Indiana’s Inheritance Tax Will Begin a Phased-in Repeal in 2013

March 15, 2012

Legal Updates

Late on March 9, 2012, the Indiana General Assembly approved a conference committee's version of Senate Bill 293, which will phase out Indiana's inheritance tax over a 9-year period, beginning for persons who die on or after January 1, 2013.

Unlike an "estate tax," which is imposed on the total combined value of the assets that pass at the death of a person (a "decedent"), an "inheritance tax" is an excise tax imposed on eachtransfer of assets at death from a deceased person (decedent) to each particular individual heir, beneficiary, or other transferee. The available exemptions and the tax rates usually vary based on how closely each transferee is related, if at all, to the decedent.

Indiana was the 42nd state to enact an inheritance tax, in 1913. The Hoosier State is currently one of only four states that can collect an inheritance tax greater than zero on transfers at death to children, grandchildren, or other descendants. The administration of Indiana's inheritance tax involves the probate courts, the county assessors, and the Inheritance Tax Division of the Indiana Department of Revenue, and the costs of compliance can be significant for relatively small estates. For example, if a decedent's taxable property passes at death to her children and grandchildren, it is not unusual for the costs of preparing and filing the inheritance tax return to be two to four times the net tax due on the return.

Four bills for repeal or reform of Indiana's inheritance tax were introduced in January during the 2012 session of the Indiana General Assembly. One of the major concerns of legislators was the loss of tax revenue to the State ($150 to $165 million per year) and to Indiana counties (about $12 to $14 million per year) if the inheritance tax were to be repealed all at once. Accordingly, most of the negotiations focused on when to begin a phased-in repeal, how many years the phase-in should take, and how to reduce the total inheritance tax owed by estates of decedents dying in each year during the phase-in period. The final version of Senate Bill 293 was a combination of provisions from House Bill 1199 and the introduced version of SB 293.

What is Changing

The Indiana inheritance tax changes made by Senate Bill 293 and by one other enacted bill, HB 1258, are as follows:

• Effective retroactively as of January 1, 2012, for decedents dying on or after that date, the group of Class A transferees (which enjoy the highest per-person exemption from the inheritance tax and the lowest inheritance tax rates) is broadened to include a spouse of the decedent's child and the spouse or step-child (whether adopted by the decedent or not). Surviving spouses of the decedent's deceased children and deceased step-children are also Class A transferees. Before 2012, such spouses of children and step-children were Class B transferees (with only a $500 exemption and with inheritance tax rates ranging from 7 to 15 percent).
• Also effective as of January 1, 2012, the Class A transferee exemption (for lineal descendants and lineal ancestors such as children, grandchildren, stepchildren, parents and grandparents) increases from $100,000 to $250,000 per person. A proposed increase in the Class B and Class C transferee exemptions to $25,000 was deleted from the bill in conference committee; a $500 exemption remains in effect for Class B transferees (siblings and descendants of siblings), and a $100 exemption remains in effect for Class C transferees (all other relatives and non-relatives who are not surviving spouses).
• A 10-percent credit will be subtracted from the bottom-line inheritance tax computed on the at-death taxable transfers of decedents dying during calendar year 2013. All the other inheritance tax rates and rules (with the modifications described above) will remain in effect. For decedents dying during calendar year 2014, the credit will be 20 percent, and the credit will increase by 10 percent per year through 2021, when the credit will be equal to 90 percent of the computed bottom-line inheritance tax.
• Effective for decedents dying after December 31, 2021, the Indiana inheritance tax will no longer exist.
• Senate Bill 293 does not repeal or change Indiana's separate and dormant estate tax, a so-called "sponge tax" or "pickup tax" that was defined in terms of and linked to the federal credit for state death taxes that has been repealed for the 2005-2012 period. Indiana's estate tax only applied to estates large enough to file federal estate tax returns. If Congress simply allows the current federal estate and gift tax reforms to "sunset" after 2012, the federal credit for state death taxes would return, and Indiana's estate tax, which remains on the books, could begin to generate revenue again.

Calculating the Inheritance Tax on Transfers to Trusts

Under Indiana's inheritance tax regime, it can be difficult to determine the taxable interests of multiple beneficiaries of a trust and to calculate the inheritance tax on their separate interests, for example, if the initial beneficiary of a trust is eligible to benefit from discretionary distributions but is not absolutely entitled to receive all the net income for life. After losing the Estate of Boehle[1] case in 2010, and in the absence of any specific rule in the statute, the Inheritance Tax Division of the Indiana Department of Revenue developed and issued some flexible guidelines for determining which beneficiaries — and how many beneficiaries — of a trust are "transferees" for inheritance tax purposes, and therefore which and how many transferee exemptions can be claimed for assets passing at death into that trust.

The General Assembly has slightly simplified this problem by amending the inheritance tax statute, effective July 1, 2012, so that when a taxable transfer occurs at death to an entity (such as a trust, an LLC, a partnership, or a corporation) that has multiple beneficial owners, the estate and the Department of Revenue will be required to "look through" the trust or other entity and treat the transfer as a series of individual taxable transfers, one to each beneficial owner who has an interest (discretionary or otherwise) in the entity, on a percentage basis.

Example. Suppose that a trust receives assets from a decedent dying in July 2012, and that the trust's three initial beneficiaries are the decedent's two children (Class A transferees) and a niece of the decedent (a Class B transferee), each of whom is entitled to receive one third of the remaining trust assets 20 years after the funding of the trust. Under the 2012 amendment to the statute, it will not matter whether the trust requires the trustee to distribute one third of the net income currently to each beneficiary, or whether the trustee merely has the discretion to make distributions from the trust on an impartial basis for the benefit of the niece and the two children. In either situation, the assets passing to the trust will be treated as a one-third transfer of property directly to each of the two Class A transferees (the children) and as a one-third transfer of property directly to the niece (a Class B transferee).

For some specific trusts with multiple beneficiaries who are eligible to benefit from discretionary "sprinkle-spray" distributions by the trustee, each beneficiary's respective "percentage interest" in the entire trust may not be obvious or may be in dispute. In such situations, existing procedures in the inheritance tax law will continue to apply, and if the decedent's estate and the Indiana Department of Revenue cannot reach an agreement on the percentage interests of the trust beneficiaries, the probate court has the power to determine those percentage interests for inheritance tax purposes.

Possible Future Changes

Depending on the future health of the economy and the ease or difficulty with which Indiana's state government manages to replace, or to do without, the inheritance tax revenue that will be lost during the 2013-2021 phase-out period and thereafter, the General Assembly could accelerate the phase-out of the inheritance tax by increasing the bottom-line credit more quickly or by moving to outright repeal in some future year. Conversely, the General Assembly could slow the phase-out of the inheritance tax or stop it altogether in some future year.

For more information about Indiana's inheritance tax repeal and how this may impact you, please contact Jeff Dible or any member in the Tax Law practice group.

More information about Jeff Dible

• Jeff Dible testified twice in favor of inheritance tax repeal during the 2012 legislative session and also attended a separate meeting with the House Republican sponsor of HB 1199 and with the chairman of the House Ways & Means Committee
• Jeff Dible testified three times in favor of inheritance tax repeal during the 2011 legislative session and before a special meeting of the Commission on State Tax and Financing Policy.

[1] 932 N.E.2d 260 (Ind. Tax Ct. 2010)