By Daniel B. Evans
Copyright 2003-2005 Daniel
B. Evans. All rights reserved.
Last updated: 1/27/2005
[Originally published in the Philadelphia Bar Association Probate and Trust Law Section Newsletter, Vol. 106, p. 5 (April 2003).]
It is said that hard cases make bad law, but sometimes hard cases force courts to rethink what everyone "knows."
Everyone "knows" that the Pennsylvania inheritance tax is imposed on the beneficial shares of the estate before taxes. So, you figure out what the shares of the estate would be if there were no federal estate tax and no inheritance tax and then apply the appropriate inheritance tax rate to the different shares of the estate. The burden of the tax (i.e., who pays the tax) is a separate issue.
Faced with a somewhat unusual estate, the Commonwealth Court re-examined what we "know" and came up with a very different result, holding that the tax rate on the taxes paid from the residue of the estate should be the rate for the beneficiaries creating the tax, and not the beneficiaries of the residue from which the taxes are paid. In re Estate of Ray Bloom Ross, 815 A.2d 30, 2002 Pa. Commw. LEXIS 1005, 2652 CD 2001, (12/20/2002), rehearing den. (2/12/2003), app. den. 177 MAL 2003 (Pa. Supreme Ct. 7/22/2003). Although the decision was based on unusual facts, the rationale of the decision could change the way the inheritance tax is calculated in many (if not most) estates in the future.
The problem in Ross was that the will left the bulk of the estate in specific gifts to lineal descendants and a relatively small residue to collateral heirs. Also, the will directed that all taxes were to be paid from the residue. As a result, the Pennsylvania inheritance tax and federal estate tax completely consumed the residue, leaving nothing for the collateral heirs. The Commonwealth Court was therefore confronted with an estate which was required to pay inheritance tax at 15% even though the 15% beneficiaries actually received nothing.
The estate argued that the lower tax rate for lineals (6% in this case, because the decedent died in 1999) should apply to the pre-tax residue because it was used to pay the taxes for the benefit of the lineal descendants. Both the Board of Appeals and the Orphans' Court disagreed, saying that the estate was essentially trying to deduct the taxes, which is not allowed. (See 72 P.S. § 9128.)
The Commonwealth Court reversed, holding that the taxes could not be deducted, but that the tax rate for lineals should apply to the pre-tax residue if the taxes paid out of the residue benefitted the lineals and not the collaterals. The court relied on the language of section 2116(a)(1) of the Inheritance and Estate Tax Act (72 P.S. § 9116), which states that the lower rate of 6% (now 4.5%) applies to property passing "to or for the use of" lineal descendants. Because the funds of the residue were "used" to pay the inheritance tax on property passing to lineal heirs, the residue was used for the benefit of the lineal heirs and the the lower tax rate of 6% should apply to the residue. (In a footnote, the court noted that, if the residue were insufficient to pay the tax then the beneficiary would be required to pay the tax directly, which the court said supported its holding that the payment of taxes from the residue benefitted the 6% beneficiaries. P. 8, note 11.)
Some questions to ponder:
Is it critical that the entire residue was consumed by taxes? In other words, does the holding in this case only apply to estates with no residue, or does it apply to estates with enough of a residue to pay taxes and make distributions to beneficiaries? The rationale of the decision, which is that the payment of tax from the residue for pre-residuary gifts is a payment for the benefit of the pre-residuary beneficiaries, should apply whether or not the residue is sufficient to pay the tax. The court also observed that the residue "can fully satisfy the six percent taxes," which means that there might be a small amount left for the residuary beneficiaries (in which case the 15% rate would apply). (P. 8, note 11.) So there is nothing in the decision to indicate that the absence of any residuary distribution was critical to the holding.
Does it matter whether the taxes are paid from the residue by the direction of the decedent or by operation of law? In this case, the will directed that the death taxes be paid from the residue, and the court stated that "Decedent made the decision that any taxes due were to be paid out of the residuary estate" (p. 3) and repeated that the use of the residue to pay the taxes on the gifts to the lineal descendants was "pursuant to instructions to in paragraph NINTH of her will" (p. 8). However, the court also recognized that the same payments would have been made by operation of law in the absence of instructions in the will, in accordance with 72 P.S. § 9144(a). (P. 3, note 7.) In conclusion, the court stated that it was the intent of the decedent "to benefit the collateral beneficiaries only to the extent that monies remained in the residuary estate after the payment of, inter alia, all death taxes." (P. 9) However, such an intent could be inferred even without a specific direction as to the payment of taxes, because the same result would occur by operation of law. All things considered, the existence of a direction in the will to pay the taxes from the residue should not be necessary to the holding in the case. A contrary decision would mean that a will that restates existing law is taxed differently than a will that relies on statutory law without restating it, which makes no sense.
And does the decision only result in a decrease in taxes? Can it work the other way around, and result in an increase in inheritance tax when the residue that would otherwise pass to a lineal descedent is used to pay the inheritance tax on a gift to a collateral heir? What is sauce of the goose is sauce for the gander, and there is no reason to believe that the decision only benefits estates, and never the Department of Revenue. And that is why the decision is so worrisome (and so important), because the more usual estate will make a few specific gifts to friends, collateral heirs, and other 15% beneficiaries, and leave the rest of the estate to lineal descendants, and so the application of the principal of Ross Estate will most often result in an increase in inheritance tax, and not a decrease.
For example, suppose there is a total of $100,000 given to one or more 15% beneficiaries out of a $1,000,000 net estate, with the residue to children or other descendants. Before Ross, the inheritance tax would be $15,000 on the $100,000 in collateral gifts and 4.5% on the remaining $900,000, for a total of $55,500. However, if the tax is paid from the residue and the tax on the residue should reflect the rate for the beneficiary who benefitted from the payment of the tax, then there is a tax on the $15,000 paid from the residue at the rate of 15%, not 4.5%. In fact, the calculation will be circular (tax on a tax on a tax), with a resulting effective tax rate of 17.647% on the $100,000. So $117,647 is subject to tax at 15%, resulting in a tax of $17,647, while the remaining $882,353 is subject to tax at 4.5%, resulting in a tax for the lineals of $39,706, or a total tax of $57,353. Which is $1,853 more than the tax would have been before Ross.
And not only is the tax more in dollars, but (as demonstrated above) it is also harder to calculate, because the taxes have to be applied on the shares of the estate after taxes, which automatically results in a circular calculation.
Having said all that, it must be admitted that the result in Ross is objectively fairer, because the tax rates are based on what beneficiaries actually receive, rather than what the will says that the beneficiaries should have received. So the effect of the decision is to protect beneficiaries from poor estate planning.
Take the situation faced by the court in Ross itself. The "gross estate" was $892,979, but $763,850 was payable to lineal heirs and the remainder was (supposedly) payable to collateral heirs. Ignoring any other deductions, the federal estate tax would have been $65,499 and, according to the Pa. Department of Revenue, the inheritance tax should have been $65,200 (6% on $763,850 and 15% on the rest), for a total death tax liability of $130,699. That would leave $762,280 for the lineal heirs and nothing for the residuary beneficiaries. However, suppose that the lawyer doing the estate planning had done the calculations and thought through the situation in advance, and then convinced the testator to change the will to leave $10,662 to the collateral heirs and the rest of the estate to the lineal heirs. In that case, the inheritance tax would be only $54,538 (15% of $10,662 plus 6% on the rest of the estate), resulting in total death taxes of $120,037, a savings of $10,662. In that case, the lineal heirs would still get the same $762,280 (after taxes), but the collateral heirs would get the $10,662 saved in inheritance tax, a saving due entirely to changes in the will which had no effect on the distribution of the estate other than to change the rate of tax to be applied to the large paid of the estate paid in taxes.
Before the decision in Ross, it was best for Pennsylvania inheritance tax purposes for the death taxes to be paid out of the fund passing to the beneficiaries with the lowest inheritance tax rate. That way, the amounts which are paid in death taxes, and not to beneficiaries, would be taxed at the lowest possible rates. The Ross decision would eliminate this kind of gamesmanship.
As a matter of tax policy, it is desireable for similar situations to be taxed similarly, and the Ross case should allow estates with the same values and the same net distributions to beneficiaries to be subject to the same taxes, regardless of what the governing document might label as the "residue" and which beneficiaries might be labeled as the "beneficiaries" of the amounts paid in taxes. But is the objective fairness worth the costs of more complicated tax calculations? And (most importantly of all) is this the tax system the legislature really intended?
The Ross case was appealed to the Supreme Court, but the Supreme Court denied the appeal. As of this update (January 2005), the Commonwealth Court decision has not yet been cited by any other court, and so it is too soon to tell whether the decision represents another hard case making bad law, or a new and improved look at an old problem.
Until there is a definitive answer from the Supreme Court or the legislature, the issue of the tax rates to be applied to the amounts paid in taxes is going to be debated and disputed and practitioners will need to be aware of the issue for the protection of their clients.
Evans Law Office
Daniel B. Evans, Attorney at Law
P.O. Box 27370
Philadelphia, PA 19118
Telephone: (866) 348-4250