The New Portability and Disclaimer Trusts

Portability:

This portability provision makes it possible for a married couple to transfer up to $10 million free of federal estate tax without having to use a Family Trust (see below). However, without further Congressional action, on January 1, 2013, the estate and gift tax exemption decreases to $1 million per person, the top tax rate increases to 55%, and portability is repealed.

Portability is available to a surviving spouse only if an election is made on a timely-filed estate tax return (Form 706) by the predeceased spouse’s estate - even if the estate is not otherwise required to file a Form 706. However, only the last spouse’s exemption is portable. So one cannot re-marry in a serial manner to accumulate estate tax exemptions.

Family Trusts:

When a married person dies, he or she can pass all of his/her property to a surviving spouse without incurring any estate tax because of the unlimited marital deduction. So, if husband and wife each have an estate of $5 million, husband can pass his $5 million to wife estate tax free. So when wife dies, her estate would be worth $10 million. Without portability, wife could pass up to $5 million estate tax free, but her estate would be required to pay a 35% estate tax on the excess.

Prior to the existence of portability, the most common way to use both estate tax exemptions of a married couple was to create a “Family Trust” upon the death of the first spouse. Other names used for a Family Trust are “Credit Shelter Trust”, “Bypass Trust” and “Residuary Trust”. Upon the first spouse’s death, an amount equal to the decedent’s estate tax exemption is allocated to the Family Trust. The surviving spouse has access to the property in the Trust, but upon the surviving spouse’s death, the property remaining in the Trust is not included in his/her estate.

The provisions that the surviving spouse can enjoy from a Family Trust during his/her lifetime are:

• The spouse can receive all of the income of the Trust. The trustee can also be given the power to “sprinkle” the income of the Trust to children and grandchildren (so as to shift that income to lower tax brackets, unless the so-called “kiddie-tax” rules apply), or accumulate the income and add it to principal.
• The spouse can receive principal distributions from the Trust (see below).
• The spouse can have the power to withdraw the greater of $5,000 or 5% of the principal of the Trust each year.
• The spouse can be given a testamentary limited power of appointment (LPA) over the assets in the Trust. An LPA allows the spouse to “rewrite” the dispositive provisions of the Trust. However, the LPA is usually drafted so that it 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.
• The spouse can be the sole trustee of the Family Trust, provided that distributions to the spouse are limited to an “ascertainable standard” (i.e., health, education, maintenance and support).
• Distributions to the spouse in excess of the ascertainable standard can be made from the Trust if an independent co-trustee is named to serve with the spouse, but discretion on such distributions must rest solely with the independent co-trustee.
• The spouse can be given 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.

Problems with Portability:

Despite the relative simplicity of just letting the surviving spouse use the predeceased spouse’s unused estate tax exemption in 2011 and 2012, there are several reasons for still using Family Trusts, including the following:

• The predeceased spouse’s unused exemption is not indexed for inflation.
• The first predeceased spouse’s unused exemption could be lost if the surviving spouse remarries and survives his/her next spouse.
• There is no transfer to the surviving spouse of the predeceased spouse’s unused generation-skipping transfer tax exemption.
• Assets that are left to a surviving spouse in trust (rather than outright) are protected from creditors.
• The predeceased spouse cannot control who receives the remaining assets upon the surviving spouse’s death.
• If the surviving spouse remarries and commingles his/her assets with those of the new spouse, it may result in the intentional or unintentional disinheritance of the children.
• The future appreciation in the predeceased spouse’s assets could be subject to estate taxes at the surviving spouse’s death.
• The portability provision is scheduled to sunset on December 31, 2012.

Problems with Family Trusts:

But, there are disadvantages to a Family Trust as well. Before the first death, the couple’s assets must be divided into separate “his and her” trusts, thereby affording a spouse the opportunity to redirect assets to others (by amendment) without the other spouse’s knowledge. For this reason and for mutual access to assets, most couples prefer to hold assets jointly. After the first death, the surviving spouse’s access to the assets in the Trust, albeit broad, is (as noted above) restricted.

If the surviving spouse withdraws more from the Family Trust than permitted, he/she may be accountable to the ultimate beneficiaries of the Trust (i.e., children and grandchildren). Moreover, the assets in the Trust do not receive a stepped-up basis upon the death of the surviving spouse. The Family Trust also adds complexity to the surviving spouse’s life in that separate records for the Family Trust must be maintained and annual trust income tax returns (Form 1041) must be filed for the remainder of the spouse’s lifetime. And, if a co-trustee over the Family Trust is used, the spouse will have to cooperate with that trustee and pay him or her a trustee’s fee.

For many couples with non-taxable estates, particularly those with children all from the same marriage, the potential problems with a Family Trust may outweigh the benefits. Therefore, they will prefer to simply leave their estate to the surviving spouse. But, if portability is repealed, or if their estate values were to increase, or if the estate tax exemption is reduced by future legislation, they could still want the ability to use both spouses’ estate tax exemptions. It is possible to accomplish both objectives with a Disclaimer Trust.

Optional Family Trusts – Disclaimer Trusts:

The solution to the problems with portability and Family Trusts may be a Disclaimer Trust. A Disclaimer Trust allows the surviving spouse to choose (at the first spouse’s death) whether or not (and to what extent) the surviving spouse wants to use a Family Trust. The Family Trust is already written into the couple’s Living Trusts but only becomes activated if the surviving spouse chooses to do so at the first spouse’s death. The Living Trusts state that the surviving spouse is to inherit all assets - unless the surviving spouse disclaims (refuses) all or part of the inheritance.

The disclaimed assets are then re-directed into the Family Trust (where they are shielded from the estate tax at the surviving spouse’s death). Even though the couple does not mandate a Family Trust ahead of time, for up to 9 months after the first spouse’s death it basically leaves the surviving spouse the option to create a Family Trust. In making an informed decision to disclaim and how much to disclaim, the surviving spouse (and his/her advisors) must examine the size of the combined estate, the surviving spouse’s age and health, whether minor children will be beneficiaries of the Trust, the potential appreciation of the assets not disclaimed, and the status of the estate tax exemption. Essentially, the Disclaimer Trust is an “Optional” Family Trust with a 9-month option (in favor of the surviving spouse) to variably fund the Family Trust to whatever level makes sense.

For couples whose estates are below the estate tax exemption, a disclaimer trust still makes sense. It’s possible the estate could grow through appreciation, inheritances, and/or by acquiring life insurance on one or both spouses’ lives. It’s also possible the estate tax exemption will be reduced by Congress in the future. The disclaimer trust avoids saddling the surviving spouse with the time and expense of administering a Family Trust, unless funding a Family Trust would result in an estate tax savings.

Qualified Disclaimer:

In order to be a “qualified” disclaimer for estate tax purposes, the disclaimer must meet the following five tax law requirements:

1. It must be an irrevocable and unqualified refusal to accept an interest in property;
2. It must be in writing, signed by the spouse;
3. It must be received by the trustee within nine (9) months of the deceased spouse’s death;
4. The surviving spouse must not have accepted the disclaimed property or any of its benefits; and
5. As a result of the disclaimer, the trust property must pass without any direction from the disclaiming spouse. Thus, the surviving spouse cannot possess a limited power of appointment over the Family Trust.

There are also state law requirements for making a disclaimer. Failure by the surviving spouse to satisfy all of the federal requirements set forth above will result in the disclaimer being treated as a taxable gift from the spouse to the remainder beneficiaries of the Family Trust (i.e., the children and grandchildren).

THIS ARTICLE MAY NOT BE USED FOR PENALTY PROTECTION.