It’s no secret that deferral is the strategy underlying many a tax plan. And, for good reason. Most understand, at least on a general level, that the longer one can delay paying an obligation, the lower its effective cost. This intuitive mathematical truth is quantified in the investment world as the internal rate of return (IRR), which measures the present value of the investment (money in) against the present value of the return (money out). If the investment and return amounts remain constant, then the rate of return is higher when the time gap between those two events is shorter (for example, the investment is delayed)—a $100 investment in Year 1 for a $1,000 return in Year 10 produces a lower rate of return than a $100 investment in Year 5 for a $1,000 return in Year 10.

The same logic applies to deferring costs, and despite their perceived complexity by many practitioners, private split-dollar life insurance arrangements are, most simply, vehicles for deferral. In essence, they allow a grantor to fund a life insurance policy for the benefit of another while deferring the transfer tax cost of the premium gift until the arrangement ends, ideally when the policy funds and there’s new money with which to pay the tax. To be certain, the split-dollar regulations impose an intermediate cost for achieving this deferral, but even so, the rate of return boost remains impressive and is well worth the relatively minor administrative attention needed in setting up and monitoring the plan. Let’s examine how an adaptable split-dollar technique—so called “switch dollar”¹—minimizes the intermediate cost in a way that makes it the most efficient method of funding a trust-owned life insurance (TOLI) policy with transfer taxable dollars.²

Split Dollar Generally

Broadly speaking, “split-dollar life insurance” doesn’t refer to a type of insurance contract, but to an ownership and funding arrangement between two or more parties. In their early years, the arrangements were primarily used in the employment context, but private split-dollar arrangements have been used in estate planning for decades and increasingly so since new regulations took effect in 2003.³ Those regulations are lengthy and cumbersome, but the underlying concepts are relatively straightforward. In a common private split-dollar arrangement between a husband and wife (the grantors) and an irrevocable life insurance trust (ILIT), the grantors will provide the funding for a survivorship policy on their joint lives, for which actual ownership and all incidents of ownership will belong to the ILIT. Each premium payment made by the grantors under a split-dollar arrangement is then taxed according to the split-dollar regulations, which alter the default rule that the premium payments are presently taxable gifts in full.

The regulations provide two mutually exclusive tax regimes that apply to split-dollar arrangements with the right regime depending on the arrangement’s structure: the economic benefit regime and the loan regime. Because the parties control how they structure the arrangement, they’re effectively provided an election as to which tax regime they wish to engage. This election becomes particularly important in the context of the switch-dollar strategy, and the specifics of how the election is made are provided in the switch-dollar example below. 

Under either structure, all of the premiums funded by the grantors will ultimately be repaid to them when the arrangement ends, ideally out of the death benefit on the death of the surviving spouse. At that point, the receivable (in an economic benefit arrangement) or the loan balance (in a loan arrangement) will be included in the gross estate of the decedent grantor. Herein lies the transfer tax deferral—rather than being subject to gift tax at the time the premium is initially paid, the premium (frozen in the form of a receivable or loan) is subject to estate tax at the time the policy proceeds are ultimately paid and the split-dollar arrangement comes to an end.  

The benefit in real numbers looks like this: If grantors pay a premium of $100,000 for the benefit of the ILIT without a split-dollar arrangement, they’ll incur a gift tax of an additional $40,000, incurred the same year the premium is paid, for a total investment in Year 1 of $140,000. If the premium is paid under a split-dollar arrangement, the additional $40,000 cost is deferred until potentially decades later when the split-dollar arrangement terminates, the policy proceeds are paid to the ILIT and the $100,000 receivable/loan is included in the grantor’s estate, incurring a $40,000 tax. If the period of time between the premium payment and the grantor’s death is 25 years, the IRR (on a $1 million death benefit) is improved by 129 basis points because of the deferral.

As mentioned, to achieve the advantages of this deferral, the split-dollar regulations impose an additional, intermediate cost pursuant to one of the two split-dollar tax regimes. This additional cost is obviously a drag on the IRR boost achieved by the deferral, so the objective in structuring the arrangement is to ensure that the governing tax regime is the least burdensome of the two. That designation will largely depend on the grantors’ ages and marital status and will change as those factors change.  

Under the economic benefit regime, the intermediate cost comes in the form of any economic benefit provided by the grantors to the ILIT being treated as a taxable gift. There are only two economic benefits specifically named in the regulations: (1) any increase in cash value to which the ILIT has current or future access, and
(2) the cost of current life insurance protection provided to the ILIT.⁴ The cost of insurance (COI) economic benefit is calculated based on the insureds’ ages (getting more expensive as age increases) and the number of lives insured (insuring two lives is cheaper than insuring one).⁵ Thus, the COI for a young married couple can be extremely low (well below the actual premium paid), and the COI on a single elderly person can be extremely high (well above the actual premium paid).

Under the loan regime, the additional intermediate cost takes the form of real or imputed interest, as the premium payments are treated and taxed as loans from the grantors to the ILIT.⁶ There are no gift tax consequences in a loan arrangement so long as adequate interest is required by the terms of the loan (which should be formalized with a written note). There are likewise no income tax consequences to the grantors resulting from the interest (real or imputed), so long as the trust maintains grantor trust status.⁷

Case Study Comparison

With this general framework in mind, consider an example using real numbers. Suppose the ILIT purchases a $20 million second-to-die universal life policy on the lives of a husband and wife, each 65 years old, and each with standard underwriting risks, for an annual premium of $200,000. An important side note regarding the policy’s structure: To maximize the strategy’s return, the policy should be structured toward a death benefit return rather than cash value growth. In such a structure, the purpose of the cash value is solely to ensure that the policy stays in force for the desired
duration—perfect efficiency would be for the cash value to equal $1 the moment before the surviving spouse dies, but planning for the perfect is obviously ill-advised. The prudent structure is to design the cash value to last several years past the couple’s joint life expectancy using conservative interest rate assumptions and monitoring the policy at least annually to ensure it remains in line with projections and changing health circumstances.  Using the cash value as a vehicle for tax-deferred growth would not only be counterproductive in this strategy (because it would drag on the death benefit return), but also would be a wasted endeavor, because the cash value is inaccessible to the grantors as an asset of the ILIT outside of their estates.

No Split-Dollar Strategy

As a starting point, imagine no split-dollar strategy is implemented, and the grantors simply gift the $200,000 to the ILIT to pay the premiums. At a 40 percent gift tax rate, the total annual out-of-pocket cost to the grantors would be $280,000. If the surviving spouse dies at the end of Year 25, at age 90, the after-tax IRR⁸ on the net death benefit paid to the ILIT is 7.32 percent.⁹

As another point of reference, if the same $280,000 annual outlay were instead invested inside the grantors’ estates and earned a generous after income tax return of 6.5 percent (a pre-tax return of 10 percent assuming a flat 35 percent income tax rate), the IRR on the net-to-heirs amount after a 40 percent estate tax in Year 25 would be only 5 percent. Clearly, a lion’s share of improvement comes through isolating assets—in this case an insurance policy—outside of the estate. The distinction between funding premiums through a private split-dollar arrangement as opposed to outright gifting is a fine-tuning of an already hugely beneficial strategy.

Generic Economic Benefit Split Dollar 

As mentioned, the split-dollar regulations alter the general rule that the $200,000 premiums will be taxable gifts in full by applying either the economic benefit regime or the loan regime, depending on how the parties structure ownership of the policy within the context of the split-dollar arrangement. To engage the economic benefit regime, the ILIT can own the policy (and all incidents of ownership), but the grantors must retain the right through the split-dollar agreement to be repaid the greater of the total premiums paid or the cash value of the policy. This “greater of” provision will ensure that the only economic benefit provided to the trust is the cost of current life insurance protection—the essential trait for engaging the economic benefit regime when the trust owns the policy.¹⁰ In practicality, if the policy is structured toward death benefit as described above, the cash value should remain below the value of the total premiums paid for most if not the entire life of the policy, such that the latter amount represents the receivable created by the split-dollar arrangement, and the cash value is largely made irrelevant. Thus, the gift tax on the premium is converted into an estate tax on the receivable and is thereby deferred until the arrangement ends.

In the meantime, each year, the grantors will be deemed to have gifted to the trust the economic benefit of the cost of current life insurance protection. That amount is calculated based on rate Table 2001, with appropriate adjustments made to account for the second-to-die nature of the policy.¹¹ In our hypothetical, the economic benefit generated in Year 1 is $3,704. The gift tax on that amount ($1,482) represents, in substance, the intermediate cost imposed by the economic benefit regime for achieving one year’s worth of deferral on the transfer tax due on the premium gift.   

This structure works wonderfully while the annual cost of insurance gift remains low; however, that luxury gradually deteriorates as the insureds get older and then ends abruptly when one spouse dies and the benefit is calculated based on a single-life rate. In our example, if we assume the husband dies at age 85 in Year 20, the economic benefit amount for the following year increases from roughly $10 per $1,000 of insurance to just over $99 per $1,000. That equates to an economic benefit value increase of over $1.4 million dollars in that year alone. The benefits of deferring the transfer tax on the premiums are soon vaporized by this heightened intermediate cost.   

Generic Split-Dollar Loan

The loan regime would avoid the poor result the economic benefit regime produces in the later years. The parties engage the loan regime simply by designating the trust as the owner of the policy and establishing that the premium payments by the non-owner grantors will be repaid to them in such a way that the payments represent genuine loans secured by the policy.¹² All of the income and transfer tax laws applicable to loans generally will apply, with some favorable regulatory adjustments to accommodate the unique nature of the split-dollar arrangement. This means the parties have options in setting the terms of the loan, with the tax treatment varying widely with each distinction. The factors controlling such treatment are essentially: (1) the loan term (demand or term certain); (2) the interest obligation (whether interest is charged, and if so, how much and when); and (3) if the interest obligation results in the loan being below market such that Internal Revenue Code Section 7872 applies, the nature of the loan as a gift, compensation or dividend. It’s beyond the scope of this article to discuss the complete range of outcomes possible, but it’s worthwhile to lay out the workings of a few structures typical in private split-dollar arrangements, limiting the differences between them to how each addresses interest.

Several assumptions with respect to our example should be made at the outset to allow for a manageable discussion. First, in a private split-dollar loan arrangement among family members for estate-planning purposes, assume any foregone, waived or forgiven interest will be in the nature of a gift. Further, assume a typical structure, unique to split-dollar arrangements, in which the term of the note will be for the life of the insureds—a so-called “hybrid” loan. The obvious benefit of tying the term of the loan to the death of the last insured is that the repayment obligation and the source of funds used to satisfy the obligation are synchronized. Most importantly, the transfer tax on the premium payments is thus deferred to the same extent as with the economic benefit arrangement—to the last death of the insureds. 

Lastly, assume that the ILIT is a grantor trust at all times with respect to the lender and that the income tax consequences of the loan can therefore be ignored.¹³ As with any loan the term of which could extend beyond the life of the grantor, maintaining wholly grantor trust status for the entire term is no guarantee; if the trust is structured as a grantor trust with respect to one spouse (such spouse being the sole lender), there’s the clear chance that the grantor spouse could be the first to die, in which case the grantor status of the trust would end, and the interest would be fully taxable income for the remainder of the term. Alternatively, if the trust is structured as a joint grantor trust with both spouses (and with both acting as lenders), when the first spouse dies, the trust will become a half-grantor trust, in which case, presumably, one-half of the interest income to the surviving lender will be recognized and one-half ignored. With spouses of similar health and age (as in our example), the probability of the wife outliving her husband is high enough to justify structuring the trust to be a wholly grantor trust with respect to the wife only and to have her be the sole lender. Our example will assume such a structure. A case-by-case analysis should always be made to determine if the probabilities of one spouse outliving the other favor using a single-grantor trust or if prudence would suggest hedging the risk of the grantor dying first by using a joint grantor trust.

With all the above assumptions clarified, the question becomes what to do about interest—first, should it be charged, and second, should it be paid? As with most other loans,¹⁴ IRC Section 7872 will apply to the extent the split-dollar loan doesn’t provide for sufficient interest. The regulations provide that a hybrid loan is tested for sufficient interest under Section 7872 as if it’s a term loan, with the term being the life expectancy of the insureds.¹⁵ This means that in addition to the maximum deferral of the principal repayment, the hybrid loan structure allows for the lowest, predictable intermediate cost for the deferral given today’s low interest rate environment. In our example, the joint life expectancy of the insureds is 25 years,¹⁶ which means the loan will be measured by a historically low, long-term applicable federal rate (AFR).

It’s important to note that each premium payment made by the grantor spouse will be considered a new, separate loan measured by the AFR that applies at the time the loan is made. Rather than creating a separate loan for each premium payment, the better strategy may be for the grantor to make a lump sum loan to the ILIT in the first year in an amount expected to cover the total premiums scheduled under the policy.¹⁷ The amount loaned should anticipate that the ILIT is able to earn a reasonable after-tax return on the principal and should therefore be less than the gross sum of the projected premium payments. The one-time loan locks in a low, long-term AFR, and by depositing the loan proceeds with the trust rather than paying them directly into the policy as a single-pay premium, the trust maintains control over the timing of the premium payments and can avoid classification of the policy as a modified endowment contract.¹⁸

In a high interest rate environment, it may be better over the long term to structure the loan as a demand loan, which uses the blended annual rate¹⁹ (based on the short-term AFR) to take advantage of falling interest rates over time. A similar strategy would be to use a note with a term of just less than three years. This would lock in the lowest AFR available at the time the loan is made, thereby avoiding short-term hikes in rates during the term, but would still take advantage of an overall downward trend in interest rates as the note is reissued at a new AFR at the end of each term.

As previously mentioned, if sufficient interest is charged and paid, there are no gift tax implications, and if the interest paid by the trust to the grantor is spent, transfer taxes on the interest are avoided altogether. The drawback to this structure is that the ILIT will need its own assets with which to pay the interest—a not entirely common scenario.²⁰

A better method may be to have the interest accrue, compound and ultimately be paid out of the death benefit when the arrangement ends.²¹ This is a seemingly ideal option because it avoids gift tax liability on the interest and obviates the need for the trust to find funds with which to pay interest as it waits for the death benefit proceeds. Such a loan would implicate the original issue discount (OID) rules of IRC Sections 1271 through 1274, which would typically force the lender onto the accrual method of accounting for reporting the interest as income each year; however, as a loan between a grantor and a grantor trust, the loan arrangement is ignored from an income tax perspective altogether.²²

What would be the income tax treatment of the deferred interest at the death of the grantor, which is the event that simultaneously triggers the repayment of the loan and ends the grantor status of the trust? A lack of direct authority makes it difficult to know with certainty how this repayment would be treated, but the most persuasive view is that there should be no income tax consequence to either the grantor’s estate or the trust for any of the accrued interest other than what accrues in the year of the grantor’s death. This result follows from the fact that income in respect of a decedent (IRD) only includes items of gross income of the decedent that weren’t properly includible in the decedent’s taxable income pre-death.²³ OID that’s accrued in years prior to the decedent’s death isn’t considered IRD because it was includible in pre-death income but rightly ignored under the grantor trust rules. OID accruing in the year of the decedent’s death, however, should be taxable because the decedent died before that interest ever had the opportunity to be ignored.

If it doesn’t make sense to pay the interest with other assets of the trust or to accrue and compound the interest, the loan can be structured so that interest is gifted to the trust by the lender/donor. Here again, we can draw distinctions. First, the parties can intentionally structure the loan as a below-market loan charging no interest. For gift tax purposes,²⁴ the regulations provide that the difference between the present value of all payments required under the loan (discounted at the appropriate AFR) and the total amount loaned is treated as having been transferred (as a gift in our case) from the grantor/lender to the ILIT/borrower in the year the loan is made.²⁵ Thus, with a below-market gift term loan, the transfer tax on the principal is deferred, but the transfer tax on all of the potential interest—the intermediate cost—is accelerated into the year the loan is made. This is clearly an undesirable result not only because the acceleration causes a hit to the rate of return (the opposite effect of deferral), but also because should the insured die earlier than his life expectancy, the gifted interest amount in the first year will have been an overpayment—a present value calculation that assumed a term of years longer than what actually occurred.

A better gift term loan structure using a unique provision of the split-dollar regulations allows the bunching rule of Section 7872 to be sidestepped. Instead of structuring the loan as a below-market loan, assume the note provides for sufficient interest at the long-term AFR that’s to be paid annually. This provision takes the loan out of Section 7872 altogether, so there’s no deemed lump sum gift in the first year.²⁶ If the grantor/lender subsequently forgives the interest due each year, subparagraph (h) of Treasury Regulations Section 1.7872-15 controls,²⁷ providing a deemed transfer from the borrower to the lender for the forgiven interest (interest income but for the grantor trust status) and a retransfer of the forgiven interest back to the borrower, as a gift, at the time of the forgiveness.²⁸ Typically, the amount of the gift retransferred to the trust would be increased by a deferral charge,²⁹ but the deferral charge is avoided in the case of a nonrecourse split-dollar loan in which the parties have filed a written representation with their respective income tax returns each year a loan is made, stating “that a reasonable person would expect that all payments under the loan will be made.”³⁰ Thus, the nuances of the split-dollar regulations offer some additional deferral over the traditional Section 7872 gift loan because the gift of the interest isn’t bunched into the first year, but is spread into multiple transfers over the life of the loan on an annual basis.  

To sum up the loan regime treatment, the transfer tax on the premiums is effectively deferred until the note is repaid out of the policy death benefit to the decedent’s estate. The intermediate cost of this deferral is the interest, or rather, the transfer tax on the interest. This cost should never experience the sort of rapid escalation seen with the economic benefit regime that makes it untenable in the later years, but it would be more expensive than the economic benefit structure in the early years when the COI is low, even under today’s extraordinarily low interest rates. Thus, in a scenario like our case study involving a married couple with a relatively long joint life expectancy, neither the economic benefit regime nor the loan regime is particularly attractive standing alone—each has its unique drawbacks.

Switch-Dollar Strategy

The switch-dollar strategy attempts to mitigate the downside of each tax regime by using both, at different times. It’s distinguished from a generic private split-dollar strategy by beginning with an economic benefit structure between the wife and the trust³¹ and pivoting to a loan structure at a time that ensures that the tax regime governing the arrangement is always the one with the lowest intermediate cost—economic benefit amount versus loan interest. This pivot almost invariably occurs on the death of the first spouse, when the economic benefit of the cost of current life insurance would switch from a two-life calculation to a much more expensive single-life calculation, based on the survivor’s then age, but could happen earlier in a low interest rate environment with older grantors.  

The switch doesn’t happen automatically, but requires the parties to take some action. Assume again that the husband dies at age 85 in Year 20. At this point, the wife and the ILIT should agree to terminate the original split-dollar agreement. By doing so, the $4 million receivable generated by all premiums paid³² by the wife in this 20-year period under the economic benefit regime will become due to her. Rather than paying the obligation outright, the ILIT should issue a note to the wife for the full amount at the appropriate AFR based on the wife’s then life expectancy.³³ A loan transaction between the wife and the grantor trust should be ignored such that interest on the note won’t generate any income tax liability during the term of the note. From a gift tax perspective, assuming she forgives the interest on an annual basis as discussed above, a gift tax will be owed each year on the forgiven interest. Alternatively, gift taxes are avoided to the extent adequate interest is paid by the trust yearly or accrues and is paid out of the death benefit. The wife may then continue paying the insurance premiums, each payment representing a new loan to the ILIT at the then appropriate AFR.³⁴

The switch from the economic benefit regime to the loan regime avoids the substantial increase in the economic benefit based on the single-life cost of insurance calculation after the death of the first spouse and keeps the intermediate cost manageable—and in today’s interest rate environment, downright attractive—for the remainder of the surviving spouse’s life. At the surviving spouse’s death, the loan balance is included in her gross estate, leaving 60 percent of that amount, plus the remaining death benefit proceeds passing outside of the estate to the ILIT.  

Under our facts, assuming the initial loan and all subsequent loans are gift loans at a 5 percent AFR and assuming as before that the surviving spouse dies at age 90 in Year 25, the switch-dollar strategy results in an after-tax IRR of 8.31 percent—a nearly 100 basis point improvement from the grantor’s outright gifting of the premiums.³⁵ If the initial loans and all subsequent loans use accruing and compounding interest rather than gifted interest, the after-tax IRR is further improved to 8.38 percent.

Switch Transfer Tax Consequences 

Finally, practitioners need to be aware that several provisions of the final regulations may trigger a deemed transfer of the policy for federal transfer tax purposes³⁶ as a result of the switch.  

One set of provisions applies to conversions of non-equity economic benefit arrangements to equity arrangements and another to conversions of non-equity economic benefit arrangements to loan regime arrangements. These provisions are an attempt to treat the net value of the policies subject to these arrangements (their value—however determined—net of the obligation to the premium provider) as a transfer for federal transfer tax purposes.³⁷

The first set of regulations³⁸ applies to the termination of the non-equity economic benefit regime arrangement and creation of an equity arrangement as a substitute arrangement. Those provisions treat a modification of an economic benefit regime arrangement that provides no benefits to the owner of the policy in addition to current life insurance protection (a non-equity arrangement) to one that does (an equity arrangement) as a deemed transfer of the policy to the owner for transfer tax purposes. Subsection (3) of that section then treats the successor split-dollar arrangement that has the effect of providing such other benefits as a “modification” of the prior split-dollar arrangement.  

It’s unclear how those provisions would apply to the switch, when a non-equity economic benefit regime arrangement is terminated and replaced not by an equity economic benefit arrangement, but by a loan regime arrangement in which, arguably, any other benefits provided under the arrangement are “accounted for” by the loan interest. Again, these provisions are arguably inapplicable because they assume a conversion of one economic benefit arrangement into another, but should be noted.

Even if those provisions wouldn’t apply to our switch, however, the other regulation provision³⁹ provides that a “deemed” transfer of the ownership of a policy occurs for federal transfer tax purposes when a party to an economic benefit split-dollar arrangement who or which is treated under the regulations as a non-owner of a policy,⁴⁰ in our case, the trust, becomes treated as the policy owner under the regulations,⁴¹ which is the result of the switch.⁴² Note that this provision treats the policy as transferred by the donor to the trust, despite the fact that the trust has actually owned the policy from inception, so there never was an actual transfer of policy ownership from the donor to the trust for transfer tax purposes. It may not be clear that such a deemed transfer will be recognized for gift or generation-skipping transfer tax purposes; however, it’s a provision that must be considered in planning for the switch.

Presumably, the value of the transfer would be determined by the policy’s gift tax value, under the Section 2512 regulations; however, this may be a situation in which it would make sense to consider hiring an appraiser to value the policy for transfer tax purposes, if the interpolated terminal reserve value of the Section 2512 regulations produces an unreasonably high value. In any event, the value of the policy for federal transfer tax purposes (however determined) would be totally or partially offset by the amount due to the donor under the prior arrangement.⁴³ The best practice would be to determine the potential federal transfer tax result of the switch under this provision prior to the switch, and, if the federal transfer tax of the value of the policy, net of the amount due the donor, isn’t reasonable, consider borrowing against the policy⁴⁴ prior to the switch to reduce its net value.⁴⁵

Tax-Efficient Funding

Tax efficiency is, in the end, a math problem and is within the lawyer’s basket of responsibilities, like it or not. Very often, a TOLI policy can be most efficiently funded without the need for a split-dollar arrangement: through the use of annual exclusion gifts, income-generating assets already owned by or to be sold or gifted to a trust or other similar strategies. But, when the only practical alternative for funding the policy is through a presently taxable gift, efficiency (and a higher rate of return) favors strategies that defer tax liability. On those occasions, appropriately structured private split-dollar arrangements prove their appeal.                

Endnotes

1. See Lawrence Brody and Richard L. Harris, “Private Split-Dollar Arrangements,” Trusts & Estates (May 2010), at p. 42 (referring to the switch-dollar technique as a possible exit strategy of a traditional economic benefit arrangement).

2. It nearly goes without saying that a taxpayer’s circumstances could allow for premiums to be funded for the benefit of an irrevocable life insurance trust (ILIT) without any transfer tax drag, for example, through the use of annual exclusion gifts to a Crummey trust, if there are enough beneficiaries to allow the exclusions to cover the premium or use of his now increased gift (and generation-skipping transfer (GST) tax exemptions). Split dollar is best used by taxpayers whose annual exclusions and gift (and GST) tax exemptions are being used in other strategies, so that funding premiums without a split-dollar arrangement would require taxable gifts in full.

3. Treasury Regulations Sections 1.61-22 and 1.7872-15.

4. Treas. Regs. Section 1.61-22(d)(2). The regulations allow for a third, unnamed category of economic benefit that isn’t properly described by either of the first two categories.  

5. See Treas. Regs. Section 1.61-22(d)(3)(ii) and Notice 2002-8, which remain the authority for valuing the cost of current life insurance protection based on Table 2001, with “appropriate adjustments” to be made in the case of a survivorship policy. 

6. Treas. Regs. Section 1.7872-15(a)(2)(i).

7. See generally Revenue Ruling 85-13. 

8. All internal rate of return (IRR) figures contained in this article are net of all income and transfer taxes.

9. This calculation includes a $240,000 gross estate inclusion for gift taxes paid on the premium gifts in the three years prior to death per Internal Revenue Code Section 2035(b). The total return is therefore: $20 million - (40 percent x $240,000) = $19.904 million.

10. See Treas. Regs. Section 1.61-22(c)(1)(ii)(A)(2), which provides that the economic benefit regime applies to an arrangement in which a non-owner is the payor, only if the owner (that is, the ILIT) is given the cost of insurance economic benefit. If the ILIT, as the owner, receives any other economic benefit, the loan regime will apply, or the premium payments by the grantor will be outright gifts. In Estate of Morrissette, 146 T.C. No. 11 (April 13, 2016), the Tax Court found that “where a donor is to receive the greater of the aggregate premiums paid or the CSV of the contract, the possibility of the donee receiving an additional economic benefit is foreclosed.”  

11. Notice 2002-8, footnote 5. Most practitioners consider the “Greenberg to Greenberg” formula to be an appropriate adjustment to the Table 2001 rates, and it’s been used for such purposes because the letter in which it was formulated was written in August 1983. The formula multiplies the two spouses’ individual rates together, then multiplies that figure by 1.025, divided by 1,000.

12. Treas. Regs. Section 1.7872-15(b)(2).

13. See generally Rev. Rul. 85-13, footnote 7.

14. See IRC Section 7872(c) for a list of the types of loans to which Section 7872 applies.

15. Treas. Regs. Section 1.7872-15(e)(5)(ii). For example, if the insureds have a joint life expectancy of more than nine years under Treas. Regs. Section 1.72-9, Table IV, the appropriate rate is the long-term applicable federal rate (AFR) at the time the loan is made.

16. Treas. Regs. Section 1.72-9, Table IV, for two 65-year-old insureds.

17. The fact that the lump-sum loan to the ILIT will be larger than necessary to make an individual premium payment won’t remove the loan from the purview of the split-dollar regulations. All the elements of a split-dollar loan provided in Treas. Regs. Section 1.7872-15(a)(2)(i) are present: (1) a payment between a non-owner and an owner; (2) the payment is a loan under general principals of federal tax law or a reasonable person would expect the payment to be repaid in full to the non-owner; and (3) the repayment is to be made from or is secured by, the policy’s death benefit proceeds, the policy’s cash surrender value or both.

18. See IRC Section 7702A. Not only will a single-pay premium create a modified endowment contract, but also it will produce a lower IRR than spreading the premium payments over the life of the policy.

19. Treas. Regs. Section 1.7872-15(e)(3)(ii).

20. Per Treas. Regs. Section 1.7872-15(a)(4), if the interest paid by the trust is provided by the lender, the interest provisions will be ignored and the loan will be treated as a below-market loan under Section 7872. 

21. Of course, if the grantor/lender specifically devises the note (which at death will be due and payable) to the ILIT, then the obligation disappears altogether, leaving the ILIT with the loan proceeds net of the estate tax liability they generate. Any discharge of indebtedness income to the ILIT is exempt under IRC Section 102. See Private Letter Ruling 9240003 (June 17, 1992).

22. See generally Rev. Rul. 85-13, footnote 7.

23. Treas. Regs. Section 1.691(a)-1(b).

24. Treas. Regs. Section 1.7872-15(e)(5)(iv)(D). For income tax purposes, the interest is deemed transferred and retransferred on a yearly basis as if the loan were a demand loan, but at the AFR appropriate for the term of the loan rather than the blended annual rate. Treas. Regs. Section 1.7872-15(e)(5)(iv)(B). Because the case study example assumes grantor trust status, the income tax treatment of the loan is ignored.

25. Treas. Regs. Section 1.7872-15(e)(4)(iv).

26. Treas. Regs. Section 1.7872-15(e)(5)(i)(B).

27. Treas. Regs. Section 1.7872-15(f)(1), last sentence.

28. Treas. Regs. Section 1.7872-15(h)(3).

29. Treas. Regs. Section 1.7872-15(h)(1)(i). See (h)(4) for calculation of the deferral charge.

30. Treas. Regs. Section 1.7872-15(h)(1)(iv). See (d)(2) for the requirements of the written representation.

31. Again, our example assumes the parties have structured the trust to be a wholly grantor trust with respect to the wife only. Therefore, no contribution to the trust should be made by the husband, a non-grantor.

32. Assuming the premiums advanced exceed the policy’s then cash value.

33. If the parties had chosen to structure the trust as a joint grantor trust, then the economic benefit arrangement would have been between the trust and both spouses, and the husband would have generated a receivable of $2 million, representing the premiums paid by him prior to his death (one-half of the total premiums paid). That receivable would be included in his gross estate and should be specifically devised in his will. See Morrissette, supra note 10, discussing the disposition of an economic benefit regime receivable. It’s important for purposes of the switch-dollar strategy that the receivable pass to his wife, taking advantage of the marital deduction and therefore generating no estate tax. The wife would then become the holder of the entire receivable for all premiums paid by both her and her husband under the economic benefit regime ($4 million in total) and can proceed with the loan transaction with the now one-half grantor trust, reporting one-half of the interest income generated thereby. 

34. Alternatively, if the AFR at that time is particularly attractive and expected to rise, she could make an additional lump sum loan for an amount necessary to cover the remaining premium payments.

35. This calculation includes a $288,000 gross estate inclusion for gift taxes paid on the interest gifts in the three years prior to death per IRC Section 2035(b).  

36. This applies for both gift, and in appropriate cases, GST tax purposes.

37. This isn’t unlike the treatment of pre-regulation equity economic benefit arrangements when they’re terminated—the equity is considered transferred for tax purposes; of course, there was no equity in this arrangement to begin with so what the regulations deem transferred is the net value of the policy, not the equity.

38. Treas. Regs. Sections 1.61-22(c)(ii)(B)(1) and (2).

39. Treas. Regs. Section 1.61-22(c)(3).

40. Because the premium provider is treated as the policy owner under the exception for non-equity economic benefit collateral assignment arrangements in a donor/donee context.

41. Because the exception that treats the premium provider as the policy owner in a non-equity collateral assignment arrangement would no longer apply after the switch (under the loan regime, the actual policy owner is treated as the owner).

42. Note that this is a deemed, not an actual, transfer of the policy; accordingly, there will be no potential transfer for value issue under IRC Section 101(a)(2) as a result of such a deemed transfer.

43. Although note that if the switch occurred at an older age for the surviving insured, depending on the type of policy, the unborrowed value of the policy for transfer tax purposes could be well in excess of the amount due the donor.

44. Note that, as discussed in the text and in endnote 40, this is a deemed, not an actual, transfer of the policy so that the loan could exceed the owner’s basis in the policy, without triggering gain under the theory of Rev. Rul. 69-187. 

45. Any such policy loan will be deducted from the policy’s interpolated terminal reserve value on the Form 712 issued by the carrier; although the IRC Section 2512 regulations don’t provide for such a deduction, the Form 712 itself and the instructions to it do so.

   Also, note that the example discussed in this article assumes that to the extent the switch creates a deemed transfer of ownership of the policy, the transfer is fully offset by the note from the ILIT; therefore, the IRR calculations don’t assume any additional transfer taxes resulting from the switch. Alternatively, in many cases, the increased gift and GST tax exemptions would exceed the net value of the policy.

Within hours of the passage of the 2017 Tax Cuts and Jobs Act (the Act), the blogosphere lit up with articles about how provisions in the Act would suddenly induce more life insurance policy owners (POs) to do a life settlement—a transaction in which the PO sells his existing policy to an unrelated third party for a cash amount greater than the surrender value and less than the death benefit. POs have a legal right to sell their existing life insurance in the regulated and institutional secondary market; however, for many, it’s an unknown option. For almost a decade, the life settlement industry has worked with regulators, lobbyists and consumer advocates to educate the public about life settlements as a way to turn an unrealized asset into a means to pay for an individual’s retirement or caregiving needs.  

Two provisions in the Act, the doubling of the estate tax exemption and more favorable tax treatment for the PO selling his policy, are the reasons the life settlement community is excited about the Act. What are the implications for estate-planning professionals advising senior clients? 

Estate Tax Exemption

The Act increased the estate tax exemption to $11.18 million per individual and $22.36 million for married couples and is expected to increase life settlement activity. Because life insurance has long been the cornerstone of estate and tax planning for high-net-worth (HNW) individuals, insurance and estate-planning professionals may have clients who decide they no longer need the insurance coverage for its original purpose, which was to protect their estates. Clients thus will benefit from knowing how much their policy is worth if they sold the policy as a life settlement for fair market value (FMV). The life settlement market provides, on average, eight times more than the surrender value to POs. Prior to a PO deciding to surrender or lapse a policy, documenting a file on the secondary market value of the policy will provide clarity of the viability of a life settlement as a potential exit strategy. As advisors discuss new planning applications for the insurance coverage post-Act, they may need to get answers to several questions if planning leads to the exploration of all available non-forfeiture options: 

• What are the tax ramifications to the PO under the Act when the policy is sold?

• What’s the likelihood of the insured(s) outliving the 2026 sunset period?

• What if the insured lives 20 percent to 30 percent longer than expected? How much more premium would need to be set aside or in reserves? Are those dollars being taken away from other planning areas?

• Does the policy provide an important benefit to the PO and/or beneficiaries above and beyond offering estate protection that may no longer be needed?

• Can the benefit previously needed for estate protection now be donated to charity? Will it be a potential burden, or can it provide an immediate cash benefit to the charity? How do you determine present value?

• How does the life settlement value compare to the policy surrender value? If it’s greater, does that open up new planning scenarios?

• Is maintaining premium payments in the best interest of the PO compared to other options? Could the proceeds of a settlement and reallocation of the premium payments provide more value to the plan?

• Does my client’s convertible term insurance policy have value on the balance sheet for an amount greater than $0? Would an unexpected influx of cash have a benefit?

• Would my client benefit from selling part of the policy while retaining a portion of the benefit?

While the increased estate tax exemption in the Act impacts only a segment of HNW clients, it follows on the heels of the 2012 American Taxpayer Relief Act (ATRA), which increased the estate tax exemption from the previous level. We saw an uptick in POs wanting to sell all or part of their permanent or term life insurance when ATRA was enacted in 2012, and we’re seeing the same increase in life settlement activity as a result of the Act. The life settlement market benefits seniors more than any other age group, which is why there’s seemingly an increase in activity after favorable estate tax laws are passed. 

Tax Treatment for Life Settlements 

In 2009, a much-anticipated revenue ruling was released regarding the tax consequences of a life settlement (Rev. Rul. 2009-13). Many advisors felt that the revenue ruling would create awareness of this option for POs, as well as result in dignifying its place in the planning community. Instead of bringing clarity to financial professionals, advisors and their clients on the tax treatment of the sale of the policy, more questions than answers were uncovered in this emerging market.

The problem created by the revenue ruling was that tax treatment for policy sale was treated differently from the tax treatment for a policy surrender, which hampered policy sales, negatively impacted consumer confidence and made it more difficult for advisors to calculate taxes for life settlements. The ruling imposed a formula on life settlements for calculating basis that required deducting the cost of insurance (COI) from the policy’s tax basis. COI is a calculation that one would think is provided by the insurance carrier; however, it became abundantly clear that wasn’t a common practice. Advisors hit road blocks in their planning and often had to gather dozens of policy statements from past years to piece together their analysis. Many felt it was extremely difficult, if not impossible, to obtain. On the other hand, when a PO surrendered a life insurance contract, there were no such penalties or convoluted formulas imposed on the client. 

The Act eliminates the requirement to remove COI from the cost basis of a policy sale, thereby putting life settlements on a level playing field with other non-forfeiture options, such as a policy surrender:

Under the new law, effectively only the Section 72(e)(6) calculation will be used to determine cost basis or investment in the contracts. The retroactive effective date of the cost basis change may provide refund or recalculation opportunities for holders of contracts that were subject to a cost basis adjustment. Clearly, such opportunities will depend on the facts and circumstances of the transaction and consideration must be given to whether the applicable tax years are already closed.¹

What does this really mean for clients who sell their life insurance policy on the secondary market? One benefit is a significant tax savings for the PO/seller. For universal life and term insurance policies, COI represents most, if not all, of the premiums paid. Now the premiums paid—which include COI—equals cost basis, thereby lowering the total tax obligation resulting from a life settlement. Another benefit is a more simplified tax calculation for tax professionals without the unnecessary obstacle of trying to determine the COI. (See “Prior vs. Current Methodology,” this page.)

Ultimately, the revision to Rev. Rul. 2009-13 will bring more clarity to planning professionals and the clients they serve. With an aging population that’s faced with the realities of outliving their savings and searching for ways to fund their independence and long-term care needs, life settlements might be the option that helps find the liquidity needed to solve today’s issues. An ancillary benefit will also be freeing up the mental and financial bandwidth of their adult children who won’t have to reallocate their planning dollars to fund their parent’s needs. Instead, these 40 to 60 year olds will be able to focus on their own planning needs so they can avoid the complicated consequences of outliving their own financial plans. 

Practice tip: When discussing life insurance scenarios and exit strategies as a result of the Act, be sure to secure an appraisal of FMV to make sure you consider all options.   

Endnote

1. https://taxnews.ey.com/news/2018-0027-president-signs-tax-reform-bill-with-numerous-changes-affecting-the-insurance-industry.

With the passage of the Tax Cuts and Jobs Act of 2017 (the Act) and the doubling of the gift, estate and generation-skipping transfer (GST) tax exemptions, only the smallest percentage of clients are now subject to the estate tax. However, clients face an unstable planning environment that likely represents the new normal. As we move into the future, income, gift, estate and GST taxes can be expected to seesaw back and forth as the political party in control of our federal government changes. Fortunately, we’re in the Golden Age of estate planning, and the full range of wealth transfer planning strategies and favorable factors remain unaffected by the Act.¹

Although generally, ultra-wealthy clients continue to plan, the Act created a substantial group of high-net-worth (HNW) clients who don’t currently have an estate tax. One of the unintended consequences of the higher exemptions is that many of these clients feel that they can defer planning. The easy answer is that the changes are temporary, sunsetting at midnight on Dec. 31, 2025.  For many clients, however, that alone isn’t a compelling reason to plan, and we need to retool our message. 

Toward that end, let’s consider a holistic approach to planning that first and foremost focuses on the clients’ financial security and then on beneficiaries. In the process, this approach identifies and addresses all the threats to wealth—not just taxes. I’ll then focus on the role of life insurance as a wealth transfer and income tax planning vehicle, illustrate the substantial cost of delaying planning and discuss the lifetime benefits life insurance can provide to help ensure the clients’ financial security. Three themes will emerge: client access and control, wealth transfer and income tax planning.

Threats to Wealth 

Estate planning isn’t solely or even primarily about taxes; it’s about minimizing or eliminating the full range of threats to wealth to ensure the financial security of the client and his family. Today, the tools are available to create the perfect hedge that addresses all threats to wealth. 

Perhaps the most basic premise of estate planning is to first ensure the client’s financial security. “What Are the Threats to Wealth?” p. 55, intentionally separates the threats to the clients from those affecting beneficiaries and places threats to the clients first. By first answering the client’s question, “What’s in it for me?” our planning becomes client-centric rather than beneficiary-centric. Consider some of the ways to address the threats to wealth:² 

1. Dual spousal lifetime access trusts (SLATs), donor asset protection trusts, self-settled trusts and beneficiary defective inheritor trusts (BDITs) all provide clients with access to trust assets and earnings. An arm’s-length loan by the trustee to the grantor provides further access to trust assets, creates a debt against the estate and, via loan interest at market rates, moves additional wealth to the trust. 

2. In effect, the irrevocable trust is no longer written in stone. The grantor retains a great deal of control through decanting statutes, trust-to-trust transfer powers, trustee removal and replacement powers,³ the use of trust protectors and non-judicial settlements. With respect to dual SLATs, the non-grantor spouse can be a co-trustee along with an independent trustee.

3. Dual SLATs, BDITs and self-settled trusts move assets beyond the reach of creditors, provided assets are transferred far enough in advance (that is, so that trust funding isn’t a fraudulent transfer) and, in many states, life insurance cash values are creditor protected.

4. Income and appreciation from trust assets are available to support the grantor and/or the grantor’s spouse throughout a long life. Life insurance on the grantor of each dual SLAT protects the surviving spouse against the loss of access to assets on a spouse’s death.⁴

5. Life insurance, discussed in greater detail below, continues to be a powerful planning tool that can protect against premature death.  

6. For many clients, estate planning will now emphasize income tax planning.⁵ Life insurance provides wealth transfer and income tax planning benefits to the client, the client’s spouse and beneficiaries. Private financing uses an intra-family loan to fund life insurance, preserving exemption for income tax planning.

Transferring interests in a flow-through entity such as a limited liability company, family limited partnership or S corporation to a trust, in which the clients retain control of the entity, continues to address many of the clients’ threats to wealth.⁶

Trust planning continues to provide the full range of benefits and protections for beneficiaries including the tax-efficient transfer of wealth, especially when coupled with favorable low valuations and split-dollar funding of life insurance. Trust ownership of assets provides spendthrift trust provisions, divorce/creditor/predator protection, avoids spoiling beneficiaries with too much too soon and protects beneficiaries from anti-social behaviors.⁷ Professional trust management and engaging professional counselors can mitigate destructive family dynamics. Swap powers allow the exchange of the trust’s low basis assets for high basis assets (cash) so that the estate will receive a stepped-up cost basis on the death of the grantor, which benefits the beneficiaries as well as the surviving spouse. Life insurance provides income tax-free death benefits.  

Dual SLATs

Today, income tax-free death proceeds, favorable lifetime access to cash values and irrevocable trust ownership make life insurance even more essential as a key component of a balanced estate plan.  

Focusing on “what’s in it for the clients,” dual SLATs, in which each spouse creates a trust for the benefit of the non-grantor spouse, children and future beneficiaries, are becoming much more prevalent in the increased exemption environment because they remove appreciation of gifted assets from the estate, provide access via the grantor’s spouse and may provide creditor protection.⁸ In their simplest form, dual SLATs merely consist of two irrevocable life insurance trusts in which the only asset is the policy insuring the grantor funded with annual exclusions and/or lifetime exemptions.
In addition to transferring wealth in an income tax-efficient manner for the benefit of children and future generations, this strategy provides the clients with substantial lifetime benefits. The independent trustee may make distributions to the non-grantor spouse from tax-free withdrawals of policy cash values⁹ or, if the policy has a long-term care rider, from qualified long-term care benefits.¹⁰ The income tax-free death proceeds can be used to support the surviving spouse and other beneficiaries as well as provide for actual or potential future taxes. Because the only gifts to the trust are those to pay premiums, clients retain full control of nearly all of their assets, and exemptions are preserved for stepped-up basis planning—to the benefit of the surviving spouse as well as future generations.  

With many dual SLATs, each spouse will make a substantial current gift. As long as both spouses are alive, the spouses retain access to 100 percent of the transferred assets but, following the first death, the surviving spouse only has access to 50 percent of the funds. Individual life insurance on the grantor of each trust can be used to replace the assets no longer accessible to the surviving spouse. 

Example: Husband and Wife each gift $5 million of assets to a trust of which the non-grantor spouse is a beneficiary. Each trust also purchases $5 million of permanent life insurance protection on the grantor. If Husband dies, Wife no longer has access to assets in her own trust. However, life insurance proceeds insuring Husband are paid into Husband’s trust and are available to support Wife. Although two $5 million life insurance policies are roughly 50 percent to 60 percent more expensive than $10 million of survivorship, the additional cost may be justified by the fact that the insurance benefits Husband and Wife directly and ensures their financial security, whereas survivorship life is strictly for the benefit of children and future generations.  See “Dual SLATs With Single Life Insurance,” this page.

As an alternative, at the time that the dual SLATs are created, clients establish a third irrevocable trust that’s authorized to purchase survivorship life insurance. That trust is a permissible beneficiary of each SLAT, adding tremendous flexibility to the plan. The grantors may make gifts directly to this third trust, or each SLAT may make distributions to the trust to pay one-half of each annual premium on the survivorship policy. Once a spouse dies, the trust of which the survivor is the grantor can distribute the full premium to the survivorship trust, freeing up cash flow in the decedent’s trust to support the surviving spouse.  

As another alternative, each SLAT can purchase term insurance on the grantor to augment the survivorship policy in the third trust. Term insurance is convertible without evidence of insurability, typically to the insured’s age 70. Term insurance protects the clients during their prime earning years and protects each grantor’s insurability. Later on, the clients can extend the term coverage by converting all or a portion of it to permanent insurance. Some carriers allow very favorable conversion of the single life term insurance to survivorship so that, at the time of conversion, it may be advisable for each trustee to distribute the term policy to the survivorship trust in which the two term policies would be converted into survivorship life.

Private Financing

Private financing¹¹ is an attractive strategy to fund dynasty trust-owned life insurance policies that protect against repeat estate taxation. Private financing consists of a large up-front split-dollar term loan that locks in the current applicable federal rate (AFR). The loan plus earnings are sufficient to pay each premium and repay the loan at the end of the term. As a loan regime split-dollar plan, it must be designed and administered to comply with Treasury Regulations Section 1.7872-15. The regulation allows the use of accrued interest based on the appropriate AFR at inception—a tremendous advantage when loan rates are low. The clients are merely giving up the asset growth in excess of the AFR interest.

Life insurance proceeds are received by the dynasty trust income, gift, estate and GST tax free and, because private financing is a loan and not a gift, it preserves exemptions for income tax or other planning. The plan can be designed so that the client is fully secured by the loan proceeds and the policy cash surrender values (except perhaps the early years). As a result, clients can feel more comfortable entering into the transaction because the plan can be unwound by the trustee and the clients repaid. The plan moves wealth to a dynasty trust without income, gift, estate or GST taxes. Finally, the strategy is relatively simple—most clients understand a loan and the trust investing those loaned assets to pay premiums and repay the loan.

Dilution Due to a Growing Family

One of the threats to wealth that’s frequently overlooked is the dilution of the estate due to a growing family. For example, if clients had three children, and each child had three children (nine grandchildren total), $100 million can, after a mere two generations, become $5.6 million per heir.¹² 

Even if the clients’ estate isn’t subject to estate taxes, by the time the wealth reaches grandchildren, it will have been diluted substantially. For example, with three children and nine grandchildren (three per child), a $10 million estate will be divided $1.1 million per grandchild. With uneven distributions of grandchildren and the common use of per stirpes allocations, the result can be skewed even more unfairly. Life insurance can be used as a wealth creation vehicle to mitigate this estate dilution and unfair allocations, for example, with a $10 million life insurance policy held in a pot trust for the benefit of all descendants.

Plan Today?

We’re in the Golden Age of estate planning. Why would a client elect to defer planning in the most opportune wealth transfer environment we’ve ever seen? Absent compelling reasons, such as a serious medical condition, few clients really want to plan—there are always more important things to do. Many clients may be reluctant to transfer substantial wealth due to their concern over their personal financial security. They may feel that the Act’s changes will become permanent or that their children already have enough. Finally, estate planning forces a client to face many uncomfortable issues including his own and his loved ones’ mortality and often complex and emotionally charged family dynamics.

Whatever their reasons, clients need to understand the risks involved. Delaying planning not only extends the exposure of a portion of clients’ assets to creditors (for example, with respect to the assets gifted to dual SLATs), but also, it has substantial costs in terms of the amount of wealth transferred. These costs are best illustrated with an example that first demonstrates the benefits of planning today and then the cost of delaying planning. 

Example: Assume Husband and Wife, each age 60 and in excellent health, are considering a combined gift of $1.75 million to a dynasty trust for the benefit of children and future generations only. The $1.75 million of assets are assumed to grow at 5 percent pre-tax and 4 percent after tax and support $10 million of permanent survivorship universal life coverage funded with a private split-dollar plan.¹³

“Plan Today,” this page, compares the net to family if the second death occurs in any given year for three scenarios:¹⁴

1. No planning (the baseline). The $1.75 million of assets are simply retained in the taxable estate.

2. The $1.75 million of assets are gifted to a dynasty trust today, no life insurance.

3. The $1.75 million of assets are gifted to a dynasty trust today, and $10 million of survivorship life insurance is funded with an economic benefit regime split-dollar plan.

The following observations can be made regarding “Plan Today”:

1. The green bars illustrate the net to family with no planning. The $1.75 million of assets grow at 4 percent after-tax and, on the second death in any given year, are subject to a 40 percent estate tax.

2. The red bars represent the improvement over Scenario 1 (“No planning”) if the assets were gifted today without life insurance. It’s important to note that this planning takes time to move substantial wealth.

3. The blue bars illustrate the improvement based on the $1.75 million gift using cash flow to fund survivorship life insurance. It’s important to note that if one of the clients lives to age 103, he would have been better off without the life insurance (the “crossover year”). Because we don’t know when deaths will occur, this suggests a balance of Scenarios 2 and 3—the gift without life insurance protects against living too long, while the gift with life insurance protects against dying too soon. Many clients object to the expense of life insurance, but as the model demonstrates, it does in fact add value in all years. 

“Net to Family,” p. 59, compares the wealth transferred at joint life expectancy of 90/90 (Year 31) for Scenarios 1, 2 and 3.

Regarding “Net to Family,” compared to Scenario 1, Scenario 3 transfers: (1) $13.65 million to a dynasty trust ($11.90 million more), and (2) $4.26 million less via the estate¹⁵—true wealth shifting at work! The bottom line: There’s more for the family, less paid in taxes.

Next, assume that the clients delay planning for 10 years.¹⁶“Cost of Delay,” this page, compares the wealth transferred at life expectancy (Age 90/90) for Scenario 3 if the $1.75 million gift (with life insurance) was made today versus in 10 years. The cost of delay can vary widely depending on the health of the clients at that time.

Assuming a $1.75 million gift in 10 years, “Cost of Delay” summarizes how the clients’ health can affect the wealth transferred: 

1. The $1.75 million gift supports $3.4 million to $7.43 million less life insurance.

2. There’s $5.09 million to $9.12 million less in a dynasty trust.  

3. In all alternatives, the children receive about $2.3 million to $2.4 million more via the estate than in the Plan Today scenario because: (1) there are 10 years less of tax burn, and (2) in the delay planning scenarios, the growth of $1.75 million over 10 years remains in the estate.¹⁷ 

From another perspective, the amount of the gift that would be required to support the full $10 million of life insurance coverage if planning in 10 years depending on the health of the clients at that time varies from $2.65 million if both clients are still preferred risks to over $6 million if only the husband is still alive and a standard risk.

Keep Existing Life Insurance?

In many cases, clients will be considering whether to maintain existing life insurance coverage. It’s essential not to make a rash decision without considering the long-term need for insurance and the many benefits it can continue to provide. Factors to consider include: the age and health of the insured, the availability and cost of replacement coverage, the lifestyle needs of clients, the estimated future value of the estate, the possible reduction of exemptions and the type of policy. If it’s decided that coverage is no longer needed, there are many options besides surrendering the policy for its cash surrender value, including reducing the policy death benefit, selling the policy on the secondary market or using policy cash values to fund an annuity.¹⁸  

Holistic Approach 

Planning isn’t just or even primarily about taxes, it’s about protecting family security from all threats to wealth. Many HNW clients will elect to delay estate planning at their own and their families’ peril. A holistic approach that first protects the clients’ financial security, identifies and addresses all threats to wealth and provides optimal wealth transfer and income tax planning for clients and heirs can help clients make the decision to move forward with planning today.   

Endnotes

1. Extremely low Internal Revenue Code Section 7520 and applicable federal rates, favorable valuation opportunities, dynasty trusts that are defective grantor trusts, extremely high and indexed gift, estate and generation-skipping transfer tax exemptions, even following sunset and favorable split-dollar rules and excellent life insurance products including fully guaranteed coverage remain after the Tax Cuts and Jobs Act of 2017.

2. This discussion is intended as a survey of available strategies, not as an exhaustive treatment.

3. Through removal and replacement powers, provided the appointed trustee is a non-adverse party who isn’t related or subordinate under IRC Section 672(c).

4. Insurance can also protect against disability and long-term care needs.

5. For example, see Ed Morrow, “The Optimal Basis Increase Trust” (Jan. 24, 2018), promoted by LISI.

6. Five of the six client threats to wealth are addressed by planning with entities:  (1) salaries or management fees provide access to income; (2) control of entity assets through voting shares, managing membership interests or general partnership interests; (3) strong creditor protection; (4) based on the growth and cash flow of the entity assets, protection against dying too soon; and (5) lower valuations result in more efficient wealth transfer, and lower income taxes may result under the new IRC Section 199A.

7. Antisocial behaviors include substance abuse, involvement in a cult or simply running with the “wrong crowd.”

8. Care must be taken to avoid reciprocal trusts. These trusts are especially powerful when executed as a dynasty trust in a state with favorable rule against perpetuities, decanting, self-settled trust and creditor protection statutes.  See state rankings charts published by The Oshins Law Firm at www.oshins.com/state-rankings-charts.

9. Partial surrenders of cash values up to basis and policy loans are tax free provided the policy isn’t a modified endowment contract.

10. Many policies provide long-term riders that must be underwritten and purchased at the time of issuance of the policy.

11. For a more complete discussion of private financing and loan regime split dollar, see Robert W. Finnegan, “Understand Split Dollar and Generational Split Dollar Plans,” Estate Planning Magazine (August 2017).

12. The example assumes that clients have a $100 million estate, $10 million of exemption available at each generation, 40 percent estate taxes, assets are left to children and growth of the estate net of lifestyle needs and charitable gifts equals inflation. In fact, inflation could erode assets further.

13. The life insurance is funded with economic benefit regime split dollar. The first death is assumed to take place in the 21st year, at which time the 1-year term cost increases to reflect the single life term cost. The 5 percent pre-tax cash flow net of the 1-year term cost is invested in a side fund. A portion of the side fund is used to roll out the split-dollar plan, so that the $1.75 million of principal is preserved.  

14. For the three scenarios, the model tracks the effect on the grantor (the estate) as well as the dynasty trust.

15. The negative $2 million from the estate in Scenario 3 is due to: (1) the tax burn, (2) the premium burn from the split-dollar plan, and (3) the lost use of those funds (Scenarios I and 2 compounded at 4 percent after tax).

16. The example assumes that the increased exemption sunsets at the end of 2025 (nearly eight years), and it takes the client another two years to implement planning.

17. In 10 years, $1.75 million at 4 percent after tax grows to $2,590,427, less the $1.75 million gift leaving $840,427 in the estate.

18. Possibly with a long-term care rider potentially converting some of the taxable policy.

Estate litigation appears to be on the rise. With more than $12 trillion in assets in the process of being transferred from the Greatest Generation to the Baby Boomers, and an additional $30 trillion in assets anticipated to pass from the Baby Boomers to their heirs,¹ one can anticipate that the number of significant estates coming under challenge or attack might also increase. It’s common in trust and estate administration and probate litigation for an individual to be a fiduciary, a beneficiary (and perhaps even a claimant) all at the same time. When a party wears multiple hats, often with conflicting rights, duties and responsibilities, it’s important from the outset of an engagement to analyze both the actual and potential conflicts of interest and carefully consider the role that legal counsel should play in properly managing such conflicts. On multiple occasions, we’ve personally experienced the benefits of collaborative representation when the potential for conflicting interests existed. We both represented the same client, with one representing the client in her fiduciary capacity and the other in her individual capacity. Not only did this approach provide the client with independence of counsel in her respective roles, but also, additional benefits inured to the client as a result of our collaborative efforts in representation.

The Initial Analysis

You’ve been contacted by a potential client. She’s been nominated as the personal representative of the decedent’s estate and trustee of his inter vivos trust. She’s also a beneficiary. Can you represent her in both capacities? Perhaps yes, but because her duties as a fiduciary may conflict with her interests as a beneficiary, often the better course is to represent her in only one capacity. Because the client may not appreciate the importance of having independent counsel for her separate roles, you must be prepared to educate the client about the subtleties of her conflicting roles and the potential risks she faces as a fiduciary should she not properly manage these conflicts of interest.

Determining how best to represent the client requires a careful analysis of other potential interested parties to the administration of the estate and trust. Are there creditors? Are there contesting parties? Is there disharmony in the family? Is there any possibility that there will be a divergence of interests? Are there ambiguities in the document requiring interpretation that could benefit some beneficiaries while adversely affecting others? Even if there’s no apparent divergence of interests between your client’s fiduciary and beneficiary capacities, there still might be benefits associated with approaching the administration cooperatively with independent counsel, such that your firm represents her in one capacity while another firm represents her in the other. Despite an anticipated increase in the cost of overall representation of the client, when a will or trust challenge is anticipated, working cooperatively with another firm can produce significant benefits to the client that far outweigh any potential for additional costs. In fact, in some instances, quality guidance provided by independent counsel for conflicting roles may actually help avoid a lengthy court battle.

Potential Benefits of Multiple Counsel

The obvious benefit of separate counsel is the availability of truly independent analysis and advice in managing conflicting roles. Particularly in contentious proceedings, fiduciaries are under hyperscrutiny, even while conducting otherwise routine administration matters. When litigation occurs, administration tends to be ongoing. Under such circumstances, fiduciaries are routinely faced with decisions that might impact beneficiaries differently, which can draw accusations of conflict of interest and breach of fiduciary duty. The circumstances in which conflicts arise are countless. For example, your client in her fiduciary capacity has a duty to maintain and preserve assets for ultimate distribution to herself and other beneficiaries. As such, every dollar spent to maintain assets may mean less for your client as a beneficiary and the other remainder beneficiaries. Independent counsel for the client’s fiduciary and beneficiary roles can prove invaluable to a fiduciary in safely navigating these sticky circumstances.

Independent counsel can also provide the client with a broader skillset. For example, if your area of expertise is probate administration and tax planning, the client may benefit if you partner up with another attorney who specializes in probate litigation. This could be important even when the client’s fiduciary and beneficial interests are aligned, but the prospects of litigation are present. The ability to litigate versus the ability to navigate the Internal Revenue Code are very different specialties. The Rules of Professional Conduct prohibit attorneys from handling legal matters that they aren’t competent to handle, unless they’re associated with a lawyer who’s competent to handle the matter.²

Because the client in her fiduciary capacity will have an undivided obligation of loyalty to the best interests of all of the beneficiaries, her individual interests may conflict with her fiduciary obligations. In such instances, separate representation will be required, or the client may have to go unrepresented in one of those capacities (most likely that as beneficiary). If the firm elects to represent the client in both her individual and fiduciary capacities, challenges may arise as to fees and costs relating to the client’s beneficial interest, if care isn’t taken to segregate and separately bill such time and expenses. Typically, only those services rendered for her benefit in her fiduciary role may be chargeable as reasonable expenses of administration to the estate or trust. When a beneficiary seeks an award of attorney’s fees, many jurisdictions limit payment from the trust only for those services that the beneficiary can prove benefited the trust as a whole.³

When beneficiaries are aligned (and there’s no anticipated divergence of interests), the firm representing the client in her individual/beneficiary capacity might represent multiple beneficiaries. Should this occur, it’s beneficial to analyze the potential for conflicts to later arise, address them in the engagement agreement and disclose to the clients what will happen with regard to representation should such conflicts arise, so that each beneficiary can execute a knowing and voluntary waiver, at least as it relates to the current potential for future conflicts.

If significant litigation is on the horizon, working collaboratively with another firm, such that the client has representation in both capacities, can provide for a division of responsibilities, enhanced strategies and collaboration of effort during all phases of a proceeding, including depositions and trial examination of witnesses. With many jurisdictions fast-tracking litigation of disputes, litigation can be a time-consuming endeavor. When discovery is compressed and multiple witnesses need to be examined and/or prepped, a collaborative approach to representation can enhance the overall quality of the representation of the client.

For example, in one substantial undue influence case, we had more than 70 depositions, many of which ran multiple days. The types of witnesses varied significantly; some were doctors, others were forensic psychiatrists and psychologists, while still others were therapists, record keepers, business associates, attorneys and, of course, a collection of lay witnesses, including family beneficiaries. By having one firm represent the client in her fiduciary capacity, while the other represented her individual/beneficiary interests, primary responsibility for the preparation and taking of depositions could be thoughtfully allocated between the firms. On occasion, primary responsibility for significant witnesses was divided topically. Also, having multiple firms representing aligned interests provided the opportunity for an attorney from each firm to ask questions of the witness at the deposition (as well as at trial). This also permits one attorney to take the bulk of responsibility for a particular witness while the other engages in tying up loose ends and addressing questions specifically pointed to the client’s individual or divergent interests. 

When interests are aligned, the responsibility for preparation of pleadings, motions, responses and other papers can also be allocated among counsel, while each has input into the final product. This approach generally results in an end product enhanced by consideration of varying perspectives and, when necessary, conflicting interests. However, when different firms are representing the same party in varying capacities, it’s important that the firms (and lawyers involved) be able to work as a “team”; this requires the attorneys to check their egos at the door, not be turf or fee driven and focus on the ultimate needs, directives and potential outcomes available to the client.

Joint Defense Agreements 

Because the firms are representing two different parties (embodied in the same individual), to preserve work product and the attorney-client privilege, consider using joint defense agreements (sometimes called “common interest” agreements) and confidentiality agreements. Use of such agreements can help effectuate and provide a mechanism for coordinating the efforts of counsel with respect to common defense or prosecution issues and to avoid duplicative costs when practicable. But, this isn’t the end of the protections required. When interests are divergent, certain communications between the client and counsel will need to be protected. Not all efforts can be pursued by the team. Therefore, while electronic file sharing can assist in the cooperative efforts in team representation, protections must remain in place with regard to confidences and advice provided to the client with regard to divergent interests. So, while discovery materials, trial books, optical character recognition copies of documents loaded into search engine programs and related material might be shared across firms, and chronologies, deposition summaries and certain other work product materials might be shared under a common file share or other format, some information must be separately maintained and protected to preserve its confidential and privileged nature. Navigating what may be shared and what must be protected requires ongoing vigilance and analysis of the potential for conflicting interests and attention to which firm is responsible for pursuing or defending a divergent (as opposed to aligned) interest.

Commencing with retention and throughout representation, it remains important to evaluate (and re-evaluate) the extent to which information, work product and strategies may be communicated among firms. Ongoing analysis of actual and potential conflicts of interest is required. Care in the drafting and amendment of joint defense or representation and confidentiality agreements remains critical. So too, the observance of a “Chinese Wall”⁴ can help protect information that must remain segregated and confidential to preserve the privileges otherwise afforded to such information, particularly when the information relates solely to the interest or defense of a claim of the client in her individual capacity.

The team approach also tends to work best if each firm specifically designates its own internal lead counsel. This facilitates coordination of efforts both within the firm and among firms. Open communication of assignments and responsibilities among lead counsel is also important when it comes to areas falling within the parameters of the joint defense and confidentiality agreement.

Other Benefits

The benefits of team representation outlined in this article, including the opportunity for examination of witnesses by both counsel, often result in more thorough and effective discovery efforts and trial presentation. However, this may not be available in every jurisdiction; therefore, a careful analysis of whether the right of examination is afforded to “a side” as opposed to “a party” can be a consideration in determining a tactical strategy for approaching the division of responsibility among members of the team.

Working collaboratively and cooperatively with other attorneys on behalf of clients with conflicting roles not only can lead to a collegial approach to issues, but also can provide an important sounding board for strategies that might be implored in the case. Consideration of different perspectives generally results in better client outcomes—but the access to independent advice of counsel and the associated expression of differing positions and perspectives remain important for the client in effectively managing conflicts.   

Endnotes

1. Accenture, “The ‘Greater’ Wealth Transfer: Capitalizing on the Intergenerational Shift in Wealth” (2015), www.Accenture.com/us-en/insight-capitalizing-intergenerational-shift-wealth-captial-markets-summary.aspx.

2. See Michigan Rules of Professional Conduct Rule 1.1. See also ABA Model Rules of Professional Conduct Rule 1.1.

3. The “American rule” provides that attorney’s fees aren’t recoverable unless expressly authorized by statute or court rule. MCL 700.7904(1) provides Michigan courts with the authority to award attorney’s fees and costs to a party who enhances, preserves or protects trust property. Therefore, unless the beneficiary’s actions can be shown to enhance, preserve or protect trust property, as opposed to being for the sole purpose of enhancing the beneficiary’s personal interest in the trust, an award of attorney’s fees may not always be a viable remedy. See Bogert, Trusts & Trustees, Second Edition, Section 871, at pp. 187-191.

4. https://en.wikipedia.org/wiki/Chinese_wall.

Section 34.40.110(k) of the Alaska Trust Act purports to grant Alaska courts exclusive jurisdiction over an action brought to avoid, as a fraudulent transfer, a transfer of property to an Alaska self-settled spendthrift trust.¹ At its core, the statute provides that “[a] court of this state has exclusive jurisdiction over an action brought under a cause of action or claim for relief that is based on a transfer of property to a trust that is the subject of this section.”² On 

March 2, 2018, however, in Toni 1 Trust v. Wacker,³ the Alaska Supreme Court ruled such provision invalid stating, “…the Alaska legislature’s purpose in enacting that statute was to prevent other state and federal courts from exercising subject matter jurisdiction over fraudulent transfer actions against such trusts…We conclude that it cannot.”⁴

Let’s examine the Toni 1 Trust decision and the court’s analysis concerning why the Alaska legislature can’t usurp subject matter jurisdiction through the enactment of AS Section 34.40.110(k). More importantly, however, let’s also examine the implications of the Toni 1 Trust decision as they relate to the typical situation involving an out-of-state settlor and the effectiveness of his self-settled spendthrift trust for estate and asset protection planning purposes.⁵

Factual Background

The procedural and factual history of Toni 1 Trust is long and convoluted. At its core, however, is a 2007 Montana state court lawsuit brought by Donald Tangwall (Donald) against William and Barbara Wacker, a counterclaim by the Wackers against Donald, his wife and his mother-in-law and a transfer, during the pendency of the suit, of Montana real estate by Donald’s wife and mother-in-law to an Alaska trust called the “Toni 1 Trust.”

The Wackers were successful on their counterclaim, and on May 17, 2011, they obtained judgment in the amount of $137,551.47. They then proceeded to file a fraudulent transfer action against the Toni 1 Trust, as transferee, in Montana state court under the Montana Uniform Fraudulent Transfer Act in connection with the real property transfer. The Wackers were again successful, and on May 7, 2012, the Montana state court entered an order holding that the real property transfer to the Toni 1 Trust was, in fact, a fraudulent transfer.

Following the fraudulent transfer finding, Donald’s mother-in-law filed a Chapter 7 bankruptcy proceeding in Alaska. Donald, as trustee of the Toni 1 Trust, then filed a complaint in the bankruptcy court alleging, among other things, that the judgment against the Toni 1 Trust in the Montana state court action was void due to defective service of process. The bankruptcy trustee responded by filing a counterclaim against the Toni 1 Trust based on federal fraudulent transfer law instead of attempting to convince the bankruptcy court that the Toni 1 Trust had been validly served in the Montana state court lawsuit. After many hearings, the bankruptcy court held that “the two real property transfers [in Montana] were made to keep the property out of the hands of the Wackers, who were on the verge of obtaining a $137,000 judgment against the debtor” and that the transfer of the real estate thereby violated the federal fraudulent transfer statute, 11 U.S.C. Section 548(a)(1)(A). 

Finally, after further proceedings in the bankruptcy court that aren’t germane to the issues discussed in this article, Donald sought relief in Alaska state court, ultimately landing before the Alaska Supreme Court.  The crux of Donald’s argument in the Alaska state courts was that AS Section 34.40.110 grants the Alaska courts exclusive jurisdiction over any fraudulent transfer action against the Toni 1 Trust. On this basis, Donald sought a declaratory judgment stating that all judgments against the Toni 1 Trust from other jurisdictions were void and that no future actions could be maintained against the Toni 1 Trust because the statute of limitations had, by then, run.

Alaska Supreme Court Analysis

In large part, the court’s determination that AS Section 34.40.110(k) can’t limit the scope of other states’ jurisdiction is based on the U.S. Supreme Court’s 1914 ruling in Tenn. Coal, Iron, & R.R. Co. v. George.⁶ In that case, an employee sued his employer in a Georgia court, relying on an Alabama statutory cause of action. The employer countered that Alabama state courts retained exclusive jurisdiction over the suit under the Alabama Code and that the Full Faith and Credit Clause of the U.S. Constitution compelled Georgia courts to respect Alabama’s assertion of exclusive jurisdiction. The Supreme Court found, however, that Full Faith and Credit doesn’t require states to go quite so far. Instead, the Supreme Court ruled that “…jurisdiction is to be determined by the law of the court’s creation, and cannot be defeated by the extraterritorial operation of a statute of another state, even though it created the right of action.”⁷ The Alaska Supreme Court recognized in the Toni 1 Trust case that its analogy to the U.S. Supreme Court’s decision in Tennessee Coal was an imperfect one because the Montana court’s judgment wasn’t based on a fraudulent transfer cause of action created by an Alaska statute, but rather on a cause of action arising under Montana law relating to an Alaska trust. However, it found the constitutional argument rejected in Tennessee Coal to be even less compelling where, as here, Alaska sought to assert exclusive jurisdiction over suits based on a cause of action (that is, fraudulent transfer law), that it didn’t itself create.

Thus, to reiterate, Toni 1 Trust stands for the proposition that Alaska, or indeed any other state, can’t reserve to its courts exclusive jurisdiction over the question of whether the transfer of property to a trust created under that state’s law is, or isn’t, a fraudulent transfer.

Fraudulent Transfers

As of the writing of this article, 16 states have enacted self-settled spendthrift trust (sometimes also called “asset protection trust”) legislation.⁸ Obviously, the inverse to this statement is that, as of the writing of this article, 34 states (and the District of Columbia) haven’t (yet) enacted self-settled spendthrift trust legislation. Thus, cases may, and do, arise in which a conflicts-of- law question exists concerning the ability of a self-settled spendthrift trust to protect assets from the claims of the settlor’s creditors. Toni 1 Trust, however, isn’t one of those cases.

The most important fact to an understanding of Toni 1 Trust isn’t that some states permit self-settled spendthrift trusts to be created under their laws and that other states don’t; rather, it’s that all of the states provide that the fraudulent transfer of property to a self-settled spendthrift trust, or indeed, any trust, will be ineffective.  This is because every state has enacted the Uniform Fraudulent Conveyance Law, the Uniform Fraudulent Transfer Act or the Uniform Voidable Transactions Act (UVTA) or alternatively continues to follow the common law as it relates to fraudulent transfers or, as in the case of Louisiana, a civil law jurisdiction, provides for the annulment of revocatory actions.⁹ 

Notably, at the edges, a state that’s enacted self-settled spendthrift trust legislation also often attempts to sharpen the parameters concerning what might constitute a fraudulent transfer of property to a self-settled spendthrift trust under that state’s law. And, it’s for this reason that a state might attempt, as Alaska did, to usurp by statute exclusive jurisdiction over the question of whether the transfer of property to a trust created under its law is, or isn’t, a fraudulent transfer.

For example, Alaska law provides that:

If a trust contains a transfer restriction allowed under (a) of this section [relating to self-settled spendthrift trusts], the transfer restriction prevents a creditor existing when the trust is created or a person who subsequently becomes a creditor from satisfying a claim out of the beneficiary’s interest in the trust, unless the creditor is a creditor of the settlor and…the settlor’s transfer of property in trust was made with the intent to defraud that creditor…¹⁰

In contrast, the comparable provision of the UVTA (formerly known as the “Uniform Fraudulent Transfer Act”), provides that a voidable transaction (that is, a fraudulent transfer), can be found “…if the debtor made the transfer or incurred the obligation…with actual intent to hinder, delay, or defraud any creditor of the debtor.”¹¹ Similarly, the U.S. Bankruptcy Code proscription against fraudulent transfers provides that the bankruptcy trustee may avoid any transfer of an interest of the debtor in property, or any obligation incurred by the debtor, if the debtor:

…made such transfer or incurred such obligation with actual intent to hinder, delay, or defraud any entity to which the debtor was or became, on or after the date that such transfer was made or such obligation was incurred, indebted…¹²

Note two potentially important differences between the Alaska statute, on the one hand, and the UVTA and the Bankruptcy Code, on the other. The first difference is that under Alaska law, a finding of a fraudulent transfer requires a finding of an intent to “defraud,” whereas under the UVTA and the Bankruptcy Code, an intent merely to “hinder” or “delay,” as well as an intent to defraud, can be the basis for a finding of a voidable transaction/fraudulent transfer. The second important difference is that under Alaska law, the intent must be directed against the creditor who’s brought the action (that is, “…the settlor’s transfer of property in trust was made with the intent to defraud that creditor…”), whereas under the UVTA, the intent can be directed against any creditor (that is, “…the debtor made the transfer or incurred the obligation…to hinder, delay, or defraud any creditor of the debtor”), which is also the case under the Bankruptcy Code (that is, the debtor “…made such transfer or incurred such obligation with actual intent to hinder, delay, or defraud any entity to which the debtor was…indebted”).

So, there are obviously differences in the law that may or may not prove relevant depending on whether an action is brought under Alaska law or under the law of another state or the Bankruptcy Code. But, the fact that Alaska, as a self-settled spendthrift trust jurisdiction, has sharpened the parameters concerning what would constitute a fraudulent transfer of property to an Alaska self-settled spendthrift trust doesn’t mean that, absent an exercise of exclusive jurisdiction by the Alaska courts pursuant to a statute like AS Section 34.40.110, no transfer of property to an Alaska self-settled
spendthrift trust would be found to be a fraudulent transfer. In fact, it would seem to be beyond question that the transfer of property to the Toni 1 Trust was an obvious fraudulent transfer, and would have been found to have been so even had the question been determined under Alaska law, because Donald’s wife and mother-in-law transferred their real estate to the trust during the pendency of the Wackers’ counterclaim against them.

Personal Jurisdiction

Finally, an entirely separate issue that further diminishes the importance of Toni 1 Trust is that of personal jurisdiction, to be contrasted with the question of subject matter jurisdiction, which was the actual matter at issue in the case. As regards personal jurisdiction, it’s important to note that the trust was funded with Montana sited real estate. As a result, the Montana courts had in rem jurisdiction over the corpus of the trust, which would have likely served to render academic the court’s decision in Toni 1 Trust, even had the Alaska Supreme Court instead determined that AS Section 34.40.110(k) was, in fact, enforceable as a valid exercise of authority by the Alaska legislature.

Ineffective Exercise of Authority

Toni 1 Trust provides a simple rule: Section 34.40.110(k) of the Alaska Trust Act, which purports to grant Alaska courts exclusive jurisdiction over fraudulent transfer actions against Alaska self-settled spendthrift trusts, was an ineffective exercise of the Alaska legislature’s authority and can’t control the jurisdictional question that it sought to control. Thus, a fraudulent transfer action against an Alaska trust may be brought outside of the Alaska courts, assuming, of course, that personal jurisdiction is found to exist. The important question, however, of whether the transfer of property to an Alaska self-settled spendthrift trust is, in fact, a fraudulent transfer in any particular case will, of course, remain. Toni 1 Trust changes nothing in the proposition that, to the extent that the funding of the trust wasn’t a fraudulent transfer, the trust will serve its purpose of protecting assets from the settlor’s potential future creditors.   

Endnotes

1. AS Section 34.40.110(k) provides that “[n]otwithstanding another provision of the law of this state, an action, including an action to enforce a judgment entered by a court or other body having adjudicative authority, may not be brought at law or in equity for an attachment or other provisional remedy against property of a trust subject to this section or to avoid a transfer of property to a trust that is the subject of this section unless the action is brought under (b)(1) of this section and within the limitations period of (d) of this section. A court of this state has exclusive jurisdiction over an action brought under a cause of action or claim for relief that is based on a transfer of property to a trust that is the subject of this section.”

2. Ibid.

3. Toni 1 Trust v. Wacker, 2018 WL 1125033 (Alaska, March 2, 2018).

4. Ibid., at *3.

5. It should be noted that Alaska isn’t the only self-settled spendthrift trust jurisdiction that’s attempted to exclude out-of-state courts from exercising jurisdiction over such trusts. For example, in Delaware, Del Code Ann tit. 6, Section 3572(a) provides, in pertinent part, that “[t]he Court of Chancery shall have exclusive jurisdiction over any action brought with respect to a qualified disposition.”

6. Tenn. Coal, Iron, & R.R. Co. v. George, 233 U.S. 354 (1914).

7. Ibid., at p. 360.

8. Those states are: Alaska, Delaware, Hawaii, Michigan, Mississippi, Missouri, Nevada, New Hampshire, Ohio, Rhode Island, South Dakota, Tennessee, Utah, Virginia, West Virginia and Wyoming. Some attorneys name Oklahoma as an additional self-settled spendthrift trust jurisdiction, but as a technical matter, the Oklahoma Family Wealth Preservation Trust Act of June 9, 2004 (O.S. Section 10, Title 31), permits the creation of asset protected revocable trusts for the benefit of third parties, not self-settled spendthrift trusts.

9. La. Civ. Code Ann. Section 12:2036, et seq.  

10. AS Section 34.40.110(b).

11. Uniform Voidable Transactions Act Section 4(a)(1). This language is also wholly unchanged from the language of the Uniform Fraudulent Transfer Act Section 4(a)(1) that preceded it. This is also the language of the Montana Uniform Fraudulent Transfer Act, MT Code Section 31-2-333 (2013).

12. 11 U.S. Code Section 548(a)(1).

Simply put when money flows into the hands of women who have the authority to use it, everything changes. 

—Melinda Gates

In the coming decades, the amount of wealth controlled by women will outpace that of men. This represents a significant shift in the philanthropic landscape. Because women drive the philanthropic decisions in families and give more than men, this shift presents a new opportunity for trusted advisors to more closely align philanthropic planning with estate planning. When philanthropy is used as a tool to unify the family around its core values and mission for its wealth, families are more likely to retain their cohesion and family assets post-estate transition. A fundamental goal most wealth creators and family leaders hope for is that their wealth won’t divide their family or dissipate over time. Yet, that’s what the statistics say will happen, at least 70 percent of the time.¹ We say, why leave the very reason the wealth was created to hope when hope is a weak strategy? The advisor is in the pivotal position to reverse the swing of the global norm of the shirtsleeves-to-shirtsleeves phenomenon.

The Economic Shift

More often than not, women are the household CFOs, making significant financial decisions for themselves, their families and extended family members. Currently, women make 83 percent of the household consumer decisions and control about $14 trillion in assets.² Through inheritance, a minimum of $22 trillion in assets will shift to women in the coming years. 

Women are earning more educational degrees than men. In the United States, they’re now the majority in undergraduate settings and are more than half of all alumni. With increased education come increased earnings.³ 

In addition, more women than men are in professional positions generating higher income. Women hold 51 percent of managerial and professional jobs in the U.S. workforce.⁴ Forty-two percent of top wealth holders in the United States  are women, including more than 3 million women with annual incomes greater than $550,000.⁵ 

This economic shift adds up to women controlling significant wealth now and continued growth of their wealth and decision making for decades to come.

The Philanthropic Shift

With increased earnings and education, women have demonstrated an increased focus on philanthropy. Women are giving more and influencing more philanthropy. Repeatedly, studies find that women have a greater inclination to giving than men: 

• Baby Boomers and women in previous generations are more likely to give than their male counterparts at all giving levels.⁶ 

• For every $10,000 that a wife’s income increases, total household giving increases by more than 5 percent. In comparison, for every $10,000 a husband’s income increases, total household giving increases by 3 percent.⁷ 

Women of the household are almost always involved in the gift decision. Research by the Women’s Philanthropy Institute found that nearly three-fourths of the general population households decide jointly on philanthropy, and in high-net-worth households, nearly one-half decide jointly. When only one spouse decides, the wife decides twice as often as the husband.⁸

We now know beyond a shadow of a doubt, thanks to research from the Women’s Philanthropy Institute, that women drive a family’s philanthropic decisions. They give more than men do. And this trend will continue, given the growth of women’s earnings, inheritances they’ll receive and the likelihood they’ll outlive men.

Women Give Differently

“Women are nearly twice as likely as men to say that giving to charity is the most satisfying aspect of having wealth,” according to “Insights on Wealth and Worth: Women and Wealth Fact Sheet.”⁹ Their philanthropic involvement is often different from men’s. “Different Perspectives,” this page, adapted from the 2016 U.S. Trust Study of High Net Worth Philanthropy highlights some key differences.

According to the study, women leverage all their resources for causes they care about. They give their time (volunteering) as well as their expertise and are more likely to leverage their networks to increase support. Women philanthropists were more likely to grow up in households with giving traditions and want to pass these on by involving the next generations. 

While both men and women are motivated to give to make a difference in the world, women ask more discerning questions before they give. They want to understand the complexities at hand and will learn from their networks and leaders in the charity, as well as by educating themselves. While it may take them longer to decide to be involved and give to a charity, they stay involved longer once the choice is made. With that in mind, women’s leadership in family philanthropy lends itself to long-term learning and patient investment (with time, talent and treasure) to bring about the desired change. 

Catalyst for Learning 

As “Different Perspectives” shows, women genuinely care about family participation in philanthropy and its impact. They know that the continued learning that can come from philanthropy and the overall alignment of the family stakeholders can often be key for a cohesive unified family.

The top four concerns affluent parents have for their children have little to do with having enough wealth to pass on, but rather, the impact of that wealth on their family (see “Top Four Parental Concerns About Their Children,” p. 30).  

At some point, many successful families find that solely building and preserving wealth becomes an unsatisfying goal by itself, and it doesn’t necessarily reflect their personal, long-term hopes for their children. At this juncture, the heads of families may choose to focus on wealth being a launch pad for good and a vehicle to create opportunities for family members, as opposed to being a threat or burden to them. Leaving a legacy of social good provides a framework the next generation is often proud to be a part of.

Family involvement in philanthropy can help the next generation learn financial skills such as due diligence and quantitative and qualitative assessment of organizations. They learn to present proposals and recommendations to maximize the impact of philanthropic dollars. They learn how to work together, or with non-profit leaders, to solve problems. Family members of all ages learn how to make effective requests, track implementation and follow through. Throughout the process, individuals learn generosity, curiosity and patience, as well as the importance of following one’s commitment. These skills aren’t just good for sound philanthropic giving, but also are the keys to building trust, managing identity and coordinating effective action.

Families who align their philanthropy around societal values and family values allow for learning about family traditions, norms, expectations and leveraging impact. Just as women take time to learn for themselves, they often set up the opportunities for their children and other family members to learn, test and grow and, in so doing, counteract the entitlement factor.  

When children are introduced to the family values of philanthropy at a young age, they find comfort and confidence in an expanded identity of their family. When the family is aligned on a clear vision and understanding of what makes it unique, as the next generation comes of age, they’re already practicing and participating in the wealth in productive ways. The onslaught of inevitable requests for money from numerous sources is mitigated by being able to state the family mission as it relates to their giving. Also, estate planning becomes easier and more sustainable when the family is aligned. Typically, when there’s alignment on family values, there’s a deeper level of trust and overall sense of team. At this point, we see family members more willing to maintain the existing advisory team for the sake of cohesiveness and familiarity with family history and sidestep the complexity that can come from introducing alternative advisory recommendations. Family members who grow up exposed to philanthropic practices can see their own roles in continuing the traditions and the opportunities philanthropy can provide for themselves and their own families. They can interface with the advisory team already in place.   

Core Drivers of Wealth Transition

Without a conversation that includes philanthropy, wealth is just about the money. When the focus is that narrow, it’s a short distance to the family losing its unity and the advisor losing the inheriting generation as clients. Wealth conversations, which often include trusted advisors, typically drift to who’s getting what distribution and when, to expectations about the size of a home and speculation about how one sibling is perceived to be getting more than another. 

As family coaches, we help advisors broaden those conversations to include how the inheriting generation can grow the wealth, contribute and ensure it lasts for generations. Conversations on this level allow the family members to see how they can contribute to the wealth, not only how the wealth is contributing to them. It’s how the family, as a high performing team, can ensure the wealth will be sustainable across generations, have a powerful impact in the world, reduce suffering of others and advance the human condition. 

An internationally recognized study conducted by The Williams Group found that there are three core drivers of successful wealth transition as it relates to families. The research, including more than 2,500 families of significant wealth, revealed a staggering 70 percent of family wealth transfers fail within three generations.  Sixty percent was due to issues related to trust and communication, 25 percent due to unprepared heirs and 10 percent due to lack of family values and mission.¹⁰ (See “Reasons for Unsuccessful Family Wealth Transfers,” this page.)

Authentic and meaningful inheritance conversations that involve philanthropy expand a whole new definition of what it is to be a family and have a common vision for how the wealth is to be used today and in the future.  Philanthropy becomes an extension and embodiment of the family values witnessed through their philanthropic action as a family team. 

Women often see philanthropy as a way to knit the family together and, as a result, gain more confidence that the larger estate plan will be embraced. A mother typically spends a lot of energy managing the emotional ties within the family with the intention of keeping the peace and civility between siblings. For women, philanthropy is a powerful force for the family members to embody the very values that operate in the background and in large part are responsible for how the wealth was created. It’s a unifying force that can build appreciation, pride and care within the family. 

Family Story

A mother recently came to us concerned that her foundation was in jeopardy of being diminished. Her larger concern was that the very tool she relied heavily on as a platform to keep her sons enrolled in a greater purpose for their wealth was becoming less viable. In a long-standing tug of war over resources for the foundation, she often found herself at odds with her husband. He wanted to redistribute their wealth into a riskier portfolio. She, on the other hand, wanted to secure more funds for the foundation. She was concerned the capacity of the foundation to realize its goals would be significantly impacted if the riskier investments didn’t pan out as hoped. Over time, this issue created greater distance between them. When her husband then wanted to pull out more of the principal potentially impacting their lifestyle, the issue came to a head. 

The essential conversation wasn’t about the wealth or even the division of funds. It was about trust. Mom was growing increasingly distrustful that her husband wasn’t listening to her concerns, putting her lifestyle at risk and threatening the source of meaning and purpose in her life, her philanthropy. Her concerns were largely about giving back, teaching her sons about philanthropy and, at the same time, protecting the quality of life they enjoyed. Her husband’s concern was growing the wealth, and riskier investments offered the highest potential payback. Left unaddressed, the dissonance would continue to grow, and their relationship become more distant. Through family coaching and skill building, the very conflict creating distance became generative. They learned to have a conversation for co-design that incorporated each of their concerns and goals. The skills they deepened included learning to listen, learning to speak up when not feeling heard and organizing as a team around a shared purpose, as opposed to individual goals. Ultimately, they were able to create a solution that met each of their concerns and requirements. A more specific plan supported the goals of the foundation. They set a percentage of principal that could be applied to risk, assuring the lifestyle they were accustomed to living would continue. Most importantly, the values of the family exemplified through their philanthropy were protected, and their relationship to trusting each other was strengthened.

Questions the advisor can ask to reveal the distrust among family members: 

• In what areas do you and your spouse see eye to eye, and in what areas do you see things differently?  What’s the consequence of not being in alignment?

• What are you doing (other than hoping) to ensure your children will still take care of each other after you’re gone?

• When you don’t agree with each other, how do you reach a solution? How’s that working for you?

• How does the subtle distrust that may be operating in the background of your family show up?

• In what ways does your family see you as a resource, not just a wealth provider?  

• Are the conversations about wealth a two-way conversation, or are you mainly calling the shots? What do you anticipate will happen after you’re gone?

• What are the conversations you don’t dare to have?

Embrace the Shift 

The rise of women as philanthropic leaders will have a significant impact on the world and their families in powerful and meaningful ways. The changing economic and philanthropic landscape is emerging as a vital opportunity to knit a family together and deepen a sense of family pride, while having a significant impact on the human condition and our world.  Philanthropy can be a means to increase levels of trust and communication in a family, provide a platform to better prepare the inheriting generation to be responsible managers of the wealth and create alignment for the purpose of the wealth. Professional advisors have an opportunity to embrace this shift to deepen their relationships with entire client families by making clients aware of the core drivers of successful wealth transition and how philanthropy can be used to align the family for successful wealth transition.     

Endnotes

1. The Williams Group.

2. Danielle Kayembe, “The Silent Rise Of The Female-Driven Economy” (Dec. 20, 2017), www.refinery29.com/2017/12/184334/rise-of-female-driven-economy-feminist-economics?bucketed=true.

3. “Spotlight: Women at Work,” U.S. Bureau of Labor Statistics (March 2011).

4. “Women in the Labor Force: A Databook,” U.S. Bureau of Labor Statistics (December 2014).

5. “SOI Tax Stats—Female Top Wealthholders by Size of Net Worth,” Internal Revenue Service (2007).

6. Debra Mesch, Una Osili, Jacqueline Ackerman and Elizabeth Dale, “How and Why Women Give: Current and Future Directions for Research on Women’s Philanthropy,” The Women’s Philanthropy Institute (May 2015).

7. Debra Mesch, “The Gender Gap in Charitable Giving,” The Wall Street Journal (Feb. 1, 2016).

8. “2011 Study of High Net Worth Women’s Philanthropy and the Impact of Women’s Giving Networks,” The Center on Philanthropy at Indiana University (December 2011).

9. “Insights on Wealth and Worth: Women and Wealth Fact Sheet,” U.S. Trust (2013), www.ncgs.org/Pdfs/Resources/Women%20and%20Wealth.pdf.   

10. “Failure” is defined as loss of control of family assets and family unity.

Knowledgeable trustees understand their roles, responsibilities and potential for personal liability and realize it can be a thankless job. The trustee who doesn’t understand her roles and responsibilities and doesn’t appreciate the diligence that comes with the job is at risk to make mistakes.

The trustee’s function is to make investment, administration, reporting and distribution decisions in accordance with the grantor’s wishes and trust documents. On the face of it, these responsibilities seem straightforward. But, once the trustee realizes that her decisions can conflict with the grantor’s desires, beneficiary needs and trust document, the job can become overwhelming.

Personal liability arises out of the breach of these fiduciary duties. There are two main fiduciary duties: the duty of care, which relates to the careful and prudent management of assets, and the duty of loyalty, which puts the beneficiaries’ interests before all other interests including those of the trustees and grantor.

Trends 

Certain trends in the wealth management industry create further challenges for fiduciaries when executing their duties. The wealth transfer business is expanding and contracting at the same time. The expansion comes from the staggering amount of wealth being transferred intergenerationally. An entire industry has been created over the last 20 to 30 years around wealth management. As wealth management has evolved, it’s become more complex and competitive. This has driven the professionals’ ability to assist families in implementing structures catering to their desire for more privacy, control of their assets and, at the same time, limiting the liability of the trustees. Leading the charge are the directed trusts and the domestic asset protection trust environment in Delaware on the east coast and Alaska, Nevada, South Dakota and Wyoming further west. These jurisdictions have become very competitive, but the laws and regulations are untested.

This trend is exacerbated by the amount of wealth coming into the United States from those seeking privacy and economic stability. This influx of funds into U.S.-based trusts creates additional consequences for trustees to ensure decisions are executed in accordance with U.S. and foreign tax laws. Staying within the bounds of these laws, which are precisely drafted, is important. The execution can be challenging, which in turn can create significant liability for institutional and individual trustees.

The nature of an advisor’s job functions is changing due to the increased exemption from federal estate tax, outsourcing to legal drafting firms and standardized/ template document providers, artificial intelligence and commoditization of the wealth management industry. This has given way to new opportunities. Lawyers, CPAs and life insurance agents wrestle with the future of their profession. Their primary roles have changed from that of a tax advisor to a well-rounded family advisor. They’re increasingly being asked to, and are now accepting, trustee positions, when historically they were uncomfortable doing so. Interestingly, on the flip side, some estate-planning attorneys concerned about serving in the trustee role are becoming fiduciary litigators. This is creating an interesting collision in the profession between lawyers acting as fiduciaries and fiduciary litigators. Additionally, due to the growing need for trustees, there’s been an increase in advisors creating paperclip companies to provide professional trustee services and other fiduciary functions as well as forming their own trust companies.

Multi-Faceted Platform

Because the industry is changing rapidly, more wealth is being passed and structures are complex, there’s more opportunity for mistakes to be made and potential for increased litigation. Consequently, there needs to be a better balance between risk and insurance. What’s needed is a multi-faceted platform. 

Risk identification. The first step to rebalance the metrics is risk identification. No trust is the same, no trustees and beneficiaries are the same and the complexity of the trusts increases the need for broad expertise or at least knowing when to hire professionals. The complexity of the trusts requires expertise identifying which potential gaps can create liability. This is true especially in the directed trust environment, where there’s significant bifurcation of duties and responsibilities. Perhaps the most vexing issue involves the unanticipated duties to monitor, report or correct improper actions of other co-trustees. Most estate plans are well drafted and thoughtful. But, problems often arise when executing the plan. I consistently find that trustees aren’t performing all required duties, and co-trustees aren’t coordinating tasks to ensure details don’t get lost. Often, there’s somebody tasked with parts of the duties who has no legal authority. This gap creates liability for all service providers. More importantly, in the directed trust environment, with so many jobs, there’s a possibility for tasks to fall through the cracks, and “it’s not my job” isn’t a good defense. Therefore, trustees should consider implementing a trust charter that identifies, in detail, all roles and responsibilities, who’s responsible for tasks and mechanisms for enforcing accountability.

Risk mitigation. As with any industry in flux, an important step in risk mitigation is education. While there are amazing trustees who understand their roles and responsibilities as well as their personal liability, continuing education is imperative. Additionally, many co-trustees aren’t well informed. Furthermore, beneficiaries are often uninformed not only about the existence and functionality of their trustees, but also about the job of fiduciaries and how to hold them accountable in a positive way. Without disclosing confidential information, better training of trustees and beneficiaries alike can reduce friction between the parties and therefore prevent unnecessary litigation.

Risk transfer and insurance. While, as an industry, we can better prepare fiduciaries and advisors to reduce their risk, we can’t completely eliminate it. Therefore, trustees and other fiduciary service providers should be able to purchase properly structured insurance policies. However, it takes an expert to identify risks unique to each situation and properly design insurance policies.

Trustee liability insurance is a form of errors and omissions coverage similar to directors and officers insurance. These insurance policies are structured by defining what’s insured (the insuring agreement), exclusions, definitions and conditions. Generally, these policies cover defense costs as well as damages when or if there’s a settlement or until a court determination of negligence. 

The insuring agreement is designed to define what’s covered, specifically: trustee’s acts, errors and omissions in carrying out his duties or alleged breach of fiduciary duty. Fiduciaries have a duty of loyalty to the trust and its beneficiaries and a duty of impartiality to the beneficiaries. Should a beneficiary allege a trustee or fiduciary service provider (that may be defined as a fiduciary by law) breached these duties, defense costs will be incurred, and potential personal liability can result. 

Typically, exclusions are included in the fiduciary policy because other insurance policies that are or should be already in place, such as property and casualty insurance, are designed to cover certain claims.  Exclusions for illegal activity, prohibited acts or proven gross negligence are also common. The insurance company won’t cover claims that are excluded from the policy. However, some policies may offer defense coverage until final adjudication of a claim.  

It’s extremely important to review the definitions contained in policies because defined terms are used throughout, and these definitions can have a significant impact on the scope of coverage. All definitions must be reviewed and understood, but some key definitions require even more attention. Examples of these are the definitions of claim, claim expense, damages, insured persons and trustee services. If these, and other definitions aren’t structured properly, the insurance may not perform as expected.

While the above is a basic primer, no one policy fits all needs. There’s a litany of available insurance policies and insurance companies with varying degrees of risk appetite. An insurance professional can help you determine which polices and carriers are the best fit for each situation. The needs of individual trustees differ from institutional and professional trustees. Advisors such as lawyers, CPAs and life insurance agents serving as trustees require different policy structures. Finally, institutions such as trust companies have very different insurance requirements dictated by laws, trust instruments and perceived risk. 

In general, limits of liability available to trustees range from $1 million to $25 million, but in certain circumstances, higher limits of liability may be available. Premiums range from $1,500 to upwards of $100,000 due to the services provided and analysis of the risk.

Some questions to ask yourself when determining the type of policy to purchase: If I’m an employed professional and/or have errors and omission policies in place, is there adequate coverage? Can the policy be amended to include excluded items or be clarified for gray areas? Am I a co-trustee, and how are the other trustees covered? If the co-trustees don’t have insurance, how will that affect my liability? What are the underlying assets held in trust, and will additional expertise be needed in carrying out my duties? How is the trust structured, and are there any applicable laws to consider?

The goal of risk identification, mitigation and insurance is to reduce personal liability and transfer risk to enable trustees and fiduciaries to serve willingly.   

—The author acknowledges Melvin A. Warshaw of Financial Architects Partners in Boston for his contributions to this article.

France doesn’t have trust laws; a trust can’t be created under French law. However, French residents, including U.S. citizens residing in France, may create trusts under U.S. law or be beneficiaries of U.S. trusts. At one time, it was unclear how France would tax its residents who were settlors or beneficiaries of trusts. As of 2011, it became all too clear.  Recent amendments have further clarified the negative treatment of trusts.

The French law enacted on July 29, 2011 affects trusts in any jurisdiction if: the settlor is French, any beneficiary is French or any trust assets are located in France (other than listed securities).  

The cornerstone of this new tax system for trusts is reporting by the trustee of the existence of a trust subject to the law to the French tax authorities. This reporting is onerous, as described below, and is in itself a reason to consider terminating trusts that have French settlors or beneficiaries or excluding the French beneficiaries.

Subject trusts are those with: (1) at least one settlor, beneficiary treated as a settlor under French law (a deemed settlor-beneficiary) or beneficiary with a French fiscal domicile (citizenship is irrelevant), or (2) at least one piece of property or one right situated in France (other than French securities listed on a national exchange).

A report must be made to the French tax authorities in the case of the creation, modification or termination (a reporting event) of a subject trust. The report is due within one month of the reporting event. A modification includes every distribution of principal or accumulated income from the trust. In addition, a similar yearly report must be made.

There’s a flat fine of €20,000 for any failure to file a required report.

Contents of the Trustee’s Report 

In the month following the creation, modification or termination of a trust, the trustee must make a declaration to the French Tax Service for Foreign Businesses.¹

Modification of a trust includes every change in: (1) the terms of the trust, (2) its functioning, (3) its settlors or beneficiaries deemed settlors, (4) beneficiaries, (5) trustees and administrators, (6) the death of any of the foregoing, (7) any transfer to or from the trust of property or rights, (8) any transfer or attribution of property, rights or income of the trust, and (9) generally any modification of any right or fact that could impact the economics or the functioning of the trust.²

The declaration must contain:

1. The identity of each settlor and deemed settlor-beneficiary, including name or company name, address and, as applicable, date and place of birth and, if deceased, of death.

2. The identity of each beneficiary, including name or company name, address and, as applicable, date and place of birth and, if deceased, of death.

3. The identity of the trustee of the trust, including name or company name and address.

4. The identity of the trust, including name and address.

5. The terms of the trust, including the terms of the instrument of trust and any other documents affecting governance of the trust, including, in particular, whether the trust is revocable or irrevocable, whether, how and to what extent it’s discretionary and the rules governing beneficial ownership of the trust’s assets, rights and income.

6. A description of the reporting event.

7. As applicable, a description of the trust assets and rights, including their value as of the date of the reporting event, and of any property, rights and income that were transferred, which vested (was attributed to a person) or which were distributed from the trust by reason of the reporting event.

8. For each piece of property and each right held in trust and mentioned in the declaration, the name or company name, address and, as applicable, the date and place of birth and, if deceased, of death of each person who placed the property or right in trust.

9. For the property, rights and income transferred, vested (attributed) or distributed from the trust and constituting the reporting event, the name or company name, address and, as applicable, the date and place of birth and, if deceased, of death of each person to whom the property, rights and income were transmitted, attributed or distributed.

French fiscal domicile (that is, tax residency) for purposes of these reports is determined as of Jan. 1 of each year.

A form is available for trustees to use for declarations made by reason of a reporting event but it isn’t mandatory. The report may be made in any form.³

The Trustee’s Annual Report

The trustee or administrator must make an annual declaration by June 15 of each year to the French Tax Service for Foreign Businesses containing:

1. The first five pieces of information included in the declaration for a reporting event (as noted in the previous subsection), except that the terms of the trust needn’t be described if a complete description was previously submitted in a declaration related to a reporting event.

2. If at least one of each settlor, deemed settlor-beneficiary or beneficiary has his fiscal domicile in France, an inventory of all the trust’s assets, rights and income, whether situated in or outside of France, and their fair market value (FMV) as of Jan. 1 of that year.

3. If no settlor, deemed settlor-beneficiary or beneficiary has his fiscal domicile in France, an inventory of the trust’s assets, rights and income situated in France and their FMV as of Jan. 1 of that year. For this purpose, financial investments (such as publicly traded securities) are generally excluded, except: (1) investments (direct or indirect) relating to French real property or real property rights, and (2) companies or assets controlled by family members owning French real property or real property rights.

As discussed more fully below, the declaration must be accompanied by any required payment of the amount of any wealth tax on the value of French real property (the new impôt sur la fortune immobilière or IFI) held in the trust due for that year.⁴ 

Fiscal domicile for purposes of these reports is determined as of Jan. 1 of each year.

A form is available for trustees to use for the annual declaration but it isn’t obligatory.⁵ The report may be made in any form.

The MTG Tax

France has a tax on gratuitous transfers (the MTG tax)⁶ by reason of gift or inheritance. The tax is generally payable by the recipient, who’s also responsible for filing a return.

Tax rates are based on the type of relationship between the transferor and transferee. Transfers to direct descendants, spouses and domestic partners are taxed at lower rates (at graduated rates from 5 percent to 45 percent, depending on the net taxable value) than transfers to brothers and sisters (at 35 percent or 45 percent), to other family members up to the fourth degree of relationship (at 55 percent) and to more remote family members and non-relatives (at 60 percent).⁷

All worldwide assets are generally fully subject to French MTG tax if: (1) the donor or decedent has his fiscal domicile in France,⁸ or (2) the inheritor, donee or legatee has his fiscal domicile in France and has had his fiscal domicile in France for at least six of the 10 years preceding the year of the transfer. (However, under Article 8 of the U.S.-France Succession and Gift Tax Treaty, if the donor, deceased or settlor is a resident of the United States, the French donee, heir or trust beneficiary isn’t taxed except on French situs real estate, tangibles and business property.)

The MTG tax applies in the normal way if the transfer from the trust is considered to be a transfer by gift or succession under French law. Assets of a trust are subject to the MTG tax, without regard to whether a gift has technically been completed under the laws of a common law jurisdiction:

1. on transmission or at the death of the settlor or deemed settlor-beneficiary; or

2. if the beneficiary of a trust, as defined in the Code géneral des impôts (CGI), has his fiscal domicile in France⁹ (except as provided otherwise by a tax treaty).

It’s the position of the French tax administration that a transfer from a trust will be considered a transfer by way of a gift or a succession only if a distribution is made to the beneficiary during the lifetime of the settlor (other than an income distribution) or at the settlor’s death.

If, however, a transfer isn’t considered a transfer by gift or by succession under French law, then those trust assets that are retained in trust are subject to the MTG tax in a different manner (sui generis taxation):

1. Any identifiable share of the trust assets attributable to a single named or identified beneficiary at the settlor’s death is taxed according to the relationship between that beneficiary and the settlor (that is, at the rates for descendants, graduated from 5 percent to 45 percent depending on net taxable value).

2. Any identifiable share of the trust assets attributable to the settlor’s descendants collectively (that is, a pot trust for direct descendants) is subject to the MTG tax at the highest rate applicable to transfers to direct descendants, 45 percent.

3. Any other share is taxed at the rate of 60 percent.¹⁰

These rules are overridden if the trustee is subject to the laws of a state deemed “non-cooperative” under the French tax code or if the trust was created after May 11, 2011 by a settlor fiscally domiciled in France, and the assets aren’t distributed to the beneficiaries at the time of his death. In such a case, all MTG taxes are paid at the rate of 60 percent.

In the case of trust property taxed under (2) and (3) above, the tax is payable by the trustee, and not the recipient, within six months from the settlor’s death, if he died in France, or otherwise within a year of death.¹¹ However, if the trustee doesn’t pay or if the trust is governed by the law of a state either considered “non-cooperative” or that hasn’t ratified a tax evasion convention with France, the beneficiaries of the trust are jointly responsible for payment of the tax.

Whether the trust is revocable or irrevocable, and when it was created, aren’t relevant. The law makes no distinction between revocable and irrevocable trusts. There’s no such thing in France as a “completed gift” to a trust.

There is, however, a better result for U.S. residents (and perhaps the residents of other countries with an applicable tax treaty): All these tax rules are subject to the U.S.-France Estate Tax Treaty. If the settlor is a U.S. resident under the treaty at the time of his death and the trust assets don’t include any French real property owned directly by the trust, or indirectly through a company, no tax will be levied in France on any French beneficiaries.

French Income Taxation

Income received from a trust by a French resident is taxed with estimated tax of 30 percent due on the 15th of the following month and total tax rate rising to 45 percent.

Original principal isn’t taxed as income on a distribution to a beneficiary.

Income that’s built up inside a trust without being distributed typically isn’t subject to French income tax but may be subject to French inheritance or gift tax.

Applicability to U.S. Citizens

A U.S. citizen who becomes a resident of France is exempt from the IFI, except on French assets, for the first five years of residence.

Special rules also apply for U.S.-source passive income (deductible tax credit in France equal to the French income tax). These rules are applicable to trust distributions.

However, a trust of which the U.S. citizen is the settlor must still be reported and the exemption claimed for purposes of the IFI.

After five years, the U.S. citizen residing in France will be fully taxed by France on all his worldwide real properties, including trust assets, for wealth tax purposes.

Succession Tax—U.S. Citizens

On the death of a U.S. citizen who resides in France, French succession tax applies to all his worldwide assets, including assets in any trust of which he’s the settlor.

Assets that pass to a trust for a single beneficiary will be taxed as part of the decedent’s worldwide estate, under the rules described above.

Assets passing to discretionary trusts at the settlor’s death will be taxed at a 60 percent rate.

A U.S. citizen fiscally domiciled in France is subject to U.S. tax (income, gift and estate taxes). Under the U.S.-France Estate Tax Treaty, a U.S. citizen residing in France who leaves his assets outright to his French citizen spouse will obtain a $11.18 million marital deduction in addition to the unified credit of $11.18 million.

Thus, a U.S. citizen may leave a total of $22.36 million outright to his French spouse.¹² That is, a U.S. citizen who passes property to his French citizen spouse won’t need to use a qualified domestic trust for property valued less than or equal to that amount.¹³

Transfers between spouses at death are exempt from tax in France.

U.S. Citizen Trust Beneficiary

A U.S. citizen living in France who’s the beneficiary of a U.S. trust will be treated as the owner of the trust if the original settlor isn’t living (that is, as a deemed settlor-beneficiary).

He’ll be subject to the IFI on distributions to French gift tax if the distribution is made to other beneficiaries and on death to French succession tax.

There will be no credit for U.S. estate tax because no tax will be payable in the United States.

Trusts Created by French Citizens

Generally, there’s no tax advantage to a French individual creating a trust. There will be substantial reporting requirements, and the tax effect will be the same as if the property were owned outright, possibly worse.

However, because trusts aren’t available under French law, a French person may want to create a trust for long-term management and control of assets if the French law regime of the fiducie is inadequate, recognizing that there will be reporting requirements and no tax advantage, but no disadvantage if it’s done properly.

The settlor, however, must not be a French resident at the time of the creation of the trust or at the time of his death, if assets are to remain in trust post-mortem. Otherwise the transfer of the trust assets to the beneficiaries, whoever they are, will be subject to a 60 percent tax in France.

Wealth Tax

France formerly had a wealth tax (the impôt de solidarité sur la fortune or ISF) that could be applied to trust assets under the 2011 trust law. This wealth tax was repealed effective Jan. 1, 2018 and replaced by a tax on French real estate, regardless of how it’s held (the IFI). An individual is subject to the IFI if he has applicable French real property with a net value exceeding €1.3 million. The tax is levied at graduated rates ranging from 0.5 percent to 1.5 percent. The first €800,000 of value isn’t taxed.  The 0.5 percent rate applies to the taxable value from €800,000 to €1.3 million, and the top rate of 1.5 percent applies to taxable value in excess of €10 million.

Under French law and for the purpose of the IFI, real property held by a trust is deemed owned by the settlor or by a deemed settlor-beneficiary.¹⁴ Accordingly, all real property of a trust will be subject to the IFI if the deemed owner of the trust is a French fiscal domiciliary (except foreign real estate exempt under an applicable income tax treaty), while only French real property will be subject to the IFI if the deemed owner isn’t a French fiscal domiciliary.¹⁵ It’s important that the deemed owner himself declare the property on an IFI return and pay the tax because the highest rate of tax will be levied for property taxed to a trust and not declared by the deemed owner.¹⁶

In addition, a trust with French real property is subject to the reporting requirements described above, aimed at revealing the trust’s subject real property and the identity of the deemed owners responsible for paying the tax.

As noted above, that annual trust declaration must be accompanied by any required payment of the amount of any IFI on the value of real property due for that year. If the real property wasn’t duly reported as owned by the deemed owners, the required tax wasn’t paid by them.¹⁷ Again, we stress that the tax will be levied at the 1.5 percentage rate when a trustee pays the tax, rather than the deemed owners.   

Endnotes

1. Decree No. 2012-1050 for the reporting obligations of trustees is found at “Décret n° 2012-1050 du 14 septembre 2012 relatif aux obligations déclaratives des administrateurs de trusts,” www.legifrance.gouv.fr/eli/decret/2012/9/14/EFIE1229648D/jo/texte.

2. Code géneral des impôts (CGI) Art. 344 G sexies.

3. The form is available at www.impots.gouv.fr/portail/files/formulaires/2181-trust1/2017/2181-trust1_1200.pdf.

4. CGI art. 990 J.

5. The form is available at www.impots.gouv.fr/portail/files/formulaires/2181-trust2/2017/2181-trust2_1209.pdf.

6. The tax on “mutations à titre gratuit,” CGI art. 750 ter et seq.

7. CGI art. 777.

8. CGI art. 750 ter.

9. CGI art. 750 ter.

10. CGI art. 792-0 bis.

11. See CGI art. 792-0 bis and CGI art. 641.

12. The marital deduction under the treaty applies if at the time of the decedent’s death: (1) the decedent was domiciled in either France or the United States or was a citizen of the United States; (2) the decedent’s surviving spouse was domiciled in either the United States or France; if both the decedent and the decedent’s surviving spouse were domiciled in the United States at the time of the decedent’s death, (3) one or both was a citizen of France; and (4) the executor of the decedent’s estate elects the benefits of the treaty provision and irrevocably waives the benefits of any other estate tax marital deduction that would be allowed under the law of the United States on a U.S. federal estate tax return for the decedent’s estate by the date on which a qualified domestic trust election could have been. See Protocol Amending the 1978 U.S.-France Estate Tax Treaty (Dec. 8, 2004), Art. VI, para. 3. Note that the unified credit against the U.S. estate and gift taxes was recently doubled from $5 million to $10 million (plus an inflation adjustment) under the Tax Cuts and Jobs Act of 2017. Public Law No. 115-97 (Dec. 22, 2017).

13. Under U.S. law, the unlimited marital deduction is only applicable in the case of a U.S.-citizen spouse, unless the property passes to a qualified domestic trust (QDOT). See Internal Revenue Code Sections 2056(d) and 2056A. Estate tax with respect to the decedent’s estate is imposed on property of the QDOT on distributions during the surviving spouse’s lifetime and on his death. IRC Section 2056A(b).

14. CGI art. 792-0 bis and 970.

15. See CGI art 965. The veil is pierced also for corporations and certain other entities.

16. CGI art. 990 J.

17. CGI art. 990 J.

The Tax Cuts and Jobs Act of 2017 (the Act), was signed into law on Dec. 22, 2017, bringing a myriad of changes to the Internal Revenue Code and sparking a substantial amount of commentary and analysis. While much attention has been centered on the consequences of the Act for individual and business taxpayers, relatively little focus has been given to the impact of the Act on trusts and estates. Many of the provisions of the Act that apply to individuals are indeed equally applicable to trusts and estates, but the suspension of miscellaneous itemized deductions under IRC Section 67(g) should prompt a renewed focus on the allocation of expenses of trusts and estates and may, for some trustees and executors, tip the scales in favor of distributing trust property to individual beneficiaries who are in a more advantageous income tax position as a result of the Act.¹

Background

Deductions for estates and non-grantor trusts² fall into two general categories: 

(1) “Above-the-line” deductions (including expenses arising from a trade or business) are generally enumerated in IRC Section 62(a) and are subtracted from gross income in calculating adjusted gross income (AGI); and 

(2) “Below-the-line” or “itemized” deductions (including most expenses arising from profit-oriented activities other than a trade or business) generally include deductions not enumerated in Section 62(a) and are subtracted from AGI in calculating taxable income (on which a taxpayer’s actual tax liability is calculated).  

This distinction is meaningful because, as further discussed, below-the-line deductions are subject to certain limitations that don’t apply to above-the-line deductions.  

Prior to 1941, taxpayers and the Internal Revenue Service treated expenses arising from a trade or business and expenses arising from profit-oriented activities other than a trade or business as above-the-line deductions under the predecessor to IRC Section 162, which on its face provided deductions only for expenses incurred in “carrying on any trade or business.”³ In 1941, however, the U.S. Supreme Court, in Higgins v. Commissioner,⁴ drew a clear distinction between profit-oriented expenses and trade or business expenses, rejecting the proposition that the petitioning taxpayer was engaged in a trade or business by virtue of managing his own investment portfolio, notwithstanding that the portfolio was large enough, and required enough attention, to warrant an office and administrative staff.⁵ Further, the Court held that the expenses of profit-oriented activities that didn’t rise to the level of a trade or business weren’t deductible under the predecessor to Section 162, reasoning that such an interpretation was contrary to the existing authority.⁶

In 1942, in response to Higgins, Congress enacted the predecessor to IRC Section 212 with the goal of, to some degree, restoring the equivalence between profit-oriented expenses and trade or business expenses.⁷ The current version of Section 212 provides:

In the case of an individual, there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year—(1) for the production or collection of income; (2) for the management, conservation, or maintenance of property held for the production of income; or (3) in connection with the determination, collection, or refund of any tax.

Section 212 expenses may include: (l) investment advisory fees; (2) subscriptions to investment advisory publications; (3) qualifying attorney’s fees; (4) expenses for clerical help and office rent in managing investments; (5) fees to collect interest and dividends; (6) losses on deposits in insolvent or bankrupt financial institutions; (7) service charges on dividend reinvestment plans; and (8) a trustee’s fees for an individual retirement account if separately billed and paid.⁸

Although the predecessor to Section 212 was enacted to establish a measure of equality between profit-oriented expenses and trade or business expenses, the latter have always enjoyed preferential treatment as above-the-line deductions.⁹ Profit-oriented expenses, on the other hand, generally constitute itemized deductions, and as a result of the Act, the bias against profit-oriented expenses is stronger than ever. 

The 2 Percent Floor

Section 67(a) requires that taxpayers further divide their itemized deductions (including most deductions for profit-oriented activities) into: (1) “miscellaneous itemized deductions” and (2) all other itemized deductions. Section 67(b) provides that all itemized deductions other than those specified therein are miscellaneous itemized deductions. Accordingly, because they’re not mentioned in Section 67(b), investment advisory expenses, tax preparation and other professional fees generally constitute miscellaneous itemized deductions.  

Prior to 2018, a taxpayer’s miscellaneous itemized deductions were allowed only to the extent that their aggregate value exceeded 2 percent of a taxpayer’s AGI.¹⁰ Put differently, the deductions were added together and then reduced (but not below zero) by 2 percent of AGI. This limitation has often been referred to as the
“2 percent floor.” Miscellaneous itemized deductions that were disallowed as a result of the 2 percent floor were permanently lost, as they couldn’t be carried forward to future tax years.

Section 67(e): An exception to the 2 percent floor. Section 67(e) directs that certain deductions of a trust or estate that would otherwise be miscellaneous itemized deductions be treated as above-the-line deductions. Specifically, “deductions for costs which are paid or incurred in connection with the administration of the estate or trust and which would not have been incurred if the property were not held in such trust or estate” are to be deducted in computing AGI of a trust or estate.¹¹ Accordingly, these deductions aren’t subject to the 2 percent floor. 

Treasury Regulations Section 1.67-4, effective for tax years beginning on or after Jan. 1, 2015, clarifies that an expense isn’t subject to Section 67(e) if it “commonly or customarily would be incurred by a hypothetical individual holding the same property” and that “it is the type of product or service rendered to the estate or non-grantor trust in exchange for the cost, rather than the description of the cost of that product or service, that is determinative.”¹² This latter distinction is in keeping with the U.S. Supreme Court’s decision in Knight v. Comm’r,¹³ in which it held that a trust’s investment advisory costs were miscellaneous itemized deductions because it’s common for individuals to hire investment advisors, notwithstanding that an individual, acting in his individual capacity, wouldn’t have the fiduciary duty of a trustee and couldn’t incur trust investment advisory fees.¹⁴

Treas. Regs. Section 1.67-4 provides the following nonexclusive list of the types of costs that are commonly and customarily incurred by individuals: (1) costs incurred in defense of a claim against the estate, the decedent or the non-grantor trust that are unrelated to the existence, validity or administration of the estate or trust, (2) ownership costs; (3) tax preparation fees; (4) investment advisory fees; and (5) appraisal fees.¹⁵ Specifically excluded from this category of expenses are certain fiduciary expenses, such as probate court fees and costs, fiduciary bond premiums, legal publication costs of notices to creditors or heirs, the cost of certified copies of the decedent’s death certificate and costs related to fiduciary accounts.¹⁶

The proposed version of the regulation also indicated that the cost of products or services related to the following items would be considered “unique” to an estate or trust: (1) fiduciary accountings; (2) judicial or quasi-judicial filings required as part of the administration of the estate or trust; (3) fiduciary income tax and estate tax returns; (4) the division or distribution of income or corpus to or among beneficiaries; (5) trust or will contest or construction; (6) fiduciary bond premiums; and (7) communications with beneficiaries regarding estate or trust matters.¹⁷ This list was nonexclusive and was ultimately omitted from the final version of the regulation following the Knight decision and the resulting shift in the standard of evaluation from “uniqueness” to whether a cost was “commonly and customarily incurred by individuals.” Nonetheless, the list remains instructive.

Generally, the regulation requires that if an estate or trust pays a single fee, commission or other expense for both types of costs (and if the costs that would be subject to the 2 percent floor are more than de minimis in amount), the taxpayer must allocate the payment using “any reasonable method” between the costs that are subject to the 2 percent floor and those that aren’t.¹⁸ If a bundled fee isn’t computed on an hourly basis, however, only the portion of that fee that’s attributable to investment advice is subject to the 2 percent floor; the remaining portion isn’t subject to the 2 percent floor.¹⁹ Additionally, out-of-pocket expenses billed to the estate or non-grantor trust are treated as separate from the bundled fee and aren’t subject to allocation.²⁰ In contrast, “payments made from the bundled fee to third parties that would have been subject to the 2 [percent] floor if they had been paid directly by the estate or non-grantor trust are subject to the 2 [percent] floor, as are any fees or expenses separately assessed by the fiduciary or other payee of the bundled fee (in addition to the usual or basic bundled fee) for services rendered to the estate or non-grantor trust that are commonly or customarily incurred by an individual.”²¹ Among the facts that may be considered in determining whether an allocation is reasonable are: (1) “the percentage of the value of the corpus subject to investment advice;” (2) “whether a third party advisor would have charged a comparable fee for similar advisory services;” and (3) “the amount of the fiduciary’s attention to the trust or estate that is devoted to investment advice as compared to dealings with beneficiaries and distribution decisions and other fiduciary functions.”²²

The New Section 67(g)

To this framework, the Act adds the new Section 67(g), which provides that “no miscellaneous itemized deduction shall be allowed for any taxable year beginning after December 31, 2017, and before January 1, 2026.” Clearly, that portion of a trust’s expenses that would previously have been subject to the 2 percent floor will be disallowed as a result of this provision. This result is consistent with the treatment of such expenses when incurred directly by individuals under the Act. However, the application of Section 67(g) to expenses that weren’t previously subject to the 2 percent floor is less clear. One may argue that because they’re not among the costs enumerated in Section 62(a), but are instead dealt with under Section 67, which otherwise addresses which itemized deductions are subject to the 2 percent floor, Section 67(e) expenses are, by implication, itemized deductions. It would follow that because these expenses also aren’t among those enumerated in Section 67(b), they must be miscellaneous itemized deductions (albeit miscellaneous itemized deductions that were granted preferential treatment prior to 2018). Based on this interpretation, the profit-oriented expenses of a trust that were previously treated as above-the-line deductions under Section 67(e) and weren’t subject to the 2 percent floor would now be disallowed as miscellaneous itemized deductions. 

We believe the better argument is that, in spite of being mentioned in Section 67 rather than Section 62, expenses addressed by Section 67(e) aren’t itemized deductions and thus can’t be miscellaneous itemized deductions. Pursuant to Section 63(d), “the term itemized deductions means the deductions allowable under [Chapter 1 of the IRC (which includes Section 212)] other than—(1) the deductions allowable in arriving at adjusted gross income, and (2) the deduction for personal exemptions provided by section 151.” Accordingly, based on the plain language of the statute, Section 67(e) expenses that are allowable under Section 67(e) in arriving at AGI can’t be itemized deductions. Section 67(e) specifically states these deductions are to be taken to arrive at AGI and so by statute are defined as not being a miscellaneous itemized deduction. While the concept of a standard deduction (which may be taken in lieu of itemized deductions) isn’t applicable to trusts and estates, the above definition is consistent with the idea that deductions that may be taken in arriving at AGI can’t be itemized deductions because they may be taken by an individual taxpayer even if he takes the standard deduction rather than itemizing. 

Form 1041, Schedule I, on which a trust or estate calculates its alternative minimum tax (AMT) liability, also supports this interpretation. For AMT purposes, “[n]o deduction shall be allowed for any miscellaneous itemized deduction (as defined in section 67(b)).”²³ This disallowance was effective prior to 2018, so logic would dictate that if Section 67(e) expenses were classified as miscellaneous itemized deductions, Schedule I would provide a clear indication that such costs are disallowed for AMT purposes. However, Schedule I doesn’t include among its adjustments any item that could reasonably be interpreted to include Section 67(e) expenses, as it directs the taxpayer to transfer to Schedule I the amount of miscellaneous itemized deductions reported on Form 1041, an amount that’s reported separately from the taxpayer’s Section 67(e) expenses.

Benefit to Trusts and Estates

Viewed in isolation, the suspension of all miscellaneous itemized deductions under Section 67(g) doesn’t disadvantage trusts and estates relative to individual taxpayers, as it applies to both groups of taxpayers. The same may be said of the $10,000 limitation on state and local taxes, which similarly applies to both groups of taxpayers. However, when one considers the overall impact of the changes, some trusts and estates will see the disparity between their tax bills and the tax bills of similarly situated individuals increase beyond 2017 levels, while others will see a relative reduction of the penalty imposed on trusts and estates under the IRC. Unlike individuals, who may elect to take a standard deduction equal to not less than $12,000 in lieu of itemizing, trusts and estates don’t receive the benefit of a minimum below-the-line deduction. Moreover, while individuals previously were subject to an overall limitation on itemized deductions under IRC Section 68 that didn’t apply to trusts and estates, that limitation has also been suspended from 2018 through 2025 under Section 68(f). Nevertheless, due to the compressed rate structure applicable to trusts and estates, the reduction in marginal tax rates under the Act provides a greater benefit to trusts and estates, all other factors being equal, and this benefit increases as the trust’s or estate’s taxable income increases. As discussed above, it also appears that trusts and estates will continue to be permitted to deduct those expenses that were previously deductible under Section 67(e). It’s unclear, then, which group of taxpayers has been made relatively better off under the Act, and those with an opportunity to remove assets from a trust or estate should consider their particular circumstances in evaluating whether, from an overall perspective, it makes sense to distribute trust assets into the hands of beneficiaries. If the goal is simply to minimize income taxes, this may or may not be accomplished by simply distributing income to trust beneficiaries,²⁴ though a variety of factors, including state income taxes, will be relevant to this determination. Nevertheless, the trustee, in discharging the trustee’s fiduciary duty, should also consider such factors as the current and future transfer tax impact of a distribution and the desirability of putting trust principal in the hands of a beneficiary (and the beneficiary’s creditors).                

Endnotes

1. For a more thorough analysis of the deductibility of trust expenses prior to 2018, see Domingo P. Such, III and Tina D. Milligan, “Understanding the Regulations Affecting the Deductibility of Investment Advisory Expenses by Individuals, Estates and Non-Grantor Trusts,” 50 Real Prop Prob. & Tr. J. 439.

2. All references to “trusts” in this article refer to non-grantor trusts, which are treated as distinct taxpayers under the Internal Revenue Code. The income and expense items of grantor trusts, on the other hand, are consolidated with those of the trust’s deemed owner (generally, the trust’s grantor).

3. Section 23(a) of the Internal Revenue Act of 1928 provided as follows:

In computing net income there shall be allowed as deductions:

         . . . All the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including a reasonable allowance for salaries or other compensation for personal services actually rendered; traveling expenses (including the entire amount expended for meals and lodging) while away from home in the pursuit of a trade or business; and rentals or other payments required to be made as a condition to the continued use or possession, for purposes of the trade or business, of property to which the taxpayer has not taken or is not taking title or in which he has no equity.

4. Higgins v. Commissioner, 312 U.S. 212 (1941).

5. Ibid., at p. 218. 

6. Ibid.

7. See IRC Section 23(a)(2) (1942). Section 23(a)(2) provided as follows: “[In computing net income, there shall be allowed as deductions:] In the case of an individual, all the ordinary and necessary expenses paid or incurred during the taxable year for the production or collection of income, or for the management, conservation, or maintenance of property held for the production of income.” See also S. Rept. 1631, 77th Cong., 2d Sess., reprinted in 1942-2 C.B. 504, 570 (stating that amendment allows a deduction for “the ordinary and necessary expenses of an individual paid or incurred during the taxable year for the production and collection of income, or for the management, conservation, or maintenance of property held by the taxpayer for the production of income, whether or not such expenses are paid or incurred in carrying on a trade or business”) (emphasis added).

8. See Temp. Treasury Regulations Section 1.67-IT(a)(1)(ii); see also Internal Revenue Service, U.S. Dep’t of the Treasury, Pub. 529, miscellaneous deductions (2014).

9. See IRC Section 62(a).

10. Ibid.

11. IRC Section 67(e).

12. Treas. Regs. Section 1.67-4(a)-(b)(1).

13. Knight v. Comm’r, 552 U.S. 181 (2008).

14. Ibid., at pp. 187-188 (2008).

15. Treas. Regs. Section 1.67-4(b)(1)-(5).

16. Treas. Regs. Section 1.67-4(b)(6).

17. Prop. Treas. Regs. Section 1.67-4(b).

18. Treas. Regs. Section 1.67-4(c)(1).

19. Treas. Regs. Section 1.67-4(c)(2).

20. Treas. Regs. Section 1.67-4(c)(3).

21. Ibid.

22. Treas. Regs. Section 1.67-4(c)(4).

23. IRC Section 56(b)(1).

24. While a full discussion of the income taxation of estates and trusts is beyond the scope of this article, pursuant to IRC Section 661(a), an estate or trust is entitled to deduct the lesser of “distributable net income” and the sum of “(1) any amount of income for such taxable year required to be distributed currently… and (2) any other amounts properly paid or credited or required to be distributed for such taxable year.” Accordingly, distributed income becomes taxable to the beneficiary and not the estate or trust.

Another year has come and gone with no shortage of interesting cases containing, among some of the more interesting topics, fiduciary mistakes and tax issues. The following noteworthy cases highlight trends we see evolving in the fiduciary field.

Digital Assets

Access to a decedent’s digital assets is becoming extremely important as more clients are going paperless, foregoing the use of written communications and discontinuing landline telephones. What happens when an appointed fiduciary is asked to access a decedent’s email accounts? What role do third-party companies play in either allowing or disallowing the release of information (for example, banks and Internet service providers)?  

In Matter of Serrano,¹ the court granted the pro se petitioner permission to view a decedent’s Google calendar, but was denied, without prejudice, permission to view the content of the decedent’s email communications without first establishing that the disclosure of that electronic information was reasonably necessary for the administration of the estate. The court acknowledged that a calendar entry isn’t a “communication” as defined by the Stored Communications Act.² 

In Ajemian v. Yahoo!, Inc.,³ the personal representatives to the estate sought access to the decedent’s email. While the court didn’t go so far as to require that Yahoo divulge the contents of the decedent’s communications to the personal representatives, it concluded that personal representatives may provide lawful consent on the decedent’s behalf to release the contents of a Yahoo email account.

Language in Wills

We’re often faced with documents drafted by attorneys who either don’t understand probate and trust law or know the law but draft documents to appease clients, rather than follow the law.  

In Estate of Rodriguez,⁴ evidently, the drafting attorney chose to use the word “desire” to delineate that the testator wanted his ranch to stay intact (rather than be sold). Among other factors, the court found that this “precatory” language wasn’t “mandatory” and allowed the sale of property to a third party (rather than a sale to a competing offer from a family member). The determination of whether a particular word is precatory or mandatory turns on “the testator’s expressed intent as evidenced by the context of the will and surrounding circumstances.”⁵

In Bogar v. Baker,⁶ the decedent’s will left specific real estate together with all contents of said real estate to one relative. This 31 acre farm had a house, several buildings, tools, equipment, vehicles and machinery. A dispute arose regarding whether the testator intended to include the automobile and farm equipment with the real estate. The appellate court found that the will contained a latent ambiguity and instructed the lower court to hold an evidentiary hearing to decide whether vehicles and farm equipment should be interpreted as “contents of” such testator’s real estate.

Trustee Discretion

Trusts frequently are drafted with broad provisions dealing with distributions of income and principal. When an individual trustee is named, there’s a sense of naivety involved at times, as clients and their attorneys hope that such trustee will actually follow a health, education, maintenance and support standard or appoint an independent or disinterested fiduciary to serve.  

In Matter of Goodman,⁷ an individual trustee distributed principal to the grantor for basic living expenses and made payments of alimony to the grantor’s ex-spouse. The court “blessed” these distributions, citing New York common law for the proposition that a trustee’s discretionary power is to be exercised free from judicial interference when exercised reasonably and in good faith.

In contrast, the court in Landau v. Landau⁸ froze trust assets after a remainder beneficiary proved that action was proper against the beneficiary-trustee to preserve assets of the estate and the trust for the protection of the ultimate beneficiaries. The remainder beneficiary alleged the beneficiary-trustee made excessive distributions to himself and failed to file tax returns and trust accountings. On ordering the freezing of the trust assets, the beneficiary-trustee provided an accounting showing distributions far exceeding such trust’s net income for the year.

Decanting

When is common law decanting appropriate? Can decanting be used as a sword to thwart creditors?  

In Ferri v. Powell-Ferri,⁹ the Massachusetts Supreme Judicial Court (SJC) on certification from the Connecticut Supreme Court, was asked to answer three questions concerning a trustee’s authority to decant. The Massachusetts SJC declared that the trustee of a Massachusetts trust could decant under Massachusetts common law even if the beneficiary was in the middle of a divorce proceeding. Additionally, when the trust was silent on the issue of whether the trustees could decant, the court opined that judges can consider an affidavit of the settlor indicating the settlor’s priority for the trustee to do whatever he believed to be necessary and in the best interest of the beneficiary. 

Removal of Trustee

If the trust instrument is silent, can consenting beneficiaries switch fiduciaries? In In re Trust Under Agreement of Taylor,¹⁰ the corporate trustee was aided by the comments to the Uniform Trust Code in having an appellate court disallow the beneficiaries’ proposed modification of a trust to permit the replacement of a corporate trustee. The trust in question was from 1928, and even though the beneficiaries unanimously agreed on the desire to switch fiduciaries, the court held that the exclusive remedy for removal was by court approval, and such power couldn’t be added to the trust instrument through judicial modification.

Formalities of Document Execution

Often, fiduciaries are asked to supervise document execution ceremonies. How stringent are those requirements? In Kelly v. Lindenau,¹¹ a trust amendment wasn’t executed with the requisite formalities under Florida law during the settlor’s lifetime. A Florida district court invalidated the attempted imposition of a constructive trust to obtain the relief sought for a petitioning beneficiary. The court held that while the imposition of a constructive trust might be appropriate if a will (and thus a trust) was validly executed, that remedy isn’t appropriate when there’s an error in the execution of the document.

Payment of Attorney’s Fees

Litigants can end up draining a trust through litigation.  When a trust is involved, a question to be debated is whether the trust is on the hook to pay attorney’s fees.  

In In re Bloom,¹² the court held that because the probate court assumed jurisdiction over the trust, Florida law applied and, on remand to the lower court, the court was instructed to decide the issue of whether an attorney who had rendered services to a trust could be awarded reasonable compensation from the trust. The court clarified that the fee-petitioning party must serve an application for attorney’s fees on various parties, among them, the beneficiaries, identified in the Florida statute on point, contemporaneously with the filing of the application with the court.

Disappearing Assets

Cash. Some of our clients choose to use a home safe instead of keeping cash with a bank or financial institution. As advisors, we need to identify potential solutions. 

In In re Estate of Crain,¹³ some of the decedent’s children (the exceptors) alleged that a significant amount of cash stored in strongboxes was missing from their father’s estate. The court held that in a case of cash missing from a strongbox, the special administrator hadn’t failed his fiduciary duty in inspecting the decedent’s home and contents, identifying decedent’s bank accounts and accounting for other money and contents held in strongboxes. The court noted that there was insufficient evidence and testimony to substantiate the amount of money that the exceptors claimed was missing.

Art. Each year, another case of a missing or forged piece captivates the art world. Increasingly, fiduciaries are asked to marshal art assets. But, what are the minimum steps that a personal representative or trustee has to take to retrieve stolen pieces of art? As 2018 moves along, it will be interesting to see the outcome of Beale v. Wallace Gallery,¹⁴ in which representatives of the estate of Edith Beale (a first cousin of Jacqueline Kennedy Onassis) are suing an art gallery claiming a portrait of Jacqueline Kennedy Onassis rightfully belongs to them.

Self-settled Spendthrift Trusts

Much has been written about the benefits of self-settled asset protection trusts. At least four states, Alaska, Delaware, Nevada and South Dakota, are consistently thought of as “the” jurisdictions to settle such trusts.  When spousal support orders are an issue, it appears Nevada achieved some separation from the group of states. In Klabacka v. Nelson,¹⁵ the court held that Nevada self-settled trusts are protected against court-ordered child support or spousal support obligations of the settlor/beneficiary that aren’t known at the time the trust is created. For our colleagues in community property states, prior to the creation of the trusts, the parties entered into a valid transmutation agreement.

In contrast, Alaska suffered a setback with the decision in Toni 1 Trust v. Wacker,¹⁶ in which the Alaska Supreme Court refused to follow the Alaska fraudulent transfer law when the cause of action arose under Montana law relating to an Alaska trust. In so holding for the creditor, the Alaska Supreme Court indicated that state and federal courts aren’t required to follow a sister state’s statute that purports to retain exclusive jurisdiction over a fraudulent conveyance action despite the Alaska legislature’s attempt to grant Alaska courts exclusive jurisdiction over a class of claims.

Beneficiary Designations

Failure to update a client’s beneficiary designation can cause major problems. We’re seeing this happen especially post-divorce and following a predeceased spouse’s death.  

In Mueller v. Edwards,¹⁷ the decedent attempted to change a beneficiary designation on a payable-on-death account by naming an individual as the sole beneficiary in a handwritten note found in decedent’s safe. The court held that this attempt to change the beneficiary was ineffective. The decedent’s attempted change wasn’t akin to a will’s separate writing. 

Releases

When a fiduciary makes a final payment to a beneficiary, thereby terminating their relationship, is his duty to the beneficiary over? What kind of a release is necessary to truly be released from a trustee’s fiduciary duties?

In Ohio, a signed release could potentially give some comfort. In a 2017 case, an Ohio court ruled that after a party signs a release, the burden shifts to such party seeking to invalidate it.¹⁸ The court noted that when beneficiaries had constructive knowledge of asset information imputed from matters freely available in the public record, they couldn’t then complain about lacking knowledge of material facts related to an asset distributed by the corporate fiduciary prior to the release.

In Matter of Ingraham,¹⁹ a former trustee sought to quash a successor trustee’s petition to account, claiming that the releases she signed with the grantor and former co-trustee barred the successor trustee from seeking to compel her to account. The court held that the release didn’t relieve the former trustee of her duty to account, indicating that without a full release from all beneficiaries or a formal discharge from the court, the former trustee remained duty bound to account.

Corporate Fiduciaries

Annually, newspapers print big bold headlines highlighting a particular charge of alleged malfeasance of a corporate fiduciary. Recently, a headline-grabbing “$8 billion verdict” was issued against one corporate fiduciary.²⁰ In the trial, it was alleged that the corporate fiduciary hired to administer an estate, with a value of less than $30 million, took too long to release basic interests in the decedent’s assets. However, the corporate fiduciary contended that the disagreements among the surviving heirs led to much of the delay. The facts appear to illustrate the need to taper a beneficiary’s expectations when it comes to distributing an estate with heirs consisting of a surviving spouse and children from a separate marriage and assets consisting of collections of unique goods such as wine and golf equipment. 

Not all published corporate fiduciary cases are negative. In the New York case of Matter of Sinzheimer,²¹ the court indicated that it was reasonable for the outgoing corporate fiduciary to petition the court to appoint a new corporate fiduciary to serve with an individual fiduciary prior to turning over trust assets to the individual fiduciary. The corporate fiduciary hadn’t unduly prolonged the possession of assets, and its actions were deemed prudent and appropriate under the circumstances.

Furthermore, one corporate fiduciary has been doing the best it can to avoid removal and competently administer a famous musician’s estate.²² In the most recent unreported case stemming from the death of Prince,²³ the court dismissed a claim from one of Prince’s former attorneys, holding that the claimant failed to meet the statutory requirement that it commence any proceeding for allowance of the claim within the 2-month statutory time limit.           

Endnotes

1. Matter of Serrano, 54 N.Y.S.3d 564 (Sur. Ct. June 14, 2017).

2. 18 U.S.C. Section 2701 et seq.

3. Ajemian v. Yahoo!, Inc., 478 Mass. 169 (2017).

4. Estate of Rodriguez, No. 04-17-00005-CV, 2018 Tex. App. LEXIS 254 (App. Jan. 10, 2018).

5. Ibid., at p. 9.

6. Bogar v. Baker, 2017-Ohio-7766 (Ct. App.).

7. Matter of Goodman, 52 N.Y.S.3d 363 (1st Dep’t 2017).

8. Landau v. Landau, 230 So. 3d 127 (Fla. 3d DCA 2017).

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

10. In re Trust Under Agreement of Taylor, 164 A.3d 1147 (Pa. 2017).

11. Kelly v. Lindenau, 223 So.3d 1074 (Fla. 2d DCA 2017).

12. In re Bloom, 227 So.3d 165 (Fla. 2d DCA 2017).

13. In re Estate of Crain, 2017-Ohio-2724 (Ct. App.).

14. Beale v. Wallace Gallery et al., No. 2:2018cv00871, N.Y. East. D. Crt. (compl. filed Feb. 8, 2018).

15. Klabacka v. Nelson, 394 P.3d 940 (Nev. 2017).

16. Toni 1 Trust v. Wacker, No. S-16153, 2018 Alas. LEXIS 27 (March 2, 2018).

17. Mueller v. Edwards, 378 Wis. 2d 689 (2017).

18. Zook v. JPMorgan Chase Bank Nat’l Ass’n, 85 N.E.3d 1197 (Ct. App. 2017).

19. Matter of Ingraham (Daphne), 2017 NYLJ LEXIS 1641.

20. Estate of Hopper v. JP Morgan Chase, N.A, et al., No. PR-11-3238-1, Probate Court No.1, Dallas Cty., TX (Sept. 25, 2017) See Mark Curriden, “JPMorgan Chase loses probate damage verdict,” Houston Chronicle (Sept. 26, 2017), www.houstonchronicle.com/business/article/JPMorgan-Chase-loses-probate-damage-verdict-12231215.php; Tom Korosec and  Margaret Cronin Fisk, “JPMorgan Says Family Awarded $8 Billion Deserves Nothing,” Bloomberg
(Nov. 11, 2017), www.bloomberg.com/news/articles/2017-11-11/jpmorgan-says-family-awarded-8-billion-verdict-deserves-nothing. See also Wassmer v. Hopper, 463 S.W.3d 513 (Tex. App. 2014).

21. Matter of Sinzheimer, 2017 NY Slip Op. 31379(U) (Sur. Ct. N.Y. Cty. 2017).

22. David Chanen, “Judge denies petition for new administrator of Prince’s estate,” Star Tribune (Dec. 18, 2017), www.startribune.com/judge-denies-petition-for-new-administrator-of-prince-s-estate/465043823/.

23. In re Estate of Prince, No. A17-0927, 2018 Minn. App. Unpub. LEXIS 181 (March 5, 2018).

I’ve been concerned about the emotional and relational impact of trusts since I had a professionally jarring encounter in 2001 with a beneficiary of an irrevocable trust established by her grandfather. The dependency, disempowerment and entitlement I witnessed led me to ask, “Is there a better way?”  

There’s a better way to think about the purpose and meaning of trusts that still honors the legal roles and responsibilities but lifts the influence of the trust to the point it becomes a generative (positive) influence in the lives of beneficiaries. The generative trust and generative trustee are that better way.

Traditional trust design centers on the choice of trustee, the tax and legal purposes of the trust instrument and the duties and powers given to the trustee. Trust administration continues to focus on managing assets, dealing with beneficiaries and managing risks.  

Over the last 20 years, I’ve witnessed delegated trusts emerge as a popular choice in many jurisdictions, particularly among the ultra-affluent. Trifurcation of trustee duties is becoming increasingly common in legal forms and drafting systems, whether or not it’s part of a delegated trust. I believe we’ll see trifurcation become an increasingly popular paradigm for design and drafting of trusts even in the mass affluent marketplace.

Little, however, has changed in the last three decades in terms of the conversations that estate-planning attorneys and prospective trustees have had with trust creators¹ around the pros and cons of corporate trustees and family trustees. Only recently, thanks to the efforts of family wealth experts Hartley Goldstone, Jay Hughes and others, are the trustee/beneficiary relationship and conversations growing healthier and more positive. The conversations among the attorneys, estate-planning strategists and trust creators need to evolve if we’re going to make trusts more generative.

Shift in Conversations 

I believe there are two fundamental but vitally important ways in which we need to shift the design and discovery conversations: 

1. The trust creators’ vision around the universe of “whys”² for creating their trusts needs to expand beyond tax minimization, asset protection and probate avoidance. A fourth “why” needs to be offered: the possibility that the trust can become a positive and meaningful influence in the lives of today’s beneficiaries and tomorrow’s remaindermen.

2. The function of the trustee needs to be designed to do more than just manage assets (the investment function), handle compliance and record keeping (the administrative function) and dispense cash or transfer assets (the distribution function). We should also offer a fourth functional description of a trustee: the potential to have a generative influence on the beneficiaries (the generative function).

The generative trustee concept aims to improve the distribution function, leading to more positive trustee/beneficiary relationships and promoting the individual growth and well-being of beneficiaries.

Defining “Generativity”

Let’s tackle the word “generativity” and learn how it applies to the trustscape.³ The concept of generativity was developed through the writings and research of Erik Erikson, the father of modern psychosocial development theory. Erikson posited that generativity arises in middle adulthood and refers to an adult’s need and ability to care for and guide the next generation.   

Generativity is usually applied to the parent-child relationship, but I believe it has great application to the role of the trustee. Through a series of questions and answers, I’d like to frame the conversation altering the potential of the generative trustee concept.

What’s a generative trust? It has two distinguishing aspects: purpose and positivity. Instead of protecting beneficiaries from themselves, the generative trust serves to empower and encourage beneficiaries. It’s a trust whose central purpose is the growth and well-being of the beneficiary. It’s also a trust grounded in the assumption that even though they may be young, immature or unproven, beneficiaries have the potential to become highly functioning adults.  

A generative trust is also built on a foundation of positive emotional energy, something completely foreign to trust design conversations but an absolute game changer for both trust creators and beneficiaries. It’s a trust that could start out with these two sentences: “This trust was created out of love, faith and hope. The paramount purpose of this trust is to nurture the growth and well-being of the beneficiaries.” Love is the most obvious of the non-tax, non-legal motivating influences for a generative trust. Faith is the confidence of the trust creator in the goodness and capabilities of the beneficiary. Hope comes from the trust creator’s dreams for the potential positive and sustainable influence the trust and trustee will be in the life of the beneficiary.

How is generativity put in motion by a generative trustee? It starts by developing a very positive trustee/beneficiary relationship. Generativity in the trust context may be expressed through mentoring, teaching, training, encouraging and even jointly participating with the beneficiary in volunteer work and charitable giving. Beneficiary grants, opportunity stipends and meaningful trustee/beneficiary conversations and celebrations are hallmarks of a generative trust. A generative trustee will attend important milestones, including sporting, educational, religious or relational (birthdays, anniversaries, holiday parties and celebrations).  

Does a generative trust require a generative trustee? No. But, it does require a trustee who’ll support the generative function by providing generative opportunities and resources as well as encouraging beneficiaries to take advantage of them. The generativity potential of the distribution function may be realized through the use of beneficiary coaches, trust advisors, distribution committees or mentors and consultants. Just exactly how much the actual trustee might do will depend on the design and the interest, capacities and aptitudes of the trustees. They may choose to actively participate or just be a committed supporter of the trust’s generative purpose.

How do you spot a generative trustee? What would you be looking for in an ideal generative trustee? A generative trustee isn’t necessarily someone age 45 or older. We can find younger individuals whose nature and drive are extremely generative. A key attribute of the generative trustee is the ability to help beneficiaries think for themselves instead of robbing them of that ability. Some of the other attributes of an ideal generative trustee include: strong communication skills, life wisdom as well as a healthy dose of common sense, the gift of holding people accountable, a non-judgmental and friendly persona, seeing the potential in others they don’t see in themselves and curiosity around what excites and fulfills others.   

Can you have a generative trustee without a generative trust? It’s certainly possible for a trustee to become a generative trustee even when the trust document isn’t generative. In rare cases, you’ll witness spontaneous generative combustion within the trustee. It’s more likely a beneficiary may learn of the generative trust and its concepts and desire to make his trustscape more generative. But, if the document doesn’t reflect that purpose, there’s no leverage. Unless the beneficiary can remove and replace the uncooperative non-generative trustee with a generative trustee, the generative possibility will fail.

Are generative trustees born or trained/coached? How do you find/become a generative trustee? While some of us may be blessed with greater generative drive than others, I’m convinced we can all become more generative with training, coaching and practice. Currently there isn’t a public directory of generative trustees. The Purposeful Planning Institute is attracting a number of trustees, professional, independent and corporate, who are committed to making the trusts they administer generative. Training and coaching are available for those who want to become generative trustees or increase their generative skills.  

Generative vs. Incentive Trusts 

Many trustees function like an ATM machine. The beneficiary shows up with the proper code, and the trustee dispenses the requested cash unless the request exceeds the limits set by the trust instrument.

Sometimes the ATM machine approach is coupled with restrictive conditions or incentives to encourage the beneficiary to do something, take a certain path in life, etc. These trusts are commonly referred to as “incentive trusts,” and I’ve lectured extensively about the unintended negative consequences that too often flow from incentive trusts.  

Incentive trusts are well-intentioned. The grantor of an incentive trust is certain he knows what’s best for the beneficiary and wants to protect the beneficiary from making costly mistakes or provide enticing pushes in the “right” life path.  

Incentive trusts are usually built on the foundation of edicts. Do this, and you’ll get this reward. Do that, and this will be withheld or withdrawn. Psychologists such as Eileen Gallo and James Grubman warn that incentive trusts more often than not fail. Why? Because human nature resists compulsion. Extrinsic financial incentives are likely to have short-term rather than long-term impact. In some cases, the incentives may actually repel rather than compel.

Another danger of the incentive trust is handcuffing the trustee’s ability to react to unforeseen circumstances that threaten the assumptions that the grantor’s incentives were built on.  

The generative trust stands in sharp contrast to the incentive trust. Generative trusts are usually designed with a best interests distribution standard and provide the trustee with discretion not only to deal with the likely and most anticipated circumstances in the path of a beneficiary but also to liberally consider how the trust can contribute to and improve the beneficiary’s happiness and well-being.

In a discussion of incentive trusts, I once heard an American College of Trust and Estate Counsel (ACTEC) fellow complain that clients were asking their trustees to become parental surrogates. He pointed out that no matter how hard a trustee tried, she would never alter the effects of poor parenting. In the almost 25 years that have elapsed since that conversation took place, I’ve seen the weeds of incentive trusts emerge. And, I’ve witnessed generative trustees overcome, or at least negate, poor parenting.

I’ve become convinced that even when clients weren’t as positive an influence as parents as they later hoped they would have been, it’s not too late to begin thinking about the generative influence a trust might have on their former (now adult) children and on the rising generations of their family.

So, how might we help a trust creator with adult or minor beneficiaries create a generative trust? The keys lie in changing our conversation and using exercises that will expand our client’s vision and allow us to capture their most positive expressions of emotional energy.  

Twenty years ago, I would have dismissed that possibility as a professional pipe dream. Today, I and an increasing number of attorneys, estate-planning strategists and trust consultants know that simple but powerful exercises are available to catalyze vision, capture purpose and positivity and provide meaningful guidance to both trustees and beneficiaries. 

Switching to a Generative Trust

In conversations around the possibility of a generative trust or trustee, clients may experience grantor’s remorse. They’ll wish they could have a mulligan on those trusts that are already established and in operation. Decanting into a new generative trust may be a possibility. Or, you may want to suggest the client encourage the trustee of his irrevocable trust documents to become a generative trustee or to bring in coaches, consultants or mentors who’ll help make the distribution function more generative.  

We can start the process of converting a non-generative trust into a generative trust or invite a trustee to become a generative trustee through what I call “guidance & guidelights.” Guidance is for the trustees. Guidelights are for the beneficiaries. Guidance & guidelights can be integrated into a trust, added as an appendix or can stand apart from the legal document.

When offering guidance & guidelights for established trusts, those documents won’t have any binding legal effect, unless of course a trust protector or redacting is part of the process. The most common form of guidance & guidelights I work with are a letter of wishes or letter of instructions. These tools can be a vital part of a process to create a new virtual climate for the old trust. It may lead to what I call a “virtual reformation.”  

A virtual reformation occurs when a cooperative generative trustee using the discretion already granted inside the old irrevocable trust document seeks to establish a healthier relationship with the beneficiaries and use the trust resources to pursue the generative purpose the trust creator expresses years after establishment of the trust agreement. Of course, the trustee has to continue to pay close attention to her legal duties under the original trust instrument. But, when a virtual reformation is possible, the generative trustee is able to see the spirit of the trust creator’s newly created purposeful vision and modify the administration of the trust so that discretion is exercised to pursue that new vision as closely as possible while staying within the legal bounds of the letter of the old instrument.

A Purposeful Trust That’s Generative

A purposeful trust is one that shares the trust creator’s positivity (love, faith and hope), values, wisdom and vision and encourages a healthy dialogue and relationship between the trustee and beneficiaries. Purposeful trusts possess the seeds of generativity. But, it takes a generative trustee to allow those seeds to germinate and produce generative results.

A friend of mine once asked, “What should I do? Build a better ship or train a better captain?” We were talking about the role of a trustee and the trustee’s potential influence, for better or worse, on the next generations of the trust creator’s family. I believe the answer to his question is: You must do both. You need both a purposeful trust and a generative trustee.  

The generative trustee will invest as much time and energy in the exercise of distribution discretion as is spent on the investment management and trust administration responsibilities. Ideally, a generative trustee will serve as both a mentor and accountability partner to the beneficiaries. In many senses, the generative trustee is the alter ego of a wise and loving parent. But, because the possible influence of a generative trustee is most strongly felt during and after the beneficiary’s journey to individuation, the generative trustee can’t approach his role in a paternalistic or hierarchical manner. He demeans the role, however, if he just becomes “best buds” with the beneficiary.

Generative Trustee in Action

When I first spoke at an ACTEC meeting about the possibility of a generative trustee more than a decade ago, a retired fellow in his 80s approached me.  

This man worked with a trial attorney who had risen to national prominence from humble beginnings in Texas. The trial attorney and his wife had only one child, a son in his late 20s, who was a twice-convicted felon then serving his sentence in a state prison. The trial attorney insisted, over his wife’s objections, that their joint trust be an incentive trust. It would provide incentives for their son to get an education, hold a job and live drug-free. If the son failed the mandatory drug tests, he’d be cut off.  

This ACTEC fellow saw this plan go into effect when the trial attorney died a short time later. The wife had wanted to change the plan but couldn’t or wouldn’t go against her husband’s wishes, and she died before her son was released from prison. One day the son showed up in the ACTEC fellow’s office. The son had been reading the trust document. He saw the possibility he could get an education. He asked the ACTEC fellow, who also served as a co-trustee with XYZ Bank, to champion his request to the corporate trustee for funds to get an education. He wanted to be a lawyer like his father.

The ACTEC fellow counseled the son that as a felon, it was a pipe dream to imagine he could get admitted to law school, let alone get admitted to the bar. The son persisted. He finished his undergraduate degree, stayed clean and volunteered in a poverty law clinic. He scored exceptionally well on his LSAT. But, he received one rejection after another from the law schools he sought to attend. He returned and asked the ACTEC fellow to accompany him to meet with the Dean of a law school in their community. In that meeting, the ACTEC fellow told the Dean he would mentor the now 30-something law student, and while it was unlikely he could ever practice law, he could use his legal education to help others by working behind the scenes in legal clinics or perhaps as a legal assistant. The Dean reluctantly agreed to the experiment.

Three years later, the son graduated with honors. He took the bar exam and passed but was denied admission because of the felony convictions. He came to the ACTEC fellow again and said, “I’m going to appeal my denial. Will you be a character witness?” The Dean and the ACTEC fellow were the key witnesses. The son was admitted to the bar and became a very successful lawyer. All of this was made possible because of a generative co-trustee. There wasn’t a purposeful trust or a generative trust. Just a generative professional who supported the dream of a beneficiary.  

Let’s all do our part, whether as the designers, drafters or administrators of trusts, to allow the generative potential of the trustscape to be realized.        

Endnotes

1. “Trust creator” is a term I’ve coined to describe the grantor of a purposeful or generative trust. It recognizes the possibility a grantor can play a much more active role in the creation of the trust when we use “Purposeful Visioning Exercises” as tools in the discovery and design phases. 

2. The Purposeful Planning Institute (PPI) has created a Why a Trust? Why This Trust? exercise that we’ll be happy to provide. Contact me at info@purposefulplanninginstitute.com.

3. “Trustscape” is a term coined by Hartley Goldstone, which refers to the entire landscape making up a healthy trust system.

The Tax Cuts and Jobs Act (the Act)¹ is the most far-reaching change to the Internal Revenue Code in over 30 years. Among other significant changes is the elimination or limitation until 2026 of most itemized deductions that had been allowed for individuals for federal income tax purposes. Although the state and local tax (SALT) deductions weren’t eliminated, the Act places an annual $10,000 limit on them under new IRC Section 164(b)(6). This new limitation has prompted certain states (and, in some cases, their political subdivisions) that impose high taxes to consider legislative proposals that would allow their residents to avoid the new $10,000 annual deduction limitation or curb its impact.

Proposals being considered by at least three states, California, New Jersey and New York, provide for contributions to certain charitable organizations, which support state (and local) functions, to be allowed as a credit against certain state (and local) taxes. This, in effect, would provide the same benefit of allowing a deduction without the $10,000 annual deduction limitation on SALT payments, although charitable contribution limits set forth in the IRC would apply. States are still in the process of considering sustainable approaches in this context. Legislation has already been introduced in California, SB 227, the “Protect California Taxpayers Act,” which would allow taxpayers to receive a dollar-for-dollar state tax credit for amounts they contribute to the “California Excellence Fund,” a fund created “to accept monetary contributions for exclusively public purposes as specified under Section 170 of the Internal Revenue Code, relating to charitable contributions and gifts” for which “[a]ll amounts in the fund shall be used for those public purposes upon appropriation by the Legislature.” Other proposals would limit the state tax credit to 85 percent of the contribution.

Governor Andrew Cuomo of New York “would transfer the personal income tax to a payroll tax on business. Because the new law allows a business to deduct that state tax expense from its federal taxes, the governor and his team reckon that the state’s residents as a whole would continue to get the federal deduction regardless of the $10,000 limit.”² The effect would be to make the employer pay the tax, which may be fully deductible for federal income tax purposes, and pay employees that much less, but only this lesser payment would be subject to federal income tax in the hands of the employee. From the employee’s perspective, it’s the same as though he’d received the gross amount, paid the state income tax on that amount and received a full deduction for the state tax payment. In fact, employees might benefit in that they could still take the standard deduction, which was significantly increased by the Act, and yet realize the benefit of itemizing as to the state income tax payment.

The issue that arises in this context, of course, is whether a purported charitable contribution to or for the benefit of a state is deductible under IRC Section 170(a) in light of the donor receiving a quid pro quo benefit in the form of state tax credits in return for the contribution. Although Section 170(c) makes it clear that a contribution to a state (or a political subdivision thereof) qualifies for a charitable tax deduction (but only if the contribution “is made for exclusively public purposes”), it’s black letter law that when a donor makes a purported charitable contribution and receives equal fair market value (FMV) in return, the transfer will be considered to lack donative intent and, therefore, won’t be deductible under Section 170(a).

Charitable Contribution Deductions 

Section 170(a) allows as a deduction any “charitable contribution” as defined in Section 170(c). Section 170(c), in turn, provides that the term “charitable contribution” means a contribution or gift to or for the use of certain specified entities under Section 170(c)(1) through (5). The deduction available for a contribution to a state is derived from Section 170(c)(1), which permits a deduction for a contribution made to a “State, a possession of the United States, or any political subdivision of any of the foregoing, or the United States or the District of Columbia, but only if the contribution or gift is made for exclusively public purposes.” 

The term “exclusively public purposes” should also be contrasted from the purposes requirement of Section 170(c)(2), which permits a deduction under Section 170(a) for a contribution made to a domestic entity organized and operated “exclusively for religious, charitable, scientific, literary, or educational purposes,” which generally includes an organization described under Section 501(c)(3). Thus, a contribution to a state for exclusively public purposes will be deductible even if it isn’t used for one of the purposes enumerated under Section 170(c)(2). Indeed, the courts have determined that a contribution made for “public purposes” may be used for different and broader purposes than a contribution that’s made for religious, charitable, scientific, literary or educational purposes.³

Meaning of Charitable Contribution 

Not every payment to a qualified organization under Section 170(c), which includes a state or local government, constitutes a charitable contribution for income tax purposes.⁴ To be considered a “charitable contribution,” a transfer of cash or property must constitute a “contribution or gift” within the meaning of Section 170(c). The requirement that a payment to charity be a “contribution or gift” is “intended to differentiate between unrequited payments to qualified recipients and payments made to such recipients in return for goods and services.”⁵ Under the case law that’s developed, a transfer of cash or property will be considered a “contribution or gift” under Section 170(c) when it’s made: (1) with a donative intent; (2) voluntarily; and (3) without the receipt of full and adequate consideration.⁶   

Donative Intent Generally

A taxpayer must have a donative intent for a transfer to a qualified charity to constitute a contribution or gift for purposes of Section 170(c). When the transfer to a charitable organization lacks donative intent but is impelled primarily by some expected benefit to the donor beyond the mere satisfaction that flows from the performance of a generous act, it isn’t considered a contribution or gift. Therefore, no charitable deduction is allowable when the donor has an expectation of receiving some substantial benefit by virtue of making a transfer to charity, even though the expectation isn’t supported by an enforceable contractual claim or the benefit isn’t received directly from the charity. The historical test for “donative intent” requires that the transfer be an expression of a “detached and disinterested generosity.” This test was originally formulated by the U.S. Supreme Court in the famous Duberstein case,⁷ involving the issue of whether a purported gift of a Cadillac from one business associate to another was a nontaxable gift or taxable compensation.⁸ 

Quid Pro Quo Test 

Under the Duberstein“detached and disinterested generosity” test, the most critical consideration is the transferor’s intention. In lieu of the Duberstein test, which focuses on motive alone, courts have more recently tended to focus on an objective standard by applying a quid pro quo test. Under that test, a transfer to a charitable organization will be considered to lack  donative intent and, therefore, not be considered a gift or contribution, when the transferor receives or expects to receive a financial return commensurate with the value transferred to the charity.⁹ 

In ascertaining whether a given payment is made with the expectation of a quid pro quo, the courts have examined the external features of the transaction in question, rather than examining the transferor’s subjective intention.¹⁰ This practice has the advantage of obviating the need for the Internal Revenue Service to conduct imprecise inquiries into the motivations of individual taxpayers, given that the focus of the quid pro quo test isn’t on the taxpayer’s motivation. Instead, the test is based on an objective examination, based on all the surrounding facts and circumstances, as to whether the transfer to charity is being made by the donor in exchange for a commensurate benefit. 

Dual Character Payments

The courts, as well as the IRS, have recognized that a payment to a charity may have a dual character as part contribution and part payment for goods or services.¹¹  The Treasury regulations adopt a consistent approach, whereby no part of a payment that a taxpayer makes to a charitable organization that’s in consideration for goods or services is a contribution or gift within the meaning of Section 170 unless the taxpayer: (1) intends to make a payment in an amount that exceeds the FMV of the goods and services received in exchange, and (2) makes a payment in an amount that exceeds the value of such goods or services.¹²

Authority 

In Chief Counsel Advice (CCA) 201105010, pursuant to a state program awarding state tax credits in return for charitable contributions earmarked for economic development, the taxpayers submitted applications to the State Department of Economic Development for approval to make a certain amount of the charitable contributions under the program. The applications were accepted, and the taxpayers were granted state income tax credits equal to a specified percentage of the approved contributions. Pursuant to the parameters of the program, the taxpayers used a certain amount of the state income tax credit to offset their Year 1 state income tax liability; sold a certain amount of the state income tax credits to other individuals; and carried forward the remaining amount of the state income tax credits to future years. The IRS ruled that the state income tax credits weren’t treated as benefits received by the donor that would reduce the amount of the charitable contribution deduction, stating that “the payment is considered a charitable contribution under § 170, not a payment of tax possibly deductible under § 164.” 

In its analysis in CCA 201105010, the IRS specifically acknowledged the firmly established legal principle that serves to eliminate or reduce an otherwise available charitable income tax deduction when the contribution is made in return for specified monetary consideration.  In determining that the tax credits provided in return for the charitable contribution didn’t constitute a quid pro quo that would reduce or eliminate any part of the charitable income tax deduction, the IRS, citing federal case law,¹³ stated that the “tax benefit of a federal or state charitable contribution deduction is not regarded as a return benefit that negates charitable intent, reducing or eliminating the deduction itself.” 

It’s interesting that, for purposes of applying the quid pro quo rules of Section 170 in CCA 201105010, the IRS equated the benefit of the income tax savings resulting from a federal income deduction to the benefit of a state income tax credit, so that in both cases, the charitable deduction otherwise available under Section 170(a) isn’t reduced by the resulting tax savings. This was the case notwithstanding that it would likely have been more favorable from the perspective of the IRS to treat the charitable deduction as the equivalent of a state income tax payment because, unlike a charitable contribution deduction, a state income tax payment is subject to the alternative minimum tax, potentially exposing the taxpayer to greater federal taxes. The approach taken in CCA 201105010 appears to have been adopted by the Tax Court in Tempel v. Comm’r,¹⁴ which may provide support for the allowance of the deduction.  

Note, of course, that CCA 201105010 may not be used or cited as precedent. And, note that the approach applied in CCA 201105010 wasn’t absolute, as the IRS specifically stated, as indicated above, that “[t]here may be unusual circumstances in which it would be appropriate to recharacterize a payment of cash or property that was, in form, a charitable contribution as, in substance, a satisfaction of tax liability.”

Issues to Consider 

While charitable contributions made to a state for exclusively public purposes are generally deductible for federal income tax purposes under Section 170(a), when state tax credits are provided by a state under a program to encourage a charitable contribution not to one or more specified third-party charities that a donor chooses to support, but to the very state (or locality) providing the tax credits, greater scrutiny appears warranted in the context of Section 170(a). Even accepting the position that a state tax benefit provided to encourage charitable giving doesn’t result in a quid pro quo transaction for Section 170(a) purposes, a charitable deduction is still premised on the transfer being motivated by a charitable intent and made on a voluntary basis. 

Contributions to one or more third-party charities chosen by a donor, even under a state program providing state tax benefits to encourage such contributions, presumably should be considered to be motivated by a charitable intent and made on a voluntary basis. In this situation, the donor has a choice that may be freely exercised: Contribute to a charity the donor seeks to support or pay taxes to the state. When, however, a donor makes a purported contribution to a qualified charity of an amount that he would otherwise be required or expected to pay to the very same organization, the actual substance of the payment will control the characterization of the payment for federal income tax purposes. In Revenue Ruling 83-104, for example, a private school described in Section 170(c) requested parents to contribute $400x to the school for each of their children enrolled in the school. Parents who didn’t make the $400x contribution were required to pay $400x tuition for each child enrolled in the school. Parents who neither made the contribution nor paid tuition couldn’t enroll a child in the school. The IRS, citing federal case law and legislative history of Section 170, ruled that because a parent had to either make the contribution or pay the tuition charge, the “payment is not voluntary and no [charitable] deduction is allowed.” The IRS stated that “a plan allowing taxpayers either to pay tuition or to make ‘contributions’ in exchange for schooling” creates a “presumption that the payment is not a charitable contribution.” In the same ruling, the IRS stated that “factors suggesting that a contribution policy has been created as a means of avoiding the characterization of payments as tuition” are indicative of the payments not being a charitable contribution.

Thus, if a purported charitable contribution made by a resident of a state is merely a substitute for a tax payment otherwise required to be made to the state if the contribution isn’t made, the characterization of such a payment as a charitable contribution for federal income tax purposes will be in jeopardy, particularly when it’s made under a legislative plan adopted for the very purpose of avoiding the characterization of the payments as taxes. Indeed, this situation may fall within the language of CCA 201105010 that there “may be unusual circumstances in which it would be appropriate to recharacterize a payment of cash or property that was, in form, a charitable contribution as, in substance, a satisfaction of tax liability.” The Treasury has very broad discretion under the so-called Chevron doctrine, based on the 1984 Supreme Court decision in Chevron U.S.A., Inc. v. Natural Resources Defense Council, Inc.,¹⁵ to issue a regulation that could provide that no deduction for a charitable contribution would be allowed to the extent a credit against a state or local tax is allowed. 

It would appear that a state seeking to adopt a legislative proposal to recast SALT payments as charitable contributions will be best situated under the Section 170 tax regime if it actually gives its residents discretion as to the public purposes to which their contributions will be used, so that the contributions aren’t essentially equivalent to a tax payment that would otherwise be required to be paid to the state but, instead, may be considered motivated by some form of charitable intent and to be made on a voluntary basis. This could include, for example, providing the donor with a choice of allocating a contribution among the wide array of activities, operations, programs and functions carried out by the state for exclusively public purposes that the donor seeks to support and creating separate funds dedicated for such purposes. Presumably, the greater the choice a donor has with respect to the use of a purported charitable contribution to a state and the less the contribution is used in the same manner as an ordinary tax payment that would otherwise be required to be made, the better the position that the contribution is motivated by charitable intent and is voluntary and isn’t merely a substituted tax payment. Of course, such a choice of funding provided to a potential donor must be reconciled with the financial and budgetary needs of the state.            

Endnotes

1. P.L. 115-97, 131 Stat. 2054. 

2. Milton Ezrati, “High-Tax States Reach for Gimmicks,” Forbes (Feb. 16, 2018).

3. Continental Illinois National Bank & Trust Co. of Chicago v. United States, 403 F.2d 721 (Ct. Cl. 1968). The court in this case recognized that many activities of government are in no sense charitable and, in fact, are generally available only to paying customers, stating that these are “proprietary activities and include the operation of golf courses, wharves, market places, transportation facilities, and such public utilities as gas, water, and electric systems. It’s a meaningful distinction to say that while these activities are not ‘charitable,’ they nevertheless are for public purposes, as the local government conceives the needs of its public.”

4. See, e.g., Murphy, 54 T.C. 249 (1970); Estate of Wood, 31 T.C. 1143 (1959).  

5. Hernandez v. Commissioner, 490 U.S. 680, 690 (1989). See also U.S. v. American Bar Endowment, 477 U.S. 105 (1986).  

6. See, e.g., U.S. v. American Bar Endowment, ibid. (“[T]he sine qua non of a charitable contribution is a transfer of money or property without adequate consideration. The taxpayer, therefore, must at a minimum demonstrate that he purposely contributed money or property in excess of the value of any benefit he received in return”); DeJong v. Comm’r, 36 T.C. 896 (1961), aff’d, 309 F.2d 373 (9th Cir. 1962) (“A gift is generally defined as a voluntary transfer of property by the owner to another without consideration thereof”); Revenue Ruling 71-112 (“A gift is generally defined as a voluntary transfer of property by its owner to another with donative intent and without consideration”).

7. Comm’r v. Duberstein, 363 U.S. 278 (1960).

8. In Duberstein, the Tax Court, T.C. Memo. 1958-4, and later the U.S. Supreme Court, agreed with the position of the Internal Revenue Service that the value of the car was taxable compensation rather than a nontaxable gift. In reaching its conclusion, the Supreme Court placed great reliance on the Tax Court’s factual finding that the gift wasn’t motivated by “detached and disinterested generosity,” stating that “it was at bottom a recompense for Duberstein’s past services, or an inducement for him to be of further service in the future.” The fact that there was no specific legal obligation to make the transfer of the car was irrelevant, as the test of whether a gift occurred, according to the Court, was based on the motivation of the taxpayer in making the transfer.

9. See, e.g., Transamerica Corp. v. U.S., 15 Ct. Cl. 420 (1988); Neher v. Comm’r, 852 F.2d 848 (6th Cir. 1988); Haak v. U.S., 451 F. Supp. 1087 (W.D. Mich. 1978): Rev. Rul. 86-63.

10. See, e.g., Singer Co. v. U.S., 449 F.2d 413 (Ct. Cl. 1971); U.S. v. American Bar Endowment, supra note 5; Hernandez v. Comm’r, supra note 5.

11. See, e.g., Rev. Rul. 68-432 (noting possibility that payment to charitable organization may have “dual character”); Rev. Rul. 67-246 (price of ticket to charity ball deductible to extent it exceeds market value of admission); see also HR Rep. No. 103-111, at 785 (1993) (a charitable deduction is limited to the amount exceeding the value of the consideration received).

12. Treasury Regulations Section 1.170A-1(h)(1).

13. See McLennan v. U.S., 23 Cl. Ct. 99 (1991) (“a donation of property for the exclusive purpose of receiving a tax deduction does not vitiate the charitable nature of the contribution”); Skripak v. Comm’r, 84 T.C. 285, 319 (1985) (“However, as stated above, the deduction for charitable contributions was intended to provide a tax incentive for taxpayers to support charities. A taxpayer’s desire to avoid or eliminate taxes by contributing cash or property to charities cannot be used as a basis for disallowing the deduction for the charitable deduction”); Allen v. Comm’r, 92 T.C. 1, 7 (1989), aff’d, 925 F.2d 348 (9th Cir. 1991); see Browning v. Comm’r, 109 T.C. 303 (1997) (value of state and federal tax benefits not part of the amount realized from a bargain sale of donated property).

14. Tempel v. Comm’r, 136 T.C. 341 (2011).

15. Chevron U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984).

Interest rates are rising, and the trend is expected to continue. Advisors must understand how interest rates impact estate planning and which techniques work best in differing rate environments. Let’s look at how interest rates affect estate planning and which techniques to consider now before rates increase further. 

Effect on Estate Planning

Interest rates affect estate planning in two important ways. First, many common planning techniques work by dividing the ownership of an asset into a current income (or annuity) interest and a remainder interest. Interest rates determine the relative present values of these interests and thus the effectiveness of such techniques. Second, interest rates dictate the minimum rate that must be charged to avoid the characterization of a loan as a gift. 

Here are a few basic rules of thumb:

• When interest rates are high, the value of an income interest is increased, while the value of a remainder interest is decreased.

• When interest rates are low, the value of an income interest is decreased, while the value of a remainder interest is increased. 

• Interest rates affect annuity interests differently from income interests.

• When interest rates are low, the value of an annuity interest is increased.

• Although annuity and income interests are interest rate-sensitive, unitrust interests aren’t.

Given these rules, certain techniques will be more effective in lower interest rate environments and others in higher interest rate environments.

Two Key Rates

Each month, the Internal Revenue Service publishes two key estate-planning rates, valid for the following month, that are tied to prevailing interest rates.

The first is known as the applicable federal rate (AFR). This is the minimum interest rate that must be charged to avoid a gift loan under Internal Revenue Code Section 7872. Pursuant to IRC Section 1274(d), there are three AFRs: a short-term rate (a maturity not over three years); a mid-term rate (a maturity over three years, but not over nine years); and a long-term rate (a maturity over nine years). The mid-term AFR is based on the average market yield (during any 1-month period selected by the Treasury Secretary and ending in the calendar month in which the determination is made) on outstanding Treasury obligations with remaining periods to maturity of more than three years but not more than nine years. AFRs, therefore, tend to lag the market.

The IRC Section 7520 rate (7520 rate) is the discount rate used to determine the present value for transfer tax purposes of the current (or retained) interest in the case of split-interest transfers. The 7520 rate is equal to 120 percent of the mid-term AFR for a given month, rounded to the nearest 0.2 percent.

Because the IRS typically publishes these rates around the third week of each month, a transaction may be timed to take advantage of the rates for either the current month or the following month.

Low(er) Interest Rate Strategies

Although interest rates have begun to rise, they’re still relatively low from a historic perspective. (See “Historic Perspective,” this page.) 

Estate freeze strategies that seek to transfer future appreciation (but not the value of the underlying assets) out of an individual’s taxable estate work best when interest rates are low because the goal is to arbitrage the spread between the AFR or 7520 rate and actual investment performance. That spread represents the potential transfer tax-free wealth transfer. Strategies to consider include intra-family loans, grantor retained annuity trusts (GRATs), sales to grantor trusts and charitable lead annuity trusts (CLATs).

Intra-family Loans

Simple yet effective, intra-family loans generally cost less and are most effective in a low interest rate environment. As noted above, to avoid the characterization of a loan as a gift, the loan must bear interest at the relevant AFR. In most instances, however, the relevant AFR will be lower than the rates charged by commercial lenders.

An intra-family loan should be documented and its formalities respected. For example, interest payments should be made on time, and there should be no pre-arranged plan to forgive the interest annually. But,  families otherwise have great flexibility in structuring these loans. 

A loan could, for example, be structured as a term loan or a demand loan, be self-amortizing (with interest and principal paid over the term of the loan) or require interest-only payments. It’s common to structure an intra-family loan as an interest-only loan with a balloon payment of principal at the end of a 9-year (or greater) term in an effort to maximize the potential transfer tax-free wealth transfer. 

Consider a loan of cash from a parent to a child. If the child can invest the borrowed funds to generate a return that exceeds the interest rate on the loan, then the return in excess of that interest rate will pass transfer tax-free from the parent to the child. The mid-term, annual AFR for a 9-year loan made in April 2018 was 2.72 percent. Even conservative projected returns on a well-balanced investment portfolio over such a term stand to exceed that rate.

A family may be able to achieve even greater benefits using a loan to an intentionally defective grantor trust (a grantor trust), which is a trust that the grantor owns for income tax purposes. A drawback of typical intra-family loans is that the lender must recognize interest income. A lender isn’t required to recognize interest income paid to him from a grantor trust of which he’s the owner, however. And, because the grantor-lender must pay any income tax due on the grantor trust’s earnings, these tax payments will constitute additional transfer tax-free gifts to the trust. 

For this strategy to work, many practitioners believe that the grantor-lender should make a small “seed” gift of approximately 10 percent of the loan value to the trust before it borrows money to demonstrate the trust’s ability to repay the loan. Making a seed gift has the added benefit of allowing the grantor-lender to allocate his generation-skipping transfer (GST) tax exemption to the gift so that all of the trust’s assets will be GST tax-exempt for future generations.

Trust-to-trust lending creates another planning opportunity. Consider, for example, a client with two grantor trusts, one that’s GST tax-exempt and one that isn’t. If highly appreciating assets are held in the non-exempt trust, the trustees could consider loaning the assets (at the appropriate AFR) to the exempt trust to lock in the transfer tax-free future appreciation for additional generations.

While intra-family loans are more effective in a lower interest rate environment, a family’s flexibility to structure a loan to lock in low rates for an extended period or refinance, if and when interest rates decline, makes this technique useful even as interest rates begin to rise. 

GRATs

A GRAT is an estate-planning technique in which a grantor transfers property into a grantor trust and takes back a fixed-term annuity interest. The goal of a GRAT is to pass any appreciation in excess of the required annuity payments to the remainder beneficiaries. GRATs are explicitly sanctioned in IRC Section 2702, making them among the safest strategies available. 

Here’s how a typical GRAT works:

• The present value of the grantor’s retained annuity is calculated using the 7520 rate, which is sometimes referred to as the “hurdle rate,” because the GRAT’s investments must appreciate at a rate higher than the applicable 7520 rate for the GRAT to succeed.

• The difference between the value of the transferred property and the present value of the annuity is a gift. The amount and term of the grantor’s annuity are often set so that the gift is zero or nearly zero.

• If the GRAT’s investments outperform the
applicable 7520 rate and the grantor survives the term of the annuity, the remaining assets will pass to the remainder beneficiaries transfer tax-free.

The performance of a GRAT typically improves at a lower 7520 rate when the value of the annuity interest is higher and declines at a higher 7520 rate when the value of the annuity interest is lower. (See “GRAT in Lower Interest Rate Environment,” p. 20 and “GRAT in Higher Interest Rate Environment,” p. 21.)

GRATs can still be an effective planning tool even as interest rates start to rise, however, particularly if the value of the assets contributed to the GRAT is depressed (due to a downturn in the economy, valuation discounts or otherwise) or is expected to appreciate significantly. Although short-term GRATs are generally preferred over longer term GRATs due to the lower risk that asset depreciation will offset appreciation during the GRAT term, a longer term GRAT that allows a grantor to lock in a lower 7520 rate may be more attractive in a rising interest rate environment. A grantor can enhance the performance of a longer term GRAT by locking in early appreciation in the GRAT assets through the exercise of a power granted in the trust instrument to substitute stable value assets for the appreciated assets.

Despite the benefits of GRATs, there are some tradeoffs. GRATs are inefficient GST tax vehicles because the estate tax inclusion period rules preclude allocation of a grantor’s GST tax exemption prior to expiration of the annuity term. Moreover, there’s a mortality risk associated with the use of a GRAT because the grantor must survive the annuity term to avoid inclusion of the GRAT assets in the grantor’s estate and accomplish a tax-free transfer. 

Sale to Grantor Trust

A sale to a grantor trust enables a grantor to further leverage the interest rate benefits of intra-family loans through the use of valuation discounts. 

Here’s how a typical sale to a grantor trust works:

• The grantor creates a grantor trust for the benefit of the grantor’s family.

• The grantor makes a seed gift to the trust of 10 percent of the total assets ultimately sold.

• The grantor sells assets (up to nine times the seed gift) to the trust in exchange for a 9-year promissory note bearing interest at the mid-term AFR. If the grantor sells a fractional or non-controlling interest in an asset, a valuation discount may be available to further leverage the sale. 

• Because the trust is a grantor trust, no gain or loss is recognized on the sale, and no interest income is generated on the promissory note. 

• If the assets transferred by gift and sale to the trust appreciate in excess of the interest rate on the promissory note, the excess is a tax-free transfer to the trust. 

• The grantor’s GST tax exemption can be allocated to the seed gift so that all trust assets are GST tax-exempt.

(See “Gift/Sale to Grantor Trust,”  p. 21.)

Like an intra-family loan or a GRAT, a sale to a grantor trust works best in a lower interest rate environment because the hurdle rate associated with this transaction is based on prevailing interest rates (in this case, the AFR). Although interest rates are rising, this technique may still be effective if the promissory note is structured for a longer term to lock in current rates. 

Compared to a GRAT, a sale to a grantor trust may be more effective because:

• The 7520 rate used to value the grantor’s retained annuity interest in a GRAT is 120 percent of the mid-term AFR charged on the promissory note. 

• It provides greater flexibility because payments of interest and principal can be structured as desired, whereas the GRAT annuity payments must be made within fixed timeframes. 

• It’s more GST tax-efficient because the grantor’s GST tax exemption may be allocated to the fixed seed gift immediately, whereas in a GRAT, exemption can’t be allocated until the end of the annuity period. At that point, allocation is inefficient because exemption sufficient to cover the unpredictable and potentially substantial asset appreciation during the GRAT term is required.

• It can be enhanced through the use of valuation discounts, whereas a valuation discount provides no benefit in the case of assets contributed to a GRAT because the grantor’s annuity payments have a fixed proportion to the value of the contributed assets. 

On the other hand, GRATs are statutorily sanctioned and may be structured to avoid generating a taxable gift. 

In a rising interest rate environment, however, the most significant advantage probably lies in the ability to use a sale to a grantor trust to lock in still relatively low interest rates for a longer period of time with less mortality risk, combined with the flexibility to refinance, if and when interest rates decrease.

CLATs

A CLAT is similar to a GRAT except that the fixed annuity is payable to charity rather than the grantor for a period of years. 

Here’s how a typical CLAT works:

• A grantor transfers assets to the CLAT either during life or at death.

• The present value of the charitable annuity is calculated using the 7520 rate.

• The difference between the value of the transferred property and the present value of the annuity is a gift. The amount of the charitable annuity is often set so that the gift is zero or nearly zero.

• If the CLAT’s investments outperform the applicable 7520 rate, the remaining assets will pass to the remainder beneficiaries at the end of the annuity period transfer-tax free.

The performance of a CLAT, like a GRAT, typically improves at a lower 7520 rate and declines at a higher 7520 rate. (See “CLAT  in Lower Interest Rate Environment,” this page and “CLAT in Higher Interest Rate Environment,” this page.) 

Unlike a GRAT, a CLAT won’t fail if the grantor dies during the annuity term, but the upfront charitable deduction of a grantor CLAT is subject to recapture if the grantor dies during the charitable term. Indeed, a CLAT may be created on the grantor’s death, although CLATs are arguably a better lifetime strategy because predicting the 7520 rate at the time of the grantor’s death can be difficult. It may therefore make sense to consider longer term CLATs now to lock in the relatively low 7520 rate.

Like the other techniques discussed, there are disadvantages and tradeoffs involved in planning with CLATs. Like a GRAT, a CLAT isn’t a good candidate for GST tax planning. Moreover, the CLAT assets are unavailable to the grantor or the remainder beneficiaries during the annuity term, and no commutation is permitted. Finally, some assets are unsuitable for CLATs under the private foundation rules applicable to charitable split-interest trusts.

Looking Forward

As interest rates continue to rise, the strategies discussed in this article will generally become less attractive while other strategies will become more attractive. In Part II, we’ll  explore effective techniques for planners to consider employing in a higher interest rate environment.           

—This article is adapted from a presentation given by the authors at the 2017 ABA Real Property, Trusts and Estates Committee Spring Symposia in Denver.

In this article, White & Case means the international legal practice comprising White & Case LLP, a New York State registered limited liability partnership, White & Case LLP, a limited liability partnership incorporated under English law and all other affiliated partnerships, companies and entities. 

Following Congress’ recent enactment of the most comprehensive federal tax reform in several decades, the topic of charitable giving has received significant attention in news outlets across the nation. Many commentators report that the new law is certain to devastate charitable giving by reducing tax incentives to give. Others counter that the changes will encourage donations by producing economic growth and increasing incomes.

Lower income donors were likely not in a position to deduct their charitable gifts for federal income tax purposes prior to tax reform and will unlikely be able to do so now. Unless the reforms change these taxpayers’ financial profiles in other respects, the new law will have minimal impact on the amount they give. 

What about other donors? Below, we discuss the principal tax reforms that may affect charitable giving, as applied to hypothetical middle and higher income taxpayers. We also discuss a variety of strategies that these donors may consider to maximize the value of their contributions under the new law, as well as the impact of their gifts.  

The reforms discussed below will expire at the end of 2025 unless extended by future legislation.

Standard and Itemized Deductions 

The new law nearly doubles the standard deduction to $12,000 for unmarried individuals, $18,000 for heads of household and $24,000 for married individuals filing jointly. In addition, it eliminates or limits various itemized deductions. In particular, the law generally caps the deduction for state and local property, income and sales taxes at $10,000 annually. Likewise, it reduces the availability of the home mortgage interest deduction and eliminates miscellaneous itemized deductions in their entirety. As a result, the number of individuals who itemize their deductions is expected to decrease significantly. An individual who doesn’t itemize may not claim a federal income tax deduction for charitable gifts.

Example: Middle income donor. Tom is an unmarried professional who lives in a high tax state, has anticipated taxable income of $140,000 and anticipated state and local income taxes of $12,000 (now limited to a $10,000 deduction). Tom rents his home and has no debt. He’s historically made modest charitable contributions each year—of approximately $1,500—motivated in part by the tax savings. He’s read the news reports, though, and is now concerned that he won’t be eligible to deduct his gifts.

While Tom previously itemized, he won’t itemize now because his deductions don’t exceed the standard deduction. He, therefore, won’t receive a tax benefit from his charitable gifts. That said, his itemized deductions are only $500 below the standard deduction. 

Bunch gifts. If Tom can afford it, he could bunch the donations he would otherwise give over the course of multiple years into one or more gifts this year that are large enough to exceed the standard deduction. Tom could then make bunched gifts every three years, for instance, rather than giving smaller amounts annually. This strategy would enable Tom to continue to support the organizations he cares about, while receiving a quantifiable tax benefit. 

Use a donor-advised fund (DAF). If Tom is able to bunch his gifts, but is concerned that the recipients would prefer to receive (and will request) annual donations, he could alternatively make his gifts through a DAF. The entire amount of Tom’s initial contribution to the DAF would be deductible in the year of contribution. Tom would then have the flexibility, subject to certain restrictions, to recommend distributions from the DAF to the charitable recipients of his choice at the times of his choosing. (Tom wouldn’t receive any further deductions for such distributions because he already received a deduction for his initial contribution to the DAF.) As an added benefit, Tom could provide guidance to the sponsoring organization of the DAF concerning the investment of the assets in the DAF account, and the assets may grow over time on a tax-free basis. A contribution to a DAF could therefore enable Tom to have a greater charitable impact.

Example: Higher income donor. Cathy is an unmarried professional who lives in a high tax state. She anticipates having taxable income in excess of $300,000, state and local income and property taxes of $27,500 (now limited to a $10,000 deduction) and deductible home mortgage interest of $15,000. Cathy has regularly made charitable gifts of $20,000 annually to organizations that have had a personal impact on her life and serves on the board of trustees of her alma mater. The board of trustees is concerned that gifts to the school from middle income donors may decline because fewer donors will itemize under the new law. In addition, Cathy would like to increase the amount she gives annually to
10 percent of her income. She would like to use this additional giving to support organizations in her immediate community.

Cathy previously itemized her deductions and will itemize now. Her gifts were previously deductible in full in the year in which she made them, and her future gifts—including the increased contributions that she’s contemplating—will likewise be deductible in their entirety on a current year basis. Cathy’s ability to save taxes as a result of her philanthropy isn’t impacted by the new legislation. 

Offer matching gifts. If Cathy would like to help boost fundraising by her alma mater, she might take advantage of her ability to give on a tax-favored basis by offering to match a certain dollar amount of gifts made by donors to the school. A matching gift program would encourage contributions by those who might otherwise be less inclined to give because of the increased standard deduction. It would also enhance the impact of Cathy’s donations.

Give locally. If Cathy would also like to assist smaller organizations in her community, she could support them directly. Alternatively, if Cathy is concerned about the organizations’ ability to manage the gifts, she could consider making her contributions through a tax-exempt intermediary, such as a community foundation, that supports local nonprofits. Community foundations and other intermediary organizations exist in many fields to direct funds and technical support to community-based entities. Cathy might also find a community foundation helpful if she’s unsure of which organizations would best advance her philanthropic goals. Community foundations are often able to identify organizations that best dovetail with a donor’s interests.

If middle income donors reduce the amount they give because they no longer itemize, community-based organizations might be disproportionately disadvantaged. Data on giving patterns shows that middle income donors tend to give more to social service and religious organizations than their higher income counterparts. Every dollar that Cathy directs to organizations in her community may therefore also have the important impact of defraying lost revenue from other donors.    

Lower Marginal Income Tax Rates

The new law lowers marginal income tax rates in general and notably reduces the top marginal rate from 39.6 percent to 37 percent. Lower tax rates reduce the tax savings generated by deductions, charitable or otherwise. The tax rates for capital gains, in contrast, have largely remained the same. Likewise, the 3.8 percent net investment income tax remains in force.  

Example: Middle income donors. Pam and John anticipate having taxable income of $175,000, consisting primarily of compensation, and hold a moderate number of investment assets. They live in a state without an income tax, but pay property taxes and have a mortgage. Nevertheless, their itemized deductions don’t typically exceed $15,000. While Pam and John have children and a good deal of expenses, they manage their finances well and live comfortably. They would like to add charitable giving to their budget.

Because of the reduction in tax rates, Pam and John’s federal income tax liability will likely decrease under the new law. They’ll therefore have increased cash in their pockets following the payment of taxes. 

Give tax savings. Unless their deductions increase materially, Pam and John won’t itemize under the new law. Nevertheless, Pam and John might take advantage of their tax savings from the higher standard deduction and reduced tax rates to make a charitable contribution they previously couldn’t afford. 

Bunch appreciated property in a DAF. As discussed above, Pam and John might also strategically structure their gifts to take advantage of the charitable deduction —by bunching their donations and using a DAF. 

In particular, if Pam and John need to retain cash for expenses but have some appreciated investment assets that they’ve held for more than one year, they could maximize their tax savings by contributing some of those assets to a DAF. Pam and John would receive a charitable deduction in the year of contribution. Moreover, donating appreciated long-term capital gains property is an especially tax-efficient strategy because it provides two tax benefits: Pam and John would avoid recognition of capital gains tax on the contributed property and, subject to certain restrictions, would be eligible for a deduction equal to the fair market value (FMV) of the property. 

This approach would also enable Pam and John to provide regular support to the causes they care about through periodic distributions from the DAF account.

Example: Higher income donors. Henry and Chris anticipate having taxable income in excess of $700,000, largely consisting of capital gains and dividends from well-performing mutual fund and public security investments. They also hold some more complex investments in real estate and private equity. Their itemized deductions, primarily consisting of home mortgage interest, typically exceed $30,000 annually. Having had significant financial success, Henry and Chris want to give back by contributing to charity.

While the federal tax liability on Henry and Chris’ ordinary income will likely decrease under the new law, the liability on their capital gains will be comparable to prior years.

Donate appreciated property. As discussed above, Henry and Chris could obtain two tax benefits from their charitable gifts and thus maximize the tax impact of their philanthropy, by donating appreciated long-term capital gains investments—including the more complex investments—rather than cash. Henry and Chris would avoid the realization of gains on the donated property and may be able to lower their income, for example, by transferring mutual fund investments before capital gains distributions are declared. In addition, subject to certain restrictions, they would receive an FMV deduction for gifts funded with such assets. Gifts of investment assets also wouldn’t deplete Henry’s and Chris’ cash reserves. As a result, they may be required to realize less overall capital gains on their investment assets to meet regular living expenditures. 

Use a DAF. If Henry’s and Chris’ chosen charitable recipients don’t have the capability to accept a gift of appreciated securities, Henry and Chris could instead contribute such assets to a DAF. They could then support the organizations by recommending distributions from the DAF account to them. DAF sponsors typically have the resources and expertise required to accept and manage non-cash assets—whether marketable securities or more complex investments.

New Charitable Contribution Limit

The new law increases the amount an individual who itemizes may deduct with respect to cash gifts to public charities and certain private foundations to 60 percent of the donor’s contribution base (up from 50 percent). The law also repeals the so-called “Pease” limitation on certain higher income taxpayers. When applicable, this provision limited certain of a taxpayer’s otherwise allowable deductions, including the charitable contribution deduction. 

Example: Middle income donor. Mark, a 75-year-old retiree, lives in a state without an income tax and rents his home. He doesn’t have any itemized deductions. Mark anticipates having taxable income of $75,000, primarily consisting of distributions from an individual retirement account. A family member also recently left him a moderate inheritance, and Mark would like to make a $10,000 charitable gift in the family member’s memory. At the same time, Mark anticipates his expenses increasing with age and so has some reservations about the gift.

Mark didn’t previously itemize his deductions. As a result, he wasn’t subject to the Pease limitation, but was also unable to deduct his charitable gifts. Going forward, his income and expenses might prevent him from strategically bunching his donations. Mark may therefore continue to be unable to claim an income tax benefit for his charitable gifts.

Use the IRA charitable rollover. Mark could obtain a meaningful tax benefit for a gift in his family member’s memory—regardless of whether he itemizes—by using the IRA charitable rollover to make a qualified charitable distribution. The IRA charitable rollover permits taxpayers age 70½ or older to transfer up to $100,000 annually from their IRAs directly to most types of public charities (but not, for example, to DAFs) without recognizing the amount contributed as taxable income. Donors who make qualified charitable distributions from an IRA therefore avoid federal income tax on the IRA withdrawal. At the same time, the amount of the qualified charitable distribution is an offset against the donor’s required minimum distribution for the year. 

Make a planned gift. If Mark remains concerned about future expenses, he could alternatively consider using a portion of his inheritance to fund a charitable gift annuity (CGA) or other planned gift. Mark wouldn’t receive a charitable deduction if he doesn’t itemize. Nevertheless, a CGA would enable him to accomplish his charitable objectives while providing him with an income stream that would mimic the investment income he would otherwise have earned on the inherited assets. 

Make a bequest. Alternatively, if Mark concludes that he’s uncomfortable parting with assets during his lifetime, he could consider making a charitable bequest in his will. The new law dramatically increased the amount an individual may transfer at death without being subject to federal estate tax. The exemption is now $10 million, adjusted for inflation since 2011, or $11.18 million in 2018. A bequest is, therefore, unlikely to provide Mark’s estate with any estate tax savings, and no income tax benefit flows to an estate from a general bequest of a fixed amount.   

Mark could direct the use of retirement assets remaining at his death to fund a charitable gift at that time, however. The charitable organization receiving the retirement plan distribution wouldn’t pay income taxes on the distribution. In contrast, if Mark names an individual to receive the remaining plan assets after his death, the individual would pay income taxes on amounts taken out of the plan. In this way, Mark could still make a bequest at death that would produce a tax benefit; he could then leave other assets without built-in income tax liability to his family and friends.

Example: Higher income donor. Susan is a wealthy, 72-year-old retiree. She has substantial IRAs and investment assets, producing anticipated taxable income in excess of $400,000 annually. She’s paid off the mortgage on her home, but has anticipated state and local income and property taxes of $25,000 (now limited to a $10,000 deduction). She’s extremely generous and would like to give away as much as possible in the form of charitable gifts over the next few years. She also has charitable bequests in her will.

Susan previously itemized her deductions, although the Pease limitation restricted them. She’ll itemize under the new law as well, but will no longer be subject to the Pease limitation. She’ll be eligible to take advantage of the increased charitable contribution limit.

Give more cash. Under the new law, Susan will be able to contribute a materially larger amount of cash to public charities and certain private foundations on a tax-favored basis. 

For example, if Susan’s adjusted gross income (AGI) was $400,000 in 2017 and she had $25,000 of state and local income and property taxes, she was eligible to deduct cash gifts to charity of up to 50 percent of her AGI, or $200,000. Susan’s itemized deductions were also subject to the Pease limitation, however, reducing them by approximately $4,000. As a result, Susan could ultimately deduct only $221,000, leaving her with $179,000 of taxable income.

If Susan has $400,000 of AGI and $25,000 of state and local income and property taxes in 2018, she may make deductible cash gifts to charity of up to 60 percent of her AGI, or $240,000. In addition, the Pease limitation is no longer applicable. The entire amount of such gifts would therefore be deductible. With her $10,000 deduction for state and local taxes, she would therefore have just $150,000 of taxable income remaining. 

 Use the IRA charitable rollover. If Susan would like to give away even more, preferably on a tax-favored basis, she could obtain significant additional tax benefits by using the IRA charitable rollover. 

For example, assume that Susan anticipates having $400,000 of income in 2018, $150,000 of which will constitute IRA distributions, as well as $25,000 of state and local income and property taxes. If Susan makes qualified charitable distributions of $100,000 from her IRA, the $100,000 would be excluded from her taxable income, and Susan would have AGI of $300,000. Of this, she could make deductible cash gifts to charity of up to 60 percent of that amount, or $180,000. By combining tax incentives, she would therefore be able to make $280,000 of charitable gifts on a tax-favored basis and would have only $110,000 of taxable income remaining (after the application of the state and local tax deduction).  

Reconsider charitable bequests. While Susan has charitable bequests in her will, the aggregate value of Susan’s assets is well short of $11.18 million. Consequently, Susan’s estate is likely to receive little or no tax benefit from her philanthropic goals at death, unless Susan makes her charitable bequests out of retirement funds, as explained above. Susan might want to consider accelerating some or all of her bequests and making them during her lifetime. If she exceeds the current year charitable deduction limits, she could carry forward the excess for up to five years. Additionally, if Susan is concerned about the timing of the charitable gifts—that is, she would prefer to make them posthumously—she could pre-fund them during lifetime, but use a DAF. Under this approach, she would receive an immediate income tax deduction and again could carry forward any excess for up to five years. She could then provide the sponsoring organization of the DAF with a set of recommended distributions to be made from the account following her death.

Looking Forward

As illustrated by the above examples, the recent changes to the law are most likely to adversely affect charitable giving by middle income donors. Whether giving by donors will actually decline remains to be seen. Many—if not most—people give not because of the tax incentive, but out of a personal commitment to the causes they care about.  

Perhaps a more critical question is whether the changes will have a long-term effect on charitable giving. The above changes are currently scheduled to expire at the end of 2025, although history has shown that lawmakers are often reticent to scale back changes billed as “tax breaks.” Even if Congress extends the current changes, other policies could help counteract any decreased giving. For instance, legislation proposed late last year would create a universal charitable deduction that would be available to all taxpayers regardless of whether they itemize. Of course, the fate of any legislation in today’s polarized political environment, particularly legislation that would contribute further to the federal deficit, is uncertain.  

Recent changes in the foreign tax provisions of the U.S. Tax Code provide a new opportunity to revisit the possible incorporation of traditional life insurance or foreign private placement life insurance issued by either a foreign carrier or U.S. carrier. In the past, U.S. practitioners relied heavily on entity structure to achieve a desired result. Given some degree of uncertainty with a new, far more complicated proposed structure, we believe practitioners will want to consider integrating other strategies including, perhaps, life insurance.

Past Practice

Prior to a change in the Tax Cuts and Jobs Act (the 2017 Tax Act), practitioners generally relied on a single foreign blocker corporation (FC) to hold U.S. non-real property assets. Any passive foreign income company (PFIC) assets would be held by a foreign grantor trust (FGT) or through another foreign company that elected to be treated as a disregarded entity for U.S. tax purposes. After the non-citizen, non-resident (NCNR) of the United States died, the trustee of the FGT or executor of the estate would file a check-the-box election effective at least two days and no more than 29 days after the date of death. Lacking a U.S. shareholder for 30 days, the FC didn’t become a controlled foreign corporation (CFC), and therefore, Subpart F income inclusion for U.S. beneficiaries (heirs of the NCNR who were U.S. persons) didn’t occur (this process was known as the “30-day rule”). The FC also blocked imposition of U.S. estate tax on the U.S. portfolio assets owned by the FC. Moreover, the basis in the underlying portfolio assets would be stepped up to their fair market value (FMV) on the date of the check-the-box election (a deemed liquidation of the FC).

Traditionally, U.S. advisors counseled multi-jurisdictional NCNR families with next generation heirs as U.S. citizens or long-term residents (U.S. persons) to organize an FGT. Typically, the NCNR parent would establish a revocable trust (that would be an FGT for U.S. income tax purposes) in a common law country with low and sometimes no taxes, located outside the NCNR’s country of domicile and residence. The primary asset of the FGT would be a non-U.S. corporation, an FC, that’s an eligible entity for U.S. tax purposes. (An eligible entity is a business entity that isn’t classified as a corporation and is eligible to elect its U.S. tax classification on Form 8832.) The FC would hold title to the U.S. portfolio investments.

Under prior law, this arrangement maintained certain U.S. income tax benefits during the NCNR’s lifetime and avoided U.S. estate tax on the NCNR’s portfolio investments at the death of the NCNR. Following the death of the NCNR, the FC would make a check-the-box election to be treated as a disregarded entity separate from its owner (that is, the FGT prior to the death of the NCNR). An FC making a check-the-box election is deemed to liquidate for U.S. tax purposes at the end of the day immediately before the effective date selected on Form 8832. Most U.S. advisors would cause the deemed liquidation of the FC to occur less than 29 days after the death of the NCNR. This prevented the punitive U.S. CFC anti-deferral income tax rules (that is, Subpart F income) from applying to U.S. persons inheriting portfolio investments directly or indirectly through a former FGT that becomes a foreign non-grantor trust (FNGT) after the death of the NCNR.

In sum, there was no Subpart F income inclusion for U.S. shareholders if an FC wasn’t a CFC for an uninterrupted period of at least 30 days during its tax year. But, this changed with the 2017 Tax Act. For tax years of foreign corporations beginning after Dec. 31, 2017, the 2017 Tax Act eliminated the 30-day threshold. As one commentator has succinctly noted:

Prior to the [2017 Tax Act], upon the death of the grantor in [this] scenario, there would have been a tax-free adjustment not only in the shares of the FC, but also in the underlying investment portfolio held in the name of the FC upon the deemed liquidation, and, as a result, little or no income or gain would be generated, and the [foreign, now non-grantor] trust structure would have a new basis in all of its investment portfolio assets. See IRC Section 1014 and 1012(a).¹ 

Multi-Tiered Structure

Practitioners have recently begun debating how best to deal with the 2017 Tax Act’s elimination of this somewhat obscure 30-day rule that provided post-mortem relief to the estates of NCNRs with family members who are U.S. persons.

At the recent Society of Trust and Estates Practitioners/New York State Bar Association International Estate Planning Conference, leading practitioners recommended using a two-tiered holding company structure involving at least three FCs to address the change in the CFC rules. The elimination of the 30-day rule means that it’s no longer possible to make a check-the-box election on a single FC owning appreciated non-U.S. real estate assets, without generating Subpart F income (assuming sufficient ownership by U.S. persons after the death of the NCNR). If a check-the-box election is made prior to the NCNR’s death, the NCNR will die holding U.S. situs assets through a disregarded foreign entity, risking U.S. estate tax inclusion of U.S. situs assets (such as U.S. securities).

This entity planning needs to be implemented prior to the NCNR’s death and employs a multi-tier FC structure. First, the NCNR or more probably the NCNR’s FGT (for example, established in the Cayman Islands) sets up two FCs. Second, these two FCs, in turn, together own the stock of a third lower tier FC. To avoid the non-recognition tax treatment under Internal Revenue Code Sections 332 and 337, each of the upper tier FCs would own less than
80 percent of the stock of the lower tier FC. The lower and upper tier companies would be liquidated following the NCNR’s death in a carefully scripted sequence.

First, the two upper tier FC holding companies would check the box on the lower tier FC effective one day prior to the death of the NCNR. By creating a deemed taxable liquidation of the lower tier FC with the filing of the check-the-box election to be treated as a disregarded entity, the upper tier FC’s basis in the underlying assets (that is, U.S. securities) of the former lower tier FC will equal the FMV on the date of the deemed taxable liquidation of the lower tier FC. The two upper tier FCs would continue in corporate form beyond the NCNR’s date of death. This prevents inclusion of the underlying assets in the NCNR’s U.S. gross estate.

Second, two days after the NCNR’s death, both upper tier holding company FCs will make simultaneous check-the-box elections. The inside basis of the underlying assets (that is, U.S. securities) previously held by the lower tier FC prior to its deemed taxable liquidation would be stepped up or down to the FMV of such assets on the day after the death of the NCNR, which will be the date immediately before the deemed liquidations of the two upper tier FCs under check-the-box elections. 

Consequences for Beneficiaries 

After the death of the NCNR, U.S. heirs will continue to be potentially adversely impacted by the U.S. foreign anti-deferral rules that impose harsh adverse tax consequences on direct and indirect U.S. shareholders of FCs that shelter passive investment income offshore. An FC that prevents U.S. estate tax for NCNRs on their U.S. securities can become problematic to U.S. heirs.

Going forward, if the FC is a CFC for even one day during the tax year, there could potentially be phantom income inclusion for the U.S. beneficiaries. Moreover, the 2017 Tax Act greatly expanded the type of phantom income that could flow up to U.S. shareholders of a CFC. In addition to the passive investment income inclusion under Subpart F, with the adoption of IRC Section 951A and the global intangible low taxed income (GILTI) regime, certain active trade or business phantom income could now be generated by the FC.

U.S. persons (citizens or residents) who inherit the foreign trust/FC structure can become owners of a CFC for U.S. income tax purposes. If, in aggregate, they exceed 50 percent ownership, 10 percent or more U.S. shareholders of the FC will be subject to tax on the investment income of the FC, including capital gains that will be taxed at ordinary income rates, in the year such income or gain is earned by the FC, regardless of when it’s distributed to shareholders. The U.S. shareholders may incur some degree of double taxation because there will be withholding taxes imposed on the FCs for U.S. source income and dividends, as well as taxation in any other country. Outside normative U.S. income taxation, Subpart F inclusion and U.S. tax on phantom income in the year earned by the FC may not generate offsetting foreign income taxation in the same year (as most foreign countries don’t have an identical CFC tax system), limiting potential foreign tax credits that would arise in a later year. 

The FC may also be a PFIC as to any U.S. person who’s a beneficiary of the foreign trust. PFIC classification is based on the nature of the investments held in the FC. An FC is a PFIC if 75 percent or more of its gross income for the tax year is passive income or the average percentage of assets held by the FC that produces passive income is at least 50 percent.² Unlike the CFC rules, PFICs don’t have minimum percentage U.S. shareholder requirements.

Key Considerations Going Forward

Leading commentators Dina Kapur Sanna and Carl Merino of Day Pitney LLP advise that, provided the NCNR doesn’t own U.S. real property interests or interests in partnerships engaged in a U.S. trade or business, the key considerations going forward are whether the trust will invest in U.S. situs assets and foreign investment funds that are likely to be treated as PFICs.³ They and other leading legal commentators now recommend that NCNRs implement the previously described, multi-tier holding company structure involving at least three FCs to achieve basis step-up without the drag of potential Subpart F and GILTI phantom income.

If the NCNR owns U.S. real property, generally a separate elaborate property by property structure is advised. As U.S. real property is a U.S. situs asset for which there’s generally no income or estate tax relief under a tax treaty, NCNR investors often will hold U.S. real property through an FC or an FNGT which, in turn, owns each U.S. property in a separate U.S. corporation or single member U.S. limited liability company (LLC). Under the 2017 Tax Act, gains on disposition of U.S. real property would be subject to U.S. corporate income tax of 21 percent for federal income tax purposes (down from 34 percent) plus state income tax. While U.S. corporate ownership might be desirable after the 2017 Tax Act, there could also be a second level branch profits tax of 30 percent on earnings that are deemed to have been repatriated by the U.S. corporation up to the FC. During the life of the NCNR, for each separate property, the FC might own a separate U.S. corporation or single member Delaware LLC (for which a check-the-box election has been made to treat such LLC as a U.S. corporation for income tax purposes). On the death of the NCNR, if the FC will become a CFC, the trustees of the FNGT might consider domesticating the FC so that the U.S. beneficiaries avoid the branch profit tax. If all the owners of the FC are U.S. persons after the death of the NCNR, it might be possible to domesticate the FC (that’s converted to a U.S. corporation for tax purposes) and then elect S corporation treatment to prevent a second level of tax on a future sale of the U.S. real property.

In a blog posted immediately after the elimination of the 30-day rule, another leading legal expert, Charles “Chuck” Rubin offered up some potential strategies for 2018 and thereafter to deal with this change in the tax law.⁴ In this blog, after pointing out that under the 2017 Tax Act, the repeal of the 30-day window can result in immediate CFC status as of the death of the NCNR whose stock in the FC is inherited by heirs who are U.S. persons, Rubin surmises that there may be investment- oriented mitigation strategies.

Rubin suggests active churning of the underlying stock portfolio during the life of the NRA matriarch. The broker on the account would have to be given clear instructions during the lifetime of the NCNR to periodically sell and repurchase the appreciated portfolio securities (not subject to the U.S. tax rules on wash sales) inside the FC without being subject to U.S. income tax. Such sales and repurchases will increase the income tax basis of the securities on a regular basis. He identifies certain potential problems with this strategy, including the difficulty of churning a non-traded U.S. security (privately owned company or investment) and possible step transaction issues. The broker will be earning added commissions that we believe would have to be disclosed and consented to by all the heirs of the NCNR.

Alternatively, Rubin suggests domesticating the FC after the death of the NCNR and then making a Subchapter S election to avoid double tax on appreciation. While potentially effective, we find most clients today don’t want to be told that they must hold all securities owned by a U.S. tax entity for five years before they can sell any one security. Market volatility suggests most investors would hesitate to organize a tax strategy that limits trading in their publicly traded U.S. portfolio for 60 months.

U.S. Tax-Compliant Insurance Policy

If an NCNR is insurable and wishes to minimize U.S. tax complications and U.S. tax reporting for heirs who are U.S. persons, advisors should consider use of some type of U.S. tax-compliant life insurance product. Generally, a policy requirement will be to satisfy one of the two actuarial tests described in IRC Section 7702(a). If a policy fails both actuarial tests, in most cases, it won’t be a life insurance policy for U.S. income tax purposes, causing two adverse U.S. income tax consequences. First, the policy owner must recognize annually the growth in the cash value as ordinary income. Second, the death benefit won’t be excluded from gross income under IRC Section 101.

By purchasing a U.S. tax-compliant life insurance policy, the NCNR will defer and possibly eliminate tax recognition of annual accretion in the cash value growth in the policy. If the policy isn’t surrendered during life, at death the cash value account effectively disappears by converting into a death benefit. Mechanically, this obviates income taxation on the growth of the cash surrender value during the insured NCNR’s lifetime.

Holding the policy until death is equivalent to receiving a U.S. basis step-up at death (basis in policy during life is generally the premiums paid, but leveraged cash death benefit is generally payable following the death of the NCNR). Even if the policy isn’t included in the gross estate of the NCNR and provided the U.S. transfer-for-value rules are observed, if the policy is owned by an FGT that becomes an FNGT after the death of the NCNR, there’s effectively basis step-up in the policy at the death of the NCNR.

When the NCNR knows that he’ll be survived by heirs who are U.S. persons, the FGT that’s fully revocable during the NCNR’s life might be structured so that benefits for such U.S. heirs will pour over at the death of the NCNR to a U.S. dynasty trust organized in a low tax jurisdiction with favorable state trust laws (including repeal of the rule against perpetuities). This will eliminate the possibility that the portion of the death benefit poured over to benefit U.S. heirs and invested through a U.S. domestic entity (trust) will become subject to the onerous U.S. tax rules otherwise applicable to FNGTs after the death of the NCNR (that is, pour over to a U.S. trust will avoid the accumulation throwback rules, deferred interest charge and conversion of capital gains to ordinary income rules, all of which are applicable to an FNGT that accumulates income for distribution in a year later than the year earned). Such punitive tax rules don’t apply to a U.S. trust. Still, domestic trust investments need to be handled in a tax-efficient manner.

A U.S. tax-compliant life insurance policy can obviate punitive CFC and PFIC rules. Due to investor control rules that must be adhered to for U.S. tax-compliant life insurance, it’s more likely that PFIC status can be avoided.

The non-U.S. admitted foreign carrier can obviate CFC status altogether for the policy and the policy owner, either an FGT or FC, by making an IRC Section 953(d) election to be treated as a U.S. domestic insurance company for U.S. tax purposes. Non-U.S. admitted carriers that make a Section 953(d) election will pay a U.S. premium tax like a U.S. admitted domestic carrier.

Aside from avoiding CFC status for the policy and its owner by making the Section 953(d) election, other U.S. tax implications of such election affect non-U.S. admitted foreign carriers. The U.S. admitted foreign carrier will generally absorb the income tax and administrative costs to comply with U.S. informational tax reporting requirements, with the result that a Section 953(d) compliant policy generally has higher premiums than a comparable non-Section 953(d) policy. The subtlety of a Section 953(d) electing non-U.S. admitted carrier voluntarily paying U.S. income tax on its investment and premium income, however, is that the U.S. Tax Code provides a special deduction for insurance companies allowing them to deduct reasonable reserves required to be held to satisfy future death benefit claims. As a practical matter, non-U.S. admitted carriers electing Section 953(d) treatment simply absorb (primarily through premiums) the cost of income tax compliance in the United States, including CFC and PFIC tax reporting required of the carrier.

Turning to a PFIC, often high-net-worth individuals’ investments fail the previously mentioned income or asset tests. Further, the rule is that “once a PFIC, always a PFIC,” so a U.S. person heir can inherit attribution of PFIC status.

The U.S. Tax Code specifies when PFIC ownership can be attributed to a U.S. person, even though the U.S. person doesn’t own the PFIC directly. There’s no rule for attributing PFICs through an insurance policy.⁵ IRC Section 1298(a) doesn’t import other typical tax attribution rules, such as the related party rules in IRC Section 267 or the constructive ownership rules in IRC Section 318, to the PFIC rules. There’s no look-through of an insurance policy that causes a PFIC to be attributed from an insurance policy through to the policy owner.

For a variety of reasons explored in greater detail in the second part of this article, the NCNR with heirs who are U.S. persons might consider investing in a private placement variable life insurance policy issued by a non-U.S. admitted carrier located outside the United States. This is particularly appealing for global NCNR investors who are attracted to hedge funds, private equity, commercial real estate or any other asset that can be properly valued but is potentially tax inefficient.

We remain concerned that the Internal Revenue Service hasn’t approved the use of the complex multi-tier FC holding company entity structure approach. It’s uncertain whether the IRS might apply a substance-over-form approach or the step transaction doctrine to disregard one or more of the three FCs on the ground that it has no non-tax business purpose. We believe that the current U.S. Tax Code provides clear support for the proposition that the PFIC and CFC rules shouldn’t apply to a U.S. tax-compliant policy issued by a foreign carrier making a Section 953(d) election, which will allow for the inside build-up in a policy held until death and then the death benefit itself to escape U.S. income tax.

In Part II of this article, we’ll explore the details concerning different types of policies available to NCNRs.                                    

Endnotes

1. Todd Rosenberg and Scott Snyder, “Post-Morten Considerations with Foreign Grantor Trusts After H.R. 1, Tax Cuts and Jobs Act,” The Florida Bar Journal (March 2018).

2. Internal Revenue Code Section 1297(b)(1).

3. Dina Kapur Sanna and Carl Merino, “Tax Planning for U.S. Beneficiaries Using Foreign Trusts and Foreign Entities,” 14th Annual STEP/NYSBA International Estate Planning Conference (March 22-23, 2018), at p. 78.

4. Charles Rubin, “Obscure Provision of New Tax Act Complicates Tax Planning for Nonresidents with U.S. Beneficiaries,” Rubin on Tax (Jan. 15, 2018), http://rubinontax.floridatax.com/2018/01/obscure-provision-of-new-tax-act.html.

5. For an excellent concise analysis of this highly technical issue, see the blog post of Haoshen Zhong, “PFIC Wrapper Miniseries #2: Participating Life Insurance,” at Hodgenlaw PC (Dec. 1, 2016), https://hodgen.com/pfic-
wrapper-miniseries-2-participating-life-insurance/.

Consider this proposition: Your wealthy clients own twice as much as you think. Three recent studies discussed below validate this assertion. Their liquid assets (the stocks, bonds and cash advisors tend to focus on) represent less than half (45 percent) of a typical millionaire’s portfolio. The other 55 percent consists of illiquid assets such as real estate, stock in privately owned companies and artwork.

It takes specialized skills to preserve the value of illiquid assets, skills your clients often lack. Most owners need help and know it: They’re more apt to worry about their illiquid assets than, say, their mutual funds. Yet most advisors offer no help: When it comes to this half of the portfolio, their clients hear nothing but crickets.  

Advisors routinely ignore this “hidden half.” This must change. I believe that: (1) illiquid assets are important so advisors shouldn’t ignore them; and (2) even advisors with limited illiquid asset experience can provide assistance their clients will value.

More Important Than Liquid Assets

Some recent studies document the importance of illiquid assets. TIGER 21 is an association with over 500 extremely wealthy members who collectively manage more than $50 billion in personal assets. Each member is required to present his personal investment portfolio annually. The association publishes quarterly reports detailing the holdings, which form a fascinating insight into how ultra-affluent families invest their money. The TIGER 21 Member Allocation Report¹ details how in Q2 2017, 55 percent of the TIGER 21 household investments were in illiquid assets; just 45 percent consisted of liquid assets. (See “TIGER 21 Member Allocation,” p. 37.) TIGER 21 has been tracking portfolios for decades. (See “Breakdown of Portfolios,” p. 39.) Note the growth over time of real estate (maroon) and private equity (gray). Particularly since the Great Recession, the clear trend is that illiquid assets are growing in importance while liquid assets are becoming less so.² 

PriceWaterhouseCoopers (PwC) issued a 2015 report³ confirming this segment’s growth and predicting illiquid assets will continue to grow by double digits annually. “Between [2015] and 2020,” notes the report, illiquid assets “are expected to grow to $13.6 trillion in our base case scenario and to $15.3 trillion in our high case scenario.”⁴ 

A third study of note is an Internal Revenue Service  analysis⁵ of estate tax returns filed in 2016. Because only estates worth over $5.4 million filed returns, the study sheds light on what the wealthy own. In 2016, over one-third of the assets listed on estate tax returns were real estate, interests in small businesses and other. That is, illiquid assets.  

As suggested by the TIGER 21, PwC and IRS studies, illiquid assets are important. Therefore, advisors should treat them with respect. Yet in my experience, advisors think that if they don’t directly manage the assets, they aren’t responsible for them. In other words, “not my problem.” To the contrary, helping owners address their illiquid asset challenges is good for any advisor’s business. 

Consider registered investment advisory firm AdvicePeriod, recently featured in Financial Advisor magazine.⁶ President Larry Miles ascribed his firm’s phenomenal growth in part to its willingness to advise clients on all their assets, not just the ones it directly manages:

Oftentimes, we’re able to advise clients on assets that are managed elsewhere, assets that are in the form of a business or real estate ... We found over the years that clients were really seeking an advisor who could offer them advice on their entire balance sheet, and all of their liabilities, regardless of where they were custodied. We believe the best advisors are able to do just that.⁷ 

Bottom line: There are many reasons for advisors to stop thinking of illiquid assets as being someone else’s problem. For advisors willing to help, happier clients and more referrals await.  

What Illiquid Asset Owners Need

Above, I noted that illiquid asset owners need help. What kind of help, exactly? My answer is “the services you might want if you owned the illiquid asset,” which vary depending on the type of illiquid asset in question. There are seven major types:

1. Real estate

2. Closely held businesses

3. Life insurance

4. Loans and notes

5. Minerals, oil and gas

6. Intellectual property

7. Tangible assets and collectibles

Each of these seven has subcategories. Real estate, for example, has six subcategories:

1. Owner-occupied home

2. Vacation home (including hunting, fishing)

3. Income-producing (multi-family residential, commercial, retail, industrial)

4. Agricultural (farm, ranch, orchard)

5. Timber

6. Raw land

To illustrate what “help” looks like, consider the example of a lakeside cottage that’s been owned by one family for generations. Advisors with experience working with multi-generational families know that by the second or third generation, such properties likely have many owners, and certain issues are sure to arise:

a. Who’s responsible for keeping critters and others outside during the off-season and in between family visits?

b. Who referees disputes if two family members want to use the cottage at the same time?

c. Who decides if a repair is needed, and if so, who pays for it (remembering that not all family members have an equal ability to pay)? 

d. What happens (and who decides) if an owner doesn’t plan to use the cottage or can’t afford to pay his fair share of the costs? 

Therefore, help with respect to a vacation cottage requires someone:

1. with diplomatic skills to help develop a governance plan for the property;

2. to pay property taxes, insurance and other routine bills;

3. to inspect the property periodically to ensure it’s being kept up;

4. to rent out the cottage during vacant periods (if the owners so decide);

5. to supervise the contractors maintaining the property;

6. to handle the property’s sale (if the owners so decide);

7. to prepare the property’s financial statements every year; and

8. to appraise the property from time to time.

Non-Fiduciary Advisors 

Often, owners can’t or won’t skillfully administer their illiquid assets. In such cases, advisors who are simply giving advice (that is, not acting as a fiduciary) can ride to the rescue by saying, “Would it be helpful if I connected you to firms providing services 1-8?” In my experience, the reaction from owners is always the same: a sigh of relief, a smile and a heartfelt “thank you, that’s exactly what we need!” (This is why advisors offering help with illiquid assets win so many referrals.)

Hundreds of firms offer specialized illiquid asset services, and each wants your clients to hire them. So, when acting in a non-fiduciary capacity, typically the advisor’s job is to connect clients to the best of these vendors. While simply Googling vendors and compiling a list is better than nothing, I recommend against it because not all vendors are competent. Instead, I suggest having the client hire an independent due diligence firm to identify the best candidates and vet their competence.  

Fiduciary Advisors 

When advisors are acting in a fiduciary capacity (for example, as trustee of a trust that owns the illiquid asset), prudence dictates that steps be taken to ensure the asset is skillfully administered, such as:

1. Adopt policies, procedures and checklists. Advisors should adopt sound policies, procedures and checklists that are succinct and flexible. Otherwise, internal auditors, regulators and plaintiffs’ attorneys will have a field day playing “gotcha.” 

2. Revise onboarding procedures. Owners are never more willing to supply information about their illiquid assets than in the days before getting advice (or transferring it to the advisor in trust). Before taking ownership, robustly gather information to ward off unnecessary future headaches.  

3.Select vendors. Unless your firm has “know-how” managing that type of illiquid asset (and I would argue not even then), have expert third parties perform the services. Outsourcing not only limits risk but also makes it easier for clients to see what portion of their fee goes to pay the vendor versus paying the advisor for providing oversight.  

4. Obtain valuation(s). Illiquid assets can be hard to value, but advisors should always get an appraisal at the outset—ideally prepared by an independent subject matter expert. Because beneficiaries often misjudge what their illiquid assets are worth, we recommend sharing the appraisal report with all the owners to help debunk unrealistic notions of value. 

5. Train staff. Don’t assume your colleagues understand illiquid assets. Training is essential.

Beyond these, other steps worth considering include optimizing accounting systems, creating useful management reports, optimizing organizational charts, reviewing service offerings, analyzing costs, beefing up annual reviews/examination preparation and revising fee schedules. 

What are the Risks?

When acting in a fiduciary capacity, what risks should advisors keep in mind? The U.S. Treasury Office of the Comptroller of the Currency’s Unique and Hard-to-Value Assets Handbook⁸ (Handbook), published in August 2012, provides an excellent overview of illiquid asset-related risk. Its observations are relevant for any advisor acting as a fiduciary, not just those working at national banks:  

Asset management risks are inherent in individually managed portfolios, but the inclusion of illiquid assets further increases a bank’s risk. Risk increases because these assets often require special expertise to manage, are
sometimes subject to special ownership rules, and are frequently hard to value. Some assets present liability concerns that may extend the risk of loss beyond the amount invested. A bank fiduciary may face liability from secondary beneficiaries when holding a nonproductive asset, such as property occupied by a primary beneficiary. Other beneficiaries might question why the property was not made more productive. A bank’s failure to properly manage illiquid assets prudently and legally can increase the bank’s risks, particularly its operational, compliance, reputation, and strategic risks (emphasis added).

1. Strategic risk. A good way to think of strategic risk is the risk your employer will pursue the wrong growth strategy. As the Handbook notes:

A bank fiduciary assumes strategic risk when taking on new product lines without having the expertise and systems to properly manage and control risks associated with the line of business …  Because the management of illiquid assets falls outside the more traditional equity and fixed-income strategies, management must ensure that personnel are qualified to manage these assets.   

Given how important illiquid assets are to affluent investors, it’s strategically risky for advisors to ignore them. The right strategy is to offer a list of competent vendors (if acting strictly as an advice-giver) or take the steps described in the section Fiduciary Advisors, above (if acting as a fiduciary).

2. Reputation risk. Reputation risk may be thought of as the risk of appearing on the front page of the local paper at the wrong end of a jury award. The Handbook states:

A bank fiduciary’s lack of expertise or oversight of illiquid assets can subject the bank to significant losses, potential litigation, and reputation risk.  

To limit reputation risk, if acting strictly as an advice-giver, offer a list of competent vendors; or, if acting as a fiduciary, take the steps described in Fiduciary Advisors, above.

3. Compliance risk. Compliance risk is the risk of violating governmental laws, rules and regulations or the organization’s internal policies and procedures. States the Handbook: 

A bank fiduciary can expose itself to compliance risk if it fails to adhere to the bank’s policies and procedures or fails to secure needed expertise.  

Again, to limit compliance risk, if acting strictly as an advice-giver, offer a list of competent vendors, or if acting as a fiduciary, take the steps described in Fiduciary Advisors, above. 

4. Operational risk. In my experience, most illiquid asset risks arise when day-to-day tasks are mishandled.  As the Handbook points out: 

Operational risk is the risk to current or anticipated earnings or capital arising from inadequate or failed internal processes or systems, the misconduct or errors of people, and adverse external events. This risk manifests itself in several ways. First, safeguarding illiquid assets owned by an account for which the bank is a fiduciary or custodian poses unique risks. This involves the physical upkeep and securing of the asset as well as maintaining the account’s legal ownership of the asset. Real estate or collectibles are in this asset type. Secondly, a bank fiduciary holding illiquid assets such as mineral interests, real estate, or interests in closely held companies generally requires specialized accounting and control systems. Without these systems, the bank risks not properly monitoring and accounting for the various income streams and related taxes associated with these assets.

As before, to limit operational risk, if acting strictly as an advice-giver, offer a list of competent vendors; or, if acting as a fiduciary, take the steps described in Fiduciary Advisors, above.         

Endnotes

1. https://tiger21.com/2017-2nd-quarter.

2. Ibid.

3. “Alternative asset management 2020, Fast forward to centre stage,” www.pwc.com/us/en/industries/asset-wealth-management/alternative-asset-management-2020.html. 

4. Ibid.

5. Internal Revenue Service Statistics of Income, “Estate Tax Returns Filed for Wealthy Decedents, 2007-2016,” www.irs.gov/pub/irs-soi/2016estatetaxonesheet.pdf.

6. Steve Sandusky, “How One RIA Got To $1.6 Billion From Zero In Four Years,” Financial Advisor (Nov. 30, 2107).

7. Ibid.

8. www.occ.gov/publications/publications-by-type/comptrollers-handbook/unique-hard-to-value-assets/pub-ch-unique.pdf.

The number of income tax returns that will report income tax savings from charitable donations is projected to plummet from 37 million in 2017 to just 16 million in 2018.¹ The staggering decline of 21 million returns is due principally to two changes in the Tax Cut and Jobs Act of 2017: (1) limiting the itemized tax deduction for state and local taxes to $10,000 per return ($5,000 for married taxpayers filing separately), and (2) increasing the standard deduction to $12,000 on single returns, $24,000 on married joint returns and $18,000 on head-of-household returns—with even higher thresholds for individuals over age 65.²   

“A Massive Conversion,” p. 42, illustrates how these changes will cause millions of itemizers to convert into non-itemizers. It demonstrates the outcome for a taxpayer who pays $20,000 of state and local taxes and who pays a combination of $5,000 of mortgage interest and charitable gifts. Among households with incomes between $86,000 and $150,000, the percentage of tax returns that will report itemized deductions is projected to fall from 39 percent to just 15 percent.³

For individuals over the age of 70½, the good news is that no change was made to the law that permits them to make charitable gifts from their individual retirement accounts without recognizing taxable income. These individuals are therefore still able to get income tax savings from their charitable gifts. They can, for example, make charitable gifts from their IRAs and apply those gifts to satisfy their required minimum distribution obligation for the year, yet pay no income tax on those charitable IRA distributions.⁴

There are hundreds of thousands of individuals over age 70½ who’ve never before taken advantage of this law. They saw little point in making charitable gifts from their IRAs because they were able to get tax savings by claiming itemized tax deductions for their charitable gifts. Please allow this article to serve as a wake-up call. Determine whether your client will be able to itemize her tax deductions in 2018. If not, then she should immediately stop making charitable gifts the way that she has in the past. Instead, she should start using her IRA to make all of her future charitable gifts.

Mechanics

The law (commonly referred to as a “charitable IRA rollover”) permits individuals over the age of 70½ to make charitable gifts directly from their IRAs to eligible charities and exclude the distributions from their gross income. “Nine Requirements,” p. 41, specifies the legal requirements. The price: There’s no itemized charitable income tax deduction for such an IRA gift.  Of course, if the taxpayer isn’t able to itemize income tax deductions, then there’s no price to pay.

Taxpayers who used to itemize their deductions but no longer can, should (in theory) make every charitable gift from their IRAs. IRA administrators should expect a surge of requests in 2018 compared to prior years. The primary obstacle is the practical impediment of making numerous small gifts—for example, $20 or $50—from an IRA. One practical solution is an “IRA checkbook” offered at some brokerage houses, where each check is a distribution from the IRA. By having the IRA account owner write a check for any dollar amount and then mailing the IRA check to the charity, the IRA checkbook alleviates the administrative burden that would otherwise be imposed on the IRA administrator. 

Bunching Charitable Gifts

For taxpayers under the age of 70½, a strategy to be able to itemize charitable deductions is to “bunch” several years of tax deductions into selected years. For example, someone who donates $5,000 per year to charities might donate a total of $15,000 in one year and nothing in the next two years. The large amount of charitable gifts might permit the taxpayer to itemize tax deductions that year, thereby generating tax savings that year from the charitable gifts, and then take the standard deduction in the next two years.

Such a strategy, of course, throws havoc into the cashflow projections of the charities. Consequently, the best way to accomplish this strategy is to make the bunched gifts to a private foundation (PF) or a donor-advised fund (DAF). The PF or DAF can then make distributions each year to the charities. The Internal Revenue Service now permits DAFs (but not PFs) to satisfy legally binding pledges.⁵ Thus, a donor can make pledges to the charities and use the bunched giving strategy to satisfy those pledges.

The Bottom Line

Time will tell whether, and by how much, the loss of itemized tax deductions might reduce the amount of charitable gifts received by the nation’s charities. But, there’s one very large group of donors who still have the ability to get income tax savings from all of the charitable gifts that they make: seniors over the age of 70½ who have IRAs.  

Endnotes

1. Howard Gleckman, “21 Million Taxpayers Will Stop Taking the Charitable Deduction Under The TCJA,”  The Tax Policy Center of The Urban Institute and The Brookings Institution (Jan. 8, 2018), www.taxpolicycenter.org/taxvox/21-million-taxpayers-will-stop-taking-charitable-deduction-under-tcja. 

2. The additional standard deduction for someone who’s age 65 or older is $1,300 for each married taxpayer or $1,600 for an unmarried taxpayer.

3. Gleckman, supra note 1.

4. Internal Revenue Service Notice 2007-7, Q&A 42 provides that a qualified charitable distribution can be applied to satisfy the annual required minimum distribution requirement.

5.  IRS Notice 2017-73.

Clients often consider whether it’s wise to convert their individual retirement accounts to Roth IRAs. There are pros and cons to doing so. But, for some clients, the reduced tax rates under the Tax Cuts and Jobs Act of 2017¹ (the Act) and other changes it made may tip the scales in favor of converting substantial amounts now.  

Benefits of Roth Conversion

There are several benefits to converting to a Roth IRA. The principal benefit is that, assuming the IRA owner has other funds to pay the tax on the conversion, the IRA owner is effectively shifting additional wealth into the IRA. Converting has the effect of making a substantial additional contribution to the IRA.  

Example: Assume a constant 25 percent income tax bracket. An IRA owner has a $100 traditional IRA and $25 in a taxable account. If he converts, he has a $100 Roth IRA. Over some period of time, it grows to $200, all of which is tax free. Over the same period of time, if he doesn’t convert, his traditional IRA will grow to $200, or $150 after income tax. His $25 taxable account will grow to less than $50, because the income and gains on the taxable account will be taxable each year.

There are several other benefits to the Roth conversion. There are no required minimum distributions (RMDs) from a Roth IRA during the IRA owner’s lifetime or the lifetime of the IRA owner’s spouse if he’s the beneficiary. The Roth conversion increases the level of asset protection in states where they’re protected against creditors. If the IRA owner leaves the IRA to his beneficiaries in trust rather than outright, the trust tax rates won’t apply to distributions from the Roth IRA that are accumulated in the trust. The Roth conversion also avoids the double tax in states that have a state estate tax because the Internal Revenue Code Section 691(c) income tax deduction for estate taxes only covers the federal estate tax but not the state estate tax. By converting to a Roth IRA, the income tax is removed from the estate.

Income Tax Tradeoff

There’s often an income tax tradeoff in converting to a Roth IRA. As a general rule, the Roth conversion makes sense to the extent the tax rate on the conversion is less than, equal to or not “too much” higher than the tax rate that would otherwise apply to distributions from the IRA. For that reason, many IRA owners spread the conversion out over a number of years or wait until they retire to convert or to begin to convert.

Many IRA owners who expected to be in the 15 percent bracket during retirement converted as much as they could each year while remaining in the 15 percent bracket. They often had a window between retirement and when they began receiving Social Security or between retirement and when they had to take distributions from their traditional IRA on reaching age 70½.² IRA owners who expected to be in higher brackets during retirement often converted up to the top of the 25 percent or 28 percent bracket.³  

Tax Rates on Joint Returns 

For many years, the tax brackets for joint returns were twice the width of the brackets for taxpayers who were single.  

To provide relief for singles, the Tax Reform Act of 1969 changed the brackets so that if two individuals with similar incomes married, their tax would increase (resulting in a marriage penalty). However, if two individuals, only one of whom had income, were to marry, their tax would decrease (resulting in a marriage bonus).

To ameliorate the marriage penalty, the Economic Growth and Tax Relief Reconciliation Act of 2001⁴ widened the 10 percent and 15 percent brackets on a joint return to be twice the width of the corresponding brackets for single returns. This continued to be the case through 2017, when the 15 percent bracket ranged from $9,325 to $37,950 for singles and from $18,650 to $75,900 for joint returns. To balance the interests of singles and married couples, the joint return brackets above 25 percent were wider than but not double the width of the corresponding single brackets. The 25 percent bracket ranged from $37,950 to $91,900 for singles and from $75,900 to $153,100 for joint returns, and the 28 percent bracket ranged from $91,900 to $191,650 for singles and from $153,100 to $233,350 for joint returns.

In addition to reducing the tax rates, the Act widened the tax brackets on joint returns to double the width of the brackets for singles up to and including the 32 percent bracket for taxable income up to $200,000 (single) or $400,000 (joint).

For single individuals, the regular income tax rates in 2018 are 10 percent up to $9,525, 12 percent up to $38,700, 22 percent up to $82,500, 24 percent up to $157,500, 32 percent up to $200,000, 35 percent up to $500,000 and 37 percent over $500,000.

For joint returns, the regular income tax rates in 2018 are 10 percent up to $19,050, 12 percent up to $77,400, 22 percent up to $165,000, 24 percent up to $315,000, 32 percent up to $400,000, 35 percent up to $600,000 and 37 percent over $600,000.

Under the new tax rates, many IRA owners will convert each year to the extent they can do so in the 10 percent or 12 percent income tax bracket. Other IRA owners may convert each year to the extent they can do so within the 22 percent or 24 percent bracket. IRA owners who expect that they and their beneficiaries will always be in a very high tax bracket may convert their entire IRA as quickly as they can.

Other factors, such as the effect of the conversion on the zero tax rate for qualified dividends and long-term capital gains for taxpayers in the 12 percent bracket and the effect of the conversion on the taxation of Social Security benefits, may affect the decision as to how much, if anything, to convert to a Roth.  

In particular, because the 22 percent and 24 percent brackets on a joint return are now twice the width of the single brackets, a couple filing a joint return will be in the 22 percent bracket up to $165,000 of taxable income and the 24 percent bracket up to $315,000 of taxable income.

This offers a window for many middle and upper middle income IRA owners to convert substantial amounts to a Roth IRA within the 22 percent or 24 percent bracket. This covers couples with taxable income up to $315,000.  

This is especially attractive to IRA owners who’ll always be in at least the 22 percent bracket as a result of pensions, Social Security, RMDs  and investment income.                                       

Endnotes

1. Pub. L. 115-97.

2. The required beginning date is generally April 1 of the year when the individual retirement account owner reaches age 70¹/2. However, if the IRA owner defers the required minimum distribution (RMD) for the year in which he reaches age 70¹/2 until the following year, the IRA owner will have to double up on the following year by taking both the RMD for the year in which he reached age 70¹/2 as well as the RMD for the following year.

3. Bruce D. Steiner, “Roth Conversions Are More Attractive Under ATRA,” Trusts & Estates (April 2013).

4. Pub. L. 107–16.