Tax Allocation Clause in Your Will
Does your Will have a tax allocation clause? How does it direct that inheritance taxes will be paid? Don't know? You probably should.
Tax allocation clauses are a standard feature of many Will forms, and are often not understood by clients (or even not explained by the attorneys at all). Understanding them requires at least a little knowledge about Pennsylvania's inheritance tax and the nature of probate vs. non-probate assets. Once a client understands those, it's fairly simple to understand how the allocation clause works in a given situation.
To start, Pennsylvania inheritance tax applies to most property a person owns at the time of death, and to gifts made within one (1) year of death. A few exceptions to the application of the tax exist: certain family farms and family-owned business will be excepted, as will the value of life insurance. While these aren't the only exceptions, they are the most common.
Probate assets are assets owned solely by the decedent at the time of death, and non-probate assets can be generally defined as assets that will pass automatically to others at the time of a person's death, such as many jointly owned assets and assets containing a beneficiary designation (such as IRAs, 401(k)s, annuities, and life insurance). Even though an asset is non-probate, it may still be subject to inheritance tax in Pennsylvania, with the notable exception being life insurance.
Two (2) illustrations can highlight how inheritance tax might be applied in a given situation:
Bob (85) dies owning real estate valued at $100,000 and a bank account valued at $100,000 and an IRA valued at $100,000. Bob's Will leaves his estate equally to his three (3) children and his IRA has a beneficiary designation naming all of his three (3) children equally. Bob's Will has a tax allocation clause stating that "all inheritance taxes payable by reason of my death shall be paid from the residue of my Estate."
When Bob dies, Pennsylvania inheritance tax of 4.5% will be applied to the net value of his estate, which will include his real estate ($100,000), bank account ($100,000), and IRA ($100,000), less any deductions for final expenses and debts. That inheritance tax will be paid from the cash bank account comprising the residue of his Estate. Since all three (3) of his children are equal beneficiaries of that residue, the tax will be borne equally by them, and none of them are benefiting more than any other child. Simple enough.
Now, let's say that Bob left his real estate solely to one of his children (Aaron) who had lived with him prior to death and cared for him in his final years. Like before, Bob's Will leaves the rest of his estate equally to his three (3) children and his IRA has a beneficiary designation naming all of his three (3) children equally. Bob's Will has a tax allocation clause stating that "all inheritance taxes payable by reason of my death shall be paid from the residue of my Estate."
Because of the specific devise of real estate, Aaron will be receiving the house ($100,000) and 1/3 of the bank account ($33,000) and 1/3 of the IRA ($33,000), for a total inheritance of $166,000. Each of the other two (2) children will receive less, only about $66,000 each (from the bank account and IRA). This was Bob's intention, and the children were comfortable with the disposition of his property, so no surprises to the family likely occur at this point.
However, when the attorney explains that the total inheritance tax on all property (including the $100,000 of real estate passing to Aaron) will be paid from the cash residue provided by the bank account, it becomes clear that all three (3) children will share in the tax payment equally, but Aaron is receiving more property than them. This may disappoint them, and may not really have been what Bob had envisioned when drafting his Will. Here, the standard tax allocation clause didn't really serve his desires, and the children may be more than a bit miffed at the drafting attorney, if he or she did not explain the clause to Bob. A better route may have been to require the children's residuary shares would be reduced by their respective inheritance tax burdens, or that they pay their shares of the inheritance tax separately.
The problem here is furthered when more assets are given unequally between children. For example, Bob left all of his IRA to Catherine, his child, and all of the residue to Doug, his other child, and kept the standard tax allocation clause. Now, the inheritance tax due on the real estate (4.5% of $100,000, less deductions) and the inheritance tax due on the IRA (4.5% of $100,000, less deductions) will be paid entirely out of the residue (only what is left of the $100,000 bank account) that would go to Doug. The other children, Aaron and Catherine, have received a bit of a windfall compared to their sibling. If it is the result that Bob originally wanted, that's not a problem; however, many clients don't appreciate the consequences of a boilerplate tax allocation clauses, and aren't informed of the alternate options for more fairly structuring their tax allocation clauses regarding non-probate assets or specific devises or bequests.
What's the take-away here? Review your Will and know how Pennsylvania inheritance tax is going to apply to your situation, in light of the various provisions of your Will. Or, if you are a professional dealing with estate planning implications for clients, make them aware that unequal dispositions of assets may require a more careful look at these clauses. They are too often glossed-over in the Will explanation phase and have real consequences to beneficiaries later on.