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

4-Dec-18

Spousal Disclaimers to Create a Basis Step-Up

Take-Aways:  Often we intentionally help clients plan to obtain an income tax basis ‘step-up’ of an appreciated asset on the death of a spouse now that federal estate tax minimization is less of a concern. As part of that basis planning:

  1. Consider the possibility of a qualified disclaimer by a surviving spouse in lieu of continuing  with a jointly owned account by the surviving spouse; and
  2. Do not be deterred from that income tax basis ‘step-up’ planning by IRC 1014(e),  which prohibits an income tax basis adjustment to the inherited asset if the recipient transferred the same low-basis asset to the decedent within one year of  the decedent’s death. A disclaimer should work to avoid the prohibition created by IRC 1014(e) to obtain an income tax basis adjustment to the ‘inherited’ assets that were disclaimed.

#1: Using Qualified Disclaimers to ‘Create” Income Tax Basis:

Practical Example: Ricky and Lucy, husband and wife, own separate marketable security investments. They decide to pool their separate investments in a single joint brokerage account to simplify their lives. Ricky and Lucy now own their joint brokerage account as ‘joint tenants with full rights of survivorship.’ Ricky dies a week later. Ricky’s Will leaves everything to Lucy. Lucy is the surviving owner of their joint brokerage account.  Lucy would like to receive a ‘step-up’ in the securities that Ricky contributed to their joint brokerage account. She can accomplish this goal making a qualified disclaimer. The following steps should lead to that result:

  1. If either Lucy or Ricky could unilaterally withdraw all assets from the joint brokerage account, without the consent of the other spouse, there is no completed gift by either Ricky or Lucy to the other. [Treas. Regulation 25.2511-1(h)(4).] Ricky and Lucy are each treated as still ‘owning’ the investments that they each transferred to their joint brokerage account-. Key is that no completed gift to the other spouse occurred.
  2. Lucy, the surviving spouse, can only make a disclaimer of the portion of the joint brokerage account that is attributable to the contribution made by Ricky. Restated, Lucy, cannot disclaim any portion of the joint brokerage account that is attributable to contributions that she made, or that she owned.
  3. If the gift to Lucy had been completed by Ricky, i.e. neither could withdraw assets from the joint brokerage account without the consent of the other, then Lucy would be treated as an owner of 50% of the joint account on Ricky’s death.
  4. If each of Ricky and Lucy are treated as joint owners of 50% of their joint brokerage account, i.e. neither could take a withdrawal without the consent of the other, then only 50% of the value of the joint brokerage account is included in Ricky’s taxable estate with a corresponding income tax basis adjustment. [IRC 2033 and IRC 2040(b)(1).]

Example : Ricky owned stock worth $800,000 that he transferred to the joint brokerage account; Ricky’s contributed stock has an income tax basis of $500,000. Lucy transferred stock to the joint brokerage account with a current fair market value of $300,000, and an income tax basis of $150,000. The joint brokerage account thus holds $1,100,000 of stock at the time of Ricky’s death. These transfers to the joint brokerage account are completed gifts, i.e. neither Ricky nor Lucy could withdraw assets from the joint brokerage account without the consent of the other.  If Ricky’s gift to Lucy was completed on the formation of that joint brokerage account, then there will be a 50% income tax basis adjustment on Ricky’s death. [IRC 2040(b)(1).][FMV $1,100,000 less basis of $650,000 = gain of $450,000: 50% of $450,000 gain= $225,000 basis adjustment. Thus, Lucy’s basis in the $1,100,000 stock held in the former joint brokerage account after Ricky’s death is $650,000 (original cost basis)+ $225,000 (‘stepped up’ income tax basis due to IRC 2040(b)(1)) = $875,000 new income tax basis in the securities.] No ‘cherry picking’ is available to Lucy for how this increase in income tax basis is ‘spread’ across all of the investments held in the former joint brokerage account.

  1. If the formation of the joint brokerage account is treated as an incomplete gift, and each of Ricky and Lucy can withdraw the securities that he/she contributed to their joint brokerage account, Lucy could disclaim that portion of the joint brokerage account that was treated as owned and controlled by Ricky. Rather than retain all of the securities as the surviving owner of the joint account, assume Lucy makes a qualified disclaimer of her survivor’s interest in the joint brokerage account. [IRC 2518.] The amount that Ricky could unilaterally have withdrawn from the joint brokerage account ($800,000) is disclaimed by Lucy. Thus, the full $800,000 is included in Ricky’s taxable estate [IRC 2033] and is subject to a basis adjustment to date-of-death fair market value. [IRC 1014.] A qualified disclaimer by Lucy of those joint held securities will cause 100% of their value to be included in Ricky’s taxable estate if originally contributed to the joint brokerage account by Ricky. [Treas. Regulation 25.2518-2(c)(5), Example (12.)]
  2. Those disclaimed $800,000 in securities by Lucy then pass to Ricky’s estate. Lucy is the residuary beneficiary under Ricky’s Will. As such, the full $800,000 in securities now ‘return’ to Lucy, not through her joint ownership of the joint brokerage account, but through Ricky’s Will as the residuary beneficiary of Ricky’s estate. The $800,000 in securities will thus be included in Ricky’s taxable estate and will receive a 100% basis step-up from their original $500,000 basis to $800,000, their date-of-death values. [IRC 1014(a).]

Example: If Lucy makes a timely qualified disclaimer of the $800,000 securities that Ricky had contributed to the joint brokerage account, then her income tax basis in the $1,100,000 of securities held in the former joint brokerage account would be $950,000, not the $875,000 had Lucy merely retained ownership in the joint brokerage account as its sole surviving joint owner.

  1. By using a qualified disclaimer Lucy will save capital gain taxes on the $75,000 (20% or maybe 28% if collectibles or gold ETFs are involved), the Medicare surtax (3.8%) and a state income tax (ranging from 0% to 14% depending on the state that imposes the income tax.)
  2. Note that Lucy could choose to disclaim only some of the  securities held in the joint brokerage account contributed by Ricky, such as only those securities that have experienced a gain, while not disclaiming  those investments contributed by Ricky that would otherwise produce a loss on their sale. This provides even greater flexibility that enables Lucy to ‘pick-and choose’ which securities will receive a ‘step-up’ in income tax basis while preserving those investments with a loss to be used in the future to off-set post-death future gains.
  3. The obvious ‘trade-off’ is the expense incurred to run the $800,000 disclaimed assets through a probate proceeding on Ricky’s death (or having to open a probate estate and have Ricky’s Will admitted to probate), and the legal costs that are incurred to prepare and execute and deliver the qualified disclaimer by Lucy. Those additional expenses may not justify saving capital gains taxes, the Medicare surtax and state income taxes on $75,000 of the basis increase following the Ricky-Lucy example. But if the gain is substantially greater in the securities that Ricky transferred to the joint brokerage account, e.g. Lucy did not contribute any securities of her own to the joint brokerage account and her name was added to the account for convenience and solely to avoid probate on Ricky’s death, substantially more gain might be avoided by a qualified disclaimer made by Lucy.

The point is that before Lucy simply decides to continue retaining the joint account owned with Ricky, she needs to determine if a disclaimer might produce a much larger ‘step-up’ in basis of assets held in that joint account than simply relying on the 50% basis increase required by IRC 2040(b)(1).

IRC 1014(e) Prohibition

If the transfers of assets to a joint account, or a joint trust, by spouses is later disputed as to ownership, most state laws deem each spouse to own that fraction that each contributed to the joint account (or trust) that is not an irrevocable gift. For example, the Michigan Trust Code provides:

(2) If a revocable trust is created or funded by more than one settlor, all of the following apply…(b) To the extent that the trust consists of property other than community property, each settlor may revoke or amend the trust with regard to the portion of the trust property attributable to that settlor’s contribution.”  [MCL 700.7602 (2)(b).]

Along these lines with regard to applying IRC 2040, there is a rebuttable presumption that the decedent furnished all of the consideration for, or held in, the joint account. [Treas. Regulation 20.2040-1(a)(2).]

There stands, then, IRC 1014(e) which could apply to prohibit the additional ‘step-up’ in income tax basis sought by the surviving spouse who decides that a qualified disclaimer may produce a higher income tax basis on assets held in the joint account. There exists a good argument that IRC 1014(e) will not apply to the disclaimer by the surviving spouse of the deceased spouse’s contributions to their joint account. For IRC 1014(e) to prohibit any income tax basis adjustment, it  requires:  (i) a gift of appreciated assets to a decedent-donee during the donee’s lifetime within one year of the decedent’s death; and (ii) the same assets pass back to the donor or to the donor’s spouse,  or potential trusts for their benefit. The first part of this ‘test’ ((i) above) is not met when a disclaimer is used by the surviving spouse. Following our earlier example, Lucy’s disclaimer would not be a gift to Ricky, as he is dead at the time of her disclaimer. At most, Lucy’s disclaimer is a gift (if at all) to any other beneficiaries of Ricky’s estate, or to Ricky’s trust if the disclaimed assets pass by virtue of Ricky’s ‘pour-over’ Will. Even if Lucy’s disclaimer is a non-qualified disclaimer, e.g. it was made more than 9 months after Ricky’s death, or Lucy took some income from the joint brokerage account prior to making her disclaimer, either of which results in a taxable gift made by Lucy, if Lucy was the residuary beneficiary of Ricky’s Will, then that ‘gift’ is to herself. Consequently,  IRC 1014(e) should not apply to prevent an income tax basis adjustment to the assets that are the subject of the disclaimer made by the surviving spouse who ultimately receives the same disclaimed assets.

Conclusion:  Implicit in this type of disclaimer planning that is used to obtain a full (100%) income tax basis adjustment to the deceased spouse’s assets contributed to a joint account [not just a 50% basis adjustment required by IRC 2040 with regard to jointly held assets by spouses] are a couple of practical observations. First, someone needs to keep track of what each spouse contributes to the joint account. Second, there should be a clear trail that documents the income tax basis for each asset that is held jointly by the spouses so the survivor can identify which assets in the account will benefit most from the disclaimer. Finally, the spouses will need to avoid a completed gift to their spouse; consequently, reference to requiring the consent of the other spouse to permit one spouse to withdraw or spend what he/she contributed to the joint account (or joint trust) should be avoided, and instead the joint account (or trust) should recognize a spouse’s unilateral right to withdraw their contributed assets to the joint account (or the joint trust.) The joint account documentation (or the joint trust) should expressly permit each spouse to withdraw what he/she contributed to the joint account (or joint trust), so that the assets to be disclaimed by the surviving spouse are clearly identified. In sum, through the use of a qualified disclaimer, a surviving spouse may be able to dramatically add to the income tax basis of assets held in a joint account, or a joint trust, thus minimizing future capital gain tax exposure.