Incorporating Flexibility in Uncertain Times

As you may or may not know, 2010 has been a tumultuous year in the area of estate planning. Currently, there is no federal estate tax.  And, worse yet, no one knows exactly what the future holds for the federal estate tax.  How do you plan when there is so much uncertainty?

Marital Deduction

Given the uncertainty in federal exemption amounts, a flexible plan is crucial. One such flexible estate planning tool for married couples is the use of disclaimers.  The marital deduction permits spouses to transfer unlimited amounts of property to each other free of estate tax. However, upon the death of the second spouse, any value above the exemption amount (currently $1 million for Minnesota estate tax purposes and there is no federal estate tax in 2010) is taxed.  Consequently, the marital deduction may not eliminate estate taxes. Instead, it may simply defer estate taxes until the death of the second spouse, as illustrated in Example 1.

Example 1.  Husband and Wife currently have a combined net worth of $2 million (or $1 million each). Their estate planning objectives are simple:  at the death of the first spouse, all assets are to be transferred to the surviving spouse and at the survivor’s death, everything is left to their adult children.

Currently, if Husband dies and leaves his $1 million to Wife, no estate tax is due at the time of his death because of the unlimited estate tax marital deduction. Wife now has a net worth of $2 million. When Wife passes, she can only utilize her exemption amount. Given current exemption amounts, $1 million passes free of estate tax while the remaining $1 million will be subject to Minnesota estate taxes of approximately $35,000 (and while Wife’s estate is not currently subject to federal estate tax, it could incur greater estate taxes depending on any future changes enacted by Congress).

Disclaimer Planning

There is a better solution:  use both spouses’ exemptions.  Disclaimer planning utilizes both spouses’ estate tax exemption amounts in order to minimize or eliminate estate tax on a couple’s accumulated wealth.  Upon the death of the first spouse, the surviving spouse has the option of accepting assets outright (which then become part of his or her estate) or disclaiming them.  A disclaimer is an irrevocable refusal to accept property, an interest in or a right to property.  The disclaimed assets are treated as never having been transferred to the disclaiming spouse.

Disclaimer planning builds flexibility into a couple’s estate plan by deferring tax planning decisions until the passing of one spouse.  At that time, the surviving spouse, after consulting with tax, financial and legal advisors, can determine, based on the tax laws in effect and his or her personal and financial circumstances following the death of a spouse, the appropriate amount of assets to disclaim and which assets to disclaim in order to best utilize each spouse’s estate tax exemption.

Example 2.  Drawing on the facts from Example 1, Husband’s estate plan leaves everything to Wife.  Upon Husband’s death, Wife can decide whether to disclaim some, or all, of Husband’s $1 million in assets.  If Wife properly makes a qualified disclaimer, Husband’s property passes as if Wife had predeceased Husband.

Remember, however, the couple’s objective:  all assets are to be transferred to the surviving spouse at the death of the first spouse, and at the survivor’s death, everything is left to their adult children.  This objective is achieved through drafting in the Will.  The deceased spouse’s Will directs that upon disclaimer by the surviving spouse, the disclaimed assets will be held in trust for the benefit of the surviving spouse.  As long as certain conditions are included and met, the surviving spouse may be the beneficiary and serve as the trustee (see Example 3 below).  Therefore, the disclaimed assets are still available to support the surviving spouse.  Upon the passing of the second spouse, the remaining trust assets may pass to charity, to children or as otherwise provided by the terms of the trust established by the first spouse who passed away.

Example 3.  In his estate plan, Husband named a trust as the contingent beneficiary with the trustee and beneficiary being Wife.  Therefore, the disclaimed assets are transferred to a trust and are excluded from the estate of the surviving spouse.

In Short …

Disclaimers are an effective way to implement tax planning into an estate plan yet allow the client to remain in control of what will happen to his or her assets.

In order to effectively disclaim assets, and qualify for all of the intended tax benefits, the surviving spouse must comply with strict federal and state requirements in making a qualified disclaimer.

Upon the passing of a spouse, the surviving spouse or a family member should notify their attorney.  The attorney can then keep track of the nine month disclaimer window and assist the surviving spouse, when he or she is ready, in making the appropriate disclaimers before the time restriction expires.

Only time will tell what action Congress will take.  Because of the uncertainty, many may prefer taking a wait-and-see approach.  However, doing nothing is not advised.  Incorporating disclaimer planning is a great way to deal with the uncertainty of what lies ahead.

Photo: Tom@HK