The Differences Between Estate and Inheritance Taxes - Rodgers & Associates
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The Differences Between Estate and Inheritance Taxes

These taxes are often confused as referring to the same thing – death taxes. However, they are completely different and are calculated in very different ways.

The Difference Between Estate and Inheritance Taxes

Bill and Ray decided that in order to be finan­cially successful, they would need to become business owners. As both had experience in the hospi­tality industry, they pooled their money to jointly purchase a property just outside of town and open a restaurant.

Ray passed away unexpectedly when they were in their 23rd year of operating the successful restaurant. Bill and Ray had long since paid off their debt and each had named the other as the heir in their wills. Bill expected it would be a simple matter of changing the title solely to his name and later decide what to do with the business. That was before he learned about the Pennsyl­vania inher­i­tance tax.

Estate Tax Rates
The federal government collects an estate tax, along with 17 states and the District of Columbia.

Most people are probably aware of the current debate surrounding the federal estate tax, which was repealed in 2010 and was scheduled to return in 2011 (see table). The Tax Relief Act of 2010 reinstated the tax with a $5 million exemption and a tax rate of 35% for the amount over the exemption. The law is temporary and is scheduled to expire on December 31, 2012. The fate of the federal estate tax will undoubtedly be a big discussion point in the election year.

An estate tax is calcu­lated based on the net value of property owned by a deceased person on the date of death. All entities that currently collect an estate tax give the deceased an exemption from the tax and apply the tax to the net value of the estate above the exemption.

An inher­i­tance tax is calcu­lated based on who receives a deceased person’s property and, in some states, how much they receive. There are currently seven states that collect an inher­i­tance tax (see second table). In all seven, transfers to surviving spouses are completely exempt from the tax, while in four of the seven states (Iowa, Kentucky, Maryland and New Jersey), transfers to surviving children and grand­children are completely exempt from the tax.

The rates for Pennsyl­vania inher­i­tance tax are as follows:

  • 0% on transfers to a surviving spouse or to a parent from a child aged 21 or younger.
  • 4.5% on transfers to direct descen­dants and lineal heirs.
  • 12% on transfers to siblings.
  • 15% on transfers to other heirs, except chari­table organi­za­tions and exempt institutions/government entities.

Inher­i­tance tax payments are due upon the death of the decedent and become delin­quent nine months after the individ­ual’s death. If inher­i­tance tax is paid within three months of the decedent’s death, a 5% discount is allowed.

Inheritance Tax Rates
Currently seven states collect an inher­i­tance tax.

Pennsylvania’s inher­i­tance tax applies to all real estate and to all tangible personal property (such as furniture, vehicles, jewelry, etc.) located in Pennsyl­vania, whether the property is owned by Pennsyl­vania residents or non-residents. It also applies to all intan­gible property of Pennsyl­vania residents (bank accounts, stocks, bonds, mutual funds and patents, etc.). Because Pennsyl­vania inher­i­tance tax will apply to all intan­gible property of a Pennsyl­vania resident no matter where the property is “located,” simply opening a joint account with a bank in another state will not avoid Pennsyl­vania inher­i­tance tax.

In the situation with Bill and Ray, it is the unfor­tunate reality that jointly titled property owned by unmarried partners who reside in Pennsyl­vania is almost always subject to inher­i­tance tax upon the death of one of the partners. Bill was surprised to find out that the real estate was now worth $1.8 million. The restaurant business itself was appraised at $500,000. Their joint ownership meant that half of the value ($1,150,000) would be included in Ray’s estate. Ray also had $300,000 in a retirement account for which he had named Bill as the benefi­ciary.

Ray’s $1,450,000 estate was below the federal estate-tax exemption. However, because he left the estate to a non-relative, it incurred a $217,500 inheritance-tax bill. The property would need to be sold or borrowed against to pay the tax. Bill could also take money out of the retirement account to pay Pennsyl­vania. The withdrawal would not be subject to penalty, but it would be subject to $61,000 of income taxes. Both options have signif­icant drawbacks.

The future of the inher­i­tance tax in Pennsyl­vania is uncertain. Governor Corbett has said that he would like to see the tax repealed. There are currently several bills up for consid­er­ation by the Pennsyl­vania General Assembly that seek to amend or eliminate the tax altogether. Those members who are in favor of a death tax want to see it replaced with an estate tax that mirrors the federal estate tax in some way. Pennsyl­vania collected over $780 million from inher­i­tance taxes in the fiscal year ending June 2011. It will be difficult to eliminate this tax without finding a way to replace the revenue.

Your estate plan should include a provision to deal with Pennsylvania’s inher­i­tance tax. (Ray and Bill could have purchased life insurance on each other to provide cash to pay the tax.) You should consult with your estate planner on other ways to deal with this important issue.

This article origi­nally appeared in Lancaster County magazine