The Forgotten Disclaimer – An Estate Planning Tool Worth Considering
At one time, American taxpayers of moderate wealth often engaged in planning to keep assets out of their estates. They did this because through 2001, Americans who died with a net worth exceeding $675,000, or even less in earlier years, owed federal estate taxes at rates that went as high as 55%.
From 2002 through 2009, the size of an estate that was exempt from taxes slowly climbed to $3.5 million. But in 2010 a miracle occurred in the tax world, and the estate tax expired. No estate paid taxes in 2010, no matter how large a decedent’s net worth. George Steinbrenner wisely picked that year to die, and his children inherited the New York Yankees tax-free.
Estate taxes returned in 2011, but with a higher exemption limit of $5 million. After the Tax Cuts and Jobs Act of 2017 (TCJA) was enacted, the limits doubled, and in 2022 that amount is slightly more than $12 million. The portability of a spouse’s exemption effectively raises it to $24.1 million for married couples.
This little history lesson makes one thing very clear. There are many Americans with a net worth of $675,000. It is a pretty select group with a net worth exceeding $24.1 million. Hence, most Americans will never pay estate tax.
Estate Tax Qualified Disclaimer
When the estate tax exemption was lower, one of the tools tax advisors used to help taxpayers save estate taxes was a qualified disclaimer. Disclaimers are still allowed, but they are not the priority they were when taxpayers knew their estates would owe up to 55% estate tax on assets exceeding $675,000. But disclaimers are still relevant because reducing the size of a decedent’s estate is not the only reason a disclaimer can be beneficial.
What exactly is a qualified disclaimer? In the most basic of terms, a disclaimer occurs when a beneficiary of an estate or gift says, “I don’t want it.” When that occurs, the asset in question goes to the next person or persons in line.
For example, Dick and Jane are a married couple. Dick has an IRA worth $1 million. Dick dies and the IRA states that Jane is the primary beneficiary. Their children, Bobby and Sally, are listed as contingent beneficiaries on the IRA. If Jane wants the IRA proceeds to go to Bobby and Sally immediately, she can make a qualified disclaimer.
A disclaimer is a legal document and requires a lawyer. Federal law states:
- A disclaimer must be in writing.
- The disclaimer must be given to the estate’s representative no later than nine months after the decedent’s death.
- The disclaiming person cannot accept the asset or any benefit from the asset.
- The disclaiming person can have no say on what happens to the asset once he or she disclaims it.
Timing is everything on a disclaimer. Way too often beneficiaries think about disclaiming assets too late. When an estate tax return is required, it is due nine months after date of death, with the option of a six-month extension. However, extensions do not apply to a disclaimer. There is only one exception to the nine-month rule, and that involves beneficiaries who are under 21. Children and young adults have until nine months after reaching age 21 to disclaim.
State laws governing disclaimers can have shorter time frames. Kansas follows the nine-month requirement.
The prohibition on accepting any benefit from the asset once a disclaimer is made is important.
An example is helpful, so back to Dick and Jane. Assume Dick also owned $2 million of farm ground that is leased in a crop share arrangement. Dick’s estate currently owns the land. Farmer Bill harvests the wheat crop two months after Dick dies and takes it to the local co-op. The co-op calls Jane and asks her if she wants to sell her third of the wheat. Jane says yes and the co-op mails her a check. If Jane cashes that check she has taken a benefit from the land even though she does not hold the title to the ground. Jane is now unable to disclaim the land.
Benefitting from an asset includes more than receiving income. The asset cannot be used as security on a loan, and the disclaiming heir cannot make decisions or use a power of appointment on that asset. If you want to disclaim an asset, then during the nine-month window when you can decide on this action, you need to keep the asset segregated from assets that you do own. Checks should not be cashed and paying the funds back to the estate will not correct the situation except for a beneficiary who is under 21. A beneficiary under 21 can reverse a distribution by returning the funds.
Why would Jane want to make a disclaimer if she is not going to have a taxable estate? If Jane kept all the assets left to her, she would inherit a $1 million IRA and $2 million worth of land from Dick. To complete the picture, assume Jane personally owns their $500,000 home, has her own IRA of $2 million and has another $2 million of farm ground. Jane now has a net worth of $7.5 million. That is well under the current threshold of $12 million.
There are several reasons for Jane to disclaim some property. First the current “doubled” limits allowed under TCJA will sunset after 2025. Inflation determines the increase to the limit each year, so no one can say exactly what the limit will be in 2026, but we anticipate it will be somewhere around $6.5 million. Now Jane has a problem if she lives until 2026. Her estate will more than likely have increased in value from the $7.5 million it was in 2022, and she has a taxable estate. That could have been avoided if she had disclaimed some assets in 2022.
A second reason to disclaim is income tax planning. The distributions from $3 million of combined IRAs are high. Depending on Jane’s age, she may have to take distributions of $100,000 – $1 million annually. In addition, the income from $4 million of land could be high, and Jane is likely in the 37% tax bracket. Her children may only be in the 22% bracket or less. Shifting a portion of that income to them saves taxes.
A third reason might be legal claims. What if someone has sued Jane and there is a potential liability of several million? Disclaiming the assets protects them from legal action.
Yet another reason for a disclaimer is to settle family disputes over the decedent’s estate. In another example, assume Dick had been divorced and remarried, but his children were from his first marriage to Jane. The children could sue their evil stepmother for a portion of the estate that was left entirely to her instead of them. If the stepmother disclaims the assets in a timely matter, those assets can go to the children tax free.
This brings up another relevant point. Disclaimers do not have to be all or nothing. In this example, assume the stepmother inherits a $4 million IRA for which she was the primary beneficiary, and her stepchildren were contingent beneficiaries. She can disclaim $2 million so the children each receive $1 million. A lawsuit can be avoided, and there are no income tax consequences to anyone. If the stepmother does not make a disclaimer and loses the lawsuit, she will pay taxes on the entire IRA distribution before giving funds to her stepchildren. She cannot transfer the IRA to them, and the payments to the children will have gift tax return requirements. As a result, the funds are greatly reduced by the taxes that must be paid on the IRA distributions before they can be moved.
In summary, qualified disclaimers can be useful in many situations, and as the sunset of the TCJA estate tax exemptions draws near more families may find them beneficial. If your family may benefit from use of a qualified disclaimer, or if you would like to learn more, contact your Adams Brown tax advisor.