The following is a clever “hybrid” tax strategy — combining estate planning and income-tax planning — that was brought to my attention by my partner and good friend, Henry Comstock.
Joint Financial Accounts
Married couples very frequently hold investment assets, including brokerage accounts, in a “joint” account where both parties are named as co-owners, and on the death of the first spouse the assets automatically pass by operation of state law to the survivor. An easy and logical marital arrangement, so far as it goes.
Tax Basis Bonanza
But in 2015, one of the dominant tax-planning objectives is making maximum use of the opportunity to increase in tax basis in marital assets in the passing of the first spouse. How does a joint bank account or joint financial account fit into the picture? Very effectively – if you know how to use a disclaimer.
First of all, if a spouse contributes assets to a joint bank, brokerage or other investment account (e.g., an account held at a mutual fund), and if the transferor may unilaterally withdraw the transferor’s own contributions to the account without the consent of the other co-tenant, then the transfer is not yet a completed gift under Reg. § 25.2511–1(h)(4). Instead, the transfer creating the survivor’s interest in the decedent’s share of the account occurs on the death of the deceased cotenant. Reg. § 25.2518–2(c)(4)(iii).
The surviving spouse/co-tenant can make a qualified disclaimer with respect to the funds contributed by the deceased spouse/co-tenant, but the disclaimer must be made within nine months of the co-tenant’s death. Reg. § 25.2518–2(c)(4)(iii). Significantly, and somewhat surprisingly to many estate planners, there is a “contribution rule” with respect to these disclaimers, and the surviving joint tenant may only disclaim the portion of the joint account attributable to contributions by the decedent, and specifically cannot disclaim any portion of the joint account attributable to contributions by that surviving joint tenant. Id.
Inclusion of 50% of Remainder in Decedent’s Estate
The interesting parallel rule is that, following the exercise of a disclaimer as described above, 50% of the joint account not disclaimed is includable in the estate of the first spouse to die, notwithstanding the fact that, following the disclaimer strategy outlined above, no portion of the joint account may be attributable to funds contributed by the deceased spouse. Code § 2040(b). This means that, for estate tax purposes, on the passing of the first-to-die spouse, the surviving spouse can potentially disclaim to the estate of the decedent all of the property contributed to a joint account by the decedent during the decedent’s lifetime, and then further include in the decedent’s estate an additional 50% of the property contributed by the surviving spouse to the joint account.
Tax-Planning Turned On Its Head
It often runs viscerally counter to the instincts of the estate planners to try and push assets into a decedent’s estate, rather than out of the estate. However, key to this tax-planning strategy is that where there is a surviving spouse (and assuming it is intended that 100% of the property in the decedent’s estate will pass to the surviving spouse and will be eligible for the estate tax marital deduction), it is possible to mix and match (1) the step-up in tax basis under Code § 1014 for federal income tax purposes with (2) an estate that owes zero federal estate tax (thanks to the effective use of the unlimited marital deduction under Code § 2056(a) and the unified credit under Code § 2010(a), which currently exempts from federal estate tax a lifetime-equivalent amount of $5,430,000 per person in 2015).
For example, assume that H and W have a joint brokerage account holding $10 million of assets, with a tax basis of $1 million, and that each has contributed 50% of the funds ($500,000 each) to the account over time. On the passing of the first spouse, the survivor could disclaim $5 million of the assets back into the estate of the decedent, since these assets are attributable to property contributed to the joint account by the decedent. In addition, one-half of the remaining $5 million, or $2.5 million, would also be includable in the estate of the decedent. Code § 2040(b). The federal tax basis in these $7.5 million of investment assets would now be the fair market value ($7.5 million).
NOTE: If the deceased spouse provided all the consideration in the account, the surviving spouse could disclaim his or her entire interest in the account, which would cause the entire amount to be included in the estate of the deceased spouse. See § 2033. This will result in a step up in tax basis of the assets in the brokerage account to $10 million.
The regulations contain three examples about how a joint bank account or joint investment account operates in connection with the disclaimer by the surviving spouse. These are found at Reg. § 25.2518–2(c)(5), Examples 12, 13, and 14, respectively, and are reproduced in full below.
Example (12). On July 1, 1990, A opens a bank account that is held jointly with B, A’s spouse, and transfers $50,000 of A’s money to the account. A and B are United States citizens. A can regain the entire account without B’s consent, such that the transfer is not a completed gift under §25.2511-1(h)(4). A dies on August 15, 1998, and B disclaims the entire amount in the bank account on October 15, 1998. Assuming that the remaining requirements of § 2518(b) are satisfied, B made a qualified disclaimer under section 2518(a) because the disclaimer was made within 9 months after A’s death at which time B had succeeded to full dominion and control over the account. Under state law, B is treated as predeceasing A with respect to the disclaimed interest. The disclaimed account balance passes through A’s probate estate and is no longer joint property includible in A’s gross estate under section 2040. The entire account is, instead, includible in A’s gross estate under § 2033. The result would be the same if A and B were not married.
Example (13). The facts are the same as Example (12), except that B, rather than A, dies on August 15, 1998. A may not make a qualified disclaimer with respect to any of the funds in the bank account, because A furnished the funds for the entire account and A did not relinquish dominion and control over the funds.
Example (14). The facts are the same as Example (12), except that B disclaims 40 percent of the funds in the account. Since, under state law, B is treated as predeceasing A with respect to the disclaimed interest, the 40 percent portion of the account balance that was disclaimed passes as part of A’s probate estate, and is no longer characterized as joint property. This 40 percent portion of the account balance is, therefore, includible in A’s gross estate under § 2033. The remaining 60 percent of the account balance that was not disclaimed retains its character as joint property and, therefore, is includible in A’s gross estate as provided in § 2040(b). Therefore, 30 percent (1/2 × 60 percent) of the account balance is includible in A’s gross estate under § 2040(b), and a total of 70 percent of the aggregate account balance is includible in A’s gross estate. If A and B were not married, then the 40 percent portion of the account subject to the disclaimer would be includible in A’s gross estate as provided in § 2033 and the 60 percent portion of the account not subject to the disclaimer would be includible in A’s gross estate as provided in § 2040(a), because A furnished all of the funds with respect to the account.
If You Do Nothing You Are Doing the Right Thing
What I especially love about this disclaimer strategy is that married couples, absent input from estate planners, generally hold assets in a joint account, and one of the most annoying issues in the old days of estate planning was getting clients to separate assets into their respective names, so that one could maximize the use of the (then paltry) unified credit amount. Today, thanks to the combination of portability, a much higher unified credit, and the foregoing disclaimer strategy, dividing assets may still be the “better” approach, but it is no longer as critical as before. In fact, for many married couples with joint financial accounts, doing nothing may be doing the right thing.