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October 7, 2020

Minimizing Estate Tax and Maximizing Flexibility With Disclaimer Trusts

What’s the difference between $5,850,000 and $1,000,000? If you answered $4,850,000, you’re correct. If you answered the former is the current New York estate tax exemption in 2020 and the latter was the New York estate tax exemption in early 2014, you’re also correct.

How can a client plan effectively to minimize estate taxes when the estate tax exemption is subject to change? Also, aside from the fluctuation in the estate tax exemption levels, clients’ wealth is likely to accumulate and appreciate over time. So if a married couple’s estates are not taxable in 2020 but very well may be taxable by 2023, how do those clients effectively plan to minimize estate taxes?

One effective tax planning strategy for married couples that maintains flexibility is the use of disclaimer trusts as part of their estate plans. A disclaimer trust is an estate planning technique in which a married couple incorporates an irrevocable trust in their planning, which is funded only if the surviving spouse chooses to “disclaim,” or refuse to accept, the outright distribution of certain assets following the deceased spouse’s death. The deceased spouse’s will leaves his or her estate to the surviving spouse but directs that, if the surviving spouse disclaims any assets, those disclaimed assets fund a disclaimer trust under the deceased spouse’s will for the benefit of the surviving spouse. Use of the disclaimer trust is entirely optional by the surviving spouse. Note that only spouses have the ability to disclaim assets into trusts where they retain the benefits.

The following example illustrates the benefits of planning for spouses with disclaimer trusts:

Pat and Jamie are married and own combined assets (including life insurance death benefits) of $5.5 million, with their assets divided relatively equally between them. Let’s assume Jamie dies first. If Jamie’s will leaves all of Jamie’s assets outright to Pat with no disclaimer trust option, Pat will end up owning all of their combined assets, and Jamie’s estate tax exemption will have been wasted. Assuming Pat’s assets appreciate, Pat’s combined net worth may very well exceed the New York estate tax exemption at Pat’s subsequent death, generating a significant New York estate tax bill. For example, if Pat’s assets grew to, say, $6.2 million, that’s a New York estate tax bill of over $500,000. New York’s estate tax also functions as a “cliff,” meaning an estate that is equal to or above 105 percent of the exemption amount enjoys no exemption at all. In this example, the result is that the amount of the tax ($500,000) ends up being more than the amount in excess of the estate tax exemption ($350,000)!

If instead Pat and Jamie’s wills included disclaimer trusts, Pat as surviving spouse could have disclaimed assets that otherwise would have been distributed outright to Pat, thereby utilizing a portion of Jamie’s estate tax exemption and keeping those disclaimed assets out of Pat’s taxable estate. The likely result is the elimination of New York estate tax upon Pat’s subsequent death, saving over $500,000 in estate taxes.

Let’s assume that, after updating their estate plan, Pat and Jamie move from New York to Florida, which has no state estate tax. At Jamie’s death with Pat surviving, there may be little or no tax advantage to Pat utilizing the disclaimer trust, so Pat simply accepts Jamie’s assets outright. Again, the result is likely no estate tax due by Pat’s estate at Pat’s subsequent death.

Disclaimer trust planning is effectively “wait and see” planning—the surviving spouse can wait until the first spouse’s death to decide if utilizing the disclaimer trust makes sense. If a married couple’s intention is to leave all assets to each other and there is even a slight possibility their estates will be taxable, there is no downside to incorporating disclaimer trusts into their wills. Also, if the surviving spouse does choose to disclaim assets and utilize the disclaimer trust, the surviving spouse can have his or her cake and eat it, too. The assets in the disclaimer trust support the surviving spouse during his or her lifetime, but the trust assets (including appreciation following the deceased spouse’s death) are excluded from his or her taxable estate.

Although incorporating a disclaimer trust in your estate plan is an easy way to maintain flexibility, because of the significant tax implications, deciding whether to utilize a disclaimer following a spouse’s death should only be done with advice from a skilled estate planning attorney.

For clients whose estates will almost certainly be subject to estate tax, other planning strategies, such as the use of a family or “bypass” trust at the death of the first spouse, are effective in leveraging the estate tax exemption of the first spouse to pass away and also may offer additional benefits, such as flexibility for the surviving spouse through inclusion of a limited power of appointment upon the surviving spouse’s death. While use of the disclaimer trust offers the surviving spouse the flexibility to establish a trust instead of taking an outright distribution, the use of the direct family or “bypass” trust offers the surviving spouse greater authority and flexibility in the distribution and administration of the trust. So if establishing the trust at the death of the first spouse is clearly advisable for estate tax purposes, the direct trust may be the best option. If establishing the trust does not provide clear estate tax benefits or if the trust is not advisable for other purposes, the disclaimer trust may be the best option.

The trusts and estates attorneys at Barclay Damon are well versed in a wide range of estate planning strategies, including disclaimer trust planning, and can help you decide if a disclaimer trust makes sense as part of your overall plan.

If you have any questions regarding the content of this blog post, please contact Rachelle Nuhfer, counsel, at rnuhfer@barclaydamon.com.

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