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Strategic Use of Disclaimers

This blog is intended to be a general overview of how one may strategically disclaim an interest in an inheritance, why they might do so, and the benefits to such a disclaimer. It will also touch briefly on the evolution of disclaimers from the old-English common law to the modern Uniform Probate Code. In order to properly discuss these issues we must first define and explain inheritance.

Basics

When a person dies they leave behind all the property that they once owned. This property is generally distributed in one of two main ways; either by will, or intestate distribution.
 
Testacy
If a person leaves behind a properly drafted and executed will then they are said to have died testate. This will should outline exactly how the person wanted his or her property to be distributed after his death. Each person named to receive something in the will is called a devisee and the gift left to him or her in the will is called an inheritance.
 
Intestacy
If a person does not leave a will, or does not leave a properly executed will he or she is said to have died intestate. The property that one leaves behind after dying intestate is passed on through something called intestate distribution. Although it may vary slightly depending on the jurisdiction essentially, intestate distribution passes one’s property to family members based on the closest relation, which could include spouses, children, parents, grandparents, siblings, etc. Each person entitled to a share of the property passing through intestate distribution is called an heir and his or her share of the estate is also called an inheritance.

Disclaimers

Although named in a will or eligible to collect through intestate distribution, one is not required to accept an inheritance and may refuse it; this refusal is called a disclaimer. When a person disclaims his interest in an inheritance it is treated as if the person pre-deceased the person who died and his share of the inheritance goes to another heir.  Disclaimers work exactly the same with distributions through trusts, as well.
With that basic information established we can now focus on why one would disclaim an interest in an inheritance and the benefits of doing so. The major reasons that one would consider disclaiming an inheritance are to avoid creditors, and  avoid, or lessen tax liabilities while keeping property in the family; or to simply avoid inheriting unwanted property.

Avoiding or Lessening Tax Liabilities

Under the English common law, there was no such thing as disclaiming an inheritance through intestate distribution; instead one could refuse the inheritance and it was then treated as if title to the inheritance passed through that heir before moving onto the next heir in line. While the end result was the same, the situation was treated as if the renouncing heir received the inheritance and then gifted it to the next heir; this created a tax liability in the renouncing heir, which they would still be responsible for paying, despite never receiving the property.
 
As mentioned earlier, when one disclaims an inheritance today they will generally not be responsible for the gift tax attached to the inheritance. Under the modern rules of inheritance established mainly by the general acceptance of the Uniform Probate Code, by treating the disclaiming heir as if they predeceased the decedent, we remove the tax liability and allow the inheritance to flow directly to the new heir without creating a tax liability in the disclaiming heir. Unless there is a specific line of distribution set out in a will or trust to account for a disclaimer to a specific piece of property the usual recipient of disclaimed property will typically be the disclaimer’s children.
 
The guidelines for properly disclaiming an interest in an inheritance in order to avoid the federal gift tax liability can be found in the Internal Revenue Code at §2518. IRC §2518 states that in order for a disclaimer to be a “qualified disclaimer” the disclaiming heir must make the refusal irrevocable and unqualified; in writing and delivered to the owner of the property, or legal representative no later than 9 months after the day the interest vested, or the disclaimant turns 21; and the disclaimant must never have accepted the property or any of its benefits. If these guidelines are properly followed then “the disclaimer causes the disclaimed property to pass—without any direction from the disclaimant—to someone else.”
 
As stated above, in virtually all circumstances a proper disclaimer must be irrevocable, this is not always true however. In 2004 the Massachusetts Supreme Judicial Court allowed a woman to reform her previously “irrevocable” disclaimer to a trust in order to prevent her children—who the disclaimed interest passed to—from having to pay excessive taxes because of a Federal generation-skipping transfer tax exemption issue that she was unaware of prior to filing the disclaimer. The SJC reasoned “that a disclaimer may be reformed in circumstances…where there is decisive evidence of the decedent’s intent to minimize tax consequences and where that intent was clearly frustrated.”1
Generation-skipping transfer taxes are complex rules set up by the federal government in an attempt to stop people from avoiding estate/lifetime gift taxes by making strategic bequests that skip generations, such as gifting to grandchildren instead of children. For a more thorough explanation of the generation-skipping transfer tax please visit the article in the footnote.2

Avoiding Creditors

Disclaiming an inheritance can allow an heir to avoid having property lost to creditors while keeping it in the family. The majority of disclaimer statutes state that the disclaimer will date back to the exact time that the interest in the inheritance vested. Because of this, it is treated as if the disclaimant never had a right to the disclaimed property.  In these situations this means that any creditors attempting to collect on debts owed by the disclaimant cannot seize or attach liens to the property that the disclaimant refused and the property will pass, unattached and unburdened to the next heir.
 
Disclaiming an inheritance to avoid creditors is a powerful tool, however it is not a complete protection from all creditors. It has been established by case law that one cannot disclaim to avoid previously existing state or federal tax bills.3  In the context of bankruptcy law there has been a bit of a change in the last couple years regarding the disclaimer of inheritance. A recent Ninth Circuit, Court of Appeals case stated that in order for a trustee to be able to avoid a disclaimer and go after the disclaimed inheritance the bankruptcy court must determine whether state law holds that the person disclaiming had a property interest in the disclaimed gift. If state law says that no property interest existed after the disclaimer, then the bankruptcy trustee may not take the property on behalf of the unsecured creditors, despite the 2 year look-back period.4

Avoiding Unwanted Property

In some instances there may be a piece of property left through a will or intestate distribution that simply is not wanted. This is perhaps best illustrated with a hypothetical: A dies, leaving her last possessions, a run-down house and all the property therein to her only surviving heir B. The only problem is that A was a pack rat and the house is filled with tons of worthless trash and newspapers from 20 years ago. It’s so bad that it would cost more money to clean the house out and bring it up to code than it would make once it was sold on the market.
 
What is B to do?
Well in this instance B can disclaim her inheritance and avoid the hassle of dealing with the struggle and expense of cleaning and fixing up the old house only to lose money on it once it could be sold. In this instance, if B truly is the only heir that A left behind the house and everything else would likely escheat.
Property will escheat if a person dies with no heirs to receive their property. When this happens the state takes possession of the escheated property and may dispose of it as it chooses.
 
While not always a perfect solution, the disclaimer of a gift can prove to be a powerful tool to the savvy estate planner. When properly implemented it can help to avoid large tax liabilities and prevent unwanted seizure by most creditors while keeping property in the family or to simply avoid an unwanted gift altogether. Whatever the intended purpose, all of the consequences of a disclaimer should be considered before making determining to make one. It is also always advisable to consult with a trusted CPA when dealing with any type of tax liability.

1 Kaufman v. Richmond, 442 Mass. 1010, (2004)
 
2 The Generation-Skipping Transfer Tax: A Quick Guide by Mark E. Powell, Esq.
http://www.journalofaccountancy.com/issues/2009/oct/20091804.htm
 
3 Drye v. United States, 528 U.S. 49, 1999
 
4 In re Costas, 555 F.3d 790 (2009)

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