Professor S.I. Strong’s groundbreaking article focuses on the future of arbitration of trust and estate disputes under the relatively new E.U. regulation 650/2012 (the regulation) (also known as Brussel IV), which has a very broad scope, affecting not only parties and practitioners in E.U. member states but also the estate plans of non-E.U. nationals, such as U.S. citizens living and dying in an E.U. member state. This new regulation went into effect on Aug. 17, 2015. 

Prof. Strong is a dual admitted multi-jurisdictional U.S. lawyer as well as a solicitor in England and Wales.  She initially provides a brief update on the state of trust arbitration around the world, including the United States. To date, she reports five states (Arizona,  Florida, Missouri, New Hampshire and South Dakota) have adopted statutes explicitly recognizing the validity of an arbitration provision found in a trust. There’s also support for trust arbitration in the Uniform Trust Code. Outside of these states, trust arbitration has been adopted in Guernsey and the Bahamas, and New Zealand is poised to follow among common law countries. Most relevant, she painstakingly footnotes evidence that a number of civil law countries (which comprise almost all of the E.U. member states, as the United Kingdom is exiting the European Union) have also shown support for arbitration of trusts or their civil law analogues.

The regulation is based on “habitual residence,” with the result that even a non-E.U. national, such as a U.S. expat who’s habitually resident in an E.U. member state at the time of his death, will be subject to the regulation’s principles and procedures. 

U.S. estate-planning lawyers don’t have longstanding familiarity with arbitration clauses in trusts or wills for a couple of reasons. First, in 1917, Austin Wakemen Scott (who was a Harvard Law School professor and is best known as the author of Scott on Trusts) wrote an influential article that laid out the fundamental differences at the time between the law of trusts and the law of contracts. Regrettably, that distinction has lived on 100 years later so that today in the United States, we have statutes in a majority of states that only enforce arbitration clauses in contracts and not in trusts and perpetuate Scott’s now dated view of the state of trust law in a modern flat world. Second, the provisions in some state constitutions and other state statutes have been construed to require disputes to be resolved in court. 

Unfortunately, of the few U.S. state courts that have considered the enforceability of arbitration clauses in a trust, all have agreed that arbitration clauses aren’t binding on beneficiaries or trustees because they’re only binding when included in a written contract. For example, in Michigan, New York and Pennsylvania, courts have determined that testamentary capacity must be determined in court and can’t be delegated to an arbitrator. Moreover, the N.Y. state constitution provides that the N.Y. Surrogate’s Court has exclusive jurisdiction over all actions relating to a decedent resident in or owning tangible or real property located in the state at death. 

While provisions in both testamentary trusts and non-testamentary trusts “requiring the arbitration of trust-related disputes could be enforceable under Regulation 650/2012,” Prof. Strong acknowledges that it’s “unclear” as to how questions of jurisdiction, applicable law and recognition of judgments (enforcement) are to be handled in cases falling outside the regulation (that is, when there’s no mandatory arbitration clause included in the will or trust instrument).

A habitual resident of an E.U. member state, such as a U.S. citizen permanently residing in an E.U. member state, has a limited amount of autonomy as to the choice of law and choice of forum to govern his succession matters. The regulation contemplates the possibility that U.S. law could control an expat decedent’s “succession as a whole” and may refer to the law of such decedent’s nationality. Prof. Strong raises an important issue by asking whether a U.S. national would have to choose the law of the country from where he was born. Most questions of trust arbitration in the United States have been decided as a matter of state law. The regulation provides that the law referring to the nationality of the decedent shall be the law of the territorial unit with the closest connection to the decedent as a national of a country (such as the United States) with multiple territorial legal systems but no internal conflict-of-laws rules regarding succession. The professor ponders what the U.S. estate planner advising a U.S. expat should do because the closest connection to the decedent at death can’t be determined until death occurs.

This is an important article for lawyers with cross-border families who are ripe for contentious disputes when a family has spread its wings beyond the country of origin and has family members residing in different E.U. countries or has a family member who’s a U.S. citizen permanently residing in an E.U. member state.

The public policy reasons for allowing greater access to arbitration in trusts and estates disputes is compelling. First, it’s more efficient and saves time and money. Rather than have the trust or estate depleted to pay for time-consuming costly litigation that may entail lengthy discovery, use of arbitration typically offers abbreviated discovery. Second, and perhaps most important, is that arbitration proceedings and their outcomes can be kept private, whereas litigation takes place in court in a public forum. Fear of such an all-out onslaught on the reputation of a deceased settlor may force a fiduciary to reward a zealous contestant threatening to smear the decedent’s name in public by offering a very generous settlement that depletes the assets remaining for other beneficiaries and heirs.

Prof. Strong’s conclusion that it’s only a matter of time before the viability of a trust arbitration provision is considered under the regulation is on point. A court’s rationale will likely be traced back to the topics covered in this article. She contemplates that a court in an E.U. member state would only overturn an arbitration award if it’s “manifestly contrary to public policy” in the member state of enforcement. I believe her groundbreaking work on the frontier of arbitration in trusts and estates disputes in Europe will indeed shed some light on how trusts and estates arbitration can and should work when considered by courts in E.U. member states in the not too distant future.     

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Trusts and estates attorneys who work with clients who run private equity (PE), venture capital (VC) and hedge funds regularly rely on the “vertical slice” exception to Internal Revenue Code Section 2701 to transfer interests in those funds to their descendants. It’s widely accepted by practitioners in this space that if a general partner (GP) transfers an equal proportion of each class of his equity in a fund, the draconian valuation methodology of IRC Section 2701 won’t be imposed. Achieving verticality, however, is more easily said than done.

Reason for Enactment

Section 2701 was enacted in 1990 to prevent what was perceived to be an abuse of the gift tax system, specifically preferred stock recapitalizations. Before 1990, a member of a senior generation of a family could recapitalize common stock in a corporation controlled by the family into common and preferred shares, exchanging the old common stock for preferred stock and common stock. The senior generation would gift the common stock to a lower generation and retain the preferred stock. Typically, the preferred stock would have noncumulative dividend rights and a fixed liquidation preference that represented a significant portion, if not all, of the value of the corporation, and the common stock had little value at the time of transfer. Because the dividend rights were noncumulative, the family could freeze the value of the preferred stock for estate tax purposes by not paying dividends, with earnings and appreciation accruing to the lower generation common stockholders.

Section 2701 was enacted to prevent this transfer of value, and it casts a wide net. It’s a gift tax valuation rule that applies to family-controlled corporations and partnerships with more than one class of equity interests. For purposes of Section 2701, in the case of a corporation, “control” means holding at least 50 percent of the total voting power or total fair market value of the stock.¹ In the case of a partnership, “control” means holding at least 50 percent of either the capital interest or the profits interest. Further, in the case of a limited partnership, control means holding any equity interest as a GP.² 

Carried vs. Capital Interests

Generally, if a senior generation family member transfers a junior, or subordinate, equity interest (for example, common stock) to a lower generation family member while retaining a senior equity interest (for example, preferred stock), the retained senior interest is deemed to have no value under Section 2701, resulting in the junior interest having a higher value for gift tax purposes, unless the retained senior interest satisfies certain requirements.³ The Tax Code and regulations use “junior” and “subordinate” interchangeably: A junior equity interest is defined as one in which “the rights as to income and capital…are junior to the rights of all other classes of equity interests.”⁴“Subordinate equity interest” is defined as “an equity interest in the entity as to which an applicable retained interest is a senior equity interest.”⁵“Senior equity interest” is defined as “an equity interest in the entity that carries a right to distributions of income or capital that is preferred as to the rights of the transferred interest.”⁶ 

A typical PE, VC or hedge fund is structured as a limited partnership (the “LP fund”), and a principal of the fund owns interests in the GP (which itself is typically an LLC or a limited partnership). The outside investors contribute capital to the LP fund, and the principals own their carry and invest in the LP fund through the GP entity, although they could also invest in the LP fund directly. As the principals are owners of the GP entity, the LP fund is a “controlled” partnership as to each principal for purposes of Section 2701.⁷ Through the GP, the principal makes a capital commitment to the fund for which he receives a capital interest (similar to the interest received by outside investors in the LP fund) and a so-called “carried interest,”⁸ which entitles the fund principals to 20 percent of the profits realized by the LP fund after the investors (holders of capital interests) receive back their capital plus a preferred return on their investment (typically 8 percent). Therefore, the capital interests are senior to the carried interests, at least until the investors have received their preferred return, and thereafter, the capital and carried interests are pari passu, sharing profits 80:20.

When Section 2701 is Invoked

The vast majority of practitioners in this space agree that Section 2701 is invoked when the principal of a fund transfers his carried interest to his children while retaining his capital interest. Such transfers are usually made at an early stage of the fund, when the carried interest has very little value and remains junior/subordinate to the capital interest. Because fund principals often invest large amounts of capital in a fund, if Section 2701 applies, a large taxable gift could result because the value of the carried interest transferred would include a proportionate share of the value of the capital interest retained. To avoid this result, the fund principal could comply with the vertical slice exception under Section 2701: Section 2701 doesn’t apply if the fund principal transfers a proportionate amount of all his equity interests in the fund; for example, by transferring 20 percent of his carried interest and capital interest in the fund to his children.⁹ Specifically, Treasury Regulations Section 25.2701-1(c)(4) provides:

Section 2701 does not apply to a transfer by an individual to a member of the individual’s family of equity interests to the extent the transfer by that individual results in a proportionate reduction of each class of equity interest held by the individual and all applicable family members in the aggregate immediately before the transfer.^[10] Thus, for example, Section 2701 does not apply if P owns 50 percent of each class of equity interest in a corporation and transfers a portion of each class to P’s child in a manner that reduces each interest held by P and any applicable family members, in the aggregate, by 10 percent even if the transfer does not proportionately reduce P’s interest in each class. See §25.2701-6 regarding indirect holding of interests. (Emphasis added.)

Issues to Consider

The obstacles an estate practitioner must navigate when transferring a vertical slice are both practical and technical, touching on securities laws and gift and income tax laws. Below are issues to consider when implementing a vertical slice transfer: 

1. Attribution rules. Do the attribution rules make achieving verticality impossible? Section 2701 looks at which “applicable family members” own interests in the fund before and after the transfer to determine whether a disproportionate transfer was made to younger generations. The term “applicable family member” is defined as the transferor’s spouse, an ancestor of the transferor or the transferor’s spouse and the spouse of any such ancestor.¹¹ 

The vertical slice rule of Treas. Regs. Section 25.2701-1(c)(4), quoted above, refers to indirect holdings of interests under the attribution rules of Treas. Regs. Section 25.2701-6. Therefore, when determining the family’s reduction in each class of equity, the attribution rules are applied to determine which family members hold what interests and whether the vertical slice rule applies. That is, the attribution rules are applied to determine whether the transfer resulted in a proportionate reduction of each class of equity interest held by the transferor and all applicable family members in the aggregate, even if the transferor doesn’t transfer a vertical slice of what he owns.  

Example. Assume that a fund principal owns 20 percent of the carried interest and 40 percent of the capital interest in a fund through the GP and that his father owns 30 percent of the capital interest directly in the fund, but no carried interest. To transfer a vertical slice comprised of 50 percent of the fund principal’s carried interest to a trust of which his descendants are the beneficiaries, the fund principal must transfer 50 percent of his carried interest and
87.5 percent of his capital interest, which is 50 percent of his and his father’s aggregated capital interests.  

The attribution rules also address the following points:

Regarding trusts:“A person is considered to hold an equity interest held by or for an estate or trust to the extent the person’s beneficial interest therein may be satisfied by the equity interest held by the estate or trust, or the income or proceeds thereof, assuming the maximum exercise of discretion in favor of the person … However, any person who may receive distributions from a trust is considered to hold an equity interest held by the trust if the distributions may be made from current or accumulated income from or the proceeds...”¹²

Regarding grantor trusts: An individual is treated as holding an equity interest held by or for a trust if the individual is considered an owner of the trust under the grantor trust rules.¹³

Tie-breakers: Treas. Regs. Section 25.2701-6(a)(5) contains tie-breaker rules when the attribution rules treat more than one person as holding equity interests. In the case of applicable retained interests (generally, the senior equity interests) attributed to more than one of the transferor and applicable family members (that is, ancestors of the transferor and his spouse and spouses of such ancestors), they’re treated as held: (1) first, by the grantor if owned by a grantor trust; (2) second, by the transferor; (3) third, by the transferor’s spouse; and (4) last, by the applicable family members on a pro rata basis.¹⁴

In the case of subordinate/junior equity interests attributed to the transferor, applicable family members and members of the transferor’s family (which includes the transferor’s spouse, descendants and their spouses), they’re treated as held (1) first, by the transferee; (2) second, by each member of the transferee’s family pro rata; (3) third, by the grantor if held in a grantor trust; (4) fourth, by the transferor’s spouse; and (5) last, by each applicable family member on a pro rata basis.¹⁵

On its face, it appears that if a fund principal transfers all of his carried and capital interests in a vertical slice to a grantor trust for his spouse and children, under the attribution rules, the interests would be deemed held by the spouse and children as beneficiaries of the trust and by the transferor/grantor. Under the tie-breaker rules, (1) because the senior/capital interest would be deemed held by the grantor and the grantor’s spouse (both applicable family members), it would be deemed to be held by the grantor; and (2) the junior/carried interests would be deemed held by the spouse and children as beneficiaries of the trust. Therefore, despite the apparent transfer of a vertical slice, the transferor is treated as having retained the capital interest and only transferred the carried interest—possibly negating the vertical slice! 

If the same transfer were made to a non-grantor trust solely for the children, all of the transferred carried and capital interests would be deemed held by the children, falling under the vertical slice rule.

Can this be? The vertical slice rule says on its face that “Section 2701 does not apply to a transfer...to the extent the transfer…results in a proportionate reduction of each class of equity interest…,” which should end the inquiry, and the attribution rules shouldn’t then be applied to negate what appears to be a vertical slice transfer. Otherwise, despite falling within the vertical slice exception to Section 2701, a gift to a grantor trust could trigger Section 2701. However, this interpretation is uncertain. It could be that a vertical slice transfer doesn’t foreclose the attribution rules, and the vertical slice rule is applied after using the attribution rules to determine who’s deemed to hold equity interests after the transfer.

2. Management fees. The GP charges and collects a management fee from the LP fund, typically 2 percent of the assets under management or capital called. This fee is used by the GP to pay expenses, salaries and overhead, and net fee income is paid to the fund principals as owners of the GP. In some cases, some or all of this fee is paid to a separate management company owned by the fund principals, which serves the same functions. Consideration should be given as to whether a proportionate share of the fund principal’s management fee income should be included in a vertical slice, particularly if the fee is paid to the GP and there’s no separate management company. The GP is almost always a partnership or limited liability company (LLC), and the allocations of income on account of the capital interest, carried interest and management fee would all be reported on the same K-1s issued to the fund principals. These are all items of partnership income, and there’s no separate 1099 for a principal’s share of net management fee income. The vast majority of estate planners take the position that inclusion of the fee income isn’t required as part of the vertical slice, likening it to compensation for services and not an economic stake in the fund investments. 

If the fee income were included as part of the vertical slice, it would greatly impact the economics of the transaction. Because the fee income has significant value, it would commensurately increase the value of the vertical slice. Practically, a fund principal is unlikely to want to transfer any part of his net fee income, as that’s his only regular source of income from the fund.  

3. Management fee waivers. Funds are sometimes structured to allow the fund principals to waive part of what they would otherwise receive as their share of net management fees and set aside such amount to cover part of their capital commitments as they come due. These “management fee waivers” are also known as “synthetic capital” or “deemed contributions.” By waiving management fees, the fund principal gives up current income (which is taxed currently at ordinary income tax rates) and converts that dollar amount into a profits interest (which is taxed in the future as capital gain, if realized). The fund principal will only benefit from, and be able to apply, waived management fees to capital calls to the extent the fund has profits. If the fund isn’t profitable, the principal will have given up fees and will need to pay his capital calls out of pocket. Fees are either waived on an annual basis, or the full amount is waived at the outset of a fund. 

Care must be taken so that management fee waivers don’t upset verticality. For example, if a fund principal waives $100 of management fees to be applied to capital calls, he, in effect, converts $100 of his capital interest/commitment into an interest that shares in net profits of the fund (a waiver profits interest). Unlike the carried interest, the waiver profits interest isn’t subject to an 8 percent preferred return and shares in all profits alongside the capital interest, making it senior to a carried interest but junior to the capital interest (which first receives its capital back). Accordingly, the principal would have three classes of interests, listed from senior to junior: capital interest, waiver profits interest and carried interest. The vertical slice rule would require a fund principal to transfer a proportionate share of that waiver profits interest, because it’s senior to his carried interest.  

If the fees are waived at the outset of the fund, it’s easy to transfer a proportionate share of the waiver profits interest, and the value of that interest can be determined. But, if fees are waived annually, the vertical slice transfer made in a prior year is no longer proportionate. The principal’s capital interest would be reduced and waiver profits interest increased each time fees are waived. It could be structured so that the principal’s and his trust’s relative interests are converted proportionately, or the principal could hold all of his fund interests in a family partnership or LLC and transfer a piece of that entity so that if fee waivers convert capital interests into waiver profits interests, proportionality (verticality) is maintained. In either case, if the trust has an unfunded capital interest that’s converted into a “funded” waiver profits interest due to the principal waiving a fee each year, the trust will have received something of value that would be a gift, if not offset by the trust issuing a note to the principal.

4. Unvested interests. A fund principal’s carried interest is typically subject to a vesting schedule with only a portion vesting immediately and the balance vesting over a period of years. In some funds, carried interest is allocated to fund principals for each investment at the time it’s made, rather than to the fund as a whole, with that carry vesting over time.  

The Internal Revenue Service has taken the position that a transfer of unvested stock options isn’t a completed gift for gift tax purposes until vesting occurs.¹⁶ If a portion of the vertical slice consists of unvested carried interest, the IRS could, by analogy, take the position that the portion of the vertical slice comprised of such interest wasn’t effectively gifted. This would upend the proportionality of the vertical slice. In this case, because a greater proportion of the senior interest would have been transferred, Section 2701 shouldn’t be triggered. However, when the carry does vest, not only would it likely be more valuable than when originally transferred (resulting in a larger gift) but also Section 2701 would apply at that time, because only the junior/subordinate carried interest would have been gifted at that time without a proportionate share of the capital interest.

Of course, unvested stock options are distinguishable from unvested carried interest. The holder of unvested stock options isn’t an owner of the stock, can’t vote the stock and won’t receive any dividends. The holder of unvested carried interest (that is, an owner of the fund GP), on the other hand, is an owner with rights associated therewith, such as voting rights and the right to financial information, and may have a right to receive distributions subject to forfeiture if he leaves the fund before the carried interest is fully vested.

5. Funding future capital calls. The trust holding the vertical slice will need to fund its share of capital calls. The trust can satisfy capital calls via management fees waived by the transferor, additional gifts to the trust by the transferor, loans to the trust by the transferor or a third party, deploying existing trust assets or by some combination thereof. As will be explained below, some of these options will impact the trust’s qualification as an accredited investor (AI) or qualified purchaser (QP) and may trigger gifts.  

6. Securities laws. Funds usually seek to qualify for an exemption from registration under the Securities Act of 1933 (the 1933 Act) and the Investment Company Act of 1940 (the 1940 Act). The exemption that funds most commonly rely on allows investments only by AIs as defined in the 1933 Act and QPs as defined in the 1940 Act. If a vertical slice is transferred, it’s of the utmost importance to the fund that the transferee satisfy an exemption from these acts, or qualify as an AI or a QP.  

A transfer of a fund interest by gift or intra-family sale generally won’t trigger registration under the 1933 Act, because gifts don’t fall within the definition of a “sale” under the 1933 Act, and there’s an exemption for sales by persons who aren’t selling a security on behalf of an issuer, such as an investment bank. However, if the transferee assumes the transferor’s capital commitment to the fund, the transferee must qualify as an AI when it makes such additional contributions, even if the trust will use cash previously received as a gift from the transferor to do so.  

To qualify as an AI, the transferee must: (1) have a net worth in excess of $5 million; and (2) be a “sophisticated person” or if a trust, have a sophisticated person directing the trust’s purchase of securities. To meet the sophisticated person test, the fund must reasonably believe the transferee (including a trustee) has “such knowledge and experience in financial and business matters that he or she is capable of evaluating the merits and risks” of the (trust’s) investment in the fund. Also, if the transferee is a trust, it must not have been formed for the specific purpose of acquiring interests in the fund.

To avoid the need for the trust to qualify as an AI, the transferor could agree with the fund and the trust that the transferor will pay all capital calls on the trust’s behalf, so that the trust isn’t assuming the obligation to pay them. Such payments would be treated as taxable gifts from the transferor to the trust. 

Generally, a gift of a fund interest won’t trigger registration under the 1940 Act unless the transferee is obligated to fund future capital calls using assets other than those received as a gift and earmarked for such purpose. If the transferee is so obligated or if the vertical slice is sold rather than gifted, the transferee must qualify as a QP by meeting at least one of four requirements: (1) the transferee must have at least $5 million of investments and, if a company, partnership or trust, be owned legally or beneficially by related parties; (2) the transferee or the person authorized to make investment decisions with respect to a transferee trust, and the transferor or person who’s contributed assets to the trust, must be QPs; (3) the transferee must own or manage, for its own account or the accounts of other QPs, in the aggregate, at least $25 million in investments; or (4) the transferor and person who makes all of the decisions with respect to the transferee’s investments, in the case of a trust, must be “knowledgeable employees,” which generally includes executive officers, directors, trustees, general partners, advisory board members or persons serving in a similar capacity at the fund.  

Note that it’s far easier to qualify as a QP than an AI, because to qualify as a QP, the transferee only needs to meet one of the four requirements, while to qualify as an AI, the transferee must meet each of the three requirements. 

7. Size of transfer. Interests in PE, VC and hedge funds—and carried interests in particular—have a high appreciation potential, which is what makes them attractive to use to transfer wealth. Clients are sometimes
concerned about transferring “too much” value to the transferee or not keeping enough for themselves. At best, a fund principal can attempt to predict the future value of the vertical slice and adjust the size of the slice accordingly. When transferring to a trust, clients can address this concern by making the transferor’s spouse a beneficiary of the trust so that assets can be distributed to the spouse, who may be willing to share them with the transferor. 

8. Income tax issues. Income tax issues need to be carefully navigated, particularly when the transferring a vertical slice to an entity other than the grantor trust.

Generally, the issuance of carried interest to a fund principal in consideration of services to be provided, whether such interest is vested or unvested, won’t trigger taxable income, even without an IRC Section 83(b) election.¹⁷ However, if the carried interest is disposed of within two years of receipt, it could trigger taxable income, unless a Section 83(b) election is made,¹⁸ as there’s a legal assumption that it was issued in anticipation of a subsequent disposition. Because a gift or sale to a grantor trust isn’t considered to be a disposition for income tax purposes,¹⁹ this should only apply to a transfer made to a person or entity other than a grantor trust. Further, a “disposition” under the IRC doesn’t have to be taxable. For purposes of IRC Section 897 (part of the Foreign Investment in Real Property Tax Act), a “disposition” means a disposition for any purpose of the IRC, which includes gifts.²⁰ Accordingly, it’s advisable to make a Section 83(b) election even though it may not seem to be required.  

Further, recent legislation under IRC Section 1061 may cause gain on the sale (and possibly a gift) of carried interests within three years of receipt, treated as short-term capital gains as opposed to the usual holding period of more than one year for long-term capital gains treatment. The sale of a vertical slice including carried interest to a grantor trust shouldn’t be treated as a sale under this section because, again, it isn’t considered a sale for income tax purposes.  

Avoid Unforeseen Gift Tax Liability

When transferring PE, hedge and VC fund interests, relying on the vertical slice exception to Section 2701 is fraught with complexity and uncertainty. It’s vital to carefully navigate the considerations discussed above or risk causing an unforeseen gift tax liability for your client and even malpractice.²¹ 

Endnotes

1. Internal Revenue Code Section 2701(b)(2)(A) and Treasury Regulations Section 25.2701-2(b)(5)(ii).

2. IRC Section 2701(b)(2)(B) and Treas. Regs. Section 25.2701-2(b)(5)(iii).

3. IRC Section 2701(a)(3).

4. IRC Section 2704(a)(4)(B)(i).

5. Treas. Regs. Section 25.2701-3(a)(2)(iii).

6. Treas. Regs. Section 25.2701-3(a)(2)(ii).

7. See also Treas. Regs. Section 25.2701-6 attribution rules, treating each principal as holding the actual general partnership (GP) interests through his ownership of the GP entity.

8. Carried interest, or “carry,” is sometime referred to as a “promote” or “incentive” interest.

9. If the principal also invests capital directly in the limited partnership fund as a limited partner (and not just through the GP entity), those capital interests must be taken into account when transferring a vertical slice.

10. Treas. Regs. Section 25.2701-1(c)(4).

11. IRC Section 2701(e)(2).

12. Treas. Regs. Section 25.2701-6(a)(4)(i).

13. Treas. Regs. Section 25.2701-6(a)(4)(ii)(C).

14. Treas. Regs. Section 25.2701-6(a)(5)(i).

15. Treas. Regs. Section 25.2701-6(a)(5)(ii).

16. Revenue Ruling 98-21.

17. Revenue Procedure 93-27 (as clarified by Rev. Proc. 2001-43).

18. Rev. Proc. 93-27. 

19. Rev. Rul. 85-13. 

20. Treas. Regs. Section 1.897-1(g).

21. See David A. Handler, Anna Salek and Angelo F. Tiesi, “Carry Derivatives: Using Your Carried Interest in Your Estate Plan,” Venture Capital Review, Issue 31 (2015).

Representing the largest overhaul of the U.S. Tax Code in more than 30 years, the Tax Cuts and Jobs Act of 2017 (the Act) was supposed to provide tax simplification. Yet, the Act is full of phase-outs, phase-ins, threshold limitations and ill-defined terminology. Instead of tax simplification, many taxpayers and advisors are faced with tax complication.  

No single planning discipline has the expertise to adequately address the many facets of the Act.  Providing proper planning advice in view of the sundry of complexities of the Act will require greater collaborative efforts by the multidisciplinary team. From the newly added Internal Revenue Code Section 199A, to the doubling of the estate, gift and generation-skipping transfer (GST) tax exemptions, new planning opportunities and pitfalls present themselves.  

Enhancing the collective wisdom of the multidisciplinary team after the Act will entail greater efforts toward mutual communication, coordination and cooperation among planning peers. The goal of delivering effective and exceptional planning advice through collaborative team efforts can be both personally and professionally rewarding. Still, the collaboration road is an uphill challenge, requiring collective team effort and intentionality.  

Filling the Estate Tax Void

Perhaps we find collaboration in estate planning to be so challenging because there’s no agreed-on definition of what estate planning is. Surprisingly, neither academics nor such leading institutions as the National Association of Estate Planners & Councils, the American College of Trust and Estate Counsel and the American College of Financial Services have a common definition.  

Understandably, the public seems to be confused as to what estate planning is and how best to go about it. According to a recent WealthCounsel survey, three-fourths of Americans are confused regarding their thoughts about estate planning.¹ This lack of clarity around estate planning may help explain the lack of public engagement (64 percent of Americans don’t have a will).²

For years, leading with estate tax minimization and tax saving strategies was an effective way to get clients in the door to do proper estate planning. Post-Act, however, the estate tax minimization card is missing from the deck for more than 99 percent of the public. As practitioners seek to fill the estate tax void, they may do well to expand their services to include more qualitative aspects of legacy planning that involve intangible client discernment, in addition to the quantitative planning techniques of estate planning that result in tangible client deliverables.   

The definition of “estate planning” should be enduring and unchanging. However, the expression of estate planning must continually adapt and change with the times. In its most fundamental form, estate planning should support the family (or the individual) first, and thereafter concern itself with the tax-efficient transition of assets. Simply put, estate planning should be a multidisciplinary process in which planning professionals are collaboratively engaged in nurturing, protecting and enhancing the family through the accumulation, conservation and distribution of one’s assets and values. 

It stands to reason that if the multidisciplinary team has a better understanding of what they’re collaborating about and what they’re trying to accomplish from an estate-planning perspective, they can more effectively advise the client in helping him to achieve his goals. 

IRC Section 199A 

When it comes to business planning, estate planners have long focused on intrafamily discounts of closely held business interests. Recapitalizing closely held companies into voting and non-voting interests and then gifting or selling the non-voting interests for discounted values into intentionally defective grantor trusts, for example, has been a staple business and estate tax planning strategy for many years. And, intrafamily discount strategies should continue unabated for the foreseeable future since the Treasury Department withdrew its proposed regulations under IRC Section 2704 toward the end of last year, which would have reduced or eliminated certain valuation discounts for family owned and operated businesses.  

Even so, intrafamily discount planning primarily focused on the succession of the entity, not on the revenue and the operation of the business or the income tax intricacies regarding the choice of the business entity. That all changed, however, with new Section 199A. Planning advice must now factor in the more complicated choice of entity and the operational revenue of the business. With business planning complexity increasing, collaborative team efforts should likewise increase, including the business owner as operator and stakeholder and perhaps senior level managers with active day-to-day management roles. 

From a business planning standpoint, the provisions of the Act that will most commonly impact the choice of entity are the flat 21 percent corporate rate for C corporations (C corps) and the potential deduction of 20 percent regarding qualified business income (QBI) for passthroughs under Section 199A. In many instances, choosing to conduct business through a C corp or a pass-through entity will depend on whether the Section 199A deduction will be available.  

Consider that without the Section 199A deduction, the combined effective tax rate of a C corp, even taking into consideration the double tax, is slightly more favorable than the highest marginal tax rate for individuals with pass-through income—39.8 percent versus 40.8 percent, respectively.³ And, C corps offer another advantage over passthroughs because earnings can grow on a tax-favorable basis before being subject to a second tax on distribution.  

At first glance, Section 199A seems to be straightforward. In general, it provides a deduction equal to the sum of 20 percent of the QBI of each of the taxpayer’s qualified businesses that operate as pass-through entities, such as sole proprietorships, S corporations, limited liability companies, trusts, estates or partnerships. Thus, eligible taxpayers can claim a 20 percent deduction and realize a maximum effective tax rate of 29.6 percent (37 percent x .80) on a taxpayer’s QBI earned in a qualified trade or business (QTB).  

But, first glances can be deceiving. Section 199A is extraordinarily involved, and it should be approached with great caution in light of the significant understatement penalty that comes with it. Even the most experienced tax professionals are often left wanting regarding how to correctly interpret Section 199A. A recent letter from the American Institute of CPAs to the Internal Revenue Service identifies a plethora of areas requiring guidance, including Section 199A.⁴ 

Critical definitions regarding this new section are less than clear. For example, QBI is generally the net amount of income, gain, deduction and loss from an active trade or business in the United States, but it excludes certain types of investment income such as capital gains, dividends and interest. Notably, however, there are a multitude of deductibility limitations on wages and qualified property that are allocable to particular qualified trade or business activities that must also be considered. 

Now consider QTBs, which include all trades and businesses except the trade or business of performing services as an employee and specified service businesses (SSBs), such as health, law, accounting, consulting, athletics, financial services, brokerage services, investing, investment management, trading and dealing in securities or any business in which the principal asset is the reputation or skill of one or more of its owners.  

Importantly, any business that isn’t an SSB is considered to be a QTB. Therefore, if the taxpayer has QBI exceeding the threshold amount, determining whether his business is an SSB or a QTB is critical in determining whether the QBI from that business will qualify for the 20 percent deduction. However, distinguishing an SSB from a QTB can be tricky, and much more guidance is needed from the IRS.  

Under Section 199A, many planning considerations, questions and issues arise for the multidisciplinary team, such as: 

• Whether a business entity should be structured as a C corp to take advantage of the lower tax rate on current income (perhaps investment income), understanding that a subsequent dividend tax applies when dividends are withdrawn by shareholders.

• Should business owners of passthroughs allow more employees to become partners so that some or all of their compensation will constitute QBI. If so, what might be the impact on the control of the entity, the owner’s estate plan, buy/sell planning and other ancillary concerns? Could more workers possibly be paid as true independent contractors? 

• Whether the taxpayer may consider a management company to be an integral part of the operating trade or business (and thus, not an SSB) if substantially all of the management company’s income is from that other trade or business. 

• Should an SSB be sliced and diced into a separate firm(s) that might provide ancillary support services (for example, IT or accounting), in the hopes that the ancillary support services charged to the SSB would quality for the 20 percent deduction? 

• What will be the impact on buy/sell agreements, life insurance arrangements and estate plans should a client restructure his business entity to capitalize on Section 199A? 

• Should closely held ownership interests be gifted to irrevocable non-grantor trusts because each trust is considered to be a separate taxpayer and has its own independent threshold amount? What about step-up and carryover basis considerations in making a gift? 

Achieving optimal results under the many nuances and planning pitfalls of Section 199A will likely require CPAs, tax attorneys and others on the multidisciplinary team to more intentionally collaborate with the business owner. While these concerted efforts may be considerable, they’re typically worth it. After all, closely held family businesses are often the most valuable assets in the family enterprise and in the taxpayer’s estate.  

Increased Planning Considerations 

The Act doubles the amount of assets that may be passed on transfer tax free. Specifically, it increases the basic exclusion amount from $5 million to $10 million (indexed for inflation occurring after 2011) for estates of decedents dying, GST transfers and gifts made after 2017 and before 2026. For 2018, the indexed exclusion amount is $11.18 million. However, this transfer tax exclusion is set to sunset back to about $5.5 million (projected indexed amount) in 2026.

Here too, questions, planning considerations and issues abound for the multidisciplinary team in such areas as: 

• Basic estate planning. Without the goal of estate tax minimization, will clients perceive the need to even do an estate plan or to update the one they have because portability and the doubling of exemptions greatly diminishes tax urgency? Will the non-tax reasons for trusts, namely, management of assets, asset protection and distribution control be enough to spur clients on to act? 

• Fundamental transfer tax formulas. Will the transfer tax formulas embedded within many outdated estate documents produce unintended funding of bequests? Might credit shelter/family trusts be overfunded (perhaps causing state estate taxes), while trusts like the marital trust remain unfunded altogether? Should planners send letters to clients warning them that their plans should be reviewed in light of the Act and the doubling of the estate tax exemptions? 

• Powers of attorney (POAs). Should POAs be reviewed and refined with respect to the ability of the attorney-in-fact to make gifts? Perhaps gifts beyond the annual gift tax exclusion should be prohibited in many circumstances. 

• Outdated irrevocable trusts. Might trust provisions in older irrevocable trusts lack the tax efficiency and asset protection of properly structured dynastic trusts today? Should irrevocable trusts be dismantled if they may no longer be needed for estate tax purposes, or should appreciated assets be distributed out for estate tax inclusion and step-up purposes? What about decanting to modify outdated irrevocable trusts? 

• Life insurance. Does the doubling of the estate tax exemption eliminate the need for most clients to purchase or maintain existing life insurance policies to pay a federal estate tax? Should practitioners caution clients against canceling existing coverage in view of a future administration changing the estate tax rules?  And, importantly, what was the purpose of the life insurance when the policy was taken out? Does that purpose still exist, and is there a good fit between the type of insurance and the irrevocable trust? If not, might the insurance be canceled or repurposed to meet other planning needs? Should insurance be considered as part of the overall investment portfolio, where it could be positioned to provide an attractive tax-free rate of return for premature death prior to life expectancy and placed into more flexible planning trusts like spousal lifetime access trusts (SLATs)?

• Basis planning considerations. Should an IRC Section 2038 power be added to the will or trust to create a mechanism to cause appreciated assets to be included in the client’s taxable estate to achieve a basis step-up?  

To Gift or Not to Gift? 

Like a new car with more overhead room for taller passengers, the doubling of the estate tax basic exclusion gives more overhead room for wealthier clients to consider making more substantial gifts (between $5 million and $11.18 million) without the fear of adverse consequences from an IRS audit. Moreover, Wandry-type⁵ defined valuation clauses, designed to control the value of a difficult-to-value asset, may be seen less often with higher transfer tax exemptions.  

Making substantial gifts through leveraging the doubled gift tax exclusion is available for eight years through 2025. Undoubtedly, this “use it or lose it” tax provision will motivate some clients to make more substantial gifts before it sunsets in 2026. Other significantly wealthy clients, however, may not be so quick to act. They may rightly remind us of our needless clarion calls for them to consider making gifts back in 2012.  

More than ever, the multidisciplinary team is needed to help these clients of means answer the difficult question of “to gift or not to gift?” Making irrevocable transfers of significant wealth is something that should be thoroughly pondered. Should dynastic SLATs be used as a primary planning tool in case access may be needed to the assets transferred? How much can a wealthy client really afford to gift away? How much does a charity or do the children really need? Can we continue to have enduring economic prosperity regarding our portfolios in the face of rising deficits? What about the unknown economic effects of reversing quantitative easing?   

In the end, estate and business planning aren’t static activities that somehow became simplified under the Act. Rather, they became more challenging in many cases, requiring the multidisciplinary team to retool their collective skillset and deepen their ongoing collaborative efforts.⁶            

Endnotes

1. https://craft.wealthcounsel.com/images/downloads/Estate-Planning-Awareness-Survey-2016.pdf?_ga=1.203089937.1805206389.1478107764.

2. www.usatoday.com/story/money/personalfinance/2015/07/11/estate-plan-will/71270548/.

3. Reuven S. Avi-Yonah, Lily L. Batchelder, J. Clifton Fleming, David Gamage, Ari D. Glogower, Daniel Jacob Hemel, David Kamin, Mitchell Kane, Rebecca M. Kysar, David S. Miller, Darien Shanske, Daniel Shaviro and Manoj Viswanathan, “The Games They Will Play: Tax Games, Roadblocks, and Glitches Under the 2017 Tax Legislation,” 103 Minn. L. Rev. __ (2018), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3089423. 

4. Letter dated Jan. 29, 2018 from Annette Nellen, chair, American Institute of Certified Public Accountants Tax Executive Committee to The Honorable David J. Kautter, assistant secretary for Tax Policy and William Paul, principal deputy chief counsel and deputy chief counsel.

5. Joanne M. Wandry, Donor v. Commissioner, T.C. Memo. 2012-88.

6. Experienced practitioners looking to up their collaborative resources and processes may do well to consider obtaining the Accredited Estate Planner designation through the National Association of Estate Planners & Councils. 

The Tax Cuts and Jobs Act (the Act) has radically changed income and estate taxation for many Americans, calling for new approaches to various aspects of planning for U.S. individuals. Although changes also were made to corporations that aren’t so-called “pass-through” entities, such as S corporations, ultimately all changes made to taxpayers affect individuals. 

Some of the most important changes directly affecting individuals are the doubling of the estate, gift and generation-skipping transfer (GST) tax exemptions to approximately $11 million per individual (and $22 million for a married couple); the increase in the standard deduction to $24,000 for married couples filing jointly and $12,000 for other individual taxpayers (but not estates and trusts); and the disallowance or limitations of many itemized deductions (other than for charitable contributions),¹ one of the most significant of which is the $10,000 per year deduction limit (for married couples, other individuals and estates and trusts) for non-business state and local income, sales and real estate taxes. Although the increase in exemption, the increase in the standard deduction and the disallowance or limitation of most itemized deductions all sunset after 2025, the changes suggest taxpayers reconsider income tax planning over the next eight years.

Here’s how so-called “incomplete non-grantor trusts” (ING trusts), which aren’t grantor trusts for income tax purposes and transfers to which aren’t completed gifts for gift tax purposes, may be used to offset some of the adverse effects of the Act. In this article, we’ll focus on grantor trust issues, while Part II will focus on gift tax and other issues. 

Avoiding State and Local Income Tax

The tax burden for many individual taxpayers who owe state or state and local income taxes will increase because they’ll get no or a reduced benefit from the deduction under Internal Revenue Code Section 164. A taxpayer will get no tax benefit if she (or a married couple filing jointly) uses the standard deduction. The taxpayer essentially will get no tax benefit to the extent she (or a married couple filing jointly) pays other taxes (such as real estate taxes), which are deductible subject to the $10,000 deduction limit. If an ING trust owned a portion of the settlor’s home and paid that proportionate share of property taxes, it could qualify for up to a $10,000 property tax deduction as the ING trust would have its own $10,000 state and local tax (SALT) limitation.² 

Note that the proposed regulations under IRC Section 199A (199A proposed regs) include restrictions on the use of multiple trusts and that they expressly state that the restrictions aren’t limited to Section 199A only.³ This may imply an intent of the Internal Revenue Service to attack the use of multiple non-grantor trusts in this regard. 

Hence, avoiding SALT, which has always been important for many taxpayers, likely has become even more important to them after the Act. To avoid SALT, many taxpayers move to states where there are reduced or no such income taxes (for example, Alaska, Florida, Nevada, South Dakota, Texas, Washington (state), Wyoming and, essentially, New Hampshire and Tennessee). Others change the type of income they receive, such as acquiring municipal bonds, the return on which is exempt from SALT.

Some have shifted income-producing assets to family members who are in lower or no effective state income tax brackets. But, shifting assets means they’re legally lost to the former owner, and if the transfer is by gift (as it almost always is to be effective), then the former owner could face gift tax or the use of the lifetime gift tax exemption.

Other ING Benefits

The traditional application of the ING arrangement involved the transfer of appreciated property or property that was anticipated to produce taxable income or to appreciate significantly following the transfer, to the non-grantor trust. An example was an interest in a family business that, if properly packaged and marketed post transfer, could increase dramatically in value and then be disposed of in a taxable transaction, such as a sale. The goal was to remove that gain from the settlor’s home state high income tax. While this planning benefit may remain and even be enhanced post-Act, the uses of ING trusts may have expanded considerably.

In the wake of the Act, other tax-advantaged uses of an ING trust might include:

• Maximizing IRC Section 199A deductions for qualified business income. This might be achieved if the settlor has taxable income above the Section 199A threshold amount ($157,500 for a single taxpayer; $315,000 for a married couple filing jointly). By transferring a portion of the equity to the ING, the non-grantor trust will have its own taxable income threshold with no phase-out or required use of W-2 income or depreciable property to determine the deduction amount. Thus, business interests could be transferred among several non-grantor trusts to maximize overall benefits. This benefit, however, will have to pass the multiple trust rules to succeed. The 199A proposed regs include IRC Section 643(f) proposed regs, which restrict the use of multiple trusts in this regard. However, it appears that the 199A proposed regs don’t challenge this use of non-grantor trusts for this purpose if there’s but one trust. Also, the provisions of the 199A proposed regs appear to exceed the scope of the statute and may not be held to be valid.⁴ 

• Removing passive non-source income from the reach of the grantor’s home state taxation—for example, transferring to the trust low basis assets that are sold at a later date.

• Providing a vehicle to make charitable contribution deductions that won’t be reduced or lost because of the use of the new high standard deduction.⁵ 

• Enhancing planning to minimize the net investment income tax by holding business interests in which the taxpayer isn’t a material participant in a trust in which the trustee is a material participant.⁶

• In a matrimonial proceeding, exclusion of income from personal income tax returns that would otherwise be included. 

Avoiding State Income Taxes 

As indicated, an individual may be able to reduce state and local income taxes by transferring income-producing assets to family members. However, that likely won’t reduce taxes if the transfer is to her spouse or perhaps to a minor child.⁷ Hence, some taxpayers transfer income-producing assets to trusts that aren’t grantor trusts (the income, deductions and credits of which are attributed for income tax purposes to their grantors under IRC Section 671). 

For example, an income tax resident of New York City and New York State, which impose, respectively, income taxes of 3.876 percent and 8.82 percent, may transfer property during her lifetime to a trust that’s not a grantor trust so that the income avoids SALT, except to the extent a distribution of distributable net income defined in IRC Section 643(a) is made to a taxpayer who’s otherwise subject to such taxes.⁸ The basis on which a state may seek to impose its income tax on income of a non-grantor trust varies significantly from jurisdiction to jurisdiction.⁹ There seem to be, however, constitutional limitations on the ability of a state to impose its income tax merely on the ground that the trust was created by an income tax resident of the state or that a beneficiary lived in the state. The latter position was contained in a North Carolina statute ruled unconstitutional in Kimberley Rice Kaestner 1992 Family Trust v. North Carolina Department of Revenue and in a Minnesota statute ruled unconstitutional in Fielding v. Commissioner.¹⁰

Although creating a non-grantor trust can avoid SALT, there are at least two reasons why that hasn’t been done widely: 

• First, it’s believed that neither the individual taxpayer who creates the trust nor her spouse may be a trust beneficiary, as if either is a trust beneficiary, the trust will be a grantor trust. The income will be attributed back to the individual taxpayer and, therefore, be subject to the state and local income taxes under the laws of most states, which would be imposed on the taxpayer if she’d directly earned the income. That’s because almost all state and local jurisdictions impose their income taxes based essentially, but subject to exceptions and special rules, on the taxpayer’s federal income—income attributed to the grantor under the grantor trust rules. Therefore, that income would continue to be taxed to the same state as would all other income reportable by the grantor.¹¹ Although excluding the grantor and the grantor’s spouse as beneficiaries means a non-grantor trust may readily be created, many taxpayers don’t want to lose access to the property transferred to a trust as well as the income the property thereafter produces. Access is more important than ever following the Act, as taxpayers endeavor to take advantage of the high temporary exemptions until the doubling of the transfer tax exemption sunsets in 2026, and they’ll likely insist on access to assets transferred to use exemptions or not consummate transfers. This latter planning step will require modification of the traditional ING plan as discussed below. 

• The second limitation is that it’s generally perceived that any transfer of property to a non-grantor trust will be a completed gift for federal gift tax purposes resulting in the use of the taxpayer’s lifetime gift tax exemption¹² and, to the extent the gift exceeds the available exemption, resulting in the payment of gift tax.¹³ Many taxpayers wish to preserve their exemptions, especially if they anticipate receiving all or a portion of the gifted property back—making a gift of property and using an exemption and/or paying gift tax seems wasteful if the property is returned to the donor. Moreover, as a general rule, taxpayers wish to avoid paying gift tax even if it reduces overall wealth (that is, gift, estate and GST taxes).

Therefore, for many individuals, a more ideal result is to create a non-grantor trust so they can avoid paying SALT without making any taxable gift, while remaining eligible to receive the income of the trust. Of course, that wouldn’t advance the estate tax planning goal but is preferred by some ultra-high-net-worth taxpayers. And, that’s been accomplished with the use of the traditional incomplete gift ING trust. However, in light of the current temporary exemptions, some taxpayers may be better served with a completed gift version.

ING Trusts

Beginning in the early 2000s, the Internal Revenue Service began issuing private letter rulings holding that the transfer of assets to a specifically designed trust wouldn’t be a completed gift and the trust wouldn’t be a grantor trust even though all the property could be returned to the grantor.¹⁴ Although under IRC Section 6110(k)(3), these PLRs couldn’t be cited or used as precedent, there were so many and they were so consistent that many practitioners created such arrangements for clients without PLRs. They called these trusts “Delaware incomplete non-grantor” (DING) trusts, although most of the PLRs were issued with respect to trusts governed by Alaska law. They’re now generically known as “ING trusts,” although sometimes called “NING trusts” if created under Nevada law, or “AKING trusts” if created under Alaska law, and so forth.

The structure of the trusts that were the subject of these PLRs was essentially the same. The trusts were irrevocable, and the trustee had authority to make distributions to any beneficiary during the grantor’s lifetime only at the direction of a group of individuals, who were beneficiaries in addition to the grantor, called the “distribution committee” (Committee),¹⁵ either by their unanimous direction or by the direction of the grantor and a member of the Committee. The grantor also retained a testamentary special (non-general) power of appointment (POA) and, in default of its effectual exercise, the trust remainder would pass to the grantor’s descendants or, if not, to alternate remainder beneficiaries (for example, charitable organizations). Under this structure, the IRS consistently held that the transfer to the trust wasn’t a completed gift, and the trust wasn’t a grantor trust. For moderate wealth taxpayers, this provision may warrant re-examination post-Act.

Eventually, taxpayers began asking for a third ruling: that the individual beneficiaries who were members of the Committee and who held the power, in a non-fiduciary capacity, to require the trustee to make distributions, wouldn’t be treated as making a gift for federal gift tax purposes by directing the trustee to make distributions to a beneficiary (for example, the grantor) other than themselves because the members of the Committee didn’t hold general POAs described in Section 2514.¹⁶ 

Release 2007-127

On July 9, 2007, the IRS issued Release 2007-127 (the Release) in which the Chief Counsel of the IRS requested comments on whether the PLRs holding that no member of the Committees held general POAs were consistent with Revenue Ruling 76-503 and Rev. Rul. 77-158. Many professional organizations submitted comments, with the greatest number concluding that no member of a Committee held a general POA.¹⁷

However, some practitioners viewed the Release as having signaled IRS displeasure with INGs, which was then reversed in later PLRs. The approval, disapproval and again approval of INGs by the IRS, coupled with the fact that a revenue ruling on INGs has never been issued, has some practitioners concerned about the viability of the ING technique. However, other practitioners feel that the unofficial implication of the many PLRs approving INGs both before and after the Release suggests that the ING technique is quite secure. Many practitioners also view the import of the Release and subsequent pronouncements as suggesting that the Release shouldn’t be viewed negatively. To date, the IRS hasn’t issued any guidance on its position with respect to the issue raised in the Release. But, beginning in 2012, the IRS began again issuing PLRs addressing all three issues involving a somewhat different trust structure, which appears to obviate the issue addressed in the Release.¹⁸ 

Grantor Trust Issues

A trust, as indicated earlier, may be a grantor trust, causing the trust income to be attributed and therefore taxed to the grantor, for one of several reasons including if it’s a foreign trust with a U.S. beneficiary as described in IRC Section 679,¹⁹ when certain administrative powers described in IRC Section 675 are present or when certain borrowing of trust property has occurred within the meaning of Section 675(3). As a general rule, careful drafting of the trust document and administration of the trust may avoid these grantor trust rules. 

However, other circumstances in which grantor trust status is sought to be avoided may be more difficult to find, such as when the grantor or the grantor’s spouse holds certain powers over or has interests in the trust. For example, if the grantor (or the grantor’s spouse) holds a reversionary interest in the trust described in IRC Section 673, it will be a grantor trust. Similarly, if the grantor (or the grantor’s spouse) holds certain powers to control the beneficial enjoyment of trust property as described in IRC Section 674, it will be a grantor trust. Moreover, if income or corpus must or may be distributed to or for the grantor (or the grantor’s spouse) as described in IRC Section 676 or IRC Section 677, it will be a grantor trust. Hence, for the trust not to be a grantor trust (one of the results sought in the PLRs), these provisions must be avoided.

IRC Section 672. It’s appropriate to note that many of the powers or interests that would make a trust a grantor trust don’t apply if these powers or interests are exercisable or enjoyable only with the consent of an adverse party. Section 672(a) uses a three-part test to define “adverse party” as any person having a: (1) substantial, (2) beneficial interest in the trust that would be, (3) adversely affected by the exercise or non-exercise of the power that he possesses respecting the trust. While the IRC is written in the singular, most of the post-2012 PLRs have the Committee functioning not in the singular but by majority rule when the settlor is acting or by unanimous consent when the settlor isn’t acting. When use of a single person as the adverse party was included in a recent PLR request, the IRS wanted to decline to rule. While they agreed as a matter of law, they were concerned that trusts are being prepared in the singular when so many so-called adverse parties have a minimal interest. This is a drafting point as well as a cautionary point. The compromise to the submitted ruling request was to remove the descriptive paragraph from the ruling request but leave the use of a singular person as the adverse party in the trust itself.

The Treasury regulations interpret the three-part test in Section 672(a) as follows:

(1) Whether an interest is substantial and whether it’s adverse are, in general, questions of fact²⁰ determined by the value of property subject to the power, which must be significant in relation to the total value of the property. Note that an independent trustee isn’t adverse merely because it has fiduciary duties to other beneficiaries.²¹

(2) The test as to whether the purported adverse party has a beneficial interest can be met even if the person to be adverse is merely a discretionary beneficiary in the trust income and principal. Although a contingent remainderman might qualify,²² there’s risk in assuming that such a remainderman makes it all work. 

(3) The requirement that the person be adversely affected requires that the exercise or non-exercise of the power could reduce the income or principal to be received by the person to be viewed as adverse. The implications of this effect aren’t always simple or obvious. Will the power affect the particular person’s interest in the trust or just another beneficiary’s interest?

The IRS apparently has concluded that, because the members of the Committee have absolute discretion to direct distributions from income and principal among themselves, the members of the Committee, at least in the aggregate, have a substantial interest in both the income and principal of the trust that would be adversely affected by any decision to accumulate income in the trust rather than distribute the income currently among the members.²³ Practitioners also might contemplate a plethora of members, some with minute interests. Because the question of whether an interest is substantial and adverse is one of fact, it isn’t possible to conclude with complete certainty that the interest of any one member is necessarily adverse and, therefore, the concern of the IRS doesn’t seem to be unreasonable. In any case, this determination by the IRS is critical to the conclusion that the trusts involved in the PLRs weren’t grantor trusts.

Section 673. A trust is a grantor trust if the grantor (or the grantor’s spouse) has a reversionary interest in the corpus or income of the trust that, at the trust’s inception, has a value of more than 5 percent of the value of the corpus or income.²⁴ It doesn’t seem that the grantor (or the grantor’s spouse) has any reversionary interest in the type of trust that’s been the subject of the PLRs. The trust agreement never provides for distributions by its trustee to the grantor; the grantor’s testamentary POA can’t be exercised in favor of the grantor, the grantor’s estate or creditors or the creditors of the grantor’s estate; and, to the extent the POA isn’t effectually exercised, the trust property passes to other default takers that don’t include the grantor or the grantor’s estate. (Of course, the grantor could exercise the retained testamentary POA to direct for the trust assets to pass to the members of the Committee, his spouse or anyone else other than the grantor’s creditors.)

Perhaps, more critical, a reversion under Section 673 apparently can arise only in situations involving a traditional reversion under property law. Under the traditional definition, a reversion arises when a person having a vested estate transfers a lesser vested estate to another. There seems to be no authority holding or commentary suggesting that a trustee’s discretionary power to distribute principal or income to the transferor, with the consent of an adverse party, constitutes a reversionary interest under Section 673. 

The IRS has acknowledged that “a reversionary interest is the interest a transferor has when less than his entire interest in property is transferred to a trust and which will become possessory at some future date.”²⁵

Similarly, in General Counsel Memorandum 36,410,when comparing a possibility of reverter under Section 676(a) with a reversion, the IRS defined a reversion as “the residue left in the grantor on determination of a particular estate” and stated that “the reversionary interest arises only when the transferor transfers an estate of lesser quantum than he owns.” Although the IRC provides that the grantor’s reversionary interest is determined assuming the maximum exercise of discretion in favor of the grantor, the trusts that are the subject of the ruling provide for alternative remainder beneficiaries so no portion of the trust may ever revert to the grantor or the grantor’s estate.²⁶ As stated in a PLR, when the number of members constituting the Committee became too small, the corpus reverted to the grantor.²⁷ This PLR was revoked by a later PLR²⁸ that held that the reversion makes the trust a grantor trust under Section 673.

Hence, the IRS seems correct in concluding in the PLR that Section 673 doesn’t apply to cause these trusts to be grantor trusts.

Section 674. Section 674(a) provides that a trust will be a grantor trust if the beneficial enjoyment of its corpus or the income is subject to a power of disposition, exercisable by the grantor or a non-adverse party, or both, without the approval or consent of any adverse party. The real scope of Section 674 is determined by the many exceptions it contains. Some powers of disposition may be held by anyone (including the grantor or the grantor’s spouse) without causing the trust to be a grantor trust. Others may be held only by persons other than the grantor (or the grantor’s spouse), and certain others may be held by persons who are neither related nor subordinate to the grantor if they’re subservient to the wishes of the grantor without causing the trust to be a grantor trust. Parties who are related include a spouse, issue, sibling, parent or employee.²⁹ 

As mentioned, the only powers retained by the grantor in the trust are: 

• A power to appoint principal exercisable by will;

• A power to appoint income (accumulated with the consent of the Committee, the members of which are adverse parties) exercisable by will; and

• A non-fiduciary power to distribute principal limited by a reasonably definite standard.

Power to appoint corpus and accumulated income by will. Under Section 674(b)(3), a trust isn’t a grantor trust merely because someone (including the grantor) holds a power exercisable only by will, other than a power in the grantor to appoint by will the income of the trust in which the income is accumulated for such disposition by the grantor, or may be so accumulated in the discretion of the grantor or a non-adverse party, or both, without the approval or consent of any adverse party. Under the trusts involved in the PLRs, the grantor has a testamentary POA not just over the original corpus of the trust but also over accumulated income. 

However, as mentioned above, accumulation of income may occur under the trust only with the consent of the Committee (as the grantor may direct the distribution of trust property only with the consent of the Committee, which Committee the IRS concluded is an adverse party). Hence, accumulation of income may occur only with the consent of an adverse party. Therefore, the Section 674(b)(3) exception to the general rule of Section 674(a) applies and, as a result, the testamentary power doesn’t trigger grantor trust status.

Power to distribute principal pursuant to a standard. Under Section 674(b)(5), a trust isn’t a grantor trust merely because someone (including the grantor) holds a power to distribute corpus to or for a beneficiary or beneficiaries or to or for a class of beneficiaries (whether or not income beneficiaries) provided that the power is limited by a reasonably definite standard that’s set forth in the trust instrument.³⁰ Such a standard is broader than the familiar ascertainable standard relating to health, education, maintenance and support (HEMS) commonly used to avoid the powerholder from being treated as holding a general POA under Section 2514 and IRC Section 2041 for gift and estate tax purposes.³¹ In any case, a HEMS standard falls within the reasonably definite standard under Section 674(b)(3).³² Hence, the retention of the power by the grantor to appoint the principal of the trust among the beneficiaries (other than the grantor) pursuant to a HEMS standard doesn’t cause a trust to be a grantor trust. 

Some powers trigger grantor trust status only if held in a non-fiduciary capacity.³³ Although it seems that the exception contained in Section 674(b)(5) applies whether the power to distribute is held in a fiduciary or non-fiduciary capacity, the reason the Section 674(b)(5) power in the post-Release PLRs is held in a non-fiduciary capacity relates to the incomplete gift aspect of the rulings.

Section 675. A swap power (a power to reacquire the trust corpus by substituting other property of an equivalent value), the power to borrow without adequate security and other powers or activity described in Section 675 also must be avoided to achieve non-grantor trust status.

Sections 676 and 677. Section 676 provides for a trust to be a grantor trust when it provides for the possible return to the grantor of the corpus of a trust but only if not requiring the consent of an adverse party. (Exercise caution as to what powers are given to a trust protector, or other powerholder, under the trust instrument or applicable law that could result in a return of corpus to the grantor.) Section 677 triggers grantor trust status in a situation in which the income of a trust may be distributed to or used for the benefit of the grantor or accumulated for the grantor (or the grantor’s spouse) but only if not requiring “the approval or consent of any adverse party.” 

Although under the terms of the trusts that are the subject of the earlier PLRs, all of the income and corpus may be returned to the grantor but only with the consent of at least one member of the Committee, the later PLRs require the consent of a majority of the members of the Committee with that of the grantor or the unanimous consent of the Committee without that of the grantor. Hence, the grantor’s power to direct the distribution of income and principal to himself doesn’t cause either Section 676 or 677 to apply because that may occur only with the consent of one or more adverse parties. 

Importance of state law. As indicated earlier, it seems all of the pre-Release PLRs deal with trusts formed³⁴ under the laws of Alaska or Delaware. Since then, several PLRs have been issued with respect to trusts formed under the laws of Alaska, Nevada and South Dakota. Although not discussed in the PLRs, the laws of those states were used because, even though the assets in the trust could be distributed to the grantor, the governing law didn’t permit creditors to attach the trust assets.³⁵ If the grantor’s creditors could attach trust property in satisfaction of the grantor’s debts, the trust would be characterized for income tax purposes as a grantor trust.³⁶ The remedy for a creditor in non-domestic asset protection trust (DAPT) states can be illustrated using the California statute as an example.³⁷ The trust may be held valid, but pursuant to the statute, the court can require the trustee to distribute to the creditor an amount equal to the maximum that the trustee could distribute to or for the benefit of the settlor. Thus, an argument can be made that the trust isn’t self-settled or violative of California (or New York or New Jersey) laws or public policy because under the ING, the trustee can’t make distributions to or for the benefit of the settlor (without the consent of an adverse party). The initial post-Release PLR dealt with a trust  formed under the laws of Nevada. The laws in each of Alaska, Nevada, South Dakota and Wyoming, as well as several other states, permit individuals to create trusts that aren’t subject to the claims of the creditors of the grantor, even if the grantor holds both a lifetime and a testamentary special POA.³⁸

Alaska, Delaware, Nevada and other states permit the grantor to hold both a lifetime and testamentary special POA without creditor attachment exposure, which seems critical to obtaining a favorable ruling.³⁹ However, as we’ll discuss in Part II, INGs to be formed for moderate wealth clients when the current gift tax exemption is so high may be structured as completed gifts, which would require the exclusion of the limited testamentary POA, which would cause estate tax inclusion under Sections 2036(a)(2) and 2038.

The need for creditors not to be able to reach ING assets for grantor trust status to be avoided has continued to evolve since the initial ING rulings were issued. From a positive perspective, about 17 states now permit self-settled trusts (assuming that an ING is even so characterized). However, there also have been a number of developments that some practitioners argue are adverse to self-settled trusts and may negate the efficacy of self-settled trusts.⁴⁰ Some commentators view the negative interpretations some have cast over self-settled trusts as overstated.⁴¹ There’s been no indication in any of the prior or recent ING rulings that a trust created by a taxpayer residing in a state that doesn’t permit asset protection for self-settled trusts but created in a state that does, wouldn’t be respected and treated as an effective ING. Nonetheless, cautious practitioners might wish to alert such clients to the possibility of these risks affecting the grantor trust income tax status and that the protection afforded by the ING plan could be jeopardized if the taxpayer resides in a state without self-settled trust legislation and if the ING is characterized as a self-settled trust. Some commentators believe that the aforementioned risk is overstated. The rationale for this latter position flows from the earlier comments that an ING trust should be disrespected in a non-DAPT state because it’s not violative of any public policy of such a state. The remedy for self-settled trusts shouldn’t necessarily be applicable to an ING trust.   

—A portion of this article is derived from Jonathan G. Blattmachr & William D. Lipkind, “Fundamentals of DING Type Trusts: No Gift Not a Grantor Trust,” 26 Probate Property Report 1 (April 2014).

Endnotes

1. In fact, the charitable deduction limitation for an individual was increased from 50 percent of the taxpayer’s contribution base (basically, adjusted gross income (AGI)) to 60 percent but only for cash gifts to so-called “public charities.” See Internal Revenue Code Section 170(b)(1)(G). This change is a permanent one. See Section 11023(b) of the Tax Cuts and Jobs Act (the Act). 

2. For a more complete discussion, see Jonathan G. Blattmachr, Martin M. Shenkman and Mitchell M. Gans, “Use Trusts to Bypass Limit on State and Local Tax Deduction,” 45 Estate Planning 3 (April 2018).

3. Proposed Treasury Regulations Section 1.643(f)-1.

4. Cf. Stephenson Trust, 81 T.C. 283 (1984).

5. See generally Jonathan G. Blattmachr, F. Ladson Boyle and Richard L. Fox, “Planning for Charitable Contributions by Estates and Trusts,” 43 Estate Planning 3 (November 2016). The Act increases the charitable deduction limitation for individuals for cash gifts to public charities to 60 percent of the taxpayer’s AGI (as specially computed). Nonetheless, there’s no limitation on the charitable deduction for non-grantor trusts (except with respect to related business income). See IRC Section 642(c).

6. IRC Section 1411; Mattie K. Carter Trust v. United States, 256 F. Supp. 536 (N.D. Texas 2003).

7. See IRC Section 1(g).

8. Like many states, New York defines a “resident trust” as one created by a New Yorker and imposes its income tax on such resident trusts. See New York Tax Law Section 605. However, no tax is imposed if the trust has no New York trustee and no New York source income.

9. Under California law, for example, the state income tax is imposed if there’s a California trustee or a California non-contingent beneficiary. See CA Rev. & Tax Code Section 17742. The tax residence of the grantor of the trust isn’t a factor in determining whether California will seek to impose its income tax. New York has passed legislation that effectively ignores incomplete non-grantor (ING) trusts by providing that if the gift to a trust that isn’t a grantor trust is incomplete, the trust will nonetheless be treated as a grantor trust for New York income tax purposes. New York Tax Law Section 612(b)(41). New York source income includes C corporations and other entities in which more than
50 percent of the fair market value of the assets is New York realty.

10. See, e.g., Kimberley Rice Kaestner1992 Family Trust v. North Carolina Department of Revenue, No. 307PA15-2 (June 8, 2018); Fielding v. Commissioner, A17-1777 (Sup. Ct. July 28, 2018); Neil Trusts v. Commonwealth of Pennsylvania, 2013 Pa. Comm. LEXIS 168 (PA Commonwealth, May 24, 2013); Linn v. Department of Revenue, 2013 IL. App (4th) 121055 (Ill. App Ct. 4th Dist. 2013); cf., however, Chase Manhattan Bank v. Gavin, 249 Conn. 172 (1999).

11. See, e.g., IRC Section 677.

12. See IRC Section 2505(b).

13. “The [Internal Revenue] Code states that if a donor ‘transfers property by gift,’ such donor will be liable for a gift tax. However, not all transfers of property are considered ‘gifts’ or, more appropriately, ‘completed gifts.’ This is important because only completed gifts are taxable gifts.” Harry S. Margolis (ed.), The Elder Law Portfolio Series (Aspen Publishers 2007), Section 4-4. Of course, a taxpayer could make a gift of property to charity and avoid gift tax under the gift tax charitable deduction of IRC Section 2522, but that’s usually not a reason to make a transfer to charity. A taxpayer also could transfer property to his spouse and avoid gift tax under the gift tax marital deduction of IRC Section 2523 if the spouse is a U.S. citizen but the income generated on the gifted property will be taxed to the spouse. If the transfer is to a marital deduction trust, at least the so-called “ordinary income” tax portion of the trust’s income will be taxed back to the grantor under IRC Section 677, although the “principal income” portion (for example, capital gains) might not be if that portion of the income isn’t available for distribution to the taxpayer or the spouse. Thus, the income portion could be a grantor trust portion and the principal portion a non-grantor portion.

14. See, e.g., Private Letter Rulings 20024713 (Aug. 14, 2002), 200502014 (Sept. 17, 2004), 200612002 (Nov. 23, 2005), 200647001 (Aug. 7, 2006), 200715005 (Jan. 3, 2007) and 200731019 (May 1, 2007).

15. In some of the trusts, this committee was called the “Power of Appointment Committee.” See, e.g., PLR 200612002 (Nov. 23, 2005).

16. See, e.g., PLR 200502014 (Sept. 17, 2004).

17. See, e.g., letter dated Sept. 26, 2007, submitted on behalf of the American Bar Association Section of Real Property, Trust & Estate Law, www.americanbar.org/content/dam/aba/publications/rpte_ereport/2007/october/comments_on_private_letter_rulings.authcheckdam.pdf and letter dated Oct. 3, 2007, submitted on behalf of the Association of the Bar of the City of New York Estate and Gift Tax Committee, www.nycbar.org/pdf/report/IR-2007-127.pdf.

18. The first was PLR 201310002 (Nov. 7. 2012). See also PLRs 201310003 (Nov. 7, 2012) through 201310006 (Nov. 7, 2012) and PLRs 201410001 (Oct. 21, 2013) through 2014100010 (Oct. 21, 2013). 

19. In each trust that’s the subject of one of the PLRs, provisions essentially prohibit the trust from being a foreign trust and, to avoid Section 677(a)(3), prohibit using income of the trust to pay premiums on a policy insuring the life of the grantor or the grantor’s spouse. Because no beneficiary may unilaterally withdraw all income or corpus from a trust, no trust could be a grantor trust with respect to a beneficiary under Section 678. See generally Jonathan G. Blattmachr, Mitchell M. Gans and Alvina H. Lo, “A Beneficiary as Trust Owner: Decoding Section 678,” 35 ACTEC Journal 35 (Fall 2009).

20. This is discussed in detail in F. Ladson Boyle and Jonathan G. Blattmachr, Blattmachr on Income Taxation of Estates and Trusts (PLI 2014), at 4:2.4[A]. 

21. Treas. Regs. Section 1.672(a)-1(a).

22. Treas. Regs. Section 1.672(a)-1(a) and (d).

23. Although the current beneficiaries in each of the post-Release PLRs were also the default remainder beneficiaries of the trust, the grantor could appoint the remainder to others pursuant to his testamentary power of appointment.

24. Treas. Regs. Section 1.671-3(b)(3).

25. Technical Advice Memorandum (TAM) 8127004. As with a PLR, under IRC Section 6110(k)(3), a national office TAM may not be cited or used as precedent.

26. IRC Section 673(c).

27. PLR 201426014 (Feb. 24, 2014).

28. PLR 201642019 (June 20, 2016).

29. IRC Section 672(c).

30. Note that a power doesn’t fall within the powers described in IRC Section 674(b)(5) if any person has a power to add to the beneficiary or beneficiaries or to a class of beneficiaries designated to receive the income or corpus, except when such action is to provide for after-born or after-adopted children.

31. See IRC Sections 2514(c)(1) and 2041(b)(1)(A).

32. Treas. Regs. Section 1.674(b)-1(b)(5)(i).

33. See, e.g., IRC Section 675(4)(C). Also see Treas. Regs. Section 25.2511-2(c), second sentence, as a cautionary matter.

34. These trusts are commonly referred to as “AKINGs” or “DINGs,” respectively. 

35. See, e.g., AS 34.40.110. Also see PLR 200944002 (July 15, 2009), discussed in detail in Gideon Rothschild, Douglas J. Blattmachr, Mitchell M. Gans and Jonathan G. Blattmachr, “IRS Rules that Self-Settled Alaska Trust Will Not Be In Grantor’s Estate,” 37 Est. Plan. 3 (January 2010).

36. See Revenue Ruling 54-516. It’s at least arguable that an ING-type trust isn’t subject to claims of creditors. Although the law in most states essentially provides that a trust a person creates or settles for himself (a so-called “self-settled trust”) is permanently subject to the claims of the settlor’s creditors (see, e.g., NY EPTL 7-3.1 and Restatement (Third) of the Law of Trusts Section 60), it seems somewhat uncertain what constitutes a self-settled trust. For example, under New York EPTL 7-3.1, a self-settled trust is void with respect to creditors of the settlor. In Herzog v. Commissioner, 116 F.2d 591 (2d Cir. 1941) decided by what some view as America’s greatest three-judge panel (Judge Learned Hand, Judge Augustus Hand and Judge Harrie B. Chase), the court held that the trust wasn’t subject to the claims of creditors of the settlor because the trustee could distribute income and corpus to persons other than the settlor. Subsequent New York state case law suggests that Herzog was incorrectly decided. See, e.g., Vanderbilt Credit Corp. v. Chase Manhattan Bank, 100 A.D.2d 544 (1984). Perhaps, even more important is that with an ING trust, the trustee isn’t authorized to make distributions to the grantor but only individuals (the members of distribution committee) who are acting in an individual and not a fiduciary capacity. 

37. Cal. Prob. Code Section 15304.

38. See, e.g., AS 34.40.110(b)(2), as amended. Some states provide this protection only in limited circumstances. For example, in Arizona and Florida, the interest of a settlor in a trust created for his benefit from a lifetime qualified terminable interest property trust (see Section 2523(f)) isn’t subject to the claims of the settlor’s creditors. Asset protection is provided for self-settled trusts other than for certain retirement plans such as an individual retirement account. See David G. Shaftel (ed.), “Eleventh Annual ACTEC Comparison of the Domestic Asset Protection Trust Statutes Updated Through August 2017,” http://shaftellaw.com/docs/article-38.pdf. It’s at least arguable that an ING-type trust may be created under the law of any state because a self-settled trust (that is, a trust the assets of which may be attached by the creditors of the settlor) includes only one from which the trustee must or may distribute assets to the settlor. As explained earlier, the trustees of the trusts that were the subject of the PLRs didn’t hold the power to distribute trust property to the grantor. The grantor couldn’t distribute trust property to himself that would make it subject to the claims of his creditors under the law of virtually all states. However, some states continue to provide protection of the trust’s assets when the grantor’s power of revocation is held only with the consent of an adverse party. See, e.g., AS 34.40.110(b)(2). Hence, the conclusion is that the trust should be formed under the law of a state that protects the trust assets from claims of the creditors of the grantor, although this technically may not be necessary even if the trust isn’t formed in an asset protection state, of which there are now 17, including Alaska, Delaware and Nevada.  

39. See AS 34.40.110(b)(2), as amended.

40. Rush Univ. Med. Center v. Sessions, 2012 IL (112906 2012); Waldron v. Huber (In re Huber), 493 BR 798 (Bankr. W.D. Wash. 2013); Battley v. Mortensen (In re Mortensen), 10 Alaska Bankr. 146 (Bankr. D. Alaska 2011). The Uniform Voidable Transfers Act at Section 4, Comment 8, makes mention that a transfer to a self-settled domestic asset protection trust (DAPT) is voidable if the transferor’s home state doesn’t have DAPT legislation. The Comment provides: “By contrast, if Debtor’s principal residence is in jurisdiction Y, which also has enacted this Act but has no legislation validating such trusts, and if Debtor establishes such a trust under the law of X and transfers assets to it, then the result would be different. Under § 10 of this Act, the voidable transfer law of Y would apply to the transfer. If Y follows the historical interpretation referred to in Comment 2, the transfer would be voidable under § 4(a)(1) as in force in Y.” Note that while there doesn’t seem to be a uniform definition of “self-settled trust,” Restatement (Second) of Trusts, Section 156(2) (1959) by providing in relevant part “[w]here a person creates for his own benefit, a trust for support or a discretionary trust, his transferee or creditors can reach the maximum amount which the trustee under the terms of the trust could pay to him or apply for his benefit” indicates that only if the trustee has the power to distribute property to the settlor will it be treated as self-settled.

41. Jonathan G. Blattmachr, Matthew Blattmachr, Martin M. Shenkman and Alan Gassman, “Toni 1 Trust v. Wacker—Reports of the Death of DAPTs for Non-DAPT Residents Is Exaggerated,” Asset Protection Planning Newsletter #362 (March 19, 2018), www.leimbergservices.com. 

In Estate of Richard E. Cahill, et al. v. Commissioner,¹ the Tax Court denied partial summary judgment to an estate that contested a deficiency notice in which the Internal Revenue Service adjusted the value of the decedent’s rights in three split-dollar life insurance arrangements from $183,700 to more than $9.61 million. The court declined to grant partial summary judgment on the estate’s arguments that Internal Revenue Code Sections 2036, 2038 and 2703 didn’t apply to the split-dollar arrangement and that Treasury Regulations Section 1.61-22 did apply in valuing the decedent’s interest in the split-dollar arrangements for estate tax purposes. 

Although this case only denies the estate partial summary judgment regarding the IRS’ arguments under Sections 2036, 2038 and 2703, it does lay out the framework that the court may very well use in ultimately determining that the cash surrender value (CSV) of the policies at the time of the decedent’s death will be includible in the decedent’s estate. While the court addressed issues under Sections 2703, 2038 and 61 in addition to 2036(a)(2), we’ll focus primarily on the latter provision as it relates to the ongoing expansion of Section 2036(a)(2) in the context of family limited partnerships (FLPs) and, now, potentially other types of arrangements. As we saw in Estate of Powell v. Comm’r,² just a year and a half ago, the Tax Court indicated that the mere ability of the decedent, in conjunction with others, to determine who’ll possess or enjoy the property or income from transferred property will trigger estate tax inclusion under Section 2036(a)(2). The court’s growing willingness to use these provisions to affect estate tax inclusion in expanded situations should serve as a cautionary reminder to estate planners to be careful about the rights retained by a transferor of property—especially with regard to rights in entities wherein some control or ongoing involvement, however minute, is retained. Cahill, however, suggests that the reach of Section 2036(a)(2) isn’t limited to family entities such as FLPs, but, can also be applicable to other types of arrangements. While the Cahill case had nothing to do with FLPs, but rather involved multigenerational split-dollar arrangements, the court’s reference to Powell highlights the potential for an even broader application of the statute, thus signifying some further erosion of the ability to structure planning in which the parent continues to hold on to different rights, even if only in connection with others.

Creation of Split-Dollar Agreements 

In 2010, when Richard Cahill was 90 years old and no longer able to manage his own affairs, his son, Patrick, entered into three split-dollar insurance agreements on his behalf. Richard (the decedent) lived in California at the time of his death in December 2011. Patrick, a Washington state resident, served as executor of the estate. 

The decedent had been the settlor of two trusts—the revocable Richard F. Cahill Survivor Trust (Survivor Trust) and the irrevocable Morris Brown Trust (MB Trust). Patrick was trustee of the Survivor Trust and was his father’s attorney-in-fact under California law. Patrick’s cousin, William Cahill, was trustee of the MB Trust, and the primary beneficiaries of that trust were Patrick and his issue. The MB Trust was formed on Sept. 9, 2010 to take legal ownership of three whole life policies, two insuring the life of Patrick’s wife and one insuring Patrick’s life. Lump sum premiums for the three policies totaled $10 million; each policy guaranteed a minimum 3 percent return of the invested portion of the premium.

Patrick, as trustee of the Survivor Trust, and William, as trustee of the MB Trust, executed three split-dollar agreements to fund the acquisition of the three life insurance policies. These agreements provided that the Survivor Trust would pay the premiums; the Survivor Trust did so by taking a $10 million loan from an unrelated third party. The obligors on this loan were the decedent (with Patrick signing for him as his attorney-in-fact) and Patrick, as trustee of the Survivor Trust. 

As a general matter, the decedent’s involvement in the three split-dollar life insurance arrangements occurred solely through the Survivor Trust, directed by Patrick. Both the estate and the IRS agreed that all assets in the Survivor Trust on the decedent’s date of death were includible in the gross estate. 

Provisions of Agreements

Each of the split-dollar agreements provided that when the insured died, the Survivor Trust would receive a portion of the death benefit equal to whichever of the following is greatest (referred to as the “decedent’s death benefit rights”): (1) the remaining balance of the loan, (2) the total premiums the Survivor Trust paid on the policy, or (3) the CSV of the policy immediately before the insured’s death. MB Trust would retain any excess of the death benefit (referred to as “MB Trust’s death benefit rights”).

Each split-dollar agreement could be terminated during the insured’s life if the trustees of the Survivor Trust and the MB Trust agreed in writing. If one of the agreements terminated, the MB Trust could opt to retain the policy or transfer its interest in the policy to the third-party lender (referred to as “termination rights”). MB Trust couldn’t sell, assign, transfer, borrow against, surrender or cancel a relevant policy without the Survivor Trust’s consent. 

Deficiency Notice

In 2010, the year before he died, the decedent reported $7,578 in gifts to MB Trust based on a determination under the economic benefit regime pursuant to Treas. Regs. Section 1.61-22. Following his death, the decedent’s estate reported the value of his rights in the split-dollar arrangements totaling $183,700. As of the date of death, the CSV of the policies exceeded $9.61 million. In its deficiency notice, the IRS adjusted the total value of the decedent’s rights in the split-dollar agreements from the reported $183,700 to the aggregate CSV, determining a deficiency of more than $6.82 million plus penalties for negligence and gross valuation misstatements. 

Estate’s Arguments

The estate argued that because: (1) the decedent’s right to terminate the split-dollar agreements was held in conjunction with the trustee of MB Trust, and (2) it would never make economic sense for MB Trust to allow the split-dollar agreements to terminate, termination was so unlikely that as of the date of the decedent’s death, the termination rights had no value. This meant, the estate asserted, that the value of the decedent’s interest in the split-dollar agreements was limited to the value of the decedent’s death benefit rights, which were only $183,700 on his date of death because the insureds (Patrick and his wife) were projected to live for many more years, and therefore, the decedent’s rights had only a small present value. 

In addition to arguing that the total value of the decedent’s rights in the split-dollar agreements exceeded $9.61 million, the IRS presented theories in the alternative under Sections 2036(a)(2), 2038(a)(1) and 2703(a)(1) and (2). The estate sought summary judgment on these issues, applying Treas. Regs. Section 1.61-22. 

Sections 2036(a)(2) and 2038(a)(1)

Section 2036 includes property in a gross estate if: (1) the decedent transferred the property during life; (2) the transfer wasn’t a bona fide sale for full and adequate consideration; and (3) the decedent kept an interest or right in the transferred property of the kind listed in Section 2036(a)(2) (that is, the right either alone or in conjunction with anyone to designate who will possess or enjoy the property or income from the property). 

Similarly, Section 2038 includes transferred property in the gross estate if: (1) the decedent made a gift during life; (2) the transfer wasn’t a bona fide sale for full and adequate consideration; and (3) the decedent retained an interest or right in the transferred property of the kind listed in Section 2038(a) (that is, a power that enables the decedent, either alone or in conjunction with another person, to alter, amend or terminate the transferees’ enjoyment of the property) that the decedent didn’t give up before death and that wasn’t relinquished in the three years prior to the date of death.

The $10 million that the decedent paid the insurance companies as lump sum premium payments for the benefit of the MB Trust was accounted for in three parts as of the date of his death—part was paid as commissions and fees; part was used while the decedent was alive to pay the cost of current life insurance protection on the insureds; and part was attributable to the CSV remaining in the policies as of the date of death. The IRS and the estate disagreed over the third part, with the estate asserting that Sections 2036(a)(2) and 2038(a)(1) didn’t apply to include the CSV in the gross estate because the decedent retained no rights with respect to the amounts transferred sufficient to justify applying these IRC sections. 

The court found, however, that “the rights to terminate and recover at least the cash surrender value were clearly rights, held in conjunction with another person (MB Trust), both to designate the persons who would possess or enjoy the transferred property under section 2036(a)(2) and to alter, amend, revoke, or terminate the transfer under section 2038(a)(1).”³ The court rejected the estate’s contention that the decedent’s right to terminate was negated by the fact that the MB Trust could prevent the decedent from terminating the split-dollar agreements, noting that this reasoning would mean that the words “in conjunction with any person” in Section 2036(a)(2) and “in conjunction with any other person” in Section 2038(a)(1) would have no meaning. The court cited to the recently issued Powell decision from May 18, 2017, which applied Section 2036(a)(2) with respect to that decedent’s limited partnership (LP) interests in an FLP, and cited to Estate of Strangi v. Comm’r,⁴ on which the Powell opinion relies heavily. The court rejected the estate’s argument that for Section 2036(a)(2) to be applicable, the decedent would need to have complete control, indicating that unilateral control isn’t required under either the statute or case law. 

Next, the court addressed whether the bona fide sale exception under both Sections 2036 and 2038 could be applicable. The court separately analyzed the two components of this exception, first addressing whether the decedent’s transfer of $10 million was “a bona fide sale” and, second, whether such transfer was for “adequate and full consideration.” As to the bona fide sale prong, the court considered whether there was a “legitimate and significant non-tax reason” for the transfer of the $10 million. The court indicated that a number of questions would need to be considered in connection with determining whether such reasons existed and consequently determined that summary judgment wouldn’t be appropriate. 

As to the adequate and full consideration prong, the court indicated that the question was whether the decedent received “roughly equal the value” of what he transferred and went on to conclude that such wasn’t the case. The court noted that, under the estate’s admitted logic, due to the MB Trust’s veto power over the termination of the split-dollar agreements, such rendered the decedent’s rights at death at essentially zero, noting that the reported value on the estate tax return was less than 2 percent of the CSV. From there, the court noted that, because the MB Trust’s veto power existed from inception, such 98 percent discount would have been present from that time, thus undercutting the estate’s argument that the decedent had received adequate and full consideration. That is, the decedent only received consideration equal to roughly 2 percent of his $10 million transfer, so by definition, such wouldn’t have been remotely close to adequate and full consideration. Therefore, the court denied summary judgment with regard to this issue as well. 

Section 2703

The IRS argued in the alternative that the MB Trust’s ability to veto termination of the split-dollar agreements should be disregarded under Section 2703(a)(1) or (2) for purposes of valuing the decedent’s rights in those agreements. The court declined to grant the estate’s summary judgment motion on these issues as well. 

The court found as lacking merit the estate’s suggestion that the IRS was attempting to ignore the split-dollar arrangement in its entirety and treat the policies themselves as assets of the decedent so as to look through the split-dollar arrangement to the underlying insurance policies. The court also acknowledged that such a look-through argument had previously been rejected by the court in Strangi, indicating that such wasn’t the intent of the statute. The court disagreed with the estate’s contention that the IRS was making this argument. Rather, the court clarified that the IRS was looking at the decedent’s interest under the split-dollar arrangement as the asset that was subject to valuation for estate tax purpose. The court clarified that the IRS’ position was that Section 2703(a) was applicable for purposes of valuing the decedent’s rights under the split-dollar agreement, rather than the underlying policies. After clarifying that both parties agreed that the decedent’s rights under the split-dollar arrangement were the interests being considered, the court then concluded that the ability of the trustee of the MB Trust to restrict the decedent’s access to the cash value of the policies by way of his termination right was a restriction that was subject to Section 2703 as “agreements to acquire or use property at a price less than fair market value.”⁵

The court concluded that under Section 2703(a)(1), the split-dollar agreements, particularly the provisions that prevented the decedent from withdrawing his investment, constituted agreements to acquire or use property at a price below fair market value. 

The court noted that, under Section 2703(a)(2), the MB Trust’s ability to prevent termination significantly restricts the decedent’s right to use the termination rights. The court found that the split-dollar agreements “clearly restrict decedent’s right to terminate the agreements and withdraw his investment from the arrangements.”⁶ Concluding that the requirements of Section 2703(a)(1) and (2) were each met, the court denied the estate’s summary judgment motion with respect to Section 2703(a). 

The court also addressed and rejected the estate’s counter arguments that the split-dollar arrangements are akin to either promissory notes or partnerships, to which, the estate argued, Section 2703(a) is inapplicable. With respect to the comparison to promissory notes, the court distinguished a promissory note, which represents a bargained-for agreement between two parties to lend and borrow money, from split-dollar arrangements, which involve no such bargain. In contrast, the MB Trust received its rights under the contract for no consideration. In distinguishing the case from Strangi, which involved an FLP, the court indicated that no partnership existed in Cahill. Lastly, the court rejected the estate’s argument that Section 2703(a) is limited in its application to buy-sell agreements, indicating that the plain meaning of the statute isn’t so limited.

Double Counting Gifts

The court also addressed the estate’s argument that the difference between the policies’ CSV of $9.61 million and the reported value of the decedent’s interest under the arrangement would already be accounted for as gifts, so that the application of Sections 2036(a)(2), 2038(a)(1) or 2703 would result in a double counting of those assets under both the gift and estate tax regimes. Rejecting the estate’s argument, the court noted that no gift tax return was filed reporting such purported gifts and that both parties agreed that the value of the current cost of life insurance protection constituted a gift under Treas. Regs. Section 1.61-22. Because the current cost of the life insurance protection had already been deducted from the policy to determine the remaining cash value, no part of the remaining cash value had been used to pay the cost of the insurance protection, and therefore, no part of the cash value remaining as of decedent’s death had already been subject to gift tax. Thus, no double counting would result.

Treas. Regs. Section 1.61-22

The estate sought summary judgment, arguing that under Treas. Regs. Section 1.61-22, the economic benefit regime applies to the split-dollar agreements. But, the court concurred with the IRS’ observation that these are gift tax rules, not directly applicable to estate tax. Nonetheless, because the gift tax is supplementary to the estate tax, the court ultimately decided to review the regulations for further consideration.

The court rejected the estate’s contention that it “should modify the approach required by Sections 2036, 2038, and 2703 so as to avoid inconsistency between these statutes and the regulations,”⁷ finding no inconsistency between the estate tax statutes and Treas. Regs. Section 1.61-22.

Furthermore, the court concluded, consistency “between the regulations and the estate tax code sections would . . . demand that the cash surrender value remaining as of decedent’s date of death be valued as part of, or included in, decedent’s gross estate. In short, the consistency the estate demands would seem to require the result respondent seeks,”⁸ making summary judgment inappropriate. 

Implications

The Tax Court’s denial of the estate’s motion for partial summary judgment with respect to its Section 2036 and Section 2703 positions isn’t particularly surprising in light of the aggressive deathbed planning that was implemented in Cahill. While it wouldn’t be an inaccurate observation to conclude that Cahill is yet another example of aggressive planning coupled with bad facts leading to a bad result, what’s potentially concerning about this case is the Tax Court’s reference to the Powell opinion with respect to Section 2036(a)(2), just one year after its issuance. It’s important to note that this was only a Tax Court Memorandum opinion in connection with a motion for partial summary judgment. However, the court’s analysis as to the ability of Section 2036(a)(2) to treat the decedent’s co-termination right of the split-dollar arrangements as tantamount to his ability as a right “alone or in conjunction with others” to access the underlying cash value does provide some further insight as to the way the court views retained rights. 

The origins of this evolution as applied to FLPs, trace back to the Strangi decision from 2003. That opinion, which involved a “bad facts” FLP, not surprisingly concluded that Section 2036(a)(1) applied when Albert Strangi contributed nearly all of his assets into an FLP and continued to have implied enjoyment of contributed assets, such as the use of the personal residence as well as distribution and use of assets for his living needs. While the Strangi court’s holding that Section 2036(a)(1) was applicable wasn’t at all surprising, what was surprising was the court’s additional and separate conclusion that the contributed assets were also included in Albert’s estate under Section 2036(a)(2) for two separate reasons: first, because Albert, who owned a 47 percent interest in the 1 percent corporate general partner (GP), retained the right, “alone or in conjunction with others” to designate who would enjoy distributions of income from the FLP (the “first application”); and, second, because Albert, in his capacity as a limited partner in the FLP, could participate with the other partners in connection with a vote to liquidate the FLP and, thereby, receive back his contributed assets (the “second application”). 

The first application of Section 2036(a)(2) was considered controversial enough and was unexpected in that it suggested that retention of even a non-controlling interest in the GP of an FLP was enough to cause contributed assets to be included in the creator’s gross estate. Indeed, for years following the Strangi decision, this holding presented, and continues to present, a dilemma to estate planners attempting to strike the balance between a parent’s often expressed desire to have some ongoing involvement (albeit without actual majority control) in the management of an FLP following gifts of partnership interests versus the risk of inclusion in the gross estate as a consequence of such ongoing involvement. This holding was followed some years later in Estate ofTurner v. Comm’r,⁹ in which it was determined that Clyde Turner’s retention of the GP interest in an FLP triggered estate tax inclusion of assets he contributed under Section 2036(a)(2). 

The second application of the Section 2036(a)(2) holding in Strangi at that time received very little attention by the estate-planning community, presumably because the practical implication of such a holding seemed so inconsistent with commercial and practical realities of structuring and operating a partnership. While the planning community was aware of this part of the Strangi decision, planners didn’t appear overly excited about this aspect, which was generally viewed as an even further stretch of the law than the first application of Section 2036(a)(2).

For several years following Strangi, the second application of Section 2036(a)(2) was an issue that was rarely given much consideration for the reasons mentioned above. In short, most planners considered it as a bit of a “nothing burger” based on what was perceived as one rogue case interpretation of the law; that, and the fact that the court didn’t need to decide the issue because it had already decided inclusion of the assets transferred to the FLP in the decedent’s estate under Section 2036(a)(1). Consistent with the industry’s view of this issue, for some 14 years, this issue went dormant, having not been raised in any cases following Strangi. As it turned out, in 2017 this perception evolved into what turned out to be a false sense of security as a consequence of the Powell decision in 2017, in which it was held that the decedent’s retention of only LP interests in an FLP (her sons owned all of the GP interests from inception) triggered the inclusion of the contributed assets into her estate under Section 2036(a)(2). It should be noted, however, that this holding wasn’t arrived at as a result of the issue being litigated by the parties but, rather, as a consequence of an admission by counsel for the estate that before Nancy Powell’s attempted transfer of her LP interests into a charitable lead trust (CLT) (by way of exercise of a power of attorney by her sons), her ownership of such LP interests constituted retained control under Section 2036(a)(2). Unfortunately for the estate and for the estate-planning community, the Tax Court concluded that the purported gift of the decedent’s 99 percent LP interest to the CLT was ineffective because the power of attorney didn’t actually authorize gifts to charities. Therefore, the court determined that by the estate’s own admission, Nancy retained control of the contributed assets under the statute. In addition, the court also noted that even had the attempted gift of the LP interests been effective, the 3-year rule under Section 2035(a) would have still resulted in Section 2036(a)(2) applying because Nancy certainly didn’t outlive the transfer by three years (she died six days following the transfer).

The Powell court did, however, provide a lengthy discussion with respect to the application of Section 2036(a)(2), in which it relied heavily on Strangi, thus giving renewed life to the second application in Strangi, which had been regarded by the estate-planning community at large as a bit of a “that can’t possibly be the right answer” issue. The Powell court, further relying heavily on the analysis of the Strangi decision, included a lengthy discussion with respect to United States v.Byrum¹⁰ and why the protections against inclusion of assets under Section 2036(a)(2) afforded by Byrum didn’t apply in the context of an FLP, with the Powell court indicating that the types of fiduciary duties involved in Byrum were distinguishable from the types of “illusory” fiduciary duties that are typically present in the context of FLPs. What’s troubling about the Powell decision is the presumption that appears to be made that fiduciary duties will necessarily be ignored in the family context. Quite to the contrary, litigation in the closely held business context often involves disputes between family members. 

In Powell, we have the situation in which an aggressive deathbed planning arrangement resulted in bad law. Certainly, the end result reached in Powell, inclusion of the contributed assets in the gross estate, wasn’t an unjust one. However, it’s the determination of the application of Section 2036(a)(2) rather than 2036(a)(1) that’s caused issues of concern to planners at large with respect to the potential impact on legitimate family transactions. Interestingly, the estate also didn’t argue that the so-called “bona fide sale exception” to the general application of Section 2036(a) was applicable.

In the wake of Powell, diverging views have emerged. On the one hand, Powell could be viewed as an isolated case involving really bad facts resulting in inclusion in the decedent’s gross estate, which is a result that feels right on the merits, and nothing further should be read into this opinion other than this being another abusive case. On the other hand, because of the holding as to Section 2036(a)(2), in which only limited partner interests were owned by the decedent, the case could be viewed as a further expansion of the application of the statute (recalling that, in Strangi, Albert had owned both GP and limited partner interests). Note, however, under the Estate of Bongard v. Comm’r¹¹ standard for determining whether Section 2036(a) is applicable, a court must first determine that the bona fide sale for full and adequate consideration in money or money’s worth exception doesn’t apply.  

The Cahill decision, while merely reflecting a motion for partial summary judgment and a Tax Court Memorandum decision, nonetheless is relevant in that it reflects a further evolution of the case law and the court’s views with respect to the application of Section 2036(a)(2) in additional circumstances, such as retention of only LP interests or, in this case, the retention of co-termination rights in split-dollar arrangements.

Where From Here?

For many “old and cold” family entities that have been created over the past decade or two, the Powell decision, which has now been cited just one year later in Cahill, will serve as a prompt for families and family offices to revisit these structures. Of course, the landscape with respect to FLPs is always changing, and there’s an ongoing evolution in the way that these structures are viewed by both the IRS and the Tax Court. Unfortunately, the practical application of this dynamic is that FLPs that may have been regarded as safe at the time they were established, and perhaps subsequent thereto, may become less certain as the law develops, through no fault of the decisions that were made when originally structuring the vehicle. 

Thus, it’s a good idea to periodically re-evaluate the structure. In light of the Tax Court’s expansion of Section 2036(a)(2), now might be an appropriate time to conduct such a “stress test.” An evaluation of an existing FLP should take into consideration an honest assessment of the relative strengths and weaknesses of the partnership as it exists and has been administered to date. It’s important to keep in mind with this evaluation that, if it can be successfully established that the bona fide sale exception to the application of Section 2036(a) was satisfied when the LP was created, then, technically, this takes Sections 2036(a)(1) and (2) “off the table,” and from a technical perspective, such should make the development in Powell and Cahill of no consequence. Of course, the practical reality with respect to this exception is that there’s no hard and fast litmus test, but, rather, it’s a facts-and-circumstances based determination; whether this exception is satisfied is only determined once the client has passed away and the merits of this argument are being evaluated in the context of an estate tax audit and possibly litigated.

If, after an evaluation of the FLP, it’s concluded that enough uncertainty exists with respect to whether the bona fide sale exception should be satisfied, and the client doesn’t wish to maintain the LP with the uncertainty of what ownership of LP interests could mean, then certain types of decontrolling actions should be considered. 

For instance, consider using the new generous $11.18 million gift tax exemption per person so as to make gifts of any remaining LP interests. If this exemption is doubled between spouses, this would largely provide enough “cover” for many families so as to rid themselves of the LP interest gift tax free. In the case of larger partnerships, such additional gift could also provide significant additional seed capital to support a sale of additional remaining LP interests in connection with a promissory note. Importantly, it’s critical to be mindful of the possibility that the 3-year rule will apply under Section 2035 to the extent that it’s determined that such LP interests while in the hands of the donor constituted retained strings under Section 2036(a). Of course, sales for full and adequate consideration could be structured in an attempt to satisfy the exception to this rule, although there’s some uncertainty as to what constitutes full and adequate consideration for these purposes.        

—The views expressed in this article are those of the authors and do not necessarily reflect the views of Ernst & Young LLP.

Endnotes

1. Estate of Cahill v. Commissioner, T.C. Memo. 2018-84 (June 18, 2018).

2. Estate of Powell v. Comm’r, 148 T.C. 18 (May 18, 2017).

3. Cahill, supra note 1, at p. 13.

4. Estate of Strangi v. Comm’r, T.C. Memo. 2003-145 (May 20, 2003), on remand from Gulig v. Comm’r, 293 F.3d 279 (5th Cir. June 17, 2002), aff’d, 417 F.3d 468 (5th Cir. July 15, 2005).

5. Cahill, supra note 1, at p. 21.

6. Ibid., at p. 22.

7. Ibid., at p. 30.

8. Ibid., at p. 33.

9. Estate of Turner v. Comm’r, T.C. Memo. 2011-209 (Aug. 30, 2011).

10. United States v. Byrum, 408 U.S. 125 (June 26, 1972).

11. The court cited to the Bongard case for this proposition. See Estate of Bongard v. Comm’r, 124 T.C. 95 (March 15, 2005).

In the first installment of this three-part article, I provided evidence that a good estate-planning result doesn’t occur in a majority of situations and introduced the Path of Most Resistance, a model that identifies and illustrates the obstacles to a good estate-planning result. In this installment, I introduce three psychological phenomena that happen in every estate-planning engagement: transference, countertransference and triangles in relationships. These three phenomena impact estate planning, either in a positive or negative way.  

Transference

Transference is fairly easy to illustrate in a few examples, but psychologists frequently disagree over its meaning. Indeed, a few major schools of psychotherapy actually deny the existence of transference. 

In psychology, the classical way to define “transference” is to simply say that it’s a phenomenon in which people transfer feelings and attitudes, often subconsciously, from a person or situation in their past onto a present person or situation. It involves the projection of a mental representation of a previous experience or person on to the present situation or person with whom they’re interacting. The recipients of the transference usually play an important role that’s necessary for the projected relationship. There are usually subconscious encouragements by the client to the recipient to take on his feelings or beliefs about the situation or person.¹

Transference occurs often in real life. For example, a boss at work reminds you of your irascible grandfather, so you’re afraid to enter into extraneous conversations with him. The person in front of you in line at the grocery store reminds you of your cousin, so you strike up a conversation, even though this person is a total stranger. Or, as one psychologist wrote, “the battle cry heard from loving couples around the world: ‘Stop treating me like I’m your mother!’”²

Transference often is witnessed in situations in which one party is in a position of confidence vis-à-vis the other, for example, psychologists, doctors and estate planners. It’s very common. The person in a position of confidence plays an important role in the transference. Transference in estate planning involves projection of feelings about some event or person from the client’s past onto the estate planner and the present situation. Transference can be a bad thing, but it doesn’t have to be if the estate planner is aware of it and uses that knowledge to guide the client.³

Let’s consider two examples of transference in estate planning:

Example 1: Birth order mismatch. Suppose your client is the youngest child in his family. In typical engagements, you usually default to naming the oldest child as successor executor and trustee if a client doesn’t express a preference. In fact, you don’t even ask and simply prepare documents appointing the oldest child as successor executor instead of another of a client’s children. In this example, the client gets irate, accusing you of acting like her father, who favored the oldest sibling.

Example 2: Professional bias. You’re meeting with a new client who’s appearing extremely anxious and checking her watch repeatedly as you talk to her. Unbeknownst to you, the client’s last experience with an estate planner went badly due to a misunderstanding about the size of the estate planner’s fees and the hourly rate. The client has transferred her anxiety, which was caused by a bad experience with a past estate planner, on to her relationship with you.

About the best that we estate planners can do is to acknowledge that the projecting client’s feelings aren’t our fault and prevent taking on the client’s invitation to engage based on the transference. However, what’s behind and giving rise to the projected feelings indeed may be critical information for us to ferret out of the client.

In Example 1, you can apologize and be more careful in the future. In Example 2, you could ask the client about her anxiety, have a frank and open discussion about both the client’s and your expectations concerning the fees and other terms of the relationship and follow up with an engagement letter that confirms what you’ve discussed.

When you look back at some rocky times with clients, chances are that an undetected transference lay at the heart of the difficulty. The transference can arise in many other different contexts in estate planning. For example, a client who had a bad experience with probate of a family member’s estate may be hell bent on not using solely a will in her estate planning, having become visibly shaken at the mere mention of the word “probate.” Digging deeper into the causes of the transference is thus critical.

Countertransference

As with transference, psychologists can and do differ about the definition of “countertransference.” Indeed, there’s at least one school of thought that denies the very existence of countertransference, opting to call it all transference, either belonging to the client or the therapist. 

Estate planners aren’t immune to the psychological process. We bring our life’s experiences and psychological baggage into every estate-planning engagement, either consciously or subconsciously, whether we want to or not. Countertransference is defined as the often subconscious response of the recipient advisor to the client’s actions or perceived actions. Countertransference responses can include both the advisor’s conscious and unconscious feelings and associated thoughts from her past regarding things that the client says or does.

Countertransference involves displacement and projection onto the client. It sometimes is, but needn’t be, harmful to the relationship, especially if the estate planner allows his personal feelings toward the client to cloud his professional judgment. On the other hand, if the estate planner is aware of his countertransference feelings and is able to deal with those feelings constructively, even being able to discuss those feelings with the client when appropriate, the countertransference can be a very helpful phenomenon in the planner-client relationship.⁴

There are all sorts of possible examples of how countertransference can arise in estate planning, but here are two examples from my practice experience:

Example 1: Flipside of birth order mismatch. Suppose that your client, who’s the youngest child in her family, expresses strong negative feelings about an oldest child automatically being designated as executor just because that child was the oldest. Suppose further that you’re an oldest child who feels strongly that oldest children should automatically be considered for such a fiduciary position. You routinely draft wills naming the oldest child as executor when a client says nothing to the contrary. When the client states that she wants a middle or youngest child to be her executor, you may view the client in a somewhat negative light, particularly because you also hold your own youngest sibling in contempt for actions that he engaged in and was allowed to get away with just because he was the “baby” of the family. You’ve allowed your decades-old disdain for your youngest
sibling to color your judgment about the client.

Example 2: Professional bias. Your new client identifies herself as an engineer. You then think to yourself, “engineers are always problem clients because they ask too many questions, reduce everything to black and white and think that they know it all” and immediately get a little defensive, condescending and short with the client about the proper estate-planning process.

In both examples, you’ve allowed something from your past or opinions cloud your judgment in the countertransference.

Countertransference also can manifest itself in biases by the estate planner either in favor of or against certain estate-planning techniques. Additionally, estate planners can be morally opposed or outraged by their clients’ behavior to the extent that it impacts the estate planner’s ability to work effectively for the client.

Triangles  

A triangle is a three-person relationship system. The late Murray Bowen, MD, a psychiatrist and professor of psychiatry and a pioneer in the area of family systems theory back in the 1950s, developed the triangle as part of an eight-concept family systems theory. The triangle isn’t universally used by psychologists and psychiatrists, given that Dr. Bowen’s theory is but one of approximately 12 major schools of family therapy. Dr. Bowen argued that the triangle is considered the base building block of larger human emotional systems because he asserted that a three-person triangle is the smallest stable human relationship system. According to Dr. Bowen, a two-person system is unstable because it tolerates little tension before one or both participants “triangle in” a third person to reduce their anxiety that the tension between the participants caused.⁵

Dr. Bowen reasoned that a triangle can withstand much more tension than a two-person relationship because the tension can be shifted among three relationships (A-B, A-C and B-C) instead of just one, and the parties subtly shift back and forth among each other during the course of their relationship triangle. In fact, Dr. Bowen further reasoned that when the triangle anxiety becomes unbearable to one or more of the participants, a series of interlocking triangles can develop.

Learning about relationship triangles assisted me in explaining previously puzzling practice situations. As Dr. Bowen has written, “[t]he triangle describes the what, how, when, and where of relationships, not the why.”⁶ I often witnessed triangles in families in my estate-planning practice. I even unwittingly participated in some of these triangles as an estate planner. Triangles can involve not just living persons but also someone who’s deceased. Triangles also can involve inanimate objects, for example, occupants of a certain bedroom in an antebellum home. Triangles can exist among the client and two estate planners whose ideas are at odds with one another. At least one writer has called for a family systems approach to estate planning.⁷ Let’s consider a couple of examples of triangles in the estate-planning process:

Example 1: The tie-breaker. You’re meeting with a husband and wife about their estate planning, when they start to squabble over which of their children should be the successor executor. Frustrated, the wife turns to you, attempting to “triangle” you into the conversation on her side of the argument by commenting with a loaded question like, “What’s your opinion?” or “Don’t you think that he [the husband] is being hardheaded?”

In this example, the wife was frustrated with her husband in their communication about the choice of executors, and she attempted to reduce her anxiety by trying to find an ally.

Example 2: Aging parents. Your clients, a husband and wife who are getting on in years, are concerned about which of their children should handle their affairs when they’re no longer able to do so. They decide on one of their children to be their agent under their powers of attorney and tell all of their children of their decision. Not long after this, you receive a phone call from a child who wasn’t selected, expressing concern that his parents “may not be thinking clearly” in their selection of his sibling as agent, intimating his belief that his sibling has unduly influenced his parents and attempting to triangle you into the conversation. Here, the parents are viewed as one person in the triangle.

In this example, the child, suffering anxiety at the possibility of having a sibling serve as agent instead of himself, attempts to reduce that anxiety by trying to find an ally.

More to Come

In the third part of this article, I’ll define and explore death anxiety and mortality salience and the role that they play in estate planning, common fears that clients face in estate planning and the complex relationship among a client’s thoughts about death, the client’s property and the objects of his bounty. I’ll also introduce estate planners to two tools to assist purposeful estate planners in the human side of estate planning: motivational interviewing and appreciative inquiry. 

Endnotes

1. See, e.g., Robert J. Marshall and Simone V. Marshall, The Transference-Countertransference Matrix: The Emotional-Cognitive Dialogue in Psychotherapy, Psychoanalysis, and Supervision, Chapter 1, which identifies at least 26 different types of transference.

2. Dr. Ryan Howes, “A Client’s Guide to Transference,” Psychology Today (June 18, 2012), www.psychologytoday.com/blog/in-therapy/201206/clients-guide-transference.

3. See, e.g., Thomas L. Shaffer, Death, Property, and Lawyers (Dunellen Press 1970). Back in 1665, in his Reflections, No. 26, Francois de La Rochefoucauld wrote, “[N]either the sun nor death can be looked at without winking.” For an extensive discussion and application of the phenomenon of transference to estate planning, see Shaffer, Chapter 7. See also Louis H. Hamel, Jr. and Timothy J. Davis, “Transference and Countertransference in the Lawyer-Client Relationship: Psychoanalysis Applied in Estate Planning,” 25 Psychoanalytic Psychology 4, at pp. 590-601 (2008) (Hamel and Davis). 

4. See, e.g., Jan Wiener, The Therapeutic Relationship: Transference, Countertransference and the Making of Meaning (Texas A&M University Press 2009), at p. 12.

5. For more information on Bowen Theory, seewww.thebowencenter.org. For another very easily accessible (and short) read on the Eight Concepts of Bowen Theory, consider Roberta M. Gilbert, M.D., The Eight Concepts of Bowen Theory (Leading Systems Press 2006). See also Peter Titelman, Triangles: Bowen Family Systems Theory Perspectives (Haworth Press 2008); Philip J. Guerin, Jr., Thomas F. Fogarty, Leo F. Fay and Judith Gilbert Kautto, Working with Relationship Triangles: The One-Two-Three of Psychotherapy (The Guildford Press 1996); and Ona Cohn Bregman and Charles M. White (eds.), Bringing Systems Thinking to Life: Expanding the Horizons for Bowen Family Systems Theory (Taylor & Francis 2011). The last book applies Bowen Theory to such diverse organizations and relationships as pastoral training and family businesses.

6. Michael E. Kerr and Murray Bowen, Family Evaluation (W.W. Norton & Co. 1988), at p. 134.

7. Charles W. Collier, “A ‘Family Systems’ Approach to the Estate Planning Process,” 30 ACTEC Journal, at pp. 146-149 (1994), reprinted in Charles W. Collier, Wealth in Families (Third edition, Harvard College 2012).

A majority of states have adopted some version of the model Uniform Trust Code (UTC). Drafted by the Uniform Law Commission in 2000, the UTC was touted as a way to standardize trust law throughout the country.

In reality, less than uniform state adoption and application of the UTC have resulted in more and more inconsistent—and sometimes wildly divergent—outcomes in trust litigation. 

At least 31 states and the District of Columbia have adopted versions of the UTC. Each jurisdiction has the option of deviating from the model code—that’s 32 (and counting) potentially different versions of “uniform” trust law. Recent court decisions indicate that these state-specific modifications have created internal conflicts among provisions of the UTC—conflicts that neither the comments nor the legislative history may adequately address. 

Years—in some cases, more than a decade—after the adoption of the UTC, state courts around the country are now grappling with issues their legislatures perhaps didn’t anticipate when drafting their states’ versions of the UTC, charting new territory in interpreting trust law and resulting in different outcomes on almost (but not quite) identical law. 

For practitioners, these outcomes at best require them to make careful choice of situs and governing law decisions and at worst create heightened uncertainty for both lawyer and client. And, for states, an unfavorable outcome may mean that practitioners will consider a particular state as a poor choice for situs and governing law of trusts, which should be of great concern to state legislatures that seek to attract trusts and not discourage business in their states. 

Two recent cases—one from Pennsylvania and one from Kansas—demonstrate just how wildly divergent state court decisions can be on very similar issues under the UTC and show the need for state legislatures to take notice of these divergences and perhaps clarify intent. 

Taylor 

In Trust Under Agreement of Edward Winslow Taylor Appeal of Wells Fargo Bank,¹ the Pennsylvania Supreme Court addressed the issue of trust modification in a dispute between three beneficiaries (the grandchildren of Edward Winslow Taylor) and Wells Fargo, the corporate trustee for the irrevocable trust Edward established in 1928. Wells Fargo asked the Philadelphia County Court of Common Pleas Orphans’ Court Division to divide the trust into four equal trusts, one for each of four grandchildren. The Orphans’ Court agreed, naming each grandchild the co-trustee of an individual trust, with Wells Fargo as corporate trustee. Three of the grandchildren later petitioned the Orphans’ Court to modify the trust under Section 7740.1 of Pennsylvania’s Uniform Trust Act (UTA) to add a portability clause giving the beneficiaries the ability to remove and replace the corporate trustee without court approval. 

The Orphans’ Court determined that despite the provisions of the UTA’s Section 7740.1 specifically permitting modification of trusts, the beneficiaries first had to satisfy the requirements of Section 7766 governing the removal of a trustee. The Superior Court disagreed and reversed, setting the stage for review by the state high court. 

On appeal, Wells Fargo argued that permitting modification to add a portability clause to an existing trust circumvents court oversight of trustee removal under Section 7766. The grandchildren countered that Section 7766 doesn’t limit trust modification under Section 7740.1 and that adding a portability clause isn’t equivalent to a trustee removal—the beneficiaries might never exercise the power to remove and replace. 

In its July 2017 opinion, the Supreme Court examined the two provisions of the Pennsylvania UTA and determined that beneficiaries have very different obligations when proceeding under each provision. Under Section 7766, only a court has the power to remove a trustee, and only in certain situations—when the trustee has committed a serious breach of trust, exhibits unfitness or unwillingness to administer the trust or lacks cooperation with co-trustees or if there’s been a substantial change of circumstances. The party seeking removal has the burden of proving that removal is in the best interests of the beneficiaries and isn’t inconsistent with a material purpose of the trust and that a suitable successor trustee is available. In contrast, Section 7740.1 allows a noncharitable irrevocable trust to be modified on the consent of all beneficiaries, but only if the court concludes that the modification isn’t inconsistent with a material purpose of the trust. As the grandchildren argued, Section 7740.1 doesn’t specifically limit modification to or for any particular purpose.

The Supreme Court agreed with Wells Fargo that the provisions of the UTA should be read together, ambiguities in the interpretation of both provisions existed and the Superior Court erred by not considering an unambiguous notation on Section 7740.1 made by the drafters (the Pennsylvania Advisory Committee on Decedents’ Estates Laws of the Joint State Government Commission) that Section 7766 is the “exclusive provision on removal of trustees.”

The legislative intent with respect to the interplay between Sections 7740.1 and 7766 is clear—the scope of permissible amendments under Section 7740.1 doesn’t extend to modifications to add a portability clause permitting beneficiaries to remove and replace a trustee at their discretion; instead, removal and replacement of a trustee is to be governed exclusively by Section 7766.² 

Hildebrandt 

Following the decision in Taylor, the Kansas Court of Appeals in In re: The Trust of Clarence Hildebrandt³ reached a surprisingly different conclusion on a similar issue involving trust modification. With the agreement of the beneficiaries, the court granted a petition to modify an irrevocable trust to substitute a different successor trustee for Clarence’s brother, Wayne, the trustee initially designated in the trust instrument. In its January 2017 decision, despite the objection of the successor trustee actually designated in the trust instrument, the Kansas court found that the settlor’s appointment of a successor trustee didn’t constitute a material purpose of the trust under the state statute. Unlike the Pennsylvania courts in Taylor, the Kansas court didn’t even consider Kansas’ trustee removal statute for purposes of determining whether the parties could proceed on the issue through modification, though Kansas’ trustee removal statute is nearly identical to Pennsylvania’s removal statute. 

Clarence Hildebrandt created a trust in 2002 to provide for the continuation of the farming operation he co-owned with his brother, Wayne. Clarence and his brother were named co-trustees of the trust. Clarence appointed his attorney, Edward Wiegers, as successor trustee of the trust. Clarence also directed that if Wiegers were unable to serve, “the two senior members of the firm Galloway, Wiegers & Henney, PA, or its successor firm who are actively engaged in the practice of law at 1114 Broadway, Marysville, Kansas, are appointed to serve as Trustees.” 

Clarence died in 2004. In 2015, Wayne, with the agreement of the beneficiaries, petitioned the court to modify the trust to name Clarence’s niece as successor trustee because Clarence’s attorney was then deceased. Over the objections of the law firm that was appointed to serve as successor trustee in the trust instrument, the district court granted the petition. On appeal, the law firm argued that Clarence’s brother couldn’t modify the trust to bypass the law firm’s appointment as the successor trustee because the proposed modification violated a material purpose of the trust. The Kansas Court of Appeals disagreed. 

Kansas’ modification provision, K.S.A. 58a-411, is nearly identical to Pennsylvania’s Section 7740.1, permitting modification “upon consent of all of the qualified beneficiaries if the court concludes that modification is not inconsistent with a material purpose of the trust.” Noting that the statute doesn’t define “material purpose” and no Kansas case law exists as to whether a change in the successor trustee constitutes a material purpose, the court looked to the Restatement (Third) of Trusts for guidance, which notes that:

[a] proposed modification might change the trustee or create a simple, inexpensive procedure for appointing successor trustees, or it might create or change procedures for removing and replacing trustees. Modifications of these types may well improve the administration of a trust and be more efficient and more satisfactory to the beneficiaries without interfering with a material purpose of the trust.⁴ 

The court concluded that no evidence existed, in the trust document or otherwise, to indicate that the settlor required that the successor trustee to Wayne be an independent third party as a material purpose of the trust. 

Curiously, the Kansas court failed to mention or consider a key comment to K.S.A. 58a-411, which notes that while beneficiaries may modify any term of the trust as long as the modification isn’t inconsistent with a material purpose of the trust, “under the [UTC] Section 706 is the exclusive provision on removal of trustees.” While unanimous agreement of beneficiaries is a factor for the court to consider, “before removing the trustee the court must also find that such action best serves the interests of all the beneficiaries, that removal is not inconsistent with a material purpose of the trust, and that a suitable co-trustee or successor trustee is available.”⁵ 

That Kansas’ UTA includes a separate trustee removal provision didn’t stop the court from allowing the modification of the trust agreement to name a substitute successor trustee. In fact, the court didn’t even mention Section 58a-706, under which a court may remove a trustee if (1) the trustee has committed a breach of trust; (2) the trustee has failed to cooperate with co-trustees to the extent that the administration of the trust is substantially impaired; (3) the trustee has demonstrated unfitness, unwillingness or persistent failure to administer the trust effectively; or (4) there’s been a substantial change of circumstances—and the court finds that removal of the trustee best serves the interests of all of the beneficiaries, is consistent with the terms of the trust and isn’t inconsistent with a material purpose of the trust and a suitable co-trustee or successor trustee is available.

Wake-up Call

These divergent rulings might be attributed to a number of factors related to the specific facts of each case. Taylor involved the modification of an irrevocable trust to include a provision enabling the replacement of a trustee by the beneficiaries at any time without court approval, while Hildebrandt involved a court-approved modification to name a specific successor trustee other than the one initially named in the trust instrument—a one-time occurrence. 

Regardless of the factual differences, however, it’s concerning that these two courts deviated quite dramatically on the same issue (modifying an irrevocable trust to accomplish some form of trustee change or removal that wasn’t initially contemplated by the settlor) under very similar modified versions of the UTC, given that the model UTC was intended to establish more uniformity in trust law among the states. 

From a practical perspective, divergent outcomes like these should serve as a wake-up call for practitioners and state legislatures alike. Attorneys in states like Pennsylvania, in view of the aftermath of Taylor, may be forced to more carefully consider choice of situs and governing law that will best serve the needs of their clients for purposes of modifying trusts. In some cases, clients may be inclined to select a different trust situs or governing law, when possible, to provide maximum flexibility on modification issues. Of course, this analysis can’t account 100 percent for the potential for more—and perhaps more problematic—cases coming down in the future.

For states like Pennsylvania, in light of Taylor and Hildebrandt, perhaps it’s time for state legislators to revisit the UTA and consider their intentions with respect to certain portions, particularly on issues of trust modification. In some cases, legislators may find that their intent may need to be clarified or even reconsidered to avoid creating wildly divergent results in the future, which may make their states less attractive than others for choice of governing law and situs purposes. And, perhaps legislatures in states considering adopting modified versions of the UTC, including Colorado, Connecticut and Illinois, which have introduced bills to enact similar statutes so far in 2018, will take notice of Taylor and Hildebrandt and legislate with an eye toward clarifying legislative intent more carefully at the inception of their statutes. Perhaps they might consider enacting more competitive trust legislation in certain areas such as trust modification as a means of attracting more business to their respective states. 

Endnotes

1. Trust Under Agreement of Edward Winslow Taylor Appeal of Wells Fargo Bank, 164 A.3d 1147 (Pa. 2017). 

2. Ibid., at pp. 1160-1161.

3. In re: Trust of Clarence Hildebrandt, No. 115,530 (Ct. App. Kansas, Jan. 13, 2017).

4. Restatement (Third) of Trusts, Section 65, comment f, at p. 481 (2003). 

5. K.S.A. 58a-411, comment to subsection (b).

Actively employing operational practices guided by the environmental, social and governance (ESG) framework within a private equity (PE) portfolio gives the fund its best chance of outsized returns.

While at times it seems like ESG priorities can be at odds with financial outcomes, we recognize that implementation of ESG practices is actually a key driver of financial returns in a world with increasing competition among investors. By using an ESG mindset in operating businesses, the PE firm makes its portfolio companies attractive places to work in a world where the labor force is increasingly wary of working for PE. We firmly believe that winning on talent is the best way to win on investments. 

Background

There’s no doubt that ESG is increasingly infiltrating the lexicon of mainstream finance from limited partners to asset managers to hedge fund traders. In an environment of increasing competition and a wider array of places to park money, shareholders and capital allocators are increasingly demanding not only financial performance but also social outcomes. By the end of 2017, there were 234 exchange-traded funds and mutual funds that purported to apply socially responsible investment practices. The number of funds claiming to use social impact frameworks in investment decisions has more than doubled since 2012. In the “Schroders Global Investor Study 2017,” 81 percent of survey respondents in the United States said sustainable investing is more important than it was five years ago.¹

Yet, some remain skeptical of this “fad.” On one hand, it seems like asset managers can fit almost any investment or company into an ESG or social impact framework as every enterprise interfaces with society in some capacity and in the free markets. We lack a quantifiable, standard measurement for ESG like we have for financial returns—there’s no GAESGS (Generally Accepted ESG Scoring) despite several attempts at a data-driven approach to measure ESG. Often, investors will just tag something as “ESG-conscious” on a binary scale at investment, check the investment criteria box and then forget about it and return to what they consider to be the more important parts of their job. They’re missing the point.

Others opine that ESG practices can seem like charity work at odds with financial outcomes, which is our commitment as financial fiduciaries. The business improvements yielded by ESG practices often require upfront investment that takes time for direct returns to be realized, if ever attributable—often beyond the life of the fund or the investment. For example, changing entire office complexes to energy-efficient light bulbs will deliver cost savings in the long term, but the inflection point in these situations often comes outside of the time horizon for many investment vehicles. Additionally, offering longer term parental leave policies may have a near-term financial cost to the business, but likely creates a more engaged workforce with less turnover … but how can you definitively measure the return on investment? 

Most research into returns parity between socially responsible and traditional investing has been focused on public markets, due to robustness of data and information. Some studies argue ESG-minded companies outperform, while others suggest no discernible difference or sometimes a decrease in returns. In March 2017, a study found that the Norway Sovereign Wealth funds had reduced returns by 1.9 percent points due to a commitment to excluding certain asset classes—related to tobacco, alcohol and coal—from the investment vehicle.² As is often the case with financial research, the jury is still out for ESG’s impact on public companies. Also, research on private markets is scarcer and more difficult to substantiate.

At Alpine Investors, we’re setting out to achieve creating the best place to work, for our own employees as well as our portfolio company employees, and in terms of our goal to achieve financial results. We’ve found that the first is a key driver towards the second, and as a result, we’ve shaped our entire investment and operations strategy around placing values and people first with an operational ESG-like mindset to attract increasingly socially conscious talent. Here are some suggestions based on our experiences.

Put People First

Operate with a “PeopleFirst” playbook. PeopleFirst is a double entendre that means putting people and values first, as well as putting people first sequentially by recruiting great people prior to making an investment and ensuring that you have strong leaders on the bench before buying companies. This ensures that your portfolio companies aren’t left with no leadership or poor leadership during some of the most critical days following a majority transaction.

A majority transaction, by its very nature, is a change that can disrupt and destabilize even the best organizations, and you’re only doing yourself a disservice if you lack strong social alignment throughout. At our firm, we have an internal talent team that identifies executives and leaders with high emotional intelligence, leadership and adversity quotient that ultimately will be paired with companies undergoing a transaction to help stabilize and align the culture. Getting the right team on the bus is Step 1 in prepping a business to hit its performance targets.

The costs of misaligned or disrupted culture in a PE transaction are real. If not managed well, the culture of a company can erode with new ownership. Employees worry about job security; there’s a divide between incumbents and new hires and strategic direction changes causing confusion. PE investors almost always experience employee turnover at the outset of a hold due to these things, and turnover is costly, often as much as six to nine months salary, as one study conducted by the Society for Human Resource Management suggested.³ Do all in your power to minimize this. For example, we use a bucket metaphor for customer retention that also applies to employee retention: Focus on plugging the hole in the bottom of the bucket first, then start filling the bucket. It’s hard to make progress with a leaky bucket. We try to make sure we’re not losing employees (or customers) out the bottom of the bucket.

Our goal is to solve the initial culture crisis by avoiding it. Employees generally have given a lot to an organization, and the worst thing is not to acknowledge that and come in with only pithy strategic goals in mind. Good leaders know how to manage these situations, and one of our guiding principles is, “first, don’t break anything.” Entering the investment with a socially aware mentality saves us a lot of operational and financial headaches and treats the employees in a way that gets them excited about the new ownership. From there, it’s crucial to ensure high employee engagement and low turnover. We measure our employee engagement quarterly at the management company level and share our employee net promote score practices across the portfolio. Make sure employees are happy, or you’ll deal with the costs of the leaky bottom of the bucket. Make the company a “best place to work” so the best employees want to work for you and don’t want to leave. Our aspiration is to have at least 50 percent of our portfolio companies be formally recognized on third-party “Best Places to Work” lists. 

Another key focus is injecting diversity and inclusion into industries and companies that historically have lacked creative thinking on how to attract and retain diverse talent. Women account for only 16 percent of executive teams, and 97 percent of companies have senior leadership teams that fail to reflect the demographic composition of the U.S. labor force and population, limiting the ability of companies to relate to key populations and adapt to changing conditions.

PE firms have a broad reach and strong influence on leadership teams within their portfolios and can directly influence both: (1) the composition of business leaders across an array of businesses, and (2) the future leaders of businesses by creating a ripe executive training ground within the portfolio. Using a CEO-in-Training program can help change the composition of executive teams in your future portfolio and across the business world. Instead of recycling the executives that have already found success in business, identify and attract high potential individuals who otherwise may have struggled to receive recognition in sectors that are entrenched with unconscious bias and develop/train them into executives, growing a new crop of business leaders with a high bar on diversity and inclusion.  

Lastly, while we recognize that many PE firms have achieved financial success by primarily leveraging cost-cutting measures, we’ve found that the inverse can be true. We believe that in a society in which PE is generally one of the most abhorred industries in the country, we have the opportunity to demonstrate the true value proposition of PE and its ability to add value to the economy at large. As of 2017, Alpine has grown employment by 61 percent across our portfolio during our ownership,⁴ which has led to similarly meaningful topline growth. We believe it’s people who drive topline growth, and so it’s crucial to get the people part of the equation right and build the right team to support sustainable growth. It’s exciting to create a flywheel effect where we increase headcount to increase success, and in turn, create even more jobs at our portfolio companies. Of course, all this is moot if you can’t attract top employees to fill the roles you’re creating—and top potential employees are increasingly intentional in selecting socially impactful roles with competitive benefits.

So What?

Taking an active role in implementing ESG-like operational policies is one of the most important things we can do as a PE firm, because it puts us in the best position to win the talent game. And, winning the talent game puts us in the best position to win the returns game. Beyond being the right thing to do, it’s the right way to win.

In looking for predictors of success, look for fresh talent in a sleepy industry. Public markets benefit from notoriety and pizzazz that attract strong talent. Private markets often struggle to entice top talent, due to limited scale, limited spotlight, limited resources or all of the above. Real value can be created with consistency by bringing top talent to businesses that are looking to grow. Talent, we’ve found, is the best leading indicator for success in an investment, and it’s nearly impossible to overweight its benefits. In private markets, investors have the luxury of longer timelines vs. public markets that must cater to quarterly earnings reports, affording private investors the chance to ensure the right people are on the bus. So, as part of your diligence in assessing where to allocate your portfolio, look for: (1) a focus on management talent, and (2) structural investment in ESG-like practices that will ensure the persistence of talent arbitrage.

In 1981, the yield on the 10-year U.S. Treasury bond peaked at 15.3 percent. For the next 35 years, investors enjoyed a relatively unbroken bull market in their bond portfolios. Interest rates slowly declined, and investors regularly gained annual positive returns on their investments. During this time, the income produced by these investments also slowly declined. In fact, interest on the 10-year U.S. Treasury bond fell below 

1.5 percent in 2012 and again in 2016. Since this low, investors and advisors alike have watched the hawkish turn in U.S. monetary policy by our Federal Reserve result in rising rates globally. Today, many investors have asked themselves a reasonable question: How should I position my portfolio for a low but rising rate environment? 

Understanding the Federal Reserve

When market participants use the term “rising rates,” they’re typically referring to increases in the benchmark policy rate set by each country’s respective central bank. In the United States, the policy rate set by the Federal Open Market Committee (FOMC) of the Federal Reserve is known as the “fed funds” target rate. The fed funds target rate is the primary tool of the Federal Reserve to fulfill their dual mandate of sustaining employment and controlling inflation.¹ 

Interest Rates and the Yield Curve

Through the fed funds target rate, the FOMC exerts control over short-term interest rates only. Rates on longer maturities are then determined by the markets. The relationship between interest rates of varying maturities is often referred to as the term-structure of interest rates or the “yield curve.” Changes in the shape of the yield curve can be a powerful tool for investors to use to adjust their portfolios when interest rates are rising as they both signal expectations for future economic growth and have a direct impact on the performance of various asset classes. 

As illustrated in “Yield Curve Movements,” p. 47, there are three different ways the yield curve might change during a period of rising rates. 

1. Parallel shift. This occurs when yields of various maturities increase (close to) equal amounts, resulting in higher yields across the curve without a change in the overall shape of the curve.

2. Bear-steepening. This results when long-term yields increase at a faster rate than short-term yields. This typically occurs when economic or inflation expectations cause the market to price in higher yields on the long end of the curve, even while the FOMC is increasing the short-term fed funds rate. 

3. Bear-flattening. This occurs when shorter term yields increase at a faster rate than longer term yields. This often happens when the FOMC increases rates, pushing up yields at the shorter end of the curve, while economic and inflation expectations cause long-term rates to remain static.

Each of these yield curve movements presents different considerations for investors and suggests different approaches to re-positioning portfolios.

Rethinking Asset Allocation 

Since the 1980’s peak in interest rates, advisors have often approached asset allocation simply in terms of portfolio growth versus income. However, in an environment of low and rising interest rates, investors need to reconsider asset allocation and the best sources for lifestyle income needs. It’s easy to understand when interest rates were 15 percent or even 5 percent how it became commonplace for financial advisors to recommend investors own fixed income in proportion to their age. Many investors could allocate an increasing portion of their portfolio to fixed income for both assured income and portfolio diversification. A 70- or 80-year old investor could often live very comfortably off the income generated from 5 percent to 7 percent bond coupon payments from his portfolio. 

In this environment, many Baby Boomers started hearing the instruction to “live off the income” of their portfolios, leaving principal untouched. Fast-forward 30 years, and this isn’t your grandparents’ bond market. It’s been many years since a portfolio of 10-year Treasury bonds produced enough income for retirees to live comfortably. In fact, it’s difficult to imagine any portfolio today of investment-grade fixed income securities that can produce sufficient lifestyle income without undue risk. In short, portfolio sources of income and capital protection have become disconnected, and investors can no longer expect to live only off the income naturally generated by their portfolios.

Many advisors have begun to encourage investors to think about their portfolios not as a combination of equities for growth and bonds for income and protection, but as a mix of three allocations—growth assets, capital protection assets and income-producing assets—that together produce a total return. Each year, a portfolio’s total return is the sum of the income it produces and the appreciation of its securities. Today, most investors who live off their portfolios must withdraw a combination of both income and appreciation. This doesn’t necessarily mean the value of their portfolios will go down; proper planning and structure with an advisor and professional portfolio manager may allow investors to withdraw total return regularly while potentially maintaining or growing the overall value of their portfolios. Using the three-bucket approach, capital protection plays its role as an anchor to windward while investors acknowledge that the growth and income sources within their portfolios all carry higher risk to support their lifestyle withdrawals. In the following sections, we’ll explore how an investor can position each of the three buckets for a rising rate environment.

Fixed Income for Capital Protection

Once investors embrace a total return approach to portfolio construction, it becomes evident that chasing higher yielding investments for the sake of income sacrifices critical capital protection in their portfolios. Instead, investors must first focus on determining the right allocation to capital protection to help mitigate the risk in other investments. Given the need for growth and other income sources in the portfolio, capital protection allocations may no longer be tightly related to an investor’s age. Depending on personal circumstances, a 70- or 80-year old investor today may have less than 50 percent of his portfolio in capital protection assets. 

When determining how an investor might reposition his portfolio for protection in a rising rate environment, a starting point is to focus on fixed income duration. As rates increase, the current price of a bond will decline. Duration measures the sensitivity of a bond or bond portfolio to a change in rates. Higher duration bonds will be more sensitive to interest rate changes, and prices will change more than those of lower duration bonds. Duration accurately reflects how a portfolio’s value will change with rates. Due to this, many investors and advisors will focus exclusively on managing duration in the capital preservation allocation and invest only in bonds such as Treasury bonds, agency bonds and even certificates of deposit, leaving credit risk for the income allocation.

The duration of a fixed income portfolio is the weighted average of the duration of each of its underlying bonds. However, two portfolios with similar durations will behave very differently during a rising rate environment, depending on the distribution of bonds of varying durations within the portfolio. Depending on expected changes in the yield curve and the investor’s personal objectives, an investor and his advisor might pursue one of three common strategies for structuring fixed income portfolios for capital protection. “Impact of Yield Curve Changes,” p. 48, illustrates the differences among each of these portfolios and their performance under different yield curve movements.

1. Laddered portfolio. Laddered structures are most appropriate for investors who plan to hold bonds until maturity. As existing bonds mature, new short-term bonds are purchased at increasing rates. Many individual investors appreciate this structure for buy-and-hold portfolios as the laddered bonds will benefit from rising rates by providing both capital protection if held to maturity and increasing income over time.

2. Barbell portfolio. Barbell structures perform better when the yield curve is moving in a bear-flattener manner. Barbell strategies concentrate bonds on both ends of the maturity spectrum, creating a “barbell.” With a concentration in shorter term bonds, the portfolio regularly reinvests at higher interest rates. The concentration at longer maturities provides higher income sources to investors, with relatively less interest rate movement due to the flattening of the yield curve.

3. Bullet portfolio. Bullet structures concentrate bonds in a tight maturity band around a target duration.  Investors often desire bullet portfolios when they have large cash flow needs in the future, such as a balloon mortgage payment or college costs. Though investors may require a bullet portfolio regardless of interest rate movements, bullet portfolios perform best when long rates are increasing faster than short-rates (a bear-steepener move of the yield curve).²

It’s important for an investor to work with an advisor and fixed income portfolio manager who will consider the investor’s goals, shape of the yield curve and the expected pace of interest rate increases. These professionals can analyze the potential impact on the portfolio and make adjustments accordingly.

Investments for Income

As we’ve described, during periods of rising rates, an investor and his advisor might choose to reduce the average duration of their fixed income allocation. While lower durations often protect capital, they may not deliver the income an investor seeks. 

One approach to maintaining income is to add floating rate bonds to a portfolio. These bonds have varying interest rates that are tied to a benchmark, such as the Consumer Price Index, 3-month U.S. Treasury bond yields or LIBOR (London Inter-bank Overnight Rate). The price on these bonds stays relatively stable as the interest moves with changes in the benchmark. While these bonds might initially offer lower yields than higher duration bonds of a similar credit quality, the yields will reset regularly with rising rates, increasing at a faster rate than a buy-and-hold portfolio of traditional bonds. Floating rate bonds will reprice at different frequencies from monthly to quarterly and, occasionally, yearly. Often these bonds will also pay interest more frequently than a traditional bond that pays out interest twice a year. For these reasons, many investors and advisors will seek out floating rate bonds or floating rate bond funds to add to a portfolio when rates are rising.

For greater income in a portfolio, an investor and his advisor might consider using corporate or municipal bonds of lower average credit quality. This can be done by moving down in credit quality within an investment grade portfolio (AAA+ through BBB-) or allocating away from investment grade to various sources of high yield credit (BB+ or lower). Investors and their portfolio managers might choose among corporate high yield bonds or credit alternatives such as non-agency residential mortgage-backed securities or emerging market bonds. An investor might also monetize equity volatility to produce yield in the form of an option overlay strategy or structured note. All these choices might generate higher levels of income and diversify the portfolio’s overall credit exposure. 

Strategies for Growth

A number of studies have demonstrated that, on average, equities tend to perform well during periods of rising rates.³ For example, “Equity Returns,” this page, demonstrates that over the past 20 years, U.S. large cap equities have delivered positive performance during the 12 months corresponding to a period of rising rates regardless of whether the yield curve adjusts in a bear-steepener or a bear-flattener manner. Both predict positive performance; however, a closer look reveals that equities deliver considerably superior performance (17 percent) during bear-steepener scenarios than during bear-flattener scenarios (14 percent). Bear-steepener changes correspond with periods of stronger economic growth. Bear-flattener regimes are associated with the late stages of the business cycle, when the Fed raises short-term rates and the market anticipates slowing growth and rising inflation. While both economic environments correspond with positive equity returns, the former represents a more constructive scenario.

While rising rates are positive for equities, individual sectors can exhibit a wide range of outcomes. “Equity Returns” also illustrates that when rates first start rising, cyclical sectors tend to outperform defensives, and this relationship holds during bear-flattener and bear-steepener regimes. 

Given the expected strength in equities as interest rates rise, investors might work with an advisor to determine if a tactical increase in their allocation to equities makes sense given their objectives and risk tolerance. They might also consider greater allocations to cyclical sectors (financials, technology, industrials etc.) over defensive sectors using sector-focused exchange traded funds or mutual funds. 

Considering that rising rates lead to falling prices for bonds, it’s understandable that some investors seek to reduce fixed income in their portfolio when rates are rising. Certain growth strategies provide a diversification benefit that can help maintain a portfolio risk and return while reducing fixed income. For qualified investors, hedge fund strategies may offer this benefit due to their exposure to different sources of return and risk that often have a low correlation to traditional asset classes.

After carefully considering an investor’s profile (liquidity, total net worth and income) and explaining the risks and terms of the investment, an advisor might recommend that an investor include hedge funds in his portfolio for greater diversification. “Benefits of Diversification,” p. 50, illustrates the correlations of several hedge fund strategies to equity and fixed income asset classes. It’s evident in Area B of this illustration that the diversification benefit of investment grade fixed income is significant. Over the past 20 years, correlations of investment grade fixed income to equity asset classes have been close to zero. This has enabled investors to achieve robust risk/adjusted returns. However, as illustrated in Area C, the correlations of most hedge fund strategies to equities and fixed income are also low enough to provide a diversification benefit. Global macro and commodity trading advisor funds, in particular, stand out as exhibiting the lowest correlations to other traditional asset classes.

In addition, many hedge fund strategies have historically exhibited less volatility (and lower returns) than equities and greater risk-adjusted returns as measured by a Sharpe ratio. Due to these characteristics, some advisors and investors may decide that a mix of hedge fund strategies can provide risk reduction through diversification.

Achieving Success

Interest rates are rising, with no clear end-target in site. Investors and their advisors want to respond to both protect capital and assure long-term growth in portfolios. Even as 10-year Treasury yields approach 3 percent, though, this isn’t our grandparents’ interest rate market, and investors can’t live off the income of their portfolios. As long as typical benchmark rates are insufficient to meet investor’s lifestyle needs, advisors and investors must work thoughtfully and closely with portfolio managers to reposition portfolios. Success requires careful consideration of the yield curve and how changes can affect different portfolio strategies. Each investor’s goals will best be met by repositioning portfolios based on rising rates, the changing shape of the yield curve and the resulting asset class strategies that best achieve the growth, capital protection and income needs of the investor.    

Endnotes

1. The Federal Reserve Bank of New York, “Fedpoint: Federal Funds and Interests on Reserve” (March 2013), www.newyorkfed.org/aboutthefed/fedpoint/fed15.html.

2. Robert Kopprasch and Steven Mann, “Portfolio Management: Yield Curve Strategies,” CFA Institute (2017).

3. For example, see Christopher Dhanraj, “What the Yield Curve Can Tell Equity Investors,” BlackRock (February 2018); Steve Chen et al., “Navigating Through Rising Interest Rates: Impact for Quant Strategies,” Deutsche Bank (June 14, 2018).

—This article is meant to serve as an overview and is provided for informational purposes only. It does not take into consideration the recipient’s specific circumstance and is not intended to be an offer or solicitation, or the basis for any contract to purchase or sell any security, or other instrument or service, or for Deutsche Bank Securities, Inc. (“DBSI”) or Deutsche Bank Trust Company Americas (“DBTCA”) to enter into or arrange any type of transaction as a consequence of any information contained herein. Deutsche Bank does not provide tax, legal or accounting advice. Deutsche Bank and Summit Place Financial Advisors, LLC have no legal or professional affiliation, and this article does not represent a commitment to such an affiliation or agreement.

While it’s important to know how to manage your clients’ investments through a period of rising interest rates,¹ don’t take your eyes off the other side of the pendulum. The strong economic growth that leads to rising rates will inevitably be followed by a recession and a period of falling rates. Importantly, the strategies that you may be considering today to mitigate the risk of rising rates might have the side effect of exacerbating your downside in the next bear market. So, unless you have incredible market timing skills (and let’s just assume that you don’t for the purposes of this article…if you do, let’s grab a drink sometime), you’ll want to be careful in calibrating your response to current conditions.

Interest Rates and Recessions

In evaluating strategies that can be defensive in bear markets, let’s take a look at the three recessions and seven market declines of 15 percent or more (bear markets) that have occurred in the United States since 1986. Each recession has been accompanied by a bear market, but not every bear market is due to a recession. While interest rates have been in a secular decline during this period, they have a tendency to rise during the good times (the current worry), but fall during the recessions and bear markets. 

Bond Investment Choices 

Given the current risk of rising rates and a flattening yield curve, the conventional wisdom is to shorten bond duration (a measure of the interest rate sensitivity of your portfolio roughly corresponding to the maturity of a bond). Long-term bonds lock you into the current interest rate, and you forgo the ability to benefit from new, higher yields. Thus, the price of longer term bonds will drop when interest rates rise as investors prefer new issues (assuming same issuer or comparable risk). Investors may even be considering going to cash. As of this writing, cash yields are about 2 percent, while 10-year Treasury yields are less than 3 percent. You’re not getting paid a lot extra to lock in your interest payment.

The other strategy investors are considering is taking on more credit risk. Perhaps it’s better to get an extra 2 percent of yield by buying a low rated, but short-term, bond so that your client can get an increased interest income without subjecting himself to impairment from rising rates. Should the economy stay strong, there’s less risk of default.

Now, let’s take a look at what may happen if you sustain that position into the next recession or bear market. “When Are Investors Better Off?” p. 53, shows the cumulative investment returns during each of those periods for intermediate duration bonds, cash and high yield bonds. Because interest rates have tended to fall in these periods and less creditworthy borrowers will be under more stress, high quality intermediate duration bonds did better in every one of these historical events. During recessions, investors have been better off in bonds by 4 percent relative to cash and by 7 percent relative to high yield. During bear markets, investors have been better off by, on average, 5 percent relative to cash and 14 percent relative to high yield.

The counter argument might be, “That’s all well and good, but won’t I get killed during the rising rate part of the cycle?” It’s true that bonds underperform cash when rates are rising. However, you’re still likely to have positive returns. “Surprise, Surprise,” p. 54,  shows the return of the Bloomberg Barclays Aggregate during the past seven times when the Fed was raising rates. Note that there’s only one period when bonds lost money … and that loss was fairly small.

For investors that have portfolios inclusive of both stocks and bonds (that is, most investors), the fact that bonds have done better during bear markets is particularly important given that, by definition, stocks had a significant decline during the bear market. This superior bond return came at the most important time to help minimize the downward movement of one’s overall wealth. Now, let’s take a look at strategies to consider within your client’s stock portfolio.

Equity Investment Choices

Recently, stock market results have been driven by technology and other growth-oriented companies, while more defensive, income-oriented sectors have lagged. “Sector Relative Return,” p. 55, shows the results by sector during the last seven bear markets and sorts the sectors by the frequency that they outpaced overall market returns.

Consumer staples and utilities are the only sectors to have outperformed during each of the bear markets. We also see high probabilities of success from health care and telecommunications. On the other hand, not only have more cyclical sectors like industrials and materials tended to lag but also have some of the growth sectors such as consumer discretionary and technology.  This makes sense as consumers and businesses might defer discretionary spending while times are tough, but are hesitant to pull back on essentials. There are definitely worries that consumer staples may not hold up well in the future as they have in the past due to the growth of the Internet and the “Amazon effect,” so  you need to carefully evaluate individual investments.  

Let’s also analyze factor returns for clues regarding what might hold up well. Factors are measurable characteristics of each company. In “Factor Relative Return,” p. 55, the U.S. equity universe is broken into five equally weighted quintiles. The numbers in the chart represent the average return of the top 20 percent minus the average return of the bottom 20 percent. For example, volatility (companies whose share prices show the most fluctuation) has been a negative for all bear markets meaning that, on average, the highest volatility companies did much worse than the lowest volatility companies. Observe that investing behind volatility and momentum (the trend that companies that have been rising the fastest recently will continue to do so) can be quite harmful when the market turns.

Yield (investing in companies with the highest dividend yields), return on equity (a measure of profitability) and quality growth (investing in companies that have had consistent earnings per share growth and a high return on assets relative to peers) have held up the best. Higher yielding stocks have lagged significantly this year as they’re also vulnerable to rising interest rates. As rates rise, bonds become a better alternative for income-seeking investors.

Another interesting observation is that while value (investing in companies with cheaper prices) worked well during the first four bear markets, it’s been less effective since the financial crisis.

This data should be a caution flag for investors who  might want to pile into the “FAANG” stocks (Facebook, Amazon, Apple, Netflix, Google) that have been leading the market higher. While these stocks exhibit a lot of quality growth characteristics, they could be vulnerable due to their momentum and volatility. Investors may want to consider trimming these holdings and adding to their more income-oriented equity services.

Consider Risks and Rewards

While no one likes to give up potential returns during the heady days of a bull market, we also know that investors are highly risk averse, and there’s nothing more painful than losing money … and nothing more harmful to a client relationship than underperforming during a bear market. Maintaining sufficient allocations to high quality intermediate duration bonds, defensive sectors such as utilities and consumer staples and factors such as quality, profitability and yield can both help grow client’s wealth should the bull market continue and mitigate the downside in bear markets. Advisors will want to ensure that actions taken today to reduce the risk of rising interest rates don’t create bigger problems during the bear market to come.   

—The views expressed herein are those of the author and do not necessarily reflect the views of Capital Group Private Client Services and should not be construed as advice. The thoughts expressed herein are current as of the publication date, are based upon sources believed to be reliable and are subject to change at any time. There is no guarantee that any projection, forecast or opinion in this paper will be realized. Past results are no guarantee of future results.  

Endnote

1. Elizabeth K. Miller and Andrew N. King, “Positioning Portfolios for a Rising Rate Environment,” Trusts & Estates (September 2018), at p. 45.

• Proposed regulations under Internal Revenue Code Section 199A reduce income tax planning strategy—Under IRC Section 199A (enacted in 2017), a deduction for up to 20 percent of certain qualified business income (income from a domestic business operated as a sole proprietorship, partnership or S corporation) is available for years 2018-2025. The deduction may be claimed by individuals, non-grantor trusts and estates. However, the deduction is limited when income exceeds certain thresholds. To circumvent this limitation, some taxpayers have established multiple non-grantor trusts and then conveyed interests in the pass-through businesses to those trusts. By partitioning ownership (and therefore income) among multiple non-grantor trusts, each trust’s share of income may be below the threshold, thereby allowing the deductions. However, on Aug. 8, 2018, the U.S. Treasury approved proposed regulations (proposed regs) under Sections 199A and 643 and published related Notice 2018-64.  

Prop. Regs. Section 1.643(f)-1 deals with this very scenario, in which multiple non-grantor trusts with the same grantor or grantors and primary beneficiary or beneficiaries are established to avoid federal income tax. Those trusts will be treated as a single trust for federal income tax purposes. 

The proposed regs are lengthy and provide definitions, computational and anti-avoidance rules and other clarifications on the application of Section 199A. 

• Marital trust with charitable remainder beneficiary not a split-interest trust subject to private foundation (PF) rules—In Private Letter Ruling 201831009 (May 2, 2018), an irrevocable marital trust was created under a revocable trust for the benefit of the grantor’s spouse. On the spouse’s death, the remaining trust property will be paid to a PF.

The trustees of the trust requested a ruling that the marital trust during the spouse’s life wouldn’t be subject to IRC Sections 4941, 4943, 4944 and 4945, which are applicable to PFs. In addition, the trustees requested assurance that the trust wouldn’t be subject to those rules after the spouse’s death.

The Internal Revenue Service ruled that the marital trust wasn’t subject to the PF rules of Sections 4941, 4943, 4944 and 4945 during the spouse’s life. Usually, PFs are tax-exempt organizations under IRC Section 501(c)(3).
However, IRC Sections 4947(a)(1) and (a)(2) subject two types of non-exempt trusts (charitable trusts and split-interest trusts, respectively) to many of the PF rules. To meet either test under Section 4947(a)(1) or (a)(2), the trust in question must already have had a charitable deduction allowed (for example, income, gift or estate tax). Here, no charitable deduction was allowable or taken with respect to any asset transferred to the marital trust on the grantor’s death.  

On the spouse’s later death, all the assets of the trust will be includible in the spouse’s gross estate under IRC Section 2044. Then, the estate tax charitable deduction will be allowable because the marital trust property will be paid to the PF. However, the regulations under Section 4947 provide that the trust won’t be considered a charitable trust (and thus subject to the PF rules) during the time reasonably required for the trustee to perform the ordinary duties of administration to settle the trust (collecting assets, paying debts, taxes and expenses, determination of the rights of the beneficiaries, arranging for distributions, etc.).  After that reasonable period, the trust will be considered a charitable trust.

However, the IRS declined to rule on whether, during the spouse’s life, the trust would be a disqualified person or on the treatment or consequences of any transaction between the trust and PF. The IRS also noted that certain transactions with the PF during the settlement period after the spouse’s death could result in indirect self-dealing (unless the requirements of another section of the regulations were met).

• Disclaimer by appointee of limited power of appointment (POA) by beneficiary under pre-1977 trust upheld—In PLR 201831003 (April 23, 2018), an individual established a trust prior to 1977 that gave the trustee broad discretion to make distributions for the benefit of a certain family member and her descendants during her life. The beneficiary also had a testamentary POA under which she could appoint the trust property to any of the descendants of her great-grandfather and great-grandmother. The beneficiary exercised her POA in her will by appointing all of the remaining property to those descendants, per stirpes. The taxpayer was one of those descendants who was entitled to a share of the trust property as a result of the exercise of her POA, but wasn’t otherwise a remainderman.

The taxpayer wasn’t actually aware of this trust during the beneficiary’s life and only learned of it after her death. He didn’t receive any benefits of the trust property. He proposed to disclaim his entire interest in the trust in a manner that met the requirements under state law. He requested a ruling that his disclaimer wouldn’t be considered a taxable gift.

The IRS agreed that the taxpayer’s disclaimer wouldn’t constitute a gift. Under Treasury Regulations Section 25.2511-1(c)(2), relating to pre-1977 trusts, refusing a property interest isn’t a gift if made within a reasonable time after learning of the existence of the property transfer. The IRS held that the transfer occurred when the trust was created, before 1977. However, the disclaimer would be timely if made within a reasonable time after the disclaimant obtained knowledge of the transfer. In this case, the IRS held if the taxpayer makes the disclaimer within nine months of learning of his interest in the trust, it would be timely. Therefore, assuming the taxpayer doesn’t accept any of the trust property and makes the disclaimer within nine months of the date when he learned of the existence of the trust in a manner that conformed with state law requirements, the disclaimer won’t be a taxable gift.

Individuals can’t anticipate many possible issues when doing their long-term and perpetual intergenerational trust planning. Both judicial and non-judicial modifications¹ as well as decanting² and trust protectors³ have been helpful to amend trust documents to accommodate many of these unanticipated changes.⁴ The grantor’s intent generally rules the day. Consequently, detailed and flexible trust drafting is generally very helpful. 

Beneficiaries

Some of the more common unanticipated happenings with long-term and generation-skipping transfer (GST) trusts  involve the definition of children/grandchildren, issue, stepchildren, foster children and spouses and their recognition as beneficiaries.⁵ This has now moved beyond family births and adoptions to surrogate, in vitro fertilization, artificial insemination and other possible definitions of children and issue.⁶ Generally, it’s helpful if a trust is drafted specifically to match the grantor’s intent regarding whom he wants to be a beneficiary.

Divorce

Spouses of beneficiaries are sometimes named as additional trust beneficiaries. Because of high divorce rates, these beneficiary spouses can also present unanticipated issues. In some instances, these spouses of beneficiaries may be named as a “floating spouse” beneficiary, that is, the spouse the beneficiary is living with and married to at the time of the distribution.⁷ Additionally, clauses may require that the beneficiaries sign a pre-nuptial agreement to be eligible for trust distributions. Other clauses require beneficiaries to remain married to their spouses while their children are young to maximize their trust distributions. This ensures that the children will be raised in the same home by two parents. In many of these instances, their distributions are subject to some type of vesting schedule based on the length of the marriage while the children are young. This can result in some miserable but well-compensated married couples.⁸

Additionally, the high divorce rate, combined with the recent Ferri v. Powell-Ferri,⁹Pfannenstiehl v. Pfannenstiehl¹⁰ and Berlinger v. Casselberry¹¹ decisions, has resulted in many trusts that are drafted as discretionary. This usually limits the divorcing spouse’s access to the trust, particularly if the trust is sitused in a jurisdiction that doesn’t define a discretionary interest in trust as a property right.¹² This isn’t the case in Florida; consequently in Casselberry, an ex-spouse was able to garnish the interest of a third-party trust set up by her ex-husband’s father.¹³ Also, in Pfannenstiehl, the Massachusetts Supreme Court left the door open for future courts to “consider the expectancy [of a distribution] ‘as part of the opportunity of each (spouse) for future acquisition of capital assets and income,’” and even stated that “the existence of a spendthrift provision alone does not bar equitable division of a trust.”¹⁴ Hence, if the trust was set up as a separate share versus a single pot trust, then access to the funds in divorce may have been granted. It’s very important to recognize that the spendthrift clause has divorce and child support as exception creditors.¹⁵ In the recent case of Ferri, as divorce proceedings were ongoing, the trustees of a discretionary trust of which the divorcing husband was a beneficiary decanted into a newly drafted spendthrift trust without informing the husband. At the time, the existing trust provided the husband a 75 percent withdrawal right to the trust corpus. The new trust instead provided only for a discretionary interest to the husband, eliminating any right to withdrawal. The Massachusetts Supreme Court approved the decant, and thereafter, the Connecticut Supreme Court held that the trust assets were moved out of reach of the divorce by the decant as the new trust was a spendthrift trust and, thus, not considered an asset of the marital estate.¹⁶ Consequently, planning for future divorces among family beneficiaries is very important with long-term and perpetual trusts.

Directed Trusts

Directed trusts¹⁷ are a great option to deal with unanticipated trust investment and distribution issues. A directed trust allows individuals who establish a trust with an administrative trustee in the directed trust state to appoint a trust advisor or investment committee, who in turn can design an asset allocation strategy and select an outside investment advisor(s) or manager(s) to manage the trust’s investments and direct the administrative trustee accordingly. Individuals may choose multiple advisors based on different asset classes/diversification, which may be as broad as a sophisticated Harvard or Yale endowment-type asset allocation. Alternatively, individuals may select a large non-diversified position in a public or private security. Moreover, the directed trust is able to hold both financial and non-financial assets (that is, offshore companies, business interests, real estate, limited liability companies (LLCs), family limited partnerships, timberland, direct private equity and more). None of these options are possible or practical with the delegated trust statutes¹⁸ of most states as a result of laws, risks, time and costs.¹⁹ Additionally, the trust can generally establish a distribution committee (DC) to determine when and to whom trust distributions should be made and to direct the administrative trustee accordingly.²⁰ Family members and their advisors can generally serve on these DCs and determine all distributions of income and principal for health, education, maintenance and support. Any additional distributions would be tax sensitive and require an independent person (for example, corporate administrative trustee, CPA, attorney or a combination thereof) who could also be part of the DC. Sickness, disability or incapacity are also usually unanticipated. In the event of these happenings, the DC of a directed trust comprised of family and family advisors can generally best deal with the situation. 

It’s currently best to draft trusts as directed for reasons previously mentioned. Additionally, there are several older trusts being reformed and modified to add directed trust administration provisions. This is usually very easy to do and won’t negatively affect grandfathered GSTs.²¹ 

Many wealthy families seek to leave their children with ample opportunity to have lives that aren’t only comfortable but also meaningful. To encourage beneficiaries to make a positive contribution, many grantors draft various forms of incentive trusts²² to ensure the beneficiaries are mentored to promote both fiscal and social responsibility with their trust distributions. These incentive trusts are carefully drafted and generally sitused in modern directed trust jurisdictions to maximize their potential.²³ It’s very difficult to use an incentive trust practically if distributions aren’t directed by a DC comprised of family and family advisors. Incentive trusts don’t generally work well with delegated trust statutes and with co-trustees versus the DC of a directed trust.²⁴

Jurisdiction-Skipping Clauses

The exploration of other planets, the future possibilities of living on other planets, the potential for asteroids hitting the United States and other related potential issues involving the planet Earth have all resulted in the drafting of very unique jurisdiction-skipping clauses. Many clients have instructed their lawyers to draft intergalactic jurisdiction-skipping clauses. An example of such a clause is “if XYZ Trust Company of [state] cannot serve, then any other comparable trust company in the United States, on the planet Earth, or in the universe may serve.”²⁵ This is also important for clients concerned about global warming and the possibility that their trustees may end up in the ocean at some point in the future. Thus, drafting a clause resulting in the ability to change the situs and the law of a trust can be very helpful. This clause can also be beneficial if a trust jurisdiction doesn’t have modern trust laws or doesn’t maintain its status as an attractive modern trust jurisdiction.

Cryonics

Another uncertainty can arise as a result of various potentially fatal diseases. Nanotechnology has dramatically improved over the years, thus increasing the interest in cryonics.²⁶ Many clients are very interested in cryonic suspension, that is, getting frozen with the hope a cure will be found for what caused their death. They’re generally considered legally dead but not medically dead. They’re carefully placed into cryonic suspension (frozen), potentially for a long period of time, as some people say, “where the elite go to beat the heat and meet St. Pete!”²⁷ Trusts are set up, either as beneficiary trusts²⁸ or purpose trusts without beneficiaries,²⁹ to accommodate these individuals. These trusts are specifically drafted to accommodate the initial cryonic suspension, the monitoring and maintenance of the cryonic suspension and the possible return to life.³⁰ Life insurance can sometimes pay for all of this.

Pet Trusts

Another unanticipated event may involve a client predeceasing his pet. Thus, the need for a pet trust. Every state and Washington, D.C. has some form of pet trust statute. Some states have statutes that are more flexible with longer durations compared to statutes in other states.³¹ It’s very important to coordinate the duration of the trust with the life of the pet. Dogs and cats have relatively short life spans (roughly 15 years for both), which most pet trust statutes can accommodate.³² Many other pets have very long life spans (for example: horse, 25-30 years; macaw, 35-60 years; tortoise,100 years; donkey, 45 years; eagle, 55 years; parrot, 80 years; and American box turtle 123 years).³³ Despite what many people think, pets are property. Consequently, pet trusts are generally purpose trusts without beneficiaries. The amount of trust funds a jurisdiction may allow to be spent on a pet may vary. In 2007, the billionaire Leona Helmsley left behind a $12 million trust for the care of her Maltese, Trouble, who was fed crab cakes and Kobe beef, provided $8,000 in yearly grooming fees and assigned her own $100,000 per year security team.³⁴ The security team was necessary both because of kidnapping as well as death threats to the dog due to the number of people she bit.³⁵ When Trouble died, the money remaining for her care was used for charitable purposes. The original trust was sitused in New York. New York put many restrictions on the trust, as well as on the amounts that could be expended for Trouble. Consequently, the trust changed situs to South Dakota to accommodate the grantor’s intent as well as the desired results for Trouble and various pet charities.³⁶ Additionally, some pet owners may elect for their pets to be put into cryonic suspension (frozen) with the hope that a cure may be found for what caused their pet’s death, so that the pet can be cured and brought back to life.³⁷ Thus, the duration of the pet trust may also be an important consideration. Grantors who want to provide extensively for their pets should consider all of these factors. 

Future Lawsuits

Lastly, grantors can’t anticipate future lawsuits so it’s crucial that they plan accordingly with their trusts. Some of the modern trust jurisdictions have powerful privacy protections³⁸ in the event of lawsuits. Additionally, some trust jurisdictions have statutes providing for the reimbursement of legal fees if someone sues a trust/trustee and is unsuccessful.³⁹ Furthermore, beneficiary quiet provisions can also be helpful in limiting the amount of trust information that beneficiaries may receive, which can help with minimizing lawsuits.⁴⁰ These beneficiary quiet provisions also differ by trust jurisdiction.⁴¹ Typically, trust drafting, situs selection, proper trust administration, layering with LLCs and special purpose entities and/or trust protector companies all minimize situs in the client’s resident jurisdiction and maximize situs and the laws of the trust jurisdiction (which typically provides greater asset protection), thus resulting in powerful asset protection/wealth preservation.⁴² 

These are just a few of the key unanticipated changes that a client can protect against with proper trust planning.                             

Endnotes

1. Non-judicial modification/non-judicial settlement agreement statutes typically allow the beneficiaries, the grantor and/or other interested parties to modify an existing trust document without having to go to court. Certain states also provide judicial reformations/modifications, typically brought by a petition to court by the trustee or majority of beneficiaries.

2. Currently, 27 states have decanting statutes. Generally, decanting is a discretionary distribution by a trustee of an older trust to a newly drafted trust. The power to decant derives from the trustee’s authority to distribute to one or more beneficiaries under the trust document, which is typically referred to as the “power to invade the trust.” However, with a decant, instead of distributing the trust corpus outright to a trust beneficiary, the trustee distributes or pours over the trust corpus to another trust. See Al W. King III, “Decanting is a Popular Strategy, But Don’t Ignore Several Key Considerations,” Trusts & Estates (August 2018). 

3. Trust protectors are recognized by statute in many of the modern trust jurisdictions (that is, Alaska, Delaware, New Hampshire, Nevada, South Dakota and Wyoming) and generally have many important personal or fiduciary powers that increase trust administration efficiency. Typically, those powers include the ability to remove or replace trustees/fiduciaries, veto or direct trust distributions, add/or remove beneficiaries (or appoint someone to do this), change situs and the governing law of the trust, veto or direct investment decisions, consent to exercise power of appointment, amend the trust as to the administrative and dispositive provisions, approve trustee accounts and terminate the trust.

4. King, supra note 2; Al W. King III, “Are Irrevocable Trusts Truly Irrevocable?—Reformation, Modification, Decanting and Trust Protectors,” Berks County Estate Planning Council (March 16, 2016).  

5. Angie O’Leary, “Planning for Modern Families,” Wealthmanagement.com (Jan. 8, 2018).

6. Wendy S. Goffe and Kim Kamin, “Estate Planning for Users of Assisted Reproductive Technology,” Think Advisor (Oct. 4, 2017).

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

8. Al W. King III, “Are Incentive Trusts Gaining Popularity,” Trusts & Estates (October 2017).

9. Ferri v. Powell-Ferri, 476 Mass. 651 (2017); Ferri v. Powell-Ferri, SC19432, SC19433 (2017). 

10. Pfannenstiehl v. Pfannenstiehl, 55 N.E.3d 933, 941-42 (Mass. 2016).

11. Berlinger v. Casselberry, 133 So.3d 961, 962 (Fla. Dist. Ct. App. 2013), appeal denied.

12. Some states codified the common law and Restatement (Second) of Trusts, which defines the types of interests a beneficiary has in a trust, and therefore, the rights of a beneficiary’s creditors. Consequently, in those states, a discretionary interest in a trust isn’t a property interest or an entitlement. States with a discretionary support statute include Alaska, Delaware, Nevada, Oklahoma and South Dakota.  

13. Supra note 11.

14. Supra note 10.

15. Ibid. 

16. Supra note 9. 

17. Generally, directed trusts allow families to tailor the trust to their needs regarding asset allocation, diversification, investment management and distributions, all while significantly increasing flexibility, control and liability protection. States with strong directed trust statutes include Alaska, Delaware, Nevada, New Hampshire, South Dakota, Tennessee and Wyoming.

18. All 50 states and Washington, D.C. have a delegated trust statute. This structure typically involves a family trustee who generally delegates certain responsibilities. It’s important to conduct due diligence on whom he’s delegating to and why he believes that the delegation is prudent. In addition, the delegating trustee is generally responsible for ongoing monitoring of the co-trustees and/or fiduciaries to whom he’s delegated. However, while the trustee is delegating the function, he isn’t delegating the liability and risk.

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

20. Directed distributions are allowed in most directed trust states (that is, Alaska, Delaware, New Hampshire, Nevada, South Dakota and Wyoming). Some exceptions are Oklahoma and Utah.

21. Regarding directed trusts, note the Wallace case, in which the court rejected an unopposed petition by the income beneficiary of an older 1934 trust to modify its administrative terms to allow for modern investment provisions involving both an investment advisor and a directed trustee. The court held that it would contradict the settlor’s intent despite arguments that the beneficiaries may be better served by the directed trust. In re: Trust Under Will of Wallace B. Flint, 118 A.3d 182, 193 (Del. Ch. 2015). This is an interesting and unique result because the directed trust laws weren’t in place at the time the trusts were executed. This type of reformation to a directed trust would generally be permitted in most of the modern trust jurisdictions.

22. Supra note 8.

23. Popular directed trust states include: Alaska, Delaware, Nevada, New Hampshire, South Dakota, Tennessee and Wyoming.

24. Supra note 8. 

25. Al W. King III, “Designing the 21st Century Irrevocable Trust,” Guardian’s BRC Symposium (August 2015). 

26. Nanotechnology uses microscopic robots that would theoretically be able to clean and heal individual human cells. Al W. King III, “Freezers—Our Future Coffins?” Trusts & Estates (August 2002). A leading cryonics organization, the Alcor Life Extension Foundation, has posited that “nanotechnology will eventually lead to devices capable of extensive tissue repair and regeneration, including repair of individual cells one molecule at a time.” See Alcor Life Extension Foundation, “What is Cryonics?”

27. King, ibid. 

28. Traditionally a self-settled/third-party spendthrift trust established by a grantor for the benefit of named beneficiaries, including the grantor who will be entering into cryonic suspension. Self-settled trusts, if properly structured, allow the grantor to be a permissible beneficiary of the trust.

29. Generally, a purpose trust is created for a purpose (something) rather than for beneficiaries (someone). Its sole purpose is to care, protect and/or preserve an asset or a purpose. Although all states and Washington, D.C. allow for pet trusts (a form of purpose trust to care for a pet), only some states permit broad purpose trusts that would allow for a variety of purposes and assets including cryonic suspension, grave sites, antiques, cars, art, jewelry, memorabilia, royalties, digital assets, land, maintenance of private family trust companies, property and buildings. States with broad purpose trust statutes with long durations include Delaware, New Hampshire, South Dakota and Wyoming.

30. Mark E. House, “Do Zombies Pay Taxes?” WealthManagement.com (Dec. 20, 2017).

31. Delaware, New Hampshire, South Dakota and Wyoming all have pet trust statutes that allow for a longer duration compared to statutes in other states. Al W. King III, “Powerful Planning Opportunities Using the Top-Rated Domestic Trust Jurisdictions, i.e., Alaska, Delaware, Nevada, New Hampshire, South Dakota & Wyoming” (Mercer County Estate Planning Council Feb. 7, 2018).

32. A typical pet trust statute covers 21 to 25 years or until the death of the animal, whichever occurs first.

33. Al W. King III and Pierce H. McDowell III, “A Bellwether of Modern Trust Concepts: A Historical Review of South Dakota’s Powerful Trust Laws,” South Dakota Law Review (Summer 2017).

34. Cara Buckley, “Cosseted Life and Secret End of a Millionaire Maltese,” The New York Times (June 9, 2011).

35. Tom Leonard, “Housekeeper sues Leona Helmsley’s £6m dog,” The Telegraph (Sept. 5, 2007).

36. Supra note 34.

37. King, supra note 26. 

38. Generally, most state statutes and courts provide that all court trust matters will be public with few exceptions. This is the general trend. However, some states allow for the court to seal trust information on a case-by-case basis by petition, and some seals are limited to a period of years (for example, Delaware). Generally, a good reason is necessary to obtain the seal. South Dakota, on the other hand, provides that all court matters involving trusts are to be sealed automatically in perpetuity.

39. Al W. King III, “Defend Against Attacks on DAPTs,” Trusts & Estates (October 2014).

40. Alaska, Delaware, New Hampshire, South Dakota and Wyoming all have beneficiary quiet statutes that allow for trust information to remain confidential from beneficiaries until instructed otherwise by the grantor/advisor/trust protector, as opposed to the typical right to trust information/accounting provided to beneficiaries. Some states allow for this beneficiary quiet provision to continue even after the grantor’s death, disability or on receiving a trust distribution. Al W. King III, “Should You Keep a Trust Quiet (Silent) From Beneficiaries?” Trusts & Estates (April 2015).

41. Ibid. 

42. Supra note 39.

Much has already been written about the tax changes made by the Tax Cuts and Jobs Act of 2017 (the Act). Articles have explained how the Act dramatically changed the way practitioners should handle tax and estate planning for many clients. But, the changes to the estate-planning environment are much broader and deeper than merely higher exemptions and the use of non-grantor trusts. Let’s take a holistic, yet practical, view of the recent changes. 

Estate planning is evolving in significant ways, and if your clients haven’t updated their planning and documents for the new world of estate planning, the planning likely won’t be as effective as they wish. More than ever before, estate planning is intertwined with income tax planning. While estate planners have been quite conscious of the income tax basis implications of estate plans, the new paradigm implicates a wide range of income tax planning decisions into the estate-planning process. Many, perhaps most, old wills and revocable trust dispositive schemes, especially if based on formula clauses, might not be optimal. They may even pose the danger of causing adverse tax results versus having no planning in place at all. 

With the estate tax exemption increased to $10 million inflation adjusted ($11.18 million in 2018), many clients believe they don’t need to address their estate planning as they don’t see themselves as having a tax problem. Practitioners may need to educate clients and show why documents that don’t contemplate the dramatic new environment caused by the Act will almost assuredly leave less than an optimal result for the intended heirs. Of importance is educating clients that failing to address robust trust planning now may result in the client incurring greater income taxes each year, even if the client’s estate will never face an estate tax.

Human Considerations 

People are complicated, and families often don’t get along. Emotional dynamics often influence or control the estate-planning process, including whether the client will even meet with the practitioner to address planning. Family tensions can be exacerbated by the division of estate assets. If practitioners don’t deal with the human elements when crafting an estate plan, it’s likely that the plan will be ineffective, and the client’s goals won’t be accomplished. In the past, many estate disputes could use tax benefits to resolve financial issues. For most clients, there will be no estate tax savings “carrot” to hold in front of warring heirs. So, whether the tax laws are new or old, practitioners can help a client reduce the potential for estate disputes with intelligent planning. This can be a challenge as it requires helping a client address family dynamics and deal with potential tensions proactively.  

In their landmark study,¹ Roy Williams and Vic Preisser found that only 30 percent of the 3,250 people interviewed successfully transitioned wealth to the next generation. Only 3 percent of the failures were due to poorly crafted estate plans. The number one issue that led to failure was lack of communication and trust (60 percent), followed by lack of preparation of heirs (25 percent). In examining the 30 percent who were successful, the commonalities included total family involvement in the estate plan, managing the family wealth as an enterprise, family mission statements that reflected the values of the individual family members and opportunities to practice skills important to building financial acumen. Many of these were and remain characterized as “soft” issues, but practitioners know they can be incredibly hard to address. With the demise of the estate tax for most clients and the aging population, addressing soft issues is critical not only for clients and their intended heirs but also for the financial success of many estate-planning practices. Soft issues remain a matter with which practitioners can assist clients, especially as the estate tax has become irrelevant for many.

As a society, we hardly seem able to talk about depression and mental health issues, the debilitating consequences of aging and chronic disease, family dysfunction and real diversity. Practitioners should integrate these considerations into most clients’ plans. Addressing these tough issues is what can personalize an estate plan for your clients. Clients and their children might choose different religions and lifestyles, be subject to difficult divorces, spend with abandon, have cognitive issues or develop major health issues. All of these client challenges present an opportunity for practitioners to provide guidance beyond saving clients’  estate or income taxes. The experienced advisor can be an advocate for addressing the human elements of estate planning with both compassion and realism. The future of estate planning will require taking this holistic view of assisting clients. With time and education, clients may come to see the value practitioners can offer in helping to steer through the many human considerations of estate planning.

Estate Planning for Real People 

The first question so many clients ask of an estate planner is, “What will it cost?” Estimating the cost for a simple plan might be easy. However, practitioners can go beyond offering their clients those simple plans. Consider discussing with clients the need to: tackle a budget and adjust their lifestyles accordingly with the financial resources they have on hand (especially to remain secure considering the potential for longevity); face the financial, physical, cognitive or other limitations they and their heirs have (which aren’t only limited to aging); and create a trust structure tailored to address concerns created by bipolar disorder, gambling or alcohol addiction or whatever else the clients’ circumstances might suggest is an important focus. Clients should be coached so that their first question becomes, “Can you help me and my family?” 

Team Approach 

Modern estate planning seeks to address a wide array of personal, financial, income tax, estate tax and asset protection goals in a flexible and robust manner. If a client’s planning documents are even a few years old, they may not incorporate many of these new concepts that estate planning has evolved to include. Modern estate planning recognizes the evolution of the American family. Modern estate planning tends to focus on long-term or perpetual trusts, directed trust structures, use of trust-friendly jurisdictions and more. So, regardless of the tax law changes, your clients’ planning may need an upgrade. Most trusts were created before many of the modern trust drafting techniques were feasible or known. Due to the multifaceted approach to modern estate planning, we highly recommend engagement by the client’s entire advisory team. This is important for estate planners in every discipline to understand. For example, while use of a non-grantor trust might provide income tax advantages, grantor trusts might remain vital to hold life insurance that’s part of the plan. So, involvement of the insurance consultant is important. The new types of non-grantor trusts, and there are several variants worthy of consideration, impact asset location decisions, so the client’s investment advisor must be involved. Many clients should take advantage of the current high temporary exemptions. But, those high exemptions require clients to shift larger portions of wealth than ever done before in history. Having a property insurance plan (for example, long-term care, personal excess liability) in place and financial forecasts to corroborate the reasonableness of the transfer require the client’s CPA and wealth advisor to provide input. Overall, collaboration has never been more critical to optimal planning.

Planning by Wealth Level 

While planning generalizations can be potentially misleading, it might help to consider how the approach for planning might differ based on clients’ wealth levels.

Ultra-high-net-worth (UHNW) clients. Most individuals with wealth that will last well beyond their lifetimes are planning aggressively. The last great chance to repeal the estate tax, in the view of many, failed with President Trump’s efforts that culminated in the Act. The current environment (no restrictions on valuation discounts, high exemptions) may just be the most advantageous the transfer tax environment will ever be. Some UHNW clients worry that a change in the administration in a future election could bring back many of the proposals President Obama put forth in his Greenbook. This provides opportunities for practitioners to discuss more robust planning with their UHNW clients. Practitioners should also caution their clients to fear the unknown. What might the 2020 election bring? Might the tax and other winds in Washington shift? It may not be worth the risk for clients to adopt a wait-and-see strategy, as many have done. Practitioners may need to discuss and implement planning now to help their clients shift wealth before that process becomes more costly and difficult. Considering the only constant in the estate, gift and transfer tax space lately has been change, be certain that the plans you craft and help clients implement incorporate as much flexibility as the clients and plans permit to be able to address future tax changes in Washington or your client’s domiciled state. 

Planning for clients at this level is always complex and risky (for example, balancing estate tax savings with the income tax savings of the loss of a potential basis adjustment on death all need to be considered in any planning implemented at this level). Educating clients so they understand both the benefits and the risks of the planning proposed will be essential before beginning implementation. But, most UHNW clients seem to believe that these negatives pale by comparison to the risk of doing nothing and waiting for Washington to change the tax rules. For example, the Estate of Powell v. Commissioner² partnership case in 2017 and the Estate of Cahill v. Comm’r³ split-dollar case in 2018 both were bad fact cases in which the Tax Court provided negative decisions for taxpayers. UHNW clients and practitioners should be concerned that additional negative decisions may erode the effectiveness of available estate-planning techniques, if not acted on with alacrity. But, how far the Internal Revenue Service or courts will interpret or apply the holdings in cases with fewer bad facts is uncertain.

Moderate wealth. The description of “moderate” wealth may now be a wide spectrum from $5 million to $40 million, given the new high exemptions. Those in these wealth ranges may benefit significantly from both the income and estate tax benefits of estate and non-grantor trust planning. The implementation of new types of trusts, and other opportunities created by the Act, might be able to save clients significant income taxes too. However, with these new options, planning has become more complicated than ever. Most moderate wealth clients seem to be under a misconception that with high exemptions, they don’t need to address planning further, but that will be a significant mistake for many. Clients will need to understand that complicated means costly too. Planning should contemplate using some of the high exemption amounts before they sunset in 2026 (or a new administration in Washington changes them). Because the new exemptions are so high, a greater percentage of clients’ wealth can potentially be transferred through planning than ever before, and practitioners should consider crafting flexibility into planning, so that clients can still benefit from assets transferred to irrevocable trusts (even if only indirectly). 

Practitioners should also consider whether clients would benefit from the income tax saving benefits of non-grantor trusts. Moderate wealth clients may need to achieve three conflicting planning objectives: (1) move assets out of their estates to lock in some of the high exemption before it’s reduced; (2) retain access to those assets because they represent a great percentage of their overall wealth; and (3) maximize income tax savings using a non-grantor trust. Practitioners can thread that planning needle for their clients, but it will require a customized approach and coordination with the other members of a client’s planning team (for example, his CPA or wealth advisor) to make these new breeds of trusts succeed. 

While planning at this wealth level can be the most complex, including the use of grantor spousal lifetime access trusts (SLATs) and domestic asset protection trusts, techniques that have been used in planning for years, may benefit the client. In addition, consider twists on these structures, such as SALTy (that is, state and local taxes)-SLATs or spousal lifetime access non-grantor trusts, which are non-grantor variations of the SLAT, and completed gift non-grantor trusts (a completed gift variant of the traditional incomplete gift non-grantor trust), among other techniques. These new types of trusts will require practitioners to develop new drafting approaches and create new forms or templates for their practices. The benefits practitioners can offer clients of moderate wealth, including greater income tax savings than in the past, additional flexibility to access funds if needed and the ability to use the temporarily doubled estate tax exclusion, should provide an incentive for clients to meet with their estate-planning practitioners to discuss options. Unfortunately, the reality in many cases is that clients below the UHNW level are merely tuning out planning as something that’s not necessary for them. This is why the CPA and wealth advisor’s role is so much more important to the estate-planning process than ever before. If they don’t educate clients as to the valuable new planning opportunities available, clients may never meet their estate-planning attorneys. 

Lower wealth. Even lower wealth clients need to address the fact that their existing planning documents may cause unintended consequences under the Act. Reviewing and possibly updating a client’s documents (for example, formula clauses, old trusts) to conform to the Act should be a priority. Lower wealth clients need education regarding the non-tax benefits of estate planning. Note that these two items—reviewing/updating documents and educating clients about the non-tax benefits of planning—are applicable at all wealth levels.

Too many clients with lower wealth are terminating old trusts without reviewing if there’s a reason to maintain them under the new tax regime. Often, terminating these trusts may not be the right move. A client might have an old insurance trust holding insurance bought to pay an estate tax that might have been owed when the exemption was $1 million, not $11.18 million. However, terminating a well-crafted existing trust and cashing in a life insurance policy that’s performing well may be the worst move for a client. For example, that policy might be a good ballast to the client’s stock portfolio or closely held business investments. The policy might be exchanged into a product that serves the client’s current needs better. It may be feasible to decant (merge) the old trust into a new and improved trust that can accomplish a range of goals. Discuss all of this with a client before decisions are made. Terminating an old trust might sound simple to clients, but practitioners will need to inform clients about the potential to transform old planning to meet current needs and goals before they take irreversible steps.     

Endnotes

1. Roy Williams and Vic Preisser, Preparing Heirs (San Francisco, Robert D. Reed Publishers, 2003).

2. Estate of Powell v. Commissioner of Internal Revenue, 148 T.C. No. 18 (2017).

3. Estate of Cahill v. Comm’r, T.C. Memo. 2018-84 (June 18, 2018).

For years, charities in the United States have promoted the so-called “individual retirement account charitable rollover” as well as the idea of leaving IRA assets to charity at death. The arguments in favor of these ways of giving are well known in the charitable community and among tax advisors. The devil, as is usually the case, is in the details.

IRA Charitable Rollover

The term “IRA rollover” is a misnomer when applied to charitable giving, but it’s taken hold. The technical term for this way to give is “qualified charitable distribution” (QCD). The Tax Code lays out the requirements for a QCD:

• The individual making the QCD must be at least 70½ years old at the time it’s made.

• The individual must make the QCD to a garden variety public charity such as a college, hospital, religious organization or an arts organization. Private foundations, supporting organizations and donor-advised funds may not receive QCDs.

• The individual may not receive anything of economic value in exchange for the QCD. The individual, however, may receive recognition for the QCD, and the individual and the donee organization may agree on the side that the QCD shall be used for a particular purpose.

• The individual must cause the assets comprising the QCD to flow directly from the IRA to the donee organization.

• The individual can use only a traditional IRA or Roth IRA to make a QCD. QCDs can’t be made from other kinds of retirement plans, such as an active Savings Incentive Match Plans for Employees IRA, Simplified Employee Pension IRA or an IRC Section 401(k) plan (401(k)). Although much has been written online and elsewhere about making a tax-free transfer from a 401(k) to an IRA, and then making a QCD from the IRA, I’m uneasy with this plan because of the step-transaction doctrine, given that the transfer from the 401(k) to the IRA has no independent economic purpose. 

• The individual is limited to making no more than $100,000 in QCDs during a calendar year. This rule doesn’t prohibit a married couple that files jointly from each giving up to $100,000 per year via QCDs.¹ 

That’s pretty straightforward, but there are a slew of questions about QCDs, many of which have no clear answers. For example:

When is a QCD deemed made for tax purposes? There are various fact patterns here. The simplest one: The IRA custodian mails a QCD check to the charity on Dec. 30. The check arrives at the charity on Jan. 2. Is this a December QCD or a January QCD? The Internal Revenue Service has provided no guidance on this question.² 

What’s the amount of the QCD? The typical fact pattern here is that the IRA custodian wires stock to the charity on Day 1, and the charity receives the stock on Day 2. This fact pattern presents two questions: (1) When is the QCD complete for tax purposes?; and (2) Which is the day to value the stock for purposes of determining the amount of the QCD? Again, the IRS has provided no guidance.

The timing question is especially important given that many individuals initiate QCD transfers at year’s end. Two fact patterns here are especially troubling.

The first involves the situation in which the IRA custodian cuts a check payable to the charity in late December and mails the check to the donor in late December.³ The donor subsequently mails the check to the charity, which receives the check in January. The question is, when is the QCD complete for tax purposes? When the IRA custodian mails the check to the donor? When the donor receives the check? When the donor mails the check to the charity? When the charity receives the check? I suspect it’s when the donor mails the check to the charity, but that’s just an educated guess. The IRS hasn’t said.

The second is when the donor has check-writing privileges on her IRA. In late December, she writes a check on the IRA made payable to the charity.⁴ Then, still in late December, the donor either mails or hand delivers the check to the charity. The charity doesn’t deposit the check, however, until January. The apparent question is, when is the QCD complete for tax purposes? Depending on the precise facts, this may be a real, burning question. The more fascinating question, though, is how will the IRA custodian report the QCD to the IRS?⁵ From the custodian’s perspective, the donor likely will have made a January QCD, because the QCD check will be presented for payment in January, and except for seeing the date on the check, the custodian will be in the dark as to all the other details of the QCD transaction, including when the donor hand-delivered or mailed the check.  

QCD Substantiation

Despite the fact no federal income tax charitable deduction is allowed for a QCD, IRS Publication 590-B provides with respect to QCDs:

[Y]ou must have the same type of acknowledgment of your contribution that you would need to claim a charitable deduction for a charitable contribution.

This means that for a QCD of $250 or more, the donor must have an acknowledgment (gift receipt) from the donee stating whether the donee provided any goods or services to the donor in consideration of the QCD.⁶

The quoted language from Publication 590-B suggests that the IRS views QCDs as being subject to the same date-of-gift rules as deductible charitable contributions. One of these rules is that a gift made via a check mailed to a charity is complete for tax purposes on the date of mailing, provided the check clears the donor’s bank in due course.⁷ If the distribution date for a QCD is determined by date-of-gift rules, it would be best for IRS to come right out and say so.

QCDs and Inherited IRAs

I’ll focus on inherited IRAs later, but at this point the question is, can a QCD be made from an inherited IRA?  

Inherited IRAs are subject to special Tax Code rules, but nothing in the Tax Code suggests that a QCD can’t be made from an inherited IRA, even though the party who’s a beneficiary of an inherited IRA isn’t considered the IRA owner (except for a surviving spouse who claims the inherited IRA as her own). The prevailing view, which I believe is correct, is that a QCD may be made from an inherited IRA. This view is bolstered by the fact that in the scant written guidance the IRS has provided on QCDs, it’s indicated that a QCD may be made from an inherited IRA, provided the IRA beneficiary is at least 70½ years old.⁸

Using a QCD to Pay a Pledge

The IRS has taken the position that a QCD may be used to pay any pledge, even an enforceable one.⁹ In taking this position on enforceable pledges, the IRS has ignored Revenue Ruling 81-110. In that ruling, which has precedential value and hasn’t been revoked, Party B paid Party A’s enforceable pledge to charity. The IRS ruled that Party B thereby made a gift to Party A for federal gift tax purposes and that Party A was entitled to the federal income tax charitable deduction for Party B’s payment. What underlies the ruling is the IRS’ ability to reconfigure transactions according to their substance; that is, the IRS isn’t bound by the form of a transaction.

If the principles of Rev. Rul. 81-110 were applied to the use of a QCD to pay an enforceable pledge, the QCD would be deemed to be a taxable distribution to the donor, and the donor, with the correct form of acknowledgment from the charity, could claim a federal income tax charitable deduction for the money paid to the charity.

This whole matter is important, given the wide variability among state laws on what makes a pledge enforceable. As just one example, an appellate court in New Jersey has held that a mere spoken promise to make a charitable gift is enforceable, notwithstanding lack of consideration for the promise.¹⁰

QCDs and State Income Tax Laws

One might think the states would follow the federal government in not subjecting the donor to income tax on a QCD. To my knowledge, all the states except one follow the federal government this way.

The lone exception is New Jersey. Its department of taxation says a QCD is reportable as income by the donor for New Jersey income tax purposes.¹¹ 

IRA Custodian Handling of QCDs

Despite the fact that the QCD made its appearance in 2006, some IRA custodians still haven’t gotten the message.

A remarkable actual example involved an individual who, in late 2017, instructed his IRA custodian to make a QCD. The custodian made the check payable to the individual and mailed it to him. The individual subsequently asked a gift officer if he could endorse the check over to the gift officer’s organization and treat the check as a QCD.  

The answer was, of course, no. The check, having been made payable to the individual, couldn’t qualify as a QCD, because the endorsement over to the charity would constitute a gift from the individual, not a distribution from his IRA directly to the charity.¹² 

A bad practice mentioned above, to which some IRA custodians adhere, is that of sending the QCD check (made payable to the charitable donee) to the donor and leaving it up to the donor to get the QCD check to the donee organization. Even though the IRS has said it’s acceptable, the practice introduces into the QCD process both uncertainty as to the date of the QCD and delay.

There’s no good reason for an IRA custodian not to mail the QCD check directly to the donee organization. My instincts tell me IRA custodians do this out of a fear of some law, perhaps the Patriot Act. But, if that’s the concern, sending the QCD check to the donor isn’t going to help. The donor is being used as a courier (agent) by the IRA custodian, and therefore the donor doesn’t shield the custodian from whatever the custodian fears.

Some IRA custodians wire the QCD to the donee. This is an excellent practice. 

IRA Assets Left to Charity at Death

Unlike the QCD, as to which there’s a specific Tax Code provision, the leaving of IRA assets to charity at death has to be analyzed using various provisions of the law.  The starting point in the analysis is IRC Section 408, which contains the definition of an IRA.

IRAs are widely regarded as mere custodial arrangements. An IRA is in fact a trust for federal tax purposes.¹³ The custodian of an IRA is the trustee of the trust.¹⁴ These facts are critically important. They mean that IRA custodians are subject not only to federal tax law requirements but also to common law fiduciary duties.¹⁵ These duties typically include those of loyalty, obedience, diligence, impartiality and care. These duties are owed not only to the individual who created the IRA but also to the beneficiaries of the IRA. In many if not all states, a deliberate breach of fiduciary duties can lead to both compensatory and punitive damage awards.¹⁶

We’ll return to these fiduciary duties and what they mean for charities that are named IRA beneficiaries, but first we need to look at how charity beneficiaries are routinely treated by IRA custodians.

Problems Faced by Charities 

Charities have faced problems in receiving IRA beneficiary distributions. By definition, an IRA beneficiary is a person (individual, charity, etc.) designated to receive IRA assets on the death of the IRA owner.¹⁷ 

Under Treasury Regulations Section 1.401(a)(9)-4, however, only an individual can be a “designated beneficiary.” Some forms that IRA custodians require charity IRA beneficiaries to complete treat the charity as a “designated beneficiary,” which is flat-out wrong.

Also by definition, the IRA owner is either: (1) the individual who established the IRA, or (2) the surviving spouse of such individual, provided the spouse has taken the steps necessary to become owner.¹⁸ These definitions are important to understanding the situation of a charity that finds it’s been named an IRA beneficiary.  

One aspect of this situation is that a charity can never be the owner of an IRA. A charity can set up an inherited IRA. But such an IRA, which can receive a trustee-to-trustee distribution from the deceased donor’s IRA, must be set up in the name of the decedent, who’s still considered the IRA owner.¹⁹ 

So, there’s no point in a charitable beneficiary’s setting up such an IRA; nothing is gained.

In sum, a charity can’t set up an IRA in its own name, either as IRA owner or as an IRA beneficiary. Yet, IRA custodians routinely demand that charities named as IRA beneficiaries do just that, establish an IRA in the charity’s name.

A risk is that a distribution from the decedent’s IRA to such a faux IRA will be subject to federal and state income tax.

Three Real-Life Examples

Charities named as IRA beneficiaries have faced various obstacles in trying to obtain IRA assets. Here are three real-life examples:

Example 1: A donor dies owning an IRA that names a charity as the sole IRA beneficiary. The IRA custodian, a Midwestern financial institution, makes a distribution to the charity but withholds and remits to the IRS 10 percent of the gross distribution, informing the charity that the withholding is mandatory.

In fact, withholding isn’t required, and the charity is wrongfully and needlessly forced to seek a refund from IRS.²⁰ 

Example 2: A donor dies owning an IRA that names a charity as the sole IRA beneficiary. The IRA custodian, a Southwestern financial institution, informs the charity that it will have to set up an inherited IRA account to get its IRA distribution. The inherited IRA will be in the donor’s name but bear the charity’s tax ID number.²¹ The explanation for this requirement is that this procedure is needed to avoid having federal income tax imposed on the distribution.

The explanation is nonsensical. A distribution directly to the charity would be free of income tax because of the charity’s tax-exempt status. Furthermore, putting the charity’s tax ID number on the IRA is equivalent to stating that the charity is the IRA owner, which, as we’ve seen, is impossible.

Example 3: A donor dies owning an IRA that names the charity as the sole IRA beneficiary. The IRA custodian, a large East Coast financial institution, informs the charity that it must set up a “dummy account” with the custodian. It further informs the charity that to establish the account, the charity will have to provide its business officer’s Social Security number and a copy of the business officer’s driver’s license. The custodian’s customer relations representative informs the charity’s gift officer and the charity’s lawyer that the IRA distribution will be made to the “dummy account,” which the charity can promptly drain and collapse.

All of this is unnecessary and, as we’ll see, breaches the custodian’s fiduciary duties.

I could go on and on with other such real-life examples of which I have first- or second-hand knowledge, but there’s an important point that needs to be drawn from these three examples: There’s no uniformity among IRA custodians as to why they don’t simply make distributions directly and without tax withholdings to charity IRA beneficiaries. (To be fair, some IRA custodians do distribute directly to the charity and don’t withhold, which further adds to the lack of uniformity.)

This lack of uniformity tells me something’s going on, and it isn’t application of the law, because the law imposes uniformity. What’s going on, I believe, is that IRA custodians have well-established procedures for making beneficiary distributions to individuals, trusts and estates, but largely, they haven’t developed any procedures for handling charitable beneficiary distributions. This has led to uninformed decision making on how to handle such distributions. That’s what’s caused lack of uniformity.

The Patriot Act

Is the Patriot Act a problem for charity IRA beneficiaries? The answer is both no and yes. It’s no because the Patriot Act isn’t aimed at the typical charity that faces the sort of obstacles just described. Such a charity is a benign, domestic, garden variety IRC Section 501(c)(3) organization such as a college or university, hospital, church or synagogue or museum, which is simply a trust beneficiary.   

But it’s also yes, because if the IRA custodian can get such a charity to set up some kind of account, it can point to Section 326 of the Patriot Act (the “know your customer” section) and say that the Patriot Act requires it to do due diligence as to the identity of its customer.  The IRA custodian account rep typically calls such an account a “beneficiary IRA” or an “inheritor IRA.” That term may sound impressive. The problem is that the so-called beneficiary IRA purportedly will be owned by the charitable beneficiary. As discussed above, a charity can never be the owner of an IRA, so the whole idea of a beneficiary IRA is invalid.

At least one financial institution has decided that a charity named as beneficiary of an IRA is a “customer” that’s setting up an account for purposes of Section 326 of the Patriot Act, which supposedly brings into play the Section 326 “know your customer” requirement.  

A charity named as beneficiary of an IRA isn’t a customer of the IRA custodian, merely being an IRA beneficiary, and it’s not setting up an account, merely being an IRA beneficiary. The charity is simply a trust beneficiary.

I understand that financial institutions want to avoid Patriot Act violations. But, in forcing clearly benign U.S. charities to go through unnecessary Patriot Act vetting to receive their IRA beneficiary distributions, financial institutions are behaving badly. The cost to U.S. charities across the board is tremendous and needless.

A Strategy for Charities

Charities are far from united in their response to financial institutions that erect the sort of obstacles I’ve described. Some charities know how to fight back and do fight. They often win their fights. These are a tiny minority of the charitable community. Most charities cave in some way, because they don’t know what else to do, and they want the money.

Here’s a strategy that I’ve found works in some situations. The first step for a gift officer is to grasp that the individual who’s presenting obstacles is a customer relations person who’s typically of low rank in the financial institution. This individual will be articulate and well-trained in presenting the particular obstacles and won’t be trained in the law. The gift officer will make no headway with this individual, who’s been trained not to give an inch and to follow institutional policies, forms and procedures to the letter.

The gift officer needs help. The help needed only can come from someone trained in the law who grasps the situation fully. This someone is a lawyer.

The lawyer’s job is to work his way up the food chain in the financial institution. The way to cut to the chase is to get to the financial institution’s general counsel.

Lawyers like to deal with other lawyers. That’s a little over broad, perhaps, but it’s true more often than not.  This means the general counsel may be willing to speak with the charity’s lawyer.

The general counsel will usually be unaware of the issue or problem. He has other fish to fry. Furthermore, he typically regards IRA distribution matters to be policy or accounting matters, not legal matters.

Here’s when knowing that an IRA is a trust and that the financial institution is the trustee of the trust comes into play. The general counsel typically will perk up on hearing that an IRA is a trust and that the financial institution is the trustee of the trust. He may really perk up on hearing that the financial institution is breaching or is about to breach its fiduciary duties. That’s not something the general counsel will want laid in front of a judge or a bank regulator. The general counsel, who has plenty of other headaches, will want this problem to go away. The general counsel has the power to make it go away.

There’s Really No Tax Problem

In two of the three real-life examples presented above, the IRA custodian was fussing about federal income tax on a charity’s IRA beneficiary distribution. IRS Forms 1099-R and W-4P make absolutely clear that such fussing is needless and pointless, not just annoying and harmful to the charitable beneficiary.²²

Form 1099-R is the basic information form for all pension, IRA and annuity distributions. In the case of an IRA beneficiary distribution to a charity, the “Payer” on the form is the IRA custodian, not the decedent’s IRA. Correspondingly, the custodian’s tax ID number goes in the box labeled “PAYER’S federal identification number.”  The charity’s tax ID number goes in the box labeled “RECIPIENT’S federal identification number.”  

Thus, Form 1099-R doesn’t refer to or identify the deceased donor or his IRA. This fact is important, because it makes clear that the distribution to charity gives the IRS no cause whatsoever to look either at the IRA or at the donor’s estate. All that’s reported to the IRS on a properly completed Form 1099-R is that the custodian made a distribution to a tax-exempt organization.

Box 2A of Form 1099-R asks for the taxable amount of the distribution. In the case of a charitable IRA beneficiary distribution, this box should either: (1) be left blank, or (2) contain a “0.” If Box 2A is left blank, Box 2B should be checked “Taxable amount not determined.” The instructions to Form 1099-R provide that an IRA custodian isn’t required to determine the taxable amount of an IRA distribution. From the 1099-R instructions regarding Box 2B: “Except for IRAs, make every effort to compute the taxable amount.”

It’s true that the instructions to Form 1099-R do require 10 percent withholding on nonperiodic IRA distributions, but one needs to read the fine print. First, the 10 percent withholding rule applies only to taxable distributions. An IRA beneficiary distribution to a charity is non-taxable. Second, even the recipient of a taxable IRA distribution can elect on Form W-4P not to have any federal income tax withheld on the distribution.

This means the Midwestern financial institution that “mandatorily” withheld 10 percent of the charity’s IRA beneficiary distribution in real-life Example 1 did so improperly, thereby breaching its fiduciary duties to the charity. The charity has a cause of action against the financial institution.

In real-life Example 2, in which a Southwestern financial institution is requiring the charity to set up a bizarre account to get its IRA beneficiary distribution without triggering income tax, the charity’s lawyer should send a letter to the institution’s general counsel, pointing out the misplaced tax concern and the fiduciary duties being breached.

Need for Change in Law 

It certainly wouldn’t hurt for the law to be changed, and it could help a great deal for Congress to serve up a law requiring financial institutions to make IRA beneficiary distributions to charities the way they should.

Even without such legislation, however, charities have currently all the law they need to fight successfully for what’s rightfully theirs. The key word, unfortunately, is “fight.”

What’s needed right now is leadership from and unity within the charitable community so that individual charities don’t have to fight in isolation.

If a change in the law is to occur, I’d lean toward an IRS pronouncement, even a private letter ruling, rather than a Congressional enactment, for two reasons: (1) the IRS knows more about IRAs than Congress as a whole does; and (2) IRS pronouncements always come with a club, express or implied. A piece of legislation, on the other hand, is not self-executing and may lack an effective enforcement mechanism.              

Endnotes

1. As to the $100,000 allowance per spouse, see Internal Revenue Service Pub. 590-B.

2. IRS guidance on qualified charitable distributions (QCDs) is scant, because the QCD provisions of the tax law weren’t made permanent until the Protecting Americans from Tax Hikes Act of December 2015.

3. This approach to making the QCD was approved in IRS Notice 2007-7, Q-41 and A-41.

4. The IRS hasn’t spoken to whether a QCD can be made by writing a check, made payable to a qualified charity, on an individual retirement account. This approach to making a QCD should work, however, because it causes a distribution to be made directly from the IRA to the charity.

5. The IRA custodian will report the QCD on IRS Form 1099-R. The question, however, which is one of both fact and law, is whether the 1099-R will reflect a December distribution or a January distribution.

6. Internal Revenue Code Section 170(f)(8)(B)(ii).

7. Treasury Regulations Section 1.170A-1(b).

8. Notice 2007-7, Q-37 and A-37.

9. See ibid., Q-44 and A-44. The IRS’ position as to allowing QCDs to be used to pay any pledge is based on the Department of Labor’s (DOL) interpretation of IRC Section 4975(d)(9), as to which the DOL has interpretive jurisdiction. The DOL has informed the IRS that the DOL considers the QCD to be received by the individual who’s caused the QCD to be made.

10. Jewish Federation of Central New Jersey v. Barondess, 234 N.J. Super 526 (1989). 

11. See NJ-1040, the New Jersey income tax form, and related instructions as to IRA withdrawals (NJ-1040, line 19b). 

12. The endorsement by the donor and delivery of the check to charity constitute a negotiation of the check, which is a change of ownership of the check from ownership by donor to ownership by charity. This is a gift from donor to charity.

13. IRC Section 408(a).

14. Section 408(a)(2).

15. IRA custodians that are banks have fiduciary duties by virtue of being banks. Non-bank IRA custodians are required to demonstrate fiduciary ability to the IRS under Treas. Regs. Section 1.408-2(e)(2).

16. Restatement (Second) of Torts Section 874, Comment b and Section 901, Comment c.

17. IRS Pub. 590-B.

18. Ibid.

19. Ibid.

20. An election not to have income tax withheld from an IRA distribution is available to any IRA beneficiary on line 1 of Form W-4P.

21. IRS Pub. 590-B provides that an inherited IRA is established in the deceased owner’s name. Accordingly, an inherited IRA must bear the deceased owner’s tax ID number.

22. www.irs.gov/pub/irs-pdf/f1099r.pdf. 

The 2017 Tax Cuts and Jobs Act (the Act) dramatically changed trust planning. But many of those provisions sunset, and it’s possible that a new administration may yet again change the rules. It’s obvious to estate planners that trusts should incorporate more flexibility to deal with tax uncertainty. For example, flexibility in changing the income tax status of a trust might be important. However, while tax-focused planning is seductive to tax practitioners, there’s so much more to consider with respect to designing trusts that can adapt to change. 

If you were creating a trust 100 years ago, what would have been on your mind? World War I had just ended. Automobiles were becoming more common. There were no commercial airplanes. Babe Ruth was a pitcher for Boston. Women didn’t have the right to vote. Divorce was very rare. Adopted children didn’t have a right to inherit from grandparents. Children born outside of marriage were scorned and had no inheritance rights. 

Consider the rapid pace of changes in social norms, technology and the law over just the past decade, let alone the past century, in terms of topics such as same-sex marriage, gender identity, assisted reproductive technologies, digital assets and cryptocurrencies. And of course, the tax landscape is always changing.

The process in which we do estate planning hasn’t changed at near this pace. Too often, the manner in which practitioners endeavor to help families plan is mired in our past ways of doing things rather than thinking ahead and planning for the next 100 years. With the trend toward longer lasting (even perpetual) trusts, most trusts are being designed to contemplate that they’ll still exist in hundreds of years, if not longer, if the assets aren’t fully depleted sooner.

With this in mind, we’re in the chorus of those singing about the need to draft trusts for flexibility. Let’s consider 14 recommendations for creating a fully flexible “Gumby” trust (name based on the green, clay, animated character of yore) that can change with the times.

Continue Sophisticated Planning 

For many wealthy clients, there may be little need in today’s environment for estate tax planning. But, given the frequent changes, estate planners consider continuing to integrate estate and generation-skipping transfer (GST) tax planning into new instruments. While it’s impossible to anticipate future changes, having more flexibility should the exemption be reduced or the estate grow is advisable. The most flexible estate plan incorporates almost all of the possible trusts that should be created at the first spouse’s passing: 

1. Bequeath property up to the decedent’s available GST tax and federal exemption into a family trust, or fund the family trust with a lesser amount if full funding would incur state estate tax, for basis step-up or if, for other reasons, such as protection of the surviving spouse, it’s decided that it would be better to underfund the family trust. In some cases, practitioners might prefer that all assets pass to a qualified terminable interest property (QTIP) trust for full basis step-up on the death of the second spouse but that precludes the flexibility of a credit shelter trust (CST) with spray provisions, which can provide personal, economic and income tax benefits.

2. Bequeath the non-qualified property that’s included in the decedent’s estate for federal estate tax purposes to the GST family trust, but only to the extent that the value of this property as finally determined for federal estate tax purposes doesn’t exceed the available GST exemption amount. Give any remaining non-qualified property to the trustee to hold in the family trust.

3. Give the state exempt gift to the GST family trust, and hold the non-GST state exempt gift portion in the family trust.

(a) Bequeath the excess federal exemption gift to the GST-exempt trust.

(b) Bequeath the residue gift to the GST marital trust, and hold the non-GST residue gift portion in the non-exempt marital trust.  

This can be accomplished by drafting carefully to use a combination of disclaimer planning and Clayton QTIP elections. But, it can be complicated. While most clients abhor complexity, flexibility should really be the objective. Even so-called “simple” trusts require a team of professional advisors to administer them properly. No client would refuse to see a specialist recommended by her internist, and there’s similarly no reason clients should logically not permit a team approach to provide proper estate planning and trust administration. 

As an alternative, some find it easier to use a bequest that says: “I give the balance of the trust estate to the trustee to hold as the marital trust.” And, you can. 

Consider Single Fund QTIP

Instead of always using a marital deduction formula, consider the single fund QTIP trust with permission for disclaimer and Clayton elections as the estate tax formula of choice, essentially delaying the decision on the funding amounts for each trust (state exempt trust, federal exemption trust, marital trust and portability considerations) until the first spouse passes away.

You can make decisions on portability, the use of a CST and deferral of state inheritance tax at a later date.

Exercise caution with some of the new fangled provisions that add flexibility to be certain that they don’t disqualify the trust intended to qualify for the marital deduction. For example, if a trust protector can add beneficiaries, that may result in an argument that the spouse isn’t the sole beneficiary during the spouse’s lifetime unless the instrument is clear that no party can amend a trust that’s electing QTIP treatment to add beneficiaries to that trust. While a trust protector likely should be used in most instruments, be wary of standard provisions without considering the above possible implications. 

Avoid Gendered Pronouns

At the turn of this century, same-sex spouses were unthinkable by many, and yet now they’re legal in the United States and many other countries. In the future, what will be permissible? Plural marriage? Other arrangements? To keep documents flexible in tone, avoid terminology like “husband” and “wife” or any other gendered nomenclature in drafting. Consider using just “spouse.” Evolving social trends is another important reason to include trust protector and decanting provisions in the trust instrument as well as a change of situs mechanism. If the old language doesn’t suffice, amending or decanting into a new instrument (and perhaps moving to a state with more favorable law before doing so) can provide the flexibility to modernize the trust as necessary.  

Use Broad POAs

Consider broader powers of appointment (POAs), for example to anyone other than creditors, the estate, self or creditors of the estate. But, as with so many suggestions for flexibility, planning must be tailored or granular to the particular client. Some client circumstances will be best served by a very broad special POA, while others require more limited POAs. But, the incorporation of POAs into documents has and will continue to grow in importance as a tool to add flexibility to plans. However, the growing use of powers demands that estate planners encourage clients to come back for periodic reviews (annually being ideal) to go over and fine tune the implications of powers and other concerns. 

The most flexible option is for the trust instrument to provide both lifetime (other than for a QTIP marital trust) and testamentary broad limited POAs. To maximize privacy and flexibility, drafters should be wary of creating a testamentary POA that can be exercised only by will. Instead, it’s prudent to allow the power to be exercised by any instrument that specifically references the POA and is delivered to the trustee of the irrevocable trust over which the POAs are being exercised.¹

Consider Trust Protectors 

Some practitioners remain uncomfortable enabling trust protectors to amend trusts. Those fears should have long since passed, and permitting a trust protector to make changes to trusts has become the norm. Also, different people/positions may be provided for in addition to a trust protector to enhance flexibility (for example, a power to loan trust assets to the grantor or to add a charitable beneficiary). Note that it isn’t necessary to name a trust protector in the instrument if there isn’t an obvious candidate, and you don’t want to involve a third party in the trust initially. But at a minimum, the trust could permit someone to be appointed who can make amendments to the trust.

If the trust protector will be empowered to add or remove individual beneficiaries, then it’s preferable to frame that instead as a “special power holder” and grant to that individual a special POA that permits changing beneficiaries or appointing the trust into a new trust with different terms. If the trust protector is designated as (or might be interpreted by a court or applicable state law as) acting in a fiduciary capacity, then a separate person who can act in a non-fiduciary capacity, and not the protector, may be better to hold powers to change beneficiaries. If a trust protector is acting in a fiduciary capacity, can she add or change beneficiaries to whom she owes a fiduciary duty?

The courts and law have viewed revocable trusts as a will substitute and, as such, have struggled to find remedies when elder abuse or other issues are perpetrated by a trustee during the settlor’s lifetime. Consider adding trust protectors for revocable trusts as checks and balances on the trustees. This can be an important safeguard with aging clients. 

Consider protections in all trusts along with express decanting powers, special limited POAs or broader trust protector provisions. Give thought as to who should hold these powers, the status of the position that’s granted each power and the impact on the overall plan.

Consider Power to Substitute Assets

Consider including the power to substitute assets. This power becomes especially important as the estate tax exemption increases and income tax planning becomes more relevant for step-up in basis purposes. In many settings, a grantor of a grantor trust may want to substitute high basis assets for low basis assets, and the substitution power is one way this can be achieved (a purchase agreement is another). These benefits are also why the view that non-grantor trusts are the new default planning tool can be inadvisable. For ultra-high-net worth clients, it may be preferable that certain of their assets be held in grantor trusts for basis step-up purposes via the swap power and other assets be distributed to non-grantor trusts that don’t need the possible benefits of the swap power. 

Name Charitable Beneficiaries

Consider granting someone the power to add charitable beneficiaries in grantor irrevocable trusts. This power should characterize the trust as a grantor trust. It may reduce amounts going to beneficiaries,² thereby providing a disincentive for beneficiaries to challenge trustee actions. Use caution in deciding how this power or similar or related powers are used. 

Given the post-Act increase in the standard deduction, it can be advantageous for many clients to structure non-grantor trusts with charitable beneficiaries so that they can use the Internal Revenue Code Section 642(c) deductions to claim a 100 percent deduction of donations, whereas the same settlors might have realized no deduction had the donations been made personally because of the doubled standard deduction. This must be distinguished from giving a power to add charitable beneficiaries, which would characterize the trust involved as grantor for income tax purposes, thereby defeating the hoped-for income tax benefits.

In all events, the flexibility to add or give to charity in irrevocable trusts can provide further flexibility to irrevocable trust plans.

Grantor Trust Status Turnoff

Consider the flexibility of providing a mechanism so that grantor trust status can be turned off. There are a number of ways to accomplish this. The settlor should have the power to renounce a grantor trust power. A spouse acting as trustee could have the power to resign. And, a trust protector should have the power to amend the trust both to add or remove grantor trust powers. Finally, in most states, there should be a provision permitting the trustee to reimburse a grantor for taxes paid.

The IRS permits reimbursement for taxes and won’t include the amount of the trust in the settlor’s taxable gross estate as long as the payment isn’t: (1) forbidden by state law, (2) subject to a pattern of abuse that suggests an agreement to reimburse, or (3) mandatory. In Revenue Ruling 2004-64, the Internal Revenue Service addressed this issue and determined that there would be no inclusion in the gross estate for federal estate tax purposes if the trustee has discretionary authority, under the instrument or applicable local law, to reimburse the grantor for the income tax liability. There must not be any facts indicating control by the grantor, such as pre-existing arrangements, powers to name the grantor as trustee or local law subjecting the trust assets to the claims of the grantor’s creditors. On the other hand, if the trust’s governing instrument were to require a mandatory payment for the income tax liability, this would trigger inclusion in the grantor’s taxable gross estate under IRC Section 2036(a)(1).

Trust Conversion

Closely related to the power to turn off grantor trust status above is the flexibility to transform a grantor trust into a non-grantor trust and vice versa. But, be cautious of possible adverse income tax implications (for example, converting a grantor trust into a non-grantor trust while the trust holds a note resulting from a note sale transaction). Income tax status planning and allocation of taxation to different parties under trusts will continue to be critical going forward. Third parties, perhaps special power holders (not trustees because fiduciary capacity may inhibit or prevent the exercise of certain powers) need to have the power to convert from grantor to non-grantor trust and back again.

This can be accomplished in a variety of ways. In certain jurisdictions, merely having the decanting power will facilitate going from non-grantor trust status to grantor trust status. For example, this approach is arguably allowed in Illinois by decanting to a trust in which the original grantor has grantor trust powers. Also, consider potential legal liability from a conversion. If a grantor trust is decanted into a non-grantor trust, might the beneficiaries sue the trustee effectuating the decanting for creating a cost to the trust or beneficiaries that had theretofore been borne by the settlor?

Allow for Change of Situs

It may be beneficial to change trust situs to a more favorable jurisdiction for state income tax and creditor protection purposes. Include both change of situs and trustee designation provisions in the documents, and discuss the benefits to clients at a follow up estate-planning meeting.

Provide Creditor Protection 

Lawsuits are becoming more plentiful, especially plaintiff actions. People are greedy, lawyers are creative, life is more complicated and people are getting more entitled. All variables to increase the abundance of lawsuits. 

Most clients, certainly those educated on possible options, want to establish trusts for creditor protection purpose. Consider several mechanisms to enhance creditor protection and thereby infuse more flexibility into the trust, for example: (1) beneficiary trustees should be able to renounce their trusteeship, and (2) trusts should provide for the appointment of independent and even institutional successor trustees, change in situs and governing law and discretionary distributions only by independent trustees.

Give Each Generation a POA 

Make sure each generation has a testamentary POA, broader than just to descendants. Consider adding trust protectors to allow change in the terms of trusts. Clients should meet regularly with an advisor team to address these issues. Further, at some point in that periodic review meeting process, the next generation should be brought in to the extent appropriate so the planning, including use of powers, can be monitored and used as appropriate.

Expand Definition of “Child”

Considering all the forms of assisted reproductive technologies like artificial insemination, in vitro fertilization and surrogacy, genetic manipulation and designer babies are likely to increase. Family definition provisions regarded as state of the art a decade ago are already outdated. Endeavor to use definitions of “child” or “descendant” that are broader. 

Allow Beneficiaries to Move Abroad

The world is becoming a much smaller place. Will our clients’ descendants continue to be U.S. citizens? Is their security in place? What kind of food considerations will be more relevant in the future? All things considered, we in the United States are doing quite well, but what will the United States be like in 50 years? Consider distribution of funds to allow beneficiaries to move to jurisdictions outside of the United States or to allow distributions for security measures for beneficiaries.  

Endnotes

1. See Private Letter Rulings 9352017 (Dec. 30, 1993) and 9239015 (Sept. 25, 1992).

2. Internal Revenue Code Section 672(b).

—This article is based on the outline created by Louis S. Harrison for the T&E Advisory Panel at the 2018 Notre Dame Tax and Estate Planning Institute in South Bend, Ind.

In the first installment of this series, I introduced a model, “The Path of Most Resistance,” which illustrates why a good estate-planning result is so hard to achieve. In the next installment, I discussed three psychological phenomena that one can witness in estate planning. In this final installment, I discuss death anxiety, the issue of mortality salience (reminders about death)¹ and common fears that clients face in estate planning. I’ll conclude this installment by introducing estate planners to two tools that can assist them in the human side of estate planning: motivational interviewing (MI) and appreciative inquiry (AI).

Death Anxiety

“Death anxiety” is defined as:

 . . . a complex phenomenon that represents the blend of many different thought processes and emotions: the dread of death, the horror of physical and mental deterioration, the essential feeling of aloneness, the ultimate experience of separation anxiety, sadness about the eventual loss of self, and extremes of anger and despair about a situation over which we have no control.² 

     These fears can cause people to act differently, even irrationally, from how they typically would under different circumstances. These actions often lead to conflict because the survivors joust for a piece of the decedent’s property, persona or symbolism, which people seek to assuage their fears and comfort themselves for their loss. Psychologists posit that all humans develop an innate ongoing existential fear of death from a relatively early age.³

Psychiatrists have determined that there are at least seven reasons why people have death anxiety:⁴

1. No more life experiences.

2. Fear of what will happen to their bodies post-death.

3. Uncertainty as to fate if there’s life after death.

4. Inability to care for their dependents.

5. Grief caused to relatives and friends.

6. All their plans and projects will come to an end.

7. The process of dying will be painful.

There are at least three defenses that individuals commonly employ to withstand death anxiety:

1. Avoidance of talk about mortality and other reminders of mortality (called “mortality salience”).

2. Minimization of mortality through jokes about death and feeling that the concern about mortality isn’t pressing enough for action at the moment.

3. A desire for symbolic immortality, which is a form of autobiographical heroism, in which individuals take actions that solidify and perpetuate causes and provide for those who are important to them.⁵

Mortality Salience

Estate planning causes people to face their own mortality. Mortality salience plays a role in estate planning by often causing people to put off their estate planning for another day, despite its apparent glaring need in particular situations. According to the research of Dr. Russell N. James III, the forms of avoidance of mortality salience are:

• Distraction: “I’m too busy to worry about that right now.”

• Differentiation: “It doesn’t apply to me because I come from a family of actuarial longevity.”

• Denial: “These death worries are overstated.”

• Delay: “I plan on worrying about death…later.”

• Departure: “I’m going to stay away from death reminders.”⁶

According to the research, mortality salience causes increases in the following:

1. Desire for fame.

2. Perception of one’s past significance.

3. Likelihood of describing positive improvements in writing an autobiographical essay.

4. Interest in naming a star after one’s self.

5. Perceived accuracy of a positive personality profile of one’s self.⁷

According to Dr. James and his research, mortality salience results in a greater attachment to and support of one’s community’s values over an outsider’s values. This includes an increase in:

1. Charitable contributions by U.S. donors to U.S. charities over foreign charities.

2. A predicted number of local NFL team wins.

3. Negative ratings by Americans of anti-U.S. essays.⁸

According to Dr. James, external realities occasionally break through avoidance of mortality salience, including illness, injury, advancing age, death of a close friend or family member, travel plans and intentionally planning for one’s death through estate planning, which cause people to tend to their estate planning. However, these external realities are unpredictable and sporadic.⁹ But, the issue of procrastination and avoidance in estate planning is far more complex than just avoidance of mortality salience.

Fears of Estate Planning

People have at least 12 fears about estate planning, of which death anxiety is but one. They fear:¹⁰

1. Contemplating death (death anxiety).

2. Not doing the right thing.

3. The unknown.

4. Hurting someone’s feelings/creating animosity/post-death squabbles.

5. Estate planners.

6.  The estate-planning process.

7. Running out of money/losing security.

8. Changes in the law.

9. Facing reality.

10. Loss of flexibility.

11. Loss of privacy.

12. Probate.

Most of these fears are irrational and can be safely and properly addressed in a well-confected estate plan. Estate planning has therapeutic and anti-therapeutic consequences, the latter of which the estate planner must identify and work to ameliorate.¹¹ Estate planning, once done and finalized, is known to reduce death anxiety, for example, recall Ishmael from Moby-Dick about his will signing.¹²

Effects of Death Anxiety

Death of a loved one or a friend conjures up two fears in most of us: 1) the loss of a source of safety and security; and 2) a fear of our own mortality.

This often causes a split in the ego,¹³ as people trick themselves through a cognitive distortion¹⁴ into thinking that their own death isn’t something that they need be concerned about at present. This typically results in repression of thoughts of death, as they’re simply too painful to be allowed into a person’s consciousness. The splitting of the ego can lead to depression and other forms of psychosis as well as the loss of internal object ties.¹⁵ 

Here are two examples of cognitive distortions: 

• People often compare themselves to individuals who are known to have abused their bodies, for example, Keith Richards, and say that if he can live that long after having done what he did, they’ll survive too until at least his age or older.

• Older persons, whose death is more imminent, focus on medical research or make deals with themselves to get healthier, and, by so doing, think they’ll live longer.

One potential consequence of death anxiety is the deterioration of the testator’s decision-making capabilities. The fear forces people into making short-sighted or ill-advised decisions that will have a lasting impact on their loved ones. Fear of making these types of bad decisions also flows out of death anxiety, as people are reluctant to act on their estate planning for fear that they’ll make a bad decision. People often cope with death anxiety by making difficult decisions quickly, thereby abbreviating the stressful experience.¹⁶ These swift decisions often are bad ones.

This oft-truncated decision-making process usually involves an erratic method of selecting information for consideration, an inadequate amount of time spent considering that information and evaluating alternatives and a lack of willingness to re-evaluate after the decision is made. Getting it done is more important than how or what was done.¹⁷ 

Humans are the only species who know cognitively that life is finite and that we’re mortal. However, that cognitive knowledge, combined with the desire to procreate and survive, create what Mario Mikulincer, Victor Florian and Gilad Hirschberger call “an irresolvable existential paradox.”¹⁸ A human’s survival mode causes him to put off thoughts of his own demise because survival is the goal, despite clear signs of eventual mortality. Hundreds of studies have proven that when confronted with mortality salience, humans adhere even more passionately to their view of the world.¹⁹ Humans resort to lots of methods to avoid the fear brought on by mortality salience, including religion, work, relationships, exercise and wealth accumulation.  

Terror management theory²⁰ (inspired by the work of Ernest Becker²¹ and Otto Rank) instructs that humans grasp for any kind of immortality to cope with mortality salience, including symbolic immortality. Symbolic immortality includes our belief in an afterlife, our descendants, our favorite institutions and our body of work, wealth and accomplishments. Estate planning properly done gives clients symbolic immortality.

Separation anxiety, which is articulated in attachment theory, also contributes to inheritance conflict. Attachment theory was formulated in the 1930s by John Bowlby, a British psychoanalyst who worked with troubled children. It postulates that infants will go to great lengths, for example, crying and clenching, to prevent being separated from their parents. Attachment theory has been extended to adults and goes a long way to explaining why adults do what they do when a loved one passes away.²² Grieving loved ones often scramble for and squabble over items that symbolically resemble the decedent’s persona or successes to which they can remain associated, for example, grandma’s china, dad’s watch or family portraits. The financial value of these items is often irrelevant.²³

According to the late clinical psychologist Edwin Schneidman, the closest that most people get to acknowledgment of their own mortality is a view of the world after our death and how we’ll be remembered—which he called the “post-self.”²⁴ Schneidman viewed each person’s property as an extension of one’s self, which is in line with Jean-Paul Sartre’s famous quote, “The totality of my possessions reflects the totality of my being. I am what I have. What is mine is myself.”²⁵ Estate planning often is viewed as one of the last opportunities to foster one’s post-self.²⁶

As mentioned previously, estate planning, once faced, confers a form of symbolic immortality on the testator, who in essence gets to continue to influence and participate in the lives of the beneficiaries after death. But, fewer than half of Americans make a will.²⁷ Why? Fears of estate planning for most exceed the purely psychological payoff of symbolic immortality and peace of mind.

Reasons for Inheritance Fights

A common reason why some people don’t engage in estate planning is a fear that their families will fight after their death, when their motives and activities will be subjected to unwanted intense public scrutiny. Because it provides a medium for the public airing of the “dirty laundry” and family secrets of testators and their families, the mere possibility of an estate squabble may cause clients stress and anxiety during the estate-planning process and cause them to put it off for that reason alone.

Why do people fight over inheritances? According to elder law attorney P. Mark Accettura, there are five basic reasons:

• Humans are predisposed to competition and conflict;

• Our psychological self is intertwined with the approval that receiving an inheritance confers; 

• Humans are genetically predisposed toward looking for exclusions;

• The death of a loved one is mortality salience that triggers the accompanying death anxiety in humans; and

• The possibility of existence of a personality disorder that causes family members to distort and escalate natural family rivalries into personal and legal battles.²⁸

While I agree with much of Accettura’s theory, he’s of the opinion that estate planning properly done through intergenerational communication for the right reasons can significantly reduce the proclivity to quarrel over inheritance. In fact, I believe that estate planning properly done can enhance a family’s emotional well-being. Furthermore, estate planning poorly done without communication between the givers and receivers can exacerbate and worsen inheritance fights.

Another reason for reticence about estate planning is a concern that too much wealth given to their loved ones will blunt their self-esteem and personal drive.²⁹ There’s ample evidence of this in some wealthy families.

Tools for Use

There are a number of tools that planners can use to assist clients/donors psychologically with respect to finishing their planning, including: reflective listening, AI and MI.

Guiding Principles of MI

MI was developed in the 1980s primarily to assist patients who had chemical dependency problems. It’s a simple and elegant system whereby the client, who wants to change at some level, finds the reasons to change within himself, with the therapist merely acting as a guide. MI is based on four guiding principles:

• Resist the righting reflex (discussed below);

• Understand and explore the patient’s own motivations;

• Listen with empathy; and

• Empower the patient, encouraging hope and optimism.

It has application to estate/charitable planning, where clients/donors often are ambivalent about doing their planning. By asking the right questions, we can guide the client/donor to the conclusion that he needs to get his estate/charitable planning done and reassure him that we’re the right people to guide him through this process.

MI is based on the assumption that the righting reflex (that reflex that causes people to tell someone else when they’re on the wrong track), which humans have and helping professsionals have often to a greater degree, is counterproductive as it encourages the other person to take up the opposing side of the argument. Advisors tend to go to this righting reflex quickly because we assume that clients want our help and opinion immediately. However, this often isn’t true.

MI is based on four processes:³⁰ 

• Engaging (establishing a helpful connection and working relationship);

• Focusing (developing and maintaining a specific direction in a conversation about change in behavior);

• Evoking (eliciting the client’s own motivations for change, which lie at the heart of motivational interviewing); and 

• Planning (developing a commitment to change and a concrete plan of action).

MI isn’t a hoax in which the therapist tricks the patient into taking a course of action. There’s a spirit to it, as discussed below. MI isn’t done to or on someone; MI is done with someone. The professional using MI is a privileged witness to change, which the client usually figures out on his own. 

The spirit of MI is based on the following four components:³¹

• Collaborative partnership. Among patient/client/donor and helping professional, particularly when behavior change is needed.

• Acceptance. It’s axiomatic that the practitioner unconditionally accepts the person just as he is at present.

• Evocative. MI seeks to evoke from the patient/client/donor that which he already has: his own motivation and resources for change, connecting behavior change with his own values and concerns.

• Honoring autonomy. MI requires a certain amount of detachment from outcomes, because the patient/client/donor can make up his own mind and is free to go in any direction, even one not advised.

Communication styles. There are essentially three communication styles that form a continuum of communication,³² and these can be used in the same conversation:

• Direct. Telling what to do.

• Follow. Listening.

• Guide. Middle ground, involving both.

MI spends most of its time in Guide mode, whereas most helping professionals use a follow-direct pattern, which often isn’t optimal and, at worst, self-defeating.

Core communication skills. They are: asking, listening and informing.³³ Too many helping professionals spend too much time in the inform or ask/inform skillsets and not enough time listening. In my experience, as much as one quarter to one third of my estate-planning clients weren’t yet ready to do some estate planning even though they were in the office, ostensibly to do just that. They often simply wanted some non-judgmental professional listening. If your clients are similar to mine, you’ll miss the boat entirely at least a quarter of the time if you take estate-planning clients literally at their initial impression of wanting to do some estate planning. 

Skills needed for MI. They include:³⁴

• Asking open-ended questions.

• Affirming the other person.

• Reflective listening—this is very important.

• Summarizing.

• Informing and advising.

Many estate planners proceed too quickly from asking questions, most of which are closed-end in the form of yes/no and multiple choice. This line of questioning results in leading the client to the desired answer and then immediately informing and advising. If they’re not being listened to, clients may decide to change professionals.

Roadblocks to active listening. In 1970, Dr. Thomas Gordon set out 12 of what he calls “roadblocks” to effective listening, which are responses by individuals that don’t constitute what he calls “active listening”:³⁵

• Ordering, directing or commanding.

• Warning, cautioning or threatening.

• Giving advice, making suggestions or providing solutions.

• Persuading with logic, arguing or lecturing.

• Telling people what they should do; moralizing.

• Reassuring, sympathizing or consoling.

• Questioning or probing.

• Withdrawing, distracting, humoring or changing the subject.

• Disagreeing, judging, criticizing or blaming.

• Agreeing, approving or praising.

• Shaming, ridiculing or labeling.

• Interpreting or analyzing.

These roadblocks to active listening can end a conversation prematurely. Not only does the purposeful estate planner or other professional helper have to suspend his own needs but also the helping professional has to avoid the “expert trap” in which asking questions one after another signifies control over the conversation. This pattern may lead to an assumption, often wrong, that once the helping professional has all of the answers to the questions, there will be a solution, which, again, often isn’t true. This heightened expectation is a trap for an expert.³⁶ The roadblocks to active listening also are examples of the righting reflex at work, because helping professionals are predisposed to and programmed to ask and respond, quite often violating one of these roadblocks. 

Reflective listening. The concept of reflective listening is easy to understand; its application to real life conversations can be difficult because of our tendency to go down the road of one or more of the 12 roadblocks set forth above, which involves the righting reflex. You simply mirror back and summarize for the client what the client just said. This is more than a mere echo; it demonstrates that you’re paying attention and can give the client a feeling that you understand him and what he’s going through.

Ambivalence. People who are thinking about making a change in their lives are ambivalent: Part of them wants to change, and part of them wants to maintain the status quo. By gently guiding clients in conversation, the planner has the clients convince themselves that the change is in their best interests. If you listen to ambivalent people discuss making that change, they’ll often engage in change talk (when they’re in favor of change—for example, completing their planning) and sustain talk (when they’re in favor of maintaining the status quo—for example, doing nothing) during the same conversation.

Planners can use the principles of MI to guide clients/donors toward closure in the estate/charitable planning process. Most clients/donors are ambivalent about doing their estate/charitable planning and engage in both change talk and behavior and sustain talk and behavior. By properly responding to the sustain talk and encouraging the change talk, the planner can play a role in assisting clients/donors to get them the therapeutic benefits of finishing their estate/charitable planning.

AI

The second tool that’s available to estate planners is AI. AI represents the intersection of the words “appreciate” and “inquire.” It’s both a philosophy and a methodology for positive change.³⁷ The proponents of AI, which was conceived in the early 1980s by David L. Cooperrider, then a Ph.D. student at Case Western Reserve University in Cleveland, believe that far more progress can be made by a focus on the positive attributes of the system than on a focus on the negatives, weaknesses or shortcomings of the system because there’s less resistance to enhancing what’s done well, even if it means phasing out or changing some weak areas.³⁸

Basis and theory underlying AI. AI is based on the theory of social constructionism, which posits that an individual’s notion of what’s real, including his sense of his problems, is constructed in daily life through communications with others and is subjective and able to be changed.³⁹ There are things that a person or organization does very well—what gives life to the person or system, and the focus is on those positives with a view toward taking one to positive changes. Contrast this with the change management or problem-solving systems, which identify problem areas and strive to solve them, ignoring that which is working well.

In addition to the social constructionist principle, AI is based on the following four principles:⁴⁰

• Simultaneity principle. Inquiry creates change and should occur simultaneously.

• Poetic principle. We can choose what we study. People have the power to choose positivity.

• Anticipatory principle. Images inspire and guide future action.

• Positive principle. Positive questions lead to positive change.

AI involves the art and practice of asking questions that strengthen a system’s capacity to understand, anticipate and heighten positive potential. 

How can AI be used in estate/charitable planning? The possibilities are endless. For starters, family businesses that need succession planning can avail themselves of AI.⁴¹ Planners can use AI with donors who are unclear about how they want their gifts used.

“The Appreciative Inquiry 4-D Model,” p. 61, explains the process of AI pictorially:⁴² 

The desired outcome of Discovery is appreciating the best of what is; 

The desired outcome of Dream is imagining/envisioning what could be;

The desired outcome of Design is innovating/co-constructing/discovering what should be; and

The desired outcome of Deploy is delivering/creating/sustaining what will be.          

Endnotes

1. L. Paul Hood, Jr.,“Back to the School of Hard Knocks: Thoughts on the Initial Estate Planning Interview-Revisited,” Wealth Strategies Journal (March 26, 2014) (“Hard Knocks”). See also L. Paul Hood, Jr., “From the School of Hard Knocks: Thoughts on the Initial Estate Planning Interview,” 27 ACTEC Journal 297 (2002).

2. Robert W. Firestone and Joyce Catlett, Beyond Death Anxiety (Springer Publishing Company 2009), at p. 16.

3. Sheldon Solomon, Jeff Greenberg and Tom Pyszczynski, The Worm at the Core: On the Role of Death in Life (Random House 2015), at pp. 26-28.

4. See, e.g., James C. Diggory and Doreen Z. Rothman, “Values Destroyed By Death,” 63 Journal of Abnormal and Social Psychology, No. 1, at pp. 205-210 (1961).

5. Russell N. James, III, Inside the Mind of the Bequest Donor (self-published 2013), Chapters 4 and 5.

6. Ibid., at p. 31.

7. Ibid., at p. 54.

8. Ibid., at p. 57.

9. Ibid., at p. 46.

10. Eleven of these were discussed in L. Paul Hood, Jr. and Emily Bouchard, Estate Planning for the Blended Family (Self-Counsel Press 2012). Recently, Hood added the fear of probate.

11. See, e.g., Mark Glover, “A Therapeutic Jurisprudential Framework of Estate Planning,” 35 Seattle University Law Review 427 (2012).

12. On being assured that his testamentary wishes are in order after he signed his will, Ishmael describes his satisfaction: “After the ceremony was concluded upon the present occasion, I felt all the easier; a stone was rolled away from my heart.” Herman Melville, Moby-Dick; or The Whale (Penguin Books 2003) (1851), at p. 249. See also Thomas L. Shaffer, Death Property and Lawyers (Dunellen 1970), at p. 77.

13. See, e.g., Nathan Roth, The Psychiatry of Writing a Will (Charles C. Thomas 1989), at pp. 44, 46 and 48.

14. Cognitive distortions have been explained as “ways that our mind convinces us of something that isn’t really true. These inaccurate thoughts are usually used to reinforce negative thinking or emotions—telling ourselves things that sound rational and accurate, but really only serve to keep us feeling bad about ourselves.” See, e.g., John M. Grohol, “15 Common Cognitive Distortions,” http://psychcentral.com/lib/15-common-cognitive-distortions/0002153.

15. Roth, supra note 13, at p. 46.

16. Glover, supra note 11, at p. 437.

17. Ibid., at p. 437.

18. See, e.g., Mario Mikulincer, Victor Florian and Gilad Hirschberger, Gilad (2003). “The existential function of close relationships. Introducing death into the science of love,” Personality and Social Psychology Review 7 (1): 20-40.

19. See, e.g., James, supra note 5, Chapter 5.

20. Abram Rosenblatt, Jeff Greenberg, Sheldon Solomon, Tom Pyszczynski and Deborah Lyon, “Evidence for Terror Management Theory: The Effects of Mortality Salience on Reactions of Those Who Violate or Uphold Cultural Values,” Journal of Personality and Social Psychology, Vol 57(4) (October 1989), at pp. 681-690.

21. See, e.g., Ernest Becker, The Denial of Death (Free Press Simon & Schuster 1973).

22. Chris R. Fraley, “A Brief Overview of Adult Attachment Theory and Research,” https://internal.psychology.illinois.edu/~rcfraley/attachment.htm.

23. I recall an unfortunate case that went to the state court of appeal twice over family portraits that could have been duplicated.

24. Edwin S. Schneidman, Death: Current Perspectives (Jason Aronson 1976); Edwin S. Schneidman, Deaths of Man (Quadrangle/New York Times Book Co. 1973), Chapter 4.

25. Jean-Paul Sartre, Being and Nothingness (1943).

26. Shaffer, supra note 12, at pp. 81-82. See also James, supra note 5. 

27. www.caring.com/articles/wills-survey-2017.

28. Mark P. Accettura, Blood & Money: Why Families Fight Over Inheritance and What To Do About It (Collinwood Press, LLC 2011).

29. Warren Buffett, in an article in Fortune magazine (Sept. 29, 1986), is quoted as saying the optimal amount of inheritance to leave children is “enough money so that they would feel they could do anything, but not so much that they could do nothing.”

30. William R. Miller and Stephen Rollnick, Motivational Interviewing: Helping People Change (3rd ed). (The Guildford Press 2013) (Motivational Interviewing), Chapter 3.

31. Ibid., at pp. 14-24.

32. Ibid., at pp. 4-5.

33. Ibid., at, pp. 4-5.

34. Ibid., Chapter 6.

35. See, e.g., www.gordonmodel.com/work-roadblocks.php.

36. Motivational Interviewing, supra note 30, at p. 42.

37. Natalie May, Daniel Becker, Richard Frankel, Julie Haizlip, Rebecca Harmon, Margaret Plews-Ogan, John Shorling, Annie Williams and Diana Whitney, Appreciative Inquiry in Healthcare: Positive Questions to Bring Out the Best (Crown Custom Publishing 2011), at p. 3.

38. David L. Cooperrider, Diana Whitney and Jacqueline M. Stavros; Appreciative Inquiry Handbook For Leaders of Change 2nd Ed. (Crown Custom Publishing 2008), at p. xv (Handbook).

39. Ibid., at pp. 14-15.

40. Ibid., at pp. 8-10.

41. Dawn Cooperrider Dole, Jen Hetzel Silbert, Ada Joe Mann and Diana Whitney, Positive Family Dynamics (Taos Institute Publications 2008).

42. https://cvdl.ben.edu/blog/what-is-appreciative-inquiry/. There are many different ways that the 4-D Cycle is illustrated and described. Handbook, supra note 38, at pp. 5 and 34. Some newer descriptions employ a 5-D model, in which the first “D” is Definition of the presenting opportunity. See, e.g., https://appreciativeinquiry.champlain.edu/learn/appreciative-inquiry-introduction/5-d-cycle-appreciative-inquiry/.

In the last six months, three interesting cases of controversy-generating philanthropy emerged. All represented some kind of fundamental miscommunication between the donor and the donee and/or the donee’s constituency. A gift was saved in one case; on the path to being lost in another; and examined by legal authorities in the third. As you’ll see, noble intentions don’t always translate to the best results.

The Wolf of Wall Street Gets Bitten

In the first case, a transformative gift from a grateful alumnus generated little appreciation and notable venom. 

One of the most generous and sophisticated philanthropists of the last 50 years, Steve Schwarzman,¹ fondly remembered his academic roots, Abington Senior High School (Abington) in suburban Philadelphia. Steve said it changed his life,² as he went on to academic success at Yale University and Harvard Business School and became a financial titan serving as CEO of Blackstone. Ten years ago, he contributed $400,000 for the renovation of the football stadium bearing his name. He’d maintained friendly relations with school superintendent Amy Sichel.

Abington formed a foundation as part of a $100 million campaign to upgrade its technology. Steve offered $25 million to Abington’s campaign, easily its largest gift and likely the largest to a public high school in the United States. What possibly could go wrong with unprecedented generosity from an engaged graduate supporting a priority of the donee? It turns out plenty.

The primary flashpoint centered on the renaming of Abington to bear its benefactor’s name. When the gift was announced at a public meeting of the school board, some of the taxpayers decried both the lack of the board’s transparency and the influence of “big money, Wall Street money.” One comment from the audience noted: “Help me understand how you could make such a monumental decision without even asking the public.” The reporter covering the meeting described the crowd as hostile to Wall Street.³

Certain details common to gift agreements, such as publicity notifications and branding strategies, seemed to some to suggest too much donor control.

The secondary flashpoint stemmed from what additional benefits Steve would be receiving beyond the naming rights to the entire school. The donor sought named spaces for his twin brothers.

To the donor’s great credit, he withdrew the request for the naming rights of the school and honored his promise to commit $25 million.⁴ One could easily imagine most donors leaving the donee empty handed.

Global Conflicts

In the second case, a transformative gift from a friend to encourage dispute resolution created two lawsuits.

Unlike Abington, the University of Chicago (the University) is accustomed to receiving transformative gifts including $300 million for the naming of its business school. With a well-earned reputation as “the teachers of teachers” and a highly productive research enterprise, it’s not surprising the University receives support from non-alumni. The Pearson brothers of Oklahoma are sons of a minister and a civil rights activist and business entrepreneurs, investors and philanthropists with a long-standing interest in the resolution of global disputes and conflicts.⁵ They felt the University fostered an environment where rigorous inquiry was applied to society’s toughest problems. And so, with the best of intentions, they executed a 61-page gift agreement.⁶   

Their $100 million gift was made at the direction of Thomas L. Pearson (chairman) and Timothy R. Pearson (president and CEO) of The Pearson Family Foundation. The gift money was to be used to establish an institute to study global conflict resolution.

The president of the University noted the gift aligned with its research practices: “The study of global conflicts is a field ripe for groundbreaking research approaches and The Pearson Institute will seek to inform more effective policy solutions to make a lasting impact around the world.”⁷ 

The Pearsons publicly acknowledged the challenge: “We know the journey ahead will be formidable—to find new ways through The Pearson Institute to study and understand global conflicts, to significantly and meaningfully impact and inform policy, and to share these findings around the world through The Pearson Global Forum.”⁸

What could go wrong as each party had its eyes wide-open as they pursued a goal of studying conflict resolution? A detailed gift agreement should anticipate and solve any disputes without lawyers, right? Emphatically no!!! 

The Pearsons sought repayment of $23 million in pledge payments. The court pleadings show their frustration about the lack of progress in hiring a director of the institute as well as the quality of the holders of the professorships. They felt excluded from certain relevant events surrounding their institute.⁹ Other counts to their complaint included breaches of contract and fiduciary duty as well as fraudulent concealment.¹⁰ 

The University would have been interested to know the brothers had in fact sued a theological seminary because of their dissatisfaction with the administration of a much smaller gift.¹¹ Had it known, perhaps it would have viewed the brothers in a different light and changed its communications strategy accordingly.

The University responded saying it met its obligations before the required fourth installment payment. Accordingly, they asked for the next installment and the dismissal of the Pearsons’ lawsuit. 

The dispute will require conflict resolution from both sides, assuming an out-of-court settlement is reached. How ironic the attempt to resolve differences ended initially in a U.S. District Court in Northern Oklahoma with the plaintiffs demanding a jury trial.

Reefer Madness

The third case involves a check intended to alleviate human suffering. 

Thomas Jefferson University of Philadelphia (Jefferson) became one of the first recipients of a gift to study medical marijuana and hemp. Founded by a $3 million gift from Australian banking tycoon Barry Lambert, Jefferson established the Lambert Center (the Center). The grandchild of the donor received relief from severe seizures through cannabis derived hemp. Barry hoped the gift would inspire more study into medicinal cannabis and offer hope to those in great suffering.

The president of Jefferson acknowledged the need for more angel investors for start-up funding for the Center. Soon thereafter, Jefferson identified six “Founding Members” who each committed $250,000. It was anticipated these gifts would develop Pennsylvania’s leadership in the medical research of marijuana. One of those funders, Matthew Mallory of Commonwealth Alternative Medicinal Options, paid $125,000 in December 2016.

So, what possibly can go wrong when research to alleviate suffering is being generously funded?

According to 420.com, Matthew was expecting more from Jefferson than a contemporaneous receipt for his “gift.”¹² He’d sought an alliance with an acknowledged player in the research of medical marijuana. He’d hoped Jefferson would facilitate a relationship with Lake Erie Osteopathic College of Medicine. Within two weeks of paying $125,000, Matthew’s lawyer was expressing great disappointment at not being able to assist in securing an affiliation with a medical facility. 

Matthew enlisted the Pennsylvania Attorney General (AG) to secure the return of the gift alleging that a consultant to Jefferson said, “If you don’t do it (make the pledge of $250K), you are not going to be part of the program.”¹³ Emails between Matthew and Jefferson were described by critics as “a crass exchange in which money was solicited to buy into the ground floor of a new pharmaceutical industry.”¹⁴ Nonetheless, the AG didn’t feel that Jefferson was obligated to return the contribution. Jefferson admitted no wrongdoing, though it did blame the consultant who helped solicit the contribution. The consultant denied any quid pro quo, stating, “there was never a promise of special favor with the commonwealth or any institution.”¹⁵ The director of the Center said the commitment as a founding member simply indicated support for research on medical marijuana.

Interestingly, of the five other founding members who gave, only one of them won a permit to operate a marijuana dispensary in Pennsylvania. They apparently thought they were making a philanthropic contribution.

It will be interesting to track the philanthropic contributions to Jefferson and the other health systems participating in the marijuana research program. My hunch is that legal counsel to those hoping to be dispensaries will recommend that their clients avoid making charitable contributions and thus avoid the appearance of a quid pro quo. Counsel for the research universities likely will err on the side of not soliciting contributions from those with potential business interests in the marijuana research arena. It was notable to me how quickly Matthew secured the AG’s attention and how quickly sensitive email exchanges became public. So perhaps “Reefer Madness” might really mean a world of altered perception in which charities refuse gifts.

(For summaries of the gifts in these three cases and lessons learned from the problems that ensued, see “Lessons Learned,” p. 44.)

Planning Pointers

All three case studies illustrate the value of a gift acceptance policy as a screener of potential problems with the gift and the donor. The more generous the contribution, the more likely the controversy generated either by the giver or how the giver created his fortune.

Some of the unpleasantries delivered on the Abington School District Foundation were avoidable or ameliorable with greater transparency between the donee and its constituents (students, alumni and taxpayers).

Avoiding such unpleasantries may require measures an institution may never be prepared to address. Part of the public regarded Steve’s gift as tainted Wall Street money. But, does an institution really wish to determine the “purity” of the donor’s fortune? Fortunes built by Andrew Carnegie, John D. Rockefeller, Sr. and Walter Annenberg all had elements of controversy. Carnegie employed strike breakers at his steel plant. Rockefeller, Sr. was deemed in violation of the antitrust laws. The Annenberg fortune was initially built in part on publishing materials to those betting on horse races, a legal activity. If such a purity test is imposed, what makes the fortunes of today’s tech billionaires more virtuous when their companies displace many workers and produce much of their value offshore? Perhaps the most reasonable approach is denying naming opportunities to individuals either indicted or convicted of civil or criminal charges. Imposing a purity test on how the wealth was created will be an exercise in futility.

The Pearson case raises the issue of how much a charity needs or wants to know about its donor, especially one who lacks a long-term, meaningful philanthropic relationship with it. Most transformational gifts come from alumni and friends known for years. A gift from a non-alumnus places a premium on truly comprehending not only the donor’s motivation but also the likelihood of the donor being pleased with the use of the gift.

Knowing whether a donor has ever sued another charity reveals much about the potential of a donor to become dissatisfied. For some charities, evidence of a lawsuit likely disqualifies receipt of the gift. For others, it requires a clear-eyed assessment of whether the donor ever can be satisfied. And perhaps for some, ignorance of the donor’s litigation history would be acceptable.

The sobering challenge, assuming the institution values this information, is securing it both inexpensively and inoffensively. Asking the donor directly is likely off-putting. Not asking directly incurs the time and expense of investigation. Each is likely to be prohibitive given the resources of the institution.

The Jefferson case should compel every charity to examine (or create) a policy for the selection of its vendors of goods and services. Many institutions will consider past philanthropic support as one of but many factors. Of course, it can’t be the dispositive factor. Correspondingly, the institution’s gift acceptance policy should explicitly bar the solicitation of or the acceptance of gifts in exchange for the awarding of contracts. Volunteer fundraisers and consultants acting on behalf of a charity must also be governed by the same restrictions imposed on the development team.

Final Thought

While the old saying that “no good deed goes unpunished” may not be true, it’s true that all good deeds are being scrutinized by a less than fawning public. Whether the donor or donee are equally matched or mismatched in terms of their philanthropic sophistication, the chance for fundamental miscommunications and misunderstandings remains possible.        

Endnotes

1. Steve Schwarzman has committed eight and nine-figure gifts to the New York Public Library, Yale University and the Schwarzman Scholars program.

2. www.forbes.com/sites/susanadams/2018/02/15/steve-schwarzman-makes-the-biggest-ever-donation-to-a-public-high-school/#407daa49320c.

3. www.nytimes.com/2018/04/13/business/steven-schwarzman-blackstone-abington-pennsylvania.html.

4. www.bloomberg.com/news/articles/2018-04-11/schwarzman-finds-high-school-immortality-harder-than-he-thought.

5. www.uchicago.edu/features/pearson_family_donates_100_million_institute_to_confront_global_conflicts/.

6. www.scribd.com/document/375888212/University-of-Chicago-Grant-Agreement-with-Pearson-Family.

7. Supra note 5.

8. Ibid.

9. www.scribd.com/document/372996048/Pearson-Family-Foundation-v-University-of-Chicago#fullscreen&from_embed. See p. 14, para. 71 of Pearsons’ complaint.

10. Ibid. The Pearsons alleged failure to name an institute director (para. 16), hire a qualified director (para. 28), hold the Pearson Global forum (para. 35) and a number of other failures.

11. www.bloomberg.com/news/articles/2018-08-15/college-donors-are-getting-picky. The Pearson brothers sued over the stewardship of a relatively small gift of $1 million.

12. www.420magazine.com/420-news/medical-marijuana-news/pa-he-gave-a-125k-gift-to-jefferson-expecting-it-would-help-get-a-marijuana-growing-license-was-it-pay-to-play/.

13. Ibid.

14. www2.philly.com/philly/business/cannabis/marijuana-weed-pennsylvania-jefferson-pay-to-play-grower-20180622.html.

15. Supra note 12.