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Post Mortum Fixes

Presented by
Thomas Christensen Esq.
Blackburn and Stoel

May 21, 2008

POST MORTEM FIXES

Thomas Christensen, Jr.
Salt Lake Estate Planning Council
May 21, 2008

I. OVERVIEW. It is not uncommon to find out after someone has passed away that the planning documents, ownership of assets or beneficiary designations are different than or in conflict with what was anticipated, or that intended steps or actions were not taken, or simply that mistakes or errors were made. Like many estate planning professionals, I have "inherited" many estate or trust situations with such problems and finding myself saying "I wish things were done differently." This outline is intended to address some of the problems encountered after the death of an individual, and options available to try to fix or correct some of the problems.

II. LACK OF ADMINISTRATION AFTER FIRST SPOUSE DIES. A common occurrence is that marital deduction planning documents are executed by husband or wife, but after first spouse dies little, if any, administration steps are taken and we don't find out about it until after the surviving spouse dies.

A. Is Estate Tax Benefit of Bypass Trust Lost? Suppose the combined total of all assets of couple exceeds the estate tax exemption amount, but nothing was done after the death of the first spouse to fund the bypass trust. Can the bypass trust established in the planning documents of the first spouse to die still be recognized to save estate taxes for the benefit of the children or other beneficiaries?

1. If all assets are held in joint tenancy or surviving spouse is designated as the beneficiary of other assets and more than nine (9) months have elapsed since the date of death of the first spouse, there is probably not much the estate planning professional can do to correct the problem.

2. If assets of first spouse to die are still held in trust or in his or her individual name, you might still be able to fund the bypass trust and take advantage of death tax exemptions for both spouses. A constructive trust argument that surviving spouse was holding assets pursuant to the terms of the bypass trust might also be pursued (may be worth a shot) or a claim against the estate of the second spouse to die for failure to perform fiduciary duties (probably a longer shot) might also be pursued.

3. Professional may want to file delinquent fiduciary income tax returns for the bypass trust for the years between the death of the first spouse and the second spouse. If surviving spouse has reported all of the after death income on his or her individual return and if bypass trust provides for at least discretionary distribution of income to the surviving spouse, there may not be any significant fiduciary income tax liabilities owing by the bypass trust.

B. Delinquent Probate. If property is titled in the name of the first spouse and more than three (3) years have elapsed since the death of the first spouse, the decedent's estate or will cannot generally be probated (U.C.A. § 75-3-107(3)). However, a formal probate proceeding to determine the heirs of the decedent can still be pursued and an Order Determining Heirs can be recorded or presented to transfer ownership to the heirs. If the beneficiaries under the will are the same as the intestate heirs, the application of the three (3) year rule should not be a major problem. But what if the beneficiaries and heirs are different? An often overlooked section is U.C.A. § 75-3-102 which provides that the will may still be used as evidence to establish title in the beneficiaries of the will, if a probate of the estate has not occurred and if the devisees or his or her successors have possessed the property devised in the will.

III. DISCLAIMERS. Disclaimers are one of the most frequent (if not most frequent) techniques used to make post mortem corrections or fixes. To be effective for federal transfer tax purposes the disclaimer must be a "qualified disclaimer" as defined in IRC § 2518. To be effective for state law purposes the disclaimer must meet the requirements of U.C.A § 75-2-801. In most cases if the disclaimer meets the federal law requirements as a "qualified disclaimer" it will also meet the state law requirements and vice versa (but there are some differences-see III. B. below).

A. Qualified Disclaimer Tests. Four tests must be met for the disclaimer to be deemed qualified for federal transfer tax purposes:

1. The "Writing" Test. The disclaimer must be in writing that adequately describes the disclaimed property.

a. The writing is not required to be notarized.

b. Writing should identify all interest in property, estate or trust or a part or fractional interest or power or right being disclaimed.

c. Writing should be signed by the disclaimant or representative of disclaimant.

2. The "Nine Month" Test. The disclaimer must be received by the transferor, legal representative or holder of title to property no later than nine (9) months after the date of the transfer creating the interest in the disclaimer that is made (or nine months after disclaimant attains the age of 21).

a. To verify receipt of the disclaimer it is a good idea to have person receiving disclaimer acknowledge receipt. Under state law, if disclaimer is not delivered it must be sent by certified or registered mail, return receipt requested.

b. The nine month period begins to run on a general power of appointment at the death of the holder of the general power of appointment, but the nine month period begins to run on a limited power of appointment (or a special power of appointment) on the date the power is created.

c. The nine month period begins to run with respect to a remainder beneficiary of a QTIP trust on the date of death or the date of gift by the first spouse (and not the death of the second spouse).

d. All disclaimers must be completed within the nine month period. For example, if parent disclaims and child is the first contingent beneficiary and grandchild is the second contingent beneficiary, a disclaimer would have to be made by the parent and a second disclaimer by the child, both in the nine month period, in order for the asset to pass to the grandchild.

e. Disclaimer of survivor's one-half (1/2) interest in joint tenancy real property other than bank and investment accounts (must be made within nine months after the death of the first joint tenant). State law may actually allow for the disclaimer of the entire interest in the joint tenancy real property (and not just the survivor's interest) if the surviving joint tenant has not contributed to the property.

f. With respect to jointly held bank and investment accounts which are revocable transfers (i.e., either party can take money out of the account) the transfer is deemed to be incomplete until sums are actually taken out of the account and surviving joint tenant should be able to disclaim the entire account within nine months from the date of death of the first joint tenant to die (except for the contributions made by the surviving joint tenant).

g. If the disclaimant is under the age of twenty-one (21), disclaimant has until nine months after the date he attains the age of twenty-one (21) to make the disclaimer (this is the only exception to the nine month period).

3. The "No Benefit" Test. Disclaimant must not have accepted the property or any benefit from it.

a. If the disclaimant actually receives the benefit of the disclaimed asset (such as taking money out of a joint account even if done by accident) it probably disqualifies the disclaimer.

b. A mere "expectation of a future benefit in return for executing a disclaimer" generally will not be treated as an acceptance to disqualify the disclaimer (in other words, a "little" pressure from parent to child to execute a disclaimer should be o.k.)

c. If a beneficiary who disclaims an interest in property is also a fiduciary, actions taken in a fiduciary capacity should not be treated as an acceptance of the disclaimed property or any of its benefits.

d. If a surviving joint tenant of residential real property disclaims the one-half survivorship interest and continues to reside in the property (i.e., the survivor is still the owner of his or her one-half interest) residing in the residence will normally not be treated as an acceptance of the asset to disqualify the disclaimer.

4. The "Passage Test". The property must pass without direction from the disclaimant, to either (1) the transferor's spouse; or (2) a person other than the disclaimant.

a. If the disclaimant (other than the spouse) disclaims an interest in the property, but would receive a portion of the disclaimed property as the default beneficiary (or one of the default beneficiaries) the disclaimer would not be considered effective unless the disclaimant also disclaims the contingent interest as well.

b. Although a spouse can disclaim an interest in property and still be a beneficiary of a trust having the same property, the surviving spouse may still not direct the transfer. If the surviving spouse disclaims an interest in property at the death of the first spouse and the disclaimed asset passes to the bypass trust, the surviving spouse can still be the trustee of the bypass trust and can still be the income beneficiary or the discretionary income and principal beneficiary of the trust (if limited to the ascertainable standard), but the surviving spouse cannot have a special power of appointment over the disclaimed property. In such a case, the surviving spouse would also want to disclaim the special power of appointment as well (in many planning documents a disclaimer trust will be created to receive the disclaimed property which has the same provisions as the bypass trust, but without the special power of appointment).

5. Non-Qualified Disclaimer. If a disclaimer does not meet the above tests and is therefore deemed not to be a qualified disclaimer, the disclaimer is treated as a gift from the disclaimant to the recipient of the disclaimed interest (and if the disclaimed interest passes to a trust, the annual gift tax exclusion might not be available because typically a transfer to a trust is deemed to be a future interest).

B. State Law Variations. In order to be deemed a qualified disclaimer for federal transfer tax purposes, the disclaimer should also meet all state law requirements. Additional state law requirements and modifications from federal disclaimer law include the following:

1. Future Interest. Under Utah law, the disclaimant may disclaim a future interest not later than nine months after the event determining that the taker of the property or interest is finally ascertained and his or her interest is indefeasibly vested (the nine month period can be extended if the disclaimant does not know the existence of the interest and disclaims within nine months from learning of the existence of the interest) (U.C.A. § 75-2-801(2)(b)). For example, an irrevocable trust created during lifetime of the settlor creates a life estate interest in a beneficiary commencing at the death of the settlor. The life estate beneficiary would still be able to disclaim the interest in the trust for Utah state law purposes (but not for federal transfer tax purposes) within nine months from the date of death of the settlor or perhaps later if the existence of the interest is not known, rather than within just nine months from the date of the creation of the trust.

2. Joint Tenancy Property (including real property). A surviving joint tenant may disclaim the entire interest in joint tenancy property (federal disclaimer law usually limits this to only the survivor's interest in joint tenancy real property, etc.) if the joint tenancy was created by act of the deceased joint tenant, the survivor did not join in creating the joint tenancy and has not accepted a benefit under it.

3. Filing Requirements.

a. If disclaimer disclaims interest in estate, disclaimer should be filed in the probate proceeding and copy given to personal representative (U.C.A. § 75-2-801(2)(a)).

b. If disclaimer disclaims interest in property or right in trust, disclaimer should be filed with trustee.

c. If disclaimer disclaims interest in a contract (such as a beneficiary designation under a retirement plan, insurance contract or annuity contract) disclaimer should be filed to the person who has legal title or possession of the interest disclaimed (plan administrator, insurance company, etc.).

d. If disclaimer disclaims survivorship interest in joint tenancy real property, disclaimer should be recorded with the county recorder's office. (U.C.A. § 75-2-801(2)(d))

C. Partial Interests. The disclaimant can disclaim an undivided interest in a property or even all interest in a specific asset and still receive the remaining undivided interest or remaining assets. However, the disclaimant cannot disclaim a remainder interest in a trust and retain a life estate interest (and vice versa).

D. Formula Disclaimer. Formula disclaimers (such as a fraction of properties based upon final values determined for estate tax purposes) have also been approved (although sometimes reluctantly) by the IRS.

E. Fiduciary as Disclaimant. A personal representative may disclaim on behalf of the decedent's estate or as guardian or conservator on behalf of an incapacitated person even if the fiduciary receives a direct benefit because the disclaimer is still in a fiduciary, not an individual capacity. Utah state law specifically provides that a fiduciary can disclaim on behalf of a person although court approval of a disclaimer for an incapacitated person may be necessary. Fiduciary should also be able to disclaim a fiduciary power, but if the power is beneficial to the beneficiaries of a trust, court approval may be required or be appropriate, if trust document does not authorize disclaimer.

F. Uses of Disclaimer. There are several reasons why a beneficiary or intestate heir may want to disclaim an interest in the will, trust, intestate estate or contract (such as an insurance contract).

1. Altruistic Motives. A common reason is simply that the disclaimant does not need the property and is agreeable that the property can pass to the default beneficiary. Typically, the default beneficiary will be the children of the disclaimant, and the effect of the disclaimer is that the property can pass to the children without any gift or deemed transfer from the disclaimant to the children.

2. Rearrange Disposition of Non-Probate Assets. An heir or beneficiary may also disclaim an interest to correct what the heir or beneficiary considers to be an inappropriate disposition under the decedent's estate (will, trust or intestate). For example, a child who is named as the 100% beneficiary of a life insurance contract could disclaim all or a portion of the contract to allow the disclaimed portion to pass to the other beneficiaries of the estate or trust and thereby equalize probate and non-probate transfers among the beneficiaries.

3. Creditor Avoidance. Creditor avoidance is often a reason for executing a disclaimer, but may not work where federal law applies.

a. If disclaimant has federal tax liens assessed against him or her, the disclaimer of property probably does not defeat the IRS' ability to reach the assets disclaimed to satisfy the federal tax liens (Dyer v. U.S., 528 U.S. 49 (1999).

b. If the disclaimant disclaims prior to filing bankruptcy, the bankruptcy trustee will probably not be able reach the disclaimed assets to include as a part of the bankruptcy estate (In re: Sanford, 2007 WL 914864 (10th Cir. BAP, Wyo)) (i.e., the disclaimer should not be treated as a transfer of interest or even a fraudulent transfer because the disclaimer relates back to the death of the decedent).

c. A disclaimer by a beneficiary currently receiving Medicaid benefits would not likely work if challenged (Query: would the disclaimer still be effective if the disclaimer is made before Medicaid qualification, but within the five year "look-back" period?).

d. If the disclaimant is facing a lawsuit or even has a civil judgment against the disclaimant, the disclaimer probably works to avoid the creditor because of the relation back doctrine (i.e., the disclaimer relates back to the death of owner and thus, should not be treated as a "transfer" for fraudulent transfer purposes).

4. Fixing the Marital Deduction. A disclaimer can also be used to cure a trust otherwise intended to qualify for QTIP treatment, but does not meet all of the requirements to qualify for the federal estate tax marital deduction. For example, if a marital trust grants trustee discretionary power to make distributions to children of first spouse to die, such children could disclaim such interest in the trust and thereby "cure" the deficiency and thereby enable the trust to qualify for the estate tax marital deduction. Further, if the surviving spouse has been granted a special lifetime power of appointment over the QTIP trust, the surviving spouse could disclaim such lifetime special power of appointment to "cure" the QTIP trust to qualify for the estate tax marital deduction.

5. Bypass Trust Cures. As noted, the surviving spouse may disclaim an interest in property that would otherwise pass to the surviving spouse outright and still be a beneficiary of the bypass trust that receives the disclaimed property. For example, if appropriate marital deduction planning is in place at the death of the first spouse to die, but too many assets are held in joint tenancy or the surviving spouse is designated as the outright beneficiary of too many assets, surviving spouse may disclaim the right to receive the asset outright so that the asset passes to the bypass trust. The surviving spouse may still be the trustee of the bypass trust (assuming discretionary principal distributions are limited to the ascertainable standard) and as long as the surviving spouse does not have a power of appointment over the disclaimed assets. Thus, if the bypass trust grants the surviving spouse a special power of appointment, the surviving spouse may have to do two disclaimers, one with respect to the outright bequest and the second with respect to the special power of appointment (many estate planning documents will provide that any assets disclaimed by the surviving spouse pass to a "disclaimer" trust which is usually identical to the bypass trust, but without the special power of appointment-this approach will still allow the surviving spouse to have the flexibility of a special power of appointment over the assets otherwise passing to the bypass trust).

A trust beneficiary could also disclaim a "bad" power granted to him that would otherwise potentially result in an adverse estate tax consequence. For example, if a child is a trustee of a generation-skipping trust and principal invasion standards contain a bad term such as "comfort", the trustee/beneficiary should be able to disclaim the right to receive any benefits under the trust pursuant to such bad term, and thereby not be treated as the owner of the assets of the trust for estate tax purposes (i.e. if standard is not appropriately limited, child would be considered as having a general power of appointment over the assets of the trust).

6. Disclaimers with Retirement Plans and IRAs. As noted, a disclaimer can be made of the disclaimant's interest in a contractual arrangement such as a retirement plan or IRA. A common estate planning technique is to name the spouse as the direct beneficiary of an IRA or retirement account, but to also provide in the estate planning documents that any disclaimed assets would pass to a disclaimer trust (or the bypass trust without a special power of appointment). Under this approach, the surviving spouse could "wait and see" how the numbers work out to determine if it would be advantageous to disclaim part of the interest in the retirement plan or IRA and allow such interest to pass to the disclaimer trust or bypass trust for the benefit of the surviving spouse. As a general rule, retirement plans and IRA accounts (other than Roth accounts) are poor assets to use to fund bypass trusts because of the income tax consequences associated with the distributions from the accounts. Thus, such a disclaimer approach to retirement plan and IRA accounts would likely only be used when an anticipated estate tax savings associated with the bypass trust outweigh the loss of some flexibility in distribution options to the surviving spouse and the potential income tax consequences to the disclaimer or bypass trust.

7. Miscellaneous Uses. Many other uses of disclaimers for transfer or other tax planning purposes may apply including increasing or deceasing charitable deductions, protecting the "grandfathered" status of generation skipping trusts, maintaining S-corporation classification status to a trust (the list goes on).

IV. STATE LAW FIXES. The Utah Uniform Trust Code provides various options to correct problems with respect to a trust. The Utah Uniform Probate Code also allows for post-mortem changes on distributions to devisees and heirs.

A. Modification or Termination of Trust.

1. If Settlor is Alive. A non-charitable irrevocable trust may be modified or terminated upon the consent of the settlor and all beneficiaries, even if the modification or termination is inconsistent with a material purpose of the trust (U.C.A. § 75-7-411(1)).

2. If Settlor is Not Alive. A non-charitable irrevocable trust may still be modified or terminated upon consent of all of the beneficiaries of the trust and if the court concludes that the continuance of the trust is not necessary to achieve any material purpose of the trust. Even if all beneficiaries do not consent the court may still approve the modification or termination if the interest to the beneficiaries who do not consent, will be adequately protected (U.C.A. § 75-7-411(2)-(5)).

3. Mistake or Unanticipated Circumstances. A trust may also reformed due to the settlor's mistake of fact or law even if the original terms of the trust, as originally but mistakenly created are unambiguous (U.C.A. § 75-7-412, 415)

4. To Accomplish Tax Objectives. A court can also approve modification of terms of a trust in order to achieve the settlor's tax objectives (U.C.A. § 75-7-416).

B. Uneconomic Trust. After notice to the qualified beneficiaries, the trustee of a small trust (assets under $100,000) may terminate the trust if the trustee concludes that the value of the property is insufficient to justify the cost of administration (U.C.A. § 75-7-414(1)). Other modifications can also be made to an uneconomical trust.

C. Combination or Division Trust. A trust can also be merged or divided if the result does not impair rights of any beneficiary or adversely affect the achievement of the purposes of the trust (such as splitting the GST Trust into the exempt and non-exempt portions) (U.C.A. § 75-7-417).

D. Statutory Ascertainable Standard. Utah also has a statutory ascertainable standard of invasion with respect to a beneficiary who is also the trustee of the trust. The effect of the statute is to limit discretionary principal distributions to the beneficiary/trustee to those allowed under IRC § 2041 (U.C.A. § 75-7-812).

E. Agreement among Heirs. Utah law allows competent successors of a decedent (heirs, devisees or even a testamentary or pour-over trust) to agree among themselves to alter their interests, shares or amounts they are entitled to receive. Such an agreement is binding on the personal representative (subject to administration obligations) (U.C.A. § 75-3-912). For example, devisees or heirs could agree to allocate all interest in one asset to one heir or devisee and all interest in another asset to another heir or devisee. Query: if the assets are not like kind, would this be treated as a taxable exchange for income tax purposes so that any gain after death is taxable to the heirs or devisees participating in the exchange?

V. ELECTIONS AND TAX CONSIDERATIONS (and I am not talking about Clinton, McCain or Obama). Many elections can be made for income and estate tax purposes that can be a benefit to the beneficiaries of the estate or trust.

A. Income Tax Elections.

1. Filing joint return with the decedent and the surviving spouse.
2. Deducting medical expenses paid after death as an income tax deduction on the final income tax return.

3. Deducting administration expenses on the applicable income tax return.

4. Reporting accrued interest on Series "E" U.S. savings bonds on the final return of the decedent or on the return of the recipient of the accrued interest when the bonds are cashed in (estate or individual beneficiaries).

5. Electing a fiscal year for the estate.

6. Making a 754 election with respect to the decedent's interest in a partnership or LLC to achieve a stepped-up basis with respect to the decedent's interest in the partnership or LLC.

B. Estate Tax Elections.

1. Assets can be valued as of the date of death of the decedent or on the alternative valuation date (i.e., six months after the date of death or sooner if the asset is sold or distributed), but only if the valuation results in the reduction in the estate taxes. Attempts by a personal representative to "create" a lesser valuation by forming a family limited partnership or limited liability company and then taking valuation discounts all within the six month period, will likely be challenged by the IRS.

2. Special use valuation with respect to agricultural real property to reduce the value of the asset for estate tax purposes.

3. Payment extensions with respect to the estate taxes (ten year or fifteen year payment extensions).

4. Family owned business interest deductions.

C. Common Tax Planning Oversights.

1. Failure to make the 754 election with respect to the interest in a partnership or LLC

2. Failure to take full advantage of stepped-up basis (depreciable assets can be re-depreciated and stepped-up basis can be taken in growing crops, cattle and other assets).

3. Failure to take an income tax deduction for estate taxes paid on income in respect to a decedent (such as accrued interest on bank accounts, accrued Series "E" U.S. government bond interest, installment payments on a contract, IRA and retirement accounts).

4. Failure to take deductions for administration expenses (including preservation and maintenance of estate assets) on applicable income tax return.

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