Foresight -- Devoted to Estate and Tax Planning
1st Quarter, 1997 -- Vol. 3, No. 1
© 1997 De Maio & De Maio

IN THIS ISSUE:

Feature Article:

Recent Developments:

The Lighter Side:


Feature Article

Using Disclaimers Effectively

By Andrew J. De Maio, Esq.

"Thank you so much! But you really shouldn't have!"

"You shouldn't have." That phrase was often heard during the recent holiday season. In most cases, the speaker doesn't truly mean it. Even if he plans on exchanging the gift, he is happy to be included in the giver's generosity.

When it comes to estate planning, sometimes we really do wish that a gift or bequest had not been made. Perhaps, for tax or other reasons, the family would be better off if things had been done differently. In those cases a disclaimer, a legal refusal to accept a gift or bequest, can be a useful planning tool.

In this article, we will examine the basic rules governing tax-qualified disclaimers. Then we'll look at three "real-life" examples of practical uses of disclaimers.We'll see how a disclaimer can be used to 1) make a tax-free gift; 2) fund a bypass trust; and 3) rewrite a will.


The Basics

To be effective for tax purposes, a disclaimer must meet these requirements:

If these requirements are satisfied, the disclaimer will not be treated as a gift for gift tax purposes.

Let's take a closer look at that fourth requirement: the one prohibiting direction by the person making the disclaimer. The recipient of the gift can refuse it, but cannot have the power to direct the gift to someone else. For example, if your Aunt Harriet gives you a Barry Manilow CD, and you don't want it (perhaps because you already have every Barry Manilow recording ever made), you can use a qualified disclaimer to refuse the gift. But your disclaimer will not be a qualified one if you give the CD to your brother. Although you have refused the gift, you have exercised control over its disposition.

Perhaps you don't want to hurt Aunt Harriet's feelings. So you politely accept the gift, and then open it and listen to it once before deciding that you don't want it. Even if you give it back, your disclaimer is not effective under the tax rules because you have accepted the gift and some of its benefits.

There is an important exception to the last requirement. It doesn't apply if the person making the disclaimer is the spouse of a decedent. In other words, a surviving spouse can disclaim property, and still benefit from the property after the disclaimer. This opens some significant planning opportunities, as we'll see later.

What happens to the property that is disclaimed? If you can't redirect it, where does it go? Under the law of most states, it passes as if you were no longer living. Let's say Aunt Harriet leaves you that CD in her Will. The Will says that if you are no longer living at the time of her death, then everything left to you goes instead to your children. If you make a qualified disclaimer, your children get the CD.

Aunt Harriet's Will can make specific provisions to apply in case a disclaimer is made. Her Will may say, for example, that if you disclaim the CD, then it passes to your brother Frank. If you want Frank to have the CD, you can file a disclaimer. The disclaimer will be qualified because the choice to give the property to Frank in the event of a disclaimer was Aunt Harriet's decision, not yours.


Example 1: Making a "tax-free gift"

Ted had recently come into some money. He was searching for most tax-effective way to make a gift to his children. "I know I can just give it to them, but how can I do it without getting killed by gift taxes?", Ted asked his lawyer. In further discussions Ted revealed that the money he wanted to give away was from his aunt's estate. In fact, he hadn't yet received the bequest; the estate was still open.

This was a perfect opportunity for a disclaimer. Nine months had not yet passed since the aunt's death. All the requirements of a qualified disclaimer could be met. And under the terms of the aunt's Will, if Ted had died first, the bequest would have passed to his children. Ted filed a disclaimer, and the kids received the money. By using a disclaimer Ted made, in effect, a tax-free gift.


Example 2: Funding a bypass trust

Alice felt uneasy as she was escorted through the hallways of the law office. The initial shock of her husband's death was beginning to subside. It was now time to get down to business. She vaguely remembered including some tax planning when she and Bill had signed their wills. But that was several years ago. She struggled to recall the details.

The fuzzy memories began to sharpen as the lawyer summarized the Will. Back in 1985 they had not been concerned much about estate taxes. The law had changed, and only people with $600,000 or more needed to worry about estate tax. Their estate was comfortably below that level. But the attorney had convinced them to include a "disclaimer trust" in each Will. It was "optional," he had explained. If there was a need for tax planning, the trust could be set up after the first death; if not, everything would go to the survivor. As part of the process, they had changed the ownership of some of the investments. That was when they had set up the brokerage account in her name.

Now, the wisdom of this approach began to set in. Over the years, they had done well financially. All told, their net worth was over a million dollars. If Alice were to inherit everything, there was the danger of hefty estate taxes on her death, to be paid by the kids. But anything held in the trust at the time of her death would not be included in her estate for tax purposes, and would pass tax-free to the children.

The attorney explained the terms of the trust. Alice could receive the income from the trust investments. She could even dip into principal if necessary for her "health, education, maintenance or support." These were some sort of "magic words," according to the lawyer. Lawyers loved their magic words, Alice thought. She also had the right to take from the trust each year 5% of the trust assets, or $5,000, whichever was more. This was "luxury money", that she could take without answering to anyone.

Best of all, Alice could choose how much to put into the trust. Within nine months, she would need to decide how much to disclaim to the trust; she would receive the rest of the estate outright.

Alice made arrangements to return the following week to review the asset values and tax projections. Some important decisions lay ahead.


Example 3: Rewriting a will

Sometimes the use of disclaimers results in an estate distribution that would hardly be recognizable by the estate's owner. A private ruling issued by the IRS late last year (PLR 9638014) illustrates. Don (we'll call him that although the ruling doesn't reveal his name) wrote a will that left nothing to his wife. The will provided that his entire estate would be divided equally between his two children. The share of each child was to be held in trust for the lifetime of the child. On the death of a child, that child's share was to pass down the line to trusts for the benefit of two grandchildren named in the will, and eventually to great-grandchildren.

Both children disclaimed their rights under the will. But they did not disclaim any of their rights under the law of intestacy, which applies in the absence of a valid disposition by will. Under the terms of the will, this meant that the estate would pass to trusts for the benefit of two grandchildren. Each grandchild disclaimed his rights to the estate, but only to the extent that the amount was greater than $500,000. In other words, each grandchild accepted $500,000 and disclaimed the rest.

How was the $500,000 figure chosen? The generation skipping transfer (GST) tax is a special tax on transfers directly to grandchildren and other younger generation beneficiaries. But the first $1 million left to these beneficiaries is exempt from the tax. By each accepting $500,000, the two grandchildren ensured full use of Don's $1 million GST tax exemption.

The great-grandchildren, acting through a guardian, each disclaimed their right to receive anything under the will. Thus, as to all but $1 million of the estate, there was no disposition provided by the will because all of the named beneficiaries had disclaimed. Under the New Jersey intestacy law, the first $50,000 plus one half of the balance of these assets passes to Don's wife, and the rest is divided equally among the children. The end result is an estate distribution unlike anything Don had contemplated. The table below illustrates.

_ Before Disclaimers | After Disclaimers
Beneficiary Interest in estate Outright/In Trust | Interest in estate Outright/In Trust
Wife None N/A $50,000 + 1/2 of residue Outright
Child 1/2 of residue In trust 1/4 of residue Outright
Grandchild Future contingent interest in 1/2 of residue In trust Present interest in $500,000 In trust
Great-grandchild Future contingent interest in 1/2 of residue In trust None N/A

 

Final thoughts

The disclaimer is a powerful postmortem planning tool. This article illustrates three potential uses. There are countless others.


Further reading

Internal Revenue Code Section 2518



RECENT DEVELOPMENTS

IRS Clarifies When Gift is Complete
Rev. Rul. 96-56

Jim decides to make a cash gift to his son Junior in December. He writes the check and gives it to Junior, and Junior brings it to his bank on December 30. But the check doesn't clear Jim's bank until early January. When is the gift considered to be made for gift tax purposes? The IRS addressed this question is a recently issued Revenue Ruling.

The IRS says the gift will be considered complete in December. Applying a 1994 decision by the Fourth Circuit Court of Appeals (Metzger v. Commissioner), the IRS agrees that the gift "relates back" to the date on which the check was presented for payment, even if is not paid until the following year. However, according to the Service, this rule applies only if certain conditions are met:

1. The check is paid by the drawee bank (Jim's bank, in our example) when first presented for payment;

2. The donor is alive when the check is paid by the bank;

3. The donor intended to make a gift;

4. The delivery of the check was unconditional; and

5. The check was deposited, cashed or presented within a reasonable time of issuance, and within the same calendar year.

Comment: This ruling does not address the situation in which a check is not deposited in the bank until after the first of the year. The IRS maintains that such a gift is not complete until January, because the donor could stop payment.

Tip: Consider using certified or cashier's checks for year-end gifts. The IRS agrees that a gift is considered complete if the gift-giver has "parted with dominion and control," and has no power to change or revoke the transfer.

Note: A different rule applies to charitable donations, which are considered complete when the check is written and placed in the mail.


Hand-printed Will May Be Valid in N.J.
In re Estate of Jeffrey A. Hand, ___ NJ Super. ___, (Ch. Div. 1996)

Jeffrey A. Hand died on Christmas Day, 1995. He was survived by a spouse, two sisters, and two brothers. On September 17, 1995, he had hand-printed the following on a sheet of paper:

9/17/96
I JEFFREY HAND LEAVE
TO MY SISTERS SHARON & SUE MY HOUSE & BANK ACCT
NORMAN & ADAM MY GUNS & TOOL
ADAM GETS MY BOAT
NORMAN GETS MY TRUCK

Holographic (handwritten) wills are valid in New Jersey, even without the signatures of witnesses. In this case, however, the document was printed in block lettering, rather than in cursive handwriting. Jeffrey's widow challenged the validity of the will on that basis.

The court held that the use of printing rather than handwriting did not necessarily invalidate the will. According to the court, even the signature could be hand-printed, as long as it was made by Jeffrey and was intended as his signature. A trial was necessary to determine those factual issues.

As for the obvious error in the date on the will, the court held that it did not nullify the document.


Trust Cannot be Amended to Permit Medicaid Qualification
In re Lennon, ____ N.J. Super ____ (Ch. Div. 1996)

Matthew Lennon received $565,000 from a medical malpractice case in 1981. In 1987 his parents, acting on his behalf pursuant to the court order in the malpractice case, placed the funds into a trust for Matthew's benefit. Under the terms of the trust the parents, acting as trustees, had the power to spend trust funds for Matthew's benefit, with court approval.

The legal issue before the court was "Who created the trust?" If Matthew was considered the creator of the trust, he would be ineligible for Medicaid benefits. However, a trust created by others (in this case the parents and the court) can exist without affecting the right to Medicaid. Such a trust is sometimes referred to as a "special needs trust."

The court decided that Matthew must be considered the maker of the trust. The judge denied the parents' request for permission to create a special needs trust by modifying the terms of the trust agreement.


Lottery Ticket is Family Affair
Estate of Emerson Winkler v. Commissioner, T.C. Memo 1997-4 (U.S. Tax Court Jan. 2, 1997)

Emerson and Elizabeth Winkler lived on a farm in Illinois. They had a close family; their five adult children visited them nearly every Sunday. During Mr. Winkler's illness in 1989, the family made a habit of buying three Illinois lottery tickets each time they traveled to the hospital to visit him. The cash to buy the tickets would come from whoever happened to have dollar bills at the time. They referred to these as "family tickets," and Mrs. Winkler always kept them in the same china cabinet in her home until the drawing was held. The family never agreed on how they would divide the prize if they won, but they often discussed how they would spend the money.

On March 4, 1989. Mrs. Winkler and one of her daughters were on an errand when they remembered that they had not purchased the family tickets for that evening's drawing. Mrs. Winkler bought three tickets with her own funds and placed them in the china cabinet. One of those tickets was the winner of a $6.5 million jackpot.

At that time the Illinois Lottery Department required a written partnership agreement before it would pay lottery winnings to more than one person. Because the Winkler family had no written agreement, they signed one on the advice of counsel and presented it to lottery officials. The agreement provided for distribution of 25% of the proceeds to each parent, and 10% to each of the children.

After Mr. Winkler's death (he died in March, 1992), the IRS claimed that gift tax should have been paid by the Winklers in 1989. The government argued that, since there was no written partnership agreement, Mrs. Winkler had purchased the winning ticket for herself and was entitled to keep all of the jackpot. By sharing it with the children, according to the IRS, she had made taxable gifts of over $1.5 million.

After reviewing all of the evidence, Tax Court Judge Whalen determined that the family had consistently engaged in the pooling of their money to purchase lottery tickets. This activity established the existence of a partnership, despite the lack of a written agreement. Mrs. Winkler had purchased the tickets on behalf of the partnership, not for herself.

Concerning the division of the prize, the court disregarded the written agreement that was signed after the drawing. Under Illinois partnership law, in the absence of a written agreement partners share equally in the profits and losses of the venture. Thus, for tax purposes, each family member was entitled to one-seventh, or14.29%, of the proceeds. Mrs. Winkler's sharing of the prize was not a gift, and no tax was due.

Comment: In fact, the court's ruling means that the family could have distributed an even larger portion of the proceeds (14.29% rather than 10%) to each of the children without making a gift.

Although the Winklers won their case, a written partnership agreement signed prior to the drawing might have saved them a trip to the courthouse.


Father Not Entitled to Claim Children as Dependents
Valarian v. Commissioner, T.C. Memo 1996-511 (U.S. Tax Court Nov. 19, 1996)

James Valarian and his wife Karen had four children during their marriage. They were divorced in 1983. Karen was awarded custody of the children. The divorce decree required James to make child support payments, and he did so.

James claimed the four children as his dependents on his 1990 income tax return. The IRS successfully challenged those deductions.

As a general rule, the custodial parent is entitled to claim the deduction for dependent children. A divorce decree or settlement agreement entered into prior to 1985 may award the deduction to one of the spouses, but James' divorce papers did not do so. Another exception applies if the custodial parent has signed a waiver releasing the right to claim the deduction, but Karen never signed such a waiver.


Legislation Expanding IRAs is Likely
S. 197

Congress is poised to pass legislation during 1997 to expand the tax benefits of Individual Retirement Accounts (IRAs). Proposals to beef up IRAs have been introduced from both sides of the aisle this session. One example is the proposed Savings and Investment Incentive Act of 1997, introduced on January 22 by Senate Finance Committee Chairman William V. Roth and Senator John Breaux, and co-sponsored by more than 30 Senators.

The Roth/Breaux legislation would:

 

THE LIGHTER SIDE:

Timing is Everything

Two men were traveling in Europe on business for their employer. As their bus traveled through the countryside, it was ambushed by a band of thieves. The armed bandits boarded the bus and began to rob the passengers, one by one, beginning at the front of the bus. All money and valuables were deposited into a pillowcase, as the two passengers and those around them watched in dismay.

As the thieves grew nearer, one of the men had an idea. He reached into his wallet and pulled out a bill. "By the way, Mike," he said to his companion. "Here's that $50 I owe you."



FORESIGHT is a publication of De Maio & De Maio, Attorneys at Law. It is not intended as and does not constitute legal advice, nor does it create an attorney-client relationship. The information contained in this publication should not be acted upon without first obtaining the advice of a professional advisor.

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