estate planning 101: from client intake to …...scope of work 11 included: we understand that,...
TRANSCRIPT
ESTATE PLANNING 101:
FROM CLIENT INTAKE
TO THE FINAL PLAN
Moderator/Speaker Dana A. Bennett, Esq. Bennett & Wyatt, LLC (Red Bank, Lakewood)
Speakers Matthew T. Aslanian, Esq. Orloff, Lowenbach, Stifelman & Siegel, P.A. (Roseland) Robert I. Aufseeser, Esq. Ansell, Grimm & Aaron, P.C. (Ocean) Adam M. Grenker, Esq. Fox Rothschild LLP (Roseland, Hackensack) Jill Lebowitz, Esq. Norris, McLaughlin & Marcus, P.A. (Bridgewater)
In cooperation with the New Jersey State Bar Association Real Property,
Trust & Estate Law Section S0017.17
© 2017 New Jersey State Bar Association. All rights reserved. Any copying of material
herein, in whole or in part, and by any means without written permission is prohibited.
Requests for such permission should be sent to NJICLE, a Division of the New Jersey
State Bar Association, New Jersey Law Center, One Constitution Square, New
Brunswick, New Jersey 08901-1520.
Table of Contents Page Client Intake in Estate Planning PowerPoint Presentation Robert I. Aufseeser, Esq. 1 Drafting Techniques to Minimize Conflict and Court Action Upon Death Dana A. Bennett, Esq. Adam S. Grenker, Esq. 41 Last Will and Testament 43 Probate Assets Versus Non-Probate Assets 43 Specific Will Provisions 43 Language Issues 49 Power of Attorney 51 Overview 51 Specific Provisions 51 Trusts 54 Specific Provisions 54 Lifetime Gift Planning Philip C. Corbo, Esq. 95 Elements of a Valid Lifetime (“Inter Vivos”) Gift 95 Capacity of Client to Make Gifts 95 Generable Durable Power of Attorney 95 Joint Accounts, P.O.D. Accounts and Trust Accounts 96 Various Gifts and Other Transfers 98 Challenges to Inter Vivos Transfers 101 Fraudulent Transfers 103 Fiduciary Duty of Trustees 105 Gift Tax Issues 106 Audit Issues 107 Contesting a Will – Selected Principles of Law Matthew T. Aslanian, Esq. 113 Undue Influence 113 Presumptions and Burdens 113 The Existence of a “Confidential Relationship” 114 “Suspicious Circumstances” Sufficient to Shift the Burden of Proof for Undue Influence 117 A Proponent’s Burden of Disproving Undue Influence 121 Due Execution of the Will 123 Statutory Requirements for a Will’s Execution 123 The Effect of a Self-Proving Affidavit Under N.J.S.A.3B:3-4 125 Competence to Execute a Will 126 Revocation 127
About the Panelists… 131
Client Intake in Estate Planning
Robert I. Aufseeser, Esq.
1
Overview of Estate Planning Services
2
Common Estate Planning Services Include:
Preparing wills, trusts, living wills, powers of attorney, and other
related documents;
Reviewing financial holdings and life insurance;
Providing guidance on family issues;
Assisting the client with asset transfers;
Transferring a business interest;
Facilitating lifetime gifting;
Minimizing estate taxes;
2
Overview of Presentation
3
Initial Consultations
Engagement Letters
Joint Representation
Rules of Professional Conduct
Who is the Client?
Capacity Issues
Storing & Protecting Client Information
3
Why is Client Intake Procedure So
Important?
4
Sets the tone for your relationship;
Having an established intake procedure avoids problems
that can otherwise arise. Problems such as:
Fee Disputes;
The Scope of Work;
Timeframe;
Who You’re Representing;
Conflict Issues;
What are you planning for?
4
Initial Consultation
5
In most cases, this is the first meeting between the
attorney and the client.
A good first impression is essential to building a lasting
relationship.
How much time does it take to make a first impression?
About 30 seconds.
A bad first impression can take hours to rectify, and the
attorney is rarely given the chance.
5
Initial Consultation
6
Let the client do the talking at first and adapt your style
to the client.
Watch your body language!
REMEMBER: “No one cares how much you know until
they know how much you care.”
Should you use a form client intake questionnaire?
6
Initial Consultation
7
What types of information should be gathered.
Family Information
Names, Relationships, Family Tree
Dates of Birth
U.S. Citizenship
Marital status
Contact Information
Other Professionals (e.g. accountants, investment advisors, etc.)
Financial Information
Real Estate
General “Non-Qualified” Assets (e.g. bank and brokerage accounts)
Retirement Accounts (e.g. IRA, 401(k), Pensions)
Life Insurance
7
Initial Consultation – Client Financials
8
Prepare a Spreadsheet:
Asset Spouse 1 Spouse 2 Joint
House (Equity) $650,000
Checking/ Sav $45,000 $17,500 $10,000
Brokerage $25,000 $385,000
IRA/401(k) $200,000 $400,000
Life Insurance $1,000,000 $250,000
Total $1,245,000 $692,500 $1,045,000
Total $2,982,500
8
Initial Consultation (cont.)
9
Significant Debts
Whether they are expecting an inheritance
Medical/ Health Information
Burial or cremation?
Religious Laws or doctrines?
Estate & Inheritance Taxes
Charitable inclinations
Review procedure and timeline
Review Probate Assets vs. Non-Probate Assets
Review the types of documents that you’re
recommending (e.g. wills, trusts, powers of attorney, etc.)
9
Engagement Letters
10
Best practice is to require a signed agreement for legal
services.
Essentials to include:
Identify the Client
Joint Representation?
Detail the Scope of Work
Consider specifically excluding any work not included
Fees & Expenses
Billing & Retainers
Termination
10
Scope of Work
11
Included: We understand that, initially, our engagement will be to
assist you in preparing a comprehensive estate plan for you. This will
include the preparation of new wills, powers of attorney, living wills, an
irrevocable life insurance trust, and various testamentary and/or lifetime
trusts deemed necessary from time to time. Our services will also include
estate tax planning, asset protection planning, and trust planning for your
family.
Excluded: It should be understood that we are not investment
advisers or insurance analysts. So, we will not undertake to review or
analyze your investment or business activities, the suitability or
diversification of your investments and other holdings, or the financial
standing, operating policies or solvency of the firms or institutions with or
through which you maintain accounts, insurance policies, contracts, or
assets.
11
Fees & Expenses
12
Hourly Rates or Flat Fees?
In addition to legal fees, you may be required to pay for
extraordinary expenses incurred in our representation. Such
expenses include messenger service, expedited or registered
mailing, photocopying and postage, recording fees, and any
other necessary expense. Any costs incurred by us not
previously advanced are your responsibility and you will be
advised of all such costs incurred. In addition, in the event we
are forced to initiate collection proceedings in any court,
administrative hearing, or otherwise, you agree to pay all costs
and attorneys’ fees, plus interest, incurred in any such
collection effort.
12
Retainer
13
It is our policy to require that our clients provide us with
an initial retainer and expense deposit which has been
established at $ for this matter. Fees and expenses
will be billed to you each month and we will anticipate
monthly payment of those amounts so that the retainer
can be maintained throughout the engagement. Any
balance at the end of the representation will be applied
against payment of the last invoice on the matter and any
remainder will be refunded to you.
13
Payment of Invoices & Interest
14
If you want the ability to charge interest on unpaid bills, you must indicate
that in the agreement.
Each invoice is payable upon receipt. Any unpaid balance not paid within
thirty (30) days of the billing date may incur interest upon such balance at
the rate of 1.5% per month. In the event we receive a payment from you at
a time when more than one invoice is outstanding on any one or more
matters, we will apply that payment to any such invoice(s), unless the
payment is accompanied by the remittance copy of the invoice(s) being paid
or by some other written indication from you directing how the payment is
to be applied. It is the policy of the Firm to discontinue representation in a
manner in accord with the Rules of Professional Responsibility for any
client whose account is more than forty-five (45) days in arrears, unless
special arrangements are made.
14
Termination
15
Every client has the right to terminate our representationat any time for any reason. We have the same right upongiving the client reasonable notice so that suitablearrangements can be made by the client to obtainalternative representation, in accordance with the Rulesof Professional Responsibility.
Following termination by us, we will continue to providerepresentation in the matter for a reasonable time, at theclient’s request, until arrangements can be made foralternate representation. However, our services willconsist of only those necessary to protect the client’sinterests and prevent prejudice.
15
No Guarantees
16
We will act on your behalf in a courteous, conscientious,
and diligent manner at all times to achieve solutions that
are reasonable and just for you. However, we do not
guarantee or predict what the final outcome of this
matter will be. Furthermore, we are not responsible or
liable for errors or omissions by any third party engaged
by you (e.g. other attorneys, CPAs, financial advisors,
appraisers, etc.) or for any taxes, interest, penalties or
expenses incurred as a result of such work.
16
Joint Representation
17
Two specific duties owed by a lawyer are implicated:
Duty to avoid conflicts under RPC 1.7
Duty to protect confidential information RPC 1.6
Best practice is to include language in the engagement
providing disclosure and seeking written consent.
Also, see the decision in A. v. B. v. Hill Wallack, 158 N.J.
151 (1999)
17
Joint Representation (cont.)
18
It is common for a husband and wife to employ the same attorney to assist them in planning
their estates. You have taken this approach by asking us to represent both of you with your
estate planning. It is important that you understand, because we will be representing you both,
that collectively you both are considered our client. Accordingly, any matter that one of you
might discuss with us may be disclosed to the other. Ethical considerations prohibit us from
making any changes to either of your estate plans without your mutual knowledge and
consent.
If a conflict should arise between you during the course of your planning or if the two of you
have a difference of opinion concerning the proposed plan for disposition of your property, or
on any other subject, we can point out the pros and cons of your respective positions or
differing opinions. However, ethical considerations prohibit us, as the attorney for both of you,
from advocating one of your positions over the other. Furthermore, we would not be able to
advocate one of your positions versus the other if there is a dispute at any time as to your
respective property rights or interests, or as to other legal issues between you.
If actual conflicts of interest do arise between you of such nature in our judgment it is
impossible for us to perform our ethical obligations to both of you, it would become
necessary for us to cease acting as your joint attorney.
18
Ethical Issues to be Considered
19
Estate planning is usually not adversarial.
The attorney provides advice, not advocacy.
New Jersey attorneys are subject to the New Jersey
Rules of Professional Conduct (“RPC”), and several are
noteworthy in this context.
19
RPC 1.1 Competence
20
A lawyer shall provide competent representation to a
client. Competent representation requires the legal
knowledge, skill, thoroughness and preparation reasonably
necessary for the representation.
In the Estate Planning context, this can mean:
Attending seminars & performing research
Understanding the forms you have clients execute
No such thing as “Form Language”
Taking on matters that you’re comfortable with, and involving
co-counsel, or simply referring matters that involve specialties
outside your practice area
20
RPC 1.2 Scope of Representation
21
Generally, a lawyer shall abide by a client's decisions
concerning the objectives of representation and shall
consult with the client as to the means by which they are
to be pursued.
A lawyer may limit the scope of the representation if the
limitation is reasonable under the circumstances and the
client gives informed consent.
Example: drafting a will without first reviewing the client’s
assets
21
RPC 1.5 Fees
22
A lawyer's fee shall be reasonable. The factors to be considered in determining the reasonableness of a fee include the following: the time and labor required, the novelty and difficulty of the
questions involved, and the skill requisite to perform the legal service properly;
the fee customarily charged in the locality for similar legal services;
the time limitations imposed by the client or by the circumstances;
the nature and length of the professional relationship with the client;
the experience, reputation, and ability of the lawyer or lawyers performing the services;
When the lawyer has not regularly represented the client, the basis or rate of the fee shall be communicated in writing to the client before or within a reasonable time after commencing the representation.
22
RPC 1.6 Confidentiality of Information
23
A lawyer shall not reveal information relating to
representation of a client unless the client consents after
consultation, except for disclosures that are impliedly
authorized in order to carry out the representation.
Cornerstone of this duty is exercising reasonable care in
protecting the client’s information.
Reasonable care, however, “does not mean that the
lawyer absolutely and strictly guarantees that the
information will be utterly invulnerable against all
unauthorized access.” —NJ Eth. Op. 701
23
RPC 1.6 Confidentiality Cont.
24
Estate planning attorneys routinely work with or are
brought in by accountants, financial planners, investment
advisors, insurance agents, etc.
The attorney must obtain the client’s consent before
information can be shared, even when you might
otherwise think that such consent is implied.
If significant accounting or tax work is needed, consider
drafting a Kovel Letter to bring the accountant within the
framework of attorney-client protection.
24
Electronic Storage
25
NJ Ethics Opinion 701:
“The touchstone in using “reasonable care” against unauthorized disclosure is that: (1) the lawyer has entrusted such documents to an outside provider under circumstances in which there is an enforceable obligation to preserve confidentiality and security, and (2) use is made of available technology to guard against reasonably foreseeable attempts to infiltrate the data. If the lawyer has come to the prudent professional judgment he has satisfied both these criteria, then “reasonable care” will have been exercised”.
Password protect whenever possible!
25
RPC 1.8: Conflict of Interest
26
A lawyer shall not solicit any substantial gift from a client,
including a testamentary gift, or prepare on behalf of a
client an instrument giving the lawyer or a person related
to the lawyer any substantial gift unless the lawyer or
other recipient of the gift is related to the client.
Related persons include a spouse, child, grandchild, parent,
grandparent, or other relative or individual with whom
the lawyer or the client maintains a close, familial
relationship.
26
RPC 1.8: Conflict of Interest (cont.)
27
A lawyer shall not accept compensation for representing
a client from one other than the client unless:
1. the client gives informed consent;
2. there is no interference with the lawyer's independence of
professional judgment or with the lawyer-client relationship;
and
3. information relating to representation of a client is protected
as required by RPC 1.6.
Best practice is to avoid this entirely and require that fees
be paid directly by the client.
27
RPC 1.9: Duties to Former Clients
28
A lawyer who has represented a client in a matter shall
not thereafter represent another client in the same or a
substantially related matter in which that client’s interests
are materially adverse to the interests of the former
client unless the former client gives informed consent
confirmed in writing.
Example: Attorney represents parents in the
preparation of an estate plan. This plan includes lifetime
trusts for children. After parents die, adult child seeks
engage attorney to terminate the trust and to have the
balance paid to him outright. What result?
28
RPC 1.14: Client Under a Disability
29
When a client's capacity to make adequately considered
decisions in connection with the representation is
diminished, whether because of minority, mental
impairment or for some other reason, the lawyer shall, as
far as reasonably possible, maintain a normal client-lawyer
relationship with the client.
29
RPC 1.14: Client Under a Disability
30
When the lawyer reasonably believes that the client has
diminished capacity, is at risk of substantial physical,
financial or other harm unless action is taken and cannot
adequately act in the client's own interest, the lawyer may
take reasonably necessary protective action, including
consulting with individuals or entities that have the ability
to take action to protect the client and, in appropriate
cases, seeking the appointment of a guardian ad litem,
conservator, or guardian?
30
RPC 1.18: Prospective Client
31
A lawyer who has had discussions in consultation with a
prospective client shall not use or reveal information
acquired in the consultation, even when no client-lawyer
relationship ensues, except as RPC 1.9 would permit in
respect of information of a former client.
A person who discusses with a lawyer the possibility of
forming a client-lawyer relationship with respect to a
matter is a prospective client, and if no client-lawyer
relationship is formed, is a former prospective client.
31
Who is the Client?
32
Manny and Patricia have been clients for several years. You
have prepared wills, trusts, and other basic estate planning
documents for them. One day you get a call from Patricia
telling you about her mother, who the day before suffered
a minor stroke and who is now resting at home. Patricia
wants to update her mother’s will and arrange for her to
be her mother’s attorney-in-fact with the power to make
lifetime gifts.
Can you prepare documents for Patricia’s mother?
What legal considerations are implicated?
32
Who is the Client?
33
What if Patricia’s mother had also been your client for
several years?
What if Patricia’s request constitutes a change from the
estate planning you have performed for her mother?
33
Issues about Capacity
34
One of the most common grounds to contest a will is to
challenge the testator’s capacity at the time of execution.
Under N.J.S.A. 3B:3-1, any person at least 18 years of age
who is of “sound mind” may make a will.
34
Issues about Capacity
35
Sound Mind can be understood as a very general
understanding of (a) the nature of the act of making a will,
(b) the distributions contained within the will and the
natural objects of the testator’s bounty, and (c) the
relationship of these factors. – see In re Blake’s Will, 37
N.J. Super. 70 (App. Div. 1955) rev’d on other grounds, 21
N.J. 50 (1956).
A very low capacity is needed. – see In re Landsman, 319
N.J. Super. 252 (App. Div. 1999)
35
Issues about Capacity (cont.)
36
The law presumes the testator had the requisite capacity
to execute a will. – see Haynes v. First Nat’l State Bank, 87
N.J. 163, 176 (1981).
The burden is on the contestant to prove, generally by
clear and convincing evidence, that the testator did not
have capacity.
Someone who has been declared mentally incapacitated
may still have the requisite capacity to make a will. – see
In re Frisch, 250 N.J. Super. 438 (Law Div. 1991).
36
Attorney as Fiduciary
37
An attorney may properly prepare a will naming himself
or herself as fiduciary, and may properly be paid for
services in both capacities.
See also N.J.S.A. 3B:18-6. “If the fiduciary is a duly licensed
attorney of this State and shall have performed
professional services in addition to his fiduciary duties,
the court shall, in addition to the commissions provided
by this chapter, allow him a just counsel fee.”
N.J. Eth. Op. 487 (Dec. 1981)
N.J. Eth. Op. 683 (Sept. 1996)
37
Terminating the Attorney-Client
Relationship
38
The engagement letter or agreement should address
terminations.
Client may be unresponsive;
Client may withhold payment for services rendered;
Client may engage in conduct that places the attorney at risk;
Attorney still has a duty of confidentiality. (See RPC 1.6)
Attorney still has a duty not to engage in representation
that would be adverse. (See RPC 1.9)
May be a good idea to obtain advance consent at the time of
the engagement.
38
Destroying Client Documents
39
A closed file may be destroyed after 7 years: “[s]imply
placing the files in the trash would not suffice.
Appropriate steps must be taken to ensure that
confidential and privileged information remains protected
and not available to third parties.” 163 N.J.L.J. 220, 221
(January 15, 2001) and 10 N.J.L. 154 (January 22, 2001)
39
40
Robert I. Aufseeser, J.D., LL.M.
Ansell Grimm & Aaron, P.C.
1500 Lawrence Avenue
Ocean Township, NJ 07712
732.643.5272
www.ansellgrimm.com
40
DRAFTING TECHNIQUES TO MINIMIZE CONFLICT
AND COURT ACTION UPON DEATH
Dana A. Bennett, Esq.
Adam M. Grenker, Esq.
41
126
LAST WILL AND TESTAMENT
I. PROBATE ASSETS VERSUS NON-PROBATE ASSETS - The overriding consideration in drafting a Will is which assets are governed by the Will. There are two categories of assets: (i) probate assets and (ii) non-probate assets.
Probate assets generally include those assets in a person’s individual name or held with someone else as tenants-in-common. They do not include assets with beneficiary designations (such as life insurance and Individual Retirement Accounts (“IRAs”)) unless the named beneficiary is the estate. Non-probate assets include jointly held assets and assets with a designated beneficiary (unless the beneficiary is the estate). These assets pass to the surviving joint owner or named beneficiary by operation of law. As a result, they do not pass in accordance with the Will. One of the biggest misconceptions among clients is that all of their assets will pass in accordance with their Will. They are unaware of the distinction between probate assets and non-probate assets. This misconception can lead to confusion and conflict upon death. Example: Mother has three children, A, B and C. Mother executes a Will leaving her assets equally to her three children. Mother dies and B and C discover that Mother maintained bank accounts with A as joint tenants with rights of survivorship. The bank accounts pass to A automatically by operation of law. The accounts do not pass in accordance with the Will. Since A receives the bank accounts, her total inheritance is more than B and C. Was this the Mother’s intent? DRAFTING POINT – An “equalization clause” can be included in the Will. The equalization clause directs the executor to take into account assets passing to a beneficiary outside of the Will in determining each beneficiary’s share of the residuary estate. With an equalization clause, the beneficiaries will receive an equal share of the total gross estate. II. SPECIFIC WILL PROVISIONS 1. Funeral Agent - New Jersey law allows a person to appoint someone in his Will to control his funeral and the disposition of his remains. N.J.S.A. 45:27-22(a). If there is no such provision in the Will, the statute determines who controls the funeral and disposition of the remains. The person designated by the statute may not be who the client wants. In addition, without a specific provision in the Will, family members may disagree about what the decedent would have wanted.
43
(a) N.J.S.A. 45:27-22(a) provides that if a decedent has not left a Will appointing a person to control the funeral and disposition of the remains, then the right shall be given in the following order:
(1) The surviving spouse of the decedent or the surviving civil
union or domestic partner; except that if the decedent had a temporary or permanent restraining order issued pursuant to P.L.1991, c. 261 (C.2C:25-17 et seq.) against the surviving spouse or civil union or domestic partner, or the surviving spouse or civil union or domestic partner is charged with the intentional killing of the decedent, the right to control the funeral and disposition of the remains shall be granted to the next available priority class as provided in this subsection.
(2) A majority of the surviving adult children of the decedent. (3) The surviving parent or parents of the decedent. (4) A majority of the brothers and sisters of the decedent.
(5) Other next of kin of the decedent according to the degree of consanguinity.
(6) If there are no known living relatives, a cemetery may rely
on the written authorization of any other person acting on behalf of the decedent.
(b) Old Bridge Funeral Home LLC v. Pruckowski, et al, No. A-0519-15T2, 2017 NJ Super. Unpub. LEXIS 397 February 21, 2017 – The main issue in this case was who had the right to make the decedent’s funeral arrangements. The decedent died in 2014 survived by her children and her brother. The decedent’s Will excluded her children as beneficiaries. Her brother was appointed as the executor of her estate. The Will did not have a provision appointing a funeral agent. However, the Will directed the executor to pay the funeral expenses. The decedent’s brother assumed he had the right to make the decedent’s funeral arrangements since he was the executor and the decedent’s children were not beneficiaries under the Will. The decedent’s children did not agree with the funeral home chosen by the brother and made alternative arrangements on their own with Old Bridge Funeral Home. The decedent’s children failed to pay the funeral home and litigation ensued. The court held that since the Will did not have a provision appointing a funeral agent, the statutory hierarchy under N.J.S.A. 45:27-22 applied. Accordingly, the decedent’s children, not the decedent’s brother/executor, had the right to make the funeral arrangements. However, since the estate was required to pay the funeral expenses, the arrangements made by the decedent’s children had to be reasonable.
44
(c) Proposed Legislation – Under current law, the appointment of a funeral agent can only be made in a Will. A separate writing is not allowed. A bill has recently been introduced to allow for a separate writing. Under S3116, if a decedent appoints a funeral agent in writing, in the presence of at least two witnesses, on a form approved by the New Jersey Cemetery Board, then the appointment will supersede any similar appointment made in the decedent’s Will. The form would have to be signed by the decedent and witnesses, and notarized. See Exhibit.
(d) SAMPLE WILL LANGUAGE:
“I appoint <> as my funeral and disposition representative pursuant to N.J.S.A. 45:27-22. My said representative shall have the authority and power to control the arrangements for my funeral and the disposition of my remains. My executors shall notify my representative of this appointment, and shall advise my representative of the financial means available to carry out the funeral and disposition arrangements. If <> shall fail to take office or cease to serve as my funeral and disposition representative, I appoint <> as my funeral and disposition representative in his place and stead.”
2. TANGIBLE PERSONAL PROPERTY – Tangible personal property is a person’s movable assets. It includes, but is not limited to, jewelry, furniture, clothing and automobiles. Tangible personal property does not include real estate, money or stock. Tangible personal property can be specifically listed in the Will. Alternatively, New Jersey law allows a person to leave a list with his Will disposing of certain items of his tangible personal property. N.J.S.A. 3B:3-11. Under the statute, the list may be handwritten or typed and signed by the decedent. The list does not need to be witnessed or notarized. DRAFTING POINT - Many clients choose to make a tangible personal property list rather than specifying all of their tangible personal property in their Will. That way, they can periodically update their list without having to incur the expense of changing their actual Will. 3. SPECIFIC BEQUESTS
(a) Cash – Some clients want to leave a beneficiary a certain percentage of their residuary estate. Other clients want to leave the beneficiary a certain dollar amount.
SAMPLE LANGUAGE #1 – “I give and bequeath the sum of
Ten Thousand Dollars ($10,000) to my child, A, if he shall survive me”. SAMPLE LANGUAGE #2 – “I give and bequeath to my child, A,
45
if he shall survive me, an amount equal to Ten Percent (10%) of my gross estate as finally determined for federal estate tax purposes in the settlement of my estate”.
DRAFTING POINT – From the executor’s standpoint, the dollar
amount is simpler. The executor merely sends a check to the beneficiary representing the dollar amount. The percentage bequest is more complicated because of the work involved in determining the amount of the decedent’s gross estate (and, hence, the beneficiary’s bequest). Moreover, the executor’s determination of the value of the decedent’s gross estate could be challenged by another beneficiary or one of the taxing authorities, particularly if the gross estate includes hard to value assets such as closely held business interests.
The disparity is even greater if the beneficiary is a charity. If the
Will includes a charitable beneficiary, New Jersey Court Rule 4:80-6 requires that a copy of the Notice of Probate be sent to the New Jersey Attorney General. The Attorney General’s role is to protect the public interest by ensuring that the charitable beneficiary receives what it is entitled to under the Will. If the Will leaves the charity a specific dollar amount, then the executor need only send the Attorney General a copy of the charity’s signed Refunding Bond and Release as proof that the charity received its bequest. If the Will leaves the charity a percentage of the estate, the Attorney General’s Office will require the executor to furnish an accounting explaining how the charity’s bequest was determined. It takes some time for the Attorney General’s Office to approve the executor’s accounting. Accordingly, if the client wishes to make a small charitable bequest, strong consideration should be given to a dollar amount instead of a percentage of the estate.
(b) Real Estate – Most Wills have a general provision directing
the executor to pay all of the decedent’s debts before making distributions to the beneficiaries. However, under N.J.S.A. 3B:25-1, mortgages are excluded from those general references to debts. Unless the Will provides otherwise, the beneficiary of the specific bequest takes the real estate subject to the mortgage.
DRAFTING POINT – The Will should be clear on its face as to
whether or not the beneficiary of the real estate is responsible for the mortgage on the property. This avoids a dispute about the decedent’s actual intent and clarifies the bequest for the beneficiary.
SAMPLE LANGUAGE – “I give and devise my interest in the real
estate and appurtenances thereto located at <>, subject to any mortgages thereon, and all policies and proceeds of insurance covering such real estate to A, if he shall survive me”.
4. RESIDUARY ESTATE – The “residuary estate” is all of the rest,
46
residue and remainder of the decedent’s estate. Once the beneficiaries of the residuary estate have been identified, the client must decide whether the bequest to the beneficiary should be made outright or held in trust. Common scenarios:
(a) Minor children – In the absence of trust language, the
bequest to the minor will typically be held in a custodial account for the minor’s benefit under the Uniform Transfers to Minors Act (UTMA). Query- Who will be the custodian?
DRAFTING POINT – Depending on the particular state law, the
child will receive the money between the ages of 18 and 21 under UTMA. Unless the bequest to the child is nominal, consideration should be given to holding the inheritance in trust until the child reaches a more mature age.
(b) Adult children with financial problems - There is no
creditor protection in New Jersey for outright bequests to a beneficiary. Therefore, if the client is aware that the beneficiary has financial problems, then a spendthrift trust should be considered for the beneficiary. Without a spendthrift trust, the beneficiary’s inheritance could be levied on by creditors.
(c) Children with special needs – Special care should be taken
to make sure the child’s inheritance does not result in the loss of means tested government assistance he may be receiving on account of his disability. This often involves the creation of a special needs trust.
(d) Second marriages – A detailed discussion should be had
with the client about the available options. A lot of the probate litigation arises from disputes between the decedent’s second spouse and the children from his prior marriage. Marital trusts for the second spouse should be considered rather than outright bequests. The relationship between the surviving spouse and the decedent’s children often changes after the decedent’s death. This might cause the second spouse to change his/her Will after the decedent’s death to exclude the decedent’s children. 5. FIDUCIARIES – The fiduciaries under the Will are the executor, trustee and guardian of minor children. DRAFTING POINT - For minor children, there is a guardian of the person and a guardian of the property. Be sure the Will addresses both. It can be two different people. Often, the guardian of the property is the same individual as the trustee of the minor’s trust. 6. ESTATE/INHERITANCE TAX CLAUSE – It is critical that the attorney address the potential estate and inheritance tax due upon client’s death.
47
(a) Identify the type of tax – Federal Estate Tax, New Jersey Estate Tax and New Jersey Inheritance Tax. The federal and New Jersey estate tax are based on the size of the estate. Each taxpayer is allowed an exemption from the estate tax. For 2017, the federal estate tax exemption is $5,490,000 and the New Jersey estate tax exemption is $2,000,000. The New Jersey estate tax is scheduled to be repealed in 2018. The New Jersey inheritance tax is based on the legal relationship between the decedent and the beneficiaries. Beneficiaries are grouped into classes and a different inheritance tax rate is applied to each class. There is no inheritance tax on bequests to Class “A” beneficiaries. Class “A” beneficiaries are spouses, children, grandchildren and step-children. Class “C” beneficiaries are siblings, sons-in-law and daughters-in-law. There is a $25,000 exemption for Class “C” beneficiaries and the balance is taxed starting at the rate of 11%. All other individuals are Class “D” beneficiaries. Class “D” beneficiaries are taxed starting at the rate of 15%. (b) Determine how the estate/inheritance tax will be paid – There are generally two types of tax clauses: (i) apportionment tax clause and (ii) residuary tax clause. Under the apportionment tax clause, estate/inheritance taxes are apportioned among the persons receiving property under the Will and outside of the Will. This results in each beneficiary being responsible for the payment of estate/inheritance taxes attributable to his/her share of the estate. Under the residuary tax clause, all estate/inheritance taxes are paid out of the residuary estate before distribution of the assets to the residuary beneficiaries. Which is the correct approach? EXAMPLE #1 – Client’s Will leaves $10,000 to niece and the balance ($500,000) to her children. The inheritance tax on the $10,000 bequest to the niece is $1,500. There is no inheritance tax on the bequest to the children. If the Will uses a straight apportionment tax clause, then niece will be responsible for paying the inheritance tax. Niece will net $8,500 after the inheritance tax is paid. If the Will contains a residuary tax clause, niece will net $10,000. The $1,500 inheritance tax will be paid out of the residuary estate which will reduce the amount the children receive. EXAMPLE #2 - Client has a $1,000,000 IRA naming Child A as the primary beneficiary. Client’s remaining assets are a home and a bank account. Client’s Will leaves her probate assets to Child B since Child A is receiving the IRA. If the Will contains a residuary tax clause, then the estate/inheritance tax due on the IRA will be paid from the assets earmarked for Child B and Child A will pay no estate/inheritance tax. Is this Client’s intent?
48
III. LANGUAGE ISSUES – The language in the Will should be clear, consistent and unambiguous otherwise conflict and unintended results may arise. EXAMPLE #1: Client has two children, A and B, and two step-children, C and D. Compare: WILL #1 Article Second: I give and bequeath all of my tangible personal property equally to my children, A, B, C and D. Article Third: I give, devise and bequeath all the rest, residue and remainder of my estate equally to my children. WILL #2 Article Second: I give and bequeath all of my tangible personal property equally to my children, A and B, and my step-children, C and D. Article Third: I give, devise and bequeath all the rest, residue and remainder of my estate equally to my children and step-children. EXAMPLE #2: Client wishes to leave the inheritance for her son, A, in trust with the principal to be distributed to A in equal thirds at ages 25, 30 and 35. Compare: WILL #1 Trustee shall distribute to A one-third of the trust fund at age 25, one-third at age 30 and one-third at age 35. WILL #2 Trustee shall distribute to A one-third of the trust fund at age 25, one-half the balance at age 30 and the remaining balance at age 35. EXAMPLE #3 (New Jersey Anti-Lapse Statute (N.J.S.A. 3B:3-35)): Client has two children, A and B, who are both living at the time Client executes her Will. A subsequently dies leaving three children surviving. Client does not update her Will after A’s death. Compare: WILL #1 I give and bequeath the sum of One Hundred Thousand Dollars ($100,000) to my son, A.
49
WILL #2 I give and bequeath the sum of One Hundred Thousand Dollars ($100,000) to my son, A, if he shall survive me. WILL #3 I give and bequeath the sum of One Hundred Thousand Dollars ($100,000) to my son, A, if he shall survive me, and if not, to his descendants, per stirpes.
50
POWER OF ATTORNEY
I. Overview. A general power of attorney should be prepared on the client’s behalf. Used by the client’s designated agent or agents in case the client is unavailable or unable to act; may avoid the need for guardianship proceedings.
Requires a written instrument. The power of the named “attorney-in-fact” is
revoked upon the death of the principal or express revocation by the principal, though an attorney-in-fact or third party may generally act in good faith pursuant to a power of attorney until he or she receives actual notice of the death or revocation. N.J.S.A. 46:2B-8.5, 8.6.
A “durable” power of attorney states that the authority conferred shall be
exercisable notwithstanding the principal's subsequent disability or incapacity, and unless it states a time of termination, notwithstanding the lapse of time since the execution of the instrument.
A “springing” power of attorney initially comes into effect only in the event of the disability of the principal. An attorney-in-fact has a fiduciary responsibility to the principal (or to the guardian of the principal, if a guardianship proceeding has occurred) and must maintain books and records for all transactions undertaken on behalf of the principal. The principal, principal’s guardian (if any) and personal representative of the guardian’s estate (if deceased) all have the right to an accounting from the attorney in fact; an heir of the principal has the ability to petition a court for an accounting from the attorney-in-fact. N.J.S.A. 46:2B-8.13. II. SPECIFIC PROVISIONS 1. Banking Powers- If the power of attorney is used for banking purposes, it should make specific reference to N.J.S.A. 46:2B-11 et. seq., which authorizes the use of powers of attorney for banking purposes.
SAMPLE LANGUAGE – “To conduct banking transactions as set forth in Section 2 of P.L. 1991, c. 95 (C.46:2B-11) which transactions shall include all those transactions enumerated in said Section and shall include, but shall not be limited to, the power to make, receive and endorse checks and drafts, deposit and withdraw funds, open new bank accounts, acquire and redeem certificates of deposit, in banks, savings and loan associations and other institutions, execute or release such deeds of trust or other security agreements as may be necessary or proper in the exercise of the rights and powers herein granted.”
2. Gifting Powers – If the principal intends for the attorney-in-fact to
have the ability to make gifts of the principal’s assets, then such power (and any
51
limitations upon such powers, such as permissible donees of the gifts) must specifically be included in the document. N.J.S.A. 46:2B-8.13a.
SAMPLE LANGUAGE – “My Agent may make outright gifts of
cash, securities, real estate, business interests or other assets, or direct or indirect interests therein, to adults or to minors under an applicable state Transfers to Minor’s Act in custodial form to persons under the age of twenty-one (21) years or to trusts created for such persons. Permissible donees hereunder shall include my spouse, my descendants, or any trusts created for any of them, notwithstanding the fact that any such persons are named as Agent herein.”
DRAFTING POINT – Consider the gift/estate tax consequences of
permitting gifts in excess of the principal’s annual exclusion.
3. Specific vs. General Power of Attorney – If the principal intends to grant general/broad powers to the attorney-in-fact, for use throughout the principal’s lifetime (as opposed to with respect to one transaction, such as a real estate closing), then this intent should be made clear.
SAMPLE LANGUAGE – “This instrument is to be construed and
interpreted as a general durable power of attorney. The enumeration of specific powers herein is not intended to, nor does it, limit or restrict the general powers herein granted to my Agent.”
4. HIPAA Authorization – If the principal intends to permit the
attorney-in-fact to receive medical information regarding the principal, then such authorization should be included within the power of attorney.
SAMPLE LANGUAGE – “In accordance with Regulation Section
164.501(g) of Title 45 of the Code of Federal Regulations and the medical information privacy law and regulations, generally referred to as the Health Insurance Portability and Accountability Act or “HIPAA”, I authorize and request any physician, health care professional, health care provider, and medical care facility to provide information relating to my physical and mental condition and the diagnosis, prognosis, care, and treatment thereof to my Agent upon the request of the Agent I have designated in this document. It is my intent by this authorization for my designated Agent to be considered a personal representative under privacy regulations related to protected health information and for my designated Agent to be entitled to all health information in the same manner as if I personally were making the request. This authorization and request shall also be considered a consent to the release of such information under current laws, rules and regulations as well as under future laws, rules, and regulations and amendments to such laws, rules and regulation to include but not be limited
52
to the express grant of authority to personal representatives as provided by HIPAA.”
5. Multiple Agents – A principal may name multiple attorneys-in-
fact. However, if the power of attorney does not expressly provide whether the attorneys-in-fact are to act severally or separately, or are to act jointly, such attorneys-in-fact must act jointly. N.J.S.A. 46:2B-8.7(d). As such, the principal should indicate his/her preference within the document.
53
TRUSTS I. SPECIFIC PROVISIONS
1. Powers of Withdrawal (“Crummey” Powers) - If the grantor intends to apply his/her annual exclusion (currently $14,000 per donee) to gifts made to a trust, then the trust instrument should contain “Crummey” withdrawal provisions that qualify the powerholders’ interests in the trust as “present interests”.
SAMPLE LANGUAGE -- 2. S Corporation Savings Clause – A grantor trust is a permissible
shareholder of a subchapter S corporation. However, a nongrantor trust is not a permissible S corporation shareholder unless the trust qualifies as either (i) a qualified subchapter S trust (QSST) or (ii) an electing small business trust (ESBT). Therefore, if it is anticipated that the trust corpus may include stock in an S corporation, then in order to prevent the corporation from losing its “S” status, the trust instrument should contain QSST and/or ESBT qualifying language.
SAMPLE LANGUAGE – “In the event any trust created under this
Agreement shall be or shall become the owner of any shares of any corporation (“S” corporation) which has elected, or which intends to elect (and has notified the Trustee hereunder in writing of such intent at least thirty (30) days prior to the time such election is to be filed) under Code Section 1362 to be an S corporation (the “S Election”), and such trust shall not be a grantor trust for any reason within the meaning of Code Section 671 et. seq., then, in any such event, notwithstanding any other provision of this Trust Agreement:
(A) Each Trustee is hereby authorized, but shall not be required, to segregate such shares of stock into as many equal, separate, and independent trusts as there shall be beneficiaries of such trust, and to take any and all action required to qualify each such separate trust as an S corporation shareholder under Code Section 1361(c)(2) and each such trust shall have only one income beneficiary (all of which separate and independent trusts may be hereinafter referred to in the aggregate as the "QSST") effective as of the date required to qualify as a shareholder under Code Section 1362(b), and such trust shall remain subject to all of the administrative and dispositive provisions of this Agreement otherwise applicable to the non-QSST Trusts, and shall have the same beneficiary as the non-QSST Trusts, except that, with respect to the QSST, the following provisions shall supplant and supersede any contrary provisions contained in this entire Agreement, in accordance with the requirements of Code Section 1361(d)(3):
54
(1) During the lifetime of the income beneficiary of the QSST, all of the income of the QSST (within the meaning of Code Section 643(b)) shall be distributed to such income beneficiary (who must be an individual U.S. citizen or resident) at least annually; (2) Any principal distributed from the QSST during the lifetime of the income beneficiary shall be distributed only to such income beneficiary; (3) The income interest of the income beneficiary in the QSST shall terminate upon the earlier of the death of the income beneficiary or the termination of the QSST; (4) Upon the termination of the QSST during the lifetime of the income beneficiary, the QSST assets shall be distributed only to such income beneficiary; and (5) Effective upon the termination of the S Election of the corporation, as to the shares of stock which were subject to this Subparagraph (A), the QSST segregation and the application of the provisions of this Subparagraph (A) shall terminate. (B) Alternatively, the Trustee is authorized to elect under Code Section 1362(c)(2)(v) to treat such trust as an electing small business trust (“ESBT”) effective as of the date required to qualify as a shareholder under Code Section 1362(b), and such trust shall remain subject to all of the administrative and dispositive provisions of this Agreement otherwise applicable to the non-ESBT Trusts, and shall have the same beneficiary as the non-ESBT Trusts.” 3. Spendthrift Provisions – In order to most effectively protect the
beneficiaries’ interests in a trust from creditors, the grantor may consider adding “spendthrift” language prohibiting the transfer (voluntary or involuntary) of a beneficiary’s interest in the trust. The benefit of this protection should be weighed against the potential benefit of estate planning transactions involving a beneficiary’s interest in a trust (for example, the sale of a remainder interest).
SAMPLE LANGUAGE -- Neither the income nor the principal of
any trust created hereunder shall be liable for the debts, undertakings, or engagements of the beneficiaries thereof, nor shall the same be assigned, pledged, alienated or anticipated; any endeavor by a beneficiary to circumvent this direction in any manner shall be wholly disregarded by the Trustee and shall be null and void.
55
GRAT PLANNING
I. GRATs
A. A Grantor Retained Annuity Trust (“GRAT”), sanctioned by Section 2702, enables a grantor to pass the future appreciation of investments, a business or real estate to his heirs while (i) continuing to enjoy the cash flow from the transferred assets and (ii) incurring minimal estate or gift tax consequences.
B. In order to qualify as a GRAT, a trust must provide for a “qualified annuity interest” to be retained by the grantor. See Treas. Reg. Section 25.2702-3(b) (and discussion below) for the requirements for a qualified annuity and the trust creating it.
C. By postponing the time at which the GRAT corpus passes to the donees, and retaining a qualified interest, the value of the remainder (gift to heirs) is reduced.
1. Example of Taxable Gift GRAT: Grantor transfers investments worth $10,000,000 to a GRAT, reserving an annual annuity of 8% or $800,000 for 10 years, after which the GRAT corpus passes to the Grantor’s children. Assuming a Section 7520 rate of 1.4%, the retained interest (value of annuity stream over 10 years) has a present value of $7,416,960, so the gifted remainder interest has a value of $2,583,040 and uses a portion of the Grantor’s gift exemption. If the investments generate a return higher than 8%, then the remainder interest is undervalued and the remaindermen will acquire property that escapes tax; conversely if the return is less than the annuity percentage, the remaindermen will acquire less property. For example, if the above investments have a return of 5%, the remaindermen would receive $6,226,632 after 10 years, at no additional gift tax cost.
2. If the present value of the retained annuity interest is equal to the value of the property placed in the GRAT, then the taxable remainder gift is zero. The annuity can be calculated to produce a zero gift, which is sometimes referred to as a “zeroed-out GRAT”.
3. Example of Zeroed-Out GRAT: Grantor transfers investments worth $10,000,000 to a GRAT, reserving an annual annuity of 10.7861% or $1,078,610 for 10 years, after which the GRAT corpus passes to the Grantor’s children. Assuming a Section 7520 rate of 1.4%, the retained interest (value of annuity stream over 10 years) has a present value of $10,000,000, so the gifted remainder interest has a value of $0, using none of the Grantor’s gift exemption. If the investments generate a return higher than 10.7861%, then the remainder interest
56
is undervalued and the remaindermen will acquire additional property without tax; conversely if the return is less than the annuity percentage, the remaindermen will acquire less property. For example, if the above investments have a return of 5%, the remaindermen would receive $2,722,305 after 10 years, with no use of the Grantor’s gift exemption.
4. In Walton, 115 T.C. 589 (2000), the Tax Court held that if the grantor’s estate is designated as the alternate payee of the retained annuity interest should the grantor die during the term, then the remainder gift amount can be zero. Essentially, the grantor and his estate are treated as one unit (the grantor cannot make a gift to himself or to his estate). As such, the possibility of death occurring within the trust term does not reduce the value of the retained annuity interest (as an example in the Regulations had held). Although the IRS initially opposed zeroed-out GRATs, the IRS has agreed to follow the Walton decision [Notice 2003-72, 2003-2 CB 964], so that zeroed-out GRATs are now acceptable. Note that if a GRAT is to be zeroed out, the GRAT corpus cannot immediately pass to the grantor’s estate on death. The remaining annuity payments must first pass to the estate of the grantor for the remaining specified term of the GRAT.
5. Example of Zeroed-Out Short-Term GRAT: Grantor transfers investments worth $10,000,000 to a GRAT, reserving an annual annuity of 51.05167% or $5,105,167 for 2 years, after which the GRAT corpus passes to the Grantor’s children. Assuming a Section 7520 rate of 1.4%, the retained interest (value of annuity stream over 2 years) has a present value of $10,000,000, so the gifted remainder interest has a value of $0. If the above investments have a return of 5%, the remaindermen would receive $559,407 after 2 years, with no use of the Grantor’s gift exemption.
6. Example of Zeroed-Out Short-Term Leveraged GRAT: Grantor transfers investments worth $10,000,000 to a family limited partnership, and transfers the limited partner interest to a GRAT. Assume the LP interest is valued by an appraiser at a 35% discount, resulting in a tax value of $6,500,000. The Grantor reserves an annual annuity of 51.05167% of the (discounted) tax value, or $3,318,358 for 2 years, after which the GRAT corpus passes to the Grantor’s children. Assuming a Section 7520 rate of 1.4%, the retained interest (value of annuity stream over 2 years) has a present value of $6,500,000, so the gifted remainder interest has a value of $0. If the above investments have a return of 5%, the remaindermen would receive $4,222,364 after 2 years, with no use of the Grantor’s gift exemption.
57
7. Note that the risk of the IRS challenging the valuation of the LP interest and causing gift tax is none, since a GRAT, by its terms, must have a self-adjusting provision, whereby if the value of the GRAT property is changed, the annuity payments must increase (or decrease) accordingly. See governing instrument requirements below.
D. If the grantor does not survive the GRAT term, then some or all the GRAT assets will generally be includible in the grantor’s taxable estate:
1. The current IRS view: Under Section 2036, only that portion of the GRAT necessary to produce the specified annuity amount if the GRAT corpus were invested at the required discount rate is includible. Reg. § 20.2036-1(c)(2). Similarly, Rev. Rul. 82-105 (CLATs) and Rev. Rul. 76-273 (CRUTs) limit the amount included to a capitalization of the annuity at the then-current §7520 rate. However, the inclusion amount cannot exceed the value of the GRAT at the time of death.
2. Long-Term GRAT
(a) Due to the above-referenced method of estate inclusion when the grantor dies during the GRAT term, the opportunity exists for significant estate tax savings from a GRAT having a term that is clearly longer than the grantor’s actuarial life expectancy. The primary benefits of a long term GRAT in a low interest rate environment are the following:
(i) The appreciation of the GRAT assets in excess of the Section 7520 rate (currently 1.4%) is not included in the grantor’s gross estate; and
(ii) The grantor will realize a further benefit if the Section 7520 rate is higher at date of death than date of funding because a higher rate at death will result in a lower amount of principal necessary to produce the decedent's retained annuity.
(b) Example of Zeroed-Out 99 Year GRAT. Grantor transfers investments worth $10,000,000 to a GRAT, reserving an annual annuity of 1.87288% or $187,288 for 99 years, after which the GRAT corpus passes to the Grantor’s descendants. Assuming a Section 7520 rate of 1.4%, the retained interest (value of annuity stream over 99 years) has a present value of $10,000,000, so the gifted remainder interest has a value of $0. Assume the GRAT corpus appreciates at a rate of 5% annually.
58
(i) Grantor dies during year 10 of the GRAT term when the value of the GRAT is $13,933,258.
(ii) If the Section 7520 upon death is still 1.4%, then the lesser of $13,377,714 (the amount of corpus necessary to produce the $187,288 annuity amount) or the remaining assets in the GRAT ($13,933,258) is includible in the Grantor’s estate, while ($13,933,258 - $13,377,714) = $555,544 is excluded from Grantor’s taxable estate.
(iii) If the Section 7520 rate stays at 1.4% but the GRAT corpus appreciates at a rate of 6% annually, so the value of the GRAT in 10 years is $15,439,872, then lesser of $13,377,714 (the amount of corpus necessary to produce the $187,288 annuity amount) or the remaining assets in the GRAT ($15,439,872) is includible in the Grantor’s estate, while ($15,439,872 - $13,377,714) = $2,062,158 is excluded from Grantor’s taxable estate.
(iv) If in the alternative, the GRAT assets appreciate at 5% and the Section 7520 rate increases to 4%, then only $4,682,200 of corpus is necessary to produce the $187,288 annuity amount and is therefore includible in Grantor’s taxable estate, while ($13,933,258 - $4,682,200) = $9,251,058 is excluded from Grantor’s taxable estate.
(v) Note that in any event, the GRAT is still committed to pay the Grantor’s estate an annuity of $187,288 for 89 more years. To eliminate the administrative burden, the remainder beneficiaries may choose to purchase the grantor’s annuity interest for its actuarial value, or the grantor’s estate may choose to purchase the remainder interest for its actuarial value.
(a) The Trustee should not be involved in such a purchase or sale, as the GRAT regulations state that “[t]he governing instrument must prohibit commutation (prepayment) of the interest of the holder.” Treas. Reg. § 25.2702-3(d)(5). References to “holder” also include the estate of that person. Treas. Reg. 25.2702-2(a)(5).
59
3. Example of Zeroed-Out 99 Year Leveraged GRAT:
(a) Grantor transfers investments worth $10,000,000 to a family limited partnership, and transfers the limited partner interest to a GRAT. Assume the LP interest is valued by an appraiser at a 35% discount, resulting in a tax value of $6,500,000. The Grantor reserves a 99 year annual annuity of 1.87288% of the (discounted) tax value, or $121,737, after which the GRAT corpus passes to the Grantor’s descendants. Assuming a Section 7520 rate of 1.4%, the retained interest (value of annuity stream over 99 years) has a present value of $6,500,000, so the gifted remainder interest has a value of $0. Assume the GRAT corpus appreciates at a rate of 5% annually.
(i) Grantor dies during year 10 of the GRAT term when the value of the GRAT is $14,757,748.
(ii) If the Section 7520 upon death is still 1.4%, then the lesser of $8,695,500 (the amount of corpus necessary to produce the $121,737 annuity amount) or the remaining assets in the GRAT ($14,757,748) is includible in the Grantor’s estate, while ($14,757,748 - $8,695,500) = $6,062,248 is excluded from Grantor’s taxable estate.
(iii) If the Section 7520 rate stays at 1.4% but the GRAT corpus appreciates at a rate of 6% annually, so the value of the GRAT in 10 years is $15,439,872, then lesser of $8,695,500 (the amount of corpus necessary to produce the $121,737 annuity amount) or the remaining assets in the GRAT ($16,303,884) is includible in the Grantor’s estate, while ($16,303,884 - $8,685,500) = $7,681,384 is excluded from Grantor’s taxable estate.
(iv) If in the alternative, the GRAT assets appreciate at 5% and the Section 7520 rate increases to 4%, then only $3,043,025 of corpus is necessary to produce the $121,737 annuity amount and is therefore includible in Grantor’s taxable estate, while ($14,757,748 - $3,043,025) = $11,714,723 is excluded from Grantor’s taxable estate.
E. If the grantor dies during the GRAT term and leaves a surviving spouse, the goal is generally to defer any estate tax by utilizing the marital deduction
60
against estate tax. In such a case, planning becomes more intricate. The remainder interest in the GRAT should then pass to the surviving spouse, and not to the remaindermen otherwise designated in the GRAT instrument.
1. Generally, for an interest to qualify for the marital deduction:
(a) The decedent must be survived by a U.S. citizen spouse;
(b) The interest must be includible in the decedent’s U.S. gross estate and pass to the surviving spouse;
(c) If the interest terminates or fails on the lapse of time or (non)occurrence of an event or contingency, and the interest passes to a third party, then it is a terminable interest. See generally Treas. Reg. Section 20.2056(b)-1; and
(d) Subject to a few exceptions, such as the “QTIP” trust rules mentioned below, the interest may not be a nondeductible terminable interest.
2. In order for a trust to qualify for the marital deduction under Section 2056(b)(7) as a “QTIP” trust:
(a) The property must pass from the decedent;
(b) The surviving spouse must be entitled to a Section 2056(b)(5) income interest for life;
(c) No other beneficiary may have any rights in the trust during the surviving spouse’s lifetime; and
(d) An irrevocable QTIP election must be made.
F. If a married grantor is willing to have the remaining GRAT annuity payments and GRAT remainder interest pass outright to the grantor’s spouse, then to qualify the GRAT assets for the marital deduction:
1. GRAT Drafting: The remaining annuity payments can be directed to pass to the grantor’s estate. The remainder interest in the GRAT can be directed to pass to the surviving spouse (if the grantor does not survive the trust term). Disposition of remainder interest to spouse should not be conditioned on spouse surviving the trust term. Therefore, remainder interest should pass to surviving spouse or to the estate of the surviving spouse should she survive the GRAT, but die before the trust terminates.
2. Will (or Codicil) Drafting: The remaining annuity payments paid to the estate can be directed to pass to the surviving spouse, if the spouse
61
survives the grantor. Payment of each annuity payment should not be conditioned on spouse’s survival. Therefore, if the spouse survives the grantor but dies before the annuity payments would otherwise cease, the remaining annuity payments must pass to the surviving spouse’s estate.
G. If all payments (annuity and remainder interest) are directed to pass to surviving spouse, there will be no nondeductible terminable interest under 2056(b)(1) and the marital deduction should be available.
H. If, instead of outright distributions to the grantor’s spouse, a QTIP trust is desired, then the annuity payments, plus the income generated from the GRAT (less income allocated to the annuity payments) can be directed to be paid to a QTIP trust for the benefit of the surviving spouse for the remainder of the annuity period, for the duration of the spouse’s lifetime. Specifically:
1. All remaining annuity payments should be directed to be paid to the grantor’s estate, as they become due.
2. The GRAT should provide that any income earned on the GRAT property for the duration of the balance of the fixed term is payable to the grantor’s estate, at least annually (less amount of income attributable to annuity payments.)
3. Donor’s Will (or Codicil) should then allocate all payments (annuity and any excess income over the annuity) to a QTIP Trust for the benefit of the surviving spouse.
(a) In the alternative, Donor’s Will (or Codicil) may provide that the payments coming into the Estate from the GRAT be split. The portion thereof representing income of the GRAT may pass outright to the surviving spouse, while any remaining amount may pass to the QTIP Trust.1
4. When the GRAT term ends, the GRAT may provide that the remaining GRAT property will be paid to the QTIP Trust.
5. Consider making the QTIP election both for the QTIP Trust and the GRAT. (See Rev. Rul. 2000-2, 2000-1 CB 305 for analogous IRA QTIP requirements.)
1 See Michael L. Graham and Jonathan G. Blattmachr, Six Steps to a Marital Deduction for a Walton GRAT
or How I Learned to Love the Bomb (Sept. 2005).
62
6. Consider adding a provision in the GRAT that empowers the donor’s spouse to require the GRAT Trustee to make unproductive GRAT property productive of income.
While the GRAT regulations allow the payment of a GRAT annuity to be deferred for up to 105 days after the payment’s due date, the QTIP marital deduction rules provide that trust income must be distributed to the surviving spouse at least annually. The QTIP rule must take priority over the GRAT rule in order to ensure that the GRAT is eligible for the marital deduction.2 II. GRAT Governing Instrument Requirements (in Treasury Regulations)
A. Annuity amount paid to Grantor must be fixed and irrevocable. § 25.2702-3(b)(1)(i)
B. The annuity payable for any one year can be up to 120% of the annuity payable for the preceding year. If designed in this manner, the increased annuity will favorably impact the value of the retained interest and reduce the amount of the gift. § 25.2702-3(b)(1)(ii)
C. The annuity must be payable at least annually.
1. Payment dates can be either on the anniversary date of the creation of the GRAT or the taxable year of the GRAT. § 25.2702-3(b)(3).
2. If payment date is the anniversary date, the annuity can actually be paid up to 105 days after the anniversary date. § 25.2702-3(b)(4)
3. If payment date is the taxable year of the GRAT, then payment must be made on or before due date of the return for the GRAT (without regard to extension) Id.
D. If the annuity is stated as a fraction or percentage of initial fair market value, the GRAT must provide for self-adjustments for incorrect valuations. § 25.2702-3(b)(2) and 1.6642(a)(1)(iii)
E. GRAT must prohibit additional contributions to the trust. § 25.2702-3(b)(5)
F. GRAT must prohibit distributions other than to the Grantor during the trust term. § 25.2702-3(d)(3)
G. GRAT must prohibit commutation of donor’s interest. § 25.2702-3(d)(5)
H. GRAT must fix the term of the annuity interest to:
2 Id.
63
1. Life of the term holder,
2. Specified term of years, or
3. Shorter of life or specified term. § 25.2702-3(d)(4)
I. GRAT must prohibit use of promissory note, other debt instrument, option or similar financial arrangement to satisfy Trustee’s obligation to Grantor. § 25.2702-3(d)(6)(i).
III. GRATs will produce tax savings.
A. When §7520 rate is low (as currently is the case), if the net return of the GRAT assets (appreciation and income) exceeds the §7520 rate, the tax benefit can be enhanced.
B. If the GRAT is a limited partner in a Limited Partnership or minority shareholder in an S Corporation, and the minority/marketability discounts are factored in, the tax benefit can be further enhanced.
C. Planning significance of a GRAT.
1. Short-term GRATs reduce mortality risk and potential defeat of strategy.
2. Also, short-term GRATs can capture increases in assets, without offsetting decreases in assets, which would possibly occur during longer term.
3. Marital deduction planning is important in the current tax environment since deferral of the tax is an appropriate objective.
64
SALES TO GRANTOR TRUSTS – KARMAZIN CASE
Overview
A sale to a Grantor Trust is a flexible and often very favorable estate planning technique. This is implemented by the client (Grantor) establishing an irrevocable trust that qualifies as a “grantor trust” for income tax purposes, under IRC Sections 671-679. Under Revenue Ruling 85-13, any transactions between a Grantor and his trust are disregarded. Therefore, the sale of appreciated assets by the Grantor to his trust does not trigger taxable gains. The Grantor is taxable on any income earned by the trust assets, but is not taxable on any interest payments from the trust to the Grantor. The sale is generally for an installment promissory note (either regular or self-cancelling) and the trust makes periodic payments of interest and/or principal to the Grantor, based upon the value of the property sold at the time of the sale. Thus, if there are valuation discounts available for the property, the note obligation is in the discounted amount. Also, if the property appreciates during the course of the installment payments, the payments are fixed based on the original value. The trust should be funded by the Grantor with some assets prior to the sale, so that the obligation of the purchasing trust is valid debt, not equity. Generally, funding with at least 10% of the anticipated purchase price is considered by practitioners to be sufficient. This funding will be a taxable gift (unless special provisions are used to render it an incomplete gift) and therefore the client’s available gift tax exemption must be considered.
Planning Techniques Post-Karmazin Settlement
I. Karmazin v. Commissioner, Docket #2127-03, was a case in which IRS challenged a sale of Family Limited Partnership (FLP) interests to a Grantor Trust.
A. The underlying partnership consisted solely of marketable securities.
B. The case settled (albeit favorably for the taxpayer); therefore the case does not constitute legal precedent.
C. The purpose of this outline is to discuss IRS objections raised in Karmazin, and to discuss the defenses raised and presented to District Counsel that ultimately convinced IRS to favorably settle.
II. Intended benefits of a sale of an interest in either an FLP, LLC or other closely held business to a Grantor Trust:
A. The selling price can be reduced through the benefits of discount in value, thereby ultimately passing the discounted portion of the purchase price and future appreciation to the beneficiaries of the purchasing trust.
B. The assets ultimately passing to the trust can avoid gift, estate and generation-skipping transfer (“GST”) tax consequences.
65
C. The sale transaction is not reportable for income tax purposes.
D. Income attributable to the trust’s assets is taxed to the Grantor of the trust and will result in an additional tax-free gift to the trust beneficiaries. The sale to the Grantor Trust is one of the few tax planning vehicles in which assets otherwise subject to GST tax can be avoided. Accordingly, the technique has become popular with clients of significant wealth.
III. Example of typical sale to trust transaction:
A. Client owns an interest in FLP, LLC or S Corporation with trade or business assets, real estate or marketable securities likely to appreciate in value.
1. Assume value of entity’s assets attributable to client’s interest is currently $10,000,000. The value had been $20,000,000 a year ago.
2. Assume assets produce $500,000 per year of income and appreciate by $300,000 per year (8% overall growth).
3. Client’s interest in the entity is non-voting.
B. A qualified appraiser determines the value of client’s non-voting interest is eligible for a 40% discount, thereby limiting its value to $6,000,000.
C. A Grantor Trust3 is created by the client for the benefit of client’s children and grandchildren.
1. Trust can be structured to continue in perpetuity in states where such structure is permitted.
2. Trustee is someone other than the Grantor.
D. Trust is initially funded with a gift from the Grantor in the amount of $1,000,000.4
E. Sometime later5, the Grantor enters into a purchase agreement with the Trustee of the trust to sell the Grantor’s non-voting interest in the entity for $6,000,000.
3 Under grantor trust rules, the grantor is obligated for income tax attributable to trust income. Also, transactions between the grantor and the trust are non-taxable and non-reportable. Revenue Ruling 85-13, 1985-1 CB 184. 4 To retain the benefits of the sale transaction and related debt, the trust should possess sufficient assets in addition to the purchased assets. Many commentators believe that the debt-to-equity ratio should not exceed nine to one. Nevertheless, the debt-to-equity ratio in Karmazin did not enter into the settlement discussions, and the fact that the initial funding of the trust consisted of a gift of a partnership interest in the same partnership that was sold to the trust was not put into issue. 5 To avoid a “step transaction” argument, a period of time should elapse between funding the entity, funding the trust, and the sale transaction. A successful step transaction argument could result in a loss of discount and
66
1. Payment is made with a Promissory Note of the Trust.
a) Interest only for a period of years with interest equal to AFR (say 5%)6 and a balloon payment of (say) 10 years.7
b) To satisfy the annual debt service, Trustee can use income generated from the $1,000,000 initial contribution and distributions from the entity to the trust.8
F. Assume in 10 years the portion of the entity’s assets attributable to the interest sold to the trust, plus the value of the $1,000,000 initial contribution now totals $18,000,000.
1. The entity then makes a pro rata distribution of sufficient assets so that the trust receives sufficient assets to satisfy the $6,000,000 principal obligation to the Grantor.
2. The trust will continue to own the non-voting interest in the entity with a pre-discounted value in excess of $12,000,000, after the debt to the Grantor has been satisfied.
G. The non-voting interest, and ultimately the underlying assets attributable to such interest, can eventually pass to children and grandchildren without gift, estate or GST tax.
H. Neither the trust nor its beneficiary incurs any income tax on the trust income because the Grantor is required to pay income taxes attributable to the trust income.
I. Furthermore, the sale transaction between the trust and Grantor, including annual interest payment and balloon payment of principal, is neither reportable nor includable in the income of the Grantor under Rev. Rul. 85-13.
IV. Benefits of sale transaction can exceed the benefits of a GRAT.
other adverse transfer tax consequences. See Senda v. Commissioner, 433 F.3d 1044 (8th Cir. 2006). No authority exists for the proper amount of time to elapse. Clearly, the sale should not be prior to the funding of the entity or even on the same day as the funding of the entity. Six-to-12 months’ lapse time may be considered appropriate. Some later cases held that the step transaction argument did not apply. (See, e.g. Bianca Gross, TC Memo 2008-221 and Holman, 130 T.C. 170 (2008); contra Heckerman, 2009-2 USTC Par. 60,578 (2009). In the most recent case, Linton, the District Court held that the step transaction applied but the Ninth Circuit reversed and remanded for factual determination. 638 F. Supp. 2d 1277 (D. Ct. WA 2009), rev’d and remanded 630 F. 3d 1211 (9th Cir. 2011). 6 The current long-term AFR is 4.19%, making the numbers even more viable. 7 The transaction may be structured with a down payment of 10 percent and with a self-amortizing promissory note for the balance. In Karmazin, the note was a 20-year note in which interest and principal were paid annually and a final balloon payment was due at the end of 20 years. 8 The distribution must be pro rata to any and all interest holders of the entity.
67
A. A grantor retained annuity trust under IRC Section 2702 (“GRAT”) requires a portion of principal to be returned to the Grantor each year, thereby reducing assets ultimately available to beneficiaries.
B. Required interest rate on a GRAT is higher than the interest rate on a sale transaction.9
C. A GRAT cannot be used effectively as a GST vehicle because of ETIP rules.10
D. Benefits of GRAT over sale.
1. Intended results are known with greater certainty.
2. Sale transaction is not specifically addressed in Internal Revenue Code, but GRAT requirements are specifically set forth in Revenue Section 2702.
9 A GRAT must use the Internal Revenue Code Section 7520 rate, which is 120 percent of the Applicable Federal Rate (AFR), in calculating the annuity payment to the Grantor, while the sale can use the AFR in calculating interest payments to the Grantor. 10 See IRC Section 2642(f), indicating that GST tax exemption cannot be allocated to the value of a GRAT until the GRAT termination (at which time the remainder interest may be worth significantly more).
68
V. IRS Audit Risks – as asserted in Karmazin11
A. Entity can be ignored.
B. Sale transaction can be ignored and restructured as a gift followed by reservation of non-qualified annuity.
C. Discount attributable to sale can be disallowed.
D. Result can be a gift of undiscounted fair market value of underlying entity assets attributable to the interests sold.
E. Karmazin case was settled for a deficiency amounting to 5% of the original deficiency asserted.
VI. History of the Karmazin transaction.
A. Transactions prior to sale.
1. Family Limited Partnership formed in 1996.
2. Funded solely with traded securities, including common stocks, options, closed-end mutual funds and municipal bonds.
3. Children contributed small amounts of cash in exchange for a small percentage interest.
4. Parent received 1% General Partnership units and approximately 98% Limited Partnership units.
5. Parent then gifted a portion of her Limited Partnership units to a Charitable Lead Annuity Trust (“CLAT”), the beneficiary of which was a private charitable foundation of which client’s children were the named Trustees.
6. Client obtained a Private Letter Ruling relating to certain issues attributable to the CLAT.12
a) Private Letter Ruling issues were not relevant to the 1999 sale transaction.
b) IRS noted that the donor funded the trust with Limited Partnership units, that the partnership received its income from dividends, interest and sale of marketable securities.
11 Karmazin v. Commissioner, Docket No. 2127-03. 12 Private Letter Ruling 9810019.
69
IRS never questioned the validity of the partnership in the ruling.
7. Annual exclusion gifts of Limited Partnership units were given in 1997 and 1998 to client’s children.
8. IRS initial examination (for years 1996, 1997 and 1998).
a) Valuation issue attributable to the partnership units gifted to children and CLAT. Taxpayers claimed 41.2% discount per appraisal. Valuation was settled at 37% discount.
b) Formula adjustment in the CLAT provided that if units were valued differently by IRS, a greater amount would pass to the Foundation.
c) IRS attempted to claim this self-adjusting feature was contrary to public policy citing Procter.13
B. Sale transaction.
1. In July 1999, client contributed an additional $5,000,000 of marketable securities to the 1996 partnership in exchange for additional Limited Partnership units.
2. On the same day, client made a gift of Limited Partnership units to two trusts for her children, designed as Grantor Trusts, representing 10% of the corpus after the sale transaction described below.
3. On the same date, client sold Limited Partnership units to the children’s Grantor Trusts for a purchase price based upon a new appraisal.
4. Purchase price was evidenced by a Promissory Note with interest at the then-applicable AFR of 5.8% The Promissory Note required semi-annual payments of interest and approximately $50,000 of principal.
5. A balloon payment was due in 20 years.
6. Each purchaser secured the Promissory Note with a Pledge Agreement covering the Limited Partnership units purchased by and gifted to the trust.
13 Under the self-adjusting clause, the annuity payable to the charity would increase or decrease, should there be a final determination in a tax proceeding in which the value of the units is adjusted. See, however, Commissioner v. Procter, 142 F.2d 824 (4th Cir. 1944).
70
7. The number of units sold was determined by a formula to equal the appraised FMV.14
8. The units subject to the sale were disclosed on the 1999 Gift Tax Return along with the outright gift to the trust.15
C. IRS Audit of 1999 Transaction.
1. The audit occurred simultaneously with discussions concerning settlement of the earlier 1997 and 1998 years with District Counsel.
2. Agent’s sole issue raised on discussion was the amount of discount and its effect upon gift tax.
3. One month later, we received a 75 page Agent’s Determination Letter in which the entire 1999 sale transaction was disallowed.
4. Agent’s position, later affirmed at the Appeals level, was the following:
a) Partnership was a device to transfer underlying partnership property at a discount, citing IRC Section 2703.
b) The sale was essentially a gift of the entire undiscounted amount of assets attributable to the partnership assets sold (valued at approximately $5,000,000 and resulting in a gift tax in excess of $2,000,000).
c) Commercial lenders would not loan funds without personal guarantees or a larger down payment.
d) Debt-to-equity ratio of 9:1 was high.
e) IRS acknowledged PLR 95350926, which sanctioned a partnership interest sale to a Grantor Trust but specifically left open the question of whether the Promissory Note was a valid debt for tax purposes.
f) If Note was not a debt, then under Section 2701, the payments were recharacterized as a retention of non-periodic rights to payments under Section 2701. The Note, according to the
14 Thus, if the Internal Revenue Service disagreed with the appraised value, a lesser number of units would be deemed sold. 15 The disclosure on the gift tax return was accomplished to meet the “adequate disclosure” requirement of Treasury Regulations Section 301.6501 (c)-1(f)(2) to commence the running of the three-year statute of limitations.
71
IRS, when recharacterized as equity, had zero value, 16 although authority exists for a Promissory Note to equal its face when the AFR interest is stated.17
g) Central to IRS argument was its assertion that the recharacterized Note to equity resulted in a retention of right to income from the transferred property in the form of the interest stream from payments on the Note, resulting in a retained interest in the transferred property under Section 2702. According to IRS, the retained interest constituted annuity payments analogous to annuity payments from a GRAT and not interest stated on a Promissory Note. However, the trust failed as a GRAT because it did not contain the required terms of a GRAT.
h) Ultimately, Agent contended that if the sale is recognized and the Note constituted valid debt, discount was limited to 3%.
VII. Karmazin Settlement
A. Case was docketed in the Tax Court.
B. District Counsel agreed to reduce the deficiency of approximately $2,000,000 to approximately $100,000 (a 95% reduction).
C. Basis of settlement.
1. Sale was a bona fide sale.
2. Note was bona fide and transaction was not recharacterized as a transfer followed by reservation of an annuity.
3. Interest payments retained their character as interest payable on Promissory Note.
4. Sections 2703, 2701 and 2701 were not applicable.
5. Discount agreed to was at 37%.
D. Specific arguments advanced:
1. Promissory Note was valid.
16 The note, however, is an obligation of the trust, and not the partnership. It is difficult to apply IRC Section 2701 under such circumstances. 17 See Frazee v. Comm’r, 98 TC 554 (1992).
72
a) Sufficient partnership assets were available so that trust could make timely payments to seller under its Promissory Note.
b) CLAT was a 12% partner in the FLP, which required a distribution of a specific sum from the partnership to fund the required annuity to the Private Foundation.
c) To achieve pro rata distributions from the partnership, each Grantor Trust (a 24% partner) was required to receive distributions double the amount paid to the CLAT.
d) The pro rata distribution to the Grantor Trusts exceeded the annual obligation of the trusts to the Grantor, thereby providing sufficient assets to fund the debt.
E. The transaction satisfied the substantial economical reality test
1. A reliable income stream was paid to fund the interest and principal obligation.
2. Payments due under the Note were independent of whether the transferred property produced income for the Trust.18
3. Under a “reality of sale” analysis, the transaction must be respected because Seller-provided financing did not exceed the value of the asset purchased, and purchaser was able to meet financial obligations as they became due.
4. Pledge of Partnership units added validity to the characterization as a sale.
5. Income generated by the underlying property transferred exceeded the annual debt service of the Note.
F. The existence of the partnership cannot be ignored for tax purposes because it is a viable entity under state law.19
G. Transaction, in fact, was commercially feasible.
1. Response to Agent’s assertion that no commercial lenders would permit a loan on this type of transaction was that a large commercial
18 Fidelity-Philadelphia Trust Co. v. Smith, 356 U.S. 274, 280 (1958); Stern v. Commissioner, 747 F.2d 555 (9th Cir. 1984); LaFargue v. Commissioner, 689 F.2d 845 (9th Cir. 1982); Becklenberg Est. v. Comm’r, 273 F.2D 297 (7th Cir. 1959) and Fabric Est. v. Comm’r, 83 TC 932 (1984). 19 Strangi Estate v. Comm’r, 417 F. 3d 468 (5th Cir. 2005); Knight v. Comm’r, 115 TC 506 (2000); Dailey
Estate v. Comm’r, TC Memo 2002-301 and TC Memo 2001-263; Thompson Estate v. Comm’r, TC Memo 2002-246; and Church v. U.S., 268 F. 3d 1063 (5th Cir. 2001).
73
institution was prepared to issue a letter of credit to the trust to secure the transaction.
2. The letter of credit we negotiated would be secured solely by the Limited Partnership units and not directly by the assets of the partnership.
3. The letter of credit effectively replaced the need for a personal guaranty.
4. The case actually settled before the letter of credit was ever presented.
VIII. Planning in Light of Karmazin
A. Karmazin was a gift tax case and not an estate tax case.
1. Section 2036 was not asserted, since that section is an estate tax inclusion section.
2. Nevertheless, under current environment, consider funding the entity with trade or business assets, including real estate or other business-related assets.
B. The funding of a Grantor Trust with assets equal to 10% of the selling price has been suggested by several commentators.20
1. The funding issue, although raised on audit, was not considered by District Counsel in reaching our settlement.
2. Prudence dictates that, prior to the sale, some substantial contribution to the trust as a gift should be considered, preferably with marketable securities and/or cash, if available.
C. Personal Guaranty by Beneficiaries
1. While this is advisable, a guaranty did not exist in Karmazin.
2. A standby letter of credit from a financial institution, if available, may be considered.
D. A substantial period of time should take place between the funding of the entity and the sale transaction.21
20 See, for example, Howard Zaritsky, Tax Planning for Family Wealth Transfers; Analysis with Forms, Warren, Gorham & Lamont of RIA, Valhalla, NY, Fourth Ed. 2002 at ¶ 12.07 [3][d][i] n. 320, based on PLR 9535026. 21 See footnote 3, supra.
74
1. No specific authority exists on the precise amount of time.
2. In Karmazin, the funding of the entity and the sale actually took place on the same day, but this is not recommended in the current tax environment.
E. Other partners or interest holders in the entity should exist in addition to the Grantor Trust.
1. In Karmazin, a CLAT was a 12% partner.
2. A significant reason for the success of Karmazin was the argument that the required annuity payments to the CLAT actually drove the pro rata distributions to the Grantor Trust.
3. The distributions to the Grantor Trust were then more than sufficient to fund the loan obligation to the Grantor.
F. Consider designing the Grantor Trust and sale transaction with “GRAT-like” provisions.
1. Potential benefit: If IRS attempts to recharacterize the sale as a gift, followed by a reserved annuity interest, then taxpayer can argue the recharacterized annuity is from a GRAT, which, when appropriately structured, can result in a zeroed value gift.
2. Annuity payments to the Grantor would be self-adjusting as in the case of a GRAT, thereby further reducing gift tax exposure attributable to differences of opinion concerning valuation discount.
3. The sale would be structured as a sale to the trust for an annuity, and not in return for a Promissory Note of the Note.
4. The trust would be precluded from issuing its own Note to satisfy any obligations to the Grantor.22
5. The required annuity would be set forth in the contract of sale.
6. The trust would have the following required GRAT language:
a) No additions permitted.
b) No distributions to beneficiaries while payments are made on the purchase price.23
22 Treas. Regs. Section 25.2702-3(b)(2) 23 Treas. Regs. Section 25.2702-3(d)(6)
75
c) Purchase Agreement would preclude prepayments analogous to the “no commutation” language of a GRAT.
d) If death occurs during the annuity period and the transaction is successfully recharacterized as a sale, the only value includable in the estate is the present value of the future annuity payments and not the entire value of the trust assets, as in the case of a pure GRAT.
IX. Davidson Case
A. In CCA 201330033, the IRS asserted for the first time that the risk premium for a SCIN should be valued based on the willing buyer/willing seller standard of Treas. Reg. section 25.2512-8 (and NOT using the 7520 tables). The decedent’s life expectancy, including medical history, on the date of gift should be taken into account.
1. This was a surprising position, because:
a) The CCA cites GCM 39503, but the GCM does not support the positions taken in the CCA – the GCM suggests that SCINs “may” be valued in this way, but explicitly gives the taxpayer flexibility in determining the risk premium.
b) The IRS has itself used the IRS’s mortality tables and rates in calculating the risk premium.
B. The CCA was issued in response to Davidson case:
1. Davidson, at age 86, issued 8 SCINs as part of transfers to many trusts set up for his children and grandchildren. Immediately thereafter he was diagnosed with a medical condition and died 4 months later (although medical evidence at the time of the transaction was actually fairly favorable to the estate).
2. No payments were ever made on the SCINs. The IRS issued a notice of deficiency, claiming his estate owed over $2.7 billion in transfer taxes and penalties.
X. Davidson case settled with a stipulated decision that was entered on July 6, 2015.
A. Since several issues were in play – including, whether debts were bona fide, valuation of his company shares, etc. – it’s not possible to isolate the resolution on the risk premium calculation issue.
B. Unfortunately, settlement means there will be no definitive resolution on the question of SCIN valuation.
76
XI. However, this is generally being interpreted as a taxpayer victory – total transfer tax liability as stipulated was just over $320 million, a small fraction of the initial $2.7 billion deficiency, and less than would have been owed had Davidson done nothing.
77
QUALIFIED PERSONAL RESIDENCE TRUSTS
A. Overview.
1. A residential grantor retained interest trust (“GRIT”) can be a valuable estate planning tool for a client who:
(a) Owns his or her residence,
(b) Desires to continue to reside in the residence, and
(c) Desires to avoid substantial estate tax consequences attributable to the value of the residence.
2. A residential GRIT provides that:
(a) The grantor retains use of the residence for a designated period (a term of years, although no specific duration is mandated by statute or regulations); and
(b) After the designated period, the residence will pass to designated beneficiaries.
(c) The grantor can be his own trustee. Thus he can also decide whether and when to sell the residence.
3. This results in a discounted gift to designated beneficiaries and removal of all appreciation from the grantor's estate.
(a) To be successful, grantor must survive the trust term.
(b) If grantor does not survive the trust term, the entire trust value is included in his estate under Section 2036(a). Any unified credit used on the original gift transfer would be restored. Section 2001(b).
(c) The longer the trust term, the greater the discount and the lower the gift will be.
B. Section 2702 creates an exception to the valuation rules with respect to transfers in trust.
1. The exception applies only to personal residences, as defined below.
2. The exception, in effect, permits a discount (even though the residence is not an income-producing asset) on gift tax transfers
78
where the ultimate enjoyment of the property for the remaindermen is postponed for a designated period.
3. The statute permits the discount in the case of a trust holding only a personal residence, and no other assets. The regulations describe this statutory exception as a Personal Residence Trust ("PRT").
4. The regulations also allow a more flexible type of trust, one which may acquire related assets in addition to one personal residence. This type of trust is known as a Qualified Personal Residence Trust ("QPRT").
C. Definitions which apply to both a PRT and QPRT:
1. A personal residence includes the principal residence of the Grantor and one other residence of the Grantor (or an undivided fractional interest therein). Reg. Sec. 25.2702-5(b)(2)(i) and 25.2702-5(c)(2)(i).
(a) Thus, a vacation home will qualify.
(b) Letter Ruling 199925027 involved a Trust funded with beneficial title to coop shares and lease pertaining to the coop apartment which met the criteria for a qualified personal residence trust.
(i) Taxpayer originally intended to transfer legal title to the trust, but the coop association refused taxpayer's request for the transfer.
(ii) Therefore, taxpayer transferred beneficial title to the trust and continued to hold legal title as nominee.
2. A portion of the residence may be used exclusively on a regular basis for business (under the home office rules). Reg. Sec. 25.2702-5(b)(2)(iii) and 25.2702-5(c)(2)(iii).
3. When the Grantor is not occupying the residence and it is being held for the Grantor's use, it cannot be occupied by any person other than the Grantor's spouse or dependent, and must be available at all times for the Grantor's use as a personal residence. Reg. Sec. 25.2702-5(b)(1).
(a) Note that this rule of the PRT regulations is not included in the QPRT regulations; however, the same "use" requirement applies to a QPRT because use by a person other than grantor, spouse or dependent constitutes a "cessation" of use as a personal residence under Reg. Sec. 25.2702-5(c)(7)(i).
79
(b) Under the literal reading of the regulations, a live-in housekeeper, girlfriend or boyfriend, or non-dependent relative cannot occupy the residence when it is not being used by, but is held for the use of, the Grantor. But see Letter Ruling 9249014, in which the IRS held that the fact that the grantor allows a friend to reside with him does not conflict with the regulation, because the friend remains only with the grantor's permission and has no legal right to continue in residence after that permission is withdrawn.
4. The residence may be rented out by the Grantor for part of the year and occupied as a residence by the Grantor for the other part. Reg. Sec. 25.2702-5(d), Ex. 2.
(a) The Grantor is exercising his use right in renting the residence.
(b) Compare with rental of the residence by the trustee, which is not permitted since the residence would no longer be available for the Grantor's use at all times.
(c) Letter Ruling 199906014 involved a house which was used as vacation residence that also included a separate apartment, which was rented to unrelated individuals. This qualified as a personal residence and the apartment was considered to be incidental to the use of the property as a residence.
5. If the Grantor is forced to move to a nursing home during the trust term, the residence continues to be held for the Grantor's use so long as the residence is available at all times for the Grantor's use as a residence during the term, without regard to the Grantor's ability to actually use the residence. Reg. Sec. 25.2702-5(d), Ex. 5.
6. Spouses may transfer all or part of their interests in a residence to a single trust if the governing instrument prohibits any person other than one of the spouses from holding a term interest concurrently with the other spouse. Reg. Sec. 25.2702-5(b)(2)(iv) and 25.2702-5(c)(2)(iv).
In Letter Ruling 9829002 the IRS approved a QPRT established for a term of years or the earlier death of the second spouse to die.
(a) At the death of the first grantor prior to expiration of the trust term, any property includible in the estate of such grantor would pass to the surviving spouse and would qualify for the marital deduction, if requirements of Section 2056 were otherwise satisfied.
80
(b) The grantors could rent the house back at fair rental value after the end of the trust term without causing the property to be included in the gross estate of either grantor under Section 2036(a).
(c) The governing instrument provided that capital gains would be accumulated and added to corpus, and that the grantors would have a general testamentary power to appoint the accumulated income. Therefore, the grantors were deemed to be the owners of trust corpus under Section 674(a) and were entitled to receive all of the trust's income. Consequently, they were deemed to own the entire trust for purposes of Section 671.
7. "Residence" may include "appurtenant structures used for residential purposes and adjacent land not in excess of that which is reasonably appropriate for residential purposes (taking into account the residence's size and location)." Reg. Sec. 25.2702-5(b)(2)(ii) and 25.2702-5(c)(2)(ii). The IRS has generally been liberal in permitting large properties with other related buildings to qualify.
(a) In Letter Ruling 9841015, property including a woodland area was a personal residence.
(i) Property qualified as a personal residence, including a residence, two barns, and a wood and tool shed.
(ii) Several parcels of residential property contain similar acreage nearby. The residence was used exclusively as a single family home for several years and no commercial activity was conducted on the premises.
(b) In Letter Ruling 199918042, a residence including a large recreational areas qualified as a QPRT.
(i) Local ordinance prevented its subdivision, and use of area was non-commercial and reasonable for the locality.
(ii) In addition, an option to lease the property at the end of the term held by the grantor and his spouse would not invalidate the QPRT.
(c) In Letter Ruling 199918049, a trust owning a residence, including a tennis cottage, caretaker's house, and adjacent land, was not in excess of reasonable for residential purposes, given the locality of the property.
81
8. "Residence" does not include any personal property such as household furnishings. Reg. Sec. 25.2702-5(b)(2)(ii) and 25.2702-5(c)(2)(ii).
D. An individual may hold term interests in no more than two trusts. Reg. Sec. 25.2702-5(a).
1. A trust converted to a qualified annuity trust, discussed below, should not count against the two-trust limitation.
2. Trusts holding fractional interests in the same residence are treated as one trust. Reg. Sec. 25.2702-5(a).
E. Personal Residence Trust ("PRT"):
1. Defined as "a trust the governing instrument of which prohibits the trust from holding, for the original duration of the term interest, any asset other than one residence to be used or held for use as a personal residence of the term holder and qualified proceeds." Reg. Sec. 25.2702-5(b)(1).
2. During the term interest, the residence cannot be sold or otherwise transferred by the trust or used for a purpose other than the term holder's personal residence.
3. Expenses of the trust, including principal expenses, may be paid directly by the term holder.
4. "Qualified Proceeds" may be held in the trust. Reg. Sec. 25.2702-5(b)(3).
(a) Qualified Proceeds are the proceeds payable as a result of damage to, or destruction or involuntary conversion of, the residence, provided that the trust requires that the proceeds (including any income thereon) be reinvested in a personal residence within two years from the date on which the proceeds are received.
(b) By implication, an insurance policy or policies on the residence may also be held in the trust.
5. Neither the statute nor the regulations discuss a prohibition against commutation.
6. Because a PRT is restricted to holding only a residence and proceeds from destruction or conversion thereof, as a practical matter, this type of trust is not as useful as QPRT.
82
F. Qualified Personal Residence Trust ("QPRT"): The following requirements contained in the Regulations must be part of the trust's governing instrument:
1. No distributions of principal may be made to any beneficiary other than the term holder during the term of the trust. Reg. Sec. 25.2702-5(c)(4).
2. Any income must be distributed to the term holder at least annually. Reg. Sec. 25.2702-5(c)(3).
3. During the trust term, the trust may not hold any asset other than one personal residence. Reg. Sec. 25.2702-5(c)(5)(i).
(a) The trust may permit the holding, in a separate account, of cash which does not exceed the amount required:
(i) For payment of trust expenses (including mortgage payments) already incurred or reasonably expected to be paid by the trust within six months from the date the addition of cash is made.
(ii) For improvements to the residence to be paid by the trust within six months from the date the addition of cash is made.
(iii) For purchase by the trust of the initial residence, within three months of the date the trust is created, provided that no addition of cash may be made for this purpose, and the trust may not hold any such addition of cash, unless the trustee has previously entered into a contract to purchase the residence.
(iv) For purchase by the trust of a residence to replace another residence, provided that no addition of cash may be made for this purpose, and the trust may not hold any such addition of cash, unless the trustee has previously entered into a contract to purchase the residence.
Reg. Sec. 25.2702-5(c)(5)(ii)(A)(1).
(b) The trust may hold improvements to the residence. Reg. Sec. 25.2702-5(c)(5)(ii)(B).
(c) The trust may hold proceeds from the sale of the residence (and any income thereon). Reg. Sec. 25.2702-5(c)(ii)(C).
83
(d) The trust may hold insurance policies and, in a separate account, insurance proceeds paid as a result of damage to or destruction of the personal residence. Reg. Sec. 25.2702-5(c)(ii)(D). Presumably, income earned on these proceeds may also be held.
(i) Amounts received by the trust as a result of the involuntary conversion of the residence are treated as proceeds of insurance.
(e) All cash held by the trust in excess of the amounts permitted in item a) above must be distributed at least quarterly to the term holder. Upon termination of the trust term, any remaining cash in the trust held for payment of these expenses must be distributed to the term holder. Reg. Sec. 25.2702-5(c)(5)(ii)(A)(2).
4. Commutation of the term holder's interest is prohibited. Reg. Sec. 25.2702-5(c)(6). Commutation is the payment of the actuarial value of the income interest to the term holder at some point during the trust term.
5. The trust will cease to be a qualified personal residence trust:
(a) If the residence ceases to be used or held for use as a personal residence of the Grantor.
(b) With respect to all proceeds of sale held by the trust not later than the earlier of:
(i) The date that is two (2) years after the date of sale;
(ii) The termination of the Grantor's interest in the trust; or
(iii) The date on which a new residence is acquired by the trust.
(c) If damage or destruction renders the residence unusable as a residence, on the date that is two (2) years after the date of damage or destruction (or the date of termination of the Grantor's interest in the trust, if earlier) unless, prior to such date:
(i) Replacement of or repairs to the residence are completed; or
(ii) A new residence is acquired by the trust.
84
(d) With respect to all proceeds of insurance received as a result of damage to or destruction of the residence not later than the earlier of:
(i) The date that is two (2) years after the date of damage or destruction;
(ii) The termination of the Grantor's interest in the trust; or
(iii) The date on which replacement of or repairs to the residence are completed, or a new residence is acquired by the trust.
Reg. Sec. 25.2702-5(c)(7).
6. If the trust, or any part of it, ceases to be a qualified personal residence trust with respect to certain property (see 5. above):
(a) The trust must distribute all such property to the term holder; or
(b) Such property must be held for the balance of the trust term in a separate share of the trust and the term holder's interest therein must be converted to a qualified annuity trust.
(c) The trustee (but not the term holder) has the discretion to choose between (a) or (b).
(i) If the term holder is given the choice between terminating the trust or converting to a qualified annuity trust, an incomplete gift may result.
(ii) We recommend requiring conversions to QAT (option (b)).
(d) The distribution or conversion must occur within 30 days of the time when the trust ceases to be a QPRT.
Reg. Sec. 25.2702-5(c)(8)(i).
7. When a QPRT is converted to a qualified annuity trust ("QAT"):
(a) The right of the term holder to receive the annuity amount begins on the date of sale of the residence, the date of damage to or destruction of the residence, or the date on which the residence ceases to be used or held for use as a personal
85
residence, as the case may be (the "cessation date"). Reg. Sec. 25.2702-5(c)(8)(ii).
(i) However, the trustee may defer payment of the annuity amount until 30 days after conversion to a QAT (the "conversion date"), subject to the payment of interest, and subject to reduction by the amount of income actually distributed by the trust to the term holder during the deferral period.
(b) A QAT must provide an annuity at least equal to:
(i) The lesser of:
(a) The value of all interests retained by the term holder (as of the date of the original transfer), or
(b) The value of all trust assets as of the conversion date;
(ii) Divided by an annuity factor determined:
(a) Using the Section 7520 rate in effect on the original transfer date, and
(b) For the original term of the term holder's interest.
8. Rev. Proc. 2003-42, 2003-1 C.B. 993, provides a sample QPRT trust document. The exhibit attached to this outline incorporates the provisions of the sample document.
ISSUES ARISING AFTER THE ESTABLISHMENT OF A QPRT
Factual Scenario: Client, 70 years old, creates a QPRT in year 1 for a 5-year term with a residence valued at $500,000. The Section 7520 rate in affect is 5.6%. Thus, the taxable gift made by client was $316,885 (value of interest grantor retains = $183,115). In year 2, the trust sells the residence. Additionally, client has found a new residence to purchase. What are the issues to be considered in this transaction?
A. Sale of the Personal Residence.
1. During the QPRT term. During the term of a QPRT, the trust instrument may permit the trust to sell the residence. However, Reg. § 25.2702-5(c)(9) prohibits such a sale to the grantor, the grantor’s spouse or any person or entity controlled by same.
86
(a) In the event that the trust sells the personal residence, such a sale should qualify for the § 121 income tax exclusion pertaining to gains on the sale of a personal residence since a QPRT should be a grantor trust.
(b) If the value of the contingent reversion interest retained by the grantor exceeds 5% of the trust value, the trust will be a grantor trust under Section 673(a). (This will be the case except if the grantor is very young.)
(c) Be sure that the trust specifically prohibits such a sale, preferably in the substantive provisions as well as the trustee’s powers provisions.
2. After the expiration of the QPRT term. If at the end of the QPRT term the residence owned by the trust vests outright and free of trust in the remaindermen, the sale of the residence will not qualify for the income tax exclusion relating to gain on the sale of a principal residence (except in the unusual case where the remaindermen have been residing in the residence and satisfy all of the other requirements of § 121).
Alternatively, if the QPRT is designed to provide that at the end of the QPRT term the residence will be held in further trust for a period of time, such an additional trust, if designed as a grantor trust, can permit the sale of the residence to qualify for the § 121 exclusion, assuming that the grantor will still be residing in the residence pursuant to an appropriate lease agreement. For example, the trust may provide that, after the initial term, the trustees of the subsequent term trust for the children have the discretion to loan principal or income to the grantor without adequate security, which gives grantor trust status under § 675(1).
3. Planning Tips. The QPRT should always provide that the trustee shall have the power to sell the residence during the initial term of the trust and subsequent term. Additionally, in the event that the grantor, upon the expiration of the QPRT term, will lease the residence from the remaindermen, consider keeping the residence in trust for the benefit of the remaindermen. If held in further trust, design the trust as a grantor trust so that a subsequent sale can qualify for the income tax exclusion from gain of the sale of a principal residence, and so the lease payments will not be taxable to the beneficiaries.
87
B. Purchase of a New Residence.
1. Generally. Unless an exception applies to an asset, as defined in the Regulations, a QPRT may not hold any asset other than one personal residence. Regulation Section 25.2702-5(c)(5)(i) states:
Except as otherwise provided in paragraphs (c)(5)(ii) and (c)(8) of this section, the governing instrument must prohibit the trust from holding, for the entire term of the trust, any assets other than one residence to be used or held for use (within the meaning of paragraph (c)(7)(i) of this section) as a personal residence of the term holder (the “residence”).
Regulation § 25.2702-5(c)(5)(ii) excepts from the general rule of Reg. § 25.2702-5(c)(5)(i):
(a) Cash for payment of:
(i) Trust expenses (if required or expected within six months of receipt of the cash);
(ii) Improvements (if being made within six months of the receipt of the cash);
(iii) Purchase of the initial residence (if purchased within three months of the creation of the trust and the contract was entered into prior to the addition of the cash); and
(iv) Purchase of a replacement residence (if the trustee has already entered into a contract for sale to buy a replacement residence and the cash is being held by the trust for less than three months).
(b) Improvements, provided that the improvements do not cause the residence to fail to qualify as a personal residence.
(c) Sale proceeds, if held in a separate account.
(d) Insurance and insurance proceeds, may be held by the trust, provided that if proceeds are being held, the proceeds must have been derived from an involuntary conversion of all, or any part of the personal residence.
2. Purchase of Residence With the Same Price. Provided that the one residence per trust rule is not violated when the new residence is purchased, the purchase of a replacement residence, if done within
88
two years of the sale of the first residence, does not require any further action on the part of the trustee. E.g.: In year 1, QPRT sells residence for $500,000. In year 2, replacement residence can be purchased by QPRT for $500,000.
3. Residence with a lower price. Pursuant to Reg. § 25.2702-5(c)(8)(i), in the event a QPRT ceases to qualify as a QPRT, within thirty (30) days, the trustee, in the trustee’s sole discretion, must either:
(a) Distribute all of the assets of the trust to the term holder; OR
(b) Hold the non-qualifying assets in a separate account and convert that account into a qualified annuity for the term holder.
In the event that a trustee determines that an annuity will be paid to the term holder, the annuity will be computed, pursuant to Reg. § 25.2702-5(c)(8)(C)(2) as follows:
A = RI x E AF T
A = Annuity RI = Initial value of retained interest AF = Annuity factor as computed using the original term of the
trust, the original Section 7520 rate and the donor's age at the time the trust was initially established
E = Amount of excess cash T = Total value of the trust assets
Based upon the options, from an estate planning point of view, payment of an annuity is the preferable choice since this will minimize the amount going back to the grantor and maximize the assets passing to the remaindermen.
Based upon the example given, assume that the new residence being purchased by the trust is $250,000 and the initial residence was sold for $500,000, the annuity payable will be computed as follows:
A = 183,115 x 250,000 3.9294 500,000
A = $23,300.63 per year
4. Residence with a higher price. As previously stated, unless there is
an exception, a QPRT may not own any assets other than the principal residence. Likewise, a QPRT may not receive any additions except as the Regulations expressly permit.
89
In the event the QPRT desires to purchase a new residence which is valued greater than the trust has assets, the QPRT will not be able to purchase the entire residence. In such a case, the QPRT may only purchase a portion of the new residence. Title will then need to be split between the QPRT and some other person or entity.
Since Reg. § 25.2702-(5)(a) provides that trusts owning fractional interests in the same residence are treated as one trust, one alternative is to purchase the excess portion in a new QPRT. This is an exception to the rule that a person can only contribute two residences to QPRT.
5. Planning Tips.
(a) The trustee of a QPRT should not enter into a contract for sale to purchase a replacement residence if the trust still owns a residence. Such a contract may be considered as equitable title and, as a result, is an impermissible asset to be held by the trust.
(b) If a QPRT is to purchase a replacement residence, such a purchase must occur after the initial residence has already been conveyed out of the trust in order to maintain the one residence per trust rule. In practice, if a Seller is unwilling to delay the closing of title to your client, a QPRT, title may need to be taken in the individual name of your client, for a brief period of time, until the initial residence owned by the QPRT can be conveyed to a Purchaser. This rule similarly applies to the execution of a contract for sale.
(c) In the event that the replacement residence to be purchased is being purchased for a lower price, the trustee should elect to pay an annuity, and not distribute the entire excess cash.
(d) If the trust is purchasing a replacement residence of greater value (e.g., if sell for $500,000 and repurchase for $700,000), the excess portion ($200,000) of the property should be purchased in a second QPRT if possible.
C. Mortgages and QPRTs.
1. QPRTs established with an existing mortgage. Reg. § 25.2702-5(c)(ii) permits a QPRT to be established with a personal residence which is encumbered with an existing mortgage. However, a QPRT subject to a mortgage presents several problems:
(a) Payment of the principal portion by the grantor may be considered a gift of a future interest.
90
(b) The gift will be reported dollar for dollar and cannot be reduced to present value. Thus, grantor will be using more of his exemption while paying the mortgage.
Therefore, to maximize the estate planning leverage obtained by a QPRT, the grantor should consider satisfying the mortgage in full prior to contribution to the QPRT. If satisfying the mortgage is not practical, the grantor should personally guarantee the existing mortgage obligations. This should permit the grantor to avoid future gifts equal to the mortgage payment. The property valued in the QPRT should not be reduced by the encumbrance. It will also help if there is an independent trustee (or co-trustee) who agrees to serve only if the grantor retains responsibility for the mortgage.
2. Obtaining a new mortgage after the establishment of the QPRT. Code § 2702 and the Regulations do not expressly prohibit a QPRT from obtaining a mortgage on the principal residence. The Regulations provide that cash may be held by the trust for certain limited purposes, see Section B.1.(a)., above. If the trust obtains a mortgage, particular attention must be given to:
(a) the intended use of such funds (i.e. whether the trust’s possession of such funds will be permissible under the Regulations);
(b) the burdens placed upon the remaindermen of the trust;
(c) whether an institution will give a loan to the trust without additional security.
(d) whether the governing document contains any language prohibiting the pledge or other use of the trust property for security on any loan.
D. Selling the Residence for a Promissory Note.
Factual Scenario: In year 1, H & W contribute their New Jersey residence to two qualified personal residence trusts having a six-year term. H & W are ages sixty-seven and sixty-four, respectively. House was appraised at $2,325,000. After applying a 15% fractional interest discount, H and W will deemed to have made gifts of approximately $570,000 and $562,000 respectively (based on an initial corpus of $988,125 contributed into each trust). H & W’s combined basis in the residence was $1,000,000.
In year 5, the QPRTs sell the residence to a buyer for $4,000,000 in exchange for $1,000,000 cash and the balance payable on a self-amortizing basis over fifteen years with interest at 8% per annum, resulting in annual payments of approximately $350,000. Clients used $500,000 of the cash received to buy
91
a replacement residence in the names of the QPRTs, but left the balance of the cash in trust.
The QPRTs terminated in year 7, at a time when the purchase money note still had thirteen years to run.
1. Gain from Sale. Because the sale price exceeded H&W's cost basis ($4,000,000-1,000,000), H&W will recognize gain to the extent of the excess gain over the Code § 121 exclusion ($3,000,000-$500,000).
2. Recognition of Gain. Because the sale was in partial exchange for a Promissory Note, the gain is to be reported over the installment method described in Section 453, with 75% of each principal payment representing taxable gain.
3. Qualified Annuity Trust. By the terms of the QPRT, the trust is required to be converted into a qualified annuity trust, effective as of the date of sale (year 5). The annuity amount is determined as:
A = RI x E AF T
(a) Husband: In year 1, based on a 6.4% Section 7520 for a person aged sixty-seven, the annuity factor is 4.5006; thus, the annuity is:
418,125 x 1,750,000 = $81,291.24 4.500 2,000,000
(b) Wife: In year 1, based on a 6.4% Section 7520 rate for a person age sixty-four, the annuity factor is 4.5721;
426,125 x 1,750,000 = $81,551.01 4.5721 2,000,000
Thus, in year 5 and in year 6, H & W collectively are to receive a combined annuity of $162,842.05.
Factual Scenario: In year 7, when the trust terminated, the assets remaining on hand (excess cash and the promissory note) pass to the remaindermen. On trust termination, there is a “disposition” of an installment note. Under Section 453B, all deferred gain is required to be recognized in the year of disposition, with the result that in year 7, H & W would have a large tax liability without the cash to pay the tax.
92
Query: What if anything, can be done to avoid accelerating the deferred gain and permit the gain to continue to be reported on the installment method?
Answer: Consider an agreement by all parties in interest to amend the trust to include a subsequent term "grantor trust" for the benefit of the remaindermen. Intended result: cash from the mortgage payments continue to be paid to the trust for the benefit of the remaindermen children. The grantors pay tax as each payment is received. However, on termination of the initial trust, the potential Section 453B gain on disposition of the mortgage obligations may be avoided. Query: who is considered the grantor of the amended Grantor Trust?
E. Can co-tenancies of QPRTs further reduce the value of the gift?
1. Many cases have permitted a discount for a fractional tenant-in-common interest. See, for example, Baird, 82 TCM 666 (2001), a case in which a fractional interest discount of 60% was accepted by the Court. See also, e.g., Estate of Ellie B. Williams, 1998-59 TCM, Dec. 52,568(M) (1998) (44%); LeFrak, 66 TCM 1297 (1993) (30%); Cervin, 68 TCM 1115 (1994) (20%); Mooneyham, 61 TCM 2445 (1991) (15%); Estate of Feuchter; 63 TCM 2104 (1992) (15%); Estate of Pillsbury, 64 TCM 284 (1992) (15%); Propstra, 82-2 USTC Par. 13,475 (9th Cir. 1982) (15%). (The larger discounts generally involved unusual types of property, such as timberland.)
2. Spouses who create separate QPRTs should be entitled to this discount.
3. Can one individual create separate QPRTs of one residence for separate durations, and obtain a co-tenancy discount?
F. Leasing the Residence from the Remaindermen.
1. If the grantor wishes to remain in the residence after the trust terminates, the grantor must pay fair market value rent to the remainderman.
(a) The payment avoids the client from being deemed to retain an interest in the transferred residence, which would cause inclusion of the trust property in grantor's estate under Section 2036.
2. The rent is taxable income to the remaindermen.
(a) This can be a way to shift funds to the younger generation without incurring gift tax.
93
(b) Taxable income can be avoided if the remaindermen's interest is held in a continuing grantor trust, following the QPRT termination. The grantor trust can also serve to reduce income tax on sale after the QPRT trust terminates, as discussed above in A.2.
94
LIFETIME GIFT PLANNING
By: Philip C. Corbo, Esq.
1. Elements of a Valid Lifetime (“Inter Vivos”) Gift.
1.1. Donative intent
1.2. Delivery
1.3. Irrevocable relinquishment of ownership and dominion by Donor
2. Capacity of Client to Make Gifts.
2.1. An Adult donor is generally presumed to be competent to make a gift. Pascale v. Pascale, 113 N.J. 20, 29 (1988).
2.2. When a gift is alleged to have been made by an individual who is later determined to be incompetent and the gift is challenged by the incompetent’s guardian, the Donee must establish the gift by clear and convincing proof. In re Dodge, 50 N.J. 192, 227 (1967).
2.3 A presumption that the gift is not valid arises when an alleged gift is made from a
ward to his guardian, and the burden is on the guardian to show there was no undue influence. Marte v. Oliveras, 378 N.J. Super. 261 (App. Div. 2005).
2.4. Practical advice: If there are concerns regarding competency, send donor to a
doctor who will prepare a report regarding competency. 3. General Durable Power of Attorney.
3.1. A power of attorney is a written instrument where an individual authorizes another individual or individuals to perform specified acts on behalf of the principal. N.J.S.A. § 46:2B-8.2a.
3.2. A “durable” power of attorney contains the words “this power of attorney shall
not be affected by subsequent disability or incapacity of the principal, or lapse of time,” or “this power of attorney shall become effective upon the disability or incapacity of the principal,” or similar words expressing the intent of the principal that the power of attorney shall be effective regardless of the principal’s subsequent disability or incapacity. N.J.S.A. § 46:2B-8.2b.
A “springing” power of attorney becomes effective upon the disability of the
principal. 21 N.J. Prac., Skills And Methods § 27:13 (3d ed.). 3.3. Gifting Provisions A power of attorney must expressly and specifically authorize the attorney-in-fact
to make gifts to the attorney-in-fact or to others. N.J.S.A. § 46:2B-8.13a.
95
When authorizing an attorney-in-fact to make gifts, consider limiting the gifting
authority to gifts that (i) qualify in full for the annual exclusion from federal gift tax as provided in Internal Revenue Code (“IRC”) §2503(b) or (ii) satisfy the definition of a “qualified transfer” under IRC § 2503 (e) (for tuition and medical care).
3.4. Power to Deal With Real Estate In connection with the conveyance of real estate, it is important for the parties
involved to be certain that the power of attorney authorizes the attorney-in-fact to convey real property. To be effective for conveying real estate, a power of attorney must be in writing, acknowledged, and recorded with the County Recording Officer in the county where the real estate is located. 21 N.J. Prac., Skills And Methods § 27:13 (3d ed.), N.J.S.A. § 46:6-1, N.J.S.A. § 46:6-2.
3.5. Maintaining and Procuring Life Insurance Give the attorney-in-fact the express authority to maintain and procure life
insurance on the life of the principal. Consider this, particularly in cases where the principal owns life insurance outright or in an irrevocable life insurance trust (“ILIT”).
3.6. Fiduciary Duty and Duty to Account
3.6.1. An attorney-in-fact has a fiduciary duty to the principal and must act solely for the benefit of the principal. N.J.S.A. § 46:2B-8.13a.
3.6.2. The attorney-in-fact is required to maintain accurate books and records of
all financial transactions. The principal, or his guardian or conservator, and the personal representative of the principal’s estate may require the attorney-in-fact to render an accounting. In addition, the superior Court may require the attorney-in-fact to render an accounting if there is doubt or concern whether the attorney-in-fact is acting within the powers delegated by the power of attorney or is acting solely for the benefit of the principal. N.J.S.A. § 46:2B-8.13b.
3.7. Practical Advice: When grandma is living with your client and your client is
acting under a power of attorney, keep accurate records and receipts. 4. Joint Accounts, P.O.D. Accounts and Trust Accounts.
4.1. Multiple-party Deposit Account Act—N.J.S.A. §17:16I-1 et seq. (Applicable to accounts opened after May 28, 1980)
96
4.1.1 A joint account belongs, during the lifetime of all parties, to the parties in
proportion to the net contributions by each. In the absence of proof of contributions, the account belongs in equal shares to all parties having a present right of withdrawal. N.J.S.A. § 17:16l-4a. This, however, has no bearing on the power of withdrawal of such parties as determined by the account contracts. It is relevant only to controversies between those persons and their creditors and other successors. N.J.S.A. § 17:16l-3.
4.1.2. A P.O.D. account belongs to the original payee during his life. N.J.S.A. § 17:16l-4b.
4.1.3. A trust account belongs beneficially to the trustee during his life. If there is an irrevocable trust, the account belongs beneficially to the beneficiary. N.J.S.A. § 17:16l-4c.
4.1.4. Right of Survivorship 4.1.4.1. Sums on deposit at the death of a party to a joint account belong to
the surviving party or parties unless there is clear and convincing evidence of a different intention at the time the account is created. N.J.S.A. § 17:16l-5a. If it can be demonstrated that the account was titled as a joint account for convenience purposes so that one party could assist the other party, then the account will not pass to the surviving joint owner. In re Estate of Penna, 322 N.J. Super. 417 (App. Div. 1999).
The statute creates a presumption of survivorship and disputes
involve whether the presumption can be rebutted. 4.1.4.2. On the death of the original payee of a P.O.D. account, the sums
on deposit belong to the P.O.D. payee. N.J.S.A § 17:16l-5b. 4.1.4.3. On the death of the sole trustee of a trust account, the sums on
deposit belong to the individuals named as beneficiaries, unless there is a clear evidence of a contrary intent. N.J.S.A. § 17:16l-5c.
4.1.4.4. A right of survivorship arising from the terms of the account, the
Multiple-party Deposit Account Act, a beneficiary designation, or a POD designation cannot be changed by a Will. N.J.S.A. § 17:16l-5e.
4.2 Practice Advice: Be sure your clients know and understand how their accounts are
titled.
97
5. Various Gifts and Other Transfers. 5.1. Outright gifts 5.1.1. Gifts between spouses
5.1.1.1. Clear and convincing evidence is required to establish a gift of personal property between spouses. Melosh v. Melosh, 127 N.J. Eq. 261 (E. & A. 1940); Bardo v. Bardo, 92 N.J. Eq. 106 (Ch. 1920); aff’d per curiam, 92 N.J. Eq. 230 (E. & A. 1920); Farrow v. Farrow, 72 N.J. Eq. 421 (E. & A. 1907).
5.1.1.2. A transfer of real property between spouses is presumed to be a
gift, but the presumption is rebuttable. Moses V. Moses, 138 N.J. Eq. 287 (Ch. 1946), aff’d in part, rev’d in part, 140 N.J. Eq. 575 (E. & A. 1947).
5.1.2. Gifts between parent & child
Minimal evidence is required to establish a gift between a parent and child. Metropolitan Life Ins. Co. v. Woolf, 136 N.J. Eq. 588 (Ch. 1945), aff’d, 138 N.J. Eq. 450 (E. & A. 1946); Peppler v. Roffe, 122 N.J. Eq. 510 (E. & A. 1937); Bankers’ Trust Co. v. Bank of Rockville Ctr. Trust Co., 114 N.J. Eq. 391, 399 (E. & A. 1933).
5.2. Gift “Causa Mortis”
5.2.1. A gift causa mortis is made by a donor in contemplation of the donor’s
impending death. A valid gift causa mortis has the following requirements:
5.2.1.1. the gift must be made in view of the donor’s impending death; 5.2.1.2. the donor must die of the disorder or peril contemplated; 5.2.1.3. the donor must be competent when the gift is made; 5.2.1.4. the donor must have intended to make a gift; 5.2.1.5. the donee must accept the gift; and
5.2.1.6. the delivery must be actual, unequivocal and complete during the donor’s life.
5.2.2. The delivery requirement is very important. It acts as a safeguard against
fraud and perjury. Scherer v. Hyland, 75 N.J. 127, 131 (1977). An
98
affirmative act by the donor is required and the mere taking of possession by the donee is not sufficient to satisfy the delivery requirement. Foster v. Reiss, 18 N.J. 41, 51 (1955).
5.3 Life Insurance
5.3.1. The interest of a designated beneficiary in a life insurance policy is a vested property right even when the insured has retained the right to change beneficiaries. The designated beneficiary’s interest in the policy can only be divested when there is a change of beneficiary made in accordance with the insurance contract. Prudential Ins. Co. of Am. v. Douglas, 110 F. Supp. 292, 294 (D. N.J. 1953). A mere statement of intent to change the beneficiary is not sufficient to effect a change. DeCeglia v. Estate of Colletti, 265 N.J. Super. 128, 132-133 (App. Div. 1993).
5.3.2. If a beneficiary is deemed “irrevocable” in accordance with the contract of
insurance, the beneficiary cannot be changed by the insured without the written consent of the beneficiary. An “absolute assignment” of a life insurance policy divests the insured of all rights to the policy. If there was no retention of the right to change the beneficiary, the beneficiary has a vested and absolute right to the insurance proceeds. Tompkins v. Tompkins, 132 N.J.L. 217, 221 (Sup. Ct. 1944).
5.3.3. Notwithstanding the foregoing, even when an insured reserves the right to
change the beneficiary of the policy, if a contractual agreement with respect to the policy is made, the beneficiary can still be held to be an “irrevocable” beneficiary. Haynes v. Metro. Life Ins. Company, 166 N.J. Super. 308, 313, 318 (App. Div. 1979).
5.3.4. Generally, life insurance proceeds are not subject to the claims of creditors
(provided, however, that does not apply if the beneficiary, assignee or payee of the policy is (i) the insured, (ii) the person effecting such insurance, or (iii) the executors or administrators of the insured or the person effecting the insurance). N.J.S.A. § 17B:24-6.
5.4. Gifts to Trusts (Some examples) 5.4.1. Irrevocable Life Insurance Trusts (“ILITs”)
Funding an ILIT is a method used to shelter life insurance proceeds from estate tax in the insured’s estate. Estate tax on life insurance can be avoided by transferring existing policies to an ILIT or having the ILIT purchase a new policy. Bogert’s The Law Of Trusts and Trustees § 1111. Under IRC §2035 and IRC §2042, if you own or have “incidents of ownership” on an existing life insurance policy on your life, and transfer
99
the policy or release the incidents of ownership within three years before your death, the proceeds will still be included in your estate. Incidents of ownership include the power to change the beneficiary, to surrender or cancel the policy, to assign the policy, to revoke an assignment, to pledge the policy for a loan, or to obtain from the insurer a loan against the surrender value of the policy. IRC §2035, IRC §2042, and Treas. Reg § 20.2042-1.
5.4.2. Grantor Retained Annuity Trusts (“GRATs”)
Grantor transfers assets to an irrevocable trust while retaining an annuity interest for a specified term of years, payable at least annually. At the end of the term, the assets remaining in the GRAT pass to the named remainder beneficiaries, either outright or in further trust. This enables the Grantor to give away the remainder interest with a reduced taxable gift. If the Grantor dies during the term, a portion of the GRAT is included in the Grantor’s estate. Zaritsky, Howard M., Tax Planning for Family Wealth Transfers, Fifth Edition, § 12.06[1]. IRC § 2702 and Treas. Reg. § 25.2702 et seq. Example A creates a GRAT with a 5 year term that provides for a level annuity payment of 5%. The value of the property transferred to the GRAT is $1,000,000 at the time of transfer, and the 7520 rate for the month in which the GRAT is created is 2%. The annual appreciation on the principal is 7%. When A creates the GRAT, A makes a taxable gift of $764,325 based on the term and 7520 rate. A will receive an annual annuity of $50,000 for 5 years. At the end of the term, the remainder beneficiaries will receive the property remaining in the GRAT having a value of $1,115,015.
5.4.3. Qualified Personal Residence Trusts (“QPRTs”)
Grantor transfers a personal residence to an irrevocable trust for a specified term of years and retains the right to live in the residence for the QPRT term. At the end of the term, the residence passes to the named remainder beneficiaries, outright or in further trust. This enables the Grantor to give away a personal residence with a reduced taxable gift. If the Grantor dies during the term, the date of death value of the residence is included in the Grantor’s estate. Bogert’s The Law of Trusts And Trustees § 264.10. IRC § 2702 and Treas. Reg. § 25.2702-5.
100
Example A (age 70) transfers a residence to a QPRT with a 10 year term. During the term, A reserves the right to live in the residence. The value of the residence transferred to the QPRT is $2,000,000 at the time of transfer, and the 7520 rate for the month in which the QPRT is created is 2%. Assume no appreciation on the residence. When A creates the QPRT, A makes a taxable gift of $1,114,780 based on A’s age, the term of the QPRT, and the 7520 rate. After 10 years, A’s beneficiaries will receive the residence valued at $2,000,000 with A only using $1,114,780 of gift exemption.
5.4.4. Intentionally Defective Grantor Trusts (“IDGTs”)
A trust that is intentionally disregarded for income tax purposes, but not for gift and estate tax purposes. Transactions between the Grantor and the trust are not subject to income tax, but the trust assets are excluded from the Grantor’s estate for estate tax purposes. Bogert’s The Law Of Trusts and Trustees § 1091. IRC § 671 et seq. All items of income, gain, loss, and deduction for an IDGT will be reported on the Grantor’s federal income tax return. Accordingly, the Grantor makes a tax free gift to the IDGT each time he pays income taxes generated by the IDGT.
6. Challenges to Inter Vivos Transfers.
6.1. Challenges to Inter Vivos Transfers can include lack of donative intent, failure to deliver, undue influence, fraud, and forgery.
6.2. Lack of Donative Intent
6.2.1. A lack of donative intent can be found when the donor retains control over the property. A donor who collects income from securities has not gifted those securities. Lebitz-Freeman v. Lebitz, 353 N.J. Super. 432 (App. Div. 2002).
6.2.2. Where donor clipped the coupons and kept the income from securities,
there was no gift where donor placed the securities in a safe deposit box in the names of donor and his daughter. In re Shiver’s Estate, 105 N.J. Super. 242, 246 (App. Div. 1969).
101
6.3 Undue Influence
6.3.1. A presumption of undue influence occurs when it can be proven that the recipient of a transfer had a confidential relationship with the donor or that a confidential relationship existed between the donor and the donee. Pascale v. Pascale, 113 N.J. 20 (1988).
6.3.2. Unlike undue influence in the context of a Will contest, there is no need to
show “suspicious circumstances” to raise a presumption of undue influence in connection with an inter vivos gift. Bronson v. Bronson, 218 N.J. Super. 389, 394 (App. Div. 1987).
In connection with a Will, a contestant must show both a confidential
relationship and “suspicious circumstances” to create a presumption of undue influence. In a gift context, the absence of a requirement of showing suspicious circumstances is based on the belief that a living donor is not likely to give away something that he or she can still enjoy. Pascale v. Pascale, 113 N.J. 20, 30-31 (1988).
6.3.3. When the relationship between the parties to an inter vivos gift is of such a
nature that there is a reasonable probability that they do not deal with each other on an equal basis because they have a friendship and justifiably have confidence in each other, that the donee has superior knowledge of the nature of the gift proposed by him, as well as the detriment to the donor, and the donee fails to be certain that the donor thoroughly understands the nature of the gift or its consequences, the gift should be regarded as voidable. In re Dodge, 50 N.J. 192, 227-228 (1967).
6.3.4. When a “confidential relationship” can be shown, the burden of proof
shifts to the recipient of the gift to show that no undue influence occurred. In re Dodge, 50 N.J. 192, 227 (1967).
6.3.5. A “confidential relationship” is a relationship where confidence is naturally inspired or reasonably exists. In re Fulper’s Estate, 99 N.J. Eq. 293, 314 (Prerog. Ct. 1926).
6.3.6. If the donor is dependent on the donee and makes a gift of all or virtually
all the donor’s assets, a presumption arises that the donor did not understand the consequences of the gift. Vanderbach v. Vollinger, 1 N.J. 481, 489, 64 A.2d 225 (1949). In this case, the recipient of the gift must show that the donor was represented by competent and disinterested counsel. Seylaz v. Bennett, 5 N.J. 168, 173 (1950). When the donor is not dependent on the donee, independent advice is not a prerequisite to the validity of the gift even if there is a confidential relationship. Seylaz v. Bennett, 5 N.J. 173, 174 (1950).
102
6.4. Joint Account – Right of Survivorship
6.4.1 If it can be shown that a “confidential relationship” is shared between the joint account holders, the burden is on the surviving owner to prove that the account was established free from undue influence. In re Penna, 322 N.J. Super. 417, 422 (App. Div. 1999).
6.4.2. The transfer of assets into a joint account where a confidential relationship
exists places the burden on the donee to demonstrate that there was no undue influence. The donee must show that the donor understood that the assets will pass to the donee rather than according to the estate plan embodied in her Will. Bronson v. Bronson, 218 N.J. Super. 389, 394 (App. Div. 1987).
6.5 Statute of Limitations
6.5.1. Actions in New Jersey based on a claim of undue influence with respect to inter vivos transfers could fall within the New Jersey “catch all” statute of limitations. N.J.S.A. § 2A:14-1, which provides for a 6 year statute of limitations, does not specifically refer to actions for undue influence. Nevertheless, the statute provides that every action for trespass to real property, for tortious injury to real or personal property, for taking, detaining, or converting personal property, for any tortious injury to the rights of another not stated in § 2A:14-2 and 2A:14-3 shall be commenced within 6 years after the cause of any such action shall have accrued.
6.5.2. New Jersey follows a “discovery rule” providing that the statute of
limitations does not begin to run until the claimant becomes aware of the injury. Molnar v. Hedden, 138 N.J. 96 (1994), rev’g 260 N.J. Super. 133 (App. Div. 1992).
7. Fraudulent Transfers
7.1. A transfer of property in trust for the use of the person making the transfer is void as against his creditors. N.J.S.A. § 25:2-1.
7.2. N.J.S.A. § 25:2-25 provides that a transfer made by a debtor is fraudulent as to a
creditor, whether the creditor’s claim arose before or after the transfer, if the debtor made the transfer:
7.2.1. With actual intent to hinder, delay, or defraud any creditor of the debtor;
or 7.2.2. Without receiving a reasonably equivalent value in exchange for the
transfer, and the debtor:
103
7.2.2.1. Was engaged or was about to engage in a business or a transaction for which the remaining assets of the debtor were unreasonably small in relation to the business or transaction; or
7.2.2.2. Intended to incur, or reasonably believed that the debtor would
incur, debts beyond the debtor’s ability to pay.
7.3. “Badges of Fraud” – In determining intent under N.J.S.A. § 25:2-25, consideration may be given, among other factors, to whether:
7.3.1. The transfer or obligation was to an insider (which under N.J.S.A. § 25:2-
22 includes relatives, certain business partners, affiliates and related entities, etc.);
7.3.2. The debtor retained possession or control of the property after the transfer; 7.3.3. The transfer or obligation was disclosed or concealed; 7.3.4. Before the transfer was made, the debtor had been sued or threatened with
suit; 7.3.5. The transfer was of substantially all the debtor’s assets; 7.3.6. The debtor absconded; 7.3.7. The debtor removed or concealed assets; 7.3.8. The value of the consideration received by the debtor was reasonably
equivalent to the value of the property transferred; 7.3.9. The debtor was insolvent or became insolvent shortly after the transfer; 7.3.10. The transfer occurred shortly before or shortly after a substantial debt was
incurred; and 7.3.11. The debtor transferred the essential assets of the business to a lienor who
transferred the assets to an insider of the debtor. N.J.S.A. § 25:2-26.
7.4. Banco Popular v. Gandi, 184 N.J. 161 (2005), holds that an attorney may be liable for conspiracy to violate the Uniform Fraudulent Transfer Act (UFTA), N.J.S.A. § 25:2-20 to -34, for his participation in a transfer. This case involved claims by a bank against an attorney for creditor fraud, common-law fraud, and negligence. Under the facts of the case, the bank claimed that the attorney assisted his client in transferring assets to defraud a creditor. According to the client/debtor, his attorney advised him to transfer all of his assets into his wife’s name to place them beyond a certain creditor’s reach. The attorney prepared deeds and other
104
documents effectuating the transfers. The bank issued the client loans before and after the fraudulent transfer, in reliance on the client’s representations and on an opinion letter from the attorney. The client was later unable to make payment on his debts.
8. Fiduciary Duty of Trustees.
8.1. Duty to retain, invest and manage the assets of the trust in a reasonable and prudent manner. In re Bayles’ Estate, 108 N.J. Super. 446 (App. Div. 1970).
8.2. Duty of “unflagging and undivided loyalty”. Cohen v. First Camden Nat. Bank &
Trust Co., 51 N.J. 11 (1967). 8.3. Duty to deal impartially with the beneficiaries. In re Koretzky’s Estate. 8 N.J. 506
(1951). 8.4. Duty to act within the scope of his powers. 7 N.J. Prac., Wills and Administration
§ 982 (Rev.3d ed.). 8.5. Duty to inform the beneficiaries of matters that materially affect the trust. 7 N.J.
Prac., Wills and Administration § 982 (Rev.3d ed.). 8.6. Duty to administer the trust solely in the interest of the beneficiaries. 7 N.J. Prac.,
Wills and Administration § 982 (Rev.3d ed.). 8.7. Standard of Care: 8.7.1. Must act within the scope of his powers.
8.7.2. Must exercise “… that degree of care and caution, skill, sagacity and judgment, industry and diligence, circumspection and foresight that an ordinary discrete and prudent person would employ in like matters of his own and in the same or similar circumstances.” In re Beales’ Estate, 13 N.J. Super. 222 (App. Div. 1951).
8.8. A fiduciary who invests and manages trust assets owes a duty to the beneficiaries
to comply with the “prudent investor rule” as set forth in the Prudent Investor Act N.J.S.A. § 3B:20-11.1 et seq. The prudent investor rule, however, may be expanded, restricted, eliminated or otherwise altered by the express provisions of the trust instrument. N.J.S.A. § 3B:20-11.2(b).
8.9. Also see the recently enacted New Jersey Uniform Trust Code N.J.S.A. § 3B:31-
54 et seq.
105
9. Gift Tax Issues
9.1. Gift Tax Returns – When is filing required?
9.1.1. If gifts were made in excess of the annual exclusion. Treas. Reg. § 25.6019-1.
9.1.2. To split gifts with a spouse (including for generation-skipping transfer
(“GST”) tax purposes). IRS Instructions to 2014 Form 709. 9.1.3. To affirmatively allocate GST tax exemption. Treas. Reg. § 26.2632-1. 9.1.4. To elect out of the “deemed allocation” rules for GST tax exemption.
Treas. Reg. § 26.2632-1. 9.1.5. To make adequate disclosure of gift or other transactions and start the
statute of limitations. Treas. Reg. § 301.6501(c)-1(f). 9.1.6. If (i) you are required to file a return to report noncharitable gifts and (ii)
you made gifts to charities, you must include all of your gifts to charities on the return. IRS Instructions to 2014 Form 709.
9.2 Adequate Disclosure Rules
9.2.1. In general, the statute of limitations (“SOL”) for assessment of tax is three years after a return is filed. IRC § 6501(a). Some exceptions:
9.2.1.1. If any gift required to be shown on a return is not reported, the
SOL remains open. This does “… not apply to any item which is disclosed in such return, or in a statement attached to the return, in a manner adequate to apprise the Secretary of the nature of such item.” IRC § 6501(c)(9). See also Tres. Reg. § 301.6501(c)-1(f) [discussed below].
9.2.1.2. For income tax, there is a six year SOL in the case of an omission
in excess of 25% of gross income, an omission attributable to a foreign financial asset, or an omission of a constructive dividend. IRC § 6501(e)(1).
9.2.1.3. For estate and gift tax, there is a six year SOL if an estate or gift
tax return omits from the gross estate or from the total amount of gifts items includible in the gross estate or total gifts as exceed 25% of the gross estate stated in the return or total amount of gifts stated in the return, as the case may be. IRC § 6501(e)(2).
106
9.2.2. General requirements of “adequate disclosure” regulations – Treas. Reg. § 301.6501(c)-1(f):
9.2.2.1 Description of transferred property and any consideration received
by transferor. Treas. Reg. § 301.6501(c)- 1(f)(2)(i). 9.2.2.2. Identify of, and relationship between, transferor and transferee.
Treas. Reg. § 301.6501(c)-1(f)(2)(ii). 9.2.2.3. If property is transferred in trust, trust’s taxpayer identification
number and either: (a) brief description of terms governing trust or (b) copy of trust instrument. Treas. Reg. § 301.6501(c)-1(f)(2)(iii).
9.2.2.4. Either of the following two requirements:
i. A description that satisfies the requirements of Treas. Reg. § 301.6501(c)-1(f)(2)(iv), which include a “detailed description of the method used to determine the fair market value of property transferred”, OR
ii. An appraisal meeting the requirements of Treas. Reg. §
301.6501-1(f)(3).
9.2.2.5. Statement describing any position taken contrary to proposed, temporary, or final Treasury Regulations or revenue rulings published at time of transfer. Treas. Reg. § 301.6501(c)-1(f)(2)(v).
10. Audit Issues
10.1. Life Insurance
10.1.1. Inclusion of life insurance proceeds on the life of the decedent under IRC § 2042.
10.1.2. Inclusion of life insurance policies transferred within 3 years of death
under IRC § 2035. 10.1.3. Federal Estate Tax Return (Form 706), Schedule D Requirements: “You must list all policies on the life of the decedent and attach a Form
712 for each policy.” 10.1.4. What is the IRS asking for on audit? “Copies of policy applications and/or
policy transfer documents; copies of cancelled checks evidencing premium payments and proof that decedent did not make these premium
107
payments or that they were reported as gift transfers.” (This is an excerpt of an actual information request from the IRS.)
10.1.5. Irrevocable Life Insurance Trust (“ILIT”)
10.1.5.1. Where are your Crummey letters? (Actual question by auditor during in person meeting)
10.1.5.2. Who paid the life insurance premiums? (Question by auditor in
initial letter notifying Estate of an audit)
10.1.6. Proof of Transfers of Life Insurance Policies During Decedent’s Life 10.1.7. How do you prove ownership transfer by Decedent more than 3 years
before death? Provide: copies of ownership and beneficiary change forms; letters from
the insurance company identifying the transferee as the owner of the policy; gift tax return reporting gift of cash to the new policy owner to be used for the payment of premiums; etc.
10.1.8. Practical Advice: Keep records. If a policy is transferred to a third party by
gift or by sale, it might not be so easy getting information from the new policy owner 10-20 years after the transfer.
10.2. Reciprocal Trust Doctrine
10.2.1. Generally, if A transfers assets to an inter vivos trust for the benefit of B and B transfers assets to an inter vivos trust for the benefit of A, the IRS may attempt to include the assets that A uses to fund the trust A establishes for B in A’s estate and the assets that B uses to fund the trust B establishes for A in B’s estate, if the trusts are too similar. Rev. Rul. 57-422, 1957-2 C.B. 617 (1957).
10.2.2. The IRS will apply the reciprocal trust doctrine if the two trusts are
interrelated and similar enough to each other such that A and B are in the same economic position had they each established the trust for their own benefit. To avoid the application of the doctrine, the trusts must have different terms. The greater the differences in the trusts, the more likely the IRS will be unsuccessful in applying the doctrine. United States v. Grace’s Estate, 395 U.S. 316 (1969). Levy Est. Comr., T.C. Memo 1983-453.
10.3. Valuation 10.3.1. Who engages the appraiser? Client or attorney?
108
It is generally preferable to have an attorney engage the appraiser rather than the client for purposes of asserting the attorney work product privilege.
10.3.2. Valuation Discounts
10.3.2.1. Discount for Lack of Marketability. Generally, a “discount for lack of marketability” is an amount or percentage deducted from the value of an interest in property reflecting the costs and barriers associated with selling the interest and the absence of a viable market.
10.3.2.2. Discount for Lack of Control (“Minority Interest”). Generally, a
“discount for lack of control” is the reduction from a pro rata share of the value of the entire entity reflecting the inability to control the entity.
10.3.2.3. Examples of actual audit results for minority interests in operating
companies: i. Example of Case Settled at IRS Appeals Office.
Federal Estate Tax Return reported the following discounts for minority interests in four different operating companies: Company A: lack of marketability – 40%; lack of control – 9.1% Company B; lack of marketability – 25%; lack of control – 29.7% Company C: lack of marketability – 40%; lack of control – 9.1% Company D: lack of marketability – 40%; lack of control – 9.1% Auditor’s Determination: Company A: lack of marketability – 15%; lack of control – 0% Company B: lack of marketability – 15%; lack of control – 0%
109
Company C: lack of marketability – 20%; lack of control – 0% Company D: lack of marketability – 20%; lack of control – 0% Settlement at Appeals Office: Combined discount of 39% for lack of marketability and lack of control for all four companies.
ii. Example of Case Settled at IRS Audit Level.
Unique facts existed in a case where Decedent owned 100% of the voting stock (5% of the equity) and none of the non-voting stock of an operating company. The entity was valued by the appraiser and the IRS on a liquidation value (as both concluded that the company had a higher value if it were liquidated than continuing to be operated as a going concern). The Estate’s appraiser found a lack of marketability discount of 10%. Case eventually settled at the audit level with a lack of marketability discount of 5%. The discount was found appropriate due to: expenses related to liquidation and asset sales (including commissions); time value of money while assets on the market; different types of assets being sold; etc.
10.3.2.4. Valuing Tenant-In-Common Interests in Life Insurance
i. Decedent owned a 1/6 tenant in common interest in a life insurance policy on the life of Decedent’s parent who survived Decedent. Estate requested and obtained from insurance company IRS Form 712 providing the date of death value. Appraiser divided the Form 712 value by 6 and then took a 14% minority interest discount and a 15% lack of marketability discount.
ii. IRS denied all discounts arguing that an insurance policy is
not a business and the discounts ordinarily used for business purposes are not applicable to life insurance policies. IRS also argued, “… the owner of a life insurance policy only needs to collect the death benefits upon the death of the insured.”
110
iii. IRS Appeals Office agreed to a combined minority interest and lack of marketability discount of 20%.
10.4 Transfers of Business Interests During Decedent’s Life. 10.4.1. What is the IRS asking for in an Estate tax audit?
“- Corporate income tax returns and complete financials for the entity from 2008-2012; - shareholder agreements; - copies of stock transfer documents; - complete listing of shareholders, including number of shares owned by each and how and when shares were acquired; - detailed information regarding any sales, transfers or redemptions of any interest in the company.” (This is an excerpt of an actual information request from the IRS.)
10.4.2. Practical Advice: Keep records of sales of business interests by the
Decedent, by an entity controlled by the Decedent, or other parties. For example, keep: appraisals and/or valuation methodologies; proof sale price was paid; if a promissory note was the consideration, keep proof that the promissory note was paid off; shareholders’ and partnership agreements; purchase and sale agreements; corporate resolutions and directors’/shareholders’ consents approving the transactions; stock powers; stock certificates; etc.
10.4.3. For an installment sale, auditor accepted IRS Form 6252- Installment Sale
Income as evidence that the note was paid off. IRS Form 6252 is used by the seller to report income under the installment method.
10.4.4. IRS will ask for records related to transactions that occurred many years
ago. In one case, the IRS requested financial information related to transactions that occurred in the 1990s. Estate provided the IRS with a letter from the accounting firm stating that their “Documentation Retention Policy” was to maintain records for 7 years. This helped, but it would be better to have the records. Estate does not want to give the impression that it is hiding anything.
The information contained in this outline is general in nature and is based on authorities
that are subject to change. It is not intended, and should not be construed as, legal or tax
advice provided to the reader. This material is not necessarily applicable to, or suitable
for, specific circumstances or needs.
111
This outline and the related discussion are not intended to summarize all issues raised by
the IRS in the past nor are they intended to be an indicator of what the IRS will be
questioning in the future. The audit results discussed in this outline are not a guaranty
or indicator of future results.
112
CONTESTING A WILL – SELECTED PRINCIPLES OF LAW
Matthew T. Aslanian, Esq.
I. UNDUE INFLUENCE
A. Presumptions and Burdens
In any attack upon the validity of a Will, it is generally presumed that “the
testator is of sound mind and competent when he executed the Will.” Haynes v. First
National State Bank of New Jersey, 87 N.J. 163, 175-76 (1981); Gellert v. Livingston, 5
N.J. 65, 71 (1951). However, if a Will contestant is able to establish that the Will was
obtained through the exercise of "undue influence" over the testator, the Will is deemed
to be invalid, as it will not reflect the testator's testamentary intent. Haynes, supra, 87
N.J. at 176.
“Undue influence” has been defined as mental, moral or physical exertion
that destroys the “free agency” of a testator and prevents the person over whom it is
exerted “from following the dictates of his own mind and will and accepting instead the
domination and influence of another.” In re Neuman, 133 N.J. Eq. 532, 534 (E. & A.
1943); Pascale v. Pascale, 113 N.J. 20, 30 (1988); In re Hale’s Will, 21 N.J. 284, 288
(1956) (to constitute undue influence, there must be a disruption of “the freedom of will
and judgment of the testator”). Thus, the voluntariness of the act is the essential point in
issue, and once the court is satisfied that there was a free exercise of judgment and discre-
tion, the Will must be upheld. In re Blake’s Will, 21 N.J. 50, 56-57 (1956); Matter of
113
Will of Liebl, 260 N.J. Super. 519, 528 (App. Div. 1992), certif. den., 133 N.J. 431
(1993).
Moreover, “[m]otive and opportunity to exercise undue influence of
themselves do not constitute sufficient proof. It must be made evident that the motive
was pursued and the opportunity actually so employed so as to destroy the free agency of
the testatrix.” See In re Filo’s Will, 9 N.J. Super. 146, 150 (App. Div. 1950).
When an allegation of undue influence is made,
[T]he burden of proving undue influence lies upon the
contestant unless the Will benefits one who stood in a
confidential relationship to the testatrix and there are
additional circumstances of a suspicious character present
which require explanation. In such case the law raises the
presumption of undue influence and the burden of proof is
shifted to the proponent. [Emphasis Supplied].
Haynes, supra, 87 N.J. at 176, citing In re Rittenhouse’s Will, 19 N.J. 376, 378-79 (1955).
Also see, of course, the more recent opinion in In Re Stockdale, 196 N.J. 275, 303
(2008).
B. The Existence of a “Confidential Relationship”
When a beneficiary stands in a “confidential relationship” to the testatrix
and additional suspicious circumstances exist, even though “slight”, a presumption of
undue influence is raised and the burden of proof is shifted to the proponent. In re
Hopper, 9 N.J. 280, 282 (1952); Matter of Will of Liebl, 260 N.J. Super. at 528. In re
Will of Catelli, 361 N.J. Super. 478, 486 (App. Div. 2003). Although a confidential
relationship “is not confined to any specific association,” an example of such a
relationship is a fiduciary relationship. F.G. v. MacDonell, 150 N.J. 550, 563 (1997);
114
Stroming v. Stroming, 12 N.J. Super. 217, 224 (App. Div. 1951), certif. denied, 8 N.J.
319 (1951). It has also been defined as a relationship in which “the circumstances make
it certain that the parties do not deal on equal terms.” Id. at 224.
In Stroming, even though the parties were mother and son, and business
associates, the court concluded that since they dealt on terms of equality, and the mother
was normal, never incoherent, of keen mind, and seemed to lack any sign of dependence,
“the essentials of a confidential relationship . . . do not appear.” Id. Thus, gestures of
friendship, care and affection alone do not equate to the dominance which is an essential
ingredient of a “confidential relationship.” In re Estate of Churik, 165 N.J. Super. 1, 6
(App. Div. 1978), aff’d, 78 N.J. 563 (1979).
Likewise in Ostlund, the Appellate Division found that a father and son did
not have a confidential relationship when the father lived independently, occasionally
worked, was of sound mind when he created a will, consulted a lawyer of his own
choosing, and was described as a stubborn man. Ostlund v. Ostlund, 391 N.J. Super. 390,
403 (App. Div. 2007). The fact that the father had certain health problems, had a 24-hour
caretaker, and was at times forgetful did not lead the court to conclude that a confidential
relationship existed between father and son.
In contrast, the Estate of Balgar court found, and the defendant daughter
conceded, a confidential relationship between a mother and daughter based on the
following facts: the mother did not speak or read English, was legally blind, the mother
executed a power of attorney designating the daughter as her attorney in fact, suffered
from a heart ailment, and the daughter was the primary person who assisted her mother
115
from 1998 until the mother’s death in 2003. Estate of Balgar, 2007 WL 1147081, *1-2
(App. Div. 2007); see also Pascale v. Pascale, 113 N.J. 20, 34 (1988) (finding a
confidential relationship when a father delegated his financial and legal affairs to his son
even though the trial court found that the father was an “obdurate, domineering, blunt,
outspoken, vindictive, crafty and intelligent”); Estate of Penna, 322 N.J. Super. 417, 424
(App. Div. 1999) (finding a confidential relationship between a mother and daughter
based on the familial relationship and the trust the mother placed in her daughter); Estate
of Fulper, 99 N.J. Eq. 293 (Prerog. 1926) (father and son had a confidential relationship
when the court found that the father depended on the son for assistance in business
matters, spent winters at the son’s home, held a joint account with the son, and was
physically dependent on the son during the time the father transferred the son’s asset).
Upon reviewing these cases, the following can be extrapolated: the granting
of a power of attorney does not necessarily give rise to a confidential relationship, but is a
factor in the determination. See Estate of Celso, 2007 WL 4105277, *5-6 (App. Div.
2007); In re Sable, 2009 WL 321558 (App. Div. 2009); Mangarelli v. Snyder, 2012 WL
1698033, *2 (App. Div. 2012).
116
C. “Suspicious Circumstances” Sufficient To
Shift The Burden Of Proof For Undue Influence
Suspicious circumstances are, in essence, “circumstances suggestive of any
inequality, unfairness, imposition, or overreaching.” In re Blake’s Will, supra, 21 N.J. at
55. The testator’s prior testamentary disposition may be examined in determining
whether “suspicious circumstances” exist to require a shifting in the burden of proof. In
re Smalley, 124 N.J. Eq. 461, 465 (Prerog. 1938), aff’d, 126 N.J. Eq. 217 (1939). Other
factors which courts have considered in evaluating whether the requisite suspicious
circumstances exist are the following: (1) changes to the general scheme of estate
planning; (2) the decedent's medical/physical condition; (3) the procurement of the
attorney drafting the Will; and (4) participation of the beneficiary in the preparation of the
Will. Skillman v. Lanehart, 73 N.J. Eq. 340, 342 (Prerog. 1907); Kuruc v. Kuruc, 23
N.J. Super. 584, 590 (Ch. Div. 1952) (finding that suspicious circumstances include: “(1)
the initiation of proceedings for the preparation of the instrument; (2) participation in
such preparation; (3) presence at the execution of the will; (4) efforts to exclude the
natural objects of testator’s bounty from his society; (5) concealing the making of the
will; and (6) taking possession of the will.”).
117
For example, in In re Neuman, 133 N.J. Eq. at 535, the court rejected the
contentions that the silence of the testatrix respecting her Will and her "denial of
execution of any papers" while she was hospitalized was indicative of suspicious
circumstances sufficient to constitute undue influence. Id. at 542, 543. In rejecting this
argument, the court concluded that the “will was her own personal affair . . . . It is not
customary to discuss the provisions of one's will or to advise even relatives what
disposition has been made of one's property.” Id. at 543.
The court also emphasized that the testatrix
. . . was not a person likely to be either coerced, intimidated or
cajoled. A reading of the record rather compels the notion
that she was a determined, strong-willed woman who knew
exactly what she wanted to accomplish and acted accordingly.
Id. at 535. Thus, the claim of undue influence was rejected, and the Will admitted to
probate. Id.
In Ward v. Harrison, 97 N.J. Eq. 309, 314 (E. & A. 1924), the court held
that no presumption of undue influence arose merely from the active participation of the
beneficiary in the preparation of the will. The court went on to state that such a
circumstance “may or may not” be a factor towards establishing undue influence, and that
whether there was such influence “must be disclosed by other circumstances and
conditions than the mere drafting of a will and being a beneficiary thereof.” Id.
Similarly, in In re Rein’s Will, 139 N.J. Eq. 122, 133 (Prerog. 1947), the
court relied upon the holding in Ward and held that no presumption of undue influence
arose from the active participation by the beneficiary in the drafting of the Will. In Rein,
118
the proffered will was typed by the named beneficiary, which the court stated
undoubtedly constituted participation in the preparation of the will. Id. However, the
court went on to hold that such participation
was no more influential in the making of the will than had the
testator requested the beneficiary to purchase for him from the
stationer a printed form of will complete except for the
insertion of the name of the beneficiary, and she had done so.
The will was not composed by her. She followed strictly the
testator's instruction to copy the will prepared by Mr.
Gibbons, making only the two changes already discussed.
Her work was wholly mechanical and there was not given to
her any discretion whatever in respect of substance, language
or form.
Id.
A similar result was reached in In re Estate of Churik, 165 N.J. Super. 1, 4
(App. Div. 1978), where the court rejected the contestant's contention that a presumption
of undue influence arose out of the alleged confidential relationship between the decedent
and her niece-beneficiary. In Churik, the niece-beneficiary arranged to find a new lawyer
for the testatrix at her request, undertook to make arrangements for the testatrix to be
moved from a hospital to a nursing home and took steps to secure information as to the
assets of the estate from the testatrix' former lawyer. Id. at 5. Despite these
circumstances, the court found that no undue influence had been exerted over the niece in
that the decedent “was an individual with a strong mind and will and in full control of her
mental faculties at the time she executed her will.” Id. The court further stated that the
niece's motives in "lavishing attention" on her aunt during the period of her illness, or
whether such attention may have influenced decedent to change her Will, were not
119
determinative of “undue influence.” Id. at 6. Indeed, the court explained that it was only
when it can be shown that the freedom of will and judgment of the testator was
“destroyed” that undue influence would be established. Id.
Likewise, although the In re Gotchal’s Estate court found that no
confidential relationship existed between a father and son when the father, who spoke
modest English, lived with the son, the son presented sufficient evidence to rebut the
presumption of undue influence even if a confidential relationship was found. 10 N.J.
Super 208, 213 (App. Div. 1950). The court concluded that the father initiated the
decision to prepare the will and the will expressed his testamentary design. Id. at 213-4.
Moreover, although the father did not speak English, he consulted an
attorney who had known the father and his family for 30 years and who spoke the father’s
native language. Id. at 214. Likewise, the fact that the son accompanied the father to the
attorney’s office and remained in the room while the attorney drafted the father’s will was
not sufficient to give rise an inference of undue influence because the son remained silent
throughout the execution of the will. Id. at 214-5. Indeed, the fact that the son lived with
and cared for the father did not rise to undue influence. Id. at 215 Thus, “[t]he
disposition [wa]s not anomalous in the circumstances proved ‘because of equal logic and
reason is the inference that it was induced by the influence of kind intentions and care,
naturally producing affection and good will.’” Id. at 215 (citing In re Filo’s Will, supra).
120
D. A Proponent’s Burden Of
Disproving Undue Influence
Under ordinary circumstances, the will proponent must overcome the
presumption of undue influence (in cases in which the burden shifts) by a preponderance
of the evidence. In re Weeks, 29 N.J. Super. 533, 538 (App. Div. 1954).
The New Jersey Supreme Court has recognized that “there [are] situations
calling for a stronger presumption of undue influence and a commensurately heavier
burden of proof to rebut the presumption [of undue influence].” Haynes, supra, 87 N.J. at
178. In Haynes, the Court held that the proponent must disprove undue influence by
“clear and convincing evidence” under the peculiar facts and circumstances of that case.
In Haynes, the factual scenario involved attorney misconduct in which the Court noted
that there should be “an especially strong presumption of undue influence.”
In Haynes, the Court stated as follows with regard to the burden of
disproving undue influence:
[A]lthough we need not decide the issue today, there may be
situations other than those raised in this case, which require
that the presumption of undue influence be overcome by clear
and convincing evidence rather than the normal requirement
that only a preponderance of the evidence need be proven.
Thus, for example, Judge Clapp would impose the higher
burden “where the finger of suspicion points strongly at the
proponent, implicating him with the alleged undue influence
and . . . where the rebuttal of the presumption must come
from him.” 5 N.J. Practice (Clapp, Rules of Administration),
Section 62 (3rd ed. 1962, supp. 1990).
Haynes, supra at 183, n. 6. Recently the Supreme Court affirmed its holding in Haynes:
Although that burden of proof is usually discharged in
121
accordance with the presumption of the evidence standard,
[…] if the presumption arises from ‘a professional conflict of
interest on the part of an attorney, coupled with the
confidential relationships between a testator and the
beneficiary as well as the attorney,’ the presumption must be
instead be rebutted by clear and convincing evidence […] “An
attorney-client relationship is inherently a confidential
relationship … and because suspicious circumstances need
only be slight, the existence of that relationship alone often
results in both the shifting of the burden of proof and in the
imposition of the heavier burden of clear and convincing
evidence to rebut the presumption.
Estate of Stockdale, 196 N.J. 275, 303-4 (2008); see also In re Probate or Alleged Will of
Landsman, 319 N.J. Super. 252 (App. Div. 1999), certif. denied, 161 N.J. 335.
In Landsman, for example, decedent died leaving two known wills.
Landsman, 319 N.J. Super. at 258. The first will named decedent’s accountant as the
executor of his estate, providing accountant and his wife with a bequest. Id. The first
will also provided for decedent’s relatives and charities. Id. The second will, drafted two
years later, increased the bequest to the accountant and disinherited one of decedent’s
closest relatives. Id. The court found that the accountant had to rebut the presumption of
undue influence by clear and convincing evidence, as there existed a conflict of interest
between the attorney who drafted the will for the decedent and the accountant, the
beneficiary. Id. at 264. The accountant had a longstanding friendship with the attorney,
the accountant performed work for the attorney, and the attorney regularly referred clients
to the accountant. Id. at 258. The court concluded, “[s]uch relationships are of the kind
that ordinarily engender a sense of loyalty, irrespective of the absence of a true attorney-
client relationship.” Id. Thus, the attorney had a conflict of interest pursuant to RPC
122
1.7(b), which imputes a conflict “if the representation of that client may be materially
limited by the lawyer’s responsibilities to … a third person, or by the lawyer’s own
interests….” due to his longstanding relationship with the accountant. Id. at 265.
II. DUE EXECUTION OF THE WILL
A. Statutory Requirements for a Will's Execution
Pursuant to N.J.S.A. 3B:3-1, any person 18 years or older who is of sound
mind may make a will. The requirements for the formal execution of a will are found in
N.J.S.A. 3B:3-2, which provides in relevant part as follows:
[E]very Will shall be in writing, signed by the testator or in
his name by some other person in his presence and at his
direction, and shall be signed by at least two persons, each of
whom witnessed either the signing or the testator's
acknowledgment of the signature or of the Will.
The requirements that the Will be in writing and signed by the testator serve
an evidentiary function by providing reliable evidence of the authentication of the Will
and of the testamentary intent. Matter of Will of Ranney, 124 N.J. 1, 11 (1991). Thus,
with respect to a formally executed Will, a presumption of due execution of testamentary
intent arises from the face of the will itself. Matter of Will of Smith, 108 N.J. 257, 263
(1987); Matter of Catanio, 306 N.J. Super. 439, 446 (App. Div. 1997).
It is generally acknowledged that the attesting witnesses to a will serve two
functions, which have been characterized as “observatory” and “signatory”. Matter of
Estate of Peters, 107 N.J. 263, 274 (1987); In re Alleged Will of Ferree, 369 N.J. Super.
136 (Ch. Div. 2003), aff’d., 369 N.J. Super. 1 (App. Div. 2004). The observatory
123
function consists of the witnessing of: (1) the testator’s signature; or (2) the testator’s
acknowledgment of the Will. Peters, 107 N.J. at 274. Similarly, the signing of the Will,
or the “signatory” function, “has significance as an evidentiary requirement or probative
element, serving both to demonstrate and confirm the fulfillment of the observatory
function by the witnesses.” Id. at 274-75. The purpose of these execution formalities is
to prevent a Will from being fraudulently obtained, or obtained through undue influence.
Id. at 276.
A beneficiary under a Will executed after the effective date of the statute, as
here, may also be an attesting witness to such Will pursuant to N.J.S.A. 3B:3-8.
It is well-established that an attestation clause that describes compliance
with all statutory requirements for the execution of a Will is prima facie evidence of due
execution. This is true even if the testimony of one of the attesting witnesses does not
confirm the attestation clause. In re Saenger’s Estate, 133 N.J. Super. 151 (Essex Cty. Ct.
1975); In re Lazzati’s Will, 131 N.J. Eq. 54 (E. & A. 1942). In addition, the facts
memorialized by the attesting witnesses in the attestation clause may not be impeached or
contradicted by such witnesses except on the clearest and most convincing proof, and all
doubts must be resolved in favor of the facts recited in the clause. In re Rein’s Will, 139
N.J. Eq. 122, 126 (Prerog. 1947).
For example, in In re Rein’s Will, one of the three attesting witnesses to a
will admitted that she was present at the time and place of the execution of the Will, to
which the other two attesting witnesses had testified, but she denied the presence of those
other witnesses, recalled no will, and questioned her own signature on the Will. Id. at
124
125. She further testified that her signature appeared to be genuine, but insisted that she
had not placed it there and could not recall the details relating to the execution of the will.
Id. The court discounted this testimony on the ground that it directly contradicted her
sworn statement in the attestation clause, as well as the testimony of the other two
attesting witnesses, holding that:
The contradiction or impeachment of an attestation clause by
one of the witnesses thereto is a grave matter and ought not be
accepted except upon the clearest and most persuasive
testimony. All doubts should be resolved in favor of the facts
recited in the attestation clause, and this principally for the
reason that the testator, the most important witness, is beyond
recall.
Id. at 126. The court summed up the credibility to be given such a witness as follows:
[A]s a matter of law, a person who as a subscribing witness
goes upon the stand and upon his oath asserts to be false that
which in the execution of the will he, by a most solemn act,
asserted to be true, deserves to be discredited, and is worthy
of but little belief. Id. at 127, citing In re Halton, 111 N.J. Eq.
143 (Prerog. 1932).
B. The Effect Of A Self-Proving
Affidavit Under N.J.S.A. 3B:3-4
Self-proving affidavits are sworn statements by eyewitnesses that the Will
has been duly executed. Matter of Will of Ranney, supra, 124 N.J. at 8. The affidavit
performs virtually all of the functions of an attestation clause, and has the further effect of
permitting probate without requiring the appearance of either witness. Id. at 8-9.
Pursuant to N.J.S.A. 3B:3-4, a Will executed on or after September 1, 1978
may be simultaneously executed, attested and made self-proved by acknowledgment
thereof by the testator and affidavits of the witnesses made before a person authorized to
125
administer oaths. Matter of Will of Smith, 108 N.J. at 262 (“[U]nder the Wills Act, an
acknowledgment by the testator and the execution of an affidavit by the attesting
witnesses make a Will self-proving”). In this matter, the testamentary character of the
will will be manifest on its face. Id.
III. COMPETENCE TO EXECUTE A WILL
However, the “legal presumption” is that a testator is of sound mind and
competent when he executed the will. Gellert, supra, 5 N.J. at 71. The contestants thus
have the burden of proving that the testator did not have the capacity to make a Will. 5
Clapp, Wills and Administration, §38, pp. 160-62 (3rd ed. 1982). Moreover, some courts
have held that such burden may only be satisfied by “clear and convincing” proof. In re
Hoover, 21 N.J. Super. 323, 325 (App. Div. 1952); In re Estate of Coffin, 103 N.J. Super.
1, 3 (App. Div. 1968); Pivnick v. Beck, 326 N.J. Super. 474, 484 (App. Div. 1999), aff’d,
165 N.J. 670 (2000); In re Araneo Will, 211 N.J. Super. 456, 460 (Law Div. 1985). The
absent-mindedness or forgetfulness of the decedent does not evidence a lack of
testamentary capacity sufficient to execute a Will. In re Livingston’s Will, 5 N.J. 65, 77
(1950).
The amount of testamentary capacity necessary to execute a Will has been
held to be minimal. See Gellert v. Livingston, 5 N.J. at 73; In re Rein's Will, 139 N.J. Eq.
at 132. Indeed, as the court held in Rein, at 132,
[A testator’s] memory may be imperfect, it may be greatly
impaired by age or disease, he may not even be able to recall
the names of his relatives, he may at times do childish things,
126
speak disjointedly, ask idle questions, repeat questions which
have before been asked and answered, and fly abruptly from
one subject to another, and yet may possess capacity to make
his will.
IV. REVOCATION
A will may only be revoked:
1. By a subsequent Will which revokes the former Will in whole or in
part, expressly or by inconsistency; or
2. By being burned, torn, cancelled, obliterated or destroyed with the
intent and for the purpose of revoking by the testator or by another
person in his presence and at his direction.1
N.J.S.A. 3B:3-13
It is well-established that a Will may only be revoked in the manner
provided by statute, and cannot be changed, annulled, or in any manner affected by only
verbal declarations of the testator made after its execution. Meeker v. Boylan, 28 N.J.L.
274 (Sup. Ct. 1860). Moreover, the party asserting a revocation has the burden of
proving it. 5 Clapp, Wills and Administration, supra, 75, p. 265. Indeed, where a will
has been regularly made, the presumption of law is strong in its favor, and the intention to
revoke must be “plain and without doubt.” Id.2
This principle was recognized by the New Jersey Supreme Court in the
seminal case of Meeker v. Boylan, 28 N.J.L. at 285, where the Court explained that the
1 By an amendment in 2004, presumably applicable only to wills executed after its effective date, N.J.S.A. 36:3-13
was amended to read as set forth in Exhibit A hereto. 2 In addition, at least one New Jersey Court held more than 65 years ago that testimony concerning purported
declarations made by a testator that he had revoked a will or intended to make a new will is hearsay and is not
admissible to establish a new will. In re Haness, 98 N.J. Eq. 645, 648 (Prerog. 1925).
127
specific “solemnities” required for revocation of a Will “show clearly the legislature’s
intent to protect wills, when executed, by the most stringent requirements of evidence of
revocation.” The court thus strongly rejected the argument that alleged verbal
declarations of a testator made subsequent to the execution of a Will constituted an
implied revocation, holding as follows:
No proof of declarations of revocation made by the testator,
though proved by a cloud of witnesses to have been made
times without number, will avail. The statutory evidence
must be had or the intended revocation fails. If proof by any
number of witnesses that the testator said, after the execution
of the will, I hereby revoke and declare it null and void, will
not avail to destroy the will, why should proof by the same
number that he said, I never executed any will, have that
effect? Is not the liability to perjury the same in both cases?
Is not the clear actual will of the testator frustrated as much by
the rejection of the one evidence as the other? Should a
difference in the phrase admit one declaration, and reject the
other, when the effect of both is the same, to change what
otherwise the law declares to be the will of the testator?3
(Id. at 285-86); In re Garver, 135 N.J. Super. 578, 580 (App. Div. 1975) (the revocation
statute “embodies a strong policy against implied revocation of wills”).
In so holding, the Court concluded that such alleged verbal declarations,
assuming they were made, were particularly untrustworthy, in that a testator may “make
statements calculated and intended to deceive those with whom he is conversing.” Id. at
283. Indeed, the court went as far as to say that “[t]he experience of every one must
satisfy him that an inquiry made of a testator, as to the contents of his will, rarely elicits
3 Indeed, in Meeker, the alleged declarations of the testator consisted of statements that he had never signed the will. Id
at 282. The court stated that, assuming the testator did declare that he had never executed the will, and that if any such
will was produced, it would be a forgery, such statements were insufficient to overcome the presumption that the duly
executed and witnessed will was valid. Id. To hold that such statements constituted a revocation would be “in clear
128
the truth.” Id.
Similarly, in In re Haness, 98 N.J. Eq. 645, 648 (Prerog. 1925), the will
contestants attempted to establish that the testator had revoked his Will through the
presentation of testimony concerning purported oral declarations of the decedent as to
whom he made beneficiaries under his Will, which statements were completely
inconsistent with the terms of the Will. For example, the court described the testimony of
the various witnesses as follows (Id.):
To some of the witnesses he is alleged to have said that he
intended to make a will in favor of a son and daughter; to
some he is alleged to have said that he had made a will in
favor of all his children; to some he is alleged to have said
that he had given his house in Dover to his daughter; to some
he is alleged to have shown a large envelope with a red seal
on its back, at the same time stating that the contents of the
envelope provided for the same daughter after his death.
In rejecting the argument that such oral declarations constituted a revocation of his Will,
the court held that the will could be revoked “only in the manner provided by statute, that
is, by burning, canceling, tearing or obliterating it by the testator, or by his direction, or by
a writing executed with the same formalities as the will itself.” Id. at 648-49. The court
went on to hold that:
No proof of declaration of revocation made by the testator
will avail the appellant below and the evidence as to the
declarations of the testator that he had made or intended to
make another will was hearsay and should not have been
admitted.
Id. at 649.
contravention of the statute of wills, its whole policy, scope and object.” Id. at 284.
129
The recent cases, In re Macool, 416 N.J. Super 298 (App. Div. 2010), and
In Re Ehrlich, 427 N.J. Super. 64 (App. Div. 2012), may also have some relevance, even
though they dealt with alleged wills rather than revocations.
130
About the Panelists… Matthew T. Aslanian is an associate with Orloff, Lowenbach, Stifelman & Siegel, P.A. in Roseland, New Jersey. He works on complex litigation matters in federal and state courts, including shareholder disputes in closely-held companies, class action defense, fiduciary disputes and consent matters, appellate practice, commercial breach of contract actions and complex lawyer-related litigation. Mr. Aslanian is admitted to practice in New Jersey and before the United States District Court for the District of New Jersey and the Third Circuit Court of Appeals. He is a member of the Brennan-Vanderbilt American Inn of Court. Mr. Aslanian received his B.A. from Rutgers University and his J.D. from Fordham University School of Law. He served as a Judicial Intern for the Honorable Denny Chin, U.S.D.J. (currently appointed to the United States Court of Appeals for the Second Circuit). He was also a law clerk, Superior Court of New Jersey, Bergen County, Law Division. Robert I. Aufseeser is an associate with Ansell Grimm & Aaron, P.C. in Ocean Township, New Jersey. His practice includes estate and trust planning, closely-held businesses, probate and related litigation. Mr. Aufseeser is admitted to practice in New Jersey and New York, and before the United States District Court for the District of New Jersey and the United States Tax Court. He is a member of the New Jersey State and New York State Bar Associations. Mr. Aufseeser received his B.A. from Rutgers University, his J.D. from Syracuse University College of Law and his LL.M. in Taxation from New York Law School. Dana A. Bennett is a Partner in Bennett & Wyatt, LLC in Red Bank and Lakewood, New Jersey, where she devotes her practice to estate planning, probate and estate administration, estate and gift tax matters, and charitable planning. Admitted to practice in New Jersey and New York, Ms. Bennett is an Officer and member of the Board of Consultors of the New Jersey State Bar Association Real Property, Trust and Estate Law Section, Chair of the Monmouth Bar Association’s Probate and Administration Committee and a member of the American and New York State Bar Associations. She is also a member and Past President of the Estate and Financial Planning Council of Central New Jersey. Ms. Bennett received her B.A., cum laude, from Villanova University, her J.D. from Seton Hall University School of Law and her LL.M. in Taxation from New York University School of Law. Adam M. Grenker is a Partner in Fox Rothschild LLP in Roseland and Hackensack, New Jersey, where he focuses his practice in sophisticated estate planning; estate and trust administration; federal estate, gift and income taxation; living trusts; tax matters affecting nonprofits and charitable planning; and business succession planning.
131
Admitted to practice in New Jersey and New York, Mr. Grenker is a member of the American and New York State Bar Associations, and has served on the Board of Consultors of the New Jersey State Bar Association Real Property, Trust & Estate Law Section. He has also been a member of the Estate Planning Council of Northern New Jersey and the Society of Financial Service Professionals. He is a lecturer for ICLE and other public and private organizations, has contributed to articles on tax law and is a co-author of the Fourth Edition of ICLE’s Estate Planning Strategist. Mr. Grenker received his B.S. from the University of Virginia and his J.D. from the University of Pennsylvania Law School. Jill Lebowitz is a Member of Norris McLaughlin & Marcus, P.A. in Bridgewater, New Jersey, where she devotes her practice to estate planning, trust and estate administration and counseling tax-exempt organizations. Regularly advising tax exempt organizations regarding federal tax exemption issues, state charitable registration filings and governance issues, she is also experienced in drafting estate planning instruments and counseling individuals and families on estate, gift and generation-skipping transfer tax issues, and the development of simple and complex estate plans. She also handles trust and estate administration and fiduciary litigation. Admitted to practice in New Jersey, Ms. Lebowitz is Vice Chair of the New Jersey State Bar Association’s Real Property, Trust and Estate Law Section and a member of the Elder and Disability Law Section. She is President and a Trustee of the Greater Middlesex/Somerset Estate Planning Council and a member of the Meritas US Trusts and Estates Practice Group Steering Committee. Ms. Lebowitz received her B.A. from New York University, her J. D. from Rutgers School of Law-Newark and her LL.M. in Taxation from New York University School of Law.
132