Article: Integrating Disclaimers into Bypass/Tax Shelter Trust Provisions in 2018 and Beyond

February 28, 2018

By: James F. Anderson, Esq.

The Estate Tax: A Moving Target

Over the past decade, there have been seismic shifts to the estate tax (sometimes called the "death tax") on both a federal and state level, most recently with the Tax Cuts and Jobs Act of 2017. The ramifications have been especially pronounced for residents of Virginia, Maryland, and the District of Columbia, where the concentrated wealth of this region in retirement plans, life insurance, and especially real estate has often meant that attention needed to be given to estate tax issues, even for persons with modest income levels.

During that time period, the federal estate tax exemption (the value of assets that can pass tax free on death) for an individual has grown from two million dollars ($2,000,000.00) to over eleven million ($11,000,000.00). Similarly, Virginia completely eliminated its estate tax in 2007, the District of Columbia estate tax exemption has increased to match the federal exemption level as of this year, and Maryland estate tax exemption is presently set to match the federal level in 2019.

In practical terms, what this means is that many local residents have estate plans that assume the existence of estate tax exemptions (federal and state) that are substantially lower than the current estate tax exemptions. Often the existing plans involve the use of a bypass/tax shelter trust structure that is designed to set aside assets for the benefit of a person (a "beneficiary") with a combined value equal to the federal, or state, estate tax exemption, and will restrict access to those set aside assets so that those assets will not be subject to estate tax when the beneficiary dies. The typical bypass trust limits the beneficiary's access to the principal and, in some cases, the income that is diverted into the bypass trust. The bypass trust also typically gets a step-up in capital gains basis only when the first of two spouses dies, and does not get a second step-up in capital gains basis when the second of two spouses dies.

In 2013, federal estate tax law changed to permanently allow portability of estate tax exemptions. This allows a surviving spouse to preserve the estate tax exemption of the first deceased spouse, to use later as part of the surviving spouse's estate. For example, if the estate tax limit was $12 Million when the first spouse dies, the surviving spouse can file a portability election within nine (9) months of the death of the first spouse to hold onto that credit. If, when the second spouse dies, the limit is $14 Million, then the surviving spouse is able to transfer a total of $26 Million tax free to beneficiaries. This can all be accomplished, at least with respect to the federal estate tax, without the need for a bypass trust.

Existing estate plans often relied on the use of formulas directly tied to the federal/state estate tax exemptions, and because the various estate tax exemptions have increased so dramatically in recent years, there is a significant possibility that many of these plans would cause the entirety of a person's estate to be placed into a bypass trust that is both unnecessary from an estate tax planning perspective, and which is subject to unnecessary restrictions on the trust's beneficiaries.

While many people might be inclined to simply remove the bypass/tax shelter trust provisions from their documents, there is still value in the bypass trust structure. For example, a properly drafted bypass trust can protect inherited assets from potential creditors, and can transfer wealth to one or more generations of beneficiaries while minimizing costs, taxes, and fees. Additionally, while there does not yet appear to be a movement to rollback the present estate tax exemption levels, the size of the present exemptions and the relatively small number of people across the nation that would be affected by a rollback to 2017 exemption levels ($5.45 million dollars per individual), means that that possibility of a rollback should not be completely discounted.

When taken all together, where does that leave people who have existing documents with outdated estate tax provisions, or who are looking to create a robust estate plan that can both navigate the current tax environment and adapt to any changes that might arise in the future? One option that might be worth considering is the increased use of explicit disclaimer provisions within estate planning documents.

How Disclaimers Work

A disclaimer is a way for a beneficiary, whether under a Will, Trust, or Payable on Death Asset (Life Insurance, Bank Account, Retirement Account, etc.) to decline the receipt of assets to which they would be entitled, and allow such assets to pass to some other person or entity. As such, a disclaimer is a reactive tool that becomes available to a person when they become a beneficiary (i.e. A person must become a beneficiary of an asset before a disclaimer can be executed). From a planning perspective, however, disclaimers can be approached more proactively and specifically incorporated into an estate plan's structure.

To understand how this might work in practice, it is important to understand how disclaimers function under federal and state law. Pursuant to federal law, a person (in this context, a "disclaimant"), who is a beneficiary of an asset from which they have not yet received any benefit, may execute a written disclaimer which is effective upon delivery to the person who has control over the asset in question (Executor, Trustee, or asset holder/manager in the case of life insurance retirement accounts, and similar transfer on death assets).

Upon delivery of an executed disclaimer, the disclaimant is treated as though he or she died before the death of the owner of the disclaimed asset. A disclaimer may be partial or full (meaning that a disclaimer could apply to the entirety of an asset, fifty percent (50%) of an asset, all but $25, etc.) Additionally, provided that the disclaimer is delivered within nine months of the date that the disclaimant acquired the interest in the disclaimed asset, the disclaimer will not be treated as a taxable transfer for gift tax purposes, nor will the disclaimant be responsible for any inheritance taxes.

Importantly, the disclaimant does not control who receives the asset. Instead, the disclaimed asset will be transferred to whomever the relevant documents identify as the appropriate recipient, which could be determined by: 1.) an explicit provision that becomes effective upon the property being disclaimed; or 2.) a more general document provision that establishes rules of succession that would apply if the disclaimant predeceased the transferor. This fact allows for the creation of flexible estate plans, because the thoughtful integration of disclaimers into estate plans can create multiple distribution paths for a deceased person's assets.

Disclaimers In Action

Estate Tax Planning

Tom Smith, a resident of Virginia, leaves the entirety of his estate to Mary, his wife, but his Trust (or Will) also provides that if Mary disclaims any portion of that bequest, the disclaimed portion will be given to the Trustee of the Tom Smith Marital Trust, which was drafted to avoid inclusion in Mary's taxable estate, and of which Mary is the primary beneficiary. When Tom dies, his estate is valued at $2 million dollars, and the state and federal estate tax exemptions have remained unchanged from their current levels. Mary elects to not execute a disclaimer, and the entirety of Tom's estate passes to Mary directly.

Alternately, if when Tom dies, he has a taxable estate that is valued at $11 million dollars, Mary's choice might be different. Virginia has continued to have no estate tax and the federal estate tax exemption is $11.2 million dollars (which is the current estimate for the new federal estate tax exemption). Additionally, Mary has $1 million dollars of her own assets. In this case, Mary might choose to execute a disclaimer for part, or even all, of the assets she is going to inherit from Tom. For example, perhaps Mary chooses to disclaim $5 million dollars of her inheritance from Tom, which is then given to the Trustees of the Tom Smith Marital Trust, thereby sheltering it from estate taxation on Mary's death. Mary continues to be able to draw assets from the Marital Trust to meet her needs. However, if she dies the very next day, the only assets that will be included in her taxable estate are her own $1 million dollars and the $6 million dollars that she did not disclaim. Because her total taxable estate is less than the $11.2 million dollar federal exemption, no estate tax will be owed to the federal government. [For simplicity's sake, this example has specifically disregarded the prospect of Mary making a federal portability election for Tom's exemption amount, which would potentially change Mary's analysis.]

The advantage to this structure, as opposed to the use of a formula, is that it can more easily adapt to changes in estate tax exemption levels. If the estate tax exemption levels continue to rise, the beneficiary does not need to execute the disclaimer, and no unnecessary bypass/tax shelter trust is ever formed. On the other hand, if the federal government does lower the estate tax exemption in the future, or if Maryland, the District of Columbia, or Virginia decides to enact a state level estate tax exemption that is less than the federal estate tax exemption, the beneficiary could choose to execute a disclaimer for an appropriate portion of the inheritance, thereby reducing (or entirely eliminating) future estate tax liabilities.

Separate and apart from the benefits related to estate tax planning, the thoughtful integration of disclaimers into estate plans can be used to achieve many other desirable outcomes.

Use of Disclaimers in Non-Estate Tax Contexts

Example 1: Arthur Jones' Will provides that fifty percent (50%) of his testamentary estate (those assets controlled by the Will) will be given to given to Mark, his son, but that if Mark disclaims his any portion of his bequest, the disclaimed portion will be divided among Mark's children/Arthur's grandchildren and held in trust, with Mark as the Trustee, until each grandchild reaches the age of twenty-five (25). This set-up, in explicit terms, gives Mark to ability to determine whether he needs the inheritance, or whether some or all of the inheritance should be passed on to his children immediately, without any gift tax implications and without ever exposing the inherited assets to Mark's creditors. Additionally, because Mark is the Trustee of his children's trusts, if the trusts allow it, he could still use the assets to provide for his children's daily needs.

Example 2:George Davis' Trust leaves everything to Dorothy, his wife, but provides that if she disclaims any portion of her bequest, the disclaimed portion will be split equally between a charity and a QTIP (Qualified Terminal Interest in Property) Trust. The QTIP Trust lists Dorothy as the Trustee and income beneficiary for life and further lists George and Dorothy's two children as the residuary beneficiaries upon Dorothy's death. On George's death, Dorothy evaluates her finances and decides that she has enough money and other assets to live comfortably. She disclaims the entirety of her bequest and it is divided as described above, with fifty percent (50%) of George's estate passing directly to the named charity and the other fifty percent (50%) passing into the QTIP Trust. It would also be possible to draft the provisions so that if Dorothy decided that she wanted to entirely forgo her interest in the QTIP, she could execute a second disclaimer, as Trustee of the QTIP Trust, and the entirety of the QTIP Trust assets would pass directly to her children.

Example 3:Dave Miller knows that his son Peter has a track record of being irresponsible with money, has had a number of problems with creditors, and is in a volatile marriage that might end in a divorce. So, Dave decides to leave Peter his inheritance in a Spendthrift Trust, with a close family friend serving as the Trustee. In this situation, Dave could also include a provision in his Will (or Trust) that if the Trustee of Peter's Spendthrift Trust disclaims the bequest, it would pass directly to Peter. Thereafter, if Dave dies and Peter has gotten his life in order, the Trustee could opt to execute a disclaimer and eliminate the need to establish and manage the Spendthrift Trust. Alternately, Dave could implement this concept in reverse, allowing Peter to disclaim his bequest, causing it to be placed into a Spendthrift Trust, isolating the inheritance from potential creditors. This later concept would also be applicable to beneficiaries of tax shelter estate plans described earlier in this article, as properly drafted tax shelter trusts will also be able to function as credit shelter/asset protection trusts, insulting those beneficiaries from creditors even if no estate tax benefit would be gained by disclaiming their bequest into the bypass/tax shelter trust.


As this article has shown, disclaimers are useful estate planning tools that can add flexibility to any estate plan. If you would like to discuss how the use of disclaimers might be implemented into your existing or new estate plan, please call or email our office to schedule a consultation.

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