Kentucky Bar Association: "Disclaimer Trusts: A Flexible Choice For Many Couples"
Published in Bench & Bar, January of 2006
Many young or middle aged couples find it difficult to take the time to plan who will receive their assets at their deaths. Jobs, children and busy schedules all combine to keep couples from meeting with their attorneys to make the tough decisions required to formalize an effective estate plan. Now with talk of permanent estate tax repeal in the air, couples have been handed another excuse for further delaying those decisions as they wait to see if Congress will abolish the estate tax, thereby eliminating the need for any estate tax planning. Unfortunately, Congress has shelved any decision on permanent estate tax repeal for the foreseeable future in the face of mounting budget deficits, recent natural disasters, and the war in Iraq.
If Congress Fails To Repeal The Current Estate Tax Regime, Who Will Be Subject To Estate Tax?
Under the Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA”), the amount of property that an individual can transfer to the next generation free of estate tax (the “exemption amount”) has risen and will continue to rise over the next few years as follows: $1,000,000 in 2002 and 2003; $1,500,000 in 2004 and 2005; $2,000,000 in 2006, 2007 and 2008; $3,500,000 in 2009; and in 2010 the estate tax is repealed altogether.[i] During this same period, the highest marginal estate tax rates continue to fall: 55% in 2001; 50% in 2002; 49% in 2003; 48% in 2004; 47% in 2005; 46% in 2006; and 45% in 2007, 2008 and 2009.[ii] However, if Congress fails to act to make estate tax repeal permanent, EGTRRA is scheduled to expire on January 1, 2011, in which case the exemption amount will drop back down to $1,000,000 and the highest marginal estate tax rate will return to 55%.
Do Traditional A-B Trust Estate Plans Remain Adequate For Most Couples Under The Current Federal Estate Tax Regime?
In order to take maximum advantage of each individual’s exemption amount, estate planning practitioners have traditionally recommended the use of two inter vivos trusts for each spouse as the main vehicles by which to administer and dispose of their separate estates.[iii]
Each trust contains provisions to establish a sub-trust for the surviving spouse that will be funded with assets owned by the deceased spouse equal in value to the exemption amount available in the year the first spouse dies. This sub-trust is commonly called a credit shelter trust (or “B” or “bypass” or “family” trust) and is designed to continue during the lifetime of the surviving spouse. By thus using the exemption amount of the first spouse to die, rather than leaving all of the assets to the surviving spouse outright, the couple thereby avoids wasting the opportunity to shelter some of the couple’s assets at the first spouse’s death.[iv]
The surviving spouse can be a co-trustee or even the sole trustee if the credit shelter trust is carefully written.[v] When he or she dies, the balance of the trust assets are free of estate tax and are usually distributed to the couple's children and/or descendants or continued in trust for later distribution when the children each reach an appropriate age. Such a trust can also include provisions to benefit charities or make distributions to other relatives or close friends.
Any assets of the first spouse to die not used to fund the credit shelter trust will pass to the surviving spouse, either in trust (commonly known as the “marital” or “A” trust) or outright, and will be included in the surviving spouse’s taxable estate at his or her death.
In short, the traditional A-B trust plan utilizes both spouses’ exemption amounts and defers any estate tax that otherwise would be due until the subsequent death of the surviving spouse.
What Is A Disclaimer Trust And What Are Its Advantages?
While traditional A-B trusts should continue to be used for couples with combined estates over $3,500,000 (which, unless the estate tax is repealed, are likely to be subject to estate tax regardless of what Congress may or may not do before EGTRRA expires in 2011), those couples with combined estates of over $1,000,000 but less than $3,500,000 may or may not need any estate tax planning in the future.[vi]
Practitioners who represent such clients should consider advising them to adopt an estate plan which names the surviving spouse as the beneficiary of the other spouse’s estate, but then gives the surviving spouse the right to renounce or disclaim all or part of those assets if their combined estates exceed the exemption amount upon the first spouse’s death. The disclaimed assets would pass to a credit shelter trust for the continued benefit of the surviving spouse and as outlined above would be sheltered from estate tax at the surviving spouse’s death.
For example, suppose the first spouse to die has an estate worth $2,000,000. He or she passes away in 2006 when the exemption amount is $2,000,000 and he or she has never made any lifetime taxable gifts. The surviving spouse also owns assets worth $1,000,000. If the surviving spouse decides to accept all of the deceased spouse’s estate, as a result of the unlimited marital deduction there will be no estate tax due at the first spouse’s death. However, the surviving spouse will have a potential taxable estate of $3,000,000 at his or her subsequent death. If he or she passes away in 2011 when the exemption amount is scheduled to return to $1,000,000 (assuming Congress has failed to make estate tax repeal permanent or raise the exemption amount), the surviving spouse’s estate will pay $945,000 of estate tax, thereby leaving the couple’s children with net assets worth $2,055,000!
On the other hand, if the surviving spouse disclaims the deceased spouse’s entire $2,000,000 estate (although the surviving spouse could disclaim only a portion of the estate if that result is appropriate), the deceased spouse’s exemption amount will “shelter” his or her assets from estate tax upon the surviving spouse’s subsequent death. Moreover, the deceased spouse’s assets can continue to appreciate in value without any of the appreciation being included in the surviving spouse’s taxable estate. The surviving spouse can be the trustee of the deceased spouse’s credit shelter trust, receive all of the net trust income and, if needed, receive principal distributions, so long as such distributions are limited by an ascertainable standard relating to his or her health, education, support, or maintenance.
This “wait-and-see” approach gives couples the flexibility to keep their assets in joint names or to name each other as the beneficiaries of their qualified benefit plan assets or life insurance policies, while retaining the ability to shelter assets from estate tax should their combined estates potentially exceed the exemption amount that may or may not be available at the death of the surviving spouse.
How Is The Disclaimer Trust Funded?
Under Indiana law, the surviving spouse must deliver his or her disclaimer to the personal representative of the deceased spouse’s estate or otherwise file the disclaimer with the court having jurisdiction to appoint a personal representative for the deceased spouse’s estate.[vii] The disclaimer must (1) be in a writing or other record, (2) state that it is a disclaimer, (3) describe the interest or power disclaimed, (4) be signed by the person making the disclaimer, and (4) be delivered or filed as provided by Indiana’s Uniform Disclaimer Of Property Interests Act.[viii] If the disclaimer meets all of these requirements, then the property or interest being disclaimed passes as if the surviving spouse had predeceased the first spouse to die. Under the terms of the deceased spouse’s Will, the disclaimed assets are then transferred to the trustee of the deceased spouse’s credit shelter trust for the lifetime benefit of the surviving spouse without any adverse gift or estate tax consequences.
With regard to non-probate assets, Indiana law allows the surviving spouse to send a written disclaimer to the person, trustee or entity having legal title to any asset governed by a non-testamentary instrument (e.g. joint property[ix], insurance policy[x], inter vivos trust agreement[xi], testamentary trust agreement[xii], qualified benefit plan[xiii], etc.). Upon receipt of the disclaimer, the recipient then transfers the disclaimed assets either to a contingent beneficiary named in the governing instrument (i.e., the then acting trustee of the deceased spouse’s credit shelter trust) or to the personal representative of the deceased spouse’s estate (which, under the terms of the deceased spouse’s Will, means that the assets will be subsequently transferred by the personal representative to the trustee of the deceased spouse’s credit shelter trust for the benefit of the surviving spouse).[xiv]
In order to be an effective or “qualified” disclaimer for federal estate tax purposes, an Indiana disclaimer must also meet the following five requirements, which are set forth in Internal Revenue Code §2518(b):
(1) It must be an irrevocable and unqualified refusal to accept an interest in property;
(2) It must be in writing;
(3) It must be received by the transferor or his or her legal representative or the holder of the legal title to the property involved within nine months after the later of (a) the date on which the transfer creating the interest is made or (b) the day on which the person in whom the interest is created attains age 21;
(4) The person in whom the interest disclaimed is created must not have accepted the interest or any of its benefits; and
(5) As the result of the disclaimer, the interest must pass without any direction by the person making the disclaimer either (A) to the spouse of the decedent or (B) to someone other than the person making the disclaimer.
Failure by the surviving spouse to satisfy all of these additional federal requirements may result in the disclaimer being treated as a taxable gift from the surviving spouse to the recipients of the disclaimed property.
What Are Some Of The “Caveats” Of Using Disclaimer Trusts?
Disclaimer trusts by their very name suggest a high degree of “trust” between spouses, as the surviving spouse could decide not to disclaim any assets and later alter his or her estate plan, especially in the case of couples who have children from a prior marriage.
In addition, the surviving spouse may be unable to cope with making difficult decisions following the death of the first spouse and thereby miss the opportunity to utilize the disclaimer trust plan within the nine month deadline for making a qualified disclaimer.
The surviving spouse could fail to consult his or her attorney before accepting the assets or receiving income and as a result be unable to make a qualified disclaimer.
Finally, the surviving spouse could remarry and leave his or her entire estate to a new spouse who in turn leaves it to his or her own family to the exclusion of the children of the first marriage.
Any couple whose combined estate is worth between $1,000,000 to $3,500,000 and has failed to design an estate tax plan or has a traditional A-B trust estate tax plan in place should consult an experienced estate planning practitioner, who can offer guidance in evaluating whether the flexibility found in disclaimer trusts may be right for them.[xv]
[i] Under EGTRRA, the amount of property that an individual can transfer to his or her descendants during his or her lifetime continues to remain at $1,000,000. Thus, there is no longer a “unified credit” for the gift and estate tax until EGTRRA expires in 2011. In addition, it is important to note that any lifetime taxable gifts continue to reduce the amount of property that an individual can transfer at death. Moreover, each individual can annually give away up to $11,000 (scheduled to increase to $12,000 in 2006) worth of assets to as many separate individuals as he or she wishes without using any of his or her lifetime credit against the gift tax. See Internal Revenue Code (“IRC”) §2503(b)(1) & (2). Each individual can also pay an unlimited amount of tuition or health expense for as many separate individuals as he or she wishes without using any of his or her lifetime credit against the gift tax, so long as the payments are made directly to the school or health care provider. See IRC §2503(e). Finally, couples can and will continue to be able to make unlimited transfers to each other during their lifetimes or at death.
[ii] Under EGTRRA, the gift tax rates match the estate tax rates. When the estate tax is temporarily repealed in 2010, the gift tax rate is scheduled to be equal to the highest individual income tax rate so as to discourage individuals from assigning income.
[iii] As an alternative to the inter vivos trust, each couple could establish a testamentary trust for the benefit of the surviving spouse in his or her Will.
[iv] Over the last three decades, most estate planning practitioners have used one of the following three standard formula clauses designed to create a credit shelter trust for the benefit of the surviving spouse: (1) fractional share, (2) pecuniary credit shelter share, and (3) pecuniary marital deduction share.
[v] If the surviving spouse is the sole trustee of the credit shelter trust, his or her ability to use trust principal for his or her benefit must be limited by an ascertainable standard relating to his or her health, education, support, or maintenance. See IRC §2041(b)(1)(A). Otherwise, the credit shelter trust’s assets will be included in the surviving spouse’s estate.
[vi] Of course, everyone will continue to need estate planning but not necessarily estate tax planning.
[vii] See IC 32-17.5-7-2.
[viii] See IC 32-17.5-3-3(b).
[ix] See IC 32-17.5-7-7.
[x] See IC 32-17.5-7-6.
[xi] See IC 32-17.5-7-4.
[xii] See IC 32-17.5-7-3.
[xiii] See IC 32-17.5-7-6.
[xiv] Only a surviving spouse is permitted to make a qualified disclaimer of assets which are then held in trust for the benefit of that spouse who disclaimed the assets. See IRS §2518(b)(5).
[xv] Internal Revenue Service (“IRS”) Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any tax advice contained in this article (including endnotes) was not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the IRC or (2) promoting, marketing or recommending to another party any transaction or matter addressed herein.