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The disclaimer trust is a common form of planning, used as an alternative to funding a bypass trust with a marital deduction formula in order to utilize a decedent’s applicable exclusion amount.  (Use of a formula generally makes sense only if the estate is large enough to be exposed to estate tax, or there is strong interest in the asset protection feature of a bypass trust.)  In a disclaimer trust, a surviving spouse may disclaim property transferred from the decedent to the surviving spouse (or to the survivor’s trust).  Often the trust is drafted so that upon disclaimer the amount disclaimed will fund a bypass trust which will benefit the survivor during life, with income and/or right to invade principal, but only if discretionary distributions are limited by an ascertainable standard when the surviving spouse is serving as trustee.  Normally, that beneficial interest would invalidate the disclaimer, bringing the property back into the disclaimer’s estate—however, the tax code allows the surviving spouse to benefit in this way as part of a qualified disclaimer. IRC §2518(b)(4)(A).  Without the beneficial interest, few spouses would disclaim.

The disclaimer trust offers a flexible solution for post-mortem estate planning, and may be suitable for younger families with smaller estates not likely to be subject to estate tax, and where the surviving spouse would rather not live with the ongoing structure and cost of a bypass trust in the unlikely event her young spouse died.  In these cases, the disclaimer-funded bypass trust can be an emergency parachute in case of a large increase in the size of the estate, or in case of a change in tax law reducing the applicable exclusion amount.  Upon the first death, surviving spouse can take a look at current tax law and current estate size and decide whether it is better to fund the bypass trust by disclaiming all or a part of the property, or whether it is better to file an estate tax return so that the Deceased Spousal Unused Exclusion Amount (DSUEA) may be used.

There are some problems with relying on disclaimer to fund a bypass trust.  It does not work well when the intended beneficiaries of the deceased spouse are not necessarily the intended beneficiaries of the survivor, for example with blended families, or remarriage.  Even if the survivor is willing to disclaim, the survivor may be unable or not get professional advice on how to make a qualified disclaimer and may engage in acts constituting acceptance of the property and waiver of the right to disclaim.  Finally, with a disclaimer trust it is not possible to give the survivor a power of appointment over the remainder.

The disclaimer trust can also be used, in addition to the bypass trust, to “even out” the estates though portability now diminishes the utility of this strategy.

A disclaimer trust may be used to reduce income tax by sprinkling income to other family members, something that cannot be done with a QTIP marital trust.

The disclaimer trust is sometimes used, where the surviving spouse is not expected to live much longer, to transfer property outside of the bypass trust in order to cause estate tax to be incurred and to thus obtain a credit under IRC §2013 for estate tax paid with respect to a transfer of property to the decedent by another person, the transferor, who died within 10 years before, or 2 years after, the decedent.  If the death is within 2 years, the credit is 100%.

Absent other provision, disclaimed property would pass as if the surviving spouse had predeceased the deceased spouse.

Clayton Election and QTIPable bypass trust

Another option allowing for postmortem flexibility is to use portability together with a “QTIPable” bypass trust structured so that a QTIP election may be made for the entire amount of the trust.  Alternatively, a similar QTIPable trust may be drafted with “Clayton” language allowing an independent executor to make a QTIP election as to only a portion of the trust, with the result that the “non-elected” portion of the property instead flows to a bypass trust.  Unlike the disclaimer trust, in the Clayton trust the surviving spouse is not actually vested until the QTIP election is made.

The Clayton method has some advantages over a disclaimer trust in that there is no danger of waiving the disclaimer by accepting the property; the time limit is 15 months rather than 9 months; there is no problem giving the surviving spouse a power of appointment over the remainder; and as the decision is made by an independent executor (to avoid gift tax exposure to the surviving spouse), the objective decision-making is more suitable to the blended family situation.

There is a disadvantage with QTIP planning in that QTIPs are irrevocable trusts requiring preparation of an annual tax return after the first death.  [Disclaimer trust planning usually involves only a revocable survivor’s trust unless the survivor actually disclaims into a bypass trust (also an irrevocable trust requiring an annual tax return).]  This disadvantage must be compared to the potential benefits, including some asset protection potential (substantial, however a bit less than with a bypass trust).  The disadvantage may be ameliorated by including a provision allowing the surviving spouse to withdraw all of the principal of the QTIP after 16 months has elapsed from the date of death (to allow time for making the QTIP election on an estate tax return), thus terminating the QTIP in its second year, if that is consistent with the joint estate plan and the QTIP is needed only as a substitute for a disclaimer trust.

However, one of the great benefits of the QTIPable trust (whether designed as a bypass trust, or with Clayton provisions), is that it offers a means for the surviving spouse to use the Deceased Spousal Unused Exclusion Amount (DSUEA) in lieu of using the deceased spouse’s exclusion to fund a bypass trust.  This might be done to avoid capital gains tax, which may be incurred on any gains within the bypass trust after the date of death because there is no step-up in basis after the first spouse dies.  Property included in the survivor’s estate however, either directly or in a survivor’s trust, or in a QTIP, will be given a second step-up in basis upon survivor’s death.  Furthermore, having the QTIP in existence allows a reverse QTIP election preserving the deceased spouse’s GST tax exemption, important because there is no portability as to GST exemption.

Careful analysis will indicate the best course.  The course may be indicated strongly by changes in asset values (economically, portability and the bypass route have the same result only on one day, the date of death).  Larger estates are likely to use a marital deduction formula to fund a bypass trust, and perhaps a QTIP as well (dual QTIPs if planning to avoid state estate tax), placing highly appreciating assets in the QTIP, at least to the extent estate tax can be avoided there, in order to obtain the second step-up and avoid capital gains tax.  Mid-range and smaller estates, where the combined estates will not grow to more than twice the Applicable Exclusion Amount (AEA), may be more likely to opt for a Clayton solution to achieve the second step-up, avoid the administrative burden of a bypass trust, and possibly to allow a reverse QTIP election to avoid wasting decedent’s GST tax exemption, which is not portable.  However, even in the mid-range, some will want the superior asset protection of a bypass trust. Remember also that DSUEA is not inflation adjusted and is only available from the last deceased spouse, and—although it may be used in gifting prior to death of the second spouse, and that process may be repeated—there is a chance it could be lost on remarriage and use of the bypass trust is a surer means of using exclusion.  The bypass trust is also a surer means of transfer to a deceased spouse’s children from a previous marriage, surer than relying on the independent executor for this decision, and it may be difficult for blended families to find an independent executor willing to make that decision.  Also note that under Rev. Proc. 2001-38 the IRS may invalidate a QTIP election if not necessary to avoid estate tax at the first death—originally issued as a relief measure, but until the question of its application is clarified in the present context there is some uncertainty attending the use of QTIPs to port DSUEA.  It is thought that a statement by the executor on the estate tax return, waiving such relief, might be effective in preserving QTIP status.

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David R. Duringer, JD, LL.M, is a concealed firearm instructor and tax lawyer specializing in business and estate planning. He is managing shareholder at Protective Law Corporation, headquartered in Laguna Hills, primarily serving Orange County and Southern California with a satellite office located in Coronado (San Diego County).

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