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Trustees throughout the United States have a continuing statutory and/or common law duty to administer their trusts in appropriate jurisdictions. Some practitioners assert that the factors that trustees must consider in fulfilling that duty don’t include a consideration of state income taxes. For the reasons set forth in this article, we disagree with that assertion and contend that trustees that don’t attempt to minimize the state income taxes paid by the trusts that they administer ignore that analysis at their peril. 

UTC Section 108(b)Section 108(b) of the Uniform Trust Code (UTC) specifies that:

A trustee is under a continuing duty to administer the trust at a place appropriate to its purposes, its administration, and the interests of the beneficiaries.1

Of the 36 states2 that have adopted the UTC, 23 of them—Arizona, Arkansas, Colorado, Connecticut, District of Columbia, Hawaii, Illinois, Kentucky, Maine, Maryland, Michigan, Minnesota, Montana, Nebraska, New Hampshire, New Jersey, New Mexico, North Dakota, Ohio, South Carolina, Tennessee, Utah and Vermont—enacted Section 108(b) verbatim.3 Six states have modified versions. Florida omits the requirement that trustees consider “the interests of the beneficiaries;”4 Wyoming adds “unless otherwise provided in subsection (a) of this section or changed as provided in subsection (c) of this section” at the end of its version.5

Alabama adds this italicized language:

A trustee shall administer the trust at a place appropriate to its purposes, its administration, and the interests of the beneficiaries; provided, however, a trustee shall not be required to transfer the trust’s principal place of administration to another state or to a jurisdiction outside of the United States.6 

The Alabama drafters rationalize the change by stating:

Alabama amends the language of subsections (b) and (c) in the UTC by giving the trustee the authority, but without imposing an affirmative duty, to transfer the trust’s principal place of administration where appropriate. The original UTC language seemed to impose an affirmative duty upon the trustee to seek best place of administration for the trust. The original language could be interpreted to require the trustee to continually “forum shop” for, among other things, the best tax situs for the trust and the best tax situs for the beneficiaries. Transferring the trust’s principal place of administration is costly and time consuming, and should not be undertaken lightly and without considering all of the relevant factors: the trust’s purposes, the trust’s interests and the interests of the beneficiaries.7

Mississippi adds comparable language italicized below:

(c) A trustee shall administer the trust at a place appropriate to its purposes, its administration, and the interests of the beneficiaries; however, a trustee shall not be required, in the absence of a court order, to transfer the trust’s principal place of administration to another state or to a jurisdiction outside the United States even though such other state or jurisdiction outside the United States could also be appropriate to its purposes, its administration, and the interests of the beneficiaries.8

Although trustees in Alabama and Mississippi might not be “required” to maintain trusts in appropriate jurisdictions, they aren’t prohibited from doing so.

Kansas adds the gloss italicized below:

(b) A trustee is under a duty to administer the trust at a place appropriate to its purposes, its administration, and the interests of the beneficiaries. In determining the appropriate place for the administration of the trust, consideration shall be given to the designation of the settlor, the purposes of the trust, the interests of the beneficiaries and the manner and costs of trust administration.9

Finally, Oregon adds the guidelines italicized below:

(2) A trustee is under a continuing duty to administer the trust at a place appropriate to the trust’s purposes, the trust’s administration and the interests of the beneficiaries. Absent a substantial change of circumstances, the trustee may assume that the original place of administration is also the appropriate place of administration. The duty to administer the trust at an appropriate place may prevent a trustee from moving the place of administration.10

Seven states—Massachusetts, Missouri, North Carolina, Pennsylvania, Virginia, West Virginia and Wisconsin—omit Section 108(b) altogether from their versions of the UTC.11 The North Carolina drafters justify the omission by stating:

Subsection (b) of the Uniform Trust Code, which provided that a trustee is under a continuing duty to administer the trust at a place appropriate to its purpose, its administration and the interest of the beneficiaries, was omitted because it would have imposed an affirmative duty on a trustee to continually monitor the place of the administration of a trust. Such a duty has not been previously recognized in North Carolina. The drafters concluded that the burden of complying with such a duty outweighed any advantage in imposing it.12

The Pennsylvania drafters also justify the omission:

UTC § 108(b) is omitted to avoid the implication of a duty that the trustee consider the laws of all conceivable jurisdictions to which the situs of a trust may be moved and establish and re-establish situs accordingly.13

At least on this issue, trustees must consider the laws of as few as two jurisdictions—North Carolina or Pennsylvania (and the circumstances, if any, in which the state will tax a resident trust as a nonresident trust) and a state that won’t tax the trust’s income. It’s generally known that Alaska, Florida, Nevada, South Dakota, Texas and Wyoming don’t have state income taxes and that trustees of Delaware trusts created by nonresidents don’t have to file Delaware returns or pay Delaware income tax if there are no Delaware resident beneficiaries.14

The drafters of UTC Section 108 clearly had state income taxation in mind. Thus, Section 108’s Comment observes: 

Locating a trust’s principal place of administration will ordinarily determine which court has primary if not exclusive jurisdiction over the trust. It may also be important for other matters, such as payment of state income tax or determining the jurisdiction whose laws will govern the trust.15

The Comment continues:

Subsections (c)-(f) provide a procedure for changing the principal place of administration to another state or country. Such changes are often beneficial. A change may be desirable to secure a lower state income tax rate, or because of relocation of the trustee or beneficiaries, the appointment of a new trustee, or a change in the location of the trust investments.16

In a recent Illinois General Information Letter (GIL),17 a trustee sought clarification of a trust’s residency status following the Illinois Appellate Court’s 2013 decision in Linn v. Department of Revenue, which held that Illinois taxation of a trust would violate the due process clause.18 The GIL gave the following guidance:

The Lewis Linn case does not apply to the situation that you have described because there are sufficient contacts between TRUSTEE Revocable Living Trust and the State of Illinois to satisfy the Due Process Clause of the U.S. Constitution given the location of trust assets in Illinois. In Lewis Linn v. Department of Revenue, the court distinguished that the focus on the due process analysis was on the tax year in question, so historic events had no influence on determining the residency of the trust.

Even if the TRUSTEE Revocable Living Trust could be considered a nonresident under the holding of the Lewis Linn case, the trust still was required to file an Illinois income tax return for tax years 2019-2022 because the trust’s income-producing assets were located here.19

The GIL notes that the trustee was cognizant of the continuing duty to administer the trust in an appropriate jurisdiction under 760 ILCS 3/108(b), Illinois’s version of UTC Section 108(b).

Other UTC Duties

UTC Section 108(b) shouldn’t be viewed in isolation because several other UTC provisions require trustees to focus on “the interests of the beneficiaries,” which UTC Section 103(8) defines as “the beneficial interests provided in the terms of the trust.”20 Thirty-five of the 36 UTC states have comparable definitions.21 Florida defines the term as “the beneficial interests intended by the settlor as provided in the terms of a trust.”22

Section 404: Trust purposes. Section 404 of the UTC provides:

A trust may be created only to the extent its purposes are lawful, not contrary to public policy, and possible to achieve. A trust and its terms must be for the benefit of its beneficiaries.23

Whereas 30 states—Alabama, Arizona, Arkansas, Colorado, District of Columbia, Hawaii, Kansas, Kentucky, Maine, Maryland, Minnesota, Mississippi, Missouri, Montana, Nebraska, New Hampshire, New Jersey, New Mexico, North Carolina, North Dakota, Ohio, Oregon, South Carolina, Tennessee, Utah, Vermont, Virginia, West Virginia, Wisconsin and Wyoming—require trusts to be for the benefit of their beneficiaries,24 six states—Connecticut, Florida, Illinois, Massachusetts, Michigan and Pennsylvania—omit this requirement from their versions of Section 404.25

Section 801: Duty to administer trust. Similarly, UTC Section 801 imposes the following duty on trustees:

Upon acceptance of a trusteeship, the trustee shall administer the trust in good faith, in accordance with its terms and purposes and the interests of the beneficiaries, and in accordance with this [Code].26

Illinois and North Dakota don’t specifically include a duty to administer trusts for the benefit of the beneficiaries in their versions of Section 801.27 The other 34 UTC states do.28

Section 802: Duty of loyalty. UTC Section 802(a) specifies that “[a] trustee shall administer the trust solely in the interests of the beneficiaries.”29 All 36 UTC states, except Illinois,30 impose this duty.31

Section 814: Discretionary powers; tax savings. Finally, UTC Section 814(a) stipulates:

Notwithstanding the breadth of discretion granted to a trustee in the terms of the trust, including the use of such terms as ‘absolute’, ‘sole’, or ‘uncontrolled’, the trustee shall exercise a discretionary power in good faith and in accordance with the terms and purposes of the trust and the interests of the beneficiaries.32

Although 28 states have the interest-of-the-beneficiaries requirement,33 eight states exclude this requirement from their versions.34

Non-UTC Statutes

Section 7-305 of the Uniform Probate Code (UPC),35 which is in effect in at least two states,36 provides:

A trustee is under a continuing duty to administer the trust at a place appropriate to the purposes of the trust and to its sound, efficient management. If the principal place of administration becomes inappropriate for any reason, the Court may enter any order furthering efficient administration and the interests of beneficiaries, including, if appropriate, release of registration, removal of the trustee and appointment of a trustee in another state. Trust provisions relating to the place of administration and to changes in the place of administration or of trustee control unless compliance would be contrary to efficient administration or the purposes of the trust. Views of adult beneficiaries shall be given weight in determining the suitability of the trustee and the place of administration.37

In addition, Indiana imposes a comparable duty.38

Common Law Duty

Trustees in the six UTC states that limit the applicability of UTC Section 108(b)—Alabama, Florida, Kansas, Mississippi, Oregon and Wyoming; the seven UTC states that don’t have a version of UTC Section 108(b)—Massachusetts, Missouri, North Carolina, Pennsylvania, Virginia, West Virginia and Wisconsin; and the 12 states that don’t have UTC Section 108(b), UPC Section 7-305 or another applicable statute—California, Delaware, Georgia, Iowa, Louisiana, Nevada, New York, Oklahoma, Rhode Island, South Dakota, Texas and Washington —shouldn’t relax because, under the duty to administer the trust in accordance with its terms and applicable law, Section 76 of the Restatement (Third) of Trusts39 offers the following comment:

A trustee’s duty to administer a trust includes an initial and continuing duty to administer it at a location that is reasonably suitable to the purposes of the trust, its sound and efficient administration, and the interests of its beneficiaries . . . 

Under some circumstances the trustee may have a duty to change or to permit (e.g., by resignation) a change in the place of administration. Changes in the place of administration by a trustee, or even the relocation of beneficiaries or other developments, may result in costs or geographic inconvenience serious enough to justify removal of the trustee.40 

The Reporter’s Notes for Section 76 cite the first portion of the Comment under UTC Section 108 quoted above.

Practical Considerations

In our view, trustees in most, if not all, states have a continuing legal duty to minimize state income taxes.

There are practical considerations as well. On the one hand, reducing state income tax is a win-win proposition for beneficiaries and trustees. If $100,000 of California or New York City income tax is saved on $1 million long-term capital gains, then an additional $100,000 (and future income produced by it) will be available for the beneficiaries, and an additional $100,000 (and future income produced by it) will be there to enhance the trustee’s performance. On the other hand, failing to save $100,000 of state income tax offers vengeful beneficiaries a measurable amount in a surcharge action.

A practitioner one of the authors spoke with recently at a conference told him that her clients’ preferences for local advisors outweigh their interest in saving state income taxes. Yet, both goals can be achieved in some states, Louisiana being a prime example. In this regard, a Louisiana statute provides:

(b) A trust other than a trust described in Subparagraph (3)(a) shall be considered a resident trust if the trust instrument provides that the trust shall be governed by the laws of the state of Louisiana. If the trust instrument provides that the trust is governed by the laws of any state other than the state of Louisiana, then the trust shall not be considered a resident trust. If the trust instrument is silent with regard to the designation of the governing law, then the trust shall be considered a resident trust only if the trust is administered in this state.41

By designating the law of another state to govern their inter vivos trusts, her clients may retain local advisors and escape Louisiana income tax, except on Louisiana source income, if any.

A Moral Duty

When carrying out the continuing requirement to administer trusts in appropriate jurisdictions, trustees have legal and practical duties to reduce the state income taxes paid by the trusts under their supervision. There’s a moral duty as well. Trustees’ fiduciary duties extend to trust beneficiaries not to state taxing authorities. When all is said and done, minimizing state income taxes on trusts at the outset and throughout trust administration is the right thing to do. 

Endnotes

1. Uniform Trust Code (UTC) Section 108(b). The text of the UTC and a list of jurisdictions that have enacted it may be viewed at www.uniformlaws.org.

2. For convenience, “state” includes the District of Columbia.

3. Ariz. Rev. Stat. Ann. Section 14-10108(B); Ark. Code Ann. Section 28-73-108(b); Colo. Rev. Stat. Section 15-5-108(3); Conn. Gen Stat. Section 45a-499h(b); D.C. Code Section 19-1301.08(b);
Haw. Rev. Stat. Section 554D-108(b); 760 Ill. Comp. Stat. 3/108(b); Ky. Rev. Stat. Ann. Section 386B.1-060(2); Me. Rev. Stat. Ann. tit. 18-B, Section 108(2); Md. Code Ann., Est. & Trusts
Section 14.5-108(b); Mich. Comp. Laws Section 700.7108(2); Minn. Stat. Section 501C.0108(b); Mont. Code Ann. Section 72-38-108(2);Neb. Rev. Stat. Section 30-3808(b); N.H. Rev. Stat. Ann.
Section 564-B:1-108(b); N.J. Stat. Ann. Section 3B:31-8(b); N.M. Stat. Ann. Section 46A-1-108(B); N.D. Cent. Code Section 59-09-08(2); Ohio Rev. Code Ann. Section 5801.07(B); S.C. Code Ann.
Section 62-7-108(c); Tenn. Code Ann. Section 35-15-108(c); Utah Code Ann. Section 75-7-108(2); Vt. Stat. Ann. tit. 14A, Section 108(b).

4. Fla. Stat. Section 736.0108(4).

5. Wyo. Stat. Ann. Section 4-10-108(b).

6. Ala. Code Section 19-3B-108(b) (emphasis added).

7. Ibid., cmt.

8. Miss. Code Ann. Section 91-8-108(c) (emphasis added).

9. Kan. Stat. Ann. Section 58a-108(b) (emphasis added).

10. Or. Rev. Stat. Section 130.022(2) (emphasis added).

11. Mass. Gen. Laws ch. 203E, Section 108; Mo. Rev. Stat. Section 456.1-108; N.C. Gen Stat. Section 36C-1-108; 20 Pa. C.S. Section 7708; Va. Code Ann. Section 64.2-706; W. Va. Code
Section 44D-1-108; Wis. Stat. Section 701.0108.

12. N.C. Gen. Stat. Section 36C-1-108, N.C. cmt.

13. 20 Pa. C.S. Section 7708, Jt. St. Govt. Comm. cmt.

14. See 30 Del. Code Ann. tit. 30 Sections 1605(b), 1636.

15. UTC Section 108 cmt. (emphasis added). This part of the Comment is quoted in the Reporter’s Notes for Section 76 of the Restatement (Third) of Trusts.

16. UTC Section 108 cmt. (emphasis added).

17. Ill. Info. Ltr. IT 22-0012-GIL (Ill. Dep’t Rev. Dec. 6, 2022),www.tax.illinois.gov. 

18. Linn v. Dep’t of Revenue, 2 N.E.3d 1203 (Ill. App. Ct. 2013).

19. Ill. Info. Ltr. IT-22-0012-GIL, at 4 (Ill. Dep’t Rev. Dec. 6, 2022),
www.tax.illinois.gov.

20. UTC Section 103(8).

21. Ala. Code Section 19-3B-103(8); Ariz. Rev. Stat. Ann. Section 14-10103(8); Ark. Code Ann. Section 28-73-103(9); Colo. Rev. Stat. Section 15-5-103(11); Conn. Gen Stat. Section 45a-499c(16);
D.C. Code Section 19-1301.03(8); Haw. Rev. Stat. Section 554D-103; 760 Ill. Comp. Stat. 3/103(19); Kan. Stat. Ann. Section 58a-103(7); Ky. Rev. Stat. Ann. Section 386B.1-010(8); Me. Rev. Stat. Ann. tit. 18-B,
Section 103(7); Md. Code Ann., Est. & Trusts Section 14.5-103(n); Mass. Gen. Laws ch. 203E, Section 103; Mich. Comp. Laws Section 700.7103(e); Minn. Stat. Section 501C.0103(h); Miss. Code Ann. Section 91-8-103(14); Mo. Rev. Stat. Section 456.1-103(12); Mont. Code Ann. Section 72-38-103(9); Neb. Rev. Stat. Section 30-3803(8); N.H. Rev. Stat. Ann. Section 564-B:1-103(7); N.J. Stat. Ann. Section 3B:31-3; N.M. Stat. Ann. Section 46A-1-103(H); N.C. Gen. Stat. Section 36C-1-103(9); N.D. Cent. Code Section 59-09-03(9); Ohio Rev. Code Ann. Section 5801.01(K); Or. Rev. Stat. Section 130.010(9); 20 Pa. C.S. Section 7703; S.C. Code Ann. Section 62-7-103(7); Tenn. Code Ann. Section 35-15-103(17); Utah Code Ann. Section 75-7-103(e); Vt. Stat. Ann. tit. 14A, Section 103(8); Va. Code Ann. Section 64.2-701; W. Va. Code Section 44D-1-103(l); Wis. Stat. Section 701.0103(14); Wyo. Stat. Section 4-10-103(a)(x).

22. Fla. Stat. Section 736.0103(13).

23. UTC Section 404 (emphasis added).

24. Ala. Code Section 19-3B-404; Ariz. Rev. Stat. Ann. Section 14-10404; Ark. Code Ann. Section 28-73-404; Colo. Rev. Stat. Section 15-5-404; D.C. Code Section 19-1304.04; Haw. Rev. Stat. Section 554D-404; Kan. Stat. Ann. Section 58a-404; Ky. Rev. Stat. Ann. Section 386B.4-040; Me. Rev. Stat. Ann. tit. 18-B, Section 404; Md. Code Ann., Est. & Trusts Section 14.5-404; Minn. Stat. Section 501C.0404; Miss. Code Ann. Section 91-8-404; Mo. Rev. Stat. Section 456.4-404; Mont. Code Ann. Section 72-38-404; Neb. Rev. Stat. Section 30-3830; N.H. Rev. Stat. Ann. Section 564-B:4-404; N.J. Stat. Ann. Section 3B:31-21; N.M. Stat. Ann. Section 46A-4-404; N.C. Gen. Stat. Section 36C-4-404; N.D. Cent. Code Section 59-12-04; Ohio Rev. Code Ann. Section 5804.04; Or. Rev. Stat. Section 130.165; S.C. Code Ann. Section 62-7-404; Tenn. Code Ann. Section 35-15-404; Utah Code Ann. Section 75-7-404; Vt. Stat. Ann. tit. 14A, Section 404; Va. Code Ann. Section 64.2-722; W. Va. Code Section 44D-4-404; Wis. Stat. Section 701.0404; Wyo. Stat. Section 4-10-405.

25. Conn. Gen Stat. Section 45a-499y; Fla Stat. Section 736.0404; 760 Ill. Comp. Stat. 3/404; Mass. Gen. Laws ch. 203E, Section 404; Mich. Comp. Laws Section 700.7404; 20 Pa. C.S. Section 7734.

26. UTC Section 801 (emphasis added).

27. 760 Ill. Comp. Stat. 3/801; N.D. Cent. Code Section 59-16-01.

28. Ala. Code Section 19-3B-801; Ariz. Rev. Stat. Ann. Section 14-10801; Ark. Code Ann. Section 28-73-801; Colo. Rev. Stat. Section 15-5-801; Conn. Gen Stat. Section 45a-499aaa; D.C. Code Section 19-1308.01; Fla. Stat. Section 736.0801; Haw. Rev. Stat. Section 554D-801; Kan. Stat. Ann. Section 58a-801; Ky. Rev. Stat. Ann. Section 386B.8-010; Me. Rev. Stat. Ann. tit. 18-B, Section 801; Md. Code Ann., Est. & Trusts Section 14.5-801; Mass. Gen. Laws ch. 203E, Section 801; Mich. Comp. Laws Section 700.7801; Minn. Stat. Section 501C.0801; Miss. Code Ann. Section 91-8-801; Mo. Rev. Stat. Section 456.8-801; Mont. Code Ann. Section 72-38-801; Neb. Rev. Stat. Section 30-3866; N.H. Rev. Stat. Ann. Section 564-B:8-801; N.J. Stat. Ann. Section 3B:31-54; N.M. Stat. Ann. Section 46A-8-801; N.C. Gen. Stat. Section 36C-8-801; Ohio Rev. Code Ann. Section 5808.01; Or. Rev. Stat. Section 130.650; 20 Pa. C.S. Section 7771; S.C. Code Ann. Section 62-7-801; Tenn. Code Ann. Section 35-15-801; Utah Code Ann. Section 75-7-801; Vt. Stat. Ann. tit. 14A, Section 801; Va. Code Ann. Section 64.2-763; W. Va. Code Section 44D-8-801; Wis. Stat. Section 701.0801; Wyo. Stat. Section 4-10-801.

29. UTC Section 802(a) (emphasis added).

30. 760 Ill. Comp. Stat. 3/802.

31. Ala. Code Section 19-3B-802(a); Ariz. Rev. Stat. Ann. Section 14-10802(A); Ark. Code Ann. Section 28-73-802(a); Colo. Rev. Stat. Section 15-5-802(1); Conn. Gen Stat. Section 45a-499bbb(a); D.C. Code Section 19-1308.02(a); Fla. Stat. Section 736.0802(1); Haw. Rev. Stat. Section 554D-802(a); Kan. Stat. Ann. Section 58a-802(a); Ky. Rev. Stat. Ann. Section 386B.8-020(1); Me. Rev. Stat. Ann. tit. 18-B, Section 802(1); Md. Code Ann., Est. & Trusts Section 14.5-802(a); Mass. Gen. Laws ch. 203E, Section 802(a); Mich. Comp. Laws Section 700.7802(1); Minn. Stat. Section 501C.0802(a); Miss. Code Ann. Section 91-8-802(a); Mo. Rev. Stat. Section 456.8-802(1); Mont. Code Ann. Section 72-38-802(1); Neb. Rev. Stat. Section 30-3867(a); N.H. Rev. Stat. Ann. Section 564-B:8-802(a); N.J. Stat. Ann. Section 3B:31-55(a); N.M. Stat. Ann. Section 46A-8-802(A); N.C. Gen. Stat. Section 36C-8-802(a); N.D. Cent. Code Section 59-16-02(1); Ohio Rev. Code Ann. Section 5808.02(A); Or. Rev. Stat. Section 130.655(1); 20 Pa. C.S. Section 7772(a); S.C. Code Ann. Section 62-7-802(a); Tenn. Code Ann. Section 35-15-802(a); Utah Code Ann. Section 75-7-802(1); Vt. Stat. Ann. tit. 14A, Section 802(a); Va. Code Ann. Section 64.2-764(A); W. Va. Code Section 44D-8-802(a); Wis. Stat. Section 701.0802(1); Wyo. Stat. Section 4-10-802(a).

32. UTC Section 814(a) (emphasis added).

33. Ala. Code Section 19-3B-814(a); Ariz. Rev. Stat. Ann. Section 14-10814(A); Ark. Code Ann. Section 28-73-814(a); Colo. Rev. Stat. Section 15-5-814(1)(a); Conn. Gen Stat. Section 45a-499lll(a); D.C. Code Section 19-1308.14(a); Fla. Stat. Section 736.0814(1); Haw. Rev. Stat. Section 554D-814(a); Kan. Stat. Ann. Section 58a-814; Ky. Rev. Stat. Ann. Section 386B.8-140(1); Mass. Gen. Laws ch. 203E, Section 814(a); Minn. Stat. Section 501C.0814(a); Mo. Rev. Stat. Section 456.8-814(1); Mont. Code Ann. Section 72-38-814(1); Neb. Rev. Stat. Section 30-3879(a); N.H. Rev. Stat. Ann. Section 564-B:8-814(a); N.J. Stat. Ann. Section 3B:31-68; N.M. Stat. Ann. Section 46A-8-814(A); N.C. Gen. Stat. Section 36C-8-814(a); Ohio Rev. Code Ann. Section 5808.14(A); Or. Rev. Stat. Section 130.715(1); 20 Pa. C.S. Section 7780.4; S.C. Code Ann. Section 62-7-814(a); Utah Code Ann. Section 75-7-812(1); Vt. Stat. Ann. tit. 14A, Section 814(a); Va. Code Ann. Section 64.2-776(A); W. Va. Code Section 44D-8-814(a); Wis. Stat. Section 701.0814(1).

34. 760 Ill. Comp. Stat. 3/814; Me. Rev. Stat. Ann. tit. 18-B, Section 814; Md. Code Ann., Est. & Trusts Section 14.5-814; Mich. Comp. Laws Section 700.7815; Miss. Code Ann. Section 91-8-814; N.D. Cent. Code Section 59-16-14; Tenn. Code Ann. Section 35-15-814; Wyo. Stat. Section 4-10-814.

35. The text of the UPC may be viewed at www.uniformlaws.org.

36. See, e.g., Alaska Stat. Section 13.36.090; Idaho Code Section 15-7-305.

37. UPC Section 7-305 (emphasis added).

38. Ind. Code Section 30-4-6-3(c).

39. Restatement (Third) of Trusts Section 76 (2003).

40. Ibid., Section 76 cmt. b(2) (2003) (cross references omitted). Like other Restatement provisions, Section 76 is understood as “describing the law in a given area and guiding its development” (Black’s Law Dictionary 1570 (11th ed. 2019)).

41. La. Stat. Ann. Section 47:300.10(3)(b) (emphasis added).

When it comes to charitable remainder trusts (CRTs), Groucho Marx’s line from the 1930 movie Duck Soup is instructive: “Why, a four-year-old child could understand this report. Run out and find me a four-year-old child.  I can’t make head or tail out of it.”1

This is the third article in our three-part series about charitable trusts. Our first article covered ugly tax schemes that caused trouble for donors and their advisors,2 and our second article discussed charitable remainder unitrusts (CRUTs) and charitable remainder annuity trusts (CRATs).3 To wrap up the series, we’ll explain the gift and estate tax rules and how to qualify for the CRAT and CRUT safe harbors. And how to fix up muck ups.  

Gift Tax Rules 

The income tax rules (previously covered) are always first on the list. Not knowing the gift tax values can do in clients (and advisors).  

Most clients need only worry about federal gift tax returns, but for those lucky enough to live in Connecticut, a state gift tax return might also be needed. Always check whether state and local tax rules apply.  

CRUTs and CRATs.  If your client has a one-life CRUT or CRAT for the donor’s life, the value of the charitable remainder interest in the qualified trust isn’t subject to gift tax. However, the donor must report the remainder gift (regardless of its size because it’s a future interest) on a federal gift tax return.4 The donor then takes an off-setting gift tax charitable deduction.5  

One-life CRUTs and CRATs for the benefit of someone other than the donor are treated differently. That donor makes two gifts: one to the beneficiary (the value of the life interest) and one to the charity (the value of the remainder interest).

Gift to life beneficiary. Say adonor makes a gift to the life beneficiary of the value of the life interest. That interest is a present interest, so it qualifies for the annual gift tax exclusion. If that interest’s value exceeds the annual gift tax exclusion and the “tentative” tax on the gift isn’t offset by the unified transfer tax credit, some gift tax will be due.6 The rules for determining the life beneficiary’s interest when the beneficiary is the donor’s spouse are similar, but with one positive exception: As long as the trust doesn’t have any non-spouse beneficiaries, the U.S. citizen spouse’s life interest qualifies for the automatic unlimited gift tax marital deduction (no election needed).7 

Suppose the second life beneficiary’s interest follows the donor’s life interest. The donor can avoid making a gift to the survivor by providing in the inter vivos trust the right (exercisable only by will) to revoke the survivor’s life interest. If the donor exercises that right, the trust terminates on the donor’s death. The trust principal is then delivered to the charity. The donor doesn’t have to exercise that right in their will. Merely retaining the right avoids the donor making a completed gift to the survivor beneficiary.8 

As long as a CRUT or CRAT doesn’t have any non-spouse beneficiaries, a U.S. citizen spouse’s future interest in a CRUT or CRAT qualifies for the automatic unlimited gift tax marital deduction (no election needed).9 Alternatively, you can avoid gift tax concerns by having the donor reserve the right in the inter vivos trust to revoke the surviving spouse’s life interest by will. 

Two-life CRUT or CRAT funded with joint, tenancy in common or community property, and donors are spouses. The trust should provide for payments to the donors jointly for life and then to the survivor for life. The charitable remainder interest is reportable (regardless of size because it’s a future interest) on the federal gift tax return, then it’s deductible as a charitable contribution, resulting in a wash. For example, an actuarially older spouse makes a gift to an actuarially younger spouse of the difference in value of their survivorship interests. As long the trust doesn’t have any non-spouse beneficiaries, the gift qualifies for the automatic unlimited gift tax marital deduction (no election need be made) for U.S. citizens.10 It’s unnecessary for gift tax purposes (although it can’t hurt) for the spouses to reserve the right to revoke, as outlined above. But the taxpayers may want to retain the right to revoke and actually revoke it if there’s a divorce. If the spouses are divorced, the gift won’t qualify for the estate tax marital deduction. A divorce settlement agreement should deal with this issue. 

Revoking a beneficiary’s interest. Although it’s retained in an inter vivos CRT, the right to revoke should be exercisable only by will. If the right is exercisable during the donor’s life, the trust will be disqualified. The right to revoke shouldn’t be retained unless the donor is a trust beneficiary. For example, in a trust providing payments to the donor’s son for life, with the remainder passing to charity, the trust could be disqualified if the donor retains the right to revoke the son’s interest. Why? The trust would potentially be measured by the donor’s life instead of the son’s life.11 Absent a retained right, the son’s interest wouldn’t be includible in the donor’s gross estate. But apparently, a non-beneficiary donor can keep a testamentary right to revoke a beneficiary’s interest in a term-of-years trust. The Internal Revenue Service approved one such trust in Private Letter Ruling 8949061 (Dec. 8, 1989). Remember, PLRs are “authority” only for the recipient. 

Estate Tax Rules 

Here’s a review of several common situations involving estate tax and marital deduction rules:

Donor is the sole beneficiary of an inter vivos CRUT or CRAT. The value of the trust assets at the donor’s death (or at the alternate valuation date) is includible in the donor’s gross estate when the donor retains a life interest in the trust. The estate deducts the value of the trust assets as a charitable contribution, resulting in a wash.12 But the value of the trust assets isn’t includible in the donor’s gross estate when the donor creates an inter vivos CRUT or CRAT for a beneficiary other than the donor.13

For two-life inter vivos CRATs and CRUTs funded with the donor’s separate property with payments to the donor for life and then to a non-spouse second beneficiary for life, the value of the trust assets at the donor’s death (or alternate valuation date) is includible in the donor’s gross estate whether or not the second beneficiary survives the donor.14 If the second beneficiary doesn’t survive the donor, the amount includible in the gross estate will be deducted as a charitable contribution—again, resulting in a wash.15 If the second beneficiary survives the donor, the donor will deduct the value of the charitable remainder as a charitable contribution. In effect, only the value of the survivor beneficiary’s life interest is subject to tax. If an alternate valuation date is elected, in computing the value of the charitable remainder, the donor must use the value of the assets at the alternate valuation date, but the donor must use the age of the survivor beneficiary (at the nearest birthday) as of the date of the donor’s death.16

Two-life inter vivos CRUT or CRAT funded with jointly owned property when donors who are beneficiaries are spouses. Only half of jointly held property owned by spouses is includible in the estate of the first spouse to die, regardless of who furnished the consideration.17 The estate of the first spouse to die gets an estate tax charitable deduction for the remainder interest in half the property includible in the gross estate and automatically gets (without an election) a marital deduction for the value of the surviving U.S. citizen spouse’s life interest in half the joint property includible in the gross estate, as long as the trust doesn’t have any non-spouse beneficiaries.18 

CRUTs or CRATs created by donor’s will for benefit of U.S. citizen spouse. The estate receives an estate tax marital deduction (no election) for the value of the surviving spouse’s life interest and an estate tax charitable deduction for the value of the charity’s remainder interest. Thus, the entire value of the trust assets isn’t subject to tax.19 The estate tax marital deduction for the spouse’s life interest is allowable only if the spouse is the sole beneficiary.20 For example, a remainder trust created by the donor’s will providing payments to spouse for life, and then to son for life, wouldn’t qualify for the estate tax marital deduction. The charitable remainder interest would still qualify for the estate tax charitable deduction. In PLR 200204022
(Jan. 25, 2002), a disclaimer saved the marital deduction, but at a price. The non-spouse beneficiaries had to give up income.

Safe Harbors

The IRS gives sample CRAT and CRUT forms. Specifically, we’ll review two revenue procedures that provide some well-drafted samples, along with annotations, which are a complete course in themselves.21 A trust instrument that contains substantive provisions in addition to those provided in the revenue procedures discussed below (other than properly integrated alternative provisions from the revenue procedure or provisions necessary to establish a valid trust under applicable local law that are consistent with the applicable federal tax requirements) or that omits any of the provisions of the revenue procedures (unless an alternative provision is properly integrated) “will not necessarily be disqualified, but neither will that trust be assured of qualification under the provisions of this revenue procedure.”22

Revenue Procedure 2005-52 provides that previously, the IRS issued sample trust instruments for certain types of CRUTs. The IRS updated the previously issued samples and issued new samples for additional types of CRUTs. Section 4 of Rev. Proc. 2005-52 presents a sample declaration of trust for an inter vivos CRUT with one measuring life that’s created by an individual who’s a U.S. citizen or resident. Section 5 provides annotations to the provisions of the sample trust. Section 6 offers samples of several substitute clauses concerning: the payment of part of the unitrust amount to an organization described in Section 170(c); a qualified contingency; the last unitrust payment to the recipient; the restriction of the charitable remainderman to a public charity; a retained right to substitute the charitable remainderman; a power of appointment to designate the charitable remainderman; the net income method of calculating the unitrust amount; the net income with make-up method of calculating the unitrust amount; and a combination of methods for calculating the unitrust amount.23 

Rev. Proc. 2003-53 deals with CRATs. Like Rev. Proc. 2005-52, this revenue procedure updates previously issued samples and provides new samples for additional types of CRATs. It also includes annotations and alternate sample provisions. Section 4  presents a sample declaration of trust for an inter vivos CRAT with one measuring life that’s created by an individual who’s a U.S. citizen or resident, and the annotations to the provisions of the sample trust are found in Section 5. Section 6 provides samples of alternate provisions concerning: the statement of the annuity amount as a specific dollar amount; the payment of part of the annuity to an organization described in Section 170(c); a qualified contingency; the last annuity payment to the recipient; the restriction of the charitable remainderman to a public charity; a retained right to substitute the charitable remainderman; and a power of appointment to designate the charitable remainderman.24

The trust forms are very helpful, but you can’t just fill in the blanks of the sample. You must first determine: the type of property ownership; whether the donor or donors will also be beneficiaries; who the donors are; whether the funding asset is marketable; the nature of the charitable remainder organization; that the payout is neither less than 5% nor more than 50%; compliance with the 10% minimum remainder interest requirement; and when to add or substitute an alternative provision. 

Use the IRS specimens as your guide. In many cases, you’ll want to mix and match and make your own modifications. To get the whole ball of tax (all the specimens, alternative provisions and annotations), see Rev. Proc. 2005-52 through Rev. Proc. 2005-59.

To avoid the torpedoes when qualifying CRUTs and CRATs for safe harbor protection:

The donor must be one individual or, if two individuals are the donors, they must be married;

The IRC requirements not relating to the provisions of the governing instrument must also be met; 

The trust must operate in a manner consistent with the terms of the trust instrument; 

The trust must be a valid trust under applicable local law; and 

The trust instrument must be substantially similar to the IRS’ sample in the applicable revenue procedure or properly integrate one or more alternative provisions from the revenue procedure.

It’s not enough to have all the required governing provisions. Even if a trust is exactly the same as an IRS safe harbor specimen, it must actually operate as a CRT and do what the trust instrument specifies. Otherwise, income, gift and estate tax charitable deductions will be denied; all capital gains will be taxable; and the gift and estate tax marital deductions will be lost. Other than that, not to worry.  

You may want to look away from your computer screen. The following may be shocking: The U.S. Court of Appeals for the Eleventh Circuit held that an inter vivos CRAT’s failure to comply with the required annual payment regulations during the donor’s lifetime resulted in a complete loss of the estate tax charitable deduction—even though substantial sums would go to charity. The loss of the charitable deduction cost the estate $2,654,976.25 Although the case dealt with a CRAT, the same rule applies to CRUTs.

Making (and Fixing) Mistakes

Throughout this and our two previous Trusts & Estates articles, we discussed how to properly use CRTs not only to achieve the most favorable tax treatment but also to provide the most benefit to charity. Sometimes, even with the best intentions, practitioners mess up. CRTs don’t always go as planned. When the unexpected happens, sometimes you can save them.

Scrivener’s error. Lucy and Ricky wanted to create a net income with make-up CRUT (NIM-CRUT), funding it with highly appreciated stock. Unfortunately, due to a lack of communication among their financial planner, their attorney and the charity’s planned giving director (who assisted the financial planner), the couple mistakenly created a standard charitable remainder trust (STAN-CRUT). The couple had filed all tax returns as if the trust were a NIM-CRUT. Lucy and Ricky soon discovered the scrivener’s (lawyer’s) error and wanted to reform the trust under state law. The reformation’s sole purpose was to convert a STAN-CRUT into a NIM-CRUT.

The IRS ruled that,provided a state court concludes that a scrivener’s error occurred and the modification is made under state law, the proposed reformation altering the payment method won’t violate IRC Section 664 and won’t disqualify the trust. The IRS based its conclusion on the landmark case, Commissioner v. Estate of Bosch,26 holding the decision of a state’s highest court on an underlying substantive rule of state law controls when applied to a federal matter.27 

Prohibited contribution returned—CRUT saved. You can’t make additional contributions to a CRAT. You can, however, make additional contributions to a CRUT if the governing instrument permits and gives a formula for determining the payments in any year of additional contributions.

In one case, thedonors (husband and wife) funded their CRUT with securities. They were the trustees and income beneficiaries. Later, they made an additional stock contribution to the trust, and the stock was sold.Just one problem:The CRUT’s governing instrument prohibited additional contributions. Soon after the second contribution, the donors realized their mistake. The trust’s custodians, at the donors’ direction, identified and maintained records of the proceeds of the second contribution. The husband and wife didn’t take a charitable deduction for the second contribution, and it wasn’t used to calculate their CRUT payments.

The donors, as trustees, proposed to return the proceeds of the second contribution to themselves,  as donors. They would amend their individual tax returns to report any capital gains and dividend income generated by the second contribution while it was in the unitrust.

The IRS ruled thatthe second contribution of stock would be ignored for federal tax purposes and wouldn’t disqualify the trust as a CRUT, provided that the donors amend their tax returns to report any capital gains and dividend income generated by the second contribution of stock while it was in the trust’s account.28 

Comment.It’s comforting that the IRS let the donors make amends for their error. But the IRS and the courts aren’t always so forgiving. Compare this ruling with the Tax Court’s decision in Atkinson v. Comm’r,29 in which a perfectly drawn CRAT was disqualified because it was imperfectly operated. Even minor infractions may do you in.

CRT with multiple muck-ups not reformable. Fixing a defective CRT to get income, gift and estate tax charitable deductions and avoid tax on the trust’s sale of appreciated assets generally involves two steps: (1) reforming the trust by deleting improper provisions and adding missing ones; and (2) getting the IRS to go along with the reformation (an approving IRS letter ruling or no challenge from the IRS on an audit).

While the first step isn’t always a gimme, courts are generally liberal in approving reformations to save charitable gifts and attendant deductions. And a trip to the court house to reform a trust can often be avoided if the trust instrument gives the trustee the power to amend the trust to comply with the requirements of Section 664, the regulations thereunder and any other Treasury or IRS requirements for CRTs. A draftsperson who drew a defective CRT may have omitted such a provision. Some states allow reformation with the consent of all the parties (the state attorney general may be a necessary party).

The second step—getting the IRS to go along with a reformation—is the tougher one. The IRC imposes not-always-achievable requirements and not-always-meetable deadlines.

Let’s look at a New York Surrogate’s Court case that describes a trust that gives new meaning to the expression “every mistake in the book.” Surrogate C. Raymond Radigan’s opinion is concise, so we’ll let him tell about the trust and why he wouldn’t allow a reformation:

This is a petition brought by the trustees of an irrevocable lifetime trust to reform the instrument to qualify as a charitable remainder trust.

It is clear from the title of the instrument, ‘The Rita Antun Irrevocable Charitable Remainder Trust-1997’ and the references therein to IRC 664 that the intent of the grantor was to create a charitable remainder trust recognized as such by the Internal Revenue Service. The document fails to carry out that intent. The petition indicates that instrument does not qualify as a charitable remainder trust because it:

1. Permits a beneficiary or member of his family to occupy real estate owned by the trust rent-free;

2. Provides for payment of income to be made to the non-charitable beneficiaries from the trust in the trustee’s discretion;

3. Permits additional contributions to be made to the trust without, if the trust was intended to be a unitrust, providing a mechanism for the computation of the unitrust amount with respect to the addition;

4. Provides for an improper method of computing the commissions of the trustee;

5. Provides the trustees with various powers to operate a business and to purchase assets and to make loans to the trust.

Additionally, the instrument fails to contain language required by the Internal Revenue Code, as amended, which:

1. Provides for a sum certain to be paid to the non-charitable beneficiaries at least annually, expressed as either a stated dollar amount or as a percentage of the fair market value of the property placed in the trust (i.e., an annuity interest or a unitrust interest, with or without a full net income limitation provision);

2. Provides language in the trust instrument addressing the computation of the annuity or unitrust amount to be paid to the non-charitable beneficiaries in a short taxable year of the trust;

3. Names as the non-charitable beneficiaries only those persons to be used as measuring lives for the term of the trust;

4. Provides language in the trust instrument to address a potential incorrect valuation of the net fair market value of the trust assets;

5. Provides language in the trust instrument prohibiting additional contributions to the trust if the trust was to be an annuity trust, or prohibiting additions or permitting additional contributions with a mechanism to compute the unitrust amount in the event of additions, if the trust was to be a unitrust;

6. Provides the trustee with the power to designate charities to receive the remainder of the trust in the event that the named charities did not qualify at the termination of the trust as organizations to which contributions qualify for income and gift tax deductions under the Code.

The petition seeks the court’s indulgence to remedy the instrument’s short comings by reformation. The court is aware that courts often reform instruments to preserve a charitable deduction or other tax benefit, and has done so itself.

What is sought here, however, is not the reformation of one or two provisions of the instrument, but a wholesale rewriting of the instrument. An expressed desire to create a charitable remainder trust will not suffice to create one and the court is not authorized to draft a new instrument under the guise of reformation. 

The petition is denied. This decision constitutes the order of the court.30

Final Thoughts

We end with the good, the bad and the ugly.

The good: Properly drawn and administered CRTs give donors the satisfaction of making important charitable gifts, a lifetime (or term-of-years) income stream and significant tax benefits. 

The bad and the ugly: Conversely, the result of a poorly drawn—or perfectly drawn but improperly administered—trust is the loss of income, gift and estate tax charitable deductions, as well as the trust’s tax exemption. Sometimes a muck-up can be fixed up by a reformation, but don’t bet the ranch on it. 

That said, though seemingly fraught with peril, CRTs are, nonetheless, effective mechanisms to benefit worthy causes while achieving favorable tax results. At the heart of it all is a donor’s charitable intent and advisors who know their stuff. As the Tax Code grows ever more complex, taxpayers need a cohesive and competent team to guide them through. We hope our three articles have helped you gain a better understanding of these powerful tools to benefit charities and your clients and how to use them. And if you still don’t get it, you can always try to find a four-year-old child. 

Endnotes

1. Duck Soup, Paramount, 1933.

2. Conrad Teitell, Heather J. Rhoades and Brianna L. Marquis, “The Ugly Side of Charitable Remainder Trusts,” Trusts & Estates (October 2023).

3. Conrad Teitell, Heather J. Rhoades and Brianna L. Marquis, “Issues Regarding Charitable Remainder Trusts,” Trusts & Estates (November 2023).

4. Internal Revenue Code Section 6019.

5. IRC Section 2522(c)(2)(A); Treasury Regulations Section 25.2522(c)-3(c)(2)(iv) and 1.664-4.

6. IRC Section 2503(a); Treas. Regs. Section 25.2503-3(b).

7. IRC Section 2523(g).

8. Ibid., Revenue Ruling 79-243; Treas. Regs. Sections 1.664-3(a)(4) and 25.2511-2(c).

9. See supra note 7.

10. Ibid.

11. Treas. Regs. Sections 1.664-2(a)(5), -3(a)(5).

12. IRC Sections 2036 and 2055(e)(1)(B); Treas. Regs. Section 1.664-4.

13. IRC Section 2035(d).

14. Section 2036.

15. IRC Section 2055(e)(1)(B); Treas. Regs. Section 20.2031-7.

16. IRC Section 2032(b)(2).

17. IRC Section 2040(b).

18. Sections 2055(e)(2)(A) and 2056(b)(8).

19. Ibid.

20. See Private Letter Ruling 8730004 (April 15, 1987), Rev. Proc. 2003-53 (Aug. 4, 2003).

21. Rev. Proc. 2005-52 (Aug. 22, 2005) (charitable remainder unitrusts); Rev. Proc. 2003-53 (Aug. 4, 2003) (charitable remainder annuity trusts).

22. Rev. Proc. 2005-53 (Aug. 4, 2005).

23. Rev. Proc. 2005-52 (Aug. 22, 2005).

24. See supra note 21. 

25. Estate of Atkinson v. Commissioner, 309 F.3d 1290 (11th Cir. 2002), cert. denied, 124 S. Ct. 388 (2003).

26. Comm’r v. Estate of Bosch, 387 U.S. 456 (1967).

27. PLR 200218008 (May 3, 2002).

28. PLR 200052026 (Dec. 29, 2000).

29. Atkinson v. Comm’r,  U.S. Tax Ct. No. 20968-97 (Oct. 16, 2002).

30. Matter of Antun, NYLJ, Dec. 14, 2000, at p. 34 (N.Y. Surr. Ct.).

•Private letter ruling confirms trust settlement doesn’t create gift or generation-skipping transfer (GST) tax issues—In PLR 202343005 (Oct. 27, 2023), a family sought confirmation that its settlement agreement regarding several family trusts wouldn’t cause adverse GST or gift tax consequences.

A married couple created a series of testamentary trusts for their children under their wills. The trusts became irrevocable before Sept. 25, 1985 and, as a result, were grandfathered for GST tax purposes. Over the years, after one child died without children and pursuant to state court orders, the trusts for the children divided into further trusts for grandchildren. 

The trust company serving as trustee of each of the trusts filed a petition with the state court to construe the definition of the term “children” and “descendants” because two of the eight grandchildren had adopted individuals who were older than 18. The issue at hand was whether those adopted individuals qualified as descendants of the original settlors and beneficiaries of the trust. A state law answered this question, but the law was enacted after the date of the settlors’ deaths, so it wasn’t clear if it was applicable to the trusts established under the settlors’ wills.

After years of litigation, the family members and trustee entered into a settlement agreement that the state court approved. The agreement provided that certain cash payments would be made to the adopted individuals and to separate trusts for their benefit.

The Internal Revenue Service ruled that the lengthy litigation clearly showed that the parties had adverse interests, the issue was bona fide and the settlement agreement was the product of an arm’s length negotiation. Further, the settlement was within the range of reasonable outcomes under the wills and state law. As a result, the various distributions and trust severances under the settlement didn’t interfere or affect the GST tax status of any of the trusts. In addition, none of the family members were treated as making taxable gifts.

•Successor trustees are liable for unpaid taxes—In May 2023, the U.S. Court of Appeals for the Ninth Circuit issued its opinion in U.S. v. Paulson (May 17, 2023) in favor of the government. The estate has filed a petition for writ of certiorari at the U.S. Supreme Court.

Alan Paulson, a Gulfstream Aerospace executive, died in 2000. He was survived by his third wife and three children from a prior marriage, as well as grandchildren. His son John Michael was appointed a co-executor and co-trustee of Alan’s living trust. The estate filed an estate tax return showing a gross estate of over $187 million. After deductions, Alan’s net estate was about $9.2 million, and estate tax of $4.4 million was due. About one-sixth of the estate tax was paid with the return that was filed on time. An election under Internal Revenue Code
Section 6166 was made to pay the remaining estate tax in installments. Most of the estate was comprised of real estate, stocks, bonds, cash and receivables, all held in Alan’s living trust. 

While disputes were ongoing and tax payments were due, the trustee made significant distributions from the trust. For example, in 2003, John Michael made distributions to Alan’s wife, which the children allege were valued at more than $42 million. 

In 2005, the Tax Court affirmed the IRS’ notice of deficiency that an extra $6.6 million in estate taxes was due. The estate elected to pay the additional amount in installments under IRC Section 6166, timely paid the installments in 2006 and 2007 and received a 1-year extension for the 2008 payment. But due to disputes among the family members and beneficiaries, John Michael was removed for misconduct as trustee in March 2009, and no further tax payments were ever made.

Vikki and James Paulson were appointed as John Michael’s successor trustee. A year later, the IRS terminated the Section 6166 election and issued a notice of final determination for all the overdue taxes. James was removed as trustee in 2010 and replaced by Crystal Christenson.

Further disputes arose among the family and, ultimately, were settled by the family with court approval. In 2015, the United States sued the estate and trust for over $10 million in unpaid estate tax,  as well as John Michael, Alan’s wife, James, Vikki and Crystal to impose a judgment against them as individuals under IRC Section 6324(a)(2).

Section 6324(a)(2) imposes personal liability for unpaid estate tax on:

the spouse, transferee, trustee . . . , surviving tenant, person in possession of the property by reason of the exercise, non-exercised or release of a power of appointment, or beneficiary who receives, or has on the date of the decedent’s death, property included in the gross estate under section 2034 to 2042.

James, Vikki and Crystal asserted the living trust was insolvent when they accepted their trusteeship years after Alan had died. They argued that Section 6324(a)(2) imposes personal liability on those individuals who receive or have property on the date of decedent’s death. Those who receive property from the estate later, after the decedent’s death, should have no personal liability for the estate tax. They cited to significant case law support.

However, the Ninth Circuit held for the IRS, basing its opinion on a close reading of the grammatical text and broader reading of the estate tax sections of IRC Sections 2034 to 2042. It noted that most of the cases relied on by the defendants predated Section 6324. This case makes it clear that successor trustees (reasonably so) take on the liability of their predecessors when it comes to unpaid taxes.  

With the holiday shopping season in full swing, many consumers enjoy the search for a bargain. In the world of philanthropy, there are “bargains” as well. The recently decided case of Braen v. Commissioner1 shows how easily the benefits of a bargain may be lost without proper documentation and calculation of the “net” provided to charity. 

Overview

The most common form of bargain is the charitable gift annuity. That involves the transfer of an asset to a charity for less than full and adequate consideration with a gift annuity agreement documenting the charitable intent. The charitable income tax deduction is the difference between the fair market value (FMV) of the asset less anything of value received by the transferor from the charity.2 The difference between the value of the cash and or property surrendered less the value of the income payments going to the annuitants will be the charitable deduction. A contemporaneous written acknowledgment (CWA) will so state the difference.3 

Sale of Real Estate

The rarer form of bargain involves the sale of appreciated real estate. The appeal to a donor is not only supporting a favorite charity but also generating a multi-year cash flow and a charitable deduction. So long as the donor is content to incur a partial capital gains tax in the year of transfer and able to restructure any debt on the property before the closing, this transaction can make sense.

The appeal to the charity often is certainty of result. The sale secures the immediate possession of the property at a fraction of its FMV. For larger charities, with access to cash and a reliable due diligence process to assess environmental risk, this approach may be attractive, especially when the real estate is near the charity.

Sale to government entities. Typically,when a taxpayer transfers property to a local government or political subdivision and a change in zoning or an approval of a subdivision follows, enhancing the value of the surrounding property of the donor, the courts won’t allow a charitable deduction.4 “If it is understood property will not pass unless the taxpayer receives a specific benefit then the transfer does not qualify for the charitable deduction.”5  

Sometimes the taxpayer can argue successfully that any benefit realized is incidental, in which case a charitable deduction is allowed.6 For example, a taxpayer was allowed a deduction for the cost of a highway interchange constructed and given to a public highway authority notwithstanding the interchange increased the accessibility of the taxpayer’s property being prepared for development.7 That case makes clear the burden is on the seller to prove any consideration received is less than what’s paid to the purchaser.

“Bargain” in Braen

Taxpayers as owners of an S corporation litigated for years in securing a mining permit from the town of Ramapo, N.Y. Part of the consideration was the rezoning of the property to be retained by the sellers as industrial and permitting quarrying. So in effect, the taxpayers sold 425.5 undeveloped acres, while receiving the right to mine on the surrounding 78 acres. The taxpayers failed to document the value of the consideration received from the purchaser. The court rejected their argument that they were legally entitled to the zoning change and would have prevailed in litigation. 

Even though there was an allusion in the acknowledgment letter to the litigation between the taxpayers and the governmental body, there wasn’t an explicit enough statement of that being something that was received. Thus, the taxpayers failed to satisfy Internal Revenue Code Section 170(f)(8)’s CWA requirement to include a description and good faith estimate of value of any goods or services received as consideration. The acknowledgment incorrectly stated that the town didn’t provide “any goods or services . . . as consideration” other than cash. 

So, how could the taxpayer approach the valuing of the consideration received? An excellent starting point would be the “before and after approach” used for valuing a perpetual easement restriction. Treasury Regulations Section 1.170A-14(h)(3) would be especially useful to study, as it addresses valuation of consideration regardless of whether the remaining property of the donor is contiguous to the donated property. Specifically, the taxpayers should have determined the value of the underlying property before and after the sale.

Braen shows the care with which charitable intent must be documented and the awareness required as to what the seller might receive from the purchaser. Notwithstanding the dramatic difference of $12.3 million between the sales price and appraised FMV, the 70% discount didn’t, by itself, prove donative intent. Charitable intent also is needed to secure the charitable deduction for split-interest gifts like charitable remainder trusts and charitable gift annuities as well as outright gifts.

Braen also shows the consequences of a defective CWA and appraisal.

Noncompliance with the documentation and substantiation not only eliminates the tax savings  but also exposes the counsel and accountants to tax malpractice. Accountants, lawyers and financial advisors be warned!

Endnotes

1. Braen, et al. v. Commissioner, T.C. Memo. 2023-85 (July 11, 2023). 

2. Treasury Regulations Section 1.1011-2(b).

3. Treas. Regs. Section 1.170A-13(f)(3).

4. Pollard v. Comm’r, T.C. Memo. 2013-38; Boone Operations LLC, Fairfax Cos v. Comm’r, T.C. Memo. 2013-101.

5. Costello v. Comm’r, T.C. Memo. 2015-1987.

6. Private Letter Ruling 8421018 (Feb. 15, 1984) and Osborne v. Comm’r, 87 T.C. 575 (1986).

7. Seventeen Seventy Sherman St. LLC v. Comm’r, T.C. Memo. 2014-124.

Advisors have an important role in convincing clients to take the necessary steps to achieve their goals. My thesis is that clients can sense our doubts. If we’re unsure about a strategy, if we worry about it, if we’re confused about it, if we think it’s too risky or complex, the client will sense that and draw back no matter how enthusiastic we try to appear. Think about your physician, who may express doubt in the face of uncertain diagnosis or may summarize the pros and cons of options, but in almost all instances will end with a hearty “here’s what we need to do”—or words to that effect. Your physician knows that their confidence is one key to your healing.

No advisor understands every idea, technique or possible plan. Often, we advisors even manage to confuse ourselves. We understand grantor retained annuity trusts (GRATs), but we’re not quite sure what seminar speakers mean when they discuss the 105-day grace period for paying the annuity. We understand charitable remainder trusts, but we’re not quite sure how a flip-charitable remainder unitrust (CRUT) operates, or we question whether we should be recommending CRUTs when we see a private letter ruling that disallows a CRUT in which a trustee could allocate 75% of the unitrust payment between a surviving spouse and charity. We’ve been drafting trusts for spouses and descendants for years, but now we hear about spousal lifetime asset trusts—are they the same or something different?  

Stick to the Basics

I bring happy news: The goals of most clients represented by most advisors, most of the time, can be met using common techniques, the basics of which are well understood and often time-tested. For instance, a GRAT in which the annuity is paid once a year or once a quarter, right on time, will work just fine for almost all of our clients almost all of the time. Even better, if we stick to those “basic” parts of even “advanced” techniques, then we’ll be much more confident in our recommendations, and that confidence will inspire our clients who will then move along with their planning.

Advisors sometimes worry that they’ll be criticized by other advisors if they don’t recommend the latest bell and whistle. When I was a young lawyer, I drafted a complicated charitable lead annuity trust (CLAT) using a form drafted and publicized by a leading lawyer in New York City. Some other lawyers sent me a list of half a dozen things that my CLAT lacked. So I called the lawyer: “None of those things are necessary,” was the simple reply. The answer is a good one and fits a myriad of circumstances. If the last bell and whistle isn’t necessary, why use it? “I don’t find it helpful to add that complexity” is a perfectly fine response to those who want to push us beyond where we’re comfortable.  

Expertise isn’t an end in itself, it’s a tool we deploy to help our clients. We understand that no matter how rich our client is, there’s always someone richer (even if sometimes our clients have a hard time remembering that), and similarly, no matter how much knowledge and experience we have, there’s always—always—someone who’s executed a great idea that we haven’t thought of. So what? Our job is to meet the needs of our clients, and for almost all of them, that last great idea isn’t necessary. If we do what we’re comfortable with and excited about doing, we’ll take care of our middle rich clients. 

That isn’t to say that each of us shouldn’t work hard all the time to learn and become more comfortable with a larger range of planning options. My observation of advisors is that those who don’t keep learning ought to retire because they’ll quickly lose the ability to inspire and lead clients. However, each of us must learn in our own way, at our own pace, not in response to pressures to solve client problems on the fly with ideas we don’t really understand.

Who’s Middle Rich?

I’ve mentioned middle rich clients, but who are they? Truth: I don’t know . . . but I have a guess. Let’s start with who’s “rich.” Reports in the summer of 2022 were that the median wealth of the top
1% in the United States was between $11 million to $11.5 million.1 And we know that there’s no estate tax in 2023 until our client has almost $13 million. It seems to me that our client isn’t rich if their estate is below the estate tax threshold. If that’s rich, who’s middle rich?

Let’s try a thought experiment. How much money would a client have to have to zero out their estate if, in 2023, they have their full exclusion amount unused, a 20-year life expectancy, spend all of the income from all of their assets—let’s say about 2.5% annually, pre-tax—and will do no estate planning other than making a large gift to a grantor trust?  That is, the client wants to give away to a grantor trust about $13 million now and then every year swap assets into the trust in exchange for the cash earnings in the trust, so that the client may always spend all the cash from the client’s original asset pile. If the client’s assets appreciate at about 5% a year, on top of the 2.5% estimated income, the client with about $21 million will exhaust all of the assets they didn’t originally give away in about 20 years. If we assume the client makes some annual exclusion gifts, and perhaps some of the assets can be discounted a little bit under existing law, then the $21 million may approach $25 million, and if the client has a longer life expectancy, the client will need a larger pile of assets on Day 1 to avoid running out prematurely.  

This thought experiment suggests that without sophisticated estate planning, a client who gives away to a grantor trust what Uncle Sam allows, pays the income tax on the assets in the trust and swaps cash in the trust for assets out of the trust can have assets in the $20 million to $25 million range, double that for a couple, without paying any estate tax. That seems like a good working range for the middle rich.  

Before going further, note what makes this thought experiment work? Time—20 years in the example. A client who dithers for years waiting for the perfect plan or looking for the best advisor will eventually become the client for whom only emergency, last minute, undoubtedly complex, planning with many bells and whistles must be done.  

The Best Gift

Where I come from, there’s an old saying: The best way to drink bourbon is however you’re drinking it. Similarly, the best gift for your client to make is the one they’ll make. However much your client will give, and whatever the terms are of the grantor trust that your client will agree to have as beneficiary, that’s the best gift for your client to start with. Once the client starts estate planning, the client will enjoy continuing because you’ll give them all sorts of ideas. And those ideas, the ones you believe and have confidence in, are the ones your client will be excited about and eager to do.

As most advisors are aware, the lifetime exemption from federal gift, estate and generation-skipping transfer tax will rise to $13.61 million in 2024. Practitioners should educate clients about the benefits of planning before the exemption is cut in half by operation of law in 2026, or earlier, depending on the outcome of the 2024 federal elections. 

Wealth advisors, accountants and tax preparers must play a prominent role because they’re often in the best position to have the initial client conversations about planning and guide clients to reach out to their estate-planning attorney. Attorneys should discuss with clients the multiple benefits of planning now to achieve significant benefits. The following is an overview of some of the many reasons planning sooner rather than later may be advantageous.  

Asset Protection 

Clients are naturally concerned about risks to their assets from litigation as borne by grim statistics: “Nearly half of physicians 55 and older report having been sued compared with just 8 percent of doctors younger than 40;”1 and “. . . 50% of all civil lawsuits target small businesses annually. And 75% fear being targeted by a frivolous lawsuit.”2   

To achieve asset protection, clients should consider: 

Settling irrevocable trusts and making transfers to them before claims arise and perhaps before any particular claim is even anticipated.3 Assets transferred after a claim might be anticipated or, after a claim is known, may not be protected from the claimant. 

Planning for creditors who may claim they’re entitled to assets from a trust if protecting assets had been a motivating factor for setting up or transferring assets to a trust, even when the claim was unknown at the time of the transfer. The looming change to the lifetime exemption may deflect a later challenge that the transfer was a fraudulent conveyance.4  

Accomplishing asset protection transfers over time rather than all at once. By making annual gifts to a trust so that no one gift transfer is a very significant portion of the client’s net worth, each transfer might be less susceptible to attack as being a fraudulent conveyance. Any such “creeping” plan necessarily requires additional time to be fully effectuated.  

Strategic Distributions 

Non-grantor trusts pay federal income taxes on income earned at the highest tax rates for net income over $14,450 in 2023. The distributing non-grantor trust will realize a deduction up to distributable net income (DNI)5 distributed to the beneficiary who will pick up the income distributed. By making strategic distributions to beneficiaries in lower tax brackets, a trustee might be able to achieve income tax savings for the family as a whole.6  

Before making distributions, the trustee should evaluate the risks: 

Funds distributed to a beneficiary may be reached by that beneficiary’s creditors. 

Certain government aid programs might disqualify a beneficiary who receives distributions from a trust.  

When the trust has no accounting income, a distribution may not reduce the trust’s tax liability, particularly when the trust owns an interest in a pass-through entity. The trust’s tax advisor should calculate DNI and confirm the benefits of a distribution.  

If any beneficiary is a foreign domiciliary, there could be foreign tax implications that may outweigh the U.S. tax benefits of making a distribution.  

State Income Taxes

Carefully planned transfers to a non-grantor trust may also facilitate state income tax savings. A client living in a high tax state, such as California or New York, could form a trust in a low tax jurisdiction, like Nevada, Delaware or Alaska, to mitigate state income tax.  

A settlor’s spouse might be a beneficiary of a non-grantor trust so long as the trust instrument requires spousal distributions to be approved in advance by an adverse party, defined as “any person having a substantial beneficial interest in the trust which would be adversely affected by the exercise or nonexercise of the power which he possesses respecting the trust . . .”7 Thus, a trust might be able to hold assets that are exempt from high state income taxes but are still within the reach of the settlor’s spouse. Those state tax savings can be realized now. Why should the client defer such planning? If the trust is a completed gift non-grantor trust, pre-2026 planning now can add state tax savings. 

Enhanced Charitable Deductions

Unlike individuals, trusts aren’t limited by percentage limitations when deducting charitable contributions. Under Internal Revenue Code Section 642(c), trusts can deduct gross income paid for a charitable purpose. Additionally, trusts can make an election to treat charitable contributions of gross income made during the taxable year as if made in the preceding taxable year. Properly planned charitable distributions from trusts can provide income tax advantages so long as:

The trust instrument requires that contributions are paid from income;  

Charitable distributions aren’t made to discharge a legal obligation (for example, binding pledge) of the settlor (as in some trusts that might create an issue of estate inclusion); and 

The charitable purpose is specified in the trust instrument. The Internal Revenue Service has taken the position that a charitable beneficiary can’t be added later through non-judicial modification or make any other change that isn’t in the original instrument.

Even when the trust instrument doesn’t satisfy the requirements to permit direct charitable contribution deductions, a trust may still be able to take charitable contribution deductions made by an underlying pass-through entity owned by the trust. This pre-2026 planning may provide immediate income tax benefits.

Basis Step-Up

Any completed gift trust, whether characterized as grantor or non-grantor, might give a senior family member with a modest estate a general power of appointment (GPOA) over a trust holding appreciated property.8 On the death of that senior family member, the basis of assets subject to the GPOA may be stepped up to the date-of-death value, creating an opportunity for substantial income tax savings. Creating the trust in advance can permit distributions from the trust to the elderly relative to support an argument that the power wasn’t a mere naked power with no economic substance to such relative’s interests in the trust. 

A trust with such a GPOA should:

Prevent unintended use by the powerholder that would diminish the trust value;  

Include automatic adjustment in case the exemption amount declines before the power holder dies.; and

Consider whether trust assets could be subject to the claims of the powerholder’s creditors. If the potential powerholder is a credit risk, it might be safer to grant the power to a different family member.  

Step Transaction Doctrine

The step transaction doctrine gives advantage to planning earlier. In the simplest of terms, the IRS could apply the step transaction doctrine to collapse separate steps of a plan to create a devastating result for the client. The Tax Court decision in Smaldino v. Commissioner provides an illustrative and cautionary tale about how the step transaction doctrine might unravel an estate plan.9 In Smaldino, the husband gave his wife interests in a family limited liability company, which she purportedly transferred the next day to a trust benefiting the husband’s children from a prior marriage. The court found that it was really the husband that made the transfer to the trust and imposed a gift tax on the transfer.

Smaldino is perhaps an egregious bad facts example of how timing between steps might facilitate the IRS’ application of the step transaction doctrine to recharacterize transfers. However, it illustrates the point that timing can be a crucial factor in protecting the plan from creditor claims and IRS challenges.  

When practitioners are working with a married couple interested in shifting assets between them to accomplish estate planning, the recipient spouse should: 

Treat gifted funds as their own in many ways by reallocating investments, withdrawing funds and commingling funds with an old account of their own;  

Engage their own investment advisor;  

Invest a cash gift in a new investment portfolio;

Rather than re-gift the funds received from the donor spouse, have an independent analysis completed to determine how much to contribute to a trust for the donor spouse; 

Allow several months to pass (the more the better, there’s no definitive time period that assures escape from the step transaction doctrine), possibly into a separate tax year, before making a gift of assets received; and  

Adhere to legal and tax formalities. For example, when interests in a closely held business are transferred, the entity should have an amended operating or shareholder’s agreement confirming the new owner. The entity should issue a Schedule K-1 to the recipient spouse for the period of ownership.  

The longer the time between each phase of a plan, the more likely that each planning step may stand independently on its own. Ideally, there should be some economic implications to each step of the plan. To the extent feasible, each step should be able to serve as the final step. There should be no requirement or even need to proceed to later steps.

Reciprocal Trust Doctrine

The reciprocal trust doctrine can “un-cross” two trusts, deemed to be too similar, such as spousal lifetime access trusts (SLATs). To prevent application of the reciprocal trust doctrine, practitioners often try to differentiate SLATs: 

Create SLATs at different times, with different assets and trustees. That requires time, so encourage clients to start planning before the end of 2023;

Establish each SLAT in a different state. Consult local counsel;   

In one trust, the beneficiary spouse can be entitled to distributions each year, have a lifetime broad special POA, can change trustees (within the Revenue Ruling 95-58 safe harbor)and withdraw under an ascertainable standard (for example, health, education, maintenance and support). In the other trust, the beneficiary spouse would have no entitlement to current distributions, no power to change trustees and no POA, but could become eligible to receive distributions only on exercise by an adult child with the power to add beneficiaries;

Give one spouse a noncumulative “5 and 5” power, but not the other; or

Give one spouse a special POA, but not the other, recognizing that the absence of a POA reduces the flexibility of the trust. 

While it’s crucial for the spouses to be in a different economic position following the establishment of the SLATs, the practitioner should conduct a cash flow analysis to ensure that planning doesn’t excessively restrict either spouse’s access to assets.  

Focused Planning

The exemption is high, and it probably won’t be reduced in 2023 or 2024. It may seem reasonable for clients to consider waiting to incur the costs and hassle of planning now if the game rules may be changed. However, members of a professional advisory team need to educate clients as to the advantages of more focused, deliberate planning over a longer period. 

Endnotes

1. www.ama-assn.org/practice-management/sustainability/1-3-physicians-has-been-sued-age-55-1-2-hit-suit.

2. www.simplybusiness.com/simply-u/articles/2022/07/how-to-protect-your-small-business-from-lawsuits/.

3. See Yegiazaryan v. Smagin, 143 S. Ct. 645 (2023).

4. Jackson v. Calone, No. 2:16-cv-00891-TLN-KJN (E.D. Cal. Sept. 30, 2019).

5. Defined in Internal Revenue Code Section 643(a).

6. The deduction for a distribution of distributable net income is allowed under IRC Section 651 or 661.

7. IRC Section 672(a).

8. IRC Section 2041.  

9. Smaldino v. Commissioner, T.C. Memo. 2021-127 (Nov. 10, 2021).

When drafting trust documents, it’s important for practitioners to know where the trust is sitused and be familiar with that state’s trust laws. That’s become harder in recent years, as states have revised their trust codes to keep up with “progressive” trends. According to Jay W. Freiberg and Jeremy Bates in their article “Progressive or Regressive?” p. 44, these trends includeminimizing trustee accountability and unbundling fiduciary powers and duties so that, for example, administrative duties are handled by a trustee in one state, while investment management obligations are handled by a trustee in a different state. Their article, part of our Estate Litigation Committee Report, goes on to explore what’s driving these changes and how they may affect estate litigation.

Another trend that some states have adopted is offering pre-mortem validation of testators’ estate plans. “Pre-Mortem Will Validation,” p. 54, by Jeremy A. Mellitz, discusses the states that allow this, in one form or another, and the benefits and disadvantages of letting testators to take this step.

The final article in our Committee Report centers around the increasing number of blended families with stepchildren in the United States. In her article, “Litigation of Nominations and Dispositions Favoring Stepchildren Under Pre-Divorce Instruments,” p. 50, Sandra D. Glazier warns that, given this trend, it’s important to exercise care when defining whether a stepchild will or won’t be considered eligible to inherit under the terms of an estate plan in the event of divorce.

It remains to be seen what new trends in estate planning emerge in 2024, but we’ll continue to look out for them and share them with you. 

Read the issue.

John Nieto’s Rancho de Taos Church sold for $34,650 at Hindman’s Western & Contemporary Native American Art auction on Nov. 1, 2023, in Denver. Nieto, who died in 2018, was from a family of 14 children raised by their Mescalero Apache/Hispanic mother and Methodist Minister father. His paintings often reflected his Hispanic and American Indian ancestry, with his New Mexican roots tracing back to over 300 years. 

The bold strokes of intense orange, red and purple, as seen in our cover image, represent Nieto’s signature style of creating dimension and character on his canvases. His use of vibrant, electric hues, an homage to the French Fauvist movement, combined with his inspiration from Picasso’s Cubism, is often applied to his portrayals of peoples and animals native to North America—subjects near and dear to his heart. 

We too, as practitioners, are called on to make sure that subjects near and dear to our clients’ hearts are taken care of. For example, as one author describes in his article “Pre-Mortem Will Validation,” we can help a client “road test” their estate plan while they’re alive, giving them peace of mind that their intended loved ones will be provided for after the client is gone. 

Some of our other favorites, from Hindman’s Western & Contemporary Native American Art auction on Nov. 1, 2023 in Denver, appear throughout the issue.