While New Jersey eliminated the estate tax in 2018, the inheritance tax is still alive and well.  The New Jersey inheritance tax is a tax on inheritances left to non-lineal, Class C and Class D beneficiaries[1]. If you are a New Jersey resident and you plan on leaving an inheritance to non-lineal beneficiaries, you should consult with an estate attorney familiar with New Jersey’s inheritance tax laws. A poorly written will could produce unintended consequences related to the handling of your estate assets.  This article will cover a few items to consider when you have Class C and Class D beneficiaries in your estate plan.

One of your initial considerations when drafting your will is who will bear the burden of the inheritance tax.  While your estate will ultimately submit payment to New Jersey, the tax paid can either reduce your residual estate or proportionally reduce the amount received by each beneficiary.  For example, John has a $200,000 estate.  He wishes to leave $20,000 to his friend, a Class D beneficiary, and the residual balance to his child, a tax exempt beneficiary.  The $20,000 bequest to his friend will generate an inheritance tax of $3,000.  If his will is silent as to the application of the inheritance tax, the tax will reduce the amount distributed to his friend.   His friend will receive $17,000, NJ will receive $3,000 and the remaining $180,000 will go to his child.  If his will specifically states that all estate and inheritance taxes will be considered a liability of his estate, the tax will be the liability of his residual estate.  In this case, the friend will receive the full $20,000, NJ will still receive $3,000 and his child will receive $177,000.

While the above example may seem immaterial, assume the same facts but you want to leave $100,000 to your friend and the residual to a tax exempt charity, a Class E beneficiary.  The inheritance tax will be $15,000 and the wording of your will decides if your friend gets $100,000 or $85,000.

Now suppose that the bulk of your estate is comprised of real estate and/or retirement accounts with named beneficiaries.  If these assets are left to Class C or Class D beneficiaries, they are subject to the inheritance tax.  Several issues can arise when the bulk of your assets are non-cash.  Let’s assume the following facts: Jane wishes to leave her NJ real estate worth $525,000 to her brother and $20,000 cash to her favorite charities.  The inheritance tax on the real estate will be $55,000, and her will is silent regarding the payment of the inheritance tax.  How will Jane’s estate pay the inheritance tax since it can’t use the $20,000 she left to charity?  Jane’s brother will have to deposit $55,000 with the executor to cover the tax.  If her brother wishes to keep the real estate, he will have to come up with the funds for the deposit.  Even if Jane left the cash to her brother, the estate would still be short on funds to cover the inheritance tax.  Her brother would still have to raise money to deposit in the estate.

A similar scenario to that above would occur if Jane had an IRA worth $525,000 with her brother as beneficiary, instead of the real estate.  Since the funds from the IRA are paid directly to Jane’s brother, her brother would have to deposit funds to the estate to cover the inheritance tax on the IRA.  This scenario is slightly easier than the real estate example as Jane’s brother could withdraw funds from the IRA to deposit in the estate.  However, the IRA withdrawal would be subject to income tax on her brother’s personal tax return, possibly an unintended tax consequence.

These are just a few situations that can arise when you leave an inheritance to non-lineal beneficiaries.  While the staff at Capaldi, Reynolds & Pelosi can assist you with some of the tax aspects of your estate plan, your will has vast legal implications on how your executor administers your estate. Having a knowledgeable estate planning team can assist you with making sure your estate is executed properly upon your passing and that your assets are divided as you intended.

[1] See A Review of NJ Estate and Inheritance Taxes for more information.

Article Submitted by Clayton Himstedt, CPA, MBA