Taking on a new representation is exciting, to be sure. Not only is there the potential for making money, but also, there’s the thrill of validation. To quote Sally Field’s acceptance speech for her 1984 Academy Award for best actress in Places in the Heart, “You like me, right now, you like me!” The excitement may be so great that it’s difficult to stop and think about reasons not to undertake the representation. To be fair, in many trusts and estates matters, the new client is a good one, the representation goes smoothly and there are no concerns. In other situations, however, clients behave badly, they turn out to be different from how they first appeared or conflicts arise down the line and the representation breaks down, sometimes with negative consequences for the attorney as well as the client. With the perfect vision of hindsight, the warning signs of a bad outcome might seem obvious. But, hindsight isn’t worth much unless it leads to foresight. With that in mind, below are some of the potential red flags a trusts and estates practitioner should watch for when taking on a new representation and the practical and ethical considerations that should be addressed when they arise.

The “Mistreated” Client

Have you ever met a prospective client who came to your office complaining about his prior counsel, and you thought to yourself that if you’d been representing this individual, you would have done a better job and would be receiving a glowing review? Then, the prospective client proceeds to complain about almost everyone under the sun, including his accountant, insurance advisor and certain family members, but tells you that he’s heard that “you’re the best,” and he’ll be so happy to work with you. Though you might have a nagging sensation that the client, not all of the people he complains of, is the real source of the problem, you ignore it, thinking that you’re special—you’ll be the savior—and, if you take on this representation, you’ll have much better and different results. Call it a hero/martyr complex if you will, many of us like jumping in to help everyone who asks for it. This trait is admirable and works well when applied to deserving clients, but it can lead to our downfall when applied indiscriminately. If this prospective client has a problem with most professionals he comes across, you’re likely to be next on that list and should be very careful about taking on the representation. In fact, you should always be listening and watching for warning signs, especially with prospective clients and new clients that you may not know very well, or you could end up finding yourself in a very aggravating representation that may lead to reputational consequences for you when you become the latest professional who’s alleged to have done a bad job for the client.

Many of us have a sixth sense regarding the veracity and character of prospective, as well as existing, clients. These feelings are often correct, and you need to be careful not to convince yourself when your “Spidey sense” is tingling that you can still be the hero and get your clients to do the right things and cooperate. A good bedside manner might make a significant difference, and many times, seemingly difficult clients really just want to be provided with good, caring and competent service and will end up being grateful and cooperative. However, sometimes that’s not the case, and caution is necessary. 

The Shifty (or Worse!) Client

Similarly, when you find out during the course of the representation that your client has been hiding certain information from you, such as undisclosed assets and income or prior frauds that he’s committed, you need to be extra cautious. While most people deserve a second chance to do the right thing, if you’re representing a client who’s had prior issues, you need to be diligent that the past isn’t repeated, and you aren’t brought down or erroneously implicated by your client’s future actions. It’s one thing if your client is upfront in disclosing data and information to you, even if it involves negative behaviors, but if a client hides information or lies to you, trust is eroded. You have to be willing to emphatically say “no” when the client wants you to validate or whitewash his pattern of unlawful or unethical conduct, and you have to be willing to end the representation if the client won’t follow your advice. You should also borrow a page from the financial service industry’s playbook and take reasonable steps, such as running credit checks and litigation searches, to “KYC” (Know Your Client) and find out who you’re dealing with before representing him to prevent problems for yourself and your firm. 

The Nonpaying Client

You also need to be wary about potential fee issues. Unlike litigation matters, in which court approval is needed before the attorney can fire a client in the middle of a case, it’s easier for estate-planning attorneys to drop clients who haven’t paid them. You should certainly make sure not to find yourself in a hole of doing many hours of unpaid work, and the terms of your engagement agreements should deal with these issues. It’s one thing if you own your firm as a solo practitioner and knowingly take on the risk of being paid, but if you work with partners and employees who rely on your collections, not paying attention to the collection of fees isn’t being a “nice guy.” In our opinion, a “nice guy” is someone who makes sure his family, partners and employees are taken care of, and precious time that could have been spent with loved ones isn’t wasted. You work very hard and shouldn’t cheapen or lessen yourself by not being on top of clients paying you. Many of them will take advantage if they see that you don’t value your time. That isn’t to say that if you have a good client who’s met unforeseen circumstances, you shouldn’t be kind and sometimes offer breaks or extensions to pay, if deserved. However, it’s okay to fire a client who has difficulty paying all of his providers, not just his attorneys, and has little appreciation for your time and efforts. To avoid taking on the nonpaying client from the outset, consider charging a substantial upfront retainer that isn’t applied until the end of the representation. If the client balks at paying the retainer, he’ll probably balk at paying your bills. Similarly, consider rendering monthly and/or multiple progress bills, and check in with your client shortly thereafter to determine whether he has any questions or concerns and when you can expect payment. 

Blended Families

Even with the best client who doesn’t present any of the above problems, a conflict of interest may arise that could necessitate certain disclosures and agreements or perhaps lead to limiting and/or declining the representation. For example, it’s common to encounter the so-called “blended” family involving children from a prior relationship. While many estate planners may jointly represent spouses in routine situations,¹ spouses in a blended family scenario deserve a closer look. You should pose a number of questions to the spouses before taking on the representation, including: 

1. What are the spouses’ intentions for their respective estate plans? 

2. Is there a prenuptial agreement? 

3. Are children from a prior marriage going to be disinherited or provided for unequally? 

4. Are stepchildren going to inherit? 

5. Will the spouses have substantially different estate plans? 

6. Will all information that’s imparted by one spouse to the attorney be shared with the other spouse? 

If the answers provided indicate that the spouses don’t have common goals, you should probably choose to represent only one spouse to avoid a concurrent conflict of interest.² If you believe that the spouses’ goals are mostly aligned, even if not identical, it may be safe to proceed with a joint representation, provided that the clients agree that information shared by one won’t be confidential with respect to the other and that both prospectively waive any future conflicts.³ Keep in mind, however, that if a non-waivable conflict of interest arises later on, it’s likely that you’ll no longer be able to represent either spouse going forward.⁴

Multiple Family Members

It’s quite common in the estate-planning world to be asked to represent multiple family members, including parents, children and siblings, in their respective estate planning, estate and trust administration and/or other related matters. Whether and how you may ethically undertake such representation depends on the circumstances. At the outset, you should inquire into the goals for the representation and the level of coordination that may be required with respect to the multiple clients, and you should try to uncover possible conflicts. Some conflicts, such as simultaneously representing the fiduciary of an estate and the decedent’s widow who may wish to exercise her elective share, or simultaneously representing both the fiduciary and a creditor of the estate, might not be waivable, thus forcing you to decline representation of one or both clients.⁵ When there might be a waivable conflict, for example, you’re asked to represent one family member as a fiduciary of a trust or estate of which another family member, whom you represent in an unrelated matter, is a beneficiary, you should obtain a prospective waiver from all parties. Assuming there are no substantial conflicts among the family members, the next question is how to structure the representation. When coordination is key, such as when a series of common transactions are contemplated or you’ll represent co-fiduciaries, the representation should probably be structured as a joint representation with the attendant waiver of confidentiality among the multiple clients. When coordination isn’t necessarily required, such as when the clients seek representation for unrelated matters, the representation may be structured as a separate representation of each client with no waiver of confidentiality. In either case, you should obtain a prospective waiver of any potential conflicts of interest that may arise from the representation.

The importance of identifying and resolving potential conflicts of interest ahead of time can’t be overstated. Violations of the ethical rules, including those pertaining to conflicts of interest, can lead to severe consequences for the attorney, including disqualification, warnings, suspensions and in extreme cases, disbarment.⁶ An individual attorney is always subject to discipline for her own conduct. However, firms, partners and supervising attorneys may be subject to discipline for another attorney’s conduct as well.⁷ Accordingly, it’s vital for law firms to have thorough conflict checking practices and procedures in place and to follow them consistently.

Trust Your Instincts

These are just a handful of the myriad practical and ethical considerations that you should address before taking on a new representation. The key takeaway is not to let the thrill of a new representation blind you to hidden dangers. Before you sign on that new client or take on that new engagement, give some careful thought to whether the client is going to be a good one or whether you’re going to have to fire him down the line, and what that might mean for you and your firm if you do. While you should always be on the lookout for conflicts of interest, be particularly cautious when asked to represent multiple family members, even if their matters seem to be unrelated at first glance. Trust your instincts—if something seems wrong, it probably is. Take the time to ask questions, analyze the answers and make a solid strategy before moving forward.          

Endnotes

1. See The ACTEC Commentaries, Fifth Edition (2016) (ACTEC Commentaries), at p. 102.

2. See ABA Model Rules of Professional Conduct (2016) (Model Rules) 1.7.

3. See ACTEC Commentaries, at p. 103.

4. See ibid., at p. 105; see also Model Rules 1.16.

5. See ACTEC Commentaries, at p. 104.

6. See ibid., at pp. 109-119 (case annotations to Model Rules 1.7). 

7. See Model Rules 5.1.

Tying the knot. Settling down. Getting hitched. Taking the plunge. Regardless of what you call it, getting married is one of life’s great events. For estate planners, the marriage of a client or a client’s family member traditionally meant one thing: the preparation of a prenuptial agreement (prenup). But, within the estate-planning world, there’s a shift taking place. Planners are moving away from the typical financially focused, quantitative estate plan toward a more comprehensive, qualitative planning process that acknowledges how important healthy family relationships are to sustaining a family’s wealth long-term.¹ Many call it the “human capital” factor, and when it comes to a new marriage in the family, making an upfront investment into the new relationship can reap a great return down the line.

Adding a person to a family through marriage can be a great blessing, but as many people unfortunately find out, it can also be a challenge. For families with great wealth, the consequences of not proactively planning for the addition of a new family member can be especially costly. Estate planners, therefore, must be prepared to guide clients through the issues that will inevitably emerge as a result of a marriage in the family. From wedding planning and prenups to the assimilation or “onboarding” of in-laws into the family, a good estate planner will be equipped to help clients address all of the “what ifs” before the “I dos.” 

Weddings and Engagements

In the United States, wedding planning is a $55 billion industry.² The average wedding costs $35,329, and for high-net-worth (HNW) families, wedding expenses can reach much higher.³ Taking into account the sheer cost of the event, it makes sense to include an estate planner in the process. And, while some estate planners may not mind being asked to tag along for a cake testing, an estate planner’s role will obviously differ greatly from that of a professional wedding planner. The ultimate goal of a wedding planner is to design the perfect event down to the very last detail. An estate planner, however, should strive to help maintain the stability of the family throughout the planning process because long after the rings have been exchanged, relationships will be the glue holding the family together. 

One of the most important things an estate planner can do is provide an objective voice of reason. Stress tends to bring out the worst in people, and planning a wedding is often as stressful as it is exciting. Parents may find themselves having to choose between practicing financial prudence or providing a child with the wedding of his dreams. Moreover, there can also be added pressure involved when dealing with the future in-laws. Are both families of equal means? Does one side have significantly greater wealth than the other? Who will pay for what? And, who gets to call the shots? Even under the most amicable of conditions, these questions are difficult—and often uncomfortable—to discuss.  

Traditionally, the groom’s parents pay for the rehearsal dinner and the honeymoon, with the bride’s parents paying for everything else. Some Orthodox Jewish families practice the FLOP rule: the groom’s side pays for flowers, liquor, orchestra and photography. Regardless of traditional norms, it’s becoming increasingly common for the two families to split costs evenly, and with adults marrying at a later age, many brides and grooms have the means to pay for some, if not all, of the wedding themselves. This more modern approach, however, can lead to tension over decision-making authority.  Some may be tempted to follow the other golden rule: he who has the gold rules. Estate planners should be there to remind clients that although it might be easy to approach the issue like a business negotiation, the rules for wedding planning are different and, with the stability of a family hanging in the balance, the stakes are much higher. When it comes to weddings, even the most trivial of decisions can become a catalyst for relationship-damaging disagreements. To successfully protect a family’s human capital, an estate planner must be able to help identify and diffuse hot-button issues before they begin to cause friction. 

One frequently disputed aspect of a wedding is the invitation list. Because the budget and the chosen venue typically dictate the number of invitations allowed, the real problems tend to emerge after the number is set. For example, 400 people may sound like a large wedding until you break down the numbers. If the bride gets 200 (which equates to 100 couples), then once you account for invitations to family and invitations to friends of the bride (and their guests), the parents of the bride may actually be left with a small number of invitations to divide among their personal friends, which can be a tremendous source of angst as parents must explain to friends and colleagues why there isn’t room for them at a wedding that will have 400 attendees. These types of issues can strain the relationship between parents and child, and estate planners can assist by facilitating open and productive communication. In some cases, the parents may simply need to be reminded that the wedding is ultimately about the child and his future spouse, but such advice is typically better received if it comes from a trusted, objective family advisor and not from the child himself. 

That pendulum, however, can swing too far in the other direction, and estate planners should be able to determine when a client’s child is causing the planning to spin out of control. In fact, one of the most profound principles a planner can impress upon clients is not to allow the wedding to become bigger than the marriage. Helping clients keep the wedding in perspective can reduce strain on relationships and prevent the planning from going significantly over budget.  

Budget guidance, itself, can be a practical way to assist clients in the planning process. Before any planning decisions are made, there should be a clear understanding regarding the amount of money that will be available to spend. Many parents like to give their child the option of foregoing the big wedding and taking the available “wedding money” to use for a down payment on a home. If the child chooses to have the big wedding, one helpful strategy is to have the bride or groom list their three top priorities for the wedding. Then, if budget concerns arise, parents will know what aspects of the event are most important to their child prior to making cutbacks. For example, if the bride’s top priorities are her dress, the music and the photography, then compromises will be easier to reach on other items like flowers, cake and dinner menu selections.  

Some say that paying for a wedding is like buying an expensive car and immediately driving it off of a cliff, but for those who are within budget, it’s helpful to remember the significance of the event. A wedding is a celebration of the joining of two lives. The memories formed at a wedding become part of the family’s legacy, and generations down the line will likely flip through a photo album and catch a glimpse of their family history. For estate planners, a marriage in the family of a client is an opportunity to shore up the foundation on which future generations of the family will be built.  

In many ways, planning a wedding is much more taxing than even the most complex of business transactions. Beyond the financial cost, there can also be a hefty emotional toll. It isn’t uncommon for clients to have little to no relationship with their child’s future in-laws, so planning an expensive wedding together is comparable to two strangers entering into a business partnership. Accordingly, estate planners should be prepared to coach clients through conflict for the sake of the health of the family, especially when the problems seem to originate between the bride and groom. Certainly, some friction can be expected in any relationship during stressful times, but estate planners, as objective bystanders, can be useful in helping families differentiate between normal strains in an engagement and red flags that may be indicative of a deeper, “pack your bags” issue. 

Regardless how tense the situation becomes during wedding planning, when the wedding is over, parents need to set aside any hard feelings and support the new couple. The parents’ relationship with the married couple (and future grandchildren) is more important than trying to settle any unfairness or holding a grudge. Put those feelings behind and move on.  

When a bride and groom do decide to call off the wedding, there’s one issue that can cause significant controversy: Who gets to keep the engagement ring? While the exact answer to this question depends on the state where the parties reside, the prevailing rule treats the ring as a conditional gift, meaning that courts will treat the ring as being gifted on the condition that the couple marry. In the event the couple doesn’t marry, the ring must be returned to the donor. Though a majority of states follow this rule, some states provide an exception for circumstances in which one party was clearly at fault for the breakup of the engagement. If the ring holder can prove the donor was at fault for the ending of the relationship, then the donor isn’t entitled to get the ring back. Of course, if the couple agrees in writing that the ring must be returned should the wedding be called off, then proof of fault is irrelevant. 

Prenups

The grim statistics for a successful marriage are well known—around half of first marriages in the United States end in divorce.⁴ Given that statistic alone, it’s irresponsible for families with great wealth to allow a child to marry without protecting assets in case of a divorce. In addition to high divorce rates, people are also choosing to marry at a later age. The median age for a first marriage is 25.8 for women and 28.3 for men.⁵ When people marry at an older age, the relationship will likely look very different from a marriage that started with a “young” bride and groom. Social scientist Charles Murray refers to these two types of relationships as “merger marriages” and “start-up marriages.”⁶ Adults in their late 20s (or older) will have had several years to establish a career, accumulate personal assets and thus bring more to the marriage—thereby creating a merger marriage between two successful adults. On the other hand, a marriage between two younger adults will more closely resemble a start-up business, with lean beginning years full of hardship and hope.  

Both types of marriages have their own advantages and disadvantages. Start-up marriages, for instance, may begin with more challenges, but those challenges can also bring the couple closer together and provide a solid foundation of memories that can be drawn on in future times of trouble. Conversely, merger marriages may allow the couple to have more financial freedom and less career-related stress, but the couple may also be more set in their ways and have a harder time forming a united front after having achieved success independently of their partner. With merger marriages becoming more and more common, couples have more to lose financially in the event of a divorce. The most effective way to avoid or diminish the many problems that arise during a divorce is to come to an agreement well in advance of the marriage, before any issues arise. 

Even if one party desires to have a prenup, broaching the conversation with a future spouse can be a delicate matter due to the stigma that prenups are essentially a way to pre-plan for an inevitable divorce. Regardless of how objectively reasonable it is to have a prenup in place, discussing a division of assets tends to evoke
emotions that dampen the excitement of an engagement. These obstacles, however, can be diminished with foresight and preparation, and a wise estate planner will have addressed the issue with clients long before the need for a prenup arises.  

The best way to alleviate some of the awkwardness of the prenup process for an engaged child is to have clients establish a “standard family practice” that all children have a prenup. A basic form can be constructed that can serve as the basis for a future negotiation. Some families even include provisions in the parent’s estate plan that allow for distributions to be withheld from children who marry without executing a prenup. With a standard family practice in place, an engaged child will have an easier time explaining the need for a prenup to a future spouse.  

If an individual is going to enter into a prenup, he should follow some recommended practices for the agreement to have a greater degree of enforceability. The Uniform Premarital Agreement Act (UPAA) provides a basis for states to determine how and when a prenup should be enforced.⁷ One potential challenge to a prenup is if the agreement wasn’t executed voluntarily. It’s important for the discussions about the prenup to have begun well in advance of the wedding date because a narrow period of time between when the prenup was signed and the wedding date could be used as evidence to support a claim of involuntary execution. Other factors that could support a claim of involuntary execution include the parties’ mental capacity, education levels and a lack of separate counsel. 

Another potential challenge to the enforceability of a prenup is that the agreement was unconscionable at the time it was executed. In determining unconscionability, a court may look to how the agreement affects the economic circumstances of the parties and the conditions under which the agreement was made.⁸ To strengthen the enforceability of a prenup against such a claim, each party should be provided a fair and reasonable disclosure of the property or financial obligations of the other party or an adequate waiver of such disclosure. The UPAA places the burden of proof on the party alleging that the agreement isn’t enforceable. However, some states have placed the burden on the party who’s relying on the agreement, and other states have chosen a middle ground, stating that if a spouse is receiving disproportionately less than the other spouse, the other spouse bears the burden of proof of showing adequate disclosure.⁹

Best practices for a prenuptial agreement include: (1) each party should have independent legal representation; (2) discussions about the prenup should begin well in advance of the wedding date; and (3) there needs to be a full disclosure (or adequate waiver of full disclosure) of all asset and liability information for both parties. It’s also important to review the governing state law to verify that any required acknowledgments or waivers are properly addressed within the prenup. 

When it comes to the details of a prenup, state laws on marital property must serve as the framework of the document. There are, however, many different considerations, both financial and non-financial, that should be addressed when constructing a prenup: (1) identifying assets each brings into the marriage; (2) specifying in community property states the manner in which the income of each party’s separate property will be classified; (3) characterizing wages, salary or other compensation in community property states; (4) assigning certain financial responsibilities like housing costs or schooling expenditures; (5) filing of income tax returns; (6) deciding on the disposition of retirement plans; (7) treating debts of a spouse; (8) dividing assets on death or divorce; (9) dealing with the issue of spousal support on divorce; and (10) handling other non-financial matters that are important to the relationship such as childrearing or religious upbringing of future children. Although the specifics of each will vary significantly from couple to couple, a solid agreement will be comprehensive and forward-thinking.

Another prenup planning concept with which estate planners should be familiar is the “reverse prenup,” which is essentially an agreement reached in anticipation that a wife may one day give up her career to raise a family. A typical reverse prenup establishes a formula payout that compensates the wife based on the number of years the parties are married. For women with successful careers, a reverse prenup provides a safety net in the event the marriage fails after she’s left the workforce.

Prenup Alternatives

The use of prenup alternatives can alleviate much of the pressure surrounding the drafting of a prenup, and in some cases, may remove the need for a prenup altogether. These prenup alternatives include irrevocable trusts and entity planning, and estate planners must recognize that it’s never too soon to incorporate one or more of these strategies into the client’s estate plan. 

Irrevocable trusts. An irrevocable trust, if carefully drafted, can allow wealth to pass down from generation to generation without future spouses having any claim to the assets of the trust. Ideally, parents will direct that all lifetime gifts and any assets that pass at death to their children or grandchildren should be held in an irrevocable trust. Because assets held in a properly drafted trust are considered non-marital assets, they aren’t subject to review or division by a family court in the event of a divorce. Furthermore, a beneficiary of the trust needn’t have his future spouse sign any agreements with respect to the trust nor does the future spouse necessarily have to know of the provisions of the trust. 

For single adults who’ve accumulated their own assets, a self-settled irrevocable trust provides another prenuptial estate-planning option. Some jurisdictions (Alaska, Delaware and Nevada) allow creditor protection to attach to self-settled trusts. The trust, which should be created and funded prior to marriage, will remove assets from the marital context, thereby preventing them from becoming subject to review or division by a family court.  

Alternatively, individuals can enter into a transaction with a 678 trust (named after the Internal Revenue Code Section on which it’s based and also known as a “beneficiary defective trust”) created by a third party for their benefit. When non-marital assets are sold to the 678 trust in exchange for a promissory note, the assets in the trust will continue to be characterized as non-marital property, post marriage, but the resulting promissory note and/or the interest payments will acquire some degree of marital characterization post marriage. 

Overall, the use of irrevocable trusts offers significant advantages not afforded by traditional prenups. Trusts, for instance, can be drafted to allow flexibility to provide for future spouses and are typically less expensive to draft than prenups because they aren’t negotiated between the parties. Moreover, whereas prenups terminate on the death of a spouse, trusts can be drafted to continue long after the primary beneficiary dies. Irrevocable trusts are also far less likely than prenups to be subjected to legal challenge, and if the characterization of assets in a trust is questioned, legal precedent tends to favor respecting the integrity of the trust. Despite this protection afforded trusts, however, there are specific drafting considerations with which estate planners should become familiar in light of some recent court decisions.

In the Massachusetts case of Pfannenstiehl v. Pfannenstiehl, the husband in a divorce proceeding was one of several beneficiaries of a pot trust established by the husband’s father.¹⁰ Although the husband had received regular distributions from the trust throughout his marriage, the distributions stopped immediately prior to the initiation of divorce proceedings. The lower court and the Massachusetts Appeals Court held for the wife, finding that due to the fact that trust distributions were subject to an ascertainable standard and that the husband would receive a share of the trust assets on termination of the trust, the husband’s interest in the trust had vested and thus could be considered a marital asset.¹¹ Ultimately, the Massachusetts Supreme Judicial Court reversed the decision and found that because the husband was one of 11 beneficiaries and the trustees were instructed to consider the long-term sustainability of the trust prior to making distributions, the husband’s interest was too speculative to be considered a marital asset. Note that while the trust assets weren’t deemed to be includible in the marital estate, the court noted that the trust could be seen as providing an expectancy of acquisition of future assets/income and thus could be considered in deciding how to divide other property subject to division.

For those wishing to take an extra measure of precaution, there are additional steps estate planners can take in drafting irrevocable trusts.¹² First, consider avoiding the use of ascertainable standards and instead provide for a trust protector (or special trustee) to have authority to amend the trust and direct or veto distributions. Second, include a special power of appointment (SPOA)—or the power to create an SPOA—to a third party who can move assets to another trust with similar (but more appealing) provisions. Finally, in some cases, it may be prudent to include a forfeiture provision that requires a beneficiary’s interest to terminate in the event such beneficiary is named as a defendant in a lawsuit or is a party to a divorce proceeding.

The Texas case of Sharma v. Routh, an appeal of a divorce decree, analyzed the issue of the characterization of the corpus of the trust and the impact of that determination on the characterization of the distributions from the trust.¹³ In Sharma, the husband was a beneficiary of two trusts created on the death of his first wife. He was also the trustee of both trusts and had power to take distributions of the trust corpus subject to an ascertainable standard (that is, health, maintenance and support, considering other resources available to the beneficiary). The trial court determined that the trust corpus was the husband’s separate property and therefore characterized the income received from the trust as community property subject to division. The Texas Appeals Court, in overturning the trial court, held that the trust corpus wasn’t owned by the husband because he didn’t hold a present possessory right over the corpus under the trust document. Because the husband didn’t own the corpus, distributions of the income received by the husband were gifts, which are non-divisible separate property under Texas law. Thus, under Sharma, the trust structure protected both trust corpus and distributions of trust income.

Entity planning. In some states, there are advantages to placing assets in an entity, such as a limited liability company or limited partnership, in contemplation of a future marriage to prevent future growth, in one form or another, from being divisible on dissolution of the marriage. For example, in Texas, the growth of value of assets owned in a partnership, as well as income earned but undistributed, aren’t divisible on divorce. Yet, this type of planning may not be as effective in other states. For example, income from separate property remains separate property in California, so this planning may not be necessary for this purpose. In Colorado, on the other hand, any growth in value of a partnership interest is considered to be marital property so a new entity may not help at all. Thus, it’s important for this entity planning opportunity to be reviewed on a state-by-state basis. For any state that does allow the growth and income in a partnership or similar entity to remain in a form not divisible on divorce, it may be prudent to provide adequate compensation to the community or marital estate to mitigate against a potential claim for a right of reimbursement by a divorcing spouse. While a person is allowed to expend a reasonable amount of time and effort in managing and preserving his separate property assets, if there are significant services and talents exercised on behalf of a party without adequate compensation to the community or marital estate, a spouse could potentially make a claim for reimbursement to the community or marital estate.  

While there may be some scenarios in which alternative premarital planning completely eliminates the need for a prenup, in certain circumstances, it will always be best to have a prenup in place. Those entering a second—or multiple—marriage often carry obligations or duties to previous spouse(s) that will need to be addressed. A child from a prior relationship will also necessitate a prenup due to issues regarding financial treatment of the stepchild and future homestead rights of a surviving spouse. Finally, if either party to a marriage has a career with increased liability (for example, neurosurgeon), a prenup, in conjunction with other asset protection planning, may be advisable to provide an added layer of protection for the other party’s property. 

Onboarding In-laws

Estate planners should be vigilant in looking out for issues that have the potential to threaten the human capital of the family, and while many feel comfortable guiding clients through the prenup process, too many estate planners fail to take the next step of teaching clients how to effectively incorporate new in-laws into the family.

As the saying goes, you can choose your friends, but you can’t choose your family. The idiom often rings especially true for in-laws. Even in circumstances in which a family and the in-laws within it enjoy strong relationships, there’s no getting around the fact that the in-laws grew up in a different home, with a different set of rules and, on some level, different values. And in many families, those differences become a source of tension. But, because human capital is vital to a family’s success, estate planners must have planning strategies to teach families the best ways to onboard in-laws and avoid problems that threaten the stability of the family. After all, the in-laws are helping to parent the next generation of the family.¹⁴

For HNW clients, a central issue within the family is often how and to what extent in-laws should be included in the family’s wealth-related affairs. Traditionally, the common approach was to largely exclude in-laws from discussions regarding the family business or wealth management, but from a practical standpoint, it becomes evident pretty quickly that an in-law will know everything that goes on within the family. The information will simply be filtered through his spouse, which can, at times, lead to a skewed view of the family and may help fuel misinformation and miscommunication. The more modern approach is to manage communication flow by including in-laws in all family affairs.

An estate planner has the ultimate goal of maintaining the wealth of a family for generations to come, and accordingly, planners should take an active role in helping clients establish policies that foster good relationships and promote family development and success. Because entering a new family can be overwhelming, estate planners should coach families to “immediately acculturate new in-laws, helping them to feel like valued members of the team.”¹⁵ Acculturation can be accomplished through the use of two big steps: (1) sharing information, and (2) getting involved in the family.¹⁶

Sharing information is a significant part of making the in-law feel included. Often, in-laws find themselves in a predicament in which they appear disinterested if they fail to ask enough questions but appear nosy if they ask too many questions.¹⁷ Granting in-laws a backstage pass to the inner workings of the family will ease anxiety and make an in-law feel like less of an outsider. Estate planners should also encourage families to allow in-laws to participate in family affairs, with such participation primarily being accomplished through the implementation of a family governance structure.  

A governance structure will help accomplish many tasks such as: (1) communicating family values and future vision, (2) keeping family members informed of family business, (3) communicating decisions that affect family members, (4) establishing open channels of communication to allow family members to provide feedback and share ideas, and (5) facilitating family meetings for group decisions.¹⁸ For in-laws, the primary goal of a governance structure is to get them to buy into the family vision. If the in-laws feel included, valued and heard, they’ll be much more likely to be emotionally invested in the outcome of the family. Additionally, estate planners should stress the importance of fun. Relationships within a family will be much stronger if they’re built on shared experiences and not just a shared name. Families should schedule events that are free of business and devoted entirely to building up relationships within the family.  

Any healthy relationship requires some work and, typically, a lot of compromise. For some families, it may seem unnatural to treat in-laws as part of the inner circle, but the benefits of doing so should far outweigh any momentary unpleasantness. Families don’t remain stagnant—they change and grow, and estate planners must be prepared to help with the growing pains. A successful transfer of wealth from generation to generation is a lofty and admirable goal, but within the estate-planning world, there should be more emphasis placed on preservation of the family. Estate planners must seize opportunities like engagements and weddings to address the human capital factor and pay a little more attention to the “family” in “family wealth.”  

Endnotes

1. Using the labels “qualitative” and “quantitative” in this sense was introduced by James E. Hughes, Jr., in his book, Family Wealth—Keeping It in the Family, at p. 11.

2. www.ibisworld.com/industry-trends/market-research-reports/other-services-except-public-administration/repair-maintenance/wedding-services.html.

3. http://money.cnn.com/2017/02/02/pf/cost-of-wedding-budget-2016-the-knot/index.html.

4. National Health Statistics Reports, “First Marriages in the United States: Data From the 2006-2010 National Survey of Family Growth” (March 22, 2012). 

5. Ibid.

6. Charles Murray, “Advice for a Happy Life,” The Wall Street Journal (March 30, 2014), www.wsj.com/articles/advice-for-a-happy-life-by-charles-murray-1396045908.

7. “Comment, The Uniform Premarital Agreement Act and its Variations Throughout the State,” Journal of the American Academy of Matrimonial Lawyers, Vol. 23 (2010), at p. 355.

8. Ibid., at p. 358.

9. Ibid.

10. Pfannenstiehl v. Pfannenstiehl, 475 Mass. 105 (2016).

11. Ibid.

12. Alexander A. Bove, Jr., “Pfollowing the Pfamous Pfannestiehl Case,” Steve Leimberg’s Estate Planning Newsletter (Aug. 18, 2016).

13. Sharma v. Routh, 302 S.W.3d 355 (2009).

14. William S. Lockington, “In-Laws Don’t Need to Be Outlaws,” presentation at The Kawartha Family Business Group (Sept. 24, 2007).

15. “In-Laws or Outlaws? Making Siblings’ Spouses Part of the Team,” The Family Business Consulting Group (May 28, 2013), www.thefbcg.com/in-laws-or-outlaws-making-siblings-spouses-part-of-the-team/.

16. Supra note 14.  

17. Patricia Angus, “Family Governance: A Primer for Philanthropic Families,” National Center for Family Philanthropy (2004).

18. Christian G. Stewart, “The Family Business Constitution: A Roadmap for Business Continuity & Family Harmony” (April 2010), www.familylegacyasia.com/whitepaper_pdf/Ten%20key%20insights%20into%20making%20a%20Family%20Constitution.pdf.

Splitting up a marital estate can be a long and complicated process, particularly if one of the assets includes a privately owned business.

Some common issues include:

• How much is the business actually worth?
• Do you need to be concerned about the issue of “double dipping” when considering the valuation of a business and the money spouses owe in support obligations?
• Is the spouse that owns and operates the business deceptive when it comes to reporting his income?

How much is the business actually worth?

There are three methods used to value a business: the asset, the market and income approaches. All of these methods start with an analysis of the company’s financial statements. But discovery shouldn’t stop there, especially for spouses who aren’t involved in the day-to-day business operations.

Valuation experts should be given equal access to financial records and opportunities to tour the company’s facilities and interview management. Inadequate discovery can cause an expert to miss critical information and possibly lead to an inaccurate conclusion of value.

If the business interest was owned prior to the marriage, it might be appropriate to include only the appreciation in value over the course of the marriage. This of course depends upon the facts of the case and relevant state law. Estimating appreciation in value requires a comparison of the current value of the business as compared to its value at the date of marriage.

How do you reconcile the valuation of the business, its potentially equitable distribution and support obligations?

In certain instances you may need to adjust the business’s value from the marital estate relating to the concept of “double dipping.” This may occur when a spouse receives double recovery for a single asset. For example, courts in some states have decided that it’s inequitable for a spouse to receive maintenance payments based on his or her spouse’s future income, in addition to a share of the value of a business. In other instances, the value of the business may be determined with a cash flow that is net of a reasonable officer’s compensation to avoid double counting. In each instance you need to consider your individual state law.

Is the business owner deceptive when reporting income?

A controlling shareholder spouse may try to hide income or assets to achieve a more favorable divorce settlement. Downplaying assets and income (or, conversely, exaggerating liabilities and expenses) can lead to lower business valuations and reduced payments for child support and alimony—unless a valuation expert identifies the anomaly and makes an adjustment to record the value of the missing or inaccurate item(s).

Reasonable “replacement” compensation, based on the market value of the owner’s contribution to the business, is a common adjustment that’s made in divorce cases. Additionally, some business owners try to deduct their personal attorney’s fees or expert fees as business expenses. Running these and other personal expenses through the business not only reduces the value of the business interest, but it could also expose the non-controlling spouse to an IRS inquiry.

Other adjustments may be needed to normalize the income stream to benchmark the subject company against comparable companies. Examples include adjustments for nonstandard accounting practices, such as cash-to-accrual basis of accounting changes, and for nonrecurring income or expenses from, say, a discontinued product line or sale of a nonoperating asset.

Looking at the big picture

The most significant asset in a marital estate is often the family business. A fair resolution hinges on an accurate valuation of same. That can be achieved by working with an experienced valuation expert who understands how courts handle challenging divorce issues and the application of sound valuation concepts.

On Jan. 16, 2018, the U.S. Internal Revenue Service released Notice 2018-01 regarding the passport revocation process for U.S. citizens with seriously delinquent tax debts. 

Background 

Under a 2015 law, the U.S. Department of Treasury must notify the U.S. Department of State of U.S. citizens with seriously delinquent tax debts. This process requires the IRS to identify those individuals and certify the identities and tax debts to the Department of Treasury. The IRS is also required to contemporaneously notify the individuals. 

After receiving the certification, the Department of State will deny passport applications of affected individuals and may revoke or limit existing U.S. passports. The Department of State can make exceptions in cases of "emergency circumstances or for humanitarian reasons." 

A seriously delinquent tax debt is an unpaid, legally enforceable federal tax liability in excess of $50,000 (adjusted for inflation) if either: 

• a levy has been issued to collect the debt; or 
• a notice of federal tax lien has been filed and the taxpayer's administrative remedies have lapsed or have been exhausted. 

Seriously delinquent tax debts don’t include debts being timely paid under an installment agreement or subject to an offer in compromise with the IRS or debts where the collection process has been suspended. 

The Notice 

The Notice states that the IRS and the Department of State will implement this law beginning in January 2018.  

In addition, the Notice indicates that the IRS will notify taxpayers through Notice CP508C, Notice of certification of your seriously delinquent federal tax debt to the State Department. Notice CP508C will include a simple, nontechnical description of the individual’s right to request judicial review by a U.S. federal district court or the U.S. Tax Court to determine whether the certification was made in error or can be reversed. Taxpayers can’t challenge a certification through IRS Appeals, but the Notice states that taxpayers may call the IRS to request reversal of a certification believed to be made in error. 

According to the Notice, affected taxpayers who apply for U.S. passports will be given 90 days to resolve their tax delinquencies by making full payment of the tax debt or by entering into an installment agreement or offer in compromise with the IRS. After expiration of this 90 day period, the Department of State will deny the application. 

Consequences and Tips for U.S. Passport Holders 

Limiting or revoking passports, as well denying applications, will cause significant hardship for U.S. citizens living outside of the United States, as well as for frequent travelers. 

Any type of federal tax liability (including interest and penalties) counts toward the $50,000 threshold, which is determined by a taxpayer's total cumulative tax debt (rather than a per year amount). 

It’s important to note that as many federal tax penalties relate to the failure to file IRS forms reporting non-U.S. assets, U.S. citizens with assets and connections outside the United States could be among those most affected. 

Taxpayers need to review IRS notices and timely respond to avoid becoming delinquent by failing to respond. Individuals resident outside of the United States and frequent travelers should ensure that they have reliable arrangements in place for receiving and responding to IRS notices.  

Taxpayers also need to be aware and act on any available remedies against IRS collection actions, which can prevent a notice of federal tax lien from becoming seriously delinquent and, thereby, delay or prevent the initiation of the passport revocation, limitation or denial process.  

As readers of Trusts & Estates know well, decanting is the process by which a trustee, exercising a discretionary distribution power, distributes assets to another trust for the benefit of the beneficiary in favor of whom the power is ostensibly exercised, and perhaps one or more others, rather than directly to such beneficiary. Decanting appears to have originated under common law in a 1940 Florida Supreme Court case,¹ but its popularity and frequency of use didn’t emerge until states began to enact statutes explicitly authorizing decanting.² Today, 24 states³ have decanting statutes, and at least one state lacking such a statute, Massachusetts, allows decanting pursuant to case law.⁴

Decanting is one of several techniques that have developed in modern trust law to enable changes to be made to irrevocable trusts whose terms have become inappropriate for current circumstances, detrimental or difficult or impossible to implement. Depending on the state whose law governs administration, the new trust, as compared to the trust out of which the distribution was made, may have different standards for distribution, permit or direct distributions at a different time or times, create a new power of appointment and include different beneficiaries. Whether decanting is good or bad depends on the facts of the particular case and the perspective of the person opining.⁵

The benefits of decanting notwithstanding, a couple of recent cases illustrate that decanting may not always deliver the expected end results.

Ferri

In Ferri v. Powell-Ferri,⁶ the husband (Paul) was the beneficiary of a trust created in 1983 by his father in Massachusetts. Paul and his wife, Nancy, resided in Connecticut. Nancy initiated divorce proceedings in 2010. At that time, Paul could withdraw 75 percent of the trust property, and, while the dissolution proceedings were underway, Paul became entitled to withdraw 100 percent of the trust property. Except to the extent Paul exercised his withdrawal rights, disposition of trust property was subject to the trustees’ very broad discretion. The trustees, concerned Nancy could successfully make a claim to trust assets in the divorce action, decanted the trust to a new, spendthrift trust under which Paul’s beneficial interest was completely subject to the trustees’ discretion. Paul didn’t approve or consent to the decanting and in fact had no knowledge of it whatsoever until after it had been accomplished. The trustees sought a declaratory judgment that the decanting was valid. Nancy argued the decanting was invalid and that, even if the decanting were valid, she could reach the trust property because the new trust was, in substance, a self-settled trust.⁷

The Supreme Court of Connecticut, relying on an advisory opinion it had received from the Supreme Judicial Court of Massachusetts,⁸ held the decanting was valid under Massachusetts law⁹ and that the new trust wasn’t, legally or in substance, a self-settled trust, despite Paul’s withdrawal rights. In the related dissolution case, Powell-Ferri v. Ferri,¹⁰ however, the Supreme Court held that, although the assets of the new trust weren’t subject to division as marital property, having effectively lost their status as marital property in the valid decanting transaction, the trial court could properly consider the new trust and Paul’s beneficial interest in that trust when decreeing an appropriate annual alimony amount to be paid by Paul. On considering the new trust, the trial court ordered that Paul must pay $300,000, annually, in alimony even though, at the time the divorce proceeding began, Paul’s annual earnings totaled $200,000. Perhaps the divorce court thought its alimony order would give Nancy an indirect path by which to gain access to some of the decanted trust’s assets.

The decanting, standing alone, obviously was successful. In fact, it could be characterized as extraordinarily successful because the court sanctioned a decanting that eliminated a presently and unilaterally exercisable power of withdrawal.¹¹ The result in the divorce case, however, which must have been a nasty surprise to Paul, substantially compromised the effect of the decanting. Paul became the beneficiary of a wholly discretionary trust, from which he may or may not ever receive any distributions, and is subject to a court order compelling him to pay alimony in an amount 50 percent higher than his annual non-trust income.

Hodges

In Hodges v. Johnson,¹² the “decanting trustee” of two irrevocable trusts engaged in three separate decanting transactions over a 3-year period. The net result of these decantings was that, among six original current beneficiaries, four were eliminated as such, and, among five original first-line contingent remainder beneficiaries, three were eliminated as such. Under applicable state law (the law of New Hampshire), a trustee is allowed to decant from one irrevocable trust (the first trust) to another (the second trust) “for the benefit of one or more” of the beneficiaries of the first trust.¹³ However, the Supreme Court of New Hampshire, affirming the trial court, held that the decantings were improper and void because the decanting trustee violated his duty of impartiality by failing to give any consideration to the plaintiffs’ future beneficial interests. The trial court had indicated discomfort with the settlor’s initiation of the decantings and “the deeply personal and harsh nature of the decantings.” The Supreme Court quoted and seemed impressed by a statement by respected commentators in a professional journal that, while a trustee may decant in a manner that eliminates the beneficial interest of a given beneficiary, “it is difficult to imagine the factual scenario where the trustee would not violate its fiduciary duty of impartiality owed to that beneficiary.”

The decanting trustee, in implementing the decantings, obviously favored one group of beneficiaries over the other. In the world of discretionary trusts having multiple concurrent beneficiaries, trustees do that all the time. The very nature of such trusts is that some beneficiaries inevitably receive more than others—sometimes to the exclusion of others. As long as the trustee exercises his discretion honestly, in good faith and consistent with the governing instrument and applicable trust law, there’s nothing insidious in particular beneficiaries of a discretionary trust receiving smaller distributions than others or no distributions at all. The operative decanting statute in Hodges appears expressly to contemplate such a result.¹⁴

So, what went wrong? First, it seems the Supreme Court, on reading the trial court’s opinion, believed the settlor had acted as the decanting trustee’s puppet master and was mightily offended at the vitriol that motivated the settlor. Second, among the facts adduced at trial was that the decanting trustee agreed he “never gave [the plaintiffs’] financial interest any consideration.” If this weren’t a fact, that is, if the decanting trustee had given the excluded beneficiaries’ financial interests honest consideration and, after having done so, sincerely concluded that the decantings were consistent with fulfillment of his fiduciary duties under the governing instruments and applicable trust law, perhaps the result in Hodges would have been different.¹⁵

Surely, it can’t be the law that any decanting that negatively impacts a beneficial interest is per se a breach of fiduciary duty. If a given decanting can pass muster under fiduciary law pertaining to discretionary distributions, the fact that the distribution was made to another trust, rather than to one or more individuals outright, should make no difference.¹⁶  

Endnotes

1. Phipps v. Palm Beach Trust Company, 196 So. 299 (Fla. 1940).

2. New York enacted the nation’s first decanting statute in 1992.

3. Alaska, Arizona, Delaware, Florida, Illinois, Indiana, Kentucky, Michigan, Minnesota, Missouri, Nevada, New Hampshire, New Mexico, New York, North Carolina, Ohio, Rhode Island, South Carolina, South Dakota, Tennessee, Texas, Virginia, Wisconsin and Wyoming.

4. Morse v. Kraft, 992 N.E.2d 1021 (Mass. 2013).

5. See Charles A. Redd, “Flexibility vs. Certainty—Has the Pendulum Swung Too Far?” Trusts & Estates (March 2015), at p. 10.

6. Ferri v. Powell-Ferri, 326 Conn. 438 (2017).

7. Neither Massachusetts nor Connecticut is a self-settled asset protection trust state.

8. Ferri v. Powell-Ferri, 72 N.E.3d 541 (Mass. 2017).

9. See Morse v. Kraft, 992 N.E.2d 1021 (Mass. 2013).

10. Powell-Ferri v. Ferri, 326 Conn. 457 (2017).

11. It’s reasonable to surmise that, had Paul consented to the decanting or even known about it before it had been consummated, the Supreme Court might well have reached a different result.

12. Hodges v. Johnson, 2017 N.H. LEXIS 232 (N.H. Dec. 12, 2017).

13. RSA 564-B:4-418(a) (Supp. 2008) (amended 2014).

14. See RSA 564-B:4-418(a) (Supp. 2008) (amended 2014); see also 12 Del. Code Section 3528(a) and Section 456.4-419.2(1), RSMo.

15. Indeed, the Supreme Court stated that a decanting that “eliminates a beneficiary’s non-vested interest in an irrevocable trust” is a breach of duty “only when the trustee fails to treat the beneficiaries equitably in light of the purposes and terms of the trust.” (Emphasis added.)

16. See, e.g., 12 Del. Code Section 3528(e).

As estate attorneys and advisors, one of our primary goals is to do what’s in the best interests of the estate. We strive to minimize the amount of the estate subject to estate tax to maximize the value of property passed tax-free to the intended beneficiaries of the decedent. While individuals prepare their wills with the best of intentions, disputes often arise even in well-prepared estates.  

The marital deduction is one of the most important tools that an estate can use. The deduction allows for the tax-free passing of assets to a surviving spouse by reducing the value of the estate for all assets that pass to the surviving spouse. But, the exact timing of when a surviving spouse has a nonterminable interest is complicated by settlement payments in estate disputes and court judgments. Let’s analyze when terminable interests prevent the marital deduction and consider some strategies to allow for the marital deduction.

Timing of Terminable Interests

The federal estate tax imposes a tax on the estate of every decedent who’s a citizen or resident of the United States and whose estate value exceeds a certain dollar threshold.¹ The marital deduction in Internal Revenue Code Section 2056 allows for assets to pass from a decedent to a surviving spouse tax-free and avoid the estate tax except when the spouse has a “terminable interest.”²

IRC Section 2056 defines a terminable interest as any interest “[w]here, on the lapse of time, on the occurrence of an event or contingency, or on the failure of an event or contingency to occur, an interest passing to the surviving spouse will terminate or fail.”³ Thus, a decedent must convey a complete interest to the surviving spouse to use the marital deduction. 

To apply the marital deduction, a surviving spouse must have a nonterminable interest in the estate property. Knowing when a surviving spouse has a nonterminable interest in estate property isn’t always clear. For instance, a prenuptial agreement (prenup) allowing a surviving spouse to only receive a life estate in estate property is a terminable interest. But, any subsequent settlement payment or court judgment received from the estate would arguably be a nonterminable interest. The exact timing of a surviving spouse’s interest in the estate is important in determining whether the estate can use the marital deduction.

The court in Jackson v. United States developed a legal doctrine to help determine when a nonterminable interest must be present for an estate to use the marital deduction.⁴ In Jackson, after the death of her husband, a surviving spouse received a widow’s allowance under California law. The state court awarded the widow payments from the estate to satisfy the widow’s allowance. The estate applied the marital deduction to the amount the estate paid to the surviving spouse as part of the widow’s allowance. The Internal Revenue Service disputed the treatment of the widow’s allowance, claiming that the payment was a terminable interest because the widow’s allowance wasn’t a vested right, and nothing accrued before payments were granted because the widow could only receive payments if certain conditions were met. Under California law, if a widow died or remarried, the widow’s estate wouldn’t be entitled to the widow’s allowance. The state court disallowed the marital deduction, and the surviving spouse appealed.

On appeal, the case went before the U.S. Supreme Court on the issue of whether the estate’s payments to the widow qualified for the marital deduction or if the widow’s allowance was a terminable interest. The Court stated that the initial rights granted by the widow’s allowance were terminable interests because to receive payments, the widow must not die or remarry. The Court also acknowledged that after a payment has been made to the widow as part of the widow’s allowance, the widow has a completed interest in the payment, and neither of the contingencies (death or remarriage) would require the widow to forfeit the payment. Thus, after a completed payment, the widow arguably has a nonterminable interest in estate property.  

The Court thus had to decide whether the surviving spouse’s initial terminable interest before payment or the nonterminable interest after completed payment determined the marital deduction. The Court stated that, “. . . courts have held the date of death of the testator to be the correct point of time from which to judge the nature of a widow’s allowance for the purpose of deciding terminability and deductibility.”⁵ The Court also stated, “there is no provision in the [Internal Revenue] Code for deducting all terminable interests which become nonterminable at a later date . . . The examples cited in the legislative history make it clear that the determinative factor is not taxability to the surviving spouse but terminability as defined by the statute.”⁶ Thus, the date of death became the point in time to determine if an interest is terminable or nonterminable, and the Court disallowed the marital deduction.

Applying the Jackson Doctrine

The Jackson doctrine states that the surviving spouse’s interest at the testator’s date of death determines the marital deduction. But, the Jackson doctrine is more complicated when estate disputes result in settlement payments and court awards. In most instances, these payments and awards are nonterminable interests because there are no conditions attached to them. If the interest at issue in settlement negotiations or litigation is terminable, the subsequent change to a nonterminable interest can obfuscate the ability for an estate to use the marital deduction. We’ll analyze a few common scenarios applying the Jackson doctrine to see how these scenarios potentially affect the marital deduction.

Example 1: Settlement payment with no prenup. In this scenario, the testator dies leaving the surviving spouse part of the estate. The surviving spouse contests the will, subsequently receiving a settlement payment. The decedent’s estate would like to use as much of the marital deduction as possible to limit any estate tax liability.  

If the testator left the surviving spouse a nonterminable interest under the will, then the surviving spouse had a nonterminable interest in the estate at the testator’s date of death. Thus, any subsequent settlement payment made by the estate to the surviving spouse would likely qualify for the marital deduction. In this case, the interest the surviving spouse received at the testator’s date of death and the settlement payment are both nonterminable interests so the Jackson doctrine doesn’t affect the outcome.

Example 2:Settlement payment with a prenup. If a prenup is present that grants a surviving spouse a life estate in estate property, the possibility of using the marital deduction becomes more complex. In this scenario, the testator and the surviving spouse enter into a prenup granting the other a life estate in the estate property. On the death of the testator, the surviving spouse challenges the validity of the prenup. The estate agrees to pay the surviving spouse a settlement payment, and the surviving spouse releases all claims against the estate.

According to the prenup, the testator granted the surviving spouse a life estate in the estate property. The IRC considers a life estate to be a terminable interest.⁷ However, instead of obtaining a life estate in the estate property, the surviving spouse received a settlement payment from the estate. The settlement payment isn’t a terminable interest because it isn’t subject to any other conditions. Thus, the surviving spouse’s interest in the estate has changed from a terminable interest into a nonterminable interest, and the Jackson doctrine will determine how the estate can treat the settlement payment. Looking at the date of death, the surviving spouse only had a terminable interest, a life estate. Thus the estate can’t use the marital deduction even under the current version of the IRC.  

While Jackson dealt with an older version of the IRC, Carpenter dealt with the current version of Section 2056. In Carpenter, a surviving spouse had a life estate under the decedent’s will.⁸ The surviving spouse and the estate entered into a settlement agreement in which the surviving spouse would receive a settlement payment. The Tax Court disallowed the marital deduction and reaffirmed the ruling in Jackson by holding that when a surviving spouse only has a life estate at the testator’s date of death, any subsequent settlement payment won’t qualify for the marital deduction. “[U]nder the Carpenter analysis, if a spouse does not have an enforceable right under state law to an interest qualifying for the marital deduction prior to the settlement agreement, the agreement cannot convey a perfected interest that qualifies for the [marital] deduction.”⁹ Therefore, the interest doesn’t qualify for the marital deduction because the surviving spouse didn’t have a nonterminable interest prior to the settlement agreement.

Example 3: Settlement payment with a prenup structured as a statutory election. Even though the scenario from Example 2 would prevent the marital deduction, another approach may allow an estate to take the marital deduction. In the scenario from Example 2, a prenup grants a life estate to a surviving spouse who later contests the will and prenup. The surviving spouse then receives a settlement payment to release all claims against the estate. If a surviving spouse elects to treat a settlement payment as a statutory election, the estate may be able to apply the marital deduction.

A statutory share election is a right granted by state law that allows a surviving spouse to elect to disregard the provisions of a will and receive a percentage of the estate determined by state law.¹⁰ In most prenups, each spouse waives the right to elect a statutory share. So, in most instances, spouses who enter into a prenup won’t be able to elect to receive a statutory share. However, if a surviving spouse challenges the validity of the prenup and the will, an exception to the general rule exists.

The IRS has stated that the waiver of statutory rights in a prenup that’s later challenged doesn’t preclude a surviving spouse from exercising his statutory election rights. In Revenue Ruling 66-139, the IRS concluded that an estate can take the marital deduction in recognition of the surviving spouse’s elective share even when a prenup is present.

In the revenue ruling, a couple entered into a prenup in which they each renounced all rights in the other’s property. When the testator passed, the surviving spouse challenged the prenup and tried to claim her statutory election rights under state law. The surviving spouse and estate settled before the dispute went to trial, and the surviving spouse received a settlement payment. The IRS allowed the marital deduction for the elective share based on the good faith nature of the settlement even without a formal finding of invalidity of the prenup.¹¹ Even though there’s been some negative treatment of the revenue ruling, the IRS continues to cite it favorably.¹² Thus, if a surviving spouse challenges a prenup, the surviving spouse can elect to receive a statutory share in the form of a settlement payment.

If the surviving spouse is allowed to elect to take the statutory election, the Jackson doctrine likely allows for the estate to use the marital deduction. Without the statutory election, the rights under the prenup only allow for a terminable interest, and the subsequent settlement payment would be a nonterminable interest. Because the Jackson doctrine requires the interest at the date of death to be controlling, the surviving spouse would only have a terminable interest at the date of death preventing the marital deduction. A statutory election right, however, exists at the date of death of the testator. When the settlement payment is structured as a statutory election, the surviving spouse’s right at the testator’s date of death would be a nonterminable interest. Thus, if the settlement payment is structured as a statutory election, the estate will likely be able to employ the marital deduction.

Example 4:Court award. Instead of settling, the estate and surviving spouse may decide to proceed forward with litigation. If a surviving spouse has a terminable interest in the estate, contests the validity of the will and prenup and then receives a court award, the result will be different from a settlement payment.

The Jackson doctrine seems to prevent the marital deduction in this situation. If a surviving spouse had a terminable interest at the date of death of the decedent, any subsequent court award, even if nonterminable, wouldn’t qualify for the marital deduction. Treasury Regulations Section 20.2056(2), however, explicitly allows for the tax-free passing of a court award resulting from a dispute over a will:

If as a result of the controversy involving the decedent’s will, or involving any bequest or devise thereunder, a property interest is assigned or surrendered to the surviving spouse, the interest so acquired will be regarded as having ‘passed from the decedent to his surviving spouse’ only if the assignment or surrender was a bona fide recognition of enforceable rights of the surviving spouse in the decedent’s estate. Such a bona fide recognition will be presumed where the assignment or surrender was pursuant to a decision of a local court upon the merits in an adversary proceeding following a genuine and active contest. . .¹³

(Emphasis added.)

Even though the surviving spouse only had a terminable interest at the testator’s date of death, this regulation explicitly allows for the marital deduction to apply to the court award paid by the estate to the surviving spouse. Thus, the estate can use the marital deduction in this scenario.

A Major Decision

Whenever an estate dispute occurs, estate attorneys and advisors need to consider all options before deciding on settlement or further litigation. A major factor is whether the course of action will allow for or prevent the estate from using the marital deduction.

A common scenario faced by estate attorneys and advisors is when a surviving spouse has a terminable interest under a prenup and decides to contest the validity of the agreement. Settling the dispute or proceeding with litigation is a major decision for the estate. If the estate decides to settle the dispute, the estate may be able to preserve the marital deduction by structuring the settlement payment as a statutory election. If the estate proceeds forward with litigation and is unsuccessful in court, any court award the estate pays to the surviving spouse would qualify for the marital deduction. Estate attorneys and advisors must consider the effect of any course of action on the marital deduction. 

Endnotes

1. Internal Revenue Code Section 2001.

2. IRC Section 2056(b).

3. Ibid.

4. Jackson v. United States, 376 U.S. 503 (1964).

5. Ibid., at p. 508.

6. Ibid., at pp. 509-510.

7. See supra note 2.

8. Estate of Carpenter v. Commissioner, 52 F.3d 1266 (1995).

9. See Julie K. Kwon, “Tax Aspects of Settlements,” SN045 ALI-ABA 325 (2008).

10. See generally Angela M. Vallario, “The Elective Share Has No Friends: Creditors Trump Spouse In The Battle Over The Revocable Trust,” 45 Cap. U. L. Rev. 333 (2017). (Every state has a statutory elective share except Georgia.)

11. Revenue Ruling 66-139.

12. See Brett L. Bueltel, et al., “Using the Marital Deduction in Settlements,” 157 Tax Notes 667, 668 (2017) (“…it is worth noting that the IRS continues to view Rev. Rul. 66-139 as an authority”).

13. Treasury Regulations Section 20.2056(2) (emphasis added).

The great comedian Richard Pryor is quoted as saying, “Marriage is really tough because you have to deal with feelings ... and lawyers.”¹  Which isn’t all that bad, because the law and the lawyers also bring certain advantages for married individuals that single individuals don’t have. With respect to property rights, in those jurisdictions that allow it, the most important property law benefit attributed to marriage is the ability to own property as tenants by the entirety (TBE). When a married couple owns property as TBE, such property is protected from the claims of each spouse’s creditors (but not from a joint creditor of both spouses). Property owned as TBE avoids probate on the death of the first spouse. Further, thanks to portability, one of the negative implications of spousal survivorship property—the loss of estate tax exemption as a result of the marital deduction—is neutralized. Let’s explore the differences among the various forms of joint ownership and how to take advantage of TBE.

Joint Ownership Primer

Joint ownership of property is often misunderstood. Many believe that if property is jointly owned by two individuals, then, on the death of one of the co-owners, the surviving co-owner always becomes the sole owner of the property. This, however, isn’t always the case because there are different types of jointly owned property, each with its own important attributes.

To understand TBE is to understand the different forms of joint ownership. There are three categories of joint ownership of property: (1) tenants-in-common (TIC), (2) joint tenants with rights of survivorship (JTWROS), and (3) TBE.² On a co-owner’s death, JTWROS and TBE pass ownership automatically to the surviving co-owner or co-owners, whereas with TIC property, the deceased co-owner’s share of the property becomes part of his probate estate.

TIC. Property held as TIC has no survivorship feature—each co-owner owns an undivided interest in the property that’s freely transferable without the consent of the other co-owner.³ In most states, a conveyance to unmarried individuals in joint names, without any further description, titles the property as TIC.⁴ As stated above, when an individual co-owner dies, the co-owner’s share becomes part of his probate estate and is devisable under his will.

JTWROS. On the death of a co-owner, property held as JTWROS passes ownership to the surviving co-owner. Because the property passes to the survivor by operation of law, the property avoids passing through the deceased owner’s probate estate. However, on the surviving co-owner’s death, absent other planning, the property will be included in the survivor’s probate estate. 

In general, for property to be held as JTWROS, five property concepts—called “unities”—must be present at the creation of the joint tenancy: (1) Time—the property must be acquired by the joint tenants at the same time;⁵ (2) Title—the interests of the co-owners must arise out of the same instrument (for example, the deed);⁶
(3) Interest—the co-owners must have the same interest in the property;⁷ (4) Possession—the co-owners must have the same right to possess the entire property notwithstanding the joint ownership; and (5) Survivorship—the survivor co-owner(s) must succeed to the interests on the death of another co-owner. 

TBE. In two-thirds of U.S. jurisdictions, the law provides some form of special property ownership with respect to married individuals. Such special property ownership takes the form of either TBE or community property rights. TBE is recognized in 25 of the 51 jurisdictions,⁸ and community property is the exclusive approach for marital property rights in nine other jurisdictions.⁹

By definition, TBE requires a sixth unity: Marriage. The owners must be married at the time that title is conveyed.  

How TBE is created, though, may vary by jurisdiction. For example, in states such as Florida and Maryland, so long as the co-owners are married at the time that title is taken, simply taking title in their individual names—even without reference to their marriage —is sufficient to create a TBE.¹⁰ In other states, such as Virginia and Illinois, intent for TBE is manifested by a designation of a husband and wife as TBE.¹¹

An important element is that titling must occur after the marriage. Property acquired by two unmarried individuals as JTWROS doesn’t automatically become TBE on their marriage because they weren’t married at the time that title was acquired. Recall above that all unities must be present at the time title is taken. Given this concept, it makes sense why JTWROS isn’t converted to TBE on the marriage because the sixth unity—marriage—wasn’t present when title was initially taken. To change the form of ownership, the parties must execute a new document of title conveying the property to themselves as TBE.¹²

Distinguishing TBE Characteristics

In addition to the unity of marriage, TBE has certain other characteristics that help distinguish it from JTWROS property.

Inability to partition. TBE property can’t be severed unless both spouses join in the severance. By comparison, the co-owners of TIC or JTWROS property can unilaterally sever or partition the property’s co-ownership at any time.

Creditor protection. As alluded to earlier, the most important attribute of TBE property is the creditor protection feature. With TBE property, a creditor of one spouse (but not a creditor of the other spouse) can’t place a lien on the TBE property. Only creditors of both spouses as to the same claim can place a lien on TBE property. The theory behind this asset protection benefit is that spouses are considered to be “one” and hence a conveyance to the spouses created only one estate. Each is owner of the whole estate, and neither can dispose of the estate without the consent of the other.¹³ Under this approach, the ability to attach a lien against one spouse’s interest is akin to allowing that spouse to unilaterally convey his interest in the property, which, as stated above, is prohibited by TBE status. By comparison, with JTWROS or TIC property, because the co-owners aren’t viewed as being one, the creditors of any co-owner can obtain a lien against such co-owner’s interest. This can result in a partition and sale of the property to enforce the judgment.

More Than Just Real Estate

Not as well-known—but just as important—is the concept that TBE may expand beyond real estate. In 18 of the 25 TBE jurisdictions (72 percent), TBE is also available for personal property, meaning that bank accounts, investment accounts and even tangible personal property can be titled as TBE.¹⁴

Statutory authority for TBE in personal property isn’t always clear. Some states have specific statutes as to TBE in personal property; others have general statutes in which the intent is clarified through case law analysis; and still others only grant TBE status in personal property through case law.

For example, Virginia’s statute expressly states authority: “any husband and wife may own real or personal property as tenants by the entireties for as long as they are married.”¹⁵ (Emphasis added.)  

In other states, such as Maryland, the analysis is somewhat technical. For example, the Maryland statute that recognizes TBE—Section 4-108—is found in the Maryland Real Property Code. Even though the particular statute is found within the real property provisions, the statutory language in the Maryland statute elected not to limit the property covered by the statute to only real property—the statute uses the general term “property.”¹⁶ Case law in Maryland supports the analysis that the general use of “property” refers to both real and personal property.¹⁷

Finally, in states such as Florida, TBE in personal property is recognized, but only as a result of case law.¹⁸ For the past few years, the Estate & Trust Tax Planning Committee within the Florida Bar’s Real Property Probate & Trust Law Section has been working on a proposed statute that would codify the principle of TBE in personal property.¹⁹

One issue that often arises is how to create TBE in personal property, such as a bank or brokerage account. Because such ownership isn’t a universally adopted concept, and because historically TBE was limited to real property, many banks and financial institutions may not have an option for titling an account as TBE.²⁰ Sometimes, even when such institutions have the option, based on historical practice, they may simply default to JTWROS.²¹ Generally, TBE must be specifically requested. The best option is to present the institution with a signed letter indicating that it’s the account owners’ intention to have the account held as TBE.²²

Concerns About TBE Status

TBE status, however, isn’t a panacea. Certain circumstances can cause TBE status, and the protection that comes with it, to be lost.

TBE is marital property for divorce purposes. TBE is jointly owned property. Should the spouses’ marriage end, TBE is likely to be considered a marital asset for property settlement purposes.²³ In TBE states, on a divorce, marital property is subject to division by “equitable distribution.”²⁴ If the married couple acquires a new property using joint funds, the classification is neutral as to the parties. This is because, regardless of the TBE titling, the property would be a marital asset because it was acquired with joint funds. Such a designation could, however, be detrimental if one spouse acquires the property with his own separate property and subsequently re-titles the property as TBE. The re-titling of separate property into TBE causes a transmutation of the separate property to marital property. Had the designation not been changed to TBE, then, on a divorce, the property would have been the acquiring spouse’s separate property and generally not classified as marital property (and therefore not subject to division).²⁵ Furthermore, if the property settlement doesn’t require any transfer or change of title of the property, then, on completion of the divorce, the property is deemed to be held by the former spouses as TIC. This can become confusing especially if the legal title still specifically refers to TBE. The result, though, makes logical sense because, to be TBE, the parties must be married.²⁶

Creditors can still have their say. Just because TBE has creditor protection status doesn’t mean that all TBE property will be exempt from creditors’ claims. If the transfer into TBE is an attempt to hinder, delay or defraud a past, present or future creditor under the jurisdiction’s applicable fraudulent transfer or fraudulent conveyance statutes, the property likely won’t be protected. In general, under fraudulent transfer or fraudulent conveyance laws, if a debtor effects a transfer or incurs an obligation with the actual intent to hinder, delay or defraud any creditor of the debtor or without receiving something of roughly equal value in exchange for the transfer or obligation, the transfer or obligation is fraudulent. The result is the same regardless of whether the creditor’s claim arose before or after the transfer was made or the obligation was incurred.²⁷

The following examples better explain this concept: 

     Example 1: C has a pending breach of contract claim against H, who’s married to W. W wasn’t a party to the contract. After the breach of contract action is
commenced, H re-titles certain real property that he owns, called Blackacre, from his individual name into TBE with W.

As stated above, TBE property is outside a particular creditor’s reach unless the creditor has a claim against co-owners of the TBE and the claim arose from the same transaction. C’s claim for breach of contract is only against H, and, because W wasn’t a party to the contract, if C is successful in his claim and receives a judgment against H, presumptively C can’t attach the judgment against Blackacre because it’s TBE property. If, however, C can demonstrate that H’s transfer of Blackacre into TBE was done with the actual intent to avoid C’s claim, the transfer can be undone, and C can attach his judgment against Blackacre.  

     Example 2: As a variation, consider the result if H had transferred Blackacre into TBE with W 18 months before meeting and entering into the contract with C. C may still have recourse against H, as fraudulent transfer or conveyance law can apply to future creditors, but C will have an uphill battle trying to prove that H undertook the transfer with actual intent to avoid his future creditors and, specifically, C’s future claim. 

     Example 3: For an additional variation, assume that both H and W were parties to the contract, and C’s cause of action was against both of them. Under this scenario, regardless of when H transferred Blackacre into TBE, because C’s action was against both H and W on the same action, that is, the contract, C should be able to proceed against Blackacre.

Internal Revenue Service can still have a lien authority. Within the law, certain creditors have standing above other creditors and may not be subject to the same set of rules as such other creditors. Such creditors may even be able to reach certain exempt property (such as TBE property). In bankruptcy, these creditors are referred to as “superpriority” creditors and often include federal, state and local governments. Perhaps the most prominent superpriority creditor is the IRS.  

Applying this concept to general debtor/creditor law, with respect to TBE property, a 2003 U.S. Supreme Court opinion held that the IRS’ lien authority may, under certain circumstances, supersede TBE protection.  In United States v. Craft,²⁸ the IRS assessed a deficiency against Don Craft for outstanding income taxes and sought to foreclose the lien against his interest in TBE property (which, although created after the IRS liens came into existence, was held not to be a fraudulent transfer under Michigan law). The Supreme Court stated that, while state law determines the nature of the rights of the taxpayer, federal law decides whether those rights are “property” or “rights to property.” While it recognized that Michigan makes a different choice with respect to state law creditors, the Supreme Court held that because this is a federal lien, it’s a federal question, which isn’t dictated by state law. Because the IRS was a superpriority creditor as to Don, it was able to attach the TBE property notwithstanding the Michigan law protections afforded to TBE property.

Planning Opportunities

“Marriage is popular because it combines the maximum of temptation with the maximum of opportunity.”

George Bernard Shaw

Many married couples with jointly owned property may not have such property titled as TBE. Instead, they may have taken title to their properties as TIC or JTWROS, or, in some cases, they may have property titled individually or in one spouse’s revocable trust. There’s no time better than the present for counsel to re-examine the manner in which their clients currently hold title to their property and determine whether any changes should be made.

Portability has changed lifetime planning. Prior to the introduction of portability (or the ability to transfer a deceased spouse’s unused applicable exclusion amount to the surviving spouse), it was common for planners to advise married clients to divide jointly owned property and transfer the property into one (or both) spouse’s individual name or revocable trust. The historical reason for giving that advice was to ensure that the estate tax exemption of the first spouse to die wouldn’t be wasted. Thus, planners recommended dividing assets so that so-called “credit shelter” trusts could be funded to fully use the estate tax exemption amount of the first spouse to die. Now, with the introduction of portability, it’s possible to transfer any remaining estate tax exemption of the deceased spouse to the surviving spouse by having the deceased spouse’s executor make the portability election. Plus, with the doubling of the applicable exclusion amount, most individuals won’t pay estate taxes, so credit shelter trust planning may not even be necessary.²⁹ Given the asset protection benefits of TBE ownership, together with the fact that most married couples are more comfortable owning their property together (as opposed to having assets held separately by one spouse or one spouse’s revocable trust), a case could be made for owning property as TBE. Of course, all other factors should be considered, such as the marital law implications mentioned above.  

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

In some jurisdictions, pre-death planning is possible to allow the TBE property to be transferred to one or more revocable trusts and still maintain the benefits of TBE. Under these types of trusts, called “TBE trusts” or “qualified spousal trusts,” the spouses transfer the property to their respective revocable trusts (in which title is technically severed into two separate undivided shares). The authorizing statute overrides the separate shares and treats them as one share for TBE purposes, thereby retaining the TBE benefits (and thereby deeming all of the requisite unities to still be present). 

On the death of the first spouse, the shares are reunified in the survivor’s revocable trust. The requirements to maintain TBE status under most of the applicable statutes are somewhat uniform: (1) the spouses must remain married; (2) the trust or trusts are, while both settlors are living, revocable by the respective settlors (or, if the trust is a joint trust, revocable by both settlors, acting together); (3) both spouses are permissible current beneficiaries of the trust or trusts while living; and (4) the trust instrument, deed or other instrument of conveyance must reference the particular statute.  

TBE trusts are specifically authorized in nine states: Delaware, Illinois, Indiana, Maryland, Missouri, North Carolina, Tennessee, Virginia and Wyoming.³⁰ In Florida, while there’s no statutory authority, there’s the suggestion that a joint TBE trust may be allowable under Florida law.³¹

Post-mortem planning. On the death of the first spouse, TBE property passes to the survivor. Death destroys the TBE nature of the property; therefore, the TBE asset protection benefits disappear at the first spouse’s death. A properly crafted estate plan, however, can allow the survivor to disclaim his interest in the TBE property and allow the decedent’s one-half interest in the property to pass into a protected trust for the surviving spouse and/or other family members (for example, children, grandchildren and more remote descendants).³² Review client plans to determine whether TBE and disclaimers should be part of the testamentary strategy.

Unique Form of Ownership

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

—The original version of this article appeared as a Franklin Karibjanian & Law PLLC “Client Alert” dated Oct. 27, 2017, which authorized the repurposing of the contents for this article.

Endnotes

1. www.brainyquote.com/quotes/richard_pryor_384864.

2. It may be argued that community property (CP) is a fourth form of joint ownership, but CP is a property right as opposed to a form of ownership. CP doesn’t require both spouses to be listed as co-owners of property so that a spouse may have a CP right in the other spouse’s property even if the property is titled in the other spouse’s individual name.

3. For purposes of discussion in this article, assume that there are only two owners. If there are multiple owners, which can happen, if one owner dies, the other owners take such owner’s share and divide it among themselves with the last standing owner becoming the full fee owner of the property.

4. See, for example, D.C. Code Section 42-516(a); Fla. Stat. Section 689.15; Md. Real Property Code Section 2-117; Mo. Rev. Stat. Section 442.450; Ohio Rev. Code Section 5302.19; and Va. Code Section 55-20.1.

5. At common law, this unity of time would be difficult to satisfy if an individual owning 100 percent of the property wished to convey the property to herself and another individual to establish the joint tenants with rights of survivorship (JTWROS); this unity couldn’t be satisfied because the owner would have owned an interest in the property before the new co-owner, which fails the unity of time. The only way to rectify this anomaly would be to transfer the property to a straw person, who would immediately re-convey the property back to the owner and the new co-owner, thereby vesting title in the owners at the same time. Some jurisdictions deem the unity of time in any transfer to co-owners, including from one of the co-owners, to be satisfied, thereby eliminating the need for a straw person. See, for example, D.C. Code Section 42-516(b)(2); Fla. Stat. Section 689.15 (as interpreted by Ratinska v. Estate of Denesuk, 447 So.2d 241 (Fla. 2nd Dist. Ct. App. 1983)); 765 Ill. Con. Stat. 1005/1c.; Mass. Gen. Law Ch. 184, Section 8; Md. Real Property Code Section 4-108(a) (which specifically references the negation of the need for a straw person); N.Y. Real Property Law Section 240-b.1; and Va. Code Section 55-9. Similar provisions may even be found in CP states; see Cal. Civil Code Section 683(a).

6. This unity is almost always satisfied because the deed conveying the real estate interest recites the ownership form.

7. In the common scenario for this unity, co-owners have an undivided full fee interest in the property; this unity wouldn’t be satisfied if, for example, one owner had an interest for only a term of years and the other had an undivided full fee interest.

8. The tenancy by the entirety (TBE) jurisdictions are: Alaska, Arkansas, Delaware, District of Columbia, Florida, Hawaii, Illinois, Indiana, Kentucky, Maryland, Massachusetts, Michigan, Mississippi, Missouri, New Jersey, New York, North Carolina, Oklahoma, Oregon, Pennsylvania, Rhode Island, Tennessee, Vermont, Virginia and Wyoming.

9. The traditional CP jurisdictions are: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin. Beginning with Alaska in 1998, three other states have opt-in provisions for CP with the creation of CP trusts: Alaska (Alaska St. Ch. 34-77); Tennessee in 2010 (Tenn. Code Ann. Section 35-17-101 et al.); and South Dakota in 2016 (S.D. Cod. Laws Section 51A-6A-1). Groups in other states, such as North Carolina and Florida, are studying whether CP trusts should become part of their jurisprudence.

10. See American Central Ins. Co. of St. Louis, Mo. v. Whitlock, 165 So. 380 (Fla. 1936) and M. Lit, Inc. v. Berger, 170 A.2d 303 (Md. 1961). 

11. See Va. Code Section 55-20.2.A. and 765 Ill. Con. Stat. Section 1005/1c.

12. Such a conveyance satisfies the unity of time in the same manner as the more traditional approach with the use of a straw person. See supra note 5.

13. See Black’s Law Dictionary, “estate by the entirety.” See also, as to D.C. law, In re Estate of Wall, 440 F.2d 215 (D.C. Cir. 1971).

14. The 18 jurisdictions that allow TBE for personal property are: Alaska, Arkansas, D.C., Delaware, Florida, Hawaii, Maryland, Massachusetts, Mississippi, Missouri, New Jersey, Oklahoma, Pennsylvania, Rhode Island, Tennessee, Vermont, Virginia and Wyoming. The seven TBE jurisdictions that don’t allow TBE for personal property are: Illinois, Indiana, Kentucky, Michigan, New York, North Carolina and Oregon. Most states that prohibit TBE in personal property don’t explicitly negate TBE status; rather, the statute granting TBE status is limited to real estate. See, for example, N.Y Real Prop. Law Section 240-b. See also Ore. Rev. Stat. Section 105.920, which provides for joint tenancy in personal property, but doesn’t reference TBE.

15. Va. Code Section 55-20.2.A. It’s important to acknowledge that, while a statute may require a “husband and wife,” based on the U.S. Supreme Court 2015 decision in Obergefell v. Hodges, 576 U.S. ___ (2015), any limitation of marriage to only a man and a woman or husband and wife is unconstitutional as a violation of the Fourteenth Amendment to the U.S. Constitution. Therefore, any statute providing any such limitation is unconstitutional and should be read as gender neutral. In Virginia, same-sex marriage became legal with the U.S. Court of Appeals for the Fourth Circuit decision in Bostic v. Rainey, 760 F.3d 352 (4th Cir. 2014).

16. Md. Real Prop. Code Section 4-108(b): “Any interest in property held by a husband and wife in tenancy by the entirety may be granted.” (Emphasis added.)

17. See Diamond v. Diamond, 467 A.2d 510 (Md. 1983).

18. See Beal Bank, SSB v. Almand & Associates, 780 So.2d 45 (Fla. 2001).

19. Such statute, if eventually adopted, would be Fla. Stat. Section 689.151.

20. See, e.g., John Ritchie III, “Tenancies by the Entirety in Real Property with Particular Reference to the Law of Virginia,” Virginia Law Review, Vol. 28, No. 5 (March 1942), at pp. 608-622, 612. 

21. Because the laws in the various jurisdictions vary widely on a particular property right like TBE, some financial institutions—especially those with a national footprint—may not provide a TBE option. Other factors involved in not providing this option are the risk and exposure to such financial institutions by having a form indicating TBE is available, which is then used in a jurisdiction where TBE isn’t available.

22. It should be noted that, even if the financial institution is offered such letter, it may not respect the letter and simply title the account as a JTWROS, listing the spouses as co-owners. Should the status of the account ever be questioned, the issue becomes whether the spouses’ intent for TBE status will be respected by third parties or the courts.

23. For example, Md. Family Law Section 8-201(e)(2) provides that marital property includes “any interest in real property held by the parties as tenants by the entirety unless the real property is excluded by valid agreement;” Va. Code Section 20-170.3.A.2.(i), as part of its definition of marital property, includes “all property titled in the names of both parties, whether as joint tenants, tenants by the entirety or otherwise”; and Fla. Stat. Section 61.075(6)(a)2 provides that marital property includes “all real property held by the parties as tenants by the entireties, whether acquired prior to or during the marriage.”

24. Under most equitable distribution provisions, the assumption is that marital property would be divided equally, but if the spouse who contributed the TBE can prove certain factors, it may be possible to effect a disproportionate division. Such factors may include the contribution to the marriage by each spouse, including contributions to the care and education of the children and services as homemaker, the economic circumstances of the parties, the duration of the marriage and any interruption of personal careers or educational opportunities of either party. See generally D.C. Code
Section 16-910; Md. Family Law Section 8-205; Va. Code Section 20-107.3; and Fla. Stat. Section 61.075(1).

25. Usually, all aspects of separate property remain separate property unless the other spouse’s efforts contribute to the growth or appreciation of the property. See, for example, Md. Family Law Section 8-201, as interpreted by Merriken v. Merriken, 590 A.2d 566 (1991); Va. Code Section 20-170.3.A.3.a.; and Fla. Stat. Section 61.075(6)(a)1.b. Such provision isn’t stated under D.C. statutory law, and no case has yet determined whether such efforts are marital property; see McDiarmid v. McDiarmid, 649 A.2d 810 (D.C. 1994).

26. For this reason, to avoid confusion, divorce or property settlement agreements should always require a formal re-titling of all TBE assets.

27. This is the general concept from Section 4 of the Uniform Fraudulent Transfer Act (UFTA). For example, with the jurisdictions comprising the Capital Beltway region, the UFTA has been adopted in D.C. but hasn’t been adopted in Maryland or Virginia, which have their own fraudulent conveyance statutes. UFTA Section 4 has been codified in D.C. as D.C. Code Section 28-3104. The Maryland equivalent statutes are Md. Comm. Law Sections 15-206 and 15-207, and the Virginia equivalent statute is Va. Code Section 55-80; note, however, that Virginia’s fraudulent conveyance statute may not apply to all future creditors. See Landon C. Davis III, Isaac A. McBeth and Elizabeth Southall, “Essay: A Distinction Without a Difference? An Examination of the Legal and Ethical Difference Between Asset Protection and Fraudulent Transfers Under Virginia Law,” 47 U. Rich. L. Rev. 381 (2012); Joseph E. Ulrich, “Fraudulent Conveyances and Preferences in Virginia,” 36 Wash. & Lee L. Rev. 51 (1979). UFTA Section 4 has also been enacted in Florida as Fla. Stat. Section 726.105. In 2014, the National Conference of Commissioners on Uniform State Laws revised and renamed the UFTA to the Uniform Voidable Transactions Act (UVTA); the changes made in the UVTA intentionally, or unintentionally, present certain detriments to certain estate planning strategies.  

28. United States v. Craft, 535 U.S. 274 (2002), rev’g. 233 F.3d 358 (6th Cir. 2000).

29. See generally Lester B. Law and George D. Karibjanian, “Just Say “NO” … to the Credit Shelter Trust! Revisiting Existing Estate Plans in Light of the 2018 Tax Act! (Part 1),” LISI Estate Planning Newsletter #2622 (Jan. 25, 2018); in particular, see endnote 21, citing the Joint Committee on Taxation, History, Present Law, and Analysis of the Federal Wealth Transfer Tax System, March 16, 2015, JCX 52-15, wherein the Joint Committee of Taxation reported that, with a basic exclusion amount of $5.43 million, 99.8 percent of taxpayers were immune from the federal estate tax.

30. See Delaware—12 Del. C. Section 3334; Illinois—765 Ill. Con. Stat Section 1005-1c; Indiana—Ind. Code Section 30-4-3-35; Maryland—Md. Est. & Tr. Law Section 14-113; Missouri—Mo. Rev. Stat. Section 456.950 (Missouri only allows for one joint trust, but it may be severed into two separate shares); North Carolina—N.C. Gen. Stat. Section 39-13.7; Tennessee—Tenn. Code. Ann. Section 35-15-510; Virginia—Va. Code Section 55-20.2; and Wyoming—Wyo. Stat. Ann. Section 4-10-402(c)-(e).

31. See R. Craig Harrison, “Trusts: TBE or Not TBE,” 87 Fla. Bar. J., No. 5 (May 2013).

32. Disclaimers are a way to renounce certain property received on death. State law and federal transfer tax law work to deem the intended recipient as having predeceased the decedent, thereby allowing property to pass to the next intended recipient without effecting any gift for gift tax or state law purposes.

The challenges of effective leadership impact not only business and politics but also affluent families. Few things trouble today’s wealth creators as much as how the next generation of family members will assume the mantle of leadership by living purposeful and impactful lives that will continue to shape business, social, cultural or political realms.

Similarly, many wealth inheritors, often in their 20s, 30s and 40s, are keenly aware of the obligations of great wealth and the expectations of family and society, so that they too want to exhibit leadership that gives their lives meaning and purpose. Increasingly, many wealth inheritors are drawn to the need to solve fundamental social and economic issues, create new companies or continue the family legacy by leading the family business or foundation. Regardless, finding one’s path toward leadership in any realm is challenging, arguably more so for those playing leadership roles in affluent families.   

While there are often generational differences with respect to exactly how the next generation will express their passions, the need and role for effective leaders transcend generations. The notion that one can create, change, shape or influence permeates the values of families who’ve created significant wealth. 

The shared motivation of the family to remain cohesive and to perpetuate its role and impact in business, culture or philanthropy begs the question, “Who will lead the family in the future?”  

Family Leadership Roles

Family leadership roles can broadly be defined by the following four (overlapping) categories:

• Family leader role. Often, the family matriarch or patriarch plays this role in either a formal capacity (Chair or CEO of the family enterprise) or informal capacity. Decisions regarding matters that impact the extended family (typically financial, dispute resolution or legal) are led, influenced or adjudicated by the family leader. The family leader is often the culture carrier who ensures that the family comes together, celebrates achievements and educates younger generations. She’ll have a forward-looking perspective on the family, navigating risks and positioning for long-term success. Optimally, this individual is a role model, exemplifying family values for current and future generations to emulate. She’ll also play a key role in external relationships (community, philanthropic, business) and is viewed as the public face of the family. While often, this is a single individual, some families opt for having multiple individuals play leadership roles based on family needs, an individual family member’s skill and her temperament. For example, a matriarch may oversee family gatherings and educational programs, while a patriarch or senior family member (aunt or uncle) may exercise leadership over family financial matters.

• Family enterprise leader role. This individual (or individuals) manages the strategic and operational matters of the family businesses, family office, family investment company or family foundation. The effective enterprise leader often exemplifies elements of technical acumen (for example, business experience) combined with exceptional judgment and a high degree of emotional intelligence. She may be the CEO, chairperson or senior director of the enterprise or multiple family enterprises. The family leader may play this role, but often, capable siblings or cousins fill this need. 

• Emerging family leader roles. These individuals combine elements of both the family leader and the enterprise leader but in a developmental capacity. Emerging leaders are often easily identified within family systems either through a formal designation (for example, as CEO of a portfolio company or board member of the family foundation) or informally based on their family circumstances (age, birth order or family branch), as well as ambition, interests and skills.  

• Informal family leaders. Informal leaders often play an influential role in the family system. They’re not defined by age or position in the family per se, yet they’re recognizable by the influence they wield in family matters, both important and trivial. They’re often consulted by family members and feel free to express views that may run counter to those of the designated family leader. They help to harmonize or disrupt the family system and, in large families, may be numerous in number.  

Leadership Challenges

Family leadership succession challenges are universal in nature. A 2015 survey conducted by the World Economic Forum¹ revealed that 86 percent of respondents felt that there was a “leadership crisis” in the world today. More noteworthy, the distribution of responses across the world illustrates that the need for future leaders is truly global in nature: Europe-85 percent, Asia-83 percent, Latin America-84 percent, Middle East-85 percent and North America-92 percent.² 

My experience working with family offices around the world provides further anecdotal evidence of the leadership gap. Often, families of meaningful wealth are ill prepared to identify, educate and transfer leadership to next generation wealth inheritors. Sadly, the results are often dissipation of family wealth, increased family discord and a diminished role and impact of the family in the lives of extended family members, as well as external ecosystems (for example, business, culture and politics). Yet, many families do navigate leadership succession successfully and serve as a model for others to learn from.

Arguably, the motivation to create future leaders is present in most families, regardless of economic circumstances. Yet the means, visibility and networks of affluent families provide a unique vehicle for future wealth inheritors to leverage, should they choose to play an active leadership role in family matters, business, philanthropy, politics or effecting social change. While affluence isn’t a guarantee of success, the launching platform afforded next generation leaders provides them at the least with a distinct competitive advantage. Imagine for a moment the potential impact of well-directed efforts by a new generation of family leaders aimed at social, medical, business, technological or cultural opportunities. 

Six Best Practices

How then, faced with the challenges as well as opportunities of leadership, can families foster strong next generation leadership?

Families who successfully navigate a generational transfer of leadership exhibit six specific characteristics or best practices.

• Acknowledgment—Most important, they recognize the need to actively manage the process of leadership development, role definition and succession.

• Well-articulated process—They embrace a clear and open policy.

• Emphasis on education and personal development—They invest in activities designed to identify and develop future leaders.

• Collaborative paradigms—They acknowledge the changing nature of family leaders from autocratic to more collaborative as a way to promote involvement, particularly from younger generations.

• Understanding motivations—They embrace open communication from the next generation, seniors and extended family about their desires to be involved in family endeavors. 

• Acknowledge and correct mistakes—They understand that not all efforts will be successful, and they act quickly to remedy bad situations. 

Let’s examine each of these six characteristics. It’s worth noting that these practices aren’t unique to family systems, and analogous efforts can be observed in major corporations. However, the ways in which they’re applied are quite unique to families and require nuance and adjustments based on the particular circumstances and dynamics of the extended family.

Acknowledgment. The recognition of the need to actively manage the development of future family leaders is fundamental to an effective process. While one might assume this to be widely accepted within a successful and affluent family, it’s often not the case. Why? One’s mortality, deeply held feelings of control, pride, interpersonal dynamics, lack of readiness among heirs and self-perceptions make this an awkward topic. Rarely does a family principal disavow the importance of leadership succession; however, she may put little effort and resource behind creating a strong process. Frequently, this results in initiatives that are started far too late in the cycle of leadership succession, or not at all.

Effective family practices begin with a sincere dialogue among key family members as to the importance of leadership succession. This dialogue will often include current generation wealth owners and those in line to inherit meaningful wealth. Typically, an estate attorney or consultant skilled in this topic mediates the process by which an agreement is ultimately reached. The outcome of this dialogue is often codified in a document that sets forth the family’s views, key roles, policies and commitment to leadership development and succession. The document serves as the basis to communicate these views to the extended family and interested parties (such as companies wholly owned by the family). Key to this process are the identification and inclusion of key stakeholders, as well as identification of the many constituencies impacted by the outcome. This should extend beyond just family members to the organizations that are owned, subsidized or endowed by the family. Often, these organizations and their employees are keenly aware of a potential leadership vacuum or lack of clarity around succession giving rise to collective uncertainty. 

Ignoring or putting off this discussion is rarely an effective strategy. Indeed, starting early, even when wealth inheritors are in their early teens, is advisable.  

Well-articulated process. Successful families embrace a clearly defined process when it comes to leadership development and succession. In the context of running the family business, for example in a family enterprise leader role, this often includes: eligibility expectations, training and development resources, mentoring, compensation policies for family members and governance (specifically, reporting, decision making, hiring and firing practices). For example, they’ll set forth what’s required of potential leaders in terms of education, work experience within or outside the family enterprise, personal conduct, characteristics and values and key measures of success. They shun nepotism and set high standards that may be met by family members or filled by outsiders. They don’t compromise when filling key leadership roles and don’t give family members an edge in promotion, compensation or key roles.  

Setting forth such eligibility expectations, practices and resources makes it clear to all what’s expected of current and future family leaders, regardless of age or role. It serves to emphasize the importance of succession in the family, and it allows for many forms of leadership to take shape. Needless to say, this process isn’t intended to ordain a specific future leader but rather to encourage any number of family members to strive for leadership roles in any number of areas. Over time, family needs, family roles and individual family member readiness will change, so maintaining flexibility is essential.  

Education and personal development. An important element to the design of an effective family leadership development process is the identification of key steps and resources available to next generation family members. Ideally, this is a life-long time horizon, as leadership development is a never-ending process. The best practices include formal and informal education, along with mentoring. While it isn’t necessary to identify every facet of who’ll carry out these activities, it’s important to describe and explain to family members why they’re essential. An effective approach will include both technical education elements (for example, business, the arts, finance and social work) as well as personal development (for example, self-awareness, communication and problem solving). Arguably, the most effective leaders, regardless of context, combine elements of both technical skill and important personal attributes.  

Families often will create an age-appropriate timeline of personal development resources, for example: 

• Teens: Exposure to seniors who share family stories, histories and values. Access to programs designed to comprehend the basics of money management, philanthropy and religious, artistic and cultural endeavors important to the family.   

• Post-college: Mentoring by a senior family member or trusted advisor to the family; exposure to next generation programs that teach the fundamentals of asset management, venture capital, estate matters and family governance. Development of peer networks that support information sharing. Periodic exposure to key medical, legal, tax, estate and investment advisors to the family. Selective participation in important meetings so as to observe the behavior and roles of senior members. Open Q&A sessions with seniors, family meetings or company meetings. Participation on committees. Occasionally, creation of programs to support specific emotional or medical needs.

• Adults: Advanced training in management, personal leadership development, governance and conflict resolution. Exposure to groups and conferences that open up new ideas and create peer networks. Continued mentoring and development of informal advisor networks. Opportunities to work in a variety of family-owned enterprises or the business, philanthropic or cultural endeavors of colleagues or family friends. Leadership roles on family or community committees. Increasing responsibilities in family enterprises commensurate with need and ability. Feedback sessions involving family and business associates. Use of personal coaches.

• Seniors: Similar to adults, with shifting emphasis on changing role definition, succession management, creation of new ventures, teaching and mentoring.

In sum, you can’t anticipate where future leaders will emerge within an extended family, nor can you predict what role they’ll play. Remain open-minded and flexible, and avoid inherent biases around family branch, age, generation or gender. Cast a wide net, set high expectations, encourage all and observe and provide feedback on a periodic basis. Ultimately, one or more strong candidates will emerge in either a family enterprise leader role or family leader role.

Collaborative paradigms. Most present day family matriarchs or patriarchs grew up under a model of autocratic family leadership, in which the family leader was the sole arbiter of major life decisions, proper behavior and reward/punishment systems. Successful family leaders shun autocratic behavior and embrace a collaborative approach to communication, engagement of family members and decision making. They’re comfortable reaching across generations to invite input and promote collaboration. 

Understand motivations. In spite of the best efforts to groom and cultivate young adults who may assume a leadership role in the family enterprise, not everyone desires to lead or even be involved in family endeavors. This is particularly true for multi-generational enterprises in which the pressures to emulate the success of past family members can be quite intense. A recent survey conducted by Citi Private Bank showed that fully 50 percent of respondents from 19 countries didn’t wish to be a part of the family business.³ This is a remarkable but not entirely surprising response. Arguably, such resistance to joining the family enterprise has been an age-old phenomenon with the only difference being today’s young adults feel a greater freedom to pursue their own interests. Regardless, a best practice among families who successfully navigate these waters is to embrace open communication, make no assumptions, encourage a range of options while making the families’ needs clear and, in the end, accept that decisions aren’t made for life. Often family members will enter (or exit) the business after having pursued other vocations or passions.   

Acknowledge and correct mistakes. In spite of our best efforts, there will be failures in leadership succession in either the developmental or formal leadership role stage. This may be due to any number of factors; however, an effective family leadership process anticipates this and acts accordingly. Best practices include the following key elements: 1) formal role and performance guidelines; 2) periodic candid feedback; 3) remediation plans; and 4) making swift changes in roles and responsibilities when necessary. Having a governing board for legal entities or a family counsel may make this process more or less difficult, depending on family dynamics. Similarly, adding outside directors may bring greater objectivity.

Shaping Well-Balanced Leadership

Effective family leaders, not unlike successful business or political leaders, display the right balance among solid judgment, breadth and depth of life experience and strong emotional intelligence. Often, leadership development plans will overlook the need to promote emotional intelligence (EQ).

EQ is most often viewed⁴ as a core set of personal characteristics, such as empathy for others, self-awareness and self-control (the ability to control ones behavior and reactions). Some have posited that EQ is arguably a more important factor than IQ when understanding successful leaders. Most promising, EQ can be enhanced while IQ can’t.⁵ 

Regardless of how one defines the boundaries of EQ, the need to include EQ in family leadership development is essential. Exposing future leaders to the fundamental tenets of EQ creates personal awareness, the opportunity to assess one’s gaps and the chance to fill those gaps through education, experience, self-awareness and coaching.

Endnotes

1. Shiza Shahid, “Outlook on the Global Agenda 2015: Lack of Leadership,” World Economic Forum (2015).

2. Ibid.

3. Survey conducted September 2017 at the Citi Private Bank Empowering Leaders Program, University of Cambridge, Cambridge, England.

4. See Daniel Goleman, “What Makes a Great Leader,” Harvard Business Review (June 1996); Warren Bennis and Robert Thomas, “Crucibles of Leadership,” Harvard Business Review (September 2002).

5. See, for example, Martyn Neman Ph.D., Emotional Capitalists (2014).

Here’s a quiz: A trustee’s responsibilities include which of the following:

a) Managing a beneficiary’s assets

b) Completing all of the necessary financial and tax documentation

c) Distributing assets as prescribed by the trust

d) Identifying signs and symptoms of a substance use disorder (SUD) in a beneficiary and adjusting his oversight in a manner that reflects the beneficiary’s clinical needs

Historically, most trustees would assume that answers a, b and c apply. However, in the wake of the opioid crisis, more trustees are expanding fiduciary duty beyond administrative and financial functions to include responsibility for beneficiary health and welfare. 

Accordingly, we’ll discuss our work with clients in addressing: 

1. The proactive trustee’s response to a substance abusing beneficiary; 

2. How to minimize potential liability by following best practice standards; and

3. Pressure points to encourage reluctant trustees to take action.

Proactive Trustee Response 

Through a variety of ways, trustees may discover a problem a beneficiary has with substance abuse. They may hear rumors from other family members; they may witness problematic behaviors; or there may be language in the estate-planning documents that suggests a beneficiary has a history of substance abuse. 

Example: Familial disclosure of substance abuse issues. George, a 72-year-old worried father, tells his nephew Bill about his son Chris’ issues.

     George confides, “Bill, I’m so grateful you’re willing to serve as Chris’ trustee. You may not have known this, but ever since Chris was a teenager, he’s struggled with a serious substance use issue. He’s been through four treatment centers and hasn’t been able to maintain sobriety for more than six months. He’s about to turn 21, and I’m worried that when he receives his money, he’ll spend it all on drugs and likely kill himself. What can I do?”

     Bill responds, “I’m honored to be selected, but I do have some concerns about Chris, and I want to make sure that I’m respecting your wishes with the way I support him. I’ve spoken with some experts, and they’ve outlined the following steps:

1. We’ll need to hire a distribution advisor. This can be a person or an entity with substance use expertise that can advise me on Chris’ current status as it relates to substance use.

a. I’m not the expert and don’t want to make judgments or design a treatment plan. 

b. This person will ideally review Chris’ history and make recommendations for a treatment plan. 

c. This same person or entity should oversee the implementation of the relevant services. 

2. We’ll have to decant the trust assets into a trust with distribution standards that address Chris’ disorder and extend the eligibility date. 

3. The distribution advisor will also serve as an intermediary for requests for money, thereby separating the roles of trustee and father.

4. The language in the new trust will reflect best practice standards.” 

     In this example, George and Bill have direct knowledge of Chris’ addiction and, given their personal relationship to Chris, are highly motivated to take all necessary action. In contrast, institutional or professional trustees often lack this knowledge and must rely on other methods to establish an evidentiary record of beneficiary behavior. (See “Trustee Information Gathering,” this page.)

Minimize Potential Liability

Minimize potential liability by following best practice standards. One consequence of being proactive is blowback from restricted beneficiaries who can no longer fund their habit. To minimize liability, use qualified experts; recite the evidence when adopting distribution standards or decanting; and follow best practices. 

Appoint experts to advise the trustee. Assuming there’s credible direct or circumstantial evidence of a beneficiary’s behavioral health disorder, the next step is to appoint an expert to assess the information and advise the trustee. The Uniform Trust Code explicitly authorizes appointment of experts, but to avoid liability, trustees must hire qualified experts:

A trustee may delegate the duties and powers that a prudent trustee of comparable skills could properly delegate under the circumstances.¹

Because SUDs and other behavioral health disorders are medical conditions defined by the American Psychiatric Association in the Diagnostic and Statistical Manual of Mental Disorders and outside the scope of a trustee’s expertise, trustees must appoint qualified experts to meet this prudent standard. At least half of addicts have co-occurring disorders, such as abuse or depression, and unlicensed help often leads to unfortunate outcomes and liability exposure. Plus, in the event of litigation, the unlicensed helper doesn’t qualify as an expert witness. 

Important qualifications to consider for an expert:

• Graduated from a credentialed, recognized educational institution.

• Holds a state-approved license. 

• Documented experience in addressing the presenting problem. 

While some trustees like to handle beneficiaries with behavioral health problems on their own, few trustees meet these qualifications. Trustees may also find that offering help isn’t received well by the beneficiary, which jeopardizes their relationship going forward.

There are several options to find experts with appropriate credentials, including:

• American Society of Addiction Medicine (www.asam.org)

• Contact the organization in your state administering the program for physicians, discussed below (Federation of State Physician Health Programs  (PHP), www.fsphp.org/state-programs). Some PHPs take outside clients or are good resources for names of competent professionals.

We also have extensive lists of experts on staff or working as independent contractors. For extended engagements, perform a credit check to assure that the expert isn’t under undue financial pressure that might influence her advice and course of action. 

Consider justifications for decanting. Professional trustees may find Bill’s choice to decant extreme, with the change in distribution date likely jeopardizing tax benefits from the annual exclusion and perhaps exceeding authority under some decanting statutes. From Bill’s perspective, tax savings are trivial in comparison to saving Chris’ life. George, the grantor, is alive and able to express his intent to support healthy behavior, not fund excessive substance use. In this situation, simply appointing an expert and adding distribution guidelines weren’t sufficient protection. 

Regarding his decanting, consider this comment from the Uniform Trust Decanting Act:

These statutes represent one of several recent innovations in trust law that seek to make trusts more flexible so that the settlor’s material purposes can best be carried out under current circumstances.²

Money fuels the fires of addiction; helps those struggling avoid the consequences of their use; and promotes relapse. Decanting is vital in encouraging beneficiaries to seek help. 

Many trustees may be reluctant to consider decanting due to traditional attitudes that no longer reflect current law. In a recent decision, the Massachusetts Supreme Court declared that: 

…the trustee could exercise his or her powers and obligations under the 1983 trust, including the duty to decant if the trustee deemed decanting to be in the beneficiary’s best interest.³

In this case, there was no explicit language authorizing decanting, nor statutory language permitting decantation, yet the court specifically refers to amending an “unamendable trust.” 

While state statutes vary, consider this example from the Trust Decanting Statute⁴ in Minnesota: 

An authorized trustee exercising the power under this section has a fiduciary duty to exercise the power in the best interests of one or more proper objects of the exercise of the power and as a prudent person would exercise the power under the prevailing circumstances.⁵

A fiduciary duty obligates a trustee to exercise the highest standard of care. Continuing to fund an active, self-destructive addict certainly isn’t in the addict’s best interest, especially when decanting is readily available. 

Statutory language similar to the above grants trustees sufficient authority to avoid liability from a litigious beneficiary and, if deemed advisable, successfully seek court approval for decanting. For trusts domiciled in states with more restricted decanting laws, we advise moving the trust to states with more receptive laws. 

Follow best practice standards in seeking SUD treatment. The final discussion point in avoiding liability is adhering to a best practice standard regarding treatment. Fiduciary obligations require trustees to follow best practice standards in SUD treatment. Unfortunately, high quality, effective programs are difficult to discern, as claims of success and treatment modalities aren’t regulated by the Federal Trade Commission or the U.S. Food and Drug Administration. Treatment is a “buyer beware” industry, in which the most common outcome is relapse. 

The good news is that programs run by medical boards for physicians meet best practice standards, as recovering doctors have very high, proven, long-term success rates (74 percent continuous abstinence at five years). We adapted their model for our work with trustees and families over 20 years ago, as we described in our prior article.⁶ 

We also developed model language for trustees to insert in trusts that provides a comprehensive approach for addicted beneficiaries, including appointment of experts and recovery management over many months, accompanied by drug testing.⁷ This article includes references to research validating the incentive-based approach underlying the model language.

In our experience, once the storm is weathered, most beneficiaries comply, as they recognize they can’t survive without their distributions. Those who do hire lawyers usually are unable to successfully sustain their claims due to relapse. Of course, armed with a best practice standard and a qualified expert, going to court for approval is always an option.

Pressure Points 

Having discussed how the proactive trustee can address SUDs in beneficiaries, let’s look at the ways concerned family members might be able to pressure pro-status quo trustees into action. 

Nadia poses the following question to her family’s attorney:

Michael serves as my brother Rob’s trustee. Rob has had a history of abusing drugs and alcohol, and Michael continues to make distributions to him. Rob has almost died several times; how can we get Michael to understand that he’s hurting Rob, not helping him?

Armed with well-documented addictive behavior that clearly demonstrates danger to the beneficiary, the first step is to present this information to the trustee, and if necessary, his superiors or associates. 

Family Argument 1: Affirmative duty of care. George and Bill were especially receptive to decanting after hearing the following passage read at a wealth management advisory group meeting:

The duty of care: A trust is not a safe and a trustee is not a guard, watching over the trust property with no purpose. The trust exists to benefit some beneficiary, and the trustee must take care to understand the beneficiary’s true needs and act accordingly.⁸ 

They believe that the beneficial relationship entails an affirmative duty by trustees to encourage addicted beneficiaries to seek help. 

Family Argument 2: Affirmative duty to decant. Case law may mandate a duty to decant—to amend an “unamendable trust”—as the Massachusetts Supreme Court stated in the decision referenced earlier. Or, when the power is authorized by statute, the trustee has a fiduciary duty to exercise the power in the best interests of the beneficiary as any prudent person would under prevailing circumstances, to paraphrase the Minnesota statute. 

Family Argument 3: Reckless indifference to interests of beneficiary. The Restatement (Third) of Trusts, in reference to exculpatory clauses, states that such a clause is unenforceable to the extent it:

…relieves the trustee of liability for breach of trust committed in bad faith or with reckless indifference to the purposes of the trust or the interests of the beneficiaries.⁹

If a trustee can’t act with reckless indifference to the interest of the beneficiary on financial matters, why is it any different when the beneficiary is substance-
dependent? 

Family Argument 4: Petition to remove trustee. In some states, the settlor, a co-trustee or a beneficiary can petition the court to remove a trustee for persistent failure of the trustee to administer the trust effectively or if there’s been a substantial change of circumstances, and removal serves the best interests of all the beneficiaries. 

Family Argument 5: Trustee fails to hire expert. Trustees aren’t licensed counselors, and failure to appoint an expert is likely to be a per se violation of fiduciary duty and the prudent trustee standard. 

Overcoming Standing 

Most trustees believe they’re immune from oversight by relatives because the relatives lack standing to bring a claim against the trustee. To the contrary, we’ve found several ways resourceful family members can work around the issue of standing with the goal of removing the trustee or seeking injunctive or declaratory relief. 

Assert an interest in the trust. One way to overcome standing is to assert an interest as a beneficiary—a person with a present or future beneficial interest in a trust, vested or contingent. This includes: siblings who are beneficiaries under a master trust; siblings of a childless beneficiary; adult child (if co- or secondary beneficiaries); and minor children (future beneficiaries) via a guardian ad litem. The grantor, if living, also has standing. 

Assert a collateral claim naming the trustee. Absent standing under trust doctrine, relatives must pursue other plausible claims. While an extensive discussion is beyond the scope of this article, potential pressure points are:

Vulnerable adult statutes. These vary from state to state, but some include fiduciaries or other professionals.

Child protection. Even well-off parents face child protection charges when interacting with school and medical personnel while under the influence. Concerned relatives can then petition for custody, and trustees may be brought into these proceedings for failing to protect the interests of the children as contingent or secondary beneficiaries or to pay for care of children in the custody of the relative. 

Tort claims. When family members have experienced the near death of a loved one due to overdose or other addiction-related perils, there may be a claim for damages or injunctive relief, when the trustee: (1) created the peril by knowingly funding a clearly self-destructive addict; (2) tried to help but botched the job due to lack of expertise; or (3) has a duty to rescue the beneficiary due to their special relationship.

Repercussions for lawyers acting as trustees. Lawyers are subject to professional complaints for acting outside their scope of expertise or failing to take protective action for a client with diminished capacity (Model Rules of Professional Conduct Rule 1.14).

The goal for the family is to present a colorable claim regarding standing or a collateral issue. Due to experience with treatment and drug courts, family members are likely to find a sympathetic judicial forum if trustees fail to take action regarding an at-risk beneficiary.

Endnotes

1. Uniform Trust Code (UTC) Section 807(a).

2. Uniform Trust Decanting Act (2015).

3. Ferri v. Powell-Ferri, 476 Mass. 651, 663 (2017). 

4. MS 502.851, Trust Decanting.

5. Ibid., Subd. 9 Fiduciary Duty.

6. Supra note 1.

7. “Model Language for Addressing Substance Use Disorders (Addiction) in Trust Documents: Best Practices for Treating Substance Disorders,” www.billmessinger.com/resources.html.

8. Hartley Goldstone, James E. Hughes Jr. and Keith Whitaker, Family Trusts, at pp. 53-54.

9. Restatement (Third) of Trusts Section 96(1) (2012)—The Restatement section is similar, although not identical, to UTC Section 1008.

In his bestseller, 1984, George Orwell explores a society where Big Brother, the head of the only political party, sees all and controls everything from the daily news to the rewriting of history. The party applies the concept of “doublethink,” which Orwell describes as: 

The power of holding two contradictory beliefs in one’s mind simultaneously, and accepting both of them… To tell deliberate lies while genuinely believing in them, to forget any fact that has become inconvenient.

In 2014, the Organisation for Economic Cooperation and Development (OECD) published the “Standard for Automatic Exchange of Financial Account Information in Tax Matters” (Common Reporting Standard or CRS)¹ with the aim to eliminate tax evasion globally. Often referred to as a global FATCA,² the CRS consists of due diligence and reporting requirements and provides for the exchange of financial account³ information among participating jurisdictions.⁴ 

The CRS has had impact on the offshore trust industry. Trust settlors and beneficiaries are clearly exposed to the possibility of being reported. However, trust protectors often don’t have any economic entitlements under the terms of a trust. Should protectors resident in reportable jurisdictions be reported irrespective of the nature of the trust or their powers?  

Under the CRS, an account holder is reportable if resident in a reportable jurisdiction. Contrary to what’s expressed in the CRS itself and to the approach under FATCA and the FATCA intergovernmental agreements (IGAs), the OECD in its CRS FAQ of June 2016 (OECD FAQ) stated that, “a protector must be treated as an Account Holder irrespective of whether it has effective control over the trust.” Let’s consider whether the OECD FAQ position on protectors is doublethink or otherwise flawed.  

How the CRS Works

Under the CRS, when a person tax resident in jurisdiction A is deemed reportable in respect of a financial account held with a reporting financial institution (RFI)⁵ in jurisdiction B:

• The RFI will report details to the competent authority⁶ in jurisdiction B with respect to the financial account, including the identity of account holders⁷ who are tax resident in a reportable jurisdiction⁸ (each a reportable person) and their deemed account⁹ balances; and

• The competent authority of jurisdiction B will exchange details reported with respect to the financial account to the competent authority of jurisdiction A.

Concerns Regarding the CRS 

Perhaps unsurprisingly, with a notable exception of the United States (which implemented FATCA),¹⁰ most major economic jurisdictions are participating jurisdictions, and many have incorporated the CRS into their domestic laws. Jurisdictions with histories of misuse of personal information are among the participating jurisdictions. Almost 50 participating jurisdictions agreed to exchange information under the CRS by September 2017 with others agreeing to commence exchanges during 2018.  

Questions remain about what’s reportable under the CRS. Notwithstanding requirements in the CRS for safekeeping of information, regular media reports of large scale cyberattacks on institutions ensure the concerns of persons who may be reported under the CRS remain. Given the aims of the CRS relate to taxation, protectors may have reason to question why they ought to be reported.  

The OECD FAQ 

The OECD FAQ’s approach may stem from the OECD not fully understanding what a protector is. The OECD’s CRS Implementation Handbook (Handbook) states that a “protector enforces and monitors the trustee’s actions, such as overseeing investment decisions or authorising a payment to a beneficiary.”  

However, a protector is a person¹¹ who’s granted one or more powers under the terms of the trust. The terms of one trust may provide a protector very limited powers and may not require any of the powers mentioned in the Handbook. Other trusts may provide protectors extensive powers.  

Neither the OECD FAQ, nor the Handbook, form part of the CRS. In most participating jurisdictions, they also haven’t been incorporated into domestic laws implementing the CRS.  

Jurisdiction-Specific Guidance 

Many participating jurisdictions have released guidance to assist RFIs to fulfill their CRS obligations. However, many guidance notes have treated the approach of the OECD FAQ with respect to protectors (notably of trusts classified as financial institutions (FI trusts)) as the elephant in the room. Few, if any, participating jurisdictions have expressed a view on this issue. Many RFIs have felt compelled to follow the OECD FAQ. However, disclosing more information than is required places RFIs at risk of breaching legal and contractual obligations. 

When Are Protectors Reportable?

Bermuda’s CRS laws and guidance are considered here for the purpose of the analysis. However, the analysis will likely be relevant for most participating jurisdictions.  

Under the CRS, all entities,¹² including trusts, are classified as either FIs or non-financial entities (NFEs). In circumstances in which an NFE can be further classified as a passive NFE and holds a financial account with an RFI (and is therefore an account holder), the RFI is required to report with respect to controlling persons of that account holder who are resident in reportable jurisdictions.  

The CRS provides that:

The term ‘Controlling Persons’ … [i]n the case of a trust … means the settlor(s), the trustee(s), the protector(s) (if any), the beneficiary(ies) or class(es) of beneficiaries, and any other natural person(s) exercising ultimate effective control over the trust…. The term ‘Controlling Persons’ must be interpreted in a manner consistent with the Financial Action Task Force Recommendations. 

(Emphasis added.)    

 Accordingly, provided such protectors are resident in a reportable jurisdiction, protectors of trusts that are classified as passive NFEs clearly are reportable by RFIs with which the trust (acting by its trustee) opens financial accounts.  

However, to be a reportable person with respect to an  FI trust, a person must be:

1. An account holder; or

2. A controlling person of a passive NFE that’s an account holder;  and 

3. A resident in a reportable jurisdiction.

The following CRS definitions are relevant for the purposes of determining whether protectors of FI trusts are account holders:

The term ‘Account Holder’ means the person listed or identified as the holder of a Financial Account by the Financial Institution that maintains the account.  A person, other than a Financial Institution, holding a Financial Account for the benefit or account of another person as agent, custodian, nominee, signatory, investment advisor or intermediary, is not treated as holding the account for the purposes of the [CRS], and such other person is treated as holding the account.

The term ‘Financial Account’ means an account maintained by a Financial Institution… and, in the case of an Investment Entity, any equity or debt interest in the Financial Institution.

The term ‘Equity Interest’ means, in the case of a partnership that is a Financial Institution, either a capital or profits interest in the partnership. In the case of a trust that is a Financial Institution, an Equity Interest is considered to be held by any person treated as a settlor or a beneficiary of all or a portion of the trust, or any other natural person exercising ultimate effective control over the trust. (Emphasis added.)

CRS Rules of Interpretation 

The expression “exercising ultimate effective control” appears in the definitions of equity interest and controlling person.  

The Multilateral Competent Authority Agreement that many jurisdictions have signed to participate in the CRS forms part of the CRS and provides that any term not defined in the CRS:

will, unless the context otherwise requires … have the meaning that it has at that time under the law of the Jurisdiction applying this Agreement, any meaning under the applicable tax laws of that Jurisdiction prevailing over a meaning given to that term under the other laws of that Jurisdiction.

Many offshore financial centers’ laws don’t have a definition of “control” for tax purposes. The laws of these jurisdictions contain definitions of “control” for use in other contexts, including in connection with preventing money laundering.

However, the context of those definitions may mean that they’re irrelevant to the application of the expression “a natural person exercising ultimate effective control” as it appears in the CRS definition of “equity interest.”  

The term “controlling persons” doesn’t appear in the definition of “equity interest” or “account holders” and is irrelevant for determining whether a protector is an account holder of an FI trust.  

As is the case with a number of participating jurisdictions, Bermuda’s CRS legislation incorporates the CRS definition of “controlling persons.” Consistent with the CRS, Bermuda’s guidance includes a list of controlling persons of trusts (that is, of passive NFE trusts), which includes protectors who are natural persons.  

The differences between the definitions of “equity interest” and “controlling persons” and their evolution demonstrate that the definition of “equity interest” targets persons who have taxable or economic interests in trusts. This purpose is more clearly reflected in the definition of “equity interest” with respect to partnerships, in which only persons who have a “capital or profits interest” in the partnership hold an equity interest. 

Equity Interest Under General Law

Under equitable principles, a person wouldn’t have a beneficial or equitable interest in a trust property unless the person has a vested interest. However, legislation can provide a meaning to terms that differs from general law. Nevertheless, to include persons who don’t have an entitlement to distributions of trust property within the definition of “equity interest” may be counterintuitive.

Discretionary beneficiaries have a mere hope that the trustee will make distributions to them. In many jurisdictions, beneficiaries who receive discretionary distributions incur a tax liability on receipt. Consequently, the Commentary (which forms part of the CRS) provides that, notwithstanding that discretionary beneficiaries fall within the definition of persons who have an equity interest in trusts, they’re only reportable for periods when distributions are actually made to them.

In some jurisdictions, settlors may incur tax liabilities in connection with trusts they establish irrespective of whether the settlor is a beneficiary. This is likely why the definition of “equity interest” expressly includes settlors.

With the exception of remuneration that they may charge for services, trustees and protectors who aren’t settlors or beneficiaries of trusts don’t ordinarily receive benefits from trusts. This may be why trustees and protectors weren’t expressly identified in the definition of “equity interest.” On this analysis alone, a person wouldn’t hold an equity interest and, therefore, be an account holder, merely because that person has been appointed as a protector of an FI trust.

Bermuda’s guidance, while not being law, provides that a trust company and service provider (TCSP) acting as trustee of an FI trust shouldn’t be treated as holding an equity interest in the trust, “as TCSPs don’t have any economic entitlement over the assets of the underlying trust.”¹³ 

Applying this approach, protectors of FI trusts who don’t have any economic interests in trusts shouldn’t be account holders.  

FATCA Recommendations 

The above analysis is consistent with the approach taken in the FATCA regulations and the IGAs. The FATCA regulations were designed to prevent U.S. persons from avoiding U.S. income tax and don’t require the disclosure of protectors in circumstances in which the protector is neither a settlor nor a beneficiary.  

The IGAs introduced the concept of reporting controlling persons in connection with FATCA. The controlling persons concept expands the idea of beneficial ownership for the purposes of combating money laundering and terrorist financing. Consequently, it expanded the scope of persons who may be reportable under the IGAs.¹⁴

The definition of “controlling persons” under the IGAs is only relevant with respect to entities that are classified under the IGAs as “passive non-financial foreign institutions,” being the substantial equivalent of passive NFEs under the CRS. The definition of “equity interest” in the IGAs is similar to that in the CRS.¹⁵ If it’s accepted with respect to the IGAs that the term “equity interest” means a person with a beneficial interest (that is, economic entitlement) in an entity, why would a definition of “equity interest” in the CRS be construed differently?

In contrast to the definition of “equity interest,” the definition of “controlling persons” in the CRS and the IGAs provides that it be interpreted in a manner consistent with the Financial Action Task Force (FATF) Recommendations. 

The FATF Recommendations include a wide definition of “beneficial owner.” The glossary of the FATF Recommendations provides that:

Beneficial owner refers to the natural person(s) who ultimately owns or controls a customer and/or the natural person on whose behalf a transaction is being conducted. It also includes those persons who exercise ultimate effective control over a legal person or arrangement.

Reference to ‘ultimately owns or controls’ and ‘ultimate effective control’ refer to situations in which ownership/control is exercised through a chain of ownership or by means of control other than direct control. (Emphasis added.)

This approach to beneficial ownership expressed in the FATF Recommendations is reflected in Bermuda’s Proceeds of Crime Regulations 2008 (PoC regulations) and similar regulations in the United Kingdom and other jurisdictions.  

However, the PoC regulations, like the FATF Recommendations, are designed for the purpose of combating money laundering and have a wider focus than, and are irrelevant to, the definition of equity interest under the CRS.

Trust Law and “Control”

In the Matter of Esteem Settlement¹⁶ (Esteem) considered what may constitute “substantial or effective control” in the context of whether it was possible to pierce the veil of a valid Jersey law trust. The Jersey court’s approach may be applied in other offshore jurisdictions.

In Esteem, the settlor was a beneficiary of a discretionary trust but didn’t have extensive powers expressly granted to him under the trust’s terms. The settlor exerted considerable influence over the trustee (a licensed trust company) in connection with several investment transactions and discretionary distributions. The trustee complied with almost all of the settlor’s requests.  

The court rejected the argument that the doctrine of piercing the corporate veil could apply in the same way to trusts. The court nevertheless considered the plaintiffs’ submission that, if the doctrine were recognized, the plaintiffs would need to demonstrate that the settlor had “substantial or effective control” over the trust. The court noted the difficulty the plaintiffs had formulating a test for “substantial or effective control.” The plaintiffs  submitted that the test should determine “who in practice determines what happens to the trust assets?” and that the degree of control was relevant. The plaintiffs maintained that something less than complete control was required, but that the test could be satisfied on the evidence by the number and nature of the requests made by the settlor and the trustee’s compliance with them.  

The court disagreed with the plaintiffs’ test and “before determining the issue of control stood back and looked at the picture as a whole”,¹⁷ holding that for the purposes of a substantive hearing:

The question in this context is whether the trustees acted in good faith, consciously put their mind to the discretion vested in them, arrived at a decision and implemented that decision. Such persons cannot be regarded as being under another’s substantial or effective control.¹⁸

STEP Guidance

The Society of Trust and Estate Practitioners CRS guidance of March 8, 2017 notes the approach in the OECD FAQ and states that:

This [i.e., FAQ] response does not address the clear distinction in the Standard [i.e., CRS] itself between the holders of Equity Interests in a trust which is an RFI … which only includes Protectors if they actually exercise ultimate effective control, when contrasted with the Controlling Persons definition of a trust that is a Passive NFE ... which includes Protectors regardless of the powers they hold … In this context, we note that the OECD’s guidance does not constitute a legally binding interpretation of the Standard … Until the legal basis for this is made clear in the CRS treaty, it is considered that there is a reasonable basis for forming the opposite conclusion. (Emphasis added.)

What Happens Next? 

An interpretation of the definition of “equity interest” under the CRS to automatically include protectors may suggest there’s no meaningful distinction between holders of equity interests and controlling persons of trusts. If this were correct, it may call into question why there’s a definition of “equity interest” for the purposes of trusts in the CRS at all. However, the definitions have a different purpose, and focus should be construed in that context. 

But, “[w]hat can you do against the lunatic … who gives your arguments a fair hearing and then simply persists in his lunacy?”¹⁹

It’s possible that, for the purpose of considering enforcement action, a competent authority may adopt the view contained in the OECD FAQ in relation to protectors of FI trusts. However, that position may be contrary to applicable CRS legislation.  

The OECD might amend the CRS to expressly provide that protectors of FI trusts are always reportable irrespective of whether they have an economic interest in the FI trust. The OECD hasn’t expressed any plans to do so. In many participating jurisdictions, such amendment to the CRS would automatically be incorporated into applicable CRS legislation.                  

Endnotes

1. This is self-evident in the unabbreviated title of the “Standard for Automatic Exchange of Financial Account Information in Tax Matters” (CRS) and in the introduction to the CRS, starting from p. 9.

2. Foreign Account Tax Compliance Act (FATCA).

3. The CRS definition of “financial account” includes an account maintained by a financial institution, including a depositary institution and a custodial account and, in the case of an investment entity, an equity interest or a debt interest in the investment entity.  

4. Jurisdictions whose governments have signed a competent authority agreement and are committed to exchanging financial account information in accordance with the CRS.

5. The CRS provides that “Reporting Financial Institution” means a financial institution in a participating jurisdiction that’s not a non-reporting financial institution. The definition of “Non-Reporting Financial Institution” in the CRS sets out a relatively long list of entities including a number of entities in the jurisdiction that are government entities, registered pensions and certain other pension funds and collective investment vehicles and, notably, trustee documented trusts.

6. The taxation authority or other government authority designated by the government of a participating jurisdiction with the responsibility of receiving and exchanging financial account information.

7. Controlling persons of certain account holders, classified as passive non-financial entities, which are entities. See definitions of “account holders,” “controlling persons” and “entities” within the article.

8. The participating jurisdictions with which a participating jurisdiction has agreed to exchange financial account information.

9. The CRS uses the terms “account” and “financial account” interchangeably.

10. FATCA has been described in the revenue-raising part of the U.S. government’s 2010 job stimulus legislation, the Hiring Incentives to Restore Employment Act of 2010 and now reflected in regulations 1.1411 to 1.1474 of the U.S. Code of Federal Regulations. The Internal Revenue Service website states that the “Foreign Account Tax Compliance Act (FATCA) is an important development in U.S. efforts to combat tax evasion by U.S. persons holding accounts and other financial assets offshore,” www.irs.gov/businesses/corporations/summary-of-fatca-reporting-for-us-taxpayers. 

11. A reference to “person” here includes a natural person or a company and may consist of a committee of persons.

12. Under the CRS, “entity” means a legal person or legal arrangement, such as a corporation, partnership trust or foundation.

13. “The Common Reporting Standard for Automatic Exchange of Financial Account Information in Tax Matters, Guidance,” Bermuda’s Ministry of Finance, (April 11, 2017), at p. 17.

14. Note that the intergovernmental agreement (IGA) between Bermuda and the United States provides that Bermuda may permit Bermuda financial institutions to apply a definition in the relevant U.S. Treasury Regulations in lieu of a corresponding definition in the IGA, provided such application wouldn’t frustrate the purposes of the IGA. The express purpose of the IGA is to improve the cooperation between Bermuda and the United States to combat international tax evasion, that is, tax evasion by U.S. citizens using offshore accounts and investment vehicles.

15. The Model 1 IGA provides that “The term Equity Interest means, in the case of a partnership that is a Financial institution, either a capital or profits interest in the partnership. In the case of a trust that is a Financial Institution, an Equity Interest is considered to be held by any person treated as a settlor or a beneficiary of all or a portion of a trust, or any other person exercising ultimate effective control over the trust…” The Model 2 IGA between the United States and Bermuda capitalizes the term “Equity Interest” but doesn’t define it. However, there wouldn’t appear to be any reason why it would have a meaning different from that ascribed to the term in the Model 1 IGA.

16. In the Matter of the Esteem Settlement (Abacus (C.I.) Limited as Trustee, Grupo Torras S.A. and Culmer v. Al Sabah and Four Others [2003 JLR 188].

17. Ibid., Deputy Bailiff Birt, para. 510.

18. Ibid., para. 123.

19. George Orwell, 1984. 

The world is full of family businesses. Literally. Most of the world’s businesses are owned, controlled and often managed by a group of family members.¹ These families face challenges that are quite complex, including how to do well in the business and in the family, too. The news is replete with stories of family feuds that spilled over into the business and vice versa. Is this how it has to be? Well, based on the experiences of business-owning families who are thriving, the answer is no. What are these families doing differently? This article is the second in a two-part series looking at how good governance can help families who own businesses and who want to do it well for the family and the business. This just might be the difference between the stories you don’t hear about (often the better ones) versus the ones that make up the headlines. 

Our Entrepreneurial Couple

Part I of this series in the March 2017 issue recognized the reality that most families overlook the challenge of “governing” all that they do together inside, and outside, of the business.² These families already have governance in place, whether they’ve acknowledged it or not. In
Part I, the reader followed George and Martha, an entrepreneurial couple, who were quite successful in developing a commercial product that increased the efficiency of farm operations. Over time, they set up limited liability companies (LLCs), trusts and related structures to organize their operations and minimize taxes and liability. They were thoughtful about the future and did some estate planning. Shares of the business were transferred into trust for their children and future generations. At the same time, their family grew, and their children, Betsy and Abe, joined them in the business. Readers learned how this couple unwittingly created a range of governance bodies and made recommendations for their advisors to help them and clients like them. 

Well, that was all some time ago. Let’s now pick up the story of George and Martha’s family some time later. 

Catching Up With the Family

Thanks to their excellent advisors, George and Martha followed some of the advice from Part I and created governing boards for each of their businesses, even including independent members to add outside expertise and perspectives. They set up formal trust meetings, and the trustees and beneficiaries are all actively engaged in understanding how their trusts can work best. The original business has expanded, and there are now several spin-offs in addition to the original one. Also, the family has been able to take some of the profits out of their businesses and has started a growing investment portfolio through another LLC. They’ve even started talking about doing some philanthropy together.  

Even though there’s so much positive activity in their lives, things aren’t always easy for the family. George and Martha are getting on in age and really want to step back from day-to-day work, which seems reasonable as they both see age 75 not far on the horizon. Over the years, the family has grown, and some tensions have arisen from time to time. Where there were just two parents and two siblings, now there are inlaws, ex-inlaws, children and stepchildren. Abe has been married twice and has two children from his first marriage. His new wife has several children of her own. Betsy was widowed young and has since remarried a man with three children. George and Martha just love being with all their grandchildren and consider them all equals. The age range is quite wide, however, and the cousins don’t all know each other. Abe and Betsy will both reach age 50 soon, but their spouses are older and younger than they are, respectively, by some years. As a three generation, blended family, things have become a little complicated. At times, the business seems to be the easiest thing the family does together. What are they to do?

Well, now’s the time for the family to think beyond business and family and focus on another kind of governance—that is, family governance. Even in a family that’s relatively small and gets along generally well, there’s still a need for family governance. As in comparable families, there are just too many people, too many ideas and too many levels of legal authority and responsibility spread throughout the family that they can’t ignore it any longer. Actually, when one of the cousins stormed out of the last family Thanksgiving gathering, it reflected the animosity that had been growing among several members over quite some time. Sadly, the family’s fortune seemed to be at risk of dissipating through family disharmony. No one is quite sure what the future holds. 

George went to a lawyer friend to talk about it. Martha confided in friends. Abe asked his college roommate what to do about it. And, Betsy found a consultant who specialized in family governance. The family didn’t know that such consultants existed, and there was much hesitation among the group, but they were open to suggestions. Here’s what they found out and the path they’re now forging.³ (See “Three Phases of Development,” p. 45.)

Starting Point: Chaos

Even though George and Martha have done excellent estate planning, and they have good relationships with their children and grandchildren, they’re actually in the first stage of family governance: Chaos. That is, there’s little alignment or integration of all the planning they’ve done, and it isn’t wholly in sync with the way the family functions together. If something happens to one of them, the rest of the family wouldn’t necessarily know what to do. Imagine that George had a stroke. He’s been the primary leader of the planning, the CEO of the company and the only one who speaks to the lawyers and accountants on a regular basis. Further, he’s the chair of the board of the holding company that owns all the family’s businesses. As in many families, the others (including the “independent” directors) tend to defer to George on major decisions. This has worked well for a long time, but—in side conversations at family gatherings—there’s often a shared concern about what to do if “something happens” to George. The unspoken thought is that “something happens” means something quite disturbing for all. Due to their love of him, they find it hard to bear the thought of his not being a part of their lives. For that reason they’re unwilling or unable to imagine a different way of doing things. Well, for that reason, and also the fact that they’re afraid of offending him. He doesn’t take his own mortality too lightly, it turns out.

Imagine—just for now—the inevitable happens. And, in fact it, could happen to any member of this family at any time. Martha might predecease George, even one of the children might. Or, maybe not as inevitable, but in some ways equally disruptive to the family, a buyer might come along with an offer that’s too good to refuse, and the family will have to decide whether to sell all or part of their business. What to do then?

Next Step: Coordination

Hopefully, long before one of these major family events ever happens, the family will decide that it’s time to get to the next phase of family governance: Coordination. Any family that shares businesses, family trusts, investments or philanthropy together must, at some point, start work on coordinating how these activities will be handled, as a family. Whether they like it or not. What does this mean? At a minimum, the family will need to have meetings to make sure that they all understand the roles and responsibilities that are already in place for them. In George and Martha’s case, they appointed their children as trustees of some long-term generation-skipping transfer trusts through their lawyers but somehow failed to mention it to either child. While the businesses have had a board of directors for a while, the family hasn’t given any guidance on what they really want out of the companies. Moreover, ownership is now dispersed across a series of trusts and individual shareholders, and they’ve never had a shareholders’ meeting. And, while the estate planning has been excellent, and their advisors are top-notch, most family members have no relationship with them and have little knowledge of the details in theory or practice. 

Most importantly, like so many families, financial returns aren’t all that they want to get out of the business —they also care about their identity, reputation, role in the community and commitment to all stakeholders. To them, success includes what’s known as “socio-emotional” wealth, something that’s hard to define, but they know it when they see it.⁴ As a practical matter, it would help to coordinate the work of their lawyers, accountants and financial and investment advisors. Not just to optimize their returns in the short run, but also to set up some back-up plans and common knowledge before it’s needed. At this stage, it’s often helpful to start having “advisors’ summits.” At least once a year, the entire team gets together to assess the overall picture. Ideally, each advisor contributes a perspective on what’s going well and what could be improved so that there’s an ongoing planning dialogue at the family level. Within the family, it’s time to start dividing up responsibilities. For George and Martha, they might realize that Betsy has the greatest interest and acumen for investing. She could take the lead on working with the investment advisor. Abe might prefer to think about the family’s role in the community. He might take the lead on some joint charitable giving that the family wants to do together. The family, with their advisors, and on their own, could start some vision exercises to articulate where they want to be in five, 10, even 50 years and discuss their common values. The key to this work is to focus on the “heart” of the family—that indescribable way that families are connected. Families who explore their relationships, communication patterns, expectations and common purpose can achieve far more than those who haven’t done so. In this area, it’s likely they’ll need to add a new advisor to the team: a consultant who can help facilitate this discussion. For some families, this will be a new member of the team; others might feel comfortable working with someone from one of the existing firms in the mix. 

Cohesion and Continuity

If all goes well, and the family has weathered the inevitable events, sometimes crises, that befall them along the way, they can look forward to reaching the third stage: Cohesion and Continuity. This is the stage at which the family knows what holds them together and what doesn’t. They’ve come to terms with what they want to do together and what they don’t. And, there’s an educated group of family members who respect each other with tolerance and understanding. Even if it’s not all “kumbaya,” they function as a healthy group. 

For George and Martha’s family, this might lead to having annual meetings of all family members, sometimes called a “Family Assembly.” The Family Assembly would be used to focus on the common values, vision and mission that define the family’s guiding principles. By coming to common agreement on these principles, it becomes much easier to do the follow-up work of setting relevant policies and making sure their practices are aligned with the principles. Governing can be an intimidating word and seem quite ephemeral or archaic. But, having a framework and process that works for the particular family can make it seem quite natural.  

At the annual meeting, it’s always good to have some time to get to know each other outside the business and outside the family. Just to relate to each other as individuals pursuing their own paths aside from the family enterprise. Many families find this enlightening and a chance to support each other in new ways. They could also set aside time for the shareholders to have their meeting(s) and for reports on investments, philanthropy and any other family endeavors. Each separate meeting would only include the family members who are appropriate for the specific meeting. And, perhaps most importantly, there would be some genuine fun time for the family together. This helps foster healthy relationships among the cousins, who may someday own the business (or make important decisions together including whether to sell the business). Of course, not all family members will be close with each other, and they might not even like each other but—if they’re going to co-own anything together as a family—they need to establish some authentic relationships, and family governance will assist in this process. (See “Family Governance Pyramid,” this page.)

Reality Check

This all might sound too good to be true. Are families really capable of governing themselves? Should they? Well, the answer is yes. First, because they’re already doing it. Whether they realize it or not, families already have a way of governing themselves. There are psychological ways of making decisions that are ingrained in the family. And, for the lawyers in the group, it’s obvious that they already have governance responsibilities—corporate boards, owners, trustees, beneficiaries and co-owned assets. The question is whether they want to be intentional—and successful—at it, or not. The business-owning families who have taken the approach outlined in this article who are thriving can attest to the power of combining framework and process.  

Endnotes

1. Seewww.ffi.org/page/globaldatapoints.

2. See Patricia M. Angus, “Governance for Business-Owning Families: Part I,” Trusts & Estates (March 2017), at p. 57. 

3. See also Patricia M. Angus, “Family Governance Pyramid: From Principles to Practice,” Journal of Wealth Management (Summer 2005), at p. 7. 

4. See, e.g., Pascual Berrone, Cristina Cruz and Luis R. Gomez-Mejia, “Socioemotional Wealth in Family Firms: Theoretical Dimensions, Assessment Approaches, and Agenda for Future Research,” Family Business Review (2012), at p. 258.

Let me state the obvious. Many family business owners (particularly founders) want to keep the business in the family after their deaths, but fail to do the necessary estate planning during their lifetimes (including liquidity planning) to make that happen. In fact, many times, they leave a mess behind for the next generation and their advisors to clean up. This can be a particular problem if the business that makes up a large percentage of the estate’s assets and liquidity isn’t available to pay estate taxes without a fire sale of the business. Fortunately, under these circumstances, three strategies are available that involve borrowing to pay the estate taxes owed. Two are statutory—based on Internal Revenue Code Sections 6166 and 6161. The third, known as a Graegin loan, is nonstatutory and based on case law and Internal Revenue Service rulings. None of these strategies are risk free or a replacement for proper lifetime planning. But, they may be the only strategies available to those administering the business owner’s estate, other than the proverbial fire sale.

IRC Section 6166

Section 6166 was first enacted in 1958 as a mechanism to mitigate a trend of small businesses having to be sold to pay estate taxes. If the business owner’s estate meets the complicated requirements of Section 6166, the estate can pay the estate tax over a period not to exceed 14 years, with interest at favorable statutory rates. But, the devil is in the details regarding whether a particular estate qualifies for Section 6166 relief. So, it pays to know the rules.

Overview. For an estate to qualify for estate tax deferral under Section 6166, three requirements must be met. They are: 

1. The deceased must have been a U.S. citizen or resident at the date of her death;

2. The value of the closely held business must exceed 35 percent of the adjusted gross estate; and 

3. The executor must make the Section 6166 election on a timely filed estate tax return. The IRS must approve the election. 

If the estate meets the requirements of Section 6166, then with respect to just the portion of estate taxes applicable to the closely held business, the estate is only required to pay interest for the first four years following the due date of the original estate tax return and then starting on the fifth anniversary, 10 equal payments of the estate tax owed plus interest. The interest rate on the estate tax owed is payable at two rates. The interest rate payable on the tax on the first $1 million indexed for inflation ($1.52 million in 2018) is 2 percent ($1.52 million x 40 percent x 2 percent). The interest rate on the remaining estate tax owed is payable at 45 percent of the IRS underpayment penalty interest rate (4 percent for the first quarter of 2018), resulting in a current interest rate on the remaining balance of 1.8 percent (4 percent x 45 percent). It’s important to note that the interest paid pursuant to Section 6166 isn’t deductible. 

Thirty-five percent threshold. Section 6166 deferral is only available if the value of the closely held business interest is greater than 35 percent of the deceased’s adjusted gross estate. For purposes of Section 6166, the term “adjusted gross estate” means the value of the gross estate minus amounts allowable as deductions under IRC Sections 2053 or 2054 (for example, debts, funeral expenses and administrative expenses). In valuing the business, any discounts for minority interests are taken into consideration. In addition, any passive assets owned by the business or cash in excess of what’s needed to operate the business shall be included in the gross estate but not taken into consideration when determining whether the business satisfies the 35 percent threshold. 

Closely held business interest. Section 6166 deferral only applies to a closely held business. Determining whether a business interest meets the Section 6166 requirement is a two-part test. The first part requires the business to be active rather than passive. This is a particular problem for real estate businesses, as it’s not always clear whether property management activities are sufficient to be considered an active trade or business. Fortunately, Revenue Ruling 2006-34 sets forth the guidelines for determining whether a business should be treated as active or passive for purposes of Section 6166.

The second part of the closely held business test deals with the nature of the entity and the percentage ownership or number of partners/shareholders that own the business. Assuming the active business requirement is satisfied, an interest in a closely held business for purposes of Section 6166 means: 

1. An interest as a sole proprietor;

2. An interest as a partner in a partnership or member in a limited liability company (LLC) if 20 percent or more of the total capital interest is included in the deceased’s gross estate or such partnership or LLC had 45 or fewer partners/members. 

3. Stock in a corporation if 20 percent or more of the value of the voting stock is included in the gross estate or the corporation had 45 or fewer shareholders. Special rules apply if the estate owns holding company stock or multiple closely held businesses. Certain family attribution rules also apply in determining whether the estate meets the above 20 percent thresholds. 

Special liens and bonds. Section 6166 permits the IRS to require a special lien or bond as security for the deferred tax and interest. Notice 2007-90 sets forth the factors determining whether the IRS will require a lien or bond. It’s a facts-and-circumstances test that considers: 

1. The financial health of the business;

2. The anticipated ability of the estate to make the annual payments; and 

3. The history of federal tax compliance of the business. 

Acceleration of tax payments. Under certain circumstances, the IRS has discretion to accelerate the tax payments under Section 6166. Section 6166(g)(1) provides for acceleration if: 

1. The estate disposes of 50 percent or more of the closely held business. It’s important to note that if there’s a buy-sell agreement in place requiring the other owners of the business to purchase all of the deceased owner’s business interest, Section 6166(g)(1) will prevent the estate from being able to take advantage of Section 6166 tax deferral because the deceased owner has already disposed of her interest by contract through the buy-sell agreement. As such, if there’s a chance that the business owner’s estate may need to take advantage of Section 6166 tax deferral, it’s critical that any buy-sell agreement be drafted in such a way as not to prohibit its availability at the business owner’s death.

2. The estate fails to make all of an estate tax payment within six months of the due date. 

3. The election may be terminated because the estate fails to provide security (lien or bond) to the IRS for the tax due, if the IRS has determined that security is necessary. 

Section 6161

Section 6161 allows the representative of the business owner’s estate to request from the IRS an extension of time for the payment of estate taxes for up to 12 months if the estate can show “reasonable cause.” In addition, if the estate can show “undue hardship,” the time for payment can be extended up to 10 years. Even with a showing of undue hardship, the extensions can only be granted one year at a time. 

In determining reasonable cause, the regulations under Section 6161 provide the following four examples: 

1. An estate has sufficient liquid assets to pay estate taxes, but such liquid assets are located in several jurisdictions and aren’t currently under the control of the executor. Consequently, the assets can’t be readily marshaled, even with the exercise of due diligence. 

2. An estate is comprised in substantial part of assets consisting of rights to receive payments in the future (for example annuities, royalties and accounts receivable). These assets provide insufficient present cash with which to pay the estate tax when due, and the estate can’t borrow against these assets except on terms that would inflict loss on the estate. 

3. An estate includes a claim to substantial assets that can’t be collected without litigation. Consequently, the size of the gross estate is unascertainable as of the time the tax is otherwise due. 

4. An estate doesn’t have sufficient funds (without borrowing at a rate of interest higher than that generally available) with which to pay the entire estate tax when otherwise due, to provide a reasonable allowance during the remaining period of administration of the estate for the decedent’s widow and dependent children and to satisfy claims against the estate that are due and payable. Furthermore, the executor has made an effort to convert assets in his possession (other than an interest in a closely held business to which Section 6166 applies) into cash.

With respect to any extension beyond the initial 12 months, undue hardship needs to be shown. The regulations provide that the term “undue hardship” requires more than an inconvenience to the estate. The regulations provide the following two examples of when an extension of time will be granted based on undue hardship that are relevant to the estate of family business owners: 

1. A farm (or other closely held business) comprises a significant portion of an estate, but the requirements of Section 6166 haven’t been satisfied. Sufficient funds for the payment of the estate tax when otherwise due aren’t readily available. The farm (or closely held business) could be sold to unrelated persons at a price equal to its current fair market value, when a market exists, but the executor seeks an extension of time to facilitate the raising of funds from other sources for the payment of the estate tax. 

2. The assets in the gross estate that must be liquidated to pay estate taxes can only be sold at a sacrifice price or in a depressed market if the tax is to be paid when otherwise due. 

If the IRS grants the Section 6161 extension, interest is payable at the applicable federal short-term rate plus 3 percent. Unlike Section 6166, Section 6161 interest should be deductible against the estate tax. The estate needs to file a Form 4768 to request a Section 6161 extension. Form 4768 must be filed before the due date for the estate tax return, and the IRS has the ability to request a bond as security for the unpaid tax.

Graegin Loans

A third borrowing strategy to pay estate taxes isn’t statutory, but rather is named after Cecil Graegin, a deceased taxpayer whose estate won the most cited case against the IRS allowing the estate to deduct all of any fully ascertainable interest to be paid in the future on a third-party loan as an administrative expense under IRC Section 2053(a)(2) on the estate tax return, thereby significantly reducing the amount of estate tax owed. Typically, the loan is made to the estate by either the family business or a bank. For the interest to be fully ascertainable, the loan must be structured to provide for a fixed, rather than variable, rate of interest, and there must be no ability to accelerate payment on the loan unless such prepayment requires all interest over the term to be paid on repayment. 

In Estate of Graegin,¹ the estate owned a family business that it didn’t want to sell. To pay estate taxes and avoid selling the business, the estate borrowed the money to pay the estate taxes from the family business. The note was unsecured, with a 15-year term and a fixed interest rate. No payments of principal or interest were due until Year 15. Prepayment of interest was prohibited. The 15-year term was tied to a date when the estate felt it would have adequate liquidity (the death of the surviving spouse). The deceased’s son, Paul, was co-executor and co-trustee, as well as the president and a board member of the family business. On the estate tax return, the estate deducted all of the interest on the loan due at maturity. The Tax Court agreed with the estate and permitted the deduction. The court was concerned with two points. First, that the lender and the debtor were related parties. The court overcame that concern based on what it thought was credible testimony from the son that the intention was to repay the loan and the fact that there was a small non-family shareholder who would object if the loan wasn’t repaid. Second, that there was only a single payment of interest and principal, but the court stated that based on the specific facts, this wasn’t unreasonable. In practice, it may be a good idea to make at least annual interest payments. It’s also important that any related party lender report the interest income for tax purposes. There’s less IRS scrutiny of Graegin-type loans when a commercial lender is involved. In that circumstance, there’s no concern over the relationship of the lender and borrower or concern that a deduction was taken on the estate tax return when there was no intent to repay the loan. In the context of a Graegin-type loan with a commercial lender, the only concerns are that the estate is actually illiquid and that the interest rate is fixed and not subject to prepayment.    

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

Endnote

1. Estate of Graegin v. Commissioner, T.C. Memo. 1988-477.

Private business owners typically have a lot on their plate. Now, with the new Tax Cuts and Jobs Act¹ (the Act), there’s even more. As if building, running and planning for a business weren’t enough, the Act has added several new and complicated tax wrinkles to the discussions advisors should be having with their business owner clients.  

Here’s an overview of the main provisions of the Act relevant to private business owners. We’ll also go through the central discussions advisors should be having with their business owner clients, flagging the key considerations now in play under the Act and how they can be used to address the issues all private business owners face.   

The Act

The Act, which became law on Dec. 22, 2017, and is effective for tax years beginning after Dec. 31, 2017, made significant changes throughout the Internal Revenue Code. From a private business owner’s perspective, these include changes to the individual income and transfer tax rules, general business taxation rules and rules specific to the taxation of corporations and pass-through entities. While certain changes are permanent, a large number are temporary and only apply to tax years beginning before Jan. 1, 2026.

Individual rules. The changes in the Act directly affecting most people, including private business owners, are those to the individual income tax rules. Under the Act, the individual income tax brackets are adjusted for the temporary period, with the top bracket set at 37 percent, down from 39.6 percent. In addition, the standard deduction for individuals has been essentially doubled, with many itemized deductions limited or eliminated. The deduction for state and local tax payments has been limited to $10,000 per year. Meanwhile, the deduction for miscellaneous itemized deductions subject to the 2 percent floor has been eliminated entirely. The thresholds for application of the individual alternative minimum tax also were raised.

These changes may not impact a private business owner’s handling of her business, but they may impact certain decisions, such as the sale of all or portion of a business, as the owner runs the numbers for her specific situation. More likely to impact a private business owner’s planning is the temporary increase of the exemption from gift, estate and generation-skipping transfer (GST) tax from its level of $5.49 million in 2017 to approximately $11.2 million in 2018. The repeal of the tax penalty for the failure by an individual to maintain minimum health insurance coverage may also impact a business owner’s operation of a business and employee arrangements as the effect impacts the country’s health insurance system.

Business rules. As widely discussed, the Act is generally favorable for businesses. While certain business deductions and credits have been limited or eliminated, the Act includes a variety of provisions that will result in tax savings for businesses.  

The most sweeping of the changes to the taxation of businesses is the reduction of the corporate income tax rate from a top rate of 35 percent to a flat 21 percent, while also eliminating the corporate alternative minimum tax. This is one of the changes that won’t sunset after 2025. The potential effect of this change on publicly traded corporations as well as domestic and global economies has received significant attention. But, the change also applies to privately held C corporations, regardless of size.

Along with the change of the corporate tax rate, the Act also effectively decreases the tax rate on certain income received through pass-through businesses, such as partnerships, limited liability companies (LLCs), S corporations (S corps) and even sole proprietorships. Under the new Internal Revenue Code Section 199A, taxpayers are able to deduct 20 percent of their “qualified business income,” a term that includes income from a “qualified trade or business” other than specified services, businesses or “the trade or business of performing services as an employee.” The deduction is subject to limits based on allocable shares of “W-2 wages” of the business as well as the “unadjusted basis” of certain “qualified property” held by the business. There are other nuances that apply as well, all of which will require advisors to run detailed numbers both to determine the benefits of the new deduction and to guide their clients around the decisions on employment arrangements, depreciation schedules and net income levels that now have a new level of tax complication tied into them. Notably, this change will sunset in 2025. 

Other changes that now apply to businesses, regardless of form, include:

• More favorable depreciation and expensing rules;

• Like-kind exchanges limited to real property not held primarily for sale;

• New limits on the application and deduction of net operating losses as well as interest expense; and  

• Increase in the threshold permitting businesses to use a cash accounting method.

The Discussions

For advisors who know they need to speak to their clients about planning for their businesses, the Act provides an opportunity to start those discussions. But, once those discussions are underway, it’s important to develop and retain a focus on the key business considerations that create the need for planning in the first place, with the tax implications of the Act one of what are usually a variety of factors. 

Identifying the business. The first part of any discussion about a private business is to identify the business. This step is so obvious it’s easy to overlook. But, identifying and segregating the different businesses of a client is crucial to structuring those businesses appropriately, ensuring the right management arrangements are in place and planning for the ultimate disposition of the business, whether it involves a sale to a third-party, transaction with an unrelated person involved in the business or passage of the business through the client’s family for generations.   

Under the Act, identifying what are or may be separate, distinguishable businesses could become relevant in navigating the limits around the IRC Section 199A deduction. It could also be relevant in deciding the type of entity used to hold or operate a business or restructuring the entities currently in place. With the “permanent” decrease of the corporate income tax rate, more businesses may elect to be treated as corporations for tax purposes. These abstract decisions begin to take form only when the details of a business or businesses are well-defined.

For example, if you have a client who owns a building in which she operates an architecture practice and sells a variety of home design products from the space adjacent to her reception area, the client may conceive of her day-to-day activities as a single business. But in reality, she’s likely operating a minimum of three separate businesses: (1) the architecture practice; (2) the ownership of the building; and (3) the retail business of selling the home design products adjacent to the reception area. 

From the tax perspective, the numbers may compel separation of the architecture practice from the other endeavors to enable a deduction under Section 199A.  From a liability protection perspective, it likely makes sense to protect the real property from the risk associated with the retail or professional business. And, from the planning perspective, the real property may be an asset the client wishes to pass on to her family, potentially during her lifetime, while her architecture practice is unique to her and will likely neither be passed down nor sold. But, until the client separates the different businesses in her head, she won’t be in a position to address any of those goals. 

Identifying the business begins by identifying the different endeavors a client is involved in. From there, it involves understanding in detail the assets and liabilities of the business, valuation concerns, income tax basis and depreciation schedules of the assets, management and employee arrangements, legal structures, tax filing status and contractual arrangements both internal to the business and with third parties. Last, but certainly not least, it involves understanding the cash flows and purpose of a business, amid the typical mix of income generation, asset preservation and growth and personal satisfaction. In a family-owned business, with multiple owners and generations, this becomes even more complicated and therefore important to identify.

Choosing the right structure. In recent years, the decision on the legal structure and tax filing status for a private business has been relatively straightforward.  Most were formed as pass-through entities such as LLCs, S corps and partnerships. Private businesses typically haven’t been formed as corporations, or treated as such for tax purposes, due to the double layer of taxation, high corporate tax rates and ability to achieve similar liability protection through an LLC. 

Now under the Act, the calculation isn’t necessarily as clear. With a “permanent” corporate tax rate of 21 percent and the ability to shift income as a corporation, and a top effective tax rate of 29.6 percent for “qualified business income” from a pass-through entity after the deduction under Section 199A, having a business taxed as a corporation may be advantageous, depending on the particular circumstances of the business and its owners. Year over year, income-producing assets taxed as a corporation would grow at a greater rate after tax than the same assets held within a pass-through entity. Only when the assets are distributed from the corporation to the shareholder, and the second layer of tax comes into play, do the numbers become more complicated and potentially favorable to the pass-through.  

The decision on the type of entity (including jurisdiction) includes considerations other than taxes, such as capital needs, employee benefits, liability exposure and preferred accounting methods. But in 2018 and going forward, the Act has made it necessary to compare corporate and pass-through treatment and the resulting tax implications by considering the cashflows of the business, distribution needs and other income levels of the owners. This applies both to new entities and businesses being formed, as well as to evaluating existing businesses and structures in place.  

The choice of entity may also have relevance as individuals look at qualification for the deduction under Section 199A in relation to income they previously may not have thought to segment as a separate business. The client with a small retail or services business may now be compelled to form an LLC to reinforce the fact she’s engaged in a business. Or, as mentioned in the example above, entities may be formed to more clearly segregate the different businesses involved in what might otherwise be considered a single endeavor. If a client decides to restructure, it’s worth also considering the tax implications of unwinding that structure should the laws change. Finally, a seemingly obvious but sometimes overlooked step is to be sure to notify the applicable state tax entity, as well as the IRS, of the change.

Management and operation. After an advisor has assisted a client in identifying the client’s business and determining the proper structure and tax filing status for it, the next set of concerns involve the actual running of the business. In relation to the Act, a key consideration is the level of debt associated with the business. With the new limits on the deduction of interest expenses, the economics of carrying debt may shift for a business. Similarly, with Section 199A, the economics of debt will shift as the decrease to net income also decreases the 20 percent deduction.

Another item for attention is a business’ employee and independent contractor relationships. Under Section 199A, the 20 percent deduction may be limited to the greater of 50 percent of “W-2 Wages” or 25 percent of “W-2 Wages” plus 2.5 percent of the “unadjusted basis” after acquisition of the business’ “qualified property.” If a client is the sole owner of the business, and she’s employing a variety of independent contractors in connection with a business producing substantial income, the client may want to consider hiring the contractors as employees or hiring employees in lieu of the contractors to create a more favorable situation in relation to Section 199A. The economics of the purchase of qualified property may also desire attention for the same reason.

These decisions are all very granular. But, each of them can be used to initiate a broader discussion with clients on the management and operation of their businesses on an ongoing basis. The client who expends significant energy to take advantage of the tax benefits under the Act should be spending similar, if not greater, energy to ensure there’s a viable succession plan for the management of the businesses in place as well. 

The temporary nature of many of the changes under the Act is an opportunity to remind clients of the need for management succession planning. The business that elects to be taxed as a corporation to take advantage of the lower corporate tax rate, unloads debt to maximize its deduction under Section 199A or hires as employees a set of contractors for the same reason, needs to have someone in charge who’ll recognize when those decisions may cease to make sense, whether in 2026 or on some earlier change in the tax law. 

All too often, inattention leads to private businesses being run by people, sometimes consisting of the original owners themselves, who become concerned solely with preservation of the day-to-day. The big picture, enterprise-level concerns become neglected, eroding the value built up within a business. Management succession planning requires patience, discernment and generous training, but it’s part of what’s necessary to make any private business an ongoing success. 

Planning for future ownership. No private business owner remains one forever. She may pass away, retire or sell or otherwise transfer the business. Businesses are often transferred from one generation to the next within a family, but unless attention is paid to the management (as discussed above), the value being passed on may erode rather than grow. A business owner always should have an exit plan, whether its the successful transition of the business to the owner’s children and grandchildren or an outright sale. Advance planning is always beneficial.² 

Under the Act, many successful private business owners will be tempted to make transfers of interests in their businesses using the increased gift and GST tax exemptions. With valuation discounts for interests in family businesses still available, there’s potential to transfer large amounts of value to lower generations through a sequence of transfers of partial interests in a business. For example, with an $11.2 million exemption, a client may transfer interests with a pro rata value of $16 million if subject to a 30 percent discount.   

But, advisors should caution clients to run the numbers before completing any gifts. Under the Act, the step-up of income tax basis still applies to property transferred at death and doesn’t apply to lifetime gifts. As a result, the transfer of low basis assets, as interests in private businesses often are, won’t make sense for tax purposes in many cases, potentially even for those clients with assets well in excess of the exemptions.

Any gifts of interests of a business also should be coordinated with the plan for management of the business, because the desire to save estate taxes always has to be balanced against the impact those gifts would have on the control and management of the company itself. Trusts are frequently used to hold these interests because they can allow for certain benefits of the gifts for family members while at the same time allowing for control and voting of the gifted shares. It’s especially important to pay attention to the terms of these trusts that may hold the gifts, whether of limited period or in perpetuity. The Act has impacted the taxation of trusts, as well as businesses and individuals. Ideally, any transfer of ownership is part of an overall plan that accounts for the impact on the current owners, the business itself and the new owners receiving the gifts. And, when it’s not possible to align those interests, it’s usually time to discuss whether the sale of the business is preferable to trying to force a transition that isn’t likely to work.  

For those clients who have an exit plan that involves a sale, the Act has changed the analysis to a degree. For clients in states with high income tax levels, a sale likely will have a greater tax cost with the deduction for the state income tax paid on the capital gains limited to $10,000. This may lead certain taxpayers to retire to a low or no income tax state before completing a sale of a business that’s structured not to generate source income in the high income tax state.  

For clients who won’t retire, the increase of the estate tax exemption creates an incentive to postpone a sale until after death to realize a step-up in basis and thereby avoid capital gains. For sales during lifetime, strategies to postpone or offset capital gains, such as a transfer to a charitable remainder trust or direct cash charitable gifts (now subject to a 60 percent limit of adjusted gross income for gifts to a public charity), remain available. 

New Concerns

It’s fitting that a change in law that’s bestowed significant potential tax savings on businesses has also bestowed a whole new set of concerns for business owners. As we know, businesses aren’t static, and as advisors, the changes present an opportunity to highlight the need for planning in relation to both the Act itself and the ever-evolving concerns around identifying, structuring, managing and owning a business that were present before the Act and will be present long after its temporary provisions expire.          

Endnotes

1. We refer to the legislation under Public Law No. 115-97 by the short title included in the bill introduced and passed by the House of Representatives, while recognizing that the short title wasn’t included in the enrolled bill.  

2. Business owners may want to consider hiring a consultant for this stage. See Paulina Mejia, “Questions to Ask Before Hiring a Family Business Consultant,” Trusts & Estates (March 2017), at p. 48.

The recent Tax Act of 2017 (the Act) made some sweeping changes to the Internal Revenue Code, including some important enhancements to the provisions regarding ABLE plans. The IRC created ABLE, which stands for “Achieving a Better Life Experience,” programs to help individuals and their families under new IRC Section 529A effective for tax years beginning after Dec. 31, 2014. These qualified ABLE programs were designed to permit an “eligible individual” to open an account to pay for his “qualified disability expenses” on a tax-favored basis.  

If properly established, earnings in an ABLE account aren’t subject to tax while held in the account, and when the funds are withdrawn to pay for an eligible individual’s qualified disability expenses, the earnings on the account aren’t subject to federal income tax. In addition to the tax benefits, ABLE permits individuals with disabilities to open accounts to save for their disability-related expenses without jeopardizing Medicaid coverage and other federal benefits and, as long as the balance in the ABLE account doesn’t exceed $100,000, without risking eligibility for Supplemental Security Income (SSI) benefits.

Background

Like their Section 529 plan cousins, ABLE accounts must be “established and maintained” by a state, agency or instrumentality. An eligible individual may only have one ABLE account to which contributions must be in cash or cash equivalents.  

However, until passage of the Act, annual contributions from all contributors to an ABLE account couldn’t exceed the annual gift tax exclusion amount, which in 2018 was increased to $15,000. For gift tax purposes, all contributions to an ABLE account are treated as a completed gift to the designated beneficiary and not a future interest in property.

Who’s Eligible?

To open an ABLE account, the account owner, who’s also the beneficiary of the account, must be an eligible individual. An individual must: 

(1) be entitled to benefits based on blindness or disability under Title II or XVI of the Social Security Act and have a condition (blindness or disability) that occurred before the individual reached age 26, or

(2) have a disability certification that’s filed with the Secretary for the taxable year.

A disability certification is a certification by the individual or the parent or the guardian of the eligible individual that:

(1) certifies that—

(a) the individual: (1) has a medically determined physical or mental impairment, which results in marked and severe functional limitations and that can be expected to result in death or has lasted or can be expected to last for a continuous period of not less than 12 months, or (2) is blind, and

(b) the blindness or disability occurred before the date on which the individual attained age 26, and

(2) includes a copy of the individual’s diagnosis relating to the individual’s relevant impairment(s) signed by a certified physician.

Qualified Disability Expenses

“Qualified disability expenses” are defined as any expenses related to the eligible individual’s blindness or disability that are made for the benefit of an eligible individual who’s the designated beneficiary, including:

• Education;

• Housing;

• Transportation;

• Employment training and support;

• Assistive technology and personal support services;

• Health;

• Prevention and wellness;

• Financial management and administrative services;

• Legal fees;

• Expenses for oversight and monitoring;

• Funeral and burial expenses; and

• Other expenses approved by the Secretary consistent with the purpose of the provision.

Proposed ABLE Treasury Regs

Proposed Treasury regulations (proposed regs) issued on June 22, 2015 provide a tremendous amount of clarifying language to help eligible individuals (and their families and advisors) make sense of the provisions included in Section 529A. 

For example, the proposed regs define “qualified disability expenses” to include “any expenses incurred at a time when the designated beneficiary is an eligible individual that relate to the blindness or disability of the designated beneficiary of an ABLE account, including expenses that are for the benefit of the designated beneficiary in maintaining or improving his or her health, independence or quality of life” (emphasis added).  

The proposed regs add that “qualified disability expenses include basic living expenses and aren’t limited to items for which there’s a medical necessity or which solely benefit a disabled individual.”  

The language of the proposed regs, consistent with the impetus that led to the creation of ABLE, reflects that what constitutes qualified disability expenses is to be broadly and liberally interpreted. This makes sense because the needs of eligible individuals who have these expenses will change over time and as improvements in their ability to be full members of society take place.

In addition, regarding the requirement that the disability certification, if required, must be filed with the Secretary, the proposed regs provide that the certification will be deemed filed with the Secretary once the qualified ABLE program has received the disability certification or deems it to be received. Most ABLE programs will deem receipt of a disability certificate based on a statement under penalties of perjury that the individual has a qualifying certification, if required, from a qualified physician.

The proposed regs also require an ABLE program to provide that no contributions to an ABLE account will be accepted to the extent that the contribution, when added to all other contributions (whether by the designated beneficiary or any other persons) to that ABLE account during the taxable year, causes the total contribution to exceed the applicable annual gift tax exclusion amount (under IRC Section 2503).

Changes in the Act

Limitation on annual contributions increased. The Act made some important revisions to the ABLE statute. First, it increased the contribution limit to ABLE accounts under certain circumstances. After the annual contribution limit discussed above has been reached, a designated beneficiary may contribute additional amounts equal to the lesser of:  

(1) compensation includible in the designated beneficiary’s gross income for the taxable year, or

(2) the poverty line for a one-person household, as determined for the preceding calendar year.

This provision is significant because it will permit some eligible individuals to fund their ABLE accounts with greater contributions than previously permitted, thereby allowing them to save more quickly for their future qualified disability expenses. In addition, earnings on greater balances in an ABLE account will grow more rapidly, which also provides for greater growth in an ABLE account.  

The fact that eligible individuals are limited to only one ABLE account coupled with the previous limitation on annual contributions has, in addition, hamstrung the amount of assets under management and thus the growth of ABLE accounts. The hope is that this new loosening of the annual limitation will help ABLE account balances grow and thus reduce fees on these accounts rendering them as more attractive investment vehicles for all eligible individuals.

The revised section on the annual contribution limitation also provides that it’s the responsibility of the designated beneficiary (or person acting on behalf of the designated beneficiary) to maintain adequate records to show that the new annual limitation hasn’t been exceeded.

Saver’s credit. The saver’s credit is a nonrefundable tax credit for eligible taxpayers for qualified retirement savings contributions. The maximum annual contribution eligible for the saver’s credit equals $2,000 per individual, and the credit rate depends on the adjusted gross income of the individual. The Act permits a designated beneficiary to claim the saver’s credit for contributions made to an ABLE account. Thus, eligible individuals who qualify for the saver’s credit will be able to both make contributions to their ABLE account and reap the benefit of the saver’s credit.

Rollovers from 529 plans. Both Section 529 and Section 529A permit rollovers of account balances to another similar account for the same designated beneficiary or a member of the family of the designated beneficiary. These rollovers are generally tax free. However, rollovers out of a 529 plan to an ABLE plan weren’t permitted (and vice versa).  

Because 529 plans were established 20 years earlier than ABLE plans, some 529 plan account owners with beneficiaries who qualify as eligible individuals for purposes of ABLE have wanted to rollover their 529 account funds to ABLE accounts.  

The Act amends Section 529 to permit these rollovers out of a 529 plan account into an ABLE plan account on a tax-free basis. However, in addition to the requirement that the designated beneficiary must be an eligible individual for ABLE purposes, the amount of any rollover from a 529 plan account to an ABLE account can’t, when added to all other contributions made to the ABLE account for that year, exceed the ABLE annual contribution limitation discussed above.

Sunset. These new provisions added by the Act are subject to sunset. Unless Congress acts to change the law, these provisions will expire on Dec. 31, 2025.

A Step Forward

ABLE accounts provide qualifying disabled individuals with an opportunity to save for their qualified disability expenses on a tax-favored basis. Many disabled individuals face additional expenses associated with their day-to-day living not encountered by most individuals. In addition, the families of disabled individuals often seek a cost-efficient vehicle to provide for their loved ones’ future expenses. Special needs trusts can be expensive to establish and to maintain on an ongoing forward basis.  

ABLE accounts provide an efficient and tax-favored vehicle to help disabled individuals and their families pay for those future expenses. In addition, the value to a disabled individual of owning an ABLE account is not just measured in dollars or tax-savings. It can be life changing.

The ABLE statute and these new revisions to ABLE provided by the Act are significant because they permit eligible individuals to save more to help themselves. Moreover, the Act improvements allow eligible individuals who qualify for the credit to take advantage of the saver’s credit for contributions made to their ABLE account. The opportunity to roll over funds from a 529 plan account to an ABLE account allows those eligible individuals to use their savings for the more expansive qualified disability expenses found in Section 529A.  

Hopefully, additional changes to the ABLE statute will increase the universe of eligible individuals and remove or lessen the limitations on those who want to contribute to an ABLE account to save for their future qualified disability expenses.                      

On July 29, 2016, Delaware enacted 12 Del. C. Section 3342, Modification of trust by consent while trustor is living (the modification statute).¹ The modification statute provides a new mechanism for the wholesale modification (including the termination) of an irrevocable trust administered under Delaware law (an irrevocable trust). Let’s discuss the mechanics of the modification statute, compare it to Uniform Trust Code (UTC) Section 411 and review potential tax consequences to consider when modifying irrevocable trusts.

General Concepts

Generally, the modification statute provides that an irrevocable trust may be modified on the written consent or written non-objection of all of the members of three groups: (1) trustors, (2) fiduciaries serving at the time of the modification, and (3) beneficiaries. Notably, the modification statute generally permits any modification, even if it violates a material purpose of the irrevocable trust.

For example, such modifications can include:

• Changes to the irrevocable trust’s administrative provisions, including the conversion of the irrevocable trust to a directed or silent trust, adding removal or appointment language for fiduciaries and changing the compensation or indemnification provisions.  

• Changes to the beneficial interests in the irrevocable trust. However, changes to the beneficial interests in the irrevocable trust shouldn’t be undertaken lightly, as they may cause significant tax consequences, as discussed below in greater detail. 

• The wholesale amendment and restatement of an irrevocable trust.

Often, the modification statute will be used to modernize older trusts created in U.S. jurisdictions other than Delaware. Before being modified under the modification statute, a trust must be administered under the laws of Delaware.² If the situs of a foreign trust is changed to Delaware to use the modification statute, it’s important to ensure that the trust is properly administered in Delaware prior to the use of the statute. Depending on the terms of the trust instrument, the laws of the original jurisdiction of the trust and any prior court supervision of the trust, administration in Delaware can generally be accomplished through the appointment of a Delaware trustee who begins administering the trust in Delaware.³

Consent of the Requisite Parties

As highlighted above, the modification statute requires the written consent or written non-objection of all of the trustors, fiduciaries then serving and beneficiaries. The written consent or non-objection of a trustor may be given by the trustor herself; by an agent under a power of attorney, but only to the extent expressly authorized by the power of attorney or the terms of the relevant trust agreement; or, if an agent under a power of attorney isn’t so authorized, by the trustor’s guardian or similar court-appointed representative with the approval of the court supervising such representative. 

All fiduciaries of an irrevocable trust must execute a written consent or written non-objection as well.  Notably, the term “fiduciaries” is far broader than trustees. In addition to trustees, fiduciaries can include, without limitation: (1) investment, distribution, trust protectors or other advisors under 12 Del. C. Section 3313, and (2) designated representatives appointed under 12 Del. C. Section 3339.⁴ In some trusts, direction advisors, trust protectors and/or designated representatives are designated “non-fiduciaries.” While such an express provision presumably would be given legal effect, many practitioners, out of an abundance of caution, will obtain the written consent or written non-objection of such non-fiduciaries.

Finally, modification pursuant to the modification statute requires the written consent or written non-objection of all beneficiaries of the irrevocable trust. Often, obtaining the direct written consent or non-objection of all beneficiaries is impossible, as many presumptive remainder beneficiaries are minors, and many contingent successor beneficiaries may be unknown. Accordingly, the linchpin of a successful modification under the modification statute often is Delaware’s virtual representation statute, 12 Del. C. Section 3547 (virtual rep. statute).⁵

Generally, Section 3547(a) of the virtual rep. statute provides that, unless otherwise represented (that is, by a court-appointed guardian or otherwise), a minor, incapacitated person, unborn person or unascertainable person may be represented and bound by a person who has a substantially identical interest with respect to the particular matter, to the extent there’s no material conflict between such parties. For example, an adult current beneficiary executing a written modification may represent and bind a minor current beneficiary, so long as there’s no material conflict among the current beneficiaries with regard to such modification.

Section 3547(b) of the virtual rep. statute provides that a presumptive remainder beneficiary (that is, the person who would take income or principal if all current beneficiaries on the relevant date were deceased) or other person authorized to represent and bind a presumptive remainder beneficiary under another provision of the virtual rep. statute may represent and bind contingent successor remainder beneficiaries. That is, the presumptive remainder beneficiaries can, through the virtual rep. statute, bind all successor remainder beneficiaries provided there’s no material conflict of interest. 

Under Section 3547(c) of the virtual rep. statute, if a minor or incapacitated beneficiary may not be represented pursuant to Sections 3547(a) and (b) of the virtual rep. statute, such beneficiary may be represented and bound by one or more of her parents, to the extent there’s no material conflict of interest with either parent or her guardian. Similarly, such representative may bind unborn or unascertainable persons with substantially identical interests to the represented minor or incapacitated beneficiary (again assuming no material conflicts of interest).  

Conflicts of interest can often arise in the context of a modification when there’s the granting of additional powers to fiduciaries or nonfiduciaries, the addition of fiduciaries with a different time horizon as it relates to investments, an alteration of standards of care or alterations in beneficial interests. Because all beneficiaries of an irrevocable trust must execute a written consent or written non-objection to a modification under the modification statute, any material conflicts of interest that would make the virtual rep. statute inapplicable will cause the modification to be a nullity if any beneficiary is a minor, incapacitated person, unborn person or unascertainable person. In situations in which the presence of a conflict of interest is unclear, the modification statute provides a viable option. That is, Section 3342(c) of that statute provides that a party in interest may petition the Delaware Court of Chancery to interpret, apply, enforce or determine the validity of a modification under the modification statute, including whether all beneficiaries lacking capacity were properly represented pursuant to the modification statute.⁶

UTC Section 411

The modification statute is modeled on UTC Section 411 but contains certain notable differences.⁷ Note that UTC Section 411 contains various options for a state to adopt. While every provision of the UTC technically is optional in that the provision can be enacted in a specific jurisdiction with any changes or variations that the relevant legislature desires,⁸ UTC Section 411 (pursuant to certain amendments to UTC Section 411 in 2004) provides (by the skillful use of brackets)⁹ a number of variations for states seeking to enact UTC Section 411(a)—the provision of UTC Section 411 dealing with modification or termination of an irrevocable trust with the involvement of the trustor.¹⁰

Some notable differences between the modification statute and UTC Section 411 include:

• UTC Section 411 is applicable only to noncharitable trusts, while the modification statute contains no such limitation and may be used to modify or terminate a charitable trust (so long as the other requirements of the statute are met). 

• UTC Section 411(b) provides that a noncharitable irrevocable trust may be: (1) terminated on consent of all of the beneficiaries if a court of competent jurisdiction concludes that the continuance of the trust isn’t necessary to achieve a material purpose of the trust, or (2) modified via court petition on consent of all beneficiaries if the modification or termination isn’t inconsistent with a material purpose of the trust. To the extent that a jurisdiction omits UTC Section 411(a) in its entirety, UTC Section 411 won’t provide any mechanism to modify or terminate an irrevocable trust to the extent that such modification or termination would violate a material purpose of the trust. Depending on the version of UTC Section 411(a) that’s adopted, a material modification or termination, even with the consent of the settlor and all of the beneficiaries, may require court approval. The modification statute, however, has no material purpose requirement, and court approval isn’t needed under any circumstance. Furthermore, an irrevocable trust always will be subject to the modification statute regardless of when such trust was created or became irrevocable.¹¹

• UTC Section 411 doesn’t require the involvement of any trust fiduciaries. Under the modification statute, all serving fiduciaries must consent or not object to the modification or termination.  

Tax Considerations 

As discussed above, the modification statute has the potential to trigger unwanted tax consequences if the statute is used to modify beneficial interests in an irrevocable trust. Notably, the tax analysis below generally can be applied to the use of UTC Section 411 in situations in which the trustor, along with the beneficiaries, provides a written consent or written non-objection. In situations in which the beneficial interests are being altered, consider the following:

Gift and generation-skipping transfer (GST) tax. If the relevant modification decreases a beneficiary’s interest in an irrevocable trust in favor of another beneficiary, because the enforceability of the modification requires the beneficiary’s written consent, such modification may give rise to gift tax obligations on the part of the beneficiary with the decreased beneficial interest.¹² On the other hand, if a beneficiary has substantially the same interests after the modification as she did before the modification, such modification likely won’t trigger gift tax obligations for the beneficiary.¹³ 

With regard to the GST tax, Treasury Regulations Section 26.2601-1(b) generally provides, among other things, that a modification under state law won’t cause a trust to lose its GST tax-exempt status if the modification doesn’t shift a beneficial interest to any beneficiary who occupies a lower generation, and the modification doesn’t extend the time for vesting of any beneficial interest beyond the period provided in the original trust.¹⁴ For example, if the modification statute is used only to divide a trust with three beneficiaries into three separate trusts for each of the then-current beneficiaries and modify certain administrative provisions, while maintaining the original perpetuities period, such modifications generally won’t affect the GST tax-exempt status of the trusts.¹⁵

Estate tax. Generally, Internal Revenue Code Sections 2036 through 2038 govern the inclusion of certain assets in a decedent’s estate and provide that assets will be included in a decedent’s estate if such decedent made a transfer of property or any interest in such property (other than a bona fide sale for adequate and full consideration) and retained an interest in, or power over, the income or corpus of the transferred property.¹⁶

With regard to the modification power pursuant to the modification statute and potential implications for the trustor’s estate tax obligations, Treas. Regs. Section 20.2038-1(a)(2) provides that a trustor’s gross estate won’t include the value of property transferred into trust, even if the trustor enjoys the power to alter, amend, revoke or terminate the relevant trust, if such power could “be exercised only with the consent of all parties having an interest (vested or contingent) in the transferred property and if the power adds nothing to the rights of the parties under local law.”¹⁷ That is, because the modification statute requires the written consent or written non-objection of all interested parties, and all interested parties were never prohibited under Delaware law from effectuating an amendment to the trust, the aforementioned exception in Treas. Regs. Section 20.2038-1(a)(2) should apply to the modification statute, ensuring that the trustor doesn’t have adverse estate tax consequences by virtue of holding the power contained in the modification statute.

As to estate tax consequences for any beneficiaries, in a case in which a modification pursuant to the modification statute doesn’t change the beneficial interests in an irrevocable trust and only affects the administrative provisions of such trust, the modification shouldn’t cause the trust assets to be includible in the beneficiaries’ gross estates for estate tax purposes.¹⁸

Income tax. A modification under the modification statute that causes a change in beneficial interests may also lead to income tax implications for the beneficiaries of an irrevocable trust. The U.S. Supreme Court has held that a taxpayer can realize a gain or loss when it exchanges interests for interests that are “materially different[.]”¹⁹ The IRS has held that modifications of the trust that don’t change the beneficial interests shall not cause the beneficiaries to realize gain for income tax purposes.²⁰ However, the IRS has indicated that gain may arise if a beneficiary’s interest in a successor trust, after pro rata division of an initial trust, was “materially different” from such beneficiary’s interest in the original trust.²¹ 

Other Delaware Modification Options

The modification statute may be the most recently codified, but it’s not the only statutory method of modifying an irrevocable trust under Delaware law. While not all-inclusive, other common modification options include mergers under 12 Del. C. Section 3325(29)²² and decantings under 12 Del. C. Section 3528.²³

To perform a merger under 12 Del. C. Section 3325(29), the trustee of an irrevocable trust will create one or more new trusts that include the desired, modified administrative provisions and merge the irrevocable trust into such new trusts. On such merger, the new trusts will survive and be subject to the newly included administrative provisions. Such merger doesn’t require the consent of the trustor, the beneficiaries or any other fiduciaries, but the trustee often won’t effect such a merger without obtaining a release from all such parties, thus effectively requiring such consent. Unlike a modification pursuant to the modification statute, however, a merger can’t be used to change any beneficial interests in the irrevocable trust.

To decant under 12 Del. C. Section 3528, the trustee of an irrevocable trust generally must have the discretionary power to invade the principal of the trust for the benefit of one or more trust beneficiaries. If the trustee has such power, she may create a new trust with the desired, modified provisions and decant the assets of the original irrevocable trust into such new trust. As with a merger, a decanting doesn’t require the consent of the beneficiaries, other fiduciaries or the trustor, but trustees often will require a release in connection with a decanting.  

Unlike a modification under the modification statute, a modification by decanting provides a much more limited ability to modify beneficial interests. The second trust into which the assets of the irrevocable trust are decanted must have beneficiaries who are proper objects of the exercise of the power to invade principal under the original irrevocable trust. That is, a trustee of an irrevocable trust for the current benefit of two beneficiaries may decant into a trust only for the benefit of one of those beneficiaries, but not into a trust for the benefit of a third party who wasn’t a beneficiary of the original irrevocable trust (keeping in mind, of course, that there likely will be tax and fiduciary implications for changing such beneficial interests between the original beneficiaries).          

A Powerful Tool

To the extent its requirements can be satisfied, the modification statute provides the broad power not just to effect administrative modifications to an irrevocable trust, but also to effect fundamental changes to such trust. While the implications of such modifications always should be considered in depth, the modification statute certainly provides a powerful and useful tool for trustors, fiduciaries and beneficiaries of Delaware trusts that can’t be found in most jurisdictions.     

Endnotes

1. 12 Del. C. Section 3342 (the modification statute) provides:

(a) Notwithstanding any provision of law or the trust’s governing instrument limiting or prohibiting amendment of the trust, an irrevocable trust may be modified to include any provision that could have been included in the governing instrument of a trust were such trust created upon the date of the modification by written consent or written nonobjection of all of the trust’s trustors, all then serving fiduciaries and all beneficiaries regardless of whether the modification may violate a material purpose of the trust.  A trustor’s power to provide a written consent or written nonobjection to a trust’s modification may be exercised: (i) by an agent under a power of attorney only to the extent expressly authorized by the power of attorney or the terms of the trust’s governing instrument; or (ii) if an agent under a power of attorney is not so authorized, by the guardian of the trustor’s property (or similar court-appointed representative) with the approval of the court supervising the guardian (or similar representative).

(b) No fiduciary shall have a duty to consent to any proposed modification nor, absent wilful misconduct, have any liability to any person having an interest in the trust for failure to consent to any proposed modification.

(c) Any interested person, including the trustor, may bring a proceeding in the Court of Chancery to interpret, apply, enforce, or determine the validity of a modification adopted under this section, including but not limited to determining whether the representation as provided in § 3547 of this title was adequate; provided, however, that any such person may waive the right to contest the modification.

(d) This section shall apply to any trust administered under the laws of this State.

2. See ibid., Section 3342(d).

3. In re Peierls Family Inter Vivos Trs., 77 A.3d 249 (Del. 2013) (holding, among other things, that: (1) absent an explicit statement in a trust agreement that the initial jurisdiction’s laws governing administration of a trust shall always govern administration, even if the trust is administered in another jurisdiction, such choice of law may be changed by changing the situs of the administration of the trust, (2) Delaware law governs the administration of a trust that allows for appointment of a trustee without geographic limitation, and a Delaware trustee is appointed and administers the trust in Delaware, and (3) Delaware courts won’t accept supervision of a trust that’s under the unterminated supervision of a court of another jurisdiction).  

4. By default, advisors and trust protectors are fiduciaries pursuant to 12 Del. C. Section 3313(a), and designated representatives are fiduciaries pursuant to 12 Del. C. Section 3339(b). 

5. The Delaware virtual representation statute provides, in relevant part:  

(a) . . . [A] minor, person who is incapacitated, or unborn person, or a person whose identity or location is unknown and not reasonably ascertainable (hereinafter referred to as an “unascertainable person’’), may . . . be represented by and bound by another who has a substantially identical interest with respect to the particular question or dispute but only to the extent that there is no material conflict of interest between the representative and the person represented with respect to the particular question or dispute.

(b) A presumptive remainder beneficiary or the person or persons authorized to represent the presumptive remainder beneficiary under any other subsection of this section may represent and bind contingent successor remainder beneficiaries for the same purposes, in the same circumstances, and to the same extent as an ascertainable competent beneficiary may represent and bind a minor or person who is incapacitated, unborn or unascertainable. . . . 

(c) In the case of a trust having a beneficiary who is a minor or incapacitated who may not be represented by another pursuant to
subsection (a) or subsection (b) of this section, the surviving and competent parent or parents or custodial parent (in cases where 1 parent has sole custody of the beneficiary), or guardian of the property of the beneficiary may represent and bind the beneficiary for purposes of any judicial proceeding or nonjudicial matter pertaining to the trust; provided that, in the case of a beneficiary represented by 1 or both parents, there is no material conflict of interest between the beneficiary who is a minor or incapacitated and either of such beneficiary’s parents with respect to the particular question or dispute. . . . 

12 Del. C. Section 3547.

6. See 12. Del. C. Section 3342(c). Such party also may waive the right to contest modification in connection with such proceeding.  

7. Uniform Trust Code (UTC) Section 411 provides as follows: 

(a) [A noncharitable irrevocable trust may be modified or terminated upon consent of the settlor and all beneficiaries, even if the modification or termination is inconsistent with a material purpose of the trust.] [If, upon petition, the court finds that the settlor and all beneficiaries consent to the modification or termination of a noncharitable irrevocable trust, the court shall approve the modification or termination even if the modification or termination is inconsistent with a material purpose of the trust.]  . . .  [This subsection does not apply to irrevocable trusts created before or to revocable trusts that become irrevocable before [the effective date of this [Code] [amendment].]] 

(b) A noncharitable irrevocable trust may be terminated upon consent of all of the beneficiaries if the court concludes that continuance of the trust is not necessary to achieve any material purpose of the trust. A noncharitable irrevocable trust may be modified upon consent of all of the beneficiaries if the court concludes that modification is not inconsistent with a material purpose of the trust. . . .

8. The UTC has been enacted—in some form—in 31 states and the District of Columbia, and the Illinois legislature has proposed a bill to enact a version of the UTC. 

9. Specifically, UTC Section 411(a) provides for the following variations for modification or termination of a noncharitable irrevocable trust with the involvement of the trustor: (1) UTC Section 411(a) can be omitted in its entirety, and the relevant state’s prior law regarding the right to modify or terminate (or not) such trust with the involvement of the trustor governs; (2) such trust can be modified or terminated with the written consent of the settlor and all beneficiaries; (3) such trust can be modified or terminated with the written consent of the settlor and all beneficiaries, to the extent approved by a court of competent jurisdiction; and (4) either clause (1) or clause (2) above will only apply to irrevocable trusts created or revocable trusts that have become irrevocable, after the date UTC Section 411(a) is adopted.

10. UTC Section 411 uses the term “settlor,” while the modification statute uses the term “trustor.”

11. See 12 Del. C. Section 3342(d). (“This section shall be available to any trust that is administered under the laws of this State.”)

12. See Comments of the American College of Trust and Estate Counsel on Transfers by a Trustee from an Irrevocable Trust to Another Irrevocable Trust (Sometimes Called “Decanting”) (Notice 2011-101), released Dec. 21, 2011, April 2, 2012 (stating, in the context of a decanting, that “[t]he requirement for beneficiary consent . . . has the potential to have gift tax consequences to a beneficiary. If a beneficiary can in effect block the decanting, then whether or not failing to exercise that right has tax consequences will depend on the effect of the decanting on the beneficiary’s interest in the Distributing Trust. If the beneficiary’s interest in the Distributing Trust is reduced, then it would appear that the beneficiary has made a taxable gift.” (citing Treasury Regulations Section 25.2512-8)).

13. See, e.g., Private Letter Ruling 201722007 (Feb. 16, 2017) (holding that there are no gift tax consequences when trust modifications and future trust divisions won’t change any beneficiary’s beneficial interest); PLR 201709020 (March 3, 2017) (holding that there are no gift tax consequences when a trust won’t make pro rata transfer of all trust assets, except S corporation stock, to separate trusts, one for each beneficiary, and beneficial interests of the beneficiaries in the new trusts would be substantially the same); PLR 201443004 (July 10, 2014) (no gift tax consequences when a trust for the benefit of three beneficiaries was divided into three separate trusts for the benefit of each beneficiary, and certain administrative provisions regarding the appointment of trustees for such trusts were modified).

14. See 26 U.S.C. Section 26-601-1(b).

15. See PLR 201443004 (July 10, 2014); see also PLRs 200919008 (Jan. 12, 2009), 200919009 (Jan. 12, 2009) and 200919010 (Jan. 12, 2009) (holding that certain administrative trust modifications won’t alter the inclusion ratio of the trust for generation-skipping  transfer tax purposes).

16. See 26 U.S.C. Sections 2036, 2037 and 2038.

17. Treas. Regs. Section 20.2038-1(a)(2); see also PLRs 200919008 (Jan. 12, 2009), 200919009 (Jan. 12, 2009), 200919010 (Jan. 12, 2009) (discussing modifications effecting certain administrative modifications). 

18. See PLR 201443004 (July 10, 2014); see also PLRs 200919008, 200919009, 200919010, ibid., (“In the instant case, the modifications to the trusts are administrative in nature and do not change any beneficial interests in the trusts . . . .  the proposed modifications will not cause any portion of the trust property to be included in the gross estate of . . . any trust beneficiary . . . .”).

19. See Cottage Savings Assn. v. U.S., 499 U.S. 554, 566 (1991).  

20. See PLR 200013015 (Dec. 22, 1999); PLR 201443004, supra note 15.

21. See PLR 200736002 (May 22, 2007).

22. 12 Del. C. Section 3325(29) provides that a trustee of an irrevocable trust may:

Declare 1 or more new trusts for the purpose of merging all, or a portion, of the trust with or into the new trust or trusts and merge all or a portion of the trust with or into any other trust or trusts, including statutory trusts and foreign statutory trusts as defined in § 3801 of this title, whether or not created by the same trustor and whether or not funded prior to the merger, to be held and administered as a single trust if such a merger would not result in a material change in the dispositive terms of the trust defining the nature and extent of any trust beneficiary’s interest in the principal or income of the trust . . . .

23. 12 Del. C. Section 3528 provides, in relevant part, as follows: 

(a) Unless the terms of the instrument expressly provide otherwise, a trustee who has authority . . . to invade the principal or income or both of a trust (the “first trust’’) to make distributions to . . . 1 or more proper objects of the exercise of the power, may instead exercise such authority . . . by appointing all or part of the such principal or income or both . . . in favor of a trustee of a second trust, which may be a separate trust or the first trust as modified after appointment under this section (the “second trust’’) under an instrument other than that under which the power to invade is created or under the same instrument, provided, however, that, except as otherwise provided in this subsection (a):

(1) The exercise of such authority is in favor of a second trust having only beneficiaries who are proper objects of the exercise of the power . . .

Estate planners, CPAs and financial planners in solo and small-to-medium size firms grapple with how to advertise or otherwise get the word out to the general public. Do you hire an advertising and public relations firm? If so, how do you select one? What amount should you budget, and how do you quantify the return on your investment? 

These vexing questions seemingly have no answer— or at least the answers seem to be particular to each firm. But, there exist general guidelines that apply when choosing whether to move forward and seek professional advice.

I’ve personally wasted tens of thousands of dollars learning valuable lessons that I share in this article.  Being intentional in your goal setting, along with ongoing communication of your expectations, means the difference between success and failure.

Benefits of Engagement

Too often legal, tax and financial professionals are “rugged individualists.” We try to do too much on our own, failing to appreciate the most valuable and scarce resource that we have—our time. We haphazardly concoct an advertising strategy, or we don’t even consider our options before hiring a firm that comes recommended.

The results are usually disappointing. Worse, we can’t quantify the outcome. This is the primary reason many service professionals don’t retain advertising firms for any period of time beyond creating an advertisement or two that run over and over again.

In today’s market, where commoditization makes it appear as if professionals are fungible, it’s important to differentiate your firm. A coherent advertising and public relations campaign is vital to elevating your firm in the marketplace. 

Further, potential clients want to know what value you add to a professional relationship. Even referrals want questions answered prior to sitting down with you. Is your web presence sufficient? Does it educate your audience appropriately? Who, exactly, constitutes that audience? Is it graphically pleasing, and does it interface with your firm brochures and other media? Does your webpage distinguish you and your firm? 

What about potential clients who’ve never heard of you? How will they find your firm? And, once discovered, what impression will they have? Well thought-out advertising and public relations strategies, consistently applied, can game change your practice. Keeping an open mind is critical, as are several steps to ensure success. 

Setting Goals

Before selecting an advertising agency, the first step is to clearly identify your goals. Too often the goal is, “I want more clients.” That’s too broad and won’t provide the direction an advertising agency needs to help you succeed. Further, it can lead to thousands of dollars of wasted time and effort.

Instead, consider and then specifically state what you believe drives more clients into your practice. Are you simply trying to get your name known around town? That would be a brand recognition campaign, which requires ad placement across many different platforms. Are you attempting to attract clients through an educational process? The creation, posting and distribution of educational multimedia require a completely different approach. 

Do you enjoy producing content? Do you write blogs and books? Do you record video, webinars or podcasts? Or, are you looking for someone else to generate them? Will the content be focused on your clients, referral sources, centers of influence or a combination of all?

Have you put together an advertising strategy beyond the simple display ad that details who you are and what you do? If you haven’t thought beyond the ubiquitous advertisement that features professionals in suits touting years of experience while listing your firm’s practice areas, then you’re wasting time and money. Those ads don’t differentiate your firm from your competition. Nearly any graphic artist is capable of putting something like that together for a nominal fee.

Selling Intangible Services

Even Madison Avenue has trouble selling intangible services. Consider television ads for financial services and tax preparation, for example. Many of the advertisements are based on price.¹ This financial firm accomplishes your trades for just a few dollars. That tax program will file your return for free.² Unless you run a huge conglomerate that serves millions, earning revenue tangentially other than through the free service, then this strategy is a non-starter. I point it out, however, to illustrate that building a campaign to sell quality professional services, offered at premium fees, isn’t easy.

On the legal side, personal injury firm advertisements are the most common, and it’s safe to say that most readers of this magazine find many of those ads distasteful. Yet, success might be found by crafting a less traditional campaign. How willing are you to push the envelope? Do you want a conservative look, or are you willing to experiment with a less conventional program?

Communicating Expectations

Considering your expectations becomes paramount. I would start with communicating a goal as we previously addressed. As I said earlier, simply stating that you want to fill your conference rooms with A+ clients is too broad to convey meaning. First, you must identify the target market. As an estate-planning attorney, are you looking for wealthy retirees, or are you more of a business succession specialist? Is your CPA firm well known for assisting new start-ups, or does it save income taxes through ingenious planning in conjunction with trust attorneys? Failure to identify and communicate your target market to your advertising firm results in the costly spinning of wheels.

Next, consider specific strategies you’re willing to employ. Are you going to conduct workshops? Would you prefer to address your advertising and public relations to fellow professionals who might refer clients? Do you want to highlight your firm’s community involvement? Each one of these strategies involves distinctively different advertising and public relations campaigns.

Defining Success Criteria

Communicating success criteria gives your advertising and public relations firm clear goals. By providing fixed targets, you’re able to move the needle from a purely subjective approach to a more objective one. Further, the firm then has the information necessary to provide guidance on whether you adequately budgeted to satisfy your criteria. You don’t want to get several months into a project only to discover that your budget is entirely inadequate. That’s how money is wasted—if this happens, will you add to the budget or abandon what you started?

It’s critical to ensure that the advertising firm understands and implements the technology necessary to track the results, so you can eliminate the media that don’t generate the returns while investing more in those that do. I discuss this more below. 

Creating Content

I personally found that I can’t rely on an advertising agency or a public relations firm to generate excellent content, whether on my website, in brochures or in other promotional materials. No matter the expertise, the agency doesn’t understand my practice and, therefore, can’t pinpoint my A+ client emotional cues I spent hours studying.

Whenever I delegate the content creation to a marketing professional, the results are disappointing with ensuing frustration over costly and ever-continuing edits and rewrites. I had one associate at an advertising agency I worked with complain, “This is the third edit associated with the webpage,” as justifying that month’s shocking invoice! The reason for the many edits was a direct result of her failure to understand what I was after.

Some turn to pre-packaged content, which you can find with various online providers.³ I found much of that content overly generic and not stimulating to my client base. Consequently, it wasn’t helpful in achieving my success criteria. When prospective clients spot canned language in websites and brochures, I believe it results in more harm than good to your practice. Further, without constant updates that speak to your target market, it quickly goes stale.

Creating custom content geared specifically to your target market is easier than you might imagine. You can hire freelancers⁴ through websites who can interview you, transforming your vast knowledge, experience, thoughts and ideas into appealing messages. This is a cost-effective avenue for those who don’t necessarily have the talent or the time to produce valuable content.

Joining a professional coaching or mastermind group can be helpful in providing a framework to undertake practice development challenges, such as those found in marketing. I established one such national group for estate-planning attorneys,⁵ act as a contributor and lecturer in another,⁶ while participating in yet another broader focused strategic planning group.⁷ There are also national networking groups⁸ that meet quarterly, and although not geared specifically to the legal, tax or financial professions, they’re often valuable to gather information from those outside of your box. 

Time well spent before the engagement of any advertising agency is essential to decide on and discuss the type of content you feel is necessary and appropriate to attract your target market, who will create that content and how often it will be updated. These elements factor significantly into a realistic budget before you begin writing checks. 

Engaging Public Relations

Public relations work is an often overlooked aspect of advertising. If you publish a book, hold a free public workshop, broadcast helpful news on a podcast or participate in a charitable community event, these are all opportunities to get publicity. A good public relations specialist has contacts with local media and quickly writes a synopsis that will find column space in local periodicals or a mention on the evening news. This publicity is invaluable in that you’re not directly paying for the space (although you are indirectly by paying for the public relations firm), and the information isn’t as skeptically received by the general public as paid advertising space might be.

Most public relations specialists also place your periodical, television and radio advertising. Beware, for much forethought is required not only in the creation of the ad, but also in its placement. Because your public relations firm that places ads generally receives a commission from the publishers, it may not have a completely unbiased eye as to which journals get the best results.

I once had a public relations professional insist that I place a costly printed advertisement in our local newspaper’s glossy bi-annual magazine geared to newcomers. This magazine’s advertising regularly featured high-end furniture stores, fine dining establishments, pricey real estate developments and plastic surgeons. It was as thick as a Vanity Fair magazine and about the same ad-to-content ratio.⁹ As such, I believed that my typical call-to-action ad would appear out of place. Once I considered my goals and success criteria, it became evident to me that this glossy publication wasn’t the best use of our limited advertising budget.

On the other hand, the best advertising firms also secure bulk discounts with local papers, journals and television stations that you can’t find on your own or that may not be available to the smaller advertising firms with less clout. It’s entirely possible that the savings justify hiring the larger, more expensive firm. One firm saved us more than 70 percent on a performing arts hall program ad, for example. 

Designing Graphics and Layout

A good advertising firm coordinates a consistent look and feel to your media. While most bring a portfolio for you to examine, take the time to review their existing clients’ websites if you’re considering engaging the same firm for both print and electronic media. That will demonstrate how current its capabilities are. 

Think about when you watch old television shows or sports programs from even 10 years ago. You might snicker at the graphics because they appear so outdated. You don’t want others thinking the same thing about your print and media work. Having the appropriate font, color palette and clean graphics means the difference between being noticed or discarded. 

Internet and Social Media

As media fragments, your advertising agency must understand the advantages and disadvantages associated with the different distribution channels found through the Internet and social media. Depending on your community, a local agency may not have the tools otherwise found with firms you may employ through the web. If this is the case, ask whether your local agency would be comfortable coordinating efforts with an Internet and social media specialist.

Again, it’s easy to waste time and money on these efforts. Self-proclaimed experts abound. It’s important to obtain references and to check out those firms’ customer satisfaction with the work performed. I once worked with a local firm that proclaimed it was highly qualified to create and implement a social media strategy. It wasn’t. Had I investigated the firm’s track history prior to engaging it, I would have found less than stellar results. Instead I wasted money paying for a learning curve.

Before relying on the Internet and social media experts, it again serves you to be clear on your goals and big-picture strategies as I discussed earlier. Your work in first identifying your target market and then determining what strategies you’re comfortable enacting may serve to filter which platforms would best serve you. If, for example, most of your clients are older retirees, Snapchat wouldn’t be the proper platform, but Google Ads might. 

Tracking Results

Don’t forget to track your results. A variety of easy-to-use, inexpensive programs exist that produce reports that will let you know which media are working and which aren’t. Grasshopper¹⁰ is an online based phone system with call tracking and analytic features. Your print advertisements contain specific phone numbers provided by Grasshopper that coordinate with your area code and in-office phone system. When the phone rings, the program provides reports as to each line’s usage. 

In my firm, we discontinued placing ads in some publications after discovering that those journals were low performers relative to the cost, saving us thousands of dollars on the next advertising run.

Rules Regulating Advertising

Whenever creating and placing advertisements, it’s important to follow the rules regulating your profession. Many state bar associations establish and enforce rules regulating lawyer advertising. Further, lawyers must be careful not to enter into contracts with advertising agencies that might be deemed prohibited fee-splitting arrangements.¹¹

Financial professionals have a variety of regulations to follow, from the Financial Industry Regulatory Authority¹² to their in-house compliance officers. Similarly, the American Institute of Certified Public Accountants¹³ and the various state institutes promulgate rules that CPAs must follow. 

As a Florida attorney, I supplied my advertising agency with a complete copy of the Florida Bar Rules governing advertisements,¹⁴ yet found that drafts of various ads would raise ethical issues had I not intervened. Nevertheless, the Florida Bar requires that advertisements be submitted for approval, which also acts as a compliance filter. It’s been my experience that the Florida Bar rules are frequently amended. Further, most advertising agencies disclaim liability for noncompliance, so it’s in your best interests to monitor the content for compliance yourself, or appoint a competent coworker to do so.

Valuable Tools

Advertising and public relations are valuable tools to promote your practice and gain new clients. As with anything worth doing, it will take both time and effort to do it right, even when hiring the best firm in your community. Intentionality and effort worthy of your budget should be built into your engagement and pre-planning process. Finally, make sure that you budget enough time and money to enjoy effective results.                 

Endnotes

1. See Charles Schwab television commercial, ‘We’ve Just Lowered the Cost of Investing. Again,” www.ispot.tv/ad/A3P9/charles-schwab-weve-just-lowered-the-cost-of-investing-again.

2. See H&R Block More Zero television commercial, “Serious,” www.ispot.tv/ad/w_BU/h-and-r-block-more-zero-serious-featuring-jon-hamm.

3. See, e.g., https://tax.thomsonreuters.com/checkpoint/marketing-for-firms/estate-planning/; OVC Online Marketing, www.ovclawyermarketing.com/online-lawyer-marketing-services/content-writing-for-attorneys.

4. See freelancer.com; upworks.com.

5. See The Freedom Practice, www.4freedompractice.com. 

6. See WealthCounsel Practice Development, www.wealthcounsel.com/legal-marketing-for- attorneys. A similar program can be found at Interactive Legal, https://interactivelegal.com/Practice-Development.php.

7. Strategic Coach, www.strategiccoach.com. 

8. See The Genius Network, www.geniusnetwork.com, Titans Marketing, www.briankurtz.me and www.gkic.com, among others. 

9. In an April 11, 2000 New York Times feature, Vanity Fair commonly averaged over 65 percent advertising while the common magazine was roughly 49.4 percent advertising to 50.6 percent editorial content. The article described advertising executives who believe that thick magazines with more advertising than editorial content are too cluttered and not worth the price. “… In some issues of Vogue, if you can’t get a good spot, you may say to yourself ‘Why would I want to be in there?’”

10. See www.grasshopper.com.

11. In a June 21, 2012 article, a Washington, D.C. attorney was sued by an Alabama-based personal injury attorney for breach of contract related to television advertisements that forwarded contacts. An issue was raised as to whether the arrangement violated attorney fee-splitting rules, http://legaltimes.typepad.com/blt/2012/06/washington-solo-practitioner-sued-for-breach-of-contract.html.

12. Seewww.finra.org/industry/advertising-regulation.

13. www.aicpa.org/Research/Standards/CodeofConduct/DownloadableDocuments/2012June1CodeOfProfessionalConduct.pdf.

14. See www.floridabar.org/rules/ads/.

Asking the right questions is critical when investing trust assets. What’s the time horizon of the trust? Are there any unusual tax characteristics? Why was it created? What are the beneficiaries’ needs and desires? 

The answers to these questions can lead to a diverse set of asset allocations. Here are some of the differentiating attributes of trusts that may lead to particular portfolio choices. Investment selection can dramatically leverage—or hinder—the value of a family’s total wealth transfer, and thoughtful decisions are an important part of the trustee’s job. 

Grantor vs. Non-grantor Trusts 

It’s important to determine whether a trust is a grantor trust or a non-grantor trust. A grantor trust is considered to be the same as its grantor for income tax purposes. Its income, deductions, credits and other tax attributes are reported as part of the grantor’s personal Form 1040. The grantor pays the related income taxes, without this payment being deemed a gift to the trust. This allows trust assets to grow free of the tax drag, which is why many trusts are drafted to be grantor trusts. A non-grantor trust is responsible for paying its own taxes. 

Grantor trust status is governed by whether certain provisions are included in the trust agreement. The easiest way to figure out the trust status is to ask the drafting attorney. If a grantor is deceased, the trust is a non-grantor trust.

Opportunities for Grantor Trusts 

Investments for grantor trusts should account for the grantor’s personal income tax situation.¹

Coordination of gain realization and/or loss harvesting. However, beware the wash sale rule! This rule generally disallows realized losses if paired with a purchase of a substantially identical security 30 days pre- or post-sale. Basis is rolled into the new security purchase. It’s important for the grantor and the trustee to stay in contact because a loss realized by the grantor can be matched with a purchase by the trust, and vice versa, to trigger the rule. 

Weigh the benefits of tax-preferred investments. All else being equal, a grantor trust should be careful about purchasing tax-preferred investments. Consider municipal bonds, which typically provide lower yields because of the accompanying tax benefit. Depending on the respective after-tax returns, a grantor trust could be better served with a taxable bond. The taxable bond might result in a higher absolute return to the trust, with the taxes absorbed at the grantor level, reducing the taxable estate. 

Asset location (income investments). Income is taxed to the grantor wherever the asset is located. It doesn’t matter whether assets producing ordinary income are held by the grantor or the grantor trust. This isn’t true of non-grantor trusts.

Strategic use of the power of substitution. Many grantor trusts allow the grantor to “reacquire” any trust property in her discretion, so long as assets of equivalent value are exchanged. Trust property not appreciating as hoped can be exchanged for property with better potential, so that the growth of the trust is accelerated and growth of the grantor’s estate is slowed. This power can also be used to move low basis assets back to the grantor in anticipation of a step-up in basis.

Managing Non-Grantor Trusts 

Weigh the benefits of tax-preferred investments. Non-grantor trusts reach the top income tax bracket at only $12,500 of income in 2018. Therefore, trustees may be more interested in purchasing tax-preferred investments than if the trust were a grantor trust. 

Asset location. If the grantor isn’t a top-bracket taxpayer (because the trust likely is), it may make sense to hold income-producing assets personally rather than in the trust. 

Trust residency. State income tax obligations can significantly drag trust performance. Examine the rules tying a trust to a particular taxing state. Can changes be made to move the trust residence elsewhere? For example, in some circumstances, having an in-state trustee resign may make a trust non-resident as to that state. In that case, the trust would be taxable only on income sourced to the state (for example, from in-state real estate) as opposed to all income (for example, passive income such as stock dividends).

Other Asset Location Issues 

Beware of investment overlap. Trusts for the same beneficiary may have different trustees, be held at different institutions or simply be thought of as entirely separate pots. The result can be that a single asset class is over- or underexposed considering the overall assets held for a beneficiary. Regularly review trust portfolios in concert so that the wealth opportunities for beneficiaries are maximized. Relatedly, there’s always the opportunity to ask if trusts can be consolidated to simplify the family’s administration. 

Basis. Keeping low basis assets in the grantor’s estate preserves the possibility of a basis step-up at death. Assets gifted to the trust take a carryover basis instead, so consider higher basis assets. 

Growth investments. Long-term growth investments inside the trust may leverage the gift tax exemption originally used, because the appreciation may escape additional transfer tax at the grantor’s death. Conversely, holding such investments in the grantor’s estate is less favorable. The step-up in basis at the grantor’s death would produce only 23.8 percent in federal savings under current law (capital gains and net investment income taxes) but create a marginal 40 percent federal estate tax rate.

Invest for Trust Goals 

Long-term trusts. Capital appreciation may be more important than immediate income, and illiquid investments could be appropriate. You may be able to skew asset allocation more aggressively to equities. Long-term trusts, for example, those to which the donor’s exemption from the generation-skipping transfer (GST) tax has been allocated, generally aren’t intended to function as a beneficiary’s primary source of income. This gives the trustee the flexibility to invest for the greatest income or growth overall, because the trust will be able to ride out temporary dips in the market. 

Mandatory income provisions. In light of the desires of the grantor and the circumstances of the current and future beneficiaries, should the trust be invested with an eye toward producing more, or less, distributable income? Investment choices can create flexibility when a trust agreement hasn’t kept up with unanticipated events.

Grantor retained annuity trusts (GRATs). These are intended to transfer appreciation on an asset to desired beneficiaries, typically children. Recently, the interest rate the GRAT must exceed to succeed in its goal has been at historic lows (although it may be creeping up), and there have been periods of strong market performance. In light of this, some GRATs have been funded with marketable securities as a simple way to use the technique. 

“Successful” GRATs pass assets to remainder beneficiaries while “failed” GRATs simply fail to do so (but have minimal negative impact to the family). Therefore, GRATs are good candidates for isolating asset classes and embracing volatility. However, when GRATs have already successfully appreciated in value, investing in stable assets may be a smart strategy to lock in the appreciation. It decreases the potential for values to drop before assets are paid to the children. 

Beneficiary needs and preferences. Understanding the beneficiary’s anticipated distribution needs can guide investment choices and help determine when to convert illiquid investments to liquid ones. Also, whether the beneficiary has a formal role or not, taking her opinions into account can make for more harmonious trust administration. 

Insurance Trusts 

Many insurance trust agreements purport to relieve the trustee of responsibility for reviewing the strength of the policy, the issuing company or anything else. Insurance is a specific asset class that, in addition to providing a fixed or variable death benefit, can: 

• last for different lengths of time; 

• have premium payments over varying lengths of time; 

• provide more or less exposure to the market, potentially impacting death benefit or cash value; and 

• have sub-optimal pricing based on changes in the insured’s health since purchase. 

A specific policy, or insurance as a general matter, may be a better or worse investment choice at any given time. Whatever the specific trust agreement may say, it’s prudent to periodically review policy performance and pricing relative to current available options. 

Conversely, trustees of trusts that weren’t originally created to hold insurance might determine that purchasing it may be desirable to address changing circumstances and to complement other trust assets. 

Charitable Trusts 

Charitable remainder trusts (CRTs). CRTs are exempt from income tax. A grantor can contribute an asset and have the trust sell it, and the trust will pay no income tax on the realized gain. However, the tax characteristics don’t disappear—they remain waiting inside the trust. As required annual payments to the grantor are made, they carry out the income tax consequences. 

CRTs are subject to a “worst first” system. Ordinary income is carried out before capital gains, which are carried out before tax-exempt income, etc.

CRTs often have significant deferred capital gains because they’re frequently used to diversify concentrated positions. Consider carefully before investing in assets producing ordinary income. This will come out before any capital gains at all. Conversely, investments in assets like municipal bonds produce a lower return on investment in exchange for a tax preference that may never be realized by the grantor (because it isn’t distributed out) or the tax-exempt remainder charity (which isn’t subject to income tax at all). 

Charitable lead trusts (CLTs). Testamentary CLTs pay a specified amount to charity over a term of years, with the remainder to designated recipients (typically children). They’re often designed to zero out some or all of the estate tax due. The hope is that sufficient appreciation will occur during the trust term so that something will be left for the children at the end. 

Stable growth investments may be appropriate for charitable lead annuity trusts (CLATs), whose charitable obligations are fixed year on year and can be planned to be surmounted. Unlike the GRAT, its non-charitable cousin, volatility doesn’t necessarily favor a CLAT. If the investment drops in value, the charity’s annuity payment takes precedence over the remainder beneficiary. In a GRAT, the remainder beneficiary is similarly harmed, but the person receiving the annuity payments is the grantor.

Trust Goals  

Considering a trust’s purpose, structure and tax characteristics can guide a trustee’s investments to better achieve the grantor’s intent. The portfolio choices aren’t a separate matter from the distributions, but work hand in hand. With a deeper understanding of the legal aspects of the trust, trustees and advisors are better able to spot opportunities, minimize inefficiencies and ensure that the trust is operating holistically to achieve its goals. 

Endnote

1. The trustee’s responsibility is to the trust beneficiaries, not to the grantor. However, managing trust investments to minimize grantor taxes can be appropriate for a number of reasons: (1) Often, the spouse is a trust beneficiary whose joint return with the grantor is impacted; (2) Minimizing the grantor’s taxes means that more overall wealth could pass to trust beneficiaries; and (3) Failure to consider the grantor’s tax burden may result in the grantor “turning off” grantor trust status, which would negatively impact the trust’s financial performance.

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

Imagine that an estate planner gives a presentation to clients on the estate and gift tax provisions of the Tax Cuts and Jobs Act (the Act). The clients hear that, as of January 2018 and running through 2025, the estate, gift and generation-skipping transfer (GST) tax exemptions are doubled to $11.18 million in 2018 and indexed thereafter, the estate, gift and GST tax rates remain at 40 percent and step-up in basis for inherited assets (other than income in respect of a decedent (IRD)) is preserved. They hear something favorable about how basis is determined when a policy is sold in a life settlement. And, as a postscript to the discussion of the Act, they hear that the current design flexibility of grantor retained annuity trusts (GRATs) and intentionally defective grantor trusts (IDGTs) is preserved and that the proposed regulations to Internal Revenue Code Section 2704 were “unproposed.”

After the presentation, several of the clients approach the planner and ask these questions: 

“While they fiddle around with that sunset business, how do I figure out how much life insurance I need for liquidity and for how long I need it?”

“They’ve just effectively repealed the estate tax as far as I’m concerned. Why should I keep paying the premiums on that policy?” 

“Those big premiums are using up a lot of gift tax exemption that you tell me that I could use (or preserve) for other things. Got a Plan B?” 

 “The agent says that life insurance is a great vehicle for ‘capital transfer.’ Huh?” 

“I’m about to buy a pretty large policy. With the increased exemptions, do I need an irrevocable life insurance trust (ILIT)?”

 “That ILIT was the dumbest thing I ever did! Maybe I don’t need it now. What can ‘we’ do about it?” 

“Should I use life insurance as an investment in my ILIT?” 

“Can’t I just sell the policy? I’d really like to have the cash.”

“I have that old split-dollar policy in my ILIT. I’m told that, unlike me of course, the plan won’t get better with age. Is it really a problem? If so, what should I do about it?” 

“They didn’t repeal the estate tax, so I’m going to move ahead with purchasing that policy in my ILIT. Have been there and done that with split dollar and don’t want to go there again. Is there a simpler way to get premium money into the ILIT?” 

However easy these questions are to ask, they aren’t particularly easy to answer in a full and fair fashion. Virtually every one of these questions calls for the planner to have a broad set of technical, consultative and collaborative skills. We won’t address each and every question in the order we posed them. Rather, we’ll address the questions in a more aggregate, contextual fashion, but we’ll defer the split-dollar discussion to a later article, in which we can address treatment of old, pre-regulation plans as well as use of new arrangements after the Act in a more comprehensive fashion.

Estate Liquidity

Like so many other areas of tax planning, it can be somewhat challenging to discuss a topic like life insurance for estate liquidity after the Act in a way that meets the clients’ needs for a clear explanation that actually answers their questions before it exceeds their attention span. The more intuitive the explanation and the more it creates a kind of a heuristic thought process that leads the client to an informed decision, the better. 

While certainly not the only way to approach that discussion, one way to think about it is to group clients into one of two categories. The first category includes clients who own a so-called “illiquid and estate tax-sensitive” asset. A good example of such an asset is a family business, which, absent a source of liquidity, could be difficult for the family to maintain for reasons that could involve more than estate taxes. The second category is pretty much everyone else. You might further categorize these clients as either having no taxable estate now but maybe having one after sunset (if that happens) or having an estate that’s taxable now and always will be, assuming no complete repeal. 

A natural point of departure for the first type of client is whether the client will keep the business (or other asset) in the family or sell it to a third party or a management team. These are two very distinctive discussion tracks, each calling for its own set of planning applications and opportunities.

Keeping the business. Let’s start on the keep side and assume that this is de novo planning, meaning that it involves a potential new purchase of life insurance. The planner, the agent and the client’s other advisors should take off the filters and identify all of the needs for liquidity, not just estate tax. Those needs can include capital for the surviving spouse, equalization among business and non-business children and so forth. The team should also look down the field, as it were, to structure the insurance so that each premium dollar can help meet more than one need. For example, the same policy that would provide capital for the surviving spouse can also provide capital for equalization among business and non-business children or estate liquidity at the death of the spouse. 

Putting the spotlight on the impact of the Act on this type of situation, we may actually find that it doesn’t have much impact. Why? Because a careful study of the situation will likely uncover a constellation of needs, both tax and non-tax, which will pretty much exhaust the budget anyway. Of course, how the prescription is ultimately filled will depend on the size and composition of the estate, the extent of the transfer planning the client is willing to do, how quickly he’ll get it done and a host of other factors. In some circumstances, typically when the transfer planning will be robust enough and timely enough to reduce the liquidity need to a manageable level, the insurance prescription can end up being an artful combination or bifurcation of term and permanent insurance. In other circumstances, the need is so great and of such duration, that planning can only mitigate the liquidity need, not eliminate it. In those situations, term insurance won’t cut it. Regardless, the big mistake is to fail to coordinate the way the insurance is selected, designed, funded and paid for with the estate and business succession planning. But, that’s for another day and another article. 

Now let’s change the facts and assume that we’re keeping the business. Let’s further assume that there’s a lot of insurance in force. But, the client believes that the combination of the increased and indexed exemptions and his ability to do (more) GRATs and sales to IDGTs will take care of the liquidity problem nicely or at least make it manageable. 

The client is likely to ask why he shouldn’t be able to cut back on the insurance, maybe even substantially. The planner should be careful to avoid what appears to be a politically based and largely self-serving response, such as, “Well, you realize that these beneficial changes are only temporary and even before then, a new administration could…” A better response might be to take the client back to basics, much like we did with the new purchaser, not only sifting through the needs for capital and liquidity at his death (and the later death of his spouse), but also taking him through what the life insurance can do for him as a pure capital transfer vehicle and, maybe even as what we might call a “default estate plan,” in which the insurance does for him what he’s not willing to do for himself. 

The main point is to underscore the value of having the coverage in force, identifying the real risks of cutting the coverage back (or worse) and then trying to replicate it at a time when the underwriters are no longer favorably impressed by the client’s medical reports. The point is that it’s not just about liquidity for estate taxes; it’s about the policy’s value as a potentially irreplaceable financial tool for him and his family. Now, in fairness, the client could rightfully say, “OK, I get it. But, let’s assume that on Monday morning, I start all that planning that you and others have been talking to me about. Isn’t there some way that I can at least reduce my outlay for the coverage? Something has to give here!” Well, now, we could have some room to maneuver and maybe, if the policy itself has a flexible premium structure, the client could choose to reduce the premiums to the minimum required to support the death benefit until there’s more visibility about his needs, the tax law and the other factors that influence his decisions.

Selling the business. The sell the business side of the discussion was interesting before the Act and continues to be with the Act. But, the paradigm is different, and the discussion track is different. Here, we need to know enough about the facts and circumstances to know when a sale transaction would take place and to have a reasonable idea for just how liquid the client will be after the sale. Of course, there are those who’ll say, “What difference does it make, he still has a big estate and a big tax?” That’s true, but he no longer has an estate tax-sensitive asset, and maybe he doesn’t care how much of that large but liquid estate the children have to pay in taxes, and maybe he’s just done with the expense and complexity of all that planning and insurance. 

A line of inquiry that clients might find helpful is basically to ask them if there’s some critical mass of capital/estate that they think is enough, that is, needs to be protected from estate tax, whether through planning or insurance. After that, the children are on their own. In most cases, the clients are ready to give the answer to that question. It’s $X, and then enough is enough. In those cases, we’ll revisit the existing insurance portfolio or construct a new one that fits the bill. 

It will be interesting to see how many of these clients who become liquid will be interested in dealing with the complexity and cost of “second act” estate tax planning and providing for/maintaining the associated liquidity. It may be a bridge too far because it just won’t offer the value proposition that it used to, all things and families considered.

Planning for everyone else. By definition, they don’t have an illiquid estate tax-sensitive asset. Run the same analyses and ask the same questions as with the other clients. Determine the optimum timing for the liquidity, that is, how much liquidity at the client’s death versus at the death of the second of the client and surviving spouse to die. If the liquidity cost curve will eventually fade away, the client can layer the coverage with different products so the client won’t pay for liquidity he won’t need.

Capital Transfer

This topic can come into play when clients are considering new purchases (in their ILITs) as long-term investments. It can also come into play when clients wonder what to do with policies in their ILITs that are no longer needed for estate liquidity. 

Many wealthy clients are shown life insurance as a trust investment for pure wealth transfer. The primary advantage of this use of life insurance is that the internal rate of return (IRR) on the death benefit may be as good or better on a risk and attitude-adjusted basis as anything else the trust would invest in. This application of life insurance could be a worthy use of some (or all) of the increased exemption. Even if the concept of life insurance as an investment for the trust makes sense for a given client, there’s still an important role for policy selection and design. Often, the default tends to be a guaranteed universal life product because it locks in the IRR on the death benefit. But, depending on the performance specs of the particular product, the guaranteed nature of the locked-in IRR may not be as attractive to the client if it trades off other characteristics such as the potential for (more) robust accumulation of cash value that can be accessed on a tax-free basis by the trust for distributions to the beneficiaries (not the insured). 

The main point from a planning perspective is that the Act didn’t alter the fundamental tax advantages of cash value life insurance as either an accumulation vehicle or a wealth transfer vehicle. Therefore, clients might well find that it makes sense to use their expanded exemption to fund an ILIT for this purpose. Similarly, clients who aren’t sure what to do with policies no longer needed for liquidity might find that this strategic redeployment of their policies is something to consider.  

Problematic ILITs 

Advisors had better be ready to handle a lot of questions about ILITs in the coming months. Consider, for example, the client who created an ILIT 15 years ago. The ILIT bought a large policy to be used for estate tax liquidity, among other things. Think about all of the personal, financial and tax changes that could have occurred in that client’s life twixt the time the ILIT was created and today. It’s entirely reasonable (likely?) that for one or more of the following reasons, the client is now unhappy with the ILIT:  

• The client says, “I just don’t care anymore! Get me out of here!”—admittedly, we don’t know if we need an estate planner or a psychologist to get to the bottom of this one, but it may just be that the client is fed up with the year-to-year hassle and expense involved in the care and feeding of the ILIT. 

• The ILIT no longer fits the client’s needs or family situation—we’ve all seen this, many times over. 

• The client is no longer on speaking terms or has no business relationship with the trustee or an affiliate of the trustee. 

• The ILIT’s design/structure is causing gift/GST tax issues with the premiums. 

• The ILIT isn’t quite income tax defective enough, thereby precluding use of advantageous strategies to leverage gift (and GST) tax exemptions or perhaps solutions to problems with a split-dollar arrangement. Grantor trust status could be a critical part of fixing the problem, for example, maybe the next premium transfer is better lent to the ILIT than given.  

If the planner doesn’t already have it, he’ll need a copy of the ILIT. He’ll also need any gift tax returns reflecting how the premium gifts have been treated and how much gift tax/GST tax exemption the client/grantor (and his spouse) have left as of 2018. A critical inquiry will be whether (and how assuredly) the ILIT is a grantor trust and, if so, how and as to whom.

If the ILIT is to be undone in one fashion or another, what are the options for the undoing? This sub-topic easily merits an article (or treatise) unto itself. As a practical matter, there’s nothing new here to report purely as a result of the Act. What’s also not new or different is that if the client wants to migrate the policy from an ILIT he dislikes to another ILIT or even to some other form of ownership, he’s probably going to have to settle for the least bad choice. There’s no perfect wave here. 

Options from one side of the fix-it spectrum to the other can include: 

• Court reformation/non-judicial modification (if permitted under local law).

• Decanting (if permitted under local law).

• Distribute the policy to adult beneficiaries (if possible under the trust).

• Distribute the policy to a new ILIT created by the grantor for the same beneficiaries. However, state law must allow this policy distribution, and there could be fiduciary issues.

• Sell the policy to a new ILIT. The grantor could create and fund a new ILIT, which could purchase the policy from the old ILIT. The sale would be a transfer for value, but the new ILIT would be a grantor trust or a partner of the insured grantor, thereby alleviating the issue. Still, there are valuation and fiduciary issues to deal with.

• Sell the policy to the grantor. The grantor says, “OK, I understand that I can’t just get it back. I have to buy it. For how much?” The trustee says, “I’ll have to talk to my manager.” The transaction wouldn’t be a transfer for value because the sale is to the insured, but again, there are valuation and fiduciary issues to deal with. But, what’s the game plan after he owns it? Does he start all over again?  

• Have the grantor acquire the policy by way of a swap power in the ILIT. Yes, there are valuation issues to deal with, but not the same fiduciary issues.

Remember, the ILIT itself may be just fine. The problem may be with the policy. 

Need for ILIT

Clients may ask you why they need an ILIT with the increased exemptions. There’s no right answer to this question, but planners should have a template for a response. Before you suggest to someone that he lay out $2,500, $5,000, $10,000 or more and go through all the initial and ongoing hassle of an ILIT, ask some probing questions: 

• First, let’s put the numbers second. Is the client (really) sure that he won’t want or need access to the policy? Clients will be well served by staying away from ILITs unless there’s a clear, convincing case that they’ll never need or want that policy back. 

• Is the family situation functional enough to use anything irrevocable? Well, that depends on what the meaning of “functional” is. We’re not sure we can describe it, but we know it when we see it. 

• Is an ILIT worth the cost, hassle and risk that you could actually have to buy your own life insurance policy back? How much of a premium, forgive the phrase, is that ILIT really worth?

• The Act aside, is the ILIT really needed for estate liquidity? In all likelihood, the surviving spouse (who receives the proceeds tax-free anyway) will spend down so much of the proceeds over the rest of his life that the estate tax issue will take care of itself. In a lot of cases, that’s just what will happen! On the flip side, there are clearly cases when the ILIT makes all the sense in the world, in that it just doesn’t make sense to expose big bucks to the transfer tax system. But, you’ll need to have some rules of thumb to guide clients through this when it might be a closer call. 

The Act has renewed interest in spousal lifetime access trusts (SLATs) as a way to use the increased exemption without, shall we say, excessive decrease in control over a transferred asset. In this context, a husband can create a SLAT for his wife’s benefit and fund it with part of his $11.18 million gift tax exemption. During the wife’s lifetime, the trustee (who may be the wife) can distribute income and principal as needed to her for her health, education, maintenance and support. She can also have a “5x5” power and a testamentary limited power of appointment. Thus, the husband has “indirect” access to the trust’s income and principal. Well, maybe. When the wife passes away, the unappointed trust property passes estate tax free to the children. 

The SLAT could function as (and instead of) an ILIT. Here, the SLAT would be the applicant, owner and beneficiary of a policy on the husband. The trust uses the funding to pay the premiums. Once cash value develops, the trustee can access the policy by way of withdrawals and loans. But, the trust shouldn’t give the husband incidents of ownership in the policy! 

Beyond the IRC Section 2042 concern, SLATs present some issues. What happens if the wife dies or the parties get divorced? Does the husband lose his indirect access to the trust’s income and principal? Apparently so.

Financing Premiums

Now we’ll offer some observations about how you can help clients fashion sensible approaches to financing premiums on ILIT-owned policies, the term “sensible” meaning an approach that: (1) doesn’t snatch complexity from the jaws of simplicity, (2) looks for real economic (out-of-pocket) savings and not just tax savings,
(3) minimizes use of gift tax exemption, and (4) can have an exit strategy other than death.  

The stair-step approach. A client establishes the ILIT as an income tax defective trust and makes outright gifts of the premium to the ILIT, using annual exclusions and/or exemptions, depending on the situation, as well as on how counsel designed the trust.

As a general rule, the ILIT should be a grantor trust. Grantor trust status helps to avoid transfer-for-value issues if the grantor/insured sells a policy to the ILIT to avoid the 3-year rule. Revenue Ruling 2007-13 holds that a transfer to a grantor trust is a transfer to the insured.

If income-producing assets are gifted to the ILIT to provide cash flow to pay premiums, the grantor’s payment of the ILIT’s income taxes will be the equivalent of a tax-free gift to the beneficiaries of the ILIT. He defunds the estate without gift tax. Grantor trust status can facilitate transfers from one ILIT to another, that is, if both ILITs are grantor trusts, transfers between the two are disregarded for income tax purposes. Grantor trust status will eliminate income tax implications of a private premium split-dollar or premium financing arrangement. We’ll get back to this point, but it doesn’t hurt to mention it now because the more important it is to save exemption for step-up, the more valuable the ability to lend those premiums to the ILIT without income or gift tax consequences will be. 

While a discussion of how to make the ILIT income tax defective is beyond the scope of this article, planners will have to determine which grantor trust powers would give the client/grantor: (1) the most assurance that the trust is income tax defective, and (2) the most flexibility to do mid-course corrections without having to get a law degree or without his having to give everyone else the third degree. 

Once the ILIT is up and running and primed with the initial gifts, the grantor can use the increased exemption to make one or more substantial tax-free gifts of income-producing property to the ILIT, property that would be discountable if possible. Then, the client establishes a GRAT, which he funds with income-producing property. Taking GST tax into consideration, the GRAT names the ILIT as remainderman, so that at the end of the term, the property is distributed to the ILIT, which isn’t subject to the GST tax. 

The objective of these large transfers is to fund the ILIT with income-producing property on a gift tax-efficient basis, thereby enabling the ILIT to pay an increasing share of the premium with its own cash (the income tax on which is paid by the client). Every dollar of premium the ILIT can pay with its own cash is a dollar of taxable gift that the client won’t have to make. 

This approach tends to make a lot of sense to our clients who have a lot of cash-flowing investment property, especially if it can be put into discountable form. We can really save them a lot of gift taxes over the years by transferring that property, which many of the clients are otherwise prepared to give to the children anyway, into the ILIT.

Selecting the policy for the stair-step approach. Let’s consider the characteristics of a policy that are likely to appeal to a client using this strategy. For starters, a 15- or 20-year term policy will keep the early year premiums and taxable gifts low while the client funds the trust. Depending on how the future and the need for liquidity unfold, the trust can convert the term policy to a cash value policy. But, the trust might not need to convert if the dominoes fall in a certain order. 

If, as is likely, a cash value policy is or becomes appropriate, the planning team will have to work with the client to determine the characteristics of a policy that would align well with the way the client is implementing the stair-step strategy and the trend of the client’s liquidity need. The determination of those characteristics might include such considerations as the need for flexibility to change the premium as the ILIT is funded, the need for an increasing rather than a level death benefit and so forth. 

Selling the policy in a life settlement. The life settlement market has improved, the process is better understood and more transparent than ever before and the market has two tailwinds at its back: (1) the high and rising estate tax exemptions that render more and more policies expendable (at least for that particular reason), and (2) low crediting rates that are increasing the carrying costs of policies. An agent who’s well-versed in this market can help your client assess the marketability of a given policy and can explain the administrative regimen, both pre and post-sale, that’s involved. 

Some Inside Baseball

Here are some generalities (meaning there will be exceptions) used to determine marketability of a policy for a life settlement transaction:

• Can sell term, universal, variable, single life or second-to-die. 

• Life insurance company is sound.

• Policy has been in force for at least two years. 

• Face amount of $250,000+. 

• Premium shouldn’t be more than 5 percent of the death benefit and cash value not more than 15 percent to 20 percent of the death benefit. The less cash value vis-a-vis the death benefit, the better.

• Insured should be at least age 65 to 70, life expectancy of up to 12 to 14 years, smoker is better than non-smoker. 

• Policy issued on a more favorable underwriting basis than warranted, and insured’s health has since turned for the worse.

The bottom line is that the life settlement buyer is looking to buy a sound policy issued by a sound insurer that’s now underpriced because it was issued at a better rate class than the insured would get today and insures someone who will, unfortunately, accelerate the IRR.  

The operative guidance on the taxation of life settlements, which is Rev. Rul. 2009-13, essentially says that gain above basis is ordinary to the extent of the amount of inside build-up that would have been ordinary income on surrender and capital gains thereafter. The ruling held that the policyholder must reduce basis by the cost of insurance charges, but that was revoked retroactively by the Act. A point that should be made clear to the client/insured is that if the policy is owned by an ILIT and the ILIT is a grantor trust, the ILIT will keep the cash but send the tax bill to the grantor/insured.

Does the life settlement make sense? It depends. Does the client plan to spend the after-tax proceeds? If so, that might be the end of the discussion. But, if the client would invest the proceeds, run some scenarios to determine if the sale and reinvestment of the after-tax proceeds would leave a larger amount of money to the survivors than if the client kept (and kept paying premiums on) the policy. Ask the agent to show the lowest premium projected to support the death benefit to just beyond life expectancy. Compare the premium cost-adjusted death benefit from the policy to the after-tax result of investing the after-tax proceeds of the life settlement. When will crossover occur, that is, when will selling the policy yield a better net result than keeping it in force? Then recheck the numbers and ask, “What if…?”  

—Portions of this article were presented at a workshop given by the authors and Mary Ann Mancini, partner at Loeb & Loeb LLP in Washington, D.C., at the 52nd Heckerling Institute on Estate Planning in Orlando, Fla.