Number Ten: Spotlight on Trust Beneficiaries’ Rights to Be Informed (Forgey)

In In re Estate of Forgey, 298 Neb. 865 (Feb. 9, 2018), the decedent had died in 1993, survived by three children. A trust into which he had transferred property during his life, with one of his children as the sole trustee, provided specific instructions about the division of the trust assets upon his death, gave the trustee broad discretion in administering the trust in good faith, and required annual reports to the beneficiaries.
The trustee failed to provide annual reports, failed to divide the trust assets, personally used land owned by the trust without paying rent, and was late in filing the federal estate tax return, resulting in an IRS assessment of over $2 million in penalties and interest. Twenty years after the decedent’s death, litigation within the family ensued over these breaches and many other allegations, too. After several years of litigation, including a four-day trial, the trial court found that a majority of the beneficiaries’ claims were unfounded. But the court did find the trustee guilty of some breaches and imposed some remedies.
The beneficiaries (including the widow of one beneficiary) appealed, claiming the remedies were not sufficient. Among other things, they specifically claimed that the trial court erred in not awarding them attorneys’ fees for their partially successful litigation efforts.
The Nebraska Supreme Court generally agreed with the trial court, but did order a larger charge to the trustee’s share of the trust assets with respect to his rent-free use of trust property. Regarding attorneys’ fees, the court was influenced by its view that much of the litigation had been caused by the trustee’s failure to keep the beneficiaries informed for 20 years. The court said that “[w]e understand the county court’s reluctance to award attorney fees, since the majority of the claims against [the trustee] were determined to be unfounded,” but noted that, in the absence of information, “the beneficiary had little choice but to file litigation to resolve any doubts about the trust’s administration.” Consistent with this view, the court denied the trustee’s cross-appeal claiming that his attorneys’ fees should have been paid by the trust.
Comment: The trust instrument in Forgey required annual reports to the beneficiaries, although the court indicated that the relevant Nebraska statute also imposed a duty to keep the beneficiaries informed. Section 105(b) of the Uniform Trust Code provides that the terms of a trust prevail over any provision of the code, with certain enumerated exceptions. One of the enumerated exceptions is the duty under Section 813(b)(2) and (3) to notify qualified beneficiaries who have attained 25 years of age about the existence of the trust, the identity of the trustee, and their right to request a trustee’s reports. Another enumerated exception is the duty under Section 813(a) to respond to a request for a trustee’s reports and other information reasonably related to the administration of the trust. But those two exceptions are placed in brackets, making them optional, explained in the comment to the 2004 amendment of Section 105 as “a recognition that there is a lack of consensus on the extent to which a settlor ought to be able to waive reporting to beneficiaries, and that there is little chance that the states will enact [these two exceptions] with any uniformity.” The explanation is correct in that regard; the versions enacted in the respective states vary greatly.
For example, in 2005 the North Carolina General Assembly enacted the Uniform Trust Code with the exceptions discussed above, thus permitting a grantor to override the default requirements to give notice to qualified beneficiaries and respond to requests from qualified beneficiaries for information. But in Wilson v. Wilson, 690 S.E.2d 710 (N.C. App. 2010), the Court of Appeals invalidated that choice, stating that “the beneficiary is always entitled to such information as is reasonably necessary to enable him to enforce his rights under the trust or to prevent or redress a breach of trust,” and that the statute “does not override the duty of the trustee to act in good faith, nor can it obstruct the power of the court to take such action as may be necessary in the interests of justice.”
Debate continues over the understandable desire of some grantors to create “secret trusts.” Cases like Forgey may be invoked by some and distinguished by others, but may not change many minds.
Number Nine: Trust Flexibility Versus “Dead Hand” Control (Horgan, Shire)
Horgan (Florida). In­ Horgan v. Cosden, 249 So.3d 683 (Fla. Dist. Ct. App. May 25, 2018), review denied, Docket No. SC18-1112 (Fla. July 30, 2018), a trust had become irrevocable when the grantor died in 2010. The trust was to pay income to the grantor’s son for his life, with the remainder distributed, upon the grantor’s son’s death, to three institutions of higher education. In 2015, the beneficiaries agreed to terminate the trust and divide the trust assets on an actuarial basis. One co-trustee agreed; the other did not. The trust was silent on early termination, although it contained a spendthrift clause.
The court noted that the grantor clearly “wanted to provide for her son financially via incremental distributions of income until he died and then give the entire principal to the three educational institutions. Terminating the Trust before this event will frustrate the purposes of the Trust. The Settlor twice amended the Trust and could have made a lump sum distribution to her son, … but she chose not to do so. She also included spendthrift provisions designed to protect each beneficiary’s interest.” The court also viewed the cited justifications for termination, such as the burden of trustees’ fees and exposure to market fluctuations, as factors of which the grantor was aware when she chose the trust terms. Accordingly, the court ruled that early termination of a trust can occur only for the best interest of the beneficiaries when viewed in the light of the settlor’s intentions, and refused to allow it here.
Shire (Nebraska). In In re Trust of Jennie Shire, 299 Neb. 25, 907 N.W.3d 263 (Feb. 16, 2018), the decedent had died in 1948, and her will created a trust paying $500 per month to the grantor’s daughter (who died in 1983) and then to her granddaughter (who was born in 1945) for life. The remainder beneficiaries will be the residuary beneficiaries of the grantor’s estate, determined when the granddaughter dies.
The granddaughter requested an increase in her distributions, and the corporate trustee petitioned the court for approval. The opinion states that the granddaughter’s annual income was less than $14,000 (including $6,000 from the trust), while the trust assets had a value of just under $1 million with annual income estimated to be from $64,000 to $81,000. The court also noted the introduction of evidence that $500 adjusted for inflation since 1948 would be either $4,997 or $5,400.29. (That would translate to annual distributions of either $59,964 or $64,803.48, which would be comparable to the projected income of the trust.) The trustee had taken measures to identify and notify the contingent beneficiaries, and many of them appeared and supported the granddaughter’s request. Other contingent beneficiaries appeared, but offered no opposition, including the Nebraska Attorney General’s Office on behalf of charitable beneficiaries. The only opposition was the virtually obligatory opposition of the court-appointed counsel for unknown and undiscovered heirs.
The trial court denied the granddaughter’s request because it would adversely affect future beneficiaries. The Nebraska Supreme Court agreed.
Comment. Flexibility in the administration of a trust is a relatively modern, but generally quite welcome, trend. Section 111 of the Uniform Trust Code, completed by the Uniform Law Commission in 2000, provides that “interested persons may enter into a binding nonjudicial settlement agreement with respect to any matter involving a trust … to the extent it does not violate a material purpose of the trust.” Section 411(c) (not included in the version approved by every state) provides that “[a] spendthrift provision in the terms of the trust is not presumed to constitute a material purpose of the trust.”
Then came these two cases. Both requests to the courts seem reasonable, and yet they were turned down. In Horgan, just five years had passed, and the beneficiaries were all known and agreed. But it was hard to say that circumstances had unforeseeably changed. In Shire, 70 years had passed and the income beneficiary was 73 years old, but the remainder beneficiaries would not be known with certainty until the death of the income beneficiary. Circumstances had obviously changed. There is no evidence that remainder beneficiaries had been anxiously waiting for their shares of the trust for 70 years, or that they generally even knew about the trust until the trustee’s efforts to locate them. There is no reason to assume that they viewed their potential interests in the trust as anything more than a windfall.
Does this mean that the movement toward more trust flexibility is being walked back? Probably not. But cases like Horgan and Shire stand as reminders that nothing should be taken for granted. That is particularly true of drafting long-term trusts with fixed references, such as dollar amounts.
Number Eight: Inclusion of the Value of GRAT Assets in the Gross Estate(Badgley)
Badgley v. United States, 2018 WL 2267566, 121 AFTR 2d 2018-1816 (N.D. Cal. May 17, 2018), app. filed (9th Cir. June 7, 2018), involved a grantor retained annuity trust (GRAT) created Feb. 1, 1998. The GRAT was to run for the shorter of 15 years or the grantor’s life and was to pay the grantor, in quarterly installments of $75,564.75, an annuity amount of $302,259, defined as 12.5 percent of the initial value of the assets transferred to the GRAT (which therefore must have been about $2,418,072). The grantor died Nov. 2, 2012, after 177 months of the projected 180-months GRAT term.
The grantor’s executor filed an estate tax return showing a total gross estate of about $37 million, including the value of the GRAT assets, and paid estate tax of about $11 million. Later, the executor filed a claim, and then a suit, for $3,810,004 she claimed was overpaid by reason of including the full value of the GRAT assets in the gross estate. The executor argued that the annuity payments did not represent “the possession or enjoyment of, or the right to the income from, the property” within the meaning of section 2036(a)(1) because the annuity could have been paid from trust principal, not income. Reg. §20.2036-1(c)(2)(i), which requires a contrary result, she argued, is an unreasonable interpretation of section 2036.
The court held that the retained annuity interest was enough to bring the value of the GRAT into the gross estate under section 2036(a)(1) and that Reg. §20.2036-1(c)(2)(i) is reasonable.
Comment. The argument that a GRAT annuity is not an “income” interest under section 2036(a)(1) has been heard from time to time, but for most estate planners, the result in Badgley is absolutely no surprise.
The opinion does not reveal the grantor’s age at the time she created the GRAT on Feb. 1, 1998, but, considering the February 1998 section 7520 rate of 6.8 percent (the lowest it had been for 22 months), it is likely that she was about 65, and therefore was about 80 when she died. It also appears that the value of the GRAT assets was about $2,418,072 (applying a 12.5 percent payout rate) when the GRAT was created and about $10,885,726 (applying a 35 percent estate tax rate) when the grantor died.
Thus, the GRAT was “working,” having achieved 350 percent growth after paying the annuity amounts, but ultimately the GRAT did not “work,” because the grantor lived for only 98.33 percent of the 15-year GRAT term.
The obvious moral of the story is to consider the consequences when creating a long-term GRAT like a 15-year GRAT. The balancing is not always easy. The 15-year term made possible the relatively low payout of 12.5 percent, which in turn was probably a factor, maybe a crucial factor, in permitting the growth that made the GRAT appear to be “working.” A 14.5-year GRAT would have “worked”! This is where other techniques, like installment sales with lower interest rates, maybe backloaded principal payments, and no exposure of the appreciation to a mortality risk, frequently are better. But the judgment of hindsight is often cruel.
Number Seven: Travails of Family Limited Partnerships (Streightoff, Turner III)
Family limited partnerships do not seem to be generating as many cases as they once did, but they may come close to making up for it by the length of time the cases seem to take. And the results still may be mixed and sometimes surprising.
Streightoff. In Estate of Streightoff v. Commissioner, T.C. Memo. 2018-178 (Oct. 24, 2018), the decedent’s daughter, acting under a power of attorney for her father on Oct. 1, 2008, created a limited partnership and transferred marketable securities and fixed-income investment assets to it. An LLC of which she was the manager was the 1 percent general partner, although under the partnership agreement 75 percent of the limited partner interests could remove the general partner, which would terminate the partnership. Also on Oct. 1, 2008, under the power of attorney, the daughter assigned her father’s 88.99 percent limited partner interest to a revocable trust created on the same day, which she described in the assignment document as the “assignee.” The decedent died May 6, 2011, and his daughter as executor, on the federal estate tax return filed on Aug. 9, 2012, applied a 37.2 percent discount in valuing his partnership interest, described as an “assignee interest” held by the revocable trust.
The Tax Court (Judge Kerrigan) held that the interest must be valued as a limited partner interest, not as a mere assignee interest, because it met all the requirements in the partnership agreement for becoming a substituted limited partner. Accordingly, the court gave little weight to the appraisal report by the estate’s expert, because the report had valued the interest as an assignee interest. That left the IRS expert’s determination of an 18 percent discount for lack of marketability, which the court accepted.
Comment: The Bad News. The planning reflected in Streightoff seems both naïve and aggressive. The partnership was evidently funded with, and continued to hold, only marketable assets. Nothing is revealed in the opinion about any alleged business purpose or nontax reason for the partnership. The decedent retained a proportionately large share — 88.99 percent — of the partnership interests, and that share apparently was not even effectively transferred when it was assigned to his revocable trust, because the revocable trust was, indeed, revocable. In fact, that 88.99 percent interest, because it was greater than 75 percent, retained the power to terminate the partnership. And all the transfers, such as they were, occurred on the same day. How could this have worked?
Comment: The Good News. With an undiscounted alternate valuation date value of about $7.3 million, and a 40 percent estate tax rate, the 18 percent discount the court allowed still saved about $526,000 in estate tax. For one day’s work!
Comment: More Bad News. It really took more than one day’s work. The decedent died in May 2011, the estate tax return was filed in August 2012, the IRS issued a notice of deficiency in January 2015, the executor filed a Tax Court petition in February 2015 and a motion for summary judgment in June 2015, the court held a hearing in September 2016 and denied the motion for summary judgment in October 2016, a trial was held in January 2018, this decision was rendered in October 2018, and the parties have until March 11, 2019, to provide the tax calculations under Rule 155. A large number of other pleadings also appear in the docket entries, many related to the executor’s attempt to get the court to acknowledge a shift of the burden of proof. Was all this hassle and delay worth it?
Turner. In April 2002, Clyde W. Turner, Sr. (Clyde Sr.) and his wife Jewell formed a limited partnership, each transferred $4,333,671 in cash, CDs, and publicly traded securities to the partnership, and each took back a 0.5 percent general partner interest and a 49.5 percent limited partner interest. On Dec. 31, 2002, and Jan. 1, 2003, they gave limited partner interests to children and grandchildren and an irrevocable trust for one child. Clyde Sr. became seriously ill and was hospitalized in October 2003 and died Feb. 4, 2004.
In Estate of Turner v. Commissioner, T.C. Memo. 2011-209 (Aug. 30, 2011) (Turner I), the Tax Court (Judge Marvel) rejected Clyde Sr.’s executor’s claims of nontax purposes of asset management and protection and resolution of family disputes, viewed the creation of the partnership as “a part of a testamentary plan” (at p. 47) in which Clyde Sr. retained both enjoyment and control, and thus found that the value of the assets he had transferred to the partnership was included in his gross estate under section 2036(a)(1) and (2).
In Estate of Turner v. Commissioner, 138 T.C. 306 (March 29, 2012) (Turner II), the executor returned to the court to seek reconsideration of its 2011 decision, which the court denied, and to claim in the alternative that a reduce-to-zero pecuniary bequest nevertheless protected the estate from estate tax by providing an increased marital deduction. The court held, in effect, that even though the value of the assets was pulled back into the gross estate, the transferred assets were out of Clyde Sr.’s control and therefore could not pass to Jewell or qualify for a marital deduction.
As clarified in Turner III (at p. 7), the result of Turner II was that “the only taxable portion of the estate is the portion attributable to the section 2036 inclusion” (implying, although not explicitly saying, that the entire estate still within Clyde Sr.’s control and therefore disposable at his death was allocated to the marital bequest). Therefore, in the calculation of the estate tax liability following Turner II, the IRS asserted that “the estate must reduce the marital deduction by the amounts of Federal estate and State death taxes the estate must pay because the only property available to fund the payments is property that would otherwise pass to Jewell and qualify for the marital deduction” (Turner III at p. 7).
In Estate of Turner v. Commissioner, 151 T.C. No. 10 (Nov. 20, 2018) (Turner III), the court rejected the IRS’s argument and held that the original marital deduction is still preserved because any payment by the executor out of assets allocated to the marital bequest (which were the only assets left) would entitle the executor to recovery under section 2207B(a), which provides:
“(1) In general.—If any part of the gross estate on which tax has been paid consists of the value of property included in the gross estate by reason of section 2036 (relating to transfers with retained life estate), the decedent’s estate shall be entitled to recover from the person receiving the property the amount which bears the same ratio to the total tax under this chapter which has been paid as—
“(A) the value of such property, bears to
“(B) the taxable estate.
“(2) Decedent may otherwise direct.—Paragraph (1) shall not apply with respect to any property to the extent that the decedent in his will (or a revocable trust) specifically indicates an intent to waive any right of recovery under this subchapter with respect to such property.”
The court noted (at p. 14) that Clyde Sr.’s will did not address the payment of taxes or their apportionment, which the court found “not surprising because Clyde Sr. did not know that the Court would apply section 2036 to his lifetime transfers.” The court also noted, however, that Clyde Sr.’s will “clearly manifests his intention that the marital deduction not be reduced or diminished by the estate’s tax liabilities.” (In fact, the reduce-to-zero marital bequest, quoted in Turner II, includes the phrase “undiminished by any estate, inheritance, succession, death or similar taxes.”)
The court concluded (at p. 20): “Accordingly, we hold that the estate need not reduce the marital deduction by the amount of Federal estate and State death taxes it must pay because the tax liabilities are attributable to the section 2036 assets, the estate has the right to recover the amount paid under section 2207B, and the estate must exercise that right to recover to give effect to Clyde Sr.’s intention that Jewell receive her share of the estate undiminished by the estate’s tax obligations.”
The court also rejected the executor’s contention that the marital deduction should be increased by the amount of income generated after Clyde Sr.’s death by assets attributable to the marital share.
Comment. Turner III is not especially interesting because it tells us rules of law we did not know. It is interesting because of the peculiar and questionable way in which it applies the rules we do know, and the implications we now see these rules might have beyond their customary context.
First, Turner I provided that the value of the assets Clyde Sr. transferred to the partnership in April 2002 was included in his gross estate, not the value of the gifts of partnership interests he made on Dec. 31, 2002, and Jan. 1, 2003. Who, then, is “the person receiving the property” from whom section 2207B(a)(1) gives his executor a right of recovery? Isn’t it the partnership? If so, how is recovery obtained? And wouldn’t recovery from the partnership reduce the value of all interests in the partnership, including, after all, Jewell’s interests? Or was the “transfer” contemplated by section 2207B(a)(1) not complete until and to the extent of Clyde Sr.’s gifts, so the recovery, if it comes from the partnership, must somehow come from the partnership interests of those transferees? Wouldn’t that be contrary to the recent application of section 2036 in family limited partnership cases even to the assets represented by the partnership interests the partner retains until death?
Second, the recovery Turner III apparently contemplated, as quoted above, is “the amount of Federal estate and State death taxes [the estate] must pay because the tax liabilities are attributable to the section 2036 assets” (emphasis added). In fact, the opinion uses the phrase “Federal estate and State death taxes” 12 other times, including as the heading for its discussion of the right of recovery. But section 2207B says nothing about state taxes. Clyde Sr. died domiciled in Georgia, a state with an estate tax coupled with the federal credit for state death taxes, and he died in 2004, when the federal state death tax credit had been phased down to 25 percent but not eliminated.
Third, footnote 2 of the Turner III opinion states that Clyde Sr.’s wife Jewell had died July 8, 2007, and that a related case for her estate (Docket No. 29411-11) was pending in the Tax Court. The petition was filed Dec. 23, 2011, and the IRS’s motion of Aug. 3, 2012, for continuance of the trial was granted Aug. 29, 2012, and there are no entries in the docket since Aug. 29, 2012. If Clyde Sr.’s executor does not seek and obtain the recovery contemplated by section 2207B(a), or if he does anything else in a manner the IRS does not like, Jewell’s estate’s pending matter may give the IRS one more setting in which to raise its concerns, for example, by asserting that Jewell was deemed to make a gift or her gross estate is enhanced by the full marital deduction Clyde Sr.’s executor eventually takes into account.
Fourth, if every lifetime transfer potentially subject to section 2036 now carries with it the potential for recovery from the transferee for additional estate taxes that might be paid, who can tell what use could be made of that potential in discounting the value of those transfers even further? A comparison could be made to Steinberg v. Commissioner, 145 T.C. 184 (2015), the “net net gift” case, in which the court allowed a reduction in the value of a gift for the actuarially calculated value of the donee’s assumption of the obligation to pay the additional estate tax under section 2035 if the donor died within three years of the gift. The problem is that in Steinberg the taxpayer conceded that there would be an increase in the gross estate under section 2035 if the donor died within three years. It is hard to imagine any donor conceding a section 2036 inclusion at the time of a transaction like the creation of the partnership in Turner III.
Fifth, Clyde Sr. died in February 2004. His executor filed the estate’s Tax Court petition in August 2008. There are a total of 82 entries in the Tax Court docket for the estate over the last ten years, although, curiously, none between February 2013 and April 2017. As with the Streightoff case, one could ask if this hassle and delay is worth it.
Number Six: State Taxation of QTIP Trusts at the Surviving Spouse’s Death (Taylor, Seiden)
The facts in these cases are simple; the consequences could be complex.
Introduction. In 1981, when Congress added section 2056(b)(7) to the code to permit what have become known as QTIP trusts, it seemed like such a perfect idea. Even though the trust for the surviving spouse, or donee spouse under section 2523(f), did not need any of the traditional features that would necessarily include the value of the trust assets in the surviving spouse’s gross estate — such as a general power of appointment in the case of sections 2056(b)(5) and 2523(e), or payment to the estate in the case of Reg. §20.2056(c)-2(b)(1)(i), (ii), or (iii)— that inclusion in the surviving spouse’s gross estate was assured by the contemporaneous enactment of section 2044, providing for inclusion whenever a marital deduction was allowed under section 2056(b)(7) or 2523(f), backstopped by section 2519 in the case of the surviving spouse’s actions during life. Thus was maintained the fundamental character of the marital deduction as a deferral only — the asset escapes tax at the first death but is taxed at the second death. Even if the surviving spouse who is a U.S. citizen moves out of the country, section 2001(a) continues to apply, and if such a surviving spouse with sufficient income or assets also renounces that U.S. citizenship, sections 877 and 2107 ensure continued taxation for 10 years. Meanwhile, the 1981 objective of making the marital deduction unlimited without having to give the surviving spouse control over the disposition of the remainder is fulfilled in the QTIP trust.
Since 2001 and the four-year phase-out of the credit for state death taxes, and especially with state legislatures setting their estate tax exemptions lower than the federal basic exclusion amount, some states that still have an estate tax have provided for a state-only QTIP election, available when the estate is under the federal exclusion amount but not under the state exemption, or applicable to the extent the state exemption is less than the federal exclusion amount. But symmetry is lost to the fact that a state is powerless when the surviving spouse moves out of the state. “Worldwide,” or nationwide, taxation is not allowed, and, under Section 1 of the Fourteenth Amendment to the U.S. Constitution, a citizen of a state loses that citizenship merely by moving to another state. That dissymmetry is the backdrop for these cases identified as the sixth top development of 2018.
Taylor (Maryland). In Comptroller of the Treasury v. Taylor, 189 A.3d 799 (Md. Ct. Spec. App. July 25, 2018), the predeceased spouse died domiciled in Michigan and created a trust. Both federal and Michigan QTIP elections were made. The surviving spouse moved to Maryland and died domiciled in Maryland.
The Maryland court held that Maryland cannot tax the QTIP trust because no Maryland QTIP election had been made. The court cited Code of Maryland-Tax-General §7-309(b)(6)(i) (emphasis added): “For purposes of calculating Maryland estate tax, a decedent shall be deemed to have had a qualifying income interest for life under §2044(a) of the Internal Revenue Code with regard to any property for which a marital deduction qualified terminable interest property election was made for the decedent’s predeceased spouse on a timely filed Maryland estate tax return.”
Seiden (New York). In In re Estate of Seiden, NYLJ 10/12/18 p. 23, col. 5 (N.Y. County Surr. Ct.), the predeceased spouse died domiciled in New York in 2010, when there was no federal estate tax. But New York still had its estate tax, and a New York-only QTIP election was made. The surviving spouse did not move out of the state and died domiciled in New York.
The New York court held that New York cannot tax the QTIP trust because New York totally piggybacks on the federal gross estate, and there was no QTIP trust for federal estate tax purposes. Like the Maryland court in Taylor, the New York court relied on the New York statute, New York Tax Law §954(a), which provides that the New York gross estate of a deceased resident “means his or her federal gross estate.” Because there was no federal QTIP election, the value of the trust assets was not included in the federal gross estate and, hence, was not included in the New York gross estate, either.
Comment. The outcomes in these cases seem rather random and state-statute-specific. For example, if the surviving spouse of the Michigan decedent in Taylor had moved to New York instead of Maryland, it appears that New York would tax the trust at the surviving spouse’s death, because the federal QTIP election would ensure inclusion in the survivor’s federal gross estate, which would then mean inclusion in the New York gross estate, too.
The New York result in Seiden is not limited to surviving spouses of predeceased spouses who died in 2010. For example, if the first spouse had died domiciled in New York in 2014 with a gross estate of $10 million, the federal exclusion would have been $5.34 million, and the New York exemption would have been $1 million. A reduce-to-zero marital bequest to a QTIP trust related solely to the federal estate tax would have been $4.66 million, leaving a tentative New York taxable estate of $3.66 million. New York tax could have been avoided with a New York-only QTIP election for a trust funded with $3.66 million. Upon the surviving spouse’s death in 2018, for example (assuming no changes in values), the federal gross estate, and thus the New York gross estate, would include the $4.66 million federal-QTIP trust, but not the $3.66 million New York-only-QTIP trust. A very odd result from the term “New York-only.”
The moral of the story is that estate planners have one more complication of clients’ mobility to anticipate and, if possible, accommodate through planning.
In addition, expect to see some corrective legislation in the states that have estate taxes. On the other hand, legislation might add even more complexity to the context of mobility among states, as in Maryland’s choice, less than four months before Taylor was decided, to add portability to its estate tax law.
Number Five: Crunch Time for Intergenerational Split-Dollar Arrangements (Cahill, Morrissette)
Introduction. Split-dollar life insurance arrangements have been in use a long time and were the subject of new Treasury regulations in 2003. Simply put, a split-dollar arrangement is an arrangement by which the cost of life insurance is split between the insured and another party. In a common early use, the payor was the employer of the insured. Then split-dollar arrangements began to be used by individuals or within families for estate planning purposes. A recent variation, the subject of the Cahill and Morrissette cases, involves the payment of premiums by a member of one generation for insurance on the life or lives of members of a younger generation – intergenerational split-dollar arrangements.
In each of these cases, a revocable trust, which of course became irrevocable when the grantor died, made payments toward premiums on life insurance owned by irrevocable trusts created by the same grantor and insuring lives of family members in the next generation. (In this legal alert, that revocable trust will be called the “premium-paying trust” and that irrevocable trust will be called the “policy-owning trust.”) In each of the two 2018 cases, upon the death of an insured, a portion of the death benefit equal to the greater of the total premiums paid or the cash surrender value of the policy immediately before the insured’s death would be payable to the premium-paying trust. Therein lies one perceived benefit of intergenerational split-dollar arrangements: Because the insureds are members of the next generation, their deaths are actuarially likely to occur long after the grantor’s death, and this reimbursement right of the premium-paying (now irrevocable) trust is valued for estate tax purposes at a significant discount reflecting the time-value of money.
Each split-dollar agreement in these two cases provided that it could be terminated during the insured’s life by the mutual agreement of the trustees of the premium-paying trust and the policy-owning trust. If one of the split-dollar agreements were terminated during the insured’s life, the policy-owning trust could opt to retain the policy. In that case, the policy-owning trust would be obligated to pay the premium-paying trust the greater of the total premiums the premium-paying trust had paid on the policy or the policy’s cash surrender value.
In each case, gift tax returns reported the cost of the life insurance protection as gifts to the policy-owning trusts, in accordance with the favorable “economic benefit regime” for the taxation of split-dollar arrangements under the 2003 regulations, Reg. §1.61-22. In each of these cases the Tax Court agreed that the economic benefit regime was appropriate because the policy-owning trusts received no additional economic benefit beyond the current life insurance protection, as explained in Estate of Morrissette v. Commissioner, 146 T.C. 171 (2016). But that still left open the determination of the amount includable in the grantors’ gross estates with respect to the arrangements, which in turn requires consideration of the basis for inclusion.
Cahill. In the Cahill case, the grantor of the trusts was Richard F. Cahill. His son Patrick was the trustee of the premium-paying trust. In September 2010, Patrick, acting on behalf of Richard pursuant to a power of attorney, created the policy-owning trust, with Patrick’s cousin and business partner as the trustee. The purpose of this policy-owning trust was to take ownership of two insurance policies on Patrick’s life and one policy on the life of Patrick’s wife. Patrick and his cousin, as the respective trustees, executed the governing split-dollar agreements with respect to those policies, reserving for the premium-paying trust a portion of each death benefit equal to the greater of the total premiums paid by the premium-paying trust or the cash surrender value of the policy immediately before the insured’s death. The total of the premiums for the three policies paid by the premium-paying trust was $10 million, the total death benefit was $79.8 million, and the aggregate cash surrender value at the date of Richard’s death in December 2011 (15 months after the split-dollar transactions) was $9,611,624.
A distinction of the Cahill case, in contrast to Morrissette, is that the premium-paying trust in the Cahill case financed its payment of the $10 million in premiums by a $10 million loan obtained from an independent lender by Patrick as trustee and guaranteed by Richard through Patrick’s exercise of his power of attorney on Richard’s behalf. If any balance on that loan is outstanding at the death of the insured, the split-dollar agreements provide that the premium-paying trust will be entitled to a portion of the death benefits equal to that outstanding balance, if it is greater than the premiums paid or cash surrender value the premium-paying trust would otherwise be entitled to. If the split-dollar agreements were terminated during the insured’s life and the policy-owning trust did not opt to retain the policy, it would be required to transfer its interest in the policy to that independent lender, and in that case the premium-paying trust would be entitled to any excess of the cash surrender value over the outstanding loan balance with respect to the policy.
For estate tax purposes upon Richard’s death, his executor (Patrick) valued the premium-paying trust’s right to recover death benefits as $183,700, reflecting the deferral of that recovery to the deaths of the younger Patrick and his wife. The IRS asserted that the value should be the cash surrender value at the time of Richard’s death, $9,611,624.
The executor moved for summary judgment that sections 2036, 2038, and 2703 did not apply in valuing Richard’s interests in the split-dollar arrangements and in the premium-paying trust. The Tax Court (Judge Thornton) denied the motion. Estate of Cahill v. Commissioner, T.C. Memo. 2018-84 (June 18, 2018). It viewed (at p. 15) the power of the decedent, through the revocable premium-paying trust, to revoke the split-dollar agreement and recover at least the cash surrender value as “clearly rights … both to designate the persons who would possess or enjoy the transferred property under section 2036(a)(2) and to alter, amend, revoke, or terminate the transfer under section 2038(a)(1).” It cited two Tax Court family limited partnership cases that have exasperated estate planners since they were published — Estate of Powell v. Commissioner, 148 T.C. No. 18 (2017) (reviewed by the court), which was Number Three in last year’s “Top Ten,” and Estate of Strangi v. Commissioner, T.C. Memo. 2003-145, aff’d, 417 F.3d 468 (5th Cir. 2005).
The court was not impressed with the executor’s argument that the premium-paying trust could exercise that power of termination only in conjunction with the policy-owning trust, because sections 2036(a)(2) and 2038(a)(1) explicitly use the phrases “in conjunction with any person” and “in conjunction with any other person.” For purposes of the summary judgment motion, the court found many disputed facts regarding whether Patrick stood on both sides of the transaction so as to prevent it from being a “bona fide sale for an adequate and full consideration in money or money’s worth” for purposes of sections 2036(a)(2) and 2038(a)(1), including (at p. 17) whether it was “a legitimate and significant nontax reason” for the transaction that “in the view of decedent’s trustee and attorney-in-fact (Patrick Cahill), decedent would have wanted, had he been able to manage his affairs, to ensure sufficient liquidity decades from now when the insured parties (Patrick Cahill and his spouse) die, so as to smooth the transfer of a business (apparently to be owned by Patrick Cahill) to decedent’s grandchildren (Patrick Cahill’s children).”
On the subject of adequate and full consideration, Judge Thornton noted that the executor valued the premium-paying trust’s right of recovery at less than 2 percent of the cash surrender value ($183,700 compared to $9,611,624), meaning that in the initial transaction the premium-paying trust would admittedly have received value less than 2 percent of what it transferred.
The same reasoning about adequate and full consideration led the court (at p. 23) to find that the “at a price less than the fair market value” requirement of section 2703(a)(1) was met. In addition, the policy-owning trust’s right to veto any termination of the split-dollar agreement was a “restriction on the right to sell or use any property” that therefore met the requirement of section 2703(a)(2). The court did not consider the exception for a “bona fide business arrangement” under section 2703(b) because the executor and the IRS had not addressed it, although that analysis might have been similar to the court’s analysis of the “bona fide sale” exception in sections 2036(a)(2) and 2038(a)(1).
In a stipulated decision of Dec. 12, 2018, the court approved a settlement of the case by the parties. The decision states the net outcome of the settlement of all issues, not just the split-dollar issues on which the executor had moved for summary judgment. The executor had reportedly accepted the IRS value of $9,611,624, as well as an accuracy-related penalty, and that is consistent with the stipulated decision. And it is not a surprise, in view of the skepticism about the transaction that appears in the court’s opinion.
Morrissette. In the Morrissette case, Clara Morrissette was the grantor of the trusts, including a revocable trust she had established in 1994 with herself as the initial trustee, funded with all her shares in a group of family-owned moving and logistics companies with a history going back to 1943. In August 2006, a court appointed a company employee as the conservator of Clara’s estate for a two-month term. Shortly thereafter, Clara’s three sons, who were active in the company, became co-trustees of Clara’s revocable trust, and the conservator established three irrevocable multigenerational trusts, one for each of Clara’s sons and their families. All those trusts, Clara’s sons, and other trusts holding interests in the business executed a shareholders agreement providing, among other things, that upon the death of any of the sons, the surviving sons and their respective trusts would purchase the stock held by or for the benefit of the deceased son. On Oct. 4, 2006, the three new irrevocable trusts became the policy-owning trusts by purchasing universal life insurance policies on the lives of the two other sons to fund the trusts’ purchases under the shareholders agreements. On Oct. 31, 2006, Clara’s revocable trust became the premium-paying trust by forming two split-dollar arrangements with each policy-owning trust and contributing a combined $29.9 million to those trusts, which the trusts used to make the lump-sum premium payments on the life insurance policies.
Clara died Sept. 25, 2009 (almost three years after the split-dollar transactions). Her executors, who were her three sons, reported on the estate tax return a total appraised value of $7,479,000 for the split-dollar receivables.
The IRS asserted that she should have reported the $29.9 million as gifts (rather than the $636,657 of net economic benefit reported as gifts under the economic benefit regime for 2006 through 2009). The executors moved for partial summary judgment that the economic benefit regime applied, which the Tax Court granted pursuant to its 2016 decision.
With regard to the value of the split-dollar receivables included in the gross estate, the executors moved for partial summary judgment that section 2703 did not apply. Three days after the similar summary judgment motion was denied in Cahill, the Tax Court (Judge Goeke), citing Cahill, denied the motion. Estate of Morrissette v. Commissioner, Order, Docket No. 4415-14 (June 21, 2018). The court’s order also notes that the IRS had raised sections 2036 and 2038 as alternative arguments.
On Nov. 2, 2018, the Tax Court calendared Morrissette for trial in Washington, D.C., on May 6, 2019. On Nov. 21, the IRS filed a motion for partial summary judgment, and on Nov. 27, the court directed the executors to file a response by Jan. 15, 2019.
Comment. If Morrissette is not resolved by summary judgment, which is unlikely, or by settlement, which seems unlikely but is always possible, the trial will be interesting, and the ensuing decision will likely be destined for another “Top Ten” list. The facts in Morrissette seem better than the facts in Cahill. The context of a family-owned business operating for 75 years should be more supportive of “bona fide sale” arguments under sections 2036(a) and 2038(a)(1) and a “bona fide business arrangement” argument under section 2703(b). An important, perhaps crucial, question will be whether, even if the shareholders agreement is a bona fide business arrangement, the choice of an intergenerational split-dollar arrangement to fund it is so integral to the underlying shareholders agreement that such a favorable characterization will apply to it as well. In any event, 30 years after section 2703 was added to the code by legislation signed into law by the late President George H.W. Bush, there may be a significant addition to its exposition.
A similar pending intergenerational split-dollar arrangement case is Estate of Levine v. Commissioner (Docket No. 13370-13, petition filed June 12, 2013), which had been scheduled for trial before Judge Holmes in November 2017.
Number Four: The Proposed “Anti-Clawback” Regulations (Proposed Reg. §20.2010-1(c))
Proposed Regulations (REG-106706-18) were released Nov. 20, 2018, and published in the Federal Register Nov. 23, 2018 (83 Fed. Reg. 59343), to prevent the “clawback” of the benefits of the doubled federal gift tax exemption during 2018 through 2025 if the “sunset” of those benefits occurs in 2026, as currently scheduled, and the donor dies in 2026 or later. Although neither the statute nor the proposed regulations use the word “clawback,” the regulations would carry out the mandate of the 2017 Tax Act in new section 2001(g)(2), which provides that Treasury “shall prescribe such regulations as may be necessary or appropriate to carry out this section with respect to any difference between (A) the basic exclusion amount under section 2010(c)(3) applicable at the time of the decedent’s death, and (B) the basic exclusion amount under such section applicable with respect to any gifts made by the decedent.”
The proposed regulations would add a new paragraph (c) to Reg. §20.2010-1, with the current paragraphs (c) through (e) redesignated as (d) through (f), providing that if the total of the unified credits attributable to the basic exclusion amount that are taken into account in computing the gift tax payable on any post-1976 gift is greater than the unified credit attributable to the basic exclusion amount that is used under section 2010(c) in computing the estate tax on the donor’s estate, then the amount of the credit attributable to the basic exclusion amount that is allowable in computing that estate tax is not determined under section 2010(c) but is deemed to be that greater total of gift tax unified credits attributable to the basic exclusion amount.
Example. Proposed Reg. §20.2010-1(c)(2) provides the following example:
“Individual A (never married) made cumulative post-1976 taxable gifts of $9 million, all of which were sheltered from gift tax by the cumulative total of $10 million in basic exclusion amount allowable on the dates of the gifts. A dies after 2025 and the basic exclusion amount on A’s date of death is $5 million. A was not eligible for any restored exclusion amount pursuant to Notice 2017-15. Because the total of the amounts allowable as a credit in computing the gift tax payable on A’s post-1976 gifts (based on the $9 million basic exclusion amount used to determine those credits) exceeds the credit based on the $5 million basic exclusion amount applicable on the decedent’s date of death, under paragraph (c)(1) of this section, the credit to be applied for purposes of computing the estate tax is based on a basic exclusion amount of $9 million, the amount used to determine the credits allowable in computing the gift tax payable on the post-1976 gifts made by A.”
Viewed another way, if what would otherwise be the basic exclusion amount for estate tax purposes is less than the total of the basic exclusion amount applied to post-1976 taxable gifts, it is increased for estate tax purposes under this new regulation to equal that total. And if, in the example, the gift had been $12 million instead of $9 million, then the entire assumed $10 million basic exclusion amount would be used with still some gift tax payable (the donor having never married), and the estate tax credit would be computed as if the basic exclusion amount were $10 million.
Under Proposed Reg. §20.2010-1(f)(2), the anti-clawback rule would take effect when it is adopted as a final regulation.
News Release. Contemporaneously with the release of the proposed regulations, the IRS issued a news release with the reassuring headline of “Treasury, IRS: Making large gifts now won’t harm estates after 2025.” The press release includes an even simpler explanation that “the proposed regulations provide a special rule that allows the estate to compute its estate tax credit using the higher of the BEA [basic exclusion amount] applicable to gifts made during life or the BEA applicable on the date of death.”
Comment. In their practical effect, the proposed regulations do what the statute asks — nothing more, nothing less. The statute compares a transfer at death after 2025 (subparagraph (A)) with a transfer by gift before 2026 (subparagraph (B)). And that’s what the proposed regulation would address. For example, the proposed regulation would not address the similar scenario of gifts both before 2026 and after 2025. If large amounts of the increased credit attributable to the new doubled basic exclusion amount are used to shelter gifts from gift tax before 2026 (like the $9 million gift in the example), then after 2025, the donor might have to wait for decades for the indexed $5 million amount to catch up so there can be more credit available for gift tax purposes.
Likewise, the text of the regulation and the example (and the description above in this alert) are painstakingly limited in all cases to the amount of credit attributable to the basic exclusion amount — that is, the amount (indexed since 2012) defined in section 2010(c)(3). Regarding portability, for example, that approach makes it clear that the deceased spousal unused exclusion amount (DSUE amount) defined in section 2010(c)(4) is not affected by this special rule and is still added under section 2010(c)(2)(B), in effect thereby generating an additional credit of its own in cases in which the anti-clawback rule applies. But it still may be that the words “lesser of” in section 2010(c)(4) will limit the DSUE amount available to the estate of a person who dies after 2025 (assuming no change in the law) to the sunsetted basic exclusion amount of $5,000,000 indexed for inflation in effect at the time of the death of the surviving spouse referred to in section 2010(c)(4)(A), despite the assertion in Reg. §20.2010-2(c)(1) that “the DSUE amount of a decedent with a surviving spouse is the lesser of the following amounts – (i) The basic exclusion amount in effect in the year of the death of the decedent” (presumably the predeceased spouse), and despite the statement in the preamble to the June 2012 temporary regulations that “[t]he temporary regulations in § 20.2010-2T(c)(1)(i) confirm that the term ‘basic exclusion amount’ referred to in section 2010(c)(4)(A) means the basic exclusion amount in effect in the year of the death of the decedent whose DSUE amount is being computed.” That limitation gives effect to the general notion held by congressional drafters that portability should, in effect, be allowed to no more than double what would otherwise be the survivor’s exemption.
But if the proposed regulations follow the statute very closely as to their practical effect, it is harder to say that they follow the context of the statute as to their approach and form. Before the proposed regulations were released, there was speculation that the regulations under section 2001(g)(2) would mirror section 2001(g)(1), with which their statutory authority is linked, and provide, in effect, that in calculating the estate tax the basic exclusion amount in effect at the time of death will be used to calculate the hypothetical “total gift tax paid or payable” on pre-2026 adjusted taxable gifts that is deducted under section 2001(b)(2) on line 7 of Part 2 of the estate tax return. By increasing the amount on line 7, which is subtracted in line 8, the estate tax would be appropriately reduced to offset the clawback effect.
The proposed regulations take a different approach. The preamble implies that other approaches were considered, but concludes that, “in the view of the Treasury Department and the IRS, the most administrable solution would be to adjust the amount of the credit in Step 4 of the estate tax determination required to be applied against the net tentative estate tax.” In the context of the new regulation, “Step 4” in the preamble most closely corresponds to line 9a of Part 2 of the estate tax return (“basic exclusion amount”); Step 2 corresponds to line 7.
By increasing the amount on line 9a, rather than the amount on line 7, the proposed regulations would achieve the same result, of course, because both line 7 and lines 9a through 9e produce subtractions in the estate tax calculation. But line 7 already requires three pages of instructions, including a 24-line worksheet, to complete, and an incremental increase of complexity in what already has a reputation for being a tangled morass might be easier to process than adding a new challenge to line 9, which now requires less than one-third of a page of instructions. But, needless to say, IRS personnel see many returns, they see the mistakes, and they hear the complaints. Presumably — one hopes — they contributed to forming the assessment that the line 9 approach is “the most administrable solution.”
That approach should work fine if the law is not changed and sunset occurs Jan. 1, 2026. But, although the example in Proposed Reg. §20.2010-1(c)(2) mentions that the donor “dies after 2025,” the substantive rule in Proposed Reg. §20.2010-1(c)(1) applies by its terms whenever “[c]hanges in the basic exclusion amount … occur between the date of a donor’s gift and the date of the donor’s death.” It is not limited to 2026 or to any other particular time period. The 2010 statutory rule in section 2001(g)(1) and the 2017 statutory rule in section 2001(g)(2) are not limited to any time period, either. Therefore, if Congress makes other changes in the law, particularly increases in rates or decreases in exemptions, and doesn’t focus on the potential clawback issue in the context of those changes, the generic anti-clawback regime of section 2001(g)(1) and (2) and these regulations could produce a jigsaw puzzle of adjustments going different directions that may strain the notion of administrability cited in the preamble.
The example in Proposed Reg. §20.2010-1(c)(2) is generally helpful, mainly because it is simpler and more readable than the rule in Proposed Reg. §20.2010-1(c)(1) itself. But, perhaps to help achieve that simplification, the drafters of the example used unindexed basic exclusion amounts of $10 million before 2026 and $5 million after 2025, thereby rendering it an example that could never occur under current law, and possibly causing concern that the proposed anti-clawback rule would apply only to the unindexed basic exclusion amount. Because the inflation adjustment is an integral part of the definition of “basic exclusion amount” in section 2010(c)(3), there should be no question that it is the indexed amount that is contemplated and addressed by the regulation, despite the potential implication of the example.
In any event, the final regulations could benefit from more examples than just one, showing how the outcome would adapt to changes in the assumptions, including examples with indexed numbers, examples with numbers below $5 million (indexed) and above $10 million (indexed), examples with portability elections, and examples with allocations of GST exemption.
There was speculation that the regulations might address the option of making, for example, a $5 million gift during the 2018-2025 period (assuming no previous taxable gifts) and treating that gift as using only the temporary “bonus” exclusion resulting from the 2017 Tax Act. This option is sometimes described as using the exclusion “off the top,” still leaving the exclusion of $5 million (indexed) to generate a credit to be used against the estate tax after 2025. But that type of relief would go beyond the objective of preserving the benefits of a 2018-2025 use of the increase in the basic exclusion amount and would, in effect, extend the availability of those benefits beyond 2025. Although the preamble to the proposed regulations does not refer directly to that issue, it appears that it would require a different regulatory analysis to achieve that result.
The notice of proposed rulemaking asked for comments from the public by Feb. 21, 2019, and announced a public hearing to be held, if requested, on March 13, 2019.
Number Three: Another Speedbump for Domestic Asset Protection Trusts (Toni 1 Trust)
The growing number of states with legislation authorizing self-settled domestic asset protection trusts (DAPTs) has been a repeat entry in the annual “Top Ten” summaries — Number Four in the 2014 Top Ten and Number Seven in the 2017 Top Ten. Occasionally a case comes along in which a DAPT fails to bail a grantor out of a really “bad-facts” mess, but such cases have not made the Top Ten list since a discussion of In re Huber, 493 B.R. 798 (Bankr. W.D. Wash. 2013), and Mortensen v. Battley, 2011 WL 5025288 (Bankr. D. Alas. 2011), barely made it as part of Number Nine in the 2013 Top Ten.
Until 2018. The Toni 1 Trust case is selected as Number Three this year because of the attention it has received from commentators and practitioners, and because of the reminder it provides that we are still waiting for the “big one.”
Toni 1 Trust v. Wacker, 413 P.3d 1199 (Alaska March 2, 2018) presents a factual twist — it begins with a lawsuit by, not against, the family that ultimately sought the protection of the Alaska DAPT statute. In 2007, Donald Tangwall sued William and Barbara Wacker in a Montana state court. The Wackers counterclaimed against Donald, his wife Barbara Tangwall, his mother-in-law Margaret Bertran, and several trusts and businesses owned or run by the family. Several default judgments were entered against members of the family over many years. In 2010, before the last judgment was issued, Barbara and Margaret (whose nickname is “Toni”) transferred parcels of real property to an Alaska trust called the “Toni 1 Trust.”
The Wackers then filed a fraudulent transfer action under Montana law in a Montana court and obtained another default judgment. As part satisfaction of their judgment, the Wackers purchased Barbara’s half interest in one of the parcels at a sheriff’s sale. But before they could purchase Toni’s half interest, she filed for Chapter 7 bankruptcy in Alaska. Thus, her interest in the trust property was subject to the jurisdiction of a federal bankruptcy court.
Donald, as trustee of the Toni 1 Trust, eventually sought relief in an Alaska court, arguing that AS 34.40.110 grants Alaska courts exclusive jurisdiction over any fraudulent transfer actions against the trust. The Alaska superior court dismissed Donald’s complaint, and the Alaska Supreme Court affirmed.
In chapter 40 of Title 34 (Property) of the Alaska Statutes, titled “Fraudulent Transfers, Revocations, and Trusts,” section 34.40.110 is titled “Restricting transfers of trust interests.” Donald Tangwall had invoked section 34.40.110(k), which provides in part that “[a] court of this state has exclusive jurisdiction over an action brought under a cause of action or claim for relief that is based on a transfer of property to a trust that is the subject of this section.”
Tantalizingly, the Alaska Supreme Court stated (footnotes omitted): “Tangwall’s argument is not frivolous. He is correct that a judgment is void if the court that entered the judgment lacked subject matter jurisdiction over the case. Furthermore, AS 34.40.110(k) purports to grant Alaska courts exclusive jurisdiction over fraudulent transfer claims against Alaska self-settled spendthrift trusts. And having reviewed the legislative history of AS 34.40.110(k), we have no doubt the Alaska legislature’s purpose in enacting that statute was to prevent other state and federal courts from exercising subject matter jurisdiction over fraudulent transfer actions against such trusts.”
But the court added: “The question, however, is whether AS 34.40.110(k) can achieve that intended result. We conclude that it cannot.” In support of its willingness to stand up to the Alaska legislature, the court, with respect to the Montana litigation, quoted the U.S. Supreme Court to the effect that, under the Full Faith and Credit Clause of the U.S. Constitution, “jurisdiction is to be determined by the law of the court’s creation [i.e., Montana in this case], and cannot be defeated by the extraterritorial operation of a statute of another state, even though it created the right of action.” Quoting Tennessee Coal, Iron & Railroad Co. v. George, 233 U.S. 354, 360 (1914).
The Alaska Supreme Court continued (footnotes omitted):
“Alaska Statute 34.40.110(k) crosses the limit recognized by Tennessee Coal: it purports to grant Alaska courts exclusive jurisdiction over a type of transitory action against Alaska trusts. We acknowledge that the analogy is imperfect; the Montana court’s judgment against Tangwall was based not on a fraudulent transfer cause of action created by an Alaska statute, but rather on a cause of action arising under Montana law relating to an Alaska trust. Nevertheless, Tennessee Coal controls. The Tennessee Coal court held that the Full Faith and Credit Clause does not compel states to follow another state’s statute claiming exclusive jurisdiction over suits based on a cause of action ‘even though [the other state] created the right of action.’ The clear implication is that the constitutional argument rejected in Tennessee Coal would be even less compelling were a state to assert exclusive jurisdiction over suits based on a cause of action it did not create.
“In seeking to void the Montana court’s judgment for lack of jurisdiction, Tangwall effectively argues that AS 34.40.110(k) can deprive Montana courts of jurisdiction over cases arising under Montana law. This is simply a more extreme interpretation of the ‘full faith and credit’ principle than the interpretation considered and rejected in Tennessee Coal.”
Comment. In view of the extreme facts in Toni 1 Trust, this case is clearly not the end of Alaska DAPTs. But the court’s focus on the federal Full Faith and Credit Clause is a reminder that this case is clearly not the end of speculation, either. There still remains the question, to be resolved by a future case, of whether, in the absence of eleventh-hour, clearly fraudulent and voidable, transfers like those in Toni 1 Trust, a Montana court, for example, considering the complaint of a Montana resident, would have to yield under the Full Faith and Credit Clause to the Alaska statute and the exclusive jurisdiction of the Alaska courts. Or whether an Alaska court, facing a Montana resident seeking to enforce a valid Montana court judgment against the assets of an Alaska DAPT, would have to yield under the Full Faith and Credit Clause to the Montana judgment.
Meanwhile, the surge of states enacting DAPT statutes seems to have slowed somewhat. Michigan became the 17th state in 2017. Georgia could have become the 18th in 2018, but Gov. Nathan Deal vetoed the necessary legislation on May 8. There was no other legislation in 2018.
Number Two: Proposed Regulations Regarding the Section 199A Qualified Business Income Deduction and the Section 643(f)
Multiple Trust Rules (Proposed Regs. §§1.199A-0 through -6 and 1.643(f)-1, Notice 2018-64)
Introduction and Comment. Few tax issues have used up as many brain cells as the mismatches between the taxation of C corporations and the taxation of similar activities engaged in by individuals and passthrough entities, including S corporations. The friction points have historically been the mismatch in rates and the “double” taxation of a C corporation’s income when it earns it and the dividends to shareholders when they are paid. Interest and efforts to “integrate” the taxation of corporations and their shareholders have ebbed and flowed over decades. Integration has been achieved, in effect, in a few special cases, but by and large, the cosmic vision of integration has been too difficult to fulfill. And when Congress finds that rate changes, especially very substantial rate reduction, would serve its current tax policy objectives, the mismatches are highlighted.
Against that backdrop, the substantial reductions in the corporate rate in the 2017 Tax Act placed enormous pressure on Congress to address the uneven playing field for otherwise similar businesses conducted in sole proprietorships or partnerships or other passthrough entities.
As if that backdrop and pressure did not make things difficult enough, without bipartisan support the deduction under section 199A for the “qualified business income” of a non-corporate taxpayer engaged in a trade or business had to be put together in a very mathematically nuanced manner, perhaps designed more around the Senate budget reconciliation rules than around a tax policy vision. Visions of job creation and capital formation were reflected in the legislation, but only in roundabout ways involving references to W-2 wages and unadjusted basis of acquired property. (The capital-formation theme also explains the sometimes-surprising special treatment of architects and engineers. They are involved in “making things.”)
In any event, the statute left much to be clarified, including the availability of the deduction to trusts. The release on Aug. 8, 2018, of a 184-page Notice of Proposed Rulemaking, REG-107892-18, 83 Fed. Reg. 40884 (Aug. 16, 2018) (including a 104-page preamble), within eight months of enactment was a remarkable accomplishment, although some of its substantive provisions have been controversial and nearly all of them are complicated. The following are the highlights addressed in McGuireWoods’ Aug. 17 legal alert.
“Trade or Business.” Proposed Reg. §1.199A-1 provides that the term “trade or business” will be applied consistently with the guidance under section 162, which allows a deduction for ordinary and necessary business expenses. The proposed regulations, however, expand the traditional definition under section 162 to include certain rental or licensing of property to related parties under common control. The proposed regulations provide that the section 199A deduction is applied at the partner or shareholder level and does not affect the adjusted basis of a partner’s interest in a partnership, the adjusted basis of a shareholder’s stock in an S corporation, or an S corporation’s accumulated adjustments account.
W-2 Wages. Proposed Reg. §1.199A-2 prescribes rules for determining W-2 wages of a qualified trade or business for purposes of section 199A, generally using the rules that applied under former section 199 with respect to the domestic production activities deduction. Contemporaneously with the notice of proposed rulemaking, Notice 2018-64 (Aug 8, 2018), 2018-35 I.R.B. 347 (Aug 27, 2018), released a proposed revenue procedure addressing alternative methods for calculating W-2 wages for this purpose. Proposed Reg. §1.199A-2 also addresses many issues concerning the related factor used in computing the deduction, the unadjusted basis immediately after the acquisition of qualified property, including its allocation among relevant passthrough entities, the effect of subsequent improvements to the qualified property, and the effect of non-recognition transactions such as like-kind exchanges.
“Qualified Business Income.” Proposed Reg. §1.199A-3 restates the definition of qualified business income (QBI) and provides additional guidance on the determination of QBI, qualified REIT dividends, and qualified publicly traded partnership income. The regulations describe in further detail the exclusions from QBI, including capital gains, interest income, reasonable compensation and guaranteed payments.
Aggregation. Proposed Reg. §1.199A-4 addresses rules for aggregating multiple trades or businesses for purposes of applying section 199A. Comments from the public had urged the IRS to apply the grouping rules for determining passive activity loss and credit limitation rules under section 469. The IRS concluded that the rules under section 469 were inappropriate for purposes of section 199A, but did agree that some aggregation should be permitted.
“Specified Service Trade or Business.” Proposed Reg. §1.199A-5 contains guidance related to a specified service trade or business (SSTB). Under section 199A, if a trade or business is an SSTB, none of its items are taken into account for determining a taxpayer’s QBI. A taxpayer who owns an SSTB conducted through an entity, such as an S corporation or partnership, is treated as engaged in an SSTB for purposes of section 199A, regardless of the taxpayer’s actual level of participation in the trade or business.
Notwithstanding that general rule, taxpayers with taxable income of less than $157,500 ($315,000 for married couples filing jointly) may claim a deduction under section 199A for QBI received from an SSTB. The section 199A deduction phases out for taxpayers with taxable incomes over this threshold amount. If a trade or business is conducted by a passthrough entity, the phase-out threshold is determined at the individual, trust or estate level, not at the level of the passthrough entity.
The proposed regulations contain a lengthy and detailed definition of an SSTB. Pursuant to section 199A(d)(2)(A), which incorporates the rules of section 1202(e)(3)(A), an SSTB is any trade or business in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, investing, investment management, or trading or dealing in securities, or any trade or business where the principal asset is the reputation or skill of one or more of its employees or owners. The proposed regulations limit “reputation or skill” to trades or businesses involving the receipt of income for endorsing products or services, licensing or receiving income for the use of an individual’s publicity rights, or receiving appearance fees.
The common law and statutory rules used to determine whether an individual is an employee for federal employment tax purposes apply to determining whether an individual is engaged in the trade or business of performing services as an employee for purposes of section 199A. In an effort to prevent taxpayers from reclassifying employees as independent contractors to claim a section 199A deduction, the proposed regulations also create a presumption that an individual who was treated as an employee for federal income tax purposes but subsequently is treated as other than an employee with respect to the same services, is still engaged in the trade or business of performing services as an employee for purposes of section 199A.
Passthrough Entities. Proposed Reg. §1.199A-6 contains special rules for passthrough entities, publicly traded partnerships, nongrantor trusts and estates. Passthrough entities, including S corporations and entities taxable as partnerships for federal income tax purposes, cannot claim a deduction under section 199A. Any passthrough entity conducting a trade or business, along with any publicly traded partnership conducting a trade or business, must report all relevant information — including QBI, W-2 wages, basis of qualified property, qualified REIT dividends and qualified publicly traded partnership income — to its owners so they may determine the amount of their respective section 199A deductions.
The proposed regulations require that a nongrantor trust or estate conducting a trade or business allocate QBI, expenses properly allocable to the trade or business, W-2 wages, and basis of qualified property among the trust or estate and its beneficiaries. The allocation is based on the ratio that the distributable net income (DNI) distributed or deemed distributed to each beneficiary bears to the trust’s or estate’s total DNI for the taxable year. Any DNI not distributed is allocated to the nongrantor trust or estate itself. The unadjusted basis immediately after acquisition of qualified property is allocated without taking into account how depreciation deductions are allocated among the beneficiaries under section 643(c). When calculating the threshold amount for purposes of applying the W-2 wage and basis limitations, taxable income is computed at the trust or estate level without taking into account any distributions of DNI.
For purposes of the proposed section 199A regulations, a qualified subchapter S trust (QSST) is treated as a grantor trust, and the individual treated as the owner of the QSST is treated as having received QBI directly from the trade or business and not through the QSST. The IRS and Treasury requested comments on whether a taxable recipient of an annuity or unitrust interest in a charitable remainder trust should be eligible for a section 199A deduction to the extent the taxpayer receives QBI from the trust.
Multiple Trust Rules. In addition to proposing regulations under section 199A, the IRS and Treasury proposed regulations under section 643(f) to prevent taxpayers from manipulating the section 199A deduction by the use of multiple nongrantor trusts. Section 643(f), enacted by the Deficit Reduction Act of 1984, states: “For purposes of this subchapter [subchapter J], under regulations prescribed by the Secretary, 2 or more trusts shall be treated as 1 trust if … (1) such trusts have substantially the same grantor or grantors and substantially the same primary beneficiary or beneficiaries, and (2) a principal purpose of such trusts is the avoidance of the tax imposed by this chapter. For purposes of the preceding sentence, a husband and wife shall be treated as 1 person.”
Proposed Reg. §1.643(f)-1(a), mirroring the statute, states: “[T]wo or more trusts will be aggregated and treated as a single trust if such trusts have substantially the same grantor or grantors and substantially the same primary beneficiary or beneficiaries, and if a principal purpose for establishing such trusts or for contributing additional cash or other property to such trusts is the avoidance of Federal income tax. For purposes of applying this rule, spouses will be treated as one person.”
Proposed Reg. §1.643(f)-1(b) adds, however: “A principal purpose for establishing or funding a trust will be presumed if it results in a significant income tax benefit unless there is a significant non-tax (or non-income tax) purpose that could not have been achieved without the creation of these separate trusts.”
The effective downgrading of the “principal purpose” standard to a “significant income tax benefit” standard, and the effective altering of the burden of proving the negative that there is no other way to achieve the non-tax purpose, have become controversial and may be challenged if they are finalized without change.
Comment. The final regulations should be published by early January. As high estate and gift tax exemptions have prompted more individuals to turn more attention to income tax planning, the QBI deduction will be important. And because so much of the application of the QBI rules occurs at the individual level, managers of partnerships and other passthrough entities, as well as trustees, will be challenged by the requirements to provide additional specialized information to owners and beneficiaries.
Number One: More Developments Regarding Limits on the State Income Taxation of Trusts (Kaestner, Fielding and maybe Wayfair)
Background and Introduction. State courts, with increasing frequency, have expressed intolerance with taxation by their states of the income of out-of-state trusts. See, for example, McNeil v. Commonwealth of Pennsylvania, Pa. Comm. Court, No. 651 F.R. 2010, 173 F.R. 2011 (2013); Linn v. Department of Revenue, 2013 Ill. App. 4th 121055 (2013); Kimberley Rice Kaestner 1992 Family Trust v. North Carolina Department of Revenue, 12 CVS 8740 (N.C. Sup’r Ct. 2015); Residuary Trust A u/w/o Kassner v. Director, Division of Taxation, 2015 N.J. Tax LEXIS 11, 2015 WL 2458024 (N.J. Sup’r Ct. App. Div. 2015), aff’g 27 N.J. Tax 68 (N.J. Tax Ct. 2013), all discussed in Number Eight of the 2015 Top Ten. In 2018 that trend was continued, possibly even expanded, by the supreme courts of North Carolina and Minnesota, while the U.S. Supreme Court threw a distracting wrench into the works.
Kaestner (North Carolina). The North Carolina Supreme Court affirmed the 2015 victory the trustee had gained in the state trial court, which meanwhile had been affirmed by an intermediate state appellate court. The Kimberley Rice Kaestner 1992 Family Trust v. North Carolina Department of Revenue, 814 S.E.2d 43 (N.C. June 8, 2018), petition for cert. filed (Docket No. 18-457, U.S. Sup. Ct. Oct. 9, 2018), brief in opposition filed (Nov. 30, 2018), reply filed (Dec. 14, 2018). The three North Carolina decisions are discussed in our Alerts of May 1, 2015, July 8, 2016, and June 18, 2018, respectively.
In this case, a New York resident created a trust under New York law in 1992 for the benefit of his three children. No beneficiary resided in North Carolina until the grantor’s daughter, Kimberley Rice Kaestner, moved there in 1997 when she was 28 years old. The original trustee was a New York resident, he was replaced as trustee with a Connecticut resident in 2005, and the custody of the financial assets of the trust was in Boston. In 2002, the trust was divided into three separate shares, and in 2006, the separate shares became three separate trusts, one for each child of the grantor. In the years 2005 through 2008, North Carolina taxed the undistributed income of Kimberley’s trust. The trust then sought a refund of those taxes, totaling more than $1.3 million, and sued in the North Carolina courts when the Department of Revenue denied the refunds. The trial court, intermediate court of appeals, and now the North Carolina Supreme Court, all held for the trust.
The North Carolina Supreme Court began its constitutional analysis (at p. 10) by quoting Quill Corp. v. North Dakota, 504 U.S. 298, 306 (1992) (a case dealing with a state’s sales tax on catalog sales of goods shipped into the state), for the principle that “[t]he Due Process Clause ‘requires some definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax.’” Applying this principle, the court stated (at p. 13): “That plaintiff and its North Carolina beneficiaries have legally separate, taxable existences is critical to the outcome here because a taxed entity’s minimum contacts with the taxing state cannot be established by a third party’s minimum contacts with the taxing state.… Here it was plaintiff’s [the trust’s] beneficiaries, not plaintiff, who reaped the benefits and protections of North Carolina’s laws by residing here. Because plaintiff and plaintiff’s beneficiaries are separate legal entities, due process was not satisfied solely from the beneficiaries’ contacts with North Carolina.”
The court considered Chase Manhattan Bank v. Gavin, 249 Conn. 172, 733 A.2d 782, cert. denied, 528 U.S. 965 (1999), and McCulloch v. Franchise Tax Bd., 61 Cal. 2d 186, 390 P.2d 412 (1964), which had been cited in support of an opposite result. It dismissed Gavin (at p. 15) because the Connecticut court had “failed to consider that a trust has a legal existence apart from the beneficiary” and dismissed McCulloch (at p. 16) because it “was decided before Quill Corporation, and therefore has a limited ability to inform our application of the Court’s due process analysis in Quill.” Thus the court held (at p. 18) that the taxing statute in question “is unconstitutional as applied to collect income taxes from plaintiff for tax years 2005 through 2008” — “as applied” being a very important limitation that was also employed by the lower courts despite the trustee’s effort to have the statute declared unconstitutional on its face.
Justice Samuel J. Ervin IV dissented. (As an aside, he is the grandson of Sen. Sam Ervin, who chaired the Senate “Watergate Committee” in 1973-1974.) Seeming to anticipate the U.S. Supreme Court’s Wayfair opinion that came out two weeks later, Justice Ervin quoted (at p. 8) Burger King Corp. v. Rudzewicz, 471 U.S. 462, 476 (1985) (which predated Quill) for the proposition that “it is an inescapable fact of modern commercial life that a substantial amount of business is transacted solely by mail and wire communications across state lines, thus obviating the need for physical presence within a State in which business is conducted. So long as a commercial actor’s efforts are ‘purposefully directed’ toward residents of another State, we have consistently rejected the notion that an absence of physical contact can defeat personal jurisdiction there.” Without needing to say that communication technology had advanced still further in the 20 years before the facts of Fielding arose, Justice Ervin concluded (at pp. 8-9) that “the trustee transmitted information to Ms. Kaestner, provided advice to Ms. Kaestner, and communicated with Ms. Kaestner in other ways with full knowledge of the fact that she resided in North Carolina. The Kaestner Trust could not have successfully carried out these functions in the absence of the benefits that North Carolina provided to Ms. Kaestner during the time that she lived here. As a result, I am unable to conclude, given the applicable standard of review, that the Kaestner Trust lacked sufficient contacts with North Carolina to permit the State to tax the undistributed income held by the Kaestner Trust for Ms. Kaestner’s benefit.”
Fielding (Minnesota). Fielding v. Commissioner of Revenue, Docket No. A17-1177 (Minn. July 18, 2018), petition for cert. filed (Docket No. 18-664, U.S. Sup. Ct. Nov. 15, 2018), also involved the state taxation of income of trusts whose trustee resided elsewhere. The grantor, a resident of Minnesota, created four generation-skipping grantor trusts, drafted by a Minnesota law firm under Minnesota law and initially funded with nonvoting common stock of a Minnesota S corporation. On Jan. 1, 2012, the trusts ceased to be grantor trusts and a resident of Colorado became the trustee.
The trusts were defined as “resident trusts” under the relevant Minnesota statute, and the trustee filed Minnesota income tax returns and paid Minnesota income tax, without protest, for the years 2012 and 2013. In 2014, a resident of Texas became the trustee. He filed a 2014 Minnesota income tax return under protest, subsequently claimed refunds for the difference in tax between resident and nonresident trusts, and appealed the Commissioner of Revenue’s denial of the claims to the Minnesota Tax Court. The tax court ruled on due process grounds that “Minnesota did not have subject matter jurisdiction over gain and income from … items of intangible personal property not located within Minnesota.” The Minnesota Supreme Court affirmed.
The Commissioner of Revenue had asserted that the trusts “ow[e] their very existence” (p. 11) to Minnesota because (i) the grantor was domiciled in Minnesota when the trusts were created, when they became non-grantor trusts, and in 2014, the year at issue; (ii) the trusts were created in Minnesota with the assistance of a Minnesota law firm, which drafted, and until 2014 retained, the trust documents; (iii) the trusts held stock in a Minnesota S corporation, (v) the trust documents invoke Minnesota law as the governing law, and (vi) one beneficiary has been a Minnesota resident at least through 2014.
The court viewed the grantor’s domicile and the facts related to the creation of the trusts as irrelevant because they predated 2014. It noted (at p. 14) that the trusts owned no “physical property” in Minnesota, specifically stating that the stock of the corporation that operated in Minnesota was indisputably “intangible property” to the trusts. The trustee had come to Minnesota only once in 2014, for a wedding, and “never traveled to Minnesota for any purposes related to the Trusts” (p. 17). Regarding the governing law provisions, the court stated (at p. 17): “Our laws protect residents and non-residents alike. We will not demand that every party who chooses to look to Minnesota law — not necessarily to invoke the jurisdiction of Minnesota’s courts — must pay resident income tax for the privilege.”
Interestingly, the court added that, “unlike cases in other states that considered testamentary trusts, the inter vivos trusts at issue here have not been probated in Minnesota’s courts and have no existing relationship to the courts distinct from that of the trustee and trust assets.”
Thus, the Minnesota court carried the principle cited in Kaestner farther than the North Carolina courts needed to, reaching the same result despite the additional factors of the grantor’s domicile, the trust’s creation, and the governing law. On the other hand, the Fielding ruling is not without limits. Like Kaestner, it holds the statute in question unconstitutional (at p. 19) only “as applied to the Trusts.” In addition, its reasoning to dismiss certain factors begs questions about how long after activity occurs in Minnesota it becomes irrelevant, or how the result might be changed if the trustee visited Minnesota for a trust purpose or even appeared as a plaintiff or defendant in a Minnesota court. And the court’s effort to distinguish these inter vivos trusts from a trust under a will probated in Minnesota begs the question of how long after a decedent’s death even probate would be viewed as too distant in the past to be relevant.
Two dissenting justices took an entirely different view of the factors cited by the Commissioner of Revenue, stating that “when [the grantor] made the Trusts irrevocable in 2011, he did so as a Minnesota domiciliary. He was on statutory notice that, as a Minnesotan, his decision would cause the Trusts to become Minnesota ‘resident trusts.’ … When a Minnesota grantor knowingly chooses to create a Minnesota resident trust and the trust itself incorporates Minnesota law, why would it be unconstitutional for Minnesota to tax that trust?”
Wayfair (South Dakota and the U.S. Supreme Court). In South Dakota v. Wayfair, Inc., 138 S. Ct. 2080 (June 21, 2018), 13 days after Kaestner and 27 days before Fielding, the U.S. Supreme Court was called upon to reconsider the seller’s physical presence in a state as a precondition to the constitutional imposition of the state’s sales tax on the seller’s shipment of goods to purchasers in the state. In this case, as the inevitable successors to the catalog/mail-order sellers of the 20th century, the merchants involved were leading online retailers of furniture, other home goods, clothing, jewelry and consumer electronics. South Dakota initiated a declaratory judgment action in the South Dakota courts, seeking an injunction requiring the out-of-state merchants to collect South Dakota sales tax on their sales into South Dakota and to remit those taxes to the state.
While the South Dakota courts viewed themselves as without power to, in effect, ignore the physical presence requirement of Quill Corp. v. North Dakota, 504 U.S. 298 (1992), the U.S. Supreme Court, with no such encumbrance, found (at pp. 10 and 22) that “Quill is flawed on its own terms” and “the physical presence rule of Quill is unsound and incorrect.” Thus, the court overruled Quill and ruled for South Dakota.
In an uncommon alignment, Justice Kennedy wrote the opinion for the court, joined by Justices Thomas, Ginsburg, Alito and Gorsuch, while Chief Justice Roberts dissented, joined by Justices Breyer, Sotomayor and Kagan.
Comment: Implications of Wayfair. Quill and Wayfair are sales tax, not income tax, cases, and they are not directed to trusts. Nevertheless, if the expansion of the trend toward exempting out-of-state trusts from income tax in Kaestner and Fielding were not enough to make this topic Number One for 2018, the speculation that Wayfair has now slowed that trend would clinch that distinction.
After all, as stated above, the Kaestner court began its constitutional analysis by quoting Quill, and it continued to cite Quill several times, as did the dissent.
In Fielding, decided after Wayfair, the opinion of the court did not cite Quill or Wayfair, but the dissent referred to a quotation from Quill in Luther v. Commissioner of Revenue, 588 N.W.2d 502, 508 (Minn. 1999) (a case that was cited frequently by the court) and added in a footnote: “The United States Supreme Court has since overturned Quill to the extent that Quill’s interpretation of the ‘substantial nexus’ prong of Complete Auto Transit, Inc. v. Brady, 430 U.S. 274, 279 (1977), ‘is an incorrect interpretation of the Commerce Clause.’ South Dakota v. Wayfair, Inc., ___ U.S. ___, ___, 138 S. Ct. 2080, 2092 (2018).”
If, as Kaestner and the cases that precede it demonstrate, Quill is the foundation of the constitutional analysis preventing the income taxation of out-of-state trusts, then isn’t that analysis flawed and the mounting precedent of income tax cases now in jeopardy? As a technical matter, probably not, for several reasons:
Quill was essentially a Commerce Clause case, and the state income tax cases have rested on due process, not Commerce Clause, grounds. The two constitutional doctrines overlap and share some rhetoric, as the Kaestner opinion confirmed when it quoted Quill’s statement that “[t]he Due Process Clause ‘requires some definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax.’” But eliminating a Commerce Clause ground that has also been argued to courts but seldom addressed by the courts in the income tax cases should leave the due process analysis intact.
In Wayfair, the court noted (at p. 10) that “[a]ll agree that South Dakota has the authority to tax these transactions,” that is, to collect the sales tax (or perhaps a use tax) from the buyer. “The central dispute,” the court continued (emphasis added), “is whether South Dakota may require remote sellers to collect and remit the tax without some additional connection to the State.” In the fiduciary income tax context, the consensus is just the opposite. With a few specialized exceptions not presented by the cases (as in the case of a “simple trust” or a “grantor trust”), a beneficiary is not taxable on the trust’s undistributed income. In Kaestner and Fielding North Carolina and Minnesota were not merely trying to get the trustees to withhold and remit tax the resident beneficiaries owed; they were trying to tax the trusts themselves — not comparable to the Wayfair construct.
In Wayfair the Supreme Court made much of the fact that “The Act applies only to sellers that deliver more than $100,000 of goods or services into South Dakota or engage in 200 or more separate transactions for the delivery of goods and services into the State on an annual basis.… And respondents are large, national companies that undoubtedly maintain an extensive virtual presence. Thus, the substantial nexus requirement … is satisfied in this case.” It is hard to imagine what the analogs to these features would be in the context of a trust — not a trust company, but an individual trust. The easiest example of “goods and services” in the case of a trust is the distribution of income. But there is no question that a distribution of DNI is taxable to the recipient in whatever state the recipient lives. The issue in these cases is accumulated trust income, to which the South Dakota sales tax parameters bear no resemblance.
In that same vein, the sale to which the Wayfair tax applies is a discrete one-and-done event. The purchased item is delivered to just one place. So there is no risk of double taxation, as there could be in the case of the taxation of the undistributed income of a trust. Under Wayfair, South Dakota buyers are taxed on the delivered goods they order online just the same as they are taxed on the goods they go to a local store and buy for the same price. Again, there is no comparison to the undistributed income of a trust.
Nevertheless, despite the lack of practical symmetry and technical equivalence between internet sales and accumulation of trust income, revenue-conscious, or revenue-starved, states will see just one headline in the Wayfair decision — STATE WINS! And aggressive efforts to superimpose the Wayfair template on Kaestner and Fielding scenarios are bound to emerge.
Sure enough, both North Carolina and Minnesota, citing Wayfair, have asked the U.S. Supreme Court to review their losses in their state supreme courts. The North Carolina and Minnesota petitions for certiorari, filed Oct. 9 and Nov. 15, 2018, respectively, point out that state courts are divided on the constitutionality of taxing trusts on the basis of the residence of beneficiaries and argue that the Due Process Clause of the United States Constitution “should not mean different things in different states.”
The Kaestner Trust’s brief in opposition, filed Nov. 30, 2018, argues that (in its view) only four states besides North Carolina purport to tax trusts on the basis of the residence of beneficiaries, that no other similar challenge has been made in any of those five states, and that therefore the U.S. Supreme Court’s intervention in the Kaestner case would be “a poor vehicle for addressing the Constitutional implications of state taxation of out-of-state trusts.” North Carolina’s reply, filed December 14, 2018, views the trust’s estimate of affected states as understated and, in any event, views the narrow facts of the case as “precisely why this case is an ideal vehicle: It presents the beneficiary’s in-state residency in clean form, allowing the Court to resolve the question presented without the need to consider other types of jurisdictional contacts.”
In Fielding, the trust’s brief in opposition is due Jan. 22, 2019.
Normally, the U.S. Supreme Court would not be expected to agree to review a case in which the law of a state has been overturned by the highest court of that same state. That is what happened in Wayfair itself, of course. But there, the South Dakota Legislature had gone to some trouble to tee up the issue — enacting a statute tailored to the objective of confronting Quill that declared a fiscal emergency and provided for expedited review by the state’s own courts as the path to the U.S. Supreme Court, the only forum where Quill could be re-examined. The court’s opinion (at pp. 3-4) emphasizes that procedure. Moreover, the opinion also notes (at p. 16) that as amici curiae 41 states, two territories, and the District of Columbia had asked the court to reject the test formulated in Quill. There does not appear to be any similarly obstructive U.S. Supreme Court precedent or other such rallying cause in the income taxation of trusts.
Even so, the U.S. Supreme Court declined to summarily deny certiorari. According to the U.S. Supreme Court’s docket, North Carolina’s petition for certiorari was filed Oct. 9, 2018, and on Oct. 16, the Kaestner Trust filed a waiver of its right to file a brief in opposition. On Oct. 24, the file was distributed to the U.S. Supreme Court justices in preparation for a conference on Nov. 9. But on Oct. 31, the court requested the Kaestner Trust to file a response, despite its previous waiver, and the trust did so on Nov. 30. The most logical explanation for requesting a brief in opposition on Oct. 31 was that some justice or justices asked for it after the file was distributed to them on Oct. 24. And that would mean that at least one justice was unwilling to deny certiorari solely on the basis of the petition, and wanted more persuading. But that is a long way from expecting the court to grant certiorari, and still a longer way from expecting at least five justices to side with North Carolina after considering all the arguments.
Thus, while Wayfair need not mean the end of the march toward stricter territoriality of trust income taxation, it will probably still be an irresistible invitation to many states looking for revenue. It will be interesting.
Private Wealth Services
McGuireWoods’ Private Wealth Services team stands ready to advise individuals, financial institutions, and other clients about planning, tax, and fiduciary matters. McGuireWoods’ private wealth services group has been ranked by Chambers, the international rating service for attorneys, as one of the top wealth management legal practices in the country for several years.

Employ these items during your next client meeting to make sure the basics are in order.

1. Check beneficiary designations for tangible assets
A review of beneficiary designations is always prudent, especially since most designations are set when an account is opened. Rarely are they revisited unless a significant event happens. While this is a good practice, how often are tangible asset designations set? Or for that matter even reviewed. In 2019, make it a point to look at beneficiary designations for your client’s tangible assets like homes, cars and collectibles. Check legal documents to make sure tangible assets are properly accounted for.
2. Check beneficiary designations for digital assets
If you haven’t noticed, we are in the digital age. Digital asset planning is a must for your clients. While clients may not believe that they have digital assets with monetary value, some have digital assets that possess sentimental value. Remember, the client may not see sentimental value in their digital assets but their beneficiaries might. Commonly overlooked items are reward points, social media photos and stories, and digital storage devices. At least inventory the digital asset so someone knows where it is.
3. Review trust funding
The reason most trusts fail is because they aren’t funded. It can be inherently a pain to change titling to bank accounts, homes, cars and other tangible assets into the name of the trust. Too often trusts are established and then not funded correctly. Conversely, sometimes major items are purchased or changed and need to have their titling corrected so they correspond with a particular trust. This year take a look at your clients trusts and make sure everything that is supposed to be contained in the trust is there.
4. Make sure you have documents for adult children
Unfortunately, this is a crazy world. When children become 18, they are adults. Maybe not in a client’s mind but certainly in the mind of the courts, hospitals and universities. Present your client with the scenario of something happening and they are unable to get information or make decisions for their babies (now adults). It’s true, if the basic documents aren’t in place it can cause a headache. In 2019, make sure your clients have documents in place for their adult children.
5. Make sure to ask about life changes
This may be common sense but you’d be surprised how many changes fall through the cracks. Professionals don’t typically review with their clients monthly. Sometimes it’s semiannually or even yearly. Many significant changes can occur during that time, and unless you ask clients, they may not remember to bring them up. Maybe they had a grandchild, bought a new car or bought a timeshare. Life changes constantly, stay up to date with their life changes and their estate plans.
6. Secure photos and memories
We have all seen the pictures, watched the news and heard the stories. Everything is lost in a fire, hurricane, flood or tornado. While it’s obvious that life is not replaceable, so too are the photos and videos. Time for your clients to secure them in some type of digital storage device or cloud service. Something that cannot get wet, destroyed, burned up or just faded over time. While this may not be a service that you provide, just helping your clients manage the backup or storage processes may preserve their memories for a lifetime.
7. Make sure others know, or make sure you know, just in case
After a death, the biggest challenge is when beneficiaries go over their loved one’s possessions. This is the biggest challenge when settling an estate. Fortunately, it’s now the digital age, so electronic organization and access is the new way of preserving items. Over the slow holidays you may want to take the time to get those assets in order; Help guide them to digital storage if you aren’t providing that service. A little organization and allowing someone the knowledge on how to get information just in case something happens can make a tremendous difference.
8. Make sure others know all medical information, just in case
No one ever knows when that moment will occur. Whether it be a moment of incapacitation or just treatment information, it’s imperative that not only their loved ones know but that first responders can find out immediately. Typically, when an accident occurs it’s first responders or medical personnel who are going to need access to that information. Review these documents (and medical directives) with your clients so that others can readily access that vital information.
Scott Huff is the CEO of Yourefolio and one of WealthManagement.com’s Ten to Watch in 2019.

The IRS has published new guidelines relating to estate and gift tax changes for 2019. Starting this year, estates of decedents who die during 2019 have a basic estate tax exemption amount of $11,400,000 (increased from $11,180,000 in 2018). This means that the estate of a person dying in 2019 with more than $11.4 million in assets may pay a federal estate tax (on assets which do not pass to charity or to a surviving spouse). Over both deaths of a married couple, $22,800,00 may pass estate tax-free to the next generation.

This basic exemption amount is also a lifetime exemption from the gift tax applicable to taxable gifts—which, generally, are gifts exceeding the annual exclusion (see below) and certain other statutory exceptions. Taxable gifts made during life reduce the basic exemption amount available to one’s estate by the reported value of the gift.
As to non-taxable gifts, the federal annual exclusion limit remains at $15,000 per recipient, per year. Annual exclusion gifts, in many cases, are not reportable on a gift tax return. Annual gifts up to $30,000 made jointly by spouses can be made to each child or other recipient. Spouses who elect to split gifts on a tax return can also make unequal separate annual gifts to a child or other recipient that together equal $30,000.
In contrast to the increased federal estate tax exemption, Massachusetts maintains its $1 million filing threshold for estate tax purposes. The Commonwealth does not tax lifetime gifts, but will include those gifts when determining whether the filing threshold has been met. This rule confuses many, so here is an example of how it works: In an estate where no lifetime gifts were made, if you have $3 million in assets and die in Massachusetts, your estate would exceed the $1 million filing threshold, and when your estate files its tax return, the entire $3 million would be shown as subject to estate tax—subject, of course, to the usual deductions available against the tax.
Instead, let’s say that before you die, you make a federally reportable gift of $2.5 million in assets to your kids (or others), and you die with $500,000 ($3 million – $2.5 million). When determining whether the $1 million filing threshold has been met, your estate must calculate the value of the assets owned at death ($500,000), plus the lifetime gifts ($2.5 million), which, in this case, total $3 million—and would cause a requirement that your estate file a return. But, because Massachusetts doesn’t impose a gift tax, your estate pays no tax on the $2.5 million gifted before death, leaving only $500,000 subject to the estate tax. In sum, the lifetime gifts remove $2.5 million from the reach of Massachusetts tax authorities. However, while the tax can be greatly reduced with this strategy, it cannot be reduced to zero.
Something else to keep in mind is that that annual exclusion gifts don’t get added back when determining whether the $1 million filing threshold is met. For instance, assume that, every year, you gift $15,000 to each of your three kids, as well as $15,000 to each of their spouses (totaling $90,000/year). If you stick with this plan for 10 years, you’ll have reduced your assets by $900,000 ($90,000 x 10 years), and at your death, because these gifts were covered by the annual exclusion and are thus not taxable gifts, they don’t get added back when determining whether the $1 million filing threshold is met. (Of course, before making any gifts, you must take into account your own current and future needs.)
Working with your advisors to develop and implement a gifting plan is a great way to make meaningful financial contributions to your loved ones while you are living, and may reduce any Massachusetts estate tax on your death. Varying structures, including trusts, can be incorporated within the plan to allow oversight of the funds, while getting the tax benefit of removing the assets from your estate.