The so-called “transfer-for-value” rules under Internal Revenue Code Section 101 govern the tax consequences of the transfer of ownership of an interest in a life insurance policy in exchange for consideration (represented by cash or other property or a change in the rights or obligations of the parties to the transfer). In addition, the Tax Cuts and Jobs Act of 2017 (TCJA) created and defined the new “reportable policy sale” and imposes enforceable reporting requirements on a taxpayer who acquires a policy in such a transfer, as well as on the transferor, the issuing insurer and any party making payments of death benefits with respect to the policy transferred. Furthermore, the transfer of a life insurance policy that constitutes a reportable policy sale under the TCJA can also affect the portion of the policy death benefit that may be subject to income tax. Final regulations were issued with respect to reportable policy sales on Oct. 31, 2019 and are generally effective with respect to transfers after that date. An understanding of the transfer-for-value rules, the reportable policy sale rules and the interplay between them is important when a client contemplates any transfer of a life insurance policy or for any business entity that owns a life insurance policy.

General Rules 

The general rule under IRC Section 101(a) is that life insurance death benefits are received by the policy’s beneficiaries income tax free. Specifically, Section 101(a)(1) provides that a taxpayer’s gross income doesn’t include amounts received under a life insurance contract if such amounts are paid by reason of the death of the insured.

In situations in which a taxpayer transfers an interest in a life insurance contract for valuable consideration (a transfer for value) or as part of, or following, a reportable policy sale, the owner of the policy will generally be subject to income tax on some or all of the death benefit unless an exception applies.1 The amount of the death benefit that’s subject to income taxes generally is the excess of the death benefit over the amount actually paid for the interest in the contract, plus any premiums and other amounts paid by the transferee following the transfer.2 Both permanent and term life insurance policies are subject to the transfer-for-value rule.3

Example 1: A pays premiums of $500 for an insurance policy with a face amount of $1,000 on the life of B and subsequently transfers the policy to C for $600. C receives the proceeds of $1,000 on the death of B. The amount that C can exclude from his gross income is limited to $600 plus any premiums paid by C subsequent to the transfer. 

Note that a transfer of policy interests may constitute a reportable policy sale even though the individual or entity receiving the policy falls under one of the exceptions of the transfer-for-value rules. Similarly, it’s possible for a transfer to violate the transfer-for-value rules, with no applicable exception available, but not constitute a reportable policy sale. As such, it’s important to understand the rules relating to each type of transfer—both transfer for value and reportable policy sale—before piecing together the broader analysis that should be done for every transfer of a policy interest.   

Transfer-For-Value Rules 

A transfer for value is any absolute transfer of a right to receive all or a part of the proceeds of a life insurance policy in exchange for valuable consideration. This includes more than a transfer of a policy in exchange for money or money’s worth. For example, the creation of an enforceable contractual right to receive all or a part of the proceeds of a policy may constitute a transfer for valuable consideration of the policy or an interest therein.4

On the other hand, the pledging or assignment of a policy as collateral security isn’t a transfer for valuable consideration of such policy or an interest therein, and Section 101 is inapplicable to amounts received by the pledgee or assignee.5

Sections 101(a)(2)(A) and (B) provide several exceptions to the transfer-for-value rule.6 Specifically, the death benefit won’t be subject to income taxes, even in the case of a transfer of the policy, or an interest in the policy, if the transfer is to:

• the insured under the policy;

• a partner of the insured;

• a partnership in which the insured is a partner; or

• a corporation in which the insured is a shareholder or officer.

It’s also not subject to income taxes if the transferee’s basis in the transferred policy is determined, in whole or in part, by the transferor’s basis in the contract (commonly referred to as the “carryover basis” exception).

Example 2: X Corporation purchases for a single premium of $500 an insurance policy in the face amount of $1,000 on the life of A, one of its employees, naming X Corporation as beneficiary. Prior to A’s death, X Corporation transfers the policy to N Corporation, in which A is a shareholder. N Corporation receives the proceeds of $1,000 on A’s death. The entire $1,000 is to be excluded from the gross income of N Corporation.7

Example 3: X Corporation purchases, for a single premium of $500, an insurance policy in the face amount of $1,000 on the life of A, one of its employees, naming X Corporation as beneficiary. X Corporation transfers the policy to Y Corporation in a tax-free reorganization (the policy having a basis for determining gain or loss in the hands of Y Corporation determined by reference to its basis in the hands of X Corporation). Y Corporation receives the proceeds of $1,000 on A’s death. The entire $1,000 is to be excluded from the gross income of Y Corporation.8

None of these exceptions apply, however, if the transfer is considered a reportable policy sale (discussed later). Additionally, even if a current transfer does qualify for one of the exceptions, if the policy was transferred in a reportable policy sale at any time prior to the current transfer, some portion of the death benefit may still be subject to taxation.9

Policies transferred by gifts. Generally, if a policy is acquired by gift, the transfer-for-value rule won’t apply because the transferee’s basis will be the same as the transferor’s basis.10 Transfers between spouses or former spouses incident to divorce are also treated the same as gifts for tax purposes.11 When a policy is transferred by gift, the amount of proceeds excluded from income is equal to the amount that would have been excluded by the transferor had the transfer not occurred. However, if a reportable policy sale has occurred prior to the gift of the policy, a portion of the death benefit may be income taxable to the recipient.

Example 4: A, the insured, sells her policy to B for $10,000. The sale constitutes a reportable policy sale because B has no substantial family, business or financial relationship with A. The following year, B gifts the policy on A’s life to C, A’s child, who does have a substantial family relationship with A. At A’s death, C receives $100,000. The amount of death benefit excludible from C’s income is equal to $10,000 (the amount that would have been excludible by B if the transfer hadn’t occurred), plus any premiums paid by C following the gift.

In the case of a gift of a policy subject to a loan, the transfer is treated as a part gift/part sale and will constitute a transfer of the policy for value. If the loan is less than basis, there’ll be no transfer-for-value issue because the transferee will take the same basis as held by the donor (that is, the carryover basis exception applies). If, however, the loan is greater than the basis in the contract, the basis to the transferee is determined using the loan amount, and the basis exception won’t apply, unless another exception to the transfer-for-value rules applies.

Transfers to trusts. The IRS held in Revenue Ruling 85-13 that the transfer of assets between a grantor and grantor trust won’t be treated as a sale for income tax purposes.12 Applying similar reasoning as that from Rev. Rul. 85-13, the IRS held in Rev. Rul. 2007-13 that a transfer between two grantor trusts with the same insured/grantor isn’t a transfer for the purposes of the transfer-for-value rule. Because the grantor is treated as the owner of both trusts for income tax purposes, the grantor is treated as the owner of both the life insurance contract and the cash received for it both before and after the exchange; therefore, there’s no “transfer” under Section 101(a)(2).13

The sale of a life insurance policy from a non-grantor trust to a grantor trust would be considered a transfer for valuable consideration within the meaning of Section 101(a)(2), but generally should qualify under the transfer-to-the-insured exception under Section 101(a)(2)(b), assuming the acquiring trust is a wholly owned grantor trust as to the insured on the policy.14

If the acquiring trust in a policy sale is a non-grantor trust with respect to the insured, the transfer-to-the-insured exception wouldn’t apply, and care should be taken to determine if any other exception may apply to avoid taxation of the death benefit within the trust.  

Keep in mind that in some of the aforementioned sales to a trust in which no transfer is deemed to have occurred or for which a transfer-for-value exception applies, the policy sale could still constitute a reportable policy sale if the beneficiaries of the trust don’t have a substantial family, business or financial relationship with the insured.15 In most cases, this shouldn’t be an issue, as typically the beneficiaries of trusts are family members of the grantor/insured, thus constituting a significant family relationship with the insured, but care should be taken when there are beneficiaries who aren’t family members.16

If a transfer to a trust constitutes a reportable policy sale due to one or more beneficiaries lacking a substantial family, business or financial relationship, then none of the transfer-for-value exceptions would be available, and the transfer could cause at least a portion of the death proceeds to be income taxable.17

Curing a transfer for value. In the case of a series of transfers, if the final transfer is to the insured, partner of the insured, partnership in which the insured is partner or to a corporation in which the insured is a shareholder/officer and no reportable policy sales have occurred along the way, the final transferee should be able to exclude the entire death benefit from gross income, assuming such final transfer doesn’t constitute a reportable policy sale.

If a reportable policy sale has occurred prior to the transfer to a partner of the insured, partnership in which the insured is a partner or corporation in which the insured is a shareholder/officer, the amount of the death benefit excluded from tax is limited to the sum of:

1. the higher of the amount that would have been excludible by the transferor if the transfer hadn’t occurred, or the actual value of the consideration paid by the transferee; and

2. the premiums paid by the transferee.18

If the final transferee in a series of transactions following a reportable policy sale is the insured and the insured acquires the policy for valuable consideration at its fair market value (FMV), then the entire death benefit can be excluded from income tax.19

Reportable Policy Sales

The TCJA added a new provision (IRC Section 101(a)(3)) under the transfer-for-value rules related to reportable policy sales.

A “reportable policy sale” is defined generally as the acquisition of an interest in a life insurance contract, directly or indirectly, if the acquirer has no substantial family, business or financial relationship with the insured (apart from the acquirer’s interest in the life insurance contract).

When a policy is acquired as part of a reportable policy sale, the portion of the death benefit that exceeds the owner’s basis in the contract generally will be subject to income tax. This new provision further provides that none of the exceptions to the transfer-for-value rules apply when a life insurance contract, or any interest in a life insurance contract, is transferred in a reportable policy sale.20 

It’s worth noting that the definition of a “reportable policy sale” doesn’t require a “sale” of the policy but merely the “acquisition” of the policy. This includes gratuitous policy transfers in which the donee lacks a substantial relationship to the insured. However, the amount of proceeds excluded from income with respect to gratuitous transfers that constitute reportable policy sales is determined by the amount that would have been excluded by the transferor had the transfer not occurred. As such, a gratuitous reportable policy sale doesn’t always translate into a taxable death benefit.21  

As defined in Treasury Regulations Section 1.101-1(d), a “substantial family relationship” includes the following relationships of the acquirer to the insured: 

1. same person;

2. a spouse (including domestic partners and other legal relationships permitted under state law);

3. a parent, grandparent or great-grandparent (or the spouse of such);

4. a lineal descendant of any of the foregoing (1), (2) or

(3) (or the spouse of such lineal descendant); or 

5. any lineal descendant of a person described in (4).

A former spouse is also considered to have a substantial family relationship with the insured if a transfer is incident to a divorce.

A “substantial business relationship” between the acquirer and the insured exists if:

1. the insured is a key person or materially participates (as owner, employee or contractor) in an active trade or business owned directly or indirectly by the acquirer, and at least 80% of the business is owned (directly/indirectly) by the acquirer or beneficial owners of the acquirer; or

2. the life insurance policy is owned by a business that’s acquired by the acquirer, and the acquirer carries on the acquired business or uses a significant portion of the assets in an active trade or business, assuming one of the following additional requirements is met:

(i) The insured, immediately before the acquisition, is an employee of the acquired business; or

(ii) The insured was a director, highly compensated employee or highly compensated individual and, immediately after the acquisition, the acquirer has an ongoing financial obligation to the insured (for example, non-qualified deferred compensation, pension plan, buy/sell, etc.)

A “substantial financial relationship” between the acquirer and the insured exists if the aquirer:

1. acquires the insurance to fund the purchase (at the insured’s death) of the insured’s assets, liabilities or interests in common investments with the acquirer;  or

2. is a charity to which the insured has been a substantial contributor or volunteer.

Care should be taken in applying these definitions when considering a policy transfer, as there may be circumstances in which an acquirer would appear to have a substantial family, business or financial relationship, but, in fact, doesn’t qualify as such as under the final regulations.  

Example 5: A is the initial policyholder of a $100,000 insurance policy on A’s life. A contributes the policy to a C corporation (C corp), Corporation W, in exchange for stock. After the acquisition, A owns less than 20% of the outstanding stock of Corporation W and owns stock possessing less than 20% of the total combined voting power of all stock of Corporation W (and is therefore not a “key person,” as defined by IRC Section 264, with respect to Corporation W). Corporation W’s basis in the policy is determinable in whole or in part by reference to A’s basis in the policy. However, no substantial family, business or financial relationship exists between A and Corporation W, so A’s contribution of the policy to Corporation W is a reportable policy sale. Corporation W receives the proceeds of $100,000 on A’s death. Thus, the amount of the proceeds Corporation W may exclude from gross income is limited to the actual value of the stock exchanged for the policy, plus any premiums and other amounts paid by Corporation W with respect to the policy subsequent to the transfer. The “shareholder or officer” exceptions to the transfer-for-value rule don’t apply because the transfer to Corporation W is a reportable policy sale.21

Planning note: Prior to the reportable policy sale rules, the transaction discussed in the previous example shouldn’t have caused the death benefit to become taxable under Section 101 as it would likely have satisfied the basis exception if the transferee takes the same basis as the transferor. Under the new rules, because the regulations identify the transfer as a reportable policy sale, no transfer-for-value exceptions will apply to keep the policy from being subject to income tax.

Exceptions to reportable policy sale rules. The regulations provide22 that none of the following transactions are considered reportable policy sales:

1. Transfers between entities with the same beneficial owners if the ownership interests of each beneficial owner in both the transferring entity and the transferee entity don’t vary by more than 20%.

2. Transfers among corporations that are members of an affiliated group (as defined in the Treasury regulations) that files a consolidated income tax return in the year the transfer is made.

3. A person acquires ownership interest in a partnership/trust or other entity (directly or indirectly) that owns a life insurance policy if the entity acquired the interest in the policy: (i) before Jan. 1, 2019, or (ii) in a reportable policy sale and complied with the requirements for such sales.

4. Immediately before a person acquires an interest in a partnership/trust/entity owning an interest in the life policy:

i. No more than 50% of the gross value of the assets held by the partnership/trust/entity consist of life insurance contracts; and

ii. Following the acquisition, the person acquiring the interest in the partnership/trust/entity and his family members own, in the aggregate:

a. For S corporations: 5% or less of total combined voting power of all voting stock and 5% or less of total value of shares of all classes of stock

b. For trusts/estates: 5% or less of the corpus and 5% or less of annual income

c. For partnerships: 5% or less of capital interest and 5% or less of profits interest.

5. A person acquires an ownership interest in a C corp, and 50% or less of the gross value of the assets of the C corp consists of life insurance contracts immediately before the person acquires its interest.

6. Acquisition of a life insurance contract by an insurance company that issues life insurance contracts in an exchange pursuant to IRC Section 1035.

7. Acquisition of a policy in a Section 1035 exchange if the policy holder has a substantial family, business or financial relationship with the insured at the time of the exchange.

Application to Section 1035 replacements. Although typically, there’s no transfer of policy interests or ownership as part of a Section 1035 policy replacement, replacing a policy can invoke the reportable policy sale rules if the policy owner lacks a substantial family, business or financial relationship with the insured at the time of the exchange because the policy owner is acquiring a life insurance policy as a consequence of the exchange.

Example 6: A, a corporation, purchased a policy on B, a key employee at the time the policy was issued. A later replaces the policy in a Section 1035 exchange at a time when B is no longer working for the company and the company has no financial relationship with respect to the insured. Because A lacks a substantial business or financial relationship with respect to the insured, the replacement of the policy would be considered a reportable policy sale.

Curing a reportable policy sale. The only way to fully cure a reportable policy sale is to transfer the policy to the insured for full and adequate consideration.23

Example 7: A is the initial policyholder of a $100,000 insurance policy on A’s life. A transfers the policy for $6,000, its FMV, to an individual, C, who doesn’t have a substantial family, business or financial relationship with A. The transfer from A to C is a reportable policy sale. Before A’s death, C transfers the policy back to A for $8,000, its FMV. A’s estate receives the proceeds of $100,000 on A’s death. The transfer from C to A isn’t a reportable policy sale because the acquirer A has a substantial family relationship with the insured, A. Although the transfer follows a reportable policy sale (the initial transfer from A to C), A’s estate may exclude all of the policy proceeds from gross income.24

As explained in other rather complicated examples from the final regulations, had A paid less than full and adequate consideration for the final acquisition of the policy, some portion of the death benefit from the policy would have been income taxable to A’s estate.25

Even if a policy is later transferred to a person or entity that meets one of the exceptions to the transfer-for-value rule (for example, a partner of the insured, partnership in which insured is a partner) and such transfer doesn’t, on its own, constitute a reportable policy sale, the amount of death benefit excluded from tax is limited to the sum of:

1. the higher of the amount that would have been excludible by the transferor if the transfer hadn’t occurred, or the actual value of the consideration paid by the transferee; and

2. the premiums paid by the transferee.26

Reporting obligations. The statute and regulations provide that anyone who acquires a life insurance contract or interest in a life policy in a reportable policy sale must file an IRS Form 1099-LS with respect to each life insurance policy (or interest) acquired.27

The 1099-LS requires information about the acquirer, including name, address, telephone number and taxpayer identification number (TIN). This form also requires the name, address and TIN for each payment recipient, name of the issuer, policy number of the contract(s), the amount paid to the payment recipient and the date of sale. A copy of the 1099-LS must be sent to each payment recipient and to the issuer of the policy. On receipt of the 1099-LS (or comparable statement providing this information), the policy issuer must also provide to the IRS information related to the transferor, including the name, address, TIN of the transferor, transferor’s investment in the contract and the policy number of each contract.28

On the death of the insured following a reportable policy sale, the payor of the death benefit must also furnish information regarding the name, address, TIN of each recipient, date of each payment, gross amount of each payment and estimate of the investment in the contract with respect to the buyer.29

To give acquirers and issuers ample time to develop and implement reporting systems, Treas. Regs. Section 1.101-1 provides that no reporting is required for reportable policy sales made and reportable death benefits paid after Dec. 31, 2017 and before Jan. 1, 2019.

Analyzing Policy Transfers 

Analyzing transfers of policy interests for potential violations under the transfer-for-value rules has become more complicated with the addition of reportable policy sale rules. To aid in this analysis, it’s helpful to break down the transaction into three simple steps. (See “Determining Potential Violations,” p. 34.) 

1. Is the current transfer a reportable policy sale? If the transferee or acquirer doesn’t have a substantial family, business or financial relationship with the insured, then the answer here is “yes.” In that case, no further analysis is needed, and the death benefit will be subject to taxation in accordance with the rules outlined above for reportable policy sales. In addition, reporting requirements associated with reportable policy sales must be followed. 

If the answer is “no,” proceed to the next question.

2. Is the current transfer a transfer for value for which no exception applies? If the transfer is to someone other than the insured, a partner of the insured, partnership in which the insured is a member, corporation in which the insured is a shareholder or officer or if the basis of the policy isn’t determined in whole or in part on the basis of the transferor, then the answer is “yes.” In that case, the policy death benefit will be subject to taxation at the death of the insured, unless further steps are taken to “cure” the transfer.

If the answer is “no,” proceed to the next question.

3. Has any reportable policy sale occurred before the transfer? Even if the current transfer of policy interests doesn’t constitute a reportable policy sale or a transfer for value, if a reportable policy sale has occurred at any time prior to the current transfer, then the answer here is “yes.” In that case, a portion of the policy death benefit will be subject to income tax as explained under the reportable policy sale regulations (and previously discussed in this article).30 The one exception here is if the policy is being transferred to the insured for full and adequate consideration; in which case, the death benefit should be received income tax free under IRC Section 101.31

If the answer is “no,” then the transfer of policy interests being contemplated shouldn’t result in the taxation of death benefit due to a reportable policy sale or transfer for value.                     

—Insurance products are issued by: John Hancock Life Insurance Company (U.S.A.), Boston, Mass. 02116 (not licensed in New York) and John Hancock Life Insurance Company of New York, Valhalla, New York 10595.

Endnotes

1. Internal Revenue Code Section 101(a)(2).

2. Ibid. “Other amounts” include interest paid or accrued by the transferee on indebtedness with respect to such contract or any interest therein if such interest paid or accrued isn’t allowable as a deduction under IRC Section 264(a)(4). 

3. See James F. Waters, Inc. v. Commissioner, 160 F.2d 596 (9th Cir. 19447), holding that a transfer for value can occur even though the policy transferred has no cash surrender value.

4. Treasury Regulations Section 1.101-1(e)(1) and (2).

5. Ibid.

6. See also Treas. Regs. Section 1.101-1(b)(1).

7. Section 101(a)(2)(B), Treas. Regs. Section 1.101-1(b)(1)(ii)(B)(1).

8. Section 101(a)(2)(A), Treas. Regs. Section 1.101-1(b)(1)(ii)(A).

9. Section 101(a)(3), Treas. Regs. Section 1.101-1(b)(1)(ii)(B)(2). 

10. IRC Section 1015.

11. IRC Section 1041(a).

12. Revenue Ruling 85-13.

13. Rev. Rul. 2007-13.

14. Ibid.

15. Section 101(a)(3)(B), Treas. Regs. Section 1.101-1(c).

16. Treas. Regs. Section 1.101-1(d)(1).

17. Section 101(a)(3), Treas. Regs. Section 1.101-1(b)(1)(ii)(A) and (B).

18. Treas. Regs. Section 1.101-1(b)(1)(ii)(B)(2).

19. Treas. Regs. Section 1.101-1(b)(1)(ii)(B)(3).

20. See supra note 17. 

21. Treas. Regs. Section 1.101-1(g)(12) (Example 12).

22. Treas. Regs. Section 1.101-1(c)(2).

23. Treas. Regs. Section 1.101-1(b)(1)(ii)(B)(3)(i). See also Treas. Regs. Sections 1.101-1(g)(6) and (7) for examples.

24. Treas. Regs. Section 1.101-1(g)(6).

25. Ibid.

26. See supra note 18.

27. IRC Section 6050Y(a)(1), Proposed Treas. Regs. Section 1.6050Y-2(a).

28. Section 6050Y(b), Prop. Treas. Regs. Section 1.6050Y-3(a).

29. Section 6050Y(c), Prop. Treas. Regs. Section 1.6050Y-4(a).

30. See supra note 18.

31. See Treas. Regs. Section 1.101-1(b)(1)(ii)(B)(3)(i).

Competitive executive compensation planning in non-profit organizations is challenging. State and federal laws as well as public policy often limit the opportunities to offer compensation packages similar to those commonly offered in for-profit companies. This often skews the talent stream in their favor. The use of split-dollar life insurance as an executive benefit has become popular to provide a bridge over the compensation gap. It’s been used as a valuable employee benefit since the 1940s. Then and now, it’s used to recruit, retain and reward key employees with a tax-arbitraged plan. The arbitrage is using the nonprofit’s untaxed dollars to provide tax-advantaged benefits to key executives. Depending on the plan design, it can provide retirement benefits to the employee and golden handcuffs and cost recovery to the employer. Although this article is focused on executive benefit planning in nonprofits, split dollar as an executive benefit may also be effective in non-publicly traded, for-profit businesses. A split-dollar life insurance plan should always be considered when one party needs or wants a benefit, and the other party has the financial ability to pay for it. 

Split-Dollar Plan Regulations

Prior to 2003, it was the wild west for split-dollar planning, meaning that many designs were developed that were eventually seen as abusive.1 The split-dollar regulations were enacted in 2003 to provide uniformity and a level playing field in split-dollar planning.2 The result of the implementation of the rules is to bring certainty to split-dollar planning and limit challenges when the rules and the spirit of the rules are followed.

The regulations provide two planning regimes: (1) economic benefit; and (2) loan. Both have beneficial applications in executive benefit planning. Because there can only be one title owner of a life insurance policy, the owner is often determined by the ownership desired on termination of the arrangement. Policy ownership is key to the type of plan chosen. With the endorsement method, the title owner of the policy owns the cash value and endorses the term portion to the other party. With the collateral assignment method, the title owner owns the term portion of the policy and collaterally assigns the cash value portion to the other party. 

Once the ownership method is chosen, the regime must be determined. The economic benefit regime applies to both equity and non-equity split-dollar arrangements. Non-equity split dollar is used for endorsement method plans. The policy title owner endorses the term portion to the party receiving the benefit. Equity split dollar also uses the endorsement method. The difference is that the policy equity, above premiums paid, inures to the party receiving the benefit without any tax consequences. This type of plan design is no longer used because the regulations imposed tax on the policy growth.

Loan regime applies to collateral assignment method plans. The policy title owner is the party receiving the benefit. The party providing the benefit makes loans of the premium amounts to the benefited party. The prevailing applicable federal rate is used to calculate the loan interest unless a below market rate is used, in which case, interest will be imputed by Internal Revenue Code Section 7872. Current low interest rates favor the use of loan regime arrangements. To lock in the low rates, a single loan for a single premium policy may be particularly attractive.

Taxation of the Plan Regimes

When using an economic benefit regime, non-equity plan for an executive benefit, the employer pays the full premium. The employee is taxed on the economic benefit of the insurance protection received using the Table 2001 rates. The premiums paid by the employer generally aren’t deductible; however, the death proceeds are generally received tax free.3  

When using the loan regime, the employee is the policy title owner, and the employer makes premium loans to the employee. The employee isn’t taxed on the loans unless they’re forgiven. The employer pays the interest on the premium loans, which is taxed to the employee as a compensation item.4 The employee isn’t taxed on the annual policy cash value growth, making the loan regime an alternative to the old equity split-dollar planning. The employer can’t deduct the loans made and if the plan is in a for-profit, must include the interest payments in taxable income. When the loans are repaid, neither nonprofits nor for-profits are taxed on the amounts.5

Famous LSDP Recovery Plans

Loan split-dollar plans (LSDPs) with cost recovery have become popular golden handcuffs for celebrity sports coaches. One of the most well-known cases is a benefit provided by the University of Michigan to its Wolverines football coach, Jim Harbaugh. To retain and reward Coach Harbaugh, the school adopted an LSDP to provide the coach with future tax-free income, while creating a golden handcuffs benefit and recovery of the plan costs. In this LSDP:

• The employee is the applicant and title owner of the life insurance policy.

• The employer loans the premiums to the employee. In this case, the loans totaled $14 million.

• The employee has no out-of-pocket costs and simply includes the loan interest imputed by Section 7872 in taxable income.

• The premium loans will be repaid to the employer from the tax-free death benefit at the employee’s death or from the policy cash value if the arrangement is terminated sooner. This is the cost recovery feature of the plan. 

• If the employee ceases to perform the agreed-on duties, the employer stops making premium loans. This is the golden handcuffs feature of the plan. 

• In retirement, the employee enjoys tax-free income through policy withdrawals and/or policy loans.

Due to the positive publicity surrounding the Coach Harbaugh LSDP, other schools have followed suit. Clemson University included a similar benefit in Coach Dabo Swinney’s latest contract extension. Louisiana State University also rewarded its winning coach, Ed Orgeron, with an LSDP. Recently, the University of South Carolina entered into a split-dollar arrangement with its women’s head basketball coach, Dawn Staley. It required Coach Staley to remain as the head coach for five years to receive the benefit.

Not-So-Famous LSDPs

A number of educational institutions have adopted LSDPs with cost recovery. In a recent case, a university wanted to provide an additional benefit to its president. It desired to retain her and reward her successes at the school. Because executive compensation in nonprofits can be statutorily and politically challenging, in this case, an LSDP was viewed as a beneficial way to meet the needs of both the university and its president. Here, as in many other cases, a critical component of the LSDP is the fully secured cost recovery feature.

LSDPs have also gained popularity in credit unions (CUs). One plan in a Texas CU was challenged by a member, claiming that the CU was making loans that it wouldn’t make to members. This CU had made loans of $36 million to its top executives to lock in these talented employees for the final 10-to-15 years of their careers. In dismissing the challenge to the benefit plan, the CU noted that executive loans are permitted under the National Credit Union Administration regulations6 and that the plan agreements were carefully drafted to protect the CU under all potential circumstances. The CU concluded that while a loan is involved, this was nothing more than a retirement plan, much like a pension plan, and the CU certainly wouldn’t offer a non-employee a pension plan.

An Alternative to DBO Plans

A death benefit only (DBO) plan provides a benefit to the employee’s designated recipient on the employee’s death. These plans are often used to provide for the employee’s family and for estate-planning needs. Because the DBO is a form of non-qualified deferred compensation, when the benefit is paid on death, it’s included in ordinary income for tax purposes as income in respect of a decedent.7

Economic benefit endorsement split dollar is a tax-advantaged possible alternative to a taxable DBO plan. In this plan, the employer is the policy owner and is entitled to the policy cash value. The employer endorses the term insurance portion of the policy to the employee, who’s responsible for the cost of the economic benefit of the coverage received, using the Table 2001 rates. Typically, the employer pays the premiums. The employee has no out-of-pocket costs but is taxed on the Table 2001 economic benefit annually. Although the premiums paid for the employer’s interest in the policy aren’t deductible, the death proceeds are received tax free.8 The value of using an economic benefit endorsement plan, when compared to a DBO, is the difference between the relatively small economic benefit cost of the term insurance coverage and the full benefit being taxed at death.

Nuts and Bolts of Planning

Choosing the appropriate life insurance product is important to the success of the plan. The choice depends on the plan design. Generally, the product should have enough cash value growth for lifetime access and sufficient death benefit for plan cost recovery. For this reason, permanent products, especially whole life and properly funded universal and indexed universal life products, are commonly used. 

There are several additional IRC sections the planner needs to be aware of when designing an LSDP. Fortunately, the Internal Revenue Service has issued Notice 2007-34, which provides that IRC Section 409A doesn’t apply because these plans aren’t non-qualified deferred compensation. The Pension Protection Act of 2009 added Section 101(j) to the IRC. For the employer to retain the tax-free status of insurance it owns on employees, it must provide them with written notice of the coverage and get their consent to having the employer insure them. Failure to obtain the notice and consent makes the policy death benefit taxable above premiums paid by the employer. This provision was enacted in response to plans adopted by several of the country’s largest employers that purchased policies on many employees as a profit center. The employer received the tax-free death benefit while the employee’s family received nothing. 

Although LSDPs aren’t subject to Section 409A regulation, care must be taken to comply with the Employee Retirement Income Security Act (ERISA) Top Hat rules. Top Hat plans are exempt from the ERISA participation, vesting, reporting and fiduciary requirements. To qualify for the exemption, the benefit must only be offered to a select group of management or highly compensated employees. The Department of Labor has concluded that the Top Hat exemption makes sense, because these individuals, by virtue of their position or compensation level, are able to affect or substantially influence the design and operation of the arrangement. They don’t need the substantive rights of Title 1 of ERISA.9

The Tax Cuts and Jobs Act of 2017 imposed a 21% excise tax on compensation exceeding $1 million.10 An LSDP may help mitigate the impact of this tax on executives by reducing the amount of compensation to the imputed loan interest, while providing a larger tax-free benefit. 

All tax-exempt organizations are required to file a Form 990 annually with the IRS. They must report all compensation for officers and key employees on Schedule J. With LSDPs, only the imputed interest cost is reported. It’s important to note on Form 990 that the plan is designed for the recovery of the plan costs. This explanation may help prevent misunderstandings about the loans made.

Before adopting an LSDP in a nonprofit, the situs state’s statutes should be reviewed. A number of states prohibit loans to executives of nonprofits. Almost all of these states, however, have exceptions permitting split-dollar loans.

A final note on the applicability of LSDPs. Their usefulness in executive compensation planning isn’t limited to nonprofits. The benefit may be used in for-profits as well. To design a viable LSDP in a for-profit, a tax analysis should be conducted because the employer’s after-tax dollars will be used to pay premiums. If the economics work, an LSDP may provide an excellent way to recruit, retain and reward top talent. Of course, the Sarbanes Oxley Act of 2002 curtailed the use of LSDPs in publicly traded companies by prohibiting personal loans to directors and officers.   

Endnotes

1. These designs include reverse split dollar, Internal Revenue Service Notice 2002-59; equity split dollar, Treasury Regulations Section 1.61-22; and economic benefit rate manipulation, IRS Notice 2002-8.

2. Treas. Regs. Section 1.61-22 applies to all shared benefit arrangements for life insurance entered into after Sept. 17, 2003 and to pre-Sept. 17 arrangements if materially modified.

3. Internal Revenue Code Section 101(a). Beware, however, of the transfer-for-value rule of IRC Section 101(a)(2).

4. Avoid below market interest rate arrangements to prevent tax disclosure reporting and the chance of causing original issue discount problems for term loans.

5. Section 101. 

6. Code of Federal Regulations, Title 12, Chapter VII.

7. IRC Section 691.

8. Section 101(a).

9. Department of Labor Adv. Op. 90-144 (May 8, 1990).

10. IRC Section 4960.

For many wealthy families, leaving a traditional individual retirement account, or better yet a Roth IRA, to the next generation remains a powerful planning tool.

The Setting Every Community Up for Retirement Enhancement (SECURE) Act1 has dramatically changed the estate-planning options available to individuals with assets held in IRAs.2 IRA owners have long relied on the ability to stretch the tax-deferred life of an IRA beyond the IRA owner’s death, that is, the IRA owner could make the IRA payable to a designated beneficiary at death, typically an individual or a special type of see-through trust, and that designated beneficiary (or trust) could then take the required minimum distributions (RMDs) over his life expectancy (or the life expectancy of the oldest living trust beneficiary). The result was that an IRA could continue to remain invested in its tax-deferred status for years, or even decades, after the IRA owner’s death. 

The SECURE Act has eliminated this stretch option for most IRAs. With the exception of five specific types of eligible designated beneficiaries,3 the life expectancy payout period has been replaced by a 10-year window, meaning that in most cases, all of the assets held in an inherited IRA must be withdrawn within 10 years of the IRA owner’s death. 

In the wake of this seismic shift, IRA owners have been left scrambling to evaluate the next best option. Many IRA owners have the same, knee-jerk reaction: Maybe I should just leave my IRA to charity? At first glance, for an IRA owner in the highest applicable tax bracket who expects to be subject to estate tax, this option may seem very appealing. After all, for an IRA owner who lives in a high tax jurisdiction like New York City, the combination of federal and state income tax rates of 49.5%4 and federal and state estate tax rates of 56%5 means the entire IRA could be taxed away at death! If the government is going to get all of the IRA assets otherwise, why not leave the IRA to charity? 

Keep or Donate?

It’s important to remember, however, that while the lifetime tax-deferred stretch may be dead, tax deferral over any period of time is still an extremely valuable and powerful tool. Our research at Capital Group Private Client Services shows that, even in a post–SECURE Act world, for an IRA owner who wants to pass significant assets to the next generation, keeping assets in a traditional IRA can still be a more attractive option than designating a charity as the IRA beneficiary. Furthermore, for an IRA owner who expects to be subject to the estate tax, a Roth conversion may be an even more attractive option. To illustrate these conclusions, we’ll use a case study (based on an actual client situation we recently encountered) to compare four different scenarios:

1. Keeping assets in a traditional IRA and designating the IRA owner’s children as beneficiaries;

2. Converting a traditional IRA to a Roth IRA and designating the IRA owner’s children as beneficiaries;

3. Designating a charity (for example, a donor-advised fund (DAF)) as the IRA beneficiary; and

4. Designating a charitable remainder trust (CRT) as the IRA beneficiary with children as lead beneficiaries to try to create a synthetic stretch IRA.

See “Key Assumptions,” this page, for a summary of the key assumptions applying to all four scenarios.

Case Study

Consider a 90-year-old widow (Mother) who’s used her entire lifetime exemption amount and has $8 million in assets that will be fully subject to federal and New York state estate tax, including a $1 million traditional IRA. The widow has a 60-year-old daughter (Daughter) who’s her sole heir. Mother and Daughter are both New York City residents subject to the top federal, state and local marginal income tax rates. Mother is ill and isn’t expected to live much longer.6 In all cases, we assume that Daughter doesn’t need to spend from this pool of assets, and they’ll continue to grow within her estate. 

Scenario 1—Mother names Daughter as the beneficiary of the traditional IRA. In this scenario, all $8 million will be subject to a 56% combined federal and state estate tax. Assuming that estate taxes will be paid from non-IRA assets, after the $4.5 million in estate tax is paid, Daughter will inherit $2.5 million in taxable assets and a $1 million traditional IRA, for a total of $3.5 million in net inherited assets. (See “Summary of Inherited Assets,” p. 41, for a summary of these calculations).

One underappreciated change made by the SECURE Act is that while the assets need to be withdrawn from an inherited IRA within 10 years of the IRA owner’s death, there are no RMDs during that 10-year period. In this scenario, this means the $1 million can remain invested and grow tax-free over the next 10 years. Furthermore, in Year 10, when the daughter must withdraw the entire IRA, she’ll receive an income tax credit for the estate taxes that were paid on the income tax liability housed within the IRA (the income in respect of a decedent deduction).7 We estimate that 10 years hence, the taxable assets will have grown to $4 million. The $1 million IRA will have been allowed to appreciate to approximately $1.8 million and would net $1.1 million after paying income taxes on the withdrawal and adjusting for any deduction allowed for income in respect of a decedent.8 In total, we estimate that Daughter will have $5.1 million of assets. (Our estimates are included at the end of this article.)

What if Mother doesn’t want Daughter to inherit the IRA assets outright? As was the case pre–SECURE Act, there are still two types of trusts that can be designated as beneficiaries of an IRA: conduit trusts and accumulation trusts (sometimes collectively called “see-through” trusts). With a conduit trust, all distributions made from the IRA flow through the trust (after applicable deductions) to the individual life beneficiary, such that the trust acts as a conduit for the IRA distributions (hence the name).9 Post–SECURE Act, a conduit trust works the same way, such that a conduit trust will be entitled to the same 10-year payout period.10

Similarly, an accumulation trust will still function the same way it did pre–SECURE Act. With an accumulation trust, the trustee can accumulate IRA distributions inside the trust for later distribution to the trust beneficiaries in accordance with the trust terms, and, if structured properly, the accumulation trust will also still qualify for the same 10-year payout period.11 

Scenario 2—Mother converts her traditional IRA to a Roth IRA and designates Daughter as beneficiary. When a traditional IRA is converted to a Roth IRA, income taxes are assessed on the market value of the assets in the IRA on the date of conversion, at the IRA owner’s current federal and state income tax rates in the year of conversion. However, once such income taxes are paid, under current law, any future withdrawals from the IRA aren’t subject to further income tax. 

In this scenario, if Mother’s $1 million traditional IRA is converted to a Roth IRA before her death, Mother’s potential taxable estate will be reduced by the amount of income taxes she paid in connection with the Roth conversion. If such income taxes can be paid with assets outside the IRA (that is, from Mother’s taxable assets), allowing the newly converted Roth IRA’s value to remain at $1 million, Daughter will inherit $2.3 million in a taxable account and a $1 million Roth IRA. We estimate that 10 years hence, the taxable assets will have grown to $3.6 million, and the $1 million Roth IRA will have appreciated to approximately $1.8 million. In total, we estimate that Daughter will have $5.4 million of assets, resulting in $300,000 more money passing to her versus the amount in Scenario 1 (leaving the assets in a traditional IRA and designating Daughter as the beneficiary). 

This may be a surprising result for some readers; however, the power of tax deferral is often underestimated. Having $1 million of after-tax money in a Roth IRA is more valuable than having $1 million in a traditional IRA, as the wealth in the Roth IRA is able to benefit from the 10 years of tax-deferred growth with no future tax liability. The embedded income tax in the traditional IRA and the estate tax due on Mother’s total assets at her death are sunk costs. The most efficient ways to pay those taxes are to: (1) pay the income tax on the traditional IRA prior to death by converting the traditional IRA to a Roth before death, avoiding an upfront payment of estate taxes on that income tax liability amount; and (2) pay the estate tax due from taxable, non-retirement assets. In fact, for families that are in this situation, the earlier Mother does the Roth conversion the better, as following conversion she’ll have eliminated RMDs for the remainder of her life.

This conclusion is specific to our assumptions that both Mother and Daughter are in the top federal income tax brackets and subject to estate tax on all assets and that Daughter can afford to leave her inherited assets untouched and invested for the full 10-year period. To the extent that Daughter is in a significantly lower income tax bracket and/or Mother or Daughter aren’t subject to estate tax, foregoing a Roth conversion and retaining the traditional IRA may be optimal. (See “A Compelling Strategy,” this page.)

Scenario 3—Mother designates a charity as the IRA beneficiary. Designating a charity as the sole beneficiary of Mother’s $1 million traditional IRA will result in a federal and state estate tax charitable deduction for Mother’s estate, and no federal, state or local income tax will be assessed on the IRA assets. After payment of federal and state estate taxes, we estimate that Daughter will inherit $3.1 million, all in taxable assets. Using our assumptions, Daughter’s $3.1 million in inherited taxable assets would grow to approximately $4.9 million over a 10-year period, approximately $500,000 less than what Daughter is projected to inherit in Scenario 2.

It’s important to note that an IRA owner’s charitable inclinations should be considered carefully in this scenario (as well as in Scenario 4, below). A charitable gift made to a DAF as the sole designated beneficiary of a $1 million traditional IRA at the IRA owner’s death would be projected to grow to approximately $1.8 million (See “Charitable Impact of Individual Retirement Account, p. 43) over the ensuing 10 years. This strategy should provide significant additional value to charitable organizations important to the family, almost doubling the size of the family’s charitable gifts, if the family is willing to wait 10 years to make those charitable gifts. This is a high leverage charitable strategy! 

Scenario 4—Mother designates a charitable remainder trust (CRT) as IRA beneficiary with Daughter as lead beneficiary. Since the passage of the SECURE Act, many commentators have suggested that a “synthetic” stretch IRA can be achieved by naming a CRT as an IRA beneficiary. The basic idea is as follows: The IRA owner creates a CRT and designates the CRT as the beneficiary of his IRA. The CRT has a non-charitable lead beneficiary or beneficiaries (that is, individual descendant(s) of the IRA owner) who receive an annual income stream from the CRT12 during life (or for a set time period not to exceed 20 years), and the remainder left in the CRT on the death of the last living lead beneficiary/expiration of the time period passes to charity. 

The IRA owner’s estate receives an estate tax deduction equal to the present value of the remainder interest passing to charity. The lead beneficiary(ies) pay income taxes on receipt of distributions from the CRT each year, as would be the case if distributions were received from an inherited traditional IRA. The difference is, with the CRT, the time period for making distributions to the lead beneficiaries isn’t limited to 10 years, but can instead be tied to the lead beneficiaries’ lifetime. Thus, goes the thinking, the IRA owner can simulate the stretch that was available on inherited IRAs pre–SECURE Act and defer the distributions made from the IRA for a longer period of time.

In this scenario, Mother creates a charitable remainder unitrust (CRUT) and designates the CRUT as the beneficiary of her $1 million traditional IRA. The CRUT has a required 5% annual unitrust lead payout to Daughter. Mother’s estate gets a $380,000 charitable deduction13 based on the present value of the CRUT remainder that will eventually pass to charity at Daughter’s death. Daughter inherits $2.7 million of taxable assets and is the income beneficiary of a CRUT funded with $1 million. 

The CRT benefits Daughter more the longer she survives. As “Charitable Remainder Trust (CRT) Result,” this page, shows, over the very long term, the CRUT creates a bit more wealth for the next generation than does leaving assets in a traditional IRA (the orange CRT line starts below the red traditional IRA line, but passes it after 30 years) while also providing a benefit to charity. However, the CRT strategy still trails the Roth IRA conversion (gray line). For a 60-year-old beneficiary like Daughter, the 30-year break-even point is likely too long to make sense in the absence of a charitable objective.

Even for a younger beneficiary who has a life expectancy of 40 years or more, designating a CRT as an IRA beneficiary may still be suboptimal given mortality and liquidity risks. If the lead beneficiary passes away earlier than expected, any remaining assets in the CRT pass to charity immediately on death, and the benefit of the synthetic stretch is lost. Furthermore, assets in an inherited IRA can always be accessed early by the IRA beneficiary if needed, whereas assets held in a CRT can’t. 

The CRT does have an estimated charitable interest of $500,000 in Year 10, as seen in “Charitable Impact of Individual Retirement Account,” this page, which may tilt the scales for a family looking for a balance between charitable and family wealth transfer objectives. The combined value to family and charity in Scenario 4 would exceed that of the value to the family only in the Roth IRA conversion in Scenario 2. 

Tax Deferral Opportunities

By limiting the ability to stretch an IRA’s tax-deferred status to 10 years in most situations, the SECURE Act has reduced the benefit of accumulating significant assets in IRAs. However, IRAs still remain more valuable than many other assets due to still-remaining opportunities to defer taxes on IRA assets. As the case study above shows, individuals should continue to evaluate and avail themselves of the various vehicles that allow them to harness the power of tax deferral.  

— Statements attributed to an individual represent the opinions of that individual as of the date published and do not necessarily reflect the opinions of Capital Group or its affiliates. This material does not constitute legal or tax advice. Investors should consult with their legal or tax advisors.

Endnotes

1. Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019, Pub. L. 116-94 (2019), www.govtrack.us/congress/bills/116/hr1865/text or Internal Revenue Code Section 401(a)(9)(H).

2. While the SECURE Act’s provisions apply to other types of employer-sponsored plans, the discussion in this article focuses on individual retirement accounts. 

3. IRC Section 401(a)(9)(E)(ii).

4. Current top marginal income tax rates are 37% federal, 8.82% New York State and 3.648% New York City. For information on current federal rates, see Revenue Procedure 2019-44, www.irs.gov/pub/irs-drop/rp-19-44.pdf. For information on current New York State rates, see www.tax.ny.gov/pit/file/tax_tables.htm. The deduction that can be taken on one’s federal income tax return for state and local taxes paid is now limited to $10,000 (see the Tax Cuts and Jobs Act of 2017, Pub. L. 115-97 (2017)). 

5. The current top federal estate tax rate in 2020 is 40%, and the New York State estate tax rate is 16%. For information on federal estate tax rates, see Internal Revenue Code Section 2001(c), as amended by Section 302(a)(2) of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (H.R. 4853), Pub. L. No. 111-312, 124 Stat. 3296, 3301 (Dec. 17, 2010), as amended by Section 101(c)(1) of the American Taxpayer Relief Act of 2012; see“Instructions for Form 706 (revised August 2019),” at p. 5, www.irs.gov/pub/irs-pdf/i706.pdf. For information on New York State estate tax rates, see www.tax.ny.gov/pit/estate/etidx.htm; www.tax.ny.gov/pdf/current_forms/et/et706i.pdf and www.tax.ny.gov/pdf/current_forms/et/et706.pdf. 

6. This case study is based on a true story. When we brought up options such as making lifetime taxable gifts or rolling grantor retained annuity trusts, which would be dependent on 2-to-3 years of survival, the daughter replied, “good luck with that!”

7. Generally, income tax must be paid on income received from an inherited IRA; however, a beneficiary can get the income in respect of a decedent (IRD) deduction on inherited IRA assets by showing that the estate of the deceased IRA owner already paid federal estate taxes on the inherited IRA assets. This rule exists to avoid double taxation. See IRC Section 691(c) for detailed information on how the IRD deduction works.

8. Ibid.

9. For a detailed discussion of how properly to structure a conduit trust as an IRA beneficiary, see Natalie B. Choate, Life and Death Planning for Retirement Benefits, 8th edition (2019), and in particular, at pps. 68, 71 and 393-485.

10. If the individual conduit beneficiary is one of the five types of “eligible designated beneficiaries,” the trust would be entitled to a life expectancy payout. See Section 401(a)(9)(E)(ii).

11. Supra note 9.

12. Supra note 9, particularly at pps. 526–531.

13. Assumes IRC Section 7520 rate of 2%.

Isabelle, a real estate agent, and Nick, a financial guy, met in their early 40s through a mutual acquaintance. Though their romantic connection was unexpected, the pair quickly committed to each other and their new relationship. However, not long into their courtship, Isabelle disclosed that her father was “kind of rich.” Though Nick was confused about what that meant, he responded with a shrug and with a simple “okay.” Bruised by similar disclosures in the past, Isabelle pressed him for a deeper understanding, “No, like, really rich. Soooo, is that going to be a problem?” 

Why is it an issue if one member of a new relationship has far more money than the other, especially if there’s a wide divergence? Money isn’t neutral and has a deep significance in a relationship. Whatever the couple would like to believe, the individual with more money will likely exercise some sort of emotional dominance over their partner. While we’re in an age when we desire gender neutrality or egalitarianism, the reality is that if the woman has greater wealth, both partners will be influenced by that inequality. How does the less wealthy partner feel if his earnings are insignificant, the house and vacations come courtesy of the wife’s inheritance or the wife’s family tries to influence her behavior because they have some control over her wealth? These factors are a significant influence and make the development of a comfortable, trusting, emotionally full relationship more difficult. Let’s consider what happens when the female partner enters the relationship with huge financial resources from her family.

Traversing Differences  

Initially things went smoothly for Nick and Isabelle. However, in time and in insidious ways, Nick began to experience the impact of Isabelle’s family’s wealth. Even with a secure sense of self, merits and accolades of his own and a solidly upper-middle class background, Nick felt the shock of entering into her land of wealth and the monolithic family system that inhabited it. Everyone in the system seemed obsessed with her father as well as with Isabelle and her siblings. He felt diminished and one down in the relationship, his work and new family. 

The first major blow came when Isabelle’s father informed Nick that somewhere down the line, Isabelle was set to inherit around $600 million. Nick felt it was too much to get his head around. Not only was Isabelle’s inheritance a challenge for Nick to comprehend, for all intents and purposes, Isabelle didn’t conceivably have a sense of the scale as to the amount she was inheriting. Following their engagement, in a meeting with her family lawyers, Isabelle rejected the idea of a pre-nuptial agreement (prenup). As Isabelle understood it, Nick was also set to receive an inheritance from his family. She didn’t realize that his was $1 million. If that were the couple’s only resource, it would be a wonderful nest egg. But in their situation, Nick’s contribution was insignificant. The couple had missed their first big opportunity to discuss “the elephant in the room”— what did their financial inequality mean to them?

In time, the couple accepted and navigated the confusion and the challenges of the new relational paradigm. However, new questions continually emerged. Should she be the only one to talk to her father about the money? Was Nick allowed to do it? Were they really going to choose her awesome family trip again over going to his parents’ house for the holidays? The answers were seemingly always out of the grips of their mutual understanding and individual comfort. Having no reflection or direction on how this type of relationship might function meant the pair would blindly forge forward.

Challenges of Financial Diversity

Couples who are in a financially diverse partnership due to inheritance, identities, cross-class backgrounds, family systems and socially held norms face a different and unique set of challenges and questions compared with their financially diverse counterparts with earned wealth. For example, inheritors may question: What does it mean to spend out of my means, when I have no idea what “my means” are? Spouses may question: What value do I provide if I’m not financially providing? or How will I live up to the achievement of—(insert whomever generated the family wealth)? For the marriage partners: If one of us wants to take up an expensive passion project or quit our job, what does that mean for the other? Of course, couples must work out their questions together. If they don’t, regrets and imbalances quickly build up, threatening to hinder the relationship development or dissolve their relationship all together. However, little guidance on their unique situation is available to these couples. Where do financially diverse couples with inherited wealth begin? 

Financially diverse partnerships, in which the wife holds greater financial capital than her husband, are on the rise. The effects on marriage when the wealth is tied to family can now be seen on screens big and small with characters like Astrid Leong-Teo and Michael Teo in the 2018 film Crazy Rich Asians or Shiv Roy and Tom Wambsgans in HBO’s Succession. According to the Boston Consulting Group, between 2010 and 2015, private wealth held by women grew from $34 trillion to $51 trillion. By 2020, women are expected to hold $72 trillion. And, most of the private wealth transfers in the upcoming decades will likely go to women.1 

Despite research efforts increasing within the realm of heterosexual marriages in which women earn more, there remains little inquiry around the psychological constructs of cross-class relationships and a notable absence on the effects of a woman’s inherited wealth on her relationships. 

Research on Financial Diversity

My experience with financially diverse couples, defined as a heterosexual couple in which the female’s inherited wealth2 significantly exceeds that of her male counterpart, came via the realization that no research had been done in this area. Noted authors Jay Hughes, Joanie Bronfman and Jackie Merrill started the dialogue,3 and subsequent papers have addressed the need for future exploration surrounding financially diverse relationships by highlighting the vast scale of the issues. These papers prompted my curiosity and ultimately an investigation into the lives of financially diverse couples resulting in a working directional theory, a discussion guide for couples and on-going study. 

The main goal of my research was to provide the basis for a conceptual language to help such couples effectively navigate this unexplored paradigm. Simply put, I wanted these couples, and those that work with them, to be able to understand the challenges at hand and talk about them. I interviewed both members of six couples from the United States, ranging in age from mid-30s to mid-70s. The couples represented a range of professions, years married (four to 46) and inherited wealth ($10 million to $900 million).

Findings and Takeaways

My research revealed that financially diverse couples overcome their unique challenges by directly addressing the deeper psychological and social forces—such as inheritance and embedded gender and social norms; struggles for balance, power and control; and pressures, assumptions and familial expectations about the roles they should play within the family. Another reason inheritors keep their wealth identity at a distance is the conscious or unconscious awareness of others’ resentment, envy or desire. I also discovered individual identifications and attributes along with relational dynamics that typically occur during the lifespan  of the relationship. I found that some couples craft a way to thrive in spite of their differences, while others continue to be plagued by challenges and conflict. Most importantly, I came to understand that if couples know what questions to ask each other and what traps to avoid, they can emerge stronger, fulfilled within their relationship and find more meaning in their inherited wealth.

Five Key Insights

I uncovered five key insights that financially diverse couples must keep in mind to side-step common traps and challenges to have a successful relationship:

1. Address confusion. Perhaps the most pervasive issue that emerged from my research was the individuals’ inability to understand how this type of relationship works. Couples spoke to the confusion on how to navigate this new relational paradigm. One husband reflected on not knowing what role to take early on as he always understood the husband to be the financial provider. Confusion can manifest within these relationships because of traditional gender role associations and embedded masculine ideologies. Or, there may be confusion due to: an inheritor’s family system, including lack of preparation for inheritance or the lack of agency with the wealth; the couple’s cross-class backgrounds and subsequent values; or some variation of all of the above. 

Most early relationships tend to steer clear of discussions that can create arguments. And, we know that money is the number one topic that ignites arguments. Not only have numerous studies suggested money as the most frequent source of spousal conflict (as reported by both husbands and wives) but also typically the most difficult issue for couples to resolve.4 So, there’s a perfect storm of uncertainty, avoidance and high stakes conflict at the onset of these relationships, as couples need to address the paradigm shift and relationship functioning.

Additionally, during these marriages, the confusing question of “Whose money really is it?” resounded. Some spoke of it as “our money,” then would say “her/my money,” or then at times, “The Money.” For the majority of couples, the answer seemed to be rather ineffable and slippery. 

Finally, some couples needed to address prenups that created extra confusion and pressure. In hearing participants describe their early experiences with prenups as an engaged couple, it was apparent that financially diverse couples face steep challenges in needing to address sensitive and confusing material perhaps before their relationship has even been able to establish stability. 

2. Consider the inheritor’s relationship to her wealth. Numerous writers have found that children of wealth are frequently underprepared for the responsibility that having and spending money entails.5 All of the participants in my study spoke about the inheritor being uninformed and ill-equipped to understand the impact of her inheritance. For instance, some inheritors may have received so many mixed messages about their money growing up, they didn’t know whether they were rich or poor. In a few cases, reviewing the prenup was the first encounter with their inheritance, the totality of their family’s wealth and the potential emotional impact of wealth diversity in their relationship. Consequently, I found the relationship then became the catalyst and tool for the inheritor to fully understand her relationship to her wealth. 

Money provides a place from which people are able to explore and experience their environment and, for the majority of Americans, it seems to provide a secure base for their sense of self-worth. However, most inheritors don’t want to talk about their wealth—what it’s afforded them, such as power and privilege, or taken from them, such as self-esteem, autonomy and subjectivity or what it means to their identity. Many don’t have the opportunity to personally understand their class/wealth identity formation. Instead, class/wealth identity is informed through family, friends and society. Relational observation and modeling then shapes the inheritor’s personal viewpoint of wealth and her sense of self. 

Also, and not surprisingly, the women I spoke with wanted to be seen for more than their money and separate it far from their sense of self. This, however, can come at a cost—as intergenerational wealth also plays a large role in individual identity. An example: One woman was aware that she would receive her inheritance as a young adult. After a meeting with the family lawyers, she was taken aback by the actual amount. She stated, “I didn’t know what it meant. I was doing Google searches of wealthiest women. And figuring, oh my god, I’m wealthier than Madonna!! That was weird to me. Like Madonna? I didn’t even know who I was anymore.” 

I believe another reason inheritors keep their wealth identity at a distance is the conscious or unconscious awareness of others’ resentment, envy or desire. We live in a society that both idealizes and vilifies the wealthy. Inheritors spoke of experiences of envy and exclusion. Social psychologists have suggested, in fact, that misfortunes of the wealthy can evoke a malicious pleasure in others, because people in general feel some satisfaction in the downfall of those far more successful than they are (a phenomenon labeled “schadenfreude”). So, not only may an inheritor’s wealth be a source of pressure stemming from family expectations, but also it can produce feelings of guilt or embarrassment and protection and explain why the inheritor excludes inherited wealth from her identity when meeting potential romantic partners.

3. Redefine “adding value.” All of the husbands and wives recognized the wealth’s effect on inherited power imbalances. They also observed their attempts to restore equity to the relationship. One woman talked about the conscious effort to balance the power by not making all the money decisions the way she desired. Instead, she deferred to her husband for a joint decision. Another woman got her husband a credit card in his name under her account and started buying public-facing items in both their names. One of the men talked about tirelessly working around the house and garden in effort “to contribute.” 

The challenge for balance and equity is real but different for each member of the couple. For the male partner, his wife’s wealth may make his own career achievements and earnings less important, noteworthy and significant. For the female, her own feelings of not deserving the wealth may lead her to devalue or have difficulty feeling that her work and life have significance. Together, the couple must find their own way to feel a sense of accomplishment and self-worth amid her world of family wealth. 

The husbands in this study found it helpful that they had already developed a secure sense of self when entering into their relationships and the land of wealth. The majority of inheritors found it helpful that their spouses seemed uninterested in money—or more importantly, the materialism that can go along with it. Yet, the husbands discussed a variety of feelings around the inability to find their place in their spouse’s family system and in the relationship due to feeling like an outsider to the wealth itself. One husband discussed the pressure from his spouse to be more ambitious, while another talked about the judgment cast by her family elders based on his job and class background. Some men admitted placing themselves directly within the family system by joining the family enterprise, though in some cases, this added a whole new set of challenges. 

Perhaps most compelling was the ability for some of the couples to reconceptualize the meaning of “adding value” to find balance in the relationship. Couples redefined what it meant for the husband to “provide for the family” and respected each other’s contributions in a variety of contexts. For those who were willing to expand their views, adopt a different perception, a new way of being—as well as fully accept their cross-class differences—there was a different and accelerated trajectory to those relationships. These relationships were more resilient and less prone to conflict. 

One inheritor put it this way: “There’s certain playing fields in this arena that he can’t compete on. So, it depends on what yard stick you use to measure stuff. If you’re using the wrong measuring stick you’re gonna be unhappy.” Her husband agreed: “It could have been a real problem real fast, if we were measuring success or wellbeing or contribution financially. It would have just blown up. It would have never worked. She has a whole bunch of things that she thinks I do or contribute to her, and to our family, and to her father, and to the whole thing—that are, in some ways, a nicer way to think about someone than just providing financially.”

4. Remember context and the power of systems. We’re cultural and relational beings who reside in systems. As the saying goes, “Birds of a feather flock together.” Indeed, there’s homophily in marriage unions as well; that is, a tendency for people to have positive ties with people who are similar to themselves in socially significant ways. Most marriages occur between men and women who live close to each other and are of the same race and similar age, education and social class. Therefore, perhaps it isn’t surprising that a recent study established that couples are less likely to form if the wife’s income or capital greatly exceeds the husband’s.6 

The central thread that ran through my research was that these are non-normative (read: even more complex) relationships that possess significant, and at times, insidious challenges due to the different systems in which they reside. Not only are these couples rewriting cultural norms, namely embedded gender role associations, but also they must continually move between multiple systems: the relationship itself, social classes and family enterprises/systems, to name a few. 

One thing that struck me was that these couples have to work against and with these external systems to understand how to make their relationship work for them—many doing so without an internal compass or capacity for mutual discovery due to age and/or lack of experience. As one husband noted, “One of the few ways that I actually do think her wealth has been an issue is she’s used to being the center of the universe. She’s used to people making her preferences into their preferences.” 

For better or worse, relational patterns along with how these multiple systems are navigated will influence how a relationship’s development unfolds. For the majority of financially diverse couples I studied, possessing assets from inheritance was a primary source of income that often carried a great deal of internal and external pressure, confusion, interdependency and power differentials within the family. It can be hard for the inheritor and couple to separate from the benefactor or family system. However, couples must figure out how to move towards the active creation of their own system. 

5. Increase communication about differences. All relationships begin, are maintained and end through communication. Americans generally dislike talking about money, class and class-based stratification. Nonetheless, they’re important features of our society and influential variables in financially diverse marriages especially as class distinctions manifest in everyday life. Differing attitudes and behaviors stemming from cross-class backgrounds impact these couples in ways big and small. Yet, the couples in my study consistently discussed how money magnified their problems. 

I believe the subjective meaning of money holds a host of conscious and unconscious feelings that can create a variety of issues while in a relationship with another. But, I also believe what happens all too often is that money becomes the vessel for which all other underlying issues get placed. Money is the easiest to blame. 

Cross-class backgrounds, along with the transmission of family values, may lay dormant in discussions but they act as directives in these partnerships. They play an important role in decisions ranging from where to live and what to do in free time, to the management and governance of inheritance structures and parenting. 

Researchers who study interracial and interfaith relationships discuss each individual bringing different and unique aspects that create a richness in the relationship. I would argue the same is true for these cross-class couples. I think the potential strengths and creative aspects of these unions are often ignored. However, these couples also encounter a unique set of challenges: one potentially being the inheritor’s lack of integrated identity to her wealth. Another challenge is the complex dialogue of intersecting identities (that is, gender, ethnicity, class, etc.). Historically, gender roles, ethnicity, wealth and social class each commonly and independently included social dictates about power and powerless, independence and dependence, but as these norms slowly change, how they interact with each other and influence the cultural zeitgeist (and one’s identity) is still unknown.

Renowned researcher and clinician John Gottman  has done extensive work over four decades on divorce prediction and marital stability. He discusses how it’s life’s every day, moment-to-moment communication attempts and how these attempts are acted on that make the difference in whether a marriage succeeds or fails. It’s no surprise then that I found the main differentiator for successful and sustainable financially diverse marriages came down to awareness and communication between partners. Without question, the communication about—and acknowledgment of—the inheritor’s wealth, along with the recognition of varying and differing attitudes and behaviors that stem from cross-class backgrounds, were crucial in determining the course of the relationship.  

Sidestepping the Traps 

Most discussions about diversity in couples tend to focus on the conflicts that arise out of challenges. Because the challenges are a developmental byproduct of this type of relationship, it’s important for couples to learn how to sidestep the traps and move through the challenges towards resiliency and growth.

Despite the power of systems and differences to damage these relationships, my research showed it can also assist in the development of a greater sense of self, more meaningful relationships to inherited wealth and an increased intimacy within these marriages. I found that the differences that complicate these relationships don’t predict relational outcomes such as satisfaction, commitment, intimacy and stability. Rather, it’s the couple’s ability to communicate effectively with one another and understand each other’s diverse and divergent points of view. 

Relational tension can be unbearable for some— and at best, uncomfortable for most. So, it’s understandable that couples often look for logistical solutions to their challenges, especially as the waters of a financially diverse relationship can be murky and anxiety provoking. However, it prolongs the struggle. The underlying confusions and tensions will remain unresolved in the relationship. Instead of simply trying to find ways to negotiate and balance differences, financially diverse couples must seek to understand, share and discuss the emotions, values and fears underlying their differences and the inherent imbalance of power. 

Talking about the feelings as well as the challenges that come with family money, non-normative partnerships, shifting power differentials and differing backgrounds can help mitigate and manage conflict. But, couples must also allow themselves to go through the feelings—the ones that typically we all prefer to stuff down—to move towards acceptance and sincere understanding. It’s similar to the grieving process, in which one has to go through it to come through it. I recommend working with a professional who has experience in couples therapy and understands the complex psychological picture of money as well as diversity for the most comprehensive approach in managing the moments when different perspectives and backgrounds clash. 

Moving Forward

Like all good change agents, in time, Nick disrupted the established systems a huge way. First, he and Isabelle had discussions that led to the mutual acceptance of the wealth disparity and their differences. Next, Nick abandoned the masculine ideologies of his youth, such as financially providing for his family, and fostered a sense of purpose by developing his own, unique role. He asked the uncomfortable questions no one else would to Isabelle’s dad, the family lawyers and perhaps most importantly, to Isabelle, so that they both could understand the wealth differently and deeply. In turn, Isabelle became more comfortable with her identity as inheritor. New conversations emerged. Nick and Isabelle now oversee the stewardship and governance of the wealth together. Admittedly, they say it’s challenging. But, they feel they make better decisions together. With time and experience under their belts, they notice a colossal shift from their early days. Nevertheless, in random moments an insidious and ambiguous question will float in: “Who’s money is it really?” And, they say, that’s “just part of the deal.”  

Endnotes

1. Data Team, “Women’s wealth is rising: Gender inequality in financial wealth is gradually narrowing,” The Economist (March 8, 2018), www.economist.com/graphic-detail/2018/03/08/womens-wealth-is-rising.

2. Men who inherit weren’t included in my inquiry as it’s normative and more socially acceptable.

3. James E. Hughes, Jr., Joanie Bronfman and Jacqueline Merrill, Reflections on Fiscal Unequals (2017). 

4. Lauren M. Papp, E. Mark Cummings and Marcie C. Goeke-Morey, “For Richer, for Poorer: Money as a Topic of Marital Conflict in the Home,” Family Relations, Vol. 58, No. 1 (February 2009).

5. Barbara Blouin, Katherine Gibson and Margaret Kiersted, “Inheritors inner landscape: Emotional challenges for heirs,” The Inheritance Project, Inc., Blacksburg, Va. (1994); Joanie Bronfman, “The experience of inherited wealth: A social-psychological perspective” (Doctoral dissertation 1987), retrieved from ProQuest Dissertations and Theses database (AAT 8715730); M.E. Burka, “Psychological implications of inherited wealth” (Doctoral dissertation 1985), retrieved from ProQuest Dissertations and Theses database (ATT 8512612); Amy L. Domini, Dennis Pearne and Sharon Lee Rich, “The challenges of wealth: Mastering the personal and financial conflicts,” Homewood, Illinois, Dow-Jones Irwin (1988); Michael H. Stone, “Treating the wealthy and their children,” International Journal of Child Psychotherapy, at pp. 15-46 (1972). 

6. Marianne Bertrand, Jessica Pan and Emir Kamenica, “Gender identity and relative income within households,” The Quarterly Journal of Economics, Vol. 130(2) (2015), at pp. 571-614.

Politics is a polarizing subject that elicits strong emotional response from most individuals. Merely uttering the names “Obama” or “Trump” is bound to get the juices flowing for many readers. Trusted advisors have the dual responsibility of ensuring they overcome these natural human instincts themselves as they act in a fiduciary capacity while also helping their clients overcome them when making financial decisions. Being a fiduciary entails making significant decisions on how to manage wealth for the benefit of grantors and beneficiaries that may impact many generations to come. Indulging in one’s emotions tied to the political landscape isn’t only imprudent but also can be very costly.

Polls and studies have illustrated that political biases impact one’s judgment. In a Quinnipiac University poll from August 2019,1 there was a large gap on how Republicans and Democrats perceived the state of the economy. In the study, 43% of Republicans described the economy as “excellent,” and another 45% described it as “good.” However, among Democrats, just 2% described the state of the economy as “excellent,” and 37% said it was “good.” Roughly 60% of Democrats thought it was “not so good” or “poor.” Overall, 88% of Republicans used positive language for the state of the economy, while only 39% of Democrats did the same. Similarly, a 2017 study in the Journal of Financial Markets found that in the last years of Bill Clinton’s presidency, Democrats were more optimistic about the economy than Republicans. However, immediately following George W. Bush’s win over Al Gore in the 2000 election, the Republicans became more optimistic.2 We’re all living in the same economy, but our political affiliation can strongly influence our view of it.

Professional investors aren’t immune from having politics impact their thinking. A study in the Journal of Banking and Finance found that a hedge fund manager’s political affiliation “can influence the portfolio decisions of even those at the very top of the financial sophistication ladder.”3 The study noted a direct correlation between the type of stocks professional money managers select and their political perspectives. This is especially interesting because hedge funds have incentive fees that serve as motivators to outperform various benchmarks. Letting politics impact your paycheck seems unthinkable. However, despite the incentives, hedge fund manager thinking is also marred by political bias. 

Historical Perspective

Understanding history provides a helpful context when making investment decisions and advising clients on how to manage their wealth. The advisor can strategically talk through the political climate in a level-headed manner and provide a data-filled perspective that will help guide future investment decisions. 

There have been 58 presidential elections throughout history, with the Republicans and Democrats tied at 24 wins each. (Note: The 48 total wins by Republicans and Democrats don’t sum to the total number of elections because different parties existed in the country’s early days.) It’s also worth comparing the first two years of the presidential cycle to the full four, because the Senate and House can change halfway through due to the midterm elections. 

According to a February 2020 paper by Fidelity, when the Republicans won the presidency and held the majority in both the House and Senate, which happened 16 times, the 2-year market return was approximately 12% annually.4 During a Democratic sweep, which occurred 19 times, there was an approximately 3.5% annual return for the first two years. However, after a full 4-year presidential cycle, the annualized returns for a one-party sweep were much closer at 8.6% for Republicans and 8.2% for Democrats. When Republicans won the presidency without a majority in the House or Senate, there was a 2-year return of approximately 1%. On the other hand, a Democratic win under the same scenario has produced a 2-year return of 14.5%. However, after a 4-year presidential cycle, the annualized returns are again similar at 8.7% and 10.9% for Republicans and Democrats, respectively. 

Overall, factoring in all presidencies, and regardless of whether there was a one-party sweep of the House or Senate, the market did better over the first 2-year period when there was a Republican win. Those periods show an 8.3% annualized return as compared with 5.8% for Democratic wins. However, over the full 4-year terms, the averages are nearly equal at 8.6% for a Republican presidency versus 8.8% for a Democratic presidency.5

There are an infinite number of statistics that one  can analyze from the markets. There are also plenty of ways, such as merely changing the start and end date slightly or reframing the data, to manipulate the numbers to prove one’s point. For example, since 1925, during a presidential election year, the market was up an average of 17.9% when a Republican was elected versus an average of -2.7% when a Democrat was elected. However, during the first year of a president’s term, the market was up an average of only 2.6% when there was a Republican compared to 22.1% for a Democrat. The analyst’s political leanings could certainly impact whether she chooses to focus on the annual period preceding or following the elections. 

The most important data point, however, is the one that illustrates the power of compounding. For example, if you started investing in the total U.S. stock market index in 1979 during President Jimmy Carter’s term and cashed out 40 years later in the middle of the Donald Trump presidency, you would have invested through three Democratic and four Republican presidents. You also would have experienced an 11.5% annualized return on your money. A single $10,000 investment would have turned into over $883,000 by the time of your retirement.6 One could parse a million statistics to highlight the relative economic benefit of one party over the other. However, the market will persevere, regardless of who’s in office. The key for all investors is to understand how their behavior is impacted by politics and implement strategies to overcome those biases.

Behavioral Finance

Understanding the field of behavioral finance can help explain why investors aren’t always rational, have limited self-control and are influenced by the way they view the world. The concept of heuristics, which is an individual’s tendency to take mental shortcuts to make quicker decisions, can help shed some light on this issue. Quick decisions are often plagued by emotions and natural biases, leading to errors in judgment. Recognizing and acknowledging these heuristics can allow investors to improve their decision-making processes and overcome these hurdles. 

Two common heuristics that come up at the intersection of politics and investing are “confirmation bias” and “herd mentality.”

Confirmation bias: Confirmation bias is the fact that people are naturally drawn to consuming information that validates their own point of view, while simultaneously blocking out any data to the contrary. This happens independently in the world of politics and investing. The folks who watch CNN will generally never watch Fox News, and vice versa. Combining political views with the markets, and only selectively reviewing information that supports an investor’s opinion, is a sure way to lose money.

In the world of investing, it’s fine to look for supporting evidence for an investment thesis. However, it’s equally important to look for conflicting evidence that doesn’t support one’s position. Taking the time to deliberate over both supporting information and data that challenges one’s view is ultimately how good investment decisions are made. 

Herd mentality: Herd mentality occurs when people want to be part of a community with a shared culture and socioeconomic norms. This can apply to being part of a team, place of worship or country club. A community will make decisions based on the shared points of view of its members, and many will share them publicly. These groupthink environments consequently lead to social pressures to conform. If someone’s herd is made up of politically like-minded individuals who express their investment philosophy in a particular way, there’s a high probability that the individual will express her investments in a similar vein.

How to Overcome Bias

It’s important to have systems and processes in place to overcome these heuristics and ensure investment decisions remain sound. The below items are essential in any fiduciary wealth management relationship and can help advisors and their clients stay the course.

Investment policy statement (IPS). A well-defined IPS is a wonderful way to clearly define a client’s objectives, keep the client on the same page as the advisor and put the client on track towards achieving her goals. While the standard IPS highlights a client’s financial goals, time horizon, risk tolerance, liquidity requirements, tax situation and income needs, it should also include any specific preferences that the client outlines. If the client is a politically charged individual, then laying out a specific framework for handling her investments during an election year is a judicious decision. 

It’s not recommended to highlight specific investments to buy or sell based on the party that’s in office. Timing any investment based on the political climate is impossible and imprudent. A good illustration of why it’s a poor approach was the concern over health care stocks due to the enactment of the Affordable Care Act. Investors were worried that “ObamaCare,” as it’s become known, would destroy health care-related stocks across the industry. In reality, there ended up being mixed results with a variety of winners and losers in the space. For example, from when President Obama signed the bill on March 23, 2010 through the end of 2013, when the insurance exchanges were open, the top nine largest publicly traded health insurance companies and the 10 largest pharmaceutical companies achieved 96.8% and 51.5% total returns, respectively. This compared to a 52.2% return of the Dow Jones Industrial Average over the same time frame. However, the 10 largest medical device companies returned only 35.8%, drastically underperforming the other categories.7

A better approach is to put guardrails on one’s investments. As an example, if a client is concerned that a particular party is in office, instead of going to all cash, an IPS can give the client the flexibility to move a portion of her portfolio, say 10%, into cash. Alternatively, if the client is attracted to certain sectors of the market based on who’s in the White House, then the IPS should outline how large of a weighting the client is permitted to allocate to any specific sector. While this may not be the ideal way of investing, it satisfies the client’s emotional need to make decisions based on politics, without derailing her plan.

Automation. One sure way to eliminate the impact of emotional decisions is to build in a level of automation into one’s investment processes. The human element in any financial plan is crucial, but there are many processes that can successfully be automated to maintain impartiality and gain efficiency. 

One type of automation is rebalancing, which is the process of adjusting the weightings of a portfolio as the investment values go up or down over time. When a portfolio is rebalanced, assets are bought or sold to maintain their original asset allocation, which is based on the investor’s risk tolerance. Investors can set their accounts to automatically rebalance at set dates throughout the year. Others may prefer for their portfolio to automatically rebalance once a position grows or shrinks beyond a certain predetermined percentage level. Regardless of the approach, the act of rebalancing has the benefit of preventing investors from letting their emotions determine when to purchase or sell existing positions.

Another automated process is setting up dollar-cost-averaging (DCA). DCA is the strategy of routinely adding money at regular intervals. The benefit is that it eliminates the desire to time when to enter the market. During both the 2012 and 2016 presidential elections, I had friends and colleagues move all their money to cash when their desired candidate didn’t win the presidency. They thought they could effectively time the opportune moment to take money out and ultimately to put money back into the markets. This turned out to be the wrong decision in both scenarios. DCA takes the urge of trying to time the market out of the equation. It’s set up effortlessly through a client’s IRC Section 401(k) plan at work and can be set up for a client’s taxable account by working with her financial advisor.

Diversification. Diversification is the concept of having exposure to various investments, such as stocks, bonds, commodities, real estate and alternative asset classes. It also means having exposure to various geographic locations, including outside of one’s home country. The beauty of always implementing portfolio diversification is that no asset class is 100% correlated with another. That means if stocks are down, bonds may be up. If one’s local market is struggling, other countries around the world may be thriving. Diversification is a powerful strategy because it allows investors to build wealth over the long term regardless of what’s happening in any one part of the market or who’s in the White House.

Advisor’s Role

A variety of factors, beyond just politics, may affect the movement of stock prices. These include: stock fundamentals, earnings, interest rates, labor growth, market sentiment, tax policy and geopolitical issues. To give any politician full credit for market performance, whether good or bad, seems disingenuous.

As the presidential election nears, it’s important to appreciate that the advisor drives the ultimate financial outcome far more than any politician. An advisor will speak to a client regularly to guide her through important issues such as cash flow management, prudent investments options, risk tolerance, time horizon, overall asset allocation, tax minimization and insurance coverage. The advisor will tweak the financial plan as life or the economic environment changes. Through it all, the advisor will also endeavor to prevent clients from making emotional decisions. In short, an advisor can help immunize a client’s portfolio from political bias and ensure the client is on track to achieve her financial objectives. 

Endnotes

1. Mary Snow and Doug Schwartz, “All Top Dems Beat Trump As Voters’ Economic Outlook Dims Quinnipiac University Poll Finds; Dem Primary Stays Stable With Biden Holding The Lead,” Quinnipiac University Poll (Aug. 28, 2019), https://poll.qu.edu/national/release-detail?ReleaseID=3638.

2. Yosef Bonaparte, Alok Kumar and Jeremy K. Page, “Political climate, optimism, and investment decisions,” Journal of Financial Markets 34 (2017), at pp. 69-94, https://doi.org/10.1016/j.finmar.2017.05.002.

3. Luke DeVault and Richard Sias, “Hedge fund politics and portfolios,” Journal of Banking and Finance 75 (2017), at pp. 80-97, https://doi.org/10.1016/j.jbankfin.2016.10.011.

4. Jurrien Timmer, “Presidential Elections and Stock Returns,” Fidelity (Jan. 29, 2020), www.fidelity.com/learning-center/trading-investing/markets-sectors/stock-returns-and-elections.

5. Ibid. 

6. Vanguard Mututal Funds, Vanguard Total Stock Market Index Fund Investor Shares, https://investor.vanguard.com/mutual-funds/profile/performance/vtsmx.

7. ProCon.org. Health Care Stocks: Performance under Obamacare (March 12, 2014), https://healthcarereform.procon.org/health-care-stocks-performance-under-obamacare/.

The political and tax uncertainty as a result of the November elections, combined with the current health pandemic and economic uncertainty, all require flexible modern estate planning more than ever. Thus, many people are updating their estate plans and using trusts, which in turn will allow a family to navigate an unknown future with flexibility and control intergenerationally. Each presidential candidate’s tax policies will be extremely important as a result of the COVID-19 pandemic and everything else going on in the world. Economic recovery, the growing deficit, health care and many other costly programs will all be debated. These programs will need to be paid for, so tax policy will be critical.

Different Ideologies

With Bernie Sanders out of the race, it appears as though it will be President Donald Trump versus former Vice President Joe Biden. Joe Biden has set forth many of his general tax policy ideas. He has a $4 trillion tax plan to increase both income and death taxes.1 Biden didn’t propose a wealth tax like his Democratic primary opponents Elizabeth Warren and Bernie Sanders, but he’s in favor of eliminating the step-up in income tax basis from inherited capital assets for individuals earning over $1 million.2 The Biden proposal wouldn’t allow individuals to avoid these taxes by gifting assets to lower income tax bracket family members during their lifetime. The appreciation on these assets would still be subject to taxes on such a transfer under the Biden proposal. According to the Joint Committee on Taxation, not taxing capital gains at death results in a loss of approximately $40 billion in tax revenue a year.3 Biden is silent on the estate tax exemption, but most experts believe that he’ll support a return to the $3.5 million estate, gift and generation-skipping tax transfer (GST) exemption. There’s also current legislation pending in the House that supports the $3.5 million exemption amounts.4  

President Trump’s signature legislation, the 2017 Tax Cuts and Jobs Act (TCJA), doubled the federal estate tax exemption for estate, gift and GST taxes to $10 million, indexed for inflation (currently $11.58 million).5 This exemption sunsets in 2026, which is a measure included to help reduce the law’s cost as scored by the Congressional Budget Office. The TCJA also called for a step-up in cost basis at death. Even before the TCJA was enacted and doubled the estate tax exemption, so much wealth could be sheltered that the actual rate paid was only about 17%.6 President Trump has continually called for a repeal of the estate tax, and the Senate has introduced bills reflecting such view recently. To date, these bills haven’t moved forward.7 Although frequently discussed, it’s unlikely the estate tax will be repealed anytime soon as a result of the growing deficit. The federal estate tax has been repealed and has returned four times in our history. The most recent repeal occurred in 2010. If it’s repealed again, the likelihood of its return is high. It’s important to note that only two out of every 1,000 Americans pay federal estate taxes, which brought in $23 billion in revenue in 2018.8 The number of individuals paying the estate tax and GST tax is less than 2,000. The repeal of the estate tax would decrease estate tax revenue by an estimated $172 billion over the next decade.9 As such, many advisors believe that estate tax repeal won’t happen in the near future but instead could be leveraged as part of the tax negotiations. It appears as though President Trump would now like to extend the income and estate tax provisions of the TCJA beyond their scheduled expiration date.10

Is the Estate Tax Voluntary? 

As Professor A. James Casner of Harvard Law School once stated, “In fact, we haven’t got an estate tax, what we have is, you pay an estate tax if you want to; if you don’t want to, you don’t have to.”11 Consequently, despite the estate tax exemption level, estate taxes may be reduced or eliminated with proper planning. This may require the use of a “Kennedy Trust,” that is, a testamentary charitable lead annuity trust (CLAT), combined with other powerful trusts, such as the dynasty trust.12 The CLAT gained popularity after the will of Jacqueline  Kennedy Onassis became public. When she passed away in 1994, her will devised most of her estate to her children; however, the plan was for her children to disclaim some of their inheritance to a testamentary CLAT that would last 24 years for the benefit of Jackie’s private foundation (PF). At the expiration of the trust term, the remaining trust principal would go to her grandchildren without being subject to any transfer tax, because the estate would generate an estate tax charitable deduction. The Kennedy children never disclaimed a portion of this bequest in favor of the CLAT; therefore, the PF was never funded, and the enormous estate tax savings were never realized. Despite the Kennedy family not using the CLAT, CLATs can provide flexibility regarding funding at death and, if funded, provide enormous tax savings. Consequently, when they’re combined with other trusts and strategies, they can render the estate tax voluntary. Why do people volunteer to pay estate taxes? Four key reasons: (1) they’re not aware of all the planning vehicles available; (2) their tax objectives don’t coordinate with their non-tax objectives; (3) they’re not aware of all the non-tax benefits of modern trusts; or (4) they’re not aware how much control and flexibility that modern trusts provide. 

Low or High Exemptions

Despite what happens with the November elections, the current opportunity has never been greater with the current estate, gift and GST tax exemptions at $11.58 million per individual in 2020 ($23.16 million per couple). Families should consider gifts to trusts sooner than later. Additionally, extremely low interest rates also provide a powerful opportunity to further leverage these high exemptions with strategies such as the promissory note sale.13 As mentioned, these historically high exemptions are due to sunset on Dec. 31, 2025 to $5 million, indexed for inflation. It doesn’t really matter whether these increased exemptions are reduced or if the estate tax is repealed altogether, because there are many other important non-tax reasons to pass family wealth intergenerationally with a trust, including:14

• family governance/succession/education

• ability to override the Prudent Investor Act, with less liability than with a delegated trust, holding one security (public or private) without diversifying (directed trust)15

• diversifying broadly into private equity, alternate investments and commercial and residential real estate, without extensive fiduciary liability (directed trust)16

• ability to work with investment advisors and managers of a family’s choice (directed trust)17

• ability to appoint a trust protector

• ability to appoint a family advisor

• asset protection/wealth preservation18

• divorce protection19

• litigation protection20

• promotion of social and fiscal responsibility in the family, thus promoting family values (directed trust)21

• privacy—court procedures (reformations/
modifications) and litigation22

• beneficiary quiet—keeping trust information from one or more beneficiaries until appropriate23

• lessening family and family advisor personal liability as fiduciaries (directed trust)24

• disability planning

• special needs planning

• preservation of treasured family assets and heirlooms —purpose trust25

It’s due to the above-mentioned non-tax reasons that it may not be prudent to automatically pass assets, outright and directly, to one’s children and/or grandchildren even if the federal estate tax is repealed. Additionally, the state tax savings can also be beneficial  for state death taxes, state insurance premium taxes and state income and capital gains taxes. Consequently, clients will continue to transfer assets to trusts, most importantly to GST and dynasty trusts. It’s important to note that the gift tax will most likely always remain to limit transfers and income tax shifting. On the other hand, federal death tax savings may be a secondary benefit in most instances with modern trusts. 

Structuring Trusts for the Future

It’s very unlikely that estate tax repeal will happen in the near future, but it could down the road. An interesting issue could arise regarding future GST tax planning if repeal were to occur: namely, how would GST tax planning work with trusts established after repeal? Also, in planning for the possibility that the GST tax could return, flexibility and proper drafting would be crucial to take advantage of GST tax repeal but avoid possible issues with any past or future legislation. This issue was also discussed back in 2010. If the estate and GST tax are both repealed, there may be four scenarios for GST issues during the repeal year and beyond:26

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

2. GST trusts created in repeal year;

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

4. Outright gifts.

These issues shouldn’t present problems, if properly planned for, but definitely need to be addressed.

Modernize Existing Trusts

Clients with existing trusts may need to modernize these trusts to maximize flexibility and control in uncertain times. This can be accomplished if the client’s resident state has flexible non-judicial or judicial reformation/modification statutes27 as well as decanting statutes.28

Generally, if the client’s state doesn’t provide such statutes, then the family can look to change the situs of a trust to a modern trust jurisdiction with these statutes and then modernize the trust so that the trust can provide flexibility and control to deal with any unanticipated changes as previously discussed. 

Step-Up in Cost Basis 

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

Many people traditionally hold low basis assets until death to obtain a step-up in basis. As previously mentioned, the Biden proposal taxes unrealized capital gains at death, thus preventing the step-up in income tax basis.29 If the Biden proposal were enacted, many of these individuals might then be willing to diversify and sell concentrated positions and restructure their entire portfolios. Deferring taxes as long as possible may also be prudent. Additionally, many individuals may be more inclined to transfer these low basis assets to charity to receive a charitable income tax deduction. 

An important option to consider when drafting control and flexibility into an irrevocable trust is a substitution or swap power.30 This wouldn’t work well under the Biden proposals but would under the Trump proposals. The swap power allows the grantor to swap personal non-trust assets with trust assets without any negative income, gift or estate tax consequences. This allows the grantor to swap high income tax basis trust assets to the trust in exchange for low income tax basis assets31 that can then receive a step-up in cost basis at the grantor’s death. Consequently, no income taxes will be owed on the grantor’s death if the asset is sold. This swap power is generally considered a grantor trust power resulting in the trust being taxable to the grantor for income tax purposes but still removed from the estate for estate tax purposes.32 The effectiveness of this power may depend on whether Biden is elected and his tax plan enacted. Either way, this swap is a very useful tool to have down the road, especially with an uncertain tax and economic future.

Investment Flexibility 

Because trusts are so important, particularly in extremely uncertain political and economic times, many families need to have control and flexibility over the investment management of the trust. Historically, many events have caused uncertainty to both U.S. and international economies. Events over the last two years, such as the trade tensions between the United States and China, Brexit, continuing Middle East conflicts and the economic shut down and unemployment caused by COVID-19, are all examples of this uncertainty. Each presidential candidate may handle these important matters differently. Both will need to deal with the issue of the estimated $8 trillion dollars (two years of tax revenue) that will be pumped into the U.S. economy for rescue and recovery purposes. The deficit created by this enormous influx of capital is an additional concern to many people particularly when interest rates rise in the future. Many investors have sold securities and bought U.S. government bonds as a result of this current, past and future uncertainty. Many others have transitioned to cash. Some feel safer with direct private equity investments, gold and other alternative investments. Other families desire a well-diversified portfolio of traditional investment assets. Each family has different investment plans to accomplish its desired goal of preserving capital. Consequently, investment management flexibility becomes key. Traditional trust laws (for example, the Uniform Prudent Investor Act (UPIA) and delegated trusts)33 may not provide families with enough flexibility and control to get through these periods of economic uncertainty. 

Most jurisdictions have enacted the UPIA,34 which provides for a general duty to diversify trust assets unless the purpose of the trust is better served without diversification. Some of the typical exceptions to this diversification requirement are low cost basis assets (sale would trigger large tax gains) and/or family business interests. Even with these exceptions, it may still be difficult to safely override the diversification requirement of the UPIA.35

The best alternative is the directed trust,36 which gives families the option to diversify by overriding the UPIA. Additionally, if they do diversify, they can do so with either traditional or sophisticated investments such as private equity (direct and via a fund), real estate, gold and other alternative investments.37 The liability standard for fiduciary investment decisions with a directed trust is typically limited to gross negligence and/or willful misconduct as compared with the reasonable care standard associated with most traditional delegated (non-directed) trustee statutes. Many family trustees or co-trustees generally don’t have investment management expertise, and they’re forced to delegate investment management. This delegation function requires that they do due diligence on the investment professionals to whom they’re delegating as well as conduct ongoing monitoring of these investment professionals and their investment management. They can delegate the duty, but not the risk. Consequently, the reasonable care liability standard for delegating may present a problem, particularly in times of economic uncertainty, depending on a family’s investment management strategy and the required level of investment sophistication.38 

Alternatively, the directed trust allows individuals to appoint a trust advisor or investment committee, which in turn can select an outside investment advisor(s) and/or manager(s) to manage the trust’s investments and direct the administrative trustee in a directed trust state. The directed trust allows a family to use and deploy a broad and sophisticated Harvard or Yale endowment-type asset allocation39 with direct private equity and alternative investments or to remain in a concentrated non-diversified position in either cash, government securities or public and/or private securities. Consequently, the directed trust allows for the trust to hold both financial and non-financial assets (for example, offshore companies, business interests, real estate, limited liability companies (LLCs), family limited partnerships, timber land and direct private equity). Many of these types of trust investments might be prohibitive from a liability standpoint as a result of most jurisdictions’ UPIAs and delegated trust statutes. Thus, the directed trust can provide a family with the desired maximum flexibility and control to navigate both political and economic uncertainty intergenerationally.

Grantor/Family Participation

The modern directed trust also provides a family with the opportunity to participate in many trust decisions involving investments and distributions, which is extremely important in times of uncertainty. Often the grantor, family members and/or close advisors serve as the investment committee. Sometimes, the grantor will serve as a member of the investment committee40 along with his family and other trusted advisors, which alleviates anxiety in this environment as well as provides a great way for the grantor to help educate the children and grandchildren regarding trust investments and asset allocation particularly during difficult and uncertain times.41 

In addition to flexibility regarding investment management, the directed trust also provides flexibility as to trust distributions. While advisors usually avoid the appointment of the grantor to the distribution committee, family members or close family advisors may be named.42 Sometimes, a non-binding letter of wishes from the grantor may be used as well to provide guidance to the distribution committee. In addition, the trust may be drafted to allow for distributions to both charitable or non-charitable organizations. The flexibility to make distributions from a non-charitable long-term or dynasty trust to charitable organizations may be very important to many families.43 These provisions must be properly drafted and included at trust formation because non-charitable trusts can’t be reformed to allow direct distributions to charity and provide the trust with an unlimited income tax deduction.44 Trusts may generally be modified or decanted to include a power of appointment to charities.45 The grantor and family beneficiaries may also have the power to remove and replace a trustee and/or investment/distribution committee members.

Many families may also want to add a trust protector to their directed trust. A trust protector is generally an individual (or a committee of individuals or an entity) with specified personal and/or fiduciary powers over the trust.46 The trust protector can have powers to veto investment or distribution decisions. The power acts as a checks and balances to such decisions. The trust protector may also have powers to amend the trust, which can be very useful in the future. The trust protector is often an extended family member or a close advisor,  providing the family with another trusted individual who has flexibility and control over the family trust. The trust protector’s statutory standard of liability is generally gross negligence and/or willful misconduct. The grantor and family beneficiaries may also have the power to remove the trust protector.

Some jurisdictions also allow for the appointment of a family advisor, which is a non-fiduciary appointment, and authorize such an individual to consult or advise on fiduciary or non-fiduciary matters.47 A family advisor can be very important in times of uncertainty. The standard of liability is generally dishonesty or improper motive, which provides family advisors with the utmost liability protection. Family advisors may have the power to remove and appoint a trustee, fiduciary, trustee advisor, investment committee member, trust protector or distribution committee member. They also have the power to advise the trustee and/or investment and distribution committees regarding beneficiary matters. Typically CPAs, attorneys and advisors are appointed as family advisors, which allow them to play an important role in the family’s trust while limiting their liability exposure during uncertain times. 

Despite the gross negligence and/or willful misconduct liability standards for both directed trust investment and distribution committee members as well as trust protectors, many advisors may wish to consider adding a trust protector company (TPC) or special purpose entity (SPE) to the directed trust structure.48 These are typically LLCs or some other form of corporation that houses the trust protector, the investment and/or distribution committees or advisors, which provides direction to a qualified directed trustee in a modern trust state. TPCs and/or SPEs aren’t private trust companies but are popular alternatives. These entities provide a family and its advisors with a great way to obtain director and officers insurance as well as errors and omissions insurance for serving as a fiduciary. This coverage typically isn’t easy to obtain if fiduciaries are serving individually. Additionally, unlike individual fiduciaries, the TPC and/or SPE never dies nor becomes incapacitated. Thus, the TPC or SPE provides an inexpensive and perpetual entity providing additional liability protection, family governance, flexibility and control in uncertain times. 

Unprecedented Planning

No matter who’s elected in November or what happens to the federal estate tax, whether it remains at historic highs, sunsets back to $5 million or is repealed altogether, trusts still make sense for a multitude of non-tax reasons and state tax reasons. Unprecedented times and an uncertain future call for unprecedented planning. Trusts are one of the best vehicles to provide this flexibility and control intergenerationally. Consequently, the need and desire of the modern directed trust continues to increase. It’s important for advisors to continue to make clients aware of such a powerful trust planning vehicle.

Endnotes

1. Darla Mercado, “This is how Joe Biden will tax generational wealth transfer,” CNBC (March 13, 2020), www.cnbc.com/2020/03/13/this-is-how-joe-biden-will-tax-generational-wealth-transfer.html.

2. Ibid. 

3. Scott Eastman, “Unpacking Biden’s Tax Plan for Capital Gains,” Tax Foundation (July 31, 2019).  

4. Christine Fletcher, “Why You Should Take Advantage of Trump’s Estate Tax Laws Now,” Forbes (Nov. 15, 2019), www.forbes.com/sites/christinefletcher/2019/11/15/why-you-should-take-advantage-of-trumps-estate-tax-laws-now/#fcd608d1befc. 

5. Ben Steverman, “The Estate Tax,” The Washington Post (Jan. 28, 2020).  

6. Ibid.   

7. Jeff Stein, “Top GOP senators propose repealing estate tax, which is expected to be paid by fewer than 2,000 Americans a year,” The Washington Post (Jan. 28, 2019), www.washingtonpost.com/us-policy/2019/01/28/top-gop-senators-propose-repealing-estate-tax-which-is-expected-be-paid-by-fewer-than-americans-year/.

8. See supra note 5. 

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

10. Galen Hendricks and Seth Hanlon, “Trump’s Rumored ‘Tax Cuts 2.0’ Proposals Aren’t Focused on the Middle Class,” Center for American Progress (March 10, 2020). 

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

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

13. Robert S. Keeber and Lyle Benson, “Income and Estate Planning Techniques That Work Well in a Volatile Market & Low Interest Rates Environment,” AICPA (March 3, 2020).

14. Al W. King III, “Preserving Family Values by Encouraging Social and Fiscal Responsibility with Modern Trust Structures i.e., Directed Trusts, Special Purpose Entities and Private Family Trust Companies,” Allied Professionals (Sept.26, 2017).

15. Al W. King III, “Myths About Trusts and Investment Management: The Glass is Half Full!” Trusts & Estates (December 2014).

16. Ibid.

17. Ibid.

18. Al W. King III, “An Update on Third-Party Discretionary Trusts With Spendthrift Provisions,” Trusts & Estates (September 2019); Al W. King III, “Defend Against Attacks on DAPTs?” Trusts & Estates (October 2014).

19. Ibid.

20. Ibid.

21. Al W. King III, “Does Estate Tax Repeal Really Matter?” Trusts & Estates (December 2017); Al W. King III, “Are Incentive Trusts Gaining Popularity?” Trusts & Estates (October 2017).

22. Al W. King III, “Privacy, not Secrecy, Is Still important to Families,” Trusts & Estates (August 2019).

23. Al W. King III, “Should You Keep a Trust Quiet (Silent) From Beneficiaries?” Trusts & Estates (March 2015).

24. Al W. King III and Pierce H. McDowell III, “Selecting Modern Trust Structures Based On a Family’s Assets,” Trusts & Estates (August 2017).

25. See Al W. King III, “Trusts without Beneficiaries—What’s the Purpose?” Trusts & Estates (February 2015).

26. Carlyn S. McCaffrey and Pam H. Schneider, “The Generation-Skipping Transfer Tax,” Trust & Estates (February 2011). 

27. Non-judicial modification/non-judicial settlement agreement statutes typically allow the beneficiaries, the grantor and/or other interested parties to modify an existing trust document without having to go to court. Generally, these non-judicial reformation/modifications are administrative. Certain jurisdictions also provide judicial reformations/modifications, typically brought by a petition to court by the trustee or majority of beneficiaries. These judicial modifications can be much broader than administrative changes. 

28. Decanting allows trust property to be appointed from one trust in favor of another trust, typically modernizing it. Providing notice to beneficiaries as well as judicially approved decantings are permissible, but not required depending on the state statute. Over 27 jurisdictions have now enacted decanting statutes. See Al W. King III, “Decanting is a Popular Strategy, But Don’t Ignore Several Key Considerations,” Trusts & Estates (August 2018).  

29. See supra note 1.

30. See Internal Revenue Code Section 675; Martin M. Shenkman and Bruce D. Steiner, “Swap Powers,” Trusts & Estates (December 2015); Al W. King III, “Can a Grantor Have His Cake and Eat it Too?” Trusts & Estates (December 2019).

31. Ibid. 

32. The tax rules that govern grantor trusts are set forth in IRC Sections 671-676 and the supporting regulations. Generally, a grantor trust is one in which trust income is attributable to the grantor instead of the trust. Thus, the grantor pays the trust income tax instead of the trust. This is achieved by the grantor retaining certain powers under the trust that trigger the grantor trust status. If structured correctly, the trust wouldn’t be includible in the grantor’s estate.

33. See supra note 24.

34. The Uniform Prudent Investor Act, passed in 1994 and adopted by most jurisdictions, requires trustees to pursue an overall investment strategy considering various factors when formulating an investment program, including: size of portfolio, nature and likely duration of trust, liquidity and distribution requirements, general economic conditions—inflation/deflation, tax consequence of investment/distribution decisions, expected total return and role of individual investments in portfolio.

35. See In re Will of Dumont, 809 N.Y.S.2d 360 (App. Div. 2006); Wood v. U.S. Bank, 160 Ohio App.3d 831 (2005); Goddard v. Cont. Ill. Nat’l Bk, 177 Ill.App.3d 504 (Ill. App. Ct. 1988); see also Mazzola v. Myers, 363 Mass. 625 (Mass. 1973) (court set high threshold for trustee to not diversify—if document waives duty, there’s no reason to fear for the safety of the investment and there’s no change in circumstances, then there’s no obligation to sell trust assets to diversify).

36. Generally, a directed trust bifurcates or trifurcates the trustee fiduciary powers, specifically administration, investments and distributions to one or more individual or corporate fiduciary advisors. Note that proliferation of directed trust states began in the 1990s, when the first boutique trust states enacted their directed trust statutes, and have increased exponentially year after year resulting in the Uniform Directed Trust Act in 2017. Traditionally, the directed boutique trust states have been Alaska, Delaware, New Hampshire, South Dakota, Tennessee and Wyoming.

37. See supra note 24. 

38. Ibid.

39. Many family offices and multi-family offices like to adopt a Harvard or Yale endowment asset allocation, which includes private equity, real estate, foreign equity, natural resource, domestic equity, bonds and cash and absolute return. See supra note 15.

40. The grantor can usually retain powers over the trust investment management decisions without any IRC Section 2036 or IRC Section 2038 estate tax inclusion issues. See Jennings v. Smith, 161 F.2d 74 (2d Cir. 1947); Old Colony Trust Company v. U.S., 423 F.2d 601 (1st Cir. 1970); Estate of Willard V. King v. Commissioner, 37 T.C. 973 (1962).

41. Al W. King III, supra note 30; Al W. King III, supra note 21; Al W. King III, “Preserving Family Values by Encouraging Social and Fiscal Responsibility with Modern Trust Structures,” Allied Professionals, Orange County, Calif. (September 2017).  

42. Unlike the investment committee, the grantor or beneficiary on the distribution committee generally triggers Section 2036(a)(2) (that is, right to designate who’ll enjoy the trust property) and Section 2038 (that is, power to designate who’ll enjoy the trust property) estate tax inclusion issues for tax-sensitive (that is, fully discretionary) distributions. The grantor can usually retain powers over the trust investment management decisions without any Section 2036 or Section 2038 estate tax inclusion issues. Supra note 10. 

43. Al W. King III, “Charitable Giving with Non-Charitable Trusts,” Trusts & Estates (June 2015).

44. IRC Section 642(c). 

45. See supra note 28.

46. Certain jurisdictions have enacted trust protector statutes that provide specific trust protector powers, while others simply recognize the trust protector by statute without delineating any powers. In addition, some advisors will draft trust protector provisions even without a state statute. It’s best to have a state statute with powers. Additional common trust protector powers include the power to remove or to replace trustees; the power to veto or direct trust distributions; the power to add or remove beneficiaries; the power to change situs and the governing law of the trust; the power to approve, veto or direct investment decisions; the right to consent to the exercise of a power of appointment; the power to amend the trust as to the administrative and dispositive provisions; the power to approve trustee accounts; the power to add a grantor as a beneficiary from a class of beneficiaries; and the power to terminate the trust. Alexander A. Bove, Jr., “Trust Protectors: A Practice Manual With Forms,” Juris Publishing, Inc. (2014).

47. For example, such states include Delaware and South Dakota. 

48. See supra note 24; Al W. King III, “The Private Family Trust Company and Powerful Alternatives,” Trusts & Estates (February 2016).

As our country works together to stem the spread of COVID-19, one major issue that seems to have been pushed to the side for the moment is the upcoming presidential and Congressional elections in November. It’s possible that whatever happens in November will mean the end of the Tax Cuts and Jobs Act (TCJA)1 and the high estate and gift tax exemptions provided for under the TCJA. There’s a strong possibility that there won’t be enough political will in Washington to make the TCJA permanent if President Trump is defeated, the Democrats retain control of the House or the Republican party can’t achieve a filibuster-proof majority in the Senate. With the future of the federal estate and gift tax uncertain, clients should focus on taking advantage of state income tax planning opportunities. 

State and Federal Interplay

The interplay between the state and the federal rules isn’t new for wealth transfer strategists. We’ve always had to consider how any plan that would work well under federal law might be impacted by state rules, particularly because any one trust may be governed by the rules of more than one state.   

The TCJA, enacted at the end of 2017, capped the deduction of state income taxes paid for federal income tax purposes to $10,000 per single taxpayer or married couple and spurred a wave of planning around limiting state income taxes on assets transferred into trusts.  In the post-TCJA world, commentators have urged practitioners to consider creating non-grantor trusts in so-called trust-friendly states like Alaska, Delaware, Nevada and South Dakota to save state income taxes, achieve asset protection and preserve other tax savings, such as maximizing the qualified business income deduction available under Internal Revenue Code Section 199A.  

Trust Residence

Many states,2 like New York3 and Illinois,4 determine residence of a trust based on where the settlor of the trust resided at the time that the trust was originally settled. For these states, residence is permanent; no matter where the beneficiaries live, the corpus is located, the trustees are located or where the settlors someday move, the trust will remain a resident trust for state income tax purposes. Generally speaking, most of these states have laws—whether by enacted statute or decided by common law—that allow fiduciaries to claim an exemption from state income tax. For example, in 1983, New Jersey determined in two landmark cases that it was unconstitutional for the state to impose an income tax on the undistributed income of trusts when both the fiduciaries and current beneficiaries resided outside of New Jersey, and no trust property was located within the state.5 In 2013, a New Jersey tax court made clear that when a resident trust had New Jersey source income, this wouldn’t create a sufficient nexus to allow the state to tax all of the income earned by the trust.6 Rather, the court confirmed that only the New Jersey source income would be taxable in New Jersey for income tax purposes, so long as the fiduciary and current beneficiaries weren’t New Jersey residents, and there were no assets located within New Jersey.  

New York’s three-prong test for exemption from income taxes is: (1) all trustees domiciled outside of New York; (2) all trust property located outside of New York, and (3) no New York source income. However, New York residents may be subject to an accumulation tax on any distributions received from a New York resident exempt trust to the extent that any distribution received is deemed to have included any undistributed net income earned in a prior year.7  

Connecticut also determines whether a trust is a resident for income tax purposes based on the residence of the settlor at the time that the trust became irrevocable.8 However, whereas other states allow exemptions from state income taxes for both inter vivos and testamentary trusts based on various factors, Connecticut treats testamentary trusts differently from inter vivos trusts. Specifically, in Chase Manhattan Bank v. Gavin,9 the Connecticut Supreme Court concluded that testamentary trusts established on the death of a Connecticut resident will remain taxable in Connecticut regardless of whether the trust has any other nexus with Connecticut. Pointing to the fact that the Connecticut probate courts were required to approve the original trustees and their successors and otherwise assure the continued existence of testamentary trusts established as part of the probate process, the court opined that the minimum contacts with the state required to satisfy due process were met by the benefits and opportunities afforded the trusts by the Connecticut courts and legal system. The state’s laws determined the validity of the trusts and assured their continued existence.  

The Illinois appellate court in Linn v. Department of Revenue10 found it compelling that the Gavin court distinguished testamentary trusts from inter vivos trusts. The Illinois court pointed out that the connection between an inter vivos trust created by a resident settlor and the state was “more attenuated than a testamentary trust” because the inter vivos trust “does not owe its existence to the laws and courts of the state of the grantor in the same way a testamentary trust does and thus does not have the same permanent tie.”11  

For both Connecticut and Illinois, an inter vivos trust established by a resident may avoid state income taxes so long as: (1) neither the trustee nor any current beneficiaries reside within the state; and (2) the trust doesn’t own any assets located within the state.  

Beneficiary Residence 

Some states tax trusts based on the beneficiary’s residence.12  In North Carolina Department of Revenue v. Kimberley Rice Kaestner 1992 Family Trust,13 the U.S. Supreme Court evaluated whether states could tax the accumulated income of trusts based on the residence of beneficiaries. The Court was particularly swayed by the fact that the resident beneficiary didn’t have any rights to compel distributions nor any control over the assets held by the trust. In Kaestner, the trustee was also a nonresident and had no contacts with the state.  

While the Court made clear that its opinion was specific to the facts at issue in that case, other states have laws on the books that are almost identical to the North Carolina statute that the Court struck down.14 It’s not clear how Georgia, North Carolina and Tennessee might update their legislation to preserve taxability by addressing the concerns raised by the Court in Kaestner. Additionally, while it appears that Kaestner didn’t strike down all beneficiary residency trust taxation statutes, it’s not entirely clear whether the findings in Kaestner might have an impact on enforcement of beneficiary residency statutes in other states.  

For example, California imposes tax on any trust with a California resident trustee or a California non-contingent beneficiary.15 The Court’s conclusion in Kaestner is inapplicable to this type of statute because the beneficiary must have a present interest to receive distributions under the California system, whereas in North Carolina, the beneficiary had no power to compel distributions and hadn’t actually received any distributions during the period at issue.  

For other states, a trust will be taxable to the extent that there’s a resident beneficiary and other factors such as assets located within the state, resident trustees, source income and/or creation of the trust by a state resident.16 Still other states determine taxability of a trust  based on the administration of the trust within the state or on the location of the fiduciary within its borders.17

Drafting Strategies

Practitioners hoping to mitigate state income tax exposure should be mindful of the various state laws that may be applicable to the particular circumstances of any given client. Possible drafting alternatives include:

1. Identify a trustee residing in a tax-friendly jurisdiction (possibly an institutional trustee); 

2. Avoid contacts with high tax jurisdictions by, for example, ensuring that trust asset custodians are physically located in tax-friendly states, not renting or owning an office within the taxing state and not owning any tangible property in the taxing state.

3. Avoid trust source income in any high tax jurisdiction by avoiding direct investments within the taxing state. Assets could be segregated among different trusts to limit the taxability of non-source income.   

4. Avoid having trusts make distributions to resident beneficiaries.  

5. To the extent that a settlor wishes to benefit an individual who resides in a beneficiary-residence trust taxation state, consider creating a separate trust for that resident beneficiary.  

For existing trusts, particularly those established in settlor-resident trust taxation states, a practitioner should review trust instruments to determine whether there might be any opportunities to achieve resident exempt status. Practitioners should confirm how the taxing jurisdiction determines whether an asset is considered tangible such that it will create a sufficient nexus to allow for resident trust treatment. Perhaps the asset should be dropped into a limited liability company (LLC). States such as New Jersey and New York view LLC membership interests as intangibles. In these states, LLC interests holding tangible property located within the state would nevertheless be considered a non-situs asset.  

Sometimes, despite a planner’s best efforts, a trust will still be subject to income taxes in a high tax jurisdiction. In such circumstances, it may help to know that New York and California both allow itemized deductions against gross income for investment fees and other expenses that had been eliminated by the enactment of the TCJA. Further, trusts that are taxable in Connecticut may reduce their tax burden based on the ratio of the number of noncontingent beneficiaries who reside in the state over the total of all current trust beneficiaries.  

Several states don’t impose income taxes on trusts.18 To take advantage of the opportunities presented by no-tax states, practitioners must be aware of the specific laws applicable in each relevant jurisdiction. This would be a great time for advisors to collaborate with one another.  

For example, a taxpayer anticipating the sale of a closely held business in a high tax jurisdiction such as New Jersey may be able to fund a trust established with a South Dakota trustee with an ownership interest in the business. The trust must be administered in South Dakota by a South Dakota trustee and have neither a New Jersey resident serving as a trustee nor any New Jersey real or tangible property so that it may be exempt from New Jersey income taxes. So long as the sale of the business is structured as a stock sale and not as an asset sale, the trust wouldn’t be deemed to have any New Jersey sourced income and should be able to avoid New Jersey state income taxes on the proceeds.19  

Those taxpayers who aren’t considering a sale of their business might minimize their overall tax burden by using non-grantor trusts established in no-tax jurisdictions to maximize deductions otherwise capped by income limitations at the federal level, such as the qualified business income deduction, which phases out as taxable income rises.20 Practitioners should be wary of the application of regulations that prevent taxpayers from establishing non-grantor trusts solely to avoid taxes.  

An incomplete non-grantor (ING) trust could be a powerful planning tool for individuals residing in high tax states other than New York who would like to minimize state income taxes without giving away their assets. New York doesn’t recognize ING trusts and will instead require these trusts to be treated as grantor trusts for state income tax purposes. New York residents would be ill-advised to set up an ING trust, as all of the income earned by the trust would nevertheless be taxable to them on their New York state income tax return.  

Practitioners should consider the effect of the 3.8% net investment income tax on those taxpayers considering a non-grantor trust to shield closely held business income from state income taxes.21 To the extent practicable, trusts should be structured to name a fiduciary who’s materially participating in the trade or business activities of the entity owned by the trust and not a resident of any state that would trigger additional income taxes.  

Changing the trustee of an existing trust may enable the trust to avoid being treated as a taxable resident of any state. For example, a trust established by a Colorado resident and administered by a New York state fiduciary won’t have any tax residence for state income tax purposes, because Colorado bases residence on the state where the trust is administered, and New York is a settlor-residence taxation trust state. Practitioners should review existing trusts for opportunities to make a change that could have a significant impact on the taxability of the trust.  

Alaska,22 Tennessee23 and South Dakota24 each have  enacted community property trust (CPT) statutes that may allow nonresidents to obtain a full basis step-up on the first spouse’s death on all assets owned by the trust. Nonresidents may settle CPTs so long as they choose a qualified trustee domiciled within the state. While other states are also contemplating adding CPT statutes, this strategy isn’t without significant risk. Practitioners would be well-advised to consider it only for clients who are in long and stable marriages because there are risks to equitable distribution determinations on divorce for assets held by the trust. Finally, there’s no guarantee that the Internal Revenue Service won’t challenge these structures as they gain in popularity and allow families to mitigate income taxes on additional depreciation or sales before the death of the surviving spouse.    

Be Prepared for Change

Our challenge is that planning may never again be more urgent or necessary than it is right now. As planning is likely far from top of mind in this unprecedented time in our collective history, wise practitioners should be educating wealthy clients that the current climate has presented the perfect storm for planning purposes. The confluence of low interest rates, artificially depressed asset values and very high federal estate and gift tax exclusion rates makes this the perfect time to leverage wealth out, address state concerns and possibly trigger opportunities available under state law to lower the overall tax burden for their clients and their clients’ families.  

The TCJA, with its exceptionally high federal estate and gift tax exclusion rates of $11.58 million per taxpayer, may not last beyond the current federal elections, and there’s reason to be concerned that the exclusion rates may be lowered as early as 2021.25 The sudden drop in economic activity and low interest rates are likely to be relatively short-lived, allowing taxpayers to transfer assets at a lower gift tax value today than the asset may be worth in six months or a year from now.  

The impending federal elections are less than six months away, and while it’s far from clear how the results might adversely impact opportunities, it seems certain that federal planning will be much different in 2021 than it is right now. Planners must act now to ensure that their clients have all of the advantages currently available to protect their future financial security as well as that of their small businesses and future generations of their families.  

Endnotes

1. The “Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018” (Pub. L. 115-97) is set to expire on Dec. 31, 2025 by its own terms, unless Congress passes a bill to make it permanent.    

2. See, e.g., Alabama, Connecticut, Illinois, Maine, Michigan, Minnesota, Nebraska, New Jersey, New York, Oklahoma, Pennsylvania, Rhode Island, Vermont, Washington, D.C., West Virginia and Wisconsin. This list is non-exhaustive. State laws are subject to change. Always check specific state statutes for guidance, and don’t rely on this listing. See Steve Oshins, “5th Annual Non-Grantor Trust State Income Tax Chart” (Oshins Chart), https://db78e19b-dca5-49f9-90f6-1acaf5eaa6ba.filesusr.com/ugd/b211fb_00566de89e6a43b4b690cb51766bfd4b.pdf.

3. N.Y. Tax L. Section 605(b)(3).  

4. 35 ILCS 5 Illinois Income Tax Act Sect. 1501(a)(20).   

5. N.J. Rev Stat Section 54A:1-2(o). See Pennoyer v. Taxation Div. Dir., 5 N.J. Tax 386 (1983) and Potter v. Taxation Div. Dir., 5 N.J. Tax 399 (1983), concluding that imposing state income taxes in such circumstances would violate the due process clause of the constitutions of both the United States and the state of New Jersey.  

6. See Residuary Trust A u/w/o Fred E. Kassner v. Director, Div. of Taxation, 27 N.J. Tax 68 (2013).  

7. See NY Tax L. 612(b)(40). Note that a distribution from a New York resident exempt trust to a New York resident beneficiary won’t be subject to the accumulation tax if one of the following exemptions apply: the trust’s income has already been subject to New York tax; the income was earned before Jan. 1, 2014; the income was earned during a period when the beneficiary wasn’t a New York resident; or the income was earned before the beneficiary turned 21. Generally, income for these purposes will include interest and dividends but not capital gains.

8. See CT Gen Stat. Section 12-701(a)(4)(C)-(D) (2018).   

9. See Chase Manhattan Bank v. Gavin, 249 Conn. 172, cert. denied, 528 U.S. 965 (1999).

10. Linn v. Dept. of Rev., 2013 IL App (4th) 121055, at para. 25. Pursuant to CT Gen. Stat. Section 12-701(a)(4) (2018), when an inter vivos trust “… has one or more nonresident noncontingent beneficiaries, the Connecticut taxable income of the trust” is determined by multiplying all non-Connecticut source income by “a fraction the numerator of which is the number of resident noncontingent beneficiaries and the denominator of which is the total number of noncontingent beneficiaries” and adding the product to all Connecticut source income. Additional modifications are required under the statute to determine the alternative minimum taxable income of the trust, based on the ratio of noncontingent nonresident beneficiaries to all noncontingent beneficiaries.  

11. Linn, ibid., at para. 28.   

12. For example, California, Connecticut, Georgia, North Carolina and Tennessee. This list is non-exhaustive. State laws are subject to change. Always check specific state statutes for guidance, and don’t rely on this listing. See Oshins Chart, supra note 2.  

13. See North Carolina Department of Revenue v. Kimberley Rice Kaestner 1992 Family Trust, 588 U.S. ___ (2019). An in-depth evaluation of the Kaestner case is beyond the scope of this article. 

14. See, e.g., GA Code Section 48-7-22 (2017) and TN Code Section 67-2-110 (2017). The North Carolina statute can be found at NC Gen. Stat. Section 105-160.2 (2018).  

15. See Cal. Rev. & Tax. Code Section 177442.  

16. See, e.g., Delaware, Hawaii, Idaho, Iowa, Massachusetts, Missouri, North Dakota, Ohio and Rhode Island. SeeOshins Chart, supra note 2.  

17. E.g., Arizona, Colorado, Indiana, Kansas, Kentucky, Mississippi, Montana, New Mexico, Oregon, South Carolina, Utah and Virginia. See Oshins Chart, supra note 2.   

18. E.g., Alaska, Florida, Nevada, New Hampshire, South Dakota, Texas, Washington and Wyoming. See Oshins Chart, supra note 2.   

19. This is a somewhat oversimplified explanation of the planning strategy that must be vetted carefully for each taxpayer. Practitioners are urged to consult the laws of the relevant jurisdictions to confirm the availability of any opportunity for any particular client.  

20. See IRC Section 199A. 

21. See IRC Section 1411.  

22. AK Stat Section 34.77.100 (2019).  

23. TN Code Section 35-17-103 (2014).  

24. SD Codified L. Section 55-17-1 (2019).   

25. This could happen on the defeat of President Trump if the Democrats retain control of the House and achieve a majority in the Senate. In that case, it’s conceivable that Congress will pass a law repealing the Tax Cuts and Jobs Act, which will be signed by the Democratic president and made retroactive to the first of the year.  

While we don’t know the outcome of the upcoming election, practitioners should counsel clients to plan in advance of possible adverse changes affecting the estate tax. Some of these changes (originally proposed by Senator Bernie Sanders) could include: a reduction in the estate and generation-skipping transfer (GST) tax exemption to $3.5 million, a reduction of the gift exemption to
$1 million, the emasculation of grantor-retained annuity trusts (GRATs), inclusion of grantor trust assets in a settlor’s estate, capping the annual gift exclusion at $20,000 per donor and more.1 Presumptive Democratic Presidential Nominee Joe Biden has proposed a capital gains tax on death.2

Current Planning Environment

Several key factors characterize the current planning environment. Practitioners should consider these factors when they select and structure the planning techniques they use for clients. Fundamental to this planning is the use of powers of appointment (POAs). Current planning should consider the following goals and circumstances:

• Values have been reduced by stock market declines, the possibility (existence) of recession and the increased uncertainty as to how the post-coronavirus economy will fare. This suggests transferring assets with lower values, which the clients believe will appreciate.

• Interest rates are at historic lows. Family loans, note sale transactions and GRATs are techniques that benefit from low interest rates. 

• The massive federal bailouts may result in tax increases on the wealthy, so that estate taxes may increase, and the current high temporary exemption might be reduced before it’s scheduled to be reduced by half in 2026. So, the use of the exemption before laws become less favorable could be important for many clients.3 Implementing planning and, in particular, using the current high temporary exemptions before the laws may be changed following the election, is important for many clients.

• Asset protection could be even more important given the possibility of recession and the potential for increases in claims during these turbulent times. Some expect a wave of bankruptcies caused by the stay-at-home orders and economic upheaval. POAs can provide a means to permit enhanced asset protection while also permitting the client to retain some measure of access to the trust post-transfer.

• The most important consideration to the acceptability of a plan for many clients will be access to wealth post-transfer. The current economic worries, stock market decline and uncertainty increase the likelihood of clients insisting on access if they’re going to transfer assets now. The use of POAs is fundamental to helping clients realize this objective. 

Two Common Techniques

Two of the common techniques to consider are spousal lifetime access trusts (SLATs) for married couples and domestic asset protection trusts (DAPTs) for single clients or married clients who want more access than provided by SLATs. These trusts can facilitate using the exemption, or transferring discounted assets, before laws may become more restrictive after the election. While GRATs are an incredible opportunity in the current very low interest rate environment, they don’t secure unused exemptions, nor do they provide significant asset protection. This is because, by definition, with a GRAT, the principal and a rate of return must be distributed back to the client as part of the required annuity payments. Wealthier clients who’ve used all their exemptions and believe that the possible asset protection disadvantages of GRATs, as contrasted with other techniques, are acceptable will find GRATs to be a favored tool. 

SLATs 

SLATs permit each spouse to be a beneficiary of the trust created by the other spouse and are a common planning technique for married clients. SLATs permit removing assets from a couple’s estate, and from the reach of creditors, but with each as a beneficiary of the other spouse’s trust, the couple can remain discretionary beneficiaries of both trusts, thus retaining limited access to all assets transferred. Each spouse creates a non-reciprocal trust for the other spouse. The theory and objective are that if one spouse creates a trust for the other, and vice versa, collectively both spouses, so long as both are alive and remain married, can benefit from potentially all of the assets that have been transferred out of their respective estates. Integral to differentiating each spouse’s SLAT from the other is incorporating different POAs into each of the two trusts.4

SLATs can have more flexibility to assure the settlor access by incorporating a floating spouse clause that provides that anyone the settlor is married to will be a beneficiary. So, if the spouse who was alive when the SLAT was created dies or divorces, and the settlor remarries, then indirect access to SLAT assets may  again be provided to the settlor through that new spouse as a beneficiary.

DAPTs and Their Variations 

Some form of a DAPT may be a choice for clients who desire more access to their wealth levels than a SLAT might provide (and certainly for single clients without a spouse who could provide indirect access to a SLAT).

DAPTs permit access by naming the grantor as a beneficiary. For those domiciled in the 19 jurisdictions with enabling DAPT legislation, most commentators see no issue with the efficacy of DAPTs. For those resident in other non-DAPT jurisdictions, there’s disagreement as to whether the creation of a DAPT in a DAPT jurisdiction will succeed.5 Some suggest that a DAPT created by a resident of a non-DAPT jurisdiction may not succeed.6

Another variation is to have a time fuse on the period after which the settlor could be named as a beneficiary or after which the settlor might automatically become a beneficiary. For example, the settlor could be precluded from receiving distributions for 10 years and one day after the creation of the trust or after additions are made to the trust. This is to avoid the provisions of the Bankruptcy Protection Act,7 which permit the bankruptcy trustee to access assets of the self-settled trust or similar device for 10 years after transfers are made to it, in some cases.

Hybrid DAPTs

Concerns over the safety of DAPTs have given rise to variations of the DAPT technique that some commentators view as safer. With a hybrid DAPT, the settlor isn’t named as a beneficiary of the trust initially. Rather an individual is granted, in a non-fiduciary capacity, a limited or special POA to add beneficiaries to the trust. While the settlor could be named as an individual who could be added, a more common approach is to create a class of potential beneficiaries, for example the descendants of the settlor’s grandparents. In that way, the settlor could be added but isn’t specified so it’s less direct to hopefully deflect a challenge that there’s an implied agreement to add the settlor. There’s uncertainty about this technique, however.8

SPATs

An alternative approach to any type of self-settled trust is the special power of appointment trust (SPAT) that may permit access to trust assets but avoids characterization as a self-settled trust.9 In a SPAT, the settlor grants an individual, also acting in a non-fiduciary capacity, the power to direct the trustee to make distributions to the settlor. However, the settlor in no event should be permitted to be added back as a beneficiary, nor can the trustee make discretionary distributions to the settlor. With these limitations, the trust shouldn’t be characterized as a self-settled trust, and it shouldn’t be subject to the law that allows creditors access to such a trust.

Additional Special POAs 

As noted above, access to assets transferred will be of paramount importance for many clients to plan in the current environment. Incorporating various types of special powers into SLATs and DAPT variants can further facilitate achieving this goal. It will be imperative for most clients to preserve access to the assets transferred to irrevocable trusts, as many clients won’t make the transfers if they can’t be comfortable that they can have some access in some manner in future years. This is important in light of economic uncertainty, longevity and the need to finance retirement especially considering reduced retirement account values. Preserving access has several planning ramifications. For example, in a non-grantor trust, client access creates a host of issues that the practitioner will need to address. Also, if the settlor’s spouse is named as a beneficiary, a non-adverse party will have to approve distributions if the trust is to retain non-grantor trust status.10 

Power to Loan Trust Assets

In a grantor trust, the settlor could provide in the trust instrument a power, held by an individual in a non-fiduciary capacity, to loan trust assets to the settlor. This power is merely a special or limited POA. While this may create a debt due to the trust by the settlor, it’s a potentially important means of preserving access to assets that the settlor may need at a future date for living or other expenses. While the loan provision has generally been viewed as a mechanism to create grantor trust status for the particular trust,11 it can also be used, when non-grantor trust status is assured by other provisions, to provide an important means of providing access to trust assets to a settlor making a large gift. Even though the settlor will have a debt to repay the trust, with interest, it nonetheless provides an access to trust assets should the settlor need or want.

Power to Reimburse for Taxes

Another means of providing the settlor access to the trust is for the trust to incorporate a tax reimbursement provision, so long as permissible under applicable state law without enabling creditors of the settlor to thereby access the trust assets. In most instances, this will have to be a discretionary distribution decision made by the trustee. Such a power, perhaps, is a special or limited power held by the trustee in a fiduciary capacity. Practitioners shouldn’t only consider this from the standpoint of providing the settlor another means of access to the trust assets. This won’t cause estate tax inclusion of the trust in the settlor’s estate.12

Substitution Power

A grantor’s power to swap or substitute assets can’t provide the grantor incremental value but may be useful to address concerns of the grantor after the trust is funded. The trust instrument can give the grantor a power to substitute trust property in a non-fiduciary capacity. 

The trustee must determine that the properties acquired and substituted by the grantor are in fact of equivalent value. Finally, the trustee must determine that the power can’t be exercised in a manner that would shift benefits among the beneficiaries of the trust. The trustee must have a fiduciary obligation to ensure that the grantor complies with the trust terms. The settlor’s substitution power can’t be exercised in a manner that can shift benefits among beneficiaries. If the requirements are complied with, the trust property won’t be included in the grantor’s estate under Internal Revenue Code Sections 2036 or 2038.13 

Trust-Owned Entities

The client may hold a special power to direct the trustee as to trust investments, for example, to hold private equity. If the client is contemplating the transfer of family business interests, or real estate entity interests, to an irrevocable trust, that transfer doesn’t have to eliminate the client’s ability to access assets held by the trust. For example, the client may be permitted to receive arm’s-length and reasonable compensation from those transferred entities for services provided as a manager or in another appropriate capacity. Such payments might be more susceptible to challenge if the entity interests so transferred merely hold passive assets, such as marketable securities, which the client isn’t actively managing. This may provide for some clients another means to access wealth transferred to a trust. Give consideration to having an analysis of reasonable compensation performed by an independent appraiser to corroborate any fees that are so paid.

Technique Combinations 

Practitioners can cobble together the various techniques and special powers available to create a mix of rights and powers for each client. By aggregating different techniques for each spouse’s trust for married clients, access under different conditions might provide more financial security. Also, differentiating the trusts using different special powers may further deflect a reciprocal trust challenge.

A broader perspective than merely defaulting to non-reciprocal SLATs for a married couple is to consider the use of DAPTs (or a variation) and not merely limit them to single clients. A DAPT can, for example, be used in combination with a SLAT. For example, one spouse could create a SLAT for the other, and the other spouse could create a DAPT, hybrid DAPT or SPAT that benefits both the other spouse as well as potentially himself. That difference between the SLAT and DAPT may be relevant to deflecting the reciprocal trust doctrine. It may also enhance access as contrasted to a more traditional reciprocal SLAT plan. 

Planning Encouraged

In the current environment, clients are concerned about economic security, making many worried about transferring assets. However, the potential for increased taxes, especially following the elections, to pay for the government bailouts, and the risks of lawsuits and claims that may be accentuated by COVID-19 and the economic downturn, all encourage current planning. The creative use of special POAs in various trust structures can help clients achieve these apparently competing goals.  

Endnotes

1. For the 99.8 Percent Act, S. 309 116th Cong. (2019).

2. Seewww.cnbc.com/2020/03/13/this-is-how-joe-biden-will-tax-generational-wealth-transfer.html.

3. See supra note 1, which might serve as a blueprint for Democratic tax legislation.

4. Estate of Herbert Levy, T.C. Memo. 1983-453 (1983). See also Private Letter Ruling 9643013 (July 19, 1996).  

5. See, for example, In the Matter of the Cleopatra Cameron Gift Trust, Dated May 26, 1998, and the Cameron Family Exempt Gst Trust Fbo Cleopatra Cameron, created under the Cameron Family Trust, dated Dec. 20, 1996, as amended, 2019 S.D. 35. The South Dakota Court didn’t permit California to enforce a judgment against a South Dakota trust. However, the challenges in this case may not be over. Some commentators suggest that domestic asset protection trusts (DAPTs) created by residents of non-DAPT jurisdictions may succeed. See“Steve Oshins on the 20th Anniversary of Domestic Asset Protection Trusts,” LISI Asset Protection Planning Newsletter #341 (April 3, 2017).

6. For example, the Uniform Voidable Transactions Act advocates in Comment 8 to Section 4 that any transfer to a DAPT is voidable if the transferor’s home jurisdiction hasn’t enacted DAPT legislation.

7. Internal Revenue Code Section 548(e).

8. Matter of Ianotti v. Comm’r, 725 N.Y.S.2d 866 (2001). 

9. Abigail O’Connor, Mitchell Gans and Jonathan Blattmachr, “SPATs: A Flexible Asset Protection Alternative to DAPTs,” 46 Estate Planning 3 (February 2019).

10. The individual holding the consent power must have a substantial interest adverse to the exercise of the power in favor of the decedent, his estate, his creditors or the creditors of his estate. Treasury Regulations Section 20.2041-3(c)(2).

11. Express loan provisions will cause grantor trust status, IRC Section 675(2). See PLR 9525032 (Dec. 13, 1999). 

12. Revenue Ruling 2004-64.

13. Rev. Rul. 2008-22.

The modern estate-planning attorney will represent a significant number of lesbian, gay, bisexual, transgender and queer (LGBTQ) clients or clients who have family members or other potential beneficiaries in the LGBTQ community.1 The number of those clients is growing.2 Laws and drafting and planning techniques often haven’t kept pace and have failed to address some of the unique needs of this community. It’s also important for practitioners to understand that even if a particular client isn’t known to be LGBTQ or have current family members who are LGBTQ, it’s possible that a future descendant will be LGBTQ. This should be factored into drafting and planning.

Confronting all issues that LGBTQ clients and their beneficiaries may experience in estate planning simply can’t be addressed in an article of this brevity. Thus, we focus on three common issues that arise: (1) defining a beneficiary, (2) changing a name or gender, and (3) a fiduciary covering expenses. While each issue may be addressed using existing techniques, we propose an alternative approach to mitigate the issues described with flexibility—by the appointment of a special trust advisor (STA).

Drafting and Planning 

No doubt the optimal means to draft for any client, including LGBTQ clients, is to tailor each provision of the document to the client’s particular circumstances and to modify governing documents if there’s a change in facts. Some practitioners may not be comfortable drafting all of the necessary provisions. Even if the practitioner is knowledgeable, will all relevant issues be addressed? Many clients will delay for years returning to counsel to update provisions in a will or other critical document. The approach we suggest might provide a practical mechanism to address these issues. While tailoring all documents and modifying them as appropriate is preferable, a fallback approach might be useful. 

Defining a Beneficiary

One of the important issues to address for LGBTQ clients is the definition and determination of who should be included in the class of children, descendants and beneficiaries. For example, children could be adopted or born through surrogacy3 so that neither parent, or only one parent, is biologically related to the particular child. Sometimes the parents aren’t married and don’t go through a formal adoption process, which can make the family structure even more complicated.

Typical drafting language may not include as beneficiaries the very people that clients love and raise as their own children. Several approaches may exist to address this, including:

1. When a particular individual is treated as a child, that individual could be formally adopted and, hence, fall within the definition of “child” (so long as the trust instrument includes “adopted children” in the definition of “child” and “descendant,” and that should be confirmed if applicable to the client). This may suffice in some instances; however, if, for legal or other reasons, the particular child isn’t formally adopted, the child may not be included in the class of intended beneficiaries under the governing instrument. The challenges and discrimination that LGBTQ clients may face may also be an impediment to adopting a child. 

   Once a situation is known, that particular child could (and probably should) be named specifically in a will, revocable trust or other appropriate documents as a “child.” However, this raises the potential problem that, if the documents aren’t revised to reflect the new child or relationship, the intended beneficiary could be omitted. An approach that could assure inclusion of the desired beneficiaries, even future beneficiaries, is desirable. 

2. Provide a trustee with the authority to add to the class of children or beneficiaries the particular individual who’s treated and loved as a child even though, technically, not a biological or adopted child of the client. While that approach could work, it may present potentially thorny issues. Someone acting as a trustee has a fiduciary responsibility to the other beneficiaries, and adding to that class of beneficiaries may incite litigation.4 Adding a beneficiary would assuredly dilute the beneficial interests of the other beneficiaries and may violate that trustee’s duty of loyalty to the current beneficiaries of the trust. If the right of the trustee to add such individual or individuals as beneficiaries is sufficiently expressed in the governing instrument, it may be legally permissible for the trustee to act. 

3. However, if the situation is emotionally charged, for example, if some of the current beneficiaries are antagonistic to the LGBTQ individual and any descendant of that individual, it may be preferable to have someone other than a trustee add the intended beneficiary. Additionally, the individual whom the client wishes to name as trustee isn’t necessarily the individual the client would most trust to make determinations regarding who should or shouldn’t be added as a beneficiary of the trust. 

Name or Gender Change 

Another category of issues arises with LGBTQ beneficiaries if a named beneficiary changes their name or gender.5 It’s possible that, in such a situation, the individual will inadvertently be omitted as a beneficiary. For example, consider a beneficiary who changes their name from “John” to “Jane.” Will a bequest of “My Picasso to John” lapse? Now, consider a situation in which the oldest son has gender confirmation surgery and transitions to female. Will a bequest of “my gold watch to my oldest son” lapse, or would another child claim the gold watch? How can planners help clients avoid ambiguity and family strife in these situations?

There are several ways to address this:

1. For existing clients and documents, the obvious and straightforward solution would be for the clients to sign a new will or amend and restate their revocable trust, revising language for the specific bequest to conform to their intent. As estate planners, we know that too often, clients delay amending and restating documents, and their intended bequest could be challenged, misdirected or lapse. 
2. For new clients and documents, consider modifying the language used in the bequest to terminology that will more specifically assure the clients’ intent regardless of future changes. For example, “I bequeath my gold watch to my oldest child assigned male at birth (cisgender son).” The preceding bequest might assure that the oldest child who was born male and remains male at the time of the client’s death might inherit the gold watch. But, is that the client’s intent? Might the client prefer to have the particular child named inherit the gold watch regardless of a subsequent name or gender transition? If a client wants to make certain gender-specific gifts, consider exploring the intent of the gift with the client to ensure that the document is appropriately drafted to reflect that intent. 

Covered Expenses 

Medical and other expenses can be substantial for LGBTQ individuals.6 Thus, another possible issue is what expenses may be encompassed within terminology for distributions that a trustee under a trust may or shall pay for. For example, if the governing instrument defines “permissible medical expenses” based on federal income tax law definitions of what constitutes a deductible medical expense, costly and important cosmetic and other procedures for an heir going through transition may not be permitted to be paid for or reimbursed. Might that payment or reimbursement be the client’s intent? One approach is to include a broader and more descriptive provision as to what constitutes reimbursable or distributable expenses for an heir. While such drafting could resolve the issue, it presumes that the settlor of a trust has knowledge that an LGBTQ beneficiary exists and that this issue needs to be addressed. Even well-crafted language, however, may not properly address expenses that may be incurred as medical science progresses.  

An Alternative Approach

An alternative approach is for the governing instrument to name a special limited trust protector (the STA) to address the issues described earlier. The idea is to name an individual, or perhaps an organization or entity (for example, the law firm that drafted documents and is intimately familiar with the client’s wishes) to act in a non-fiduciary capacity, to the extent permitted under state law. Expressly address those matters specific to the LGBTQ community in the powers granted to this STA, which may be a clear way to provide the appropriate authority to overcome many of the common issues discussed above. Of course, if the drafting attorney knows of concerns particular to the client or the client’s family, the provisions of the document should more specifically address those concerns. However, in many situations, the particular concerns may not be known at the time the document is drafted, and it’ll be prudent to add provisions allowing flexibility in managing issues that may arise in the future. To the extent many of these matters can be addressed in a single provision, it may be feasible to more economically (in terms of drafting time) address many of these matters than taking a specific approach of drafting for each of the many different issues that may come up in the appropriate portion of a trust instrument. 

Non-fiduciary capacity. Specifying that the STA will act in a non-fiduciary capacity should eliminate some of the fiduciary duty concerns that a trustee might have when changing a bequest or appointing a new beneficiary of a trust, such as a non-adopted child who’s clearly an intended beneficiary. While specific drafting might suffice to permit a fiduciary, such as a trustee, to add a beneficiary, naming someone in a non-fiduciary capacity might avoid concerns associated with fiduciary duties.

This power would be analogous, in some respects, to the power given to an individual in a hybrid domestic asset protection trust (DAPT) to appoint additional beneficiaries (although the uncertainties of adding the settlor in a hybrid DAPT aren’t relevant to this application of the concept). You can also give the STA the power to direct distributions to beneficiaries for medical, adoption, family planning and other costs that a trustee may not believe are covered under the terms of the governing instrument.

Note that it may not be possible, under the law of some jurisdictions, to name an STA to act in a non-fiduciary capacity. The STA may be considered a trust director within the meaning of the Uniform Directed Trust Act or an individual with the power to direct the trustee under former Section 808 of the Uniform Trust Code. If the governing jurisdiction has adopted a version of one or both of those acts, the applicable statutory law may provide that the STA, if considered a trust director, acts in a fiduciary capacity. In some cases, that may be the default under the statute, which may be overridden by the terms of the governing instrument. In any case, it’ll be necessary to know the jurisdiction’s applicable law on this subject.

To the extent the applicable law requires the STA to act in a fiduciary capacity, it may be prudent to consider taking the necessary steps to situate the trust in a different jurisdiction that doesn’t require a trust director to act in a fiduciary capacity. Moreover, the document should state the client’s intent that the STA not act in a fiduciary capacity to override any default to the extent possible and for the avoidance of any doubt.

Who should be named. A critical consideration to address is who should be named in the capacity of the STA. A member of the LGBTQ community knowledgeable and sensitive to the range of issues that might arise is perhaps the ideal individual to serve. In any event, the STA should be an independent individual and not a beneficiary or someone otherwise having any direct or indirect interest in the outcome of the decisions involved, to avoid potential transfer-tax consequences. Although this technique will generally be used in testamentary trusts, in the event it’s used in an inter vivos trust, also consider grantor trust issues in selecting the STA. As with other roles within the trust, it’s prudent to name successors or, in the event of a vacancy, include provisions that specifically address appointing a successor if the named STA ceases to serve for any reason. The typical approach of having a vote by adult beneficiaries or something similar to that may be inadvisable given the risk that one or more of those beneficiaries may not approve, or worse, be antagonistic to, the entire provision, which would defeat the purpose of having the STA. Furthermore, the individual acting as STA shouldn’t act in a fiduciary capacity in another role in the trust that might adversely affect the status as a non-fiduciary, which is intended.

A particular issue that might arise if the STA exercises the power to change a name or gender reference in a separate instrument (for example, a signed action by the STA) is that a transgender individual may not wish to have their dead name (that is, the name that the trans individual may have used before transition that they no longer use) continue to be reflected in the instrument. This is far more of a concern than merely semantics in the instrument. The incidence of violence and discrimination that transgender individuals have experienced and continue to experience is real and needs to be addressed. This problem might be resolved by the trustee thereafter decanting the trust into a new instrument reflecting solely that individual’s current name (so that there’s no legacy language remaining in the governing instrument). Perhaps the STA could be given the authority to direct the trustee to decant the trust to accomplish this objective. The STA could, or even should, be given the power to direct specifically how the name of the individual should be reflected in that new trust.

If a practitioner is satisfied with the approach suggested, she may nonetheless wish to revise other aspects of the governing document and planning, for example, to address proper use of pronouns, gender and other terminology. However, a client may be willing to accept the manner in which this provision addresses key issues.

For language to consider regarding the appointment of an STA in the governing instrument, see “Sample STA Clauses,” p. 18.

Endnotes

1. A 2017 Gallup poll concluded that 4.5% of adult Americans identified as lesbian, gay, bisexual, transgender and queer (LGBTQ). https://en.wikipedia.org/wiki/LGBT_demographics_of_the_United_States.

2. The figure was 3.5% in 2012, which grew to 4.5% in 2017, so the trend is certainly an increasing number of adults identifying as LGBTQ. As a result, it’s become and will continue to be more likely that practitioners will encounter LGBTQ clients and need to be prepared to address planning needs of the community. https://news.gallup.com/poll/234863/estimate-lgbt-population-rises.aspx.

3. See, for example, https://surrogate.com/intended-parents/surrogacy-for-lgbt-parents/. 

4. Trustees are held to a fiduciary standard and owe a duty of loyalty to beneficiaries of a trust. Exercising the power to add beneficiaries may breach the trustee’s duty of loyalty to the initial beneficiaries.

5. Seewww.lambdalegal.org/know-your-rights/article/trans-changing-your-documents-resources for resources to facilitate a change in name.

6. For example, “Oft-cited figures from the Philadelphia Center for Transgender Surgery place the total cost of male-to-female and female-to-male surgeries at more than $100,000…,” www.marketwatch.com/story/the-difference-gender-affirming-surgery-can-make-in-a-transgender-persons-life-2019-10-07.

For many, religion can be very personal and important, especially when attending to familial matters. Many religious individuals wish to pass on their personal beliefs, values and traditions to future generations. On occasion, individuals who value religion may want to add provisions to their estate-planning documents to ensure that their heirs continue to honor and respect their religious beliefs and traditions. However, attorneys should take care when preparing estate-planning documents with religious provisions to ensure they’re explicit and defensible. Individuals have been including religious requirements in their estate-planning documents for 130 years,1 if not longer, but courts haven’t always upheld these provisions when challenged. Religious provisions often can lead to disputes between the beneficiaries and the fiduciaries if they’re not drafted properly, and worse yet, don’t honor the testator/grantor’s wishes. We’ll briefly address conditional bequests in general, analyze how the law on religious requirements in conditional bequests has developed over the years and discuss the modern approach. We’ll also provide recommendations for attorneys with clients who wish to include religious requirement provisions in their testamentary documents.

Conditional Bequests

Testators of wills and grantors of trusts often include bequests conditioned on the beneficiary doing (or not doing) a certain thing. Such provisions allow a testator or grantor to incentivize a beneficiary’s behavior by requiring that the beneficiary meet the condition to receive the bequest due to her under the governing instrument. Historically, courts have upheld conditional bequests, provided the conditions are: (1) not illegal, (2) not contrary to public policy, and (3) able to be performed.2 Testamentary freedom often is cited as the primary reason for the wide berth granted to individuals who wish to dispose of their wealth subject to conditions. A common restriction found in many wills and trusts is adherence to religious traditions.3 In the case of conditional bequests relating to religious practices, courts tend to focus on whether the conditions are contrary to public policy (typically by encouraging divorce) and whether the conditions are clear enough to be able to be performed, as we’ll see in the cases discussed below.   

Development of Modern Approach

As early as 1883, courts were asked to determine the validity of provisions in wills that required beneficiaries to meet certain religious conditions in order to inherit. In Magee v. O’Neill, a decedent died leaving a will that provided for a trust for his granddaughter, Elizabeth Magee, with the following language:

[P]rovided she is educated in some Roman Catholic female seminary or school, and is reared as a Roman Catholic in the communion and faith of her deceased father, the said Arthur Magee; and on her day of marriage, or attaining the age of twenty-one years, the bequest—the whole amount—shall be paid over to her and her heirs, forever freed from all trusts whatever. But if the said Elizabeth Magee is not educated at a Catholic seminary or school, and reared as a Roman Catholic in the faith of the Roman Catholic Church, then it is my intention, will and direction that the bequest shall accumulate, the interest or income as it arises shall be added to the principal until the said Elizabeth Magee’s death or marriage or attaining the age of twenty-one years, when, on the happening of either of these events, the whole amount—principal and interest—shall be divided and paid over to the trustees of my daughter Elizabeth West.4

The facts of Magee indicate that Elizabeth Magee wasn’t educated at a Catholic seminary or school, and there was no evidence that she was reared as a Roman Catholic in the faith of the Roman Catholic Church.5 Elizabeth argued that it was impossible, practically speaking, to meet the conditions set forth in the will and contended that the conditions set forth in the will were against public policy.6 The Supreme Court of South Carolina rejected both contentions, stating first that “the condition cannot be disregarded upon the ground that it could not be performed in whole or at least in part.”7 Explaining that the condition also wasn’t void as against public policy, the court focused on the testator’s freedom to dispose of his property as he wished. The court stated:

We do not understand that there was anything in this bequest which can be properly called coercion, or that Elizabeth was ‘deprived’ of the liberty of conscience. Terms were attached to the bequest which may seem to us exacting, unkind and unnecessary, but we cannot say they were unlawful or that they were complied with.8

More than 80 years later, courts began to call religious conditional bequests into question. In In re Keffalas’ Estate, the decedent died leaving a will that provided to each of his children except one daughter, a bequest of $2,000 on the condition that the child marry an individual of “true Greek blood and descent and of Orthodox religion.”9 The excluded daughter had married prior to the execution of the will; for her, the will provided a bequest of $2,000 on the condition that she remarry a man of true Greek blood and descent and of Orthodox religion after her first marriage was terminated by death or divorce.10 The will also included a bequest of $2,000 to any child who originally married a non-Greek individual but later, as a result of death or divorce, remarried a Greek individual.11 

Unlike most prior court rulings, the Keffalas court held that religious provisions that encouraged divorce were against public policy, but the provisions that were subject to a marriage condition were upheld.12 Specifically, the Supreme Court of Pennsylvania stated:

The condition . . . although not violative of freedom of religion, was conducive to divorce and thus violative of public policy. We cannot accept the contentions of appellants that evidence of an actual subjective intent to cause divorce is a prerequisite to striking down a condition based on divorce. On the contrary, the distinguishing factorseems to be whether the disposition is reasonably related to the contingency of divorce. . . . In the instant case, an additional gift is conditioned on divorce (or death) and remarriage to a Greek. The disposition is not logically related to the changed circumstances of the child, but is rather a channel for the testator’s ethnocentricity and an encouragement to divorce.13 

The Keffalas court did, however, uphold the disposition of the testator’s business establishments to his three eldest sons on the condition that they marry an individual of “true Greek blood and descent and of Orthodox religion”:

Testator intended one potential gift of $2,000 to each child on condition of either marriage or remarriage to a Greek. The conditions on those $2,000 bequests are, indeed, tainted, and fall as conducive to divorce. However, the remarriage conditions, the fly in the ointment, do not attach to the gifts of the businesses in Paragraphs Twelfth and Thirteenth. As we have seen, the marriage conditions of themselves are valid.14  

In short, the conditional bequests that reward divorce were deemed to be against public policy, but those that simply encouraged marriage within a particular faith were validated.

Notably, after the Keffalas ruling, some courts continued to uphold provisions relating to a beneficiary’s spouse’s religion. The wording of such conditional bequests is crucial as to whether the grantor’s or testator’s intent will be upheld. For example, in Shapira v. Union National Bank, the decedent died leaving a will with the following condition for the bequest to his son:

My son Daniel Jacob Shapira should receive his share of the bequest only, if he is married at the time of my death to a Jewish girl whose both parents were Jewish. In the event that at the time of my death he is not married to a Jewish girl whose both parents were Jewish, then his share of this bequest should be kept by my executor for a period of not longer than seven (7) years and if my said son Daniel Jacob gets married within the seven year period to a Jewish girl whose both parents were Jewish, my executor is hereby instructed to turn over his share of my bequest to him. In the event, however, that my said son Daniel Jacob is unmarried within the seven (7) years after my death to a Jewish girl whose both parents were Jewish, or if he is married to a non Jewish girl, then his share of my estate, as provided in item 8 above should go to The State of Israel, absolutely.15

At the time of the decedent’s death, Daniel was 21 years old and unmarried.16 In court, Daniel argued that the condition on his inheritance was: (1) unconstitutional because it was a restriction on his constitutional right to marriage, (2) contrary to public policy as a restriction on marriage, and (3) unenforceable because of its unreasonableness.17 Seven years after the Keffalas decision, the Court of Common Pleas of Ohio upheld the provision, noting that the condition wasn’t a restriction on marriage, but a restriction on a beneficiary’s ability to take under the will.18 The court specifically held that: “It is a fundamental rule of law in Ohio that a testator may legally entirely disinherit his children. . . . This would seem to demonstrate that, from a constitutional standpoint, a testator may restrict a child’s inheritance.”19 Unlike the language in Keffalas, which was deemed problematic, the language at issue in Shapira was rewarding Daniel for marrying a Jewish girl rather than rewarding him for divorcing a current spouse.

Application of Modern Approach

The provisions must not restrain marriage. Across the country, courts generally have found religious requirements in conditional bequests to be reasonable and not against public policy or constitutional law, so long as they’re not conditions in total restraint of all marriage or to induce divorce. “Courts have consistently upheld restrictions that require a beneficiary to observe certain religious practices. . . . The reasoning behind permitting religious restraints is that society is not concerned with an individual’s religious beliefs or practices.”20 However, courts may look more skeptically at provisions that promote divorce.  

The Restatement (Third) of Trusts (Restatement Third) confirms that trust provisions that are contrary to public policy are void and sets forth as a specific example of such contrary language a provision that states that all of a beneficiary’s rights to a trust would terminate if she married an individual who wasn’t of a specified religion. The example provides that:

. . . the marriage condition terminates all of [settlor’s nephew ‘N’] N’s rights if, before termination of the trust, he ‘should marry a person who is not of R Religion,’ with the same gift over to C College. The condition is an invalid restraint on marriage; the trust and N’s rights will be given effect as if the marriage condition and the gift over to C College had been omitted from the terms of the trust.21 

As noted in the Keffalas case, “[w]hen a disposition tends to lead to divorce, as this one does, despite the relatively small amounts involved, then it is void.”22 While the Restatement Third asserts, in the above example and the related Comment, that attempting to influence religious choices of adults is contrary to public policy and would make such a provision void, it also cautions that “Some of the personal relationships or freedoms considered [in the Comment] may be protected in some fashion by federal or state statutes or constitutions (such as religious freedom).”23 Further, the Restatement Third states that it disagrees with the holding in Shapira and with the rule set forth in the Restatement (Second) Property (Donative Transfers) Section 8.1, which states that language drafted to prevent the acquisition or retention of property on account of adherence to or rejection of certain religious beliefs or practices on the part of the transferee is valid.24 However, it also notes that most of the few U.S. decisions on this point support the position taken by the Restatement (Second) Property (Donative Transfers) (that is, the validity of conditional gifts based on religion).25 Accordingly, perhaps little weight should be given to the Restatement Third on this point.

Thus, while individuals have broad freedom to require the beneficiaries of their bounty to adhere to religious practices, it’s crucial that the draftsperson avoid requirements specifically rewarding the beneficiaries to divorce. For example, the court in Keffalas may have upheld the language at issue if the will didn’t explicitly incentivize the married daughter with a bequest if she divorced and remarried a Greek Orthodox man. Instead, the will could have simply provided for specific bequests of cash to the decedent’s children who were married to a Greek Orthodox individual, without the mention of the termination of prior marriages or divorce. In sum, “[a] condition which in terms is in general restraint of marriage is void . . . but conditions forbidding the marriage of a beneficiary to a certain person or to a nonmember of a certain faith are valid.”26 Many modern courts likely would try to find a donative intent that was consistent with public policy even if there was also an effect on freedom to marry.

The provisions must be able to be performed. Furthermore, as noted in the above cases, when a beneficiary challenges a conditional testamentary gift, the claim typically will also focus on whether the terms of the condition are too ambiguous for the condition to be performed. When the conditions required to receive a bequest are poorly drafted so that they can’t be met, either due to impossibility or vagueness, a court usually will find such conditions to be void and unenforceable. This concern arose in In re Lesser’s Estate, in which the will at issue included the following provisions:

To pay said sums to the children, that may survive me, of my son, Max Lesser, on their respective twenty-first birthdays, provided these children are given a normal Jewish, liberal education including an ability to read Hebrew, up to and including at least their fourteenth year: and, further provided that the Jewish dietary laws are observed by their parents up to and including the confirmation of these my present grandchildren: provided, however, that these my present grandchildren visit my grave at least once a year up to and including the twenty-first birthday of my youngest grandchild. If these conditions are not complied with to the complete satisfaction of my executor or his successor or successors, then the funds herein bequeathed are to go to the ‘Federation for the Support of Jewish Philanthropic Societies of New York City,’ . . . 27

The will also directed that the residue of his estate was to be paid to his grandchildren “provided in the opinion of my executor, his successor or successors, they and their parents have complied with all the terms and conditions of [the above quoted language]: otherwise, then, the funds herein bequeathed are to go to the ‘Federation for the Support of Jewish Philanthropic Societies of New York City.’”28

Some of the beneficiaries under the will contested these provisions, claiming in part that some of the terms of the conditions couldn’t be implemented.29 They argued, for example, that the will didn’t set forth the duration of grave visitations that were to be measured by the age of the decedent’s “youngest grandchild.”30 The beneficiaries contended that the will didn’t take into account grandchildren born after the death of the decedent, who could be deemed to be the decedent’s “youngest grandchild,” thus continually changing the duration of the grave visitations required for the beneficiaries to receive funds from the decedent’s estate.31 

The Kings County Surrogate’s Court ultimately disagreed, stating that issue didn’t require serious attention because the will “speaks from the date of death of the testator.”32 The court found that the decedent’s “youngest grandchild” meant the youngest grandchild who had been conceived—but not necessarily born—as of the decedent’s death, explaining that this question was “presently academic” because the youngest living grandchild of the testator was born slightly over eight months after the testator’s death.33 “It was obviously ‘alive’ in ventre sa mere at the time of the decedent’s demise and is not only entitled to the benefits which he gave to the specified class of grandchildren . . . but comes within the description of the person whose minority is to measure the period of grave visitation.”34 

Similarly, in In Re Paulson’s Will, the Supreme Court of Wisconsin was asked to interpret vague provisions in a testamentary document that provided that if the decedent’s son “attend the regular meetings of worship of the Emanuel Church near the village of Cashton, Wisconsin, when not sick in bed, or prevented by accident or other unavoidable occurrence,” he would receive his bequest.35 The son claimed that the condition didn’t include clear criteria for what would constitute “regular” meetings or “unavoidable occurrence” and thus was unenforceable due to uncertainty and indefiniteness.36 The court held that it was proper for a court to provide clarity on these questions:   

It is said there is nothing to indicate when the attendance at church is to commence, nor how long it is to continue, nor who is to judge whether Peter Paulson has attended the ‘regular meetings’ of the church named, and, if he has not attended, who is to be the judge whether or not he was ‘sick in bed.’ But we think all of these questions are properly for the determination of the court in case judicial determination should be necessary. It does not seem that they are incapable of judicial determination, or that the conditions are so uncertain and indefinite that a court could not determine whether they had been performed
 . . . while the period of time of attendance is not stated, we think it a proper matter of judicial determination under all the terms of the will.37

Another example of a vaguely drafted conditional bequest involves a will that revoked certain bequests to the decedent’s children if the children were married to non-Jewish individuals.38 Several years after the decedent’s death, the decedent’s only son married a woman who wasn’t Jewish.39 A few months after their civil ceremony wedding, the son’s wife converted to Judaism, and they had a Jewish wedding ceremony while she was pregnant.40 The decedent’s other children petitioned the court to determine whether the son had lost his rights to the decedent’s estate based on the provision.41 Ultimately, the Supreme Judicial Court of Massachusetts interpreted the conditional bequest to mean that the future spouse of a child of the decedent must be Jewish as of the date of the legal marriage between the child and the future spouse.42 “Regardless of the dogmatic dispute as to the retroactive effect of conversion, we think that the provision as to marriage with ‘a person not born in the Hebrew faith’ must be judged in this case on the facts as they stood on May 11, 1949 [the date of the son’s civil ceremony wedding].”43 A properly drafted will could have avoided the time and cost necessary to obtain a judicial determination of these conditions. It’s worth noting that the court upheld the religious provisions. It’s essential, therefore, that any conditions included for a testamentary bequest be drafted with the utmost clarity and attention to detail. While the courts upheld the provisions, a judicial interpretation of a decedent’s testamentary document may not actually follow what the testator intended. In addition, poorly drafted religious requirements in a testamentary document could lead to costly legal actions to ensure the conditions are properly met.  

Sample Provisions/Suggestions

Thus, when drafting a testamentary document with a religious condition, the draftsperson should consider the mechanisms of the condition and how the executors or trustees, as the case may be, will be able to determine if the condition is met. What constitutes “regular” church attendance? For how long must the religious practice be observed? What’s the measuring life governing the duration of the conditions to be met? What’s the relation of the beneficiaries to the grantor or testator? It’s notable, for example, that a majority of the cases upholding restraints on religion in donative transfers have involved situations in which the transferor and transferee were related by blood, marriage or adoption.44 A court might conclude that such restraints shouldn’t be upheld when the beneficiary at issue isn’t related to the transferor. In addition, draftspersons may need to include language in the document to specify how to determine whether an adopted descendant or a descendant conceived through artificial reproductive technology (ART) is considered to be born a member of the particular faith of the testator or grantor. If the governing instrument isn’t clear on how the condition can be performed, it may lead to burdensome disputes between beneficiaries and fiduciaries and the possible invalidation of the condition.  

Below is a sample provision that expresses the grantor’s donative intent with regard to the grantor’s descendants’ spouses without encouraging divorce:

The grantor places great significance on the grantor’s descendants being Protestant. Nothing herein is intended to express disapproval of the decision of a descendant of the grantor to marry or the choice of his or her spouse. If a child of the grantor after the date of this agreement (i) marries an individual who is not a Protestant or (ii) converts to a religion or faith based organization other than Protestantism, such child of the grantor shall not be considered a beneficiary at such time.  

Alternatively, such language could be incorporated directly into the dispositive provisions of the trust as follows:

Upon her attainment of the age of thirty-two years (the ‘Determinative Date’) by the grantor’s daughter, Ann, the trustees shall distribute one-half of the then-remaining principal of the trust to Ann, provided that from date of her attainment of the age of majority through and including the Determinative Date, Ann shall have not (i) married an individual of the Episcopalian faith or (ii) baptized any child of hers in the Episcopalian faith.

The below language provides guidance for a draftsperson to consider when a bequest is conditioned on a descendant’s parent being of a particular faith when there’s a possibility that descendants will be born or have been born through the use of ART:

If a descendant of the grantor is conceived by artificial reproductive technology through the use of a donor oocyte or zygote (the ‘Donor Egg’) [an ‘ART Descendant’], the following shall be applicable for such ART Descendant to be a beneficiary:

(i) If such ART Descendant is married, such ART Descendant is married to a Catholic Individual;

(ii) Either (A) such ART Descendant converted to Catholicism, (B) the donor of the Donor Egg used for the conception of the ART Descendant is Catholic if such donor is a child or more remote descendant of the grantor, or (C) the director of the fertility center providing the Donor Egg for the conception of such ART Descendant certified in an acknowledged writing that the donor of such Donor Egg provided for the conception of such ART Descendant is Catholic if the donor of the Donor Egg used for the conception of such ART Descendant is not a biological or adopted child or more remote descendant of the grantor; and

(iii) Such ART Descendant has not converted to a religion or faith based organization other than Catholicism.

Well-Drafted Documents

It’s possible for testators and grantors to include in their testamentary documents and irrevocable trusts, religious requirements for the beneficiaries so long as the documents are well-drafted:

Having chosen to make [a particular beneficiary] an object of his bounty, the testator had the right to burden his gift with conditions. If those conditions are legal, the petitioner can’t disregard the burden and successfully demand the bounty.45 

When drafting a will or trust that will include restrictions based on the religious practices of the beneficiaries under the instrument, the draftsperson must ensure that such provisions: (1) can’t be construed as promoting divorce but rather merely donative intent, and (2) are clear and reasonable enough to be achieved by the beneficiary should the beneficiary wish to do so. With proper and careful drafting, attorneys can provide their clients with excellent service by ensuring their estate-planning documents accurately express their testamentary intent and include religious provisions in these documents. 

Endnotes

1. Magee v. O’Neill, 19 S.C. 170 (1883). 

2. See, e.g., ibid.; Barnum v. Baltimore, 62 Md. 275 (Md. Ct. App. 1884); In Re Paulson’s Will, 127 Wis. 612 (1906).

3. Lauren J. Wolven and Shannon L. Hartzler, “Carefully Craft Conditions on Lifetime and Testamentary Gifts,” Estate Planning Journal (August 2011). 

4. Supra note 1, at p. 178.

5. Ibid., at p. 179.

6. Ibid, at p. 180.

7. Ibid., at pp. 184-85.

8. Ibid., at p. 190.

9. In re Keffalas’ Estate, 426 Pa. 432, 434 (1967). 

10. Ibid.

11. Ibid.

12. Ibid., at p. 435.

13. Ibid., at pp. 435-36.

14. Ibid., at pp. 436-37.

15. Shapira v. Union National Bank, 39 Ohio Misc. 28, 29 (Ohio Com. Pleas 1974).

16. Ibid.

17. Ibid., at pp. 29-30 and 33-35.

18. Ibid., at p. 39.

19. Ibid., at p. 32.

20. See supra note 3. 

21. Restatement (Third) of Trusts (Restatement Third) Section 29, Explanatory Notes, Comment j, Illustration 3, at pp. 62-64 (2003).

22. See supra note 9, at p. 435.

23. See supra note 21, at p. 62.

24. Ibid., at p. 91.

25. Ibid., at p. 93.

26. In re Kempf’s Will, 252 A.D. 28, 32-33 (N.Y. App. Div. 1937).

27. In re Lesser’s Estate, 158 Misc. 895, 897 (N.Y. Surr. Ct. Kings Co. 1936).

28. Ibid., at p. 897.

29. Ibid., at p. 898.

30. Ibid.

31. Ibid.

32. Ibid.

33. Ibid.

34. Ibid., at p. 899.

35. In Re Paulson’s Will, 127 Wis. 612, 615-16 (1906).

36. Ibid., at p. 618.

37. Ibid., at pp. 620-21.

38. Gordon v. Gordon, 332 Mass. 197, 198-200 (1955).

39. Ibid., at p. 199.

40. Ibid., at pp. 199-200.

41. Ibid., at pp. 200-01. 

42. Ibid., at p. 201. 

43. Ibid.

44. Restatement (Second) Property(Donative Transfers) Section 8.1, Reporter’s Note 3, at p. 323 (1983).

45. Supra note 26, at p. 32.

The pandemic has prompted an increased focus on charitable giving. In an effort to encourage donations, recent stimulus legislation made cash gifts to many public charities fully deductible for income tax purposes—but notably excluded contributions to donor-advised funds (DAFs). Notwithstanding this incentive, many large donors will likely continue to provide philanthropic support indirectly through grantmaking (that is, non-operating) private family foundations (PFFs) or DAFs rather than directly to traditional public charities because these vehicles enable donors to obtain an upfront income tax charitable deduction in one year for contributions that may be distributed to charity over a period of years.  

Generally speaking, a donor’s family can have significantly more control over an independently run PFF than an institutionally administered DAF. But, this greater control comes at the cost of the PFF and its managers being subject to the more burdensome rules and potential excise taxes for certain prohibited activities described in Chapter 42 of the Internal Revenue Code (that is, self-dealing,1 holding excessively large interests in businesses,2 investing in a manner that jeopardizes the organization’s ability to carry out its charitable purposes,3 making taxable expenditures4 and failing to meet minimum charitable distribution requirements5) and greater Internal Revenue Service scrutiny.

Misconceptions regarding PFFs are common, with some people overestimating the magnitude of the challenges posed by these restrictions and others underestimating them. To facilitate informed decision making, let’s focus on correcting some key operational, grant-making and investment misconceptions regarding PFFs through a discussion of straightforward, practical measures that a PFF can take to set itself up for success in the face of common pitfalls.  

Operational Misconceptions

The word “private” in “private foundation” is in some ways a misnomer. While PFFs have greater control over their activities, investments and operations than public charities (especially DAFs) and are more private in that sense, the steep price of that control can seem overwhelming at first glance. Fortunately, a PFF can take simple steps to minimize the potential for self-dealing and conflicts of interest that pose the greatest operational risk to PFFs.

Adoption of policies and procedures and adherence to formalities. The implementation of internal protocols and a commitment to good recordkeeping and adherence to proper organizational formalities (for example, holding required annual meetings) can mean the difference between success and failure for PFFs.  Even though not technically required to obtain tax-exempt status,6 the best practice for a PFF is to implement policies and procedures for determining and recording decisions about conflicts of interest and compensation, which are the areas that tend to raise the most self-dealing issues.

Conflicts of interest policy and vendor review procedures. Adopting a well-drafted conflicts of interest policy that requires directors and officers to identify and analyze conflicts of interest and following vendor review procedures that are commensurate with risk and materiality can alert a PFF’s officers and directors to—and help to ensure that they seek competent advice regarding—common potential self-dealing transactions that might otherwise go unnoticed, such as renting office space in a building owned by a disqualified person (DP)7 with respect to the PFF or sharing assets or personnel with another entity owned by one or more DPs.

Compensation and expense reimbursement policies. Similarly, adopting and following a compensation policy that requires consideration of market compensation practices and documentation of the decision-making process and an expense reimbursement policy that requires the submission of receipts and explanatory information, and, in some cases, advance approval, can help to ensure that a PFF doesn’t pay excessive compensation to DPs, such as the founder’s family members, and that only those expenses that are reasonable and necessary to carry out the PFF’s proper purposes are paid by the PFF.8  

Such policies can also help to highlight instances in which a PFF may be able to re-characterize improper benefits to DPs as reasonable compensation to avoid an act of self-dealing, such as if: (1) the PFF has purchased gala tickets for a director and the director’s spouse to attend primarily in a social capacity and not in the course of ordinary and necessary business for the PFF, or (2) the PFF has paid all travel costs for a director to attend a board meeting as part of an extended stay to visit with friends or family.

Grant-making Misconceptions 

Although PFFs have significant flexibility in their grantmaking activities, adopting and following appropriate governing documents and a grant-making policy, along with engaging an accountant experienced with PFFs, can enable a PFF to define and monitor its mission as part of fulfilling it and avoid common pitfalls. In this context, meeting the minimum distribution requirements while avoiding the prohibitions on taxable expenditures and self-dealing typically pose the greatest challenges.

Instrument of formation. A PFF must be both organized and operated exclusively for one or more purposes specified in IRC Section 501(c)(3) (qualifying purposes), and the PFF’s instrument of formation must limit its purposes accordingly.9 Because a PFF’s grants must be made in furtherance of its stated purposes and most donors seek maximum flexibility in this regard, it’s  typical for a PFF’s instrument of formation, which must be filed with the state of incorporation, to track the language of Section 501(c)(3).

Bylaws. A PFF’s bylaws are typically easier to amend than its governing instrument, so the governing body of the PFF often determines the specific current goals and values of the PFF and memorializes those in a mission statement included in the bylaws. A PFF’s mission statement guides its activities, which include determining to which organizations a PFF can make grants. The mission statement can be limiting both in its purpose (for example, the PFF is founded to help combat homelessness) as well as the types of organizations to which the PFF can make grants (for example, the PFF makes grants to organizations that qualify as exempt organizations under Section 501(c)(3)).  

Another factor that can limit potential grant recipients is the requirement under IRC Section 4942 that a PFF make annual “qualifying distributions”10 in an amount equal to 5% of the fair market value of its net investment assets. Therefore, a PFF’s bylaws will almost always require that the PFF make distributions so as not to subject it to the penalty tax under Section 4942. Because not all distributions are qualifying distributions, in practice many PFFs will only make qualifying distributions to maintain their endowments. 

Grant-making policy. A well-drafted grant-making policy can help to ensure that a PFF doesn’t make grants for prohibited purposes to prohibited organizations or without following required procedures by reflecting and implementing the following limitations.

Punitive taxes are imposed on a PFF, and in some case its managers, for making certain expenditures classified as “taxable expenditures.”11 In general, taxable expenditures include grants for propaganda, lobbying and other political activities and for purposes other than those described in IRC Section 170(c)(2)(B).

Grants to organizations other than U.S. public charities and private operating foundations, including foreign charities that haven’t received a favorable IRS determination of their U.S. tax-exempt status, also constitute taxable expenditures—unless the PFF either: (1) exercises expenditure responsibility12 as described below, or (2) makes a good faith “equivalency determination” (that is, determines that the foreign organization is equivalent to a U.S. public charity).13

Making grants only to U.S. public charities is generally a safe way to avoid making taxable expenditures and is favored by many PFFs, although others choose to exercise expenditure responsibility to increase their flexibility. Expenditure responsibility encompasses formalized procedures to demonstrate to the IRS that the PFF has taken over responsibility for ensuring that the grant is expended for qualifying purposes.14 If the PFF will make grants to foreign organizations, it should exercise expenditure responsibility and document its specific procedures to ensure that all donations to the PFF will be entitled to income tax charitable deductions.15

In any case, a well-drawn and publicized grant-making policy should cause a family member with a passion for the arts to think about whether a U.S. “friends of” organization exists or an equivalency determination can be made before impulsively donating PFF funds to an iconic Italian church undergoing restoration during a vacation to Italy.

Two common self-dealing transactions that can also be easily avoided by adhering to a well-drafted grant-making policy include: (1) making a grant or other payment that satisfies a pledge or other legal obligation of a DP;16 and (2) paying for a DP to receive a benefit in exchange for a grant (for example, admission to a gala or dinner).17

Holding an annual meeting at which proposed grants are considered and approved in accordance with the PFF’s governing documents and grant-making policy is a simple way to help ensure that all required grants—and no impermissible grants—are made.  

Investment Misconceptions

For many individuals, investing isn’t the first thing that comes to mind when discussing philanthropy. Yet, when developing and monitoring a PFF’s investment portfolio, PFF directors and officers must weave carefully through a web of excise taxes, avoiding jeopardizing the PFF’s ability to carry out its qualifying purposes, self-dealing and holding excess business interests, all while ensuring that the PFF will be able to satisfy its annual distribution requirement. Unfortunately, these restrictions are also among the least intuitive and most technical of all of the restrictions applicable to PFFs.

For instance, no asset class is a per se prohibited investment for a PFF, although certain assets are subject to additional scrutiny.18 And, whether an investment is deemed a jeopardy investment turns on the application of the ordinary business care and prudence standard at the time the investment is made and in the context of the PFF’s entire portfolio.19 Additionally, PFFs can’t have excess business holdings, which are defined for most purposes as any holdings that exceed a 20% ownership interest in any business enterprise, reduced by the percentage owned by DPs.20

Accordingly, although it isn’t a legal requirement, the best way for a PFF to promote sound investment decision making and avoid excise taxes is to engage professional investment advisors and adopt an investment policy.

A typical investment policy will include a framework of goals and investment objectives, risk tolerance profile, total return objective and target asset allocation strategy. It should also include procedures for reviewing and correcting conflicts of interest and excess business holdings and a list of prohibited investments, such as any investment that will cause the PFF to recognize income from debt-financed property that could cause the PFF to become subject to unrelated business income tax (UBIT).21

While the IRS has taken the position that it won’t issue a ruling on whether a proposed investment procedure will preclude the imposition of the jeopardy investment excise tax,22 an investment policy can be guided by the IRS’ rulings on whether specific transactions would be deemed jeopardy investments,23 and the PFF’s directors and officers can help to protect themselves from personal liability by including a requirement that any investment subject to additional scrutiny can only be made on the advice of legal counsel expressed in a reasoned written legal opinion that the particular investment won’t jeopardize the PFF’s qualifying purposes.24 

Many considerations may be taken into account when determining whether a PFF should invest in a certain asset, including the asset’s special relationship or special value to the PFF’s qualifying purposes,25 and such a consideration can be reflected in the PFF’s investment policy. In addition, a PFF’s investment policy can provide separate rules for: (1) donated business interests, which aren’t subject to the same divestiture rules for excess business holdings26 and the jeopardy investment rules,27 and (2) interests in a business in which at least 95% of the gross income is derived from passive sources, which are excluded from the prohibition against excess business holdings.28

Further, because income from debt-financed property that gives rise to UBIT is common with pass-through entities such as private equity and hedge funds organized as partnerships and real estate investment trusts, an investment policy should highlight and prohibit investments in these popular investments unless they’re structured to avoid UBIT.

A recurring theme of this article has been the ability of well-drafted formal policies and procedures to both generate awareness of applicable requirements and provide guidelines for acting within them. A typical PFF that adopts and adheres to such policies and procedures should be well-positioned to succeed in its mission, while mitigating its risk of running afoul of IRS restrictions or incurring excise taxes.

— Any views expressed in this publication are strictly those of the authors and should not be attributed in any way to White & Case LLP. 

Endnotes

1. Internal Revenue Code Section 4941. 
2. IRC Section 4943. 
3. IRC Section 4944. 
4. IRC Section 4945. 
5. IRC Section 4942. 
6. See instructions for Form 1023. 
7. As defined in IRC Section 4946. 
8. Compensation payments for personal services rendered aren’t considered excessive if they’re reasonable under the circumstances, meaning that similarly situated organizations pay similar amounts for similar personal services. Section 4941(d)(2)(E); Treasury Regulations Section 53.4941(d)-3(c)(1), citing Treas. Regs. Section 1.162-7. 
9. Treas. Regs. Section 1.501(c)(3)-1. 
10. The term “qualifying distributions” generally refers to amounts distributed for qualifying purposes and expenses of administering the private family foundation’s (PFF) activities in furtherance of its qualifying purposes. IRC Section 4943(g). 
11. Section 4945. 
12. Section 4945(d)(4)(B). 
13. Treas. Regs. Section 53.4945-5(a)(5). 
14. Section 4945(h). 
15. Revenue Ruling 63-252. 
16. Treas. Regs. Section 53.4941(d)-2(f)(1). 
17. The charitable contribution that a PFF is permitted to pay would be the amount of the grant in excess of the fair market value of the benefit received in exchange for such grant. Treas. Regs. Section 1.170A-1(h). 
18. Treas. Regs. Section 53.4944-1(a)(2)(i). 
19. Treas. Regs. Section 53.4944-1(a)(2)(i); note also that program-related investments under Section 4944(c) are an exception to the prohibition against jeopardy investments. 
20. IRC Section 4943. 
21. IRC Section 511. 
22. Rev. Rul. 74-316. 
23. E.g., Private Letter Ruling 8125038 (March 24, 1981). 
24. Treas. Regs. Section 53.4944-1(b)(2)(v). 
25. Notice 2015-62. 
26. Sections 4943(c)(6) and (c)(7). 
27. Treas. Regs. Section 53.4944-1(a)(2)(ii)(a). 
28. Section 4943(d)(3). 

“Once plague had shut the gates of the town, they had settled down to a life of separation.”1 

When plague attacks and quarantine is imposed, it causes a sense of imprisonment that includes feelings of overwhelming stress, fear and anxiety. This phenomenon, so aptly described in Albert Camus’ The Plague,2 also epitomizes today’s reality. Prior to the COVID-193 pandemic, financial exploitation of the elderly was of significant concern, but social isolation, quarantine and fear of infection heighten the risk of abuse to seniors and members of other vulnerable groups. Now, more than ever, it’s important for individuals, especially those most vulnerable to financial abuse, to take steps to protect themselves. This may include designating a trusted contact person (TCP) for securities accounts.

Through this designation, a financial advisor is provided with someone to contact if he suspects financial abuse or that the account holder is suffering a mental decline. The Financial Industry Regulatory Authority (FINRA) initiated the TCP system as a means of curtailing elder financial abuse. FINRA Rule 4512 (Rule 4512) requires that financial advisors make reasonable efforts to obtain from the account holder the name and contact information of a TCP whenever a non-institutional account is opened or updated. Although financial advisors must make reasonable efforts, the account holder isn’t required to designate a TCP. However, if the account holder designates a TCP, that designee can serve as a resource for the FINRA member institution (financial institution) in protecting the individual’s account and quickly responding to suspected financial exploitation.4 In conjunction with Rule 4512, FINRA Rule 2165 (Rule 2165) permits a temporary hold to be placed on the disbursement of funds or securities under certain circumstances.

Elder Financial Abuse

While COVID-19 affects every generation, self-isolation disproportionately affects elderly individuals. Those who don’t have close family or friends, and rely on the support of community centers, social services and religious organizations whose programs may be limited or unavailable during the pandemic, may experience increased feelings of loneliness, isolation and seclusion.  Even those who have close family or friends may now be isolated from those individuals due to social distancing restrictions and fear of disease transmission.  

Social isolation is one of the greatest risk factors for elder financial exploitation. According to the American Bar Association Commission on Law and Aging, COVID-19 isolation may heighten the risk for elder abuse in a number of ways: (1) adults who are vulnerable to maltreatment may be isolated with their abusers; (2) financial pressures may result in an increase in financial exploitation; (3) caregivers may neglect their duties out of fear or inability to provide care; (4) increased self-neglect may result from isolation and curtailment of local services; and (5) scams related to COVID-19 will inevitably target seniors.5

In recent years, efforts to identify emerging trends in financial crime have significantly increased in an effort to protect vulnerable individuals. For example, in February 2019, the Consumer Financial Protection Bureau (CFPB) released a study on elder financial abuse entitled “Suspicious Activity Reports on Elder Financial Exploitation: Issues and Trends.”6 Using information from Suspicious Activity Reports (SARs) to identify emerging trends in financial crime, this study called on financial institutions proactively to monitor and report suspicious activity to law enforcement and adult protective services.  

The CFPB analyzed 180,000 elder financial exploitation SARs filed with the Financial Crimes Enforcement Network from 2013 to 2017, involving more than $6 billion. This first-ever public analysis provided a chance to better understand elder fraud and to find ways to improve prevention and response. Important findings from the study included: (1) SAR filings on elder financial exploitation quadrupled from 2013 to 2017; (2) older adults ages 70 to 79 lost on average $45,300; and (3) when the older adult knew the suspect, the average loss was even larger—about $50,000.7

New FINRA Rules

In an effort to curb rampant financial abuse of the elderly and other vulnerable groups, FINRA and the U.S. Securities and Exchange Commission’s Office of Investor Education and Advocacy began urging individuals to add a TCP to securities accounts.

On Feb. 5, 2018, amendments to Rule 4512 and Rule 2165 became effective. These two rules address concerns raised by FINRA over several years that financial institutions weren’t doing enough to prevent financial exploitation of vulnerable account holders.

The amendments to Rule 4512 require that financial institutions make reasonable efforts to obtain a TCP for each applicable account; however, they don’t prohibit financial institutions from opening and maintaining an account if an account holder fails to identify a TCP.  Reasonable efforts may be satisfied simply by a financial advisor asking the account holder if he wishes to identify a TCP. In this sense, arguably the amendments don’t go far enough. 

If a financial institution “reasonably believes that financial exploitation has occurred, is occurring, has been attempted or will be attempted,” Rule 2165 permits a temporary hold to be placed on the disbursement of funds or securities from the account of a “specified adult” customer. Specified adults include: (1) individuals age 65 or older, and (2) individuals age 18 or older who are reasonably believed to have a mental or physical impairment rendering them unable to protect their own interests. The financial institution’s decision that an account holder is unable to protect his own interests may be based on the facts and circumstances observed in a financial advisor’s business relationship with the account holder.

If a financial institution places a temporary hold on an account, Rule 2165 requires that an internal review of the facts and circumstances be immediately initiated. The temporary hold expires no later than 15 business days after the date on which the hold was placed, unless otherwise terminated or extended. Rule 2165 permits an extension of up to 10 business days.

A financial institution isn’t required to withhold a disbursement of funds or securities under Rule 2165. Instead, the rule creates a safe harbor from activities that would otherwise be violations when withholding, even temporarily, a requested disbursement from an individual’s account.  

It’s important to note that the rule permits a temporary hold to be placed on a particular suspicious disbursement, but not on other, non-suspicious disbursements. Also, Rule 2165 doesn’t apply to transactions in securities. For example, Rule 2165 wouldn’t apply to an account holder’s order to sell shares of stock. However, if an account holder requested that the proceeds of the sale be disbursed out of his account, then the rule applies. Also, the financial institution is required to notify all parties authorized to transact business on the account and the TCP of the temporary hold.  

Estate Planner’s Role

In light of Rule 4512’s requirement that financial institutions make reasonable efforts to have a TCP selected for securities accounts, it’s important for estate planners to add the selection of a TCP to the list of items they discuss with clients. Selection of a TCP is an important decision and one that needs to be carefully coordinated with a client’s overall estate plan.

If a financial advisor notices suspicious activity or other red flags indicating suspected financial exploitation or fraud in connection with an individual’s account or if the financial advisor suspects that the account holder is in mental decline, the designation of a TCP gives the financial advisor someone to contact to raise these concerns. In that sense, the TCP is the first line of defense, and it’s important to take care in selecting the right person for this important role.

The TCP is also the individual the financial advisor will turn to in the event that he can’t reach the account holder or if he needs to verify information, such as the account holder’s address or phone number, the identity of an agent under a power of attorney (POA) or to find out if such information has changed.

While the TCP has no authority to act on the account, sensitive account information may be released to the TCP for him to fulfill his role as liaison between the financial institution and the account holder. This may include disclosing information to the TCP about the account for the purpose of addressing suspected financial exploitation, confirming the account holder’s current contact information, health status or the identity of any legal guardian, executor, trustee or holder of a POA. Releasing this personal information into the wrong hands can be detrimental to the account holder.

Unfortunately, financial exploitation of seniors is most often perpetrated by someone the individual knows and trusts. According to one study, family members were the most common offenders, followed by friends and neighbors and then home care aides.8 If a potential wrongdoer is named as the TCP, gaining information about the account holder’s finances may encourage him to prey on the account holder.

Selecting a TCP

While anyone over the age of 18 can be named as the TCP, there are obviously a number of important factors that should be considered in selecting an appropriate individual to serve in this capacity. Often, the TCP will be a family member, such as a spouse or a child, with whom the client has a close relationship and who’ll be aware of changes in the client’s life. However, in selecting a suitable TCP, it’s important to be mindful of family dynamics and to be sensitive to other factors that may influence an individual’s suitability. A professional advisor can be instrumental in helping to guide the client in the selection of the most appropriate TCP.   

The TCP may find himself in a situation in which he’ll need to manage conflicts arising among other family members. Can the potential nominee handle this responsibility? In the case of a second (or third) marriage, should the spouse be the TCP? Will this cause conflict with the children of a prior marriage? Likewise, would naming one of the children as the TCP cause conflict with the current spouse?

What if an individual has named his spouse as the TCP, but is now embroiled in a divorce? As with other estate-planning documents, such as a health care directive and POAs, it’s important to remember to update the designation of a TCP in the event of the commencement of a divorce if a spouse was named.

While the TCP can be a family member, it doesn’t need to be. In the case of a complex family situation or when there’s a clear threat of financial elder abuse, the prudent course may instead be to name a professional advisor, such as an attorney or accountant, as the TCP.

It’s also important to designate a TCP before mental decline occurs and for advisors to be involved in the selection so that the account holder doesn’t inadvertently name someone as a TCP who could be the abuser, thereby defeating the purpose of naming a TCP. Above all else, the TCP should be someone who won’t take advantage of the role.

Rule 4512 doesn’t prohibit joint account holders, trustees, agents under POAs and other authorized parties on an account from being designated as the TCP. With that being said, Rule 4512 arguably doesn’t provide adequate protections against misdeeds committed by someone acting in one of those capacities. To whom could a financial advisor turn, for instance, if a joint account holder is named as the TCP and is the one suspected of taking financial advantage of the other account holder?

For this reason, perhaps advisors should recommend that the TCP be someone different from the individual currently acting as agent under a POA. Would this provide some level of protection against an individual abusing his fiduciary role? How does the client decide who should be the TCP and who should be the agent under the POA? If each role is filled by a different individual, what should be done if there’s a conflict?

Similarly, would having another individual acting as agent under a POA with respect to the account provide a check and balance against misdeeds by the TCP if he’s the one poised to take financial advantage of the account holder?

Although the TCP rules were initially contemplated for accounts in the name of a natural person, the rules are also useful for other accounts. For example, if an individual is serving as the sole trustee of a revocable trust created by him during his lifetime, designating the successor trustee under the trust instrument as the TCP would be prudent.  

Finally, insofar as the rule requires the financial institution to provide notification of the hold and the reason for the hold to the TCP and all parties authorized to transact business on the account, Rule 4512 arguably could lead to disharmony in the event the TCP is being named specifically to provide a check and balance against the authorized party.

Designation Process

The process for designating a TCP may vary from institution to institution. Some institutions may permit this to be done online when the account holder logs on to his account. While this may provide convenience, it also opens the door for abuse if there isn’t a means to verify that the account holder is the one making the designation, such as two-way video or telephone confirmation. It also doesn’t facilitate a dialogue between the account holder and the financial advisor as to who’s being selected as the TCP and the appropriateness of the selection.  

An Important Discussion

In light of the unprecedented social isolation of already vulnerable individuals stemming from the COVID-19 pandemic, it’s increasingly important to use mechanisms designed to allow financial institutions proactively to monitor suspicious activity. Now, more than ever, it’s important for estate planners to add the selection of a TCP to the list of items they discuss with clients. Failure to carefully coordinate this decision with a client’s overall estate plan could undermine the system’s effectiveness—or worse. 

At the end of The Plague,“we learn in time of pestilence: that there are more things to admire in men than to despise.”9 Zealous advocacy by members of the estate-planning community during the current pandemic has resulted in sweeping legislation and executive orders including those authorizing remote notarization and remote witnessing of documents. This has ensured that clients have been able to work with their estate planners to implement their lifetime and testamentary planning objectives without jeopardizing their health and safety. Because part of this process requires an open and honest discussion as to whom should be selected to fill a number of fiduciary roles, the estate planner is well positioned to discuss the selection of a TCP in this context. 

Endnotes

1. Albert Camus, The Plague (1948) at p. 308.

2. Ibid.

3. On Feb. 11, 2020, the World Health Organization announced an official name for the disease that’s causing the 2019 novel coronavirus outbreak, first identified in Wuhan, China. The new name of this disease is coronavirus disease 2019, abbreviated as COVID-19. In COVID-19, “CO” stands for “corona,” “VI” for “virus” and “D” for “disease.” Formerly, this disease was referred to as “2019 novel coronavirus” or “2019-nCoV.” There are many types of human coronaviruses. COVID-19 is a new disease, caused by a novel (or new) coronavirus that hasn’t previously been seen in humans. See Centers for Disease Control and Prevention, Coronavirus Disease 2019 (COVID-19), Frequently Asked Questions, www.cdc.gov/coronavirus/2019 ncov/faq.html#Coronavirus-Disease-2019-Basics.

4. Financial Industry Regulatory Authority (FINRA) Rule 4512 defines “financial exploitation” as:

(A) The wrongful or unauthorized taking, withholding, appropriation, or use of a specified adult’s funds or securities; or (B) any act or omission taken by a person, including through the use of a power of attorney, guardianship, or any other authority, regarding a specified adult, to: (i) obtain control, through deception, intimidation or undue influence, over the specified adult’s money, assets or property; or (ii) convert the specified adult’s money, assets or property.

See FINRA Rule 4512, Customer Account Information, www.finra.org/rules-guidance/rulebooks/finra-rules/4512.

5. David Godfrey, “Coronavirus Isolation May Heighten Risk for Elder Abuse,” American Bar Association, www.americanbar.org/groups/law_aging/resources/coronavirus-update-and-the-elder-law-community/coronavirus-and-elder-abuse/.

6. “Consumer Financial Protection Bureau, Suspicious Activity Reports On Elder Financial Exploitation: Issues And Trends” (2019), www.consumerfinance.gov/data-research/research-reports/suspicious-activity-reports-elder-financial-exploitation-issues-and-trends/.

7. Ibid.

8. Janey C. Peterson, et al., “Financial Exploitation of Older Adults: A Population-Based Prevalence Study,” J. Gen. Internal Med. 29, 1615-1623 (2014).

9. Supra note 1. 

Recent events, such as the COVID-19 global pandemic, have forced the debate on electronic wills, notaries and signatures back to the forefront of legal conversation. Ironically, in the midst of this pandemic that’s paralyzed our nation, people all over the country have rushed to complete their estate plans. Some have avoided attorneys and turned to online electronic wills, unaware of the uncertainty and debate that currently surrounds their validity. For elderly clients with mobility issues or who are self-isolating for fear of contracting COVID-19, the ability to use electronic signatures on estate-planning documents is even more important.

Meanwhile, attorneys have been grappling with how best to accommodate and assist their elderly clientele to execute essential documents without jeopardizing their health, all while simultaneously balancing statutory requirements for a valid will, power of attorney, trust, health care proxy, etc. Electronic wills have been the topic of fervent debate for over a decade, with some arguing that it’s time to move into the digital age making estate planning more accessible, while others fear that allowing electronic documents and signatures will undermine the historic purposes behind formal will executions, resulting in fraud, the inability to easily authenticate documents and inconsistency in form.

In addition to considerations regarding electronic wills or other estate-planning documents, questions and concerns have arisen regarding remote signings. While an electronic document is one in which the writing and signature are all electronic or digital in nature, remote signings refer to formal executions in which the signer, witnesses and notary aren’t all in the same location. During COVID-19, questions have arisen about what “in the presence” means, and the ambiguity has led to numerous emergency orders from governors all around the United States that authorize such remote proceedings. However, the remote process was a major cause for concern when Florida’s governor vetoed Florida’s Electronic Wills Act in 2017. Ironically, Florida’s governor has issued an emergency order authorizing remote notarization.

We’ll focus primarily on electronic wills because, while not widely used in the estate-planning context, other legal documents may be subject to the Uniform Electronic Transactions Act (1999) (UETA), which authorizes electronic signatures on documents. However, the UETA specifically excludes wills and testamentary trusts, making their execution particularly problematic during these unusual times.

A Brief History of Wills

The Probate Code of every state, known for historical reasons as the “Wills Act,”1 includes a provision that proscribes rules for making a valid will. The Wills Act requires wills to comply with particular formalities. The purpose of these formalities is, and has always been, to enable a court to easily and reliably determine the authenticity of a supposed testamentary act.2 These formalities also ensure a standardized form for wills that simplifies judicial review of whether an instrument was intended to be a will,3 emphasizes the importance of making a will4 and protects the testator from manipulative imposition.5 Accordingly, given the anonymity of the Internet, the challenge in developing these same formalities for electronic wills (and other documents) has been in balancing formalities and the risk of probating an inauthentic will with the risk of denying an authentic will. 

There are three core formalities for the making of a valid attested will: (1) writing; (2) signature; and (3) attestation.6 The Statute of Frauds, adopted in 1677, required that a written will be signed by the testator in the presence of three witnesses for a testamentary disposition of land.7 In 1837, England enacted a Wills Act requiring the same formalities for all wills regardless of the nature of the property disposed of under the will.8 The Wills Act reduced the number of necessary witnesses to two but required that they both be present when the will was signed or acknowledged. 

Electronic Wills

One major part of the debate surrounding electronic wills focuses on the ability to comply with statutory formalities including style, content and execution. The failure to satisfy these requirements renders a will invalid and unenforceable, resulting in the often undesirable alternative of intestate provisions of the applicable state intestacy laws determining the distribution of an estate. This assumes that the applicable state doesn’t have a holographic will9 or harmless error10 provision that might save a will that otherwise doesn’t meet the statutory requirements.

The Uniform Electronic Wills Act (the Act) was finalized this past fall by the Uniform Law Commission (ULC). The Act addresses the formation, validity and recognition of electronic wills.11 According to a statement from the ULC, the Act:

. . . permits testators to execute an electronic will and allows probate courts to give electronic wills legal effect. Most documents that were traditionally printed on paper can now be created, transferred, signed, and recorded in electronic form.12

Although the Act is referred to as “uniform,” it doesn’t apply in any given state unless it’s adopted. As of now, no states have adopted the Act, and no version is currently pending in any state legislatures.

Electronic Writing

Wills are required to be in writing. The Restatement of Property defines this requirement as a reasonably permanent record of the marking constituting a will.13 However, what’s determined to be a “writing”? Traditional wills complying with the formalities of execution were first typed into a word processor and printed or typed onto paper using a typewriter, subsequently signed by the testator, witnessed by at least two witnesses and notarized. Holographic wills were instead written on paper in a testator’s own handwriting. Notably, since the widespread adaptation of word processing, wills that were found to be valid were first in electronic form. Courts grappled with whether typewritten wills were a “writing” within the meaning of the Wills Act.14 Ultimately, courts decided that typewritten wills were a reasonably permanent marking and could be admitted to probate. Most state statutes now define a “writing” as being a handwritten or typed document. 

Yet, technology has advanced well beyond traditional word processing, and the public at large has embraced that advanced technology (which is small enough to fit in the average person’s pocket). The public has expanded its definition of “writing,” yet legislation hasn’t been widely modified to adapt to technology, and courts are being asked to validate electronic wills without the statutory language in place to deal with them. In what’s probably the best known case and the first American case to probate an electronic will, In Re Estate of Castro,15 Javier Castro dictated a will to his brother, who wrote the will on a tablet. Javier then signed the will on the tablet, using a stylus, and two witnesses signed on the tablet as well. The probate court held that the electronic writing on the tablet met the statutory requirement that the will be in “writing.” The court admitted the will to probate because it had two witnesses as required by Ohio law. The court, here, had little trouble expanding traditional wills law to cover a different medium.

But, what if, instead of printing a will on paper, it’s stored on a USB flash drive or hard drive, or it’s a PDF saved in cloud storage? Ongoing digitization of society is quickly replacing (and in many ways has already replaced) the use of paper with electronic forms as the new norm. Federal court pleadings are signed and submitted electronically, contracts for the sale of real estate are signed and submitted electronically, yet the ULC just released the Act in 2019, which has yet to be adopted by any state.

Electronic Signatures 

Many property transfers are initiated and confirmed with electronic signatures. Instead of ink on paper, many transactions are completed by clicking a button and typing the signers’ names into a form or signing a tablet using a finger or a stylus, or even via audio or video recording, in which the signers denote that they agree to complete a transaction. Such electronic signatures aid efficiency in that as soon as the transaction is completed, there’s a digital record of what took place. Several states have adopted laws defining electronic signatures to include “an electronic sound, symbol, or process” affiliated with a document that’s made by an individual with intent to sign that document.16 But, many states, including Virginia, have specifically excluded wills, codicils or testamentary trusts from the statutes allowing electronic signatures.17 

However, non-probate property transfers are effective with electronic signatures. Payable on death, transfer on death and other beneficiary designations are valid if they’re electronically signed. But, in most states, an electronically signed will is invalid because electronic signatures are statutorily invalid for testamentary documents.

Despite the lack of existing statutory authority on electronic signatures and wills, courts have been dealing with whether an electronically typed name or electronic mark on a document constitutes a signature as far back as the early 2000s. In 2003, the Court of Appeals of Tennessee determined that a testator created a valid will when he prepared it on his computer and affixed a computer-generated signature to the end of it.18 Two witnesses watched him make his electronic signature and signed a paper copy.19 The will was neither electronically witnessed nor digitally stored. The testator’s sister argued that the will wasn’t valid under Tennessee probate laws. The court of appeals upheld the will despite its electronic creation and electronic signature, because a mark intended to act as the testator’s signature was valid.20 The fact that the decedent used a computer rather than an ink pen as a tool to make his signature wasn’t so drastically different as to put the testator’s will out of compliance with Tennessee law.

However, at least one court has recently found that the definition of “signature” doesn’t include a printed name on the document. In Litevich v. Probate Court, a testator drafted a will using an online service provider.21 The testator created an account, drafted a will and electronically confirmed the documents she had prepared. The company mailed her a paper copy, but she failed to sign it. The court determined that even though she had electronically confirmed portions of the will, had created the account and had typed her name on the document, she hadn’t satisfied the signature requirement of the Wills Act under Connecticut law.22

Electronic Attestation

The third and final requirement under the Wills Act is that two witnesses must sign the will attesting that they either were in the presence of the testator when she signed it or that the testator acknowledged in their presence that the will and signature were hers. A majority of states require two witnesses to attest to a will for it to be valid. States have been strict about the attestation requirement and having witnesses who actually see the testator sign the document. 

The requirement for physical presence has been the biggest barrier to the transition of wills into the digital age. The problem with electronic attestation is that most states require that attestation of a will occur in the “presence” of the testator. No case law or statutory language defines “physical presence.” Some courts have interpreted presence to mean that a testator must be in the line of sight of the witnesses when she signs her will, and other states have adopted the conscious presence test, finding that a witness is in the presence of the testator if through sight, hearing or even general consciousness of events she understands that the testator is in the act of signing and has capacity to do so. Neither test uses literal physical presence to determine whether the parties were actually “present.”

As with the concept of “writing,” technology has given us the ability to communicate beyond what’s contemplated by existing statutes. In In Re McGurrin, a testator sought to have an individual witness a will over the phone. The court found that the Wills Act required the witness to have an “observatory function,” which couldn’t be accomplished by a telephonic acknowledgment by the testator.23 A New York appellate court also held that a telephonic communication couldn’t satisfy the requirement of witnessing a will. In Whiteacre v. Crow, witnesses viewed the signing of a testator’s will on a video monitor.24 That court held that the conscious presence test wasn’t met partly because the video monitor only worked one way.25 The witnesses saw and heard the testator’s actions, but the testator couldn’t hear and see the witnesses. “Presence” was defined in the statute as being “within the range of any of the testator’s senses,” and the court found that excluded sights and sounds relayed through electronic means.26

At the forefront of the COVID-19 estate-planning crisis is attestation by electronic means. Cellphones have given us the ability to video chat since 2010, and video conferencing has been widespread in the corporate world for years. Yet, it was the inability of attorneys to meet with their clients in person that caused attorneys, state bar associations and professional organizations like the National Academy of Elder Law Attorneys and the American College of Trust and Estate Counsel to strongly advocate for electronic attestation. A number of states such as Georgia, Massachusetts, North Carolina and Texas have issued temporary orders and regulations that allow remote witnessing and notarization using technology. However, some states, such as Virginia, considered options but didn’t elect to adopt any given the ability to bypass will formalities by executing holographic wills or using revocable trusts. Interestingly, all such remote attestation authority is only temporary. So, while the technology that makes remote attestation possible is permanent and improving daily, the authority to use such is only temporary.

Electronic Notarization

Finally, with the possibility of more states adopting legislation allowing for electronic wills, how these documents will be notarized is an important consideration. Remote notaries and electronic notaries are two such considerations. These two types of notarization are, understandably, often confused with each other. However, they’re not the same and shouldn’t be confused.

With regards to remote notarization, a signer personally appears before the notary at the time of notarization using audio-visual technology over the Internet instead of being physically present in the same room.27 Documents are exchanged, and both the signer and the notary affix wet signatures and a seal. Electronic notarization, on the other hand, involves documents that are notarized in electronic form, and both the notary and document signer use an electronic signature as discussed above.28 The confusion arises from the fact that, while both require the use of technology, electronic notarizations involve digital documents that are signed and notarized electronically, and no wet signature is involved.

Currently, 24 states have passed remote notarization (RON) laws.29 Out of those states, 17 have laws that are in effect as of April 1, 2020.30 Currently 14 of those states have fully implemented their remote notarization procedures, meaning the law has taken effect, and notaries are currently authorized to perform remote online notarizations in those states. Also, due to the COVID-19 pandemic, several states that haven’t fully implemented RON or currently have pending legislation have issued special orders authorizing notaries to perform remote notarizations early due to the emergency.31 

A Last Hold Out

The debate among practitioners regarding electronic wills, remote notaries and electronic signatures isn’t new. Practitioner proponents of advancements in technology in estate planning have been on the losing side of the debate for quite some time. However, the current pandemic has thrust electronic wills back into the public eye and has resulted in new conversations as to their importance, usefulness and validity, especially for elderly clients. While professionals continue the conversation, estate-planning documents have been produced during this pandemic. Some have been electronic wills, some were remotely attested and notarized and some may result in litigation. 

While evolution and expansion is expected in this area of the law, the law of wills currently remains one of the last holdouts when it comes to embracing and accepting digitization. In our digital world, documents on our devices are just as real as documents that are printed out, electronic signatures are just as binding as ink signatures and video conferencing is just as instantaneous as physical presence. While legislative reform seems inevitable but slow-coming, COVID-19 may accelerate the timeline. 

Endnotes

1. Wills Act, 1 Vict. c 26 (1837).

2. Robert H. Stroff and Jesse Dukeminier, Wills, Trusts, and Estates (10th ed. 2017), at p. 141.

3. Ibid., at p. 142.

4. Ibid., at p. 144.

5. Ibid. 

6. Uniform Probate Code (UPC) Section 2-502 (amended 2019), 8 U.L.A. 506 (1990); Restatement (Third) of Property: Wills and Other Donative Transfers (Restatement Third) Section 3.1 (1999).

7. Statute of Frauds, 29 Car 2 c 3 (1677).

8. Supra note 1.

9. UPC Section 2-502 (amended 2019).

10. UPC Section 2-503 (amended 2019).

11. Uniform Electronic Wills Act (the Act).

12. Uniform Law Commission comment on the Act (November 2019).

13. Restatement Third Section 3.1 cmt. I (2003).

14. Stuck v. Howard, 104 So. 500, 502 (Ala. 1925), overruled in part by Reynolds v. Massey, 122 So. 29 (Ala. 1929).

15. In Re Estate of Castro, No. 2013ES00140 (Ohio Ct. Common Pleas, Prob. Div., Lorain County, June 19, 2013).

16. 15 U.S.C. Section 7006(5).

17. Ibid.

18. Taylor v. Holt, 134 S.W.3d 830 (Tenn. Ct. App. 2003).

19. Ibid. 

20. Ibid.

21. Litevich v. Probate Court, 2013 WL 2945055, at *1 (Conn. Super. Ct. 2013).

22. Ibid.

23. In Re McGurrin, 743 P.2d 994, 995 (Idaho Ct. App. 1987).

24. Whiteacre v. Crow, 972 N.E.2d 659, 662 (Ohio Ct. App. 2012).

25. Ibid.

26. Ibid.

27. Michael Lewis, “Remote Notarization: What You Need to Know,” Notary Bulletin (June 27, 2018).

28. Ibid.

29. Remote Electronic Notarization, National Association of Secretaries of State (May 20, 2020).

30. Ibid.

31. Ibid. 

Many are unsettled by the COVID-19 outbreak and its continued medical, economic, psychological and societal effects. Elders in particular, and those who love them, are thinking critically about what they should be doing to be as prepared and protected as possible in this quickly changing landscape. As elders and their loved ones navigate this challenging time together, it may be helpful to focus on what can be controlled: washing one’s hands, keeping socially distanced and making sure one’s affairs are in order. For some elders, the current period of volatility may also create opportunities.

While elders and their families are spending more time at home, their advisors should recommend that they consider two categories of planning concerns:

The Basics. Make sure basic estate-planning documents are current and executed and that the location of the originals or signed copies of these important documents is known and accessible. Beyond estate planning, address certain related practical concerns heightened by COVID-19.1

The Opportunities. Wealthier elders or elders with wealthy children or grandchildren who’ll potentially be subject to federal and/or state estate tax should consider taking advantage of the estate-planning opportunities that may be afforded by the current high lifetime exemption amounts, market volatility and low interest rates. 

The Basics

The following concerns generally apply to any elderly individual, regardless of wealth. All elders appear to be at increased risk for contracting COVID-19, and many have had to shelter at home alone during the spring of 2020. At publication, it appeared that many states would be loosening stay-at-home guidelines by the summer of 2020, with another potential wave of virus infections and lockdowns expected in the upcoming fall and/or winter. With social distancing in mind, suggested solutions to these basic concerns are broken into tasks that could be accomplished remotely from home “During lockdown” and tasks that might be prioritized during a “Restrictions lifted” time when it’s easier for elders to leave their homes. 

Who’ll oversee my elderly client’s health care?  Now, more than ever, it’s vital for every individual to have a health care directive document in place that evidences his wishes regarding life-sustaining treatment and identifies an individual authorized to make medical decisions on an elder’s behalf in the event he becomes seriously ill with COVID-19 (or any other ailment). In most states, the individual authorized to make these decisions is typically referred to as a health care “proxy” or health care “agent,” and this individual typically can access the principal’s (client’s) medical records. Clients should also confirm that doctor relationships and standing prescriptions are up to date.

During lockdown: Now’s a good time for clients to review health care directives and, if necessary, to contact an attorney regarding any needed revisions or updating.  It’s important to make sure that the designated health care proxy/agent remains willing, capable, trusted and, importantly, accessible. (Someone in the middle of a sailing trip around the world or recovering from COVID-19 himself won’t be very useful.) Clients should make sure they have an original or signed copy of their health care directive in their possession, and, it’s a good idea to make sure that a trusted loved one (it could be the individual designated) also has an original or signed copy. It may be helpful to provide both paper and digital versions. Suggest that clients confirm that their health care agents know who the clients’ doctors are and how to contact them and ascertain which hospital they prefer if hospitalization is required. Do clients have a large supply of needed prescription medications that can be delivered at home? If not, this is a good time to set up pharmacy home delivery and consider renewing prescriptions using a telemedicine appointment. 

Restrictions lifted: If it couldn’t be done during lockdown, any new or updated health care documents should be executed. Consider where original documents or signed copies are physically located and how they can be accessed. For example, if documents were held in a safe at the attorney’s firm, the client and attorney should discuss how such documents can be accessed during a prolonged closure of professional offices. If documents are stored digitally, how can they be accessed? In-person appointments with doctors should be scheduled, if needed, and clients might discuss with their doctors whether a “Do Not Resuscitate” order is right for them. Clients should consider rescheduling and completing any surgeries or out-patient procedures that were delayed by the lockdown period or interviewing and engaging a new doctor if their prior doctor’s office had to close permanently during lockdown.2 

Who’ll pay my elderly clients’ bills and file their taxes? A financial power of attorney (POA) allows a third party (usually an individual called “the agent”) to undertake personal financial or legal decisions on the principal’s behalf, such as paying bills or signing and filing income tax returns, if an elderly client is too ill to perform those tasks himself. The agent generally has power over any assets titled in the client’s name, such as a checking account, but doesn’t have authority over assets titled in the name of other entities, such as a corporation or trust. If an elderly client is hospitalized and/or unable to manage his financial affairs, the POA is a vital tool. Check to see if your elderly clients have POAs in place, and suggest they review them to ensure that the individuals designated as agents are still the appropriate choices. 

During lockdown: Encourage elderly clients to review their financial POAs and determine whether they need to be updated. It’s a good idea for them to create lists of assets, bills and passwords and make sure their agent has a general knowledge of their financial affairs and how to pay their bills. Do they need help paying bills? If so, now might be the time to encourage them to start training a family member agent or to hire an outside bookkeeper or bill-pay service to help. Have they fallen behind on filing income tax returns? This is a good time for them to gather documents, contact their CPA and catch up with tax filings. Updated tax filings will in many cases also increase an elderly client’s chances of receiving any future stimulus payments. 

If an elderly client is on a budget, have you already confirmed with her whether she’s eligible for needs-based benefits such as affordable housing, Medicaid or Social Security income? Even if an individual was denied benefits earlier, her eligibility may have changed due to diminished income or relaxed restrictions. If a client is hitting a milestone birthday, you might help her to enroll in Social Security, Medicare and/or begin taking required minimum distributions (RMDs) from retirement accounts, all remotely. 

Restrictions lifted: Clients should execute a new or updated POA document, if needed, if they weren’t able to do so during lockdown. Consider advising an elderly client to visit her bank in person when it’s safe to do so, ideally with her agent designated under the POA, to make sure the agent’s authority is properly added to the client’s bank accounts and that her bank will honor that authority if the time comes. Many banks transition authority more easily when their in-house forms have been executed in person. An in-person visit may be especially important for an elderly account holder, as bankers are trained to assess in person whether an elder is competent to add an agent to her account or whether she may be the subject of financial elder abuse. Elderly clients might consider providing their CPAs with a copy of their POA document, in case it’s needed to help file their income taxes later. 

Happy homes. Sheltering in place at home during the spring of 2020 forced us all to evaluate how well-suited our homes are to our everyday living needs. Some elders may have suffered from loneliness or the inconvenience of being stuck in a home that’s become difficult to navigate or is no longer the right fit. For elders living in assisted living or nursing homes, the spring of 2020 allowed them to experience how their residence dealt with the logistical demands of the coronavirus, as well as the inability to have visitors. Now’s the time for elders to critically evaluate that experience with their families and advisors.

During lockdown: Elders should consider whether they’ll want to stay in their current home setting if another lockdown period occurs. For those still in their own homes, have they been able to get supplies, and do they have a system in place for someone to check on their welfare at least every 24 hours? Does the home need any changes or repairs that they could make themselves? If not, consider using the time to remotely gather information about contractors and bids on home improvements. If an elder is considering a move, encourage her to use the time at home to discuss this possibility with family and advisors and remotely consult with realtors or assisted living communities. For those already living in facilities, was the facility’s handling of the first coronavirus wave satisfactory, or should the elder be looking to move facilities before a potential second wave?

Restrictions lifted: Is this the time to allow contractors inside an elder’s home to perform needed repairs or remodeling? If an elder is considering selling her home, should she now allow a realtor to visit the home in person to prepare it for listing? This may be the time to visit and tour an assisted living community that might be a better fit for the elder or to look at a more desirable unit within the community that’s become available. 

Retirement accounts. Many people, including elders, are wondering how the recent decline in the stock market will affect the value of their retirement savings and how current low interest rates may impact those planning to use bond portfolios as a part of their income in retirement. This concern may be heightened for older clients who are nearing retirement or already relying on distributions from their retirement accounts to supplement their living expenses. And, for those still in the workforce, an economy in recession may have them concerned about job security.

The Setting Every Community Up for Retirement Enhancement (SECURE) Act, passed into law on Dec. 20, 2019, changed the age when retirement account holders must start taking required minimum distributions (RMDs) from 70½ to 72 (for those who turned 70½ on Jan. 1, 2020 or later).3 Account owners under age 72 may now want to consider delaying starting distributions until age 72 to allow their accounts more time to recover and grow. The SECURE Act also introduced a new provision that allows for retirement account owners who are old enough to be taking RMDs to continue contributing to their retirement accounts at the same time, if they continue to have earned income. Such continuing contributions, when possible, may be more important in today’s environment. Finally, encourage elders to meet with their financial advisors to determine whether their current lifestyles and budgets are sustainable and whether their retirement investments should take on incremental increases in equity exposure with the aim of allowing for more growth and recovery in their account values.

The Coronavirus Aid, Relief, and Economic Security Act, broad federal legislation signed on March 27, 2020 and designed to respond to the pandemic, suspended the requirement to take RMDs in 2020 for almost all retirement owners and beneficiaries.4 For elders who can afford not to take their 2020 RMDs, taking advantage of this provision may be wise, so that they’re not withdrawing from their retirement accounts at a time when most accounts’ investments are at depressed values.

Opportunities

Pull the trigger on gifting. If an elderly client has been mulling whether to make gifts to loved ones, now may be the time to move forward. The value of a gift is generally measured by its fair market value on the date of transfer. If an elder makes a gift when asset values are depressed, any appreciation the asset may experience as its value recovers, as well as the initial value of the gift itself, is removed from her taxable estate and passes to the recipient without gift and estate tax consequences.  

In short, there may be no time like the present to give a present. Elders who make yearly annual exclusion gifts to family members or other loved ones (that is, gifts of up to $15,000 per donor to each recipient that don’t eat into the lifetime exemption amount) should consider making such annual gifts for investment now instead of waiting until year-end. 

It’s also a very attractive time to use annual exclusion gifts to contribute to Internal Revenue Code Section 529 plans and allow a potential recovery to help fund children’s or grandchildren’s educations. Beyond annual exclusion gifts, remember that the lifetime exemption amounts remain (temporarily) at an all-time high. Currently, individuals can transfer up to $11.58 million or couples can transfer more than $23.16 million, during life or at death, without triggering federal gift or estate tax consequences. However, after December 2025 (unless new laws are passed earlier), the exemption is scheduled to drop to $5.49 million or $10.98 million for couples, indexed for inflation. These currently high exemption amounts, coupled with currently depressed asset values, afford individuals with the financial capacity to make large gifts an incredible opportunity to reduce the size of their taxable estates.5

Don’t miss out on interest rate-sensitive strategies while rates are historically low. Many sophisticated wealth transfer strategies are most attractive in a low interest rate environment, meaning that the success of the strategy depends on whether the gifted asset appreciates at a rate greater than the monthly interest rate set by the Internal Revenue Service, commonly referred to as the “hurdle rate” (0.6% for certain gifts in June 2020).6 When the hurdle rate is low, many planning techniques available to clients are especially attractive, including:

Grantor retained annuity trusts (GRATs). This is a type of irrevocable gift trust that can allow the grantor to transfer the appreciation on assets that exceeds the hurdle rate out of her estate and to loved ones without any gift or estate tax. Creating a GRAT in today’s environment can allow for the recovery of an equity portfolio to occur outside of the grantor’s taxable estate and can be a highly effective strategy for those with concentrated stock holdings. 

Intrafamily loans. Loans can be made to family members or loved ones at today’s historically low interest rates and can be used for something as straightforward as helping an adult child purchase a home or start an investment account. Further, if the loan is made to a grantor trust created for the benefit of a family member, the interest payments received back needn’t be included in the lender’s taxable income.

Sales to grantor trusts. Like a GRAT, this technique can allow the grantor to transfer appreciation on assets out of his estate to the extent that such appreciation beats the hurdle rate. This strategy may be more appropriate for less liquid, income-producing assets that are hard to value, such as real estate or a private business.

Charitable lead trusts (CLTs). If a client has both charitable and wealth transfer objectives, a CLT is a type of irrevocable gift trust that provides an income stream to a charity for a certain period; after that period expires, the remainder left in the trust passes to a noncharitable beneficiary, such as a child. Depending on the structure, when the client creates a CLT, she may receive either a gift or income tax deduction based on the present value of the charitable income stream. The lower the interest rates, the higher the deduction, making this an ideal time to consider such a vehicle.

Consider upstream gifting. Elders who aren’t wealthy enough to have taxable estates themselves but who have children or grandchildren with larger taxable estates may have a unique opportunity to explore a multigenerational planning strategy. Upstream gifting refers to a child or grandchild making a gift of assets to an older beneficiary, such as a parent or grandparent. The gifted asset typically has an extremely low basis with market value that’s since greatly appreciated—for example, early-issue stock of a now wildly successful tech company. 

The donor may use some of the currently high lifetime exemption amount while it’s still available to make a simple outright gift to the older donee and/or may use some of the more complex transfer strategies described above. The transfer must constitute a completed gift, fully removing the gifted asset from the donor’s taxable estate. The older donee can benefit from having more assets to live on for her remaining lifetime. In the case of an income-producing asset, the donee may choose to supplement her living expenses with the income while never touching the principal asset. Such income might make a significant difference in the older donee’s quality of life, in enabling the older donee to be able to live in a desirable assisted living facility, for example.

On the older donee’s death, the asset can be gifted back to the younger donor as a part of the donee’s estate plan. This returns the principal asset back to the donor, but with a newly stepped-up basis as of the donee’s date of death. Ideally the gifted asset isn’t large enough to catapult the older donee into having a taxable estate at death, but with shifting lifetime exemption amounts, the estate tax outcome for the older donee may be hard to guarantee. For this reason, the older donee’s estate plan may want to include a provision that any estate tax due not be spread pro rata among all estate assets, but rather be borne by the gifted asset.

An upstream gifting strategy has other potential pitfalls. For the strategy to make sense, the gifted asset must be an appropriate candidate with low basis and high current value, but the family dynamics are just as important. To avoid any appearance of a step transaction, there can be no legal requirement or obligation for the older donee to leave the gifted asset back to the younger donor. Making a death-time gift of the asset back to the donor must be entirely the donee’s free choice. So, potential pitfalls include the older donee’s testamentary or contractual capacity to make such a death-time gift, the older donee’s ability to follow through with doing the necessary estate planning and living long enough to complete that planning, the risk that the older donee spends more of the gifted asset during life than the younger donor anticipated or loses it to creditors and the possibility that the newly wealthier older donee will become the target of financial elder abuse or other family drama. Still, many of these concerns may be mitigated with careful planning for a trust to hold the gifted asset. For the right situation, upstream gifting should be considered.

Roth conversions. For elders who are wealthy enough not to need to spend down their retirement accounts during retirement and who are looking to pass their retirement assets to loved ones, the Roth IRA often remains the best strategy. When converting a traditional retirement account to a Roth, the account owner will pay income taxes today on the value of the IRA on conversion (ideally paid for with assets outside the IRA), but the beneficiaries won’t owe any income tax when they receive a distribution from the Roth account later. Converting to a Roth when asset values are depressed reduces the up-front income tax on the amounts converted. Once converted, assets in a Roth IRA grow income tax free and don’t have any lifetime RMDs, possibly leaving more of wealth growing tax free for longer than a traditional IRA would. 

—This material does not constitute legal or tax advice. Investors should consult with their legal or tax advisors.

Endnotes

1. For more information on helping clients marshal basic estate-planning documents, seewww.wealthmanagement.com/high-net-worth/encourage-clients-compile-their-legal-vault.

2. For more information about helping clients formulate health care directives, seewww.wealthmanagement.com/estate-planning/eight-steps-updating-health-care-documents.

3. Setting Every Community Up for Retirement Enhancement Act of 2019, Pub. L. 116-94 (2019),www.govtrack.us/congress/bills/116/hr1865/text or Internal Revenue Code Section 401(a)(9)(H).

4. Coronavirus Aid, Relief and Economic Security Act, Pub. L. 116-136 (2020), www.govtrack.us/congress/bills/116/hr748/text.

5. For more information on helping clients consider the dollar value of different gifting strategies, see Gregory D. Singer and Gordon P. Stone III, “A Taxing Dilemma,” Trusts & Estates (July 2019).

6. Internal Revenue Code Section 7520; see alsowww.irs.gov/businesses/small-businesses-self-employed/section-7520-interest-rates.

Property or financial powers of attorney (POAs) are ubiquitous in estate planning and with very good reason. The likelihood of becoming incapacitated prior to death is significantly greater than the risk of dying at any particular time.1 Therefore, the actuarial odds are that the property or financial POA will be needed before other estate-planning documents are required.

Many estate planners pay lip service to the fact that the property or financial POA is the most important estate-planning document. However, the sad fact is that the POA too often is treated as a throw-in document that’s not even reviewed by the principal prior to execution. Few estate planners spend any time customizing a POA for a particular client. Because of this practice, most clients believe that all POAs are merely forms, and most are similar and really boilerplate. Nothing could be further from the truth!

Simply put, the vast majority of property or financial POAs used for estate-planning purposes are very broad because the goal is to obviate the need for a conservatorship, interdiction or guardianship. Unfortunately, the breadth of most property or financial POAs also creates opportunities for abuse, as several articles in the popular press have called property or financial POAs “licenses to steal.”2

Here are some selected best practices and tips in the drafting and execution of property or financial POAs. For purposes of this article, I use the Uniform Power of Attorney Act (the Act) as a surrogate for applicable state law. However, caution always is advisable because some significant differences exist in the law among the states on property or financial POAs.3

Lies, Damn Lies and Statistics 

According to a recent study by the U.S. Consumer Financial Protection Bureau Office of Financial Protection for Older Americans (CFPB),4 if a fiduciary (agent, trustee, guardian or agent) was behind the loss due to financial abuse, the amount of money involved was steeper than in any other category, an average of $83,600 per victim.

If a non-family caregiver was the culprit, the average loss was $57,800; if it was a family member, the average loss was $42,700; and if it was a stranger, the average loss was $17,000. CFPB analyzed government reports of suspicious financial activity, which CFPB said involved more than $6 billion in attempted and actual losses between 2013 and 2017.

How much warning do you give to clients who sign POAs? Could a client sue an estate planner for failure to warn about the risks of a POA? Could a scrivener be sued for failure to explain the duties, powers and obligations of the agent to the agent? Unfortunately, the answer is “yes” to the last two questions.

The CFPB study cited above shows that the cases of elder financial exploitation (EFE) filed with the government in suspicious activity report (SAR) monthly filings quadrupled from 2013 to 2017, with money services businesses, for example, banks and other financial institutions, filing an increasing percentage of these SARs. Sadly, that report further indicates that EFE SARs likely account for but a tiny fraction of actual incidents of EFEs.

The amount of money that perpetrators stole or attempted to steal from older adults is substantial but likely significantly understated. In 2017, EFE SAR filers reported that $1.7 billion was involved in suspected incidents. According to one study cited by the National Council on Elder Abuse,5 approximately one in 10 Americans aged 60 and older have experienced some form of elder abuse. Some estimates range as high as five million elders who are abused each year. One study estimated that only one in 25 cases of abuse is reported to authorities.6

Abusers are both women and men. In almost 60% of elder abuse and neglect incidents, the perpetrator is a family member. Two thirds of perpetrators are adult children or spouses.

Elders who’ve been abused have a 300% higher risk of death when compared to those who haven’t been mistreated. While likely significantly underreported, estimates of elder financial abuse and fraud costs to older Americans range from $2.9 billion to $36.5 billion annually.7 Yet, financial exploitation is self-reported at rates higher than emotional, physical and sexual abuse or neglect.

Liability  

Abuse of property and financial POAs is increasing, as are situations in which estate planners are being sued for, among others, not explaining the breadth of the instrument to the principal and for not explaining the agent’s powers, duties and obligations to the agent. I’ll quickly analyze just two cases (there are others) in which a lawyer was successfully sued for malpractice for failing to do exactly that. There are cases in which the scrivener was sanctioned ethically.8

In Meyer v. Purcell,9 a lawyer was held liable for malpractice in the amount of $256,896 in litigation fees pursuant to a contingency fee agreement in an asset recovery action in connection with a POA in favor of a niece when a jury found that the lawyer was negligent because he:

. . . [1] caused the transfer of all of the assets of [Holtz] and [Boliance] to [Niece] in her own name, without regard to their estate plans, or [2] failed to advise [Niece] to cooperate with the personal representative of the Estates . . . and failed to advise or assist [Niece] to return the assets [to Estates]. . .10

The expert for the plaintiffs testified that the lawyer:

 . . was negligent for, among other things, failing to consult with Boliance and Holtz [who were in their 90s] pursuant prior to drafting their respective powers of attorney, failing to make any reasonable inquiries when meeting with them, and for instructing Niece to retitle Boliance’s and Holtz’s assets and property to include herself in joint capacity. Schuster testified Purcell should have consulted with Boliance and Holtz to ascertain their wishes prior to drafting the powers of attorney, and should have made reasonable inquiries into their prior estate plans and their respective capacities to execute powers of attorney.11 

(Emphasis added.)

The lawyer prepared the POAs at the niece’s request, and the lawyer never instructed the niece as to the powers and obligations of being an agent prior to the execution and delivery of the POAs. Does this sound at all familiar to you?

Tip: Don’t get dragged into a potential “emergency” mess by someone who’ll benefit by the POA and who wants you to drop everything and do immediate work. Insist on representing the real client and talking to that client outside of the presence of the protagonist. If the agent isn’t available, insist on educating the agent as to his duties, powers and responsibilities. Explain the import and impact of an immediately effective POA to the client before he executes it. Put this all in writing!

In Svaldi v. Holmes,12 a lawyer drafted a POA for an elderly client that appointed two neighbors as agents. The lawyer included a protective provision in the POA that required the agents to give the lawyer an inventory of the principal’s assets within 30 days of appointment and to give the lawyer annual accountings. The agents proceeded to ignore those duties and purloined approximately $800,000 from the client. Unfortunately, the lawyer failed to follow up with the agents on their duties, which they never performed.

Nonplussed (to say the least), the client then sued the lawyer for malpractice. He alleged that the lawyer had negligently failed to monitor the neighbors as provided for in the POA. The court held that by including this provision, the lawyer had increased the scope of his representation and had assumed a responsibility to attempt to make it work. The court relied on a comment in the Restatement (Third) of the Law Governing Lawyers Section 50 (a lawyer “must exercise care in pursuit of the client’s lawful objectives in matters within the scope of the representation”). The appellate court, in reversing the grant of summary judgment in favor of the lawyer and remanding for trial, as corrected, noted:

We conclude that, by incorporating the inventory and accounting scheme into the power of attorney, Holmes expanded the scope of his representation of Svaldi beyond the mere drafting of legal documents. By setting up the inventory and accounting scheme, Holmes assumed a responsibility to attempt to make it work. Thus, Holmes had a duty to follow up with Johnson and Esquibel regarding their obligation to complete an inventory and the annual accountings and encourage Johnson and Esquibel to comply with the scheme.13 

(Emphasis added.)

This one had to hurt because the lawyer got half of it right, that is, putting in some accountability rules. However, he failed to monitor obvious miscreant thieves pursuant to the accountability scheme that he devised. His failure to monitor meant that he had to go to trial wearing a duty that portended his future liability for damages as a result of the failure to monitor the agents. If you take on an accountability function, you had better do that, or face the consequences.

Best Practices

Here’s a checklist of items to consider in POAs: 

Durability and effectiveness. Clearly, a property POA is of little use to avoid a court-supervised proceeding if it isn’t durable, that is, survives the incapacity of the principal. Therefore, best practice is to use durable POAs.

Despite the fact that the Act provides that POAs are durable unless they say otherwise,14 it’s best practice to specifically so provide because this isn’t the law in every state.15 As of this time, approximately 30 U.S. jurisdictions have adopted the Act, although all states recognize durable POAs. 

Best practice is to include the word “durable,” together with an affirmative statement about incapacity having no impact on its continuing viability to fully cover the waterfront.

The meaning and effect of a POA is determined by the law of the jurisdiction indicated in the POA and, in the absence of an indication of jurisdiction, by the law of the jurisdiction where the POA was executed.16 A POA executed other than in the jurisdiction of execution is valid in that jurisdiction if, when the POA was executed, the execution complied with the law of the jurisdiction that determines the meaning and effect of the POA pursuant to Section 107 of the Act or with the requirements for a military POA pursuant to 10 U.S.C. 1044b.17 

Here are some other tips:

• There will be times that you’ll want to expressly provide which jurisdiction’s laws govern the interpretation of the POA.
• Newly executed property or financial POAs don’t automatically revoke prior POAs. Each property POA should expressly revoke all prior property POAs (but cull out health care POAs from this revocation).
• The POA should be in writing, signed, witnessed by two people who aren’t involved, dated and notarized. You never know where or why it’s needed, so you have to shoot for the highest common denominator, which is Louisiana and New York (although New York recognizes foreign POAs if valid in that state).18
• You should ask the client for the right to contact the banks, brokerage houses and other financial institutions to review the POA in advance for their input and blessing or acceptance. 
• Expressly authorize the agent to sign any additional POAs on forms required or preferred by the third party. 
• Put a formal certification process in the POA instrument.
• Authorize the agent to pursue damages and costs of litigation when a recalcitrant third party either refuses to accept the POA or drags its feet in so doing, and you should indicate to the agent that he should aggressively pursue that third party. Unfortunately, not every jurisdiction adopted Section 120 of the Act as written,19 so some jurisdictions that have adopted the Act don’t expressly allow for damages and attorney’s fees for failing to accept a legitimate property or financial POA.

Incorporation by reference? The Act contains a laundry list of areas that one can cover in a POA by mere reference to the applicable section of the Act.20 Should you incorporate those powers by reference, or should they be expressly separately stated? There’s a difference of opinion here.

I believe in a “belts and suspenders” approach, in which you incorporate by reference and specifically provide for certain enumerated powers. I believe that the POA form should nevertheless carefully and expressly provide for the powers that the principal wants the agent to have, because the incorporation by reference powers are very broad. In fact, those broad powers can be more than your client principal wants the agent to have. In addition, what happens if the POA is needed in a jurisdiction that hasn’t yet adopted the Act? Incorporation by reference may cause a delayed acceptance during which damage occurs while the third party confirms what applicable law provides. 

Best practice is not solely to rely on incorporation by reference.

Usually, the client should affirmatively negate certain powers if that’s what the client intends, because, again, agents in other places may have these powers under the law applicable in that jurisdiction. Quite often, the client wants to authorize some part, but less than all, of the powers that must be expressly authorized, so you should discuss that list with the client.

Do you specifically discuss the so-called “hot powers21 with the principal to see whether he wants them? Or, do you simply include them in the POA without discussing or highlighting them? If your answer to the first question was “yes,” you’re using best practices. However, if your answer to the second question is “no,” then you’re not using best practices and are at some risk.

Blended family issues. POA modifications often are necessary to your regular forms, particularly in blended families. The POA shouldn’t permit an agent partner to significantly alter the principal’s estate plan; likewise, the powers of an agent child should be similarly restricted. 

The limitations might need to be both affirmative and negative. For example, a negative limitation might include restricting beneficiary changes and gifts that aren’t in accord with the principal’s estate plan. An example of an affirmative limitation might include requiring continuation of annual gifts. To dispel uncertainty, the POA should require the agent to give the children of the principal access to financial and medical information, or to the partner, if a child is the agent.

Here are some other tips:

• The POA in a blended family should limit giving away precious family heirlooms (for example, silverware, china and family pictures). I’ve seen this misused to divert family heirlooms, and people get very upset about that.
• It also should limit changing beneficiary designations and distribution provisions in individual retirement accounts and retirement plans. 
• The POA should automatically terminate on separation or divorce, including appointments of relatives of the now former spouse. 
• The POA should severely limit the exercise of powers of appointment, and it shouldn’t waive any accountings and, in fact, should probably require periodic accountings by the agent, including to a third party, particularly after the principal’s incapacity. 
• The POA should affirmatively and broadly restrict self-dealing, including hiring relatives or affiliates.

Avoiding tax problems for the agent. A well-drafted POA should expressly not create a transfer-tax issue for the agent and should cull out of the powers of the agent certain prohibited powers to avoid a general power of appointment, for example, the power to appoint to himself, his estate, his creditors or the creditors of his estate, which could cause inclusion of the principal’s property in the agent’s estate.

Cut Down on Abuse  

Various methods can be employed to attempt to cut down on agent abuse of the property POA. Each option comes with advantages and disadvantages, which I’ll discuss. 

Select two agents instead of one.

Advantages:

• Have two agents who can keep each other accountable.
• More flexibility.

Disadvantages:

• One more unrestrained individual to worry about.
• The potential for collusion between the co-agents.
• Unless the POA allows each agent to operate independently, which puts the principal at risk for a second agent who may be acting at cross-purposes with the other agent, the POA instrument must provide for what happens when the agents disagree in a matter that requires the consent of both agents, that is, a way to settle the dispute.
• A twist on this idea: Make one individual the “acting agent” and the other individual the “accountability agent.” The accountability agent’s sole role is to review the actions and accountings of the agent and empower that agent to take whatever actions are necessary to protect the principal, literally from the acting agent.
• Choose your agents and backups wisely. Inquire as to the mental health and financial condition of the individual chosen to be an agent or a backup.
• As a general rule, lawyers are required to discuss with the client all of the material risks, and advantages and disadvantages, of a particular strategy.22 Because of the sheer amount of jurisprudence and popular press articles involving abuses of POAs, the risks of using or misuing a POA are real and significant. 
• Based on the identity and condition of the parties, there may be situations in which the lawyer shouldn’t permit the client to sign an immediately effective POA. A lawyer can recommend a springing POA or an escrow system for an immediately effective POA.

Bottom line: Two agents can be helpful to cut down on abuse if one agent essentially keeps up with the actions of the other agent.

Really hold the agent accountable. Don’t take “not yet” or “I’ll get around to it” excuses. Regularly demand, receive and review the accountings, which should look like a trustee’s accounting. 

Have the agent formally accept the duties of agent and educate the agent as to his fiduciary duty and explain the powers, duties and obligations under the POA. Underscore the solemn importance of the property or financial POA with an execution ceremony. Make it clear to the agent that all violations will be considered serious and pursued and prosecuted to the fullest extent of the law and that his actions will be closely monitored.

Except as otherwise provided in the POA, an agent isn’t required to disclose receipts, disbursements or transactions conducted on behalf of the principal unless ordered by a court or requested by the principal, a guardian, a conservator, another fiduciary acting for the principal, a governmental agency having authority to protect the welfare of the principal or, on the death of the principal, by the personal representative or successor in interest of the principal’s estate.23

In a blended family, when a representative from one side of the family is serving as agent, it’s best practice to require the agent to account to the other side of the family or to some independent third party, at least after the principal is incapacitated. This might be an appropriate use of the two agent strategy discussed earlier. It’s also prudent to name different individuals as agent and as executor, or the POA should require an agent-executor to account to someone other than himself, which can be dangerous in a blended family. 

Prohibit self-dealing between the agent (and a broad definition of affiliates) and the principal.

Have a different individual serve as agent and as successor trustee of a revocable trust or as executor because the agent has an accounting obligation that would be considered effectively moot if the agent is accounting to himself wearing a different hat.

Bottom line: The POA is very dangerous unless the proper context is set with the agent. Agents who know that their actions are going to be reviewed and scrutinized are more likely to tow the line.

Informal escrow approach. In this method, the estate planner would hold the original and all copies of the POA until such time as the principal was in distress or incapacitated, at which time that the estate planner would release the property POA.

Advantages:

• Provides a level of protection.
• The estate planner doesn’t have to determine whether the principal is incapacitated legally, so there’s some flexibility here, which many like.
• It helps to retain the client long term.

Disadvantages:

• Usually uncompensated.
• Runs the risk of having a “dormant client” who’s actually still a real client.
• There are storage concerns, for example, what happens if the estate planner dies or retires? 
• What happens when you want to retire and can’t find the principal?24
• There are real liability concerns, for example, liability to the principal for wrongful release, especially if the POA is abused.

Bottom line: On balance, I don’t generally recommend this approach. Best practice dictates that estate planners never hold original documents for clients.

Formal escrow approach. In this approach, the client actually puts the original and all copies of the POA in a formal escrow with a third-party escrow agent who’s authorized to release the instrument and copies on the occurrence of some event, for example, the principal’s incapacity, which would have to be formally defined. Alternatively, it could be released on the order of someone (you should name backups for this individual).

Advantages:

• Stronger protection for the principal than the informal “escrow” arrangement.
• It’s better for the estate planner, who doesn’t have to worry about holding and releasing a POA.
• It’s the core business for a company in the escrow business.

Disadvantages:

• Probably has a cost associated with it.
• It’s not as flexible as the informal arrangement in which the estate planner, who’s probably more familiar with the family and psychological dynamics of the principal, could release it on his decision.
• There’s another contract to interpret.
• Delays.
• Interpretation of the defined term “disabled” in the escrow agreement, although better practice may be for a third party to make that determination, which escrow agents probably don’t want to make.

Bottom line: On balance, the escrow arrangement is best in my opinion, but could be saved for what I believe to be “high risk” situations, for example, a blended family, a non-family member, particularly a caregiver, as agent, and the informal escrow could be used for other cases, although I far prefer that clients receive all original documents, and I rarely if ever retain a client’s original documents. The two agents approach is preferable to informal escrow.

Springing POAs. In a classic springing POA, the powers aren’t immediately in effect on execution, but they “spring” into existence on satisfaction of some criteria, for example, a disability determination. 

However, a springing POA needn’t be solely sprung on the principal’s incapacity. Instead, it could be triggered on the decision of some neutral third party, which is more flexible and doesn’t necessarily require a formal determination of incapacity, particularly if the instrument requires a formal determination by a qualified physician, because a principal might be teetering on the edge of capacity and frustrate the process by refusing to submit to the capacity examination. I’ve seen this scenario occur several times. Or a physician, sensing an unpaid witness deposition in his future, declines to get involved.

Advantages:

• Provides a layer of protection and comfort not provided by any of the other methods because, in the case of a springing POA, the powers aren’t effective immediately. Even in a formal escrow arrangement, there’s a small chance that the POA is released improvidently.

Disadvantages:

• The powers aren’t immediately effective, which creates its own set of problems for third parties asked to rely on the POA because the third party must go outside of the four corners of the instrument. This greatly troubles many third parties, particularly financial institutions.
• There are potential delays between the principal not being able to care for himself and the formal determination of incapacity or whatever other means by which the POA springs into existence. 
• The POA spring is subject to potential conflicting interpretations, particularly around the definition of “disability.”
• Sometimes, the principal frustrates the process by refusing to submit to an examination.
• Some physicians balk at getting involved in these potentially contested matters.
• Suppose that the principal disappears, for example, a mountain climber or spelunker. Because the principal isn’t available to be examined, and because the laws of declaring someone deceased require significant time, measured in years, the POA literally doesn’t spring into existence unless that possibility is built into the agreement.

Bottom line: On balance, I prefer immediately effective POAs, with appropriate protections offered either by the two agent approach or the formal escrow arrangement.

License to Steal?

Contrary to the common practice of most lawyers, the POA used for estate planning isn’t a throwaway document filled with regular boilerplate, so you shouldn’t treat it like one—it’s a real potential source of liability—for you! In fact, in the hands of the wrong person, a broad POA can be a license to steal, which makes it a more dangerous document than a will! As I discussed earlier, most money or other property purloined by a crooked agent is never recovered. A property or financial POA in the wrong hands can change the principal’s estate plan beyond recognition unless appropriate measures are taken.

With that said, the grieving principal or the principal’s beneficiaries will want to be made whole, and they’ll start looking for deep pockets to sue. Guess what? Your malpractice insurance policy (or your personal assets) is low hanging fruit, particularly if you failed to go over the form and what it meant with the principal before he signed it, confirmed these instructions and explanations in writing and educated the agent, in writing. 

Endnotes

1. If you want proof of this statement, simply compare the prices of life insurance and disability insurance.

2. See, e.g., Debra Whitman and Jilienne Gunther, “Get a Power of Attorney (But Make Sure It’s Not a License to Steal),” AARP Blog (March 3, 2017), https://blog.aarp.org/thinking-policy/get-a-power-of-attorney-but-make-sure-its-not-a-license-to-steal; Deborah L. Jacobs, “Putting Your Faith in a Power of Attorney,” The New York Times (May 20, 2009), www.nytimes.com/2009/05/21/your-money/estate-planning/21POWER.html, which quotes prominent elder law attorney Bernard A. Krooks as describing the property or financial power of attorney as a license to steal.

3. New York General Obligations Law Section 5-1501B.

4. “Suspicious Activity Reports on Elder Financial Exploitation: Issues and Trends,” Consumer Financial Protection Bureau (February 2019).

5. Mark S. Lachs and Karl A. Pillemer, “Elder abuse,” New England Journal of Medicine, 373, 1947–56 (2015), www.nejm.org/doi/full/10.1056/NEJMra1404688.

6. Lifespan of Greater Rochester, Inc., Weill Cornell Medical Center of Cornell University and New York City Department for the Aging, “Under the Radar: New York State Elder Abuse Prevalence Study” (May 2011),https://ocfs.ny.gov/main/reports/Under%20the%20Radar%2005%2012%2011%20final%20report.pdf. 

7. Supra note 5. 

8. See, e.g., Atty. Grievance Comm’n of Md. v. Hodes, 441 Md. 136 (Ct. App. Md. 2014).

9. Meyer v. Purcell, 405 S.W.3d 572 (Mo. Ct. App. 2013).

10. Ibid., at p. 577.

11. Ibid., at p. 579.

12. Svaldi v. Holmes, 986 N.E.2d 443 (OH Ct. App. 2012).

13. Ibid.

14. Uniform Power of Attorney Act (Act) Section 104.

15. See, e.g., Cal. Probate Code Arts. 4124, 4215 and 4128.

16. Act Section 107.

17. Act Section 106(c).

18. La. Civ. Code Arts. 1833 and 1836; New York General Obligations Law Section 5-1501B.

19. See, e.g., Ohio.

20. Act Section 202(a).

21. Act Section 201(a).

22. Model Rules of Professional Conduct Rule 1.4.

23. Act Section 114(h).

24. See, e.g., NYSBA Ethics Opinion 1182 (Jan. 23, 2020).

For a period of time, Tax Court decisions regarding family limited partnerships (FLPs) had a familiar read to them. A typical FLP case involved an assertion by the Internal Revenue Service that the transferor retained rights to transferred property that were impermissible under Internal Revenue Code Section 2036(a)(1), and the defense would stand or fall on whether the transfer was a bona fide sale for full and adequate consideration. Case analysis largely focused on what worked and didn’t regarding the estate’s ability to demonstrate legitimate non-tax purposes for the transfer. In 2017, Estate of Powell v. Commissioner raised new issues.1 While variety can be the spice of life—this case certainly left a bad taste for two reasons: (1) the revitalization of the IRS argument that rights held by a limited partnership interest could constitute impermissible control under IRC Section 2036(a)(2); and (2) a new method was used to compute the amount included in the gross estate when an FLP is included under Section 2036. After Powell, practitioners were left wondering whether this Section 2036(a)(2) argument would be routinely applied and if this new computational method would be applied again despite years of practice and precedent to the contrary. The Tax Court’s memorandum decision in Estate of Howard V. Moore v. Commissioner provided some insight on these issues as well as an important reminder to practitioners about what information in their files will come into evidence.2

Another Bad Facts FLP Case 

Occasionally, there’s a good facts case regarding an FLP that informs practitioners of what they should advise their clients to do.3 More often though, the FLP cases that work their way to a decision in Tax Court are bad facts cases—and Howard Moore’s estate was a very bad facts case. It does, however, make for a good story and provides some useful lessons. Howard was the “rags to riches” American dream. Born in 1916 in Texas, Howard’s family lost their home and farm when Howard was a young child. The family moved to Arizona where the family had very little, and Howard’s education ended after eighth grade. Despite the rough start, Howard worked his way to financial prosperity. He was a land leveler in Arizona, where he leveled the ground for farm owners to help with irrigation. In exchange for this hard work, he was often paid in land as his customers had little cash. It was from this bartering (leveling land for land) that he amassed more than 1,000 acres over time, which he turned into his own farming operation. 

Howard’s story wasn’t all positive though, as he had his personal struggles despite his financial success. He did get married and had four children (three sons and a daughter), but due to his battle with alcoholism, he became separated from his wife in the 1970s. His relationship with his children was complicated. At trial, his children described him as “strong,” “manipulative,” “firm” and “tough.” One anecdotal story included in the case recalled an incident when one of his sons came home injured from a school fight, only to have Howard tell him to fight harder, and the next time, he “[didn’t] want to see no skin on them knuckles.” Howard would also pit his sons against each other, which ultimately resulted in a total breakdown of the family. For example, in 1987, one son borrowed another son’s tractor without telling the owner. The son who owned the tractor became irate and unloaded an entire clip from a semiautomatic rifle into his own tractor. The damage to the tractor was minor compared to the irreparable damage to the Moore family.   

After this 1987 blow up of the family (and tractor), an estate planner might see a prime opportunity to do estate planning. Howard’s wealth was tied up in an illiquid asset (an operating farm) that required active management.4 Further, with a dysfunctional family, a governance structure was needed to keep order and have proper succession of an operating farm.5 But, Howard’s controlling ways wouldn’t allow for proper estate planning. Instead, he carried on controlling every aspect of his operation. At one point, he made an unreported gift of farm land to one of his sons, but the land would effectively be returned to Howard before he died. In 2004, with Howard nearly a nonagenarian, he turned his attention towards liquidating his holdings. Howard and one of his sons had negotiated the sale of part of the land and had begun negotiations with a potential buyer for the rest of it. 

In December 2004, before the deals to sell the land were finalized, Howard had a heart attack and a stroke. He was given less than six months to live, and Howard made clear he wanted to spend that time getting his affairs in order. On his metaphorical deathbed, though with full capacity, Howard decided to do estate planning. He called an attorney who had done Howard’s deceased wife’s estate plan and told him he wanted to try to “save the millions of dollars of taxes…”  Howard then indicated during the “design phase” of the estate plan that his primary goals were to: (1) eliminate any estate taxes; and (2) maintain control. Just four days after being discharged from the hospital (still in December 2004)—Howard set up a partnership, a charitable foundation and some trusts. 

The FLP Howard established in December 2004 had an initial funding of $10,000—$100 from each of his four children and $9,500 from a revocable trust he just established. These contributions accounted for the 99% limited partnership interest. Another trust he set up (the Management Trust) also contributed $100 for the 1% general partnership interest. In February 2005, Howard contributed the farmland into his revocable trust, which in turn contributed most of the farmland into the FLP. Simultaneously with this contribution, and despite the ownership structure in which the Management Trust should control the FLP, at Howard’s direction, all of the farmland was sold in exchange for $16.512 million from the previously identified buyers. As was customary in the area, Howard was allowed as part of the deal to continue to live on the land he just sold for the rest of his life. Also as part of the deal, he continued his farming operation after the sale, which wasn’t the local custom. 

After the sale, an irrevocable trust established by Howard was gifted $500,000 as seed funding. The irrevocable trust then purchased the revocable trust’s FLP interest using the $500,000 it just received from the revocable trust and a promissory note for the balance of the purchase price. In terms of the purchase price, the trustee of the revocable trust (the seller in the transaction) testified that she didn’t know where the price came from. At trial, it came out that the price was based on the net asset value with a 53% valuation discount applied. After the partnership liquidated all of its real estate holdings, the assets were invested by a professional financial advisor, and the family was passive in its management of the partnership. 

There’s more to this story and the case. There were purported loans to family members with no evidence that there was intent to repay. The IRS challenged  the allowance of the attorney’s fees for estate administration purposes as it wasn’t clear what services he provided. There was a charitable deduction formula that was intended to eliminate all taxes if the planning was challenged but was ultimately held to be invalid by the court. While interesting, we’re not going to focus on those issues in this article. Instead, we’ll focus on the Sections 2036 inclusion and 2043  computation issues in relation to the FLP. 

(1) is Moore Welcome Than (2) 

One doesn’t really need to read past the description of the facts to know that the value of the FLP assets was going to be included in the gross estate by virtue of Section 2036—the only question is whether that value would be included under Section 2036(a)(1) or Section 2036(a)(2). So, if the taxpayer is going to lose on account of Section 2036, does it matter under which specific subsection the decedent’s planning falls? “When the fall is all that is—it matters,”6 and here planners can take some comfort in the Moore ruling. Historically, FLPs were often included under Section 2036(a)(1) because the decedent maintained some possession or right to income of the property. There’s also been a concerning development in which certain rights held by the interest can be considered an inclusionary power under Section 2036(a)(2) as “the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income therefrom.”7 In Estate ofStrangi v. Comm’r, there was clear inclusion under Section 2036(a)(1) as partnership assets were used to pay personal expenses of the donor, and the donor continued to use partnership property as his own. Nevertheless, the Tax Court went on to find that because the limited partnership interest held by the donor could give him a vote on the liquidation of the partnership, that also triggered Section 2036(a)(2).8 In Estate ofTurner v. Comm’r, the Tax Court found that Section 2036(a)(2) inclusion applied when the donor (and donor’s spouse) retained the general partnership interest because the donor had the ability to amend the partnership agreement and make distributions without the consent of the limited partners.9 In Turner, the donor also retained a majority of the limited partnership interests, thus controlling those rights as well. 

More recently came the Powell decision. Like Moore, the Powell case involved a bad facts deathbed estate plan. Multiple statutory provisions could have been cited by the Tax Court to include the underlying FLP assets in Nancy Powell’s gross estate.10 Notwithstanding, the Tax Court relied on Section 2036(a)(2) in including FLP assets in the gross estate, focusing on the decedent’s retained right to vote as a limited partner on the liquidation of the FLP as impermissible control. This transformation of the Section 2036(a)(2) dicta from Strangi to the holding in Powell has given planners much to consider in both existing and new FLPs.11

The IRS asserted its Section 2036(a)(2) inclusion argument in the Moore case. However, the court first looked at the Section 2036(a)(1) issue—and there was a lot to look at. First, the fact that Howard continued to live and work the land in the same manner as he did prior to the contribution to the FLP and even after the sale was a clear retention of the possession and enjoyment of the property. Second, in addition to using the land, he used the sale proceeds to pay his own personal expenses. Third, although he put the general partnership interest into a trust—there was a clear implied agreement with the trustees (two of his children). The court described the power of the trustees as only “nominal ‘power’” as they did whatever Howard asked, and he had indicated maintaining control was a primary goal of his estate plan. Given the IRS prevailed on its Section 2036(a)(1) argument, the court found that it “need not address the Commissioner’s alternative arguments that Moore’s estate plan triggered their inclusion under section 2036(a)(2).”12 The holding in Moore certainly doesn’t undo the troubling analysis in Strangi or Powell, but at least it didn’t reinforce or further develop the Section 2036(a)(2) line of attack by the IRS.13

Keep It Bona Fide

Regardless of which subparagraph of Section 2036 the IRS is asserting, Moore is an important reminder of how practitioners must maintain their files and document their interactions with clients. With very few exceptions, taxpayers have been unsuccessful in a Section 2036 defense if they can’t meet the “bona fide sale for an adequate and full consideration” exception. Whether a transfer meets this exception depends on two questions. First, was the transfer for “adequate and full consideration?” This is a question of value (that is, did the taxpayer receive a partnership interest equivalent in value to what was contributed to the partnership). That’s usually an easy question to answer and satisfy. The second question is tougher, which is whether the sale was “bona fide,” and that question “turns on motive.”14 To satisfy the bona fide test, “the objective evidence must establish that the nontax reason was a significant factor that motivated the partnership’s creation.”15 

Motive can be difficult to definitively determine in estate tax cases because the individual whose motive matters is deceased. Without the decedent’s direct testimony, the objective evidence that can be put forward to establish motive for creating an FLP can be divided into two categories: (1) evidence that was contemporaneous with the creation of the FLP; and (2) evidence of how the partnership was operated to achieve the decedent’s goals. In Moore, the objective evidence was pretty damaging, but the case serves as an important reminder of what not to do. As noted above, the attorney’s own records and testimony showed that tax was the primary factor underlying the planning with the second place finisher (maintaining control) being just as damning. The case is certainly an extreme example of what happens when the decedent did no estate planning for his entire adult life and then in just a few months engaged in a great deal of planning leaving clear evidence that the planning was tax driven. 

Such blatant cases can serve as an important warning for planners to remember that communications with their clients can become discoverable. Practitioners must be proactive about discussing and documenting the non-tax benefits of FLPs. Transfer tax consequences certainly may be discussed, but why not also explain the income tax consequences in the same manner as transfer taxes? This may show that the practitioner was explaining all aspects of the planning to a client—not just pushing estate tax savings. Moore also highlights the importance of client intake notes and questionnaires. Having an item that welcomes a client to tell a planner, “I’m coming to you just to save taxes,” cuts the legs right out from under any bona fide sale defense. Communications with elderly clients or clients in poor health must detail the non-tax considerations of the planning because the Tax Court has repeatedly held that deathbed planning suggests the primary purpose was estate tax reduction.16

The second bona fide sale lesson from Moore is that reality needs to match the claimed purposes of an FLP, as a court won’t be inclined to find generic reasons to set up an entity persuasive. In Howard’s case, his children asserted two non-tax reasons. The first “was to bring his family together so that they could learn how to manage the business without him…”17 Establishing efficient and effective succession of management is certainly a valid non-tax reason that’s been recognized before. Unfortunately, the evidence didn’t support this was a valid reason in the Moore case. The children blindly signed the partnership agreement; there was no negotiating or independent counsel sought—they did as their father told them. Then there was no business to run and not even a business to sell as the deal for the farm was already negotiated by the time the farmland was contributed to the partnership. The partners only had one initial meeting, and an investment advisor managed  the liquid assets after the sale was done. It was therefore easy for the court to dismiss business succession/family reunification as a valid business reason for the partnership. 

The other non-tax reason claimed by the family was creditor protection. However, the court didn’t find objective evidence supporting this. Howard’s children couldn’t identify any actual or potential creditors. One son claimed that there was a risk of a claim because farmers routinely incur liability for illegal use of pesticides, yet the court noted there was no evidence Howard ever used such pesticides. The children also claimed a concern about potential “bad marriages” they had, but again, the court found that there was nothing in the record that supported that any of the children had or were having marital problems.18 The takeaway point here is that how a partnership operates is just as important as its structure in estate tax audits. 

Further Exploring the Lacuna 

One of the most (if not the most) troubling parts of the Powell decision was an introduction of a new way to compute the amount included in a decedent’s gross estate when an FLP is included under Section 2036. Historically, if there was inclusion of an FLP interest, the value of the FLP itself would be disregarded, and the value included would be that of the underlying assets without the benefit of any valuation discounts. This would avoid double counting an asset by including the FLP interest under Section 2033 and the underlying assets under Section 2036. While the parties in Powell contested whether there was estate tax inclusion, neither party raised what computation would be used if there was inclusion because the historical approach had longstanding precedent and produced an equitable result. 

Nevertheless, the majority in Powell found that the logic behind the avoidance of double inclusion had gone “unarticulated” and that the case presented an opportunity to “fill that lacuna and explain why a double inclusion in a decedent’s estate is not only illogical, [but] it is not allowed under IRC Section 2043(a).”19 Given that the Tax Court raised the issue on its own, it didn’t have the benefit of competing arguments that undoubtedly would have exposed the problems with a new analytical framework and the fact that the court had previously found that the application of Section 2043(a) was inappropriate.20 There was a concurring opinion in Powell that accepted the Section 2036(a)(2) inclusion but disagreed with creating a new computation of the inclusion as it was “a solution in search of a problem.”21 Ultimately in Powell, the new analytical framework had no impact in the case given its unique facts, but both the majority and concurring opinions noted that there could be duplicative tax results in future cases in which this framework is applied.22

In Moore, Judge Mark V. Holmes found that the Powell computation needed to be applied as the court was required to apply the IRC as interpreted by a full Tax Court opinion despite the potential for what he called “odd results.” While the decision to give further life to the Powell analysis is unwelcome, the Moore opinion is useful because it delves into the computational detail in a way Powell didn’t. The Moore opinion presents an algebraic formula that ties together the various IRC sections in play. At the end of the day, we’re looking for the total value included in an estate (Vincluded). Prior to Powell, this was simply the fair market value (FMV) of the underlying partnership assets as of the decedent’s date of death (FMVd), with this value being included because of Section 2036. Thus, the equation was simple: Vincluded = FMVd. 

What Powell effectively did was add two additional variables. The first is the FMV of the partnership as of the date of death. It’s included in determining Vincluded because Section 2033 would include the decedent’s holding in the partnership interest itself (this is in addition to the underlying assets being included under Section 2036). The Moore opinion referred to this as “Cd” because it was for the consideration (partnership interest) the decedent received when he contributed assets to the partnership valued at the date of death. Including both the underlying assets (FMVd and Cd) creates a double inclusion issue. This is where Section 2043(a) comes in according to Powell. The second variable is a reduction for the value of the partnership interest as of the date of the transfer of assets to the partnership (Ct), which is meant to address double inclusion. The Moore opinion formulated the Powell inclusion computation as: Vincluded = Cd + FMVd - Ct. Though many of us became lawyers because we didn’t want to do math—certainly this succinct formula more accurately captures the Powell computation than prose.

While the formula as stated in Moore is helpful, the ordering of the variables doesn’t drive home the change to the historical approach, so let’s reorder them. Using algebra, what you can end up with is Vincluded = FMVd + (Cd-Ct). What this reordering highlights is that, just as had been the historical computation, the value included is the date-of-death value of the underlying assets, but is now adjusted by the change in the FMV of the consideration received between the date of the transfer and the date of death. To the extent the value of the partnership appreciated (meaning Cd will be greater than Ct), then this new computational method will result in a greater value being included in the estate. To the extent the value of the partnership depreciated (meaning Cd will be less than Ct), then this new computational method will result in a lower value being included in the estate because the resulting number in the parenthesis will be negative.

To the extent that the value of the consideration stayed flat, then the number in the parenthesis will be zero, which means the outcome under the Powell formula (that is, Vincluded = FMVd + (0)) will be the same as the historical approach Vincluded = FMVd. This was the case in Powell, in whichthe partnership interest values at the date of transfer and death were the same given the deathbed planning. As is apparent, the more time that passes, the greater the probability that the Cd and Ct values will be different. The Moore decision illustrated this with hypotheticals, in which in all three cases, a decedent started with contributing $1,000 in land and getting a partnership interest back for $500 (that is, a 50% valuation discount). In one scenario, the values remain stagnant, in another the value of the land and in turn the partnership interest double and finally there’s a scenario in which the property and in turn the partnership interest have their values halved. See “Powell Formula,” this page.

What can be seen from the Powell formula are results that don’t necessarily achieve the intended policy objectives of Section 2036, which the pre-Powell computation did handle appropriately. If the value of the partnership increases, double counting value will result, as the date-of-death value of the partnership assets plus post-contribution appreciation of the partnership interest will be included in the decedent’s estate. Section 2036 wasn’t meant to be draconian—like all of the string provisions, it’s simply meant to undo a structure in which the decedent retained impermissible control or access to the property. Further, if the value of the partnership decreases, then the decedent is in better shape from an estate tax perspective had he not entered into the transaction—the exact opposite outcome Section 2036 seeks to achieve.

As is likely apparent, the more time that passes between the date of contribution to the partnership and the date of death, the greater the probability that Cd won’t equal Ct, especially in an active partnership (particularly one that makes distributions). Using an example given in Moore, a father contributed $1,000 of property to a partnership for a limited partnership interest while his son holds the general partnership interest, which creates a 25% valuation discount. The FLP then sells the land for $1,000 (so appreciation/depreciation doesn’t impact the hypothetical) and distributes $400 to the father, which leaves $600 of value in the FLP interest owned by the father. Before the Powell computational method, $1,000 would be included in the estate—$400 of the cash that was distributed out and the remaining $600 in the FLP with no valuation discount applied to it. Thus, the policy objective of Section 2036 is achieved when the father is in no better or worse a position after the application of Section 2036. The Powell method produces a different outcome though because Cd will be greater than Ct because the $400 of cash distributed out will be part of Cd with no discount applied, while that same property included in Ct has 25% discount applied. The result under the Powell formula is that Vincluded is $1,100. This occurs because FMVd is $1000, Cd is $850 ($400 of the cash distributed and the remaining $600 of underlying assets being reduced by the 25% valuation discount), and Ct is $750 (the $1,000 of assets prior to the cash distribution with a 25% valuation discount). It’s the $100 difference between Cd and Ct that creates the extra $100 of value when compared to if the father never entered into the FLP structure or did so but didn’t take a distribution.

While Moore touches on the impact of discounts in the context of whether FLP assets are distributed or not, there’s another issue with discounts not discussed. The examples in Moore all assumed the discount rates would remain the same even as the value of property fluctuated or the nature of the assets of the partnership changed  (for example, a real estate holding company becoming liquid). Increasing and decreasing discount rates that occur between the date of the transfer and date of death could create similar fluctuations as changing values. If discount rates increase from the transfer to death, then Cd would become lower than Ct, which would reduce the amount included. Conversely, decreasing discount rates would result in Ct being higher relative to Cd.

Planning With Section 2043

After the decision in Moore, it appears that the Tax Court will routinely implement the new Powell formula. This means that for FLPs that are successful and appreciate, the total cost of Section 2036 inclusion has gone up so that a client will be worse off compared to the result if he hadn’t done the planning. Planners should reconsider the arithmetic before trying hastily implemented FLP planning when the client is on his deathbed, as an estate-planning Hail Mary (as was the case in Powell and Moore) because the old thinking that one is no worse off for doing the planning is no longer accurate. This should also give planners concerns about existing partnerships that have appreciated over time and whether that planning should be revisited, potentially ending the FLP, to avoid the draconian result.

There are also short-term possibilities in the current environment given the impact of COVID-19. The impact of the pandemic has driven asset values down relative to their worth before this crises. Correspondingly, discounts for lack of marketability and control are higher because the factors and benchmarks used to determine those rates have been impacted by COVID-19. This could result in scenarios in which Ct is higher relative to Cd, which as discussed above can result in the estate paying less in taxes had the planning never been undertaken. It’s certainly possible that an estate may wish to assert Section 2036 against itself for an FLP the decedent contributed to because the math could work out under the Powell computational method that would reduce the overall tax burden being lowered when compared to the FLP interest being outside of the estate. So much for going into law to avoid math. 

—The authors would like to thank Jeremy Lent, a consultant at Withers Bergman LLP in New Haven, Conn., for his assistance with this article.

Endnotes

1. Estate of Powell v. Commissioner, 148 T.C. 392 (2017).

2. Estate of Moore v. Comm’r, T.C. Memo. 2020-40.

3. See, e.g., Estate of Purdue v. Comm’r, T.C. Memo. 2015-249.  

4. See, e.g., Church v. United States, 85 A.F.T.R.2d 804 (W.D. Tex. 2000), aff’d 268 F.3d 1063 (5th Cir. 2001) (holding that operating a family ranch was a valid business purpose).

5. See, e.g., Estate of Stone v. Comm’r, T.C. Memo. 2003-309 (holding that using a family limited partnership (FLP) to settle disputes among quarrelsome siblings was a valid business purpose).

6. “The Lion in the Winter,” AVCO Embassy Pictures and Haworth Productions (1968).

7. For a discussion of potentially problematic powers in an FLP from an Internal Revenue Code Section 2036 perspective, see Chanie S. Fortgang and Christine R.W. Quigley, “Help for Control Freaks,” Trusts & Estates (November 2014).

8. Estate of Strangi v. Comm’r, T.C. Memo. 2003-145, aff’d 417 F.3d 468 (5th Cir. 2005). 

9. Estate of Turner v. Comm’r, T.C. Memo. 2011-209. For more analysis of the Turner decision, see Stephanie Loomis-Price and N. Todd Angkatavanich, “Turn(er)ing the Tables on Taxpayers,” Trusts & Estates (July 2012).

10. Internal Revenue Code Section 2033 (if transfer of FLP interest was void under an invalid exercise of a power of attorney); IRC Section 2038(a) (if transfer of FLP interest was voidable under an invalid exercise of a power of attorney); IRC Section 2035(a) (as estate conceded the bona fide sale exception would apply and retained interests were terminated less than three years from death); and Section 2036(a)(1) (because of an implied agreement). 

11. For more on this issue, see N. Todd Angkatavanich, James I. Dougherty and Eric Fischer, “Estate of Powell: Stranger than Strangi and Partially Fiction,” Trusts & Estates (September 2017).

12. Moore, supra note 2, at n. 17.

13. Note that this expansion of Section 2036(a)(2) isn’t limited to FLPs, as the Internal Revenue Service has successfully asserted it in other situations that are commonly used in estate planning. See Estate of Cahill v. Comm’r, T.C. Memo. 2018-84. 

14. Moore citing Estate of Bongard, 124 T.C. 8 (2005).

15. Moore quoting Estate of Turner v. Comm’r, T.C. Memo. 2011-209.

16. Estate of Rector v. Comm’r, T.C. Memo. 2007-367; Estate of Erickson v. Comm’r, T.C. Memo. 2007-107; Estate of Rosen v. Comm’r, T.C. Memo. 2006-115.

17. Moore, supra note 2, at p. 2.   

18. Query whether the only marital problems resulted from any of the children saying under oath they had marital issues.

19. Powell, supra note 1, at p. 410.

20. See Estate of Harper, T.C. Memo. 2002-121.

21. Powell, supra note 1, at p. 424.

22. For more on this issue with Powell, see supra note 11.

Almost every estate is comprised of tangible personal property (TPP) that will be subject to division and distribution. Some TPP may be distributed by list disposition. Some may be donated under a charitable bequest. Other items may be divided pursuant to a general bequest among a class of beneficiaries. Still others may be sold with proceeds distributed as part of the residue. Regardless of the devise, the value, methodology, mechanism and power to resolve disputes as well as the potential tax consequences attendant to the TPP merit consideration. Even the location of the bequest and whether it’s considered a specific bequest or a general bequest can have significant implications as to whether the bequest will ultimately be satisfied, especially if the estate is illiquid, or the potential for exercise of a statutory election exists, because of the order that bequests abate.

Battles over TPP have made the headlines. Remember the battle over Robin Williams’ personal belongings? But, these battles happen all too frequently in estates both big and small. Hurt feelings created during the division of the TPP and inter-family litigation over an estate can cause irreparable rifts in a family. Not every battle can be avoided, but planning and forethought may avoid some.

Consider the following illustrative scenarios.

Second Marriage

H and W’s estate plan leaves the TPP to the survivor, subject to list disposition. No list is ever prepared or found. H survives and remarries. He’s in possession of W’s jewelry, family heirlooms, family photos and historical family documents. H dies survived by W2. H’s estate plan continues the same provisions (all TPP to W2, subject to list disposition and, if she doesn’t survive, equally to his children who survive him). The children from H’s first marriage may be upset to learn that W2 is receiving items that had been their mother’s or accumulated during H’s marriage to W. Things can be further complicated if W2 and the children aren’t on good terms. Even if H specifies that he wants certain items to go to the children, W2 may claim H gifted some of those items to her during their marriage and argue that those specific bequests should be adeemed because they were no longer H’s. 

How to avoid? Consider a specific bequest of sentimental items that one spouse may wish to keep in the family on the death of the first spouse. W could have provided that some of the items go to the children on her death. Clearly, a discussion at the planning stage might identify issues so that proactive planning may avoid future disputes.

Item No Longer Owed at Death

Grandma prepares an estate plan and specifically provides for certain special items to go to each grandchild. Grandma thoughtfully tried to provide each grandchild with an item that had specific importance to the family’s history. The balance of her TPP is to be divided equally among her then-living children. Over time, she starts to declutter or downsize. She gives items away. She forgets that she listed that items are designated to go to different individuals in her estate plan. By the time grandma dies, some but not all of these special items have been gifted away to grandchildren different from those delineated in the estate plan. While some grandchildren still receive special items at her death, others receive nothing. Hard feelings arise.
The children also fight over what “equal” means. Is it equal in value or equal in number of items? 

How to avoid? Clear drafting might avoid these battles. We generally reflect that an item specifically devised, but that’s no longer owned at death, lapses. Consider including a provision that permits a grandchild to select another item of sentimental value (not to exceed $X in value) if her bequest would otherwise adeem, and specify how equality is to be achieved. 

Disproportionate Distribution

Dad has a valuable art collection. When he prepares his estate plan, he provides for specific devises of various paintings among his children. Other works are directed to be sold or donated. The residue is to be equally divided. Initially, he thought each child was getting art that was approximately equivalent in value. Over time, some works appreciated more than others such that a significant disparity in the values of those works (perhaps in the millions) exists by the time he dies. What if, in addition to the disparity in value, dad’s will indicates that all taxes are to be paid from the residue. Not only will some children receive a disproportionate distribution based on the value of the art, but also children who are already receiving less will also suffer the tax consequences of the disparity.

How to avoid? Perhaps a valuation and equalization clause might soften the blow and avoid an unintended disproportionate division of his estate among his children. When valuable tangible property or a disproportionate division may occur, consider whether an equitable apportionment clause or use of the state’s default apportionment provisions results in a more equitable distribution than a “pay the taxes from the residue” would provide. We generally exempt generation-skipping transfer tax out of apportionment provisions—allocating the tax consequences related to tangible personal property over a specified value might also be appropriate in some circumstances.

Bequest Restrictions

Joe is a professor in a university art department. He has no close living relatives. He has passionately collected pottery. He wants to leave his vast collection to the university, but also wants to restrict the bequest to display in the university’s museum. But, the museum may not want to accept the gift with those limitations.

How to avoid? As part of the planning process, it’s important for Joe to discuss his plans with the university. It may not want all of the collection and may have no desire to display pieces it accepts. The university’s position may affect Joe’s plan. In fact, after speaking with the university, Joe decides to limit the bequest to certain pieces over which an agreement is reached. Joe is then able to make other plans for the remaining pieces.

Issues With “Collections”

Mary is a “collector.” Some of what Mary collects is valuable; some isn’t. Some items have greater value as a “collection” but are worth less on a piecemeal basis. Mary’s home is packed to the brim with items, and her sister, Sue, who’s nominated to administer her estate, has always thought Mary’s collecting habits were just an absurd obsession and that she has nothing of real value. Sue lacks knowledge of what’s valuable, and to her, it all looks like items to sell at a garage sale. Mary’s children live out of state; some live out of the country. The plan permits each child to select TPP on a round-robin basis. As to items not specifically selected, Sue is given discretion to distribute the TPP in kind or otherwise sell the items and distribute the proceeds equally among Mary’s children. The plan also provides for Sue to pay the storage and shipping costs associated with TPP distributed in kind as an administrative expense. Sue is tasked with traveling to Michigan to clean out the house and get it on the market quickly. It could be helpful for Mary to leave Sue a binder, or other organized documentation, that identifies items of value and their provenance, so they aren’t accidentally disposed of at garage sale prices. Mary’s son, Mark, selects the baby grand piano he played as a child. Mary’s daughter, Jennifer, selects the etching that always hung over the mantle. Mary’s son, Chris, selects a miniature carving. All these items should be insured, but it’s not clear who’s responsible for bearing the cost of insurance during the shipping or extended storage process.

How to avoid? It would be helpful if the estate-planning documents indicate who’s to bear the costs of insuring the items. Because Mark is career army and stationed overseas, the cost of shipping the piano to him and/or insuring it and keeping it in a humidity-controlled storage unit until he ultimately (if ever) returns stateside, can be significant (especially given the overall size of the estate). The etching turns out to be a Rembrandt, and special packing, storage and insurance is required to protect the item in transport from Michigan to Jennifer in California. Chris is an executive who currently lives in England, and it turns out the little carving is ivory, and the true provenance of the carving can’t be established. Export restrictions on ivory may present a problem in legally getting the item to Chris. Consideration of these issues may have resulted in Mary providing necessary information and drafting that might help Sue fulfill her fiduciary responsibilities in administering the estate.

Obstacles to Estate Administration

Max is a survivalist who’s gone on numerous big game African hunting safaris. When he dies, his estate is comprised of a large collection of taxidermy, guns (both historical and working), ammunition, knives and tribal art. Max nominates his son, Sam, to administer his estate. Sam has a felony conviction. Max has been estranged from his daughter, Julie, since Max and her mother divorced 30 years earlier. Julie and Sam haven’t spoken since Sam went to prison. Since his release from federal prison, Sam has been a model citizen. Both children live in a different state than where Max resided at the time of his death. Max didn’t consider that Sam won’t be able to possess the guns and that some of the items may be otherwise protected or transfer restricted. These issues might impair the estate’s ability to obtain full fair market value or impair Sam’s ability to properly administer the estate or even receive items left to him. 

How to avoid? A review of options during the planning process and as circumstances change can be extremely important. A public administrator or a mechanism for the appointment of an independent fiduciary may be important to the administration of this estate.

Importance of Recordkeeping

Frank has been an ardent art collector. His collection spans many genres, and significant portions of his collections are on loan to a variety of prestigious galleries and museums. He also has valuable art in his residence and multiple vacation properties, while other pieces are in storage, and some have been entrusted to private galleries and art dealers for consignment sale. Frank’s estate plan contains a number of specific charitable bequests, but not all of the art is to be donated. This can create confusion when it comes time to administer the estate.

How to avoid? During the planning process, it’s important to advise Frank of the need to keep records of where all of his art is located, maintain information regarding provenance, perhaps list the reputable dealers and experts he’s dealt with and regularly update values. Maintaining adequate insurance and abiding by the terms of those policies remain important throughout. When it comes to disposing of the art, it will be important to have knowledgeable advisors involved. Because Frank has a taxable estate, art valued at over $50,000 may need to be submitted to the art advisory panel for valuation, in addition to obtaining an independent valuation. Disposing of all pieces of a certain genre, or by a single artist, may depress the value ultimately attained. Selling items through a private gallery may place the art at risk if the gallery goes bankrupt and a Uniform Commercial Code filing reflecting the estate’s ownership of the art isn’t on file. Placing the art with a reputable auction house will subject the proceeds to a fee that may not be deductible if the need to sell the art wasn’t established. Therefore, rather than giving the fiduciary discretion as to which pieces the grantor desires to be sold following his death, a direction in the estate plan to sell certain pieces may assist in making the disposition costs a deductible expense when the need to sell isn’t otherwise necessary to provide liquidity to meet costs of administration. 

Need for Inventory

Let’s add another layer of complexity to the scenario regarding Frank’s estate. At the time of his death, Frank is on his third marriage. At the time of his marriage to his third wife, Betty, he entered into a prenuptial agreement (prenup) that required he provide her with a bequest of $5 million and the right to reside in their primary residence for the balance of her life. It also provided her with the right to direct that the trustee sell the home and replace it with a home of equal or lesser value or simply not replace it at all. The home has been in Frank’s family for three generations. No right of sale or disposition was provided with regard to the tangible personal property located in the home. The prenup provided that Betty would have the right to continue to use the furniture and furnishings located in the home, subject to ordinary wear and tear. The home contains Ming dynasty pieces, valuable art hung on the walls, collectibles and items of sentimental value to the children of his first marriage. Betty won’t let the children ever come and visit. At Frank’s death, she claims some items in the home are hers (not Frank’s) or jointly acquired such that she has survivorship interests. Bills of sale and records of purchase don’t exist or have been destroyed. No itemization was ever prepared to reflect what was Frank’s, Betty’s or jointly acquired property. When Frank dies, various paintings have just been returned to the home from exhibition and are still in crates. Betty claims that under the terms of the prenup (and his estate plan that incorporated the terms of the prenup), all items in the home are to be part of her life estate interest (including the just returned/crated art) or are hers. A battle over Frank’s intent and her rights to the TPP located at the home ensues. The rift between her and the children naturally widens. Betty leaves her entire estate to her children. She acquires TPP of her own in the years following Frank’s death. When she dies, the trustee determines that Betty permitted her grandchildren to play with collectible Disney characters, and limbs have been torn off of several in the process of regular toddler play. Numerous items from Frank’s estate that were subject to Betty’s life estate are no longer located at the home. Betty’s son, who has a significant long-standing substance abuse problem, stole items or pawned them, and they can’t be located. Because police reports weren’t timely filed (as Betty didn’t want to get her son in trouble), the insurance refuses to pay. 

How to avoid? Under these circumstances, providing a life estate may not have been prudent. Discussions on the front end, and along the way, may have identified concerns that could have been addressed while Frank was still alive. Otherwise, provision for regular inventorying, inspections and a mechanism to verify that items of value are maintained in a fashion that maintains value and permits continued insurance coverage may be important. Allocating the furniture and furnishings to a non-marital trust may preserve the marital deduction. Providing a mechanism to sell items, whether they be TPP or the house, to the residuary beneficiaries, perhaps via a right of first refusal, might help preserve items in the family while also protecting a marital deduction. Providing a requirement that family photos be duplicated can make sure some of these items are preserved for the family. A video or photo record of items in the home (and their condition) might also be helpful in identifying items, as will as an indication of who they belong to.

Dysfunctional Family

In Jack’s family, dysfunction with a capital “D” has been abundant. Jack can’t deal with it and believes less is best. His plan merely states that his personal belongings shall be divided among his children as they may agree (knowing that they never agree on anything but being unrealistically optimistic that they’ll be able to agree on the division of the items he leaves behind). He nominates his children, in order of age, to administer his estate. They can’t even agree on what’s meant by personal property (which can be more expansive, by definition, than TPP) or whether a collection represents a single item or each item in the collection is to be subject to separate selection. 

How to avoid? Care in defining what’s intended can help reduce the acrimony and areas of dispute. Providing a mechanism, whether it be drawing straws to effectuate a round robin selection of property on a 1-2-3, 3-2-1 or 1-2-3, 1-2-3 basis, bidding and purchasing items out of the beneficiary’s residuary bequest, bidding with factiously allocated emotional points or leaving the selection of items to the sole discretion of the fiduciary (which will likely result in claims against the fiduciary under the circumstances presented), can provide extremely helpful direction. In this instance, less is simply less and may result in more acrimony and administrative expense when litigation over the division of the TPP ensues.

Wrongfully Retrieving Items

Marilyn’s children tell her items they want. At various times during her life, Marilyn tells different children they can have the same item when she dies. Before her body is cold and in the grave, John goes into the house to retrieve items he believes Marilyn wanted him to have. His sister, Joan, believes she was to receive those very same items. By the time she comes to town for the funeral, the items are gone. Can she prove they were still around when Marilyn died? John went in and retrieved the items before a personal representative was even appointed or a trustee accepted the nomination to act. This scenario happens all too often and can lead to family strife and even claims of conversion. John also took care of Marilyn during her final days. Out of gratitude she gave him items, but Joan wasn’t aware that she did so and believes John wrongfully took those items as well.

How to avoid? The ability to secure the home and eliminate access can be extremely important but not always possible. Documenting that items have been gifted during life can also be helpful.

Estate Enmeshed in Litigation

Mike is on his third marriage. His business interests are illiquid and speculative in nature. His business gambles have resulted in great success but not all interests permit his estate to defer taxes under an Internal Revenue Code Section 6166 election. His estate is enmeshed in litigation. He has valuable TPP, worth in the millions of dollars, some of which represents family heirlooms and items of sentimental value. His plan specifies that his children receive the bulk of his TPP items, but it may matter where that direction appears and whether the items are specified. In some jurisdictions, if the provision is contained under the general disposition of his TPP, it may not be considered a specific devise. His third wife also elects a large family allowance and exercises other statutory elections and attempts to select some of the items of import to the children to satisfy her elections, and the costs of administration and tax obligations are mounting such that the fiduciary needs to liquidate TPP to meet these obligations. Unless otherwise provided in the instruments, a statute may direct the order in which bequests will abate. 

How to avoid? If a different order for abatement is desired and Mike wants to preserve the possible distribution of key items to his children, the estate-planning attorney may be able to create a different result by including specific provisions intended to draft around the statutory default abatement provisions or draft the bequest in a way that will qualify it as a specific devise to give the bequest a priority position. 

Eliminating Points of Contention

In any event, securing all TPP, preparing thorough inventories, attempting to achieve consensus as to a mechanism for division (if none is specified in the governing instrument), considering apportionment clauses and properly valuing assets can all be steps toward eliminating points of contention in the division of TPP.

With disputes over the division of TPP reportedly ranking as one of the top three causes for disputes in the administration of a decedent’s estate, giving due regard to planning for its disposition merits taking the requisite time in the planning stage to garner an understanding of the client’s possessions, desires, family dynamics and issues that might arise in its management, division and disposition.

Two opinions were issued last year that changed the landscape of valuing pass-through entities (PTE) for transfer tax purposes. These two cases, Estate of Jones v. Commissioner and Kress v. United States, broke with the 20-year-old convention that tax-affecting the earnings of a PTE, such as an S corporation (S corp), partnership and limited liability company, for an assumed corporate tax rate is disallowed when determining such entity’s fair market value (FMV).1 In contravention of this practice, both Jones and Kress hold that it’s appropriate to tax-affect the earnings of a PTE for federal gift tax purposes if the facts of the case and the accompanying valuation can support its application. A third opinion, Cecil v. Comm’r, is currently in the Tax Court’s pipeline and is expected to fully address and further clarify the permissibility of tax-affecting the initial valuation of PTEs.2

Prior to these cases, in the 1999 seminal case Gross v. Comm’r, the Tax Court agreed with the Internal Revenue Service’s valuation experts and held that an S corp’s earnings shouldn’t be tax-affected for a corporate rate in the context of valuing non-controlling interests.3 Disallowing this practice effectively increased a PTE’s estimated FMV for transfer tax purposes with a corresponding increase in transfer tax liability. This prevailing view continued for two decades until the Jones and Kress rulings were released in 2019.

Though Jones and Kress are groundbreaking opinions on the issue of tax-affecting, there’s some irony in that the Tax Cuts and Jobs Act of 2017 (TCJA) was enacted years after the gifts in question were made, but prior to the judges’ rulings. The transfers in both Jones and Kress were made during the sub-prime mortgage crisis circa 2008. By permanently lowering the top corporate income tax rate from 35% to a flat 21%, the TCJA limited the benefits of tax-affecting that had for so long eluded planners.4 That said, tax-affecting can still be a valuable tool for minimizing transfer tax liability and delivering the best possible result for clients.

In fact, the current trend toward the acceptance of tax-affecting makes now a good strategic time to transfer business interests to the next generation in a tax-efficient manner. Given the current COVID-19 global pandemic, estate-planning professionals should discuss with their clients whether it makes sense to plan more aggressively to take advantage of depressed market conditions, high transfer tax exemptions, low interest rates and the ability to value a PTE on a C corporation (C corp) equivalent basis. 

Effect of Tax-Affecting

The concept of FMV is well known and whether income or asset based, the valuation methodology implemented in an appraisal has a significant effect on the value of the interests for transfer tax purposes.5 To highlight the benefits of tax-affecting, let’s focus on the income-based method. The income-based (or discounted cash flow) method discounts to present value the anticipated future income of the company whose stock is being valued. More often than not, comparables for valuations in these cases are C corps that measure returns on an after-tax basis. C corps’ earnings are taxed at the entity level and are taxable as dividends to the shareholder when distributed. PTEs aren’t subject to this double layer of taxation as there’s not an entity-level tax, and the individual owners are responsible for paying tax on their proportionate share of the entity’s earnings at ordinary tax rates, whether that income is distributed or not. 

Once the initial value for a PTE is established based on C corp data, valuation professionals will determine whether any adjustments need to be made to account for the differential in taxation between the PTE and the C corp form. Prior to Gross, it seemed customary to adjust the earnings from the PTE to reflect estimated corporate income taxes that would have been payable had the pass-through form, specifically S status, not been elected.6 These adjustments were meant to avoid distortions when applying industry ratios such as price to earnings. In finding that tax-affecting of an S corp’s earnings wasn’t supported by the facts, and going so far as to call the assumed corporate tax rate of 40% “fictitious,” Judge James S. Halpern’s opinion in Gross marked a defining moment. The ruling obstructed the taxpayers’ ability to reap the potential benefits of tax-affecting a PTE.

In Gross and subsequent cases, a 0% corporate tax rate was applied, and tax-affecting was categorically rejected on the grounds that PTEs aren’t subject to an entity-level tax. Twenty years later, there was a reversal of fortune with Jones and Kress. In finding resoundingly for the taxpayer, the Tax Court in Jones held that tax-affecting the earnings of an S corp and a limited partnership at a 38% combined federal and state tax rate was appropriate under the circumstances. As mentioned earlier, the gifts in Jones were made between 2007 and 2009 when the top federal corporate tax rate was 35%, and the top dividend tax rate was 15%. Tax-affecting the earnings of the family businesses resulted in significant tax savings for the Jones’ estate. Similarly, in Kress, the district court sided with the taxpayers’ expert that tax-affecting the earnings of the family company was appropriate and concluded that S corp status was a neutral factor and not a valuation premium as the IRS expert contended.

Impact of the TCJA

The ability to fully tax-affect the earnings of a PTE for a C corp equivalent using the higher pre-TCJA corporate level tax rate remarkably improves tax savings on transfers of the company interests. The TCJA’s modifications to the Tax Code, however, dulls the blade of tax-affecting post-Jones and Kress for transfers made after its enactment. To summarize the relevant provisions, the TCJA lowers the top corporate income tax rate from 35% to a flat 21%, and the qualified dividend tax rate remains at its 2017 level of 20%. The top individual ordinary income tax rate, which applies to a PTE owner’s earnings, marginally dropped from 39.6% to 37%, and new Internal Revenue Code Section 199A provides a deduction of up to 20% of qualified domestic business income for PTEs.7 The 21% corporate tax rate is permanent, while the latter two provisions sunset after Dec. 31, 2025.  

Consider the following hypothetical example for a single individual using pre- and post-TCJA federal tax rates for a company with $1 million in pre-tax income, using the highest individual rate, and assuming the owner isn’t subject to additional state tax and doesn’t qualify for a deduction under IRC Section 199A. Using 2017 tax rates, a C corp shareholder’s total tax liability is 50.47% of the total earnings, while an S corp shareholder’s total tax liability is 43.40%. When applying 2018 rates, as illustrated in “Comparison of Tax Liability,” p. 32, the spread between a C corp shareholder’s total tax liability and an S corp shareholder’s tax liability is so narrow that it can be characterized as a rounding error.

Under the TCJA, it appears that tax-affecting the earnings of a large PTE for an assumed corporate tax rate no longer has the profound effect on the FMV of an entity for transfer tax purposes that it once had. Additionally, the ability of a PTE to offer a greater return on earnings compared to a C corp is further weakened once the TCJA’s individual tax benefits, including Section 199A, expire.

Keep Persisting 

One could argue that valuing PTEs may now be less complicated, as previous methods using C corp comparables are outmoded. Ultimately, appraisers must determine whether it’s still prudent to award a premium or to consider a PTE more favorable than a C corp when determining the FMV of an entity for transfer tax purposes. 

Tax and valuation professionals should persist with tax-affecting for several reasons. First, smaller businesses that qualify for the 20% deduction in qualified business income under Section 199A benefit from a more significant spread in the total tax liability between a PTE and a C corp equivalent. Second, the impact of tax-affecting will be greater in states that assess a state-level corporate tax, especially in situations in which the corporate tax and individual income tax gap is substantial. Third, because it’s been allowed in cases such as Jones and Kress, and its benefits have been diminished by the TCJA, the IRS may be less motivated to challenge its use going forward. Though the IRS hasn’t released guidance as to whether it’s acquiesced to the practice of tax-affecting, IRS valuation experts might not want to waste time and energy in argument.

Moreover, valuation professionals should create a habit of tax-affecting when appropriate to anticipate a potential change in the corporate tax rate so that they have solid methods and data readily available to support its application. In tracking the key factors in Jones and Kress, the appraisal should explain any PTE benefits and detriments to clearly demonstrate why tax-affecting is appropriate.

Given the reduction in tax revenue from the TCJA, coupled with the massive $2 trillion Coronavirus Aid, Relief, and Economic Security Act stimulus bill, a future corporate tax rate hike isn’t out of the question.8 It could be triggered by a change in administration or if Congress determines it’s the best way to raise revenue and to recoup the cost of the stimulus package. Implementing the logic applied by the respective valuation experts in Jones and Kress as a matter of practice, including tax-affecting, valuation professionals can ensure a better result for their clients now and be prepared for future changes in the law.

The current pandemic environment, though fraught with uncertainty and market decline, is prime for those who have the means and liquidity to transfer assets without jeopardizing their own financial security. The Jones and Kress decisions substantiate the benefits of tax-affecting the earnings of a PTE on a corporate tax basis. Combining tax-affecting with other valuation adjustments for lack of control and lack of marketability, the FMV of a PTE such as a family-owned business can be further depressed. Volatility tends to lend itself to larger lack of marketability discounts for closely held businesses. This is supported by the opinions in both Jones and Kress, in which the gifts were made during and around the 2008 recession. Beginning the wealth transfer process with a reasonable and substantiated FMV is the first step in any effective estate plan. 

Due to the depressed market, the applicable federal rates (AFRs) are historically low. AFRs are used for setting the minimum interest rate for intra-family loans, among other things, and are a crucial component of several sophisticated estate-planning techniques. Sales to intentionally defective grantor trusts typically use the mid-term AFR as the interest rate for the promissory note between the seller and buyer, and grantor retained annuity trusts (GRATs) use the IRC Section 7520 rate as the interest rate for the annuity payments made from the GRAT to the grantor. Both techniques are highly effective in “freezing” the value of the transferred asset for transfer tax purposes, while transferring the appreciation to the beneficiaries through the trust vehicle. The July 2020 mid-term AFR is a mere 0.45% (compared with the July 2019 mid-term AFR of 2.08%), and the July 2020 Section 7520 rate is 0.6% (compared with the July 2019 Section 7520 rate of 2.6%).9 Both of these strategies can be leveraged when the FMV of the transferred asset has been tax-affected and discounted.

The TCJA also provides an increased estate and gift tax exemption of $10 million, indexed for inflation, per individual ($11.58 million in 2020) and a corresponding increase in the generation-skipping transfer tax exemption. These increases, like the individual income tax benefits under the TCJA, sunset after Dec. 31, 2025. There are many advantages to using the exemption to transfer assets such as closely held business interests to the next generation now. These opportunities should be thoroughly discussed with tax and financial planning counsel. Consider maximizing the benefit of the current high exemptions by transferring assets that may be less valuable in the current climate, so that appreciation will occur in the hands of the next generation and won’t be included in the donor’s estate for transfer tax purposes. Similar to the reduced corporate tax rate, these benefits could also be on the chopping block prior to the sunset date if there’s a change in administration or if Congress needs to increase revenue.

A Formidable Tool

Though tax-affecting may not move the needle as it once did, it’s still a formidable tool available to planners when assisting clients with the transfer of closely held business interests. The long-awaited Tax Court opinion in Cecil could provide additional support for the validity of tax-affecting as a trusted and established economic theory. Under the TCJA, the benefits of tax-affecting have been tempered, but given the unpredictable nature of changes to our tax laws, tax-affecting could become more of a force should the corporate tax increase. If tax-affecting becomes a widely accepted practice now, it may be less likely that the courts will revert to the dark and draconian days of Gross and the cases that followed in its footsteps. 

Endnotes

1. Estate of Aaron Jones v. Commissioner, T.C. Memo. 2019-101 (Aug. 19, 2019); Kress v. United States, 123 A.F.T.R.2d 2019-1224 (E.D. Wis. March 26, 2019).

2. Estate of Mary R. Cecil v. Comm’r, No. 14640-14 (U.S. Tax Ct. filed June 23, 2014). For additional discussion, see Daniel R. Van Vleet, “Kress, Jones and Cecil,” Trusts & Estates (May 2020).

3. Walter L. Gross, Jr. v. Comm’r, T.C. Memo. 1999-254, aff’d 272 F.3d 333 (6th Cir. 2001), cert. denied, 537 US 827 (2002). See also Estate of Gallagher v. Comm’r, T.C. Memo. 2011-148, modified by T.C. Memo. 2011-244 (Oct. 11, 2011); Estate of Natale B. Giustina v. Comm’r, T.C. Memo. 2016-114, supplementing Estate of Giustina v. Comm’r, T.C. Memo. 2011-141, rev’d and remanded (on other grounds), 586 F. App’x 417 (9th Cir. 2014).

4. Tax Cuts and Jobs Act, Pub. L. No. 115-97 (Dec. 22, 2017).

5. Treasury Regulations Sections 20.2031-1(b); 25.2512-1. All section references herein are to the Internal Revenue Code of 1986, and to the regulations promulgated thereunder, unless otherwise stated.

6. Namely, the “IRS Valuation Guide for Income, Estate and Gift Taxes: Valuation Training for Appeals Officers and the IRS Examination Technique Handbook.”

7. For additional discussion on IRC Section 199A, see Alvina Lo, “Getting the Facts Straight on the 199A Deduction,” www.wealthmanagement.com/high-net-worth/getting-facts-straight-199a-deduction (Jan. 17, 2019).

8. Coronavirus Aid, Relief, and Economic Security Act, Pub.L. 116–136 (Mar. 27, 2020).

9. Revenue Ruling 2020-14; Rev. Rul. 2019-16.