Tag: trust

Understanding Post-Bankruptcy Liquidation Trusts

A main goal in bankruptcy is to get in and out as quickly as possible to minimize costs. It is often the case that even though a substantial portion of a debtor’s assets have been liquidated in bankruptcy, some valuable assets will remain that can provide additional sources of recovery to creditors. These assets may include smaller pieces of real estate, accounts receivable, joint venture ownership interests, and claims and causes of action, among others.

In a chapter 11 case, the debtor exits bankruptcy by confirming a plan and having the plan go effective. When a debtor has assets remaining but is otherwise ready to exit the bankruptcy case – for example, because it has closed a sale of a substantial portion of its assets – the plan typically provides for the formation of a liquidation trust on the plan effective date. All remaining assets are transferred to the trust for liquidation, and any proceeds are distributed to creditors, i.e., the trust beneficiaries, in accordance with the plan.

The liquidation trust is established and governed by the plan and a liquidation trust agreement. A liquidation trustee is appointed to administer the trust and is granted broad powers to, among other things, liquidate assets, investigate, prosecute, and settle causes of action, object to, resolve, and pay claims, and make distributions to trust beneficiaries.

Trust beneficiaries typically appoint members of a trust advisory or oversight committee who have consultation and approval rights over certain actions proposed to be taken by the liquidation trustee. For example, the trustee may need approval from the oversight committee to resolve claims or causes of action above a certain amount, or to liquidate certain high-value assets.

Who serves as liquidation trustee and how many representatives each trust beneficiary appoints to the oversight committee are typically negotiated in connection with the plan process. The liquidation trustee may have been a professional involved in the bankruptcy, or it may be an outsider with experience serving in such a role. The oversight committee members may be creditors themselves or may be appointed as representatives of the creditors. Trust assets are typically used to compensate the liquidation trustee for its services and reimburse it for its costs and expenses, including for its retained professionals, though oftentimes initial seed funding is also required. Trust oversight committee members may receive modest compensation, which is typically capped, but which may offer an incentive for a creditor or a creditor-appointee to serve.

The role of the trust oversight committee is an important one, as the assets transferred to the trust may provide additional valuable sources of recovery to creditors. Trust beneficiaries are often creditors from different classes under the plan, and therefore may have differing interests and be entitled to different treatment. For example, a secured creditor with a lien on a parcel of real estate may be the sole beneficiary from the sale of such real estate, and therefore has an interest in overseeing how the property is marketed and sold. Even when trust beneficiaries share a right to recover from the same assets, such as from the prosecution of causes of action, they may have differing views or interests as to the potential value of the claims, whether it makes sense to settle them, and overall strategy.

When all assets are liquidated, claims resolved, distributions made, and the estates are otherwise wound down, the trust will be dissolved. Often, this does not occur until years later.

©1994-2024 Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P.C. All Rights Reserved.
For more news on Post-Bankruptcy Trusts, visit the NLR Bankruptcy & Restructuring section.

Don’t Let the Power Go Sour – Pitfalls of Powers of Appointment

Powers of appointment are among the most versatile tools in estate planning. They are often underutilized due to a lack of understanding of their benefits and limitations. At their core, a power of appointment allows an individual, designated by a legal instrument (the “donee” or receiver of the power of appointment), to determine who will receive certain property or interests in the future. The donor, who creates this power, retains flexibility in managing and distributing their estate.

However, caution is necessary when structuring powers of appointment, particularly in the context of the marital deduction. Improperly crafted powers can inadvertently invalidate the marital deduction, leading to significant estate tax consequences. For instance, if a power of appointment does not allow the donee (often the surviving spouse) to appoint property to themselves or their estate, the property may fail to qualify for the marital deduction. This is typically the case with a special (or limited) power of appointment. In contrast, a properly structured general power of appointment can ensure that the property qualifies for the marital deduction, deferring estate taxes until the surviving spouse’s death

Clarification – Donor and Donee Examples

A wealthy individual, the donor of the power of appointment, sets up a trust for their children. The trust includes a special power of appointment allowing the spouse (the donee) to distribute the trust’s assets among their children or grandchildren after the donor’s death. The spouse can decide which child receives what portion of the assets, giving flexibility to address changing family dynamics. This type of power is often chosen to retain control within the family while protecting the assets from the spouse’s creditors and excluding the assets from the spouse’s taxable estate.

A woman (the donor) creates a will that gives her husband (the donee) a general power of appointment over certain assets. This power allows the husband to decide who will inherit those assets upon his death, including the ability to appoint them to himself, his estate, or creditors. This flexibility can be particularly useful in managing taxes and ensuring the estate is distributed according to the most current family needs. However, because the assets are included in the husband’s estate for tax purposes, this power may also increase the taxable estate, potentially leading to higher estate taxes.

Types of Powers of Appointment

Powers of appointment are classified into several categories:

  1. Imperative vs. Non-Imperative Powers: Imperative powers must be exercised by the donee, while non-imperative powers are optional.
  2. Exclusive vs. Non-Exclusive Powers: Exclusive powers allow the donee to exclude certain eligible appointees, while non-exclusive powers require the donee to allocate some property to each appointee.
  3. General vs. Nongeneral (Special) Powers: General powers allow the donee to appoint property to themselves, their estate, or their creditors. In contrast, nongeneral powers restrict the donee from appointing property to these entities.
  4. Presently Exercisable vs. Postponed Powers: Presently exercisable powers can be used immediately, while postponed powers can only be exercised at a future date, often upon the donee’s death.

When to use General vs. Limited Powers of Appointment

General Power of Appointment: Best used in Marital Trusts (QTIP) or Revocable Trusts when flexibility, step-up in basis, and marital deduction eligibility are the primary goals, even though the assets will be included in the donee’s taxable estate.

Limited (Special) Power of Appointment: Best used in Irrevocable Trusts, Dynasty Trusts, Bypass Trusts, and Generation-Skipping Trusts where asset protection, tax minimization, control over distribution, and maintaining favorable tax treatment are the main objectives.

Estate Planning Goal/Consideration General Power of Appointment Limited (Special) Power of Appointment
Asset Protection Not recommended. Assets are exposed to the donee’s creditors. Recommended. Assets are protected from the donee’s creditors.
Typical Trusts  Rarely used in asset protection trusts.  Common in Irrevocable Trusts, Dynasty Trusts, and Spendthrift Trusts.
Inclusion in Donee’s Taxable Estate Recommended when a step-up in basis is desired. Not recommended. Assets are generally excluded from the donee’s taxable estate.
Typical Trusts Marital Trusts (QTIP) for step-up in basis. Irrevocable Life Insurance Trusts (ILITs), Generation-Skipping Trusts.
Eligibility for Marital Deduction Recommended. Ensures property qualifies for the marital deduction, deferring estate taxes. Not recommended. May disqualify property from the marital deduction.
Typical Trusts QTIP Trusts, Marital Trusts.  Not typically used in marital deduction trusts.
Control over Ultimate Distribution Provides flexibility but less control over final asset distribution. Recommended. Allows the donor to set clear boundaries on asset distribution.
Typical Trusts Marital Trusts, Family Trusts. Family Trusts, Bypass Trusts, Generation-Skipping Trusts.
Minimizing Estate Taxes for Donee Not recommended. Assets are included in the donee’s taxable estate. Recommended. Helps reduce the size of the donee’s taxable estate.
Typical Trusts Marital Trusts (when step-up is more beneficial). Bypass Trusts, Generation-Skipping Trusts.
Avoiding Generation-Skipping Transfer Tax (GSTT) Not recommended. May trigger GSTT if assets are transferred to skip generations. Recommended. Allows for strategic distribution to avoid GSTT.
Typical Trusts Marital Trusts (with no intent to skip generations). Generation-Skipping Trusts, Dynasty Trusts.
Flexibility for Changing Family Needs Recommended if flexibility to appoint to any individual or entity is desired. Provides some flexibility within the confines set by the donor.
Typical Trusts Revocable Trusts, Marital Trusts. Irrevocable Trusts, Family Trusts.
Retaining Favorable Tax Treatment in Trusts Not recommended. Could disrupt the trust’s tax status. Recommended. Helps maintain the trust’s favorable tax status, particularly for pre-existing trusts.
Typical Trusts  Rarely used in older trusts with favorable status. Grandfathered Trusts, Irrevocable Trusts.
When to Use in Marital Trusts (QTIP) Recommended if the intent is to qualify for the marital deduction. Not recommended for QTIP trusts as it may disqualify the trust.
Typical Trusts QTIP Trusts, Marital Trusts. Bypass Trusts, Family Trusts (outside of QTIP).

Table 1. General Overview of the suse of General and Limited(Special) Powers of Appointment in differnt estate plang contexts.

Exercising Powers of Appointment

The exercise of powers of appointment involves several considerations:

  • Class of Appointees: The group eligible to receive the property, which can range from specific individuals to broad categories like “descendants.”
  • Manner and Methods of Exercise: Powers can be exercised through various methods, including specific or blanket clauses. The intention to exercise must be clear and comply with any conditions set by the donor.
  • Capacity to Exercise: The donee must have the legal capacity to exercise the power, similar to the capacity required for property disposition.

Tax Implications

The tax consequences of powers of appointment are significant and complex. Please refer also to Table 1.

  1. Estate and Gift Tax: A general power of appointment can result in the inclusion of property in the donee’s estate, subjecting it to estate tax. The exercise or release of a general power is treated as a gift for tax purposes.
  2. Generation-Skipping Transfer (GST) Tax: Exercising a power of appointment can trigger GST tax if it involves skipping generations, though careful planning can mitigate this.
  3. Income Tax: Under Section 678 of the Internal Revenue Code, the exercise of a general power can result in the donee being treated as the owner of the trust for income tax purposes.

Planning Opportunities

Powers of appointment offer various strategic benefits in estate planning:

  • Flexibility: They allow the donee to adapt the distribution of property based on changing circumstances, providing tailored solutions for beneficiaries.
  • Extending Trust Terms: Powers can be used to extend the duration of a trust, potentially postponing tax consequences and providing long-term asset protection.
  • Generation Jumping: Powers can be used to skip generations, reducing the impact of GST tax by directly benefiting more remote descendants.

Selected Case Law and IRS Private Letter Rulings

The following cases and Private Letter Rulings (PLRs) illustrate the application and interpretation of powers of appointment, particularly general powers of appointment, in the context of federal estate tax law. Specifically, the cases address the tax implications of these powers concerning the marital deduction under Section 2056 of the Internal Revenue Code and whether certain powers of appointment qualify as general powers under Section 2041. Additionally, the cases and rulings explore the implications of trust reformation, particularly how state court modifications of trust instruments may or may not be recognized for federal tax purposes and how these reforms affect the classification and taxability of powers of appointment.

Estate of Kraus v. C.I.R, 875 F.2d 597 (7th Cir. 1989)

Issue

The primary issue in Estate of Kraus v. Commissioner is whether the reformation of a trust by a lower Illinois state court, which corrected a scrivener’s error that omitted a general power of appointment necessary for the marital deduction under Section 2056 of the Internal Revenue Code, should be recognized by the federal Tax Court for estate tax purposes.

Rule

Federal courts, including the Tax Court, are not bound by decisions of lower state courts when interpreting state law for federal tax purposes. According to the precedent established in Commissioner v. Estate of Bosch, only a state’s highest court can issue rulings on state law that are binding on federal courts. Federal courts are required to give “proper regard” to lower state court rulings but are not obligated to follow them if they conflict with federal tax law principles.

Application

In this case, Arthur S. Kraus amended his insurance trust in 1977, inadvertently converting a general power of appointment into a special power due to a scrivener’s error. This error prevented the estate from qualifying for the marital deduction under Section 2056 of the Internal Revenue Code. After Kraus’s death, the estate sought reformation of the trust in an Illinois state court, which granted the reformation, restoring the general power of appointment.

The estate argued that the reformed trust should be recognized by the Tax Court to allow the marital deduction. However, the Tax Court ruled that the state court’s reformation was not binding for federal tax purposes and determined that the trust, as amended in 1977, did not qualify for the marital deduction. The Tax Court found that the estate had not provided sufficient evidence to prove that the omission of the general power of appointment was a mistake warranting reformation under Illinois law.

Furthermore, the Tax Court noted that the decedent, Arthur S. Kraus, was aware of the language necessary to include a general power of appointment, and the amended trust explicitly created a special power instead. This finding was based on the court’s review of stipulated facts, the testimony of attorney Rotman (who drafted the trust amendment), and the original and amended trust documents.

The estate later discovered new evidence that corroborated the claim of a scrivener’s error. The Tax Court initially denied the estate’s motion for reconsideration based on this newly discovered evidence. However, on appeal, the Seventh Circuit Court of Appeals found that the newly discovered evidence was material and likely to change the outcome of the case. The appellate court ruled that the Tax Court abused its discretion in denying the motion for reconsideration and remanded the case for further proceedings.

Conclusion

The Seventh Circuit Court of Appeals affirmed the Tax Court’s decision to uphold the deficiency assessment, agreeing that the original reformation by the state court was not binding for federal tax purposes. However, the appellate court reversed the Tax Court’s denial of the motion for reconsideration, holding that the newly discovered evidence should be admitted and that the case should be reconsidered in light of this evidence. The case was remanded to the Tax Court for further proceedings.

This case illustrates the principle that federal tax courts are not bound by lower state court decisions regarding the reformation of legal instruments when determining federal tax liabilities. It emphasizes the importance of a state’s highest court in issuing binding interpretations of state law for federal purposes.

LTR 9303022 IRS Private Letter Ruling

Issue:

In this case, the issue is whether the reformation of a will by a state court, which retroactively removes a general power of appointment granted to certain beneficiaries, should be treated as a release of that power under Sections 2041 and 2514 of the Internal Revenue Code, thereby subjecting the property to estate and gift taxes.

Rule:

According to Sections 2041(a)(2) and 2514(b) of the Internal Revenue Code, the exercise or release of a general power of appointment is considered a transfer of property and may result in the inclusion of that property in the gross estate of the individual holding the power. See, however, above. Per Estate of Bosch v. United States, the Internal Revenue Service (IRS) is not bound by decisions of lower state courts unless those decisions are consistent with the rulings of the state’s highest court.

Application:

In this case, the Husband and Wife created testamentary trusts that inadvertently granted their Son and Daughter 1 general powers of appointment over their respective trusts, allowing them to invade the trust principal for purposes not limited by an ascertainable standard. This mistake occurred due to an oversight by the law firm drafting the wills, as it failed to include a provision that would restrict the exercise of discretionary powers by beneficiaries who are also trustees.

After the Wife’s death, the Husband petitioned the probate court to reform the trusts to retroactively limit the exercise of the discretionary powers to an independent trustee, thereby preventing the Son and Daughter 1 from holding general powers of appointment. The probate court issued a conditional order to this effect.

The IRS examined whether this reformation constituted a “release” of a general power of appointment, which would trigger estate and gift tax consequences under Sections 2041 and 2514. The IRS concluded that the reformation did not constitute a release because the intent of the Husband and Wife was clearly to prevent their children from holding such powers. The IRS reasoned that, in a bona fide adversarial proceeding, the highest state court would likely deny the Son and Daughter 1 the general powers of appointment before they could become exercisable.

Therefore, the reformation by the lower court would not be considered a release of a general power of appointment under Section 2514, and the trust property would not be included in the taxable estates of the Son or Daughter 1 under Section 2041. Additionally, the reformation did not alter the trust’s status as irrevocable before September 25, 1985, for the generation-skipping transfer tax purposes.

Conclusion:

The IRS ruled that the reformation of the will to limit the discretionary powers of the Son and Daughter 1 did not constitute a release of a general power of appointment. Consequently, the reformation would not cause the inclusion of the trust property in the taxable estates of the Son or Daughter 1, nor would it impact the treatment of the trusts for generation-skipping transfer tax purposes. This ruling was based on the specific facts and applicable law at the time of the request and would not be retroactively applied if there were material fact or law changes.

LTR 9516051 IRS Private Letter Ruling

Issue:

Does the power held by the trustee of a testamentary trust, which allows the trustee to distribute principal to herself as a beneficiary, constitute a general power of appointment under Section 2041 of the Internal Revenue Code?

Rule:

Under Section 2041(a)(2) of the Internal Revenue Code, the value of any property over which the decedent has a general power of appointment is included in the gross estate for estate tax purposes. A general power of appointment is defined under Section 2041(b)(1) as a power exercisable in favor of the decedent, the decedent’s estate, creditors, or the creditors of the decedent’s estate. However, if the power is limited by an ascertainable standard relating to the health, education, support, or maintenance of the decedent, it is not considered a general power of appointment.

Application:

In this case, the decedent was the trustee of a trust created by her deceased spouse’s will, with the power to distribute principal to herself as the beneficiary if, in her sole discretion, it was deemed “requisite or desirable.” This power would generally constitute a general power of appointment under Section 2041, as it allows the trustee to distribute principal to herself without restriction.

However, North Carolina General Statute 32-34(b) imposes limitations on a fiduciary’s power to exercise such discretion. Specifically, the statute prohibits a trustee from exercising a power in favor of themselves, their estate, their creditors, or the creditors of their estate unless the trust document explicitly overrides this limitation. Since the trust document in this case did not override the statute, the decedent, as trustee, did not have a general power of appointment under North Carolina law.

The IRS recognizes that state law governs the creation of legal rights and interests in property, including the scope of powers of appointment. Consequently, under North Carolina law and similar IRS precedents (Rev. Rul. 76-502 and Rev. Proc. 94-44), the decedent’s power as trustee did not qualify as a general power of appointment for federal estate tax purposes.

Conclusion:

The power held by the decedent as trustee of her spouse’s testamentary trust does not constitute a general power of appointment for purposes of Section 2041. Therefore, the value of the trust property is not included in the decedent’s gross estate for estate tax purposes under Section 2041.

Leahy Guiney v. United States of America 425 F.2d 145

Issue:

Does the language in Item Second of Arthur Hamilton Leahy’s will grant his widow a “general power of appointment” sufficient to qualify for the marital deduction under Section 2056(b)(5) of the Internal Revenue Code?

Rule:

Under Section 2056(b)(5) of the Internal Revenue Code, a marital deduction is allowed if the surviving spouse is entitled for life to all the income from the entire interest in the property and has a general power of appointment over the property. A general power of appointment is defined under Section 2041(b)(1) as a power exercisable in favor of the decedent, the decedent’s estate, creditors, or the creditors of the decedent’s estate. The interpretation of whether a power qualifies as a general power of appointment is determined according to the applicable state law.

Application:

In this case, Arthur Hamilton Leahy’s will included language that explicitly stated his intention to grant his widow a “general power of appointment” over the trust assets to ensure that one-half of his estate qualified for the marital deduction. The key issue was whether this language effectively granted the widow the power to appoint the trust principal to herself or her estate, as required by Section 2056(b)(5) of the Internal Revenue Code.

The IRS Commissioner initially denied the marital deduction, arguing that under Maryland law, the language used in the will did not grant the widow a general power of appointment that would allow her to appoint the trust principal to herself or her estate. The District Court upheld the Commissioner’s decision, relying on prior Maryland case law that had narrowly construed similar language as not granting a general power of appointment.

However, upon appeal, the Fourth Circuit considered more recent developments in Maryland law, particularly the decision in Frank v. Frank and the prior decision in Leser v. Burnet by the same court. The appellate court recognized that Maryland courts had evolved to a more modern interpretation that allowed for a general power of appointment when the testator’s intent to grant such power was clear. The court found that the language in Mr. Leahy’s will, which explicitly referred to the “general power of appointment” and the marital deduction under the Internal Revenue Code, was more precise and explicit than the language in previous cases where the power had been found lacking.

The Fourth Circuit concluded that the language used in Mr. Leahy’s will was sufficient to grant his widow a general power of appointment that met the requirements of Section 2056(b)(5) of the Internal Revenue Code, thereby qualifying the estate for the marital deduction.

Conclusion:

The language in Item Second of Arthur Hamilton Leahy’s will effectively granted his widow a general power of appointment over the trust principal, sufficient to meet the requirements for the marital deduction under Section 2056(b)(5) of the Internal Revenue Code. The Fourth Circuit reversed the District Court’s decision and remanded the case for the entry of judgment in favor of the taxpayer.

Special Issues for Fiduciaries and Creditors

Fiduciaries and creditors have specific considerations when dealing with powers of appointment:

  • Creditor Rights: Generally, property subject to a nongeneral power is protected from the donee’s creditors. However, property under a general power may be vulnerable, depending on the circumstances.
  • Fiduciary Responsibilities: Fiduciaries must carefully manage and exercise powers of appointment, balancing the donor’s intentions with the donee’s interests and tax implications.

Powers of Appointment and Decanting

Decanting, the process of transferring assets from one trust to another, can be facilitated through powers of appointment. This allows for the modification of trust terms, potentially reducing tax burdens and enhancing the trust’s effectiveness.

Conclusion

Powers of appointment are powerful and flexible tools in estate planning, offering both opportunities and potential pitfalls. When structured properly, they can achieve various planning goals, such as securing the marital deduction, ensuring flexibility in asset distribution, and protecting assets from creditors. However, the complexity surrounding the different types of powers—general versus limited—requires careful consideration and precise drafting to avoid unintended tax consequences. The discussed cases and rulings highlight the critical importance of understanding how powers of appointment are treated under both federal tax law and state law, particularly in the context of trust reformation. As illustrated, the reformation of trusts by state courts may not always be recognized for federal tax purposes, emphasizing the need for estate planners to carefully navigate these issues to ensure that the donor’s intentions are fulfilled and tax benefits are preserved. In summary, while powers of appointment are versatile tools, their effective use in estate planning necessitates a thorough understanding of their implications, meticulous drafting, and, where necessary, appropriate legal reformations.

Further Reading

Jonathan G. Blattmachr, Kim Kamin & Jeffrey M. Bergman, Estate Planning’s Most Powerful Tool: Powers of Appointment Refreshed, Redefined, and Reexamined, https://perma.cc/AQ6W-PH72.

© 2024 wealthcarelawyer.com. All rights reserved.
 For more news on Powers of Appointment, visit the NLR Estates & Trusts section.

Grantor Trusts Rules – Will the Loopholes be Closed in 2025?

While some may see the discovery and use of tax loopholes as a triumph of human ingenuity, others see their exploitation as an abuse of the tax code. The concepts developed here are complex but worth understanding if you want to use them for your clients or participate in the public discourse about related tax law reforms.

When anticipating significant appreciation of an asset, affluent taxpayers typically have two options: 1.  transfer the property now (as a gift) to avoid estate taxes on future appreciation, or 2. transfer the property upon death to avoid income taxes on the appreciation. For each of these options, there is good news and bad news:

If the taxpayer gifts the property today, its value is fixed for transfer tax purposes as of the gift date per IRC Sec. 2512. This avoids transfer taxes on any future appreciation. However, the donee inherits the donor’s basis, often low, under IRC Sec. 1015 and will pay income tax on the appreciation when selling the property.

If the property is transferred at death, its value is determined at the date of death under Sec. 2031, capturing all appreciation for transfer tax purposes. The donee receives a stepped-up basis under IRC Sec. 1014, eliminating income tax on the appreciation that occurred before the donor’s death. However, the property is subject to the estate tax at its current fair market value.

In addition to the above, we need to mention an intermediate situation, the incomplete gift. An incomplete gift occurs when the donor retains certain powers or interests over the transferred property, which prevents the gift from being considered complete for tax purposes. This can have various implications, including the deferral of gift tax liability and the potential inclusion of the property in the donor’s estate.

Tax Planning Conundrum: Wouldn’t it be nice if a taxpayer who has an estate large enough to be subject to estate taxes could do both: avoid capital gains taxes and avoid additions to the taxable estate due to appreciation? In other words, could one obtain a stepped-up basis for income tax purposes while also “freezing” the value of the wealth for transfer tax purposes?

Let’s hold that thought and review the Grantor Trust Rules. They determine when a trust is a grantor trust and when it is not, which in turn determines who pays income taxes. This will be important to solving the tax planning conundrum posed above.

Grantor Trust Rules

The distinction between a grantor trust and a non-grantor trust depends on whether the settlor (grantor) retains any incidents of ownership over the trust. If they do, it is a grantor trust; if they don’t, it’s a non-grantor trust. Incidents of ownership can be any number of things by which control over the trust is exerted, for example, the right to change beneficiaries (Table 1).

As stated, in a grantor trust, the grantor maintains a certain degree of control over the trust’s assets or income. In contrast, non-grantor trusts include irrevocable trusts in which the grantor has relinquished control over the trust assets and does not retain any powers that would cause the trust to be treated as a grantor trust.

Provision Description
Power to Revoke (§ 676) If the grantor has the power to revoke the trust and reclaim the trust assets, the trust is considered a grantor trust.
Power to Control Beneficial Enjoyment (§ 674) If the grantor retains certain powers to control the beneficial enjoyment of the trust’s income or principal, the trust may be treated as a grantor trust.
Administrative Powers (§ 675) If the grantor retains administrative powers that can affect the beneficial enjoyment of the trust, the trust may be considered a grantor trust.
Reversionary Interests (§ 673) If the grantor retains a reversionary interest in the trust that exceeds 5% of the trust’s value, the trust is considered a grantor trust.
Income for the Benefit of the Grantor (§ 677) If the trust income is or may be used to pay premiums on insurance policies on the life of the grantor or the grantor’s spouse, the trust is treated as a grantor trust.

If the trust income can be distributed to the grantor or the grantor’s spouse or held for future distribution to them, the trust is considered a grantor trust.

Table 1: The most important grantor trust rules

The distinction between grantor and non-grantor trusts was made to determine who has to pay income taxes on the trust’s income. In a grantor trust, it’s the grantor; in a non-grantor trust, it’s the trust.

The transfer tax and income tax regimes are closely aligned. When a grantor retains control over transferred property in a trust, they have a grantor trust.  This property is generally considered owned by the grantor at death for estate tax purposes. For instance, if a grantor has the power to revoke a trust, Section 676 treats the grantor as owning the property for income tax purposes, and Section 2038 treats it as owned by the grantor at death for estate tax purposes. However, there is a loophole.

The Loophole – The Intentionally Defective Grantor Trust

An Intentionally Defective Grantor Trust (IDGT) is a type of trust designed to be treated as owned by the grantor for income tax purposes but not for estate tax purposes. This means that the income generated by the trust is taxable to the grantor, but the trust’s assets are not included in the grantor’s estate for estate tax purposes. To draft an IDGT, certain provisions must be included to ensure that the trust is considered defective for income tax purposes. These provisions typically involve intentionally violating one of the above grantor rules so that the trust is taxed on the trust’s income.

A more descriptive name for an Intentionally Defective Grantor Trust (IDGT) could be “Swap Power Grantor Trust”. The swap power is a common feature in the drafting of an Intentionally Defective Grantor Trust (IDGT). It allows the grantor to reacquire trust property by substituting other property of equivalent value. This power is crucial because it helps ensure that the trust is considered a grantor trust for income tax purposes while not causing the trust property to be included in the grantor’s estate for estate tax purposes.

The “Swap Power” in Action:

  • Income Tax Implications:
    • Section 675: The swap power causes the grantor to be treated as owning the property for income tax purposes.
    • No Corresponding Estate Tax Rule: There is no rule that includes this property in the grantor’s estate for transfer tax purposes. Thus, the value of the property for transfer tax purposes is fixed at the time of the gift (Section 2512).

Transferring Property to the Trust:

  • Initial Transfer:
    • When the grantor transfers property to a trust with a swap power, the property is valued for gift and estate tax purposes as of the date of the gift, which freezes its value.
  • Appreciation:
    • Inside the trust, after the transfer, the property may enjoy unlimited appreciation; however, its value for estate tax purposes remains “frozen” at the time of the gift.

Income Tax Treatment of Transactions with the Trust:

  • Disregarded Transactions:
    • Under Section 675, transactions between the grantor and the trust (due to the swap power) are disregarded for income tax purposes.
    • Exercise of Swap Power:
      • When the grantor exercises the swap power (exchanging property within the trust), it is seen as moving assets between the grantor’s own “pockets,” so there are no income tax consequences.

Basis and Tax Implications:

  • Carryover Basis Rule (Section 1015):
    • Normally, the basis of the gifted property carries over to the donee, meaning any appreciation is subject to income tax when the property is sold.
  • Stepped-Up Basis (Section 1014):
    • By using the swap power, the grantor can transfer appreciated low-basis property out of the trust and high-basis property of the same value into the trust.
    • The appreciated property is back in the grantor’s hands. When the grantor dies, it gets a stepped-up basis to its fair market value at death.
    • This eliminates the capital gains tax on the appreciation of the property that occurred before the grantor’s death.
    • In addition, estate taxes are at a lower level because the valuation for estate tax purposes was frozen before appreciation in the trust.

This is all very well, but let’s see how this works out in practice.

Simplified Example

  • Grantor: John
  • Trust Beneficiary: Emily
  • Property: Real estate
  • Initial Value: $2 million
  • Appreciated Value: $6 million

Steps:

See Figure 1.

  1. Initial Transfer:
    • John transfers real estate valued at $2 million to a trust with a swap power. This value is fixed for gift and estate tax purposes.
  2. Appreciation:
    • The property appreciates to $6 million over several years, but its value for estate tax purposes remains “frozen” at $2 million.
  3. Using the Swap Power:
    • John uses the swap power to exchange the $6 million property in the trust for $6 million in cash or other assets.
    • This transaction has no income tax consequences because it is disregarded under Section 675.
  4. Basis Adjustment:
    • Normally, the property in the trust would retain John’s original basis, making any appreciation subject to income tax when sold.
    • By swapping the property out of the trust for $6 Million, John reclaims the house. Upon his death and transfer to beneficiaries, the property gets a stepped-up basis to its fair market value of $6 million.
    • This eliminates capital gains tax on the appreciation that occurred before John’s death.

avoid capital gains and estate taxes with a swap power

Figure 1: How to avoid capital gains and estate taxes with a swap power in a grantor trust (Intentionally Defective Grantor Trust)

John effectively avoids income tax on the property’s appreciation during his lifetime and ensures the property gets a stepped-up basis at his death, providing significant tax advantages for Emily. Our tax planning conundrum from above has been solved.

A number of other techniques have a similar effect, but their discussion goes beyond the scope of this article.

Biden’s Reform Plans

Historical Background

Until 1986, taxpayers aimed to avoid having their trusts classified as grantor trusts to escape the burden of personally paying income taxes on trust earnings. This was crucial in an era with a highly progressive income tax system, exemplified by 1954’s 24 tax brackets ranging from 20% to 91%. In 1954 Congress, codifying judicial decisions and wanting to prevent income shifting from higher to lower tax brackets, enacted the grantor trust rules. However, the 1986 Tax Reform Act and subsequent reforms compressed income tax rates, making grantor trusts more favorable. Today, classifying a trust as a grantor trust often results in better tax outcomes. Moreover, as explained above, careful drafting of grantor trusts can limit both estate and income taxes to an extent otherwise not possible (1).

The current situation subverts Congress’s original intent and is also perceived as societally unfair, as it benefits only the already very wealthy. Reforms are periodically suggested, most recently by the Biden administration in the Greenbook, the Tax Proposal for 2025 (2).

Several reform efforts are aimed at Grantor Retained Annuity Trusts, which we will discuss in a follow-up article but list here for context.

1. Grantor Retained Annuity Trusts (GRATs)

  • Minimum Value for Gift Tax: The remainder interest in a GRAT must have a minimum value for gift tax purposes equal to the greater of 25% of the value of the assets transferred or $500,000.
  • Annuity Payments: The annuity payments cannot decrease during the term of the GRAT.
  • Minimum and Maximum Terms: The GRAT must have a minimum term of ten years and a maximum term equal to the annuitant’s life expectancy plus ten years.
  • Prohibition on Tax-Free Exchanges: The grantor cannot exchange assets held in the trust without recognizing gain or loss for income tax purposes.
  • Impact: These changes aim to reduce the use of short-term and “zeroed-out” GRATs, which are often used for tax avoidance purposes.

2. Sales and Transfers Between Grantor Trusts and Deemed Owners

  • Taxable Events: Sales of appreciated assets between a grantor and a grantor trust will be recognized as taxable events, requiring the seller to pay capital gains tax on the appreciation.
  • Basis Adjustment: The buyer’s basis in the transferred asset will be the amount paid to the seller.
  • Purpose: This proposal aims to prevent tax-free transfers of appreciated assets and ensure that such transactions are treated similarly to sales between unrelated parties.

3. Income Tax Payments as Gifts

  • Gift Treatment: The grantor’s payment of income tax on the trust’s income will be treated as a taxable gift to the trust. This gift will occur on December 31 of the year the tax is paid unless the trust reimburses the grantor.
  • Impact: This change ensures that the grantor’s payment of the trust’s income tax liabilities is recognized as a transfer of value subject to gift tax.

4. Realization of Capital Gains

  • Realization Events: Unrealized capital gains on appreciated property will be taxed at the time of transfer by gift or upon death. This includes transfers to or from most types of trusts and distributions from revocable grantor trusts to persons other than the trust’s owner or their spouse.
  • Impact: This would treat transfers of appreciated assets as taxable events, departing from the current practice of realizing such gains only upon sale. It aims to ensure that high-income taxpayers do not benefit from deferred capital gains taxes indefinitely.

5. Intrafamily Asset Transfers

  • Valuation Discounts: Discounts for lack of marketability and control will be reduced or eliminated for intrafamily transfers of partial interests in assets if the family collectively owns at least 25% of the property.
  • Collective Valuation: The transferred interest’s value will be calculated as a pro-rata share of the total fair market value of the property held by the transferor and their family members, as if a single individual owned all interests.
  • Purpose: This proposal aims to curb the use of valuation discounts to reduce the taxable value of intrafamily transfers.

What if the Republicans Gain Control of Congress?

The Republican proposals regarding grantor trusts largely focus on maintaining the status quo established by the 2017 Tax Cuts and Jobs Act (TCJA). This includes making the increased estate, gift, and generation-skipping transfer (GST) tax exemptions permanent, thus avoiding the reduction scheduled for 2026. Additionally, Republicans are likely to oppose the Biden administration’s suggested reforms, such as treating sales between a grantor and a grantor trust as taxable events and recognizing the payment of income tax on trust income as a taxable gift.

Conclusion

As we anticipate potential changes to the grantor trust rules in 2025, it’s clear that the landscape of estate planning may undergo significant transformations. The Biden administration’s proposals, likely to be adopted in a similar form by Vice President Harris, aim to close loopholes that currently allow for substantial tax advantages through mechanisms like the swap power and GRATs. These reforms would impose stricter requirements and tax consequences, curbing the ability to avoid capital gains and transfer taxes. Conversely, Republican proposals focus on maintaining the current tax benefits established by the 2017 Tax Cuts and Jobs Act. Understanding these proposals and their potential impacts is crucial for tax professionals and affluent taxpayers. Staying informed and proactive will ensure the optimal structuring of trusts and asset transfers, aligning with the evolving tax regulations and maximizing the benefits within the legal framework.

 References:

1  Jesse Huber. The grantor trust rules: An exploited mismatch. The Tax Adviser. November 1, 2021

2  Department of the Treasury March 11, 2024. General Explanations of the Administration’s Fiscal Year 2025 Revenue Proposals. Green Book p.127

© 2024 wealthcarelawyer.com. All rights reserved.

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.

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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For more on Trusts, Grantors and Beneficiaries, see the National Law Review Estates & Trust law section.

Tax Court Holds that a Trust can Qualify for the "Real Estate Professional Exception" of Section 469(c)(7)

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The Tax Court recently handed down its decision in Frank Aragona Trust v. Commissioner, ruling that a trust can qualify for the real estate professional exception of Section 469(c)(7). By taking into account the actions of the trustees, a trust can be considered to be materially participating in real estate activities. This means that losses from real estate activities can be treated as nonpassive and therefore deductible in determining the trust’s taxable income. This decision is especially relevant to trusts that own business as it affects the application of the passive activity loss rules in Section 469 and whether income from those activities is subject to the new 3.8% net investment income Medicare surtax under Section 1411.

The Frank Aragona Trust (the “Trust”) was a Michigan trust that owned several pieces of real property and was also involved in the business aspects of developing and maintaining the property. The Trust had six trustees, three of whom were also employees of Holiday Enterprises, LLC (the “LLC”). The LLC was owned 100% by the Trust. The LLC also employed other professionals.

The Trust had losses in 2005 and 2006 from its real estate activities and deducted those losses(on the basis that they resulted from nonpassive activities) on its income tax returns. In issuing a notice of deficiency for those tax years, the Service determined that the real estate activities were passive under Section 469 and therefore any related losses were not deductible.

In general, real estate rental activity is considered passive regardless of whether the taxpayer materially participates in the real estate business. However, there is an exception for “real estate professionals” under Section 469(c)(7). Before the Tax Court, the Trustees argued that the Trust was a “real estate professional” as defined in Section 469(c)(7) so that the losses were considered to be from nonpassive activities and therefore deductible. To qualify for the real estate professional exception, a taxpayer must pass two tests. First, more than one-half of the personal services performed in a taxable year must be performed in real property trades or businesses in which the taxpayer materially participates. Second, the taxpayer must perform more than 750 hours or services during the taxable year in real property trades or businesses in which the taxpayer materially participates. The Service argued that the regulations to Section 469(c)(7) define “personal services” as “work performed by an individual in connection with a trade or business [emphasis added].” Because the trust was not an individual, it could not perform personal services and therefore did not fall under the Section 469(c)(7) exception.

The Tax Court rejected the Service’s argument that the trust could not be considered an individual under Section 469(c)(7) and the associated regulations. Further, the Court found that the Trustees’ participation in the real estate activities met the material participation requirements of Section 469(c)(7) because they were regular, continuous and substantial. The Court determined that the participation of the Trustees should be considered in determining whether the taxpayer (the Trust) materially participated in the real estate activities. The Service argued that the activities of the Trustee should only apply if they are performed in their capacity as Trustees (as opposed to employees of the LLC). Here, the Court looked to Michigan law, under which trustees are required to administer trusts solely for the benefit of the trust beneficiaries. The Court explained that the Trustees could not simply stop acting as Trustees because they were also employees of the LLC, so that their activities in other capacities could be considered in whether the Trust was a material participant in the real estate activities.

In summary, a trust may be able to qualify for the real estate professional exception of Section 469(c)(7). If the trust qualifies for the exception, losses from the associated real estate activities may be deductible on the trust’s income tax return. This distinction has increased importance with the application of the new 3.8% net investment income Medicare surtax under Section 1411.

Article By:

Albert W Gortz
George D Karibjanian
David Pratt
Mitchell M Gaswirth
Andrew M Katzenstein
Henry J Leibowitz
Of:
Proskauer Rose LLP

 

U.S. Tax Court Rejects Internal Revenue Service's (IRS) Restrictive View of Trust Material Participation

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The U.S. Tax Court recently issued a taxpayer favorable opinion regarding how a trust materially participates in its activities. The court’s holding will make it easier for trusts to currently deduct expenses against non-passive income and to exclude income from the reach of the new 3.8% net investment income tax.

In Frank Aragona Trust v. Comm’r, the court held that in determining whether a trust materially participates in its activities, the activities of the trustees, including their activities as employees of the businesses owned by the trust, should be considered. The court’s opinion directly conflicts with recent IRS guidance that only a trustee’s time spent acting in a fiduciary capacity counts toward the trust’s material participation – a standard that would be very difficult for most trusts to meet. See Technical Advice Memorandum 201317010.

In Frank Aragona Trust, a Michigan trust owned rental real estate activities and engaged in holding and developing real estate. The trust conducted some of its activities directly, and others through its wholly-owned business, Holiday Enterprises, LLC. The trust had six trustees, three of whom worked full-time for Holiday Enterprises. The IRS argued that the participation of the trustee-employees should be disregarded. The court disagreed and concluded that the participation of the trustee-employees should be counted and further, that the participation of the trust’s six trustees was sufficient to meet the material participation standard. The court based its decision, in part, on the fact that Michigan law requires trustees to “administer the trust solely in the interest of the trust beneficiaries” even when they are participating through a business wholly-owned by the trust. This decision provides helpful authority for trusts, their trustees and their advisors in navigating the complex passive activity loss and net investment income tax rules.

However, the decision in Frank Aragona Trust does not answer all of the outstanding questions regarding material participation of trusts. In recently finalized regulations implementing the net investment income tax, the Treasury Department and the IRS requested public comments on rules regarding material participation of trusts, which indicates that the IRS may finally undertake a formal project to provide long-awaited guidance on this issue.

Article By:

Michala P. Irons
Randal J. Kaltenmark
William M. Pope
Douglas S. Robson
Howard J. Rubin
Of:
Barnes & Thornburg LLP

Illinois Trust Taxation Deemed Unconstitutional

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In Linn v. Department of Revenue, the Illinois Fourth District Appellate Court reviewed the state’s statutory framework for taxing trusts. Linn v. Department of Revenue, 2013 Il App (4th) 121055.  On constitutional grounds, the court limited Illinois’ power to impose taxes under its “once subject to tax, forever subject to tax” regime.

This case creates planning opportunities to minimize Illinois income taxes.  However, it should be noted that the Linn case applies to trusts that pay Illinois income tax on trust dividends, interest, capital gains or other income retained by the trust and not distributed to a beneficiary.  This case does not apply to income distributed to an Illinois beneficiary; that income clearly can be taxed by Illinois.

Illinois Trusts

Illinois trusts are subject to a 5 percent income tax plus a 1.5 percent personal property replacement tax.  A nonresident trust is subject to taxation only on income generated within Illinois or apportioned to the state.  Resident trusts, on the other hand, are subject to tax on all income, regardless of the source of that income.  For an individual, state income taxation on a resident basis generally requires domicile or residence within the taxing state.  With respect to a trust, one or more of the grantor, trustees and beneficiaries may have contacts with a state sufficient to uphold as constitutional a tax on all of the trust income.

Illinois defines a resident trust based solely on the domicile of the grantor. 35 ILCS 5/1501(a)(20).  A resident trust means:

  • A trust created by a will of a decedent who at death was domiciled in Illinois or
  • An irrevocable trust, the grantor of which was domiciled in Illinois at the time the trust became irrevocable.  For purposes of the statute, a trust is irrevocable when it’s no longer treated as a grantor trust under Sections 671 through 678 of the Internal Revenue Code.

The Illinois statute would forever tax the income generated by the trust property, regardless of the trust’s continuing connection to Illinois.  One can analogize the Illinois statute to a hypothetical statute providing that any person born in Illinois to resident parents is deemed an Illinois resident and subject to Illinois taxation no matter where that person eventually resides or earns income.  Many lawyers believe that the Illinois statute is unconstitutional.

Linn

Linn involved a trust established in 1961 by A.N. Pritzker, an Illinois resident.  The trust was initially administered under Illinois law by trustees who lived in Illinois.  In 2002, the trustee exercised a power granted in the trust instrument to distribute the trust property to a new trust (the Texas Trust).  Although the Texas Trust generally provided for administration under Texas law, certain provisions of the trust instrument continued to be interpreted under Illinois law.  The Texas Trust was subsequently modified by a Texas court to eliminate all references to Illinois law, and the trustee filed the Texas Trust’s 2006 Illinois tax return as a nonresident.  At that time:

  • No current trust beneficiary resided in Illinois;
  • No trustee or other trust officeholder resided in Illinois;
  • All trust assets were located outside Illinois; and
  • Illinois law wasn’t referred to in the modified trust instrument

The Illinois Department of Revenue (the IDR) asserted that the trust was a resident trust for 2006 and that, as such, the trust pay Illinois income tax on all income.  The trustee countered that the imposition of Illinois tax under these circumstances was unconstitutional as a violation of the due process clause and the commerce clause.  The court held the statute was unconstitutional based on due process grounds (not reaching the commerce clause arguments), and stated that the following are the requirements for a statute to sustain a due process challenge:  (1) a minimum connection must exist between the state and the person, property or transaction it seeks to tax during the period in issue and (2) the income attributed to the state for tax purposes must be rationally related to values with the taxing state. Quill Corp. v. North Dakota, 504 U.S. 298, 306 (1992).

This was the first case in Illinois on this issue so the court cited cases from other jurisdictions, including Chase Manhattan Bank v. Gavin, 733 A. 2d 782 (Conn. 1999), McCulloch v. Franchise Tax Board, 390 P.2d 412 (Cal. 1964), Blue v. Department of Treasury, 462 N.W.2d 762 (Mich. Ct. App. 1990) and Mercantile-Safe Deposit & Trust Co. v. Murphy, 242 N.Y.S.2d 26 (N.Y. App. Div. 1963).  Gavin, which upheld the application of the Connecticut income tax on the undistributed income of a lifetime trust created by a Connecticut grantor, was cited at length by the court.  A critical fact in that case was that the beneficiary resided within the state for the year in question and the court assumed that the beneficiary would receive all trust property shortly.  In Linn, the court noted, there were no Illinois beneficiaries.  Relying on Blue and Mercantile, the court found that a grantor’s residence within a state isn’t itself enough to satisfy due process.

The IDR argued that significant connections with Illinois existed, maintaining that the trust owed its existence to Illinois law and listing legal benefits Illinois provides to the trustees and beneficiaries. The IDR cited some cases that involved trusts created by a will (i.e.,testamentary trusts).  The Illinois court disagreed with the testamentary trust cases the IDR relied on, finding that a lifetime trust’s connections with a state are more attenuated than in the case of a testamentary trust.  Further, the court found that the Texas Trust wasn’t created under Illinois law, but rather by a power granted to the trustees under the original trust instrument.  The court proceeded to dismiss the trust’s historical connections to Illinois and focused on contemporaneous connections, finding that “what happened historically with the trust in Illinois courts and under Illinois law has no bearing on the 2006 tax year.”  Linn at ¶30.  For 2006, the court concluded that the trust received the benefits and protections of Texas law, not Illinois law.

Steps to Consider

The IDR did not appeal the Linn decision to the Illinois Supreme Court.  We anticipate that additional cases will test and define the boundaries of the Linn decision.  Of course, Illinois might change its statute. For the time being, however, the Linn decision is binding authority for trustees of trusts that can eliminate all contact with Illinois.

Trustees of resident trusts with limited contacts to Illinois (in particular, those trusts without trustees, assets or non-contingent beneficiaries in Illinois) should consider the following issues.

  • Review state taxation:  The trustee should review connections to Illinois and consider whether actions could be taken to fall within theLinn holding.  Contacts with other states and those states’ rules for taxing trusts should also be reviewed.
  • File Illinois return with no tax due:  Pending guidance from the IDR, the trustee could consider filing an IL Form 1041, referencing theLinn case and reporting no tax due.  For each tax year, a tax return must be filed in order to commence the running of the statute of limitations.  An Illinois appellate court decision that supports the taxpayer’s position will ordinarily provide a basis for the abatement of tax penalties. 86 Ill. Admin Code Section 700.400(e)(8). However, if the facts are not exactly like those in Linn, a penalty cold be imposed on the trustee.  A safer method for trusts when the facts are not the same as in Linn would be to file and pay the Illinois tax in full but then file a claim for refund.  This should eliminate penalties but likely will result in a dispute with the IDR.
  • Amend prior tax returns:  The trustee could consider filing amended tax returns for prior years and claim a refund.  A trustee that has timely filed prior year tax returns may file an amended tax return at any time prior to the third anniversary of the due date of the tax return, including extensions.  For example, the 2010 tax year return may be amended at any time prior to October 15, 2014.

Other Considerations

Given the holding in Linn and uncertainty regarding trust tax law, trusts that offer flexibility and can adapt to changing circumstances may have a distinct advantage.

  • Officeholders:  Carefully consider the residency of trustees and other trust officeholders (such as investment advisers) and provisions regarding the appointment and removal of those officeholders.
  • Decanting provision:  Consider providing the trustee with broad authority to distribute trust property in further trust.
  • Lifetime trusts:  While the legal basis for the continued income taxation of a testamentary trust may also be questionable, testamentary trusts can be avoided by creating lifetime trusts.
  • Situs and administration:  Consider establishing and administering the trust in a state that doesn’t assess an income tax against trust income.
  • Governing law:  Consider including trust provisions that allow the trustee to elect the laws of another state to govern the trust.
  • Discretionary dispositive provisions:  Consider including discretionary rather than mandatory trust distribution provisions, as some states may tax a trust based on the residence of beneficiaries with non-contingent trust interests.
  • Division provisions:  Consider including provisions authorizing a trustee to divide a trust without altering trust dispositive provisions.  This type of provision may allow a trustee to divide a trust into separate trusts and isolate the elements of a trust attracting state taxation.  For example, a trust may simply be divided into two separate trusts, one trust for the benefit of a child and his descendants that live in Illinois and a second trust that might not be subject to Illinois taxation, for a child and his descendants that don’t live in Illinois.
Article By:

James H. Cundiff
L. Timothy Halleron
Of: 
McDermott Will & Emery

 

Has Your Trust Lost Touch With Illinois? If So, It May Not Be Subject to Illinois Income Tax

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Overview

In December 2013, an Illinois Appellate Court of the Fourth District held that an inter vivos trust – that had no connections with Illinois other than the fact that the settlor of the trust was residing in Illinois when the trust was created – was not subject to Illinois income taxation.  Linn v. Department of Revenue, 213 IL App (4th) 121055.  Even though the Illinois Department of Revenue (“IDOR”) had the opportunity to appeal the ruling, it did not do so.  As a result, there may be an opportunity for inter vivos trusts established by an Illinois settlor to avoid Illinois income tax – if such trusts no longer have sufficient contact with the State of Illinois.

Background

The relevant portion of the Illinois Income Tax Act defines an Illinois resident as “[a]n irrevocable trust, the grantor of which was domiciled in [Illinois] at the time such trust became irrevocable.” 35 ILCS 5/1501(a)(20)(D).  The trust at issue in Linn was established in 1961 when the grantor and trustee of the trust were Illinois residents.  At the time the trust was established, the beneficiary of the trust resided in Illinois, and the trust assets were deposited in Illinois.  The trust instrument provided that Illinois law would govern the construction, administration and validity of the trust.

In 2007, the trust filed a 2006 nonresident Illinois income tax return – as the trustee and beneficiaries were no longer residents of Illinois and the trust had no Illinois situs income.  Additionally, the trust agreement had been modified in 2002 to provide that it shall be construed and regulated under Texas law.  Due to the lack of sufficient contact with Illinois, the Illinois Appellate Court held that the imposition of Illinois income tax on the trust was unconstitutional in violation of the due process clause – as the trust did not meet any factors that would give Illinois personal jurisdiction over the trust.

Review of Existing Irrevocable Trusts

As a result of the decision in Linn, there may be an opportunity for certain trusts that have no contact with Illinois to avoid Illinois income tax.  In spite of Illinois law that deems a trust to be an Illinois resident if the grantor of a trust resides within the State when it becomes irrevocable, the decision in Linn effectively invalidates that law when a trust no longer has any connections to Illinois.  In the wake of Linn decision, we recommend that you review any irrevocable trusts established by a grantor who resided in Illinois (at the time of creation) to consider the following:

  • The current residence or location of the trustee and the beneficiaries, and the present location of the trust assets.
  • Whether the trust agreement contains provisions that (i) allow a trustee to be appointed outside the State of Illinois, or (ii) permit the law governing the trust to be changed to another state.
  • Whether the trust allows “decanting” – which is a process authorized by a recent Illinois statute that allows the transfer of assets to a new trust, which could be governed by the law of another state.
  • Whether a trust with no connections to Illinois for the past several years (and which filed Illinois income tax returns and paid Illinois income taxes) should file a claim for refund.  Generally, there is a three year period from the due date (or filing date) of an income tax return to file an amended return and claim a refund.

Conclusion

The Linn decision is now the law in Illinois.  Therefore, if you are a beneficiary or a trustee of a trust originally created in Illinois (or an advisor to any such beneficiary or trustee), you should examine whether the trust has sufficient connections to Illinois to be taxed.

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