By Cowles Liipfert & Don Wells

Changing Tax Environment

(Note: This article is written discussing North Carolina law.  North Carolina is a “common law” state and is not a “community property” state.  This state’s laws may be similar to those in other common law states, but they generally are very much different from those in community property states.)

The federal gift and estate tax laws occasionally change with the blowing of the political winds and with annual inflation adjustments.

With the high gift and estate tax exemptions now in effect ($13.61 million per person in 2024 and over $27 million for a married couple, assuming that both spouses’ exemptions are utilized), estate taxes are currently not a problem for most of us.  However, the current estate tax exemption is scheduled to expire after 12/31/2025, at which time it will be cut in half unless the laws are changed.  Elections will be held later in 2024, which could impact those laws.

Consequently, it is important to build flexibility into one’s estate planning documents, so that they can be adapted to fit the laws in effect at the time of one’s death, whenever death may occur and whatever the laws may be at that time.  Those documents can consist of more than wills and trust agreements.  They can include life insurance and retirement account beneficiary designations, and ownership or survivorship designations, such as payable-on-death (POD) accounts and transfer-on-death (TOD) accounts.  These documents can be set up to anticipate the possible use of qualified disclaimers as a means of fitting one’s estate plan to the tax laws in effect at some time in the future to achieve one’s goals.

Also qualified disclaimers sometimes can be used to improve poor estate plans or even the estates of individuals who die without wills, but disclaimers in such situations would likely be less effective than if they had been anticipated during the estate planning process.

A qualified disclaimer of property which passes at death in North Carolina needs to be in writing and filed with the Clerk of Court within 9 months after the donor’s date of death, among other requirements.  The disclaimer must clearly identify the property which is being disclaimed (such as a survivorship interest in a joint-and-survivor account).  Also, the person making a disclaimer cannot appoint someone to whom the disclaimed assets pass.  Disclaimed assets must pass to a successor by operation of law.    

A qualified disclaimer will not be effective if the property has been “accepted” prior to the disclaimer.  For example, if an individual accepts a stock dividend check, he or she cannot later disclaim the shares on which those dividends were paid.  One must be very careful when using qualified disclaimers.

This article addresses specifically how disclaimers may be used as a means of accomplishing a couple of specific tax planning goals: (1) federal estate tax savings, and (2) reducing capital gains taxes.

Disclaimers to Minimize Taxable Estate of Surviving Spouse

Most assets left by one spouse outright to the other spouse qualify for the federal estate tax marital deduction, which is not limited to any specific dollar amount.  Due to the marital deduction, when one spouse dies and leaves all his or her assets to the surviving spouse, there is no federal estate tax.  Consequently, if the surviving spouse disclaims assets, up to his or her applicable exemption amount, there are no immediate estate tax savings attributable to the disclaimer – because there’s no federal estate tax in either event, but there can be benefits later.

The rules applicable to qualified disclaimers favor disclaimers by a surviving spouse over disclaimers by others.  Persons other than a spouse cannot disclaim assets which go into a trust of which they are beneficiaries, for example, unless they also disclaim their beneficial interest in that trust.  A spouse, on the other hand, can be a beneficiary of a trust into which disclaimed property passes. 

If a surviving spouse disclaims property at the death of the first spouse to die, the disclaimed property does not become part of the surviving spouse’s taxable estate, which presumably will save estate taxes at the second death.

An estate plan can be established so that assets can be left to a family trust by disclaimer, instead of outright to the spouse, which trust will not become part of the taxable estate of the surviving spouse.  A family trust would not be subject to federal estate tax at the first spouse’s death if it did not exceed his or her applicable exemption at the time of the disclaimer.  The trust would minimize estate taxes upon the death of the second spouse to die, since that trust would not be subject to federal estate tax as part of the surviving spouse’s taxable estate.

That is, an estate plan can allow the surviving spouse to disclaim assets which would otherwise pass outright to him or her, in which case the assets could pass under an alternative provision into a Family Trust. The Family Trust can be for the benefit of the surviving spouse and other family members.  The income and principal assets of the trust could be available for the benefit of the surviving spouse, if needed. The qualified disclaimer would be drafted to disclaim the outright gift to the surviving spouse, but he or she could still be a beneficiary of the Family Trust.

In other words, the overall estate planning documents would include two alternative plans – let’s call them Plan A and Plan B.   Plan A could provide that the assets would pass to the surviving spouse, outright and free of trust, but if the spouse disclaimed that devise (a devise is a testamentary gift), the assets would pass under Plan B into a Family Trust, which would not deprive the surviving spouse from access to the trust’s income and assets, if needed, but which would not be subject to federal estate tax at the death of the surviving spouse.

There would be no federal estate tax at the first death under either plan, but Plan B would result in a smaller taxable estate at the surviving spouse’s death.

By including both alternatives in the planning process, the decision could be postponed, and it would not be necessary to choose between Plan A and Plan B until after the testator’s death, at which time the facts and applicable law would be known.

Portability of Deceased Spousal Unused Exclusion (DSUE)

Portability is another alternative for preventing the total loss of a deceased spouse’s unused estate tax exclusion, for assets left by a deceased spouse to the surviving spouse.  Portability is not automatic but requires the personal representative of the deceased spouse to file a timely Form 706, Federal Estate Tax Return, for the deceased spouse, electing on the return to preserve the unused estate tax exclusion of the deceased spouse to reduce estate taxes upon the death of the surviving spouse.

This is a valuable option, but it has some drawbacks, as compared to leaving the assets to a Family Trust:

For one, the amount of the exclusion is frozen and is not indexed for future inflation, whereas if the assets of a Family Trust appreciate in value, the appreciation occurring after the first spouse’s death would not be taxable as part of the estate of the surviving spouse.  Historically, investment assets have appreciated in value, often doubling or tripling in value over 10 to 20 years. 

Another drawback:  If the surviving spouse remarries and predeceases the successor spouse, the DSUE amount from the prior spouse can be used on his or her federal estate tax return, but if the successor spouse also predeceases him or her, the surviving spouse will lose the ability to use the DSUE amount from the prior spouse, because a surviving spouse is limited to only one such exclusion – the exclusion of his or her last spouse to die.   The surviving spouse may be able to claim the DSUE of the successor spouse, if available, by filing file a Form 706 for the successor spouse, and claiming the exclusion for the successor spouse on that return, but loses the DSUE amount of the prior spouse.  In other words, the surviving spouse cannot claim more than one spousal exemption.   With a Family Trust, the trust assets remain exempt from federal estate tax at the death of the surviving spouse, whether or not he or she has remarried and whether or not he or she is predeceased by a successor spouse.

Disclaimer by Spouse to Achieve Higher Cost Basis for Income Tax Purposes

A seldom-used opportunity for tax planning is the use of a qualified disclaimer to achieve higher cost basis for capital gains tax purposes for assets owned by someone who has low-cost-basis assets, which have appreciated considerably in value since they were acquired.

For example, one spouse may own securities now worth $3.5 million, which were acquired, either by purchase or by gift or by family inheritance, at a value of $500,000.  If those assets were sold for $3.5 million, the taxpayer would likely incur over $900,000 in combined state and federal capital gains taxes.

If the taxpayer was not in a hurry to sell those assets when he or she was doing estate planning, perhaps for sentimental reasons, but generally felt that diversification in investments would be a good long-term strategy for the family, he or she could have an estate plan which included a method by which potential capital gains tax liability could be reduced or possibly even eliminated after the death of his or her spouse.

Let us assume that a wife owned those assets worth $3.5 million and was in her late sixties or early seventies, and that her husband was older – say in his seventies or early eighties, and was in fairly good general health.  Because women generally live longer than men and because she was younger than her husband, the wife would be likely to outlive her husband.

In this situation the wife could transfer some assets into a joint-and-survivor account with her husband, but could retain practical control of the account with his cooperation and assuming that he would not have a need to take distributions from the account during her lifetime.  Later, if the husband predeceased the wife, she would disclaim her right of survivorship over her husband’s joint interest in the account, which would then pass the disclaimed assets under his will or revocable trust agreement into a family trust for the benefit of the wife and children.

Discussion of Legal Fictions

This alternative can be better understood if the reader is familiar with the term, “legal fiction.”  A “legal fiction” is a rule of law which is assumed to be true and is not allowed to be disproved, but which is actually false.  Legal fictions are intended to be beneficial in character. 

An example of a legal fiction is adoption, in that the adoptive parents become the legal parents notwithstanding the lack of a biological relationship, and the biological parents are deemed to be no longer related to the child.

There are three legal fictions involved in the disclaimer example discussed above, where the wife opened a joint-and-survivor account with her husband and after her husband’s death disclaimed her survivorship interest in his share of the account:

First, the initial transfer of assets to the joint-and-survivor account is deemed to be an incomplete gift for gift and estate tax purposes even though the husband has all legal rights as a co-owner of the account.

Second, the disclaimer by the wife after the husband’s death would be deemed to have occurred retrospectively, prior to the husband’s death, even though no formal disclaimer was made until after his death.

Third, the husband and wife would each be deemed to own separate one-half interests in the account, although the account was owned jointly at the time of his death.

By virtue of these three legal fictions working in tandem, the “incomplete” gift to the husband of a joint interest in the account would be deemed to have been completed when he died, and the husband would be deemed to be the owner of one-half the account at his death.  Due to the disclaimer, that interest would pass to the Family Trust at his death.  The wife’s ownership of the other half interest in the account would not be terminated by the disclaimer of her survivorship interest in her husband’s half of the account, and would remain an asset of the wife’s estate at its low cost-basis. 

Consequently, the Family Trust could sell the assets which it received from the account at little-to-no capital gain, and could re-invest the proceeds in other securities, to diversify the overall family portfolio.  

Conclusion

Consequently, one-half of the account would be included in the husband’s taxable estate for federal estate tax purposes and a step-up in cost-basis would apply to that half interest.  There would be no basis step-up for the wife’s separate interest in the account, since she originally funded the account with her assets and retained her interest after the husband’s death.

By the way, it is not necessary to file a federal estate tax return to qualify for a step-up in basis.  The test for getting a step-up in basis would be that, if an estate tax return had been required, whether the value of the husband’s half of the assets in the account would be included as a taxable asset of his estate.  It makes no difference whether an estate tax return was actually filed.

Under the example discussed above in which the wife’s cost basis was $500,000 in an account worth $3.5 million on the date of transfer into the joint-and-survivor-account, there would be potential tax savings of several hundred thousand dollars when the assets in the account were later sold.  For determining gain or loss, each asset in the account would be itemized separately on the capital gains schedule of the trust’s fiduciary income tax return, and the account would not be listed as one collective asset. 

This plan would not be appropriate for many taxpayers due to their personal circumstances, but might be appropriate for someone as part of an overall estate plan.  One risk is that the value of assets in the account could nose-dive before the husband’s death, for example, or other unanticipated circumstances could occur.

If such a plan were implemented, the husband and wife would need to be very careful not to upset the applecart.  The husband in our example should not take any distributions from the joint-and-survivor account during his lifetime, which would be deemed an acceptance of the asset which made the distribution, and upon the sale of such asset, there would be no step-up in cost basis.

Please note that the plan would need to be managed carefully, that is:

• To be safe, the account should be created when the husband was likely to live for several years. He should have a medical examination to determine his actual health, and his life expectancy should not be determined by an actuarial table.
• The spouse must not receive any benefits from the account during his or her lifetime.
• The disclaimer should be filed before those assets were transferred to the trust, and also prior to the sale.

The use of a qualified disclaimer to obtain a partial step-up in cost basis is very technical, and a family which utilizes such a plan should have the assistance of a qualified attorney in doing so.

The financial advisor should also be apprised of the purpose of the plan, preferably in writing, and given strict orders not to issue distribution checks, either to the donee spouse or in the names of both spouses.  Such checks might be considered distributions to the donee spouse.  Distributions from the account should be to the donor spouse only.  If a financial advisor does not know the purpose of the tax planning, he or she might suggest that any similar accounts owned by a husband and wife with each other should be put into one joint account with survivorship, which the advisor might consider easier to manage, but which would mess up the entire tax plan.

This type of plan is not for everyone, but it can save substantial capital gains tax in some circumstances. 

If you want to discuss such a plan with our firm, please feel free to contact us at 336-725-2900.