January 2009
Use Of Qualified Disclaimers In Conjunction With Revocable Trusts
By Colleen Cowles
With 2009 upon us, our clients now benefit from the $3,500,000 applicable exclusion amount for federal estate tax purposes. It's very likely that we will see estate tax legislation during 2009, considering looming deficits and the full repeal of federal estate tax in 2010 under current law if legislative changes are not made. This leaves our clients in a state of uncertainty as estate plans are completed this year.
I.R.C. 2518 allows a beneficiary to execute a qualified disclaimer, resulting in treatment of the disclaimed property as if the disclaimant had predeceased the decedent. Utilizing disclaimers as part of the estate plan builds in flexibility with is extremely useful since, at the time the estate plan is executed, ascertaining future estate values and anticipating what tax law may be as of the date of a death is very difficult. This article will discuss requirements of a qualified disclaimer, potential use of the disclaimer in estate plans, potential issues with disclaimers, and considerations required when the disclaimer is executed after a death occurs.
Requirements of a Qualified Disclaimer Are:
- The disclaimer must be an irrevocable and unqualified refusal to accept an interest in property.
- The refusal must be in writing.
- The written refusal must be received by the transferor of the interest, his/her legal representative or the holder of the legal title to the property interest within nine months of the date of 1) the creation of the property interest (typically the date of grantor's death) or 2) the day the disclaimant reaches the age of 21.
- The disclaimant must not have accepted the interest or any of its benefits.
- As a result of the disclaimer, and without the direction of the disclaimant, the interest must pass to a person other than the disclaimant. However, a surviving spouse can disclaim a property interest that passes to a trust in which the surviving spouse has an interest.
Use of Disclaimers in Estate Plans
Husband-Wife Plan Where Flexibility is Desired in Funding Credit Shelter Trust
Asset values, client goals and tax law may change greatly between the time an estate plan is drafted and when it's administered. Suppose that the combined estates of Tom and Laura Lee are valued at $3,000,000. The Lee's have been married long term and would simply leave all assets to one another if estate tax was not a concern. If a credit shelter trust is required to be funded with either a pecuniary or a fractional share formula, the survivor could potentially be left with fewer assets than needed. If the $3,500,000 applicable exclusion amount is retained through change in tax law, a plan for distribution outright to spouse would be appropriate. On the other hand, if the exclusion amount is reduced or if the estate grows significantly during lifetime, funding of a credit shelter may be necessary to utilize both spouses' credits and eliminate the estate tax. Drafting an estate plan which names the spouse as primary beneficiary with the right to disclaim to a credit shelter trust allows the surviving spouse to make decisions based on needs, goals, assets and tax law upon one spouse's death, rather than at the time the estate plan is drafted. Use of a disclaimer also allows state estate tax to be considered as of the death of the first spouse.
In large estates, the flexibility of the disclaimer is also beneficial since it may be advantageous to disclaim more than the credit equivalent in order to reduce the ultimate tax rate applied. At the time an estate plan is drafted, it is difficult to balance the benefits of splitting the estates to reduce the tax rate vs. the negatives of triggering some estate tax on the first estate, loss of stepped up basis on growth of credit shelter trust assets during the surviving spouse's lifetime, and the restrictions on management of credit shelter trust assets. Utilizing the disclaimer, actual values and tax law on date of death may be used to calculate income and estate tax liability created by various amounts and types of assets which could potentially be disclaimed. Decisions on the disclaimer may then be based on those calculations, as well as the client's preferences at the time.
Flexibility in Non-Spousal Situations
Suppose Helen and Sarah are sisters who have been very close over the years. Neither one married or had children. Their primary motivation is to protect one another, and, if the other doesn't survive, to have assets transferred to their nieces and nephews. Each sister may name the other as primary beneficiary, with nieces and nephews as contingent beneficiaries. In this way, the surviving sister may accept assets desired and disclaim other assets so the surviving sister's estate doesn't exceed the unified credit equivalent. This technique also works well for domestic partners. Even though the marital deduction does not apply so assets in the decedent's taxable estate that exceed the credit equivalent will be subject to tax in the decedent's estate, using the disclaimer to limit amounts that will be in the survivor's estate can minimize tax in the survivor's estate while giving the survivor the right to decide to what extent the inheritance will be accepted.
The disclaimer does not have to be utilized in conjunction with a credit shelter trust. Disclaimed assets will be transferred to contingent beneficiaries who would inherit if the disclaiming beneficiary did not survive. The disclaimer may be used in regard to all or a portion of inherited assets.
Potential Pitfalls in Utilizing Disclaimers and Considerations When the Disclaimer is Executed
Practicality of Disclaiming Assets Considering the Specific Client's Financial Situation
Although theoretically a disclaimer may be used to utilize the decedent's credit, before depending upon the potential disclaimer, consider the practicality. If substantially all assets are tied up in a family business or are needed as collateral on outstanding loans, it may not be practical to disclaim them. In these circumstances, a disclaimer provision allows the survivor to decide whether to retain all assets or to disclaim all or some, depending on circumstances at the time of the first death. An irrevocable life insurance trust could hold enough insurance to cover the estate tax liability created by retaining all assets in the survivor's taxable estate. The insurance cost may be justified to enable the surviving spouse to retain full management and control of assets throughout his/her lifetime. In this situation, estate planning documents could include the disclaimer to a credit shelter trust, with the irrevocable life insurance trust also structured. In this way, the surviving spouse may disclaim but isn't in a position where, if the disclaimer is not practical at the time, major tax issues result.
Avoiding 'Acceptance of Benefits Issues
Completing an inventory can be time consuming. Making decisions in regard to which assets to disclaim and the total value to disclaim is very difficult without an inventory. Until titling and beneficiary designations are verified, it is impossible to determine which assets may be disclaimed and the effect of the disclaimer. Making certain that activity occurring between date of death and date of the disclaimer does not jeopardize the disclaimer is essential but becomes more challenging when the disclaimer is delayed in order to complete an inventory. Acceptance of benefits is the greatest pitfall, especially when many clients have assets in brokerage accounts including money market accounts with check writing privileges. As soon as possible after the law office receives notification of a death, information should be provided to surviving spouse or successor trustee regarding requirements of a disclaimer and 'acceptance of benefits' issues. Notices are easy to create in the TrusTerminator system.
Be Certain That Assets Intended to be Disclaimed can be Disclaimed
Remember that only assets which would be inherited may be disclaimed. For example, a spouse may not disclaim the portion of an asset (s)he already owns. If individual trusts are utilized, only assets in the decedent's trust may be disclaimed. If a joint trust is used, decedent's portion of assets may be disclaimed. If the desire is for disclaimed assets to be transferred to the credit shelter trust, then assets should either be titled in the trust in which the credit shelter trust terms are included, or the trust should be primary or contingent beneficiary so that the trust provisions will apply to the disclaimed asset.
To prevent division of specific assets between the credit shelter trust and the revocable trust, assets may be exchanged between the credit shelter trust and the revocable trust, but if full step up in basis was not achieved on assets in decedent's and survivor's estates, income tax considerations must be taken into account. Exchanging is easiest when the disclaimer is from a joint trust in a community property state since in that situation, double step up in basis negates capital gains tax on values as of date of death. Suppose Alex and Mary hold $8,000,000 in their joint trust including stock, real estate, miscellaneous bank accounts and certificates of deposit. The trust provides that all assets are to be transferred to the surviving spouse (as trustee and beneficiary of the revocable trust) but grants the surviving spouse the right to disclaim, with disclaimed assets transferred to the credit shelter trust. At the time of Mary's death, Alex decides that he would like to place all stock and certain parcels of real estate in the credit shelter trust. Having all of one asset (e.g. a parcel of real estate), or one type of asset (stock account) in the credit shelter simplifies accounting and overall account management. Alex believes that stock and real estate values will grow significantly during his lifetime, so he would like those values to be in the credit shelter trust, keeping appreciated values from being included in his taxable estate. (On the other hand, if it's likely that assets will be spent during Alex's lifetime, or if Alex believes that estate tax exclusions may increase, then it may be better to retain appreciating assets outside of the credit shelter, to receive another stepped up basis upon Alex's death.) Estate tax vs. income tax ramifications should be compared and considered prior to making funding decisions. When selecting trustee(s) who are also beneficiaries, review the authority provided to them.
Consider this example:
A revocable trust names grantor-parents as primary trustees, child as successor trustee, and child as trustee of the Credit Shelter Trust. Child is also the remainder beneficiary. Mandatory funding of the Credit Shelter Trust is utilized, and standard trustee powers allow the trustee to execute a disclaimer.
The child, as trustee of the credit shelter, has the power to disclaim assets, which then go to him/herself as remainder beneficiary without approval from the surviving grantor (parent).
Additionally, when selecting trustees and granting trustee powers, if trustees are also beneficiaries, beware of general power of appointment issues which are created if a trustee has the unilateral right to transfer assets to him/herself. If this authority to make gifts is given to the trustee (or the trustee could end up with it if the right combination of facts occurred) then the assets available for such 'transfer' may be included in the taxable estate of the trustee for estate tax purposes. In larger estates, authorizing gifting up to annual gift tax exclusion amounts may be very beneficial to continue annual gifts to reduce the value of the taxable estate, even if the client becomes incapacitated. Limiting gifting to the annual exclusion or designating gifting to specific beneficiaries rather than giving broad discretion to the trustee (who may be a gift recipient), limits the extent of the power of appointment issue.
It is also important that gifting powers are consistent between the trust agreement and the power of attorney. Cowles Trust Plus automatically makes adjustments to assure consistency between these documents. If the 'gifting allowed' selection is made for the power of attorney, authorization to gift will also be included in Article Five of the trust agreement. Specific authorization to gift trust assets will match authorization to gift as determined by the selections made for the power of attorney. In a joint trust, if both spouses do not authorize gifting in their power of attorney, gifting language will not be inserted into the joint trust, so authorization to gift language in the revocable trust will always be the most restrictive desired by either spouse.
Each estate plan is obviously different and the best options for each client must be considered, but the Cowles Trust Plus system provides many checks and balances to help in systematic consideration of alternatives, and to keep documents consistent.
See all articles in current issue