Disclaiming inheritances: What taxpayers should do when they inherit something they don’t want
Prevention is best – but taxpayers can take specific steps when inherited assets cause more problems than they’re worth by disclaiming an inheritance.
When someone learns that he or she has inherited something from a recently deceased friend or relative, many thoughts and questions come up. Usually, tax considerations aren’t high on the list. One of the first things many beneficiaries will ask themselves, though, is whether they even want to receive the inherited item or if they should consider disclaiming the inheritance.
More often than not, the answer will be yes. But sometimes it will be no. For people who don’t want an inherited item, there are ways to avoid inheriting that unwanted bequest, and avoid any taxes that might be associated with it. Beneficiaries can turn down an inheritance by making a qualified disclaimer.
From cash to clown doll collections – assets sometimes come with consequences
For beneficiaries, inherited assets aren’t all equal. Some assets are easy to inherit, and others can cause tax consequences, unexpected responsibilities, and nuisances that beneficiaries aren’t always prepared to take on.
Cash. Beneficiaries generally don’t turn down cash or something that can easily be sold and converted into cash. For tax purposes, beneficiaries can also exclude inherited money, such as cash and money in a bank account, from their income, so that should not come up as a concern.
More complex property. With more complex items, such as a personal residence or an ongoing business, certain beneficiaries may be less willing to take on the responsibilities associated with them, even if beneficiaries can exclude the items from their income.
Retirement plans. A wrinkle can come up with inherited retirement plans, including 401(k) plans and IRAs. The named beneficiary who receives these items will usually owe income taxes whenever he or she takes distributions.
Unlike inherited property items like a home or business, balances held in retirement plans fall into a special category of “income in respect of a decedent,” or IRD. In the case of IRD, the beneficiary will pay tax just as the deceased taxpayer would have paid on the asset. The new income can also push beneficiaries into a new tax bracket or subject them to the Alternative Minimum Tax.
Unwanted or less marketable items. Sometimes, beneficiaries receive items that they don’t want to keep and will be hard to sell. This could be bad news for anyone trying to find an enthusiastic recipient for their recently inherited expansive antique ceramic clown doll collection.
Property with restrictions. Beneficiaries often have concerns when the deceased taxpayer placed restrictions on the inherited property.
For example, imagine that Eric’s estate includes farmland he owns. Eric dies, and the farmland passes to Sal under the terms of Eric’s will – on the condition that Sal maintains the land as farmland during Sal’s life. This restriction creates a problem for Sal, since he doesn’t have any interest in maintaining this farmland. The land may be more valuable if Sal uses it for another purpose. The restriction will also limit the pool of potential buyers if Sal tries to sell the land.
How to avoid (or “disclaim”) an inheritance
If a beneficiary winds up inheriting an asset he or she doesn’t want, the beneficiary may be able to avoid the inheritance by making a “qualified disclaimer.” To be successful, the disclaimer must meet a special set of requirements:
- The beneficiary must refuse the property irrevocably and without any qualifications,
- The beneficiary must make the refusal in writing and sign it,
- The beneficiary must give the written refusal to the person transferring the property (usually, the executor of the deceased individual’s estate) within nine months of the later of: 1) the date of the original transfer, or 2) the day the disclaiming person turns 21 or learned of the inheritance (whichever comes later).
- The beneficiary cannot accept the property or any of its benefits, and
- As a result of the refusal, and without any direction from the disclaiming person, the property passes to either the deceased individual’s spouse or somebody other than the disclaiming person.
If the disclaimer meets all of these requirements, the disclaiming person shouldn’t face any consequences, tax or otherwise, relating to the disclaimed asset. In effect, it’s as if the original inheritance never took place.
Beneficiaries can make a disclaimer for a specific property bequest or an entire beneficial interest. Disclaimers can also work for gifts.
Common pitfalls of making a qualified disclaimer of inheritance
Since there are many requirements for a successful disclaimer, individuals may not meet all of them. If that happens, the disclaimer won’t be qualified, and the individual will be responsible for the property inherited.
Consequences become apparent too late. One common slip-up involves the fourth requirement, which says that the beneficiary can’t accept the property or any of its benefits. Beneficiaries may not realize the consequences associated with an asset until they have already taken possession of it or received a distribution.
No input on who gets the asset. Even more problematic is the last requirement, which says that the beneficiary must transfer the property without giving any input on who will receive the asset. If the beneficiary directs how the asset should pass, it will instead be treated as a gift. Making a gift allows that original beneficiary to control the disposition, but it may cause him or her to have additional reporting requirements.
Instead, the terms of the will or other governing instrument, such as a trust, will determine who inherits the asset following a disclaimer. If the deceased person didn’t have a will, trust, or other guidance, state law will control who gets the asset (usually the state where the deceased person lived when he or she died).
Planning ahead is the best thing to do
Because of these hurdles associated with the qualified disclaimer process, it’s often far easier for individuals and their potential heirs to communicate proactively to prevent these issues before transferring assets.
Individuals putting together an estate plan or naming beneficiaries for retirement accounts, bank accounts, life insurance contracts, etc., should first make sure that the beneficiaries named for these assets actually want to receive them.
The same principle also applies when the proposed recipient is not an individual, but an entity, such as a charity.
Have other tax questions? Connect with the experts at Block.
For more information on how to handle an unprepared individual's estate, see the Insights article, "Post-death tax planning for the unprepared, Part 1: Who is responsible for managing tax issues?"
Originally published on January 19, 2016.