The principal objective when drafting wills or trust agreements is to best effectuate the intent of the settlor or testator, while at the same time ensuring that the most advantageous tax and legal objectives are met. Since the will may be revised only infrequently, and irrevocable trusts are difficult and some even impossible to amend, competently drafted instruments are at a premium. To ensure present and future viability, many legal and tax issues, some rather complex and others not intuitive, should be considered in drafting. Some are discussed below.
“Decanting” describes the transfer of trust res from an existing irrevocable trust (the “invaded” trust) to a new or existing irrevocable trust (the “appointed” trust). EPTL § 10-6.6 allows the trustee to amend the terms of an irrevocable trust to accomplish any of the following desirable objectives: (i) to extend the termination date of the trust; (ii) to add or modify spendthrift provisions; (iii) to create a supplemental needs trust for a beneficiary who is or has become disabled; (iv) to consolidate multiple trusts; (v) to modify trustee provisions; (vi) to change trust situs; (vii) to correct drafting errors; (viii) to modify trust provisions to reflect new law; (ix) to reduce state income tax imposed on trust assets; (x) to vary investment strategies for beneficiaries; or (xi) to create marital and non-marital trusts. Decanting is becoming increasingly common in New York and other states. Although EPTL §10-6.6 applies by default, the trust should still define circumstances in which it should be utilized. If the settlor is opposed to decanting, the trust should also so state. As statutes go, this one is still relatively new; caution is therefore advisable when drafting. Following the precise statutory procedure is important.
II. Scope of Trustee Discretion
Eliminating trustee discretion with respect to distributions provides certainty to beneficiaries, and reduces the chance of conflict. Nevertheless, the trustee will also be unable to increase or decrease the amount distributed in the event of changed circumstances. If the trustee is given no discretion, the trust could also never be decanted, as a requirement of the New York decanting statute (as well as other states which have decanting statutes) is that the trustee have at least some discretion with respect to trust distributions.
At the opposite end of the spectrum lie trusts which grant the trustee unlimited discretion with respect to distributions. If the settlor were the trustee of this trust, estate inclusion would result under IRC §2036 — even if the settlor could make no distributions to himself — because he would have retained the proscribed power in IRC §2036(a)(2) to “designate the persons who shall possess or enjoy the property or the income therefrom.” Disputes among beneficiaries (or between beneficiaries and the trustee) could occur if the trustee possesses absolute discretion with respect to trust distributions. By adding the term “unreviewable” to “absolute discretion,” the occasion for court intervention would appear to be limited to those circumstances where the trustee has acted unreasonably or acted with misfeasance. Another disadvantage of giving the trustee absolute discretion is that it diminishes asset protection, since the creditor will argue that the trustee should exercise absolute discretion to satisfy creditor claims. A beneficiary’s power to make discretionary distributions to himself without an ascertainable standard limitation would constitute a general power of appointment under Code Sec. 2041 and would result in inclusion of trust assets in the beneficiary’s estate, and would also decimate creditor protection. Still, a trustee vested with absolute discretion will find decanting easier to accomplish under the statute. And finally, it may also be the settlor’s desire that the trustee be accorded absolute discretion.
In the middle of the spectrum lie trusts which grant the trustee discretion limited to an ““ascertainable standard.” If the trustee’s discretion is limited by such an ascertainable standard, no adverse estate tax consequences should result if the settlor is named trustee. Since this degree of discretion affords the trustee some flexibility regarding distributions without adverse estate tax consequences, and now qualifies under the New York decanting statute, many settlors find this model attractive. The most common ascertainable distribution standard is that of “health, education, maintenance and support” (“HEMS”). In practice, the HEMS standard allows for considerable trustee discretion. Despite this flexibility, issues may arise as to what exactly is meant by the standard. Is the trustee permitted to allow the beneficiary to continue to enjoy his or her accustomed standard of living? Or is the trustee required to do that? Should other resources of the beneficiary be taken into account or not? To illustrate, a beneficiary living an extravagant lifestyle may request a distribution of $1 million to be among those to first travel into space. While the distribution could conceivably fall within the ambit of distributions allowing the beneficiary to continue to enjoy an accustomed standard of living, it would also likely raise the ire of remainder beneficiaries. Even a trustee granted absolute discretion to maintain a beneficiary in an accustomed standard of living might have a problem with such a request.
The trustee should be informed by the trust with respect to discretionary distributions. A clear and well drafted trust provision is the most effective way to convey the settlor’s intent. While some might object to the technical legal language required to effectively implement the settlor’s intent, there is unfortunately no simple way for a drafter attempting to create a lasting trust to best address unforeseeable circumstances without some complexity. Each possible future occurrence necessarily adds to trust complexity.
The HEMS standard itself provides a fair amount of asset protection. In practice, it may be helpful to include another provision whose exclusive purpose is to further asset protection objectives. That provision is termed a “hold back” provision. Basically, when the terms of the provision are triggered (e.g., the beneficiary gets divorced or has a health problem occasioning astronomical costs) the trust would go into a “lockdown” mode unless and until the creditor threat ceases to exist. Although not a failsafe, the holdback provision is another arrow in the settlor’s quiver to protect the trust property from unforeseen creditor threats. Even though implied in law, most trusts also contain a “spendthrift”” provision, which bars alienation or transfer of trust assets. A holdback provision is a specific use of the concept of a spendthrift limitation.
III. Annual Accounting
The Uniform Trust Code (“UTC”) is a model code that has been adopted by a majority of states. UTC § 813(c) requires that trustees provide annual accountings to beneficiaries unless that requirement is waived within the trust instrument. Some settlors may believe this requirement places an excessive burden on trustees and may be economically unnecessary, particularly if the trust will last for decades. New York has not adopted the UTC. SCPA §2306 requires trustees to provide annual accountings to any beneficiary receiving income or any person interested in the principal of the trust if a request for an annual accounting is made. It may be desirable for the trust to waive the requirement of annual accountings. Although the SCPA does give the beneficiary the right to demand an annual accounting, trust language stating that the trustee is under no obligation to furnish an annual accounting might tend to minimize the frequency of unwanted requests.
Obviously, in some cases — such as where there is a corporate or bank trustee — the settlor might not want to condition annual accountings to situations where the beneficiary requests it, but might want to impose upon the trustee the obligation to furnish an annual account without any request by the beneficiary. If this is the case, the trust should so state. Bear in mind however that (barring misfeasance) accountings are paid for by the trust, and a bank will spare no expense in engaging legal counsel to ensure that the account is complete and accurate.
IV. Non-Beneficiaries’ Right to Information
New York has no statutory requirement that trustees provide information to individuals who are not beneficiaries. Thus, even the settlor might not be entitled to information concerning the trust. This could be problematic if the settlor retained the right to replace the trustee or trust protector. Therefore, if the trust grants the settlor or other non-fiduciary the power to remove a trustee, the trustee should be required to furnish such information (unless a compelling reason exists not to do so). Frequently, banks also require copies of trust instruments. Simply providing the first and signature pages of the trust may satisfy the banking institution. If not, the document should be redacted to exclude information not reasonably necessary for the bank in performing its due diligence. Although it is possible for a trust to be “silent,” meaning that the beneficiary does not even know of the existence of the trust, these cases are unusual. It is good practice to provide an inquisitive beneficiary with a copy of a trust (which may be redacted where appropriate). It is unclear whether the trustee is under such a legal requirement in New York. A beneficiary is not represented by counsel to the trustee, and communications between counsel for the trustee and the beneficiary are best kept to an minimum. This is true even though the interests of the beneficiaries are not adverse to that of the trustee. It is justified by the fact that it is the trustee who engages the attorney. As a corollary to this, the confidentiality privilege would likely not extend to communications between counsel to the trustee, and trust beneficiaries.
EPTL § 2-1.11(d) provides that a disclaimant is treated as predeceasing the donor (or testator), or having died before the date on which the transfer creating the interest was made. Since the disclaimant is treated as never having received the property, a disclaimer qualified under federal law occasions no gift or estate tax consequences. To qualify under IRC §2518, property must pass to someone other than the disclaimant without any direction on the part of the disclaimant. However, with respect to a surviving spouse, the rule is more lenient. Estate of Lassiter, 80 T.C.M. (CCH) 541 (2000) held that Treas. Reg. §25.2518-2(e)(2) does not prohibit a surviving spouse from retaining a power to direct the beneficial enjoyment of disclaimed property, even if the power is not limited by an ascertainable standard, provided the surviving spouse will ultimately be subject to estate or gift tax with respect to the disclaimed property. The disclaimant may not have the power, either alone or in conjunction with another, to determine who will receive the disclaimed property, unless the power is subject to an ascertainable standard. Accordingly, it is important that the trust specify what happens to the disclaimed property if a disposition other than that which would occur under the existing will provisions is desired. To illustrate, assume John disclaims. The effect of John disclaiming would result in Jane receiving the property under the will. However, the will may be drafted to provide that if John disclaims, Susan will receive the property. The will cannot provide that if John disclaims, then either he or the executor may decide who receives the property. It would be permissible however to provide that if John disclaims, he may still receive a benefit under a marital trust in which he is a beneficiary.
VI. Dispositions Per Stirpes or By Representation
Most wills and trusts provide for a “per stirpes” distribution standard. This means that the decedent’s property is divided into as many equal shares as there are (i) surviving issue in the generation nearest to the deceased ancestor which contains one or more surviving issue and (ii) deceased issue in the same generation who left surviving issue. If the decedent had three children, each would take a third provided they all survive the decedent. Should one predecease, the predeceasing child’s children would share equally in their parent’s third.
If two children predeceased, each leaving differing numbers of children, there are generally two means of disposing of the grandchildren’s shares. Either each grandchild could take a proportionate share of his predeceasing parent’s third; or each grandchild could take a proportionate share of the sum of the two predeceasing children’s respective one third shares. If one predeceasing child had a single child and the other, nine children, the difference in the chosen standard becomes apparent. To illustrate, if the will provides for a per stirpital standard (which is not the default but is more common) then the grandchild (in the case described in the preceding paragraph) with no siblings would take 1/3(i.e., his parent’s), and the other 9 grandchildren would each take 1/27th (i.e., 1/9 of 1/3). Conversely, if the will provides for distribution by representation (which is the default standard in New York but less common) then each of the 10 grandchildren would be treated equally, and each would take 1/15 (i.e., 1/10 of 2/3). New York has modified its statute in a novel way. Under New York law, the number of “branches” is determined by reference to the generation nearest the testator that has a surviving descendant. Therefore, if the will provides for a per stirpes distribution standard, and all of the children predecease the testator, then each grandchild is treated as a separate “branch.”
VII. Personal Liability for Actions of Co-Trustees
Trustees may be held personally liable for breach of fiduciary duty by a co-trustee. In Matter of Rothko, 401 N.Y.S.2d 449, 372 N.E. 291 (N.Y. 1977), The Court of Appeals found that an executor was liable for failing to challenge actions taken by co-executors. Rothko found that all three executors of an estate had breached their fiduciary duties where a contract was entered into which served the self-interest of two of the executors. Although one executor had not engaged in conduct benefitting himself (as had the other two) his failure to challenge actions taken by two other executors was itself a breach of fiduciary duty. The Court remarked:
[a]n executor who knows that his co-executor is committing breaches of trust and not only fails to exert efforts directed towards prevention but accedes to them is legally accountable even though he was acting on advice of counsel.
To diminish the possibility of a co-trustee being held accountable for the misfeasance of a co-trustee, the trust could contain a provision either requiring that a majority of trustees approve a major decision, with no liability to the dissenting trustee; or the trust could require unanimity. Requiring unanimity could also elevate the significance of trustee discord in situations not involving self-interest. Therefore, it might not be desirable. Simply inserting exculpatory language would probably be ineffective under Rothko. A trust instrument cannot absolve the trustee from failing to act in a fiduciary capacity.
VIII. Prudent Person Standard
The New York Prudent Investor Act (EPTL § 11-2.3) is effective for all trust investments made on or after January 1, 1995. It imposes an affirmative duty on trustees to “invest and manage property held in a fiduciary capacity in accordance with the prudent investor standard defined in this section.” The prudent investor standard (EPTL § 11-2.3(b)) provides that a trustee shall exercise reasonable care, skill and caution to make and implement investment and management decisions as a prudent investor would for the entire portfolio, taking into account the purposes, terms and provisions of the governing instrument. The statute further requires that trustees diversify assets unless they ““reasonably determined that it is in the interest of the beneficiaries not to diversify taking into account the purposes and terms and provisions of the governing instrument.” Compliance with the Prudent Investor Act is determined not by outcome or performance, but rather in light of facts and circumstances prevailing at the time of the decision or action of the trustee. Some factors that court will consider where a trustee fails to diversify are liquidity of assets, tax consequences, and settlor intentions (as demonstrated by the trust instrument). Although the Prudent Investor Act generally requires diversification, courts do not always find trustees liable for failures to diversify. Thus, it may be desirable to include a provision in trust instruments requiring diversification of assets.
IX. Exculpatory and Indemnification Clauses
A trusteeship imposes fiduciary obligations upon the person or company which assumes that office. By reason of the high standards of fealty to which a trustee is held, the trust may contain an exculpatory clause which exonerates the trustee for liability which might not otherwise be forgiven. Exculpatory clauses protect a trustee from personal liability arising from acts or omissions that do not amount to willful wrongdoing. Trusts may attempt to limit liability to the malfeasance of the trustee himself, but not of a co-trustee. However, as was the case in Rothko, the co-trustee cannot with impunity cast a blind eye to actions taken by another trustee acting with misfeasance. Without an exculpatory clause excusing some actions short of misfeasance, many persons would be reluctant to assume a trusteeship. Even so, both the Uniform Trust Code (§ 1008(b)) and the Restatement (Third) of Trusts (§ 96 cmt. d) provide a presumption of unenforceability for exculpatory clauses. To overcome that presumption, the clause must be fair and adequately communicated to the settlor. Obviously, a trust clause cannot exculpate bad faith, reckless indifference, or intentional or willful neglect.
Notably, New York has not adopted the UTC, and has no presumption against the enforcement of exculpatory clauses. Nevertheless, EPTL § 11-1.7(a)(1) does bar testamentary instruments from exonerating trustees from liability for failure to exercise reasonable care, diligence and prudence. However, New York statutory law is silent with respect to exculpatory clauses appearing in inter vivos trusts. New York case law has provided conflicting determinations in connection with the enforceability of exculpatory clauses appearing in inter vivos trust instruments. Although an exculpatory clause might not be enforced by a New York court, it may nevertheless be desirable to include such a clause, especially if the trustee is a family member, relative, or friend. There is less of a reason to include an exculpatory clause where the trustee is a bank or trust company. (In all likelihood, a bank or trust company would insist upon such a clause.) Indemnification clauses may be drafted in such as manner as to appear to entitle trustees (e.g., a bank) to indemnification for costs and legal fees incurred in actions concerning breach of fiduciary duty, unless it is proven that the trustees engaged in willful wrongdoing or were grossly negligence. Such clauses are presumptively unenforceable. The First Department held unanimously in Gotham Partners, L.P. v. High Riv. Ltd. Partnership (2010 NY Slip Op 06149) that unless an indemnification clause of a contract is “unmistakably clear” and meets the “exacting”” test set forth twenty years previously in Hooper Associates v. AGS Computers (74 N.Y.2d 487), the victorious party in a contractual dispute will not be awarded attorney’s fees, regardless of the parties’ intent. This is consistent with the general proposition in most U.S. jurisdictions that the prevailing party may not generally recover legal fees from the defeated party in litigation. This promotes litigation but also encourages meritorious claims by persons with few resources. The U.S. view emphasizes one’s right to his “day in court.” The U.S. rule is in distinct contrast with the English Rule, where attorney’s fees are typically awarded.
X. Survivorship and GST Tax
The Generation-Skipping Transfer (GST) tax thwarts multigenerational transfers of wealth by imposing a transfer tax “toll” at each generational level. Prior to its enactment, beneficiaries of multigenerational trusts were granted lifetime interests of income or principal, or use of trust assets, but those lifetime interests never rose to the level of ownership. Thus, it was possible for the trust to avoid imposition of gift or estate tax indefinitely. The GST tax, imposed at rates comparable to the estate tax, operates for the most part independently of the gift and estate tax. Therefore, a bequest (i.e., transfer) subject to both estate and GST tax could conceivably require nearly three dollars for each dollar of bequest. The importance of GST planning becomes evident. The GST tax operates by imposing tax on (i) outright transfers to “skip persons” (“direct skips”); (ii) transfers which terminate a beneficiary’s interest in a trust (“taxable terminations”), unless (a) estate or gift tax is imposed or unless (b) immediately after the termination, a “non-skip” person has a present interest in the property; and (iii) transfers consisting of a distribution to a “skip person,” unless the distribution is either a taxable termination or a direct skip (“taxable distributions”).
IRC § 2651(e) provides an exception which allows a lineal descendant to “move up” a generational level where that decedent’s parent (who is also a lineal descendant of the transferor) is deceased at the time of the original transfer by the transferor. For example, where a gift is made to a grandchild whose parent predeceased the transferor, the grandchild will be deemed to be at the same generational level as his deceased parent and the GST tax will be inapplicable. With respect to trusts, an original transfer is deemed to occur on the date the trust is funded, and not on the date that a beneficial interest vests.
Treas. Reg. § 26.2651-1(a)(2)(iii) will treat the parent as predeceasing the transferor — thus falling within the exception which allows avoidance of the GST tax — if the descendant’s parent dies within 90 days of the transfer. The regulation would only apply if the trust actually provides that the descendant’s parent is deemed to have predeceased the transferor if the descendant’s parent dies within 90 days. Thus, the inclusion of a “survivorship provision” in a will containing a testamentary trust could well achieve the result of avoiding the GST tax in some situations, such as where a simultaneous death occurs. The survivorship provision typically states that no person be deemed to have survived the decedent for purposes of inheriting under the will unless that person is living on the date 90 days after the decedent’s date of death. Since the applicable exclusion amount is now well over $5 million, the GST tax applies to relatively few people today. However, there may be other reasons for including a survivorship provision. Many testators would not want their entire estate to pass to their spouse if the spouse died within a very short period of time. Thus, survivorship provisions requiring survival for more than three months may be chosen. Longer survivorship provisions would also be consistent with the requirement for qualifying for the GST exception.
XI. Governing Law
If privacy is important, the settlor might choose Delaware as the situs of the trust. Delaware, as well as Nevada, also provide a greater degree of asset protection than would New York. States’ perpetuities periods also vary. It might be desirable for a trust to state that the laws of another state would control disputes arising under the trust, especially if the beneficiaries and trustees reside in another jurisdiction. There are limits to what choosing the governing law may achieve. While the trust may provide that another state’s governing law will control in many situations, it would not be possible — and would be against public policy — for a New York resident to deprive New York of its right to tax New York source income by stating that another jurisdiction’s law will control. In fact, in direct response to a tax planning technique explicitly permitted by the IRS, New York now treats income of a New York resident as New York source income and thus subject to tax in New York, in a manner different from how the income is treated for federal tax purposes. Therefore, defeating the ability of New York to impose tax on a trust having a nexus with New York would likely be impossible.
XII. Trustee Incapacity
The incapacity of a trustee would render the trustee incapable of fulfilling fiduciary obligations and in that sense would defeat the purpose of the trust. New York does not specifically refer to incapacity as a basis for removing a trustee. SCPA § 711 does provide a mechanism that permits co-trustees, creditors, and beneficiaries to commence trustee removal proceedings in Surrogates Court. However, Section 711 provides specific grounds for removal which at best only vaguely apply to incapacity. For example, SCPA §§ 711 (2) and (8) both authorize removal of a trustee that is unfit by reason of “want of understanding.” SCPA §711(10) permits removal where a trustee is an “unsuitable person to execute the trust.” Given the limited guidance provided by New York statute, trusts should define incapacity and provide a procedure for removing trustees believed to be incapacitated. Such provisions would be particularly helpful in the case of inter vivos trusts, which may generally be administered without court intervention.
Including clear language in an inter vivos trust could avoid the necessity of litigation, or reduce litigation costs if they are still necessary. One means of resolving the troublesome issue of removing an incapacitated trustee is to specifically provide within the trust that any trustee who is or becomes incapacitated shall be deemed to have resigned. A clear definition of incapacity should then be drafted. Incapacity may be defined in a number of ways. Someone who is a minor, or who is legally disabled, or who has been incarcerated is considered “incapacitated” in a legal sense, and would clearly be unsuitable trustees. Perhaps the most common definition of incapacity of an acting or appointed trustee references a licensed physician who has examined the person within the preceding six months, and makes a written statement to the effect that the person is no longer competent to (or in the case of an appointed trustee, is not competent to) manage the business and legal affairs in a manner consistent with the manner in which persons of prudence, discretion and intelligence would, due to illness or physical, mental or emotional disability.
The trust may include procedures permitting a co-trustee (or, in the case were there is no trustee, a beneficiary) to compel a person suspected to be incapacitated to prove capacity as a condition to continue serving as trustee (or be appointed as trustee).
However, no trustee will appreciate being summoned by a beneficiary or co-trustee to prove competence, and the possible abuse of such a provision is evident. The settlor’s choice of trustee is paramount and beneficiaries should not have the power to remove trustees except as explicitly permitted in the trust or by commencing appropriate proceedings in Surrogates Court. Therefore, the use of such a provision should be carefully circumscribed to where deemed absolutely necessary.
XIII. Single Signatory
Where a trust has more than trustee, there may be a question as to whether all co-trustees need participate in actions taken on behalf of the trust. Such action could include the signing of a check, agreement or other legal document. For enhanced administrative efficiency, a trust could provide that the approval of only one trustee is required to evidence trustee approval of a legal action taken on behalf of a trust. Note that this type of provision would not conflict with a trust provision requiring that a majority of trustees approve a particular substantive decision; only that the approval may be evidenced by a single signature.
XIV. Portability and Marital Deduction Election
The concept of “portability” allows the estate of the surviving spouse to increase the available lifetime exclusion by the unused portion of the predeceasing spouse’s lifetime exclusion. Thus, the applicable exclusion of the surviving spouse is augmented by that of the predeceasing spouse. In technical terms, IRC § 2010 provides that the Deceased Spouse Unused Exclusion Amount (“DSUE,” pronounced “dee-sue”) equals the lesser of (A) the basic exclusion amount, or (B) the excess of (i) the applicable exclusion amount of the last such deceased spouse of such surviving spouse, over (ii) the amount of the taxable estate plus adjusted taxable gifts of the predeceased spouse. The basic exclusion amount for 2016 is $5.45 million. As the term “election” implies, portability is not automatic. An abbreviated Federal estate tax return must be filed. This raises the possibility of a Federal estate tax audit. This and other factors may result in a preference by the executor for funding a credit shelter trust instead of electing portability.
If, after funding a credit shelter trust there remains a portion of the applicable exclusion amount, portability may be elected with respect to that portion. If the amount is small, it may not make sense to elect portability, if the chance for an audit would be increased by reason of filing the estate tax return. All of this counsels for allowing the executor considerable discretion with respect to electing the marital deduction and portability, or absorbing as much of the exclusion amount as is available at the death of the first spouse.
The difference between electing portability and utilizing a credit shelter trust involves the weighing of a number of factors. When a credit shelter trust is funded, the trust may be funded with rapidly appreciating assets that will remain out of the estates of both spouses. However, there will be only one basis step up, and that will be at the death of the first spouse. If portability is elected, two basis step up opportunities will occur: the first at the death of the first spouse (since the assets are included in the estate even though the marital deduction will absorb any potential estate tax liability); and the second at the eventual death of the second spouse, which could be many years later.
If one presumes that the estate tax will be abolished by the time the second spouse dies, then the basis step up would be invaluable. However, if the estate tax (which seems to have nine lives) still exists, the benefit of a basis step up must be weighed against the possibility of a large estate tax at the death of the second spouse. At the present time, the disparity between the capital gains tax and the estate tax is not so great as to be of monumental concern. This would seem to militate in favor of electing portability and foregoing the funding of a credit shelter trust, at least for tax purposes. However, important non-tax reasons might favor funding a credit shelter trust, such as providing for children in a second marriage situation. The following language grants the executor discretion with respect to electing the marital deduction and portability:
Notwithstanding any other provisions in this Will, my Executors are authorized, in their absolute and unreviewable discretion, to determine whether to elect under Section 2056(b)(7) of the Code and the corresponding New York State statute to qualify all or any portion of the residuary estate for the Federal (or New York) estate tax marital deduction and, to the extent that the law permits different elections, whether to elect to qualify any portion of the residuary estate for the New York State estate tax marital deduction only or for the Federal estate tax marital deduction only. I also grant my Executors absolute and unreviewable discretion with respect to whether to elect Federal portability or New York State portability, if the latter is available at that time. Generally, I anticipate that my Executors will endeavor to minimize both Federal and New York State estate tax liability of my estate and to seek the maximum basis step up available at my death and at the death of JOHN SMITH. In accomplishing that objective, I would expect that due consideration be given to the Federal estate tax payable upon the estate of JOHN SMITH, the availability of Federal (and perhaps New York State) portability, and the importance of the basis step up for income tax purposes both at my death and at the death of JOHN SMITH. Nevertheless, the determination of my Executors with respect to the exercise of the portability election shall be absolute, binding, unreviewable and conclusive upon all persons affected (or potentially affected) by the election.
XV. Children Born to Future Spouses
When drafting a trust with children as beneficiaries, one should consider the possibility that the settlor may have issue with another spouse. To prevent an unanticipated benefit to issue not intended to benefit from a particular trust, it might be desirable to be specific with respect to the exact identity of ultimate beneficiaries. The trust might limit the definition of the term “issue” to the issue of the spouses at the time the trust was settled.
It is also important to contemplate the possibility of after-born children. An after-born child has no interest in a trust in which only children recited to in the trust are designated. Including trust language taking into account possibility of after-born children may be prudent, especially if the spouses are young.
XVI. Trusts and S Corporations
Only certain trusts, i.e., (i) grantor trusts; (ii) Qualified Subchapter S Trusts; and (iii) Electing Small Business Trusts, may own S corporation stock. A grantor trust that becomes a nongrantor trust at the death of the grantor will no longer be an eligible S Corporation shareholder. Without some affirmative action, the S corporation election could be lost, with attendant adverse income tax consequences. Two options are available which will prevent the inadvertent termination of a S Corporation election. The first involves the trust making an election to be treated as a “Qualified Subchapter S Trust,” or “QSST.” To qualify as a QSST, IRC §1361(d)(3)(B) requires that trust instruments provide that all income be distributed annually to the sole trust beneficiary. An election must be made by the beneficiary to qualify the trust as a QSST. If the trust cannot qualify as a QSST because the trust instrument does not require all income to be distributed annually (i.e., the trustee is given discretion to distribute income) it cannot qualify as a QSST.
Qualification for a nongrantor trust may also be possible by making an election to be treated as an Electing Small Business Trust, or “ESBT” under IRC §1361(e). While it is somewhat easier for a trust to qualify as an ESBT rather than a QSST, there is a tax trade-off: A flat tax of 35 percent is imposed on the ESBT’s taxable income attributable to S corporation items. Income of a QSST is taxed to the beneficiary’s income tax rate. An ESBT does not require that all income be distributed annually. The ESBT election is made by the trustee, rather than by the beneficiary. The ESBT, rather than the income beneficiary, reports the beneficiary’s share of S Corporation income. Expenses of the trust will be allocated the Subchapter S interest of the Trust and the interest of the Trust consisting of non-S Corporation assets. Treas. Reg. § 1.1361-1(j)(6)(ii)(A).
Testamentary trusts may own S Corporation stock for the two-year period beginning on the date the stock is transferred to the trust. Following that two-year period, the trust must qualify as a QSST, an ESBT, or a grantor trust for the S Corporation election to continue. During the two-year period in which the trust owns S corporation stock, tax must be paid by the trust itself if no other person is deemed to be the owner for Federal income tax purposes. In light of the complexity and importance of making these elections, the will or trust should contain explicit language. The trust may direct the trustee to separate any shares of S Corporation stock into a separate trust intended to qualify as a QSST or ESBT. It may also be desirable to permit the trustees to amend the trust such that it would qualify to hold stock in an S Corporation or it could be converted from a QSST to an ESBT, or vice versa. Allowing the trustee to elect either QSST or ESBT status is particularly significant in light of the 3.8 percent net investment income tax now imposed on trusts. The surtax is only imposed on passive income and is not imposed on income resulting from “material participation” in a business by the taxpayer. The trust beneficiary is deemed to be the taxpayer for purposes of determining material participation in the case of a QSST. Conversely, it is the trustee who is deemed to be the taxpayer for the purpose of determining material participation of an ESBT. This highlights the importance of being able to convert an ESBT to a QSST. It may be beneficial for a trust to convert to a QSST where a beneficiary, and not the trustee, materially participates in the business activities of the corporation in order to avoid the 3.8 percent surtax