qualified disclaimers and disclaimer trusts after tax...

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Qualified Disclaimers and Disclaimer Trusts after Tax Reform Using Disclaimers, Clayton QTIPs and OBITs to Optimize Basis Increase; Maximize Flexibility for the 2026 "Cliff and"Stretch" for IRA See-Through Trusts

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1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

WEDNESDAY, FEBRUARY 21, 2018

Presenting a live 90-minute webinar with interactive Q&A

Edwin P. Morrow, III, Esq., Regional Wealth Strategist,

U.S. Bank Private Wealth Management, Cincinnati

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Understanding Qualified (and

Non-Qualified) Disclaimers: Optimizing Estate & Income Tax Planning After the Tax Cuts

and Jobs Act with Qualified Disclaimers

Strafford CLE/CPE Webinar February 21, 2018

Edwin P Morrow III, JD, LL.M., MBA, CFP®

Wealth Strategist, Eastern U.S. Region

[email protected]

6

Agenda

1. Review of IRC §2518 and Regulations

2. State Law Variations and Nuances

3. Fixing Community Property IRA Disasters with Disclaimers

4. Comparing and Synthesizing Disclaimer and Clayton QTIP Planning

5. Cascading “Waterfall” Spousal Disclaimers, “Deemed” Disclaimers

6. Reducing Estates and/or Increasing Basis w/Disclaimers

7. Unique Flexible Gifting Opportunities with Disclaimers

8. Unique Features of Optimal Basis Increase Trusts vis a vis disclaimers

9. Common Post Mortem “Fixes” via disclaimer (incl. IRA “see through trusts”)

10.Contrasting Non-Qualified Disclaimers and Releases

11.Asset Protection Effects (and Traps) of Disclaimers

7 Please refer to disclosures in the appendix.

What’s New in Estate Tax Planning?

• “Permanent” $5 million estate/gift/GST, adjusted for inflation, with spousal “portability”

• Tax Cut and Jobs Act: “doubles” exclusion base - estimated $11.18 million (with spousal portability $22.36 million) in 2018 (slightly lower than $11.2 million estimate due to chained CPI), adjusting for inflation for 2019-2025, reverting to $5 million adjusted for inflation in 2026 (approx. $6-7 million, depending on level of inflation).

• Treasury directed to address 2026 “clawback”


Challenge for Sub $11.18 ($22.36) Million Estates

• Do 99.9% even need trusts? This is being questioned

by popular financial press, CFPs, CPAs, and attorneys

• Can we predict what will happen on January 1, 2026,

much less due to elections before then?

• Most common “solutions” cited are to ditch the trust

altogether, use disclaimer or Clayton QTIP funding, or

use an “all marital” approach – all of these have

significant issues and flaws – but we can improve

them. This CLE will focus on options, primarily for non-

blended families, that utilize some form of qualified

disclaimer planning for maximum flexibility.


Challenge for Sub $11 Million Estates

• How do we build flexibility into both gifting and estate

plans to adapt to changes in tax law due to new

Congress/President and/or 2026 “cliff”, as well as client’s

financial situations?

• How do we analyze the decision post-mortem, and what

criteria should we use for best practices?

• How do disclaimers (both qualified and perhaps non-

qualified) fit into proactive and post-mortem strategy?

• How do disclaimers help maximize the “stretch IRA”?


Sims v. Hall, 592 S.E.2d 315 (S.C. Ct. App. 2003):

• Alice Sims was the beneficiary of two estates (her sister, who died

first, and mother’s) and the personal representative for both of them.

• She hired attorney to assist her with her sister’s estate, then also her

mother’s estate.

• The trial court found attorney was negligent in failing to counsel Alice

and her mother on their ability to file a qualified disclaimer of her

sister’s estate, causing additional estate taxes, and awarded Sims

$191,543 in actual damages.

• The appellate court affirmed. Attorney’s initial ignorance of the size

of mom’s estate was unavailing.

Ignore Advising on Disclaimers at Your Peril


• It’s only one tax code section!

• Unlike many regulations that add nothing to help understand the

law, there are 62 examples in the 2518 regulations that are much

more helpful than most. See attachment.

• As noted, the estate and GST code sections incorporate IRC

§2518, which is in the gift tax code section.

• There is no analogous income tax code section, unless you

count IRC §678(d), which is an income tax section, which concerns

disclaiming a withdrawal right in a trust within a reasonable time of

learning of it. However, it appears that the IRS will honor qualified

disclaimers for income tax purposes based on several PLRs. It

may even honor a non-qualified disclaimer, e.g. one executed past

9 months, if there is no acceptance of benefits and state law

“relates back”, but this area has no statute; it’s fuzzy case law. If

there is acceptance, it would probably be assignment of income.

How Hard Could it Be?


Qualified Disclaimer Basics – IRC § 2518

Disclaimer is an irrevocable, unqualified refusal to accept a property interest and must be:

1. In writing

2. Within 9 months

3. No acceptance of the interest or any of its benefits, and

4. Interest passes without any direction on the part of the person making the disclaimer and must pass to either the decedent’s spouse or to a person other than the disclaimant.



– In writing – state law may vary on exact requirements, but why not send certified mail return receipt requested?

– Delivery – usually this is only necessary to the party holding the asset, which might be a trustee, bank, brokerage firm, or other custodian (e.g. IRA custodian, qualified plan trustee, etc.). However, some state statutes may also require filing with the local probate court. Obviously disclaiming a probate asset would involve notice to the personal representative (executor). See your state disclaimer statute (list in handout material) for specifics.



Within 9 months of completed gift (or death)

– No 6 month extension allowed!!!

– Exception for potential disclaimants under age 21, who have until 9 months after reaching that age to disclaim (but, has anyone ever run into a 21 year old who will disclaim???)

– It is the completed gift (death) of the settlor, not the death of spouse or other prior beneficiary, which starts the clock, unless the beneficiary dies holding a general power of appointment.



– Example 1: John Doe funds an ILIT for the children during his lifetime. His children have to disclaim within 9 months of each complete gift, not John’s death.

– Example 2: At John’s death, he establishes a bypass trust and QTIP trust for his wife Mary for her life, then their children. His children have within 9 months of John’s death. Mary’s date of death is irrelevant.

– Example 3: John establishes an optimal basis increase trust that grants Mary a testamentary general power of appointment over any appreciated assets, up to her available applicable exclusion amount. The children may disclaim within 9 months of her death, but only over those assets subject to a general power.


Qualified Disclaimer Basics – IRC § 2518 No acceptance of the interest or any of its benefits,

– Important to understand this concept more than most – mere retitling or naming a revocable beneficiary of an account is not “acceptance”.

– Selling/buying/rebalancing, or spending or reinvesting dividends from stock or pledging assets for a loan is acceptance.

– Taking cash from a brokerage account does not preclude disclaiming the stock or bonds in the account (unless traceable to dividends, etc.) See PLR 2005-03024 for example.

– Exercising a power of appointment can be acceptance (see Estate of Engelman v. Comm. 121 T.C. 54 (2003) (beneficiary had died and her will exercised TPOA, family’s attempts to disclaim her share were unavailing due to acceptance).


Qualified Disclaimer Basics – IRC § 2518 No acceptance of the interest or any of its benefits,

– Also important, joint tenants who reside or use property in which they inherit the remainder of are not precluded from disclaiming.

– Accepting role as trustee/fiduciary is OK

– Paying real estate taxes does not preclude disclaimer of real estate

– De facto ordering trustee/executor about how to manage property might well be, even if the beneficiary has no right to direct them

– Taking a decedent’s RMD does not preclude disclaiming the rest of the plan/IRA – see Rev. Rul. 2005-36 and the highlighted portions in handout material



– Interest passes without any direction on the part of the person making the disclaimer

– Cannot retain spray power, powers of appointment (except as noted later herein)

– If disclaimant is a co-trustee or on a board of directors of a private foundation that receives disclaimed funds, the disclaimant should be excluded from decisions regarding the disclaimed assets (see PLR 2008-02010)

– There can be no quid pro quo, but let’s mention the surprising outcome of the Monroe and Lute cases…



Estate of Monroe v. Commissioner, 104 T.C. 352 (1995):

– The tax court ruled that disclaimers were not qualified because the

decedent’s husband indicated that he would “take care of” 29

disclaiming parties (but no binding contract).

– He thereafter made a cash gift to the disclaiming parties

approximating the value of their disclaimed interest.

– Appellate court (with one dissent) surprisingly reversed the trial

court, stating that actual consideration rather than an expectation

or implication was required and that a disclaimer would stand or

fall on the factual issues.

124 F.3d 699 (5th Cir. 1997).


Qualified Disclaimer Basics – IRC § 2518 Estate of Lute by Lane v. United States, 19 F. Supp. 2d 1047 (D.

Neb. 1998):

– Taxpayer favorable.

– Mr. Lute, Sr.’s son dies at age 48.

– He disclaims his interest in his estate so that it all passes to his

son’s widow.

– Days later, the widow places the inherited property in trust with

her and Mr. Lute as two of four trustees (herself and children

beneficiaries), and the trust thereafter has ranch and cattle

business dealings with various family partnerships so he later

effectively controls the disclaimed property.

– The IRS tried to deny the qualified disclaimer on grounds that

oral contract or understanding made it not “unqualified” (quid pro

quo) but like Monroe, the court found for the taxpayers.



– Can be an undivided portion of an interest (e.g. 44 of 100 shares of stock, 40 of 100 acres of land, etc.)

– Must be a vertical, not horizontal slice (not, e.g., five years of income, etc.)

– Powers of appointment (limited or general, which might be a power of withdrawal such as a 5/5 power) can be separately disclaimed from interests in the trust assets that they pertain to



– Disclaimer can clearly be by formula (also see the Christiansen case in additional material):

Treas. Reg. § 25.2518-3, Ex (20):

– “A bequeathed his residuary estate to B. B disclaims a fractional share of the residuary estate. Any disclaimed property will pass to A's surviving spouse, W. The numerator of the fraction disclaimed is the smallest amount which will allow A's estate to pass free of Federal estate tax and the denominator is the value of the residuary estate. B's disclaimer is a qualified disclaimer.”


Qualified Disclaimer – State Law Variations

– Some states have passed the Uniform Disclaimers of Property Act

– See its commentary for interpretation if you live in AK, AZ, AR, CO, DE, DC, FL, HI, IN, IA, MD, MN, NV, NM, ND, OR, TX, VA, WV

– Fiduciaries may disclaim but this is sticky:

– Caution - state laws will vary on this point. E.g. see Ohio R.C. §5815.36(c) and (B)(4).

– Some states may require language in document or petition in local probate court.


The “Deemed” Qualified Disclaimer – § 2055(a)

– One instance where another code section affects disclaimer and “deems” it to have been made

– Remember to look up if two deaths close in time; may affect charitable deduction if charity a remainderman

– “For purposes of this subsection, the complete termination before the date prescribed for the filing of the estate tax return of a power to consume, invade, or appropriate property for the benefit of an individual before such power has been exercised by reason of the death of such individual or for any other reason shall be considered and deemed to be a qualified disclaimer with the same full force and effect as though he had filed such qualified disclaimer.”


The “Deemed” Qualified Disclaimer – § 2055(a)

– Allows planning to permit lapses to be deemed qualified that would not otherwise be qualified under §2518

– Example: John has a $16 million estate and leaves $6 million in artwork and $10 million in trust granting two beneficiaries a power to withdraw 1/2 each that lapses the day before 9 months after his death and to the extent they do not take the cash/art, it converts to a private foundation/wholly charitable trust run by them as trustees. Normally, their disclaimer would not be qualified. However, their interests will be deemed to be qualified disclaimers under §2055(a) & John’s estate can receive a deduction for the amount they don’t take.

– Can they “double dip” and take an income tax deduction under §170 for the amount they allowed to lapse and go to charity? Remember it’s a gift under §2514 of 95% to charity.


Disclaimer Example - IRA

IRA

IRA Trust

F/B/O SPOUSE and CHILDREN

Contingent

• “Designated Beneficiary” Status – Trust is Irrevocable

• No Separate Share Treatment • Life Expectancy of Oldest Beneficiary • Mother disclaims 100% • Oldest Child is now Designated Beneficiary

Whose Life Expectancy is Used for RMDs, but Testing for Accumulation Trusts can be Tricky


Disclaimer Planning – Example w/ IRA

IRA

IRA Trust

F/B/O Child 1 as Contingent

• Contrast – if the Beneficiary Designation Form pays to spouse, then 50% to trust for child 1, and 50% to trust for child 2. Use separate trusts, not merely separate shares, if you want to use each life expectancy.

• Assume spouse disclaims • Life expectancy of each child

may be used (if so drafted) for RMD calculations

IRA Trust

F/B/O Child 2 as Contingent


Disclaimer Planning – Common Problem with IRA Beneficiary Designations

IRA

Child #1

• Many IRA beneficiary designation forms (BDFs) do NOT default to “per stirpes”

• Assume child #1 disclaims, hoping her children can benefit from longer stretch

• Default under many IRA prototype forms is to send the IRA to Child #2!!

• Obviously, change of BDF can prevent this. Check each account’s defaults.

Child #2

Child #1’s Children

??


Fixing Plans with Community Property IRAs

• IRS takes the position that a court order granting a surviving spouse 50% of an IRA that

was community property is ineligible for a rollover! In PLR 2016-23001:

– Decedent left 100% of his community property IRA to his son, not wife. In settling

estate, court ordered a portion (probably 50%) of IRA to wife. She asked IRS to rule

that it was not a taxable event. DENIED.

– IRS held: it would be taxable to son because Section 408(g) provides that §408

“shall be applied without regard to any community property laws.” No rollover

permitted, nor can wife be designated beneficiary.

Three lessons:

1. Had son simply filed a qualified disclaimer, it would have likely passed via intestacy

or will to spouse would have been entitled to rollover! If son had minor children,

and they were contingent, then state law would likely permit guardian to make

disclaimer. But, we do not know son/wife’s relationship in this PLR.

2. Check the BDF- naming spouse as 50% of IRA avoids the issue (as would

transmuting to separate property prior to death)

3. Prevention is cheaper than PLRs!


Disclaimer Trust Planning for Spouses

• A “wait-and-see” approach where estate taxes may be a

consideration

• Essence:

– All to Marital Share, with disclaimed amount to bypass trust

– Some may also name spouse outright, with disclaimer funding bypass

• Advantages:

– Maximum discretion to surviving spouse

– Marital Share distribution flexibility

• Disadvantages:

– Surviving spouse cannot have a limited power of appointment over the

disclaimed assets or be trustee w/spray powers (Bypass Trust)

– Surviving spouse may blow the disclaimer


Disclaimer Example

•Alex dies at age 70. Alex’s wife Betty

disclaims amount to bypass trust for benefit

of herself and their children. – Within 9 months from date of death

– Must be provided to Trustee (and any other custodian if

Betty was a primary beneficiary and the trust contingent)

• If IRA or qualified plan, it is probably best to also send

to IRA/plan custodian/trustee as well, due to the Oct 31

rule about providing appropriate documentation about

the trust terms as a prerequisite for qualifying for

designated beneficiary status.


Clayton QTIP Election

•Twist on disclaimer trust

•All to a QTIP designed trust – Any portion not elected to qualify for estate tax marital deduction

funds the non-marital bypass (credit shelter) trust share

– Option to fund with % that maximizes or minimizes the federal and

state marital deduction; a majority of states with an estate tax, but

not all, allow separate state QTIP election

– Usually recommended that spouse not be the executor making the

QTIP election (otherwise IRS may consider a gift – this is uncertain

– if the bypass trust has the exact same rights to all net income as

the QTIP, there may be no gift being made)



Advantages: – Not subject to disclaimer requirements

• Up to 15 months to decide if 6 month extension filed

– Spouse can keep limited testamentary power of

appointment over bypass or QTIP trust

– Spouse can keep lifetime powers over bypass that

would not be allowed post-qualified disclaimer

– Reliance on action of someone other than surviving

spouse (if someone else is executor)

– Added flexibility to exploit portability



Disadvantages: – Marital Share must be a QTIP

• Option to give spouse a demand right after 16 months

– Finding a fiduciary (and spouse agreeing), willing to make the QTIP election

– If no Form 706 is filed, property will not be included in surviving spouse’s estate

– Unlike qualified disclaimer, must file Form 706 to make QTIP election

– Unclear result for IRA see through trusts if not done by the beneficiary designation date (September 30 of year after death)


Disclaimer & Clayton Election

•Disclaimer & Clayton election provides flexibility of

a second-look at death of surviving spouse

•Does require action on death of first spouse to die

– Requires a close analysis of:

• Current assets

• Likely growth of assets until death of survivor

• Survivor’s plans for assets (hold or sell)

• Flexibility of the ultimate post-QTIP or post-disclaimer trust for

the surviving spouse (and/or family)


• Issues and Solutions to exploiting Clayton QTIPs: – Is spouse executor? Often so.

• Some claim there may be a gift tax issue.

• Can’t we simply get around it? e.g. the bypass trust initially has the same “all net income” provision, without a spray, so the IRS cannot claim that the spouse’s election is somehow a gift, because the spouse gives up NOTHING (nor could creditors claim it was a gift and therefore somehow funding a self-settled trust).

• Then, spouse simply disclaims the right to all net income. Voila! Now income can be sprayed to lower bracket beneficiaries! No gift issue.

• This would require the QTIP election be made within nine months. Note, this kind of disclaimer would blow a QTIP election if made over the QTIPped Trust.

Marital Trusts – The Clayton QTIP and “One

Lung Trusts”


• Issues and Solutions to exploiting Clayton QTIPs:

– Might asset protection be affected if spouse’s actions cause the bypass to be funded? Very doubtful – not “asset” per UFTA, nor would the trust typically be included in bankruptcy estate under 11 USC §541(c)(2).

– Can a surviving spouse inheriting outright disclaim into a trust and then make a decision as executor over a “Clayton QTIP” that changes trust terms whether and to what extent the QTIP election is made? Is this power as executor prohibited “control” that would disqualify the disclaimer? I could find no case or authority, but there is a potential that it is, since the examples of exceptions only include powers restrained by HEMS or a general power. There is no clear exception for a discretionary decision such as how much to QTIP a trust. Thus, consider having the spouse resign as executor and have the successor make the QTIP election.

Marital Trusts – The Clayton QTIP and “One

Lung Trusts”


– “Waterfall disclaimers” – spouses can keep disclaiming successive interests and it can pass through several iterations. There is no limit on the number of estates/trusts/foundations the asset can pass through via spousal disclaimer. See I.R.C. § 2518(b)(4); Treas. Reg. § 25.2518-2(e)(2); also Treas. Reg. § 25.2518-2(e)(5) examples 5-8 (giving examples regarding the passage of disclaimed interests)

Example in PLR 2004-42027:

– H created trust for W that would pay all income and then principal to W, but if she disclaimed then to trust #2, if she disclaimed from that, to trust #3, then if she disclaimed that to trust #4, etc. Wife proposed to disclaim trusts #1-4 and take under trust #5 which allowed income and principal to be distributed to wife and H’s descendants. No problem if made within 9 months of date of death.

Marital Trusts – The Clayton QTIP and

Cascading Spousal Disclaimers


• Disclaimers 201: Exploiting Qualified Disclaimer Rules for Joint Bank, Brokerage and Investment Accounts that are joint with right of survivorship

• Putting your spouse on an account as joint with right of survivorship is generally not a completed gift (US citizens), unless/until the spouse takes funds out or you die, because until then you can get the funds back

• This affects qualified disclaimers – the time to disclaim runs from date of death, not time placed on account

• Spouses may disclaim any percentage/amount except to the extent the disclaimant contributed to the account. If spouse did not contribute, this is 100%

• Let’s review one of the examples from article.

Using Disclaimers to Increase Basis


• John provides all the funding for a $ 4 million joint brokerage account (not community property), with:

• Fund Q: $1.6 million, basis of $1 million

• Fund X: $1.2 million, basis of $800,000

• Fund Y: $800,000, basis of $1 million

• Fund Z: $400,000, basis $500,000

• Typically when John dies, IRC §2040 includes 50% in his estate ($2 million), and his wife now gets a partial step up in basis for funds Q and X, and a partial step down in basis for funds Y and Z: $3.65 million

• Contrast, if Mary disclaims Funds Q and X, 100% is now in John’s estate, therefore these are stepped up to $1.6 million/$1.2 million, total basis $4.15 million.

• Contrast, if community property, basis is $4 million.

Using Disclaimers to Increase Basis


• Like the prior example, we can use a disclaimer to affect estate taxation of a decedent.

• In prior example & for 99% of estates, we probably want to INCREASE the taxable estate to attain basis.

• Can exploit IRC 2040 and its opt-out of FMV rules, coupled with a disclaimer, to reduce the estate.

• Extreme example (using pre-tax reform AEA): – John and Mary own a $13 million JTWROS property.

– John dies in 2016, followed by Mary. You represent Alice, their daughter (remember the Sims case???).

– If you do nothing (assume $100,000 costs), $12.9 million estate will cost $800,000 estate tax ($2 million over Mary’s applicable exclusion amount w/DSUE)

Using Disclaimers to Reduce Estate Tax


• With Sims case in mind, you counsel Alice to make a qualified disclaimer, as executor of her mother Mary’s estate.

• Result: – A 50% tenancy in common interest will get a valuation

discount (cases range 15%-60%, likely to be on the low end).

– Assume appraiser comes in at 15% - the value of a 50% TIC being $6.5 million x.85 = $5.525 million.

– Alice inherits that 50% from her father’s estate, then remaining 50% from her mother’s estate, and voila, $800,000 estate tax saved! (the attorney charged a bit more in fees for the clever disclaimer planning).

– Her basis, however, is $11.05 million, rather than $13 million. Even if she sold right away, used no CRUT or installment sale, the capital gains would be much less.

Using Disclaimers to Reduce Estate Tax


• Be careful to advise spouses who have joint tenancy real estate that disclaiming 50% to fund a bypass or marital trust or simply fund a non-taxable gift to children can lead to reduced basis.

• Extreme example Revisited: – Let’s assume the same 15% discount for 50% TIC interests.

– John’s wife Mary decides she will disclaim 50% to either fund a bypass or marital trust or allow it to pass to her daughter.

– The new basis for the 50% is not 50% of $13 million, it is 85% of 50% of that. Maybe good for taxable estates, but for others??

– Whereas if Mary had inherited outright, JTWROS, it would be undiscounted 50% ($6.5 million), pursuant to IRC §2040.

• An overlooked advantage to using portability for jointly held real estate interests, but JTWROS is a lousy option for many blended families for non-tax reasons.

Beware Spousal Disclaimers Reducing Basis


• Be careful to advise spouses who might consider disclaiming partial interests of LLC/LP, closely held business or real estate tenancy in common valued in decedent’s estate at no or minimal “discount”.

• Consider Disanto v. Comm’r, T.C. Memo. 1999-421, where a marital deduction was reduced with greater discounts when the decedent’s estate held a controlling interest in closely held stock, but the surviving spouse disclaimed only a portion of the stock bequeathed to her, resulting in her receiving only a minority interest. E.g. if decedent has $1 million 100% interest in LLC, bequeathed to spouse, and spouse disclaims 60%, the 40% remaining may receive a marital deduction of $250-$300,000, not $400,000, reflecting a lack of control discount.

Beware Spousal Disclaimers Reducing

Marital Deduction for Fractional Interest


• Remember that the donative instrument (usually a trust) can have a different dispositive provision for disclaimer than if the donee/beneficiary dies – this is true for lifetime gifts as well as bequests.

• E.g. you have a client nervous about a making a large gift to exploit the additional $5.69 million gift tax exclusion added by tax reform that may go away at the end of 2025. She has a grandchild age 16.

• She establishes trust in 2018 for grandchild, but if the grandchild disclaims, the property reverts to the settlor. Grandchild can disclaim from age 18 (under most state laws), until 9 months after reaching age 21. While we may think those age 18-21 will never disclaim, they will if they know rich grandma will be upset and write them out of the estate plan!

Unique Flexible Gifting Opportunities


• The rules regarding disclaimers by those under age 21 are much more liberal than you would think:

• “Any actions taken with regard to an interest in property by a beneficiary or a custodian prior to the beneficiary's twenty-first birthday will not be an acceptance by the beneficiary of the interest.”

Unique Flexible Gifting Opportunities


• We have all been taught that spouses using any disclaimer

funding have to disclaim any powers of appointment in

trusts receiving disclaimed assets.

• This is wrong, or at least, overbroad

• A power of appointment that can only trigger estate/gift tax,

or that is limited by ascertainable standard, CAN BE

retained. Optimal Basis Increase Trust (OBIT) clauses

meet this requirement. For a clear example in the

regulations of a surviving spouse retaining a general power

of appointment in a trust without disqualifying the disclaimer,

see Treas. Reg §25.2518-2(e)(5), Example 7

Busting Spousal Disclaimer Myths –

Integrating “Optimal Basis Increase” Designs


• Powers of appointment have TREMENDOUS income tax planning potential for both stepping up basis (at death, aka testamentary) and spraying income (lifetime). Powers can be limited, capped, targeted.

• General POA (GPOA): – power to appoint to yourself, your estate, or creditors of either

– can be lifetime, or testamentary (only effective at death)

– triggers estate inclusion (§2041), which is favorable for 99.8% of the population that does not pay tax but would prefer the basis increase afforded under IRC §1014

• Limited POA (LPOA): – power to appoint that excludes power to appoint to self, estate, or creditors or

either

– usually does NOT trigger gift tax or estate inclusion, except special circumstance, such as the Delaware Tax Trap

Understanding Powers of Appointment


Traditional AB Trust - Basis Effect

John and Mary Doe Trust

(could be joint or two

separate trusts)

John Doe Bypass

Fbo Spouse (& children?)

< $11.18mm (or basic

exclusion amount)

Trust for children

No change in basis for any

asset (when children/trust

sell property, capital gains on

any post-death appreciation)

John Doe Marital Trust

Fbo spouse only,

> $11.18mm (or basic

exclusion amount)

Trust for children

All new basis except IRAs,

Qualified plans, annuities

(including step down)

Planning Steps

At John’s Death

At Mary’s Death


52

Optimal Basis Increase Trust – Basis Effect

John Doe Trust

(could be joint trust)

w/optimal basis

provisions

John Doe OBIT

Fbo Spouse (& children?)


exclusion amount)

Trust for children

Step up in basis for

assets w/basis < FMV

(up to spouse’s AEA)

Trust for children

No change in basis (IRD,

assets w/ basis => FMV,

no step down)


Fbo spouse only,


exclusion amount)

Trust for children

All new basis

(including step down)

Planning Steps & Strategies

Uses GPOA or LPOA, Section 2041, capped to not cause estate tax,

To trigger estate inclusion and therefore Section 1014 step up

At John’s Death

At Mary’s Death


Usually, Mary resigns as trustee (req’d if discretionary powers),

disclaims any lifetime or testamentary power of appointment,

which reduces the ability to shift income, seize basis at death.

Traditional AB Trust – Disclaimer Plan/Effect

John Doe Trust

(could be joint trust

or testamentary)

To Mary Outright

John Doe Bypass Trust fbo Mary (& children?) < $5.49 million ($11.18 million in 2018). No

LPOA, no power to “rewrite” via testamentary POA to adapt trust.

Or to John Doe

Marital Trust

Fbo Mary

Planning Steps At John’s Death Alternate Method

Usual Method- 1st outright - 1st to QTIP

After Mary’s Disclaimer


Mary has fiduciary POA limited by HEMS and “taxable” LPOAs to shift

income (lifetime), testamentary GPOA and/or LPOA coupled with exercise

triggering the Delaware Tax Trap to increase basis (at death)

Disclaimer Plan/Effect of “OBIT” Optimal

Basis Increase and Income Tax Efficient Trust

John Doe Trust


To Mary Outright or

Marital Trust

John Doe Bypass Trust fbo Mary (& children) < $11.18 million (AEA).

Keeps HEMS LLPOA, gift-taxable LLPOA and estate-taxable capped testamentary POA “rewrite” power

Planning Steps At John’s Death

Usual Disclaimer Plan

At Mary’s Disclaimer


Children cannot make a qualified disclaimer, unless Mary happened to die

shortly after John. They have nine months from John’s death, not Mary’s.

Exception for those under 21.

Traditional AB Trust – Disclaimer at 2nd Death

John Doe Trust


To John Doe

Bypass Trust

Children typically have no power

to disclaim per IRC §2518.

John Doe QTIP Trust

Fbo Mary

Planning Steps At John’s Death

Usual Method - Outright Alternate (to QTIP)

After Mary’s Death


Children can make a qualified disclaimer within nine months of

Mary’s death over any assets that were subject to a GPOA

OBIT – Disclaimer at 2nd Death

John Doe Trust


To John Doe

Bypass Trust

Children would have power to

disclaim per IRC §2518, any

assets subject to GPOA

John Doe QTIP Trust

Fbo Mary

Planning Steps

At John’s Death

Usual Method

After Mary’s Death


John Doe Trust

(could be joint trust or two

separate trusts)

John Doe Bypass Trust fbo

spouse (& children?)

< $11.18 mm (or basic

exclusion amount)

Capital Gains taxed at 23.8% (long

term)/40.8% (short term) even if

arguably distributed;

Ordinary income at 23.8%

(QD)/40.8% if not distributed


(QTIP) fbo spouse only,

> $11.18 mm (or basic

exclusion amount)

Capital Gains taxed at 23.8% (long

term)/40.8% (short term) even if

arguably distributed;

Ordinary income at 23.8%

(QD)/40.8% if not distributed

At John’s Death

Tax Effect to Spouse and Doe Family, during spouse’s

lifetime

Above rates refer to trust income above $12,500 in 2018 (top rates),

ignoring state income tax, or special tax rates for collectibles and Section

1250 gains (28%, 25% plus potential 3.8% surtax respectively)

Ordinary “A/B” Trust – Ongoing Tax Effect


Income Tax Efficient Trust– Ongoing Tax Effect

John Doe Trust

(with different trust

provisions and/or trustee

actions to shift tax)

John Doe Bypass

Trust fbo wife (& children?)


exclusion amount)

All income can be taxed at

spouse’s, children’s or even

charity’s rates to the extent

distributed (appointed), or subject

to unfettered withdrawal power


(QTIP) fbo spouse only,


exclusion amount)

All income can be taxed at spouse’s

rates if distributed or subject to

unfettered withdrawal (no ability to

spray to children or charities)

At John’s Death

Tax Effect to spouse and Doe Family during spouse’s life


• Many states permit a disclaimer after nine months. This may be a useful disclaimer under state law, but not a qualified disclaimer under IRC §2518.

• For federal tax law, non-qualified disclaimers and their close counterpart, a common law release, causes a taxable gift, but be careful of effect on any Roth IRA/IRA type benefits.

• A common law release may also be available, e.g., even after some benefits have been accepted. For example, a surviving spouse may no longer need a bypass trust and might be fine if a release causes a taxable gift based on the actuarial value of their interest (or, with a QTIP, the entire amount pursuant to IRC §2519). But verify it does vest under trust/state law!

• For a clever use of such technique, consider PLR 2012-03033, where it was too late to make qualified disclaimer, but before the beneficiary finalization date (Sept 30 of year after death), the beneficiary w/ a GPOA disclaimed the right to appoint to all persons or entities except individuals younger than the power holder to keep DB status for IRA see through trust.

Contrast Non-Qualified Disclaimers, Releases


• Terminating a trust if remaindermen inherit outright

• Adjusting an unintended unequal division of estate

• Increasing marital deduction to save state or federal estate tax, e.g., if others disclaim rights to enable trust to make a QTIP election.

• Decreasing the marital deduction (e.g. disclaiming a general testamentary power of appointment in marital trust, Clayton QTIP, allowing distribution to children, etc)

• Fixing estate plans thwarted by common disasters or close in time deaths

• Enabling younger generation to use “stretch” for IRA/QPs.

• Disclaiming environmentally suspect CERCLA property

• Helping an excluded or needier child, sibling

• Fixing defective charitable trusts to achieve deductions

Common Post-Mortem Fixes Via Disclaimer


• General rule in vast majority of states is that disclaimer “relates back” and is not a fraudulent transfer (but MN, FL may prevent if disclaimant is insolvent), at least as to ordinary creditors

• Beware – it’s still an improper transfer for Medicaid!

• Beware - it cannot avoid federal tax liens which attach at the time the interest is created (gift/death). Drye v. U.S. 528 U.S. 49 (1999). Restitution orders are treated like tax liens! See U.S. v. Harris, 9th Cir. 2017

• Beware – it cannot avoid a non-tax federal debt, such as a defaulted small business loan that is guaranteed by the U.S. Small Business Administration (common for small business). See Bernal v. SBA., 9th Cir. 2017. Should executors/trustees investigate disclaimants’ tax and debt problems prior to distribution to any beneficiaries in default resulting?

• If an intended beneficiary has tax debts, either help them pay their taxes (some might be discharged in bankruptcy) or disinherit them completely, don’t use a HEMS or even discretionary trust or disclaimer plan! See Duckett v. Enomoto, Case No. CV-14-01771-PHX-NVW. (D. AZ, April 18, 2016), U.S. v. Harris.

Asset Protection Issues of Disclaimers


• Even though there is favorable case law that disclaimers may not be a fraudulent transfer in bankruptcy, In re Costas, 555 F.3d 790 (9th Cir. 2009), beware that disclaimers by a debtor may prevent a discharge if done within one year of filing, which in some cases may be even worse than having the disclaimer avoided! In re White, 2014 Bankr. LEXIS 578 (Bankr. D. Neb. Feb. 12, 2014)



• Practice Tip: NEVER say in a disclaimer, side agreement or other document that is not protected by attorney-client privilege, even if it’s obvious and seems innocuous, superfluous, harmless and moot and any assignment is denied, WHERE the assets will go after the disclaimer or the ultimate rationale.

• In re Estate of Sterba – son executed a document purporting to “disclaim any and all interest or interests” in his mother’s estate, “so that…[his sister] shall take the shares which [he] would have received but for this disclaimer of interest”. Noteworthy – he had three siblings, not just the one sister, who would have taken if he had predeceased. The son filed bankruptcy three months after filing the purported disclaimer. Based on this seemingly superfluous “so that” language, the bankruptcy trustee claimed that the disclaimer was actually a non-qualified ASSIGNMENT, therefore did not “relate back” as if the disclaimant had predeceased, therefore it was subject to avoidance as a fraudulent transfer. The court sided with the bankruptcy trustee. What if he had named all three siblings who would have taken in default? Estate of Dearth v. Estate of Sterba (In re Estate Sterba), 2016 IL App (3d) 150483 (Ill. App. Ct. 3d Dist. 2016)



• Communicate to clients and their advisors the acceptance rule ASAP after gift or death to prevent inadvertent disqualification.

• Very important for IRA “see through trust” planning, not only to help fix trusts, but to allow income tax shifting and longer “stretch” deferral when disclaimed assets pass to younger generation, through trust or not. Be careful – default beneficiaries vary greatly in IRA BDFs.

• If client’s child is already well-off, or conversely, in hot water w/creditors, and may disclaim, plan ahead by looking to name contingent beneficiaries (e.g. name subtrust for grandchild as contingent beneficiary of IRA, not the main trust) or craft appropriate receptacle trusts.

Conclusions – Qualified Disclaimers


• Watch out for bank, brokerage, investment account opportunity to disclaim portions of joint with right of survivorship (JTWROS) or tenancy by the entirety (TbyE) accounts to obtain a higher basis in separate property states – finding that makes you a hero! Consider the possibility for joint trusts as well if they are equivalent.

• Consider what “optimal basis increase” powers of appointment may be added and kept post-disclaimer in bypass/QTIPs for more powerful income tax planning.

• Be careful with any disclaimers by debtors who may have federal debt (e.g. SBA loans) or tax liens – consider protecting trustee/executor with a signed statement that disclaimant has no known tax liens or federal debt (or even a Lexis search for large enough suspicious case?)

Conclusions – Qualified Disclaimers


• Updated material on basis and income tax planning will be periodically added to the Optimal Basis Increase Trust white paper at http://ssrn.com/abstract=2436964

• Ed’s contact information:

– Email [email protected]

– Email [email protected]

– 1-513-632-4350

– While effort is made to make this outline accurate, this material is not intended as specific tax advice – see your own counsel regarding specific tax issues. No opinion expressed herein is that of U.S. Bank, but is only the author’s personal observations.

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