A number of years ago I wrote about the dangers of accidentally triggering a Compromise Tax in New Jersey and in Pennsylvania. It occurs to me that most dynasty trusts are set up to go to children, grandchildren and more remote descendants, but there is also boilerplate that says if the Grantor doesn’t have any living descendants, it will go to other family members or friends.
This is where the tax gets tricky. As a refresher, if money goes to a child, in New Jersey there is no inheritance tax and in Pennsylvania there is a 4.5% inheritance tax. If money goes to other parties, like nieces and nephews, there can be an inheritance tax of 15-16%. So, when money goes into trust for the life of a child, and then it goes to a niece or nephew after that, the tax must be computed based upon the value of the remainder interest.
Now let’s take it a step further, what happens if the trust doesn’t say upon the death of the child that it goes to nieces and nephews, but rather there is a contingency. The contingency being that it goes to the child’s heirs, and if the child doesn’t have any heirs, it goes to the nieces and nephews.
In this situation, technically you still have to calculate the actuarial interest of the child’s interest, but now you also have to calculate the actuarial interest that the nieces and nephews will receive the remainder interest rather than any descendants of the child.
If the chance that the nieces and nephews will receive the remainder interest is too remote that there will not be a tax, the question then becomes what is too remote? In a call to the New Jersey Division of Inheritance Tax, they advised me that there is no bright-line rule. Each situation is a facts and circumstances test.
For example, in the situation described above, they might look at the age of the child when the trust is created, whether there are actually any grandchildren alive at that point, the terms of the trust, and many other factors. So in a situation where the children are older, unmarried and without children of their own, there is a much higher chance that nieces and nephews will wind up with the remainder interest.
So how can you complete the inheritance tax return when there are so many possible contingencies? The safe route, and the one recommended by the New Jersey Division of Inheritance Tax, is to make a note of the potential tax and explain why you think there should only be a minimal or no tax. Usually this is the better way to go in New Jersey because if someone is setting up a dynasty trust, they typically are doing it with a fair amount of assets and are going to be paying the New Jersey estate tax anyway. In Pennsylvania, because there is no estate tax, this may be a tougher negotiation.
Because of the complexity of these situations, I strongly recommend hiring a competent estate administration attorney to assist. Failure to deal with this at the time the inheritance tax return is due could lead to substantial interest and penalty costs.