Post-mortem flexibility is imperative for Elder Law practitioners and their clients. Careful attention must be given to potential income, estate and gift tax issues and potential disqualifying transfers for Medicaid. What is favorable from a tax perspective can be detrimental for Medicaid purposes. They have to make decisions today which may be judged years in the future.

I. The Importance of Flexibility

This concept is paramount when designing an estate plan. Retaining flexibility is critical when state estate taxes may be a concern and protecting the surviving spouse should Medicaid be needed. It is not the intent of this Article to be an exhaustive dissertation on every aspect of Qualified Disclaimers and partial QTIP elections, but rather to discuss those issues germane to the Elder Law practitioner.

II. Background

Until 1976 post mortem planning was virtually non-existent. The Tax Reform Act of 1976 introduced the concept of the Qualified Disclaimer by creating Section 2518 of the Internal Revenue Code. For the first time post-mortem decisions were able to address tax and inheritance issues. Practitioners no longer had to make decisions years before death without taking into account changes in facts and law. A Qualified Disclaimer can be used to determine the ultimate disposition of an estate including fixing the amount of the Marital Deduction; however, the requirements for Qualified Disclaimers are severe and can create problems of their own

Qualified Disclaimer

A Qualified Disclaimer must be valid under state law and meet a four prong test: ¹

• Written Test: The disclaimer must be in writing and describe the property being disclaimed
• Nine Month Test: The disclaimer must be received by the transferor, her legal representative or the holder of legal title to property no later than nine months after the later of: (a) the date on which the transfer creating the interest in the disclaimant is made; or (b) the date on which the disclaimant turns twenty-one [emphasis added]
• No Benefit Test: The disclaimant must not have accepted the property or any benefits from it
• 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.

If the above tests are met, the disclaimed property passes as if the disclaimant predeceased the decedent.

While the tests may appear straightforward, there are perils. For the purpose of the Nine Month Test, the disclaimer must be made within nine months of the creation of the interest. This is an inflexible rule; even lack of knowledge in the interest is not relevant. ² There is no extension available, even if an extension to file the estate tax return was granted. ³ In the case of probate estates, intestate estates, and revocable trusts, the decedent’s date of death is the date of creation of the interest and the Nine Month Test begins that date. Contrast this to the treatment of an irrevocable trust; should the remaindermen of an irrevocable trust wish to make a Qualified Disclaimer, it must be done within nine months of the creation of the trust. ⁴

The primary use of a Qualified Disclaimer in the context of Elder Law planning is to allow the surviving spouse to file a Qualified Disclaimer and allow the disclaimed property to pass to a testamentary trust for the benefit of the surviving spouse.

The final regulations confirm that a surviving spouse can, through a Qualified Disclaimer, allow property to pass to a trust for his or her own benefit.⁵ However, the surviving spouse may not be given any power of appointment over the disclaimed property. ⁶

The Qualified Disclaimer by the surviving spouse to a trust for his or her benefit enables the use of the unified credit and gives the surviving spouse the benefit of the disclaimed property without having the property taxed at his or her death; the trust is considered to have been created by the decedent and not the surviving spouse.

The disclaimed property will no longer qualify for the marital deduction, but the final regulations state the surviving spouse can disclaim a fixed dollar amount of the decedent’s estate, so the disclaimer can be structured to use up the decedent’s unified credit and not generate any federal estate tax. The final regulations state that the disclaimer may include a formula, similar to marital deduction formulas now in use, to insure the disclaimer is of the maximum amount sheltered by the unified credit and does not result in any tax. ⁷

The Clayton Election

The Qualified Disclaimer was essentially the only post mortem planning tool until the creation of the Qualified Terminal Interest Property Trust (QTIP) by the Economic Recovery Tax Act of 1981. ⁸ In addition to the unlimited marital deduction, for the first time it allowed a decedent to pass an interest in property for the surviving spouse’s lifetime without the decedent’s losing the ability to control the disposition of such property upon the death of the surviving spouse. It also allowed an executor or trustee to make a partial election to qualify QTIP property for the marital deduction. In this respect, the final effect was the same as the Qualified Disclaimer; a decision to make use of the marital deduction can be made after the death of a decedent.

However, the partial QTIP election presented its own set of issues; mainly the disposition of the trust property not covered by the QTIP election. The original position of the IRS was even if QTIP treatment was not elected, terms of the trust holding such property had to be identical to the QTIP trust; in other words, the surviving spouse must remain the sole income and principal beneficiary of the trust. In fact, the initial Tax Court decision in Clayton ⁹ held the surviving spouse did not have a qualifying income interest for life because the passage of an income interest in the property to the surviving spouse was contingent upon the executor’s QTIP election as to such property and was therefore subject to the executor’s power to appoint the property to someone other than the surviving spouse. Accordingly, the Tax Court concluded that the surviving spouse did not have a “qualifying income interest for life”, and that the property therefore was not QTIP.

The Tax Court followed its ruling in Clayton in two successive cases in which partial QTIP election was the issue. In both cases, the Tax Court followed its decision in Clayton. ¹⁰ Subsequently, all three cases were reversed by Court of Appeals in their respective Circuits. ¹¹ In reversing the decision of the Tax Court, the Fifth Circuit Court of Appeals concluded:

“Congress clearly could not care less about the post-mortem disposition of that  portion of the residue of the testator’s estate for which the QTIP election was not made, because every dollar’s worth of that property was taxed currently in the estate of the Testator as the first spouse to die. That is the very reason for   allowing a partial election and for treating specific portions of interests in property separately. As such the Will and the administration of the Testator’s estate, including the partial QTIP election, met the only conditions that Congress has placed on the ability to defer estate tax on a terminable interest via the Marital Deduction, i.e., that the specific portion of the terminable interest property for which the election is made be taxed in the estate of the surviving spouse, and that all other property and interests in property–terminable or not–be taxed in the estate of the first spouse to die.” ¹²

Finally, in 2006 when faced with the same issue, the Tax Court in Clack v. Commissioner ¹³ adopted the same position as the Circuit Courts of Appeal in reversing its prior decisions. Very soon after the decision in Clack, the IRS acquiesced to the decision in Clack. ¹⁴ Shortly thereafter, the IRS acquiesced that any property for which QTIP treatment was not elected can have a different distribution plan without disqualifying property covered by the QTIP election. ¹⁵ Although the IRS finally acquiesced in Clack, the entire concept of the partial QTIP election was named after the parent case and is known as the “Clayton Election” or “Clayton QTIP”. The IRS eventually amended the final regulations to recognize the Courts’ decisions. ¹⁶ In sum, if the personal representative of an estate partially elects QTIP treatment for an estate, the disposition of the balance of an estate will not affect the QTIP Election even if such property passes to someone other than the surviving spouse. ¹⁷

As a result, the Clayton Election is governed by the rules governing the election of QTIP treatment. The Clayton Election must be made on the last estate tax return filed by the executor on or before the due date of the return, including extensions or, if a timely return is not filed, the first estate tax return filed by the executor after the due date. ¹⁸

To facilitate the Clayton Election, the marital deduction trust should include language instructing that the trust can be divided into QTIP and non-QTIP property, and the personal representative must declare this on the estate tax return. ¹⁹

Special attention must be paid to tax apportionment when using a Clayton Clause. Many apportionment clauses direct that the estate taxes should be paid from the estate’s residue. This type of apportionment clause could impair the marital deduction if estate taxes are apportioned against it, as it would effectively render the marital trust taxable for the surviving spouse. It is therefore prudent for the estate planner to include a provision mandating all estate taxes to be paid from the non-QTIP property.

III. Analysis – Disclaimers as Disqualifying Transfers under OBRA 93

With the Omnibus Reconciliation Action on August 10, 1993 (“OBRA ’93”), the federal administration of the program provided that “waving the right to receive an inheritance” was a disqualifying transfer for Medicaid benefits. While every state adopted its own administrative rules, Medicaid agencies began to deny benefits to those who made a Qualified Disclaimer and their spouses. In upholding the denial of benefits to a recipient who disclaimed, a New York appellate court held renunciation was the equivalent of a transfer as her family would benefit from the money. The Appellate Court cited public policy considerations as a justification for Medicaid to be permitted to force a recipient to accept an inheritance and spend it down. ²⁰

In a recent Rhode Island case, the court cited to and upheld the oft-cited case of Troy v. Hart ²¹ and found that a Medicaid recipient’s inheritance and subsequent disclaimer of two real properties was an improper and uncompensated transfer of assets. The court upheld the Medicaid ineligibility as the real property was an available resource for the applicant to use to pay for the cost of her medical care. ²²

IV. Why a Clayton Election is preferable

When planning for a couple whose assets are below the federal exclusion amount but may be facing an estate tax at the state level, the attorney must plan for maximum tax protection while ensuring the tactic used is not a disqualifying transfer for Medicaid. This can best be accomplished by using a Clayton Clause.

With a Qualified Disclaimer, an affirmative action by the spouse is necessary to make a Qualified Disclaimer, which is generally considered a disqualifying transfer. Contrast this with the Clayton Election, which is made by the personal representative of the estate. The surviving spouse can serve as personal representative; however the will can strip the surviving spouse of the right to make the Clayton Election and name another personal representative whose sole power is to make the Clayton Election This will make it difficult to asset the Clayton Election constitutes a disqualifying transfer.

Besides preventing a potential disqualifying transfer, a Clayton Election also provides the attorney and his or her clients with an additional six months to consider their options. While a Qualified Disclaimer must be made within nine months of the deceased spouse’s date of death, the personal representative has a minimum of fifteen months—the nine months prior to when estate taxes are due, plus a six month extension—to consider the needs of the surviving spouse. As stated above, if a return was not timely filed, the first filed return can still make the Clayton Election. At the start of the fifteen month period, long-term care financing may not be an issue, but the surviving spouse could be in a completely different situation fifteen months later. The additional time provides the client’s family with the time to assess their situation and determine the proper course of action.

Both the Qualified Disclaimer and Clayton Election allows assets to be shifted, post-mortem, and accomplish the estate tax goals. However, a Clayton Election has major benefits over a Qualified Disclaimer:

• The Clayton Election will not be a disqualifying transfer;
• The property not covered by the Clayton Election can be held in a Supplemental Needs Trust;
• The surviving spouse can be given a special power of appointment over property not covered by the Clayton Election;
• There is no hard and fast deadline for making the Clayton Election.

An Elder Law attorney is tasked with the obligation of creating a plan that is flexible, as the unknown future could create havoc and significant financial burdens. The Elder Law practitioner must be prepared to change his plan from tax planning to long-term care planning. While using a Clayton Election is not a perfect solution, the additional flexibility and protection from disqualifying transfers makes it a superior tool to use when both long-term care and state estate taxes are on the horizon.

 

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Footnotes

<sup>1. 26 U.S.C. § 2518(b) (2006) ^
2. PLR 200339021 (9/26/2003) ^
3. Fitzgerald v. U.S., 94-1 USTC ¶60,152 (W.D. La. 1993) ^
4. Reg. § 25.2518-2(c)(5), Example 3. ^
5. Reg. § 25.2518-2(e)(2) ^
6. Reg. § 25.2518-2(e)(5) ,Example 4 ^
7. Reg. § 25.2518-3(d), Example 20 ^
8. Pub. L. 97-34 ^
9. Estate of Clayton v. Commissioner, 97 T.C. 327 (1991) ^
10. Estate of Robertson v. Commissioner, 98 T.C. 678 (1992); Estate of Spencer v. Commissioner, T. C. Memo. 1992-579 ^
11. Estate of Clayton v. Comm’r, 976 F.2d 1486 (5th Cir. 1992); Estate of Robertson v. Commissioner, 15 F.3d 779 (8th Cir. 1994) (8th Cir. 199); Estate of Spencer v. Commissioner, 43 F.3d 226 (6th Cir. 1995) ^
12. Estate of Clayton, 976 F.2d 1486, page 1501 ^
13. Estate of Clack v. Commissioner, 106 T.C. 131, 106 (1996) T.C. No. 6 (February 29, 1996) ^
14. Action on Dec. CC-1996-011, AOD 1996-011, 1996 AOD LEXIS 5 (I.R.S. 1996) ^
15. 1996-2 C.B. 1; 1996 IRB LEXIS 404 ^
16. Reg. §20.2056(b)-7(d)(3)(i) ^
17. Estate of Robertson, 98 T.C. 678; Estate of Spencer v. Commissioner, T. C. Memo. 1992-579, rev’d, Estate of Spencer, 43 F.3d 226 and ^
18. Reg. §20.2056 (b)-7(b)(4)(i) ^
19. Reg. §20.2056(b)-7(b)(2)(ii) ^
20. Molloy v. Bane, 631 N.Y.S.2d 910, 913 (N.Y. App. Div. 1995) ^
21. Troy v. Hart, 697 A.2d 113 (Md. Ct. Spec. App. 1997) ^
22. Lapointe v. R.I. Dep’t of Human Servs., 2013 R.I. Super. LEXIS 80 (Apr. 26, 2013) (R.I. Super. Ct. 2013) ^</sup>

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