A bill signed into law by Gov. Andrew Cuomo in September requires state agencies to create guidelines that will assist healthcare providers in identifying elder abuse.

The law calls for the development of screening tools, questions that healthcare providers can ask and other resources they can use to report abuse or seek additional assistance. The law aims to help address elder self-neglect as well as abuse by others.

Sen. Sue Serino, R-Hyde Park, Dutchess County, sponsored the legislation and said that it will help medical providers play a proactive role in preventing the abuse of seniors, an important issue that receives too little attention.

The Office of Children and Family Services and the Department of Health will develop the guidelines and post them on their websites.

Elder abuse may be significantly under reported. A state survey conducted in 2011 found an elder abuse incidence rate was almost 24 times greater than the number of incidents reported to state agencies or law enforcement. The study applied the estimated incidence rate to the population of seniors in New York State, and estimated that 260,000 older adults had been victimized by some kind of elder abuse in a one-year period. Elder abuse can be physical, psychological or financial. The study found that psychological abuse was the most prevalent form of abuse reported by agencies, but financial abuse was the most common form of abuse self-reported by survey respondents.

The National Council on Aging estimates that 10 percent of the population over age 60 has suffered some form of elder abuse. According to the council, many seniors don’t report the abuse, in many cases because it’s perpetrated by a family member. Advocates say the new law will help healthcare professionals identify and report abuse.

On June 26, 2017, the final version of the Money Laundering, Terrorist Financing and Transfer of Funds (Information on the Payer) Regulations 2017 (MLR 2017) came into effect in the United Kingdom. One of the effects of this legislation requires certain trustees to report to HM Revenue & Customs (HMRC) on, and maintain a register of, “beneficial ownership information” in relation to any relevant trusts which they administer.

Broadly speaking, all U.K. trusts (trusts that are treated as U.K. resident for income tax (IT) and capital gains tax (CGT)), and non-U.K. trusts which receive income from a source in the U.K. or have assets in the U.K. on which there is a U.K. tax liability (including IT, CGT, inheritance tax (IHT), Stamp Duty Land Tax (SDLT) or Stamp Duty Reserve Tax (SDRT)), are “relevant trusts” and are therefore affected. The respective trustees of such trusts are required to comply with the reporting regulations via an online Trust Register which is available through HMRC’s online Trust Registration Service (TRS). The Trust Register will not be open to the public, but will be made available to law enforcement bodies in the U.K. and European Economic Area states (if requested), and the U.K. Financial Intelligence Unit.

Who Must Register?

Currently, registration on the Trust Register is only required for deliberately created express trusts (a trust created intentionally by an act of the settlor). Statutory, resulting, constructive or unit trusts don’t currently need to be registered. Additionally, Employee Ownership Trusts are deemed to be relevant trusts as defined by the legislation and need to be registered, but only if the trustees incur a U.K. tax liability in the relevant year.

Non-U.K. trusts will be outside the registration and reporting requirements, provided they don’t become subject to any U.K. tax liabilities (such as IT, CGT, IHT, SDLT or SDRT). If U.K. tax obligations are incurred only at the level of a company underlying the trust, then the trust will not (currently) be subject to these requirements.

Reporting Requirements

The term “beneficial owner” has been given a wide meaning, and trustees will be required to provide information on the identities of the settlors, other trustees, beneficiaries (including discretionary objects) and all other natural or legal persons exercising effective control over the trust. In this context “control” means power to deal with trust assets, to vary or terminate the trust, to add or remove a beneficiary, to appoint or remove trustees and to exercise consent or veto powers. On that basis a protector is also likely to be someone who exercises control. The information which trustees are required to report in relation to any beneficial owners includes:

• their name;
• their correspondence address and other contact details;
• their date of birth;
• if they are resident in the U.K., their National Insurance Number or their Unique Taxpayer Reference; and
• if they aren’t resident in the U.K., their passport or ID number with its country of issue and expiry date. 

If a trust has a class of beneficiaries, not all of whom have been determined, then it will not be necessary to report all of the above information. Instead, trustees will need to provide a description of the class of persons who are entitled to benefit from the trust. Trustees will also be required to provide general information on the nature of the trust. This includes:

• its name;
• the date on which it was established;
• a statement of accounts describing the trust's assets (which includes addresses of any U.K. property it owns);
• the country where it’s resident for tax purposes;
• the place where it’s administered; and
• a contact address.

Trustees must take action to collate the necessary information to comply with these regulations, as a failure to comply could lead to criminal repercussions (however, at this stage it isn’t clear what the penalties are for non-compliance). HMRC has stated in its guidance that “[it] will set out [its] penalty framework in the near future, but the legislation requires that any civil penalty imposed must be proportionate to the offence committed.” It’s important to note that trustees' agents can also access the TRS and submit any reportable information, but must first create an Agent Service Account.

Important Deadlines

Trustees who have already reported their trust on the now-discontinued paper Form 41G must still register online. Originally, the first reporting deadline was set at Oct. 5, 2017, but this has now been postponed to Jan. 5, 2018 and looks unlikely to move. HMRC’s comments on the TRS state that new trusts must register by Oct. 5 of the tax year after the trust is set up or when it starts to become liable to IT or CGT. However, the regulations state that the relevant information must be provided on or before Jan. 31 following the end of the first tax year in which the trustee first became liable to pay the applicable U.K. taxes, the same as for online self-assessment income tax returns.

Actions to Take Immediately

Trustees and trustees’ agents need to take a careful look at some measures to ensure that current and future compliance with the new regulations is achieved:

• Review existing trusts and decide which are in scope.
• Ensure that the trusts’ accounts are up to date.
• Decide who the beneficial owners are in each case and review the information held on them. Note that the definition of “control” has a wide meaning and may include protectors (don’t assume that it’s the same as under the Foreign Account Tax Compliance Act, Common Reporting Standard or your local anti-money laundering regulations).
• Ensure that you have the necessary information on record that’s required to be reported on any beneficial owner.
• Ensure that appropriate systems are in place within your organization to satisfy the reporting obligations going forward.
• Check regularly for HMRC updates on the Trust Register and the TRS, as changes to deadlines and the reporting requirements are likely!

It seems to me that this publication, as well as others, has recently started to place more emphasis on the “softer side” of the practice, by which I mean the non-tax-related issues, such as the psychological and emotional aspects. For example, in “Filling in the Gaps,” Marvin E. Blum encourages clients to create a “red file” that contains their wishes for future care, financial intentions and a list of personal information in the event of incapacity.¹ After all, transfer taxes before and after death, with inclusion of potential federal and state gift, estate and generation-skipping transfer taxes, will at most help evaporate approximately 40 percent to 50 percent of an estate, but estate disputes, waste, greed and the destruction of the family business could wipe out much more and leave behind terrible family scars and relationships that will never totally heal. The industry is now recognizing the importance of non-tax issues because of: more frequent and bitter estate disputes; lower transfer tax rates and higher exemptions; greater potential for estate tax repeal; and a more enlightened society regarding dealing with personal and family psychology and dynamics. It seems we live in this age of entitlement in which many of us deal with our own family members who feel everything is deserved and coming to them, yet these same individuals don’t have the ability to handle or appreciate what they’ll receive. 

Human Capital

In a previous article, “Rethinking the Fabric of Estate Planning: Have We Gotten It Wrong?” my co-author and I discuss how large transfers of wealth can have the potential to create future generations who are unmotivated and immature and have poor self-esteem.² The article concludes that the most successful estate plans transfer not just monetary assets but also human capital, meaning the client transfers his skills and knowledge so that the future generation is prepared to perform in the world and produce economic value. 

In “Changing the Playbook,” another article by Blum,  he discusses “now planning” as one strategy for transferring this human capital.³ Under this strategy, a system is established “through which family members may grow to understand the responsibilities of ownership.”⁴ This can include creating open dialogue among family members, scheduling annual family meetings, involving family members in community matters or involving family members in the family business at a young age. By participating in “now planning,” the next generation is able to gain human capital from the previous generation before it’s too late.

Solving the Impossible

Yet, when clients, who are already in their 60s, 70s and 80s, come to me for estate-planning advice and ask me about potential family sensitivities and conflicts (or when they don’t ask, and I offer my input anyway), I often feel like I can place Band-Aids on the issues, but I can’t ever really solve them. How can I solve impossible issues such as how to divide the family business among the children or make descendants like and respect each other and be happy and satisfied with what they will or won’t receive? Many of the deeper emotional and psychological issues involved likely have persisted for decades, maybe even since the children were very young, and relate to how their parents raised them. Some may involve individual mental health issues that even psychologists and therapists can’t solve. Perhaps we can state that part of these issues is “nature” and the other part “nurture,” but in either case, the estate-planning professional can only do so much, especially so late in the game. 

Getting to the Root of It

Many of my clients are (or at least should be) worried about future estate disputes, the success of their businesses, waste and squandering of assets by spoiled descendants and how their children will get along when the clients are no longer living. Often, to help deal with these issues, we create legal structures like partnerships, draft key employee and company operating agreements and all sorts of types of trusts, such as incentive, marital, discretionary, support and asset protection and focus on who will serve as trustees and their powers to help deal with these issues. Don’t get me wrong. The wise and empathetic estate planner can certainly help minimize the potential for, and the effects of, a later dispute or problem and help descendants to become more productive as well as protect their assets. However, as my own still-young children and I grow older, I realize that these structures and documents don’t get to the root of the issues. What’s really needed is teaching the next generation to be self-sufficient, productive, grateful, self-fulfilled, loving and happy people. Obviously, when substantial money is involved (or conversely, sometimes if too little money is involved and there’s tremendous hardship), it’s much more difficult to inculcate higher ideals and values.  

So, what’s the solution? Well, certainly as Blum points out in his “Playbook” article, it’s education and preparedness starting at a young age.⁵ We can’t just start educating our loved ones in the later years of our lives. It’s likely too late if our children are already grown. We also have to start leading by example, and it has to start much earlier. However, to convey this message to relatively young or new parents who may not yet be visiting an estate-planning attorney, there must be far greater understanding and collaboration among all the financial professionals including insurance, banking, brokerage, accounting, legal and perhaps the educational and mental health communities as well, to truly get this important message across. I certainly welcome feedback and advice from the readers of this article as to how to accomplish this extraordinarily complex mission.    

Endnotes

1. Marvin E. Blum, “Filling in the Gaps,” Trusts & Estates (February 2017), at p. 38. 

2. Avi Z. Kestenbaum and Amy F. Altman, “Rethinking the Fabric of Estate Planning: Have We Gotten It Wrong?” Trusts & Estates (February 2016), at p. 32.

3. Marvin E. Blum, “Changing the Playbook,” Trusts & Estates (February 2016), at p. 34.

4. Ibid.

5. Ibid.

From a philanthropic perspective, 2017 has been a year of “business as unusual.” 

The year began with the inauguration of a new administration promising an unprecedented package of legislation that would replace the nation’s health care system with a less expensive approach offering more benefits, address the nation’s infrastructure challenges and, at the same time, provide sweeping tax cuts for everyone.

Those working with individuals contemplating larger charitable gifts either as isolated transactions or as part of a broader estate and financial plan began the year with uncertainty. Would there be a charitable deduction in the future? Would the deduction survive but be capped in some way? Would estate and gift taxes be repealed? Would qualified appreciated assets continue to be deductible at fair market value? 

Tax Reform

For the first several months of the year, Congress wrestled with the health care issue before abandoning it after two abortive attempts. Congress then turned its attention to tax reform. That process began with a number of competing plans—all put forth by various segments of the majority party.  

As the late summer and fall progressed, it became clear that the blueprint for tax reform appeared to be the 2014 House Ways and Means plan known as the “Camp Proposal.”

As of early December, both the House and Senate had passed bills that significantly lowered corporate tax rates while adapting a modified flat tax approach on the individual side. Both bills eliminated most deductions, including those for state and local taxes, with the exception of the charitable deduction and mortgage interest deductions (with different caps on mortgage interest) and state and local taxes with the exception of property taxes with a $10,000 cap.

Both the House and Senate tax writers were careful to exempt the charitable deduction from direct cuts and even increased the adjusted gross income (AGI) limit from 50 percent to 60 percent for gifts of cash.

So far, so good, for philanthropy and tax reform. But as always, the devil is in the details. While it’s true that both houses of Congress chose to retain the full charitable deduction and the mortgage interest and property tax deduction with caps (and a capped deduction for property taxes in the House bill), both houses eliminated personal exemptions and increased the standard deduction to $12,000 for individuals and $24,000 for married taxpayers. This is tantamount to a flat tax for most Americans as a significantly small number of taxpayers would find themselves with enough mortgage interest, property taxes and charitable deductions to itemize. The provision for up to a $10,000 deduction for property taxes in both bills, would, however, go a long way to restoring a “practical” charitable deduction for many middle and upper middle class taxpayers.

On the other hand, both houses of Congress voted to repeal the Pease limitation on itemized deductions. When combined with the fact that many higher income individuals have mortgage interest and other deductions that nearly, if not completely, clear the standard deduction hurdle, these taxpayers would continue to make their gifts from pre-tax dollars while the remainder of donors would be giving from after-tax dollars.

Above-the-Line Treatment

When it became clear in early November that tax cuts were being partially funded by new taxes on charitable giving by those who may have to earn $15,000 in pre-tax income to give $10,000 (in the case of a non-itemizing donor in a 33 percent marginal tax bracket), charities finally began mobilizing their attempts to have Congress backtrack and return tax incentives to the middle class. 

The leading contender to repair the damage that tax simplification threatens to visit on middle class giving was the so-called “universal charitable deduction.” Sometimes referred to as an “above-the-line deduction,” it’s in reality not a deduction but rather an exemption from AGI for amounts given to charity.  

Much like the traditional treatment of alimony and unreimbursed business expenses, this approach recognizes that, unlike mortgage interest, charitable gifts don’t represent a choice of ways to expend discretionary income, but rather, these gifts are income that’s foregone in favor of voluntarily funding societal needs that would otherwise be borne by government or not met at all.

As we went to press, Congress was engaged in the process of reconciling the House and Senate tax bills in conference, and the charitable community continued to push for the above-the-line treatment of charitable gifts. The issue may boil down not to whether there’s some relief in this form, but whether it’s subject to a floor based on a dollar amount or a more progressive approach through a percentage of gross income floor or whether there’s a ceiling carefully tailored to rescue middle income donors from the impact of the increased standard deduction that taxpayers benefit from whether or not they give to charity.

Looking to the Future

The most sophisticated donors and advisors have been contemplating the future under a number of potential scenarios. As the end of the year approached, many began to notice other factors that often influence the nature and scope of charitable gifts, including the rapid increase in real estate and other investment values during 2017.  

It became increasingly clear to many that gifts of securities and other qualified assets that had increased in value may never yield more tax benefits than if they were donated before the end of 2017. Many astute planners advised their clients to accelerate gifts that may be planned for future years into 2017. Not only would gifts made this year not trigger a capital gains tax on the increased value, but also, the entire value of the asset may be deductible against a higher tax rate than that in future years, perhaps never saving as much in taxes again.

Another byproduct of this strategy for those who believe a correction may be in the offing: The conservation of cash that will be available to buy back into the market at lower values without having to realize taxable gains to free cash to diversify through purchases of shares at bargain prices not seen since 2009.

In a similar vein, many thoughtful investors with philanthropic leanings took a fresh look at charitable remainder trusts (CRTs) and other split-interest gifts that allow for charitable deductions in 2017 against what may be higher rates than in future years while also cashing in gains free of capital gains tax. A CRT also offers a tax-free trading environment and a way to build a future source of income that could be taxed at more favorable rates than other income under the tier structure of income reporting from CRTs.

Early Trump proposals eliminated the federal estate tax while preserving the gift tax to prevent income splitting and other lifetime maneuvers designed to transfer unlimited amounts to heirs while living.

Both the House and Senate versions of tax reform double the current threshold of estate and gift taxes to $11 million for singles and $22 million for couples. The House bill retained the gift tax while repealing the estate tax in six years. The Senate bill retained both the estate and gift tax at the higher threshold.

In any event, it’s become clear to those planning large charitable transfers that the world of estate and gift tax planning was heading to the most rarified strata of American society, the 1/10 of 1 percent, or one out of 1,000 persons, who still needed to seriously consider the impact of federal estate taxes.  

This may, in fact, be the best news for those helping clients plan for the eventual transfer of their assets. In fact, this may usher in a golden age of estate planning—a world where clients can actually do what they would like to do without the artificial strictures imposed by a tax system that too often interfered with what people actually wanted to achieve.

The future of estate planning in general, and philanthropic planning in particular, may only be limited by the imagination of clients and advisors who are able to navigate the planning waters guided only by the desires of their clients. 

Last year’s developments serve to remind planners what can go wrong—and what can go right with planning.

Settlement Proceeds

In Ozimkoski v. Commissioner,¹ Thomas W. Ozimkoski, Sr. died testate, and his individual retirement account was payable to his estate. A will contest between his widow, Suzanne, and his son from a prior marriage, Thomas Jr., ended in a settlement agreement. Under that agreement, Thomas Jr. became entitled to his father’s 1967 Harley-Davidson motorcycle and $110,000 cash, free of income taxes. Suzanne was entitled to the rest, except for some personal property. 

Suzanne’s share included her husband’s IRA. In 2008, Suzanne transferred $235,495.46 into a rollover IRA titled in her name and treated it as her own IRA. Later that year, Suzanne withdrew $174,597.17 from her rollover and paid Thomas Jr. his $110,000 cash award out of the proceeds. 

The IRA custodian reported to the Internal Revenue Service total 2008 IRA distributions to Suzanne of $174,597.17, coded as distributions before age 59½. Suzanne reported no IRA taxable income in her 2008 income tax return, wrongly believing that Thomas Jr. would have to pay income taxes on the $174,597.17.

Based on the IRA custodian’s reporting, the IRS assessed income taxes against Suzanne, along with late payment interest, a penalty for failing to timely file her income tax return and a penalty for substantial understatement of tax. Suzanne petitioned the Tax Court, claiming she didn’t owe the assessed additional income tax, interest and penalties.

Because Thomas Sr.’s IRA was transferred to Suzanne’s own IRA, the Tax Court found distributions to her were taxable. That Suzanne was required to pay $110,000 to Thomas Jr. couldn’t change that result. The court sustained the IRS’ claims.

Taxable Distributions

After serving as a mutual fund company’s call center manager for 23 years, Candice Elaine lost her job. A single mother with two daughters, she rolled over her retirement benefits to an IRA and was later compelled by financial hardship to make IRA withdrawals. 

Because she was under age 59½, the IRS assessed Internal Revenue Code Section 72(t)’s 10 percent additional tax on early withdrawals, along with a 20 percent substantial income understatement penalty. Candice asked the Tax Court to reverse the penalty.  

In Elaine v. Comm’r,² the Tax Court noted that financial hardship isn’t among Section 72(t)’s enumerated exceptions and upheld the additional tax. But the court, observing that her error is commonplace, held that Candice’s error fell within the penalty tax’s reasonable cause exception and reversed the 20 percent substantial income understatement penalty.

In Kevin Cheves, et ux. v. Comm’r,³ economic hardship followed after the loss of Kevin’s job. Unfortunately, when Kevin’s IRA had to be tapped to make ends meet, he was under age 59½, causing imposition of the 10 percent early distributions tax. Adding insult to injury, his Form 1099-R underreported Kevin’s and his wife’s withdrawals by $15,221. As economic hardship isn’t listed in the IRC as an exception to the early distributions tax, the Tax Court found it couldn’t grant relief from that tax. However, it did grant relief from the substantial underpayment penalty because of Kevin’s reliance on a faulty Form 1099-R.

Roth IRAs

In Summa Holdings, Inc. v. Comm’r,⁴ the U.S. Court of Appeals for the Sixth Circuit overturned a Tax Court’s decision holding that excess contributions to Roth IRAs occurred. Family-controlled enterprises made payments to JC Export, a domestic international sales corporation (DISC). The DISC was owned by JC Holding, a taxable corporation. There were two equal owners of JC Holding: a Roth IRA of Clement C. Benenson and a Roth IRA of James Benenson III.

The Sixth Circuit found that because the DISC and the Roth IRAs were authorized by statute, the Tax Court erred in disregarding them for purposes of determining that the Roth IRA contribution limits were violated.

In contrast, the Roth IRAs in Block Developers, LLC v. Comm’r⁵ didn’t fare as well. Jan Jansson developed and obtained a patent on interlocking concrete blocks. He formed three corporations: Toy Rentals, to hold equipment; SR Products, for manufacturing and distribution; and SR designs, for sales. Jan continued to hold the patent. Block Developers LLC (Block) was formed to purchase the patents from Jan, securing his retirement and providing a source of cash replenishment for SR Products.

Jan, his wife and their two sons formed Roth IRAs, each funded with $2,000. Each Roth IRA bought a 23.75 percent interest in Block, and Jan’s attorney purchased the remaining 5 percent interest.

But, the Tax Court observed that $249,000 of the money that Block used to pay for the patents came from SR Products. Furthermore, SR Products allowed Block to offset that amount against its royalty payments owed to SR Products. The court also found that Block’s payments to SR Products weren’t consistent with billing statements. The end result was that SR Products provided all of the funds that found their way into the Roth IRAs, except for the initial Roth IRA contributions of $2,000 each. The court ultimately found “that Block Developers was just a conduit to shunt money to the Janssons’ Roth IRAs and was not engaged in any real business activity.” It therefore ruled that Block’s transfers to the Roth IRAs were excess contributions that triggered the excise tax the IRS was seeking.

Beneficiaries 

An attempt to change a beneficiary of an employee stock ownership plan and 401(k) retirement accounts subject to the Employee Retirement Income Security Act of 1984 (ERISA) was challenged and ultimately set aside in Arlene Ruiz v. Publix Super Markets, Inc.⁶ The method for changing beneficiary designations was set forth in the retirement plan’s summary description, which the court found was part of the retirement plan documents. 

In 2008, Irialeth Rizo named a nephew and two nieces as beneficiaries of her retirement accounts. In September 2011, she sent a letter and two cards in which she attempted to change the beneficiary to Arlene Ruiz. Written on the cards’ signature line was “as stated in letter.” The letter directed that Arlene be the beneficiary of 100 percent of the accounts. The letter was signed.

The court refused to read the documents together because, under ERISA, strict compliance, not substantial compliance, is required. The cards weren’t completed as required to change beneficiaries, and Arlene’s attempted change of beneficiaries therefore failed.

Late Rollovers 

John C. Trimmer, et ux. v. Comm’r⁷ involved a New York City police officer who suffered from a major depressive disorder and retired. He could no longer conduct his and his wife’s financial affairs and as such, failed to make a timely IRA rollover of funds distributed to him in 2011 from the New York City Employees’ Retirement System and the New York City Police Pension Fund.

John’s wife had no involvement in the couple’s financial affairs. Although she was aware he’d received payments of his retirement funds, she wasn’t aware that an IRA rollover might be needed. 

In 2012, John’s condition abated, and he met with his income tax preparer. Noting Form 1099-R reporting the distributions, the preparer advised John to open a rollover IRA and deposit the proceeds of his retirement distributions into that account. 

Based on information reporting by the retirement plans’ administrator, the IRS assessed underpayment of income taxes for 2011. John responded by letter, explaining his condition and asking for additional time to make the rollover. The IRS denied his request.

Noting that the IRC grants the IRS authority to waive the 60-day rollover requirement “where the failure to waive such requirement would be against equity or good conscience, including casualty, disaster, or other events beyond the reasonable control of the individual subject to such requirement,”⁸ the Tax Court held that the rollover was valid and reversed the IRS’ assessment.

Disability Payments 

Taylor v. Comm’r distinguishes taxable retirement income from non-taxable disability payments.⁹ Retired fireman Jack Howard Taylor served the City of Asheville, N.C. for nearly 24 years. After retiring because of disability, he began receiving payments from Local Governmental Employees’ Retirement System of North Carolina (LGERS). His payments were based on his age, length of service and average final compensation before his disability retirement occurred. After payments began, North Carolina Firemen and Rescue Squad Workers’ Pension Fund (FRSWPF) also began making pension payments to Jack.

Shortly after Jack turned 60, he was notified that, effective Sept. 1, 2004, he was being transferred from disability retirement to regular service retirement. Nevertheless, he continued to claim that his payments were exempt from income taxes as part of workmen’s compensation.¹⁰ 

During 2012, LGERS paid Jack $34,505; FRSWPF paid him $2,000. He characterized the payments as tax-free disability income, but the IRS disagreed.

The court concluded the payments made in 2012 weren’t excludible amounts received under IRC Section 104(a), relating to workmen’s compensation. Instead, the payments were taxable pension payments. The court took pains to acknowledge that, “[t]he fireman’s vocation is not an easy one. Petitioner fought fires for over 24 years and retired disabled. But Lady Justice is blind, and the tax law takes its toll without regard for sentiment.”

Spousal Rollovers

In Private Letter Ruling 201707001 (released Feb. 17, 2017), a deceased spouse’s IRAs and Roth IRAs were payable to a trust. The trust was to be divided between a survivor’s trust, holding property having a combined value of half of the couple’s assets, and two other trusts, together holding property having a combined value of half of the couple’s assets. One of those two other decedent’s share trusts, the bypass trust, was to be allocated the amount that could pass from the decedent free of estate taxes. The other decedent’s share trust, the marital trust, qualified for the estate tax marital deduction by making a qualified terminable interest property (QTIP) election. Provided an election was made to treat the marital share as a QTIP,¹¹ no federal estate taxes would be payable on the death of the first spouse.

The surviving spouse, as trustee, could decide which trust got which assets. She also had the power to take personal possession of any survivor’s trust property, but not the other two trusts. That meant that she could allocate IRAs to the survivor’s trust—and she did so, as to four Roth IRAs and a traditional IRA. She proposed to roll those over to a traditional IRA and Roth IRAs held solely in her name, and the IRS confirmed she could do so.

As a result, beginning with the calendar year following the year of the rollover, required minimum distributions (RMDs) from her rollover traditional IRA and her Roth IRA would be determined under rules applicable to an IRA or Roth IRA owner instead of those that apply to an IRA beneficiary. Thus, no lifetime Roth IRA distributions will be required. Traditional IRA RMDs will be based each year on her attained age and the RMD Uniform Table. While the ruling doesn’t specifically say so, when the wife dies, RMDs will be based on her designated beneficiary’s age.  

Sixty-Day Rollover Waived 

PLR 201737016 (June 21, 2017) involved an IRA owner’s attorney who held himself out as a tax and real estate specialist. Acting on her attorney’s suggestion, the IRA owner authorized the attorney to use IRA funds to purchase real estate and hold it in an IRA. Relying on the attorney’s instructions, the IRA owner wired funds from her IRA into a non-IRA escrow account of a title company. The attorney owned the title company.

The title company established a new escrow account through Trust Company F, and the attorney then transferred funds from the title company account to the escrow account.

The attorney then assisted the IRA owner in purchasing real estate, but the IRA was never recorded on the title. In addition, the settlement papers listed the purchaser of the properties as “Trust Company F as Custodian” for the benefit of the IRA owner, rather than for the benefit of the IRA. 

At that time, the IRA owner flew out of the country to help her ill mother. Between her “preoccupation with caring for her mother and her reliance on Attorney G,” the IRA owner wasn’t aware any issue had arisen until after the 60-day rollover period had lapsed. Sometime after that deadline, she became aware that there weren’t funds in the escrow account and that her attorney had been arrested and charged with multiple felonies for theft of trust assets. To make matters worse, the escrow company was insolvent.

The IRA owner requested an extension from the 60-day IRA rollover period, and the IRS granted that relief under IRC Section 408(d)(3)(I), because the funds withdrawn from the IRA had been used for no other purposes and because the failure to make a rollover within 60 days was due to mishandling of the transaction by her attorney.

Similarly, in PLR 201739017 (July 3, 2017), an IRA owner needed an extension of the 60-day IRA rollover period because three withdrawals were made without the IRA owner’s knowledge or consent. The thefts were committed by the IRA owner’s spouse. 

On learning of the thefts, the IRA owner instituted criminal charges against her spouse. She also requested an extension of the 60-day IRA rollover period. Because the funds withdrawn from the IRA had been stolen, the IRS waived the 60-day rollover requirement under Section 408(d)(3)(I).

In PLR 201742034 (July 24, 2017), the IRS granted a wife’s request for waiving the 60-day rollover requirement. Both the wife and her husband worked in his medical practice; both participated in a SEP-IRA plan. The wife filed for divorce. In violation of an injunction issued during the divorce proceedings, her husband informed her that he was closing his medical practice, thus terminating her employment. Before mediation proceedings began, the husband promised to provide his wife with funds to buy a residence. 

Believing that state law and her husband’s promise would result in a new residence, the wife withdrew IRA funds and purchased a residence with those funds. But, the husband didn’t fulfill his promise until a court issued an order requiring him to transfer funds from his SEP-IRA account to his wife’s account. By the time that transfer occurred, more than 60 days had lapsed. The wife sought and was granted a waiver of the 60-day rollover requirement.

Note that the husband didn’t get stuck with the tax bill. Although his transfer wasn’t a rollover to his own IRA, any transfer to a spouse or former spouse under a divorce or separation instrument isn’t a taxable distribution to the transferor.¹²  

Death of Stretch Distributions? 

As Congress looks for ways to finance tax reform, RMDs for non-spouse beneficiaries of employer-sponsored qualified retirement plans and IRAs could get curtailed or completely axed. That would do to America’s working middle class the very thing that many in Congress object to about the estate tax: reduce the value of inheritances.

Here’s a possible fix: Name a charitable remainder trust (CRT) as beneficiary of the retirement account. Funds held in a CRT aren’t subject to tax. Family members can then receive payments over their lifetimes, with income taxes being paid on each year’s distributions. But, to get those payments, at least 10 percent of the value passing to the CRT must pass to a qualifying charity.

For the charitably minded, it’s an easy move to make. Others may not find it as attractive. Advisors can make clients aware of the CRT opportunity and provide financial modeling comparing CRTs to the loss of RMDs. Remember to count the value passing to charity as money that isn’t going to the government.

Here’s a crude comparison. The value of a $500,000 IRA distributed immediately on death subject to 45 percent combined federal and state income taxes is worth $275,000. The value, net of 45 percent income taxes, of a lifetime unitrust interest paying 9.8 percent of the trust’s annual value to a beneficiary aged 50 is $247,129. The present value of the charity’s interest is $50,675. The combined value of the life beneficiary and the charity is $297,804.

But, if spreading the income over lifetime lowers the lifetime recipient’s effective income tax rate to, say, 33 percent, the present value of the lifetime payments is $301,048. The present value of the charity’s interest is still $50,675. The combined value of the life beneficiary and the charity is $351,723.              

Endnotes

1. Ozimkoski v. Commissioner, T.C. Memo. 2016-228 (Dec. 19, 2016).

2. Elaine v. Comm’r, T.C. Memo. 2017-3 (Jan. 3, 2017).

3. Kevin Cheves, et ux. v. Comm’r, T.C. Memo. 2017-22 (Jan. 30, 2017).

4. Summa Holdings, Inc. v. Comm’r, CA-6, No. 6476-12 (Feb. 16, 2017), rev’g. T.C. Memo. 2015-119 (June 29, 2015).

5. Block Developers, LLC v. Comm’r, T.C. Memo. 2017-142 (July 18, 2017).

6. Arlene Ruiz v. Publix Super Markets, Inc., No. 8:17-cv-735-T-24 TGW, DC M.D. Florida (March 30, 2017).

7. John C. Trimmer, et ux. v. Comm’r, No. 27238-14, 148 T.C. No. 14 (May 9, 2017).

8. Internal Revenue Code Section 408(d)(3)(I).

9. Taylor v. Comm’r, T.C. Memo. 2017-132 (July 5, 2017).

10. IRC Section 104(a).

11. IRC Section 2056(b)(7).

12. IRC Section 408(d)(6).

Let me start by answering the questions that I get asked most often when I start talking about cryonics—yes, Ted Williams was cryopreserved; no, Walt Disney wasn’t. No, I’m not worried about creating the zombie apocalypse. Yes, people really do this, and they’re not crazy. With an estimated 5,000 people as members of the various cryopreservation firms¹ and double-digit annual increases in membership, this is an issue about which more planners are going to be asked in the future. Let’s take a serious look at the planning process and how to provide for a client on being revived from cryopreservation.

Cryonics is the process by which a dying human being is preserved in the hope that scientific advancements will allow him to be revived in the future. Contrary to popular belief, the process isn’t simply to freeze the body or the head. The true process, called “vitrification,” uses a method of removing most of the water from cells, then reducing the temperature to the point where cellular activity ceases. The idea is that, one day, advances in medical technology will allow for the human being to be restored to life.  

When Does Death Occur? 

The Uniform Determination of Death Act provides that: “an individual who has sustained either (1) irreversible cessation of circulatory and respiratory functions, or (2) irreversible cessation of all functions of the entire brain, including the brain stem, is dead.” It further states that, “a determination of death must be made in accordance with accepted medical standards.” At present, it’s clear that a body that’s been cryopreserved will be treated as dead due to the complete cessation of bodily functions.  

To date, no one has disputed that cryonics patients are, in fact, dead. In Alcor Life Extension Foundation, Inc. v. Mitchell,² the issue was that the California Department of Health Services (CDHS) refused to issue death certificates and disposition certificates for bodies designated to pass to Alcor pursuant to the Uniform Anatomical Gift Act. The California Court of Appeals affirmed an injunction against the CDHS and compelled the agency to issue the certificates. Neither party in Mitchell asserted that the patients weren’t dead. The Mitchell court specifically raised many of the questions being addressed in this article, such as whether such a person is really dead, what happens to the estate and what happens if the person is successfully revived. The court, however, didn’t answer any of the questions, stating that, “we are confident that those persons who will then head our various branches of government will be far wiser than we and entirely capable of resolving such dilemmatic issues without our assistance.”³ Therefore, determination of death is likely to remain a simple matter for the cryopreserved. 

The Right to Dispose of Remains 

Almost all jurisdictions have adopted the Revised Uniform Anatomical Gift Act (RUAGA). Although cryopreservation is a bargained-for exchange of services, RUAGA should still govern.⁴ In Alcor Life Extension Foundation, Inc. v. Richardson,⁵ the Iowa Court of Appeals ruled that Alcor is an “appropriate person for research,” relying on the RUAGA Section 11 comment, which provides, “[A]n anatomical gift of a body for research or education can be made to a named organization. These gifts typically occur as the result of a whole body donation to a particular institution in the donor’s will or as the result of a prior arrangement between a donor and a particular research or educational institution.” Because cryopreservation constitutes a prior arrangement between the donor and the cryopreservation firm, clients shouldn’t have an issue providing for the disposition of their bodies to a cryopreservation facility. 

Typical Costs

It’s important for estate planners to have a basic understanding of the cost of cryonics when discussing it with interested clients. Although the comprehensive structure and variations in cost for cryopreservation are beyond the scope of this article, the prices range depending on whether a whole body preservation is sought (ranging from about $60,000 to $200,000) or a neurocryopreservation, that is, the head only (ranging from $40,000 to  $80,000). All of the companies allocate the fee among: (1) the costs of preservation; (2) the costs of maintaining cryopreservation (usually in the form of a common trust for all patients); and (3) the costs of medical standby and retrieval.   

Funding the costs of cryopreservation can be accomplished using a life insurance policy or simply by the transfer of funds. Ongoing membership dues may also be payable while the patient is alive. 

Saving for Revival 

In addition to the trust established for the care of the cryopreserved client during biostasis, attorneys must consider how to provide for clients when they’re revived. After all, no one would want to be revived only to find he had no money or other assets.

The future income trust (FIT) is designed as a solution to this problem. The FIT shouldn’t be the primary estate-planning vehicle in the estate plan. Rather, it should be separately funded—either directly during lifetime or by distribution from other estate-planning instruments (that is, life insurance, distribution from the revocable trust or by beneficiary designation).

During lifetime, the FIT is a simple revocable trust. To the extent assets are funded into the FIT, those assets would be subject to the same rules, and treated the same for tax purposes, as any other revocable trust. At legal death, the trust would become irrevocable.  

Material Purpose

To limit the possibility of premature termination of the FIT, include express language regarding the material purpose of the trust. Section 404 of the Uniform Trust Code (UTC) provides that, “A trust may be created only to the extent its purposes are lawful, not contrary to public policy, and possible to achieve.” This provision can’t be waived. The Restatement (Third) of Trusts (Restatement Third), Section 30 provides that, “If all of the purposes for which a private trust is created are or become impossible of accomplishment, the trust will be terminated.” The material purpose clause of the trust should address that the grantor believes the purpose will become possible; therefore, the trust shouldn’t be terminated due to impossibility. 

Because the FIT is a revocable trust during the grantor’s life, if the remaining assets of the client’s gross estate are insufficient to pay expenses of administration or taxes, the assets would be available to pay those items. An express provision that the assets of the FIT be used last is ideal. There’s a concern that the family may not wholly support the idea of funding the FIT to the exclusion of a trust for the benefit of the family, such that if the probate assets weren’t sufficient to cover administration expenses, the personal representative may seek to use the assets in the FIT prior to the assets that pass to the family. At minimum, a discussion about abatement is appropriate.  

Administration During Biostasis

Given that the FIT will likely be administered for over a century, there are a variety of options for its administration during the grantor’s biostasis. The first option is an accumulation trust, without any current distributions. The clear advantage of this trust is that its growth would be solely for the benefit of the settlor once revived. Although this is certainly possible, the likelihood of a challenge becomes greater, although surviving the challenge shouldn’t be a problem. The Restatement (Second) of Trusts, Section 62, comment (k), provides that enforcing a trust that vests at too remote a time may be a violation of public policy. Comment (l) provides, however, that as long as a definite beneficiary is ascertainable within the period of the rule against perpetuities, there’s a purpose. The Restatement Third, Section 29, comment (g) echoes this interpretation. As there will be a definite beneficiary within the applicable rule against perpetuities, the remoteness issue shouldn’t be a problem. There’s nothing to indicate that the trust would be deemed “capricious,” so that shouldn’t be a viable challenge either.⁶ Without a current beneficiary, a skeptical judge could rule that revival is impossible and terminate the trust. 

The second option is an accumulation trust with current distributions, either by reference to an ascertainable standard or by a percentage of assets (that is, a unitrust). This would clearly be allowed under current law. The trustee would be given discretion to make payments to the descendants or whomever else the settlor designated. This would resemble a standard dynasty trust, with the revived grantor becoming a beneficiary at a later date. The advantage of this option is that a challenge is less likely to occur, and if it does, it isn’t likely to be successful even with the most skeptical judge. The disadvantages, however, are numerous. One major disadvantage is that there would be a class of beneficiaries who have standing to object to the failure of the trustee to make distributions. Thus, although the validity of the trust itself won’t be an issue, a skeptical judge may order the trustee to make distributions that reduce the assets available to the settlor once revived, thereby impairing the growth of the assets for the benefit of the settlor. Furthermore, the administrative burden on the trustee would be much higher.

A third option is to draft a simple trust with payment of income only. While possible, this has all the disadvantages of an accumulation trust that allows for distributions. A fourth possibility is to use a charitable lead annuity trust, so that the FIT would have a current beneficiary.  

Duty to Account? 

UTC Section 105 allows for a trust instrument to restrict information to qualified beneficiaries; however, the duty to respond to requests from qualified beneficiaries for “trustee’s reports and other information reasonably related to the administration of a trust” can’t be waived.⁷ Given the breadth of the definition of “qualified beneficiary,” which includes all those beneficiaries who would be distributees if the trust were to terminate (UTC Section 103(13)(B)), the scope of the potential requests could be overwhelming. Of course, this assumes that the grantor elects to have the trust distributed to family and/or other specified beneficiaries should the trust terminate without a revival. To avoid this issue, the trust agreement could provide the trust protector with the ability to approve an accounting. 

From a tax standpoint, because the grantor is deceased, there should be nothing special about the tax status during the biostasis phase. The trust would be treated as any other irrevocable trust.

Administration During Revival Phase 

The trust agreement should define “revival.” The purpose of the revival language is to establish that, even if the revival is only mostly successful (that is, the settlor is brought back, but is incapacitated in some form), the terms of the trust still apply. Revival is likely to be determined by the trust protector or cryopreservation firm. In my discussions with corporate trustees, they’ve been very reluctant to make decisions about when to revive someone and whether the person is revived. As such, the trust agreement may need to be drafted to leave this decision to the trust protector.

Trust Protector

The role of the trust protector is greatly expanded in the FIT. The trust protector is in place to ensure that the grantor is placed in, maintained and revived from biostasis. Additional useful powers that the trust protector should have are: (1) trustee removal powers; (2) power to change domicile; and (3) general amendment powers. Given the expansive powers, including the power to approve accountings, a strong argument can be made that the trust protector be treated as a fiduciary, which isn’t the case under current law in many states.

Ongoing Trust After Revival

Although several types of trusts are possible here, the trust for the revived grantor should be a mandatory income, discretionary principal trust. Such a trust would allow the revived grantor access to the funds in the trust.  The reason for an ongoing trust, rather than an outright distribution upon revival, is twofold: (1) holding the assets in further trust allows for the possibility that the revival isn’t completely successful; and (2) to the extent possible, the revival trust wouldn’t be treated as a grantor trust, and therefore, not be subject to creditors’ claims. The revived grantor would then have a limited power of appointment at death (assuming a revived person will face death again).

There’s a question as to whether an asset protection trust might also make sense. If the determination is made that the revived grantor is legally the same person, an asset protection trust should solve any creditor issues (for creditors established by the revived person).

Status of the Revived Grantor 

Under current law, the status of the grantor prior to being revived is clear: The grantor is deceased. As discussed above, there’s nothing in the law that would give rise to an argument otherwise.  

The interesting issue, however, is what the status of the revived grantor would be. Is he a new “person?” The closest current analogy would be the treatment of an individual who was presumed dead under a disappearance statute⁸ and later found to be alive. This analogy, however, breaks down quickly. Under most existing law, a person found to be alive is revested with the property that was part of his estate.⁹ This isn’t a uniform result. But, because all of the reappearance cases are premised on the fact that the decedent was, in fact, not dead, the application is limited when compared to the cryonics situation, in which there’s no legal doubt under current law that the grantor is deceased. That is, under the reappearance cases, the presumed decedent wasn’t treated as a new “person,” nor should he be.  

Without some guidance from the legislature, the status of a revived grantor should be determined by the fact that such person was declared dead, the estate fully administered and all property rights were addressed.   

Tax Status 

The tax status of a revived grantor is undetermined. As expected, there’s currently nothing in the Internal Revenue Code that addresses this issue, so we can only speculate how the Internal Revenue Service might treat a revived grantor. On one hand, there’s a possibility that the IRS could consider a revived body as the same person, while instituting a statute of limitations to prevent such revived persons from filing any potential claim for refund. The more likely result is that the IRS wouldn’t accept the revived grantor as the same person because the IRS would challenge any claim that a cryopreserved individual wasn’t deceased. In fact, the Richardson and Mitchell cases don’t dispute the fact that a cryopreserved person is deceased. The grantor would thus be considered deceased and, as such, any estate taxes and final income taxes would be payable on legal death. That determination should also be applicable to pension plans, Social Security and life insurance. Any other treatment would result in significant chaos. As such, the conclusion should be that any person who’s revived should be treated as a new “person” for purposes of the IRC.  

The GST Issue  

Assuming that the revived grantor would be treated as a new person, the revived grantor would also be treated as an unrelated person for purposes of the generation-skipping transfer (GST) tax. This would be by default because the revived grantor couldn’t be assigned to a generation based on being a lineal descendant. The generation assignment from IRC Section 2651(d) would be determined by the time the grantor is revived. Assuming the grantor is revived more than 37.5 years after being placed in biostasis, the revived grantor would be treated as a skip person.

If instead, we assume that the revived grantor is the same person, there would be no GST tax issue at all. The trust agreement provides for permission to divide into exempt and non-exempt trusts, but nothing more. Depending on the variations of the trust during the biostasis phase, GST allocation may vary. Alternatively, there may be a legislative answer. If and when the science of cryonics catches up to the theory, legislatures will have to address these issues. In the meantime, the trust should be drafted under the assumption that the revived grantor won’t be treated as the grantor under state and federal law.                    

Endnotes

1. There are a few major companies in the cryopreservation market. The two largest are Alcor Life Extension Foundation, Inc. (www.alcor.org) and Cryonics Institute (www.cryonics.org). 

2. See Alcor Life Extension Foundation, Inc. v. Mitchell, 7 Cal.App.4th 1287 (1992).

3. Ibid., at p. 1293.

4. See Alcor Life Extension Foundation, Inc. v. Richardson, 785 N.W.2d 717 (Iowa App. 2010) (ruling that the Revised Uniform Anatomical Gift Act (RUAGA) allowed for Alcor to take possession of Richardson’s head and providing a very well articulated opinion regarding the application of RUAGA). RUAGA Section 11 provides that “an anatomical gift may be made to the following persons named in the document of gift: (1)…other appropriate person, for research or education.”

5. Ibid.

6. See also Restatement (Third) of Trusts, Section 30 regarding impossibility.

7. Uniform Trust Code Section 105(b)(9). 

8. For example, Uniform Probate Code Section 1107(5).  

9. See 140 A.L.R. 1403, “Administration of Estate of One the Fact of Whose Death Rests upon a Presumption or Circumstantial Evidence” (1942). 

Gridlock continued in Washington throughout most of last year. On inauguration day, the new administration put a freeze on new government regulations, which included the proposed regulations (proposed regs) under Internal Revenue Code Section 2704. Nearly nine months later, the Treasury proposed to withdraw the proposed regs as too burdensome on taxpayers. The formal freeze on regulations seemed to carry over informally to few valuation cases emerging from the courts. Also contributing to the uncertain environment in the trusts and estates community was the slow movement on tax reform and associated estate tax repeal. The administration’s outline for tax reform¹ wasn’t made public until late September; Congress released the initial version of legislation² in early November; and by early December, the House and Senate had passed their respective versions of tax reform legislation. No matter how skillful planners can be in drafting flexible plans for clients, it’s difficult to overcome the natural reaction of waiting until there’s some clarity on what the rules will be. Uncertainty will continue until the Congressional chambers reconcile the House version that provides for future estate tax repeal with the Senate version that doesn’t.

Withdrawn But Forgotten?

On Oct. 2, 2017, the Secretary of the Treasury recommended that proposed regs under IRC Section 2704 be withdrawn in their entirety.³ The proposed regs sought to restrict valuation discounts applicable to family-held businesses. The proposed regs were released in August 2016, followed by a 90-day period for comments and a Dec. 1, 2016 public hearing. The proposed regs attracted thousands of comments and a full slate of testifiers at the public hearing. We may never know how persuasive the comments and testimony were in the Treasury’s recommendation to withdraw because the intervening event of President Trump’s election victory in early November sealed the fate of these regulations.   

The proposed regs were crafted to eliminate or minimize valuation discounts in transfers of family businesses to other family members. The linchpin for the regulations was family attribution when family members had control. Much of the focus was on specific mechanisms to accomplish the objective of the proposed regs, such as a 50 percent ownership threshold among the family group, a 3-year look-back rule on transfers and a put right for a cash payout at pro rata value. A withdrawal of the proposed regs does away with these rules for Section 2704. However, the concept of family attribution may not die so readily.

Family attribution as addressed in the proposed regs is a workaround of the fair market value premise of a hypothetical willing buyer and seller. Before the proposed regs were released, the issue of family attribution was front and center in a federal estate tax deficiency case with approximately $1.2 million at stake. In Estate of Pulling,⁴ the estate had ownership interests in five contiguous parcels of land. The decedent owned three small parcels outright, and a land trust of which the decedent held a 28 percent interest owned two parcels. The sum value of the individual parcels was substantially less than the value of the five parcels when combined. The three parcels the estate owned were small and burdened by limited public right-of-way access. It wasn’t disputed that the value of the five parcels could be enhanced by consolidating them into a single property for residential development.

The attribution issue related to the land trust, which held the critical two parcels. The decedent owned a noncontrolling 28 percent interest in the land trust, but other members of his family held sufficient ownership interests to provide control. The Internal Revenue Service argued that the economic benefits of assembling the parcels and the ties among the owners of the land trust made it reasonably likely that such assemblage would occur and avail the estate of the higher value. The court found that, without specific evidence that family members would agree to combine the properties, “the mere fact that they are related to decedent is not enough.” Thus, the court concluded that the five parcels should be treated and valued as individual parcels, rather than as an assembled whole.

A withdrawal of the proposed regs isn’t a deterrent to the IRS arguing that clear economic benefits flow to a decedent’s interest and all parties if they agree to act as one in a family limited partnership (FLP) or limited liability company setting. This is a variation on automatic family attribution of interests called for in the proposed regs by inserting economic benefit as the focus to attack discounts applicable to standalone noncontrolling interests. The withdrawal of the proposed regs increases the degree of difficulty for the IRS in pursuing family attribution, but the issue lives on.

Cross Your T’s and Those of Others

Charitable contribution deductions continued to attract the attention of the IRS. Two easement cases were decided during 2017 with unfortunate results for the taxpayers. In both cases, the compliance failures under IRC Section 170 were those of the recipient or third parties rather than the taxpayer or the supporting appraisal.  

In RP Golf, LLC⁵ a conservation easement was the subject of the charitable contribution. RP Golf, LLC (RP Golf) was the sole member of National Golf Club of Kansas City LLC (National Golf), which held two golf courses it purchased and developed. In the purchase and development of the golf properties, RP Golf and National Golf entered into various loan agreements.  These agreements contained language that prohibited any oral modifications.

On Dec. 29, 2003, National Golf entered into an agreement to grant a conservation easement to a valid IRC Section 501(c)(3) organization, Platte County Land Trust (PLT). RP Golf took a $16.4 million conservation easement charitable deduction on its 2003 tax return.

On April 14, 2004, bank officers executed consents subordinating the interests of the two banks, approximately 100 days after the PLT agreement, and recorded the consents in the Platte County Recorder’s Office on April 15, 2004. Each consent states that the subordination was made effective as of Dec. 31, 2003, even though National Golf executed the PLT agreement on Dec. 29, 2003 and recorded it on Dec. 30, 2003.

The Tax Court ruled that written subordinations by lenders, issued within 100 days of a conservation easement charitable donation and legally enforceable as of the day after the donation, failed to comply with the strict requirements of Section 170 which, as interpreted by the courts, have held that such written documents of subordination must be dated and issued prior to any charitable conservation easement donation. The taxpayer wasn’t entitled to a deduction on its 2003 tax return for a qualified conservation easement. 

In Ten Twenty Six Investors,⁶ the taxpayers donated a façade easement of a warehouse to the National Architectural Trust, Inc. (NAT), a qualified Section 501(c)(3) organization under Section 170. Late in 2004, investors in the warehouse donated a façade easement and claimed an $11.355 million charitable deduction, which amount was determined by appraisal. All appeared well, until the IRS denied the deduction because NAT hadn’t recorded the deed in 2004. A representative of NAT accepted and signed the deed on Dec. 30, 2004. However, NAT didn’t record the deed until 2006. Because the deed wasn’t recorded until 2006, the IRS argued that the taxpayer couldn’t have taken a valid deduction for a charitable gift in 2004, determined a 40 percent gross valuation misstatement penalty under IRC Section 6662(a) and filed for summary judgment. 

In its decision, the court turned to New York law (NYECL Section 49-0305(4)), which stated, “An instrument for the purpose of creating, conveying, modifying or terminating a conservation easement shall not be effective unless recorded.” As a result, in 2004, the perpetuity requirements of Sections 170(h)(2)(C) and (5)(A) couldn’t have been satisfied because the façade conservation easement transfer wasn’t “effective” until it was recorded. The result was that no charitable deduction was permitted.

In easement cases, the appraisal is typically the primary focus of the IRS, and the issue is the amount of the deduction. Both of these 2017 cases were technical process matters in which compliance with the letter of the law was the linchpin. The result for the taxpayer in each case was the denial of any deduction rather than a reduced deduction. These cases provide a taxpayer with justification to micromanage when an easement charitable deduction is at stake.

Expanded Reach of Section 2036 

Typically, a bad facts IRC Section 2036 case isn’t particularly significant beyond the specific matter, but Estate of Powell⁷ is an exception. It was a full Tax Court case, and it expanded the reach of Section 2036 to a decedent that only held a limited partnership interest. 

In this case, a son, using a power of attorney for his mother, contributed approximately $10 million of cash and marketable securities on her behalf to an FLP in return for a 99 percent limited partner (LP) interest. Her two sons contributed promissory notes to the FLP for the 1 percent general partner (GP) interest. On the same day that the FLP was formed, the son transferred all of his mother’s LP interest to a charitable lead annuity trust with the remainder to the two sons. The mother died seven days after formation of the FLP.

The outcome of Powell resulting in the estate inclusion of the amount transferred on the mother’s behalf to the FLP wasn’t surprising in light of the deathbed aspects of the transfers and the apparent absence of non-tax purposes. The application of Section 2036(a)(2)⁸ is the noteworthy issue from the case. Finding that a decedent, in conjunction with other partners, could dissolve the partnership and control distributions, which led to gross estate inclusion, had previously only applied in the Strangi⁹ and Turner¹⁰ cases, in which a decedent’s interest also included some GP interest. In Powell, the decedent only had an LP interest and never owned a GP interest. The court’s decision regarding the application of Section 2036(a)(2) didn’t appear to be premised on the large LP percentage owned by the decedent or that there were only two other partners to act “in conjunction with.” Any LP interest, regardless of how small, can conceivably act “in conjunction with” the other partners to dissolve the partnership if Section 2036(a)(2) is broadly extended in the most unfavorable way for taxpayers.

From a valuation perspective, the court provided the mechanics as to how Section 2036 inclusion works with IRC Section 2043¹¹ inclusion to avoid double inclusion of the same asset. This has been a non-issue in previous Section 2036 inclusion decisions because by disregarding the FLP and bringing the undiscounted underlying assets into the estate, the full value of transferred assets are recognized under IRC Section 2033. Coming to the same result as taxing the underlying assets, the majority of the court chose to outline the mechanism for partial inclusion under Section 2033 and partial inclusion under Section 2043. Under Section 2036, the LP interest is recognized and is included in the estate with applicable valuation discounts. Then, under Section 2043, the difference in the value of the underlying assets transferred to the FLP less the discounted value of the LP interests is included in the estate.¹² 

In this situation, there were only seven days between formation of the FLP and the decedent’s death, and the parties agreed to disregard any change in the value of assets between the dates. The court observes in Footnote 7 of the opinion that the difference between the value in the estate by Section 2036 inclusion as compared with the two-pronged Section 2033 and Section 2043 approach proffered by the majority won’t avoid double inclusion if there’s appreciation in the assets between transfer and date of death.

Changes in the value of the transferred assets would affect the required inclusion because Section 2036(a) includes in the value of decedent’s gross estate the date-of-death value of those assets, while Section 2043(a) reduces the required inclusion by the value of the partnership interest on the date of the transfer. To the extent that any post-transfer increase in the value of the transferred assets is reflected in the value of the partnership interest the decedent received in return, the appreciation in the assets would generally be subject to a duplicative transfer tax. (Conversely, a post-transfer decrease in value would generally result in a duplicative reduction in transfer tax.)

Looking Forward 

At the time of this writing, it was likely that tax reform would be effective in 2018. However, the specific provisions for estate tax, corporate and personal tax rates and the implications for various valuation issues will remain uncertain until a reconciled version of tax reform is enacted. Much as 2017 experienced relative inactivity in Tax Court decisions involving valuation issues, the uncertainty surrounding tax reform has frozen developments in valuation.

The repeal of the federal estate tax is the foremost item of interest for the estate-planning community. The House-passed version of the Tax Cuts and Jobs Act provides for repeal of the estate tax and generation-skipping transfer tax as of Jan. 1, 2024 and immediately doubles the unified credit amount. The Senate-passed version also doubles the unified credit amount, but leaves the estate tax in place. Additionally, proposed changes in corporate income tax rates for both C corporations and S corporations (S corps) have the potential to alter the 18-year struggle over the appropriate gift and estate tax value of S corps. The enhanced value of S corps is premised on the difference in income tax rates experienced by S shareholders in comparison with C shareholders. Tax reform has the potential to increase, reduce or eliminate the rate gap benefits that S shareholders currently enjoy over C shareholders. At this time, it’s unknown where the comparative rates will settle, but for clients owning S corps or pass-through entities, changes in corporate and personal tax rates that emerge from the reconciliation process have the potential to significantly affect the valuation of their holdings independent of what happens to the federal estate tax.

The IRS has published the inflation-adjusted estate and gift tax exemptions for 2018.¹³ The basic exclusion amount for the unified credit against estate tax increases to $5.6 million (or $11.2 million for a married couple). Since both the House and Senate versions of tax reform provide for a doubling of the unified credit amount, it’s expected that the exemption will increase in 2018 to $11.2 million per person. For those individuals who have exhausted their existing credit amount, the doubling of the credit provides a new opportunity to make tax-free transfers of property. The annual exclusion for gifts will increase to $15,000 per person. In the recently released IRS priority guidance plan,¹⁴ there were only three items listed under “Gifts and Estates and Trust.” The priority guidance plan issued the prior year listed 12 items. Of interest in the current plan is a focus on Graegin loan issues with a priority of “Guidance under §2053 regarding personal guarantees and the application of present value concepts in determining the deductible amount of expenses and claims against the estate.”

Major tax reform legislation is an infrequent event in the United States and when it occurs, new planning opportunities surface. Tax reform is a catalyst for planning, which suggests robust opportunities in 2018.          

Endnotes

1. Unified Framework for Fixing Our Broken Tax Code, Sept. 27, 2017.

2. Tax Cuts and Jobs Act, H.R. 1, introduced on Nov. 2, 2017.

3. Identifying and Reducing Tax Regulatory Burdens, Executive Order 13789, Oct. 2, 2017.

4. Estate of John A. Pulling, Sr. v. Commissioner, T.C. Memo. 2015-134 (July 23, 2015).

5. RP Golf, LLC et al. v. Comm’r, No. 16-3277, 11th Circuit (June 26, 2017).

6. Ten Twenty Six Investors et al. v. Comm’r, T.C. Memo. 2017-115 (June 15, 2017).

7. Estate of Nancy H. Powell v. Comm’r, 148 T.C. No. 18 (May 18, 2017). 

8. Internal Revenue Code Section 2036(a)(2)—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.

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

10. Estate of Clyde W. Turner, Sr. v. Comm’r, T.C. Memo. 2011-209 (Aug. 30, 2011).

11. IRC Section 2043(a): “If any one of the transfers, trusts, interests, rights, or powers enumerated and described in sections 2035 to 2038, inclusive, and section 2041 is made, created, exercised, or relinquished for a consideration in money or money’s worth, but is not a bona fide sale for an adequate and full consideration in money or money’s worth, there shall be included in the gross estate only the excess of the fair market value at the time of death of the property otherwise to be included on account of such transaction, over the value of the consideration received therefor by the decedent.”

12. An example of the mechanism presented by the court: The decedent transfers $9.9 million of assets into the family limited partnership (FLP) in exchange for a 99 percent limited partner (LP) interest valued at $7.425 million (incorporating a 25 percent discount). The value of the LP interest in the estate is
$7.425 million under IRC Section 2033. Section 2043 picks up $2.475 million that represents the excess in value of the $9.9 million transferred to the FLP and the $7.425 million LP interest received in exchange. The combined
$7.425 million under Section 2033 and the $2.475 million under Section 2043 equals $9.9 million or the same result as if the FLP were disregarded, and the underlying assets transferred were returned to the estate. 

13. Revenue Procedure 2017-58.

14. Department of the Treasury 2017-2018 Priority Guidance Plan (Oct. 20, 2017).

State legislatures have been very busy on a number of trust- and estate-related fronts. Here’s an update on some key planning developments across the country, through Nov. 15, 2017.

Estate and Gift Tax 

To be more competitive, some jurisdictions with separate estate taxes have been increasing the amount that’s exempt from state estate taxes or even phasing out their estate or inheritance taxes. What happens at the federal level will be key in determining the trickle-down effect for those states that tie their exemption amounts to the federal exemption. If the federal exemption amount doubles (or is repealed) and the intent wasn’t to mimic such a dramatic change in the state exemption amount, it’s likely that state legislatures will need to act. Here’s some of the latest state-level activity:

Connecticut. Connecticut remains the only jurisdiction in the country with a true gift tax. Connecticut had a $2 million gift and estate tax exemption amount in 2017.¹ On Oct. 31, 2017, Governor Daniel P. Malloy signed the state’s budget into law, increasing the estate and gift tax exemption amount to $2.6 million for those dying on or after Jan. 1, 2018 and to $3.6 million for those dying on or after Jan. 1, 2019.² In 2020, the exemption amount will match the federal exemption, and legislative action will be necessary to decouple. More importantly for planning purposes, Connecticut doesn’t impose a tax on gifts of tangible or real property located outside the state.³ The new legislation⁴ also provides for a $15 million estate and gift tax cap effective Jan. 1, 2019, meaning no further estate or gift tax will be owed once the cap is reached. This cap reduces the current legislative cap of $20 million.⁵ Using current rates, the new cap will generally kick in for estates exceeding $130 million (the old cap applied to estates exceeding $170.5 million). For a nonresident decedent who owns real or tangible property in Connecticut, beware that the state can impose an estate tax on that Connecticut property, even if the value of the property is less than the state exemption amount. This is due to the fractional tax apportionment computation. The amount of tax due is computed as if the decedent was a resident of the state, multiplied by a fraction equal to the percentage of estate property located in Connecticut.⁶ For example, if the nonresident decedent owned real property located in Connecticut that was valued at 10 percent of the size of the entire estate, the tax payable will be 10 percent of the tax that would have been payable had the decedent been a Connecticut resident. Connecticut also imposes a 0.5 percent probate fee on all estate assets over $2 million.⁷ The probate fee can’t be avoided even if an individual has no probate property, because the fee is imposed on the taxable estate. For estates of individuals dying on or after July 1, 2016, a $40,000 probate cap applies, which freezes the fee for estates over $8.877 million.⁸ 

Delaware. On July 2, 2017, Gov. John Carney Jr. enacted legislation that repeals the estate tax, effective for individuals dying after Dec. 31, 2017.⁹ The repeal of the Delaware estate tax also benefits out-of-state residents who own real or tangible property located in Delaware. Previously, the estate of a nonresident who owned a vacation home in Delaware could have been liable to pay Delaware estate tax. Additionally, Delaware has become a favored jurisdiction in which to store artwork, due in part to the absence of a sales tax. Delaware will likely become even more attractive in this regard, as nonresidents won’t owe a Delaware estate tax if they die while owning tangible property physically located in the state. 

District of Columbia. Following recommendations issued by the D.C. Tax Revision Commission in February 2014, this jurisdiction’s current $1 million exemption was slated to increase to $2 million as early as Jan. 1, 2016 and then to match the federal exemption if certain revenue surplus targets were met.¹⁰ The revenue targets that would have triggered the increase to $2 million in 2016 weren’t met, so the $1 million exemption remained in effect for that year. As a result of revenues raised in 2016, the exemption amount increased to $2 million in 2017. The 2018 budget bill,¹¹ projected to become law on Dec. 9, 2017, aligns the D.C. estate tax exemption with the federal estate tax exemption effective Jan. 1, 2018 for decedents dying after Dec. 31, 2017. 

Hawaii. This state’s exemption amount is linked to the federal exemption amount. 

Maine. For individuals dying on or after Jan. 1, 2016, Maine’s estate tax exemption is linked to the federal exemption.¹²

Maryland. On May 15, 2014, this state increased its estate exemption amount from $1 million in 2014 to $1.5 million in 2015, $2 million in 2016, $3 million in 2017 and $4 million in 2018.¹³ Beginning in 2019, the state exemption amount will be linked with the federal exemption amount. In addition, Maryland continues to impose an inheritance tax of 10 percent, which is triggered based on the relationship of the decedent to a beneficiary.

Minnesota. As part of a larger bill signed into law on March 21, 2014,¹⁴ this state increased the estate tax exemption amount in 2014 from $1 million to $1.2 million, to be increased by $200,000 annually until 2018, when it would reach $2 million, where it was slated to remain. However, Gov. Mark Dayton signed legislation on May 30, 2017 that further increases these exemption amounts to: $2.1 million for decedents dying in 2017; $2.4 million for decedents dying in 2018; $2.7 million for decedents dying in 2019; and $3 million for decedents dying in 2020 and thereafter.¹⁵ 

New Jersey. This state is phasing out its estate tax over two years.¹⁶ Specifically, for individuals dying after Jan. 1, 2017, the exemption amount increased from $675,000 to $2 million, and the estate tax is fully repealed for those dying after Jan. 1, 2018. Note, however, that New Jersey still imposes an inheritance tax at rates between 11 percent and 16 percent.

Some practitioners have expressed skepticism that the estate tax will remain repealed. 

New York. As a result of enacting the Executive Budget on March 31, 2014, New York increased its exemption amount from $1 million to $2,062,500 for those dying on or after April 1, 2014, to $3.125 million for those dying on or after April 1, 2015, to $4,187,500 for those dying on or after April 1, 2016 and to $5.25 million for those dying on or after April 1, 2017 and on or before Dec. 31, 2018. For those dying on or after Jan. 1, 2019, state and federal exemption amounts will be linked to the 2010 federal exemption amount of $5 million, as indexed for inflation, so a potential doubling of the federal amount won’t affect the New York exemption amount.¹⁷ However, the New York estate tax regime has a built-in “cliff:”¹⁸ Only estates that are less than or equal to the exemption amount on the date of death will pay no tax; for those estates that are between 100 percent and 105 percent of the exemption amount, there’s a rapid phase-out of the exemption; and those estates that exceed 105 percent of the exemption amount will lose the benefit of the exemption amount entirely and be subject to tax from dollar one. Note, however, that nonresidents who own real or tangible property located in New York won’t owe any New York estate tax if the value of their New York property is below the New York exemption amount at the date of death. There’s no longer a requirement to calculate the estate tax as if the nonresident was a resident and apportion the tax based on the percentage of property located in the state. 

On the income tax front, however, New York Tax Law Section 631 imposes a personal income tax on a nonresident’s New York source income. New York source income is defined to include gains from the sale of real property or co-operative apartment interests located in New York.¹⁹ Real property located in the state was further defined to include interests in certain legal entities²⁰ if the value of the real property located in New York was at least 50 percent of the entity’s value.²¹ Notably, this rule omitted co-operative apartment shares from the definition of real property, thereby enabling a nonresident to exclude from source income the gain from the sale of a New York co-operative apartment that was held in an entity. As a result of legislation enacted on April 10, 2017,²² as part of New York’s 2017-18 Executive Budget, if more than 50 percent of an entity’s value consists of co-operative apartment shares, gains from the sale of an ownership interest in that entity will be taxable to a nonresident as source income.   

Rhode Island. Pursuant to a law signed on June 19, 2014, this state increased its estate tax exemption amount to $1.5 million in 2015, indexed for inflation.²³ For 2017, the estate tax exemption amount increased to $1,515,156.

Washington State. There’s a $2 million exemption, indexed for inflation, which was $2.129 million in 2017.

Use it or lose it! Portability—the ability of one spouse to pass the unused exemption amount to the survivor—generally isn’t available at the state level. That means state exemption amounts are usually use-it-or-lose-it propositions. If one spouse simply leaves everything to the other, the exemption of the first to die is wasted. If state exemption amounts dramatically rise as a result of being linked to an increased federal exemption amount, the state amount that potentially will be wasted if not used also dramatically increases.

Beware of formula bequests for tax reasons. With the proposals to double the federal exemption amounts, the gap between state and federal exemption amounts could potentially widen significantly. In those jurisdictions where the federal exemption exceeds the state exemption, care must be taken in pegging a credit shelter bequest to take advantage of the full federal exemption. In New York, for instance, the combination of the disparity between state and federal exemption amounts and the cliff effect might trigger substantial state taxes. For example, if the New York exemption is $5.25 million, a credit shelter disposition of the state exemption amount wouldn’t generate any New York tax. However, if the credit shelter disposition was tied to a federal exemption amount of $11.2 million, that would generate a state estate tax of over $1.25 million. One solution to avoid this result is to define a formula credit shelter bequest to mean the maximum amount that can pass free of both federal and state taxes. 

Beware of formula bequests for dispositive reasons. In states that have rising exemption amounts, a formula bequest pegged to the state exemption amount may produce distorted results if the state exemption amount has risen beyond what was originally envisioned. Clearly, the dispositive distortion will become magnified if estate tax exemption amounts double. In New Jersey, for example, a formula bequest pegged to the largest amount that can pass free of state estate taxes would have produced a bequest of $675,000 in 2016, a bequest of $2 million in 2017 and a bequest of the entire estate in 2018 when the New Jersey estate tax is slated to be eliminated. 

Flexibility Is Key

The bottom line is that building flexibility into plans to deal with a variety of outcomes is the key. Even if changes are made to federal tax laws, the permanence of any changes can’t be predicted with any confidence.

Flexibly drafted documents. Many practitioners now rely on techniques that maximize flexibility after death, enabling family and fiduciaries to make a post-mortem determination regarding trust funding amounts. Some of these techniques include:

• Disclaimer trusts: The first spouse to die leaves everything outright to the survivor, who can disclaim an appropriate amount, considering the tax laws, amount of wealth, family situation and specific needs, into a disclaimer marital and/or credit shelter trust.
• Partial qualified terminable interest property election: The first spouse to die leaves assets to the survivor in a QTIP marital trust, and the fiduciary can make a partial QTIP election to use the exclusion amount of the first spouse to die. Because the trust must be drafted to qualify for the marital deduction, there isn’t any ability in this scenario to accumulate income or make distributions to any beneficiaries other than the spouse. However, the trust can be invested to maximize growth if the spouse doesn’t require a high income yield.
• Clayton QTIP: The first spouse to die provides that the estate is eligible to pass into a QTIP marital trust, but only if the executor makes a QTIP election. To the extent the QTIP election isn’t made, property typically passes into a credit shelter trust. To avoid adverse tax consequences, practitioners generally recommend that a Clayton QTIP election be made by a fiduciary other than the surviving spouse, often an independent corporate trustee.

Decanting. There’s been continued state-level activity regarding “decanting,” which allows the trustee of an otherwise irrevocable trust potentially to appoint the trust assets into a new trust with different terms. The rationale behind decanting is that, if a trustee has the ability to make discretionary distributions to or for the benefit of a beneficiary, the trustee should also be permitted to exercise that discretion to distribute trust assets into another trust for that beneficiary. More than half the states now have statutory authority to decant trusts. 

Some states have adopted the Uniform Trust Decanting Act, which creates a complete model set of rules intended to allow decanting for appropriate purposes, while preventing abuse. Since its promulgation in July 2015, Colorado,²⁴ New Mexico,²⁵ North Carolina,²⁶ Virginia²⁷ and Washington²⁸ have enacted the UTDA. The legislation has been introduced in Illinois²⁹ and Nevada.³⁰ Under the UTDA, how broadly a trustee can exercise a decanting power depends on the breadth of the trustee’s discretionary distribution power. The UTDA bifurcates a trustee’s discretion into two categories: limited or expansive. Limited distributive discretion is subject to an ascertainable standard or reasonably definite standard. Under the UTDA, this standard requires the trustee to decant so that each beneficiary’s interest is “substantially similar” in the second trust. Accordingly, limited discretion usually allows only for administrative, not dispositive, changes. UTDA provides broader rules for decanting under an expanded distributive discretion. For example, although the fiduciary may not add new beneficiaries or eliminate vested interests, the fiduciary may grant a power of appointment to a beneficiary of the second trust that’s exercisable among a class of permissible appointees that’s broader or different from beneficiaries of the first trust. Further, the fiduciary can also remove beneficiaries, omit POAs and eliminate rights that aren’t vested interests. Court approval of a decanting isn’t required, nor is beneficiary consent, but there’s a 60-day notice requirement to interested persons. 

Decanting can be an invaluable tool for trustees in dealing with changed circumstances, correcting mistakes or optimizing a trust’s administration. 

Indeed, in a case decided in Connecticut last August, Ferri v. Powell-Ferri and Powell-Ferri v. Ferri,³¹ a trust created for the benefit of a husband was decanted into a new trust with different terms, putting the trust assets (valued between $69 million to $98 million) out of reach of the divorcing wife, though the trust assets were considered for alimony purposes. The decanting was successful even though the husband had a right to request 75 percent of the trust assets under the terms of the original trust and, during the course of the legal proceedings, his right matured to 100 percent. The new trust into which the assets were decanted extinguished the husband’s power to request trust assets at stated ages, making distributions solely discretionary with the trustees. The trusts were settled in Massachusetts, and the wife had filed to dissolve the marriage in Connecticut. The Connecticut Supreme Court asked the Supreme Judicial Court of Massachusetts to determine whether the trustees, one of whom was the husband’s brother, validly exercised their powers under the original trust to distribute the trust property to the new trust. The SJC determined that decanting was authorized under the trust instrument. According to the SJC, because the husband’s father, who created the original trust, intended to convey to the trustees almost unlimited discretion to act, the conclusion that he intended to authorize decanting seemed to follow necessarily. The Connecticut Supreme Court adopted the opinion of the Massachusetts SJC and held that the decanting was proper. It was important that the decanting occurred without the husband’s permission, knowledge or consent. Query if the same result would follow if a beneficiary was given notice of the decanting, or whether notice alone wouldn’t detract from the Connecticut Supreme Court’s holding that the husband took “no active role in planning, funding or creating the 2011 Trust” (emphasis added). Including decanting provisions in trust instruments may maximize flexibility without resort to state default law.

Indeed, many practitioners include their own decanting provisions in their trust documents, tailored to the desires of the trust creator, so there’s no need to rely on state default law. In a recent New York case, In re Hoppenstein,³² the trustees successfully relied on their powers under a trust document to distribute a life insurance policy on the settlor’s life to a new trust that excluded an estranged daughter of the settlor and her issue. Dismissing an objection that the transfer didn’t satisfy the requirements of the New York decanting statute, the Court held that the New York decanting statute had no bearing on the case because the trustees relied on their powers under the document to effectuate a transfer.

Gifting via trusts with flexible terms. Gifting is a strategy that remains attractive. If the federal gift tax exemption does double, that will create added incentive for some to make significant lifetime gifts.

Many people are choosing to fund irrevocable trusts up to the federal gift tax exclusion amount to facilitate their succession planning goals, while building in flexible terms, designed to adapt to possible future tax regimes. Generation-skipping transfer tax exemption can also be allocated to these trusts to protect against the future imposition of those taxes, potentially in perpetuity in jurisdictions like Delaware that permit perpetual trusts. The trust can be drafted flexibly to allow the trust assets to remain outside the creator’s estate and minimize estate tax or be included back in the creator’s estate if a step-up in basis is preferred. The power for the creator to substitute existing trust assets with other assets can maximize this type of basis versus estate tax consideration. The power to substitute assets would also potentially make the trust a so-called grantor trust, which is taxable to the trust’s creator. This enables the trust to essentially grow tax-free for the trust beneficiaries, who are relieved of the tax burden, significantly magnifying the value of the transfer to family members. Grantor trust status also allows the grantor to engage in sale or other transactions with the trust without gain recognition. In addition, with inheritances often delayed due to much longer life expectancies nowadays, many people find pleasure in transferring assets to family members while they’re still around to watch their family enjoy use of those assets. 

Many individuals choose to set up these trusts under Delaware law. Some of the reasons Delaware is often a jurisdiction of choice include:

• Directed trusts: The settlor may continue to control the trust’s investments, often particularly attractive for business owners, who want the benefit of trust planning while continuing to manage their businesses.
• Tax advantages: The trust might avoid state income taxes on accumulated income and capital gains.
• “Quiet” trusts: You can restrict beneficiary access to information under certain circumstances.
• Delaware “tax trap”: More aptly named the Delaware tax “opportunity,” this gives the donee of a non-general POA the option of exercising the power to produce a stepped-up income tax basis.
• Asset protection: Delaware trusts can be designed to protect trust assets from creditors, even if the settlor is a beneficiary of the trust.
• Unlimited duration: You can create perpetual dynasty trusts that may be exempt from federal gift and estate taxes, allowing the settlor to create a legacy for generations to come.
• Investment flexibility: Trustees have broad flexibility in selecting investment vehicles.
  Pre-mortem validation procedure: The trust can be validated before death, with the goal of precluding a contest after death, allowing the person who created the trust to defend the plan while alive.
• Confidentiality: Delaware courts are sensitive to a grantor’s right to confidentiality and don’t require some of the court filings required in other jurisdictions.
• Court system: Delaware’s Court of Chancery has over 200 years of history developing legal precedent in trust and corporate law.

Delaware trusts are increasingly popular with multi-national families to bring family wealth into the United States for future generations or prior to immigration. They’re also used to hold real estate or tangible personal property to escape federal estate taxes that may apply if nonresident aliens hold this property directly.

Children Conceived After Death 

With advances in medical technology, a child can be conceived with stored genetic material after the death of one or both of the child’s genetic parents. 

As state legislatures struggle to keep pace with an area in which technology has fast outpaced the law, we’re confronted with the question: How should posthumously conceived children, or PCC, be treated for inheritance, intestacy and other purposes? Intestacy statutes drafted long before the new technologies could have been contemplated are often ambiguous in this context. Competing interests clash: those of the children born of these new technologies and those of existing beneficiaries in certainty and finality. To strike a balance, many jurisdictions have responded with legislation that requires an individual to consent to posthumous reproduction specifically, and some impose time limits within which a child must be conceived or born after death. Those time periods typically range from requiring birth within one to four years after death.³³

To date, 26 states³⁴ have enacted statutes dealing with those conceived posthumously. 

Here are the latest developments for 2017:

Illinois. On Aug. 11, 2017,³⁵ this state enacted a law that permits a child who wasn’t in utero at the decedent’s death to inherit in intestacy if all of the following conditions are met:

1. The child is born of the decedent’s gametes.

2. The child is born within 36 months of the decedent’s death.

3. The decedent had provided written consent to be a parent of any child born of such gametes posthumously.

4. The administrator of the estate receives notice within six months of the decedent’s death from the person to whom such consent applies that: (a) decedent’s gametes exist; (b) the person has the intent to use the gametes so that a child could be born within 36 months of the decedent’s death; and (c) the person has the intent to raise any child as his own.

For the purpose of determining the property rights of any person under an instrument, the law provides that a child in utero at the time of a decedent’s death is entitled to inherit unless a contrary intent is evident. For those not in utero at the time of death to inherit under an instrument, one of the following conditions must be met: 

1. The intent to include the child is demonstrated by clear and convincing evidence; or 

2.  The fiduciary or other property holder, in good faith, treated the child as the decedent’s for purposes of a property division or distribution made before Jan. 1, 2018.

Ohio. Ohio’s statute, which dated back to 1953, provided that descendants of an intestate “begotten” before the intestate’s death, but born after the intestate’s death, would inherit as if born during the intestate’s lifetime; but in no other case could a person inherit unless living at the time of the death of the intestate. While 1953 obviously predates posthumous conception technology, Ohio’s statute was amended in 2012 to make it gender neutral, without amending its substance. However, this state passed legislation on Dec. 13, 2016, which, effective as of March 14, 2017,³⁶ amends the substance of this statute by providing that “[n]o descendant of an intestate shall inherit ... unless born within three hundred days after the death of the intestate and living for at least one hundred twenty hours after birth.” It also provides that when a decedent dies testate, the decedent’s will must specifically provide for any child born more than 300 days after the decedent’s death. That heir can inherit only if born within one year and 300 days from the decedent’s date of death. A separate provision applies to trusts, the exercise of a POA or any other power to expand the class of beneficiaries under a trust instrument. A PCC born more than 300 days after the death of the settlor won’t be considered the settlor’s child under the trust agreement or the exercise of a POA unless the terms of the trust clearly provide otherwise. The settlor can select a time period within which the PCC must be born to benefit from the trust, subject to a maximum period of five years. If the trust doesn’t provide for a specific time period, the PCC must be born within one year and 300 days.

Planning considerations in light of rapidly advancing technology. As assisted reproductive technology continues to advance and become more widespread, practitioners might consider incorporating these suggestions in their practices:

Advise clients with stored genetic material to properly document their intent regarding use of that material posthumously, or in the event of divorce, including in the agreement the fertility clinic, estate planning documents and other memoranda.

Consider drafting specific provisions to address how a client wants to treat PCC. Many states have no laws regarding the inheritance rights of PCC. Even if there’s a relevant statute, clients may wish to modify the statutory default provisions. Some may wish to exclude PCC; others may want to include them subject to certain conditions, such as specific consent to posthumous reproduction, a time frame within which birth must occur, birth to a surviving spouse or life partner and proof of maternity or paternity.

Remember that provisions governing PCC can be applicable both to the testator/grantor and to the descendants. Even if not applicable to a given client’s situation, the client’s descendants may use reproductive technology. In the context of a dynasty trust, for example, set up to last for future generations when available technologies can’t currently be contemplated, it will be important to define the class of potential beneficiaries.
Digital Assets 

As technology continues to expand, the ownership, transfer and disposition of digital assets present unique challenges. Family members can face many hurdles in unlocking a decedent’s digital information, which can include social media accounts, email accounts and other personal and financial accounts. Practical obstacles include retrieving confidential user IDs and passwords. Establishing rights to access that information is complicated by Terms of Service agreements with individual providers, which typically are entered into by clicking “I agree” on account opening. The TOS agreements usually govern the fate of an account upon the owner’s death. They can provide that all rights to the account cease on death and that all data will be deleted. State and federal privacy laws and laws that criminalize unauthorized access to computers and prohibit the release of electronic account information present further obstacles.³⁷ The Uniform Law Commission approved a revised Uniform Fiduciary Access to Digital Assets Act,³⁸ on July 15, 2015, that uses a three-tiered approach:

I. Directions given via an online tool provided by a custodian that can be modified or deleted at all times prevail over any other direction in a will, trust, power of attorney or other record; 

2. In the absence of availability or use of an online tool, a user’s direction in a will, trust, power of attorney or other records prevails; and

3. In the absence of any direction, the TOS agreement controls.

RUFADAA has been introduced or enacted in at least 49 jurisdictions. The following jurisdictions have enacted some version of RUFADAA: Alabama,³⁹ Alaska,⁴⁰ Arizona,⁴¹ Arkansas,⁴² California,⁴³ Colorado,⁴⁴ Connecticut,⁴⁵ Florida,⁴⁶ Hawaii,⁴⁷ Idaho,⁴⁸ Illinois,⁴⁹ Indiana,⁵⁰ Iowa,⁵¹ Kansas,⁵² Maryland,⁵³ Michigan,⁵⁴ Minnesota,⁵⁵ Mississippi,⁵⁶ Montana,⁵⁷ Nebraska,⁵⁸ Nevada,⁵⁹ New Mexico,⁶⁰ New Jersey,⁶¹ New York,⁶² North Carolina,⁶³ North Dakota,⁶⁴ Ohio,⁶⁵ Oregon,⁶⁶ South Carolina,⁶⁷ South Dakota,⁶⁸ Tennessee,⁶⁹ Texas,⁷⁰ Utah,⁷¹ Vermont,⁷² Virginia,⁷³ Washington,⁷⁴ Wisconsin⁷⁵ and Wyoming.⁷⁶ Jurisdictions where RUFADAA has been introduced include: Georgia,⁷⁷ Louisiana,⁷⁸ Maine,⁷⁹ Massachusetts,⁸⁰ Missouri,⁸¹ New Hampshire,⁸² Oklahoma,⁸³ Pennsylvania,⁸⁴ Rhode Island,⁸⁵ Washington, D.C.⁸⁶ and West Virginia.⁸⁷

Advisors should consider speaking with clients about their digital assets, in particular:

1. Creating inventories of electronic data, with log-in IDs and passwords. 

2. Ensuring the inventories are stored in a secure and private location and are kept up-to-date.

3. Using providers’ online tools regarding disclosure of digital information, such as Google’s “Inactive Account Manager” or Facebook’s “Legacy Contacts.” Although these tools require individuals to give separate directions to each custodian, RUFADAA defers first to the direction given via a custodian’s own online option.

4. As to the critical second-tier direction that will be respected if an online tool isn’t available or used, including provisions in: (a) wills and trust agreements that expressly deal with disposition of and access to digital assets and (b) powers of attorney regarding access to digital assets, including content, if that’s desired.

Power to Adjust/Unitrust Regimes 

The precepts of the prudent investor rule govern the investment of trust assets. Pursuant to those precepts, a trustee is required to invest for “total return.” That is, a trustee is required to invest in a way that benefits both income and principal beneficiaries. However, when beneficial interests clash, the source of return becomes critical, and the tension between investing for income and investing for growth can become more pronounced. Fortunately, the power to adjust and unitrust regimes provide trustees with the means to implement the mandate of total return investing, in effect, by preempting the definition of fiduciary accounting income. Under a power to adjust regime, the trustee is permitted to make adjustments between income and principal to be fair and reasonable to all beneficiaries. Under the unitrust regime, the trustee can convert the income beneficiary’s interest into a unitrust payout of a fixed percentage of the trust’s principal.  

Until 2017, every state, except North Dakota, had enacted one or both of these regimes. On March 21, 2017, North Dakota enacted power to adjust and unitrust legislation.⁸⁸ Under the power to adjust regime, a trustee may adjust between income and principal if the trustee is managing the assets pursuant to the prudent investor rule, the terms of the trust describe the amount that may or must be distributed to a beneficiary by referring to the trust’s income and the trustee determines he can’t administer the trust impartially without making an adjustment. Under the unitrust regime, a payout between 3 percent and 5 percent is permissible.

Every jurisdiction in the country now has some form of total return legislation, and every trustee and advisor should be aware of these powerful tools.  

A trustee’s ability to allocate capital gains to income has become increasingly important, given the rise in capital gains tax rates, including the 3.8 percent tax on undistributed income, which includes realized capital gains. To achieve reasonable and impartial results, a trustee must be able effectively to determine whether to tax gains to the income beneficiaries or the trust. A proposal pending in New York⁸⁹ clarifies that a trustee can, in a reasonable and impartial exercise of discretion, allocate gains to income when exercising the power to adjust. The power to do so would apply when the trustee is investing for total return pursuant to the power to adjust,⁹⁰ or if the trustee has unlimited discretionary power to distribute principal, which in effect permits total return investing because the power to distribute principal can be used in a similar manner as the power to adjust. A Nevada⁹¹ law permits gains to be taxed to income that’s been increased by an adjustment from principal to income, a unitrust distribution or a distribution of principal to a beneficiary.

Portability 

With federal portability, a deceased spouse’s executor can transfer the deceased’s unused exemption amount to the surviving spouse. Hawaii appears to be the only state that allows portability of the state exemption amount.⁹² Portability in Hawaii applies only to individuals dying after Jan. 25, 2012 if the personal representative of the predeceased spouse files a Hawaii estate tax return.⁹³ Maryland’s estate tax exemption will be portable, beginning in 2019.⁹⁴ Illinois,⁹⁵ Massachusetts⁹⁶ and Rhode Island⁹⁷ currently have portability proposals pending. 

The author would like to thank her colleague Alex E. Waxenberg, a private client advisor at Wilmington Trust, N.A. in New York, for his assistance with this article.

This article is for general information only and isn’t intended as an offer or solicitation for the sale of any financial product, service or other professional advice. Wilmington Trust is a registered service mark. Wilmington Trust is a wholly owned subsidiary of M&T Bank Corporation.

Endnotes

1. CT. Gen. Stat. §§ 12-391(d)(1)(D), 12-391(e)(1)(C).

2. CT. SB 1502 (2017).

3. CT. Gen. Stat. § 12-641.

4. CT. SB 1502 (2017).

5. Connecticut HB 7061 (2015).

6. CT. SB 1502 (2017) § (e)(1)(D).

7. CT. Gen. Stat. § 45a-107.

8. CT. Gen. Stat. § 45a-107(b)(2).

9. Delaware HB 16 (2017).

10. See www.dcfpi.org/wp-content/uploads/2014/03/Tax-toolkit-FY-2015-budget-Approved.pdf.

11. District of Columbia LB 244 (2017).

12. 36 MRSA § 4102, sub-§ 5. 

13. Md. Tax Code § 7-309(b)(3)(i).

14. Minnesota HF 1777 (2014).

15. Minn. 1st Sp. Sess. Ch. 1 (H.F.1).

16. N.J. P.L. Ch. 57 and N.J. P.L. Ch. 56.

18. N.Y. Tax Law § 952(c)(2)(A).

17. N.Y. Tax Law § 952(c)(1).

19. N.Y. Tax Law § 631(b).

20. This includes an interest in a partnership, limited liability corporation, S corporation or non-publicly traded C corporation with 100 or fewer shareholders.

21. N.Y. Tax Law § 631(b)(1)(A)(1).

22. New York A.3009-C/S.2009-C (2017).

23. R.I. Gen. Law § 44-22-1.1(a)(4).

25. Colo. Rev. Code §§ 15-16-901–15-16-931.

25. NM Stat § 46-11-102. 

26. N.C.G.S. § 36C-8-816.1.

27. Va. Code Ann. §§ 64.2-779.1–64.2-779.25.

28. Washington SB 5012.

29. Illinois HB 2526 (2017).

30. Nevada AB 197 (2017).

31. Ferri v. Powell-Ferri, SC 19432, SC 19433 (Sup. Ct. Conn. Aug. 8, 2017) and Powell-Ferri v. Ferri, SC 19434 (Sup. Ct. Conn. Aug. 8, 2017). Notably, the trial court ordered the husband to pay the wife $300,000 in alimony annually, despite the fact that when the action was commenced he’d been earning only $200,000 annually.

32. In re Hoppenstein, 2015-2918/ANYLJ 1202784244139 (Sur. Ct. N.Y. Co., March 31, 2017), 2017 N.Y. Slip Op. 30940(U).

33. Cmt. j to § 15.1 of Restatement (Third) of Property: Wills and Other Donative Transfers provides that a child produced posthumously by assisted reproduction is treated as in being at the decedent’s death, if the child were born within a reasonable time after death. The Uniform Probate Code time frame of a child in utero within 36 months or born within 45 months is referred to as appropriate for a court to adopt as reasonable.

34. Alabama, Arkansas, California, Colorado, Connecticut, Delaware, Florida, Illinois, Iowa, Louisiana, Maine, Maryland, Minnesota, Nebraska, New Hampshire, New Mexico, New York, North Carolina, North Dakota, Ohio, Oregon, Texas, Utah, Virginia, Washington and Wyoming. It’s extremely unlikely that North Carolina’s statute applies to posthumously conceived children, although it can be literally read to do so.

35. Illinois SB 883 (2017).

36. Ohio SB 232 (2015).

37. Privacy of Customer Information (47 U.S.C. § 222); Stored Communications Act (18 U.S.C. Ch. 121, §§ 2701–2712); Computer Fraud and Abuse Act (18 U.S.C. § 1030).

38. Revised Uniform Access to Digital Assets Act (2015), http://bit.ly/2nwx4EO.

39. Alabama SB 110/HB 138 (2017).

40. Alaska SB 16/HB 108 (2017).

41. Arizona § 14-13101.

42. Arkansas HB 2253 (2017).

43. Calif. Prob. Code § 870.

44. Colo. Rev. Stat. § 15-1-1501.

45. Conn. Gen. Stat. § 45a-334b.

46. Fla. Stat. § 740.001.

47. Hawaii Rev. Stat. § 556A-1.

48. Idaho Code § 15-14-101.

49. Illinois 755 ILCS 70/1.

50. Ind. Code § 32-39-1-1.

51. Iowa SB 333 (2017).

52. Kansas SB 63 (2017).

53. Md. Estates and Trust Code § 15-601.

54. Mich. § 700.1001.

55. Minn. Stat. § 521A.01.

56. Mississippi HB 849 (2017).

57. Montana SB 118 (2017). 

58. Neb. § 30-501-518.

59. Nevada AB 239 (2017).

60. New Mexico SB 60 (2017).

61. New Jersey AB 3433 (2017).

62. New York EPTL § 13-A-1.

63. N.C. Gen. Stat. § 36F-1.

64. North Dakota HB 1214 (2017).

65. Ohio Code § 2137.01.

66. Oregon SB 1554 (2016).

67. S.C. Code § 62-2-1010.

68. South Dakota HB 1080 (2017).

69. Tenn. Code § 35-8-101.

70. Texas SB 1193 (2017).

71. Utah HB 13 (2017).

72. Vermont HB 152 (2017).

73. Virginia SB 903/HB 1608 (2017).

74. Wash. § 11.120.010.

75. Wisc. § 711.01.

76. Wyo. § 2-3-1001.

77. Georgia SB 301 (2017).

78. Louisiana HB 1118 (2016). This legislation has since died.

79. Maine HP 595 (2017).

80. Massachusetts HB 3083 (2017).

81. Missouri SB 129/HB 379 (2017).

82. New Hampshire SB 93 (2017).

83. Oklahoma SB 1107 (2016). This legislation has since died.

84. Pennsylvania SB 518 (2015). This legislation has since died.

85. Rhode Island HB 5443 (2017).

86. Washington, D.C. LB 199 (2017).

87. West Virginia SB 693 (2017).

88. North Dakota HB 1228 (2017).

89. New York S.4866 (2017).

90. N.Y. EPTL § 11-2.3(b)(5).

91. NV-BDR 3-1087.

92. Although Delaware also allowed portability of the estate tax exemption amount between spouses, the repeal of the Delaware state estate tax will render state level portability moot.

93. Hawaii Rev. Stat. § 236D. See Instructions for Form M-6 Hawaii Estate Tax Return (2013), http://files.hawaii.gov/tax/forms/2013/m6ins.pdf. 

94. Maryland TAX General § 7-309.

95. Illinois HB 2489 (2017).

96. Massachusetts H.1510/S.1669 (2017).

97. Rhode Island SB 144 (2017). 

In our view, the four top-tier jurisdictions for 2018 (listed by the year they adopted their Rule Against Perpetuities (RAP) legislation) are South Dakota, Delaware, Alaska and Nevada. Each of these jurisdictions is ranked in the first tier and scored high in most categories of the trust matrix included in this article. These jurisdictions are followed closely by Tennessee, Wyoming, Ohio and New Hampshire in the second tier. The top three tiers of trust jurisdictions are described in this article, together with a matrix that explains the factors in the ranking of 32 jurisdictions. 

Why is this so important? 

In 2018, the trust company business in the United States represents a multi-trillion dollar industry in assets under management. Competition for trust business among U.S. jurisdictions and institutions remains robust, especially for high-net-worth (HNW) individuals. That trend should continue, but the focus of such competition will evolve with changes in the federal transfer tax and state statutory regimes.

Over nearly the past 19 years, we’ve witnessed federal transfer tax exemptions increase from $600,000 in 1999 for individuals, to $5.6 million in 2018 (or, it’s possible that the current exemption will double to $11.2 million under the new tax law proposal).¹ 

For the past six years, we’ve reported that this federal tax regime represented “the perfect storm” for HNW clients as a planning environment. Today, even with the possibility of estate tax repeal in 2024, the benefits of trust planning remain critical and go well beyond possible estate tax savings. The development of flexible planning tools over the past two decades and “best in class” trust laws found in the best jurisdictions permit HNW individuals and their professionals to craft elegant asset protection, governance and long-term transfer strategies that protect a national network of HNW multi-generational enterprises.² 

While the tax proposals of the Trump administration represent an about-face from the 2016 Obama administration’s direction affecting HNW planning strategies and valuation rules, those proposals represent a shift in political winds that may be as fickle as the next election cycle. Careful trust planning today locks in advantages and increases predictability in result and assists in controlling future risk, including governmental risk. 

There’s a marked difference between the laws of those jurisdictions that we consider “the best” for trusts and those that we deem less competitive. Planning professionals who cater to HNW clients need to understand the different trust laws and planning opportunities and how it affects those clients and their beneficiaries. This is especially true when the landscape for planning strategies for their HNW clients is under tremendous pressure to change. 

In those jurisdictions that have the best trust laws, clients are still able to provide their assets with the most effective wealth transfer for generations, even perpetually, while legally eliminating current and future federal or state gift and death taxes and state income taxes. So, which factors are most important to consider?

In the January 2016 issue of Trusts & Estates, we provided a matrix to compare the relative strengths of the then-31 jurisdictions that had repealed or modified their RAPs.³ In 2018, the number of perpetual or near-perpetual jurisdictions is 32, with the addition of Kentucky. Laws in several jurisdictions have changed, and the factors that we consider important to compare have been modified, so we’ve updated the ranking matrix and expanded our discussion of those factors. (See “Best Situs at a Glance,” pp. 92-95.)

New Developments

Seven new developments have added complexity to the question of which situs is best.

Increase in federal estate exemption. The Trump administration and congressional Republicans have proposed a doubling of the gift, estate and generation-skipping transfer (GST) tax exemption in 2018, thus increasing the exemption from $5.6 million to $11.2 million per individual. The House version of the bill proposes a six-year phase-in of an estate tax repeal. The Senate version doesn’t repeal the estate tax. The House version keeps intact the step-up in basis rules and retains the larger gift and GST tax exemptions on estate tax repeal. If passed, this bill creates a tremendous (albeit perhaps short-lived) boon for HNW clients.

No revision to the Internal Revenue Code Section 2704 valuation and installment sales rules. During the Obama administration, the Treasury department was pursuing changes to valuation discounts of closely held business entities and to the estate tax benefits of installment sales rules. Those changes would have significantly reduced the effectiveness of intrafamilial asset sales and other transfer strategies to trusts, thus largely negating the benefits of those transactions. 

On April 21, 2017, President Trump directed the Treasury Department in Executive Order 13789 to identify tax regulations issued on or after Jan. 1, 2016, “that (i) impose an undue financial burden on United States taxpayers; (ii) add undue complexity to the Federal tax laws; or (iii) exceed the statutory authority of the Internal Revenue Service.” In a second report in response to Executive Order 13789, the Treasury Department and the IRS announced that they’ll withdraw the controversial proposed regulations about disregarded restrictions and lapsing rights under IRC Section 2704, and those proposed regulations were officially withdrawn.⁴ 

State constitutions and conflicts of laws. In 2016, we reported that an article entitled “Unconstitutional Perpetual Trusts”⁵ by Steven Horowitz and Harvard Professor Robert H. Sitkoff raised the question of the constitutionality of perpetual trusts in certain jurisdictions that have proscribed them in their constitutions. They also raised important questions about conflict-of-law issues when a trust settlor’s resident state may have a strong legitimate public policy against perpetual trusts. 

We concluded then “that with respect to constitutional questions and conflict-of-law issues, practitioners should look at the quality of the perpetuities laws of the subject jurisdiction, the quality of other laws that are available to benefit the client and the jurisdictional ‘nexus’ requirements that have been defined on behalf of prospective clients.”⁶

State income taxation of non-resident trusts. Income tax proposals have arisen in certain boutique states. For example, over the past couple of years, we’ve seen advisors focus on Alaska’s budget issues; specifically, Governor Bill Walker has proposed the first state income tax in 35 years to combat a $3+ billion deficit. This deficit is a result of the state’s heavy reliance on the oil industry as a main generator of jobs and state funds. That reliance has become quite problematic with the drop of oil prices. As such, this could potentially lead to trusts with Alaska situs to incur state income tax if the proposal goes through.⁷ Similarly, Nevada has recently imposed a commerce tax on its businesses that many advisors have taken issue with. Consider the health of the economy and tax base when selecting a potential trust situs, because the state income tax laws could change based on political and economic conditions.

In another development, Residuary Trust A (Kassner) v. Director calls into question the legitimacy of resident state taxing authorities attempting to tax trusts created in non-taxing jurisdictions.⁸ While in recent history, states have been permitted to tax trusts that were created in other jurisdictions under long-arm jurisdictional rules, the case law in some instances is trending the other way.

Changes in premium tax. Delaware lowered its premium tax from 200 basis points (bps) to 0 bps in excess of $100,000 for trust-owned life insurance policies covering the life of an individual who participates in private placement.⁹ However, Delaware’s low premium tax doesn’t apply to policies owned by limited liability companies (LLCs). The other two lowest premium tax states, South Dakota and Alaska, provide a low premium tax, 8 bps, for both trust and LLC-owned policies. Alaska recently lowered its premium tax, so it’s now the same as South Dakota. 

No federal RAP. Among President Obama’s 2016 budget proposals was a durational limit on the GST tax exemption of 90 years. This proposal gained no traction with Congress, which we believe is the correct result.¹⁰

Domestic asset protection trust (DAPT) case. In Klabacka v. Nelson,¹¹ a Nevada case, the court held that since no child or spousal support obligations were known at the time of the formation of the DAPT, the DAPT was protected. No court order or agreement for child support or alimony was present at the time of formation. Other DAPT states (for example, South Dakota) would likely provide the same exception creditor protection, given the same facts. There’s nothing to suggest that a South Dakota court would come to a different result given the same facts. For example, South Dakota’s requirement of notice for transfers of marital property wouldn’t have been applicable in this case because it involved separate property, not marital property (and in either case, the notice requirement likely would have been met since the husband and wife created the separate DAPTs together). The Nevada court in dicta provided a possible key distinction between community property and separate property. 

The Trust Matrix

We’ve outlined five broad categories (including 25 sub-categories) as they relate to the strength of trust laws and how to evaluate them: (1) a jurisdiction’s form of any applicable RAP or the law that determines how long a trust may legally exist; (2) whether a state has inheritance, income or premium taxes; (3) what modern trust laws have been adopted, how state courts have interpreted those laws and how accommodating the financial and legal system is to trusts; (4) what asset protection laws exist and their legal interpretations; and (5) the effect of migration on the rights of beneficial interests from state to state.

Top-tier Jurisdictions

In our view, the four top-tier jurisdictions for 2018 (listed by the year they adopted their RAP legislation) are South Dakota, Alaska,¹² Nevada and Delaware. Each of these jurisdictions scored high in most categories of the trust matrix.¹³ While Delaware has been in the top four jurisdictions consistently for the past 10 years, we think its asset protection laws still need to be strengthened for it to remain competitive.

We rank New Hampshire, Ohio, Tennessee and Wyoming in the second tier. New Hampshire is a perpetual trust jurisdiction that’s strengthened its trust laws similar to the top tier jurisdictions. But, New Hampshire’s DAPT laws aren’t, in our opinion, as strong as those of most of the highest ranked states. Tennessee and Ohio have done the most to strengthen their laws in the past two years and are emerging jurisdictions, and Tennessee has a 360 term-of-years RAP period and both decanting and directed trust statutes, and it recently improved its asset protection laws. Ohio is an “opt-out” state, but is similar to Tennessee in that it’s adopted a stellar DAPT statute. Tennessee is one of the states that has a constitutional prohibition against perpetuities that may be of a concern. Ohio’s discretionary trust protection also remains problematic. Wyoming has been in the second tier consistently for six years. Wyoming has a 1,000-year RAP period and other features, including, recently, a decanting statute. Wyoming has both regulated and unregulated private trust company statutes.

Three jurisdictions have improved their laws and asset protection reputations in the past several years and round out the third tier of ranked jurisdictions. These jurisdictions are: Florida, Illinois and Utah. Illinois is an opt-out jurisdiction and has added new directed trust and trust protector provisions. Florida has a 360 term-of-years RAP period and no state income tax but lacks domestic DAPT features. The recent Casselberry case in Florida appears to create a serious issue with Florida’s spendthrift and wholly discretionary trusts.¹⁴ Utah has a 1,000 term-of-years RAP period and has adopted directed trust and self-settled trust legislation, but it has an income tax.

Most of the remaining trust jurisdictions, however, have lagged with respect to modern trust laws or have less impressive DAPT laws.

We’ve created our rankings using objective criteria similar to what we used in the 2010, 2012, 2014 and 2016 articles in this journal. We have, however, modified the importance of several factors. We hope these changes will help bring more clarity and provide you with a balanced view as you consider the nuances of all the jurisdictions’ laws and how those laws might serve your clients’ needs—or adversely impact them.

The RAP: Perpetual or Near-Perpetual

Under the common law RAP, an interest in trust must vest, if at all, within the period of a life in being, plus 21 years (plus a reasonable period for gestation). Several states have adopted the Uniform Statutory Rule Against Perpetuities (USRAP), which sets the duration of a trust to the greater of the RAP or 90 years. In those states that have repealed or modified the RAP, it’s possible to exempt from gift, estate and GST taxes all trust assets for as long as the trust is permitted to exist. Over the past 62 years, 31 states and Washington, D.C. have abolished or modified their RAPs, in whole or in part, so that trusts created in those jurisdictions can last forever or, at least, for very long periods of time.

In 1986, Congress adopted the GST tax regime, which incorporated some assumptions and safe harbors patterned after either the RAP or the USRAP. But, three jurisdictions already had abolished their RAP and, instead, adopted a more flexible rule against alienation and suspension of powers (RAASP): Idaho (1957), Wisconsin (1969) and South Dakota (1983). These actions established the first perpetual trust jurisdictions.¹⁵

Since the federal GST tax was adopted, 29 more jurisdictions have modified or repealed their RAP or USRAP (and Oklahoma purports to have an exception under case law). Of those, nine abolished their RAP and/or USRAP: Alaska, Delaware, Kentucky, Missouri, New Hampshire, New Jersey, North Carolina, Pennsylvania and Rhode Island.

There are 21 jurisdictions that didn’t abolish it altogether—some because of longstanding policy concerns, constitutional barriers or political resistance. Rather, they’ve merely modified the RAP in some way. In those jurisdictions, it may be impossible to abrogate the rule fully. Seven of those states have extended the RAP periods to a term of years: Colorado (1,000 years), Florida (360 years), Nevada (365 years), Tennessee (360 years), Utah (1,000 years), Washington (150 years) and Wyoming (1,000 years). Georgia is in the process of changing their USRAP to 360 years (scheduled now for 2018).

The remaining 13 jurisdictions are opt-out jurisdictions. There, the RAP or USRAP is retained, and by statute, the interests in a trust are permitted to opt out of or be exempted from the RAP period. These jurisdictions include: Alabama, Arizona, Hawaii, Illinois, Maine, Maryland, Michigan, Nebraska, North Dakota, Ohio, Oklahoma (case law only), Virginia and Washington, D.C.

In 2003, author Garrett Moritz, in a Harvard Law Review Note,¹⁶ outlined six approaches that jurisdictions have undertaken to create perpetual or long-term trusts. These approaches fall into three broad categories:

1. the Murphy perpetual trust,

2. the term-of-years trust, and

3. the opt-out trust.

Murphy Approach

In Murphy v. Commissioner, the Tax Court affirmed Wisconsin’s method of repealing its RAP. Known as “the Murphy approach,” this case upholds a Wisconsin law that provided for the complete repeal of the RAP and substitution of a more flexible, alternate vesting statute. This approach addresses both the RAP’s timing and vesting elements for GST tax exemption purposes. The Murphy approach is considered the best perpetual trust jurisdiction law method.

Alaska, Delaware, New Hampshire and South Dakota are the strongest of these truly perpetual jurisdictions.

South Dakota is the only original Murphy jurisdiction of the three. Alaska is also a very strong contender, but has a 1,000-year power of appointment (POA) statute.

Delaware has similar issues if a limited POA (LPOA) is used.

The remaining Murphy trust jurisdictions have done little to maintain their competitiveness in trust law or asset protection. Exceptions are Idaho, which has adopted a trust protector statute and, recently, North Carolina, which now has a directed trust statute. Kentucky has adopted a decanting statute.

Term-of-Years Approach

The second most used approach is the term-of-years approach. Nevada, Tennessee and Wyoming are the most progressive jurisdictions using this approach; they also keep their trust laws current, and Nevada and Wyoming have no income tax. Tennessee taxes only the dividends and interest of residents.

Florida, however, has adopted a directed trust statute, decanting and reformation and virtual representation laws, and it has no state income tax. Florida appears to have a problem with wholly discretionary and spend- thrift trust protection.¹⁷ Tennessee has also adopted self-settled trust legislation. Utah added a directed trust statute, decanting and reformation laws and adopted self-settled trust legislation but has done little else in the asset protection arena.

As noted by trust expert Richard Nenno, the term-of-years approach isn’t preferred to the Murphy approach. However, if a term-of-years jurisdiction has incorporated the safe harbor vesting provisions of Murphy, we believe that the result for GST tax exemption purposes may be the same as with other Murphy jurisdictions, except for the term of years specified rather in perpetuity.¹⁸ If both the vesting and timing requirements of Murphy are met, the term-of-years period should work for the purposes of the GST tax and continue the GST tax exemption.

For example, while the Tennessee statute limits the RAP period to 360 years, it also provides an alternate possible vesting at 90 years.¹⁹

Opt-out Approach

The opt-out RAP approach remains the least favorable for trusts, primarily because the RAP or USRAP is maintained as part of state law, so the underlying RAP period is unchanged. Illinois and Ohio are the strongest opt-out jurisdictions. Ohio doesn’t tax trusts created by non-resident grantors and has a directed trust statute.²⁰ It also added asset protection and self-settled trust legislation. Neither state taxes non-resident trusts; each has domestic trust protection, DAPT statutes and decanting provisions. Illinois has among the lowest premium tax; has adopted both directed trust and trust protector elements in its laws; and provides a virtual representation feature (that is, provides for the administration and court supervision of trusts in which there are contingent, unborn or unascertainable beneficiaries). 

Arizona has an income tax, and it now has directed trust, trust protector, decanting and reformation and virtual representation statutes.²¹ Maine, Virginia and Washington, D.C. also have directed trust statutes, and Virginia has added additional creditor protection and self-settled trusts. The remaining opt-out jurisdictions lack any modern trust features that are important in our rankings.

The result of these opt-out exception statutes remains unclear for the purposes of continued GST tax exemption, beyond the stated underlying statute (RAP/USRAP) of the jurisdiction. While some opt-out states have attempted to blend the Murphy vesting exception into their statutes, it’s unclear whether the Murphy vesting language is effective, unless the underlying RAP/USRAP is abrogated.

State Income 

Whether a state imposes a state income tax and, to a lesser extent, taxes insurance premiums, are important issues. The state income taxation of a non-grantor trust accumulating income can have a deteriorating effect on trust corpus. This erosion is particularly evident with perpetual trusts. Often, clients choose to change the situs of their trust just to legally avoid the payment of state income taxes. Seven states—Alaska, Florida, Nevada, Pennsylvania, South Dakota, Washington and Wyoming—are the only perpetual or nearly perpetual jurisdictions with no state income tax, but, as was stated above, Alaska is considering an income tax to offset oil and gas tax revenue shortfalls. The final form of the tax and its application to non-resident trusts will be of important note.

Nevada recently enacted a “commerce tax,” which taxes business activity in the state when revenues are in excess of $4 million annually. The applicable tax rate differs depending on the primary market sector in which business activity is engaged. An annual report is required from all businesses, even if they’re exempt from the tax.²² There are six additional jurisdictions that have a state income tax for residents, but exempt non-resident grantors and beneficiaries of perpetual trusts from state income tax: Delaware, Illinois, New Hampshire, Ohio, Tennessee and Wisconsin.²³ 

Income taxation of trusts is becoming a more complex question resulting from states eager to extend the reach of their taxing authority. For example, there’s been past litigation in Connecticut and Washington, D.C., as well as proposed legislation and informational reporting requirements in New York and elsewhere.²⁴ A handful of states attempt to continue to tax a trust regardless of a change of situs to another jurisdiction. This trend has become more common as states have looked for additional tax revenues in a tight economy. However, recently, a series of cases have gone the other way.²⁵

Premium Taxes 

Taxes on insurance premiums are another factor to consider with billions of insurance premium dollars at play. The least expensive premium tax jurisdiction is now Delaware (0 bps) after premiums of $100,000 for policies in trust. Policies owned by LLCs are still subject to Delaware’s higher premium tax. South Dakota continues to be 8 bps for all insurance premiums, Alaska (8 bps), Illinois (50 bps), Wyoming (75 bps) and Nebraska (100 bps). The other highly ranked jurisdictions have higher premium taxes: New Hampshire (125 bps), Ohio (140 bps), Florida (175 bps), Tennessee (175 bps), Utah (225 bps) and Nevada (350 bps). (See “Best Situs at a Glance,” pp. 92-95, for a list of premium taxes for all jurisdictions.)

The premium tax issue becomes particularly important when considering entities like LLCs in private placement life insurance programs. Properly sitused and administered LLCs avail clients to lower premium taxes and allow a client to be a look-through “qualified purchaser” for securities law purposes; otherwise, additional funding is needed to qualify. 

Modern Trust Laws

During the past decade, competitive perpetuities jurisdictions have tried to keep pace with the development of modern trust laws. Flexibility is a key concern when considering the creation and administration of multigenerational trusts. Consider laws that provide:

1. Effective flexible trust planning and administration tools, including LPOAs and the ability to decant or reform a trust if necessary;

2. The ability to change situs for income tax and estate tax purposes without triggering a constructive addition for GST tax exemption purposes;

3. An effective directed trust statute so that investment and distribution direction may be separated from the duties of the administrative trustee;

4. Statutory acknowledgment of the role of trust protector;

5. Statutory ability to change provisions in an irrevocable trust through decanting or reformation;

6. Clear situs rules (including possible conflict-of-law issues) and setting unambiguous standards for which situs’ laws to apply;

7. Statutory authority for trust reformation and decanting, with clear access to courts;

8. Statutory authority for virtual representation of all beneficial interests;

9. Effective privacy laws and beneficiary quiet statutes; and

10. The ability to facilitate and administer private family trust companies (PFTCs) in a Securities and Exchange Commission-exempt environment.

LPOA. This tool is included to create intergenerational flexibility by allowing a powerholder to appoint assets to various beneficiaries. But, note IRC Section 2041(a)(3), which prevents the abuse known as the “Delaware tax trap,”²⁶ referring to the exercise of successive LPOAs over successive generations, allowing for a virtual perpetual trust without federal transfer taxes. As such, the use of LPOAs are generally reserved for beneficiaries and decedents who are ascertainable on the creation of the trust to prevent the inadvertent violation of Section 2041(a)(3). Otherwise, this action could be considered a constructive addition (that is, a material or substantial change in the beneficial interests of the beneficiaries) and potentially endanger a trust’s zero GST tax-exempt inclusion ratio.

Flexibility for future generations is often achieved through other means for discretionary trusts, such as decanting, reformation, advisory committees, trust advisors with the power to invest and direct distributions and removal and replacement powers.

Alaska and Tennessee are the only perpetuities jurisdictions that have adopted a POA statute that exceeds what would be typically permitted under the safe harbor under Section 2041(a)(3). While Alaska is a Murphy jurisdiction for RAP purposes, at least one authority²⁷ is concerned that the use of a POA provision beyond the safe harbor would create a constructive addition for GST tax purposes.

Change of situs. The ability to change the situs of trusts is often important to HNW clients who seek to shop for the most favorable laws. When considering a situs change, examine the wording of the trust’s provisions, including perpetuities language and the applicable law. Look at a possible negative impact such a change would have on the GST tax-exempt status of the trust and its effect on beneficiary rights.

Another related issue is which law may apply to a trust that’s changed its situs to take advantage of a perpetual state’s trust laws. The Delaware Supreme Court Peierls decisions²⁸ make clear that Delaware law will govern the administration of any trust that allows for the appointment of a successor trustee without geographic limitation once a Delaware trustee is appointed and the trust is administered in Delaware, unless the choice-of-law provision expressly provides that another jurisdiction’s laws shall always govern the administration (even if the place of administration or situs changes). According to Peierls, the ability to appoint a trustee in Delaware reflects the settlor’s implied intent that Delaware law will govern the administration of the trust.

This result occurs when the trust instrument is silent as to governing law or even when the trust instrument provides that some other jurisdiction’s laws shall govern. A change of situs among Murphy states isn’t likely to create a constructive addition because the perpetuities laws are the same. But, a change in situs may affect which state’s law applies. It should be noted that, for example, a Florida trust with specific language requiring the Florida perpetuities period to apply could be administered in another state that would continue to honor and apply Florida law.²⁹

Directed trust statute. A directed trust statute generally provides that an administrative or directed trustee be appointed and then permits bifurcating or even trifurcating the fiduciary responsibility among different trust advisors. This freedom allows the client to select independent parties, typically designated as co-trustees or trust advisors, to manage both closely held and investment assets, distributions or other fiduciary duties. This selection relieves the directed or administrative trustee from the duty and liability to manage the trust assets. Directed trusts also provide more flexibility and control over asset allocation, concentration and selection of investments. It also allows the client to continue to employ trusted advisors in the professional roles to which the client is accustomed.³⁰

A national survey we recently conducted reveals that directed trust fees are typically lower to reflect the fact that the administrative trustee isn’t liable for the trust’s investment activities because other fiduciaries have those duties.³¹ (See “Best Situs at a Glance,” pp. 92-95, for a list of jurisdictions with directed trust statutes.)

Trust protector statute. Such a statute recognizes the authority and limitations of a person or entity that’s been appointed as a trust protector. A trust protector is any disinterested third party whose appointment is provided by the trust instrument and whose powers are provided in the governing instrument and in state law. This recognition provides greater flexibility for future generations as conditions change. The strongest trust protector statutes are in Alaska, Delaware, Nevada, New Hampshire, South Dakota and Wyoming.³² 

Such powers may include: modification or amendment of the trust instrument to achieve a favorable tax status or to address changes in the IRC, state law or applicable rules and regulations; the increase or decrease of the interest of any trust beneficiaries, including the power to add beneficiaries in some circumstances; removal and replacement of a trustee; and modifications of the terms of a POA. 

A trust protector and trust enforcer is a “must” for a non-charitable purpose trust (NCPT) (that is, a trust that lacks beneficiaries and instead exists for advancing a non-charitable purpose of some kind). Delaware and South Dakota have special provisions for perpetual purpose trusts. Hawaii, Idaho, Illinois, Michigan and Tennessee are newer states that have passed trust protector statutes. The Uniform Trust Code (UTC) also permits trust protectors in a more limited way in states that have adopted its provisions.³³

NCPTs. NCPTs generally require a trust protector and trust enforcer because the trusts aren’t required to have beneficiaries. Their sole purpose is to care for the underlying property that’s the corpus of the trusts. Commonly, NCPTs are permitted for the care of pets and cemetery plots. Delaware and South Dakota allow very broad NCPTs. For example, some of the common purposes for establishing an NCPT are: 1) pet care (including offspring); 2) support of religious gravesite ceremonies; 3) maintenance of: gravesites; honorary trusts; family property (for example, antiques, cars, jewelry and memorabilia); art collections; family homes (residence and vacation); buildings, property or land; and PFTCs;³⁴ 4) protection of: business interests; royalties; and digital assets; and 5) to provide for a philanthropic purpose not qualifying for a charitable deduction.

Changing Irrevocable Trusts

Changing irrevocable trusts is done on a case-by-case approach because of sensitivity to gift, estate and GST tax issues that may be triggered. There are certain ways to modify irrevocable trusts: trusts settling trusts; decanting; distributing property to a beneficiary in trust; trust protector amendment powers; and reformation. The first three methods involve the creation of a new trust. The latter two methods involve amendment of the current trust. Historically, only judicial action could reform a trust; this process often required the consent of all the beneficiaries or a court-approved equitable deviation.³⁵

When we discuss the concept of a trust “settling” a new trust, we mean that the trust provisions of the original trust provide limitations and terms of settling a new trust. A decanting statute may be used as an alternative when a trust doesn’t have specific trust provisions allowing the trustee or protector to settle a new trust. South Dakota has the most flexible decanting statute.

Many trust provisions allow a trustee to make a distribution to a beneficiary in trust, rather than outright. Generally, this is the least favored option, because the trust language doesn’t specify whether the trust must have been in existence before the distribution or whether the trustee may merely settle a new trust. If it’s interpreted that the distribution language gives the trustee the power to settle a new trust, then the question presented is whether there are any limits on provisions in the new trust.

The fourth method is to grant a protector or trustee the power to amend the trust, and the fifth method is through the trust reformation process.

Estate Inclusion Issues

With these methods of creating new trusts or modifying a current trust, there’s the question of whether such creation or modification creates an estate tax, gift tax or GST tax issue. Specifically, does changing the dispositive provisions in a trust create a tax issue to the settlor or a beneficiary?

As to the settlor, the estate inclusion issue is whether the settlor, with the consent of anyone, is involved in modifying the old trust or creating a new trust that changes the dispositive provisions. If he is, then there’s an estate tax inclusion issue under IRC Section 2036(a)(2). You can remove this estate tax inclusion issue if the settlor’s power is limited by an ascertainable standard. While it’s a remote argument, if the settlor is attributed the powers of the trustee or protector under an implied (generally oral) promise, and the trustee or protector has the ability to create a new trust or modify a current trust, then there’s an estate tax inclusion issue under Section 2036(a)(1).³⁶

As it relates to a beneficiary, if an independent trustee exercises the power to create or modify the dispositive provisions, generally there shouldn’t be an estate inclusion issue, unless the implied promise argument is used to attribute the trustee or protector powers to the beneficiary. By definition, an independent person isn’t a beneficiary of the trust, and estate and gift tax inclusion issues apply to the settlor or a person who holds a POA.³⁷ 

While most estate planners aren’t concerned with an attribution issue when using an independent trustee or protector to modify the dispositive provisions of a trust, the IRS hasn’t issued definitive guidance and is currently studying the issue. Therefore, some conservative planners advocate that when they use one of the trust creation or modification techniques, the dispositive provisions should remain the same. 

Change of situs, standards and Covey provisions. State law may actually change the dispositive provisions when a trust changes its governing law. Or, the trustee or protector adding or removing any standard may change the dispositive provisions.

For example, Ohio’s UTC takes the most restrictive definition of a discretionary trust. Under common law, a beneficiary of a discretionary trust didn’t have an enforceable right to a distribution or a property interest, and the trustee’s discretion could only be challenged for: (1) improper motive; (2) dishonesty; and (3) failure to act.³⁸ The Ohio UTC restricts a discretionary trust to one that has no standards or guidelines. Conversely, the top trust jurisdictions generally define a discretionary trust as one that gives the trustee any discretion in making a distribution, regardless of whether there’s a standard or guideline. For example, in Alaska, South Dakota, Tennessee and Wyoming, the following language would be classified as a common law discretionary trust: “The trustee may make distributions to the beneficiaries on Section 2.01 for health, education, maintenance, and support.”

Therefore, when a trust that has any standards or guidelines moves from Ohio to Alaska, South Dakota, Wyoming or Tennessee, the beneficiary’s interests are reduced from having an enforceable right to a distribution, which most likely is a property interest, to no enforceable right to a distribution and no property interest. That is, the beneficial interests have been changed. For conservative practitioners who don’t want any change in beneficial interests, the state statute must provide for keeping an enforceable right. Only South Dakota and Tennessee provide such a provision, which is contained in its discretionary support trust. This provision was recommended by Richard Covey, when he reviewed the South Dakota discretionary support statute. Hence, we use the term “Covey Provision” in one of the columns in our matrix.

On a side note, author Mark Merric met an estate planner who said that almost all his clients wanted the beneficiaries to have an enforceable right to a distribution. From an asset protection perspective, we would generally disagree with this position, particularly for sophisticated or HNW clients. However, the flexibility of the South Dakota discretionary support statute allows for creation of an enforceable right, regardless of the distribution language, should a client desire to do so.

UTC Section 411(a) provides two options: modification with, or without, court approval. Older versions of the UTC didn’t require court approval for a modification with the consent of the settlor and all the beneficiaries.³⁹ Choosing the most appropriate decanting statute depends on the nature of the trustee’s discretionary authority and whether the beneficiaries of the new trust include contingent beneficiaries of the original trust.⁴⁰

South Dakota’s decanting statute appears to provide the best example of flexibility for trust remodeling.⁴¹ Several states have followed this model.⁴²

Trustees or beneficiaries might wish to modify an irrevocable trust to:

1. Improve a trust’s governance structure;

2. Change the law applicable to the trust when the terms of the trust don’t facilitate a change to its governing law;

3. Change dispositive provisions;

4. Change the administrative terms of the trust to ensure that the trust provides the proper tools to its fiduciaries for the best management of the trust; or

5. Modernize an outdated trust agreement.

Another situs consideration: Advisors should check the respective state courts’ experience with judicial reformation and modification of trusts and the procedures, costs and time involved.

Both reformation and decanting statutes provide trustees and trust beneficiaries flexibility without negative GST tax consequences if certain requirements are met. The GST tax regulations create a safe harbor for four types of modifications, none of which affect the grandfathered status of a trust.⁴³ A decanting or modification that qualifies for one of these safe harbors won’t cause a GST tax-exempt trust to lose its exempt status.⁴⁴ Recently, the National Conference of Commissioners on Uniform laws issued a Uniform Trust Decanting Act (2015).⁴⁵ (See “Best Situs at a Glance,” pp. 92-95, for the jurisdictions that have adopted decanting statutes.)

Special purpose entities/trust protector companies (SPEs/TPCs). Unregulated SPEs/TPCs are, generally, business entities used in combination with a directed trust structure to limit the liability of fiduciaries and more directly tie the trust to the chosen jurisdiction. These may include trust protectors, trust advisors and investment and distribution committees, as well as other individuals and professional entities that serve in advisory and investment roles on behalf of a directed trust or the family. These entities are typically in the form of an LLC organized under the laws of the jurisdiction that permits them. The purpose of such entities is generally limited by statute to a single client or family group. SPEs/TPCs can be created to act on behalf of a family or family group to provide non-trustee fiduciary services akin to a family office. Only New Hampshire and South Dakota have a specific SPE statute. Alaska, Arizona, Delaware, Illinois, Nevada, New Hampshire, South Dakota and Wyoming permit SPEs/TPCs.⁴⁶ 

Family offices organized as SPEs can fall within the SEC safe harbor rules.⁴⁷ The advantage is that some insurers provide directors and officers and errors and omissions coverage to an entity established specifically for these purposes, thus protecting the trust protector and committee members. In contrast to PFTCs, SPEs also provide legal continuity beyond any single individual’s death, disability or resignation. The entity’s bylaws generally allow for additional members to be added or removed so that the entity can continue along with the trust. These entities need to be properly structured so that they also avoid estate tax inclusion issues.  

Virtual representation statutes. Virtual representation statutes are important for discretionary multigenerational trusts. These statutes are designed to facilitate the administration and court supervision of those trusts in which there are contingent, unborn or unascertainable beneficiaries. Typically, if there’s no person “in being” or ascertained to have the same or similar interests, it’s necessary to appoint a guardian ad litem to accept service of process and to protect such interests.

Several jurisdictions that have specific virtual representation statutes include: Alaska, Arizona, Florida, Illinois, Nevada, South Dakota and Washington. Delaware has a limited version of virtual representation. The UTC also provides a form of virtual representation.⁴⁸ Under South Dakota’s virtual representation statute,⁴⁹ service of process when notifying beneficiaries is generally limited to persons in being and parties to the proceeding. The court shall appoint a guardian ad litem to represent or protect the persons who may eventually become entitled to an interest, if it doesn’t appear that there’s a person in being or ascertained as having the same interest. Further, under South Dakota law, it may not be necessary to serve the potential appointees of a POA or the takers in default of the exercise of a general POA. Alaska has a comparable statute, while Delaware and Nevada’s virtual representation statutes are more limited. (See “Best Situs at a Glance,” pp. 92-95.)

Privacy laws and quiet statutes. Of the top-tier jurisdictions, South Dakota has the best trust privacy laws. For example, its “quiet statute” not only allows a trust to be quiet during the grantor’s life, but also applies after the grantor’s death or disability and isn’t limited to a period of time, which is unique. Alaska, Delaware and Nevada’s privacy laws aren’t as extensive.⁵⁰ For example, Delaware and Nevada’s quiet statutes restrict to a period of time and don’t expressly allow for the trust protector to modify notice to beneficiaries. Delaware only provides a 3-year seal period for court matters. In addition, South Dakota has an automatic total seal statute for all court matters involving trusts (for example, litigation or court reformation). In South Dakota, the privacy seal also extends to any possible future litigation or court reformation, which is a significant advantage.⁵¹ 

PFTCs. Many HNW families want to establish PFTCs to handle administration of all their family trusts. Often, PFTCs are administered with the assistance of a local trust company that can provide situs-based administrative services at greater cost efficiencies.

In 2016, the most popular perpetual or near-perpetual jurisdictions that permitted PFTCs were: Nevada, New Hampshire, South Dakota and Wyoming. These are still the most popular jurisdictions in 2018. Tennessee’s PFTC statute attempts to permit a PFTC and business in one entity. Missouri is the most recent state to enact PFTC legislation.⁵² Of all these jurisdictions, Nevada and South Dakota have historically contained the greatest number of PFTCs.⁵³

The capital requirements for establishing a PFTC differ by jurisdiction and remain the same as they did in 2016. Currently, in capital, Nevada requires $300,000, New Hampshire requires $250,000,⁵⁴ South Dakota requires $200,000⁵⁵ and Wyoming requires $500,000 for regulated PFTCs. Increasingly, banking regulators are encouraging PFTCs to pledge larger capital requirements than just the minimum amount, especially as PFTCs mature.⁵⁶

Of the key PFTC states, Florida, Ohio, South Dakota, Tennessee and Wyoming are accredited by the Conference of State Bank Supervisors. New Hampshire and Nevada aren’t accredited; only four of the 50 states aren’t accredited. This accreditation may be a key point if a family is seeking to qualify from SEC exemption via a regulated PFTC.⁵⁷ 

Independent Trust Companies 

These give HNW families more choices. As reported in 2016, many independent trust companies have emerged because of modernization of trust laws, which means that HNW clients have many choices for trust laws and services across 32 different jurisdictions within the United States that offer multigenerational trust planning opportunities. 

We conducted a recent survey of what are largely considered the top 50 trust companies within the United States. The trust executives we interviewed were universally concerned with providing high quality service to their clients, while providing compliance that protects the integrity of both the service providers and clients. In our opinion, independent trust companies provide more choices to clients and more flexibility to individuals and families than traditional trust departments because they don’t have the inherent conflicts of interest created by the banking and investment side of the business. We also believe that clients can achieve superior accountability and transparency for family investments in a properly managed directed family trust when they choose their own independent advisors. 

The modern trust can provide individuals and families far more flexibility intergenerationally, so it’s no longer true that the trust needs to be governed by the “dead hand,” as some in academia have accused. Rather, modern trusts are living and adaptable documents capable of being managed in a dynamic way. Gone are the days of the slanted standard trust forms written to confine clients behind the walls of big bank trust departments and to tie the hands of future generations. This flexibility requires more involvement and training of members of the next generation so that they have the maturity and sophistication to participate in the inevitable course corrections that are required to take place over time.

The modern trust can be designed and administered purposefully and in concert with multigenerational goals. Often, HNW individuals combine trust planning with their family foundation and charitable goals to create a connection between wealth and responsibility in successive generations.

Asset Protection—Third-Party Trusts

In our 2016 article,⁵⁸ we mentioned that if the Massachusetts Supreme Court upheld the appellate decision in Pfannenstiehl v. Pfannenstiehl,⁵⁹ many Massachusetts trustees should consider moving trusts to jurisdictions that had more favorable asset protection. Fortunately, the Massachusetts Supreme Court reversed the decision. Our concern was based on the Massachusetts appellate court finding that a discretionary trust interest was marital property eligible for division in a divorce. The Massachusetts Court of Appeals in Pfannenstiehl v. Pfannenstiehl ⁶⁰ had held, “For these reasons, we conclude that the ascertainable standard embedded in the 2004 trust, the enforceability of that standard for distributions to the husband, and the vested nature of the husband’s interest in the 2004 trust warranted the judge in including the 2004 trust in the marital estate.” The appellate court cited several Massachusetts cases apparently not understanding the difference among conflicted language, Massachusetts case law, the Restatement (Second) of Trusts (Restatement Second) and the Restatement (Third) of Trusts (Restatement Third). As we noted in our 2016 article, the Massachusetts appellate court could have decided the case either way based on the facts and uncertainty within Massachusetts law; however, its inability to articulate the reasons for its decision was particularly concerning. Unfortunately, this is what happens when a trust statute doesn’t define “discretionary interest” and explain the legal results from being classified as a discretionary interest.  

When clients seek asset protection for their children and descendants, there are typically two issues they’re concerned about: (1) protecting a child’s inheritance from claims of an estranged spouse; and/or (2) dealing with claims from third parties. With first marriage divorce rates around 50 percent and divorce rates for subsequent marriages much higher, protecting a child’s inheritance from an estranged spouse is typically a much greater concern when compared to third-party creditors.

In our 2012 article,⁶¹ we discussed in detail the greater asset protection provided by a discretionary trust, particularly when states had codified the Restatement Second.⁶² This is because discretionary trust protection originated under English common law and has nothing to do with spendthrift protection. Rather, it’s based on the fact that a beneficiary doesn’t have an enforceable right to a distribution,⁶³ and therefore, no creditor may stand in the shoes of a beneficiary. In this respect, the beneficiary’s interest isn’t a property interest⁶⁴ and is nothing more than an expectancy that can’t be attached by any creditor.⁶⁵

A discretionary trust under the Restatement Second protects against the most likely creditor, an estranged spouse, in the following three ways:  

1. Because a beneficiary’s interest in a trust doesn’t rise to the level of property, it doesn’t become marital property, and therefore isn’t subject to division in a divorce.

2. An estranged guardian spouse can’t stand in the shoes of a minor child beneficiary and force a distribution on behalf of a minor child.

3. Maintenance or child support is determined by historic distributions to a beneficiary, not an imputed amount that’s based on what the trust could have distributed to a beneficiary.⁶⁶ 

The asset protection planning key to almost all of the aforementioned issues is to draft a discretionary trust when the beneficiary doesn’t have an enforceable right to a distribution.⁶⁷ Under English common law, the Restatement of Trusts (Restatement First), the Restatement Second, as well as almost all case law on point, all of this law was relatively consistent, and estate planners could draft a discretionary distribution standard with relative certainty so that a beneficiary had neither an enforceable right to a distribution nor a property interest. Unfortunately, with almost no case law to support its position, the Restatement Third reverses how a court should interpret a distribution standard so that it will almost always create an enforceable right in a discretionary trust.⁶⁸ Many estate planners believe that the national version of the UTC follows the Restatement Third’s position regarding this issue. In response to this problem created by the Restatement Third, states (including some UTC states) are beginning to respond with statutes codifying the Restatement Second in this area. Absent such statute, even if a state has strong Restatement Second case law, a court may reverse its position and inadvertently adopt the Restatement Third’s new view of discretionary trusts. In this respect, a statute codifying the Restatement Second is the only sure method to preserve the asset protection of a common law discretionary trust.  

In our 2016 article, we changed the order of importance of the following four key areas that need to be included:

1. The definition of a discretionary trust so planners will know the correct distribution language that should be used.

2. The legal ramifications of a discretionary interest. That is, the statute states that the beneficiary who holds a discretionary interest doesn’t hold a property interest or an enforceable right to a distribution.

3. The Restatement Second’s elevated judicial review standard for a discretionary interest when a judge would only review the trustee’s distribution decision if the trustee acted: (1) with an improper motive;
(2) dishonestly; or (3) without using its judgment.⁶⁹

4. No creditor may attach a discretionary interest. 

The appellate court in Pfannenstiehl struggled with two major questions. What’s a discretionary trust, and what are the legal ramifications if it is a discretionary trust? To avoid this confusion, most of the lead trust states have defined a discretionary trust and then stated that a discretionary interest doesn’t hold a property interest or an enforceable right to a distribution.  

For example, the most detailed definition of a discretionary trust was first adopted by South Dakota and later incorporated into both Nevada trust law⁷⁰ and the Tennessee UTC.⁷¹ It was also partially adopted by Indiana.⁷² The South Dakota Trust Code begins by classifying distribution interests into three major categories pursuant to Section 55-1-38:

A distribution interest can be classified in three ways:

(1) As a mandatory interest, which is a distribution interest, in which the timing of any distribution must occur within one year from the date the right to the distribution arises, and the trustee has no discretion in determining whether a distribution shall be made or the amount of such distribution;

(2) As a support interest, which is not a mandatory interest but still contains mandatory language such as ‘shall make distributions’ and is coupled with a standard capable of judicial interpretation; or

(3) As a discretionary interest, which is any interest where a trustee has any discretion to make or withhold a distribution.

A discretionary interest may be evidenced by permissive language such as ‘may make distributions’ or it may be evidenced by mandatory distribution language that is negated by the discretionary language of the trust, such as ‘the trustee shall make distributions in the trustee’s sole and absolute discretion.’ An interest that includes mandatory distribution language such as ‘shall’ but is subsequently qualified by discretionary distribution language shall be classified as a discretionary interest and not as a support or a mandatory interest. A discretionary interest is any interest that is not a mandatory or a support interest.

Both the South Dakota Statute and Tennessee Trust Code give the following examples of trust language classification in Section 55-1-40:

Although not the exclusive means to create a distribution interest, absent clear and convincing evidence to the contrary, the following language by itself results in the following classification of distribution interest:

(1) Mandatory interest:

(a) ‘All income shall be distributed to (named beneficiary)’; or

(b) ‘One hundred thousand dollars a year shall be distributed to (named beneficiary)’;

(2) Support interest:

(a) ‘The trustee shall make distributions for health, education, maintenance, and support’;

(3) Discretionary interest:

(a) ‘The trustee, may, in the trustee’s sole and absolute discretion make distributions for health, education, maintenance, and support’;

(b) ‘The trustee, in the trustee’s sole and absolute discretion, shall make distributions for health, education, maintenance, and support’;

(c) ‘The trustee may make distributions for health, education, maintenance, and support’;

(d) ‘The trustee shall make distributions for health, education, maintenance, and support. The trustees may exclude any of the beneficiaries or may make unequal distributions among them’;

(e) ‘The trustee may make distributions for health, education, maintenance, support, comfort, and general welfare.’

When the proposal was first made to include drafting language as examples of types of classifications in the trust statute, some drafters were concerned that the corporate trustees may have a negative reaction. Actually, the reverse occurred. The corporate trustees were very happy to be able to read the statute, rather than to try to sift through case law and decipher numerous court cases.  

Some less detailed approaches, which most likely will have the same effect, are those adopted by Alaska, Oklahoma and Wyoming.⁷³ These statutes define a discretionary trust very broadly. For example, the Wyoming Statute Section 4-10-103(xxix) defines a discretionary interest as:

. . . a distribution which the trustee is not directed to make, but is permitted to make in the trustee’s discretion. For example, the language in a trust instrument providing for a discretionary distribution may contain the words ‘may’ or ‘in the trustee’s discretion’. The language providing for a discretionary distribution may include a standard of distribution or other guidance as long as the language or other guidance does not require the trustee to make a distribution in accordance with the standard or guidance.

At the opposite end of the spectrum, and probably the least desirable definition for a discretionary trust, is the Ohio UTC. It creates something it refers to as a “wholly discretionary trust,” which is a trust without any standards or guidelines. Richard Covey criticized Ohio’s approach due to its very limited definition.⁷⁴ 

While the Ohio UTC has at least defined a discretionary trust, it doesn’t have the other elements that should be included in a discretionary-support trust statute. In particular, the statute didn’t state that a discretionary interest is neither an enforceable right nor a property interest. This resulted in Ohio’s Supreme Court case of Pack v. Osborn,⁷⁵ holding, “A significant aspect of a pure discretionary trust is that its assets are not recognized as an available resource in the Medicaid-eligibility review because a pure discretionary trust lacks a mechanism through which a beneficiary may compel a distribution.” That is, the beneficiary has no enforceable right to force a distribution. Wouldn’t it have been much easier to have stated this in the statute, rather than having to appeal a case to the Ohio Supreme court so that they could correct the Ohio appellate court’s interpretation?

This second key element of a discretionary interest statute stating both: (1) the beneficiary doesn’t have an enforceable right to a distribution, and (2) the discretionary interest isn’t a property interest, has been codified by Alaska, Indiana, Oklahoma and South Dakota. Conversely, the Nevada statute⁷⁶ states only that the beneficiary doesn’t have an enforceable right to a distribution, and the Wyoming statute⁷⁷ states only that the discretionary interest isn’t a property interest. As between stating one of the two elements, it’s better to state that the beneficiary doesn’t have an enforceable right, as the lack of the enforceable right generally prevents the creation of a property interest under federal and state law.⁷⁸ Conversely, the statement that a discretionary interest isn’t a property interest is a conclusion based on having no enforceable right to a distribution. The reason this has been added to the statute is so courts don’t have to attempt a detailed analysis of the sticks of rights necessary to create a property interest under their state laws.⁷⁹

When searching for more favorable trust law, there are some very key lessons that may be learned from Pfannenstiehl. First, to think that a domestic relations trial judge is going to spend 150 to 200-plus hours to learn the difference among a discretionary trust, a support trust, a spendthrift trust, the Restatement Second and how the Restatement Third rewrote the definition of a discretionary trust, and whether the UTC adapts the Restatement Third’s position, is simply ludicrous. The same is true for many appellate courts. Therefore, the importance of having a discretionary-support statute that clearly defines the language that creates a common law discretionary trust is a critical issue in determining the asset protection provided by a trust. The second significance of Pfannenstiehl is the legal finding that the beneficiary of a discretionary trust holds neither an enforceable right for a distribution or a property interest. Third is the dual judicial standard of review, and the determination that a creditor can’t attach a discretionary interest. Also, many planners will disagree on whether the activities of the trustees and the relationship of the trustees to the beneficiaries in Pfannenstiehl rose to the level to support an alter ego argument method of piercing the trust. For this reason, a “dominion and control” statute becomes important. Estate planners don’t want a judge to treat related trustees and advisors of the client serving as a trustee negatively, solely by their relationship to the settlor or a beneficiary.

Dominion and Control Arguments

Other methods that a creditor might use to pierce a third-party trust are dominion and control arguments, as well as alter ego arguments. Therefore, we previously discussed the importance of a statute that protects trust assets from such claims. We noted that South Dakota has the “best” protection against these types of claims, followed by Indiana, Nevada and Oklahoma, which have “good” protection in this category as listed on our matrix. Delaware took a different approach. Its statute provides that a creditor has no more rights than provided by the trust document itself. On one hand, for so long as the drafting attorney is aware of the type of creditor language that needs to be added to a Delaware trust, this may prove to be a novel approach. On the other hand, whether this approach will prevent a Delaware court from using the equitable dominion and control remedy is uncertain.

Self-Settled Trust Legislation

Seventeen states have self-settled trust legislation. Space doesn’t permit a detailed discussion of the pros and cons of each of these statutes, except for the limited discussion below. In this respect, the table has been limited to a “Best,” “Yes,” “Limited” or “No” approach. In our 2017 article, we opined that Nevada, Ohio and South Dakota had the best self-settled trust legislation.⁸⁰

Charging Order Protection

Many times, either a family limited partnership (FLP) or LLC is owned partially or wholly by a trust(s). This strengthens the likelihood that an out-of-state judge will apply the governing law of the trust under conflict-of-laws principles. This is because an LLC or FLP interest is personal property, and, in addition to the factors of the governing law of the trust and the place of administration, some of the trust property is now held in the same state.

When evaluating state charging order statutes, the following categories were used in our matrix. Best jurisdictions (denoted by “Best” in our matrix) have a statute that: (1) prevents the judicial foreclosure sale of the partner’s or member’s interest; (2) includes a provision denying any legal or equitable remedies against the partnership; and (3) includes a provision preventing a court from issuing a broad charging order interfering with the activities of the partnership. “SR” is used in the matrix to indicate the statute states when a charging order is the sole remedy, and there’s no other language in the statute (or comments in the case of a uniform act) stating that a court may issue additional orders to affect the charging order or a court may order the judicial foreclosure sale of the partner’s or member’s interest. “JF” denotes that either the statute or case law allows the judicial foreclosure sale of the partner’s or member’s interest. For LLCs, the six lead states on charging order protection are: Alabama, Alaska, Nevada, North Dakota, Ohio and South Dakota. For FLPs, the four lead states are Alabama, Alaska, Nevada and South Dakota.

Migration

Most trust instruments are silent on whether the trustee should look to a beneficiary’s resources before making a distribution. Under the Restatement First, Restatement Second and most common law, if a trust instrument is silent, then the trustee doesn’t have an obligation to look to a beneficiary’s resources in determining whether or the amount of a distribution. Rather, the assumption is that the settlor wanted to treat his beneficiaries equally, regardless how well a beneficiary did in his personal life. Unfortunately, the Restatement Third reverses common law and prior Restatements in this area, by requiring a trustee to look to a beneficiary’s resources when the trust instrument is silent. While it isn’t certain, it’s highly probable that the UTC also adopts this position.  

Assume for example that Mom created a trust for the benefit of her three children, the trust instrument was silent as to whether the trustee should look to the beneficiaries’ resources and state law followed the general common law that didn’t require the trustee to do so when a trust instrument was silent. Now, the beneficiaries wish to move to one of the lead trust jurisdictions to take advantage of their much more favorable trust laws. Would such beneficiaries ever consent to such a change if it would have the effect of decreasing their beneficial interests? In this respect, a state statute that codifies the Restatement Second view, in which a trustee isn’t required to look to a beneficiary’s resources in determining the amount of the distribution, becomes very important as to whether a beneficiary should be in favor of a change in the governing law and place of administration of the trust.

For purposes of the matrix, we’ve classified the migration column with the titles “Restatement 2d” (meaning the state codified the Restatement Second) or “Restatement 3d” (meaning it’s a UTC state, and it will take future litigation to determine whether the UTC adopted the Restatement Third view in this area). If the column states “No statute,” then the issue hasn’t been addressed by statute, and it will be up to the court to determine whether the Restatement Second or RestatementThird view should prevail.  

Endnotes

1. The estate tax, which is paid only when property and other assets worth over $5.6 million are passed on to heirs, doubles to $11.2 million in 2018 (around $22.4 million for couples), resulting in a lot fewer people paying the tax. Under the House Bill, the estate tax goes away entirely in 2024. High-net-worth individuals also would get to keep charitable deductions, and they no longer would have to pay the alternative minimum tax, a safeguard against excessive tax dodging that’s been in place since 1969. Some wealthy business owners would be able to take advantage of the lower pass-through rate as well. Overall, the Tax Policy Center found that half the benefits of the bill go to the top 1 percent by 2027. Seewww.washingtonpost.com/news/wonk/wp/2017/11/16/the-house-is-voting-on-its-tax-bill-thursday-heres-what-is-in-it/.

2. Daniel G. Worthington and Mark Merric, “Which Situs is Best in 2016?” Trusts & Estates (January 2016), at p. 61; Daniel G. Worthington and Mark Merric, “Which Trust Situs is Best in 2014?” Trusts & Estates (January 2014), at p. 53; Daniel G. Worthington and Mark Merric, “Which Situs is Best in 2012?” Trusts & Estates (January 2012), at p. 51; Daniel G. Worthington and Mark Merric, “Which Situs is Best?” Trusts & Estates (January 2010), at p. 54; Daniel G. Worthington, “Latest Perpetual Trust States—Latest Rankings,” Trusts & Estates (January 2007), at p. 59; Mark Merric, “How to Draft Distribution Standards for Discretionary Dynasty Trusts,” Estate Planning (March 2009). Compare Steven J. Oshins, “4th Annual Dynasty Trust State Rankings Chart” (updated 2014), www.oshins.com/images/Dynasty_ Trust_Rankings.pdf with “6th Annual Domestic Asset Protection Trust State Rankings Chart” (updated January and February 2015), www.oshins.com/ images/DAPT_Rankings.pdf.

3. Ibid. See also Howard Zaritsky, “The Rule Against Perpetuities: A Survey of State (and D.C.) Law,” American College of Trust and Estate Counsel (ACTEC) (2012), www.actec.org/assets/1/6/Zaritsky_RAP_Survey.pdf; Jesse Dukeminier and James E. Krier, “The Rise of the Perpetual Trust,” 50 UCLA L. Rev. 1303, 1316. See Idaho Code Section 55-111 (Michie 2000); Wisconsin Statute Section 700.16(5) (1999); South Dakota Codified Laws Section 43-5-8 (Michie 1997). See also Delaware Code Ann. Tit. 25 Section 503(a) (Supp. 2000); 765 Illinois Comp. Stat. Ann. 305/4 (West 2001); Alaska Stat. Section 34.27.100 et al.; New Jersey Stat. Ann. Section 46:2F-9 (West Supp. 2002); Ohio Rev. Code Ann. Section 2131.08(B) (West Supp. 2003); Maryland Code Ann. Estates & Trusts Section 11-102(C) (2001); Florida Stat. Ann. Section 689.225 (West 2003); Arizona Rev. Stat. Ann. Section 14-2901(A)(1) (West Supp. 2002); Missouri Ann. Stat. Section 456.025 (West Supp. 2003); Nebraska Rev. Stat. Sections 76-2001 (1996 and Supp. 2002); Colorado Rev. Stat. Sections 15-11-1102.5 (2006); Maine Rev. Stat. Ann. Tit. 33, Sections 101 (West 1964); Rhode Island Gen. Laws
Section 34-11-38 (Supp. 2003); Virginia Code Ann. Section 55-13-3(C) (Michie Supp. 2002); District of Columbia Code Sections 19-904(a)(10), 19-901 (2002); Washington Rev. Code Ann. Section 11.98.130 (West 2002); Wyo. Stat. Ann. Section 34-1-139 (2003); New Hampshire Rev. Stat. Ann. Section 547:3-k and 564:24 (West, Westlaw through 2003 Sess.); Utah Code Ann. Sections 75-2-1201 (Lexis Supp. 2002); Nevada Rev. Stat. Section 111.1031 (Nev. Rev. Stat. Ann. 2 Sections 111.103-1039 (Michie Supp. 2004)); Tennessee Code Ann. Section 66-1-202(f) (2007); North Carolina Gen. Stat. Section 41-15 (2007); 20 PSA Section 6107.1 (2007); MCLA Section 554.71 (2008); Haw. Rev. Stat. Section 525-4(6) (2010); Ala. Code Section 35-4A-5(9) and N.D. Cent. Code Sections 47-02-27.1 to 47-02-27.4; KRS Chapter 381.224 (2010); Annotated; See generally Richard A. Oshins and Steven J. Oshins, “Protecting and Preserving Wealth into the Next Millennium [Part Two],” Trusts & Estates (October 1998), at p. 68; Daniel G. Worthington, “The Problems and Promises of Perpetual Trusts,” Trusts & Estates (December 2004), at p. 15; N.D. Cent. Code Sections 47-02-27.1 to 47-02-27.5: The Rule Against Perpetuities (RAP) doesn’t apply to a “fiduciary’s power relating to the administration or management of assets” or to a “discretionary power of a trustee to distribute principal before termination of a trust to a beneficiary having an indefeasibly vested interest in the income and principal;” Oklahoma: The RAP doesn’t apply to a trust if the trustee is granted the full power to sell or transfer the trust assets. See Pipkin v. Pipkin, 370 P.2d 826 (Okla. 1962). In our view, the methodology for ranking trust jurisdictions addresses two related questions: (1) Does the jurisdiction permit truly perpetual trusts or something less? and (2) Does the jurisdiction have other trust laws and practices that give it an edge? We believe that experience with existing perpetual trust laws, administrative issues, ease of interaction with the courts and other trust law issues are all important considerations.

4. Executive Order 13789 (2017); see www.actec.org/resources/capital-letter-no-42/.

5. Steven Horowitz and Robert H. Sitkoff, “Unconstitutional Perpetual Trusts,” 67 Vand. L. Rev. 1769 (2014).

6. In Estate Planning Newsletter #2263, Jonathan Blattmachr, Mitchell Gans and William Lipkin provided their views of the Horowitz/Sitcoff article, ibid, and claimed that its position may be correct. “It is … appropriate to determine what the effect would be if the statute under which the trust is created is invalid under the state constitution. That in turn raises other issues, such as: (1) whether the effect of declaring the state statute allowing long-term trusts unconstitutional might be a ‘reversion’ to the common law rule, and (2) whether the trust is entirely invalid....” Although the Horowitz/Sitcoff article doesn’t directly suggest potential remedies, at least two may be available: (1) a reformation under which a court may reduce the term to one that doesn’t violate the application rule on trust duration; or (2) a court can adopt the “wait and see” rule to see if the duration, in fact, violates the rule. If the trustee has the power to terminate the trust by, for example, paying the assets to someone before the allowable duration passes and does so, that might salvage the trust. The article also suggests the use of “Maximum Duration for Trusts” language to save the perpetuities period if necessary. Compare Steven J. Oshins, “The Rebuttal to Unconstitutional Perpetual Trusts,” Steve Leimberg’s Estate Planning Email Newsletter—Archive Message #2265, in which the author describes why the questions Horowitz/Sitkoff raised in their article shouldn’t be applied to Nevada trusts because of Nevada legislative history and case law. Compare Bullion Monarch Mining, Inc. v. Barrick Goldstrike Mines, Inc., 131 Nev. Advance Opinion 13 (2015); Steve Leimberg’s Estate Planning Email Newsletter—Archive Message #2297.

7. “Gov. Walker pitches 1.5 percent income tax with a limit,” www.alaskapublic.org/2017/09/22/gov-walker-pitches-1-5-percent-income-tax-with-a-limit/. 

8. See Residuary Trust A (Kassner) v. Director, Docket No. 0A-3636-12T1 (App. Div. Unpublished May 28, 2015); Kassner Residuary Trust A v. Director, 27 NJ Tax 68 Tax 2013) and McNeil v. Commonwealth, PA Comm. Court, No. 651 FR 2010, 173 FR 2011 (May 24, 2013). See Pennoyer v. Taxation Division Director, 5 N.J. Tax 386 (1983); Potter v. Taxation Division Director, 5 N.J. Tax 399 (1983).

9. See Chart, www.debankers.com/Assets/Tuesday%20Sessions/Session%204A%20-%20You%20Can%20Go%20Your%20Own%20Way/You%20Can%20Go%20Your%20Own%20Way%20-%2010-25-16.pdf.

10. General Explanations of the Administration’s Fiscal Year 2016 Revenue Proposals, www.treasury.gov/resource-center/tax-policy/Documents/General- Explanations-FY2016.pdf; Mitchell A. Drossman, “Reviewing Obama’s 2016 Tax Proposals: So many proposals in the Administration’s fiscal 2016 budget, but do any of them stand a chance of passing?” Trust Acumen, Issue 29, U.S. Trust (2015); see alsowww.bna.com/states-sidestepping-congress-n73014445289/.

11. Klabacka v. Nelson, 133 Nev. Adv. Op. 24 (May 25, 2017). 

12. While Alaska adopted an opt-out type perpetuities statute in 1997 for certain trusts, it later adopted a Murphy-type statute (in 2000) to resolve the RAP problem. It also adopted a 1,000-year power of appointment (POA) statute that may effectively limit the generation-skipping transfer (GST) tax exemption of a trust. See Richard Nenno, “Relieving Your Situs Headache: Choosing and Re-choosing the Jurisdiction for a Trust,” 2006 Heckerling Tax Institute.

13. Compare Steven J. Oshins, 6th Annual Dynasty Trust State Rankings Chart (October 2017), http://ultimateestateplanner.com/free-resources/6th-annual-dynasty-trust-state-rankings-chart/; The criteria for Oshins’ ranking is based on seven factors. He places the jurisdictions in the following order:
(1) South Dakota; (2) Nevada; (3) Tennessee; (4) Alaska; (5) Wyoming; (6) Rhode Island; (7) Ohio; (8) Delaware and Illinois (tie); (10) Missouri and New Hampshire (tie); and (12) Florida.

14. In Berlinger v. Casselberry, Case No. 2D12-6470, 6 (Fla.2d DCA Nov. 27, 2013), the Florida Second District Court of Appeal upheld a writ of garnishment issued by a trial court against the trustee of a discretionary trust over any present and future distributions made to or for the benefit of a trust beneficiary. The holding is unique as it’s the first case to interpret the Florida Trust Code spendthrift/discretionary trust provisions (since the Florida Trust Code became effective on July 1, 2007) and the first case to hold that the well-known Bacardi v. White decision (463 So.2d 218 (1985)) is still applicable to Florida trusts (both those protected by spendthrift clauses and those that are wholly discretionary).

15. These jurisdictions often are referred to as the “original Murphy jurisdictions” after the case that validated this approach. See Estate of Murphy v. Commissioner, 71 T.C. 671 (1979), in which the Tax Court held that the Delaware tax trap wasn’t violated in Wisconsin. The Internal Revenue Service acquiesced in Murphy. 

16. See Garrett Moritz, “Dynasty Trusts and the Rule Against Perpetuities,” 116 Harv. L. Rev. 8 (June 8, 2003). See also Daniel G. Worthington, “Problems and Promises of Perpetuities Planning,” Trusts & Estates (October 2005), at p. 10.

17. Berlinger, supra note 14.

18. The GST tax result in the term-of-years states may be different from the result in Murphy unless: there’s a real possibility of a vesting or alienation of the trust interests; and that method of vesting is described in the statute (for example, vesting or alienation occurs with the trustee’s ability to sell or distribute assets). If these conditions are met, the term-of-years period should work for purposes of the GST tax and continued GST tax exemption for the term of the trust. For a contrary view, see Nenno, supra note 12, at 3-1; 3-51.

19. See TCA Section 66-1-202(f). The common law rule is generally applicable, but: “[a]s to any trust created after June 30, 2007, or that becomes irrevocable after June 30, 2007, the terms of the trust may require that all beneficial interests in the trust vest or terminate or the power of appointment is exercised within three hundred sixty (360) years. Provided, however, this section (f) shall only apply to trusts that grant a power of appointment at death to at least one member of each generation of beneficiaries who are beneficiaries of the trust more than ninety (90) years after the creation of the interest. The permissible appointees of each such power of appointment must at least include all descendants of the beneficiary, yet may include other persons.”

20. Residency is determined by the domicile of the person who transferred the net assets to the trust. See OHIO R.C. 5747.01(A)(6), (I) and (S), 5747.02 and 5747.05 at Section 5.

21. See Arizona’s ARS Section 14-2901(A)(3) and compare with Illinois’ IL ST Ch. 765, Section 305/4 and Maine’s 33 MERSA Section 101-A. See also Maryland’s MD Est. & Trust Section 11-102(5); Missouri’s V.A.M.S. Section 456.025(1); and Elizabeth M. Schurig and Amy P. Jetel, “Summary of State Rule Against Perpetuities Laws,” www.abanet.org/rppt/meetings_cle/2007/Jointfall/Joint07/JointEstateandGiftax/50-statecomparison ofspendthrifttrustlaws.pdf.

22. On June 10, 2015, Governor Brian Sandoval of Nevada signed SB 483, thus enacting a new “commerce tax” (effective July 1, 2015) applicable to each “business entity” engaged in business in Nevada with Nevada situs gross revenue exceeding $4 million in a taxable year. If a business
entity’s Nevada gross revenue exceeds $4 million, the excess is subject to tax at various rates that depend on the industry in which the business entity is “primarily engaged.”

23. See Steven J. Oshins, “1st Annual Non-Grantor Trust Statute Income Tax Chart” (July 2015), www.oshins.com/images/State_Income Tax_Chart.pdf for reference statutes, rates and conditions.

24. See Paul Comeau and Jack Trachtenberg, “Corporate Fiduciaries, Advisors and Other ‘Co-Trustees’—Perhaps Your Trust Isn’t Exempt from New York Income Tax,” 38 NYSBA Trusts & Estate Law Section Newsletter 1 (Spring 2005).

25. See line of cases represented by Kassner, supra note 8.

26. The Delaware tax trap is one example of how the federal and state laws may interact to create unexpected results. It may be a concern for a trust created in a state where a trust might last beyond the common law RAP or the Uniform Statutory Rule Against Perpetuities. Prior Delaware law provided the opportunity for a perpetual trust without federal transfer taxes through the exercise of successively limited POAs over generations. Internal Revenue Code Section 2514(d) was enacted to prevent this result from happening. The current section dealing with this issue is IRC Section 2041(a)(3).

27. See Nenno, supra note 12. 

28. See In the Matter of Peierls Family Inter Vivos Trusts, No. 16812 (Del. Oct. 4, 2013); In the Matter of Ethel F. Peierls Charitable Lead Trust, No. 16811 (Del. Oct. 4, 2013); and In the Matter of Peierls Family Testamentary Trusts, No. 16810 (Del. Oct. 4, 2013). “Todd Flubacher & the Delaware Supreme Court’s Opinions in Peierls,” Steve Leimberg’s Estate Planning Email Newsletter—Archive Message #2152. See also Nenno, supra note 12; and Dukeminier and Krier, supra note 3, at p. 1316.

29. Some states require a trust be administered in the state for the laws of the state to apply. This requirement is important because one can’t merely say in a trust instrument that the laws of State X will apply, if State X has rules that govern the situs of trusts. See Peierls, ibid.

30. See Richard W. Nenno, “State Directed Trust Statutes with Related Uniform Trust Code Statutes,” Wilmington Trust Company (Oct. 1, 2013). 

31. Daniel G. Worthington conducted a survey of 50 trust companies that offer directed trust services, and the result was similar throughout the United States. See, e.g., SDCL 55-1B et seq. Similar directed trust statutes were patterned after the South Dakota law in other jurisdictions, including Nevada, New Hampshire, Utah, Wyoming, and most recently, Alaska’s newest statute. See“Best Situs at a Glance,” at pp. 92-95.

32. See, for example, SDCL 55-1B-6 (South Dakota), the first modern trust protector statute adopted in 1997. Also, South Dakota has the most expansive quiet trust statute, allowing the protector to keep the trust quiet after a grantor’s death or disability, if desired. In addition, trust protectors are required for purpose trusts. Only Delaware and South Dakota have the special dynasty provisions for purpose trusts.

33. South Dakota is followed by Idaho, Alaska, Wyoming, New Hampshire, Tennessee, Delaware, Arizona, Michigan, Nevada and Vermont in adopting a modern trust protector statute. Connecticut’s statute dealing with the creation of a trust to provide for the care of animals contains the concept of a trust protector, but otherwise there isn’t a specific trust protector statute. Alaska Stat. Section 13.36.370; Ariz. Rev. Stat. Ann. Section 14.10818; 12 Del.C. Section 3570(8)c; Idaho Code Ann. Section 15-7-501; Nev. Rev. Stat. Section 163.5553; N.H. Rev. Stat. Ann. Section 564-B:12-1201(a); S.D. Codified Laws Section 55-1B-6; Vt. Stat. Ann. Section1101(a); and Wyo. Stat. Section 4-10- 710(a). Uniform Trust Code (UTC) trust protectors permitted: Alabama, Arizona, Arkansas, Florida, Kansas, Maine, Michigan, Missouri, Nebraska, New Hampshire, New Mexico, North Carolina, North Dakota, Ohio, Oregon, Pennsylvania, South Carolina, Tennessee, Utah, Vermont, Virginia, West Virginia and Wyoming. Six of these states and the District of Columbia also have a specific trust protector statute: Arizona, Michigan, New Hampshire, Tennessee, Vermont and Wyoming. See Andrew T. Huber, “Trust Protectors: The Role Continues to Evolve,” Prob. & Prop. (January/February 2017), www.americanbar.org/content/dam/aba/publications/probate_property_magazine/v31/01/2017_aba_rpte_pp_v31_1_article_huber_trust_protectors.authcheckdam.pdf, https://www.americanbar.org/content/dam/aba/publications/probate_property_magazine/v31/01/2017_aba_rpte_pp_v31_1_article_huber_trust_protectors.authcheckdam.pdf.

34. Al W. King, III, “Trusts Without Beneficiaries—What’s the Purpose?” Trusts & Estates (February 2015), at p. 7.

35. See Rashad Wareh, “Trust Remodeling,” Trusts & Estates (August 2007), at p. 18. Restatement (Third) of Trusts (Restatement Third), Section 66, provides: “The court may modify an administrative or distributive provision of a trust, or direct or permit the trustee to deviate from an administrative or distributive provision, if because of circumstances not anticipated by the settlor the modification or deviation will further the purposes of the trust.” This section presents an interpretation of the doctrine of equitable deviation. See also Jonathan G. Blattmachr, Diana S.C. Zeydel and Michael L. Graham, “The Act of Decanting: Amending Trusts Without Going to Court,” InterActive Legal (2009), at pp. 1-5. 

36. Matthew Lahti, 6 TC 7 (1946). The gift argument is based on two old cases. In Mathew Lahti, the Internal Revenue Service attempted to assert a second gift tax to the settlor when one trust transferred assets to a newly created trust. The petitioner’s spouse was a discretionary beneficiary under the first trust and, pursuant to a divorce settlement, also received an income interest of up to $1,000 a year withdrawal right. This 1946 case had little analysis, other than to note that the distribution standard was sufficient to allow the 1934 trust to create the 1942 trust and that parties were adverse because of the divorce. It didn’t address any estate inclusion issue as to the settlor being involved in the modification of the trust.

37. The second case provides a better analysis of a gift tax issue to a beneficiary. In Estate of Franklin Lewis Hazelton, 29 T.C. 637 (1957), Frank was the primary discretionary beneficiary of a trust created by his father in 1935. His sister was a contingent beneficiary. Any future wife or child would also be a discretionary beneficiary but only up to one-third of the income. In 1942, Frank married, and it appears that the couple had no children. In 1951, Frank eventually convinced the trustees to transfer part of the trust property to a new trust for the benefit of himself, as the primary discretionary beneficiary, and his spouse, with the same terms as the first trust, except no restriction that distributions to the spouse were limited to one-third of the income. The Tax Court held there was no gift tax issue because the trust was the donor, not Frank. The Tax Court secondarily noted that, “the transfer resulted in no decrease in the decedent’s interest . . . over what he had before [under the first trust]. . .  So long as the only interest he had, namely, a primary life interest, was not decreased by the transaction he cannot be said to have parted with anything.”

38. Mark Merric, “How to Draft Distribution Standards for Discretionary Dynasty Trusts,” Estate Planning (March 2009). Endnote 33 of the article cites both Restatement (Second) of Trusts (Restatement Second), Section 187 comment j and Section 122, as well as cites cases in 14 states and in two countries other than the United States.

39. Wareh, supra note 35, at p. 14. The UTC was amended at the request of ACTEC to include an option requiring court approval. ACTEC’s concern was that if court approval wasn’t required, IRC Section 411(a) might expose irrevocable trusts in those states that previously required court approval to estate tax. See Blattmachr, supra note 35, at p. 3. See Diana S.C. Zeydel, LISI Estate Planning Newsletter #2139 (Sept. 10, 2013), www.LeimbergServices.com, citing Morse v. Kraft, 466 Mass. 92 (2013); Phipps v. Palm Beach Trust Company, 142 Fla. 782 (1940); Wiedenmayer v. Johnson, 106 N.J. Super. 161 (App. Div.), aff’d sub. nom., Wiedenmayer v. Villaneuva, 55 N.J. 81 (1969); Restatement Third; Treasury Regulations Section 26.2601-l(b)(4)(i)(A)(l)(i).

40. Wareh, supra note 35, at note 3. First New York (1991), then Alaska (1998), Delaware (2003), Tennessee (2004), South Dakota (2007) and North Carolina (2009) enacted decanting statutes. See New York Estates Powers & Trusts Law 10-6.6(b); Alaska Statutes Section 13.36.157; Delaware Code Annotated 12 Section 3528; Tennessee UTC Section 816(b)(27); South Dakota 2007 Session Laws HB 1288; North Carolina General Statutes, Section 36C-8-816.1. See also Blattmachr, supra note 35, at p. 1 (Arizona and Florida as additional states that have adopted decanting statutes).

41. Blattmachr, supra note 35, at p. 19 (South Dakota’s decanting statute, effective July 1, 2007, provides the most flexibility for trust remodeling). Compare Jonathan G. Blattmachr, Bethann B. Chapman, Mitchell M. Gans and David D. Shaftel, “New Alaska Law Will Enhance Nationwide Estate Planning—Part 1,” Estate Planning, Vol. 40/No. 9, at p. 3 (September 2013). 

42. In “4th Annual Trust Decanting State Rankings Chart (2016),” Steven J. Oshins ranks 25 jurisdictions based on decanting statutes and various factors. The top 10 listed are: (1) South Dakota; (2) Nevada; (3) Tennessee; (4) New Hampshire; (5) Delaware; (6) Ohio; (7) Alaska and Illinois (tie); (9) Indiana; and (10) Missouri and Wyoming (tie).

43. In addition, some states have newer statutes that may have never been fully tested in the courts. Some of the more established jurisdictions have more streamlined procedures. Legal fees and other considerations may differ based on the court required process and delays. See Wyo. Stat. Ann.
Section 4-10-816(a)(xxviii) for an example of a basic decanting statute. 

44. Treas. Regs. Section 26.2601-1(b)(4). One safe harbor applies to the exercise by a trustee of a discretionary power to distribute trust principal from a grandfathered trust to a new trust, but only if the discretionary power is pursuant either to the terms of the trust instrument or to the state law in effect at the time the trust became irrevocable. Another safe harbor applies to a modification of a grandfathered trust that doesn’t shift a beneficial interest to a lower generation or postpone vesting. ACTEC’s concern was that if state law didn’t require court approval, IRC Section 411(a) might expose irrevocable trusts in those states that previously required court approval to estate tax under an IRC Section 2038 theory. South Dakota has modified its law to require court approval. Telephone discussion between Daniel G. Worthington and Al W. King III, CEO, South Dakota Trust Company, Oct. 26, 2009, discussing Rashad Wareh’s concern.

45. Uniform Trust Decanting Act (2015), National Conference of Commissioners on Uniform State Laws, www.uniformlaws.org/shared/docs/trustdecanting/UTDA_Final%20Act.pdf. The UTC, which has virtual trust provisions, has been adopted by 22 states. For a full treatment of virtual representation statutes see “Virtual Representation Statutes Chart Revised,” ACTEC website (April 14, 2015). Seewww.sidley. com/~/media/uploads/virtual-representation-statutes-chart.pdf.

46. Only two states have specific special purpose entities (SPE) statutes—New Hampshire and South Dakota. Delaware and Wyoming call the entities they permit—“trust protector companies,” but these entities aren’t recognized by statute. Alaska and Nevada recognize SPEs indirectly.

47. The Securities and Exchange Commission-adopted rule to define “family offices” that will be excluded from the definition of an “investment adviser” under the Investment Advisers Act of 1940 (Advisers Act). Seewww.sec.gov/rules/final/2011/ia-3220.pdf.

48. Virtual Representation Statutes Chart (2016), www.sidley.com/-/media/uploads/virtual-representation-statutes-chart.pdf.

49. SDCL Section 55-3-32. South Dakota’s Virtual Representation statute was reworked and is effective July 2017. 

         Sample Trust Provision Notice: “I hereby direct that the Trustee is not required to provide the notice set forth in SDCL § 55-2-13 to qualified beneficiaries.”

50. Alaska (AK Stat. Section 13.36.080(b)) allows for beneficiary waiver of notice but limits the settlor to exempt the trustee from the notice requirements during the life of the settlor or until the settlor’s incapacity, whichever is shorter; Delaware (Del. Code Ann. Tit. 12 Section 3303) does allow for the waiver of beneficiary notice but restricts it to a period of time and doesn’t expressly allow for the trust advisor or trust protector to modify notice to beneficiaries; Nevada (Nev. Rev. Stat. Section 163.004) enacted legislation effective 2015, but restricts it to a period of time and doesn’t expressly allow for the trust advisor or trust protector to modify notice to beneficiaries; North Dakota (Cent. Code 59-14-03) enacted new legislation in 2017 that makes an exception for cases in which the qualified beneficiary is unknown, because a person holds a power to change such qualified beneficiary; New Hampshire (RSA 564-B:1-105; RSA 564-B:8-813(d)) is silent on timing, but has no specific provision regarding whether advisors can withhold after death/disability that South Dakota provides. See Al W. King III, “Tips From the Pros: Should You Keep a Trust Quiet (Silent) From Beneficiaries?” Trusts & Estates (April 2015), at p. 12.

51. Seewww.macpas.com/privacy-and-trust-planning-the-south-dakota-advantage. Privacy and Trust Planning: The South Dakota Advantage, Quiet Trust—“Most wealthy families want the option of deciding whether to reveal to a child or grandchild that they have a beneficial interest in a trust. However, most states require trustees to inform a beneficiary of his or her beneficial interest in a trust at the age of eighteen (18).  …Referred to as a Quiet Trust, settlors of trusts in the above-mentioned states have control over what information is revealed to a beneficiary and when it is revealed, if at all. South Dakota …the most comprehensive and flexible quiet trust statute in the nation, granting the settlor, trust protector, and the investment/distribution advisor the power to expand, restrict, eliminate, or modify the rights of the beneficiaries to discover information about a trust.”

52. See Greg Omer, Larry Katzenstein and Jason Thein, “Private Trust Companies Authorized under new Missouri Law” (2017), www.thompsoncoburn.com/insights/blogs/bank-check/post/2017-07-28/private-family-trust-companies-authorized-under-new-missouri-law.

53. South Dakota and New Hampshire have regulated private family trust companies (PFTCs), while Nevada and Wyoming focus on unregulated PFTCs for families, even though they have regulated statutes. While Texas isn’t a perpetual jurisdiction, it ranks third with Nevada as the state that has the largest number of PFTCs. See John P.C. Duncan, “Risks and Opportunities for Private Trust Companies and Family Offices from State and Federal (Non-Tax) Legislative Developments and Proposals, Fiduciary Income Tax Committee,” ABA Section on Taxation 2010 ABA Mid-Year Meeting (Jan. 21-23, 2010), https://www.americanbar.org/groups/taxation/events_cle/taxiq_meeting_materials_archives/midyr10.html.

54. New Hampshire recently reduced its capital requirement to $250,000. RSA 383-A and RSA 383-C.

55. South Dakota regulators do prefer that applicants meet larger capital requirements. 

56. Some commentators view lower capital requirements as an advantage because they’re less of a barrier to entry into the PFTC arena. Others say that having larger capital requirements tends to weed out less serious and capable PFTC candidates.

57. However, compare Todd Ganos, “Putting ‘Family’ In Private Family Trust Companies—A Follow-Up Discussion on Regulation,” Forbes.com (Nov. 10, 2015), www.forbes.com/sites/toddganos/2015/11/10/putting-family-in-private-family-trust-companies-a-follow-up-discussion-on-regulation/#7155dd8d28cd.

58. Worthington and Merric, “Which Situs is Best in 2016?” supra note 2.

59. Pfannenstiehl v. Pfannenstiehl, 55 N.E.3d 933 (Mass. 2016), reversing 12137 N.E.3d 15 (Mass. App. 2015).

60. Pfannenstiehl v. Pfannenstiehl, 12137 N.E.3d 15 (Mass. App. 2015).

61. Worthington and Merric, “Which Situs is Best in 2012?” supra note 2.

62. Restatement Second Section 155(1) and comment (1)(b).

63. Ibid.

64. Mark Merric, “How to Draft Distribution Standards for Discretionary Dynasty Trusts,” Estate Planning (March 2009). Endnote 41 lists cases from 16 states noting that a discretionary distribution interest isn’t a property interest.

65. Under common law, the strong majority rule was a discretionary interest couldn’t be attached at common law. Please note that the Restatement Third and the UTC reverse common law in this area allowing a creditor to attach a discretionary interest. However, five UTC states have modified the national version of the UTC to retain common law in this area.

66. Tannen v. Tannen, 31 A.3d 621 (N.J. 2011) affirming the appellate court 3 A.3d 1229 (2010) decision for substantially the same reasons. The appellate court case discusses in detail the proposed change to discretionary trust law by the Restatement Third, concludes that it would create an enforceable right in all discretionary trusts for imputing maintenance and declines to adopt the new position.  

67. One of the other issues discussed above was a remainder interest being considered a future marital property interest under some states laws. The solution to this issue was to draft dynasty trusts.

68. Supra note 6.  

69. Restatement Second Section 187, comment j and Section 122. While this is the judicial standard of review adopted by all courts, it’s by far the most common discretionary trust judicial review standard with courts from 14 states and two other countries using it. See Merric, supra note 64.

70. Originally, Nev. N.R.S. 163.4185 was almost identical to South Dakota St. Section 55-1-138. However, it was modified in 2017 to state that a support interest needed to be a required distribution with an ascertainable standard as defined under the IRC.

71. TN Code Section 35-15-103(10)(c).

72. Ind. Code Section 30-4-2.1-14 and Section 30-4-2.1-14.5.

73. Okla. St. Section 175.825, par. 5.

74. Richard Covey, Practical Drafting (April 2007), at p. 8,918.

75. Pack v. Osborn, 881 N.E.2d 237 (Ohio 2008). Please note that this case has been distinguished by Cook v. Ohio Department of Job & Family Services, 2015 WL 7738415; Gsellman v. Ohio Department of Job & Family Services, 2012 WL 1207419; and Kormanick v. Cooper, 961 N.E.2d 1187 (Ohio App. 10 Dist. 2011).

76. Nev. Rev. St. Section 163.419 par. 1.

77. Wyo. Stat. Section 4-10-504(g).

78. Mark Merric, Michael J. Bland and Mark Monasky, “Beware of Federal Super Creditors,” Trusts & Estates (July 2010), at p. 14.

79. Ibid.

80. Mark Merric and Daniel G. Worthington, “Best DAPT Jurisdictions Based on Three Types of Statutes,” Trusts & Estates (January 2017), at pp. 64, 76; David G. Shaftel, “Comparison of Domestic Asset Protection Trust Statutes,” Estate Planning (March 2008); Mark Merric, John E. Sullivan III and Robert D. Gillen, “Wyoming Enters the DAPT Legislation Arena,” Steve Leimberg’s Asset Protection Planning Email Newsletter #109 and “Searching For Favorable DAPT Legislation:  Tennessee Enters the Arena,” #105.

Attorneys

Butler v. LeBouef*

Gifts to a drafting attorney subject to additional scrutiny 

The drafting attorney in Butler v. LeBouef (248 Cal.App.4th 198 (Ct. App. Calif. 2016)), was the principal beneficiary of the decedent’s $5 million estate. The evidence showed the attorney’s intent to enrich himself and, therefore, the court invalidated the will and trust and removed the trustee.

Charitable Trusts

Private Letter Ruling 201730012

CLAT converts from non-grantor trust to grantor trust

In PLR 201730012 (May 1, 2017), a taxpayer established a charitable lead annuity trust (CLAT). The taxpayer sought to amend the CLAT under state law to allow the grantor’s sibling (who wasn’t a trustee) to have the power to substitute trust property under the meaning of Internal Revenue Code Section 675(4), which would convert the trust from a non-grantor trust to a grantor trust.

The grantor of the trust requested three rulings: (1) the conversion from a non-grantor trust to a grantor trust wasn’t a taxable transfer of property to grantor, (2) the conversion wasn’t an act of self-dealing under IRC Section 4941, and (3) the grantor would be entitled to an income tax charitable deduction in the year of conversion.

The Internal Revenue Service ruled that converting the trust from a non-grantor trust to a grantor trust wouldn’t be treated as a transfer of property to the grantor under any income tax provision. It referred to Revenue Ruling 77-402, which dealt with the income tax consequence of relinquishing grantor trust status or other lapse of grantor trust status. This ruling wasn’t applicable here because the conversion was to grantor trust status, rather than from grantor trust status. While Rev. Rul. 85-13 related to a transaction that was in the right “direction” (the grantor who acquired trust property in exchange for a promissory note caused grantor trust status by “borrowing” the trust corpus), it didn’t conclude that the action was an income recognition event for the grantor. The IRS therefore held that because Rev. Rul. 85-13 didn’t treat conversion of a non-grantor trust to a grantor trust as an income tax realization event and there was a lack of authority imposing such consequences, conversion of the trust to a grantor trust wouldn’t be treated as a transfer of property to the grantor for income tax purposes. 

On the self-dealing issue, the IRS noted that the self-dealing rules in Section 4941 apply to the CLAT as if the trust were a private foundation (PF). The IRC defines “self-dealing” as any direct or indirect transfer to a disqualified person, including a substantial contributor, a manager or certain family members of those persons. The family members who are included as disqualified persons don’t include siblings. Therefore, because the power to substitute trust assets was given to the grantor’s sibling and the sibling wasn’t a disqualified person, holding or exercising such power wasn’t an act of self-dealing.

While the taxpayer received favorable rulings on the first two issues, he wasn’t so fortunate with the last. The IRS ruled that the grantor was unable to take an income tax deduction under IRC Section 170(a). Applying Section 170(a), the IRS reasoned that when the trust converts from a non-grantor trust to a grantor trust, the owner of a grantor trust can only claim a federal income tax deduction if there’s a property transfer to the grantor trust for income tax purposes, and because the conversion isn’t treated as a transfer of property for income tax purposes per the first ruling, no deduction was allowed. 

PLR 201714002

PLR holds that improperly administered CRUT is a PF 

In PLR 201714002 (Dec. 12, 2016), a beneficiary of a charitable remainder unitrust (CRUT) requested guidance on the tax implications of terminating a CRUT gone wrong. On the advice of his lawyer, a taxpayer established a CRUT in part to avoid capital gains tax on sale of low-basis assets. The CRUT provided for a unitrust payment to the taxpayer, and certain other persons, with a net income make-up provision. The lawyers preparing the trust incorrectly advised the taxpayer/beneficiary that he would be guaranteed a certain percentage unitrust payment every year; however, the trust limited the payment to the lesser of the unitrust amount or the trust’s net income (a NICRUT). As it turned out, the trust’s net income actually was often less than the unitrust amount.

Several other errors were made. The lawyers advised the taxpayer that funding the trust wouldn’t be a completed gift because the taxpayer would retain the right to change the successor beneficiaries, but they didn’t include such a provision in the document, and the taxpayer failed to file a gift tax return. The trust was administered by including capital gains in the calculation of the trust’s net income so the payments to the income beneficiary were incorrectly inflated. The taypayer also made additions to the trust after the initial funding, based on the incorrect advice from his lawyer that the trust property was excludible from his taxable estate (which it wasn’t due to his retained interest). The taxpayer died, and a successor unitrust recipient petitioned a local court to terminate the trust. The court issued a declaration that the trust was void ab initio, contingent on a ruling from the IRS that there wouldn’t be additional federal income tax consequences, otherwise the court would declare the trust terminated.

The IRS held that the trust wasn’t void ab initio. It found that while it wasn’t operated properly as a CRUT (because it made distributions to the income beneficiary in excess of what should have been paid), it should be treated as a PF. As a PF, if the trust were to distribute its assets to the unitrust beneficiary, it would be a taxable expenditure and, as the beneficiary was a disqualified person, an act of self-dealing and, further, possibly justify an involuntary termination by the IRS and assessment of further tax and transferee liability. To avoid the various excise taxes, the trust could terminate its PF status under IRC Section 5701(a)(1) by giving notice and paying the required tax. In addition, the trust was required to correct prior year income tax returns.

Digital Assets

Ajemian v. Yahoo

Massachusetts case addresses digital assets

In Ajemian v. Yahoo (478 Mass. 169 (2017)), the Massachusetts Supreme Judicial Court addressed whether the personal representatives of a decedent’s estate had a right to access the decedent’s personal email account managed by Yahoo.

John Ajemian died at a young age in a bicycle accident. His brother and sister were appointed as the personal representatives of his estate and sought access to his Yahoo account. Yahoo agreed to turn over certain limited information to them when presented with a court order, but refused to provide them unfettered access to the account.  

The estate and Yahoo each filed for summary judgment.  John’s siblings claimed that as personal representatives of the estate, they were entitled to access the email account because it was an asset of the estate. Yahoo claimed that it was prohibited from permitting access to the account under the federal Stored Communications Act (the SCA) and, in the alternative, it wasn’t obligated to allow them access under the terms of service (TOS) that John agreed to when opening the account.

The court held that the SCA didn’t prohibit Yahoo from disclosing John’s emails. The SCA allows disclosure with the “lawful consent” of the originator. The court determined that a personal representative of the estate could lawfully consent to the disclosure under the SCA. The court reasoned that to find otherwise would result in a preemption of state law and concluded that Congress intended for lawful consent to encompass certain forms of implicit consent. It also noted that general purposes of the SCA were to prevent unauthorized access by law enforcement and private parties, not personal representatives of estates working to manage estate assets. As a result, Yahoo couldn’t claim that it was prohibited from providing access.

Then, the court remanded to the lower court on the issue of whether the TOS constituted a binding contract. Therefore, there was no resolution as to whether the TOS allowed Yahoo to refuse to grant access.

In summary, the case acknowledges that John’s email account is an estate asset of which the personal representative may seek access and control.  While the SCA doesn’t preclude a personal representative from accessing the account, it isn’t clear if the fine print relating to the email account in this case would give Yahoo authority to prevent access.

While state law on digital assets is evolving (and the interplay with federal law is complicated), estate planners should consider including provisions that authorize fiduciaries to handle digital assets even though there’s currently no guarantee that such provisions will be effective.  Such provisions should be discussed with clients, as many might not want to give family members access to certain digital assets, such as emails, following their death.

Estate & Gift Tax

Estate of Nancy H. Powell v. Commissioner

Tax Court rules on consequences of deathbed FLP transfer

In Estate of Nancy H. Powell v. Comm’r (148 T.C. 18 (May 18, 2017)), the Tax Court ruled on summary judgment motions relating to the estate tax consequences of certain deathbed transfers of decedent Nancy Powell’s assets made by her son, Jeffrey, under her durable power of attorney (POA).

On Aug. 6, 2008, Jeffrey formed NHP Enterprises LP, a Delaware family limited partnership (FLP). The opinion doesn’t say whether Jeffrey contributed assets to the FLP, but he was designated the general partner. The FLP could be dissolved with the consent of all partners. Two days later, just over $10 million in cash and securities were transferred from Nancy’s revocable trust to the FLP in exchange for a 99 percent FLP interest. On the same day (Aug. 8), using Nancy’s durable POA, Jeffrey transferred the 99 percent FLP interest to a CLAT. (Query why the FLP interests weren’t held by the revocable trust and transferred to the CLAT by the trustee.) Under the terms of the CLAT, an annuity was to be paid to the Nancy H. Powell Foundation, a Delaware nonprofit, for the remainder of Nancy’s life and, on her death, the assets to be split among her children. Nancy died one week later, on Aug. 15.

The estate filed a gift tax return for 2008, reporting the gifts relating to the CLAT, along with its estate tax return. The IRS issued a notice of deficiency disputing the value of the gift and included the value of the partnership assets in the estate.

The Tax Court held that the value of the cash and securities transferred to the FLP were includible in Nancy’s taxable estate under two alternative grounds. The first was based on the ability to dissolve the partnership and IRC Section 2036(a)(2). If Nancy had remained the owner of the 99 percent interest in the FLP on the date of her death, the court concluded that she had the ability to dissolve the FLP with the cooperation of her sons (the court didn’t go into detail regarding the revocable trust’s ownership of the interest versus Nancy individually and didn’t state explicitly whether Nancy was the sole trustee). The court held that this ability to dissolve the FLP was a right to designate who would possess or enjoy the property she transferred to the FLP, which would have caused inclusion of the cash/securities in her estate under IRC Section 2036(a)(2) had Nancy held it on the date of her death.  

The estate argued that Nancy didn’t hold this power on the date of her death because the FLP interest had been transferred to the CLAT. However, transferring that 99 percent FLP interest days before her death didn’t change matters, because IRC Section 2035 applied. Section 2035 includes in the estate certain property: (1) transferred, or (2) subject to a power if that transfer is made or that power is relinquished within three years of date of death, if that property would have otherwise been includible in the decedent’s estate.

The second ground for inclusion was based on the right to direct partnership distributions. In its analysis, the court analogized to the foundational case, Strangi v. Comm’r (417 F.3d 468 (5th Cir. 2005)), and noted that even in the absence of the dissolution power, the assets should still be includible under Section 2036(a)(2) because Jeffrey was acting as Nancy’s agent under her POA and was, in his individual capacity, the general partner of the FLP. In effect, Nancy’s attorney-in-fact had the power to make distribution decisions, although in his individual capacity. Unlike the holding in the well-known case
U.S. v. Byrum (408 U.S. 125 (1972)), which held that a decedent, as a majority shareholder, held fiduciary duties to minority shareholders that precluded inclusion under Section 2036(a)(2), the court in Powell found that any fiduciary duties allegedly held by Jeffrey were illusory because his duties were nearly exclusively to Nancy (or to her revocable trust) as the 99 percent limited partner.

The court then applied IRC Section 2043, in concert with Sections 2036 and 2035, to determine that the value includible in the estate was the excess of the value of the cash and securities over the value of the partnership interest. This, essentially, negated the benefit of any purported valuation discounts for lack of control and/or marketability. IRC Section 2043 (titled “Transfers for insufficient consideration”) provides that if a transfer is made for consideration but isn’t a bona fide sale for adequate and full consideration in money or money’s worth, and such property is included under Sections 2035 to 2038, only the excess of the fair market value at the time of death over the consideration paid is included in the gross estate. In this case, the estate didn’t challenge the IRS determination that the sale wasn’t bona fide so the court held that Section 2043 applied, and the value of the assets in excess of the value of the partnership interest was includible.

The court also found that Nancy’s gift of her FLP interest to the CLAT was void under California law (and therefore revocable under Section 2038(a)) because the POA gave Jeffrey only the authority to make annual exclusion gifts to Nancy’s children and not to charities, as required under state law. There was therefore no gift to the CLAT and no gift tax deficiency. However, because no gift occurred, Nancy was treated as owning the FLP interest on the date of her death, and it was includible in her estate.

All together, the end result is that the value of the cash and securities was still includible in Nancy’s estate, and there was no estate tax benefit from the transactions executed by Jeffrey.

The application of Section 2043 in this case is interesting because it’s so unusual. In prior cases, the factual scenario usually involved a decedent who continued to own an FLP interest until his date of death, and the IRS included the value of the assets held in the FLP in lieu of including the partnership interest under Section 2036. Several judges on the Tax Court acknowledged this and concurred in the result only. The concurring opinion held that the same result may be reached more simply by just applying Section 2036(a)(2) as the “string” that pulls the value of the assets transferred to the partnership back into the taxable estate. It argued that the application of Section 2043 simply wasn’t necessary.

Based on Powell, clients who create FLPs and family limited liability companies (LLCs) would be wise to not own any interest at death and not have any voting powers, including any vote on distributions or dissolution. 

Center of Budget and Policy Priorities

Report issued on estate tax facts

In light of the proposals to repeal the estate tax at the time this is written, the following facts may be of interest. According to a report published by the Center on Budget and Policy Priorities on May 5, 2017: 

• Only about 0.2 percent of estates are federally taxable.

• While the top statutory federal estate tax rate is 40 percent, the average effective federal tax rate is about 17 percent, after taking into account the federal estate tax exemption and estate-planning techniques, such as valuation discounts.

• While the estate tax would generate less than 1 percent of federal revenue over the next decade, the Joint Committee on Taxation estimates that repealing the estate tax may cost $269 billion over the same time frame.

Pfannenstiehl v. Pfannenstiehl*

Husband’s right to trust distributions not included in marital estate 

The Massachusetts Supreme Judicial Court reversed the appellate court’s ruling in Pfannenstiehl v. Pfannenstiehl, (475 Mass. 105 (Mass. 2016)) and held that a husband’s right to trust distributions based on ascertainable standards was too speculative and thus wasn’t included in the marital estate. In determining whether an irrevocable trust should be included in the marital estate for division on divorce, the court will closely examine the trust instrument, along with the facts and circumstances of each case to make its decision. When a court determines that an interest in trust property is too speculative, the court may consider the expectancy as a possible future asset or source of income in determining how to divide the marital estate. In other words, the spouse-beneficiary may end up with a smaller share of the marital estate.

Estate Tax Return 

IRS Notice 2017-12 

How to confirm closing of an examination of an estate tax return

On Jan. 6, 2017, the IRS issued Notice 2017-12. The notice provides guidance on the methods available to confirm the closing of an examination of a decedent’s estate tax return. Specifically, the notice announces that an account transcript issued by the IRS can serve as the “functional equivalent” of an estate tax closing letter (Letter 627), in that each of these documents may serve to provide estates and their representatives notice that the IRS has closed a decedent’s estate tax return. Importantly, the IRS stated it will no longer automatically issue estate tax closing letters for estate tax returns filed after June 30, 2015 (with the exception of those returns that were filed solely for the purpose of electing portability, and the portability election was denied) but one can be requested. Therefore, going forward, the account transcript will likely be the primary means by which estates and their representatives are provided notice that the IRS has closed an estate tax return. 

An account transcript is a computer-generated report, available free of charge, that provides current account data such as payment history, refund history, penalties assessed and the date on which the examination was closed. An account transcript presents this data by including numerical codes and descriptions of what each of these codes indicates. For example, code “421” indicates “closed examination of estate tax return.” Therefore, an account transcript showing a transaction code of “421” can independently serve the same purpose as an estate tax closing letter.

Typically, after the issuance of a closing letter or the entry of transaction code “421” on an account transcript, the IRS examination of the corresponding estate tax return is closed. However, the IRS may reopen the examination of an estate tax return after the issuance of a closing letter or the entry of transaction code “421” on an account transcript for the purpose of determining the estate tax liability of a decedent under circumstances described in the closing letter, Revenue Procedure 2005-32 and Rev. Proc. 2005-1.   

Rev. Proc. 2005-32, Rev Proc. 2005-1 and the estate tax closing letters state that an estate tax closing letter doesn’t prevent the IRS from reopening or re-examining the estate tax return to determine estate tax liability if there’s: (1) evidence of fraud, malfeasance, collusion, concealment or misrepresentation of a material fact, (2) a clearly defined, substantial error based on an established IRS position, or (3) another circumstance indicating that a failure to reopen the case would be a serious administrative omission. Additionally, in the case of the estate of a decedent (survived by a spouse) who elects portability of the deceased spousal unused exclusion (DSUE) amount, the issuance of an estate tax closing letter doesn’t prevent the IRS from examining the estate tax return of that decedent for the purpose of determining the transfer tax liability of the surviving spouse of that decedent (specifically, the DSUE amount to be included in the applicable exclusion amount of the surviving spouse).    

Estates and their authorized representatives may request an account transcript by filing Form 4506-T, Request for Transcript of Tax Return via mail or facsimile (per the instructions on the form). Account transcripts for estate tax returns aren’t currently available through the IRS’ automated online system, but the IRS website will have current information should an automated online method become operational. Those who wish to receive an estate tax closing letter may call the IRS at 866-699-4083 to request one. Requests for either document should be made no earlier than four months after filing the estate tax return.  

Estate of Esther M. Hake

U.S. district court finds estate executor’s reliance on erroneous advice on filing deadlines was reasonable

In Estate of Esther M. Hake, No. 1:15-CV-01382 (M.D. Pa. March 9, 2017), the estate filed an action for an abatement of penalties relating to the late filing of its federal estate tax return. The valuation of estate assets was in dispute, and the estate was unable to file its return on time. The executors retained counsel who filed the Form 4768 to extend the due date of the return and payment of tax. As a result, the estate was granted a 1-year discretionary extension of the deadline for payment. With regard to filing, the Form 4768 permits an automatic 6-month extension of the due date. However, the attorneys advised the family incorrectly that the estate had a 1-year extension to file. Based on this advice, the executors made an estimated estate tax payment of $900,000 prior to the extended payment deadline, in an amount of $100,000 more than the actual tax liability. Then, they filed the federal estate tax return on the date they thought it was due, according to advice of counsel, which was actually six months late. The IRS notified the estate that penalties and interest had been assessed for failure to file a timely return.

The court held that the estate’s reliance on their attorneys’ advice was reasonable cause to avoid the assessment of late filing penalties and interest. When a taxpayer fails to file a tax return by the due date, including any extensions of time, a late penalty applies unless it’s shown that such failure is due to reasonable cause and not due to willful neglect. The court held for the estate on its motion for summary judgment because the executors filed the return objectively late, but within the time instructed by their attorneys, and had paid the estate taxes in advance of the payment deadline. The executors exercised ordinary business care and prudence, making their reliance reasonable.

Fiduciary Liability

U.S. v. McNicol*

Decedent’s wife personally liable for unpaid federal tax liabilities

The decedent in U.S. v. McNicol (829 F.3d 77 (1st Cir. 2016)) died owing over $340,000 in unpaid federal income tax liabilities. The decedent’s wife was appointed as executrix, who chose not to pay the tax and instead transferred assets to herself. The court held that the wife, as fiduciary, was personally liable for the unpaid federal tax liabilities following her transfer of estate assets to herself without first paying the estate’s federal tax debts. 

Incomplete Gifts

George Fakiris v. Comm’r 

Restrictions in contract of sale render gift incomplete; income tax charitable deduction denied

In George Fakiris v. Comm’r (T.C. Memo. 2017-126, (June 28, 2017)), George, a real estate developer who owned a 60 percent interest in a real estate development company (the Company), deducted on his personal income tax returns for several years the value of a property that the Company had donated to a charity. The IRS issued a notice of deficiency denying the initial deduction and carryforwards.

The Company purchased an old theater in Staten Island, N.Y., in 2001, planning to build a high-rise development on the property. The community surrounding the historical theater opposed the plan and ultimately a local community dance ensemble expressed interest in the property. The Company decided to make a charitable donation of the theater. However, the dance ensemble hadn’t yet obtained tax-exempt status. So, the Company made a bargain sale to a different charitable organization (the Charity), which already had tax-exempt status. As part of the deal, the Charity agreed to transfer the theater to the dance ensemble once it received tax exempt status from the IRS.

In the summer of 2004, the Company and the Charity signed a contract of sale. Two provisions of the contract were particularly important to the IRS.  First, the Charity was prohibited from transferring the theater property for five years after the conveyance, other than to the dance ensemble. Second, the Company was permitted to transfer the premises to the dance ensemble once the dance ensemble received its tax-exempt status. This second provision was inconsistent with the rest of the contract because the Company no longer had title to the premises after conveyance but the court interpreted it to mean that the Company retained the right to direct the Charity to transfer the property to the dance ensemble.

On the same date that the contract was signed, the theater property was conveyed by deed to the Charity. In addition, the individual who established the dance ensemble and orchestrated the transfer paid the Company $470,000 for the property. The Charity didn’t pay anything to the Company for the theater. An appraisal of the theater property at the time of transfer estimated its value to be about $5 million.

The Company’s income tax return for 2004 shows a sale for $470,000 and a related capital gain. George, however, claimed a noncash charitable contribution of $3 million, which was 60 percent of the $5 million appraised value of the theater (as he owned 60 percent of the Company). The appraised value wasn’t reduced by the consideration paid of $470,000. In 2004 and for the next four years, George claimed charitable deductions related to the contribution and its carryforwards. The IRS disallowed the income tax deductions for three years and issued a notice of deficiency. 

The Tax Court interpreted the contract of sale and held that under New York law, the Company had retained the right to direct the Charity to transfer the theater to the dance ensemble.  The court held that the Company therefore retained “dominion and control” over the property, causing the transfer to be an incomplete gift. A critical part of the opinion analyzed New York state law and concluded that the problematic provisions of the contract of sale didn’t merge with the deed because the contract specifically stated that those provisions survived the transfer of title. As a result, the restrictions were still operative and prevented completion of the gift.

Because the gift was incomplete, the value of the charitable contribution was zero. Due to the disparity between the value of the property claimed on the return and as determined by the court, the court then applied accuracy-related penalties, noting that the accuracy-related penalties don’t distinguish between a valuation misstatement due to legal error versus a valuation error.

Portability

Rev. Proc. 2017-34

IRS simplifies procedures for portability extensions

The IRS issued Rev. Proc. 2017-34, which provides a simpler method for extending the time to file for portability elections.

In 2010, the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act amended Section 2010 of the IRC to allow a “portability” election for the estates of persons who died leaving a surviving spouse. The election permits the DSUE to be used by a spouse, subject to certain rules. To take advantage of portability, the executor of the first spouse to die must make an election on a timely filed estate-tax return.

In 2012, the IRS finalized regulations regarding portability, providing that estates under the federal filing threshold could obtain an extension of time to file the portability election. An estate could initially file for the extension by requesting a PLR under Treasury Regulations Section 301.9100-3 and showing that: (1) the estate acted reasonably and in good faith, and (2) the extension wouldn’t prejudice the interests of the government.

In 2014, the IRS published Rev. Proc. 2014-18, which provided a method for obtaining an extension to make a portability election, but it was only available until Dec. 31, 2014. 

Since the end of December 2014, due to the numerous PLRs issued under Treas. Regs. Section 301.9100-3 granting extensions, the IRS determined that it needed to implement a simplified extension process again. Rev. Proc. 2017-34 provides that process for the 2-year period after the decedent’s death, or prior to Jan. 2, 2018 (for those decedents who died more than two years ago).

Under the revenue procedure, estates may make the portability election by filing Form 706 within the necessary time frame (that is, before the later of two years after the decedent’s date of death or Jan. 2, 2018) by making a special note that it’s filed pursuant to Rev. Proc. 2017-34 on the top of the form. To be eligible, the decedent must have died after Dec. 31, 2010, be survived by a spouse and be a citizen or resident of the United States. The estate must be under the filing threshold and not have filed any prior estate tax return.

Form 706 will be considered complete if it’s prepared according to the portability regulations under IRC Section 2010 (these regulations allow exceptions for valuing certain property eligible for the marital and/or charitable deduction). If the filing is made properly, the DSUE will be available for the surviving spouse’s transfers during lifetime or at death. However, the surviving spouse may not use the DSUE obtained through the extension process to claim a credit or refund of gift or estate tax if the statute of limitations for the claim has expired. (However, the spouse could make a protective credit or refund claim within the statute of limitations period, pending the filing of the portability return.)

If a PLR was pending on June 9, 2017, the IRS will close its file and refund the fee paid. The estate should follow Rev. Proc. 2017-34 to obtain an extension.

Estate of Sower v. Comm’r

Tax Court upholds review of return for portability of DSUE

In Estate of Sower v. Comm’r (149 T.C. No 11. (Sept. 11, 2017)), the Tax Court ruled against an estate and held that the IRS was able to review the estate tax return of a decedent’s predeceased spouse for purposes of adjusting the DSUE applicable to the decedent’s return.

After Frank Sower’s death, his estate filed an estate tax return but didn’t use his entire basic exclusion amount. His return showed the remaining amount (the DSUE) to be over $1.2 million. After submitting the return, Frank’s estate received a letter from the IRS stating that the estate tax return was accepted as filed.

Frank’s wife, Minnie, survived him. On her death, her estate filed an estate tax return using Frank’s DSUE. However, as part of its examination of Minnie’s return, the IRS reviewed the calculation of the DSUE on Frank’s estate tax return. It determined that the DSUE wasn’t calculated properly because taxable gifts were omitted from the calculation. After reducing the amount of the DSUE available for Minnie’s estate to just over $282,000, the IRS found that estate tax was due, and it issued a notice of deficiency to her estate for $788,165.

Minnie’s estate filed a petition disputing the deficiency. First, the estate argued that the letter from the IRS to Frank’s estate should be treated as a closing agreement that binds the IRS. However, the court held that only particular IRS forms qualify as closing agreements. In the absence of the proper form, courts have held certain agreements reached between the IRS and an estate have bound the IRS as closing agreements but only when reached through a process of negotiation. In this case, the “accepted as filed” letter sent to Frank’s estate was neither one of the requisite forms nor an agreement obtained after negotiations.

In addition, Minnie’s estate argued that reviewing Frank’s estate tax return for the calculation of the DSUE was an improper second examination. However, the court again disagreed. First, it held there was no examination because an “examination” means a request for further facts. The IRS didn’t request any additional information from Frank’s estate, it just reviewed the returns already filed and in its possession. Second, if there were any such second examination, it was of Frank’s estate tax return, not Minnie’s. Minnie’s estate couldn’t use a purported second examination of Frank’s estate tax return to its own advantage.

The estate made several other unconvincing arguments based on statutory interpretation. It argued that the effective date of the statute didn’t allow the IRS to adjust the DSUE for gifts made before 2010. Lastly, it suggested that when the IRS applied the portability statute, it overrode the statute of limitations on assessment under IRC Section 6501, which violated due process. The court ruled against the estate on both claims.

This case is a reminder that if your clients use the DSUE, the IRS may review and examine the deceased spouse’s return with respect to the calculation of the DSUE when the surviving spouse files his gift or estate tax return, regardless of the statute of limitations under IRC Section 6501. However, under temporary regulations, the IRS may only assess additional tax on the deceased spouse’s estate within the statute of limitations period.

Private Foundations

Rev. Proc. 2017-53

Updates to PF procedures

Rev. Proc. 2017-53 updates the procedure that PFs follow to make good faith determinations that a foreign grant recipient qualifies as a public charity.

Generally, PFs are restricted to making grants to charitable organizations. However, if a PF plans to make a grant to a foreign organization that doesn’t have U.S. charitable status, it may assess whether that grant recipient is the equivalent of a public charity. If it makes a good faith determination that the organization is the equivalent of a U.S. public charity, then distributions to that foreign organization won’t require “expenditure responsibility” under IRC Section 4945, and the grant may count as a “qualifying distribution” under IRC Section 4942. This determination by the PF is often referred to as an “equivalency determination.”

In 2015, final regulations regarding equivalency determinations were issued. These 2015 regulations provide that a PF’s determination will be considered made in good faith if it’s based on written advice that’s current and from a qualified tax practitioner concluding that the grant recipient is a qualifying public charity.  

This new standard, which is elaborated under Rev. Proc. 2017-53, makes several changes to the rules under prior regulations. First, it broadens the class of qualified tax practitioners who can prepare the written advice. Second, it eliminates the special prior rule that allowed a PF to rely solely on grantee affidavits. Third, it now provides a rule for the period during which the PF can rely on that written advice.

Under the revenue procedure, the written advice qualifies as “current” if the law relating to the advice hasn’t changed, and the factual information on which the advice is based is from the current or prior taxable year. As a result, written advice can remain current for two years.

A “qualified tax practitioner” is an attorney, CPA or enrolled agent. A PF may reasonably rely on the written advice in good faith. The standard isn’t met if the PF knows or should know that a qualified tax practitioner lacks knowledge of U.S. tax law relating to charities, or the practitioner wasn’t fully informed as to relevant facts or is otherwise relying on incorrect assumptions.

To meet the standard, written advice should show that the foreign grant recipient meets the general standards of a U.S. charity by including (among others):

• The grant recipient organization’s articles of organization, bylaws or other organizing document;

• The tax-exempt purposes of the organization;

• Confirmation that if the organization terminates or dissolves, its assets will be distributed to another charitable organization;

• Confirmation that the organization has no shareholders or members who have an ownership interest in its assets or income; 

• Confirmation that the organization doesn’t attempt to lobby or influence legislation;

• A description of the past, current and future activities of the organization;

• Confirmation that the organization hasn’t been designated as a terrorist organization; and

• Financial information and demonstration that the organization satisfies any applicable financial/support test.

Same-Sex Spouses

IRS Notice 2017-15

IRS issues guidance on applicable exclusion amount and generation-skipping transfer (GST) tax exemption for same-sex spouses

To apply the U.S. Supreme Court decision in United States v. Windsor and Rev. Rul. 2013-2017, the IRS has issued Notice 2017-15. This notice outlines administrative procedures for taxpayers and their estates to recalculate the remaining applicable exclusion amount and GST tax exemption to the extent that an allocation of that exclusion or exemption was made to certain transfers while the taxpayer was married to a person of the same sex. 

If a taxpayer made a gift to his same-sex spouse prior to Windsor and the limitations period with respect to filing an amended return hasn’t yet expired, then the taxpayer may file an amended gift tax return or supplemental estate tax return to claim the marital deduction (if it would have qualified) and restore the applicable exclusion amount and GST tax exemption allocated to that transfer. However, if the limitations period has expired, pursuant to Notice 2017-15, the taxpayer can recalculate his remaining applicable exclusion amount as a result of the recognition of the taxpayer’s same-sex marriage as if a marital deduction applied. Importantly, Notice 2017-15 doesn’t permit the change in value of the transferred interest or any other change in position concerning a legal issue after the limitations period has expired. Additionally, no credit or refund of tax paid on the marital gift can be given after the expiration of the period for credit or refund.

Following Windsor, generation assignments of a same-sex spouse and that spouse’s descendants made for GST tax purposes are established based on the familial relationship between the same-sex spouses and not their age difference. Regardless of whether the IRC Section 6511 limitations period has expired, if a taxpayer had previously allocated GST tax exemption by filing a return or by operation of law before the date Notice 2017-15 was issued, and such transfer was based on a same-sex spouse’s age-based generation assignment, the exemption allocated to such transfer is void. Therefore, the taxpayer is permitted to restore GST tax exemption allocated to transfers that were made for the benefit of transferees whose generation assignment subsequently changed pursuant to the Windsor decision, so that such transfer was now deemed to be made to a non-skip person.   

To recalculate the remaining applicable exclusion amount or the taxpayer’s remaining GST tax exemption accordingly, the taxpayer should use a Form 709, an amended Form 709 if the limitations period hasn’t expired or Form 706 for the taxpayer’s estate if the gift isn’t reported on a Form 709. The taxpayer should include the statement “FILED PURSUANT TO NOTICE 2017-15” on the form filed. To recalculate an applicable exclusion amount pursuant to a marital deduction, the taxpayer should attach a statement supporting the claim for a marital deduction. If a taxpayer is making a qualified terminable interest property or qualified domestic trust election to obtain the marital deduction, the taxpayer must also file a separate request for relief in accordance with Treas. Regs. Section 301.9100-3. For recalculations of GST tax exemption, the taxpayer should attach a statement that the allocation of GST tax exemption in a prior year is void pursuant to Notice 2017-15 and a computation of the resulting exemption allocation(s) and the amount of the taxpayer’s remaining exemption amount.  

State Income Tax

Bank of America, N.A. v. Comm’r*

Bank was subject to Massachusetts fiduciary income tax 

Bank of America sought an abatement from the Massachusetts Department of Revenue for tax incurred during the 2007 tax year, asserting that because it wasn’t a natural person, it wasn’t an inhabitant of the commonwealth for income tax purposes. The Supreme Judicial Court in Bank of America, N.A. v. Comm’r (SJC-11995 (Mass. July 11, 2016)) reaffirmed that despite having its principal place of business in Charlotte, N.C., the bank nonetheless qualified as an “inhabitant” and accordingly was subject to Massachusetts’ fiduciary income tax. The court’s decision narrowed the prior 2015 ruling to state that to be subject to the Massachusetts fiduciary income tax, a corporate trustee must act in a material fashion within the Commonwealth.

Tax Reimbursement Clause

PLR 201647001

PLR permits addition of tax reimbursement clause

In PLR 201647001 (released Nov. 18, 2016), Grantor 1 and Grantor 2 created an irrevocable grantor trust for the benefit of their children. Due to unforeseen circumstances, payment by the grantors of the income taxes on the trust became unduly burdensome.  

The trustee sought court approval to modify the trust, including a modification allowing the trustee, in his discretion, to reimburse the grantors for tax liability either of them might incur because part or all of the trust’s income was reportable by him to the trust’s status as a grantor trust.    

This clause was in conformance with Situation 3 of Rev. Rul. 2004-64. That ruling states that a reimbursement clause won’t cause inclusion of the value of the property of a trust in the settlor’s gross estate under IRC Section 2036, even when the trustee exercises his discretion to make the reimbursement, so long as this isn’t done by pre-arrangement. The disbursement won’t be deemed pre-arranged if there’s no express or implied agreement between the settlor and the trustee regarding the trustee’s exercise of his discretion. Also, the trustee must be independent, as the trustee was here. 

The IRS held that the foregoing modifications to the trust were administrative in nature, complied with the requirements of the revenue ruling and didn’t result in a deemed transfer of any property by the grantors or their children for federal gift tax purposes. Furthermore, the foregoing modifications wouldn’t result in the inclusion of any trust property in the gross estates of the grantors or their children under Section 2036.  

Trust Accountings

Hilgendorf v. Estate of Coleman*

Court denies request for trust accounting

In Hilgendorf v. Estate of Coleman (41 Fla. L. Weekly D2402 (Fla. 4th DCA Oct. 26, 2016)), a beneficiary requested trust accountings for the period that the settlor was living. The court held that an estate or beneficiary of a revocable trust can’t compel the trustee to render an accounting of transactions that occurred while the settlor was living when: (1) the trust didn’t require accountings during the settlor’s life; (2) the settlor never requested accountings; and (3) there’s no showing of any breach of fiduciary duty.

Valuations

Estate of Eva Kollsman

Court upholds IRS valuation of paintings

In Estate of Eva Kollsman, T.C. Memo. 2017-40 (Feb. 23, 2017), the IRS assessed a deficiency related to the valuation of two paintings. The estate owned two paintings, one known as Maypole, by Pieter Brueghel the Elder, and the other known as Orpheus, the artist of which was in some dispute (it was believed to be painted by Jan Brueghel the Younger, Jan Brueghel the Elder or a Brueghel studio). Under Eva’s estate plan, the executor was also the residuary legatee and therefore due to inherit the paintings.

After Eva’s death, Sotheby’s gave an estimate of the paintings’ values in an opinion letter based on personal inspection: $500,000 for Maypole and $100,000 for Orpheus. These values were ultimately used as the estate tax values, and the opinion letter was attached to the estate tax return. At the same time, Sotheby’s and the executor entered into an agreement giving Sotheby’s the exclusive right to auction the paintings for a 5-year time period.  

The executor hired a restoration company to remove layers of dirt from the paintings. The restoration company insured the artwork while it had the paintings under its custody. The amount of insurance was determined based on recommendations by the executor: $2 million for Maypole and $500,000 for Orpheus. The cleanings were relatively low risk and very successful.

Three and a half years after the valuation date, Maypole was auctioned by Sotheby’s and sold for a hammer price of $2.1 million.   

The IRS determined a deficiency, asserting a higher value for the paintings ($2.1 million for Maypole and $500,000 for Orpheus), and the estate petitioned the court for a redetermination. The estate’s expert from Sotheby’s explained the discrepancy in his valuation date value and sale price of Maypole as a result of the unexpected improvement in condition due to the cleaning and a change in market conditions that had increased demand for paintings of this type. However, the court wasn’t convinced. It found that Sotheby’s’ conflict of interest rendered its opinion unreliable and that the opinion exaggerated the risk that cleaning posed to the painting. It also was unpersuaded by the valuation report, which didn’t include analysis of any sales of comparable paintings. Instead, it accepted the government’s expert’s valuation of Maypole at the sale price and accepted the government’s expert’s value of Orpheus. It found the analysis of comparable sales and reasoning of the government’s valuations convincing and ultimately accepted its initial values, making some adjustments for the uncertainty of the artist and the paintings’ condition. The court settled on a value of $1.995 million for Maypole and $375,000 for Orpheus.

This case demonstrates the importance of a thorough, independent, substantive and well-reasoned valuation report.

Estate of John F. Koons, III, et al. v. Comm’r

Estate denied deduction for Graegin loan

The estate of John F. Koons, III was denied a deduction of $71,419,497 for interest payable on a loan made to John’s revocable trust to pay estate taxes (Estate ofJohn F. Koons, III, et al. v. Comm’r, T.C. Memo. 2013-94). 

The estate held about $19 million of liquid assets, and John’s revocable trust owned 50.5 percent of Central Investment LLC (CI LLC), which included a 46.94 percent voting interest and a 51.59 percent non-voting interest. The estate tax liability was approximately $21 million, and the revocable trust was subject to a GST tax liability of approximately $5 million. On audit, the estate tax and GST tax liability were determined to be $64 million and $20 million, respectively. The deficiency was related to the valuation of the interest in CI LLC owned by the revocable trust and a denial of the deduction for the interest on the loan made to the estate by CI LLC, described below.

To pay the taxes, on Feb. 28, 2006, CI LLC loaned the estate $10.75 million with interest accruing at 9.5 percent. Interest and principal were payable in 14 equal installments, with payments due between 2024 and 2031. At the time, CI LLC owned two operating companies and more than $200 million of liquid assets. CI LLC was the successor, in part, to a family business that bottled and distributed soft drinks and operated a vending machine business.

Before John’s death, agreements had been signed in which CI LLC agreed to redeem the interests of John’s children (these redemptions didn’t close until after John’s death). Prior to the redemptions, John’s revocable trust owned a 49.64 percent voting interest. After the redemptions, John’s revocable trust owned a 70.42 percent voting interest. In addition, before John’s death, pursuant to a settlement and sale agreement with PepsiAmericas, CI LLC revised its operating documents to include certain restrictions, including requirements to hold at least $40 million in assets and a vote of the majority of the members to permit discretionary distributions.

The Tax Court held that the estate couldn’t deduct the interest payable on the loan. Interest on a so-called “Graegin loan” to pay estate taxes must be “actually and necessarily incurred in the administration of the decedent’s estate” to be deductible under Treas. Regs. Section 20.2053-3(a).
(A Graegin loan is named after the case Estate of Cecil Graegin, T.C. Memo. 1988-477, which held that interest on a loan taken out by an estate to pay its estate taxes because it has insufficient liquid assets may be a deductible expense for estate tax purposes.) The Tax Court held that the loan wasn’t necessary because, at the time of the loan, after the children’s interests were redeemed, the revocable trust held a 70.42 percent voting interest in CI LLC, which allowed it to force distributions to the members of CI LLC. The estate’s assets were not only insufficient to pay the estate tax, but also were insufficient to pay the required principal and interest on the loan, which would have required future distributions from CI LLC as well. Because CI LLC would have needed to eventually make distributions to the revocable trust to pay back the loan, there was no reason to make the loan, rather than an initial distribution to the revocable trust.

The Tax Court also agreed with the IRS’ expert on valuation, applying only a 7.5 percent discount for lack of marketability (the estate had applied a 31.7 percent discount) due to the highly liquid nature of the company.

This case shows that a deduction won’t be allowed if the loan isn’t necessary and reasonable. CI LLC’s loan to the estate for a little over $10 million generated interest payments and a claimed deduction of over $70 million, all while the estate controlled a limited liability company with over $200 million in liquid assets. The estate’s position was too good to be true.

Treasury Report in Response to Executive Order 13789 

Treasury to withdraw IRC Section 2704 proposed regulations 

On Oct. 2, 2017, the Treasury issued a report (the October report) to Presidential Executive Order 13789, which directed the Treasury to identify proposed, temporary and final regulations for withdrawal, revocation or modification because they are unnecessary, unduly complex or excessively burdensome or fail to provide clarity and useful guidance.

The October report recommended that the proposed regulations under Section 2704 be withdrawn, finding them to be a “web of dense rules and definitions” that are “unworkable.” The proposed regulations were an attempt to counteract state statutes and case law that, over time, have reduced the ability of Section 2704 to curtail artificial valuation discounts for interests in family controlled entities. The proposed regulations required an interest in an entity to be valued as if certain restrictions on withdrawal or liquidation didn’t exist, either in the entity’s governing documents or state law, without exception for active or operating businesses. Commenters noted that it wasn’t feasible to value an entity in a vacuum, as if there were no restrictions on liquidation or withdrawal. The Treasury agrees, and it plans to publish a withdrawal of the proposed regulations shortly.

The IRS published a notice on Oct. 20, 2017 withdrawing the proposed regulations (REG-163113-02).

2018 Inflation & Other Adjustments

Rev. Proc. 2017-58

IRS sets certain inflation-adjusted tax items for 2018

In Rev. Proc. 2017-58, the IRS published the inflation adjustments for tax items for 2018.  

For an estate of any decedent dying in calendar year 2018, the basic exclusion amount is $5.6 million for determining the amount of the unified credit against estate tax under IRC Section  2010. The exemption for GST tax, which is determined by reference to the unified credit, will also be $5.6 million. 

The annual exclusion is also (finally) increased.  In 2018, the first $15,000 of qualifying gifts to any person are excluded from the calculation of taxable gifts under IRC Section 2503 made during that year.

For calendar year 2018, the first $152,000 (up from $149,000) of qualifying gifts to a non-citizen spouse who isn’t a U.S. citizen (other than gifts of future interests in property) are excluded from the total amount of taxable gifts under IRC Sections 2503 and 2523(i)(2) made during that year.

*Cases denoted with an asterisk originally appeared in the discussion by Joshua S. Miller and Michael Sneeringer in “Fiduciary Law Trends” (Trusts & Estates, May 2017, at p. 25). 

David gratefully acknowledges the assistance of his colleagues in the trusts and estates group at Kirkland & Ellis LLP in preparing this report. They are: partners Angelo F. Ties, Patricia Ring and Anna Salek; and associates Joe Higgins, Kristen Curatolo and Thomas Norelli. He also gratefully acknowledges Alison E. Lothes, an attorney at Gilmore, Rees & Carlson P.C. in Wellesley, Mass.

Residents of the District of Columbia and Maryland will have the benefit of higher estate tax exemptions in 2018.¹   

Federal Exclusion Amounts

For 2018, the federal basic exclusion from gift and estate tax is $5.6 million, which is a $110,000 increase from the 2017 basic exclusion amount.² The annual gift tax exclusion increased by $1,000 to $15,000 per donee for 2018, and the annual exclusion for gifts to non-U.S. citizen spouses is increased by $3,000 to $152,000.³ 

If Congress enacts H.R. 1 as currently written by either the House or Senate, the gift and estate tax exclusion will double to $11.2 million starting Jan. 1, 2018.⁴ The annual exclusions aren’t further increased under this proposed legislation. 

D.C. Estate Tax

As a result of legislation enacted in 2015 and additional D.C. revenue in 2017, the D.C. estate tax exemption for 2018 and future years will be increased to match the federal exclusion amount (for example, $5.6 million for 2018).⁵ This is the highest the D.C. estate tax exemption has been since the current D.C. estate tax system became effective. 

As modified by legislation in 2017, the D.C. estate tax exemption will match the federal basic exclusion amount, as it’s indexed for inflation.⁶ This means that if Congress enacts H.R. 1 as currently written by either the House or Senate, the D.C. estate tax exemption will jump from $2 million in 2017 to $11.2 million starting Jan. 1, 2018.

Maryland Estate Tax

For individuals dying in 2018, the Maryland estate tax exemption will be $4 million, which is a $1 million increase from the 2017 Maryland estate tax exemption. The Maryland increase is part of a 2014 law that gradually increases the Maryland estate tax exemption each year until 2019, when it will match the federal basic exclusion amount.  

Similar to D.C., the Maryland estate tax exemption will match the federal basic exclusion amount starting in 2019, as it’s indexed for inflation. This means that if Congress enacts H.R. 1 as currently written by either the House or Senate, the Maryland estate tax exemption will jump from $4 million in 2018 to approximately $11.2 million starting Jan. 1, 2019.⁷ 

Endnotes:

1. Virginia repealed its estate tax, effective July 1, 2007. Florida’s estate tax ceased to apply when the federal government repealed the credit for state estate taxes. 

2. Rev. Proc. 2017-58, § 3.35 (Oct. 19, 2017). 

3. Rev. Proc. 2017-58, § 3.37(1) and (2). 

4. H.R. 1 – 115th Congress (2017-2018), § 1602. The method for computing the inflation adjustments to the basic exclusion amount could be changed in H.R. 1 from the method being used in 2017. If that occurs, the exclusion amount for 2018 might be slightly different. 

5. D.C. Code § 47-3701(14), as modified by Fiscal Year 2018 Budget Support Act of 2017 (D.C. Council Bill 22-244), § 7173(b) (effective Dec. 13, 2017). 

6. Fiscal Year 2018 Budget Support Act of 2017 (D.C. Council Bill 22-244), § 7173(b) changes D.C. Code § 47-3701(14) to read in part: “‘Zero bracket amount’ means ... (C) For a decedent whose death occurs after December 31, 2017, an amount equal to the basic exclusion amount as prescribed in section 2010(c)(3)(A) of the Internal Revenue Code and any cost-of-living adjustments made pursuant to section 2010(c)(3)(B) of the Internal Revenue Code.” 

7. Md. Code Ann., Tax-General § 7-309 (2017). 

Hugh Hefner, the late founder of Playboy, has always been vocal about his distaste for drugs and alcohol. It’s now been revealed that Hefner’s trust stays true to those views—by including a substance abuse clause that requires his heirs (third wife Crystal Harris and his four children) to stay sober or risk missing out on their inheritance.

According to new details that emerged thanks to a petition filed in Los Angeles by the trustee, the clause specifically provides that “if the trustees reasonably believe that a beneficiary of any trust routinely or frequently uses or consumes any illegal substance so as to be physically or psychologically dependent upon that substance, or is clinically dependent upon the use or consumption of alcohol or any other legal drug or chemical substance that is not prescribed by a board certified medical doctor or psychiatrist in a current program of treatment supervised by such doctor or psychiatrist,” any distributions to the beneficiary will be suspended. Hefner, however, is clearly a believer in second chances, as the trust instructs that distributions can resume after indication that a beneficiary has been clean for 12 months. Determining sobriety, and whether the beneficiary is able to care for himself or herself, is left in the discretion of the trustee, who’s allowed to request a drug test on suspicion of any substance abuse. 

Notorious for his sexual lifestyle, Hefner also went to great lengths to take posthumously conceived children into consideration (or at least his extra savvy estate planner certainly did). His trust makes sure to disinherit “any person who claims to be a child of mine, including any child of mine conceived after my death, unless such child lived with me in my household and was acknowledged by me in writing to be my child.” 

Also notably, Hefner allowed for his sons, Marston and Cooper Hefner, to be appointed as co-trustees after they turn 30 years old, acknowledging they may have “existing or potential conflicts of interest in the administration, management and distribution” of the estate, but explaining that this was his desire given their “special knowledge and skills and relationship” to him. Such appointment certainly must have been a point of contention for the estate planner, who likely advised Hefner of the risks of family tension and disputes that may arise as a result, but it’s a great reminder that a client’s wishes are the driving force of an estate plan.

For more information on effectively advising clients with a family member suffering from addiction and some language to include in a trust when dealing with a known addict, see Kevin L. Johns’ recent article on the topic.

It seems to me that this publication, as well as others, has recently started to place more emphasis on the “softer side” of the practice, by which I mean the non-tax-related issues, such as the psychological and emotional aspects. For example, in “Filling in the Gaps,” Marvin E. Blum encourages clients to create a “red file” that contains their wishes for future care, financial intentions and a list of personal information in the event of incapacity.¹ After all, transfer taxes before and after death, with inclusion of potential federal and state gift, estate and generation-skipping transfer taxes, will at most help evaporate approximately 40 percent to 50 percent of an estate, but estate disputes, waste, greed and the destruction of the family business could wipe out much more and leave behind terrible family scars and relationships that will never totally heal. The industry is now recognizing the importance of non-tax issues because of: more frequent and bitter estate disputes; lower transfer tax rates and higher exemptions; greater potential for estate tax repeal; and a more enlightened society regarding dealing with personal and family psychology and dynamics. It seems we live in this age of entitlement in which many of us deal with our own family members who feel everything is deserved and coming to them, yet these same individuals don’t have the ability to handle or appreciate what they’ll receive. 

Human Capital

In a previous article, “Rethinking the Fabric of Estate Planning: Have We Gotten It Wrong?” my co-author and I discuss how large transfers of wealth can have the potential to create future generations who are unmotivated and immature and have poor self-esteem.² The article concludes that the most successful estate plans transfer not just monetary assets but also human capital, meaning the client transfers his skills and knowledge so that the future generation is prepared to perform in the world and produce economic value. 

In “Changing the Playbook,” another article by Blum,  he discusses “now planning” as one strategy for transferring this human capital.³ Under this strategy, a system is established “through which family members may grow to understand the responsibilities of ownership.”⁴ This can include creating open dialogue among family members, scheduling annual family meetings, involving family members in community matters or involving family members in the family business at a young age. By participating in “now planning,” the next generation is able to gain human capital from the previous generation before it’s too late.

Solving the Impossible

Yet, when clients, who are already in their 60s, 70s and 80s, come to me for estate-planning advice and ask me about potential family sensitivities and conflicts (or when they don’t ask, and I offer my input anyway), I often feel like I can place Band-Aids on the issues, but I can’t ever really solve them. How can I solve impossible issues such as how to divide the family business among the children or make descendants like and respect each other and be happy and satisfied with what they will or won’t receive? Many of the deeper emotional and psychological issues involved likely have persisted for decades, maybe even since the children were very young, and relate to how their parents raised them. Some may involve individual mental health issues that even psychologists and therapists can’t solve. Perhaps we can state that part of these issues is “nature” and the other part “nurture,” but in either case, the estate-planning professional can only do so much, especially so late in the game. 

Getting to the Root of It

Many of my clients are (or at least should be) worried about future estate disputes, the success of their businesses, waste and squandering of assets by spoiled descendants and how their children will get along when the clients are no longer living. Often, to help deal with these issues, we create legal structures like partnerships, draft key employee and company operating agreements and all sorts of types of trusts, such as incentive, marital, discretionary, support and asset protection and focus on who will serve as trustees and their powers to help deal with these issues. Don’t get me wrong. The wise and empathetic estate planner can certainly help minimize the potential for, and the effects of, a later dispute or problem and help descendants to become more productive as well as protect their assets. However, as my own still-young children and I grow older, I realize that these structures and documents don’t get to the root of the issues. What’s really needed is teaching the next generation to be self-sufficient, productive, grateful, self-fulfilled, loving and happy people. Obviously, when substantial money is involved (or conversely, sometimes if too little money is involved and there’s tremendous hardship), it’s much more difficult to inculcate higher ideals and values.  

So, what’s the solution? Well, certainly as Blum points out in his “Playbook” article, it’s education and preparedness starting at a young age.⁵ We can’t just start educating our loved ones in the later years of our lives. It’s likely too late if our children are already grown. We also have to start leading by example, and it has to start much earlier. However, to convey this message to relatively young or new parents who may not yet be visiting an estate-planning attorney, there must be far greater understanding and collaboration among all the financial professionals including insurance, banking, brokerage, accounting, legal and perhaps the educational and mental health communities as well, to truly get this important message across. I certainly welcome feedback and advice from the readers of this article as to how to accomplish this extraordinarily complex mission.    

Endnotes

1. Marvin E. Blum, “Filling in the Gaps,” Trusts & Estates (February 2017), at p. 38. 

2. Avi Z. Kestenbaum and Amy F. Altman, “Rethinking the Fabric of Estate Planning: Have We Gotten It Wrong?” Trusts & Estates (February 2016), at p. 32.

3. Marvin E. Blum, “Changing the Playbook,” Trusts & Estates (February 2016), at p. 34.

4. Ibid.

5. Ibid.

As recently as a little over five years ago, estate planners were facing the issue of how the Internal Revenue Service would handle the situation if, say, their client made a gift of $5 million under the available gift tax exemption at the time, but the amount exempt from estate tax reverted to some lesser number prior to the client’s death. Simply put, the issue was whether the Internal Revenue Code Section 2001(b)(1) offset for gift taxes payable would use the estate and gift tax exemption amount applicable at the time of the gift or at the time of the client’s death. If the former was used, the client effectively hadn’t taken full advantage of the larger lifetime gift tax exemption.

The Senate introduced at least one bill at the time that would have had the general effect of restoring the full exemption used by the client at the time of the gift.¹ This bill provided:

(2) DECREASING EXCLUSIONS.—

(A) ESTATE TAX ADJUSTMENT.—Section 2001 is amended by adding at the end the following new subsection:

    “(h) ADJUSTMENT TO REFLECT CHANGES IN EXCLUSION AMOUNT.—

“(1) IN GENERAL.—If, with respect to any gift to which subsection (b)(2) applies, the applicable exclusion amount in effect at the time of the decedent’s death is less than such amount in effect at the time such gift is made by the decedent, the amount of tax computed under subsection (b) shall be reduced by the amount of tax which would have been payable under chapter 12 at the time of the gift if the applicable exclusion amount in effect at such time had been the applicable exclusion amount in effect at the time of the decedent’s death and the modifications described in subsection (g) had been applicable at the time of such gifts.

“(2) LIMITATION.—The aggregate amount of gifts made in any calendar year to which the reduction under paragraph (1) applies shall not exceed the excess of—

“(A) the applicable exclusion amount in effect for such calendar year, over

“(B) the applicable exclusion amount in effect at the time of the decedent’s death.

“(3) APPLICABLE EXCLUSION AMOUNT.—The term ‘applicable exclusion amount’ means, with respect to any period, the amount determined under section 2010(c) for such period, except that in the case of any period for which such amount includes the deceased spousal unused exclusion amount (as defined in section 2010(c)(4)), such term shall mean the basic exclusion amount (as defined under section 2010(c)(3), as in effect for such period).”

Although at first blush, this Senate bill language seemed to adequately cover the estate planner’s concerns, this isn’t the approach the Senate adopted in their most recent legislation. Instead of adding an entirely new subsection (h) to Section 2001, the Senate added the following new subparagraph to subsection (g):

‘‘(2) MODIFICATIONS TO ESTATE TAX PAYABLE TO REFLECT DIFFERENT BASIC EXCLUSION AMOUNTS.—The Secretary shall prescribe such regulations as may be necessary or appropriate to carry out this section with respect to any difference between—

‘‘(A) the basic exclusion amount under section 2010(c)(3) applicable at the time of the decedent’s death, and

‘‘(B) the basic exclusion amount under such section applicable with respect to any gifts made by the decedent.’’

The Conference Committee Report makes two clarifying additions to the bill language itself. First, it inserts the words “the purposes of” after the words “carry out” in the introductory clause.² Second, it adds words that make clear that the basic exclusion amount referred to in paragraph (B) is the basic exclusion amount in effect “at the time of” any gifts made by the decedent.

Why Leave Decision to the IRS?

The obvious question is: Given the potential magnitude of the issue, why did the Senate choose to leave the different basic exclusion amount issue up the IRS to decide, when they had previous bill language available to them that they could have adopted? One reason might be that the 2012 bill language may not have gone far enough.

Assume, for example, that in 2018, an individual with an $11 million net worth gifts all of his assets to his children and pays no federal gift tax. The individual then dies in 2026, with a $0 estate and when the basic exclusion amount has reverted to $5.5 million (on an inflation adjusted basis). Under the 2012 bill, the decedent’s estate would arguably pay no estate taxes.³

Assume instead that the same individual only gave away $5.5 million of assets in 2018 and died in 2026 with a taxable estate of $5.5 million, again when the basic exclusion amount has reverted to $5.5 million (on an inflation adjusted basis). Under the 2012 bill, the decedent’s estate would pay approximately 40 percent estate tax on $5.5 million.

Is this a fair system, or is further thought needed, especially in light of the fact that many of our clients made $5 million taxable gifts before this exemption level was made permanent at the beginning of 2013? Congress may be thinking the same way, as evidenced by its directing the IRS to prescribe “necessary or appropriate” regulations with respect to any difference between the basic exclusion amount in effect at the time of any gifts made by the decedent and at the donor’s death.        

Another reason the Senate may have chosen to defer to the IRS on the different basic exclusion amount issue is that the “limitation” language they employed in proposed Section 2001(h)(2) of the 2012 bill is confusing, at best. Assuming the 2018 gift in the above example was of $11 million, what does it mean to say “the aggregate amount of gifts made in any calendar year to which the reduction under paragraph (1) applies shall not exceed the excess of (A) the applicable exclusion amount in effect for such calendar year, over (B) the applicable exclusion amount in effect at the time of the decedent’s death?” It sounds like this number is $5.5 million, but the gift tax on $5.5 million is $0, so the limitation on the additional tax reduction is $0?

Gleaning the Purposes of Section 2001(g)

Regardless of Congress’ reasons for deferring to the IRS on the different basic estate tax exclusion issue, one thing we do know at this point is that, once again, we unfortunately still have no certainty on the dreaded “clawback” issue. Although the Conference Report tells us that Congress wants the IRS to draft such regulations as may be necessary or appropriate to carry out “the purposes” of Section 2001(g), Congress has given us no express guidance as to what those purposes are. 

One could argue that the “purpose” of Section 2001(g)(1) [previously Section 2001(g)] is to arrive at a unified estate and gift tax system at an individual’s death, that is, through treating all gifts as though they were made at the time of the decedent’s death by using the tax rate that’s in effect at the decedent’s death versus at the time of the gift, for purposes of the Section 2001(b)(2) offset. One could also argue that the purpose of Section 2001(g)(1) is to provide fairness to the decedent’s estate by reducing the estate tax owing by the larger number in a situation in which gifts had been made under a more favorable gift tax, for example, 35 percent rate versus 40 percent rate.

Under either formulation of purpose, that is, the “unified” approach or the “fairness” approach, in issuing its regulations, the IRS would be compelled to use the basic exclusion amount in effect the time of the decedent’s death for purpose of computing the offset under Section 2001(b)(2), assuming the decedent’s death occurred after 2025.  However, the problem remains that Congress has provided us with no express purpose to Section 2001(g), and therefore we can still only speculate as to how the IRS will ultimately handle this issue.

            My next article will address steps an estate planner can take today to best protect his clients in the event the regulations that are eventually issued by the IRS aren’t entirely favorable.   

Endnotes

1. S. Senate. 112th Congress. 2d Session. Middle Class Tax Cut Act. S. 3393, Section 201(b)(2) (July 17, 2012).
2. Note that the Conference Report actually refers to Internal Revenue Code Section 2010(g), which does not exist.
3. But see the argument below where not even this much is clear under the language of the 2012 Senate bill.

The Internal Revenue Service published guidance yesterday that may limit individuals’ ability to deduct prepayments in 2017 of real property tax not assessed until 2018 or later.

Beginning in 2018, the Tax Cuts and Jobs Act limits the combined deduction for state and local tax and property tax to $10,000 ($5,000 in the case of a married individual filing separately). The Act prevents individuals from prepaying 2018 state and local income tax but doesn't prevent individuals from prepaying real property tax. That has set off a scramble to prepay property tax in 2017, when the full deduction is still allowed. In Cook County, Illinois, for example, 47,000 taxpayers have prepaid more than $312 million, according to the Chicago Tribune, compared with just 1,700 who prepaid $13 million one year ago.

An IRS advisory published yesterday, however, could prevent individuals from deducting property tax prepayments in 2017. According to the advisory, whether a taxpayer can deduct a property tax prepayment in 2017 depends on whether the tax was both assessed and paid before Jan. 1, 2018. Prepayments of anticipated real property taxes that haven’t been assessed before Jan. 1, 2018 are not deductible in 2017. Whether a tax has been assessed is a question of state or local law, and states vary widely in when and how they assess property tax.

The IRS advisory includes an example of a county that normally bills residents on July 1, 2018 for property tax for the period beginning July 1, 2018 and ending June 30, 2019. County residents who prepay their 2018-2019 property tax in 2017 can’t deduct the prepayment in 2017, according to the IRS advisory, because the tax wasn’t assessed until July 1, 2018.

The IRS guidance doesn’t address the relatively common situation in which property tax is paid entirely or partially in arrears. In Illinois, for example, tax bills mailed in the spring (sometimes earlier) relate to assessments as of January 1 of the prior year. Thus, an Illinois homeowner who prepays property tax in 2017 should be allowed to deduct the payment in 2017 because the bill the homeowner will receive in 2018 will relate to a 2017 assessment.

Already, questions are being raised about whether the IRS advisory is correct. The Tax Code section that allows a deduction for property tax refers to when the tax is “paid or accrued,” not when the tax is assessed. Thus, the IRS advisory, arguably, is inconsistent with the law.

Even if the IRS guidance is incorrect, however, there are several issues individuals should consider before prepaying property tax. First, the deduction is only available to individuals who itemize their deductions; individuals who claim the standard deduction will receive no tax benefit from prepaying their property tax. Secondly, the deduction will not provide a tax benefit to individuals who are subject to the Alternative Minimum Tax. In addition, homeowners should confirm that their locality will accept a property tax prepayment. Many jurisdictions have expanded their prepayment programs to accommodate individuals who want to prepay their property tax in 2017; however, not all localities accept property tax prepayments. Finally, taxpayers whose mortgage lenders require taxes to be paid into an escrow (but who prepay 2018 property taxes directly to the local taxing authority) may inadvertently trigger an audit of their 2017 federal return since the amount of taxes reported to the IRS by their escrow agent will not include the direct 2018 prepayment.

For decades, attorneys and trustees have relied on the definition of “ascertainable distribution standards” in Internal Revenue Code Sections 2044 and 2514. Commonly referred to as the “HEMS” standard, the terms “health,” “education,” “maintenance” and “support” have become mainstays of many trust distribution provisions. While there’s significant authority, in both case law and dicta, about the meaning of “support” and “maintenance,” attorneys and trustees often rely on very general, and liberal, definitions of the terms “health” and “education.” The result is a highly permissive attitude towards discretionary distributions of principal and income of a trust for purposes of health and education. Compare this permissive oversight to distributions for less specific purposes, which are shoehorned into definitions such as “maintenance” and “support,” which become subject to intense scrutiny by an independent trustee or beneficiaries with an adverse interest. 

In many cases, trust documents provide scant defining language for trustees to limit the distribution scheme for health and education expenses. The intent of settlors, either express or implied under the trust agreement, often serves as the primary source of this permissive distribution scheme. Without the input or consent of settlors, a modification to this scheme may not be possible unless otherwise permitted by applicable state law.¹ Indeed, state laws define and limit discretionary distributions bound by ascertainable standards,² and frequently, states offer no precedent, or precedents vary widely among states.³ Even if a modification of the distribution scheme was possible, such a modification may result in unnecessary liability for a trustee, especially in cases in which a refusal to make a distribution results in physical or financial harm to a beneficiary.  

On the other hand, unrestricted distributions for health and education purposes can have a dramatic effect on the remaining trust beneficiaries. For example, a beneficiary with a catastrophic illness, whose insurance doesn’t cover all necessary treatments, could quickly drain the assets of a common sprinkle or pot trust with multiple beneficiaries. In addition, a beneficiary whose educational pursuits extend well beyond the reasonable time frame for earning a degree could, in the best case, establish a precedent for other beneficiaries and, in the worst case, also quickly drain trust assets at the expense of other beneficiaries. 

The changing costs and value, of both health and education, may require trustees to take a much more proactive role in monitoring distributions for these purposes. If distributions can’t be restricted, proper counseling for beneficiaries for health care and educational decisions may be important. Attorneys, trust settlors and trustees should employ the following suggestions for drafting and administering health and education distribution standards. 

Defining “Health” 

In many trusts, the term “health” isn’t defined, and a settlor often hasn’t given much thought to the health goals of a trust. Sometimes, the settlor wants to maintain flexibility and avoid dead-hand control. In other cases, the attorney interviewing the settlor simply hasn’t inquired about these goals. Regardless of the reason, silence on the settlor’s intentions with respect to health may not provide enough flexibility to avoid catastrophic losses for the trust.

Custom definitions of “health” can fill these gaps. It’s important to include language that creates flexible guidelines that can adapt to the circumstances of each individual beneficiary, as well as the economic and political environment in which the trust is administered. If the settlor desires, certain goals can be made mandatory, such as the maintenance of adequate primary health care coverage. Attorneys must include appropriate Health Insurance Portability and Accountability Act waivers to enable a trustee to exercise discretion that calls for investigating health or obtaining information as suggested herein.⁴

There are a variety of ways in which a trust can define “health,” including:

• The definition of the ascertainable standard itself could limit the term. For example, distributions can be limited to purposes of unreimbursed health and medical expenses or out-of-pocket medical expenses. This approach treats the trust as last-dollar, while requiring the beneficiary to rely primarily on available health care coverage. Limiting language could permit a trustee to secure trust assets from forced distributions.   

• A formal definition of “health” may require a beneficiary to obtain health care coverage for which he’s eligible as a condition to receiving distributions for health purposes. The trustee could work with the beneficiary to shop for and obtain adequate coverage, with the beneficiary’s share of premiums, deductibles, coinsurance and other cost-shifting mechanisms being billed to or reimbursed by the trust. 

• Settlors who create trusts intended to provide for a beneficiary for the remainder of his life before passing corpus to remainder beneficiaries might encourage the trustee to consider using trust assets for the purchase of a long-term care insurance policy. 

• The trust could include incentive provisions to encourage preventative health care. Distributions for health, or other purposes, could be conditioned on the beneficiary maintaining certain health standards, such as annual checkups, acceptable markers (such as cholesterol, blood pressure), etc. Additional incentives could be provided for exercise programs, weight loss or improvement in health markers over time. However, care must be taken to design and implement incentives that are objective, ascertainable and encouraging. If, for example, a trustee informs a beneficiary that he’s visibly gained weight, this revelation may discourage the beneficiary and could cause irreparable harm to the relationship between the beneficiary and trustee.

• Remedies associated with Eastern health care warrant consideration as practices like acupuncture, herbal medicines, cupping, massage and aromatherapy gain more awareness and acceptance by Western cultures. 

• A trust could set mental health guidelines and permit a trustee to make distributions for counseling, rehabilitation and substance abuse programs. Again, this expansive and often misunderstood area of a person’s health can leave a trustee guessing at the settlor’s intent. Moreover, psychiatric well-being needs to represent an area of health often unmet by traditional health insurance policies.  

• A trust could limit the types of distributions that can be made for health purposes. For example, a settlor may wish to prohibit distributions for purposes of unnecessary cosmetic surgery, in vitro fertilization, adoption, family planning, hormone replacement or gender reassignment surgery.  

Defining “Education” 

Many trusts contain a definition of “education” which, at a minimum, requires a beneficiary to enroll in an accredited educational institution and pursue a course of instruction leading to an undergraduate or graduate degree or specialized or vocational training and certification. While these requirements are still practical, this boilerplate definition ignores common political and economic issues with education.⁵

First, commonly accepted standards for accreditation have changed, especially in the wake of highly publicized scandals and shutdowns involving for-profit colleges such as ITT Technical Institute. Even law schools and non-profit educational institutions haven’t been immune to these troubles, with schools such as Charlotte School of Law, Whittier Law School and Minnesota Music College recently shutting their doors. While there’s no universal standard for accreditation within most trusts, the question of whether an educational institution is eligible to receive the proceeds of aid, such as federal grants and loans from the Department of Education, often serves as the sole criterion. With Congress debating the eligibility of institutions to receive aid, this assumption may no longer be practical.⁶

Second, the traditional path to earning a bachelor’s or graduate degree has evolved. For example, in the past, the timeframe for earning a college degree usually involved eight semester hours of credits, taken over a 4-year period, with summers off to seek employment experience and internships. Many students, however, now have expanded options to reduce this timeframe. Internships can be used to earn credit hours, summer school can accelerate the traditional 4-year timeframe and some institutions may even follow a cooperative model to alternate classroom instruction and on-the- job training. Many schools offer activities such as study abroad programs, structured social and athletic dorms and communities and Greek life. Ultimately, these opportunities may not align with a trust settlor’s vision of college education for trust beneficiaries.  

Third, higher education costs have skyrocketed. On average, the cost of college education has outpaced inflation by 3.2 percent to 4.4 percent over the last three decades.⁷ The payment of the face amount of tuition for one or more trust beneficiaries can rapidly deplete the trust estate, while leaving few remaining assets to satisfy the beneficiary’s other needs. However, the limitation of educational opportunities for a beneficiary who would otherwise have the means through a trust can have a chilling effect on the beneficiary’s livelihood, confidence and experience.  

While these illustrations provide a snapshot of the common current issues, it’s important not to focus myopically on present issues. Different issues may ultimately be relevant when beneficiaries of a trust begin attending college. Accordingly, drafting educational standards must strike a balance between being reactive and forward thinking. For example, some states now subsidize community college or the pursuit of a bachelor’s degree for residents.⁸ If a beneficiary qualifies for state or private assistance, such as scholarships or grants, the practical approach for a trust is to maximize such assistance before making distributions. 

In addition, beneficiaries who don’t receive funding from their own efforts or from the trust have the option to seek federal and private student loans. Given this option, the language of a trust should take into account the practicalities of education finance. For example, could a trust pay off a beneficiary’s student loans incurred prior to the death of his parents? Could the trust provide a loan to the beneficiary for education with favorable payment terms on completion of a degree and attainment of employment? Encouraging the beneficiary to get some “skin in the game” can yield stronger beneficiary commitment to the educational program. Trust language can address troubling issues head-on and enable the trustee to incentivize beneficiaries and hold them accountable for their educational pursuits. 

Due to the ever-evolving issues in education, it can be very difficult to draft language that’s flexible enough to address all possible outcomes while also honoring the intent of the settlor. To satisfy both goals, it’s important for advisors to create a more meaningful and efficient process for analyzing the settlor’s goals. The following list contains helpful questions to facilitate this process:

• Should the trustee decline to pay for education at for-profit institutions?

• Should a more objective system for determining quality of education be used? For example, a settlor may wish to limit the choices of colleges to those that are ranked at a certain level nationally or that are accredited by specific organizations. 

• Should the trust impose a dollar limit on tuition (in total or annually) and/or impose a time limitation on the achievement of a degree or certificate program?

• Should continued academic achievement or progress be incentivized? For example, should the beneficiary be required to maintain a certain grade point average (GPA) and/or complete a certain number of credit hours each semester?

• Should the trustee work with the beneficiary to assist with the choice of college?  

• Should the trust be treated as last-dollar? That is,  should beneficiaries be incentivized to maximize scholarship opportunities?

• Should the trust pay for cultural experiences, such as study abroad programs?

• Should the trust pay for college preparation, such as college preparatory academies and preparation programs for college admissions tests such as the SAT or ACT?

• If a beneficiary has the potential to gain an athletic scholarship, should the trust also pay for athletic training and competition expenses?

• Should the trust provide for retroactive reimbursement of educational expenses, or student loans, incurred prior to a beneficiary’s interest vesting in a trust?

• Should ancillary costs, such as room and board, be limited? For example, should a trust pay more for a single occupancy dorm room for a beneficiary, instead of a less expensive double occupancy room?  

• Should social costs, such as Greek life, be subsidized in full or in part? If so, should the beneficiary also be required to submit to the trustee for drug testing or participate in drug and alcohol awareness and education programs?

• Should a trustee or a trust protector have the authority to adapt any of these educational guidelines to take into account changing circumstances?

In some cases, the trust instrument may not always be the appropriate place to include the settlor’s wishes. Objective or rigid goals that apply to all beneficiaries, such as avoiding for-profit colleges or maintaining a certain GPA, could be included in the trust itself. In cases in which a settlor’s goals are flexible or unique to a specific beneficiary, a better approach would be for a settlor to create non-binding letters of instruction to a trustee that could serve as evidence of a settlor’s intent if the terms of the trust are called into question.  

Health and Education Gap Fillers

Absent guidance, trust documents offer little opportunity for a trustee to limit health and education expenses. Often, the health and education terms of a trust can’t be changed, due to the death of the settlor(s) and/or the irrevocability of the trust. In this scenario, trustees may find themselves in a difficult situation. Life-and-death consequences tied to health distributions and generally accepted health care needs won’t challenge trustees as much as distributions for newer health care practices or expenses associated with healthy lifestyles. Educational expenses that were acceptable yesteryear may not be acceptable in the future. A trustee acting on current standards may end up in conflict with a beneficiary who’s damaged based on future standards.  

As noted above, the question of whether a distribution for health or education is appropriate is primarily driven by an analysis of the settlor’s intent.⁹ In the absence of ambiguity in the trust, or evidence of a mistake of law or fact by the settlor, the only source of settlor’s intent is the trust instrument itself.¹⁰ This leaves very little room for extrinsic evidence to be used, by either a trustee or a beneficiary, when a question of the necessity of a distribution arises. However, this general principle of law can also provide more certainty in such a case.  

Given this reality, a trustee should analyze the reasonableness of any limitation on distributions for health or educational purposes. While trustees often can’t deny distributions couched as necessary for health or education, they can use some common grounds to limit them, including:

• The trustee feels that the proposed distribution will rapidly deplete the trust at the expense of other beneficiaries.

• The trustee questions whether the purposes for which a distribution is proposed will actually advance the beneficiary’s health or education.  

• The trustee believes that the beneficiary’s own resources are sufficient so as not to require the distribution.  

• The trustee fears that allowing the distribution could cause a breach of fiduciary duty.  

• The trustee believes the distribution will frustrate another purpose of the trust.

• The trustee’s exercise of discretion in denying the requested distribution aligns with the trustee’s established and consistent prior administration. 

• The trustee observes that the distribution varies from the beneficiary’s accustomed standard of living prior to the settlor’s death.

Common trust provisions can preclude a trustee from limiting a distribution based on these grounds. For example, provisions waiving the trustee’s duties to equalize distributions to beneficiaries, or to preserve trust assets for remainder beneficiaries, may not support a trustee’s objection to a distribution. On the other hand, trust provisions requiring the trustee to take into account the beneficiary’s resources outside of the trust, or to limit distributions to emergencies or basic education, may serve as sufficient grounds for a denial.  

If issues aren’t resolved by the terms of a trust, state law and dicta may become a necessary resource. Applicable authorities may be on point if the trust is organized and administered under the laws of the same state. However, if the trust is formed in one state, but administered in another state, a trustee often must reconcile conflicting principles of trust administration. The interpretation of the terms “health” or “education” could be based on the trust’s choice-of-law provision or based on the situs of the administering trustee. Variations among state laws could provide grounds for conflict between beneficiaries and trustees.

Beneficiaries and trustees may resolve these conflicts by agreeing to policies for distributions, including for purposes of health and maintenance. Unfortunately, these agreements stem from costly litigation billed to the trust. Many states permit beneficiaries and a trustee to consent, in writing, to specific actions in administering a trust.¹¹ Such policies could include, for example, a requirement that beneficiaries maintain adequate health care coverage to be paid for by the trust or a requirement that beneficiaries complete college within a certain amount of time. If the beneficiaries can’t all agree on major issues, the trustee may have additional remedies to act unilaterally, such as decanting or modification of the trust in response to unforeseen circumstances.¹²

Practical considerations also abound in resolving questions of distribution. When compared to educational expenses, distributions for health tend to carry the greatest necessity and urgency. However, this reality doesn’t completely discount the importance of swiftly analyzing distributions for purposes of education. If a beneficiary’s tuition is due and remains unpaid by a trustee, such a delay could cause disenrollment or a loss of credit hours to a beneficiary. These risks and consequences are external to the trust, as opposed to internal (such as trust depletion). The trustee should always consider these external risks to an individual beneficiary. 

Responding to Changing Landscape

Beneficiaries of a trust have highly individualized needs, and it can be difficult to anticipate their individual health and education needs based on the information available at the time that a trust is created. Recently, both technology and public policy with regard to health and education have changed, and trusts created before these changes occurred may not provide trustees with guidance needed to implement the settlor’s intent. Conflicting viewpoints in the public eye between the necessity, or luxury, of health and education have yet to stabilize and will likely continue to vacillate for the foreseeable future. More than ever, the rapidly changing health and education landscape makes it imperative  for attorneys, settlors and trustees to define “health” and “education” and set distribution guidelines in trusts.  

Endnotes

1. Revenue Ruling 77-194; Philip E. Heckerling Institute on Estate Planning, Vol. 23, Section 1902.1 (1989).

2. See Uniform Trust Code (UTC) Section 107 (2000).

3. See, e.g., Carol Warnick, et al., “Drafting and Interpretation of Discretionary Distribution Standards,” Colorado Estate Planning Handbook, Section 26.2.2 (Sixth ed.).

4. Jacqueline Myles Crain, “HIPAA—A Shield for Health Information and a Snag for Estate Planning and Corporate Documents,” 40 Real Prop. Prob. & Tr. J. 357 (Summer 2005). 

5. See, e.g., H.R. 1, Tax Cuts and Jobs Act, Section 11032, 115th Congress (2017-2018) (expanding permissible distributions of Internal Revenue Code Section 529 plans to include elementary and secondary educational expenses).

6. See, e.g., College Transparency Act, H.R. 2434, 115th Cong. (2017).  

7. See The College Board, “Trends in College Pricing,” at p. 3 (2017), https://trends.collegeboard.org/sites/default/files/2017-trends-in-college-pricing_1.pdf.   

8. See, e.g., Tennessee Promise, which provides a 2-year scholarship to Tennessee residents for the pursuit of an associate’s degree, http://tnpromise.gov/about.shtml.  

9. See UTC, “Overview of Uniform Trust Code,” Article 4 (“preserving the settlor’s intent is paramount”) (2000).

10. See Uniform Probate Code Section 2-805.

11. See, e.g., Section 111 of the UTC of 2010, permitting a trustee and beneficiaries to enter into a binding nonjudicial settlement agreement. 

12. See Article 4 of the UTC of 2010 for the most common remedies available to a trustee; see also the Uniform Trust Decanting Act (2015). 

Families wishing to pass down wealth to future generations are increasingly turning to long-term trusts as a way to protect their assets and serve the needs of their heirs. In establishing such trusts, wise settlors realize that, despite the initial appeal of controlling the funds through strict provisions in the trust document, the trusts must be flexible enough to give their trustees the ability to adapt to changing times.

However, settlors may still wish to ensure that decisions are made in accordance with the values and practices behind their own success as wealth creators. When family members are spread throughout multiple countries, settlors have even greater challenges in incorporating their wishes and objectives into their estate plans. For tax and other reasons,¹ they often establish trusts based in countries other than their own. Trustees are provided with broad discretion, because with multinational families, it’s especially important to be able to take into account and provide for the increasing mobility of family members who may be living in different cultures and/or have various tax residencies. At the same time, settlors struggle to articulate their wishes so that future trustees and beneficiaries understand and embrace their intentions. 

There’s no magic bullet to guarantee success. Whatever actions one takes, myriad legal obstacles and family dynamics may intervene. Let’s explore varying views across jurisdictions as to the relative importance of adhering to the settlor’s intent versus administering a trust primarily for the benefit of the beneficiaries. 

Offshore Trusts

Global families often favor offshore trusts as a way to maintain and protect the family’s nest egg for the benefit of future generations who will long outlive them. However, offshore trusts have historically been shrouded in secrecy. Beneficiaries may not become aware of their interests in such trusts until the settlor has passed away, and they’re contacted by the trustee. For instance, countries following the conventions of English law, such as the Cayman Islands, don’t generally require trustees to notify beneficiaries of traditional trusts until their interests are vested, unless there’s a demand for documents or the trust deed provides otherwise. And, under the newer types of trusts in many of these offshore jurisdictions, beneficiaries may not even have standing to enforce the trust.² Although the current global movement to transparency at all levels may change this, trustees don’t always have the opportunity to meet with beneficiaries while the settlors are alive and aren’t able to ensure that everyone is on the same page in terms of the purpose of the trust fund. There’s often nothing linking future trustees or trust beneficiaries to the settlor’s objectives in establishing the trusts.

A Global Overview

One of the key challenges facing trustees of trusts for multinational families is the possibility of significant differences between how settlors envisioned their trust funds being handled and the needs and desires of their beneficiaries. In balancing these potentially competing objectives, trustees are guided by the laws and practices of the jurisdictions where the trusts are located, by provisions in the trust documents and, to varying degrees, by external input, both written and oral. The degree to which settlors’ wishes trump or are subservient to the beneficiaries’ requests varies among trust jurisdictions. There are continuing shifts in the balance between upholding the settlor’s intent and acting in the best interests of the beneficiaries. 

For instance, as noted in Lewin on Trusts, a seminal treatise by British jurists, “in a conventional family trust, the funds comprised in the settlement are the settlor’s bounty… So far as the trustees are given dispositive powers, they are to make choices which the settlor could have made himself.”³ However, this guidance notwithstanding, in the United Kingdom, thinking has evolved to give an equal and sometimes even greater weight to the rights of the beneficiaries. This may even extend to allowing a trust to terminate or be resettled in a manner completely at odds with the settlor’s intention after the settlor’s death, provided all the adult beneficiaries agree.⁴ 

Courts and practitioners in the British Crown Dependencies, British Overseas Territories and in countries that are members of the British Commonwealth tend to have a less consistent approach. On the one hand, they generally consider settlors’ wishes to be relevant in the administration of a trust.⁵ This is evident in a Canadian case in which the clarity of the settlor’s wishes supported the court’s decision to uphold the settlor’s controversial dispositive provisions despite challenges by a disappointed daughter.⁶ Further, the weight given to the settlor’s intent may even extend to modifying the trust, as in a recent case in which the Supreme Court of Bermuda varied a trust to eliminate the rule against perpetuities and extend the duration of the trust. This decision was based on the belief that the settlor wanted this $2 billion trust to be dynastic and didn’t want succeeding generations of beneficiaries to be spoiled by large personal inheritances.⁷

On the other hand, practitioners and courts in these same countries are also quick to opine that fiduciaries are charged with administering the trust in the best interests of the beneficiaries. This is evidenced by a 1993 case in which the court in the Isle of Man opined that a fiduciary’s duty “was in this instance owed not to the settlor but to the beneficiaries,”⁸ and according to leading Guernsey lawyers, “a protector’s role should always involve consideration of whether or not an action is in the best interest of the beneficiaries.”⁹ So, while any of these countries may appear to be a jurisdiction where the settlor’s intent is primary, in some cases, the interests of the beneficiaries may prevail. The Cayman Islands provide an insightful illustration of this dichotomy. Beneficiaries of Cayman trusts may get together to terminate a trust after the settlor’s death (unless there are minor beneficiaries who may not be “virtually represented” by anyone else). However, the beneficiaries may generally not vary the trust terms unless the changes are in keeping with the settlor’s intent.¹⁰

In keeping with the long-standing importance of individuals’ property rights, the United States historically gave greater deference to settlors’ intent for the trust. This is sometimes expressed in the trust document as the “material purpose” of the trust. However, courts in the United States stop far short of allowing trustees to blindly follow input from settlors if doing so would result in a violation of public policy or would harm people or property. More recently, in some parts of the United States, the balance has shifted to giving greater weight to beneficiaries’ best interests, even if possibly contrary to settlor’s intent.¹¹ However, the current trend in some states is to repudiate the benefit of beneficiary rule in favor of respecting settlor’s wishes.¹² Such states are enacting legislation to clarify this trend and eliminate statutes that appear to support the “benefit-of-the-beneficiary rule.”

In countries where tax minimization is a significant issue, there may also be a tax-related rationale for adhering to a settlor’s wishes as expressed in some trust documents. Varying the provisions of certain types of irrevocable trusts in the United States and other higher tax countries can lead to major tax liabilities. This is especially true of trusts that benefit charities, either through current distributions and/or as remainder beneficiaries. It also applies to most marital trusts, which typically benefit from estate tax deferral if they meet very specific requirements. Changing provisions in trusts such as these may lead to complicated recapture of tax deductions or exemptions that were realized when the trust was originally funded.

In civil law jurisdictions, where trusts haven’t been recognized in the past, forced heirship laws have historically played a major role in placing the presumed interests of certain beneficiaries above the desires of settlors. However, in some civil law jurisdictions, there’s evidence of a shift to adhere to the wishes of settlors as stated in their common law trust documents, provided there’s no fraudulent intent and the trusts were established in conformity with the laws of common law countries. In May 2016, the Paris Court of Appeal upheld the provisions of a trust that benefited only a spouse and not the settlor’s children, having determined that forced heirship rules don’t defeat the terms of a trust. This decision was followed by two 2017 cases involving French nationals who, as California residents at death, successfully disinherited their adult children in favor of their spouses. These cases are viewed as confirmation of the trend toward placing the freedom of a trust settlor above what were previously viewed as the rights of the legal heirs under French law.¹³ 

Communicating Settlors’ Wishes

Giving trustees freedom to administer the trust as they deem appropriate has long been the norm in many offshore jurisdictions. However, while giving trustees broad discretion provides the ultimate flexibility critical to achieving the benefits of a multigenerational trust, trustees will be most effective in carrying out the settlors’ intent when settlors have communicated their objectives for the trusts. They may do so through letters of wishes (LOWs), trust protectors and/or specific provisions in the trust document.

LOWs. LOWs have long been used in many offshore jurisdictions. Often, they conveyed settlors’ specific recommendations for division and distribution of trust assets. As settlors and their advisors in North America and other locations begin to recognize the benefits, the content and focus of LOWs are evolving to include a deeper look into the settlor’s personal aspirations for the trust. 

A LOW is a separate document, and because it’s not legally binding like the provisions in an actual trust document, it’s viewed as wishful guidance for the trustee. Some respected practitioners suggest that, at a minimum, trustees should consider the content of LOWs when administering a trust, but opinions as to how much weight they should give them when making discretionary decisions vary among practitioners in different jurisdictions.¹⁴ 

Given the depth of such personal insights, some settlors may intend their LOWs be for the trustees’ eyes only. While trustees will do their best to honor this, and courts will generally support the confidentiality, future privacy isn’t guaranteed.¹⁵ Even when the trust instrument provides that beneficiaries have no right to see a LOW or that a court can’t order disclosure, English courts have demonstrated a willingness to override these provisions if they feel such restrictions are contrary to the “irreducible core” features of a trust.¹⁶ If the trustee seeks guidance from the courts, judges in the United Kingdom may feel the contents of LOWs are relevant to the issue and require the trustees to disclose them to the beneficiaries.¹⁷ 

In litigation, courts may often order disclosure, as happened in a Channel Islands case in which the court deemed that although the LOWs didn’t bind the trustees, the LOWs could provide important insights into the settlor’s intent and come under a court order for disclosure.¹⁸ Similarly, disclosure isn’t uncommon in divorce situations.¹⁹ Looking forward, the trend to global transparency may lead to details in estate-planning documents being accessible to various parties, possibly including the general public. 

Trust protectors. Settlors wishing to combine future flexibility with recognition of their goals may consider including a trust protector in their trust agreement. As with LOWs, trust protectors have been used in offshore trusts for many decades. As the title of trust protector gains traction, the question of liability becomes more widely discussed. In litigious jurisdictions such as the United States, some states have enacted trust protector statutes that provide that a protector is a fiduciary unless the trust agreement states otherwise. Similarly, the role of trust protector may be viewed as fiduciary in nature in offshore trusts.²⁰

In terrorem clauses. So-called “in terrorem” or “no contest” clauses in trusts and other legal documents are a somewhat crude but potentially effective way for settlors to assure that at least the specific provisions in their documents are upheld. Settlors discourage otherwise litigious beneficiaries from seeking, and possibly obtaining, rights or property that the settlor didn’t intend to pass to them by including language declaring that anyone who contests any of the provisions of the trust is to be considered to have been deceased as of the effective date of the document.

In the United States, a few states expressly prohibit enforcement of in terrorem clauses. However, in keeping with the trend to consider the settlor’s intent, in terrorem clauses are increasingly being enforced. The position of different offshore jurisdictions varies. In the Bahamas, in terrorem or forfeiture provisions in a trust have been codified to discourage any challenges to the validity of the trust or any of its dispositive provisions and ensure the settlor’s wishes will be carried out in accordance with the terms of the trust instrument.²¹ However, in the Cayman Islands, case law has set out that while no contest clauses are enforceable, trustees ultimately can’t be exonerated from their core obligations, and public policy allows a beneficiary to justifiably enforce a trust. ²²

While it may appear so, we don’t intend to discourage the use of trusts, which are a valuable and powerful planning tool to pass wealth to the next and future generations. We intend, however, to highlight the different positions in various jurisdictions with respect to the upholding of a settlor’s intent for settlors to keep in mind as they work to create trusts and establish a long-term legacy.²³                         

Endnotes

1. Additional motivations behind choosing a trust situs outside a home country include privacy, asset protection, location of other family members and security.

2. Under Section 100(1) of the Trusts Laws, beneficiaries of STAR trusts (Special Trusts (Alternative Regime)) in the Cayman Islands have no right to enforce the trust and no enforceable right against a trustee, enforcer or the trust property. Other new forms of statutory trusts include VISTA (Virgin Islands Special Trusts Act) trusts (British Virgin Islands) and discretionary trusts with designated representatives in various states in the United States.

3 Lewin on Trusts, 18th edition (2008), at pp. 1039-1041.

4. Saunders v. Vautier (1841), 41 Eng. Rep. 482. See also John H. Langbein, “Burn the Rembrandt? Trust Law’s Limits on the Settlor’s Power to Direct Investments,” 90 B.U.L. Rev. 375 (2010).

5. Timothy Youdan, “Trust Issues,” presented at the Law Society of Upper Canada, 3rd Annual Family Law Summit, June 11-12, 2009, Toronto.

6. Verolin Spence, et al. v. BMO Trust Company, 2016 ONCA 196.

7. In Re the C Trust (2015:473), the first case heard under Section 4 of the Bermudian Perpetuities and Accumulations Act 2009 as amended by the Perpetuities and Accumulations Amendment Act 2015 by the Supreme Court of Bermuda.

8. Rawcliffe v. Steele [1993-1995] Manx LR 426 (Isle of Man).

9. Alasdair Davidson and Rupert Morris, “To Protect & To Serve,” STEP Journal (April 5, 2017).

10. Sophia Harris, “Cayman Islands: The Trustees’ Perspective: When the Trust Doesn’t Work!” Tax Planning Int’l Review (October 2011).

11. Thomas P. Gallanis, “The New Direction of American Trust Law,” 97 Iowa L. Rev. 215 (2011): “In navigating between the extremes of settlor control and beneficiary control, the law of trusts has at times taken a position more favorable to the settlor, and at other times a position more favorable to the beneficiaries…After decades of favoring the settlor, [American trust law] is moving in a new direction, with a reassertion of the interests and rights of the beneficiaries.”

12. Pamela Lucina and John K. Welsh, “Through a Glass Darkly: Determining Settlor’s Intent in Construing Long Term Trusts,” Tax and Estate Planning Forum 2016, at pp. 10-13 – 10-14.

13. Geoffroy Michaux, Patrice Bonduelle and David Fremont, “Statement of Intent,” STEP Trust Quarterly Review (March 2017), Cour de Cassation Michel X (No. C101004) and Michel Y (No. 101005).

14. Shan Warnock-Smith, Q.C., “Letters of Wishes: Use and Abuse,” STEP Caribbean Conference (2009).

15. In re Rabaiotti 1989 Settlement [2000 JLR 173] (leading Jersey case on beneficiaries’ rights to trust documents when the Royal Court ruled there’s a strong presumption that letters of wishes (LOWs) not be disclosed as they’re confidential to the trustee and its decision-making process). See also Schmidt v. Rosewood Trust Ltd. [2003] 3 AII ER 76 (the Privy Council held that beneficiaries don’t have an absolute right to trust documents).

16. Armitage v. Nurse [1998] Ch 241, England.

17. Breakspear v. Ackland, WTLR 777 (2008) (English case in which trust beneficiaries couldn’t force disclosure of the LOWs, but when the trustees themselves sought the court’s blessing with respect to an exercise of their discretion, the court ordered its disclosure as material relevant to such exercise). 

18. Bathurst v. Kleinwort Benson (Channel Islands) Trustees Limited.

19. Dillon & Dillon, FamCA 319 (2012) Australia.

20. “Cayman Courts and Resolving International and Trust Disputes” by Hon. Anthony Smellie, Chief Justice, The Cayman Islands, presented to the International Trusts and Private Client Forum: Cayman Islands, Oct. 24-25, 2016; see Jersey case of Mourant v. Magnus, JRC 056 (2004), which held “[a] Protector is in a position of a fiduciary…”

21. Bahamas Trustee (Amendment) Act, 2011 (TAA 2011) Section 87A.

22. AN v. Barclays Private Bank & Trust (Cayman) Limited and Others [2006 CILR 367] confirmed by the ruling in AB Jnr & Another v. MB & Others (Dec. 18, 2012).

23. The statements in this article reflect the views of the authors and don’t reflect the opinion or views of BNY Mellon Wealth Management or The Bank of New York Mellon.

Premium financing can be an attractive strategy to fund indexed universal life (IUL) policies. Let’s examine the rewards of a premium financing plan, use a model to analyze IUL returns in relation to the underlying index fund returns, stress test an aggressive plan and the risks it poses and outline a prudent approach to designing, monitoring and managing a successful premium financing plan. I’ll close with a word of caution with issues from actual disputes involving premium financing plans based on attorney Richard L. Harris’ experience as a consultant and expert witness.

Rewards 

The rewards of premium financing are simple: It provides the opportunity to use other people’s money to fund an established need for life insurance. An established need may include estate planning (trust owned life insurance (TOLI) is the focus of this article), wealth creation, buy-sell and other business planning or to fund a personal planning need. The client may not have sufficient current cash flow to pay premiums or may expect a liquidity event in the near future and therefore may prefer to borrow to fund the life insurance. In addition, premium financing allows the client to retain high return assets that would otherwise have been used to pay premiums.  

Premium financing is attractive due to current low commercial loan rates coupled with an IUL policy’s potential to generate reasonable market based returns. Both the policy performance and borrowing rates will vary over the duration of the program, so it’s important to understand their variability, the risks they introduce and how to design and manage the plan to minimize those risks.

Understanding IUL Returns

As discussed in Part I of this article,¹ IUL policies reflect the returns of an index fund,² for example, the S&P 500.  IUL premiums net of expenses and charges aren’t invested directly in the index fund, but rather rely on hedging strategies that reflect the index fund’s performance. The actual IUL return can vary substantially from the index fund’s return due to the fact that the IUL return excludes dividends earned on the stocks comprising the index fund and that adjusted return is subject to a cap (for example, 10.5 percent), a floor (for example, 0 percent) and a participation rate (most commonly, 100 percent).³

Based on these policy limitations, it’s important to understand how IUL returns relate to the returns of the index fund. It’s a simple matter to exclude dividends and then apply the cap, floor and participation rate parameters to a specific annual index return. However, how do you put illustrated IUL returns in perspective, taking into account the long-term performance of the index fund’s underlying stocks with their many and substantial ups and downs?  

All carriers calculate the maximum illustrative rate under AG49⁴ based on historical S&P 500 index 1-year point-to-point returns (excluding dividends on the underlying stocks), a 0 percent floor, a 100 percent participation rate and the carrier’s current cap. Most carriers’ policy illustrations include a table showing how their product parameters would affect the year-by-year historical index fund returns over the past 20 years.  A few carriers offer tools for evaluating IUL rates of return in relation to historical equity returns.⁵ Historical returns are of limited use, however, because no IUL product has been in force over the historical time frame; the non-guaranteed cap, floor and participation rates may have varied from those in the current product; and the historical rates can’t be used as the basis for predicting future performance.  

The John Hancock Life Insurance Company has developed a “rate translator model”⁶ (RTM) that’s based on the capital asset pricing model⁷ rather than on historical returns.⁸ The RTM “translates” a given or assumed equity index fund return into an assumed IUL return. For example, a 6.75 percent index fund return may translate to a 5.50 percent IUL return. Although the model is certainly not the final word on the subject, it’s a useful tool for understanding IUL returns in relation to index fund returns, as well as for comparing IUL returns among various products, each with different cap, floor and participation rates. For a given equity return, the RTM takes into account the long-term performance of the equities market with its expected ups and downs (excluding dividends on the underlying stocks) and then subjects those returns to the specified participation, cap and floor rates of the IUL product indexed account to provide an approximation of the corresponding IUL return.  

“John Hancock Rate Translator Examples” and “Index Fund Returns v. IUL Returns,” this page, show how a given index fund return “translates” to a corresponding assumed “IUL return” based on a 1-year point-to-point IUL strategy with a 0 percent floor, 10.5 percent cap, 100 percent participation rate and excluding dividends. 

The IUL return limitations significantly compress the assumed index fund returns. While the index fund return ranges from 0 percent to 12 percent (a 12 percent swing), the corresponding translated IUL return ranges from 4.01 percent to 6.70 percent (a 2.69 percent swing).  

• In Example 3 of “John Hancock Rate Translator Examples,” 5.15 percent represents the “crossover return,” where the index fund and the corresponding translated IUL return (based on the given IUL limitations) are equivalent. 

• In Examples 1 and 2 of “John Hancock Rate Translator Examples,” we can see that over time, as the index fund performs below the crossover return, the IUL return will be greater because, for the underlying index to return 0 percent or 4 percent over a long term, it would experience many years with returns less than zero, and the IUL 0 percent floor would eliminate those negative returns. 

• Examples 4 to 6 of “John Hancock Rate Translator Examples” show that if over time, the index fund performance exceeds the crossover return, the IUL return will be smaller because it would experience more years with returns in excess of 10.5 percent, and the IUL cap would limit those higher returns to 10.5 percent. Examples 4 and 5 form the basis for Scenarios I and II in the example below.  

Finally, for a given index fund return, the IUL crediting rate will vary depending on the floor, cap and participation rates. For example, given a 7 percent index fund return, a 0 percent floor and 100 percent participation rate, based on the RTM, an IUL product with a
10.5 percent cap will produce a 5.8 percent IUL return, while an IUL product with a 12.5 percent cap will produce a 6.5 percent IUL return.

Aggressive Premium Financing Plans

IUL premium financing plans implemented within the last 15 years have experienced favorable IUL policy returns and progressively lower borrowing rates. But, is this what the future holds? Regardless of the need for life insurance, many clients have been induced to purchase plans that purport to offer no cost or very low cost life insurance. As previously discussed, policy and loan illustrations shouldn’t be taken as guarantees or predictions, yet that’s exactly what the aggressive premium financing plans presume. It’s up to the client based on sound advice from his advisors to determine the acceptable level of risk and whether a premium financing plan is a suitable funding structure.  

These aggressive plan designs are typically based on the following core assumptions:

• The IUL policy illustration is based on the highest illustrative rate allowed by the carrier (6.30 percent in our example below).  

• The loan remains in effect for the insured’s lifetime.⁹ 

• Loan interest is accrued and remains at today’s low levels for all years of the plan.¹⁰ 

Although an aggressive premium financing program may look good based on historical index fund performance and might live up to its promise, there’s a substantial chance that it won’t and that it could fail spectacularly.  

What Could Go Wrong? 

Poorer than expected policy performance and higher loan rates can lead to several negative outcomes. Once performance starts to slip, the grantor would have to post and place at risk additional collateral to keep the loan fully secured. If the decreasing plan performance continues over time, tremendous costs can result. A collateral call by the lender or simply unwinding the loan could be a financial disaster: 

• The policy would be surrendered for its cash value to repay a portion of the loan, thereby triggering income taxation of gain at ordinary income tax rates. The grantor would recognize taxable gain if the policy owner is a defective grantor trust, otherwise the trust would recognize it.  

• If the commercial loan exceeds the policy cash surrender value (CSV), the collateral posted by the grantor/insured would be “called” by the lender to repay the shortfall, creating a taxable gift to the trust with generation-skipping transfer (GST) tax implications for a dynasty trust. If the trust isn’t defective, then the income tax paid by the trust on the policy gain will reduce the CSV available to repay the loan, thereby further increasing the amount of the collateral call and the resulting gift.  

• If the commercial loan has been repaid with a policy loan and the policy subsequently underperforms, there’s a significantly greater risk of the policy lapsing without value, creating a large taxable gain on the phantom income.¹¹  

These issues might not be uncovered until years into the plan. The costs of an aggressive no cost life insurance program could far exceed the cost of having simply purchased the insurance on a premium paying basis in the first place.  

Premium Financing Example

“Policy and Loan Performance,” this page, compares Scenario I, an aggressive “no cost” design, with Scenario II, a more conservative design, each with accrued loan interest, otherwise representing two extremes on the design spectrum.¹² 

For both Scenarios, assume that the client, a male age 50, is in excellent health and has an established need for $10 million of TOLI. The agent proposes funding an IUL policy with an increasing death benefit by borrowing seven annual premiums of $562,270 from a commercial lender ($3,935,890 total)¹³ accruing loan interest. The policy is designed with an increasing death benefit, so the policy cash value and death benefit will keep pace with the loan. Scenario I represents a no cost design, in which the grantor has no out-of-pocket costs.  Scenario II stress tests the design by reducing the IUL policy illustrative rate and increasing the assumed commercial loan rate.

Scenario I: Assume a 6.3 percent illustrative rate (a 10.25 percent index fund return), level 3.5 percent loan rate and accrued interest. After repaying the loan plus accrued interest, the program provides a net death benefit ranging from $9.3 million to $13.2+ million. Allowing 95 percent of the CSV as collateral, the collateral posted by the grantor maxes out at $1 million in the sixth year, then grades to zero by the 17th year. That is, 95 percent of the CSV exceeds the loan balance by the 17th year. If the actual policy and loan rates meet or exceed these assumptions over time, the program could, in fact, provide no cost life insurance.  

Scenario II: Assume a 5.5 percent illustrative rate (a 6.75 percent index fund return), 3.5 percent increasing to 5.25 percent loan rate and accrued interest. Based on these more conservative assumptions, the policy CSV is always less than the outstanding policy loan, and the client always has an increasing amount of  collateral at risk. In the 20th year, the outside collateral at risk exceeds $1.8 million; in the 35th year, it exceeds $8 million. The plan has a steadily diminishing net death benefit, and by the 37th year, a few years beyond life expectancy, the death benefit net of the loan is underwater by $950,000! Because life expectancy represents a 50 percent probability that the individual will live to age 85, there’s nearly a 50 percent chance that the plan could fail.

Unwinding the loan in the 20th year would be costly based on Scenario II assumptions, and assuming that the trust is a defective grantor trust, the client doesn’t have any lifetime gift or GST tax exemption available and the income, gift and estate tax rates each equals 40 percent. In the 20th year, the outstanding loan equals $8.7 million. In addition to surrendering the policy and applying the $6.9 million CSV to repay a portion of the loan, the grantor’s out-of-pocket cost of unwinding the plan is $3.7 million, itemized as follows:  

• The policy is surrendered for its CSV of $6.9 million. Based on the $3.9 million cost basis, there’s $3 million of taxable gain creating $1.2 million of income taxes (40 percent) payable by the grantor.  

• Because the trust has no assets other than the policy, the $1.8 million collateral shortfall is paid with the assets posted by the grantor.

• The $1.8 million collateral call is a taxable gift from the grantor to the trust creating $700,000 of gift tax.

In comparing Scenario II to Scenario I (the no cost insurance plan), the grantor’s heirs would receive $11.5 million less. In Scenario I, the trust will receive at least $9.3 million of death benefit. Based on Scenario II, on termination during the grantor’s lifetime, the heirs would lose the death benefit, and they would receive $2.2 million ($3.7 million x (1-40 percent)) less from the estate due to the costs to unwind the plan. Finally, if the trust is a dynasty trust, there are potential GST tax implications not factored into the calculations above, for example an inclusion ratio for the trust that’s greater than zero.  

A few important observations are in order. First, this analysis compares one design with accrued loan interest in both scenarios. The comparison emphasizes the importance of a prudent design based on reasonable assumptions, including having the trust pay all or a portion of loan interest. Second, as loan rates increase, carrier general account performance may improve as well, creating a larger “options budget” and lead to better performance of the IUL policy. Third, the scenarios assume “tame” year-after-year IUL returns and loan rates. The reality is that the policy and loan performance will vary significantly from the assumed performance. Fourth and a corollary of the third point, annual monitoring and stress testing are essential and would have identified performance problems in time to address them.    

Monitoring Existing Plans

Many clients may have implemented aggressive plans that are currently underperforming. These plans should be analyzed annually. If the plan is consistently underperforming the original projections, the following key questions should be asked and, when appropriate, remedial steps taken:

• Do in-force projections based on reasonable policy and loan assumptions indicate that the performance is likely to turn around? 

• Should remedial action be taken such as the trust paying loan interest and/or a portion of loan principal? 

• Is it a funded trust with other assets available to support the plan? 

• Are gifts to the trust advisable?  

• Are there steps that can be taken to enhance cash value performance, such as reducing the face amount?

• Are there GST tax as well as gift tax implications?  

Prudent Premium Financing Design

Best practice suggests designing, implementing and managing a prudent premium financing plan from the outset.¹⁴ Prudent design begins with an established life insurance need and reasonable assumed IUL rates of return and loan rates. For example, advisors might determine that translating a 7 percent S&P 500 rate (including dividends) to an IUL illustrative rate and a 3.5 percent loan increasing to 4.5 percent is reasonable.¹⁵ 

Unlike Scenarios I and II based on accruing loan interest, most prudent plan designs are based on the trust paying part or all of the loan interest. Funds to pay interest may be from gifts of cash or from cash flow generated by other trust assets. If the trust is a dynasty trust, gifts will have to be sheltered from gift and GST taxes.  

It’s advisable to consider an exit strategy as part of the initial design combining premium financing with other non-insurance wealth transfer strategies, such as grantor retained annuity trusts, gifts and/or sales to defective grantor trusts or intra-family loans. Financing insurance in an existing funded trust with sufficient cash flow may be attractive. Either way, a trust’s non-insurance assets may generate cash flow that can pay interest costs and ongoing premiums as well as repay the loan in the future. In addition, those assets act as a backstop to ensure the successful completion of the plan.  

Stress testing the initial plan design to evaluate how the plan will perform based on various loan rate and policy performance scenarios is strongly advised. The expected investment performance of the assets not used to pay premiums should be factored into the analysis.  This investment performance offsets the cost of the plan and may be a key driver in the decision to finance the life insurance. It should also compare the economics of the premium financing plan to the baseline of simply paying the annual premium for equivalent net coverage.  

Prudent design also includes carefully selecting the lender, carrier, product and writing agent.   

• When comparing lenders, it’s important not just to compare rates but rather to carefully assess and compare each lender’s experience in the market, long-term commitment to the market, the size of the premium finance portfolio and whether the loan has pre-payment penalties (the better programs don’t), as well as to carefully review the conditions under which the loan may be called.  

• Is the carrier highly rated by the major rating agencies? Has the carrier increased the cost-of-insurance (COI) charges on in-force policies? Has the carrier credited performance improvements to the in-force block as opposed to using them to support competitive pricing on new policies?¹⁶ Has the carrier unfairly increased COI charges? What’s the carrier’s record for reducing non-guaranteed elements of the IUL policy (typically the cap)?  

• Is the product proposed designed to accumulate cash values rather than emphasize death benefit? If the product has performance bonuses, are they fully disclosed? Does the product offer uncapped index options so that the product has the potential to experience greater upside in the market? Is it a true uncapped option, or are there other limitations built in?  

• Does the agent have experience designing and, most importantly, administering and monitoring premium financing plans? Does the agent represent a range of carriers and products and understand how to optimize the policy design for premium financing? As part of the sales process, has the agent introduced robust stress testing of the policy on his own?  

Finally, the importance of annual monitoring of plan performance can’t be overemphasized. It uncovers issues in the early stages when it’s easier to address them. Annual monitoring evaluates performance to date and includes re-stress testing the plan parameters, primarily policy performance and projected loan rates. Re-stress testing consists of projecting future policy performance with in-force ledgers in conjunction with projecting the current loan balance plus expected additional premium loans based on reasonable assumptions as to forward borrowing rates. If the policy performance and/or loan rates are better than expected, then it may be possible to skip premiums or use cash values to repay the loan without jeopardizing the policy.  

What’s Actually Gone Wrong?

As a consultant and expert witness, Richard L. Harris¹⁷ has been on the front line of litigation over aggressive premium financing designs. His resulting observations can be taken as a cautionary tale with respect to issues raised by the improper use of premium financing:

• In many cases, the death benefit bore no relationship to the need for insurance, and the insurance amount was greater than the need. The hook that led the prospect to buy that much insurance was the small or nonexistent outlay illustrated in the financing projections.

• The promoters sold the maximum amount of insurance that the insurance carriers would allow based on the insured’s finances, generating maximum revenue. Suitability was never considered. In one case, an insurance company ignored its own financial underwriting guidelines to issue coverage well in excess of its guidelines. 

• The assumed loan interest rate was low, for example, based on the current 12-month London Interbank Offered Rate and projected to stay the same well into the future.

• The illustration earning assumptions were the highest the carrier would allow.

• The promoter never explained all the details and what could go wrong. The focus was always on the history of the S&P index—without going into the policy limitations, costs and expenses.

• Even though they earned commission from the sale, the promoters often held themselves out as educators and consultants, not sales people.

• Promoters have literally pulled numbers out of thin air to make the transaction attractive without any supporting basis. In one case, the full amount of insurance was used without deducting the
outstanding loan payable. 

• Comparisons to the cost to purchase a similar policy outright were strongly biased in favor of the premium finance transaction, or the supporting illustrations were never provided. 

• In some cases, term insurance would have satisfied the insurance need.

• The client was led to believe that the policy performance and loan rates were fully guaranteed.

An Attractive Alternative

For high-net-worth and ultra-high-net-worth clients purchasing large TOLI policies, premium financing may be an attractive alternative to simply paying the annual premium. Premium financing plans can be in effect for many years. Neither policy performance nor commercial loan rates are guaranteed. In a worse case, aggressive premium financing designs can lock clients into a progressively deteriorating program with escalating and substantial costs to unwind.    

Best practice dictates designing the premium financing plan with prudent policy and loan assumptions, with a well thought out exit strategy and subjecting the plan to careful annual monitoring. Such monitoring should review and compare the actual policy and loan performance and re-stress test the design going forward. Prudent design allows flexibility, while careful monitoring allows issues to be uncovered and addressed before they become major problems.  

With premium financing, it’s essential to understand the risks as well as the rewards.                       

Endnotes

1. Robert W. Finnegan, “Premium Financing With Indexed Universal Life: Part I,” Trusts & Estates (December 2017), at p. 42.

2. For purposes of this article, the underlying index fund such as the S&P 500 index is referred to as the “index fund.” In all references to index fund, specific rates such as 7 percent include dividends of the stocks comprising the index.

3. The cap, floor and participation rates vary from product to product.

4. The National Association of Insurance Commissioners approved adoption of Actuarial Guideline 49 (AG49) governing the maximum illustrative rate for indexed universal life illustrations effective for policies sold after Sept. 1, 2015. The AG49 rate is calculated in a complex formula averaging 25-year rolling averages for the S&P 500 index over the last 66 years. See Timothy C. Pfeifer, “Actuarial Guideline 49—A Closer Look,” LifeTrends (July 27, 2015). 

5. VOYA offers a percentile model that calculates the probability of realizing a specific indexed universal life (IUL) return based on historical S&P 500 returns.  

6. Used with permission of the John Hancock Life Insurance Company.  

7. The capital asset pricing model (CAPM) is designed to account for systemic risks that can’t be addressed through portfolio diversification. It reflects the premise that a higher return introduces a higher level of investment risk. Although there have been many criticisms of the CAPM, it’s still widely used by investment managers as a tool for managing systematic risks.

8. Of note, John Hancock verified the results of the translator model with a separate stochastic model that’s based on the historical S&P 500 index returns.

9. With some plans, the loan is repaid with a policy loan, for example in the 15th year of the plan, shifting the commercial loan to a policy loan. Policy loan parameters may be aggressive and should be reviewed.

10. Accrued loan interest is a substantial benefit. For example, it doesn’t make sense to repay that loan accruing interest at 3.5 percent with cash values earning 5.5 percent net of expenses and charges.

11. Phantom income is created because the policy cash surrender value (including outstanding policy loans) in excess of basis was never taxed.  

12. Based on the Rate Translator Model results: Example 5 is the basis for Scenario I, in which a 10.25 percent index fund return corresponds to a 6.3 percent IUL return. Example 4 is the basis for Scenario II, in which a 6.75 percent index fund return corresponds to a 5.5 percent IUL return. A
3.5 percent difference in the index fund return corresponding to a mere 80 basis points difference in the IUL policy crediting rates!  

13. Does this already look questionable, borrowing $4 million to fund a $10 million policy?

14. It’s worth noting that there are some interesting designs beyond the scope of this article in which the client borrows funds from a commercial lender and lends those funds to the trust pursuant to a loan regime split-dollar plan. These plans shift the borrowing risk to the client and take advantage of favorable split-dollar rules and current low applicable federal rates for significantly greater wealth transfer efficiency.

15. In fact, it’s frequently advisable to evaluate a number of scenarios varying policy performance and loan assumptions.

16. For example, one prominent carrier has provided in-force improvements 125 times in the last 30 years.  

17. Richard L. Harris is the managing member of Richard L. Harris LLC, a life insurance sales and consulting firm in Clifton, N.J., devoted to helping ultra-high-net-worth clients and their professional advisors deal with issues regarding life insurance. He works as a back-office life insurance expert for many accountants, attorneys and trust officers. With 40 years of experience, Richard is a nationally recognized expert in very advanced planning with life insurance. He’s on the Insurance Committee for this magazine and has written extensively for various trade publications.

Wherever you work, whether it’s at a law firm, family office, accounting firm or some other type of company, you need to make sure you don’t run afoul of the rules prohibiting sexual harassment in the workplace. Not only can violations result in penalties, but also the publicity of a lawsuit can harm your organization’s reputation and negatively affect your business.   

A recent poll from The Wall Street Journal and NBC found that nearly half of females said they personally experienced sexual harassment at work.¹ Clearly, a significant number of individuals continue to engage in sexually offensive workplace behavior despite employer policies prohibiting harassment, workplace training and increased awareness of the problem.  

The persistence of sexual harassment may in part be due to confusion about what constitutes prohibited conduct and the extent of an employer’s responsibility to address it. Consider the following 10 misconceptions:²

It’s No Joke

Misconception 1: Jokes that could be considered offensive are fine in the workplace as long as they’re welcome to others present. 

Many assume that potentially offensive jokes are okay if others enjoy them. But, that’s not the case. An employee who’s offended by a joke may feel intimidated about expressing offense, particularly if the person who uttered the remark is in a supervisory position. Therefore, the lack of a clearly negative reaction doesn’t necessarily mean the joke is welcome.

The exchange of jokes that are degrading to women cultivates sex-biased attitudes. Moreover, an employer that tolerates the remarks effectively endorses the underlying bias. Thus, a claim of sexual harassment will more likely succeed if there’s evidence that managers were aware of but failed to stop such remarks.

Broader Standard Applied

Misconception 2: The definition of “harassment” in an employer’s anti-harassment policy should mirror the legal definition of the term.

Employers need to step in before harassment rises to the level of a violation of federal law. Federal law prohibits unwelcome conduct based on sex, race, color, religion, national origin, age (40 or older) or disability when: 1) enduring the conduct becomes a condition of continued employment, or 2) the conduct is severe or pervasive enough to create a work environment that a reasonable person would consider intimidating, hostile or offensive. As the U.S. Equal Employment Opportunity Commission (EEOC) has explained, “to discharge its duty of preventive care, the employer must make clear to employees that it will stop harassment before it rises to the level of a violation of federal law.”³ The EEOC’s policy covering its own workforce therefore states, “The conduct covered by this Order is broader than the legal definition of unlawful conduct
. . . It includes hostile or abusive conduct based on race, color, religion, sex (whether or not of a sexual nature), national origin, age, disability, sexual orientation, or retaliation, even if the conduct has not risen to the level of illegality.”⁴

Workplace Romance

Misconception 3: A consensual sexual relationship between a supervisor and subordinate can’t give rise to a claim of unlawful sexual harassment.

In June 2017, the Society for Human Resource Management reported on a survey of 1,000 respondents regarding workplace romance. A quarter of the respondents said they had a workplace romance, and nearly 40 percent of those individuals were top-level employees.⁵

If you have a supervisory position, think twice before starting a relationship with one of your subordinates.  Various legal claims can arise from consensual sexual relationships between supervisors and subordinates. For example, a subordinate may claim she consented to sexual behavior because of threats of adverse consequences for refusal; third parties may challenge preferential treatment by the supervisor toward the subordinate; and if a romantic relationship between a supervisor and subordinate sours, the subordinate may claim that subsequent adverse treatment by the supervisor constitutes retaliation.

In light of the risks, a prudent employer should implement a policy requiring supervisors and managers to disclose the existence of a romantic or sexual relationship with an employee. If the employer learns of such a relationship, it should seek to determine whether the relationship truly is consensual in light of the power imbalance. If the subordinate indicates the relationship is coercive, management should swiftly investigate the matter. If the relationship truly is consensual, the employer should reallocate job duties to avoid any actual or perceived reward or disadvantage to the subordinate.

Responsibility for Non-Employees

Misconception 4: An employer isn’t legally responsible for sexual harassment of its employee by a non-employee.

An employer is liable for harassment by non-employees if it knew or should have known of the harassment and failed to take prompt and appropriate corrective action. According to the EEOC, the appropriateness of the response depends on the extent of the organization’s control over the non-employee’s actions.⁶ An employer might not be able to control the actions of a one-time visitor to the workplace, but it would have more control over the actions of independent contractors, vendors and regular customers.

Outside the Workplace

Misconception 5: An employer isn’t legally responsible for sexual harassment of its employee outside the workplace.

Don’t be complacent about what goes on outside the office. The federal law prohibiting sexual harassment, Title VII of the Civil Rights Act of 1964, covers workplace conduct. Courts have applied the law to behavior that occurs in a work-related context outside the employer’s premises. For example, an employer can be held responsible for harassment that occurs during work travel or at an employer-sponsored event.  

Conduct occurs within the work environment if it’s conveyed with work email, regardless of whether the individual who initiated the communication did so while located on the employer’s premises. Moreover, an employee’s posting on social media of derogatory remarks linked to a co-worker’s gender or other EEO characteristic may contribute to a hostile work environment.  

Harassment by a supervisor outside the workplace is more likely to contribute to a hostile work environment than similar conduct by co-workers due to a supervisor’s ability to affect a subordinate’s employment status.  Thus, a court evaluating a claim of workplace sexual harassment by a supervisor might consider evidence of the supervisor’s unwelcome sexual advances to the employee that occurred outside a work-related context.

Conduct Directed at Others 

Misconception 6: An employee can’t establish a legal claim of harassment based on conduct directed only at others.

Once an employee engages in harassing conduct against one individual in the workplace, the door is opened to claims by others, even if the conduct wasn’t directed at them. Unwelcome and offensive workplace conduct violates the law if it’s sufficiently severe or pervasive to create a hostile work environment and is linked to the claimant’s sex, race or other EEO protected characteristic. Harassing conduct can affect an employee’s work environment even if the behavior is directed at someone else. The individual may even be able to challenge workplace conduct that occurred outside her presence as long as she became aware of it during her employment. 

Shush, Don’t Tell Anyone

Misconception 7: If an employee informs a supervisor about sexual harassment but asks that the matter be kept confidential with no further action, the supervisor should honor that request.

Inaction by a supervisor in these circumstances could lead to employer liability. A supervisor is an agent of the employer. Therefore, an employer can’t claim lack of knowledge if a supervisor knew of the harassment. While it may seem reasonable to let the employee determine whether to pursue a complaint, the employer must exercise reasonable care to prevent and correct harassment whenever it gains knowledge of it. 

An employer can’t guarantee complete confidentiality of harassment allegations, because an effective investigation generally requires disclosure of relevant information to the alleged harasser and potential witnesses. However, information about the allegation should be shared only with those who need to know about it. Records relating to harassment complaints should be kept confidential on the same basis.

Retaliation

Misconception 8: Harassment is the most common complaint filed with the EEOC.

Workplace harassment remains a persistent source of employee complaints, representing nearly one third of all charges filed with the EEOC. However, the most common allegation by far is retaliation—approximately 45 percent of charges include that claim. Moreover, nearly three-quarters of sexual harassment charges filed with the EEOC include an allegation of retaliation.⁷ 

An employment policy prohibiting harassment is ineffective without protection against retaliation. The employer therefore should make clear that it will protect complainants and those who provide related information against any adverse repercussions for participating in the complaint process. Managers also should be alert for any possibility of retaliation and undertake corrective action if it occurs.

Investigation

Misconception 9: An employer needn’t conduct its own investigation of an employee’s harassment allegation if the employee has filed a formal charge with the EEOC and that agency is investigating the matter.

Employers are obligated to exercise reasonable care to prevent and correct harassment. That duty includes launching a prompt and thorough investigation whenever an employer has reason to know of alleged harassment, regardless of whether an employee has filed a formal charge regarding the matter.  

The individual who conducts the investigation should be impartial, experienced and familiar with EEO obligations. The investigator should seek information from all involved parties and potential witnesses. If there are conflicting versions of relevant events, it may be necessary to make credibility assessments. On completion of the investigation, the employer should inform the parties of its determination. Corrective action should extend to behavior that may not be legally actionable but that, if not stopped, may lead to a violation of federal or state law.

When the alleged harassment is particularly severe, it may be necessary for the employer to take intermediate steps to separate the parties while it determines whether a complaint is valid. For example, the employer should consider scheduling changes to avoid contact between the parties; temporarily transferring the alleged harasser; or placing the alleged harasser on non-disciplinary leave with pay pending the conclusion of the investigation.  

Ignoring the Signs

Misconception 10: An employer can rest assured there’s no problem in its workforce of sexual harassment if no employees have made complaints.

A survey conducted by Redbook found that the most popular method of dealing with sexual harassment is ignoring it and hoping it will stop.⁸ The EEOC similarly has found that common employee responses are to avoid the harasser; deny or downplay the gravity of the situation; or attempt to ignore, forget or endure the behavior. The least common response is to report the harassment internally or file a formal legal complaint. According to the EEOC, employees fail to report the behavior because they fear disbelief of or inaction on their claim, blame for causing the offending actions, social retaliation and professional retaliation.⁹

Courts have made clear that an employer is liable if it knew or “should have known” of unlawful harassment.  For example, if the harassment is pervasive, management should have known of it. Therefore, management should initiate an investigation whenever it gains awareness of potentially harassing conduct, regardless of whether an employee has made a complaint.  

The employer also should regularly distribute its anti-discrimination policy. That policy should clearly explain prohibited conduct; clearly describe the complaint process; assure protection against retaliation for making complaints; protect the confidentiality of complaints to the extent possible; provide for prompt, thorough and impartial investigations of complaints; and ensure immediate and appropriate corrective action when the employer determines that harassment has occurred.

There are many good reasons to prevent and stop harassment beyond risks of liability. Harassment can cause the target of the behavior to suffer psychological, physical, occupational and economic harm.  Moreover, the costs include decreased productivity, increased turnover and harm to the employer’s reputation. The organization’s leadership therefore should meaningfully hold responsible those who engage in harassment and foster an organizational culture that doesn’t tolerate such misconduct.                  

Endnotes

1. Rob Wile, “A New Poll Shows How Common Sexual Harassment is in the Workplace,” Money Magazine (Oct. 30, 2017), http://time.com/money/5002066/sexual-harassment-work-men-women-survey/.

2. While this article focuses on sexual harassment, the same principles apply to all forms of harassment prohibited by federal law, that is, harassment based on sex (including pregnancy), race, color, religion, national origin, age of 40 or older and disability.

3. “Enforcement Guidance on Vicarious Employer Liability for Unlawful Harassment by Supervisors” (June 18, 1999), www.eeoc.gov/policy/docs/harassment.html. 

4. Equal Employment Opportunity Commission (EEOC) Order, “Prevention and Elimination of Harassing Conduct in the Workplace” (Aug. 9, 2006), www.eeoc.gov/eeoc/internal/harassment_order.cfm.

5. Alison E. Curwen, “Workplace Romance: Who-Dates-Who Might Surprise You,” SHRM Online (June 29, 2017), www.shrm.org/resourcesandtools/hr-topics/employee-relations/pages/workplace-inappropriate-relationships.aspx.

6. 29 C.F.R. Section 1604.11(e).

7. “Not Just the Rich and Famous,” Center for American Progress (Nov. 20, 2017), www.americanprogress.org/issues/women/news/2017/11/20/443139/not-just-rich-famous/.

8. Ashley Mateo and Kaitlin Menza, “The Results of a 1976 Survey of Women about Sexual Harassment at Work Remain Virtually Unchanged in 2017,” Redbook (March 27, 2017), www.redbookmag.com/life/money-career/a49220/sexual-harassment-in-the–workplace/.

9. EEOC, “Select Task Force on the Study of Harassment in the Workplace,” Report of Co-Chairs Chai R. Feldblum and Victoria A. Lipnic (June 2016), www.eeoc.gov/eeoc/task_force/harassment/report.cfm.

Confidential data in computers and information systems, including those used by attorneys and law firms, faces greater security threats today than ever before. And, they continue to grow! They take a variety of forms, ranging from email phishing scams and social engineering attacks to sophisticated technical exploits resulting in long-term intrusions into law firm networks. They also include lost or stolen laptops, tablets, smartphones and USB drives, as well as inside threats—malicious, untrained, inattentive and even bored personnel. Trusts and estates practitioners face cybercriminals targeting money, banking information, personally identifiable information that can be used for identity theft and other confidential data.

These threats are a particular concern to attorneys because of their duty of confidentiality. Attorneys have ethical and common law duties to take competent and reasonable measures to safeguard information relating to clients. They also often have contractual and regulatory duties to protect client information and other types of confidential information. Breaches are becoming so prevalent that there’s a new mantra in cybersecurity today—it’s “when, not if” there will be a breach. This is true for attorneys and law firms as well as other businesses and enterprises. Consistent with this threat environment, New York Ethics Opinion 1019 warned attorneys in May 2014:

Cyber-security issues have continued to be a major concern for lawyers, as cyber-criminals have begun to target lawyers to access client information, including trade secrets, business plans and personal data. Lawyers can no longer assume that their document systems are of no interest to cyber-crooks.

Ethics Rules 

Several ethics rules¹ have particular application to protection of client information, including Competence (Model Rule 1.1), Communication (Model Rule 1.4), Confidentiality (Model Rule 1.6) and Supervision (Model Rules 5.1, 5.2 and 5.3).

Model Rule 1.1: Competence covers the general duty of competence. It provides that, “A lawyer shall provide competent representation to a client.” This “requires the legal knowledge, skill, thoroughness and preparation reasonably necessary for the representation.” It includes competence in selecting and using technology, including cybersecurity. It requires attorneys who lack the necessary technical competence for security to learn it or to consult with qualified individuals who have the requisite expertise.

The American Bar Association (ABA) Commission on Ethics 20/20 conducted a review of the Model Rules and the U.S. system of lawyer regulation in the context of advances in technology and global legal practice developments. One of its core areas of focus was technology and confidentiality. Its recommendations in this area were adopted by the ABA at its annual meeting in August 2012.

The 2012 amendments include addition of the following italicized language to the Comment to Model Rule 1.1:

[8] To maintain the requisite knowledge and skill, a lawyer should keep abreast of changes in the law and its practice, including the benefits and risks associated with relevant technology…

As of September 2017, 28 states have adopted the new comment to Model Rule 1.1, some with variations from the ABA language. 

Model Rule 1.4: Communication also applies to attorneys’ use of technology. It requires appropriate communications with clients “about the means by which the client’s objectives are to be accomplished,” including the use of technology. It requires keeping the client informed and, depending on the circumstances, may require obtaining “informed consent.” It requires notice to a client of a compromise of confidential information relating to the client.

Model Rule 1.6: Confidentiality of information defines generally the duty of confidentiality. It begins as follows:

A lawyer shall not reveal information relating to the representation of a client unless the client gives informed consent, the disclosure is impliedly authorized in order to carry out the representation or the disclosure is permitted by paragraph (b). . . 

Model Rule 1.6 broadly requires protection of “information relating to the representation of a client;” it isn’t limited to confidential communications and privileged information. Disclosure of covered information generally requires express or implied client consent (in the absence of special circumstances like misconduct by the client).

The 2012 amendments added the following new subsection (italicized) to Model Rule 1.6:

(c) A lawyer shall make reasonable efforts to prevent the inadvertent or unauthorized disclosure of, or unauthorized access to, information relating to the representation of a client.

This requirement covers two areas—inadvertent disclosure and unauthorized access. Inadvertent disclosure includes threats such as leaving a briefcase, laptop or smartphone in a taxi or restaurant, sending a confidential email to the wrong recipient, producing privileged documents or data in litigation or exposing confidential metadata. Unauthorized access includes threats like hackers, criminals, malware and insider threats.  

The 2012 amendments also include additions to Comment [18] to Rule 1.6, providing that “reasonable efforts” require a risk-based analysis, considering the sensitivity of the information, the likelihood of disclosure if additional safeguards aren’t employed and consideration of available safeguards. The analysis includes the cost of employing additional safeguards, the difficulty of implementing them and the extent to which they would adversely affect the lawyer’s ability to use the technology. The amendment also provides that a client may require the lawyer to implement special security measures not required by the rule or may give informed consent to forgo security measures that would otherwise be required by the rule. 

Significantly, the Ethics 20/20 Commission noted that these revisions to Model Rules 1.1 and 1.6 make explicit what was already required rather than adding new requirements.

Model Rule 5.1: Responsibilities of partners, managers and supervisory lawyers include the duties of competence and confidentiality. 

Model Rule 5.2: Responsibilities of a subordinate lawyer also includes these duties. 

Model Rule 5.3: Responsibilities regarding nonlawyer assistants were amended in 2012 to expand its scope. “Assistants” was expanded to “Assistance,” extending its coverage to all levels of staff and outsourced services ranging from copying services to outsourced legal
services. This requires attorneys to employ reasonable safeguards, like due diligence, contractual requirements, supervision and monitoring, to ensure that nonlawyers, both inside and outside a law firm, provide services in compliance with an attorney’s duty of confidentiality.

Ethics Opinions

A number of state ethics opinions, for over a decade, have addressed professional responsibility issues related to security in attorneys’ use of various technologies. Consistent with the Ethics 20/20 amendments, they generally require competent and reasonable safeguards. 

Examples include: State Bar of Arizona, Opinion No. 05-04 (July 2005) and State Bar of Arizona, Opinion No. 09-04 (December 2009): “Confidentiality; Maintaining Client Files; Electronic Storage; Internet” (Formal Opinion of the Committee on the Rules of Professional Conduct); New Jersey Advisory Committee on Professional Ethics, Opinion 701 (April 2006): “Electronic Storage and Access of Client Files;” State Bar of California, Standing Committee on Professional Responsibility and Conduct, Formal Opinion No. 2010-179; and New York State Bar Association Ethics Opinion 1019 (August 2014): “Confidentiality; Remote Access to Firm’s Electronic Files.” 

Significantly, California Formal Opinion No. 2010-179 advises attorneys that they must consider security before using a particular technology in the course of representing a client. Depending on the circumstances, an attorney may be required to avoid using a particular technology or to advise a client of the risks and seek informed consent if appropriate safeguards can’t be employed. 

There are now multiple ethics opinions on attorneys’ use of cloud computing services like online file storage and software as a service.² For example, the New York Bar Association Committee on Professional Ethics Opinion 842, “Using an outside online storage provider to store client confidential information” (September 2010), consistent with the general requirements of the ethics opinions above, concludes: 

[a] lawyer may use an online data storage system to store and back up client confidential information provided that the lawyer takes reasonable care to ensure that confidentiality is maintained in a manner consistent with the lawyer’s obligations under Rule 1.6. 

The most recent opinion on safeguarding client data is ABA Formal Opinion 477, “Securing Communication of Protected Client Information” (May 2017). While focusing on electronic communications, it also explores the general duties to safeguard information relating to clients in light of current threats and the Ethics 20/20 technology amendments to the Model Rules. Its conclusion includes:

Rule 1.1 requires a lawyer to provide competent representation to a client. Comment [8] to Rule 1.1 advises lawyers that to maintain the requisite knowledge and skill for competent representation, a lawyer should keep abreast of the benefits and risks associated with relevant technology. Rule 1.6(c) requires a lawyer to make ‘reasonable efforts’ to prevent the inadvertent or unauthorized disclosure of or access to information relating to the representation.

The key professional responsibility requirements from these various opinions on attorneys’ use of technology are competent and reasonable measures to safeguard client data, including an understanding of limitations in attorneys’ knowledge, obtaining appropriate assistance, continuing security awareness, appropriate supervision and ongoing review as technology, threats and available safeguards evolve. They also require obtaining clients’ informed consent in some circumstances. It’s important for attorneys to consult the rules, comments and ethics opinions in the relevant jurisdiction(s).

Electronic Communications

Ethics rules. Email and electronic communications have become everyday communications forms for attorneys and other professionals. They’re fast, convenient and inexpensive, but present serious risks to confidentiality. It’s important for attorneys to understand and address these risks.

The Ethics 2000 revisions to the Model Rules, over 10 years ago, added Comment [17] (now [19]) to Model Rule 1.6. It requires “reasonable precautions to prevent the information from coming into the hands of unintended recipients.” It provides:

 …This duty, however, does not require that the lawyer use special security measures if the method of communication affords a reasonable expectation of privacy. Special circumstances, however, may warrant special precautions. Factors to be considered in determining the reasonableness of the lawyer’s expectation of confidentiality include the sensitivity of the information and the extent to which the privacy of the communication is protected by law or by a confidentiality agreement…

This Comment requires attorneys to take “reasonable precautions” to protect the confidentiality of electronic communications. Its language about “special security measures” has often been viewed by attorneys as providing that they never need to use “special security measures” like encryption. While it does state that “special security measures” aren’t generally required, it contains qualifications and notes that “special circumstances” may warrant “special precautions.” It includes the important qualification—“if the method of communication affords a reasonable expectation of privacy.” 

There are, however, questions about whether unencrypted email affords a reasonable expectation of privacy. Respected security professionals for years have compared unencrypted email to postcards or postcards written in pencil.³

Comment [19] to Rule 1.6 also lists “the extent to which the privacy of the communication is protected by law” as a factor to be considered. The federal Electronic Communications Privacy Act⁴ and similar state laws make unauthorized interception of electronic communications a crime. Some observers have expressed the view that this should be determinative and attorneys aren’t required to use encryption. The better view is to treat legal protection as only one of the factors to be considered. As discussed below, some of the newer ethics opinions conclude that encryption may be a reasonable measure that should be used, particularly for highly sensitive information.

Ethics opinions. An ABA ethics opinion in 1999 and several state ethics opinions concluded that special security measures, like encryption, aren’t generally required for confidential attorney email.⁵ However, these opinions, like Comment [19], contain qualifications that limit their general conclusions.

Consistent with the questions raised by security experts about the security of unencrypted email, some ethics opinions express a stronger view that encryption may sometimes be required. For example, New Jersey Opinion 701 (April 2006), discussed above, notes at the end: “where a document is transmitted to [the attorney] … by email over the Internet, the lawyer should password a confidential document (as is now possible in all common electronic formats, including PDF), since it is not possible to secure the Internet itself against third party access.”⁶ This was over 10 years ago.

California Formal Opinion No. 2010-179, Pennsylvania Formal Opinion 2011-200 and Texas Ethics Opinion 648 (2015) provide that encryption may sometimes be required. A July 2015 ABA article notes, “The potential for unauthorized receipt of electronic data has caused some experts to revisit the topic and issue [ethics] opinions suggesting that in some circumstances, encryption or other safeguards for certain email communications may be required.”⁷

ABA Formal Opinion 477, “Securing Communication of Protected Client Information” (May 2017), consistent with these newer opinions and the article, concludes:

A lawyer generally may transmit information relating to the representation of a client over the Internet without violating the Model Rules of Professional Conduct where the lawyer has undertaken reasonable efforts to prevent inadvertent or unauthorized access. However, a lawyer may be required to take special security precautions to protect against the inadvertent or unauthorized disclosure of client information when required by an agreement with the client or by law, or when the nature of the information requires a higher degree of security.

The Opinion references the Ethics 20/20 amendments to Comment [18] to Model Rule 1.6 and its discussion of factors to be considered in determining reasonable and competent efforts. It provides general guidance and leaves details of their application to attorneys and law firms, based on a fact-based analysis on a case-by-case basis. 

In addition to complying with any applicable ethics and legal requirements, the most prudent approach to the ethical duty of protecting electronic communications is to have an express understanding with clients (preferably in an engagement letter or other writing) about the nature of communications that will be (and won’t be) sent electronically and whether encryption and other security measures will be used. It’s now reached the point at which all attorneys should have encryption available for use in appropriate circumstances.

Common Law and Contractual Duties

Along with the ethical duties, there are parallel common law duties defined by case law in the various states. The Restatement (Third) of the Law Governing Lawyers (2000) summarizes this area of the law, including Section 16(2) on competence and diligence, Section 16(3) on complying with obligations concerning client’s confidences and Chapter 5, “Confidential Client Information.” Breach of these duties can result in a malpractice action.

There are also increasing instances when lawyers have contractual duties to protect client data, particularly for clients in regulated industries, such as health care and financial services, which have regulatory requirements to protect privacy and security.

Regulatory Duties

Attorneys and law firms that have specified personal information about their employees, clients, clients’ employees or customers, opposing parties and their employees or even witnesses may also be covered by federal and state laws that require reasonable safeguards for covered information and notice in the event of a data breach.⁸

Complying With the Duties

Understanding all of the applicable duties is the first step, before moving to the challenges of compliance by designing, implementing and maintaining an appropriate risk-based information security program. The program should address people, policies and procedures and technology and be appropriately scaled to the size of the practice and the sensitivity of the information.  

Endnotes

1. American Bar Association (ABA) Model Rules of Professional Conduct (2017).

2. The ABA Legal Technology Resource Center has published a summary with links, “Cloud Ethics Opinions around the U.S.,” http://bit.ly/2duVMwC.

3. For example, Bruce Schneier, E-Mail Security—How to Keep Your Electronic Messages Private (John Wiley & Sons, Inc. 1995), at p. 3; Bruce Schneier, Secrets & Lies: Digital Security in a Networked Work (John Wiley & Sons, Inc. 2000), at p. 200; Larry Rogers, “Email—A Postcard Written in Pencil, Special Report” (Software Engineering Institute, Carnegie Mellon University 2001); Google Official Blog, “Transparency Report: Protecting Emails as They Travel Across the Web” (June 3, 2014); and Molly Wood, “Easier Ways to Protect Email from Unwanted Prying Eyes,” New York Times (July 16, 2014).

4. 18 U.S.C. Sections 2510-2522.

5. For example, ABA Formal Opinion No. 99-413, “Protecting the Confidentiality of Unencrypted E-Mail” (March 10, 1999) (“based upon current technology and law as we are informed of it … a lawyer sending confidential client information by unencrypted e-mail does not violate Model Rule 1.6(a) …  this opinion does not, however, diminish a lawyer’s obligation to consider with her client the sensitivity of the communication, the costs of its disclosure, and the relative security of the contemplated medium of communication. Particularly strong protective measures are warranted to guard against the disclosure of highly sensitive matters”) and District of Columbia Bar Opinion 281, “Transmission of Confidential Information by Electronic Mail” (February 1998) (“In most circumstances, transmission of confidential information by unencrypted electronic mail does not per se violate the confidentiality rules of the legal profession. However, individual circumstances may require greater means of security”).  

6. File password protection in some software, like current versions of Microsoft Office, Adobe Acrobat and WinZip uses encryption to protect security. It’s generally easier to use than encryption of email and attachments. However, the protection can be limited by use of weak passwords that are easy to break or “crack.” 

7. Peter Geraghty and Susan Michmerhuizen, “Encryption Conniption,” Eye on Ethics, Your ABA (July 2015), http://bit.ly/2Cl615N. 

8. For example, Internal Revenue Code Section 6713, Internal Revenue Procedure 2007-40, Gramm-Leach-Bliley Act, 15 U.S.C. Sections 6801-6809 and National Conference of State Legislatures—State Data Security Laws, http://bit.ly/2zVyXvW, and State Security Breach Notification Laws, http://bit.ly/1ao7NAi.