Analysis of 2012 Fiduciary Decisions in Surrogates Court
I. Constructive Trusts & Powers of Attorney. A “constructive trust” arises when equity intervenes to protect the rightful owner from the holder of legal title, where legal title was acquired through fraud, duress, undue influence, mistake, breach of fiduciary duty, or other wrongful act, and the wrongful owner is unjustly enriched. In New York, four conditions must exist before a constructive trust is imposed: (i) a fiduciary or confidential relationship; (ii) a promise; (iii) a transfer in reliance on the promise; and (iv) unjust enrichment.
In a recent case, the Surrogate held that in certain circumstances, a constructive trust can be established even after the death of the Settlor. Thus, in Matter of Chantarasmi, 2012 N.Y. Misc. Lexis 302 (2012), the court granted a petition requesting the creation of a constructive trust in a situation where the decedent died intestate, and there had been clear language in a prenuptial agreement requiring the decedent to create a trust for the benefit of his children.
The court reasoned that the decedent’s failure to leave a will constituted a breach of the premarital agreement that could be remedied only by the creation of a constructive trust. The prenuptial agreement clearly contemplated the existence of the trust, and designated the intended beneficiaries, the trustees, and the subject property of the proposed trusts.
In Peroise v. LiGreci, 2012 WL 2819300 (2nd Dept. 2012), the court addressed the issue of whether personal involvement of the settlor is required for trust terms to be amended. In that case, fifteen days before the settlor’s death, his daughter executed an amendment to an irrevocable trust replacing the trustee and successor trustee. The daughter was acting under a power of attorney, and the trust was for the benefit of the daughter and her siblings.
The trustee who was replaced objected. The court vacated the trust amendment reasoning that the trust was irrevocable and could only be amended by complying with the statutory requirement of obtaining the consent of all persons with a beneficial interest in the trust.
The Second Department reversed, stating that “absent any special circumstances or contrary directives, the amendment of the Trust by the attorney-in-fact, with the consent of all the beneficiaries, was not an act which ‘by [its] nature, by public policy, or by contract,’ required the creator’s personal performance.” The court further held that unless a trust by its very terms prohibits the creator from amending by way of his attorney-in-fact, the attorney in fact, as the alter ego of the creator, may amend the trust.
II. Prudent Investor Standard
Matter of Korn, 36 Misc.3d 1224A (Sur. Ct. 2012) involved an objection to an accounting by a trust beneficiary, the brother of the trustee, who was also a trust beneficiary. The alleged breach of fiduciary duty related to whether the trustee had failed to act prudently in not exercising a right of first refusal to acquire certain real estate. The Surrogate held that the prudent person standard of investing governed the trustee, and required that the trustee employ prudence in the care of trust assets equivalent to that of a prudent person of discretion and intelligence in managing his or her own affairs. Applying that standard, the Surrogate found that the trustee had invested prudently in that the trust had insufficient liquid assets available to purchase the real estate, and also was already heavily invested in real estate. EPTL 11-2.3[b]-2.3 (the NY Prudent Investor Act) 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.
In Matter of Knox, 2012 N.Y. App. Div, LEXIS 4880 (4th Dept. 2012), trust beneficiaries objected to a trust accounting alleging a failure to properly diversify stock investments. The beneficiaries alleged that the trustee had breached his fiduciary duty by imprudently retaining a high concentration of stock in two companies. The beneficiaries further alleged that the trustee had improperly relied upon the advice of a family member who was not a trustee. The Surrogate held that the trustee had negligently managed the trust by failing to maintain proper documentation and failing to develop an investment plan. The Appellate Division reversed primarily on the ground that the trust instrument itself expressly granted the trustee the power to invest without regard to diversification. The Court also noted that even though assets were held in “overweight” positions, the objectant had failed to demonstrate that it was imprudent to do so, and the objectant had failed to show a financial loss from the holdings.
In contrast, in Matter of Hunter, 2010 NY Slip Op 50548U, the Surrogate of Westchester County imposed a surcharge of $4.322 million against JP Morgan Chase, a trustee that had failed to diversify a stock portfolio which consisted entirely of Eastman Kodak stock. The Surrogate held that a prudent trustee would have sold 95 percent of the Kodak stock, noting that JP Morgan Chase had no written investment plan for the trust, other than to eventually sell some of the Kodak Stock. The Surrogate imposed a surcharge based upon the lost capital to the trust. On appeal, the Second Department found “no reason” to disturb the Surrogate’s finding that JP Morgan Chase had violated both the prudent-person standard of investing and the Prudent Investor Act, noting that the high concentration of Kodak stock had been held for twenty years. The Appellate Division also remarked that JP Morgan Chase had “acted contrary to its own internal policies, which restrict the retention of any one stock unless certain circumstances existed, none of which were present. Matter of Hunter, NY Slip Op 08124, 11/28/12.
III. Delays in Distribution
When a trust terminates, trustees who delay in distributing assets to the beneficiaries do so at their own peril. In Matter of McCluskey, 951 N.Y.S.2d 852 (Nassau Cty Surr. 2012), the trustee failed to distribute trust assets for over a year after the trust terminated, by which time trust assets had declined in value. The trustee argued that damages should be mitigated if (i) the beneficiaries would have made the same mistake as the trustee or if (ii) the value of the trust assets appreciated subsequent to the distribution such that any theoretical loss was negated. Finding the arguments without merit, the Surrogate denied the motion made by the Trustee to compel production of the beneficiaries’ personal investment portfolios for the period during which it was alleged that the Trustee had been neglectful in distributing trust assets.
Matter of Lasdone, 2011 NY Slip Op 51710U (NY Cty Surr. Court, 2011) also presented a situation where the trustee had delayed distribution of trust assets, during which time the value of trust assets declined. The trustee had refused to timely distribute trust assets to two beneficiaries who had been entitled to receive trust assets upon attainment of age thirty-five. The Surrogate granted summary judgment to the beneficiaries on their surcharge claim. With respect to the issue of damages, the Surrogate ruled that the surcharge award should not be reduced by the capital gains tax that would have been incurred by the beneficiaries, since the beneficiaries could have held the stock until their respective deaths, thus benefitting from a stepped up basis. The Surrogate held that reasonable attorneys’ fees should be chargeable to the estate, and not to the trustee, since the cost of preparing the accountings and other work done by the attorneys was necessary to the administration of the estate.
IV. Importance of
Trust Definitions
In re: the Trust created by Lydia Butler Dwight, 2012 NY Slip Op 22229, dealt with a trust created for the benefit of the Settlor’s “lawful issue.” The question was whether the term “lawful issue” includes a premarital child. The Surrogate held that a premarital child was not a beneficiary of the trust because under the law as it existed when the trust was created, the term “lawful issue” included only children born in wedlock.
V. Jurisdiction and Standing
In Cohen v. Cohen, 2012 N.Y. Misc. LEXIS 25 (Jan. 5, 2012), the president of a for-profit university created a trust to hold real property on which the university was located for the benefit of his children and a family limited partnership used to transfer shares in the university to his children as part of an estate plan. There were lease and loan agreements between the trust, college, family limited partnership, and the children. One of the children brought an action against the father, the college, and its board of trustees, alleging breach of fiduciary duties. The college and its board of trustees intervened in the action and moved for summary judgment dismissing the complaint on the ground that the family limited partnership and the trust was formed in violation of tax law, and that enforcement of the partnership agreement and trust agreement would thereby result in judicial enforcement of an illegal contract. The children challenged the college’s intervention, arguing that the college lacked standing to challenge the enforceability of the partnership and trust agreements. The court held that the issue of standing was not relevant to the proceeding because New York case law permits a court to allow a motion based on illegality that invokes principles of public policy, regardless of the movant’s standing.
IRS Ruling Provides Basis for Asset Protection Trust in Nevada
IRS Ruling Provides Basis for Asset Protection Trusts in NevadaPLR 201310002 blessed a theorized tax planning and asset protection strategy that fuses elements of grantor trusts, asset protection and trust taxation in a manner that accomplishes many salient tax and asset protection objectives. The objectives are achieved by forming a grantor trust in a state with no income tax that also recognizes the ability of a grantor to establish and fund a self-settled spendthrift trust.
I. Tax & Asset Protection Benefits of PLR 201310002. New York imposes among the highest level of income tax of all states. New York City residents pay even more tax for the privilege of residing there. Income is taxed to the grantor of a grantor trust. Since income is taxed to the grantor of a grantor trust, it is axiomatic that a New York resident who creates a grantor trust with its situs in New York will be taxed at a high rate on trust income. New York also does not recognize the right of a person to create a self-settled spendthrift trust that will be beyond the reach of the settlor’s creditors.
II. Assumptions
¶ Assume New York resident owns assets with unrealized capital gain or assets which produce a high stream of annual income. If the assets are sold, or when the income is received, New York will take a large tax bite out of the sale or the annual income stream.
¶ Assume further that even if the trust is a New York “resident” trust, and therefore potentially subject to New York tax, that New York will not tax the trust because it meets the exception provided in Tax Law §605(b)(3)(D)(i): (i) All of the trustees are domiciled in another state; (ii) the entire trust corpus is located outside of New York and (iii) all income and gains are derived from out of state sources. Therefore, the New York resident trust (i.e., an inter vivos trust created by a New York resident) escapes taxation because it meets the exception in the exception in Tax Law §605(b)(3)(D)(i),
¶ Finally, assume that asset protection is an important objective of the settlor, since unknown future creditors may appear down the road and may be attracted to the scent of the grantor’s assets. How can taxes be reduced? How can gift tax be avoided? Finally, how can the assets be protected against claims of future unknown creditors?
III. Avoid Grantor Trust Status
& Protect The Trust Assets
First, how can grantor trust status be avoided so that trust income does not flow through to the New York resident and be taxed by New York? Treas. Reg. §1.677(a)-1(d), the first impediment, states that a trust is a grantor trust if the grantor’s creditors can reach trust assets under applicable state law. However, a few states, among them Nevada, Delaware, and Alaska now recognize the right of a settlor to create a self-settled spendthrift trust. If the trust were established as an irrevocable non-grantor trust in Nevada, a state that also imposes no income tax, New York would have no claim to tax the trust, provided the exception to resident trust taxation was met.
It should be noted, if not emphasized, that not all states employ the criteria utilized by New York in defining and taxing resident state trusts. Unlike New York, some states do not impose income tax based upon the residence of the grantor. In those states, the benefit of PLR 2013110002 would be more easily achieved. In New York, the New York resident trust would have to fall within the exception in Tax Law §605(b)(3)(D)(i). Nevertheless, for New York residents able to meet the exemption in Tax Law §605(b)(3)(D)(i), the ruling may be of considerable value. See “Income Tax Planning for New York Trusts,” Tax News & Comment, October 2012.]
IV. Facts in PLR 201310002
The facts in PLR 201310002 involve a situation where the grantor creates an irrevocable trust in which the grantor and his issue are discretionary beneficiaries. The trust provides that a corporate trustee distributes income and principal to the discretionary beneficiaries, consisting of the grantor and his issue.
For reason stated above, settling the trust in Nevada will avoid the application of Treas. Reg. §1.677(a)-1(d), and the trust will not automatically be a grantor trust, since self-settled spendthrift trusts are valid in Nevada. However, another vexing problem in avoiding the application of the grantor trust rules lies in IRC §674, which provides that the Grantor is treated as the owner of any portion of a trust in respect of which the beneficial enjoyment is controlled by the Grantor or a “nonadverse” party.
The facts in PLR 201310002 present a situation where the consent of an adverse party is required with respect to all distributions made during the grantor’s lifetime. IRC §672(a) provides that for the purpose of the grantor trust rules, the term “adverse party” means any person having a substantial beneficial interest in the trust that would be adversely affected by the exercise or nonexercise of the power which he possesses respecting the trust.
If by now one is getting a sense of déjà vu, then that sense is correct. The situation involved in PLR 201310002 is the inverse of the familiar sale of assets to grantor trusts, which is a staple in estate planning. In sales to grantor trusts there is a complete transfer for transfer (gift, estate and GST) tax purposes, but an incomplete transfer for income tax purposes. Sales of assets to grantor trusts are generally made for estate tax purposes, as the asset is sold to the trust in exchange for an asset expected to appreciate less rapidly. The sale evades the capital gains tax because under Revenue Ruling 85-14, the sale by the grantor to a grantor trust has no income tax consequences.
In sharp contrast to sales to grantor trusts, transfers to the trusts contemplated in PLR 201310002 result in a complete transfer for income tax purposes, but an incomplete transfer for transfer tax purposes. Such trusts are referred to by tax and estate lawyers as “DING” trusts, or a “Delaware Incomplete Gift Non Grantor Trust,” or “NING” trusts, with Nevada substituted for Delaware.
The grantor trust provisions in IRC Sections 671 through 679 cast a wide net. How exactly does PLR 201310002 suggest the resolution of the problem of the self-spendthrift trust avoid being taxed as grantor trust for other reasons? Very carefully and very methodically. The facts in PLR 201310002 provide that a corporate trustee is required (i) to distribute income or principal at the direction of a ““distribution committee” or (ii) to distribute principal at the direction of the grantor.
In the facts of the ruling, the distribution committee consists of the grantor and his four children. At least two “eligible individuals” must at any time be serving as members of the distribution committee. The direction made by the distribution committee to the corporate trustee may be made in three ways:
Grantor-Consent Power:
Distribute income or principal upon direction of a majority of the distribution committee with the written consent of the Grantor. Note: The PLR expressly concludes that distributions pursuant to the Grantor-Consent Power can be made only with the consent of an adverse party, and thus the provision does not cause the trust to be a grantor trust. Thus, the PLR implicitly concludes that the distribution committee members are adverse to the grantor for purposes of the grantor trust rules.
Unanimous Member Power:
Distribute income or principal upon direction by all distribution committee members other than the Grantor. Note: the PLR expressly concludes that distributions pursuant to the Unanimous Member Power can be made only with the consent of an adverse party, and thus the provision does not cause the trust to be a grantor trust. Thus, the PLR implicitly concludes that the distribution committee members are adverse to the grantor for purposes of the grantor trust rules.
Grantor’s Sole Power:
Distribute principal to any of grantor’s issue (not to grantor, and not income) upon direction from grantor as grantor deems advisable in a nonfiduciary capacity to provide for the health, maintenance, support and education of the issue. Distributions can be directed in an unequal manner among potential beneficiaries. Note: Here, it would seem at first blush that the grantor has retained some power that might cause grantor trust problems. However, that bullet is dodged, as IRC §674(b)(5)(A) provides an exception to grantor trust status for a grantor who has retained the power to distribute corpus (i.e., principal) that is limited by a reasonably definite standard.
IV. Avoiding The Gift Tax
The DING or NING trust must also be structured to avoid gift tax, since the gift tax rate is now 40 percent once the lifetime exemption of $5 million is breached. The trust also needs to be irrevocable. Making an irrevocable trust incomplete for gift tax purposes is difficult, though possible. PLR 201310002 sanctions the use of a testamentary limited power of appointment to make the gift incomplete.
There is some concern that Chief Counsel Advisory 201208026 takes the position that the grantor’s retention of a testamentary power of appointment over a trust renders the remainder interest a completed gift, but not the term interest. If this is indeed the case, then the grantor would need to retain other powers in order to make the gift incomplete.
However, the retention of other powers could cause the ship to list, and fall back into the gravitational pull of the grantor trust provisions, defeating the raison d’etre for the trust. For now, the planning tool of using DING or NING trusts to avoid state income taxation and to protect assets seems viable, if for no reason other than the fact that PLR 201310002 approved of the technique and without discussing the possible application of CCA 201208026.
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