Why Flexibility at the First Spouse’s Death Can Also Create Risk
For married couples in California, one common estate planning strategy is to create a joint revocable living trust that divides after the first spouse dies. Under one version of this plan, the deceased spouse’s assets initially pass to the surviving spouse’s Survivor’s Trust, but the surviving spouse is given the option to “disclaim,” or refuse, some of those assets that were owned by their spouse.
If a proper disclaimer is made, the disclaimed assets instead get moved into a separate irrevocable trust, often called a Disclaimer Trust or Disclaimer Bypass Trust.
At first glance, this approach can be very attractive. Instead of deciding today how much should pass into an irrevocable trust when the first spouse dies, the couple postpones that decision. After the first death, the surviving spouse can look at the estate tax laws, the size of the estate, the family’s circumstances and other factors and decide whether creating the Disclaimer Trust makes sense.
That flexibility can be valuable.
But it comes with an important tradeoff: the plan only works if the surviving spouse takes the right actions, within a relatively short period of time, and follows strict legal requirements.
For families with substantial estates, this can be a significant limitation. Some limitations and issues with Disclaimer Bypass Trusts are:
1. The Surviving Spouse Can Simply Decide Not to Disclaim Assets to the Disclaimer Trust
Perhaps the biggest limitation is also the most obvious.
The Disclaimer Trust is optional.
When the first spouse dies, the surviving spouse generally receives the deceased spouse’s assets under the terms of the estate plan. The surviving spouse then decides whether to disclaim some or all of the property that represents trust property owned by their spouse to pass into the Disclaimer Trust.
If the surviving spouse decides not to make the disclaimer, the Disclaimer Trust may never be funded. This is very different from an estate plan that automatically funds a bypass or family trust at the first spouse’s death.
For example, assume a husband and wife create a Disclaimer Trust plan intending that, when the first spouse dies, the survivor will consider placing several million dollars into an irrevocable trust for the survivor during his or her lifetime and then later will be inherited by their children.
The husband dies first.
The wife may decide:
“I would rather keep everything in my own trust.”
If the estate plan leaves the decision entirely to her, she may be entitled to do exactly that.
That may be perfectly appropriate based upon the circumstances existing at that time. But it also means the deceased spouse cannot be certain that the Disclaimer Trust will ever be created or funded.
For couples who strongly want assets protected in a separate trust after the first death—or who want to make certain that particular estate tax, remarriage, creditor, or inheritance-planning objectives are implemented—this lack of certainty should be carefully considered.
2. There Is a Strict Nine-Month Federal Deadline
A qualified disclaimer for federal tax purposes generally must be made in writing and delivered within nine months of the transfer creating the interest, which, for property passing because of a spouse’s death, will commonly mean nine months following the deceased spouse’s death.
Nine months may sound like plenty of time. In practice, it can pass remarkably quickly. Immediately after a spouse dies, the surviving spouse may be dealing with grief, funeral arrangements, family matters, appraisals, financial accounts, real estate, tax returns, attorneys, financial advisors and dozens of other issues.
Meanwhile, determining whether a disclaimer should be made may require analyzing:
- The value of the couple’s assets;
- The current federal estate tax laws;
- Future anticipated appreciation of the estate;
- Income tax considerations;
- The surviving spouse’s financial needs;
- The ages and circumstances of the children;
- Creditor and remarriage concerns; and
- The advantages and disadvantages of placing assets into an irrevocable trust.
If the deadline is missed, the surviving spouse generally cannot simply decide in the tenth or twelfth month that a federal qualified disclaimer would have been a good idea.
The opportunity is gone.
California has its own disclaimer statutes as well, including timing rules, while federal law imposes the requirements for a qualified disclaimer for federal transfer-tax purposes. California also specifically recognizes certain disclaimers that qualify under federal law. For this reason, a family using a Disclaimer Trust plan should contact its estate planning attorney promptly following the first spouse’s death.
3. The Surviving Spouse Gives Up Important Control Over the Disclaimer Trust
Another limitation is less obvious.
A disclaimer is fundamentally a refusal to accept property. To receive favorable treatment under the federal qualified-disclaimer rules, the surviving spouse cannot disclaim the property and then retain unrestricted power to decide where that same property ultimately goes.
Federal law generally requires the disclaimed property to pass under the estate plan without direction by the person making the disclaimer. This can affect the powers that the surviving spouse may have over the Disclaimer Trust.
In many traditional bypass trusts, a surviving spouse might be given what is called a limited power of appointment. For example, the surviving spouse might be allowed to change how the remaining trust assets are divided among children or other descendants at the survivor’s later death.
That type of flexibility can be extremely useful.
However, when a trust is funded through the surviving spouse’s qualified disclaimer, allowing the spouse to retain a broad discretionary limited power of appointment over the disclaimed assets can cause the disclaimer to fail. In fact, the federal Treasury Regulations specifically give an example involving a surviving spouse who disclaims assets into a Bypass trust but retains a nongeneral power of appointment. The regulations provide that the disclaimer requirements are not satisfied unless the spouse also disclaims the applicable power of appointment.
There are technical exceptions for certain powers limited by an objective or “ascertainable” standard, but the important point for clients is much simpler:
A Disclaimer Trust generally cannot give the surviving spouse the same degree of control over the ultimate beneficiaries that may be available with other types of bypass trust planning.
That loss of flexibility can become particularly important years later if a child develops creditor problems, gets divorced, becomes financially irresponsible, develops special needs, or if other family circumstances change.
4. The Surviving Spouse Must Also Be Extremely Careful Not to “Blow” the Disclaimer
This is one of the biggest practical risks of a Disclaimer Trust plan.
Before making the disclaimer, the surviving spouse generally cannot accept the property or its benefits.
Federal regulations state that acceptance can occur through actions that are consistent with ownership. Examples include using property, accepting income from it, or directing others to take certain actions regarding it. The regulations also provide examples in which pledging property as collateral causes a later attempted disclaimer to fail.
California law similarly restricts disclaimers after a beneficiary has accepted an interest and identifies certain assignments, transfers, encumbrances and pledges as acts of acceptance. This creates what estate planning attorneys sometimes informally refer to as a “blown disclaimer.”
Imagine that a husband dies and his assets are eligible to be disclaimed into a Disclaimer Trust. Before obtaining legal advice, the surviving wife begins moving assets between accounts, retitles property, pledges an asset as collateral, directs transactions involving inherited assets, or otherwise exercises ownership and control over the property. She later meets with her estate planning attorney and decides she would like to disclaim those assets into the Disclaimer Trust.
There may now be a serious problem.
Depending upon exactly what occurred, her previous actions may constitute acceptance of the property or its benefits. If so, a subsequent disclaimer may no longer qualify. Not every administrative action automatically destroys a disclaimer. The federal regulations recognize, for example, that certain actions taken by a fiduciary merely to preserve or maintain property do not necessarily constitute acceptance.
Nevertheless, the safest approach is simple:
Before moving, selling, retitling, pledging, distributing or otherwise exercising control over assets that might be disclaimed, the surviving spouse should obtain legal competent advice.
5. What Happens If the Surviving Spouse Lacks Capacity?
A Disclaimer Trust assumes something else that cannot be guaranteed:
The surviving spouse will be capable of making an informed decision when the first spouse dies.
Suppose a couple creates their estate plan when they are both healthy at age 60.
Twenty years later, the husband dies. By then, the wife has significant cognitive impairment and is unable to understand the estate, evaluate the tax consequences and make the necessary decisions.
Who makes the disclaimer?
The answer can become considerably more complicated.
Federal regulations permit a disclaimer document to be signed by the disclaimant or the disclaimant’s legal representative. But state law also becomes important in determining who has authority to act. Under California law, an attorney-in-fact does not automatically have authority to disclaim an inheritance simply because he or she holds a general power of attorney. California Probate Code Section 4264 identifies disclaiming an interest as one of the actions requiring specific authority in the power of attorney.
Depending upon the circumstances, incapacity can therefore introduce additional legal issues, fiduciary considerations and potentially court involvement. And all of this is occurring while the federal nine-month disclaimer clock may still be running.
For an older couple, or a couple concerned about declining capacity, this can be an important weakness in relying on a disclaimer as the primary mechanism for creating a bypass trust.
6. A Disclaimer Is a Technical Legal Transaction—Not Simply a Letter Saying “I Don't Want It”
Finally, disclaimers must be handled carefully because both federal tax law and California law contain rules governing them.
For federal tax purposes, a qualified disclaimer generally must be irrevocable and unqualified, must be in writing, must be timely delivered, must occur before the disclaimant has accepted the property or its benefits, and must result in the property passing without prohibited direction by the disclaimant.
California has its own statutory framework for disclaimers under Probate Code Sections 260–295. Among other things, California law addresses the required contents, filing, timing, acceptance and legal effect of a disclaimer. California Probate Code Section 295 also coordinates California law with federal disclaimer treatment by recognizing a disclaimer or transfer that is treated under applicable federal law as never having been transferred to the beneficiary.
The practical lesson is that a disclaimer should not be treated as a do-it-yourself document.
The exact property being disclaimed, the timing, the surviving spouse’s prior actions, the language of the trust, where the property passes after the disclaimer, and the powers retained by the surviving spouse can all matter in the drafting of a valid Disclaimer.
Does This Mean a Disclaimer Trust Is a Bad Estate Plan?
Not at all.
A Disclaimer Trust can be an excellent planning tool, particularly when a married couple wants to preserve flexibility because no one knows what the estate tax laws, asset values or family circumstances will look like when the first spouse dies. The important question however is whether flexibility or certainty is more important to that particular family.
A Disclaimer Trust provides flexibility because the surviving spouse can decide after the first death whether the additional trust is needed.
But that flexibility comes at a price.
The surviving spouse must:
- Decide to use the disclaimer;
- Act within the applicable 9 month deadline;
- Avoid accepting or improperly exercising control over the property before disclaiming it;
- Give up certain powers over the disclaimed assets;
- Have sufficient capacity—or have appropriate legal arrangements in place—to complete the transaction; and
- Make certain the disclaimer and resulting trust administration satisfy the applicable legal requirements under state and federal law.
For some families, those conditions are entirely reasonable. For others, particularly families with larger estates, substantial expected asset appreciation, blended-family concerns, or a strong desire to preserve assets in trust after the first spouse’s death, an estate plan that automatically creates and funds a bypass or other irrevocable trust such as a QTIP trust may provide greater certainty.
The Bottom Line
A Disclaimer Trust is sometimes described as giving a married couple the “best of both worlds” because it allows the family to wait until the first spouse dies before deciding whether an irrevocable trust is necessary.
But there is another way to look at it:
A Disclaimer Trust postpones an important estate planning decision until a time when one spouse has died and the surviving spouse may be grieving, overwhelmed, incapacitated, or unaware that a relatively short deadline is running. For that reason, married couples considering a Disclaimer Trust should understand not only its flexibility, but also what must go right after the first spouse dies for the strategy to work as intended.
The appropriate structure depends upon the size and composition of the estate, the couple’s objectives, their family circumstances, applicable tax laws and how much control and certainty they want built into their estate plan.
If your estate plan has been updated in years and you have a Disclaimer Trust plan you would like reviewed, reach out to us at (760) 448-2220 or at https://www.geigerlawoffice.com/contact.cfm. We proudly serve families in California and have offices in Carlsbad and Laguna Niguel.
