Disclaimer Trusts and Portability

disclaimer trustThe usual testamentary intent for a couple is for the deceased spouse’s estate to pass to the surviving spouse.   The IRS allows the estate of the first spouse to die to pass to the surviving spouse estate tax deferred.  Taxes only become due and payable on the surviving spouse’s estate upon the subsequent death of the surviving spouse.  Currently, each spouse has more than $12M of exemption to use during life or upon death ($24+M per couple).  This level drops to $5M per spouse (adjusted for inflation) in January 2026.  This means that taxes are only owed in amounts in excess of the exemption level.  Accordingly, the exemption of the first spouse to die is squandered because of the tax deferral, unless a Disclaimer Trust is funded or Portability elected.

A Disclaimer Trust is a trust created in a last will and testament.  The purpose of the trust is to capture the exemption of the first spouse to die and keep the assets of the deceased spouse out of the surviving spouse’s taxable estate.  The surviving spouse can be both the beneficiary of the Disclaimer Trust and the trustee of the trust provided that distributions from the trust are limited to (1) income earned by the trust, (2) an ascertainable standard, and (3) a 5&5 power.  The ascertainable standard usually reads “for the health, education, maintenance and support of the beneficiaries.”  This is IRS lingo for living expenses.  The 5&5 Power allows the surviving spouse to request the greater of $5,000.00 and 5% of the trust principal every year to be used in any manner of the surviving spouse’s choosing.

The beauty of the Disclaimer Trust is that it is flexible.  The couple does not have to decide if they want to fund the trust, and if so, at what level at the time they prepare the Wills.  They can take a wait and see approach and make the decision after the first spouse dies.  The Will directs that the estate of the first spouse to die goes to the surviving spouse outright.  The surviving spouse then has up to nine (9) months to disclaim, or refuse, some or all of the inheritance to be directed into the Disclaimer Trust.  In the event there is no estate tax at the time of the first spouse’s death or the exemption amount is well above the couple’s net worth the surviving spouse may opt not to disclaim the inheritance rendering the Disclaimer Trust unused.

 Upon the death of the surviving spouse, the balance of the trust, including the appreciation since the death of the first spouse,  transfers to the children or other beneficiaries estate tax free.

Alternatively, Portability provides that the surviving spouse can add to his or her exemption the unused exemption of the deceased spouse, provided an election is made on the federal estate tax return for the deceased spouse.

The Disclaimer Trust has two significant advantages over Portability.  First, what Congress giveth, Congress can taketh away.  Congress can repeal Portability at any time.  Second, without a trust, all of the assets of the deceased spouse’s estate appreciate inside of the surviving spouse’s estate adding to a potential estate tax liability.  With a Disclaimer Trust the original assets from the deceased spouse’s estate and the appreciation on those assets pass estate tax free.

Some simple examples will illustrate the utility of the Disclaimer Trust. For purposes of this exercise assume that the exemption is $5M/person.

Scenario 1:  NO TRUST/NO PORTABILITY:           Spouses have reciprocal wills and estates of $5M each.  First spouse dies and the estate goes to the surviving spouse with no taxes due because of the tax deferral.  The surviving spouse dies years later with an estate of $15M (the sum of two estates valued at $5M each and appreciation of $2.5M on each estate) but only one $5M exemption.  Accordingly, the estate of the surviving spouse owes 40% (federal estate tax rate) of $10M or $4M in taxes.

Scenario 2:  PORTABILITY:          Same as Scenario 1, except the estate of the deceased spouse files a federal tax return and elects portability.  Now the surviving spouse has an estate of $15M and $10M of exemption and owes  40% of $5M or $2M in taxes.

Scenario 3:  DISCLAIMER TRUST:            Same as Scenario 1, except the reciprocal wills had Disclaimer Trusts.  When the first spouse died the surviving spouse disclaimed the $5M from the deceased spouse’s estate into the Disclaimer Trust.  Now the surviving spouse has an estate of $7.5M ($5M original value plus $2.5M appreciation) and an exemption of $5M and owes 40% of $2.5M or $1M in taxes.  The $7.5M in the Disclaimer Trust passes to the beneficiaries estate tax free. 

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