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Notes from Heckerling - Pressing the "Do Over" Button: Strategies for Modifying Wills and Trusts after Formation

January 16th, 2012

Probate Litigation,  Estate Taxation,  Trust Litigation,  Guardianship Litigation,  Income Taxation,  Real Estate Litigation,  

Title: Pressing the “Do Over” Button: Strategies for Modifying Wills and Trusts after Formation

Presenter: Joshua S. Rubenstein

                Mr. Rubenstein opened his presentation discussing a few current events that weren’t expected such as the European debt crisis, the Asian spring, and the Yankees failing to reach the World Series. He noted that you cannot anticipate all changes and issues that may arise in the future.   Clients often make bad decisions regarding their estate plans, and lawyers sometimes make mistakes. In addition, people are living longer than ever before which raises the question, so how long does a person have to wait to inherit? There is an increase in litigation, and trust beneficiaries often few trusts negatively. Mr. Rubenstein divided the presentation into four different sections in discussing how to address some of these issues:  I) Tax Considerations Underlying Modifications: Income and Transfer Taxes, II) Retroactive Modifications, III) Prospective Modifications, and IV) Special Considerations with Respect to Litigation Settlements. 

I) Tax Considerations

                In describing the tax consideration’s underlying modifications, he noted the current low income tax rates, which he only expects to increase.  Historically income tax rates are as high as 90% for the top rates as opposed to the current 35-40% income tax rates and 15-28% capital gains rates.   He also discussed the various forms of taxation for different entities and how gifts, legacies and distributions from estate/and or trusts are generally tax exempt, except for income in respect of a decedent, distributable net Income, and gifts to employees.   The most common deductions are charitable, businesses, and administration expenses which are all subject to substantial limitations. He also noted many states and municipalities impose income tax rates, while eight states levy no income tax. 

Furthermore, transfer taxes have been at 55% for the last several decades, and historically have been as high as 90%, although today we are at 35%. The deductions on the transfer tax side include the marital deduction, charitable deduction, debts/claims, administration expenses, and exclusions. These deductions can often be claimed on the estate tax return, income tax return, or a decedent’s final Income tax return. He noted that the true cost of estate tax repeal did not take into account the shifting of deductions. This increased the cost of estate tax repeal significantly. All states impose an estate tax or inheritance tax, but due to the current federal credit many states effectively do not impose an estate tax. Gift taxes are levied by two states, Connecticut and Tennessee. Most GST taxes mirror the federal credit. As all these taxes increase, the importance of their effect on trust and will modifications increase as well.

II) Retroactive Modification

                Reformation proceedings are statutorily allowed in certain circumstances. Today a charitable gift can be modified if it would otherwise be disqualified as a charitable split interest trust. In addition, a trust can be modified to correct errors that would otherwise disqualify the trust form being GST exempt. Finally, a qualified domestic trust (QDOT) can be modified to allow it to qualify for the marital deduction (oddly the same is not available for a QTIP trust). There is also 9100 relief for botched elections, but this has had mixed results with QTIP elections. In discussing the effectiveness of retroactive modification, he noted the IRS will generally not respect them due to Commissioner v. Estate of Bosch, 387 US 456 (1967), which provided in the absence of a determination by the state’s highest court, only “proper regard,” not finality, should be given to interpretations by state courts, provided it was entered by a court in a bona fide adversary proceeding.   

He noted that if there is a genuine ambiguity, IRS is more likely to respect a construction proceeding than a reformation proceeding. He noted that tax allocation provisions often have problems and can result in significant rewriting of a will, since tax provisions can often dramatically shift who receives assets or may disinherit someone entirely.   Disclaimers are also beneficial to resolve problems of disqualifying dispositions and people can also disclaim powers. In addition, a person may be able to disclaim a tax apportionment clause resulting in a significant shifting of property. He also noted that people should keep in mind the non-qualified disclaimer as it may be available to solve problems, although it may be subject gift tax.

Litigation settlements also provide opportunities to rewrite documents. Probate contests can substantially rewrite wills from bequests in trust to outright distributions. Elective share contests can also rewrite wills, but will often result in an increase or decrease in taxes; and contests involving conflicting agreements, the agreement often trumps the Will. Examples of agreements that may trump a Will include: separation agreements, prenuptial agreements, shareholder and partnership agreements, pledges and contracts to make wills.

III) Prospective Modifications 

Decanting is the often used to change trust terms. He noted three main basis for decanting are: (i) the trust instrument, (ii) common law, and (iii) state statute.   As for the statutes, he noted many new changes to statutes allow decanting in most all situations in a state such as New York.  He discussed various reasons for decanting such as: to correct drafting errors, modify trust provisions, improve administration or managements, address changed circumstance, remove unworkable restrictions, change provisions relating to trust powers and succession, achieve tax savings, change trust situs, combine or divide trusts, and GST planning. He also noted notice 2011-101 which the IRS has issued to look into the various impacts of decanting. Often modification of trust documents can be done pursuant to the trust’s terms. Resignation of disqualified fiduciaries can resolve the reciprocal trust doctrine. Trust splitting can also resolve GST or S corporation taxes, and partial QTIP elections. In addition, he noted some states allow parties to amend irrevocable trusts if the grantor is alive and all parties are adult and competent. 

IV) Litigation Settlements

                A fiduciary being sued should always look to ways to benefit the beneficiaries in the litigation by taking the opportunity to improve the document provisions. He noted that special consideration must be given to marital and charitable deductions in litigation settlements. For a marital deduction to be valid, under state law, an interest must pass form the decedent, property must be included in the gross estate, property must pass to the surviving spouse, and it cannot be a terminable interest, unless statutorily exempted. Similarly a charitable interest to be allowable under state law, must pass form decedent, must be included in the gross estate, must pass to charity, and the contest must be bona fide.

The tax treatment of settlements can often dramatically change results. If the marital deduction is lost, this can increase taxes and perhaps penalties and interest. The charitable deduction can also do the same. Also the values on interests cannot change considerably otherwise you can have gift tax consequences. It should also be noted that section IRC 102(a) exempts gifts and inheritances except for income from gifts and inheritances, gain on conversion or deemed conversion, and compensation for damages or services. Legal fees are also deductible by a fiduciary on the estate or trust return and a beneficiaries fees are generally not deductible by an estate or trust, except for probate contests and construction proceeding. These may or may not be deductible by the beneficiary. If the estate pays the beneficiary’s legal fees there may be a possible deduction that helps resolve the litigation.

Mr. Rubenstein reminded us to think outside of the box and be creative. Consider the following strategies that can be employed to achieve substantial tax savings when modifying governing instruments as part of litigation: (i) Careful consideration of all claims should be reviewed to ensure proper consideration is given to each claim; (ii) enhance tax advantaged trusts such as credit shelter trusts or trusts not in the gross estate, estate tax deferred trust such as marital, and GST exempt trusts; (iii) consider possible benefits of exercising a right of contribution, transfer of debt to lower generations, discounting long term notes, consider deducting payments to charity, buy back assets from charity, characterizing transfers as gifts versus loans, and consider unitrust conversion options.