Disclaimers and Family Settlement Agreements as Possible Solutions to Election Out and Document Construction Problems

S. Alan Medlin, F. Ladson Boyle, and Howard M. Zaritsky, 2010: It Was A Very Good Year . . . To Die—Or Was It?, 45 Real Prop. Tr. & Est. L.J. 589 (2011).

In this comprehensive article, the authors address the effects of Congress’ reinstatement, on December 17, 2010, of the estate tax and the generation skipping transfer tax. The authors first analyze how the reinstatement presents certain election out and document construction problems, and then they propose disclaimers and family settlement agreements as possible solutions.

The authors have two election out problems: First, tax-sensitive language in documents may be difficult to interpret because estate or GST taxes may not have been applicable on the date of the decedent’s death in 2010–possibly even without regard to any retroactivity. (P. 592.) Second, the personal representative of the estate of a decedent who died in 2010 must decide whether to elect out of the estate tax regime (and therefore into the carryover basis regime for income tax purposes) or to allow the default estate tax regime to apply. (P. 592.) The tax results under both scenarios must be compared, including reviewing the “calculation of the net appreciation in each asset, the character of the gain on the sale of each asset, the tax rate applicable to the gain on the sale of each asset, when each asset is likely to be sold and whether tax benefits exist that might reduce the tax on such sales, and how the modified carryover basis rules will apply to these assets” as well as related factors such as passive losses and partnership interests. (P. 595.)

With the decision to elect out or not, a personal representative may face a conflict with beneficiaries because “the personal representative of an estate owes both a duty of fairness and impartiality towards all of the beneficiaries of the estate and a duty to conserve the estate, including a duty to minimize taxes.” (P. 595.) For example, the beneficiary of a specific gift (which generally bears estate taxes only if the residuary is insufficient), if the gift is of an appreciated asset, may prefer that the estate tax regime apply instead of being subject to income tax on the gain on sale of the appreciated asset. (P. 596.) A second example occurs when equitable apportionment applies such that, for example, a surviving spouse receiving substantially appreciated assets (under a distribution that does not bear any estate taxes) may object to an election out of the estate tax regime even though the estate may benefit from the election out. (PP. 596-597.) Yet another conflict may arise when the decedent’s documents address the possibility of estate and GST tax repeal. (P. 597.) If a document provides different dispositions depending upon whether the personal representative elects out of the estate tax regime, then a personal representative who is a family member of the decedent also has a duty of loyalty to the estate and must prioritize the estate’s interests before those of the personal representative (P. 597.) Also, the personal representative’s conflict of interests “may be more serious if a 2010 ‘patch’ statute has been enacted” (P. 598.) The authors suggest to personal representatives facing the foregoing conflicts that they provide detailed analyses to the beneficiaries and then seek the beneficiaries’ consent for all actions (or non-actions); if consent is not obtained, the authors propose seeking a court order approving the personal representative’s actions (or non-actions). (PP. 597-599.) Finally, as to the election out or not, the authors note that courts may require, or at least permit, a personal representative to adjust the shares of the various beneficiaries of an estate “when an election clearly works a disproportionate disadvantage” (P. 599.) The failure to make an equitable adjustment “may create income and transfer tax consequences for an estate or beneficiary.” (P. 602.)

The authors’ document construction problems include interpreting such terms as “unified credit, the applicable credit amount, the applicable exclusion amount, the exemption equivalent, the optimal marital deduction, the maximum marital deduction, or the GST exclusion” because those terms “had no meaning in 2010 until December 17.” (PP. 592-593.) These construction problems remain “despite the 2010 Tax Act” as follows:  First, “the usual rule for construing a testator’s intention applies the law in effect at the date of death,” so the authors posit that, “If the will or revocable trust of a 2010 decedent contained tax-sensitive terms but no express provisions about allocating the estate if no estate or GST taxes existed at the time of death, then the retroactive application of the 2010 Tax Act arguably should not cure property allocation construction issues because no estate or GST taxes existed at the time of death.” (P. 593.) Second, the “construction problem clearly exists for estates of 2010 decedents whose personal representatives elect out of the retroactive estate tax,” and, third, the construction problem may arise when certain documents contain “alternative dispositive provisions based on whether the estate is subject to estate or GST tax.” (P. 594.)

As to the foregoing problems, the authors propose disclaimers and family settlement agreements as possible solutions. For a decedent’s will leaving a nonmarital or bypass trust an amount equal to the decedent’s applicable exclusion amount and the residue to the surviving spouse, the authors posit that, when there is no “applicable exclusion amount” such that all property goes to the surviving spouse, a disclaimer may be appropriate to fund the nonmarital or bypass trust. (PP. 611-612.) For a will leaving to the decedent’s adult children an amount equal to the most that can pass free from federal estate taxes and the balance outright to the decedent’s surviving spouse, the authors posit that, if all property goes to the adult children, a disclaimer may be appropriate to fund the marital share. (P. 613.) The authors provide other possible disclaimers and address the attendant tax, timing, family harmony, and state law issues. (PP. 613-618.) Family settlement agreements may also address election out and construction problems because the beneficiaries agree to the settlement of an estate. (P. 618.) Any agreement, though, may have adverse tax consequences and may raise some risks under Commissioner v. Estate of Bosch. (PP. 627-634.)

This summary obscures the depth and breadth of the article. The authors’ discussion of the fiduciary duties of a personal representative in the election out decision is comprehensive, as is the analysis of possible income and transfer tax consequences for both actions and non-actions by a personal representative. The discussion of document construction problems is particularly thought-provoking, explicitly and implicitly addressing both the advantages and disadvantages of document language mirroring terms in the Internal Revenue Code. Finally, disclaimers and family settlement agreements, if the authors’ concerns about them are overcome, provide great solutions to the election out and document constructions problems impressively discussed by the authors.