April 8, 2011

Disclaimer Trust

The following are some questions that relate to a disclaimer trust.

1. What is a disclaimer?

A disclaimer is basically a refusal to accept an interest in property via inheritance.

2. What is a disclaimer trust?

A disclaimer trust is a type of trust where a disclaimant, often the surviving spouse, disclaims property from the deceased person’s estate, whereby the disclaimed property is transferred to a disclaimer trust.

3. Why would I use a disclaimer trust?

Disclaimer trusts are used by couples to take advantage of the marital deduction formula that cushions the blow of the estate tax.

4. How does a disclaimer trust work?

First, the surviving spouse will disclaim a certain amount of property from the deceased spouse’ estate which will be held in the disclaimer trust. Then, the surviving spouse may make distributions to themselves from the disclaimer trust "if the power is subject to an ascertainable standard." Treas Reg §25.2518-2(e)(1). This ascertainable standard is generally thought to be limited to health, maintenance, or support. Treas Reg §25.2518-2(e)(5), Example 12. The disclaimer trust will most importantly not be considered an asset of the surviving spouse’s estate for estate tax purposes but instead the deceased spouse’s estate.

The following example should offer guidance:

Harry and Wendy, a mature married couple, resided in lovely Campbell, California. Harry and Wendy had two children, Sampson and Donna. Harry passed away in 2011 in a tragic hot air balloon accident. At such time, the marital estate was worth $7M. Prior to Harry’s passing, the couple executed a marital trust in which the survivor would inherit the decedent’s entire estate subject to a disclaimer trust.

The sole assets of Harry and Wendy were a home worth $5M and $2M in Google stock. Since Wendy was a frugal person, she believed that she would be unable to exhaust the entire marital estate, namely $7M, before she passed away. Of note, if Wendy did pass away in 2011 or 2012 and her estate was greater than $5M, her estate would be subject to the estate tax. 

Wendy decided to disclaim her entire interest in the Google stock, specifically $2M, through the medium of a disclaimer trust in order to avoid the potential implication of the estate tax. The result of Wendy’s disclaimer would create 2 trusts, a survivor’s trust for Wendy and a disclaimer trust for Wendy as well. Wendy could use the survivor’s trust for any purpose she wanted whereas the disclaimer trust could be used for matters involving an “ascertainable standard” as mentioned earlier. For instance, if Wendy was in need of a hip replacement surgery, she could distribute a portion of the disclaimer trust, namely Google stock dividends, to herself to pay for the surgery because it was a medical expense.

Furthermore, Wendy’s disclaimer would appreciably benefit her children, Sampson and Donna, because the assets of a disclaimer trust would not be included in her estate for estate tax purposes. Thus, even though Wendy’s two trusts might total over $5M, the estate tax exemption amount for 2011 and 2012, her estate would not subject to the estate tax. The reason for this is because the disclaimer trust would be considered part of Harry’s estate and the survivor’s trust would be part of Wendy’s estate. Therefore, Wendy’s children would reap a significant tax savings thanks to Harry and Wendy’s prudent planning.

5. Is a disclaimer trust an irrevocable trust?

Yes, a disclaimer trust is an irrevocable trust.

6. Can I make an oral disclaimer?

No, federal and California law requires that a disclaimer be in writing. IRC §2518(b)(2); Prob C §§265, 278.

7. Is a disclaimer trust comparable to an A/B trust?

Yes, a disclaimer trust is a document that seeks the same goal as an A/B trust, avoidance of the estate tax to the fullest extent possible through a marital deduction formula.

8. What type of people use disclaimer trusts?

The disclaimer trust is designed for people with an estate where the estate tax might be an issue. An A/B trust is geared towards couples where the estate tax will be an issue.

Unfortunately, nobody knows the estate tax’s long-term future given that the current law is set to expire in 2013.

9. How do you value assets that might or might not be disclaimed?

The value of the asset is the fair market value of the property on the date of death. IRC §2031(a). For example, if James purchased a home for $300,000 in 1985 and died in 2011 when the home was valued at $500,000, the value of the asset would be $500,000.

10. What is the legal effect of a disclaimer?

If the disclaimant executes a proper disclaimer, then the disclaimant will be treated as having predeceased the decedent and the disclaimant’s inheritance will vest in another individual except in the case of a spouse. IRC §2518(b)(4)(A); Treas Reg §25.2518-2(e)(2). 

11. Can a disclaimer be used by a disclaimant to avoid creditor claims?

Yes, a disclaimer is binding on creditors and does not constitute a fraudulent conveyance. Prob C §§281, 283. However, federal tax liens do attach to the disclaimed property. Drye v U.S. (1999) 528 US 49.

For example, if a hotel heiress incurred substantial debt by means of outlandish purchases, she could actually disclaim her inheritance so that creditors could not attach their claim to her inherited property. Yes, sad but true.

12. Is there a time limit to make a disclaimer?

Yes, the disclaimer must be delivered within 9 months of death (or other date of transfer) to "the transferor of the interest, the transferor's legal representative, the holder of the legal title to the property to which it relates, or the person in possession of such property." Treas Reg §25.2518-2(b).

13. Can I disclaim only a portion of the inheritance?

Yes, a beneficiary can disclaim one interest in property and retain another. IRC §2518(c); Treas Reg §25.2518-3. For example, if a beneficiary was left with 100 shares of Exxon Mobil, the person could disclaim 50 shares and keep 50 shares because stock is considered severable property. Treas Reg §25.2518-3(a)(1)(ii).