Disclaimer Trusts

With fewer married couples having taxable estates, learn how a disclaimer trust may provide greater flexibility over the typical “reduced-to-zero” marital deduction formula.

While there is a present lapse in the estate and generation-skipping transfer taxes,Guest Posting it’s likely that Congress will reinstate both taxes (perhaps even retroactively) some time during 2010. If not, on January 1, 2011, the estate tax exemption (which was $3.5 million in 2009) becomes $1 million, and the top estate tax rate (which was 45% in 2009) becomes 55%. Assuming the federal estate tax (FET) exemption is reinstated at $3.5 million or more, then for most people the FET has been repealed. According to the Tax Policy Center, only five of every 100,000 people who die have estates over $3.5 million.

For married couples with taxable estates, the common planning tool is for each spouse to establish a revocable living trust. Upon the death of the first spouse, an amount equal to his/her FET exemption is allocated to a Credit Shelter Trust (CST). Other terms for the Credit Shelter Trust are Bypass Trust, Family Trust and Residuary Trust. A CST allows the surviving spouse broad access to the assets in the CST without the assets being included in the spouse’s estate. Thus, the CST allows each spouse to leave his/her FET exemption to their children. Without a CST, the first spouse to die “wastes” his/her estate tax exemption.

The provisions that the spouse can enjoy from the CST during his/her lifetime (without causing the assets in the CST to be taxable in the surviving spouse’s estate) are:

The spouse can have all of the income of the CST. Treas. Reg. Sec. 25.2518-2(e)(5), Example 4. Alternatively, the trustee can “sprinkle” the income of the CST to children and grandchildren so as to shift that income to lower tax brackets, or can accumulate the income and add it to principal.
The spouse can receive principal distributions from the CST (see Paragraphs 5 and 6 below).
The spouse can have the power to withdraw the greater of $5,000 or 5% of the principal of the CST each year. IRC Section 2041(b)(2).
The spouse can have a testamentary limited power of appointment (LPA) over the assets in the CST. An LPA allows the spouse to “rewrite” the dispositive provisions of the CST. However, the LPA is usually drafted so that the LPA can only be exercised in favor of the grantor’s descendants and/or charities. The LPA cannot be exercised in favor of the spouse, his/her creditors, his/her estate, or the creditors of his/her estate. IRC Section 2041(b)(1).
The spouse can be the sole trustee of the CST, provided that distributions to the spouse are limited to an “ascertainable standard” (i.e., health, education, maintenance and support). IRC Section 2041(b)(1)(A).
Distributions to the spouse in excess of the ascertainable standard can be made from the CST if an independent co-trustee is named to serve with the spouse, but discretion on distributions to the spouse must be limited solely to the independent co-trustee.
The spouse can have the power to remove the co-trustee and appoint an individual or corporate successor co-trustee that is not related or subordinate to the spouse (within the meaning of IRC Section 672(c)). Rev. Rul. 95-58.
The deceased spouse’s estate, over and above the amount allocated to the CST, will pass estate tax free to the Marital Trust because of the unlimited marital deduction. When the surviving spouse dies, the assets in the Marital Trust (along with the assets in the spouse’s Living Trust) will be subject to estate taxes, but only after subtracting the surviving spouse’s FET exemption.

The two most common types of Marital Trusts are the General Power of Appointment (GPA) Trust and the Qualified Terminable Interest Property (QTIP) Trust. Both types of Marital Trusts must provide the surviving spouse with all of the income and may (but need not) provide the spouse with principal. The typical GPA Marital Trust allows the spouse to determine the ultimate beneficiaries of the Marital Trust upon his/her death, and usually allows the spouse to withdraw the principal of the Marital Trust during his/her lifetime without restriction. The QTIP Marital Trust, on the other hand, does not allow the spouse to determine the ultimate beneficiaries and usually restricts the spouse to principal as needed for health, education, maintenance and support. But, to add flexibility to a QTIP Marital Trust, the spouse may be given a $5,000/5% annual withdrawal power and/or a limited power of appointment over the QTIP Trust.

A CST has the following advantages: It utilizes both spouses’ FET exemptions, while giving the surviving spouse access to and control over the assets in the CST; it preserves assets for the couple’s descendants (in case the spouse remarries); and it protects the spouse and descendants from creditors.

But, there are disadvantages to a CST as well. The surviving spouse’s access to the assets in the CST, albeit broad, is (as noted above) restricted. Moreover, if the spouse withdraws more from the CST than permitted, he/she may be accountable to the ultimate beneficiaries of the CST (i.e., children and grandchildren). The CST also adds complexity to the spouse’s life in that separate records for the CST must be maintained and annual income tax returns (Form 1041) must be filed for the remainder of the spouse’s lifetime. And, if a co-trustee over the CST is used, the spouse will have to cooperate with that trustee.

For many couples with non-taxable estates, particularly those with children all from the same marriage, the disadvantages of a CST outweigh the advantages. Therefore, they would prefer to simply leave their estate to a GPA Marital Trust for the surviving spouse. But, if their estates were to increase and/or the FET exemption was reduced by future legislation, they still want the ability to use both spouses’ FET exemptions. It is possible to accomplish both objectives with a Disclaimer Trust.

Disclaimer Trusts became popular after the 2001 Tax Act was passed because of the increasing FET exemption and the uncertainty created by the Act. With a Disclaimer Trust, a married couple’s revocable living trusts leave the deceased spouse’s entire estate to a GPA Marital Trust. The CST is then funded only if the surviving spouse disclaims (refuses) part of the deceased spouse’s estate. This enables the spouse to decide how much to keep outright (to be taxed at the second death) and the amount to be allocated to the CST (where it is shielded from estate tax at the second death). In making an informed decision to disclaim and how much to disclaim, one must examine the size of the combined estate, the spouse’s age and health (which impacts the spouse’s needs for funds), whether minor children will be beneficiaries of the CST, the potential appreciation of the assets not disclaimed, and the status of the FET exemption.

For example, assume a married couple has combined assets of $4.5 million, which are evenly divided between their revocable living trusts. Each trust provides that 100% of the trust property is allocated to a GPA Marital Trust upon the death of the grantor-spouse. But, if the surviving spouse disclaims all or a portion of the decedent’s estate, the disclaimed portion passes to a CST. If, at the time of the first death, both husband and wife are in their seventies or eighties and the FET exemption is $3.5 million, it might make sense for the spouse to disclaim $1 million of the deceased spouse’s $2.25 million estate. This will leave the spouse with a $3.5 million taxable estate (i.e., $2.25 million in the spouse’s living trust and $1.25 million in the GPA Marital Trust), which will be completely sheltered from estate taxes by the spouse’s FET exemption.

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