Right to Be Free of Estate Tax Liability May Be Disclaimed

The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) introduced significant changes and great uncertainty to estate and gift taxes. It generally provides for a gradual phaseout and eventual repeal of the Federal estate tax over the next nine years, with a return to pre-EGTRRA estate tax law in year 2011.

Due to the EGTRRA's swiftly changing set of rules (and a genuine doubt as to whether its provisions will withstand the test of time), wealthy individuals may have a difficult time establishing an estate plan that will continue to accomplish its intended results. As a result, post-death disclaimers may be used more frequently to achieve desired outcomes. Such disclaimers allow willing beneficiaries to view the estate makeup after a decedent's death and to correct some (if not all) unintended results.

For tax purposes, a qualified disclaimer has the effect of treating the disclaimed interest as if it had never been transferred to the disclaimant. Thus, the disclaimed interest never becomes part of the disclaimant's gross estate, nor is he deemed to have made a gift to the person to whom the disclaimed interest passes.

Example: Decedent D's will leaves her entire estate to her husband H, if he survives. If not, it will be left to their son S. D did not use any of her lifetime estate exemption. On D's death, the value of her estate is $200,000. H survives her, but is independently wealthy and would rather the $200,000 go to S. H makes a qualified disclaimer of his bequest under the will and the estate property passes to S.

 Because his disclaimer was qualified, H is not deemed to have made a gift to S for gift tax purposes. Additionally, the property would pass estate-tax free to S, because the property's value does not exceed D's lifetime estate exemption.

Under Sec. 2518(b), a qualified disclaimer must be (1) an irrevocable and unqualified refusal by the disclaimant to accept an interest in property, (2) made in writing and (3) made within nine months after the interest being disclaimed was created (i.e., when the decedent died); as a result of the disclaimer, the property must pass to the decedent's spouse or to someone other than the disclaimant without any direction by the disclaimant. Additionally, the disclaimant must not have accepted the interest or any of its benefits prior to disclaiming.

Recently, in Letter Ruling 200127007, the IRS had to consider whether estate beneficiaries could disclaim a benefit bequeathed to them by the decedent that they would not have to share in the payment of estate taxes generated by the estate. In the ruling, the decedent was the second to die, as he survived his spouse (decedent's spouse). The will of the decedent's spouse placed the residue of her estate into two marital trusts that provided the decedent with a lifetime income interest in both. The remainder of the first trust was to be held in further trust for the benefit of the couple's grandchildren, while the remainder of the second trust was to be held in further trust for the benefit of the couple's children. (The couple's children in varying combinations were designated trustees over the continuing trusts.) The executors of the decedent's spouse's estate made a qualified terminable interest property (QTIP) election for both marital trusts; as a result, the trusts were included in the decedent's estate on later death (under Sec. 2044).

After providing for specific legacies to his children and grandchildren, the decedent's will left the residue of his estate to a private foundation previously established by him and his spouse. Additionally, the decedent's will provided that the estate taxes payable on the property constituting his gross estate were to be paid from the principal of his residuary estate before any distribution to the foundation.

Finally, his will expressly waived his residuary estate's right to be reimbursed for taxes paid under Sec. 2207A(a). This gives a surviving spouse's estate the right to recoup taxes attributable to QTIP included in the estate under Sec. 2044 from the beneficiaries of the QTIP property. Thus, as a result of such waiver, the beneficiaries of the two QTIP marital trusts (i.e., the couple's children and grandchildren) were relieved from reimbursing the estate (i.e., the private foundation) for the taxes due as a result of the QTIP marital trusts' inclusion in the decedent's gross estate. Because the foundation would be bearing the additional taxes as a result of the waiver, its share in the estate would be reduced, thereby reducing the estate's estate tax charitable deduction; the estate taxes would be much higher on a total basis than they would have been if each of the estate's beneficiaries had incurred his share of the estate taxes. Recognizing this after the decedent's death, the beneficiaries of the QTIP marital trusts proposed to execute qualified disclaimers to disclaim their interests in the benefit conferred by the waiver of the estate's right of tax reimbursement provided in the decedent's will. Representing that these disclaimers would meet all five Sec. 2518 requirements, the beneficiaries sought a ruling that such benefit conferred by the waiver was an "interest in property" that could be disclaimed.

In the ruling, state law had to be reviewed to determine if the state would consider such a benefit as an interest in property that could be disclaimed. Examining relevant Pennsylvania statutes, legislative history and case law, the Service concluded that the state supreme court would hold that the benefit conferred by the waiver is an interest in property that could be disclaimed. As a result, the proposed disclaimers would constitute effective qualified disclaimers.

The IRS went on to rule that if the proposed disclaimers had the effect under Pennsylvania law of removing the tax burden from the residuary estate (i.e., the foundation's share) and shifting it to the QTIP beneficiaries, the resulting increase in the interest received by the foundation would qualify for the estate tax charitable deduction under Sec. 2055(a). As a result, the decedent's estate would owe less estate tax on a total basis than it would have without the disclaimers.

Letter Ruling 200127007 introduces another item that could be potentially corrected through a post-death qualified disclaimer, assuming state law would recognize that such item, by its nature, is capable of being disclaimed.

From Steven Cohen, CPA, and Ira Olshin, CPA, J.D., LL.M., New York, NY