By Amy Feldman
NEW YORK, July 11 (Reuters) - When someone you love dies, the last thing you want to think about is money, yet a surprising number of people inherit tax problems along with the family china.
“One in 10 estates have some tax issues,” says Scott Cripps, chief fiduciary officer and head of trust services at Bank of the West in San Francisco. “There’s nothing worse than being in your worst grieving moments and having to deal with financial chaos.”
Tax problems that may occur after death run the gamut. There may be unpaid federal or state taxes, perhaps because of an extended illness.
Or there may be surprise estate or inheritance taxes due. State estate taxes typically kick in at levels far below the $5.25 million federal estate tax trigger, and families do not always plan for them. State inheritance taxes, meanwhile, are levied directly on beneficiaries rather than on estates.
The deceased person may not have considered the varying tax consequences of assets left behind, unintentionally causing the beneficiaries to end up with bequests worth vastly different amounts after the taxes have been paid.
“When the estate goes to settle, the taxing authorities are right at the front of the line,” Cripps says. “It can eat away at the estate pretty hard if it isn’t done right.”
Families often fail to do it right, in part because taxes are not a high priority during discussions about life and death. As people get older and confront the chronic illnesses and mental fog that comes with aging, taxes can fall even further from consideration.
“It’s not about having an estate plan with a complicated credit shelter bypass trust,” says Don Williamson, executive director of American University’s Kogod Tax Center. “It’s simple communication.”
Williamson points to the case of a woman who had escaped the Nazis in the 1930s, leaving her husband a big surprise after she died. “They open up the will, and it says, ‘Please send this guy in Geneva, Switzerland, $5,000,'” Williamson recalls.
The widower, wanting to follow his spouse’s last wishes, discovered $5 million in a Swiss bank account. “The best he can figure is that was her hidden money in case the Nazis took over America,” Williamson says.
While the widower ended up with a windfall, he had to bring in top tax lawyers because those millions had never been reported to the Internal Revenue Service.
Finding vast sums stashed overseas is rare; bumping up against unforeseen state tax issues is not. Bank of the West’s Cripps recalls a couple who lived in Texas, but maintained an apartment in New York City for business purposes.
After the wife died, the state tried to assert that she was a resident - a designation that has its own set of rules - to claim taxes on her share of the estate, worth some $30 million.
“There was a long battle, with lots of attorneys’ fees,” Cripps says. After much expense and aggravation, the widower prevailed.
They might have avoided the entire fight if they had asked a lawyer to clarify their legal ties to New York.
Upper-middle-income snowbirds may face the same problem. Retiring to Florida may not be enough to give up legal residency elsewhere. But you may head off such an issue if you stop voting in the former state, change your driver’s license and otherwise cut legal ties, even if they seem like mere technicalities.
Perhaps more troubling, the deceased may not consider taxes in making bequests. The result: Two beneficiaries may end up with roughly equal amounts before the taxes are paid, but vastly different ones afterward.
Consider an elderly widow who names her son the beneficiary of her life insurance and her daughter the recipient of an Individual Retirement Account. Because proceeds of life insurance are generally free of income tax, while those from an IRA are generally taxable, the daughter will owe taxes on her inheritance while the son will not.
Once you inherit a tax mess, about all you can do is try to untangle it with the help of your accountant or a tax lawyer. If the deceased person failed to pay income taxes for a year or two, the estate’s executor will need to play catch up, no matter how hard it is to complete those tax forms after the fact.
You can pre-empt the issue in advance. That requires the benefactor to understand the state estate tax rules and take them into account during the estate-planning process. And beneficiaries should not be afraid to have a conversation about financial affairs and desires - including any tax implications.
“Most families don’t want to let assets blow up their kids financially or create a wedge within the family,” says Douglas Rothermich, vice president of wealth planning strategies at TIAA-CREF. “It’s really important that older people planning their affairs think it through ahead of time so their loved ones don’t inherit a tax mess.”