Pennsylvania inheritance tax law allows a trust for the “sole use” of the surviving spouse to be taxed entirely at the death of the surviving spouse, rather than having to pay tax on the present value of the taxable remainder upon the first death, when the trust is created. However, the estate can elect to pay the tax on the present value of the remainder, essentially prepaying the tax, and there are sometimes a benefit to making that election.
When a trust is for the sole use of the surviving spouse, the executor has a choice: pay tax now on the present value of the remainder interests (the present value of what is likely to remain in the trust at the death of the surviving spouse), or pay no tax now and pay tax on the full value of the trust at the death of the surviving spouse.
In theory, prepaying the tax is beneficial, because determining the present value of the remainder acts as a discount on the rate of tax.
For example, take the case of a $1,000,000 estate which is to be held in trust for the benefit of a surviving spouse, paying income to the spouse for his or her life. If the executor does not elect out of section 2113, then there is no tax payable now, but the entire value of the trust will be taxed at the spouse’s death. If there is no change in the value of the trust, and the remaindermen are all children (or grandchildren or other lineal descendants), then the tax at the spouse’s death will be $45,000 (4.5%), and the beneficiaries will receive $955,000.
If the executor elects out of section 2113, then there is tax payable immediately on the present value of the remainder interests, and the value of the remainder is determined by factors which are based on mortality (the likelihood of the spouse dying in any particular year) and an assumed interest rate (which is used to discount the value of the future remainder back to present value). The Internal Revenue Service has published tables of life estate and remainder factors for different ages and interest rates, and those factors are used to determine the present value of life estates and remainders.
In the case of a $1,000,000 trust that pays the income to a surviving spouse for life, the present value of the income interest might be 40% of the current value of the trust, and the present value of the remainder might be 60% of the present value of the trust, depending on the age of the spouse and interest rates in effect when the trust is created. In that case, the remainder would have a present value of $600,000, and the inheritance tax would be 4.5% of $600,000, or $27,000, leaving $973,000 in the trust. There would be no additional tax payable at the death of the surviving spouse so, assuming no change in the value of the trust during the surviving spouse’s lifetime, the remaindermen will receive $973,000 instead of $955,000, an increase of $18,000.
There is value to tax deferral, but that's only when the tax is on income. When the tax is on the principal (i.e., the investment itself rather than the income from the investment), then the timing of the tax payment is economically irrelevant, and the most important issue is the rate of tax.
To illustrate, assume that the investments of the trust could increase by 30% during the surviving spouse's lifetime, so that a $1,000,000 trust would be worth $1,300,000 at the death of the spouse. The tax at 4.5% on $1,300,000 would $58,500, leaving $1,241,500 for the remaindermen.
If the tax of 4.5% were paid at the first death instead of being deferred until the second death, and the tax were paid on the original $1,000,000 (without any remainder discount), then the trust would have only $955,000 to invest during the lifetime of the surviving spouse. If that $955,000 increased by then same 30%, then it would be worth $1,241,500 at the death of the surviving spouse, which is the exact same value that results when the tax is paid at the death of the survivor.
Because the timing of the payment of the tax is economically irrelevant, and only the rate of tax is significant, the prepayment of the tax is beneficial because, as previously stated, the remainder discount acts like a discount to the rate of tax.
Despite the economic benefit of prepaying the inheritance tax, there are practical reasons why deferring the payment of the tax may produce the better result, mainly because changes in circumstances could reduce (or eliminate) the inheritance tax payable at the death of the surviving spouse, making tax deferral the better choice. For example:
Perversely, there is a trade-off between the remainder discount and the risks of changes in circumstances that could undermine the discount, because there is a greater remainder discount for younger spouses with longer life expectancies, but the longer life expectancy increases the opportunities for (and likelihood of) changes in circumstances that might reduce or eliminate the inheritance tax payable at death on the value of the trust.
If the financial needs of the surviving spouse can be determined with some certainty, then the first possibility, the possible decrease in the value of the trust, can be calculated.
Although payment of inheritance at the first death, on the present value of the remainder, should reduce the ultimate tax burden in theory, there are practical circumstances which might make tax prepayment inadivisable. Prepayment of tax should always be considered, but will probably only be advisable in larger estates, when the surviving spouse will have more income than will be spent, and in cases in which the spouse is elderly or in ill health and has a relative short life expectancy.