Who Plays and Who Pays?

Who Plays and Who Pays?

Once you sign a contract, you are legally bound by it. You are presumed to have read the contract carefully and agreed with its terms, whether or not you have in fact done so. Therefore, be very careful to read every provision of every contract. Sometimes, you really don’t care much about the terms of the contract. For instance, if you buy a cheap pair of headphones and they break down, you will most likely buy a new pair of headphones rather than sue the manufacturer. In other instances, however, you care very much about the terms of the contract. You probably care what the contract says when you sell or purchase a business or a home or when you enter into a construction contract or a loan. In those instances, you might want to consult a lawyer and have the lawyer review the terms of the contract and, if need be, negotiate the terms with the other side. If you need help in preparing a contract or if you would like us to review or negotiate a contract for you, we will be happy to assist you.

Most people, when they plan on who will receive a certain asset or a portion of their estate after their death, do not think about the tax consequences of their bequests, except maybe in general terms. Yet most of us realize that, if our estate exceeds a certain amount, some type of transfer tax or taxes will be due. Following is a brief analysis of the allocation process of the transfer tax with illustrations as to how that process affects specific distribution provisions in a will or trust.

Absent instructions to the contrary, Oregon law provides that estate or inheritance taxes (transfer taxes) must be paid by the person receiving the property, the recipient. If property is transferred to more than one person, then the transfer tax must be paid by each recipient proportionally to the value he or she receives. By way of example, assume that the total amount to be distributed is $300,000. The testator, the person making the bequest, provides in his will that $10,000 goes to an individual as a specific bequest, and the remainder is to be divided among three other individuals. Because $10,000 is 3 1/3 percent of $300,000, the recipient of the specific bequest must pay 3 1/3 percent of any transfer tax payable. The remainder of the tax payable will be deducted from the remaining $290,000 and the residue, which is the remainder of the testator’s estate after the taxes, the expense of probate, debts, and any other types of specific gifts, is then distributed to the remainder beneficiaries. This outcome may very well be what the testator wanted. However, in most instances, the testator really wants the recipient of a specific bequest to receive a specific dollar amount or a certain asset, in this particular case $10,000, without any tax liability attached.

In larger estates, the issue of “who pays the tax?” can get more complicated. For example, bequests to a qualified charity are exempt from tax and such gifts are deductible from the adjusted gross estate in determining what tax to pay. If, however, the charitable gift is a portion of the residue of the estate, and if the tax apportionment provision in the will requires that the tax be paid from the residue of the estate, the charitable deduction will be reduced. The effect is that the estate may end up paying more tax than would have been the case if a different apportionment direction were used.

Another instance where very careful consideration needs to be made regarding tax apportionment is where the estate provides benefits to grandchildren in such a way and in such amounts that the “generation-skipping” transfer tax comes into play. Such tax comes into play whenever there is a bequest from a testator to a person two generations or more removed from the testator and the amount exceeds the exemption amount. At the present time, the amount which can be exempt for generation skipping transfers is about $1,000,000. Amounts going to grandchildren or other “skip persons” which exceed that exclusion are subject to an additional tax equivalent to the highest transfer tax rate, which is 55%. This is a tax over and above the regular transfer tax. Accordingly, if there is a provision requiring all transfer taxes to be paid out of a specific portion of the estate, such as the residue, and if the residuary beneficiaries are not the grandchildren or other skip beneficiaries, the resulting tax burden could either substantially reduce or perhaps even eliminate the bequest to the residual beneficiaries.

These are just two instances where it is critical to understand the effect of tax and tax appointment in an estate. Failure to pay close attention to this matter can result in significant unintended results.

If you want to know more about tax consequences and tax apportionment in your estate plan, give us a call.