Disclaimer Plan to the Rescue

In 2012 the exemption from the federal estate tax is $5 million. It has risen in leaps and bounds from $600,000 in 1997 to the current $5 million. Part of the tax uncertainty facing us is that unless Congress acts before the end of 2012, the estate tax exemption will fall back to $1 million.

I have given up predicting what our Congress will do. I suppose we could place bets on it? But a more productive approach is to be prepared with an estate plan that will produce the minimum in estate taxes regardless of what the federal exemption is. You need a plan that is flexible and self-adjusts so that you don’t have to do it over every year.

I recommend a plan to my clients I call the “Disclaimer Plan.”

The text-book solution for couples whose combined net worth exceeds the federal exemption is to divide the title to assets between spouses and to have each spouse create an estate plan with a “by-pass” or “credit shelter” trust. (This type of plan is sometimes called an A-B Trust.)

If the federal exemption is $1 million, this is how the credit shelter or by-pass plan works. On the death of the first spouse, property titled in that spouse’s name alone (up to but not exceeding $1 million) passes to the by-pass trust. This uses the first-to-die spouse’s exemption from federal estate tax. Then on the death of the surviving spouse, he or she is entitled to a second $1 million exemption.

One concern couples often express about a by-pass trust plan is that it leaves the surviving spouse with a trust during his or her period of survivorship, and the survivor may prefer unfettered control. This is of particular concern when it is possible the federal estate tax exemption will be raised and this type of planning will be unnecessary for you. If Congress keeps the exemption at $5 million, most people will not need to have by-pass plans. A solution to this is to set up an empty by-pass trust and leave it up to the surviving spouse to choose whether it will be funded or not. This is a disclaimer plan.

In a disclaimer plan, your documents are designed so that the surviving spouse may elect after the death of the first spouse for the tax-saving trust to be created. The surviving spouse may disclaim part or all of his or her inheritance. Disclaimed property goes into trust for the benefit of the surviving spouse.

The disclaimer plan gives maximum flexibility. If you have a disclaimer plan, each of you should be aware that as soon as possible after the death of the spouse you should get advice on the pros and cons of making a disclaimer. A disclaimer must be made within nine (9) months of death, and the surviving spouse must have received no benefit from the disclaimed property during that period.

For tax purposes, Section 2518 of the Internal Revenue Code permits the beneficiary of an estate or trust, in this case the surviving spouse, to make a “qualified disclaimer,” in which case the disclaimant will be treated, for estate and gift tax purposes, as though he or she had never received any interest in the estate or trust. Unlike other beneficiaries, the regulations provide that a surviving spouse can, through a qualified disclaimer, allow property to pass to a trust for his or her own benefit.

The principal disadvantage of the disclaimer plan is that a decision must be made by the surviving spouse at a time when he or she is likely emotionally upset and perhaps feeling financially insecure. Also, the surviving spouse can have accepted no benefit from the property that is ultimately disclaimed. With good advisors this should not be a problem for the surviving spouse, but some spouses simply do not want the responsibility of making the decision.

It is very important that the survivor do nothing with the deceased spouse’s assets until the disclaimer decision is made. If any of the assets have been used or “accepted”, the opportunity to disclaim them will be lost.

The disclaimer trust is the ideal solution for many couples who have “medium” sized estates. We write wills or a revocable living trust in which each client leaves his or her entire estate to the survivor. The wills can, however, contain a special disclaimer clause directing that, if the surviving spouse should for any reason make a qualified disclaimer of his or her interest in the estate, the disclaimed property will pass into a trust for the benefit of the surviving spouse.

It is possible to give the surviving spouse broad powers and interests in the disclaimer trust to make it as palatable as possible for the surviving spouse. The surviving spouse can have all of the income. The surviving spouse can have the power to withdraw the greater of $5,000 or 5% of the principal each year. The surviving spouse can serve as the sole trustee so long as any discretionary power to distribute principal is limited by an ascertainable standards, such as for health, education, maintenance and support, but cannot have any power to direct the beneficial enjoyment of the disclaimed property unless the power is limited by an “ascertainable standard.” The surviving spouse may not have a testamentary power of appointment.