Disclaimers vs Releases vs Lapse: Hidden IRS Traps

Take-Away: As we continue to help clients understand their estate plans, it is important to keep in mind that often a named beneficiary will disclaim, or sometimes release, an interest in an estate, trust, or beneficiary designation. Knowing the distinction between a disclaimer and release is critical when you factor the gift tax consequences into the beneficiary’s decision.

Background: A disclaimer or a release can remove an interest from a taxable estate and accelerate benefits to remainder beneficiaries (or contingent beneficiaries if dealing with a beneficiary designation.) To that end, a disclaimer and a release are flexible tools to move assets to individuals who may have greater needs for the asset, or who may be in a lower marginal income tax bracket than the person who makes the disclaimer or release. But the transfer tax consequences of a qualified disclaimer are different than a release. A common use of a disclaimer is with an IRA beneficiary designation, which moves part or all of the disclaimed IRA assets to a younger contingent beneficiary who has a longer life expectancy in which to take required minimum distributions.

Example: Assume Dad dies leaving a $1.0 million IRA. Dad names Son as the beneficiary of Dad’s IRA. Son is successful in business and his own earned income is currently at the 37% federal income tax bracket. As such, if Son takes Dad’s inherited IRA, each required minimum distribution taken will be subject to Son’s 37% federal income tax rate. If Granddaughter (Son’s child) is named as Dad’s contingent IRA beneficiary, Son can disclaim some or all of Dad’s inherited IRA. The result is that Granddaughter becomes the beneficiary of Dad’s inherited IRA. Granddaughter will have to take required minimum distributions from Dad’s IRA, but she will use her own (longer) life expectancy to take the required minimum distributions from the inherited IRA. In addition, Granddaughter is in a much lower marginal federal income tax bracket than Son. The result of Son’s qualified disclaimer of some (or all) of Dad’s inherited IRA is to expose the distributions to a much lower marginal federal income tax rate, while also removing those after-tax assets from Son’s own taxable estate for federal estate tax calculation purposes.

Disclaimer – Refusal to Accept an Interest: Under IRC 2518 a qualified disclaimer must satisfy the following 4 formalities: (i) the disclaimer must be in writing; (ii) the writing must be timely received by the appropriate person, e.g. the Personal Representative of the estate, the trustee of the trust, the transferor of the interest, like an IRA custodian, i.e. within 9 months of the creation of the interest; (iii) the person who makes the disclaimer (the disclaimant) cannot have accepted the interest or any benefits from the disclaimed interest; and (iv) as a result of the disclaimer, the interest passes to another person without any direction of the person who makes the disclaimer. [Treas. Reg. 25.2518-2.] If any of these 4 requirements is not met, the disclaimer will be non-qualified, resulting in negative tax consequences to the disclaimant. Restated, a nonqualified disclaimer is treated as a release of an interest. If the disclaimer is qualified then the disclaimant is not treated as making a taxable gift to the person to whom the disclaimed interest passes. If is in a non-qualified disclaimer, then it is treated as a release, and a release results in a taxable gift by the disclaimant.

Disclaimer Spousal Exception: It is permissible for a spouse to disclaim an interest and still benefit from the disclaimed interest. For example, a surviving spouse could disclaim assets that are intended to pass to a marital deduction trust, with the result that the disclaimed assets instead pass to a credit shelter trust of which the surviving spouse is the lifetime income beneficiary. But the spouse cannot retain any control over the disclaimed assets. Thus, if the credit shelter trust also gave to the surviving spouse a power of appointment over the credit shelter trust assets, the surviving spouse would also have to timely disclaim that power of appointment over the credit shelter trust in order for the disclaimer to be a qualified disclaimer. Note, that this ability to disclaim and continue to enjoy the disclaimed asset is limited solely to a surviving spouse, and is not available for any other individual recipient.
9 Month Rule: The nine month rule in which to make a qualified disclaimer can sometimes act as a trap. Example: Dad creates an irrevocable trust for the benefit of Son, paying to Son all trust income for 20 years. Thereafter the trust income and principal is paid to Granddaughter. Upon Granddaughter’s death all assets are paid to Great Grandson. 1 year after the creation of the trust Son and Granddaughter want some of the trust assets to flow to Great Grandson to pay for his college education. Son and Granddaughter can each disclaim $20,000 from the trust that Dad set up. But the disclaimers were not done within 9 months of the creation of their interests in the trust that Dad set up. Thus, while the disclaimers can be effected by both Son and Granddaughter, each will be treated as making a taxable gift to Great Grandson, and with Son a generation skipping transfer tax would also be imposed.
9 Month Exception: If the interest to be disclaimed is created for a minor, that minor beneficiary has until 9 months after their 21^st birthday in order to timely file a qualified disclaimer of their interest in the trust.
State Law Controls: While the tax consequences of a disclaimer are controlled by the federal Tax Code, the property interests that are subject to the disclaimer are controlled by state law. Consequently, each state’s disclaimer statutes need to be consulted if the asset to be disclaimed is located in another jurisdiction and the rules of each state followed as to how the disclaimant makes the qualified disclaimer.
Michigan Disclaimer Statute: Michigan’s Disclaimer of Property Interests is part of EPIC. [MCL 700.2901-2912.] With a disclaimer under the Michigan statute, the disclaimant is treated as having died prior to the transfer (whether or not the disclaimer takes place within 9 months of the created interest that is disclaimed.)

Release- Relinquishment of an Existing Interest: Under IRC 2514, an interest or benefit can be released, but the tax consequences are different than a disclaimer. A release is of an interest that is already in possession, such that the release of the interest is treated as a taxable gift by the releasor.

Lapse and 5% or $5,000 Exception: IRC 2514 provides that the lapse of a general power of appointment is deemed to be a transfer of property by the individual who possesses the power. [IRC 2514(a).] You will recall that a power of appointment is the ability to affect who ultimately receives or benefits from the assets subject to the power of appointment, assets which are usually held in trust. The lapse of a right during any calendar year is considered a release so as to be subject to it to the federal gift tax, but only to the extent that the property which could have been appointed exceeds the greater of: (i) $5,000 or (ii) 5% of the aggregate value at the time of the lapse of the assets out of which, or the proceeds of which, the exercise of the lapsed power of appointment could be satisfied. [IRC 2514(e).] Restated, a power of appointment, like a withdrawal right, can result in gift taxation if the power of withdrawal lapses, but it is a gift only to the extent that the lapsed power of withdrawal exceeds either $5,000 or 5% of the trust corpus. Lapsed amounts below those floors will not be treated as a gift, which is why you often find a 5% withdrawal right given to a surviving spouse in a credit shelter trust.

Traps:

Timing of a Qualified Disclaimer: Many trust beneficiaries are mistaken in their belief that they have the right to make a qualified disclaimer within 9 months from when their interest becoming a present interest or vested in their possession. Example: Dad creates credit shelter trust for Mom on Dad’s death. When Mom dies, the children are the remainder beneficiaries of the credit shelter trust. The children think that when Mom dies they have until 9 months after Mom’s death in order to disclaim some or all of their interest in the credit shelter trust. Unfortunately the 9 months in which the child must file a qualified disclaimer is when the credit shelter trust was originally created, i.e. on Dad’s death, not years later when Mom finally dies. While the children can release their interest in the credit shelter trust at any time, the release will be treated as a taxable gift by the child.
$5,000 or 5% Limitation: This limited lapsing power is one of those rules that is frequently encountered when a trust beneficiary is given a crummey withdrawal right, which is technically a general power of appointment over assets held in trust. If the power to withdraw trust assets lapses, i.e. it is not exercised by the trust beneficiary, then the lapse of that withdrawal right, up to $5,000 or 5% of the trust corpus, will not be treated as a taxable gift by the power holder over the assets subject to the withdrawal right. Example: If a trust beneficiary possesses a noncumulative right to withdraw $10,000 of principal from a trust each year, the failure to exercise this right of withdrawal in a particular year will not constitute a taxable gift but only if the trust estate at the end of the year equals or exceeds $200,000. In contrast, if at the end of the calendar year the trust estate is worth only $100,000, the failure to exercise the $10,000 withdrawal power will be considered to be a taxable gift to the extent of $5,000, the excess of $10,000 over 5% of trust estate of $100,000, or $5,000.
Lapse Rights Aggregated: Another trap arises when the beneficiary who holds the withdrawal power holds withdrawal powers over several trusts; it is only one lapse right per year [with the dollar limits] that is available to the trust beneficiary, not a lapse right for each trust, so that if two or more lapsed withdrawal powers occur in a single year by the beneficiary, it is possible to exceed the dollar limits imposed by the Tax Code. Example: Dad and Mom each create an irrevocable trust for Son. One trust holds $25,000 in assets, the other trust holds $150,000 . Son is given the right to withdraw $10,000 a year from each trust. Son permits the withdrawal powers over each trust to lapse. Son has made a taxable gift over each trust ($5,000 of the $25,000 trust is protected, but not the 5% of the $150,000 trust, or $7,500, is not fully protected, so that Son made a gift of $2,500 under the second trust with the lapse of his withdrawal right over the second trust.
Release of Rights of Withdrawal: A common mistake is when a beneficiary who is given a crummey withdrawal notice each year signs a document in which they claim to release their right of withdrawal. Example: “I hereby release and waive all rights of withdrawal that I may have over this trust, and I hereby release all future withdrawal rights held by me over this trust.” The use of the word release is viewed by the IRS as a gift by the beneficiary to the trust of which they are normally a trust beneficiary. The result is not only has the beneficiary made a taxable gift by releasing their withdrawal right, but they are then treated as grantors to the trust of which they are trust beneficiary for income and estate tax purposes. The result is to expose some of the irrevocable trust’s assets to estate taxation on the beneficiary’s death, since that beneficiary will be treated as having retained an interest in a trust to which the beneficiary added his/her own assets by his/her release, i.e. estate tax inclusion under IRC 2036 (a)(1).

Conclusion: There is a big difference between a disclaimer and a release for transfer tax purposes. And there is equally a big difference between the release of a right and a lapse of the same right. These are all tools used to redirect the benefit of assets, but the tax consequences are dramatically different. The big ‘take-away’ is be careful when you use these terms, and with the flexibility afforded through qualified disclaimer planning, make sure that you understand the 9 month window period in which a disclaimer is made.