeathed 25% of his estate to be divided among his nieces and nephews, with the rest and residue of the estate to pass to his wife, and testator left a net estate of $100,000, excluding marital property passing outside probate to the wife, $25,000 would be divided among the nieces and nephews, while, the $75,000 passing to the wife under the residue would be reduced by $3,750.00 (the inheritance tax on the $25,000 passing to the nieces and nephews). Moreover, an added consequence of paying the inheritance tax will be if the estate is not liquid, property may have to be sold to pay the inheritance tax, which, depending on the type of property, could result in additional income taxes, too.

An obvious solution to avoiding the above issues, or at least minimizing them, is to discuss with the testator who should pay the estate and inheritance tax on what they receive, and reminding them to consider non-probate property such as annuities and an IRA. While it may seem simple to simply state that debts and expenses are paid from the residue, while estate and inheritance taxes are paid by the individual who receives the asset in question, reduced by the applicable tax, this is not as simple as it sounds.

Under Pennsylvania law the executor or other fiduciary, excluding fiduciaries of certain pension and similar plans, has the obligation to collect the inheritance tax due DPR on behalf of the Commonwealth, and cannot distribute the asset to the beneficiary without the tax having been paid. 20 Pa. C.S. § 9146. If the property came into possession of the executor, such as bonds held as joint tenants with rights of survivorship between decedent and one or more survivors that were in the decedent´s safe deposit box, for example, prior to distributing the bonds to the survivor, the executor would have an obligation to make sure that the inheritance tax on the bonds were paid.

Hence, an executor may be caught between Scylla and Charybdis in the form of competing beneficiaries in their demand of their inheritance, and the funding of the tax and assets to sell. While such conflicts might easily be settled in the form of a family settlement agreement, absent agreement of all heirs (a fact made difficult if there are unborn, minor or incapacitated beneficiaries that are potential parties) an executor may have no choice but to commence an action for a declaratory judgment (42 Pa. C.S.A. § 7535) or in lieu thereof, a formal Accounting and Petition for Adjudication, leaving it to the Court to resolve any ambiguities or conflicts in interpretation.

In the end, meeting with the client to review all such issues, possible disputes, and drafting documents with contingencies in place to address possible disputes as to allocation and payment of inheritance tax, may, in the end, result in substantially less litigation among the parties.

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