Who Should Bear the Bite of Estate Taxes on Non-probate Property

• Publication year: 2022

43 Creighton L. Rev. 747. WHO SHOULD BEAR THE BITE OF ESTATE TAXES ON NON-PROBATE PROPERTY

WHO SHOULD BEAR THE BITE OF ESTATE TAXES ON NON-PROBATE PROPERTY?

MARK R. SIEGEL(fn*)

I. INTRODUCTION AND OVERVIEW

A. INTRODUCTION: SETTING THE STAGE

As you begin to study the property transfer provisions in the will, you immediately detect a similar pattern. The initial articles of the will that you are reviewing make several different dispositions of property. One disposition is a general bequest of cash. Further, the preliminary articles bequeath personal property and thereafter devise the home. The final provision disposes of the balance of the property.(fn1)Several hundred thousand dollars are owed in estate taxes. The estate tax bill is attributable not only to assets disposed of by the will, known as the probate estate, but also to assets passing outside of the will, or the non-probate estate.(fn2) Will each asset be responsible for its pro rata share of the taxes, or will certain assets be relieved of the burden of taxation? How the tax liability is shared will undoubtedly create the potential for adversarial relations if certain beneficiaries receive their property free and clear of any pro rata share of tax liability while others bear more than their pro rata share. In this manner, one can readily see how an allocation of tax liability in the tax clause of the governing instrument is most properly viewed as a dispositive provision even if the tax clause is not technically a pre-residuary or residuary disposition.

A long standing tradition exists in this country to impose a tax on property held by the decedent at the time of death. Taxes imposed upon death may take one of two primary forms. An estate tax is levied on the transfer of property by the decedent.(fn3) The federal estate tax is an example of this form because it is a tax on the right to transfer property. An inheritance tax, in contrast, is imposed on the beneficiaries receiving the property from the estate.(fn4)

As a wealth transfer tax, the federal estate tax is not limited to those assets disposed of by will or transferred through intestacy. The federal estate tax is imposed on the transfer of probate and non-probate property. By federal statute, the personal representative of the estate has personal liability for the payment of federal estate taxes attributable to the probate and non-probate property.

Few tax lawyers and estate planners would contest the notion that a will should address how any estate taxes owed are to be paid and by whom. Charging the taxes solely to the assets passing under the will achieves a very different outcome compared to apportioning the taxes to all beneficiaries of the decedent's wealth, including those receiving assets passing outside of the will.(fn5)

Suppose Tom Testator's will left cash bequests to his children, a specific bequest of his car to his brother, a devise of his principal residence to his sister, and the residue of his estate to be divided equally among his siblings and descendants. At common law, because the pre-residuary dispositions of cash, the car, and the principal residence were not responsible for the payment of the estate taxes, these beneficiaries received these assets without reduction for any estate taxes attributable to them. The residuary estate, and in turn, the residuary beneficiaries, would ultimately be responsible for the estate taxes, including any taxes on amounts passing to the pre-residuary beneficiaries or passing outside of the will. Payment of the estate taxes by the residuary beneficiaries reduces the value of the property passing to them. This common law rule came to be known as the "burden on the residue" rule. This rule serves to facilitate administration of the decedent's estate because the executor does not have the task of collecting from each beneficiary a proportionate share of the estate tax. Moreover, by making the residuary beneficiaries responsible for the estate tax, those beneficiaries receiving pre-residuary bequests or property outside of the will were absolved from liability for any portion of the estate tax. Thus, pre-residuary and non-probate beneficiaries did not have to find an available source of cash to contribute to the executor. The balance struck by the burden on the residue rule avoided cash liquidity problems for pre-residuary takers but created concerns for residuary beneficiaries who were then burdened by the taxes. Depending on the magnitude of both pre-residuary dispositions and property passing outside of the will, the consequences to the residue may range from diminution to complete depletion.

Since the common law approach(fn6) failed to apportion the estate tax to property contributing to the tax liability, complaints arose from residuary beneficiaries whose bequests were effectively reduced by the estate taxes. This displeasure prompted many state legislatures and courts to change state law by adopting estate tax apportionment rules. The apportionment rules addressed the issue by striking a balance different from the burden on the residue rule. The standard rule divides the burden of estate taxes among the decedent's beneficiaries creating a burden on the recipient rule. Under the estate tax apportionment regime, the estate tax is allocated among the recipients of both probate and non-probate property, as both classes of property are included in the estate tax calculation and contribute to the tax liability. Equitable apportionment reflects an important principle that non-probate property should bear a proportionate share of the estate tax where such property contributes to the tax amount due. This principle, provided for in the Uniform Estate Tax Apportionment Act,(fn7) will yield to the testator's expressed desire to have estate taxes paid in a different manner.(fn8)

Under equitable apportionment, the notion of burdening the recipient rather than the residue does not universally make estate administration more difficult. Not only may the non-probate assets be liquid(fn9) but also the residue may be comprised of illiquid assets.(fn10)Therefore, the needed cash that the executor must generate for the estate tax payment may be more readily forthcoming from the non-probate property than illiquid residuary assets. Further, testators frequently designate beneficiaries for property passing outside of probate. By applying rules that make beneficiaries of non-probate property responsible for any estate tax liabilities attributable to such property, potential inequitable and unintended results may be avoided.

The question arises whether a decedent who provides for a beneficiary through a pre-residuary bequest or non-probate transfer necessarily intends for that person to be exonerated from state law apportionment of estate taxes so that such beneficiary receives the financial benefit of the property in full.

B. OVERVIEW: COMPONENTS OF THE WILL AND GENERAL APPROACHES TO APPORTIONMENT

Well drafted wills not only provide for property dispositions but also do so in a particular order. There are several classes of dispositions within the will. The pre-residuary dispositions under the will most typically take the form of specific,(fn11) general,(fn12) and demonstrative.(fn13) As its name implies, the residuary clause operates to dispose of all other property not effectively disposed of by the pre-residuary specific, general, or demonstrative bequests.

The focal point in estate tax apportionment concerns where the burden of the estate tax falls. If applicable state law(fn14) or the governing instrument allocates the estate tax burden to the residuary probate estate, these assets are subject to consumption and attendant reduction while the recipients of the pre-residuary bequests are spared. As an alternative approach to estate tax apportionment, governing law may apportion estate taxes against each asset included in the gross or taxable estate based on the value of those assets. In contrast to the first approach, this alternative approach places responsibility on each beneficiary under the will, whether the recipient of a specific, general, demonstrative, or residuary bequest, for a proportionate share of the estate taxes payable.

An approach to estate tax apportionment that allocates the tax to those assets generating the tax may give rise to further complications beyond the preceding probate estate example. Suppose there are beneficiaries of probate and non-probate assets, all of which contribute to the estate tax liability.(fn15) Full apportionment would mean that each asset, whether or not the asset passes under the will, bears a proportionate share of the tax the asset helps generate. In this manner, each beneficiary, including the beneficiaries of non-probate assets contributing to the estate tax bill, bears a fair share of the taxes.

For a typical estate comprised of both probate and non-probate assets, in the absence of full apportionment, the residuary assets would be responsible for paying the taxes attributable to the non-probate property. The presence of non-probate property may serve to diminish or even exhaust the residuary estate if there is significant fair market value inherent in the non-probate assets.

In certain situations full apportionment may trigger unwanted results. Property passing in a qualified manner to a surviving spouse or qualified charity will generate an estate tax...