When an estate planner schedules an initial family consultation, Ozzie and Harriet (or Homer and Marge) may not be the couple that shows up for the appointment. Instead, the estate planner may encounter an alternative family—Ozzie and Homer, for example. In an earlier article by Jerry Simon Chasen and Elizabeth F. Schwartz, Estate and Gift Tax Planning for Non-traditional Families
, Prob. & Prop., Jan./ Feb. 2001, at 6, the authors emphasized the special care and skill needed in this context, with a focus on estate plans that simultaneously minimize the tax burden through the use of discounts and the charitable deduction and provide for a nonspousal loved one.
Homer and Ozzie
Homer, age 64, and Ozzie, age 68, have been domestic partners for 23 years. As a successful financial adviser, Homer accumulated an IRA worth $1.3 million. Ozzie did rather well as a real estate broker, and his retirement plan just exceeds $2.1 million. Homer has an additional $900,000 in assets; Ozzie, an additional $1,050,000.
Ozzie and Homer own homes in Miami’s South Beach and in Provincetown, Massachusetts. The estate tax laws treat real estate owned by domestic partners differently from real estate owned by legally married couples. The gross estate of a decedent who was legally married at death includes only one-half of the value of any property owned by the decedent with his or her spouse as tenants by the entireties or as joint tenants with rights of survivorship. That one-half interest qualifies for the marital deduction. When a domestic partner dies as a joint tenant with rights of survivorship, the estate tax presumes that the deceased joint owner’s gross estate includes the value of the entire property. The deceased joint owner’s gross estate must include the value of the entire property, except to the extent that the executor can prove that the surviving joint owner furnished any of the consideration for the property. Homer and Ozzie have owned their homes together as joint tenants for so long that it will be virtually impossible to distinguish who contributed how much when.
Being charitably inclined, Homer and Ozzie set up a donor advised fund at a community foundation. Their estate planning goals are rather simple: to care for the survivor between them; and, on the survivor’s death, to divide the remaining assets between a list
of beneficiaries and their donor advised fund.
Homer and Ozzie’s advisors explained the heavy tax burden imposed on retirement plans at death without the “spousal rollover.” Because each man is relatively well off, the survivor may not need the other’s retirement assets. However, the survivor will not know how much he will need until the death of the first between them actually occurs.
For this reason, flexibility is critical.
Assume that Ozzie dies in 2001, leaving the following assets:
South Beach house $700,000
Provincetown house $350,000
Personal property $35,000
Retirement account $2,100,000
Total estate $4,235,000
Homer is the primary beneficiary of Ozzie’s estate, including his retirement plan. If Homer receives all of Ozzie’s assets, Ozzie’s estate will pay a combined federal and state estate tax of $1,764,750. The remaining income tax burden will further erode the remaining $2,470,250.
Planned charitable giving can remedy this situation in three alternative ways. The first alternative, although clearest in terms of authority, is not as flexible as the other alternatives. The second alternative is more flexible, but the outcome is less clear. The final alternative is complicated, but it maintains maximum flexibility and some clarity. Each of the three alternative plans relies on the use of a “qualified disclaimer.”
If a donee of property executes a “qualified disclaimer,” then for transfer tax purposes the donee is treated as if he never received the disclaimed property. The disclaimed interest never becomes part of the disclaimant’s gross estate, and the disclaimant is not deemed to have made a gift to the person to whom the disclaimed interest passes. To be treated as a “qualified disclaimer,” the disclaimant must execute the disclaimer in writing within nine months after the interest being disclaimed was created. In addition, the property must pass to the decedent’s spouse or to someone other than the disclaimant without any direction by the disclaimant. If a disclaimer is not a “qualified disclaimer,” the disclaimant is treated as if he had received the property and immediately made a gift of it to the successor in interest.
Disclaimers can be used to save transfer taxes both during a taxpayer’s lifetime and after his or her death. If a taxpayer inherits a share of a relative’s estate, that property increases the value of the taxpayer’s estate. Through the use of a qualified disclaimer, a married disclaimant avoids the increase in value of his estate, and the disclaimed interest often passes, without additional gift or estate tax, to the disclaimant’s descendants by the terms of the underlying gift instrument. Thus, the qualified disclaimer can often result in the passage of property to the disclaimant’s intended beneficiaries free of any additional gift or estate tax. In an alternative family situation, the decedent’s assets can pass to charity as a result of the disclaimer, with a corresponding estate tax charitable deduction.
Charitable Contingent Beneficiary
The first planning option would be for Ozzie to name the donor advised fund or another qualified charitable organization as the contingent beneficiary of his retirement plan. A “qualified charitable organization” is a charity that is both
(1) in existence and operating and
(2) described in Code §§ 170(c) and 2055(a).
On Ozzie’s death, Homer may not need all of what Ozzie left him. Because a qualified charitable organization is the contingent beneficiary of the IRA, Homer retains tremendous flexibility. Homer can disclaim any assets he does not need, including the IRA. Because of the income tax burden associated with retirement plan assets, the IRA will probably be the first asset Homer disclaims. Since a disclaimed interest passes as if it never had been transferred to the disclaimant, the disclaimed portion of the IRA will be treated for estate tax purposes as passing directly from Ozzie to the donor advised fund. The estate can take a full charitable deduction for the disclaimed IRA.
Assume that Homer determines that he does not need $1 million from Ozzie’s $2.1 million retirement account. He would execute a qualified disclaimer of that amount of the plan. The disclaimed amount ($1 million) passes directly to the contingent beneficiary of the plan, Homer and Ozzie’s donor advised fund. Ozzie’s executor would take a $1 million charitable deduction from the value of Ozzie’s estate. Homer escapes the income tax liability associated with the retirement plan assets, and the donor advised fund, as a tax-exempt entity, also would not pay income taxes on the plan assets.
Disclaim into a CRUT
When Ozzie dies, Homer could decide that he does not need all of the retirement assets but that he could use an income stream from the plan. It may be possible to accomplish this result through the use of a qualified disclaimer. Instead of naming a qualified charitable organization as the first contingent beneficiary of his retirement plan, Ozzie could name it as the second contingent beneficiary. The first contingent beneficiary is a charitable remainder unitrust (CRUT) that names Homer as the unitrust beneficiary for his life and the donor advised fund as the remainder beneficiary.
Assume, for example, that Homer determines that he does not need $500,000 of the $2.1 million IRA principal but that he does need at least an income stream from $600,000 of the remaining $1.6 million. As the primary beneficiary of the IRA, Homer would receive $1 million outright. Homer would execute a disclaimer of $1.1 million in IRA benefits, all of which would then go to the first contingent beneficiary, the CRUT. Homer would then execute a second disclaimer of a portion of his unitrust interest in the CRUT, worth $500,000. The disclaimer would accelerate the remainder interest, which would pass directly to the donor advised fund.
Under this plan, Homer can make a more realistic assessment of his needs and assets at Ozzie’s death. Optimally, this would result in an estate tax charitable deduction of $500,000 (the amount going to the donor advised fund outright) plus a charitable deduction equal to the present value of the donor advised fund’s remainder interest in the CRUT. Homer would receive $1 million from the IRA outright and a unitrust interest for the rest of his life. In addition, he benefits further by limiting his income tax exposure on the plan assets.
Unlike the prior option, this plan does have some legal uncertainty. Treas. Reg. § 25.2518-2(e)(1)(ii) provides that “[t]he requirements of a qualified disclaimer under section 2518 are not satisfied if . . . [t]he disclaimed property or interest in property passes to or for the benefit of the disclaimant as a result of the disclaimer.” (Emphasis added.) There is an exception to this rule for transfers to spouses, however, so that a legally married spouse can retain an interest in property that he or she has disclaimed.
Under this regulation, Homer may have retained an interest in part of the property he disclaimed. When Homer executes the first disclaimer, the disclaimed amount passes into the CRUT of which Homer is also the unitrust recipient. Homer then executes the second disclaimer that results in only a portion of the disclaimed amount passing directly to their donor advised fund. It may be argued that only the amount that actually passes to the donor advised fund—the amount Homer disclaimed in both the first and the second disclaimers—will be eligible for an estate tax deduction, since Homer retains no interest in this property.
An argument can be made that the IRS should allow an estate tax charitable deduction for the amount passing to the donor advised fund, which was subject to both disclaimers, as well as the present value of the remainder in the CRUT, which was subject only to Homer’s first disclaimer. Under Treas. Reg. § 25.2518-3, an individual may disclaim less than an entire interest in property. This regulation provides that “the disclaimer of all or an undivided portion of any separate interest in prop- erty may be a qualified disclaimer even if the disclaimant has another interest in the same property.” For example, a beneficiary of an income and remainder interest in the same property can make a qualified disclaimer of the income interest and not the remainder interest, or vice versa.
To take advantage of this rule, Ozzie could name a trust for Homer’s benefit as the primary beneficiary of the plan. Homer would have an income interest in the trust principal, and the trustee could invade trust principal for Homer’s health, support and maintenance. At Homer’s death, a CRUT would receive the remainder. The CRUT remains the first contingent beneficiary of the trust. Homer now would have three separate interests: an income interest, a support interest and a unitrust interest. Homer would then disclaim his income and support interests in the trust for his benefit, which would accelerate the payment of the remainder to the CRUT. In other contexts, the IRS has made clear that an income interest is not the same as a unitrust interest. See Rev. Rul. 92-48. If the three interests are clearly delineated, it may be possible to bring this plan under the separate interests rule of Treas. Reg. § 25.2518-3.
If the IRS disagrees, all is not lost. Even though estate tax is due on the amount passing to the CRUT because Homer’s disclaimer will not be a “qualified disclaimer,” he will be deemed to have made that transfer. As the deemed donor to the CRUT, Homer will be entitled to both income and gift tax charitable deductions, which he may well need.
Powers of Appointment
As a variation on the use of a CRUT, Ozzie could incorporate a power of appointment into his plan. A donor creates a power of appointment when he confers upon another, by will, trust or other instrument, the right to designate who will receive certain specific property or an interest in property at some future time. The power to appoint property is, in essence, a right to decide who will eventually be its owner.
The disclaimer regulations do not allow anyone other than a legally married spouse to continue to benefit from an interest in property that has been disclaimed. Unlike the disclaimer of an interest in property, the regulations provide that, if a power of appointment over property is disclaimed, the disclaimant can still receive another interest in the same property so long as the disclaimant does not direct who ultimately receives the property. Treas. Reg. § 25.2518-2(e)(1).
Under this planning option, Ozzie names the CRUT as the primary beneficiary of the IRA. The terms of the CRUT grant Homer a power of appointment to withdraw as much of the principal of the trust as he wants. If this power remains, it will disqualify the CRUT. Homer then decides how much of the principal of the IRA he needs to own outright and exercises his power to withdraw that amount from the CRUT. He disclaims the power of appointment for the amount he wants to remain in the CRUT and disclaims his unitrust interest in the amount he wants to go outright to charity.
Using the same numbers as in the CRUT example, Homer decides that he does not need $500,000 of the IRA principal but that he needs an income interest from $600,000 of the $1.6 million remaining in the plan. Homer would exercise his power of appointment to invade the CRUT principal for $1.0 million. He would disclaim his power of appointment for the remaining $1.1 million and would disclaim his unitrust interest from the $500,000 in the CRUT. The result would be the same as for a CRUT without a power of appointment.
CRUT forms issued by the IRS do not include a power of appointment. In other contexts, the IRS has approved the use of disclaimers of offending property interests to qualify for deductions. For example, the IRS has long held that disclaimers can fix trust and beneficiary designations that otherwise would have failed to qualify for the marital deduction. See, e.g., Rev. Rul. 84-105.
The estate tax regulations governing gifts to charity specifically allow an estate tax charitable deduction for any interest in property that passes to charity as the result of either a qualified disclaimer or the complete termination of a power of appointment, “if the termination occurs within the period of time (including extensions) for filing the decedent’s Federal estate tax return and before such power has been exercised.” Treas. Reg. § 20.2055-2(c)(1). The regulations further provide that charitable remainder trusts are acceptable deductible interests for estate tax charitable deduction purposes. Thus, this plan includes both a qualified disclaimer of a power and an interest that thereafter passes to a unitrust. Under this plan, Ozzie and Homer can have the flexibility they want and the certainty they need.
Estate planning for alternative families presents as many potential pitfalls as it does opportunities for creative thinking and drafting. Gay and lesbian couples seek to protect their loved ones, and many heterosexual couples choose, for whatever reason, not to wed. As clients expand the definition of family, estate planners must expand the options available to these clients in order to serve them well.
Jerry Simon Chasen is the principal of Chasen & Associates, P.A., in Miami, Florida.