DISCLAIMING YOUR INHERITANCE

By:  Jerry Shiles

If you have been watching the news or reading the newspaper, you know a movement is afoot to revise the Federal Estate Tax Program. Some elected representatives want to permanently repeal the estate tax, while other merely want to tinker with the system some more. Regardless of what happens, the uncertainty created by the various proposals has left clients concerned about how to structure their estate plans.

One tool which may help during this time of uncertainty is the inheritance disclaimer. A disclaimer is a legal refusal to accept an inheritance. If you "disclaim" an inheritance, the property passes instead to the next heir in line. Since you (the "disclaimant") never receive the property, it passes down the line without you having to pay any gift tax.

Disclaimers have been around for many years and have different purposes. For example, you might want to leave everything to your children. When you execute your Will or Trust, this is a good idea. Time passes, however, and your children now are financially set. If they inherit anything from you, it will increase the complexity of their own estate planning or even increase their estate taxes. They can disclaim their inheritance, which then passes to your contingent beneficiaries, probably their children. This way, your assets reach the generation which actually needs them. Be aware, though, that this type of disclaimer might result in a generation skipping transfer tax.

Disclaimers are particularly relevant when we aren’t sure what the estate tax rules will look like from one year to the next. The disclaimer allows the surviving heir to wait and see what rules are in effect at your death and decide then how to proceed. It takes a great deal of the guesswork out of your estate planning. For example, we currently have an unlimited marital deduction. You can leave everything to your surviving spouse and your estate will not pay any estate tax at your death.

We also have a $1 Million exemption which means you can leave up to $1 Million to anyone you choose without any federal estate tax. The exempt amount continues to grow under current law until 2010 when your entire estate becomes exempt from federal estate tax. In 2011, however, we revert to the pre-2001 tax rules and the exempt amount comes back down to $1 Million again.

What does this mean for you? If you have an estate of several million dollars and die in 2010, you can leave everything to your children and not pay any tax. If you die on January 1, 2011, anything you leave to your children in excess of $1 Million will be taxed at estate tax rates which can exceed 50¢ on the $1. Since you have no idea when you will die, how can you intelligently plan your estate? One answer is to rely on the disclaimer formula.

Let’s look at a common estate plan which leaves everything to your wife and if she predeceases you, then to your children in equal shares. At the time you prepared it, you wanted your wife to have whatever she might need to take care of herself. Instead of revising and fine-tuning your distribution scheme over the years, you chose instead to rely on your wife’s ability to disclaim whatever she doesn’t need. If she is fifty when you die, she will need much more money to cover her needs than she will if she is eighty-five or ninety. The disclaimer allows her to figure out what she will need and then allow the rest of your assets to pass equally to the children through the disclaimer process.

It works like this. You leave everything to your wife and if you should suddenly die this year, she can disclaim up to $1 Million of your estate and let it pass to your children tax free. As the exempt amount grows, she can disclaim even more without incurring any federal estate tax. Your estate plan becomes a living, breathing document with the flexibility to react to the laws in place when you die.

A particular area in which we see disclaimers used is with pension plans and IRAs. At your death, you leave a significant IRA to your spouse as your primary beneficiary. Your spouse can accept the IRA and roll it over into one of her own. Or she can disclaim all or part of the IRA and let it instead pass to your children. Assuming your beneficiary form contains the correct instructions, each of your children will be required to take minimum required distributions calculated by using their respective life expectancies, rather than the shorter lifespan of your spouse. They can take out distributions over a greater period of time, which allows them to benefit from tax-deferred growth in the meantime. If your spouse withdraws the money from the IRA and gives it directly to your children, she may incur gift tax and loses the opportunity for tax-deferred growth.

Estate tax planning is not the only use of disclaimers. You own a farm and have three teenage children who work the farm with you. You want to leave the farm to the three of them equally. This might not be a good idea. You don’t know how well they will get along and whether all three will continue farming in the future. To account for this, you can leave everything to your wife instead. At your death, she will decide how the farm should be divided up. This requires forethought on your part because if your wife disclaims the property, she cannot dictate who receives it. Instead, it will pass under the terms of your Will. You can work around this problem by cutting up your farm, at least on paper, into three parcels, A, B, and C. Then specify in your Will that if your wife predeceases you, parcel A goes to son A, parcel B to son B, and so forth. If at your death, only A and B are still farming, your wife can disclaim her interest in parcels A and B and let them pass to the farming children. She will retain her interest in parcel C and lease it to sons A and B, thus accomplishing your purposes, and provide in her Will what will happen to parcel C at her death. Your Will (and your wife’s) must be very specific to avoid shortchanging one or more of your children.

The use of disclaimers doesn’t necessarily simplify estate planning–it is more like constructing a jig saw puzzle. When correctly done, disclaimers allow your surviving heir to adjust the distribution of your estate after your death to accomplish your wishes regardless of the tax laws then in effect.

Disclaimers have been with us for many years and can be effective estate planning tools, especially when tax rules are in turmoil or your financial future is uncertain. Contact an estate planning attorney who can help you evaluate your situation and, if appropriate, implement an estate planning disclaimer strategy.

© Jerry E. Shiles 2003

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