FIXING BROKEN MARITAL DEDUCTION AND CREDIT SHELTER TRUSTS (WITH DRAFTING EXAMPLES)

Transcription

1 FIXING BROKEN MARITAL DEDUCTION AND CREDIT SHELTER TRUSTS (WITH DRAFTING EXAMPLES) BY: DOMINGO P. SUCH, III 1 McDermott Will & Emery LLP 227 W. Monroe Street Chicago, IL (312) dsuch@mwe.com [Revised thru ] Introduction Estate plans go through numerous iterations prior to being finalized. Provisions that were appropriate initially may seem less so when the estate matures. Many reasons exist for issues and complications that arise during the administration of an estate plan. Most commonly, changes in the tax law have been problematic, as has been the recent experience with changes to the federal estate tax and decoupling of state death taxes. Other issues arise from scrivener s errors, mistakes and changes in circumstances. In order to plan effectively, flexibility is critical, especially when drafting marital and credit shelter trusts. Estate planning documents are necessarily complex and the trend of using long-term trusts is likely to increase the number of trusts that will be scrutinized after they have become irrevocable. Fortunately, as the need for estate plan fix-ups has grown, the range of available techniques has also expanded. 2 The Internal Revenue Service (the IRS ) seems somewhat 1 Copyright All rights reserved by Domingo P. Such. Mr. Such (dsuch@mwe.com) is a partner in the international law firm of McDermott Will & Emery LLP, resident in its Chicago office. The author thanks Mr. Michael J. Sorrow, an associate at McDermott Will & Emery LLP, for his invaluable assistance in the preparation of this outline. To comply with IRS requirements, any U.S. federal tax advice contained in this article is not intended or written to be used, and cannot be used, for the purposes of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing, or recommending to another party any transaction or matter. 2 See generally, Unif. Trust Code, (amended 2005); Restatement (Third) of Property, Division IV (2003); William R. Burford, Practical Prescriptions for Fixing a Broken Irrevocable Trust, 36 Estate Planning 9 (September 2009); F. Ladson Boyle, When It s Broke Fix It: Reforming Irrevocable Trusts to Change Tax Consequences, 53 Tax Law 821 (2000); Ronald Chester, Modification and Termination of Trusts in the 21 st Century: The Uniform Trust Code Leads a Quiet Revolution, 35 Real Property, Probate and Trust Journal 698 (Winter 2001); Mary Louise Fellows, In Search of Donative Intent, 73 Iowa L. Rev. 611(1988); Joseph W. de Furia, Jr. Mistakes in Wills Resulting From Scriveners Errors; The Argument for Reformation, 40 Cath. U. L. Rev. 1 (1990); Clifton B. Kruse, Jr., Reformation of Wills: The Implication of Restatement (Third) of the Law of Property (continued )

2 accepting of these techniques. This outline explores the different methods currently available for modifying and changing marital and credit shelter trusts. Necessarily, state law will impact the terms of the trusts and will need to be examined. I. Saving the Marital Deduction 3 A. Restrict Boilerplate Powers 1. When drafting a marital deduction trust, restrict the traditional boilerplate powers given to the trustee to avoid the impairment of the marital deduction. 2. In Revenue Ruling 69-56, C.B. 224, the IRS ruled that the following fiduciary powers do not result in the disallowance or diminution of the marital deduction if: (i) the governing instrument contains no provision directing the fiduciary to favor the remainder beneficiaries over the surviving spouse; (ii) the governing instrument does not preclude a court of competent jurisdiction from imposing reasonable limitations upon the exercise of the fiduciary powers in order to protect the surviving spouse s interest; and (iii) the governing instrument does not evidence an intent to deprive the surviving spouse of the beneficial enjoyment of the marital trust property, as required by the Internal Revenue Code: a. To apportion or not to apportion, between successive beneficial interests, interest income and expense, rental income and expense, real estate taxes, or other items of periodic income and expense. (Under applicable state law, the fiduciary s determination must be made so as to balance fairly the interests of successive beneficiaries.) b. To treat ordinary cash dividends as income when received, regardless of the declaration date or record date. c. To treat extraordinary cash dividends as principal. (Donative Transfers) on Flawed by Unambiguous Testaments, 25 ACTEC Notes 299 (2000); John H. Langbein and Lawrence W. Waggoner, Reformation of Wills on the Ground of Mistake: Change of Direction in American Law?, 130 U. Pa. L. Rev. 521 (1982); Marilyn G. Ordover & Charles F. Gibbs, Correcting Mistakes in Wills and Trusts, N.Y. Law J. 3 (August 6, 1998); James L. Robertson, Essays: Myth and Reality or, Is it Perception and Taste? in the Reading of Donative Documents, 61 Fordham L. Rev (1993); Barry F. Spivey, Completed Transaction, Qualified Reformation and Bosch: When Does the IRS Care About State Law of Trust Reformation?, ACTEC Notes (Spring 2001). 3 The author appreciatively acknowledges the contributions of Sebastian V. Grassi, Jr. in the writing of this section as significant portions of this section has previously appeared in the same or substantially similar form in Sebastian V. Grassi, Jr., A Practical Guide To Drafting Marital Deduction Trusts (With Sample Forms and Checklists) (ALI/ABA, Philadelphia, PA (2008), (800)

3 d. To treat stock dividends as principal. e. To treat capital gains dividends of regulated investment companies as principal. f. To charge to income or principal executor s or trustee s commissions, legal and accounting fees, custodian fees, and similar administration expenses. g. To maintain reasonable reserves for depreciation, depletion, amortization, and obsolescence. h. With respect to interest-bearing bonds and like obligations, to amortize or not to amortize both premium and discount. i. To retain cash included in any trust fund without investment thereof for such period of time as the fiduciary shall deem advisable, whenever he shall determine that it is inadvisable to invest such cash. j. To make distributions in cash, or in kind at current values, or partly in each, allocating specific assets to particular distributees, and for such purposes to make reasonable determinations of current values. B. Include A Marital Deduction Savings Clause 1. In addition to limiting a trustee s powers, a marital deduction savings clause can be useful to determine the grantor s intent when resolving an ambiguity in the governing instrument, and should be included in all marital deduction trust agreements However, the IRS will not give credence to a savings clause when there is unambiguous language in the document that is inconsistent with or thwarts the marital deduction. The IRS adheres to the general rule of construction that the specific overrides the general Sample Marital Deduction Savings Clause: It is my intent that the marital deduction gift to my Spouse and the property comprising the trust estate of the Marital Trust shall qualify for the federal estate tax marital deduction applicable to my estate (except to the extent such property is not elected/deducted for the marital deduction by my personal representative 4 See Rev. Rul ; I.R.S. Priv. Ltr. Ruls , and See I.R.S. Priv. Ltr. Rul (refusing to give effect to a savings clause purporting to limit the power of a trustee to whatever extent necessary to prevent loss of the gift tax present interest exclusion)

4 or Trustee). In all matters involving my estate, my will and this Trust Agreement, the same shall be construed in such a manner as to accomplish this tax objective, and my personal representative and Trustee shall exercise no power in a manner that would be inconsistent with this tax objective. To this end, all Trustee powers and discretions with respect to the administration of the Marital Trust shall not be exercised or exercisable except in a manner consistent with this intent. All doubtful questions regarding the allocation or apportionment of Marital Trust receipts and disbursements to or between principal and income shall be resolved in favor of the income beneficiary, it being intended that, at the very least, my Spouse be given substantially that degree of beneficial enjoyment of the Marital Trust property during the remainder of my Spouse s lifetime which the principles of the law of trusts accord to a person who is unqualifiedly designated as the life beneficiary of a trust. Furthermore, if the Marital Trust consists of any property that is not productive of a reasonable rate of income, my Spouse may require Trustee to make the property productive or convert it within a reasonable time to income-producing property or to provide out of other assets of the Marital Trust the equivalent of the income such property would produce if it were productive of a reasonable rate of income. 4. A marital deduction savings clause is not a substitute for careful drafting nor is it truly a savings clause. 6 In Private Letter Ruling , the IRS disqualified a trust for QTIP treatment (despite a general savings clause contained in the QTIP trust) because of an overriding administrative provision authorizing a court of competent jurisdiction to amend the overall trust agreement if the purposes of the trust could be defeated or hindered because of change in circumstance or change in law.the court may amend the terms of this Agreement and restrict or remove any of the powers, duties, rights and privileges of the Trustee, the beneficiaries or any other person. The IRS ruled that the specific unrestricted administrative provision overrode the general marital deduction savings clause contained in the QTIP trust. The ruling indicates that had a marital deduction savings clause been contained in the administrative powers section of the trust (so as to limit the court s authority), the QTIP marital deduction would have been available. This ruling serves as a reminder that special trust powers that are designed to provide post-mortem flexibility need to be expressly limited in their scope 6 The savings clause is not a savings clause in the strict sense of the term, but is an aid in determining the testator s intent; that is, the existence of a savings clause that would void a disqualifying power given to the trustees of the marital deduction trust is relevant here only because it helps indicate the testator s intent not to give those trustees a disqualifying power. Rev. Rul Nonetheless, as discussed in Rev. Rul , [savings clauses] can be used as an aid in determining testator s intent where the instrument presents an ambiguity. I.R.S. Pvt. Ltr. Rul

5 II. Correcting QTIP Elections 8 so as to not impair or thwart a marital or charitable deduction otherwise available to the decedent s estate. 7 A. Internal Revenue Code 2056(b)(7) provides an exception to the general rule that terminable interests do not qualify for the marital deduction. A marital deduction is allowed for property transferred to a QTIP trust if the following requirements, in addition to the general requirements required for the marital deduction, are met: 1. The property passes from the decedent The surviving spouse is entitled to all the income from the trust for life, which must be paid to the surviving spouse at least annually No person, including the surviving spouse, may possess a power to appoint any part of the trust to any person other than the surviving spouse during the surviving spouse s life The decedent s executor makes an election on the decedent s estate tax return to treat all or a specific portion of the trust as qualified terminable interest property. B. Partial QTIP Election 1. Even if all the requirements of IRC 2056(b)(7) are met, an executor is not required to elect to treat all of the trust property as a QTIP trust. Internal Revenue Code 2056(b)(7)(B))(iv) provides that an executor may elect QTIP treatment for a specific portion of the trust. 2. If a partial QTIP election is made, Treasury Regulations (b)- 7(b)(2)(ii)(A) provides that the single trust may be divided into separate trusts to reflect a partial election that has been made, or is to be made, if authorized under the governing instrument or otherwise permissible under local law. Such a severance must be accomplished no 7 See also, I.R.S. Pvt. Ltr. Rul (marital deduction savings clause was not effective in overriding unambiguous prohibited power held by the surviving spouse over the QTIP trust). 8 Sebastian V. Grassi, Jr., A Practical Guide To Drafting Marital Deduction Trusts (With Sample Forms and Checklists) (ALI/ABA, Philadelphia, PA (2008), (800) IRC 2056(b)(7)(B)(i)(I). 10 IRC 2056(b)(7)(B)(ii)(I). 11 IRC 2056(b)(7)(B)(ii)(II)