Cases decided over the past several years have demonstrated that defective trust administration, whether negligent or intentional, can cause a tax disaster even if the underlying trust instrument is technically sound.
CRAT Regs Not Followed
In Estate of Atkinson,1 Melvine Atkinson created a charitable remainder annuity trust (CRAT) funded with stock worth about $4 million. Under the CRAT’s governing instrument, Melvine was to receive an annual annuity of $200,000 for her life. The trust instrument provided for annuity payments to be made to successor beneficiaries following Melvine’s death if they agreed to pay their share of any estate taxes due at her death. After the death of the last annuity amount beneficiary, all remaining trust property was to be distributed to charity. Melvine died, and her estate claimed a charitable estate tax deduction in an amount equal to the present value of the charitable remainder interest in the CRAT as of Melvine’s date of death.
There was just one problem. It turned out that, although there was no ambiguity or defect whatsoever in the trust instrument, no annuity payments had ever actually been made to Melvine. Accordingly, the Internal Revenue Service, on audit of Melvine’s estate tax return, disallowed the charitable deduction for the CRAT remainder because the CRAT had failed to operate in accordance with Internal Revenue Code Section 664, the applicable Treasury regulations and the requirements of the trust instrument. The estate argued that the IRS, by focusing stringently on the CRAT rules, would deny a substantial charitable deduction because of a “foot fault” or a minor mistake, ignoring the certainty that CRAT property worth millions of dollars would pass to charity as a result of Melvine’s death.
The U.S. Court of Appeals for the Eleventh Circuit sided with the IRS. The court concluded the CRAT didn’t give rise to an estate tax charitable deduction under IRC Section 2055 because “the CRAT regulations were not scrupulously followed.”2 The court said:
It is not sufficient to establish a trust under the CRAT rules, then completely ignore the rules during the trust’s administration … Despite the certain charitable donation in this case, the countervailing Congressional concerns surrounding the deductibility of charitable remainders in general counsel strict adherence to the Code, and, barring such adherence, mandate a complete denial of the charitable deduction.3
Actions Created Grantor Trust
In Securities and Exchange Commission v. Wyly,4 Sam and Charles Wyly created and funded 17 offshore trusts and designated professional asset managers in the Isle of Man as trustees. The beneficiaries, in a variety of combinations among the trusts, included Sam and Charles, their spouses, their children and charitable organizations. Each trust had three trust protectors: Sam and Charles’ lawyer, the chief financial officer (CFO) of the Wylys’ family office and the CFO of a Wyly-related offshore entity. Neither any of the trustees nor any of the trust protectors was a “related or subordinate party” within the meaning of IRC Section 672(c). Among the trust protectors’ powers were to “add or substitut[e]” a charitable organization as a beneficiary and to remove and replace the trustees.
In making investments (including in Wyly family businesses and a fund run by Sam’s son-in-law), and in purchasing lavish personal use items accessed and enjoyed by the trust beneficiaries, the trustees always followed the directions of the trust protectors, who received their marching orders from Sam and Charles.
The trusts were designed to be non-grantor trusts for federal income tax purposes. The trusts’ governing instruments were properly drafted to accomplish this purpose. Because these were foreign, non-grantor trusts, none of the income generated by and retained in the trusts would be subject to U.S. income tax. At least that’s what Sam and Charles thought.
The court first observed that the trustees had powers of disposition in respect of beneficial enjoyment potentially giving rise to grantor trust treatment under IRC Section 674(a) but then said the trustees were ostensibly independent within the meaning of Section 674(c). The court concluded, however, that the Section 674(c) independent trustee exception (which, if it applied, would have rendered Section 674(a) inapplicable) didn’t apply because the trustees’ powers of disposition weren’t solely exercisable by them. Taking note of the facts that: (1) the trustees invariably followed the directions of the trust protectors; (2) in giving directions to the trustees, the trust protectors invariably followed the instructions of Sam and Charles; (3) the trust protectors were explicitly empowered to remove and replace the trustees; and (4) Sam and Charles had close relationships with the trust protectors, the court reached this conclusion notwithstanding that Sam and Charles had no legal right to control the trust protectors.
The court acknowledged but rejected as “rigid” and “unwarranted” the Wylys’ construction of the holding of a very analogous case, Goodwyn,5 in which the Tax Court stated a grantor may be subject to tax under Section 674(a) only on “a power reserved by instrument or contract creating an ascertainable and legally enforceable right, not merely the persuasive control which he might exercise over an independent Trustee who is receptive to his wishes.”6
In the end, the court had no difficulty concluding that economic realities, rather than the literal terms of the underlying trust instruments, should control the income tax status of the trusts. The court was convinced Sam and Charles, as trust settlors, effectively controlled the actions of the trustees. The result was that, since the Section 674(c) independent trustee exception didn’t apply, the trusts were treated as grantor trusts, a disastrous result that ultimately forced the Wyly brothers into bankruptcy.
In Estate of Dieringer,7 Victoria Dieringer died in 2009 and left her personal effects to her children, made $600,000 in pecuniary gifts and left all the rest of her estate and trust (revocable until her death) to the Bob and Evelyn Dieringer Family Foundation (Foundation). Victoria’s son, Eugene, was sole executor of her will, sole trustee of her trust and sole trustee of the Foundation.
Most of Victoria’s assets consisted of a majority interest in Dieringer Properties, Inc. (DPI), a closely held business that managed commercial and residential real estate. Eugene was president, a director and a shareholder of DPI. Victoria’s trust owned 425 of 525 voting shares and 7,736.5 of 9,220.5 non-voting shares of DPI at the time of her death. The federal estate tax return for Victoria’s estate (Form 706) reflected that her equity in DPI at her death had a fair market value of $14,182,471. Each voting share had an estate tax value of $1,824, and each non-voting share had an estate tax value of $1,733 per share. Victoria’s DPI stock was valued on a majority interest basis. The estate reported no estate tax liability.
In connection with a redemption of the trust’s DPI stock, Eugene inexplicably arranged for an appraisal of the trust’s DPI shares on a minority interest basis. The appraiser, simply following Eugene’s directions, applied various discounts and determined that the redemption price should be $916 per voting share and $870 per non-voting share. After the redemption (and implementation of the terms of a separate subscription agreement), Eugene owned 70 percent of DPI’s voting stock and 48.6 percent of its non-voting stock. The Foundation received from Victoria’s trust only 2,163 non-voting shares of DPI, a short-term note receivable in the amount of $2.25 million and a long-term note receivable in the amount of $2,921,312.
On audit of the Form 706, the IRS reduced the estate’s charitable deduction to the amount equal to the value of property actually distributed to the Foundation. In holding for the Commissioner, the Tax Court found that the Foundation didn’t receive the DPI shares (or their value following the redemption) to which it was entitled under the governing instrument of Victoria’s trust (the trust instrument). The Tax Court determined that the charitable deduction was limited to the amount actually transferred to the Foundation, rather than the amount to which the Foundation was entitled under the trust instrument and claimed as a charitable deduction on the
Form 706. The Tax Court stated that:
[i]f a trustee has the power to divert property to be transferred for charitable purposes ‘to a use or purpose which would have rendered it, to the extent that it is subject to such power, not deductible had it been directly so bequeathed, devised, or given by the decedent’…the charitable contribution deduction is limited to the portion, if any, of the property that is exempt from the trustee’s exercise of the power.8
Similar Results Possible
Atkinson involved what was apparently an innocent mistake but seems like a roadmap for courts to reach similar results in circumstances involving unassailable trust instruments coupled with maladministration. A grantor-retained annuity trust (GRAT) could be considered not to qualify as such under IRC Section 2702 only because a GRAT payment wasn’t made (or even if it was made but not timely). A qualified terminable interest property trust could be held not to qualify for the marital deduction under IRC Section 2056(b)(7) for no reason other than that, in a given year, an amount less than the entire net income was distributed to the surviving spouse/beneficiary. The value of assets in a non-marital trust, intended to be excluded from the surviving spouse/beneficiary’s gross estate, could be included in the gross estate under IRC Section 2041 if the surviving spouse/beneficiary, as trustee, made a principal distribution to himself for a purpose broader than health, education, maintenance and support.
Wyly and Dieringer show the lengths to which a court may go to reach the “right” result in a case with egregious facts. In Wyly, the court ignored Goodwyn, 40-year-old contrary precedent that most knowledgeable observers thought was settled law. The Dieringer court sought to buttress its conclusion by referencing “a trustee [who] has the power to divert property to be transferred for charitable purposes,”9 but the trustee in Dieringer had no such power at all. The Dieringer trustee grossly breached his fiduciary duties to the Foundation, and the Foundation inexcusably sat on its hands and accepted from Victoria’s trust far less than that to which it was entitled.
1. Estate of Atkinson v. Commissioner, 309 F.3d 1290 (11th Cir. 2002).
2. Ibid., at p. 1295.
3. Ibid., at p. 1296.
4. Securities and Exchange Commission v. Wyly, 56 F. Supp.3d 394 (S.D.N.Y. 2014).
5. Estate of Goodwyn v. Comm’r, T.C. Memo. 1976-238.
6. See supra note 4, at p. 428.
7. Estate of Victoria E. Dieringer v. Comm’r, 146 T.C. No. 8 (March 30, 2016).
8. Citing to Treasury Regulations Section 20.2055-2(b)(1).
9. Dieringer, supra note 7, at p. 20.