Retaining a
Right to Revoke an Interest in a Charitable Plan
This second part of a two-part article analyzes a donor's
retention of the right to revoke another's interest in a charitable life income
plan (such as a charitable remainder trust, charitable gift annuity, or pooled
income fund).
Author:
MARY C. HESTER AND LIZBETH A. TURNER, ATTORNEYS
MARY C.
HESTER is a shareholder with the law firm of Liskow
& Lewis in New Orleans, and is certified by the Louisiana Board of Legal
Specialization as a specialist in estate planning and administration. LIZBETH
A. TURNER is the Director of Planned Gifts at Tulane University in New Orleans,
where she assists donors and their advisors in charitable gift planning. Both
authors serve on the Charitable Trust Law Revision Subcommittee of the
Louisiana State Law Institute, and both have lectured and written on estate
planning and charitable giving.
The first
part of this two-part article analyzed the transfer tax rules applicable to
charitable life income plans, including the availability of the annual
exclusion and the availability of the marital deduction. 1
This second part of the article will examine the authority allowing a donor to
retain the right to revoke another's interest in a charitable life income plan,
the effect of retaining the right to revoke, and the advantages and
disadvantages of retaining such a right.
Authority
for retained right to revoke
The gift tax
Regulations specifically provide that a gift is incomplete if the donor
reserves an unrestricted power to name new beneficiaries or to change or
terminate beneficiaries' interests. 2
CRTs. The Regulations applicable to charitable
remainder trusts (“CRTs”) provide that the grantor may retain the power exercisable
only by will to revoke or terminate the interest of any noncharitable
beneficiary. 3
Retaining an inter vivos, rather than a testamentary,
right to revoke would presumably disqualify the CRT. 4
The donor may avoid making a taxable gift by retaining a testamentary right to
revoke a successor beneficiary's interest. The donor need not actually exercise
the right—its mere retention is enough to make the gift incomplete. 5
CGAs. Although commentators agree that donors may
retain either an inter vivos or testamentary right to
revoke an annuitant's interest in a charitable gift annuity (“CGA”), no
specific reference to retaining the right to revoke exists in the Code section
and Regulations setting forth the CGA requirements. 6
In contrast to specific requirements for qualification of CRTs and
pooled income funds (“PIFs”), the CGA requirements
appear in a Code section that excludes qualifying CGAs
from treatment as “acquisition indebtedness” in determining unrelated business
taxable income. Only the Regulations on the treatment of capital gain
specifically refer to the right to revoke in providing that the retention of
such a right will not cause the annuity to be considered as assignable to
someone other than a charity and will not prevent capital gain from being
reported over the donor's life expectancy. 7
The
Regulation most often cited as authority that a donor may retain either a
testamentary or lifetime right to revoke is the general gift tax Regulation
stating that a gift is incomplete if the donor reserves a power to name new
beneficiaries or change the beneficiaries' interests. 8
Therefore, the conclusion that either a testamentary or lifetime right to
revoke is permitted appears to be based on the fact that neither right is
expressly prohibited.
PIFs. The PIF Regulations expressly permit a donor
to retain a power exercisable only by will to revoke or terminate the interest
of any beneficiary other than the charity that maintains the fund. 9
A donor who reserves the right to revoke during life will not be eligible for
an income or gift tax deduction for the charitable remainder interest. Even
worse, since the right to revoke is addressed in the Regulations dealing with qualification
of a PIF, retention of a lifetime right to revoke could possibly disqualify the
entire trust as a PIF. 10
Effect of
retaining the right to revoke
A donor's
retaining the right to revoke the interest of a successor income beneficiary
will clearly make the gift incomplete when the life income plan is created.
Retaining a right to revoke does not affect the income tax charitable deduction
because the charity's interest is valued assuming that the donor will not
exercise that right. 11
Therefore, if the donor names herself first and then a successor as lifetime
income beneficiaries, both life expectancies will be considered in calculating
the charitable income tax deduction.
Retaining the
right to revoke may have estate tax consequences. For CRTs and PIFs, if the donor retains the testamentary right to revoke
until death or within three years of death, and the successor beneficiary
survives the donor, then the value of the entire trust or PIF units will be
included in the donor's taxable estate. 12
(In the case of CRTs, the trust assets will also be included if the donor
retains the power to change or designate the charitable beneficiary.) 13
For CRTs, the charitable estate tax deduction will be available for the
charitable remainder interest in the donor's estate. For PIFs,
if the successor beneficiary is a nonspouse, the
charitable deduction will also be available for the remainder interest; for a
spouse, the QTIP election is available for the entire value of the PIF units,
and the charitable deduction will be available for the remainder in the donee spouse's estate. 14
If a donor
dies without exercising a right to revoke a CGA interest, the present value of
the successor annuity interest will be included in the donor's estate. Unlike
CRTs and PIFs, there is no charitable remainder to
include in the estate. If the donor revokes the successor annuity interest by
will, then the right to future annuity payments ends with the donor's death and
nothing should be includable in the estate. 15
Alternatively, the value of the annuity payments might be includable under Section
2038 but eligible for a charitable deduction under Section
2055 . 16
We believe, however, that since after revocation no value remains, nothing is
included in the donor's estate.
Completed
gift during donor's lifetime?
Because the
right to revoke a CRT or PIF income interest can be exercised only by will,
retaining the revocation right may not make the entire gift incomplete. If the
beneficiary will receive income immediately, the gift of the right to receive
income during the donor's lifetime could be considered complete when the CRT or
PIF agreement is funded. Some commentators suggest that the value of such a
gift is measured by the actuarial value of the beneficiary's right to receive
income during the donor's life expectancy. 17
Others suggest that a completed gift occurs only when each payment is actually
received by the nondonor beneficiary during the
donor's lifetime, rather than there being a single completed gift when the CRT
or PIF is funded. If the gifts are completed only when the annual payments are
received, then the annual exclusion could be applied to each year's payments.
18
This issue
arises both with a single-life CRT or PIF naming a nondonor
as income beneficiary and with a joint-and-survivor CRT or PIF naming nondonors or both the donor and another as income
beneficiaries. The value of the single-life CRT or PIF beneficiary's
irrevocable right to receive payments during the donor's life could be equal to
the actuarial value of that right to receive payments during the donor's
lifetime. 19
A joint-and-survivor CRT or PIF funded with separately
owned property results in a gift by the donor to the nondonor
of a half interest in the payments during their joint lifetimes and of the
survivorship interest. The right to revoke may make the gift of the
survivorship interest incomplete, but the gift of payments during their joint
lifetimes cannot be revoked by the testamentary right and may therefore be
complete. 20
For this
reason, some suggest that donors should give a nonspouse
beneficiary only a successor interest and retain the right to revoke. 21
For a PIF interest, the same issue arises even for concurrent spouse
beneficiaries because the spouse's interest will not qualify for a QTIP
election.
For CGAs, this issue does not arise if the donor retains a
right to revoke during life. The issue does arise if only a testamentary right
to revoke is retained, but the marital deduction is available for spouse donees. 22
The gift tax
Regulations give some indication that retaining a testamentary right to revoke
an interest that begins during the donor's lifetime does not make the entire
gift incomplete. In describing circumstances making a gift incomplete, the
Regulations include as an example a donor's retaining the unrestricted power to
reduce a gift to one of less value. 23
In contrast is an example of a restricted power to reduce a life estate from a
term of life to a term of five years. The Regulations conclude that the gift of
the life estate for the five-year term is certain, and is “to that extent
complete.” 24
Accordingly, the IRS might argue that a donor who retains the testamentary
right to revoke a gift of an income interest that begins during the donor's
lifetime has nevertheless made a completed gift for the period of the donor's
actuarial life expectancy because the donor cannot reduce the gift to a period
less than the donor's life expectancy.
In Rev.
Rul. 79-243 , 25
the donor named himself as lifetime income beneficiary of a CRT and retained
the testamentary right to revoke his wife's successor interest. The Ruling
found the gift to the spouse incomplete, specifically noting that she would not
receive anything until the donor's death. This focus on the fact that the right
to revoke preceded the spouse's interest suggests that the result might have
been different if the spouse's interest had begun before the donor's
testamentary right to revoke could terminate it.
Ltr. Rul.
8949061 provides some support for the interpretation that, if the donor
reserves the testamentary right to revoke, then each gift to the income
beneficiary becomes complete only in the year in which the payment is actually
received, and no completed gift is made at the CRT's creation. In the letter
ruling, the donor had created a charitable remainder unitrust
(“CRUT”) with a 6% unitrust payment to be divided
among seven beneficiaries, and had reserved the testamentary right to revoke
the interest of each income beneficiary. The CRUT terminated on the earliest of
(1) the end of a 15-year term, (2) the beneficiary's date of death, or (3) the
donor's death if the donor exercised the testamentary right to revoke. The donor
requested a ruling on the tax effects of releasing his right to revoke.
The IRS ruled
that the gift to the seven income beneficiaries was incomplete as long as the
donor retained his right to revoke. The ruling further concluded that only the
annual unitrust amounts actually paid to the
beneficiaries constituted completed gifts and were eligible for the annual
exclusion. If the donor relinquished the right to revoke, a gift of all future unitrust payments to the beneficiaries would be complete
and taxable at its then present value. 26
Could
retaining the right to revoke disqualify a life income plan?
Another
relevant issue is whether retaining the right to revoke could actually
disqualify the plan.
CRTs. The CRT Regulations initially state that the
donor may retain the power exercisable only by will to revoke the interest of
any noncharitable beneficiary. 27
But in the following subsection, the Regulations address the right to revoke in
the context of the permitted period of the annuity or unitrust
amount. The Regulations for both charitable remainder annuity trusts (“CRATs”) and CRUTs provide that
the permitted payment period may be either for the life or lives of a named
individual or individuals or for a term not to exceed 20 years. 28
The Regulations further provide that “if an individual receives an amount for
life, it must be solely for his life.” 29
According to the Regulations, a term-of-years CRT may be terminated by the
death of the recipient or the grantor's exercise of a testamentary right to
revoke. 30
The
Regulations therefore specifically approve the donor's retaining the right to
revoke for a term-of-years CRT, but not for a lifetime CRT. Does this disparity
mean that a donor may not retain the right to revoke a beneficiary's lifetime
interest if the beneficiary's interest runs concurrently with the donor's or if
the donor has no interest in the CRT? In either situation, the beneficiary's
lifetime interest could terminate on the date of the donor's death, rather than
on the date of the beneficiary's death. The issue does not arise when the donor
retains the right to revoke a successor lifetime interest because there the
beneficiary's interest does not begin until after the donor's death. If the
interest were not revoked, it would begin at the donor's death and would continue
for the beneficiary's lifetime without the threat of revocation. If the
beneficiary's interest were revoked, it would never come into existence.
Commentators
concerned about this issue warn that the donor's retaining the right to revoke
a beneficiary's existing lifetime interest could disqualify the trust as a CRT,
resulting in the donor's loss of both the income and the gift tax charitable
deductions. 31
These commentators advise against retaining a right to
revoke that could terminate an existing lifetime interest and suggest that
retaining the right to revoke be limited to CRTs for a term of years or CRTs in
which the beneficiary's interest succeeds that of the donor rather than running
concurrently with it. 32
Other commentators are less concerned, citing (1) the Regulations' general
statement that the donor may retain the testamentary right to revoke the
interest of noncharitable beneficiaries and (2)
private letter rulings approving CRTs that include a retained right to revoke
the interest of a current lifetime beneficiary. 33
Ltr. Rul.
8120056 seems to support the broader view. There, the donor had retained
the right to revoke the interest of the lifetime CRUT beneficiary. The IRS
cited both the Regulations' general approval of retention of the testamentary
right to revoke and the requirement that a lifetime income interest must be
measured solely by the beneficiary's own life. 34
The IRS concluded that the “life of the Current Beneficiary will be the
measuring life in the computation of the contribution to the Remainderman” and that the donor's retained right to
terminate the interest by testament would “not affect the qualification of the
Trust as a charitable remainder unitrust.” 35
Presenting
the right to revoke as a qualified contingency permitted under Section
664(f)(2) has been proposed. For example, the CRT
instrument could provide for termination on the first to occur of the income
beneficiary's death or the donor's testamentary revocation of the beneficiary's
income interest. 36
It is further suggested that the requirement that a lifetime interest be
measured solely by the beneficiary's life was made obsolete by the allowance of
qualified contingencies under Section
664(f) . 37
Ltr. Rul.
200414011 supports the position that the allowance of qualified
contingencies permits a beneficiary's interest to be terminated by the death of
another person. The CRT at issue in this ruling provided that the successor
interests of three beneficiaries would terminate at the death of a fourth
successor beneficiary. Although the IRS found that the CRT was disqualified
because it failed the 10% remainder requirement, the IRS specifically ruled
that “the termination of the unitrust payments upon
the death of Y [the fourth successor beneficiary] is a qualified contingency
within the meaning of 664(f).”
The updated
sample forms for CRATs published by the IRS in 2003
do not clearly resolve this issue. The sample form for a CRAT created for two
consecutive lives includes an alternate provision for retaining the
testamentary right to revoke the successor beneficiary's interest. 38
The new form for a sample inter vivos CRAT for one
measuring life, however, does not include such an alternate provision. 39
Is this provision omitted from the single-life CRAT form because the IRS does
not approve of the donor's retaining a right that could cause the CRAT to terminate
on a date other than the death of the lifetime income beneficiary? Or did the
IRS simply assume that a single-life CRAT would typically be created for the
donor's own benefit and thus have no need of such a provision?
The
annotations included with the sample form for consecutive life interests
explain that the donor's retention of the testamentary right to revoke “may
have gift and estate tax consequences. It will affect the value of the annuity
interests transferred. It may also cause a portion of the trust to be included
in the donor's gross estate for federal estate tax purposes, even if it would
otherwise not be includible.” 40
Retaining the right to revoke a successor income interest will presumably cause
the gift to be incomplete, removing any gift tax liability, and will make the
gift includable in the donor's estate if the right is held through the donor's
death. Thus, the meaning of the first and third of these sentences is clear.
But less clear is the meaning of the statement that retention of the right
“will affect the value of the annuity interests transferred.” If the gift is
incomplete, no gift tax valuation question arises. Perhaps the IRS is referring
to the fact that the beneficiary will be older at the donor's death, so that if
the right is retained, the value of the annuity may then be less than when the
CRT was created.
The IRS
sample form for a joint-and-survivor CRAT also includes in an alternate
provision the donor's retained right to revoke and the same language regarding
the possible consequences. 41
Here, the statement that retaining the right to revoke will affect the value of
the interest is consistent with a position that only the portion of the gift
for the period exceeding the donor's life expectancy is made incomplete. But
because the same language is included in the form for consecutive life
interests, it is unclear whether any different meaning is intended.
The alternate
provisions for retaining the right to revoke included in both two-life CRAT
forms make it clear that the donor is one of the income beneficiaries of the
trust. None of the provisions, therefore, specifically imply approval of
retention of the right to revoke by a donor who is not a beneficiary of the
CRT.
One could
infer from the CRAT forms that the IRS does not object to the retention of the
right to revoke if the donor is an income beneficiary, whether the interest
subject to the revocation succeeds the donor's or is concurrent with it, but it
has been predicted that the “issue of cutting off a lifetime interest will
likely still be debated.” 42
If the donee's interest in a joint-and-successor CRT
is viewed as a 50% interest during the donor's lifetime and a 100% interest at
the donor's death, then it could be argued that it is “the new 100% interest
that is terminated in the revenue procedure, while others will argue the
co-beneficiary's lifetime interest was obviously cut off.” 43
CGAs. Little concern exists about a donor's
retaining the right to revoke another's interest in a CGA, perhaps because the
right to revoke is not limited to a testamentary right or because any
consequences would affect the charity rather than the donor. 44
PIFs. As with CRTs, reserving the
right to revoke a PIF interest when the donor is not a beneficiary could be
viewed as creating an income interest potentially measured by the donor's
lifetime rather than the beneficiary's. 45
The Code and
Regulations do not prohibit a reservation of the right to revoke in that
situation. The Regulations permit a donor to retain the power to revoke the
interest of any beneficiary other than the charity that maintains the
PIF. 46
Also, the IRS sample instrument of transfer for a one-life interest in a PIF
specifically gives a donor the option of subjecting a beneficiary's lifetime
payments to the donor's retained testamentary right to revoke. 47
It seems unlikely that the IRS could validly argue that a transfer to a PIF
using its own sample revocation language disqualifies the fund or transfers to it.
48
Advantages
and disadvantages of retaining the right to revoke
Whether
retaining the right to revoke is the right decision for a particular donor will
depend on that donor's situation. It may be helpful to consider the
consequences of retaining the right.
If the
right to revoke is retained, the gift to the noncharitable
beneficiary is—at least to some extent—incomplete.
1. To the
extent that the gift is incomplete, there is no taxable gift, and no gift tax
is incurred on funding.
2. The donor
may apply the annual exclusion to the payments made to the beneficiary each
year as they are made. If the donor is likely to outlive the
beneficiary (or the term of a CRT), this may be the best approach.
3. The donor
will have the right to revoke the gift for nontax
reasons. For example, an income interest given to a spouse could be revoked if
the donor and spouse are later divorced. Similarly, unmarried partners may wish
to reserve the right to revoke in case the relationship ends. For CRTs,
however, divorce or other changes in circumstances may now be listed as qualified
contingencies to accomplish the same result. 49
4. If a CRT
were disqualified (which would also make the marital deduction unavailable),
the beneficiary's interest could be revoked. 50
5. Retaining
the right to revoke may be advantageous if the interest does not clearly
qualify for the marital deduction. For example, the marital deduction may not
be available for a CGA that makes payments first to the donor and then to the
donor's spouse. Yet, a donor contributing appreciated separate property to a
CGA may prefer to structure it with successive interests because it is unclear
if the Regulations require a donor to be the sole primary annuitant for the
transfer to be eligible for favorable capital gains treatment. 51
Both issues can be resolved by retaining the right to revoke the donee spouse's secondary interest.
6. If it is
difficult or unclear how to calculate the value of a noncharitable
beneficiary's income interest, it may be simpler for the donor to reserve the
right to revoke and thereby defer valuing the survivorship interest until it is
done for estate tax purposes.
If the donor retains the right to revoke through the donor's death
(or within three years of it), the value of the life income plan will be
included in the donor's taxable estate.
1. For a CRT
or a PIF, the value of the charity's remainder interest will be deductible, and
the noncharitable beneficiary's income interest will
be subject to estate tax, based on the values of these interests on the donor's
date of death. For a CGA, the value of the annuity on the date of death will be
subject to estate tax.
2. Under
current law, the donor's $1 million lifetime exemption from gift tax will be
smaller than the amount that can pass free of federal estate tax if the donor
dies in any year from 2004 through 2010. If the donor wishes
to preserve the gift tax exemption, or has already used it, postponing any
transfer tax until death may be advantageous. If the combined taxable
value of the beneficiary's interest and the rest of the donor's estate is less
than the donor's remaining applicable exclusion amount, no transfer tax may be
due on the interest at the donor's death. Thus, a donor could take a chance
that the estate tax burden in the future would be less than the gift tax burden
today.
3. The value
of the CRT's assets or the PIF units will increase the total value of the
donor's gross estate. Even if the donor revokes the noncharitable
beneficiary's interest, the charitable remainder interest will be included in
the donor's estate. This inclusion of value might necessitate filing an estate
tax return when one would not otherwise be required, and could also disqualify
the estate for special-use valuation under Section
2032A , stock redemptions to pay death taxes (
Section 303 ), or installment payment of estate tax for a closely held
business (
Section 6166 ). 52
4. For CGAs, if the right to revoke a survivor's annuity is not
exercised, then the value of the survivor's annuity will increase the total
value of the donor's gross estate, with the same potential consequences
described in the preceding paragraph. If the donor exercises the right to
revoke, nothing is included in the donor's estate because there is no
charitable remainder to include. 53
5. If both
the donor and the beneficiary live for a long time after the life income plan
is created, the charitable deduction for a CRT or PIF included in the donor's
estate could be more valuable, and the beneficiary's interest might be less
valuable, than on the date that the plan is created because the beneficiary
will be older. Alternatively, if the CRT or PIF assets have greatly
appreciated, the income interest could be worth more. If interest rates have
dropped steeply, the income interest in the life income plan could be more
valuable (particularly for a CRAT or CGA) because valuation of the income
interest is sensitive to a drop in interest rates.
If the
donor does not retain the right to revoke, the gift will be complete when the
life income plan is created.
1. The value
of the income interest will be subject to gift tax on funding of the life
income plan.
2. If the
donor is not a beneficiary, the plan and any appreciation on CRT assets or PIF
units will be excluded from the donor's estate.
3. For life
income plans that create a present interest, the donor may apply the annual
exclusion to the value of the beneficiary's income interest. If the value is
close to the current amount of the exclusion, the donor should consider not
retaining the right to revoke.
4. If the
donor expects estate tax to be due, it may be advantageous to pay gift tax
rather than estate tax because the value subject to gift tax is tax-exclusive,
whereas the value subject to estate tax is tax-inclusive. This advantage will
be lost if the donor dies within three years of making the gift because the
gift taxes would then be included in the donor's estate.
5. For a CRT
naming only a citizen spouse (or the spouse and donor) as income beneficiary,
the unlimited marital deduction will be available. A PIF naming only a citizen
spouse as beneficiary will also be eligible for an unlimited marital deduction
(but a PIF naming the donor as primary or as joint beneficiary will not
be eligible for the marital deduction). An immediate (nondeferred)
CGA solely for a citizen spouse will be eligible for the marital deduction, as
will an immediate (and probably a deferred) CGA naming only the spouse and
donor as joint-and-survivor annuitants.
The transfer
tax issues affecting life income plans are complex due to the differences in
the types of plans and the many ways they can be structured. We suggest the
following framework for analyzing transfer tax consequences:
- Is there a gift to another person?
- If there is a gift, is it eligible for the
annual exclusion?
- If a spouse is given an income interest, is it
eligible for the marital deduction?
- If there is a taxable gift, can it be avoided
by retaining a right to revoke the income interest?
- Do the costs of retaining the right to revoke
outweigh the tax and nontax benefits?
In some
circumstances, there will not be clear answers to all of these questions. In
all cases, a careful analysis of transfer tax consequences is essential in
determining whether the right to revoke should be reserved.
PRACTICE
NOTES
Retaining a right
to revoke does not affect the income tax charitable deduction because the
charity's interest is valued assuming that the donor will not exercise that
right.
See Hester and Turner, “Navigating the Transfer Tax
Maze of Charitable Life Income Plans,” 32 ETPL 32 (May 2005).
Regs.
1.664-2(a)(4) and 1.664-3(a)(4)
.
Regs.
1.664-2(a)(4) and 1.664-3(a)(4)
; Donaldson and Osteen, The Harvard Manual on Tax Aspects of Charitable
Giving, p. 313 (8th ed., 1999), citing Ltr. Rul. 8430006 .
Regs.
1.664-2(a)(5) , 1.664-3(a)(5)
, and 1.642(c)-5(b)(2)
; Rev.
Rul. 79-61, 1979-1 CB 220 ; Rev.
Rul. 79-243, 1979-2 CB 343 .
Section 514(c)(5) ; Reg.
1.514(c)-1(e)(1) .
Teitell, Deferred Giving:
Explanation, Specimen Agreements, Forms, Vol. 1, ¶4.07[c][2] (2000) (hereinafter “DG”); Minton, Charitable Gift
Annuities: The Complete Resource Manual, p. 2-11 (2004), citing Reg.
25.2511-2(c) .
Toce et al., Tax Economics of Charitable Giving, ¶¶19-14,
19.04[3]. (RIA 2004/2005).
Section 664(f) ; Rev.
Rul. 79-243, 1979-2 CB 343 ; Ltr. Rul. 9421047 .
Sections 2056(b)(7) , 2044
, and 2055(a)
.
Minton, supra note 8, at pp. 2-11 through 2-15.
Finestone, “Charitable Gift Annuities,” 29 ACTEC J. 37, 41, §5.3.1 (2003).
Charitable Giving Tax Service,
7-26 (R&R Newkirk Co., 2001) (hereinafter “CGTS”); Charitable Giving and
Solicitation, ¶¶23,090, 24,009 (RIA 1990) (hereinafter “CGS”).
CGTS, supra note 17, at 7-26 (2001), 9-33
(1994); CGS, supra note 17, at ¶23,086 (1990).
Tidd, “Transfer Tax
Considerations in Gift Planning,” Planning for Tomorrow: Eighth National
Conference on Planned Giving, XXIII-11 (10/11-14/95,
CGS, supra note 17, at ¶23,086 (1990).
CGS, supra note 17, at ¶23,090 (1990).
See the discussion of the marital deduction for gift
annuities in Part 1 of this article, supra note 1.
1979-2 CB 343.
Ltr. Rul. 8949061
, citing Sections
2503(b) and 2513(a)
.
Regs.
1.664-2(a)(4) and 1.664-3(a)(4)
.
Regs.
1.664-2(a)(5)(i) and 1.664-3(a)(5)(i) .
Teitell, DG, supra
note 8, at ¶2.11[F] (2002); Toce,
supra note 10, at ¶19.04[3].
Teitell, DG, supra
note 8, at ¶2.11[B][2] (2002) and ¶2.11[F] (2002); Toce, supra note 10, at ¶19.04[3].
Osteen, “More Than You Ever Wanted to Know About Charitable Remainder Trusts,” CASE, Advanced Planned
Giving Institute (3/12-14/97,
Ltr. Rul. 8120056
, citing Regs. 1.664-3(a)(4) and 1.664-3(a)(5)
.
Private letter rulings, of course, may not be used or
cited as a precedent and are directed only to the taxpayers who have requested
them. Section
6110(b)(3) .
CGTS, supra note 17, at 7-116(a) (1995).
CGTS, supra note 17, at 7-116(b) (1995).
Rev. Proc. 2003-55, 2003-31 IRB 242 .
Rev. Proc. 2003-53, 2003-31 IRB 230 .
Rev. Proc. 2003-55 , supra note 38, at
section 6.04.
Rev. Proc. 2003-56, 2003-31 IRB 249 .
Pusey, “Exploring the New
Model Charitable Remainder Annuity Trust Forms,” Gift Planner's Digest
(9/17/03).
Minton, supra note 8, at p. 2-11; Finestone, supra note 16, at p. 39, ¶4.2.3.
Toce, supra note 10,
at ¶19.04[3].
Rev. Proc. 88-53, 1988-2 CB 712 .
Section 664(f) ; Teitell,
DG, supra note 8, at ¶2.11[B][3] (2002).
Teitell, DG, supra
note 8, at ¶2.11[B][3] (2002).
Reg. 1.1011-2 (pertaining to the
spreading of capital gain over a donor's life expectancy).
Teitell, DG, supra
note 8, at ¶2.11[F] (2002), ¶3.20[B] (2002).
Minton, supra note 8, at pp. 2-11 through 2-15.
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Disclaimer
Reform: New Developments and Additional Reflections
The authors examine recent developments concerning disclaimers and
the Uniform Disclaimer of Property Interests Act, including devolution of a
disclaimed interest, disclaimer by a trustee, and partial acceptance of a
disclaimed interest.
Author:
ADAM J. HIRSCH AND RICHARD R. GANS, ATTORNEYS
ADAM J.
HIRSCH is the David M. Hoffman Professor of Law at
In a previous
article, 1
we offered a series of proposals for the revision of the Uniform Disclaimer of
Property Interests Act (“UDPIA” or “the Act”), 2
now grafted into the Uniform Probate Code (“the UPC”), 3
embodying the most recent effort by the National Conference of Commissioners on
Uniform State Laws (“NCCUSL”) to produce model legislation covering the
refusal, or “disclaimer,” of an inheritance. We urged NCCUSL to amend UDPIA
along the lines of our proposals. Failing that, we urged states that have
already adopted or hereafter adopt the Act to tinker with it along the lines we
suggested—a process under way in
Our previous
article has had an impact within both NCCUSL and the other prominent model
lawmaking body, the American Law Institute. In this article, we report on and
critique the respective reactions of these bodies to our proposals, along with
other recent developments in the realm of disclaimer law that merit
examination. We also reexamine part of our own analysis, coming to the
conclusion that one aspect of our original proposal was flawed and needs to be
corrected.
Revising
UDPIA
Our proposed
revisions of UDPIA were designed, among other things, (1) to require trustees
and other fiduciaries to gain court approval before executing a disclaimer, (2)
to limit disclaimer by a joint tenant to the amount by which the death of
another joint tenant increases the survivor's interest, (3) to ensure that a disclaimant can never dictate the identity of the
alternative beneficiary of the disclaimed property, (4) to clarify that a
disclaimer can be executed at any time (and not merely within a reasonable
time) after the death of the benefactor, (5) to give substantive effect under
state law to any disclaimer that is tax-qualified under the Internal Revenue
Code (“the IRC”) only as of the effective date of the disclaimer statute, not
as the IRC is subsequently amended, and (6) to bar common law disclaimers as an
alternative to statutory disclaimers.
At several
levels, we have been gratified by NCCUSL's response
to our proposals. As a structural matter, UDPIA's
Reporter accepts that “the Act provides a skeleton, a starting point, for
states to make their own policy decision[s]” regarding disclaimer law.
Accordingly, “the Florida process was exactly what had been contemplated by the
drafters.” 5
In adopting this stance, UDPIA's Reporter
demonstrates a welcome receptiveness to local variations in an area of law
where uniformity for its own sake is not an overriding concern.
What is more,
at its spring meeting in February 2005, the Joint Editorial Board of the
Uniform Probate Code (“the JEB”) took up the question of amending UDPIA itself,
in response to the suggestions put forward in our previous article. 6
The JEB elected to recommend that NCCUSL make two changes in the Act. First,
the JEB proposes to alter section 6 of UDPIA dealing with the devolution of disclaimed
interests to remove any possibility that the disclaimant
could name the alternative beneficiary. The members have yet to resolve how
they will accomplish this result, however, and no draft language is yet on the
table. We shall address this problem at greater length below.
Second, the
JEB proposes to revise the comment accompanying section 14 of UDPIA, which
gives substantive effect to any disclaimer that is tax-qualified under the IRC
as presently enacted or subsequently amended. As we pointed out in our
previous article, this provision may violate state constitutions as a
delegation of powers or an incorporation by reference.
7
The JEB will recommend that the accompanying comment flag this hazard, leaving
it to local drafters to assess whether the provision requires amendment on a
state-by-state basis; the JEB suggests no changes in the language of the
provision itself.
Both of these
decisions by the JEB are commendable, although in our view they remain
insufficient. UDPIA reflects additional dubious policy judgments, together with
seeming failures of technical virtuosity, with which we took issue in our
previous article. Most troubling of all, UDPIA will continue to allow joint
owners to disclaim more than they inherit, 8
an eccentric rule that facilitates manipulations to avoid creditors' claims
that would otherwise constitute fraudulent conveyances. 9
We stand by our proposals to rework the Act. Yet, wholesale revision of UDPIA
so soon after its promulgation was probably not in the cards. That is a task
local drafting committees will have to undertake, as the one in
Devolution
of a disclaimed interest
In our
previous article, we proposed to amend UDPIA to restore the conventional rule
of previous Uniform Acts and most state statutes that a disclaimed interest
passes “as if the disclaimant had predeceased the
benefactor.” 10
By comparison, UDPIA provides that the disclaimed interest passes “as if the disclaimant had died immediately before the time of distribution.”
11
UDPIA's revision makes no difference when the
disclaimed interest comprises a present interest, because the time of
distribution is also the time when the benefactor dies. When a future interest
is at issue, though, these two moments in time differ.
UDPIA's rule is potentially disastrous in connection with
disclaimers of vested future interests. In the vast majority of jurisdictions,
a vested future interest is devisable, so a disclaimed interest that devolves
as if the disclaimant died just before the interest
becomes possessory would go to whomever the disclaimant names as devisee, an unprecedented substantive
result, 12
and one that is incompatible with tax-qualifying the disclaimer under the IRC.
13
It is this concern, highlighted in our previous article, 14
that underlies the JEB's recommendation to amend
UDPIA in some as yet undetermined way.
By proposing
to dial back the time of the disclaimant's
constructive death to before that of the benefactor (i.e., before the interest
was created), we intended to ensure that the disclaimant's
will would play no role in determining the disposition of a disclaimed future
interest. Alas, to paraphrase John Chipman Gray,
drafting disclaimer legislation is a constant school of modesty. 15
A difficulty remains with this conventional rule, insofar as it applies to
disclaimed interests under will substitutes (living trusts and the like). 16
And so we have returned to the drawing board.
In substance,
will substitutes are the functional equivalent of wills. As such, public policy
dictates that beneficiaries' interests under will substitutes be treated the
same as bequests under wills; both, in other words, ought to comprise
expectancies. Historically, however, lawmakers validated will substitutes as nontestamentary, nonprobate
instruments by conceptualizing them as inter vivos
transfers. 17
Hence, in theory if not in reality, beneficiaries' interests under will
substitutes comprised inter vivos transfers of vested
future interests (subject to divestment upon exercise of the benefactor's right
of revocation) following the interest retained by the benefactor.
This legal
fiction his proven remarkably resilient; to this day, in any particular state, and
with no apparent inter- or even intra-jurisdictional consistency, any given
sort of will substitute may be deemed to constitute either an expectancy or a
vested future interest. The matter depends on the vagaries of local law, which
(in light of spotty legislation and court rulings) may not even be clearly
resolved.
If, under
local law, a beneficiary's interest under a particular sort of will substitute
constitutes a vested future interest, it could be devisable, even prior to the
death of the benefactor. 18
If the disclaimed interest created under such a will substitute were to devolve
as though the disclaimant predeceased the benefactor
(as we had proposed), the interest would again go to the disclaimant's
devisee, an unacceptable outcome. This problem also crops up under UDPIA's rule that a disclaimed interest passes as if the disclaimant dies just prior to the time of distribution,
which is equivalent to just before the benefactor's death in the case of a will
substitute.
UDPIA's Reporter has suggested one means of removing the
possibility that a disclaimant's devisee could ever
take as alternative beneficiary. He proposes to amend UDPIA so that a
disclaimed interest is treated as if the disclaimant
had died intestate (or, alternatively, intestate and unmarried)
immediately before the time of distribution. 19
This proposal displays two virtues: It is economical, requiring only a small
modification of the current language of UDPIA; and it is serviceable,
unquestionably taking the disclaimant's devisee out
of the equation. Perhaps this concept will now provide the framework for the
Act's prospective revision. Whether there are better ways to solve the problem,
however, remains an open question.
The law
governing devolution of disclaimed interests, like that of inheritance law in
general, has been informed by an essential principle: Effectuate the intent of
the benefactor. A benefactor who anticipates the possibility of a disclaimer is
free to determine who receives the bequest in lieu of the disclaimant
under the terms of the estate plan. 20
It follows that, in the absence of such an express contingency, lawmakers ought
to provide a default rule that accords with the benefactor's probable intent.
21
Lawmakers
have traditionally sought to do so by amalgamating the problem of disclaimer
with its structural correlate, the problem of lapse (and antilapse).
Lapse and antilapse laws dictate the alternative
disposition of bequests to persons who likewise give up their inheritance, in
this instance because they cannot accept them, having predeceased the
benefactor. Here, lawmakers assume that when a predeceasing beneficiary is a
close blood relative of the benefactor, the benefactor would likely care enough
about the beneficiary's descendants to want them take the inheritance in the
decedent's place. On the other hand, if the predeceasing beneficiary was, say,
a friend or an employee, the benefactor is less likely to have had a
relationship with the decedent's descendants sufficient for the benefactor to
view them as testamentary surrogates. Under these conditions, the benefactor
would probably prefer to substitute for the decedent the benefactor's own
residuary legatee.
The doctrine
of lapse, as modified by antilapse statutes,
accomplishes this intent-premised result in connection with wills. 22 Disclaimer laws treating
beneficiaries under wills who choose not to inherit as having constructively
predeceased the benefactor produce the same result.
Under the
Reporter's proposal, however, this symmetry would disappear in connection with
will substitutes. Whereas disclaimed interests under wills would continue to be
governed by the principles of lapse and antilapse,
flowing either to the disclaimant's descendants or to
the benefactor's residuary legatee depending on the benefactor's relationship
to the disclaimant, disclaimed interests under will
substitutes—when found under local law to comprise vested future
interests—would instead devolve as if the disclaimant
died intestate before the time of distribution, and hence would pass to the disclaimant's intestate heirs (but not devisees),
irrespective of the relationship between disclaimant
and benefactor. The disclaimed interest would never devolve to the benefactor's
residuary legatee.
Now, there is
an argument for disconnecting the rules of disclaimer from the rules of lapse.
23
Unlike predeceasing beneficiaries, surviving beneficiaries have a say in
whether they will accept or decline an inheritance. If they are unhappy with
the alternative disposition of a disclaimed inheritance, they will not choose
to disclaim. Benefactors who care enough about beneficiaries to provide for
them ought to want to make them still better off by making disclaimers as
attractive as possible for them, thereby giving them the opportunity to send an
inheritance on, tax-free, to those whom the disclaiming beneficiaries would
most like to have it—presumably their own heirs. In other words, benefactors
should themselves intend whatever result beneficiaries prefer.
Persuaded by
this logic, the Commissioners initially included in the draft of UDPIA a
provision giving disclaimed bequests under wills to the disclaimants' heirs. But, fearful of controversy, the
Commissioners ultimately shied away from this idea and, in the promulgated
version of the Act, restored the connection between disclaimer and lapse. 24
To revise
UDPIA as its Reporter suggests would resurrect a proposal the Commissioners
explicitly rejected—not necessarily a bad thing—yet in the process would
introduce a structural inconsistency into the Act between its treatment of
disclaimers under wills and under will substitutes, arbitrarily disconnecting
disclaimer from lapse only as concerns will substitutes, which is somewhat more
troubling.
In fact, one
can also make a case on substantive grounds for the traditional connection
between lapse and disclaimer, best illustrated by a hypothetical. Suppose a
benefactor has a sister and two nieces, one of whom the benefactor dislikes.
The benefactor might well execute an instrument providing for the sister with
the caveat that if the sister predeceases him, only the favored niece would
take in his sister's place. Suppose further that the sister survived and
disclaimed, a contingency not provided for in the instrument. Cold-blooded
logic might suggest that the benefactor would want to facilitate a disclaimer
in favor of both of the sister's children, in order to augment the
sister's utility, but human nature suggests otherwise.
The same
psychology may well apply less dramatically to simple instances of disclaimer
by beneficiaries unrelated to the benefactor. The benefactor could conceive of
gifts to unrelated persons as intended for their own consumption. If these
persons predecease, or simply do not wish to accept the gift, the benefactor
would prefer to substitute his relatives as beneficiaries, following the
rules of lapse.
It was the
first hypothetical, offered by a “prominent lawyer” at a meeting of the Council
of the Louisiana State Law Institute that convinced the Institute to recommend
repeal of a recent
For state
lawmakers who prefer to ensure that disclaimed interests under will substitutes
devolve according to the rules of lapse, we recommend adding to disclaimer
statutes (including our proposed modification of section 6 of UDPIA) a
provision stating: “For purposes of this section, a disclaimed interest in a
[list all will substitutes acknowledged in the jurisdiction that do not already
lapse with certainty under statutory or case law] shall pass as if the interest
had been created under a will.” Combined with the rule that a disclaimed
interest devolves as if the disclaimant predeceased
the benefactor, this language ensures that disclaimed interests under will
substitutes lapse, and also follow the dictates of the local antilapse statute.
One drawback
of this solution is that it requires a degree of legislative vigilance: “New
kinds of nonprobate transfers are invented every
year,” 27
and these might have to be added to the list contained in this provision by
amendment. Furthermore, to the extent that uncertainty surrounds the rules applicable
to predeceasing beneficiaries of will substitutes, inclusion on the list in the
disclaimer provision could potentially produce inconsistencies down the road.
If, for
example, living trusts were placed on the list, and a subsequent case resolved
that interests in living trusts are implicitly contingent on survival under
local law without being subject to the antilapse
statute, 28
then lapsed and disclaimed interests would again devolve differently. Once
again, the legislature would have to take action to amend either the antilapse statute (adding living trusts) or the disclaimer
statute (striking living trusts from the list) if it wished to eliminate the
inconsistency.
These dynamic
concerns to one side, our provision deals effectively with the problem of
survival contingencies. Suppose that a jurisdiction included living trusts (for
example) under our provision, and a benefactor inserted in a trust instrument a
clause stating that an interest created therein was contingent on surviving the
benefactor, naming an alternative taker in the event the primary beneficiary
predeceased, but without making an explicit provision for a disclaimer. If the
beneficiary survived and proceeded to disclaim the interest, the contingency
clause would still take effect by implication. This result follows because our
provision requires one to imagine that the disclaimer had occurred under a
will. Under a will, the disclaimed interest passes as if the bequest had
lapsed; and if the bequest lapsed, then the clause providing for its
alternative disposition in the event of lapse would supersede the rules of
lapse.
Accordingly,
whether or not a benefactor takes contingencies into account, our proposed
provision maintains symmetry between lapse and disclaimer, ensuring that
alternative beneficiaries are the same in both cases. 29
Disclaimer
by a trustee
Under the
common law together with the vast majority of non-Uniform state statutes and
prior Uniform Acts, a trustee cannot (without authority in the governing
instrument) disclaim trust property. Instead, it is up to beneficiaries to make
that decision for themselves. On the other hand, other
sorts of fiduciaries (guardians, executors, etc.) are allowed to disclaim as
surrogates for beneficiaries who cannot make that decision for
themselves under many state statutes. Quite a few of those statutes require the
fiduciary first to obtain a court order authorizing the disclaimer, although
some do not. 30
Without
explanation or even articulation of the shift, UDPIA extends the right of
disclaimer to all fiduciaries, including trustees. Furthermore, under UDPIA,
all fiduciaries (including trustees) can disclaim gratuitous transfers to
beneficiaries, or to trusts for beneficiaries, without the beneficiaries' approval
and without court order. 31
If a trustee executes a disclaimer against the wishes of beneficiaries, their
only recourse is to sue for breach of the trustee's fiduciary duties. 32
We rejected
this approach in our previous article. Particularly among unsophisticated
trustees, an unfettered power to disclaim carries the potential for abuse and
threatens to embroil parties in unnecessary litigation after the fact. This
power also creates an anomaly in jurisdictions that elsewhere mandate more
restrictive oversight for other fiduciaries.
Consider the
UPC. By incorporating UDPIA, the UPC gives both trustees and other fiduciaries
the power to disclaim without court order. 33
Yet, a separate provision of the UPC directed specifically to the powers of
conservators mandates that a conservator can execute a disclaimer only “upon
express authorization of the court.” 34
This qualification continues to apply, because the general power of fiduciaries
to disclaim under UDPIA, and now under the UPC, operates “[e]xcept to the extent a fiduciary's right to disclaim is
expressly restricted or limited by another statute of this State,” 35
which another provision of the UPC would surely be.
Hence the
anomaly: The UPC embraces as a public policy the notion that decisions to
reduce the potential wealth of persons under a disability merit judicial
oversight, 36
and accordingly limits a conservator's power to disclaim. Yet, seemingly
contrary to this policy, the UPC allows the trustee of a trust for a
person under a disability to disclaim unimpeded. For no apparent reason, a
trustee can do what a conservator cannot.
In our
previous article, we instead proposed to extend the right of disclaimer to a
trustee (along with other fiduciaries) but only with the approval of the court,
unless the governing instrument provides otherwise. 37
Under our proposal, the safeguard of prior judicial oversight applies uniformly
to all fiduciaries.
The American
Law Institute has now turned its attention to this issue. The Restatement
(Third) of Trusts is a work in progress, parts of which have already been
promulgated, and other parts of which remain in draft. It establishes a model
common law of trusts, often cited as authority by state courts, which would
have relevance in those jurisdictions where disclaimer statutes establish
nonexclusive rules, supplemented by common law. 38
The latest
tentative draft of the Restatement (Third) proposes to allow trustees, for the
first time, to disclaim property that would otherwise flow into the trust.
39
No prior authorization by the court would be required but, as an alternative
safeguard, the draft proposes to require trustees to inform beneficiaries of a
contemplated disclaimer before the fact. 40
Under this framework, beneficiaries could not “veto ... the trustee's plan of
action,” but they would have “an opportunity to express their concerns,” and,
if necessary, to initiate judicial proceedings to enjoin the trustee from
acting. 41
The drafters of the Restatement (Third) consider their proposal “a position
between the position” advocated in our previous article and the one taken by UDPIA,
avoiding “the delays (which might be fatal, especially in a tax context) and
costs of obtaining court approval,” while still enabling beneficiaries to
protect their interests. 42
The drafters
of the Restatement (Third) are probably correct to surmise that a trustee's
duty to furnish information to beneficiaries before the trustee acts affords
them sufficient protection in the case of private trusts for competent
beneficiaries. In the case of minor, unborn, or incapacitated trust beneficiaries,
however, there is no middle ground: Fiduciaries representing the interests of
these beneficiaries must either be subject to judicial supervision, or not. In
jurisdictions where disclaimer statutes or other laws require court approval
for a disclaimer by conservators or guardians, a rule permitting a trustee to
disclaim merely by notifying beneficiaries (or in this instance, presumably,
their representatives 43)
in advance defeats the purpose of the safeguard.
This rule
also appears inadequate in connection with charitable trusts. Like UDPIA, the
draft of the Restatement (Third) draws no distinction between the trustee's
power to disclaim property bequeathed to private and charitable trusts. In the
context of a charitable trust, the trustee's duty to inform beneficiaries of a
planned disclaimer presumably is owed to the state attorney general. Yet,
experience shows that attorneys general are notoriously inattentive to the
charitable trusts they are supposed to monitor. Court ratification of disclaimers
by trustees of charitable trusts may well provide a level of scrutiny that, in
practice, is difficult to duplicate otherwise.
Even in the
case of private trusts for competent beneficiaries, the benefits of switching
from a court-monitored to a beneficiary-monitored regime are not manifest. The
administrative costs of court approval in all cases need to be weighed against
the costs of litigation over disclaimers by unsophisticated trustees that will
likely ensue absent a requirement of prior court approval.
Although the
deadlines imposed by the IRC can add an element of urgency to the process of
disclaiming, these should not stand in the way of a court-monitored regime.
Clerks of courts can expedite hearings in time-sensitive matters. 44
Furthermore, under the statutory scheme we recommend, courts can come to a
decision quickly, if necessary: Although some state statutes require proof that
a disclaimer contemplated by a fiduciary meets some standard (such as the
"best interest" of the beneficiary), our proposed provision frees
courts to consider the totality of the circumstances 45
and hence to make do with less evidence if a tax deadline looms. Alternatively,
competent beneficiaries can execute disclaimers of trust property themselves.
Nevertheless,
the Restatement draft may offer a workable alternative to our proposal; and the
notification model at least improves on UDPIA's
approach, which relies exclusively on the power to sue trustees after the fact
for breach of fiduciary duty to protect beneficiaries' interests.
Partial
acceptance of disclaimed interest
Under common
law, once a beneficiary accepts inherited property, it can no longer be
disclaimed. The decision to accept is irreversible. Most state disclaimer
statutes (and the IRC) have codified this rule. UDPIA likewise provides that
“[a] disclaimer of an interest in property is barred if ... the disclaimant accepts the interest sought to be disclaimed.”
46
Our previous article proposed no revision of this language.
Like most
preexisting statutes, UDPIA does not elaborate on what constitutes acceptance,
allowing courts to flesh out its meaning on a case-by-case basis. 47
Given the variety of fact patterns that could arise, this decision appears
wise. The issue has produced a fair bit of litigation over the years, and a
store of case law on the matter has gradually built up, increasing the rule's
clarity. 48
Nevertheless, legislators in a few states have tinkered in small ways with the
statutory parameters of the acceptance bar. 49
Even without such tinkering, the Commissioners can use the comments
accompanying UDPIA to clarify how they wish its general language concerning
acceptance to be interpreted. A recent decision on point suggests the expediency
of adding such a clarification to the sub-text of UDPIA.
In Whitney
v. Faulkner, 50
following the death of the settlor of a living trust,
one of the beneficiaries took possession of several minor items of tangible personalty, as the trust provided. 51
Thereafter, but prior to the distribution of the cash within the trust, the
same beneficiary executed a document ostensibly disclaiming “ all ...
right, title, interest, or claim as a beneficiary of the estate.” 52
The $29,244 that otherwise would have gone to the beneficiary was then
distributed to the alternative taker. A creditor of the beneficiary sought to
garnish the cash in the hands of the alternative taker, on the theory that the
beneficiary's receipt of the tangible personalty
barred his disclaimer in its entirety.
The Utah
Supreme Court held for the creditor: “Having accepted property representing a
portion of the interest he purported to completely disclaim, [the beneficiary]
is legally barred from disclaiming that interest.” 53
This result, the court insisted, comports with both “the language and policy of
the statute.” 54
In actuality,
the court's holding is dubious on both counts. The statutory bar on disclaimer
as set out in Utah (and under UDPIA) is triggered by “acceptance of the
property,” 55
not by acceptance of any part of the property. The statute fails to
address explicitly the consequences of partial acceptance, but it would be well
within the bounds of orthodox construction to interpret the statutory bar as
operating pro tanto on whatever part of the
property the beneficiary accepts. In a recent letter ruling, the IRS addressed
a fact pattern equivalent to the one in Whitney, and construed the IRC's
analogous statutory bar 56
in precisely this way, tax-qualifying what was technically a complete
disclaimer as a partial disclaimer. 57
Alternatively,
even if the statute were construed to bar the disclaimer in its entirety, it
need not be read to preclude the beneficiary from executing a second, more
limited disclaimer thereafter. In other words, if a disclaimer of all
the property is now barred by its partial acceptance, the beneficiary could
still be allowed subsequently to execute a partial disclaimer of that
part of the property not accepted by the beneficiary. Nothing in the statute
rules out such a sequence, notwithstanding the Whitney court's assertion
to the contrary. 58
Nor do either of these interpretations contradict public policy.
The function of the acceptance bar is to protect creditors who might extend
credit based on the beneficiary's apparent ownership of inherited property.
59
Because the beneficiary never took possession of that part of the property
which he wishes to disclaim, no creditor could claim to have been deceived into
lending by the beneficiary's actions. Nor is anyone else's interest affected:
Personal representatives will know their duties upon receipt of an overbroad
disclaimer, which can cover only whatever property remains undistributed within
the probate estate.
Moreover, the
beneficiary in Whitney could have achieved the result he wished to
achieve by more precise drafting. Had he initially disclaimed only the cash
portion of the inheritance, the disclaimer would unquestionably have been
effective. The court's insistence on this degree of irremediable precision,
exalting form over substance, merely creates a trap for the unwary. As always,
such traps are more likely to be sprung upon poorer, less well-counseled,
beneficiaries, who suffer disproportionately as a consequence.
Because
disclaimer statutes, including UDPIA, are currently silent on the issue raised
by Whitney, litigation along the same factual lines could arise in other
states. If and when the issue surfaces again, the decision in Whitney
could be cited as extra-jurisdictional authority. We urge other courts to
reject Whitney as poorly reasoned, both as a matter of statutory
construction and as a matter of public policy. Likewise, we urge the
Commissioners to amend the comments accompanying UDPIA to make clear that its
bar on disclaimer following acceptance of an interest in property, employing
statutory language very similar to that construed in Whitney, was not
intended to hinder partial disclaimers. By adding an explicit rejection of Whitney
to the relevant comment, 60the
Commissioners will help both to forestall litigation and to achieve a
preferable substantive result.
Conclusion
Just as UDPIA
is not the last word in the story of disclaimer reform, neither are our
proposals for the Act's revision. Doubtless, local drafters can continue to
raise questions leading to the improvement of disclaimer law, questions that we
have overlooked. One of the dangers implicit in model lawmaking, however, is
that the erudition of its architects and the prestige of the organizations that
endorse it will blind local drafters to the need for independent reflection. We
would caution drafters to resist this inclination.
If our
experience in drafting the
See Hirsch and Gans,
“Perfecting Disclaimer Reform: Suggestions for a Revised Uniform Act,” 31 ETPL
185 (Apr. 2004).
8A U.L.A. 159 (2003)(as
amended 2002). Promulgated in 1999, UDPIA was incorporated into the Uniform
Probate Code (“UPC”) in 2002. UPC §§2-1101-17 (as amended
2002).
UPC §§2-1101-17 (as amended 2002).
The
Minutes of the meeting of the Legal Education
Committee, ACTEC Annual Meeting, 3/13/04 (remarks by Professor William LaPiana); see also LaPiana,
“Uniform Disclaimer of Property Interests Act,” UTC Notes, at 17, 18 (Summer
2004).
See LaPiana, supra note 5, at 18. The minutes of the JEB's spring meeting, 2005, are not yet available.
Hirsch and Gans, supra
note 1, at 192.
UDPIA §7(a). See also Minutes
of the JEB Spring Meeting, at 27 (Feb. 2004) (raising concern about this
provision, which the JEB nevertheless has now declined to amend).
Hirsch, “The Uniform Disclaimer of Property Interests
Act: Opportunities and Pitfalls,” 28 ETPL 571, 574 (Dec. 2001)(hereinafter
“Hirsch, Uniform”); Hirsch and Gans, supra
note 1, at 189-90, 192; Hirsch, “Revisions in Need of Revising: The Uniform
Disclaimer of Property Interests Act,”
Hirsch and Gans, supra
note 1, at 188-89. See UPC §2-801(d)(pre-2002 art.
II), in 8 U.L.A. 207-08 (1998).
UDPIA §6(b)(3)(A).
A beneficiary can of course assign an interest,
but only after accepting it.
For discussions, see Hirsch and Gans,
supra note 1, at 188-89; Hirsch, Revisions, supra note 9, at
175-78; Hirsch, Uniform, supra note 9, at 580.
Cf. Gray, The Rule Against
Perpetuities at xi (4th ed., 1942).
We thank Professor William LaPiana
for bringing this difficulty with our proposal to our attention.
For a discussion of the historical evolution of will
substitutes, see Hirsch, "Inheritance Law, Legal Contraptions, and the
Problem of Doctrinal Change," 79 Or. L. Rev. 527,
542-46 (2000).
That is the rule concerning living trusts in
LaPiana, “Some Property Law
Issues in the Law of Disclaimers,” 38 Real Prop., Prob. and Tr. J. 207, 218-19
(2003).
E.g., UDPIA §6(b)(2).
Hirsch, “Default Rules in Inheritance Law: A Problem
in Search of Its Context,” 73 Fordham L. Rev. 1031 (2004).
See Hirsch, “Inheritance and
Inconsistency,” 57
One of us was once persuaded by the argument but has
since reconsidered his position. See Hirsch, Revisions,
supra note 9, at 165.
The story is recounted in Hirsch, Revisions,
supra note 9, at 163-68.
Letter from Professor Cynthia Samuel, Tulane School of
Law, to the authors (8/29/03); see also Samuel, “The 1997 Successions and
Donations Revision—A Critique in Honor of A.N. Yiannopoulos,”
73 Tul. L. Rev. 1041, 1060-61 (1999).
La Civ.. Code art. 965
(2000 and Supp. 2003).
Wellman and Brucken, “NCCUSL
to Your Rescue: New UPC Sec. 6-102,” 26 ACTEC Notes 361, 361 (2001).
According to the American Law Institute, antilapse statutes should be construed to apply to will
substitutes that are otherwise subject to lapse. Restatement (Third) of
Property: Donative Transfers §5.5 cmt.
p (1999). Whether a court will agree, however, is far
from clear.
For still another possible solution to the problem of
the devolution of will substitutes, albeit with difficulties of its own, see
the Uniform Disclaimer of Transfers Under Nontestamentary Instruments Act (1978) (withdrawn).
Hirsch, Revisions, supra note 9, at 132-33,
146.
UDPIA §§5(b), 8. This rule
applies to trusts unless the governing instrument expressly provides otherwise.
UDPIA §8 cmt.
UPC §2-1105(b).
UPC §5-411(a)(6).
UPC §2-1105(b).
“Monitoring of ... conservatorships
is critical.” UPC art. 5, prefatory
note.
Hirsch and Gans, supra
note 1, at 187.
Although our proposal calls for a disclaimer statute
to operate as an exclusive source of disclaimer law (see id. at 186),
some existing statutes, together with UDPIA, do not. UDPIA
§§4, 13(e).
Restatement (Third) of Trusts
(“Rest. 3d”) §§85(1)(a), 86 and cmt. f (tentative draft no. 4)
(4/5/05). Cf. Restatement (Second) of Trusts (“Rest. 2d”)
§102 and cmts. (1959).
Rest. 3d §§82(1)(c) and cmt. d,
86 and cmt f.
In those instances where a trustee wishes to disclaim
the inheritance of a minor, unborn, or incapacitated trust beneficiary for whom
no guardian of the property has been appointed, it would seem the court must
appoint a guardian ad litem in order for the trustee
to carry out the notification obligation. Hence, under the Restatement draft
judicial action prior to disclaimer by a trustee may still be necessary. Cf. Id. §82 cmt. a(1).
A formal motion to shorten time may be available,
depending on the jurisdiction.
Hirsch and Gans, supra
note 1, at 187.
UDPIA §13(b)(1).
See Annot., “What Constitutes or Establishes Beneficiary's Acceptance
or Renunciation of Devise or Bequest,” 93 ALR2d 8 (1964); Reg.
25.2518-2(d)(1) .
See
To wit, “television equipment and household items, a
kiln, and an opal ring.” 95 P.3d at 271.
The beneficiary “did not comply with the statutory
requirements for a partial disclaimer, and cannot now avail himself of its
protections.” 95 P.3d at 274. The court offered no
statutory analysis to support this conclusion.
See In re Kolb, 326 F.3d 1030 (CA-9,
2003) (holding that the acceptance bar applied when a beneficiary listed the
interest he later sought to disclaim on a loan application). For additional
references, see Hirsch, Revisions, supra note 9, at 127 and n.95.
UDPIA §13 cmt.
© Copyright 2005 RIA. All rights reserved.
How Circular
230 Final Regs. Will Affect Estate Planners
Author:
MICHAEL D. MULLIGAN, ATTORNEY
MICHAEL D. MULLIGAN is a member in the St. Louis office of the law
firm of Lewis, Rice & Fingersh, L.C. He is also a Fellow
of the
Because estate planning transactions fall within the requirements
of Circular 230, practitioners should take steps to ensure compliance with the
mandates of Circular 230 and the recently issued final Regulations.
Pursuant to 31 U.S.C. section 330 , the Secretary of the
Treasury has published Regulations in Circular 230 regulating practice before
the Treasury Department. On 12/30/03, the Treasury and the IRS issued Proposed
Regulations governing “tax shelter opinions.” 1
These Proposed Regulations were discussed in a previous Estate Planning article
by this author 2
(hereinafter referred to as the “previous article”).
Final
Regulations modifying Circular 230 were issued on 12/17/04, 3
with an effective date postponed until 6/20/05. The Preamble to the final
Regulations states that the effective date of the final Regulations was
postponed to eliminate any adverse impact that the adoption of the new
requirements for written advice could have on pending or imminent transactions.
This author's
previous article commented on the breadth of the definitions of the terms “tax
shelter” and “tax shelter opinion” in the Proposed Regulations. It observed
that the definitions in the Proposed Regulations might encompass a written
description of an estate planning technique for a client which the practitioner
does not intend to rise to the level of a formal opinion.
Evidently
seeking to avoid the adverse connotations associated with the term “tax
shelter,” the final Regulations have abandoned that term in favor of the term
“covered opinion.” However, instead of remedying potential problems which the
previous article pointed out with respect to the Proposed Regulations, the
final Regulations actually make matters worse.
Final Reg.
10.33 prescribes “best practices” that should be followed by tax advisors, and
provides that a tax advisor with responsibility for overseeing a firm's tax
practice should take steps to ensure that the firm's procedures are consistent
with best practices.
Reg.
10.35 contains rules governing the contents of “covered opinions.” Reg.
10.36 contains procedures designed to ensure compliance with the
requirements of Reg.
10.35 . Reg.
10.37 sets forth requirements for other written advice that is not governed
by Reg.
10.35 .
Reg.
10.38 authorizes the Director of the Office of Professional
Responsibility to establish one or more advisory committees composed of
individuals authorized to practice before the IRS for the purpose of reviewing
and making general recommendations regarding professional standards or best
practices for tax advisors. This article does not discuss Reg.
10.38 .
Reg.
10.52 prescribes sanctions for violations of Reg.
10.35 , 10.36
, or 10.37
. Sanctions apply only if a practitioner has acted willfully, recklessly,
or through gross incompetence.
Best
practices
Reg.
10.33 identifies what the Preamble describes as “aspirational”
(not mandatory) practices which should be followed by tax advisors. According
to Reg.
10.33 , tax advisors should provide clients with the highest quality
representation concerning federal tax issues by adhering to best practices in
providing advice and in preparing or assisting in the preparation of a
submission to the IRS. Best practices include the following:
(1) Communicating clearly with the client
regarding the terms of the engagement. For example, the advisor should
determine the client's expected purpose for, and use of, the advice and should
have a clear understanding with the client regarding the form and scope of the
advice or assistance to be rendered.
(2) Establishing the facts, determining which
facts are relevant, evaluating the reasonableness of any assumptions or
representations, relating the applicable law (including potentially applicable
judicial doctrines) to the relevant facts, and arriving at a conclusion
supported by the law and the facts.
(3) Advising the client regarding the import
of the conclusions reached, including, for example, whether a taxpayer may
avoid accuracy-related penalties under the Internal Revenue Code if the
taxpayer acts in reliance on the advice.
(4) Acting fairly and with integrity in
practice before the IRS.
Reg.
10.33 states that tax advisors with responsibility for overseeing a
firm's practice of providing advice concerning federal tax issues or of
preparing or assisting in the preparation of submissions to the IRS should take
reasonable steps to ensure that the firm's procedures for all members,
associates, and employees are consistent with best practices. Because the
provisions of Reg.
10.33 are “aspirational” and not mandatory, a
practitioner is not subject to sanction for violations of Reg.
10.33 . It is likely, though, that the provisions
of Reg.
10.33 will be referred to in malpractice actions as establishing a standard
for professional conduct.
Covered
opinions
Reg.
10.35 sets forth standards that apply to “covered opinions.” This
Regulation defines a “covered opinion” as written advice (including electronic
communications) by a practitioner concerning one or more “Federal tax issues”
arising from:
- A transaction that is the same as or
substantially similar to a transaction identified as potentially abusive
under Reg.
1.6011-4(b)(2) (a “listed transaction”);
- Any entity, plan, or arrangement the
“principal purpose” of which is the avoidance or evasion of any tax
imposed by the Internal Revenue Code; or
- Any entity, plan, or arrangement a
“significant purpose” of which is the avoidance or evasion of any tax
imposed by the Internal Revenue Code if the written advice is: (1) a
“reliance opinion,” (2) a “marketed opinion,” (3) subject to “conditions
of confidentiality,” or (4) subject to “contractual protection.”
A “Federal
tax issue” is a question concerning the federal tax treatment of an item of
income, gain, loss, deduction, or credit, the existence or absence of a taxable
transfer of property, or the value of property for federal tax purposes. The
definition of “covered opinion” includes written communications (including
email) which do not rise to the level of a formal opinion. As with the Proposed
Regulations, this breadth of coverage is a significant issue with respect to
the final Regulations. The term “covered opinion” does not include written
advice provided to a client during the course of an engagement if a
practitioner is reasonably expected to provide a subsequent written advice to
the client that satisfies the requirements of Reg.
10.35 .
`Significant purpose' transactions. Although listed third
in the definition of covered opinions, this article will discuss “significant
purpose” transactions first. One reason for discussing “significant purpose”
transactions first is to illustrate the exceptions to “significant purpose”
status which are not available with respect to either “listed” transactions or
“principal purpose” transactions.
Besides the
requirement that the avoidance or evasion of tax be a
significant part of the transaction, a “significant purpose” transaction must
have an additional element before the written advice becomes a covered opinion.
Such written advice must be a “reliance opinion,” a “marketed opinion,” subject
to “conditions of confidentiality,” or subject to “contractual protection.”
Reliance opinion. Written advice is a “reliance opinion” if the
advice concludes at a confidence level of more likely than not (a greater than 50% likelihood) that one or more significant
federal tax issues would be resolved in the taxpayer's favor. Written advice given
in a “significant purpose” transaction (but not a “listed” transaction or a
“principal purpose” transaction) which concerns the qualification of a
qualified plan, is a state or local bond opinion, or is included in documents
required to be filed with the Securities and Exchange Commission is not a
covered opinion.
For reliance
opinion status, not only must the written advice relate to a federal tax issue,
that issue must be significant. Under the final Regulations, a federal tax
issue is significant if the IRS has a reasonable basis for a successful
challenge and its resolution could have a significant impact—whether beneficial
or adverse and under any reasonably foreseeable circumstance—on the overall
federal tax treatment of the transaction(s) or matter(s) addressed in the
opinion.
Written
advice that does not relate to an issue with respect to which the IRS has a
reasonable basis for challenge is not a reliance opinion, and therefore not a
covered opinion which must satisfy the stringent requirements of Reg.
10.35 . This exception makes sense. There are many
federal tax issues on which an estate planner may given written advice with
respect to which there is no basis or reason for challenge by the Service
(e.g., qualifying for the estate or gift tax marital or charitable deduction by
following the conditions established by applicable statutes and Regulations).
Reg.
10.35 does not define “reasonable basis.” However, Reg.
1.6662-3(b)(3) also uses the term in describing
the level of authority needed to avoid a negligence penalty. In that
Regulation, a “reasonable basis” standard is described as “a relatively high
standard of tax reporting, that is, significantly higher than not frivolous or
not patently improper.”
A
practitioner is also permitted to avoid reliance opinion status with a
prominent disclosure in the written advice that such advice is not intended or
written by the practitioner to be used, and that it cannot be used by the
taxpayer, for the purpose of avoiding penalties that may be imposed on the
taxpayer. Under Reg.
10.35(b)(8) , an item required to be “prominently disclosed” must be set
forth in a separate section at the beginning of the written advice in a bolded
typeface that is larger than any other typeface used in the written advice. It
is hoped that this definition will be construed as referring only to the type
used in the opinion itself and not any printing (e.g., firm name) that might
appear at the top of the stationery or other paper on which the opinion
appears.
In permitting
written disavowal of reliance opinion status via disclosure, Reg.
10.35(b)(4)(ii) excludes any written advice
arising from a “listed” transaction or a “principal purpose” transaction. The
exclusion of “listed” and “principal purpose” transactions is unnecessary
because reliance opinions exist only with respect to “significant purpose”
transactions.
Although one
might quibble with the strictures of written disavowal, the final Regulations
at this point appear to reflect an attempt at flexibility. If a written advice
is not to be used by a taxpayer to avoid penalties, it is not required to
satisfy the standards for covered opinions established by Reg.
10.35 . However, even though a written advice may
avoid covered opinion status, the written advice is still required to conform with the requirements of Reg.
10.37 (discussed later).
Marketed opinions. Written advice is a “marketed opinion” if the
practitioner knows or has reason to know that the written advice will be used
or referred to by a person other than the practitioner (or a person who is a
member of, associated with, or employed by the practitioner's firm) in
promoting, marketing or recommending a partnership or other entity, investment
plan or arrangement to one or more taxpayer(s). As in the case of reliance
opinions, a practitioner can disavow marketed opinion status by prominently
disclosing in the written advice that:
(1) The advice was not intended or written by
the practitioner to be used, and that it cannot be used by any taxpayer, for
the purpose of avoiding penalties that may be imposed on the taxpayer;
(2) The advice was written to support the
promotion or marketing of the transaction(s) or matter(s) addressed by the
written advice; and
(3) The taxpayer should seek advice based on
the taxpayer's particular circumstances from an independent tax advisor.
The
requirements for “prominent disclosure” to avoid marketed opinion status are
the same as set forth above to avoid reliance opinion status.
Reg.
10.35(b)(5)(ii) excepts from the general rule permitting written disavowal
of marketed opinion status any written advice related to a “listed” transaction
or a “principal purpose” transaction. Unlike the situation with Reg.
10.35(b)(4)(ii) discussed above in connection with reliance opinions, the
reference to “listed” transactions and “principal purpose” transactions in Reg.
10.35(b)(5)(ii) is not error. As discussed later, the final Regulations
establish rules for marketed opinions given in connection with “listed”
transactions and “principal purpose” transactions. The term “marketed opinion” has
relevance to “listed” and “principal purpose” transactions as well as
“significant purpose” transactions.
The
definition of “marketed opinion” does not encompass a practitioner's
self-marketing or self-promotion or marketing or promoting of the practitioner
by his firm. Such promotional or marketing materials may nevertheless be
subject to the requirements of Reg.
10.35 if they otherwise constitute covered opinions. If not encompassed by Reg.
10.35 , such promotional or marketing material is
subject to the requirements of Reg.
10.37 .
Conditions of confidentiality. Written advice is
subject to “conditions of confidentiality” if the practitioner imposes on one
or more recipients of the written advice a limitation on disclosure of the tax
treatment or tax structure of the transaction and the limitation on disclosure
protects the confidentiality of that practitioner's tax strategies, regardless
of whether the limitation on disclosure is legally binding. A claim that a
transaction is proprietary or exclusive is not a limitation on disclosure if
the practitioner confirms to all recipients of the written advice that there is
no limitation on disclosure of the tax treatment or tax structure of the
transaction that is the subject of the written advice. This definition is the
same as the definition of confidential transactions under Reg.
1.6011-4(b)(3) , dealing with reportable
transactions.
Contractual protection. Written advice is subject to
“contractual protection” if the taxpayer has the right to a full or partial
refund of fees paid to the practitioner (or a person who is a member of,
associated with, or employed by the practitioner's firm) if all or part of the
intended tax consequences from the matters addressed in the written advice are
not sustained, or if the fees paid to the practitioner (or a person who is a
member of, associated with, or employed by the practitioner's firm) are contingent
on the taxpayer's realization of tax benefits from the transaction. All the
facts and circumstances relating to the matters addressed in the written advice
will be considered when determining whether a fee is refundable or contingent,
including the right to reimbursements of amounts that the parties to a
transaction have not designated as fees or any agreement to provide services
without reasonable compensation. This definition is similar to the definition
of “contractual protection” found in Reg.
1.6011-4(b)(4) , dealing with reportable
transactions.
`Listed'
and `principal purpose' transactions. The IRS publishes
Notices from time to time identifying “listed” transactions. As of March 2005,
the latest such Notice is Notice
2004-67 . 4
An up-to-date list of all “listed” transactions can be found at
http://www.irs.gov/business/corporations/article10,,id=120633,00.html. While it
is possible to identify “listed” transactions (and, by inference, similar
transactions) with some certainty, the same cannot be said with respect to
“principal purpose” transactions.
The final
Regulations do not define or give examples of “principal purpose” transactions.
This uncertainty creates problems, given the fact that if a transaction is
either a “listed” transaction or a “principal purpose” transaction, a written
advice is a covered opinion even if the IRS has no basis (or inclination) to
challenge the transaction. To be a “covered opinion” with respect to a “listed”
or “principal purpose” transaction, the written advice need only relate to a
“Federal tax issue” and not a “significant Federal tax issue.”
The IRS's
hostility to “listed” transactions is understandable, even though the fact that
a transaction is “listed” or similar to a “listed” transaction does not mean
that the transaction is not valid. On the other hand, there are many
transactions that are arguably “principal purpose” transactions which the IRS
has no reason to challenge. It is conceivable that any transaction in which a
taxpayer would not engage but for the potential tax savings might be considered
a “principal purpose” transaction. A GRAT or a personal residence trust might
be viewed as such a transaction. A taxpayer would not likely become involved
with the intricacies of either a GRAT or a personal residence trust were it not
for the potential gift and estate tax savings. Yet neither a GRAT nor a
personal residence trust is the kind of transaction to which the strict rules of
Reg.
10.35 should apply.
A
practitioner giving written advice concerning a “listed” transaction or a “principal
purpose” transaction is not permitted to avoid covered opinion status by
disavowing reliance on the advice to avoid penalties. That possibility exists
only with respect to reliance opinions and marketed opinions. There appears to
be no justifiable policy reason for not permitting disavowal with “listed” and
“principal purpose” transactions. One suspects that prohibiting disavowal is
simply intended to make it more difficult to give written advice with respect
to those transactions. This approach is inappropriate, especially with respect
to GRATs, personal residence trusts, and other noncontroversial estate planning devices.
Requirements
for covered opinions
The rules
established by the final Regulations for covered opinions generally reflect
good practice. The final Regulations place particular emphasis on the
practitioner's evaluation of the correctness of factual representations and
disclosure by the practitioner of financial arrangements with promoters.
Factual
matters. The Regulations require the practitioner to use reasonable
efforts to identify and ascertain the facts, which may relate to future events
if a transaction is prospective or proposed, and to determine which facts are
relevant. The opinion must identify and consider all facts that the
practitioner determines to be relevant.
The opinion
must identify in a separate section all factual assumptions relied upon by the
practitioner. A factual assumption includes reliance on a projection, financial
forecast, or appraisal. The practitioner must not base the opinion on any
unreasonable factual assumptions (including assumptions as to future events).
An unreasonable factual assumption includes a factual assumption that the
practitioner knows or should know is incorrect or incomplete.
Reg.
10.35 states specifically that it is unreasonable to assume that a
transaction has a business purpose or that a transaction is potentially
profitable apart from tax benefits. It is unreasonable for a practitioner to
rely on a projection, financial forecast, or appraisal if the practitioner
knows or should know that the projection, financial forecast or appraisal is
incorrect or incomplete or was prepared by a person lacking the skills or
qualifications necessary to prepare it.
A covered
opinion must identify in a separate section all factual representations,
statements or findings of the taxpayer relied upon by the practitioner. The
practitioner must not base the opinion on any unreasonable factual
representations, statements, or findings of the taxpayer or any other person.
An unreasonable factual representation includes a factual representation that
the practitioner knows or should know is incorrect or incomplete. For example,
a practitioner may not rely on a factual representation that a transaction has
a business purpose if the representation does not include a specific
description of the business purpose or the practitioner knows or should know
that the representation is incorrect or incomplete.
Relate
law to facts. A covered opinion must relate the applicable law
(including potentially applicable judicial doctrines) to the relevant facts.
Except with respect to “limited scope opinions” and the ability to rely on
other experts (discussed below), the practitioner must not assume the favorable
resolution of any significant federal tax issue, or otherwise base an opinion
on any unreasonable legal assumptions, representations, or conclusions. The
opinion must not contain internally inconsistent legal analyses or conclusions.
Evaluation of significant federal tax issues and conclusion with
respect to each such issue. The opinion must consider all
significant federal tax issues. The opinion must provide the practitioner's
conclusion as to the likelihood that the taxpayer will prevail on the merits
with respect to each significant federal tax issue considered in the opinion.
If the practitioner is unable to reach a conclusion regarding one or more of
those issues, the opinion must state that the practitioner is unable to reach a
conclusion concerning those issues.
The opinion
must describe the reasons for the conclusions, including the facts and analysis
supporting the conclusions, or describe the reasons that the practitioner is
unable to reach a conclusion as to one or more issues. If the practitioner
fails to reach a conclusion at a confidence level of at least more likely than
not with respect to one or more significant federal tax issues considered, the
opinion must include the appropriate disclosure(s) set forth below for opinions
failing to reach a more likely than not conclusion. In evaluating the
significant federal tax issues addressed in the opinion, the practitioner must
not take into account the possibility that a tax return will not be audited,
that an issue will not be raised on audit, or that an issue will be resolved
through settlement if raised.
Marketed opinions. A marketed opinion
must provide the practitioner's conclusion that the taxpayer will prevail on
the merits at a confidence level of at least more likely than not with respect
to each significant federal tax issue. If the practitioner is unable to reach a
more likely than not conclusion with respect to each significant federal tax
issue, the practitioner must not provide the marketed opinion, but may provide
written advice which is not a marketed opinion because of a disavowal that
satisfies the requirements set forth above with respect to disavowals in
marketed opinions.
Limited scope opinions. If a transaction is
not a “listed” or “principal purpose” transaction and if the advice is not a
marketed opinion, the practitioner may provide an opinion that considers less
than all of the significant federal tax issues so long as the practitioner and
the taxpayer agree that the scope of the opinion and the taxpayer's potential
reliance on the opinion for purposes of avoiding penalties that may be imposed
on the taxpayer are limited to the federal tax issue(s) addressed in the
opinion. In such a case, the opinion must include the appropriate disclosure(s)
required for “limited scope opinions,” discussed below. A practitioner may make
reasonable assumptions regarding the favorable resolution of a federal tax
issue (an assumed issue) for purposes of providing an opinion on less than all
the significant federal tax issues. The opinion must identify in a separate
section all issues for which the practitioner assumed a favorable resolution.
Overall conclusion. A covered opinion
must provide the practitioner's overall conclusion as to the likelihood that
the federal tax treatment of the transaction or matter that is the subject of
the opinion is the proper treatment and the reasons for that conclusion. If the
practitioner is unable to reach an overall conclusion, the opinion must state
that the practitioner is unable to reach an overall conclusion and describe the
reasons for the practitioner's inability to reach a conclusion. In the case of
a marketed opinion, the opinion must provide the practitioner's overall
conclusion that the federal tax treatment of the transaction or matter that is
the subject of the opinion is the proper treatment at a confidence level of at
least more likely than not.
Competence to provide opinion/reliance on opinions of others. The practitioner must
be knowledgeable in all aspects of federal tax law relevant to the opinion
being rendered, except that the practitioner may rely on the opinion of another
practitioner with respect to one or more significant federal tax issues, unless
the practitioner knows or should know that the opinion of the other
practitioner should not be relied on. If a practitioner relies on the opinion
of another practitioner, the relying practitioner's opinion must identify the
other opinion and set forth the conclusions reached in the other opinion. The
practitioner must be satisfied that the combined analysis of the opinions,
taken as a whole, and the overall conclusion, if any, satisfy the requirements
of Reg.
10.35 .
Required disclosures. A covered opinion
must contain all of the following disclosures that are applicable:
Relationship between promoter and practitioner. An opinion must
disclose (and this disclosure must be “prominent”) any compensation
arrangement, such as a referral fee or a fee-sharing arrangement, between the
practitioner (or the practitioner's firm or any person who is a member of,
associated with, or employed by the practitioner's firm) and any person (other
than the client for whom the opinion is prepared) with respect to promoting,
marketing or recommending the entity, plan, or arrangement (or a substantially
similar arrangement) that is the subject of the opinion, or any referral
agreement between the practitioner (or the practitioner's firm etc.) and a
person (other than the client) engaged in promoting, marketing or recommending
such entity, plan, or arrangement.
Marketed opinions. A marketed opinion must prominently disclose
that the opinion was written to support the promotion or marketing of the
transaction(s) or matter(s) addressed in the opinion, and that the taxpayer
should seek advice based on the taxpayer's particular circumstances from an
independent tax advisor.
Limited scope opinions. A limited scope opinion must
prominently disclose that:
(1) The opinion is limited to the one or more
federal tax issues addressed in the opinion;
(2) Additional issues may exist that could
affect the federal tax treatment of the transaction or matter that is the
subject of the opinion, and the opinion does not consider or provide a
conclusion with respect to any additional issues; and
(3) With respect to any significant federal
tax issues outside the limited scope of the opinion, the opinion was not
written, and cannot be used by the taxpayer, for the purpose of avoiding
penalties that may be imposed on the taxpayer.
Opinions
that fail to reach a more likely than not conclusion. An opinion that does
not reach a conclusion at a confidence level of at least more likely than not
with respect to a significant federal tax issue must prominently disclose that
fact and also state, with respect to that issue, that the opinion was not
written, and cannot be used by the taxpayer, for the purpose of avoiding
penalties that may be imposed on the taxpayer.
Consistency. A practitioner may not provide advice that is
contrary to or inconsistent with any required disclosure.
Effect of opinion. A covered opinion that meets the requirements
of Reg.
10.35 satisfies the practitioner's responsibilities under that Regulation,
but the persuasiveness of the opinion with regard to the tax issues in question
and the taxpayer's good faith reliance on the opinion will be determined
separately under applicable provisions of the law and Regulations.
Procedures
to ensure compliance with Reg.
10.35
These
procedures are found in Reg.
10.36 . Practitioners having principal authority
and responsibility for overseeing a firm's federal tax practice must take
reasonable steps to ensure that the firm has adequate procedures in effect for
all members, associates, and employees for purposes of complying with Reg.
10.35 . Any such practitioner who through
willfulness, recklessness, or gross incompetence does not take reasonable steps
to ensure that the firm has adequate procedures to comply with Reg.
10.35 is subject to discipline if individuals affiliated with the firm
engage in a pattern or practice of failing to comply with Reg.
10.35 . Any such practitioner who knows or should know that an individual
affiliated with the firm is engaging or has engaged in a pattern or practice
that does not comply with Reg.
10.35 is also subject to discipline if the practitioner, through
willfulness, recklessness, or gross incompetence, fails to take prompt action
to correct the noncompliance.
Requirements
for written advice not subject to Reg.
10.35
Reg.
10.37 contains requirements for any written advice that is not a covered
opinion. Reg.
10.37 provides that a practitioner may not give written advice based on
unreasonable factual or legal assumptions (including assumptions as to future
events). A practitioner may not unreasonably rely on representations,
statements, findings or agreements, and must consider all relevant facts that
the practitioner knows or should know. In evaluating a federal tax issue, a
practitioner may not take into account the possibility that a tax return will
not be audited, that an issue will not be raised on audit, or that an issue
will be resolved through settlement if raised.
All facts and
circumstances, including the scope of the engagement and the type and
specificity of the advice sought by the client, will be considered in
determining whether a practitioner has failed to comply with Reg.
10.37 . In the case of an opinion the practitioner
knows or has reason to know will be used or referred to by a person other than
the practitioner (or a person affiliated with the practitioner's firm) in
promoting, marketing or recommending a “significant purpose” transaction to one
or more taxpayers, the determination of whether a practitioner has failed to
comply with Reg.
10.37 will be made based on a heightened standard of care because of the
greater risk caused by the practitioner's lack of knowledge of the taxpayer's
particular circumstances.
Penalties
Reg.
10.52 provides that a practitioner may be censured, suspended, or
disbarred from practice before the IRS for willfully violating any of the
Regulations composing Circular 230 (other than Reg.
10.33 ). Any such penalty may also be imposed on a practitioner who
recklessly or through gross incompetence violated Reg.
10.34 , 10.35
, 10.36
, or 10.37
. Reg.
10.34 , which was not changed by the final
Regulations, establishes standards for advising with respect to tax return
positions and for preparing and signing returns.
Taking
action to comply with the final Regulations
Planning
techniques designed to reduce estate, gift, and generation-skipping taxes are
not reportable transactions under the Regulations promulgated under Section
6011 unless they constitute “listed” transactions. As of March 2005, there
were 31 “listed” transactions. Of these 31 transactions, four might be
considered as tangentially related to estate planning. Reg.
1.643(a)-8 recharacterizes distributions of
principal from charitable remainder trusts in certain circumstances as a
distribution of capital gain. Notice
2003-47 5
deals with the sale of compensatory stock options in exchange for a promissory
note. Rev.
Rul. 2004-20 6
involves insurance policies in retirement plans. Notice
2004-20 7
deals with the attempt to avoid taxation on S corporation income by gifting
nonvoting stock to charity.
Terms and
concepts used in Reg.
10.35 are drawn from the Regulations under Section
6011 —e.g., “conditions of confidentiality” and “contractual protection.”
For the sake of consistency, it would seem that written advice with respect to
estate, gift, and generation-skipping tax transactions should not be subject to
the requirements of Reg.
10.35 unless they involve “listed” transactions.
While it may
be hoped that estate planning transactions will some day be eliminated from the
requirements of Circular 230, that is presently not
the case. Accordingly, practitioners should take steps to ensure compliance
with the mandates of Circular 230 by the 6/20/05 effective date, including the
following:
1. Current
policies with respect to written tax advice should be compared to the
requirements of Circular 230 and modified, if necessary.
2. Lawyers
who have occasion to give tax advice (including estate planners) should be
identified, and they should be informed of the requirements under Circular 230.
In-house seminars might be conducted to discuss the requirements of the final
Regulations.
3. Department
or practice group heads should determine whether and what additional steps may
be needed to satisfy Circular 230's supervisory lawyer provisions.
4. Procedures
should be adopted to conform a firm's written advice
to clients on federal tax matters with the applicable requirements of Regs. 10.35 and 10.37
. Specifically, memoranda that are furnished in suggesting estate planning
techniques to clients should be reviewed. These memoranda are explanatory in
nature, frequently address noncontroversial issues,
and are not intended to be used in avoiding penalties.
Because (1)
the absence of a significant federal tax issue and (2) disavowal provide relief
from Reg.
10.35 only with respect to “significant purpose” transactions, a memorandum
dealing with what might be characterized as a “principal purpose” transaction
might be modified to include a statement of authority in support of the
transaction. With a GRAT, personal residence trust, or other estate planning
device that is unlikely to be challenged by the Service, a statement of
statutory, regulatory or judicial authority hopefully will suffice. A separate
statement of facts might also be included even though there may be few facts
existing when the memoranda are submitted to clients. Even if excepted from the
requirements of Reg.
10.35 , all memoranda and other written advice
relating to federal tax issues should be reviewed to ensure conformance with Reg.
10.37 .
Conclusion
It is not the
“principal purpose” of this article to avoid or evade any tax imposed by the
Internal Revenue Code. However, such avoidance or evasion may be considered to
be a significant purpose of this article. Accordingly, BE ADVISED THAT THIS ARTICLE IS NOT INTENDED OR
WRITTEN BY THE AUTHOR TO BE USED, AND IT CANNOT BE USED BY ANY TAXPAYER, FOR
THE PURPOSE OF AVOIDING PENALTIES THAT MAY BE IMPOSED ON THE TAXPAYER. [Please
detach and reattach at the beginning of this article.]
PRACTICE NOTES
The rules
established by the final Regulations for covered opinions generally reflect
good practice. The final Regs.
place particular emphasis on a practitioner's
evaluation of the correctness of factual representations and disclosure of
financial arrangements with promoters.
See REG-122379-02.
See Mulligan, “Impact of Tax Shelter Regulations on
Estate Planning,” 31 ETPL 363 (Aug. 2004).
T.D. 9165, 69 Fed. Reg.
75839-75845.
2004-41 IRB 600.
2003-2 CB 132.
2004-10 IRB 546.
2004-11 IRB 608.
Income Tax
Planning Now That Estate Taxes Are Less Significant
Author:
JOHN J. SCROGGIN, ATTORNEY
JOHN J.
SCROGGIN, AEP, LL.M., of the Georgia and Florida Bars, is a member of the law
firm of Scroggin & Company, P.C., in Roswell,
Georgia. He is also a CPA. Mr. Scroggin is a
nationally recognized speaker and author, and has previously written for Estate
Planning. Copyright © 2005, FIT, Inc.
Now that the federal estate tax exemption has increased and the
top federal estate tax rate has decreased, income tax planning is likely to
become more important to clients. This article explores income tax planning
opportunities.
For decades,
estate planning has been dominated largely by the desire to avoid a
confiscatory federal estate tax. In the early 1980s, the estate tax exemption
was $175,000. This amount gradually grew, and the Taxpayer Relief Act of 1997
1
provided for a phased-in increase in the exemption to $1 million by 2006. The
Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA”) 2
provided for even higher tax-free transfers. While elimination of the federal
estate tax is unlikely, significant estate tax exemptions will probably remain
for the foreseeable feature, reducing the federal estate tax confiscation many
clients had anticipated at their death.
These changes
mean that fewer Americans than at any time in recent history will be subject to
federal estate tax. By one estimate, in 2006, less than 1% of all decedents'
estates will owe federal estate tax. 3
For the vast majority of Americans, estate planning will no longer be driven by
the avoidance of a federal transfer tax. Instead, personal and family concerns
and other tax issues will drive the estate planning process.
Nevertheless,
the substantial federal estate tax exemptions will be partially offset by
higher state estate taxes. As part of EGTRRA, Congress replaced the state death
tax credit with a state estate tax deduction. 4
This change will require many states to impose new death taxes—an unpleasant
political act. Even if Congress restores the federal state estate tax credit,
many states will be reluctant to adopt the higher federal estate tax
exemptions. As a result:
- Thirty-eight states which were using the
federal estate tax law as the basis of their state estate tax will have to
revise their estate tax statutes or incur a significant loss of revenue.
5
- Many states will adopt estate tax exemptions
that are lower than the higher federal exemptions, creating a state estate
tax when no federal estate tax is due.
- Some states will freeze their state estate tax
rate at the pre-EGTRRA federal credit, resulting in a top effective state
tax rate of 16% (i.e., the top rate for the previous federal state estate
tax credit).
- Some states could adopt inheritance taxes,
whereby the tax rate would be determined by the relationship of the
decedent to the heir (i.e., the more remote the heir, the higher the tax
rate).
- As the federal government did in 1924, more
states will adopt a state gift tax 6
to stop the loss of transfer tax revenue through lifetime gifts. 7
- The lack of uniformity in state death taxes
will add complexity to estate plans. For example, if a person owns
property in more than one state, avoiding the cost and taxes of ancillary
probate will become a greater part of the estate plan.
- The pressure to forum shop will increase as
taxpayers attempt to move their tax domicile to states—like
- In the past, many states made little effort to
audit the estate tax returns of their deceased citizens. Instead, they
relied on the federal government to validate the returns. However, with
many states now having lower exemptions than the federal exemptions,
states will have to beef up their estate tax audit staffs if they hope to
preserve this revenue source.
For most
Americans, state and
federal income tax planning will trump federal estate tax avoidance. This
article will discuss some of the income tax planning opportunities of this new
environment.
Income tax
planning
Many planning
opportunities have been limited by concerns over the avoidance of federal
estate tax. When estate tax rates reached as high as 60%, while federal income
rates topped out at 39.6%, this concern was certainly valid. But these estate
tax restrictions will disappear for the vast majority of Americans, whose tax
planning strategies will shift from federal estate tax avoidance to state and
federal income tax reduction. Here are some of the possible opportunities.
Income shifting. A client who is funding benefits or
obligations (e.g., college tuition or support costs) for someone (e.g., a
college age child or a parent in a nursing home) who is in a lower income tax
bracket should consider adopting approaches by which the ordinary income or
capital gains of the client are shifted to the lower tax rate taxpayer. There
are a number of methods for accomplishing this task, including the following:
9
1. Trusts can
be created to hold income-producing assets; the trust income is allocated among
the beneficiaries based on the trustees' discretion. These “spray trusts” are
discussed in more detail later.
2. The
transfer of noncontrolling interests in flow-through
entities (e.g., limited liability companies (“LLCs”),
partnerships, and S corporations) may be used to shift income to lower-bracket
family members without giving up control over the underlying asset or the
family business. The recent IRS assaults on family limited partnerships (“FLPs”) have focused primarily on the estate tax aspects of FLPs. However, for most clients, the federal estate tax
issues surrounding FLPs will become moot. FLPs remain an excellent tool for maintaining control of an
asset, while income earned from the asset is allocated to lower-bracket family
members.
3. A business
could hire family members to work in the business. However, if the business
owner has earned income over $90,000 (in 2005), then this approach could create
Social Security taxes which the business owner would not have incurred. 10
Planning example. Assume a client has a
rental property that produces ordinary taxable income of $200,000 per year. The
client is in the 35% federal income tax bracket, but his five children and ten
adult grandchildren are all in an effective tax bracket of 15%. The client
places the rental property in an FLP and retains a 2% general partnership
interest. Over two years, he transfers the FLP interests to a spray trust for
his descendants using Crummey withdrawal rights to
preserve his state and federal estate tax exemptions. The trust has the right
to spray income among his descendants. Using the income tax brackets of the 15
trust beneficiaries, the overall federal income tax on his rental property
would drop by up to $39,200. 11
Income
shifting can also result in changes in the character of shifted income. For
example, suppose that a client is a real estate developer. Because the
developer is considered a “dealer” in real estate, income from the developer's
development of real property will generally be treated as ordinary income.
12
If property were initially acquired by, or transferred to, family members who
were not developers, sale of the real estate could be treated as a capital gain
transaction.
Income
shifting may also be used to reduce the phase-out of tax benefits that apply to
many higher income taxpayers. For example, the ability to fund a Roth IRA is
phased out for married taxpayers with a modified adjusted gross income of over
$150,000. If the shifting of income took the taxpayer below the limits for any
applicable deductions or tax benefits, it could provide an additional advantage
to the donor.
Income
shifting does carry some risks. For example:
- Clients who adopt income shifting strategies
should make sure the transactions have economic substance, do not run
afoul of the “assignment of income doctrine,” 13
and do not result in the IRS' reconfiguring the transaction 14
to avoid the evasion of taxes or to clearly reflect the taxpayer's income.
If these doctrines and rules are violated, the client may remain taxable
on the income that was supposedly shifted to lower-bracket taxpayers.
- In creating such structures, planners should
keep in mind the state income tax ramifications of shifting income. Many
states have begun taxing nonresidents on the income distributed from local
flow-through business entities. For example, Georgia requires that
nonresident owners pay income taxes on the income distributed from some S
corporations, partnerships, and LLCs. 15
While forum shopping for estate tax and asset protection purposes has been
in vogue for some time, clients may also use forum shopping to minimize
any state and local income tax liability.
- Payments of unearned income to beneficiaries
who are under age 14 can result in the income taxes being calculated using
the parent's income tax bracket, not the child's bracket. 16
- The client must give up the income. In most
cases, income shifting makes sense only if the client is willing to forgo
future income and/or if the client is already funding a need of a
lower-bracket taxpayer (e.g., nursing care costs).
The increased focus on basis. The cost basis of
assets generally is stepped up to their fair market value (FMV) at the time of
death. The new higher estate tax exemptions frequently mean that less of an
estate is subject to federal estate tax. As a result, a quantum shift in tax
planning may occur. Instead of lowering the value of assets to reduce transfer
taxes, clients may actually want to increase the value of assets to obtain a
higher basis step-up. The higher basis will reduce the income taxes paid by
heirs on the sale of inherited assets and will create new depreciable values
for depreciable assets. 17
Planning example. A chronically ill father
owns 40% of a family business worth $3 million. Assume the available estate tax
exemption is $2 million and a 40% discount would apply to the father's
ownership interest. Also assume there is a 10% control premium. His wife and
heirs own the remaining 60% of the business. Wife transfers 11% of the business
ownership to the husband as a marital gift. The husband's will provides that the amount of his estate tax exemption
equivalent is placed in a spray trust for the benefit of the wife and
descendants. If the father dies before the transfer, the value of his interest
in the family business would be $720,000 (i.e., $3 million times 40% times
60%). If the 11% interest is transferred, the effective value of the 40% stock
interest would be $1,320,000. The creation of a controlling interest creates an
additional $500,000 of basis.
It will be a
crazy world in which the IRS and tax practitioners will be swapping asset
valuation arguments. Moreover, techniques such as intentionally defective
grantor trusts will be turned on their heads to become Estate Defective Trusts
(discussed later).
Charitable bequests and IRD. When clients want to
make a charitable bequest, they should consider funding that bequest with
qualified retirement plan assets or other assets that would have created
“income in respect of a decedent” (“IRD”). 18
Because of the current rules on naming beneficiaries of retirement accounts,
the client is best advised to bifurcate any IRA into
an account that names a charity as beneficiary and one or more other accounts
that name noncharitable beneficiaries. 19
If the client either does not want retirement assets to go to charity or does
not have retirement assets, the will or living trust could provide that any charitable
bequest first be funded from IRD assets to the extent the estate or trust held
or receives such assets.
Planning example. A client wants to
pass $30,000 to a charity at his death. He holds an IRA worth $25,000. The
client could name the charity as beneficiary of his IRA and provide in his will
that the estate pay to the charity the difference between $30,000 and the IRA
value at his death. Assume the IRA was worth $20,000 at death and the client's
only heir is in a 40% state and federal income tax bracket. The passage of the
$20,000 in IRA funds to charity would save the heir up to $8,000. 20
Investment decisions. Investments in trusts
and estates may be changed to investments that are more tax-effective. Net
after-tax returns will become a critical part of investment evaluations. For
example, fiduciaries will be more prone to use tax-efficient mutual funds and
capital gain investments rather than those that may be taxed at higher ordinary
income rates, particularly when trusts and estates will be accumulating income.
This trend is
already evident in the growth of total return trusts. One motivation for total
return trusts is the desire to move away from strict definitions of income and
principal that tend to distort fiduciary investment decisions. When fiduciaries
are free to make the best economic decisions to produce the highest after-tax
return, the net return to all beneficiaries should increase. (Total return
trusts are discussed more later.)
Not only the
form of the investment (e.g., stocks or bonds), but also the tax vehicle that
holds the investment may be important. In an appropriate situation, Roth IRAs,
charitable remainder trusts, health savings accounts, 21
Coverdell savings accounts, and Section 529 plans 22
can offer tremendous tax savings.
Planning example. A terminally ill
client has an IRA with $100,000 in assets. The client could convert the IRA to
a Roth IRA and pass the Roth to heirs. 23
If the client has an estate below the federal exemption equivalent, the Roth
IRA will not be subject to federal estate tax, and the growth in the Roth from
the conversion date will not be subject to any further income taxes. While the
conversion will create an immediate income tax cost to the IRA owner, the tax
cost is not paid from the Roth account, reducing the tax depletion of the
account. If the client has a net operating loss (“NOL”) that was going to
disappear at death, the income tax conversion cost of the IRA could be offset
by the NOL.
Payment of fees. For most estates, deductions for
fiduciary fees will now shift to the fiduciary income tax return. But when a
personal representative receives a payment for performing fiduciary functions,
that income is taxable at ordinary income rates. However, unless the personal
representative is in the trade or business of serving as a fiduciary, the
income is not generally subject to Social Security taxes. 24
If an estate
will not incur a federal or state estate tax, the payment of fiduciary fees
does not generate an estate tax benefit as a deduction, but could increase the
income tax burden of the personal representative. In many cases—especially when
a trusted heir is going serve as personal representative—the client should
consider making a special bequest to that heir. To assure that the heir does
not also seek to obtain fiduciary fees, the will could deny personal
representative fees to any heir who serves as a personal representative. As
further protection, the document might provide that the special bequest lapses
if the heir is incapacitated or dead (i.e., the chosen fiduciary cannot serve).
The net
effect of using this special bequest is that the estate's taxable income that
would have otherwise been offset by a deduction for an executor's fee is now
taxable to either the estate or the other beneficiaries. If the personal
representative is the only heir, this technique could be of nominal benefit.
Planning for
the decedent and his estate
Pre-mortem planning. Although death is
often an unexpected event, there are cases in which a terminally ill client can
plan for the reduction of his or her taxes. For example, consider the
following:
1. The losses
of a decedent are not carried over to the estate or heirs. 25
Instead, they simply vanish. There are at least three ways that expiring losses
could be used. First, the client (or persons holding a general power of
attorney) could take actions to use any expiring losses (e.g., accelerating
taxable income). Second, in the case of a married client who files a joint
return, the spouse might take pre-mortem actions to create taxable income to
offset the soon-to-expire losses. Third, a surviving spouse who is entitled to
file a joint return in the decedent's year of death could take year-of-death,
postmortem steps (e.g., accelerating income) to offset the losses.
Planning example. Suppose that a client
has an NOL of $100,000 and an IRA worth $50,000. The payout of the $50,000 IRA
could be substantially tax-free because of the NOL. The client could consider
converting the IRA before death to a Roth IRA in order to provide future
tax-free income benefits for heirs. If a married client's spouse had a
significant retirement plan or IRA, the spouse could withdraw funds from that
account before the end of the year of the decedent's death to offset the
expiring NOL.
2. Assume
that a terminally ill client with a nontaxable estate has a will that makes
significant charitable bequests. Making the charitable bequests after the death
of the client does not provide any estate or income tax savings. On the other
hand, if the charitable transfers were made before death, the income tax
charitable deduction could reduce the client's personal income taxes. Make sure
the will is rewritten to remove the charitable bequests or, if applicable state
law permits advancements, consider making the bequest as a
pre-death gift advancement.
Postmortem tax planning for the estate. While a certain
amount of postmortem planning has been focused on achieving estate tax savings,
much of this focus may shift to reducing income taxes of the estate and its
heirs. For example, consider the following strategies:
1. While a
trust is generally required to use a calendar year, 26
an estate can elect any calendar or fiscal year of not more than 12 months.
27
By selectively choosing a fiscal year, the planner can effectively lower the
overall income taxes of heirs and the estate. For example, suppose that a
client dies in October and the estate has considerable income before the
calendar year-end. The personal representative could elect to use a January 31
year-end for the estate. With proper planning for any underpayment penalty, the
taxes on the income that is distributed to beneficiaries would not be taxable
until the April 15 of the following year.
2. If an
estate anticipated having large income tax deductions early in its first year,
the estate might consider using a longer fiscal year to allow the estate to
earn sufficient income to offset the early deductions.
3. The
trustee of a “qualified revocable trust” and an executor have
the right to elect to treat such a trust as part of the estate. 28
This election can provide living trusts with the unique tax benefits of
estates, such as the use of a fiscal year, the limited right of an estate to
own S corporation stock, and the two-year waiver of the passive loss rules.
4. Similar
planning decisions must be addressed in determining when the estate is to be
closed. This decision should be analyzed based on the income tax impact on the
beneficiaries. For instance, assume that most of the estate administration has
been completed in November, but the tax year of the estate ends in February. If
the estate administration is not completed until the following January, the
distributable net income (“DNI”) of the estate from March through January will
not be reported on an heir's tax return until April 15 of the year after the
estate was closed. In contrast, if the estate were to be closed in November,
two years of the estate's DNI would be reported on the heirs' tax returns
(i.e., for the tax year ending in February and that ending upon the closing of
the estate in November).
5. It is
important to consider not only the tax years of the estate, but also the tax
brackets of heirs when making estate or trust distributions. For example,
assume in the previous example that an heir was closing the sale of his
business in January. The increased taxable income anticipated upon the sale of
the business might make it more advantageous to close the estate in November.
6. Because of
broad variations in state income taxes, planners should also take into account
the relative state income tax brackets of the grantor, the estate or trust, and
the beneficiaries. For instance, assume an estate is opened in a state with a
fiduciary income tax, but the beneficiaries are all
7. The timing
of payment of deductible expenses is also a critical income tax planning issue.
Most estate administration deductible expenses are not considered business
expenses. Therefore, they cannot generate an NOL for the estate. Consequently,
to the extent that such deductions exceed income, they are not carried over to
future years.
However, the
Code provides that to the extent estate deductions exceed the estate's income
in the final year of the estate, the excess deductions
can be carried over to the estate beneficiaries. 29
Hence, personal representatives of cash basis estates with substantial
deductible expenses (such as commissions and legal fees) should consider
delaying the payment of non-business deductions until the final year of the
estate, so that heirs can receive the benefit of the pass-through of the excess
deduction. Personal representatives should also be careful about paying too
many non-business expenses in any year in which the estate has insufficient
income to offset the deduction of such expenses.
8. The bases
of depreciable estate assets are generally stepped up to FMV at the time of
death. Because the estate is a new taxpayer, the estate can elect whatever new
depreciation method it deems appropriate to reduce income taxes. The estate is
not bound by the depreciation methods that the decedent used.
9. If an
estate or trust sells an asset, receives an installment note, and then
distributes the note to a beneficiary, the distribution of the note may trigger
recognition of the inherent gain in the note, resulting in income taxation to
the distributing trust or estate. 30
If a distribution to heirs proximate in time to the sale is anticipated, and
the sale is expected to result in a significant recognized gain, it would be
far better to distribute the asset to the beneficiary prior to the sale,
permitting deferral of the gain over the term of the note.
10.
Traditionally, the use of disclaimers in postmortem planning has focused
primarily on minimizing estate taxes. Now that federal estate taxes are less of
an issue, tax planning will refocus on using disclaimers to minimize income
taxes.
Planning example. A grandparent dies
with an IRA worth $100,000. The sole heir has four children in college. Each
child is in a 10% income tax bracket, while the parent is in a 40% income tax
bracket. If the parent took the IRA funds and used them for the college costs
of children, the parent would pay $40,000 in income taxes. If the parent
disclaimed the IRA and it passed to the college-attending children, the tax
would be only $10,000, saving $30,000 to help cover the cost of college.
Planning for the decedent's final income tax return. Income tax planning
also encompasses planning for the reduction of income taxes based on the decedent's
final income tax return. 31
The final return is generally due on April 15 of the year after the year of
death. Nevertheless, if reasonable cause exists, the personal representative
can request up to a six-month extension for the filing of the final return.
32
This planning
should focus on the relative income tax brackets of the decedent, the estate,
any trusts, and the heirs. By judiciously making elections and allocating
income and deductions, the overall tax cost to the heirs can be reduced.
However, when the family members have differing goals and tax rates, this
planning may create new sources of conflict. Among the tax planning
possibilities are these:
- An election may be made to accrue the interest
on Series E or EE
- The final medical expenses of the decedent can
be deducted on the decedent's final income tax return. 34
- Income from partnerships, LLCs,
and trusts from the year of the decedent's death must be allocated to the
decedent's final income tax return. Thus, decisions about the timing of
distributions of income and payment of deductible expenses by the entity
or trust, and the allocation of income to the decedent may be part of the
income tax planning for the decedent's estate and heirs.
- In certain circumstances, a decedent's final
income tax return can be filed as a joint return with the surviving spouse.
35
The impact
on the use of trusts
This new tax
environment is also changing how clients and planners approach the use and
creation of trusts. Trusts remain one of the most adaptable planning tools
available. As a result, clients will continue to use trusts to accomplish both
tax and nontax estate planning goals. Income tax
planning opportunities using trusts will increasingly become part of the estate
planning process. Among the expectations are the following:
`Spray
trusts.' As discussed earlier, the new tax environment will encourage the
allocation of income to lower-bracket taxpayers. The use of a trust spray power
to allocate income among various family members (particularly those in lower
tax brackets) will be an increasing part of the planning process. Accordingly,
a college student who is in a 10% income tax bracket may be sprayed income from
a trust, resulting in more after-tax dollars to fund the child's college
education. 36
Forum shopping. The income taxation of grantors,
trusts, and beneficiaries varies widely from state to state. Even though the
tax rate in most states is relatively low, the long-term imposition of a state
income tax can amount to substantial tax dollars, especially in states that do
not provide any tax break for capital gains. Moreover, the income tax rates on
estates and trusts range from zero (e.g.,
Planning example. A client intends to
create a trust, contributing an asset that has a value of $500,000 and a basis
of zero. The trust will sell the asset for an installment note payable annually
over ten years at 8% interest. The trust is intended to provide for the college
education of grandchildren who will not begin college for 11 years. Assume that
the grantor's state of domicile will impose an 8% tax on the income and capital
gains retained in the trust. The grantor is considering establishing the trust
in
Fiduciary income tax issues. Income tax planning
will become a higher priority for the majority of estates and trusts. For
example, advisors will also need to examine estate and trust investments based
on the relative after-tax returns. 39
Planning example. A trustee intends to
accumulate trust income for ten years until grandchildren of the grantor reach
college age. The trustee has two investment choices: an ordinary income
investment that generates an 8% return and a capital gain investment that
generates a 6.5% annual return. The trust is in an ordinary income tax bracket
of 35%, while the capital gain rate is 15%. Ignoring any other investment or
tax issues (e.g., trust deductions, investment risk, diversification, etc.),
which is the better investment? The net after-tax yield on the ordinary income
investment is 5.2%, while the net after-tax yield on the capital gain
investment is 5.5%.
Total
return trusts. Investment models no longer fit into a pure allocation
between income and principal. States have been adopting statutes that permit
existing trusts to be modified to become total return trusts. Based on the
number of states that have adopted or are considering adopting total return legislation,
the use of these types of trusts should be expected to increase. 40
The acceleration of states' adopting such provisions is at least partially due
to the issuance of IRS Regulations 41
which provide that such changes may not cause the trust to lose the benefit of
either the marital deduction or the generation-skipping exemption.
Total return
trust legislation is directed primarily at correcting unexpected consequences
in existing irrevocable documents. However, trust instruments can adopt similar
approaches, without having to comply with the restrictions of a state statute.
For example, the unitrust amount set forth in most
state statutes is 3% to 5%. A client might provide that an annual trust
distribution is to equal all the income from the trust, but not less than 8% of
the value of the trust assets.
Exposure of fiduciaries to liability. The failure of a
fiduciary and the estate planner to plan properly for the estate or trust and a
beneficiary's tax liability may expose fiduciaries and planners to new
liability claims. 42
Moreover, the conflicting tax rates and diverse goals of beneficiaries may
place fiduciaries in the untenable position of being asked to manage family
conflicts concerning the tax aspects of the estate or trust's investments and
the tax elections.
As a result,
planning for estates and trusts will increasingly include ways to minimize the
liability of fiduciaries who are acting in good faith. 43
The terms may include revising the standard of fiduciary liability in the
applicable instruments, broadly indemnifying fiduciaries and liberal payment of
any legal fees incurred by fiduciaries acting in good faith.
Estate
Defective Trusts. For years, clients and planners have used intentionally
defective grantor trusts, which cause the trust's income to be taxable to the
grantor while the transfer of assets to the trust is complete for estate tax
purposes. The objective of such trusts, which I will refer to as “Income
Defective Trusts,” is to reduce a client's federal estate taxes. 44
An Income Defective Trust uses the differences in the income tax and estate tax
rules 45
to create a trust that remains taxable to the grantor for income tax purposes
(pursuant to Sections 671-678), while the trust assets are removed from the
grantor's taxable estate.
However, with
the recent increases in the applicable exemption amount (and with more
increases still to come), the gap between the income tax and transfer tax rules
may create planning opportunities for “Estate Defective Trusts” (“EDT”). 46
Such trusts are intentionally created to have the trust income taxable to the
trust or its beneficiaries, but to have the trust assets remain in the
grantor's taxable estate.
An EDT has
two major income-tax-related benefits. First, the tax on the income of an EDT
is allocated to either the trust or its beneficiaries. Unlike an Income
Defective Trust, the EDT can effectively permit a grantor to use the lower
income tax brackets of the trust beneficiaries to reduce the overall taxes of
the family.
Planning example. A client has a
grandchild in college, and the client owns an asset that generates an annual
income stream of $40,000. The client is in an effective income tax bracket of
40%, while the grandchild is in an effective income tax bracket of 15%. Using
an EDT, the family saves $10,000 in annual income taxes. 47
If the grantor were paying Social Security or self-employment taxes (e.g., by
being the manager of an LLC), the savings would be even more significant.
Not only are
income taxes reduced, but the after-tax proceeds from the income are not includable
in the grantor's estate, reducing the possibility that the grantor may be
subject to either state or federal transfer taxes.
Planning example. Assume in the above
example that the client dies in 20 years, but retained the asset that generated
$40,000 in annual income until his death. Assuming an annual 6% return, the
annual after-tax income (even at a 40% income tax rate) from the asset could
create an additional estate value of over $685,000 at the grantor's death.
Second, many
clients hold low-basis assets (e.g., a family farm or business). The client may
desire to gift the asset to family members, but does not want to lose the
benefit of the step-up in basis which occurs at death. The client can place the
asset in an EDT. Beneficiaries will receive the current benefit of the asset,
but the asset will remain part of the grantor's taxable estate, permitting a
step-up in basis.
Planning example. A client owns a
business that has a zero basis, but is worth $500,000. The business is growing
at an annual rate of 5%. The client's son is taking over the business. If the
father gifted the asset to his son, the son would take over the father's zero basis. Assume the father dies in five years, when the
business is worth $640,000. By placing the business in an EDT, if the son sold
the business when he was in a 20% effective tax bracket, he would save $128,000
because of the EDT.
Conclusion
Benjamin
Franklin said that only taxes and death are inevitable. As long as we have
taxes, tax avoidance will remain an important motivation for many clients. With
federal death taxes no longer affecting the vast majority of clients, the
avoidance of state and federal income tax and state death taxes is becoming the
prime focus for tax planning.
PRACTICE
NOTES
Instead of
lowering the value of assets to reduce transfer taxes, clients may actually
want to increase the value of assets to obtain a higher basis step-up. The
higher basis will reduce the income taxes paid by heirs on the sale of
inherited assets and will create new depreciable values for depreciable assets.
Pub. L. No.
105-34.
Pub. L. No.
107-16.
See Godfrey, “
See Gans and Blattmachr, “Quadpartite Will:
Decoupling and the Next Generation of Instruments,” 32 ETPL3 (Apr. 2005);
Steiner, “Coping With the Decoupling of State Estate Taxes After EGTRRA,” 30
ETPL 167 (Apr. 2003); Woods, “Decoupling Dilemma,” 143 Tr. & Est. 50 (Apr.
2004); Godfrey, “The Phaseout of the Federal State
Death Tax Credit,” 35 Tax Advisor (Feb. and Mar. 2004); McNichol,
“Assessing the Impact of State Estate Taxes,” Center on Budget and Policy
Priorities (2/18/04), available at www.cbpp.org/2-18-04sfp.htm.
For example,
As of 12/31/03, only
See Stetter, “Deathbed
Gifts: A Savings
Surkin, “The Impact of the
Decoupling of State Estate Taxes on a Taxpayer's Choice of Domicile,” 101 J. Tax'n
49 (July 2004) .
See Westfall and Mair, Estate
Planning Law and Taxation, ¶10.02 (Warren, Gorham & Lamont).
I.e., in 2005, above the $90,000 wage base, the
combined employer and employee Social Security rate drops to 2.9%, a rate
savings of 12.4% when compared to the combined 14.3% tax rate on earned income
below the wage base.
I.e., $200,000 per year times the 98% limited
partnership interest times the 20% difference in tax rates.
Section 1221 provides that capital gain treatment is
not available for property held “primarily for sale to customers in the
ordinary course of business.”
See Lucas v. Earl, 8 AFTR 10287 , 281 US 111 , 74 L Ed 731 ,
2 USTC ¶496 (S.Ct.,
1930), and Helvering v. Clifford, 23
AFTR 1077 , 309
Section 482.
Section 1(g).
For more information on this topic, see Scroggin, “Brave New World of Basis Planning,” 144 Tr.
& Est. (Apr. 2005).
Section 691(c). See
Schlesinger and Mark, “Charitable Estate Planning With Retirement Assets,” 28
ETPL 390 (Aug. 2001), and Maydew, “How the Courts
Interpret Income in Respect of a Decedent,” 92 J. Tax'n 41 (Jan. 2000) .
Schlesinger and Mark, supra note 18.
This example ignores the possible benefit of using a
“stretch IRA” or other techniques to provide long-term deferral benefits to an
heir. See Guglielmo, Wave, and Hamilton, “Managing
the Tax Consequences of Large IRAs: The Emergence of Integrated Solutions,” J.
Practical Est. Plan. (Nov. 2002).
Leimberg and McFadden,
“Health Savings Accounts—An Important New Tool for Estate Planners,” 31 ETPL 194
(Apr. 2004); Baum, “The Advantages of Health Savings Accounts—the Code's Newest
Healthcare Arrangement,” 100 J. Tax'n 101 (Feb. 2004) .
Schlesinger, “Qualified State Tuition Programs: More
Favorable After 2001 Tax Act,” 28 ETPL 412 (Sept. 2001); Fox and Root, “New
Dimensions in Education Planning,” J. Practical Est. Plan. (Aug./Sept. 2001).
Steiner, “Eight Reasons to Convert to a Roth IRA,” J.
Retirement Plan. (May/June 1998); Rotenberg and LaVangie, “To Roth or Not to Roth,” J. Retirement Plan.
(Jan./Feb. 2004).
Rev. Rul. 58-5, 1958-1 CB
322, and McDowell v. Ribicoff, 8
AFTR 2d 5016 , 292 F2d 174
, 61-2 USTC ¶9514 (CA-3, 1961). But see Ltr. Rul. 9107009
, where the fiduciary fees paid to an attorney who served as a
fiduciary for 12 trusts were considered self-employment income.
Rev. Rul. 74-175, 1974-1 CB 52 .
Section 645(a).
Sections 441-443 and Section 645(a).
Section 645. Dennett and
Moseley, “Maximizing the Benefits of the Section 645 Election,” 31 ETPL 546
(Nov. 2004).
Section 642(h).
Section 453B. If the
installment note was obtained by the holder before death and was transferred as
a result of the death of the holder, a non-sale transfer is not a taxable
disposition. See Section 453B(c). However, if the note is returned to the
obligor of the note, the estate is taxable on the remaining gain. See Section
691(a)(5).
For a thorough examination of this topic see, Kasner, Post Mortem Tax Planning, “Elections That
Affect Income and Deductions in the Decedent's Final Income Tax Return,” §2.02
(Warren, Gorham &Lamont).
Section 6081.
Section 454(a) permits accrual of the interest on
certain non-interest bearing bonds, but is not limited to
Section 213(c).
Section 6013(a).
Kamm, “Discretionary Trust
Distributions—A People Oriented Approach; How to Help Our Clients Make Informed
Decisions,”
Schoenblum, 2004 Multistate Guide to Estate
Planning, Table 12 (CCH 2004).
E.g.,
VanDenburgh, Harmelink, Crumbley,
and Apostolou, “Investment and Tax Considerations for
Capital Preservation,” J. Retirement Plan. (Nov./Dec.
2002).
At least 40 states have adopted or are considering
adopting total return trust legislation.
Merric, Gillen and Freeman,
“Malpractice Issues and the Uniform Trust Code,” 31 ETPL 586 (Dec. 2004); Abendroth, Bieber, and Hodgman, “Managing the Risk of Liability in an Estate
Planning Practice,” 30 ETPL 373 (Aug. 2003).
Kurlander, “Enhancing the
Protection and
Cushing, “Planning with Intentional
Grantor Trusts,” ALI-ABA Sophisticated Estate Planning Techniques,
Huffaker and Kessel, “How the Disconnect Between the Income and Estate
Tax Rules Created Planning for Grantor Trusts,” 100 J.
Tax'n 206 (Apr. 2004) .
See Scroggin, “The Estate
Defective Trust,” Taxes (Jan. 2005), and Scroggin,
“The Nuisances of Estate Defective Trusts,” J. Tax'n
(2005).
I.e., $40,000 times the 25% difference in tax
brackets.
© Copyright 2005 RIA. All rights reserved.
Offshore
Trusts Are More Than Just Asset Protection Vehicles
Author:
RICHARD J. RAZOOK AND KATHERINE E. RAMSEY, ATTORNEYS
RICHARD
J. RAZOOK is a partner in the law firm of Hunton
& Williams LLP in the firm's
Although foreign trusts are often thought of in connection with
tax avoidance or asset protection, these trusts may also be used to circumvent
forced heirship laws and to trigger or avoid grantor
trust status, as needed.
Offshore
trust: For many advisors and their clients, the term carries the negative
connotation of impermissible income tax avoidance or asset protection schemes.
Still others believe that such trusts are too complex or expensive to be of
much use.
But are these
perceptions entirely accurate? Although undoubtedly more expensive to use than
a U.S. trust, are there circumstances when a client—even someone who is not
overly concerned with income tax or asset protection issues—might find an
offshore trust beneficial? This article explores two of the more common uses
for offshore trusts other than the more typical purposes of income tax
avoidance and asset protection.
First, with a
steadily rising number of nonresident aliens traveling to the United States on
business or family matters, investing in U.S. assets or otherwise developing
closer contacts with this country, more and more of these individuals are
seeking the advice of local attorneys, accountants, and financial planners in
the face of restrictive laws in their country of domicile regarding the
disposition of both their U.S. and non-U.S. holdings. While such activity is
currently concentrated in the larger international “gateway” cities such as
Second, even
for U.S. residents or citizens, creating an irrevocable trust offshore rather
than domestically may be a simple way to ensure that it is taxed for federal
income tax purposes as a grantor trust, while retaining the future ability to
change to a nongrantor trust (and then back again) as
desired without the potential complications associated with other triggering
provisions that are more typically used under Section
673 through Section
678 .
This article
is intended to remove some of the mystique surrounding the use of offshore trusts.
It is hoped that more advisors will keep these trusts in mind as a viable
estate planning alternative for their clients.
Nonresident
aliens and forced heirship laws
Originally,
the offshore trust industry targeted wealthy individuals seeking tax-avoidance
strategies or protection for their assets from domestic political instability
or creditors. However, as the United States and other developed countries have
modified their laws to close tax loopholes, 1
the industry's focus has shifted somewhat to the use of offshore trusts as part
of the overall estate planning for wealthy clients domiciled in jurisdictions
that do not recognize the trust concept. 2
Generally, these countries include those governed by civil law, such as most of
Latin America, continental Europe, and the
An
international client may wish to incorporate one or more trusts into his or her
estate plan for many of the same reasons U.S. citizens or residents do,
including: the ability to direct the manner and time in which the beneficiaries
will receive their inheritance; the retention of some measure of control over
the investment and management of the transferred assets; the ability to allow
multiple beneficiaries to benefit from a single asset without partition; the
protection of the trust assets from waste by spendthrift beneficiaries or from
claims by creditors and former spouses; and, significantly, increased
confidentiality. 3
If not for the availability of offshore trusts in countries such as Bermuda,
Bahamas, Cayman Islands, Belize, British Virgin Islands, Isle of Man, and
Jersey—as well as statutory “private foundations” such as those available in
Panama and the Netherlands Antilles—these clients' planning options would be
severely restricted.
Many civil
law countries require that a percentage of a decedent's estate pass outright to
his or her descendants, without exception. 4
Roughly equivalent in concept to the augmented estate protection afforded
surviving spouses in non-community property states in the
Of course,
the client could possibly achieve the same desired benefits through the
judicious use of a
In some
situations, a nonresident alien client may still want to create a
U.S.
Even for
estate planning professionals who do not count foreign individuals among their
client base, an offshore trust can be a very useful planning tool because of
its ability to be used to trigger or avoid grantor trust status, as needed, for
There are
many circumstances in which grantor trust status is desirable. For example, a
client may avoid the three-year inclusion rule under Section
2035 on the distribution of an insurance policy on his life from the
trustees of a qualified retirement plan if the policy is distributed directly
from the plan to an irrevocable trust created by the client which is treated as
a grantor trust. 8
Perhaps the most common reason to create an “intentionally defective” grantor trust
is to permit the grantor to effectively make additional tax-free gifts to the
trust beneficiaries by paying the income tax due on the trust's income instead
of requiring the trust to pay the tax. Not only does this preserve the trust
assets for future investment and appreciation, but it also reduces the
grantor's taxable estate by the amount of the income tax paid.
Until
recently, there was some concern that, despite the clear language of Section
671 , the IRS would claim that the grantor's
payment of the tax on the trust's income was an additional taxable gift to the
trust. These concerns have largely been put to rest by Rev.
Rul. 2004-64 , 9
in which the Service acknowledged that no gift results from the grantor's
payment of the tax on the income of a grantor trust, because the liability for
the tax belongs to the grantor alone.
There are
several powers that, if held by the grantor or a nonadverse
party, will trigger grantor trust status. Possession of many of these powers
would also cause the trust assets to be included in the grantor's gross estate
for estate tax purposes, but a few do not cause estate tax inclusion. For
example, one commonly used power is the power to reaquire
trust property by substituting other property of equivalent value. 10
Another is the power of a nonadverse party to add one
or more charitable beneficiaries without the consent of any adverse party.
11
Unfortunately,
what may seem like a great planning idea initially can quickly become a burden
for the grantor as the size of the trust, and consequently the income tax
liability, increase over the years. It is important, therefore, to plan for a
way to “turn off” the grantor trust status when desired. Of course, it is a relatively simple matter to have the grantor relinquish
the undesired power at the appropriate time. There should be no gift or estate
tax consequences from such a one-time unilateral act. But what if circumstances
change and grantor trust treatment is once again desired?
If the
grantor is given the power to repeatedly “turn on” and “turn off” grantor trust
status, has he retained such control over the trust assets that they would be
included in his gross estate under Section
2036 ? Alternatively, would he be deemed to be the
grantor even where the power is turned off because of his ability to reacquire
the power unilaterally? If the trustee is instead given the power to grant to
and withdraw from the grantor the power, would the trustee's fiduciary duties
interfere with the exercise of those powers, at least with respect to any
withdrawal of the power which would result in an increased tax liability for
the trust? If the grantor's release of an undesired power is combined with the
trustee's right to regrant the power, would there be
enough evidence of an implied agreement that would cause the assets to be
included in the grantor's estate under Section
2036 ? These uncertainties can be avoided if Section
679 is used to achieve grantor trust status.
Section
679 provides that if a U.S. citizen or resident is the grantor of a
foreign trust that has at least one U.S. beneficiary, the trust is a grantor
trust for U.S. income tax purposes, even if the grantor retains no other powers
under Section
673 through Section
677 . Key to this provision is the definition of a “foreign trust.” Under Section
7701(a)(31) , a foreign trust is one that is not
subject primarily to the jurisdiction of a
Implementation
To minimize
the potential for attack when dealing with forced heirship
laws, the assets and administration of the trust should be as far removed from
the domicile jurisdiction as possible. For this reason, it is not advisable to
transfer real estate located in the client's home country to the trust. On the
other hand, one may exchange investments held outside the client's domicile for
shares in a corporation formed under the laws of the offshore jurisdiction and
then transfer the shares to the trustee, although the advisor should consult
local counsel to determine whether funding the trust with local assets will
trigger any additional taxes on the trust in the chosen jurisdiction. These
concerns are not an issue when forming an offshore trust as a grantor trust.
Once the
assets to be transferred are identified, the next step is to select the
jurisdiction in which to form the trust. Because little will be gained if a
trust formed for testamentary purposes is vulnerable to attack by disgruntled
heirs, at a minimum the chosen situs should offer a
well-developed body of trust law and conflicts-of-law rules, as well as a
strong judicial history of protecting trusts against the claims of heirs and
foreign judgments.
Other
desirable qualities common to all situations include the availability of
reputable professionals who may assist as advisor and/or trustee in the
formation of the trust and its future administration, the existence of an
established financial center, relatively strong confidentiality laws, easy
communications and travel access, and a stable political and economic
environment. Bermuda is one example of such a jurisdiction (although there are
a number of other suitable jurisdictions offering similar benefits to varying
degrees, such as the Bahamas, Cayman Islands, the Cook Islands, etc., the
choice of which will depend on the client's particular circumstances and
purpose in creating the trust).
The terms of
the trust will depend on the degree of control and benefit the grantor wishes
to retain and the client's purpose(s) for creating the trust. In the case of an
irrevocable trust created by a U.S. citizen or resident for purposes of
qualifying for grantor trust tax treatment under Section
679 , the grantor will retain little, if any, control or benefit. On the
other hand, for a nonresident alien, retention of control may be desired, but
will certainly increase the jurisdictional nexus between the trust and the
domicile country. Depending on the laws of the trust jurisdiction and the
nature of the powers reserved, the retention of control may give the heirs a
better basis for challenging the trust. 12
Even if the
client would otherwise prefer to retain control over the trust's management and
administration and is not concerned about whether a court in his home
jurisdiction would recognize the trust, practical considerations may weigh
against doing so. To continue with Bermuda as an example, 13
the Bermuda government may impose a significant stamp duty on transfers to
trusts that do not have a local trustee. 14
If a single initial transfer is contemplated, this may not be a serious issue.
However, the issue may be avoided completely (and any potential nexus or
governing law problems reduced) if the client is willing to use a
Alternatively,
the client may minimize fiduciary fees and retain a greater measure of control
by forming a
A
A Bermuda
private trust company must maintain a local registered office, and it must
observe all the normal corporate formalities, including an annual meeting
(which need not be held in
Certain
information about the private trust company, the trust it administers, and the
client must be supplied to the
If nexus
issues with the grantor's domicile are important, they may be minimized by
using a
In the
context of a private trust company, the goals of the purpose trust would be to
form the private trust company and to hold the shares of company stock. As sole
shareholder, the trustee of the purpose trust may act to ensure that the board
of directors of the private trust company prudently act as trustee and properly
carry out its fiduciary duties under the trust agreement. In turn, the trustee
of the purpose trust is answerable first to the person(s) named specifically in
the trust instrument for that purpose, then to the grantor (unless the
agreement provides otherwise), then to the trustee, and finally to any other
person with a sufficiently significant interest in the trust. These parties may
apply to the court to enforce the terms of the purpose trust.
Obviously,
the use of a purpose trust to form the private trust company will involve
additional expense. Depending on the size of the trust estate, the potential
for claims by disgruntled heirs, and the client's goals and degree of aversion
to risk, the client may decide against its use after consultation with local
counsel.
Risks
Before
embarking on the creation of an offshore trust, the advisor should emphasize to
the client who desires to avoid forced heirship that
there are no guarantees. The arrangement may not survive challenge by someone
who would otherwise be entitled to the trust assets under the laws of the
client's domicile. Depending on the property to be transferred to the trust,
the method of transfer, the identity of the trustee and beneficiaries, and the
place of trust administration, the courts in the client's home country may
retain some measure of ability to reach the trust assets for the benefit of
disgruntled heirs.
- Even if the trust itself is valid under the
laws of the offshore jurisdiction, the heirs may seek to set aside the
client's transfer of the assets under the laws of the jurisdiction in
which the assets were originally situated. This may be less of an issue if
the client first exchanges assets for other assets (such as stock) that
are situated in the offshore jurisdiction, but local counsel should be
consulted regarding any consequences of funding the trust with local
assets.
- The heirs may seek to recover against the
trust beneficiaries. This is particularly a problem if the beneficiaries
are entitled to mandatory distributions from the trust, as there would be
little need to seek enforcement of the court order against the trustee in
the offshore jurisdiction.
As regards
offshore trusts created for grantor trust tax purposes, the primary risk is
that upon the grantor's death, there will be a deemed sale of the trust assets
for income tax purposes under Section
684 . The grantor's estate would be required to recognize all the
appreciation in the trust assets, which could be significant. Many commentators
argue, though, that if there is a deemed sale from the grantor to the trust at
death, then the grantor's estate should also be entitled to a step-up in basis
under Section
1014 . 16
In all cases,
to avoid attacks on the trust under fraudulent transfer laws, the client would
be well-advised to retain enough assets outside the trust to satisfy any
potential creditors' claims. But doing so may leave open the possibility that
disgruntled heirs, if any, could simply sue for a larger share of the portion
of the decedent's estate that remains outside the trust.
Lastly,
although the client may profess not to have any motive other than the avoidance
of forced heirship laws or other benign estate planning
objectives, the advisor should take reasonable protective measures to ensure
that he or she is not being used to assist the client in fraudulent conduct. At
a minimum, the advisor should insist on full disclosure from the client
regarding his or her assets and liabilities, both existing and potential, and
should obtain an affidavit of solvency if the trust will include any asset
protection features.
Reporting
requirements
U.S. tax
reporting requirements will vary, depending on whether the offshore trust is a
grantor or nongrantor trust for income tax purposes,
whether there are U.S. beneficiaries, and whether the nonresident alien grantor
later becomes a U.S. resident or citizen.
1. The
nonresident alien grantor (grantor trust) or the trustee (nongrantor
trust) must file an income tax return (Form 1040NR) for any taxable year in
which the trust was engaged in a U.S. trade or business, regardless of whether
income was earned or not, or in which the trust had any taxable U.S. income,
unless the trust's liability for such tax is fully satisfied through
withholding. 17
2. The
3. If the
nonresident alien grantor later becomes a
4. If a
foreign trust transfers
Conclusion
With careful
planning and attention to the requisite formalities, most estate planning
advisors should not find it difficult to assist a client with the formation and
funding of a valid trust in any one of a number of offshore jurisdictions for
estate planning purposes. However, the advisor and client are cautioned to pay
particular attention to the myriad reporting requirements applicable to foreign
trusts and to seek qualified and reputable counsel in the target trust
jurisdiction. Also, if applicable, counsel should be consulted in the
nonresident alien client's home jurisdiction to review the arrangement and to
advise as to its relative vulnerability to claims by disappointed heirs.
See, e.g., Tax Reform Act of 1976,
Small Business Job Protection Act of 1996, and Taxpayer Relief Act of 1997.
Duckworth, “The Role of Offshore Jurisdictions in the
Development of the International Trust,” 32 Vand. J. Transnat'l L. 879, 881, 899 (1999).
The authors are referring to the inherent
confidentiality of trust provisions as opposed to the terms of a will or other
recorded document. Increased cooperation and information-sharing among
authorities continue to erode the secrecy laws that once sheltered an
individual's offshore assets from government eyes. See, e.g., “
For example, see note 2 supra, at 901, for an
in-depth discussion of the forced heirship rules in
Cf. Rahman v. Chase
Bank (Cayman) Ltd. (Royal Court of Jersey, 2/12/90).
See, e.g., Spencer, “OECD Model Agreement Is a Major
Advancement in Information Exchange,” 13 J. Int'l Tax'n 10 (Nov. 2002) . See also OECD Report, Harmful Tax Competition: An Emerging Global Issue (1998).
Nevertheless, if such a client is willing to wait at
least five years before establishing residency in the U.S., he may still be
well-advised to place at least a portion of his assets that produce non-U.S.
source income in an offshore trust that does not contain any provisions that
would trigger grantor trust status under Section
673 through Section
678 . As long as at least five years elapse between the time
the trust is created and the time the grantor becomes a
Such a transfer is permitted following the issuance of
Department of Labor Prohibited Transaction Exemption (PTE) No. 92-6, 67 Fed.
Reg. 56,313 (9/3/02).
2004-27 IRB 7.
Section 675(4)(C) .
Sections 674(b)(5) and 674(b)(6)
, flush language.
See, e.g., note 5 supra.
See, e.g., materials regarding
Some Bermuda advisors take the position that so long
as no
For example, they must be licensed by the Bermuda
Monetary Authority, which also oversees them. The trustees are required also to
provide audited annual financial statements of their assets (but not the trust
assets) and are subject to inspection from time to time.
See, e.g., Engel, “Foreign Situs
Trusts: An Overview of Various Uses and Applications,” 61 N.Y.U. Inst. on Fed. Tax'n (2002).
Sections 6012(a)(1) , 6012(a)(4)
, 6072(c)
; Regs. 1.6012-1(b) , 1.6072-1
.
Section 6048(c) ; Notice
97-34, 1997-1 CB 422 .
See Section
6677(a) .
© Copyright 2005 RIA. All rights reserved.
Innovative
Planning With `No Lapse Guarantee' Life Insurance
Author:
TIMOTHY P. MALARKEY, ASA, MAAA, CLU, ChFC, AND
STEPHAN R. LEIMBERG, ATTORNEY, CLU
TIMOTHY
P. MALARKEY, ASA, MAAA, CLU, ChFC, is a Principal in
the life insurance firm of Lee, Burke & Malarkey, LLP, in Berwyn,
Pennsylvania. He is also an Associate of the Society of Actuaries, a member of
the
This article explains the most important characteristics of
currently available life insurance products, including `No Lapse Guarantee'
policies. The authors then examine an advantageous practical application of No
Lapse Guarantee contracts.
Background
of product development
Much of this
section of the article will involve defining the terms and characteristics of
today's state-of-the-art life insurance products. We will touch on the
generically-named products found in today's marketplace, and outline a
discrete, almost chronological progression—even though in actuality, product
evolution has been much more of a fuzzy continuum.
Although we
will focus on the products, 1
their characteristics, the catalysts for their development, and relative
strengths and weaknesses from an insurance perspective, it should be recognized
that changes in tax laws, interest rates, and equities markets as well as many
other forces shape product development and suitability for use in a given case.
Much of the commentary here will be directly applicable to life insurance
contracts that insure one life. A very similar, albeit slightly different,
product development history would be necessary to outline second-to-die
products.
Term
insurance
Term
insurance is an appropriate beginning point. The key characteristic of term is
that the insurer assumes a death benefit risk only for a finite period of time.
Bluntly stated, term runs out. At the end of the stated term, typically, there are no nonforfeiture rights (e.g.,
cash values) afforded to term policyholders. The insured must die in order for
any payments to be made, and no death benefit will be paid unless the insured
dies within the specified term. If the insured survives the specified term,
absent an exercised renewal provision, the contract expires and provides no
payment of any kind.
For many
years, term insurance was sold in an “annual renewable term” (“ART” a/k/a
“yearly renewable term” or “YRT”) format. ART typically featured a premium that
increased each year to track the presumed increase in the likelihood of
mortality as (1) the insured aged and (2) time moved farther away from the
underwriting process that took place before the policy's inception.
ART was
guaranteed to be “renewable” for some number of years (rarely less than four or
five and sometimes until age 70 or beyond) as long as the policyowner
paid the next premium. The ever-increasing premiums often could or would change
annually from a stipulated initial amount, and the ultimate years' premiums were
guaranteed only to be below very high levels.
For much of
the past 15 years or so, sales of ART contracts have given way to much more
cost-effective policies that feature a level (and usually guaranteed) premium
for a specified number of years. The duration of these “level term” policies is
usually between ten and 20 years, but sometimes longer. Level term policies are
usually renewable beyond the “level” period, but the premiums will be
unattractive for those individuals who are not able to favorably pass through
the underwriting process again.
Over the past
15 years, the inherent price of these policies has continued to fall
dramatically, but recently the rate of price decrease has slowed substantially
and in some cases increased (because the NAIC clarified the amount of reserves
that needed to be set aside for this product). However, even given the
slow-down in price decrease, it is still likely that any term insurance more
than a few years old for someone who has not experienced an adverse change in
health is probably more expensive than what may be available to that client
today. So planners with healthy clients should review all
term policies more than three or four years old.
An important
feature of most high-quality term contracts is the “conversion” feature—the
ability of the policyowner to “convert” the policy to
a form of cash value insurance (discussed below) without new evidence of
insurability. This conversion takes place at the insured's attained age, and
can be a very important hedge against the risk that the end of the term
coverage will occur at a time when continuance of the coverage is desired but
circumstances prohibit the implementation of new coverage. (These circumstances
could include an insured's change in insurability or lack of time to implement
a new policy before the term policy practically or literally terminates.)
Conversion
features are usually available until a certain
duration after policy issue and/or until a specified age, and the products to
which the policy can be converted are determined by the insurance carrier.
Thanks to the design flexibility and wide product array of cash value insurance
products, the converting policyowner should be able
to structure a cash value policy to closely, if not
exactly, achieve the desired objectives of policy conversion.
Term
insurance is indicated when the need for life insurance is temporary, when the
largest possible amount of coverage is desired for a given amount of annual
cash outlay, when the need is intermediate or long-term but the buyer's cash
flow is currently insufficient to purchase the needed coverage under a higher
premium permanent policy, when the policyowner has
better investment opportunities outside the insurance policy than inside it,
and as a "rider" when additional death benefits are desired in
conjunction with cash value life insurance or "packages" of policies.
Cash value
insurance
In essence,
all policies that do not fit into the category of term should be in this
category, which encompasses any life insurance that could or does have a cash
value, some or all of which is available as a nonforfeiture
right if the policy is surrendered.
Cash value
insurance (“CVI”) is often mistakenly called “whole life” but, in reality,
“whole life” is only one form of CVI. CVI is also sometimes thought of as
“permanent insurance;” however, while many CVI products can be and/or are
designed to be kept “forever” (i.e., until the insured dies), the term
“permanent” may be a bit misleading since a number of these policies can (and
are designed to) last only a finite number of years.
CVI is
indicated when the need for life insurance is intermediate, long-term, or
indeterminate—for example, when insurance is needed to provide cash for federal
and/or state estate, inheritance, or other death taxes, funeral expenses, and
administration costs, to provide funding for a business or professional
practice "buy-sell" agreement, to indemnify a business for the loss
of a key employee, to provide financing for a salary continuation, nonqualified
deferred compensation, or death benefit only (survivor's income benefit) plan,
to fund personal and charitable bequests, to equalize inheritances, to provide
the most efficient and certain method of transferring wealth and assuring
financial security to others (especially given the favorable income tax
attributes of CVI), to preserve the confidentiality of financial funding (i.e.,
to provide financial security for an individual in a manner the insured may not
want to acknowledge publicly or to provide wealth to someone in an amount the
insured does not want to become a matter of public record), and as a tool to
help recruit, retain, retire, and reward key employees.
Whole life. Whole life (“WL”) is the oldest form of CVI,
and for a number of years it was the only real form of CVI. WL has had many
variations over the years (e.g., adjustable WL, participating and
nonparticipating WL, current assumption WL, modified and increasing premium
WL). The form of WL that is most commonly available today is usually a fairly
straightforward version of the product. Compared with other forms of CVI, WL is
less common today than it once was, especially in the sophisticated estate
planning market.
Although
there are fewer sales of this product, WL does have specific advantages that
lead to its continued use. WL is most generally available from mutual insurance
carriers, and is suitable for those seeking the unique insurance attributes of
a mutual company (versus today's more common stockholder-owned structure).
As its name
implies, whole life is a contract designed to provide level death benefit
coverage over the entire lifetime of the insured. 2
As noted below, level or fixed periodic premiums are computed on the assumption
that the contract can be retained—assuming premiums are paid—for as long as the
insured lives. The purpose of the level premiums is to make the WL contract
affordable for as long as the policyowner wants and
is able to pay premiums. 3
Policy cash values are an outgrowth and natural byproduct of the level premium
system. WL policies are issued with a table that illustrates the guaranteed
fixed cash values the owner of the contract can obtain in any given year, by
either borrowing or surrendering the policy.
The most
defining characteristics of WL are (1) a fixed premium, (2) the guarantees
available with respect to both the cash value and the death benefit, and (3)
the allocation of assets underlying the contract. The premise of a WL contract
is that if the fixed premium is paid for the “whole life” of the insured, the
death claim is guaranteed to be paid. For that fixed premium, there will be
cash values and death benefits that are guaranteed, assuming that the premium
is paid each year for the insured's “whole life” (hence the product's name).
(It is important to note, though, that the guaranteed cash values and
death benefits are often a good bit lower than the projected nonguaranteed values [which include both the guaranteed
segment and a nonguaranteed supplement], and it is
these latter amounts on which clients are usually most focused.)
The dollars
that back a WL contract become part of the general account of an insurance
carrier, which, under heavy regulation, is typically invested in a portfolio of
mid-term bonds, real estate, and mortgage-backed securities. (Depending on the
carrier, some small allocations to the equity market place do take place.)
The fixed
premium for a whole life contract is calculated by the insurance carriers, so
that, if the premium is paid each year (and when enhanced by earnings on those
dollars), the guaranteed cash value at some point in the future (often age 100)
will equal the guaranteed death benefit. It is this relatively conservative,
cash-heavy design that sets WL apart from other products and their guarantees.
However, WL
is most typically presented and/or designed to have a premium paid, on a nonguaranteed basis, for a finite number of years
(i.e., not each year for the insured's whole life). Rather, the premiums are
usually designed to be paid only until the accumulation of cash value within
the policy, along with future projected dividends, supports the death benefit
“forever” on a nonguaranteed basis. Nevertheless, the
best performance of a WL policy can often be achieved when the premium is
continued to be paid beyond the point where the policies are projected to be
self-supporting.
In most cases, continuing to pay WL premiums results in
accumulations of cash value and death benefit that offer very attractive returns
due to the accumulation of dividends, especially given the extremely low
likelihood that the cash value would ever decrease. (Cash value in a WL
contract would be compromised only in the unusually rare event of an insurance
company failure.) In short, continuing to pay premiums into a WL contract can
offer some of the most attractive after-tax fixed-income returns, given the
deferral of the cash value build-up and the tax-free treatment of death benefits, that are available today.
The dividend
credited within a WL contract is, simply, the mechanism through which a (most
commonly) mutual life insurance carrier credits growth in value in excess of
the guaranteed level of growth back to the policy. The dividend is a function
of both the carrier's underlying asset performance (in excess of guaranteed
performance levels) and the carrier's mortality and expense experience (to the
extent these costs are less than the conservatively anticipated levels of those
expenses).
Variable life. Variable life insurance (“VL”) is
essentially a WL policy 4
that allows the policyowner 5
to select among (and typically switch annually or more often between, or
rebalance among) a menu of insurer-determined investments 6
similar in many respects to stock, bond, and money market mutual funds. 7
VL 8
provides a guaranteed minimum face amount (death benefit) and a level premium
but differs from classic WL in three important ways: First, premiums (after the
insurer charges for expenses and sales costs and mortality costs) are poured
into an investment account that is separate and legally distinct from the
general investment fund of the insurance company. The general account assets
are limited by reserving requirements to be invested primarily in bonds and
mortgages. For those policyholders who want any significant exposure to
equities, variable life is the choice. The trade-off is that contracts shift
investment risk entirely to policyowners. This means
the insurer provides no guarantees with respect to policy cash values. Instead,
investment risk—and potential growth in both cash values and death benefits—are
shifted to the policyowner. Cash values in a VL
contract are determined as of a given point in time based on the policyowner's share of the market value of the assets in
the separate account. Finally, the death benefit is variable. It may grow or
shrink (but not below a stated and guaranteed minimum) according to a formula
based on the separate account's investment performance.
The first VL
contracts appeared around 1976. The earliest forms of VL were a variation on
WL—that is, the premium was fixed, but rather than the assets backing the
contract being bound to an insurance carrier's general account, the policyowner now had a choice to allocate some or all of the
assets to a separate account, where there is some choice of investment class.
The appeal of
VL was originally, and still is, largely driven by the ability to access the
potential upside of the equity markets. Also, there is a unique appeal to VL in
that, in the event of an insurance carrier insolvency,
the assets allocated to a policy—as part of a separate account—will not be
subject to the claims of the insurer's general creditors.
Variable life
is indicated where the policyowner (1) is confident
he/she/it can select an account that can significantly exceed the return and
growth of the insurer's general account, (2) desires long-term coverage, (3)
wants a measure of control over the selection of the underlying investments,
and (4) needs increasing life insurance protection.
Because
policy cash values are not guaranteed and all investment risks (and some death
benefit risks) are shifted to the policyowner, VL
should be chosen only by those willing to bear these risks in return for the
potential upside gains. Some authorities suggest that VL be used primarily as a
supplement to a minimum basic level of coverage provided by other types of CVI.
Universal life. Universal life (“UL”) is a
"flexible-premium" 9
"current assumption" 10
"adjustable death benefit" 11
type of CVI contract. These contracts are also referred to as flexible premium
adjustable life.
UL was
developed in the late 1970s and early 1980s, as interest rates soared and the
change in dividend rates of WL policies significantly lagged behind the
interest rates available in the market.
In comparing
UL policies to WL, the key difference is that UL does not have a fixed premium.
Rather, a UL contract is flexible and can accept a premium, at any given time,
from $0 to a very high level. The incredibly flexible premium of a UL policy
allowed policyholders more freedom to adapt their future cash flow commitments
to the dynamically changing interest rate world and their own financial situations
and constantly varying needs.
Mechanically,
as long as there is enough cash inside a UL policy to support that month's
charges, the policy will continue to provide full coverage for another month.
That said, the actual recommended premium for a UL policy is a function of (1)
how long the coverage is desired, (2) the number of years the owner wishes to
pay premiums, and (3) the assumed rate of interest backing the policy. As these
factors change, premiums can change; further, a policyowner
can diverge from a given course at any time. This makes UL a very flexible
policy that can be adapted to a client's constantly varying financial
circumstances.
When UL was
first introduced, it also featured a practical advantage compared to WL in that
many of the new UL blocks of business were backed by a portion of a carrier's
general account that was, at the time, invested in fixed-income instruments
that were newer and, therefore, earning (and returning to those who purchased
UL contracts) significantly higher rates of return than WL owners were
receiving.
As the years
have passed, though, the insurer's assets that back UL and the assets backing
WL policy series have, essentially, grown together (driven largely by
regulation). So both types of policy can be thought of as having similar asset
characteristics—that of a mid-term fixed-income portfolio. Because of this
similarity, UL and WL contracts are commonly lumped together to make up the
“traditional” forms of CVI.
UL is
indicated in long-term coverage needs where maximum flexibility of premium cash
flow is desired, and where the insured's financial needs and cash flow are
likely to change. This makes UL suitable in the business, retirement planning,
and employee benefits fields to finance salary continuation and nonqualified
deferred compensation plans, death benefit only plans, key person coverage,
buy-sell agreements, and insurance inside qualified retirement plans.
Variable universal life. The next logical
entrant in the life insurance arena is variable universal life (“VUL”), which
combines the flexible premium design of UL with VL's
ability to choose the asset allocation supporting the contract. Sometimes
called flexible-premium variable life or universal life II, VUL is an attempt
to capture the best features of UL and VL. VUL policyowners
can—within limits—determine the timing and amount of premium payments,
eliminate one or more premium payments entirely (assuming cash value is great
enough to pay current mortality and expense charges), increase or decrease
death benefits (within limits and assuming evidence of insurability with
respect to increases), make withdrawals of cash without generating a loan
against the policy and without interest charges (assuming there is enough cash
value to pay current mortality and expense charges), and select between two
death benefit options—one level and the other equal to a level pure insurance
amount plus the policy's cash value. 12
VUL contracts
represent a large portion of the insurance sold today. Whether it is because of
the many varied types of funds (especially equity-based funds) that are
available within the policies, the aspect of the “separate account” resting
outside the insurance carrier, the idea of a flexible premium, or some
combination of the above, VUL has been a major force in the CVI market for the
past decade.
The ability
to optimize these features, along with the unique tax attributes of life
insurance (tax-free death benefits, tax-free buildup of cash value, ability to
reallocate assets without taxation, and, uniquely, the ability to withdraw
after-tax basis and access gain without current taxation), can create a
powerful financial instrument that is particularly appealing to high-income,
high-net worth individuals and businesses.
VUL is particularly
indicated for estate planning and business insurance needs where the potential
increase in cash values and death benefits resulting from the successful
exposure to underlying assets invested in the equity markets is deemed
attractive or necessary. If a policyowner believes
that the portfolio he can assemble (from the available choices) underlying the
policy will significantly outperform the assets of the (tightly regulated)
insurance company's general account, then VUL can make good sense.
Further, VUL
offers the best protection of a policy's cash value from future adverse changes
at an insurance carrier, or indeed from carrier failure, thanks to the fact
that the assets are held in a separate account from the carrier. (Many
practitioners speculate that, based on past experience, some carriers may not
return to policyholders enough of the “upside” of their general account
performance in other types of CVI policies, due to future changes at carriers,
carrier consolidations/mergers, etc. The separate account feature of a VUL
insulates these contracts from some of these concerns. Even with VUL, however,
the nonguaranteed insurance charges within a policy
will still be subject to future carrier performance.)
VUL contracts
are appropriate for key person coverage, Section
162 (executive bonus) arrangements, financing of salary continuation and
nonqualified deferred compensation plans, death benefit only (survivors' income
benefit) plans, key person coverage, buy-sell agreements, and insurance inside
qualified retirement plans.
Private
placement VUL. A variation on VUL, private placement VUL (“PPVUL”) 13
is available only as a nonregistered product to those
who qualify. Generally, the buyer is a high-net-worth individual willing to
invest at least $500,000 either initially or over a relatively short period of
time. PPVUL is insurance which, as its name implies, is coverage obtained by
direct (and often vigorous) negotiation with the insurer to bargain costs and
charges to a minimum. These contracts are attractive to high-net-worth
individuals and corporations because of the income tax treatment and investment
flexibility (including dynamic hedging strategies) that make PPVUL a prime
capital accumulation and wealth transfer vehicle. 14
Advantages
include impressive internal performance through lower policy charges and
institutional pricing, surrender fees, fund asset charges, and reduced (or no)
sales loads. Special investment management design as well as a wider array of
investment options, insurer responsiveness, privacy, confidentiality, and
access to nonregistered investments (e.g., hedge
funds) supporting the insurance contract are additional benefits.
These
contracts are usually issued either as a modified endowment contract (“MEC”) on
a single premium basis or with limited payment periods to produce a non-MEC.
15
These contracts are sold as private placements by both on and offshore
insurers, and are provided on a policy-by-policy basis; thus, they avoid SEC
registration. 16
Purchasing the policy through an offshore insurer results in a high degree of
creditor protection, freedom from state regulation, and a reduction in costs
due to the absence of the insurer's obligation to pay either state premium
taxes or federal income taxes. (It is important to note, though, that in any
given case, the performance of offshore PPVUL may not be as favorable as a
contract available domestically due to the policy-specific insurance charges in
some offshore vehicles. Moreover, policy ownership structures, or laws
applicable to assets within a policy, may also provide attractive asset
protection without going offshore.)
To avoid
For all
flexible-premium insurance contracts (UL, VUL, PPVUL), in most cases the best
performance of the policy occurs when the premium is approaching, or at, the
upper limits allowable by the various threshold tests called for by government
regulation. 17
In addition, prospective illustrated performance is, in almost all cases,
heavily dependent on a number of nonguaranteed
factors. Exhibit 1 shows a comparison of UL, VL, and VUL.
No Lapse
Guarantee universal life
As the last
significant entrant into the life insurance arena, No Lapse Guarantee universal
life (“NLGUL”) contracts were first introduced a little more than ten years
ago. In their early years, they gained only moderate momentum. But due to a
number of forces, NLGUL contracts have become common in today's marketplace.
This recent surge in NLGUL has been due to (1) absolute improvements—the
increasingly innovative and competitive pricing of these policies (largely
driven by the shadow account methodology explained below), and (2) gains
relative to other products such as UL or VUL, which have been hampered by low
interest rates or difficult equity markets.
Background of NLGUL. Before digging into
the details of NLGUL, it may be helpful to discuss more of the technical
underpinnings of UL versus WL. The economics behind a WL contract involve only
“prospective” accounting. That is, the current value of a WL contract is,
actuarially speaking, equal to the present value of future liabilities, less
the present value of future premiums and earnings. In other words, the dollars
that a carrier must have on “reserve” today to meet the promises implicit in a
WL policy must equal the difference between (1) what the carrier will someday
pay to a beneficiary (assuming premiums are paid and the policy is kept in
force), and (2) what the carrier will receive in premiums and investment
returns between now and then.
These
calculations, resulting in the policy's reserve and then, in turn, the policy's
cash value, are done only prospectively. There is no specific accounting as to
the dates premiums in the past were actually received.
In order for
the mechanics of a UL policy to work, the accounting processes were, in a
sense, “flip-flopped.” A UL accounting system, which is used to calculate a
policy's reserve and cash value, operates only retrospectively. The premiums
that have been paid, the monthly charges that have been deducted, and the
interest that has been credited—all these elements are factored into today's
cash value.
Product development. A WL policy includes
an intrinsic guarantee that if the premium is paid “forever,” (1) cash values
will be guaranteed at the promised level and (2) the death benefit will be
paid. That premium, however, if required to be paid forever to support the
death benefit, represents a fairly expensive and unattractive return in today's
marketplace.
Many of
today's buyers are focused primarily or solely on guaranteeing the death
benefit, and are willing to trade guaranteed cash value in exchange for a lower
premium. To meet that objective, following the predominant use of UL through
the 1980s, carriers began in the early 1990s to add a “rider” to some UL
policies that provided a “secondary” premium-based death benefit guarantee.
These earliest riders ensured that, in addition to the fundamental guaranteed
maximum charges and minimum interest rates of a UL policy, if the policyowner were also to pay some (relatively low, compared
to WL) model extra premium each year, the death benefit would be guaranteed.
These early
“secondary guarantee” UL contracts essentially found a crack in the armor of
the regulations surrounding UL cash values and reserves. Because all UL rules
and regulations revolved around retrospective accounting, a carrier could offer
a prospective premium-based “secondary” guarantee without a significant change
in reserves and/or cash value. The earliest “secondary guarantee” UL policies
were fairly stringent, though. It was not uncommon to see that, if a premium
were paid a few days after a grace period, even though the policy itself was in
no danger of lapsing, the secondary guarantee could be totally lost. In other
words, there was no ability to have any kind of catch-up to re-start the
secondary guarantee that the death benefit would be paid no matter how long the
insured lived.
Regulations
and product development over the last half of the 1990s changed somewhat
dramatically (by insurance community standards). Regulations known as XXX and
AXXX, and responsive product development, led to the concepts of the “shadow
account” and “No Lapse Guarantee” UL policies. In short, these NLGUL policies
have the same retrospective accounting as any UL policy (with a cash value
resulting from premiums, historical charges, and interest-to-date). The primary
guarantees within the policy are that the monthly charges will never go above a
certain level and the interest rate will never go below a certain level. These
primary guarantees have an ultimate effect on both the death benefit and the
cash value of the policy.
For a No
Lapse Guarantee (“NLG”) policy, the accounting of premiums, interest, and
charges results in the regular cash value, and the primary guarantees govern
the worst-case performance for the death benefit and cash value. At the same
time, the death benefit (and the death benefit only) is also subject to a
secondary “no lapse” guarantee. This new form of secondary guarantee is a
result of the retrospective accounting done “on the side,” in a “shadow
account,” and it factors in actual premiums paid to date, a level of charges
better than the worst-case guaranteed charges, and a level of interest at or
higher than the worst-case guaranteed interest rate.
The result of
the shadow account calculation is that, if the shadow account is sufficient to
keep the policy in force, the death benefit will not lapse. In this manner,
most carriers are addressing the danger that the guarantee might be lost
because of the client's failure to pay premiums on time. So, while the UL
policy may have what appears at first to be typical current interest rate
performance, its death benefit (but not cash value) is also protected by the
shadow account. Thus, the shadow account offers a built-in premium catch-up
mechanism to prevent a loss of the death benefit guarantee.
The end result. The “bottom line” of today's NLGUL
policies is a type of CVI that perhaps should be thought of in its own
insurance asset class. WL and UL offer interest-rate-based performance while
VUL is generally used by those seeking equity-based performance. In all three
of those cases, policy attractiveness is measured by both the
cost-effectiveness of the death benefit as well as the performance of the cash
value.
In the
opinion of many, the NLGUL asset class is unique. It features (relatively
inexpensive) permanent death benefit guarantees at the expense of cash value
performance. Analytically, NLGUL policies typically offer very attractive
guaranteed death benefit internal rates of return (“IRR”) up to, and a bit
past, life expectancy. (It is not uncommon to see these death benefit IRRs approach, and exceed, an after-tax rate of 7% even
beyond life expectancy.) WL and UL death benefit returns may be (or may not be,
depending on the case) projected to be as favorable, but the illustrated WL and
UL death benefit returns will assuredly carry the assumption of performance
risk by the policyowner.
Some argue
that it is prudent to think of NLGUL policies as largely illiquid. The reason
is that it is unlikely that these contracts will have a cash value that is
attractive for any other possible uses in the future—due to the projected
underperformance of the cash value. The lack of a significant cash value is
clearly a disadvantage if a cash value that can be rolled over to another new
product innovation is desired in the future. Nevertheless, most who use NLGUL are not uncomfortable with the illiquidity,
given the relatively certain shifting of permanent death benefit risk to the
insurance carrier. Further, proponents argue that, in many cases of trust-owned
insurance, the existence of a notable cash value is, at best, a secondary bonus
to a family, given that the cash is likely to have been tied up in trust
anyway.
On the other
hand, the lack (or non-existence) of cash value within an NLG contact creates a
“last stop on the train” phenomenon—that is, the policyowner's
options to perhaps make a change in the future will be very much limited, if
not precluded. The policyowner needs to be permanently
comfortable with those death benefit returns of the NLG policy—because once the
policyowner gets on this train, the reality is that
he can't (economically) get off.
NLGUL also
bears the solvency risk of the carrier issuing it, especially because the low
cash value and attractive guarantee of the death benefit create a situation
where the policy's risk is less likely to be transferred elsewhere in the
future. Those advisors who are comfortable with this point out that this risk
does—to at least some degree—exist with any insurance, and there are some
protection mechanisms to mitigate the risk. Some authorities, however, argue
that these policies increase the solvency risk of carriers that issue them,
particularly those insurers that have underpriced
their NLG products. 18
The greatest risk to policyholders is the possibility that in an insolvency, the rehabilitator would "reform the
contract." Most state guarantee funds only provide that limited death
benefits and cash value will be paid. This risk is more than theoretical;
contracts were reformed in the several large insurance company failures.
Finally, the
last potential disadvantage of NLGUL is that, while the death benefit is likely
to have relatively little downside, NLGUL is also less likely than alternative
contracts to have a notable performance upside in the event of rising interest
rates, or bull equity markets (which could positively drive the WL/UL and VUL
markets, respectively). Those who favor NLGUL would counter that the lack of
upside is a fair trade-off for the very attractive “locked-in” IRR at death.
Obviously, an NLGUL contract is most appealing and appropriate for clients
seeking to assure the financial security of future generations through the most
cost- and tax-effective and economically certain wealth transfer mechanism
possible.
Aside from
the issue of proper reserves (which in itself is a complex, difficult to
determine, highly controversial, and very important issue), planners should
give special attention to (1) suitability (e.g., is the client better served by
a product that is flexible enough to meet life's inevitably changing
circumstances than by the features of a policy that guarantee the sufficiency
of the premium?) and (2) fitting this type of contract to a buyer's
circumstances. It is essential that clients be informed—in writing—of how those
products really work, what's required to maintain the guarantee, and what
happens to the product if the client fails to meet those requirements.
It is also
essential that the products being considered for purchase are compared with a
current assumption product and tested for relative premium flexibility, cash
values, and potential to benefit from higher interest rates. In other words,
would some other type of product be more suitable for the client's particular
facts and circumstances? It's essential that the client be presented with an
array of choices that allow an informed decision.
At the “end
of the day,” the tried-and-true principle of diversification—not one but two or
three different life insurance contracts, across more than one carrier—may
provide the best answer to the question of product selection. For some clients,
the assurance of a death benefit at a certain level with no future
volatility—especially in the face of an otherwise well-diversified financial
picture—could make a heavy concentration of NLG desirable. But because of NLG's
illiquidity and consequent lack of flexibility, in most cases clients will be
best served by using NLG as a relatively modest portion of an insurance
portfolio that is carefully diversified across carriers, products, and cash
value/death benefit performance projections.
Future. Natural evolution is likely to lead to more
carriers entering the NLGUL market, and those that are already in it may
further enhance their contracts. Opposing forces, however, are likely to be the
pressures caused by the regulatory bodies that may further tighten carriers'
ability to offer these policies, as well as the hardening reinsurance marketplace
that most carriers use to enhance product competitiveness.
We have begun
to see notable product development of NLG Variable UL, and the
development of this hybrid will assuredly continue in the near term.
NLGUL and
fixed annuities—Guaranteeing a transfer of wealth
Fixed annuities. Although a description of the general
annuity marketplace is beyond the scope of this article, 19
a bit of background may be useful. The annuity universe can be divided in half
from two different perspectives. First, there are “fixed” and “variable”
annuities. The former rely on a declared interest rate and are backed by an
insurance company (similar to UL and WL). On the other hand, “variable”
annuities allow the contract owner to choose the assets that back the policy
from among a number of different funds or asset allocations (similar to VL and
VUL).
Second,
annuities can also be divided between “immediate” and “deferred” contracts. The
former call for payments to the annuitant to begin now and continue for some period
of time (tied to the annuitant's life, a guaranteed period, or some combination
thereof). Alternatively, “deferred” annuities are simply vehicles where dollars
rest while (hopefully) growing until the point of “annuitization”
(i.e., when payments to the annuitant begin).
In all cases,
annuities enjoy one of the tax-favored aspects that characterize CVI—the
ability for dollars to grow (assuming cooperation from the underlying assets)
without current taxation. Unlike life insurance, however, when money comes out
of the annuity contract, any gain in excess of after-tax premium deposits will
always be taxed as ordinary income.
The rest of
this article will focus on the use of “fixed immediate” annuities (“FIA”).
These are contracts under which an amount of money (i.e., premium) is
transferred to an insurance company in exchange for the insurer's promise to
immediately start to pay to the annuitant a stream of dollars consisting of
principal and interest. Embedded within the calculation of the stream of annuity
payments is an assumed internal rate of return declared by the insurance
company (as opposed to market-based performance that the annuitant controls).
The level of this internal rate of return will drive the competitive
differences between different annuity products.
As has been
the case in the life insurance marketplace, FIAs have
improved over the years due to declining expense levels and market competition.
On the other hand, at this time, FIAs face one of the
same great challenges confronting any interest rate-sensitive product—the low
yields in the current interest rate environment.
Annuity pricing. Despite the low interest rates in the
FIA market place, annuities can still provide an attractive return on an
initial premium in absolute terms (and a very attractive return in relative
terms) if the annuity stream is tied to a life that extends beyond life
expectancy.
The periodic
(usually monthly or quarterly) payments from an FIA will be at a maximum level
if the payment is tied to a single life, with no guarantee feature. Simply put,
the annuity will continue as long as the annuitant is alive. These FIAs are called “life only” payouts. Such “life only”
payments provide the maximum annuity payouts because the risk to the annuitant
is greatest, and, correspondingly, the least risk is passed to the insurance
carrier. At the extreme, with a “life only” annuity, if an annuitant were to
die soon after paying the initial premium and after receiving only a few (or
potentially no) periodic payments, the insurance carrier will have
significantly “won” and the annuitant will have experienced a complete loss of
principal.
Depending on
the client's age and the product/pricing structure for a given carrier, other
FIA payment options could be selected instead of “life only.” These are
typically (1) “life with refund” (resulting in payments that continue for life,
but if the total aggregate payments at death don't exceed the initial premium,
a refund of the balance is made), or (2) “life with x-year certain” (payments
for the greater of life or × years). Payments can also be tied to more than one
life (i.e., “joint-and-survivor annuities”).
Because all
these FIA variations pass more risk from the annuitant(s) to the insurance
carrier, the level of each periodic annuity payout will decrease, for a given
single premium, versus the individual “life only” option. And, because the
periodic payments will be lower, the rate of return delivered to an annuitant
will be less than it would have been, given the same life expectancy, under the
“life only” option.
Transferring
wealth with an annuity tied to an NLG life insurance contract. Clearly, an FIA will
deliver an optimal return under a “life only” option if the annuitant lives
beyond life expectancy. But in reality, while an annuitant can clearly choose
the “life only” option, it is not so easy to simply elect an extended life
expectancy.
We can
mitigate, and in essence hedge, the economic risk of the annuitant's premature
death, if we synchronize a life insurance contract with an FIA. This concept is
not new; it has been a part of pension-based planning for many years. (In
advising someone about a pension payout choice, the discussion is quite similar
to choosing, or not choosing, the “life only” annuity option in an FIA
discussion.)
A “new” twist
on this planning technique arises from the recent product development and
popularity of NLG life insurance contracts. In the traditional setting, if a
person chose a “life only” annuity (or pension) option, and wanted to hedge
that risk by purchasing a life insurance policy, there still may be some
noteworthy risk that will be borne by the annuitant/insured. That is, if the
interest rate (for WL and UL buyers) or equity (for VL and VUL buyers) markets
don't perform well, the “life only” annuitant will have traded the risk of a
premature death for the risk of a poorly performing life insurance policy.
With the
option of using the relatively inexpensive death benefit guarantee offered by
an NLG contract, in conjunction with an FIA, an annuitant/insured has the
opportunity to “lock in” a guaranteed return. For a given single premium, an
annuitant will get a fixed “life only” annuity payment for as long as he or she
lives, and the economic risk of premature death is then hedged by using part or
all of the annuity payments received to purchase and maintain an NLG life
insurance contract that has a guaranteed death benefit for a given annual
premium. Further, because the timing of payments from an FIA is predictable and
fixed, they will dovetail well with, and will address, the premium-timing
sensitivity that can exist with an NLG contract.
On the other
hand, although the return is “locked in” and guaranteed, the policyowner and all advisors must be comfortable that the
return is, in absolute terms, attractive. Again, the NLG contract is best
thought of as a last stop on a train from which the client can't easily or
inexpensively get off, and there is assuredly a risk that the NLG/fixed annuity
locked-in return could be lower—perhaps significantly lower—than the returns
available in the marketplace in the future. So, this strategy is appealing for
those who think the locked-in return is an attractive number, but will be
unappealing for those who think they might be able to find a higher return in
the future.
Quantitatively,
it is not uncommon today for an annuitant, who would qualify for a favorable
life insurance classification, to be able to buy a single premium FIA and then
use the after-tax periodic FIA payments to purchase a life insurance contract
to “fully guarantee” a net return of 7%, or more, at—or a bit beyond—life
expectancy. (The term “fully guarantee” is realistically threatened only by the
ability of the insurance carrier[s] to deliver on its promises. While this risk
is hopefully negligible, it should not be overlooked.)
For an
example with real numbers, a $400,000 single premium from a healthy 65-year-old
individual could fund an FIA stream which, after paying tax on a portion of the
annuity payments, could purchase a guaranteed death benefit of more than $1.4
million. If the annuitant died at age 83, the return on the initial premium is
more than 7.2%. With a death at age 83, the 7.2% return was truly guaranteed 18
years earlier because the annuity will pay all the premiums over the
intervening 18 years, and because the NLG contract guarantees that the death
benefit premium will not change during that time.
As with any
insurance-based solution, if a premature death occurs, the return will be even
higher. On the other hand, if death occurs well beyond life expectancy, the net
return may still be in the 4%-5% range. These returns, compared with others in
today's interest rate market, are attractive, especially considering that they
are after-tax returns (the ultimate payment of the life insurance death
benefit, if structured properly, will be income tax-free).
This
technique can be made even more powerful if some relatively simple estate
planning techniques are used. If (1) the initial would-be lump sum annuity
premium were in the client's otherwise taxable estate, (2) the ultimate NLG
contract were owned by, and payable to, a device outside the estate (such as an
irrevocable trust), and (3) the periodic annuity payments were transferred out
of the estate by way of tax-free transfers, then the leverage created by using
an asset (which would otherwise be significantly taxed in the estate) to “lock
in” a 4% to 7% return, or more, on an after-tax basis, is significant. In
comparing this method of wealth transfer to other strategies, consider that
here there is no probate or administrative cost or other "slippage"
that can reduce the value passing to the named beneficiary.
Similarly,
suppose that a healthy person already holds an appreciated deferred annuity in
his estate. If that deferred annuity will be unused and therefore will be
subject to both income and estate tax at his death, purchasing the most
competitive FIA (via a tax-free Section
1035 exchange) and an NLG life insurance contract will assure a much more
favorable result than will the previous taxable strategy.
Finally, if
an annuitant has a history of health problems that could shorten his life
expectancy, there is a chance that even greater leverage may be created thanks
to underwriting “arbitrage” available in the marketplace today. If an annuitant
can legitimately demonstrate to some insurance carriers that his life
expectancy is likely to be materially shortened (i.e., if the insurer can be
convinced that the annuitant is not a "standard" risk), the client
may be able to purchase a “rated” FIA, which will increase the payout of a
“life only” option.
On the other
hand, despite the person's medical history, it may still be possible for him to
obtain a favorable NLG contract because of another life insurance carrier's
current aggressive underwriting practice (some of these are called “table
shaving” programs). With this confluence of facts, the effective “guaranteed”
return of the FIA/NLG combination can be even greater (especially considering
the possibility of a sooner-than-normal life insurance payout).
Caution. Anyone marketing any UL, VUL, or NLGUL
policies—especially in conjunction with an FIA—should consider the tax
consequences if the insured lives beyond the policy maturity date (e.g., age
100). Different contracts and different states may have entirely different rules
concerning the cash value and the death benefit of the policy after the
maturity date. Obviously, this is a greater concern in the case of very elderly
insureds. Certain contract provisions may cause
uncertain tax results for the policyowner and should
be reviewed by tax counsel.
Conclusion
At no time in
recent years have practitioners had as many cost-efficient options to (1) help
clients "match the product to the problem," (2) better address
clients' changing circumstances, and (3) accomplish estate planning objectives.
This unprecedented opportunity is accompanied by a responsibility and
professional obligation to work with competent insurance specialists to learn
more about the pros and cons of currently available life insurance products and
how they can be used to meet clients' needs and goals.
Exhibit
1.Comparison of UL, VL, and VUL
Feature UL VL VUL------- -- -- ---Death Benefit Yes Yes YesGuaranteed WhilePolicy in Force?
Premium Amounts Yes No YesFlexible?
Policyowner No Yes Yes
Chooses HowPremiums Invested?Policyowner Can Yes No Yes
Vary Frequency orAmount ofPremiums Paid?Policyowner Can Yes No Yes
Increase orDecrease DeathBenefits?
Death Benefit Yes No YesOptions A and BAvailable?
Cash Values No * Yes YesFluctuateDepending onPerformance ofUnderlying Asset?Interest Rate on Yes No NoCash ValuesGuaranteed?Partial Withdrawals Yes No YesAllowed FromCash Values?
Cash Value Grows Yes Yes YesTax-DeferredAnnual Statements Yes No YesDetail MonthlyDeductions forCosts and C.V.
Growth?
Considered a No Yes YesSecurity?
* The current interest credited to cash values of UL contracts fluctuates withthe performance of the insurer's general portfolio, but cash values, once
accumulated, do not fluctuate in value with fluctuations in the market value
of the assets in the general portfolio. Table courtesy of Tools and Techniques
of Life Insurance Planning (800-543-0874).
See Leimberg and Doyle, Tools
and Techniques of Life Insurance Planning (800-543-0874), and Zaritsky and Leimberg, Tax
Planning With Life Insurance (800-950-1216), for
more specific guidance as to life insurance products and their taxation and
use. See also Baldwin, New Life Insurance Investment Advisor
(McGraw-Hill Trade, 2001);
There are many types of whole life contracts. The
oldest and most common is ordinary level-premium whole life, more commonly
known as ordinary or straight or traditional or continuous premium whole life.
During the early years of the contract, premiums
charged are greater than necessary to provide a pure insurance death benefit
equal to the “face amount,” the amount promised by the insurer in the event of
the insured's death. This excess amount, together with earnings on policy
values, is held in a reserve and gradually “used up” during the years when the
insured's probability of death is more likely and therefore the cost of
providing the agreed-upon amount of insurance is higher than the money received
from the policyowner, and the level premiums are no
longer sufficient. In essence, there is an “overcharge” in the early years of
the policy to compensate for an “undercharge” in later years.
Most of the key legal benefits of a WL contract are
also contained in VL. These include guaranteed maximum mortality charges, nonforfeiture values, a policy loan provision, a
reinstatement period, and settlement options.
See the Estate Planning Newsletter Archives in Leimberg Information Services, Inc.
(http://www.leimbergservices.com) for the latest information on Section
817 , which covers the taxation in this area.
Because variable life contracts are considered
securities, a prospectus must be provided to prospective buyers. This
prospectus sets forth information on the insurer, including certain financial
data, the way the insurer will use the policyowner's
premiums, the investment characteristics of the policy, and most importantly,
extensive information about the contract's expenses, fees, loads, and rights of
the policyowner.
Some insurers offer a wide choice that might include
foreign stock funds, bond funds, GNMA funds, real estate funds, zero-coupon
bond funds, and even funds that specialize in specific areas (such as small
capitalization stock funds), market index funds, or funds that focus on sectors
of the economy (such as utilities, high tech, or communications).
Rybka, "A Case for Variable Life," J. Am. Soc'y
of CLU & ChFC (May 1997), and Black and Skipper, Life
Insurance (13th ed., Prentice-Hall, 1999).
Under a flexible premium contract, the policyowner can, within limits, decide how much he, she, or
it wants to pay and even skip a payment entirely—as long as there is sufficient
cash value in the policy to cover current policy charges.
Additions to policy cash values are determined by
current interest rates, current mortality costs, and current expense charges.
A policyowner of an
adjustable death benefit contract is allowed to lower policy death benefits or,
assuming he or she is able to prove insurability, increase the policy's death
benefit.
These two death benefit options are typically called
Option A (or I) and Option B (or II). The death benefit stays level under A just as it would in a classic WL contract.
See Harris, "Due Diligence Tips for Private
Placement VUL,” Nat'l Underwriter (
One cost of the underlying investment options is a
much reduced liquidity, which results in unique problems and challenges for
both the policyowner and the insurer. For example,
policy values are not determinable on a daily basis. Moreover, limited
liquidity complicates the processing of recurring monthly charges—a problem
often solved by a requirement that some level of liquidity be maintained to cover
those charges.
The trade-off here is that the internal rate of return
(“IRR”) on surrender is greater with a MEC than with a non-MEC because a MEC
provides less life insurance and therefore lower costs while a non-MEC provides
a higher net amount at risk—i.e., more insurance and greater liquidity but
greater consequent insurance charges and lower cash values. Therefore, many
individuals try to obtain the minimum face amount that will still satisfy the
Guideline Premium test.
Theodore, "Introduction to Private Placement
VUL," Product Matters, p. 22 (Nov. 2002).
Regardless of whether the policy is issued on or
offshore, if the policyowner is a
See Rybka and Jones,
"Guesses, Projections, Promises & Guarantees," 59 J. Soc'y Financial Service Professionals No. 4 (July 2005).
Mr. Rybka notes, "While secondary guarantees
constitute an unequaled marketing success, they have triggered growing concerns
among the industry's leading pricing actuaries and rating agencies. They
caution that some companies having large blocks of secondary guarantee products
may, in some circumstances, cause long-term financial impairment to their
reserves and create risk for those very policyholders who were seeking the
safety of guarantees."
For more information on annuities, see Tax Planning
With Life Insurance (800-950-1216), and Tools
and Techniques of Life Insurance Planning (800-543-0874). See also Leimberg and Gibbons, “Annuities and Estate Planning,” 29
ETPL 360 (July 2002).
© Copyright 2005 RIA. All rights reserved.
Drafting
Wills and Trust Agreements: A Cost-Effective Program for Preparing High-Quality
Documents
Author:
DONALD H. KELLEY
DONALD H. KELLEY practices law in Denver, and is of counsel to the
law firm of Kelley, Scritsmier & Byrne, P.C., in
North Platte,
Drafting
Wills and Trust Agreements on GhostFillTM
V. 2.0
(“DWTA”) by Michael L.M.
In addition
to revocable trusts and simple, long form and pour-over wills, DWTA prepares Joint
Property Trusts, Community Property Trusts, Irrevocable Long-Term GST Trusts,
Irrevocable Life Insurance Trusts, Irrevocable 2503(c) Trusts, Irrevocable
Charitable Remainder Trusts, NIMCRUTs, Irrevocable
Grantor Retained Annuity Trusts, and Irrevocable IRA Management Trusts. It also
prepares General Durable Powers of Attorney (nonstatutory)
and Special Durable Powers of Attorney (nonstatutory).
In addition, the software prepares Letters and Supplemental Documents,
including a Client Intake Form, Engagement Letter, Appointment Letter,
Transmittal Letter, Statement Letter, Statement, Closing Letter, and Durable
Powers of Attorney Supporting Documents. The program generates a plain-English
client explanation of each clause in the documents you draft.
DWTA uses an
intuitive question-and-answer approach to the selection of clauses during
drafting. It allows you to adapt clauses and content to meet your own
preferences as to style and language.
DWTA is
constructed on the GhostFillTM document
assembly platform, with GhostFillTM
Explorer providing the user interface.
A Quick Start
Guide is furnished in hard copy. Also furnished and installed in PDF format
(which requires Adobe Reader to view) are the following: DWTA Quick Start
Guide, GhostFillTM Orientation Tour, and
End User Orientation. The GhostFillTM help
system is included. The DWTA help system is a three-pane HTML system with
detailed descriptions of the operation of the program and extensive and
relevant drafting suggestions. It is context-sensitive with Help buttons on
appropriate screens. At particularly sensitive drafting areas, a “Warning”
button appears that links to the related topic in the Help system.
Program
capabilities
DWTA is
designed for use on IBM PCs or compatible hardware. It requires Windows 2000 or
XP, a minimum of 256MB RAM, and a minimum of 120MB of hard disk space. The
completed documents may be loaded into either Microsoft Word (2000 or later) or
WordPerfect (V. 9 or later), as you select. You will need a CD-ROM drive for
installation. Installation may be stand-alone or on a network. The product is
licensed for use on an annual basis, and Internet access is required for
licensing.
You may set
up system and document defaults, and enter information that will be used
throughout the system, such as the name of your firm. You may also select
preferences for fonts, typeface, and formats for wording in documents (such as
dates). Furthermore, you may select optional wording for standard terms,
customize various terms and phrases, and enter exemption and exclusion amounts
to be used in appropriate clauses and flowcharts. More advanced document styles
may even be created using the Word Styles tool. You may choose the numbering
system for clauses, select the document structure, set up the preferred output
format for cover pages, and set up the manner in which you want the table of
contents page to be constructed. Titles are included at the beginning of each
clause, rather than as part of the numbering system. You need to enter client
information only once, and these answers automatically populate across the
document.
In creating a
document, you first choose the document you wish to prepare. Document drafting
is done through an interview process in the course of which you enter client
information and select the appropriate clauses for your document.
You may use
the system language for document clauses, permanently modify the system
clauses, or even create user-defined clauses using your own language. Such
clauses will then be included in the appropriate interview dialogs. You may
also modify language for a particular client, including modifications (1) to a
given document in the Document Preview stage, or (2) to the finished document
in your word processor.
When the
interview process is completed, DWTA compiles the form language and variables
to produce the assembled document. You may then preview the assembled document
and modify clauses and answers before creating the final document. A spousal
mirror of the finished document may be easily created by merely directing the
program to do so.
DWTA
generates flowcharts demonstrating the flow of property directed by the dispositive provisions in the will or trust. The flowcharts
are printed through Windows Paint and may be easily copied from that program
and pasted into your word processor for inclusion with the client explanation.
They may also be saved in a graphic file format.
As part of
the selection of plan options, you may choose marital legacy allocations based
on federal law, state law, or a combination of state and federal law (for
"decoupled" states). You may also select a Clayton allocation
for a variable marital QTIP election.
You may
create or modify Models of interviews for special types of clients for
convenience in future drafting, and modify the language used in the clauses
referenced in such Models. The interview selection list may be saved as a
Model, including tailored clauses for each type of client, and tailored
transmittal letters. Significant time may thus be saved in the interview
process for types of clients you regularly encounter.
The Client
Utilities feature allows you to import, export, or copy DWTA files to
facilitate moving files to other computers, such as laptops. You may also use
it to create spousal mirrors with divergent provisions for the mirrored spouse.
The program
does not endeavor to be state-specific, although the appropriate clauses may be
readily edited at the system level to add language (such as attestation and
fiduciary powers) required in your state's practice.
Program
operation
The first
step in the creation of a document is to select the type of document you wish
to prepare from the main screen, which is illustrated in Exhibit 1.
A dialog then
appears from which you may select the specific variation of the document type
(e.g., Wills—Simple, Long Form, Pour-over, etc.). The DWTA dialogs and subdialogs are dynamic, shrinking or expanding according to
the complexity of the dialog and the selections you make. An interview screen
then appears for the type of document selected, as shown in Exhibit 2.
The topics to
be included in the document are selected by selecting or deselecting the topics
to be included from a list of topics. For each topic selected, you may then
click on “Edit Details” to make further selections of alternate language and
insert specific language. In wills or revocable trusts involving marital/credit
shelter trusts, a dialog offers a choice among six types of marital
deduction/GST/QTIP plans or gives you the opportunity to create your own plan.
Selection of any plan offers a Help topic detailing the circumstances for using
that plan.
After
selection of a plan, a dialog offers choices among the types of allocation
(whether based on federal or state law), the type of marital deduction clause
(pecuniary or fractional), and selection of whether the marital legacy and
family legacies are to be in trust or outright. This process requires learning
a few coding designations, but is not demanding. You may then select the
details for the credit shelter trust (or long-term GST trust)—i.e., whether the
net income will be distributed or whether a unitrust
distribution will be directed—and the details for distribution at the death of
the spouse/life beneficiary. You may also select a clause with choices of how
the plan will be adjusted to the vagaries of EGTRRA or in the event of outright
repeal of the federal estate tax.
At the
conclusion of the interview process, clicking on “OK” brings up a dialog screen
from which you may preview the document, preview the flowchart, or load the
document into your word processor. Selecting “Preview Document” causes the
document to appear as shown in Exhibit 3.
On this
screen, you may edit the text of any clause of the document or add a variable
to the clause. The left-hand frame provides convenient navigation to each
clause. You may return to the Interview mode to change any interview responses.
The preview screen must then be updated by clicking on the “Refresh Preview”
button.
Procurement
information
Drafting
Wills and Trust Agreements on GhostFillTM
V. 2.0
is available from Thomson-West at 1-800-762-5272 or online at website
http://west.thomson.com/store/product.asp?product%5Fid=DWTA. The website
includes an online demo.
DWTA is
priced on a per-computer (seat) basis with one seat at $984.96. The charge may
be paid monthly or one time for the year. Additional seats are $715.92. There
is also an annual upkeep price.
The Drafting
Wills and Trust Agreements, 3d form volumes, with federal and state law
explanations, are available online at http://west.thomson.com/dwta for $405.
Updated
program files (patches) are periodically available for downloading from the
DWTA web page. You may request email notification of updates. Each time the
product is updated on the West Electronic Software Download page, you will
receive a notification message with a link to the update.
DWTA is
supported by telephone at Customer Technical Support, 1-800-277-9378, or email
west.support@thomson.com, and training by telephone is available.
Conclusion
DWTA is a
time-saving, user-friendly program for drafting estate planning documents. This
cost-effective program produces consistently high-quality documents.
Exhibit
1.Main Screen
Exhibit
2.Interview Screen
Exhibit
3.Document Preview
© Copyright 2005 RIA. All rights reserved.