The most basic ingredient in any estate plan for married couples with potential federal estate tax exposure is the bypass trust. This trust, also known as the credit shelter trust, is generally what distinguishes a simple will from a document that contemplates the potential impact of federal estate taxes.
However, mandatory implementation of a bypass trust at the death of the first spouse may prove too inflexible for some clients. For those clients, disclaimer trusts may offer the best of both worlds – maximum flexibility and the ability to minimize or avoid estate taxes in the spouses’ combined estates.
A bypass trust is normally incorporated into each spouse’s will. Whereas the simple, or sweetheart, will provides that all property of each spouse passes outright to the survivor, a will containing a bypass trust generally provides that an amount equal to the then-applicable exemption from estate and gift taxes, referred to here as “the exemption,” is set aside in trust for the survivor’s benefit.
That trust may contain one or more of the following provisions without subjecting the trust assets to estate and gift tax (i.e., the assets “bypass” the survivor’s estate): (1) the survivor may be entitled to all of the income earned by the trust assets; (2) if the survivor is the sole trustee, he or she may have access to trust principal, but only in accordance with a “ascertainable standard” for his or her needs in terms of health, maintenance and support; (3) if the survivor is not the sole trustee, a co-trustee may have a broader principal invasion power; (4) the survivor may be entitled to annually withdraw the greater of 5 percent of the trust principal or $5,000 (a “five and five power”); and (5) the survivor may be permitted to appoint the trust assets, during lifetime or at death via his or her last will and testament, to a limited class of beneficiaries (a “special power of appointment”).
The following simple example illustrates how bypass trusts work: Mom and Dad, each 60 years old and in good health, own combined assets worth $1.25 million, each with $625,000 in their names. If Mom and Dad have simple wills, the survivor will end up owning all of the combined assets and the exemption of the first spouse to die will have been wasted.
The estate tax due at the second death, assuming that occurs in 1998, will be $246,250 (without accounting for deductible administration expenses and debts). Conversely, if bypass trusts are incorporated into the wills, $625,000 will be set aside in trust for the benefit of the survivor. Notwithstanding the substantial access that the survivor will have to the bypass trust assets, almost no portion of the trust assets will be included in his or her estate. The result in this simple example is zero tax due, resulting in federal estate tax savings of $246,250.
Note, however, that the five and five power is considered to be a “general power of appointment” for estate and gift tax purposes. Accordingly, the amount of trust property over which the power is exercisable as of the survivor’s death will be included in his or her estate. one simple and effective way for dealing with this issue is to limit the period of time during the year that the power is exercisable. For example, if the power is only exercisable during the last two weeks of the year, no inclusion will result if the survivor dies at any other time during the year when the power is not exercisable.
The foregoing example illustrates a neat and effective result. However, in practice, things do not always work out so neatly. The Taxpayer Relief Act of 1997 amended the provisions relating to the exemption. Beginning in 1998, the exemption was increased from $600,000 to $625,000 (a $1.3 million combined exemption for married couples) and gradually thereafter.
By 2006, the exemption amount will be $1 million. Thus, in 2006, Mom and Dad’s combined exemption will be $2 million. Assume now that Mom and Dad’s assets grow by approximately 2 percent per year, so that in 2006, combined assets are $1.4 million, one-half of which are titled in each of their respective names. If either Mom or Dad die in 2006, all of his or her assets – $700,000 – will be set aside in a bypass trust for the benefit of the survivor.
This will be the case notwithstanding the fact that the survivor can hold up to $1 million in assets in his or her own name without exposure to estate tax. Thus, the bypass trust is technically “overfunded” by $300,000. from an estate tax perspective, it is preferable to hold assets in a bypass trust rather than in the survivor’s name because all appreciation on the trust assets will escape estate taxation in the survivor’s estate.
However, the survivor may, for whatever reason, want unfettered access to as many assets as possible. Disclaimers offer the survivor the flexibility to determine the extent that the bypass trust will be funded given the personal and financial circumstances which exist at that time, and given the then-applicable amount of the exemption.
A disclaimer is an irrevocable and unqualified refusal to accept an inter vivos or testamentary gift. For federal gift tax purposes, a disclaimer of property will not be treated as a taxable gift by the disclaimant (i.e., the individual disclaiming property) to the individual or entity to whom the property passes if the disclaimer meets the following requirements: (1) the disclaimer is in writing; (2) it is made within nine months of the later of (a) the day on which the transfer creating the interest in such person is made (generally, the date of death or date of gift), or (b) the day on which the disclaimant attains age 21; (3) the disclaimant has not accepted any of the benefits of the disclaimed property; and (4) as a result of the disclaimer, the interest passes without any direction on the part of the disclaimant and passes either (2)to the spouse of the decedent, or (b) to a person other than the disclaimant. A disclaimer meeting all the foregoing requirements is known as a “qualified disclaimer” pursuant to Section 2518 of the Internal Revenue Code.
new Jersey also imposes similar requirements for disclaimers of transfers by will, intestate succession or under powers of testamentary appointment at N.J.S.A. 3B:9-1, et seq., and for inter vivos transfers at N.J.S.A. 46:2E-1, et seq. These statutes should always be consulted before proceeding with any disclaimer. Moreover, New Jersey law dictates the manner in which disclaimed property devolves. Generally, in the case of testamentary transfers, unless otherwise provided by the decedent the disclaimed property passes as if the disclaimant pre-deceased the decedent. See N.J.S.A. 3B:9-8 (emphasis added). Thus, an individual may make a provision in his or her will that dictates the manner in which property devolves in the event the named beneficiary thereof disclaims that property.
The term “disclaimer trust” is somewhat of a misnomer, because in fact, this is a bypass trust. However, the term generally refers to a bypass trust that is funded by using disclaimers. This approach gives the surviving spouse maximum flexibility in terms of: (a) whether a bypass trust should be created, and (b) if so, the extent to which such trust will be funded. Under the Internal Revenue Code’s requirements for a qualified disclaimer, it is generally not possible for an individual to disclaim property and then receive the benefits therefrom as the beneficiary of a trust to which that property devolved. This would violate the requirement that the disclaimant not accept the benefits of the disclaimed property (known as “the no-interest rule”).
The result of such a non-qualified disclaimer would be a taxable gift charged to the disclaimant to the extent of the interest received by the other trust beneficiaries. Since the interest of such beneficiaries would likely not be considered “present interests,” such gifts would probably not qualify for the $10,000 annual gift tax exclusion, thereby resulting in some loss of exemption, and, possibly, gift tax.
However, the no-interest rule does not apply to a surviving spouse. Thus, the surviving spouse may disclaim an outright (i.e., non-trust) interest in property in favor of a beneficial interest in a trust which holds the disclaimed property, without gift tax consequences. This makes the disclaimer trust possible.
Returning to the Mom and Dad example, Mom and Dad could draft their wills to provide that all of their respective property pass outright to the survivor through simple wills. But, given the amount of assets involved – currently $1.25 million – the simple wills should contain the following twist: any assets disclaimed by the survivor should be directed to pass to a bypass trust for the benefit of the survivor.
The bypass trust can contain the same provisions described above, which offer the survivor substantial access to the trust assets without corresponding estate tax inclusion. There is one important exception, however: Treasury regulations prohibit the surviving spouse from having an inter vivos or testamentary special power of appointment over the trust assets. Sec. 25.2518-2(e)(2).
Accordingly, of a disclaimer of assets into a bypass trust is contemplated, the trust should not contain provisions for a special power of appointment. The rationale for the prohibition of special powers is that while the no-interest rule is not applicable to surviving spouses, the rule prohibiting the disclaimant from directing the beneficial enjoyment of the property does apply.
If Mom and Dad implement wills with disclaimer trusts, the survivor will have the option of receiving all of the decedent spouse’s property outright. Any disclaimed property will pass to the bypass trust for the spouse’s benefit. If the first death occurs in 2006, at a time when the combined assets are $1.4 million and the exemption is $1 million, the survivor may decide to fund the bypass trust with $400,000 worth of the decedent spouse’s property and keep the remaining $300,000 in his or her own name. Theoretically, there would be no tax due at the second death since the assets in the survivor’s name, $1 million, would equal the amount of the exemption, and the assets contained in the bypass trust would not be subject to estate tax.
However, in determining the amount with which to fund the bypass trust, the survivor should consider the potential appreciation of the assets held outright. In this example, any appreciation in the retained assets would push the survivor into a taxable situation. Conversely, all appreciation on assets contained in the bypass trust would escape estate taxation. Note that if the creation of the trust were mandated by the terms of the will, all $700,000 worth of the decedent’s property would pass to the bypass trust.
Factors to Consider
The following factors should be considered when determining whether the wills should contain mandatory bypass or disclaimer trusts:
• Assets. Disclaimer trusts are commonly used in situations where it is uncertain whether a couple’s combined assets will exceed the exemption when neither is surviving. For example, assume Mom and Dad have combined assets worth $800,000, each owning one-half in their respective names. Presently, their assets exceed the amount of the exemption by $175,000 (i.e., $800,000 minus $625,000).
However, it is likely that in 2006, when the exemption is $1 million, their assets will not exceed it, making full funding of a bypass trust unnecessary. Notwithstanding this fact, if the wills provide for the mandatory creation of a bypass trust, all of the decedent’s assets will pass to that trust. On the other hand, under the disclaimer trust approach, the survivor would be free to retain all of the couple’s combined assets without (absent significant appreciation) exposure to estate tax.
In addition to the amount of assets involved, consideration must also be given to how those assets are titled. For example, assume in the example above hat $600,000 of the couple’s combined $800,000 in assets were titled in Dad’s name. While it is usually advisable for assets to be equalized between a married couple, for a variety of reasons this may never happen.
In this scenario, if the couple implemented wills with mandatory bypass trusts and Dad died first, all $600,000 of the assets titled in his name would pass into the trust, leaving Mom with only $200,000 in her own name. While the bypass trust will give Mom access to the trust’s assets, she may have been much more comfortable with all of the assets in her own name.
• Age. It must always be kept in mind that estate tax is generally not an issue for married couples until the second death. Accordingly, for young couples in their 30s, 40s and possibly 50s, disclaimer trusts may make sense even where the clients have already built substantial estates which exceed the exemption amount.
For instance, consider the situation of a couple in their early 40s with two minor children who have assets of approximately $1.5 million on one-half of which are titled in each of their respective names. Clearly, there is estate tax exposure at the second death. However, if the husband dies suddenly, does it make sense for all $750,000 in his name, or a substantial portion it, to be set aside in a bypass trust? From a pure estate tax perspective, the answer is yes. Again, the spouse will have substantial access to the trust assets, and any appreciation thereon will escape estate taxation in their combined estates. But, the survivor will likely live for another 30 to 40 years. Are estate taxes going to be her primary concern right now?
In that scenario, the survivor might appreciate the additional flexibility afforded by the disclaimer trust in that she may take nine months to decide whether to implement the bypass trust, and, if so, the extent to which it should be funded.
• Objectives. Flexibility may not, however, be the clients’ primary objective. They might like the idea of a mandatory trust for the survivor for a variety of reasons, to wit, the possibility of a subsequent marriage and/or asset management concerns. Moreover, the idea of a special power of appointment over the trust assets may be particularly appealing to some clients. Remember that a disclaimer will not be “qualified” for estate and gift tax purposes if the surviving spouse has a special power of appointment over the trust assets.
• Attitudes. Some clients simply do not like the idea of their wills containing trusts. Notwithstanding repeated assurances that trusts are a basic component to many estate plans (not just for the Kennedys and Rockefellers), some clients view them as an unnecessary complication. In those situations, disclaimer trusts may prove invaluable. Clients tend to take comfort in the knowledge that, in essence, they have simple wills. And, without any affirmative action on their part, they will receive all of their deceased spouse’s property outright. You then have nine months to assist the survivor in making the determination as to whether the bypass trust should be funded and, if so, to what extent.
Disclaimer trusts are very similar to bypass trusts – they are merely funded using post-mortem disclaimers. Accordingly, other than excluding language granting a special power of appointment to the survivor, drafting is essential identical. However, the formula language by which the amount of a mandatory bypass trust is determined will not be necessary. Instead, the following language might be inserted:
“I give, devise, and bequeath all the rest, residue and remainder of my estate, real, personal and mixed, of whatsoever the same may consist, and wheresoever the same may be situate, including any lapsed legacies and any property over which I may now or hereafter have any power of appointment or other disposition, which power I do hereby exercise (all such property is hereinafter collectively referred to as “my residuary estate”) as follows:
(A) If my spouse shall survive me, I give outright to my spouse my entire residuary estate. provided, however, in the event my spouse shall disclaim, within the meaning of Code Sec. 2518, any portion (either expressed as a fraction or a specific amount) or all of the assets passing to my spouse under this Subparagraph, or passing to my spouse outside of this will, then such disclaimed assets shall be held and administered under the provisions of Subparagraph (B) of this Paragraph FOURTH.”
Subparagraph (B) of Paragraph FOURTH, in the above example, would contain the bypass trust provisions.
Bypass trusts are an invaluable component of any estate plan for married couples where there is the potential for estate tax. But they should not be inserted into wills blindly. The nature and extent of the clients’ assets must first be considered, along with their ages, objectives and attitudes. Where maximum flexibility is desired, disclaimer trusts may be the best approach.
This article is reprinted with permission from the December 21, 1998 issue of the New Jersey Law Journal ©1998 New Jersey Law Journal