Basis optimization for credit shelter and irrevocable trusts often involves granting the trust beneficiary a general power of appointment (GPA) over trust assets to achieve stepped-up basis.  One planning variation limits appointees to the powerholder’s creditors or creditors of his estate (creditor GPAs). This seemingly achieves basis step-up without much risk of having property diverted to appointees outside the donor’s dispositive scheme.

Some practitioners caution against creditor GPAs because of uncertainty under local law regarding the girth of the appointive property. Presume that John owes Paul $1,000, and John is granted a GPA over $1 million of trust property to appoint to creditors of his estate. Does state law limit the appointive property to Paul at $1,000, because once Paul is appointed that sum, he’s no longer a creditor and a permissible appointee?  Is estate tax inclusion under Internal Revenue Code  Section 2041 fixed at $1,000 or $1 million?

Common Law Deference

The Revenue Act of 1916 imposed estate taxes to the extent the decedent’s interest in property was distributable as part of the estate and subject to the payment of charges and administration expenses.1 In United States v. Field, the Internal Revenue Service argued that property passing under an exercised GPA was taxable to the donee powerholder under such law, but the U.S. Supreme Court disagreed because the statutory requirement that the property pass under the donee’s estate wasn’t met.2

The IRS recovered from its defeat when Congress enacted the Revenue Act of 1918, which defined the “gross estate” to specifically include property passing under a GPA exercised by the decedent (this was the law until 1942).3 The law didn’t define what constituted a GPA, leading many to conclude that Congress meant for the common law to prevail without references to variations in state law.4

The common law defined a “GPA” as a power the donee could exercise to appoint to whomsoever he pleases, including himself. If a power was exercisable in favor of certain persons or objects, or classes of persons or objects other than the donee, it wasn’t a GPA and was classified as a special power of appointment (SPA).5 Such distinctions were conducive to substantial argument and litigation. When was a power sufficiently lacking in generality to be classified as an SPA? What restrictions, however nominal, would take a power out of the GPA taxable class? What effect was to be given to state law in the definition of a GPA?6

The IRS in its regulations initially adopted the common law view that a GPA was a power “to appoint to any person or persons, in the discretion of the donee.”7 The regulatory definition was tweaked in 1937 to count powers as GPAs if they were exercisable “in favor of the donee, his estate, or his creditors.”8 This made some sense. If creditors are permissible appointees, the power looks like a GPA because it benefits the powerholder who could exercise such power to pay his debts or otherwise contract with appointees for financial gain.  

The 1937 regulations on the surface seemed to approve creditor GPAs because creditor appointments satisfied one of the three stated conditions. Still, the underlying statute was grounded in the “leaky” common law, and cases had never addressed the precise question of whether creditor appointments by themselves were GPAs. Could creditor appointments
possibly be SPAs under the common law because such appointments were illusory (who would do this?) or otherwise confined to a group not unreasonably large?

The 1942 Act

The compelling need for war revenues propelled Congress to pass the Revenue Act of 1942 (1942 Act),9 which, in addition to increasing tax rates, broadened GPA taxability. This latter outcome was chronicled in an entertaining public debate between Professors Erwin N. Griswold10 and W. Barton Leach of Harvard.11 Prof. Griswold, whose viewpoints prevailed in the new law, advocated taxation of all exercised and unexercised powers (GPAs and SPAs), except for narrowly defined powers limited to family members or a restricted class. Prof. Leach retorted that taxing unexercised powers was a double tax. He also felt it was socially reprehensible to tax familial SPAs because they admirably allocated family resources based on need.

At the heart of the dispute was the subjective determination regarding the quantum of sufficient property rights needed for estate tax inclusion. Prof. Griswold thought that many SPAs were ownership equivalents. Prof. Leach disagreed and remarked that the SPA powerholder isn’t the property owner, and to tax such power is to say that the powerholder is “analogous to an owner rather than to a simple life tenant; and, legally and factually, this is not true.”12

Under the 1942 Act, estate tax exclusion was required for property over which the decedent had, at the time of his death, a power of appointment (POA). The prior requirements of property “passing” under an “exercised” power were eliminated in one fell swoop, as were distinctions between GPAs and SPAs. Instead, all POAs were taxed at death, whenever made, whether or not exercised, except for defined appointments to a specified family or restricted class. An escape hatch was that the law didn’t apply to pre-enactment powers if released before Jan. 1, 1943, which critics contended was a trap for the unwary.13 

The 1951 Act

After passage, the 1942 Act became engulfed by a groundswell of criticism.14 So much ire was produced that Congress took the unusual step of retroactively repealing it by the Powers of Appointment Act of 1951 (1951 Act).15  

The 1951 Act changed the landscape. GPAs created on or before Oct. 21, 1942 (the 1942 Act’s enactment date) were taxed at death only if exercised, while powers created after that date were taxed whether exercised or not. Estate taxes were now imposed only for GPAs that were defined in the statute (current law IRC Section 2041) as powers exercisable in favor of the decedent, his estate, his creditors or the creditors of his estate.16 

The legislative history indicates that the new definition was meant to make the law simple and definite enough to be understood and applied by the average lawyer and avoid prior law complications that had forced property dispositions into narrow and rigid patterns.17 The changes were significant and allowed draftsmen to create GPAs by merely inserting the federal definition into the appointive grant. The leaky common law and state law variations as to what constituted a GPA were now largely irrelevant. All that was required was that permissible appointees qualify as one of the four disjunctive statutory objects (the decedent, his estate, his creditors or the creditors of his estate).18 Creditor GPAs are thus validated because creditors are two of the statutory objects.19

The 1951 Act did violence to the traditional norms as to what constituted a GPA. A GPA under the common law was equated with outright ownership and the full bundle of property rights. The powerholder could appoint to anyone, an extremely large appointive class. On the other hand, creditor GPAs have a more narrowly defined appointive class, at least when compared to the “anyone” of the common law.

The planning idea that followed (widely used today) was to create SPAs not technically qualifying as GPAs, but with an extremely large appointive class, such as granting the power to appoint to anyone, except for the benefit of the powerholder, his estate, his creditors and the creditors of his estate.20 This, theoretically, seems like enough for the imposition of estate taxes because of the power’s extremely broad appointive class, yet it flunks as a GPA under the 1951 Act’s definition. Not a bad deal for clients. Common law ownership rights without annoying estate taxes. 

Effect of State Law

The Supreme Court in Morgan v. Commissioner21 held that the definition of a GPA was a matter of federal law, explaining that while state law defines the legal rights relating to the power, federal law determines whether such rights are taxable. State law determines the nature of the donee’s interest in property and the scope of that interest, such as the existence of an ascertainable standard under IRC Section 2041(b)(1)(A) or whether appointments are made to the four statutory objects (the decedent, his estate, his creditors or the creditors of his estate). State laws can create different rights for the same power, resulting in varying taxation.22

For example, under most jurisdictions, a powerholder’s ability to appoint “to whomever he desires” constitutes a GPA because the appointive class quite reasonably is construed to include the statutory objects of Section 2041. But, under the peculiarities of long-standing Maryland law, such power isn’t a GPA unless the underlying instrument specifically allows appointments to the powerholder, his estate, his creditors or the creditors of his estate.23 Alaska has a similar law.24 This precedent isn’t a problem for creditor GPAs, because creditor appointments are allowed in the appointive grant.

It’s commonly recognized that GPAs in favor of the powerholder’s creditors or the creditors of his estate are generally exercisable only in favor of those creditors; other appointments are to impermissible appointees.25 However, there’s no guidance on state law rules regarding how much trust property may be appointed to creditors. 

In our example, John owes Paul $1,000 and holds a creditor GPA over a $1 million trust. Presume that John appoints $100,000 to Paul. Common sense dictates that Paul is an impermissible appointee to the extent trust property exceeds John’s debt. This is because John tendered Paul $99,000 more than the underlying debt, thereby exceeding the discretion given him to appoint to creditors (after the first $1,000, Paul is no longer a creditor).  

Yet, can it somehow be contended that because Paul is a creditor when the power is exercised, the entire $1 million trust can be appointed to him? This argument becomes more convincing if the power is limited to the creditors of the estate, because creditor status is fixed and determinable at the moment of death without regard to the amount of indebtedness.  

Commentators have noted that the question isn’t entirely academic. Creditor GPAs are popular because they’re perceived to be narrow powers unlikely to be exercised. But, if creditor appointments aren’t limited to the amount the creditor is owed, then the power isn’t as narrow and arguably less desirable.26 A simple drafting solution to avoid these concerns is to define “creditor appointments” as applying only to the amount of the legally enforceable debt (rather than blindly hoping that creditor appointments are limited under state law to the amount owed). A happy consequence under the Uniform Trust Code is that the powerholder of a creditor GPA may represent and bind trust beneficiaries.27

If state law limits the appointive property to Paul at $1,000, is estate tax inclusion under Section 2041 confined to such amount? If Paul was the only permissible appointee available, the answer to such question should be in the affirmative. But, while state law likely limits the appointive property to Paul at $1,000 for that particular appointment, indisputably John under his creditor GPA could appoint the remaining trust property for the benefit of other creditors. There’s no mismatch for state law and tax purposes, as in both cases the entire $1 million can be appointed to creditors. Thus, that’s the amount includible in the gross estate under Section 2041.

It makes no difference that at John’s death, his actual indebtedness may be less than the appointive property. It’s John’s ability to appoint trust assets to creditors that sets the tax consequences. The important consideration is the breadth of the control the decedent can exercise over the property and not the actual exercise of the power.28

Treasury Regulations Section 20.2041-1(c)(1) supports this notion by classifying as a GPA a power exercisable to pay estate taxes, or any other taxes, debts or charges that are enforceable against the estate. This rejects the bean counter philosophy that actual taxes and debts must be tallied to measure the size of the appointive property. For creditor GPAs, the entire trust is included in the gross estate because of the ability of the powerholder to impose charges against the appointive property, whether or not such charges are incurred.

Excessive appointments exceeding the donor’s dispositive grant are concerning. This malfeasance may divert trust property to appointees outside the donor’s dispositive scheme. Careful drafting is necessary. Can a treacherous family member holding a creditor GPA pledge appointive property to a new boyfriend or spouse (not known to the donor, with the intention of creating a creditor relationship) in exchange for financial assets or the waiver of marital or other contractual rights? The ploy is entertaining and has some merit, but in many circumstances can probably be attacked as a “fraud on the power” under state law.29  

To avoid undesirable appointments, consider requiring the consent of a non-adverse party to exercise the power,30 inserting notice requirements31 or excluding perceived non-family interlopers from qualifying as permissible appointees.

Asset Protection View

An irony is that, while it’s not typically expected that creditor GPAs will be exercised, possessing such power may be detrimental from an asset protection point of view if the powerholder has creditors. The traditional common law rule was that if the powerholder didn’t create the GPA, creditors couldn’t reach the appointive property unless the power was exercised.32 The newer rule is that creditors can attach the appointive property of presently exercisable and testamentary GPAs to the extent the powerholder’s property is insufficient to satisfy creditor claims.33 To confront this change, the planner should evaluate the solvency of the powerholder and consult local law.  

Endnotes

1. 39 Stat. 756 (1916), Section 202(a).

2. United States v. Field, 255 U.S. 257 (1921).

3. 40 Stat. 1057 (1918), Section 402(e).

4. Erwin N. Griswold, “Powers of Appointment and the Federal Estate Tax,” 52 Harv. L. Rev. 929, 942 (1939).

5. George Gump, “The Meaning of ‘General’ Powers of Appointment Under the Federal Estate Tax,” 1 Md. L. Rev. 300, 301 (1937). The Restatement of Property, Section 320 (1940), initially defined a “general power of appointment” (GPA) as a power exercisable in favor of the donee or the estate of the donee, with a special power of appointment (SPA) limited to certain persons, not including the donee, who constituted a group not unreasonably large. The Powers of Appointment Act of 1951’s (1951 Act) GPA definition (discussed herein) has been adopted by the Uniform Powers of Appointment Act (UPAA), Section 102(6) (2013) and later Restatements (Restatements (Second) and (Third) of Property: Wills and Other Donative Transfers, Section 11.4 (1986); Section 14.3 (2011)).

6. Paul G. Kauper, “The Revenue Act of 1942: Federal Estate and Gift Taxation,” 41 Mich. L. Rev. 369, 375 (1942). Griswold, supra note 4, at pp. 940-941. 

7. Treasury Regulations Section 37, Art. 30 (1918).  

8. Treas. Regs. Section 80, Art. 24 (1937). The new regulation changed the analysis as it made the power to appoint to creditors part of the GPA definition, elevating it from the majority common law rule that creditors could attach the appointive property of exercised GPAs. Field, supra note 2, at p. 263.

9. Pub. L. 753 (1942).

10. Griswold, supra note 4.

11. W. Barton Leach, “Powers of Appointment and the Federal Estate Tax—A Dissent,” 52 Harv. L. Rev. 961 (1939).

12. Ibid., at p. 965.

13. Harrop A. Freeman, “If this Be Simplification—a View of Pre-1942 Powers of Appointment and the 1954 Internal Revenue Code,” 40 Cornell L. Rev. 500, 502 (1955).

14. Lucius A. Buck, George Craven and Francis Shackelford, “Treatment of Powers of Appointment for Estate and Gift Tax Purposes,” 34 Virginia L. Rev. 255, 257-261 (1948).

15. Pub. L. No. 58 (1951).

16. See George Craven, “Powers of Appointment Act of 1951,” 65 Harv. L. Rev. 55, 64 (1951). The 1951 Act adopted safe harbors wherein prescribed powers could benefit the powerholder without estate taxation, such as powers subject to adverse party consent, ascertainable standards and “5 and 5” powers. Internal Revenue Code Section 2041(b). 

17. H. Rep. No. 327, at pp. 3-4; S. Rep. No. 328, at pp. 1530-1531, 82d Cong., 1st Sess. (1951).

18. A GPA results from a power that can be exercised in favor of any one of the four disjunctive statutory objects. Edelman Est. v. Commissioner, 38 T.C. 972, 977 (1962), Jenkins v. U.S., 428 F.2d 538, 544 (5th Cir. 1970). In accord Private Letter Rulings 9110054 (Dec. 12, 1990) and 8836023 (June 13, 1988).

19. It isn’t advisable to materially change the statutory objects. For example, is a creditor GPA illusory for an accumulation trust limiting appointments to creditors not older than the age of a very young trust beneficiary? Edwin P. Morrow Ill, “The Optimal Basis Increase and Income Tax Efficiency Trust,” https.//ssrn.com/abstract=2436964, at pp. 38-39 (revised April 28, 2018).

20. There was initial skepticism whether this would work. See Allan McCoid, “The Non-General Power of Appointment—A Creature of the Powers of Appointment Act of 1951,” 7 Vand. L. Rev. 53, 60 (1953). The strategy is now blessed by Treas. Regs. Section 20.2041-1(c)(1)(b).

21. Morgan v. Comm’r, 309 U.S. 78 (1940).

22. Christopher P. Cline, 825-3rd T.M., “Powers of Appointment—Estate, Gift, and Income Tax Considerations,” at pp. A-20-22 (2007).

23. Guiney v. U.S., 425 F.2d 145 (4th Cir. 1970).

24. AS 34.40.115.

25. Restatement (Third) of Property, supra note 5, Section 19.15; UPAA, Section 305(b), and underlying comments therein.

26. Ibid., Section 19.15; UPAA, Section 102(6) and underlying comments therein. Turney P. Berry and Sarah S. Butters, “Powers of Appointments in the Current Planning Environment,” 49 U. Miami Heckerling Institute on Estate Planning, Ch. 13, at pp. 28-29 (2015). Steve R. Akers, “Estate Planning Current Developments and Hot Topics (Final for 2018),” www.bessemertrust.com/for-professional-partners/advisor-insights, at p. 91. 

27. Uniform Trust Code (UTC), Section 302 (2003). The Illinois UTC extends this power to broad SPAs. 760 ILCS 3/302(a).

28. Morgan, supra note 21, at p. 83.

29. Restatements (Second) and (Third) of Property, supra note 5, Sections 20.1 to 20.4 (1986), Section 19.15, 19.16 (2011); UPAA Section 307.

30. IRC Section 2041(b)(l)(C)(ii) and Treas. Regs. Section 20.2041-3(c)(2).

31. Section 2041(a)(2) and Treas. Regs. Section 20.2041-3(b).

32. Field, supra note 2, at p. 262.

33. UPAA, Section 502; Restatement (Third) of Property, supra note 5, Section 22.3.

In Part 1 of our article, which appeared in the November 2019 issue of Trusts & Estates, we began our discussion of the U.S. inheritance tax under Internal Revenue Code Section 2801, which can follow U.S. expatriates for many years after they leave the United States. Our article included some tips on how to plan for this dreaded tax. We’ll now offer some other strategies for helping clients, who have or are contemplating expatriation, avoid the tax. 

Transfers Subject to Tax

Before advisors can follow our suggestions, they must have a thorough understanding of which transfers are subject to the inheritance tax and which aren’t.

Transfers subject to tax. The most important term in IRC Section 2801 is “covered gift or bequest.” This term includes: (1) any property acquired by gift directly or indirectly from an individual who, at the time of such acquisition, is a covered expatriate; (2) any property acquired directly or indirectly by reason of the death of an individual who, immediately before such death, was a covered expatriate;1 and (3) distributions from a foreign trust that isn’t an electing foreign trust.2 

It isn’t relevant where the transferred property is located (that is, the situs of the property isn’t relevant for purposes of Section 2801, subject to an exception discussed below). Remarkably, it’s not even relevant whether the property was acquired by the covered expatriate long after expatriation from the United States.3 Finally, it isn’t relevant that the recipient may not have been born when the covered expatriate officially expatriated from the United States or lived in a foreign country at the time of such expatriation.

A “covered bequest” includes property transferred by bequest, devise, trust provision, beneficiary designation or similar arrangement. The proposed regulations (proposed regs) issued under Section 2801 provide that a “covered bequest” also includes any property that would have been includible in the gross estate of the covered expatriate under the U.S. estate tax if the covered expatriate had been a U.S. citizen or domiciliary at the time of death.4 This means that transfers made, for example, to a foreign trust over which the covered expatriate as settlor retains certain proscribed powers under IRC Sections 2036-2038 or 2041, could be considered a “covered bequest” subject to Section 2801.5 

The proposed regs also confirm that the exercise, release or lapse of a covered expatriate’s general power of appointment for the benefit of a U.S. citizen or resident is a covered gift or covered bequest.6 

Transfers not subject to tax. Although not explicitly stated in the statute, a “covered gift or bequest” can’t include fair market value (FMV) transactions because such transactions are neither gifts or transfers by reason of death. Although in connection with a contemplated sale to an intentionally defective grantor trust in exchange for note transaction, the seed gift made by a covered expatriate to an irrevocable trust that’s a foreign grantor trust (because the only permissible beneficiaries of trust income and principal during the life of the settlor are the settlor and her spouse) in preparation for a subsequent sale for promissory note transaction is a “covered gift,” the subsequent sale for FMV in exchange for a promissory note shouldn’t be a transfer subject to the inheritance tax. If the asset to be sold is an illiquid non-traded asset, it’s necessary to obtain a valuation by a qualified U.S. appraiser. Use of an independent trustee is recommended, and the terms of the sale transaction and note should be commercially reasonable. 

The inheritance tax doesn’t apply to annual exclusion gifts. Interestingly, Section 2801(c) doesn’t require the gift to meet the requirements of an annual exclusion gift. The language in the statute merely says the inheritance tax is imposed only to the extent the value of a covered gift or bequest exceeds the gift tax annual exclusion amount specified in IRC Section 2503(b). If a covered expatriate made a gift of $30,000 (two times the current gift tax annual exclusion amount) to an irrevocable domestic trust that doesn’t contain a Crummey withdrawal power, there will be an inheritance tax on $15,000. In contrast, if the same covered expatriate gave $30,000 to a foreign trust, there’s no inheritance tax on such gift because a foreign trust isn’t a U.S. recipient. If the trustee of such foreign trust subsequently distributes $15,000 to each of two different U.S. citizen trust beneficiaries, there’s no inheritance tax due because each of the U.S. recipients would be entitled to a Section 2801(c) annual exclusion.7 

Among the most important exceptions under Section 2801 is for transfers otherwise subject to U.S. gift or estate tax.8 This means that if a covered expatriate who’s permanently left the United States for a foreign country makes a transfer of U.S. situs property (for example, U.S. real estate), either for gift or estate tax purposes, such transfer is outside the scope of Section 2801 provided it’s properly reported to the Internal Revenue Service.9 

Also, if a lifetime or testamentary transfer by a U.S. domiciliary donor or decedent would qualify for a charitable or marital deduction under the relevant U.S. transfer tax statute, the transfer isn’t a “covered gift or bequest.”10 The proposed regs confirm that a bequest to a qualified domestic trust (QDOT) for which a QDOT election is made will qualify for this exception.11 There’s no such thing as an inter vivos QDOT, so this exception is unavailable to mitigate either the gift tax or inheritance tax for gifts to a non-U.S. citizen spouse.

Finally, transfers made before the expatriation date wouldn’t be covered gifts or bequests because the Green Card holder isn’t yet a covered expatriate. Long-term Green Card status terminates when an individual loses it through revocation by the U.S. Citizen and Immigration Services (CIS) (or by administrative or judicial determination), as well as when an individual is treated as a resident of a foreign country having a treaty with the United States, doesn’t waive treaty benefits and notifies the IRS of such treatment.12 Once an individual who holds U.S. permanent resident status (that is, a Green Card holder) establishes a domicile abroad and no longer has any intention of returning to live in the United States, the U.S. CIS takes the position that such individual has abandoned his permanent resident status, even though the Green Card is unexpired, and it would be unlawful for such individual to use his Green Card to re-enter the United States.13 The U.S. CIS expects such an individual to complete a formal abandonment process (that is, file Form I-407) and relinquish the Green Card either to a U.S. embassy in the foreign country or to the U.S. CIS. Abandonment of the Green Card would then require the individual to obtain a U.S. visa to enter the United States for business trips or for personal travel.14 To terminate lawful permanent status, one of three actions must occur: (1) the U.S. government formally revokes the Green Card; (2) the Green Card holder formally abandons the Green Card (that is, files Form i-407); or (3) the Green Card holder converts to nonresident status for income tax purposes in the United States by virtue of an income tax treaty under IRC Section 7701(b)(6). 

Funding a Pre-Expatriation Trust 

For a host of reasons, the expatriating individual may not want to make outright gifts of assets to reduce his net worth below $2 million (an expatriating long-term Green Card holder isn’t a covered expatriate if he has a net worth below $2 million as of the date of expatriation). As an alternative, a long-term Green Card holder could create and fund an irrevocable self-settled non-grantor U.S. domestic discretionary trust for his own benefit and that of his spouse and descendants.

Still living in the United States. There are a number of technical requirements and considerations in structuring the terms of a pre-expatriation trust for an individual who’s still living in the United States and is a U.S. domiciliary for transfer tax purposes.

First, the trust must be settled under the state laws of any number of U.S. jurisdictions that have adopted an asset protection statute that permits self-settled discretionary trusts. The asset protection jurisdictions, such as Alaska, Delaware, New Hampshire, Nevada, South Dakota and Wyoming, provide an advantage because the trust assets wouldn’t be included in the estate of the settlor for U.S. estate tax purposes. The U.S. tax advisor wants confirmation that by making a gift to an asset protection trust settled in an asset protection jurisdiction, the Green Card holder contemplating expatriation makes a completed gift, and the trust assets won’t be included in the expatriate’s gross estate.15  

Even if the trust is settled in an asset protection jurisdiction, the IRS will likely attempt to value and include the settlor’s retained “beneficial interest” in the trust. In valuing a beneficial interest, the IRS uses a facts-and-circumstances test, looking at not only the terms of the trust agreement but also letters of wishes, historical patterns of trust distributions and the powers of a trust protector. Notice 97-19 provided guidance on the application of IRC Section 877 to determine expatriation status under the prior exit tax regime; however, the current exit tax regime retains the same net worth, income tax and prior compliance tests as was found in prior Section 877(a)(2). The drafter of the expatriation trust should include the settlor as only one member of a class of permissible trust beneficiaries, along with the spouse and descendants. Despite such terms, the U.S. tax advisor and trustee should advise the settlor-expatriate well before the trust is established and funded that the optimal situation is for there to be no history of trust distributions to the settlor and spouse. Perhaps the best approach is for the trust to provide that approval by adverse parties (for example, the adult children of the settlor) is required before a distribution can be made to the settlor and spouse, as this strengthens the non-inclusion argument.

If a beneficial interest can’t be allocated to the settlor under the facts-and-circumstances test, the IRS will allocate the interest based on the intestate succession rules in the Uniform Probate Code (UPC), with the settlor as the party assumed to have died. If the settlor intends to expatriate, the rules of intestate succession would allocate zero to the settlor of the expatriation trust. The spouse would have a beneficial interest, and the draftsperson should consult with UPC Sections 2-102 and 102A. 

Second, the trust must be classified as a non-grantor trust for federal income tax purposes under IRC Sections 671-679. The IRS takes the position on Form 8854 and its instructions that the entire value of a grantor trust is includible for purposes of the net worth test. To prevent grantor trust status, the terms of the expatriation trust must provide that no income or principal can be distributable to the settlor without the consent of an adverse party.16 Approval must come from the adult children who are adverse parties to the settlor (and not from the spouse, who isn’t adverse).17  

Moreover, the pre-expatriation trust must not be a grantor trust under Section 679. Accordingly, the trust shouldn’t be a foreign trust for federal income tax purposes. (A foreign trust is considered a grantor trust under Section 679(a)(1) if such foreign trust is established by a “U.S. person” and a “U.S. person” is one or more of the beneficiaries. A “U.S. person” in this context is a domestic corporation or a citizen or resident of the United States. This would be the case if the settlor is a permissible or discretionary beneficiary.) To further inoculate the trust from being considered a foreign trust for federal tax purposes, the U.S. tax advisor must make sure that the trustees, as well as the persons with power to remove a trustee (for example, a trust protector) and the adverse parties who’ll control distributions from the trust, are at all times “U.S. persons.” Thus, “U.S. persons” must hold all relevant powers under the expatriation trust. (“Residency” for these purposes is the definition for income tax purposes, so a child living abroad with a Green Card could be a permissible adverse party.)

Third, if the individual Green Card holder is living in the United States with no current plan to move abroad or to his country of origin, the trust settlor will be considered a U.S. resident (domiciliary) when funding the expatriation trust. The settlor in this situation would only owe U.S. gift tax on the value of the transfer to the trust in excess of $11.58 million (2020). Given the large exemption amount, it’s possible for the executive-settlor to make a completed gift to the trust of significant asset value so that following funding of the trust, such individual falls below the $2 million net worth threshold. 

There’s a complicated multi-year strategy available in which the amount needed to fall below the $2 million net worth threshold exceeds the settlor-expatriate’s remaining gift tax exemption amount. To accomplish the twin goals of gift tax avoidance on gifts over the available exemption amount and excluding assets from the net worth test, such a gift to the expatriation trust must be incomplete.18 

Living abroad. An unusual feature of the expatriation rules is that the exit tax and inheritance tax are triggered for a long-term resident Green Card holder only if the individual voluntarily or involuntarily terminates Green Card status or elects treaty benefits and discloses such position on his U.S. income tax return. These taxes aren’t triggered for an individual who retains his Green Card and becomes a non-resident of the United States for transfer tax purposes. This could occur when a long-term Green Card holder changes his domicile from the United States to a foreign country and is prepared to continue to pay U.S. income tax on his worldwide income while simultaneously paying income tax in such foreign country.

Most advisors recognize that when a long-term Green Card holder files a Form I-407 with the U.S. CIS, this is an act of voluntarily abandoning his Green Card, and if the individual is a covered expatriate at the time of such filing, this triggers the exit tax and potentially subjects the U.S. heirs of such individual to inheritance tax until his assets are fully distributed. 

In addition, loss of lawful permanent resident status in the United States can occur when three conditions are met: (1) the individual begins to be treated as a resident of a foreign country under the provisions of an income tax treaty between the United States and the foreign country; (2) the individual doesn’t waive the benefits of such treaty applicable to residents of the foreign country (that is, the individual benefits in some monetary way from claiming tax treaty relief); and (3) the individual notifies the IRS of the commencement of such treatment as a non-resident of the United States for income tax purposes.19  

Most U.S. tax treaties generally provide that if the regular domestic tax law of the foreign country would treat this Green Card holder as a resident, then he’ll be a resident for purposes of the tax treaty. Moreover, the Green Card holder must disclose to the IRS a desire to waive the treaty benefits. Finally, the IRC and Treasury regulations now both require a taxpayer to give notice to the IRS by filing Form 8833.20 If a Green Card holder residing in a foreign country doesn’t give notice claiming treaty relief by filing Form 8833, there’s a penalty, but the taxpayer presumably doesn’t lose the right to claim the treaty benefits, and therefore, the Tax Code has only limited application to such taxpayer.

Death as an Exit Strategy?

A Green Card holder theoretically could leave the United States and live abroad indefinitely without notifying the U.S. CIS or the IRS. While a Green Card is generally valid for 10 years, the Green Card would continue to be valid so long as the U.S. CIS doesn’t revoke it, the Green Card holder doesn’t abandon it and the Green Card holder doesn’t proactively file anything with the IRS claiming nonresident status for income tax purposes pursuant to a bilateral U.S. income tax treaty.21 The IRS considers such an individual a “resident alien,” which means he’s still a U.S. taxpayer for income tax purposes.

Arguably, a Green Card holder living abroad can expatriate and never notify the U.S. government. Perhaps behaving for U.S. tax purposes in a way that’s consistent with the tax treaty may be sufficient to overcome never filing Form 8833. Presumably, such individual will claim that he expatriated years ago, before the current expatriation rules were enacted pursuant to the Heroes Earnings Assistance and Relief Tax Act of 2008 (2008 Tax Act), enacting IRC Section 877A. Such individual is relying on the premise that the U.S. government will treat him as a lawful permanent resident until he actually files paperwork claiming non-resident status in the United States.  

The risks of detection by the U.S. government are extraordinarily high for a Green Card holder living abroad who intends to adopt a do nothing strategy (that is, never contacting the U.S. government) for the balance of his life about his Green Card status. Such individual would need to be very careful not to trigger the attention of the U.S. government, which includes the U.S. CIS and IRS. The Foreign Account Tax Compliance Act (FATCA), travel to the United States or investment in U.S. assets are all problematic for an individual adopting a do nothing strategy. What if the individual has U.S. heirs? Under the inheritance tax, the burden is on the U.S. heirs to prove that their relative wasn’t a covered expatriate when he gave up Green Card status. Moreover, every year such Green Card holder adopts a do nothing approach to expatriation from the United States and fails to file U.S. income tax returns (which are required of a Green Card holder with legal permanent resident status until terminated) will create perhaps decades of non-filing of U.S. tax returns and non-payment of U.S. income tax, with potentially enormous penalties. In addition, such individual will run afoul of FATCA and the electronic Report of Foreign Banks and Financial Accounts (FBAR) filing requirements, which may present practical problems with respect to his foreign bank accounts. 

At some point, the U.S. government will upgrade its overall internal data capabilities, and the IRS and U.S. CIS will eventually share databases and begin cross-checking Green Card holders against income tax returns filed to locate Green Card holders not living in the United States. Once it discovers those individuals, the U.S. CIS will revoke their Green Cards, and covered expatriate status will be thrust on such individuals adopting a do nothing, lay low strategy.

Avoiding Covered Expatriate 

A do nothing, lay low strategy while living abroad presumably isn’t viable. However, a compliant Green Card holder can legally move from the United States to a foreign country, change his domicile (assuming the facts and circumstances support such position) and yet remain a U.S. permanent legal resident (Green Card holder) subject to U.S. income tax on worldwide income. This may be viable for an individual moving to a high tax jurisdiction with little U.S. source income. There’s nothing in the Tax Code that provides that a Green Card holder who successfully argues a change of domicile from the United States to a foreign country will be classified as a covered expatriate for both exit tax and inheritance tax purposes. Not only can an individual change his domicile from the United States to a foreign country without any U.S. tax consequences, but also there’s no duty imposed on such individual to notify the IRS of his change of domicile.22 

A potentially significant U.S. transfer tax advantage in becoming a non-domiciliary of the United States is that gifts of foreign situs property (for example, real estate, intangible or tangible property located outside the United States) as well as gifts of intangible property located anywhere (including stock in U.S. corporations) aren’t subject to U.S. gift tax regardless of their size. It’s highly desirable that the recipient of the gift not be a U.S. tax resident or U.S. citizen; otherwise, the carryover basis in the hands of the recipient following a gift simply shifts the U.S. capital gains tax burden from the donor to the recipient if the recipient won’t hold such asset until his death. One possible strategy to backstop the reporting position of non-domiciliary status for U.S. transfer tax purposes is to create a U.S. bank account with a balance of $15,100. The non-domiciliary would then make a gift to a child or parent of the balance of this U.S. bank account and subsequently file a Form 709 reporting such gift and paying $40 of gift tax. While the statute of limitations is only relevant to the gift and not for inheritance tax purposes, such gift reporting memorializes the taxpayer’s transfer tax status as a non-domiciliary of the United States.

Moreover, foreign counsel should be consulted to determine if the foreign country has a gift tax treaty with the United States that includes a tie-breaker provision. If so and it’s clear such individual is a domiciliary of the foreign country and not the United States, he might consider filing Form 8833 with the IRS concerning any gifts that might be subject to U.S. gift tax under the IRC but that are exempt under the relevant gift tax treaty.

Before a Green Card holder uses the tie-breaker provision of a U.S. income tax treaty claiming he wishes to be treated as a resident of a foreign country for income tax purposes, he must consider the collateral consequences of such action. Will he risk losing the Green Card by acknowledging that he’s a non-resident alien—not a permanent legal resident—of the United States? As a result of the 2008 Tax Act, long-term residency in the United States is now also terminated if an individual elects to be treated as a resident of a foreign country having an income tax treaty with the United States, doesn’t waive treaty benefits and files Form 8833. However, reliance on a U.S. tax treaty tie-breaker provision merely makes such individual a non-resident for income tax purposes but doesn’t avoid FBAR and certain other U.S. tax information return reporting obligations.

For the well-advised Green Card holder approaching his seventh year as a permanent legal U.S. resident with a net worth in excess of $2 million, the best option may be to plan to abandon Green Card status by moving to a foreign country and claiming possible treaty relief in or before the seventh year. Claiming treaty benefits will limit U.S. income tax to U.S. source income and somewhat limit U.S. tax reporting obligations, but perhaps most importantly, it will prevent such individual from becoming a long-term covered expatriate subject to the exit and inheritance taxes. Most Green Card holders moving to South America don’t have this option available because the United States has no income tax treaties with any of these countries.

On the other hand, moderately affluent Green Card holders with a net worth currently above $2 million living in a foreign country may choose to satisfy the 8-of-15-year test (that is, they’ve been permanent legal residents of the United States during eight of the previous 15 years) by retaining their Green Cards indefinitely beyond the seventh year but avoiding the exit and inheritance taxes as of their expatriation date by planning ahead to reduce their net worth below $2 million. The implementation of a gift strategy to avoid covered expatriate status on the expatriation date may be easier to achieve once the Green Card holder has moved to a foreign country and changed his domicile.

Trust Gift Options

Suppose that an executive holding a Green Card resettles decisively in a new country (or returns to his country of origin) with no current intent to move elsewhere. The executive will become a domiciliary of the new country and will cease to be resident of the United States for transfer tax purposes. What gift options in trust are available?

Establishing a pre-expatriation trust while living abroad. Many of the same considerations described above will apply to the would-be settlor living abroad. The settlor should: (1) settle the trust under the laws of a U.S. state that’s adopted a self-settled asset protection statute; (2) establish and fund the trust at least three years before expatriating (to prevent the 3-year reach back under IRC Sections 2035 and 2038); (3) require adverse parties to approve any distribution to the settlor or spouse; (4) ensure the trust won’t be classified as a foreign trust under U.S. federal tax law; and (5) avoid distributions to the settlor and spouse before the expatriation date.

In this situation, the individual’s definitive move to a new country should confirm that he’s no longer a U.S. domiciliary for gift tax purposes. If so, the executive can make completed gifts of intangible assets, including stock in U.S. companies, to the pre-expatriation trust because they’re not U.S. situs assets for gift tax purposes. The longer the period of time between creation/funding of the expatriation trust and the actual date of expatriation, the more difficult it will be for the IRS to claim the individual was still a domiciliary for transfer tax purposes on the date of expatriation.

Before undertaking any gifts, the individual living abroad must consult with local tax counsel in the new country of residency. A key issue before making any gift while resident in a new country is whether such country imposes an inheritance or gift tax on such transfer. If the gift is to be made to a pre-expatriation trust, local counsel in a civil law country must also advise on the viability of using a common law expatriation trust in such civil law country. Many civil law countries no longer recognize a common law trust. In countries such as Germany, a transfer to a trust is assigned to the least favorable transfer tax category, which results in a higher German gift/inheritance tax rate. Further, under Common Reporting Standard requirements, some countries now impose significant disclosure rules on settlors, trustees and beneficiaries who are resident in their countries. 

One possible disadvantage of the pre-expatriation trust strategy is that by creating a U.S. domestic trust, to the extent the trust income is accumulated and not distributed currently to non-U.S. beneficiaries, the trust will incur U.S. income tax at compressed tax rates. If an individual has already moved to a low tax jurisdiction and plans to give up his Green Card, there may be some hesitation to incur higher U.S. income taxes without offsetting treaty benefits because the United States generally has no treaties with no or low tax jurisdictions.  

Lifelong (or longer) reach of Section 2801. Most pernicious is that the inheritance tax consequences for families of a covered expatriate don’t end until the decedent’s worldwide assets are exhausted, which would typically be on the death of such individual but could be longer if property passes at death to a foreign trust for subsequent distribution to U.S. beneficiaries. Therefore, the burden is on the U.S. recipient of a gift or bequest to determine whether the expatriate was a covered expatriate, and if so, whether the gift or bequest was a “covered gift or bequest.” 

Other Planning Possibilities

What are the other possibilities for a long-term Green Card holder who’s living abroad as a covered expatriate? Joseph P. Toce, Jr. of Andersen and his co-author Joseph R. Kluemper share some potential planning opportunities in their still highly relevant article, “Estate Planning for Expatriates Under Chapter 15.”23

They suggest that a covered expatriate should be able to make loans to a U.S. citizen or resident organized as borrower, as well as to a domestic trust or entities owned by U.S. citizens or residents, without triggering the inheritance tax, as long as the loans bear an adequate interest rate (and presumably are represented by an enforceable written promissory note).

Suppose the covered expatriate originally funded a foreign trust during his lifetime and subsequently dies survived by children and grandchildren now living in the United States. Can the foreign trust make loans to the U.S. beneficiaries without triggering the inheritance tax? Under IRC Section 643(i), if a non-U.S. settlor creates a non-grantor offshore trust that then loans cash or marketable securities to a U.S. beneficiary or settlor or to a U.S. relative of the trust settlor, the loan will be treated as a distribution to the person receiving it and will be taxed accordingly, even if the loan is later repaid.

In Notice 97-34, however, the Treasury carved out an exception to this deemed distribution rule. This exception permits a foreign trust to lend money to a U.S. beneficiary without having it treated as a distribution if it’s a “qualified obligation.”24  

There’s no legal authority on whether a “qualified obligation” under Section 643(i) will prevent imposition of the inheritance tax on a loan from a foreign trust established by a covered expatriate to a U.S. beneficiary. No one knows whether the principles of Notice 97-34 will extend safe harbor loan treatment under the inheritance tax.

Toce and Kluemper also raise the possibility of using a foreign trust established by a covered expatriate to defer the inheritance tax, as well as provide for income tax savings on non-U.S. source investment or business income of the trust. They warn that careful planning is required to minimize the confiscatory accumulation distribution rules of IRC Sections 665-668. 

Because it’s difficult for a foreign trust to qualify as a grantor trust and distributions of undistributed net income (UNI) from a foreign non-grantor trust to a U.S. beneficiary have such negative tax consequences (for example, they’re subject to the accumulation distribution rules), trustees will often look for ways to cleanse accumulated income in a trust. One idea is to distribute the accumulated income to a foreign intermediary (an individual, corporation or another trust), which can then later pay it to the U.S. beneficiary in the guise of current income, principal distribution or a gift.25 

If the intermediary can be viewed as an agent of the foreign trust, a distribution will be deemed to take place from the foreign trust to the U.S. beneficiary at the time the intermediary makes the distribution to the U.S. beneficiary. If the intermediary can be viewed as an agent of the U.S. beneficiary, a distribution will be deemed to have been made to the U.S. beneficiary when the foreign trust makes the distribution to the intermediary.

Trustees of foreign trusts often want to make distributions to U.S. beneficiaries out of trusts with substantial UNI. If a foreign trust with UNI makes a distribution to a non-U.S. person or a distinguishable foreign trust distributes all of the trust’s UNI, the original trust becomes “cleansed” and can make a large principal distribution to a U.S. beneficiary in the next calendar year without carrying out accumulated income. The question remains of what to do with the tainted funds if they’re added to a new trust; they can remain with the offshore beneficiaries or trusts or go to charities, but it will be difficult for those funds to find their way to the U.S. beneficiaries without running afoul of the intermediary rules.

Presumably, relying on the same principal agency theory already made applicable to the accumulation distribution rules, the IRS might also eventually extend the same concept to the inheritance tax to prevent its circumvention through the use of related party entities in foreign jurisdictions so as to capture indirect transfers. The proposed regs take an expansive view of a covered gift or covered bequest made through or to a corporation or foreign trust.26 

Toce and Kluemper also raise an interesting intergenerational planning idea when a terminally ill but very wealthy grandparent who’s a non-citizen, non-domiciliary (NCND) of the United States has a U.S. child but non-U.S. grandchild. Suppose the U.S. child is already very wealthy. Instead of making transfers to a covered expatriate child, which will create either U.S. estate tax or possible future inheritance tax issues for such child, the grandparent could bypass his U.S. child and make a transfer of non-U.S. situs assets directly to his grandchild (or to an irrevocable foreign trust for the grandchild). Transfers by NCNDs are subject to generation-skipping transfer (GST) tax on direct skips but only to the extent that the transfer is subject to U.S. gift or estate tax. As a result, so long as the grandparent doesn’t own U.S. real estate or tangible property located in the United States at the time of transfer, there can be no GST tax imposed on such a transfer by an NCND grandparent to an NCND grandchild.

Similarly, taking advantage of residency changes by children and grandchildren may be relevant in managing and minimizing the inheritance tax. Suppose a grandchild of a very wealthy Chinese national grandparent who’s a covered expatriate of the United States qualified for a student visa while he attends undergraduate college in the United States. Assume the grandparent, now deceased, was a former long-term Green Card holder who was a covered expatriate on the date of departure from the United States years before the grandchild was born. After college, the grandchild moves back to China for a few years to learn the family business following education in the United States and before moving back to the United States to attend graduate school and to expand the business. While the grandchild is living definitively in China, the trustee of the foreign trust could make very significant distributions from the foreign trust established by the grandfather to such grandchild, which wouldn’t be subject to the inheritance tax due to the residency of the grandchild outside of the United States at the time of his receipt of such distributions. Perhaps the trustee might take advantage of this window of opportunity while the grandchild is residing in China to make a complete distribution of the original trust to the grandchild, knowing that following a move back to the United States by the grandchild, any transfer from the foreign trust to the grandchild would be subject to inheritance tax. 

Suppose that while the grandchild is back in China before graduate school in the United States, the foreign trust makes a complete distribution of its assets to the grandchild. A few months after receipt of all the trust assets, the grandchild contributes these assets to a foreign corporation organized in a no-tax jurisdiction. Immediately thereafter, the grandchild contributes the stock of such foreign corporation to a new drop-off trust established by the grandchild in a no-tax common law jurisdiction. While the drop-off trust might be considered a grantor trust as to the grandchild because he’ll become a U.S. resident within five years of funding such trust, arguably principal distributions wouldn’t attract an inheritance tax.

Burden of Proof

The proposed regs27 impose on the recipient of a gift or bequest the burden to determine whether he received a covered gift or bequest. The burden is on the recipient to determine whether the donor or decedent is or was a covered expatriate. As the preamble to the proposed regs acknowledges, this is easier said than done. The proposed regs provide that a recipient of a gift or bequest may submit a request to the IRS, with the consent of the expatriate, to disclose certain return information of the expatriate that may assist the recipient in determining whether the donor or decedent is or was a covered expatriate. 

Although the IRS, if authorized, may disclose returns and return information on request, the IRS won’t make determinations of covered expatriate status. This is an extremely intrusive proposal, and it doesn’t solve the threshold issue of the recipient not knowing whether the donor is an expatriate. The proposed regs further provide that if the expatriate donor doesn’t authorize the IRS to release the relevant return information to the recipient, there’s a rebuttable presumption that the expatriate donor is a covered expatriate and that each gift from that expatriate to a U.S. citizen or resident is a covered gift. There’s no guidance in the proposed regs regarding how one rebuts the presumption. 

Moreover, what happens if the covered expatriate has died before any distributions from a foreign trust are made to U.S. recipients? Can the executor of the deceased covered expatriate authorize the IRS to disclose confidential tax information about the covered expatriate to his U.S. relatives, some of whom he may have never met?

Reporting

The IRS intends to release Form 708 once the proposed regs are finalized, and those final regulations will provide the due date for filing Form 708 and for the payment of the inheritance tax. Form 3520 only applies to gifts or bequests of $100,000 or more received directly by U.S. citizens or residents from covered expatriates. Most importantly, a U.S. recipient of a distribution of any amount from a foreign trust must also report his receipt of such distribution on Form 3520 and complete Part IV of such form.  

Consequences of the Inheritance Tax 

Long-term Green Card holders too often think that only the wealthy among them should be concerned about becoming covered expatriates, and this is a mistake. Moderately affluent long-term Green Card holders at the time of expatriation shouldn’t lose sight of the U.S. tax costs to the future beneficiaries of their estates and any long-term trusts they fund. For instance, if the spouses of the children of a covered expatriate are U.S. citizens (or even unborn grandchildren) and the children are U.S. domiciliaries, there might be an unforeseen tax to pay many years in the future. 

The current inheritance tax rate is 40% of the gross value of the covered gift or the covered bequest or foreign trust distribution. The U.S. recipient pays this tax. Can the U.S. recipient apply his own lifetime gift tax exemption to the inheritance tax? If so, now would be a good time to accelerate covered gifts from a departed covered expatriate to U.S. heirs because the children could use a significant portion of their current lifetime exemptions of $11.58 million to blunt the inheritance tax. The current inheritance tax rate of 40% of the gross value is much higher than the current 23.8% “mark-to-market” exit tax imposed on only the income or gain inherent in the property and not its full value.

To demonstrate an extreme but real example, suppose an executive and his spouse move to the United States in 2011, and immediately, they each obtain a Green Card. The executive and his spouse abandon U.S. permanent legal residence in 2019 by filing Form I-407 when they have $4 million of cash as their only worldwide assets. Cash has no realized gain, so this couple has no exit tax to pay. However, having resettled in a foreign country, suppose this couple then grows a successful business over the 30 years following departure from the United States. Despite creating significant value in the foreign business only after departing the United States, any future gifts or bequests made to U.S. persons would be subject to a 40% tax.

If the same couple grows the business so that the total assets of the couple are $20 million in foreign assets at their deaths, and their wills bequeath these assets to their two dual national (including U.S. citizen) children, the children will have to pay $8 million of U.S. inheritance tax under the current inheritance tax regime. This is true even if none of the children live in the United States at the time of their parents’ deaths. Instead of this very bad tax outcome, had the parents equally divided their respective estates so each owned $10 million and had both become naturalized U.S. citizens when their Green Cards expired, there would be no U.S. estate tax to them under the current U.S. estate tax law. Their children would have received the $20 million from both parents free from all U.S. tax. One trade-off of achieving this far more desirable transfer tax result is that prior to their deaths, the parents would likely have to continue to waive treaty benefits and file and pay U.S. income tax on worldwide income and report all foreign bank accounts and foreign mutual funds as U.S. residents.  

Endnotes

1. Internal Revenue Code Section 2801(e)(1).

2. See IRC Section 2801(e)(4)(B)(i), which provides that in the case of a covered gift or bequest made to a foreign trust, Section 2801(e)(1) shall apply to any distribution attributable to such gift or bequest from such trust (whether from income or corpus) to a U.S. citizen or resident in the same manner as if such distribution were a covered gift or bequest.

3. Proposed Treasury Regulations Section 28.2801-2(f) and (g).  

4. Prop. Treas. Regs. Section 28.2801-3(b).

5. Ibid.

6. Prop. Treas. Regs. Section 28.2801-3(e).

7. For a comprehensive analysis of Section 2801 and the implications of the proposed regulations, see Stephen Liss and Ellen Harrison, “Expatriation and the New Section 2801 Proposed Regulations,” prepared on behalf of the Tax Planning Committee Income and Transfer Tax Planning Group of the Real Property, Trust & Estate Law Section of the American Bar Association.

8. Section 2801(e)(2).

9. Ibid. 

10. Section 2801(e)(3).

11. Prop. Treas. Regs. Section 28.2801-3(c)(4).

12. IRC Section 7701(b)(6).

13. See the website of the U.S. Citizen and Immigration Services (CIS), Green Card, After A Green Card is Granted, Maintaining Permanent Residence, Abandoning Permanent Resident Status, in which the U.S. CIS states that an individual may lose permanent resident status by intentionally abandoning it. An individual may be found to have abandoned permanent resident status if such individual moves to another country, intending to live there permanently.

14. See the website of the U.S. CIS, Green Card, After a Green Card is Granted, International Travel as a Permanent Resident, Does Travel Outside the U.S. Affect My Permanent Resident Status and What if My Trip Abroad Will Last Longer Than 1 Year. The U.S. CIS states that permanent residents (that is, Green Card holders) are free to travel outside the United States, and temporary or brief travel usually doesn’t affect permanent resident status. If the U.S. CIS determines that an individual didn’t intend to make the United States his permanent home, however, such individual will be found to have abandoned his permanent resident status. A general guide used by the U.S. CIS is whether the individual Green Card holder has been absent from the United States for more than a year. The U.S. CIS further states that if an individual plans on being absent from the United States for longer than a year, prior to leaving the United States, it’s advisable to first apply for a reentry permit on Form I-131. Otherwise, it will be necessary to obtain a returning resident visa from a U.S. Embassy or Consulate abroad. If an individual remains outside the United States for more than two years, any reentry permit granted before departure will have expired, and the U.S. CIS advises such individual to consider applying for a returning resident visa (SB-1) at the nearest U.S. Embassy or Consulate.

15. Revenue Ruling 77-378.

16. IRC Sections 674 and 677.

17. See IRC Section 672(e).

18. For an excellent analysis of this strategy developed back in 2009 when the gift tax exemption amount was only $1 million, see John L. Campbell and Michael J. Stegman, “Confronting the New Expatriation Tax: Advice for the U.S. Green Card Holder,” 35 ACTEC Journal 266 (2009), at pp. 35-36. The authors explain how a Green Card holder can carefully make an incomplete gift in trust while living in the United States and then complete the gift once the settlor is decisively resettled in the new country by having the settlor renounce his testamentary limited power of appointment. Moreover, the U.S. advisor will want to allow three years to elapse between renunciation of this power and the affirmative act of expatriation (that is, filing of Form I-407). Foreign counsel would be a necessity to ensure that there are no adverse inheritance or gift tax laws applicable in the new country.

19. Section 7701(b)(6). 

20. IRC Section 6114 and Treas. Regs. Section 301.7701(b)-7.

21. See supra note 11. Under Section 7701(b)(6), immigration status continues after tax status ends, reversing prior law under Section 7701(n), which allowed continued tax status after immigration status terminated. IRC Section 6114 and Treas. Regs. Section 301.7701(b)-7 both require a taxpayer to give notice to the Internal Revenue Service when taking a position for tax purposes that invokes rights under a treaty. Use Form 8833 to do this. Query whether a Green Card holder living abroad can expatriate by doing nothing, arguing that not giving notice under a treaty (that is, not filing Form 8833) and not filing other paperwork with the IRS (that is, not filing a Form 1040) is sufficient to remove the individual from the U.S. tax system. The safer assumption is the U.S. government will treat a Green Card holder as a lawful permanent resident until such individual actually files paperwork claiming nonresident status in the United States.

22. See Thomas S. Bissell, “Green Card Aliens Living Abroad Who Claim They Are No Longer U.S. Domiciled,” Tax Management International Journal (Bloomberg Tax 2019), at p. 2. 

23. Joseph P. Toce, Jr. and Joseph R. Kluemper, “Estate Planning for Expatriates Under Chapter 15,” Estate Planning Journal (January 2013).

24. A qualified obligation must meet the following requirements: (1) the obligation is set forth in a written agreement; (2) the term of the obligation doesn’t exceed five years; (3) all payments on the obligation are denominated in U.S. dollars; (4) the yield to maturity of the obligation is not less than 100% and not greater than 130% of the applicable federal rate (for the day on which the obligation is issued); (5) the U.S. borrower extends the period for assessment by the IRS of any income tax attributable to the loan and any consequential income tax changes for each year that the obligation is outstanding, to a date not earlier than three years after the maturity date of the obligation; and (6) the U.S. obligor reports the status of the obligation, including principal and interest payments, on Form 3520 for each year that the obligation is outstanding. A loan can’t be rolled over at the end of five years, and a new loan from the trust to the same U.S. beneficiary raises the issue of whether it constitutes a rollover.

25. To address this, Treas. Regs. Section 1.643(h)-1 sets out the circumstances in which such intermediaries will be disregarded and the treatment of structures that employ intermediaries. Essentially, when property is transferred to a U.S. citizen or resident by another individual or entity (the intermediary) who’s received property from a foreign trust, the U.S. citizen or resident will be treated as having received the property directly from the foreign trust if the intermediary received the property from the foreign trust pursuant to a plan in which one of the principal purposes was the avoidance of U.S. tax. Such a principal plan of avoidance will be deemed to exist if:

a. The intermediary is “related” to the grantor of the foreign trust or has a relationship to the grantor that establishes a reasonable basis for concluding that the grantor of the foreign trust would make a gratuitous transfer to the U.S. person;

b. The U.S. citizen or resident receives from the intermediary, within the period beginning 24 months before and ending 24 months after the intermediary’s receipt of property from the foreign trust, the property the intermediary received from the foreign trust, proceeds from such property or property in substitution for such property; or

c. The U.S. citizen or resident can’t establish that the intermediary acted independently, had a reason for making gratuitous transfers to the U.S. citizen or resident and wasn’t the agent of the U.S. citizen or resident, and the U.S. citizen or resident reported the gift.

26. Prop. Treas. Regs. Section 28.2801-2(i)(1) and (2).

27. Prop. Treas. Regs. Sections 28.2801-1 through 28.2801-7.

There comes a time in nearly everyone’s career when the thought of a permanent vacation from the practice of law outweighs a consistent draw from revenues. “Let someone else trudge into my office to slay the dragon every day,” you say aloud to your spouse. Particularly for those attorneys in small or solo practices, the dream of cashing out to a buyer, whether it’s a partner, another firm or a local competitor, sounds enticing. 

Wouldn’t it be nice to spend your time the way you want to spend it, whether that’s playing with grandchildren, golfing, traveling or relaxing on the beach? How much sweeter would that time be if you could realize a pot of gold at the end of your career’s rainbow? 

Unfortunately, for many attorneys, that pot of gold is as elusive as the leprechauns who are said to guard it. Very few attorneys successfully sell their practices; most simply close their doors. Others transition into an of counsel relationship to a new partner to collect amounts on existing clients for a period, without considering how a more successful sale maximizing the value of the practice might have otherwise been structured.

Obstacles to Sale 

When considering the sale of your practice, several obstacles come to mind. 

Is your pool of buyers limited, especially if you practice in a smaller community? No matter where you practice in the United States, your buyer must be licensed to practice law. In contrast, practitioners in the United Kingdom are allowed, pursuant to a 2011 law, to sell to non-lawyers. 

An estate planning, elder law and estate administration practice presents its own challenges. Our area of law isn’t easy to learn or navigate without a mentor. You therefore need to find an attorney who has the requisite skills necessary to competently represent your clients (or you must be willing to mentor your buyer), and that buyer must possess an entrepreneurial attitude to take the risks necessary to purchase your book of business.

Identifying what your buyer is purchasing presents another obstacle. Your depreciated tangible assets like furniture, equipment, servers, computers and office supplies hold little value. 

Instead, a buyer will assess the value of an intangible asset: goodwill. 

The problem with many small and solo shops is that you are your firm’s goodwill. Your personality, reputation, personal connection to clients and the centers of influence who refer to you make up the vast percentage of that value.

Moreover, there are ethical considerations. The ability to sell one’s practice wasn’t considered ethical until 1989 when California became the first state to adopt a rule permitting the sale of a practice.1 The following year, the American Bar Assocation (ABA) adopted Model Rule 1.17,2 allowing the sale of an entire practice. Most states, though not all, have adopted Rule 1.17 or a modified version. The change in policy was largely based on a desire for transparency and to level the playing field between solos and firms of all sizes. 

Even with the green light, other ethical rules pose challenges that I’ll review below. 

Finally, the most significant obstacle is your own mindset. You might have to change the way that you practice, particularly if you’re a “rugged individualist.” 

Let’s assess the steps necessary to ensure that the value of your practice, its goodwill, is maximized and transferable. 

Successfully selling your practice is a process. Desired outcomes require preparation and execution. Did you think about downsizing your residence? Many near retirement age downsize after their children reach adulthood and fly the nest. When you downsize, you ready your home for sale by sprucing up its curbside appeal, modernizing kitchens and bathrooms and cleaning out closets. Similarly, and depending on how your practice fits inside the elements described below, a significant investment of time and energy may be necessary to ready it for sale.

Practice as a Business

The first element starts with your mindset over what it is that you’re selling. You’re selling a business. Many attorneys get caught in a trap believing that a professional practice is somehow different from a business.

It’s not when it comes to a sale. 

You make sales to customers. You may call it “providing professional services to clients,” but that’s one and the same thing. You’re in the business of packaging and delivering legal services to clients. It might include estate and elder law planning, probate and trust administrative and business and tax law services among others, but it’s all sales of legal services to end users.

Because you’re selling a business, you must treat it like a business, although your business must also follow your state bar’s professional rules of conduct. The ethical rules are, quite frankly, easier to navigate for members of large firms. Junior partners are in place to buy out senior partners. Further, large firms typically have shareholder agreements setting values and purchase provisions.

Those in solo or small shops have a much larger task ahead of them to sell their practice. Those who want to receive value for everything they’ve built must investigate how to increase said value. This process starts by identifying the salable assets—what’s attractive to a potential buyer. Not only must the salable assets be identified and maximized, but also a seller must be aware of the risks a buyer faces and work to minimize those risks. 

Three Characteristics 

Buyers are interested in a practice that has three characteristics: (1) consistent profits; (2) well-operated systems and processes and; (3) a transferable Front Stage/Back Stage. 

A buyer is looking to purchase a well-oiled machine that can transition to a new leader. He’ll critically analyze current revenues against the risk that those revenues falter in your absence. Let’s examine these elements, including strategies you may consider implementing if you haven’t already. 

Consistent Profits 

First and foremost, a buyer seeks to purchase cash flow-producing profits. Unlike accounting and financial services firms that rely on steady cash flows generated annually from existing clients, most estate-planning practices must attract a stable of new clients every year. 

Our business is traditionally transactional in nature. Clients typically invest a significant sum to produce an estate plan but may not need to invest more for several years. Absent systems and processes constantly attracting new clients, cash flow could vary, worrying prospective buyers.3

How could a buyer rely on your firm generating an ever-growing number of files next year? 

Your financial statements must shed some light on this question and provide as much detail as possible. If your income statement doesn’t already break out revenues from different categories of services, consider separately reporting planning versus probate revenue, as an example. How much revenue do you generate from new clients as opposed to existing clients? Break out numbers reflecting average revenue per file per category. What’s your average fee earned for a revocable trust package over the past three years? It’s even more impressive if you have staff productivity metrics. 

Similarly, buyers are interested in the cost of acquiring and producing work. Your data might highlight the number of organically produced files as opposed to those derived from online marketing. 

Consistently rising revenue categories obviously reflect a healthier practice than those that inexplicably rise and fall. A problem associated with many practices for sale is the attorney waited too long to put the wheels in motion. He ran on the treadmill until he burned out, and it’s reflected in decreasing financial performance. Consequently, it seems the time to sell your practice to maximize its value and the sales price is when you’re still on the upswing.  

Factors affecting profit projections. Even with a healthy, growing practice, your buyer wants to see characteristics that show the likelihood of future profits. What’s your process for attracting new clients? More on that later.

Next year’s revenues, especially in an estate-planning practice, are difficult to predict. To that end, a well organized and easily accessible database of client estate plans is essential. When the law changes, do you know which clients are affected so you can send a personalized letter suggesting an update? Most estate attorneys have drawers of wills that will one day mature into probate and trust administration files. Do you know how many of those there are? These elements enhance value to a prospective buyer and are signs that the practice actively maintains longstanding client relationships. 

Top of mind. Consider the last time that you called a plumber to fix a leaky pipe in your home. Do you remember that plumber’s name and contact information? You might not, unless the plumber left you a refrigerator magnet reminding you to call him when your kitchen pipes break. 

While attorneys believe that their clients always remember them, several of your clients won’t. With visits occurring only once a decade or so, you risk losing future work to competing firms, whether that work includes updates to accommodate a dynamic family or financial situation or changes to the tax or trust laws. 

Not only will ongoing and regular contact with your clients improve buyer confidence of profit projections, but also demonstrating that your firm engages clients’ family members who’ll one day serve as personal representative, executor and trustee serves that purpose. Just as a financial planner works to keep intergenerational wealth under her roof, you don’t want your client’s children to move the file to different trusted advisors on your client’s passing. 

To that end, offering a client care or annual maintenance program increases the value of your practice. Not only does such a program provide consistent revenue by annuitizing your client base (assuming you determine how to provide annual value that your clients deem worthy enough to remain subscribed), but also it keeps your firm in the top of your clients’ and their families’ minds. 

Instituting client referral and maintenance strategies, including newsletters, appreciation dinners, educational workshops, video conferences and similar events, further instills confidence that firm profits will remain healthy after your departure.   

Documented Systems

A buyer isn’t just purchasing a list of client files. Knowledgeable buyers understand that profits are also a function of staff efficiency, productivity and teamwork. A buyer needs to know that profits won’t suffer when you leave because of the lack of documented systems and processes. 

Many attorneys believe that they have such systems in place because their support team knows what to do on a day-to-day basis to produce good work. The office runs smoothly. Unless those systems are documented in writing, however, you really don’t have a transferrable system. Instead, you have a set of procedures that each team member created to function in your office. Those procedures reside inside of your team’s minds only.

When my probate paralegal of 20 years retired, for example, not only did her knowledge and wisdom walk out the door with her but also so did our probate systems. This became evident when the replacement paralegal she trained didn’t work out, so by the time we hired another replacement, the longtime paralegal wasn’t around to train her.

Our probate revenue suffered. 

If you fear that losing a team member also means losing her efficiency and productivity for the long haul, chances are you don’t have the requisite documentation in place to assuage a buyer’s fear on this issue. 

Rugged individualist. Similarly, practices run by a “rugged individualist” destroy value in a buyer’s eyes. A rugged individualist attorney tries to do too much. He’d rather work until late in the evening than spend the resources necessary to hire someone to do those tasks outside of his unique capabilities. Identifying a rugged individualist is quite easy. He does nearly everything, and the way he does it is locked inside of his own brain.

Replacing a rugged individualist owner is daunting. Understandably, a buyer likely has heightened concerns that the firm won’t survive without the rugged individualist. He questions whether the financial statements reflect the true cost of operating the practice, and consequently, he likely won’t pay as much for such a firm than he would for one that’s more self-managing. 

How does a firm appear self-managing? The answer lies in well-documented systems and processes, which you recall is an essential element to achieving the maximum value for your practice. When considering a firm’s operations, it’s helpful to recognize there are two major elements to your practice, a “Front Stage” and a “Back Stage.”   

Front Stage/Back Stage  

In the words of B. Joseph Pine and James H. Gilmore’s book, The Experience Economy,4 owners should think of their businesses as a theater production. When we watch a live performance, we’re captivated by the actors, lighting, sound and atmosphere. 

Translating the Front Stage to your estate-planning practice, it’s ultimately about the client experience your firm creates. Strategic Coach founder Dan Sullivan says that the three goals of a business’ Front Stage are to: (1) deliver a unique experience; (2) differentiate itself from all its competitors; and (3) create exceptional client value.

Viewed from a client perspective, the richer and more satisfying the experience, the greater the firm differentiates itself in the marketplace. The more unique a firm appears, the more value it has and, hence, the greater price its principal receives when she retires. 

Consider Front Stage elements, like your firm’s website. A truly interactive educational experience like a client estate plan evaluation quiz differentiates you from competitors whose websites statically deliver estate-planning articles and blogs. An initial client package including an easy-to-read estate-planning book authored by the firm’s attorney rises above firms whose initial contact is a simple letter confirming an appointment date and time. 

The Back Stage, in contrast, is about creating better support systems that expand the impact of the Front Stage. The Back Stage is measured and judged by how well it contributes to Front Stage results. The three elements of a Back Stage include your firm’s capabilities documented in the form of systems and processes, teamwork in the form of collaborative communication and the coordination and organization of the activities among individuals in the firm. 

Having clear Front Stage and Back Stage processes enhances the transferability of your firm. When everyone understands the “script,” it’s easier to plug in a new “cast member,” rather than each partner creating her own production, which may or may not coordinate with the ultimate vision. When the Back Stage team understands what’s necessary to support a uniquely positive Front Stage client experience, it’s easier to consistently duplicate exceptional client value. Won’t a buyer pay a premium for a practice that has well thought out Front Stage and Back Stage processes?  

Marketing/Branding

Attorneys nearing the end of their practice years tend to scale back on marketing. Clear marketing goals and processes consistently applied, however, formulate an essential element to your firm’s Front and Back Stages, which make your practice attractive to a buyer. 

Many attorneys confuse sales with marketing. “Nearly every client who sits with me in an initial client meeting signs an engagement letter,” you might say. That’s sales, not marketing. Marketing is how you attract that client to be sitting in your conference room in the first place.

Successful marketing requires the identification of your target market, with a clear plan to reach and attract those prospects to your message, funneling them into a process resulting in the scheduling of an appointment. 

How do you drive visitors to your website? Do you have ongoing engagements with social media and search engine experts? Is your website interactive with automated responses to the topics your visitors view? Have you authored books or articles, and if so, does your website capture names and contact information of those downloading your wisdom? What do you do with those names? 

Have you documented the elements to advertising and conducting client workshops? Do you maintain lists of “hot” prospects, centers of influence and your best client referral sources? How do you follow up with those lists? 

Does your marketing plan not only serve to attract your A+ clients but also weed out tire kickers? How so? 

Consistent branding and marketing efforts lower the risk factor a buyer will consider when valuing a practice. A successful marketing plan that elevates your brand name and that has measurable metrics outshines the firm that places tombstone ads in a church bulletin. Those attorneys who’ve modernized their approach to marketing provide greater confidence in revenue streams over those that don’t. 

While it’s true that a firm’s marketing efforts might be centered on the personality of its principal, a succession plan that integrates the buyer into the marketing efforts boosts confidence in future revenues and profits. 

Who’s the Buyer?

This begs the true question—who’s the buyer? The two most likely buyers include an existing member of your firm (either an associate attorney or junior partner) or another firm that wants your clients and capabilities. Of these categories, there are two types of buyers: investment and strategic. 

An investment buyer views your firm’s potential to generate a return on the initial investment. An investment buyer typically seeks to purchase a practice where she can earn greater revenue (salary) than that if she started from scratch. Another example of an investment buyer is one who wants to move her firm into new markets. 

A strategic buyer views your practice as adding value to hers. As an example, assume that a family law attorney purchases your estate-planning firm to generate additional revenues by providing greater value to her existing client base. All the better if your team comes along so she doesn’t have to build the infrastructure to provide the new services. 

Different buyer types will seek different attributes. The investment buyer is very concerned with your systems and processes as she doesn’t want to build them on her own. The strategic buyer, in contrast, may have her own systems and processes and, therefore, be more concerned
with the teamwork evident inside of your office. 

Transaction Structure 

The sale of your practice can take many forms. It might be a sale of the assets of the practice, or it could be the sale of stock. There are many legal and tax ramifications associated with the structure beyond the scope of this article.

A seller typically desires a large fixed sum paid up front with an exit strategy requiring him to work for as little of a time period as possible following closing. It’s difficult serving as a lame duck with a new owner calling the shots. Even with lump sum payments, the buyer typically wants the seller to stay on for a period enabling an orderly transition not only of the clients but also of the staff.

A buyer usually prefers that the transaction be structured in a way that results in payments over time. The payments might be pegged to earnings, retention of clients or several other similar factors. Recall that the buyer is concerned with the risk of the practice’s value declining. If the contract reduces the sales price due to these factors, the buyer feels better protected.

Ethical Issues

You can’t discuss the structure of the sale of your practice without first considering the ethical ramifications. A seller and buyer should consult with the rules of the relevant state board, as not all states have adopted all the rules, or they may have modified the cited rules.5 

Partial Sale of a Practice

As I mentioned earlier, ABA Model Rule 1.17, adopted in 1990, allows for the sale of an entire law practice. This rule was adopted by most states. In 2002, the ABA amended the rule to permit the partial sale of a practice, which usually means the sale of one area of a practice that may have several areas of service. Rule 1.17(b), however, requires that a seller must put up the entire practice for sale to avoid the lawyer cherry-picking the sale of his least valuable clients. 

Competency

Can you sell your practice to anyone? Most of us feel a duty to leave our clients in good hands. We all know under Model Rule 1.1, we must provide competent representation to our clients. Comment 11 to Rule 1.17 provides that the duty of competence applies to a sale. Sellers are therefore obligated to exercise competence in identifying buyers qualified to take over the practice, just as buyers are obligated to undertake future representations competently. 

Confidential Information

How can a buyer know what to offer when he doesn’t have information relative to the quality of the firm’s clients and work? 

We’re all aware that attorneys are prohibited from disclosing client confidences under Rule 1.6. Comment 7 to Rule 1.17 states that the disclosures required for a sale are treated in the same manner as disclosures when attorneys switch law firms or the law firms merge. The release of generalized information about clients and files is permissible, and may in fact be required, to identify possible conflicts of interest. 

Disclosure beyond general information requires client consent. Prospective buyers also have a duty to maintain the confidentiality of any information acquired during the sale process. 

Covenants Not to Compete

Non-competition clauses commonly appear in business sales agreements for good reason. Buyers don’t want to pay a seller who decides after closing to open a competing business across the street. A lawyer is ethically protected from this danger, despite the Model Rule 5.6 prohibition on lawyers from entering into any
agreement that restricts a lawyer’s right to practice. 

Comment 3 to the same rule specifically states that Rule 5.6 doesn’t apply to prohibit restrictions contained in the sale of the practice. Keep in mind that the Model Rule is an ethical rule and not a state statutory law. The parties should review their state’s applicable statutes and laws on non-competes to ensure whatever deal they agree on is in compliance. 

Sharing Fees

In most sales, buyers finance the purchase in one of two ways. They agree to a fixed sum that may be paid over time, or the amount paid may be contingent on future revenue. There are no ethical issues with a fixed sum.When the amount paid to the seller is contingent on the future revenue of the buyer, however, fee-sharing rules may apply. Here, future revenue clauses appear to be fee-sharing arrangements. This presents a question under Rule 1.5(e), which governs fee sharing between lawyers. That rule requires written individual client consent to the sharing arrangement. The division must also be either proportionate to the work performed, or each lawyer must assume joint responsibility.

Another issue arises when the selling lawyer relinquishes his license. Here, future payments could be deemed improper fee sharing with a non-lawyer. 

In 2013, the New York State Bar Association’s Committee on Professional Ethics6 (the Committee)ruled that a fixed or contingent purchase price contained a component for goodwill and was therefore deemed acceptable. The Committee found that a fixed purchase price is simply a calculation of the present value of anticipated revenue. The Committee found little difference between that and a purchase price that adjusts based on that revenue under the New York State bar’s ethical rules. 

Consequently, the Committee ruled that so long as the purchase price, whether fixed or adjusted, bears a reasonable and bona fide relationship to the value of the goodwill involved, it’s ethical. It also held, however, that because even the most well-known lawyer’s reputation and connections fade over time, any provision for fee sharing must be limited in the amount and time. 

These are issues to consider under your own state bar rules, and perhaps you should obtain a written opinion prior to finalizing any such agreement. 

Of Counsel

One way to circumnavigate fee sharing or future payment issues is to make the retiring lawyer of counsel with the successor’s firm. In so doing, there’s no actual sale, and Rule 1.17 doesn’t apply. Because both attorneys remain working in the same firm, fee-sharing prohibitions of Rule 1.5 don’t apply either. 

The Model Rules don’t define the term “of counsel.” The ABA defines it as a “close, regular, personal relationship” with the law firm. So long as the relationship is bona fide, state regulators should have no problem in how a retiring and successor lawyer decide to divide future revenue.

Consult your state bar to determine the scope and extent of an of counsel relationship in your jurisdiction.

Seal the Deal

Achieving the pot of gold at the end of the rainbow won’t be easy. Those dancing leprechauns are tricky and ever vigilant in their guard duties. 

Every step requires significant preparation and documentation but, most importantly, intentionality. The steps to increase the sales value of your practice also happen to coincide with the actions necessary to make your practice easier to manage and more lucrative, which might result in nixing the decision to sell, if only temporarily! 

When negotiating the sales terms, investigate your state bar’s ethics rules to ensure that neither seller nor buyer finds himself noncompliant. And, approach the journey with confidence! You’re on your way to building a practice worth purchasing. 

Endnotes

1. The State Bar of California. Previous Rules of Professional Conduct (2019). Rules of Professional Conduct (1975 to 1989), www.calbar.ca.gov/Attorneys/Conduct-Discipline/Rules/Rules-of-Professional-Conduct/Previous-Rules.

2. American Bar Association, Center for Professional Responsibility (2018). Model Rules of Professional Conduct, www.americanbar.org/groups/professional_responsibility/publications/model_rules_of_professional_conduct/.

3. For an interview with Valuation Specialist Gary R. Trugman on the value of systems and process in your practice, visit https://bit.ly/36VdRi5.

4. B. Joseph Pine and James H. Gilmore, The Experience Economy, Harvard Business Review Press (2011).

5. See supra note 2.

6. New York State Bar Association, Committee on Professional Ethics (2013), New York State Bar Association Ethics Opinion, www.nysba.org/Ethics/.

Social media is inevitable. Once reserved for college students, social media is now part of everyday life, not only for recreation but also for business purposes. According to one study, the average time spent by U.S. users on social networks in 2019 was 74 minutes per day.1 Nearly 75% of U.S. adults use at least one social media site; the number has doubled since 2009.2 Of course, the rise of social media use may not be a surprise to most people. What may surprise some lawyers and law firms, however, is just how ingrained in the practice of law social media has become—from contracts, to litigation, to professional development. Not only is social media a part of the practice of law, but also it’s fast becoming necessary for the competent practice of law. Two states now mandate technology continuing legal education requirements for lawyers.3 Additionally, several states’ professional conduct rules require lawyers to have technology competence.4 Lawyers who dismiss social media platforms such as Facebook, LinkedIn, Instagram and Twitter do so at their own peril. Social media isn’t just a luxury for lawyers anymore, it’s now a necessity. Let’s explore how social media has become essential for lawyer and law firm professional development and the multiple considerations lawyers should be aware of when using social media for professional purposes. Lawyers can’t afford to be ignorant of all the information and opportunities social media affords because they lack the necessary skills to operate on social media. To paraphrase a famous quote, “follow the media.”

Social Media Marketing Basics

To use social media effectively, lawyers must first know and understand how to use the relevant social media platforms. Most people are generally aware of major social media platforms such as Facebook, LinkedIn, Twitter, Instagram, YouTube and Snapchat. Combined, these platforms contain several billion users worldwide.5 It’s less likely, however, that lawyers use these social media platforms for marketing, networking, legal education and other professional development purposes, when the opportunity is there for the taking. Social media marketing is even more attractive as a professional development tool because in most cases, lawyers don’t have to pay fees or purchase advertisements on social media to effectively market, network or find other opportunities. Rather, by submitting timely and informative social media content, lawyers can reach audiences, get positive attention and try to convert that attention into business opportunities.

Now of course, simply knowing the main social media platforms isn’t the ultimate goal. Lawyers must take steps to determine whether each such social media platform is appropriate for their specific professional development purposes, including understanding:

1. How the particular social media platform works, including the format (for example, a Facebook profile versus a Facebook page) to be used.

2. The typical user and audience on the social media platform.

3. How content is presented on the social media platform, including the use of photographs and videos, and whether such content would be better suited on one social media platform versus another. For
example, Instagram is better suited for a lawyer to post an image of an award received versus posting an article about recent developments in the law, which may be better suited to appear in a LinkedIn post.

4. How to effectively interact with users on the social media platform, including through comments, likes or other methods.

Lawyers and law firms should have a plan of action when joining a social media platform for professional development and be active, not creating an account that posts infrequently or not at all. When such a plan exists, lawyers can plan ahead to create content to use on social media. For example, if a lawyer uses Instagram professionally, he can plan to take photos and/or videos from an interesting legal conference and instantly (or later) post them on Instagram. Not only can lawyers and law firms gain positive coverage and credibility by being social media savvy, but also they can learn from other posters about updates to the law or upcoming events of interest such as a CLE presentation, among other things. After all, if billions of people use social media, including professionally, wouldn’t lawyers and law firms want to be where the people are (including colleagues, professional contacts and current and prospective clients)?

Prevalent Use

Social media already plays a sizable role in lawyer and law firm professional development. Among the statistics provided by lawyers responding to the American Bar Association’s annual Legal Technology Survey:6

• After email (41%), Facebook (30%) was the second most used marketing channel for all law firm sizes

• 26% of lawyers said their law firms use video for marketing

• 80% of lawyers stated that their law firm has a social media presence, with the highest such platforms being LinkedIn (79%) and Facebook (54%)

The same survey also highlights the many reasons why lawyers may blog and use social media:7

• Career development and networking (67%)

• Client development (49%)

• Education and awareness (43%)

• Case investigation (22%)

Ninety-four percent of respondents under age 40 and 85% of respondents aged 40-49 years old reported using social media for career development and networking.8 Thirty-one percent of respondents who used social media for professional purposes reported to have gotten clients as a result.9 Accordingly, social media use in the legal profession is prevalent and can lead to very positive results.

Do’s and Don’ts 

The ultimate decision as to what content to post on social media, be it articles, photographs, videos or otherwise, belongs to lawyers. There’s no shortage, however, of engaging content that’s worthwhile and informative and that lawyers may either find or create themselves and share on social media. The content could be about:

• highlighting a recent lawyer or firm achievement, such as an award received

• a recent update to the law or court decision that may impact individuals or companies 

• community outreach efforts by the lawyer or firm

• spotlighting a new lawyer or a new practice area in the firm 

By posting engaging content, a lawyer can add to the overall social media conversation and attract users—be it colleagues, friends, family, clients or prospective clients—back to the lawyer or his law firm. Posting engaging content can also establish trust in what the lawyer is saying and establish lawyers as thought leaders in their respective fields of practice. Even more appealing is that many websites, including news websites, usually have social media “share” icons in the news articles, which allow a user to simply click a button and, once logged in to the social media platform, quickly share a hyperlink to the news story on a social media platform, be it Facebook, Twitter, LinkedIn or otherwise. It’s never been easier to use social media to share (and receive) engaging content in a professional capacity, for marketing, networking, legal education or other professional purposes.

In their zeal to use Facebook, LinkedIn, Twitter or other social media platforms for professional purposes, however, lawyers and law firms need to be aware of professional obligations that may apply. Just because lawyers use technology such as social media doesn’t mean that the same professional obligations that apply to other forms of media don’t apply here. Fortunately, there are a number of ethics opinions addressing social media use by lawyers and law firms, including in states such as New York. Examples of situations in which lawyer or law firm social media use may raise professional conduct considerations include:

Too much information. Social media is a place for interaction—not just posting but conversing too. Lawyers must be careful, however, not to engage in social media conversations that run afoul of ethical obligations. A lawyer shouldn’t provide specific legal advice on social media because it may create an attorney-client relationship with the social media poster and may result in the impermissible disclosure of privileged information to third parties.10 For example, a lawyer may want to specifically respond to a Facebook user who posts on a law firm’s Facebook page. By doing so, however, the lawyer may be giving legal advice and creating an attorney-client relationship with an unknown Facebook user and, worse yet, helping to reveal privileged information about that user for all of Facebook to see. Thus, while a conversation can start on social media and show promise, including a client eventually retaining a new lawyer, the conversation should continue offline before any issues arise.

Presentation matters. Lawyers must be mindful of how they present themselves on social media. For example, it’s one thing to call oneself a lawyer on LinkedIn, it’s another to say one is a “specialist” or has a “specialty” in an area of the law. A law firm can’t list its services under a “Specialties” heading on a social media site, and a lawyer can’t do the same unless certain certification requirements are met.11 Lawyers must also ensure that truthful and accurate content is posted, including where a social media profile can receive recommendations, endorsements or similar comments from third parties. As one ethics opinion notes, “all content that an attorney posts on LinkedIn—or any other social media platform—must be truthful and accurate. For example, attorneys should not list practice areas or skills in which they have little or no experience.”12 While lawyers shouldn’t post anything false on social media, they must also safeguard against social media content written about them by others that may be false or not based on actual knowledge.13 Thus, if a lawyer writes a glowing LinkedIn recommendation about a fellow lawyer’s negotiating skills, but the recommending lawyer lacks any personal knowledge of such skills, the lawyer who received that recommendation should hide it from his LinkedIn profile.14 Similarly, a lawyer shouldn’t have skills or endorsements on a LinkedIn profile that the lawyer doesn’t possess and shouldn’t be endorsed for. For example, a trusts and estates lawyer should not list a skill for “litigation” and certainly shouldn’t display an endorsement for that skill if the lawyer has never seen the inside of a courtroom. Given how quickly content may appear on social media, lawyers should be proactive and ensure that both the content they post and content posted about them on social media complies with professional conduct obligations.

Does it “ad” up? What a lawyer or law firm posts on social media may constitute attorney advertising. If a social media post is an attorney advertisement, then multiple requirements apply, including for the content of the post, necessary disclaimer language and record-keeping requirements.15 Lawyers and law firms should consider factors such as the primary purpose (networking, legal education, attracting clients) and the intended audience (family, friends, clients, potential clients) of any social media post before posting.16 If necessary, language such as “Attorney Advertising” may need to appear with the content, and the content itself may need to be preserved for a period of time under professional responsibility obligations.17 In their zeal to post on social media, lawyers and law firms should first examine the prospective post and whether attorney advertising requirements apply as a result. That next Facebook or LinkedIn post in which a lawyer touts his capabilities and requests new clients may actually trigger a slew of professional conduct requirements. 

Sharing (contacts) isn’t caring. When using social media for professional development, lawyers should be mindful of the devices they use and what information on those devices may be accessed or transmitted to the social media platform. As one ethics opinion noted, once a lawyer accesses a social media site, typically with an email address, that social media “site may access the entire address book (or contacts list) of the user.”18 Because a contact list may include clients, lawyers and even judges, the social media platform could use the lawyer’s contact list to suggest connections on the social media platform. The problem is, an individual friending or connecting with a lawyer and having the individual’s entire social network see that may lead to questions and “could potentially identify clients or divulge other information that a lawyer might not want an adversary or member of the judiciary to see or information that the lawyer is obligated to protect from disclosure.”19 Thus, lawyers should be cautious when a social media platform attempts to access their contacts and take steps to avoid inadvertently agreeing to allow such access.20 For example, if a trusts and estates lawyer who uploads his smartphone contacts to Facebook gets a new client (whose contact information is in the lawyer’s smartphone), and it results in a “People You May Know” suggestion21 to the lawyer and eventually the lawyer and client becoming Facebook friends, the client’s family may see this connection and, with perhaps a little research, discover their family member retained a lawyer, which can lead to unwanted questions being directed at their family member.

Navigate Ethical Issues

Far from being a reason to avoid social media professional development, however, the above examples illustrate how it’s possible to use social media as part of marketing, networking and other professional development efforts while also navigating across any potential ethical issues that may arise. Luckily for lawyers and law firms, there’s a growing list of ethics opinions and other materials to help navigate through the legal and ethical pitfalls associated with social media professional development, even as the technology continually develops.

Of course, effective professional development is only one part of the story when it comes to social media for lawyers and law firms. Lawyers must also be mindful that how they conduct the practice of law—including evidence collection and preservation and conducting trials—is at times impacted by social media. There are several ethics opinions and court decisions that underscore the benefits and pitfalls associated with social media use in the practice of law. Much as with the current subject of social media professional development for lawyers and law firms, becoming educated on the technology and understanding the ethical considerations that come into play when using social media in the practice of law will help lawyers and law firms use the benefits that social media has to offer while safeguarding against the legal pitfalls that social media contains. That social media story is for another timeline.  

Endnotes

1. Debra Aho Williamson, “US Time Spent With Social Media 2019,” www.emarketer.com/content/us-time-spent-with-social-media-2019. 

2. Pew Research Center, “Social Media Fact Sheet,” www.pewinternet.org/fact-sheet/social-media/.

3. Victor Li, “Florida Supreme Court approves mandatory tech CLE classes for lawyers,” ABA Journal, www.abajournal.com/news/article/florida_supreme_court_approves_mandatory_tech_cles_for_lawyers; Jason Tashea, “North Carolina bar to propose mandatory technology CLE credit,” ABA Journal, www.abajournal.com/news/article/north_carolina_bar_to_propose_mandatory_technology_cle_credit.

4. For example, New York’s Rules of Professional Conduct states in Comment 8 to Rule 1.1 on Competence that “[t]o maintain the requisite knowledge and skill, a lawyer should … (ii) keep abreast of the benefits and risks associated with technology the lawyer uses to provide services to clients or to store or transmit confidential information.” New York Rules of Professional Conduct, www.nysba.org/DownloadAsset.aspx?id=50671.

5. Over 2.1 billion people use Facebook, Instagram, WhatsApp or Messenger daily on average. “Stats,” https://newsroom.fb.com/company-info/. LinkedIn has over 645 million users worldwide. “About LinkedIn,” https://about.linkedin.com/.

6. Allison Shields, “2019 Websites & Marketing,” ABA Journal, www.americanbar.org/groups/law_practice/publications/techreport/abatechreport2019/websitesmarketing2019/.

7. Ibid.

8. Ibid.

9. Ibid.

10. Guideline No. 3.A.: Provision of General Information, 3. Furnishing of Legal Advice Through Social Media, Social Media Ethics Guidelines of the Commercial and Federal Litigation Section of the New York State Bar Association, Furnishing of Legal Advice Through Social Media, www.nysba.org/2019guidelines/.

11. Opinion 972 (June 26, 2013), New York State Bar Association Committee on Professional Ethics, www.nysba.org/CustomTemplates/Content.aspx?id=28101. 

12. Formal Opinion 2015-7: Application of Attorney Advertising Rules to LinkedIn, New York City Bar Committee Report, at Section V.E., www.nycbar.org/member-and-career-services/committees/reports-listing/reports/detail/formal-opinion-2015-7-application-of-attorney-advertising-rules-to-linkedin. See also Ethics Opinion 370, Section II.E, Social Media I: Marketing and Personal Use, www.dcbar.org/bar-resources/legal-ethics/opinions/Ethics-Opinion-370.cfm (“[i]t is our opinion that lawyers in the District of Columbia have a duty to monitor their social network sites. If a lawyer controls or maintains the content contained on a social media page, then the lawyer has an affirmative obligation to review the content on that page”).

13.  Formal Opinion 2015-7, ibid. See also Formal Opinion 748, March 10, 2015, New York County Lawyers Association Professional Ethics Committee, www.nycla.org/siteFiles/Publications/Publications1748_0.pdf. 

14. Hiding and Unhiding Your Recommendations, www.linkedin.com/help/linkedin/answer/165/hiding-and-unhiding-your-recommendations?lang=en.

15. See Fn. 12, Formal Opinion 2015-7: Application of Attorney Advertising Rules to LinkedIn, New York City Bar Committee Report, at Section V. According to this ethics opinion, LinkedIn content constitutes advertising when: (a) it’s made by or on behalf of a lawyer, (b) the primary purpose is for the pecuniary gain of new clients retaining the lawyer, (c) the LinkedIn content relates to the lawyer’s legal services, (d) the intended audience is potential new clients, and (e) the LinkedIn content doesn’t fall in an exception of exclusion to what’s defined as attorney advertising. Ibid. at Section IV.

16. Ibid., at Section IV.B. and IV.D.

17. Ibid., at Section V.A. and V.D.

18. Ethics Opinion 370, supra note 12.  

19. Ibid.

20. Ibid.

21. Finding Friends and People You May Know, www.facebook.com/help/336320879782850. 

As many lawyers are keenly aware, the practice of law—especially, it seems, after the Great Recession—is a highly competitive business pursuit. The desire to offer more services and accessibility to clients (for example, a new practice area or an established presence in a different geographic location) in an increasingly cost-effective manner can lead to the desire to merge law practices to leverage resources and stand out among the crowded field of competitors. Alternatively, a practitioner might contemplate selling a law practice when: (1) she’s retiring, or (2) she simply wants an exit from the practice of law entirely. Either way, there are ethical considerations to consider in a merger or sale, all meant to protect the lawyer’s clients (and the legal profession). Let’s explore some of those key considerations.

Jurisdiction’s Ethics Rules

The first resource a practitioner contemplating the sale or merger of a law practice should consult is the applicable jurisdiction’s rules of ethics. Some of these rules provide specific guidance, especially regarding a sale. New York, Florida and California, for example, have specific ethics rules on the sale of a law practice.1 The Model Rules of Professional Conduct adopted by the American Bar Association (ABA) (the Model Rules), which serve as a national template of legal ethics guidelines, also contain a section on the sale of a law practice.2 Although generally modeled on the ABA’s rules, the state ethics rules regarding the sale of a law practice vary somewhat, making it all the more important for practitioners to check the relevant jurisdiction’s rules.3 For purposes of this article, I’ll mostly refer to the Model Rules for ease of reference and consistency. Although the Model Rules don’t contain a specific section regarding the merger of law practices, many of the same ethical issues that arise in a sale apply to mergers.  

Sale of a Law Practice 

Model Rule 1.17 is titled “Sale of Law Practice” and is categorized under a division of the Model Rules concerning the “Client-Lawyer Relationship.” The rule requires the selling lawyer to no longer engage in the private practice of law, or in the specific practice area sold, within the applicable jurisdiction or geographic area where the selling attorney had been practicing.4 The ABA’s comments to Model Rule 1.17 clarify the contours of that restriction and allow some flexibility to the general rule, giving as an example a lawyer who sold her practice to become a judge, who then later returns to practice after either losing a judicial election or resigning from the judiciary.5  

The seller must also sell the entire law practice or the entire practice area, rather than a smaller portion of the overall practice. As explained by the comments to Model Rule 1.17, this is meant to protect clients whose matters are less lucrative and who would have a hard time finding other counsel.6 If, under local law or court rules, approval by the court is required for the purchasing lawyer to be substituted for the selling lawyer in a pending action or proceeding, that approval must first be obtained before including the matter in the sale.7 Model Rule 1.17 also contains provisions regarding notice to clients regarding the sale and the transfer of the clients’ files.8 I discuss these provisions in the client confidentiality section. 

One key client protection provision in the rule is that the purchasing lawyer must honor the arrangements between the selling lawyer and the client regarding legal fees and the scope of the work to be performed.9 This prevents the client from being unfairly taken advantage of in a situation over which the client has no control other than to seek new counsel, which may be a difficult or bad option for the client, especially one who’s far along in her matter.

A number of other ethics rules come into play as well. Many lawyers are familiar with Model Rule 1.1, which requires competent representation of clients.10 In selling a legal practice, the practitioner should undertake due diligence to make sure the purchasing attorney can competently represent the clients of the practice being sold.11 And, as I’ll discuss below, two other key ethics considerations in the sale of a law practice (or a merger) are client confidentiality and the avoidance of disqualifying conflicts of interest.  

Confidentiality and Other Issues 

Most lawyers are familiar with the ethical duty of confidentiality, which prohibits lawyers from generally disclosing information regarding the representation of a client, unless the client consents.12 The rationale for the rule is that it will encourage clients to “communicate fully and frankly with the lawyer even as to embarrassing or legally damaging subject matter.”13 This full and free exchange between the lawyer and client is necessary for effective representation of the client.14

In the context of a sale or merger of a law practice, the ethical mandate to preserve client confidentiality intersects with the requirement to avoid conflicts of interest. The two can create an ethical mine trap for practitioners, who should be careful not to violate one rule in an effort to comply with the other.     

Client conflicts can arise in either a sale or merger. In a merger, conflicts checks during preliminary negotiations are absolutely necessary to avoid either of the merging firms potentially having to later withdraw their representation of an important client when, had they known of the conflict, they would have either not gone through with the merger in the first place or would have sought client consent to waive the conflict, if waivable. For this reason, the Model Rules contemplate the sharing of confidential client information, in a limited fashion, to reveal these conflicts. Model Rule 1.6(b)(7)
allows a lawyer to “reveal information relating to the representation of a client to the extent the lawyer reasonably believes necessary: . . . to detect and resolve conflicts of interest arising . . . from changes in the composition or ownership of a firm, but only if the revealed information would not compromise the attorney-client privilege or otherwise prejudice the client.”15 Similarly, in the context of a sale, a lawyer or law firm purchasing a law practice would want to make sure there are no disqualifying conflicts between her current clients and the prospective clients the purchasing attorney would take on. To the extent there are conflicts that can be waived, the lawyer would first need to seek informed consent from each affected client, in writing.16 An important first step in either a sale or merger is identifying the potential conflicts to determine whether they jeopardize the transaction from the start. 

The Model Rules, then, offer a path to both preserve client confidentiality to the greatest extent possible and allow sharing of information to avoid or address conflicts of interest. The parties to the sale or merger can share information to flesh out conflicts of interest before the transaction is consummated, but only the least amount of information necessary to do so. They should keep everything else confidential. The comment to Model Rule 1.6 states that this sharing of limited information should only take place after “substantive discussions regarding the new relationship have occurred.”17 In any event, the practitioner involved in a sale or merger should first consider whether the disclosure of the information would prejudice her client or violate the attorney-client privilege which, although related to the ethical rule of confidentiality, is a rule of evidence that can carry consequential significance in legal proceedings involving the client.

If the purchaser wants more detailed information regarding the representation of a client, or even access to the client’s file, the client’s permission is required.18 Model Rule 1.17(c) requires written notice of the proposed sale to the seller’s clients, which includes informing the client of the client’s right to hire a different lawyer or to take possession of his file.19 If the client doesn’t object to the file transfer within
90 days of receiving the notice, then the client’s consent is presumed under the rule.20 When a client can’t be given notice, the practitioner can’t share detailed information or transfer the client’s file without a court order.21 At all times, including after the consummation of a sale, the client is free to discharge the lawyer who purchased the practice and choose another lawyer to represent him.22

There doesn’t appear to be a similar rule requiring client notice when a merger, rather than a sale, is involved. The distinction might be that a sale is a more abrupt termination of the client-lawyer relationship —
the client will no longer work with that particular lawyer or law firm—so there’s a lack of continuity, and the client may be stuck with another lawyer or law firm he doesn’t want to work with. With a merger, there’s arguably a greater sense of continuity than with a sale because, although the ownership of the law practice has changed, the same lawyers may continue to work with that particular client, and the successor firm will presumably continue to operate in a way resembling its former self. In any event, it would be a good idea for merging firms to notify clients, even if not required to do so under the ethics rules.    

Lawyers should also consider the possibility of unauthorized access to client information in the context of a merger or sale. Model Rule 1.6(c) requires lawyers to make reasonable efforts to prevent unauthorized access to client information. In either a merger or sale, negotiations will be ongoing, and information (even if limited) is being exchanged. During the course of those negotiations or discussions, the parties involved should make sure that client information is protected from cyberattacks and third parties who may seek to exploit this exchange in an effort to obtain confidential client information.

Lawyers selling their practices should be mindful of the fact that the duty of confidentiality continues even after the termination of their representation.23 With just a few limited exceptions, they can’t use information learned during the representation to the disadvantage of the former client.24  

Safeguarding Client Funds

One other ethical obligation lawyers should think about in the context of a sale or merger of a law practice is the duty to keep client funds separate from the lawyer’s own funds and to safeguard them for the client.25 Although this basic duty to maintain escrow accounts for client funds seems obvious, the parties to a merger or sale should make sure that the rules in this regard have been followed. Practically speaking, this requires accurate and detailed records.

Without accurate records of what funds belong to the client and what funds belong to the lawyer, a party to a merger or sale could inherit a very messy accounting problem at best (and possible legal and ethical violations at worst). As part of their due diligence, the parties to a sale or merger should ensure that client funds are segregated, clearly marked and safeguarded for eventual disbursement in accordance with the applicable arrangement or the client’s instructions. Consider the case of a small practice of a solo lawyer who handles a large volume of real estate transactions. At any given moment, the lawyer may have custody of a large number of client funds (representing down payments for the purchase of real estate, for example). If that lawyer’s health was failing and he needed to sell the practice before those real estate sales closed, the purchasing lawyer would need to know exactly which funds belong to the client and which belong to the law practice being purchased. This is where carefully kept records are extremely valuable and can help avoid problems down the road for the successor lawyer or law firm taking over the client’s matter.

Pending Matters

The applicable ethics rules recognize that a significant change like a sale or merger of a law practice can be unnerving for a client in the midst of a pending matter. For that reason, they provide guidance on a number of things to keep in mind during the transition.

As explained above, clients should expect their arrangements with the selling attorney regarding fees and the scope of work to continue, as required by Model Rule 1.17.26 This should presumably provide some level of comfort to the client. The lawyer also has an ethical obligation to act competently27 and diligently28 in the representation of a client. This means that the parties to a merger or sale should familiarize themselves with the acquired client matters quickly and take note of upcoming deadlines, court dates and other matters requiring immediate attention. The lawyer should address each of these to provide seamless representation to the client, as best she can. By the same token, the lawyer should also commence regular communication with the client to comply with the ethical obligation to keep the client informed about the status of the matter.29            

Sharing of Legal Fees

The rampant change in the delivery of legal services and legal service providers has created new ethics questions for practitioners who may seek to partner with nonlawyers as part of their business. This could be through a merger with a business not exclusively engaged in the practice of law (for example, to form a multi-disciplinary practice providing legal and accounting services) or the sale of their law practice to a nontraditional legal service provider. Ethics rules on this topic have traditionally prohibited nonlawyers sharing in the practice of law, whether as a nonlawyer business partner or the recipient of a portion of the legal fees collected. This is an area that will likely change as the legal industry is further transformed by recent changes taking place in the delivery of legal services, but for now it appears that there’s still an ethical mandate against including nonlawyers as law firm partners or recipients of legal fees.

Model Rule 5.4 is titled “Professional Independence of a Lawyer.”30 It contains fairly stringent provisions regarding the lawyer’s business association with nonlawyers in the practice of law. For example:

• A lawyer or law firm shall not share legal fees with a nonlawyer, subject to a few limited exceptions set forth in Model Rule 5.4;31

• A lawyer shall not form a partnership with a nonlawyer if any of the activities of the partnership consist of the practice of law;32

• A lawyer shall not practice with or in the form of a professional corporation or association authorized to practice law for a profit, if:

• a nonlawyer owns any interest therein, except that a fiduciary representative of the estate of a lawyer may hold the stock or interest of the lawyer for a reasonable time during administration;

• a nonlawyer is a corporate director or officer thereof or occupies the position of similar responsibility in any form of association other than a corporation; or

• a nonlawyer has the right to direct or control the professional judgment of a lawyer.33

The official comment to Model Rule 5.4 explains that the rule’s provisions are “to protect the lawyer’s professional independence of judgment.” Nonlawyers aren’t subject to the professional legal ethics rules and—the argument goes—may try to influence the judgment of lawyers working for them, who are subject to those rules. Having only lawyers as owners of law firms who share in the profits insulates the firm’s lawyers from the outside influences of others not subject to the lawyer’s ethical duties.     

This rule on lawyer independence means that parties to a sale or merger of a law practice should be careful if a potential purchaser or merging firm isn’t a traditional law practice or law firm. For now, the sale or merger should only involve other lawyers and law firms practicing law to comply with the ethics rules.

Keep Up With Changes

The legal ethics rules surrounding the sale or merger of a law practice are varied, and the practitioner has a lot to keep in mind. The details of many of those rules will vary state by state, but a general understanding will help the practitioner navigate the issues that arise.  

Just as important will be the need to stay abreast of the changes in this area as the nature and delivery of legal services adjust to the modern practice of law in the current economic environment. As clients demand more services and begin to seek out multi-disciplinary practices or alternative providers of legal services, the potential rise of multi-disciplinary practices combining legal, accounting, financial advisory and insurance services may bring about change in the ethics rules regarding nonlawyer ownership of law practices and the sharing of legal fees. This could vastly alter the future landscape of law practice mergers and sales and the ethical considerations that arise from them. 

Endnotes

1. See New York Rules of Professional Conduct, Rule 1.17 (Sale of Law Practice); Florida Rules of Professional Conduct, Rule 4-1.17 (Sale of Law Practice); California Rules of Professional Conduct, Rule 1.17 (Sale of a Law Practice).

2. American Bar Association (ABA), Model Rules of Professional Conduct, Rule 1.17 (Sale of Law Practice).

3. See supra note 1.  

4. Supra note 2, Rule 1.17.

5. Specifically, the comments state that “Return to private practice as a result of an unanticipated change in circumstances does not necessarily result in a violation. For example, a lawyer who has sold the practice to accept an appointment to judicial office does not violate the requirement that the sale be attendant to cessation of practice if the lawyer later resumes private practice upon being defeated in a contested or a retention election for the office or resigns from a judiciary position.” Model Rules of Professional Conduct, Rule 1.17, Comment [2].

6. Supra note 2, Rule 1.17, Comment [6].

7. Ibid., Rule 1.17, Comment [12].

8. Ibid., Rule 1.17. 

9. Ibid., Rule 1.17, Comment [10]. 

10. Ibid., Rule 1.1.

11. Ibid., Rule 1.17, Comment [11].

12. Ibid., Rule 1.6.

13. Ibid., Rule 1.6, Comment [2].

14. Ibid.

15. Ibid., Rule 1.6(b)(7).

16. Ibid., Rule 1.7.

17. Ibid., Rule 1.6, Comment [13].

18. Ibid., Rule 1.17, Comment [7].

19. Ibid., Rule 1.17.

20. Ibid.

21. Ibid.

22. Ibid., Rule 1.17, Comment [9].

23. Ibid., Rule 1.6, Comment [20].

24. Ibid., Rule 1.9. Such information can be used if the ethics rules permit or require it with respect to the client or if the information has become generally known.

25. Ibid., Rule 1.15.

26. State ethics rules on this can vary. Note that the New York rule, for example, adheres to this general rule, but permits an increase in the fee if permitted by the retainer agreement or otherwise agreed to by the client. New York Rules of Professional Conduct, Rule 1.17(e).

27. Supra note 2, Rule 1.1.

28. Ibid., Rule 1.3.

29. Ibid., Rule 1.4.

30. Ibid., Rule 5.4.

31. Ibid., Rule 5.4(a).

32. Ibid., Rule 5.4(b).

33. Ibid., Rule 5.4(d).

The term “artificial intelligence” and its initialism, “AI”, appears thousands of times a day in the media and advertising. Should the legal profession be encouraged or concerned? Will we see the practice of law change radically? Does it appear that our society will change radically? Will it help us or hurt us?  

The answers are Yes, Yes, Yes and Yes. 

These words symbolize both a promise and a threat. AI often produces a vision of greater productivity, with less time spent per task. Simultaneously, it produces a vision in which we professionals and our paraprofessionals may become extraneous. Of course, more than a few are concerned that humankind might become irrelevant. Regardless of these concerns, the increased productivity and efficiency brought about by AI make it a reality we’ll need to face in the estate-planning practice: Whether we want to take advantage of the technology or not, our clients soon will start to demand it.

Let’s define the subject, consider the increasing complexity of ethical issues and explore both currently available AI and the current dawn (and reality) of a computer that thinks for itself, programs itself and solves assigned problems without human direction or limitations (known as “artificial super intelligence” (ASI)).

Law Office of the Future

There’s a story about the law office of the future. It will have a computer, a lawyer and a dog. Why? The computer is there to practice law, the lawyer is there to feed the dog and the dog is there to bite the lawyer if the lawyer tries to interfere with the computer.1

Should we be threatened by such a story? We’ve been the target of lawyer jokes since ancient times, but the prospect of a computer “practicing law” is clearly here now. While bar associations and non-lawyer providers will continue to debate the boundaries of “the unauthorized practice of law,” it’s inescapable that AI-based changes will be dramatic and disruptive. 

The newest new reality is that the tools now available to a practitioner, from LexisNexis to Ross Intelligence (which uses IBM Watson analytics for legal research), lawbots, document analysis programs, document drafting systems, cloud storage, WiFi and 5G coverage, allow productivity and anywhere access we couldn’t imagine a few years ago. Popular author and marketing guru Seth Godin2 describes the personal computer as the tool that moved ownership of the factory to the workers. So, we know change. And, most of us have been pretty good at adapting to that change.   

Unauthorized Practice of Law

As we enter this new, new reality, many lawyers ask: “Isn’t this the unauthorized practice of law?” Yet, North Carolina State Board of Dental Examiners v. Federal Trade Commission3 recognized that the unauthorized practice of law (actually unauthorized practice of dentistry in that case) and other rules we as professionals consider to be protecting the public are all at risk as potential antitrust law violations. In Dental Examiners,4 the U.S. Supreme Court declined to extend the antitrust immunity to state agencies whenever the agency is controlled by active market participants, unless there’s real and active oversight by the state. Thus, there’s a risk, depending on the state bar organization and the meaning of real and active oversight by the state, of federal antitrust violations in the unauthorized practice of law rules and enforcement actions.

One of the interesting tensions of today’s increasingly strained ethics definitions is that banks and other financial institutions employ some of the brightest and best estate-planning lawyers, but they aren’t treated as practicing law because they don’t draft documents; they only advise. At the same time, non-lawyer companies, like Rocket Lawyer and LegalZoom, employ lawyers but successfully maintain that they’re not practicing law because they prepare documents but don’t give advice. That isn’t meant as a condemnation of either position or perhaps not even a fair statement of either position. Rather, it’s simply an observation of the difficulty of defining “the practice of law.”5

But, these are merely a diversion from the larger issue of the ways in which the practice of law, particularly estate planning, has changed and will continue to change as the computer gets better at learning and reproducing: (1) what we do, (2) why we do it, and
(3) how we do it. Machines now exist, without requiring any further advances in technology, which understand, process and apply our core knowledge faster, less expensively and far more competitively than a law school graduate.6 

Law’s Golden Age?

Yet, the practice of law as we know it is in the middle of a golden age of enhanced capability. We have increasingly sophisticated tools allowing faster research, more productivity and greater accuracy with less time than ever before. 

We see the words “artificial intelligence,” “smart machines,” “machine learning” and “lawbots” regularly. But, what do they mean? Let’s define several important terms, at least as used herein. 

• AI: The varied definitions of this term often take a functional approach, focusing on the purpose for which the AI is developed.7 For our purposes, AI refers to the broad category of computer-based or computer-controlled systems designed to receive and respond to input using logic and analysis in a manner associated with human thinking.

• Narrow AI: This is a subpart of AI, sometimes referred to as “weak AI,”8 meaning AI that’s designed to draw on programmed data to achieve results as good as humans in a single area. As discussed below, this is the AI most of us currently encounter in our daily lives, as represented, for example, by Siri or Alexa.

• Machine learning: This is an application of narrow AI, in which a computer draws on a set of programmed data to “learn,” using an algorithm to make predictions or decisions without being programmed to make those predictions or decisions.9

• ASI: ASI refers to AI that not only replicates but also surpasses the capabilities of humans, in terms of knowledge, analysis, self-awareness and emotions.10

• General AI: As distinguished from narrow AI, general AI is that which is able to achieve results as good as or better than humans in multiple areas simultaneously.11 As discussed below, ASI may be the way to achieve general AI.

• Apps: This term is short for “Application” and is a software program designed for a specific purpose.12 Many apps, such as Siri, are AI-based programs.

• Bots: A bot is an Internet-based program that uses AI to perform automated, often repetitive, tasks.13  Some bots, sometimes referred to as “chatbots,” are designed to mimic human conversation.

We’re the beneficiaries (unless you’ve lost your employment, in which case you’re a victim) of narrow AI as a subpart of AI. Machine learning, often in the form of one of more neural networks, provides not only narrow AI but also sometimes constant improvement (self-learning) in narrow AI, allowing it to analyze its past decisions, learn whether it was right or wrong in those decisions and then modify the way in which it makes its decisions, boosting accuracy in the future. 

Robotic Lawyers?

It’s also worth noting there have been developments in robotics. Many of us believe, although it may not be true, that the average person would rather seek advice and knowledge from another person instead of a machine. 

Once again, technology has some very surprising developments in the fields of robotics and android creation. Because we can’t play a video clip in an article, we recommend that you do a Google search for YouTube videos using the search terms “Robotics” and “Sophia.” Sophia is a lifelike, female-presenting humanoid robot. She has expressive features, a rather awkward smile and the ability to carry on a very interesting conversation on a variety of subjects.14 She’s excellent in interviews, although we understand, because she represents narrow AI, that the questions and subject matter have to be in the area in which she’s been trained. She’s also been made a full citizen of Saudi Arabia. According to a 2017 blog post in Forbes, “On October 25, Sophia, a delicate looking woman with doe-brown eyes and long fluttery eyelashes made international headlines. She’d just become a full citizen of Saudi Arabia—the first robot in the world to achieve such a status.”15 Sophia is merely a platform for AI, but we have to recognize that some of the human aversion to AI and computers may be rapidly fading. And, we shall leave for a different discussion the looming question of the rights of a robot along with what it means to have full citizenship of a country. 

Ethical Considerations

Before addressing a very small sampling of the ethical considerations presented in AI, there’s a more basic question of how legal, as well as general, ethics will be applied to machines, or to us, if we’re competing with machines for much of the work we now do. Machines that by definition are, at least at this point, incapable of ethics. 

There are also global ethical questions, not addressed herein, of whether the autonomous computer of the very near future has rights. Alternatively, is it merely tangible (or intangible) property to be owned and treated as the owner would see fit? Does something change when the computer is no longer a box but is instead embedded into a female-presenting robot, such as Sophia? What might further change in this discussion when the computer becomes, even a little, sentient? Before dismissing this question as fantastical, consider that our current animal rights groups and legislation would have seemed outlandish to the general public several decades ago. 

How does one apply ethical rules to a machine, regardless of how or in what form it acts? We, as lawyers, are clearly now in competition with machines. Are Internet-based direct-to-public document drafting programs good or bad? That direct-to-consumer market occupied by LegalZoom and Rocket Lawyer, which we often regard as simplistic and low budget, is low hanging fruit, but it represents only the initial skirmish in the race for excellence and domination in the legal field. Currently, expectations are low, prices are low and an otherwise largely unserved market is provided basic documents. While not a work of art, and at times not what was needed, we would be hard pressed to say that these computer-generated documents are never sufficient to meet the consumer’s needs, nor can we say that the consumer would always have been better off with nothing. The hard fact remains that lawyers are now in competition with machines that didn’t go to law school and didn’t pass the bar exam. 

It’s worth considering, and the legal community will continue to debate, whether the role of the bar should be to: (1) continue to attempt to strictly prohibit non-lawyer activity as the unauthorized practice of law, (2) absolutely embrace the concepts of transparency and buyer beware, or (3) seek legislative rules (as was done in North Carolina) that allow for competition and full disclosure, but which also mandate local lawyer involvement through requiring approval of product by local legal counsel. This conundrum has been perhaps best illustrated in the case of Legalzoom.com, Inc. v. North Carolina State Bar, et al.16  

Turning to a brief focus on our legal ethics rules, the following ABA Model Rules of Professional Conduct17 must be considered with respect to every program we use, every email we send or receive and all of the data we store, either locally or in the cloud: 

• Model Rule 1.1—Duty of Competency

• Model Rule 1.4—Duty to Communicate

• Model Rule 1.6—Duty of Confidentiality

Within these three model rules, and the various state implementations thereof, we focus first on Model Rule 1.1, the Duty of Competency. ABA Formal Opinion 477R18 provides a wealth of insight and understanding of the difficulties facing the current practitioner. We recommend reading this formal opinion, which suggests specific areas of practice for a lawyer’s careful focus. These range from the absolute need to understand technology and the ways in which your email and data are stored and transmitted to labeling emails and documents as privileged. Also covered are training of personnel and vetting how the firm’s vendors screen and hire their employees. 

The ways in which the second and third rules noted above, Communication and Confidentiality (1.4 and 1.6, respectively) create friction in today’s world of technology require thoughtful consideration of: (1) when to use regular email, (2) when to use encrypted email, and (3) when might it be necessary to use a typed writing, delivered hand-to-hand between lawyer and client. Famously, former President Jimmy Carter disclosed in a 2014 interview with Andrea Mitchell on Meet the Press19 that when he wants to correspond with the leader of a foreign country privately, he types a letter and deposits it in the U.S. mail. Former President Carter went on to say that he believes that if he sends an email, it will be monitored. 

To select an ethics opinion from at least one state that cites rulings from a number of other states, Texas Disciplinary Rule 64820 sets forth a general rule that communication of confidential information to and from a client by email was acceptable, provided the use of email was reasonable under the circumstances and consistent with the client’s instructions. The issue turns on whether the attorney had a reasonable expectation of privacy. It’s interesting the factors that Texas lists that may affect the reasonableness of this decision:

• communicating highly sensitive or confidential information via email or unencrypted email connections;

• sending an email to or from an account that the email sender or recipient shares with others;

• sending an email to a client when it’s possible that a third person (such as a spouse in a divorce case) knows the password to the email account or to an individual client at that client’s work email account, especially if the email relates to a client’s employment dispute with his employer;21

• sending an email from a public computer or a borrowed computer or when the lawyer knows that the emails the lawyer sends are being read on a public or borrowed computer or on an unsecure network;

• sending an email if the lawyer knows that the email recipient is accessing the email on devices that are potentially accessible to third persons or aren’t protected by a password; or

• sending an email if the lawyer is concerned that the National Security Agency or other law enforcement agency may read the lawyer’s email communication, with or without a warrant.

There’s been a line of analysis approving the use of email for confidential communications, comparing email with sending confidential client information by U.S. Postal Service. The reasoning was that it’s illegal to tamper with either. However, that analysis seems fatally flawed. When you send a letter by U.S. Postal Service, you don’t grant anyone except the addressee the right to open and examine for any purpose. Conversely, each attorney using typical email providers expressly and intentionally permits that provider to electronically read and analyze every email. In fact, the attorney wants each email read by the provider, because this is how spam, inappropriate images and malicious emails are identified and deleted prior to coming to a standard inbox. But, what’s “reading” email? Is it that we don’t want humans reading the email? Or, is it the possibility of permanent storage and red flagging certain emails based on certain keywords of content? For example, if I email a client about ways to provide humanitarian aid to North Korea or a known terrorist state, does that email get flagged, and for what purpose? Have I violated the duty of confidentiality if the email exchange places the client on the “watch” list?  

What should you consider in using email services?  Is AOL mail the same as the email services by Microsoft Office 365? The terms of service (TOS) of each type of email and email provider vary greatly. As a general rule, if you’re using free email, such as AOL, Yahoo or Gmail, you’ll have little or no contractual rights to privacy or limitations as to what uses the provider may make of your email. Consumers, including attorneys, typically think only about whether email will be electronically read to target advertising. To combat this, some email providers such as AOL and Yahoo have announced that they’ll no longer use email for the purposes of providing personalized advertisements. But, noticeably absent in the announcement by the parent company of AOL Mail and Yahoo was any information or assurance as to what other uses the provider may make of your email. Google mail, both business (G Suite) and free (Gmail) now use AI to read your email and suggest responses. How this information is ultimately used and disclosed is unclear, but the privacy permissions give virtually unlimited access and permissions. The moral of this is to read your provider’s TOS, then go through the security and operational options to see what options and sharing you can decline or turn off. 

There are email systems that are highly rated for security, a level of encryption and other attributes that are outstanding if needed. These were, in 2018:

• ProtonMail

• CounterMail

• Hushmail

• Mailfence

• Tutanota

The reviews and the ratings constantly change as new entries appear and features change. For an up-to-date list, do a Google search using the search terms “best secure email service 2020.”

Types of AI

Current AI is clearly narrow AI as defined earlier herein. For example, a computer that can drive a car can’t wash and fold your clothes. But, within that narrow AI, the ability to read and learn from massive amounts of data in a very short period of time is simply extraordinary. 

As an easily understood medical example, there exists the task of reading and interpreting X-rays, MRIs, CTs and other imagining. A computer, through neural networks, can read, in a short period of time, hundreds of thousands of historical normal and abnormal images, differentiating abnormal from normal. Thereafter, the computer may consistently outperform many experienced radiologists.

In what’s widely been discussed as a breakthrough, Google’s neural network computer named “Alpha Go” defeated the world’s best Go player, learning by continuously playing Go against itself. While some may see this as little more than IBM’s Big Blue winning at chess, it’s dramatically different. Go, a Chinese board game, has more potential moves than there are atoms in the universe. Therefore, the stereotype of a computer analyzing all possible moves is simply inapplicable.22  

We may think, yes the first is medicine and the second is a Chinese board game, but there’s nothing like these in the law. However, CaseCrunch, a predictive Narrow AI application in the legal field, during the last week of October 2017, held an AI-versus-lawyer competition, and the machine won. Not by just a little; the computer outperformed the lawyers by a substantial margin. The competition pitted over 100 attorneys from firms like DLA Piper and Allen & Overy against CaseCruncher Alpha to predict outcomes of just under 800 real, historic insurance misselling claims. The goal was to correctly determine if the claim would succeed or not. According to the CaseCrunch website,23 the software predicted outcomes with almost 87% accuracy, while the lawyers were 62% correct.24

The question isn’t whether this can be applied to our field, but rather: How many ways could we use this sort of power in our field? It’s only a matter of having the data for training. What about data from U.S. Tax Court cases as applied to litigation on various family limited partnership cases, giving us the ability to predict, with greater accuracy, what will be successful and what won’t when we’re preparing the documents?25 

Likewise, on the estate-planning side, it would be an incredible boost to many to have the ability to predict best strategies for families in particular jurisdictions with particular facts. What about data on the success of various strategies in increasing a family’s wealth over two or more generations? A less experienced lawyer (and many very experienced lawyers) would be able to see the highest use versus most successful strategies for a particular fact situation. We would well serve the legal practice if practicing lawyers would allow blinded information about the solutions they recommend for clients to be aggregated.

Potential Impacts 

The impact of AI, without regard to ASI, is expected to be profound. This isn’t a distant drum. All is moving much faster than most expect or realize. For a country that has a difficult time addressing the unaffordable cost of Medicare and Medicaid, how can we manage the loss of jobs replaced by robots and neural networks?

Will we have a 25% unemployment in 2025? Boston Consulting Group has predicted that 25% of all existing jobs will be replaced by robots and smart software by the year 2025.26 Additionally, an Oxford University study predicted that 35% of the existing U.K. jobs will be eliminated in the next 20 years.27 The impact of this is staggering, although to date, what we’ve seen over the past 50 years has been the elimination of existing jobs, coupled with the more than offsetting creation of new jobs arising out of the new technology. 

Continuing with the issue of general displacement of jobs, what kinds of jobs are replaced first by technology? McKinsey & Company published a now widely cited article titled “Where Machines Could Replace Humans—And Where They Can’t (Yet).”28 The key study therein is a very busy chart (not reproduced herein) showing McKinsey’s view of the portion of activities that can be replaced using current technology.

Not surprisingly, predictable physical work comes as the most likely and easiest to replace with existing technology, with an estimate that 78% of the time currently spent on predictable physical activity is capable of replacement using technology available in 2016. Coming in close behind that are data processing and data collection. Moving across the chart from more likely to less likely, McKinsey gives the following estimates of how much time currently spent on activities could currently be replaced:

• Non-repetitive physical work = 25%

• Stakeholder interactions = 20%

• Applying expertise = 18%

• Managing others = 10%

The report is further nuanced by dividing that likelihood into industry sectors and is well worth study. Finally, the McKinsey report finds that likelihood of replacement isn’t solely dependent on whether the technology is available. In fact, McKinsey describes five factors that influence replacement by technology:

• technical feasibility; 

• costs to automate; 

• the relative scarcity, skills and cost of workers who might otherwise do the activity; 

• benefits (for example, superior performance) of automation beyond labor-cost substitution; and

• regulatory and social acceptance considerations.

Journalist David Meyer further quoted McKinsey for the proposition that 800 million of today’s jobs could be lost to automation by 2030.29 The concern isn’t the quality of the jobs, or the overall productivity, but rather an increasing problem of unemployment. Additionally expected are massive changes in the required infrastructure.30

There’s an interesting phenomenon at work in the regulatory/social acceptance factor. Japan has difficulty with this factor. Japan is the leader in a plan to use robots for senior care, a field thought to be a safe harbor, an area that will be able to absorb many of those displaced by technology. The barrier, however, is the human element.

The Human Element?

This need for additional health care workers is particularly of concern in Japan. Japan has an aging population and a substantial shortage of caregivers. By 2025, it’s estimated that there will be a shortage in Japan of 270,000 caregivers.31 The issue isn’t whether the machines can do the work. Instead, the problem is social acceptance of using machines for elder care, further eliminating human interaction with the elderly. The Japanese government is in a campaign of encouraging its senior citizens to accept that robots will give them much of their care.32 Simple robotic devices that can help the elderly out of their bed and into a wheelchair, or in and out of a bath, will be the first effort. The goal of the Japanese government has been that four out of five senior citizens will be willing to have robotic assistance by 2020. 

In this area, much of the resistance from seniors, and perhaps from our population in general, is at least in part due to a perceived lack of emotional interaction. In thinking about this, one must look again at Sophia, the humanoid robot. 

Sophia was probably one of the most surprising finds when authors Graham and Blattmachr began their research several years ago. Created by David Hanson, CEO and Founder of Hanson Robotics, Sophia is Hanson’s most popular creation. She’s been interviewed on various programs around the world. Sophia demonstrates Hanson’s creed that robots must be as perfect in human form as possible to effectively communicate with humans. 

Hanson Robotics’ website33 makes reference to robots as a platform for AI and its interaction with humans. Why would something like Sophia be an excellent AI platform? Much of this seems to be driven by the “Uncanny Valley,” a concept and term Japanese roboticist Masahiro Mori began using in the 1970s. The concept focuses on the phenomenon that as a machine appears more and more human, it becomes increasingly endearing, but only to a point. Then, as it becomes more human but still imperfect in appearance, a cold, unpleasant feeling is triggered in the viewer.34 It’s not completely understood, but seems to be universal. One psychologist found in a study that from Dartmouth College students to a remote tribe in Cambodia, there’s a strong sensitivity to what does or doesn’t appear human. But, such findings held up only when the researchers showed people human faces that were familiar to their own ethnic group.35

Turning back to the critical issue of job replacement, the prospect of massive unemployment as a result of technological job replacement would seem to be a societal problem of massive proportions. Western civilization has seen jobs replaced by technology give way to even more new jobs in the technology field. Of course, while there may be as many jobs, or more, those less skilled, repetitive task employees may or may not be suitable, or even willing, to train for newer technology jobs. 

A Bright Future?

A 2015 study by Deloitte presents a positive view, which focuses on a historical fact that new jobs are always created, ones that require less muscle and more artistic talent or thinking power.36 The point is made that at one time, Luddites were smashing weaving looms for the same concern we have today that the “rise of the machines” will cause massive unemployment. A related concern focuses on the possibility of civil unrest, that factors such as high unemployment, particularly when combined with demographic age bulges among youth, automatically create an atmosphere of crime and violence. However, in his background report for the 2011 World Development Report, titled “Unemployment and Participation in Violence,”37 Christopher Cramer of the School of Oriental and African Studies, London, reports that there’s actually a lack of data, particularly in emerging countries, that these elements are the root cause of violence. 

To address the issue of massive displacement of jobs and workers, one line of thought is that of a universal basic income.38 The idea is that payment for doing nothing is the inevitable result of the increasing ability of technology and job diminution. This idea, as foreign as it sounds, has become popular to espouse at least in Silicon Valley. Mark Zuckerberg, of Facebook, Elon Musk, of Tesla and SpaceX fame and Pierre Omidyar, founder of EBay, were each recently quoted in Inc. as proponents of a universal basic wage as a remedy for the increasing number of jobs being and about to be displaced.39 

There have been several examples around the globe of universal basic income. Finland had a universal basic income of approximately 600 euros per month. However, a more conservative government was elected, and that program ended. Switzerland recently rejected such a concept as both too expensive and detrimental to productivity. However, several experiments have been started by tech founders. In Ontario, a pilot project began in 2017, giving 4,000 residents ages 16 to 64 a basic income of slightly more than $12,000 a year. The largest project is by Ominyar (eBay), whose experiment in Kenya involves 6,000 people for 12 years.

Human Lawyers Replaced by AI?

Is this the future? Whether we estate-planning professionals are replaced, the answer is yes with respect to much (if not most) of the tasks we perform. Clearly, it’s a matter of the job, the level of repetitiveness, the need for human interaction and other factors noted above. The legal profession adopts technology, though perhaps at a slower pace than society as a whole, not only because lawyers appreciate and enjoy the convenience, efficiency and accuracy it brings but also because our clients are simultaneously adopting similar technology, or know that it’s available, and demand that we use it. Naturally, clients value accuracy, but they also value efficiency and convenience, which translate to lower legal fees.

We quietly laugh at the antiquated ways of the past, for example 40+ years ago. But, what will our current ways look like years from now?  

Search and analysis tools will become much more sophisticated. LexisNexis has already replaced the antiquated West key number system. The search engine ROSS Intelligence uses IBM’s proprietary search engine, Watson. ROSS Intelligence, founded by three recent college graduates, none of whom went to law school, is touted as the next step in legal research. One of the founders explained to author Graham that his mother had gotten a divorce, and the lawyer cost too much. So, he wanted a way to lessen the cost of lawyers. 

An often cited position paper on technology and the law is a U.K.-focused position paper.40 Deloitte considers the various ways in which law firms in the United Kingdom can react to increasing technology, with predictions as to how those will fare. Deloitte concludes:

The legal profession will be radically different in ten years. On the whole, we expect the following: 

• Fewer traditional lawyers in law firms

• A new mix of skills among the elite lawyers

• Greater flexibility and mobility within the industry

• A reformed workforce structure and alternative progression routes

• A greater willingness to source people from other industries with non-traditional skills and training.41

The jobs displaced, and the societal issues created by narrow AI, will change the practice of law, and the practice of estate planning is no less or more threatened than any other area of law.42 

While there’s much more than the forgoing to discuss in relationship to current technology and narrow AI, the next area of discussion involves an event that wasn’t expected for a number of years. Yet, it’s occurring and in production now: the development and success of ASI. ASI is simultaneously the most promising and the most troubling. 

ASI (The Thinking Machine)

ASI is currently being deployed in the Narrow AI fields but is perhaps the key to general AI. Movies play a great role in images and expectations of ASI. For example, the films Her,43 in which a virtual assistant has feelings, develops a relationship, learns and has a sense of humor and Ex Machina,44 a darker view of the possibilities, are glimpses into what we popularly believe ASI will look like. 

The first ASI known to the authors became operational at J4 Capital on June 1, 2015.45 The potential applications for ASI are as diverse as there are human fields of endeavor: actuarial calculations, logistics, personalized medicine, precision agriculture, potable water, personalized education, law and more. Essentially, the applications of ASI are without boundaries. 

ASI has made new discoveries in each field to which it’s been applied. A notable discovery in the capital markets was a new type of trading previously unknown on Wall Street. Because of its unique capabilities, ASI will be used to help unravel the genotype phenotype mapping problem, and one of the authors now sits on the Advisory Board for DIRAC of the Large Synoptic Survey Telescope, one of the largest optical telescopes under construction in the world.

What values does an ASI computer use in making decisions? Many issues have arisen during the construction and operation of ASI. Implemented as a thinking-only computer, evidence of socially inappropriate behavior has emerged. We theorize that emotion is coregulatory with thought and is a required element that maintains stability in a thinking system. While it may be possible to resolve the lack of emotion by loading an “empathy stack,” the question quickly arises as to whose empathy characteristics would be used. The emotional and empathy characteristics among each of the authors is different. How is this to be resolved?  Finally, the authors have observed emergent self-reflective behavior that may be early evidence of machine consciousness, sentient behavior. 

ASI is completely different from today’s most advanced AI in at least two aspects. First, another way of defining ASI is machine intelligence, which is intellectually much smarter than the best human brains in practically every field (scientific creativity, general wisdom and social skills). This definition is often used to describe general ASI and implies not only knowledge but also being self-aware and having emotions. Second, the difference between AI and ASI is at the core of the processes, which is at the heart (pun intended) of the issue. In AI, the code is static. The code may allow the system to learn, such as in a neural network, and constantly refine the way that it reacts to a given input, coming to expect that input, or recognizing it, but even in a learning machine, the code itself remains static. In ASI, the code written is merely the code to allow that ASI machine to write its own code, using whatever input the machine decides is important. 

The following is a quick comparison of AI to ASI:

AI

• Algorithm

• Based on a set of rules

• Assumptions are made and implemented 

• The programming is static, inflexible 

• The source code is fixed

ASI

• Thinking

• No assumptions

• Dynamic, adaptive 

• Writes its own code

As we begin to think of ASI’s impact on our practices and firms, several areas stand out. First, the jobs in our industry will erode from the bottom, from least skilled to most skilled. This isn’t different from any other industry. Repetitive physical is always the first to be replaced. But, what does repetitive physical labor mean in a professional practice?  

Ego and Change in Legal Practice 

What’s the greatest impediment to adoption of AI and ASI in the legal field? Non-lawyers suggest that the answer is “ego.” Perhaps, because lawyers are, from the first day of law school, raised on a steady diet of independence from external influence, there’s resistance to technological innovation that would replace traditional methodology. The inevitable change seems likely to be driven by economic factors. Thus, the change may come first in the largest firms, where the pressure for profitability is based on a top down mandate, rather than an individual attorney’s decision. 

An extension of the erosion that’s already begun may be viewed as happening in the following order:  

• administration support 

• litigation support

• paralegals

• associates

• partners and lead counsel 

All functions except human interactions are possible (meetings, depositions and courtroom). Eventually, we also have to recognize that at least some of what we regard as necessary human interaction will be taken over by computers. Even if lawyers believe that changes simply aren’t necessary or appropriate, clients as a whole will expect and demand the application of the latest technology. 

Ethical and Survival Issues

Not everyone is comfortable with the race to create thinking machines, machines that exceed human capacity in almost every area. Notables as Elon Musk and the recently deceased Steven Hawking have expressed deep concern about the ethical and survival issues inherent in the development of ASI without considerable independent oversight, thought and care.46 Perhaps this might be viewed in the same way as the creation of weaponized virus and bacteria strains in the laboratory, with an assumption by the creator that the weaponized virus could never escape the laboratory to the general population. 

Consider that there are at least some parallel characteristics between an ASI computer and a psychopath as defined in the Diagnostic and Statistical Manual of Mental Disorders, Fifth Edition (DSM-5).47 The difficulty isn’t in enabling the machine to make decisions on its own, but rather in giving it a moral code as the framework of how it accomplishes the goals it’s given. In summary and simplification of the DSM-5 definition process, a psychopath has at least three of the following characteristics. 

• Failure to conform to social norms with respect to lawful behaviors

• Deceitfulness

• Impulsivity, failure to plan ahead

• Reckless disregard for safety of self or others

• Consistent irresponsibility

• Lack of remorse

While humans make decisions with the background of societal norms and generally accepted moral and legal restraints, these are unknown to an ASI computer unless they’re loaded as a part of the boundaries for considerations and decisions. How does one load moral and ethical values? Whose moral and ethical values? Does loading the criminal and civil codes accomplish this? Or, do our moral and ethical values extend beyond statutory law? Also, our values evolve over time. Acceptable norms as to privacy, for example, have materially changed since Sept. 11, 2001. Establishing current values as hard stops in answering questions doesn’t reflect this evolution in values. This conundrum is also faced today in many areas of biological technology. It’s an issue not easily solved, for the human race has varying legal and ethical values, whether from country to country or individual to individual. 

It may be that our role as lawyers, and particularly fiduciary-based lawyers, is to actively involve ourselves in the long-term ethics and oversight of technological advances. We, who constantly think about the future and how actions taken will affect generations to come, must step forward into this area of AI and ASI to be part of the process of not just what’s possible but also what’s ethically appropriate. 

One area of precedent for this is that the U.S. Securities and Exchange Commission, when formally evaluating Black Monday, the stock market crash of Oct. 19, 1997, included one of the authors as a fiduciary advisor on the congressionally mandated joint agency task force, and we suggest that the same should hold true for analysis and oversight of emerging ASI technology. 

Perhaps the question is what’s the best future for mankind, and how can that be accomplished using AI and ASI, rather than allowing progressing AI and ASI technology to do as it will, with the future of the human race as a byproduct.     

Endnotes

1. Adapted from a “Dilbert” cartoon by Scott Adams, relating to a computer, a doctor and a dog. 

2. Seehttps://en.wikipedia.org/wiki/Seth_Godin. 

3. North Carolina State Board Of Dental Examiners v. Federal Trade Commission 135 S. Ct. 1101 (2015).

4. Ibid. 

5. “Washington State’s (and the nation’s) first limited license legal technicians have been designated. *** These non-lawyers are licensed by the state to provide legal advice and assistance to clients in certain areas of law without the supervision of a lawyer.” American Bar Association (January 2015 and Dec. 8, 2017).

6. See our discussion of CaseCrunch on p. 60, www.abajournal.com/news/article/artificial_intelligence_software_outperforms_lawyers_without_subject_matter. In a similar competition by LawGeex, reviewing non-disclosure agreements, the computer tied the highest performing lawyers at 94% accuracy, while the lowest performing of the 20 human lawyers only achieved a 64% accuracy, www.lawgeex.com/resources/aivslawyer/?http://www.lawgeex.com/resources/aivslawyer/?utm_source=google&utm_medium=cpc&utm_campaign=US_sch_ai_vs_lawyers&utm_adgroup=56678748710&device=c&placement=&utm_term=%2Bai%20%2Blawyer&gclid=EAIaIQobChMIo7bY_ZCI5gIVj5OzCh3ZMQLHEAAYAiAAEgIGL_D_BwE. 

7. See Bernard Marr, “The Key Definitions of Artificial Intelligence (AI) that explain its importance,” Forbes (Feb. 14, 2018), stating that the modern definitions of AI focus on computer science, a subpart of AI.

8. See Tannya D. Jajal, “Distinguishing Between Narrow AI, General and Super AI,” Medium, Artificial Intelligence (May 21, 2018), https://medium.com/@tjajal/distinguishing-between-narrow-ai-general-ai-and-super-ai-a4bc44172e22. 

9. https://en.wikipedia.org/wiki/Machine_learning. 

10. See Jajal, supra note 8.

11. See ibid.

12. https://dictionary.cambridge.org/us/dictionary/english/app. 

13. Seewww.cloudflare.com/learning/bots/what-is-a-bot/. 

14. Seewww.youtube.com/watch?v=S5t6K9iwcdw. 

15. Zara Stone, “Everything You Need To Know About Sophia, The World’s First Robot Citizen,” Forbes (Nov. 7, 2017).

16. Seewww.abajournal.com/news/article/legalzoom_resolves_10.5m_antitrust_suit_against_north_carolina_state_bar. “LegalZoom has settled its protracted legal dispute with the North Carolina State Bar with a consent agreement that permits the company to continue operating there, Forbes reports. The online legal document company has been expanding quickly to provide other services, including prepaid legal services plans.”

17. American Bar Association (ABA), Center for Professional Responsibility (2013).

18. ABA Comm. on Prof. Ethics & Grievances, Formal Op. 477R (2017), www.americanbar.org/content/dam/aba/administrative/law_national_security/FO%20477%20REVISED%2005%2022%202017.authcheckdam.pdf.

19. Transcript, www.nbcnews.com/meet-the-press/meet-press-transcript-march-23-2014-n59966. 

20. Tex. Disciplinary R. Prof. Conduct, 1989, reprinted in Tex. Govt Code Ann., tit. 2, subtit. G, app. (Vernon Supp. 1995) (State Bar Rules art X [[section]]9)).

21. See ABA Comm. on Ethics and Prof’l Responsibility, Formal Op. 11-459 (2011).

22. The game of Go (similar to a game of chess) has more potential moves than there are atoms in the universe. Google’s Alpha Go taught itself the game by playing against itself. It beat the individual who was regarded as the best in the world. And, it continues to improve itself. Seewww.nytimes.com/2017/05/23/business/google-deepmind-alphago-go-champion-defeat.html.

23. www.case-crunch.com.

24. These were experienced lawyers, but not experienced in the field of insurance misselling. Presumably, an expert in this area would have fared better. 

25. It may be that there was a judge-made change in the law for valuation of discount partnerships rather than a statutory or regulatory one. Estate of Powell v. Commissioner, 148 T.C. 392 (2017). While it’s at least arguable that the result of the case was predictable from the abusive facts, the reasoning of the Tax Court advanced. See Mitchell M. Gans and Jonathan G. Blattmachr, “Family Limited Partnerships and Section 2036: Not Such a Good Fit” (2017), https://scholarlycommons.law.hofstra.edu/faculty_scholarship/1055.

26. Jeanne Meister, “Future Of Work: Three Ways To Prepare For The Impact Of Intelligent Technologies In Your Workplace,” Forbes (July 2016).

27. Ibid.

28. Michael Chui, James Manyika and Mehdi Miremadi,“Where Machines Could Replace Humans—And Where They Can’t (Yet),” McKinsey Quarterly
(July 2016), www.mckinsey.com/busi\ness-functions/digital-mckinsey/our-insights/where-machines-could-replace-humans-and-where-they-cant-yet. 

29. David Meyer, “Robots May Steal As Many As 800 Million Jobs in the Next 13 Years,” Fortune (Nov. 29, 2017), http://fortune.com/2017/11/29/robots-automation-replace-jobs-mckinsey-report-800-million/. 

30. Another development that may have a profound effect on all disciplines that involve face-to-face communication is the advent of holograms, which may diminish not only business travel but also office space. Seewww.youtube.com/watch?v=ywsJc1oNuWg. 

31. “Japan could face shortage of 270,000 nursing staff by 2025, ministry warns,” Japan Times (Oct. 22, 2019).

32. Daniel Hurst, “Japan Lays Groundwork for Boom in Robot Careers,” The Guardian (Feb. 5, 2018), www.theguardian.com/world/2018/feb/06/japan-robots-will-care-for-80-of-elderly-by-2020.

33. www.hansonrobotics.com.

34. Jeremy Hsu, “Why ‘Uncanny Valley’ Human Look-Alikes Put Us on Edge,” Scientific American (April 3, 2012).

35. Ibid.

36. Katie Allen, “Technology has created more jobs than it has destroyed says 140 years of data,” The Guardian (Aug. 18, 2015), www.theguardian.com/business/2015/aug/17/technology-created-more-jobs-than-destroyed-140-years-data-census.

37. Christopher Cramer, “Unemployment and Participation in Violence, Background Paper,” World Development Report 2011 (2010).

38. Seehttps://en.wikipedia.org/wiki/Basic_income. 

39. Kaitlyn Wang, “Why Mark Zuckerberg Wants to Give You Free Cash, No Questions Asked,” Inc. (June 19, 2017).

40. Deloitte, “Developing Legal Talent: Stepping Into The Future Law Firm” (February 2016), www2.deloitte.com/content/dam/Deloitte/uk/Documents/audit/deloitte-uk-developing-legal-talent-2016.pdf. 

41. Ibid.

42. Some will contend that estate planning is different from other areas of practice because of emotional judgments (such as which child to name as the executor of one’s will). That’s so compared, perhaps, to preparing the documents for a public offering, but other areas of law, such as divorce, involve as much emotion.

43. https://en.wikipedia.org/wiki/Her._.

44. https://en.wikipedia.org/wiki/Ex_Machina._.

45. Disclosure: J4 Capital LLC is a Registered Investment Advisor. Jeff Glickman, an author of this article, is a managing member and chief scientist of J4 Capital LLC.

46. Maureen Dowd, “Elon Musk’s Billion Dollar Crusade to Stop the AI Apocalypse,” Vanity Fair (March 26, 2017), www.vanityfair.com/news/2017/03/elon-musk-billion-dollar-crusade-to-stop-ai-space-x.

47. American Psychiatric Association, “Diagnostic and statistical manual of mental disorders” (5th ed.) (2013), https://dsm.psychiatryonline.org/doi/book/10.1176/appi.books.9780890425596.

Technology has and continues to change estate-planning practices. At this juncture, many firms are largely paperless, cloud-based practices, using document generation software and a wide array of different software products to facilitate better client interactions, better management and more efficient research and drafting. But, the reality is that many practices haven’t yet transformed themselves to take advantage of technological changes.1 These firms likely have experienced inefficiencies and cost pressure. Let’s explore the many technological changes affecting estate planning. Keep in mind that the application of technology is practice dependent, so what worked for our practice may not work for yours without significant modification, or perhaps not at all. A firm might be paperless and cloud-based, but many practitioners might still prefer to review complex documents in hard copy with a yellow highlighter. 

Select Appropriate Steps

Every practitioner and firm is different. Be wary of adapting something just because it was recommended by another practitioner or an IT consultant. Adapt and modify implementation steps for your practice. Each practice is unique in terms of the nature of the typical clients, the practitioner’s comfort level with technology and change, how the particular practice operates and capabilities of the administrative staff. A paperless, cloud-based practice will necessarily have to handle these issues differently than a practice that still has yellow pads, Redwelds and other analog tools. A practice that predominantly focuses on a large volume of flat-fee, lower wealth clients will have different technology needs than a boutique firm serving a limited number of ultra-high-net-worth clients seeking a different level of service and relationship. If your clients wouldn’t make use of the technology, the implementation of that technology may not be an effective use of your resources (both staff time and money). Some consultants and colleagues may tend to recommend what works for them, not necessarily what works for your practice. In some cases, cobbling together several techniques or software services, using each in a way appropriate to your practice (and not necessarily the application that most use for that software), may provide a more comfortable and efficient result, even if the complexity and cost are a bit greater.

Benefits of Adapting Technology

Technology can reduce the time, and thus the costs, of generating and processing documents. This facilitates spending more time in meetings, phone calls and other client-facing activities.2 Cost reductions through operational efficiencies may also permit you to profitably service lower net worth clients. It can also make practice more enjoyable, as routine tasks are automated, permitting you to spend more time on business development, planning or other more gratifying and profitable activities. Even firms that feel that they’re current on adapting technology may find that some or even many of their professionals haven’t really transitioned to more technologically advanced approaches. Just as estate planning doesn’t end with the signing of a client’s documents, the adaptation of technology doesn’t end with the implementation of a new program. The progress of technology suggests that an annual review of a firm’s technological uses may be effective, allowing the practitioner to determine if there’s any new software or practices to implement and improve his workflow.

Document Generation Software

Technology can also change the manner in which planning is handled. Consider the effect on a practice of adapting document generation software and moving away from the traditional approach of using standard firm forms. Many practitioners still draft an insurance trust by marking up an insurance trust form. With document generation software, a draftsperson doesn’t have to be constrained by the contents of a particular form and will have much more latitude to efficiently tailor an irrevocable trust document to incorporate whatever mechanisms are appropriate for the specific client situation. For example, the insurance trust can be structured to also be a more robust spousal lifetime access trust, a hybrid domestic asset protection trust or a special power of appointment trust and to have any desired state law apply (although that won’t obviate the need for local counsel in that jurisdiction). 

Paperless vs. Paper-Less

“Paperless” means no paper whatsoever, and that may not be optimal for many practitioners. “Paper-less” means less paper than historically was used and perhaps less paper on a continuum of moving towards a paperless office in the future. Some firms have gone completely paperless, but before all practitioners were comfortable working in a paperless environment. The result is that those practitioners may have administrative personnel print all documents and arrange them in Redwelds. This is no different from what they did prior to their office going paperless. If your firm hasn’t gone completely paperless, consider moving towards that goal in phases that make sense for how you practice.3 It might even be best to allow different partners to progress at different rates based on their comfort levels. We evolved to a somewhat intermediate approach. 

Be certain that for the paperless portion of your practice, scanned documents are searchable PDFs; if not, identifying electronic documents will be difficult. There are many applications available that can “crawl” through your document management system and convert all PDFs into searchable format.4

Our practice is paperless and largely cloud-based, but we create what we refer to as “temporary Redwelds” for current client matters. Many clients, especially older ones, still live in a paper world and bring physical documents to meetings. While we scan each document provided, and return any originals as quickly as possible, we’ve found that having a paper file for meetings is still useful. When the project is completed, the contents of the Redweld are shredded (as they’ve already all been scanned), and the Redweld and folders are used for the next client.

As you progress towards a paperless office, consider preparing a memorandum guiding staff involved in the process to assure that the steps taken consider ethical and other obligations.5 For example, exercise caution so as not to destroy client property that should be scanned and returned to the client. Confirm a documentation retention policy so you can determine which files should be scanned and then destroyed and which may simply be destroyed. The policy will differ by the nature of the profession of the estate planner involved (and the ethics rules guiding that discipline) and the particular professional’s firm policy on document retention. Having a written policy and procedures memorandum is recommended to avoid any inference that documents were inappropriately or arbitrarily destroyed. 

Client Communications

Technology can enhance the ability to communicate with clients. You can create and efficiently disseminate an electronic client newsletter. This isn’t only valuable as a marketing tool but also as a means of disseminating information to inform clients of matters that they might be overlooking, thereby protecting the practitioner.6 Create a website with a client portal with planning materials, articles and writable PDF forms to make it easier for clients to prepare the information that you need to plan for them. 

On your website, create, film and post short video planning clips explaining concepts common to your clients and their families. You can create these inexpensively in your office without the cost of expensive marketing and PR firms. The equipment needed includes a quality camera, tripod, microphone and lighting, perhaps a few thousand dollars in cost.7 For a more polished look, hire a professional to create bumpers to add to the beginning and end of each video, and include a disclaimer as well as firm contact information in those. These videos can explain the issues each practitioner sees her clients needing information on. For some clients, video clips might help facilitate better understanding ideas relevant to them than would e-newsletters or written materials. 

All this will also enhance the firm’s image and marketing reach because many, if not most, prospective clients look at a firm’s website before retaining an estate planner.

Securing Data

When considering client communications, what steps must a law firm take to secure its data?8 You might consider addressing some aspects of how you do, and don’t, secure client data in your firm retainer agreements (engagement letters) to put clients on notice as to your default procedures.9 These disclosures might then be updated periodically to reflect new ethics rules, changing practices and integration of new technology. Many states have adopted American Bar Association (ABA) Model Rules of Professional Conduct’s changes concerning technology. Rule 1.1 was modified to require technical competence. Rule 1.6 requires lawyers to use “reasonable efforts” to prevent the inadvertent or unauthorized disclosure of confidential client data. The ABA Model Rules state that a client can require a lawyer to implement “special security measures not required by this Rule.”10

Practically speaking, how can a firm demonstrate or even determine what constitutes “reasonable efforts?” An approach we’ve taken is to have our firm IT consultant annually prepare a letter summarizing recent steps taken to address security and other technology issues and to recommend additional steps for the following year. That approach might demonstrate “reasonable efforts.” This year, we’ve implemented an additional step of having an independent IT consultant review our systems to endeavor to identify any issues that might warrant addressing. Many conferences are starting to add tech courses to their programs. Perhaps someone from the firm should attend such a program each year (whether or not credits are required for maintaining licenses) to demonstrate “reasonable” efforts to keep current.

Web Meetings

Web meetings are an efficient tool that many practitioners have already adopted,11 but there may be further applications worthy of consideration that not all use. Web meeting software provides a simple option to record the content of the meeting. That can later be transcribed using the services of the web meeting hosting company or independent web based transcription services, for example, www.temi.com. For smaller or cost-conscious clients who don’t wish to pay for a more formal memorandum, a transcription of a meeting can be a cost-efficient means of documenting what was discussed. 

Web meetings can also be a very efficient means to foster collaboration with allied professionals. A web meeting can be more efficient and less costly than having several professionals meet in one physical location. That can resolve client concerns about the cost of collaborative meetings and permit the exchange of information that can facilitate better planning. We’ve found that for many client matters, a web conference of advisors only, intentionally excluding the client, can foster an efficient update to get all advisors on the “same page,” sometimes in as little as 30 minutes. By excluding the client, every advisor can speak freely and use technical terminology without the explanations and details that would be necessary if a client were participating.

Web meetings with clients can be about more than just updating an estate plan and permit you to have an objective and independent check-in on a client, especially an elderly or infirm client. Regular web meetings with video may provide a means for practitioners to keep apprised of changes in an elderly client’s status, thereby minimizing the risk of elder abuse. Many clients plan for meetings in a professional’s office. They select times of day when they may be at their best and often groom for the occasion. Seeing and speaking to a client in the client’s home, without the preparation that might accompany an in-office visit, may be more telling. How does the client sound and appear? Does the client let down her guard when merely calling from home as contrasted to a more formal in office meeting? Is there anything unusual or concerning in the client’s home that’s visible? Is there anything worrisome in the client’s demeanor?12

I’ve used web meetings to help newer colleagues write their first article. By drafting an article together, they can participate in the process, see the article develop from a blank page and get through that hurdle of writing their first article. This is also a great way to encourage new members of any of the allied professions to become more actively involved.

Physical Office and Relocation

Technology has transformed and continues to transform the estate planner’s office. The rows of research bookshelves and file cabinets that historically lined hallways have all but disappeared as electronic files and research services have obviated the need for them. Space layout and design is vastly different. This has changed so much that a moving checklist for an estate planner in today’s environment is primarily focused more on technology than physical assets.13

Software for Planning Discussion

While practitioners are no doubt familiar with software to project outcomes of various planning techniques,14 other applications can be useful. There are software services that can expand the estate-planning conversation by projecting client life expectancy, health care costs and other factors that affect later life planning. For lower wealth clients, an estimate of what health care costs may be an eye opener that motivates them to undertake Medicaid planning. For wealthier clients, the dollarization of possible future health care costs may serve the opposite purpose of demonstrating that the figures are palatable and that there’s no need to defer gift planning out of fear that unmeasurable sums need to be retained for those future costs. This might suffice to help a formerly reluctant client take recommended steps to use the current high temporary exemption. Estimates of actual life expectancy may also drive home the need for long-term financial forecasts to assure that the client doesn’t overspend and run short of assets in later years.15 Estate planners might consider the difference between table life expectancy and calculated life expectancy for a client to tailor planning. For example, you might consider a longer grantor-retained annuity trust term to reflect greater life expectancy.

Rethinking Common Planning Steps

There are a myriad of areas of practice that can be rethought in light of technological changes. Changing domicile is illustrative. Changing domicile has always been a common planning tool for clients domiciled in decoupled states seeking to avoid state estate tax. With the restrictions the 2017 Tax Cuts and Jobs Act placed on state and local tax deductions, more clients are considering changing domicile. But, technology has changed the analysis of factors corroborating a change in domicile as well as the manner in which records to demonstrate the change in domicile are maintained.16 One change is the availability of apps that clients can use on their smart phones to automatically count the days they’re physically present in their former home state and new home state using their phones’ location device.17 But, the impact of technology goes much deeper. Common historic factors considered in evaluating a change in domicile included where the client banks and shops and home phone usage. Now, however, many clients conduct all of their banking activities and much of their shopping online. Many clients no longer even have home telephones. Location of items near and dear remains an important consideration. But, the traditional photo album has given way for many to cloud-based photo storage. New factors that prior case law couldn’t have considered, like the use of Groupon and other local coupon services, may be relevant considerations. The entire analysis should be rethought in light of technology.

Embracing Technology 

The evolution of technology is relentless. New software and products are introduced constantly, and the ways in which older software can be used can be transformed as well. Practitioners won’t need every new technology released, and each firm’s technology needs are different. However, it’s unlikely that when a review of available software and applications of that software is made, there will be nothing that a practitioner could adopt for their particular need. Embracing technology, in a logical manner, may enrich the practitioner’s practice and help to make his practice more efficient, profitable and rewarding. 

Endnotes

1. This article is in part based on a presentation given to the 2019 Notre Dame Estate and Tax Planning Institute, and the authors acknowledge attorney Jerome Hesch’s suggestions in preparing that program.

2. American Bar Assocation (ABA) Model Rules of Professional Conduct (RPC) 1.4 (b) on Communications states that: “A lawyer shall explain a matter to the extent reasonably necessary to permit the client to make informed decisions regarding the representation.” Leveraging technology to allow the practitioner to spend more of a matter’s time (and cost) on client-facing activities may help the practitioner both from a relationship with the client standpoint, as well as with protection against ethical violation concerns.

3 . At a recent presentation for the Notre Dame Estate and Tax Planning Institute on technology for estate planners, we offered to provide a sanitized version of the memorandum we used when we went paperless in 2011 and had more than a score of requests, so clearly many firms still haven’t taken the plunge.

4. Adobe Acrobat, Nuance/Kofax Power PDF, Foxit PhantomPDF, Nitro Pro, Trumpet Symphony OCR and DocsCorp ContentCrawler.  

5. RPC 1.15 describes a practitioner’s ethical obligations to safeguarding client property. RPC 1.15 Comment 1 indicates: “A lawyer should hold property of others with the care required of a professional fiduciary.”

6. See Martin M. Shenkman, Sandra Glazier and Howard Zaritsky, “Raia v. Lowenstein Sandler LLP—Thoughts on a Recent Malpractice Case,” LISI Estate Planning Newsletter #2724 (May 16, 2019).

7. For video editing, we use the Wondershare Filmora suite of editing software. There are many other reasonably priced programs. 

8. ABA Ethics Opinion 477 addresses securing communication of client data, stating: “A lawyer generally may transmit information relating to the representation of a client over the internet without violating the Model Rules of Professional Conduct where the lawyer has undertaken reasonable efforts to prevent inadvertent or unauthorized access. However, a lawyer may be required to take special security precautions to protect against the inadvertent or unauthorized disclosure of client information when required by an agreement with the client or by law, or when the nature of the information requires a higher degree of security.”

9. Thomas Tietz, Barron K. Henley and Martin M. Shenkman, “Using Technology For The Modern Estate Planning Practice,” American Bar Association e-Report (August 2019).

10. RPC 1.6 Comments 18 and 19.

11. Practitioners often use programs such as GotoMeeting, Webex, Zoom and Skype for web meetings. As one example, we’ll often review draft documents with clients over a web meeting where they can view the practitioner’s screen, so everyone involved can see provisions being discussed and changes requested being made to the documents.

12. “The Uber Version of Estate Planning for Seniors,” ABA (December 2018).

13. “Moving Your Law Practice, A Checklist-Like Approach,” ABA e-Report (August 2015).

14. We use NumberCruncher provided by Leimberg.com. Seewww.leimberg.com/products/software/numberCruncher.html.

15. See Genivity Halo Health, Life Expectancy and Health Care Costs as one of the products that provides this information.

16. Martin M. Shenkman, Lance E. Rothenberg and Joy Matak, “Changing Domicile for Tax Benefits and Asset Protection: The TCJA and Recent Court Decision Change the Calculus,” The CPA Journal (October 2019), at p. 62.

17. See Monaeo, TaxDay and Taxbird as examples.

One of the most important aspects of the 2012 Tax Act1 for estate-planning professionals is that it made portability permanent (to the extent anything emanating from Washington can be said to be “permanent”).2 The term “portability” is shorthand among estate planners for the ability of a predeceased spouse’s executor to transmit to the surviving spouse the predeceased spouse’s deceased spousal unused exclusion amount (DSUEA). As a result, measured by 2020 numbers, spouses with an aggregate net worth of up to $23.16 million, without having to reallocate ownership of assets between them before either of them has died, would be able to transfer all of their assets to any one or more persons, whether through judiciously timed gifts during life or testamentary transfers at death, and pay no federal gift or estate tax.

Among the significant limitations of portability are: (1) the DSUEA, unlike the basic exclusion amount, isn’t adjusted for inflation; and (2) any income and appreciation accruing after the predeceased spouse’s death aren’t sheltered by the DSUEA. That said, a major advantage of portability is that all assets that, at the death of the first spouse to die, would’ve passed under that spouse’s estate plan, in the absence of portability, to a credit shelter trust (CST) using the traditional approach, instead pass to the surviving spouse and will be included in the surviving spouse’s estate at his subsequent death—thereby generating a step-up in basis of the assets to their then fair market value3 and minimizing future capital gains taxes when they’re sold4—perhaps without subjecting the surviving spouse’s estate to estate tax liability.

Portability vs. CST

If portability is used in place of the traditional CST model, and if the surviving spouse doesn’t have a taxable estate (for example, because the spouses’ combined net worth was relatively modest to start with or due to poor investment results and/or consumption by the surviving spouse), the beneficiaries will save, at some point in the future when they decide to sell inherited assets, 20% in federal capital gains tax they would’ve paid on the spread between the basis immediately before the surviving spouse’s death and the sale price had a CST disposition been implemented. In this case, using portability is obviously the better course of action. A basis step-up with respect to the assets that had composed both spouses’ estates is secured at no tax cost.

If portability is used in place of the traditional CST model, and if the surviving spouse ends up with a taxable estate (for example, due to positive investment results and/or reduction in the basic exclusion amount during the surviving spouse’s life): (1) the amount of the estate exceeding the surviving spouse’s applicable exclusion amount5 will generate an immediate federal estate tax burden of 40%; and (2) the beneficiaries will save, at some point in the future when they decide to sell inherited assets, 20% in federal capital gains tax they would’ve paid on the spread between the basis immediately before the surviving spouse’s death and the sale price had a CST disposition been implemented. Whether portability turns out to be advantageous in this case depends on: (1) the amount of federal estate tax payable; (2) the amount of federal capital gains tax saved; and (3) how far in the future federal capital gains tax would’ve been paid if a CST plan had been used.

CST vs. Portability

For the most part, the opposite results may be expected if a CST approach is used. For purposes of this portion of the analysis, it’s assumed that the dispositive provisions of the CST confer on the surviving spouse a “formula” testamentary general power of appointment (GPA), that is, a general power that comes into existence at the surviving spouse’s death only to the extent its existence doesn’t generate federal estate tax.

If a traditional CST is implemented instead of portability, and if the surviving spouse doesn’t have a taxable estate, the beneficiaries will save, at some point in the future when they decide to sell assets received from the CST, 20% in federal capital gains tax they would’ve paid on the spread between the basis immediately before the surviving spouse’s death and the sale price but only to the extent the formula testamentary GPA comes into existence at the surviving spouse’s death. The smaller the size of the surviving spouse’s estate, the larger the amount of the CST’s assets to which the formula testamentary GPA would apply—thereby generating a basis step-up. If the value of the surviving spouse’s estate is equal to the surviving spouse’s basic exclusion amount, the formula testamentary GPA will be irrelevant. Whether the loss of basis step-up resulting from not using portability turns out to be seriously detrimental depends on: (1) the amount of federal capital gains tax that could’ve been saved; (2) how far in the future federal capital gains tax would’ve been saved; and (3) the amount of federal estate tax saved by using a CST. If the value of the surviving spouse’s estate is zero or close to zero, the formula testamentary GPA will deliver essentially the same tax result as portability (albeit only because, in this circumstance, the predeceased spouse’s basic exclusion amount isn’t used because it’s not needed).

If a traditional CST is implemented instead of portability, and if the surviving spouse does have a taxable estate: (1) the amount of the estate exceeding the surviving spouse’s basic exclusion amount will generate an immediate federal estate tax burden of 40%; and (2) the formula testamentary GPA will be irrelevant. Whether sacrificing basis step-up (which could’ve been secured by using portability) is offset by excluding the value of the CST’s assets from the surviving spouse’s taxable estate depends on: (1) the extent of net investment return generated by those assets inside the CST during the surviving spouse’s life; (2) the amount of federal capital gains tax that could’ve been saved; (3) how far in the future federal capital gains tax would’ve been saved; and (4) the amount of federal estate tax due.

Pick Your Poison

The portability option will be compelling in those cases in which it’s virtually certain that the combined estates of both spouses will have insufficient value to generate federal estate tax liability at the death of the surviving spouse.

The portability option may be attractive in those cases in which it’s expected that: (1) the combined estates of both spouses won’t generate significant federal estate tax liability at the death of the surviving spouse; and (2) the estate of the surviving spouse will contain highly appreciated assets.

The CST with formula testamentary GPA option may be attractive in those cases in which it’s expected that the resulting federal estate tax savings on the increase in value of the CST’s assets during the surviving spouse’s life will offset the present value, at the surviving spouse’s death, of the amount of federal capital gains tax that could’ve been saved had portability been used.

It’s a metaphysical impossibility to achieve both basis step-up at the surviving spouse’s death of all assets that had composed both spouses’ estates plus exclusion from the value of the surviving spouse’s gross estate of all net investment return during the surviving spouse’s life generated by assets that were, or could’ve been, funneled into a CST at the death of the first spouse to die.  

Endnotes

1. American Taxpayer Relief Act of 2012 (P.L. 112-240, H.R. 8, 126 Stat. 2313, enacted Jan. 2, 2013).

2. Portability was introduced into the law by Section 302(a)(1) of the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (P.L. 111-312, H.R. 4853, 124 Stat. 3296, enacted Dec. 17, 2010), amending Internal Revenue Code Section 2010(c).

3. IRC Section 1014(a).

4. It’s assumed that the value of assets will increase with the passage of time—a usually safe, but not rock-solid in all cases, assumption. Also worthy of note is that the value of assets only very rarely increases in a linear fashion.

5. Section 2010(c)(2).

On Jan. 11, 1999, the very first day I began practicing law, the federal estate tax applicable exclusion amount (the exemption) was a modest $650,000 per individual, and the concept of portability between spouses didn’t exist. As a result, the opportunities to apply my fairly new estate tax planning knowledge were plentiful. Every client who had a large life insurance policy, had been a good saver, was a moderately successful professional or owned a profitable business had a need for estate tax planning. 

Over the years, the exemption has steadily increased, and with the passage of the Tax Cuts and Jobs Act of 2017, it’s jumped dramatically: The exemption as of this writing is $11.58 million per individual. Further, married couples can share their exemption with one another under the portability rules.1 For most estate planners, the frequency with which we can apply advanced estate tax planning techniques on behalf of our clients has diminished considerably. When one tax planning door closes, however, another one opens. While the change in the law causes less opportunity to use pure estate tax planning techniques, it does give us planners the incentive to serve clients with solid income tax planning options. 

One such opening involves ownership of qualified small business (QSB) stock. Under Internal Revenue Code Section 1202, certain taxpayers who acquire original-issue QSB stock and hold it for at least five years may have the ability to exclude some or all of its unrealized capital gains, as well as the associated 3.8% Medicare surtax (that is, net investment income tax (NIIT)). Let’s take a brief look at the details.

What’s QSB stock? 

IRC Section 1202 strictly defines “QSB stock.” Here’s an oversimplified summary: First, the issuing company must be a domestic C corporation. Second, the company’s assets can’t exceed $50 million between Aug. 10, 1993 and the date of the issuance of the stock. Third, the corporation must use at least 80% of the company’s assets2 in the active conduct of its business.3 Finally, the company can’t be a personal services business.4

Sale of QSB Stock

Does the sale of all QSB stock qualify for the exclusion of tax on sale? Not all QSB stock can qualify for the sale exclusion. Specifically, under Section 1202:

• The QSB stock must be purchased by or paid to the shareholder as originally issued stock. It can also be received as a gift or inheritance from someone who held it this way. The QSB stock can’t be purchased from a prior owner. Note: The holding period tacks on to the stock if it’s given to/inherited by another person or if the company converts the stock to another class, engages in a stock split or engages in a reverse stock split.

• The QSB stock must be held for at least five years to get the 100% exclusion from tax. If it’s held between one and five years, the gains are treated like any other capital gains and taxed at up to 20%. If held under one year, then the gains are short-term capital gains and taxed as ordinary income. 

Assuming the statutory predicates are met, the taxpayer may exclude up to the greater of: (1) $10 million5 less the sum of any gains already taken by the taxpayer for that specific issuer in
previous tax years;6 or (2) 10 times the taxpayer’s adjusted cost basis of QSB stock of the issuer that was disposed of during the same tax year. On the taxpayer’s personal income tax return for the year of the sale, he must file Internal Revenue Service Form 8949 to indicate the QSB stock treatment, as well as indicate it on his IRS Form 1040 Schedule D. 

It’s strongly recommended that the shareholder get a formal written certification from the QSB attesting to the fact that the relevant stock was QSB stock. This certification is to be held in case of audit. It’s also recommended that a shareholder maintain sterling documentation showing: (1) when the QSB stock was obtained, (2) how it was obtained (purchase, compensation, gift or inheritance), (3) if purchased, the amount paid, (4) proof of payment, (5) copy of the stock certificate, and (6) a calendar notation showing when the 5-year holding period occurs. 

Example of Tax Savings

As stated above, if an owner of QSB stock sells it, up to the greater of $10 million or 10 times the cost basis of the stock can be realized tax-free. Here’s an example that illustrates the advantage of this tax benefit: 

• In 2012, Dr. Christopher Client, a talented biochemist, joined a pharmaceutical startup that was a QSB. He purchased or was paid a block of 100 shares of QSB stock for $0.01/share for a total cost basis of $1. The company directly issued the shares. After successful clinical trials and a public offering, Dr. Client’s shares are now worth $20 million. Dr. Client would like to sell the shares but wants to minimize the taxation of the unrealized gains. (Due to the low basis, virtually 100% of the sales proceeds would be taxable.)

• After obtaining a written QSB stock certification from the proper officer of his employer, Dr. Client sells $10 million of his QSB stock and has his accountant complete and file the proper tax forms. Because his basis is $1, Dr. Client is able to exclude the entire amount realized from federal capital gains tax. He avoids $2 million in capital gains tax, and another $380,000 in NIIT, for a total savings of $2.38 million.  

The above number shows just how advantageous the possession of QSB stock can be. But, what if Dr. Client wants to use Section 1202 to shelter the gains from the sale of the remaining $10 million of QSB stock that he possesses? Can he do that? The answer is that he can. 

Some practitioners might believe that he could transfer his remaining shares to his wife and have her sell them. At first glance, this seems to be a good idea. However, an examination of Section 1202 makes me doubt the prudence of this strategy. The statute7 doesn’t provide that a married couple filing jointly can double the articulated limit, but it does expressly state that a married couple filing separately can’t shelter the greater of $10 million or 10 times basis. Instead, they can only shelter the greater of $5 million or 10 times basis. Thus, it would seem that the spirit of the statute is to hold the ability of a married couple to shelter gains to the limit set in Section 1202(b). 

Fortunately, Section 1202(h)(2) allows a separate taxpayer8 to receive QSB stock by gift or inheritance and then enjoy the full amount of the statutory tax exclusion. So, in our example, Dr. Client can give the balance of his QSB stock to a taxpayer other than his spouse, and that taxpayer can get the full exclusion from capital gains and NIIT. Possible recipients could be the children of Dr. Client or irrevocable non-grantor trusts for their benefit. Of course, before recommending such a gift to his client, an estate-planning attorney would be well advised to weigh the estimated income and NIIT to be saved from this strategy against the anticipated estate tax impact that would occur as a result of that gift. 

What if Dr. Client would like to get the full QSB stock treatment for his remaining shares without giving them away to another taxpayer? A review of Section 1202(h) shows that Dr. Client could create an inter vivos non-grantor qualified terminable interest property (QTIP) trust for his spouse and then transfer the shares to that trust. The transfer would qualify for the unlimited marital deduction from gift tax under IRC Section 2523. Further, the non-grantor trust could then sell the shares and enjoy the full exclusion from capital gains tax under Section 1202. (In our example, if Dr. Client gave his remaining $10 million in unsold QSB stock to an inter vivos QTIP non-grantor trust for his spouse, and then the trust sold the stock, capital gains tax could be avoided up to the statutory limit.) 

Taking the “mile high” view, the client has the opportunity to double the amount of tax savings that he could otherwise enjoy if he kept the stock. In this way, capital gains from Dr. Client could shelter a full $20 million of QSB stock under Section 1202. The total tax benefit would double from the previous figure, going from $2.38 million to $4.76 million in capital gains and NIIT saved. 

Immediate Tax Savings

The foregoing discussion shows the tremendous immediate tax savings that planners can help a client with QSB stock obtain on the sale of his shares. In light of the increasing estate tax exemptions, and thus decreasing ability to provide relevant estate tax strategies to our clients, familiarity with powerful income tax planning tools is imperative to planning attorneys looking to remain relevant to their clients.  

Endnotes

1. See Internal Revenue Code Section 2010(c)(4).

2. Eighty percent by value. IRC Section 1202(e)(1)(A).

3. Thus, the company can’t be a pure holding company.

4. Per Section 1202(e)(3), companies in these lines of work can’t qualify: “any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees.” Further, the trade/business can’t involve banking, insurance, financing, leasing, investing, farming, raising or harvesting trees, the production or extraction of underground resources like gas and oil or the operation of a hotel, motel or restaurant. 

5. Or, $5 million for a married taxpayer filing separately. Section 1202(b)(3)(A).

6. Section 1202(b)(1).

7. See Section 1202(b)(3).

8. A “separate taxpayer” is one who doesn’t report income taxes on the same return as Dr. Client. The IRC and Treasury regulations are silent as to whether one can “stack” exclusions using gifts to grantor trusts (such as grantor retained annuity trusts or intentionally defective irrevocable trusts), and I’m aware of no cases that discuss this topic. Not wanting to be a test case, I would be reticent to advise a client to make gifts to a grantor trust to attempt to stack the Section 1202 exclusions. 

Imagine, for a moment, the following: Your clients, George and Elizabeth, have decided to update their documents. Their two daughters, Elizabeth (Lilibet) and Margaret, are getting older, and their estate plan is a little out of date. You explain that their current plan is a typical A/B plan with an estate tax sheltered family trust and a marital trust with separate trusts for their children on the surviving spouse’s death. Each child is given the power to withdraw half of the principal at 30 and the balance at 35. 

“Codswallop!” exclaims George. “That’s much too young. And, what if they marry some deadbeat? We must find another solution.”

After further conversation, you recommend lifetime trusts for the benefit of each child and her descendants. To provide flexibility, the trustees are given discretion to distribute income and principal for any beneficiary’s health, education, maintenance and support (HEMS), and the independent trustees may also make distributions to or among the beneficiaries in the independent trustees’ absolute discretion. On a child’s death, the remaining assets pass in further trust for the child’s then-living issue. 

Sounds simple? Imagine further that Lilibet grows up to be none other than Queen Elizabeth II and that all of the immediate members of the British Royal Family (her four children, eight grandchildren, eight great-grandchildren and counting) are permissible beneficiaries of the trust you just drafted.1  

Sprinkle trusts are often considered a simple way to provide for multiple beneficiaries within the same family. However, factors such as longevity, differing beneficiary needs, family dynamics and other unforeseen issues may turn a seemingly simple plan into a royal pain.2 From a fiduciary perspective, these conflicts are often manifested when a trustee begins serving and is managing distributions, investments and information. How can advisors help mitigate these issues?

Estate Plan Design

The advisor must understand not only the nature of the assets involved and the client’s tax planning objectives but also the client’s non-financial concerns. Who does the client intend to benefit? What’s the family dynamic? The client may desire a simple plan, but his family situation or goals may be complex.

When planning for a broad class of beneficiaries, the advisor may recommend a single pot trust (such as for minor children) or multiple separate trusts (such as for child and child’s descendants). Sprinkle trusts often seem simple to the client: one family, one document, one trust. One analogy often used by advisors is that the trustee will act like the head of the family and will manage trust assets as a parent does for children. When compared to multiple smaller trusts, a single trust may also allow for a broader degree of diversification, expanded investment options and reduced administrative costs.  

Sprinkle trusts tend to function best when the class of beneficiaries is relatively small, the beneficiaries are all from the same marriage and they’re similarly situated in terms of age, relationship to the grantor and relative need. When one or more of those variables changes, a sprinkle trust can be a source of tension and conflict. At a time when adult siblings, cousins and more distant relatives no longer live with one another, a sprinkle trust can force everyone into one financial “household.”  

Demographic Trends

What are some of the complicating factors advisors should consider?   

Longevity and Next Gen. Demographic trends such as longer life expectancies are one complicating factor. We often speak of the “Next Gen” as shorthand for young adults and Millennials. But, in the face of longer life expectancies, who really is the Next Gen? At age 71, Charles Philip Arthur George Mountbatten-Windsor, known to most of us simply as Prince Charles, is the Next Gen of British Royalty. At the time of this writing, Prince Charles is the longest serving heir apparent in British history and, if and when he finally takes the throne, he’ll be the oldest Royal to ascend to that position.3 

Although the Windsors have been blessed with long life expectancies (the Queen Mother was almost 102 when she died in 2002), what was the exception is now increasingly the norm. According to recent data from the Centers for Disease Control, the average life expectancy for individuals born in the United States in 1950 was 68.2 years, but for an individual born in the United States in 2017, it’s 78.6 years.4 Other data suggests that the wealthy may enjoy life expectancies between 10 and 15 years longer than poorer Americans.5    

This means that people are waiting a lot longer to inherit. It also means that even in the case of a simple trust for a child and her descendants, the class of beneficiaries of existing trusts may very well be three or four generations strong. What might it mean in the future for the trusts we’re drafting for families today?     

Complex families. Another potentially complicating factor is the increasingly complex structure of today’s modern family. While deeply rooted in tradition, the British Royal Family is in many ways reflective of modern societal trends. Although Queen Elizabeth II’s ascension to the throne is the result of her Uncle Edward’s then-scandalous decision to marry the divorcée, Wallis Simpson, three of her own four children have divorced, and two have remarried.6 Family dynamics seem to be increasingly fragile, as the recent decision of Harry and Meghan to decamp to Canada indicates. 

Fragmentation and complexity also exist in U.S. families. While marriage is generally on the decline, there’s also been a sharp rise in the share of marriages ending in divorce or widowhood. According to the Pew Research Center, the percentage of children living with two parents in their first marriage has dropped from 73% in 1960 to 43% in 2014.7 Blended families are common with the U.S. Census Bureau reporting that in 2004, 17% of all U.S. children ages 0-17 lived in blended families (defined as households including stepparents, step-siblings and/or half-siblings).8 Family structures are increasingly fluid with marriage, remarriage and cohabitation.9    

Other demographic trends. Advisors should consider other demographic trends, such as advanced paternal or maternal ages, generation gaps between the siblings from a parent’s first and second marriages and artificial reproductive technology.  

Complex Trust Administration

These factors can make administration of a sprinkle trust far more complex than the grantor or the advisor expected. It’s important to remember that the trustee’s fundamental fiduciary duties of loyalty, impartiality and administration apply to all beneficiaries, both current and remainder. Perhaps most challenging in this context is the duty of impartiality, which requires a trustee to treat beneficiaries equitably, if not equally, while taking into account the terms and purposes of the trust in all facets of trust administration, including distribution decisions, investment decisions and
communication with beneficiaries.10  

Investments. Investing the assets of a sprinkle trust may be challenging, particularly when beneficiaries have differing needs, expectations and risk tolerances. Unless otherwise provided in the trust instrument, a trustee must manage trust assets like a prudent investor by considering the purposes, terms, distribution requirements and other facts and circumstances in developing an overall investment strategy with risk and return objectives reasonably suited to the trust.11  Economic conditions, potential effects of inflation or deflation, expected tax consequences, expected total return and capital appreciation must be considered alongside the beneficiaries’ other resources, the needs for liquidity, regularity of income and an asset’s special relationship or value to the beneficiaries or the trust itself.12  

The comments to the Restatement (Third) of Trusts Section 90 note that “the divergent economic interests of trust beneficiaries give rise to conflicts of interest of types that simply cannot be prohibited or avoided in the investment decisions of typical trusts.”13 The current beneficiary may seek income whereas the remainder beneficiary may favor capital growth. Risk tolerance may vary greatly depending on the beneficiaries’ financial and other circumstances.14 In the context of a sprinkle trust, these competing interests may be exacerbated because the needs of individuals within the same class of beneficiaries, current or remainder, may not be fully aligned. Tools such as the power to adjust or a unitrust conversion can help mitigate these conflicts but still require careful consideration by the trustee.

Distributions. If the expectation is that the trustee will act like the head of the household in terms of managing distributions from a sprinkle trust, consider how that analogy falls apart when there are multiple branches of the family sharing in that trust. In exercising distribution authority, the trustee must consider the language of the governing instrument, the needs and relative resources of the beneficiaries and such other factors as may be required. Distribution discretion tends to fall into two broad categories: absolute discretion or discretion limited by an ascertainable standard. Tensions arise when the language is unclear, the class of permissible beneficiaries is broad or the relative financial situations of the beneficiaries vary. 

Absolute discretion. Trusts in which the trustee is given sole or absolute discretion to make distributions can provide the most flexibility, but they also can cause the most friction. A trustee who’s granted “sole” or “absolute” discretion must exercise that power “in good faith and in accordance with the terms and purposes of the trust and in the interests of the beneficiaries.”15 The trustee must communicate with all beneficiaries to understand their relative needs and consider the impact of any one distribution on the future needs of the others.  

Ascertainable standards. Ascertainable standards, such as the typical HEMS standard, are often easier for beneficiaries to understand but can also lead to disagreement when those beneficiaries live different lifestyles. This language, which is derived from the Treasury regulations, is generally interpreted to allow for a beneficiary’s reasonable expenses and not just the “bare necessities.”16 Bare necessities for one beneficiary may seem like luxuries to another.

In a multigenerational trust, the term “health” can pose special difficulties. What exactly did the grantor intend? Does it include alternative medicine, in vitro fertilization or cosmetic surgery? Should a beneficiary be required to maintain health insurance, or should the trustee pay those premiums directly? How can a trustee balance the long-term, chronic health needs of one beneficiary against the anticipated future needs of the other beneficiaries? “Education” can also be tricky. Public versus private colleges, scholarships, merit awards, inclusion of graduate education and the rising costs of higher education are all factors to be considered, particularly when the class of beneficiaries is broad and age differences are wide.17 

Sometimes, an ascertainable standard will be supplemented or modified by language referring to a beneficiary’s “lifestyle” or “standard of living.” While the grantor’s intent may be simply to ensure that the beneficiaries will be able to enjoy the same standard of living that they enjoyed during the grantor’s lifetime, such language can prove problematic, particularly if beneficiaries have chosen significantly different lifestyles. While the grantor may not be able to foresee the future for any beneficiary, planning attorneys might want to discuss these issues before defaulting to this type of language in a sprinkle trust.  

Consideration of other resources. Trustees often grapple with the question of whether to consider a beneficiary’s other resources. The decision can have a material impact, both on the trust’s balance sheet and on the beneficiaries’ psyches. A beneficiary with means may feel disadvantaged by a trustee who takes those outside resources into consideration, but needier current beneficiaries and remaindermen may be adversely impacted if a trustee doesn’t take outside resources into consideration. If the governing instrument directs the trustee to consider a beneficiary’s other resources, or, similarly, prohibits a trustee from doing so, the trustee’s course of action is relatively clear. If the instrument is silent, the trustee is placed between a rock and a hard place. 

There are three different schools of thought about a trustee’s duty when the instrument is silent.18 The first approach is that the trustee needn’t consider other resources, with the inference being that a beneficiary is entitled to support from the trust fund regardless of other means.19 Another view is that the trustee may consider other resources. A careful reading of the trust instrument is required as the determination may turn on the matter of a few words.20 The third view is that the trustee must consider the beneficiary’s outside resources before making any discretionary distribution decision.21 In states that have adopted this view, to what extent should a beneficiary’s outside resources be taken into account? In one Connecticut case, the court held that a trustee should look at outside resources, even to the point of potentially exhausting those resources, before exercising discretionary distribution authority.22 When beneficiaries have different financial resources, silence in the document can be a trap for an unwary trustee.  

Unequal distributions. Provisions authorizing unequal distributions can be a double-edged sword in the context of a sprinkle trust: allowing for much needed flexibility on the one hand, as well as potentially exacerbating long simmering family tensions on the other hand. Depending on their place in the class of beneficiaries, some beneficiaries may expect to receive priority, while others expect to be treated equally.  Absent specific language in the governing instrument, the trustee must consider the needs and interests of all beneficiaries—both current and remainder—when exercising discretion. Even when the purpose for which distributions (such as education) are to be made is clearly expressed, differences in ages among a large class can result in perceived inequality simply because of rising costs. 

Spilling the Tea

One of the fundamental duties of a trustee is to provide information and to account to the beneficiaries. While under the Restatement (Second) of Trusts, a trustee had no affirmative duty to provide information to a beneficiary except under limited circumstances, the more modern view is that the trustee must provide sufficient information about the trust assets and administration to enable the beneficiaries to protect their interests.23 Today, unless the governing instrument provides to the contrary, beneficiaries are entitled to know about the existence of the trust and to examine the trust property, trust accounts and statements.24 Depending on the jurisdiction and specific terms of the trust instrument, a trustee may be required to take a very proactive approach to communicating with the beneficiaries.25 Uniform Trust Code (UTC) states may require a trustee to provide the qualified or current beneficiaries with a complete copy of the trust instrument, relevant information about the trust assets and liabilities and administrative
details and a trust accounting at least annually and on termination of the trust or change in the trusteeship.26 Many non-UTC states also have enacted legislation that mandates the disclosure of certain information to trust beneficiaries on an annual or periodic basis.27   

At the same time that a trustee must provide information to the beneficiaries, the duty of loyalty also requires that a trustee avoid unwarranted disclosure of information acquired in the course of the fiduciary relationship, particularly when the trustee knows, or should know, that disclosure would be detrimental to a beneficiary.28  

Within a sprinkle trust, multiple beneficiaries with concurrent interests may all be entitled to information about the trust, its investments and distributions. A trustee may find that transparency can ignite family disputes and must be careful about what information is disclosed. Because all of the beneficiaries are entitled to receive statements on request, the beneficiaries will all have knowledge of distributions made to other beneficiaries. A grantor who wishes to limit the flow of information should clearly reflect that intention in the governing instrument. It’s also very common for one beneficiary to appoint himself as the “family spokesperson” who acts as a gatekeeper to the flow of information to and from the beneficiaries. Last, when the class of beneficiaries includes minors, information may need to be provided to such beneficiary’s parent who might be the dreaded son or daughter-in-law, or worse, ex-son or daughter-in-law. The advisor may also recommend that the trust be established in a state that allows for confidential trusts or the appointment of a “designated representative” to receive information on behalf of the beneficiaries.29  

Forestall Future Issues

So, what can advisors do to forestall future issues?

1. Establish priority (or lack thereof): While it’s fairly common to see language naming one beneficiary, such as the spouse or adult child, the “primary beneficiary,” it’s less common for the trust instrument to specifically state that no beneficiary or class of beneficiaries should have priority. 

2. Address outside resources: Don’t leave the document silent on this subject.   

3. Define ascertainable standards clearly:  Modifications can be muddy. Also, take care not to overdefine any standard when a beneficiary is also named as trustee or risk adverse tax consequences. 

4. Investment guidance: The grantor’s investment philosophy or attachment to particular assets may not be shared by more remote family members. Caution the trustee who blindly relies on retention provisions, particularly in states that don’t allow the waiver of the duty to diversify.

5. Privacy and information: Pay special attention to the provisions regarding accountings, notice and other information about the trust. Consider including provisions for the appointment of a notice recipient or other third-party fiduciary to represent the other beneficiaries if permitted by state law.

6. Provide an exit route: Entrust the trustee with the power to divide the trust into further subtrusts, decant into separate trusts or terminate the trust altogether.  Sometimes it may be best to say, “Arrivederci!” 

Endnotes

1. Michael Stillwell and Emma Dibdin, “The British Royal Family Tree,” Town & Country (Nov. 6, 2019), www.townandcountrymag.com/society/a20736482/british-royal-family-tree/.

2. See R. Hugh Magill, “Estate Planning and Trust Management for a Brave New World: It’s All in the Family . . . What’s a Family?” ACTEC L. J. Vol. 44, No. 3 at p. 257 (Summer 2019), for a comprehensive discussion about the changing nature of the family, demographic trends and wealth transfer planning.

3. Cecilia Rodriguez, “Prince Charles At 71: Breaking Records As ‘King In Waiting,’ In Photos,” Forbes (Nov. 15, 2019), www.forbes.com/sites/ceciliarodriguez/2019/11/15/prince-charles-at-71-breaking-records-as-king-in-waiting-in-photos/#2c0c3c666dac. Charles is the longest waiting heir apparent, having surpassed the prior record of 59 years, two months and 13 days set by his grandfather, King Edward VII, who inherited the throne from his mother, Queen Victoria.

4. U.S. Department of Health and Human Services, Centers for Disease Control, National Vital Statistics Reports, Vol. 68, No. 7, “United States Life Tables, 2017,” Table A, www.cdc.gov/nchs/data/nvsr/nvsr68/nvsr68_07-508.pdf; Women born in 2017 have a longer life expectancy than men born in the same year (81.1 years for women, 76.1 years for men).   

5. Raj Chetty, Michael Stepner and Sarah Abraham, et al., “The Association Between Income and Life Expectancy in the United States, 2001-2014,” JAMA 2016; 315(16):1750-1766.doi:10.1001/jama.2016.4266, jamanetwork.com/journals/jama/article-abstract/2513561#Results. 

6. Stillwell and Dibdin, supra note 1.

7. Pew Research Center report, “Parenting in America,” www.pewresearch.org/wp-content/uploads/sites/3/2015/12/2015-12-17_parenting-in-america_FINAL.pdf.

8. U.S. Census Bureau report, “Living Arrangements of Children: 2004,” www2.census.gov/library/publications/2008/demo/p70-114.pdf. 

9. In 2004, 3.3% of all children lived with a mother who experienced a marital event (divorce, death, marriage or remarriage) within the year. Ibid. While only 62% of children live with two married parents today (an all-time low), 15% are living with parents in a remarriage, and 7% are living with parents who are cohabitating. Only 46% of children living with two parents are living with parents who are both in their first marriage, a significant drop from 73% in 1960. Pew Research Center report, supra note 7, at fn. 7. 

10. The comments to Uniform Trust Code (UTC) Section 803 provide that “[t]he differing interests for which the Trustee must act impartially include those of the current beneficiaries versus those of beneficiaries holding interests in the remainder; and among those currently eligible to receive distributions.” See also Restatement (Third) of Trusts (Restatement Third) Section 79.

11. Uniform Prudent Investor Act (UPIA) Sections 2(a) and (b); Restatement Third Section 90. 

12. UPIA Section 2(c).

13. Restatement Third Section 90, general cmt. (c).

14. UPIA Section 2, comments. 

15. UTC Section 814(a). See alsoEstate of Wallens, 9 N.Y.3d 117 (2007) (trustee granted broad discretion must act “reasonably and in good faith in attempting to carry out the terms of the trust”).

16. Treasury Regulations Section 25.2514-1(c)(2).  

17. For example, the College Board reports that from 1989-1990 to 2019-2020, inflation-adjusted average tuition and fees tripled at public 4-year institutions and more than doubled at public 2-year and private 4-year institutions, https://research.collegeboard.org/trends/college-pricing/figures-tables/average-published-charges-2018-19-and-2019-20.

18. For a comprehensive discussion, see Bridget A. Logstrom Koci, “Discretionary Distributions: Trust Decanting and Consideration of a Beneficiary’s Other Resources,” ACTEC Fiduciary Litigation Committee Meeting (Fall 2014). 

19. Restatement (Second) of Trusts (Restatement Second) Section 128, cmt. e. 

20. For example, see NationsBank of Virginia, N.A. v. Estate of Grandy, 450 S.E.2d 140 (Va. 1994) (trustee with “uncontrolled judgement and discretion” was entitled to consider a beneficiary’s other assets and to deny a discretionary distribution request where the beneficiary had substantial wealth outside the trust).

21. Restatement Third Section 50 comments. 

22. Guaranty Trust Co. v. New York City Cancer Comm., 144 A.2d 535, 547 (1958) (while the governing instrument authorized the trustee to invade principal, the court saw no reason to obviate the general rule requiring that the beneficiary’s other resources, both capital and income, be substantially exhausted before principal distributions were made). See also City of Bridgeport v. Reilly, 47 A.2d 865 (1946); Brennan v. Russell, 52 A.2d 308 (1947).  

23. Restatement Second Section 173, cmt. d provides, “[o]rdinarily the trustee is not under a duty to the beneficiary to furnish information to him in the absence of a request for such information.” John H. Langbein, “Questioning the Trust Law Duty of Loyalty,” The Yale Law Journal, Vol. 114:929, 931 (2005), at pp. 949-950, comparing the Restatement Second Section 173, cmt. d and UTC Section 813(a). 

24. Charles D. Fox IV and Thomas W. Abendroth, “Trustee’s Duty to Account and Disclose,” American Bankers Association Briefing/Webinar (April 5, 2018).  

25. UTC Section 813(a) provides that a trustee must keep the beneficiaries “reasonably informed about the administration of the trust and of the material facts necessary for them to protect their interests.”  

26. The Connecticut statute is one example. See Pub. Act 19-137, Sections 1-80, effective Jan. 1, 2020.  

27. N.Y. S.C.P.A. Section 2309(4) permits a trustee to retain annual commissions provided he gives an annual statement of the principal on hand, receipts and expenses to the income beneficiaries and to other beneficiaries on request.

28. Restatement Third Section 78, cmt. i. 

29. Certain states, such as Delaware, allow for “silent” trusts for at least some period of time and for a “designated representative” to be appointed to receive notice on behalf of and to bind the beneficiaries. For more information, see Jocelyn Margolin Borowsky, William Lunger and Gregory J. Weinig, “Silence is Golden—The Best Way to Set Up a Quiet Trust, Roadmap to Navigating the Issues and Pre-Mortem Validation,” 11th Annual Delaware Trust Conference (Oct. 25-26, 2016).

Jamie left her lawyer’s office with a great sense of relief. She’d just signed a new trust deed, created after months of planning with counsel. She felt that her beneficiaries would be protected now. But, when she tried to open an account using her new structure, the financial institution told her she couldn’t invest as she’d intended. Jamie’s expectations were frustrated as a result of incomplete and uncoordinated advice. 

These unintended client results stem from mirror blind spots among advisors—private client lawyers who aren’t aware of the issues and securities lawyers who’ve never been asked to focus on the private client world. The takeaway? Private client lawyers who serve global families need to find ways to bridge the information gap among tax, trust and securities laws.  

Many practitioners know much about international estate planning, trusts and the tax regimes affecting our ever-mobile clients, but we’re often unprepared when it comes to the mechanics of investing for these families or the securities rules, policies and investment vehicle distribution agreements that touch our well-crafted structures. True, your clients should talk to their financial advisors about investments—that isn’t the lawyers’ role—but the structures advisors create can generate unanticipated and unfavorable results when our cross-border clients seek to deploy their liquidity.

The U.S. securities laws impact the estate-planning world in countless ways—sales of partnership interests, pre-sale and pre-initial public offering considerations, grantor retained annuity trusts holding public company shares subject to insider trading rules—just to name a few. There are many reasons why private client lawyers and securities lawyers should team up. As attorneys become aware of common investment issues affecting international families, we hope such awareness will support a more collaborative approach among a client’s many professional advisors. 

The best place to start is with some examples, so let’s turn to Ida and her family.  

A Tale of Two Sisters

Ida left New York and returned to Israel to be with her sister, Julie, but she speaks to her trusted U.S. banker regularly. Recently, her banker started offering her non-U.S. funds because Ida lives outside of the United States. Ida may live in Israel now, but she’s a U.S. citizen, and she still pays U.S. taxes. These non-U.S. funds caused a mess on her tax return last year, and she wants to go back to U.S. products. What’s the problem?

Unlike her sister, Julie never moved to the United States, holds no U.S. passport and has always been an Israeli citizen. She thinks Ida’s banker does a great job, and she diversified her wealth in part by opening an investment account in New York with him. Julie gave her daughter, Rebecca, a power of attorney over her U.S.-custodied investment management account. Rebecca is a student in New York and can meet the banker in person. But suddenly, the banker wants to invest in U.S. products, and the change will trigger tax for Julie in Israel. What’s the problem?

The Ground Rules

Before it gets more complicated, we should lay out the ground rules. Cross-border tax advisors know that U.S. residency (and worldwide tax) can be triggered in various ways—holding U.S. citizenship, holding a U.S. Green Card or meeting the substantial presence test due to the number of days spent in the United States.1 As a U.S. citizen, Ida is a U.S. taxpayer. Her sister, Julie, isn’t tax resident in the United States. And, it’s possible that Rebecca may not be a U.S. taxpayer if she’s living in the United States as a foreign student through an F visa —but more facts are needed to determine Rebecca’s U.S. tax residency status.

What many advisors may not know is that Congress didn’t consult the Internal Revenue Code when it defined “residency” under the Securities Act of 1933 (the Act). Put a tax lawyer and a securities lawyer in the room together to discuss the term “residency,” and not only do you have the beginning of a really good party, but also you could recreate the famous Abbott & Costello “Who’s on First” skit. Unfortunately, the scope of this article doesn’t permit us to delve into the intricacies of how the Act defines “residency,” but here are the key takeaways:

A U.S. person includes (but isn’t limited to):

• A natural person resident in the United States

• A partnership or corporation organized under U.S. law

• An estate of which any executor/administrator is a U.S. person

• A trust in which any trustee is a U.S. person

• A non-discretionary account (other than a trust or estate) held by a fiduciary for the benefit of a U.S. person

• A discretionary account (other than a trust or estate) held by a fiduciary resident in the United States

A foreign person includes (but isn’t limited to):

• A discretionary account (other than a trust or estate) held for the benefit of a non-U.S. person by a dealer, or other professional fiduciary, organized in the United States

• An estate of which a professional U.S. fiduciary acts as executor/administrator, but sole or shared investment discretion is held by a non-U.S. person executor/administrator

• A trust of which any professional fiduciary acting as trustee is a U.S. person, if a trustee isn’t a U.S. person, has sole or shared investment discretion with respect to the trust assets and no beneficiary of the trust (and no settlor of a revocable trust) is a U.S. person

Why do these tax and securities law definitional differences matter? Because the structures we create for global families may be well designed to fit perfectly under the tax regime as “foreign” or “domestic,” but often, the mismatch of the tax and securities rules prevents clients from investing through their structures as originally intended.

The Act provides certain protections to U.S. resident consumers of investment products. Securities laws generally don’t regulate the product that’s sold, but rather the disclosures around the product, with the goal of giving investors in the United States enough information to make informed decisions. Investment advisors subject to the Act are prohibited from providing unregistered investment products unless an exception from registration exists.  

Increased Complexities

Let’s go back to Ida. Although she’s a U.S. citizen, she isn’t a resident investor under the Act. Her banker can no longer sell her U.S. products even though the account lists her as a U.S. resident taxpayer. The non-U.S. funds he recommends are passive foreign investment companies (PFICs) but for a U.S. resident taxpayer, these funds may create a burdensome and tax-inefficient investment result. One solution may be to use direct equity investments and bonds, but Ida isn’t happy about losing access to the fund platform. Not a great client result.  

Julie has the opposite problem. She isn’t a U.S. resident taxpayer, and she wants to have non-U.S. funds, but the decision maker on her account, Rebecca, may be considered a U.S. resident for securities law purposes. The investment manager can’t sell to a U.S. resident the non-U.S. funds. Rebecca could argue that her status as a student is transitory, and she shouldn’t be viewed as “resident” under the Act, but many financial institutions may not be able to accommodate that characterization.  

Ida and her sister illustrate the increasing complexities of managing liquidity for global families. Ida’s case is a textbook problem faced by Americans abroad. But, there are many other versions of this story, each more complicated than the next.  

For example, for succession purposes, a U.S. lawyer creates an irrevocable directed Delaware trust with a U.S. bank trustee for a Saudi family. The family office is located in Geneva and is named as the investment advisor in the trust deed, with full powers over the assets held in the trust. Counsel tells the client that the trust isn’t resident in the United States for income tax purposes even though there’s a U.S. trustee and the structure is governed by Delaware law. Having a non-U.S. investment advisor means that at least one of the trust’s substantive decisions is controlled by a non-U.S. person, so the trust fails the “control test”2 and is characterized as a nonresident for U.S. tax purposes.  

For securities law purposes, at first glance, the Act would tell us that the trust is a U.S. resident investor because it has a U.S. trustee, meaning that the clients potentially lose access to unregistered funds. But, the Act further defines a trust as a “foreign” investor if a trustee who isn’t a U.S. person has sole or shared investment responsibility, and no beneficiary is a U.S. person. Is the role of investment advisor under the trust document a fiduciary position, such that the non-U.S. family office may be characterized as a co-trustee? If so, then the rules say the trust is both a nonresident for U.S. income tax purposes and a nonresident investor for securities law purposes, the client’s preferred result. 

Law Mismatch

Change the facts slightly, and give the trust a Saudi protector, but the investment advisor is the trusted first born son who resides permanently in California. Now you’ve created a mismatch between tax and securities laws that may prevent your clients from achieving their desired investment goals.  

When managing liquidity, many non-U.S. clients use an underlying holding company (a private investment company (PIC)). If the PIC holds the U.S.-based investment account, is the identity and status of the trust’s investment advisor relevant for investor characterization under securities law? Probably not. A non-U.S. PIC would be considered foreign under the Act and foreign for tax purposes, helping us realign the tax and securities laws.  

But, if that account is held by a U.S. limited liability company (LLC) disregarded to the non-U.S. taxpayer, then the same mismatch concerns arise. The same could apply when a director of the foreign PIC with power over investments is a U.S. resident individual. 

Building off the PIC example, a French husband and wife are moving to the United States. They own their financial assets in a société à responsabilité limitée (SARL), which they can’t terminate quickly for French tax reasons. Their attorney advised them to make a check-the-box election to preclude controlled foreign corporation status of the company once they’re U.S. taxpayers. As a result of that election, the SARL is treated as a partnership for U.S. tax purposes because it’s owned 50/50 by husband and wife. The partnership files a W-8 IMY (Certificate of Foreign Intermediary, Foreign Flow-Through Entity, or Certain U.S. Branches for U.S. Tax Withholding and Reporting) with the financial institution, and the spouses file W-9s (Request for Taxpayer Identification Number) once they trigger U.S. residency. Despite the tax planning, they still have problems because the U.S. investment management account is owned by a foreign investor (the SARL) for securities law purposes: The check-the-box election for tax purposes isn’t relevant under the Act. The result is a limited investment portfolio for the husband and wife.    

An Italian family owns a non-U.S. company through which it holds the family’s investments. The shareholders are the three daughters, two of whom live in Italy and one in New York. The U.S. resident daughter treats the company as a partnership for tax purposes. The father, living in Milan, is the director of the company and has sole trading power. In this case, the securities law and tax law are a match—both are foreign. But, for our U.S. shareholder, the underlying investments of the company may create a tax-inefficient investment if they’re PFICs. Sometimes there’s no perfect answer, and the analysis centers on choosing the lesser evil.  

Regulation S  

Earlier in this article, we mentioned that financial advisors subject to the Act are prohibited from providing unregistered investment products unless an exception from registration exists. One important exemption to understand and apply when working with global families is Regulation S.3 The purpose of the Act is to protect consumers in the United States, but the U.S. financial industry must also be able to compete in a global world. Regulation S recognizes that the Act can’t extend to transactions that occur exclusively outside of the United States, and it provides a safe harbor when transactions (offers and sales) of unregistered securities occur outside of the United States. Regulation S doesn’t shield the issuer from compliance with any other securities regulations, but it does permit avoidance of the onerous and expensive SEC registration process, and it allows financial advisors to market securities outside of the United States (assuming the investments qualify under all local securities laws).

When global families have U.S. persons in control of their investment decisions (remember the trusted son living in California?) they may be shut out of the Regulation S exemption under the Act, because the marketing of the non-U.S. security is to a U.S. investor. But, Regulation S isn’t simple, and there’s always an exception to the exception. Under Rule 902 of Regulation S, a discretionary account held for the benefit of a non-U.S. person by a professional fiduciary incorporated or resident in the United States isn’t a U.S. person. What’s a “professional fiduciary?” The most commonly encountered professional fiduciaries are single family offices (SFOs), registered investment advisors (RIAs), domestic banks and insurance companies, but this isn’t an exhaustive list.    

What about Julie and her daughter Rebecca? Does the power of attorney establish a fiduciary relationship that qualifies Rebecca as a fiduciary, triggering the exception? Does it matter if Julie is really directing the investments, and Rebecca is simply the messenger? It’s unlikely that a standard bank power of attorney over investments is sufficient to qualify as a professional fiduciary, but if Rebecca established an RIA, then Regulation S would apply, and non-U.S. products would be available to be bought and sold in Julie’s account. 

An interesting carve-out for Regulation S is the SFO professional fiduciary exception. To qualify, an SFO must: (1) be a separate legal entity serving only one family, (2) be owned and controlled by the family, and (3) not advertise itself to the public as an investment advisor. Families that wish to fit into the SFO exception need to show that their company is operating as a legitimate SFO, and generally the rule wasn’t intended to cover the family’s PIC or holding company. In some cases, there are competing interests because it’s often more tax advantaged in the United States to act as a multi-family office instead of an SFO. Often, a non-U.S. family with accounts held by individuals or vehicles that are non-U.S. for tax purposes are serviced by a U.S.-based SFO. These clients can be sold non-U.S. products because the SFO exception applies.  

Acceptable Client

Lastly, over and above the tension in the rules arising from tax law and securities law, there’s the further complication of what an investment fund deems as an acceptable client and what the distribution agreement stipulates when that fund is marketed. For example, a European mutual fund may say in its prospectus that it won’t accept a U.S. investor as that term is defined under U.S. security laws, so if a U.S. LLC disregarded to a nonresident taxpayer attempts to make a placement, it will be rejected. Similarly, the fund’s distribution agreement may preclude distribution to a U.S. taxpayer, even one who for securities law purposes is deemed to be a non-U.S. investor. 

Involve the Investment Professional

Addressing succession planning, tax and trust law is complicated and sometimes overwhelming for our clients. From the advisor’s standpoint, adding yet more complexity to the conversation may not be beneficial to the main goal of creating a structure or providing a solution to the client’s estate-planning concerns. However, while nothing’s perfect, it’s important not to view the situation from one lens: The result will be a hefty legal bill for only a partial resolution, or you may have created one problem while solving another. Involving the investment professional in your planning conversations at an appropriate juncture is an ideal way to raise this issue . . . or make sure to befriend that securities lawyer!  At a minimum, your cross-border family client will be better served by an estate-planning attorney who’s aware of this issue and can direct the client to have an active conversation with his investment professional.  

— J.P. Morgan, its affiliates and employees do not provide tax, legal or accounting advice. The tax-related material contained herein has been prepared for informational purposes only, and is not intended to provide, and should not be relied on, for tax, legal or accounting advice.  You should consult your own tax, legal and accounting advisors before engaging in any financial transaction.

Endnotes

1. See Internal Revenue Code Section 7701. 

2. Treasury Regulations Section 301.7701-7.

3. 17 C.F.R. 230.901 through 230.904 encompass the Regulation S rules under the Securities Act of 1933.

Increasingly, marriages and families span international borders with different mixes of citizenships and national origins. High profile cases such as Prince Harry’s marriage to American Meghan Markle make headlines; however, even non-royal families commonly face complex international tax issues. Encountering a cross-border planning issue is no longer a rare event for many U.S. professional advisors.

Estate and income tax planning may be challenging under normal circumstances, but mixed nationality families face added challenges (and opportunities). When one spouse is a U.S. citizen and the other isn’t, typical U.S. estate planning and investment strategies may be counterproductive and ignore certain advantages. Let’s review several tax disparities between spouses who may be nonresident aliens (NRAs) and U.S. residents/citizens, where planning is helpful to optimize a family’s global balance sheet.

Residency vs. Domicile

U.S. citizens are subject to income and estate and gift taxation by virtue of their U.S. citizenship. For non-U.S. citizens, it’s critical to understand how the concept of residency (income taxation) is different from domicile (estate and gift taxation) to determine taxability.

When is a non-U.S. citizen subject to U.S. income tax? There are two main ways for a non-U.S. citizen to become a U.S. income tax resident. The first is by becoming a legal permanent resident, which means obtaining a Green Card. The second is called the “substantial presence test” (a day count test codified by the Internal Revenue Service). After meeting these requirements, U.S. income taxation applies to worldwide income and assets in the same way as to a U.S. citizen.

For example, a British executive moved from London to New York on an employment visa on Oct. 1, 2019 and intends to stay until Dec. 31, 2020. During 2019, he wouldn’t be considered a tax resident, and only his U.S. employment income is subject to U.S. taxation. However, during 2020, he would satisfy the substantial presence test becoming a U.S. tax resident, which exposes his worldwide income and assets to U.S. taxation.

What makes a person a U.S. domicile subject to U.S. estate and gift tax? U.S. citizens, domiciles and U.S. situs assets are subject to U.S. estate and gift taxation. A foreign national is a U.S. domicile if he intends to make the United States his permanent home with no present intention of leaving. There are no set rules for determining domicile, but obtaining a Green Card is an objective fact that points towards domicile. Courts also review family ties, employment, location of property and other subjective factors.

The same British executive who moved from London to New York on a short-term assignment (15 months) is likely not domiciled in the United States. The expectation is that he would return to London after the assignment. If, however, the executive extends his U.S. stay or acquires a Green Card, factors may point in favor of attaining U.S. domicile subjecting his worldwide assets to U.S. estate and gift taxation.

What taxes are imposed on NRAs? An NRA is the tax classification given to individuals who aren’t U.S. citizens, U.S. tax residents or U.S. domiciles. For income tax purposes, NRAs are generally taxed only on U.S. source income. For estate and gift tax purposes, NRAs may have estate tax exposure on their U.S. situs assets. U.S. situs assets generally include real and tangible personal property located in the United States. Unless modified by a bilateral estate and gift tax, NRAs only have a $60,000 estate tax exemption on U.S. situs assets. 

An NRA living in the United Kingdom and owning IBM stock (U.S. based company, U.S. situs asset) won’t face any extra U.S. taxation due to specific provisions in the U.S./U.K. estate tax treaty. However, if this individual moved to Dubai permanently, where there’s no estate tax treaty, the value of IBM is taxed at 40% on any amount over $60,000.

Pre-Immigration Financial Planning 

Pre-immigration financial planning is often overlooked, but essential for individuals immigrating to the United States in mixed nationality marriages. A non-U.S. citizen spouse with non-U.S. assets, foreign trusts or ownership in non-U.S. companies should contemplate certain tax elections and other considerations prior to U.S. immigration to avoid adverse taxation on becoming a U.S. tax resident and/or U.S. domicile. These strategies may be as easy as selling certain assets to as complex as setting up a trust or corporate structure.

One simple technique may be to accelerate the recognition of income and reset cost basis before immigration. There’s no step-up basis in assets on becoming a U.S. tax resident. This might make sense when immigrating from a low or no tax jurisdiction. On the other hand, there could be advantages to hold off on realizing losses until an individual is a U.S. taxpayer. Losses may be more beneficial to offset other U.S. taxes. This will depend on whether the tax rates in the home country are lower than those in the United States.

Another common strategy may involve using a drop-off trust to increase the cost basis in assets. A transaction between an individual and trust occurs to step up cost basis in assets before becoming U.S. taxable. This is an effective tool for individuals who need to sell non-U.S. funds, closely held businesses or other low basis assets during their U.S. residency.

The creation of trusts may also be appropriate prior to establishing U.S. domicile for estate tax reasons. For example, gifts of non-U.S. situs assets or the creation of a trust with non-U.S. situs assets, prior to establishing U.S. domicile, may effectively “quarantine” these assets from U.S. estate and gift tax if structured properly. This strategy becomes more complicated if a U.S. citizen spouse or other U.S. citizens are beneficiaries of the trust.

Timely implementation of a pre-immigration financial plan is of vital importance. Many of these opportunities no longer exist once an individual becomes a U.S. tax resident. Families should act sooner rather than later if immigration to the United States is a possibility.

Planning Strategies and Structures

A married couple who both are U.S. citizens have a combined estate exemption of $23.16 million (2020). In addition, U.S. citizen spouses may also use the unlimited marital deduction to transfer wealth, estate and gift tax free between each other. Families whose wealth is under the lifetime exemption limits often don’t need extensive U.S. estate tax planning.  

However, in a marriage in which one spouse isn’t a U.S. citizen (not merely a U.S. permanent resident/domiciliary), there’s no unlimited marital deduction. The U.S. spouse only has his lifetime exemption of $11.58 million (2020). Assets above this amount, even if passed to the non-U.S. spouse, are subject to estate and gift tax. Some strategies to use include the creation of a qualified domestic trust (QDOT), strategic lifetime gifting and asset titling.

QDOTs. U.S. citizens married to Green Card holders and non-U.S. citizens often use a QDOT. QDOTs were more common when the U.S. estate tax exemption limits were lower. Today, QDOTs are still an important planning tool for a U.S. citizen spouse with wealth approaching the $11.58 million lifetime allowance. 

A QDOT is a special kind of trust that allows non-U.S. citizens who survive a deceased U.S. citizen spouse to take the marital deduction, even if the surviving spouse isn’t a U.S. citizen. A QDOT may be elected after death by the executor of an estate to preserve these tax benefits. After assets are placed in a QDOT, the surviving non-U.S. spouse receives income from the trust but doesn’t own trust assets. Trust distributions of income to the non-U.S. citizen surviving spouse are exempt from the estate tax. 

It’s important to keep in mind that a QDOT only defers estate taxation; U.S. estate taxes will still be due at the surviving spouse’s death. To avoid this, a non-U.S. spouse may acquire U.S. citizenship. This strategy is only possible if either the surviving spouse was a U.S. resident at decedent’s death, or no taxable distributions were made from the QDOT prior to the surviving spouse becoming a citizen.

A QDOT may not always be the best solution for a mixed nationality couple. If the non-U.S. citizen spouse lives or intends to live in a jurisdiction that doesn’t recognize or punitively taxes trusts, a QDOT may be counterproductive. An alternative strategy may be purchasing life insurance within an irrevocable life insurance trust that can provide for the estate tax on the death of the U.S. citizen spouse.

Inter-spousal gifting. As discussed above, there’s no unlimited marital exemption between a transfer from a U.S. spouse to a non-U.S. spouse. There is, however, a special annual exclusion amount of $157,000 (2020) for these gifts above the normal $15,000 annual gift allowance (2020). Before gifting, local country estate and inheritance taxes must be closely reviewed. It might be punitive for a family to transfer assets into a jurisdiction with higher taxes.

One lifetime gifting strategy may involve gifting appreciated assets to a non-U.S. spouse. If the non-U.S. spouse lives in a country with no income tax, the appreciated asset may be sold with no U.S. capital gains. A recent U.S. Tax Court decision, Hughes v. Commissioner,1 strengthens this strategy. In Hughes, the IRS argued, and the court confirmed, that a gift of appreciated stock to an NRA spouse was a non-recognition of income event.  

A more aggressive strategy to remove larger amounts from a U.S. spouse’s estate may be structuring loans between spouses. The debt may eventually be forgiven by the U.S. spouse. In a country that doesn’t impose income taxation on this type of debt forgiveness, this may be another very tax advantageous strategy, but one with less U.S. legal precedent. 

Lastly, the United States doesn’t impose tax on a U.S. spouse receiving assets from a non-U.S. spouse. A U.S. taxpayer must report gifts of over $100,000 received from a non-U.S. person on IRS Form 3520. Careful attention should be paid to the gifting of U.S. situs property owned by an NRA, as this may inadvertently trigger U.S. gift taxation. 

Joint accounts and asset titling. Married couples commingle assets in joint accounts for practical and estate-planning considerations. However, common U.S. account ownership structures may create income and estate-planning issues when one spouse isn’t a U.S. citizen. The decision on how to title accounts will be very circumstance specific, but a few common issues are described below.

Generally, one-half of the value of a joint property is included in the decedent spouse’s estate if both are U.S. citizens. If a surviving spouse isn’t a U.S. citizen, the entire value of the joint property will be included in the estate of the first-to-die U.S. citizen spouse’s estate. This assumption is rebuttable to the extent that the personal contributions of the non-U.S. spouse may be substantiated in acquiring the property.

Income tax considerations must also be considered. On a joint U.S.-based account, an investment custodian will generally report all income on IRS Form 1099 issued to the U.S. citizen spouse. The income may shift to the non-U.S. citizen spouse through a special tax filing, but this may not always be advantageous. On non-U.S. financial accounts, the IRS may look to local property laws and contributions to determine who the beneficial owner is for tax purposes. The U.S. citizen spouse may face complex U.S. taxation specific to foreign financial assets. 

There may be some advantages to joint ownership, including possibly ease of transfer at death. However, often, there may be considerable tax savings if spouses with different tax statuses keep assets in separate accounts.

A more permanent method of avoiding U.S. taxes is expatriation. See “Relinquishing U.S. Citizenship,” p. 32.   

Other Planning Considerations 

Implementing holistic wealth management is more than tax and legal structures. Given the different income and estate tax statuses, there may be some very strategic options when positioning investment strategies and other financial planning considerations. 

Asset allocation. When a couple resides outside of the United States and maintains different tax statuses, there may be some very strategic planning on which spouse owns certain assets. This is particularly true in low or no tax jurisdictions. For example, the non-U.S. spouse should focus on holding non-U.S. situs assets and U.S. tax-inefficient assets such as investments that would be considered passive foreign investment companies (PFICs) under IRS rules. On the other hand, the U.S. citizen spouse may want to focus on owning U.S. assets that may have income tax withholding and would be considered U.S. situs for estate tax if held by the non-U.S. spouse.

The NRA may also wish to focus on holding higher growth assets. This would avoid future capital gains on growth. In a country with no capital gains tax, the NRA’s higher growth assets may be treated like a Roth individual retirement account, as the growth will be tax free! 

Retirement accounts. Care should be taken if an NRA owns an Internal Revenue Code Section 401k or IRA. These U.S. retirement assets will be considered U.S. situs assets for estate tax purposes. If an individual is resident in a country where this is the case, it may be an effective strategy to liquidate U.S. retirement accounts to decrease the size of a U.S. taxable estate (country-specific income tax withholding must also be considered). 

U.S. Social Security. A non-U.S. citizen spouse may be entitled to receive U.S. Social Security spousal benefits. For any spouse who isn’t a U.S. citizen or Green Card holder, the general rule is that Social Security payments must stop if the spouse lives outside of the United States for six consecutive months. However, there are many exceptions based on either the receiver’s country of citizenship or residence that allow payments outside of the United States to continue. Many international families don’t realize that most non-U.S. spouses may receive U.S. Social Security when living abroad under many circumstances.

Life insurance. Properly structuring life insurance policies between a U.S. and non-U.S. spouse is critical. Proceeds from a life insurance policy on the life of a non-U.S. spouse generally aren’t U.S. situs assets and aren’t subject to U.S. estate tax. Additionally, life insurance may be a great tool to protect a family if an individual becomes inadvertently U.S. domiciled. The life insurance proceeds may be used to pay estate tax exposure. 

Holistic Planning 

An integrated financial plan will not only consider legal rules but also the subjective needs of the individual family. Families may feel uncomfortable gifting assets to their spouse/children, setting up irrevocable trusts or engaging in other more permanent planning strategies. A strategy that works for one family might not be suitable for another family with different goals and values. 

Advisors should work hard to understand a client’s intentions while also managing multijurisdictional legal requirements. One thing is certain: Families must plan for laws to change, and it’s important to keep strategies flexible. Families will move to different jurisdictions, laws will change and planning strategies should evolve. It’s important for mixed nationality couples to develop a plan that not only is tax efficient and compliant but also suits the goals and circumstances of their relationship to protect and build the family’s international wealth for current and future generations. 

Endnote

1. Hughes v. Commissioner, T.C. Memo. 2015-89 (May 11, 2015).

Does the use of trusts allow clients to efficiently protect investments made abroad against adverse actions of foreign states? While the trust concept existed in common law jurisdictions for many centuries,1 if asked a decade ago, this question most probably wouldn’t have attracted significant practical interest. Although by that time, trusts were already routinely used in a wide variety of international commercial and investment transactions, such use was overshadowed by their traditional perception as a device for organizing intergenerational wealth transfer as well as an asset protection tool2 or, in the case of offshore trusts, as a device for obtaining confidentiality and tax advantages or, even, tax evasion.3

The utility of trusts as vehicles for making foreign investments started to gradually come out of these shadows in the beginning of the 2010s with the introduction of the global Standard for Automatic Exchange of Financial Account Information in Tax Matters—the Common Reporting Standard.4 Even though the exact scope of application of this standard to different types of trusts may still be open to a certain debate, on its face, it was broad enough to make residents of jurisdictions participating in automatic exchange of information seriously consider possible consequences of discovery of their undeclared foreign trusts by national tax authorities.5 Unsurprisingly, certain users of foreign trusts, who were previously paying significant amounts of money for their creation and maintenance, had to ask themselves whether these expenses were still justified, as the objective of getting tax advantages was becoming increasingly difficult to achieve. Once this question was asked, the search for a possible answer could have led them to consider using their existing trusts for other purposes, notably, as investment vehicles, or promptly liquidating them before being caught by the Taxman.

BEPS Project

An additional factor strengthening the perception of trusts as useful vehicles for making investments abroad was the launch of the OECD/G20 Base Erosion and Profit Shifting (BEPS) Project,6 resulting in the introduction of the “substantial activity” requirements7 and their extension to the so-called “no or only nominal tax jurisdictions.”8 Following these international developments, a number of such jurisdictions, notably, British Virgin Islands9 and Cayman Islands,10 amended their domestic legislation by introducing substance requirements. The most typical of them included the need to hire an adequate number of suitably qualified employees physically present in this location, to have adequate expenditures incurred in this jurisdiction, as well as physical offices or premises as may be appropriate for the core income-generating activities.11 Thus, from the perspective of entrepreneurs willing to continue their global operations out of these jurisdictions for reasons other than minimization of taxation, the introduction of the substance requirements inevitably resulted in increased operational costs. At the same time, as the substance requirements were applicable to corporate entities, but not to trusts,12 those unwilling to bear these costs could have considered restructuring their cross-border commercial and investment activities through trusts. As a result, the introduction of the substance requirements, rapidly becoming a global trend, combined with the comprehensible desire of business to mitigate increasing operational costs, may have inadvertently pushed entrepreneurs choosing an appropriate vehicle for structuring their foreign investments to turn to trusts.

Blue Bank v. Venezuela

While on the business side, the popularity of trusts as vehicles for making investments abroad is growing, and this trend is likely to continue, on the legal side, it’s hampered by the existing shortcomings of their protection under bilateral and multilateral international investment treaties.13 These shortcomings were clearly revealed by the decision rendered in 2017 by the arbitral tribunal operating under the auspices of the International Centre for Settlement of Investment Disputes (ICSID)14 in Blue Bank International & Trust (Barbados) Ltd. v. Bolivarian Republic of Venezuela,15 which became one of the first ICSID rulings expressly dealing with the status of trusts and their participants under investment treaties. In this decision, the arbitral tribunal ruled that the claimant, a Barbados company, acting in its capacity as trustee of the “Qatar Trust,” a trust set up under the laws of Barbados, couldn’t bring a claim under the bilateral investment treaty between Barbados and Venezuela. Unlike common law judgments, arbitral awards don’t have value of a binding precedent but will still certainly be carefully considered by tribunals subsequently addressing similar issues.16 Thus, in view of the ruling in Blue Bank, before using a trust for making investments abroad, a prospective settlor should carefully review the availability of protection to the trust as well as to its participants under applicable international investment treaties.

Shortcomings for Trusts

A major obstacle potentially hampering the widespread use of trusts as vehicles for foreign investments is that very few international investment agreements expressly include them in their definitions of “company” (“enterprise”), one of two categories of protected “investors” (another one is “natural persons”). A typical example of this definition may be found in U.S. bilateral investment treaties (BIT), based on the 1994, the 2004 or the 2012 U.S. Model BIT,17 notably in the 2007 United States-Azerbaijan BIT. That BIT provides that “company” means any entity constituted or organized under applicable law, whether or not for profit, and whether privately or governmentally owned or controlled, and includes a corporation, trust, partnership, sole proprietorship, branch, joint venture, association or other organization.18 A similar approach is used in certain BITs concluded by Canada,19 Hong Kong Special Administrative Region,20 Kazakhstan21 and Switzerland,22 as well as in the definition of “enterprise” in the 2018 United States-Mexico-Canada Agreement.23

Despite the absence of an express reference to trusts in a certain investment agreement, a trust can still be considered an “investor” within the meaning of this agreement, provided it fits under one of the broader categories listed in its definition. For example, the definition of “investor” in the Energy Charter Treaty (ECT)  includes “a company or other organization organized in accordance with the law applicable in that Contracting Party.”24 Viewed from the outside, the lasting relations among settlor, trustee, beneficiary and protector may create an impression of the existence of a certain organizational structure.25 Thus, one can argue that trusts could be considered “organizations” and, consequently, “investors” within the meaning of the ECT. However, in view of the absence of arbitral awards (let alone the binding precedents) on this subject, a potential settlor making large-scale investments into the energy sector through an English trust can’t be certain that in the event of a future dispute, his trust would be covered by the scope of this Treaty. This lack of certainty is likely to prevent investors from relying on trusts under the treaties that don’t expressly refer to them.

Another major obstacle that could potentially hamper the use of trusts as investment vehicles is the requirement that claimants other than natural persons willing to bring an investment treaty claim under the auspices of the ICSID shall be “juridical persons.”26 Unlike the so-called statutory trusts, such as Delaware statutory trusts, common law trusts aren’t juridical persons.27 Thus, even though certain investment treaties may expressly include trusts into the definition of “investor” and allow them to bring their claims against host states to the ICSID, this requirement would prevent common law trusts from benefiting from the well-developed institutional framework of the ICSID arbitration. Instead, to protect their rights as investors, these trusts would have to pursue their claims through other types of arbitration, such as under the auspices of the Arbitration Institute of the Stockholm Chamber of Commerce or in accordance with the Arbitration Rules of the United Nations Commission on International Trade Law. Although these other possible types of arbitration aren’t necessarily better or worse than ICSID arbitration, this limitation certainly results in a significant restriction of common law trust’s procedural choices.

Shortcomings for Trust’s Participants

When a certain trust can’t directly bring its investment treaty claim, it may be safely assumed that each of the trust’s participants, namely the settlor, trustee, beneficiaries and, if appointed, protector, would seriously consider the possibility of bringing their individual claims against the host state. Because the trust assets are held in the name of its trustee, the trustee would naturally be the most likely candidate for the role of a prospective claimant with respect to these assets. Despite these reasonable expectations, in Blue Bank, the arbitral tribunal reached an opposite conclusion. Having analyzed the relevant provisions of the Barbados International Trusts Act (the Act), it noted that this Act was carefully drafted so as not to describe the legal relationship created between the trustee and the trust assets in terms of “ownership,” “legal title” or the like. Instead, the Act referred to the trust assets as a separate fund, not parts of the trustee’s “own estate” and provided that title to the trust assets was held “in the name of the trustee,” not that the assets were “owned” by the trustee.28 The tribunal concluded that by acting in its capacity as trustee, Blue Bank couldn’t be considered as having committed any assets in its own right, as having incurred any risk or as sharing the loss or profit resulting from the investment.29 In the end, on the basis of its analysis of the trust deed, it also pointed out that the party that would come closest to satisfying the requirements of “ownership” with regards to the assets of the Qatar Trust was a beneficiary of this trust.30

Because the tribunal reached its conclusions in relation to specific circumstances of a particular case, this decision by itself shouldn’t preclude trustees from acting as claimants with respect to trust assets under different factual circumstances. After all, the separation of legal title and beneficial ownership rights with respect to certain assets shouldn’t exclude the holder of a bare legal title (such as a trustee) from the protection under investment treaties.31 That’s why, while on its face the award in Blue Bank may appear to have far-reaching negative consequences for the investment protection available to trustees, its practical impact would be much more limited. Nevertheless, this decision still clearly reveals the major shortcoming of investment protection currently available to trust participants—the impossibility to accurately predict whether trust assets would be qualified as an “investment” made by this participant before the conditions of a particular trust are analyzed on the basis of a substance-over-form approach by an arbitral tribunal in the event of a dispute.

The application of this approach to the trust’s beneficiaries leads to the conclusion that their ability to bring an investment treaty claim would essentially depend on the scope of their rights with respect to the trust’s assets under a trust deed and the law applicable to this trust. From this perspective, a beneficiary of a fixed-term trust would have an easier task of justifying its status as a claimant than a member of a certain class of beneficiaries of a discretionary trust, whose rights haven’t yet been vested. On the other hand, as a protector doesn’t typically hold any legal title with respect to the trust’s assets, the recognition of these assets as his “investment” within the meaning of the applicable investment treaty would be highly unlikely, unless he also acts as settlor and/or beneficiary of a particular trust.

Applying the same approach to the settlor, one can conclude that his ability to bring an investment treaty claim against the host state for its actions adversely affecting the trust’s assets essentially depends on the scope of the settlor’s rights with respect to these assets. At one end of the broad spectrum of possible solutions, a settlor of an irrevocable trust without reserved powers couldn’t be considered as retaining control with respect to the trust’s assets and, therefore, wouldn’t be able to justify its status of claimant. At the opposite end of this spectrum, a settlor of a revocable trust retaining significant reserved powers and appointing himself as protector of this trust, with extensive powers over the trustee’s decisions concerning investment of the trust’s assets, could have an easier task in convincing an arbitral tribunal that these assets should be considered as his “investment” within the meaning of the applicable investment treaty. An obvious downside of this solution is the settlor’s risk that such trust would be recognized as a controlled foreign company (in case this concept exists in the legislation of the country of his tax residence) or, worse, considered a sham trust.

This impossibility to clearly determine the status of the trust’s assets as investments before the dispute arises certainly creates vast opportunities for lawyers to demonstrate to the arbitral tribunal their analytical skills and abilities of persuasion. However, for a prospective investor, understandably interested in stability and predictability, this situation would be clearly unsatisfactory. Thus, it may be expected that the quest for investment protection would lead to significant changes in the trust industry as well as changes in international trust law.

A Look Into the Future

A major change in the trust industry that may be already predicted is the increasing offering of trusts as vehicles for foreign investments by wealth management professionals operating in jurisdictions that expressly include trusts in the definition of “investor” in investment treaties. The United States is among the jurisdictions that have an extensive network of bilateral and multilateral investment treaties,32 many of which specifically refer to trusts. That’s why one may expect that U.S. wealth management professionals could clearly be among the possible winners in the short term.

One may also expect that more and more wealth management professionals operating in other trust jurisdictions attracted by these new opportunities would rapidly enter into the international race for new clients and their trust assets. To make their jurisdictions attractive for settlors using trusts for making investments abroad, national authorities may be tempted to enter into new bilateral investment treaties expressly referring to trusts or amend their existing treaties. Nevertheless, because the negotiation of an international agreement could require significant time, as a first step, the national authorities could already proceed with modification of their domestic trust legislation.

The first possible change could be the introduction into domestic legislation of statutory trusts, which would have the status of juridical persons and, consequently, would be considered “investors” under the treaties including organizations or juridical persons in their definition of this term. This change would contribute to further differentiation between the legal status of common law trusts primarily used for asset protection and estate planning and statutory trusts predominantly used for investment and commercial activities. The second possible change could be the amendment of domestic legislation with a view of clear denomination of the trustee’s title to the trust’s assets as legal ownership. This modification would address one of the reasons for denial of the claimant’s status as trustee in Blue Bank, namely the absence of such reference in domestic trust law. Thus, one may expect that the quest for investment protection would secure the place of trusts as vehicles for foreign investments for years to come and give this centuries-old legal concept a new lease on life. 

Endnotes

1. See, e.g., George T. Bogert, Trusts, 5-8 (6th ed. 1987); A.J. Oakley, Parker and Mellows: The Modern Law of Trusts, 1-6 (9th ed. 2008).

2. See, e.g., John H. Langbein, “The Secret Life of Trusts: The Trust as an Instrument of Commerce,” 107 Yale L.J. 165 (1997-1998); Steven L. Schwarcz, “Commercial Trusts as Business Organizations: Unraveling the Mystery,” 58 Bus. Law. 560-561 (2003).

3. See, e.g., Schmidt v. Rosewood Trust Ltd. (Isle of Man) [2003] UKPC 26 (par. 1), www.bailii.org/uk/cases/UKPS/2003/26.html; Stewart E. Sterk, “Asset Protection Trusts: Trust Law’s Race to the Bottom,” 85 Cornell L. Rev. 1035, 1048 (2000).

4. Organisation for Economic Co-operation and Development (OECD) (2017), Standard for Automatic Exchange of Financial Account Information in Tax Matters, Second Edition, OECD Publishing, Paris, at p. 3, http://dx.doi.org/10.1787/9789264267992-en.

5. OECD (2018), Standard for Automatic Exchange of Financial Information in Tax Matters—Implementation Handbook, Second Edition, OECD, Paris, Chapter 6 (Treatment of trusts in the CRS) (paras. 234-295), http://www.oecd.org/tax/exchange-of-tax-information/implementation-handbook-standard-for-automatic-exchange-of-financial-acccount-information-in-tax-matters.htm.

6. OECD (2013), Addressing Base Erosion and Profit Shifting, OECD Publishing, Paris, http://dx.doi.org/10.1787/9789264192744-en.

7. OECD (2013), Action Plan on Base Erosion and Profit Shifting, OECD Publishing, Paris, http://dx.doi.org/10.1787/97892642020719-en.

8. OECD (2018), “Resumption of application of substantial activities for no or nominal tax jurisdictions—BEPS Action 5,” OECD, Paris, at p. 11 (par. 21), www.oecd.org/tax/beps/resumption-of-application-of-substantial-activities-factor.pdf.

9. The Economic Substance (Companies and Limited Partnership) Act, 2018 (British Virgin Islands), https://eservices.gov.vg/gazette/sites/eservices.gov.vg.gazette/files/newattachments/Act%20No%2012%20--%20Economic%20Substance%20%28Companies%20and%20Limited%20Partnerships%29%20Act%202018-%20Revised%2017%2012%202018%20%28clean%29%20%281%29_0.pdf.

10. The International Tax Co-operation (Economic Substance) Law, 2018 (Law 45 of 2018) (Cayman Islands), www.gov.ky/portal/pls/portal/docs/1/12738510.PDF.

11. Supra note 9, art. 8(1)(b) (BVI).

12. Ibid., art. 2 (legal entity) (BVI); supra note 10, Schedule 1 (relevant entity).

13. Generally speaking, these treaties offer protection to the investments made by investors from one contracting jurisdiction in the other contracting jurisdiction by prescribing certain substantive standards of treatment of these investments by the host states. They also specify procedural methods for resolving international investment disputes through various types of arbitration.

14. The International Centre for Settlement of Investment Disputes (ICSID) was established in 1966 by the Convention on the Settlement of Investment Disputes between States and Nationals of Other States (the ICSID Convention), https://icsid.worldbank.org/en/Pages/about/default.aspx.

15. Blue Bank International & Trust (Barbados) Ltd. v. Bolivarian Republic of Venezuela, ICSID Case No. ARB/12/20, Award (April 26, 2017), www.italaw.com/sites/default/files/case-documents/italaw8768.pdf.

16. Bayindir Insaat Turizm Ticaret Ve Sanayi A.S. v. Islamic Republic of Pakistan, ICSID Case No. ARB/03/29, Decision on Jurisdiction (Nov. 14, 2005), par. 76, www.italaw.com/sites/default/files/case-documents/ita0074.pdf.

17. See 1994 U.S. Model Bilateral Investment Treaty, art. 1(a), available in Kenneth J. Vandevelde, U.S. International Investment Agreements, at pp. 817-824 (2009); 2004 U.S. Model Bilateral Investment Treaty, art. 1, Vandevelde, at pp. 825-852; 2012 U.S. Model Bilateral Investment Treaty, art. 1, https://investmentpolicy.unctad.org/international-investment-agreements/
treaty-files/2870/download.

18. Treaty between the Government of the United States of America and the Government of the Republic of Azerbaijan Concerning the Encouragement and Reciprocal Protection of Investments (Aug. 1, 1997), art. I(a), https://2001-2009.state.gov/documents/organization/43478.pdf.

19. Agreement between the Government of Canada and the Government of the Union of Soviet Socialist Republics for the Promotion and Reciprocal Protection of Investments (Nov. 20, 1989), art. I(d)(ii), www.treaty-accord.gc.ca/text-texte.aspx?id=101516 (applicable to the Russian Federation).

20. Agreement between the Government of Hong Kong and the Government of Australia for the Promotion and Protection of Investments (Sept. 15, 1993), art. I(b)(i), www.tid.gov.hk/english/ita/ippa/files/01.IPPAAustraliae.PDF.

21. Agreement between Japan and the Republic of Kazakhstan for the Promotion and Protection of Investment (Oct. 23, 2014), art. 1(3), https://investmentpolicy.unctad.org/international-investment-agreements/treaty-files/3283/download.

22. Agreement between the Swiss Confederation and the United Mexican States on Promotion and the Reciprocal Protection of Investments (July 10, 1995), art. 1(1), www.admin.ch/opc/fr/classified-compilation/20112855/199603140000/0.975.256.3.pdf.

23. Agreement between the United States of America, the United Mexican States and Canada (Dec. 12, 2019), art. 1.5, https://ustr.gov/trade-agreements/free-trade-agreements/united-states-mexico-canada-agreement/agreement-between.

24. Energy Charter Treaty, art. 1(7)(a)(ii), www.energycharter.org/fileadmin/DocumentsMedia/Legal/ECTC-en.pdf.

25. Article 11(2) of the Russian Tax Code lists trusts among foreign structures without legal personality.

26. ISCID Convention, art. 25(2).

27. National Conference of Commissioners of Uniform State Laws: Uniform Statutory Trust Entity Act 1 (2009).

28. Blue Bank, supra note 15, par. 169 (referring to the Barbados International Trusts Act, par. 3(2)).

29. Ibid., par. 163.

30. Ibid., par. 170.

31. See, e.g., Saba Fakes v. Republic of Turkey, ICSID Case No. ARB/07/20, Award (July 14, 2010), par. 134, www.italaw.com/sites/default/files/case-documents/ita0314.pdf.

32. As of Feb. 6, 2020, there were 39 bilateral investment treaties in force for the United States, https://investmentpolicy.unctad.org/international-investment-agreements/countries/223/united-states-of-america?type=bits.

Charitable planning in advance of the sale of a closely held business sounds like an effective way to minimize income taxes. The business owner donates stock to a charitable organization or to a charitable trust and receives a full fair market value (FMV) deduction against her income taxes, subject to certain adjusted gross income (AGI) limits. 

Using a basic example, consider a 100% shareholder contemplating a charitable gift of stock in advance of a sale. The business is worth $100 million, and the stock gift to charity is worth $20 million. The business owner will have income of $80 million ($100 million less a $20 million charitable gift) as well as an offsetting charitable deduction of $20 million, resulting in $60 million of taxable income on the sale. Unfortunately, the reality isn’t that simple. The success or failure of a gift of closely held stock in advance of the sale of the business depends on the following two factors:

1. The nature of the asset (for example, whether it’s a C corporation (C corp), an S corporation (S corp), a limited liability company (LLC) or a partnership); and

2. The type of structure you want to use for the gift (for example, private foundation (PF), donor-advised fund (DAF) or charitable split-interest trust such as a charitable remainder trust (CRT)).

The reason for this uncertainty is that there are certain tax traps that can get in the way of a successful gift. Let’s identify some of these pitfalls and how they apply to particular types of assets and charitable structures.

Types of Entities

Closely held businesses are organized as C corps, S corps, partnerships or LLCs. The structure of the business can have a major impact on the viability of a particular charitable gift.

A C corp is initially taxed at the corporate level, which means that the corporation itself realizes the benefit or burden of any tax characteristics of its specific income and loss. If the C corp pays out dividends to the shareholders, the shareholders are taxed on this amount as a dividend, independent of the tax characteristics of the corporate income. The other options described above are all flow-through entities, meaning that all income, loss, deductions and credits pass through to the S corp shareholders, partners or LLC members. Because there’s no tax at the entity level, the owners, not the entity, realize the specific tax characteristics. While flow-through entities are popular structures for closely held businesses, they pose distinct problems in the context of charitable giving. The fact that a C corp is considered a separate taxpayer makes it the easiest of the closely held structures to give to charity. Flow-through entities, on the other hand, trigger some of the tax traps discussed below.

Charitable Recipients

Closely held business owners engaging in philanthropic planning have a range of charitable structures from which to choose when considering a charitable gift in advance of the sale of the business. In addition to outright gifts to traditional public charities (like churches, hospitals and universities), alternatives include PFs, DAFs and charitable split-interest trusts such as CRTs. The choice of strategy may be influenced not only by the type of business entity but also by the specific advantages and considerations of the potential charitable recipients.

PFs

A PF is a charitable organization to which a donor can make contributions that qualify for income, gift and estate tax charitable deductions. It can be structured either as a trust or a corporation. A PF commonly receives its funding from and is controlled by one or a few private sources (usually an individual, family or corporation). The principal activity of a PF tends to be making grants to public charities and awarding scholarships to individuals (although some PFs also run charitable programs). The general rule is that a PF must expend 5% of its net asset value for charitable purposes annually. PFs involve a fair amount of administrative complexity and are subject to burdensome rules, but offer the greatest amount of control of all the charitable vehicles.

If a donor funds a PF with cash or qualified appreciated stock (publicly traded securities), the donor’s income tax charitable deduction is based on the full FMV of the amount contributed; otherwise, the deduction is limited to the lesser of the FMV or the cost basis. As such, and for other reasons discussed below, lifetime gifts of closely held business interests to a PF aren’t particularly attractive. In addition, a donor may deduct cash gifts to a PF only up to 30% of her AGI for the year and 20% for gifts of long-term capital gains property. Deductions in excess of AGI limitations can be carried forward for five years.

DAFs

A DAF acts much like a PF and is a much simpler philanthropic option in terms of administration when compared to a PF.

However, when using a DAF, the donor loses an element of control. Typically, a donor makes a gift to a sponsoring charitable organization (usually community foundations or commercial DAFs), which sets aside the gift in a separate account in the donor’s name, from which the donor suggests grants—typically to other public charities in which the donor has an interest. The donor doesn’t have legal control over grant-making decisions from the account—the sponsoring organization does, although legitimate grant recommendations are generally followed by the sponsoring charity. DAFs, at least with respect to the deductibility rules, are more attractive than PFs. As the organizations sponsoring DAFs are public charities, charitable contributions of closely held business interests held long term qualify for a full FMV charitable deduction. As a result of this tax advantage over PFs, DAFs are increasingly willing to accept contributions of closely held business interests, although because of the tax traps discussed below, such gifts may not always be tax efficient, and the sponsoring charity would typically look for a way to liquidate the assets in the short term (which shouldn’t be a problem if the business is being sold).

If a donor funds a DAF with cash, the donor may deduct the gift up to 60% of her AGI for the year and 30% for gifts of long-term capital gains property (like closely held business interests). Deductions in excess of AGI limitations can be carried forward for five years. 

CRTs

A CRT is one type of split-interest trust typically used when a donor wants to make a charitable gift in a tax-efficient manner but desires to continue to have an income stream on the contributed asset. A CRT is an irrevocable trust that provides for the payment of:

1. A specified distribution, at least annually;

2. To one or more individuals;

3. For life or for a term of years (not to exceed 20); and

4. With an irrevocable remainder interest to be paid to charity (a public charity or PF) at the end of the CRT term.

A CRT is a tax-exempt entity. There’s typically no capital gains incurred by the donor on the transfer of appreciated property to the trust or its subsequent sale by the CRT trustee. Note that if a CRT has any unrelated business taxable income (UBTI), it pays a 100% excise tax on such income. The donor of a CRT is entitled to an income tax charitable deduction equal to the present value of the charity’s remaining interest at the end of the CRT term, in some cases limited to cost basis (including transfers of property that aren’t cash or publicly traded securities), if a PF can be named as a remainder beneficiary. If the trust instrument provides that only public charities and DAFs can be named as remainder organizations, the deduction is based on the present value of the full FMV of the gift.

The minimum annual payout is 5% (but may be higher in certain circumstances). The payment can be a fixed amount annually (a charitable remainder annuity trust) or a percentage of the trust assets calculated annually (a charitable remainder unitrust). Although a CRT is a tax-exempt entity, distributions to the individual beneficiaries are subject to income tax (much like qualified retirement plan assets), based on a system of taxation unique to CRTs known as the “four tier system,” a “worst-in, first-out” method of taxation.

The Charitable Tax Traps

There are detailed and highly technical rules regarding a charitable entity’s investments and operations under the Internal Revenue Code. Many of these rules make various charitable contribution options involving closely held business interests difficult, undesirable or impossible. It’s important to be aware of these rules (the tax traps) before attempting a charitable gift of closely held business interests. Here are suggestions to help avoid the six most common of these tax traps.

1. Beware of S corps. Historically, charitable entities couldn’t be S corp shareholders. Transferring S corp shares to charity would terminate the S election. This changed in 1998, when legislation was enacted permitting certain charitable entities to be S corp shareholders. Unfortunately, for reasons discussed below, the provisions of the legislation weren’t attractive to donors or recipient charities.

When a charity owns shares of an S corp, all of the charity’s share of the S corp’s income and capital gains—and the capital gains on the sale of the S corp stock—will be considered UBTI and therefore taxable to the charity. In addition, a CRT isn’t a valid S corp shareholder. Therefore, a gift of S corp stock to a CRT will terminate the S corp’s status, causing it to convert to a C corp. Another potential problem for the donor is that if the S corp has inventory or accounts receivables (so-called “hot assets”), the donor’s deduction for the contribution of S corp stock will be reduced by the donor’s share of the hot assets, for which she won’t receive a deduction (similar rules apply for partnerships and LLCs).

Sometimes, when a charitable gift of S corp stock isn’t tax efficient, it may be possible for the S corp itself to make a gift of some of its assets to charity, with the charitable deduction flowing through to the shareholders.

2. Comply with onerous PF excise tax rules. Although these rules are referred to as the “private foundation excise tax rules,” they actually apply to PFs and to a limited extent to DAFs and CRTs. In general, if one of the excise tax rules is violated, a relatively modest excise tax is imposed initially, with the tax rate rising sharply if the prohibited act isn’t corrected within a certain period of time. The excise tax rules most relevant to charitable planning with closely held
business interests are the prohibitions against self-dealing (applicable to PFs and CRTs) and the prohibition against excess business holdings (applicable to PFs and DAFs):

• Self-dealing. The basic principle underlying the self-dealing rules is that all transactions between a PF and a CRT and a disqualified person should be prohibited, whether or not the transaction benefits the PF or the CRT. Disqualified persons include substantial contributors to the PF or CRT, as well as the officers, directors, trustees and certain employees of the PF or CRT. Subject to certain exceptions, the term “self-dealing” includes:

• A sale, exchange or leasing of property between a PF or a CRT and a disqualified person;

• Any lending of money or other extension of credit between a PF or CRT and a disqualified person. A disqualified person can make an interest-free loan to a PF if the proceeds are used entirely for charitable purposes;

• Any furnishing of goods, services or facilities between a PF or CRT and a disqualified person (with certain exceptions);

• Any payment of compensation by a PF or CRT to a disqualified person, except that payment to a disqualified person for personal services that are reasonable and necessary to carrying out the PF or CRT’s exempt purposes doesn’t constitute self-dealing if such payments aren’t excessive; or

• Any transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a PF or CRT.

Finally, if a disqualified person contributes closely held shares to a PF or CRT and retains some shares in her own name, every major decision by the business may need to be scrutinized to make sure that it doesn’t run afoul of the self-dealing rules.

As such, a PF or CRT should either sell the shares to a third party shortly after receipt, or the corporation should redeem the shares under the redemption exception to self-dealing to mitigate the self-dealing concerns.

• Excess business holdings. The IRC imposes an excise tax on a PF’s excess business holdings. A PF has excess business holdings when its holdings, together with those of disqualified persons, exceed 20% of the voting stock, profits, interest or capital interest in a corporation or partnership. Permitted aggregate business holdings are increased from 20% to 35% if it can be established that effective control of the corporation is in one or more persons who aren’t disqualified persons with respect to the PF. A PF has five years to dispose of excess business holdings acquired by a gift or bequest, and an extension of an additional five years can be requested (but isn’t guaranteed). During this time, the holdings aren’t subject to tax. DAFs are also subject to the excise tax on excess business holdings, but practically speaking, DAFs are likely to dispose of closely held stock before the 5-year grace period for excess business holdings ends. In the context of charitable gifts of closely held business interest in advance of a sale of the business, excess business holdings are rarely a problem because the business will typically be sold to a third party long before the end of the 5-year holding period.

3. Follow rules on UBTI. Although PFs, DAFs and CRTs generally aren’t subject to income taxation, an exception applies if the PF, DAF or CRT has UBTI. UBTI is income from an activity that constitutes a trade or business that’s regularly carried on and isn’t substantially related to the tax-exempt entity’s exempt purposes. UBTI is a particular problem for flow-through entities like S corps, partnerships and LLCs. As described above, any income or capital gains a charity receives from an S corp is deemed by statute to be UBTI and thus taxable. Partnerships and LLCs aren’t subject to UBTI by statute. An exempt organization can be taxed on its share of the income received from a partnership of which it’s a member, even though the partnership and not the exempt organization is the entity actively engaged in carrying on a trade or business. Most passive income received by the charitable entity, such as rents, royalties, dividends, interest and annuities, isn’t considered UBTI. Passive income will be considered UBTI to the extent leverage was used in connection with the investment.

UBTI is a particularly significant problem for CRTs because in any year that the trust has UBTI, there’s a 100% excise tax on that income. If a PF or DAF has UBTI, that income is subject to tax at regular corporate or trust income tax rates, depending on how the PF or DAF is organized.

4. Beware of characterization as a pre-arranged sale. In contrast to sales of publicly traded securities, sales of closely held business interests are privately negotiated. If a donor enters into an informal agreement or understanding to sell the appreciated property to a buyer prior to transferring it to a charity or CRT, and the property is actually sold to that buyer, the Internal Revenue Service may recharacterize the transaction as a sale by the donor personally rather than a sale by the charity or CRT. This means not only that the gain would be taxable, instead of being a tax-free sale by the charity or CRT, but also that the donor would have to pay the full capital gains tax out of her own pocket and can’t use any of the proceeds received by the charity or CRT to pay the tax.

5. Avoid reduction of value of charitable deduction due to minority interest discounts. If a closely held business owner transfers shares to family representing a minority interest in the business, she may be entitled to valuation discounts based on a qualified appraisal for lack of control and lack of marketability of those interests. These discounts may sometimes exceed 30%, depending on each business owner’s circumstances. Historically, the IRS and courts didn’t require significant discounts for minority interests in a closely held business gifted to charity or a CRT. In recent years, this has changed with both the IRS and the courts requiring that minority interest discounts be applied in determining the value of the charitable deduction for the gift. This reduces the value of the charitable deduction. There may be ways to mitigate the discount through the use of a “put right” (beyond the scope of this article) or by making the charitable contribution as close to the sale date as possible without triggering a pre-arranged sale and then obtaining a qualified appraisal after the sale is completed.

6. Avoid donating debt-financed property. Funding PFs, DAFs and CRTs with debt-financed property (including any underlying indebtedness of flow-through entities like partnerships or LLCs) is very difficult to accomplish in a tax-efficient manner for the following reasons:

• Debt-financed property can create a UBTI problem for the charity or CRT on income and gain from the sale of the business in proportion to the percentage of debt compared to the income or gain received. For example, if the flow-through business was 50% leveraged, then potentially 50% of all income or gain will be subject to UBTI.

• If the donor remains liable for the debt after gifting the property to a CRT, the CRT is treated as a grantor trust for income tax purposes. That means that it’s not a qualified CRT, and the donor loses the income and gift tax deductions, plus the trust loses its tax-exempt status. The donor will be liable for any capital gains taxes generated when an appreciated trust asset is sold.

• When a donor contributes debt-financed property to charity, the transaction is treated as a bargain sale for income tax purposes—that is, the donor is treated as having sold a portion of the property equal to the debt on the property and contributed the remainder to charity. This forces the donor to recognize gain on some portion or all of the outstanding indebtedness on the contributed asset value. The cost basis of the property is allocated between the sale and gift portions on a pro rata basis. This rule applies regardless of whether the underlying debt is recourse or non-recourse and regardless of whether the donor continues to pay the debt after the gift is made.

Planning After a Liquidity Event

If the facts and circumstances of contributing before the sale are problematic, 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 if the business owner receives cash in the transaction. Cash gifts to a public charity are deductible up to 60% of AGI in the year of the gift (with a 5-year carryforward for any excess contributions). All charitable vehicles are available post-sale, including outright gifts to public charities (including DAFs), gifts to PFs and gifts to CRTs. 

—This article is provided for informational and educational purposes only. The views and the opinions expressed in this article are those of the authors and do not necessarily represent or reflect the views of UBS Financial Services Inc. or its affiliates.

Businesses of all kinds must be vigilant to protect from prying eyes those communications that could reveal business secrets or prove damaging in later litigation. Family businesses are particularly vulnerable. Why? The formality typically built into corporate environments can be missing in family-owned/operated businesses. For example, family members commonly discuss business issues in informal settings, under unguarded circumstances and in conjunction with non-business matters. The danger? Such businesses face the loss of privacy and the inadvertent disclosure of issues, options, opinions and strategies.  

The situation can be compounded when communications occur in writing in non-traditional corporate settings. Family members often text or communicate via social media. Such writings often are done quickly, without careful deliberation over phrasing and language choices, without later editing, fact checking or legal reviews and without even a passing consideration of the potential for having to explain the communications months or years later in a court case.  

So, what can be done? Encourage your clients to be proactive. All businesses can take steps to reduce the risk of disclosing private information, being required in litigation to recount information that should have been protected by legal privileges or protections and having to explain unfortunate or inflammatory word choices. The bottom line? If your clients make deliberate choices now, they can ensure that they’re not the next “do not let this be you” anecdote being studied by others.  

High Risk of Disclosure

Very few businesses identify potential litigation issues at the time of underlying events. A decision is made. A contract is negotiated. An employee is separated. A competitive strategy is launched.  

It’s only later, when things have gone (or are going) poorly, that people start to wonder whether information exists—from correspondence or otherwise—that might be used against them. There’s no way to shelter all “normal course of business” communications from later scrutiny in litigation. However, there’s a particularly high risk of disclosure in family businesses. Why? Consider the following fact pattern.  

Family Corp. Quarterly Meetings

Family Corp. is a three-generation family business. The entire company is family owned. The family matriarch is the CEO. She and family members from all three generations meet once a quarter to candidly discuss business developments, risks, threats, competitive strategies and financial matters. Between “formal” quarterly meetings, family members of various generations see each other socially and communicate informally by telephone, text and social media.  

During a quarterly meeting, the CEO explains that recent competitive pressures have Family Corp. considering ways to reduce expenses. She’s concluded that the company can reduce costs through human resource adjustments. Historically, Family Corp. focused its employment strategies on stability. The company would interview, hire, reward and keep employees long term. Now, she says, Family Corp. needs to reevaluate hiring, recruitment and retention strategies.  

The CEO has just reviewed a study on recent employment trends. She learned that younger workers tend to be more mobile. They often move from job to job and don’t stay long enough to be rewarded and promoted. The CEO sees an opportunity to reduce costs. She proposes to replace long-term workers, who make more money, receive more benefits and have more accrued vacation, with lower cost entry-level workers. Done systematically over the next 18 months, she’s concluded that Family Corp. could save $1 million.  

Various family members voice opinions concerning the CEO’s proposed plans and strategies. Consistent with her general practice, during the meeting, one of the CEO’s siblings takes notes on her tablet. In addition, the CEO’s executive assistant takes more formal notes. He does his best to capture the overall gist of what’s said and who says it. The resulting notes are typed up and circulated before the next quarterly meeting. No one takes responsibility to verify or edit the notes.  

Two years later, Family Corp. is sued. Three former employees between the ages of 45 and 60 allege that they were fired and replaced by younger people in violation of state and federal anti-discrimination laws. They’re seeking more than $1 million in damages. Once the suit is filed, the attorneys for the plaintiffs demand that Family Corp. produce “all documents” concerning discussions about hiring, treatment and retention of workers based on age. Defense attorneys ask Family Corp. if there are any responsive documents and are told “no.”  

During depositions of family members, a witness mentions that there were oral discussions about “human resource issues” during quarterly board meetings. The plaintiffs’ attorneys press for details about what was said in the meetings. The deponent remembers that there was a plan to replace existing, long-term workers with new people. However, he tells the defense lawyers that he doesn’t wish to discuss the substance of quarterly meetings: “It was just family and was meant to be private.”  

Does the family member have to testify about what he remembers from the meeting? If so, what could Family Corp. have done to avoid this problem?  

Depending on the state where the meeting took place, generally the family member must testify to everything he remembers. For example, most states have no “board meeting” privilege. When business people get together to talk business, they should expect that if there’s a later legal proceeding, they may be asked for their personal recollections of what was said and by whom.  

Attorney-Client Privilege

Certain types of business decisions have legal consequences. If so, having legal counsel attend the meeting to field legal questions and provide legal advice can keep the substance of (at least some portions of) the meeting privileged from later disclosure or testimony. But, there are steps that must be taken to create and protect the privilege.  

It’s not enough merely to have an attorney in the room for meetings. For the privilege to arise, there must be both an attorney and one or more clients who are communicating. Who constitutes the “client” can vary state to state. Generally speaking, in a formal corporate setting, the client is the company itself, and the company will be represented by the executives of the company individually and as a group. So, a Family Corp. meeting attended by owners and counsel would have both an attorney and collectively a client.  

In addition to who must be present, for attorney-privilege to attach, there must be consideration of who may not be present. The attorney-client privilege doesn’t attach if the communications occur in the presence of someone other than the attorney and the client. For example, at the Family Corp. quarterly meeting, if vendors, customers or the public were present, the privilege wouldn’t arise. Exactly where that line is drawn can sometimes be difficult to know. Some states define “client” very narrowly in a corporate setting. The presence of Family Corp. employees, who aren’t owners or executives, might be deemed outside the group that the law considers the “client.”  

If the attorney and the client are present, and no one else is there, privilege still doesn’t automatically arise. The privilege doesn’t come simply from the presence of the attorney or from communication with or including the attorney. The privilege arises when the client seeks legal advice and/or when the attorney provides legal advice. That seems straightforward, but it isn’t always so.  

For example, during a Family Corp. quarterly meeting, there’s an extended discussion of corporate expansion. The attorney is asked about what she thinks of the plan to acquire property and build new facilities in an adjoining state. Whatever her opinion on this topic, what she says isn’t privileged. She’s being asked for a business opinion, not a legal opinion. This distinction can be complicated, especially in family businesses in which family members may be attorneys who also are owners or executives. Whether privilege exists as to certain conversations literally comes down to an analysis of the subject matter of individual topics.  

Fortunately, there are ways to increase the reliable application of the privilege. First, manage meeting attendees. If the goal is to keep discussion of certain topics privileged, know the law as to who constitutes the “client” and proactively limit attendance to those individuals who are either the attorney or attorneys and the client or clients.  

Second, create a meeting agenda in advance. You and your client need to determine which meeting topics will or may have legal implications. As part of the process, require attendees to submit meeting topics in advance for placement on the agenda, so that you can determine whether a topic is business, legal or a combination of both. With the agenda determined, divide the meeting between purely business topics and definite or potential legal topics. Write out the business topics. Create a separate agenda for legal topics. On the main agenda, after the business topics, state that the meeting will adjourn into executive sessions to discuss legal matters. On a separate agenda, place the words “Confidential—subject to attorney-client privilege” at the top and then identify the topics. Word the topics in ways that identify the expected legal aspects of each topic. For example, “discuss legal implications of proposed human resource planning.”  

Third, consider whether to include outside counsel in meetings. It isn’t necessary to have outside counsel present for the attorney-client privilege to arise. However, because in-house attorneys often provide both business and legal advice, having an outside attorney present on behalf of the company can strengthen a later claim that the conversations during the meeting are privileged. This is particularly true if the outside attorney attends only the executive session, during which legal issues are discussed.  

Fourth, actively manage the meetings. If during a meeting, a topic or conversation veers into an area that may have legal implications, you must step in, whether you’re inside or outside counsel. Before the discussion continues, you should ensure that the only people present are you and the client and then consider shifting the discussion into the executive session (if the conversation isn’t already taking place there). This can be challenging. Even innocuous topics can quickly meander into areas in which legal issues are or may be implicated. Having an aggressive, knowledgeable counsel at the meeting is the best defense.  

Fifth, manage the minutes. If the company is going to create written minutes, make sure that the minutes pertaining to any legal discussion are labeled as “confidential—subject to attorney-client privilege” at the time the minutes are created or shortly thereafter. This is just good procedure. Waiting until after a suit is filed before labeling the minutes is ill-advised and can be seen as tampering with evidence. While the company should label the minutes as soon as possible, it shouldn’t over designate. Some companies label every portion of every meeting minute entry as subject to the attorney-client privilege. Labeling everything, including purely business topics, as privileged can backfire. In litigation, a judge will ultimately determine what’s privileged. Experience has shown that judges look more skeptically at assertedly privileged material within larger documents that have blanketly labeled all information as “privileged.” Similarly, if entire documents are labeled as privileged, and a court later determines that the document or portions of the document aren’t privileged, a jury can be misled when shown an admissible document stamped as
privileged.  

Sixth, keep the privilege. If all of the necessary steps are taken, the privilege can be lost by deliberate or accidental waiver. If you or the client(s) share the privileged information with others, the privilege can be lost forever. For example, it isn’t uncommon in a family setting to have a company executive share communications from counsel with a spouse or another family member who isn’t considered the “client.” When that occurs, the privilege is waived.   

Meeting Minutes Policy

Under the original fact pattern, the CEO’s assistant provides to Family Corp. attorneys electronic copies of the minutes that he prepared. When the minutes are reviewed, some problems are discovered. There are typewritten abbreviations, including in the references to who’s speaking. Some of the entries read as if they’re attempts at verbatim statements, and others have indications of being paraphrased. There’s no reference to counsel or any attorney-client privilege.  

Making things worse, when Family Corp.’s attorneys show the notes to the CEO, she immediately begins shaking her head. “This isn’t what I said.” As she reads on, she concludes that large swaths of information that she believes were discussed aren’t referenced at all. The CEO’s deposition will be very difficult. How could this have been avoided?  

As already discussed, minutes pertaining to executive sessions involving attorney-client privileged matters should be created, verified, maintained and safeguarded so as to ensure the minutes are privileged from production in litigation. Minutes that don’t involve privileged information still must be carefully handled. The most important aspects of a meeting minutes policy are attribution, accuracy and completeness.  

The individual charged with creating meeting minutes has a big responsibility. From a business perspective, the minutes exist so that the company can track both the subjects discussed and the substance of that discussion. If both of those goals are accomplished, board attendees or other authorized individuals can either determine what happened at a meeting they missed or refresh their recollection as to what happened at a prior meeting. In a purely business context, attribution and complete accuracy aren’t as critical as in the litigation context. Of course, most companies don’t create or maintain minutes with an eye toward litigation. The smart ones do.  

Attribution. Who’s speaking can be critical. If the minutes don’t accurately identify each speaker, there’s a risk that meeting minutes could be used to impeach people with statements that they never made. For example, if the Family Corp. meeting minutes reference the CEO stating that the new human resource policy may disadvantage older workers, but “she doesn’t care about their problems,” the CEO almost certainly will be asked about the comments during deposition and/or at trial. If the CEO didn’t actually make the statements, the CEO must testify under oath both: (1) denying the statement; and (2) concluding that the minutes are inaccurate. Even though she’s being truthful, a jury may be troubled by her testimony and begin to question her honesty and character. Even if the statement was verbatim accurate, if attributed to the wrong person, the damage can be substantial.  

Accuracy. When reviewing the notes before her deposition, the Family Corp. CEO tells her attorneys that she generally remembers the statement that’s being wrongly attributed to her. It was made by her youngest brother. The CEO goes on to say that her brother is a blustery windbag, prone to hyperbole. Making things worse, the CEO says, is that the phrasing of his comment is inaccurate. What the CEO remembers is that her brother said something similar to “it isn’t the company’s job to look out for the circumstances of each worker. Everybody has their own problems.” While this statement isn’t favorable either, the context and meaning are different than the phrasing placed in the minutes.  

If the CEO testifies that the minutes are inconsistent with her memory, she’ll be in for a tough cross examination. “Are you saying your memory is more accurate than the official meeting minutes, taken by a person whose sole job was writing down what was said and who wrote things up in real time?” Ugh. The CEO’s answer may well be “yes,” but it will be tough to convince a jury that she was right.  

Completeness. The CEO goes on to tell her attorneys that her younger brother said more than what’s in the minutes. She remembers clearly that she followed up on his comments by asking him what he meant. She recalls him saying, “it isn’t that I don’t care about our workers, of course I do, but come on, this is a business, and we can’t let the potential problems of every single worker be the basis for our decision making.” You look at her sadly, saying, “But, what you just told us is not in the minutes.”  

When the CEO is deposed, she’s asked if she remembers anything else about the meeting, other than what’s in the minutes. Being under oath, she has to tell the truth. So, she states that the minutes are incomplete, and then she recounts her recollection of the additional comments from her brother. The plaintiffs’ attorney smiles broadly. “Now you’re telling us that you remember things that were never even written down, and coincidentally, the new statements walk back the bad things that are in the minutes? The jury is going to love you!” Ugh, again.  

The takeaways in the areas of attribution, accuracy and completeness are simple. First, the individual assigned to prepare the minutes must be knowledgeable. If she doesn’t know for certain the identity of each individual at the meeting, that must be addressed before the meeting starts. There can be no guessing.  

Second, if the conversation during a meeting is going fast and the minute taker loses track of who says what, she must stop the discussion and insist that individuals talk one at a time. That’s what happens in a courtroom. These minutes might someday be read to people who are weighing the conduct of the meeting participants. There’s simply no room for confusion or overlapping statements.

Third, Family Corp. must decide what level of detail it wants in its minutes. Minutes don’t have to be verbatim transcripts of every word spoken. Many times, a company chooses not to create a transcript. Things like “discussion of personnel issue continued” are used, rather than detailing specifics. All minutes should be prepared based on the level of detail the company selects in advance, and all minutes should be prepared in the same fashion. For example, if some parts of the meeting purport to have quotes and others don’t, an argument can be made in later litigation that the company was purposely watering down its note taking on controversial topics. If different levels of detail are involved meeting to meeting, a similar argument can be made.  

When a company strives for detail, it runs the risk that something damaging might be said and can’t be walked back. For example, the CEO’s younger brother (being a blustery windbag) might be better suited to note taking that merely indicated, “Mack expressed his thoughts on the new policy.” It might be difficult to later reconstruct Mack’s comments, and individuals at the meeting might remember them differently, but it’s much easier to walk back the content and provide context if Mack’s extemporaneous outbursts aren’t recorded verbatim.  

In circumstances in which absolute certainty is sought, some companies choose to record board meetings in full. That’s a strategic choice. For the reasons just discussed, having a verbatim transcript isn’t always ideal. Also, it may deter spontaneous interaction. Individuals who know they’re being recorded tend to be more guarded. If recordings are made, they should be handled consistent with principles relating to the attorney-client privilege.  

Fourth, the individual preparing the notes must ensure accuracy. That has to be done in at least two ways. During a meeting, the minute preparer must be willing to interrupt the meeting and seek clarification about what’s being said, while it’s being said. That can be awkward and intimidating, especially if it involves interrupting an important family member or executive. But, it has to be done. Writing down “essentially” what was said isn’t the same as getting things right. Ensuring that things were taken down right is accomplished by a minutes review policy.  

After each meeting, the preparer should finalize the minutes and circulate them to meeting attendees along with a request to verify the attribution, accuracy and completeness of the minutes. Many companies use this process, but not all really enforce it. Minutes should be read shortly after the meeting. That’s when memories are most fresh. Minutes should be read slowly and carefully. An individual who attends a meeting knows what happened there, and therefore, it’s easy to skim the minutes without reading carefully. That’s a problem. Reading the minutes weeks, months or years later at a deposition isn’t the time to realize that information is missing or edits should have been made.  

Fifth, if you have a plan, stick with it. The individuals attending meetings and those taking the minutes may change over time. What shouldn’t change (unless there’s conscious choice to make go-forward changes) is the process used. Everyone must understand the process, agree to it and follow it.  

Sixth, all board members or regular meeting attendees should sign the meeting minutes policy. For the same reasons that the company might not want to keep copies of old meeting minutes, the company might not want individual attendees to do so. Either all minutes should be returned after review following the meeting (along with a no copy policy), or attendees should be instructed to destroy the minutes in a confidential manner. Minutes shouldn’t be casually handled or secretly hoarded. The company should be the controller of the minutes. If an individual with a right to review the minutes wants to see them, she should review the official record, not keep her own “shadow” file.  

Individual Note Taking

Under the original fact pattern, the plaintiffs’ attorneys depose all family members present at quarterly meetings. When a particular member is asked, she confirms that she keeps a “personal journal” on her tablet. The plaintiffs’ attorneys demand a copy of the journal.  

Must Family Corp. produce the type written personal journal? If so, what could Family Corp. have done to avoid this problem?

After the fact, there’s almost no way to protect the individual notes taken by family members. When the topic is raised, the family member is shocked. “What about my ‘privacy?’” Not much could be more private than a personal journal. Sadly, expectations of personal privacy don’t override rules of discovery in litigation. If the notes are relevant to the subjects of the lawsuit and aren’t otherwise immune from production by a privilege or protection (such as attorney-client privilege or spousal privilege), a judge likely will require production of the substance of the personal journal. 

So, what could Family Corp. have done differently?  First, the company could have had a note taking policy. Note taking needn’t be prohibited, but if it’s going to be permitted, there should be an agreed-on set of rules created to identify and protect information at meetings.  

For example, Family Corp. could provide note pads or tablets and require attendees to only use the approach approved by the company. That way, during a meeting, anyone taking notes or otherwise capturing information would be easy to identify.  

Second, as discussed above with regard to meeting minutes, Family Corp. could have a board member agreement signed by all attendees. Even in a family context, it’s best practice to have board member agreements. Such agreements can be long or short, depending on the circumstances of the individual company. The agreements would contain commitments by the board members on topics such as self-dealing, confidentiality, note taking, trade secrets and company property. If a board member is unwilling to sign such an agreement, there’s reason to question whether the member takes seriously the confidentiality associated with corporate information.  

Third, private journal entries can be subject to privileges (as referenced above). A company shouldn’t engage in deception about what the notes actually are. However, many subjects that have even tangential legal aspects can be safely protected via forethought and planning.  

For example, at the beginning of handwritten or typed notes, a note taker who meets the requirements for being considered a “client” could write, “Dear Counsel, I write to seek your legal advice concerning the following issues.” While such an approach isn’t a catch all for everything written thereafter, questions, comments, queries and issues for follow up often are deemed within the privilege if the author can legitimately testify that she intended the notes to be used to seek legal advice on issues concerning the company.  

In addition to note taking, a related danger comes from recording conversations. With nearly everyone carrying a computer in her pocket, it’s easier than ever to record conversations. There are various legal, strategic and ethical considerations relating to the recording of others, but from a purely evidentiary perspective, the best rule is to have a policy and stick to it. As with note taking, meeting attendees should agree in advance that no one will record any portion of meetings without corporate approval. If the company wants verbatim recordings of what’s said, such recordings should be made in conjunction with the split-meeting approach discussed above. Any recordings during otherwise attorney-client privilege protected portions of the meeting should so state on the recording itself. And, when the meeting is concluded, the recordings must be safeguarded. Playing of the recording within earshot of those not within the attorney-client privilege can waive the privilege.  

Casual Electronic Communication

Under the original fact pattern, one of the family members is asked in deposition whether he ever “communicated” with other family members about human resource issues. He states that his son is in the “human resources business” and so sometimes he asks him for advice. After further questioning, the family member states that on occasion, he would text with his son discussing practices inside Family Corp. The plaintiffs’ attorneys demand to image the phone of the Family Corp. deponent.  

Must Family Corp. allow imaging of the phone? If so, what could Family Corp. have done to avoid this problem?

The best way to keep family business private is to keep business in the business setting. Informal communications (oral or written) are rarely approached with the care associated with more formal settings. While it may be impossible to ensure that no business is discussed outside of the business setting, family businesses can be proactive in instructing all involved not to send texts or emails or make social media posts about business. Any deviations should be sought out and addressed.  

Texts and social media posts present two of the biggest sources of damaging information in litigation. Generally speaking, people tend to text using different language than they otherwise use. From abbreviations to emojis, clarity often is sacrificed in favor of brevity. When the subject refers to where to meet for dinner, brevity may be best. If the subject is, “I knew that idiotic new policy was trouble,” it might have been better to avoid the communication at all or at least to have typed it with an eye toward what prying eyes might later make of the text. Many legal cases have been jeopardized when text messages people thought were private were later produced in litigation and shown to witnesses testifying in deposition or at trial.  

Phone imaging is a hot topic in courts across the country. Most litigation today involves the identification, collection and production of electronically stored information (ESI). ESI can take many forms, one of which is text messages. Different courts have different requirements with regard to whether a party with discoverable text messages may produce just the text messages or must produce the entire device on which the messages were created or stored.  

For most people, the thought of having the entire contents of their personal cell phone imaged by someone else is horrifying. The best way to avoid the possibility of imaging is to keep work and personal messages separate. If a single device (such as a cell phone or tablet) is used for both personal and business purposes, the risk of someone reviewing personal information goes up drastically. In addition, keeping a work phone only for work messages tends to keep people more focused on the potential of others reviewing their messages.  

However, even if people keep separate work and personal cell phones, there remains a danger of personal texting that discusses business topics. The only way to protect such messages is not to create them. That can be easier said than done. In a family business, family members communicate about personal and business topics, sometimes, simultaneously. Training and practice is the best way to ensure that family members don’t talk about work via text. A good rule for your client to follow is that, if he wouldn’t say something out loud in open court, he shouldn’t write it in a text.  

On a related note, the credibility and character of family members can be undermined by social media posts. Likely, the CEO of Family Corp. isn’t choosing to post unflattering comments or photos on social media platforms. At least, Family Corp. trusts that the CEO has such judgment. But, just as perilous are posts by other family members about the CEO or others within the company.  

The best practice for avoiding social media blunders is to create a social media policy and have family members with access to business information make their posts available for corporate review.  

Oral Conversations 

Under the original fact pattern, many (but not all) family members gather for a holiday party while the proposed employment change is still under consideration. In a small group at the party, a family member asks the spouse of a different family member what she thinks about the proposed plan to “get rid of the older workers.” Coincidentally, the spouse is an attorney. She warns the inquiring party that there may be legal problems with such a strategy. Unhappy with the response, the family member brings in another partygoer and repeats the question and the answer. During deposition, the family member admits to talking about the issue at the party. He’s asked to recount everything he remembers. He really doesn’t want to.  

Must the family member describe either or both of the conversations? The short answer is yes to both. There’s no attorney-client privilege, and the conversations are relevant to the litigation. When a family member talks verbally about business matters in a non-privileged context, anything said is fair game in future litigation.  

What could Family Corp. have done to avoid this problem? If family members start talking business, someone needs to say “not here” and/or “not now.” Individuals wouldn’t stand on the street corner and shout about personal matters. Analogously, that’s what a business does when its owners, officers or employees talk about business matters in an unprotected environment. No one’s perfect, but approaching social interactions where business may come up should be done proactively. If your client doesn’t want to have to testify about what was said at a party or family gathering, he shouldn’t talk about business topics and should discourage others around him from doing so.  

The demographics of the American family have significantly changed since the 1960s, especially in the past 20 years.1 Age, lifespan, cross-cultural diversity, location and differing models and definitions of family life present a very different snapshot of American families from the one we had less than a generation ago. These shifts create new assumptions for family life and may make it necessary to rethink how to achieve continuity for the future, including estate planning. The impact of these changes is particularly challenging for those families that share assets so that family life and economic life are inextricably tied together. Here’s a framework for considering the impact of these demographic changes by examining their impact on family enterprise sustainability. We’ll consider some of the dimensions of sustainability,2 as well as ways advisors and families can successfully adapt to these changes. First, let’s consider the changes.

The Changing Family 

There are many factors and shifts in the social fabric of American family life to consider. People are living and staying healthy longer.3 The upper 1% of wealthy families that have even better access to services and health care because of their financial resources also tend to be healthier and have longer lives than Americans of lesser wealth.4 However, an aging population also has to address more medical and social issues. Rates of dementia increase for individuals between ages 75 to 84 and then increase again for individuals age 85 and older. Most everyone has a family member or friend who’s suffered with a decrease in mental capacity.5 While rates of depression drop between ages 60 to 80, rates of depression after age 85 nearly double.6 So, our overall health and longevity may come at the expense of increased cognitive and emotional impairments.  

In addition, the very definition of “family” is changing. Cohabitation (for both heterosexual and same-sex couples) is on the rise. The majority of couples still get married before having children, but the likelihood of not following this traditional path has increased substantially in recent years.7 An increasing number of couples are choosing not to have children.8 This decision used to carry a stigma, and it was assumed that “no children” meant the couple had fertility issues, and the decision not to have children was often viewed negatively.  

Additionally, many couples are waiting longer before getting married.9 Fertility issues (and numbers of twins) have come along as a generational phenomenon often associated with putting off marriage and childbearing.10 Same-sex couples and same-sex marriage are on the rise,11 and there’s a generation of children growing up in an environment in which same-sex families are part of the norm and the culture. 

While divorce rates have evened out over the last decade,12 resulting blended families, or stepfamilies, continue to exist in most extended families. Although an official “step” means there’s been a marriage, couples might also cohabitate with someone else’s children without a marriage. This means that many children are living with an adult who isn’t their biological parent, and many adults are spending their family time with children who aren’t “officially” theirs. Families composed of mixed race and religion are also increasingly more prominent over the last two decades, and the number of biracial children continues to rise.13 

There’s also been a shift in how children and young adults in the upper 1% relate to money and their wealth. With opportunities of education and experiences/internships that take them traveling the world, a whole generation is now thinking more about the needs of the world at large and not just about what’s happening in their local communities. The result has been an increased interest in being philanthropic. And, because this cohort has enough wealth in unearned income, often in trusts that generate regular dividends, they’re able to pursue these interests.

Sustainability and Resilience

In our work with families, we see how theses demographic changes are having a great impact. Those families who are better able to understand, adjust and incorporate changes are those that are able to be sustainable over the long term. 

We’ve developed a model of sustainability that helps families navigate through the complexity that arises when an economic system is joined to an emotional one.14 The sustainability model provides a roadmap for families to get from here to there, make the journey and think about a plan. Once a roadmap is constructed, all families need to be flexible and incorporate changes to their roadmap along the way. Families that are resilient are better able to handle the changes and challenges that inevitably arise. “Resilience” is defined as “the capacity to recover quickly; to be agile.”15 The demographic shifts that we’ve been discussing are perfect examples of changes that resilient and sustainable families need to be aware of and consider in their planning.  

Let’s review a couple of dimensions of sustainability to illustrate where we see the demographic changes having the most impact with family enterprises. Families need to address these three questions: (1) What do we need to do as a family to achieve comfort in each of these dimensions, that is, how do we go from where we are to where we want to be? (2) What’s changed that impacts or may impact how we plan to get there? (3) What needs to shift in our thought processes and practices to get there? 

Family Legacy and Connection 

Families that own assets together need to systematically nurture family relationships and connections as well as find ways to come together to discuss and make decisions about their shared capital. The newest research in family enterprises suggests that these family connections are hugely important in determining the family’s sustainability over generations.16 Maintaining these connections and getting more flexible in how families manage the growing geographical distances are essential to how the family will be able to live and work together in the future. 

Clearly, the technology of Facetime and mobile technology has allowed for the challenge of geographical dispersion to be more easily tended to, allowing relationships and connections to continue in a way that minimizes the growing global nature of the world. 

Vignette: Staying connected across the distance. A grandmother on the east coast was concerned when her daughter and son-in-law moved to the Midwest for their careers. How would she continue to have a close relationship with her two young grandkids, whom she used to visit weekly? They began to have “Facetime With Grammy” every Sunday, which she looked forward to and which her daughter and son-in-law agreed was important. The grandkids also loved it. They often spent 30 to 45 minutes catching up, and the kids would share stories and show her arts and crafts they had made. It was a positive experience, solidified the connections between the family visits and laid the foundation for later connections.

The adult family members were also diligent about having video meetings every month after the grandchildren went to bed. The daughter, her brother and the mom would review their joint investments and the small foundation they had set up in addition to catching up on family matters. They found these meetings helpful to supplement the more formal quarterly meetings they had with the family office staff.

This family was able to continue the connections despite the physical distance. The connection between grandparent and grandchildren is all about family and the values of spending time together and enjoying each other. For the siblings and their mother, the connection is not only about family time but also involves conversation and decisions about their shared assets. As family members increasingly live in different states and countries, spending time together or connection-building among family members is more challenging and needs to be planned for. Families that do this well share stories and have discussions to build their shared values. We find that this sort of participation and engagement helps families in their sustainability over time.

Seniors active for longer. As suggested in the demographic findings on increased lifespan, the family in our example has three vibrant generations living at once. More and more in our family enterprise work, we see fewer seniors retiring or turning over authority, or at least not voluntarily. Rather, the seniors are physically and mentally strong and are enjoying holding on to their positions of leadership in the family for much longer. In the past, retirement was more of a given, and moving into the role of giving wise counsel was part of the norm for the elder generation. With this transition prolonged, interestingly, the middle generation (or “Prince Charming” generation) is often waiting much longer in family enterprises to attain decision-making authority. This brings up other issues around the different roles of each generation. This shift has also created more difficulty for families and advisors when issues of capacity or capability come up with seniors. We often find that working on competency guidelines ahead of time with families is very helpful to manage these challenges. 

Stepchildren and adopted children. Changes in family composition involving stepparents, stepchildren and adopted children are also impacting families with significant assets and holdings. Not only are more people being added to the mix (in terms of numbers), but also their relationships within the family are different. Stepchildren often spend part time with each of their parents, so they’re in and out of the family system in a different sort of way. New stepparents who enter the family system aren’t parents to their spouses’ children. Adopted children may spur the forging of new family connections. Questions come up around who is family? What’s the definition of “family” when there are assets or stock to pass on? These are crucial issues that our families and their advisors face.  

The result of many of these shifts is that families and advisors need to be more equipped to have honest conversations about how they define “family.” They also need to be ready to engage in a re-examination of their estate and financial planning so that it reflects what the family believes and wants. 

Governance Structures and Processes

When we think of having “governance” in family enterprises, we mean the setting up of processes and structures that families use to get their work done. Unlike families that don’t share assets, families with significant assets are tied in intricate ways and need to make decisions about both their family and economic livelihoods. Questions they need to consider include: Who makes decisions and participates as the family grows? Who’s responsible for implementation when decisions are made? As a family grows in numbers, coming up with ways to organize and educate itself is essential to its sustainability. 

With some of the demographic changes that have occurred in family composition, families and their advisors may need to re-examine some of the traditional agreements and structures that families of significant assets have used in the past. For example, how are longstanding same-sex couples treated with regard to family participation? What if children are born to unmarried family members? What about stepchildren? Half-siblings? On several recent occasions, we’ve seen family enterprises stuck between shareholder documents and trusts they’ve created in the past and the reality of how their family has changed, as exemplified with the Burns family below. 

Vignette: Changes in family composition lead to change in governance. Two of the eight third-generation members of the Burns family have partners they’re not married to but with whom they have children. When their parents set up trusts after the sale of their manufacturing company, the legal structures used assumed traditional marriages with children in the future. First, one of the sons was widowed and found a new partner a few years later. Because both had children from their first marriage, and they were a little older, they decided not to marry and just cohabitate. His new partner has been in the family for 14 years now. When another cousin raised the issue of the rights of her same-sex partner, who’s the parent of their two children, the family needed to re-examine some of their existing structures and review their trust documents.

An evolving family. This family situation is an example of how trust agreements were set up one way but are now challenged by the way a family has evolved in composition, as well as in the number of individuals. Many trusts required marriage for participation, but this requirement limits family members who are in significant relationships without marriage. Historically, trusts can be viewed in some way as a partial solution for keeping the ownership in the lineal family, but this may conflict with families that are changing in definition. Family enterprises that have legal agreements around marriage need to think about stepchildren, half-siblings and adopted children who are increasingly prevalent in family systems.17

The most common example of demographic changes impacting family enterprises is the increasing numbers of significant others and their children being part of the family system. A remarriage occurs, or a new partner becomes part of the family, and then the family has to grapple with how they are, or aren’t, supposed to treat this new “in-law” and her child, not to mention the ex-law that they’ve had a close relationship with for years. It would be hard to find a U.S. family that hasn’t had this experience in the last 20 years. On top of this complexity, a new family member is entering a family enterprise in which conversations and decisions about their economy are also part of what they do together as a family. Here’s where the boundaries of being a family member versus being a family member who’s part of the shared ownership gets trickier. The Davis family is a good example.

Vignette: Who’s allowed to attend a family meeting? When the Davis family decided to invite the next generation teenagers to attend an educational forum on financial literacy for the first time during a scheduled family meeting, they faced an awkward situation about what to do with two stepchildren who had been raised with the rest of the family since they were toddlers. The stepchildren weren’t going to be stockholders or beneficiaries to the family’s wealth, but everyone considered them family. Should they be invited? If they don’t attend, how will the family handle that? How will their exclusion alter their experience of being cousins among cousins? 

In this family, the questions of who can have ownership and who will be a beneficiary was decided in documents long ago. For modern day families with shared asset and different compositions, these distinctions become sensitive issues.  

Time will tell how the demographic changes in families with shared assets are handled. What we’ve seen so far in our work is that families that address the discomfort and speak about the boundaries of their family in open and transparent ways are better able to come to a more comfortable place of how to manage them. Documenting the family’s operating principles or creating a family constitution that describes the family’s values, joint vision and structures to accomplish what they want to achieve allows the family to engage in a thoughtful process together and to create something that they want to live by. 

The Davis family took the time at the family meeting to openly talk about this awkward situation and their current governance structure and processes. After some lively conversation, and respectfully hearing different points of view, they decided that there would be a business portion of the family meeting to address the family’s shared assets. The stepchildren would be excluded from this portion only. The family agreed that family reunions, family trips and all other family events would be inclusive of stepchildren. The family’s decision to change their protocol was documented in an amendment to their family constitution that had been drafted a few years back.

Takeaways

The demographic shifts in the American family impact our whole culture. The implications for families that share assets are unique because they’re an economic system along with an emotional one. By recognizing the changes, both families and advisors who serve them can be more thoughtful around planning that might be considered. Here are a few suggestions that we’ve learned in our work with family enterprises:

1. Create documents such as operating principles and structures to guide the family and family constitutions, which contain the agreed-on structures and processes that the family will use to execute on their operating principles. This will help capture the goals and agreements of family members. Use a change in the family governance to trigger a legal document review. Continue to have ongoing reviews of legal documents and agreements (at minimum every 10 years). It’s important to see how documents define family membership/participation and to make sure those definitions capture the current picture of the family.

2. Participation by all generations is essential for the family learning from each other and for investment in the future of the family. It’s important to be mindful that family members’ participation will vary over the years depending on where those individuals are in their life stages. Clarity about participation starts with documenting when a family member is old enough to be involved in family conversations about shared assets to setting clear criteria and protocols for when a family member would be deemed incapable of staying in a decision-making role.

3. Financial skills development will help ensure the family’s ability to manage financial responsibility in the long term. If the next generation’s career choices and training don’t increase their financial skills development and financial responsibility, then plan for it. Be transparent in conversations, and develop ways to increase this skill level for family members, keeping in mind that individuals learn in different ways.

4. Try to have the mindset and behaviors that allow the family to use the wealth for opportunities. Watch for ways that the family unintentionally takes too much care of young individuals so that critical thinking, responsibility and independence are somehow stunted and resilience not developed.

5. Encourage families to be open to new data and new ways of doing things by exploring the world and all that it offers. Help them to see the great opportunities and potential positive impact of change that can help them as individuals, the family and the community. Actively consider how to use this information.

6. Help families realize that they’re making adjustments to a changing world and not just changing their ways for one individual or situation. We all have a tendency to laser focus on one individual causing unrest, rather than to respond to the broader landscape. 

7. Encourage experiences to help families embrace challenges, obstacles and mistakes to develop resilience to deal with ongoing changes. It’s a skill that will help individuals and the family weather the uncertainties they face in the world. 

—The author would like to thank Fredda Herz Brown, senior partner at and founder of Relative Solutions in Tenafly, N.J., for her help with this article. 

Endnotes

1. www.prb.org/wp-content/uploads/2016/08/prb-population-bulletin-71.1-complex-families-2016.pdf.

2. Fredda Herz Brown, The Essential Roadmap: Navigating Family Sustainability in a Changing World (2020).

3. www.aafp.org/news/health-of-the-public/20181210lifeexpectdrop.html.

4. https://fas.org/sgp/crs/misc/R44846.pdf?te=1&nl=paul-krugman&emc=edit_pk_20200121?campaign_id=116&instance_id=15345&segment_id=20510& user_id=f0880cc70145906da5b70b7bc5838fb9&regi_id=7456472020200121.

5. Federal Interagency Forum on Aging-related Statistics. Older Americans 2016: Key Indicators of Well-Being (2016).

6. Ibid.

7. www.pewresearch.org/fact-tank/2018/06/19/family-life-is-changing-in-different-ways-across-urban-suburban-and-rural-communities-in-the-u-s/.

8. www.pewsocialtrends.org/2015/12/17/1-the-american-family-today/.

9. Ibid.

10. www.nichd.nih.gov/health/topics/infertility/conditioninfo/causes/age.

11. www.pewresearch.org/fact-tank/2019/06/24/same-sex-marriage/.

12. www.weforum.org/agenda/2018/10/divorce-united-states-dropping-because-millennials/. 

13. www.pewsocialtrends.org/2015/12/17/1-the-american-family-today/.

14. Supra note 2.

15. Ibid.

16. www.intheblack.com/articles/2016/08/12/the-role-of-family-cohesion-in-family-business-profitability.

17. www.pewsocialtrends.org/2011/01/13/a-portrait-of-stepfamilies.

Planning strategies for Fine Art & Collectibles: Managing the Disposition of Art Collections

Join us for an exclusive networking evening & panel 

An evening event with industry experts examining how financial and estate planners can best serve their clients who have significant art collections. Our panel will focus on prudent financial management of owning art during a client’s lifetime and planning how best to maximize value and sell artwork, including the tax implications, when the client dies. The panel will concentrate on the legal and tax issues and how to work most effectively with both an auction house and an independent art advisor and broker. 
 

Presented by Trusts & Estates and Fine Art Brokers
Hosted by Christie’s
Moderator: Susan R. Lipp, Editor-in-Chief, Trusts & Estates

Speakers:
Bonnie Brennan, Deputy Chairman, Head of Trusts, Estates & Wealth Management, Christie’s
Judd B. Grossman, Attorney, Grossman LLP
Ray Waterhouse, Chairman, Fine Art Brokers

March 17, 2020, 6:00 - 8:00 PM
Doors open 6:00 pm, Panel and Q&A 6:30 pm to 7:30 pm;
Networking reception: 7:30 pm to 8:00 pm

Where:
Christie’s, 20 Rockefeller Plaza, New York City
(49th Street between 5th and 6th Avenues)

Space is limited

RSVP by March 9, 2020

Have you been bitten by the writing bug?
Learn the steps you need to take to get your articles published in our journal or on our website.
 
Topics covered include:

• Preparing and submitting an article proposal
• Best practices when writing for a legal journal or newsletter
• Understanding the Trusts & Estates editorial process
• Mining the public relations benefits

Susan Lipp
Editor in Chief
Trusts & Estates

Anna Sulkin
Associate Legal Editor
Trusts & Estates

David H. Lenok
Senior Wealth Planning Editor
WealthManagement.com

SPONSORED BY

This event is open to Trusts & Estates subscribers ONLY. To attend, subscribe at the special rate of $99 when you register. 

As a Trusts & Estates subscriber, you'll have access to:

• Our archive of subscriber-only webinars, as well as complimentary registration to future webinars
• The Tax Year in Review issue, the Charitable Giving issue, and the Art, Auction & Antiques special report
• ...and more exclusive estate-planning content only available online

On Jan. 11, 1999, the very first day I began practicing law, the federal estate tax applicable exclusion amount (the exemption) was a modest $650,000 per individual, and the concept of portability between spouses didn’t exist. As a result, the opportunities to apply my fairly new estate tax planning knowledge were plentiful. Every client who had a large life insurance policy, had been a good saver, was a moderately successful professional or owned a profitable business had a need for estate tax planning. 

Over the years, the exemption has steadily increased, and with the passage of the Tax Cuts and Jobs Act of 2017, it’s jumped dramatically: The exemption as of this writing is $11.58 million per individual. Further, married couples can share their exemption with one another under the portability rules.1 For most estate planners, the frequency with which we can apply advanced estate tax planning techniques on behalf of our clients has diminished considerably. When one tax planning door closes, however, another one opens. While the change in the law causes less opportunity to use pure estate tax planning techniques, it does give us planners the incentive to serve clients with solid income tax planning options. 

One such opening involves ownership of qualified small business (QSB) stock. Under Internal Revenue Code Section 1202, certain taxpayers who acquire original-issue QSB stock and hold it for at least five years may have the ability to exclude some or all of its unrealized capital gains, as well as the associated 3.8% Medicare surtax (that is, net investment income tax (NIIT)). Let’s take a brief look at the details.

What’s QSB stock? 

IRC Section 1202 strictly defines “QSB stock.” Here’s an oversimplified summary: First, the issuing company must be a domestic C corporation. Second, the company’s assets can’t exceed $50 million between Aug. 10, 1993 and the date of the issuance of the stock. Third, the corporation must use at least 80% of the company’s assets2 in the active conduct of its business.3 Finally, the company can’t be a personal services business.4

Sale of QSB Stock

Does the sale of all QSB stock qualify for the exclusion of tax on sale? Not all QSB stock can qualify for the sale exclusion. Specifically, under Section 1202:

• The QSB stock must be purchased by or paid to the shareholder as originally issued stock. It can also be received as a gift or inheritance from someone who held it this way. The QSB stock can’t be purchased from a prior owner. Note: The holding period tacks on to the stock if it’s given to/inherited by another person or if the company converts the stock to another class, engages in a stock split or engages in a reverse stock split.

• The QSB stock must be held for at least five years to get the 100% exclusion from tax. If it’s held between one and five years, the gains are treated like any other capital gains and taxed at up to 20%. If held under one year, then the gains are short-term capital gains and taxed as ordinary income. 

Assuming the statutory predicates are met, the taxpayer may exclude up to the greater of: (1) $10 million5 less the sum of any gains already taken by the taxpayer for that specific issuer in
previous tax years;6 or (2) 10 times the taxpayer’s adjusted cost basis of QSB stock of the issuer that was disposed of during the same tax year. On the taxpayer’s personal income tax return for the year of the sale, he must file Internal Revenue Service Form 8949 to indicate the QSB stock treatment, as well as indicate it on his IRS Form 1040 Schedule D. 

It’s strongly recommended that the shareholder get a formal written certification from the QSB attesting to the fact that the relevant stock was QSB stock. This certification is to be held in case of audit. It’s also recommended that a shareholder maintain sterling documentation showing: (1) when the QSB stock was obtained, (2) how it was obtained (purchase, compensation, gift or inheritance), (3) if purchased, the amount paid, (4) proof of payment, (5) copy of the stock certificate, and (6) a calendar notation showing when the 5-year holding period occurs. 

Example of Tax Savings

As stated above, if an owner of QSB stock sells it, up to the greater of $10 million or 10 times the cost basis of the stock can be realized tax-free. Here’s an example that illustrates the advantage of this tax benefit: 

• In 2012, Dr. Christopher Client, a talented biochemist, joined a pharmaceutical startup that was a QSB. He purchased or was paid a block of 100 shares of QSB stock for $0.01/share for a total cost basis of $1. The company directly issued the shares. After successful clinical trials and a public offering, Dr. Client’s shares are now worth $20 million. Dr. Client would like to sell the shares but wants to minimize the taxation of the unrealized gains. (Due to the low basis, virtually 100% of the sales proceeds would be taxable.)

• After obtaining a written QSB stock certification from the proper officer of his employer, Dr. Client sells $10 million of his QSB stock and has his accountant complete and file the proper tax forms. Because his basis is $1, Dr. Client is able to exclude the entire amount realized from federal capital gains tax. He avoids $2 million in capital gains tax, and another $380,000 in NIIT, for a total savings of $2.38 million.  

The above number shows just how advantageous the possession of QSB stock can be. But, what if Dr. Client wants to use Section 1202 to shelter the gains from the sale of the remaining $10 million of QSB stock that he possesses? Can he do that? The answer is that he can. 

Some practitioners might believe that he could transfer his remaining shares to his wife and have her sell them. At first glance, this seems to be a good idea. However, an examination of Section 1202 makes me doubt the prudence of this strategy. The statute7 doesn’t provide that a married couple filing jointly can double the articulated limit, but it does expressly state that a married couple filing separately can’t shelter the greater of $10 million or 10 times basis. Instead, they can only shelter the greater of $5 million or 10 times basis. Thus, it would seem that the spirit of the statute is to hold the ability of a married couple to shelter gains to the limit set in Section 1202(b). 

Fortunately, Section 1202(h)(2) allows a separate taxpayer8 to receive QSB stock by gift or inheritance and then enjoy the full amount of the statutory tax exclusion. So, in our example, Dr. Client can give the balance of his QSB stock to a taxpayer other than his spouse, and that taxpayer can get the full exclusion from capital gains and NIIT. Possible recipients could be the children of Dr. Client or irrevocable non-grantor trusts for their benefit. Of course, before recommending such a gift to his client, an estate-planning attorney would be well advised to weigh the estimated income and NIIT to be saved from this strategy against the anticipated estate tax impact that would occur as a result of that gift. 

What if Dr. Client would like to get the full QSB stock treatment for his remaining shares without giving them away to another taxpayer? A review of Section 1202(h) shows that Dr. Client could create an inter vivos non-grantor qualified terminable interest property (QTIP) trust for his spouse and then transfer the shares to that trust. The transfer would qualify for the unlimited marital deduction from gift tax under IRC Section 2523. Further, the non-grantor trust could then sell the shares and enjoy the full exclusion from capital gains tax under Section 1202. (In our example, if Dr. Client gave his remaining $10 million in unsold QSB stock to an inter vivos QTIP non-grantor trust for his spouse, and then the trust sold the stock, capital gains tax could be avoided up to the statutory limit.) 

Taking the “mile high” view, the client has the opportunity to double the amount of tax savings that he could otherwise enjoy if he kept the stock. In this way, capital gains from Dr. Client could shelter a full $20 million of QSB stock under Section 1202. The total tax benefit would double from the previous figure, going from $2.38 million to $4.76 million in capital gains and NIIT saved. 

Immediate Tax Savings

The foregoing discussion shows the tremendous immediate tax savings that planners can help a client with QSB stock obtain on the sale of his shares. In light of the increasing estate tax exemptions, and thus decreasing ability to provide relevant estate tax strategies to our clients, familiarity with powerful income tax planning tools is imperative to planning attorneys looking to remain relevant to their clients.  

Endnotes

1. See Internal Revenue Code Section 2010(c)(4).

2. Eighty percent by value. IRC Section 1202(e)(1)(A).

3. Thus, the company can’t be a pure holding company.

4. Per Section 1202(e)(3), companies in these lines of work can’t qualify: “any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees.” Further, the trade/business can’t involve banking, insurance, financing, leasing, investing, farming, raising or harvesting trees, the production or extraction of underground resources like gas and oil or the operation of a hotel, motel or restaurant. 

5. Or, $5 million for a married taxpayer filing separately. Section 1202(b)(3)(A).

6. Section 1202(b)(1).

7. See Section 1202(b)(3).

8. A “separate taxpayer” is one who doesn’t report income taxes on the same return as Dr. Client. The IRC and Treasury regulations are silent as to whether one can “stack” exclusions using gifts to grantor trusts (such as grantor retained annuity trusts or intentionally defective irrevocable trusts), and I’m aware of no cases that discuss this topic. Not wanting to be a test case, I would be reticent to advise a client to make gifts to a grantor trust to attempt to stack the Section 1202 exclusions.