Court Says No Iowa Estate Tax on Life Insurance Proceeds That Aren’t Included in the Probate Estate – Update: Reversed on Appeal

July 29, 2010 | Erin Herbold

 

Updated July 29, 2010

The decedent died in 1998.  At the time of his death he had two sons that were named as beneficiaries of his life insurance policy.  The decedent’s estate was probated but, of course, the life insurance policy was not included in the probate estate – it’s “bypass” or “will substitute” property via the beneficiary designations.  After payment of administrative expenses, the estate lacked the funds to pay the federal and Iowa estate taxes.  When it was closed, the estate was insolvent, and the two surviving sons did not inherit any probate assets.

In 2004, the IDOR assessed Iowa estate tax of approximately $31,000 against the two sons- attempting to collect the tax through a levy on the life insurance proceeds that they received.   The parties agreed that the proceeds of the insurance policy were not includable in or taxable to the probate estate for inheritance tax purposes- though they were included in the decedent’s gross estate.  Under Iowa Code Ch. 450, life insurance proceeds that are paid to a “named beneficiary” are exempt from Iowa inheritance tax.  The sons paid the tax and sued for a refund. 

An administrative law judge (ALJ) ruled that the IDOR was not authorized to collect the estate tax from the sons. The IDOR appealed and the director of the IDOR reversed the ALJ’s decision. The trial court affirmed the director’s decision and the sons appealed to the Iowa Court of Appeals.

While Iowa law (Iowa Code§451.6) specifies that the estate tax imposed shall be paid by the personal representative (here, the sons), the appellate court noted that does not mean that the personal representative has personal liability for the taxes. The tax is the estate’s responsibility, not the personal representative’s.  In addition, Iowa law does not authorize the collection of Iowa estate tax from non-probate assets. The appellate court noted that Iowa Code §450.7 excludes children and other lineal descendants, such as parents and spouses, from being subject to a tax lien. Thus, the beneficiaries were entitled to a refund of tax, penalties and interest. As the prevailing taxpayers, the brothers were also entitled to their “reasonable costs of litigation.” Tremel v. Iowa Dept. of Rev., No. 9-592/08-1718 (Iowa Ct. App., Oct. 7, 2009).

UPDATE: The Iowa Supreme Court has now vacated the decision of the Iowa Court of Appeals and affirmed the trial court and IDOR director’s decision in this case. The Iowa Supreme Court found that Iowa Code §451.12 permits the IDOR to assess and collect estate tax from the beneficiaries of a life insurance policy. The Court opined that the state legislature gave the IDOR and its director the authority to interpret §451.12.  The court looked to the interaction between the inheritance tax provisions under Iowa Code Ch. 450 and the estate tax provisions of Iowa Code Ch. 451, and several provisions of the federal tax code. For federal estate tax purposes, under the Internal Revenue Code, the taxable estate is the gross estate minus certain allowable deductions.  At the time of the decedent’s death, a credit was allowed for the amount of state death taxes paid.  Also, at the time of the decedent’s death, the State of Iowa imposed an estate tax upon the transfer of the total net estate for those dying after April 1929. The Iowa Estate Tax was governed by Iowa Code Ch. 451 (since repealed). The Internal Revenue Code specified that the gross estate subject to estate tax encompasses the value of all property, including life insurance proceeds. 

The IDOR director argued that he had the authority under Iowa Code §§ 451.12 and 450.55 to collect Iowa estate tax.  The Iowa Supreme Court found that it was clear from the language of the statute that the director had the authority to promulgate administrative rules and collect the tax in the way they see fit under the statute.  Even though the sons argued that as lineal descendants of the deceased, any property received by them was exempt from inheritance tax, they could not make an argument exempting them from estate tax under Iowa Code Ch. 451. There was no exemption under §451 for life insurance proceeds received by lineal descendants. Thus, the brothers were liable for estate tax in this situation and the IDOR’s interpretation of §451.12 was “not irrational, illogical, or wholly unjustifiable.”  Tremel v. Iowa Dept. of Revenue,785 N.W.2d 690 (Iowa Sup. Ct. 2010).