Unique (and Some Immediate) Challenges and Opportunities for Fiduciaries under New Tax Law

The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act that President Obama signed on December 17, 2010 (2010 Act) makes fundamental changes to the estate, gift, and generation skipping-transfer (GST) tax laws applicable in 2010 (and beyond). The 2010 Act also provides fiduciaries an essential measure of certainty when considering opportunities available until the end of 2010. The new law confirms broad relief for certain 2010 transfers that would otherwise be subject to the GST tax, imposes a federal estate tax on 2010 decedents but provides a $5 million exemption, and allows executors of 2010 estates a unique election out of estate tax and into a modified carryover basis regime.

McGuireWoods’ Private Wealth Services Group is preparing a white paper on the Act that will be distributed in early January. However, some aspects of the Act present challenges and opportunities that justify fresh attention by, and in some limited cases action by, fiduciaries during the few remaining days of 2010.

The Act

In general, the Act extends several provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001 (2001 Tax Act) for an additional two years. Some of the most significant (albeit largely temporary) aspects of the Act include:

• Retroactive reinstatement of the federal estate tax for 2010 decedents with an exemption of $5 million.
• Election out of estate tax, and into a modified carryover basis regime, for 2010 decedents.
• A zero GST tax rate for 2010.
• An increase in the estate tax exemption from $3.5 million in 2009 to $5 million.
• Reunification of the estate tax and gift tax in 2011 so that the gift tax exemption in 2011 and 2012 is $5 million. This is expected to be the catalyst for significant lifetime estate planning transactions (i.e., gifts, sales, etc.) in 2011 and 2012.
• An increase in the GST tax exemption from $3.5 million in 2009 to $5 million.
• Retention of the deduction for state death taxes.
• Starting in 2011, the ability to transfer a decedent’s unused estate tax exemption to the decedent’s surviving spouse, which is referred to as “portability.” This may have a significant impact on future estate planning for many married couples.
• Extension of lower income tax rates, with a top rate of 35%.
• Extension of lower capital gains and dividend tax rates, with a top rate of 15%.
• Ability to rollover directly from an IRA to a qualified public charity through 2011.
• Alternative Minimum Tax relief.
• A 2% reduction in the Social Security payroll tax rate for 2011 only.

No GST Tax for (What Little Bit is Left of) 2010

Although the 2001 Tax Act eliminated the GST tax for transfers in 2010, many fiduciaries had valid concerns about the possibility of retroactive legislation which understandably deterred fiduciaries from taking significant action in reliance on the 2001 Tax Act. The 2010 Tax Act provides much needed certainty by confirming that 2010 will indeed be a tax “holiday” with respect to the federal GST tax. Unfortunately, that certainty arrived only with President Obama’s signing of the Act on December 17, 2010, which left fiduciaries with little time to take advantage of the opportunities that will expire at the end of 2010.

The Act provides that the applicable rate for GST transfers made in 2010 is zero. This means that there is no GST tax payable in 2010 on: (1) direct transfers to “skip persons” (either outright or in trust); (2) otherwise taxable distributions from trusts that are not exempt from the GST tax; and (3) terminations of GST non-exempt trusts. For direct skip gifts to trusts for the benefit of grandchildren in 2010, there will also be no GST tax payable upon the later distribution of the trust assets to the grandchildren (although the GST tax may still apply to certain distributions to younger generations).

This temporary zero GST tax rate confirms a very short-lived opportunity to make distributions to skip beneficiaries from GST non-exempt trusts, or to terminate these trusts in favor of skip beneficiaries or possibly new trusts for their benefit. Because of the significant burden of the GST tax, this opportunity to avoid the GST tax raises immediate questions about the duties of fiduciaries concerning distributions from or termination of GST non-exempt trusts.

Some trustees have previously contacted beneficiaries of GST non-exempt trusts to discuss this opportunity. Before the Act, many trustees and beneficiaries were reluctant to take advantage of this opportunity due to the uncertainty in the tax law. Even with the passage of the Act, many trustees and beneficiaries will not be able to take advantage of this opportunity, because of the short period of time between the passage of the law and the end of the year. Trustees may receive requests before year-end from trust beneficiaries for distributions from trusts that are subject to the GST tax. Those beneficiaries seeking distributions to save GST taxes may not appreciate and may have little patience for the process a prudent trustee must follow before making such distributions, including properly evaluating the tax benefits and risks of such distributions relative to the particular circumstances of the trust and the beneficiaries.

For example, a prudent trustee may be concerned that distributions may violate the trust terms and the settlor’s intent, extinguish the interests of future beneficiaries, or expose otherwise protected assets to the claims of the beneficiaries’ creditors. Beneficiaries will have a hard time understanding that in many (if not most) cases it will be impossible to make the requested distributions in the very little amount of time allowed by the Act, or, the distributions will not be in the best interests of all trust beneficiaries to whom the trustee owes duties.

While the tax benefits of distributions and terminations through 2010 are now clearer, the duty of the trustee of those trusts is very much unclear. The trustee will need to carefully review the governing instrument and state law to determine whether the trustee has the authority to make the requested distribution, and many trustees will find that authority lacking. The most basic duty of the trustee is to administer a trust on its actual terms and in furtherance of the intent of the settlor. Relatively few trusts will actually provide for distributions or termination solely for the purpose of saving GST taxes, and are more likely to condition distributions on the needs of beneficiaries for support, health, education, and the like. In fact, in the past, some trustees have been criticized for making distributions for tax purposes where the document did not expressly allow the distribution.

If beneficiaries request a distribution to save GST taxes, the trustee should consider employing financial and legal advisors in order to evaluate whether it is prudent or even possible to make significant distributions from or terminate GST non-exempt trusts before the end of the year.

Of course, just as in any discretionary action that involves significant fiduciary risk, trustees should consider taking advantage of tools for managing or eliminating that risk, such as beneficiary consents, releases, indemnification, and court approval (although it is unlikely that there is adequate time to obtain approval before the end of the year). If a trustee is relying on a beneficiary agreement in connection with the termination of a trust, the trustee must consider carefully whether it is possible to bind minor and unborn contingent beneficiaries to the agreement. In states that have enacted the Uniform Trust Code, this will be easier to accomplish through virtual representation.

Difficult Election for Executors of 2010 Estates – To Pay Estate Tax or Modified Carryover Basis

The Election

The Act reinstates the estate tax retroactively effective as of January 1, 2010, with a $5 million exemption and a 35% tax rate. However, the executor of a 2010 decedent’s estate may elect instead to have the modified carryover basis rules established for 2010 under the 2001 Tax Act apply. The executor must make an affirmative election to apply the carryover basis rules. Once this election is made, it is revocable only with the consent of the Secretary of the Treasury.

The Act provides that the estate tax return for a decedent dying in 2010 before December 17, 2010, the date of enactment, is not required to be filed until September 2011, to provide executors with time to make such an election.

Modified Carryover Basis

Under the 2001 Tax Act, carryover basis rules govern the method by which executors and beneficiaries of 2010 estates determine the income tax basis of property acquired from a decedent, which is then used to calculate the gain or loss upon the ultimate sale of the property. Under an estate tax regime, beneficiaries took as their basis in inherited property the fair market value of the property on the date of the decedent’s death (or, in certain circumstances, a later “alternate valuation date”) as finally determined for estate tax purposes.

Therefore, the decedent’s basis in appreciated property was often “stepped-up” in the hands of the beneficiaries. Under a pure carryover basis regime, beneficiaries hold the property with the same basis that the decedent had in the property (or the fair market value of the property at the date of death, whichever is less). In other words, unrealized appreciation in the property passing to beneficiaries will become taxable gain upon the sale of the property. The basis of each item of property in the decedent’s estate must be determined separately for this purpose.

As a substitute for an estate tax exemption, the 2001 Tax Act has a “modified” carryover basis regime that allows each estate a $1.3 million basis increase, known as the Special Basis Adjustment, which may be allocated by the executor to certain appreciated property, but not in excess of the fair market value of the property. Further, an additional $3 million basis increase is allowed for property passing to the decedent’s spouse (including non-U.S. citizen, non-resident spouses), known as the Spousal Basis Adjustment.

Particularly where the appreciation of assets in a decedent’s estate is greater than the amount of the available basis adjustments, the allocation of this basis among assets passing to various beneficiaries may be a contentious issue. Certain beneficiaries may dispute the executor’s allocation of basis adjustments and executors may need to seek guidance and approval by the court with respect to these adjustments. However, the challenge for executors in allocating the basis adjustments pursuant to the carryover basis rules is minor compared to the potential fiduciary minefield regarding the executor’s election of whether a 2010 decedent’s estate should be taxed under the carryover basis rules or under the estate tax system.

The Challenge of the Election

For many estates, especially very large estates, the tax benefits will be obvious and the decision to make this election will be easy. For other estates, the tax benefits will be less clear and the analysis will be more challenging. While projecting the federal estate taxes that would be due on an estate tax return for a particular estate may be relatively straightforward, forecasting the total tax liability under a carryover basis regime, which is dependent on a number of independent factors, could be a significant challenge for executors.

Partial List of Factors Impacting Carryover Basis Election

• Calculation and apportionment of estate tax burden.
• Impact of election on formula clauses.
• Projected date of sale of each asset.
• Ability to allocate basis.
• Basis of each estate asset.
• Date of death value of each estate asset.
• Projected future value of each asset.
• Projected earnings from each asset.
• Tax character of any future gains or earnings on assets.
• Identity of the beneficiaries.
• Cash needs of the beneficiaries.
• Future income and estate tax rates.
• Domicile of beneficiaries and personal income tax information.
• Availability of asset-specific tax deductions and credits.
• Potential for disagreement among beneficiaries concerning the allocation of basis.
• Conflicts of interest in making the election and allocating basis.
• The availability of binding consents or court approval.
• Whether a compensating equitable adjustment is appropriate, and whether it should be approved by a court.

Some historical guidance may be found in a prior carryover basis election, enacted with the federal Crude Oil Windfall Profit Tax Act of 1980, permitted executors of certain estates to elect by July 31, 1980 to have the basis of property received from the estate determined for federal income tax purposes according to the decedent’s basis, rather than according to the value for estate tax purposes (market value at date of death or alternate valuation date).

Otherwise, there is little historical guidance for executors faced with the 2010 estate tax election in terms of implementing a process that will fulfill their fiduciary obligations and avoid liability. Current tax elections (such as the QTIP election, the alternate valuation date election, and the election to deduct estate expenses against income) offer little procedural direction to serve as a bright line limit on a fiduciary’s liability when making a tax election. These elections simply do not implicate the executor’s duties to the same degree as the 2010 carryover basis election, or present nearly comparable risks. State law offers little comfort, and merely charges the executor with making elections in the best interests of the estate.

Managing Risks in Making the Election

The 2010 election is unique in the degree of discretion afforded executors, and accordingly, there is no prescribed one-size-fits-all process that will shield a fiduciary from liability when determining whether to pay estate tax or to opt-out in favor of the 2010 carryover basis rules. General state law principles of fiduciary duty in estate administration should guide executors; however, these flexible guides offer little certainty or solace to the fiduciary making the election.

Generally, the executor has a duty to preserve assets, defend against claims, and to use reasonable care and skill in administration. Fiduciary actions are governed by many fiduciary duties including the duties of loyalty and impartiality, and are evaluated within the confines of the discretion granted the executor under the provisions of the testator’s will and based on the testator’s intent. With these principles in mind, fiduciaries must develop a systematic approach to evaluate the 2010 election that includes extensive information gathering, detailed calculations, and the involvement of beneficiaries and the courts to limit liability.

Potential problems may arise in basis allocation among beneficiaries if the appreciation in assets at the decedent’s death is greater than the amount of basis adjustments available. In this situation, executors may have to choose between (1) a 35% tax on the entire estate (in excess of the $5 million exemption amount), a burden that may be more easily divisible among beneficiaries, and (2) no estate tax, but a basis allocation that may fall more or less favorably on certain beneficiaries. Difficulty will arise when the testator has made specific bequests of appreciated assets and has not provided for pro rata distribution among residual beneficiaries. These tough decisions may lead to unhappy beneficiaries and potential claims against the executor.

Executor discretion in allocating basis will also depend on whether the testator’s estate planning instruments grant the executor specific authority to allocate basis and exonerate the executor from liability for any basis allocation decisions. Even if broad discretionary authority is given to the executor and the optimal allocations are made to minimize tax paid, perceived unfairness may result in certain beneficiaries claiming violations of the duty of impartiality.

Adding to this challenge for executors is the fact that many decedents’ wills contain provisions which provide for different dispositions of certain assets depending upon the applicability of the estate tax. Thus this election could affect the dispositive scheme of the estate assets, and should be made with utmost caution. In such a case, the executor must be mindful of the allocation issues discussed above and aware of both the testator’s goals when formulating the estate plan and the impartiality due each of the beneficiaries.

Because of the complicated problem such an election presents and the many factors that must be taken into account to make an informed decision, the fiduciary should employ the financial and legal advisors necessary to evaluate each of these factors and arrive at a proposed course of action.

• Beneficiary Consents. After the executor has conducted a thorough analysis, calculations and comparison of the tax consequences to the estate under each approach, if possible, the executor should involve the beneficiaries in the ultimate decision over whether or not to make the election. Further, the executor should work with beneficiaries developing a proposed division of the estate assets and proposed basis adjustment allocations in a manner agreed to by all of the beneficiaries. If the carryover basis election is made, because of the potential for huge shifts in economic value from the basis allocation decisions, an executor should obtain beneficiary consents to any allocation of the basis increase if possible.
• Court Approval. Regardless of whether the election is made, the fiduciary may desire the protection of court approval of the ultimate decision. If the fiduciary chooses to seek court approval, the fiduciary should determine the tax and other consequences to the estate and the beneficiaries of each scenario, and present recommendations to the court. Interested parties should be provided notice and opportunity to contest the recommendations.
• Address Conflicts of Interest. Because of the delicate nature of the election, an executor who is also a beneficiary of the estate should consider resigning as executor to avoid any issues related to self-dealing (or its appearance) and be replaced by an independent or corporate fiduciary. However, professional fiduciaries may balk at being appointed under such circumstances. It is recommended that fiduciaries seek not only advice of counsel regarding this election, but also court approval for any election made.
• Conflicts between Executors and Trustees. Fiduciaries who are acting as trustees but not executors should request information regarding the decedent’s basis and the executor’s proposed basis allocations. If proposed allocations do not meet the standards of fairness and loyalty owed to the trust beneficiaries, the trustee must consider how to proceed and protect the interests of the trust beneficiaries.

Uncertainty for Formula Clauses

The estate plans of many 2010 decedents contain formula clauses that are dependent on federal tax concepts such as the amount of the estate tax exemption or the GST tax exemption, the most ubiquitous being a division of the decedent’s assets between a family share or trust (in the amount that can pass free of federal estate tax by virtue of the estate tax exemption), and the marital share or trust (the balance of the decedent’s assets).

When the federal estate tax was “repealed” for 2010, the interpretation of these formulas became uncertain, and the literal language of the formulas could at times produce results that were detrimental to the estate beneficiaries or contrary to the testator’s intent.

In response to this problem, 20 states passed legislation that provided default rules of construction to clarify the meaning of the formula clauses or other relief from uncertainty. The following states passed corrective statutes:

Under the Act, the federal estate tax has been imposed on 2010 estates with a higher $5 million exemption, but with an election to choose instead a modified carryover basis regime. All formula clauses must be carefully reviewed in light of the $5 million estate and GST tax exemptions for 2010. Also, for states with corrective statutes imposing a default rule of construction, the statute must be carefully reviewed to determine whether it will have any affect on the interpretation of formula clauses. Particular attention must be paid to whether the election into carryover basis will impact the operation of the corrective statutes. The possibility of such an election was not generally considered in the drafting or enactment of the state corrective statutes.

An additional concern is that the corrective statutes include a statute of limitations for filing a suit to seek relief from the statute (most states require the suit within one year from date of death). For decedents that died in early 2010 and where there is the possibility of disagreement among the beneficiaries, it may be necessary to initiate a suit very early in the 2011. Many executors, understandably, will not have completed the analysis of the carryover basis election by the date the suit must be filed under these statutes. However, the courts generally welcome fiduciaries facing uncertainty and it should be adequate to plead the basis for needing guidance without needing to have fully developed any recommendations to present to the court.

This subject will be included in McGuireWoods’ Private Wealth Services Group white paper on the Act that will be distributed in early January.

Help Moving Forward

The Act has created a virtual minefield of fiduciary liability for executors and trustees that can be navigated by prudent process, thorough analysis, and affirmative management of beneficiary expectations and concerns. The McGuireWoods’ Fiduciary Advisory Services Team stands ready to provide service and advice in the days and months ahead to aid fiduciaries in this process.

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