Summary
The
increase in the number and value of family trusts in the United States
has been accompanied by an evolution, even revolution, in the ways in
which families participate in trust decision-making. In the past, a
single family member might participate as trustee or hold a power of
appointment to change the trust disposition, but collective
decision-making was rare, even for larger trusts. A family member
might also serve as an "advisor" on investments or distributions, but
trust law did not allow a true division of the trustee's legal
authority. The list of choices was short; other alternatives for
family participation were either unavailable or unknown.
In contrast, modern trust law and practice have spawned a wide variety
of formats and methods for family participation in trust decisions.
Recognizing the reality that not everyone can or should serve alone as
an individual trustee, families have utilized these alternatives in
their trusts. Advisors from various disciplines encourage this trend
on the ground that it facilitates responsible use and management of
wealth.
But now there are signs
that the Internal Revenue Service may undermine this progress by
expanding the restrictions it applies to trust decisions it
characterizes as tax-sensitive. Concerned that vote-trading within the
family could potentially be used to evade these restrictions, the IRS
is considering rules that would effectively ban all family
participation in most key trust decisions. The IRS would apparently
justify this ban by combining an expansive reading of the reciprocal
trust doctrine with a broader application of its restrictions on powers
to change trustees. The family would then face the threat that its
continued involvement would trigger a severe penalty-an estate, gift,
or generation-skipping tax on all the assets in all the trusts in
question, whether or not there is any evidence of reciprocal voting or
even any exercise of the tax-sensitive powers. Choices for family
participation would once again be limited, undermining years of
progress in modernizing the role of families in family trusts.
Options
abound for opening up decision-making to the family under modern trust
law. The family can take responsibility for its own wealth. But the
efforts of the IRS to combat presumed tax abuse may take away that
choice.
Source of the Threat
Under the trust laws of most states today, options abound for opening
up the trust structure to the family, so it can collectively
participate in the control and management of its wealth. Trust
companies organized under state law but privately owned or controlled
by the family or other family trusts--so called "limited purpose,"
"private," or "family" trust companies--were relatively rare 15 years
ago. Now this option is promoted, or accommodated, by the regulatory
law and banking commissions in at least a dozen jurisdictions.
Moreover, for smaller concentrations of wealth, the family can opt for
less expensive methods by using multiple family co-trustees, trust
committees or specialized fiduciary roles.
CHOICES FOR FAMILY PARTICIPATION
- Several
family members may serve as co-trustees and share sophisticated
administrative support staff and systems, with different combinations
of individuals serving, as appropriate, to each of the several trusts
in question; or different parts of the trustee's role may be allocated
among different family members so no one is nominally responsible for
everything.
- Family
members can also serve on investment or distribution committees that
either make decisions directly, or share decision-making authority with
the trustee.
- Such
positions can now be assigned legally meaningful roles if the trust
document is governed by the Uniform Trust Act, already enacted in 19
states, or by the laws of Delaware, South Dakota and similar modernized
trust codes. In some states, the family can form an unregulated
fiduciary company to hold similar powers.
- Alternatively,
family members can act at an oversight level if they have smaller
trusts or less time to devote to these matters. They can serve on a
committee or on the board of a special purpose non-stock company that
has various oversight powers, e.g., to change trustees or investment
advisors, approve a change to the trust terms, or review the
administration of professional trustees.
- New state trust laws also facilitate amending existing trusts to add choices.
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All
of this collective family involvement in family trust
affairs--understandably considered a positive development--is now
threatened by an unduly restrictive application of the tax law. The
Internal Revenue Service Priority Guidance Plan for 2006-2007 (and the
prior year) includes this project: "Guidance regarding the
consequences under various estate, gift, and generation-skipping
transfer tax provisions of using a family-owned company as the trustee
of a trust." The IRS is reviewing how decision-making powers held by
board members and executives of a family trust company can run afoul of
the income-tax grantor trust rules and, more importantly, the estate,
gift and generation-skipping rules when a family trust company holds
powers that the IRS considers tax-sensitive.
In the simple context of a single trust with an individual trustee who
is also a beneficiary, this is a garden variety estate tax issue, e.g.,
a power to control distributions under a non-ascertainable standard
cannot be held by beneficiaries for their personal benefit, even in a
trustee capacity, without triggering taxation as a general power of
appointment. The IRS project addresses such questions in the more
rarified context of a family-owned trust company. When a family forms
its own trust company, can beneficiaries sit on the distribution
committee that would make the same discretionary decisions to
distribute to them? When does that result in transfer tax liability?
Is there any provision for recusal or other prophylactic language that
can be used in the trust or trust company documents to avoid such a bad
result?
If limited to family trust
companies, with no impact on other choices for family participation,
the answers to these questions would warrant scant attention by the
broader estate planning community. Unfortunately, death and taxes are
not that simple. Indeed, it appears the IRS analysis is moving in a
direction that threatens not only such trust companies, but almost all
forms of family participation.
The IRS appears ready to expand the reach of existing precedents and
effectively ban family members from exercising tax-sensitive powers,
such as distribution powers and powers to change trustees, even when
the family is not acting through an elaborate structure and the trust
document prevents the affected individual family member from voting on
the tax-sensitive question. For example, in a case where three family
co-trustees, A, B, and C, serve together as co-trustees on each of
three trusts, and each trust allows for "best interests" discretionary
distributions to its respective primary beneficiary (A, B, or C), it
would no longer be sufficient to preclude individual A from voting as
trustee on a distribution to A, with parallel restrictions on B and C
for their trusts. All of the family trustees would have to be
disqualified from voting on "best interests" distributions to any one
of them.
Moving in the Wrong Direction
Though Justice Holmes famously declared that the life of the law has
not been logic but experience, experience with the life of the Internal
Revenue Code is that the IRS, and sometimes Congress, can carry tax
logic to the extreme and end up with a result that defies common
sense. In this instance, as a result of the proliferation of state
laws permitting family trust companies, the IRS began to receive an
increasing number of private letter ruling requests concerning how to
treat decision-makers in family trust companies when the trustee's
authority included "Tax-Sensitive Powers"--powers held by an individual
that would cause trust property to be included in the power holder's
gross estate; a gift made by the power holder to be incomplete for gift
tax purposes; or the power holder or another to be treated as the owner
of the trust under the grantor trust rules of Subchapter J.
The question in these ruling requests, essentially, was whether
including certain kinds of restrictions in the governing documents
would insulate the grantors, beneficiaries, and other family members
from having to worry about the attribution of Tax-Sensitive Powers held
in their capacity as board members, executives, or officers of the
trust company. These requests required extensive document reviews, and
while many families did not seek a ruling in these circumstances, the
burden was enough to prompt the IRS to seek comments from tax
practitioners as to how to replace this process with a revenue ruling
or other published guidance.
At the same time, the IRS had begun to associate the family trust
company with tax abuse, or at least the potential for tax abuse, as if
these trust companies were being formed, or at least could be formed,
to make an end run around restrictions that have been applied to
choosing an individual to serve as trustee when holding Tax-Sensitive
Powers. Some private letter rulings were explicitly conditioned on
very broad prohibitions against family participation in decisions on
Tax Sensitive Powers, and others contained such restrictions with
sufficient regularity to imply that their presence was considered
important to receiving a favorable ruling.
The New York Tax Bar seems to endorse the IRS concern that family decision-making in trusts fosters tax abuse.
More recently, the tax bar in New York supported the concerns of the
IRS. In response to the IRS request for comments on how to fashion its
new guidance on family trust companies, the New York State Bar
Association ("NYSBA") generally endorsed the same broad approach
reflected in the private letter rulings. Specifically, , the NYSBA
submitted an extensive discussion and set of recommendations regarding
the tax consequences of appointing a family-owned trust company (an
"FTC") to serve as trustee of a trust for the benefit of members of the
same family (an "FTC Trust").
As explained in the cover letter, the NYSBA Report recommended that the
IRS "preclude attribution of Tax Sensitive Powers ... by reason of owning
an interest in, being employed by or participating in the governance of
a FTC" if the governing documents satisfy the following four
requirements.
Two of those four requirements provided as follows (emphasis supplied):
(1) "The by-laws of the FTC should provide that, if a grantor or a beneficiary of an FTC Trust participates
in the removal and replacement of a member of a committee who holds
powers that are Tax-Sensitive to her, the replacement member must not
be related or subordinate to the grantor or such beneficiary," (called the "Replacement Restrictions" in the discussion of the Examples below);
(2) "The by-laws of the FTC should prohibit grantors and beneficiaries from participating in decisions regarding the exercise of any Tax-Sensitive Powers over any trusts as to which any other member of the committee exercising the power is the grantor or a beneficiary.
The purpose of this rule is to avoid reciprocal arrangements among
grantors and beneficiaries,"(called the "Participation Restriction" in
the discussion of the Examples below).
While
these recommended rules on their face apply only to FTCs, the Report
takes the general view that these rules employ tax principles that are
not so limited and that parallel the accepted practice for individual
trustees. The cover letter concludes:
"Our proposed guidelines are similar to the existing income and transfer tax rules that
provide boundaries within which individual and institutional trustees
have operated for many years. We believe that if these rules are
incorporated into the proposed guidance, equal tax treatment
for all grantors and beneficiaries will be available, regardless of
whether an FTC, an independent trust company or an individual trustee
is in control."
These broad prohibitions on
family participation apparently are being justified by applying the
following two principles in combination:
(1) The "Reciprocal Trust Doctrine."
Under this doctrine (also called the "Reciprocal Transfer Doctrine"),
interrelated transfers can be "uncrossed" in order to determine who is
the transferor in substance of each transfer. In the typical case, the
economic interests or powers granted by person A to or for the benefit
of person B can be attributed instead to A if B has made a reciprocal
transfer to or for A's benefit, and A's interests and powers under the
transfer from B can be attributed to B, and the tax rules applicable to
retained interests or Tax Sensitive Powers can be applied accordingly;
and
(2) The principle first adopted in Revenue Ruling 95-58. Under this and related rulings, a power to remove and replace a
trustee will cause the trustee's powers to be attributed to the power
holder (potentially resulting in the attribution of a Tax Sensitive
Power), if the replacement trustee can be a person who is related, or
subordinate, to the power holder within the meaning of Internal Revenue
Code §672(c).
Unfortunately,
the position suggested by the IRS private letter rulings and now
followed in the NYSBA recommendations does not put proper limits on
these two principles and does not acknowledge the volatile impact of
combining both rules to justify a new set of prohibitions.
Both
restrictions recommended by the New York Tax Bar rest on a single
policy judgment: that the sharing of tax-sensitive trust decisions by a
family group leads to tax abuse because of the opportunity for
collusive behavior, and these powers must therefore be taxed as if they
were unqualified and unrestricted. This represents a new family
attribution rule without any legislative authorization or limits.
Boundaries of the Reciprocal Trust Doctrine and Rev. Rul. 95-58
Under existing law and practice, these two principles are limited, or
at least have not been extended to certain circumstances.
The Reciprocal Trust Doctrine has not been applied where there has been
no reciprocal transfer. Except one private letter ruling cited in the
NYSBA Report [7] in which the taxpayer requested the result (and which is inconsistent with a more recent private letter ruling)the Doctrine has not been applied to uncross interests or powers held
by persons who are not transferors, i.e., when the reciprocal powers or
interests were conferred by another person.
Similarly, the Reciprocal Trust Doctrine has not been applied to
persons holding interests or powers unless there is a showing of interrelated conduct, i.e., the parties have made transfers (or at a minimum engaged in some relevant conduct) in a reciprocal fashion. Grace and Bischoff, involved demonstrated reciprocal conduct and did not tax assets merely because of the "possibility" of collusion.
The power to change trustees in Rev. Rul. 95-58 was "unqualified"
(as recognized in the NYSBA Report). The existing authorities do not
directly address, much less resolve, the question of how the power to
remove and replace should be treated if the power cannot be exercised
without the consent of one or more persons or is otherwise restricted
by being shared.
The power to remove and replace
the trustee in Rev. Rul. 95-58 was directly exercisable, i.e., it was
not attributed through multiple steps, such as a power to remove and
replace some other individual fiduciary who in turn had the power
(directly, as part of a group, or as an agent of some entity) to make
or participate in the decision to change the trustee.
If we do not appreciate the significance of these boundaries, and
especially if we simultaneously combine the operation of these two
principles, the resulting mixture will undoubtedly cause serious
practical issues in application, and clearly truncate family
participation in trust management. This can be illustrated by two
typical examples involving individual trustees. As noted earlier, in
this discussion we will refer to the first NYSBA recommendation quoted
above as the "Replacement Restriction" and the second as the
"Participation Restriction."
Example 1
Parent
dies leaving two equal trusts for young children, one for the daughter
and one for the son, with a family friend as trustee. Each trust
allows discretionary principal distributions without regard to an
ascertainable standard. Some years later the original independent
trustee resigns and names the children, now adults, as co-trustees of
each trust. As to each trust, a governing statute prohibits the
beneficiary of that trust from exercising a power as trustee to invade
principal for personal benefit pursuant to a Tax Sensitive Power, but
permits the co-trustee (who is not the beneficiary of that trust, but
in this instance is the beneficiary of the similar parallel trust) to
exercise the power as if sole trustee, as in NY CLS EPTL § 10-10.1
(2006). (These facts are similar to those in Priv. Ltr. Rul. 9235025,
noted above. Assume that the daughter is not a material contingent
beneficiary of the son's trust, and vice versa, so there is no
adversity of interests). |
Example 1 illustrates the difficulties caused by a jaundiced view of
family decision-making, where vote trading is presumed and the
opportunity to ask another family member to serve as a member of a
committee presumes that you can control the committee's fiduciary
decisions:
1(a) Under the NYSBA analysis the trustee powers in Example 1
would be attributed to the beneficiary-trustee in each trust because of
presumed reciprocal conduct, even though the trustees are not
transferors. (Does it matter whether the children were the original
co-trustees named by the parent? What if they were first alternates?)
Priv. Ltr. Rul. 9235025 takes the same position on similar facts,
relying on a local law decision that, oddly enough, at the request of
the trustees, chose to bless vote-trading by fiduciaries in such a case
because the circumstances "invite a trade." (Question: What part of
trust law sanctions self-interested vote trading? Answer: None.)
This earlier PLR is the only support for uncrossing the powers of
individual trustees in such a case, but the NYSBA Report also cites the
subsequent contrary conclusion in Priv. Ltr. Rul. 9451049 (September
22, 1994). As to FTCs, the NYSBA Report offers a single rationale for
the Participation Restriction: to prevent "reciprocal arrangements"
that would make it "possible" for persons in different family trusts
"to work together to ensure that each follows the wishes of the other
regarding decisions each could not otherwise make directly".[11] Given this rationale of the perceived need to prevent the "possibility"
of collusion, and its position that the rules for FTCs should be the
same as for individual trustees, the NYSBA Report seems to adopt Priv.
Ltr. Rul. 9235025 as the prevailing law for individual trustees.
1(b) If so, it is difficult to explain why the New York statute
cited above ignores this result and leaves the trusts exposed to
taxation, especially since the statute was clearly intended to curb Tax
Sensitive Powers and has actually been amended several times at the
request of the New York estate planning bar to achieve certain tax
results.
1(c) In the same way, the NYSBA Report recommends the
Participation Restriction for FTCs and states that the recommendations
would achieve "equal tax treatment" for all trustee arrangements. The
Participation Restriction applies a taxable taint merely because the
participant has a trust subject to the decision of other members of the
committee. That analysis would also threaten a taxable result in the
case of individual trustees who are related, or even for those who
serve as trustees of each other's trusts because they are neighbors,
business associates, or in the best foursome at the country club, since
abusive vote-trading can be conclusively presumed under this view.
1(d) These two rules (the Participation Restriction and the
Replacement Restriction) are even more problematic because they could
both apply together. For example, do the facts in Example 1 always
lead to attribution of the power if the children became co-trustees by
exercising a shared power to remove and replace the original trustee
and thereby appointed themselves as co-trustees?
1(e) Restrictions on "participation" naturally raise the question
of how to define that term. Voting, or mere "participation" in the
discussion? Presence in the room? A ban on any involvement in the
process would certainly be an odd requirement to impose on a
beneficiary. Vague terminology is not a suitable foundation for
administering a tax of over 40% of asset value.
Example 2
While
in their sixties, husband and wife each simultaneously establish funded
revocable trusts as the core document in their respective estate plans,
providing after death for a sprinkling trust, without an ascertainable
standard, for the children and surviving spouse in each case, and after
the surviving spouse's death, for the sprinkling trust to divide into
two trusts, one for each child. All of the family members are
co-trustees. Assume local trust law applies the same rules as in the
New York statute in Example 1 and that the trust agreement provides
those co-trustees permitted to exercise a power may act by majority
vote (or unanimously if there are only two co-trustees). Husband and
wife die 10 years apart without changing these documents. |
2(a)
Does existing law and practice completely preclude the surviving
spouse's participation as trustee on distribution decisions for the
sprinkling trust? Presumably not, since the two spouses obviously
cannot act as trustees over each other's sprinkling trust. Therefore,
it is very hard to conclude that the trusts are reciprocal in any
sense. The children had even less opportunity to collaborate on
determining the final trust terms, so the trusts should not be
considered reciprocal as to them under existing law and practice. The
trusts are simply not interrelated and the trustees were not
transferors of any contemporaneous trusts.
2(b) Yet, the vote-trading analysis of the NYSBA Report would find
taxable reciprocity here simply because the trustees are family
members. For example, if the family in Example 2 later chose to
establish an FTC, none of the three surviving family members could
serve on the trust company's distribution committee under the NYSBA's
recommended Participation Restriction, which is designed to preclude
vote-trading. Without the Participation Restriction, the vote-trading
analysis of the NYSBA Report would cross-attribute powers, causing
taxation unless the exception to Internal Revenue Code § 2041(b)
applies (if the trustee powers are not Tax Sensitive because the
trustees are adverse to each other as to the exercise of the power).[12]
2(c) This vote trading analysis has boundless potential to cause
mischief, and taxation. Going back to the original Example 2 with
individual trustees, assume in Example 2 that the wife is the surviving
spouse and she is also the trustee of an irrevocable gift trust funded
by the husband many years ago, established for the benefit of the
children when they were first born. No FTC is involved, but the
vote-trading analysis of the NYSBA presumes she will trade
distributions from the gift trust to buy her children's votes over the
sprinkling trust. Even if the gift trust has an ascertainable
standard, the conclusion would hold; that is, if the ascertainable
standard is written as a limit on distributions rather than as
requiring distributions for support, her veto power still provides
leverage for trading votes. Yet the traditional Reciprocal Trust
Doctrine should not apply because the two trusts are not interrelated
at all, either in time, by parallel transferors, or by similarity of
terms. A jaundiced view of family decision-making has no limits, but
the Reciprocal Trust Doctrine does.
2(d) If this negative view of family decision-making is adopted,
it seems likely that the "adverse interest" exception will rarely
prevent taxation because, under this analysis, powers can be attributed
across a large group of participants even when the ability of any one
of them to influence the result is marginal and they are not
beneficiaries of each other's trusts. Put another way, if vote-trading
can be conclusively presumed, the analysis of what is an "adverse
interest" becomes elastic and uncontrolled in most family participation
structures. Adversity can be presumed to vanish because vote trading
can be used to make an "end run" around adverse interests. For
example, in 2(b) above, there would be no adverse interest exception
because the surviving spouse can--and presumably will, according to the
theory--reciprocally trade votes with one of the children in order to
deplete the trust in favor of those two family members. This theory
has no discernible limits once we presume that the members of a family
will trade votes even when they have not collaborated in the first instance as transferors to create interrelated powers and interests.
2(e) Going back to the original Example 2 with individual
trustees, what would be the result under existing law and practice if
the surviving spouse had the power to remove and replace one of the
children as trustee, with the consent of the other child, and could
then appoint a related party as a replacement? The power is shared and
thus not "unqualified" as in Rev. Rul. 95-58. Yet, the Replacement
Restriction is characterized in the NYSBA Report as treating FTCs in a
manner equivalent to existing law for individual trustees, and clearly
applies to shared powers, i.e., where the beneficiary merely
"participates" in the replacement decision.
2(f) Assume, in Example 2, a family company or family committee
holds the power to change individual trustees, and the three family
members in that Example serve as the decision-makers. If the
Replacement Restriction recommended by the NYSBA applies to FTCs it
should apply to this case to prevent, for example, the appointment of a
replacement trustee who is a spouse of any one or more of the three
family members. The naming of spouses would be treated as reciprocal
conduct and the spouse of one member treated as "related" to any other
member of the group making the appointment. Note the Replacement
Restriction applies to appointments of persons related to the grantor
or beneficiary in question, not persons related to any member in the
group, but the use of the term "Tax Sensitive Power" in the NYSBA
Report appears to include a power to change trustees and thus to
broaden the application of the rule. The Report also employs an
illustration suggesting the Participation Restriction is designed to
prevent "abuse through such reciprocal arrangements" by which two
individuals holding replacement powers can replace members of the
distribution committee with related parties by arranging for each to
exercise the power with respect to the other's trust.[13]
Conclusion
A ban on family participation would be virtually impossible to
articulate and administer without endless line drawing and questionable
judgments, which then undercuts the purpose of the IRS guidance in
providing clarity for family trust companies. Moreover, if adopted,
such rules would cast considerable doubt on the tax treatment of more
common trust structures, in the absence of a consistent and defensible
explanation.
Some families would inadvertently over the course of time fall into
this trap of presumed abuse. Other families who actively pursue family
decision-making in its various modern forms would be discouraged by the
need for extensive legal analysis and the continuing threat of
taxation. These difficulties can be avoided by confining Rev. Rul.
95-58 and the Reciprocal Trust Doctrine to their existing limits and
adopting a policy that does not presume tax abuse when a family
participates in trust decisions.
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