The Taxman Cometh (Apologies to Eugene O’Neill): Even After Death

The charitable world knows that tax considerations can loom over bequest administration.  The looming becomes more menacing in proportion to the size of the estate.  Most charitable beneficiaries pay little attention to tax matters, as it is widely known that so-called “death taxes” are not levied against bequests to exempt organizations.

So why raise the issue?  As the subtitle suggests, there are situations that can ensnare charities in death tax issues.  These predicaments are somewhat rare but should be on the radar of the conscientious bequest manager.  They involve the so-called “inheritance taxes” and the federal estate tax.  The former snafu is fixable but burdensome.  The latter, thankfully less frequent, is potentially devastating.

Inheritance Taxes

Inheritance taxes are imposed by six states: Iowa, Kentucky, Maryland, Nebraska, New Jersey and Pennsylvania.   Unlike the more familiar estate taxes, which are paid by the estate itself, these payments are the responsibility of the beneficiary/recipient.  Although the applicable statutes typically provide exemptions for close family members, and for charities, the amount of the tax is substantial, frequently in the 20% range.

The risk to a charity in these six states can be summarized in three words:  the overenthusiastic executor.  It is quite common for a PR in these venues to make a blanket payment for any inheritance taxes that may be due, and to make it prior to releasing distributions.  Sometimes, this payment will be made, erroneously, on all entitlements, including those to charities.  In the typical case where a charity receives a percentage of the residuary estate, this mistake will cost the organization a significant percentage of its entitlement.

For example, suppose a charity is entitled to 30% of the residuary estate in a taxing jurisdiction.  Suppose further that the residuum is $1,000,000.  The charity’s share is $300,000.  If the executor pays a 15% inheritance tax on the charity’s portion, the bequest is reduced by $45,000.  While the charity can file for a refund, it may never notice the deduction without a meticulous examination of a final accounting.

What triggers this error?  Either or both of two practices:

1. It is not unusual for wills in the “inheritance tax states” to contain a provision requiring the executor to pay all inheritance taxes prior to making final distributions.
2. Some judges in probate courts in the taxing states insist on inheritance tax payment before permitting closure of an estate.

In cases where a significant entitlement is involved, a charity might wish to contact the executor early in the administration process to ensure that no inheritance tax is paid on its behalf.

CCK TIPS:  Although most charities will be exempt from inheritance taxes in all six states, the pertinent statutes are not uniform.  Sometimes, exemption hinges on the corporate situs or corporate form of the beneficiary organization.  The law and facts need to be analyzed on a case-by-case basis in the taxing jurisdictions.

Federal Estate Tax

The estate, and not the beneficiaries, pays the federal estate tax in cases where it is applicable.  Bequests to charities are exempt from such taxation.  With that double layer of protection, why should a charity care at all about the tax?

This answer can be summarized in four words:  the estate tax lien.  This is not a problem that arises frequently.

There are two reasons for this: (1) relatively few estates are large enough to trigger federal estate tax; and (2) IRS appears to have a limited appetite for enforcing the lien against charities (internal IRS guidelines on the similar “gift tax” lien discourage, but do not prohibit, such enforcement).

The estate tax lien is a complicated and convoluted subject.  For purposes of this brief treatment, the following will serve as an introductory outline:

1. An estate tax lien attaches to all a decedent’s property at the moment of death. The lien arises as a matter of law.  No recordation is required.  The purpose of the lien is to secure the payment of any estate tax that may be due.
2. The lien has a ten-year duration, but sometimes extends far beyond that point in cases of litigation, tax audits, etc.
3. The lien is against estate property and continues when the property is transferred to a beneficiary. A charitable organization qualifies as a beneficiary for these purposes.
4. The existence of the lien may as a practical matter prevent the re-transfer of property from beneficiaries to third parties. When such transfer does occur, the beneficiary (i.e., the charity) often retains liability for unpaid estate tax, at least up to the value of the re-transferred property.  (The fact that the original transfer to the charity was presumptively exempted from estate tax does not change this outcome!) [For an interesting peek into the “mind” of IRS on this subject, the reader may wish to peruse the IRS Field Service Advisory from September 5, 1997, which clearly contemplates holding charitable transferees liable for unpaid estate tax.]

CCK TIPS:  The existence of the estate tax lien should encourage prudence but not panic among bequest management specialists.  The situation arises infrequently, as only the largest estates trigger federal estate tax and are frequently, but not always, under the control of professional fiduciaries.  We offer the following general recommendations:

• Where possible, a charity receiving a large bequest from a taxable estate should ensure that the lien on property received has been released by IRS. There are various ways of accomplishing that, most of which involve the payment of tax by the estate.  There are also times when it may be possible for an estate to post a bond prior to distribution if, for some reason, the executor wishes to distribute prior to the “estate tax letter” confirming payment of all taxes.
• The issue of the estate tax lien also has implications for any release of liability that is presented to a charitable beneficiary for signature.
• There are state estate taxes in about a dozen jurisdictions. Many of these mirror the federal structure and include similar liens.  Charities should be mindful that these taxes become applicable at levels much lower than the federal threshold.