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Inheritance and Taxes

In last week’s article I discussed the tax returns that can arise when administering a decedent’s estate and some of the pitfalls the person responsible for administering the estate should be aware of.  In this article, I will discuss some of the ways in which you can plan ahead to reduce the tax burdens of inheritance on your beneficiaries and prevent some of the administrative challenges.

When you are putting together your estate plans, you should be aware that the inheritance you leave behind to your loved ones will include tax consequences.  Tax consequences might be harsher than you anticipate and can create headaches and hoops for your loved ones to jump through.  Smart estate planning can help maximize the benefit your beneficiaries receive from your estate and manage the tax consequences.

Final Income Tax Returns

                After you pass away, the taxing authorities continue to expect further tax returns from you, and your estate will need to file your final income tax returns.  For you, the process of gathering all of your tax forms and filing them is old hat.  You know what forms to expect and you may have a regular accountant who knows your finances.  Your heirs will need this information.  You should maintain copies of your tax returns for the last five to seven years in an organized file where your heirs can easily locate them.  This will give them a concise picture of your finances and the name of any accountant who can best help your personal representative with your financial records and taxes.

Another pitfall is that difficulties and delays can arise when someone needs to recover a tax refund owed to a decedent.  Although it may seem like a good idea to leave a tax refund as an inheritance in addition to other assets, the refund can cause headaches and delays.  Taxing authorities will not release refunds to just anyone.  They may flag it as identity theft, require additional forms, and force your personal representative to jump through hoops if a refund is due on your final income tax return.  If you are approaching end of life, you should adjust any tax withholding to reduce the likelihood that there will be a refund due after your death.  It is best to plan for your tax return to result in either a $0 balance or a small balance owed.  As an added benefit to your heirs, that final income tax payment is deductible on the Inheritance Tax Return.

Inheritance Tax Return

The Inheritance Tax Return is a state tax filing that applies to property inherited from any decedent who was a resident of Pennsylvania.  The tax is based upon the relationship of the heirs to the decedent.  The inheritance tax rate is 0% for a spouse or a qualifying charity, 4.5% for children or grandchildren, 12% for siblings, and 15% for any other person who receives an inheritance. 

Property subject to inheritance tax includes some items that might not be expected.  For example, if a child held a joint bank account with a parent, half of the balance in that bank account will be taxed as an inheritance to the surviving child, even if the account was entirely funded by the child’s money.  You can prevent some inheritance tax consequences by talking to your estate planning attorney about how your accounts are titled and whether there is a better way to achieve your goals.  In the example given here, the goal may have been convenience, allowing the parent to help manage the child’s finances.  That goal could have been achieved through a Power of Attorney, with the bank account only in the child’s name, thus avoiding inheritance tax on the child’s own money. 

It may also make sense gift some property to your heirs during your lifetime rather than waiting until after you pass away.  Make sure to consult with an attorney before doing so, though.  Over-gifting could result in other consequences.  Gifting too close in time to when you may need long term care could interfere with your eligibility for Medicaid.

Fiduciary Tax Returns for a Trust

                Some people benefit from setting up a trust during their lifetimes or as part of their estate plans.  Some benefits, depending upon the type of trust, include minimizing inheritance tax, providing for a disabled relative, providing for a relative who has trouble managing money, protecting assets from creditors, assisting with Medicaid eligibility and providing for a Medicaid beneficiary’s supplemental needs, setting aside money or property for a child, or to benefit a charitable cause that is near and dear to your heart.  The trust can be provided for in your will, which causes it to be created after your death if certain circumstances are met, or it can be created immediately during your lifetime.  If the trust is created immediately, you should know how it will be treated for tax purposes, so the Trustee appointed to manage that trust can meet their tax reporting obligations.  If the trust is provided for upon your death, you should have a conversation with your designated Trustee so they understand what their obligations will be when the time arises. 

                Most Trusts file a Form 1041 and PA-41 Fiduciary Return to report the Trust’s income and distributions.  This should be prepared by a tax professional who is familiar with the Internal Revenue Code’s trust provisions and has reviewed the trust instrument. 

Grantor Trusts, which are a popular tool used for estate planning purposes, have an unusual tax treatment.  During the Grantor’s lifetime, the Grantor Trust is a disregarded entity for tax purposes.  Any income to the Grantor Trust gets reported on the Grantor’s 1040 personal income tax return as though the Trust did not exist.  That allows you to have the benefit of a trust without added complication to your tax filings.  After you pass away, your Trustee will need to report the Trust’s income on a Fiduciary return until it is wound up.  You should make sure to provide your Trustee with a copy of the Trust Instrument and discuss its tax treatment with them in advance, so they are not surprised by it.

Kelly Walsh Appleyard, attorney