Is the Pennsylvania Personal Property Tax Constitutional?

By Daniel B. Evans
Copyright © 1996-1998 Daniel B. Evans. All rights reserved.

[First published 4/10/96; last revised 10/10/98]

Is the Pennsylvania personal property tax constitutional?

No, according to Judge Smyth of the Court of Common Pleas of Montgomery County, but his recently published conclusions of fact and law, Interim Report, Annenberg v. Com. of Pennsylvania, Montg. C.P. No. 98-08615, Sup.Ct. Misc. Nos. 003 and 004 of 1997 (Oct. 7, 1998), may not provide any relief to any taxpayers in Pennsylvania.

The issue of the constitutionality of the personal property tax arose out of the decision of the United States Supreme Court in Fulton Corp. v. Faulkner, 516 U.S. 324 (1996), in which the Supreme Court found that a similar tax in North Carolina was unconstitutional as a violation of the Commerce Clause of the U.S. Constitution because it discriminated between the stock of corporations that did business in North Carolina (and paid North Carolina taxes) and corporations that did no business, the tax falling on the stock of the out-of-state corporations. Shortly afterwards, several residents of Pennsylvania (including Walter H. Annenberg) sued for refunds of the Pennsylvania personal property tax, relying on a statute in Pennsylvania allowing actions for refunds on taxes paid to counties (and other political subdivisions) within the preceding three years if the county was not “legally entitled” to the tax.

In an order issued April 7, 1998, the Pennsylvania Supreme Court agreed that the personal property tax is facially discriminatory, and remanded the issue to a trial court for hearings and a determination on whether the tax was “compensatory” and constitutional, or unconstitutional and, if unconstitutional, what remedy is appropriate for taxpayers who have paid the tax or have been billed for the tax. Annenberg v. Commonwealth, et al., Slip Opinion J-109-1997 (Pa. Supreme Court, 4/7/98). The hearings were held in Montgomery County before President Judge Joseph A. Smyth, who determined that the tax is not “compensatory” but that the exclusion for stock of Pennsylvania corporations could be severed from the rest of the tax, and that it was the exclusion that was unconstitutional, not the tax itself.

If adopted by the Pennsylvania Supreme Court, Judge Smyth’s determinations will probably mean that there will be no refunds for taxpayers, and that the counties may collect a personal property tax on all stocks, both of Pennsylvania corporations and of corporations operating outside of Pennsylvania.

What is the Pennsylvania Personal Property Tax?

The “personal property tax” is a tax on various forms of intangible personal property, such as stocks, bonds, and certain other forms of indebtedness. There are a number of exemptions, including an exemption for the stock of corporations which are subject to the Pennsylvania capital stock tax or franchise tax. Act of June 17, 1913, P.L. 507, §1. It is that exemption that causes the constitutional problem.

What is the Commerce Clause?

Article I, Section 8, clause 3, of the Constitution of the United States gives Congress the power to “regulate Commerce … among the several States….” That provision has long been interpreted as both giving power to Congress and restricting the power of the states. Congress has the power to regulate businesses and business activities that affect more than one state, and states are prohibited from enacting legislation that restricts or burdens commerce that crosses their borders from another states. As a result, a state cannot impose a tax that falls more heavily on businesses from another state than on businesses within the state.

The Fulton Decision

In Fulton Corp. v. Faulkner, 516 U.S. 324 (1996), the U.S. Supreme Court was asked to review the constitutionality of the North Carolina personal property tax. Like Pennsylvania, North Carolina taxed corporate stock, and distinguished between corporations already paying taxes to the state and those not paying any taxes. Under the North Carolina system, a corporation paid corporate income tax on that portion of it’s income attributable to operations in North Carolina. The stock of the corporation was then subject to personal property tax in the hands of the shareholders in the same percentage that the income of the corporation was not subject to income tax in the state. So the stock of corporation which operated entirely within North Carolina was not subject to the personal property tax, while the stock of a corporation which did not earn any income at all in North Carolina was entirely subject to the personal property tax. If a corporation earned 5% of its income in North Carolina, then 95% of the value of the stock was subject to personal property tax.

The Supreme Court recognized that the tax discriminated between corporations that operated within the state and corporations that did not operate within the state. However, it also recognized that a tax may be applied to interstate commerce if the tax is “compensatory” and simply makes interstate commerce bear a tax burden already borne by commerce within the state. The classic example of a “compensatory” tax is a “use” tax imposed on personal property purchased outside of the state and brought into the state to be used there. A use tax that is equal to the sales tax already imposed by the state has been held to be constitutional because the consumer pays the same tax in each case, either at the time of purchase within the state or at the time the property is brought into the state from another state.

Based on earlier decisions, the Supreme Court declared that there were three conditions that a discriminatory tax must satisfy in order to be constitutional:

1. The state must identify the tax burden within the state for which the state is attempting to compensate;
2. The tax on interstate commerce must roughly approximate the tax on commerce within the state; and
3. The taxable events must be “substantially equivalent” for the interstate and intrastate taxes.

Applying those tests to the North Carolina tax, the court unanimously found that the tax failed all three tests.

Applying Fulton to Pennsylvania

The similarities between the North Carolina personal property tax and the Pennsylvania personal property tax suggest that the Supreme Court would hold that the Pennsylvania tax is unconstitutional as well. A review of the opinion of the court, and the discussions of why the North Carolina tax failed the three part test described above, shows that the Pennsylvania tax is no more constitutional than the North Carolina tax, and may be less constitutional.

• When comparing the intrastate tax for which the interstate tax is supposed to compensate, the court held that the intrastate tax must serve a purpose for which the state may impose a burden on interstate commerce. North Carolina claimed that the tax on the value of corporate stock compensated the state for the income tax it could not collect on out- of-state income. However, the court held that North Carolina had no right to tax incomes earned outside of the state. Pennsylvania personal property tax appears to be linked to the capital stock tax or franchise tax. The capital stock tax is a property tax on domestic entities, and the franchise tax is a privilege tax on foreign organizations doing business in Pennsylvania. However, both taxes are calculated in the same way, based on a series of formulas that calculate stock values from net worth and net income, then apportion the value between activities in Pennsylvania and activities outside of Pennsylvania. Like North Carolina, Pennsylvania has no right to tax property outside of Pennsylvania or the privilege of doing business outside of Pennsylvania, so the personal property tax on the stock of corporations doing business outside of Pennsylvania does not serve a purpose for which the state may impose a burden on interstate commerce.North Carolina attempted to justify the personal property tax on the grounds that the tax was a payment for the privilege of access to the capital markets of the state, which other corporations supported through payment of the corporate income tax, but Supreme Court rejected that argument, quoting from Oregon Waste Systems, Inc. v. Department of Environmental Quality of Ore., 511 U.S. ___ , ___ (slip opinion at 13, n. 8), (1994), holding that “(p)ermitting discriminatory taxes on interstate commerce to compensate for charges purportedly included in general forms of intrastate taxation would allow a state to tax interstate commerce more heavily than in-state commerce anytime the entities involved in interstate commerce happened to use facilities supported by general tax funds.” There is no reason to believe that Pennsylvania could distinguish itself from North Carolina on this issue, or advance a more convincing argument.

   

   

• The Supreme Court also held that North Carolina had failed to show that the tax on interstate commerce be shown “roughly to approximate” the tax on intrastate commerce. Although North Carolina attempted to show that the personal property tax burden might be similar to the corporate income tax burden, the Supreme Court rejected the argument as a comparison of “apples to oranges,” because a corporate income tax supports a wide range of government services, while the personal property tax was supposedly imposed to support capital markets in North Carolina, and the court held that North Carolina could not carry its burden of proving what proportion of the corporate income tax goes to support the capital market, or whether that proportion represents a burden greater than the one imposed on interstate commerce by the intangibles tax. Pennsylvania would have an even greater burden of proof, because the North Carolina personal property tax was at least proportionate to the income of the corporation outside of the state, while the stock of a corporation that is “subject” to the capital stock or franchise tax to Pennsylvania is wholly exempt from the Pennsylvania personal property tax even though the corporation pays little or no tax to Pennsylvania. For example, a foreign corporation that conducts a small percentage of its business in Pennsylvania will pay a franchise tax on a small percentage of its income and net worth, yet its stock will be entirely exempt from Pennsylvania personal property tax. However, the personal property tax will apply in full to the stock of an otherwise identical corporation with no operations in Pennsylvania. Within this statutory framework, it will be impossible for Pennsylvania to show any equivalence between the capital stock/franchise tax burden and the personal property tax burden. 
• Finally, the Supreme Court held that the North Carolina personal property tax and corporate income tax did not fall on events that were “substantially equivalent,” despite evidence that net income and stock values were closely related, because the taxes were “apparently different in a number of obvious respects, including the parties ostensibly taxed.” North Carolina tried to argue that a tax on shareholders could be equivalent to a tax on a corporation, but the court was not convinced, and expressed doubt that any such showing could ever be made outside the limited confines of sales and use taxes. Pennsylvania would have the same difficulties in claiming that the personal property tax and the capital stock/franchise tax are “substantially equivalent” because, like North Carolina’s taxes, the two taxes fall on different taxpayers. There are other differences between Pennsylvania’s taxes that could cause even greater problems. For example, there is a manufacturing exemption for the capital stock/franchise tax in Pennsylvania, but no equivalent exemption for the personal property tax. A corporation that derives all of its income from manufacturing in Pennsylvania would pay no capital stock/franchise tax in Pennsylvania, and its shareholders would pay no personal property tax. However, the personal property tax would apply to the shareholders of a corporation with the same manufacturing operations entirely outside of Pennsylvania. The capital stock/franchise tax and the personal property tax are simply too different to be considered “substantially equivalent.”

There is, therefore, no reason to believe that Pennsylvania’s personal property tax is distinguishable from the North Carolina tax (at least not in ways that are helpful to Pennsylvania), and every reason to believe that Pennsylvania’s personal property tax is unconstitutional.

Judge Smyth’s Determinations

In the hearing before Judge Smyth, the counties of Pennsylvania that had been imposing the personal property tax attempted to prove that the tax was “compensatory,” meaning that the tax on the stock of corporations not doing business in Pennsylvania was roughly equivalent to the capital stock or franchise tax paid by corporations doing business in Pennsylvania. In his recently published Interim Report, Judge Smyth concluded that the Pennsylvania personal property tax was not “compensatory,” because the capital stock and franchise was not part of a comprehensive scheme of taxing corporations, it does not roughly approximate the personal property tax, and imposes a tax based on “events” that are not similar to the personal property tax.

In its 4/7/98 opinion and order, the Pennsylvania Supreme Court concluded that the personal property tax was discriminatory and unconstitutional unless it was “compensatory,” and Judge Smyth concluded that the tax was not “compensatory.” However, Judge Smyth also concluded that it was not the tax that was unconstitutional, but the exclusion from tax of the stock of corporations not doing business in Pennsylvania. There is a general law that declares that the provisions of statutes in Pennsylvania are “severable.” See 1 Pa.C.S. § 1925. This means that, if a provision of a statute is invalid for any reason, only that one provision should be invalid, and not the entire statute, unless the entire statute cannot (or was not intended to) exist without the invalid provision. In this case, Judge Smyth found that the personal property tax existed in Pennsylvania for more than 50 years without the exemption for the stock of corporations that are subject to the capital stock or franchise tax (i.e., corporations doing business in Pennsylvania), and so the tax could exist without the exemption. Judge Smyth also concluded that the Pennsylvania legislature would have enacted the tax without the exemption if it had known that the exemption was invalid. (Interim Report, page 25.)

What does Judge Smyth’s Decision Mean?

If the personal property tax itself is constitutional and only the exclusion is constitutional, does that mean that the counties not only don’t need to refund any money, but can now go back and collect additional taxes on the value of stocks of Pennsylvania corporations and corporations doing business in Pennsylvania? Not according to Judge Smyth, who said the ruling should operate “prospectively only,” and that the counties can collect a personal property tax on stock of domestic corporations only after adopting new tax resolutions or ordinances.

This portion of Judge Smyth’s report, dealing with the remedies of taxpayers and the powers of the counties, is the most troubling. Judge Smyth concludes that “Since the exclusions are unconstitutional, leaving a valid tax, counties should be permitted to retain and collect the personal property tax on stock that is not subject to the capital stock or franchise taxes.” (Interim Report, page 26.) In other words, counties can keep the money already collected and can even continue to collect the tax. By why? Why are the counties allowed to retain monies collected under a tax system that is admittedly unconstitutional? Even more puzzling is why counties can continue to collect a tax imposed under an unconstitutional system. The only explanation provided by Judge Smyth is that counties and taxpayers “have planned their financial affairs” on the assumption that the tax was constitutional. (Interim Report, page 26.) Is that it? The fact that the Constitution has been violated, and continues to be violated, is all right because the counties had relied on it? Despite the legal and logical flaws in Judge Smyth’s opinion, it is quite likely that the report will be adopted by the Supreme Court of Pennsylvania, and quite likely that the Supreme Court of the United States will not hear any appeal on this dispute.

What Should You Do?

Although it is likely that there will be no refunds of Pennsylvania personal property tax, taxpayers who want to preserve the possibility of a refund must find a claim for a refund, because the present action by Walter H. Annenberg, even if ultimately successful, will not eliminate the need for each taxpayer to file a separate refund claim, and will not stop the statute of limitations from running on refund claims.

In order to obtain a refund of personal property tax to which a county or other political subdivision is not entitled, the taxpayer must file a written claim for refund within three years after the tax is paid. Act of May 21, 1943, P.L. 349, § 1, as amended, 72 P.S. § 5566b. Therefore, if you have paid any personal property tax within the last three years, you can file a refund claim before the end of the three year period.

Taxpayers who did not pay the personal property tax and are now facing collection efforts by the counties also face a difficult choice. It is possible that the Pennsylvania Supreme Court might distinguish between refund claims for past taxes and collection actions, holding that the counties do not need to pay refunds but cannot force a taxpayer to pay a tax that is admittedly unconstitutional, but it is more likely that the Supreme Court will follow the lead of Judge Smyth and agree that the counties may continue to collect the tax for past years. In that case, continuing to delay payment may result in nothing more than additional interest (and possible penalties).

 

Shareholder Agreements

By Daniel B. Evans
Copyright © 1995 Daniel B. Evans. All rights reserved.

Agreements among the shareholders of a corporation can take a number of different forms, and it is important to consider all possible options.

PERMITTED TRANSFERS. An agreement can prohibit all transfers, or it can permit gifts to certain family members, outright or in trust, and during lifetime or at death. (Permissible recipients can be limited to the founders, their issue, and the spouses of issue, so that stock does not pass to parties unrelated to the original shareholders.)

REDEMPTION OR CROSS-PURCHASE. An agreement can require (or allow):

• Redemption of stock by the corporation;

• Cross-purchases by the other shareholders; or

• Both an option to the corporation to redeem and an option to the shareholders to purchase any stock not redeemed.

MANDATORY OR OPTIONAL SALES. When a death or other triggering event occurs, the rights of the parties will fall into one of three possible patterns:

• Mandatory buy-sell. The shareholder is required to sell and the corporation (or other shareholders) is required to buy.

• Call option. The shareholder is required to sell if the corporation (or the other shareholders) decide to buy, but they are not required to buy.

• Put option. The shareholder can decide whether or not to require the corporation (or the other shareholders) to buy, but they cannot require the shareholder to sell.

EVENTS REQUIRING SALES OR OFFERS. An agreement can provide for sales or redemptions of stock in any or all of the following cases:

• Voluntary offers to sell to a third party. (The rights of the corporation or shareholders to purchase stock before it can be sold to another person is sometimes called a “right of first refusal.”)

• Bankruptcy, insolvency, or involuntary attachments. So that stock does not wind up in the hands of creditors or trustees for creditors.

• Death of the shareholder.

• Disability of the shareholder, making him or her unable to work for the corporation.

• Termination of employment with the corporation (other than by death or disability).

An agreement can deal with different situations in different ways. For example, an agreement could give the corporation the option to purchase stock in the event of an insolvency or third party offer, but could also give a shareholder the right to require the redemption of stock in the event of death or disability.

PURCHASE PRICE. The purchase price for shares to be sold or redeemed can be determined in a number of different ways:

• Third party offer. When the corporation or other shareholders have a right of first refusal, the option price is usually the price offered by the third party.

• Independent appraisal. An independent third party can be hired to appraise the stock of the company and set the purchase price.

• Book value formula. The audited financial statements of the corporation can be used as the basis for the purchase price, and there may be adjustments for the appraised value of real estate and tangible assets, discounts of inventory or receivables, or a predetermined value for “goodwill.”

• Earnings formula. The current year’s earnings, or an average of two or three recent years, can be multiplied by a predetermined “capitalization factor” (or price/earnings ratio) to determine a value for the corporation.

• Periodic agreements. The shareholders can agree to set a value themselves, and review that value periodically. (This works best of all of the shareholders are equally likely to buy or sell stock, so that no shareholder will have a reason to undervalue or overvalue the stock.)

OTHER TERMS. An agreement can also provide for:

• Installment sales of stock, so that the corporation or purchase shareholders can pay the purchase price in installments, with interest. The unpaid purchase price is usually evidenced by a note, and there is usually a security interest in the stock sold.

• Escrow of certificates, so that the certificates are held by a third party, who enforces the agreement.

• Arbitration of any disputes.

 

 Rights of Families of Comatose Patients

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By Daniel B. Evans
Copyright © 1996 Daniel B. Evans. All rights reserved.

The Pennsylvania Supreme Court has recently upheld the right of the family of a patient in a permanent vegetative state to remove life support from the patient without court approval and without a written advance health care declaration (or “living will”), provided at least two doctors agree with the decision. However, other family members, doctors, hospitals, or other interested parties who disagree with a family’s decision to remove life support can still challenge the decision in court. In re Fiori, 543 Pa. 592, 673 A.2d 905, 1996 Pa. LEXIS 551 (April 2, 1996), aff’g, 438 Pa. Super. 610, 652 A.2d 1350 (1995).

This decision will make it easier to remove life support when there is no advance health care declaration. However, the decision only applies to patients in a “permanent vegetative state,” while an advance health care declaration would allow a family to terminate life support or other medical treatments when the patient is suffering from a terminal condition (an incurable and irreversible medical condition that will result in death), but not in a “permanent vegetative state”. Another advantage to an advance health care declaration is that it make your wishes known and can reduce the possibility of disputes within your family or between your family and your doctors.

 

What is the Inheritance Tax Rate on the Inheritance Tax?

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).]

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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 Facts

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.)

Applying the Holding

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.

Promoting Fairness

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?

Conclusion

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.

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Pennsylvania Inheritance Tax Marital Exemption

By Daniel B. Evans
Copyright © 1995 Daniel B. Evans. All rights reserved.

By Act 21 of 1995, Pennsylvania finally joined the federal government and most other states in exempting transfers to a surviving husband or wife from death taxes.

Pennsylvania began phasing out the inheritance tax on transfers to a surviving husband or wife with the enactment of Act 48 of 1994, but the exemption was supposed to be adopted in stages over four years. Beginning July 1, 1994, transfers to a husband or wife were subject to Pennsylvania inheritance tax of only 3%, instead of the 6% that had previously applied. In 1996 and 1997, the tax was to have been reduced to 2% and 1%, and then eliminated in 1998. However, the legislature has accelerated the reduction, and the zero tax rate will apply retroactively to all deaths in 1995.

Beginning January 1, 1995, there is no tax on transfers to a surviving spouse. There is also not tax on transfers to a trust for the surviving spouse if the trust is for the sole benefit of the spouse during the spouse’s lifetime (unless the executor elects for the inheritance tax to apply to the trust). However, the full value of the trust will be taxed on the death of the spouse.

When an estate passes into a trust and the surviving spouse is a beneficiary of a trust but not the sole beneficiary (or the spouse is the sole beneficiary but the executor elects to have the trust taxed), the interests of the surviving spouse and the remaindermen (usually children or other relatives) must be valued separately, and the inheritance tax applied to the value of the interests other than the interests of the surviving spouse. For example, the actuarial value of a life interest in a trust might be 85% for a fifty-five year old widower, so that 85% of the value of the trust would be free of tax and the remaining 15% of the trust would be taxed at 6%.

Before the 1995 amendments of the inheritance tax laws, the rules regarding the taxation of a trust after the death of the surviving spouse could have caused problems for wills and estates that pour over into revocable trusts or irrevocable life insurance trusts, because non-taxable assets (like life insurance) might have been mixed with taxable assets in a trust for the sole benefit of the surviving spouse and would have become taxable upon the death of the spouse. The flexible election provisions of the new law should allow families to avoid unnecessary taxes as long as the correct tax decisions are made after the death of a husband or wife.