How Planned Disclaimers Can Improve an Estate Plan

A key to successful Estate Planning these days is flexibility. Scheduled changes in the federal estate tax, and the possibility of additional changes, make flexibility essential.

In past visits we have discussed language that can be included in wills to increase flexibility. Another tool to make available to your heirs is the disclaimer. Normally, disclaimers are used during the estate settlement process when a savvy estate planning attorney sees that circumstances changed or there were mistakes in the estate plan. Then, heirs are encouraged to use disclaimers to reduce taxes or change the distribution of assets.

Now, the possibility of disclaimers should be incorporated in the planning process. Doing so increases the probability the results you want can be achieved even when the law changes.

The estate tax exemption rises to $3.5 million in 2009 (from $2 million today). The tax rate declines to 45% in 2007 from 46% today. Then, in 2010 the estate tax is scheduled to be repealed. But after 2010, if Congress does not act the estate tax that was in place in 2001 is restored. That would make the lifetime exemption only $1 million.

To further complicate matters, Congress is considering additional estate tax changes. It might make repeal of the estate tax permanent. Or it might lock in an estate tax exemption much higher than today’s level. Or it might be unable to reach and agreement and make no change.

Let’s take a look at a few examples of how planned disclaimers can reduce taxes or otherwise improve an estate plan.

A typical will leaves assets equal to the tax exempt amount to the children and the rest of the estate to the surviving spouse. That made a lot of sense when the exempt amount was relatively low. But with the exempt amount at $2 million and ready to climb higher, this provision could cause problems.

Suppose the estate is worth $3 million. Under this provision, the children would get $2 million, and the spouse only $1 million. After the exemption rises, the children would get the entire estate.

An alternative would be for the will to leave all the assets to the surviving spouse. But that could mean taxes on part of the estate, depending on the estate tax law that applies when the owner dies.

Here’s how planning for disclaimers can help the situation.

The will could leave entire estate to the surviving spouse, with a provision that if the spouse disclaims any of the assets they will go to the surviving children. The will can direct that the disclaimed assets go equally to the children or that the division be unequal.

An alternative is to use the traditional form of leaving the exempt amount to the children and the rest to the surviving spouse. But there is a provision that any assets disclaimed by the children go to the surviving spouse.

The advantage of planning for disclaimers is that the person scheduled to inherit the assets can assess the tax law and other factors and decide whether or not to disclaim. Consider the case when the surviving spouse inherits the entire estate. He or she can consider any other assets owned, the tax law, personal health, and other factors to determine the amount of wealth he or she needs. The rest can be disclaimed.

Consider the other situation, in which the children inherit most of the estate because of a high estate tax exemption. They would work with the estate planner to consider the circumstances and decide if they should disclaim part of the inheritance. The children can ensure that the surviving spouse is taken care of and that taxes are minimized.

State death taxes also are a factor heirs should consider. A number of states have estate or inheritance taxes that can exceed federal estate taxes. Heirs should not think that no decision needs to be made because no federal estate taxes are due.

The use of disclaimers requires planning, because if the will does not state what happens to disclaimed assets, state law determines who receives the assets. To ensure the right result, the will should state explicitly contingent and remote beneficiaries for the disclaimed assets.

Disclaimers also can be used for assets that do not pass by the will, such as IRAs and annuities. For this to work, the contingent beneficiaries must be named in the beneficiary designation form filed with the IRA custodian.

Of course, for the disclaimer strategy to work the heirs and estate planner must know your intentions. You should have a discussion about the strategy, and also prepare a letter to the heirs reiterating your intention. They also must know to consult with the estate planner so that the best decisions can be made.

A disclaimer has a technical definition under the tax law. To use disclaimers effectively, the heirs must follow the rules. The disclaimer must be in writing and must be made within nine months of the estate owner’s death. The written disclaimer must be delivered to the estate executor in most cases and must identify the property that is being disclaimed.

A disclaimer can be for all or part of an inheritance. The disclaimer also can state which specific assets are disclaimed, or it can apply to a dollar amount of assets and let the executor determine which assets are disclaimed.

An essential element of every estate plan right now is flexibility. Making the potential for disclaimers a part of the estate planning process can enhance a legacy.