What is a Disclaimer Trust?

A Disclaimer Trust is a special type of trust often created under a Will (or as a sub-trust of a revocable living trust) that generally allows a person to refuse an asset and still benefit from it under a trust.  In order to understand Disclaimer Trusts, you first need to understand what a disclaimer is and what happens when you make a disclaimer so that you can understand the purpose and mechanics of Disclaimer Trusts.

What is a Disclaimer?

A disclaimer is literally when someone refuses to accept money or an inheritance.  A person can disclaim a gift, an inheritance, an interest in a trust, or certain powers.  (Let's call this the "Disclaimed Interest".) A person can also make a partial disclaimer, such as disclaiming half of their inheritance (although special rules apply to this).

What Happens When a Disclaimer Is Made?

When a Disclaimer is done correctly, it has the affect of treating the person who disclaims as if he or she died prior to the Disclaimed Interest being made.  So, if a Wife is disclaiming an inheritance from her Husband, it treats the Wife as if she had died before the Husband for whatever amount Wife disclaims.  Generally, in order for a disclaimer to be effective for tax purposes, it must be done within nine months from the date of death AND the beneficiary cannot have accepted the Disclaimed Interest.

Since the Disclaiming party is treated as if he or she died before the gift or bequest was made, the Disclaimed Interest will pass to the next person in line who is suppose to receive that.  For example, if a Will says, everything to my spouse, and upon the death of my spouse, it all goes to my children, then if the surviving spouse disclaims her inheritance, it would all go to the children.  However, that may not be the result the surviving spouse wants.  She might want to have access to that money during her lifetime and only have it go to the children upon her death.

What is the Purpose of a Disclaimer Trust?

The purpose of a Disclaimer Trust is that it allows a surviving spouse to inherit money, but to do so in a way that would be more tax efficient for the descendants of the person creating the Will.

This tax efficiency is probably best illustrated by two examples of how it affected NJ residents prior to 2017.  Back when NJ had a state estate tax, it often wasn't beneficial for the surviving spouse to inherit everything outright. New Jersey had a 'use it or lose it' state estate tax exemption of $675,000.  So, if a married couple owned $1,350,000 of assets, and when one spouse dies they wish everything to go for the benefit of the survivor and then down to the children:

1. Example 1 - Upon the first to die, everything goes to surviving spouse outright.  When the second spouse dies, she would only have one NJ estate tax exemption of $675,000.  So assuming no growth in assets, the remaining $675,000 would have been subject to the NJ estate tax, resulting in a tax of almost $55,000.
2. Example 2 - Upon the first to die, everything goes into trust for the surviving spouse.  This utilized the estate tax exemption of the first person to die.  The surviving spouse still had access to the funds in trust, but when she died and everything went to the children, there was no NJ estate tax because she also had an estate tax exemption.

Under What Circumstances Should a Surviving Spouse Disclaim Assets into a Disclaimer Trust?

A surviving spouse should disclaim an inheritance into a Disclaimer Trust when it would be tax efficient to do so.  If we go back to our example above, let's say the couple with $1,350,000 has their estate dwindle down to $500,000, or they move to another estate without a state estate tax, or the estate tax exemption has increased well beyond what they expect to have when the surviving spouse dies, there would be no point in the surviving spouse disclaiming. 

If it is highly like that the surviving spouse will live in a state that has a state estate tax, and it the surviving spouses assets (including the inheritance) would be above that state's estate tax thresh-hold, then it often beneficial for the surviving spouse to disclaim the assets into a Disclaimer Trust.

(Incidentally, before the federal government had portability between spouses of the federal estate tax exemption, this was a part of practically every single Will for married couples.  Since portability and the increase the federal estate tax thresh-holds, fewer attorneys are including these clauses unless the state has an estate tax.)

When Should a Surviving Spouse Disclaim Assets into a Disclaimer Trust?

For a disclaimer to be effective for tax purposes, it must be done within nine months from the date of death.  The nice thing about Disclaimer Trust planning for couples is that it allows the surviving spouse to take a look at all the facts and circumstances when the first spouse dies.  

It is important to remember that the funding of a Disclaimer Trust is always optional.  A disclaimer Trust will NOT get funded unless the surviving spouse makes files a qualified disclaimer according to local state rules.  You can analyze your wealth situation, need for cash, look at the tax laws and figure out what is best for your situation.

What are the Tax Consequences of a Disclaimer?

If a Surviving Spouse disclaims within the nine period and does so according the rules set out by the IRS (basically not taking the property first, not directing where the disclaimed property goes, and complying with state rules on disclaimers), then the disclaimed amount will be includible in the decedent's taxable estate.  This is generally what you want as you are disclaiming to utilize the decedent's estate tax exemption amount.

The person disclaiming must be careful not to disclaim too much, otherwise that might trigger an estate tax on the first to die.

It should be noted that failing to disclaim in a timely fashion or in a way proscribed by the IRS will result in the disclaimer be treated as a taxable gift by the Disclaimant.  Basically, it's as if the surviving spouse accepted the property and then gifted it away.

Alternatives to a Disclaimer Trust Plan

The question I always ask my clients is whether or not they want to guarantee that money go into trust for the surviving spouse.  If they want to guarantee the use of an estate tax exemption or if they want to protect the money from a future spouse, we wouldn't do a Disclaimer Trust plan, we would just automatically fund a trust for the benefit of the surviving spouse upon the death of the first spouse instead of giving the surviving spouse the option to fund it upon the first to die.

However, many people aren't concerned about the surviving spouse remarrying, and they want to keep things simple.  Usually in those cases, we would allow the surviving spouse to disclaim their inheritance into a Disclaimer Trust upon the first to die if there is a tax reason to do so.

If the surviving spouse really doesn't need the money, he or she can also take the money and gift it to the children (or wherever you wish). Remember, this can result in a taxable gift.  However, with the high estate and gift tax exemption limits ($11.2M per person in 2018), most people will not actually incur a gift tax unless you make a very large gift.

Who Can Make a Disclaimer?

Throughout this post I have talked about the ability of a Surviving Spouse to make a disclaimer, and while anyone can disclaim an asset, only a Surviving Spouse can disclaim an asset in to a trust for the benefit of himself or herself.  The general rule for anyone other than a surviving spouse is that you cannot disclaim money and still benefit from it.  Accordingly, your child can never disclaim into a trust for his or her benefit.  

On the other hand, attorneys frequently create estate plans that give money to child, but if child dies, her share goes to grandchild in trust.  If the child is wealthy, she might not want or need the money and then Child can disclaim funds into grandchild's trust and act as trustee of that trust.

Problems With Disclaimer Trust Planning

The biggest problem with Disclaimer Trust planning is that the surviving spouse often fails to make an effective disclaimer.  If the surviving spouse doesn't seek counsel within nine months of the first spouse's date of death, or they transfer money into their own name, then an effective disclaimer cannot be made.

Balancing Estate Tax Planning and Capital Gains Tax Planning

One of the trickiest aspects of deciding whether or not to do a disclaimer is calculating whether a disclaimer will minimize overall taxes and expenses.  If the assets are in the surviving spouse's name, it can be subject to extra estate taxes.  If the assets are titled in the name of a Disclaimer Trust, it could produce additional capital gains taxes, accounting fees and other costs.  I would strongly urge you to consult with a tax attorney before exercising a disclaimer.

How Do I Know if My Estate Plan Includes a Disclaimer Trust?

The Will or Revocable Trust usually says something to the effect of "I leave everything to my spouse, but if my spouse disclaims all or a part of his or her inheritance, such disclaimed portion will be distributed pursuant to the Disclaimer Trust created hereunder."

A surviving spouse should be careful of disclaiming if no Disclaimer Trust is established under the Will or Revocable Living Trust as a disclaimer could have the effect of sending everything to the children.

If a Disclaimer Trust is Primarily for Married Couples Living in a State That Has a State Estate Tax, Why Do My Documents Have a Disclaimer Trust?

Disclaimer Trust planning is most useful in states still have a state estate tax.  However, many attorneys will automatically put it in the estate planning documents for a married couple even if they live in a state that doesn't have a state estate tax just in case the client moves to a jurisdiction that does have the tax.  Moreover, it was common practice to do Disclaimer Trust planning prior to 2001 when the federal government allowed spouses to port their unused federal estate tax exemption to the surviving spouse.  Accordingly, there is a historical component to this in all states.

Is there Any Harm to Having a Disclaimer Trust in my Will or Revocable Trust Even Though I Know I Will Never Use It?

Attorneys never like to use the word "never".  So, I will say that it would be very surprising if there is any harm in having a Disclaimer Trust in your Will or other estate planning documents.  It is a great failsafe.