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Blog: Inheritance Tax Family Planning

March 25, 2015

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Recently, a question was posed on a probate list serve that I follow.  The question raised was whether Iowa inheritance tax could be avoided by having the intended beneficiary of an estate (a nephew) be adopted by his aunt.  The full scenario was a little more complicated than that.  The real estate was currently owed by three people: two aunts and the mother of the intended beneficiary.  The question was whether each aunt could adopt their nephew, and whether the adoption would cut off the inheritance rights from the biological mother.

If the idea sounds extreme, it is.  But the inheritance tax rate schedule demonstrates why the question was being asked.  If the farmland that is to be inherited is worth $2,100,000.00, the inheritance tax consequences are significant.  The beneficiary would receive $700,000 in land from his mother free from inheritance tax.  But when each aunt died, the inheritance tax on the $700,000 in land from each child would be $101,000 (Iowa inheritance tax for uncles, aunts, nieces and nephews starts at 10% for the first $50,000 in value, increases to 12% for the next $50,000 in value, and is 15% of the value in excess of 15%).  So the proposed adoption is potentially a $202,000.00 inheritance tax savings if it would work.

The proposed adoption scenario would not work in Iowa.  Iowa Code section 633.223 notes that “a lawful adoption extinguishes the right of intestate succession of an adopted person from and through the adopted person’s biological parents.”  Thus, an adoption by an aunt would cause the beneficiary to have to pay tax on a bequest from his biological mother, since there would no longer be a legally recognized lineal relationship between the beneficiary and his biological mother.

Iowa Code section 600.4 also limits the persons who may file an adoption petition to “an unmarried adult”, “husband and wife together”, or “husband or wife separately” in the case of stepparent adoptions or other limited circumstances.  In the scenario posed, the two aunts would not be possible adopting petitioners, even in a state which now accepts same-sex marriage, because the two aunts have a blood relationship that would void a marriage under Iowa Code section 595.19.

Although farmland cannot be moved out of the state, there are alternatives to consider which could reduce the inheritance tax liability.  If the aunts have the financial ability to do so, a gift during lifetime is not subject to Iowa inheritance tax unless it is made within three years before the death of grantor.  If the aunts need the farmland, annual gifting strategies could be used to transfer the farmland in smaller increments.  Even if annual gifting is not practiced because the current owners need the income stream during their lifetime, the farmland should still be put into a family limited liability company.  Ownership of the farmland by an entity facilitates annual gifting, if mom or the aunts would decide to do so.  Ownership by an entity would allow for a claim of minority and marketability discounts, which can reduce the value of the real estate for tax and gift purposes by 30%.  Presumably, if the aunts in question were willing to consider adoption, they would also be willing to consider workable strategies to reduce the inheritance tax that will be due when they die and the land transfers to their nephew.

This blog post is authored by Joel Vos and meant for informational purposes only.  It is not meant to provide legal advice in any particular circumstance or factual situation.  You should consult with an attorney prior to taking any action regarding the information contained herein.

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