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2012 Federal Estate and Gift Tax Forms Released & New York Issues Guidance on Federal Portability

October 12, 2012

Sharon L. Kleini

Form 706: Final Return and Instructions are Posted On June 15, 2012, the IRS released temporary regulations and proposed rules regarding the portability of the deceased spousal unused exclusion (DSUE) amount. On October 4, 2012, the IRS posted final Form 706 for 2012 decedents that embodies the guidance in the temporary regulations. The form includes a new Part 6, Portability of Deceased Spousal Unused Exclusion and a new Schedule PC, Protective Claim for Refund. On October 12, 2012, the IRS posted final updated instructions to accompany Form 706 for individuals dying in 2012. Reviewed together, here are some of the highlights of the new form and instructions:

Portability Get it Automatically or Opt Out With a Check-the-Box Election The new Part 6 of Form 706 states that a decedent with a surviving spouse elects portability of the DSUE amount, if any, by completing and timely-filing Form 706. No further action is required. However, portability must be elected on a “timely filed” Form 706, which (regardless of the size of the estate) is a return filed within 9 months of death, or if an extension has been granted, the last day of the extension period. There is a box to check to opt out of portability that has been highlighted compared to a draft version of the form by including it in its own separate section “Section A. Opting Out of Portability.” Presumably, the intent was to further minimize the risk of mistakenly checking the box and inadvertently opting out of portability. The DSUE amount that can be transferred to a surviving spouse is calculated in Part 6, Section C. DSUE amounts received from predeceased spouses are calculated in Part 6, Section D. The tax computation (line 9 of Part 2) now includes a computation to calculate the applicable exclusion amount and applicable credit amount (formerly unified credit amount), factoring in any DSUE amount received from a predeceased spouse. The applicable exclusion amount equals the total of:

• Line 9a: the basic exclusion amount ($5,120,000 for 2012); and • Line 9b: the DSUE

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QDOT Trust? Not so Fast… The Temporary Regulations provide special rules with respect to the application of portability to qualified domestic trusts (QDOT trusts), pursuant to which the decedent's DSUE is finally redetermined upon occurrence of final distribution or other final event (usually death of the surviving spouse) that triggers estate tax liability under IRC Section 2056A. If the termination event is death, this generally means that the DSUE will not be available to the surviving spouse during life (except for gifts in the year of death). Accordingly, if any assets of the estate are being transferred to a QDOT, a box must be checked and the form states that the DSUE amount portable to the surviving spouse is preliminary and must be redetermined at the time of the final distribution or other taxable event imposing estate tax under IRC Section 2056A. Special Rule For Estates Filing Solely To Make The Portability Election

An estate tax return prepared in accordance with all applicable requirements is considered "complete and properly-prepared." However, estates that do not otherwise have a filing requirement (ie, Form 706 is filed solely to elect portability) do not have to report the value of certain property that qualifies for the marital or charitable deduction. Only the description, ownership and/or beneficiary and other information necessary to establish the right to the deduction need be reported. A detailed note is included at the top of Schedules A, B, C, D, E, F, G, H, I, M and O to direct those under the filing threshold who are filing solely to elect portability to consider whether it is necessary to report the value of certain assets eligible for the marital or charitable deduction. If the value of an asset is not required to be reported pursuant to the special valuation rule, the executor must:

1. Report the assets on the appropriate schedule, but without any value on the schedule itself; and

2. Estimate in good faith and with due diligence the total value of the gross estate, using ranges of dollar values provided in Form 706 instructions. The instructions provide guidance for assets valued up to $5,120,000, in $250,000 increments (with the last increment being $5,000,000 - $5,119,999).

Executors' estimates are subject to penalties for perjury. An executor cannot use the special rule under certain circumstances, including if a partial QTIP election is made. There is also a box to check on the face of the return (Part 1, line 11) to alert the IRS if an executor is taking advantage of this special rule to estimate the value of the assets included in the gross estate. Line 7 Worksheet – Used to Determine Applicable Credit Allowable for Prior Periods…

The Line 7 Worksheet (used to determine the applicable credit [formerly unified credit] allowable for prior periods) has been amended in final Form 706, compared to a previously posted draft version of the form. A column has been added for specifically

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listing the cumulative DSUE amount from predeceased spouse(s) actually applied to current and prior gifts, which amount is to be taken from the gift tax return for the applicable year. Additional columns clarify that the DSUE amount applied against lifetime gifts is added to the applicable exclusion amount for the current period and multiplied by the 2012 unified rate schedule to compute the maximum applicable credit. The "total gift tax paid or payable" is determined on the Line 7 Worksheet and entered on Line 7 of Part 2-Tax Computation. …And Must be Submitted with Form 706

Filers were previously directed not to file the Line 7 Worksheets, but to keep them for their records. Now a specific cautionary note appears in the instructions directing the filer to submit a copy of the Line 7 Worksheet when filing Form 706. A Few Reminders

The instructions remind the reader that, although a spouse can use the DSUE amount from prior predeceased spouses in succession, a surviving spouse cannot use the sum of the DSUE amounts from multiple predeceased spouses at the same time or use the DSUE of a prior predeceased spouse after the death of a later spouse. Also, if an executor is acting, only the executor (not a surviving spouse), can make or opt out of a portability election.

Protective Claim for Refund

The Form 706 also includes a new Schedule PC, to be filed to preserve the estate's right to claim a refund based on the amount of an unresolved claim or expense that may not become deductible under IRC Section 2053 until after the limitation period ends. Pursuant to Form 706:

Schedule PC can be used to file a protective claim for refund and, once the claim or expense becomes deductible, Schedule PC can be used to notify IRS that a refund is being claimed;

Schedule PC can be used by the estate of a decedent dying after 2011; Schedule PC must be filed with Form 706 and cannot be filed separately. (To file

a protective claim for refund or notify IRS that a refund is being claimed in a form separate from the Form 706, a Form 843, Claim for Refund and Request for Abatement, is instructed to be used.);

Each separate claim or expense requires a separate Schedule PC (or Form 843, if not filed with Form 706); and

Schedule PC must be filed in duplicate for each separate claim or expense. A note has been added to the top of Schedules J, K and L to advise that Schedule PC should be used to make a protective claim for refund due to an expense not currently deductible. Expenses not currently deductible should also be reported on the appropriate Schedule J, K or L, but without a value.

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You Will Receive a Written Acknowledgment...Or Will Have to Follow Up The instructions provide that the first schedule PC to be filed is the initial notice of protective claim for refund, and the estate will receive a written acknowledgement of receipt from the IRS. Certified mail receipt is not sufficient to confirm delivery of the claim, and if no acknowledgement is received from the IRS within 180 days, the fiduciary is advised to contact the IRS at 866-699-4083. Professional Fees If a protective claim has been adequately identified, the IRS will presume that the claim includes certain expenses related to resolving the claim, including attorney and accounting fees. The estate is not required to separately identify or substantiate those expenses, but they must meet Section 2053 requirements to be deductible. Notify IRS of Resolution of Claim When the claim is finally determined, the estate should notify the IRS within 90 days of the date the claim is paid or the date on which the claim becomes certain, whichever is later. The notification should provide facts and evidence substantiating the deduction and resulting recomputation of estate tax liability. There are two options with regard to notification:

1. File a supplemental Form 706 with an updated Schedule PC that contains the notation "Supplemental Information - Notification of Consideration of Section 2053 Protective Claim(s) for Refund." The initial notice of claim should also be submitted; or

2. File an updated Form 843 containing the notation "Notification of Consideration of Section 2053 Protective Claim(s) for Refund." The initial notice of claim must also be submitted.

Separate notifications must be submitted for every protective claim.

Form 709: Draft Return and Instructions are Posted The IRS posted the latest draft 2012 Form 709 on September 26 and posted draft instructions on September 28, 2012. Reviewed together, here are some of the highlights of the new draft form and instructions: Check the Box to Indicate Use of DSUE There is a new line in Part 1 (Line 19), which asks: "Have you applied a DSUE amount received from a predeceased spouse to a gift or gifts reported on this or a previous Form 709?" If the answer is yes, there is a box to check and a direction to complete new Schedule C - Deceased Spousal Unused Exclusion (DSUE) Amount.

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The instructions remind the reader that, in order to be eligible to use a predeceased spouse’s DSUE, the spouse’s executor must have made an election to use the unused exclusion amount on Form 706. If the election was made, a copy of Form 706 must be attached to Form 709, as well as a calculation of the DSUE amount (either as an attachment or as reflected on Form 706, Part 6). Line 7 of Part 2-Tax Computation now refers to the maximum applicable credit amount (formerly unified credit amount), which factors in any DSUE amount from a predeceased spouse, computed on the new Schedule C. Schedule C – Portability of DSUE Amount Schedule C is for reporting the DSUE amount received from a last deceased spouse, as well as the DSUE received from other predeceased spouse(s) and used by the donor. In Parts 1 & 2 of Schedule C, the DSUE received from a last deceased spouse and the DSUE received from other predeceased spouse(s) are reported (predeceased spouses must have died on or after January 1, 2011). The donor’s applicable credit amount is calculated by (1) adding (a) the basic exclusion amount and (b) the total DSUE amount from the last and previously predeceased spouses applied by the donor to lifetime gifts (including current and prior gifts), and (2) applying to that sum the appropriate tax rate from the rate table in the instructions. The result is to be entered on Line 7 of Part 2-Tax Computation. Several lines marked “reserved” have been added to Schedule C on the latest draft Form 709. The instructions provide that the reserved lines are “inactive” and that no information is to be entered on those lines. Act Now? Using the DSUE during the lifetime of the surviving spouse may make good sense given: • If the surviving spouse remarries and the next spouse dies, any remaining DSUE of

the first surviving spouse will be lost, even if the last deceased spouse has no or a smaller amount of DSUE than the prior spouse, if the portability election was ineffective or not made at all, or if the DSUE amount from the last deceased spouse has been fully applied to gifts in previous periods;

• When the surviving spouse makes a gift, the DSUE of the last deceased spouse is

applied before the surviving spouse's own exclusion amount; • A spouse who has had more than one predeceased spouse can use the DSUE of

each surviving spouse in succession, as long as the DSUE of the last deceased spouse is used before any subsequent spouse dies. There is no recapture of previously gifted amounts in which the DSUE of a prior deceased spouse was

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utilized. In fact, the surviving spouse can include in her applicable exclusion amount the DSUE amount of her most recently deceased spouse, even if she is then married to another individual. If the second marriage ends in divorce and the divorced spouse dies, the first predeceased spouse remains the last predeceased spouse for DSUE purposes. The divorced spouse is not considered the last predeceased spouse because he was not married to the surviving spouse at death; and

• The last deceased spouse is identified as of the date of a taxable gift by the

surviving spouse.

New York Issues Guidance Regarding Federal Portability On September 26, the New York State Department of Taxation and Finance issued TSB-M-12(4)M - New York State Reporting Requirements for Certain Estates Making a Federal Portability Election.

A Special Federal Rule For Estates Filing Solely To Make The Portability Election... As noted, there is a special federal valuation rule for estates that do not otherwise have a federal filing requirement (ie, Form 706 is filed solely to elect portability). Those estates do not have to report the value of certain property that qualifies for the marital or charitable deduction. …But No “706 Lite” For New York Estates... According to the Technical Memorandum, the New York State estate tax is generally conformed to the IRC of 1986, including all amendments enacted on or before July 22, 1998. As a result, the special valuation rule does not apply for New York State estate tax purposes. Accordingly, even estates filing solely to take advantage of portability that are eligible for the special rule for federal purposes must submit the following when filing Form ET-706, New York State Estate Tax Return (the New York filing threshold is $1,000,000):

• A copy of the actual federal estate tax return filed with the IRS; and • a completed (pro forma) Part 5 - Recapitulation (Form 706) and all applicable

schedules reporting the actual date of death value of all property subject to the special rule.

Download final Form 706 and instructions for individuals dying in 2012, and draft Form 709 and instructions for 2012 gifts.

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i Sharon Klein is the Managing Director & Head of Wealth Advisory, Lazard Wealth Management LLC, 30 Rockefeller Plaza, New York, New York 10020. Phone Number: 212-332-4504. E-Mail: sharon.klein@lazard.com. This material is written by Lazard Wealth Management LLC for general informational purposes only and does not represent our legal advice as to any particular set of facts and does not convey legal, accounting, tax or other professional advice of any kind; nor does it represent any undertaking to keep recipients advised of all relevant legal and regulatory developments. The application and impact of relevant laws will vary from jurisdiction to jurisdiction and should be based on information from professional advisors. Information and opinions presented have been obtained or derived from sources believed by Lazard Wealth Management LLC to be reliable. Lazard Wealth Management LLC makes no representation as to their accuracy or completeness. All opinions expressed herein are those of the author and made as of the date of this presentation and are subject to change.

IRS Circular 230 disclosure: To ensure compliance with requirements imposed by the IRS, please be advised that any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Copyright 2012. All Rights Reserved

ABA Section of Taxation and Trust & Estate Division of Real Property Trust & Estate Law 2011 Joint Fall CLE Meeting

Denver, Colorado October 21, 2011

Uplifting Gifting - Using Additional Gift, Estate and Generation-Skipping

Tax Exemption to Maximize Business Succession Planning

Robert M. Nemzin Butzel Long, P.C.

41000 Woodward Avenue Bloomfield Hills, MI 48304

Telephone: (248) 258-2909 Facsimile: (248) 248-1439

nemzin@butzel.com  

 

 

 

©    Robert M. Nemzin  2011.    All  rights  reserved.    The  statements  contained  in  this Outline  are  the 

author’s alone and should not be attributed to any other person and/or the respective law firms of the 

authors.    The  statements  contained  in  this Outline  should  not  be  relied  upon without  separate  and 

independent verification of their accuracy, appropriateness given the particular facts presented and/or 

potential  tax  consequences.    The  authors  hereby  disclaim  any  warranty  as  to  the  accuracy  of  the 

statements contained in this Outline.  Any tax advice contained in these materials was 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 and cannot be used as a basis for a tax return reporting 

position.   Any  tax advice  contained  in  these materials was written  to  support, within  the meaning of 

Treasury Department Circular 230, the promotion or marketing of the transactions or matters addressed 

by such advice because the author has reason to believe that it may be referred to by another person in 

promoting, marketing or recommending a partnership or other entity, investment plan or arrangement 

to one or more taxpayers.  Before using any tax advice contained in these materials, a taxpayer should 

seek  advice  based on  the  taxpayer’s particular  circumstances  from  an  independent  tax  advisor.    Tax 

advisors should research these issues independently rather than rely on these materials. 

Uplifting Gifting - Using Additional Gift, Estate and Generation-Skipping Tax Exemption to Maximize Business Succession Planning

 

  The Tax Relief, Unemployment  Insurance Authorization, and  Job Creation Act of 2010 

(the “2010 Act”) has changed, at least temporarily, the planning landscape for estate planners.  

As  a  result  of  the  increased  estate,  gift  and  GST  exemptions,  a  number  of  new  planning 

opportunities exist until at least the 2010 Act’s sunset on December 31, 2012.   

With the increase of the federal gift tax exclusion to $5 Million per person, donors now have 

the ability to make substantial gifts without having to pay gift taxes.   The  following are some 

initial questions that a client should consider. 

How Much Should a Client Give Away? 

An  initial question  that must be answered  is how much a donor  can afford  to give away 

during  the  donor’s  lifetime.    Clients must  be  careful  in  determining  how much  additional 

property  the  client has  to  live on  for  the  remainder of  their  lifetime.   A possible option  for 

spouses  is  to  have  each  spouse  establish  a  gifting  trust which make  the  other  spouse  and 

additional  family members discretionary beneficiaries of  the  trust;  this  arrangement  thereby 

make  those assets available  to  the spouses during  their  lifetime  in  the event  such assets are 

needed for their use.  Care should be given in implementing this type of planning arrangement 

to avoid the imposition of the reciprocal trust doctrine. 

When Should a Client Use the Increased Gift Tax and GST Exemptions? 

The  increased gift tax and GST exemptions expires at the end of 2012.   As the gift tax and 

GST exemptions could be reduced in 2013, clients should be advised of the potential temporary 

planning  opportunity  that  currently  exists.    Gifts  should  be made  now  if  the  client  thinks 

exemptions will decrease in the future. 

How Should Gifts be Made? 

The client will have  to determine  the proper  form  for making gifts  to beneficiaries.   Does 

the client wish to make an outright gift to the beneficiary?   Or does the client prefer to make 

the gift  in trust for the benefit of the beneficiary?   The client’s goals and objectives should be 

properly  identified when  considering  the optimal method  in  taking advantage of  the gift  tax 

exemption.  Does the client want to provide for dynasty planning for successive generations?  A 

gift in trust allocating GST exemption to the gifts is may be more appropriate in this instance.   

 

What Assets Should be Gifted? 

Clients  should properly  identify which assets  should be  selected  in making gifts.    Factors 

including future potential for appreciation or depreciation in the asset, the ability to make use 

of  valuation discounts,  liquidity needs  and expected  cash  flow  from  the  assets  should  all be 

considered. 

Planning Opportunities 

Grantor Trust Planning 

The  increased  gift  tax  exemption  dramatically  increases  the  ability  to  transfer  a  larger 

amount of wealth out of a client’s gross estate.  In a typical situation involving a grantor trust, a 

loan or sale of property is made to the trust in connection with a “seed” gift to the trust.  The 

“seed” gift should normally be at  least 10% of  the overall  trust assets  in connection with  the 

loan or sale transaction.  See PLR 9535026.  A $5 Million gift tax exemption allows for the ability 

to  loan or sell an additional $45 Million of assets to a grantor trust without the  imposition of 

gift taxes.  For married individuals, the combined $10 Million gift tax exemption can be used to 

transfer an additional $90 Million without the imposition of gift taxes. 

GST Planning 

A  $5  Million  GST  exemption  greatly  increases  the  ability  to  transfer  assets  to  lower 

generations.    Given  the  temporary  nature  of  the  2010  Act,  clients may want  to  fully  take 

advantage of the entire $5 Million GST exemption prior to the 2010 Act’s sunset  in the event 

there is concern that the GST exemption will decrease in the future.   

Life Insurance Planning  

Life insurance is often an integral part of the estate plan.  Whether life insurance is used to 

provide liquidity for an illiquid estate or it is used to provide an additional asset following death, 

life  insurance remains a prevalent part  in  the estate planning process.   The  increased gift  tax 

exemption provides the ability for additional opportunities in planning with life insurance.  With 

a $5 Million gift tax exemption, the ability to make contributions to  irrevocable  life  insurance 

trusts has dramatically increased.  A donor now has the ability to make increased gifts on a non‐

taxable basis to an ILIT for the purposes of covering current or future premium payments. 

For  clients  that  previously  implemented  split  dollar  arrangements,  the  increased  gift  tax 

exemption can also be used  to unwind  these  transactions and  simplify  the planning process.  

For example, the donor can make a gift to the trust to cover the repayment of the split dollar 

loan agreement obligation. 

With  the  increased  estate  tax  exemption,  some  clients may  believe  life  insurance  is  no 

longer necessary  if they believe estate taxes are no  longer a concern and the only reason the 

client maintained the  insurance policy was for the payment of estate taxes.   However, due to 

the temporary nature of the 2010 Act, there is no guarantee that the estate tax exemption will 

remain at $5 Million.   The  insurance proceeds may actually be needed  in  the  future.   Clients 

should be  cautioned not  to  cancel existing  insurance policies  if  there  is a possibility  that  the 

insurance still may be needed in the future.  For example, the client may not be insurable in the 

future in the event the client reapplies for insurance. 

Forgiveness of Existing Loans 

The increased gift tax exemption can be used to forgive existing loans if a client has made a 

loan  to  a  family member.    Loans  to  family members  are  a  common  transaction,  and  the 

forgiveness  of  all or part of  the debt obligation  is  a  simple way  to make use of  the  client’s 

increased gift tax exemption. 

In  addition,  guarantees  are  often  used  in  structuring  the  necessary  seed  equity  for  a 

transfer  to a grantor  trust.   The  increased gift  tax exemption can be used  to make additional 

gifts to the grantor trust to eliminate the guarantee arrangement. 

GRAT Planning 

Some clients may view GRATs as being unnecessary now that they have the increased ability 

to make non‐taxable gifts during their lifetime.  However, GRATs remain an excellent planning 

opportunity because they have the ability to transfer wealth without using any significant gift 

tax exemption.   

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NEXT GENERATION DISPUTES IN THE FAMILY BUSINESS: NAVIGATING THE

REMEDIAL, ETHICAL AND TAX QUAGMIRES - A CASE STUDY

AN OVERVIEW OF FAMILY BUSINESSES IN AMERICA

(From the ABA Section of Taxation/Section of Real Property, Trust & Estate Law’s 2011 Joint Fall Meeting in Denver, CO)

By Morton A. Harris1

OVERVIEW OF FAMILY BUSINESSES I. In General. There are approximately 27 million privately owned businesses in the

country, of which 21 million are either part-time operators (e.g., the weekend

musician, construction contractor, “moonlighters,” etc.), or full-time operators where

only the owner is involved. Of the over 6 million businesses which have

“employees”, only 18,000 have more than 500 employees, approximately 120,000

businesses have more than 100 employees, and less than 700,000 have more than

20 employees.2. By comparison, there are approximately 30,000 publicly owned

companies in the United States, approximately 3,800 traded on the New York Stock

Exchange (NYSE), 750 on the American Exchange (AMEX), 2,800 on NASDAQ,

3,700 on the “OTC Bulletin Board” and 6,200 on the “Pink Sheets” 3. The

remaining 10,000-12,000 companies are traded so rarely they are not listed. From

these statistics, it can be seen that privately owned businesses (over 90% of

businesses with employees being “family businesses”) represent over 99% of all

businesses in the country.

Although most “family businesses” are privately owned, an estimated 60% of

publicly traded companies are under family control. Studies show an estimated

33% of the "Fortune 500" companies are family controlled, e.g., Wal-Mart, Marriott,

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Berkshire -Hathaway, Tyson, and News Corporation, and Heinz. Many owners of

family controlled public corporations are listed in the “Forbes 400”, e.g., Warren

Buffett, Rupert Murdoch, and Christy Walton and family. 4

It has become increasingly clear from published statistics that privately owned

businesses (employing over 58% of all working Americans, generating

approximately 59% of Gross Domestic Product, and responsible for 31% of our

nation's exports) are the most dynamic and vibrant segment (most new jobs and

innovations) of our country's economic system. In fact, many say that America's

family owned small businesses are our country's best hope to maintain a successful

free enterprise system5.

Congressional recognition of “small business” (often used synonymously with

“family business”) was first formalized in 1950 when both houses of Congress

established Committees on Small Business. In 1953, the Small Business

Administration (SBA) was created as an independent agency based on the

recognition that “small businesses” have special needs, a unique philosophy and

different capabilities. Also in 1953, an independent Office of Advocacy within the

SBA was created and charged with the responsibility for promoting the cause of

small enterprises in Congress and the Executive Branch. Since that time, Congress

has consistently encouraged federal agencies to be sensitive to the special needs of

small business.

Beginning in the 1980's, “small business" (most of which are privately-owned family

businesses) became very popular in Washington. In 1981, Congress authorized,

and President Reagan convened, the first President’s White House Conference on

Small Business. Another White House Conference was held in 1986, and the most

recent Conference was held in June of 1995. The major purpose of the White

House Conferences was to create a forum for small business owners to

communicate with each other and determine the priority needs and concerns of the

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small business community with a view towards Congress and regulatory agencies

enacting, repealing or amending legislation, regulations, etc., to meet those needs

and concerns.

Notwithstanding Congress' general “love affair” with “small business”, the practical

needs and interests of small business are often overlooked when major legislation is

finally adopted, especially when it involves complex tax and employee benefit

matters. During the thirty-year period from 1981, there has been a flood of tax and

employee benefit legislation (over 30 major Revenue Acts involving changes to over

17,000 sections and subsections of the Internal Revenue Code). Unfortunately,

much of this legislation, added significant additional complexities and restrictions

and were particularly onerous to small businesses and their owners6. From these

actions in Congress, it is evident that the small business community (although much

"loved") is in need of better understanding and a stronger "voice" in Washington.

Since 2001, there have been several major tax laws, which have added even more

complexity7.

In analyzing the reasons behind the inconsistency in Washington between “mouth”

and “motion” (“expression” and “action”), one is drawn to the conclusion that small

businesses are typically much less effective (when compared with large businesses)

in dealing with proposed legislation. Large businesses have full-time lobbyists

monitoring and timely focusing on specific legislative issues, whereas most owners

and representatives of small businesses are often not even aware of proposed

legislation (especially tax and employee benefit legislation) until the legislation is

well on its way to being enacted. Although there are a number of small business

organizations which actively monitor legislation (e.g., the National Federation of

Independent Businesses [NFIB]; the Small Business Council of America [SBCA]

which focuses on tax and employee benefit issues; and the National Small Business

Association [NSBA], etc.), the broad diversity of interests of the millions of small

businesses, due to the vast differences in size, level of economic success and types

4

of business, often results in the wishes of the “small business community” being

unfocused and, in some cases, contradictory. One reason given for much of the tax

and employee benefit legislation and regulations (which have negatively affected

small businesses) is the notion, held by some in Washington, that small business

owners can, to a greater degree than large businesses, manipulate the tax and

employee benefit rules to avoid paying their "fair share" of taxes or to avoid

providing appropriate levels of employee benefits to their

employees. In recent years, this notion has been expanded to include large

businesses after the Enron, WorldCom, Tyco, Parmalot, and Lehman Bros.,

debacles, and the implosion of the banking and financial sector which led to the

passage of the Sarbanes/Oxley legislation designed to protect shareholders, and

the Dodd-Frank legislation to protect the public from various practices of large

financial institutions which contributed to the current recession. It is the author's

opinion that much of the reason for the “hyper” frequency of legislation in

Washington is to be found in the basic nature of our political environment which

reflects the public's clamor for both “action” and “fairness” and puts strong political

pressure on members of Congress (aided by dozens of highly competent and

specialized staff) to stay active and to promote new legislation, especially in the tax

and employee benefit area, which has resulted in enormous “complexity.”8

The constant change and expansion of our laws has had a disproportionately

negative impact on small businesses, which have little or no internal specialized

staff, by increasing the need for costly outside professional support to help them

comply with the ever more complex and constantly changing rules9.

Congress did, however, adopt some tax legislation specifically designed to

encourage small businesses, e.g., Subchapter S, added to the Code in 1958. The

rules of Subchapter S were partially in response to earlier proposals (which continue

to this day) to eliminate the taxation of corporations entirely on the theory that

"double taxation" is inherently unfair. Critics of the system (pointing to Subchapter

5

K and its taxation of partners) argue that a tax at the corporate level, in addition to a

tax on shareholders, amounts to a penalty for conducting business in corporate

form. Although Congress did not eliminate taxation at the corporate level (in fact,

for some, it increased the corporate level tax in 1986 with the legislative elimination

of General Utilities), significant changes were made in the taxation of small business

corporations electing under Subchapter S which, for the most part, results in a

single tax at the shareholder level10. More recent legislation further simplified and

expanded the usefulness of Subchapter S11.

II. Importance of Family Businesses.

A. Important Segment of U.S. Economy. With over 6 million full-time privately

owned businesses with employees (90% family owned and operated), small

business is the most dynamic segment of our economy representing more

than 99% of all businesses, 58% of all working Americans, 59% of Gross

Domestic Product, and 31% of U.S. exports. The net worth of these

businesses is estimated to be in excess of $10 trillion. Small businesses are

responsible for most new jobs which have averaged 64% of all new jobs over

the past decade.12

B. Large Portion of Transferred Wealth. It is estimated that over two-thirds of

the wealth of this country has been created since World War II, much of

which is represented by family businesses. A large portion of this wealth

consists of businesses under control of an aging generation of

entrepreneurs. Within the next two decades, many members of this

generation will die or retire, and the transfer of wealth from the older

generation to the next is estimated to be the largest in U. S. history13. A

study by the Family Enterprise Center at Cornell University estimated that

over $6.5 trillion in wealth would be transferred from one generation to the

next during the next 25 years with over $10 trillion being transferred by the

6

year 204014. Another survey estimated that almost 40% of all family

businesses would change leadership within the next five (5) years.15

C. Importance Recognized by Institutions and Businesses. Prior to 1990, there

was little or no research on, or academic interest in, “family businesses.”

However, within the past twenty (20) years, family business programs have

become a part of business school curriculum at over 100 colleges and

universities throughout the country (e.g., Wharton, Harvard, Northwestern,

Baylor ). One of the first programs (also ranked as one of the best along with

Harvard and Northwestern) was established at Kennesaw State University, in

Atlanta Georgia, which offers a full range of courses on family businesses as

part of its business school curriculum16. In discussing the reasons for

establishing its Family Business Center, the founding director of the program

at Kennesaw described the importance of the “family business” in the

following manner:

“The family unit has long been recognized as the foundation of

our society and the family business is the foundation of our

economy. Family businesses have special problems and

opportunities that traditional business education does not

address.”

-Craig Aronoff, Kennesaw State College (1989)

In addition, a number of private sector family business “programs,” including

insurance companies, law firm practice groups, etc., were developed during

this period. For example, Massachusetts Mutual Life Insurance Company

(Mass Mutual) and National Life of Vermont (in conjunction with the Small

Business Council of America) have conducted research and have sponsored

“family business” institutes; and law firms, WilmerHale, Troutman Sanders

LLP, and McDermott Will & Emery along with many other large firms, have

7

created special “practice groups” that focus on Closely Held and Family

Businesses. Further, there have been dozens of books and hundreds of

academic research studies, popular press articles, newsletters and seminars

on “family businesses,” almost all being published or presented since 199017.

D. Important Part of Professional Practice. Family businesses (and the

individual family members) are a significant part of the practices for many

professional advisors. Surveys show that accountants, lawyers, financial

planners, life underwriters, bankers, and industrial psychologists (in the order

listed) are the closest advisors to the owners of family businesses and are

uniquely positioned to be of the most help18. A 1992 Mass Mutual survey

showed that among the 53% of family business owners who have prepared

written estate plans, 74% reported that a lawyer played a major role in the

planning process, followed by accountants (38%), financial estate planners

(29%), and insurance agents (14%). A recent survey shows the number of

owners who have engaged in estate planning has increased to 81%, and

lawyers and accountants are the top two advisors19. For the very large

family businesses, there has been an explosion of “wealth management”

advisors and so-called “Family Offices” which provide personal, business and

investment advice and other family services (e.g. protection, coordinating

family meetings, etc.) to family business owners and their families.20

E. Family Businesses Need Special Attention. Research shows that less than

one-third of the family businesses succeed into the next generation, less

than 15% make it into the third generation21 and less than 4% make it to the

fourth generation. It is widely recognized that family businesses have special

problems in addition to the normal business problems which make them

uniquely vulnerable, especially at the time of transition of management and

ownership to the next generation.22

8

III. Reasons for Family Business Failures. It was not until 1993, that the first

comprehensive study was made to determine the reasons why such a large number

of family businesses failed at the time of transition of ownership and management to

the next generation. The study, sponsored by National Life of Vermont and the

Small Business Council of America (conducted by Prince and Associates), was

based on personal interviews with next generation owners of 749 family businesses

that had failed within three years following the death or retirement of the founder.

All of the businesses in the study had previously been successful and in business

for at least 10 years, many between 20 and 40 years.

From these interviews, it was determined that the transition of management and/or

ownership occurred: (1) in 75% of the cases, following the death of the founder

(often unexpected); and (2) in 25% of the cases, following the founder's retirement

(often due to his unexpected disability).

Although the survey showed a number of reasons for these family business failures,

the major reasons given for failure of the businesses following the death or

retirement of the principle owner and CEO are described as follows.

A. Lack of Adequate Capital. It was long assumed that lack of adequate capital

was a primary reason for failure of a family business upon transition of

ownership. However, it was not until the National Life/SBCA study in 1993

that the truth of this assumption was confirmed, both following the death of

the principle owner or his retirement.

1. Death of Principal Owner/CEO. Lack of capital was cited as the

largest single reason for failure of over 70% of the family businesses

which failed following the death of principal owner. Lack of capital

was primarily caused by estate tax obligations or the need to provide

9

retirement funds to a surviving spouse; however, lack of access to

capital or credit from traditional sources for current operational needs

was also cited as a major problem. This, typically, was the result of

trade and banking sources being less accommodating to the

successor owners (and managers) following the death of the principal

owner/CEO. In many cases, these financial strains led to the

bankruptcy of the business. With the onset of the Great Recession in

2008, the unmet need for capital by many family businesses, whether

or not in transition, has dramatically increased. Today, the ability of

many small businesses to borrow has been severely restricted due to

significant increases in banking regulations and oversight scrutiny by

State and Federal regulatory agencies.

2. Retirement of Principal Owner/CEO. Where the principal owner/CEO

retired from the business during his lifetime, the study showed the

owner often retired without adequate financial resources, most of his

wealth consisting of his interest in the business. This resulted in

additional financial burdens being placed on the business to distribute

funds in order to make up for the shortfall in the owner's retirement

needs and this financial burden was cited as a predominant reason

for the failure of the business. This same failure to provide

adequately for his and his spouse's retirement is also given as the

prime reason why many owners are unwilling to voluntarily relinquish

control of the business.

B. Family Conflict Over Assets. Lack of “fairness” in the distribution of the

founder's estate was also cited as a key problem. Almost 81% of the failed

businesses were negatively impacted by family conflicts among the

survivors. Often, these conflicts grew out of a perception by the survivors of

unfairness in the division of the founder's assets between heirs active in the

10

business and those who were not. From the writer's own experience, this

conflict results because many parents are strong in their determination to

treat their children “equally” in the distribution of their estates. Unfortunately,

“equal” is not always “fair”, and “fair” is not always “equal”, where a family

business represents a large portion of the principal owner's estate, especially

where some children are active in the business and some are not. This

inflexible desire of parents to give “equal” treatment to their children is often

given as a principal cause of failure of the business23.

C. Loss of Key Employees. In many cases, the loss of a non-family key

employee (especially after the founder's death) significantly contributed to

the failure of the business. Almost 60% of those surveyed (where a non-

family key employee had left the business following the principal owner's

death or retirement) cited this loss as an important contributing reason for the

failure of the business.

D. Poor or No Transition Planning. The studies also reveal the basic (and often

preventable) underlying cause behind most of these failures as being little or

no prior planning for either the capital needs or the transition of management

and/or ownership of the business. Not only is “failure to plan” the biggest

obstacle to successfully passing on a family business to the next generation,

it often results in lifelong family feuds. The National Life/SBCA study showed

that 97% of the successor-owners of the 749 failed businesses in the survey

stated that the founder had no written succession plan and 40% had no

succession plan of any kind. The 2003 Mass Mutual/Raymond Family

Business Institute survey showed that only 63% of family businesses utilize a

written strategic business plan in their operations, that 20% of the business

owners have no written “estate plans” beyond a will, and only 38% have a

written “business” succession plan. Although almost 90% of business

leaders surveyed recognize that failure to have an effective succession,

11

estate, and investment plan and a strategic business plan for the company

would greatly promote the successful transition of the business to the next

generation, less than half of the family business CEO’s who expect to retire

within five (5) years, had chosen a successor24.”

1 Morton Harris is a Partner at Hatcher, Stubbs, Land, Hollis & Rothschild. Morton concentrates his practice in the areas of business and tax law, qualified retirement plans, estate and retirement planning, estate administration, wills, trusts and estates, and charitable foundations. He can be reached at mah@hatcherstubbs.com. 2 Small Business Administration, “Small Business Profile” (2009) based on latest source information from U.S. Department of Treasury, IRS Report, Tax Returns; U.S. Dept. of Commerce, Bureau of the Census, and U.S. Dept. of Labor, and Bureau of Labor Statistics; J. Astrachan and M. Shanker, “Family Businesses’ Contribution to the U.S. Economy – A Closer Look,” (2002) at 213. 3 Web Sites of NYSE, AMEX, NASDAQ, OTC Bulletin Board, and Pink Sheets (September 2011). 4 See J. Astrachan and M. Carey, “Family Business in the U.S. Economy,” presented at The Center for the Study of Taxation, Costa Mesa, California (1994); and J. Astrachan and M. Shanker, “Family Businesses’ Contribution to the U.S. Economy – A Closer Look (2003) at 214; ‘Forbes’ (Oct. 10, 2011); R. Sorenson, “Family Business: The New Heartland of America”, presented at the Center for Family Enterprise, University of St. Thomas Opus College of Business, September of 2008. 5 See “Blood and Money,” Newsweek Special Edition, "The 21st Century Family," Winter/Spring 1990, at 82-84; “The Adolescence of American Family Business,” FBN Newsletter, No. 9 (May 1994); and “Politics and Policy,” Wall Street Journal, June 14, 1995, at A20; and J. Astrachan, “Family-Sponsored Ventures,” (April, 2003). 6 H. Apolinsky, “Need for Ten Year Moratorium,” Survey for Small Business Council of America (1997), and H. Apolinksy, “Need for Fundamental Tax Reform” Survey for the American’s for Fair Taxation (2002). 7 “Economic Growth and Tax Relief Reconciliation Act of 2001,” (EGTRRA),“Jobs and Growth Tax Reconciliation Act of 2003,” (“2003 Tax Act”), “Working Families Tax Relief Act of 2004”, “ Tax Increase Prevention Reconciliation Act of 2005”, “Small Business Jobs Act of 2011”, “Tax Relief and Health Care Act of 2006”, “Economic Stimulus Act of 2008”, “Health Care and Education Reconciliation Act of 2010”. 8 For an interesting analysis of the reasons for the proliferation of laws at all levels of our legal system. See I. Younger, “Socrates, Law, and the Congress of the United States,” Charles Evans Hughes Memorial Lecture delivered at New York County Lawyers' Association, New York, N.Y. (May 1980). 9 “There are No Simple Businesses Anymore,” The State of Small Businesses at 72-78 (1995). 10 Subchapter S Revision Act of 1982, Pub. L. No. 97-354, (1982). 11 See Small Business Job Protection Act of 1996, Pub. L. No. 104-188 (1996); The American Jobs Creation Act of 2004 Pub. L. 108-357(2004). 12 J. Astrachan and M. Carey, “Family Business in the U.S. Economy,” presentation at the Center for the Study of Taxation, Costa Mesa, California (1994); and D. Kirchoff, Entrepreneurship and Dynamic Capitalism: The Economics of Business Firm Foundation and Growth (1994); “The Facts of Small Business,” SBA Report (2009). 13 Fortune, May 7, 1990, at 81, and Hale and Dorr, “Family Business Report,” June 1994. 14 See R. Avery and M. Rendall, “Inheritance and Wealth,” presented at the Philanthropy Roundtable (Nov. 1993); and, “There are No Simple Businesses Anymore--Will the Family Business Survive?” The State of Small Business, at 70 (1995).

12

15 Mass Mutual Financial/Raymond Family Business Institute, “American Family Business Survey,” (2003) at 2; “Major Findings of the Family Business Survey,” Massachusetts Mutual Life Insurance Company (Oct. 2007) at 4. 16 “Can You Teach Entrepreneurship?” Business Week, Nov. 7, 1993, at 140; and Mass Mutual Financial/Raymond Family Business Institute, “American Family Business Survey,” (2003) at 32. 17 See, e.g., C. Aronoff and J. Ward, Family Business Sourcebook (1991); “Are Your Kids Good Enough to Run the Business?” Inc. Magazine, August 1994; “Estate Planning for the Family Business Owner,” American Law Institute/American Bar Association Annual Seminar on Family Business (July, 2003); and The Family Firm Institute, Family Business Review, Vol XVI, No. 1 (March 2003). C. Aronoff and O. Baskin, Effective Leadership in the Family Business (2010); A. Schuman, “Nurturing the Talent to Nurture the Legacy”; Preparing Yourself to Relinquish Control of Your Family Business” (2010). 18 “Major Findings of the Family Business Survey,” Massachusetts Mutual Life Insurance Company (Oct. 2007) at 8. 19 “Major Findings of the Family Business Survey,” Massachusetts Mutual Life Insurance Company (Sept. 1994) at 22; and Mass Mutual/Raymond Family Business Institute, “American Family Business Survey,” (2003) at 27 and 30. “Major Findings of the Family Business Survey,” Massachusetts Mutual Life Insurance Company (Oct. 2007) at 4. 20 “Private Wealth”, Advising the exceptionally affluent. Vol. 5. No. 5 (Sept/Oct 2011) 21 J. Ward, Keeping the Family Business Healthy, at 1-19 (1987); “Blood and Money,” Newsweek Special Edition, “The 21st Century Family,” Winter/Spring 1990, at 82-84. Richard M. Segal, Family Firms vs. Their Counterparts- Best Practices for Success, Corp. Magazine, January 1, 2008, Private Wealth”, Advising the exceptionally affluent. Vol. 5. No. 5 (Sept/Oct 2011). 22 See G. Le Van, Getting to Win-Win in Family Business, at 218 (3rd ed. 1993); See also, L. Danco, Beyond Survival: A Guide for the Family Business Owner and His Family, at 4 (4th ed. 1982); “Are Your Kids Good Enough to Run Your Business?” Inc. Magazine, Aug. 1994, at 36; and S. Danes and P. Olson. “Women’s Role Involvement in Family Businesses, Business Tensions, and Business Success,” The Family Firm Institute, Family Business Review, Vol. XVI, No. 1 (March 2003) at 53-68; R. Segal, “Family Firms vs. Their Counterparts- Best Practices for Success”, Corp. Magazine, January 1, 2008,; “Private Wealth”, Advising the exceptionally affluent. Vol. 5. No. 5 (Sept/Oct 2011). 23 See G. Le Van, Getting to Win-Win in Family Business, at 182 (3rd ed. 1993); and “Succession Planning: Family Continuity vs. Business Continuity,” The Family Business Professional, July 1997, at 1; and K. Smyrnios, et al, “Work-Family Conflict: A Study of American and Australian Family Businesses,” The Family Business Review, Vol. XVI, No. 1 (March 2003) at 35-50. 24 “Mass Mutual/Raymond Family Business Institute; “American Family Business Survey” (2003) at 1, 25, and 26, updated: (2007) at 4.

PROPOSED REVISIONS TO CIRCULAR 230 by

Jim Robertsi

The Secretary of the Treasury has the power under 31 USC Section 330 to regulate practice before the Treasury Department, including the IRS. The Secretary has published regulations to do just that. Those regulations are commonly referred to as Circular 230. On September 14, 2012, Treasury issued proposed new regulations (REG-138367-06).

There are several changes. Some of them are minor, but the key areas the new

regulations attempt to cover are: • Substantially rewriting the rules regarding written tax advice by:

o Eliminating the complex rules for covered opinions; o Eliminating the special rules for state and local bond opinions (cancelling

the proposed regulations issued in 2004 that would have amended Section 10.39);

o Eliminating the distinction between those opinions and other written tax advice;

o Replacing all three with a single standard for written tax advice based on reasonable factual and legal assumptions, reasonable reliance, and reasonable efforts to uncover relevant facts;

o Eliminating the provision that prohibits a practitioner from taking into account the possibility that an issue will be resolved through settlement if raised (but still prohibited would be discussing whether an audit might occur, and whether an issue might be raised on audit);

o Eliminating the requirement to describe fully all of the relevant facts and the application of the law to those facts; and

o Eliminating the Circular 230 disclaimers. • Expanding the duties of firm managers by expanding the scope of their duties to

include all aspects of work that involves federal tax issues, including advice, and the preparation of returns, claims for refund and other submissions.

• Modifying the provisions on expedited suspension by: o Adding persistent disregard of federal tax laws as a basis for suspension;

and o Clarifying the length of suspension.

• Making clear that the Office of Professional Responsibility has exclusive responsibility for discipline.

• Updating the regulation prohibiting a practitioner from negotiating a taxpayer’s check to include all forms of payment, electronic and otherwise.

Appendix: Attached is a draft prepared by the author that attempts to highlight

the differences between the current version of Circular 230 and the changes the proposed regulations would make. The author cannot guarantee the accuracy of the draft, and invites comments and corrections.

2

Written Tax Opinions: Back in 1984, Treasury started a process to reign in tax shelter opinions, and, more recently, in 2001, additional amendments were proposed regarding tax shelter opinions. A second proposed rulemaking came forth on December 30, 2003. That second set of propose regulations set forth best practices for tax advisors and again modify the standards for tax shelter opinions.

The American Jobs Creation Act of 2004 amended 31 USC Section 330 to clarify

that the Secretary may impose standards for written advice relating to a matter that is identified as having a potential for tax avoidance or evasion. In December 2004, Treasury IRS finalized the 2003 proposed regulations by publishing final regulations setting forth best practices. The biggest part of that rulemaking was the creation of standards for “covered opinions” in section 10.35 of Circular 230.

The current form of Circular 230 is contained in the August 2011 iteration

available online at http://www.irs.gov/pub/irs-utl/pcir230.pdf.

Section 10.35 was, and continues to be, controversial. According to Treasury, the responses it got from practitioners were overwhelmingly unfavorable. Practitioners characterized it as overbroad, difficult to comprehend and more difficult to apply, counterproductive (in terms of elevating the quality of tax advice), and expensive. One of the more obvious and continuing outgrowths of those new regulations is the ubiquitous disclaimer at the end of every letter and every email (even at the end of this article). Another practical result has been the shift to more oral communications of tax advice which are not covered by Section 10.35.

In addition to Section 10.35, there is Section 10.37 regarding “other” written tax

advice. And there are proposed regulations that would amend the requirements for bond opinions, which were supposed to be added to Section 10.39. The new proposed regulations drop the proposed revision of requirements for bond opinions, and re-write Sections 10.35 and 10.37.

The new proposed regulations do not expressly say anything about the

disclaimers. However, with the re-writing of Section 10.35 and 10.37, Treasury hopes practitioners will do away with those.

The preamble to the new proposed regulations says: The proposed regulations will streamline the existing rules for written tax advice by removing current section 10.35 and applying one standard for all written tax advice under proposed section 10.37. Proposed section 10.37 provides that the practitioner must base all written advice on reasonable factual and legal assumptions, exercise reasonable reliance, and consider all relevant facts that the practitioner knows or should know. The proposed removal of section 10.35 will eliminate the requirement that practitioners fully describe the relevant facts (including the factual and legal assumptions relied upon) and the application of

3

the law to the facts in the written advice itself, and the use of Circular 230 disclaimers in documents and transmissions, including e-mails. Treasury’s revision of Section 10.35 is nothing short of stunning. Gone are the 5

pages of regulations about opinions. There would be no more distinction between reliance opinions vs. marketed opinions vs. limited opinions, and no more excluded advice. The rules related to conditional opinions and confidentiality rules would be gone. The contractual protection rules would be eliminated. And, as noted above, the disclosure rules, requirements for slicing and dicing the facts, and covering every significant federal tax issue, would all be eliminated.

Old Section 10.35 and Section 10.37 would be combined into a much shorter,

more understandable 10.37 titled “Requirements for written advice” which would say, in essence, that a practitioner:

• Must base written advice on reasonable factual and legal assumptions; • Must reasonably consider all relevant facts that the practitioner knows or

should know; • Must use reasonable efforts to identify and ascertain the relevant

additional facts needed; • Must not:

rely on any facts from the taxpayer or anyone else if the practitioner knows or should know those “facts” are unreasonable or incomplete;

rely on any advice from someone else if the practitioner knows or should know the other person is not competent or his/her opinion is not reliable or has a conflict of interest;

take into account whether an audit might occur; and take into account, if an audit does occur, whether the issue will be

raised. • May consider, if an audit occurs and the issue is raised, whether the issue

will be resolved through settlement, if available.

Clearly, the watchword is “reasonable.” And when it comes to what the Commissioner can do in terms of reviewing the practitioner’s conduct, as one might expect, the Commissioner will apply a reasonableness standard, considering all of the facts and circumstances including the scope of the engagement and the type and specificity of advice the client wants.

No surprisingly, when the opinion is going to be used to market or promote a tax deal the standard of review is higher. Treasury says that is because of the greater risk caused by the practitioner’s lack of knowledge.

Some of the Same Rules. To some extent, the rules regarding what goes into

the opinion are the same. Old Section 10.35(c)(1)(i) says, “The practitioner must 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

4

opinion must identify and consider all facts that the practitioner determines to be relevant.” New Section 10.37 (2) says, “(2) The practitioner must -- (i) Base the written advice on reasonable factual and legal assumptions (including assumptions as to future events); (ii) Reasonably consider all relevant facts that the practitioner knows or should know; (iii) Use reasonable efforts to identify and ascertain the facts relevant to written advice on each Federal tax matter;…” These are very similar provisions.

Old Section 10.35(c)(1)(ii) says, “(ii) The practitioner must not base the opinion

on any unreasonable factual assumptions (including assumptions as to future events)... 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 such projection, financial forecast or appraisal. ... “ New Section 10.37(2) says, “(2) The practitioner must -- (iv) Not rely upon representations, statements, findings, or agreements (including projections, financial forecasts, or appraisals) of the taxpayer or any other person if reliance on them would be unreasonable; …” and 10.37(b), “(b) Reliance on advice of others. A practitioner may only rely on the advice of another practitioner if the advice was reasonable and the reliance is in good faith considering all the facts and circumstances. Reliance is not reasonable when -- (2) The practitioner knows or should know that the other practitioner is not competent or lacks the necessary qualifications to provide the advice; or (3) The practitioner knows or should know that the other practitioner has a conflict of interest as described in this part.” And Section 10.37(b)(3) says, “(3) Reliance on representations, statements, findings, or agreements is unreasonable if the practitioner knows or should know that one or more representations or assumptions on which any representation is based are incorrect or incomplete.”

An entirely new insertion is in Section 10.37(b)(1) which says, “(1) The

practitioner knows or should know that the opinion of the other practitioner should not be relied on;” There is nothing that defines exactly what that means. Perhaps we are supposed to “know it when we see it.”

There are other similarities, and likewise some differences. But overall, the vast

majority of what was in Section 10.35 is gone. Disclaimers. Old Section 10.35(a)(4) defined a “Reliance opinion” but said that

written advice “is not treated as a reliance opinion if the practitioner prominently discloses in the written advice that it was 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.” Similarly, old Section 10.35(a)(5) defined a “Marketed opinion” but said that written advice “is not treated as a marketed opinion if the practitioner prominently discloses in the written advice that — (A) 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; (B) The advice was written to support the promotion or marketing of the transaction(s) or matter(s) addressed by the written advice; and (C) The taxpayer should seek advice

5

based on the taxpayer’s particular circumstances from an independent tax advisor.” And old Section 10.35(c)(4) said that opinions that failed to reach a “more likely than not conculsion” must “must prominently disclose that —(i) The opinion does not reach a conclusion at a confidence level of at least more likely than not with respect to one or more significant Federal tax issues addressed by the opinion; and (ii) With respect to those significant Federal tax issues, 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.” These provisions generally resulted in disclaimers that said something like, “STATEMENTS CONTAINED HEREIN ARE NOT INTENDED OR WRITTEN BY THE WRITER OR THIS FIRM TO BE USED, AND NOTHING CONTAINED HEREIN CAN BE USED BY YOU OR ANY OTHER PERSON FOR THE PURPOSE OF: (1) AVOIDING PENALTIES THAT MAY BE IMPOSED UNDER FEDERAL TAX LAW; OR (2) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY TAX-RELATED TRANSACTION OR MATTER ADDRESSED HEREIN.” If the underlying provisions in Circular 230 that created the disclaimer are gone, will the disclaimers themselves disappear? While Treasury hopes that those disclaimers will disappear, they may not. Almost all disclaimers begin by saying that nothing in the writing can be used to avoid penalties. Proposed Section 10.37(c)(1) says, “In evaluating whether a practitioner giving written advice concerning one or more Federal tax matters complied with the requirements of this section, the Commissioner, or delegate, will apply a reasonableness standard, considering all facts and circumstances, including, but not limited to, the scope of the engagement and the type and specificity of the advice sought by the client.” If the disclaimer is removed, then the practitioner may be subject to scrutiny under the foregoing standard. On the other hand, if the disclaimer remains, its presence serves as evidence that the “scope of the engagement and the type and specificity of the advice sought” did not include tax advice to be relied on by the client.” It may not be conclusive, but then the client is going to have trouble using something in a letter or email with that disclaimer to stake out a position before the IRS.

Many disclaimers flatly say that nothing in the written advice can be used to promote, market or recommend to another party any tax related transaction of matter addressed in the letter or email. But note that Section 10.37(c)(2) says, “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 who is a member of, associated with, or employed by the practitioner's firm) in promoting, marketing, or recommending to one or more taxpayers a partnership or other entity, investment plan or arrangement a significant purpose of which is the avoidance or evasion of any tax imposed by the Internal Revenue Code, the determination of whether a practitioner has failed to comply with this section will be made on the basis of a heightened standard of review because of the greater risk caused by the practitioner's lack of knowledge of the taxpayer's

6

particular circumstances.” That provision may make some cautious practitioners, and firm managers, opt to keep that portion of the disclaimer.

The bottom line is that clients are now used to seeing the disclaimers, and

removing them exposes the practitioner to some additional examination. Whether the disclaimers will disappear, or remain, perhaps in a modified form, remains to be seen.

Expanded Requirements for Firm Managers. The task of firm managers will be expanded. The old version of Section 10.36(a) required any practitioner with principal authority and responsibility for overseeing a firm’s tax practice to make sure written advice complied with Section 10.35. Treasury’s propose revision of Section 10.36(a) would eliminate the cross-reference to Section 10.35, and, instead, replace it with a cross-reference to “this part.” The term “this part” encompasses everything in Circular 230. To reinforce that, Treasury has inserted language into Section 10.36(a) that specifically mentions the “preparation of tax returns, claims for refund, or other documents for submission to the Internal Revenue Service,” in addition to “the provision of advice concerning Federal tax matters.” Expedited Suspensions. Section 10.82 related to expedited suspensions has been modified substantially. The first major change is the expansion of what is covered. The existing version addresses suspensions of licenses, criminal convictions, disbarment, sanctions for delay or frivolous proceedings, and failures to pursue administrative remedies. Added to that list is an entirely new subsection that adds willful failure to comply with the practitioner’s own Federal tax obligations. The added language is a revised version of the proposed regulations issued in 2006. Those proposed regulations could have allowed immediate suspension if the practitioner had not paid a Federal tax obligation. Treasury, in the preamble to the new proposed regulations, indicated that it had received feedback that a failure to pay could be as a result of circumstances beyond the practitioner’s control. The new language addresses those concerns by saying that expedited suspension is available only when the practitioner “demonstrates a pattern of willful disreputable conduct by (1) failing to make an annual Federal tax return during four of five tax years immediately before the institution of an expedited suspension proceeding; or (2) failing to make a return required more frequently than annually during five of seven tax periods immediately before the institution of an expedited suspension proceeding. . . . Additionally, the practitioner must be noncompliant with a tax filing obligation at the time the notice of suspension is served on the practitioner for the expedited procedures to apply.” The preamble justifies this addition by saying, “Treasury and the IRS have determined that the proposed rule is appropriate because practitioners demonstrating this high level of disregard for the Federal tax system are unfit to represent others who are making a good faith attempt to comply with their own Federal tax obligations.”

The new proposed regulations would close a gap that exists in the current rules related to the length of suspension. The current version of Section 10.82(f) is silent about the length of a suspension under those rules, other than to say it continues until

7

the suspension is lifted by the IRS, an Administrative Law Judge or the Secretary. By contrast, Section 10.81, which relates to disbarred practitioners or disqualified appraisers, sets suspensions at 5 years. The new proposed regulations would expand the Section 10.81 5-year rule to practitioners suspended under the expedited suspension procedure under Section 10.82. The preamble to the proposed new regulations indicates that some non-substantive changes have been made, and those are:

• The existing procedure speaks of the “filing” of a “complaint” and the practitioner filing an “answer.” The new language would refer to a “show cause order” (which conveys the concept of immediacy) and to the practitioner filing a “response.” That change is proposed so as to distinguish the language used in regular proceedings under Section 10.60 from the expedited suspension process under Section 10.82.

• If a practitioner is suspended, the existing language of Section 10.82(g) say the IRS is required to commence a Section 10.60 proceeding. The lead in phrase to that says the practitioner may “ask” the IRS to issue a complaint under Section 10.60. The new language replaces “ask” with “demand”, and replaces “issue a complaint” with “institute a proceeding.” And furthermore, the revision requires that the practitioner specifically refer to suspension under Section 10.82 to initiate this procedure.

• The time frame for commencing a proceeding under Section 10.82(g) has been extended from 30 to 45 days.

In addition, there is one minor technical change not mentioned in the preamble, and that is the elimination of the reference to “filing” of the complaint in the current version of Section 10.82(c). That provision cross-references Section 10.63(a), which address service but never mentions filing.

Proposed by Not In Effect. These are proposed and not final. That means that

practitioners must follow the existing rules set out in the current August 2011 version of Sircular 230 until the new regulations are finalized.

Effective Date. The proposed revisions would be effective when they are

adopted in final form and published in the Federal Register. Comments: Comments must be received by November 16, 2012. At public

hearing is scheduled for December 7, 2012 at 10 a.m., in the Auditorium of the Internal Revenue Service building at 1111 Constitution Avenue, NW, Washington, DC 20224. Outlines of topics to be discussed at that hearing must be received by November 16, 2012. Send submissions to:

CC:PA:LPD:PR (REG-138367-06), room 5205, Internal Revenue Service,

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P.O. Box 7604, Ben Franklin Station, Washington, DC 20044.

Submissions may be hand delivered Monday through Friday between the hours of 8 a.m. and 4 p.m. to:

CC:PA:LPD:PR (REG-138367-06), Courier's Desk Internal Revenue Service 1111 Constitution Avenue, NW Washington, DC

Comments may also be submitted electronically via the Federal eRulemaking Portal at www.regulations.gov (indicate IRS and REG-138367-06).

Further Information: For further information concerning issues for comment, contact Matthew D. Lucey at (202) 622-4940. For more information concerning submissions of comments the public hearing, or to be placed on the building access list to attend the hearing, contact Oluwafunmilayo Taylor at (202) 622-7180.

ANY STATEMENTS CONTAINED HEREIN ARE NOT INTENDED OR WRITTEN BY THE WRITER TO BE USED, AND NOTHING CONTAINED HEREIN MAY BE USED BY YOU OR ANY OTHER PERSON, FOR THE PURPOSE OF (1) AVOIDING PENALTIES THAT MAY BE IMPOSED UNDER FEDERAL TAX LAW, OR (2) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY TAX-RELATED TRANSACTION OR MATTER ADDRESSED HEREIN.

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APPENDIX The following is a draft prepared by Jim Roberts which attempts to highlight the differences between the current language in Circular 230, and the new language that the new proposed regulations would insert or alter. Care should be taken in using this appendix, and it should not be relied on exclusively in analyzing the proposed changes to Circular 230. § 10.1 Offices.

(a) Establishment of office(s). The Commissioner shall establish the Office of Professional Responsibility . . . to administer or enforce this part. Offices established under this part include, but are not limited to:

(1) The Office of Professional Responsibility, which shall generally have responsibility for matters related to practitioner conduct and shall have exclusive responsibility for discipline, including disciplinary proceedings and sanctions; and

* * * * *

§ 10.3 Who may practice.

(a) Attorneys. Any attorney who is not currently under suspension or disbarment from practice before the Internal Revenue Service may practice before the Internal Revenue Service by filing with the Internal Revenue Service a written declaration that the attorney is currently qualified as an attorney and is authorized to represent the party or parties. Notwithstanding the preceding sentence, attorneys who are not currently under suspension or disbarment from practice before the Internal Revenue Service are not required to file a written declaration with the IRS before rendering written advice covered under §10.37, but their rendering of this advice is practice before the Internal Revenue Service.

(b) Certified public accountants. Any certified public accountant who is not

currently under suspension or disbarment from practice before the Internal Revenue Service may practice before the Internal Revenue Service by filing with the Internal Revenue Service a written declaration that the certified public accountant is currently qualified as a certified public accountant and is authorized to represent the party or parties. Notwithstanding the preceding sentence, certified public accountants who are not currently under suspension or disbarment from practice before the Internal Revenue Service are not required to file a written declaration with the IRS before rendering written advice covered under §10.37, but their rendering of this advice is practice before the Internal Revenue Service.

* * * * *

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(g) Others. Any individual qualifying under paragraph §10.5(e) or §10.7 is eligible

to practice before the Internal Revenue Service to the extent provided in those sections.

* * * * * § 10.22 Diligence as to accuracy.

(a) In general. A practitioner must exercise due diligence — (1) In preparing or

assisting in the preparation of, approving, and filing tax returns, documents, affidavits, and other papers relating to Internal Revenue Service matters; (2) In determining the correctness of oral or written representations made by the practitioner to the Department of the Treasury; and(3) In determining the correctness of oral or written representations made by the practitioner to clients with reference to any matter administered by the Internal Revenue Service.(b) Reliance on others. Except as provided in §§ 10.34 and 10.37, a practitioner will be presumed to have exercised due diligence for purposes of this section if the practitioner relies on the work product of another person and the practitioner used reasonable care in engaging, supervising, training, and evaluating the person, taking proper account of the nature of the relationship between the practitioner and the person.

* * * * * § 10.31 Negotiation of taxpayer checks.

A practitioner who prepares tax returns may not endorse or otherwise negotiate

any check (including directing or accepting payment by any means, electronic or otherwise, in an account owned or controlled by the practitioner or any firm or other entity with whom the practitioner is associated) issued to a client by the government in respect of a Federal tax liability. * * * * * § 10.35 Competence.

(a) A practitioner must possess the necessary competence to engage in practice

before the Internal Revenue Service. Competent practice requires the knowledge, skill, thoroughness, and preparation necessary for the matter for which the practitioner is engaged.

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§ 10.36 Procedures to ensure compliance.

(a) Any practitioner who has (or practitioners who have or share) principal

authority and responsibility for overseeing a firm’s practice governed by this part, including the provision of advice concerning Federal tax matters and preparation of tax returns, claims for refund, or other documents for submission to the Internal Revenue Service, 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 this part, as applicable. Any such practitioner will be subject to discipline for failing to comply with the requirements of this paragraph (a) if —

(1) The practitioner through willfulness, recklessness, or gross incompetence does not take reasonable steps to ensure that the firm has adequate procedures to comply with this part, as applicable, and one or more individuals who are members of, associated with, or employed by, the firm are, or have engaged in a pattern or practice, in connection with their practice with the firm, of failing to comply with this part, as applicable; or (2) The practitioner knows or should know that one or more individuals who are members of, associated with, or employed by, the firm are, or have, engaged in a pattern or practice, in connection with their practice with the firm, that does not comply with this part, as applicable and the practitioner, through willfulness, recklessness, or gross incompetence, fails to take prompt action to correct the noncompliance.

* * * * * § 10.37 Requirements for written advice.

(a) Requirements. (1) A practitioner may give written advice (including electronic communications) concerning one or more Federal tax issues subject to the requirements in paragraph (a)(2) of this section.

(2) The practitioner must --

(i) Base the written advice on reasonable factual and legal assumptions (including assumptions as to future events);

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(ii) Reasonably consider all relevant facts that the practitioner knows or should know; (iii) Use reasonable efforts to identify and ascertain the facts relevant to written advice on each Federal tax matter; (iv) Not rely upon representations, statements, findings, or agreements (including projections, financial forecasts, or appraisals) of the taxpayer or any other person if reliance on them would be unreasonable; and (v) Not, in evaluating a Federal tax matter, take into account the possibility that a tax return will not be audited or that a matter will not be raised on audit.

(3) Reliance on representations, statements, findings, or agreements is unreasonable if the practitioner knows or should know that one or more representations or assumptions on which any representation is based are incorrect or incomplete. (b) Reliance on advice of others. A practitioner may only rely on the advice of

another practitioner if the advice was reasonable and the reliance is in good faith considering all the facts and circumstances. Reliance is not reasonable when --

(1) The practitioner knows or should know that the opinion of the other practitioner should not be relied on; (2) The practitioner knows or should know that the other practitioner is not competent or lacks the necessary qualifications to provide the advice; or (3) The practitioner knows or should know that the other practitioner has a conflict of interest as described in this part.

(c) Standard of review. (1) In evaluating whether a practitioner giving written

advice concerning one or more Federal tax matters complied with the requirements of this section, the Commissioner, or delegate, will apply a reasonableness standard, considering all facts and circumstances, including, but not limited to, the scope of the engagement and the type and specificity of the advice sought by the client.

(2) 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 who is a member of, associated with, or employed by the practitioner's firm) in promoting, marketing, or recommending to one or more taxpayers a partnership or other entity, investment plan or arrangement a significant purpose of which is the avoidance or evasion of any tax imposed by the Internal Revenue Code, the determination of whether a practitioner has failed to comply with this section will be made on the basis of a heightened standard of review because of the greater

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risk caused by the practitioner's lack of knowledge of the taxpayer's particular circumstances.

* * * * *

§ 10.52 Violations subject to sanction.

(a) A practitioner may be sanctioned under §10.50 if the practitioner —

(1) Willfully violates any of the regulations (other than §10.33) contained in this part; or (2) Recklessly or through gross incompetence (within the meaning of §10.51(a)(13)) violates §§ 10.34, 10.36 or 10.37.

* * * * * § 10.81 Petition for reinstatement.

(a) In general. A practitioner disbarred or suspended under section 10.60, or

suspended under section 10.82, or a disqualified appraiser may petition for reinstatement before the Internal Revenue Service after the expiration of 5 years following such disbarment or disqualification. Reinstatement will not be granted unless the Internal Revenue Service is satisfied that the petitioner is not likely to engage thereafter in conduct contrary to the regulations in this part, and that granting such reinstatement would not be contrary to the public interest. * * * * * § 10.82 Expedited suspension.

(a) When applicable. Whenever the Commissioner, or delegate, determines that a practitioner is described in paragraph (b) of this section, the expedited procedures described in this section may be used to suspend the practitioner from practice before the Internal Revenue Service.

(b) To whom applicable. This section applies to any practitioner who, within 5

years of the date that a show cause order under this section's expedited suspension procedures is served:

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(1) Has had a license to practice as an attorney, certified public accountant, or actuary suspended or revoked for cause (not including a failure to pay a professional licensing fee) by any authority or court, agency, body, or board described in §10.51(a)(10).

(2) Has, irrespective of whether an appeal has been taken, been convicted of any crime under title 26 of the United States Code, any crime involving dishonesty or breach of trust, or any felony for which the conduct involved renders the practitioner unfit to practice before the Internal Revenue Service. (3) Has violated conditions imposed on the practitioner pursuant to §10.79(d). (4) Has been sanctioned by a court of competent jurisdiction, whether in a civil or criminal proceeding (including suits for injunctive relief), relating to any taxpayer’s tax liability or relating to the practitioner’s own tax liability, for —

(i) Instituting or maintaining proceedings primarily for delay; (ii) Advancing frivolous or groundless arguments; or (iii) Failing to pursue available administrative remedies.

(5) Has demonstrated a pattern of willful disreputable conduct by --

(i) Failing to make an annual Federal tax return, in violation of the Federal tax laws, during 4 of the 5 tax years immediately preceding the institution of a proceeding under paragraph (c) of this section and remains noncompliant with any of the practitioner's Federal tax filing obligations at the time the notice of suspension is issued under paragraph (f) of this section; or (ii) Failing to make a return required more frequently than annually, in violation of the Federal tax laws, during 5 of the 7 tax periods immediately preceding the institution of a proceeding under paragraph (c) of this section and remains noncompliant with any of the practitioner's Federal tax filing obligations at the time the notice of suspension is issued under paragraph (f) of this section.

(c) Expedited suspension procedures. A suspension under this section will be

proposed by a show cause order that names the respondent, is signed by an authorized representative of the Internal Revenue Service under §10.69(a)(1), and is served according to the rules set forth in paragraph (a) of §10.63. The show cause order must give a plain and concise description of the allegations that constitute the basis for the proceeding. The show cause order must notify the respondent —

(1) Of the place and due date for filing a response;

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(2) That an expedited suspension decision by default may be rendered if the respondent fails to file a response as required; (3) That the respondent may request a conference to address the merits of the show cuase order and that any such request must be made in the response ; and (4) That the respondent may be suspended either immediately following the expiration of the period within which a response must be filed or, if a conference is requested, immediately following the conference.

(d) Response. The response to a show cause order described in this section

must be filed no later than 30 calendar days following the date the show cause order is served, unless the time for filing is extended. The response must be filed in accordance with the rules set forth for answers to a complaint in §10.64, except as otherwise provided in this section. The response must include a request for a conference, if a conference is desired. The respondent is entitled to the conference only if the request is made in a timely filed response. (e) Conference. An authorized representative of the Internal Revenue Service will preside at a conference described in this section. The conference will be held at a place and time selected by the Internal Revenue Service, but no sooner than 14 calendar days after the date by which the response must be filed with the Internal Revenue Service, unless the respondent agrees to an earlier date. An authorized representative may represent the respondent at the conference.

(f) Suspension -- (1) In general. The Commissioner, or delegate, may suspend the respondent from practice before the Internal Revenue Service by a written notice of expedited suspension immediately following:

(i) The expiration of the period within which a response to a show cause order must be filed if the respondent does not file a response as required by paragraph (d) of this section; (ii) The conference described in paragraph (e) of this section if the Internal Revenue Service finds that the respondent is described in paragraph (b) of this section; (iii) The respondent's failure to appear, either personally or through an authorized representative, at a conference scheduled by the Internal Revenue Service under paragraph (e) of this section.

(2) Duration of suspension. A suspension under this section will commence on the date that written notice of expedited suspension is served on the practitioner, either personally or through an authorized representative. The suspension will remain effective until the earlier of the following:

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(1) The Internal Revenue Service lifts the suspension after determining that the practitioner is no longer described in paragraph (b) of this section or for any other reason; or (2) The suspension is lifted by an Administrative Law Judge or the Secretary of the Treasury, or delegate deciding appeals, in a proceeding referred to in paragraph (g) of this section and instituted under §10.60.

(g) Practitioner request for section 10.60 proceeding. If the Internal Revenue

Service suspended a practitioner under the expedited suspension procedures described in this section, the practitioner may demand that the Internal Revenue Service institute a proceeding under §10.60. The request must be made in writing, specifically reference the suspension action under section 10.82, and be made within 2 years from the date on which the practitioner’s suspension commenced. The Internal Revenue Service must issue a complaint requested under this paragraph within 45 calendar days of receiving the demand. i Jim Roberts is an estate planning attorney in the Dallas office of Glast, Phillips & Murray, PC, is an ACTEC Fellow, and board certified in estate planning and probate by the Texas Board of Legal Specialization. Jim can be reached at (972) 419-7189 or jvroberts@gpm-law.com.

Shelter From the Gathering Storm: Protection for Trustees Facing Fiduciary Challenges

Eric A. Manterfield1

Investment Management 1

Investment concentrations, closely-held businesses and real estate 1 Can the trustee rely on consents to solve the problem? 2 Did the right people sign the consent? 2 Did they understand what they were signing? 4 How long ago were the consents signed? 5 Asset allocations that violate the trustee’s policy 5 Someone else manages the investments 6 What’s the real problem? 10 Who bears the expense of the court action? 13 Administration of the Trust 14 Discretionary distributions - why is the money needed? 14 Discretionary distributions - outside resources 18 Loans as disguised distributions 21 Ambiguity in the trust instrument 21 Total return trusts v. Uniform Principal and Income Act 24 The allocation and distribution of trust assets 29 Conflicts of Interest 31 A beneficiary is serving as the trustee 32 A beneficiary is serving as a co-trustee with a bank 33 A corporate trustee is also trustee of a related trust 33 How to deal with this problematic issue 34 New trust instruments 34 Existing trust instruments 35 Successor Trustee Liability for Acts of Prior Trustee 35 Revocation of a Revocable Trust 38 Conclusions and Final Recommendations 40

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It never was easy to be a trustee and now it seems to be getting harder.

Perhaps there was a time when beneficiaries were forgiving of trustees; however, those

days are long gone. Beneficiaries today are perfectly willing (and eager) to use 20-20

hindsight to second guess every decision made by a fiduciary. It seems not to matter

whether the trustee is an individual or a corporate fiduciary. What can a trustee do to

minimize exposure in this mine field?

Investment Management

A trustee's greatest after-the-fact exposure arises whenever the investment

management of the trust does not conform to the terms of the trust instrument. How

could this ever happen, you wonder. Here are some examples I have encountered.

Investment concentrations, closely-held business interests and real estate. The

assets of the trust may be concentrated in one specific stock or even in one industry

group. The stock may have been acquired by the testator and left to the trust at his or

her death. The family does not want to sell it, either for sentimental or capital gains tax

reasons.

The trust may hold an interest in a closely-held family business or a family farm.

The beneficiaries to not want the asset sold, even if the Prudent Investor Act would

seem to require that action.

2

The creator of the trust can override the trustee’s normal duty to diversify

investments. Look at the trust instrument (will or trust agreement). Does the trust

instrument specify any treatment for this asset?

A document which merely authorizes a trustee to retain originally deposited

assets does not protect the trustee against liability. The power to retain does not have

to be exercised; it is discretionary with the trustee. The power to retain necessarily

includes the power not to retain. Authorization alone is not enough to override the duty

to sell this asset.

In order to permit the trustee to retain this concentration, closely-held business

interest or real estate, the trust instrument must (a) mandate the retention of the asset

by name and (b) relieve the trustee of liability for its retention. If your trust instrument

does not do these two things, the trustee is still liable for the investment.

The creator of the trust could have solved this problem with careful drafting of the

trust instrument. If he or she failed to include the appropriate mandate to retain and the

necessary release of trustee liability, the trustee has to take positive steps to address

the problem.

Can the trustee rely on consents to solve the problem? If the trustee obtains the

written consents of the beneficiaries, is that not sufficient protection? There are several

potential areas of concern for a trustee who has these consents.

Did the right people sign the consents? If the consent is signed only by the current

income beneficiary, the trustee still has exposure to the remainder beneficiaries. The

widow who does not want her children to learn about the trust until her later death has

3

put the trustee in an untenable position. Any consent to retain these assets must also

be signed by the remainder beneficiaries.

Even if the consent was signed by the remainder beneficiaries, is that consent

binding on those who might succeed to the interest of those who signed? If the trust is

to terminate at a widow's death, for example, with the assets distributed outright to

grown children, is the consent of the grown children enough protection? What if a child

dies before the widow, leaving minor children to take his or her share when the widow

later dies? Is that consent binding on those contingent remainder beneficiaries?

Indiana has codified the common law doctrine of "virtual representation."2 If the

interest of the contingent remainder beneficiaries is exactly the same as the interest of

the remainder beneficiary who signs the consent, that consent is binding on the

contingent remainder beneficiaries.

If the descendants of a deceased child will take exactly the same interest which

the child would have received if living when the trust terminated, the doctrine of virtual

representation means that the child's consent is binding on his descendants. I

recommend that the consent be signed by the remainder beneficiary "both individually

and on behalf of anyone who may succeed to my interest in the trust."

The consent is binding on those contingent remainder beneficiaries only so long

as their interest is contingent. If the child who consented on behalf of those contingent

remainder beneficiaries were to die during the administration of the trust (in which case

his or her descendants are now the remainder beneficiaries to the extent of the

deceased child’s interest), the trustee must get new consents from these new actual

remainder beneficiaries. While the deceased child's consent would prevent these new

4

remainder beneficiaries from criticizing the trustee for prior acts in reliance on the

consent (before their parent died), it will not protect the trustee going forward after the

child's death. A new consent is required from these new beneficiaries.

Recall that this doctrine can be utilized only if the interests are identical. An

income beneficiary's consent is not binding, for example, on the interests of the

remainder beneficiaries because their interests are not the same. The widow cannot

sign consents on behalf of the children under this doctrine.

Did they understand what they were signing? It may be too easy for an unhappy

beneficiary to get out from under a previously signed consent by claiming he or she did

not understand what was being signed. “I did not know what my rights were.” “The

trustee never advised me to seek the advice of my lawyer.” “My mother would not feed

us Thanksgiving dinner until we all signed the consents!”

The younger the beneficiary who consents, the harder it is to enforce. The less

sophisticated the beneficiary who consents, the harder it is to enforce. The consent

signed by an older, infirm person may be difficult to enforce.

Indiana law states that the consent by a beneficiary does not relieve the trustee

of liability if the beneficiary was under an incapacity.3 A beneficiary may be under an

“incapacity” even if not under a court supervised guardianship. The unhappy

beneficiaries (such as children of an elderly mother who signed the consent) will argue

that she actually was incapacitated when she signed the consent. Obviously, a consent

signed by a beneficiary who is under eighteen does not relieve the trustee of liability.

Indiana law goes on to provide that, even if the beneficiary was not incapacitated,

the consent does not relieve the trustee of liability if “the beneficiary did not know of his

5

rights or all of the material facts which the trustee knew or should have known.”4 The

trustee should advise each beneficiary in writing to seek advice from his or her own

lawyer before signing the consent. If a beneficiary signs the consent without seeking

advice of counsel, that fact should be documented.

The trustee should tell each beneficiary why the consent is being requested and

what will happen if not all the consents are signed. Policies should be in place to deal

with the possibility that some, but not all, of the beneficiaries will sign consents. Can the

trust be partitioned, perhaps with court authority, to retain the asset in one new account

which benefits those who signed consents and to diversify the asset in the other new

account which benefits those who refused to consent?

How long ago were the consents signed? How stale is the consent? Can the

beneficiary later claim that, due to new circumstances (market conditions, cash needs

and so forth), an old consent should no longer be binding. "I signed the consent under

different economic circumstances, which have significantly changed over time. I would

not have signed a new consent had one been asked of me.

If your consent is more than one year old, it may not be sufficient to relieve the

trustee of liability. Get them updated each year.

Asset allocations. Many corporate trustees have a written policy about the

percentage of trust principal which is to be invested in fixed income and in equity,

depending on the investment goals of the beneficiaries. Are there maximum

percentages which can be invested in stocks or in bonds? How does an individual

trustee invest the trust assets?

6

How are the investment objectives of the beneficiaries to be determined? How is

investment risk tolerance measured? Did the trustee consult only with the income

beneficiary or also with the remainder beneficiaries? How are these efforts

documented?

Can an unhappy beneficiary later claim that he or she was not consulted, did not

understand what was being asked or said and so forth? Of course! Once again, the

younger, the less sophisticated or the elderly are the beneficiaries, the more the trustee

must redouble the efforts to have meaningful conversations about investment risk

tolerance, investment objectives, non-trust assets available to the beneficiary and so

forth. Must the trustee consult with the remainder beneficiaries about these matters,

too? Of course.

What happens when a widow who is stretching for income pleads that all the

portfolio be invested in (low to no growth) bonds? What happens, on the other hand, if

the widow explains that she has ample income from other sources, so all the portfolio

should be invested in low yield (but higher risk) equities?

I believe the issues are the same with respect to any consents signed by the

beneficiaries. Did the right people sign the consents to the investments? Did they

understand what they were signing? How long ago were the consents signed?

Someone else manages the investments. More and more people are attempting

to involve someone other than the trustee in the management of the trust assets. This

may be the decedent's stock broker or financial planner, for example. These people do

7

not want to be the trustee, but they do want to manage the assets after the death of

their good clients.

In an effort to accommodate the wishes of the beneficiaries, a trustee may allow

this to happen. What liability does the trustee have for investment decisions made by

this third party? Does the trust instrument direct or permit this delegation of the

investment management responsibility? What exactly is said in the trust instrument?

Some wills or trust agreements permit a trustee to delegate investment

management. But does the trust instrument merely authorize this action or does it

mandate it? If the trustee is merely permitted to delegate investment management

decisions to a third party, the trustee remains liable for decisions made by that advisor.

The trustee was merely permitted to do so and was not required to delegate investment

management. If the trustee elects to do so, the trustee is still liable for the third party’s

management of the trust assets.

If the trust instrument directs the trustee to work with a third party on

investments, does the advisor merely give advice or must the trustee do what the

outsider directs? If it is not crystal clear that the trustee must follow the direction of the

third party, the trustee may easily be liable if the trustee does not stop the advisor from

making an inappropriate investment.

Is the trustee relieved of liability for following the directions of the investment

manager? Indiana law provides that a trustee must follow the third party’s direction and

is relieved of liability only if (a) the trust instrument specifically gives to the third party

the power to direct the trustee and (b) the trust instrument specifically relieves the

trustee from liability if the trustee does follow the third party’s directions.5

8

If the trust instrument directs the trustee to delegate investment management

and makes it clear that the trustee must follow the instructions of the outsider, but does

not expressly relieve the trustee of liability, then that language does not relieve the

trustee of liability. Indeed, the trustee is required to refuse to comply with the outsider's

directions if the trustee "knows or should know" that the instructed action would

constitute a breach of trust.6

If there is no language in the trust instrument or if the language provides

inadequate protection to the trustee, the trustee should have all the parties sign a

document which does provide that needed protection from liability. I recommend that

this agreement be signed by the trustee, the outside investment manager and the

current and remainder beneficiaries of the trust.

The agreement needs to address a number of significant issues:

• Does the outside investment manager merely give advice or must the trustee

follow the instructions?

• Is the trustee specifically relieved of liability for following those directions? If the

trustee is to be "indemnified and held harmless," by whom is the trustee so

indemnified? Will the outside investment manager hold the trustee harmless?

What if the outside investment manager dies or retires or files for bankruptcy?

Will the beneficiaries hold the trustee harmless? Who is liable to protect the

trustee?

• Does the trustee still have investment oversight and must the trustee still make

investment recommendations? If the trustee is relieved of those duties, what

impact will that have on the fees which the trustee can reasonably charge?

9

• Who custodies the trust assets?

• Does the outside investment manager actually make the trades for the trustee or

does the outside investment manager direct the trustee to make the trades?

Must those instructions be in writing?

• Who can remove the outside investment manager from that office? The trustee

still has investment liability if the trustee can remove the investment manager;

that is, if the trustee can fire the outside investment manager at any time, how

can the trustee later claim the trustee is protected against liability for actions

taken by the investment manager? “You should have fired the advisor before that

investment was made!” If one or more of the beneficiaries is given this power,

can or must they name a new investment manager? Does the trustee take back

the investment management responsibility if there is no outside investment

manager serving at any given time?

• How are the outside investment manager's fees to be charged? Against principal

or income? Does the trustee have liability for paying those fees without question

or must they first be approved by the beneficiaries? If the advisor is

compensated when trades are made, how mechanically are those fees to be split

between income and principal by the trustee?

• Who is responsible for tax reporting? If the assets are custodied by the outside

investment manager, how will the trustee get 1099s?

10

What’s the Real Problem?

The creator of the trust could have dealt with each of these issues by carefully

drafting the trust instrument. That was not done. The trustee who seeks to comply with

the wishes of the beneficiaries is required to take steps which could have been and

should have been taken by the patriarch of the family.

Can the trustee rely on the consents of the beneficiaries? Can the trustee

comply with investment management decisions of a third party even with a complete

agreement among all the parties?

Is there still potential liability? Of course! Beneficiaries are more and more

anxious to seek relief from a trustee with the benefit of hind sight.

What is the preferred strategy to minimize the trustee’s potential liability? Get a

court order.

I recommend that you get court approval whenever the administration of

the trust is at variance with the terms of the document. Consents alone are not

sufficient protection for the trustee.

Consents are the minimum protection you should have; however, the larger the

size of the trust, the more inadequate is the protection provided by the consents. It is

simply too easy for beneficiaries later to claim that they were not adequately informed

by the trustee when the consent was signed, did not understand their rights or that

circumstances changed after the consent was signed, rendering it meaningless (in their

opinion).

11

If the trustee has current, adequate consents from all the beneficiaries, it

probably is not worth the expense of getting court approvals in small trusts. But in

larger trusts, why would the trustee not demand the protection of a court order? If the

beneficiaries all want the trustee to deviate from the terms of the trust on these issues,

the trustee should reasonably ask for a court order to accomplish their wishes.

Suppose the beneficiaries do not want the trustee to diversify an investment

concentration, do not want the trustee to sell non-approved securities, or want the

trustee to delegate investment management to an outside investment manager? The

trust instrument could have provided for each of these things, but did not do so.

Nevertheless, the beneficiaries want the trustee to deviate from the express terms of the

trust instrument to accomplish their objectives.

Indiana law permits a trustee to petition the local court to permit a deviation from

the express terms of a trust instrument if the court finds that (a) there are new

circumstances which exist that were not reasonably foreseen by the creator of the trust

and (b) due to these new circumstances, compliance with the terms of the trust, as

written, would "defeat or substantially impair the accomplishment of the purposes of the

trust."7 If the court makes that determination, the judge can approve new language to

be put into an otherwise irrevocable trust agreement or last will and testament, which

would "direct or permit the trustee to do acts which are not authorized or are forbidden

by the terms of the trust, or may prohibit the trustee from performing acts required by

the terms of the trust."

How can a trustee utilize this statutory procedure? Suppose the trust holds an

investment concentration or wants to delegate investment management

12

responsibilities? Indiana law requires a trustee to comply with the "prudent investor"

rule.8 An investment concentration are generally understood to violate that rule. A

trustee cannot delegate investment management responsibilities.

The "new circumstance" which might exist is the requirement that the trustee

diversify the concentration and manage the trust assets regardless of the wishes of the

beneficiaries.

The trustee can assert that, had the creator of the trust known that the trustee

would be required to overrule the wishes of the beneficiaries, he or she would have

directed in the trust instrument the retention of the concentration or the investment

management delegation. This new circumstance was not reasonably anticipated by the

creator of the trust. Compliance with the terms of the trust instrument, as written, would

require the trustee to overrule the wishes of the beneficiaries, which would "defeat or

substantially impair the accomplishment of the purposes of the trust."

Therefore, the trustee requests that the court insert a new provision in the trust

instrument which prohibits the trustee from diversifying the investment concentration or

permits investment management delegation. Because no one can predict the future, I

recommend that the new court-approved provision prohibit the sale without the written

consent of specific beneficiaries.

Those issues identified above with respect to a written contract with an outside

investment manager must also be addressed in the new provision which the trustee and

beneficiaries wish the court to insert into the trust instrument.9

13

Who bears the expense of the court action? This is an appropriate expense

of the trust, to be charged to trust principal. The trustee does not bear this expense

personally. The legal fees and court costs are paid out of the trust assets themselves.

It is possible that the beneficiaries will object to the expense of a court order on

the grounds that it is being sought merely to protect the trustee. Why should the trust

bear that expense? The proper response to this objection is that the requested court

order merely puts into the trust instrument language which the creator of the trust

should have included. The trustee is seeking a court modification of the language in

order to accomplish the wishes of the beneficiaries.

If the beneficiaries are not willing to bear the expense, the trustee has no

alternative but to diversify the concentration, and manage the trust assets. If the

beneficiaries do not want the trustee to take those actions – which are required by

Indiana law because the creator of the trust failed to include the necessary language in

the trust instrument – they should and must bear the expense of “cleaning up” the trust

instrument.

If the beneficiaries realize that, without a court order, the trustee has no

alternative but to diversify the concentration and manage the investments without the

assistance of the outside investment manager, I believe the beneficiaries will

understand that the court process is not designed to protect the trustee, but is to give

the trustee the authority to do (or not do) what the beneficiaries want.

14

Administration of the Trust

A trustee faces similar exposure whenever the administration of the trust does

not comply with the terms of the trust instrument. How is this possible?

Discretionary distributions - why is the money needed? The trustee must not

assume that every trust instrument gives discretion to make distributions for "health,

education, maintenance and support." Some documents restrict those four purposes to

only education, for example. Some documents permit broader latitude, with

distributions authorized for “happiness” or “comfort.”

Does the purpose for which the distribution is requested meet the standards of

the trust instrument? A reasonableness factor comes into play here. These four

standards are very, very broad. Let's examine them in a little more detail.

"Health." The trustee may reasonably interpret this language to permit the

payment of those medical expenses incurred by the beneficiary which are not covered

by the beneficiary's medical insurance. But what if the beneficiary has no medical

insurance coverage? The beneficiary may elect not to incur that personal expense

because of the expectation that all medical expenses will be paid from the trust.

I recommend that the trustee demand annual proof the fact that the beneficiary

has adequate medical insurance coverage. If the beneficiary refuses to provide that

information or has no coverage, I recommend that the trustee consider the acquisition of

coverage at the expense of the trust. Depending on the terms of the trust, the trustee

can reasonably charge the premiums to the interests of that beneficiary. It is not

15

reasonable, on the other hand, for a trustee to permit a beneficiary to have no medial

insurance and to pay all the health expenses from the trust, in my opinion.

How does the trustee know whether the beneficiary has adequate medical

insurance? Ask!

"Education." I'm all in favor of education; however, I do not like perpetual

students. The old four year undergraduate program has turned into a five, six or even

more year marathon (at least my children tell me that!). When can and should a trustee

say "no" to a beneficiary who stays on and on and never seems to reach graduation?

I think the answer to that question depends on the size of the trust assets, the

existence of other beneficiaries who are dependent on those assets and the probable

intention of the parents who created the trust.

Suppose the child who wants to stay in college is the sole beneficiary of the trust,

which might terminate, for example, when he or she reaches a higher age, with the

assets distributed to that same child? By consuming his or her own trust assets for

these continuing education pursuits, the beneficiary is hurting no one other than himself

or herself. I see no reason, under those circumstances, to say "no" to the request for

more tuition dollars.

But if this is a "family" trust, designed to hold all the assets together in one trust

for the benefit of several children, one child's continued demand for tuition dollars might

jeopardize the trustee's financial ability to educate the younger children. It is under

these circumstances that I recommend the trustee put a limit on the number of years of

undergraduate education which will be paid from the trust.

16

A related problem arises with a “small” trust. If the oldest child of four children

requests distributions for an expensive undergraduate education from a trust holding

only $300,000, it is certainly possible that the trust assets will be exhausted long before

the youngest child graduates from high school. While the parents, if still living, would

have incurred that expense (with the expectation that, some how, they will get more

money to educate the younger children), the trustee must understand that there will be

no new money coming into the trust.

A reasonableness standard must be adopted by the trustee of a trust with limited

assets. If the trustee believes that there is a risk the trust assets will be consumed if the

trustee pays all the anticipated education expenses of one child, the trustee must limit

how much is distributed for the education of that child. Even though the trust instrument

permits distributions for that child’s “education,” the trustee has a duty of impartiality and

cannot favor the interests of that child at the expense of the other children.

“Maintenance and support" can literally mean whatever the trustee decides those

words should mean. Almost any expenditure can arguably be brought within the scope

of that standard. So when can and should a trustee say "no" to a beneficiary? Once

again, a reasonableness standard must be applied.

I know of beneficiaries who demand to be supported and maintained by

benevolent trustees long after they have left school. Trustees know of "trust babies"

who lie around the swimming pool and expect a trustee to pay their rent and buy them

groceries. Is this what the parents intended when they included the words "support and

maintenance" in the trust instrument? Probably not.

17

If there are other beneficiaries of the trust, I believe that it is unreasonable for a

trustee to give in to a beneficiary's demand to be supported and maintained, even if that

is a standard in the trust instrument. To do so might jeopardize the trustee's ability to

raise and educate the younger children. The trustee who depletes trust assets in the

support of an older child may face liability to the younger beneficiaries when the trustee

later has insufficient funds to meet their legitimate needs.

A reasonableness standard should be applied. A trustee might, for example, tell

a child who is in his twenties that the trust will only match the child's own earned

income. The trust will supplement, but not replace, the beneficiary's ability to support

and maintain himself or herself. This standard may not be necessary if the trustee has

millions of dollars in trust; however, I believe it to be a reasonable standard in many

smaller trusts.

Many trust instruments authorize a trustee to help a child purchase a residence

or start a business. How much of the trust principal should be depleted for these

purposes? Should the principal be distributed to the beneficiary who then purchases

the home or business in his own name or could not the trustee buy those as assets of

the trust? Title to the home or the business can later be distributed to the child when

the beneficiary reaches the stated ages for distribution.

Should the trustee expect the beneficiary to contribute some amount towards the

purchase of the residence or business? Perhaps the trustee would agree to match

whatever down payment is put up by the beneficiary. A beneficiary who has his own

money invested in a new business (perhaps matched by a discretionary distribution

from the trust) will devote more effort to the success of the venture.

18

Discretionary distributions - outside resources. Must the trustee consider the

resources otherwise available to the beneficiary when requested to make a

discretionary distribution? What are the terms of the trust instrument? There are

probably three alternatives:

1. The trust instrument expressly directs the trustee to take into

consideration the outside resources which can meet the beneficiary's needs. But does

the document direct the trustee to consider "all resources" or only the "income" of the

beneficiary?

Must the trustee require the beneficiary to use up all those outside resources

before any distribution can be made from the trust? The instrument typically says that

the trustee is to "take into consideration" those resources. The beneficiary should not

be required to exhaust them.

If the outside resources are illiquid, for example, the trustee should not refuse a

reasonable request for distributions. But if the beneficiary has ample outside liquid

resources, on the other hand, it would violate the terms of the trust instrument if the

trustee, in spite of those outside liquid resources, distributed money from the trust.

If the trustee is to consider outside resources, the trustee should request a

personal financial statement from the beneficiary. The trustee might also request

copies of back income tax returns, to see whether the reported income on the tax

returns is consistent with the income producing assets disclosed on the financial

statement. If the beneficiary refuses to supply this requested documentation, the

trustee should refuse to make the requested distribution.

19

The trustee's "consideration" of these outside resources should be documented

in writing and saved with the records of the trust.

2. The trust instrument expressly directs the trustee not to take into

consideration the outside resources which can meet the beneficiary's needs. While this

type of provision is unusual, I have seen it in a number of documents.

If this is the controlling language in the trust instrument, of course, the outside

resources and income of the beneficiary are irrelevant. So long as the need is

legitimate, the distribution may be made.

If the remainder beneficiaries are unable to accept the language of the trust and

express displeasure with the trustee's discretionary distributions (when the beneficiary

has ample non-trust liquid resources which could meet the need), I recommend the

trustee petition the court for instructions. Does the language (“do not take into

consideration the beneficiary’s non-trust assets”) really mean what it says?

Send notice of a hearing to all the beneficiaries and let them argue to the judge

that the trust assets should not be depleted under these circumstances. When the court

issues an order confirming the language of the trust instrument, it will later be difficult for

the remainder beneficiaries to complain.

3. The trust instrument is silent on this issue. If that is the case, look

carefully the wording of the instrument when it gives the trustee the discretion to make

distributions.

Some documents permit the trustee to make discretionary distributions of those

amounts of trust income or principal that "the trustee determines to be necessary for the

reasonable health, education, maintenance and support" of the beneficiary. If the

20

beneficiary has adequate outside liquid resources available, how can the trustee

determine that a distribution from the trust is "necessary"? If the beneficiary satisfied

those needs with the outside resources, the distribution from the trust would not be

necessary, of course. If the trustee nevertheless distributes net income or principal, the

trustee may have exposure to those remainder beneficiaries who would otherwise have

received those distributed amounts.

Other documents permit the trustee to make discretionary distributions of those

amounts of trust income or principal that "the trustee determines to be necessary or

convenient for the reasonable health, education, maintenance and support" of the

beneficiary. If the beneficiary has adequate liquid outside resources available to meet

the need, but feels that it would be more convenient to have money distributed from the

trust, how can a trustee refuse the request? “Why should I spend my money when I can

get the trust to pay for it?”

Remember that it is the trustee, rather than the beneficiary, that makes the

"convenient" determination. The greater the outside resources available to meet the

request, the greater is the trustee's liability for distributing money from the trust in my

opinion.

There are two considerations at work here: (a) if the trust assets will not be

subject to taxation at the death of the requesting beneficiary, while his or her outside

assets will be taxed, it makes no tax sense to distribute assets from the trust when the

beneficiary has outside resources; and (b) if the remainder beneficiaries are step-

children or other third parties, it makes no sense to distribute assets from the trust

without their knowledge and consent, particularly when it is only “convenient” to do so.

21

Once again, the trustee's consideration of these issues should be documented

and saved in the trust records.

Loans as disguised distributions. Some beneficiaries request that the trustee

"loan" principal to the beneficiary when the standards for a discretionary distribution are

not met. A beneficiary who is scheduled to receive all the trust assets when he reaches

thirty may request that the trustee "loan" the entire trust principal to the child at age

twenty-seven.

"What is the harm," he asserts, "because I will get the money in less than three

years anyway? And since the trustee is to pay all the income earned by the trust assets

to me, there is no reason for me to pay interest on this loan," he argues!

If the trustee gives in to this demand/request for the "loan," Murphy's Law can

almost guarantee that (a) the loaned funds will be depleted and (b) the beneficiary will

die before he reaches age thirty! The trustee will then be required to explain to the

remainder beneficiaries why this "loan" was made in the first place.

Do not pretend that a loan under these circumstances is anything other than a

disguised discretionary distribution. If the trustee is not willing to make a discretionary

distribution, do no make one under the guise of a loan.

Ambiguity in the trust instrument. Ambiguities may arise when a trust is being

administered. The language is simply not clear or the situation presented to the trustee

was not dealt with in the trust instrument.

22

Here is one example of how ambiguities can arise in the administration of a trust.

Suppose the trust assets are divided when both parents have died into separate trusts

for each of the children. The assets are then to be distributed as each child reaches 25,

30 and 35. If a child were to die before his 35th birthday, his or her remaining trust

assets are to be distributed to his or her descendants or, if none, are to be added to the

trusts for the siblings.

Suppose the son dies when he is 28 and has no children of his own. The

remaining assets are added to the trust for his sister when she is 33 years old. She

had previously received distributions from her trust when she had reached 25 and 30.

She now demands that the trustee distribute two-thirds of the assets which have been

added to her trust.

Does the trust instrument deal with the possibility that assets will be added to her

trust after a distribution has been made? Many do not.

What should the trustee do when presented with this ambiguity? The trustee

must always petition the court for instructions to resolve any ambiguity. The trustee

must not interpret the language and come up with the trustee's own interpretation.

Almost by definition, the trustee's resolution of an ambiguity will harm the interests of

some of a beneficiary.

If the trustee in the example just given decides to distribute two-thirds of the

addition to the daughter who survived her brother's death, what liability does the trustee

have to her descendants if she dies at age 34? Those descendants would have

received the distributed assets had no distribution been made.

23

It is important that, when the trustee seeks a judicial interpretation of the trust

instrument, the trustee not argue for a particular construction. This may be difficult to do

when the trustee (or the trustee's lawyers) participated in the planning and the drafting

of the trust instrument. The trustee may rightly feel that he or she knows the "correct"

interpretation of the language which creates the ambiguity.

If the trustee asserts a position in the judicial proceedings, however, that action

will violate the trustee's duty of impartiality towards the interests of all the beneficiaries.

This well settled matter of common law was expressed in the dissenting opinion in

Estate of Goulet v. Goulet10 as follows:

"It has long been settled, not only in California but elsewhere, that a fiduciary (such as the trustee of a trust or the personal representative of a decedent's estate) administering property on behalf of multiple beneficiaries must act impartially towards all the beneficiaries and must not favor, or expend funds litigating, the interest of one beneficiary over another. The fiduciary may not take sides when a dispute arises as to the relative rights and interests of various beneficiaries, and may not work to advance or oppose the claim of any beneficiary." (emphasis added)

The application of this principle to ambiguities in the interpretation of a trust

instrument was brought vividly home in The Northern Trust Company v . Heuer.11 The

trustee asserted a construction in the judicial proceeding which was unfavorable to the

position taken by a beneficiary. The court held that, while it was proper for the trustee

to seek the court's construction of the trust instrument by filing the action and in

gathering and presenting the information necessary for the court to interpret the

instrument, the trustee breached its duty of impartiality and exceeded its duty as the

trustee when it argued for an interpretation adverse to a beneficiary.

24

The court disallowed the trustee's request that the attorneys' fees it incurred in

the construction action be paid out of trust assets:

"[G]enerally the costs of litigation to construe a trust in which there are adverse claims are paid by the trust estate .... [W]here a trustee breaches its duty to administer the trust according to its terms and performs in a manner which favors one beneficiary over another, the trustee is not entitled to attorney fees and costs even though the breach is technical in nature, done in good faith and causes no harm." (emphasis added)

Northern Trust was required to pay the trustee's legal fees out of its own assets, rather

than from the trust.

The trustee's duty of impartiality applies to the trustee's attorneys, of course, who

also may not assert a position which is adverse to the interests of any trust beneficiary.

Suppose the trustee is an individual and one of several beneficiaries of the trust.

He or she wishes to take a position on the resolution of the ambiguity. I recommend that

the individual trustee engage a new lawyer who can petition the court for instructions on

behalf of the trustee. That new lawyer thereafter takes no position on the resolution of

the ambiguity. The “regular” lawyer for the individual trustee can then enter an

appearance on behalf of the individual as beneficiary and not as trustee and the

beneficiary can then argue in favor of a particular resolution of the ambiguity.

Total Return Trusts v. Uniform Principal and Income Act. Indiana law was

changed to permit a trustee to convert an ordinary "income only" trust to a total return

unitrust.12 If a trustee decides not to convert an ordinary "income only" trust to a total

return unitrust, the trust will be subject to Indiana’s Uniform Principal and Income Act.13

What should a trustee do? With respect to trusts which call for only the

distribution of income (and not principal), it is no longer business as usual. That is, the

25

trustee cannot merely continue to distribute net income and ignore the option of

conversion to a total return unitrust or to adjust income and principal under the UPIA.

The trustee must either convert the trust to a total return unitrust or elect to be governed

by the Uniform Principal and Income Act. The option of “continue as we have always

done” is not available.

If the trust instrument gives the trustee the discretion to distribute principal as

needed, however, there is no reason, in my opinion, to convert the trust to a total return

unitrust or to make adjustments between income and principal under the UPIA. Rather,

the trustee can make reasonable distributions of trust principal in those amounts

necessary to accomplish the purposes of the trust.

If the trustee manages a portfolio of marketable securities, I do not believe the

trustee need convert the trust to a total return unitrust nor be terribly concerned with

adjustments between income and principal. Nevertheless, conversion to a unitrust

means that both the current and the future beneficiaries share an investment goal of

growth and the age old tug of war over the asset allocation decisions can be minimized.

But if the trust has an investment concentration in a stock with a low dividend

yield (hopefully with language in the trust instrument or a court order directing its

retention and relieving the trustee of liability), capital appreciation favors the remainder

beneficiaries over the interests of the current income beneficiaries. If the trust is not

converted to a unitrust, the UPIA requires the trustee to consider shifting some of the

principal appreciation to income. That is, the income beneficiary suffers financially due

to the retention of the concentration; the concentration is retained so as to obtain capital

26

appreciation which, in the absence of an adjustment under UPIA, would benefit only the

remainder beneficiaries.

The trustee might also hold commercial real estate as a trust asset. If the tenant

leaves at the end of the lease and the rental income ceases, the income beneficiary will

suffer financial harm unless and until the real estate is sold. Should the trustee consider

shifting some principal to income under UPIA or should the trustee convert the trust to a

total return unitrust?

Finally, the trustee may hold farm land as a trust asset. The value of the ground

continues to appreciate, which drives the current income yield to low levels. The family

wants to maintain the farm in the trust for ultimate distribution to the remainder

beneficiaries. Should the trustee consider shifting some the real estate appreciation to

income, so as to compensate the current beneficiary?

If the trustee is dealing with a document which permits or requires the distribution

of only trust income, I recommend that the trustee make an affirmative decision either

(a) to convert the trust to a total return unitrust or (b) to continue the administration of

the trust as written, but with application of UPIA. The trustee must make a decision to

go one way or the other. It is no longer business as usual.

If the trustee merely ignores this choice and continues to distribute only the

income, the trustee could easily have liability to the beneficiary who later argues that the

trustee should have converted the trust to a unitrust or should have made adjustments

between income and principal under UPIA. A decision not to decide merely postpones

the inevitable second guessing.

27

Should the trustee consult with the beneficiaries before making this decision? Of

course!

A trustee may decide to convert the income only trust to a total return unitrust. If

this conversion takes place, the trustee will thereafter determine the net fair market

value of the trust assets on an annual basis and will distribute a "unitrust" amount in the

following year to the beneficiary. The unitrust rate cannot be less than 3% nor more

than 5% of the value of the trust assets.14

The trustee’s conversion to a total return unitrust is done primarily to resolve the

historic asset allocation battle between the income and remainder beneficiaries. If the

"current beneficiary" is to receive a fixed percentage of the annually revalued trust

portfolio, that beneficiary shares the same investment goals with the remainder

beneficiaries. All the trust beneficiaries want the value of the trust assets to increase

over time.

If the decision is made to convert the trust to a total return unitrust, the trustee

should follow the procedures outlined in I.C. 30-2-15-1 et seq. If all the beneficiaries

consent in writing to this conversion, no court order is required.15 If the trustee receives

an objection or if the trustee merely wants the comfort of a court order, the trustee

should follow the procedures outlined in I.C. 30-2-15-11. Because an unhappy

beneficiary is always able to argue in the future that he or she did not know her rights

when signing the consent, I still recommend court approval of the conversion to a

unitrust, with the consents of the beneficiaries attached as exhibits to the trustee’s

petition.

28

If the trustee elects to continue to administer the trust as written, on the other

hand, the Uniform Principal and Income Act will apply to the trust unless to do so might

jeopardize an estate tax deduction or a gift tax exclusion, would violate a fixed annuity

distribution provision or would cause the trustee to be treated as the owner of the trust

assets for income or estate tax purposes. The power to make adjustments between

income and principal also cannot be exercised if the trustee is a beneficiary of the

trust.16

For the thousands of trusts which are now subject to UPIA, the trustee must

follow the procedures outlined in the Act when deciding whether to shift income to

principal or vice versa for trust accounting purposes.17

The trustee must become familiar with the nine factors which the Act says the

trustee should consider when deciding whether to make an adjustment:

1. The nature, purpose and expected duration of the trust;

2. The identity of the person who created the trust;

3. The identity and the circumstances of the beneficiaries of the trust;

4. The needs for liquidity, regularity of income and preservation and

appreciation of principal;

5. The assets in the trust, including the extent to which they consist of liquid

investments, ownership interests in a closely held business, tangible personal property,

intangible personal property or real estate; the extent to which these trust assets are

used by a beneficiary; and whether the assets were deposited to the trust by its creator

or were purchased by the trustee;

29

6. The normal allocation of receipts and disbursements between income and

principal;

7. Whether the trust instrument permits the trustee to make discretionary

distributions of trust principal and the extent to which the trustee has exercised this

power from time to time;

8. That actual and anticipated effects of the economy and inflation; and

9. The anticipated tax consequences of the adjustment.18

I recommend that the trustee establish a written checklist, with these nine factors

identified, so that the trustee can document the trustee’s consideration of these issues

every year. Even if, after consideration, the trustee determines that no adjustment

between income and principal should be made, the trustee should document the

consideration of these nine factors, so that the trustee can later justify the decision not

to adjust income and principal.

The allocation and distribution of trust assets. A trustee is commonly called

upon to allocate trust assets to one or more continuing trusts, perhaps between a credit

trust and a marital gift. What liability might a trustee incur when performing these routine

functions?

If assets are to be allocated between a credit trust and a marital gift, the manner

in which those allocations are made can be very complex. Suppose the trust instrument

calls for the trustee to allocate to the credit trust the largest amount which can pass free

from federal estate tax by reason of the decedent's applicable credit amount, with the

remaining trust assets to be distributed outright to a surviving spouse? The trust holds

30

$5 million in assets, based on the final date of death federal estate tax values; therefore,

the trustee thinks that $3.5 million should be allocated to the continuing credit trust and

the remaining $1.5 should be distributed to the surviving spouse.19

However, the assets cannot be divided between the credit trust and the marital

gift on the date of death. The estate must be administered and tax clearances must be

obtained. Months will pass before the trustee is in a position to distribute the assets.

When it is appropriate to fund the trusts, the trustee must determine the current value of

the assets which remain to be distributed.

Suppose, when the trustee revalues the assets before making these allocations,

the trustee learns that the assets have appreciated during the estate administration

period and are now worth $6 million. Where should the trustee allocate the $1 million of

appreciation which has occurred after the date of death? If the value of the assets

which are available to fund the trusts has fallen to $4 million, on the other hand, which

trust bears the market loss?

The answer depends on the language in the trust instrument. If the trustee is

directed to distribute assets in kind at their value on the date of distribution, the trustee

must allocate assets which, when the allocation is made, equal the date of death value

of the first gift made in the trust instrument. Is that the credit trust or the marital gift? All

the appreciation or depreciation then passes to or falls on the residuary gift.

If the trustee, on the other hand, is to distribute assets in kind which are fairly

representative of overall appreciation and depreciation which has occurred during the

estate administration, then both the allocation to the credit trust and the distribution to

the surviving spouse are to be increased by the amount of the appreciation (or

31

decreased by the amount of depreciation). Both gifts share ratably in the appreciation

or depreciation which has occurred. 20

Next, what does the trustee do with the income which has been earned on those

assets during the estate administration? The answer to that question may be even

more complicated due to arguable conflicts between the Probate Code and the Trust

Code.

If these distribution decisions are being made by a personal representative in a

supervised estate, the fiduciary can ask the court to approve the proposed action after

notice to all the beneficiaries. However, if these decisions are being made by a trustee

who receives assets under a pour over will, no thought may be given to court approval.

Why not? I recommend that the trustee docket the trust and petition the court for an

order which, after notice to all the beneficiaries, approves of the allocation to the credit

trust and the distribution to the surviving spouse and the distribution of the net income.

The Internal Revenue Service is now routinely looking at these funding decisions

when the surviving spouse later dies. There is anecdotal evidence that the IRS is

finding that credit trusts were incorrectly funded more than 50% of the time. If a trustee

incorrectly funds a credit trust, causing assets to be subject to federal estate tax at the

death of the surviving spouse, will the trustee have liability for that error? Of course.

Conflicts of Interest

A very pervasive problem for trustees arises when a trustee has a conflict of

interest. Conflicts can arise in two fairly common situations: (1) when a beneficiary is

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serving as a trustee or co-trustee; and (2) when the same trustee is serving as trustee

of two related trusts.

Indiana Code Section 30-4-3-5(a) reads as follows:

“If the duty of the trustee in the exercise of any power conflicts with the trustee’s individual interest or the trustee’s interest as trustee of another trust, the power may be exercised only under one (1) of the following circumstances:

(1) The trustee receives court authorization to exercise the power with notice to interested persons as the court may direct.

(2) The trustee gives notice of the proposed action in accordance with IC 30-2-14-16 and (A) The trustee receives the written authorization of all

interested persons to the proposed course of action within the period specified in the notice of the proposed action; or

(B) A beneficiary objects to the proposed action within the period specified in the notice of the proposed action, but the trustee receives court authorization to exercise the power.

(3) The exercise of the power is specifically authorized by the terms of the trust.”

A beneficiary is serving as the trustee. How many beneficiaries are serving as a

trustee or as a co-trustee of Indiana trusts today? I believe that the number will be in

the thousands. How many of those trust instruments specifically acknowledge the

trustee/beneficiary’s conflict of interest and waive any liability which the

trustee/beneficiary may have? I believe that the number will be very, very low.

Every beneficiary who serves as a trustee or a co-trustee inherently has a

conflict of interest in the exercise of virtually every trustee power. The allocation of trust

assets between stocks and bonds will have an economic impact on all the beneficiaries,

including the conflicted trustee. The trustee/beneficiary’s exercise (or refusal to

exercise) the power to make discretionary distributions will have an economic impact on

all the beneficiaries, including the conflicted trustee.

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I.C. 30-4-3-5(a) gives to every other beneficiary of that trust the power to bring

an action against the trustee/beneficiary who failed to comply with subjections (1) and

(2), all with the benefit of hindsight. Suppose, for example, that the trustee/beneficiary

purchased an investment which later declined in value.

Another beneficiary could bring an action to compel the trustee/beneficiary to

reimburse the trust for the full amount invested in that stock. The traditional defense to

that sort of action was to show that the investment was prudent when made and that

there is no trustee liability if it later declines in value.

The unhappy beneficiary will argue, however, that the action is not brought

because the investment was imprudent; rather, the action was brought because the

trustee/beneficiary had no power to make the investment in the first place! That is,

because the conflicted trustee failed to comply with I.C. 30-4-3-5, the investment was

per se invalid.

A beneficiary is serving as a co-trustee with a bank. This statute presents a

serious problem to professional trustees and individual trustees alike. If a beneficiary is

serving as a co-trustee with a corporate fiduciary, all decisions of the co-trustees must

be unanimous unless the trust instrument provides otherwise.21 Assuming that the trust

instrument does not provide otherwise, that necessarily means that the “vote” of the

individual trustee is required for every decision made by the co-trustees. Unless the co-

trustees comply with I.C. 30-4-3-5, the participation by the co-trustee/beneficiary is not

authorized. I argue that this means evert decision by the co-trustees was invalid.

A corporate trustee is also trustee of a related trust. Kentucky has a statute

which is remarkably similar to I.C. 30-4-3-5. PNC Bank was serving as the trustee of an

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irrevocable trust created by the beneficiary’s mother. The daughter also created her

own revocable trust and named PNC Bank as her trustee. When the daughter

requested a discretionary distribution of principal from her mother’s trust, PNC Bank

failed to realize that it had a conflict of interest because it simultaneously served as

trustee of the daughter’s revocable trust.

Because the remainder beneficiaries of the two trusts were different, PNC Bank’s

decision to make a discretionary distribution from the mother’s trust violated its fiduciary

obligation to take only those actions which are in the best interests of the beneficiaries.

PNC Bank’s failure to obtain prior court authorization for the discretionary distribution

violated Kentucky’s version of I.C. 30-4-3-5. While the amount of damages was

remanded to the trial court, it appears likely that PNC Bank would be ordered to

reimburse the mother’s trust for the entire amount of the discretionary principal

distribution.22

How to deal with this problematic issue?

New trust instruments. If you are drafting new trust instruments which name a

beneficiary as the trustee or as a co-trustee, you must have the client specifically

acknowledge the trustee/beneficiary’s conflict of interest and waive any liability which

the trustee/beneficiary would otherwise have under I.C. 30-4-3-5.

The mere naming of a beneficiary as the trustee or as a co-trustee is not

sufficient to overcome I.C. 30-4-3-5. The waiver of the conflict must be “specifically

authorized by the terms of the trust.” (emphasis added) If the mere naming of a

conflicted beneficiary as the trustee or as a co-trustee were sufficient to overcome the

statute, why have the statute in the first place?

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Existing trust instruments. If you today are a trustee who is also a beneficiary of

an irrevocable trust, you must take corrective action now. I recommend that you docket

the trust and petition the court to modify the provisions of the irrevocable trust in

accordance with the provisions of I.C. 30-4-3-26. The “new circumstance” not foreseen

by the creator of the trust, I believe, would be the inability of the named

trustee/beneficiary to exercise the powers of the trustee without prior court authority.

You ask the court to modify the language of the trust instrument to insert language in

which the creator of the trust acknowledges the trustee/beneficiary’s conflict of interest

and waives any liability which the fiduciary may otherwise have.

The failure to take this corrective action leaves a loaded shotgun in the hands of

every other beneficiary who can bring an action against the trustee/beneficiary with the

full benefit of hindsight.

Successor Trustee Liability for Acts of Prior Trustee

There are many instances in which the serving trustee was not the original

trustee. This is the successor trustee. Indiana law23 provides that the successor

trustee can exercise all powers granted to the original trustee in the will or trust

agreement.

However, Indiana law24 is equally clear that a successor trustee “becomes liable

for a breach of trust of his predecessor if he … fails to make a reasonable effort to

compel a redress of a breach of trust committed by the predecessor trustee.”

The steps which can and should be taken by the successor trustee depend on

the circumstances in which the successor becomes the trustee.

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The trustee who succeeds a deceased creator of a revocable trust. Suppose

an individual creates a revocable living trust and is the initial trustee. The trust

agreement becomes irrevocable when the creator of the trust dies and a successor

trustee takes over. That successor trustee should have no liability to the beneficiaries

of the trust for any action taken while the trust was revocable because those

beneficiaries had no real interest in the trust until it became irrevocable.

The trustee who succeeds a trustee of an irrevocable trust. Suppose the trust

is already irrevocable, on the other hand. There is an existing trustee of this irrevocable

trust. That trustee becomes incapacitated, resigns, is removed or dies. A successor

trustee takes over.

I.C. 30-4-3-13(b) states that the new trustee must make a “reasonable effort” to

redress any breach of trust committed by the predecessor trustee. However, the terms

of the trust may expressly relieve the successor trustee of any liability for acts of the

predecessor trustee.25

Therefore, if the terms of the trust instrument expressly relieve the successor

trustee of liability for acts of the predecessor trustee, there is no reason for the

successor trustee to examine the books and records of the predecessor trustee. I

recommend, however, that the successor trustee be certain that the beneficiaries of the

trust understand that the predecessor trustee may still be liable to the beneficiaries for

any breach of trust committed by the predecessor trustee while in office, so they can

take the necessary steps to protect their interests.

If the terms of the trust do not expressly relieve the trustee of liability for acts of

the predecessor trustee, on the other hand, the successor trustee must take steps to

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protect itself from fiduciary liability for acts of the predecessor trustee. If the successor

trustee takes no action before the applicable statute of limitations expires, the

beneficiaries can bring an action against the successor trustee for breaches of trust

committed by the predecessor trustee.

Therefore, I recommend that the successor trustee do one of two things: (a)

docket the trust and ask the court to order the predecessor trustee to prepare and file a

complete accounting of the acts of the predecessor trustee for the entire period in which

the predecessor trustee was in office. Have the accounting, when filed, served on the

beneficiaries who should be given a reasonable opportunity to file objections. The

successor trustee is not relieved of fiduciary liability if the beneficiaries fail to object,

however, because it is the successor trustee who must protect their interests;

nevertheless, it is reasonable for the successor trustee to give them that opportunity.

The successor trustee must conduct a careful review of the accounting and must file

appropriate objections with the court, which will ultimately rule on any alleged breaches

of trust; or (b) the successor trustee must obtain written consents from the beneficiaries

which expressly relieve the successor trustee of liability for acts of the predecessor

trustee. I note that all of the problems with written consents noted earlier26 have equal

applicability to this issue.

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Revocation of a Revocable Trust

When the creator of a revocable trust elects to revoke the trust agreement, it

seems pretty straightforward. Right? Not necessarily.

If the trustee has any question about the competency of the creator of the trust or

the susceptibility of that person to undue influence by others, alarm bells should sound.

A recent Kentucky Supreme Court case illustrated the point.

J.P. Morgan Chase Bank, N.A. v. Longmeyer27 dealt with the trustee of a

revocable trust which had been revoked. Because the trustee suspected that the

creator of the trust had been unduly influenced to revoke the trust, the trustee notified

the charitable beneficiaries of the revoked trust of its revocation. After the charities

brought an action to invalidate the revocation, the trustee of the new trust created by the

settlor brought this action against the predecessor trustee. The successor trustee

argued that notice should not have been given to the charitable beneficiaries, that notice

was a breach of trust and that the predecessor trustee should be personally liable for

the costs of the settlement which had been paid to the charities.

Is the trustee of a revoked revocable trust under a fiduciary duty to notify the

beneficiaries of the revocation? The Kentucky Supreme Court not only ruled that the

predecessor trustee had no liability for notifying the charities, it went further and ruled

that the trustee had an affirmative duty to notify the beneficiaries of the revoked trust.

Kentucky’s statute requires a trustee to “keep the beneficiaries of the trust reasonable

informed of the trust and its administration.”28

Many of us thought that the purported beneficiaries of a revocable trust had no

real interest in the trust until it became irrevocable; therefore, we thought that there was

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no duty to keep those maybe beneficiaries informed. Nevertheless, the Kentucky court

refused to create an exception for revocable trusts.

I believe that the ruling in this case may have turned on the trustee’s suspicion of

undue influence. That is, if the creator of the trust lacked the capacity to revoke the

trust, its beneficiaries did have an interest which needed to be protected.

If the trustee of a revocable trust has no reason to believe the creator of the trust

lacks competency or is the victim of undue influence or fraud, there is no reason in my

opinion to notify the beneficiaries of the revoked trust. The competent creator of the

trust is the only beneficiary of the trust so long as it is revocable and it is a real stretch to

believe that the trustee must notify the maybe beneficiaries.

If the trustee of a revocable trust has reason to believe, on the other hand, that

the creator of the trust lacks competency or is the victim of undue influence or fraud, I

believe that the trustee must notify the beneficiaries of the trust. Indeed, I recommend

that the suspicious trustee docket the trust and petition the court for instructions before

the trustee recognizes the validity of the revocation.

If the trustee fails to do that and honors the revocation, the trustee may end up in

a very difficult position. Suppose that the creator of the trust dies shortly after revoking

the trust. Federal estate tax is payable by the creator’s estate; however, none is paid by

those who now have the assets which had been in the trust.

The Internal Revenue Service is not bound by any determination of state law by

any court other than the Supreme Court of that state.29 Even if the trustee obtains a

court order affirming the revocation of the trust, the IRS can later assert that the

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revocation was invalid for any number of reasons. If successful, the trustee will become

personally liable for the unpaid federal estate tax.30

Even if the suspicious trustee obtains a court determination which upholds the

validity of the attempted revocation, I recommend that the trustee deposit into an

escrow account sufficient funds with which to pay the federal estate tax due from the

creator’s estate simply because the IRS is not bound by the trial court’s determination

of an effective revocation.

Conclusions and Final Recommendations

An individual who is serving as trustee of one or only a few trusts should examine

these issues immediately.

No corporate trustee can review all its accounts after reading this material.

There are too many accounts to look at. I recommend, on the other hand, that careful

attention be paid as accounts are cycled up for administrative or investment review.

Are the investments being made in accordance with the terms of the trust

instrument? Is there an investment concentration or are there non-approved securities

whose retention is not directed by the trust instrument, with the trustee relieved of

liability? Has the trustee informally permitted an outside investment manager to make

investment decisions? How old are the consents which approve of the trustee's actions

or inactions? Do the consents expressly relieve the trustee of liability?

Is the trust being administered in accordance with the terms of the trust

instrument? Should discretionary distributions be denied because they are excessive?

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Has the trustee given appropriate consideration to outside resources available to the

beneficiary before making a discretionary distribution from the trust? Has that

consideration been documented in the trust records? Has the trustee made disguised

discretionary distributions in the form of unsecured loans to a beneficiary?

Has the trustee considered conversion of an income only trust to a total return

unitrust or has the trustee decided to continue administration of the trust as written, but

with application of Indiana's Uniform Principal and Income Act?

The first step for a trustee is to evaluate the trusts of which the trustee serves as

fiduciary. Identify the skeletons in the closet. The trustee can then determine what

action to take, whether that be (at a minimum) updated consents from all the

beneficiaries or court orders after notice to the beneficiaries.

Doe the trustee have a conflict of interest in the exercise of the trustee’s powers?

Does the trust instrument specifically acknowledge the conflict of interest and waive any

liability? If not, has the trustee complied with I.C. 30-4-3-5 every time it exercises the

powers of trustee? If not, should the trustee seek judicial modification of the trust

instrument to insert the necessary language?

It never was easy to be a trustee and now it seems to be getting harder.

1 Eric Manterfield, Krieg DeVault LLP, Indianapolis, IN, emanterfield@kdlegal.com 2 I.C. 29-1-1-20(a)(4) and I.C. 30-4-6-10. 3 I.C. 30-4-3-19(b)(1). 4 I.C. 30-4-3-19(b)(2). 5 I.C. 30-4-3-9(a). 6 I.C. 30-4-3-9(b). 7 I.C. 30-4-3-26(a).

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8 I.C. 30-4-3.5-1. 9 See the discussion which begins "The agreement needs to address a number of significant

issues" on page 7 of this paper. 10 10 Cal. 4th 1074 at 1086, 898 P.2d 425 at 432 (1995). See, also, In the Matter of the Trust for

Duke, 305 N.J. Super. 408, 702 A.2d 1008 (1995), In re Cudahy, 26 Wis.2d 153, 131 N.W.2d 882 (1965) and In re James Estate, 86 N.Y.S.2d 78 (Surr. Ct. 1948).

11 202 Ill.App.3d 1066, 560 N.E.2d 961 (1990). 12 I.C. 30-2-15-1 et seq. 13 I.C. 30-2-14-15. 14 I.C. 30-2-15-15. 15 I.C. 30-2-15-10. 16 I.C. 30-2-14-15(c). 17 I.C. 30-2-14-15. 18 I.C. 30-2-14-15(b). 19 Assume the decedent died when the applicable credit amount would shelter $3.5 million from

federal estate tax. 20 A fractional formula allocation between a credit trust and marital gift works the same way. 21 I.C. 30-4-3-4(a). 22 Wiggins et al. v. PNC Bank, Kentucky, Inc., 988 S.W.2d 498 (Ky. 1999). 23 I.C. 30-4-3-4(d). 24 I.C. 30-4-3-13(b). 25 I.C. 30-4-1-3 states that the terms of the trust instrument can override the provisions of the Trust

Code “unless the rules of law clearly prohibit or restrict the article which the terms of the trust purport to authorize.” Because the rule of I.C. 30-4-3-13(b) does not clearly prohibit a trust instrument from varying the general rule of trustee liability for acts of a predecessor trustee, the trust instrument can relieve the successor trustee of this liability if it expressly does so.

26 See the discussion beginning on page 2. 27 275 S.W.3d 697 (Ky. 2009). 28 Ky. Rev. Stat. Section 386.715. 29 Commissioner v. Bosch’s Estate, 19 AFTR 2d 1891 (2d Cir., 1967). 30 Internal Revenue Code of 1986, as amended, Section 1002; Regulations Section 20.2002-1.

NEW GUIDANCE FOR GUARDIANS: THE THIRD NATIONAL GUARDIANSHIP SUMMIT AND THE DEVELOPMENT AND IMPLEMENTATION OF GUARDIAN

STANDARDS OF CONDUCT

KAREN E. BOXXi

For the past 25 years, guardianship reform has become a topic of national discussion, and progress has been made in the area of safeguards for the incapacitated person in the guardianship initiation and appointment process. However, until recently, the need for clear standards for the guardian's performance post-appointment has not received much attention. Other fiduciaries, such as trustees and executors, have significant guidance from statutes and case law regarding the extent and nature of their duties. By contrast, guardianship statutes give only minimum descriptions of a guardian's duties and there are very few reported cases on the parameters of a guardian's responsibilities and the framework for making decisions for the incapacitated person. One reason for this may be the expectation that a guardian is supervised by the court and will receive direct guidance and oversight from an involved judiciary. However, the combination of a dramatic increase in the number of adult guardianships and a decrease in court resources has created a crisis in guardianship monitoring. Comprehensive data is lacking, but anecdotal evidence shows that guardians are for the most part acting on their own. For example, in 2007 a task force in Washington state formed by the Washington State Bar Association surveyed the state courts’ regarding monitoring of guardianships. The responses revealed that fifteen of the state’s thirty-nine counties (thirty-three of which responded to the survey) had no procedures for monitoring guardian compliance, and only five counties had relatively active monitoring procedures, such as reminding guardians of upcoming deadlines and verifying information in reports. This lack of supervision not only allows unscrupulous guardians to abuse and neglect the incapacitated persons in their care, but also leaves well-meaning guardians in the dark as to how to carry out their duties. The lack of standards also leaves courts with little guidance when judging a guardian’s performance, resulting in potential inconsistencies and risks to the guardian. When an errant guardian is caught, because of the absence of advance direction to the guardian, some courts may be hesitant to discipline a guardian for all but the most egregious transgressions, and some courts may choose to discipline a guardian for mistakes that a guardian made out of ignorance. The need for comprehensive standards for guardians' performance was the focus at the Third National Guardianship Summit, held at the University of Utah S.J. Quinney College of Law October 2011. The first national conference on guardianship reform, referred to as the Wingspread Conference, was held in 1988, and brought together experts from multiple disciplines to address the various problems of the guardianship process. The second, called the Wingspan

conference, was held in 2001. Both conferences made sweeping recommendations, intcluding the need for standards of conduct for guardians, but the implementation efforts focused on protections in the initial hearings on incapacity and appointment of a guardian, and on using least restrictive alternatives. The Third National Guardianship Summit focused only on post-appointment issues and the creation and adoption of standards for guardians. The Summit's 93 participants met in separate workgroups and as a whole to adopt recommendations for standards for the various areas of guardian duties, such as financial, healthcare and housing management and decisionmaking, and for basic principles of how guardians should weigh the best interests of the incapacitated person and the desires of the incapacitated person when making decisions. The Summit resulted in a set of specific recommendations and its organizers are continuing work to see these recommendations implemented in state guardianship law. The RPTE section participated in the Summit as a member of the National Guardianship Network, a coalition of organizations involved in guardianship law that was was the primary organizer of the Summit. At the ABA annual meeting in Chicago in August 2012, the House of Delegates passed a resolution adopting the Summit's Standards and Recommendations and urging courts and goverments to implement them. As part of the Summit, nine background articles were written on the topics studied at the conference and those articles will be published in a forthcoming issue of the Utah Law Review. The topics covered in the articles are: an overview of the status and need for guardianship standards; surrogate decision-making standards; person-centered decision-making; financial decision-making; guardian medical decision-making; residential decision-making; guardian fees and compensation; the guardian’s relationship to the court; and interdisciplinary guardianship committees. The full text of the Summit recommendations can be found at: http://www.americanbar.org/content/dam/aba/uncategorized/2011/2011_aging_summit_recs_1111.authcheckdam.pdf The Summit participants used the National Guardianship Association's very thorough Standards of Practice (available online at http://guardianship.org/guardianship_standards.htm) as a starting point for the recommendations. The decisions reached at the Summit are set forth in three parts: a definitions section, recommended standards for guardians, and recommendations for courts and other entities regarding use of the standards and implementation. The standards give specific guidance to guardians, such as how to avoid conflicts of interest, when to factor in the incapacitated person's wishes, and issues the guardian should research, such as the specific health condition of the incapacitated person. The standards clarify that all guardians, both professional and volunteer/family guardians, should be held to the same standards. Most of the recommendations are addressed to the courts and recommend areas for the court to give guidance to guardians. The

recommendations also advise adoption of specific standards in state guardianship statutes and give other implementation recommendations. Guardianship practitioners should review the Summit recommendations, for several reasons. First, such review would update their knowledge of guardianship reform developments. Guardianship practitioners can also use the recommendations as guidelines for their guardian clients, even if not binding. Finally, it is important that practitioners understand and be able to advise their guardian clients about the current lack of specificity in the law about their duties and the risks of taking actions that may be questioned later by a court. The Elder Law, Disability Planning and Bioethics Group is planning a free group conference call in December with members who were participants at the Summit, to discuss the Summit in detail and answer questions.

i Professor of Law, University of Washington. Professor Boxx is Vice Chair of the ABA RPTE Elder Law, Disability Planning and Bioethics Group.

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Charitable Giving Alert Grace Allison

Adjunct Professor of Law, University of New Mexico School of Law

This year, there are many reasons to carefully consider the timing of substantial lifetime charitable gifts. As we go to press, uncertainty is inescapable: no one knows whether we will have a stalemate (reinstatement of prior law in 2013), a one-year reprieve (one-year extension of current law with tax reform effective no earlier than 2014), and/or a series of half-measures (including extension of some expiring or expired temporary provisions into 2012 and 2013) culminating in tax reform at some future date. In order to capture opportunities that may vanish at year’s end, clients—and their advisors—may need to act quickly.

STALEMATE

For upper-tier charitable donors, a return to prior law would mean return of the potentially draconian Pease limitation on itemized deductions.

Pease limitations in 2013?

Background. As enacted in 1990, the Pease limitation (IRC Section 68) reduced certain otherwise allowable itemized deductions (including the charitable deduction) by up to 80 percent. Under Pease, the exact amount of the reduction was the lesser of (a) 80 percent of the otherwise allowable deductions or (b) three percent of the amount by which adjusted gross income exceeded a statutory floor, which was indexed for inflation. Had Pease been in place in 2012, the statutory floor would have been $173,650 ($86,825 for marrieds filing separately).

The Pease limitation was phased out over a four year period (2006-2009) by the 2001 Tax Act and has not been in effect since 2009. Unfortunately, like all the other provisions of the 2001 Tax Act, the elimination of Pease sunsets at the end of 2012. If Congress fails to act, it will be in full force on January 1, 2013.

Strategy. No matter how you handicap the stalemate alternative, becoming subject to the Pease limitation could devastate your client’s expected charitable income tax deduction. When deciding whether to accelerate charitable deductions into 2012, be sure to take the Pease calculation into account.

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ONE YEAR REPRIEVE

H.R. 8, as passed by the House of Representatives on August 1, 2012, would extend the sunset of 2011 income tax law until December 31, 2013. This would allow donors to remain in a familiar tax landscape for another twelve months—and give their advisors a comfortable interval in which to complete major charitable transfers.

EXTENSION OF “TEMPORARY” PROVISIONS

A number of temporary provisions (known as “the extenders”) expired at the end of 2011 or will expire at the end of 2012. Four popular charitable provisions are included in the current extenders package, which is pending in the Senate and anticipated to be considered during the November lame-duck session.

$100,000 charitable rollover for 2012 and 2013?

Background. Enacted by the Pension Protection Act of 2006 (“PPA”), IRC Section 408(d)(8) allowed individual taxpayers age 70 ½ or older to direct lifetime contributions up to $100,000 per year from their IRAs to qualified charities. The distribution was not included in the individual’s gross income but did count towards satisfying the applicable minimum distribution requirement. As enacted, this taxpayer-friendly rule expired at the end of 2007, but was subsequently extended through the end of 2011.

The current extenders package pending in Congress, the “Family and Business Tax Cut Certainty Act of 2012 (S___),” would revive IRC Section 408(d)(8) for both 2012 and 2013.

Strategy. In order to lock-in the potential benefits of this provision for 2011, donors age 70 ½ or older will need to act before year-end. Simply direct the IRA custodian or trustee to distribute the desired amount (up to $100,000) to a qualified charity on or before December 31. (Be sure to check with the specific financial institution; internal processing deadlines may be stricter.) If the extenders legislation becomes law, the distribution will qualify for treatment under IRC Section 408(d)(8). If Section 408(d)(8) is not extended, the distribution will instead be treated as if made to the donor and then contributed by the donor to the qualified charity, subject to all the usual income tax limitations.

Comments. 1. Section 408(d)(8) was last extended by legislation signed into law on December 17, 2010. That legislation (the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010) included a special election that allowed

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distributions made to charity on or prior to January 31, 2011 to be treated as if they were made on December 31, 2010. There is no comparable provision in the pending Senate legislation.

2. As under prior law, distributions to donor advised funds, supporting organizations, and private foundations are not “qualified charitable distributions.”

3. Lifetime transfers from an IRA to charity, unlike ordinary charitable contributions, are not subject to itemization requirements or to contribution base limitations. This makes the extension of Section 408(d)(8) particularly attractive to those who have excess charitable contribution carryovers or who do not itemize their deductions. Reinstatement of the Pease limitation on itemized deductions (see above) would make the potential tax benefits provided by Section 408(d)(8) even more valuable.

Qualified conservation contributions for 2012 and 2013?

Background. PPA also added IRC Section 170(b)(1)(E), which increased the maximum contribution base limitation for qualified conservation contributions from 30 percent to 50 percent, with a special 15-year excess charitable contribution carryover. Also part of Section 170(b)(1)(E): even more generous rules that applied only to qualified farmers or qualified ranchers. As enacted, these provisions expired at the end of 2007, but were subsequently extended through the end of 2011.

The current extenders package pending in Congress, the “Family and Business Tax Cut Certainty Act of 2012 (S___),” would revive IRC Section 170(b)(1)(E) for both 2012 and 2013.

Strategy. Qualified conservation contributions are generally complex transactions, requiring months of preparation. Keep close watch on the extenders legislation to gain the maximum lead time for 2013 transfers.

Favorable basis adjustment for S-corporation shareholders?

Background. When S corporations make contributions of appreciated property to charity:

* the charitable deduction flows through pro rata to its shareholders and

* the shareholder’s basis in his stock is decreased.

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Prior to PPA, the required basis adjustment was equal to the shareholder’s pro-rata share of the fair market value of contributed property. PPA relaxed this rule so that the decrease was limited to the shareholder’s pro-rata share of the adjusted basis of the contributed property. As enacted, the amendment to IRC section 1367(a)(2) expired at the end of 2007; it was subsequently extended through the end of 2011.

The current extenders package pending in Congress would make the favorable rule of IRC Section 1367(a)(2) effective for both 2012 and 2013.

Strategy. When considering charitable distributions from S corporations, check first on the status of the extenders legislation.

Enhanced charitable deduction for contributions of food inventory by businesses?

Background. Prior to 2012, three temporary provisions under IRC Section 170(e)(3) provided enhanced charitable deductions for certain contributions of food inventory, book inventory and computer equipment. Only one of these now-expired provisions –the enhanced charitable deduction for contributions of food inventory-made its way into this year’s slimmed-down extenders package.

The current extenders package would make IRC Section 170(e)(3)(C) effective for both 2012 and 2013.

Strategy In a time of widespread hunger, any business that holds food as inventory should be aware of the potential revival of this provision.

TAX REFORM

Income tax rate changes?

Background. The current political debate provides a clear dichotomy: Democrats generally favor higher rates for upper-income taxpayers, while Republicans have proposed a 20 percent across-the-board rate cut. Republicans would make their tax reform proposals effective in 2014. Democrats, if empowered, might raise rates for upper-income taxpayers as early as 2013.

Strategy. If all other factors were likely to be held constant, one might advise delaying charitable gifts to hedge against the possibility of higher rates. Unfortunately, it appears that higher rates could be accompanied by other law changes that would make delay an

5

unattractive tactic. For example, the Obama 2013 Budget Proposal would reinstate both Pease limitations and higher tax rates for upper-income taxpayers.

Waiting to see which way the pendulum swings could be expensive for other reasons as well. As described in more detail below, one potentially influential tax proposal would combine lower tax rates with a maximum 12 percent income tax credit for charitable contributions; the contribution amount itself would be reduced by a two percent floor.

Status of the income tax charitable deduction?

Background. Although the income tax charitable deduction now appears “untouchable,” the tide could turn as Congress digs into deficit reduction. In successive budget proposals, including the most recent, President Obama has recommended capping most itemized deductions, including the charitable deduction, at 28 percent for marrieds with $250,000 or more of adjusted gross income ($200,000 for singles). The Obama 2013 budget proposal also includes reinstatement of the Pease limitation for those upper-income taxpayers. Together, Pease and the 28 percent cap would prevent outsized tax benefits (36% or 39.6%) going to those in the top Obama income tax brackets. Significantly, the 2012 Republican platform is less specific on this point, saying only that “donations to [charitable organizations] should continue to be tax deductible.” This, theoretically at least, leaves room for a wide range of modifications to the existing charitable deduction, all of which would be effective only in 2014. In addition, Republicans have called for a 20 percent across the board reduction in tax rates. Assuming such a reduction took place in 2014, the maximum tax benefit from the income charitable deduction would be correspondingly reduced in that year. Given the uncertainties of the moment, it is also important to consider outliers such as the bi-partisan Simpson-Bowles proposal. If implemented, Simpson-Bowles would replace the arguably regressive income tax charitable deduction with a flat 12 percent income nonrefundable income tax credit available to all taxpayers ( but with a 2% of AGI floor.) Simpson-Bowles has been mentioned by both parties in recent weeks. Strategy. Donors may be well-advised to make substantial charitable contributions before the tax reform proposals go into effect. Comments. Both deficit concerns and policy imperatives may lead to changes in the income tax charitable deduction. In 2010, the Joint Committee on Taxation (JCS-3-10) estimated the five year revenue cost of the income tax charitable deduction at $230 billion, making the charitable deduction one of the ten most expensive income tax expenditures. Among the intriguing policy questions are those raised in a December 2011 National Tax Journal article authored by Joseph J. Cordes:

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* How sensitive is charitable giving to changes in the charitable income tax deduction? (Cordes reports a current lack of consensus among economists.)

* To the extent that the charitable deduction subsidizes the favorite charities of the rich, does it also subsidize “activities that generally serve an important public purpose”? (An example here is the relatively high proportion of itemized charitable giving to educational institutions, at least some of which primarily educate the children of the affluent.)

* Is the current income tax charitable deduction “unfair”? (In 2008, 32.4% of the tax benefits from the income tax charitable deduction accrued to those with adjusted gross income of $1 million or more. Cordes, Table 5)

IRS Finally Blesses Charitable Gifts Directly to a Charity’s Single Member LLC

Elaine Waterhouse Wilson Associate Professor, West Virginia University

Many charities use single member LLCs (SMLLC) to hold problematic assets. For example, a donor may wish to give to a charity a piece of commercial real estate that might have environment issues. The charity would rather not be in the chain of title for that piece of real estate, but it would still like to benefit from the potentially valuable gift. By having the donor give the real estate directly to a SMLLC, the charity gets out of the chain of title, isolates any liabilities generated by the property, but eventually benefits from the sale of the property.

The donor, on the other hand, is understandably concerned. The donor should get a charitable deduction for a gift made directly to a SMLLC that is wholly owned by a Section 170(c) organization. After all, the tax law treats the SMLLC as a disregarded entity. Therefore, the gift ought to be deemed made to the single member – the charity. While this is the logical result, the IRS had been hesitant to confirm it in writing. Donors are understandably unwilling to make a large gift directly to a SMLLC when their tax advisors tell them that while they ought to get a very large charitable deduction, there is no guarantee.

Charities everywhere rejoiced with the issuance of IRS Notice 2012-52 (July 31, 2012), which states that a gift to a domestic SMLLC will be treated as "a charitable contribution to a branch or division of the U.S. charity.” The Notice is effective for "charitable contributions made on or after July 31, 2012. However, taxpayers may rely on this notice prior to its effective date for taxable years for which the period of limitation on refund or credit under § 6511 has not expired."

The Notice contains some specific guidance with regard to substantiation of these types of gifts. The charity – not the SMLLC - is treated as the donee organization for purposes of Section 170(f), including the written acknowledgement rules. The IRS goes on to state: "[t]o avoid unnecessary inquiries by the Service, the charity is encouraged to disclose, in the acknowledgment or another statement, that the SMLLC is wholly owned by the U.S. charity and treated by the U.S. charity as a disregarded entity." Practitioners should review the Notice carefully to make sure that their written acknowledgements continue to comply with Section 170(f).