Taxes

The Purpose of Disclaimers and How to Use Them

Although most individuals gladly welcome an inheritance, there are occasions in which one may want to forego part or all of one.  The vehicle by which to do so is known as a disclaimer.

A disclaimer is a post-mortem estate planning device which affords the estate a limited opportunity to alter the distribution of assets following the death of a decedent.  Although an individual can always disclaim the receipt of a full or partial inheritance, such disclaimer will act as a taxable gift unless it is executed, served upon the personal representative and filed with the surrogate’s court within nine months after the decedent’s date of death.

A disclaimer is used for a variety of reasons.  The three primary reasons are : (1) simple generosity, (2) to fund a tax planning trust, and (3) to otherwise minimize the exposure of one’s estate to death taxes.

The first reason is very straightforward.  For example, a parent dies and leaves her estate equally among her own children.  One of the children who does not need or desire the inheritance would rather see it distributed to his own children.  By using a disclaimer, assets that would otherwise pass to him may pass to his children.  (This assumes they are the contingent beneficiaries of their father’s share.)

The second is to fund a tax planning trust.  For example, many married couples execute disclaimer trusts to minimize exposure to federal and state estate taxes.  In New Jersey, the applicable exclusion amount from this tax is currently $675,000.  When one spouse dies, the other can put a portion of the deceased spouse’s estate into a trust for his or her benefit but which will pass tax free to the children or other heirs when both spouses die without being taxed.  In essence, the proper use of a disclaimer trust can shield twice the exclusion amount, or $1,350,000, from this tax.  To do so, assets passing to the surviving spouse can be disclaimed to go into this trust.

The third reason is to minimize an heir’s own estate from tax planning.  If an heir has a taxable estate of their own, they may not wish to add to it.  A disclaimer of an inheritance allows them to do so.

A disclaimer can be used for both probate and non-probate assets.  It can also be used to disclaim future interests.  A disclaimer may be of a full or fractional share.  A disclaimer of a fractional share may be expressed either as a dollar amount or percentage, or any limited interest or estate.  N.J.S.A. 3B:9-2.

Pursuant to N.J.S.A. 3B:9-3, as well as Section 2518 of the Internal Revenue Code, in order for a disclaimer to be effective, the writing of disclaimer must be signed and acknowledged by the person disclaiming and shall: (a) describe the property or interest disclaimed, (b) note the municipality and county of the property if it is real estate, and (c) declare the disclaimer and extent thereof.

In the event the disclaimer is being made on behalf of another decedent’s estate, a minor or an incompetent, such disclaimer may be made by the personal representative or guardian.  However, such disclaimer must be made with the approval of the surrogate’s court controlling the other decedent’s estate or in which the incapacitated person or minor resides.  N.J.S.A. 3B:9-4.

It must be noted that the right to disclaim does not give the disclaiming party a right to appoint a successor party to obtain the disclaimed property or interest.  A disclaimer will act to pass the property or interest to the next party or parties in interest per the will or intestacy statute as if the disclaiming party predeceased the decedent.  As such, it is imperative to ascertain who will be the successor(s) in interest prior to making a disclaimer.  If the party who wishes to disclaim wants other individuals to received the inheritance, he or she will have to accept them first, then make gifts.  This is not a tax free event like a disclaimer though and would be subject to rules regarding gift, estate and inheritance taxes.

There are a variety of transfer taxes which affect a decedent’s estate.  In the State of New Jersey, the estates of decedents are subject to two primary forms of death tax.    The first is the New Jersey Transfer Inheritance Tax which is a tax on the heirs of an estate.  The second is the New Jersey Estate Tax which is a tax upon the estate itself and is based on the size of the estate.  Our previous blog focused on the New Jersey Transfer Inheritance Tax.  This entry reviews the basics of the New Jersey Estate Tax.

The New Jersey Estate Tax originally acted to absorb the maximum credit allowed for estate death taxes under federal law when a federal estate tax was due and owing.  It provided for an estate tax in addition to the inheritance tax in instances in which the inheritance taxes paid to New Jersey and/or any other state, as well as the District of Columbia, were not sufficient to fully absorb the maximum allowable credit for such payments against the federal estate tax upon a New Jersey resident. N.J.S.A. 54:31-1 et.seq.  Like the federal return, the state estate tax return is due within nine months of a decedent’s date of death.

This tax only applied for New Jersey residents. For non-resident and alien decedents, New Jersey merely collects the inheritance tax.

Until 2002, no New Jersey estate tax was due when the aggregate of the inheritance tax paid to New Jersey and the similar taxes paid to other states exceeded the maximum credit allowable under IRC Section 2011(c), which currently is 80%. N.J.A.C. 18:26-3.1(b). Moreover, no tax was due nor was there any requirement to file a New Jersey Estate tax return if a federal return was not required.

However, on July 1, 2002, legislation was enacted to limit the exemption on state estate tax returns.  N.J.S.A. 54:38-1.  The most notable part about this change is that the state unified credit or exemption amount no longer rises in the same manner as the federal credit or exemption.  Effective retroactive to January 1, 2002, the exemption for state estate tax was frozen at $675,000, which was the same level for the state and federal estate tax returns initiated by a death occurring in 2001.

In light of the foregoing, any estate between $675,000 and the federal estate tax exclusion amount (currently $5,340,000) will not have to pay federal estate tax, but will have to file a state estate tax return.  In addition, this tax is considered a lien of unlimited duration against the estate until it is paid.

In short, in 2002, the New Jersey Estate Tax transformed from being a sponge tax to an independent tax.  In planning for and administering an estate, it should not be overlooked.  It should be noted that spouses and Class E beneficiaries are exempt from both federal and state death taxes. Spouses are exempt due to the unlimited marital deduction whereas charities are exempt due to the charitable deduction.

A New Jersey Estate Tax may be assessed those to other Class A beneficiaries which include parents, children and other lineal descendants.  Although such beneficiaries are exempt from the New Jersey inheritance tax, they are still limited by the applicable exclusion amount set forth in federal estate tax system.

The New Jersey estate tax is calculated as follows:

Inheritance Tax Rates

Pursuant to statutory law, the aforementioned beneficiaries are taxed at the following rates:

1.  Class A: beneficiaries are completely exempt from the inheritance tax N . J . S. A. 54:34-2, et.seq.;
2. Class C: beneficiaries are each entitled to an exemption for the first $25,000.00. Thereafter, they are taxed at the following rates, pursuant to N.J.A.C. l8:26-2.7:

   • Taxable Inheritance	Net Tax	% on Excess
     $25,000.00	$0	11%
     $1,100,000	$118,250.0	13%
     $1,400,000.0	$157,250.0	14%
     $1,700,000.00	$199,250.0	17%

3. Class D beneficiaries are entitled to an exemption of $499.00 each. Thereafter, they are taxed at the following rates, pursuant to N.J.S.A. 54:34-2(d):15% on any amount up to $700,000.00, and16% on any amount in excess of $700,000.00.Interestingly, the tax on Class D transferees has a cruel twist in that a bequest in the amount of $500.00 or greater is taxed retroactive to the first dollar. Thus, an individual who receives $499.00 from an estate pays no tax, yet an individual who is to receive $500 must first pay a tax of $75.00 before receiving his or her net inheritance of $425.00.
4. Class E beneficiaries are totally exempt from the inheritance tax. N.J.S.A.54:34-4.ValuationProperty must be appraised on its clear market value as of the date of death. N.J.A.C. 18:26-8.10. This rule applies not only to post-mortem transfers, but certain inter vivos transfers which are deemed taxable as well (as noted in following section).Transfers Subject to Inheritance TaxThe following transfers are subject to the inheritance tax:

• transfers by will;
• transfers by intestacy;
• transfers of jointly held property in which a beneficiary inherited by right of survivorship;
• transfers, such as revocable trusts and annuities, which are intended to take effect upon or after death; and
• transfers made within three years of death. This last category presumes that gifts made three years prior to death were in contemplation of death and were only made to avoid the inheritance tax. However, this presumption is can be rebutted.

Exempt Transfers

Certain transfers are exempt from the inheritance tax. Such exempt transfers include:

1. exemptions for each class of transferee, as detailed in Subsection 2, entitled “Inheritance Tax Rates”, above;
2. most public employee pensions and annuities; and
3. most notably, life insurance proceeds which are payable to a named beneficiary other than decedent’s estate, executor, trustee, or administrator.

Deductions

Permissible deductions include, but are not limited to:

1. reasonable funeral and burial expenses;
2. reasonable administrative expenses, including attorneys’ fees and accountants’ fees;
3. commissions for the executor or administrator, as set for in the state’s regulations:
4. expenses for last illness; and
5. debts due and owing on the date of death so long as such debts actually diminish the estate.

With the beginning of another year comes changes in the laws effecting federal estate and gift taxes.  There are three primary taxes in this area: (1) federal estate, (2) the generation skipping transfer (GST), and (3) the gift tax.

For the year 2014, the exclusion from the federal estate tax is $5,340,000.  This is an increase of $90,000 over last year’s exclusion amount of $$5,250,000.  The exemption from the GST tax similarly increased from $5,250,000 to $5,340,000.  The gift tax annual exclusion remains at $14,000.  However, the lifetime gift tax exclusion increased to $5,340,000 as the lifetime gift exclusion is unified of linked with the federal estate tax.  Specifically, the exclusion can be used either during lifetime or upon death.  Any amount of the exclusion used during lifetime offsets that which can be used upon death.

For New Jersey residents, the state estate tax exemption remains unchanged at $675,000.

As always, proper planning is imperative.  In addition for individuals and couples to desire shielding the exposure of estates to death taxes, prudent planning can preserve assets from long term care costs and unnecessary administrative fees.  Moreover, it can insure that distributions to heirs can be undertaken in a manner to minimize income tax ramifications among other goals.

On behalf of the Trusts and Estates group at Capehart & Scatchard, we wish you a very prosperous 2014.

Lou Grant owned a successful horse tack business worth millions.  Through gifting and his estate, this business passed to his son, Lou Jr.  His daughters, Nancy and Virginia, had an opportunity to participate in this business but refused to sign the requisite agreements to do so based on the advice of Virginia’s husband who is an attorney.  Ironically, despite this apparent poor counsel, they filed a Will contest and other litigation to get the benefits of the business divided equally among the three children after their father died.

The good news for Lou Jr.was that the Will was upheld and he kept the business.  However, the bad news was that Lou was left with approximately 97% of the tax bill for the estate taxes which exceeded $1,000,000.  This result was mandated by the New Jersey Appellate Court despite language in the Will which said that the taxes were to be paid from the residuary estate.  However, after rounds of protracted litigation, the amount in the residuary estate was approximately $150,000.

This case highlights the need to closely examine how the provisions in a Will interact.  After gifting the business, there was not enough funds to pay the taxes from the residue.  Thus, clear direction needs to be obtained regarding these issues.  Moreover, this case reinforces the need for competent advice and the acknowledgement that Wills can’t be treated as fill-in-the-blank forms.

Questions regarding this article may be sent to Publications@Capehart.com.

Although the American Taxpayer Relief Act of 2012 (“ATRA”) might have made estate planning simpler for most taxpayers by “permanently” increasing the federal estate tax exemption to $5,000,000 (indexed for inflation), it has simultaneously increased the income tax cost of creating and maintaining trusts to protect those assets from the beneficiaries’ creditors (including spouses), and to keep those assets out of the beneficiaries’ estates for estate tax purposes.

Under ATRA, effective January 1, 2013, the top income tax rate for estates and trusts increased from 35% to 39.6% for taxable income over $11,950.00, and the tax rate on qualified dividends and capital gains increased from 15% to 20% for taxable income over $11,950.00.  In addition, under the Affordable Care and Patient Protection Act, there is a 3.8% Medicare tax on the lesser of net investment income or taxable income above $11,950.00 for estates and trusts.

As a result, many estates and trusts will be hit with a tax of 43.4% on ordinary income and 23.8% on qualified dividends and capital gains, and these rates are higher than would be the case if the assets generating that income were owned by individuals and not held in trust.

This is significant because trusts are an integral part of many estate plans.  For example, the Will of a married person typically creates a Credit Shelter Trust for the estate tax exempt amount, to keep that amount, together with the income and growth thereon, out of the surviving spouse’s estate, but available for the spouse in case he or she ever needs it.  The Credit Shelter Trust also protects against the spouse’s potential creditors (including future spouses).  Additionally, many married persons also leave the amount in excess of the estate tax exempt amount in a marital Q-tip trust for the benefit of the spouse – similarly protecting the principle against the spouse’s potential creditors (including future spouses).  And significantly, many people establish trusts for the benefit of their children and/or grandchildren (whether because of their age, spendthrift tendencies, incapacity, or any number of other reasons).  Such trusts may or may not be tax motivated, but could nevertheless feel the pinch of these new income tax laws.

Bottom line, although trusts continue to protect assets against estate taxes and potential creditors, and in some cases protect children or even grandchildren against their own indiscretions (and against creditor and spousal claims), ATRA has increased the income tax cost of maintaining such trusts.  Clients may therefore wish to consider whether the benefits of creating such trusts now outweigh the costs, and Trustees should consider whether the benefits of maintaining trusts outweigh the income tax costs.  If trusts are to be implemented or maintained both clients and Trustees should consider some or all of the following ways to mitigate the effect of the increased tax rates for estates and trusts:

a.  Distribute income to beneficiaries .  To the extent the trust distributes income, the income will be taxable to the beneficiary at the beneficiary’s rate.

b.  Invest for qualified dividends, long-term capital gains and tax-exempt income.

c.  Limit turnover, so as to minimize capital gains taxes.

d.  Distribute capital gains to beneficiaries.  It is sometimes possible to include capital gains in distributable net income (DNI), in which case the capital gains will pass through to the beneficiaries.

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This blog was prepared by Robert S. Lewis, Esq. For over 45 years, Mr. Lewis has concentrated his practice in estate planning, estate and trust administration, real estate, and corporate and business matters. Contact him at: rlewis@capehart.com

Whew!  I don’t know about you but I am glad that Fiscal Cliff stuff is over — well, at least the automatic tax increase part of it. Among other issues covered in the American Taxpayer Relief Act of 2012, Congress finally resolved the uncertainty in the federal estate and gift tax law that has been plaguing us since 2009.  Starting in 2010, there was no estate tax, then there was a tax but only on assets above $5 million, then there was the possibility that a 55% tax would apply in 2013 to assets above $1 million…how could we possibly plan in that climate?

Well the uncertainty is gone and we are all in a much better place.  I won’t go into all the details of the Tax Act, because you will be bombarded with numerous summaries of the new Act.  But we now know that the federal estate and gift tax will only apply to assets over $5 million (actually $5.25 million as adjusted for inflation in 2013) at a maximum rate of 40%. For families with less than $5 million, the planning becomes much easier and certain.  I would still recommend that, if you are in this category, you create trusts in your Will for your beneficiaries – not for tax reasons, but to protect your beneficiaries from claims of creditors, matrimonial claims, or to protect a beneficiary who can’t make wise financial decisions.  As I have mentioned before, there are many different types of trusts and a full discussion of those is not the point of this post.

The Tax Act also made permanent the concept of “Portability” – the ability of a surviving spouse to “use” the unused share of the $5 million exemption of his or her deceased spouse.  Remember, you can leave any amount to a spouse (transfers to a spouse are exempt from estate or gift tax) and can devise assets (including lifetime gifts) worth up to $5 million to all others without paying any estate tax.  But what if the first spouse to die does not use all of his exemption? With Portability, the surviving spouse can use the unused portion of the deceased spouse’s exemption amount to protect her own assets.  Say the first spouse to die has an estate of $2 million and the surviving spouse has $6 million. Using Portability, even with total family wealth of $8 million, no federal estate tax would be due after the death of both spouses. If the first to die leaves his assets to his spouse, he uses none of his exemption (since transfers to a spouse are gift and estate tax free). His entire unused exemption of $5 million can be carried over (it’s portable – get it?) to the surviving spouse. She can now protect the family wealth of $8 million, and could even protect an additional $2 million, using her own exemption of $5 million plus the $5 million from her deceased husband.

There are many regulations and limitations, but that is the concept of Portability. It was first introduced on a temporary basis for 2011 and 2012, but no one knew what was supposed to happen to it after 2012.  So it was not very valuable – to be effective, both spouses would have to die no later than 2012.  But now it is permanent. It will be especially helpful for families where one spouse has more assets than the other if ownership cannot be equalized easily.  For instance, suppose one spouse has the bulk of her assets tied up in an IRA. It is impossible to transfer ownership of assets tied up in retirement accounts between spouses, so Portability can help eliminate estate tax in this situation.

There will be many uses for the concept of Portability.  While it will not replace a well thought out estate plan, Portability will be another tool for an estate planner to consider in helping you in the future.

Questions regarding this article may be sent to Publications@Capehart.com.

Well, the results are in.  President Obama has been re-elected.  The Democrats have won the Senate.  The Republicans have won the house.  No party can claim a mandate.

What does this mean for us?  From the standpoint of estate and gift taxes, it means a lot.  Currently, each individual has a $5,120,000 exemption from the federal estate tax.  The exemption also applies to lifetime giving.

These exemptions are scheduled to expire at the end of this year.  Absent new legislation, the current law will sunset and the exemptions will revert to $1,000,000.  In that event, estates in excess of this amount will be taxed at rates ranging from 41% to 55%.   The exemption for gifting will be $1,000,000 as well.

Three scenarios could occur as to this law: (1) the current law could be extended, (2) the current law can expire and we can revert to the old law, or (3) new legislation can be passed.  Most likely, the second scenario will play out.

Why? President Obama has stated that he would not extend the current law before and that was when he had incentive to work with the Republicans on this issue.  He proposed a compromise of a $3,500,000 exemption which was rejected.  Moreover, he does not have to do anything to reinstate the $1,000,000 exemption.  The law will change, for lack of a better term, due to inaction.  Finally, the chance of new legislation being passed is slim.  The gridlock inWashington will not be broken over this issue.

So, what should you do?  Without question, you should review your existing estate plan.  Gifts can be made between now and the end of the year up to the $5,120,000 exemption amount.  These can be outright gifts or those made through a variety of trusts.

Contact an attorney in our group.  We will be happy to assist you in any way we can.