by William H. Newton III
The extant concept of renunciation or disclaimer of an interest in property arose from the common law. It is predicated on the notion of a gift that requires acceptance of the property interest by the donee in order for the gift to be complete. Absent acceptance, a gift is necessarily incomplete with the donee correspondingly acquiring no interest in the subject property. So also, a donee or a trust beneficiary, though entitled to ownership of an interest in property, may nevertheless choose to renounce or disclaim that property interest.
The disclaimer may be particularly invaluable as an estate planning strategy, especially in the international context. To illustrate, a U.S. citizen or domiciliary on becoming a trust beneficiary may desire to disclaim the beneficial interest in the trust to avoid otherwise being potentially exposed to U.S. tax consequences in favor of a separate and distinct beneficiary, e.g., one who is a nonresident, nondomiciliary alien of the U.S.
A key consideration in this respect is for the beneficiary to be in a position to disclaim under the literal terms of the pertinent trust instrument when viewed in light of the applicable law. Though seemingly a facile proposition, this is not necessarily so, especially when considerations involving a trust governed by foreign (non-U.S.) law and the concept of a qualified disclaimer as defined under I.R.C. §2518 (1986) are both at issue. In such scenario, the preferable approach in addressing the potential utilization of a disclaimer is at the very outset in connection with drafting the trust instrument itself, instead of after the fact. Delay until the very point in time when utilization is desired may limit, if not preclude entirely, the use of a disclaimer.
To illustrate, consider a trust governed by foreign legal principles that, as drafted, does not expressly address disclaimer considerations, but otherwise contains the following provision:
After the death of the Settlor, the Trust Fund shall be divided into two equal shares to be held for the benefit of the Child of the Settlor (the “Child”) and the Grandchild of the Settlor (the “Grandchild”), respectively, who may from time to time by writing delivered to the Trustees demand all or any part of the income or capital of their respective shares, or, if one has predeceased the Settlor, the entire Trust Fund both as to income and capital shall be held for the benefit of the survivor, or if both the Child and the Grandchild predecease, then the Trust Fund shall be distributed outright to Charity A.
For this same purpose, further assume 1) the applicable governing law is that of a foreign jurisdiction, which as in the case of the Cayman Islands, is based on nonstatutory common law; 2) the settlor who has just passed away was the surviving grandchild is a nonresident, nondomiciliary alien of the United States; 3) the situs of the trust for U.S. income taxation is at all times foreign; and 4) the surviving child of the settlor is a U.S. citizen who otherwise has substantial independent means and who correspondingly desires to disclaim in favor of the grandchild. The issue is whether the child may so disclaim.
The stakes in terms of the child’s ability to disclaim for purposes of avoiding U.S. tax consequences may be quite high. For example, under the above provision, the child would be a vested trust beneficiary as to both the income and capital that the child would be entitled to demand from the child’s share. Accordingly, absent an effective disclaimer and irrespective of an actual distribution, the child would have constructive receipt of the income attributable to such share.1 Correspondingly, as a result of the child’s vested rights in income and capital, the child is necessarily exposed to potential U.S. estate, gift, and generation-skipping transfer tax consequences. Moreover, significant U.S. compliance issues, again absent an effective disclaimer, likewise exist, e.g., Form 8938 reporting, Form 3520 as activated due to the constitutive receipt of income, the requirement of submission of a nongrantor trust beneficiary statement from the trustee, appointment of a U.S. agent, etc. 2
Regrettably, absent an express disclaimer provision in the trust itself, the child under the governing law of the trust, i.e., the common law, would be unable to disclaim in favor of the grandchild. This is because under such law, the child did not indeed predecease, but instead survived the settlor.3 Accordingly, the desired objective of the child’s disclaiming under the applicable foreign law with passage of the property interest to the grandchild cannot be achieved.
Moreover, even apart from this negative consequence under the governing law, because the child is a U.S. citizen, the criteria of I.R.C. §2518 must be considered as well in that a qualified disclaimer as defined thereunder must nevertheless exist. Notably, I.R.C. §2518, as applicable for U.S. estate, gift, and generation-skipping transfer taxation, has as its underlying policy the creation of uniformity in disclaimer procedures (whether statutory on nonstatutory) as otherwise applicable under local law. In general, a qualified disclaimer is defined in pertinent part under I.R.C. §2518(b) as follows: 1) Existence of an irrevocable and unqualified written refusal to accept an interest in property; 2) receipt of the written refusal by the transferor of the property interest, not later than nine months after the later of the date of the transfer creating the interest,4 or the day on which the person disclaiming reaches age 21; 3) nonacceptance of the property interest or any of its benefits by the person disclaiming; and 4) as a result of the refusal, the interest passes without direction on the part of the person disclaiming to a person other than the person disclaiming.5
The fourth element is itself interrelated with the underlying local law, i.e., due to the disclaimer, the interest must indeed pass to another person under such law. Moreover, consistent with such element, the passing of such interest must occur without any direction by the person disclaiming.
Subsequently, Congress perceived that excessive reliance continued to be placed on local law. As a result, I.R.C. §2518(c)(3) was enacted with the stated underlying intent as follows:
Local law will be applicable to determine the identity of the transferee, but transfer need not satisfy the requirements of the local disclaimer statute. In addition, the individual’s direction of the transfer to the individual who would have taken under local law pursuant to an effective disclaimer will not be construed as acceptance of the property.6
Consistent with this underlying policy and I.R.C. §2518(c)(3) itself, an otherwise qualified disclaimer, continues to be so treated provided the recipient is one who would have received the property had a qualified disclaimer been made. Notably, while an individual’s direction of the transfer is in this respect immaterial, local law nevertheless remains applicable in determining the identity of the recipient transferee.7
Returning now to the pertinent trust provision as presented above, a qualified disclaimer would nevertheless fail irrespective of the subsequent enactment of I.R.C. §2518(c)(3). This is because under the applicable local law, i.e., as based on the common law, an ostensible transfer by way of disclaimer by the child of the child’s income and capital interests in the trust fund to the intended recipient transferee, the grandchild, is ineffective. Accordingly, not only would the property interest fail to pass, but a qualified disclaimer would likewise not exist. This is so since again the intended recipient, i.e., the grandchild, is not a viable transferee for this purpose under local law.
The effect is to present the issue of what steps may prospectively be taken to avoid this unintended result. Again the preferable approach is to consider and to address this matter at the very outset in connection with drafting of the trust instrument itself. Specifically, an express provision should be included in the instrument at the time of trust formation that addresses disclaimer considerations both from the perspective of the applicable foreign law and from the standpoint of existence of a qualified disclaimer under I.R.C. §2518.
To illustrate, such a provision could potentially state as follows:
Notwithstanding any provision of the governing law to the contrary, any Beneficiary as specified herein may transfer the beneficiary’s entire interest in any property held within the Trust Fund for or on behalf of such beneficiary provided the transfer is in writing, of the transferor’s entire interest in the property, otherwise meets the requirements of I.R.C. §2518 (b)(2) and (3), and such transfer is to a person or persons who would have received the property had a qualified disclaimer under I.R.C. §2518(b) been made. For these purposes, the written instrument effecting the transfer may be denominated as a disclaimer, renunciation, or words of similar effect consistent with the governing law.8
Other variations of the above language and the considerations as reflected therein are most assuredly feasible. The basic point is to address the matter of applicable foreign law when U.S. beneficiaries will be present, and also satisfy the criteria of a qualified disclaimer.
In conclusion, the disclaimer concept may serve invaluable purposes, particularly as an estate planning strategy in the international context. A key aspect of its utilization is to address its application at the very outset in conjunction with drafting the relevant instrument itself. The objective is to be in position to effectuate a seamless, straightforward exercise of an express right of disclaimer at an appropriate subsequent point in time.
1 See, e.g., Seligson v. Commissioner, 63 T.C.M. 3101 (1992), aff’d., unpublished opinion (9th Cir. 1994).
2 Notably, as a result of the child’s vested rights in income and capital, the inclusion of special inter vivos and/or testamentary powers of appointment would be ineffective to preclude the child’s exposure to the collective, enumerated U.S. tax consequences.
3 While reformation of the trust in a court proceeding in the jurisdiction of the governing law could be feasible, the issue then becomes whether the Internal Revenue Service would accept the reformed instrument as being I.R.C. §2518 compliant. Certainly, a ruling on such a matter would be appropriate in any event.
4 In the case of transfers made by a decedent at death or transfers that become irrevocable at death, the transfer creating the interest is treated as occurring at death. Moreover, this is so even in the case of a nondomiciliary alien decedent bequeathing or devising foreign situs property that is not subject to estate taxation. Treas. Reg. §25.2518-2(c)(3)(i).
5 In addition, the disclaimed interest may also pass to the decedent’s spouse. I.R.C. §2518(b)(4)(A). Notably, and in this respect, a surviving noncitizen spouse may disclaim any portion of the property at issue that is included in a decedent’s gross estate under I.R.C. §2040 instead of being limited to one-half the interest in the property. See, e.g., Treas. Reg. §25.2518-2(c)(5), Example 9.
6 H.R. Rep. No. 201, 97th Cong., 1st Sess. 191, reprinted at 1981-2 C.B. 391.
7 As implemented, I.R.C. §2518(c)(3) is effective for transfers which create an interest in the person disclaiming after December 31, 1981. In terms of the effect of local law, Treasury Regulations have been issued effective for transfers prior, but not subsequent to, such date. See Treas. Reg. §§25.2518-1(c)(1)(i) and (ii) (expressly reserving comment as to the impact of local law for interests created after 1981). The effect is to produce a degree of uncertainty regarding the precise contours of I.R.C. §2518(c)(3).
8 The governing law, even if based on the common law instead of being statutory, will typically give force and effect to an express disclaimer provision as included in the trust instrument. Even so, counsel in the jurisdiction of the governing law should in all events be consulted and requested to opine on the validity and effectiveness of the trust itself under local law including, in particular, the disclaimer provision. In so doing, Circular 230 (Rev. 4-2008) necessarily bears consideration. Specifically, the circular correspondingly restricts the ability to diminish responsibility for tax-related considerations through reliance on third persons. See Circular 230 §10.22(b). Thus, due care should necessarily be exercised in the selection of such opining foreign co-counsel.
William H. Newton III is author of the two-volume treatise International Income Tax and Estate Planning, published by Thompson-West, a practicing attorney in Miami, an adjunct professor of law in the master’s of tax and estate planning programs at the University of Miami School of Law, author of numerous articles regarding international tax and international estate planning, and a graduate of the Massachusetts Institute of Technology and the Southern Methodist University.
This column is submitted on behalf of the Tax Section, Michael Allen Lampert, chair; and Michael D. Miller and Benjamin Jablow, editors.