A BRIEF OVERVIEW OF THE USES OF DISCLAIMERS IN ESTATE PLANNING
Copyright 1998 - Thomas J. Keating, IV
All Rights Reserved
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The law, clever and far-sighted thing that it is, provides a mechanism, known as a "disclaimer", which permits a person to refuse a property right which has been conferred upon him by another, in order to produce an ultimate result which is more agreeable to the person who is refusing. In words of one syllable, it is a device which permits you to say, with regard to a gift or bequest, "I don't want it, don't give it to me!". Although the law provides the tools, and prescribes the procedures, by which this is accomplished, the underlying reasons and issues are generally not "legal" ones so much as they are the product of personal, economic and/or tax considerations. A person who makes a disclaimer is called a "disclaimant".
For simplicity's sake, this discussion will generally be confined to bequests made under a decedent's Will, but similar principles are applicable to (a) interests in the estates of persons who die without a Will, (b) distributive gifts from trusts, (c) certain jointly owned property, (d) lifetime gifts, etc. If this were intended to be a general treatise on the subject, which it is not, then those issues would be discussed also, but in the interest of keeping this explanation relatively simple and reasonably digestible, I have deliberately not discussed those additional factual possibilities.
The law on this subject is found in two parts; State Law governs and controls the property law requirements and implications, and Federal Law principally controls the tax law requirements and implications.
1. Property Law Which Governs. Many, if not most, states have specific statutes which govern the use of disclaimers with respect to property which is subject to the laws of that state. However, even in states which do not have a specific statute governing the matter, it is relatively certain that the common law rule, to the effect that no one can be forced to accept a gift or bequest, would be in effect anyway, so the principle would be thus established . . . it is simply that the precise mechanism for invoking the principle might not be prescribed by law. If such a statute exists in a particular state it will govern all of the property law aspects of the matter. In a number of states, including Maryland, there is a statute titled something like the "Disclaimer of Property Interests Act". In Maryland, it is found in Sub-title Two of Title Nine of the Estates and Trusts Article of the Maryland Code.
2. Tax Law Which Governs. Because a disclaimer, unless it is made in conformity with certain federal tax law requirements, may be treated as a taxable gift for federal gift tax purposes, it is important to understand the steps which must be taken in order to exempt a disclaimer from those potentially unattractive gift tax consequences. An exempt disclaimer, which in tax parlance is called a "qualified disclaimer", must meet a number of specific tests. Those tests are described in Section 2518 of the Internal Revenue Code and the Regulations which relate to it. It must be (a) irrevocable and unqualified, (b) in writing and signed by the person making it, (c) received by the transferor in a timely fashion, (d) made prior to accepting any benefit, (e) made without consideration, (f) made without any attempt to direct the re-distribution of the disclaimed property, and (g) effective under local law.
Let me now expand somewhat on each of these seven criteria, so you will have a more complete understanding. In the order mentioned above, the several tests are:
A. Irrevocable and Unqualified. This requirement simply means that a disclaimer cannot be conditioned upon some other action being taken or condition being met; and that once it has been decided upon and put in motion it must in all events be carried out. This suggests, of course, that it is important for the client to understand the practical and legal consequences of a disclaimer prior to making one, as once made, it cannot be cancelled or changed.
B. Written and Signed. The requirement of a signed writing is to reduce the risk of fraud or mistake, and conforms with long-established legal tradition that actions relating to property must be in written form and provably issued by the person purportedly making them. Generally speaking, a disclaimer can be made in any reasonable fashion; there are no prescribed or "official" forms for making one. It is good practice to have the signing of the document independently witnessed and notarized, to authenticate both the fact of, and the date and place and circumstances of, its execution.
C. Received in Proper Fashion. This is a two-pronged test; the disclaimer (a) has to be received by the correct individual or entity and (b) has to be received by that individual or entity in a timely fashion. The identity of the receiving entity differs according to the type of transaction, and I am not going to go into the complexities of that question here. Insofar as timeliness goes, the rule is, generally speaking, that the document must be in the hands of the receiving entity within nine months following the date on which the transfer creating the interest was made.
D. Without Benefiting. In keeping with the theory that disclaimers must be absolute and untainted, and that the transfer to the ultimate recipient "relates back" to the date of the original attempted transfer, the disclaimant is prohibited from taking any action which could be construed as an acceptance of the interest, or any benefits from that interest, prior to making the disclaimer.
E. Without Consideration. The person making the disclaimer may not receive anything of value from any other person in exchange for making the disclaimer, which must be given freely and for no benefit or advantage, direct or indirect, of any sort. Stated another way, a disclaimant cannot "sell" his interest in the property which is being disclaimed.
F. Without Re-direction. The person making the disclaimer has no power or authority to determine what happens to the disclaimed property, which will pass in whatever manner it would have passed if the person making the disclaimer were not living at the time the transfer being disclaimed was made.
G. Effective Under Local Law. Finally, the federal tax law also requires that the disclaimer must be effective under the laws of the state governing the transaction for property law purposes.
3. Why Bother to "Qualify". Why, you might ask at this point, should one be concerned whether a disclaimer is "qualified" or not. As noted above, this is purely a federal gift tax question, and it might be that you feel that federal gift taxes don't apply to you or, if they do apply, that the consequences are so remote in time and/or speculative or inconsequential in amount that they can safely be ignored. Let me say by response that you may be right, that because of your economic circumstances the gift tax rules will never touch you in a meaningful way. But in saying that, you are making certain assumptions that may not ultimately turn out to be true, and I would caution you to step carefully in letting the transfer tax system get its hooks into you when there is a relatively simple and straightforward way to prevent it. You may say "I'll never have enough money to worry about gift taxes/estate taxes/etc., so I'll just make the disclaimer without worrying about its being "qualified" or I'll simply accept the property and then give it away." What happens if you do that, incur a resulting gift tax exposure, and then later have an unexpected financial windfall, such as an inheritance, a win in the lottery, etc.? I suggest that, on those facts, it may turn out that you have made an expensive decision.
4. What about "Partial" Disclaimers. What if you are willing to give up some of the property rights which have been conferred upon you by a particular transaction (e.g. by a persons' Will) but would prefer not to give up certain others. Is this disclaimer business an "all or nothing" proposition? The answer is that it depends. The fundamental test is this. . . if the property interest which is to be accepted is clearly separate, severable and distinct from the property interest which is to be rejected, the partial disclaimer is permitted . . . otherwise it is not. Let's look at a few examples:
A. The Will leaves to you, (a) in Item Third, all of the decedent's tangible personal property, and (b) in Item Fourth, an outright pecuniary legacy of $10,000, and (c) in Item Fifth, a life interest in a specific piece of real property. You wish to (a) accept certain specified items of the personal property and reject others, (b) accept ½ of the cash legacy and reject the rest, and (c) reject the life estate. You can do this because, within each category and otherwise, each of these property interests is separate, severable and distinct from each of the others.
B. The Will leaves to you (a) in Item Fourth, an outright pecuniary legacy of $50,000 and (b) in Item Sixth, a life income interest in the entire residuary estate, which has a value of $1,000,000. You wish to (a) accept only a life interest in the $50,000 pecuniary legacy, and (b) accept a life interest in only one-third of the residuary estate. You cannot do the former, because a disclaimer cannot be used to "carve out" a specific terminable interest in the entire bequest. Using the terminology described above, a life interest is not "separate, severable and distinct" from the remainder interest. You can do the latter, however, because the amount of the entire bequest, $1,000,000, is clearly divisible into three separate and distinct thirds, one of which would fund the portion of the bequest you wish to accept and two of which would fund the portion of the bequest you wish to reject.
Needless to say, it is crucially important that the disclaimer be clearly and unambiguously worded, so there will be no uncertainty or misunderstanding about just what is being disclaimed and what is not. In practical effect, a disclaimer is an amendment to the Will, and deserves no less care and precision in drafting.
5. Disclaimers by Trust Beneficiaries. It sometimes happens that the current beneficiary or beneficiaries of a trust which has been created by someone else feel that they do not need the economic security provided by the trust and are willing to disclaim their interest in it. What happens in that case? The answer is that, upon the making of the required disclaimer(s), either (a) the trust terminates and the trust principal is immediately distributable, or (b) the trust continues in existence for the benefit of any other class of non-disclaiming beneficiaries, according to the terms of the trust, in the same manner which would have happened if the disclaimant(s) had died prior to the time of the creation of the trust.
6. What Tax Reporting is Required. According to the current instructions for the U.S. Federal Gift Tax Return (Form 709), a "qualified disclaimer" is not treated as a reportable transfer, and therefore no gift tax return is required to be filed. I believe, however, that some tax practitioners would suggest filing an "information only" return, nonetheless, to preserve an "official" record of the transaction and all of its related and surrounding circumstances, for possible future reference.
7. State Inheritance Tax Implications. In the event of a disclaimer, the disclaimed property is treated as having been transferred directly from the transferor (in our example the deceased person) to the person(s) who receive the property as a result of the disclaimer. The disclaimant is completely ignored for purposes of this determination. In states whose death taxes are imposed at rates which differ according to the relationship between the transferor and the transferee (e.g. Maryland), the state death tax burden may change dramatically in the event of a disclaimer. By way of example, if the child of a transferor disclaims a $100,000 bequest and as a result the disclaimed amount passes to the transferor's nephew, the Maryland Inheritance Tax would change from $1,000 to $10,000. This kind of potential adverse result should be identified and considered prior to making any disclaimer.
8. Generation-Skipping Tax Implications. For reasons similar to those which were set forth in the preceding Section, any proposed disclaimer which would result in property passing to a grandchild or more remote descendant of the transferor should be examined for generation-skipping tax implications, which can be most serious but which will not be discussed in detail here.
9. Planning Suggestions. The inability of a disclaimant to re-direct the disclaimed property suggests that planners should always ask themselves (and indeed also ask their clients!) who should be named to receive the subject matter of each bequest in the event that the person primarily named to receive it is not living, as the named alternative person (or group of persons) will also be the one(s) who would receive the property in the event of a disclaimer. If no alternative persons are named, the disclaimed property will pass, generally speaking, under the intestacy laws, which might not produce a desirable result.
10. In Conclusion. Disclaimers are a practical and effective tool by which persons presently living, who are perhaps aware of facts and circumstances unknown to the decedent, can often "re-arrange" an estate plan to better cope with current personal, economic and/or tax issues facing their family. Planners and their clients should be mindful, at all stages of the process, of the availability of this tool and how it may be utilized to meet changing family objectives.
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