What Is a Disclaimer Trust, and Why Use One As Part of a California Estate Plan?
Another Reason to Talk to Our San Jose Estate Planning LawyersFor decades prior to 2001 when President Bush signed what became known as the “Bush tax cuts,” the most common approach to minimize the effects of the estate tax in estate planning both in California and in other states was the use of what was called “A-B” trusts. A-B trusts involved drafting provisions into a marital revocable living trust (or, less commonly, into testamentary trust provisions within married couples’ wills) that mandated the creation of two subtrusts upon the death of the first spouse. Into the “B” trust would go the full amount of the deceased spouse’s estate tax exemption according to a marital deduction formula. Into the “A” trust, or “Survivor’s trust” would go the survivor’s half of all community property, her separate property, and any excess over the deceased spouse’s estate tax exemption. In this way, the “B” trust, also known as the “bypass” trust, or the “credit shelter” trust, would preserve the deceased spouse’s full estate tax exemption. The B trust was an irrevocable trust, and while the surviving trust could be the sole trustee of that trust, she could not change its beneficiaries or successor trustees. Importantly, it was also protected from her creditors, so served an asset protection function as well. The B trust required a separate tax ID number, and annual tax returns separate from the survivor’s return.
Because the B trust never became part of the survivor’s estate, it could then pass to the couple’s heirs later at the survivor’s death tax free. In the meantime, the surviving spouse could use the income from the B trust, and even take from principle (but only for her “health, education, maintenance, and support”). The A trust, or survivor’s trust, on the other hand, remained a revocable living trust, which the survivor could use in any way she desired, including gifting assets from it or changing beneficiaries.
As we stated above, this was how estate planning used to be done for couples that would likely have a taxable estate at death. While there are still good reasons for providing for an A-B trust scheme where estate taxes are highly likely, or for non-tax purposes such as providing for a mandatory B trust to benefit, for example, children from a prior marriage in a so-called “blended family” context, most estate planning attorneys have since 2001 largely abandoned the use of the rigid A-B trust scenario for tax planning – at least for middle class people unlikely to ever have a taxable estate.
Because our estate planning practice is focused entirely on the vast majority of people who will almost certainly never have a taxable estate, we almost never use a rigid A-B trust for tax planning.
The Disclaimer Trust: A More Flexible Alternative to a Traditional A-B TrustWhat most estate planning attorneys have favored instead of the traditional A-B Trust is what is called the “Disclaimer” trust. Rather than requiring that upon the first death, a B trust be created and requiring that it be funded with all or a portion of the deceased spouse’s estate under a marital deduction formula, the Disclaimer trust leaves the decision as to whether to create such a trust until the death of the first spouse.
When a married couple’s revocable living trust (RLT) includes the language necessary to provide for a disclaimer trust, this method provides for maximum flexibility while still providing for the possibility that the estate tax could affect a married couple’s estate. How does it do this? By default, a marital RLT using a disclaimer trust, will simply leave all of the first spouse’s estate to the survivor. It is, of course, very important to remember that this works very well for a couple whose testamentary goal is “everything to my spouse, and then to our children after my spouse dies.” Again, however, if the couple has children from other marriages, then it is not recommended that one leave “everything to my spouse” because once such an outright gift is made, all control over where that gift will go at the survivor’s death is lost. There is no way to require that the survivor give anything to the deceased spouse’s children from a former marriage.
But in the context of a middle class couple with children only of that marriage, and who may eventually have a taxable estate, but who in all likelihood will not, a Disclaimer trust can be ideal. Again, by default, the RLT provides that all of the estate of the first spouse to die will go to the surviving spouse. In that case, no “B” trust would ever be created. However, with the appropriate disclaimer language, the surviving spouse is afforded the opportunity to “disclaim” or reject the gift of the deceased spouse’s estate. It is absolutely imperative to note, however, that this “disclaimer” must be in writing, must adhere to the requirements of IRC section 2518 and California Probate Code sections 265 and 278, and it must be made within 9 months of the date of the first spouse’s death. If nine months passes without the disclaimer being made, the opportunity to do so is lost.
If the disclaimer is made by the surviving spouse, then she may disclaim all or a portion of the deceased spouse’s estate, and such disclaimed property will be placed into a “disclaimer trust.” Such a disclaimer trust, functions just like the traditional “B” trusts (or “bypass” trusts) before it. That is, it will preserve the deceased spouse’s estate tax exemption and will never become part of the surviving spouse’s estate. Like a “B” trust, the disclaimer trust will pass to the couple’s heirs at the survivor’s death tax free. Also like a “B” trust, the surviving spouse may be the sole trustee of the disclaimer trust, but again like a “B” trust, the disclaimer trust is an irrevocable trust, and she cannot divert the trust’s principle to make gifts or change the beneficiaries.
This brief overview of disclaimer trusts should shed some light on why the use of disclaimer trusts has become so popular since 2001. With very large estate tax exemptions ($5 million dollars per person in 2011 and 2012), the rigid A-B trust that was preferred for so long is now out of favor for all but the wealthiest of people at least as a tax planning strategy. Additionally, for 2011 and 2012, the new “portability” rules allow for the combination of the deceased spouse’s estate tax exemption with that of the surviving spouse without any planning at all (the survivor merely needs to file IRS form 706 to claim the deceased spouse’s unused estate tax exemption). However, reliance on portability is probably not good practice since, as it stands right now, the portability rule applies only to deaths that occur in 2011 and 2012, and no one knows what will happen with the estate tax thereafter.
For now, at least, the use of disclaimer trusts for married couples with only a possibility of ever having a taxable estate and who only have children from this marriage, remains the preferred method of dealing with tax planning in estate plans because it offers the greatest flexibility for middle class couples.
By Jon G. Brooks