It’s not enough for the founder of a closely held business to have successfully established the business. The business has to grow, not only to increase profits, but also to make it more competitive and to diversify its customer base. Such “smart” growth will attract talented employees to the business, facilitate borrowing, prepare the business to withstand economic downturns, and make it more attractive to potential buyers.
All the while, however, the founder has to consider what will become of their business, or of the value it represents, upon their demise. There are many factors to be considered; for example, will the business be sold; if all or part of the business is to remain in the hands of the founder’s family, to whom and how should that ownership be transferred; should the business be obligated to redeem at least a some of the deceased founder’s equity; should the business own life insurance on the founder to fund such a redemption, or to offset any loss of revenue that may result from their absence; will a key employee have to be enlisted to manage the business and help preserve its value; and how will the estate taxes imposed upon the fair market value of the founder’s interest in the business be managed and satisfied.[i]
Many owners will develop an estate plan that may attempt to address and perhaps reconcile at least some of the foregoing considerations. For some, this may include a gifting program to transfer partial ownership of the business,[ii] and of the future appreciation thereon, to members of their family (often in trust).
This estate plan, however, should be flexible enough to adapt to changing circumstances, including a change in assumptions from those on which the plan was initially based. Sometimes, the shortcomings resulting from such a change are not discovered until after the owner’s demise, at which point it may be difficult, if not impossible, to reverse or minimize the damage. In other cases, the decedent’s advisors may have anticipated, or at least considered, various scenarios, as illustrated by a private letter ruling recently issued by the IRS.[iii]
Decedent established Trust as a revocable trust.[iv] Upon Decedent’s death, Trust became irrevocable. Decedent was survived by Spouse, Child 1, and Child 2.
The trust agreement provided that, upon Decedent’s death, Trust was to be divided into two separate trusts: a Marital Trust and a Non-Marital Trust.
Marital Trust was to be funded with property having a fair market value that would generate the lowest marital deduction while also ensuring that no federal estate tax would be owed by reason of Decedent’s death.[v]
The remaining portion of Trust was to fund Non-Marital Trust, which was intended to function as a so-called credit shelter or bypass trust,[vi] the income from which may be available to Spouse but the future value of which would not be included in Spouse’s gross estate.
The trust agreement required the trustee to pay Spouse all the net income of Marital Trust for her lifetime. In addition, the trust agreement provided that the trustee may distribute to Spouse, and only to Spouse during her lifetime, as much principal from Marital Trust as the trustee, in its sole discretion, deemed necessary or advisable for Spouse’s comfort, support, or welfare.[x]
On the basis of these dispositive provisions, the property transferred from Trust to Marital Trust would have qualified for the estate tax marital deduction[xi] – provided the trustee elected such treatment[xii] – and Decedent’s estate would not owe any federal estate tax. However, as a result of making this election, the fair market value of Marital Trust as of Spouse’s date of death would be included in Spouse’s gross estate for purposes of determining her estate tax liability.[xiii]
The executor of Decedent’s estate timely filed Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return. On Schedule M of the estate tax return, the executor elected to treat Marital Trust as qualified terminable interest property.[xiv]
According to the trust agreement, upon Spouse’s death, the remaining principal and income of Marital Trust was to pass to Non-Marital Trust, after payment of any taxes attributable to Marital Trust’s inclusion in Spouse’s estate.
All income of Non-Marital Trust was required to be distributed at least annually among Spouse, Child 1, and Child 2. Trustee was authorized to distribute as much principal of Non-Marital Trust to Spouse, Child 1, or Child 2 as the trustee in its sole discretion deemed necessary for their health, education, maintenance and support.
Upon Spouse’s death, Non-Marital Trust would split into separate and equal shares for Child 1 and Child 2. The assets of each child’s separate share would be distributed outright to him or her at a designated age. At the of Decedent’s death – who predeceased Spouse – both Child 1 and Child 2 had already attained such age – in other words, whatever property was intended for Non-Marital Trust would have immediately passed through to the two children.
Change in Plans
It appears from the facts recited in the ruling, however, that Spouse did not need the income stream from – or the principal of – whatever property would have funded Marital Trust or Non-Marital Trust.[xv]
The trust agreement provided that Spouse could disclaim her right to receive income and principal from part or all of Marital Trust. The agreement provided further that any property disclaimed by Spouse would be added to Non-Marital Trust.
This feature of the trust agreement allowed[xvi] Spouse to remove property from Marital Trust – which would be included in her gross estate at the time of her passing at its then fair market value – by disclaiming her interest in such trust, following which it would pass to Non-Marital Trust.
Spouse proposed to disclaim or renounce both her interest in Marital Trust and, in accordance with State law, her interest in Non-Marital Trust.
After the renunciations, because both Child 1 and Child 2 had attained the age designated in the trust agreement, the property of Non-Marital Trust would be distributed outright to Child 1 and Child 2 under the express provisions of the agreement.
Prior to implementing the foregoing, however, the parties in interest requested that the IRS consider the estate and gift tax consequences arising from the proposed plan.
Decedent’s estate requested the following rulings:[xvii]
1. Spouse’s renunciation of her interest in Marital Trust will be treated as a gift of Spouse’s qualifying income interest in Marital Trust[xviii] and a gift of the remaining portion of Marital Trust.[xix]
2. Spouse’s renunciation of her interest in Non-Marital Trust will be “timely,” and thus, will be a qualified disclaimer for federal tax purposes.
3. After Spouse’s renunciation of her interest in Marital Trust and Non-Marital Trust, no portion of Marital Trust or Non-Marital Trust will be included in Spouse’s gross estate.
Before reviewing the IRS’s analysis and conclusions, it may be helpful to summarize the basic transfer tax principles applicable to the foregoing scenario.
The Code imposes a tax on an individual donor’s transfer of property by gift.[xx] The tax applies whether the transfer is in trust or otherwise, whether the gift is direct or indirect, and whether the property is real or personal, tangible or intangible.[xxi] Thus, any transaction in which an interest in property is gratuitously passed or conferred upon another, regardless of the means or device employed, constitutes a gift subject to tax.
The gift tax imposed a primary and personal liability of the donor,[xxii] is an excise upon the donor’s act of making the transfer, is measured by the value of the property passing from the donor, and attaches regardless of the fact that the identity of the donee may not then be known or ascertainable.
If a person makes a “qualified disclaimer” with respect to any interest in property, the disclaimed interest is treated as if it had never been transferred to the person making the disclaimer for purposes of the federal estate, gift, and generation-skipping tax provisions.[xxiii] Consequently, the disclaiming person is not treated as having transferred the disclaimed property to another – they have not made a gift thereof.
The term “qualified disclaimer” means an irrevocable and unqualified refusal by a person to accept an interest in property, provided (1) the refusal is in writing, (2) the disclaimer is received by the transferor of the interest, their legal representative, or the holder of legal title to the property to which the interest relates within nine months from the date on which the transfer creating the interest in such person is made, (3) the person refusing the interest has not accepted the interest or any of its benefits, and (4) as a result of the refusal, the interest passes without any direction on the part of the person making the disclaimer and passes either to the spouse of the decedent or to a person other than the person making the disclaimer.[xxiv]
The above-referenced 9-month period for making a disclaimer generally is to be determined with reference to the transfer creating the interest in the disclaimant.[xxv] With respect to lifetime transfers (basically, gifts), a transfer creating an interest occurs when there is a completed gift for federal gift tax purposes regardless of whether a gift tax is imposed on the completed gift. With respect to transfers made by a decedent at death or transfers that become irrevocable at death, the transfer creating the interest occurs on the date of the decedent’s death.
Any disposition of all or part of a surviving spouse’s qualifying income interest in any trust property for which a marital deduction was allowed to the predeceasing spouse’s estate (as in the case of Marital Trust)[xxvi] is treated as a transfer of all the interests in the trust property other than the spouse’s qualifying income interest.[xxvii]
Specifically, if a surviving spouse disposes of all or part of their lifetime income interest in any trust property for which a marital deduction was allowed, the surviving spouse is treated as making two transfers: (i) an actual gift of their income interest in the trust,[xxviii] and (ii) a deemed gift of all other interests in the trust (basically, the remainder interest).[xxix]
The amount of the deemed gift resulting from a disposition of all or part of a qualifying income interest for life in the trust is equal to the fair market value of the entire trust property that is subject to the qualifying income interest, determined on the date of the disposition, less the value of the qualifying income interest in the property on the date of the disposition.[xxx]
In this case, Spouse’s renunciation of her interest in Marital Trust will not constitute a qualified disclaimer because it was not made within nine months of the creation of the interest (which in this case was Decedent’s death) and Spouse has already accepted benefits from the Marital Trust.
Thus, the renunciation of Spouse’s interest in Marital Trust will be treated as a disposition of Spouse’s qualifying income interest for life in the Trust property for which a marital deduction was allowed in Decedent’s estate. As a result of this disclaimer, Spouse will make a completed gift of her qualifying income interest in Marital Trust and will be deemed to have made a completed gift of all of the other property and other interests in property then owned by Marital Trust.
Although the ruling was silent on the point, it is reasonable to think that Spouse still had some, if not all, of her exclusion amount available to shelter at least some of the above gifts.[xxxi] By using her remaining exclusion amount now, Spouse removed the Marital Trust property and the future appreciation thereon from her estate. She also made use of her exclusion amount before it is greatly reduced or eliminated after 2025.[xxxii]
Because Spouse’s renunciation of her interest in Marital Trust will result in a completed transfer to Non-Marital trust, Spouse will be considered to make a lifetime gift transfer to Non-Marital Trust. Consequently, the Non-Marital Trust beneficiaries’ interests (including Spouse’s) with respect to the property transferred from Marital Trust will be created as of the date of Spouse’s renunciation of her interest in Marital Trust. Accordingly, the beneficiaries of Non-Marital Trust may disclaim their interests in the property transferred by Spouse to Non-Marital Trust within nine months of Spouse’s renunciation of her interests in Marital Trust.[xxxiii]
Therefore, Spouse’s renunciation of her interest in the property transferred to Non-Marital Trust will constitute a qualified disclaimer. If a person makes a qualified disclaimer with respect to any interest in property, the disclaimed interest is treated as if it had never been transferred to the person making the qualified disclaimer for purposes of the federal transfer taxes. Thus, Spouse’s disclaimer of her interest in Non-Marital Trust will not constitute a gift for purposes of the gift tax.[xxxiv]
When Spouse renounces her entire interest in Marital Trust, Spouse will have made a gift of her qualifying income interest in Marital Trust[xxxv] and a gift of all of the other property and other interests in property then owned by Marital Trust. Accordingly, none of Marital Trust will be includible in Spouse’s gross estate on her passing.[xxxvi]
Finally, because Spouse’s disclaimer of her interest in Non-Marital Trust qualified,[xxxvii] Spouse will be treated as never having received an interest in Non-Marital Trust for estate tax purposes. Accordingly, none of Non-Marital Trust will be includible in Spouse’s gross estate.
The foregoing illustrates just one of many scenarios in which a beneficiary’s disclaimer of an interest in property may be used to save federal transfer taxes.
By disclaiming her interest in Marital Trust and Non-Marital Trust, Spouse was able to eliminate both trusts on an expedited basis, and to facilitate the transfer of Decedent’s property to the Children, as contemplated by Decedent’s Trust, while also reducing her own future estate tax liability.
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[i] Including the federal estate tax, at a rate of 40%.
[ii] I explain to folks that any equity interest they transfer to or for the benefit of family will entail an economic cost; for example, foregone distributions in respect of the transferred interest.
[iii] PLR 202339008 (9/29/2023).
[iv] The Decedent probably also had a pour-over will that directed his probate assets into the former Revocable Trust. Non-probate assets would have passed outside the Decedent’s will and Trust; for example, property owned by the Decedent jointly with Spouse, with right of survivorship (which would qualify for the marital deduction).
[v] After accounting for various deductions (for example, administration expenses under IRC Sec. 2053) and the Decedent’s exclusion amount.
[vi] In general, this trust is funded with an amount equal to the decedent’s remaining exclusion amount. Thus, it is not taxable in the decedent’s estate. In addition, because it is not included in the surviving spouse’s estate, it escapes the estate tax at the death of such spouse.
[vii] IRC Sec. 2010 and Sec. 2505. The exclusion amount is $12.92 million per individual for 2023; it increases to $13.61 million in 2024.
[viii] In other words, Decedent made significant taxable gifts during his lifetime that were sheltered to the extent of his then exclusion amount.
[ix] Because of the uncertainty surrounding the federal estate tax exclusion amount, many estate planners draft “disclaimer” wills or trusts that leave property to the surviving spouse outright, leaving it for such spouse to disclaim a portion of the property, which would then fund the credit shelter trust.
Previously, instruments may have been drafted that provided for the funding of a credit shelter trust with any excess assets passing to the spouse. With the increase in the exclusion amount, however, many surviving spouses faced the prospect of being de facto disinherited.
[x] Spouse had a “qualifying income interest.”
[xi] IRC Sec. 2056.
[xii] IRC Sec. 2056(b)(7) – the “QTIP” election.
[xiii] IRC Sec. 2044. The price of permitting a marital deduction for property that does not pass directly to a decedent’s spouse – only indirectly though a trust – is the inclusion of such property in the spouse’s estate.
Specifically, IRC Sec. 2044(a) provides that the value of the surviving spouse’s gross estate shall include the value of any property in which such spouse had a qualifying income interest for life. IRC Sec. 2044(b) provides that Sec. 2044(a) applies to any property if (1) a marital deduction was allowed with respect to the transfer of such property to the decedent under IRC Sec. 2056(b)(7), and (2) IRC Sec. 2519 did not apply with respect to a disposition by the surviving spouse of part or all of such property.
[xiv] Pursuant to IRC Sec. 2056(b)(7).
[xv] Spouse certainly did not need the accumulation of unspent income in her future gross estate.
[xvi] Wills and trusts often include provisions regarding a beneficiary’s ability to disclaim an interest in property otherwise passing to the beneficiary. Such language is not necessary because state law already provides that right to a beneficiary.
[xvii] These are only three of the rulings requested. Others pertained to Spouse’s condition that the Children pay the gift tax associated with the disclaimed income interest in Marital Trust (a net gift), the reduced value of the deemed gift of the remaining interests in the Marital Trust attributable to Spouse’s right to recover the tax thereon from the Children pursuant to IRC Sec. 2207A, and the inclusion in Spouse’s estate of any gift tax paid by her within three years of her death, under IRC Sec. 2035(b).
[xviii] under § 2511
[xix] under § 2519
[xx] IRC Sec. 2501.
[xxi] Section 2511(a); Reg. Sec. 25.2511-1(c)(1).
[xxii] IRC Sec. 2502(c); Reg. Sec. 25.2511-2(a).
[xxiii] IRC Sec. 2518(a).
[xxiv] IRC Sec. 2518(b).
[xxv] Reg. Sec. 25.2518-2(c)(3).
[xxvi] Under IRC Sec. 2056(b)(7).
[xxvii] IRC Sec. 2519(a) and Sec. 2519(b).
[xxviii] Under IRC Sec. 2511.
[xxix] Under IRC Serc. 2519. Reg. Sec. 25.2519-1(a). The gift tax consequences of the disposition of the qualifying income interest are determined separately under Reg. Sec. 25.2511-2.
[xxx] Reg. Sec. 25.2519-1(c)(1).
Reg. Sec. 25.2519-1(c)(4) provides that the amount treated as a transfer under Sec. 25.2519- 1(c)(1) is further reduced by the amount the donee spouse is entitled to recover under IRC Sec. 2207A(b). If the donee spouse is entitled to recover gift tax under Sec. 2207A(b), the amount of the gift tax recoverable and the value of the remainder interest treated as transferred under IRC Sec. 2519 are determined by using the same interrelated computation applicable for other transfers in which the transferee assumes the gift tax liability.
[xxxi] As indicated earlier, Spouse required that the Children assume responsibility for any gift taxes resulting from the two transfers.
[xxxii] When the enhanced exclusion amount under Pub. L. 115-97 is scheduled to expire.
[xxxiii] State Statute provides, in part, that a person may disclaim, in whole or in part, conditionally or unconditionally, any interest in or over property. Under State Statute, a disclaimer becomes irrevocable when any conditions to which the disclaimant has made the disclaimer are satisfied and when the disclaimer is delivered and filed in accordance with State law. Further, State Statute provides that if a donative instrument expressly provides for the distribution of property if there is a disclaimer, the property shall be distributed in accordance with the donative instrument. However, in the absence of express provisions to the contrary in the donative instrument, the property or interest in property disclaimed, and any future interest that is to take effect in possession or enjoyment at or after the termination of the interest disclaimed, shall be distributed as if the disclaimant had predeceased the decedent.
[xxxiv] What if Spouse’s disclaimer of her interest in Non-Marital Trust were not a qualified disclaimer? In that case, Spouse would be treated as having made a gift of such interest. Query how this discretionary interest would have been valued.
[xxxv] Under IRC Sec. 2511.
[xxxvi] Under IRC Sec. 2044(a).
[xxxvii] Under IRC Sec. 2518.