Disclaiming an interest in property has always been a way to add flexibility to an estate plan. By exercising of a timely qualified disclaimer, the disclaimant effectively moves assets to another individual, or to a trust, without incurring any gift tax. Consequently, disclaimer planning takes center-stage in many estate plans these days by spouses to shift the testamentary transfer of an interest from the unlimited marital deduction to a trust for the survivor’s lifetime benefit, e.g. the shift of assets from an outright gift to the surviving spouse, to a credit shelter trust that is established for the spouse’s lifetime benefit sheltered by the deceased spouse’s applicable exemption amount.
Income Tax Basis Planning: A qualified disclaimer is often made in order to protect assets from the survivor’s future creditors or with the goal to remove the disclaimed assets and their future appreciation from the survivor’s taxable estate. An ancillary benefit, often overlooked, is that a spousal disclaimer can also be used to increase the income tax basis in inherited assets that were jointly owned by the spouses when federal estate taxes are not a concern in light of the survivor’s large applicable exemption amount and the survivor’s access to the deceased spouse’s unused applicable exemption amount. [IRC 2010(c).]
Disclaimer of Property Interest: A disclaimer is governed by the property laws of each state. Michigan’s comprehensive disclaimer of property interests law is part of its Estates and Protected Individuals Code. [MCL 700.2901, et. seq.] That statute contemplates the disclaimer of an interest in joint property with rights of survivorship. [MCL 700.2901(2)(g).] Jointly owned property is treated as consisting of a both present and a future interest in the jointly owned property. Thus, a surviving spouse may disclaim the future interest in jointly owned property on the death of their spouse, including assets that were held by the spouses as tenants by the entirety. The Michigan disclaimer statute permits a surviving spouse to disclaim either a specific asset, an interest in a specific asset, or a fractional or percentage share of the property interest. [MCL 700.2902(2).] Consequently, a disclaimer of a surviving spouse’s interest in the jointly owned asset results in the disclaimer of the future interest in the disclaimed asset, which means that the disclaimed future interest does not pass to the surviving spouse. [MCL 700.2905(2).]
Tax Consequence of a Qualified Disclaimer: A qualified disclaimer, which must occur within 9 months of the transferred interest is made pursuant to IRC 2518. Key to that section is that a disclaimer by the intended recipient is treated as if the interest had never been transferred to the intended recipient, (the disclaimant.) While the disclaimed property interest must pass without the direction on the part of the disclaimant, the disclaimed property may nonetheless initially pass “to the spouse of the decedent.” [IRC 2518(4)(A).] Accordingly, a surviving spouse can disclaim the future interest in joint property that otherwise would pass from their deceased spouse and still enjoy the disclaimed asset, even though the survivor cannot direct who will enjoy the disclaimed property interest. In short, if the spouses owned an asset jointly, on the death of one spouse, the survivor can disclaim his/her future interest in the jointly owned property, and still enjoy the disclaimed asset.
Example: Assume that Fred and Wilma own a joint account that holds appreciated securities. Fred and Wilma own the account as ‘joint tenants with full rights of survivorship.’ Fred contributed $1.0 million of stock with a $300,000 basis to the joint account. Wilma contributed $200,000 of stock with a basis of $100,000 to the joint account. Each spouse is free to withdraw the investments that he/she contributed to that joint investment account. Since either spouse can withdraw the securities that he/she contributed to the joint account, no completed gift occurred on the transfer of the securities to the joint account. [Treas. Reg. 25.2518-2(c)(4)(iii).] Fred has a simple Will that names Wilma as the sole residuary beneficiary of his estate. Fred dies.
- IRC 2040(b)(1)- 50% Basis Rule: Under normal tax rules there would be an income tax basis adjustment, or in this example a ‘step-up,’ in the income tax basis of 50% to all of the securities that are held in Fred and Wilma’s joint investment account. [IRC 2040(b)(1).] This is a blanket adjustment to the income tax basis of all of the securities that are held in Fred and Wilma’s joint investment account, including the securities Wilma contributed, as well as the negative prospect of an income tax basis ‘step-down’ to an asset’s date-of-death value. The fair market value of all securities that are held in Fred and Wilma’s account is $1,200,000 with a combined basis of $400,000. Thus, on Fred’s death, one-half (50%) of the income tax basis in the account securities would be increased, so that Wilma, as the surviving joint account owner, would own an investment account with an aggregate value of $1,200,000 with an aggregate income tax basis of $600,000 [$300,000 (Fred’s) + $100,000 (Wilma’s) + $200,000 (IRC 2040 50% basis adjustment) = $600,000.].
- IRC 2518 Disclaimer- 100% Basis Rule: Rather than continue as the surviving joint owner of their investment account, suppose Wilma instead makes a qualified disclaimer of her survivor’s interest in the joint investment account that she held with Fred. Since Fred could withdraw what he initially contributed to the joint account, Wilma was not gifted an interest in the securities that Fred contributed to their account. Wilma’s disclaimer has the effect of moving the all of the $1.0 million of securities that Fred contributed to their account back to Fred’s probate estate, i.e. she disclaimed her future interest in Fred’s contributed securities. But Wilma remains the residuary beneficiary of Fred’s estate under his Will. As a result of Wilma’s qualified disclaimer, the entire $1.0 million of marketable securities will be included in Fred’s taxable estate. [IRC 2033.] The result of that estate inclusion is that the income tax basis of Fred’s transferred securities will be subjected to a new, date-of-death, income tax basis. [IRC 1014.] Therefore, the income tax basis in Fred’s contributed securities goes from $300,000 to $1.0 million. Now, after Wilma receives the inherited securities from Fred’s estate as its residuary beneficiary, and she adds the inherited securities to the securities that she had contributed to the joint account, Wilma will still own an investment account that holds $1,200,000 in securities, just as if the account had continued as jointly owned. But now Wilma’s income tax basis in those same securities is $1,100,000 [Wilma’s original basis in her contributions of $100,000 + the 100% basis step-up in Fred’s $1.0 million of securities using their values on the date of Fred’s death.].
Wilma’s qualified disclaimer of the $1.0 million of the securities Fred contributed to the joint account caused those investments to receive a 100% income tax basis increase, in contrast to if Wilma had simply continued to hold the securities in the former joint account, where the income tax basis in the investments would have been increased by only 50% under IRC 2040(b)(1). Wilma’s income tax basis in the $1,200,000 of investments went from $600,000 to $1,100,000 simply by using a qualified disclaimer.
Obviously with the dramatic increase in an individual’s applicable exclusion amount, and the advent of portability of a deceased spouse’s unused applicable exclusion amount, most spouses are less concerned about avoiding federal estate taxes and intent on saving income taxes. By using the qualified disclaimer to force the inclusion of appreciated assets into the deceased spouse’s taxable estate, it is possible that substantial capital gains taxes [ranging from 15% to 28%], and the net investment income tax [3.8%], and state income taxes [potentially as high as 14%] can all be avoided through the basis ‘step-up’ with a qualified disclaimer by a surviving spouse.
Planning Considerations: To exploit this opportunity to gain a full income tax basis adjustment by the surviving spouse’s qualified disclaimer, a few ‘stars will need to be in alignment.’
- Joint Accounts: The spouses will have to own property as joint tenants with full rights or survivorship in order to possess a future interest that can be disclaimed by the surviving spouse.
- Tracing: A qualified disclaimer of joint property will cause 100% of the value of the disclaimed property to be included in the decedent’s estate if originally contributed by the deceased spouse. [Treas. Reg. 25.2518-2(c)(5), Example (12.)] Thus, some tracing will be required, not only of the assets that each spouse contributed to the joint account, but also the income tax basis in those contributed assets, so that the property interests to be disclaimed can be readily identified by the surviving spouse. A record of the income tax basis for each disclaimable asset enables the surviving spouse to then ‘cherry pick’ those assets for which an income basis ‘step-up’ is sought.
- Right of Withdrawal: Each spouse needs to be able to unilaterally withdraw the assets that he/she contributed to the joint account. Under most state laws the contributor is entitled to receive their property back from the joint account. For example, the Michigan Trust Code provides that if there are two or more settlors of a joint trust, each settlor may amend or revoke the trust with regard to the portion of the trust property that is attributable to that settlor’s contribution. [MCL 700.7602(2)(b).] Therefore, it is important to pay close attention to the custodial agreement for the account to which the property is contributed to make sure that each spouse retains the right to withdraw what he/she contributed to that account.
- Incomplete Gifts: The transfer by the spouses to their joint account cannot be completed gifts. [Treas. Reg. 25.2511-1(h)(4).] To make a qualified disclaimer the surviving spouse may only disclaim that portion of the joint account that is attributable to the contribution made by the deceased spouse. The survivor cannot disclaim that portion of the joint account that is attributable to the contributions that were made by the survivor, or which are ‘owned’ by the survivor. Each spouse must be able to unilaterally withdraw that which he/she contributed to the joint account for there to be a larger disclaimable interest. If a completed gift has occurred between the spouses, the survivor will be treated as each owning 50% of the joint account, and as noted, the surviving spouse cannot disclaim that which he/she already owns. [IRC 2040 (b)(1).]
- Probably Not Real Estate: This type of disclaimer planning is usually not available for some jointly held assets like real estate, because that form of ownership, unlike a joint investment or bank account, usually results in a completed gift, as the donor-spouse cannot unilaterally reacquire the entire property he/she contributed to joint ownership (even though that gift might still qualify for the federal gift tax marital deduction.) The disclaimer Regulations under IRC 2518 refer only to accounts, so it is not clear if other types of assets that are jointly owned by spouses would be subject to a qualified disclaimer. [Treas. Reg. 25.2518-2(c)(4).]
- Probably Not LLC Membership Interests: If the subject of the joint ownership is a hard-to-value asset, like an LLC membership interest, then the disclaimed property interest may be subject to valuation discounts for lack of control or lack of marketability which would reduce the amount of the income tax basis ‘step-up’ if any valuation discounts are applied to the disclaimed assets.
- Expect to Incur Additional Costs: Disclaimer planning will cause some additional costs, such as the attorney’s fees that are incurred to prepare and deliver the qualified disclaimer instrument, and the additional cost of estate administration with regard to the disclaimed property interests that pass through probate.
IRC 1014(e): One final observation is with regard to the applicability of IRC 1014(e). That is the Code section that prohibits an income tax basis adjustment on a spouse’s death if (i) a gift of appreciated assets to the spouse during that spouse’s lifetime is within one year of the spouse’s death and (ii) the transferred assets are returned to the donor-spouse or a trust for their benefit of the donor-spouse. The qualified disclaimer by the surviving spouse occurs after the death of his/her spouse, so there is no lifetime ‘gift’ as required by IRC 1014(e) from the survivor to the decedent which would otherwise cause IRC 1014(e) to apply.
Conclusion: More thought needs to go into how a joint account is handled on the death of a spouse. The usual approach is to simply treat the joint account as owned by the surviving spouse, which will lead to a 50% income tax basis adjustment of all assets that are held in the joint account. But if the survivor’s name was added to the account solely as a convenience to the marriage, or to avoid probate, then thought needs to be given to a qualified disclaimer by the survivor, especially if the disclaimed assets will ultimately return to the surviving spouse after the qualified disclaimer. Key is to make sure that each spouse retains the right to withdraw from that joint account the assets that he/she initially contributed.