Be Careful Making Disclaimers Where Trusts Are Involved

Editor: Greg A. Fairbanks, J.D., LL.M.

Disclaimers are very useful tools for estate planners, especially in postmortem planning. Disclaimers allow interests in property to pass to parties other than the original object of a donation or bequest. In postmortem planning, a disclaimer is often used to qualify an interest for an estate tax deduction (e.g., marital or charitable) or to more efficiently use a decedent’s estate tax applicable credit amount or generationskipping transfer (GST) exemption amount. However, if an estate planner is not diligent in the planning and execution of a disclaimer, it can have adverse transfer tax consequences.

Disclaimers are governed by both state and federal law. State law disclaimers determine how property interests pass to other parties as the result of a disclaimer. Under many states’ disclaimer laws, if the requirements of a disclaimer are met, disclaimed property interests flow as if the disclaimant had predeceased the donor or decedent.

Under federal tax law, if a person makes a “qualified disclaimer” with respect to an interest in property under Sec. 2518, the disclaimed interest is treated for gift, estate, and GST tax purposes as if the interest had never been transferred to that person. Thus, if a person makes a qualified disclaimer, that person will not incur transfer tax consequences as a result of the qualified disclaimer because he or she is disregarded for transfer tax purposes. Note, however, that unlike many states’ disclaimer laws, the federal law does not treat the disclaimant as if he or she had predeceased the decedent.

Sec. 2518 provides that a qualified disclaimer is an irrevocable and unqualified refusal by a person to accept an interest in property, but only if: (1) the disclaimer is in writing; (2) the disclaimer is received by the transferor of the interest, his or her legal representative, or the holder of the legal title to the property to which the interest relates not later than nine months after the later of (a) the date on which the transfer creating the interest in the person is made or (b) the day on which the person attains age 21; (3) the person has not accepted the interest or any of its benefits; and (4) as a result of the disclaimer, 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.

Assuming an estate planner is aware of the requirements, he or she should not have difficulty in executing a qualified disclaimer. However, a recent Tax Court case and a recent letter ruling highlight how tricky it can be to meet the fourth requirement for a qualified disclaimer when disclaimed property passes to a trust, and the negative tax consequences that may occur if the requirements of a qualified disclaimer are not met.

Estate of Christiansen

In Estate of Christiansen, 130 T.C. No. 1 (2008), the decedent left the residue of her estate (which included interests in two family limited partnerships) to her daughter. The daughter made a partial disclaimer of the bequest to the extent the value of the residue exceeded a formula amount determined by reference to a fraction, the numerator of which was the fair market value (FMV) of the gift (before the payment of debts, expenses, and taxes) on the date of the decedent’s death less $6,350,000, and the denominator of which was the FMV of the gift (before the payment of debts, expenses, and taxes) on the date of the decedent’s death “as such value is finally determined for federal estate tax purposes.”

The decedent’s will provided that if the daughter disclaimed any portion of the bequest, 75% of the disclaimed portion would go to a charitable lead annuity trust (CLAT) (the annuity interest passing to the family foundation and the remainder interest passing to the daughter, if living at the end of the annuity term) and 25% would go to the family foundation outright.

The decedent’s estate claimed an estate tax marital deduction for the present value of the income interest in the CLAT passing to the family foundation. The IRS disallowed the deduction because the disclaimer was not a qualified disclaimer as defined in Sec. 2518. Specifically, the IRS argued that the daughter’s disclaimer did not meet the requirement that the disclaimed property must pass without any direction on the part of the disclaimant and must pass to someone other than the disclaimant.

The Tax Court agreed with the IRS. It noted that:

• The daughter was not a surviving spouse of the decedent;
• The daughter received a specific bequest of a fee simple interest in her mother’s property under the mother’s will;
• As a result of the disclaimer, such property passed to a trust in which the daughter had a remainder interest; and
• The daughter did not disclaim that remainder interest.

Finding that the daughter’s disclaimer was not a qualified disclaimer, the Tax Court held that the annuity interest in the CLAT passing to charity did not qualify for the estate tax charitable deduction under Sec. 2055.

For state law purposes, it is likely that the disclaimer was valid and the disclaimed property passed to the CLAT. Because the daughter’s disclaimer was not a qualified disclaimer for federal gift tax purposes, the daughter is deemed to have transferred the property passing via the disclaimer to the CLAT. Although not addressed in Christiansen, one possible silver lining in the case was that the daughter should be entitled to a gift tax deduction under Sec. 2522 for the present value of the annuity interest passing to the family foundation (a silver lining that was absent in the letter ruling discussed below ).

Letter Ruling 200846003

In Letter Ruling 200846003, the children of the decedent disclaimed their interests as beneficiaries of an individual retirement account (IRA). The IRA custodial agreement provided that if the children predeceased the decedent, the decedent’s estate would be the beneficiary of the IRA. As a result of the disclaimer and by operation of state law, the children were treated as having predeceased the decedent.

The decedent’s will specifically provided that the IRA was to pass to a trust for the benefit of the decedent’s spouse during his life (Trust 1). Upon the death of the decedent’s spouse, the assets of Trust 1 were to pass to another trust (Trust 2) of which the children were the beneficiaries. The children failed to disclaim their interests in Trust 2. The objective of the children’s disclaimers was to have the IRA pass to Trust 1, which would qualify for the estate tax marital deduction under Sec. 2056.

The IRS noted that because the children did not disclaim their interests in Trust 2, the children had not disclaimed their entire interests in the IRA. Thus, the IRS ruled that the children’s disclaimers were not qualified disclaimers for purposes of Sec. 2518. The IRS also noted that in order for Trust 1 to qualify for the marital deduction, the IRA must have passed from the decedent. Thus, the IRS ruled that for gift tax purposes, the children had made a taxable gift of the IRA’s FMV. Accordingly, for estate tax purposes, the IRA passed from the children, not the decedent. Therefore, the decedent’s estate was not entitled to a marital deduction for the IRA passing to Trust 1.

Conclusion

This letter ruling highlights the “double whammy” that may occur if a disclaimer is not properly executed. Not only was the property that was the subject of the disclaimer taxable for estate tax purposes, it was also taxable for gift tax purposes.

The Christiansen case and the letter ruling emphasize the importance of mapping the flow of a property interest that is the subject of a proposed disclaimer. Remember that when a disclaimer results in the property interest passing to a trust, you must look through the trust until the property rests in the hands of a natural person. Failure to do so may lead to adverse tax consequences for your client.

EditorNotes

Greg A. Fairbanks, J.D., LL.M., is a tax manager with Grant Thornton LLP in Washington, DC.

For additional information about these items, contact Mr. Fairbanks at (202) 521-1503 or greg.fairbanks@gt.com.

Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.