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Recent Change in Pennsylvania's Inheritance Tax - An Overview
Silverman Bernheim & Vogel

To our Friends and Clients:

Over the past several months, you may have read about a renewed effort on the part of Congress to make permanent the repeal of the Federal estate tax (scheduled to occur in 2010) or to increase or to accelerate the scheduled increases in the exemption equivalent (now $1,000,000 and scheduled to increase in stages over the next several years to $3,000,000). Although the initiative has attracted a great deal of publicity, so far, nothing has happened.

However, a change in the Pennsylvania Inheritance Tax has taken place, to much less fanfare but with significant effect, which requires Pennsylvania residents to choose between flexibility in their estate plans and tax deferral.

Like the Federal estate tax, the Pennsylvania Inheritance Tax is deferred on transfers to a surviving spouse, including transfers in trust for the benefit of a surviving spouse. In the case of direct transfers, i.e., outright bequests, the tax rate is simply set at zero percent. In the case of transfers into a qualifying trust, i.e., a trust for the “sole use” of the surviving spouse, the executor of the estate has the option either to defer the tax on the assets in the sole use trust until the death of the surviving spouse, in which event the remaining principal in the trust is included in his or her estate, or to pay the tax¹ , in which event the succeeding transfer on the death of the surviving trust would not be subject to tax.

Prior to 2003, it was successfully argued that a trust was a “sole use” trust even if the spouse had the right to give away assets held in the trust. Despite the objections of the Pennsylvania Department of Revenue, it was successfully argued by our firm, and by others, that a power to give away an asset was the ultimate indicia of control so that giving a surviving spouse that power was wholly consistent with the notion of a “sole use” trust such that it should qualify for the deferral. After the courts sustained the taxpayers’ position, the Department of Revenue decided that if it wanted to have its way the only recourse was to ask the state legislature to change the statute. Here, the Department was successful.

Earlier this year the Inheritance Tax provisions of the Tax Reform Code were amended to re-define the term “transfer of property for the sole use” of a surviving spouse. Now, for a trust to qualify as a “sole use” trust, all of the principal and income of the trust must be for the exclusive use of the surviving spouse and, during the lifetime of the surviving spouse, no one, not even the surviving spouse, can have the power to divert any of the principal or income to anyone other than the surviving spouse. Thus, as a result of this definitional change, a power left to the surviving spouse to make gifts from the trust to children will disqualify the trust for tax deferral.

The Department of Revenue further takes the position that the inclusion of such a power also denies the taxpayer the right to apportion the tax between the interest of the spouse and the interest of the remaindermen, typically the children. Because the amount of principal which can be given away is often unlimited, the Department of State takes the position that none of the principal is subject to the zero percent spousal rate and that all of it should be assessed at the rate applicable to the remainder interest, not less that 4.5%. Doing the arithmetic, a $1,000,000 Credit Shelter Trust (often referred to as the “Family Trust”) will suffer a tax cost of $45,000. If the surviving spouse has a right to make gifts from a QTIP (a trust which qualifies for the marital gift deduction for Federal estate tax purposes) the Pennsylvania Inheritance Tax would be 4.5% of the principal amount of that trust as well.

With this change, it is important that all wills and associated trusts which contain trusts for the benefit of surviving spouses be re-examined to see whether they will continue to qualify as sole use trusts. If they do not, a decision must be made whether the flexibility of allowing the surviving spouse the right to use trust principal for the benefit of children is worth the tax cost.

Please give us a call to set up a meeting to review your current estate planning documents so that we can assess the situation as assist in making an informed judgment on this issue.

In the meantime, we suggest that you check our website for developments on this and other matters of interest.

¹ If an executor elected to pay the tax on sole use trust property, that tax was typically a blend of the tax on the life interest of the surviving spouse, using the zero percent spousal rate, and a tax on the remainder interest taxed at the rate applicable to those beneficiaries, e.g., 4.5% for children or grandchildren.

For more information contact Warren Vogel, Esquire
Copyright 2003 by Silverman Bernheim & Vogel - All Rights Reserved.

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