2012 federal estate and gift tax forms released & new · pdf file2012 federal estate and...
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2012 Federal Estate and Gift Tax Forms Released & New York Issues Guidance on Federal Portability
October 12, 2012
Sharon L. Kleini
Form 706: Final Return and Instructions are Posted On June 15, 2012, the IRS released temporary regulations and proposed rules regarding the portability of the deceased spousal unused exclusion (DSUE) amount. On October 4, 2012, the IRS posted final Form 706 for 2012 decedents that embodies the guidance in the temporary regulations. The form includes a new Part 6, Portability of Deceased Spousal Unused Exclusion and a new Schedule PC, Protective Claim for Refund. On October 12, 2012, the IRS posted final updated instructions to accompany Form 706 for individuals dying in 2012. Reviewed together, here are some of the highlights of the new form and instructions:
Portability Get it Automatically or Opt Out With a Check-the-Box Election The new Part 6 of Form 706 states that a decedent with a surviving spouse elects portability of the DSUE amount, if any, by completing and timely-filing Form 706. No further action is required. However, portability must be elected on a “timely filed” Form 706, which (regardless of the size of the estate) is a return filed within 9 months of death, or if an extension has been granted, the last day of the extension period. There is a box to check to opt out of portability that has been highlighted compared to a draft version of the form by including it in its own separate section “Section A. Opting Out of Portability.” Presumably, the intent was to further minimize the risk of mistakenly checking the box and inadvertently opting out of portability. The DSUE amount that can be transferred to a surviving spouse is calculated in Part 6, Section C. DSUE amounts received from predeceased spouses are calculated in Part 6, Section D. The tax computation (line 9 of Part 2) now includes a computation to calculate the applicable exclusion amount and applicable credit amount (formerly unified credit amount), factoring in any DSUE amount received from a predeceased spouse. The applicable exclusion amount equals the total of:
• Line 9a: the basic exclusion amount ($5,120,000 for 2012); and • Line 9b: the DSUE
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QDOT Trust? Not so Fast… The Temporary Regulations provide special rules with respect to the application of portability to qualified domestic trusts (QDOT trusts), pursuant to which the decedent's DSUE is finally redetermined upon occurrence of final distribution or other final event (usually death of the surviving spouse) that triggers estate tax liability under IRC Section 2056A. If the termination event is death, this generally means that the DSUE will not be available to the surviving spouse during life (except for gifts in the year of death). Accordingly, if any assets of the estate are being transferred to a QDOT, a box must be checked and the form states that the DSUE amount portable to the surviving spouse is preliminary and must be redetermined at the time of the final distribution or other taxable event imposing estate tax under IRC Section 2056A. Special Rule For Estates Filing Solely To Make The Portability Election
An estate tax return prepared in accordance with all applicable requirements is considered "complete and properly-prepared." However, estates that do not otherwise have a filing requirement (ie, Form 706 is filed solely to elect portability) do not have to report the value of certain property that qualifies for the marital or charitable deduction. Only the description, ownership and/or beneficiary and other information necessary to establish the right to the deduction need be reported. A detailed note is included at the top of Schedules A, B, C, D, E, F, G, H, I, M and O to direct those under the filing threshold who are filing solely to elect portability to consider whether it is necessary to report the value of certain assets eligible for the marital or charitable deduction. If the value of an asset is not required to be reported pursuant to the special valuation rule, the executor must:
1. Report the assets on the appropriate schedule, but without any value on the schedule itself; and
2. Estimate in good faith and with due diligence the total value of the gross estate, using ranges of dollar values provided in Form 706 instructions. The instructions provide guidance for assets valued up to $5,120,000, in $250,000 increments (with the last increment being $5,000,000 - $5,119,999).
Executors' estimates are subject to penalties for perjury. An executor cannot use the special rule under certain circumstances, including if a partial QTIP election is made. There is also a box to check on the face of the return (Part 1, line 11) to alert the IRS if an executor is taking advantage of this special rule to estimate the value of the assets included in the gross estate. Line 7 Worksheet – Used to Determine Applicable Credit Allowable for Prior Periods…
The Line 7 Worksheet (used to determine the applicable credit [formerly unified credit] allowable for prior periods) has been amended in final Form 706, compared to a previously posted draft version of the form. A column has been added for specifically
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listing the cumulative DSUE amount from predeceased spouse(s) actually applied to current and prior gifts, which amount is to be taken from the gift tax return for the applicable year. Additional columns clarify that the DSUE amount applied against lifetime gifts is added to the applicable exclusion amount for the current period and multiplied by the 2012 unified rate schedule to compute the maximum applicable credit. The "total gift tax paid or payable" is determined on the Line 7 Worksheet and entered on Line 7 of Part 2-Tax Computation. …And Must be Submitted with Form 706
Filers were previously directed not to file the Line 7 Worksheets, but to keep them for their records. Now a specific cautionary note appears in the instructions directing the filer to submit a copy of the Line 7 Worksheet when filing Form 706. A Few Reminders
The instructions remind the reader that, although a spouse can use the DSUE amount from prior predeceased spouses in succession, a surviving spouse cannot use the sum of the DSUE amounts from multiple predeceased spouses at the same time or use the DSUE of a prior predeceased spouse after the death of a later spouse. Also, if an executor is acting, only the executor (not a surviving spouse), can make or opt out of a portability election.
Protective Claim for Refund
The Form 706 also includes a new Schedule PC, to be filed to preserve the estate's right to claim a refund based on the amount of an unresolved claim or expense that may not become deductible under IRC Section 2053 until after the limitation period ends. Pursuant to Form 706:
Schedule PC can be used to file a protective claim for refund and, once the claim or expense becomes deductible, Schedule PC can be used to notify IRS that a refund is being claimed;
Schedule PC can be used by the estate of a decedent dying after 2011; Schedule PC must be filed with Form 706 and cannot be filed separately. (To file
a protective claim for refund or notify IRS that a refund is being claimed in a form separate from the Form 706, a Form 843, Claim for Refund and Request for Abatement, is instructed to be used.);
Each separate claim or expense requires a separate Schedule PC (or Form 843, if not filed with Form 706); and
Schedule PC must be filed in duplicate for each separate claim or expense. A note has been added to the top of Schedules J, K and L to advise that Schedule PC should be used to make a protective claim for refund due to an expense not currently deductible. Expenses not currently deductible should also be reported on the appropriate Schedule J, K or L, but without a value.
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You Will Receive a Written Acknowledgment...Or Will Have to Follow Up The instructions provide that the first schedule PC to be filed is the initial notice of protective claim for refund, and the estate will receive a written acknowledgement of receipt from the IRS. Certified mail receipt is not sufficient to confirm delivery of the claim, and if no acknowledgement is received from the IRS within 180 days, the fiduciary is advised to contact the IRS at 866-699-4083. Professional Fees If a protective claim has been adequately identified, the IRS will presume that the claim includes certain expenses related to resolving the claim, including attorney and accounting fees. The estate is not required to separately identify or substantiate those expenses, but they must meet Section 2053 requirements to be deductible. Notify IRS of Resolution of Claim When the claim is finally determined, the estate should notify the IRS within 90 days of the date the claim is paid or the date on which the claim becomes certain, whichever is later. The notification should provide facts and evidence substantiating the deduction and resulting recomputation of estate tax liability. There are two options with regard to notification:
1. File a supplemental Form 706 with an updated Schedule PC that contains the notation "Supplemental Information - Notification of Consideration of Section 2053 Protective Claim(s) for Refund." The initial notice of claim should also be submitted; or
2. File an updated Form 843 containing the notation "Notification of Consideration of Section 2053 Protective Claim(s) for Refund." The initial notice of claim must also be submitted.
Separate notifications must be submitted for every protective claim.
Form 709: Draft Return and Instructions are Posted The IRS posted the latest draft 2012 Form 709 on September 26 and posted draft instructions on September 28, 2012. Reviewed together, here are some of the highlights of the new draft form and instructions: Check the Box to Indicate Use of DSUE There is a new line in Part 1 (Line 19), which asks: "Have you applied a DSUE amount received from a predeceased spouse to a gift or gifts reported on this or a previous Form 709?" If the answer is yes, there is a box to check and a direction to complete new Schedule C - Deceased Spousal Unused Exclusion (DSUE) Amount.
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The instructions remind the reader that, in order to be eligible to use a predeceased spouse’s DSUE, the spouse’s executor must have made an election to use the unused exclusion amount on Form 706. If the election was made, a copy of Form 706 must be attached to Form 709, as well as a calculation of the DSUE amount (either as an attachment or as reflected on Form 706, Part 6). Line 7 of Part 2-Tax Computation now refers to the maximum applicable credit amount (formerly unified credit amount), which factors in any DSUE amount from a predeceased spouse, computed on the new Schedule C. Schedule C – Portability of DSUE Amount Schedule C is for reporting the DSUE amount received from a last deceased spouse, as well as the DSUE received from other predeceased spouse(s) and used by the donor. In Parts 1 & 2 of Schedule C, the DSUE received from a last deceased spouse and the DSUE received from other predeceased spouse(s) are reported (predeceased spouses must have died on or after January 1, 2011). The donor’s applicable credit amount is calculated by (1) adding (a) the basic exclusion amount and (b) the total DSUE amount from the last and previously predeceased spouses applied by the donor to lifetime gifts (including current and prior gifts), and (2) applying to that sum the appropriate tax rate from the rate table in the instructions. The result is to be entered on Line 7 of Part 2-Tax Computation. Several lines marked “reserved” have been added to Schedule C on the latest draft Form 709. The instructions provide that the reserved lines are “inactive” and that no information is to be entered on those lines. Act Now? Using the DSUE during the lifetime of the surviving spouse may make good sense given: • If the surviving spouse remarries and the next spouse dies, any remaining DSUE of
the first surviving spouse will be lost, even if the last deceased spouse has no or a smaller amount of DSUE than the prior spouse, if the portability election was ineffective or not made at all, or if the DSUE amount from the last deceased spouse has been fully applied to gifts in previous periods;
• When the surviving spouse makes a gift, the DSUE of the last deceased spouse is
applied before the surviving spouse's own exclusion amount; • A spouse who has had more than one predeceased spouse can use the DSUE of
each surviving spouse in succession, as long as the DSUE of the last deceased spouse is used before any subsequent spouse dies. There is no recapture of previously gifted amounts in which the DSUE of a prior deceased spouse was
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utilized. In fact, the surviving spouse can include in her applicable exclusion amount the DSUE amount of her most recently deceased spouse, even if she is then married to another individual. If the second marriage ends in divorce and the divorced spouse dies, the first predeceased spouse remains the last predeceased spouse for DSUE purposes. The divorced spouse is not considered the last predeceased spouse because he was not married to the surviving spouse at death; and
• The last deceased spouse is identified as of the date of a taxable gift by the
surviving spouse.
New York Issues Guidance Regarding Federal Portability On September 26, the New York State Department of Taxation and Finance issued TSB-M-12(4)M - New York State Reporting Requirements for Certain Estates Making a Federal Portability Election.
A Special Federal Rule For Estates Filing Solely To Make The Portability Election... As noted, there is a special federal valuation rule for estates that do not otherwise have a federal filing requirement (ie, Form 706 is filed solely to elect portability). Those estates do not have to report the value of certain property that qualifies for the marital or charitable deduction. …But No “706 Lite” For New York Estates... According to the Technical Memorandum, the New York State estate tax is generally conformed to the IRC of 1986, including all amendments enacted on or before July 22, 1998. As a result, the special valuation rule does not apply for New York State estate tax purposes. Accordingly, even estates filing solely to take advantage of portability that are eligible for the special rule for federal purposes must submit the following when filing Form ET-706, New York State Estate Tax Return (the New York filing threshold is $1,000,000):
• A copy of the actual federal estate tax return filed with the IRS; and • a completed (pro forma) Part 5 - Recapitulation (Form 706) and all applicable
schedules reporting the actual date of death value of all property subject to the special rule.
Download final Form 706 and instructions for individuals dying in 2012, and draft Form 709 and instructions for 2012 gifts.
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i Sharon Klein is the Managing Director & Head of Wealth Advisory, Lazard Wealth Management LLC, 30 Rockefeller Plaza, New York, New York 10020. Phone Number: 212-332-4504. E-Mail: [email protected]. This material is written by Lazard Wealth Management LLC for general informational purposes only and does not represent our legal advice as to any particular set of facts and does not convey legal, accounting, tax or other professional advice of any kind; nor does it represent any undertaking to keep recipients advised of all relevant legal and regulatory developments. The application and impact of relevant laws will vary from jurisdiction to jurisdiction and should be based on information from professional advisors. Information and opinions presented have been obtained or derived from sources believed by Lazard Wealth Management LLC to be reliable. Lazard Wealth Management LLC makes no representation as to their accuracy or completeness. All opinions expressed herein are those of the author and made as of the date of this presentation and are subject to change.
IRS Circular 230 disclosure: To ensure compliance with requirements imposed by the IRS, please be advised that any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Copyright 2012. All Rights Reserved
ABA Section of Taxation and Trust & Estate Division of Real Property Trust & Estate Law 2011 Joint Fall CLE Meeting
Denver, Colorado October 21, 2011
Uplifting Gifting - Using Additional Gift, Estate and Generation-Skipping
Tax Exemption to Maximize Business Succession Planning
Robert M. Nemzin Butzel Long, P.C.
41000 Woodward Avenue Bloomfield Hills, MI 48304
Telephone: (248) 258-2909 Facsimile: (248) 248-1439
© Robert M. Nemzin 2011. All rights reserved. The statements contained in this Outline are the
author’s alone and should not be attributed to any other person and/or the respective law firms of the
authors. The statements contained in this Outline should not be relied upon without separate and
independent verification of their accuracy, appropriateness given the particular facts presented and/or
potential tax consequences. The authors hereby disclaim any warranty as to the accuracy of the
statements contained in this Outline. Any tax advice contained in these materials was not intended or
written by the author to be used and it cannot be used by any taxpayer for the purpose of avoiding
penalties that may be imposed on the taxpayer and cannot be used as a basis for a tax return reporting
position. Any tax advice contained in these materials was written to support, within the meaning of
Treasury Department Circular 230, the promotion or marketing of the transactions or matters addressed
by such advice because the author has reason to believe that it may be referred to by another person in
promoting, marketing or recommending a partnership or other entity, investment plan or arrangement
to one or more taxpayers. Before using any tax advice contained in these materials, a taxpayer should
seek advice based on the taxpayer’s particular circumstances from an independent tax advisor. Tax
advisors should research these issues independently rather than rely on these materials.
Uplifting Gifting - Using Additional Gift, Estate and Generation-Skipping Tax Exemption to Maximize Business Succession Planning
The Tax Relief, Unemployment Insurance Authorization, and Job Creation Act of 2010
(the “2010 Act”) has changed, at least temporarily, the planning landscape for estate planners.
As a result of the increased estate, gift and GST exemptions, a number of new planning
opportunities exist until at least the 2010 Act’s sunset on December 31, 2012.
With the increase of the federal gift tax exclusion to $5 Million per person, donors now have
the ability to make substantial gifts without having to pay gift taxes. The following are some
initial questions that a client should consider.
How Much Should a Client Give Away?
An initial question that must be answered is how much a donor can afford to give away
during the donor’s lifetime. Clients must be careful in determining how much additional
property the client has to live on for the remainder of their lifetime. A possible option for
spouses is to have each spouse establish a gifting trust which make the other spouse and
additional family members discretionary beneficiaries of the trust; this arrangement thereby
make those assets available to the spouses during their lifetime in the event such assets are
needed for their use. Care should be given in implementing this type of planning arrangement
to avoid the imposition of the reciprocal trust doctrine.
When Should a Client Use the Increased Gift Tax and GST Exemptions?
The increased gift tax and GST exemptions expires at the end of 2012. As the gift tax and
GST exemptions could be reduced in 2013, clients should be advised of the potential temporary
planning opportunity that currently exists. Gifts should be made now if the client thinks
exemptions will decrease in the future.
How Should Gifts be Made?
The client will have to determine the proper form for making gifts to beneficiaries. Does
the client wish to make an outright gift to the beneficiary? Or does the client prefer to make
the gift in trust for the benefit of the beneficiary? The client’s goals and objectives should be
properly identified when considering the optimal method in taking advantage of the gift tax
exemption. Does the client want to provide for dynasty planning for successive generations? A
gift in trust allocating GST exemption to the gifts is may be more appropriate in this instance.
What Assets Should be Gifted?
Clients should properly identify which assets should be selected in making gifts. Factors
including future potential for appreciation or depreciation in the asset, the ability to make use
of valuation discounts, liquidity needs and expected cash flow from the assets should all be
considered.
Planning Opportunities
Grantor Trust Planning
The increased gift tax exemption dramatically increases the ability to transfer a larger
amount of wealth out of a client’s gross estate. In a typical situation involving a grantor trust, a
loan or sale of property is made to the trust in connection with a “seed” gift to the trust. The
“seed” gift should normally be at least 10% of the overall trust assets in connection with the
loan or sale transaction. See PLR 9535026. A $5 Million gift tax exemption allows for the ability
to loan or sell an additional $45 Million of assets to a grantor trust without the imposition of
gift taxes. For married individuals, the combined $10 Million gift tax exemption can be used to
transfer an additional $90 Million without the imposition of gift taxes.
GST Planning
A $5 Million GST exemption greatly increases the ability to transfer assets to lower
generations. Given the temporary nature of the 2010 Act, clients may want to fully take
advantage of the entire $5 Million GST exemption prior to the 2010 Act’s sunset in the event
there is concern that the GST exemption will decrease in the future.
Life Insurance Planning
Life insurance is often an integral part of the estate plan. Whether life insurance is used to
provide liquidity for an illiquid estate or it is used to provide an additional asset following death,
life insurance remains a prevalent part in the estate planning process. The increased gift tax
exemption provides the ability for additional opportunities in planning with life insurance. With
a $5 Million gift tax exemption, the ability to make contributions to irrevocable life insurance
trusts has dramatically increased. A donor now has the ability to make increased gifts on a non‐
taxable basis to an ILIT for the purposes of covering current or future premium payments.
For clients that previously implemented split dollar arrangements, the increased gift tax
exemption can also be used to unwind these transactions and simplify the planning process.
For example, the donor can make a gift to the trust to cover the repayment of the split dollar
loan agreement obligation.
With the increased estate tax exemption, some clients may believe life insurance is no
longer necessary if they believe estate taxes are no longer a concern and the only reason the
client maintained the insurance policy was for the payment of estate taxes. However, due to
the temporary nature of the 2010 Act, there is no guarantee that the estate tax exemption will
remain at $5 Million. The insurance proceeds may actually be needed in the future. Clients
should be cautioned not to cancel existing insurance policies if there is a possibility that the
insurance still may be needed in the future. For example, the client may not be insurable in the
future in the event the client reapplies for insurance.
Forgiveness of Existing Loans
The increased gift tax exemption can be used to forgive existing loans if a client has made a
loan to a family member. Loans to family members are a common transaction, and the
forgiveness of all or part of the debt obligation is a simple way to make use of the client’s
increased gift tax exemption.
In addition, guarantees are often used in structuring the necessary seed equity for a
transfer to a grantor trust. The increased gift tax exemption can be used to make additional
gifts to the grantor trust to eliminate the guarantee arrangement.
GRAT Planning
Some clients may view GRATs as being unnecessary now that they have the increased ability
to make non‐taxable gifts during their lifetime. However, GRATs remain an excellent planning
opportunity because they have the ability to transfer wealth without using any significant gift
tax exemption.
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NEXT GENERATION DISPUTES IN THE FAMILY BUSINESS: NAVIGATING THE
REMEDIAL, ETHICAL AND TAX QUAGMIRES - A CASE STUDY
AN OVERVIEW OF FAMILY BUSINESSES IN AMERICA
(From the ABA Section of Taxation/Section of Real Property, Trust & Estate Law’s 2011 Joint Fall Meeting in Denver, CO)
By Morton A. Harris1
OVERVIEW OF FAMILY BUSINESSES I. In General. There are approximately 27 million privately owned businesses in the
country, of which 21 million are either part-time operators (e.g., the weekend
musician, construction contractor, “moonlighters,” etc.), or full-time operators where
only the owner is involved. Of the over 6 million businesses which have
“employees”, only 18,000 have more than 500 employees, approximately 120,000
businesses have more than 100 employees, and less than 700,000 have more than
20 employees.2. By comparison, there are approximately 30,000 publicly owned
companies in the United States, approximately 3,800 traded on the New York Stock
Exchange (NYSE), 750 on the American Exchange (AMEX), 2,800 on NASDAQ,
3,700 on the “OTC Bulletin Board” and 6,200 on the “Pink Sheets” 3. The
remaining 10,000-12,000 companies are traded so rarely they are not listed. From
these statistics, it can be seen that privately owned businesses (over 90% of
businesses with employees being “family businesses”) represent over 99% of all
businesses in the country.
Although most “family businesses” are privately owned, an estimated 60% of
publicly traded companies are under family control. Studies show an estimated
33% of the "Fortune 500" companies are family controlled, e.g., Wal-Mart, Marriott,
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Berkshire -Hathaway, Tyson, and News Corporation, and Heinz. Many owners of
family controlled public corporations are listed in the “Forbes 400”, e.g., Warren
Buffett, Rupert Murdoch, and Christy Walton and family. 4
It has become increasingly clear from published statistics that privately owned
businesses (employing over 58% of all working Americans, generating
approximately 59% of Gross Domestic Product, and responsible for 31% of our
nation's exports) are the most dynamic and vibrant segment (most new jobs and
innovations) of our country's economic system. In fact, many say that America's
family owned small businesses are our country's best hope to maintain a successful
free enterprise system5.
Congressional recognition of “small business” (often used synonymously with
“family business”) was first formalized in 1950 when both houses of Congress
established Committees on Small Business. In 1953, the Small Business
Administration (SBA) was created as an independent agency based on the
recognition that “small businesses” have special needs, a unique philosophy and
different capabilities. Also in 1953, an independent Office of Advocacy within the
SBA was created and charged with the responsibility for promoting the cause of
small enterprises in Congress and the Executive Branch. Since that time, Congress
has consistently encouraged federal agencies to be sensitive to the special needs of
small business.
Beginning in the 1980's, “small business" (most of which are privately-owned family
businesses) became very popular in Washington. In 1981, Congress authorized,
and President Reagan convened, the first President’s White House Conference on
Small Business. Another White House Conference was held in 1986, and the most
recent Conference was held in June of 1995. The major purpose of the White
House Conferences was to create a forum for small business owners to
communicate with each other and determine the priority needs and concerns of the
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small business community with a view towards Congress and regulatory agencies
enacting, repealing or amending legislation, regulations, etc., to meet those needs
and concerns.
Notwithstanding Congress' general “love affair” with “small business”, the practical
needs and interests of small business are often overlooked when major legislation is
finally adopted, especially when it involves complex tax and employee benefit
matters. During the thirty-year period from 1981, there has been a flood of tax and
employee benefit legislation (over 30 major Revenue Acts involving changes to over
17,000 sections and subsections of the Internal Revenue Code). Unfortunately,
much of this legislation, added significant additional complexities and restrictions
and were particularly onerous to small businesses and their owners6. From these
actions in Congress, it is evident that the small business community (although much
"loved") is in need of better understanding and a stronger "voice" in Washington.
Since 2001, there have been several major tax laws, which have added even more
complexity7.
In analyzing the reasons behind the inconsistency in Washington between “mouth”
and “motion” (“expression” and “action”), one is drawn to the conclusion that small
businesses are typically much less effective (when compared with large businesses)
in dealing with proposed legislation. Large businesses have full-time lobbyists
monitoring and timely focusing on specific legislative issues, whereas most owners
and representatives of small businesses are often not even aware of proposed
legislation (especially tax and employee benefit legislation) until the legislation is
well on its way to being enacted. Although there are a number of small business
organizations which actively monitor legislation (e.g., the National Federation of
Independent Businesses [NFIB]; the Small Business Council of America [SBCA]
which focuses on tax and employee benefit issues; and the National Small Business
Association [NSBA], etc.), the broad diversity of interests of the millions of small
businesses, due to the vast differences in size, level of economic success and types
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of business, often results in the wishes of the “small business community” being
unfocused and, in some cases, contradictory. One reason given for much of the tax
and employee benefit legislation and regulations (which have negatively affected
small businesses) is the notion, held by some in Washington, that small business
owners can, to a greater degree than large businesses, manipulate the tax and
employee benefit rules to avoid paying their "fair share" of taxes or to avoid
providing appropriate levels of employee benefits to their
employees. In recent years, this notion has been expanded to include large
businesses after the Enron, WorldCom, Tyco, Parmalot, and Lehman Bros.,
debacles, and the implosion of the banking and financial sector which led to the
passage of the Sarbanes/Oxley legislation designed to protect shareholders, and
the Dodd-Frank legislation to protect the public from various practices of large
financial institutions which contributed to the current recession. It is the author's
opinion that much of the reason for the “hyper” frequency of legislation in
Washington is to be found in the basic nature of our political environment which
reflects the public's clamor for both “action” and “fairness” and puts strong political
pressure on members of Congress (aided by dozens of highly competent and
specialized staff) to stay active and to promote new legislation, especially in the tax
and employee benefit area, which has resulted in enormous “complexity.”8
The constant change and expansion of our laws has had a disproportionately
negative impact on small businesses, which have little or no internal specialized
staff, by increasing the need for costly outside professional support to help them
comply with the ever more complex and constantly changing rules9.
Congress did, however, adopt some tax legislation specifically designed to
encourage small businesses, e.g., Subchapter S, added to the Code in 1958. The
rules of Subchapter S were partially in response to earlier proposals (which continue
to this day) to eliminate the taxation of corporations entirely on the theory that
"double taxation" is inherently unfair. Critics of the system (pointing to Subchapter
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K and its taxation of partners) argue that a tax at the corporate level, in addition to a
tax on shareholders, amounts to a penalty for conducting business in corporate
form. Although Congress did not eliminate taxation at the corporate level (in fact,
for some, it increased the corporate level tax in 1986 with the legislative elimination
of General Utilities), significant changes were made in the taxation of small business
corporations electing under Subchapter S which, for the most part, results in a
single tax at the shareholder level10. More recent legislation further simplified and
expanded the usefulness of Subchapter S11.
II. Importance of Family Businesses.
A. Important Segment of U.S. Economy. With over 6 million full-time privately
owned businesses with employees (90% family owned and operated), small
business is the most dynamic segment of our economy representing more
than 99% of all businesses, 58% of all working Americans, 59% of Gross
Domestic Product, and 31% of U.S. exports. The net worth of these
businesses is estimated to be in excess of $10 trillion. Small businesses are
responsible for most new jobs which have averaged 64% of all new jobs over
the past decade.12
B. Large Portion of Transferred Wealth. It is estimated that over two-thirds of
the wealth of this country has been created since World War II, much of
which is represented by family businesses. A large portion of this wealth
consists of businesses under control of an aging generation of
entrepreneurs. Within the next two decades, many members of this
generation will die or retire, and the transfer of wealth from the older
generation to the next is estimated to be the largest in U. S. history13. A
study by the Family Enterprise Center at Cornell University estimated that
over $6.5 trillion in wealth would be transferred from one generation to the
next during the next 25 years with over $10 trillion being transferred by the
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year 204014. Another survey estimated that almost 40% of all family
businesses would change leadership within the next five (5) years.15
C. Importance Recognized by Institutions and Businesses. Prior to 1990, there
was little or no research on, or academic interest in, “family businesses.”
However, within the past twenty (20) years, family business programs have
become a part of business school curriculum at over 100 colleges and
universities throughout the country (e.g., Wharton, Harvard, Northwestern,
Baylor ). One of the first programs (also ranked as one of the best along with
Harvard and Northwestern) was established at Kennesaw State University, in
Atlanta Georgia, which offers a full range of courses on family businesses as
part of its business school curriculum16. In discussing the reasons for
establishing its Family Business Center, the founding director of the program
at Kennesaw described the importance of the “family business” in the
following manner:
“The family unit has long been recognized as the foundation of
our society and the family business is the foundation of our
economy. Family businesses have special problems and
opportunities that traditional business education does not
address.”
-Craig Aronoff, Kennesaw State College (1989)
In addition, a number of private sector family business “programs,” including
insurance companies, law firm practice groups, etc., were developed during
this period. For example, Massachusetts Mutual Life Insurance Company
(Mass Mutual) and National Life of Vermont (in conjunction with the Small
Business Council of America) have conducted research and have sponsored
“family business” institutes; and law firms, WilmerHale, Troutman Sanders
LLP, and McDermott Will & Emery along with many other large firms, have
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created special “practice groups” that focus on Closely Held and Family
Businesses. Further, there have been dozens of books and hundreds of
academic research studies, popular press articles, newsletters and seminars
on “family businesses,” almost all being published or presented since 199017.
D. Important Part of Professional Practice. Family businesses (and the
individual family members) are a significant part of the practices for many
professional advisors. Surveys show that accountants, lawyers, financial
planners, life underwriters, bankers, and industrial psychologists (in the order
listed) are the closest advisors to the owners of family businesses and are
uniquely positioned to be of the most help18. A 1992 Mass Mutual survey
showed that among the 53% of family business owners who have prepared
written estate plans, 74% reported that a lawyer played a major role in the
planning process, followed by accountants (38%), financial estate planners
(29%), and insurance agents (14%). A recent survey shows the number of
owners who have engaged in estate planning has increased to 81%, and
lawyers and accountants are the top two advisors19. For the very large
family businesses, there has been an explosion of “wealth management”
advisors and so-called “Family Offices” which provide personal, business and
investment advice and other family services (e.g. protection, coordinating
family meetings, etc.) to family business owners and their families.20
E. Family Businesses Need Special Attention. Research shows that less than
one-third of the family businesses succeed into the next generation, less
than 15% make it into the third generation21 and less than 4% make it to the
fourth generation. It is widely recognized that family businesses have special
problems in addition to the normal business problems which make them
uniquely vulnerable, especially at the time of transition of management and
ownership to the next generation.22
8
III. Reasons for Family Business Failures. It was not until 1993, that the first
comprehensive study was made to determine the reasons why such a large number
of family businesses failed at the time of transition of ownership and management to
the next generation. The study, sponsored by National Life of Vermont and the
Small Business Council of America (conducted by Prince and Associates), was
based on personal interviews with next generation owners of 749 family businesses
that had failed within three years following the death or retirement of the founder.
All of the businesses in the study had previously been successful and in business
for at least 10 years, many between 20 and 40 years.
From these interviews, it was determined that the transition of management and/or
ownership occurred: (1) in 75% of the cases, following the death of the founder
(often unexpected); and (2) in 25% of the cases, following the founder's retirement
(often due to his unexpected disability).
Although the survey showed a number of reasons for these family business failures,
the major reasons given for failure of the businesses following the death or
retirement of the principle owner and CEO are described as follows.
A. Lack of Adequate Capital. It was long assumed that lack of adequate capital
was a primary reason for failure of a family business upon transition of
ownership. However, it was not until the National Life/SBCA study in 1993
that the truth of this assumption was confirmed, both following the death of
the principle owner or his retirement.
1. Death of Principal Owner/CEO. Lack of capital was cited as the
largest single reason for failure of over 70% of the family businesses
which failed following the death of principal owner. Lack of capital
was primarily caused by estate tax obligations or the need to provide
9
retirement funds to a surviving spouse; however, lack of access to
capital or credit from traditional sources for current operational needs
was also cited as a major problem. This, typically, was the result of
trade and banking sources being less accommodating to the
successor owners (and managers) following the death of the principal
owner/CEO. In many cases, these financial strains led to the
bankruptcy of the business. With the onset of the Great Recession in
2008, the unmet need for capital by many family businesses, whether
or not in transition, has dramatically increased. Today, the ability of
many small businesses to borrow has been severely restricted due to
significant increases in banking regulations and oversight scrutiny by
State and Federal regulatory agencies.
2. Retirement of Principal Owner/CEO. Where the principal owner/CEO
retired from the business during his lifetime, the study showed the
owner often retired without adequate financial resources, most of his
wealth consisting of his interest in the business. This resulted in
additional financial burdens being placed on the business to distribute
funds in order to make up for the shortfall in the owner's retirement
needs and this financial burden was cited as a predominant reason
for the failure of the business. This same failure to provide
adequately for his and his spouse's retirement is also given as the
prime reason why many owners are unwilling to voluntarily relinquish
control of the business.
B. Family Conflict Over Assets. Lack of “fairness” in the distribution of the
founder's estate was also cited as a key problem. Almost 81% of the failed
businesses were negatively impacted by family conflicts among the
survivors. Often, these conflicts grew out of a perception by the survivors of
unfairness in the division of the founder's assets between heirs active in the
10
business and those who were not. From the writer's own experience, this
conflict results because many parents are strong in their determination to
treat their children “equally” in the distribution of their estates. Unfortunately,
“equal” is not always “fair”, and “fair” is not always “equal”, where a family
business represents a large portion of the principal owner's estate, especially
where some children are active in the business and some are not. This
inflexible desire of parents to give “equal” treatment to their children is often
given as a principal cause of failure of the business23.
C. Loss of Key Employees. In many cases, the loss of a non-family key
employee (especially after the founder's death) significantly contributed to
the failure of the business. Almost 60% of those surveyed (where a non-
family key employee had left the business following the principal owner's
death or retirement) cited this loss as an important contributing reason for the
failure of the business.
D. Poor or No Transition Planning. The studies also reveal the basic (and often
preventable) underlying cause behind most of these failures as being little or
no prior planning for either the capital needs or the transition of management
and/or ownership of the business. Not only is “failure to plan” the biggest
obstacle to successfully passing on a family business to the next generation,
it often results in lifelong family feuds. The National Life/SBCA study showed
that 97% of the successor-owners of the 749 failed businesses in the survey
stated that the founder had no written succession plan and 40% had no
succession plan of any kind. The 2003 Mass Mutual/Raymond Family
Business Institute survey showed that only 63% of family businesses utilize a
written strategic business plan in their operations, that 20% of the business
owners have no written “estate plans” beyond a will, and only 38% have a
written “business” succession plan. Although almost 90% of business
leaders surveyed recognize that failure to have an effective succession,
11
estate, and investment plan and a strategic business plan for the company
would greatly promote the successful transition of the business to the next
generation, less than half of the family business CEO’s who expect to retire
within five (5) years, had chosen a successor24.”
1 Morton Harris is a Partner at Hatcher, Stubbs, Land, Hollis & Rothschild. Morton concentrates his practice in the areas of business and tax law, qualified retirement plans, estate and retirement planning, estate administration, wills, trusts and estates, and charitable foundations. He can be reached at [email protected]. 2 Small Business Administration, “Small Business Profile” (2009) based on latest source information from U.S. Department of Treasury, IRS Report, Tax Returns; U.S. Dept. of Commerce, Bureau of the Census, and U.S. Dept. of Labor, and Bureau of Labor Statistics; J. Astrachan and M. Shanker, “Family Businesses’ Contribution to the U.S. Economy – A Closer Look,” (2002) at 213. 3 Web Sites of NYSE, AMEX, NASDAQ, OTC Bulletin Board, and Pink Sheets (September 2011). 4 See J. Astrachan and M. Carey, “Family Business in the U.S. Economy,” presented at The Center for the Study of Taxation, Costa Mesa, California (1994); and J. Astrachan and M. Shanker, “Family Businesses’ Contribution to the U.S. Economy – A Closer Look (2003) at 214; ‘Forbes’ (Oct. 10, 2011); R. Sorenson, “Family Business: The New Heartland of America”, presented at the Center for Family Enterprise, University of St. Thomas Opus College of Business, September of 2008. 5 See “Blood and Money,” Newsweek Special Edition, "The 21st Century Family," Winter/Spring 1990, at 82-84; “The Adolescence of American Family Business,” FBN Newsletter, No. 9 (May 1994); and “Politics and Policy,” Wall Street Journal, June 14, 1995, at A20; and J. Astrachan, “Family-Sponsored Ventures,” (April, 2003). 6 H. Apolinsky, “Need for Ten Year Moratorium,” Survey for Small Business Council of America (1997), and H. Apolinksy, “Need for Fundamental Tax Reform” Survey for the American’s for Fair Taxation (2002). 7 “Economic Growth and Tax Relief Reconciliation Act of 2001,” (EGTRRA),“Jobs and Growth Tax Reconciliation Act of 2003,” (“2003 Tax Act”), “Working Families Tax Relief Act of 2004”, “ Tax Increase Prevention Reconciliation Act of 2005”, “Small Business Jobs Act of 2011”, “Tax Relief and Health Care Act of 2006”, “Economic Stimulus Act of 2008”, “Health Care and Education Reconciliation Act of 2010”. 8 For an interesting analysis of the reasons for the proliferation of laws at all levels of our legal system. See I. Younger, “Socrates, Law, and the Congress of the United States,” Charles Evans Hughes Memorial Lecture delivered at New York County Lawyers' Association, New York, N.Y. (May 1980). 9 “There are No Simple Businesses Anymore,” The State of Small Businesses at 72-78 (1995). 10 Subchapter S Revision Act of 1982, Pub. L. No. 97-354, (1982). 11 See Small Business Job Protection Act of 1996, Pub. L. No. 104-188 (1996); The American Jobs Creation Act of 2004 Pub. L. 108-357(2004). 12 J. Astrachan and M. Carey, “Family Business in the U.S. Economy,” presentation at the Center for the Study of Taxation, Costa Mesa, California (1994); and D. Kirchoff, Entrepreneurship and Dynamic Capitalism: The Economics of Business Firm Foundation and Growth (1994); “The Facts of Small Business,” SBA Report (2009). 13 Fortune, May 7, 1990, at 81, and Hale and Dorr, “Family Business Report,” June 1994. 14 See R. Avery and M. Rendall, “Inheritance and Wealth,” presented at the Philanthropy Roundtable (Nov. 1993); and, “There are No Simple Businesses Anymore--Will the Family Business Survive?” The State of Small Business, at 70 (1995).
12
15 Mass Mutual Financial/Raymond Family Business Institute, “American Family Business Survey,” (2003) at 2; “Major Findings of the Family Business Survey,” Massachusetts Mutual Life Insurance Company (Oct. 2007) at 4. 16 “Can You Teach Entrepreneurship?” Business Week, Nov. 7, 1993, at 140; and Mass Mutual Financial/Raymond Family Business Institute, “American Family Business Survey,” (2003) at 32. 17 See, e.g., C. Aronoff and J. Ward, Family Business Sourcebook (1991); “Are Your Kids Good Enough to Run the Business?” Inc. Magazine, August 1994; “Estate Planning for the Family Business Owner,” American Law Institute/American Bar Association Annual Seminar on Family Business (July, 2003); and The Family Firm Institute, Family Business Review, Vol XVI, No. 1 (March 2003). C. Aronoff and O. Baskin, Effective Leadership in the Family Business (2010); A. Schuman, “Nurturing the Talent to Nurture the Legacy”; Preparing Yourself to Relinquish Control of Your Family Business” (2010). 18 “Major Findings of the Family Business Survey,” Massachusetts Mutual Life Insurance Company (Oct. 2007) at 8. 19 “Major Findings of the Family Business Survey,” Massachusetts Mutual Life Insurance Company (Sept. 1994) at 22; and Mass Mutual/Raymond Family Business Institute, “American Family Business Survey,” (2003) at 27 and 30. “Major Findings of the Family Business Survey,” Massachusetts Mutual Life Insurance Company (Oct. 2007) at 4. 20 “Private Wealth”, Advising the exceptionally affluent. Vol. 5. No. 5 (Sept/Oct 2011) 21 J. Ward, Keeping the Family Business Healthy, at 1-19 (1987); “Blood and Money,” Newsweek Special Edition, “The 21st Century Family,” Winter/Spring 1990, at 82-84. Richard M. Segal, Family Firms vs. Their Counterparts- Best Practices for Success, Corp. Magazine, January 1, 2008, Private Wealth”, Advising the exceptionally affluent. Vol. 5. No. 5 (Sept/Oct 2011). 22 See G. Le Van, Getting to Win-Win in Family Business, at 218 (3rd ed. 1993); See also, L. Danco, Beyond Survival: A Guide for the Family Business Owner and His Family, at 4 (4th ed. 1982); “Are Your Kids Good Enough to Run Your Business?” Inc. Magazine, Aug. 1994, at 36; and S. Danes and P. Olson. “Women’s Role Involvement in Family Businesses, Business Tensions, and Business Success,” The Family Firm Institute, Family Business Review, Vol. XVI, No. 1 (March 2003) at 53-68; R. Segal, “Family Firms vs. Their Counterparts- Best Practices for Success”, Corp. Magazine, January 1, 2008,; “Private Wealth”, Advising the exceptionally affluent. Vol. 5. No. 5 (Sept/Oct 2011). 23 See G. Le Van, Getting to Win-Win in Family Business, at 182 (3rd ed. 1993); and “Succession Planning: Family Continuity vs. Business Continuity,” The Family Business Professional, July 1997, at 1; and K. Smyrnios, et al, “Work-Family Conflict: A Study of American and Australian Family Businesses,” The Family Business Review, Vol. XVI, No. 1 (March 2003) at 35-50. 24 “Mass Mutual/Raymond Family Business Institute; “American Family Business Survey” (2003) at 1, 25, and 26, updated: (2007) at 4.
PROPOSED REVISIONS TO CIRCULAR 230 by
Jim Robertsi
The Secretary of the Treasury has the power under 31 USC Section 330 to regulate practice before the Treasury Department, including the IRS. The Secretary has published regulations to do just that. Those regulations are commonly referred to as Circular 230. On September 14, 2012, Treasury issued proposed new regulations (REG-138367-06).
There are several changes. Some of them are minor, but the key areas the new
regulations attempt to cover are: • Substantially rewriting the rules regarding written tax advice by:
o Eliminating the complex rules for covered opinions; o Eliminating the special rules for state and local bond opinions (cancelling
the proposed regulations issued in 2004 that would have amended Section 10.39);
o Eliminating the distinction between those opinions and other written tax advice;
o Replacing all three with a single standard for written tax advice based on reasonable factual and legal assumptions, reasonable reliance, and reasonable efforts to uncover relevant facts;
o Eliminating the provision that prohibits a practitioner from taking into account the possibility that an issue will be resolved through settlement if raised (but still prohibited would be discussing whether an audit might occur, and whether an issue might be raised on audit);
o Eliminating the requirement to describe fully all of the relevant facts and the application of the law to those facts; and
o Eliminating the Circular 230 disclaimers. • Expanding the duties of firm managers by expanding the scope of their duties to
include all aspects of work that involves federal tax issues, including advice, and the preparation of returns, claims for refund and other submissions.
• Modifying the provisions on expedited suspension by: o Adding persistent disregard of federal tax laws as a basis for suspension;
and o Clarifying the length of suspension.
• Making clear that the Office of Professional Responsibility has exclusive responsibility for discipline.
• Updating the regulation prohibiting a practitioner from negotiating a taxpayer’s check to include all forms of payment, electronic and otherwise.
Appendix: Attached is a draft prepared by the author that attempts to highlight
the differences between the current version of Circular 230 and the changes the proposed regulations would make. The author cannot guarantee the accuracy of the draft, and invites comments and corrections.
2
Written Tax Opinions: Back in 1984, Treasury started a process to reign in tax shelter opinions, and, more recently, in 2001, additional amendments were proposed regarding tax shelter opinions. A second proposed rulemaking came forth on December 30, 2003. That second set of propose regulations set forth best practices for tax advisors and again modify the standards for tax shelter opinions.
The American Jobs Creation Act of 2004 amended 31 USC Section 330 to clarify
that the Secretary may impose standards for written advice relating to a matter that is identified as having a potential for tax avoidance or evasion. In December 2004, Treasury IRS finalized the 2003 proposed regulations by publishing final regulations setting forth best practices. The biggest part of that rulemaking was the creation of standards for “covered opinions” in section 10.35 of Circular 230.
The current form of Circular 230 is contained in the August 2011 iteration
available online at http://www.irs.gov/pub/irs-utl/pcir230.pdf.
Section 10.35 was, and continues to be, controversial. According to Treasury, the responses it got from practitioners were overwhelmingly unfavorable. Practitioners characterized it as overbroad, difficult to comprehend and more difficult to apply, counterproductive (in terms of elevating the quality of tax advice), and expensive. One of the more obvious and continuing outgrowths of those new regulations is the ubiquitous disclaimer at the end of every letter and every email (even at the end of this article). Another practical result has been the shift to more oral communications of tax advice which are not covered by Section 10.35.
In addition to Section 10.35, there is Section 10.37 regarding “other” written tax
advice. And there are proposed regulations that would amend the requirements for bond opinions, which were supposed to be added to Section 10.39. The new proposed regulations drop the proposed revision of requirements for bond opinions, and re-write Sections 10.35 and 10.37.
The new proposed regulations do not expressly say anything about the
disclaimers. However, with the re-writing of Section 10.35 and 10.37, Treasury hopes practitioners will do away with those.
The preamble to the new proposed regulations says: The proposed regulations will streamline the existing rules for written tax advice by removing current section 10.35 and applying one standard for all written tax advice under proposed section 10.37. Proposed section 10.37 provides that the practitioner must base all written advice on reasonable factual and legal assumptions, exercise reasonable reliance, and consider all relevant facts that the practitioner knows or should know. The proposed removal of section 10.35 will eliminate the requirement that practitioners fully describe the relevant facts (including the factual and legal assumptions relied upon) and the application of
3
the law to the facts in the written advice itself, and the use of Circular 230 disclaimers in documents and transmissions, including e-mails. Treasury’s revision of Section 10.35 is nothing short of stunning. Gone are the 5
pages of regulations about opinions. There would be no more distinction between reliance opinions vs. marketed opinions vs. limited opinions, and no more excluded advice. The rules related to conditional opinions and confidentiality rules would be gone. The contractual protection rules would be eliminated. And, as noted above, the disclosure rules, requirements for slicing and dicing the facts, and covering every significant federal tax issue, would all be eliminated.
Old Section 10.35 and Section 10.37 would be combined into a much shorter,
more understandable 10.37 titled “Requirements for written advice” which would say, in essence, that a practitioner:
• Must base written advice on reasonable factual and legal assumptions; • Must reasonably consider all relevant facts that the practitioner knows or
should know; • Must use reasonable efforts to identify and ascertain the relevant
additional facts needed; • Must not:
rely on any facts from the taxpayer or anyone else if the practitioner knows or should know those “facts” are unreasonable or incomplete;
rely on any advice from someone else if the practitioner knows or should know the other person is not competent or his/her opinion is not reliable or has a conflict of interest;
take into account whether an audit might occur; and take into account, if an audit does occur, whether the issue will be
raised. • May consider, if an audit occurs and the issue is raised, whether the issue
will be resolved through settlement, if available.
Clearly, the watchword is “reasonable.” And when it comes to what the Commissioner can do in terms of reviewing the practitioner’s conduct, as one might expect, the Commissioner will apply a reasonableness standard, considering all of the facts and circumstances including the scope of the engagement and the type and specificity of advice the client wants.
No surprisingly, when the opinion is going to be used to market or promote a tax deal the standard of review is higher. Treasury says that is because of the greater risk caused by the practitioner’s lack of knowledge.
Some of the Same Rules. To some extent, the rules regarding what goes into
the opinion are the same. Old Section 10.35(c)(1)(i) says, “The practitioner must use reasonable efforts to identify and ascertain the facts, which may relate to future events if a transaction is prospective or proposed, and to determine which facts are relevant. The
4
opinion must identify and consider all facts that the practitioner determines to be relevant.” New Section 10.37 (2) says, “(2) The practitioner must -- (i) Base the written advice on reasonable factual and legal assumptions (including assumptions as to future events); (ii) Reasonably consider all relevant facts that the practitioner knows or should know; (iii) Use reasonable efforts to identify and ascertain the facts relevant to written advice on each Federal tax matter;…” These are very similar provisions.
Old Section 10.35(c)(1)(ii) says, “(ii) The practitioner must not base the opinion
on any unreasonable factual assumptions (including assumptions as to future events)... It is unreasonable for a practitioner to rely on a projection, financial forecast or appraisal if the practitioner knows or should know that the projection, financial forecast or appraisal is incorrect or incomplete or was prepared by a person lacking the skills or qualifications necessary to prepare such projection, financial forecast or appraisal. ... “ New Section 10.37(2) says, “(2) The practitioner must -- (iv) Not rely upon representations, statements, findings, or agreements (including projections, financial forecasts, or appraisals) of the taxpayer or any other person if reliance on them would be unreasonable; …” and 10.37(b), “(b) Reliance on advice of others. A practitioner may only rely on the advice of another practitioner if the advice was reasonable and the reliance is in good faith considering all the facts and circumstances. Reliance is not reasonable when -- (2) The practitioner knows or should know that the other practitioner is not competent or lacks the necessary qualifications to provide the advice; or (3) The practitioner knows or should know that the other practitioner has a conflict of interest as described in this part.” And Section 10.37(b)(3) says, “(3) Reliance on representations, statements, findings, or agreements is unreasonable if the practitioner knows or should know that one or more representations or assumptions on which any representation is based are incorrect or incomplete.”
An entirely new insertion is in Section 10.37(b)(1) which says, “(1) The
practitioner knows or should know that the opinion of the other practitioner should not be relied on;” There is nothing that defines exactly what that means. Perhaps we are supposed to “know it when we see it.”
There are other similarities, and likewise some differences. But overall, the vast
majority of what was in Section 10.35 is gone. Disclaimers. Old Section 10.35(a)(4) defined a “Reliance opinion” but said that
written advice “is not treated as a reliance opinion if the practitioner prominently discloses in the written advice that it was not intended or written by the practitioner to be used, and that it cannot be used by the taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer.” Similarly, old Section 10.35(a)(5) defined a “Marketed opinion” but said that written advice “is not treated as a marketed opinion if the practitioner prominently discloses in the written advice that — (A) The advice was not intended or written by the practitioner to be used, and that it cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer; (B) The advice was written to support the promotion or marketing of the transaction(s) or matter(s) addressed by the written advice; and (C) The taxpayer should seek advice
5
based on the taxpayer’s particular circumstances from an independent tax advisor.” And old Section 10.35(c)(4) said that opinions that failed to reach a “more likely than not conculsion” must “must prominently disclose that —(i) The opinion does not reach a conclusion at a confidence level of at least more likely than not with respect to one or more significant Federal tax issues addressed by the opinion; and (ii) With respect to those significant Federal tax issues, the opinion was not written, and cannot be used by the taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer.” These provisions generally resulted in disclaimers that said something like, “STATEMENTS CONTAINED HEREIN ARE NOT INTENDED OR WRITTEN BY THE WRITER OR THIS FIRM TO BE USED, AND NOTHING CONTAINED HEREIN CAN BE USED BY YOU OR ANY OTHER PERSON FOR THE PURPOSE OF: (1) AVOIDING PENALTIES THAT MAY BE IMPOSED UNDER FEDERAL TAX LAW; OR (2) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY TAX-RELATED TRANSACTION OR MATTER ADDRESSED HEREIN.” If the underlying provisions in Circular 230 that created the disclaimer are gone, will the disclaimers themselves disappear? While Treasury hopes that those disclaimers will disappear, they may not. Almost all disclaimers begin by saying that nothing in the writing can be used to avoid penalties. Proposed Section 10.37(c)(1) says, “In evaluating whether a practitioner giving written advice concerning one or more Federal tax matters complied with the requirements of this section, the Commissioner, or delegate, will apply a reasonableness standard, considering all facts and circumstances, including, but not limited to, the scope of the engagement and the type and specificity of the advice sought by the client.” If the disclaimer is removed, then the practitioner may be subject to scrutiny under the foregoing standard. On the other hand, if the disclaimer remains, its presence serves as evidence that the “scope of the engagement and the type and specificity of the advice sought” did not include tax advice to be relied on by the client.” It may not be conclusive, but then the client is going to have trouble using something in a letter or email with that disclaimer to stake out a position before the IRS.
Many disclaimers flatly say that nothing in the written advice can be used to promote, market or recommend to another party any tax related transaction of matter addressed in the letter or email. But note that Section 10.37(c)(2) says, “In the case of an opinion the practitioner knows or has reason to know will be used or referred to by a person other than the practitioner (or a person who is a member of, associated with, or employed by the practitioner's firm) in promoting, marketing, or recommending to one or more taxpayers a partnership or other entity, investment plan or arrangement a significant purpose of which is the avoidance or evasion of any tax imposed by the Internal Revenue Code, the determination of whether a practitioner has failed to comply with this section will be made on the basis of a heightened standard of review because of the greater risk caused by the practitioner's lack of knowledge of the taxpayer's
6
particular circumstances.” That provision may make some cautious practitioners, and firm managers, opt to keep that portion of the disclaimer.
The bottom line is that clients are now used to seeing the disclaimers, and
removing them exposes the practitioner to some additional examination. Whether the disclaimers will disappear, or remain, perhaps in a modified form, remains to be seen.
Expanded Requirements for Firm Managers. The task of firm managers will be expanded. The old version of Section 10.36(a) required any practitioner with principal authority and responsibility for overseeing a firm’s tax practice to make sure written advice complied with Section 10.35. Treasury’s propose revision of Section 10.36(a) would eliminate the cross-reference to Section 10.35, and, instead, replace it with a cross-reference to “this part.” The term “this part” encompasses everything in Circular 230. To reinforce that, Treasury has inserted language into Section 10.36(a) that specifically mentions the “preparation of tax returns, claims for refund, or other documents for submission to the Internal Revenue Service,” in addition to “the provision of advice concerning Federal tax matters.” Expedited Suspensions. Section 10.82 related to expedited suspensions has been modified substantially. The first major change is the expansion of what is covered. The existing version addresses suspensions of licenses, criminal convictions, disbarment, sanctions for delay or frivolous proceedings, and failures to pursue administrative remedies. Added to that list is an entirely new subsection that adds willful failure to comply with the practitioner’s own Federal tax obligations. The added language is a revised version of the proposed regulations issued in 2006. Those proposed regulations could have allowed immediate suspension if the practitioner had not paid a Federal tax obligation. Treasury, in the preamble to the new proposed regulations, indicated that it had received feedback that a failure to pay could be as a result of circumstances beyond the practitioner’s control. The new language addresses those concerns by saying that expedited suspension is available only when the practitioner “demonstrates a pattern of willful disreputable conduct by (1) failing to make an annual Federal tax return during four of five tax years immediately before the institution of an expedited suspension proceeding; or (2) failing to make a return required more frequently than annually during five of seven tax periods immediately before the institution of an expedited suspension proceeding. . . . Additionally, the practitioner must be noncompliant with a tax filing obligation at the time the notice of suspension is served on the practitioner for the expedited procedures to apply.” The preamble justifies this addition by saying, “Treasury and the IRS have determined that the proposed rule is appropriate because practitioners demonstrating this high level of disregard for the Federal tax system are unfit to represent others who are making a good faith attempt to comply with their own Federal tax obligations.”
The new proposed regulations would close a gap that exists in the current rules related to the length of suspension. The current version of Section 10.82(f) is silent about the length of a suspension under those rules, other than to say it continues until
7
the suspension is lifted by the IRS, an Administrative Law Judge or the Secretary. By contrast, Section 10.81, which relates to disbarred practitioners or disqualified appraisers, sets suspensions at 5 years. The new proposed regulations would expand the Section 10.81 5-year rule to practitioners suspended under the expedited suspension procedure under Section 10.82. The preamble to the proposed new regulations indicates that some non-substantive changes have been made, and those are:
• The existing procedure speaks of the “filing” of a “complaint” and the practitioner filing an “answer.” The new language would refer to a “show cause order” (which conveys the concept of immediacy) and to the practitioner filing a “response.” That change is proposed so as to distinguish the language used in regular proceedings under Section 10.60 from the expedited suspension process under Section 10.82.
• If a practitioner is suspended, the existing language of Section 10.82(g) say the IRS is required to commence a Section 10.60 proceeding. The lead in phrase to that says the practitioner may “ask” the IRS to issue a complaint under Section 10.60. The new language replaces “ask” with “demand”, and replaces “issue a complaint” with “institute a proceeding.” And furthermore, the revision requires that the practitioner specifically refer to suspension under Section 10.82 to initiate this procedure.
• The time frame for commencing a proceeding under Section 10.82(g) has been extended from 30 to 45 days.
In addition, there is one minor technical change not mentioned in the preamble, and that is the elimination of the reference to “filing” of the complaint in the current version of Section 10.82(c). That provision cross-references Section 10.63(a), which address service but never mentions filing.
Proposed by Not In Effect. These are proposed and not final. That means that
practitioners must follow the existing rules set out in the current August 2011 version of Sircular 230 until the new regulations are finalized.
Effective Date. The proposed revisions would be effective when they are
adopted in final form and published in the Federal Register. Comments: Comments must be received by November 16, 2012. At public
hearing is scheduled for December 7, 2012 at 10 a.m., in the Auditorium of the Internal Revenue Service building at 1111 Constitution Avenue, NW, Washington, DC 20224. Outlines of topics to be discussed at that hearing must be received by November 16, 2012. Send submissions to:
CC:PA:LPD:PR (REG-138367-06), room 5205, Internal Revenue Service,
8
P.O. Box 7604, Ben Franklin Station, Washington, DC 20044.
Submissions may be hand delivered Monday through Friday between the hours of 8 a.m. and 4 p.m. to:
CC:PA:LPD:PR (REG-138367-06), Courier's Desk Internal Revenue Service 1111 Constitution Avenue, NW Washington, DC
Comments may also be submitted electronically via the Federal eRulemaking Portal at www.regulations.gov (indicate IRS and REG-138367-06).
Further Information: For further information concerning issues for comment, contact Matthew D. Lucey at (202) 622-4940. For more information concerning submissions of comments the public hearing, or to be placed on the building access list to attend the hearing, contact Oluwafunmilayo Taylor at (202) 622-7180.
ANY STATEMENTS CONTAINED HEREIN ARE NOT INTENDED OR WRITTEN BY THE WRITER TO BE USED, AND NOTHING CONTAINED HEREIN MAY BE USED BY YOU OR ANY OTHER PERSON, FOR THE PURPOSE OF (1) AVOIDING PENALTIES THAT MAY BE IMPOSED UNDER FEDERAL TAX LAW, OR (2) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY TAX-RELATED TRANSACTION OR MATTER ADDRESSED HEREIN.
9
APPENDIX The following is a draft prepared by Jim Roberts which attempts to highlight the differences between the current language in Circular 230, and the new language that the new proposed regulations would insert or alter. Care should be taken in using this appendix, and it should not be relied on exclusively in analyzing the proposed changes to Circular 230. § 10.1 Offices.
(a) Establishment of office(s). The Commissioner shall establish the Office of Professional Responsibility . . . to administer or enforce this part. Offices established under this part include, but are not limited to:
(1) The Office of Professional Responsibility, which shall generally have responsibility for matters related to practitioner conduct and shall have exclusive responsibility for discipline, including disciplinary proceedings and sanctions; and
* * * * *
§ 10.3 Who may practice.
(a) Attorneys. Any attorney who is not currently under suspension or disbarment from practice before the Internal Revenue Service may practice before the Internal Revenue Service by filing with the Internal Revenue Service a written declaration that the attorney is currently qualified as an attorney and is authorized to represent the party or parties. Notwithstanding the preceding sentence, attorneys who are not currently under suspension or disbarment from practice before the Internal Revenue Service are not required to file a written declaration with the IRS before rendering written advice covered under §10.37, but their rendering of this advice is practice before the Internal Revenue Service.
(b) Certified public accountants. Any certified public accountant who is not
currently under suspension or disbarment from practice before the Internal Revenue Service may practice before the Internal Revenue Service by filing with the Internal Revenue Service a written declaration that the certified public accountant is currently qualified as a certified public accountant and is authorized to represent the party or parties. Notwithstanding the preceding sentence, certified public accountants who are not currently under suspension or disbarment from practice before the Internal Revenue Service are not required to file a written declaration with the IRS before rendering written advice covered under §10.37, but their rendering of this advice is practice before the Internal Revenue Service.
* * * * *
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(g) Others. Any individual qualifying under paragraph §10.5(e) or §10.7 is eligible
to practice before the Internal Revenue Service to the extent provided in those sections.
* * * * * § 10.22 Diligence as to accuracy.
(a) In general. A practitioner must exercise due diligence — (1) In preparing or
assisting in the preparation of, approving, and filing tax returns, documents, affidavits, and other papers relating to Internal Revenue Service matters; (2) In determining the correctness of oral or written representations made by the practitioner to the Department of the Treasury; and(3) In determining the correctness of oral or written representations made by the practitioner to clients with reference to any matter administered by the Internal Revenue Service.(b) Reliance on others. Except as provided in §§ 10.34 and 10.37, a practitioner will be presumed to have exercised due diligence for purposes of this section if the practitioner relies on the work product of another person and the practitioner used reasonable care in engaging, supervising, training, and evaluating the person, taking proper account of the nature of the relationship between the practitioner and the person.
* * * * * § 10.31 Negotiation of taxpayer checks.
A practitioner who prepares tax returns may not endorse or otherwise negotiate
any check (including directing or accepting payment by any means, electronic or otherwise, in an account owned or controlled by the practitioner or any firm or other entity with whom the practitioner is associated) issued to a client by the government in respect of a Federal tax liability. * * * * * § 10.35 Competence.
(a) A practitioner must possess the necessary competence to engage in practice
before the Internal Revenue Service. Competent practice requires the knowledge, skill, thoroughness, and preparation necessary for the matter for which the practitioner is engaged.
11
§ 10.36 Procedures to ensure compliance.
(a) Any practitioner who has (or practitioners who have or share) principal
authority and responsibility for overseeing a firm’s practice governed by this part, including the provision of advice concerning Federal tax matters and preparation of tax returns, claims for refund, or other documents for submission to the Internal Revenue Service, must take reasonable steps to ensure that the firm has adequate procedures in effect for all members, associates, and employees for purposes of complying with this part, as applicable. Any such practitioner will be subject to discipline for failing to comply with the requirements of this paragraph (a) if —
(1) The practitioner through willfulness, recklessness, or gross incompetence does not take reasonable steps to ensure that the firm has adequate procedures to comply with this part, as applicable, and one or more individuals who are members of, associated with, or employed by, the firm are, or have engaged in a pattern or practice, in connection with their practice with the firm, of failing to comply with this part, as applicable; or (2) The practitioner knows or should know that one or more individuals who are members of, associated with, or employed by, the firm are, or have, engaged in a pattern or practice, in connection with their practice with the firm, that does not comply with this part, as applicable and the practitioner, through willfulness, recklessness, or gross incompetence, fails to take prompt action to correct the noncompliance.
* * * * * § 10.37 Requirements for written advice.
(a) Requirements. (1) A practitioner may give written advice (including electronic communications) concerning one or more Federal tax issues subject to the requirements in paragraph (a)(2) of this section.
(2) The practitioner must --
(i) Base the written advice on reasonable factual and legal assumptions (including assumptions as to future events);
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(ii) Reasonably consider all relevant facts that the practitioner knows or should know; (iii) Use reasonable efforts to identify and ascertain the facts relevant to written advice on each Federal tax matter; (iv) Not rely upon representations, statements, findings, or agreements (including projections, financial forecasts, or appraisals) of the taxpayer or any other person if reliance on them would be unreasonable; and (v) Not, in evaluating a Federal tax matter, take into account the possibility that a tax return will not be audited or that a matter will not be raised on audit.
(3) Reliance on representations, statements, findings, or agreements is unreasonable if the practitioner knows or should know that one or more representations or assumptions on which any representation is based are incorrect or incomplete. (b) Reliance on advice of others. A practitioner may only rely on the advice of
another practitioner if the advice was reasonable and the reliance is in good faith considering all the facts and circumstances. Reliance is not reasonable when --
(1) The practitioner knows or should know that the opinion of the other practitioner should not be relied on; (2) The practitioner knows or should know that the other practitioner is not competent or lacks the necessary qualifications to provide the advice; or (3) The practitioner knows or should know that the other practitioner has a conflict of interest as described in this part.
(c) Standard of review. (1) In evaluating whether a practitioner giving written
advice concerning one or more Federal tax matters complied with the requirements of this section, the Commissioner, or delegate, will apply a reasonableness standard, considering all facts and circumstances, including, but not limited to, the scope of the engagement and the type and specificity of the advice sought by the client.
(2) In the case of an opinion the practitioner knows or has reason to know will be used or referred to by a person other than the practitioner (or a person who is a member of, associated with, or employed by the practitioner's firm) in promoting, marketing, or recommending to one or more taxpayers a partnership or other entity, investment plan or arrangement a significant purpose of which is the avoidance or evasion of any tax imposed by the Internal Revenue Code, the determination of whether a practitioner has failed to comply with this section will be made on the basis of a heightened standard of review because of the greater
13
risk caused by the practitioner's lack of knowledge of the taxpayer's particular circumstances.
* * * * *
§ 10.52 Violations subject to sanction.
(a) A practitioner may be sanctioned under §10.50 if the practitioner —
(1) Willfully violates any of the regulations (other than §10.33) contained in this part; or (2) Recklessly or through gross incompetence (within the meaning of §10.51(a)(13)) violates §§ 10.34, 10.36 or 10.37.
* * * * * § 10.81 Petition for reinstatement.
(a) In general. A practitioner disbarred or suspended under section 10.60, or
suspended under section 10.82, or a disqualified appraiser may petition for reinstatement before the Internal Revenue Service after the expiration of 5 years following such disbarment or disqualification. Reinstatement will not be granted unless the Internal Revenue Service is satisfied that the petitioner is not likely to engage thereafter in conduct contrary to the regulations in this part, and that granting such reinstatement would not be contrary to the public interest. * * * * * § 10.82 Expedited suspension.
(a) When applicable. Whenever the Commissioner, or delegate, determines that a practitioner is described in paragraph (b) of this section, the expedited procedures described in this section may be used to suspend the practitioner from practice before the Internal Revenue Service.
(b) To whom applicable. This section applies to any practitioner who, within 5
years of the date that a show cause order under this section's expedited suspension procedures is served:
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(1) Has had a license to practice as an attorney, certified public accountant, or actuary suspended or revoked for cause (not including a failure to pay a professional licensing fee) by any authority or court, agency, body, or board described in §10.51(a)(10).
(2) Has, irrespective of whether an appeal has been taken, been convicted of any crime under title 26 of the United States Code, any crime involving dishonesty or breach of trust, or any felony for which the conduct involved renders the practitioner unfit to practice before the Internal Revenue Service. (3) Has violated conditions imposed on the practitioner pursuant to §10.79(d). (4) Has been sanctioned by a court of competent jurisdiction, whether in a civil or criminal proceeding (including suits for injunctive relief), relating to any taxpayer’s tax liability or relating to the practitioner’s own tax liability, for —
(i) Instituting or maintaining proceedings primarily for delay; (ii) Advancing frivolous or groundless arguments; or (iii) Failing to pursue available administrative remedies.
(5) Has demonstrated a pattern of willful disreputable conduct by --
(i) Failing to make an annual Federal tax return, in violation of the Federal tax laws, during 4 of the 5 tax years immediately preceding the institution of a proceeding under paragraph (c) of this section and remains noncompliant with any of the practitioner's Federal tax filing obligations at the time the notice of suspension is issued under paragraph (f) of this section; or (ii) Failing to make a return required more frequently than annually, in violation of the Federal tax laws, during 5 of the 7 tax periods immediately preceding the institution of a proceeding under paragraph (c) of this section and remains noncompliant with any of the practitioner's Federal tax filing obligations at the time the notice of suspension is issued under paragraph (f) of this section.
(c) Expedited suspension procedures. A suspension under this section will be
proposed by a show cause order that names the respondent, is signed by an authorized representative of the Internal Revenue Service under §10.69(a)(1), and is served according to the rules set forth in paragraph (a) of §10.63. The show cause order must give a plain and concise description of the allegations that constitute the basis for the proceeding. The show cause order must notify the respondent —
(1) Of the place and due date for filing a response;
15
(2) That an expedited suspension decision by default may be rendered if the respondent fails to file a response as required; (3) That the respondent may request a conference to address the merits of the show cuase order and that any such request must be made in the response ; and (4) That the respondent may be suspended either immediately following the expiration of the period within which a response must be filed or, if a conference is requested, immediately following the conference.
(d) Response. The response to a show cause order described in this section
must be filed no later than 30 calendar days following the date the show cause order is served, unless the time for filing is extended. The response must be filed in accordance with the rules set forth for answers to a complaint in §10.64, except as otherwise provided in this section. The response must include a request for a conference, if a conference is desired. The respondent is entitled to the conference only if the request is made in a timely filed response. (e) Conference. An authorized representative of the Internal Revenue Service will preside at a conference described in this section. The conference will be held at a place and time selected by the Internal Revenue Service, but no sooner than 14 calendar days after the date by which the response must be filed with the Internal Revenue Service, unless the respondent agrees to an earlier date. An authorized representative may represent the respondent at the conference.
(f) Suspension -- (1) In general. The Commissioner, or delegate, may suspend the respondent from practice before the Internal Revenue Service by a written notice of expedited suspension immediately following:
(i) The expiration of the period within which a response to a show cause order must be filed if the respondent does not file a response as required by paragraph (d) of this section; (ii) The conference described in paragraph (e) of this section if the Internal Revenue Service finds that the respondent is described in paragraph (b) of this section; (iii) The respondent's failure to appear, either personally or through an authorized representative, at a conference scheduled by the Internal Revenue Service under paragraph (e) of this section.
(2) Duration of suspension. A suspension under this section will commence on the date that written notice of expedited suspension is served on the practitioner, either personally or through an authorized representative. The suspension will remain effective until the earlier of the following:
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(1) The Internal Revenue Service lifts the suspension after determining that the practitioner is no longer described in paragraph (b) of this section or for any other reason; or (2) The suspension is lifted by an Administrative Law Judge or the Secretary of the Treasury, or delegate deciding appeals, in a proceeding referred to in paragraph (g) of this section and instituted under §10.60.
(g) Practitioner request for section 10.60 proceeding. If the Internal Revenue
Service suspended a practitioner under the expedited suspension procedures described in this section, the practitioner may demand that the Internal Revenue Service institute a proceeding under §10.60. The request must be made in writing, specifically reference the suspension action under section 10.82, and be made within 2 years from the date on which the practitioner’s suspension commenced. The Internal Revenue Service must issue a complaint requested under this paragraph within 45 calendar days of receiving the demand. i Jim Roberts is an estate planning attorney in the Dallas office of Glast, Phillips & Murray, PC, is an ACTEC Fellow, and board certified in estate planning and probate by the Texas Board of Legal Specialization. Jim can be reached at (972) 419-7189 or [email protected].
Shelter From the Gathering Storm: Protection for Trustees Facing Fiduciary Challenges
Eric A. Manterfield1
Investment Management 1
Investment concentrations, closely-held businesses and real estate 1 Can the trustee rely on consents to solve the problem? 2 Did the right people sign the consent? 2 Did they understand what they were signing? 4 How long ago were the consents signed? 5 Asset allocations that violate the trustee’s policy 5 Someone else manages the investments 6 What’s the real problem? 10 Who bears the expense of the court action? 13 Administration of the Trust 14 Discretionary distributions - why is the money needed? 14 Discretionary distributions - outside resources 18 Loans as disguised distributions 21 Ambiguity in the trust instrument 21 Total return trusts v. Uniform Principal and Income Act 24 The allocation and distribution of trust assets 29 Conflicts of Interest 31 A beneficiary is serving as the trustee 32 A beneficiary is serving as a co-trustee with a bank 33 A corporate trustee is also trustee of a related trust 33 How to deal with this problematic issue 34 New trust instruments 34 Existing trust instruments 35 Successor Trustee Liability for Acts of Prior Trustee 35 Revocation of a Revocable Trust 38 Conclusions and Final Recommendations 40
1
It never was easy to be a trustee and now it seems to be getting harder.
Perhaps there was a time when beneficiaries were forgiving of trustees; however, those
days are long gone. Beneficiaries today are perfectly willing (and eager) to use 20-20
hindsight to second guess every decision made by a fiduciary. It seems not to matter
whether the trustee is an individual or a corporate fiduciary. What can a trustee do to
minimize exposure in this mine field?
Investment Management
A trustee's greatest after-the-fact exposure arises whenever the investment
management of the trust does not conform to the terms of the trust instrument. How
could this ever happen, you wonder. Here are some examples I have encountered.
Investment concentrations, closely-held business interests and real estate. The
assets of the trust may be concentrated in one specific stock or even in one industry
group. The stock may have been acquired by the testator and left to the trust at his or
her death. The family does not want to sell it, either for sentimental or capital gains tax
reasons.
The trust may hold an interest in a closely-held family business or a family farm.
The beneficiaries to not want the asset sold, even if the Prudent Investor Act would
seem to require that action.
2
The creator of the trust can override the trustee’s normal duty to diversify
investments. Look at the trust instrument (will or trust agreement). Does the trust
instrument specify any treatment for this asset?
A document which merely authorizes a trustee to retain originally deposited
assets does not protect the trustee against liability. The power to retain does not have
to be exercised; it is discretionary with the trustee. The power to retain necessarily
includes the power not to retain. Authorization alone is not enough to override the duty
to sell this asset.
In order to permit the trustee to retain this concentration, closely-held business
interest or real estate, the trust instrument must (a) mandate the retention of the asset
by name and (b) relieve the trustee of liability for its retention. If your trust instrument
does not do these two things, the trustee is still liable for the investment.
The creator of the trust could have solved this problem with careful drafting of the
trust instrument. If he or she failed to include the appropriate mandate to retain and the
necessary release of trustee liability, the trustee has to take positive steps to address
the problem.
Can the trustee rely on consents to solve the problem? If the trustee obtains the
written consents of the beneficiaries, is that not sufficient protection? There are several
potential areas of concern for a trustee who has these consents.
Did the right people sign the consents? If the consent is signed only by the current
income beneficiary, the trustee still has exposure to the remainder beneficiaries. The
widow who does not want her children to learn about the trust until her later death has
3
put the trustee in an untenable position. Any consent to retain these assets must also
be signed by the remainder beneficiaries.
Even if the consent was signed by the remainder beneficiaries, is that consent
binding on those who might succeed to the interest of those who signed? If the trust is
to terminate at a widow's death, for example, with the assets distributed outright to
grown children, is the consent of the grown children enough protection? What if a child
dies before the widow, leaving minor children to take his or her share when the widow
later dies? Is that consent binding on those contingent remainder beneficiaries?
Indiana has codified the common law doctrine of "virtual representation."2 If the
interest of the contingent remainder beneficiaries is exactly the same as the interest of
the remainder beneficiary who signs the consent, that consent is binding on the
contingent remainder beneficiaries.
If the descendants of a deceased child will take exactly the same interest which
the child would have received if living when the trust terminated, the doctrine of virtual
representation means that the child's consent is binding on his descendants. I
recommend that the consent be signed by the remainder beneficiary "both individually
and on behalf of anyone who may succeed to my interest in the trust."
The consent is binding on those contingent remainder beneficiaries only so long
as their interest is contingent. If the child who consented on behalf of those contingent
remainder beneficiaries were to die during the administration of the trust (in which case
his or her descendants are now the remainder beneficiaries to the extent of the
deceased child’s interest), the trustee must get new consents from these new actual
remainder beneficiaries. While the deceased child's consent would prevent these new
4
remainder beneficiaries from criticizing the trustee for prior acts in reliance on the
consent (before their parent died), it will not protect the trustee going forward after the
child's death. A new consent is required from these new beneficiaries.
Recall that this doctrine can be utilized only if the interests are identical. An
income beneficiary's consent is not binding, for example, on the interests of the
remainder beneficiaries because their interests are not the same. The widow cannot
sign consents on behalf of the children under this doctrine.
Did they understand what they were signing? It may be too easy for an unhappy
beneficiary to get out from under a previously signed consent by claiming he or she did
not understand what was being signed. “I did not know what my rights were.” “The
trustee never advised me to seek the advice of my lawyer.” “My mother would not feed
us Thanksgiving dinner until we all signed the consents!”
The younger the beneficiary who consents, the harder it is to enforce. The less
sophisticated the beneficiary who consents, the harder it is to enforce. The consent
signed by an older, infirm person may be difficult to enforce.
Indiana law states that the consent by a beneficiary does not relieve the trustee
of liability if the beneficiary was under an incapacity.3 A beneficiary may be under an
“incapacity” even if not under a court supervised guardianship. The unhappy
beneficiaries (such as children of an elderly mother who signed the consent) will argue
that she actually was incapacitated when she signed the consent. Obviously, a consent
signed by a beneficiary who is under eighteen does not relieve the trustee of liability.
Indiana law goes on to provide that, even if the beneficiary was not incapacitated,
the consent does not relieve the trustee of liability if “the beneficiary did not know of his
5
rights or all of the material facts which the trustee knew or should have known.”4 The
trustee should advise each beneficiary in writing to seek advice from his or her own
lawyer before signing the consent. If a beneficiary signs the consent without seeking
advice of counsel, that fact should be documented.
The trustee should tell each beneficiary why the consent is being requested and
what will happen if not all the consents are signed. Policies should be in place to deal
with the possibility that some, but not all, of the beneficiaries will sign consents. Can the
trust be partitioned, perhaps with court authority, to retain the asset in one new account
which benefits those who signed consents and to diversify the asset in the other new
account which benefits those who refused to consent?
How long ago were the consents signed? How stale is the consent? Can the
beneficiary later claim that, due to new circumstances (market conditions, cash needs
and so forth), an old consent should no longer be binding. "I signed the consent under
different economic circumstances, which have significantly changed over time. I would
not have signed a new consent had one been asked of me.
If your consent is more than one year old, it may not be sufficient to relieve the
trustee of liability. Get them updated each year.
Asset allocations. Many corporate trustees have a written policy about the
percentage of trust principal which is to be invested in fixed income and in equity,
depending on the investment goals of the beneficiaries. Are there maximum
percentages which can be invested in stocks or in bonds? How does an individual
trustee invest the trust assets?
6
How are the investment objectives of the beneficiaries to be determined? How is
investment risk tolerance measured? Did the trustee consult only with the income
beneficiary or also with the remainder beneficiaries? How are these efforts
documented?
Can an unhappy beneficiary later claim that he or she was not consulted, did not
understand what was being asked or said and so forth? Of course! Once again, the
younger, the less sophisticated or the elderly are the beneficiaries, the more the trustee
must redouble the efforts to have meaningful conversations about investment risk
tolerance, investment objectives, non-trust assets available to the beneficiary and so
forth. Must the trustee consult with the remainder beneficiaries about these matters,
too? Of course.
What happens when a widow who is stretching for income pleads that all the
portfolio be invested in (low to no growth) bonds? What happens, on the other hand, if
the widow explains that she has ample income from other sources, so all the portfolio
should be invested in low yield (but higher risk) equities?
I believe the issues are the same with respect to any consents signed by the
beneficiaries. Did the right people sign the consents to the investments? Did they
understand what they were signing? How long ago were the consents signed?
Someone else manages the investments. More and more people are attempting
to involve someone other than the trustee in the management of the trust assets. This
may be the decedent's stock broker or financial planner, for example. These people do
7
not want to be the trustee, but they do want to manage the assets after the death of
their good clients.
In an effort to accommodate the wishes of the beneficiaries, a trustee may allow
this to happen. What liability does the trustee have for investment decisions made by
this third party? Does the trust instrument direct or permit this delegation of the
investment management responsibility? What exactly is said in the trust instrument?
Some wills or trust agreements permit a trustee to delegate investment
management. But does the trust instrument merely authorize this action or does it
mandate it? If the trustee is merely permitted to delegate investment management
decisions to a third party, the trustee remains liable for decisions made by that advisor.
The trustee was merely permitted to do so and was not required to delegate investment
management. If the trustee elects to do so, the trustee is still liable for the third party’s
management of the trust assets.
If the trust instrument directs the trustee to work with a third party on
investments, does the advisor merely give advice or must the trustee do what the
outsider directs? If it is not crystal clear that the trustee must follow the direction of the
third party, the trustee may easily be liable if the trustee does not stop the advisor from
making an inappropriate investment.
Is the trustee relieved of liability for following the directions of the investment
manager? Indiana law provides that a trustee must follow the third party’s direction and
is relieved of liability only if (a) the trust instrument specifically gives to the third party
the power to direct the trustee and (b) the trust instrument specifically relieves the
trustee from liability if the trustee does follow the third party’s directions.5
8
If the trust instrument directs the trustee to delegate investment management
and makes it clear that the trustee must follow the instructions of the outsider, but does
not expressly relieve the trustee of liability, then that language does not relieve the
trustee of liability. Indeed, the trustee is required to refuse to comply with the outsider's
directions if the trustee "knows or should know" that the instructed action would
constitute a breach of trust.6
If there is no language in the trust instrument or if the language provides
inadequate protection to the trustee, the trustee should have all the parties sign a
document which does provide that needed protection from liability. I recommend that
this agreement be signed by the trustee, the outside investment manager and the
current and remainder beneficiaries of the trust.
The agreement needs to address a number of significant issues:
• Does the outside investment manager merely give advice or must the trustee
follow the instructions?
• Is the trustee specifically relieved of liability for following those directions? If the
trustee is to be "indemnified and held harmless," by whom is the trustee so
indemnified? Will the outside investment manager hold the trustee harmless?
What if the outside investment manager dies or retires or files for bankruptcy?
Will the beneficiaries hold the trustee harmless? Who is liable to protect the
trustee?
• Does the trustee still have investment oversight and must the trustee still make
investment recommendations? If the trustee is relieved of those duties, what
impact will that have on the fees which the trustee can reasonably charge?
9
• Who custodies the trust assets?
• Does the outside investment manager actually make the trades for the trustee or
does the outside investment manager direct the trustee to make the trades?
Must those instructions be in writing?
• Who can remove the outside investment manager from that office? The trustee
still has investment liability if the trustee can remove the investment manager;
that is, if the trustee can fire the outside investment manager at any time, how
can the trustee later claim the trustee is protected against liability for actions
taken by the investment manager? “You should have fired the advisor before that
investment was made!” If one or more of the beneficiaries is given this power,
can or must they name a new investment manager? Does the trustee take back
the investment management responsibility if there is no outside investment
manager serving at any given time?
• How are the outside investment manager's fees to be charged? Against principal
or income? Does the trustee have liability for paying those fees without question
or must they first be approved by the beneficiaries? If the advisor is
compensated when trades are made, how mechanically are those fees to be split
between income and principal by the trustee?
• Who is responsible for tax reporting? If the assets are custodied by the outside
investment manager, how will the trustee get 1099s?
10
What’s the Real Problem?
The creator of the trust could have dealt with each of these issues by carefully
drafting the trust instrument. That was not done. The trustee who seeks to comply with
the wishes of the beneficiaries is required to take steps which could have been and
should have been taken by the patriarch of the family.
Can the trustee rely on the consents of the beneficiaries? Can the trustee
comply with investment management decisions of a third party even with a complete
agreement among all the parties?
Is there still potential liability? Of course! Beneficiaries are more and more
anxious to seek relief from a trustee with the benefit of hind sight.
What is the preferred strategy to minimize the trustee’s potential liability? Get a
court order.
I recommend that you get court approval whenever the administration of
the trust is at variance with the terms of the document. Consents alone are not
sufficient protection for the trustee.
Consents are the minimum protection you should have; however, the larger the
size of the trust, the more inadequate is the protection provided by the consents. It is
simply too easy for beneficiaries later to claim that they were not adequately informed
by the trustee when the consent was signed, did not understand their rights or that
circumstances changed after the consent was signed, rendering it meaningless (in their
opinion).
11
If the trustee has current, adequate consents from all the beneficiaries, it
probably is not worth the expense of getting court approvals in small trusts. But in
larger trusts, why would the trustee not demand the protection of a court order? If the
beneficiaries all want the trustee to deviate from the terms of the trust on these issues,
the trustee should reasonably ask for a court order to accomplish their wishes.
Suppose the beneficiaries do not want the trustee to diversify an investment
concentration, do not want the trustee to sell non-approved securities, or want the
trustee to delegate investment management to an outside investment manager? The
trust instrument could have provided for each of these things, but did not do so.
Nevertheless, the beneficiaries want the trustee to deviate from the express terms of the
trust instrument to accomplish their objectives.
Indiana law permits a trustee to petition the local court to permit a deviation from
the express terms of a trust instrument if the court finds that (a) there are new
circumstances which exist that were not reasonably foreseen by the creator of the trust
and (b) due to these new circumstances, compliance with the terms of the trust, as
written, would "defeat or substantially impair the accomplishment of the purposes of the
trust."7 If the court makes that determination, the judge can approve new language to
be put into an otherwise irrevocable trust agreement or last will and testament, which
would "direct or permit the trustee to do acts which are not authorized or are forbidden
by the terms of the trust, or may prohibit the trustee from performing acts required by
the terms of the trust."
How can a trustee utilize this statutory procedure? Suppose the trust holds an
investment concentration or wants to delegate investment management
12
responsibilities? Indiana law requires a trustee to comply with the "prudent investor"
rule.8 An investment concentration are generally understood to violate that rule. A
trustee cannot delegate investment management responsibilities.
The "new circumstance" which might exist is the requirement that the trustee
diversify the concentration and manage the trust assets regardless of the wishes of the
beneficiaries.
The trustee can assert that, had the creator of the trust known that the trustee
would be required to overrule the wishes of the beneficiaries, he or she would have
directed in the trust instrument the retention of the concentration or the investment
management delegation. This new circumstance was not reasonably anticipated by the
creator of the trust. Compliance with the terms of the trust instrument, as written, would
require the trustee to overrule the wishes of the beneficiaries, which would "defeat or
substantially impair the accomplishment of the purposes of the trust."
Therefore, the trustee requests that the court insert a new provision in the trust
instrument which prohibits the trustee from diversifying the investment concentration or
permits investment management delegation. Because no one can predict the future, I
recommend that the new court-approved provision prohibit the sale without the written
consent of specific beneficiaries.
Those issues identified above with respect to a written contract with an outside
investment manager must also be addressed in the new provision which the trustee and
beneficiaries wish the court to insert into the trust instrument.9
13
Who bears the expense of the court action? This is an appropriate expense
of the trust, to be charged to trust principal. The trustee does not bear this expense
personally. The legal fees and court costs are paid out of the trust assets themselves.
It is possible that the beneficiaries will object to the expense of a court order on
the grounds that it is being sought merely to protect the trustee. Why should the trust
bear that expense? The proper response to this objection is that the requested court
order merely puts into the trust instrument language which the creator of the trust
should have included. The trustee is seeking a court modification of the language in
order to accomplish the wishes of the beneficiaries.
If the beneficiaries are not willing to bear the expense, the trustee has no
alternative but to diversify the concentration, and manage the trust assets. If the
beneficiaries do not want the trustee to take those actions – which are required by
Indiana law because the creator of the trust failed to include the necessary language in
the trust instrument – they should and must bear the expense of “cleaning up” the trust
instrument.
If the beneficiaries realize that, without a court order, the trustee has no
alternative but to diversify the concentration and manage the investments without the
assistance of the outside investment manager, I believe the beneficiaries will
understand that the court process is not designed to protect the trustee, but is to give
the trustee the authority to do (or not do) what the beneficiaries want.
14
Administration of the Trust
A trustee faces similar exposure whenever the administration of the trust does
not comply with the terms of the trust instrument. How is this possible?
Discretionary distributions - why is the money needed? The trustee must not
assume that every trust instrument gives discretion to make distributions for "health,
education, maintenance and support." Some documents restrict those four purposes to
only education, for example. Some documents permit broader latitude, with
distributions authorized for “happiness” or “comfort.”
Does the purpose for which the distribution is requested meet the standards of
the trust instrument? A reasonableness factor comes into play here. These four
standards are very, very broad. Let's examine them in a little more detail.
"Health." The trustee may reasonably interpret this language to permit the
payment of those medical expenses incurred by the beneficiary which are not covered
by the beneficiary's medical insurance. But what if the beneficiary has no medical
insurance coverage? The beneficiary may elect not to incur that personal expense
because of the expectation that all medical expenses will be paid from the trust.
I recommend that the trustee demand annual proof the fact that the beneficiary
has adequate medical insurance coverage. If the beneficiary refuses to provide that
information or has no coverage, I recommend that the trustee consider the acquisition of
coverage at the expense of the trust. Depending on the terms of the trust, the trustee
can reasonably charge the premiums to the interests of that beneficiary. It is not
15
reasonable, on the other hand, for a trustee to permit a beneficiary to have no medial
insurance and to pay all the health expenses from the trust, in my opinion.
How does the trustee know whether the beneficiary has adequate medical
insurance? Ask!
"Education." I'm all in favor of education; however, I do not like perpetual
students. The old four year undergraduate program has turned into a five, six or even
more year marathon (at least my children tell me that!). When can and should a trustee
say "no" to a beneficiary who stays on and on and never seems to reach graduation?
I think the answer to that question depends on the size of the trust assets, the
existence of other beneficiaries who are dependent on those assets and the probable
intention of the parents who created the trust.
Suppose the child who wants to stay in college is the sole beneficiary of the trust,
which might terminate, for example, when he or she reaches a higher age, with the
assets distributed to that same child? By consuming his or her own trust assets for
these continuing education pursuits, the beneficiary is hurting no one other than himself
or herself. I see no reason, under those circumstances, to say "no" to the request for
more tuition dollars.
But if this is a "family" trust, designed to hold all the assets together in one trust
for the benefit of several children, one child's continued demand for tuition dollars might
jeopardize the trustee's financial ability to educate the younger children. It is under
these circumstances that I recommend the trustee put a limit on the number of years of
undergraduate education which will be paid from the trust.
16
A related problem arises with a “small” trust. If the oldest child of four children
requests distributions for an expensive undergraduate education from a trust holding
only $300,000, it is certainly possible that the trust assets will be exhausted long before
the youngest child graduates from high school. While the parents, if still living, would
have incurred that expense (with the expectation that, some how, they will get more
money to educate the younger children), the trustee must understand that there will be
no new money coming into the trust.
A reasonableness standard must be adopted by the trustee of a trust with limited
assets. If the trustee believes that there is a risk the trust assets will be consumed if the
trustee pays all the anticipated education expenses of one child, the trustee must limit
how much is distributed for the education of that child. Even though the trust instrument
permits distributions for that child’s “education,” the trustee has a duty of impartiality and
cannot favor the interests of that child at the expense of the other children.
“Maintenance and support" can literally mean whatever the trustee decides those
words should mean. Almost any expenditure can arguably be brought within the scope
of that standard. So when can and should a trustee say "no" to a beneficiary? Once
again, a reasonableness standard must be applied.
I know of beneficiaries who demand to be supported and maintained by
benevolent trustees long after they have left school. Trustees know of "trust babies"
who lie around the swimming pool and expect a trustee to pay their rent and buy them
groceries. Is this what the parents intended when they included the words "support and
maintenance" in the trust instrument? Probably not.
17
If there are other beneficiaries of the trust, I believe that it is unreasonable for a
trustee to give in to a beneficiary's demand to be supported and maintained, even if that
is a standard in the trust instrument. To do so might jeopardize the trustee's ability to
raise and educate the younger children. The trustee who depletes trust assets in the
support of an older child may face liability to the younger beneficiaries when the trustee
later has insufficient funds to meet their legitimate needs.
A reasonableness standard should be applied. A trustee might, for example, tell
a child who is in his twenties that the trust will only match the child's own earned
income. The trust will supplement, but not replace, the beneficiary's ability to support
and maintain himself or herself. This standard may not be necessary if the trustee has
millions of dollars in trust; however, I believe it to be a reasonable standard in many
smaller trusts.
Many trust instruments authorize a trustee to help a child purchase a residence
or start a business. How much of the trust principal should be depleted for these
purposes? Should the principal be distributed to the beneficiary who then purchases
the home or business in his own name or could not the trustee buy those as assets of
the trust? Title to the home or the business can later be distributed to the child when
the beneficiary reaches the stated ages for distribution.
Should the trustee expect the beneficiary to contribute some amount towards the
purchase of the residence or business? Perhaps the trustee would agree to match
whatever down payment is put up by the beneficiary. A beneficiary who has his own
money invested in a new business (perhaps matched by a discretionary distribution
from the trust) will devote more effort to the success of the venture.
18
Discretionary distributions - outside resources. Must the trustee consider the
resources otherwise available to the beneficiary when requested to make a
discretionary distribution? What are the terms of the trust instrument? There are
probably three alternatives:
1. The trust instrument expressly directs the trustee to take into
consideration the outside resources which can meet the beneficiary's needs. But does
the document direct the trustee to consider "all resources" or only the "income" of the
beneficiary?
Must the trustee require the beneficiary to use up all those outside resources
before any distribution can be made from the trust? The instrument typically says that
the trustee is to "take into consideration" those resources. The beneficiary should not
be required to exhaust them.
If the outside resources are illiquid, for example, the trustee should not refuse a
reasonable request for distributions. But if the beneficiary has ample outside liquid
resources, on the other hand, it would violate the terms of the trust instrument if the
trustee, in spite of those outside liquid resources, distributed money from the trust.
If the trustee is to consider outside resources, the trustee should request a
personal financial statement from the beneficiary. The trustee might also request
copies of back income tax returns, to see whether the reported income on the tax
returns is consistent with the income producing assets disclosed on the financial
statement. If the beneficiary refuses to supply this requested documentation, the
trustee should refuse to make the requested distribution.
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The trustee's "consideration" of these outside resources should be documented
in writing and saved with the records of the trust.
2. The trust instrument expressly directs the trustee not to take into
consideration the outside resources which can meet the beneficiary's needs. While this
type of provision is unusual, I have seen it in a number of documents.
If this is the controlling language in the trust instrument, of course, the outside
resources and income of the beneficiary are irrelevant. So long as the need is
legitimate, the distribution may be made.
If the remainder beneficiaries are unable to accept the language of the trust and
express displeasure with the trustee's discretionary distributions (when the beneficiary
has ample non-trust liquid resources which could meet the need), I recommend the
trustee petition the court for instructions. Does the language (“do not take into
consideration the beneficiary’s non-trust assets”) really mean what it says?
Send notice of a hearing to all the beneficiaries and let them argue to the judge
that the trust assets should not be depleted under these circumstances. When the court
issues an order confirming the language of the trust instrument, it will later be difficult for
the remainder beneficiaries to complain.
3. The trust instrument is silent on this issue. If that is the case, look
carefully the wording of the instrument when it gives the trustee the discretion to make
distributions.
Some documents permit the trustee to make discretionary distributions of those
amounts of trust income or principal that "the trustee determines to be necessary for the
reasonable health, education, maintenance and support" of the beneficiary. If the
20
beneficiary has adequate outside liquid resources available, how can the trustee
determine that a distribution from the trust is "necessary"? If the beneficiary satisfied
those needs with the outside resources, the distribution from the trust would not be
necessary, of course. If the trustee nevertheless distributes net income or principal, the
trustee may have exposure to those remainder beneficiaries who would otherwise have
received those distributed amounts.
Other documents permit the trustee to make discretionary distributions of those
amounts of trust income or principal that "the trustee determines to be necessary or
convenient for the reasonable health, education, maintenance and support" of the
beneficiary. If the beneficiary has adequate liquid outside resources available to meet
the need, but feels that it would be more convenient to have money distributed from the
trust, how can a trustee refuse the request? “Why should I spend my money when I can
get the trust to pay for it?”
Remember that it is the trustee, rather than the beneficiary, that makes the
"convenient" determination. The greater the outside resources available to meet the
request, the greater is the trustee's liability for distributing money from the trust in my
opinion.
There are two considerations at work here: (a) if the trust assets will not be
subject to taxation at the death of the requesting beneficiary, while his or her outside
assets will be taxed, it makes no tax sense to distribute assets from the trust when the
beneficiary has outside resources; and (b) if the remainder beneficiaries are step-
children or other third parties, it makes no sense to distribute assets from the trust
without their knowledge and consent, particularly when it is only “convenient” to do so.
21
Once again, the trustee's consideration of these issues should be documented
and saved in the trust records.
Loans as disguised distributions. Some beneficiaries request that the trustee
"loan" principal to the beneficiary when the standards for a discretionary distribution are
not met. A beneficiary who is scheduled to receive all the trust assets when he reaches
thirty may request that the trustee "loan" the entire trust principal to the child at age
twenty-seven.
"What is the harm," he asserts, "because I will get the money in less than three
years anyway? And since the trustee is to pay all the income earned by the trust assets
to me, there is no reason for me to pay interest on this loan," he argues!
If the trustee gives in to this demand/request for the "loan," Murphy's Law can
almost guarantee that (a) the loaned funds will be depleted and (b) the beneficiary will
die before he reaches age thirty! The trustee will then be required to explain to the
remainder beneficiaries why this "loan" was made in the first place.
Do not pretend that a loan under these circumstances is anything other than a
disguised discretionary distribution. If the trustee is not willing to make a discretionary
distribution, do no make one under the guise of a loan.
Ambiguity in the trust instrument. Ambiguities may arise when a trust is being
administered. The language is simply not clear or the situation presented to the trustee
was not dealt with in the trust instrument.
22
Here is one example of how ambiguities can arise in the administration of a trust.
Suppose the trust assets are divided when both parents have died into separate trusts
for each of the children. The assets are then to be distributed as each child reaches 25,
30 and 35. If a child were to die before his 35th birthday, his or her remaining trust
assets are to be distributed to his or her descendants or, if none, are to be added to the
trusts for the siblings.
Suppose the son dies when he is 28 and has no children of his own. The
remaining assets are added to the trust for his sister when she is 33 years old. She
had previously received distributions from her trust when she had reached 25 and 30.
She now demands that the trustee distribute two-thirds of the assets which have been
added to her trust.
Does the trust instrument deal with the possibility that assets will be added to her
trust after a distribution has been made? Many do not.
What should the trustee do when presented with this ambiguity? The trustee
must always petition the court for instructions to resolve any ambiguity. The trustee
must not interpret the language and come up with the trustee's own interpretation.
Almost by definition, the trustee's resolution of an ambiguity will harm the interests of
some of a beneficiary.
If the trustee in the example just given decides to distribute two-thirds of the
addition to the daughter who survived her brother's death, what liability does the trustee
have to her descendants if she dies at age 34? Those descendants would have
received the distributed assets had no distribution been made.
23
It is important that, when the trustee seeks a judicial interpretation of the trust
instrument, the trustee not argue for a particular construction. This may be difficult to do
when the trustee (or the trustee's lawyers) participated in the planning and the drafting
of the trust instrument. The trustee may rightly feel that he or she knows the "correct"
interpretation of the language which creates the ambiguity.
If the trustee asserts a position in the judicial proceedings, however, that action
will violate the trustee's duty of impartiality towards the interests of all the beneficiaries.
This well settled matter of common law was expressed in the dissenting opinion in
Estate of Goulet v. Goulet10 as follows:
"It has long been settled, not only in California but elsewhere, that a fiduciary (such as the trustee of a trust or the personal representative of a decedent's estate) administering property on behalf of multiple beneficiaries must act impartially towards all the beneficiaries and must not favor, or expend funds litigating, the interest of one beneficiary over another. The fiduciary may not take sides when a dispute arises as to the relative rights and interests of various beneficiaries, and may not work to advance or oppose the claim of any beneficiary." (emphasis added)
The application of this principle to ambiguities in the interpretation of a trust
instrument was brought vividly home in The Northern Trust Company v . Heuer.11 The
trustee asserted a construction in the judicial proceeding which was unfavorable to the
position taken by a beneficiary. The court held that, while it was proper for the trustee
to seek the court's construction of the trust instrument by filing the action and in
gathering and presenting the information necessary for the court to interpret the
instrument, the trustee breached its duty of impartiality and exceeded its duty as the
trustee when it argued for an interpretation adverse to a beneficiary.
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The court disallowed the trustee's request that the attorneys' fees it incurred in
the construction action be paid out of trust assets:
"[G]enerally the costs of litigation to construe a trust in which there are adverse claims are paid by the trust estate .... [W]here a trustee breaches its duty to administer the trust according to its terms and performs in a manner which favors one beneficiary over another, the trustee is not entitled to attorney fees and costs even though the breach is technical in nature, done in good faith and causes no harm." (emphasis added)
Northern Trust was required to pay the trustee's legal fees out of its own assets, rather
than from the trust.
The trustee's duty of impartiality applies to the trustee's attorneys, of course, who
also may not assert a position which is adverse to the interests of any trust beneficiary.
Suppose the trustee is an individual and one of several beneficiaries of the trust.
He or she wishes to take a position on the resolution of the ambiguity. I recommend that
the individual trustee engage a new lawyer who can petition the court for instructions on
behalf of the trustee. That new lawyer thereafter takes no position on the resolution of
the ambiguity. The “regular” lawyer for the individual trustee can then enter an
appearance on behalf of the individual as beneficiary and not as trustee and the
beneficiary can then argue in favor of a particular resolution of the ambiguity.
Total Return Trusts v. Uniform Principal and Income Act. Indiana law was
changed to permit a trustee to convert an ordinary "income only" trust to a total return
unitrust.12 If a trustee decides not to convert an ordinary "income only" trust to a total
return unitrust, the trust will be subject to Indiana’s Uniform Principal and Income Act.13
What should a trustee do? With respect to trusts which call for only the
distribution of income (and not principal), it is no longer business as usual. That is, the
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trustee cannot merely continue to distribute net income and ignore the option of
conversion to a total return unitrust or to adjust income and principal under the UPIA.
The trustee must either convert the trust to a total return unitrust or elect to be governed
by the Uniform Principal and Income Act. The option of “continue as we have always
done” is not available.
If the trust instrument gives the trustee the discretion to distribute principal as
needed, however, there is no reason, in my opinion, to convert the trust to a total return
unitrust or to make adjustments between income and principal under the UPIA. Rather,
the trustee can make reasonable distributions of trust principal in those amounts
necessary to accomplish the purposes of the trust.
If the trustee manages a portfolio of marketable securities, I do not believe the
trustee need convert the trust to a total return unitrust nor be terribly concerned with
adjustments between income and principal. Nevertheless, conversion to a unitrust
means that both the current and the future beneficiaries share an investment goal of
growth and the age old tug of war over the asset allocation decisions can be minimized.
But if the trust has an investment concentration in a stock with a low dividend
yield (hopefully with language in the trust instrument or a court order directing its
retention and relieving the trustee of liability), capital appreciation favors the remainder
beneficiaries over the interests of the current income beneficiaries. If the trust is not
converted to a unitrust, the UPIA requires the trustee to consider shifting some of the
principal appreciation to income. That is, the income beneficiary suffers financially due
to the retention of the concentration; the concentration is retained so as to obtain capital
26
appreciation which, in the absence of an adjustment under UPIA, would benefit only the
remainder beneficiaries.
The trustee might also hold commercial real estate as a trust asset. If the tenant
leaves at the end of the lease and the rental income ceases, the income beneficiary will
suffer financial harm unless and until the real estate is sold. Should the trustee consider
shifting some principal to income under UPIA or should the trustee convert the trust to a
total return unitrust?
Finally, the trustee may hold farm land as a trust asset. The value of the ground
continues to appreciate, which drives the current income yield to low levels. The family
wants to maintain the farm in the trust for ultimate distribution to the remainder
beneficiaries. Should the trustee consider shifting some the real estate appreciation to
income, so as to compensate the current beneficiary?
If the trustee is dealing with a document which permits or requires the distribution
of only trust income, I recommend that the trustee make an affirmative decision either
(a) to convert the trust to a total return unitrust or (b) to continue the administration of
the trust as written, but with application of UPIA. The trustee must make a decision to
go one way or the other. It is no longer business as usual.
If the trustee merely ignores this choice and continues to distribute only the
income, the trustee could easily have liability to the beneficiary who later argues that the
trustee should have converted the trust to a unitrust or should have made adjustments
between income and principal under UPIA. A decision not to decide merely postpones
the inevitable second guessing.
27
Should the trustee consult with the beneficiaries before making this decision? Of
course!
A trustee may decide to convert the income only trust to a total return unitrust. If
this conversion takes place, the trustee will thereafter determine the net fair market
value of the trust assets on an annual basis and will distribute a "unitrust" amount in the
following year to the beneficiary. The unitrust rate cannot be less than 3% nor more
than 5% of the value of the trust assets.14
The trustee’s conversion to a total return unitrust is done primarily to resolve the
historic asset allocation battle between the income and remainder beneficiaries. If the
"current beneficiary" is to receive a fixed percentage of the annually revalued trust
portfolio, that beneficiary shares the same investment goals with the remainder
beneficiaries. All the trust beneficiaries want the value of the trust assets to increase
over time.
If the decision is made to convert the trust to a total return unitrust, the trustee
should follow the procedures outlined in I.C. 30-2-15-1 et seq. If all the beneficiaries
consent in writing to this conversion, no court order is required.15 If the trustee receives
an objection or if the trustee merely wants the comfort of a court order, the trustee
should follow the procedures outlined in I.C. 30-2-15-11. Because an unhappy
beneficiary is always able to argue in the future that he or she did not know her rights
when signing the consent, I still recommend court approval of the conversion to a
unitrust, with the consents of the beneficiaries attached as exhibits to the trustee’s
petition.
28
If the trustee elects to continue to administer the trust as written, on the other
hand, the Uniform Principal and Income Act will apply to the trust unless to do so might
jeopardize an estate tax deduction or a gift tax exclusion, would violate a fixed annuity
distribution provision or would cause the trustee to be treated as the owner of the trust
assets for income or estate tax purposes. The power to make adjustments between
income and principal also cannot be exercised if the trustee is a beneficiary of the
trust.16
For the thousands of trusts which are now subject to UPIA, the trustee must
follow the procedures outlined in the Act when deciding whether to shift income to
principal or vice versa for trust accounting purposes.17
The trustee must become familiar with the nine factors which the Act says the
trustee should consider when deciding whether to make an adjustment:
1. The nature, purpose and expected duration of the trust;
2. The identity of the person who created the trust;
3. The identity and the circumstances of the beneficiaries of the trust;
4. The needs for liquidity, regularity of income and preservation and
appreciation of principal;
5. The assets in the trust, including the extent to which they consist of liquid
investments, ownership interests in a closely held business, tangible personal property,
intangible personal property or real estate; the extent to which these trust assets are
used by a beneficiary; and whether the assets were deposited to the trust by its creator
or were purchased by the trustee;
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6. The normal allocation of receipts and disbursements between income and
principal;
7. Whether the trust instrument permits the trustee to make discretionary
distributions of trust principal and the extent to which the trustee has exercised this
power from time to time;
8. That actual and anticipated effects of the economy and inflation; and
9. The anticipated tax consequences of the adjustment.18
I recommend that the trustee establish a written checklist, with these nine factors
identified, so that the trustee can document the trustee’s consideration of these issues
every year. Even if, after consideration, the trustee determines that no adjustment
between income and principal should be made, the trustee should document the
consideration of these nine factors, so that the trustee can later justify the decision not
to adjust income and principal.
The allocation and distribution of trust assets. A trustee is commonly called
upon to allocate trust assets to one or more continuing trusts, perhaps between a credit
trust and a marital gift. What liability might a trustee incur when performing these routine
functions?
If assets are to be allocated between a credit trust and a marital gift, the manner
in which those allocations are made can be very complex. Suppose the trust instrument
calls for the trustee to allocate to the credit trust the largest amount which can pass free
from federal estate tax by reason of the decedent's applicable credit amount, with the
remaining trust assets to be distributed outright to a surviving spouse? The trust holds
30
$5 million in assets, based on the final date of death federal estate tax values; therefore,
the trustee thinks that $3.5 million should be allocated to the continuing credit trust and
the remaining $1.5 should be distributed to the surviving spouse.19
However, the assets cannot be divided between the credit trust and the marital
gift on the date of death. The estate must be administered and tax clearances must be
obtained. Months will pass before the trustee is in a position to distribute the assets.
When it is appropriate to fund the trusts, the trustee must determine the current value of
the assets which remain to be distributed.
Suppose, when the trustee revalues the assets before making these allocations,
the trustee learns that the assets have appreciated during the estate administration
period and are now worth $6 million. Where should the trustee allocate the $1 million of
appreciation which has occurred after the date of death? If the value of the assets
which are available to fund the trusts has fallen to $4 million, on the other hand, which
trust bears the market loss?
The answer depends on the language in the trust instrument. If the trustee is
directed to distribute assets in kind at their value on the date of distribution, the trustee
must allocate assets which, when the allocation is made, equal the date of death value
of the first gift made in the trust instrument. Is that the credit trust or the marital gift? All
the appreciation or depreciation then passes to or falls on the residuary gift.
If the trustee, on the other hand, is to distribute assets in kind which are fairly
representative of overall appreciation and depreciation which has occurred during the
estate administration, then both the allocation to the credit trust and the distribution to
the surviving spouse are to be increased by the amount of the appreciation (or
31
decreased by the amount of depreciation). Both gifts share ratably in the appreciation
or depreciation which has occurred. 20
Next, what does the trustee do with the income which has been earned on those
assets during the estate administration? The answer to that question may be even
more complicated due to arguable conflicts between the Probate Code and the Trust
Code.
If these distribution decisions are being made by a personal representative in a
supervised estate, the fiduciary can ask the court to approve the proposed action after
notice to all the beneficiaries. However, if these decisions are being made by a trustee
who receives assets under a pour over will, no thought may be given to court approval.
Why not? I recommend that the trustee docket the trust and petition the court for an
order which, after notice to all the beneficiaries, approves of the allocation to the credit
trust and the distribution to the surviving spouse and the distribution of the net income.
The Internal Revenue Service is now routinely looking at these funding decisions
when the surviving spouse later dies. There is anecdotal evidence that the IRS is
finding that credit trusts were incorrectly funded more than 50% of the time. If a trustee
incorrectly funds a credit trust, causing assets to be subject to federal estate tax at the
death of the surviving spouse, will the trustee have liability for that error? Of course.
Conflicts of Interest
A very pervasive problem for trustees arises when a trustee has a conflict of
interest. Conflicts can arise in two fairly common situations: (1) when a beneficiary is
32
serving as a trustee or co-trustee; and (2) when the same trustee is serving as trustee
of two related trusts.
Indiana Code Section 30-4-3-5(a) reads as follows:
“If the duty of the trustee in the exercise of any power conflicts with the trustee’s individual interest or the trustee’s interest as trustee of another trust, the power may be exercised only under one (1) of the following circumstances:
(1) The trustee receives court authorization to exercise the power with notice to interested persons as the court may direct.
(2) The trustee gives notice of the proposed action in accordance with IC 30-2-14-16 and (A) The trustee receives the written authorization of all
interested persons to the proposed course of action within the period specified in the notice of the proposed action; or
(B) A beneficiary objects to the proposed action within the period specified in the notice of the proposed action, but the trustee receives court authorization to exercise the power.
(3) The exercise of the power is specifically authorized by the terms of the trust.”
A beneficiary is serving as the trustee. How many beneficiaries are serving as a
trustee or as a co-trustee of Indiana trusts today? I believe that the number will be in
the thousands. How many of those trust instruments specifically acknowledge the
trustee/beneficiary’s conflict of interest and waive any liability which the
trustee/beneficiary may have? I believe that the number will be very, very low.
Every beneficiary who serves as a trustee or a co-trustee inherently has a
conflict of interest in the exercise of virtually every trustee power. The allocation of trust
assets between stocks and bonds will have an economic impact on all the beneficiaries,
including the conflicted trustee. The trustee/beneficiary’s exercise (or refusal to
exercise) the power to make discretionary distributions will have an economic impact on
all the beneficiaries, including the conflicted trustee.
33
I.C. 30-4-3-5(a) gives to every other beneficiary of that trust the power to bring
an action against the trustee/beneficiary who failed to comply with subjections (1) and
(2), all with the benefit of hindsight. Suppose, for example, that the trustee/beneficiary
purchased an investment which later declined in value.
Another beneficiary could bring an action to compel the trustee/beneficiary to
reimburse the trust for the full amount invested in that stock. The traditional defense to
that sort of action was to show that the investment was prudent when made and that
there is no trustee liability if it later declines in value.
The unhappy beneficiary will argue, however, that the action is not brought
because the investment was imprudent; rather, the action was brought because the
trustee/beneficiary had no power to make the investment in the first place! That is,
because the conflicted trustee failed to comply with I.C. 30-4-3-5, the investment was
per se invalid.
A beneficiary is serving as a co-trustee with a bank. This statute presents a
serious problem to professional trustees and individual trustees alike. If a beneficiary is
serving as a co-trustee with a corporate fiduciary, all decisions of the co-trustees must
be unanimous unless the trust instrument provides otherwise.21 Assuming that the trust
instrument does not provide otherwise, that necessarily means that the “vote” of the
individual trustee is required for every decision made by the co-trustees. Unless the co-
trustees comply with I.C. 30-4-3-5, the participation by the co-trustee/beneficiary is not
authorized. I argue that this means evert decision by the co-trustees was invalid.
A corporate trustee is also trustee of a related trust. Kentucky has a statute
which is remarkably similar to I.C. 30-4-3-5. PNC Bank was serving as the trustee of an
34
irrevocable trust created by the beneficiary’s mother. The daughter also created her
own revocable trust and named PNC Bank as her trustee. When the daughter
requested a discretionary distribution of principal from her mother’s trust, PNC Bank
failed to realize that it had a conflict of interest because it simultaneously served as
trustee of the daughter’s revocable trust.
Because the remainder beneficiaries of the two trusts were different, PNC Bank’s
decision to make a discretionary distribution from the mother’s trust violated its fiduciary
obligation to take only those actions which are in the best interests of the beneficiaries.
PNC Bank’s failure to obtain prior court authorization for the discretionary distribution
violated Kentucky’s version of I.C. 30-4-3-5. While the amount of damages was
remanded to the trial court, it appears likely that PNC Bank would be ordered to
reimburse the mother’s trust for the entire amount of the discretionary principal
distribution.22
How to deal with this problematic issue?
New trust instruments. If you are drafting new trust instruments which name a
beneficiary as the trustee or as a co-trustee, you must have the client specifically
acknowledge the trustee/beneficiary’s conflict of interest and waive any liability which
the trustee/beneficiary would otherwise have under I.C. 30-4-3-5.
The mere naming of a beneficiary as the trustee or as a co-trustee is not
sufficient to overcome I.C. 30-4-3-5. The waiver of the conflict must be “specifically
authorized by the terms of the trust.” (emphasis added) If the mere naming of a
conflicted beneficiary as the trustee or as a co-trustee were sufficient to overcome the
statute, why have the statute in the first place?
35
Existing trust instruments. If you today are a trustee who is also a beneficiary of
an irrevocable trust, you must take corrective action now. I recommend that you docket
the trust and petition the court to modify the provisions of the irrevocable trust in
accordance with the provisions of I.C. 30-4-3-26. The “new circumstance” not foreseen
by the creator of the trust, I believe, would be the inability of the named
trustee/beneficiary to exercise the powers of the trustee without prior court authority.
You ask the court to modify the language of the trust instrument to insert language in
which the creator of the trust acknowledges the trustee/beneficiary’s conflict of interest
and waives any liability which the fiduciary may otherwise have.
The failure to take this corrective action leaves a loaded shotgun in the hands of
every other beneficiary who can bring an action against the trustee/beneficiary with the
full benefit of hindsight.
Successor Trustee Liability for Acts of Prior Trustee
There are many instances in which the serving trustee was not the original
trustee. This is the successor trustee. Indiana law23 provides that the successor
trustee can exercise all powers granted to the original trustee in the will or trust
agreement.
However, Indiana law24 is equally clear that a successor trustee “becomes liable
for a breach of trust of his predecessor if he … fails to make a reasonable effort to
compel a redress of a breach of trust committed by the predecessor trustee.”
The steps which can and should be taken by the successor trustee depend on
the circumstances in which the successor becomes the trustee.
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The trustee who succeeds a deceased creator of a revocable trust. Suppose
an individual creates a revocable living trust and is the initial trustee. The trust
agreement becomes irrevocable when the creator of the trust dies and a successor
trustee takes over. That successor trustee should have no liability to the beneficiaries
of the trust for any action taken while the trust was revocable because those
beneficiaries had no real interest in the trust until it became irrevocable.
The trustee who succeeds a trustee of an irrevocable trust. Suppose the trust
is already irrevocable, on the other hand. There is an existing trustee of this irrevocable
trust. That trustee becomes incapacitated, resigns, is removed or dies. A successor
trustee takes over.
I.C. 30-4-3-13(b) states that the new trustee must make a “reasonable effort” to
redress any breach of trust committed by the predecessor trustee. However, the terms
of the trust may expressly relieve the successor trustee of any liability for acts of the
predecessor trustee.25
Therefore, if the terms of the trust instrument expressly relieve the successor
trustee of liability for acts of the predecessor trustee, there is no reason for the
successor trustee to examine the books and records of the predecessor trustee. I
recommend, however, that the successor trustee be certain that the beneficiaries of the
trust understand that the predecessor trustee may still be liable to the beneficiaries for
any breach of trust committed by the predecessor trustee while in office, so they can
take the necessary steps to protect their interests.
If the terms of the trust do not expressly relieve the trustee of liability for acts of
the predecessor trustee, on the other hand, the successor trustee must take steps to
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protect itself from fiduciary liability for acts of the predecessor trustee. If the successor
trustee takes no action before the applicable statute of limitations expires, the
beneficiaries can bring an action against the successor trustee for breaches of trust
committed by the predecessor trustee.
Therefore, I recommend that the successor trustee do one of two things: (a)
docket the trust and ask the court to order the predecessor trustee to prepare and file a
complete accounting of the acts of the predecessor trustee for the entire period in which
the predecessor trustee was in office. Have the accounting, when filed, served on the
beneficiaries who should be given a reasonable opportunity to file objections. The
successor trustee is not relieved of fiduciary liability if the beneficiaries fail to object,
however, because it is the successor trustee who must protect their interests;
nevertheless, it is reasonable for the successor trustee to give them that opportunity.
The successor trustee must conduct a careful review of the accounting and must file
appropriate objections with the court, which will ultimately rule on any alleged breaches
of trust; or (b) the successor trustee must obtain written consents from the beneficiaries
which expressly relieve the successor trustee of liability for acts of the predecessor
trustee. I note that all of the problems with written consents noted earlier26 have equal
applicability to this issue.
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Revocation of a Revocable Trust
When the creator of a revocable trust elects to revoke the trust agreement, it
seems pretty straightforward. Right? Not necessarily.
If the trustee has any question about the competency of the creator of the trust or
the susceptibility of that person to undue influence by others, alarm bells should sound.
A recent Kentucky Supreme Court case illustrated the point.
J.P. Morgan Chase Bank, N.A. v. Longmeyer27 dealt with the trustee of a
revocable trust which had been revoked. Because the trustee suspected that the
creator of the trust had been unduly influenced to revoke the trust, the trustee notified
the charitable beneficiaries of the revoked trust of its revocation. After the charities
brought an action to invalidate the revocation, the trustee of the new trust created by the
settlor brought this action against the predecessor trustee. The successor trustee
argued that notice should not have been given to the charitable beneficiaries, that notice
was a breach of trust and that the predecessor trustee should be personally liable for
the costs of the settlement which had been paid to the charities.
Is the trustee of a revoked revocable trust under a fiduciary duty to notify the
beneficiaries of the revocation? The Kentucky Supreme Court not only ruled that the
predecessor trustee had no liability for notifying the charities, it went further and ruled
that the trustee had an affirmative duty to notify the beneficiaries of the revoked trust.
Kentucky’s statute requires a trustee to “keep the beneficiaries of the trust reasonable
informed of the trust and its administration.”28
Many of us thought that the purported beneficiaries of a revocable trust had no
real interest in the trust until it became irrevocable; therefore, we thought that there was
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no duty to keep those maybe beneficiaries informed. Nevertheless, the Kentucky court
refused to create an exception for revocable trusts.
I believe that the ruling in this case may have turned on the trustee’s suspicion of
undue influence. That is, if the creator of the trust lacked the capacity to revoke the
trust, its beneficiaries did have an interest which needed to be protected.
If the trustee of a revocable trust has no reason to believe the creator of the trust
lacks competency or is the victim of undue influence or fraud, there is no reason in my
opinion to notify the beneficiaries of the revoked trust. The competent creator of the
trust is the only beneficiary of the trust so long as it is revocable and it is a real stretch to
believe that the trustee must notify the maybe beneficiaries.
If the trustee of a revocable trust has reason to believe, on the other hand, that
the creator of the trust lacks competency or is the victim of undue influence or fraud, I
believe that the trustee must notify the beneficiaries of the trust. Indeed, I recommend
that the suspicious trustee docket the trust and petition the court for instructions before
the trustee recognizes the validity of the revocation.
If the trustee fails to do that and honors the revocation, the trustee may end up in
a very difficult position. Suppose that the creator of the trust dies shortly after revoking
the trust. Federal estate tax is payable by the creator’s estate; however, none is paid by
those who now have the assets which had been in the trust.
The Internal Revenue Service is not bound by any determination of state law by
any court other than the Supreme Court of that state.29 Even if the trustee obtains a
court order affirming the revocation of the trust, the IRS can later assert that the
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revocation was invalid for any number of reasons. If successful, the trustee will become
personally liable for the unpaid federal estate tax.30
Even if the suspicious trustee obtains a court determination which upholds the
validity of the attempted revocation, I recommend that the trustee deposit into an
escrow account sufficient funds with which to pay the federal estate tax due from the
creator’s estate simply because the IRS is not bound by the trial court’s determination
of an effective revocation.
Conclusions and Final Recommendations
An individual who is serving as trustee of one or only a few trusts should examine
these issues immediately.
No corporate trustee can review all its accounts after reading this material.
There are too many accounts to look at. I recommend, on the other hand, that careful
attention be paid as accounts are cycled up for administrative or investment review.
Are the investments being made in accordance with the terms of the trust
instrument? Is there an investment concentration or are there non-approved securities
whose retention is not directed by the trust instrument, with the trustee relieved of
liability? Has the trustee informally permitted an outside investment manager to make
investment decisions? How old are the consents which approve of the trustee's actions
or inactions? Do the consents expressly relieve the trustee of liability?
Is the trust being administered in accordance with the terms of the trust
instrument? Should discretionary distributions be denied because they are excessive?
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Has the trustee given appropriate consideration to outside resources available to the
beneficiary before making a discretionary distribution from the trust? Has that
consideration been documented in the trust records? Has the trustee made disguised
discretionary distributions in the form of unsecured loans to a beneficiary?
Has the trustee considered conversion of an income only trust to a total return
unitrust or has the trustee decided to continue administration of the trust as written, but
with application of Indiana's Uniform Principal and Income Act?
The first step for a trustee is to evaluate the trusts of which the trustee serves as
fiduciary. Identify the skeletons in the closet. The trustee can then determine what
action to take, whether that be (at a minimum) updated consents from all the
beneficiaries or court orders after notice to the beneficiaries.
Doe the trustee have a conflict of interest in the exercise of the trustee’s powers?
Does the trust instrument specifically acknowledge the conflict of interest and waive any
liability? If not, has the trustee complied with I.C. 30-4-3-5 every time it exercises the
powers of trustee? If not, should the trustee seek judicial modification of the trust
instrument to insert the necessary language?
It never was easy to be a trustee and now it seems to be getting harder.
1 Eric Manterfield, Krieg DeVault LLP, Indianapolis, IN, [email protected] 2 I.C. 29-1-1-20(a)(4) and I.C. 30-4-6-10. 3 I.C. 30-4-3-19(b)(1). 4 I.C. 30-4-3-19(b)(2). 5 I.C. 30-4-3-9(a). 6 I.C. 30-4-3-9(b). 7 I.C. 30-4-3-26(a).
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8 I.C. 30-4-3.5-1. 9 See the discussion which begins "The agreement needs to address a number of significant
issues" on page 7 of this paper. 10 10 Cal. 4th 1074 at 1086, 898 P.2d 425 at 432 (1995). See, also, In the Matter of the Trust for
Duke, 305 N.J. Super. 408, 702 A.2d 1008 (1995), In re Cudahy, 26 Wis.2d 153, 131 N.W.2d 882 (1965) and In re James Estate, 86 N.Y.S.2d 78 (Surr. Ct. 1948).
11 202 Ill.App.3d 1066, 560 N.E.2d 961 (1990). 12 I.C. 30-2-15-1 et seq. 13 I.C. 30-2-14-15. 14 I.C. 30-2-15-15. 15 I.C. 30-2-15-10. 16 I.C. 30-2-14-15(c). 17 I.C. 30-2-14-15. 18 I.C. 30-2-14-15(b). 19 Assume the decedent died when the applicable credit amount would shelter $3.5 million from
federal estate tax. 20 A fractional formula allocation between a credit trust and marital gift works the same way. 21 I.C. 30-4-3-4(a). 22 Wiggins et al. v. PNC Bank, Kentucky, Inc., 988 S.W.2d 498 (Ky. 1999). 23 I.C. 30-4-3-4(d). 24 I.C. 30-4-3-13(b). 25 I.C. 30-4-1-3 states that the terms of the trust instrument can override the provisions of the Trust
Code “unless the rules of law clearly prohibit or restrict the article which the terms of the trust purport to authorize.” Because the rule of I.C. 30-4-3-13(b) does not clearly prohibit a trust instrument from varying the general rule of trustee liability for acts of a predecessor trustee, the trust instrument can relieve the successor trustee of this liability if it expressly does so.
26 See the discussion beginning on page 2. 27 275 S.W.3d 697 (Ky. 2009). 28 Ky. Rev. Stat. Section 386.715. 29 Commissioner v. Bosch’s Estate, 19 AFTR 2d 1891 (2d Cir., 1967). 30 Internal Revenue Code of 1986, as amended, Section 1002; Regulations Section 20.2002-1.
NEW GUIDANCE FOR GUARDIANS: THE THIRD NATIONAL GUARDIANSHIP SUMMIT AND THE DEVELOPMENT AND IMPLEMENTATION OF GUARDIAN
STANDARDS OF CONDUCT
KAREN E. BOXXi
For the past 25 years, guardianship reform has become a topic of national discussion, and progress has been made in the area of safeguards for the incapacitated person in the guardianship initiation and appointment process. However, until recently, the need for clear standards for the guardian's performance post-appointment has not received much attention. Other fiduciaries, such as trustees and executors, have significant guidance from statutes and case law regarding the extent and nature of their duties. By contrast, guardianship statutes give only minimum descriptions of a guardian's duties and there are very few reported cases on the parameters of a guardian's responsibilities and the framework for making decisions for the incapacitated person. One reason for this may be the expectation that a guardian is supervised by the court and will receive direct guidance and oversight from an involved judiciary. However, the combination of a dramatic increase in the number of adult guardianships and a decrease in court resources has created a crisis in guardianship monitoring. Comprehensive data is lacking, but anecdotal evidence shows that guardians are for the most part acting on their own. For example, in 2007 a task force in Washington state formed by the Washington State Bar Association surveyed the state courts’ regarding monitoring of guardianships. The responses revealed that fifteen of the state’s thirty-nine counties (thirty-three of which responded to the survey) had no procedures for monitoring guardian compliance, and only five counties had relatively active monitoring procedures, such as reminding guardians of upcoming deadlines and verifying information in reports. This lack of supervision not only allows unscrupulous guardians to abuse and neglect the incapacitated persons in their care, but also leaves well-meaning guardians in the dark as to how to carry out their duties. The lack of standards also leaves courts with little guidance when judging a guardian’s performance, resulting in potential inconsistencies and risks to the guardian. When an errant guardian is caught, because of the absence of advance direction to the guardian, some courts may be hesitant to discipline a guardian for all but the most egregious transgressions, and some courts may choose to discipline a guardian for mistakes that a guardian made out of ignorance. The need for comprehensive standards for guardians' performance was the focus at the Third National Guardianship Summit, held at the University of Utah S.J. Quinney College of Law October 2011. The first national conference on guardianship reform, referred to as the Wingspread Conference, was held in 1988, and brought together experts from multiple disciplines to address the various problems of the guardianship process. The second, called the Wingspan
conference, was held in 2001. Both conferences made sweeping recommendations, intcluding the need for standards of conduct for guardians, but the implementation efforts focused on protections in the initial hearings on incapacity and appointment of a guardian, and on using least restrictive alternatives. The Third National Guardianship Summit focused only on post-appointment issues and the creation and adoption of standards for guardians. The Summit's 93 participants met in separate workgroups and as a whole to adopt recommendations for standards for the various areas of guardian duties, such as financial, healthcare and housing management and decisionmaking, and for basic principles of how guardians should weigh the best interests of the incapacitated person and the desires of the incapacitated person when making decisions. The Summit resulted in a set of specific recommendations and its organizers are continuing work to see these recommendations implemented in state guardianship law. The RPTE section participated in the Summit as a member of the National Guardianship Network, a coalition of organizations involved in guardianship law that was was the primary organizer of the Summit. At the ABA annual meeting in Chicago in August 2012, the House of Delegates passed a resolution adopting the Summit's Standards and Recommendations and urging courts and goverments to implement them. As part of the Summit, nine background articles were written on the topics studied at the conference and those articles will be published in a forthcoming issue of the Utah Law Review. The topics covered in the articles are: an overview of the status and need for guardianship standards; surrogate decision-making standards; person-centered decision-making; financial decision-making; guardian medical decision-making; residential decision-making; guardian fees and compensation; the guardian’s relationship to the court; and interdisciplinary guardianship committees. The full text of the Summit recommendations can be found at: http://www.americanbar.org/content/dam/aba/uncategorized/2011/2011_aging_summit_recs_1111.authcheckdam.pdf The Summit participants used the National Guardianship Association's very thorough Standards of Practice (available online at http://guardianship.org/guardianship_standards.htm) as a starting point for the recommendations. The decisions reached at the Summit are set forth in three parts: a definitions section, recommended standards for guardians, and recommendations for courts and other entities regarding use of the standards and implementation. The standards give specific guidance to guardians, such as how to avoid conflicts of interest, when to factor in the incapacitated person's wishes, and issues the guardian should research, such as the specific health condition of the incapacitated person. The standards clarify that all guardians, both professional and volunteer/family guardians, should be held to the same standards. Most of the recommendations are addressed to the courts and recommend areas for the court to give guidance to guardians. The
recommendations also advise adoption of specific standards in state guardianship statutes and give other implementation recommendations. Guardianship practitioners should review the Summit recommendations, for several reasons. First, such review would update their knowledge of guardianship reform developments. Guardianship practitioners can also use the recommendations as guidelines for their guardian clients, even if not binding. Finally, it is important that practitioners understand and be able to advise their guardian clients about the current lack of specificity in the law about their duties and the risks of taking actions that may be questioned later by a court. The Elder Law, Disability Planning and Bioethics Group is planning a free group conference call in December with members who were participants at the Summit, to discuss the Summit in detail and answer questions.
i Professor of Law, University of Washington. Professor Boxx is Vice Chair of the ABA RPTE Elder Law, Disability Planning and Bioethics Group.
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Charitable Giving Alert Grace Allison
Adjunct Professor of Law, University of New Mexico School of Law
This year, there are many reasons to carefully consider the timing of substantial lifetime charitable gifts. As we go to press, uncertainty is inescapable: no one knows whether we will have a stalemate (reinstatement of prior law in 2013), a one-year reprieve (one-year extension of current law with tax reform effective no earlier than 2014), and/or a series of half-measures (including extension of some expiring or expired temporary provisions into 2012 and 2013) culminating in tax reform at some future date. In order to capture opportunities that may vanish at year’s end, clients—and their advisors—may need to act quickly.
STALEMATE
For upper-tier charitable donors, a return to prior law would mean return of the potentially draconian Pease limitation on itemized deductions.
Pease limitations in 2013?
Background. As enacted in 1990, the Pease limitation (IRC Section 68) reduced certain otherwise allowable itemized deductions (including the charitable deduction) by up to 80 percent. Under Pease, the exact amount of the reduction was the lesser of (a) 80 percent of the otherwise allowable deductions or (b) three percent of the amount by which adjusted gross income exceeded a statutory floor, which was indexed for inflation. Had Pease been in place in 2012, the statutory floor would have been $173,650 ($86,825 for marrieds filing separately).
The Pease limitation was phased out over a four year period (2006-2009) by the 2001 Tax Act and has not been in effect since 2009. Unfortunately, like all the other provisions of the 2001 Tax Act, the elimination of Pease sunsets at the end of 2012. If Congress fails to act, it will be in full force on January 1, 2013.
Strategy. No matter how you handicap the stalemate alternative, becoming subject to the Pease limitation could devastate your client’s expected charitable income tax deduction. When deciding whether to accelerate charitable deductions into 2012, be sure to take the Pease calculation into account.
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ONE YEAR REPRIEVE
H.R. 8, as passed by the House of Representatives on August 1, 2012, would extend the sunset of 2011 income tax law until December 31, 2013. This would allow donors to remain in a familiar tax landscape for another twelve months—and give their advisors a comfortable interval in which to complete major charitable transfers.
EXTENSION OF “TEMPORARY” PROVISIONS
A number of temporary provisions (known as “the extenders”) expired at the end of 2011 or will expire at the end of 2012. Four popular charitable provisions are included in the current extenders package, which is pending in the Senate and anticipated to be considered during the November lame-duck session.
$100,000 charitable rollover for 2012 and 2013?
Background. Enacted by the Pension Protection Act of 2006 (“PPA”), IRC Section 408(d)(8) allowed individual taxpayers age 70 ½ or older to direct lifetime contributions up to $100,000 per year from their IRAs to qualified charities. The distribution was not included in the individual’s gross income but did count towards satisfying the applicable minimum distribution requirement. As enacted, this taxpayer-friendly rule expired at the end of 2007, but was subsequently extended through the end of 2011.
The current extenders package pending in Congress, the “Family and Business Tax Cut Certainty Act of 2012 (S___),” would revive IRC Section 408(d)(8) for both 2012 and 2013.
Strategy. In order to lock-in the potential benefits of this provision for 2011, donors age 70 ½ or older will need to act before year-end. Simply direct the IRA custodian or trustee to distribute the desired amount (up to $100,000) to a qualified charity on or before December 31. (Be sure to check with the specific financial institution; internal processing deadlines may be stricter.) If the extenders legislation becomes law, the distribution will qualify for treatment under IRC Section 408(d)(8). If Section 408(d)(8) is not extended, the distribution will instead be treated as if made to the donor and then contributed by the donor to the qualified charity, subject to all the usual income tax limitations.
Comments. 1. Section 408(d)(8) was last extended by legislation signed into law on December 17, 2010. That legislation (the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010) included a special election that allowed
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distributions made to charity on or prior to January 31, 2011 to be treated as if they were made on December 31, 2010. There is no comparable provision in the pending Senate legislation.
2. As under prior law, distributions to donor advised funds, supporting organizations, and private foundations are not “qualified charitable distributions.”
3. Lifetime transfers from an IRA to charity, unlike ordinary charitable contributions, are not subject to itemization requirements or to contribution base limitations. This makes the extension of Section 408(d)(8) particularly attractive to those who have excess charitable contribution carryovers or who do not itemize their deductions. Reinstatement of the Pease limitation on itemized deductions (see above) would make the potential tax benefits provided by Section 408(d)(8) even more valuable.
Qualified conservation contributions for 2012 and 2013?
Background. PPA also added IRC Section 170(b)(1)(E), which increased the maximum contribution base limitation for qualified conservation contributions from 30 percent to 50 percent, with a special 15-year excess charitable contribution carryover. Also part of Section 170(b)(1)(E): even more generous rules that applied only to qualified farmers or qualified ranchers. As enacted, these provisions expired at the end of 2007, but were subsequently extended through the end of 2011.
The current extenders package pending in Congress, the “Family and Business Tax Cut Certainty Act of 2012 (S___),” would revive IRC Section 170(b)(1)(E) for both 2012 and 2013.
Strategy. Qualified conservation contributions are generally complex transactions, requiring months of preparation. Keep close watch on the extenders legislation to gain the maximum lead time for 2013 transfers.
Favorable basis adjustment for S-corporation shareholders?
Background. When S corporations make contributions of appreciated property to charity:
* the charitable deduction flows through pro rata to its shareholders and
* the shareholder’s basis in his stock is decreased.
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Prior to PPA, the required basis adjustment was equal to the shareholder’s pro-rata share of the fair market value of contributed property. PPA relaxed this rule so that the decrease was limited to the shareholder’s pro-rata share of the adjusted basis of the contributed property. As enacted, the amendment to IRC section 1367(a)(2) expired at the end of 2007; it was subsequently extended through the end of 2011.
The current extenders package pending in Congress would make the favorable rule of IRC Section 1367(a)(2) effective for both 2012 and 2013.
Strategy. When considering charitable distributions from S corporations, check first on the status of the extenders legislation.
Enhanced charitable deduction for contributions of food inventory by businesses?
Background. Prior to 2012, three temporary provisions under IRC Section 170(e)(3) provided enhanced charitable deductions for certain contributions of food inventory, book inventory and computer equipment. Only one of these now-expired provisions –the enhanced charitable deduction for contributions of food inventory-made its way into this year’s slimmed-down extenders package.
The current extenders package would make IRC Section 170(e)(3)(C) effective for both 2012 and 2013.
Strategy In a time of widespread hunger, any business that holds food as inventory should be aware of the potential revival of this provision.
TAX REFORM
Income tax rate changes?
Background. The current political debate provides a clear dichotomy: Democrats generally favor higher rates for upper-income taxpayers, while Republicans have proposed a 20 percent across-the-board rate cut. Republicans would make their tax reform proposals effective in 2014. Democrats, if empowered, might raise rates for upper-income taxpayers as early as 2013.
Strategy. If all other factors were likely to be held constant, one might advise delaying charitable gifts to hedge against the possibility of higher rates. Unfortunately, it appears that higher rates could be accompanied by other law changes that would make delay an
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unattractive tactic. For example, the Obama 2013 Budget Proposal would reinstate both Pease limitations and higher tax rates for upper-income taxpayers.
Waiting to see which way the pendulum swings could be expensive for other reasons as well. As described in more detail below, one potentially influential tax proposal would combine lower tax rates with a maximum 12 percent income tax credit for charitable contributions; the contribution amount itself would be reduced by a two percent floor.
Status of the income tax charitable deduction?
Background. Although the income tax charitable deduction now appears “untouchable,” the tide could turn as Congress digs into deficit reduction. In successive budget proposals, including the most recent, President Obama has recommended capping most itemized deductions, including the charitable deduction, at 28 percent for marrieds with $250,000 or more of adjusted gross income ($200,000 for singles). The Obama 2013 budget proposal also includes reinstatement of the Pease limitation for those upper-income taxpayers. Together, Pease and the 28 percent cap would prevent outsized tax benefits (36% or 39.6%) going to those in the top Obama income tax brackets. Significantly, the 2012 Republican platform is less specific on this point, saying only that “donations to [charitable organizations] should continue to be tax deductible.” This, theoretically at least, leaves room for a wide range of modifications to the existing charitable deduction, all of which would be effective only in 2014. In addition, Republicans have called for a 20 percent across the board reduction in tax rates. Assuming such a reduction took place in 2014, the maximum tax benefit from the income charitable deduction would be correspondingly reduced in that year. Given the uncertainties of the moment, it is also important to consider outliers such as the bi-partisan Simpson-Bowles proposal. If implemented, Simpson-Bowles would replace the arguably regressive income tax charitable deduction with a flat 12 percent income nonrefundable income tax credit available to all taxpayers ( but with a 2% of AGI floor.) Simpson-Bowles has been mentioned by both parties in recent weeks. Strategy. Donors may be well-advised to make substantial charitable contributions before the tax reform proposals go into effect. Comments. Both deficit concerns and policy imperatives may lead to changes in the income tax charitable deduction. In 2010, the Joint Committee on Taxation (JCS-3-10) estimated the five year revenue cost of the income tax charitable deduction at $230 billion, making the charitable deduction one of the ten most expensive income tax expenditures. Among the intriguing policy questions are those raised in a December 2011 National Tax Journal article authored by Joseph J. Cordes:
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* How sensitive is charitable giving to changes in the charitable income tax deduction? (Cordes reports a current lack of consensus among economists.)
* To the extent that the charitable deduction subsidizes the favorite charities of the rich, does it also subsidize “activities that generally serve an important public purpose”? (An example here is the relatively high proportion of itemized charitable giving to educational institutions, at least some of which primarily educate the children of the affluent.)
* Is the current income tax charitable deduction “unfair”? (In 2008, 32.4% of the tax benefits from the income tax charitable deduction accrued to those with adjusted gross income of $1 million or more. Cordes, Table 5)
IRS Finally Blesses Charitable Gifts Directly to a Charity’s Single Member LLC
Elaine Waterhouse Wilson Associate Professor, West Virginia University
Many charities use single member LLCs (SMLLC) to hold problematic assets. For example, a donor may wish to give to a charity a piece of commercial real estate that might have environment issues. The charity would rather not be in the chain of title for that piece of real estate, but it would still like to benefit from the potentially valuable gift. By having the donor give the real estate directly to a SMLLC, the charity gets out of the chain of title, isolates any liabilities generated by the property, but eventually benefits from the sale of the property.
The donor, on the other hand, is understandably concerned. The donor should get a charitable deduction for a gift made directly to a SMLLC that is wholly owned by a Section 170(c) organization. After all, the tax law treats the SMLLC as a disregarded entity. Therefore, the gift ought to be deemed made to the single member – the charity. While this is the logical result, the IRS had been hesitant to confirm it in writing. Donors are understandably unwilling to make a large gift directly to a SMLLC when their tax advisors tell them that while they ought to get a very large charitable deduction, there is no guarantee.
Charities everywhere rejoiced with the issuance of IRS Notice 2012-52 (July 31, 2012), which states that a gift to a domestic SMLLC will be treated as "a charitable contribution to a branch or division of the U.S. charity.” The Notice is effective for "charitable contributions made on or after July 31, 2012. However, taxpayers may rely on this notice prior to its effective date for taxable years for which the period of limitation on refund or credit under § 6511 has not expired."
The Notice contains some specific guidance with regard to substantiation of these types of gifts. The charity – not the SMLLC - is treated as the donee organization for purposes of Section 170(f), including the written acknowledgement rules. The IRS goes on to state: "[t]o avoid unnecessary inquiries by the Service, the charity is encouraged to disclose, in the acknowledgment or another statement, that the SMLLC is wholly owned by the U.S. charity and treated by the U.S. charity as a disregarded entity." Practitioners should review the Notice carefully to make sure that their written acknowledgements continue to comply with Section 170(f).