Despite several major changes introduced into the federal law “[o]n currency regulation and currency control” (the Currency Control Law (CCL)) since its adoption in 2003,¹ this law still significantly restricts the ability of Russian nationals who are considered “residents” to use foreign currency as an instrument of payment in their domestic and international commercial transactions, particularly with the use of their bank accounts abroad. Because non-observance of these restrictions could result in the imposition of severe monetary penalties of up to 75 percent to 100 percent of the total amount of the unauthorized transaction,² or even in criminal proceedings,³ U.S. wealth management professionals need to take them into account to avoid possible negative consequences for their Russian clients. To facilitate this task, let’s focus on the extraterritorial reach of the CCL and analyze the practical effect of its rules on certain typical scenarios involving Russian clients in the United States, namely, opening a U.S. bank account, purchasing or renting real estate, purchasing private jets, yachts or securities, as well as liquidating a U.S. company. Also, long-awaited changes to this law are currently under discussion and could take effect as early as 2018.

CCL

The application of the CCL not only to Russian nationals permanently living in Russia but also to those Russian citizens who permanently live abroad but visit their native country at least once a year remains one of its most controversial aspects. Such extraterritorial reach of the currency control rules beyond the country’s borders is based on the broad interpretation of the statutory definition of “resident” by Russian governmental agencies, notably the former Federal Service for Financial and Budget Supervision (Rosfinnadzor).⁴ Among various categories of individuals considered residents, this definition specifically mentions citizens of the Russian Federation, with the exception of those Russian citizens who are permanently residing in a foreign state not less than one year, including those having a residence permit, issued by an authorized state body of a foreign state or those temporarily staying in a foreign state not less than one year on the basis of a work visa or a student visa, with the period of validity of not less than one year or on the basis of combination of such visas with the total period of validity of not less than one year.⁵ While on its face this definition doesn’t say anything about the reinstatement of resident status when a Russian citizen permanently living abroad visits his native country, according to Rosfinnadzor, in such case this status is automatically reinstated, and it could be lost only after one year of permanent absence from the country.⁶ A challenge to this position before Moscow courts wasn’t successful.⁷

To illustrate the practical consequences resulting from such interpretation of “resident” for Russian citizens permanently living abroad, consider a U.S./Russian national living in California who, feeling nostalgic after several years of absence, flies to the Winter Olympic Games in Sochi in his private jet to watch ice hockey games, stays there for one week and then goes back. As this individual spent less than 183 calendar days within 12 consecutive months in his native country, he won’t be considered a Russian “tax resident” within the meaning of the Tax Code (NK RF).⁸ Thus, assuming that shortly after returning from Sochi, he decides to sell his jet to buy a bigger (and better) one, despite this trip, the proceeds of this sale won’t be subject to Russian taxation.⁹

At the same time, because of his trip to Sochi, during the next 12 months, this ice hockey fan will be considered a “resident” within the meaning of the CCL. Although this individual doesn’t need to pay any Russian taxes with respect to the proceeds from this sale, the subsequent use of these proceeds will be subject to the same currency control rules as those applicable to his compatriots permanently living in Russia, and the same sanctions will apply for the non-observance of these rules. From this perspective, the verification of resident status under the CCL becomes an indispensable element of any wealth management advice involving Russian nationals.

Impact on Certain Typical Scenarios

In view of the relatively small amounts of money required for its implementation and lack of legal complexity, the most common scenario involving a Russian client in the United States is the opening of a bank account. Unless a certain client, considered a “resident” within the meaning of the CCL, also occupies one of the public positions in Russia in accordance with the list approved by the President of the Russian Federation,¹⁰ is a member of the Council of Federation or a deputy of the State Duma of the Federal Assembly¹¹ or belongs to another category of persons who are expressly prohibited from having foreign bank accounts,¹² (or is a spouse or minor child of any of these persons), he may freely open such account in a foreign currency or in Russian rubles.¹³ Following the opening of the account, its holder shall report it to the tax authorities at the place of his registration in the Russian Federation, as well as notify them in case of a change of its requisites or its closing within one month after the respective event in accordance with the form approved by the Federal Tax Service.¹⁴ In addition, the account holder shall inform the same tax authorities about movement of assets on this account on an annual basis until June 1 of the year following the reporting year.¹⁵ In case the account holder fails to report his account or comply with these periodic reporting obligations, according to the Federal Tax Service, all transactions with the use of the assets on this account shall be considered as “illegal currency operations.”¹⁶

Once a U.S. account is opened and properly reported to the Russian tax authorities, a Russian client may freely transfer to this account money from his accounts in domestic banks and in other foreign banks.¹⁷ Moreover, this client may freely use money on this account for his acquisitions outside the Russian Federation, including, for example, the purchase of a New York apartment with a Central Park view, a penthouse with an ocean view in Miami Beach or a luxurious yacht moored not far from this penthouse.¹⁸ At the same time, the CCL will allow the use of the same account to receive payments from other individuals in a limited number of cases specifically listed in this law.¹⁹ In all other cases, the incoming payments could only be credited to the resident’s account in the “authorized bank,” meaning a bank in Russia authorized by the Central Bank to carry out currency operations.²⁰

Because the sale of aircrafts, yachts and real estate currently doesn’t appear on the list of cases when the proceeds can be directly credited to a foreign account, assuming that our ice hockey fan received the money from the sale of his private jet directly to his U.S. bank account within a year after his return from Sochi, he committed a violation of Russian law.²¹ The same violation would be committed by a Russian millionaire living in Monaco, but visiting his native country from time to time for business reasons, in case he decides to sell his New York apartment (or Miami Beach condominium) as well as his yacht and receive the proceeds from this sale to his account in the United States, Monaco or Cyprus. At the same time, if instead of selling, he decides to rent his U.S. real estate, he’ll be able to receive the rent payments to his accounts at banks located in the Organisation for Economic Co-operation and Development (OECD) or the Financial Action Task Force (FATF) member countries, provided that the lessee isn’t a “resident” within the meaning of the CCL.²² Because the United States is an OECD and an FATF member country, but Monaco and Cyprus aren’t,²³ he’ll be able to receive rent payments to his U.S. bank account, but not to his bank accounts in Monaco or Cyprus. When the lessee is a resident, the owner of real estate will be able to receive the rent payments only to his account in an authorized bank in Russia.

Suppose the same Russian client also purchased U.S. Treasury bonds, shares of a company listed on the New York Stock Exchange (NYSE) and the majority of shares in a closely held U.S. corporation. He may freely receive interests and dividends on these securities to his U.S. bank account and to his accounts in other OECD and FATF countries. He may also receive to the same account income generated by his assets and securities that he previously transferred into trust management (doveritelnoe upravlenie) to a manager who isn’t a “resident” within the meaning of the CCL.²⁴ On the other hand, in case he decides to sell his U.S. securities, unless they’re listed on the NYSE, Nasdaq or another foreign stock exchange included in the list of the Federal Service for Financial Markets,²⁵ he’ll have to transfer the proceeds from their sale to his account in Russia.²⁶ Finally, because the liquidation of “controlled foreign companies” within the meaning of NK RF isn’t included in the list of cases in which a foreign account could be used, in case of liquidation of a U.S. corporation that he controls because of his majority stake, or by other reasons stipulated in NK RF,²⁷ the proceeds from this liquidation shall also be transferred to his Russian bank account.

Proposed Legislative Changes

In 2016, the Ministry of Finance of the Russian Federation prepared a draft federal law (the Draft Law). Its contents and the views expressed during its subsequent public discussion reflect the growing recognition by Russian governmental authorities, as well as by the public at large, that a number of currency control rules no longer reflects Russia’s modern realities and undermines the objectives of the de-offshorization campaign launched by the country’s leadership several years ago.²⁸ While one of this campaign’s major objectives was the reduction in the use of foreign companies and foreign law by Russian nationals, the existing restrictions on the use of foreign accounts by residents may have induced them to open these accounts in the name of their offshore companies, not considered as residents and, therefore, not subject to the existing restrictions. Furthermore, the mandatory need to transfer the proceeds from the liquidation of a controlled foreign company to an account in an authorized bank could have created significant practical difficulties for many law-obedient Russian citizens willing to close their offshore companies and re-invest the remaining assets abroad. In addition, the existing statutory definition of “resident” and its interpretation by administrative authorities and courts may discourage certain Russian citizens permanently living abroad from visiting their native country and, if they still have to go there for personal or professional reasons, to induce them to give up their Russian citizenship. Needless to say, this would have undermined the efforts of the country’s leadership to strengthen ties with compatriots living in other countries within the State Program to assist the voluntary resettlement of compatriots residing abroad,²⁹ as well as directly affected human ties with their relatives continuing to live in Russia.

In an apparent effort to address these problems, the Draft Law proposes several major modifications to the existing currency control rules. First, while the Draft Law extends the scope of the term “resident” to all citizens of the Russian Federation regardless of the place of their residence, it simultaneously exempts from the application of rules concerning the opening and use of accounts (deposits) in foreign banks outside the territory of the Russian Federation those residents staying outside the territory of the Russian Federation in total more than 183 days during the calendar year, regardless of the number of their entries to the territory of the Russian Federation in such year. Second, the Draft Law allows residents to transfer proceeds from the sale to non-residents of their foreign real estate, on the condition that: (1) this real estate is registered in the territory of the OECD or the FATF member state; (2) this foreign state joined the Multilateral Competent Authority Agreement on Automatic Exchange of Financial Account Information, dated Oct. 29, 2014 (the CRS MCAA);³⁰ and (3) the account (deposit) of the resident is opened in a bank located in the territory of such foreign state. Third, the Draft Law allows residents to transfer the proceeds from the sale to non-residents of their foreign means of transportation to the account of the seller in a bank located in OECD or FATF countries.

Although at this point, it isn’t clear when the Draft Law may enter into force, it’s possible this may happen in 2018. Once the proposed changes take effect, Russian nationals staying in their native country less than 183 days in a calendar year will no longer need to regularly provide information about movements of assets on their U.S. bank accounts to Russian tax authorities and will be able to credit to these accounts proceeds from sales of any foreign assets or securities. Russian citizens staying in their native country for more than 183 days in a calendar year will be able to credit to their accounts abroad the proceeds from the sale to non-residents of their foreign aircrafts and yachts. However, until the United States signs the CRS MCAA, if such Russian citizen sells his New York apartment or Miami Beach penthouse, he’ll still need to transfer the proceeds from this sale to the bank account in his native country.

Significant Restrictions

The very technical nature of the CCL, which contains repeated internal cross references³¹ as well as references to other federal laws and regulations,³² may require U.S. wealth management professionals to conduct a diligent review of each scenario involving their Russian clients. While the proposed legislative changes may certainly be welcoming news for residents having foreign bank accounts, it may be expected that even in its amended form, the CCL will continue to impose significant restrictions on their activities abroad. That’s why the verification of compliance of the proposed activities with the requirements of this law shall remain a mandatory part of any meaningful wealth management advice provided to Russian clients.              

Endnotes

1. Federal Law No. 173-FZ, “On currency regulation and currency control” (Dec. 10, 2003). For a summary of changes, see, e.g., Glenn S. Kolleeny, Artem V. Zhavoronkov and Dmitry A. Pentsov, “Major Changes in Russian Currency Control Law Create New Opportunities For Foreign Investors,” BNA’s Eastern Europe Reporter, 2007, Vol. 17, No. 1, at pp. 30-33. Russian legislation and court cases can be found at www.consultant.ru or www.garant.ru.

2. Currency Control Law (CCL), art. 25; Code of the Russian Federation of Administrative Violations (KOAP RF), art. 15.25(1).

3. Criminal Code of the Russian Federation (UK RF), art. 193.

4. The Federal Service of Financial-Budget Supervision (Rosfinnadzor) performed functions of the currency control authority. In accordance with the Decree No. 41 of the President of the Russian Federation, “On certain matters of state control in the financial-budget sphere” (Feb. 2, 2016), the Service was liquidated and its functions of the currency control authority were transferred to the Federal Customs Service and the Federal Tax Service.

5. CCL, art. 1(1)(6)(a).

6. “Federal Service for Financial and Budget Supervision: Information concerning the determination of status of resident (non-resident) of the citizen of the Russian Federation living on the territory of a foreign state” (undated), www.consultant.ru; “The currency should flow out of Russia in accordance with the rules”: Interview of Natalia Plotnikova, Deputy Chief of Rosfinndazor (Nov. 12, 2013), www.rosfinnadzor.ru.

7. Appellate Ruling of the Moscow City Court in case No. 33-10871/14 (April 4, 2014).

8. Tax Code (NK RF), art. 207(2).

9. Ibid., art. 207(1).

10. Decree No. 32 of the President of the Russian Federation, “On public positions of the Russian Federation” (Jan. 11, 1995).

11. Federal Law No. 3-FZ, “On the status of a member of the Council of the Federation and the status of a deputy of the State Duma of the Federal Assembly of the Russian Federation” (May 8, 1994), art. 6(2)(k).

12. Federal Law No. 79-FZ, “On the prohibition to certain categories of persons to open and possess accounts (deposits), to keep cash and assets in foreign banks, situated outside the territory of the Russian Federation, to possess and (or) to use foreign financial instruments” (May 7, 2013).

13. CCL, art. 12(1).

14. CCL, art. 12(2); Order No. MMB-7-6-457@ of the Federal Tax Service, “On the approval of the forms of notification about the opening (closing), changing of requisites of an account (deposit) located outside of the territory of the Russian Federation and about the possession of an account in a bank outside the territory of the Russian Federation” (Sept. 21, 2010).

15. Resolution No. 1365 of the Government of the Russian Federation, “On the procedure for providing information by natural persons—residents to the tax authorities of the reports about the movements of assets on the accounts (deposits) in banks outside the territory of the Russian Federation” (Dec. 12, 2015).

16. Letter No. ZN-3-17/5523@ of the Federal Tax Service (July 16, 2017).

17. CCL, art. 12(6)(2).

18. Ibid.

19. CCL, art. 12(4) and (5).

20. CCL, art. 1(8).

21. CCL, art. 15.25(1).

22. CCL, art. 12(5.1)(3).

23. Currently, there are 35 OECD (Organisation for Economic Co-operation and Development) member countries. See www.oecd.org/about/membersandpartners/list-oecd-member-countries.htm. The Financial Action Task Force currently comprises 35 member jurisdictions and two regional organizations. Seewww.fatf-gafi.org/about/membersandobservers/.

24. CCL, art. 12(5.1)(6). About the Russian concept of “trust management” and its differences from the common law concept of “trust,” see Dmitry A. Pentsov, Glenn S. Kolleeny and Anna Zhukova, “Russian Law Governing Trust Management of Assets,” BNA’s Eastern Europe Reporter, 2007, Vol. 17, No. 7, at pp. 23-30.

25. CCL, art. 12(5.1)(5); Order No. 07-51/pz-n of the Federal Service for Financial Markets (April 27, 2007).

26. CCL, art. 12(5.1)(5).

27. NK RF, art. 25¹³(3).

28. Draft Federal Law, “On the introduction of modifications into the Federal Law on currency regulation and currency control” (draft No. 02/04/09—16/00053390), http://regulation.gov.ru/projects#npa=53390.

29. Decree No. 637 of the President of the Russian Federation, “On measures for assisting voluntary resettlement to the Russian Federation of compatriots, residing abroad” (June 22, 2006).

30. Multilateral Competent Authority Agreement on Automatic Exchange of Financial Account Information (Oct. 29, 2014), www.oecd.org/tax/automatic-exchange/international-framework-for-the-crs/multilateral-competent-authority-agreement.pdf.

31. See, e.g., CCL, art. 9(1(1); art. 12(5); art. 12(6.1(4); art. 14(3)(8).

32. See, e.g., CCL, art. 12(1); art. 12(5.1)(5); art. 25.

The regulation of inheritance—as it relates to social welfare—is a profound societal issue that’s especially timely in this era of unprecedented wealth inequality. The impact of the accumulation and disposition of wealth by the “1 percent” is a question no longer asked solely by economists and “occupiers.” Indeed, trusts and estates practitioners working with clients at all wealth levels face questions of accumulation and disposition every day as they help clients to decide how they’ll leave behind whatever they’ve accumulated during life. But, rarely does one ask about how all of these decisions in the aggregate impact the welfare of society as a whole. And, what role should the state have in regulating such decisions?

These are the “big picture” policy questions that underlie Professor Mark Glover’s forthcoming article, “A Social Welfare Theory of Inheritance Regulation.” For practitioners, it presents some useful perspective on whether, and how, these individual decisions should be regulated. For policymakers, it provides a framework and makes some recommendations for policy changes.  

The article makes three key points: (1) in the United States, the law of succession is based on the fundamental principle of an owner’s freedom of disposition of property; (2) this freedom of disposition supports social welfare because the donor can best determine the social utility of various dispositive alternatives; and (3) some regulation of inheritance is necessary, and there are a few ways that it could be increased or decreased. Because these statements seem—on the surface—to be a bit tautological, additional context would help anyone reading this article. Indeed, Prof. Glover’s 2017 article, “Freedom of Inheritance,” might best set the context for this 2018 article.¹

Freedom of Disposition 

Prof. Glover starts his analysis by citing the Restatement (Third) of Property: “the main function of the law … is to facilitate … rather than regulate” inheritance. He reviews “how and why the law defers to individual decision-makers regarding the disposition of property after death.”  

The freedom of disposition theory rests in part on the notion that a property owner has an incentive to be productive during life, and her heirs have an incentive to take care of her while she’s alive to increase their chances of inheriting later. Donors are in the best position to assess their situation when developing estate plans, which on the whole serve the greatest social utility when they’re ultimately transferred. The law facilitates this freedom through the probate process and its emphasis on plain meaning and donor’s intent.    

Regulation of Inheritance 

Unfettered freedom, in disposition of property as in all areas, presents potential problems that are best handled with regulation, which, in this case, Prof. Glover asserts should be as limited as possible. He notes that there isn’t a cohesive framework for regulation and cites a few examples of where regulation exists. Inheritance is regulated in both prescriptive and proscriptive ways. Prescriptive restraints include rights of spouses and creditors to take from the estate of a decedent, which serve societal purposes of supporting a marriage partnership and providing certainty for creditors when making loans. Proscriptive restrictions include prohibitions on supporting illegal activity or interfering with marriage.  

The rationales for limiting freedom rest on mitigating the risk that—without restrictions—suboptimal decisions could occur based on imperfect information, negative externalities and moral hazards. There’s also a risk that regulation could incentivize conduct against social welfare. This is an area that’s hard to summarize succinctly, but Prof. Glover does it well.  

Future Regulations 

Prof. Glover ends with a few “Opportunities for Reform.” He proposes increased regulation including establishing a right for the county of the decedent’s death to a share of the estate to provide for a minor child who needs support not provided for in the estate. He would decrease regulation by changing the so-called “slayer rule” (which automatically disinherits a decedent’s killer). He suggests a rebuttable presumption of a donor’s intent to provide for a killer who’s named in the will rather than an outright prohibition on the inheritance. He asserts the social welfare justifications of this change, and this makes for the most interesting, if potentially controversial, part of the article.  

Beyond Property 

From the first sentence of this article, Prof. Glover places his analysis solely in property law. A natural starting point, this insular focus is perhaps the greatest strength and weakness of his analysis. For example, there are cultural and historical underpinnings of the U.S. concept of “social welfare” and “inheritance” that could shed light on the topic. Similarly, some of the arguments made by Prof. Glover might be better tested by comparison to legal systems beyond U.S. common law. When discussing the obligations of parent to child, for example, it would be useful to contrast the U.S. system of freedom in this area with civil law’s forced heirship. At base, the U.S. emphasis on the individual is embedded in more than just property law, and a discussion of inheritance seems incomplete when it’s purely defined in economic terms. Anyone with a client grappling with the questions of “equality” and “fairness” among children might balk at the assertion that a parent is in the best position to determine his children’s needs, and thus, providing the parent full leeway serves the social utility of meeting these needs economically. Clients are often driven by far more than economic considerations in developing their estate plans.  

Similarly, when Prof. Glover asserts the social welfare theory of “externalities” that might incentivize family members, further evidence or justification would be helpful. For example, he cites the notion that children who don’t know whether they’ll inherit from their parents will have an incentive to take care of their parents in the hopes of a “reward” after death. This may be a justification for the freedom of disposition, but it would be helpful to see if any research supports this claim. Anecdotally, and perhaps statistically, the United States has fostered dispersed families in which children may in fact be less inclined to take care of parents than those in other cultures. Conversely, forced heirship in other countries doesn’t seem to have reduced the incentive to take care of aging parents. Cultural issues can be far more influential than legal or economic incentives, as any second generation Chinese family business member well knows.  

Prof. Glover notes that there’s yet to be developed an overarching framework to analyze inheritance regulation, and his article is his attempt to provide one. It’s a worthy endeavor, and one hopes that Prof. Glover will continue probing these ideas that should be on policymakers’ minds. It would help to put the analysis into broader context, including comparative law and historical/cultural context.² Property law alone can’t explain, or manage, the profound issues that social welfare and inheritance regulation must address.  

Endnotes

1. See Turney P. Berry, “Review of Reviews,” Trusts & Estates (May 2017), at p. 39. 

2. See, e.g., Ray D. Madoff, “Immortality and the Law,” Yale University Press, New Haven, Conn. (2010). See also Brooke Harrington, “Capital Without Borders: Wealth Managers and the One Percent,” President and Fellows of Harvard College, Boston (2016).

Professor Roger Colinvaux is a frequent writer on charitable topics, particularly private foundations and community foundations (CFs). His article has three parts. First, he provides a thorough, excellent discussion of the history of CF regulation, from its 1914 beginning in Cleveland, through the Tax Reform Act of 1969 and the 1976 CF regulations, until 2014 when the charitable gift funds maintained by Fidelity, Schwab and Vanguard (in the author’s phrase, “national sponsoring organizations” (NSOs)) exceeded in asset value the donor-advised funds (DAFs) of the largest 274 traditional CFs. Any lawyer, trust officer, accountant or member of a family office who works with CFs will benefit from reading the review with some care.

CF law can be confusing because CFs began as a collection of charitable trusts administered together but today are usually organized as state law non-profit (or not-for-profit) corporations that have all sorts of funds including DAFs. In layman’s terms, what the two forms have in common is that the CF has ultimate authority over the charitable funds—the donor hasn’t imposed a material restriction—including the ability to redeploy the funds if the original charitable purposes become obsolete or new conditions create the need for a change. That ability is referred to as the “variance power,” and it’s largely replaced, for CFs, the more traditional, and cumbersome, method of modifying a charitable trust, the doctrine of cy pres. The definition of “material restriction” can be argued about as the article quite properly notes, and even whether the term applies to charitable corporations in the same way it does to charitable trusts is disputed. At a minimum, if a donor retains more than advisory authority over funds contributed, that’s likely a material restriction, hence the name donor “advised” funds.

Second, the author voices his concern that if CFs present themselves as being essentially equivalent to the DAFs maintained by NSOs, then over time, they’ll be regulated in the same manner as the NSOs. The article states:

[i]n sum since the rise of the NSO the unmistakable trend is to view DAFs as an activity to be regulated, without regard to sponsor. For community foundations, what was once a useful fundraising tool that attracted little attention has become a national debating point. The practical impact on community foundations is that new donor advised fund rules inevitably will apply to them unless efforts are made to distinguish sponsoring organizations legislatively.

Prof. Colinvaux believes that CFs ought to receive rather better tax treatment than the DAFs created by NSOs. What sorts of rules might be imposed on DAFs? Reading the mind of a regulator is always uncertain, but one issue commonly lifted up is that contributions to a DAF generate an immediate income tax deduction but perhaps provide only delayed benefits to charity (a statement that presupposes that a CF itself isn’t “really” a charity). That is, I contribute $100,000 to my DAF today, but advise the DAF to make contributions to my church, school and other favorite charity over a period of time. In fact, the period of time may be significant, particularly when endowments are created with advisors spanning multiple generations. The question of whether that “delay” ought be viewed as a benefit or detriment to society hasn’t been settled, at least in the mind of this reviewer, and this article doesn’t purport to argue the case, although the author appears sympathetic to the claims that so-called “warehousing” is generally bad. Another common concern is that because DAFs are generally pass-throughs to other charities, various sorts of donor abuses can occur and are more likely than when charitable contributions go directly to “real” charities. Such abuses range from sophisticated estate-planning transactions down to donors running contributions to athletic departments for tickets through a DAF to obtain a 100 percent charitable deduction rather than the allowed 80 percent deduction. Lest the reader think that such concerns are fanciful or obscure, the international magazine,The Economist, in its March 25, 2017 issue, highlighted potential DAF abuses, as well as warehousing, and concluded of DAFs: “At present, there is scant evidence to suggest they fuel an overall rise in giving. Many philanthropists sing DAFs praises. But that does not prove their worth to society as a whole.”

We ought note in passing that many in the CF field believe that the NSOs actually limit the degree to which CFs will be regulated. That’s because the lobbying power of the NSOs is assumed to far outstrip that of CFs. Of course, even if that were true, on some issues, the two groups have differing concerns; for example, we can reasonably assume that in 2006, when the Pension Protection Act imposed excess business holdings rules on all DAFs, those maintained by CFs were more heavily affected than those held by NSOs.

Third, Prof. Colinvaux points out that there’s a solution to this potential regulation: CFs should distinguish themselves from DAFs maintained by NSOs because they’re located in, serve and are responsive to particular communities, especially geographic communities. Not only does community service have its own charitable purpose that’s independent from merely maintaining advised funds, but also the presence of a community board and the need to raise funds from a particular community limits the likelihood of donor abuse. The author would have CFs limit their grantmaking and activities outside of their geographic service area to enhance this distinction. Accordingly, CFs would occupy a different niche in U.S. philanthropy from not only PFs but also from NSO-advised funds, and for that matter, from national DAFs operated by other kinds of communities like churches or causes. This would enable CFs to argue for an appropriate level of regulation that, the author believes, would be less burdensome than is likely otherwise. As a technical matter, the specific proposal is for a definition of a CF in the Internal Revenue Code itself (we have a definition, since 2006, of a DAF but not of a CF), although the author recognizes such a proposal focuses attention, and once attention is focused by Congress, staff, Treasury and the Internal Revenue Service, undesirable results may result.

The issues identified in the article are significant and are worth keeping an eye on. The point for all those interested in philanthropy to remember is that in all political settings, advocacy for CFs and DAFs is worthwhile and may ultimately make a difference in the timing and degree of regulation.

With much 2017 discussion on the possible repeal of estate tax, estate planners are being asked by their children, “Daddy and Mommy, in the non-federal estate tax world, what will you do when you grow up?” 

The answer is well known to all estate planners. Estate tax planning is only a small facet of what we do day in and day out. We act, more globally, as advisors on all things family: how to properly be a wealthy person, how to provide funds to your children without encouraging lethargy and lack of effort, how to use wealth to instill charitable values, how to avoid bad characters trying to take money away from clients, counseling on marriage and unmarriage (“divorce” is such an ugly word) and overall the steps to lead productive and value-laden lives.

And, to add to the list, Professor Kimberly E. O’Leary and law lecturer Marie Were, in “Cultivating Gardens and Cultivating Generations: Purposeful Living as Standard of Care for Elder Law Attorneys,” do an excellent job expanding on the universe of roles for the estate planner, emphasizing that we need to make sure our elderly clients approach the 18th hole with purpose, dignity and financial protection. Those under age 70 tend to have blinders on as to what it’s like to be elderly. “Ahhh, I can’t wait to be retired and older; I will have no worries about work.” True enough, perhaps, but at 70 and beyond, we’re no longer doing “down and outs” on Sunday football games. Financial matters become a bit more complicated and worrisome. Living arrangements are at the forefront of daily considerations. Spouses often become deceased spouses; friends are fewer; and opportunities are more limited by physical and mental constraints. In a sense, an older individual’s universe becomes a continually decreasing orb. 

And, here the estate planner can step in to add a bit of optimism and protection. On the protection side, the planner can make sure there are structures in place such that caregivers and others can’t exercise undue or improper influence over financial matters. 

On the optimistic side, we can work with our clients to ensure they have a “purpose” in life. 

The authors introduce the topic of representing the elderly with two of the most important aspects for practitioners: (1) what it means to represent the elderly, and (2) the thoughtful way in which planners can add value.

On representing the elderly, the authors note the following universe of areas for a practitioner to focus on: estate planning, of course, independence planning (where the clients will live as their care becomes more relevant), availability of governmental benefits, avoiding both financial and physical abuse situations, health care access, long-term care insurance, pension rights and how to deal with declining faculties.

Then, the authors introduce the most important theme, advancing the happiness of the elderly by making sure they have purpose, or what the authors reference as “Purposeful Living.” They emphasize to the planner: “We need to advocate just as passionately in favor of encouraging and enabling purposeful living.”

A note for all of us, elderly and young, in reference to Purposeful Living research: “Researchers have controlled for other factors, and greater sense of purpose highly correlates with longer life and better quality of life as a factor on its own.”

And, with the possible repeal of the estate tax and a renewed emphasis on how to intelligently leave funds to adult children without discouraging Purposeful Living, this theme is relevant for all clients.

The authors suggest how planners can implement the Purposeful Living concept into their practice. Impliedly, they suggest that planners should have “discussions [with clients] about their goals and opportunities to actually practice behaviors that will give them this sense of purpose.” Planners can do this by making this a discussion and theme in estate-planning meetings and, I suggest, by having resource materials available (the authors cite the Maslow pyramid and Viktor Frankl’s psychological theory referred to as “logotherapy,” which would be two excellent resources for clients).

In addition, a good part of the article is spent reviewing customs overseas on practices that will help the elderly in terms of their living arrangements. 

For practitioners who are looking to add value to their practice, beyond estate tax reduction (meaning all of us), the principles and discussions in this article can be quite useful not only for the elderly but also for the young, for the well to do, for the retired and, essentially, for all of us. The theme, incorporating Purposeful Living into our discussions with clients, is one that will be meaningful for all of our clients and is within our skill set.    

In April 2017, a new tax law took effect (the 2017 Reform) in Japan making it more difficult to avoid Japanese inheritance and gift tax by moving overseas. Before the 2017 Reform, wealthy Japanese individuals were able to avoid inheritance tax and gift tax by changing the residency of both the decedent/donor and the heir/devisee/donee more than five years before a lifetime gift or death. The government has now made that tax avoidance more difficult by extending the 5-year period to 10 years. Some Japanese senior business owners had moved to Singapore, where there’s no gift or death tax. They brought their children with them, and all have been counting to five on their fingers. But, the wealthy father and his son now need to live outside of Japan for more than 10 years. The 2017 Reform was a part of the series of Japanese legislation to expand the scope of taxation on worldwide assets. Let’s review the ramifications of the 2017 Reform on inheritance and gift taxation involving Japanese citizens and foreign citizens having a connection with Japan. 

Inheritance Tax in General

Japan imposes inheritance and gift tax on an heir/devisee/donee who receives the assets (collectively, the beneficiary). Neither the estate itself nor the executor is a taxpayer. 

Basic exclusion. The basic exclusion amount (which is deducted from the amount of the total taxable¹ assets held by the decedent to calculate the tax base) for inheritance tax is: (1) 30 million² Japanese yen (JPY), plus (2) the amount obtained by multiplying JPY 6 million³ by the number of legal heirs (= JPY 30 million + (JPY 6 million × number of legal heirs)). For example, if a husband dies leaving a wife and two children (three heirs), the basic exclusion is JPY 48 million.⁴ Some adopt their grandchildren to increase the number of legal heirs to reduce the inheritance tax.⁵ 

Inheritance tax rate. The calculation of the total inheritance tax amount is complicated. One doesn’t multiply the value of the estate as a whole (after deducting the basic exclusion amount) by the tax rate to determine the total inheritance tax.⁶

Spousal credit. Unlike the unlimited marital deduction in the United States, the spousal credit for the Japanese inheritance tax is limited. That is, no Japanese inheritance tax will be imposed on amounts that the spouse receives up to the greater of: (1) the spouse’s statutory share of the total taxable assets, and (2) JPY 160 million.⁷ The statutory share of the spouse will be one-half⁸ if the decedent is also survived by children. A wealthy U.S. husband with a Japanese wife told me, “My U.S. attorney made a perfect plan. No U.S. estate tax will be due when I die. I didn’t expect that my wife would have to pay the tax on my U.S. assets to Japan!” He didn’t know this limitation.

Gift tax. One can’t avoid the inheritance tax by making a gift during the donor’s lifetime. To deter such tax avoidance, the graduated gift tax rate structure imposes a higher tax rate at a lower threshold than in the inheritance tax. 

Narrowing the Loopholes

Wealthy Japanese individuals have tried to avoid taxes by transferring their assets overseas. In response, the Japanese tax agency has been expanding the scope of the taxes on overseas assets under the 2000, 2013 and 2017 Reforms.

Before the 2000 Reform. Only the residency⁹ of the beneficiary mattered. So, a wealthy Japanese father used to tell his son, “Move out of Japan. I will give you my overseas assets. Then, you won’t have to pay any Japanese gift tax.” The son of a billionaire, the founder of a large consumer finance company in Japan, successfully escaped gift tax of JPY 133 billion¹⁰ by moving to Hong Kong and receiving a gift of Dutch assets. The son won a case¹¹ filed against the tax agency. The tax agency refunded JPY 200 billion,¹² including interest, to the son. 

Before the 2013 Reform. The citizenship of the beneficiary mattered. So, a wealthy Japanese grandfather was able to use a loophole by telling his son and his pregnant wife, “Why don’t you have the baby born in the United States?¹³ I will give my grandchild, a U.S. citizen, my overseas assets. Then, he won’t have to pay Japanese gift tax.”

These loopholes are no longer available after the tax reforms in 2000 and 2013.

After the 2013 Reform.¹⁴ There was, however, still a loophole. That is, when both the father and the son resided outside Japan for more than five years, no Japanese inheritance or gift tax would apply to overseas assets. 

Imagine a wealthy retired Japanese owner of a big company. He lives alone in a luxury condo in Singapore. He has few friends. He’s just killing time. He always says, “I have to stay alive more than five years. Just a little more patience!” His son lives in the United States. If the owner resided in Singapore for more than five years after leaving Japan, no gift or death tax from any country would apply to his overseas assets.

The 2017 Reform

A nightmare for this owner has occurred. The Japanese tax agency has extended the 5-year period to 10 years this year. He’s beginning to think about returning to Japan. 

The 2017 Reform is also relevant to foreign citizens with worldwide assets. Relief is provided only to foreign residents temporarily working and living in Japan. In contrast, no relief is provided to other foreign residents. The 2017 Reform introduced a harsher rule, making the transfer of worldwide assets by foreigners who were long-term residents subject to Japanese inheritance and gift tax even after they leave Japan.

Worldwide taxation. Because of the beneficiary-based tax in Japan, a beneficiary who’s a resident of Japan is subject to Japanese taxation on worldwide assets. A beneficiary who’s a non-resident in Japan can also be subject to the same worldwide taxation (excluding the case where the decedent/donor falls within certain exceptions), to prevent tax avoidance.¹⁵ See “Scope of Japanese Inheritance and Gift Taxation,” p. 46. Note that this new rule will apply to a death or gift on and after April 1, 2017. 

When can your client avoid Japanese inheritance tax on his U.S.-situs assets? Here’s the outline of the new rule from the standpoint of a decedent. 

1. Japanese citizen. Suppose your client is a Japanese citizen. Your advice to him is to stay alive more than 10 years after he leaves Japan. Count 10 years from the date of his departure. The beneficiary, who’s a Japanese citizen, also needs to meet that requirement. 

2. Temporary resident. Suppose your client is a U.S. citizen temporarily living and working in Japan. There are two requirements to be a temporary resident: (1) to reside in Japan with a “Table 1” visa¹⁶ under the Immigration Control and Refugee Recognition Act (the Act), such as a work visa, and (2) having resided in Japan for not more than 10 years. Because the Table 1 visa includes work visas such as intra-company transferee and dependent visas, many foreign citizens and their family members are likely to satisfy these two requirements. Then, Japanese worldwide taxation won’t apply.

3. Not temporary resident. In contrast, if your client is a U.S. citizen who: (1) resides in Japan with a “Table 2” visa¹⁷ under the Act, such as a spouse visa, or (2) has resided in Japan for more than 10 years, your client won’t be a temporary resident, and Japanese worldwide taxation will apply.

4. Foreigners who left Japan. Suppose your client is a U.S. citizen who’s resided in Japan for more than 10 years and decides to return to the United States in the near future. Surprisingly, all your client’s worldwide assets will remain subject to Japanese inheritance and gift tax for five years even after leaving Japan. A 10-year residency in Japan makes your client subject to Japanese worldwide taxation, but the 10-year period (from departure) for Japanese citizens is shortened to five years for foreign citizens.¹⁸

In that case, the advice to your client is: Don’t die within five years after leaving Japan. If he does, all his worldwide assets will be subject to Japanese taxes. Your client must stay alive more than five years after leaving Japan. Then, he’ll fall within Exception B in the chart. After that, among your client’s worldwide assets, only assets inherited by a beneficiary who’s subject to Japanese taxes (for example, your client’s Japanese wife) will remain subject to Japanese inheritance tax for 10 years after your client’s wife leaves Japan. 

This new rule will affect in particular U.S. citizens with U.S. assets worth below the U.S. estate and gift tax exclusion amount ($5.49 million in 2017) and above the Japanese basic exclusion amount. Because no U.S. estate tax is paid, there’s no foreign tax credit against Japanese inheritance tax. Your client may have only U.S. assets, but your client’s U.S. children who’ve never visited Japan will have to pay inheritance tax to Japan. On the other hand, suppose your client is a very wealthy U.S. citizen with U.S. assets worth above the U.S. exclusion amount. Here, double taxation will occur. The foreign tax credit under the U.S.-Japan Estate, Inheritance and Gift Tax Treaty and the Japanese Inheritance Tax Act¹⁹ may provide some relief. But, the United States is the only country with an inheritance tax treaty with Japan. There will be more cases with no relief to avoid double taxation. 

Where Will Japan Go? 

The 2017 Reform targets wealthy Japanese citizens to prevent the outflow of wealth from Japan. It won’t let anybody go. But, the 2017 Reform has widened the scope of worldwide taxation too much by taxing foreigners who left Japan with respect to their foreign assets inherited by foreigners who are non-residents of Japan.   

The policy reason of preventing tax avoidance isn’t well grounded. Some U.S. citizens accumulated their U.S. assets before they came to Japan. Their heirs may be only U.S. children or U.S. siblings who’ve never visited Japan. A question about the basis of Japanese taxation on these beneficiaries exists.²⁰ It will also be difficult from a practical standpoint to enforce the taxes on foreign assets.²¹

Rather, we should consider the adverse impact of the 2017 Reform from broader economic and social perspectives. Many countries have abolished the death tax.²² We shouldn’t discourage foreigners from making long-term commitments to Japan. Otherwise, we won’t be able to transition to a truly global community.         

Endnotes

1. Taxable assets can be only Japanese-situs assets.

2. JPY 30 million = about $278,220 (JPY 1 million = $9,274, as of Sept. 8. The same conversion rate applies throughout this article.)

3. JPY 6 million = about $55,644.

4. JPY 48 million = about $445,152.

5. Only up to two adopted children (only one for a decedent with one or more biological children) can be counted as legal heirs for this purpose. Inheritance Tax Act, Article 15, Paragraph 2.

6. For the inheritance and gift tax rate, see Kenichi Sadaka, Kei Sasaki and Akira Tanaka, “Japan,” Private Client 2017 (November 2016), at p. 69.  

7. JPY 160 million = about $1,483,840. Inheritance Tax Act, Article 19-2.

8. Civil Code, Article 900.

9. The legal residency for inheritance and gift tax purposes is the “principal place of living” under the Civil Code, Article 22. It’s determined by objective factors such as the length of the person’s stay, the person’s occupation, the location of the person’s spouse and other family members and the person’s assets/property.

10. JPY 133 billion = about $1,233,442,000.

11. Japan Supreme Court decision, in the case of Takefuji Corp. (Feb. 18, 2011). 

12. JPY 200 billion = about $ 1,854,800,000.

13. The son and his wife didn’t reserve Japanese citizenship for the baby; thus, the baby held only U.S. citizenship status. This is because an individual with dual citizenship is deemed to be a Japanese citizen under the Inheritance Tax Act. Inheritance Tax Act Basic Circular (Directive), 1 no 3-1 no 4 kyo-7.

14. For the scope of the Japanese inheritance and gift tax before the 2017 Reform, see Akane R. Suzuki, Tomoko Nakada, Shigehisa Miyake and Hidehito Ogaki, “Navigating United States-Japan Estate Planning,” Trusts & Estates (November 2013), at p. 67.

15. Inheritance Tax Act, Article 1-3 and Article 1-4. 

16. Table 1 Visa: For example, highly skilled professional, business manager, legal/accounting services, medical services, engineer/specialist in humanities/international services, intra-company transferee, temporary visitor or dependent.

17. Table 2 Visa: permanent resident, spouse or child of Japanese citizen, spouse or child of permanent, long-term resident.

18. As a transition measure from April 1, 2017 to March 31, 2022, the 5-year rule (from departure) won’t apply to foreigners who haven’t resided in Japan from April 1, 2017 to the date of death or gift.

19. Inheritance Tax Act, Article 20-2.

20. See Masahiro Shibuya, “Implication of the Japanese Inheritance and Gift Tax Reform,” 1455 Jurist (June 2013), at p. 46.

21. Enforceability on foreign assets is also a question. No information will be available to the Japanese tax agency about: (1) deaths of foreign citizens living outside Japan, and (2) their foreign assets.  

The tax agency needs to ask the United States for assistance under the Convention on Mutual Administrative Assistance in Tax Matters as well.

22. Barbara R. Hauser, “Death Taxes Around the World in 2013,” Trusts & Estates (November 2013), at p. 56.

The destruction caused by Hurricanes Harvey, Irma, and Maria and the wildfires in California have led to an outpouring of charitable gifts and donations. Some of the giving has come in the form of contributions to the American Red Cross and other public charities, which are deductible to the donor (assuming the donor itemizes deductions), but can’t be earmarked for particular recipients. In other cases, storm victims have solicited gifts through gofundme.com and similar platforms. These kinds of gifts are paid directly to a specific person but can’t be deducted by the donor, no matter how sympathetic the recipient.

Employer Sponsored Charities

For businesses whose employees were affected by disasters, however, there may be another way to provide relief: an employer-sponsored public charity or private foundation. These employer-sponsored organizations combine many of the tax benefits of a typical charitable organization, such as a deduction for donors and tax exemption for the charity, with the ability to provide relief to a relatively small group of people, such as the employees of a particular company affected by a disaster.

For large- and medium-sized employers that are committed to providing relief to employees affected by disasters or personal hardships, an employer-sponsored charity offers several attractive benefits: tax deductibility of contributions, tax exemption on the charity’s income, and tax exclusion for recipients, together with the ability to focus its relief on a relatively small group of people, for example, employees and former employees of the sponsoring employer. In order to enjoy these benefits, however, employers must be careful to ensure that their sponsored charities are organized and operated according to Internal Revenue Service rules. 

IRS Requirements

Historically, the IRS was wary of employer-sponsored organizations providing disaster relief to employees of the sponsoring company. Among other reasons, the IRS was concerned such organizations would provide a private benefit to the sponsoring employer and would allow the sponsoring employer to pay disguised compensation to employees. Not long after the terrorist attacks of Sept. 11, 2001, however, the IRS reconsidered its position. The IRS now allows employer-sponsored public charities and private foundations to offer disaster relief to employees, as long as three conditions are satisfied:

1. The class of beneficiaries is large or indefinite;
2. The recipients are selected based on an objective determination of need; and
3. Recipients are selected by an independent selection committee, or adequate substitution procedures are in place, to ensure that any benefit to the sponsoring employer is incidental and tenuous.

When these requirements are met, employer-sponsored charity payments to employees are presumed to be for charitable purposes and won’t result in taxable compensation to the recipient. The requirements aren’t unique to employer-sponsored charities but reflect the IRS’s unique concerns when such organizations provide disaster relief to the sponsoring company’s employees. 

1. Charitable Class

The first requirement relates to the general rule that a charity must benefit a “charitable class” rather than a particular person or a small, pre-selected group of people. The charitable class requirement is the reason that contributions to particular individuals, no matter how deserving, aren’t deductible. The charitable class requirement doesn’t mean, however, that a charity must actually provide relief to all class members. Rather, the charitable class must be large enough that potential beneficiaries can’t be identified in advance.

 If the group of potential beneficiaries is limited to a smaller group, such as the employees of a particular employer, the group of persons eligible for assistance must be indefinite. The IRS will consider a group indefinite where it includes not only employees affected by a current disaster, but also employees who may be affected by future disasters. Thus, a company with a single employee who lost her home in Hurricane Harvey couldn’t form a charity solely to assist that employee, but might be able to provide disaster relief to the employee through a charity formed to assist victims of Hurricane Harvey and future disasters.

Very small employers may be unable to show that a company-sponsored charity benefits a charitable class, because the group of potential beneficiaries is too small. Companies with a few thousand or even a few hundred employees, however, should be able to satisfy the charitable class requirement, particularly if relief is available not only to current employees, but also to former employees and the families of employees and former employees. Small companies may also be able to fulfill this requirement by providing disaster relief to others in the community in addition to company employees.

2. Determination of Need

The second condition relates to the requirement that a charity providing disaster relief must make an objective determination that recipients are financially or otherwise in need. While not unique to employer-sponsored charities, this requirement speaks to the IRS’s concern that such charities not be used to pay disguised compensation to the employees of the sponsoring employer. 

In the immediate aftermath of a disaster, a charity may provide certain kinds of relief, such as rescue services, blankets, water and hot meals, without regard to financial need. As time goes by, however, charities must assess each recipient’s resources before providing aid. If an executive of a company loses her home to a storm, for example, but the home is insured and the executive has the resources to rebuild or buy a new home, the executive probably will not qualify as being financially in need even though she may be in need of food, water and shelter in the immediate aftermath of a disaster. 

3. Independent Selection Procedures

The third requirement is intended to ensure that an employer-sponsored charity remains independent of the sponsoring employer. The purpose of the requirement is to prevent an employer from using a company-sponsored charity to enhance employee recruitment or retention, which would be a private benefit to the sponsoring employer.

The IRS will consider a charity’s selection committee to be independent if a majority of its members consists of persons who aren’t in a position to exercise substantial influence over the affairs of the employer. For example, a sponsoring employer can’t appoint its board of directors as the directors of the employer-sponsored charity’s selection committee, but can appoint one or two board members, so long as the appointed board members don’t make up the majority of the committee and aren’t able to exercise undue influence over the selection process.

Kinds of Relief 

The kind of aid an employer-sponsored charity may provide depends on whether the charity is a public charity or a private foundation. In general, a public charity receives broad financial support from the public, which may include a cross section of employees from a sponsoring company, while a private foundation’s support generally comes exclusively or predominantly from a single individual, family or employer. Because private foundations are funded by a single person or small group of people, there are more rules and restrictions on a private foundation’s activities, including restrictions on deducting contributions above a certain threshold and excise taxes on prohibited transactions.

Employer-sponsored private foundations that provide relief to the sponsoring company’s employees may do so only in the case of a “qualified disaster,” which includes a federally declared disaster, accidents involving common carriers and disasters resulting from terrorist attacks or military action.

Employer-sponsored public charities, conversely, are thought to be more transparent because they are answerable to the general public. Therefore, they are allowed more leeway to provide relief. An employer-sponsored public charity may, for example, provide relief not only in the case of a qualified disaster, but also in the case of an employee emergency personal hardship situation, such as an illness or personal casualty loss.

Employers that would like more flexibility to provide relief in emergency hardship situations may be able to qualify as public charities by, among other things, receiving contributions from employees, customers, clients, suppliers and others to ensure a broad base of support.

State Compliance Issues

In addition to the federal tax rules for organizing and operating an employer-sponsored public charity or private foundation, there are a myriad of state-specific rules. Most states require charities to register, for example, if they’ll be soliciting funds or making distributions in the state.

There’s currently no uniformed or 50-state registration procedure, which can make the state registration requirements burdensome for charities that intend to solicit funds in most or all 50 states. The rules may be less daunting, however, for charities that intend to operate in only one or a few states, or for private foundations that will be funded solely by the sponsoring employer, and thus, will not solicit contributions at all. Such charities generally will, however, still need to register in the states in which they’re operating or soliciting contributions.

Marriage offers many benefits!

From an estate planning and property law standpoint, this too is true! In those jurisdictions that allow it, the most important “property law benefit” of being married is the ability to own property of any kind as “tenancy by the entirety,” or TBE. When a married couple owns property as TBE, such property is protected from creditors’ claims of each spouse, individually (but not from a joint creditor of both spouses). Property owned as TBE avoids probate on death of the first spouse to die. Further, thanks to portability, one of the negative implications of spousal survivorship property—the loss of estate tax exemption as a result of the marital deduction—is neutralized. Here’s how to take advantage of tenancy by the entirety.¹ 

Planning Opportunities

Many married couples with jointly owned property may not have such property titled as a TBE. Instead, they may have taken title to their properties as tenants-in-common or joint tenants with right of survivorship, or in some cases they may have property titled individually or in one spouse’s revocable trust. Now is an opportune time to re-examine the manner in which couples currently hold title to their property and determine whether any changes should be made.

Lifetime Planning; Portability Has Changed Planning

Prior to the introduction of “portability” (or the ability to transfer a deceased spouse’s unused applicable exclusion amount to the surviving spouse),² it was common for planners to advise married clients to divide jointly owned property and transfer the property into one (or both) spouse’s individual name or revocable trust. The historical reason for giving that advice was to ensure that the estate tax exemption of the first spouse to die wouldn’t be wasted. Thus, planners recommended dividing assets so that so-called “credit shelter” trusts could be funded to fully utilize the estate tax exemption amount of the first spouse to die. Now, with the introduction of portability, it’s possible to transfer any remaining estate tax exemption of the deceased spouse to the surviving spouse by having the deceased spouse’s executor make the portability election. Given the asset protection benefits of TBE ownership, together with the fact that most married couples are more comfortable owning their property together (as opposed to having assets held separately by one spouse or one spouse’s revocable trust), a case could be made for owning your property as TBE. Of course, all other factors should be considered, such as the marital law implications mentioned above.

Avoiding Probate on Simultaneous Death; TBE Trust

On the death of the first spouse to die, TBE property passes to the survivor in the survivor’s individual name. Without any further action, the property would be subject to probate on the survivor’s death. Once the first spouse dies, usually the surviving spouse would subsequently transfer the property into his revocable trust so that it avoids probate. In most situations, this is sufficient; the only situation in which this wouldn’t be feasible is if there’s a simultaneous death, in which case the property would be subject to probate in at least one of the spouse’s estates. 

In some jurisdictions, pre-death planning is possible to allow the TBE property to be transferred to one or more revocable trusts and still maintain the benefits of TBE. Under these types of trusts, called “TBE trusts” or “qualified spousal trusts,” the spouses transfer the property to their respective revocable trusts (title is technically severed into two separate undivided shares). The authorizing statute overrides the separate shares and treats them as one share for TBE purposes, thereby retaining the TBE benefits. On the death of the first spouse to die, the shares are reunified in the survivor’s revocable trust. The requirements to maintain TBE status under most of the applicable statutes are somewhat uniform: (1) the spouses must remain married, (2) the trust or trusts are, while both settlors are living, revocable by the respective settlors (or, if the trust is a joint trust, revocable by both settlors, acting together); (3) both spouses are permissible current beneficiaries of the trust or trusts while living; and (4) the trust instrument, deed or other instrument of conveyance must reference this particular statute.

TBE trusts are specifically authorized in Maryland and Virginia.³ TBE trusts haven’t yet been adopted in Washington, D.C. or Florida, although there’s the suggestion that a joint TBE trust may be allowable under Florida law.⁴ In addition to Maryland and Virginia, seven other states have adopted TBE trust statutes.⁵

Post-Mortem Planning

On the death of the first spouse to die, TBE property passes to the survivor. Death destroys the TBE nature of the property; therefore, the TBE asset protection benefits disappear at the first spouse’s death. A properly crafted estate plan, however, can allow the survivor to “disclaim” his interest in the TBE property and allow the decedent’s half of the property to pass into a protected trust for the surviving spouse and/or other family members, such as children, grandchildren and more remote descendants.⁶ Clients’ plans should be reviewed to determine whether TBE and disclaimers should be part of the testamentary strategy.

“Extra” Marital Benefits

If available in a particular jurisdiction, TBE is a unique form of ownership that can provide certain “extra” marital benefits. Some spouses may already own their property as TBE and not even realize it. TBE, however, isn’t “bullet proof” as the transfer into TBE must still satisfy the applicable state’s fraudulent transfer law and may nevertheless still be reachable by the Internal Revenue Service. TBE can also have the negative effect of converting separate property into marital property (as to this issue, it’s best to consult with a local family law attorney to confirm the implications in your particular jurisdiction). There are opportunities to take advantage of TBE until the first spouse’s death and other opportunities to further protect assets, while still maintaining estate tax benefits for the survivor and other family members.

DISCLAIMER:This material is not intended to constitute a complete analysis of all tax or legal considerations. This material is not intended to provide financial, tax, legal, accounting, or other professional advice. Consult with your professional advisor to obtain counsel based on your individual circumstances.

Endnotes:

1. This article focuses on the laws of the jurisdictions covered by our firm’s offices, i.e., the “Capital Region” (District of Columbia, Maryland and Virginia) and Florida. Other jurisdictions where our business contacts and friends are located may have similar laws.
2. See, e.g., our firm’s prior articles on portability: Portability, Act Now, Estate Planning in 2013 and Portability – Immediate Action Items.
3. Md. Est. & Tr. Law Section 14-113; Va. Code Section 55-20.
4. See R. Craig Harrison, Trusts: TBE or Not TBE, 87 Fla. Bar J., No. 5 (May 2013).
5. The other states are: Delaware, 12 Del. C. § 3334; Illinois, 765 Ill. Con. Stat. § 1005-1c; Indiana, Ind. Code § 30-4-3-35; Missouri, Mo. Rev. Stat. § 456.950 (Missouri only allows for one joint trust, but  may be severed into two separate shares); North Carolina, N.C. Gen. Stat. § 39-13.7; Tennessee, Tenn. Code. Ann. § 35-15-510; and Wyoming, Wyo. Stat. Ann. § 4-10-402(c)-(e).
6. “Disclaimers” are a way to renounce certain property received upon death. State law and federal transfer tax law work to deem the intended recipient as having predeceased the decedent, thereby allowing property to pass to the next intended recipient without effecting any gift for gift tax or state law purposes. 

According to a survey in Rocket Lawyer, 63 percent of people don’t know what happens to their online or digital assets after death. Facebook, Twitter, Instagram, iCloud and a host of other online applications store a wealth of your personal information, and competent estate planning advice now includes advice regarding the disposition of these digital assets and the related information. A failure to account for such digital assets may lead to hacking or fraud, particularly for assets linked to a credit card, especially if no one knows of the accounts’ existence and therefore doesn’t have the ability to deal with such accounts. 

Most of us now employ a number of digital assets, including social media accounts, blogs and websites, online financial accounts, email accounts, online retail accounts and retailer apps, photo- and video-sharing sites, music sites, online payment accounts including utility accounts and other online and data storage accounts. In most cases, someone will need your username and password for any accounts to carry out your wishes.

After you create a secure inventory of these digital assets, including usernames and passwords (perhaps by using a digital wallet), you should make sure your loved ones will be able to access this information should you end up in the proverbial “cloud.” However, you also need to know several things regarding online tools, “digital” executors and service agreements that may govern your digital assets.

Online Tools

Authorized by the Revised Uniform Fiduciary Access to Digital Assets Act of 2015 (the “Act”), a given service provider’s “online tool” mechanism supersedes a contrary direction in an estate plan or in a Terms of Service Agreement, called TOSA for short, to determine a digital asset’s ultimate disposition. Google’s Inactive Account Manager, for example, automatically alerts you if your account remains inactive for a set amount of time. Failure to respond to the alert in a timely manner causes Google to notify a friend or family member—or your digital executor—to confirm your death before carrying out your instructions. Like a financial beneficiary designation, such online tools provide a quick and easy way to dispose of digital assets. Consider using them wherever available and remember to update them periodically. 

Appointing a Digital Executor

If a service provider fails to offer such an online tool, or if you want to guard against the misuse of such a tool, consider naming a digital executor to carry out a digital estate plan at your death. The Act extends the traditional power of a fiduciary to manage tangible property to include management of a person’s digital assets to allow fiduciaries to manage digital property like computer files, web domains and virtual currency, but it restricts a fiduciary’s access to certain electronic communications. Thus, email, text messages and social media accounts remain private unless the original user gives consent in a will, trust, power of attorney or other similar record. 

A website, blog, affiliate accounts, Google AdSense accounts and the like attached to a business may require an employee familiar with the business to serve as your digital executor. However, personal accounts may only need a family member or close friend. If your wishes require physical access to a computer, account for this in choosing the person to handle such matters. Appointing a digital executor in Seattle to handle tasks requiring a physical presence in Atlanta may cause more problems than it solves. In all events, choose a person with the knowledge and ability to carry out your requests or that allows that person to hire a professional to assist. 

Inform your digital executor about accessing your digital estate plan and make sure your digital executor understands how you want your digital assets handled after your death. For example, let your digital executor know if you have automated any of your accounts using an online tool so he or she will not waste time and money dealing with that digital asset.

Provide explicit written instructions in your will consenting to the release of data to a fiduciary at death, but be careful that you don’t go overboard and release content that you don’t want disclosed. Your will should already dispose of financial assets, including online banking and brokerage accounts so you shouldn’t need a separate set of instructions for those digital assets. But your other, non-financial digital assets require further explicit instructions.   

Service Agreements 

Under the Act, a TOSA controls your digital assets without express written consent to the contrary, so clearly spell out your wishes either through the use of an online tool or by explicit instructions in your will. TOSAs favor the online providers and, like intestacy provisions, often lead to unexpected, time-consuming and expensive results. Generally speaking, TOSAs refuse access to anyone who isn’t an account owner so beware of leaving your family in this situation.

Planning for your digital assets requires careful thought about the person who will have access to the intensely personal information associated with your digital assets and about the manner in which you want that person to maintain or dispose of your digital assets. As always, consult with an experienced estate planning professional to save your family time and money in dealing with these assets.

The Internal Revenue Service Large Business and International (LB&I) Division has announced on Nov. 3, 2017 the identification and selection of 11 new compliance campaigns, in addition to 13 already announced at the beginning of 2017. Compliance campaigns are areas identified for specific review and enforcement efforts, including but in many cases not limited to examinations of taxpayer filings. 

Many of these new campaigns will directly impact U.S.-resident individuals and corporations with international tax issues, and some will impact non-U.S. corporations, including financial institutions, with U.S. tax and reporting obligations. Among the areas recently identified include compliance of taxpayers with accounts identified under the Swiss Bank Program. 

LB&I announced the rollout of its first 13 campaigns to be implemented on Jan. 31, 2017. With this latest announcement, LB&I continues to focus on issue-based examinations and a compliance campaign process where the IRS decides which compliance issues are deemed to present a risk. The IRS will then focus on these issues in the form of one or multiple so-called “treatment streams” to achieve its compliance objectives. This approach makes targeted use of IRS knowledge and deploys its resources to address these specific issues. 

The recently identified issues affect both individuals and corporations, including many financial institutions that incur U.S. tax and reporting obligations as intermediaries or withholding agents for payments. The IRS may address each issue through a variety of treatment streams, including examination of taxpayers’ filed tax returns. 

Issues Affecting Individual Taxpayers 

Among the recently identified international compliance campaign issues primarily affecting individuals are the following: 

• Swiss Bank Program Campaign 

In 2013, the U.S. Department of Justice (DOJ) announced the Swiss Bank Program as a path for Swiss financial institutions to resolve potential criminal liabilities. Banks participating in the Swiss Bank Program have provided information to the IRS and DOJ on U.S. persons with beneficial ownership of foreign financial accounts. This campaign will address noncompliance involving those taxpayers who are, were, or may be beneficial owners of accounts identified through the Swiss Bank Program.

• Foreign Earned Income Exclusion Campaign 

Individual U.S. taxpayers who meet certain requirements may qualify for the foreign earned income exclusion and/or the foreign housing exclusion or deduction. Generally, this exclusion applies to US citizens or residents living abroad and whose tax home is in another country. Further, such individuals must meet either a bona fide resident test or be present in the other country during at least 330 days in a consecutive 12-month period. This campaign addresses taxpayers who have claimed these benefits but don’t meet the requirements. 

• Verification of Form 1042-S Credit Claimed on Form 1040NR 

This campaign is intended to verify the amount of withholding tax credits, and the election of a refund/credit claimed on Form 1040NR (U.S. Nonresident Alien Tax Return) by non-U.S. taxpayers with U. S. sourced income. The campaign is also intended to address whether the taxpayer has properly reported the income reflected on Form 1042-S (Foreign Person’s U.S. Source Income Subject to Withholding), which is required to be filed by the non-U.S. financial institution reporting the payment of such income. Before a refund is issued or credit allowed, the IRS will verify the withholding credits reported on the Form 1042-S. 

• Individual Foreign Tax Credit (Form 1116)  

Individual U.S. taxpayers may file Form 1116 (Foreign Tax Credit) to claim a credit against U.S. income tax for the amount of foreign income taxes paid on foreign source income, which serves to reduce their U.S. income tax liability. This campaign addresses taxpayer compliance with the computation of the foreign tax credit limitation on Form 1116. Due to the complexity of computing the Foreign Tax Credit and challenges associated with third-party reporting information, some taxpayers may claim an incorrect Foreign Tax Credit amount. 

Issues Affecting Corporate Taxpayers and Financial Institutions 

The following recently identified compliance campaigns are targeted at corporate taxpayers, also including non-U.S. financial institutions and intermediaries: 

• Form 1120-F Chapter 3 and Chapter 4 Withholding Campaign 

This campaign is designed to verify refund claims made on Form 1120-F (U.S. Income Tax Return of a Foreign Corporation) in connection with U.S. income tax withheld at source. To make a claim for refund or to elect to credit the withheld tax as estimated tax paid with respect to any tax withheld under U.S. source income or FATCA withholding rules, a foreign entity must file a Form 1120-F. Before a refund claim is paid or credit is granted, the IRS must verify that withholding agents have filed the required returns with respect to the tax withheld. This campaign focuses on verification of the withholding credits before the claim for refund or credit is allowed.

• Corporate Direct (Section 901) Foreign Tax Credit 

Domestic corporate taxpayers may elect to take a Foreign Tax Credit (FTC) for foreign taxes paid or accrued instead of a deduction. The goal of the Corporate Direct FTC campaign is to improve the selection of corporate tax returns that claim a direct FTC for examination, as well as the issues reviewed during such examination, and the utilization of IRS resources in connection with examination of these returns. This campaign will focus on taxpayers who are in an excess limitation position (where foreign tax rates are lower than US tax rates). The IRS has further announced that this is the first of several FTC campaigns. Future FTC campaigns may address indirect credits and FTC limitation issues. 

• Section 956 Avoidance 

If a Controlled Foreign Corporation (CFC) makes a loan to its U.S. parent corporation (USP), U.S. tax law generally requires that the USP include in its income an amount equal to the loan amount. This campaign focuses on situations where a CFC loans funds to a USP, but the USP does not include the amount of the loan in its income. The goal of this campaign is to determine to what extent taxpayers are utilizing cash pooling arrangements and other strategies to improperly avoid the tax consequences of this income inclusion requirement. 

What Is Next? 

In the era of FATCA, CRS and Country-by-Country Reporting, the automatic exchange of information will continue to allow tax authorities to focus on more targeted international compliance goals, using the account and payment information now available. In addition, the IRS will continue to leverage its information from the QI Program, the Swiss Bank Program, and other targeted enforcement efforts. Both individual and corporate taxpayers, including financial institutions subject to intermediary and withholding agent requirements, should take note of these and other existing IRS enforcement initiatives and in all cases ensure careful compliance with their information reporting and tax obligations. 

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Depending on who one speaks with regarding the current status of the estate tax, one of the following two quotes might be appropriate. First, as Will Rogers once said, “the difference between death and taxes is death doesn’t get worse every time Congress meets.”¹ Second, as President Ronald Reagan once said of the Tax Reform Act of 1986, “I feel like I just played the World Series of Tax Reform, and the American people won.”² The federal estate tax has been repealed and has returned four times in our history. The most recent repeal occurred in 2010. If it’s repealed again, the likelihood of its return is high. The current estate tax rate is 40 percent on both individual estates over $5.49 million and married couple’s estates over nearly $11 million. These exemptions are due to increase to $5.6 million per person in 2018. Pursuant to the Tax Cuts and Jobs Act (the Act) issued by the House Ways and Means Committee on Nov. 2, 2017, the estate, generation-skipping transfer (GST) and gift tax exemptions would all double to $11.2 million per individual and $22.4 million for a married couple.³ On Nov. 9, the Senate followed up with their own tax bill, which matched the House’s proposal to double the exemptions for the estate and gift taxes (although silent on GST and stepped-up basis).⁴ 

It’s important to note that only 0.2 percent of all U.S. estates are expected to pay estate taxes in 2017.⁵ In 2017, the estate tax is projected to generate an estimated $19.7 billion in revenue.⁶ If the Act passes and the exemptions double in 2018, the number of individuals paying the estate tax and GST tax would decrease from roughly 5,000 to less than 2,000.⁷ The House’s proposal also calls for the repeal of the estate tax in 2024, which would decrease estate tax revenue by an estimated $172 billion over the next decade.⁸ However, importantly, the Senate bill doesn’t call for the repeal of the estate and GST taxes.⁹ As such, many advisors believe that estate tax repeal may never happen, but instead could be leveraged as part of the tax negotiations. 

Is the Estate Tax Voluntary?

As Professor A. James Casner of Harvard Law School once stated, “In fact, we haven’t got an estate tax, what we have is, you pay an estate tax if you want to; if you don’t want to, you don’t have to.”¹⁰ This quote says it all. In 2018, only about 0.1 percent are projected to pay the tax despite the proposed higher exemptions;¹¹ however, estates exceeding the exemption can also avoid the estate taxes with proper planning. This may require the use of a “Kennedy trust,” that is, a testamentary charitable lead annuity trust (CLAT), combined with other powerful trusts, such as the dynasty trust.¹² The CLAT gained popularity after the will of Jackie Kennedy Onassis became public. When Jackie passed away in 1994, her will devised most of her estate to her children; however, the plan was for her children to disclaim some of their inheritance to a testamentary CLAT that would last 24 years for the benefit of Jackie’s private foundation (PF). At the expiration of the trust term, the remaining trust principal would go to her grandchildren without being subject to any transfer tax, because the estate would generate an estate tax charitable deduction. The Kennedy children never disclaimed a portion of this bequest in favor of the CLAT, and therefore, the PF was never funded, and the enormous estate tax savings were never realized.¹³ Despite the Kennedy family not using the CLAT, CLATs can provide flexibility regarding funding at death and, if funded, provide enormous tax savings. Consequently, when they’re combined with other trusts and strategies, they can render the estate tax voluntary. Why do people volunteer to pay estate taxes? Two key reasons: 1) they’re not aware of all the planning vehicles available, and
2) their tax objectives don’t coordinate with their non-tax objectives. 

Repeal or Not—Trusts Still Popular

Despite the proposed high estate, GST and gift tax exemptions and whether there’s repeal, trusts will remain extremely popular for many non-tax reasons, including: 

• family governance/succession/education

• ability to override the Prudent Investor Act, with less liability than with a delegated trust, holding one security (public or private) without diversifying (directed trust)

• diversifying broadly into private equity, alternate investments, commercial and residential real estate, without extensive fiduciary liability (directed trust)

• ability to work with investment advisors of the family’s choice (directed trust)

• asset protection/wealth preservation

• promotion of social and fiscal responsibility in the family, thus promoting family values (directed trust)

• privacy

• beneficiary quiet

• lessening family and family advisor personal liability as fiduciaries (directed trust)

• disability planning

• special needs planning

• savings of state death taxes, state premium taxes and state income taxes

It’s due to the above-mentioned non-tax reasons and state tax reasons that it may not be prudent to automatically pass assets, outright and directly, to one’s children even if the federal estate tax is repealed. Consequently, clients will continue to transfer assets to trusts, most likely GST and dynasty trusts. It’s important to note that the gift tax will most likely always remain to limit transfers and income tax shifting. The House’s proposal is for the gift tax exemption to double in 2018 and to remain when and if the estate and GST taxes are repealed effective Jan. 1, 2024. This increase provides a huge opportunity for families to fund trusts, as well as increase their funding for all of the previously mentioned reasons. Additionally, the gift tax rate would drop from 40 percent to 35 percent.

Structuring Future GST Trusts 

An interesting issue could arise regarding future GST tax planning if repeal were to occur: Namely, how would GST tax planning work with trusts established after repeal? Also, in planning for the possibility that the GST tax could return, flexibility and proper drafting would be crucial to take advantage of GST tax repeal, but avoid possible issues with any past or future legislation. This was also an issue discussed back in 2010. If the estate and GST tax are both repealed, there may be four scenarios for GST issues during the repeal year and beyond:¹⁴

1. The administration of existing non-exempt GST trusts;

2. GST trusts created in repeal year;

3. Testamentary GST trusts created as a result of deaths in repeal year; and

4. Outright gifts.

Step-Up in Cost Basis Rules

Under current law, unrealized capital gains aren’t taxed because assets in an estate are generally valued at their fair market value at date of death or one year after (that is, step-up in cost basis). Consequently, when they’re sold at the date-of-death value, there are no income taxes. The original purpose of these step-up in basis rules was to avoid double taxation, that is, income and estate taxes. The current House proposal is for step-up in basis for assets held at death to be retained during the proposed increased exemption and planned phase-out of the estate tax. Consequently, step-up would also apply during repeal, which would be very important for many families, particularly those in high tax states. 

Legislative Roadmap 

President Donald Trump released his guidelines for a tax plan to take effect in 2018. The House and Senate both followed with their own proposals. President Trump called for total repeal of the estate and GST taxes and was silent on step-up in basis. The House proposal calls for a doubling of the estate, GST and gift tax exemptions to $11.2 million per person and phase out repeal of the estate and GST taxes in 2024. It also calls for step-up in basis.

The Senate’s proposal was released on Nov. 9, 2017. While the Senate’s proposal does match the House’s doubling of the estate and gift tax exemptions (although silent on GST and step-up in basis), it doesn’t call for the elimination of the estate and GST taxes by 2024.¹⁵ Consequently, whether the final bill calls for total repeal is likely to be the subject of negotiations between the two chambers going forward. The Republicans have only 52 seats in the 100-member Senate and little hope of Democratic support or even enough Republican support. Many senators oppose the tax bill because it adds to the deficit. Susan Collins (R-ME) recently said that she cares about the debt but doesn’t want the tax bill to “blow a hole” in the deficit.¹⁶ She went on to say that “certain tax cuts done right will increase economic growth” and produce revenue.¹⁷ GOP lawmakers indicate that the tax bill may add up to $1.5 trillion to the federal deficit over the next decade, but also argue that the economic growth as a result of the income tax cuts will boost tax revenues over that time, thus compensating for the gap.¹⁸ Many experts claim that a 1 percent increase in annual gross domestic product growth will translate to $3 trillion in extra tax revenues.¹⁹ Despite these expert opinions, some Republicans and many Democrats don’t want to add to the deficit at all and remain resistant to the idea that tax cuts might stimulate economic growth and thus increase tax revenue that would compensate for the immediate deficit increase. The Byrd provision in the Senate requires 60 votes to enact any law beyond 10 years. Otherwise, any new legislation may be phased out after that 10-year period. Consequently, legislation could pass with 51 votes so Republicans can’t afford too many non-supporters. 

Glass Half Full

Trusts should remain extremely popular whether the estate and GST tax exemptions are increased, decreased, repealed or remain status quo. Consequently, the glass should remain half full for estate planners.    

Endnotes

1. Robert W. Wood, “20 Inspirational Quotes ... About Taxes,” Forbes (Sept. 20, 2013).

2. Ronald Reagan, “Remarks on Signing the Tax Reform Act of 1986,” National Archives and Records Administration.

3. House Bill H.R. 1 (Nov. 2, 2017) The generation-skipping transfer tax applies to both lifetime and testamentary transfers that skip a generation.

4. Joint Committee on Taxation, “Description of the Chairman’s Mark of the ‘Tax Cuts and Jobs Act’” (Nov. 9, 2017).

5. Chye-Ching Huang and Chloe Cho, “Ten Facts You Should Know About the Federal Estate Tax,” Center on Budget and Policy Priorities (May 5, 2017).

6. Jeff Bukhari, “If Trump Repeals the Estate Tax, the Federal Government Will Hardly Notice” Fortune.com (April 27, 2017).

7. Heather Long, “3,200 Wealthy Individuals Wouldn’t Pay Estate Tax next Year under GOP Plan,” The Washington Post (Nov. 5, 2017).

8. Ibid.

9. Supra note 4.

10. James Casner, “Hearings Before the House Ways and Means Committee 94th Congress, 2d. Sess., pt. 2, 1335” (March 15-23, 1976).

11. Supra notes 5 and 7.

12. Conrad Teitell, “Charitable Lead Trusts: Jackie O, Recent Final Regulations and an Interesting Letter Ruling,” www.wealthmanagement.com/blog/charitable-lead-trusts-jackie-o-recent-final-regulations-and-interesting-letter-ruling (June 5, 2012). 

13. Ibid.

14. Carlyn S. McCaffrey and Pam H. Schneider, “The Generation-skipping Transfer Tax,” Trust & Estates (February 2011), at p. 30. 

15. Supra note 4.  

16. Sahil Kapur, “Key GOP Senator Susan Collins Lays Out Her Demands for Tax Bill,” Bloomberg.com (Oct. 30 2017).

17. Ibid.

18. Shawn Tully, “Why Trump’s Tax Reform Won’t Fix America’s Federal Budget Mess,” Fortune (Sept. 26, 2017).

19. Ibid.

The trust relationship is a creature of equity, not statute. So is the office of trust protector or trust director. In 2017, the National Conference of Commissioners on Uniform State Laws approved the Uniform Directed Trust Act (UDTA). Let’s review general equity doctrine that’s been governing directed trusts and that presumably will continue to govern them in non-UDTA jurisdictions. In addition, I’ll address how equity doctrine applicable to directed trusts would be altered in UDTA jurisdictions.¹ 

Pre-UDTA Equity Doctrine

In the 1960s, primarily in the employee benefit space, a non-beneficiary third party who was granted a power to control a trustee in the performance of its investment responsibilities was known as a trust “advisor,” an obvious misnomer in that far more was going on than the mere rendering of investment advice.²“By the 1990s, trust advisers had morphed into trust protectors, who were conceived of as a means of securing the settlor’s control over an off-shore asset protection trust. More recently, trust protectors have become popular for all trusts, not just the off-shore variety.”³ The powers of a trust protector supersede those of the trustee.⁴ Noted trusts and estates attorney Alexander A. Bove, Jr., of Bove and Langa in Boston, defines the trust protector as a “party who has overriding discretionary powers with respect to the trust but who is not a trustee.”⁵ That is, a trust director is a trust advisor whose powers can extend beyond asset management to include some form of non-judicial oversight of the trustee’s other activities.

Scope of the trust protector’s duties. Because the scope of a trust protector’s duties may fall somewhere between the nonexistent (think holder of a special non-fiduciary power of appointment (POA)) and the broad (think full-fledged trustee),⁶ one contemplating serving as a trustee or a trust protector of a trust that provides for both offices needs to be wary.⁷ What are: (1) the trustee’s duties, if any, to monitor the activities of the trust protector; (2) the duties and liabilities of the trustee protector, for example, whether he’s a fiduciary; (3) the rights of the trust protector, for example, whether he’s entitled to be compensated for his services and indemnified for his liabilities; and (4) the tax consequences for all concerned of the trust protector possessing and/or exercising his authority?⁸

When the protector is the de facto trustee. Equity looks to the intent (substance) of an arrangement, not to its form. Thus, “[w]here the trustee is not able to take any—or practically any—step in the … [trust] … administration without securing protector approval, the balance of power is so radically altered that it may be concluded that the trustee is no more than a custodian and the protector is, in reality, the trustee.”⁹

Protectors are generally fiduciaries. 
Restatement (Third) of Trusts (Restatement Third) says that: “[a]bsent some clear indication of a settlor’s contrary intent, powers granted to a protector … probably should be deemed to be held in a fiduciary capacity … , even if not strictly that of a trustee.”¹⁰ Bove is generally in accord.¹¹ So is the UDTA. The scholarly writings of Kathleen R. Sherby, partner at Bryan Cave in St. Louis, suggest that she’s generally not in accord.¹² In any case, in a jurisdiction that endorses the Restatement Third’s presumption of fiduciary status, indicating a contrary intent may be easier said than done. Take the following provision: “For the avoidance of doubt, it is hereby declared that no power is vested in the protector in a fiduciary capacity.” In a case involving a trust with just such language, the court held that because elsewhere, the instrument provided that the protector shall exercise his powers for the benefit of the beneficiaries, specifically the powers to appoint successor trustees and protectors, he was bound by fiduciary constraints in their exercise.¹³ The only purpose of the exoneration language was to relieve the protector of any fiduciary duty to consider from time to time whether or not to exercise.¹⁴ 

If a protector’s authority is neither personal nor fiduciary, then what, if any, are its limitations?: 

At a minimum, an adviser or protector with powers over a trust that are neither fiduciary nor personal would not be allowed to exercise them fraudulently and presumably would at least be held to a good faith standard…Further, if, as typically would be the case if the power were not personal, the power had been granted to the adviser or protector to further the settlor’s purposes in benefitting the trust’s beneficiaries, it presumably could not be exercised for the powerholder’s own benefit.¹⁵

The power of a protector to appoint a successor trustee is almost certainly a fiduciary power, absent special facts. The UDTA, as we shall see, would seem not to be in accord.¹⁶ One Jersey court (the Crown dependency) offers a list of the duties a protector assumes in electing to exercise such a power:

• To act in good faith and in the interests of the beneficiaries as a whole;

• To reach a decision open to a reasonable appointor;

• To take into account relevant matters and only those matters; and

• Not to act for an ulterior purpose.¹⁷

While the fiduciary protector takes on more general liability exposure than the non-fiduciary protector, the opposite may well be the case in one context, namely, when it comes to personal liability for trust-related expenses, such as attorney’s fees. One court has ordered that a fiduciary protector, whose discretionary actions were challenged by a trust beneficiary, be indemnified from the trust estate for his personal litigation defense costs, the court suggesting that had the protector not been a fiduciary, he, qua protector, wouldn’t have had recourse to the trust estate.¹⁸ As the UDTA generally deems a trust director to be a fiduciary, the commentary accompanying its Section 14 should come as no surprise: 

Attorney’s fees and indemnification for a trust director are governed by Section 6(c)(1), which establishes a default rule that allows a trust director to exercise ‘any further power appropriate to the exercise or nonexercise of the director’s power of direction.’ By default, therefore, a trust director has a power to incur attorney’s fees and other expenses and to direct indemnification for them if ‘appropriate’ to the exercise of the director’s express powers.  

The UDTA

The UDTA would govern irrevocable directed trusts. For its purposes, a directed trust is a trust whose terms grant a power of direction to someone other than the trustee, such as a power over the investment, management or distribution of trust property. That someone is a “trust director.” A non-fiduciary POA isn’t such a power.¹⁹ Background general principles of equity, however, would continue to govern whether a holder of a particular power of direction isn’t a trust director but either a true co-trustee or the donee of a non-fiduciary POA.²⁰ The UDTA makes no effort to regulate the critical threshold exercise of sorting out whether someone who’s been designated a trust director in the terms of a particular trust actually is one, or whether, for that matter, an express negation of trust director status in the terms of a particular trust is effective.²¹

The public policy that the UDTA would implement is that a trust director should be a fiduciary with an affirmative duty to act.²² A breach of the trust director’s fiduciary duty should be a breach of trust.²³ A beneficiary’s primary recourse for misconduct by a trust director should be an action against the director for breach of the director’s fiduciary duty to the beneficiary.²⁴ The directed trustee incurs secondary liability only to the extent of his own willful misconduct.²⁵

It’s black letter law that neither the holder of a non-fiduciary POA nor an agent fiduciary has an affirmative duty to act.²⁶ A trustee, on the other hand, does. Now, so would a trust director. Subject to the limitations of his powers of direction and to legal title to the subject property being in someone else, under the UDTA, the trust director essentially possesses all the rights, duties, obligations and liabilities of a true trustee.²⁷

It’s been classic equity doctrine that a directed trustee, no matter how expansive the exculpatory language, at least owes the trust beneficiary a duty not to knowingly participate in a breach of trust, particularly as even a non-party to the trust relationship would owe the beneficiary such a duty.²⁸ The Uniform Trust Code (UTC) seems in accord.²⁹ In the directed trust context, however, the knowing participation standard apparently would be replaced by a willful misconduct standard. UDTA Section 9(b) provides that a directed trustee may not comply with the exercise of a power of direction to the extent that by complying, the trustee would engage in willful misconduct. Are “knowing participation in a breach of trust” and “willful misconduct” synonymous proscriptive standards in the directed trust context? Or, is the willful misconduct standard more encompassing? Or, is it less? Though Section 9(b) is by no means the only place in the UDTA where the term “willful misconduct” is employed, nowhere in the UDTA is it defined.³⁰

The UDTA declines to regulate the powers of a trust director to appoint or remove a trustee or trust director.³¹ Presumably, general principles of equity would regulate the exercise of such a power, such as the duty of even a non-fiduciary, non-party to a trust relationship to refrain from knowingly participating in its breach. An appointment or removal incident to a conspiracy to embezzle comes to mind.

Trustees subject to third-party veto would definitely have oversight responsibilities under the UTC: “A trustee who administers a trust subject to a veto power occupies a position akin to that of a co-trustee and is responsible for taking appropriate action if the third party’s refusal to consent would result in a serious breach of trust.”³² The UDTA isn’t in accord. It provides that “a trustee that operates under this kind of veto or approval power has the normal duties of a trustee regarding the trustee’s exercise of its own powers, but has only the duties of a directed trustee regarding the trust director’s exercise of its power to veto or approve.”³³

UDTA Traps for the Unwary 

As is the case with any piece of legislation that would tweak equity doctrine, the UDTA has its traps for the unwary. Here are a few:

• Under the UDTA, the directed trustee is liable only for his own “willful misconduct,” while under the UTC, specifically Section 808(b), the trustee may not honor a direction that’s “manifestly contrary to the terms of the trust or the [directed] trustee knows the attempted exercise would constitute a serious breach of a fiduciary duty that the person holding the power owes to the beneficiaries of the trust.” 

• While the UDTA is almost all about non-trustee directors, buried in the UTC, specifically Section 12, is some co-trustee to co-trustee direction doctrine.

• The UDTA doesn’t apply to powers to hire and fire trustees and trust directors.³⁴ Presumably background principles of equity will continue to regulate those types or directions.

• The UTC and the UDTA treat veto powers differently when it comes to directed trustee liability.³⁵

What’s Intended

While at the technical level, parts of the UDTA aren’t models of clarity, and its synchronization with other trust-related codifications could be better, at the policy level there can be no doubt as to what’s intended. In a jurisdiction that enacts the UDTA, a trust director shall be a fiduciary with an affirmative duty to act; a breach of a trust director’s fiduciary duty to the beneficiaries shall be a breach of trust; a trust beneficiary’s primary recourse for a trust director’s breach of trust shall be an action directly against the director; and a directed trustee shall incur secondary liability only to the extent of his own willful misconduct.         

Endnotes

1. For purposes of the Uniform Directed Trust Act (UDTA) and this article, a “trust protector” and a “trust director” are synonymous. The UDTA employs the term “trust director.”

2. See generally Note, “Trust Advisers,” 78 Harv. L. Rev. 1230 (1965).

3. Lawrence A. Frolik, “Trust Protectors: Why They Have Become ‘The Next Big Thing,’” 50 Real Prop, Tr. & Est. L. J. 267, 270 (2015).

4. Ibid.

5. See Alexander A. Bove, Jr., “The Trust Protector: Friend, Foe, or Fiduciary?” 34th Annual Notre Dame Tax and Estate Planning Institute, South Bend, Ind. (Sept. 25-26, 2008).

6. Trust protectors have been given authority to do one or more of the following: remove and appoint trustees; review trust administration and approve accounts; appoint auditors; agree to trustee compensation; approve self-dealing by trustees; petition the court on behalf of unborn or unascertained remaindermen; export the trust and change the governing law; trigger or cancel flight arrangements in flee clauses; withhold consent to investment, distributive and administrative decisions of the trustees; direct trustees to exercise of investment, distributive and/or administrative discretions; provide and obtain tax advice for the trustees; veto a settlor’s exercise of reserved powers; decide whether the settlor is incapacitated so as to trigger suspension of reserved powers; and add members to or subtract members from a class of permissible discretionary beneficiaries. Jeffrey A. Schoenblum, Multistate and Multinational Estate Planning 1372–1374 (1999). Professor Schoenblum acknowledges Prof. David Hayton for developing a comprehensive list of trust protector functions. David Hayton, “English Fiduciary Standards and Trust Law,” 32 Vand. J. Transnat’l L. 555, 583-584 (1999). That list is reproduced in par. 18.18[C][9] of Prof. Schoenblum’s treatise. A slightly modified version of the list appears in this endnote. See generally 3 Scott & Ascher par. 16.7 (Effect of Power to Direct or Control Trustee).

7. See generally James L. Dam, “More Estate Planners Are Using ‘Trust Protectors,’” 2001 LWUSA 854 (Oct. 29, 2001) (citing a Pennsylvania estate-planning attorney to the effect that in the United States, settlors who designate trust protectors are venturing into “uncharted territory”).

8. See ibid. (suggesting that there’s little “default law” addressing the powers and duties of protectors). See generally Scott & Ascher, supra note 6. 

9. Dawn Goodman and Sarah Aughwane, “Who Holds the Gun?” 21 STEP J. 51 (October 2013).

10. Restatement (Third) of Trusts, Reporter’s Notes on Section 64. See also 5 Scott & Ascher, supra note 6, at Section 33.1.3 (Termination or Modification by Third Person).

11. See Alexander A. Bove, Jr., The Development, Use, and Misuse of the Trust Protector and its Role in Trust Law and Practice 2, Schulthess (2014); supra note 5; Alexander A. Bove, Jr., “The Case Against the Trust Protector,” 37 ACTEC L.J. 77 (Summer 2011) (making the case that a trust protector can’t be the agent of either the settlor or the trustee).

12. See, e.g., Kathleen R. Sherby, “In Protectors We Trust: The Nature and Effective Use of Trust Protectors,” 49th Annual Heckerling Institute on Estate Planning (Jan. 12-16, 2015). In his article, Bove endeavors to make the case that Sherby’s advocacy for a default presumption that a protector isn’t a fiduciary is doctrinally incoherent. See Alexander A. Bove, Jr., “A Protector by any Other Name ….,” 8 Est. Plan. & Cmty. Prop. L.J. 389 (2016).

13. Centre Trs. v. Van Rooyen, WTLR 17 (R.C. Jersey 2010).

14. Ibid.

15. Alan Newman, “Trust Law in the Twenty-First Century: Challenges to Fiduciary Accountability,” 29 Quinnipiac Prob. L. J. 261, 300-301 (2016).

16. See UDTA Section 5(b)(2), cmt.

17. See Representation of Jasmine Trustees Ltd., JRC 196 (R.C. Jersey 2015).

18. See In the Matter of the Piedmont Trust and the Riviera Trust, JRC 016 (R.C. Jersey 2016).

19. See UDTA Section 5(b)(1). Non-fiduciary powers of appointment are taken up generally in Section 8.1.1 of Loring and Rounds: A Trustee’s Handbook (2018) (Lorings and Rounds).

20. See UDTA Section 4, cmt. (“This section confirms that the common law and principles of equity remain applicable to a directed trust except to the extent modified by this act or other law.”)

21. See UDTA Section 2(9), cmt. 

22. In a given situation, a trust director may not necessarily be authorized to act immediately on acceptance of the directorship, such as in the case of a springing directorship. See UDTA Section 8, cmt.

23. UDTA Section 2(1).

24. UDTA, Prefatory Note.

25. Ibid.

26. See generally Loring and Rounds supra note 19, Section 8.1.1 (the holder of a non-fiduciary power of appointment generally isn’t duty-bound to exercise the power) and Section 6.1.2 (under classic black letter law, an agent qua agent isn’t duty-bound to act; he’s merely authorized to act).

27. See, e.g., UDTA Section 8(a) (providing that if a power of direction is held individually rather than jointly, the trust director has the same fiduciary duty and liability in the exercise or non-exercise of the power as would a sole trustee in a like position and under similar circumstances). See also Section 16 (providing that the default rules applicable to a trusteeship apply as well to a trust directorship when it comes to acceptance of the fiduciary office, giving of fiduciary bond, fiduciary compensation, fiduciary resignation, fiduciary removal and the filling of fiduciary vacancies).

28. See generally Section 7.2.9 of Loring and Rounds, supra note 19 (personal liability of non-parties to the trust relationship).

29. Uniform Trust Code Section (UTC) 808(b) (providing that a trustee shall honor the direction of a trust director “unless the attempted exercise is manifestly contrary to the terms of the trust or the trustee knows the attempted exercise would constitute a breach of fiduciary duty that the … [trust director] … owes to the beneficiaries of the trust”).

30. That having been said, there’s UDTA commentary to the effect that “willful misconduct” and “intentional misconduct” are synonymous. See UDTA Section 9, cmt.

31. See UDTA Section 5(b)(2).

32. UTC Section 808, cmt.

33. UDTA Section 9, cmt. 

34. See UDTA Section 5(b)(2).

35. See UTC Section 808, cmt and UDTA Section 9, cmt.

There’s been a veritable explosion of fiduciary litigation in recent years, attributable to a host of factors, including the escalating amount of wealth at stake; the reduction in transfer taxes leaving larger inheritances to fight over; the lengthening of life spans causing beneficiaries to wait longer than ever to inherit; the changing nature of families with the legalization of gay marriage, adult adoption and other alternative family structures; and the ever more litigious society we live in. Because of these factors, it’s increasingly likely that fiduciaries (and particularly corporate fiduciaries, which often are perceived as deep pockets) will become embroiled in litigation or other contested legal proceedings.  

Historically, fiduciary litigation has been the province of state courts, and, in particular, specialized state probate courts, such as the surrogate’s courts in New York and New Jersey, the orphans’ courts in Pennsylvania and Maryland and the probate courts in California and Illinois, all of which typically are devoted to the probate of wills, the administration of trusts and estates, guardianships/conservatorships and other matters dealing with the succession of wealth. Plaintiffs increasingly have been bypassing state courts in favor of a federal forum when they can assert a basis for the federal court’s jurisdiction, typically by alleging diversity of citizenship. The federal constitutional right to a jury trial, to which they might not otherwise be entitled in specialized state courts, is a frequent motivating factor. Another motivating factor is the hope that a court of general jurisdiction isn’t steeped in the arcana of the laws of descent and distribution. 

If faced with federal litigation, and diversity of citizenship or another basis for federal jurisdiction is sufficiently pleaded, consider two strategies for challenging a federal court’s jurisdiction. The first, and most common, strategy is to seek dismissal of the federal suit based on the probate exception to federal jurisdiction, which reserves to state probate courts the probate or annulment of a will and the administration of a decedent’s estate, and precludes federal courts from interfering with a res in the custody of a state court. The second is to ask the federal court to abstain from exercising its jurisdiction if a related state court proceeding is already pending until that proceeding is resolved.

The Probate Exception

Federal courts have limited jurisdiction, meaning they can only hear cases authorized by the U.S. Constitution or federal statutes. It’s long been held that a federal court has no jurisdiction to probate a will or administer an estate because the equity jurisdiction conferred by the Judiciary Act of 1789, which is that of the English Court of Chancery, didn’t extend to probate matters.¹ By a long series of decisions of the U.S. Supreme Court, as laid out in Markham v. Allen, it’s been established that:

. . . federal courts do have jurisdiction to entertain suits ‘in favor of creditors, legatees and heirs’ and other claimants against a decedent’s estate so long as the federal court does not interfere with the probate proceedings or assume general jurisdiction of the probate or control of the property in the custody of the state court.² 

     Similarly, the Markham court held that:

. . . while a federal court may not exercise its jurisdiction to disturb or affect the possession of property in the custody of a state court, ... it may exercise its jurisdiction to adjudicate rights in such property where the final judgment does not undertake to interfere with the state court’s possession save to the extent that the state court is bound by the judgment to recognize the right adjudicated by the federal court.³

Following Markham, although it was clear that federal courts couldn’t probate wills, courts puzzled over the meaning of the words “interfere with the probate proceedings” and struggled with where to draw the line in determining the scope of the probate exception, with varying and inconsistent results. Sixty years later, in Marshall v. Marshall,⁴ the Supreme Court sought to clarify the scope of the exception.

Marshall arose from claims asserted by Vickie Lynn Marshall, a/k/a Anna Nicole Smith, the widow of J. Howard Marshall II, who died without providing for her in his will. According to Anna Nicole, Howard intended to provide for her through a gift in the form of a “catch-all” trust.⁵ Howard’s son, E. Pierce Marshall, was the ultimate beneficiary of Howard’s estate plan.⁶ During the course of the proceedings in the Texas probate court, Anna Nicole filed for bankruptcy in California, where hotly contested litigation involving Pierce ensued. Following a trial, the bankruptcy court awarded Anna Nicole substantial compensatory and punitive damages on her claim that Pierce had tortiously interfered with a gift she expected to receive from her husband.⁷ Pierce then filed a post-trial motion to dismiss for lack of subject matter jurisdiction, asserting that Anna Nicole’s tortious interference claim could be tried only in the Texas probate proceedings.⁸ The bankruptcy court denied the motion.⁹ Relying on Markham, the bankruptcy court observed that a federal court has jurisdiction to adjudicate rights in probate property, so long as its final judgment doesn’t interfere with the state court’s possession of the property. Subsequently, the Texas probate court declared that Howard’s estate plan was valid.¹⁰

Pierce then sought district court review of the bankruptcy court judgment. The district court held that the probate exception didn’t reach Anna Nicole’s counterclaim because it wouldn’t “interfere” with the probate proceedings.¹¹ It wouldn’t do so, the court concluded, because: (1) success on the counterclaim didn’t necessitate any declaration that Howard’s will was invalid, and (2) under Texas law, probate courts don’t have exclusive jurisdiction to entertain claims of the kind Anna Nicole asserted.¹² Because the court also held that the claim didn’t qualify as a “core proceeding,” the district court undertook de novo review and determined that Pierce had tortiously interfered with Anna Nicole’s expectancy and awarded substantial compensatory and punitive damages.¹³

The U.S. Court of Appeals for the Ninth Circuit reversed.¹⁴ Although the Ninth Circuit recognized that Anna Nicole’s claim didn’t involve the administration of an estate, the probate of a will or any other purely probate matter, it nevertheless held that the probate exception barred federal jurisdiction.¹⁵ It read the exception broadly to exclude from the federal courts’ adjudicatory authority not only direct challenges to a will or trust, but also “questions which would ordinarily be decided by a probate court in determining the validity of the decedent’s estate planning instrument, whether those questions involve fraud, undue influence [, or] tortious interference with the testator’s intent.”¹⁶ The court also held that a state’s vesting of exclusive jurisdiction over probate matters in a special court strips federal courts of jurisdiction to entertain any probate-related matter, including claims respecting tax liability, debt, gift and tort.¹⁷ 

The Supreme Court reversed, holding that the Ninth Circuit had no warrant for its sweeping extension of the probate exception.¹⁸ It read Markham’s enigmatic words concerning interfering with the probate proceedings in sync with those that proscribe “disturb[ing] or affect[ing] the possession of property in the custody of the state court” and comprehended the language as a reiteration of the general principle that, “when one court is exercising in rem jurisdiction over a res, a second court will not assume in rem jurisdiction over the same res.”¹⁹ Thus, the Court concluded, “the probate exception reserves to state probate courts the probate or annulment of a will and the administration of a decedent’s estate; it also precludes federal courts from endeavoring to dispose of property that is in the custody of a state probate court. But it does not bar federal courts from adjudicating matters outside those confines and otherwise within federal jurisdiction.”²⁰ The Court determined that Anna Nicole’s claim didn’t “involve the administration of an estate, the probate of a will, or any other purely probate matter,” but rather alleged a tort for which Anna Nicole sought an in personam judgment against Pierce to which the probate exception didn’t apply.²¹

Following Markham, federal courts have more consistently applied the probate exception, adjudicating matters that fall outside of its confines but otherwise within federal jurisdiction and ceding jurisdiction to state courts over matters that fall within it. In doing so, courts closely scrutinize the claims asserted and parse them as necessary, as exemplified in the Second Circuit’s decision in Lefkowitz v. Bank of New York.²² In that case, a beneficiary brought claims arising out of the administration of the estates of her parents against the executor and the law firm representing those estates. The district court dismissed the action for lack of subject matter jurisdiction based on the probate exception.²³ The plaintiff had alleged a dozen causes of action in her complaint, each sounding in tort seeking payment of monies allegedly owed, specific performance of certain consent orders or declaratory relief confirming her entitlement to estate assets.²⁴ Certain of her causes of action sought, in essence, disgorgement of funds that remained under the control of the probate court.²⁵ These claims included allegations that the executor wrongfully withheld estate funds from her, that defendants were unjustly enriched when they failed to distribute income belonging to her, that she had unpaid claims for monies owed with respect to legal fees she incurred in connection with determining her rights to payment from the estates and that the executor was obligated pursuant to consent orders to pay certain debts she owed.²⁶ In scrutinizing these claims, the Court of Appeals determined that the plaintiff was seeking “to mask in claims for federal relief her complaints about the maladministration of her parent’s estates, which [had] been proceeding in probate courts.”²⁷ The court determined that to provide the relief the plaintiff sought in connection with these claims, the federal court would have to assert control over property that remained under the control of the state courts, which it wasn’t permitted to do.²⁸ Accordingly, the district court had determined correctly that under the probate exception, it lacked jurisdiction to consider these claims and properly dismissed them.²⁹

However, as to the plaintiff’s in personam claims for breach of fiduciary duty, aiding and abetting breach of fiduciary duty, fraudulent misrepresentation and fraudulent concealment, the Second Circuit determined that the probate exception didn’t apply because the plaintiff sought damages from the defendants personally rather than assets or distributions from either estate.³⁰ The district court had concluded that the claims, “albeit ‘framed as in personam actions [that] do not directly implicate the res of either estate .... are entirely intertwined with nitty-gritty issues of estate administration”’ and were thus subject to the probate exception.³¹ It held that should it address the “substantive wrongs” asserted in these claims, it would impermissibly usurp the role of the probate court.³² The Second Circuit reversed, noting that, while the issues involved in these claims “undoubtedly intertwine” with the litigation proceeding in the probate courts, the federal court in addressing the claims wouldn’t be asserting control of any res in the custody of a state court.³³ Accordingly, these claims couldn’t be dismissed under the probate exception.³⁴

Thus, the probate exception is a valuable tool for challenging claims brought by a litigant against your fiduciary client in federal court and provides a compelling opportunity to revert claims concerning trust and estate administration to the specialized state courts.

Abstention Under Colorado River

If a proceeding is already pending in state court that concerns the fiduciary’s administration of the estate or trust, such as an accounting proceeding, federal abstention may be appropriate under the doctrine set forth in Colorado River Water Conservation Dist. v. U.S.,³⁵ which permits a federal court to stay or dismiss an action in favor of a concurrent state court action based on considerations of “[w]ise judicial administration, giving regard to conservation of judicial resources and comprehensive disposition of litigation.”³⁶ For this type of abstention, the threshold requirement is that the state and federal actions be parallel, meaning that “substantially the same parties are contemporaneously litigating substantially the same issue in another forum.”³⁷ Cases are parallel when the main issue in the case is the subject of already pending litigation.³⁸ Complete identity of parties and claims isn’t required.³⁹ Rather, “parallelism is achieved where there is a substantial likelihood that the state litigation will dispose of all claims presented in the federal case.”⁴⁰

In the recent case of Phillips v. Citibank, N.A.,⁴¹ a scholarly decision that would be a model template for any Colorado River abstention motion, the federal court found this threshold requirement of parallelism satisfied because the federal action involved the same issues and events that had been the subject of: (1) litigation in the surrogate’s court dating back to the probate of the grandfather’s will nearly three decades earlier, and (2) the pending accounting proceeding for the trust created under the grandfather’s will, of which the plaintiffs were remainder beneficiaries. Those common issues included the intent and administration of the grandfather’s will; the administration of the trust created under the will; and the management of assets within the purview of that trust.⁴² Indeed, in the federal action, the plaintiffs sought an accounting despite the fact that the trustee had already voluntarily initiated an accounting in surrogate’s court, and the plaintiffs asserted breach of fiduciary duty and trust maladministration claims nearly identical to their objections to the accounting that they had filed in that court.⁴³ Further, the plaintiffs’ complaint appeared to challenge positions taken by the trustee in the surrogate’s court without letting those positions resolve themselves in that court first.⁴⁴ Although some of the allegations and requests for relief in the two actions differed or even conflicted, the court found that this was no bar to parallelism when the underlying events remained identical.⁴⁵ Rather, the court determined that “the introduction of theories of recovery in [the federal court] that would necessarily interfere with the Surrogate’s Court proceedings demonstrates exactly why the two actions should not proceed contemporaneously.”⁴⁶

Although the plaintiffs in Phillips didn’t contest that the proceedings were parallel, the court rejected the plaintiffs’ argument that the fact that two of the defendants in the federal action weren’t defendants in the accounting proceeding disfavored abstention.⁴⁷ As to the one federal defendant, the court noted that he’d been named as an interested party as a representative of the father’s estate in the surrogate’s court proceeding and was served accordingly.⁴⁸ Although this defendant was also named in the federal action in his individual capacity, the only claim against him in that capacity was “for aiding and abetting breach, a claim whose survival depends on whether [the father] committed a breach in the first instance.”⁴⁹ Thus, the court concluded,
“[i]f the Surrogate’s Court determines that the Trust was dutifully administered, there will be no basis for a claim against [the defendant] in this Court either.”⁵⁰ As to the other federal defendant, from whom the plaintiffs sought rescission of a contract by which the defendant purchased real estate from the trust, because the primary relief sought against it was equitable, which could be asserted more easily against the trust, the court determined that “not only could this relief be requested in Surrogate’s Court, it should be.”⁵¹ The court also noted that it was “far from clear that [it] even has jurisdiction to entertain claims implicating the property of a trust involved in ongoing accounting proceedings.”⁵² Thus, the inclusion of additional claims or parties in the federal action didn’t defeat the otherwise parallel nature of the two proceedings.⁵³

Six Factors

After determining that the state and federal proceedings are parallel, the question becomes whether the federal court should exercise its discretion to abstain. This decision turns on consideration of six factors: (1) assumption of jurisdiction over any res, (2) inconvenience of the federal forum, (3) avoidance of piecemeal litigation, (4) order in which the actions were filed, (5) the law that applies the rule of decision, and (6) protection of the federal plaintiff’s rights.⁵⁴ These factors must be weighed against a federal court’s “virtually unflagging obligation … to exercise the jurisdiction given them.”⁵⁵ No one factor is determinative, and the balance is “heavily weighted in favor of the exercise of jurisdiction.”⁵⁶ The first factor—assumption of jurisdiction over the res—weighs in favor of abstention when the state court has assumed jurisdiction over the trust or estate at issue, as it does in any proceeding involving the administration of a will or trust, such as a probate or accounting proceeding.⁵⁷ The requirement here is that the state court is in fact exercising jurisdiction. If, for example, the account of a trustee has already been settled, then the corpus of the trust is returned to the hands of the trustee for further administration of the trust, and the court would no longer be exercising jurisdiction.⁵⁸ Furthermore, even if the claims at issue, such as those for personal damages, don’t directly implicate a res, this factor may still favor abstention. In Phillips,⁵⁹ the court held that although the personal damages claims didn’t implicate the trust res, they were inextricably linked with the issues of trust administration pending before the surrogate’s court and, in some cases, were only requested as an alternative to relief affecting property under the surrogate’s court’s jurisdiction, so this factor weighed in favor of abstention. Additionally, claims against trustees or executors in their fiduciary capacities could implicate the res because any relief ordered would necessarily implicate the distribution of a res that’s under the control of the state court.⁶⁰

As to the second factor—the inconvenience of the federal forum—when the federal forum is equally convenient to the state forum, this factor tilts toward exercise of jurisdiction.⁶¹ However, federal courts have recognized that “there is plainly inconvenience in having to litigate actively in both state and federal courts at the same time.”⁶² In Phillips, the court found that this factor weighed “at least modestly” in favor of abstention.⁶³

The third factor—the avoidance of piecemeal litigation—is the “paramount consideration” in the analysis due in part to the possibility of inconsistent disposition of claims.⁶⁴ Although there’s generally no threat of piecemeal litigation when the issues in the two actions are separate and distinct,⁶⁵ courts have held that this factor favors abstention even when the actions are “merely duplicative,” such that the availability of res judicata or collateral estoppel would mitigate the risk of inconsistent outcomes.⁶⁶ This is because the “value of judicial economy … animates Colorado River” and thus the need to “avoid duplicative simultaneous litigation” supports abstention.⁶⁷ In Phillips, the court found that this factor favored abstention because the claims in the complaint were inherently intertwined with issues that the surrogate’s court was better-positioned to decide, including the intent of the decedent’s will and the tumultuous history of family conflict.⁶⁸ Further, the claims regarding the administration of the trust reached back over a decade, a period during which the surrogate’s court had jurisdiction over the estate and one encompassed by the pending accounting petition.⁶⁹ Although the Phillips court recognized that the presence of additional defendants in federal court meant that the surrogate’s court action couldn’t be a “complete and perfect substitute” for the federal action, it determined that the resolution of the surrogate’s court action would “either preclude recovery completely or collectively estop the relitigation of substantive issues in [the federal] action, thus alleviating the risk of duplicative effort and varied results.”⁷⁰ It also determined that, because the surrogate’s court action also involved allegations and remedies not raised in the federal action, proceeding forward with the federal case “would only lead to a heightened risk of inconsistent recovery, and not a complete resolution of the issues.”⁷¹

The fourth factor is concerned with the order in which jurisdiction was obtained and examines when each action began and the relative progress that’s been made.⁷² This factor weighs in favor of abstention when there’s been more substantive progress in the state court action than in the federal action.⁷³ Thus, seeking Colorado River abstention at the outset of the federal case as part of a dispositive motion will postpone substantive action in the federal case until the jurisdictional issue is determined, tilting the scale toward abstention.⁷⁴ Notably, federal courts particularly have been predisposed to abstaining in favor of pending accounting proceedings in which interim or final accountings and objections thereto have been filed, precisely the situation in Phillips.⁷⁵

As to the fifth factor—the law that applies the rule of decision—the absence of a federal question may favor abstention.⁷⁶ Although the absence of federal issues “does not strongly advise dismissal, unless the state law issues are novel or particularly complex,” it does favor abstention “where the bulk of the litigation would necessarily revolve around the state-law rights of numerous parties.”⁷⁷ Additionally, federal courts regularly point to expertise of specialized state courts in interpreting state law as a key factor favoring abstention.⁷⁸ In Phillips, the court determined that because the New York surrogate’s court has “special expertise” in “matters related to the probate and administration of wills”—not to mention the particular affairs of the parties—it was “better situated to resolve the controversy over the parties’ rights as … distributees or legatees of [the] estate.”⁷⁹

The sixth factor—protection of the federal plaintiff’s rights—requires the federal court to determine whether the parallel state court litigation will be an adequate vehicle for the complete and prompt resolution of the issues between the parties.⁸⁰ Generally, a plaintiff’s rights will be adequately protected if the plaintiff can assert the same claims in the state and federal actions.⁸¹ When seeking abstention in favor of a state court proceeding, the key question is whether the state court is able to entertain all of the claims.⁸² In Phillips, the court rejected the argument that the plaintiffs’ rights wouldn’t be protected because the federal case asserted claims and involved parties not involved in the state court proceeding because the primary relief sought against the additional federal defendant was reversal of a property sale and imposition of a constructive trust, forms of relief that may be sought in the state court proceeding.⁸³ And, although the plaintiffs also sought damages in the event rescission wasn’t available, the Phillips court found this no bar to abstention because following the state court’s determination regarding liability and relief, the claim would either be foreclosed completely or the federal court would be left with very little to do, militating in favor of a stay.⁸⁴ Finally, when no federal rights are at stake, this factor also favors abstention.⁸⁵

Thus, Colorado River abstention is another valuable tool for challenging a federal court’s jurisdiction when a parallel state court proceeding already is pending, and, like the probate exception, provides a compelling opportunity to revert claims concerning trust and estate administration, no matter how characterized, to the specialized state courts that possess expertise in interpreting state law relating to trusts and estates.    

Endnotes

1. Markham v. Allen, 326 U.S. 490, 494 (1946).

2. Ibid.

3. Ibid. (internal citations omitted).

4. Marshall v. Marshall, 547 U.S. 293 (2006)

5. Ibid., at p. 300.

6. Ibid.

7. Ibid., at p. 301.

8. Ibid.

9. Ibid., at pp. 301-02.

10. Ibid., at p. 302.

11. Ibid.

12. Ibid., at pp. 302-03.

13. Ibid., at p. 304.

14. Ibid.

15. Ibid.

16. Ibid. (internal quotations omitted).

17. Ibid., at pp. 299, 304-05.

18. Ibid., at pp. 299-300.

19. Ibid., at p. 311 (internal quotations omitted).

20.Ibid., at pp. 311-12.

21. Ibid., at p. 312.

22. Lefkowitz v. Bank of New York, 528 F.3d 102 (2d Cir. 2007).

In their recent article entitled, “Innovate or Die,” Timothy J. Belber, Ian McDermott, and John A. Warnick assess the current estate-planning landscape and perceptively find the profession to be at a turning point.¹ While tactical, tax-driven planning (along with asset protection planning) was the driving force for estate planning throughout the 1980s, 1990s and early 2000s, the authors point out that there are forces at work disrupting the traditional paradigm of tax-centered estate planning. The passage of the American Taxpayer Relief Act of 2012 and its increased exemptions, higher income tax rates and portability may have triggered a renewed emphasis on technical estate-planning practices, but a number of societal changes are placing a new demand on estate planners. There’s a chasm developing between what constitutes a traditional estate plan and what clients need and expect. Belber, McDermott and Warnick make it clear that estate planners must address these new developments or run the risk of becoming obsolete.   

For those seeking to stay ahead of the changing landscape, the first step is an understanding of the ways in which traditional estate planning falls short of meeting a client’s needs. The problem with traditional planning is that it’s far too narrow in its scope. Historically, an expertly crafted estate plan would transfer wealth from one generation to the next in a tax-efficient manner, protecting the client’s assets and ensuring an effective system was in place to administer those assets for heirs. While this process remains the foundation of estate planning, it’s become only the first part of a two-part race. More and more, clients are beginning to understand that even the most well-crafted estate plan will be useless if it fails to address their qualitative goals and/or if their heirs are unprepared to receive the inheritance. The innovative, adaptive estate-planning attorney will break from the confines of the traditional model to include “expanded planning” as the second part of the estate-planning process.  

Two-Stage Process

Stage 1: This stage is twofold: (1) begin the process of teaching and enhancing family communication skills, and (2) work with family members and spouses at the first generation (G1) and second generation (G2) levels (and third generation (G3) if practical) to clarify and commit to family beliefs, shared values and goals. The ultimate objective of this first stage is to create a collective family mission statement outlining the family’s core values, beliefs and goals. This process can yield three useful results for moving to the next level of expanded planning.  

1. Start the ongoing process of garnering participation and buy-in from G1, G2 and G3 (if practical), building cohesion and connection and giving the family members a cause behind which they can unite.

2. Identify relationship issues that can be addressed and resolved while the matriarch and patriarch are alive and participating. Relationship issues can spring from obvious situations such as a family business, a second marriage or access, use and management of a family ranch or vacation home. Further, the process can identify subtle, yet important, conflicts among family members that can emerge as a disruptive influence on family harmony if not identified and resolved while G1 is still living.  

3. The family mission will be the springboard from which will emerge the estate plan for the family. The mission will drive the estate plan, and the estate plan will in turn be structured to support the mission.  

Stage 2: Build and implement the family estate plan. Planning under the expanded model will differ from the traditional system in two primary ways. First, the plan will be purpose-driven and tailored to the family in that its purpose will be to advance the values, beliefs and goals set forth in the family mission statement. Second, the plan will be beneficiary-focused and oriented toward ensuring a family’s wealth exists for more than one generation.  

Tools to Implement Plan

With these parameters of the expanded planning model in place, the question remaining is what tools will be used to implement and operate the plan on an ongoing basis. For this, it’s helpful to look to successful multi-generational families as models. No two families are the same, but through the use of concepts such as family retreats, educational development and organized governance, families who’ve managed to skirt the old “shirtsleeves-to-shirtsleeves” adage provide a template of best practices to incorporate into a client’s expanded planning. For some estate planners, the idea of expanded planning may seem too abstract. Often, the concepts may be easy to discuss with the client but ultimately become too difficult to implement, which is why it’s necessary for planners to have a practical tool available to help achieve the objectives of expanded planning. One such tool is a family advancement sustainability trust (FAST), a new type of trust that essentially serves as the legs of expanded planning, providing both the money to fund planning strategies and the leadership to place those strategies into motion.² It isn’t enough for G1 to implement best practices and just hope that the family will continue them. To beat the odds and overcome the “shirtsleeves” adage, G1 needs to put a structure in place. For example, when G1 is gone, G2 (or their spouses) may resist paying for their portion of the family retreats out of their pocket. Once G1 creates a FAST and funds it, the FAST can provide the funds to pay for the retreat, and one of the FAST’s decision-making bodies is charged with the responsibility of making sure the retreat actually happens.

The FAST

To appreciate how a FAST facilitates expanded planning, it’s first necessary to understand the technical nuts and bolts of what a FAST is. At its core, the FAST is created to support the institution of the family, investing in family members rather than simply distributing assets to heirs. Structurally, a FAST is a standard dynasty trust, but with a spin—it’s a directed trust created in Delaware or a state with similar directed trust laws. With a directed trust, decision-making authority isn’t concentrated solely in the trustee, but instead can be split among one or more advisors to the trust. Specifically, decisions regarding administrative matters, trust investments and trust distributions may be assigned to separate co-trustees, advisors or trust protectors. Thus, the significance of the directed trust is that it allows family members and trusted advisors of the family to directly participate in the governance of the trust.  

Accordingly, a FAST contains four decision-making bodies, described in detail below. Individuals may serve on more than one committee, and non-family
committee members receive compensation for serving on a committee. The grantor(s) would likely desire to be a member of each committee.   

Four Decision-Making Bodies

1. Administrative trustee. Typically, a corporate trustee serves as the administrative trustee. The administrative trustee has no control over investment or distribution decisions but rather deals strictly with generic trust-related tasks such as recordkeeping and maintaining custody of the trust’s assets.

2. Investment committee. The investment committee is commonly comprised of three members: two family members and one professional advisor. The professional advisor could be a peer, such as a family investment advisor or some other type of fiduciary, or could be a hired investment advisor. The investment committee is charged with making all decisions relating to the investment of trust assets.  

3. Distribution committee. The distribution committee is comprised of several members, for example: two family members, a professional consultant who has experience working with families on legacy planning, an individual who’s a like-minded peer to the grantor and one other advisor (family attorney or accountant) with professional expertise who also brings a knowledge of or familiarity with the family. A key aspect of the FAST is that the responsibilities of the distribution committee are much broader than in typical trusts. Whereas in other trusts, a distribution committee makes decisions regarding the disbursement of trust assets, in a FAST, the distribution committee is charged with spending trust assets to preserve and strengthen the family institution.  

4. Trust protector committee. The trust protector committee may be comprised of three professional members such as the family’s attorney, CPA, financial advisor and/or a trusted fiduciary. Although it wouldn’t be advisable to have a family member serve on the trust protector committee, family members could serve as consultants to the committee. The trust protectors are individuals charged with playing the role of the grantor once the grantor is no longer able to do so. Some typical trust protector duties include removing or appointing trustees, committee members or other advisors and amending the governing instrument of the trust to efficiently administer the trust or to achieve favorable tax status for the trust. 

As noted above, a key component of the FAST is that it allows family members and trusted advisors of the family to directly participate in the governance of the trust. A way to be sure these fiduciaries are accountable to carry out the tasks that have been assigned to them is to include a peer review process in the FAST to be administered by the trust protector committee. Within the context of trusts, peer review is a tool used solely as a positive review process of trust operations. Essentially, peer review is a way for an objective person or committee to perform a check-up on how well the trust is continuing to meet the patriarch’s and matriarch’s original objectives. As such, it’s a healthy way to assure the patriarch and matriarch that the long-term stability and effectiveness of the trust will continue to be monitored. A peer review system requires careful thought and drafting. The trust agreement should include a requirement that the review occur periodically. The reviewers should be objective and unbiased and should receive reasonable compensation for their efforts and expenses. Although peer reviewers have no enforcement authority, their reports act as checks on the committees and can provide clients with the assurance of knowing that as younger generations become committee members, they won’t be without continued guidance.

Creation and Funding

It’s important to consider when to create and how to fund the FAST. Creating a FAST should ideally occur during the patriarch’s and matriarch’s lifetimes to allow G1 to mold the trust to reflect the needs and ideals of the family. Moreover, initiating operation of a FAST during the lifetime of G1 helps to guide family members and advisors and establish the direction of the FAST for future generations.  

The FAST may be minimally funded during the lifetimes of G1, with additional funds contributed to the trust on their deaths. The amount of funding can be either a fixed amount or a percentage of the estate. It will vary from family to family according to their means and the FAST’s agenda. During the patriarch’s and matriarch’s lifetimes, FAST-related activities such as family retreats and educational programs can be paid for either out of G1’s pocket or from the FAST.    

Although there are several ways to fund a FAST, two primary funding techniques are the special purpose irrevocable life insurance trust (ILIT) and the 678 trust (also known as a “beneficiary defective irrevocable trust” or “BDIT”). With a special purpose ILIT, a stand-alone ILIT holds a life insurance policy on the patriarch or matriarch that funnels additional funds into the FAST at the death of G1. The other funding technique involves the use of a 678 trust, which is a unique estate-planning tool that allows clients to combine asset protection, estate tax savings and the continued ability to benefit from the assets they’ve accumulated. On the death(s) of G1 (the primary beneficiaries of the 678 trust), generation-skipping transfer (GST) tax-exempt assets from the 678 trust pour over to the FAST. This pour-over can be achieved by G1 exercising a special power of appointment directing assets into the FAST, which also allows them to periodically adjust the amount of the pour-over. When funding a FAST, it’s important to do so in a way that avoids potential GST tax liability.  

Strengthen Family Cohesiveness 

Whether a family realizes it or not, the patriarch and matriarch often act as the glue that holds the family together. Once they pass away, the dynamics of the family can shift drastically. By establishing a FAST, the family leaders are essentially creating a replacement glue that will assume the responsibility of fostering and nurturing family relations and of maintaining a family identity.  

Shared values. Ensuring that the family has a clear understanding of the patriarch’s and matriarch’s intentions and vision for the family can be crucial to the family’s ability to work together as one unit. Creating a family mission statement can be a particularly impactful tool in this regard. According to an article from The New York Times entitled “The Stories That Bind Us,” it’s recommended that families craft a mission statement to preserve the core—similar to the way a large company often uses a mission statement to maintain its core values.³ With a FAST, the trust agreement lays out the process to determine and preserve the family mission, beliefs, values and goals. Moreover, the drafting of the trust itself can serve as a way to initiate a conversation among the different generations of the family.

Family retreats. Another significant way the FAST promotes family relations is through the planning, coordination and financing of an annual family retreat. While conflicts and busy schedules are a typical part of any family, real problems emerge when there’s no positive force pushing the family closer together acting as a balance against the stress. Family retreats can provide an ideal atmosphere for fellowship and the facilitation of meaningful and informative conversations regarding family affairs, all of which help to reinforce the stability and connectedness of the family. The distribution committee assumes responsibility for the planning of the family retreat, preparing activities and creating agendas for formal family meetings.  

Family history. In addition to a clear family mission, a family’s history can also serve as a unifier for the family. Furthermore, a knowledge of family history has been linked to higher self-esteem and better emotional health in children. Because a family’s history is integral to maintaining a family identity, the distribution committee acts as a family historian, ensuring the documentation and dissemination of important aspects of the family’s history. In practice, each distribution committee will carry out its role differently. Accordingly, overseeing the preservation of family history could include various tasks, including the safekeeping of family heirlooms, the creation of a written history of the family that’s accessible to family members or the incorporation of family history lessons into family meetings or educational curriculum.  

Maximize Heirs’ Potential

In addition to strengthening the familial bond, expanded planning aims to prepare heirs to reach their maximum potential. Equipping a family to receive and successfully manage an inheritance is no small task, but it can be broken down into three parts: (1) education; (2) mentoring and practical experience; and (3) family philanthropy.  

Education. The most effective way to approach the education of future heirs is to establish an education strategy. The strategy should be a dynamic, multi-faceted plan that aims to instill knowledge and wisdom in the next generation. Because creating and implementing this strategy can be an overwhelming task for any one family member, transferring that responsibility to a FAST can reap great rewards. Taking into account the ages, occupations and sophistication levels of the family members, as well as the characteristics of the family assets, the distribution committee determines what types of programs will be beneficial for preparing the family members to manage their inheritance and function as responsible members of society. Generally, an education plan will aim to cover basic topics: an understanding of family virtues, values and history; financial education; the ability to read and understand legal documents; the skills to make competent decisions in coordination with financial advisors; and the desire to participate in family meetings. A more sophisticated education plan would include additional curriculum related to the family business, as well as integrated family wealth management (financial planning, taxes, sustainable spend rates and market cycles). The distribution committee disseminates materials, schedules outside speakers to lead family meetings and ultimately ensures (and funds) the successful implementation of the family’s education strategy.  

Mentoring and practical experience. Overall, one of the primary benefits of the FAST is the message it sends to the family—specifically, that the family leaders aren’t primarily interested in saving taxes or attaching strings to monetary gifts, but rather desire to empower the younger generations of the family. In this regard, the FAST aims to provide practical experience by serving as a mentor to beneficiaries, imparting wisdom instead of simply acting as a gatekeeper to the family wealth. The trust decision makers—the committee members—are in an ideal position to act as mentors to members of the younger generations.⁴ For example, the investment committee could provide investment mentoring to the younger generations by meeting with each member annually to explain the investment decisions that have been made with respect to the trust. Some younger family members may need advice on how to be a better investor, while others may need advice on how to read a balance sheet. The mentor should make resources available to the family member that will complement his unique learning needs.  

The distribution committee grants practical experience to family members by making decisions regarding whether family funds should be gifted or loaned to a family member for entrepreneurial endeavors. Encouraging budding entrepreneurs not only teaches valuable business and money management skills, but also increases family interaction. It’s important to note that the FAST itself doesn’t gift or loan funds for entrepreneurial endeavors, but rather listens to proposals, advises and makes a recommendation as to whether family assets should be accessible to the applicant. The actual funds to be gifted or loaned should come from one of two places: if G1 is still living, then the funds should be drawn directly from them; if G1 is deceased, then the funds should come from a separate trust or family bank. 

Under the structure of a FAST, the process of requesting money provides invaluable real-world experience. The FAST can implement protocols for the borrowing process, requiring the beneficiary to submit a lending request that summarizes the purposes of the loan, the proposed loan terms and how he plans to repay the money. Moreover, the distribution committee can maintain guidelines and limitations for the amounts that should be administered, with increasingly higher standards for those with a history for entrepreneurial failures or poor performance.  

Family philanthropy. In addition to education and practical experience, family philanthropy is vital to preparing heirs for their inheritance. Charitable giving shows younger generations the value of helping others, and statistics show that the use of family philanthropy as a teaching tool is a determining factor in whether a family remains united. The FAST prepares the next generation to be leaders in the family’s philanthropic activities by demonstrating how to give effectively and by allowing younger generations to select causes and take ownership of their own charitable investments. As with entrepreneurial development, no funds will be distributed directly from the FAST for charitable purposes. The distribution committee makes recommendations and approves charitable initiatives, while the actual charitable funds are drawn from the family’s typical charitable gifting vehicle (for example, a family foundation or donor-advised fund).  

Helping to preserve a family and prepare heirs for their inheritance may not be traditional estate-planning tasks, but there’s a growing demand for this type of expanded planning. Our world is rapidly changing, and the estate-planning landscape has changed along with it. Clients are increasingly expecting more than just a set of documents from their estate planners, and those planners who refuse to adapt their practices, or move too slowly, will ultimately be left behind. The current state of estate planning may be one scenario where slow and steady won’t win the race—it’s time to act FAST.    

Endnotes

1. Timothy J. Belber, Ian McDermott and John A. Warnick, “Innovate or Die,” Trusts & Estates (September 2017), at p. 53.  

2. This trust was jointly developed by Thomas Rogerson, a senior managing director and family wealth strategist at Wilmington Trust, NA and The Blum Firm, P.C. 

3. Bruce Feiler, “The Stories that Bind Us,” The New York Times (March 15, 2013).

4. James E. Hughes, Jr., “The Trustee as Mentor,” The Chase Journal (Volume II, Issue 2, Spring 1998).

When individuals are engaged in extensive wealth transfer planning, issues related to gifting and efficient funding of life insurance policies are often key topics in minimizing the impact on an estate. Within the context of that planning, individuals secure traditional life insurance products owned by irrevocable trusts while at the same time seek options to effectively manage their investments for optimal performance from a tax perspective. The product and funding alternatives merge and create opportunities to incorporate split-dollar financing for private placement life insurance (PPLI). 

To minimize or eliminate estate taxes, PPLI is generally owned or placed in an irrevocable life insurance trust (ILIT), usually designed as a grantor trust. Like other forms of life insurance, PPLI owned by an ILIT provides a means to manage investments in an income and estate tax efficient manner. However, PPLI generally offers more extensive investment options, including alternative asset classes.

Purchasers of PPLI are generally estate owners with significant personal assets that they hope to conserve for their children and grandchildren. But of course, the premiums for large PPLI policies are often substantial, and planning concerns remain regarding the federal and state gift taxes associated with the transfer of assets or cash to heirs or ILITs to fund PPLI premiums. Frequently, the estate owners have used up their federal lifetime exemption¹ and find their federal annual gift exclusion² to be of modest effect. 

PPLI Products

PPLI is similar to a traditional retail variable universal life insurance contract supported by a segregated asset account (separate account). The PPLI contract makes available various investment fund options (referred to as “insurance dedicated funds” in the case of private investment funds or “variable insurance trusts” in the case of registered funds). Alternatively, assets can be managed through a “separately managed account” (SMA). An investment manager may manage assets for an investment subaccount of a separate account of the insurance company. The asset manager has full discretion over the investment management of the SMA featured in the PPLI policy. The SMA may invest in a broad range of investments, including equities, fixed income, hedge funds, registered mutual funds and commodities. The contract owner’s separate account value varies over time with the investment performance of the investments to which contract premium is allocated.

The principal benefit of properly designed and administered life insurance is tax deferral. Returns on investments held for the benefit of these products aren’t subject to income taxation until the products are surrendered or withdrawals taken. Additionally, in the case of a properly designed and administered life insurance contract, death benefit proceeds pass to beneficiaries free of income tax. A secondary benefit of such products is administrative, in that product owners are generally relieved of tax reporting obligations (for example, K-1s) for the distinct investments held for the benefit of such products.

Benefits of PPLI?

PPLI differs from traditional life insurance in several beneficial ways. As noted above, investment options within PPLI products are generally broader than those available in traditional retail products. Further, PPLI products can provide greater flexibility in allocating contract values among new investment options as events and circumstances change.

Fees and expenses for PPLI products tend to be lower than in traditional life insurance products, and PPLI products thus tend to impose less expense pressure on policy investment account value (cash value). Subject to statutory limits, PPLI policy death benefit can be minimized, further reducing expense pressure on cash value. 

The Role of Split Dollar 

Split-dollar life plans offer an effective means to limit or eliminate gift tax issues associated with funding a life insurance policy owned by an ILIT, by reducing the amount deemed to be gifted from the full premium funded. A split-dollar plan may be implemented under two regimes. One is the economic benefit regime,³ which uses the economic benefit on the death benefit, and the other is the loan regime, which involves a loan whose proceeds are used to acquire a life insurance policy.⁴ Although both approaches are available, it’s more common to see the loan regime used in a private split-dollar arrangement than the economic benefit regime. A major advantage with a properly structured loan regime plan is that the policy is owned by the ILIT, and cash values and growth remain available to the ILIT and its beneficiaries.  The estate of the insured/trust grantor retains a right to the repayment of its loan and accrued interest, either at termination of the agreement or at death of the insured.

In a typical loan regime arrangement, the estate owner will be the grantor of a grantor ILIT and will loan the premium amount to the ILIT. The ILIT can either pay or accrue the interest on the loan. As an alternative, the amount of unpaid interest can be imputed as a current gift by the grantor/donor to the beneficiaries of the ILIT.⁵ Properly designed, when the loan interest is deemed to be at an applicable federal rate (AFR) or higher, no additional gift will be imputed.⁶ 

The term of the loan dictates the AFR that applies.⁷ As an example, in October 2017, the mid-term AFR (loans for more than three, but less than nine years) was 1.85 percent, and long-term loan rates (longer than nine years) were 2.5 percent.⁸ An optional approach to consider is a demand loan, which allows the use of a blended rate.⁹ Blended rates are published solely in July of each year and used for transactions for the given calendar year. That published rate in July of 2017 was 1.09 percent.¹⁰

Risk Management Factors

Certain risks arise in a private split-dollar transaction involving a PPLI policy. Those risks are generally related to either the structure of the split-dollar note or to the insurance carrier and its product performance and features. As with any purchase of PPLI, it’s important to review the financial strength of the carrier and its commitment to the market. Flexibility in product design as well as the variety of available investment options are also important factors.

A fundamental risk of PPLI worth noting is the possibility of loss of some or all of the premium paid. Often, PPLI products provide no guarantees of investment returns and therefore there’s a risk that the ultimate cash surrender value (CSV) of a PPLI product will be lower than originally illustrated. 

When private split-dollar is used to fund the PPLI premium and the policy significantly underperforms, there may be a plan to fund additional premium and reallocate to other investments in an effort to boost the potential for future performance. In that scenario, additional funding provided by a new or increased loan may take place in an environment in which the AFR is higher than the original split-dollar AFR, resulting in less benefit from a gift tax perspective. 

Another risk factor associated with a PPLI policy is the potential for a mismatch between the liquidity provided by the policy and the grantor/lender’s future liquidity needs. Because the underlying investments of a PPLI policy often aren’t publicly traded, those investments may impose lock-ups or other liquidity restrictions that prevent an immediate liquidation of separate account investments in connection with a policy surrender or withdrawal request. 

Independent of these product-related risks, the structuring of the private split-dollar transaction also may introduce variables that must be managed. For example, because the monthly published AFRs are used for term loans, if a split-dollar funding plan contemplates a series of term loans to fund each premium payment, the AFRs of those loans will likely be different. That potential variability in AFRs may, depending on the movement in interest rates, make the funding plan more or less efficient from a gift tax perspective. This risk can be managed with a single lump sum, long-term loan, but that may not be feasible for all clients. In a low interest rate environment, the risk of rising AFRs increases and should be actively monitored to maximize the economic efficiency of an ILIT funding plan.

Case Considerations and Steps

Identifying the profile for private split-dollar funding is important so the advisor can assess when to introduce it as an option. When a client is interested in purchasing a PPLI policy and having it removed from the taxable estate, that would generally involve planning with an ILIT. The question becomes whether the client has sufficient gift tax exemption to fund the ILIT and is willing to use it for that purpose. More often, PPLI policies are funded with total premiums in excess of $10 million, so flexibility with gifting is limited. Recall that private split dollar also arises when clients wish to maintain a degree of control and the ability to have their premium dollars returned to them plus interest in the form of full or partial repayment of the existing note. 

Once a client has decided to proceed, implementation of a private split-dollar plan is carried out through a series of steps when using the loan regime to fund PPLI. The client often selects the split-dollar loan regime as the method of implementing the plan, because access to CSV is wholly controlled by the policy owner—namely the ILIT. The client must have significant liquidity available as a preliminary requirement to engage in the private split-dollar arrangement.

Step 1: Create and structure an ILIT so that assets owned by such ILIT are outside of the client’s taxable estate. 

Step 2: The ILIT trustee applies for a PPLI policy on the life of the client or another individual in which the trust has an insurable interest.

Step 3: Prior to policy issue, the client loans the amount of premium desired to fund the PPLI. Depending on the length of the loan term, the rate of interest will be the short-, mid- or long-term AFR, as previously noted. The benefit of structuring the note as a lump sum loan is the ability to lock in the lower long-term AFR for added leverage.

Step 4: The client receives the split-dollar note from the ILIT (the note is included in the client’s taxable estate).  

Step 5: The client and the ILIT enter into a split-dollar agreement. Generally, no interest or principal payments are due until the death of the insured, but there’s flexibility in structuring the term depending on the client’s circumstances.

Step 6: The split-dollar note may be repaid from the PPLI policy cash values during the client’s life. In the event the client doesn’t wish to reduce the CSV of the policy, the note can be repaid on the death of the insured.

Opportunities for Tax Efficiency

Consider James, 50 years old, married with two teenage children. As a successful investment banker, he’s accumulated significant wealth. His current net worth is $60 million, and he continues to earn in excess of $1 million annually. James is well aware of his annual tax bill and is regularly seeking ways to mitigate his tax liability. He invests regularly and is interested in incorporating alternative investments in his portfolio. James has a gross annualized return of 7 percent on his investments, but understands that the tax drag is significant because much of his gain annually is a blend of ordinary income and short-term capital gain. 

James meets with his advisory team and is introduced to PPLI as an option for tax-efficient portfolio management and long-term accumulation. His advisors obtain a PPLI illustration and prepare a comparison for discussion with James. (See “PPLI Illustration,” p. 40.)

The analysis showed that in Year 20, when James is age 70, a PPLI policy will produce a 6 percent internal rate of return (IRR) on the cash value versus net 4.2 percent on the taxable investment portfolio. After review of the projected growth under his current versus proposed PPLI, as well as full review of available products and investment options in the market, he decides that PPLI is appropriate for his planning and investment needs. 

With the assistance of his advisor team, James evaluates structuring options for the PPLI policy and decides to form an ILIT that’s a grantor trust for income tax purposes. The ILIT, as owner and beneficiary of the policy, is structured so that the PPLI policy isn’t included in James’ taxable estate.

The funding options being evaluated include funding the ILIT via a taxable gift, use of a lifetime exemption or entering a split-dollar agreement with the ILIT. Neither he nor his wife had their lifetime gift exemption available so that left them with the choice to pay a gift tax today or avoid it entirely while maintaining the ability to later collect the premium he funds the PPLI with via a split-dollar agreement. 

James and his advisor team reviewed the short-term and long-term economics of a funding comparison for the PPLI premium with: (1) outright gifts, and (2) a split-dollar arrangement.¹¹ (See “Funding Comparison,” p. 41.)

If James were to fund the premium with gifts of $2 million for five years, he would have a cumulative gift tax of $4 million paid by Year 5. Ultimately, the cost of funding the PPLI increased by 40 percent and if factored in to the net impact of James’ estate, it would have significant drag on the growth.

A split-dollar arrangement using loan regime would produce a significantly different result. Assuming the note was structured so that a lump sum loan of $10 million is made to the ILIT in Year 1 at the long-term AFR of 2.5 percent (as of October 2017), the growth removed from the taxable estate of James is equal to the difference between the long-term AFR and the annual growth of the PPLI. As long as the PPLI policy returns in excess of 2.5 percent, the split-dollar plan has been effective in shifting growth from being subject to estate tax.

The cumulative gift tax on split-dollar loan regime interest is the interest on the split-dollar loan that would be due to the lender, James in this case. James may allow that interest to accrue on the loan balance for the term of the loan. Assuming in Year 40, James elects to waive collection of the loan interest, it would be deemed a gift to the ILIT, and gift taxes would need to be paid. Not until Year 40 does the amount of gift tax that would need to be paid under the split-dollar plan equal the $4 million that would have been paid by Year 5 if gifted outright. 

To illustrate the impact on James’ estate, we see in “Funding Comparison” that if the $4 million that would be paid in gift taxes under the outright gift plan were retained by James and had a net investment return of 3 percent on the savings of cumulative gift tax, then by Year 20, he would have retained $6,815,684, and by year 40, or age 90, the savings would have accumulated to $12,309,883. This reinforces the financial impact that saving gift taxes today and allowing those savings to accumulate over 20 years and 40 years has on James’ estate. While that growth creates an estate tax issue, there may be other assets that he would opt to shift out through alternative planning techniques and then elect to spend down some of this accumulated growth.

Ultimately, a split-dollar arrangement allows James to eliminate current gift tax to the ILIT, maintain flexibility in his future gifting options and have the ability to secure cash payments via interest payment from the ILIT to himself. 

Key Solutions

When you align family assets with higher net investment returns, you can unlock significant value, especially for families focusing on future generations. PPLI products are key solutions to tax-efficient investing. PPLI products can be used along with, or in addition to, many other structures to enhance family wealth planning. 

PPLI products offer the qualified purchaser access to both investment alternatives and product designs that may not exist with traditional tax-inefficient investment products. These products can be used to defer or potentially eliminate income tax or any tax reporting associated with investment activities. They provide a low cost, transparent, efficient and flexible approach to address a number of financial, estate and income tax planning objectives. Simply put, structured expense (that is, the cost of implementing the PPLI structure) may be substantially less than the taxes the family would otherwise incur. It’s just math.  

Endnotes

1. Internal Revenue Code Section 2010.

2. IRC Section 2503.

3. Treasury Regulations Section 1.7872-15.

4. Treas. Regs. Section 1.61-22

5. To qualify for the annual federal gift tax exclusion, Crummey provisions will be included in the irrevocable life insurance trust. 

6. IRC Section 7872 and Treas. Regs. Section 1.7872-15(e).

7. Treas. Regs. Section 1.1288-1.

8. Revenue Ruling 2017-20.

9. IRC Section 7872(e)(2) 

10. Rev. Rul. 2017–14, Section 7872(e)(2) blended annual rate for 2017 is 1.09 percent.

11. Follows guidelines of split-dollar regulations; long-term applicable federal rate for a note over nine years (annual compounding) is 2.5 percent as of October 2017. The term of the note is structured to be for the lifetime of the insured.

—This material is designed to provide accurate and authoritative information with regard to the subject matter covered. This informational material isn’t intended as a solicitation to the general public and is designed for use with qualified financial professionals.

In the last 15 years, premium financing has become a popular strategy for funding large trust-owned life insurance (TOLI) policies. The rise of premium financing plans can be attributed to a number of factors, including high-net-worth clients being comfortable borrowing funds to finance transactions, ongoing favorable borrowing rates and the development of indexed universal life (IUL) policies that reflect the returns of an equity index fund (index fund), typically, the S&P 500.¹ Lenders are willing to make these loans because they’re fully secured at all times and are therefore never at risk.

Premium financing provides many opportunities to fund life insurance using other people’s money.  Appropriate uses of premium financing begin with an established need for life insurance, typically for estate or business planning, and include scenarios in which:

• The client doesn’t currently have the cash flow to pay for the insurance. For example, the client’s closely held business may be in growth mode, and the owner is reinvesting profits back into the business.

• Short-term financing may make sense, including the accrual of loan interest. For example, a client may expect a liquidity event in the next three to five years that will generate cash flow to pay interest, repay the loan and pay future premiums.

• The client’s business, real estate or other investments have a proven track record of generating substantially greater after-tax returns when compared to the projected loan rates so that he prefers to borrow to fund the life insurance rather than reposition high performing assets.

With the potential for strong cash value returns based on the associated index fund, IUL policies are frequently used for premium financing plans.² Depending on performance, policy values may be available to pay a portion of interest costs and loan principal. However, just as direct investment in an index fund bears the risk and reward of the performance of the fund, IUL bears that same risk with significant differences and limitations. In addition, most policy components aren’t guaranteed. Unfortunately, designs that purport to create no cost or very low cost TOLI have been and are being aggressively marketed. And, who wouldn’t want free insurance? Although it’s possible that these aggressive plans might live up to their promise, they expose clients and their families to tremendous financial and tax risks.  

I’ve divided this article into two parts. Part I provides an overview of premium financing plans and IUL policies. Part II will evaluate IUL returns; stress test an aggressive plan design; and illustrate the financial and compounding tax risks it poses. It will then outline a prudent approach to designing, funding and monitoring premium financing plans.    

Premium Financing Overview 

In a typical premium financing plan, an irrevocable life insurance trust (ILIT) borrows from a commercial or third-party lender, typically a bank, to pay the premiums on a policy owned by and payable to the trust. The trust either: (1) accrues the interest, or (2) pays the loan interest with cash flow from trust assets or with gifts from the client/insured. Sufficient collateral acceptable to the lender is posted so that the lender is fully secured at all times.  

At inception, the lender agrees to a total loan for a term of years based on expected premium payments and subject to the guarantors continuing to meet financial qualifications. For example, assume a client desires to establish an ILIT and finance purchase a policy with five annual premiums of $500,000. The lender agrees to a $500,000 loan in Year 1 and total additional loans of $2 million to cover the remaining four premiums. The client guarantees the loan and posts collateral as needed. The lender pays the first premium and, on each anniversary during the 5-year period, provides an invoice for interest due, trues up collateral (to ensure that the lender remains fully secured) and, provided the loan isn’t in default and the client as guarantor continues to meet financial qualifications, offers the borrower the option to finance all or a portion of the next premium. As part of the annual review, the client certifies to the lender that his financial net worth hasn’t decreased, and the lender reserves the right to request a current financial statement. At the end of the 5-year period, the borrower will be given the opportunity to repay the loan or re-apply. The loan will be re-underwritten, and if approved, the borrower may re-up for another 5-year period, but subject to the lender’s terms in effect at that time and based on the new underwriting. If the lender doesn’t renew the loan, it will be due and payable in full, and the borrower may be scrambling to find an alternate financing source.

The loan interest rate typically varies annually and is based on the current 12-month LIBOR³ at the time of implementation, plus a spread ranging from approximately 100 to 350 basis points (bps). The spread will depend on the lender, the size of the loan and the creditworthiness of the borrower, and it isn’t guaranteed over the term of the loan. On each annual renewal date, the loan rate is adjusted based on the then-current  12-month LIBOR plus the spread and applied to the entire outstanding loan balance. It’s important to put the 12-month LIBOR in perspective by reviewing historical rates:

• In June 2014, the 12-month LIBOR reached an all-time low of 53 bps, and over the last nine years,⁴ it reached a high of 2.1 percent with an average of 1 percent.  

• For the calendar years 2006 and 2007, the 12-month LIBOR averaged over 5 percent.  

• Over the last 20 years, the 12-month LIBOR reached a high of 7.5 percent and averaged 2.74 percent.

• Since 1990 (28 years), the 12-month LIBOR reached a high of 9.25 percent with an average of 3.6 percent.  

Assuming a current 12-month LIBOR of 1.71 percent⁵ and a 175 bps spread, 3.5 percent would be a reasonable current loan rate. If the 12-month LIBOR increased from 1.75 percent to the 28-year average of 3.6 percent, the loan rate would increase to 5.35 percent (3.6 percent LIBOR + 175 bps spread). As the historical LIBOR rates indicate, the loan rate could in fact go far higher, and the premium financing plan is likely to experience substantial swings over its lifetime.    

Most lenders will provide the option to lock in a level multi-year loan rate at inception with an “interest rate swap,” for example for five years. A 5-year lock would add approximately 100 to 125 bps to the annually renewable loan rate, so that, assuming a 3.5 percent annually variable rate, a current level 5-year loan rate would be approximately 4.5 percent to 4.75 percent. The additional cost of the locked-in rate is based on the expected premium loans so that once a level rate is locked in, the borrower is committed to borrow the specified amounts on the pre-designated dates. For example, the trust will be committed to borrow five annual premiums. If the client doesn’t adhere to the premium borrowing schedule, including if the loan is repaid during the period, there will be a breakage fee, plus a possible pre-payment penalty.

Regarding collateral, the trust posts the policy cash surrender value (CSV) as collateral with any shortfall, the amount by which the loan exceeds the policy CSV being secured by assets acceptable to the lender. Typically, lenders will credit 90 percent to 95 percent of the policy CSV and will require that the insurance carrier meet financial strength guidelines. To the extent that the trust doesn’t hold sufficient assets to meet the shortfall, the grantor/insured pledges assets. Although there’s no authority on point, most advisors believe that the posting of collateral isn’t considered a gift to the trust.⁶ 

Most lenders will accept cash, certificates of deposit, money market funds, a letter of credit from a highly rated bank, a portfolio of quality marketable securities, life insurance cash values and some annuities as collateral. For collateral other than cash and letters of credit from a highly rated bank, the lender will require a greater amount than the outstanding loan balance (a margin) to reflect the risk that the value of the collateral will fluctuate during the loan period, thus ensuring that the lender is fully secured at all times. The riskier or less liquid the collateral, the greater the margin. Lenders monitor collateral closely to ensure that the loan isn’t in default. Although the collateral posted is tied up, frequently, the client may trade the marketable securities held as collateral as well as receive income and dividends provided that such actions don’t jeopardize the lender’s security. Some specialty lenders will accept art or real estate, but with a substantially larger margin and/or higher borrowing rates.  

When comparing lenders, it’s important not just to compare rates, but also to carefully assess and compare each lender’s experience in the market, long-term commitment to the market, the number and amount of premium financing loans in place and whether the loan has pre-payment penalties (the better programs don’t). Also, carefully review the conditions under which the loan may be called. The better lenders will only call the loan if it’s in default, that is, when the loan balance exceeds combined collateral, and that shortfall hasn’t been remedied following notification.

Alternatives for Repayment 

Because most premium financing plans are between an unfunded ILIT and a bank, transfers to the trust, whether to pay interest, to repay the loan or as a collateral call, are gifts. Such gifts could expose the estate to greater transfer taxes, whether as taxable gifts and/or smaller available exemptions. In addition, if it’s a dynasty trust, there will be generation-skipping transfer tax implications. With all premium financing plans, it’s therefore essential to carefully consider how the loan will be repaid. Consider these alternatives:

1. Some plans are designed to be maintained until death and repaid with the policy death benefit. That means that loans must be regularly renewed until death (subject to availability of credit, lender receptivity and ongoing commitment to the market and potentially different borrowing rates), and the policy must remain inforce.⁷   

2. If CSV growth is sufficient, the loan may be repaid with a policy loan. This may, however, place tremendous strain on the policy, risking a reduced death benefit or a policy lapse and recognition of phantom income.  

3. The premium financing plan may be implemented in a trust that’s already funded and holds sufficient assets to repay the loan.  

4. Other assets may be transferred to the trust using gifts, discounted gifts, grantor retained annuity trusts, intra-family loans and/or sales to a defective grantor trust. Such transfers may not only backstop the loan, but also, they may generate cash flow to pay loan interest and simply constitute sound estate planning.  

It’s essential that all premium financing plans, consisting of the policy, the loan and the collateral, be thoroughly stress tested, carefully administered and closely monitored at least annually, reviewing the performance of each component individually as well as collectively.  

IUL

Universal life (UL) is a generic name for a non-fully guaranteed⁸ flexible premium life insurance policy. With non-guaranteed UL policies, the carrier collects the annual premium, deducts charges and fees and invests the balance to generate the policy cash values. Each month, the cost of insurance (COI) (the 1-year term cost) is deducted from the cash values.⁹ The COI is determined by multiplying the net amount at risk (the policy death benefit less the policy cash values) times the carrier’s rate per $1,000 of insurance based on the insured’s age and rating (determined initially based on medical underwriting). As a 1-year term cost, the rate per thousand increases each year based on the insured’s attained age. Neither the investment returns nor the current fees and charges including the COIs are guaranteed but rather can fluctuate based on the carrier’s experience.¹⁰ If overall carrier performance is worse than expected, initial projected premiums may not be sufficient to ensure that the policy stays in force and doesn’t lapse or, if overall carrier performance is better than expected, lower premiums may result. 

IUL¹¹ is a cash value general account product¹² that’s based on the returns of an index fund, typically the S&P 500. IUL has a number of important and unique characteristics that advisors should understand that distinguish the IUL returns from the associated index fund. IUL premiums net of expenses and charges aren’t invested directly in the underlying index fund. Rather, the carrier employs standard general account investment strategies combined with hedging strategies that are based on the underlying index fund. The actual IUL return can vary substantially from the index fund’s return because: (1) the IUL return excludes dividends earned on the stocks comprising the index fund, (2) a participation rate or weighting (typically 100 percent) is then applied, and (3) the resulting return is then subject to a minimum (floor)¹³ and maximum (cap).¹⁴ These factors allow the carrier to employ hedging strategies to achieve the IUL policy’s investment returns and develop policy cash values:

• On receipt of a premium, the carrier deducts policy expenses, charges (including the COI) and loads and invests excess premiums along with the policy’s cash values as part of its general account portfolio, generally consisting of high grade bonds and mortgages.  

• The bonds and mortgages ultimately return principal, providing principal protection. The carrier applies the associated portfolio income, referred to as the “options budget,” to purchase options to meet the specific product’s cap and floor based on the index fund and the current participation rate.   

• One or more of the cap, floor or participation rate isn’t guaranteed and can therefore be adjusted up or down as the carrier’s experience dictates. As a result, the carrier has little investment risk in the IUL product, whereas the policyowner bears that risk.  

Typically, a number of index fund and other options are available, the most common being the S&P 500 1-year point-to-point, but international indices and index fund with different terms¹⁵ may also be available.   A 1-year point-to-point term is most common, but the policies may also offer 2-year or 5-year point-to-point durations. Policies also include a fixed rate option based on the carrier’s general account investments. For example, the carrier might offer a 3.75 percent guaranteed rate for one year, after which the fixed rate will change based on the carrier’s expected general account investment performance for the coming year. Policy values may be allocated among the various investment options offered within the policy.

IUL investments are managed in segments. New net premiums along with policy cash values may be invested in different segments. For example, one segment may be based on the S&P 500 for a 12-month duration (1-year point-to-point). At any time, the policy may be invested in multiple segments representing different index funds, durations and start and end dates. Each segment is reinvested as it matures based on the floor, cap and participation rates in effect at that time.

Factors Affecting Performance

The following factors aren’t guaranteed and can therefore affect IUL policy performance. It’s important to understand that all of the non-guaranteed factors can either improve or weaken and that they can move independently and in opposite directions creating a complex interplay. Again, this emphasizes the need for annual monitoring of policy performance.

First, the IUL policy investments will reflect the upward and downward movement of the associated index fund (in turn reflecting performance of the stocks comprising the index). That performance may be helped or hindered by the cap, floor and participation rates discussed above. The product cap will limit the upside earnings. For example, if the policy has a 10.5 percent cap and the index fund has a 35 percent return, the policy will only credit 10.5 percent on those funds.¹⁶ The IUL product floor will mitigate market corrections. If the policy has a guaranteed 0 percent floor and cash values are invested in an index fund that has a -35 percent return, the policy will credit 0 percent on those cash values.¹⁷ Market corrections tend to be followed by strongly positive return years. A good example is 2008, when the S&P 500 lost approximately 37 percent followed by positive returns of 27 percent and 15 percent in 2009 and 2010, respectively. One dollar invested in the S&P 500 on Jan. 1, 2008 would have been worth $.92 at the end of 2010. On the other hand, one dollar in an IUL policy with a 0 percent floor, 10.5 percent cap and assuming 2 percent policy fees and charges would have fared better, ending 2010 with $1.15.  

Second, a number of non-guaranteed factors unrelated to the performance of the index fund can affect the IUL policy return including:

• The carrier could increase or decrease the product’s costs and charges, including the COIs.¹⁸   

• The options budget, which is a function of a carrier’s general account investment performance, could increase or decrease. For example, if interest rates rise, a carrier’s new investment in higher rate mortgages may generate a larger options budget. Conversely, continued downward pressure on carrier investment returns could shrink options budgets.

• The cost of options creating the cap and floor could increase or decrease.

• Depending on circumstances, the carrier may increase or decrease the non-guaranteed cap rate and/or participation rate.

Third, with most IUL policies, mid-segment withdrawals, whether due to policy fees, charges or policyowner withdrawals, are either not credited with interest during the partial segment period or are credited at a low fixed rate, for example 2 percent. This has the effect of depressing policy returns, and the larger the mid-segment withdrawals, the greater this downward pressure. 

Policy Illustrations

Finally, a word on policy illustrations. Illustrations aren’t a guarantee or a projection of future performance. They’re based on non-guaranteed assumptions that reflect a combination of current carrier experience (expenses, COIs, investment returns and option prices), profit targets and pressure to remain competitive in the marketplace. One of the key factors driving aggressive premium financing designs is the ability to illustrate rates of return that generate strong cash values in the policy. Actuarial Guideline 49 (AG49)¹⁹ was implemented to curb the use of unrealistic illustration rates by imposing limits on the maximum rate a carrier may use in product illustrations.²⁰ However, even within the AG49 constraints, the ability to illustrate high rates of return has led to many aggressive designs. The bottom line is that the policy contract, not the illustration, sets forth the legal rights and obligations of the parties, and the policyowner can be assured that actual policy performance will vary substantially from the illustration.

Many Components

As with all non-guaranteed UL policies, IUL has a number of non-guaranteed components that will affect policy performance upward or downward. Investment returns will vary significantly from the returns of the underlying index fund, which are themselves quite variable. One or more of the factors that define IUL returns can be adjusted downward if it suits the carrier’s objectives. Likewise, commercial loan rates can and will vary substantially from current rates. Historical rates demonstrate the volatility of both the underlying index defining policy returns and the LIBOR rates that form the basis of most loan rates. Furthermore, these historical rates should never be viewed or relied on as predictive. The bottom line is that policy and loan illustrations shouldn’t be taken as guarantees or predictions of future performance. Yet, that’s exactly what the aggressive premium financing plans presume. The importance of prudent design, thorough initial and ongoing stress testing, careful administration and close monitoring of all premium financing plans can’t be overemphasized.    

Endnotes

1. Whole life policies, occasionally used for premium financing plans, aren’t the subject of this article.

2. Unlike variable universal life (UL), indexed UL (IUL) isn’t a security. It’s therefore not subject to the 50 percent margin rule of Regulation U allowing up to 100 percent of the policy cash value to secure the loan.  

3. LIBOR is the London Interbank Offering Rate. Some loans are based on 1-month LIBOR or prime.

4. The calendar year average LIBOR cited herein treats the 9-month average LIBOR of 2017 as a full year.

5. The average 9-month LIBOR for January to September 2017 equals 1.71 percent.

6. Best practice is for the guarantor to charge a fee to the trust in exchange for the guarantee to reduce the possibility of the guarantee being treated as a gift.

7. Maintaining the loan for the insured’s lifetime is generally unrealistic. Few clients want to borrow over that long a period, and experience shows that few loans remain on the books after seven to 10 years.

8. Fully guaranteed or no-lapse UL policies are excluded from this discussion. They’re not considered suitable for premium financing because they have little or no cash value with which to secure the loan, requiring the posting of greater amounts of external collateral by the grantor. Such policies are fully guaranteed provided premiums are paid on a timely basis (neither too early nor too late) as required by the contract.

9. It’s important to distinguish between the policy cash value and the cash surrender value. The difference represents a surrender charge that the insurer assesses if the policy is surrendered, typically grading to zero in the first 10 to 20 years, allowing the carrier to recover early acquisition costs of the policy.

10. Fees and charges including costs of insurance (COIs) do have guaranteed limits; however, they’re well in excess of current charges.

11. See Richard L. Harris, “New Actuarial Guidelines Issued in 2015,” Trust & Estates (January 2016), at p. 24, for a more complete discussion of the risks involved with an IUL policy.

12. Excess premiums from all general account products are pooled and invested in the insurer’s general investment account. General account assets are subject to the claims of the insurer’s creditors.

13. The existence of the floor, for example 0 percent, doesn’t mean that the policy cash value won’t experience negative returns because policy charges and expenses can reduce the return below zero.

14. The floor and the cap limit the downside and the upside of the underlying index. Assume the IUL product has a 0 percent floor, a 10.5 percent cap and a 100 percent participation rate. If the S&P 500 index fund (excluding dividends) has a negative 10 percent return over the segment, the product will credit 0 percent (the floor). If the S&P 500 index fund has a positive 27 percent return over the period, the product will credit 10.5 percent (the cap).  

15. International indices may include the Hang Seng, the EURO STOXX 50 or the MSCI Merging Markets index. Index funds with other terms may include a high cap, high par or a fund based on a 2-year average of the S&P 500.

16. As with all UL policies, COIs have a compound effect on the expected earnings of policy investments. If policy cash values earn less than expected, the net amount at risk increases and the resulting COIs will be greater, reducing relative cash value growth. Likewise, if the policy earns more than expected, the net amount at risk will decrease and COIs will be less than expected, further improving relative cash value growth.  

17. Again, after deducting fees and charges, the policy will have a negative return.  

18. Many carriers have strong histories of improving inforce policy performance reflecting improved mortality and expense experience. 

19. The National Association of Insurance Commissioners approved adoption of Actuarial Guideline 49 governing the maximum illustrative rate for IUL illustrations effective for policies sold after Sept. 1, 2015.

20. Many carriers have also added persistency and other bonuses to enhance illustrations and possibly performance.

Superman is the most powerful S corporation (S corp) in the world. He’s so proud of his S status, he wears it on his chest. 

Until now, most people thought that only kryptonite could take away Superman’s powers. Read on, and you’ll learn the many ways he can lose his S corp status, actions his advisors can take to prevent its loss and sometimes get it back after it’s lost.

Why an S corp? It has only one level of taxation, the shareholders. By comparison, C corporations (C corps) have a corporate level tax, and distributed earnings are taxed again to the shareholders. 

Overview

An S corp elects to pass through corporate income, losses, deductions and credits to shareholders for federal income tax purposes. (We’ll talk about state tax laws later.) For an S corp to enjoy only one taxation level, stringent requirements must be met. So-called foot faults aren’t overlooked. Penalties for noncompliance can be costly to an S corp and its shareholders. (For definitions of terms used in this article, see “High Speed Glossary,” p. 52.)

S Corp vs. LLC

Before we go any further: An S corp or limited liability company (LLC)? Each has different rules for state organization and state and federal taxation. Entity choice often comes down to the preference of investors. Generally, S corps are subject to more stringent requirements and, thus, greater room for error. That makes the LLC a safer choice. LLCs offer greater flexibility. Some examples: S corps may not have more than 100 shareholders,¹ can have only one class of stock² and can’t have foreign investors or investors who want a preferred return. 

First, some history. Before the existence of LLCs (the first state to enact LLC legislation was Wyoming in 1977), the choice for multi-member pass-through entities was generally between an S corp and a partnership. Partners are subject to unlimited personal liability and don’t have asset protection enjoyed by S corp shareholders. That made the S corp a popular choice despite the unforgiving rules that apply. In 1988, the Internal Revenue Service issued Revenue Ruling 88-76, which said that a Wyoming LLC could be taxed as a partnership. Many states have enacted their own LLC acts having pass-through tax attributes and fewer rigid rules than S corps. (Geographically, Wyoming is one of the largest states. But, it has the smallest population. Some Wyomingites boast that their state has more cows than people. It’s not true that the first LLC was called “LLC the Cow.”) 

So why are there still S corps? An entity’s owner would prefer an S corp to an LLC if he wants to qualify as an employee of the entity. A member of an LLC isn’t considered an employee for income tax and employee benefits. Also, compensation earned by an LLC member is subject to self-employment tax, as compared to an S corp’s employee, who shares the employment tax burdens with the S corp.

S corps can be costly to unwind. An S corp may choose to convert to another form, such as a C corp or an LLC. Factors going into this decision include: state law considerations; the assets held by the S corp; and the potential tax bill that may result from the conversion. 

State laws may provide for a statutory conversion from an S corp to an LLC. An S corp can also organize a wholly owned LLC and transfer assets to it. The S corp could then distribute its shares in the LLC and dissolve. Alternatively, the S corp could distribute its assets to its shareholders, who could then contribute the assets to a newly created LLC. These conversions are commonly known as “assets over” and “assets up” respectively. Caution: Do it right. The IRS is unforgiving if it’s scrambled.

An LLC might be federally taxed as a partnership, a C corp or an S corp. If an LLC makes no tax election, it’s taxed as a partnership (or disregarded entity if the LLC has only one member. A disregarded entity is a single member entity that isn’t recognized as separate from its owner for tax purposes). An LLC wishing to be taxed as an S corp without changing its state law form does so by making an election on Form 8832, pursuant to the entity classification or “check-the-box” regulations.³ If the LLC also wants to change its form under state law from an LLC to an S corp, the LLC must convert to a C corp either by operation of state law or by creation of a new C corp with a contribution of the LLC’s assets. It then makes a timely S corp election.

Tax Year is Important 

Similar to the rules governing partnerships, the S corp rules state that an S corp must use a permitted tax year.⁴ If an S corp wants to use a tax year other than a calendar year, it must establish a business purpose to the satisfaction of the IRS. There are certain fiscal years that may be automatically established provided the S corp meets certain automatic approval provisions.⁵

Inadvertent Terminations

S corps and their shareholders can run afoul of the S corp rules by: having ineligible shareholders; making a late S corp election; inadvertently creating a second class of stock; and inadvertently exceeding the passive income limitation.

Running afoul of any of these rules results in termination of S corp status as of the date of the offending event or not qualifying at all if failing to make a timely S corp election. 

Adding tax injury to tax injury: When a corporation’s S corp status is terminated, it can’t make a new S corp election for five years!⁶

Sudden death. If S corp stock ends up in the hands of an ineligible shareholder, the S corp status is terminated immediately.

Eternal vigilance required. Advisors to corporations wishing to make an S corp election should review shareholder documents and lists of shareholders to confirm eligibility. And, once the S corp election is made, they should review shareholder lists regularly. 

Death and divorce of S corp shareholders. It’s often said that half the marriages in the United States end in divorce; the other half end in death. We ask you, which is worse? 

Both death and divorce of S corp shareholders can lead to inadvertent termination. This can occur if a shareholder’s interest passes to an ineligible shareholder or if the transfer of S corp stock results in more than
100 shareholders. Also, the addition of a trust beneficiary may inadvertently terminate an S corp if the beneficiary is an ineligible shareholder. That situation occurred in Private Letter Ruling 9042031 (July 23, 1990), in which an eligible S corp shareholder died and left her shares to her daughter, directing that she share earnings with her sister. The S corp thought the daughter was the sole beneficiary of the S corp stock. Pursuant to local law, the daughter decided to hold the shares in trust for her and her sister. The trust wasn’t an eligible S corp shareholder, and the S corp’s status was inadvertently terminated.

Shareholder Agreements

Be aware of and carefully review shareholder agreements that often define shareholders’ rights, obligations and restrictions on the transfer of stock.

If the S corp doesn’t have a shareholders’ agreement or terms in its organizational documents restricting transfer, advise that it adopt provisions to protect the company’s S corp status. Protections include restrictions on transferring shares to only eligible shareholders and requiring company consent or approval prior to transfer. Shareholders who may give their S corp shares through their estate plans should add protective language to their planning documents to prevent transfers to an ineligible shareholder. Giving a fiduciary discretion or providing for backup beneficiaries can be helpful.

Eligible Shareholders

Eligible shareholders include: individuals who are U.S. residents or citizens; estates for a certain period of time;⁷ certain types of domestic trusts;⁸ and certain not-for-profit corporations.⁹

Partnerships, corporations and nonresident alien (NRA) individuals aren’t eligible shareholders of an S corp.  

Trusts that qualify as eligible shareholders include: grantor trusts with deemed owners that are U.S. residents or citizens;¹⁰ testamentary trusts for a period of two years from the date the S corp stock is transferred to the trust;¹¹ voting trusts;¹² electing small business trusts (ESBTs); and qualified subchapter S trusts (QSSTs). 

The only eligible shareholder of a qualified subchapter S subsidiary (QSub) is an S corp. A QSub is a wholly owned domestic subsidiary of an S corp.¹³ It’s generally not treated as a separate corporation except for employment taxes, certain excise taxes and credits and certain information returns. To qualify, a QSub must make a valid election on Form 8869.

Caution about an eligible shareholder who’s married to an NRA. Property ownership is typically governed by state or local law. In community property jurisdictions, an NRA spouse may be entitled to an undivided one-half interest in the beneficiary’s shares. An NRA beneficiary may receive
S corp shares under the S corp shareholder’s estate plan. Such ownership could destroy the S corp election. Take care in drafting an estate plan to avoid these situations or provide for flexibility when distributing S corp shares to individuals.

Address Involuntary Termination 

The IRS may grant relief, waive the termination and continue to treat the corporation as never having lost its S corp status.¹⁴ This happened in PLR 200847013 (Aug. 1, 2008). Stock in an S corp was transferred to a partnership and then to another partnership. Eventually the stock was transferred to a trust eligible to make an ESBT election. As a result of the initial transfer, the S corp’s election was terminated. The IRS ruled that the termination was inadvertent; the corporation was treated as not having terminated its S corp status.

Late Elections

An S corp election can be made for any tax year on Form 2553.¹⁵ That election must be filed within two months and 15 days after the beginning of the tax year the election is to be effective or at any time during the tax year preceding the tax year the election is to take effect. 

Relief is on the way. An organization that neglected to file an S corp election can request relief. For many years, the only relief for missing the election deadline was requesting a PLR. Obtaining a PLR is expensive and with uncertain result. Since 2013, a simplified method of relief for late S corp, QSST, ESBT and QSub elections is available, and no user fee is required. To qualify, specific requirements must be met.¹⁶ If taxpayers don’t qualify, a request for a PLR will be necessary. 

One Class of Stock

An S corp may have only one class of stock.¹⁷ Stock is generally considered part of the same class if dividend and liquidation preferences are the same. Shares may be subject to different voting rights without running afoul of the rules. Typically, these rights are defined in a shareholder’s agreement or in the entity’s charter. 

Plethora of Pitfalls 

Look out for these situations:

• Disproportionate distributions from the S corp may create another class of stock in some circumstances.

• Issuing debt that’s deemed to be equity may also create another class of stock.¹⁸ However, if the debt meets the definition of “straight debt,”¹⁹ the debt instrument won’t inadvertently create a second class of stock. To qualify as straight debt, it must be a written unconditional obligation to pay a sum certain on demand or on a specified date and mustn’t have interest rates or payment dates contingent on profit. Further, the loan must be issued to an individual U.S. resident or citizen, an estate or a trust described in Internal Revenue Code Section 1361(c)(2). This safe harbor is especially helpful for an S corp having a large redemption on a shareholder’s death and not having the liquidity to pay for the redemption immediately. 

• Passive income limitation.²⁰ A tax, known as the “sting tax,” is imposed on excess net passive income. That includes dividends, interest, royalties and certain rents. Excess net passive income is any amount of passive income that exceeds 25 percent of gross receipts. The excess net passive income is taxed at the highest corporate tax rate, currently 35 percent.²¹ The S corp must have accumulated earnings and profits for this tax to apply. The IRS may waive the sting tax if the corporation mistakenly determined that it had no earnings and profits and distributes the earnings and profits within a reasonable time after discovery, as approved by the IRS. 

  A corporation has accumulated earnings and profits if prior to being an S corp, it was taxed as a C corp and had accumulated earnings and profits not distributed prior to making its S corp election. Alternatively, an S corp can acquire accumulated earnings and profits through acquisition of a C corp in a tax-free reorganization.  

• But wait, there’s an even greater pitfall. If the entity has accumulated earnings and profits at the close of each of three consecutive years and has gross receipts for each of those tax years, more than 25 percent of which is passive investment income, then the entity’s status as an S corp automatically terminates on the first day of Year 4.²² That’s what happened in PLR 200526005 (March 25, 2005) and PLR 201222003 (Feb. 8, 2012). While relief is available for inadvertent termination, the relief generally requires a PLR. That process can be lengthy and expensive and isn’t automatic or guaranteed.²³ 

• It’s important to keep these rules in mind. If at any time, an S corp fails to meet the requirements under IRC Section 1361 or its passive income exceeds the passive income limitation, the S corp election is terminated—effective on the date of the triggering act.

Check State Law 

Always check applicable state laws:

• Shareholders and their advisors should know the state laws that will apply to the S corp. Those laws lack uniformity. Some states, such as New Hampshire and Tennessee, don’t recognize S corps as flow-through entities. Thus, S corps operating in those states are usually taxed at the entity level and the shareholder level. States may impose a franchise, gross receipts or excise tax on the entity even if they recognize the entity’s status as an S corp.²⁴ Some states have adopted the American Bar Association’s Model S Corporation State Income Tax Act.²⁵

• Some states, such as New Jersey and New York,²⁶ require a separate S corp election to be filed at the state level. Thus, even if the entity has filed a federal election, until it files a state election, it will continue to be treated as a C corp. Other states, such as California, allow the entity to opt out of
S corp treatment under state law even if the entity is federally taxed as an S corp.²⁷ 

• Some states allow a composite return to be filed by an S corp on behalf of all shareholders. The S corp pays the tax on behalf of shareholders. 

• Other states accept composite returns but restrict their use. 

• A state that accepts composite returns will usually apply the highest rate of tax to the shareholders’ income. 

• Many states also require estimated tax payments to be made on behalf of shareholders or withholding on behalf of nonresident shareholders. 

You’ve heard this before. Due to the lack of uniformity in state laws, check out the state laws that may apply in each situation. 

QSSTs and ESBTs 

QSSTs and ESBTs allow trusts to qualify as eligible shareholders by making a timely election and meeting stringent requirements. 

QSSTs. To qualify as a QSST, all the trust income is required to be distributed, or is actually distributed, to the income beneficiary.²⁸ And, the trust terms must have several provisions including the requirement that during the income beneficiary’s lifetime, there’s only one income beneficiary, and principal distributions may be made only to that beneficiary. If the trust terminates during the income beneficiary’s lifetime, all the assets must be distributed to the beneficiary.²⁹ 

QSSTs have beneficial tax rules that differ from other trusts. Generally, the portion of the QSST holding the S corp stock is ignored for income tax purposes, and any income is taxed directly to the QSST’s beneficiary.³⁰ Thus, the allocable portion of income derived from the S corp stock isn’t subject to the current distribution requirements. If the result of this allocation is harsh, the Uniform Principal and Income Act allows a fiduciary to adjust between principal and income to offset shifting of tax benefits or interests between income and remainder beneficiaries. When a QSST disposes of the S corp stock—either through distribution or sale—the QSST is treated as the owner for income tax purposes.³¹ Any non-S corp assets are subject to the subchapter J rules (with the exception of deductions under at risk and passive loss rules). Generally, subchapter J rules provide that distributions to a beneficiary carry out distributable net income (DNI) and are taxed directly to the beneficiary.

The QSST terms govern both at the trust’s formation and at any time during its existence. Consequently, if a trust qualifies at the date of formation but a mere possibility exists of an event that would violate the eligibility rules, the trust won’t qualify as a QSST. 

In Rev. Rul. 89-45, a trust was created for the benefit of a grandchild and funded with S corp stock. Under the trust’s terms, if another grandchild were to be born, the principal would be used to fund a new trust for the after-born grandchild. The IRS ruled the trust wouldn’t qualify as a QSST because the after-born provision created the possibility that the principal could be distributed to someone other than the income beneficiary. In Rev. Rul. 89-55, a trust permitted principal distributions to individuals other than the current income beneficiary if the trust no longer held S corp stock. Again, the IRS ruled that the trust didn’t qualify as a QSST because of the possibility that someone other than the current income beneficiary would receive principal distributions. Similarly, a trust doesn’t qualify as a QSST if the current income beneficiary has a power during his lifetime to appoint the income of the trust to someone other than himself.³² The IRS has also ruled that distributions from a trust in satisfaction of parental support obligations doesn’t constitute a distribution to the current income beneficiary; accordingly, the trust won’t qualify as a QSST.³³ 

What happens if S corp stock is transferred to a trust not meeting the QSST requirements? The IRS has ruled: 

• The trust may be reformed by removing the disqualifying feature. 

• The settlor of a trust may give his reversionary interest to the current income beneficiary to satisfy the QSST requirements.³⁴

• A court order eliminating a trustee’s power to sprinkle income will allow a trust to qualify as a QSST.³⁵

• A court order eliminating a spendthrift provision allowing for principal distributions to the current income beneficiary’s descendants in violation of the single beneficiary requirement would enable a trust to qualify as a QSST.³⁶

• A renunciation of the right to income and principal distributions by current beneficiaries to leave only one current beneficiary entitled to receive distributions will enable a trust to qualify as a QSST.³⁷

Disclaimers to the rescue. The disclaimer requirements vary by state; it’s essential that the disclaimer be complete and perfected under local law. In PLR 9025086 (March 28, 1990), a trust provided that income could be accumulated or distributed to the beneficiary, and on his death, the trust would continue for the benefit of his spouse with mandatory distributions of income. The IRS ruled the beneficiary’s disclaimer of all his interest in the trust would allow the trust to qualify as a QSST because it would be held in trust for a single beneficiary and would meet the income distribution requirement.³⁸ 

The income beneficiary of the QSST must timely make the QSST election.³⁹ Generally, the election must be filed within two months and 16 days after the S corp stock is transferred to the trust (or after the S corp election is effective if a corporation makes such election while the trust holds the stock).⁴⁰ A separate QSST election must be made for each S corp held by the trust.⁴¹ The election continues for a successor beneficiary unless he affirmatively refuses to consent.⁴²

ESBTs. The ESBT requirements are less restrictive than those for QSSTs because unlike a QSST, an ESBT may have multiple beneficiaries. In addition, trust income may be accumulated or sprinkled among the beneficiaries. Trust beneficiaries may only be individuals, estates of individuals and/or certain charities.⁴³ If the trust has another trust as a beneficiary, all the beneficiaries of the distributee trust must also fall in one of the permissible categories of beneficiaries.⁴⁴ Another requirement for an ESBT: A beneficiary’s interest in the trust can’t have been acquired by purchase.⁴⁵Crucial: The proper election must be made to qualify as an ESBT.⁴⁶ 

The IRC distinguishes between a current beneficiary and a potential current beneficiary. Each person who subsequently becomes a potential current beneficiary has the potential to invalidate the election for the trust and the S corp! 

To solve the problem, the trust can dispose of all the S corp stock—any potential current beneficiary won’t be treated as one as of one year before the stock’s disposition. Additionally, a trust could be judicially severed so that an ineligible beneficiary (such as an NRA) is no longer a trust beneficiary holding the S corp stock,⁴⁷ or a court could modify a trust to prohibit distributions to a nonresident alien until the time nonresident aliens are no longer impermissible potential current beneficiaries under the relevant provisions of the IRC—or for as long as the trust continues to hold S corp stock.⁴⁸

An ESBT is treated as two separate trusts for income tax purposes.⁴⁹ An ESBT has an S portion and a non-S portion. The S portion is treated as a separate taxpayer and subject to the special rules of IRC Section 641(c). The S portion of the trust is subject to the highest rate of tax.⁵⁰ The exemption amount is zero.⁵¹ The non-S portion is taxed under subchapter J of the IRC, which provides that distributions to a beneficiary carry out DNI and are taxed directly to the beneficiary. However, distributions to a beneficiary from either the S portion or the non-S portion may carry out DNI to the extent of the non-S portion. Additionally, either portion may be treated as owned by a grantor and subject to the grantor trust rules under subpart E. Subpart E generally provides that for income tax purposes, the trust is disregarded and the grantor is treated as the owner of all trust assets.

The trustee must make the election to treat the trust as an ESBT⁵² within the time requirements prescribed for a QSST.⁵³ Generally, only one ESBT election is made, regardless of the number of S corps whose stock is held by the ESBT.⁵⁴ However, if the ESBT holds stock in multiple S corps that file their income tax returns in different IRS service centers, the ESBT election must be filed with all the relevant service centers.⁵⁵ This requirement applies only at the time of the initial ESBT election. If the ESBT later acquires stock in an S corp that files at a different service center, a new ESBT election isn’t required.⁵⁶

Be Careful Out There

If your client is about to form a business entity, generally LLCs are preferable to an S corp.

But, many clients already have S corps that can’t be easily dismantled. So, as an advisor, show them how to be careful out there!                             

Endnotes

1. Members of a family are treated as one shareholder for this requirement. “Members of a family” means a common ancestor, lineal descendant of the common ancestor and any spouse or former spouse. Descendants include adopted children. Internal Revenue Code Section 1361(c)(1).

2. IRC Section 1361(b)(1)(D).

3. IRC Section 7701.

4. IRC Section 1378(b).

5. Treasury Regulations Section 1.1378-1.

6 IRC Section 1362(g).

7. An estate is an eligible shareholder for a reasonable period of time required to administer the estate. Section 1361(b)(1)(B); Old Virginia Brick Co. v. Commissioner, 367 F.2d 276 (4th Cir. 1966). If the administration of the estate is unduly prolonged, the Internal Revenue Service may take the position that the estate is closed for federal income tax purposes.

8. Section 1361(c)(2)(A).

9. Eligible nonprofits are subject to unrelated business income tax on all income earned from an S corporation (S corp), including gains from the sale of S corp stock.

10. Section 1361(c)(2)(A)(i). After the death of the deemed owner, the trust may continue to hold S corp stock but only for a period of two years. If the trust makes a valid IRC Section 645 election, the trust may hold the S corp stock for the entire Section 645 election period. Treas. Regs.
Section 1.1361-1(h)(1)(iv)(B).

11. Section 1361(c)(2)(A)(iii).

12. Section 1361(c)(2)(B)(iv) and Treas. Regs. Section 1.1361-1(h). The voting trust must meet several requirements to qualify as an eligible shareholder.

13. Section 1361(b)(3).

14. To apply for relief, a ruling request must be filed within a reasonable time after the inadvertent termination is discovered. Treas. Regs. Section 1.1362-4(c).

15. Available at www.irs.gov/pub/irs-pdf/f2553.pdf.

16. Revenue Procedure 2013-30. The request must: (1) be made within three years and 75 days of the intended effective date; (2) include an election form signed under penalties of perjury describing its reasonable cause for failing to timely file the election or describing why its failure to timely file was inadvertent, describing the diligent actions that were taken to correct the error once it was discovered and containing information that the trust meets the appropriate qualified subchapter S trusts or electing small business trusts  requirements; and (3) include statements from all the shareholders that the income reported on all affected tax returns was consistent with the S corp election.

17. Section 1361(c)(4).

18. Treas. Regs. Section 1.1361-1(l).

19. Treas. Regs. Section 1.1361-1(l)(5).

20. IRC Section 1375.

21. IRC Section 11(b).

22. Section 1362(d)(3) and Treas. Regs. Section 1.1362-2(c).

23. Section 1362(f).

24. Cal. Rev. and Tax Code Section 23802; M.G.L. c. 63. S. 32D; Ohio Rev. Stat. Ann. Section 5751; Tex. Tax Code Ann. Section 171.0002.

25. E.g., Haw. Rev. Stat. Section 235.

26. See Form CBT-2553, available at www.state.nj.us/treasury/revenue/sub-s.pdf and Form CT-6, available at www.tax.ny.gov/pdf/current_forms/ct/ct6_fill_in.pdf.

27. E.g., California allows entities to remain a California C corporation by timely filing Form 3560.

28. Section 1361(d)(3)(B).

29. Section 1361(d)(3)(A).

30. IRC Section 678(a).

31. Treas. Regs. Section 1.1261-1(j)(8).

32. Private Letter Ruling 201426001 (March 12, 2014).

33. PLR 9028013 (April 3, 1990).

34. See example 7 of Treas. Regs. Section 1.1361-1(k)(1).

35. PLR 9040031 (July 6, 1990).

36. PLR 9040019 (July 5, 1990).

37. PLR 8907007 (Nov. 10, 1988).

38. PLR 9025086 (March 28, 1990).

39. Section 1361(d)(2)(A) and Treas. Regs. Section 1.1361-1(j)(6)(ii).

40. Treas. Regs. Section 1.1361-1(j)(6)(iii).

41. Section 1361(d)(2)(B)(i) and Treas. Regs. Section 1.1361-1(j)(6)(i).

42. Section 1361(d)(2)(B)(ii), Treas. Regs. Section 1.1361-1(j)(9) and Treas. Regs. Section 1.1361-1(j)(10).

43. Section 1361(e)(1)(A)(i).

44. Treas. Regs. Section 1.1361-1(m)(1)(ii)(B).

45. Section 1361(e)(1)(A)(ii).

46. Section 1361(e)(1)(A)(iii).

47. PLR 200913002 (Nov. 24, 2008).

48. PLR 200816012 (Dec. 26, 2007).

49. Treas. Regs. Section 1.641(c)-1.

50. Section 641(c)(2)(A).

51. IRC Section 55(d).

52. Section 1361(e)(3).

53. Treas. Regs. Section 1.1361-1(m)(2)(iii).

54. Treas. Regs. Section 1.1361-1(m)(2)(i).

55. Treas. Regs. Section 1.1361-1(m)(2)(i).

56. Treas. Regs. Section 1.1361-1(m)(2)(i).

Addiction has become a frequent news headline due to the alarming increase in opioid abuse and heroin use. Addiction manifests itself in many forms and can be behavior based, such as gambling, pornography and compulsive shopping. It can also be substance based, as in alcohol, opioid or other drug addictions. Irrespective of its form, addiction has devastating effects on clients and their families.  

Epidemic of Addiction 

On Oct. 26, 2017, President Donald Trump declared the opioid crisis a national public health emergency.¹ Statistics are startling and indicate that approximately 142 Americans die every day from a drug overdose, the loss of life equivalent to the Sept. 11 terrorist attacks every three weeks.² Further, a forecast by STAT concluded that as many as 650,000 people will die over the next 10 years from opioid overdoses.³ This growing epidemic of addiction is changing the landscape of our clients’ estate plans, and practitioners need to be prepared.

A multitude of issues associated with opioid and other addictions will cross our desks in the preparation and implementation of estate plans. All addictions tend to produce feelings of failure, guilt and embarrassment on the part of our clients, but opioid addiction tends to inflict particular shame. There are no identifiable causes of addiction (aside from substance abuse), and there’s no way to predict who will become an addict.⁴ In fact, it’s common knowledge that most heroin users began their use of opioids with a lawful prescription for a valid medical problem. Prescription opiates whose refills have run out are often the gateway for heroin.⁵ Heroin is cheap, easy to obtain and highly addictive. Opioid addiction is no longer limited to the urban poor; rather, opioid and heroin addicts are found in the suburbs and were raised in “good families.” As practitioners, we must be able to effectively advise clients dealing with a family member suffering from addiction.

Estate Planning for Addiction 

Tax planning has been the primary focus of estate-planning professionals for decades. Many practitioners have built their careers on helping families avoid the dreaded “death tax.” However, the dramatic rise in estate tax exemptions over the last few years, coupled with the permanence of portability, has eliminated significant tax exposure for families. Proposed tax legislation again calls for complete repeal of the estate tax. Nevertheless, the need for sophisticated estate plans will persist due to the alarming increase in societal addictions, in particular the opioid and heroin epidemic.

An addict places intolerable emotional and financial strain on a family.⁶ Clients are fearful of the addict’s unpredictable and sometimes violent behavior, and many families are in constant conflict over the addict. Clients are often divided on how to deal with their child’s addiction and behavior, leading to stress in the marriage, possible divorce and further dysfunction in the family. In addition, the addicted child’s siblings often lack sympathy and harbor resentment against the addict and their parents for financing the situation. So, what are practitioners to do when faced with a family in crisis over addiction?

Estate-Planning Options

Disinheritance. Not surprisingly, the potential disinheritance of the addicted child is a common consideration. Parents don’t want their legacy to fund destructive and possibly deadly behavior. However, caution clients contemplating disinheritance that disinheriting an addicted child could leave the addict destitute and unable to seek treatment. Warn parents considering disinheritance that their addicted child could contest the estate plan, further alienating the beneficiary from his family while wasting estate assets on needless litigation.

Outright bequest. Some parents may opt to leave their addicted child a smaller outright bequest, after having exhausted the child’s “inheritance” during the parent’s lifetime. However, leaving an addicted child funds outright is fraught with issues. The child would now have the financial means to challenge the estate plan, also resulting in expensive litigation, and with full access to his inheritance, the child would have unconstrained funding for his addiction.  

Distribution of funds to siblings for the benefit of the addicted beneficiary. Because of the risks associated with an outright bequest, some clients elect to give the addicted child’s inheritance to a sibling, with the understanding that the sibling will expend such assets for the addict’s benefit. There are underlying risks with such an approach, including loss of assets to the sibling’s creditors, mismanagement of funds, refusal to uphold the parents’ wishes, bankruptcy, divorce and death of the sibling, not to mention the inevitable strain on the relationship between siblings.

Trust Planning 

Given the shortcomings associated with these approaches, the best option is to create a discretionary trust for the addicted beneficiary.

Discretionary trusts. The most common discretionary trust distribution standard is health, education, maintenance and support (HEMS), as referenced in Internal Revenue Code Section 2041(b)(1)(A) and in Treasury Regulations Section 20.2041-1(c)(2).⁷ But, the IRC doesn’t define the term “health, education, maintenance and support,” and both the trustee and the beneficiary can have subjective interpretations. As a result, practitioners may wish to consider the use of a purely discretionary trust that gives the trustee the sole and absolute discretion to make (or suspend) distributions to or on behalf of the beneficiary, thereby greatly diminishing the addicted beneficiary’s challenges to the trustee’s actions. 

Choice of trustee. Choosing a trustee is difficult. Choosing the right trustee of a trust for an addicted beneficiary is doubly difficult. Many clients are hesitant to place this responsibility on a family member. Naming a bank or trust company may seem like a logical choice, but some corporate trustees are reluctant to serve as trustee for an addict, particularly when the addiction involves an illegal substance. 

Language to Include in Trust

Given the complexities involved in the trust administration for a known addict, and to alleviate some of the concerns associated with a wholly discretionary trust, the trust agreement should include language that offers the trustee clarity and guidance concerning distributions for an addicted beneficiary. For example, a purely discretionary trust could include some of the following provisions:⁸

Drug testing procedures and suspension of discretionary distributions. The addicted beneficiary should be required to submit to a random drug test if requested by the trustee (or its designee). Further, the trust should give the trustee the power to suspend discretionary distributions to the beneficiary who has a positive test result for the presence of an illegal drug (and possibly alcohol) or a drug for which the beneficiary doesn’t have a prescription. The trust should give the trustee the authority to suspend discretionary distributions to any beneficiary who refuses to submit to a random drug test. While distributions to the addicted beneficiary are suspended, the trustee should be authorized to make payments directly to third parties on the beneficiary’s behalf, until such time as the trustee determines that the addict is in recovery. The trust should specifically provide that the trustee won’t be deemed to have breached its fiduciary duty if it decides either not to exercise its discretion to request a random drug test or only does so irregularly. The trust should give the trustee the express authority to use trust assets to defend itself in any legal action brought against the trustee involving the exercise (or non-exercise) of its discretion regarding the payment (or suspension) of discretionary distributions for an addicted beneficiary and for requiring (or failing to require) drug testing. The trust agreement should also contain an indemnity clause for the trustee to help protect the trustee from claims and costs that may arise in the administration of a wholly discretionary trust. 

Recovery from addiction. The trust agreement should define “recovery” because it will likely have a different meaning for the settlor, the trustee and the addicted beneficiary. “Recovery” could be defined to be a minimum of “X” years of continuous sobriety (“X” being a number selected by the settlor) and determined to commence after the addict has successfully completed a treatment program. (The trustee could also be given the sole discretion to extend the time frame required to achieve recovery.) In addition, the trust could define “recovery” to require the addicted beneficiary’s continuing participation in therapy or support groups and to refrain from associating with individuals who may create an atmosphere conducive to drug and alcohol abuse.⁹ Last, the trust should provide that the trustee has the discretion to suspend payments if the addict stops attending the treatment program or participating in therapy.

Addiction advisors and authorization to engage professionals. To address a trustee’s potential concern over serving as trustee for an addict under a wholly discretionary trust, practitioners should consider naming an “addiction advisor” to provide directions to the trustee for matters pertaining to the beneficiary’s addiction.¹⁰ The addiction advisor could be a family member,  friend or paid professional. The trust agreement should authorize the trustee to employ “addiction experts” to advise the trustee and the addiction advisor and to recommend and oversee treatment and recovery programs. Addiction experts should be broadly defined to include (but not limited to) physicians, counselors, probation officers and other professionals engaged to evaluate and treat the addict. Decisions made by the trustee concerning the suspension (or resumption) of discretionary distributions to or on behalf of an addicted beneficiary can be based on the directions of the addiction advisor (if one is named) or based on the recommendations of such addiction experts.

Definitions for alcohol and drug abuse and other additions. The trust should define what constitutes alcohol abuse, drug abuse and other addictions to provide clarity for the trustee and the addicted beneficiary. Definitions for alcohol and drug abuse and other addictions could be modeled after the criteria provided in the most recent edition of the Diagnostic and Statistical Manual of Mental Disorders.¹¹

No-contest clauses. The trust document should include a no-contest clause, also known as an “in terrorem clause,” to dissuade the addicted beneficiary from challenging the trust. For example, if valid under the laws of the state having jurisdiction over the administration of the trust, the trust agreement could provide that any beneficiary who contests any of its provisions, or elects to take a statutory share of the settlor’s estate, will be deemed to have predeceased the settlor for purposes of the trust. The American College of Trust and Estate Counsel (ACTEC) has posted a summary tracking the state law treatment of no-contest (in terrorem) clauses on its public website.¹²

Addicted Beneficiary’s Duties

Consent to trust terms. After giving the addicted beneficiary the opportunity to review the trust, require him to sign a consent evidencing the beneficiary’s agreement to the trust terms. If the beneficiary refuses to sign the consent, the trust wouldn’t be funded for the beneficiary, and the assets would be distributed as otherwise directed in the trust.

Release of protected health care information. The trust document should require the addicted beneficiary to sign a consent authorizing the release of information to the trustee (or the trustee’s designee), waiving the privacy requirements of the Health Insurance Portability and Accountability Act of 1996¹³ so that the trustee (or its designee) can receive drug test results, medical reports, information from treatment centers and addiction experts and all other relevant information pertaining to the beneficiary’s addiction. The trust should provide that an addicted beneficiary’s refusal to sign such a consent means the beneficiary isn’t in “recovery,” thereby triggering the suspension of trust distributions.

Trust Advisors and Trust Protectors

Because we’re unable to predict future events that may impact trust administration, especially when dealing with an addicted beneficiary, practitioners are increasingly incorporating the use of trust advisors and trust protectors.¹⁴ The trust advisor is usually given the power to advise the trustee regarding the administration of the trust. A trust protector is typically given the power to approve or disallow discretionary trust distributions and to amend the trust’s administrative provisions. Further, a trust protector may be given the power to appoint the assets of an existing trust to a new trust, which may have expanded provisions to deal with a beneficiary’s addiction. The trust document could also give the trust advisor, the trust protector or the trustee the authority to appoint an addiction advisor if one isn’t named initially to direct the trustee as to the exercise of its discretion regarding all matters pertaining to the beneficiary’s addiction. 

Modification Options for Existing Trusts 

Thus far, I’ve reviewed estate-planning options for trust beneficiaries who suffer from known addictions.¹⁵ What remedies are available when dealing with an existing irrevocable trust for a beneficiary who subsequently develops an addiction?

Uniform Trust Code (UTC). The UTC has been adopted in 31 states and the District of Columbia and offers some practical options for modifying existing trusts.¹⁶ The UTC contains two different modification provisions that may allow the amendment of an otherwise irrevocable trust for the benefit of an addicted beneficiary. 

Modification by consent. UTC Section 411 provides that a “noncharitable irrevocable trust may be modified or terminated upon consent of the settlor and all beneficiaries, even if the modification or termination is inconsistent with a material purpose of the trust.” 

Court modification. Perhaps more applicable to the modification of an irrevocable trust for an addicted beneficiary is UTC Section 412, which states that a “court may modify the administrative or dispositive terms of a trust or terminate the trust if, because of circumstances not anticipated by the settlor, modification or termination will further the purposes of the trust. To the extent practicable, the modification must be made in accordance with the settlor’s probable intention.”

Decanting. Decanting is an act of transferring the assets of an existing trust to a new trust with provisions that are better suited to the current situation. In the case of an addicted beneficiary, the new trust could include the provisions suggested in this article. A few states have enacted the Uniform Trust Decanting Act, which permits decanting for appropriate purposes.¹⁷ Every state allows decanting in some form, but only some states have statutes governing decanting.¹⁸ ACTEC has included a summary of state decanting statutes on its public website.¹⁹ The various tax consequences associated with decanting are uncertain and involve complicated income, gift, estate and generation-skipping transfer tax considerations and risks, an analysis of which is beyond the scope of this article.

Peace of Mind

Few practitioners are trained to deal with the emotional turmoil that an addiction inflicts on a family. Yet, during the course of representing and advising our clients, it’s inevitable that we’ll be drawn into a family’s crises due to an addiction. We must be empathetic and provide candid counsel to our clients. There’s no perfect estate plan for a client whose beneficiary suffers from addiction, but by applying some of the strategies discussed in this article, practitioners can help craft an estate plan to promote recovery and future stability for the addicted beneficiary, and hopefully, some peace of mind for their clients.   

Endnotes

1. www.cnn.com/2017/10/26/politics/national-health-emergency-national-disaster/index.html.

2. www.nytimes.com/2017/07/31/health/opioid-crisis-trump-commission.html.

3. STAT (also called Stat News) is a national publication produced by Boston Globe Media focused on producing daily news stories, investigative articles and narrative projects in addition to multimedia features about health, medicine and scientific discovery. Seewww.statnews.com/2017/06/27/opioid-deaths-forecast/.

4. Seewww.psychologytoday.com/basics/addiction/causes.

5. Roy A. Krall, “Estate Planning for Beneficiary Who is a Heroin Addict,” 25 No. 6 Ohio Prob. L.J. NL 7 (2015) citing David DiSalvo, “Why is Heroin Abuse Rising While Other Drug Abuse is Falling?” Forbes Magazine (Jan. 14, 2014).

6. See also Patricia Annino, “Does Your Client Have a Substance Abuse Problem?” AICPA Wealth Management Insider (Feb. 16, 2012) for a detailed discussion of substance abuse and its effects on families, a list of recommended questions to consider when designing estate plans for families dealing with substance abuse and a variety of estate-planning tools and options, some of which are also discussed in this article. Seewww.aicpastore.com/Content/media/PRODUCER_CONTENT/Newsletters/Articles_2012/Wealth/ubstance_Abuse_Problem.jsp.

7. See Cynthia D. M. Brown, “Discretionary Distributions: A Trustee’s Guideline,” Commonwealth Trust Company (May 1, 2013), www.comtrst.com/discretionary-distributions-a-trustees-guideline, for an in-depth analysis of various discretionary trust distribution standards.

8. Recommended provisions are based, in part, on the suggested language in William F. Messinger and Samuel Dresser, “The Demise of Trustee Discretion and Ascertainable Standards as Effective Control on Dysfunctional and Underperforming Beneficiaries: Solutions for Trustees,” Appendix A, Suggested Language Restricting Access to Assets and Income When a Beneficiary or Family Member May Have Problems with Alcohol, Drug, Other Addictions, or Mental Health Concerns. Seewww.clereconsulting.com/wp-content/uploads/2015/02/WHITE_PAPER_Demise-of-Trustee-Discretion-1.pdf.

9. Krall, supra note 5. 

10. See also Krall, ibid., for a discussion regarding the appointment and use of a “chemical dependency advisor.”

11. The Diagnostic and Statistical Manual of Mental Disorders (DSM) is the handbook used by health care professionals in the United States and much of the world as the authoritative guide to the diagnosis of mental disorders. DSM contains descriptions, symptoms and other criteria for diagnosing mental disorders. It provides a common language for clinicians to communicate about their patients and establishes consistent and reliable diagnoses that can be used in the research of mental disorders. It also provides a common language for researchers to study the criteria for potential future revisions and to aid in the development of medications and other interventions. Seewww.psychiatry.org/psychiatrists/practice/dsm/feedback-and-questions/frequently-asked-questions.

12. See T. Jack Challis and Howard M. Zaritsky, “State Laws: No Contest Clauses” (March 24, 2012), www.actec.org/resources/state-surveys.

13. Health Insurance Portability and Accountability Act of 1996, H.R. 3103, 104th Cong. (Aug. 21, 1996), www.govtrack.us/congress/bills/104/hr3103.

14. See Suzanne L. Shier and Tami Conetta, “Trust Protectors,” Northern Trust Insights On Wealth Planning (May 2016), www.northerntrust.com/documents/commentary/wealthplanning-insights/trust-protectors.pdf, for an expanded discussion of the use and powers of trust protectors.

15. See also Richard E. Barnes, “Repairing Broken Trusts and Other Fallen Estate Plans,” Estate Planning, Vol. 41, No. 11 (November 2014), at p. 3 for a more detailed discussion of modification options for existing irrevocable trusts.

16. Alabama, Arizona, Arkansas, District of Columbia, Florida, Kansas, Kentucky, Maine, Maryland, Massachusetts, Michigan, Minnesota, Mississippi, Missouri, Montana, Nebraska, New Hampshire, New Jersey, New Mexico, North Carolina, North Dakota, Ohio, Oregon, Pennsylvania, South Carolina, Tennessee, Utah, Vermont, Virginia, West Virginia, Wisconsin and Wyoming have adopted the Uniform Trust Code. Illinois has introduced it into the legislature for adoption, HB 2526. 

    See The Uniform Law Commission (ULC, also known as the National Conference of Commissioners on Uniform State Laws), www.uniformlaws.org/LegislativeFactSheet.aspx?title=TrustCode.

17. Colorado, New Mexico, North Carolina, Virginia and Washington have adopted the Uniform Trust Decanting Act. Illinois (HB 2526) and Nevada (AB 197) have introduced it into the legislature for adoption. See “The Uniform Law Commission, Legislative Fact Sheet—Trust Decanting,” www.uniformlaws.org/LegislativeFactSheet.aspx?title=TrustDecanting.

18. See“The Uniform Law Commission, The Uniform Trust Decanting Act—A Summary,” www.uniformlaws.org/Act.aspx?title=Trust%20Decanting.

19. See Susan T. Bart, “Summaries of State Decanting Statutes” (Aug. 22, 2014), www.actec.org/resources/state-surveys.

From Silicon Valley to Boston and virtually everywhere in between, we’re in a golden age of startup businesses. Some of the industries in which startups have flourished include technology, life sciences and social media, but startups are transforming virtually every sector of the economy. Startup founders are passionate about their businesses and willing to take great risks and fail. Many of these businesses are funded by venture capitalists and angel investors with the ultimate goal of being sold to a larger competitor or going public. So much time and effort is spent growing the business and preparing for a liquidity event at the business level that the founder’s personal planning often takes a back seat. This is unfortunate. While fortunes can be made through ownership of a single business, they can also be lost. By planning for the personal side of the liquidity event, both before and after the transaction, a startup founder can help mitigate risks associated with founder’s equity (particularly income tax, estate and gift tax and concentrated equity risk) and set the stage for personal financial success. As they say, “failing to plan is planning to fail.” Just remember how many rich startup founders of the dotcom boom in the late 1990s lost everything in the dotcom bust of the early 2000s.

Anatomy of a Startup

Most startups begin life with a few founders, a business idea and a small pool of capital contributed by the founders, their friends and their families. Knowing that they hope to seek venture capital funding as they grow, the business is typically formed as a C corporation (C corp) (to be able to take advantage of the tax benefits of qualified small business stock discussed below). The founders are issued restricted common stock (sometimes referred to as founders’ stock), some or all of which is subject to a vesting schedule. An options pool is also set aside for employees. After the company has some success, it’s able to attract funding from venture capitalists and angel investors (basically wealthy individuals and family offices). These funders receive preferred stock, which has preferential rights to the common stock. The preferred stock can be converted to common stock, thereby diluting the percentage ownership of the founders and employees. If the business continues to grow, additional rounds of venture funding may occur. At a certain point, the venture capitalists expect the business to be sold to a larger company or go public. An acquisition of the business is far more likely than an initial public offering (IPO). The timeframe for the liquidity event typically ranges from five to 10 years following initial venture funding. Assuming everything works out as hoped, the liquidity event will result in a large payday for investors. 

Along the way, there are certain traps for founders (particularly dilution of ownership through rounds of financing) as well as opportunities (including income tax mitigation through certain tax elections, estate tax reduction and windows to diversify out of a concentrated equity position).

Planning Prior to the Liquidity Event

1. Putting together the team. Startup founders are typically young and not wealthy. As such, they’ve rarely worked with outside professionals regarding their personal financial affairs. This will need to change as the business increases in value. Choosing a good CPA is the first step. Making sure tax returns are properly filed and tax elections timely made is extremely important. Next up is a trusts and estates attorney to make sure an estate plan is in place if the founder is hit by the proverbial bus. The attorney can also help draft documentation regarding gifts to family members and charity. Finally, a startup founder should retain a qualified wealth manager. The wealth manager can help with financial planning, including modeling of making early tax elections in connection with equity holdings. For best results, the outside advisors would collaborate with each other regarding important decisions along the way, each bringing to bear his specific expertise.

2. Importance of financial planning. Financial plans, typically prepared by a qualified wealth manager, can be important foundational documents in the personal planning of startup founders anticipating a liquidity event. A good financial plan begins with the long-term financial goals of the startup founder. Once goals are established, the plan will determine cash flow needs and wants going forward. These fall into three buckets. The first bucket relates to liquidity, which is basically the assets needed to maintain your client’s lifestyle. The second bucket deals with longevity; the assets needed to improve your client’s lifestyle. The final bucket pertains to legacy, which are the resources your client would like to use to improve the lives of others—either through gifts/bequests to family and friends or philanthropic contributions. A good financial plan will also help the founder manage restricted stock and equity compensation, including understanding company transfer restrictions, tax elections and liquidity necessary to pay taxes on equity transactions. Finally, the financial plan can deal with single stock diversification strategies and inform a proper investment strategy based on the founder’s risk tolerance after the founder has become liquid.

3. Basic estate planning. Because many startup founders are young, it isn’t unusual for there to be no estate plan in place. Startup founders can have significant paper wealth, which could pass without a will in place to unintended individuals. In addition, if the startup founder dies, any amounts over $5.49 million in 2017 (if he’s single) will be subject to a 40 percent federal estate tax (and an additional state estate tax in several states). Paying the tax may be difficult if the stock is illiquid. As such, the founder should consider term life insurance to provide liquidity for any estate taxes owed. In addition, if the founder is married, life insurance may be required to provide income replacement for the surviving spouse until the startup shares become liquid. Finally, a good estate plan includes documents providing for what happens should the startup founder become incapacitated, including revocable living trusts, durable powers of attorney and appointment of health care agents.

Startup Equity Compensation

Startups typically issue equity-based compensation to incentivize employees and give them the opportunity to share in the growth of the business and to align their interests with the interests of other shareholders. Equity-based compensation also helps preserve the startup’s cash position. The types of equity-based compensation frequently used are restricted stock awards, restricted stock units, incentive stock options and nonqualified stock options.

Vesting and change of control. Virtually all
equity-based compensation is subject to vesting. Vesting can occur over time or be based on a mix of time and the achievement of certain performance goals. Typically, vesting takes place over three or four years, with the first vesting date occurring on the first anniversary of the grant. Many equity compensation plans include change of control provisions, allowing for full or partial acceleration of unvested grants on a change of control of the company. This is known as “single trigger” vesting. Other companies use “double trigger” vesting, under which, if there’s a change of control, vesting will accelerate if the employee is terminated without cause within a specific period of time after the deal closes (typically six to 18 months).

Restricted stock awards. Restricted stock is common stock that’s sold or granted to a startup founder. It’s subject to vesting and is forfeited if vesting requirements aren’t satisfied. If restricted stock is granted, the grant isn’t a taxable event. At the time of vesting, restricted stock is taxed on its fair market value (FMV) less any amounts paid for the stock. It’s treated as wages and subject to withholding. Any future sale of the stock will be treated as capital gains or capital losses.

Restricted stock units. Restricted stock units (RSUs) are similar in most respects to restricted stock awards. The primary differences are twofold. First, although an RSU grant is valued in terms of stock, no company stock is issued at the time of the grant. Second, when vesting requirements are satisfied, the employee typically is given the choice to settle in stock or cash.

Stock options. A stock option is the right given by the company to an employee or consultant (the “option holder”) to purchase company stock in the future at a fixed price (typically FMV at the date of the grant) and exercisable for a fixed period of time (typically 10 years). Like restricted stock awards and RSUs, options are subject to vesting. There are two different kinds of options. The first are statutory stock options known as “incentive stock options” (ISOs). The statutory requirements are set forth in the Internal Revenue Code, and if they’re met, ISOs receive favorable income tax treatment. ISOs may only be issued to employees. The second type of stock options are known as “nonqualified stock options” (NSOs). Grants of NSOs may be made not only to employees, but also to directors and consultants. Unlike ISOs, NSOs don’t provide special tax treatment to the recipients. Typically, there’s no taxable event to the recipient on the grant of either ISOs or NSOs.

Income taxation of ISOs. On the exercise of ISOs, there’s no taxable income recognized by the option holder. However, the spread (difference) between the strike price (price at grant) and the value of the stock at exercise is subject to the alternative minimum tax (AMT) (potentially at the highest rate of 28 percent). Any gain post- exercise of an ISO is treated as a capital gain as long as the required holding periods are met. The required holding periods are one year from exercise and two years from grant, and the employee must have been employed on the date three months before the exercise date. If holding periods aren’t met, a “disqualifying disposition” occurs, resulting in ordinary income taxation on the spread between the strike price and the value of the option on exercise. Only $100,000 of stock, based on the strike price, may become exercisable in any calendar year, inclusive of all ISO grants that have been made. 

Income taxation of NSOs. NSOs are compensatory stock options that don’t meet the statutory requirements for ISOs. Recipients of NSOs generally are taxed at ordinary income rates on exercise on the spread between the strike price and the value of the stock on exercise. Post-exercise appreciation is taxed as capital gains (long-term capital gains (LTCGs) if held more than a year after exercise). Unlike ISOs, there are no limits on the value of NSOs that can be exercised by an employee, director or consultant each year. There are no AMT issues involved with the exercise of NSOs.

IRC Section 83(b) election. An election under Section 83(b) may provide significant income tax benefits to the holders of both stock options and restricted stock awards. Because there’s no actual stock issued until vesting, a Section 83(b) election isn’t permitted for RSUs. Section 83(b) allows a taxpayer to elect to be treated for income tax purposes as if he received vested, unrestricted property from the employer, thereby triggering immediate income tax liability, even if the stock is subject to a substantial risk of forfeiture. Why would the founder or employee make this election? Because it can result in a large income tax benefit if the stock is expected to, and actually does, appreciate. Any future appreciation is taxed at capital gains rates, and if held for more than one year after the
Section 83(b) election is made, would receive LTCGs treatment rather than ordinary income tax treatment.

A Section 83(b) election must be filed with the IRS and is generally irrevocable. In addition, a significant consideration is that if the property is forfeited in the future because vesting requirements aren’t met, the founder or employee may not take a loss for taxes already paid.

For an award of restricted stock, a Section 83(b) election is straightforward. The employee makes an election to be treated as if he received the stock immediately without vesting restrictions. As such, the employee would have ordinary income equal to the number of shares times the current FMV of the stock (the 409A valuation obtained by the company in the case of a closely held company).

For a stock option grant, the ability to make a Section 83(b) election will depend on whether the stock option grant agreement allows employees to make an early exercise. If the plan permits early exercise and at the time of exercise, the FMV is low and the strike price is close or equal to the FMV, the spread will be small, thereby minimizing current income tax on NSOs and AMT on ISOs.

Gifts to Charity

Some founders and employees may be interested in transferring equity compensation to charity prior to a liquidity event. While the intent is noble, it’s not always possible. Equity compensation can be difficult to gift. Many times, there are restrictions put in place by the company that prohibit transfers. In addition, the Internal Revenue Service takes the position that the transfer of an unvested NSO isn’t a completed gift for gift tax purposes.¹ Most tax professionals apply the same methodology to restricted stock and advise that unvested shares of restricted stock may not be gifted. The IRC specifically prohibits lifetime gifts of ISOs.² Therefore, only charitable gifts of vested restricted stock and vested NSOs may provide opportunities for gifting to charities.

Charitable gifts of vested restricted stock (not subject to company transfer restrictions) if held for more than one year after exercise or a Section 83(b) election should be considered an LTCG asset and entitle the donor to an FMV deduction when contributed to a public charity, including a donor-advised fund (DAF). The deduction will be limited to 30 percent of the donor’s adjusted gross income (AGI) in the year of the gift, with a 5-year carryforward for any unused deduction. Because the business is closely held, a qualified appraisal will determine FMV, taking into consideration discounts for lack of marketability and lack of control. These discounts can range from 15 percent to 30 percent, which, depending on the extent of the discount, can basically wipe out the income tax benefit of contributing prior to a liquidity event. Qualified appraisals typically value NSOs based on the Black-Scholes model. Gifts of closely held stock to private foundations (PFs) are treated less favorably. The deduction is typically limited to the donor’s tax basis.

Charitable gifts of freely transferable vested NSOs typically aren’t attractive. When the charity exercises the NSOs, the donor will recognize taxable income, and unless a Section 83(b) election has been made, the income will be taxable as ordinary income to the donor, and the donor’s charitable deduction will be limited to tax basis, which is typically zero.³

Gifts to Family

Like gifts to charity, only freely transferable, vested restricted stock and NSOs are available for gifting to family. Restricted stock, assuming a low qualified appraisal, can be an excellent asset to gift to family. If the stock is expected to appreciate significantly, all future appreciations beyond the gift value won’t be includible in the founder’s estate. Valuation discounts for minority interests in the context of gifts to family can help reduce the gift’s value by up to 35 percent. Therefore, a gift of one dollar of restricted stock will only use 65 cents of gift tax value, thereby allowing the founder to leverage his $14,000 annual exclusion gifts and $5.49 million lifetime and generation-skipping transfer tax exemptions. Though beyond the scope of this article, the founder has an alphabet soup of irrevocable trusts that are available for gifting to family, including a grantor retained annuity trust, in which, if successful, future appreciation can be taken out of the founder’s estate without using any lifetime exemption.

Gifts to family of freely transferable, vested NSOs can also be attractive, but the founder needs to understand that the income tax liability on the NSOs doesn’t transfer to the beneficiary or to the trust for the benefit of the beneficiary. If the founder gifts NSOs, he’ll still be liable for the income taxes payable on the subsequent exercise of the NSOs. This may actually be an advantage because the tax payment reduces the founder’s estate without incurring additional gift taxes.

After the Liquidity Event

Restrictions on transfer, hedging or pledging public securities. Just when your client thinks he’s seen the other end of a successful liquidity event and is ready to diversify his concentrated stock position, corporate lock-up agreements and certain securities law requirements say not so fast. Public stock received in an IPO or an acquisition is typically subject to a lock-up period (imposed by the underwriters in the case of an IPO and the acquiring public company in the case of an acquisition) of up to 180 days before the stock is permitted to be sold. In addition, most companies have restrictions on insider trading, hedging and pledging shares by executives. Founders may want to consider an SEC Rule 10b5-1 plan (a pre-established trading plan) to allow them to avoid violating corporate policies or securities laws. Finally, SEC Rule 144 provides a safe harbor from registration of certain securities so that an employee may sell securities in a public market place. The rules differ depending on whether the employee is considered a control person or a non-control person.

Concentrated equity planning. Assuming transfers, hedging and pledging of public stocks is permissible, there are a variety of concentrated stock strategies (in addition to outright sale) that can help with the risk of a concentrated stock position. The most common strategies are equity collars, prepaid variable forward contracts, charitable remainder trusts and exchange funds.

Charitable planning. Charitable planning after a liquidity event can be a tax-efficient way to be philanthropic while offsetting some of the taxes in the year of the liquidity event. Unlike pre-liquidity charitable planning, post-liquidity charitable planning is fairly straightforward. In the liquidity event, the founder received cash, public stock or a combination of cash and public stock. While cash gifts are deductible up to 50 percent of AGI in the year of the gift (with a 5-year carryforward), they’re not as tax efficient as gifting public stock (deductible up to 30 percent of AGI with a 5-year carryforward). When gifting the stock to a public charity or PF (deductible at FMV for public stock), any income tax on the built-in capital gains on the stock disappears. All charitable vehicles are available post sale, including outright gifts to public charities (including DAFs), gifts to PFs and gifts to charitable remainder and charitable lead trusts.

Investment/financial planning. Once the liquidity event has occurred, the founder, working with his investment advisor, should update the financial plan with the actual dollar amounts (taking into consideration taxes that may be owed on the liquidity event). Once the financial plan is updated, the founder will be able to determine which of the three buckets (discussed above) the net worth should be divided into. Again, the liquidity bucket contains the portion of the net worth necessary to maintain lifestyle. The second bucket is the longevity bucket and is made up of the assets needed to improve lifestyle. Any remaining assets go into the legacy bucket, which includes assets to help improve the lives of family and friends and to support philanthropic endeavors. Once the buckets are in place, the wealth advisor can put together a proper investment strategy for each bucket. The financial plan should be updated annually to reflect markets, changes in circumstances and any necessity to move assets among the buckets.

Qualified small business stock. Post-liquidity, there are some attractive income tax savings and deferral opportunities if the stock is considered qualified small business stock (QSBS).⁴ QSBS is stock in a small, domestic C corp that operates an active business. To qualify, the corporation must use at least 80 percent of its asset value in the active conduct of one or more qualified trades or businesses (certain industries are excluded), and the gross assets of the corporation, as of the date the stock was originally issued, can’t exceed $50 million.

On the sale of QSBS, the seller may exclude between 50 percent and 100 percent of the gain (depending on when acquired), up to the greater of: (1) $10 million, or (2) 10 times the basis in the QSBS. To qualify, the QSBS must be held for at least five years prior to the sale, and the shareholders must have acquired the stock at its original issue, in exchange for money or property, or as compensation for services rendered.

In addition, on the sale of QSBS (held more than six months), the seller may elect to defer realized gain by reinvesting the sale proceeds into a new QSBS investment within 60 days of the sale.⁵ The seller’s basis in the replacement stock is reduced by the amount of the gain deferred. This ensures that gain continues to exist, but is merely deferred.

—The views expressed herein are those of the author and may not necessarily reflect the views of UBS Financial Services Inc. UBS Financial Services Inc., its affiliates and its employees don’t provide tax or legal advice. You should consult with your legal or tax advisor regarding your particular circumstances.   

Endnotes

1. Revenue Ruling 98-2.

2. 26 U.S.C. Section 422(b)(5).

3. Private Letter Rulings 9737014, 9737015 and 9737016 (1997).

4. 26 U.S.C. Section 1202.

5. 26 U.S.C. Section 1045.

In the United States, many philanthropic individuals take Thanksgiving literally—the last two months of the year are considered giving season, with Americans donating tens of billions of dollars to charity. According to a recent study by Fidelity Charitable, “Overcoming Barriers to Giving,” of the 3,200 donors surveyed, 64 percent said they would like to give more, but 72 percent are concerned about personal finances, and 65 percent worry about the impact of their donations.

Donors Don’t Give As Much as They’d Like

An overwhelming majority of the donors surveyed determine how much they give each year based on their discretionary income. Only 9 percent of respondents put charitable needs or requests first, ahead of their own personal financial situation and needs. Nearly half indicated that a greater tax benefit or deduction would influence them to give more.

With proper knowledge of financial planning and the tax benefits of giving, clients can attain their goal of giving more. The study found that 59 percent of donors are likely missing out on tax advantages related to giving. For example, in a separate study of giving, Fidelity Charitable found that 80 percent of respondents had appreciated stock in their portfolio but only 21 percent ever used such stock as a charitable contribution—despite the fact that such method can allow donors to give up to 20 percent more.

Administrative tasks such as keeping copies of acknowledgment letters and properly electing deductions can also be burdensome for donors, especially for those giving to multiple charities or making multiple donations a year. Providing clients with a better process for organizing giving can allow them to better fulfill their charitable goals.

Impact of Donations and Other Concerns

The second biggest factor preventing donors from giving more is concerns about how their donation will be used. These concerns aren’t completely unwarranted; earlier this month the Red Cross apologized for losing $5 million in Ebola funding to fraud. In fact, 81 percent of respondents are concerned with non-profit transparency and want to better understand the exact impact of their donations. Sixty-seven percent also cite uneasiness as a result of not being able to determine a charity’s credibility or trustworthiness.

Although donors don’t typically give just for the recognition, the study found that they would like to be acknowledged and/or thanked for their efforts. And like most of us, they also prefer not to be continuously solicited for further donations (49 percent said they are hesitant to give because they’re worried the organization may ask for further donations).

Other influences that sway giving include pressure from family and peers to give to certain organizations, despite a donor’s desire to support a different cause, and privacy concerns such as other finding out how much and to who you give. 

Strategies For Giving More

Fidelity Charitable shared some of their strategies that can help your clients give more. Some notable suggestions for clients include:

1. Make regular contributions using a scheduled bank deduction rather than giving in lump sums at year’s end.
2. The donation jar is still alive—teach children to set aside extra cash or change so that they can see their donations visibly (rather than digitally) add up over time.
3. As previously mentioned, consider donating tax-friendly assets, such as appreciated stocks, rather than just cash.
4. Use available research tools to learn more about organizations you want to give to, and don’t hesitate to contact a charity directly to clear up concerns and ask questions.
5. Use a giving guide from a reputable source such as Center for High Impact Philanthropy’s annual giving guide to help identify opportunities that make dollars go further.