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- Tax News & Comment – April 2017 March 13, 2017
- Tax News & Comment — May 2016 May 14, 2016
- FROM WASHINGTON & ALBANY — Current Election Probabilities; Tax Plans of Trump and Clinton May 13, 2016
- FROM FEDERAL AND NYS COURTS: Recent Developments & 2015 Decisions of Note May 13, 2016
- IRS & NYS DTF MATTERS: Recent Developments & 2015 Regs. & Rulings of Note May 13, 2016
- Creating and Maintaining Flexibility in Wills and Trusts May 13, 2016
- Escaping the Quandary Posed by Unreported Foreign Accounts May 13, 2016
- Like Kind Exchanges Alive and Well: An Update May 13, 2016
- Tax News & Comment — March 2015 February 19, 2015
- From Washington & Albany — Income & Estate Tax Planning in 2015 February 19, 2015
- From Federal Courts, NYS Courts & Tax Tribunals — Recent Developments & 2014 Decisions of Note February 19, 2015
- Legal Basis for Seeking Abatement of New York State Tax Penalties
- Executor and Trustee Commissions Under NY EPTL
- Executor and Trustee Commissions Under the New York EPTL
- Modifying or "Decanting" Irrevocable Trusts
- Defeating The Right of Election in EPTL § 5-1.1-A
- Depreciation Recapture
- Life Insurance Trusts Mitigate Estate Tax Uncertainties
- Income Tax Planning for New York Trusts
- Tax News & Comment - April 2017
- Use of Disclaimers in Pre and Post-Mortem Estate Planning
As of April 22, the probability of Hillary Clinton becoming the Democratic nominee is .939 (1/15 odds); that of her becoming President, .727 (2/5 odds). Mr. Trump now has a .664 probability (1/2 odds) of prevailing in Cleveland, but only a .149 probability (5.75/1 odds) of winning in November. The odds are a snapshot, and do not fully reflect momentum. Following his New York win, Mr. Trump appears to have regained momentum. The odds reveal that Mr. Trump’s problem will not likely be winning the nomination, but rather defeating Secretary Clinton in the general election. These probabilities are based on betting odds in Las Vegas, which are more accurate than polls in predicting the outcome of future elections. Their accuracy may be attributable in part to a hypothesis advanced by James Surowiecki, business columnist for the New Yorker, in his book The Wisdom of Crowds (Doubleday, 2004) which draws parallels to polling but depends more upon the aggregation of decisions of independently deciding individuals, which have been shown to be extremely accurate.
Overview of Tax Plans of Secretary Clinton & Mr. Trump
The tax plans of Mr. Trump and Secretary Clinton differ markedly. Mr. Trump favors reducing taxes and compressing the rate structure. He would eliminate “loopholes” and limit itemized deductions. “Revenue neutrality” would be achieved by limiting current deductions. A new 15 percent rate bracket would apply to corporations, partnerships and other pass-through entities. A one-time repatriation tax would be assessed on corporations repatriating accumulated profits to the United States. Mr. Trump would eliminate the estate tax. (Trump tax plan discussed on pages 4-5)
Secretary Clinton would severely restrict the current favorable taxation of long term capital gains, and would set the clock back on the estate tax. Ms. Clinton would impose a new tax — resembling but not replacing the AMT — on the highest income earners. All taxpayers with an AGI exceeding $1 million would pay a minimum 30 percent tax. A new surtax would also be imposed on AGI exceeding $5 million. Her plan would eliminate favorable capital gain treatment for assets held less than two years, and would phase in favorable capital gain treatment over years two through six. She would also reinvigorate the gift and estate tax regime by (i) increasing the top tax rate to 45 percent; (ii) reducing the applicable exclusion amount for estate tax to $3.5 million, and (iii) “decoupling” the gift tax and the estate tax, and in the process decimating the gift tax lifetime exclusion amount to $1 million. The tax proposals of Ms. Clinton are ill-conceived and not well thought out. (Clinton tax plan discussed on pages 5-6)
Reflections on President Obama’s Tenure
As of April 21, President Obama’s approval rating polled at 52 percent by Gallop. This continued an upward trend from the 40 percent nadir registered two years ago and suggests that Mr. Obama may help the efforts of Ms. Clinton in November. Personal income taxes have increased under the Obama Administration. New Yorkers, especially New York City residents, along with Californians, are assessed the highest combined income tax rates of any states in the nation. Taxes are always high on the list of Americans’ concern. Inexplicably, there has been little dialogue concerning taxes this election cycle. Therefore, the candidates’ tax policies are far from lucid. Fairly considered, though much has been accomplished, the Presidency of Mr. Obama has not been a resounding success. Perhaps the greatest failing of Mr. Obama is his unwillingness or inability to work with Congress. One has never heard “Barack has the votes,” a phrase often associated with President Johnson who, before assuming the Presidency from slain President Kennedy, was a Senator from Texas. Johnson was a master of political horse trading. His perseverance led to the enactment of the Civil Rights Act of 1964.
The economy, though perhaps not approaching the heady days of the Clinton years, is much better than when President Bush left office. Unemployment is now at 4.9 percent. When Mr. Bush left office, the rate was 7.8 percent. The Dow was at 7,949 when Mr. Obama assumed office. Today it trades near 18,000. During the Obama presidency, oil drilling has boomed, leading to what would have been unthinkable only a few years ago: America is now an oil exporter and no longer dependent on OPEC. Relations with Cuba have been resumed for the first time since the Cold War. More Americans now have health insurance. Climate change has been addressed. Russian aggression appears to have been contained to Crimea and eastern Ukraine, both of which have been historically Russian. Relations with China are generally good. However, Mr. Obama has failed in important areas. While he has kept the nation out of wars claiming American casualties, his Mideast policy has been disastrous for Israel, a close ally. The Affordable Care Act is at best a work in progress. Taxes are high, and complaints about the IRS targeting specific groups are troubling. Mr. Obama has failed to impress upon Congress the need to implement gun control. Civil unrest has risen markedly of late.
Yet time spent in office has burnished Mr. Obama’s image. Many Americans are fond of him, believing him to be trustworthy and possessed of extremely high moral character. He is well respected internationally and presents an image of the United States which is sanguine. These positive attributes will likely help Democrats in November. Still, the President should have achieved more than he has, and that is lamentable.
III. Electoral College Outlook
All current polls show that Mr. Trump would lose the election to Secretary Clinton. However, at the end of the day, four key states will likely decide the election, as has been the case in the past few Presidential elections. As election day approaches, history shows that polls converge. There is no reason to believe that the Presidential election will not be close. The Electoral College results do not always accord with the popular vote. Two hundred and seventy electoral votes are needed to win the presidency. All states in New England and New York, New Jersey, Maryland, Delaware, and the District of Columbia in the mid-Atlantic , as well as Illinois, Michigan and Minnesota in the Midwest , and California, Oregon, Washington, New Mexico, Colorado  and Hawaii  in the west appear safe for Clinton. Thus, Ms. Clinton now appears to have 230 safe electoral votes.
States in the deep south, Texas, Louisiana, Mississippi, Alabama, Georgia, and North and South Carolina , the plains states north of Texas to the Canadian Border, comprising Oklahoma, Kansas, Nebraska and the Dakotas , Appalachian states of Tennessee, West Virginia, Kentucky, and Missouri, , the Midwestern state of Indiana  and the western states of Arizona, Utah, Wyoming, Idaho, Montana  and Alaska  appear to be safe Republican states. North Carolina  leans Republican. Obama defeated McCain by 0.3% in 2008 but Romney flipped the state in 2012 and beat Obama by 2%. Thus, the Republicans now appear to have 200 safe electoral votes.
Ms. Clinton would need 53 additional electoral votes to prevail, while the Republicans, perhaps Trump, would need 85 additional electoral votes, to win the election. Pennsylvania , Ohio , Virginia  and Florida , with a total of 80 electoral votes, will again likely decide the election. Virginia  had voted for Republicans in the previous eight Presidential elections until 2008, when Obama defeated McCain by 6.3%. In 2012, Obama’s margin over Romney was 3.9%. Democrats have carried Pennsylvania  in the last six Presidential elections. Obama carried Pennsylvania by 10.2% in 2008 and by 5.4% in 2012. Only once since 1976 — when George Bush beat Clinton by 2% — has Florida  not voted with the winning Presidential Candidate. Obama won by 2.8% in 2008 and by 0.9% in 2012. However, Florida is perennially close, and as all remember, in 2000 the popular vote identical, with Bush and Gore each receiving 48.8% in a contested election.
Florida resembles a northern state that happens to be situated in the tropics. Its population is diverse and like Ohio has an uncanny ability to correctly predict Presidential winners. In 2016, those states will again play a pivotal role if the election is close. It now appears that voting trends indicate that Clinton could conceivably win without carrying Florida, but for the Republicans, Florida appears to be a must-win state. Clinton may do extremely well in the populated areas of Palm Beach, Broward and Miami-Dade counties, which comprise 28 percent of Florida’s entire population, and is the home of a great many elderly persons, who overwhelmingly appear to support Ms. Clinton. However, Mr. Trump may do very well north of West Palm Beach, and in the western part of the state.
Even if the Republicans were to prevail in Florida  and Ohio , they could still be lose the election if they were unable to turn the tide in Virginia  and Pennsylvania . Finally, any scandal visited upon Clinton nearing the election could result in close states tilting Republican. The probability of such a scandal now appears slim.
Mr. Trump’s professed greatest strength — his being outside of the Washington establishment and political circles — is also his greatest weakness. Mr. Trump obviously possesses business acumen, but he lacks political experience. Although he has struck a chord with many voters, especially Republicans, he appears to have alienated a large portion of the electorate. However, the electorate is fickle, and it may be possible that Mr. Trump can regain the support of some whom he has alienated. His promise to reduce taxes imposed on individuals is appealing. His pledge to reform corporate tax is refreshing. His policies, unlike that of Ms. Clinton, would lessen federal administrative involvement in taxation, rather an increase it. There is little doubt that if elected, Mr. Trump would choose competent advisors.
Individual Income Tax Proposals and Proposal to Eliminate Estate Tax
Mr. Trump asserts that his tax plan would simplify the Internal Revenue Code, reduce taxes for all taxpayers, and yet remain “revenue neutral.” Tax experts have opined that the proposed plan cannot be revenue neutral. The Tax Foundation (a Washington-based “think tank” established in 1937 by Alfred P. Sloan, Jr., Chairman of GM, that collects data and publishes research concerning federal and state tax policies) estimates that Mr. Trump’s plan would decrease tax revenues by nearly $12 trillion over a ten year period. The Tax Policy Center estimates that Mr. Trump’s plan would similarly reduce tax revenues by $9.5 trillion over that period.
The existing Federal deficit is estimated to now be approximately $15 trillion. Mr. Trump has pledged to reduce government spending, but has been vague with respect to how he would accomplish that objective. In any case, the Tax Policy Center (also known as the Brookings Tax Policy Center, a non-partisan Washington-based research center whose professed objective is to provide independent analyses of tax issues) has stated that Mr. Trump would need to initiate unprecedented (and likely politically infeasible) spending cuts to offset the tax cuts. Mr. Trump states that he would eliminate the federal income tax on single taxpayers earning less than $25,000 and on married taxpayers earning less than $50,000. These taxpayers would be required to submit only a one page form. Mr. Trump believes that 50 percent of taxpayers would owe no personal income tax as a result of this change. At the same time, according to Mr. Trump, this would simplify tax filing for the approximately 42 million taxpayers that currently file tax returns only to establish that they owe no tax. Mr. Trump would compress the current seven tax brackets into only four. Four brackets would impose tax at rates of 0, 10, 20, and 25 percent. The highest current tax rate is 39.6 percent. As would many of his proposals, this would require Congressional approval.
The new 10 percent bracket would apply to single taxpayers earning from $25,001 through $50,000 and to married taxpayers earning from $50,001 through $100,000. The new 20 percent bracket would apply to single taxpayers earning from 50,001 through $150,000 and to married taxpayers earning from $100,001 through $300,000. The 25 percent bracket would apply to single taxpayers with an income exceeding $150,000 and married taxpayers with an income exceeding $300,000. Mr. Trump also favors the elimination of the 3.8 percent net investment income tax on high-income taxpayers enacted as part of the Affordable Care Act. This would also significantly reduce tax revenues, as the tax falls principally upon high income taxpayers with net investment income. To compensate for lower tax revenues occasioned by the lower rates, Mr. Trump states that he would eliminate or reduce most deductions and “loopholes” currently available to high-income taxpayers. His proposal would also reduce the availability of itemized deductions. Mr. Trump has not provided details concerning new limits on deductions, but has expressed the view that deductions for charitable contributions and mortgage interest would remain.
According to the Tax Policy Center, the planned limitations on itemized deductions would offset less than a sixth of tax revenue losses attributable to the lower tax revenues expected under the proposals set forth by Mr. Trump.
Mr. Trump plans to end the “carried interest” tax break, which allows investment fund managers to pay tax on portfolio profits at the lower capital gains rate (rather than the ordinary income rate). Although Mr. Trump has touted the termination of the carried interest tax break as an element of his plan that would significantly contribute to offsetting lost tax revenues, some believe that elimination of the deduction would not appreciably affect tax revenue neutrality. The tax revenue neutrality generated by the proposal is somewhat misleading, since it assumes the top 25 percent ordinary rate proposed by Mr. Trump is never enacted. If the 25 percent top ordinary rate is enacted, then little or no benefit to revenue neutrality would occur, since the difference between the current 23.8 percent rate (including the 3.8 percent net investment income tax) imposed on carried interest is only 1.2 percent less than the proposed 25 percent ordinary income rate. (Of course, were the current top ordinary rate of 39.6 percent to remain but the carried interest “loophole” be eliminated, then the proposal would indeed contribute to tax revenue neutrality.) Mr. Trump favors eliminating the gift and estate tax. Although the tax affects far fewer estates than in the past, the existence of portability and an exclusion amount of $5.45 million, the revenue loss occasioned by the elimination of the estate would be approximately $25 billion.
Corporate Tax Proposals
Mr. Trump proposes reducing the corporate tax rate to 15 percent from 35 percent. He believes this reduction would cause the rate to be competitive with other industrialized countries and would encourage corporations to repatriate. The loss of tax revenues would be partially compensated for by a one-time 10 percent repatriation tax on accumulated profits, which would be payable over 10 years. Future profits of foreign subsidiaries of U.S. companies would be subject to tax each year as profits were earned. Currently, accumulated foreign source profits may be deferred. The 15 percent tax rate under Mr. Trump’s plan would also apply to pass-through entities, which include sole proprietors, partnerships, and limited liability corporations. [Partnership income is taxed to the partner at the partner’s tax rate, which will depend upon the character of the income (i.e., capital gain or ordinary) which also passes through to the partner. Some critics have noted that the attractiveness of the 15 percent corporate rate would create a strong incentive for employees to seek to characterize themselves as independent contractors. This would result in significant revenue loss.
Ms. Clinton was an excellent Senator and generally capable Secretary of State. Yet doubts persist as to her honesty. Now that she has disposed of the challenge of Senator Sanders, her rhetoric against the drug and biotech firms, and against banks, neither of which is particularly helpful, may lessen. To be sure, she is far from a perfect presidential candidate. Her tax policies are far to the left of Mr. Obama and Mr. Clinton. One wonders how far to the left she will be pulled from young Sanders supporters at the Democratic convention in July, and whether Ms. Clinton may emerge from the Convention beholden to socialist positions not in accord with even most Democrats’ political beliefs. The use by Ms. Clinton of her personal email server was a mistake that could have put the nation at risk. Evidently, it did not. Whether what she did was criminal will be decided by the FBI and the Justice Department. However, as of now there is little indication that the government intends to proceed against her criminally.
Individual and Estate Tax Proposals
The tax proposals of Ms. Clinton are not only unfair to even most middle income taxpayers, but if enacted would create new administrative nightmares, would overburden an IRS that even now is underfunded to the point of not being able to properly function, and present Constitutional issues involving retroactivity if her proposed estate and gift tax changes were enacted. Her proposals could only become law if passed by both houses of Congress. That now that appears remote, even if Ms. Clinton were to win by a landslide since Republicans now control both houses of Congress — the Senate by 54-44, and the House by 246—188. Senate Democrats must defend 10 seats in November, as opposed to 24 seats which Republicans must defend. Over the past century, there has been a high correlation between Presidential and Senate election results. However, unless the Republications falter badly in November, their 58 member advantage in the House (246—188) is unlikely to be reversed, even if they were to lose control of the Senate.
Ms. Clinton has proposed tax law changes that she believes would decrease the federal deficit. It should be noted that economists differ over the importance ascribed to reducing the federal deficit. Most of the revenue gain would emanate from new taxes imposed on high income taxpayers. According to the Tax Policy Center, the top ten percent of taxpayers would see a 0.7 percent reduction in after-tax income and the top one percent of taxpayers would see a 1.7 percent reduction. As yet, Ms. Clinton made no proposals that would affect middle income taxpayers, but there have been indications that proposals may be forthcoming. The Tax Foundation estimates that the proposed plan to impose new taxes on the wealthy would increase tax revenues by $498 billion over a 10 year period; the Tax Policy Center estimates revenue increases over the same period would be $1.1 trillion. Although revenues generated by the proposed plan would not eliminate the federal deficit in the immediate future, Ms. Clinton believes that it would make significant inroads into reducing the deficit. However, the plan would likely make the Internal Revenue Code more complex. Some believe that the new taxes would reduce the incentive of those affected to invest. The first of the new taxes on high income earners would be a new minimum 30 percent tax imposed on taxpayers with over $1 million adjusted gross income (AGI). This change reflects the “Buffet Rule,” inspired by Warren Buffet who claimed that he paid a lower effective tax rate than that of his secretary. The new minimum tax appears to constitute a variation of the present alternative minimum tax.
The second new tax on high income taxpayers would be a 4 percent surtax imposed on taxpayers whose AGI exceeds $5 million. Since AGI includes capital gains as well as ordinary income, both of these two new taxes imposed on high income taxpayers would work to diminish the favorable taxation of investment income, which often comprises the largest portion of income of high income taxpayers. Ms. Clinton has also proposed limiting the tax benefit of most deductions and exclusions to 28 percent. This limitation applies to all itemized deductions (except for charitable contributions), tax exempt interest, excluded employer-provided health insurance, and deductible contributions to tax-preferred retirement account. As would Mr. Trump, Ms. Clinton would seek to tax carried interest as ordinary income rather than as capital gains. The impact of this provision would be more pronounced if the top rate for ordinary income remains at 39.6 percent, which is more likely to occur if Ms. Clinton, rather than Mr. Trump, is elected.
Ms. Clinton has proposed a radical change to the taxation of capital gains. Under current law, short term capital gains are taxed as ordinary income. Long term capital gains are taxed at a favorable rate of 20 percent (23.8 percent if the net investment income tax is included). To qualify as a long term capital gain, the asset must be held for more than one year. Under the proposal, all capital gains would be taxed as short term gains for two years. Following that two-year period, the benefit of the favorable long-term capital rate would be phased in at the rate of 4 percent per year over four years. This proposal is unsound. Requiring an asset to be held for two years before beginning to achieve a favorable tax rate would discourage new investment. Equities investors would flee short-term growth opportunities in favor of dividend-paying companies since dividends are taxed at favorable rates and have no comparable holding period. The proposal would also be an administrative nightmare and would add to the list of tasks which an overburdened IRS cannot deal with even now.
Ms. Clinton has proposed restoring the tax rates and exclusion amounts for estate tax to those that existed in 2009. Thus, the top estate tax rate would rise to 45 percent from 40 percent, and the applicable exclusion amount would be reduced by nearly $2 million, to $3.5 million. The most significant change would be a reduction in the gift tax to $1 million. Today, gifts of up to the limit of the annual exclusion amount, currently $5.45 million, may be made without the imposition of gift tax. This proposal is also unsound. Requiring estates over $3.5 million to pay estate tax would again encourage the formation of unnecessary entities and would renew haggling between the IRS and the taxpayer concerning valuation discounts. “Decoupling” the estate and gift tax, which have been unified for more than a decade, would create new administrative nightmares. Constitutional issues would arise concerning retroactivity, as many persons would already have made gifts exceeding $1 million.
Gift and estate taxes have always been a “one way” street. Turning the law around and reverting to laws that were discarded years earlier would wreak havoc and would further destabilize the relationship between federal and state taxation. As was the case in 2010, when uncertainty existed with respect to what the exemption amount would be, and whether there would be a low gift tax exemption, the problems associated with these proposed changes far outweigh the benefit of revenue increases to the Treasury that these changes would produce. The IRS would likely spend an inordinate amount of resources on the task of auditing countless gift tax returns. Finally, there seems to be little point in reinvigorating a tax which has only barely survived extinction for the past two decades. It is more than likely that the tax would again be repealed if a Republican congress were elected. If the gift tax exemption amount were reduced to $1 million, many gift tax returns reporting gifts in the range of $500,000 to $1 million might become subject to audit. Since many gift tax returns now claim valuation discounts, the question arises how the IRS would choose which gift tax returns to audit.
Fortunately, it appears unlikely in the extreme that either the capital gain proposal or the estate tax proposal would pass in the House.
Corporate Tax Proposals
Ms. Clinton has expressed concern with corporations leaving the U.S. or shielding their income from tax. Instead of creating an incentive for corporations to return to the U.S. by reducing the corporate tax rate, Ms. Clinton would strengthen rules to prevent “corporate inversions,” which occurs when a foreign corporation merges with a U.S. corporation to avoid tax on the foreign earnings of the formerly U.S. corporation. The proposal would reduce from 80 to 50 percent the percentage of the entire corporation that the former U.S. corporation may own and avoid U.S. taxation. Ms. Clinton has also proposed an “exit tax” on the accumulated untaxed earnings of the foreign subsidiaries of U.S. corporations that have left the U.S.
United States v. Stiles, 114 AFTR2d 2014-6809, 2014 BL 338556 (W.D. Pa. Dec. 2, 2014) held a personal representative liable for distributing estate assets before paying the decedent’s outstanding tax debt. Distributions made to the fiduciary and his siblings nearly approximated the estate tax liability. The District Court, in granting summary judgment to the government, rejected as irrelevant reliance on the advice of counsel, reasoning that personal liability may be imposed upon a fiduciary of an estate in accordance with IRC § 6901(a)(1)(B) and 31 U.S.C. § 3713(b). The defendants were held personally liable for the unpaid taxes because (i) they distributed assets of the estate; (ii) the distribution rendered the estate insolvent; and (iii) the distribution took place after the fiduciary had actual or constructive knowledge of the liability for unpaid taxes.
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In Specht v. United States, 115 AFTR2d 2015-357 2015 BL 1651 (S.D. Ohio Jan. 6, 2015), the Court sustained penalties and interest assessed against an estate despite reliance on the advice of counsel concerning when or whether to file or pay. The executor who retained the decedent’s attorney to assist her was unaware that the attorney had brain cancer. (The attorney was later declared incompetent and voluntarily relinquished her law license.) The attorney incorrectly advised the executor that the estate tax return was due on September 30, 2009. Nevertheless, prior to that date, the executor received several notices from the probate court warning her that the estate had missed probate deadlines. In response to inquiries posed by the executor, the attorney advised that the estate had been granted an extension. In July 2010, another family which had engaged the attorney for a probate matter informed the executor that they were seeking to remove the attorney as co-executor for incompetence. Ultimately, the estate tax return was not filed until January 26, 2011. The District Court held that the “failure to make a timely filing of a tax return is not excused by the taxpayer’s reliance on an agent, and such reliance is not ‘reasonable cause’ for a late filing.”
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Similarly, the District Court for the Eastern District of Virginia sustained late filing and late payment penalties for estate tax in West v. Koskinen, No. 1:15-cv-131, 2015 BL 343234 (E.D.Va. 2015) despite claims by taxpayers of reliance on erroneous advice by counsel. The Court held that “reasonable cause” did not exist since counsel had never advised the taxpayers regarding filing deadlines.
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In Mikel v. Comm’r, T.C. Memo 2015-64 (Apr. 5, 2015), the Tax Court allowed the use of Crummey powers given to sixty beneficiaries in a situation where an irrevocable trust contained a no-contest clause and a mandatory arbitration clause. The Court held that neither clause deprived the beneficiaries of a present interest required to qualify for the gift tax annual exclusion. The no-contest clause did not invalidate the Crummey power because it applied only to disputes over certain discretionary distributions by the trustees. The mandatory arbitration clause did not invalidate the Crummey powers because the trust explicitly stated that an arbitration panel was to apply New York law in granting the beneficiaries the same rights they would have under New York law. The Court also noted that any beneficiary disagreeing with the decision of the arbitration panel could still commence legal proceedings.
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Estate of Redstone v. Comm’r, 145 T.C. No. 11 (Oct. 26, 2015) held that the transfer of stock of a family business into a trust for the benefit of the shareholder’s children in settlement of litigation was a bona fide business transaction rather than a taxable gift. In so concluding, the Court cited to the oft-cited Treas. Reg. § 25.2511-1(g)(1) which provides that “[t]he gift tax is not applicable to a transfer for a full and adequate consideration in money or money’s worth, or to ordinary business transactions.” The fact that the children were not parties to the settlement agreement was irrelevant in determining whether the shareholder received full consideration in settlement. As part of the settlement, the Company agreed that it would (in consideration of the stock transfer) recognize that the shareholder was the outright owner of his remaining shares, which it would redeem for $5 million. In determining that the transfers made pursuant to the settlement were made in the ordinary course of business, the Court found (i) that the transfers were “bona fide, at arm’s length, and free from any donative intent;” (ii) that a genuine controversy existed; (iii) that the parties engaged in adversarial negotiations and were represented by counsel; and (iv) that the settlement was motivated by the desire to avoid litigation.
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SEC v. Wyly, 56 F. Supp. 3d 394 (S.D.N.Y. 2014), held that two sets of trusts were grantor trusts and that the settlors (the “Wyly brothers”) should have been taxed on the gain and income of the trusts. The Court emphasized that although the trusts had unrelated corporate trustees, the trust protectors had too much control over the corporate trustees. The first set of trusts (the “Bulldog Trusts”) were created by the Wyly brothers for the benefit of their wives, children, and several charitable organizations. Trust protectors could add to or substitute the charitable organizations. The second set of trusts (the “Bessie Trusts”) were nominally funded by foreign individuals. The beneficiaries of the Bessie Trusts were the Wyly brothers and their families. Offshore professional management companies acted as trustees of both sets of trusts. There were three trust protectors of each trust with the power to remove and replace trustees of all of the trusts. The trustees always followed the investment directions of the trust protectors, who in turn followed the investment directions of the settlors. The basis for the Court’s holding that all of the Bulldog Trusts were grantor trusts was that in reality, the trustees were acting at the direction of the settlors, so the independent trustee exception of Section 674(c) was inapplicable. With respect to the Bessie Trusts, the Wyly brothers were deemed to be the true grantors of the trusts and the named nominal settlors were found to have made no gratuitous contributions to the trusts.
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In Estate of Pulling v. Comm’r, T.C. Memo 2015-134 (July 23, 2015) the Tax Court found in favor of the taxpayer in a dispute concerning the valuation of land held by the estate. The estate held three undeveloped agricultural parcels of land. All three parcels were contiguous with each other and with two other parcels of land (one of which was also undeveloped). The three parcels held by the estate were situated such that they could only be developed if developed together with the other two parcels. The Court held that joint development was not reasonably likely and that the three parcels should be valued independently.
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Estate of Badgett v. Comm’r, T.C. Memo 2015-226 (Nov. 24, 2015), held that a pending income tax refund was includable in the decedent’s gross estate. The Tax Court reasoned that “[t]he status of the tax refund is more than a mere expectancy; the estate has the right to compel the IRS to issue a refund for the years for which decedent overpaid his tax.” The Court distinguished this case from those in which the taxpayer had undisputed and unpaid tax liabilities which offset tax overpayments. In those cases, estate inclusion was not required since the estate had offsetting current tax liabilities.
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The Seventh Circuit found in Billhartz v. Comm’r, 794 F.3d 794 (July 23, 2015), that the Tax Court had not abused its discretion in refusing to set aside a settlement between an estate and the IRS. The settlement involved a deduction claimed by the estate as payments for a debt. The payments were made to the children of the decedent pursuant to a divorce settlement agreement. Under the settlement, the IRS recognized 52.5 percent of the claimed deduction. However, the children later sued the estate for failing to pay to them the full amount to which they were entitled. As a result, the estate moved the Tax Court to vacate the settlement since it would prevent the estate from claiming an estate tax refund for any additional amount paid to the children. By settling, the appeals court held that the parties “close the door to new information.”
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In Estate of Sanfilippo v. Comm’r, T.C. Memo 2015-15 (Jan. 22, 2015), the Tax Court held that an illiquid estate liable for $15 million in taxes had been denied a fair hearing with respect to the extension of estate tax payments. Appeals based the decision to sustain a levy on “incorrect and illogical factual and legal assumptions” in that it failed to consider the discussions between the estate beneficiary and the prior Appeals Office regarding collection alternatives. Moreover, the decision to sustain the levy was based primarily on an analysis ignoring the fact that the beneficiary owned a majority interest in certain property before inheriting an additional ten percent interest.
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Windford v. United States, 587 F. App’x 207 (5th Cir. 2014), aff’g 970 F. Sup. 2d 548 (W.D. La. 2013), demonstrates the importance of distinguishing between a tax payment and a tax deposit. The executors were unable to determine the amount of estate tax in a timely manner because of ongoing litigation. A remittance was sent to the IRS, which treated it as a “payment” rather than as a “deposit.” After litigation had concluded, the executors requested a tax refund. The IRS denied the refund stating that the three year statute of limitations for refunds of tax payments had expired. While remittances designated as tax deposits were refundable, those remittances designated as tax payments were not. Utilizing a “facts and circumstances” approach, the Court held that the remittance was a payment and not a deposit. First, it was not “disorderly” since it was a good faith approximation of the estate’s tax liability. Second, the executors did not dispute the tax liability. Finally, the executors did not designate the remittance as a deposit and the IRS did not treat the remittance as such.
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The Tax Court denied charitable deductions in Beaubrun v. Comm’r, T.C. Memo 2015-217 (2015), because the taxpayer had not obtained sufficient substantiation. To take a charitable deduction of an amount exceeding $250, taxpayers must have a contemporaneous written acknowledgment. The acknowledgment must include a description of any property contributed, a statement concerning whether any goods or services were provided in consideration by the donee, and a description and good-faith estimate of the value of any goods or services provided in consideration. Here, the written statement obtained by the taxpayer was not contemporaneous because it was not written prior to the earlier of the date on which the taxpayer filed a return, or the due date (including extensions) for filing a return.
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The Court in Hughes v. Comm’r, T.C. Memo 2015-89 (2015), rejected the taxpayer’s position that a gratuitous transfer to a non-U.S. citizen spouse would receive a basis step-up to fair market value, and that there would be no income tax on the transfer itself. The basis for the taxpayer’s position that a transfer to his wife would be considered a gain rather than a gift was that § 1041(d) denies nonrecognition on spousal transfers where one of the spouses is a nonresident alien. Further, the taxpayer argued that under United States v. Davis, 370 U.S. 65 (1962), the Supreme Court held that that a taxpayer recognized a gain on the exchange of assets with a spouse pursuant to a divorce settlement agreement. The taxpayer argued that an income tax treaty with the United Kingdom exposed him subject to capital gains tax only in Britain. The Tax Court rejected all of the arguments advanced, finding that Davis applies only in cases of an exchange of assets. Here, since the transfer constituted a gift, the done took a zero basis. In upholding the imposition of penalties, the Court appeared perturbed, commenting that “[g]iven his extensive knowledge of and experience with U.S. tax law, Mr. Hughes should have realized” that his conclusion was incorrect.
NYS Courts & Tax Tribunals
In Matter of Gaied, 2014 NY Slip Op 01101, the Court of Appeals narrowed the scope of those persons held to be a New York resident for tax purposes. Gaied was decided in 2014. Residency disputes often arise between New York and part year residents, and the Department of Taxation is aggressive in this area.
The statutory interpretation at issue involved the asserted imposition by New York of income tax on commuters (or those present in New York for more than 183 days) who also “maintain a permanent place of abode” in New York. The high New York State Court — without extensive discussion — observed that the erroneous interpretation of the lower administrative tax tribunals found no support in the statute or regulations, and consequently lacked a rational basis. Mr. Gaied owned a multi-family residence in Staten Island in which his elderly parents resided. Mr. Gaied commuted to an automotive repair business in Staten Island form New Jersey, but did not reside in the residence. Since Mr. Gaied concededly spent more than 183 days in New York, under the statute his New York State income tax liability hinged on whether the residence constituted a “permanent place of abode” maintained in New York. The Court of Appeals observed that the Tax Appeals Tribunal had interpreted the word “ ‘maintain’ in such a manner that, for purposes of the statute, the taxpayer need not have resided there, A unanimous Court held that this interpretation had “no rational basis.” Both the legislative history and the regulations supported the view that in order to maintain a permanent place of abode in New York, the taxpayer “must, himself, have a residential interest in the property.” The Court declined to speculate as to the amount of time that a nonresident would be required to spend in the New York Resident — or to elaborate upon any other factor justifying the conclusion that a taxpayer “maintained” a permanent place of abode in New York — since that issue was not before the Court. However, given the tenor of the language of the Court, it might appear reasonable to infer that a nonresident taxpayer spending only a de minimis amount of time in a dwelling maintained in New York might not thereby become subject to New York income tax.
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In 2015, the Court of Appeals again had occasion to reconsider the residency rules in Matter of Zanetti, 2015 NY Slip Op 3894 (3rd Dep’t, 2015). This time the issue concerned the effect of the taxpayer spending only partial days in New York. The Third Department in Zanetti held that partial days spent in New York constitute a full day for the purpose of determining New York residency. The determination resulted in the taxpayer being a resident of New York for income tax purposes.
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The taxpayer in Matter of Ryan, 2015 NY Slip OP 8012 (3rd Dep’t 2015), requested a conciliation conference in response to receiving a notice of deficiency. As instructed in the notice, the taxpayer made the request within 90 days. The request was denied because it was required to have been made within 30 days. The shorter statute of limitations applies where a fraud penalty is the subject of the requested conciliation conference. The Court held that the Division was not estopped from enforcing the 30-day statute of limitations.
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The Court of Appeals recently considered a civil enforcement action in which the Attorney General alleged that Sprint knowingly submitted false tax statements in violation of the New York False Claims Act. People v. Sprint Nextel Corp., 2015 NY Slip Op 7574 (NY 2015). The tax law at issue was Section 1105(b), which imposes a sales tax on flat-rate plans for voice services to customers whose “place of primary use” is in New York. The Supreme Court denied a motion made by Sprint to dismiss the complaint for failure to state a cause of action. The Appellate Division affirmed the decision of the Supreme Court. The Court of Appeals also affirmed, finding that the statute is unambiguous, that the statute is not preempted by federal law, and that the complaint sufficiently pleads a cause of action.
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In Exxon Mobil Co. v. State, 2015 NY Slip Op 1840 (3rd Dep’t 2015), the issue was whether required environmental testing and monitoring services relating to petroleum spills are subject to New York sales tax as services relating to “maintaining, servicing and repairing” real property or land. The taxpayer argued that these services were not taxable since the intention was only to assess the condition of property, rather than to remediate petroleum spills. The Tax Appeals Tribunal disagreed with the taxpayer, holding that monitoring and testing services, whether performed before or after remediation work, if any, would be taxable as standalone services because they are necessary for the properties to be in compliance. In an Article 78 proceeding, the Third Department affirmed the decision of the Tax Appeals Tribunal.
IRS Issues Final Regulations on Portability
The Treasury and the IRS have released the final regulations on portability of a Deceased Spouse’s Unused Exclusion Amount (“DSUE amount”). These regulations modify the Temporary Regulations issued on June 18, 2012. The final regulations became effective June 12, 2015. Several issues in connection with extensions of the deadline to elect portability are addressed. First, no extension of time to elect portability will be granted under Reg. §301.9100-3 because the portability requirement is statutory and not regulatory. However, under circumstances addressed in Rev. Proc. 2014-18, in some cases a taxpayer may obtain a discretionary extension of time in which to file an estate tax return for the purpose of electing portability without the need to obtain a Private Letter Ruling. One such case would be the situation in which the taxpayer is not required to file an estate tax return by reason of the value of the gross estate and adjusted taxable gifts, without regard to portability.
The final regulations also clarify which individuals may elect portability. The Internal Revenue Code requires that the election be made by the decedent’s “executor.” The final regulations clarify that although an individual may be deemed to be an executor if in possession of estate assets, an appointed executor has the right to make the portability election. The final regulations do not address whether a surviving spouse who is not an executor to make the portability election. Treasury affirmed its position that the IRS has broad authority under IRC § 2010(c) to examine the correctness of any estate return to determine the allowable DSUE amount without regard to the period of limitations on the return of the decedent. Whether an estate tax return is complete and properly prepared would be determined on a case-by-case basis by applying standards as prescribed in current law. Applicability of portability to a surviving spouse that becomes a U.S. citizen subsequent to the death of a spouse is addressed by the final regulations in favorable manner. The final regulations allow a surviving spouse to take into account the DSUE amount of the deceased spouse as of the date he or she becomes a U.S. citizen. Thus, the spouse would benefit from the DSUE for any subsequent lifetime transfers made. Of course, the estate of the deceased spouse must have made a portability election.
The Surface Transportation and Veterans Health Care Improvement Act of 2015
The Surface Transportation and Veterans Health Care Choice Improvement Act of 2015 (enacted July 31, 2015) created new Code §§ 6035 and 1014(f). IRC § 6035 provides that an executor required to file an estate tax return file a valuation statement with the IRS and with beneficiaries within thirty days of the earlier of (i) the date on which the estate tax return was required to be filed, or (ii) the date on which the estate tax return was actually filed. Only those estates that are required to file an estate tax return must file valuation statements. Executors that file an estate tax return to elect portability are not required to file valuation statements.
Valuation statements must identify the value reported on the decedent’s estate tax return for each property interest. A supplemental statement reporting any later adjustment in the value of the property must be filed no later than thirty days after the adjustment. For the purpose of penalties, the statement filed with the IRS is an information return, while the statement filed with beneficiaries is a “payee statement.” IRC § 1014(f) introduces the “consistent valuation rule.” Subsection (f) states that the basis of property acquired from a decedent shall not exceed the value determined for estate tax purposes or, for property the value of which has not been determined for federal estate tax purposes, the value identified in a valuation statement filed pursuant to IRC § 6035.
The purpose of Section 1014(f) is to prevent taxpayers from using a lower value for an asset in order to reduce estate tax while at the same time using a higher value to reduce gain for income tax purposes. The IRS made proposals similar to the consistent basis rule in its General Explanations of the Administration’s Fiscal Year 2016 Revenue Proposals. The Joint Committee on Taxation estimated that Section 2014(f) will raise $1.54 billion in revenues for the ten year period 2015 through 2025.
New Rulings and Procedures
The IRS made additions to the “no-rulings” list in Rev. Proc. 2015-37. With respect to all ruling requests received after June 15, 2015, the IRS will no longer rule on whether the assets in a grantor trust will receive a Section 1014 basis adjustment if they are not includible in the gross estate of the owner at death. This is an issue which has elicited a fair amount of commentary by tax attorneys. The prevailing and preferred view is that assets in a grantor trust not includible in the gross estate would not receive a basis step up.
In PLR 201544005, the IRS agreed with the taxpayer, and found that amending an irrevocable trust to correct scrivener’s error retroactively created a completed gift, which resulted in the avoidance estate taxation. Here, a husband and wife created an irrevocable trust for the benefit of their two children. They intended that transfers to the trust be completed gifts that would not be included in their gross estates. Gift tax returns were filed reporting the transfers as gifts. The settlors later discovered that transfers to the trust were not completed gifts, because they had retained the power to amend the trust to change the beneficial interests. At the request of the settlors, a local court amended the trust language to correct the error. The IRS respected the amendment because it effectuated the intent of the settlors.
Two recent rulings, PLRs 201507008 and 201516056 address the time at which contributions to a trust will be deemed as completed gifts subject to federal gift tax. In PLR 201507008, the IRS examined an irrevocable trust and the effect of settlor’s powers over distributions. The Service concluded that the settlor’s contributions were not completed gifts, reasoning that the settlor had retained lifetime and testamentary powers of appointment, as well as the power to veto distributions. The IRS further determined that a distribution of income or principal by a “distribution adviser” to a beneficiary that was not the settlor was a completed gift. Upon the settlor’s death, the fair market value of the property remaining in the trust (less distributions made to beneficiaries) would be included in the settlor’s gross estate for estate tax purposes.
In PLR 201516056, the taxpayer’s proposed disclaimers of securities gifted by his wife prior to her death constituted qualified disclaimers. The disclaimers involved securities held in two accounts. With respect to the first account, securities transferred by the wife were a completed gift at the time of transfer. With respect to the second account, the wife added her husband as a joint owner with right of survivorship. That transfer became complete only upon the death of the wife. The disclaimers would be qualified with respect to the completed gift in the first account since the disclaimer occurred within nine months of the date of transfer of securities; and would be qualified with respect to the second account because the disclaimer was made within nine months of the date of death.
Treasury General Explanations of the Administration’s Fiscal Year 2016 Revenue Proposals
Treasury proposed changes in connection with estate tax procedures. The first involves broadening the term “executor,” thereby giving that person the authority to act on behalf of the decedent with respect to all tax matters, rather than only estate tax matters. The second would be that the special lien imposed under IRC § 6324(a)(1) for taxes deferred under IRC § 6166 be extended from ten years to fifteen years. Treasury General Explanations of the Administration’s Fiscal Year 2016 (the “Green Book”) proposed various changes involving capital gains: First, the capital gains tax would increase to 24.2 percent; second, the basis step up upon death would be eliminated; and third, gratuitous transfers of appreciated property (either by gift or at death) would be treated as a sale for income tax purposes, with the donor or decedent realizing capital gain at the time of the gift or death.
The following exceptions would apply to the somewhat draconian proposed third change:
(i) Taxes imposed on gains deemed realized at death would be deductible on any estate tax return of the decedent’s estate;
(ii) Capital gains on a gift or bequest to a spouse would not be realized until the spouse disposes of the asset or dies;
(iii) Each decedent would have a $100,000 exclusion for capital gains recognized by reason of death, portable to the decedent’s surviving spouse;
(iv) Gifts or bequests to a spouse or charity would carry out the basis of the donor or decedent;
(v) Appreciated property given or bequeathed to charity would be exempt from capital gains tax;
(vi) The final income tax return of a decedent may utilize unlimited capital losses and carry-forwards against ordinary income;
(vii) There would be no capital gain tax imposed on tangible personal property;
(viii) The $250,000 per person exclusion for capital gain on a principal residence would apply to all residences, portable to the decedent’s surviving spouse; and
(ix) A deduction would be available for the full cost of appraisals of appreciated assets.
Sales of assets to grantor trusts have also attracted the attention of Treasury, which proposed that the gross estate of a decedent deemed to own a trust under the grantor trust rules would include that portion of the trust attributable to a sale, exchange, or “comparable transaction” between the grantor and the trust, if that transaction was disregarded for income tax purposes. The gross estate would include any income, appreciation and reinvestments (net the amount of consideration received by the grantor) therefrom. These amounts would also be subject to gift tax at any time during the life of the deemed owner if grantor trust treatment terminated, or to the extent any distribution were made to another person.
New York State Matters
Determining Residency for Income Tax Purposes Where Property Straddles a Boundary Line
The NYS Department of Taxation and Finance (“DTF”) recently advised whether married taxpayers were residents of New York City for income tax purposes where their residence was located on both sides of the border separating the Bronx (a borough of New York City) and Yonkers. The taxpayers do not work in New York City or hold any other property located in New York City. New York (Tax Law § 605(b)), New York City (N.Y.C. Administrative Code § 11-1705(b)(1)(A)) and Yonkers (Yonkers Income Tax surcharge § 15-99) all define residence as the place where an individual is domiciled and maintains a permanent place of abode. The tax law defines “domicile” as “the place which an individual intends to be such individual’s permanent home.” (20 NYCRR 105.20(d)(1)). “Permanent place of abode” is defined as “a dwelling place of a permanent nature maintained by the taxpayer.” (20 NYCRR § 105.20(e)(1)).
TSB-A(15(8)I advised that a house meets the definition of “permanent place of abode” and that its location determines the residency of the taxpayers. Since the portion of the property located in the Bronx consisted entirely of vacant land, while the house itself was located in Yonkers, the taxpayers were domiciled in Yonkers rather than New York City. Although the TSB provides some clarity in this particular situation, questions still remain. DTF did not opine as to whether taxpayers would be treated as residents of either or both locations where a house straddles two different jurisdictions.
Interests in Disregarded Single Member LLCs are Tangible Property for New York Estate Tax Purposes
A recent advisory opinion (TSB-A-15(1)M) stated that a membership interest in a single-member LLC disregarded for income tax purposes is not intangible property for New York State estate tax purposes. However, this result would not obtain if a single member LLC elected to be treated as a corporation. The New York resident intended to transfer real property with a situs in New York to a non-New York LLC prior to moving permanently to another state. New York imposes estate tax on real property and tangible personal property that is physically located in New York. However, New York imposes no estate tax on a nonresident’s intangible property since such property is considered to be located at the domicile of the owner. New York regulations state that a single member LLC disregarded for Federal income tax purposes is treated as owned by the individual owner. Activities of the LLC are treated as activities of the owner. Thus, the New York real property held by a single member LLC that is disregarded for income tax purposes would be treated as real property held by the taxpayer for New York estate tax purposes.
There is a question as to the Constitutionality of the conclusion reached in this TSB since the New York Constitution prohibits the imposition of an estate tax on the intangible property of a nonresident, even if such property is located within New York State. While it is true that single member LLCs are ignored for federal income tax purposes, they are not ignored for other federal (or state) legal purposes. Therefore, it arguably an unjustified logistical jump to conclude that because the entity is ignored for federal income tax purposes, it should also be ignored for purposes of the New York State Constitution.
DTF Explains 2015 Legislative Amendments to Estate Tax Provisions Enacted in 2014
The year 2015 saw significant changes in New York estate tax. On April 13, 2015, the legislature enacted technical amendments which provided some clarity. DTF then issued a technical memorandum on July 24, 2015 explaining the amendments. (TSB-M-15(3)M). Some amendments clarify certain issues relating to the new three year “add-back” rule. The add-back rule provides that any gifts made within three years of death that are taxable for federal gift tax purposes will be added back to the New York taxable estate. The first amendment to the add-back rule provides that the rule will not apply to estates of decedents dying on or after January 1, 2019. A second specifically excludes from the scope of the rule any gifts of real or tangible personal property located outside of New York at the time the gift was made.Estate Tax § 960(b) was amended to disallow deductions related to intangible personal property for non-resident decedents otherwise available for federal estate tax purposes. The amendment is logical since intangible personal property is excluded from the taxable estate of a non-resident.
Another amendment made to the estate tax law in 2015 corrects a drafting error which would have resulted in the estate tax expiring on March 31, 2015. There was no tax rate schedule applicable after that date. The tax tables have now been made permanent.
Neither the amendments nor the technical memo address a significant change to New York estate tax made effective in 2014. That change related to the exemption amount. Prior to 2014, an estate was only subject to estate tax to the extent that it exceeded the exemption amount. For the first time, estates considered too large could not benefit from the tax exemption at all. Under current law, if an estate exceeds 105 percent of the basic exclusion amount, the entire estate becomes subject to New York estate tax, rather than just the amount which exceeds the exemption amount. Those estates between 100 percent and 105 percent of the exemption amount are subject to a phase-out of the estate tax exemption. With the law remaining unchanged, marginal changes in the size of the New York estate may cause disproportionate differences in the amount of estate tax imposed. One means of easing the resulting burden would be to extend the phase-out of the exemption to apply to larger estates. A Senate budget proposal would have extended the phase-out of the exemption to those estates between 100 percent and 110 percent of the exemption amount. The proposal was not enacted.
Decanting Bill Passes Both Houses
EPTL §10-6.6 allows trustees to decant or transfer trust property from an existing irrevocable trust to another existing irrevocable trust or a new irrevocable trust. The statute provides that a trust decanting becomes effective within thirty days of notifying interested persons. Although current law allows interested parties to object to a decanting, it does not provide any mechanism for a trustee amendable to the objection from preventing the decanting from becoming effective by operation of law after thirty days. A bill passed by both houses would allow a trustee to void a proposed decanting in response to objections by interested persons. However, the bill would not grant interested parties any power to compel the trustee to void the decanting. Governor Cuomo has not signed the bill.
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
Many U.S. taxpayers have at least one financial account located in a foreign country. Failure to report an offshore account carries with it possible civil and criminal penalties. Foreign account reporting requirements are provided for under the Bank Secrecy Act, enacted in 1970. The legislation was intended to assist U.S. investigators in preventing offshore tax evasion and in tracing funds used for illicit purposes. Actual reporting of foreign accounts and the filing of Foreign Bank and Financial Account Reports (FBARs) has been required since 1972, but the rule had been largely ignored by taxpayers., prompting Congress to amend the requirements.
Amended FBAR regulations became effective in 2011. 31 C.F.R. § 1010.350 now provides that each “United States person” having a financial interest in, or “signature authority” over, a bank, securities, or other financial account in a foreign country must file an FBAR. A United States person includes U.S. citizens and residents, and domestic corporations, partnerships, estates, and trusts. Having signature authority over a foreign financial account means that the person can control the disposition of money in the account by sending a signed document to, or orally communicating with, the institution maintaining the account. The FBAR has proven to be an effective tax compliance tool for the IRS, since penalties may be imposed upon taxpayers maintaining foreign accounts which earned no income. This unfairness led to the inauguration of a “streamlined” disclosure program, discussed below.
31 C.F.R. § 1010.306(c) provides that an FBAR must be filed if the aggregate value of all foreign financial accounts is more than $10,000 at any time during the calendar year. Therefore, a U.S. person who owns several small financial accounts in various countries, whose total value exceeds $10,000 at any time during the calendar year, would be required to file an FBAR. Some exceptions to the FBAR filing requirement exist. For example, no FBAR is required to be filed by the beneficiary of a foreign trust. The FBAR must be filed by June 30. (Form TD F90-22.1). The existence of foreign financial accounts is reported by checking the appropriate box on Schedule B of Form 1040. 31 C.F.R. § 1010.306(c). Extensions given by the IRS for income tax returns will not operate to extend the FBAR filing deadline of June 30.
The civil penalty for failure to file the FBAR is $10,000 for each non-willful violation. Where a taxpayer willfully fails to file, civil penalties are the greater of $100,000 or fifty percent of the highest balance of the unreported account per year, for up to six years. Criminal penalties for willful violations run as high as $500,000, with the possible sanction of imprisonment for up to ten years. Those taxpayers required to file FBARs may also be required to file Form 8938 (Statement of Specified Foreign Financial Assets) if the amount of assets exceeds a certain threshold.
Form 8938 is required if the taxpayer has foreign financial accounts (or other specified foreign financial assets) exceeding $50,000 ($100,000, if married filing jointly) on the last day of the tax year or $75,000 ($150,000, if married filing jointly) at any time during the tax year. For the purpose of Form 8938, specified foreign financial assets include partnership interests in foreign partnerships, notes or bonds issued by a foreign person, and interests in foreign retirement plans. Note that taxpayers are not required to report ownership of foreign real property on Form 8938, as Form 8938, as well as the FBAR, operate exclusively to apprise the Service of the existence of foreign financial accounts. Failure to file Form 8938 may result in a penalty of $10,000, even if the foreign assets were actually reported on the FBAR.
Other information returns that may be required for persons owning foreign assets include (i) Form 3520 (Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts); (ii) Form 3520-A (Annual Information Return of Foreign Trust with a U.S. Owner; (iii) Form 5471 (Information Return of U.S. Persons with Respect to Certain Foreign Corporations); (iv) Form 5472 (Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business); (v) Form 926 (Return by a U.S. Transferor of Property to a Foreign Corporation); and (vi) Form 8621 (Information Return by a Shareholder of a Passive Foreign Investment Company or a Qualified Electing Fund).
Remedies for Taxpayers Who Have Failed to Report Foreign Assets, Foreign Accounts, or Foreign Source Income
Taxpayers who have failed to report foreign source income or foreign assets may be eligible to participate in a disclosure program. Acceptance into the OVDP program is conditioned upon IRS approval following partial disclosure. Those participating in a disclosure program enjoy the elimination of exposure to criminal sanctions, and may incur fewer tax penalties. Participation in these programs can only occur if the taxpayer has not been subject to audit. The existence of an audit will result in all bets being off for the taxpayer. One downside to electing to apply for the OVDP programs is that if the taxpayer is ultimately not accepted into the program, he may have provided the IRS with a blueprint for audit. Taxpayers not participating in any program may instead choose to make a “soft disclosure” by filing all required returns with the hope that no tax audit occurs within the applicable period of limitations. Currently, the following four disclosure programs exist:
(i) the Offshore Voluntary Disclosure Program (the “OVDP”);
(ii) the Streamlined Filing Compliance Procedures (the “Streamlined
(iii) the Delinquent FBAR Submission Procedures (the “FBAR Procedures”);
(iv) the Delinquent International Information Return Submission Procedures (the
“International Return Procedures”).
The Offshore Voluntary Disclosure Programs
To penalize more sharply taxpayers who have willfully failed to report foreign financial assets and to ease the burden on taxpayers who have non-willfully failed to comply with foreign reporting requirements, the IRS modified the Offshore Voluntary Disclosure Program (OVDP) on July 1, 2014. Subsequent to the modifications, the OVDP has generally remained the best available disclosure option for taxpayers who have acted willfully. Taxpayers falling into the non-willful category may seek to participate in the Streamlined Procedures.
The OVDP permits taxpayers who have willfully failed to disclose foreign accounts to correct past non-compliance. Taxpayers accepted in the OVDP program will avoid criminal prosecution and benefit from fixed, ascertainable penalties. A taxpayer may be accepted into the OVDP program if no audit or investigation has been commenced, or if the IRS has not received information from a third party concerning non-compliance. Understandably, taxpayers maintaining offshore accounts housing illegal sources of funds may not qualify for relief under the program.
To participate in the current OVDP, taxpayers must first make a partial disclosure. The modified OVDP now requires the disclosure of more information at this pre-clearance stage. In addition to taxpayer identifying information, information concerning financial institutions, foreign entities, and domestic entities at issue must also be provided. The IRS will notify taxpayers within thirty days concerning whether conditional acceptance has been approved. Taxpayers that obtain pre-clearance to enter the OVDP must make the next required submission within 45 days. That submission consists of a narrative identifying the accounts, the location of the accounts, and the source of the income of the offshore accounts. IRS Criminal Investigations will review the submission and issue notification within 45 days. Taxpayers passing the second submission stage are allowed 90 days in which to make a final disclosure submission, which includes copies of previously filed original tax returns, as well as amended tax returns, for the prior eight tax years. Payment of tax on unreported income, as well as an accuracy-related penalty of twenty percent, and interest, must be paid as part of the final disclosure submission.
Following the IRS review and approval of the final disclosure submission, the taxpayers will be furnished with a closing agreement, setting forth the penalty structure. Taxpayers may make an irrevocable election to forego the closing agreement and instead submit to a standard audit. Taxpayers opting to not execute the closing agreement will not forego protection against criminal prosecution provided the taxpayer continues to cooperate. The “miscellaneous penalty” imposed on taxpayers accepted into the OVDP is equal to a percentage of the highest aggregate value of foreign accounts. That percentage is 27.5, rising to fifty percent if the foreign financial institution holding the account is under investigation by the IRS or the Department of Justice. The IRS publishes an updated list of these “blacklisted” institutions on its website. The number of such institutions has increased steadily, and consisted of ninety-five institutions as of February 5, 2016.
The Streamlined Procedures
Recent modifications to the OVDP created for the first time a separate filing procedure for taxpayers who non-willfully failed to comply with reporting requirements. Unlike the OVDP, the “Streamlined Procedures” provide no assurance that criminal prosecution will be avoided. The Streamlined Procedures are, as its name implies, simpler than the procedures involved in participating in the OVDP. Multiple submissions are not required. Instead, participating taxpayers submit all required documentation in one phase. The Streamlined Procedures also require the submission of fewer tax returns. While the OVDP requires the submission of eight years of amended income tax returns and information returns (e.g., FBARs and Form 8938) , the Streamlined Procedures require only three years of amended income tax returns (and the payments of associated taxes, interest, and penalties), six years of FBARs and three years of any other information returns (e.g., Form 8938). The Streamlined Procedures impose significantly lesser penalties than the OVDP. Eligible taxpayers residing in the United States, in addition to paying tax (and applicable penalties, if any) on unreported income, must pay a miscellaneous offshore penalty equal to five percent (rather than 27.5 or fifty percent, as the case may be) of the highest aggregate year-end value of the unreported foreign financial assets. Non-resident taxpayers are exempt from the miscellaneous offshore penalty.
Only individual taxpayers (including estates of deceased taxpayers) may participate in the Streamlined Procedures. An important part of the submission consists of the Certification: Participating taxpayers must certify that their failure to report all income, pay all tax, and submit all required information returns was due to non-willful conduct. As with the OVDP, participation is excluded if the IRS has initiated a civil examination of taxpayer’s returns for any taxable year or has commenced a criminal investigation. So too, electing to participate in the Streamlined Procedures precludes participation in the OVDP and vice versa. Although the Streamlined Procedures impose lower penalties than the OVDP, there is less assurance that the taxpayer will be accepted, since he must demonstrate that the failure was non-willful. Again, failing to be accepted into the program will result in the IRS possessing a significant amount of information which it may then use in an audit, be it civil or criminal.
The element of non-willfulness in failing to properly report and pay tax must be shown by means of a detailed narrative. The IRS will reject submissions which it finds lack sufficient detail. As noted, there is also a risk that the IRS will determine that individual taxpayers in fact acted willfully, thus opening up a potential Pandora’s box. According to the IRS (but not necessarily the Courts), “non-willful” conduct is conduct due to negligence, inadvertence, or mistake or conduct that is the result of a good faith misunderstanding of the requirements of the law. In determining whether a taxpayer has acted non-willfully, the IRS states that it will consider the facts and circumstances. However, the IRS has provided little guidance as to specific circumstances that will be considered. Further, there is a dearth of case law providing clarity on this issue.
The Fourth Circuit recently determined that a taxpayer acted willfully by failing to disclose the existence of a foreign account by falsely checking the box “no” on Schedule B (which elicits a response concerning the existence of a foreign account.) United States v. Williams, 489 F. App’x 665 (4th Cir. 2012), reasoned that the question instructed taxpayers to refer to the FBAR instructions, putting the taxpayer on notice with respect to FBAR requirements. The Court remarked that willfulness can be inferred from a conscious effort to avoid learning about reporting requirements . . . and may be inferred where a defendant was subjectively aware of a high probability of the existence of a tax liability, and purposely avoided learning the facts. The Court dismissed as irrelevant the claim that the taxpayer had not in fact reviewed the return.
In determining willfulness, the IRS may also consider the source of funds held in foreign account. The Service is more likely to find a taxpayer acted willfully if the foreign financial account either produced unreported income or if the source of funds of the foreign financial account derived from unreported foreign source income. The IRS may also consider the financial sophistication and education of the taxpayer, any history of tax compliance (or lack thereof) by the taxpayer, and also whether the taxpayer disclosed the existence of foreign accounts to the return preparer or tax preparer.
III. Delinquent FBAR Submission Procedures and Delinquent International Information Return Procedures
Delinquent FBAR Submission Procedures
The Delinquent FBAR Submission Procedures (“Delinquent FBAR Procedures”) supersede provisions of the OVDP existing prior to the OVDP modifications. Those terms provided for automatic exemption from penalties where the taxpayer had no unreported income and whose only failure consisted of not filing FBARs (or filing inaccurate FBARs). The FBAR Submission Procedures made no changes to OVDP provisions which it superseded. To qualify for the Delinquent FBAR Procedures, the taxpayer must not be under a civil examination or criminal investigation and must not have been taxpayers must have been contacted by the IRS concerning an audit or delinquent information returns.
Delinquent International Information Return Submission Procedures
The Delinquent International Information Return Submission Procedures (“International Return Procedures”) also supersede provisions of the OVDP existing prior to the OVDP modifications. Those terms also provided for an automatic exemption from penalties where the taxpayer had no unreported income and whose only failure related to the non-filing of international information returns other than FBARs (or the failure to file accurate international information returns that were not FBARs). Applicable international information returns include, but are not limited to, Form 8938, Form 3520, and Form 5471.
As is the case with the Delinquent FBAR Procedures, taxpayers must not be under either a civil examination or criminal investigation, or have been contacted by the IRS concerning an audit or delinquent information returns. However, Unlike the Delinquent FBAR Procedures described immediately above, the International Return Procedures apply to taxpayers irrespective of whether there was or was not unreported income. In addition, penalties may now be imposed if the taxpayer cannot demonstrate reasonable cause for the failure to file the required information returns.
The IRS has elaborated that longstanding authorities regarding what constitutes reasonable cause continue to apply, citing as examples Treas. Reg. §§ 301.6679-1(a)(3) and 1.6038A-4(b), and 301.6679-1(a)(3). § 301.6679-1(a)(3) provides that a taxpayer that exercises ordinary business care and prudence has reasonable cause. § 1.6038A-4(b) provides that the determination of whether a taxpayer acted with reasonable cause is made considering all the facts and circumstances. Circumstances that would qualify as reasonable cause include honest misunderstanding of fact or law, as well as reasonable reliance on the advice of a professional.
Treas. Reg. §301-6724-1 provides a list of factors that may demonstrate reasonable cause. For example, reasonable cause is more likely to be found to exist where the taxpayer has an established history of compliance (Treas. Reg. §301-6724-1(b)(2), where the compliance failure concerned a requirement that was new for a particular taxpayer (Treas. Reg. §301-6724-1(b)(1)), or where the compliance failure was due to events beyond the control of the taxpayer (Treas. Reg. §301-6724-1 (c)).