Disclaimers as a fix for old trusts

By Andrew L. Whitehair, CPA/PFS, Cleveland

Editor: Anthony S. Bakale, CPA

A taxpayer may have established a trust long ago for a specific purpose only to have life circumstances and/or legislative changes derail well-thought-out estate planning. Fortunately, there has been much discussion in recent years of fixing or remaking old irrevocable trusts.

Various continuing-education seminars have explored numerous ideas for "fixing" old irrevocable trusts, including decanting, loans, joint ventures, and other techniques. A full discussion of all available techniques is well beyond the scope of this discussion and would be difficult to cover in summary fashion, given that laws regarding trusts vary significantly from state to state—specifically, the rules covering the decanting of a trust, which can be quite complex. However, another technique may be simple to implement and prove helpful in many situations. The use of a disclaimer by a trust beneficiary may be helpful to adjust the results of a previously established irrevocable trust.

Disclaimer background

A disclaimer is essentially a refusal of a gift or bequest. For example, if a parent dies and leaves assets via a will to a child and the will names the grandchildren as the successor beneficiaries, a disclaimer of the bequest by the child would result in the assets' passing to the next person entitled to the property, in this case, the grandchildren.

Disclaimers typically arise in the context of postmortem estate planning where a beneficiary may desire to make a qualified disclaimer under Sec. 2518 to achieve certain tax results such as qualifying for a marital deduction. If properly executed, a qualified disclaimer results in the property's being treated as if it had never been transferred to the disclaimant, i.e., the named donee. Basically, the disclaimant is disregarded for estate, gift, and generation-skipping transfer (GST) tax purposes, and the interest is treated as having transferred directly from the donor to the successor donee named in the document, or under state law provisions if there is no document or the document is silent.

Sec. 2518(b) lists the requirements to properly execute a qualified disclaimer:

  • The disclaimer must be in writing;
  • The writing must be received by the transferor's legal representative not later than nine months after the later of the day on which the transfer creating the interest in such person is made or the day on which such person attains age 21;
  • The recipient must not accept the interest or any of its benefits; and
  • The interest passes without any direction on the part of the person making the disclaimer and passes either to the decedent's spouse or to a person other than the person making the disclaimer.

A disclaimant meeting the above requirements will not be treated as the donee for estate, gift, and GST tax purposes and will not be treated as having made a gift to the successor donee. Additionally, state law may require the disclaimer to be executed within a shorter time frame, so taxpayers would need to be aware that the deadline may be sooner than nine months.

Nonqualified disclaimers

If the disclaimer does not meet the Sec. 2518 requirements, then it is a nonqualified disclaimer. With a nonqualified disclaimer, the disclaimant, rather than the donor, is treated as having transferred his or her interest in the property to the successor donee. Additionally, the disclaimant is treated for gift tax purposes as the transferor and will need to apply the gift tax rules to determine whether he or she made a taxable gift to the successor donee.

The problem

A disclaimer can be a useful tool when dealing with outdated irrevocable trusts.

Example: A client established an irrevocable life insurance trust, and the trust agreement provides for his spouse and children. Since the trust's creation several years ago, circumstances have changed such that his spouse is no longer a desired beneficiary of the trust. Perhaps the children have matured and are more capable of managing a distribution from the trust on their own, or perhaps the spouse has accumulated sufficient other assets that she no longer needs access to the insurance proceeds.

What options are available if it is no longer desired to have the spouse as a beneficiary of the trust? As noted in the introduction, several options are available to achieve the desired result. Depending on state law and the terms of the trust, the trustee may or may not be able to decant the assets into a new trust that excludes the spouse as a beneficiary. Additionally, a private settlement agreement or other modification under state law may not be an option or may give rise to potential estate tax problems under Sec. 2036 and/or Sec. 2038.

The disclaimer fix

Consider instead a disclaimer. Given that the example trust was established several years ago and the nine-month window for a qualified disclaimer under Sec. 2518 has expired, the disclaimer in this case would be a nonqualified disclaimer. Assuming the spouse is amenable to the idea, she would work with legal counsel to execute a disclaimer of her interest in the trust. She would no longer have an interest in the trust, and in this example, the children's interest in the trust would follow the terms of the trust agreement. For gift tax purposes, she would be treated as having made a gift to the trust.

If the adviser does not expect the disclaimant to be subject to estate tax, then use of the lifetime exemption upon the gift triggered by the nonqualified disclaimer may be a nonissue, especially considering that the lifetime exclusion is $5,490,000 in 2017. Additionally, if this is a trust subject to withdrawal powers, perhaps the gift deemed made by the disclaimant could be considered a gift of a present interest and qualify for the annual exclusion under Sec. 2503(b)(1), assuming the requirements of Crummey powers are respected.

The other issue that arises with a nonqualified disclaimer is the valuation of the gift. The normal valuation rules for gift tax would apply, but one must consider what the taxpayer actually gifted. The valuation of the disclaimed interest depends highly upon the terms of the trust agreement. For example, if the spouse has only a mandatory income interest in the trust, then a disclaimer of her interest would result in a gift to the trust in the amount of the present value of the income interest. In this case, the actuarial tables described under Sec. 7520 should be referenced to determine the value for gift tax purposes. Disclaimers of a trust with a discretionary interest would likely require an appraisal of the interest.

A cost-effective solution

A nonqualified disclaimer needs to be carefully considered. As noted above, the disclaimant is treated as having made a gift. Because the original donor was likely already subject to transfer tax on the original transfer, a nonqualified disclaimer could result in double taxation for transfer-tax purposes. However, in the right circumstances, a nonqualified disclaimer could be a cost-effective and simple solution to remove a beneficiary from a stale irrevocable trust.

EditorNotes

Anthony Bakale is with Cohen & Company Ltd. in Cleveland.

For additional information about these items, contact Mr. Bakale at 216-774-1147 or tbakale@cohencpa.com.

Unless otherwise noted, contributors are members of or associated with Cohen & Company Ltd.

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