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George F. Bearup, J.D. Senior Legal Trust Advisor

6-Sep-16

Disclaimer Planning

I had a brief discussion this morning about disclaimers with regard to a trust that she is currently administering and how disclaimer planning is becoming  more prevalent in estate plans these days.

You will recall that a disclaimer is the exercise of a right to reject a gift or inheritance [e.g. bequest, interest in a trust, a beneficiary designation]. A disclaimer made by a person implicates both state law [which defines an interest in property and the legal rejection of that interest- see MCL 700.2901 et seq] and federal gift tax law, which addresses the federal transfer tax implications of a qualified disclaimer– IRC 2518.

Disclaimers are becoming more popular in estate planning because of the opportunity to use ‘wait-and-see’ principles in marital deduction planning,  along with the uncertainty of what federal estate and gift tax laws will be at the time of the decedent’s death since the transfer tax laws seem to change every three or four years or so.

The typical disclaimer planning technique which is popular today is the transfer of a deceased  spouse’s entire estate to their surviving spouse [which is covered by the unlimited marital deduction] with the contingent transfer of that bequest to a credit shelter trust if the spouse does not  survives, or chooses instead to disclaim the transferred interest  [which is a transfer that will cause federal estate taxes to be intentionally be incurred]. The thought is that the surviving spouse can wait for 9 months after their spouse’s death to decide what assets to take, what assets to disclaim, and to assess the impact of estate and income taxation resulting from a disclaimer of some or all of the transferred assets. If the testamentary gift from the deceased spouse is disclaimed, the gifted assets are thus automatically transferred  by the exercise of the disclaimer into the credit shelter trust [the named contingent beneficiary], where the survivor normally has access to the income generated by the credit shelter trust, yet those assets will not be taxed on the survivor’s subsequent death- and the same trust assets will be beyond the reach of the survivor’s creditors. The transferred assets to the credit shelter trust will be exposed to estate taxation, but the deceased spouse’s federal estate tax exemption will be expected shelter the transferred assets from federal estate taxation. Balanced against this planning technique is the loss of a second basis step-up on the survivor’s death.

With a disclaimer the surviving spouse can ‘cherry pick’ which assets to disclaim, and which assets to retain title. Consider as an example what Lauree and I discussed this morning, the disclaimer of the family cottage owned by the decedent. In this situation the surviving spouse is too old  to regularly use and enjoy the cottage,  in contrast to the couple’s children who regularly use the family cottage with their children. By (i) disclaiming the cottage into the credit shelter trust, and then (ii) disclaiming her beneficial interest in that credit shelter trust’s asset, i.e. the family cottage [a second cherry picking disclaimer], the widow can effectively move title to the cottage ‘downstream’ to the children without it being treated as a taxable gift by the widow- i.e. she disclaimed her late husband’s bequest, she did not make the gift of the cottage by herself to her children. The children will then own the cottage after the disclaimer, but they will now be responsible for real property taxes, utilities, insurance and maintenance expenses, not the widow or the credit shelter trust that is established for her lifetime benefit. With the recent change in Michigan’s real property tax exemptions, there will be no ‘uncapping’ of the cottage’s taxable value in the hands of the children.

It is the ability to exploit the 9 month period after a decedent’s death to decide whether to accept the gift or bequest, or to disclaim the gift/bequest, that makes disclaimer planning so popular, with the ability to focus on the recipient’s health, cash flow needs, and assessment of what the tax laws might look like in the near future, before making the final decision to disclaim or not. But as is always  the case, there are those darn rules that have to be compiled with in order to meet the definition of a qualified disclaimer. Michigan’s technical rules are set forth primarily in MCL 700.2901 and 2902 and they are not too difficult to meet, e.g. in writing, delivery, etc. The federal tax rules which drives the gift tax implications of a qualified disclaimer are found in IRC 2518, the two most important of which are: (i) the disclaimer must be made within 9 months of the transferred interest; and (ii) during that 9 month period, the recipient cannot actually use,  enjoy, or take the income from, aka accept,  the transferred asset. The state and federal rules are not the same, despite what the Michigan Court of Appeals says in Solomon v Milmet (2012) Mich App LEXIS 1551. That said, each contains an acceptance rule, and that rule usually trips up the ability to make a disclaimer it is the limited use or enjoyment of the transferred asset, or receipt of minimal income generated by it, after which the recipient then attempts to disclaim the same asset having accepted some of its benefits.

Some planning traps associated with disclaimer planning include the following:

  • Medicaid authorities will treat a disclaimer as a divestment even though all the state and federal rules are fully complied with. Consequently, if there is a sense that the survivor may sometime in the next 5 years apply for Medicaid benefits, then making a disclaimer, albeit legal and qualified,  may not be wise because that divestment would disqualify the disclaimant from Medicaid benefits for a period of time tied to the value of the disclaimed property interest;
  • Similarly, the federal government that places tax liens on all assets for the recipient’s unpaid taxes will ignore a qualified disclaimer when it wants to levy, attach, and sell assets in order to satisfy its tax lien;
  • The exercise of a qualified disclaimer will be viewed as an effort to defraud, hinder, or delay creditors and thus implicate the Uniform Voidable Transfer Act as adopted in Michigan if a creditor seeks to collect on a judgment;
  • If consideration is paid for the exercise of a disclaimer [in the above example, the children pay their mother to induce her to exercise her right to disclaim her interest in the cottage and her beneficial interest in the credit shelter trust as it relates to the cottage held in that trust] then it is not a valid disclaimer for federal gift tax purposes- it’s a sale with capital gains exposure;
  • Some disclaimers are legally barred under Michigan law. For example, in State Treasurer v Snyder, 294 Mich App 641 (2011) the State Correctional Facility Reimbursement Act, MCL 800.401 barred a named beneficiary’s ability to disclaim the proceeds of a life insurance policy.
  • By far the biggest trap under both the federal and state statutes is the recipient’s acceptance of the disclaimable interest or a benefit under that interest after actual knowledge that a property right has been conferred. This is the situation where the recipient takes income from the asset, e.g. dividends paid from an investment account, receives rent for a short period of time, yet then later attempts to disclaim the same investment account or commercial real estate. Often by the time the survivor’s advisors become involved and alert the survivor of the acceptance rule, it is too late.

But despite some of the traps associated with effecting a qualified disclaimer, there are some clear tax benefits that can be derived from a qualified disclaimer:

  • Jointly held interests can be disclaimed, such that a surviving spouse can disclaim the decedent’s one half interest in real estate. If disclaimed, the decedent’s 50% interest in the real estate then passes to a credit shelter trust for the spouse’s lifetime use and benefit. Why disclaim? When the surviving spouse dies, owning the other one-half tenant in common interest in the parcel, that 50%  interest will attract valuation discounts since it is an unmarketable, non-controlling interest in a single parcel of land. Often the valuation discount associated with a 50% tenant in common interest that is subject to estate taxation on the survivor’s death ranges from 15% to 20%, which will be useful if the surviving spouse owns a taxable estate after the use of their federal estate tax exemption- in other words, a timely filed disclaimer is used to create fractional valuation discounts;
  • If grandchildren are named as contingent beneficiaries of IRAs, the surviving spouse can disclaim a portion of the decedent’s IRA, which causes the grandchildren to become the beneficiaries of the decedent’s IRA;  while the grandchildren will be required to take immediate required minimum distributions, the amount taken will be much smaller since it is tied to the grandchild’s life expectancy, so that there will not be much income taxes currently paid, thus permitting most of the disclaimed IRA to continue to grow in a tax deferred IRA environment, which would not be the case if the surviving spouse rolled the decedent’s entire IRA into their own IRA where their taxable required minimum distributions would be much larger based upon their much shorter life expectancy; or
  • If the surviving spouse is subject to the 3.8% medicare surtax on net investment income, shifting some income producing assets via a disclaimer, e.g. commercial rental property,  either to a credit shelter trust that accumulates income, or shifting the anticipated rental  income to other family members through the disclaimer will reduce the survivor’s overall income tax liability by keeping their reported income below the 3.8% surtax threshold.

While disclaimer planning is popular from an estate planner’s perspective with its ‘wait-and-see’ perspective the reality is, however, that few surviving spouses will actually disclaim any assets or beneficial interests despite the tax savings that can arise with a timely disclaimer. Most surviving spouses will have the anxiety of running out of money, and the thought of gifting [tax free] an asset to others that they may later on require to sustain themselves is simply asking too much of them given those latent fears. Despite those predictable fears, it is still  good practice to always bring up the opportunity to make a timely disclaimer and the perceived tax savings and property law benefits, and then let the client decide the best strategy to pursue.