Same-Sex Marriages and Employee Benefits

The Internal Revenue Service (IRS) has issued a notice providing guidance on the application of the decision in Obergefell v. Hodges, 576 U.S. ___, 135 S.Ct. 2584 (2015), to retirement plans qualified under section 401(a) of the Internal Revenue Code (Code) and to health and welfare plans, including cafeteria plans under section 125 of the Code.  Notice 2015-86, 2015-52 IRB 1 (12/9/15).

“Personal Effects” Included Automobile; Priority of Gifts Among Children

Provision of will directing executor to pay the costs of delivering “such tangible property” expanded the meaning of “personal effects” to include a gift of automobiles, which is consistent with a previous will and a summary of that will prepared by the decedent’s lawyer.  It was the intention of the testator that his four children should receive equal gifts, and so a cash gift to one child should have the same priority as gifts of real property to the other three children, and cash gifts to step-children will abate.  Lozinak Estate, 5 Fid.Rep.3d 398 (O.C. Montg. 2015) (opinion by Ott, J.)

Beneficiary not Entitled to Lease or Buy Property, and Letter is not Codicil

Administrator properly rejected offers of one beneficiary to rent or purchase real estate owned by decedent, and letter from the decedent, which expressed a desire that the beneficiary reside at the property, was not a codicil because it expressed no testamentary intention to transfer the property to the beneficiary.  Smolsky Estate, 5 Fid.Rep.3d 392 (O.C. Bucks 2015), aff’d, No. 2182 EDA 2015 (Pa. Super. 2/4/2016) (memorandum by Platt, J.), pet. for app., No. 193 MAL 2016 (Pa.).

Inheritance Tax on IRA Paid from Residue; Guidelines for Executor Commissions and Attorney Fees

Estate’s payment of inheritance on individual retirement accounts was proper when will directed that “all taxes that may be assessed in consequence of my death” be paid “from my residuary as a part of the expense of the administration of my estate.”  Reasonable executor commission and attorney fees determined in accordance with guidelines different from Johnson Estate, with a reduction in attorney fees for accountant fees for preparing tax returns.  Donofrio Estate, 5 Fid.Rep.3d 384, 96 Wash.Co.Rep. 16 (O.C. Wash. 2015).

New Orphans’ Court Rules

The Supreme Court has entered an order adopting new Orphans’ Court rules, generally effective September 1, 2016.  In re: Order Rescinding and Replacing Rules 1.1 through 13.3 and Rule 17, and Amendment Rules 14.1 through 16.12 of the Pennsylvania Orphans Court Rules, No. 682 Supreme Court Rules Docket (12/1/2015), 45 Pa.B. 7098 (12/19/2015).

The Orphans’ Court Procedural Rules Committee Report, summarizing and explaining the rules, states that in response to some of the comments that were received some revisions were made to the rules as originally proposed, but it is not immediately apparent which of the proposed rules were revised.  [Update: An unofficial copy of a comparison between the proposed rules and the final rules can be found here.]

We hope to provide some commentary on the new rules in the near future.

[Update (12/15/14): On 12/14/2015, the Supreme Court entered an amended order, the purpose of which was reportedly to correct the underlining and brackets for some additions and deletions to Chapter 14 (incapacitated persons) and Chapter 16 (abortion control).]

[Update: The Supreme Court entered a later order regarding the review of local rules for which there is a “continued necessity.”]

Preliminary Objections Sustained

Preliminary objections sustained to civil complaint transferred from the Civil Division of Philadelphia County to the Orphans’ Court of Montgomery County after challenges to will and trust document had already been dismissed in Montgomery County, although claims of fraud and tortious interferece with inheritance were dismissed without prejudice to replead.  Kaplan Estate and Trust, 5 Fid.Rep.3d 379 (O.C. Montg. 2015) (opinion by Murphy, J.)

No Reallocation of Inheritance Tax from Charitable Shares

Direction in will that all estate, inheritance, and other death taxes be paid “out of and charged against my estate” overcame statutory direction that inheritance tax be paid from shares of estate subject to tax, and not from charitable shares. Davis Estate, 128 A.3d 819,  2015 PA Super 249 (2015), rev’g 5 Fid.Rep.3d 8 (O.C. Erie 2014).

Surrogacy Contract Upheld

In an appellate case of first impression, the Superior Court has upheld the validity of a surrogacy contract, finding that the contract did not violate public policy and that, under the contract, the woman who was the “intended parent” under the contract was a parent of the child even though she was neither the gestational mother nor the biological mother (the egg coming from an egg donor).  In re: Baby S, 2015 PA Super 244, No. 1259 EDA 2015 (11/23/2015), aff’g 5 Fid. Rep. 3d 221 (O.C. Montg. 2015) (Opinion by Ott, J.).  Both the Orphans’ Court and the Superior Court placed significant reliance on the 20-year existence of policies and procedures of the Pa. Department of Health for birth registrations for babies born through assisted conception, the Superior Court concluding that:

“The legislature has taken no action against surrogacy agreements despite the increase in common use along with a DOH policy to ensure the intended parents acquire the status of legal parents in gestational carrier arrangements. Absent an established public policy to void the gestational carrier contract at issue, the contract remains binding and enforceable against Appellant.”

Constitutionality of Decoupling

[This article was originally published in Probate & Property, Vol. 19, No. 4, p. 22 (July/August 2005).]

The year 2004 marked the end of the federal estate tax credit for state death taxes, and the end of any state death tax in those states that have relied exclusively on a “pick-up tax” equal to the federal credit allowed. Seventeen states, however, are “decoupled” and will continue to impose a tax based on the state death tax credit as it existed under the Internal Revenue Code that was in force at the beginning of 2001, before Congress began the phase-out of the state death tax credit. But is it constitutional for a state to impose a tax based on the federal taxable estate if that taxable estate includes real property or tangible personal property located in other states?

Under Supreme Court decisions from 1925 and 1949, it is unconstitutional for a state to impose a succession tax on tangible property, whether real or personal, that is located in another state, and practitioners representing estates with tangible property in more than one state should challenge attempts by any state to impose a tax based on a value that includes tangible property in another state.

Decoupling

Under Code § 2011 as it existed before the enactment of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), Pub. L. No. 107-16, 115 Stat. 38 (2001), estates were allowed a credit against the federal estate tax for death taxes paid to the state, but the credit was limited to an amount determined by applying a progressive schedule of rates against the federal taxable estate. EGTRRA reduced the credit by 25% for deaths in 2002, by 50% for deaths in 2003, and by 75% for deaths in 2004, then replaced the credit with a deduction for deaths in 2005 and later years.

Before EGTRRA, most states had state death taxes that were simply equal to the amount of the credit allowed against the federal estate tax. (Some states had separate inheritance, succession, or estate taxes, but even those states imposed a tax equal to the difference, if any, between the separate tax and the credit, so that every state imposed a death tax that was at least equal to the federal credit.) These “pick-up taxes” cost the residents of the state nothing because if the state did not impose the tax then the federal tax would be increased dollar-for-dollar and the same total amount of tax would be paid. The taxes were also easy to administer because the IRS would audit estate tax returns and check to see that the state death tax was actually paid, so all the states had to do was sit back and collect the money.

After EGTRRA, every state was faced with a choice: either change its death tax system or suffer a loss in tax revenues as the federal credit was phased out. In some states, the statutory definition of the state death tax was based on the Internal Revenue Code as of a date before EGTRRA, so in those states the pick-up tax would be calculated according to pre-EGTRRA law (and without any phase-out of the credit) until the state legislature amended the statutes to change the cross-reference to the Code. In those states, all the legislature needed to do was nothing.

In other states, the legislatures decided to roll back the clock and stop the phase-out, by changing the law to define the state death tax by reference to federal law as it existed before EGTRRA.

Regardless of how they got there, seventeen states are now”decoupled” and are claiming a state death tax based on a percentage of the federal “adjusted taxable estate” as defined in Code § 2011. But is that constitutional if the federal taxable estate includes tangible property located in another state?

State Taxes and the Constitution

Most lawyers and accountants know that there are geographical limits to what states can tax. So, for example, it has been held to be a violation of the Due Process Clause of the Fourteenth Amendment for states to impose taxes on the value of property outside of the state. Compare Union Refrigerator Transit Co. v. Kentucky, 199 U.S. 194 (1905). The same principle applies to the taxation of decedent’s estates. (The same principle does not apply to income taxes, because a tax on the receipt of income is not the same as a tax on the property itself, and so a state may tax a resident on income received from property located outside of the state.  New York ex rel. Cohn v. Graves, 300 U.S. 308 (1937).)

In Frick v. Pennsylvania, 268 U.s. 473 (1925), the Supreme Court ruled that Pennsylvania could not impose a tax on the value of tangible personal property that was located outside of Pennsylvania (in New York and Massachusetts), even though the property was owned by a decedent who was domiciled in Pennsylvania, because Pennsylvania had no power over property outside of the state. In Treichler v. Wisconsin, 338 U.S. 251 (1949), the court applied the same reasoning to hold that Wisconsin could not impose a tax on the estate of a decedent who was domiciled in Wisconsin when (1) the tax was a percentage of the federal estate tax payable and (2) the federal taxable estate included property located outside of Wisconsin. The tax was held to be invalid to the extent that it was measured by tangible property outside of Wisconsin.

These cases have never been overruled and were cited with approval as recently as 1982, when the Supreme Court stated that “[p]hysical presence also is required to justify a state succession tax on the transfer of real property occasioned by the death of the owner.” Cory v. White, 457 U.S. 85, 98-99 (1982).

Effects of Decoupling

Before decoupling, pick-up taxes sometimes resulted in what amounted to a tax on property outside of the state, but it did not matter because it never cost any estate any money.

Before decoupling, every state had a pick-up tax and every state dealt with the problem of property in other states in one of three different ways. When a resident decedent had property in another state, the pick-up tax was either (1) reduced by the proportion of the federal taxable estate located outside of the domiciliary state, (2) reduced by any death tax imposed by the other state on the property located within that other state, or (3) reduced by the lesser of (1) or (2). Some of these formulations meant that a state might get more than its proportionate share of the federal credit, but only if the total of the state death taxes did not exceed the federal credit. (This would happen if, for example, there was property in another state, but that other state claimed a death tax that was less than a proportionate part of the federal credit. In that case, the domiciliary state would take the difference as part of its tax.)

As long as the total state death taxes did not exceed the federal credit, the estate would not be able to complain, even if the state claimed a credit attributable to property in another state. The estate would not be able to complain because the amount of the tax was a credit against the federal estate tax, and if the total amount of the state taxes did not exceed the federal credit, then the estate would have no standing to complain because there was no additional tax to pay and so no damage or loss to the estate.  Any reduction in a pick-up tax would have increased the federal estate tax by the same amount, leaving the estate in the same position as before.  In other words, “no harm-no foul.” (The Pennsylvania Supreme Court relied on this rationale in rejecting a challenge to the Pennsylvania estate tax in Knowles’s Estate, 145 A. 797 (Pa. 1929).  The IRS, however, could still object to an unconstitutional state death tax.  In Rev. Rul. 56-230, 1956-1 C.B. 660, the IRS announced that it would refuse to allow a credit for state death taxes claimed on property located outside of the taxing state.)

Decoupling has changed all that.  Some states are now imposing a state death tax based on the federal taxable estate, even though there is no longer a federal credit for the tax, so there can be an additional cost to the estate and the estate has standing to complain.  And there is reason to complain, because many states are no longer imposing any death tax and so states that have decoupled are now collecting taxes on property located in states that have not decoupled.  For example, if a decedent who was a resident of New York or New Jersey (both of which have decoupled) also owned a condominium in Florida (which now imposes no death tax), the death tax imposed by New York or New Jersey will be as unconstitutional as the death tax imposed by Wisconsin in the Treichler case. The New York or New Jersey tax will be based on the value of the federal taxable estate, the federal taxable estate will include the value of property located out of state, and the tax on that property will be unconstitutional.

Of the seventeen jurisdictions that are decoupled, twelve will reduce the decoupled tax only by taxes actually paid to another state and will therefore be taxing property outside of the state when the other state imposes no death tax. Those twelve jurisdictions are the District of Columbia, Illinois, Kansas, Maine, Massachusetts, Nebraska, New Jersey, New York, North Carolina, Vermont, Virginia, and Washington. The five states that will reduce the decoupled tax in proportion to the value of property outside of the state (which is the constitutional formula) are Maryland, Minnesota, Oregon, Rhode Island, and Wisconsin.

Nondomiciliary States

A similar problem can arise with nondomiciliary states, but most nondomiciliary states calculate the decoupled tax in proportion to the value of the property located in the state compared to the value of the entire federal taxable estate, which is constitutional.

One state that initially tried to collect more than a proportion of the decoupled tax was New York, but the constitutional issue was recognized and the law has been amended to make the tax proportionate. For a discussion of the constitutional issue, see Mal L. Barasch & Kara B. Schissler, The New York Non-Resident Estate Tax: A Tax That Can Be Less Than It Seems to Be, 36 NYSBA Trusts and Estates Law Section Newsl. No. 4 (Winter 2003).

Tax Rates

For both domiciliary states and nondomiciliary states, it could also be argued that there is a problem even if the decoupled tax is apportioned between the states, because the rate table in Code § 2011 is progressive and the use of the federal taxable estate as the tax base causes the property in any one state to be taxed at a higher rate than would be the case if the same rate table were applied only to the value of the property in that state.  So, for example, if $2 million of a $8 million estate were located in a decoupled state, a proportionate tax would be $193,300–one-fourth of the $773,200 tax on $8 million–while the tax on a $2 million taxable estate would be only $99,600. It could be claimed that the increase in tax rates caused by the inclusion of property outside of the states is unconstitutional.

Unfortunately, the Supreme Court considered this argument in 1919 and rejected it.  Maxwell v. Bugbee, 250 U.S. 525 (1919).  The reason the Supreme Court rejected the argument was that the issue was not whether the state had the power to tax the property, but whether it was applying a proper rate of tax, and the constitutional standard is different. When applying the Equal Protection Clause to challenges to the rates of taxes imposed by states, courts have applied the “rational basis” test, which is a very minimal standard. Courts have therefore allowed different tax rates for different beneficiaries with different relationships to the decedent, as well as progressive tax rates for larger inheritances.  See, e.g., Magoun v. Illinois Trust and Savings Bank, 170 U.S. 283 (1898).  The imposition of a progressive tax rate based on property outside of the taxing jurisdiction is just as defensible.  (Similar constitutional arguments have been made about the so-called ” kiddie tax,” which causes the unearned income of a minor child to be taxed at the marginal tax rates of the parent, and the constitutionality of that tax has been upheld by at least two federal district courts.)

Conclusion

Even simple laws often have consequences that are difficult to predict. Decoupling may have seemed like a simple solution to states facing a loss of revenue after Congress decided to phase out the state death tax credit, but it has raised some complex issues, including the constitutionality of a state attempting to tax the value of tangible property located in another state. Lawyers and accountants representing estates with property in more than one state should be mindful of the constitutional issue and should resist overreaching by the states that have decoupled.