Category: Estates & Trusts

2021 Biden Plan Estate Planning Advisory

After President-Elect Joe Biden’s Electoral College victory over President Donald Trump, the nation’s eyes were largely focused on the two US Senate run-off elections in Georgia, which determined the makeup of the US Senate for the coming years and, with that, affected the likelihood of the enactment of President-Elect Biden’s tax agenda and other initiatives. Now that Democrat candidates Jon Ossoff and Raphael Warnock have won their respective elections, the Senate is divided 50-50, with any potential tie-breaking vote resting in the hands of Vice President-Elect Kamala Harris. As a result of these elections, many are left wondering how President-Elect Biden procedurally will go about enacting his various tax proposals and intentions (collectively, the “Biden Plan”), the likelihood of the enactment of the Biden Plan, whether the effective date of the Biden Plan could be made retroactive to January 1, 2021, and, if so, what can be done about this in the planning process. While the Biden Plan is comprehensive and contains proposals for individual income tax, taxes related to real property, and corporate tax reform (including increasing the top individual income tax rates, limiting deductions and taxing capital gains as ordinary income), this advisory is limited to the potential estate, gift and generation-skipping transfer (GST) tax reforms that President-Elect Biden has discussed.

Overview of President-Elect Joe Biden’s Estate, Gift and Generation-Skipping Transfer Tax Plan

President-Elect Biden has expressed an intention to decrease an individual’s federal estate tax exemption amount either to $5 million per individual (and $10 million for a married couple), perhaps indexed for inflation and perhaps not, or to the pre-Tax Cuts and Jobs Act amount of $3.5 million per individual (and $7 million for a married couple). This decrease in lifetime exemption could be coupled with an increased top tax rate of 45 percent. Additionally, although Biden does not support a “wealth tax,” and there has been no discussion of including a “wealth tax” in the Biden Plan, the Biden Plan might repeal stepped-up basis on death and, moreover, might tax unrealized capital gains at death at the proposed increased capital gains tax rates. While anything is possible, it should be noted that although transfer tax rates have gone up and down, transfer tax exemption amounts have never decreased before and prior attempts to repeal stepped-up basis on death have not been successful.

Likelihood of Enactment of the Biden Plan

Congressional Procedures

With the Democrats capturing Georgia’s two seats in the US Senate in run-off elections, they will control both chambers of Congress, including their tax-writing committees. While this should give President-Elect Biden an easier path to pass much of his tax agenda, there are certain additional Congressional procedures that need to be considered before that happens.

In the Senate, subject to limited exceptions, it typically takes 60 votes to avoid a filibuster (which otherwise could delay or block legislative action). Although Democrats “control” the Senate, they hold only 50 seats. Barring filibuster repeal (which would be an unexpected change to the long-standing Senate rules), the support of at least some Republican Senators will be needed to achieve the 60 votes required to avoid a filibuster and allow tax reform legislation to proceed. That being said, there is also a process referred to as “budget reconciliation” by which some types of legistation (including certain tax measures) can be moved forward in the Senate with a simple majority vote.

The purpose of budget reconciliation is to provide a process by which Congress, once it has adopted a fiscal budget, can change existing spending and revenue laws to bring their application into conformity with the adopted budget. In other words, Congress must reconcile existing laws with the newly adopted budget. The Congressional Budget and Impoundment Control Act of 1974 provides for an expedited procedure in both the House and the Senate that limits debate to 20 hours, foreclosing the possibility of filibuster. Budget reconciliation cannot be used for all types of legislation. In President-Elect Biden’s favor, however, the budget reconciliation process has been used since the late 1990s to enact revenue reducing legislation (i.e., tax decreases) and historically has been employed to achieve revenue increasing legislation (i.e., tax increases). While President-Elect Biden campaigned on his ability to work with lawmakers from across the aisle, it is likely that budget reconciliation may be attempted to advance his tax-based legislative policies, but it will succeed only if the entire Democratic caucus votes in favor of the proposed bill (which is by no means guaranteed).

Retroactivity

Assuming that some version of the Biden Plan is passed into law, one needs to consider its effective date. Typically, tax legislation is prospective, and might not be effective until January 1, 2022 or later (depending upon how long the enactment process takes). Sometimes, however, tax legislation is retroactive, in which case it would either be effective as of its date of introduction (which would in all events be sometime after the inauguration) or possibly even effective as of January 1, 2021.

Although many high-net-worth individuals are contemplating additional planning in 2021 to use more or all of their remaining estate, gift and GST tax exemptions before a potential reduction in those exemption amounts (currently $11.7 million under each tax regime), one reason to proceed with some amount of caution is the possibility that any changes to these tax regimes may be retroactive to January 1, 2021. In other words, a retroactive reduction in exemption amounts to, for example $5 million, could cause otherwise gift-tax free transfers retroactively to be subject to a large amount of gift tax. There is some precedent in previous court cases that suggests such a retroactive law lowering exemption amounts would be legal and constitutional, but it should be noted that this precise issue previously has not been litigated and its outcome would be uncertain. Still, much case law points to the fact that a retroactive change would be appropriate except in a situation where the taxpayer had no reason to think that the tax treatment would later change. Given the amount this topic has been discussed, such an argument that the taxpayer could not have foreseen the change may not be persuasive.

Accordingly, while the law appears to suggest that a change to the estate and gift tax regime may be applied retroactively to January 1, 2021 (if such legislative act is enacted within a reasonable time, such as calendar year 2021), there are, on the other hand, legitimate arguments that suggest a retroactive decrease in exemption amounts unfairly would prevent taxpayers from the opportunity to plan their affairs — and penalize those who attempt to undertake such planning — and so such retroactive treatment could be disallowed. Regardless of whether such a retroactive change in exemption amounts would be constitutional, it also is important to consider whether Congress would even attempt to make a new law retroactive. Although we are still evaluating the current political landscape, which inherently is an ongoing matter, our general view is that the political forces at play likely would not be supportive of a retroactive law given the Democratic control of the Senate by the slimmest of margins (in other words, there is not likely to be strong support for a retroactive law, but it is impossible to foresee how legislative negotiations will play out). Therefore, although it is possible that a retroactive change to the gift and estate tax regime can be legitimate, because the law is not entirely clear on this issue and political pressure suggests it is not a high priority, at present, it seems questionable that any change in exemption amounts would be applied retroactively. More likely, any change in law that is passed in 2021 would be effective on a forthcoming date, such as January 1, 2022. That said, due to the uncertainty of what laws might change and when they would take effect, we recommend all individuals contemplating additional 2021 estate and gift planning to contact an experienced estate planning professional to navigate the various issues, and to take action sooner rather than later to get a planning strategy in place.

Counteracting Buyer’s Remorse

If reductions to the gift, estate and GST exemption amounts are made retroactive to January 1, 2021, is there anything that can be done for individuals who made gifts in 2021 prior to the enactment of these changes in law? Individuals contemplating such gifts should speak with an experienced estate planning professional to discuss certain techniques that can be considered to unwind estate planning in order to avoid an unintended gift or GST tax. For example, the individual could consider disclaimer planning, including allowing one beneficiary of a trust to disclaim on behalf of all trust beneficiaries. This should provide the designated beneficiary with nine (9) additional months to disclaim the gift and, if the designated beneficiary does so, the result should be that the gifted assets are returned to the donor without using any of the donor’s gift and/or GST exemption.

Individuals could also consider planning with qualified terminable interest property (QTIP) elections. A married person could make a gift to a trust for the benefit of a US citizen spouse that would qualify for the marital deduction if a QTIP election is made or, if no election is made, would instead pass to a non-qualifying trust for the spouse that would use up the donor spouse’s lifetime exemption. This provides the donor spouse with flexibility either to make the QTIP election or not in the following calendar year when the related gift tax return is due, depending on whether any reduction of the gift and/or GST exemption amount is made retroactive to January 1, 2021.

Finally, an individual could consider making gifts utilizing a formula transfer clause. The donor would make a gift of a fractional interest of an asset where the numerator is the donor’s available exemption on the date of the gift and the denominator is the fair market value of the gifted assets, as finally determined for federal gift tax purposes. If the exemption amount on the date of the gift is retroactively reduced, the formula should “self-correct” so that the donor only gives away an amount equal to the donor’s available exemption on that date.

Takeaway Observations

As the last four years in general, and the last four weeks in particular, graphically have demonstrated, anything is possible. But panicked responses or knee-jerk reactions to what might happen never make sense. It is, of course, likely that taxes will go up. But in trying to assess the likelihood of dramatic or radical changes to existing tax laws, and the timing of any such changes, in order to make reasoned decisions, it may be helpful to keep the following in mind:

  • Joe Biden is a moderate Democrat.
  • The Biden Plan is a proposal that Biden campaigned on in order to garner as many votes as possible from voters ranging from moderate to liberal. It does not mean, once he is inaugurated, that he will necessarily propose every aspect of the Biden Plan.
  • Biden has a lifelong track record of forging compromises across both sides of the aisle.
  • Even in the absence of compromise, it is not clear that 100 percent of the Democrats in the Senate would support extreme or retroactive tax changes (there are a few “conservative” Democrats that may vote against it).
  • While everyone should be vigilant and prepared, there likely will be time to assess any proposed legislation and consider your options.
  • Countries in the rest of the world have been imposing wealth taxes, making expatriation more penal and requiring public registers of beneficial ownership. All of those items are absent from the Biden Plan.
  • As important as trying to anticipate change is, no one can predict the future. At least as important, if not more so, will be promptly and thoroughly reviewing your estate plans once change is enacted to make certain the plans still function as intended, in order to forestall dashed expectations and/or intra-family litigation.

Neil Carbone, Mackenzie Collins, Nancy Collins and Alexandra Copell contributed to this article.

©2020 Katten Muchin Rosenman LLP

ARTICLE BY David M. Allen, Mal L. Barasch,
Diane B. Burks,  Lawrence B. Buttenwieser,
Jonathan C. Byer,  and Michelle R. Canerday of
Katten
For more, visit the NLR Estates & Trusts section.

Court Affirmed Finding That Testator Had Capacity To Execute A Will, Was Not Unduly Influenced, And That The Appointment of Co-Executors Was Appropriate

In In the Estate of Flarity, a son of the testator challenged the trial court’s probating of a 2004 will and the appointment of two of his siblings, named in that will, as executors. No. 09-19-00089-CV, 2020 Tex. App. LEXIS 7536 (Tex. App.—Beaumont September 17, 2020, no pet. history). The contestant alleged that the testator did not have mental competence. The court of appeals disagreed. The court first addressed the standard for mental competency challenges:

In reviewing evidence addressing a testator’s capacity, we focus on the condition of the testator’s mind on the day the testator executed the will. Under Texas law, whether a testator has the testamentary capacity hinges on the condition of the testator’s mind the day the testator executed her will. Thus, the proponents of the will must prove that, when the testator signed the will, she could understand: the business in which she was engaged, the nature and extent of her property, the persons to whom she meant to devise and bequeath her property, the persons dependent on her bounty, the mode of distribution that she elected to choose among her beneficiaries, a sufficient memory so she could collect the elements of the business she wanted to transact and hold it in mind long enough to allow her to perceive the relationship between property and how she wanted to dispose of it, all so she could form reasonable judgments about doing those things.

Id. Applying those legal principals, the court held that the evidence was sufficient to support the trial court’s finding that the testator had capacity. There was testimony from the two children that were executors that the testator knew what she was doing. The contestant relied on his own testimony that the testator suffered from recurring depression many times in her life, including 2004. The court held:

But there is no expert testimony showing Paula was clinically depressed. There are not medical records in evidence that support Joe’s claim. While Joe argues Paula was not being treated for her condition in 2004, he never established that she was suffering from depression that year, as the parties never developed evidence about whether Paula was or was not seeing doctors at any time for any reasons at a time relevant to the day Paula signed the will. Furthermore, even Joe and Becky never testified that Paula told them at any time in 2004 that she was being treated for depression.

Id. Further, the court held that the testator had a reason for her will and there was no evidence that the executors influenced her:

Generally, the evidence admitted in the trial reflects that Paula chose to give her children a percentage share of her estate based on how much time they spent with her as she aged. Joe does not contend the evidence shows he spent more time with Paula than his siblings. Nor does he suggest that Paula miscalculated how much time he spent with her when compared with his siblings. Instead, Joe argues that Wes and Merrie obtained a larger share because they spent more time with her. That may be true, but that evidence does not show that Merrie and Wes used their influence to get Paula to change her will in a way that favored them during a period that Paula could not freely make that decision on her own.

Id.

Finally, the court of appeals affirmed the trial court’s appointment of the co-executors. The court stated the legal standard as:

When a testator nominates a person to be the executor of her will, the law requires the probate court to appoint that person to that office unless one of the enumerated exceptions in the Estates Code applies. The exceptions allow the probate court to choose someone else other than the person the testator named if the person the testator named renounces the appointment, or the evidence shows the person is “not qualified,” statutorily disqualified, or “unsuitable” for the office. Since the Estates Code requires probate courts to appoint the person the testator nominated in her will absent one of the listed exceptions, Joe was required to prove in the trial that Wes and Merrie were not qualified, statutorily disqualified, or unsuitable for the office. Thus, since Joe is attacking an adverse finding on which he had the burden of proof in the trial, he “must demonstrate on appeal that the evidence establishes, as a matter of law, all vital facts in support of the issue.” To do that, he must show the evidence before the probate court conclusively shows one of the enumerated exceptions to the provisions requiring probate courts to appoint the person the testator designated applies

Id. The court held that evidence from the contestant of hostility was not sufficient to show that the co-executors were not suitable. The court also held that the fact that one of the co-executors let her son live a home owned by the estate without the payment of rent was not a conflict as that could be viewed as a benefit to the estate (having someone protect and upkeep estate property) and that the co-executor was a part owner of the home and had the right to have her son live there without paying rent (in the absence of an objection co-owner). The court of appeals affirmed the trial court in all things.

© 2020 Winstead PC.
For more articles on wills, visit the the National Law Review Estates & Trusts section.

Ten Estate Planning Tips as We Emerge from a Pandemic and Head into a Presidential Election

No one can say that 2020 has been an ordinary year – from the outbreak of COVID-19 in the first quarter of 2020 to the death of Supreme Court Justice Ruth Bader Ginsburg to the upcoming Presidential election.

So, amidst such an unusual year, why not think about estate planning? These times provide an exceptional backdrop to engaging in thoughtful consideration about planning, and the economic environment provides unique opportunities.

Here are ten estate planning tips worth considering, right here, right now, during the final three months of 2020:.

Planning with Continued Low Interest Rates.

The Federal Reserve’s decision to keep interest rates historically low, even at the risk of inflation, has created a fertile environment of estate planning freeze strategies which utilize the IRS’s published interest rates. The Grantor Retained Annuity Trust (or “GRAT”) and the Charitable Lead Annuity Trust (or “CLAT”) are two techniques which, when most successfully deployed, allow for the transfer of wealth at a reduced gift tax cost and provide that the future appreciation on the assets transferred passes without exposure to the individual’s estate tax. The GRAT pays a defined sum back to the creator for a fixed number of years, and the remainder passes to family; the CLAT pays a fixed sum to a named charity for a defined number of years, and then the remainder passes to the creator’s family. The current applicable Federal interest rate for determining the gift tax value of these techniques is currently 0.4%, having dropped from 2.2% in February. Normally a GRAT or CLAT is most successful when a client transfers an asset which has significant appreciation potential, such as a closely-held entity where the owner expects a successful sale in the future. However, funding a GRAT with securities (or swapping them into an existing GRAT, as described below), given the relatively depressed and volatile capital markets and the low interest rates, means that more long term growth resulting from the rebounding stock market will be able to be passed to family.

Lower Values in Commercial Real Estate.

If your commercial real estate holdings have recently decreased in value, this could be an ideal time for making a gift of interests in these assets to family. When gifts are made in the form of interests in limited liability companies or limited partnerships, discounts continue to be appropriate for lack of marketability and lack of control even on top of lower real estate appraised values. The result is that owners of commercial real estate may be in a position to move quickly by transferring that property now to family trusts before the value rebounds in coming years. Such transfers may be most effective in the form of an outright gift or a gift to an irrevocable trust which is not considered to be owned by the creator for income-tax purposes or perhaps using promissory notes to family members.

Checking the Existing Basic Estate Plan.

Now is the time to review your will or your revocable living trust agreement (or both) to see if they still accurately reflect your wishes.

Testamentary Provisions.

Reconsider whether inheritances should be outright or placed in trust for the benefit of children and more remote descendants. Parents have a unique ability to provide meaningful asset protection for children by utilizing trusts for their benefit, to shield children from claims in divorce and other predatory maneuvers. Simple wills can overlook nuances that perhaps now during this period have become magnified, particularly in younger families struggling economically and emotionally with the pandemic. Review and reconsider choices for executors, trustees and guardians.

Testamentary Tax Strategies and the 2020 Presidential Election. Tax strategies and language contained in the will need to be reviewed as the Presidential election approaches and in its aftermath. Most sophisticated estate plans are framed around optimizing an individual’s estate tax “applicable exclusion amount” (or “AEA”) using a credit shelter trust, and his or her generation-skipping transfer (“GST”) tax exemption amount using a “dynasty” or descendants’ trust. Attorneys draft for these strategies in wills or living trusts using a formula meant to maximize the allowance. For many wills, after the Tax Cuts and Jobs Act of 2017 that formula was impacted by the increase of the AEA and the GST exemption from $5,000,000 to $10,000,000. (Increased for inflation, that amount is $11,580,000 today.) Barring Congressional action, the AEA and the GST exemption is set to retreat to $5,000,000 (again indexed for inflation) on January 1, 2026.

Clients and their advisors should evaluate these formulas on a case-by-case basis, with an eye towards the 2020 Presidential election. Vice President Biden has spoken of his intention to repeal the 2017 Tax Cuts and Jobs Act, which, presumably, means restoring the AEA and the GST exemption to the $5,000,000 level, as indexed. A long-standing Democratic agenda item has been to restore the AEA to the Clinton-era $3,500,000. Curiously, the Trump campaign lacks a definitive statement either to eliminate the Federal estate tax or even take decisive action to make permanent the exemption increases in the Tax Cuts and Jobs Act. The one secure tax take-away is that there is no telling what Congress and the President will do in 2021 and the years following, and so having the flexibility in a will or living trust to optimize the wealth tax environment, should death occur during this period of uncertainty, is essential.

How is this accomplished? Avoid or revisit formula clauses for credit shelter trusts where a surviving spouse is involved. These clauses might result in an unexpected and disproportionate benefit passing to a trust which is not exclusively for a spouse’s benefit. Better planning suggests drafting to set up a marital trust for the surviving spouse to hold the estate’s financial assets, which, through elections made during the period of administration and the ability to divide it into different shares, can provide the same benefits of planning with the AEA but offer more flexibility to achieve the best tax strategy overall.

Check Advance Directives and Durable Powers of Attorney.

Usually an integral part of the basic estate planning package, advance directives for health care and durable powers of attorney tend to gather dust as years wane. Unlike wills, which only take effect at death, these documents state an individual’s wishes regarding financial decision-making and health care decision-making while he or she is alive but unable to act or express intentions. These documents should be reviewed and refreshed at least every ten years, even if there is no change.

 Advance Directive for Health Care.

Different practitioners may use different forms, but at its core, this documentation sets out wishes about health care decisions and end-of-life views (end-of-life decisions are sometimes set out in a separate document known as a living will), and the appointment of a health care representative to act as the agent to make medical decisions including end-of-life decisions (sometimes set out in a separate document known as a health care proxy or proxy directive).  Are these choices and wishes still accurate? Is the agent’s information up to date?  Have the wishes been discussed with the agent? If the pandemic has taught many families one thing about estate planning, it has stressed the importance of having this document prepared, properly executed, and having the agent informed and ready with decision-making knowledge and resolve.

Durable Power of Attorney.

A durable power of attorney as created by most practitioners immediately grants authority to an agent to conduct business or financial transactions in the name of the individual who executes it. That being said, these documents can often be the most difficult to use. Many banks and financial institutions will insist on their own forms, whenever possible. In view of these hurdles, these documents should be reviewed and updated, if necessary, to avoid a costly confrontation with an uncooperative bank representative should the need arise to have them implemented. Check the names and addresses of the named agent. If there are co-agents, can they act independently or is unanimity required? Is there a power in the agent to make gifts? Is there authority to deal with digital assets? What is the relationship between the agent and the named executor in the client’s will?

Check Existing Estate Planning Strategies.

Individuals should take stock and review their other irrevocable strategies implemented in years past which may be impacted by the current economic and political climate. Existing life insurance trusts, spousal lifetime access trusts (described below), dynasty trusts, GRATs, qualified personal residence trusts, and charitable trusts, to name the most common, all may be accomplishing a desired goal of minimizing a client’s exposure to estate tax, but they need care and feeding, and a proper audit from time to time is essential. For example:

Insurance Trusts. Are Crummey notices being sent faithfully to trust beneficiaries in the case of insurance trusts where transfers are being made to the trust to pay premiums? Are the trust provisions still desirable? Are the successor trustees still acceptable? Are beneficiary designation forms up to date?

GRATs. Is the property in an existing GRAT subject to volatility such that it might be appropriate to freeze the fluctuation by having the creator substitute the property for a less volatile asset class (like cash) having an equivalent value? Have the required GRAT payments been made faithfully as prescribed in the trust agreement? If a GRAT has terminated, has the remaining property been transferred to the beneficiary of the remainder?

Dynasty Trusts and Spousal Lifetime Access Trusts. Are the provisions in the governing instruments regarding trust benefits and distributions and trustees still desirable? How are the assets performing? Is there an opportunity to do income tax planning for an asset otherwise excluded from the creator’s estate by swapping it out, as described above with the GRAT?

In many instances, upon reviewing these existing strategies, clients or their counsel have identified concerns or issues which need immediate attention, either because the provisions are no longer desirable or the technique has lost its purpose relative to size of his or her estate. Many states, including New Jersey, have adopted in one form or another, the Uniform Trust Code, which can help practitioners address changes needed to outdated or out-of-touch trusts. Decanting, combining or merging may also present viable options.

Renegotiate Family Loans.

Intra-family loans can often be a pragmatic solution for individuals looking to transfer wealth using the technique of an estate freeze.  The transfer itself is not a gift, but the value of the transfer is frozen at the time it takes place, meaning that the expected return of the principal amount is fixed by the value of the loan, whereas the asset or funds in the hands of the borrower is allowed to appreciate free of estate tax. For example, assume in 2015 a parent lends $1,000,000 to a child to purchase a home. If the parent had the child sign a promissory note and mortgage with a market rate of interest, no gift occurred. In October 2015, the applicable Federal interest rate (i.e., the minimum rate the parent must charge to avoid characterizing the loan as a gift) was 2.44%. In October 2020, the AFR for the same term loan is 1.12%. By refinancing the indebtedness, the child can lower his/her payments of interest by more than half. And if the parent is forgiving the interest as part of an annual gifting program, the annual gift tax cost has dropped from $24,400 to $11,200. Consideration should be given, however, to determine if refinancing to a lower rate and the benefit which the child realizes is, itself, a taxable gift. This may be avoided if the child pays to the parent the points associated with the adjustment to the lower interest rate at the time of the refinancing.

Using (or Losing) Your AEA before 2021 (or 2026).

As mentioned above, the AEA is currently $11,580,000 per person and, absent any legislative overhaul, will continue to be adjusted for the next five years with inflation and then disappear, reverting to the base amount of $5,000,000. Neither candidate seems to have mentioned gift, estate or GST taxes directly in any public discourse, but the Biden tax platform does include ending the income-tax benefit of the step-up in basis on appreciated property at death. The step-up at death currently allowed under the tax laws offers pragmatic and economic benefits for all taxpayers, regardless of affluence. Although not entirely clear as yet, a Biden administration agenda item appears to suggest that previously-unrealized gains are to be taxed at an individuals death, regardless of whether they are sold. Similarly, if Republicans were to revive their efforts at full-blown estate tax repeal, it is likely that the measure would follow the pattern of the repeal which occurred in 2010, namely that outside of an exemption, most of a decedent’s assets would not be allowed a step-up in basis.

Sunsetting and “Clawback.”

Putting aside these possibilities, the enhanced AEA will, absent any legislative action, sunset on January 1, 2026, thereby eliminating a meaningful amount of tax-free wealth which an individual can pass to family.  Individuals planning for this increasingly-likely situation are being encouraged to make taxable gifts immediately which use their AEA (i.e., gifts of up to $11,580,000 for individuals or $23,160,000 for married couples). In addition, the IRS has confirmed that taxpayers who make such gifts during this period will not be penalized even if the base amount of the AEA reverts to $5,000,000 as a result of the sunset in 2026.  Prior concerns of this “clawback” have discouraged gifts in the past, but with this pronouncement, there is no downside for making the gifts today and, potentially, no time like the present.

Techniques.

While any irrevocable family dynasty trust can be effective to make a lifetime gift of AEA, the most pragmatic technique which keeps the assets within the creator’s reach is the spousal lifetime access trust (or “SLAT”). SLATs are appealing for married individuals because, when properly set up, SLAT property remains accessible to the creator of the trust through their spouse as the beneficiary. However, the growth on the assets in the SLAT not consumed is passed on to the lower generation without further exposure to estate tax. Obtaining a policy of insurance on the life of the beneficiary (in an irrevocable trust) can be a way to insure for the creator that the death of the spouse-beneficiary does not compromise the access to funds otherwise being enjoyed by the couple prior to the creation of the trust. Spouses can set up SLATs for each other, but care must be taken to avoid the IRS’s “reciprocal trust doctrine” and the “step transaction doctrine,” both of which can cause undesirable consequences.  Clients who are considering the technique but not sure if or when they want to pull the trigger should take steps now to prepare for the eventual transfer of assets by making a substantial gift to the spouse who may not have sufficient assets in her or his own name, in order to enable that spouse to create the gift. In this way, there is a meaningful amount of time which has passed and allows the gift to “cure” in the hands of the spouse before being moved into a trust. Just how much should be considered to be placed in the trust? The answer will vary from client to client and will likely depend upon resources outside of the SLAT, but ultra-high net worth couples are advised to take a large bite of their unused exemption, using the SLAT, while it is still available.

Don’t Forget about the GST: Are Existing Trusts Being Optimized?

Many family wealth portfolios already have in existence trusts which provide benefits in the form of income, savings or potential future educational funds for children. Such trusts may have been created by parents or grandparents or even by the clients themselves during the last “fiscal cliff” estate planning crisis of 2012. Many of these trusts present challenges and opportunities for multi-generational wealth planning which, in this dynamic tax environment, require attention. Many individuals are unaware of the impact of the Federal generation-skipping transfer (or “GST”) tax, which, when applicable, creates an additional tax of up to 40% on transfers which land in the laps of beneficiaries who are two or more generations removed from the creator of the trust. In reviewing these trusts clients should be aware of the following:

“Grandfathered Trusts.”

Is the trust even subject to the GST tax? In general, any trust which was already in existence and irrevocable prior to September 25, 1985, enjoys the status of being a so-called “grandfathered trust,” meaning it is not subject to the tax at any point. Trusts of this nature should be carefully administered to avoid potential unintended exposure to the tax resulting from the exercise of certain rights or powers by beneficiaries or the modification of the terms (using certain statutory techniques or judicial actions). Such actions have the potential to cause the trust to be subject to the tax.

“Non-Exempt” Trusts Fully Subject to the Tax.

As wealth from “the greatest generation” passes down to baby boomers, many sophisticated estate plans have irrevocable trusts that are literally GST tax ticking time bombs. These trusts were created with an individual’s wealth which, at the time of transfer, exceeded his or her GST exemption amount available. By definition, these trusts upon termination will suffer the full blow of the 40% GST tax, thereby depleting the wealth otherwise intended to be passed to the family. Trustees have a fiduciary duty to minimize all taxes – including GST taxes – consistent with the intent of the creator. In many cases there are options available which should be considered at this time, particularly in the face of potentially shrinking estate tax exemptions. For example, assume the principal trust beneficiary is a child of the creator who has personal assets which fall below the AEA. Here, a trustee might do well to consider making a large principal distribution to the beneficiary to enable him to create a SLAT or a dynasty trust using the beneficiary’s own AEA so the trust escapes both the GST tax as well as estate tax when the beneficiary dies. Another strategy might include granting the beneficiary a testamentary general power of appointment which changes the impact of the GST tax and causes the trust to be included in the beneficiary’s estate for estate tax purposes.

Capital Gain Taxes and GST-Exempt Trusts.

Apart from the GST tax planning opportunities and obligations, trustees should also consider the fact that many generational trust strategies may be victims of their own success in another way:  appreciated assets – particularly in GST-exempt trusts such as dynasty trusts – may be harboring large unrealized gains. Family members may be pleased to receive appreciated assets free of GST tax, but that good feeling may soon dissipate if the appreciated asset is sold and the individual is subject to income tax on a large, long-term capital gain. Such gains by definition are not stepped up (as they are in the case where the underlying assets are subject to estate tax) because they bypass the beneficiary’s estate. Trustees, therefore, need to consider strategies which might be employed to minimize the potential gain. Unlike the GST strategies above, these income tax-driven techniques are more complex and need to be vetted against the individual variables of a client’s tax picture.

Strategize about Business Succession and Long-Range Planning.

The national lock-down which began in March not only locked down the economy, but it created a unique environment for business owners to stop and reflect about their enterprises and the future. Is this the time to liquidate a business? A division? Sell certain assets to raise cash and redeploy in a different line of products or services? Professional advisors are essential because they can help provide perspective and options. And if a business owner is looking to stay the course and transition the business to the next generation, an important consideration will be the fitness of the family to continue the legacy in the “new normal.” Business succession experts and consultants are well aware of the expression “shirtsleeves to shirtsleeves in three generations,” meaning an entrepreneur’s ability to have a business thrive multi-generationally is a direct function of the ability of the family members in the next generation to work hard, continue to innovate and adapt to new challenges.

Consider State Estate and Income Tax Effects on Your Domicile.

One of the unintended silver linings of the past six months has been the surprising ease with which certain businesses can conduct their operations in a remote capacity. The increased reliance on web-based video conferencing technology has revolutionized the way employees can accomplish tasks. The long-range effect of this shift in employment platforms may be that companies no longer need employees to remain in a centralized locale. Indeed, many individuals fled their homes and urban apartments to take refuge in the Berkshires, the Jersey Shore and Florida, where they continue to work productively. If business in the post-pandemic age permits migration, individuals now have a unique opportunity to re-evaluate their domicile in terms of tax and estate planning. Florida, for example, affords the benefits of no state income or estate tax and a generous homestead exemption. New Jersey has – for the moment – repealed its estate tax but has retained its inheritance tax. Residing in other jurisdictions could have other benefits. This may be the time to consult a tax advisor to determine if shifting domicile creates an overall tax reduction. In so doing, clients need to remember that a residence maintained in a former domicile renders them vulnerable to tax challenges by that jurisdiction. A legal domicile is a factual consideration made up of a series of intent-driven indicators which go beyond an individual’s physical presence in a jurisdiction. Factors include the individual’s driver’s license, voter registration, club and religious affiliations and the like. If social contacts relating to the former domicile become more prevalent, that state might be able to prove that the individual ultimately intended to return to that jurisdiction and negate even a temporary change in domicile. Here again, a legal advisor can assist in advising which steps are best to accomplish the desired result.

Conclusion

Neither the pandemic nor the upcoming Presidential election promises us any certainty anytime soon. In the midst of this climate, it is important to remember that certain opportunities for shifting wealth down to lower generations may be expiring within the next few years. The pandemic and its effect on the economy continue to keep interest rates at historic lows, which make this an ideal environment to engage in all aspects of estate planning, from the simple to the comprehensive. Now is the time to take stock of what is driving your estate planning, to think through existing choices and options with the help of legal and financial advisors, and then decide how best to optimize the strategies going forward.

© Copyright 2020 Sills Cummis & Gross P.C.
For more articles on estate planning, visit the National Law Review Estates & Trusts section.

Register for the 51st Annual PLI Estate Planning Institute

Live Webcast: Sept 14 – 15, 2020, 9 a.m. EDT

Click here to register.

The Tax Cuts and Jobs Act of 2017 (the “2017 Act”), which was enacted on December 22, 2017, included significant changes to the federal transfer tax regime and related income tax provisions.  More recently, the financial and societal impact of the COVID-19 pandemic of 2020 continues to reverberate and create uncertainty in the future.

This program will review the transfer tax and related income tax developments with the 2017 Act as a starting point, and will discuss how such developments impact estate, trust and income tax planning, and the administration of decedents’ estates.  Moreover, the program will review other recent developments regarding estate, trust and transfer tax and income tax planning.  Further, the COVID-19 crisis and the related estate, trust and income tax legislation and rulings promulgated in response to such crisis will be discussed.

What You Will Learn

  • Advising clients in a time of unprecedented uncertainty
  • An update on recent developments in all areas of estate, trust and transfer tax planning including legislation and rulings issued as a result of the COVID-19 crisis
  • A review of the interaction between the federal transfer tax regime and state transfer tax regimes
  • A review of the transfer tax and related income tax provisions of the 2017 Act
  • Income tax planning for estates and trusts
  • Administering estates and trusts during and after the COVID-19 pandemic
  • A review of the SECURE Act of 2019
  • A review of international estate planning and tax changes
  • FATCA and its progeny
  • A discussion of trust planning and divorce
  • Ethical considerations for attorneys
  • Elder law and special needs planning considerations
  • A review of tax issues for art collectors
  • An update on charitable donation planning
  • A review of electronic Wills and modern-day estate planning
  • Asset protection planning in a pandemic world

…and much more!

Special Features

  • Full hour of ethics credit

Who Should Attend

Attorneys and other professionals advising on estate planning and/or transfer tax planning, including accountants, financial planners and anyone else whose practice requires a solid understanding of estate planning.

Program Level: Overview

Prerequisites: Attendees should have a basic understanding of trusts and estates terminology and a foundational background in tax

Intended Audience: Attorneys, accountants, financial planners, and other professionals who specialize in estate planning, life insurance products and/or transfer tax planning

Advanced Preparation: None

See other upcoming events from PLI here.

Court Rejected A Trustee’s Objection To Personal Jurisdiction In His Individual Capacity But Affirmed The Objection In His Capacity As Trustee

In Hanschen v. Hanschen, a trustee challenged a default judgment. No. 05-19-01134-CV, 2020 Tex. App. LEXIS 4075 (Tex. App.—Dallas May 28, 2020, no pet. history). The family sued the trustee in his personal capacity and in his capacity as trustee for breaching fiduciary duties. While the trustee was in Texas, the family served him in his personal capacity. The family then obtained a default judgment against him in both capacities when he did not file an answer. Later, the trustee filed a special appearance challenging the court’s personal jurisdiction, and the trial granted the motion. The family then appealed.

The court of appeals reversed the special appearance against the trustee in his personal capacity. The court held that because the trustee was personally served in Texas, the trial court had personal jurisdiction over him:

In this case, the family personally served James with the petition and citation while he was in Texas. The family concedes they “have never asserted that Texas has general jurisdiction over James or that the traditional minimum contacts analysis would be met in the absence of his physical presence.” They are correct and the case law is clear that a trial court has authority to exercise in personam jurisdiction over a nonresident where the court’s jurisdiction grew out of the personal service of citation upon the nonresident within the state. A nonresident, merely by reason of his nonresidence, is not exempt from a court’s jurisdiction if he voluntarily comes to the state and thus is within the territorial limits of such jurisdiction and can be duly served with process.

Id. The trustee also argued that the court did not have adequate jurisdiction over him in his personal capacity because there were no claims against him in that capacity, but the court of appeals disagreed:

While we may agree with James that the default judgment granted relief against the entities for which it would be necessary for Texas courts to have jurisdiction over James in representative capacities, the family’s petition pleaded causes of action against James individually for breaches of fiduciary duties arising from his role as trustee of the Progeny Trust and his roles in NBR-C2, NBR-C3, and NBR-Needham. The family seeks exemplary damages against James for these alleged breaches of fiduciary duties. James does not make a specific argument why these claims are not pleaded against him personally. In Texas, generally an agent is personally liable for his own tortious conduct. For these reasons, we agree with the family that James was personally served with process in Texas, so the trial court has personal jurisdiction over him in that capacity.

Id.

The court of appeals then turned to whether the trial court had personal jurisdiction over the trustee in his capacity as trustee. The court noted that the citation was not issued to him in that capacity. The court held that this defect was dispositive and affirmed the special appearance for the trustee in his representative capacity:

We have held, “[t]he capacity in which a non-resident has contact with a forum state must be considered in the jurisdictional analysis.” James was not served with a citation directed to him in any representative capacity; only “JAMES HANSCHEN WHEREEVER HE MAY BE FOUND.” At oral argument, the family argued the listing of all the parties in the citation was sufficient to constitute service on James in each representative capacity he was listed as a defendant. We reject this contention and the family’s counsel acknowledged in oral argument a citation addressed to one defendant inadvertently served on a different, unrelated defendant would not constitute good service of process merely because all defendants’ names were in the list of defendants in the style of the lawsuit… In this case, James was not served with citations which were returned to the court clerk stating he had been served in his representative capacities. Any failure to comply with the rules regarding service of process renders the attempted service of process invalid, and the trial court acquires no personal jurisdiction over the defendant. A default judgment based on improper service is void. Accordingly, the trial court did not have personal jurisdiction over James in his representative capacities.

Id.

© 2020 Winstead PC.

Court Holds That A Deceased Testamentary Trust Beneficiary Can Still Be A Beneficiary

In In the Estate of Mendoza, a decedent’s son’s children filed a petition claiming their entitlement to their father’s beneficial interest in a trust created under the decedent’s will. No. 04-19-00129-CV, 2020 Tex. App. LEXIS 1845 (Tex. App.—San Antonio March 4, 2020, no pet. history). The son had predeceased the decedent. The decedent’s daughters moved for summary judgment on the sole ground that a dead person could not be a beneficiary of a trust. The trial court granted the daughters’ summary judgment motion. The son’s children appealed.

The court of appeals reversed the summary judgment, holding that the mere fact that the decedent’s son predeceased the decedent did not establish the son’s beneficial interest in the trust created under the decedent’s will lapsed as a matter of law. The daughters argued that a dead person cannot be a beneficiary of a trust and cited to Longoria v. Lasater, 292 S.W.3d 156, 167 (Tex. App.—San Antonio 2009, pet. denied) and Section 112, comment f of the Restatement (Second) of Trusts. However, the court of appeals held that the daughters ignored the difference between an inter vivos trust, which was the type of trust analyzed in Longoria, and a testamentary trust. The court cited to Section 112, comment f, of the Restatement (Second) of Trusts:

A person who has died prior to the creation of a trust cannot be a beneficiary of the trust. Thus, if property is transferred inter vivos [i.e., not by will] in trust for a named person who is dead at the time of the transfer, no trust is created… So also, if a testator devises property in trust for a person who predeceases him, the devise of the beneficial interest lapses, and the person named as trustee ordinarily holds the property upon a resulting trust for the estate of the testator. By statute, however, in many States a devise does not lapse under certain circumstances, as for example if the devisee leaves a child; and under similar circumstances a devise of the beneficial interest under a trust does not lapse.

Id. (citing Restatement (Second) of Trusts § 112 cmt. f (1959) (internal citation omitted); see also Restatement (Third) of Trusts § 44 reporter’s notes on cmt. d (2003) (citing authorities discussing the application of the lapse doctrine and anti-lapse statutes to persons taking under trusts created by a will and noting “[a] comprehensive discussion of the lapse doctrine and anti-lapse statutes is beyond the scope of this Restatement”)). Accordingly, the court of appeals concluded: “the trial court erred in granting summary judgment in favor of the Daughters based on the mere fact that Eduardo predeceased Jose because that fact alone did not establish Eduardo’s beneficial interest lapsed as a matter of law.” Id. Further, the court refused to address an argument about Texas’s anti-lapse statutes because the arguments had not properly raised below. The court reversed the summary judgment and remanded for further proceedings.

© 2020 Winstead PC.

529 Plans: Estate Planning Magic

The most common way to reduce state and federal estate taxes is to make lifetime gifts to irrevocable trusts. However, in order for an irrevocable trust to escape estate taxation at the grantor’s death, the grantor may not retain the power to “designate the persons who shall possess or enjoy the property or the income therefrom.” (IRC § 2036(a)(2).) In other words, the grantor cannot change the beneficiaries of the trust.

This poses a problem. What if circumstances change? What if a grantor creates a trust for a child, but the child no longer needs the funds? What if the grantor ends up needing the funds themselves? A grantor can build flexibility into irrevocable trusts by granting powers of appointment to the beneficiaries or by appointing a trust protector, but these powers may not be held by the grantor. Thus, reluctance to give up control keeps many clients from making gifts to irrevocable trusts.

The general rule that a grantor must relinquish all control over gifted assets has been seared into the mind of every estate planning professional fearful of accidentally causing estate tax inclusion. But there is one exception: the humble 529 Plan.

Section 529 of the Code contains a shocking statement:

“No amount shall be includible in the gross estate of any individual for purpose of [the estate tax] by reason of an interest in a qualified tuition program.” (IRC § 529(c)(4)(A))

There are, of course, exceptions. 529 plans are (likely) includible in the estate of the beneficiary upon the beneficiary’s death. Also, if the grantor has made the election to “front load” five years of annual exclusion gifts to the 529 Plan (discussed further below) and dies before the five years expires, a portion of the gifted amount will be includible in the grantor’s estate.

Still, 529 Plans offer unparalleled flexibility in estate tax planning. A grantor can remain the “owner” of a 529 Plan and retain the power to change the beneficiary to a qualifying family member (which includes grandchildren, nieces and nephews, and others), while still removing the assets in the 529 Plan from his or her estate. This is in contrast with an irrevocable trust, in which the grantor cannot act as trustee and cannot retain the power to change the beneficiaries.

The other “magic” of 529 Plans is the ability to “front load” annual exclusion gifts. The annual exclusion from gift tax allows a grantor to transfer up to $15,000 per year, per person. But, if a grantor makes the proper election on a gift tax return, he or she can make five years of annual exclusion gifts in a single year and use no transfer tax exemption. If the grantor is married and elects “gift‑splitting,” the couple can transfer $150,000 to a 529 Plan in a single year and use no estate and gift tax exemption.

529 Plans are, of course, designed for education, and are not complete substitutes for irrevocable trusts. The “earnings portion” of non-qualified distributions (i.e., distributions not used for “qualified higher educational expenses”) from a 529 Plan are subject to ordinary income tax at the beneficiary’s tax rate plus a 10% penalty, and for this reason, care should be taken not to “overfund” a 529 Plan. However, 529 Plans can nevertheless serve as effective wealth transfer vehicles because of their income tax benefits and the high probability that a grantor will wish to make significant contributions to the education of at least some members of his or her family. Combined with their unparalleled estate tax features, this makes 529 Plans “estate planning magic.”

© 2020 Much Shelist, P.C.

For more Estate Planning, see the Estates & Trusts section of the National Law Review.

Choosing a Trustee for Your Children – Should Foreign Family Members Apply?

Often the most difficult decision parents need to make when writing a Will is whom to appoint as the trustee for their children. The choice becomes particularly tricky for clients whose families live outside the U.S. since choosing a foreign trustee will cause the children’s trusts to be classified under U.S. income tax laws as “foreign trusts” – with lots of ensuing complications.

Under the Internal Revenue Code, trusts are by default “for­eign trusts” for U.S. income tax reporting purposes unless a U.S. court exercises both primary supervision over the administration of the trust (the “court test”), and one or more U.S. persons have authority to control all substantial decisions of the trust (the “control test”). The choice of a foreign trustee causes the trust to flunk the control test because a non-U.S. person controls substantial decisions of the trust. Being classified as a foreign trust results in some problematic U.S. income tax consequences. For example:

  •  U.S. beneficiaries who receive distributions from the trust will be taxed to the extent that any trust income, including foreign-source income and capital gains, is included in the distribution. Normally, non-U.S. source income and realized capital gains are not deemed to constitute any part of a distribu­tion to a beneficiary unless specifically allo­cated to a beneficiary. The foreign trust rules change this tax treatment such that non-U.S. source income, as well as capital gains, are deemed to be part of any taxable income distributed to a U.S. beneficiary.
  • Trust income not distributed in the year it is earned becomes undistributed net income (UNI). If, in a later year, a trust distribution to a U.S. beneficiary exceeds that year’s trust income, the distribution carries out UNI and is deemed to include the accumulated income and capital gains realized by the foreign trust in prior years. These gains do not retain their character but rather are taxable to the U.S. beneficiary at ordinary income tax rates.
  • Also, to the extent that a distribution to a U.S. beneficiary exceeds the current year’s trust income, a non-deductible interest charge will be assessed on the tax that is due with respect to the accumulated income and capital gains that are now deemed distributed. This charge is based upon the interest rate imposed upon underpayments of federal income tax and is compounded daily.
  • Finally, accumulated income and capi­tal gains are taxable to the U.S. beneficiary at the beneficiary’s ordinary income tax rate for the years during which it was earned under a complex formula designed to capture the U.S. tax that would have been payable if the accumulations had been distributed in the years earned – called the “throwback tax”.

Foreign trusts also trigger additional reporting obligations that carry heavy pen­alties for failure to comply. A U.S. beneficiary who receives a distribution from a foreign trust must file Form 3520 (“Annual Return to Report Transactions with Foreign Trusts”) reporting the distribution and the character of the distribu­tion. The failure-to-file penalty is equal to 35 percent of the gross distribution.

Recognizing, however, that a domestic trust can inadvertently become a foreign trust through changes in the identity of the trust­ee – such as a trustee’s resignation, disability, or death (but not removal) or the trustee ceasing to be a U.S. person (i.e. change of residency or expatriation) – U.S. Treasury Regulations pro­vide for a 12-month period within which to cure the unintentional conversion. The trust can replace the foreign trustee with a U.S. per­son trustee, or the foreign person can become a U.S. person during these 12 months. The foreign per­son can effectuate the cure simply by making the United States his place of residence; he need not become a U.S. citizen.

Rather than rely upon the 12-month cure period, however, a trust agreement should provide for a means to remove a non-U.S. person trustee to assure that the trust qualifies as a domestic trust. Trustee removal and appointment provisions are critical but should be reserved to individuals or entities in the United States. These powers can also create inadvertent gift and estate tax issues, so consulting a qualified trusts and estates lawyer to draft them is critical.

To avoid these problems, it might seem to make sense to allow the for­eign trustee to appoint a U.S. co-trustee or to grant certain reserved powers over the trust to a foreign family member in lieu of naming them as trustee (for example, reserving to them the power to remove and replace the U.S. trustee.) But this will not solve the problem. A trust is defined as foreign unless it satis­fies both the court test and the control test.

  • The safe harbor provisions of the court test require that the trust must “in fact” be administered exclusively within the United States, meaning that the U.S. trustee must maintain the books and records of the trust, file the trust tax returns, manage and invest the trust assets, and determine the amount and timing of trust distributions.
  • The safe harbor provisions of the control test provide that, in addition to making decisions related to distributions, the U.S. trustee must be entirely responsible for a laundry list of decisions including selecting beneficiaries, making investment decisions, deciding whether to allocate receipts to income or principal, deciding to termi­nate the trust, pursue claims of the trust, sue on behalf of or defend suits against the trust, and deciding to remove, add or replace a trustee or name a successor trustee.

And just to be sure, a well-written document should include a backstop provision that requires the trust to always qualify as a U.S. trust for income tax purposes and to have a majority of U.S. trustees. The inclusion of such a provision, at the very least, alerts those administering the trust to consider these issues before making any changes to the trustee or after an inadvertent change in trustees has occurred.

The increase in cross-border families and multinational asset portfolios have added complexities to the financial planning of families. Familiarity with the impact that these rules may have to existing or proposed estate plans is critical when designing a comprehensive plan for clients.

© 1998-2020 Wiggin and Dana LLP

For more on wills and inheritance trusts, see the National Law Review Estates & Trusts law section.

Why is Section 962 Back in the Spotlight? [Podcast]

In this podcast, international tax and estate planning attorneys Megan Ferris and Paul J. D’Alessandro, Jr. provide an overview of how individuals and corporations are taxed under the GILTI regime and discuss why section 962 has come back into the spotlight in a post-2017 Tax Act world.

Transcript:

PAUL D’ ALESSANDRO

Good morning, everybody, and welcome to our first Bilzin Sumberg Tax Talk podcast. My name is Paul D’Alessandro, and I’m a tax associate here with our international private client group. I focus my practice on inbound planning and estate planning for international high net worth individuals. I’m here today with my colleague, Megan Ferris.  How are you doing this morning, Megan?

MEGAN FERRIS

Hi, Paul. My name is Megan Ferris. I am an international tax associate with Bilzin Sumberg in Miami, Florida. I focus primarily on inbound and outbound tax structuring for businesses, typically closely held businesses. Our hope with this podcast is to bring you current issues related to various tax, trust, and estate matters.

PAUL D’ ALESSANDRO

Thanks, Megan, and I think we have a great topic for you this morning. Our first topic to kick off our podcast series. And we’re going to be talking about Section 962 and why it’s come back into the spotlight as of late. So, I think we’re going to hop right into it. And, Megan, I think a good way to start would be, can you give us a quick overview of the way individuals and corporations are taxed under the new GILTI regime in a post-2017 Tax Act world?

MEGAN FERRIS

Sure. Generally speaking, and especially when it comes to CFCs, the Tax Cuts and Jobs Acts of 2017, or the Tax Reform Act, treats U.S. corporations much more favorably than U.S. individual shareholders. First, at a high level, individuals are taxed in the U.S. on their ordinary income at graduated rates up to 37%, plus an extra 3.8% net investment income tax on their passive income. Corporations, on the other hand, are taxed at a flat 21% rate on their net taxable income.  Next, the Tax Reform Act introduced a handful of new across border taxes and anti-deferral measures.  One of these is Section 951A which, is called Global Intangible Low Tax Income, or GILTI, as you referred to it, which basically applies to the active operating-income of the CFC.  Now pre-tax reform, this income would not be taxed to the CFC’s U.S. shareholders until it was distributed, but today that income is taxed annually at the shareholder’s ordinary income rate.  Congress, however, went a step further by introducing Section 250, which gives U.S. corporations, and only U.S. corporations, a 50% deduction on their GILTI income and that essentially results in a 10.5% tax rate.  But wait, there’s more. U.S. corporations can also take a foreign tax credit for up to 80% of the foreign taxes paid by the CFC. So essentially, if the CFC paid at least a 13.2% tax rate, or specifically a 13.125% tax rate in its local country, then a U.S. corporate shareholder can use foreign tax credits to offset its entire U.S. income tax liability for that underlying GILTI income.  And that’s great for corporations.  An individual shareholder, on the other hand, has no Section 250 deduction and no foreign tax credit for taxes paid by the CFC.  The individual pays up to 37% U.S. tax on GILTI, end of story.  So, as you can see, the disparity between individual and corporation taxation can be quite dramatic.  And I guess that brings us back to the theme of today’s podcast, which is how some individual tax payers might use Section 962 to avail themselves of these benefits that are available only to domestic corporations.

PAUL D’ ALESSANDRO

Thanks, Megan. So that was a great overview I think of the general operating rules for the taxation of offshore income in a post-2017 Tax Act world. So as Megan alluded to, and our next question here in our podcast is, what is a 962 election, and how might an individual consider using the 962 election?

MEGAN FERRIS

Right.  So, in short, Section 962 allows individual U.S. shareholders of CFCs to elect to be taxed as domestic corporations. The election is available to direct and indirect shareholders of CFCs, so if an individual owned their interest through a partnership or certain trusts, they would still be able to make the election.  So now I’ll get into the mechanics of the election, but first I think it would help to give some historical context. Section 962 first became effective beginning in the tax year 1963 along with the rest of subpart F. Back then, the top individual tax rate in the U.S. was 91%, and the top corporate rate was 52%. So if you think we have it bad today, just be thankful we’re not in the 1960s.  Anyhow, with the introduction of subpart F and the new concept of taxing the U.S. individual shareholder on a CFCs income that the shareholder didn’t actually receive, Congress decided to give taxpayers a break and the means of reducing that current tax burden to the lower corporate tax rate of then only 52%. In addition, taxpayers were permitted to claim deemed paid tax credits under Section 960 for foreign taxes that were paid by that CFC. Now the legislative history under Section 962 tells us that, and I quote, “The purpose of Section 962 is to avoid what might otherwise be a hardship in taxing a U.S. individual at high bracket rates with respect to earnings in a foreign corporation which he does not receive. Section 962 gives such individuals assurance that their tax burdens with respect to these undistributed foreign earnings will be no heavier than they would have been had they invested in an American corporation doing business abroad.”  So, as far as tax policy goes, that’s a breath of fresh air for the taxpayers. Okay, now the mechanics.  This is how a U.S. individual is taxed under a Section 962 election. First, the individual is taxed on amounts that are included in gross income under Section 951a and now Section 951A, which is GILTI, at a corporate tax rate, which are currently 21%. Second, the individual is entitled to a deemed paid foreign tax credit under Section 960 with respect to the subpart F or GILTI inclusion as if the individual were a domestic corporation. Third, when an actual distribution of earnings is made from amounts that were already included in the U.S. shareholder’s gross income under Sections 951a and Section 951A, and just a reminder Section 951a is subpart F income, 951A is GILTI, those earnings are included in gross income again, but only to the extent that they exceed the amount of U.S. income tax paid at the time of the Section 962 election.  So, if an individual initially used foreign tax credits to offset his or her entire U.S. tax liability related to GILTI income in the year that the income was reported, then when the income is actually distributed, it will be includable again as dividend income. If the underlying CFC is in a treaty jurisdiction, then that individual will benefit from qualified dividend rates, which are currently 20% plus a 3.8% tax on passive income, that brings us to a total U.S. effective tax rate of 23.8%.

PAUL D’ ALESSANDRO

Interesting, Megan. So it seems like there’s definitely some benefits to be gained potentially under Section 962, but how does an individual taxpayer make a Section 962 election?

MEGAN FERRIS

An individual would typically file a Section 962 election with his or her timely filed tax return for the year to which the election relates, although in certain circumstances, case law would permit a retroactive election. The election is made on an annual basis, meaning each year you have the option to make the election or not, and you also have the opportunity to miss it, so be careful about that. Once made, the election applies to all Section 951a and 951A, included to the U.S. shareholder for all CFCs for that year.

PAUL D’ ALESSANDRO

So that’s an interesting point there you made at the end and something our readers — our listener’s rather, might want to pick up on.  The election applies to all CFCs that are owned by the individual.  So keep that in mind when you’re analyzing Section 962 and whether it makes sense to make the election based on your facts and circumstances.  So I think we kind of gave an overview here of Section 962 and why it matters now.  But what we’re going to do now is drill really down into the pros and cons of 962, what are the benefits to be gained, and what are some of the drawbacks as well by making the selection. So, Megan, do you want to start by taking us through the benefits of the 962 election?

MEGAN FERRIS

Sure. If the circumstances are right for the taxpayer, then the benefits should certainly outweigh any drawbacks for making this election. For example, the subpart F inclusions and the GILTI inclusions, and those are under Section 951a, and Section 951A are subject to tax at the lower corporate tax rate, which is now 21%.  There is a 50% deduction available for the GILTI inclusions. With a Section 962 election, an individual can take a credit for up to 80% of the foreign taxes paid by the CFC to offset the tax paid on the subpart F and the GILTI.  But keep in mind that the individual would still be subject to tax on any Section 78 gross-up based on foreign taxes.  With the Section 962 election, there is no corporate restructuring required that would otherwise take time and money to implement.  There’s no impact on the other shareholders of the CFC, whether there’s domestic shareholders or foreign shareholders.  And finally, there’s no double tax on the future sale of the CFC. Now on the downside, when those previously taxed earnings are distributed, they are taxed again to the extent that the distribution exceeds the tax paid on the initial inclusion.  Now, if the CFC is not in a treaty country, then under Smith v. Commissioner, ordinary tax rates would apply because the dividends are treated as coming from the CFC and not from the deemed U.S. corporation.  And lastly, on the downside, any basis increase in CFC stock as a result of the subpart f or GILTI inclusion is limited to the amount of tax paid on the inclusion.  So, I’ll give an example.  We recently did some tax planning for a client, an individual U.S. tax resident who owned an S corporation that, in turn, owned a Mexican CFC.  The CFC operates hotels throughout Mexico and pays a 30% income tax in Mexico on its net income.  From the U.S. federal tax perspective, that CFC’s operating income is all GILTI income to our client.  And so under his existing structure, the GILTI would flow up to him, and he would be subject to 37% tax on that income without any offset for the Mexican taxes paid.  We recommended making a Section 962 election, which he did.  Now, under his current structure, the client is treated, for U.S. federal income tax purposes, as if the GILTI is earned by a domestic corporation.  U.S. tax is fully offset with the foreign tax credits for the next to get income taxes paid.  And when CFC eventually distributes the income, the client is taxed on their distribution.  However, because the U.S. and Mexico have an income tax treaty in effect, the clients benefit from qualified dividend rates, which total 23.8%.  So in effect, we helped our client reduce his effective U.S. federal income tax rate with respect to GILTI from 37% to 23.8%.

PAUL D’ ALESSANDRO

So there you have it; 962 potentially can result in a lower effective tax rate for an individual, you get the benefit of the lower corporate tax rate, the 50% GILTI deduction, the 80% indirect foreign tax credit.  On the downside, you have to watch out for actual distributions because there’s less PTI than there would have been otherwise.  So a little bit of balancing based on the facts and circumstances to see if 962 is going to make sense in your case. I think we’re going to wrap up now.  Megan, you alluded to it earlier, but, you know, why has Section 962 come back into the spotlight this past year or two, and really when might a person consider making a 962 election?

MEGAN FERRIS

That’s a great question, Paul.  Now, in the decade since Section 962 was passed, it was rarely used planning tool unless the CFC was located at a high tax treaty country, like Mexico or France.  But fast forward to February 1, 2018, when tax reform became effective, now everything has changed because the corporate tax rates dropped from 35% to 21%.  And the effective tax rate on GILTI emerged at 10.5% for U.S. corporations.  Now finally, it’s an attractive option because even when you account for the 23.8% shareholder level dividend tax, the effective tax rate is still lower with a Section 962 election than if the CFC shares were treated as owned directly by the individual.  As far as U.S. tax planning goes, the Section 962 election can be an incredibly useful and cost-saving tool for the taxpayer who fits the profile that I alluded to, and that would be a U.S. shareholder of a CFC that generates GILTI or subpart F income where CFC has foreign taxes paid in this local country where the CFC is located in a treaty jurisdiction.  Now these individual U.S. shareholders can take advantage of the lower corporate tax rate, they can take advantage of the 50% deduction for GILTI income, and they can obtain a foreign tax credit for foreign taxes paid by the CFC, all without any restructuring required.  On the other hand, if the CFC is not organized in a treaty jurisdiction, then the election may not result in a net benefit to the taxpayer.  Now, in this case, it might make more sense to forego the Section 962 election in lieu of interposing an actual UFC corporation which would feature the same mechanical benefits of the Section 962 election, but it would also open the door to taking advantage of the dividends received deduction on distributions from the CFC.  Alternatively, the taxpayer might consider setting up a flow-through structure, and that would also permit the use of foreign tax credits to offset the GILTI inclusions, although the GILTI inclusions would generally be subject to the higher individual tax rate.

PAUL D’ ALESSANDRO

So those are some great points you made, Megan, and I’ll just piggyback off a few of them before we wrap up here. Section 962, I think you’re going to want to look at whether your CFC is in a treaty jurisdiction versus a non-treaty jurisdiction, as Megan said.  The 962 election is more beneficial when you’re in a treaty jurisdiction because you can take advantage of the lower qualified dividend income rates of 23.8%.  Like anything else in tax planning, I think you have to do a little bit of modeling when you’re looking at 962, and by that I mean you have to see if you’re in a situation where your client is going to be looking to pull dividends out of his CFC on a regular to semi-regular basis, or whether the income realization event is really going to be had upon exit when an individual is going to sell shares in a CFC. In that case, 962 is going to provide some benefit there simply by providing deferral in the years where you’re not taking distributions.  And I think a final point worth noting, and Megan touched on this; there’s been a lot of talk about simply having an individual drop their CFC shares into a parent USC corporation to achieve a lot of these results that we’ve been talking about.  That sounds great in theory, but it cannot always be done tax-free in the foreign country where the CFC is located.  Many times, contributing those shares to a U.S. corporation is a taxable event in that foreign country, and it could even result in that foreign country’s own CFC laws now applying to the U.S. parent corporation.  So 962, in that case, could also serve a tremendous benefit by avoiding all those foreign taxes and local taxes that would otherwise be triggered by dropping shares into an actual U.S. parent C corporation.  And with that, I think we’ve concluded our first podcast.  I hope you all enjoyed it and found it useful.  We‘re going to be looking to bring everybody more timely tax topics and hopefully more useful planning tips over the next few months and in the next year.  Megan, is there anything you want to say before we sign off?

MEGAN FERRIS

Thanks, Paul. I think you made some great points just to wrap up there.  And again, yeah, I hope everybody enjoyed this. I hope they can take some of these points and integrate them into their practices, and I hope you continue to tune in and listen to us as we bring you more current tax topics that might apply to your own practice.

PAUL D’ ALESSANDRO

Okay.  Very good. And with that, we’re signing off. Happy holidays and a happy new year to everyone, and we’ll see you next time.

 

© 2020 Bilzin Sumberg Baena Price & Axelrod LLP

More tax guidance on the National Law Review Tax Law page.

Letters of Wishes: An Administrative and Moral Headache in Disguise?

1. LETTERS OF WISHES ARE THEORETICALLY SOUND

Trustees may have difficulties determining whether to make distributions when the grantor’s intentions are unclear. Consider a trust provision that provides for a beneficiary’s support in the form of reasonable medical expenses. The trust’s sole beneficiary approaches the trustee requesting a distribution for a gastric bypass surgery. The surgery can cost upwards of $45,000 and is the preferred method of achieving seventy-five pounds of weight loss. However, the surgery may be unsuccessful, and may result in post-operation complications and side effects that could impact the beneficiary’s health and require further distributions. Is the surgery a reasonable medical expense? Should the trustee make the distribution for the surgery?

Depending on the trustee, and his or her relationship to the grantor, the answer to the above questions is likely different. Scholars suggest that trustees should administer a trust “in [the] state of mind in which it was contemplated by the settlor that [the trustee] would act.”[1] If a spouse is serving as a trustee, he or she seemingly has ample opportunity to determine the grantor’s intent. If the drafting attorney is the trustee, the trustee may have gathered insight into the grantor’s mindset and goals while drafting the trust that could be applied to administration. Consider next a corporate trustee who enters the picture well after the grantor’s death. These trustees may have never met the grantor and are unlikely to have anything more than the trust instrument to guide administration. When contemplating a distribution to a beneficiary, each trustee should rely on the terms of the trust to determine whether the distribution should be made, although it is likely that each trustee’s perspective and relationship with the grantor will impact his or her decision.

A significant challenge many trustees face is that terms like health, education, maintenance, support, and best interests are as common in trust instruments as they are interpretive. Because these terms are interpretive, their application can be challenging even for the most diligent trustee; the interplay between these interpretive words/phrases and social, economic, and legal changes that occur during the administration of a trust can prove difficult to manage. In determining whether to make a discretionary distribution what must, or may the trustee rely on? Just the trust instrument? Extrinsic evidence? Personal opinion?

A. Enter the Letter of Wishes

A letter of wishes is a document that allows a grantor to express his or her goals for the trust. Information included can vary, but they offer information about how the grantor wants the trust to be administered by giving insight into the grantor’s state of mind, opinions on distributions, and issues that may arise with the trust’s beneficiaries.[2] These letters can serve two separate but equally important purposes. First, a letter of wishes can give the grantor the sense that the trustee fully understands their goals for the trust and can administer it in accordance with those goals. Second, letters of wishes can give a trustee something to proverbially hang their hat on when looking for guidance as to whether to make a distribution as the letter can clarify a trust instrument’s general terms.

In the example above, a letter explaining the trustee’s hesitance toward making distributions for cosmetic medical procedures would be valuable. Instead of guesswork, a letter outlining the grantor’s interpretation of the trust’s terms can assist a trustee in choosing to make distributions with greater confidence and flexibility.[3] This is the crux of the argument for many proponents of letters of wishes.[4]

2. LOGISTICS OF INCORPORATING A LETTER OF WISHES INTO AN ESTATE PLAN

Though letters of wishes are thought of as an informal tool[5] drafted by the grantor for the trustee’s benefit, the timing and method of drafting should be considered in relation to state trust laws by any practitioner who recommends its use to a client. Consideration should also be given to whether the letter should be incorporated into the trust as an exhibit or whether the letter should bind the trustee.

A. What is the Ideal Time to Draft a Letter of Wishes?

Practitioners should consider advising clients to draft letters of wishes close to the time the trust is settled in order to avoid disputes over whether the letter is representative of the grantor’s intent.[6] The following is illustrative: in 2017, immediately after selling his business, at his attorney’s advice, Grantor executes a discretionary trust for Grantor’s grandchildren to provide for their college educations. In 2022, the Grantor is now retired and has time to finally read the education trust that his attorney prepared for him.  At that time, the Grantor writes a letter of wishes explaining the grantor’s preference for distributions from the trust that further the pursuit of a STEM college education by Grantor’s grandchildren.  Shortly thereafter, all but one of Grantor’s grandchildren enroll in college to pursue liberal arts degrees.  The golden grandchild enrolls in a STEM program at his grandfather’s alma mater. The letter of wishes, drafted well after a significant passage of time, reflects that perhaps the Grantor’s opinions and relationships with his grandchildren may have changed. The trust does not have sufficient funds to cover the college tuition for all of the grandchildren and so the trustee must determine whether or not to make tuition payments for each grandchild or only certain grandchildren.  What is the trustee to do – follow the terms of the trust or follow the current wishes of the grantor?  Because of the timing as to the execution of the letter of wishes – there is an argument that the letter of wishes should be ignored.

Hugh v. Amalgamated Tr. & Sav. Bank[7] illustrates how timing can impact the effectiveness of a grantor’s extrinsic letters.[8] In Hugh, the Illinois Court of Appeals determined that the grantor did not gift land to a trust for the benefit of his grandchildren in part because letters expressing the grantor’s desire that the land be gifted to the grandchildren’s trust were delivered to the trustee several years after the trust was settled.[9] The court noted that the grantor’s exercise of dominion and control over the land in the time between when the grantor settled the trust and drafted the letters and when the letters were actually delivered to the trustee indicated that the grantor’s intent was to retain the property and not to make a gift.[10] Therefore, given the complications that may arise, the timing of the letter is very important.

B. How Involved Should an Estate Planning Attorney be in Drafting a Letter of Wishes?

Practitioners should consider their own involvement in drafting a letter of wishes and how differing degrees of involvement can impact the trust. Letters of wishes are often personal documents that allow a grantor to express his or her feelings about beneficiaries, philosophy on distributions, and goals for how the grantor’s legacy should be maintained.[11] Though the letter may be of great importance to the grantor, significant attorney involvement can complicate the trust drafting process by risking inclusion of precatory language in the trust instrument and presenting an opportunity for a grantor to incur significant legal fees for something of questionable utility. Executing a letter of wishes in conjunction with a trust instrument may cause a grantor to request that language from the letter be incorporated into the trust. Though many estate planning clients are sophisticated, the risk of creating ambiguity in the trust with emotional, personal, and imprecise language may be lost on them.[12] This risk should not be lost on their attorney. Time constraints and workload may cause estate planning attorneys to devote little thought to the letter of wishes, even though the letter may be important to the client and may risk insertion of precatory language into the trust document.

C. To be Effective, Must a Letter of Wishes be Incorporated into the Trust?

As letters of wishes are not legally binding on the trustee in and of themselves,[13] grantors must rely on a trustee feeling morally and ethically obligated to administer the trust in accordance with the letter. A solution to this problem may be to incorporate the letter of wishes into the trust as an exhibit. Matter of Estate of Kirk suggests that this option may be feasible as the court found a handwritten note attached to a formal trust amendment to be part of the amendment for purposes of administering the trust.[14] However, some scholars counsel against this, as attaching the letter as an exhibit would make the letter discoverable by beneficiaries, who may use the letter as an opportunity to increase the likelihood of getting a distribution or may find the letter hurtful.[15] Practitioners should counsel clients using this option to be sure that the letter does not contradict the trust instrument’s terms. Contradictions of this sort could be used as evidence of ambiguity, subjecting the trust to attacks from dissatisfied beneficiaries.

D. Should the Letter be Binding on the Trustee?

Scholars agree that letters of wishes should be made explicitly non-binding on the trustee, arguing that binding letters would interfere with the trustee’s discretion and hinder administration.[16] This argument is bolstered by the fact that the purpose of using more general language in a trust instrument is to provide the trustee with flexibility so that the trust can adapt to social, legal, and economic changes that impact administration.[17] Although the lack of litigation over letters of wishes may indicate that letters of wishes are often taken into account and used in administering the trust,[18] grantors should understand that the letters are deliberately non-binding in order to reap the benefits of adaptability. Grantors and their counsel should evaluate the risks of making a letter of wishes binding, and consider the benefits of a non-binding instrument.

3. DIGGING DEEPER: ARE LETTERS OF WISHES TRULY A POSITIVE ADDITION TO AN ESTATE PLAN?

Fast forward 10 years in the hypothetical posed in Part 1. Suppose you are approached by the trustee who has just found the letter expressing the grantor’s distaste for cosmetic procedures. Also assume that the trustee just received the gastric bypass distribution request. The trustee asks the attorney whether he or she must rely on the letter, what do you tell them? What if they ask whether they can exercise their discretion? Or what the trustee’s moral obligations are? Could the letter be deemed an amendment? The answers are unclear, but the following section applies scholarly opinion, statutory authority, and case law to explain how these issues can be addressed by practitioners.

A. Does the Trustee Have to Rely on the Letter?

While scholarly opinion is generally favorable toward letters of wishes, issues can complicate the positive purpose for which these letters are drafted. The first issue is whether the trustee has any obligation to rely on a letter of wishes. While trustees have historically abided by letters of wishes,[19] the letters are usually non-binding and often do not need to be disclosed to beneficiaries.[20] This means that the trustee has no legal obligation to make or forego making distributions in accordance with a letter of wishes.[21] Further, as noted by the restatement, letters of wishes are generally considered private correspondence between the grantor and trustee that offer guidance to the trustee, suggesting that the trustee has no duty to consider or abide by the letter in making a discretionary distribution.[22] Practitioners should be sure to discuss this with clients when deciding who to name as trustee to ensure that the client picks a trustee who is capable of managing the trust financially and effectuating the grantor’s intent to the full extent allowed by the law.

B. If the Trustee Wants to Consider a Grantor’s Letter of Wishes, Can They?

Further, a trustee may not be able to consider a grantor’s letter of wishes even if they want to. For example, Illinois common law provides that the general goal in construing a trust is to determine the grantor’s intent and to give effect to that intent if it is not contrary to law or public policy.[23] The grantor’s intent is to be determined solely by reference to the plain language of the trust itself.[24] Extrinsic evidence is only appropriate if the trust is ambiguous and the grantor’s intent cannot be ascertained.[25] When the language of a document is clear and unambiguous, a court should not modify or create new terms.[26] While Illinois courts have not addressed how a letter of wishes should be treated in relation to these rules of interpretation, Illinois’ Court of Appeals in In re Estate of Crooks noted that a decedent’s letter directing parcels of land to be transferred to him individually—which contradicted his previously executed will, trust, and quitclaim deeds directing the parcels to be transferred to a revocable trust—could not be used by a disgruntled heir to create an ambiguity in the decedent’s will, trust, or quitclaim deeds.[27] This suggests that a letter of wishes would be treated similarly unless there was an ambiguity in the four corners of the trust.

Practitioners should ensure that they are familiar with the statutes and common law governing trust interpretation for the state that governs the trusts they administer. While Illinois is fairly restrictive as far as what the trustee can rely on in administering the trust, Florida is more liberal.[28] In Kritchman v. Wolk, Florida’s Court of Appeals found that co-trustees of a revocable trust breached their duties of prudent administration and impartiality by failing to pay a beneficiary’s education expenses as requested in a letter from the grantor to the co-trustees prior to her death.[29] As such, the state where a letter of wishes is executed could impact whether a trustee may refer to it in administering the trust.[30] Further, the trust’s terms should be considered carefully to determine whether a letter of wishes or other written directive from the grantor should have any impact on administering the trust.

C. Moral and Ethical Obligations

While a trustee is unlikely to be required by law to consider a letter of wishes when administering a trust—and may, in fact, be prohibited from considering such a letter—they may feel a moral or ethical obligation to consider the grantor’s wishes when making discretionary distributions. Scholars suggest that trustees should administer trusts “in the state of mind contemplated by the settlor.”[31] Scholars also note that letters of wishes are “[m]oral and emotional accompaniments to a formal distribution scheme, [which]. . . have an important role to play in the planning process.”[32] This suggests that trustees may feel obligated to administer a trust consistently with a grantor’s letter of wishes. However, as shown by Kritchman, trustees without a personal connection to the grantor may feel no obligation to administer trusts in accordance with a grantor’s letter of wishes and may instead rely solely on the terms of the trust.[33] grantors and attorney’s should consider a potential trustee’s moral or ethical disposition towards a letter of wishes because this sense of obligation may depend on the trustee’s relationship with the grantor.[34]

D. Is the Letter an Amendment?

Depending on the circumstances under which a letter is drafted and signed, in addition to the letter’s content, some could argue that a letter of wishes is an amendment to a trust. Though many trust statutes require amendments to be made in accordance with the trust’s terms, a significant number of states allow a trust to be amended “by any other method manifesting clear and convincing evidence of the settlor’s intent.”[35] Arguably, a letter of wishes expressing a grantor’s specific desire as to what distributions should and should not be made could function as an amendment. However, no United States federal or state court has addressed the issue.

In Illinois, a trust can be amended by reserving the right to amend in the trust instrument.[36] If the trust instrument specifically describes the method for amendment then that method alone must be used to amend the trust.[37] Scholars suggest that Illinois trusts should be drafted in such a way that all amendments must be prepared by a lawyer familiar with the trust instrument.[38] Despite this guidance, the status of a letter of wishes as an amendment to an Illinois trust uncertain. While it is possible that a letter of wishes could be drafted in such a way that it meets the trust’s requirements, it is dependent on the trust instrument’s amendment provision(s). If the grantor wants their letter to function as an amendment, the trust instrument would need to be drafted to ensure that the letter meets the trust instrument’s formal requirements. Drafting a trust instrument in this way may not be advisable because of the potential for introducing precatory language and ambiguity into the trust.

An example serves to further illustrate this issue. Consider a marital trust instrument that allows discretionary distributions for either the beneficiary-spouse’s support or best interests. Assume that both terms are defined with substantive differences. Suppose the grantor drafts a subsequent letter of wishes explaining how the grantor would determine what is in his or her spouse’s best interest, but uses language that mirrors the trust instrument’s definition of support. Should the trust be considered amended to reflect a support standard for all discretionary distributions? The answer depends on the letter’s wording, governing state law, and the trust’s terms. In Illinois, such a letter would be unlikely to amend the trust unless the trust instrument’s amendment provision was drafted to allow for such a letter to function as an amendment.[39] However, a letter of wishes may be more likely to amend a trust in states like Wisconsin[40] and Kentucky[41] that follow the UTC’s more lenient provision.[42]

4. CONCLUSION

While letters of wishes may aid a trustee in administering a discretionary trust and provide the grantor with peace of mind, grantors and their counsel should think carefully about whether a letter of wishes is appropriate for the grantor’s situation. The uncertain state of the law as to the effect that a letter of wishes has on trust administration suggests there is more to letters of wishes than meets the eye. Though scholars generally praise letters of wishes as a means for a grantor to “communicate their cultural beliefs, values, and practices”[43] or as “helpful to a trustee in ascertaining the settlor’s state of mind, objectives, and purposes in establishing [a] discretionary trust,”[44] counsel should be aware that a letter may cause problems in administering the trust instead of solving them.[45] Practitioners who recommend a letter of wishes and/or whose clients choose to include them in their estate plan should advise clients as to the uncertain status of letters of wishes as a viable estate planning tool. Further, any decision to include a letter of wishes in an estate plan should only be made with an understanding of state trust statutes and case law and careful consideration of who to name as trustee.

[1] Austin Wakeman Scott & William Franklin Fratcher, The Law of Trusts § 187 (2006).
[2] See Alexander A. Bove, Jr., The Letter of Wishes: Can We Influence Discretion in Discretionary Trusts?, 35 ACTEC J. 38, 39 (2009).
[3] Id.; Edward C. Halbach, Problems of Discretion in Discretionary Trusts, 61 Colum. L. Rev. 1425 (1961) (arguing that the trustee should be given notice of the trust’s purpose and the grantor’s goals and beliefs to administer the trust in the way the grantor intended).
[4] See e.g., Bove, supra note 2, at 43; Henry Christensen III, 100 Years is a Long Time – New Concepts and Practical Planning Ideas, SN025 ALI-ABA 149, 183–84 (2007) (“[A letter of wishes] permits much more flexibility to. . . the trustee, who has more flexibility built into the trust instrument to exercise powers consistently with the intent of the settlor, rather than at the precise direction of the settlor, which was usually expressed in the vacuum of unknown and unanticipated events.”).
[5] Christensen, supra note 4, at 185.
[6] See Wakeman & Fratcher, supra note 1.
[7] 602 N.E.2d 33 (Ill. Ct. App. 1992).
[8] Note that the Hugh court referred to the grantor’s letters as “letters of direction” as opposed to “letters of wishes.” That said, the grantor’s “letter of direction” served essentially the same purpose that a letter of wishes would have.
[9] Id. at 35.
[10] Id. at 35–37.
[11] Bove, supra note 2 at 40; Deborah S. Gordon, Letters Non-Testamentary, 62 U. Kan. L. Rev. 585, 589 (2014).
[12] Both precatory language and ambiguity should be avoided in trust instruments. Trusts with patent or latent ambiguities are subject to having extrinsic evidence used in interpretation. See Koulogeorge v. Campbell, 983 N.E.2d 1066, 1073 (Ill. App. Ct. 2012). Further, including precatory language in a trust runs the risk that the preacatory terms will not be binding on the trustee. See Duvall v. LaSalle Nat. Bank, 523 N.E.2d 974 (Ill. Ct. App. 1988).
[13] See infra § 3(a).
[14] 907 P.2d 794 (Idaho 1995).
[15] See Bove, supra note 2, at 43.
[16] Id. at 43–44 (“Binding instructions on the trustee can interfere with the concept of full discretion and undermine or diminish the opportunity of exercising that judgment. If such instructions are that important and inflexible, they should be included in the body of the trust. . .”); Christensen, supra note 4, at 183–84.
[17] Gordon, supra note 10, at 616.
[18] Christensen, supra note 4, at 183–84. This lack of case law may also be explained by the fact that letters of wishes are likely to be considered non-discoverable trust documents. As such, beneficiaries are unlikely to see letters of wishes unless the trustee voluntarily discloses them.
[19] Id. at 184 (describing how letters of wishes are widely used and that trustees often fulfill their duties as outlined in letters of wishes).
[20] Restatement (Third) of Trusts § 87 cmt. 3 (2007); Bove, supra note 2, at 43–44; Christensen, supra note 4, at 184; Steven M. Fast and Steven G. Margolin, Whose Trust is it Anyway?, SM001 ALI-ABA 187, 199-200 (2006).
[21] Note that some foreign jurisdictions legally require a trustee to consider a letter of wishes in making trust distributions. That said, these jurisdictions do not require the trustee to make discretionary distributions in accordance with the letters nor do the letters create any additional duty for the trustee. Bove, supra note 2, at 41; see also, Anguilla Trusts Ordinance 1994 §13(4); Belize Trusts Act 1992 §13(4); and Niue Trusts Act 1994, §14(4).
[22] Restatement (Third) of Trusts § 87 cmt. 3 (2007); see also Bove, supra note 2 at 42.
[23] Citizens Nat. Bank of Paris v. Kids Hope United, Inc. 922 N.E.2d 1093 (Ill. 2009).
[24] Koulogeorge v. Campbell, 983 N.E.2d 1066 (Ill. App. Ct. 2012).
[25] Stein v. Scott, 625 N.E.2d 713 (Ill. App. Ct. 1993).
[26] Ruby v. Ruby, 973 N.E.2d 36 (Ill. App. Ct. 2012).
[27] 638 N.E.2d 729 (Ill. App. Ct. 1994). However, the court suggested that if the letter, will, trust, and quitclaim deeds had been executed simultaneously, the letter could indicate an ambiguity for which extrinsic evidence could be admitted to determine the decedent’s intent. The Idaho Supreme Court dealt with a similar issue, but decided differently in Matter of Estate of Kirk. 907 P.2d 794 (Idaho 1995). In Kirk, the court allowed a settlor’s handwritten note to be considered for purposes of construing her previously executed trust agreement. Id.
[28] See Fla. Stat. Ann. § 736.0804 (2017) (requiring a trustee to “administer the trust as a prudent person would, by considering the purposes, terms, distribution requirements, and other circumstances of the trust.”) (emphasis added).
[29] 152 So.3d 628, 631–32 (Fla. Dist. Ct. App. 2014). Note, however, that the grantor’s letter differed from a standard letter of wishes as it was delivered to the trustee during the grantor’s lifetime pursuant to the trust instrument’s provision allowing her to direct the trust to make payments as requested. Id. at 629–30.
[30] See e.g., Baker v. Wilburn, 456 N.W.2d 304, 306 (S.D.1990) (“[W]hen two or more instruments are executed at the same time by the same parties, for the same purpose and as part of the same transaction, the court must consider and construe the instruments as one contract.”).
[31] Wakeman & Fratcher, supra note 1; Bove, supra note 2, at 38.
[32] Gordon, supra note 10, at 617.
[33] Kritchman v. Wolk, 152 So.3d 628, 630–31 (Fla. Dist. Ct. App. 2014) (describing trustee/defendant’s position that the terms of the trust nullified all of the grantor’s written directives).
[34] See id. at 615 (“These letters, which in general avoid theatricality for simplicity and performance for connection, reinforce the social relationship between writer and recipient without disrupting the estate plan or manipulating the beneficiaries.”).
[35] Unif. Trust Code § 602; see also, Colo. Rev. Stat. Ann. § 15-16-702; Fla. Stat. Ann. § 736.0602(3)(b)(2); Mich. Comp. Laws Ann. § 700.7602; Mont. Code Ann. § 72-38-602; ; N.H. Rev. Stat. § 564-B:6-602;  Ohio Rev. Code Ann. § 5806.02; S.C. Code Ann § 62-7-602; Wyo. Stat. Ann. § 4-10-602.
[36] Parish v. Parish, 193 N.E.2d 761, 766 (Ill. 1963).
[37] Id.; Northwestern University v. McLoraine, 438 N.E.2d 1369 (Ill. App. Ct. 1982).
[38] Robert S. Hunter, § 213:23. Amending the trust agreement, 19 Ill. Prac., Estate Planning & Admin (4th ed. 2016).
[39] Supra § 3(d).
[40] Wis. Stat. Ann. § 701.0602 (2017).
[41] Ky. Rev. Stat. Ann. § 386A.2-020 (2017).
[42] Unif. Trust Code § 602.
[43] Gordon, supra note 17, at 617.
[44] Bove, supra note 2, at 39.
[45] See e.g., Matter of Estate of Kirk, 907 P.2d 794 (Idaho 1995) (describing a conflict between potential beneficiaries over changes in their interests in the decedent’s trust caused by decedent’s handwritten letter attached to a trust amendment).

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