Disclaimer trusts

By Julius Giarmarco

Giarmarco, Mullins & Horton, P.C.


Assuming the federal estate tax (FET) exemption remains at its current level of $3.5 million or more, then for most people the FET has been repealed. According to the Tax Policy Center, only five of every 100,000 people who die have estates that value at more than $3.5 million.

For married couples with taxable estates, the common planning tool is for each spouse to establish a revocable living trust. Upon the death of the first spouse, an amount equal to his/her FET exemption is allocated to a Credit Shelter Trust (CST). Other terms for the Credit Shelter Trust are Bypass Trust, Family Trust and Residuary Trust. A CST allows the surviving spouse broad access to the assets in the CST without the assets being included in the surviving spouse's estate. Thus, the CST allows each spouse to leave his/her FET exemption to their children. Without a CST, the first spouse to die "wastes" his/her estate tax exemption.

The provisions that the surviving spouse can enjoy from the CST during his/her lifetime (without causing the assets in the CST to be taxable in the surviving spouse's estate) are:

1. The surviving spouse can have all of the income of the CST. Treas. Reg. Sec. 25.2518-2(e)(5), Example 4. Alternatively, the trustee can "sprinkle" the income of the CST to children and grandchildren so as to shift that income to lower tax brackets, or can accumulate the income and add it to principal.

2. The surviving spouse can receive principal distributions from the CST (see bullets 5 and 6 below).

3. The surviving spouse can have the power to withdraw the greater of $5,000 or 5 percent of the principal of the CST each year. IRC Section 2041(b)(2).

4. The surviving spouse can have a testamentary limited power of appointment (LPA) over the assets in the CST. An LPA allows the surviving spouse to "rewrite" the dispositive provisions of the CST. However, the LPA is usually drafted so that the LPA can only be exercised in favor of the grantor's descendants and/or charities. The LPA cannot be exercised in favor of the surviving spouse, his/her creditors, his/her estate, or the creditors of his/her estate. IRC Section 2041(b)(1).

5. The surviving spouse can be the sole trustee of the CST, provided that distributions to the spouse are limited to an "ascertainable standard" (i.e., health, education, maintenance and support). IRC Section 2041(b)(1)(A).

6. Distributions to the surviving spouse in excess of the ascertainable standard can be made from the CST if an independent co-trustee is named to serve with the surviving spouse, but discretion on distributions to the surviving spouse must be limited solely to the independent co-trustee.

7. The surviving spouse can have the power to remove the co-trustee and appoint an individual or corporate successor co-trustee that is not related or subordinate to the surviving spouse (within the meaning of IRC Section 672(c)). Rev. Rul. 95-58.

The deceased spouse's estate -- over and above the amount allocated to the CST -- will pass estate tax-free to the Marital Trust because of the unlimited marital deduction. When the surviving spouse dies, the assets in the Marital Trust (along with the assets in the surviving spouse's Living Trust) will be subject to estate taxes, but only after subtracting the surviving spouse's FET exemption.

The two most common types of Marital Trusts are the General Power of Appointment (GPA) Trust and the Qualified Terminable Interest Property (QTIP) Trust. Both types of Marital Trusts must provide the surviving spouse with all of the income and may (but need not) provide the spouse with principal. The typical GPA Marital Trust allows the surviving spouse to determine the ultimate beneficiaries of the Marital Trust upon his/her death, and usually allows the spouse to withdraw the principal of the Marital Trust during his/her lifetime without restriction. The QTIP Marital Trust, on the other hand, does not allow the surviving spouse to determine the ultimate beneficiaries and usually restricts the spouse to principal as needed for health, education, maintenance and support. But, to add flexibility to a QTIP Marital Trust, the surviving spouse may be given a $5,000/5 percent annual withdrawal power and/or a limited power of appointment over the QTIP Trust.

A CST has the following advantages: It utilizes both spouses' FET exemptions, while giving the surviving spouse access to and control over the assets in the CST; it preserves assets for the couple's descendants (in case the surviving spouse remarries); and it protects the surviving spouse and descendants from creditors.

But, there are disadvantages to a CST as well. The surviving spouse's access to the assets in the CST, albeit broad, is (as noted above) restricted. Moreover, if the surviving spouse withdraws more from the CST than permitted, he/she may be accountable to the ultimate beneficiaries of the CST (i.e., children and grandchildren). The CST also adds complexity to the surviving spouse's life in that separate records for the CST must be maintained and annual income tax returns (Form 1041) must be filed for the remainder of the surviving spouse's lifetime. And, if a co-trustee over the CST is used, the surviving spouse will have to cooperate with that trustee.

For many couples with non-taxable estates, particularly those with children all from the same marriage, the disadvantages of a CST outweigh the advantages. Therefore, they would prefer to simply leave their estate to a GPA Marital Trust for the surviving spouse. But, if their estates were to increase and/or the FET exemption was reduced by future legislation, they still want the ability to use both spouses' FET exemptions. It is possible to accomplish both objectives with a Disclaimer Trust.

Disclaimer Trusts became popular after the 2001 Tax Act was passed because of the increasing FET exemption and the uncertainty created by the Act. With a Disclaimer Trust, a married couple's revocable living trusts leave the deceased spouse's entire estate to a GPA Marital Trust. The CST is then funded only if the surviving spouse disclaims (refuses) part of the deceased spouse's estate. This enables the surviving spouse to decide how much to keep outright (to be taxed at the second death) and the amount to be allocated to the CST (where it is shielded from estate tax at the second death). In making an informed decision to disclaim and how much to disclaim, one must examine the size of the combined estate, the surviving spouse's age and health (which impacts the spouse's needs for funds), whether minor children will be beneficiaries of the CST, the potential appreciation of the assets not disclaimed, and the status of the FET exemption.

For example, assume a married couple has combined assets of $4.5 million, which are evenly divided between their revocable living trusts. Each trust provides that 100 percent of the trust property is allocated to a GPA Marital Trust upon the death of the grantor-spouse. But, if the surviving spouse disclaims all or a portion of the decedent's estate, the disclaimed portion passes to a CST. If, at the time of the first death, both husband and wife are in their seventies or eighties and the FET exemption is $3.5 million, it might make sense for the surviving spouse to disclaim $1 million of the deceased spouse's $2.25 million estate. This will leave the surviving spouse with a $3.5 million taxable estate (i.e., $2.25 million in the surviving spouse's living trust and $1.25 million in the GPA Marital Trust), which will be completely sheltered from estate taxes by the surviving spouse's FET exemption.

But, if at the first death the surviving spouse is only in his/her forties or early fifties, the decision might be to forgo the disclaimer. The younger the surviving spouse, the more likely the estate will not increase, but instead be consumed and decline in value. This would be particularly true if there are young children involved. Moreover, the surviving spouse will have ample time to gift a portion of the combined estate to children and grandchildren (using his/her $13,000 annual gift tax exclusion) so that there may be no estate tax due upon the death of the surviving spouse.

For couples whose estates are below $3.5 million, a disclaimer trust still makes sense. It's possible the estate could grow through appreciation, inheritances, and/or by acquiring life insurance on one or both spouses' lives. It's also possible the estate tax exemption will be reduced by Congress in the future. The disclaimer trust avoids saddling the surviving spouse with the time and expenses of administering a CST, unless funding a CST would result in an estate tax savings.

In order to be a "qualified" disclaimer for FET purposes, the disclaimer must meet the following five requirements set forth in Internal Revenue Code Section 2518(b):

1. It must be an irrevocable and unqualified refusal to accept an interest in property

2. It must be in writing, signed by the surviving spouse

3. It must be received by the trustee within nine (9) months of the grantor-spouse's death

4. The surviving spouse must not have accepted the disclaimed property or any of its benefits

5. As a result of the disclaimer, the interest must pass without any direction from the surviving spouse

Because IRC Section 2518 prohibits the surviving spouse from holding a power to direct the disposition of the disclaimed property, the surviving spouse cannot be given a limited power of appointment over the CST (unless limited by an ascertainable standard). See Treas. Reg. Sec. 25-2518-2(e)(2) and Treas. Reg. Sec. 25-2518-2(e)(5), Example 5. Nor can the surviving spouse (either as a beneficiary or as the sole trustee) have any discretion over the CST's property. But, the surviving spouse can serve as the sole trustee of the CST if the trust agreement contains mandatory distributions (i.e., no discretion on part of the trustee) or ascertainable standards for distributions of principal and income. Treas. Reg. Secs. 25-2518-2(e)(2) and 25-2518-2(e)(5), Examples 11 and 12.

There are also state law requirements for making a disclaimer. Failure by the surviving spouse to satisfy all of the federal requirements set forth above will result in the disclaimer being treated as a taxable gift from the surviving spouse to the remainder beneficiaries of the CST (i.e., the children and grandchildren).

In summary, for a married couple whose combined estate may or may not exceed the FET exemption, a disclaimer trust will provide the couple with the greatest degree of flexibility. But, for couples with children from a prior marriage, a disclaimer trust will not guarantee that the children will receive an inheritance (as would be the case where the CST is funded automatically with the deceased spouse's FET exemption). Even with a first marriage, the surviving spouse could remarry and leave the estate to the new spouse with a disclaimer trust. Finally, care must be taken immediately after the first spouse's death (when the surviving spouse may be unable to cope with making financial decisions) to protect the qualified disclaimer. Thus, the flexibility found is disclaimer trusts may not be right for every couple and, therefore, the couple should consult with an experienced estate planning attorney.

THIS ARTICLE MAY NOT BE USED FOR PENALTY PROTECTION.

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