Posts Tagged ‘disclaimer’

Bypass Trusts, Disclaimer Trusts and Portability in Estate Planning

MAY 6, 2013 VOLUME 20 NUMBER 18
Last week we wrote about questions we often hear from our clients in the wake of big changes to the federal estate tax structure. Almost immediately we heard from a reader asking about portability and disclaimer trusts; our reader suggested we try to explain the two concepts and how they are related. It’s a good idea.

First, a caveat: if you are not married OR if you are married but you and your spouse are “worth” less than about $5 million, then your interest in this topic is probably academic. That doesn’t mean you shouldn’t read on, but only that the explanation won’t affect you much — except perhaps to alert you if you have a more-complicated estate plan than you need.

Let’s start, as we often do, with a brief explanation of the classic A/B trust setup that prevailed in estate planning for married couples for nearly three decades. In an environment where estate taxes kicked in at the relatively low level of $600,000 of net worth, many couples had estate plans that created an irrevocable trust (sometimes called the “bypass” or “decedent’s” trust) on the first death. That typically allowed the surviving spouse to get the benefit of the money left to the trust, but not include it in her (or his) estate — thereby effectively doubling the $600,000 exemption amount to a total of as much as $1.2 million.

Of course, over the last decade the exemption amount rose from $600,000 to $3.5 million and then settled at $5 million (plus an annual increase for inflation). That meant that only couples with estates  of $5 million would need to create the two-trust setup, and that their estates would be covered up to a total of over $10 million with fairly simple estate planning.

But the other change made by the 2010 tax law (and made permanent effective this year) makes it harder to explain the planning options. That change is usually called “portability.” Here’s how it works:

Each spouse in a married couple has an exemption amount of $5 million (plus the inflation adjustment effective the year of that spouse’s death). If, say, the husband dies in 2013, with a $5.25 million exemption amount, but leaves his entire estate outright to his wife — she inherits his estate PLUS his exemption amount. She immediately has a $10.5 million exemption amount, and it goes up (or at least “her” half does) next year for inflation. No irrevocable trust needed. No fancy estate planning required. No legal fees, no accounting or tax preparation until the surviving spouse dies.

That’s a great outcome. It should save money for most married couples, and it is much easier to understand (and execute) than the two-trust solution. The hardest thing to understand about portability might just be its formal name: DSUEA (“Deceased Spousal Unused Exclusion Amount”).

There are, though, a number of wrinkles that well-informed planners need to appreciate. Note that these wrinkles do not mean that you should not rely on the portability arrangement. Most people will not be affected by them.

Generation-skipping tax. The generation-skipping tax exemption is a flat $5.25 million this year (it is also indexed for inflation). if you and your spouse are worth more than about $5 million AND you plan on leaving your assets to grandchildren, or in trusts for your children lasting past their deaths, then you might not want to rely on the portability arrangement.

Filing an estate tax return. The portability of the exemption amount is not automatic. The surviving spouse can only keep the deceased spouse’s exemption amount IF a federal estate tax return is filed. Say what? In order to get this benefit you have to file a return that almost no one else has to file, and to incur the expense of valuing assets (which would not have to be done otherwise)? Yes.

State estate taxes may not work the same way. Arizona, as we keep reminding clients, does not have a state estate tax. But a number of other states still do, and they will apply even to Arizona residents if they own real estate in one of those states. So portability may not be enough in cases where there are significant out-of-state assets.

Remarriage can cause loss of the portability exemption. Let’s sketch out a story. Martha’s husband David died in 2011, leaving his $2 million estate to Martha. She filed a federal estate tax return and claimed David’s $5 million unused estate tax exemption. In 2013, she has $10.25 million in exemption equivalent amount (David’s $5 million plus her $5.25 million). Note that she inherited more exemption amount from David than she inherited of actual estate value.

This year Martha’s wealthy parents died, leaving her their estate; she is now worth $8 million. She remarries. Her new husband, Hal, is a wealthy and very generous man; he has previously given his children a total of $5 million in gifts.

Does this story seem absurdly fanciful? Do you wish you had these problems? Do you want to tell Martha she shouldn’t have married Hal? Because if Hal dies, Martha “loses” David’s unused estate tax exemption, and gets Hal’s instead — and that could mean estate tax on a couple million of her estate. On the other hand, if Martha dies Hal inherits her unused exemption (the exact amount depends on who she leaves her estate to), making it possible for him to give several millions of dollars more to his children with no gift or estate tax consequences.

Can you just imagine the prenuptial agreement? And aren’t you glad that the estate tax system has been simplified?

The truth is, of course, that it has been simplified — vastly simplified, in fact, for individuals and couples worth less than about $5 million. That means most of us — about a quarter of one percent of American households are worth more than $5 million, according to some calculations.

What does all this say about disclaimer trusts? As we reported last week, having a back-up trust for your spouse might make sense in at least some circumstances, and one way to do that would be to give the surviving spouse the power to fund the trust by disclaiming the ability to inherit outright. But we predict that disclaimer trusts will be implemented infrequently.

Disclaimer Ineffective When Signed After Accepting Benefit of Property

A recent Arizona appellate court decision gives us an excuse (not that we really needed one) to write about an arcane planning technique: disclaimer. How do you disclaim an interest in property, and why might you want to? We’ll see if we can give you an introduction to the concepts. Warning, though: this will be brief, and Arizona-specific. If you have a real-world question, talk to a lawyer in your jurisdiction.

When J. Scott Gardner died in Phoenix in 2008, he left a house in the Prescott area. The house had a $205,330 mortgage; Mary Richards (not her real name) lived there. Mr. Gardner’s trust directed that Ms. Richards should be able to live in the house, provided that she pay all taxes, utilities, homeowners association fees and insurance. She was also to pay “any other reasonable and customary fees that would normally accompany a property.”

The trust directed that when Ms. Richards died, Mr. Gardner’s two children would take ownership of the house. Mr. Gardner’s brother was named as trustee of the trust.

The trustee’s first question arose pretty quickly. Who was to pay the mortgage payments on the house while Ms. Richards lived there? He turned to the local probate court for instructions; the judge ruled that Ms. Richards should pay the interest on the mortgage, and the two children could pay the principal amounts due on each payment (since principal reduction on the mortgage would ultimately flow to their benefit).

Now a second problem arose. Mr. Gardner had died just before real estate values all across Arizona declined steeply, and everyone agreed that the house was no longer worth the amount of the mortgage. Ms. Richards had asserted her right to use of the house in correspondence among the parties, but had not paid the interest payments even after the probate court directed that they were her responsibility. In May, 2010 — a year and a half after Mr. Gardner’s death and Ms. Richards’ assertion of her interest in the property — she sent the trustee a letter attempting to disclaim her interest.

Why would she do that? The appellate decision does not deal with the parties’ strategy, but it is fairly easy to deduce her reasoning. If she was held to have taken possession of the house, then any money she was entitled to receive from the rest of Mr. Gardner’s trust estate would be reduced by the unpaid interest — and that interest debt would continue to accrue until the property was disposed of. Since there would likely be no net return from the sale of the house, that would mean that her inheritance was being reduced by the amount of the interest payment each month.

It doesn’t actually matter to the legal issue, but you probably are wondering what happened to the house. The trustee asked the probate court for permission to stop making any payments on the mortgage. The judge agreed that it made no economic sense to keep paying on a house with no equity, or even a negative equity, and so payments were stopped. The mortgage holder repossessed the property. But the legal problem remained: did Ms. Richards owe the trust the unpaid interest payments?

The probate court decided (and the Arizona Court of Appeals agreed) that Ms. Richards’ attempted disclaimer was invalid. To be valid under Arizona law, a disclaimer of a bequest or inheritance must be in writing, signed by the person disclaiming, and delivered (or recorded) according to the statute. If all those conditions are met, then the disclaimer can be effective — and it has the effect of causing the disclaimed person to be treated as if they had died before the person transferring the property to them.

There are two other important rules, though, and one of those tripped up Ms. Richards. A person can not disclaim property after they have already accepted it — or received the benefit of the property. Since Ms. Richards had possession of the Prescott house, knew of her liability for payment of expenses and asserted her interest in letters she wrote to the trustee, she could no longer disclaim her life estate.Estate of Gardner, August 9, 2012.

The other “rule” about disclaimers, widely understood, is actually a little bit trickier. Most lawyers, when asked about disclaimers, will recite the requirement that any disclaimer must be completed within nine months of the date on which the property interest would have passed (ordinarily, the date of death of the person leaving the property to the disclaimant). That is actually a requirement of federal tax law — in order to receive favorable tax treatment a disclaimer must be within that time limit. Some states have also adopted that nine-month limitation for all disclaimers, but Arizona has not. A disclaimer within the nine months is usually said to be a “qualified” disclaimer — a disclaimer that is otherwise valid under Arizona law but not qualified for favorable tax treatment is, unsurprisingly, known as a “non-qualified” disclaimer.

All that begs the question we began with: why would anyone want to disclaim the inheritance or gift they were set to receive? There are lots of reasons. A few of the more common ones we see:

  • The recipient has a very large estate, and is happy to have the inheritance pass on down to (usually) the next generation — perhaps to keep from having a large estate tax on their own estate, or perhaps just because they don’t want or need the inheritance.
  • The recipient has a lot of debt, and creditors standing ready to seize any property they might inherit. By disclaiming, the intended recipient can allow the property to get to the next recipient without being subject to those creditors’ claims.
  • The recipient does not feel deserving of the gift. Perhaps the decedent’s will or trust was written years earlier, when the recipient and the decedent were close friends or business associates — or romantically involved. The recipient might feel uncomfortable taking the property after a long estrangement, and recognize that the only reason the decedent didn’t make changes in his or her will or trust was the ordinary inertia that sometimes overcomes people faced with estate planning decisions.
  • The alternate beneficiary is particularly well-suited to handle the property. Perhaps it is a well-crafted special needs trust benefiting a close family member, or a charitable organization set up to deal with the property in question. The recipient might decide to just let the next person or entity in line deal with the inheritance.
  • Perhaps the property is more of a liability than a benefit — as turned out to be the case for Ms. Richards. We have seen other cases where the property subject to the inheritance was tainted by pollutants, or subject to a big property tax liability.

One key thing to understand about disclaimer: if you sign an effective disclaimer, you have no control over where the property goes. You can not disclaim “to” another person. When you disclaim, the property passes as if you had predeceased the donor; that might be to someone (or some entity) you don’t like or don’t approve of. If that troubles you, disclaimer might not be for you. The only way to control where the property goes is to accept the inheritance and then make a gift yourself — and that might involve creditor claim issues, estate tax issues or even gift tax issues. Get good legal advice. But at least now you’ll be a little bit familiar with the concepts.

©2021 Fleming & Curti, PLC