Death & Taxes: All My Children—Inheritance Tax Exemptions and Beneficiaries

From the Brady Bunch to the Kardashians, some of the most famous families in American culture are blended families. While fairy tales like Cinderella and Snow White may give stepparents a bad rap, stepparents can also be loving and generous to their stepchildren. However, no matter how stepparents treat their stepchildren in reality, they may still be legally treated differently when it comes to inheritance tax.

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Recently, in Tyler v. Iowa Dept. of Rev., the Iowa Supreme Court considered this issue when two stepchildren challenged their $203,000 inheritance tax bill. The stepchildren’s parents divorced when they were fairly young, and their mother subsequently remarried. These children grew up on their stepfather’s farm and were treated as his own children. The stepfather paid for their college, and the stepchildren kept a close bond with him even after they moved away. After 35 years, the stepchildren’s mother and the stepfather divorced, but the stepfather’s relationship with the children remained relatively unchanged.

When their stepfather died, he left 77 percent of his estate to his stepchildren. Under Iowa law, had he remained married to their mother, then the stepchildren would have received their inheritance tax-free. However, Iowa allows only current stepchildren to receive the exemption. The stepchildren challenged the tax and argued it was unconstitutional to differentiate between current versus former stepchildren. The Supreme Court in Iowa ultimately upheld the tax and ruled it constitutional.

Step by Step, Tax by Tax

Iowa is not alone in differentiating between categories of children when it comes to inheritance taxes. Of the six states that currently impose an inheritance tax, each one varies on which beneficiaries are subject to the tax.

Class A beneficiaries, which typically include surviving spouses and biological children, either receive a 100 percent tax exemption or are subject to the lowest inheritance tax rate. However, states do not always concur on who qualifies as a “child” when there is no blood relation.

Maryland specifically states that “child” includes both current and former stepchildren. Pennsylvania also imposes the same inheritance tax rate for all children, including stepchildren and even biological children who were adopted by others. The remaining states go further and allow tax exemptions for children who fall into a gray area of being neither related by blood or legally adopted.

Nebraska: Apparently a Parent

Nebraska may be geographically adjacent to Iowa, but it holds opposite views on stepchild beneficiaries. Both biological and legally adopted children are specifically given equal treatment for tax exemption purposes. But unlike Iowa, Nebraska does not directly include stepchildren and instead looks at the acknowledged relationship between a decedent and child, as opposed to the legal relationship.

Under Nebraska law, a person may receive a favorable inheritance tax rate if, for at least 10 years prior to the decedent’s death, the person and the decedent had a parent-child-like relationship. Although stepchildren are not specifically listed, some would still fall under this category based on the factors the courts use to evaluate parental relationships.

In fact, the petitioners in the Iowa case may have received a different outcome under Nebraska’s factors. For example, under the assumption of responsibility factor, they could have shown how their stepfather paid for their college. Other factors like family, sharing of time and affection, and advice and guidance of the child, could have been proven with specific evidence gathered from the over 40-year relationship with their stepfather. However, using a factor list results in case-by-case determinations, so there’s not a 100 percent guarantee on qualifying for the $40,000 exemption.

New Jersey: It’s Mutual

New Jersey also allows favorable inheritance tax exemptions for non-biological children, provided there was a “mutually acknowledged” relationship. Unlike Nebraska, New Jersey has stricter guidelines regarding when the relationship began. Nebraska only examines the previous 10 years before the decedent’s death, but New Jersey requires that the relationship began at or before the child turned 15 years old and continued for at least 10 years.

In other words, New Jersey wants to cover taxpayers who grew up in a household and were treated as children but never adopted. But they exclude parent-child relationships that began when the children were nearly or fully adults. New Jersey does not differentiate between current and former stepchildren, but the Iowa petitioners likely would have met the mutually acknowledged child standard regardless.

Kentucky: Not So Easy A

Kentucky includes stepchildren as Class A beneficiaries, regardless of age or the stepparent’s marriage status. Interestingly, adopted children are not automatically included. Adopted children seeking an inheritance tax exemption must have been adopted during infancy or raised by the decedent from infancy and adopted later. This is likely to avoid adult adoptions done solely to avoid inheritance taxes.

The outcome of the definition may still result in people inheriting as children despite lacking a true parent-child relationship. For example, a stepchild of a fairly recent marriage could inherit tax-free but an individual who developed a child-parent relationship with the decedent late in life would be subject to a different tax rate.

In short, navigating inheritance tax exemptions can be tricky. But that’s the story on how to (maybe) become a tax-free bunch!

Continue the discussion on Bloomberg BNA’s State Tax Group on LinkedIn: How should states define children beneficiaries for inheritance tax exemptions?

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