National Association of Estate Planners and Councils

June, 2009 Newsletter
Provided by Leimberg Information Services

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McDaniel on Costas – New Disclaimer Case

"Death and taxes and childbirth. 

There's never any convenient time for any of them."

– Margaret Mitchell

In his commentary, Steve McDaniel , an authority and frequent lecturer on the topic of disclaimers, reviews the case of In re:  John M. Costas and Rachelle M. Costas, where the Court of Appeals for the Ninth Circuit held that a disclaimer was not a transfer of property within the meaning of the bankruptcy statute.

A. Stephen McDaniel is the senior attorney with Williams, McDaniel, Wolfe & Womack, P.C., and the managing attorney for the firm's estate planning/probate section.  Steve's practice is limited to estate, charitable and business continuation planning, and probate and trust administration. 

Steve is a Fellow in the American College of Trust and Estate Council, a Certified Estate Planning Specialist by the Tennessee Commission on Continuing Legal Education and Specialization, an Accredited Estate Planner (AEP), and holds an Estate Planning Law Specialist (EPLS) designation awarded by the Estate Law Specialist Board, the only approved American Bar Association program which certifies specialists in the field of estate planning.

Steve is also Past President of the National Association of Estate Planners and Councils. But perhaps most important to all of us who are grandfathers, Steve is a co-author of  A Grandparent's Guide to Gifted Children  which covers the unique roles of grandparents, building a bond with a grandchild, and maximizing grandparenting.

EXECUTIVE SUMMARY:

Disclaimers represent perhaps the most valuable post mortem tool available to us.  The current economic storm, coupled with the increase in the federal estate tax exemption equivalent from $2 million to $3.5 million, makes the utilization of disclaimers perhaps our first line in fixing an estate plan after death for tax purposes.  But disclaimers do more.

The Costas case[[1]] is a classic example of the utilization of a disclaimer for other than tax purposes.  In Costas, the Court of Appeals for the Ninth Circuit held that a disclaimer was not a transfer of property within the meaning of the bankruptcy statute.  The ruling of the Court affirms that, properly done and based on applicable state law, disclaimed property may not be brought back into the bankrupt's estate.

FACTS:

In October, 2001, Edward Dittlof created a Revocable Living Trust under Arizona law which distributed his property at his death to his children, including daughter, Rachelle.  The trust provided that should a beneficiary die prior to the distribution, the beneficiary's children would take the share.

Dittlof died in 2002 leaving Rachel a portion of his estate.  Later that year, Rachel executed a disclaimer under Arizona law relinquishing her claim to the trust property.  Shortly thereafter, Rachel filed for bankruptcy under Chapter Seven.

The Trustee in bankruptcy sought to void the disclaimer under 11 U. S. C. 548 as a "transfer" before the date of the filing of the petition on the basis of actual or constructive fraud.  The Trustee argued that the Supreme Court's decision in Drye[[2]], which generally held that a disclaimer was not effective with respect to federal tax liens against the disclaiming party, required the Court to direct the same result and avoid the disclaimer thus making the property available to the Trustee in bankruptcy.  The bankruptcy appellate panel ruled in favor of the disclaiming party.  The Ninth Circuit affirmed.

A REVIEW OF DISCLAIMERS

Before returning to the Costas decision, a review of disclaimers is appropriate.

The concept of refusing an inheritance is not as basic as one might assume.  In Hardenbergh v. Commissioner[[3]], the Court noted that "the general rule as to intestate succession is that the title to the property of an intestate passes by force of the rule of law . . . and that those so entitled by law have no power to prevent the vesting of title in themselves."

The Court found that absent statutory authority to the contrary, an heir entitled to inherit through intestacy has no right to disclaim or refuse the inheritance.  Rules as to devisees or legatees under Wills have generally been that the recipient can refuse such an inheritance.[[4]]

The current statutory world changed in 1976 with the enactment of the Internal Revenue Code 2518.  Every state followed with the enactment of new disclaimer statues.

Section 2518 sets forth five basic requirements for the execution of a qualified disclaimer.  Causing the disclaimer to be "qualified" is important in that failure to meet the rules results in the disclaimer constituting a taxable gift for gift tax purposes.  Thus, if the disclaimer is not "qualified," not only is the original transfer taxed, such as the death of the parent, but the transfer is taxed again as a gift at the time the disclaimer is made.

The requirements of a disclaimer are as follows:

·        It must be irrevocable and unqualified.[[5]]

·        The disclaimer must constitute a refusal by a person to accept an interest in property distributable to the person by gift or by reason of death.

·        The disclaimer must be in writing.[[6]]  No specific form is required.

·        The disclaimer must be received by the transferor or his legal representative no later than nine months from the date on which the transfer creating the interest in such person is made.[[7]]  The nine month rule is unforgiving.  Knowledge of the transfer is not important. The rule applies to direct and indirect beneficiaries and holders of powers of appointment as well as vested and contingent remainder holders.  No extensions are available for the nine month rule.

·        The person making the disclaimer must not have accepted any interest in the disclaimed property or any of its benefits.[[8]]  No consideration may be given for the disclaimer.  Thus, entering into a "plan" whereby "if you disclaim for my benefit, I will do something for your benefit such as gift property back to you" effectively destroys the qualification of the disclaimer.  There are multiple rulings addressing what is and what is not acceptance of an interest in the disclaimed property, many of which are actually favorable to the taxpayer.

 

·        The disclaimed interest must pass without any direction or control by the disclaimant.[[9]]  The disclaiming party cannot direct the disposition of the disclaimed assets.  The assets pass either as provided in the document (Will, trust or beneficiary designation) which may or may not contemplate the disclaimer, or by law as though the disclaiming party is deceased.  Knowing where the property will pass before executing a disclaimer is most important.

An exception to the fifth rule relates to a spouse.[[10]]  A spouse can disclaim and still benefit from the property.  Thus, assets distributable outright to a spouse who disclaims may pass into a trust for the benefit of the spouse.

Such disclaimers allow for the funding of a Credit Shelter Trust when assets are not otherwise owned in a manner conducive to same.

WARNING:

In the case of assets such as insurance which is payable outright to a spouse who disclaims into a Credit Shelter Trust, it is imperative that the spouse does not retain any form of limited power of appointment.  To do so violates the rule. The spouse cannot direct the later disposition of the property.

WHAT CAN BE DISCLAIMED

 

Most everything can be disclaimed.  Property which can be divided into separate parts each of which, after severance, maintains a complete and independent existence can be disclaimed.[[11]] Fractions or percentages can be disclaimed.[[12]] Pecuniary interests can be disclaimed.[[13]] Powers of appointment can be disclaimed.[[14]]  Joint property[[15]], IRAs [[16]] and most all assets can be disclaimed.

A trust beneficiary may not disclaim income from specific assets that remains in the trust[[17]] nor may a beneficiary of a fee simple interest in real property disclaim the remainder interest but retain the life estate.[[18]]

But let's go back to Costas.

COMMENT:

The primary question in Costas was whether a disclaimer qualifies as a "transfer . . . of an interest of the debtor in property" under the bankruptcy law.  Although the case was based on Arizona law, it is likely applicable to most jurisdictions.

We begin by looking at the words "transfer" and "property" contained in the bankruptcy statute.

The Code defined the term "transfer" as "each mode, direct or indirect, absolute or conditional, voluntary or involuntary, of disposing of or parting with – (i) property; or (ii) an interest in property."

The Court in Costas rightly held that whether a particular action constituted a "transfer" was a matter of federal law.  The Court did, however, note that a transfer "cannot occur without 'property' or 'an interest in property.'"  Thus, the case turned on whether the disclaiming party transferred a "property interest" as determined under state law.

As a general rule, bankruptcy courts look to Butner v. United States[[19]], in determining what is or what is not "property."  The Court in Butner concluded that Congress left the determination of property rights in the assets of a bankruptcy's estate to state law.  The question was whether the rule in Butner was perhaps modified by Drye.

In Drye, the disclaiming party inherited an interest in his mother's estate after the IRS had obtained a tax lien on all of the disclaiming party's property and rights to property. Drye disclaimed his inheritance and argued that he had no "property" to which the IRS lien could attach.

The Supreme Court disagreed and held that the tax lien attached to the disclaiming party and the disclaimed assets despite state law disclaimer relation back rules.  The Court found that the power to "channel" property through a disclaimer constituted "property" under federal tax lien provisions.

In Costas, the bankruptcy Trustee argued that the "right to channel" had been recognized as property in Drye for tax lien cases.  Why should it not be recognized as property for other purposes such as bankruptcy?

The Costas court found the Drye case distinguishable based on timing issues pointing out that in Drye the tax lien was already in place prior to the execution of the disclaimer and that in Costas the disclaimer occurred before the petition for bankruptcy was filed meaning that the "retroactive divestment of property interests occurred prior to the bankruptcy estate gaining any interests in the right to disclaim."

Secondly, the Court pointed out that Drye was a tax lien case and the Court's language in Drye repeatedly stressed this limitation.  Thus, tax lien rules do not necessarily translate directly into bankruptcy rules and in the tax lien context, collection of taxes is the primary focus and "justifies the extraordinary priority accorded federal tax liens."

This case reminds us of the value of utilizing disclaimers for non-tax purposes.  Properly used, a disclaimer will not help us avoid death but it may well help us avoid taxes.  In this case it helped avoid creditors, too.

Hope this helps you help others make a positive difference.

Steve McDaniel

CITE AS:


LISI Estate Planning Newsletter # 1463 (May 14, 2009) at http://www.leimbergservices.com  Copyright 2009 Leimberg Information Services, Inc. (LISI).  Reproduction in Any Form or Forwarding to Any Person Prohibited - Except With Specific Permission.

CITES:


[[1]] In re:  John M. Costas and Rachelle M. Costas, No. 06-16520 (9th Cir., February 6, 2009).

[[2]] Drye v. United States, 528 U. S. 49 (1999).

[[3]] 198 F.2d 63 (8th Cir. 1952), cert. denied, 344 U. S. 836 (1952).

[[4]] See, Brown v. Routzahn, 63 F.2d 914 (6th Cir. 1933), cert. denied, 290 U. S. 641 (1933).

[[5]] Section 2518(b).

[[6]] Section 2518(b)(1).

[[7]] Section 2518(b)(2).

[[8]] Section 2518(b)(3).

[[9]] Section 2518(b)(4).

[[10] ]Section 2518(b)(4)(A).

[[11]] Section 25.2518-3(a)(1)(i).

[[12]]Section 25.2518-3(b).

[[13]] Section 25.2418-3(c).

[[14]] Section 25.2518-3(a)(1)(iii) and Section 25.2518-3(d), ex 21.

[[15]] Section 25.2518-2(c)(4)(iii).

[[16]] Rev. Rul. 2005-36.

[[17]] Section 25.2518-3(a)(2).

[[18]] Section 24.2518-3(b).

[[19]] 440 U.S. 48 (1979).

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