Just Say No Thanks: Disclaiming Gifts Or Bequests May Be Best Way to Fix Estate Planning Errors


There is a saying, "Don't look a gift horse in the mouth." Obviously, the speaker never had to deal with the U.S. tax system. Sometimes, due to tax and other implications, the costs of receiving a gift outweigh the benefits. Under certain circumstances, the renunciation of a gift may be the wisest action.

The renunciation of a gift or bequest-known for federal tax purposes as a "qualified disclaimer"--is described under § 2518, the following must happen:

  1. The disclaimant puts the disclaimer in writing;
  2. The disclaimer is received by the transferor of the interest, his legal representatives, or the holder of legal title to the property to which the interest relates no later than nine months after the date of transfer creating the interest (or nine months after the disclaimant reaches 21);
  3. The disclaimant does not accept the interest or any of its benefits; and
  4. As a result of the refusal, the interest passes without direction on the part of the disclaimant either to the spouse of the transferor/decedent or to a person other than the disclaimant.

If these four conditions are met, the disclaimant will be treated as if he never received the gift in the first place. The property interest will pass to whomever is specified, whether by instrument or operation of law, as the "taker in default" (an alternative donee), without such passing being considered a gift or transfer by the disclaimant. It is this that makes the disclaimer an attractive and most effective post-mortem estate-planning tool.

If properly planned and administered, the qualified disclaimer can be an added dimension to a person's tax and estate plan. It is perhaps one of the only techniques that allows a decedent's estate plan to be analyzed retrospectively and necessary adjustments made based upon the current circumstances of the estate's beneficiaries. In this way, the qualified disclaimer creates flexibility in the often-rigid world of estate planning.

Myriad of Uses

The following are some of the purposes for which a qualified disclaimer can be used to improve estate plans post-mortem:

Optimizing use of the applicable credit. Every individual starts out with a $675,000 applicable tax exemption, which is equivalent to a tax credit of $220,550, to be used during his lifetime against gift taxes and after death against estate taxes. The entire estate can also be passed to a surviving spouse free of estate tax, but this is not always the best plan, because it may partially or entirely waste the predeceasing spouse's applicable credit. In addition, where there is more than enough in the estate for the surviving spouse to live comfortably, the excess will simply be taxed upon that spouse's death. Bear in mind, as well, the estate taxes are a progressive nature-given the same total value, one large estate will pay more in estate taxes then two smaller estates.

Therefore, to optimize use of the decedent's applicable credit, as well as her own, the surviving spouse can at the time of her spouse's death determine how much, up to the $675,000 exemption limit, to disclaim so that such amounts will pass to the next generation estate tax-free. In this way, not only does the decedent's estate benefit tax wise while still providing for the spouse, but also the spouse's eventual estate is reduced, thereby decreasing any tax liability upon her death.

Optimizing use of the marital deduction. Many taxpayers create a martial trust either by will or trust instrument, which by election of the estate's executor/personal representative uses the martial deduction to equalize the estates of the decedent and a surviving spouse (because, as previously mentioned, the smaller the estate, the lower the tax). Unfortunately, not all estate-planning documents provide for such an election. In addition, some people have no estate planning documents at all and die intestate. In either of these situations, a well-thought-out disclaimer can enable a surviving spouse to take full advantage of the unlimited marital deduction.

For instance, Ms. Nowill dies intestate leaving a spouse and two children. Under applicable state law, 50 percent of her estate passes to her children and 50 percent passes to her spouse. To prevent any estate taxes at this time, the children may disclaim all or a portion of their inheritance and that disclaimed amount will go to the surviving spouse as a take in default under the applicable intestacy laws. All amounts passing to the spouse will be of federal estate taxes under the marital deduction.

Optimizing use of the generation-skipping tax exemption. Disclaimers can be sued to transfer wealth from one generation to another. A typical example would be when children who already have substantial estates of their own inherit from a parent's estate. If the will of the decedent provides that the children's issues shall take in the event the child has predeceased the decedent, then the child can use a disclaimer to allow such inheritance to pass directly to the younger generation. There will be no gift tax consequences for the disclaimant provided this is a qualified disclaimer, and there will be no generation-skipping tax for the decedent's estate provided part of the $1,010,000 generation-skipping tax exemption is available to allocate to the transfer.

Passing ownership of a family business. Disclaimers can be used to gain control of a closely held corporation, pass the business on to younger generations or get around certain shareholders' agreements. An illustration of this is given in Private Letter Ruling 81-07-073, in which the Internal Revenue Service discussed a disclaimer transaction involving a woman who already owned 50 percent of a business and then inherited the other 50 percent. By disclaiming the inherited stock, the woman was able to pass it on to her son. Subsequently, she had the corporation redeem all her shares under I.R.C. § 302, thereby making her son the sole stockholder.

A disclaimer of inherited stock can also be used to force the sale of shares or to keep shares from being sold under an existing shareholders' agreement. For example, a shareholder' agreement may dictate that stock must be sold if it ends up with someone who is not a permitted transferee (someone not permitted under the agreement to own stock). If there is a benefit to having the stock sold, a permitted transferee who inherits the stock may disclaim to case the stock to pass to a non permitted transferee. Conversely, a family member who is not a permitted transferee may still be able to keep the stock in the family by disclaiming if the taker in default is a permitted transferee

Avoiding creditors. An intended beneficiary of a gift may have creditor problems, and any property received would immediately be subject to the claims of those creditors. In fact, creditor avoidance was a primary reason that disclaimers were used in the first place. Under the rule of relation back, a qualified disclaimer is treated as effective on the date the interest was actually created. For example, Ms. Nodebt died on Jan. 1, 1996, and her intended beneficiary, Ms. Indebt, disclaims on August 10, 1996, Ms. Indebt's disclaimer will be deemed effective as of January 1, 1996. In effect, this means that the property interest never belonged to the beneficiary, and thus he creditors have no rights to such property.

The use of disclaimers to avoid creditors' claims is not always foolproof, however. State court and/or federal bankruptcy court precedent, as well as state laws, may prohibit the use of disclaimers to defeat creditors' claims. Therefore, it is necessary to review the local laws before disclaiming.

Qualifying for or enlarging a charitable deduction. Certain people with charitable inclinations make bequests which establish a life estate for an individual with the remainder to go to a qualified charity. The estate will not get a deduction for the value of the remainder passing to the charity unless the estate is set up as a charitable remainder trust, but such deduction can be obtained in full bequest immediately passes to the charity. If the beneficiary of the life estate disclaims his interest, the remainder will automatically transfer to the charity, allowing the estate to take advantage of the charitable deduction.

Making corrections. Sometimes a testamentary document should have been updated due to changes in circumstances, changes in laws or errors made in drafting that were never caught. These flaws can be easily corrected by use of a qualified disclaimer.

For example, Mr. Mistake had a will that was drafted with the intent of creating a credit shelter trust for his surviving spouse and children. Such a trust, if properly drafted, maximizes the applicable credit by forcing the available credit amount into a trust for the benefit of younger generations, while at the same time allowing for income to be paid to the surviving spouse without including the trust corpus in the spouse's estate upon her death. Unfortunately, Mr. Mistake's will also provided the spouse with a general power of appointment over the trust, thereby making the trust's value incluable in her estate upon her death. This oversight may be rectified by the surviving spouse making a qualified disclaimer of her general power of appointment.

FOUR CONDITIONS

As explained above, there are four conditions that must be met in order to make a qualified disclaimer. This is how the requirements are satisfied.

Writing. According to Treasury Regulations § 25-2518-3(b), the writing must identify the property interest disclaimed and be signed by either the disclaimant of the disclaimant's legal representative. The writing must also be delivered to the appropriate individual.

Time Limit. It is imperative that a disclaimer be delivered no later than nine months from either the date on which the transfer creating the interest occurred or the date on which the disclaimant attains age 21. Treasury Regulations § 25.2518-2(c)(2) specifies that a timely mailing is considered a timely delivery.

No acceptance of disclaimed interest or benefits. Under Treasury Regulation § 25-2518-2(d)(1), acceptance express or implied is an affirmative act consistent with ownership of the interest in the property, such as using the property; accepting dividends, rents, interests, etc. The regulations offer many examples illustrating what is acceptance of benefits and what is not. However, a disclaimant is not considered to have accepted property merely because, under applicable local law, title to the property vests immediately in the disclaimant upon the decedent's death.

Passing without direction. The disclaimed interest must pass to another without direction from the disclaimant---this is, the disclaimant cannot specify the take in default- and to a person other than the disclaimant. The one exception to this is where the disclaimer is made by the surviving spouse, in which case the spouse may still receive the property at long as it was not by the spouse's own direction. For example, a spouse may disclaim an outright gift, which will then be transferred to a marital trust, as take in default, for the spouse's benefit.

LOOK BEFORE YOU LEAP.

When contemplating using qualified disclaimers, there are a few other considerations to keep in mind. First and foremost, one must always inquire into the local law of the jurisdiction, especially for timing and creditor issues. As set forth in Treasury Regulation § 25.2518-1(c), "the fact that a disclaimer is voidable by the disclaimant's creditors has no effect on the determination of whether such a disclaimer constitutes a qualified disclaimer. A disclaimer, however, that is wholly void or that is voided by the disclaimant's creditors cannot be a qualified disclaimer."

Second, watch for deadlines carefully. Often, state deadlines may be a lot earlier than federal deadlines.

Third, in order to reach some end result, several disclaimers by various parties may be necessary. One should be aware of such multiple transactions and ensure that all parties involved are prepared.

Fourth, before using a disclaimer, it is extremely important to review who will be the taker in default. A disclaimer may have tax benefits for the disclaimant, yet create serious adverse effects for the taker in default or the estate itself. For example, if the taker in default is a grandchild and there is no remaining generation-skipping tax exemption to cover the bequest, unforeseen taxes may be imposed on the estate.

Lastly, although disclaimers are generally a post-mortem mechanism, a practitioner preparing an estate plan should give serious consideration to the choices that such disclaimers may allow in the future. The most strategic use of disclaimers is that which is already provided for within the structure of a testamentary document or trust agreement. Some state statutes do not provide automatic powers of disclaimer for fiduciaries (such as trustees, executors, etc), so such powers must be granted within the estate planning documents.

Practitioners should discuss the potential uses of disclaimers with their clients, explain the planning benefits, and determine who the logical takers in default should be in the event the surviving spouse or beneficiaries desire to use this technique. To provide for the use of disclaimers, residuary clauses are important components of the estate plan.

Although there are many more specialized uses for qualified disclaimers and this article is not all-inclusive, it does demonstrate the broad scope of this flexible planning tool. If factors mentioned here are taken into consideration, the qualified disclaimer can be extremely useful. The disclaimer is truly one gift that cannot be refused.