Tax Reduction Strategies
for the PA Inheritance Tax
Charles Bender, Esq.
November 8, 2016
© 2016 Fox Rothschild
Summary of PA Inheritance Tax
• PA is one of the few states that still has an
inheritance tax
– NJ also has inheritance tax
• Most states adopted a pick-up tax tied to the
federal state death tax credit
– When credit was changed to a deduction, many states
decoupled their state tax from federal rules
• NJ, NY, DE among local states that decoupled
– NJ recently repealed it’s estate tax effective in 2018
• PA and FL constitutions prevented decoupling
Summary of PA Inheritance Tax
• Applies to transfers of most assets at death
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Cash
Securities
Real estate
Most retirement accounts
Joint assets
• Other than joint with spouse
– Revocable trusts
– Tangible personal property
Summary of PA Inheritance Tax
• Exemptions
– Life insurance
– Certain retirement accounts
• Deductions
– Charitable
– Administration expenses
Summary of PA Inheritance Tax
• Tax rates:
Spouse:
0%
Children/grandchildren/
parents:
4.5%
Siblings:
12%
All other beneficiaries:
15%
Summary of PA Inheritance Tax
• Differences between federal and PA rules
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Life Insurance
Marital Deduction
Applicable Exclusion
Inclusion of joint property
• PA uses % of ownership rule
• Federal uses contribution rule
– Joint property with spouse
• Federal includes ½ and qualifies for marital deduction
• PA does not report it at all
Planning with Joint Assets
• One of the simplest ways to reduce PA tax
• Example
– $200,000 house that parent wants to leave to child
– Inheritance tax = $9,000 ($200,000 x 4.5%)
– If parent puts house in joint names with child
• Tax will be $4,500 ($200,000 x 50% x 4.5%)
– If house is put in joint names with 4 children
• Tax will be $1,800 ($200,000 x 20% x 4.5%)
– Must be made joint more than 1 year before death
Planning with Joint Assets
• This technique works with
– real estate
– bank accounts
– securities accounts
• Convenience account issue
– If account made joint just to pay bills – 100% taxable
– Donative intent
– Contemporaneous documentation important
Planning with Joint Assets
• Powers of Attorney
– Include power to make gifts
– Include power to make accounts joint
– New power of attorney statute, both are hot powers
• Must be specifically authorized by grantor
Planning with Joint Assets
• Primary residence
– Excluded asset for Medicaid purposes
• Medicaid will have a lien on estate assets
• If house is a probate asset at death, lien will attach
– If house was titled JTWROS with child
• Not a probate asset
• Lien should not attach
Planning with Life Insurance
• Life Insurance is exempt from PA Inheritance Tax
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Different from federal estate tax treatment
Doesn’t matter who owns it
Doesn’t matter who the beneficiary is
No need for ILIT to keep insurance from being taxed
Planning with Life Insurance
• Example - Using life insurance to minimize tax
– Assets:
• House worth $200,000
• Bank account worth $200,000
• Life insurance with $200,000 death benefit
– Beneficiaries:
• Brother - $100,000
• Children - $100,000
• Spouse - residue
Planning with Life Insurance
• Plan 1
– Spouse is beneficiary of life insurance
– Will provides
• $100,000 to children
• $100,000 to brother
• Residue to spouse
– Inheritance tax will be $16,500
• Brother – 12% x $100,000 = $12,000
• Children – 4.5% x $100,000 = $4,500
– Who pays the tax?
• Depends
Planning with Life Insurance
• Plan 2
– Change beneficiary of life insurance
• $100,000 to brother
• $100,000 to children
– Change will to leave entire estate to spouse
– Under this plan, the PA inheritance tax is zero
• Disposition is the same
• Allows beneficiaries to inherit the entire estate, tax free
– Who pays the tax?
• Nobody
Planning with Life Insurance
• Naming spouse as beneficiary of life insurance
– Not taxable for two reasons
• Insurance is not taxable
• Tax rate on assets going to spouse = 0%
– But when spouse dies
• Insurance is just cash in his/her estate
• It will be taxed based on who receives the cash
– If spouse does not need the cash
• Consider leaving insurance to children on first death
• Consider naming trust as beneficiary
Planning with Life Insurance
• Naming trust as beneficiary of life insurance
– Spouse and or children can be beneficiaries
– If spouse is income beneficiary
• Do not elect to treat trust as sole use trust
• This will make it taxable in spouse’s estate
– Do not commingle life insurance with other assets in a
sole use trust
• This will cause life insurance to be taxable in second estate
• Segregate life insurance in separate trust
Planning with Retirement Assets
• Retirement assets excluded if decedent < 59 ½
– If decedent would have incurred significant penalty for
withdrawing assets, they are not taxable
– The federal 10% penalty for early withdrawal is
considered significant for this purpose
– So if decedent is < 59 ½ at date of death
• Retirement assets are exempt regardless of the beneficiary
Planning with Retirement Assets
• Federal rules generally determine beneficiary
– Spousal rollover to defer income tax
– Marital deduction to defer estate tax
• May not be true in second marriages
– Decedent may want children to benefit
• Inherited IRA rules can defer income tax
• Children may be in low income tax bracket
– Property settlement agreement may control
– Pre-nuptial may control
Planning with Retirement Assets
• Example: Paying charitable gifts from IRA
– Assets
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House - $200,000
Cash - $200,000
Life insurance - $200,000
IRA - $200,000
– Beneficiaries
• Charity - $100,000
• Children - $100,000
• Spouse - residue
Planning with Retirement Assets
• Plan 1
– Spouse is beneficiary of IRA
– Child and spouse are equal beneficiaries of insurance
– Will leaves $100,000 to charity and residue to spouse
• Tax result – no inheritance tax
• No tax on insurance going to child
• Charitable deduction for bequest to charity
• No tax on assets going to spouse
Planning with Retirement Assets
• So what’s the problem?
• Income tax when spouse withdraws $ from IRA
– If spouse is in 39.6% bracket, tax will be $39,600
– Spouse will only net $61,400 from IRA
• Solution
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Name charity as beneficiary of $100,000 from IRA
Charity pays no income tax; receives entire $100,000
Saves family $39,600 of income tax
Everyone wins except IRS (Yay!)
Domicile Planning
• The place where you live and have your
permanent home
– You can only have one domicile
– Subjective test – based on state of mind and intention
– Objective factors used to show intent
Domicile Planning
Objective Factors
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Voter registration
Driver’s license
Auto registration
EP documents
Address used for
credit cards, social
security, passport,
federal taxes
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State tax returns
Bank relationships
Health insurance
Church / synagogue
Club memberships
Place of work
Number of days in the
state – 183 day rule
Domicile Planning
• Domicile determines
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Where you pay most taxes
Where you vote
Where your driver’s license is issued
Where Last Will and Testament is probated
Domicile Planning
• Domicile determines the state that has primary
taxing authority over you
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Income taxes
Personal property / Intangible taxes
Inheritance taxes
State estate taxes
Sales and use taxes
Domicile Planning
• Domicile planning opportunities
– Some states have no death taxes
• AK AL AR AS AZ CA CO FL GA ID IN KS LA MI MO MS MT NC
ND NH NM NV OH OK SC SD TX UT VA WV WI WY
– Some states have no income taxes
• AK FL NV SD TX WA WY
• Domicile planning
– Structuring affairs to create residency in state of choice
– Minimizing income and inheritance taxes
Domicile Planning
• Changing Domicile Requires
– Intention to adopt a new home
– Relinquishing former home
– An act of removal to the new home
• Burden of proof is on the taxpayer
• Establish as many favorable factors as possible
• Filing Declaration of Domicile
PA Inheritance Taxation of Trusts
• When a trust is a beneficiary of an estate
– What tax rate applies to the trust assets
– Look through trust to identify beneficiaries
– Tax rate is based on rate applicable to beneficiaries
• If all beneficiaries are lineal descendants – tax rate = 4.5
PA Inheritance Taxation of Trusts
• What if beneficiaries are in different tax classes
– Income to brother (12%)
– Remainder to children (4.5%)
• Future Interest Compromise
– Schedule M of Form Rev-1500
PA Inheritance Taxation of Trusts
• Factors used in future interest compromise
– Ages of beneficiaries
– Terms of trust
• Withdrawal rights
• Principal invasion provisions
• Powers of appointment
– Financial circumstances of beneficiaries
• Likelihood of principal distributions
– Types of assets
– Anticipated investment returns
PA Inheritance Taxation of Trusts
• Explanation of compromise offer
– Need for principal distributions
– Beneficiaries other sources of support
– Likelihood that assets will be needed for
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Health
Education
Maintenance
Support
– Special needs
PA Inheritance Taxation of Trusts
• Compromise offer
– How much of trust assets allocated to each class
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Charity (0%)
Spouse (0%)
Lineal descendants/ascendants (4.5%)
Siblings (12%)
Others (15%)
PA Inheritance Taxation of Trusts
• Example 1
– Parent created education trust for child
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$100,000
Child about to enter college at $50,000/year
Anything left at age 25 paid outright to child
If child dies before, remainder to parent’s siblings
– You could argue that entire trust is taxed at 4.5%
– But
• What if child is getting full scholarship
• What if other parent is obligated to pay for college
PA Inheritance Taxation of Trusts
• Example 2
– Client creates trust
• Income to parents
• Followed by income to spouse
• Followed by remainder to children
– Calculate value of parents life estate
• Adjust for factors like health, other assets, special needs
– Do the same for spouse
– The balance then goes to children
PA Inheritance Taxation of Trusts
• Example 2 (continued)
– There is room for creativity
• Minimize likelihood that parents will need trust assets
• Maximize likelihood that spouse will need trust assets
• Minimize assets available for children
– If your compromise is reasonable, the Department of
Revenue is usually reasonable
– In drafting trusts with multiple classes of beneficiaries
• Take compromise factors into account to allow for planning
• Disclaimers can help
PA Inheritance Taxation of Trusts
• Sole Use Trusts – Schedule O
– Trust for the sole use of surviving spouse
– Similar to marital trust for federal estate tax purposes
– Options for taxation
• Elect to tax as sole use trust
– Tax rate is 0%
– Tax is deferred until spouse dies
• Make a compromise offer
– Portion of trust allocated to spouse is taxed at 0%
– Balance taxed at remainder beneficiary rates
– Trust is not taxed when spouse dies
PA Inheritance Taxation of Trusts
• When to consider paying tax on sole use trust
– Spouse is in poor health
– Assets in trust are expected to appreciate
– Spouse will not need distributions from trust
• When to consider deferring tax on sole use trust
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Spouse is in excellent health
Assets in trust are expected to depreciate
Spouse will need to spend trust assets
Spouse will move to another state
PA Inheritance Taxation of Trusts
• Non-sole use trust for spouse (credit shelter trust)
– Where trust allows distributions to others (children)
• Income & principal sprinkled among spouse and children
– Compromise must be filed
– Alternative
• Have non-spouse beneficiaries disclaim their interests
– Just for distributions during spouse’s lifetime
– They can still be remainder beneficiaries
Exemption for QFOBIs
• Section 2111(t) provides new exemption from PA
inheritance tax:
A transfer of a qualified family-owned business interest
to one or more qualified transferees is exempt from
inheritance tax
Statutory Requirements
• Definitions
– Qualified family-owned business interest (QFOBI)
– Qualified transferee (QT)
• Provisions for recapture of tax
Definition of QFOBI
• Sole proprietorship or interest in an entity
carrying on a trade or business
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Fewer than 50 employees
Net book value less than $5M
In existence for 5 years prior to decedent’s death
Wholly owned by decedent or decedent and QTs
Engaged in trade or business other than management
of investments or income producing assets
Definition of QT
• Husband and wife
• Lineal descendants
– Children, grandchildren and great grandchildren
• Siblings and sibling’s lineal descendants
– Brothers, sisters, nephews and nieces
• Ancestors and ancestors siblings
– Parents, grandparents, uncles, aunts, great uncles
and great aunts
• Trusts for any of above family members
– Added by Act 84 of 2016
Recapture Provisions
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QTs must continue to own QFOBIs for 7 years
Must report QFOBI on inheritance tax return
Each QT must file annual certification
If QFOBI is no longer owned by QT
– Tax will be due on the QFOBI
– Tax becomes lien on assets of QT
– Act 84 of 2016 makes liability “joint and several”
Other Statutory Provisions
• Property transferred to business within 1 year of
death is not eligible for exemption
• Applies to decedents dying on or after 7/1/2013
Potential Tax Savings
• Depends on relationship of QT to decedent
• Suppose $5M business interest
Husband/wife:
Child/grandchild:
Brother/sister:
All others:
$5M x 0% = $0
$5M x 4.5% = $225,000
$5M x 12% = $600,000
$5M x 15% = $750,000
Issues with Definition of QFOBI
• Sole proprietorship or interest in an entity
carrying on a trade or business
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Fewer than 50 employees
Net book value less than $5M
In existence for 5 years prior to decedent’s death
Wholly owned by decedent or decedent and QTs
Net book value < $5M
• Relates to value of business as a whole
– Not decedent’s interest in the business
• If decedent owns 50% of business with net book
value of $10M, the interest is not a QFOBI
Net book value < $5M
• Book value is an accounting concept
– Based on historical cost of assets
– Less accumulated depreciation
– Less liabilities
Net book value < $5M
• Inheritance tax is imposed on FMV of assets
• Book value bears no relationship to FMV
• Example:
• Investment real estate purchased for $5M
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$500K allocated to land; $4.5M allocated to building/improvements
Over time, building/improvements are fully depreciated
Over time, FMV of building appreciates to $10M
• Book value of building will be $500K
• FMV of building will be $10M
• Ownership interest in investment property would qualify as
QFOBI, and $10M will be excluded from PA inheritance tax
Net book value < $5M
• In above example, tax savings would be:
Husband/wife:
Child/grandchild:
Brother/sister:
All others:
$10M x 0% = $0
$10M x 4.5% = $450,000
$10M x 12% = $1,200,000
$10M x 15% = $1,500,000
Net book value < $5M
• Many family owned businesses will have balance
sheets showing a book value significantly below
the FMV of the business
– Book value does not include good will unless paid for
– “Sweat equity” does not impact book value
– Intellectual property created by business may have
low book value compared to FMV
– Liabilities reduce book value
Unlimited QFOBIs
• Statute does not limit decedent to one QFOBI
– Operating company can be a QFOBI
– Real estate entity can be separate QFOBI
• In example above, suppose operating company
rents real estate from real estate entity
– If book value of operating company < $5M, it will be a
QFOBI as well
– Operating company could have FMV > $100M, and it
would be still be exempt from PA inheritance tax
Issues with Definition of QT
• QFOBI must be wholly owned by decedent or
decedent and QTs
– No key employees
– No non-QT partners/shareholders
– No FLPs if there is a corporate GP
Issues with Definition of QT
• Lineal descendants
– Children, grandchildren and great grandchildren are QTs
– Spouses of lineal descendants are not QTs
• Sons-in-law and daughters-in-law are not QTs
– Trust for lineal descendants are now are QTs
• Added by Act 84 of 2016
Issues with Definition of QT
• Siblings and siblings’ lineal descendants are QTs
– Nieces and nephews are QTs
• Spouses of siblings and descendants are not QTs
• Spouse’s siblings are not QTs
– Brothers-in-law and sisters-in-law are not QTs
• Trusts for siblings and descendants are now QTs
– Added by Act 84 of 2016
Issues with Definition of QT
• Ancestors and ancestors’ siblings are QTs
– Parents, grandparents, aunts and uncles are QTs
– Children of aunts and uncles are not QTs
• Cousins are not QTs
• Spouse’s ancestors and their siblings are not QTs
– Mother-in-law and father-in-law are not QTs
• Trusts for ancestors and their siblings are QTs
– Added by Act 84 of 2016
Issues with Definition of QT
• Trusts now are QTs
– Added by Act 84 of 2016
– Parent can now put QFOBI in trust for a child
– Decedent can now put QFOBI in trust for spouse
• You can use QTIP/UCT planning with QFOBIs
• Sole use trust is now a QT on death of surviving spouse
– You can now put QFOBI in living trust for yourself
Issues Related to Recapture of Tax
• QFOBI must continue to be owned by QT for 7
years following decedent’s death
• Transfer to non-QT triggers tax and interest
• Tax and interest become lien on property of QT
who transferred the QFOBI
– May be contrary to terms of decedent’s will
– Tax clause may charge tax to a different beneficiary
• Liability for recapture tax is joint and several
– Added by Act 84 of 2016
Issues Related to Recapture of Tax
• Statute allows transfers between QTs
– Transferee must be a QT with respect to the decedent
• If QT is child, transfer to QT’s spouse triggers recapture
– Recapture tax is now joint and several
• Added by Act 84 of 2016
• If one QT transfers QFOBI to a non-QT, recapture applies to
all QTs
Issues Related to Recapture of Tax
• What tax rate applies in event of recapture
– If original QT transfers to non-QT, use QT’s tax rate
– If original QT transfers to second QT with different rate
• If second QT transfers to a non-QT, which rate do you use?
• Example: if decedent’s son transfers QFOBI to decedent’s
brother, and brother transfers to third party, is the tax rate
4.5% or 12%?
Issues Related to Recapture of Tax
• Recapture only if QT transfers QFOBI to non-QT
• Sale of assets does not trigger recapture tax
– If the business sells assets, but QT retains QFOBI,
there is no recapture under statute
• Does closing business trigger recapture?
• Does bankruptcy trigger recapture?
• Does change of active business to management
of investment assets trigger recapture?
Other Issues
• The business must be in existence 5 years
• Decedent not required to own interest 5 years
– You could buy interest in business for cash shortly
before death
– If business was in existence for 5 years, it could
qualify as a QFOBI
Other Issues
• Transfers within year of death
– Not exempt unless for business purpose
– Avoids stuffing cash into business to avoid tax
• But statute exempts QFOBIs from tax
– Assets of business are not subject to tax
– So exemption does not apply to assets in business
• Statute should provide that transfers to a
business within one year of death are subject to
tax unless there is a business purpose
Other Issues
• Business purpose other than managing
investments
– Aimed at preventing decedent from putting cash in
entity, buying securities and claiming exemption
– FLP owning securities will not qualify as QFOBI
• This restriction does not appear to apply to real
estate investments
Planning Opportunities
• Using $5M book value requirement
– Client with low basis assets can pass substantial value
free of PA inheritance tax
• No limit to the PA inheritance tax savings
– Also obtain step up in basis
– Planners need to know book value as well as FMV
Planning Opportunities
• Create multiple QFOBIs
– Put separate assets into separate entities
• We do this for liability purposes anyway
• Now there is additional PA inheritance tax benefit
– Example:
• If client owns 10 rental real estate properties in individual
name, they may constitute one real estate business
• But if each property is owned by a separate LLC, they could
constitute 10 businesses, and all be exempt under the statute
Planning Opportunities
• Planning for transfers of QFOBI’s on first death
– Consider giving QFOBIs up to federal estate tax
exemption amount to QTs on first death
Don’t Let the Tail Wag the Dog
• Reasons for trusts may outweigh tax savings
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Divorce
Creditors
Disability
Beneficiary lacks financial skills
• Federal tax savings may outweigh PA tax savings
– QTIP/UCT planning
– GSTT planning
Don’t Let the Tail Wag the Dog
• Business planning may outweigh PA tax planning
– Capital structure
– Need to raise funds from outside investors
– Non-QT might be the right successor
• Maybe the son-in-law should own the business
• Success of business more important than tax savings
• QT could always choose to transfer QFOBI if
needed, and just pay recapture tax
Conclusions
• Statute’s flaws create planning opportunities
• Potential for tax savings is unlimited
– Statute could have capped benefit at $5M of value
• Structures to take advantage of statute make
sense for other reasons
– Limitation of liability
– Step up in basis
• Expect to see changes to statute
– As in Act 84 of 2016
Charles Bender, Esq.
215.918.3546
[email protected]