In the world of estate planning, there are many things an individual can do in order to avoid estate and inheritance taxes. A relatively little-known preparative measure is something called a disclaimer trust. But before we talk about the specifics of the disclaimer trust, it’s important to first establish what it’s meant to minimize estate and inheritance taxes.

What Is an Estate Tax?

An estate tax is primarily levied by the federal government, although several states also have their own estate taxes. Often referred to as a “Death Tax,” an estate tax aims to tax a deceased person’s estate before the assets are disseminated to beneficiaries, or heirs.

Luckily, the estate tax at the federal level only kicks in for estates valued higher than $12,060,000 if the owner dies in 2022. If the gross estate is valued at less than that amount, the estate tax won’t apply. This means that only about 0.1% of estates in the U.S. actually receive estate taxation. However, for those that do, the estate tax can create quite a burden on beneficiaries. Additionally, come 2026, the estate tax rate will be reduced to $5,000,000 per individual estate, meaning many more households will be subjected to it in the near future. It’s important to begin planning now.

What Is an Inheritance Tax?

While an estate tax targets the deceased, an inheritance tax targets the beneficiaries of the estate. So, when it comes to the inheritance tax, the recipient of the estate will be taxed based on their specific share. An inheritance tax is a type of state tax levied by only certain states; there is no federal inheritance tax.

A state inheritance tax works this way: Linda wishes to leave a $600,000 inheritance to her husband, her son, and her sister, split equally among the three. Under certain state inheritance tax rules, when Linda passes away, her son and husband will not need to pay any inheritance taxes on their $200,000 shares. However, her sister will need to pay sizable inheritance taxes on her $200,000 share.

How Does a Disclaimer Trust Work?

A disclaimer trust is a special kind of trust that directly relates to estate planning. The creator of the trust will include many provisions, often created within a will. When the creator of the trust passes away, the special circumstances of the trust can allow their surviving spouse to “disclaim” some portions of the estate. These disclaimed portions will then be included in the disclaimer trust that the original estate owner set up.

A disclaimer trust is robust in its flexibility. It even offers options for regular payouts from the trust to be given to the beneficiaries, functioning as income.

How Can a Disclaimer Trust Avoid Taxes?

Typically, any transfers to a surviving spouse due to death or incapacitation are free from federal and state estate and inheritance taxes. A disclaimer trust, which will sometimes be referred to as a “marital disclaimer trust” for this reason, is a trust that will ultimately be controlled by a surviving spouse, but is created by the deceased spouse before their passing.

A disclaimer trust is used by married couples to create an irrevocable trust for their estate plans. An irrevocable trust is a trust that cannot be altered or ended after its creation, even by the grantor of the trust. Irrevocable trusts are brilliant tools in estate planning to avoid or minimize certain taxes, as they are not taxed under the estate and inheritance tax laws.

What makes a disclaimer trust unique is that the deceased spouse assigns their entire estate to their surviving spouse with a stipulation. The stipulation is that the spouse is allowed to “disclaim” or “reject” any part of the estate or inheritance. Any rejected assets get funneled into the irrevocable trust, which is typically controlled by the surviving spouse, meaning that the surviving spouse will still get all of the income and benefits of the disclaimed assets, subject to some conditions. It is entirely up to the spouse how much they disclaim, and often a spouse will disclaim an amount that brings the estate below the federal estate taxation rate of $12,060,000.

For example, let’s say Alex and Betty are a married couple. Betty passes away with assets worth $13,060,000, which means that $1,000,000 would be subject to an estate tax upon Betty’s death. Luckily, Betty had the foresight to set up a disclaimer trust, and left her entire estate to Alex. Alex then disclaims about $1,000,000 worth of assets to be put into the trust, thus dropping the estate value below the tax threshold and avoiding estate taxes.

What Is an Alternative to a Disclaimer Trust?

When it comes to an estate tax, a married couple is allowed a certain amount that is exempt from any federal estate taxes – $12,060,000 as noted earlier. Portability is an alternative to a disclaimer trust which allows a living spouse to make use of any unused exemption that the deceased spouse did not.

For example, let’s go back to the couple in our last example: Alex and Betty. Betty passes away with an estate worth $8,000,000, meaning that her entire estate is exempt from any estate taxes. Alex then passes away a decade later, but his estate is now worth $14,000,000, which would ordinarily be subject to an estate tax. Betty did not use $4,060,000 of her exemption, and if it was elected on her last tax return after she passed away, Alex can “port” (or carry over) that excess exemption to his estate, meaning that he will not have to pay estate taxes despite his estate being over the $12,060,000 threshold.

While portability is an option, a disclaimer trust is usually the preferred method to reduce estate taxes due to its consistent reliability. Namely, a disclaimer trust will not cause the appreciating estate to be taxed. Portability does not create a trust, meaning those same assets can be taxed based on their appreciation. This inflates the value of the estate of the surviving spouse, potentially subjecting it to higher taxes if the excess deceased spouse exemption does not cover the entire value.

Considerations for Creating a Disclaimer Trust

The biggest potential issue is that a disclaimer trust hinges upon the trust the creator has with their spouse. There is a time period on how long the spouse has to disclaim assets. This time period is generally nine months, and any assets that are not disclaimed by the spouse will be subject to ordinary estate and inheritance taxes.

The process of disclaiming assets is complicated, and a persistent issue is that the spouse will fail to seek an estate attorney to help with the disclaiming process before the nine-month period is over. Consulting an experienced estate attorney can help avoid these situations. An attorney will know what questions to ask in order to understand spousal dynamics, and whether a disclaimer trust is the best option for a particular situation.

Why Hire an Attorney?

It’s always difficult to contemplate one’s possible future incapacity and how to manage assets, estates, and affairs before it happens. Disclaimer trusts can be particularly volatile and complicated. While they can be a good option, it is crucial that an estate attorney be consulted to find out whether it’s the right option for your specific situation. A variety of estate plans exist, and a disclaimer trust is just one option.

At Rosenblum Law, we’ll work with you to create a plan that covers all of your bases and leaves your family prepared to take on any situation and manage your affairs in the way you wish. Call us today to get started with a free consultation with one of our experienced estate planning attorneys.