Inheritance tax: Life estates, elections, exemptions and the early payment discount

Part III of this series on the Pennsylvania inheritance tax deals with the taxation of future interests, the sole use trust election, the family exemption and the early payment discount.

The Pennsylvania inheritance tax is an excise tax on the receipt of inherited property by a beneficiary. The rate that applies depends on the beneficiary’s relationship to the decedent. The tax rate for spouses is 0 percent. For lineal descendants – mother, father, grandmother, grandfather, wife or widow of a child, husband or widower of a child – the rate is 4.5 percent, for siblings 12 percent and for all others, the rate is 15 percent.

This is easy enough to calculate when Sister gets $10,000 and Son gets $40,000. But what if Father leaves $100,000 in his will to pay the income to his Sister for life, and on her death, to pay the remainder to his Son? How do we compute the tax? Sister doesn’t get all the property. She is only entitled to the income. Son eventually gets the entire remainder but not for some years, until Sister dies. What is that worth now?

When property passes to a trust, like the above example, or a life estate is given to one person and the remainder to another, the interests of the beneficiaries who receive the property at some later date are called “future interests.” In our example, Father created a trust which is to pay the income to his Sister, and on Sister’s death, to pay the remainder to his Son. Son’s right to the remainder is a future interest.

We do not know how much income the trust will generate, how long Sister will live, or whether there will be any capital appreciation in the trust’s assets. Nevertheless, the tax on both Son’s and Sister’s interests in the trust property is due nine months from the decedent’s death.

The executor is required to value the interests of Sister and Son in accordance with methods of computation and actuarial assumptions that are the same as those used for the federal estate tax. The IRS publishes life expectancy tables from which we can determine Sister’s life expectancy. The IRS also publishes a monthly rate, called the applicable federal rate, which is an interest rate assumption of the income production of assets. Using these published numbers, the executor computes the present value of Sister’s life estate, and the present value of Son’s remainder interest.

Sounds complicated? It is, unless you are familiar with doing these calculations. The Department of Revenue will provide the life estate factor to compute the valuation of the interest as a service to taxpayers.

If Father died in November 2013 and Sister was closer to 70 than any other age, the life estate factor would be 0.23740. Sister’s life estate would be valued at $23,740 and Son’s Remainder interest would be $76,260. The total of the inheritance tax Sister and Son would be $6,280.50. These numbers would have been the same for an August and September date of death but would have been different for an October death due to changes in the federal rate.

There is an added complication if the person receiving the life interest is the decedent’s surviving spouse and the trust is for the “sole use” of the surviving spouse. Then the tax on the remainder interest is not due until the death of the surviving spouse, at which time the entire property passing to the remaindermen is taxed at the appropriate rate, that is, depending on the remaindermen’s relationship to the decedent.

There is a special provision in the inheritance tax law under which the executor may elect to pay this tax early, that is, nine months from the decedent’s death instead of waiting until the surviving spouse’s death. If the “pay early” election is not made, then the tax won’t be due until the surviving spouse dies. Whether or not to make the election depends on the nature of the assets, the life expectancy of the spouse and other variables. The decision should be made with the advice of competent counsel. Once the inheritance tax return is submitted, it cannot be changed.

A number of deductions are allowed in computing the inheritance tax. Deductions reduce the taxable value of the property passing to beneficiaries. Expenses of estate administration including probate fees, appraisal fees, and attorney and executor’s fees are deductible. Funeral and burial expenses are deductible. Debts of the decedent including, for example, unpaid bills, expenses of the last illness, income taxes due, and mortgage balances are deductible.

There is a deduction for the family exemption up to $3,500. The amount must be claimed by and paid to a surviving spouse if any, or to child if any, or to a parent who lived in the same household with the decedent. It is payable only out of probate assets (those listed in schedules A through E) that pass under a will or by intestacy.

After the determination of all taxable property, taking deductions, and calculating the tax for each rate and summing, one arrives at the amount of Pennsylvania inheritance tax that is due.

A 5 percent discount on the tax is available if a payment of the tax is made “on account” within three months of the date of death. This payment is made to the Register of Wills who acts as agent for the Department of Revenue. Since the discount is 5 percent for paying the tax six months early (the tax is due 9 months from the date of death), on an annualized basis the discount is 10 percent.