A recent unpublished opinion by the U.S. Court of Appeals for the Fourth Circuit, Estate of Wellin v. Farace et al., WL 5445968 (Nov. 22, 2021), (a malpractice case) has critical lessons for estate planners.
Most efficient estate tax planning advice occurs through transactions undertaken during the lifetime of the property owner and built on the chassis of grantor trusts. A grantor trust, of course, is one from which the income, deductions and credits against tax are attributed under Internal Revenue Code Section 671 to the person who created the trust (the grantor) or, in one instance, to a beneficiary. The Internal Revenue Service has long taken the position that a grantor trust doesn’t exist for income tax purposes even though it may be an enforceable arrangement under local law and is respected for estate and gift tax purposes. (See, e.g., Revenue Ruling 85-13.) That means that there are no income tax effects by the transfer of assets between a grantor trust and its grantor even if the transfer is a sale or for consideration and even if the trust is structured so it isn’t includible in the grantor’s estate for estate tax purposes.
One of the more common “sophisticated” estate-planning arrangements built on the grantor trust framework has been a sale of appreciated assets to a grantor trust, especially for a note. This is commonly called an “installment sale to a grantor trust” or simply a “note sale. “Although income and gain after the sale on the assets sold may be received and kept by the trust, they’re taxed to the grantor. (See Rev. Rul. 2004-64.) This later factor allows the trust to grow on an income tax free basis, one of the most powerful factors in all of tax planning. And the grantor’s payment of income tax on trust income reduces (burns) the grantor’s estate, possibly providing further estate tax savings.
Sale of Trust Assets Can Cause Recognition of Large Gain by Grantor
Wellin deals with certain aspects of such a note sale. The decision doesn’t directly involve the tax consequences of the transaction but deals with a claim against the law firm that set it up. In fact, the decision is very narrow, only holding that the statute of limitations to sue the attorneys hadn’t run so the suit against them could continue. According to the court, the lawyer recommended that the client (Keith Wellin) contribute his Berkshire Hathaway shares (worth about $90 million at the time) to a partnership in exchange of 98.9% of the interests in the partnership. A limited liability company (called a limited liability corporation by the court), controlled by Keith’s children from a prior marriage, held the 1.1% controlling interest in the partnership. Keith sold his 98.9% partnership interest to a grantor trust, of which the children from his prior marriage were the beneficiaries, for a note which, according to the court, was worth only $50 million. Late in the year before the year in which Keith died, the partnership, again controlled by the children, sold the Berkshire Hathaway stock for $157 million, causing the recognition of considerable gain. That gain experienced by the partnership was attributed to the partners of which Keith’s grantor trust was the 98.9% partner and, because it was a grantor trust, was, in turn, attributed under the grantor trust rules to Keith as the trust’s grantor.
According to the court, Keith became concerned over the loyalty of the lawyer to him and filed a suit to set aside sale of the partnership units to the trust he had created. He discharged the law firm that had represented him in that transaction.
Supposed Failure to Inform of Risks of Transaction
About two years after Keith died, his estate sued the lawyer and the law firm for negligence, breach of fiduciary duty and breach of contract, which were premised on the same underlying facts and conduct by the defendants. The particular claim at issue, according to the court, was the estate’s allegation that the defendants failed to inform Keith about the “risks and consequences” of the 2009 transaction, including his potentially substantial tax exposure. Footnote 2 to the decision states, “During oral argument before this Court, counsel for the Estate represented that ‘the tax consequences [of the 2009 transaction] are the fundamental claim.’” As indicated, it seems that the estate contended that the defendants failed to inform Keith about the consequences of the 2009 transaction.
Now it might seem that the complaint was the failure to advise Keith that, if the partnership sold its assets (which it did), he would be responsible for the income tax on any gain recognized by the grantor trust. But according to the court, “The Estate did not pay any tax on the Wellin children’s sale of the stock shares, and any attempt to collect such a tax by the IRS appears now to be barred by the statute of limitations.” (Footnote 4.) Although not certain, it seems that the complaint relates to income taxation, not any gift or estate taxation.
So why did the estate complain especially considering the statement by the estate’s counsel in oral argument that the “tax consequences are the fundamental claim”? That is, how was Keith or his estate “injured” even if there was a duty to inform him and there was a failure to do so? Indeed, the plan produced a beneficial result from an estate tax planning point of view. In fact, even if the lawyers had a duty to advise Keith of the income tax effects of the transaction, it seems there was no harm, and the tax wasn’t paid and apparently could no longer be assessed. (Apparently, some evidence was presented as to whether Keith knew or was, in fact, informed about the consequences of using a grantor trust—after all, presumably he was advised or otherwise knew that his sale of his partnership interest to the grantor trust wouldn’t be income taxable. Also, evidence may have been presented as to whether he should have known.)
It may be that those who take Keith’s “probate” estate feel they were injured because the Berkshire Hathaway stock (or Keith’s interest in the partnership which owned the stock) didn’t form part of his probate estate. Rather, instead, the estate included the note Keith received when he sold his partnership interest to the grantor trust.
The court’s decision suggests that the law firm had a duty to advise Keith of the consequences of the transactions. What was stated to Keith, no doubt, may be in dispute. But, as mentioned above, the court stated that, during oral argument, the estate represented that the “the tax consequences of the 2009 transaction” was the fundamental claim of the estate but the court also states that no one paid income tax on the gain recognized when the Berkshire Hathaway stock was sold.
Wellin provides lessons for practitioners to consider. Even though it seems that Keith must have known the basic consequences of a grantor trust (in fact, presumably, he was told or knew that his sale of the partnership units to the trust wouldn’t trigger any income tax effects) or, even if someone in his position and with his wealth should have known the consequences, attorneys and CPAs should take more steps to document that they’ve informed clients of options and tax consequences. Practitioners might prepare a somewhat “standard” writing that’s delivered to clients about strategies they may recommend, including note sales, grantor retained annuity trusts, gifts, grantor trusts, annual exclusion gifts, irrevocable life insurance trusts and mention potential tax and other risks (for example, that no automatic change in basis may occur if property is transferred prior to death and that the law will change and develop to change the results described). Practitioners might also expressly advise each client that they’re under no duty, once the transaction is complete, to inform and won’t inform the client if there’s a law change that would affect any transaction undertaken. And there may yet be another lesson: practitioners might consider the consequences of recommendations on “other” family members. Indeed, part of the complaint against the lawyers is that they were in a position of conflict in representing both Keith and his children. Hence, practitioners should perhaps obtain a formal waiver of any conflict of interest from all family members whom the firm represents. Collaborative planning is important to the protection of every estate-planning discipline. If Keith’s CPA, wealth advisor and insurance consultant had been at meetings, they may have been able to corroborate what information was given to the client. Also, with more advisors involved, each viewing planning from a slightly different lens, the client might receive more information. That is better both for the client and for the advisors. The bottom line is, as Sergeant Phil Esterhaus said on Hill Street Blues, always said, “Let’s be careful out there.”