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ESTATE AND TAX PLANNING
JANUARY 1994 REPORT

Trusts and Beneficiaries

This report focuses on recent developments having an impact on Trustees, trust beneficiaries and the administration of trusts. Certain developments create planning opportunities, while others call for a change in thinking or at least the exercise of caution.

Allocation of Trustee Commissions

By statute, New York authorizes a Trustee to receive annual commissions. The commissions, computed on the value of the principal of the trust, have traditionally been payable one-half from the income of the trust and one-half from the principal of the trust.

In August 1993, the New York commission statute was amended to provide that a Trustee's annual commissions will now be payable one-third from the income of the trust and two-thirds from the principal of the trust, unless the Will or trust instrument expressly directs otherwise. The New York Legislature determined that capital markets have seen significant growth over the last several decades -- growth that would add to the value of the principal of a trust invested in securities -- and concluded that trust principal should bear a greater portion of the annual commission cost.

This statutory change means that an income beneficiary of a New York trust will see a modest rise in annual income since a smaller portion of commissions will be paid from the income. A more subtle issue is whether, based on the legislative rationale, Trustees of some trusts will feel pressed to alter current investment objectives and place more emphasis on growth.

1993 Tax Law Changes

President Clinton's Revenue Reconciliation Act of 1993 attempted to reduce the budget deficit through a combination of spending cuts and tax increases. While most commentators have focused on the provisions which increase income tax rates for wealthy individuals, it is important to be aware of the new income tax rates for estates and trusts, which are retroactive to January 1, 1993. Prior to the enactment of the Act, the top fiduciary income tax rate was 31% for taxable income over $11,250. The new law adds a 36% bracket for taxable income between $5,500 and $7,499, and a 39.6% bracket (termed a "surtax") on taxable income over $7,500. Unlike individual taxpayers, estates and trusts are not allowed a three- year period during which to pay any additional tax in interest-free installments.

In discretionary trusts, Trustees and planners are now confronted with the question of whether to distribute income to beneficiaries whenever the beneficiaries may be subject to lower individual rates, regardless of possible non-tax reasons for accumulating income. These new fiduciary income tax rates may also heighten interest in the use of "defective grantor trusts" as a way to enhance transfers in trust for a junior family member.

Deductibility of Investment Advisory Fees

Generally, expenses incurred by trusts are deductible, subject to a two percent floor. However, if a trust incurs an expense solely by reason of the fact that the property subject to the expense was held in trust, the trust may fully deduct the expense without regard to the two percent floor. The scope of this exception was expanded in a recent Federal case, O'Neill, to include fees paid to a professional investment advisor. In O'Neill, the Trustees lacked expertise in investing and managing large sums of money, and therefore sought the services of an investment advisor. Whereas individual investors would neither be required to consult advisors for the management of their personal assets nor suffer any legal liability if they acted negligently, Trustees are held to a higher standard of care and therefore have an obligation to the beneficiaries to exercise proper skill and care with the investment of the trust assets. The Court held that the investment advisory fees were incurred as a result of the trust arrangement and were therefore fully deductible.

The result in O'Neill will clearly be beneficial when inexperienced Trustees utilize investment advisors to responsibly invest and manage trust assets. Fees for such services, provided they are allowable under the trust instrument or applicable law, will now be fully deductible by the trust. It remains to be seen whether a trust with one or more professional Trustees experienced in investing and managing assets can fully deduct the fees of investment advisors hired by the trust.

Proposed Delegation of Investment Power

A 1993 Surrogate's Court decision held that an Executor can delegate his investment powers even if the decedent's Will did not contain such an authority. In Estate of Helen Gallagher, the Court based its opinion on a report of the Estates, Powers & Trusts Law Advisory Committee recommending the enactment of a Prudent Investor Act. Under the proposed Act, which has been introduced to the Legis- lature, fiduciaries would be authorized to delegate to more experienced persons those functions better suited to professional advisors, thereby resulting in the more efficient administration of estates and trusts.

The proposed Act would require delegees to exercise reasonable care, skill and caution in the managing of assets. The fiduciary must periodically review the exercise of the delegated function and would be responsible for controlling the costs of the delegated services.

The Trustee-Beneficiary

In a typical reciprocal trust situation, a husband and a wife (or other relatives) each creates a trust for the benefit of the other, in which the husband is Trustee of the trust for the benefit of the wife and vice versa. In a 1969 case concerning such a situation, United States v. Grace, the Supreme Court treated the husband as the grantor of the trust created by his wife so that upon his death the principal of the trust created for his benefit was deemed includible in his estate.

In a recent private letter ruling, the Internal Revenue Service purports to extend the Grace doctrine to a situation in which two discretionary trusts were created by an individual for the benefit of his two sons, with each son acting as a Trustee of the other's trust. In the ruling, each son as Trustee had the absolute discretion to distribute principal for his sibling's support, maintenance, comfort, emergencies and serious illness. When one of the sons died, the Service determined that it could be "objectively inferred" that the decedent and his sibling would exercise their respective powers of distribution on a reciprocal basis and thereby ensure that each received whatever he desired from his own trust. The deceased son's trust was therefore includible in his estate.

The cautionary message is that when family members act as Trustees of discretionary trusts for each other, and can control the distribution of principal to each other, the Service may take the position that each has a taxable general power of appointment over the trust for his benefit.

Expansion of the Trustee's Power of Invasion

Trustees who have the absolute discretion to invade principal for the benefit of income beneficiaries of a trust have been given an additional power under a new statutory provision in New York. EPTL § 10-6.6 has been amended to permit a Trustee with an absolute and unlimited power over principal to appoint part or all of the principal to another trust. The law requires that the appointment in further trust (i) not reduce the fixed income interest of any income beneficiary, (ii) be for the beneficiaries of the old trust, and (iii) not be against public policy. The appointment may be made either with the approval of all interested parties to the trust or in a court proceeding upon notice to such persons.

The new provision was designed in part to permit a Trustee of a trust created prior to the effective date of the U.S. Generation-Skipping Transfer Tax rules to fund a new trust for a beneficiary in order to extend the length of time in which property may be exempt from the GST Tax (provided the trust term does not violate the rule against perpetuities).

Although the official commentary to the statute states that the exercise of such a fiduciary power to appoint in further trust would not subject a GST-exempt trust to the GST Tax, practitioners have questioned whether the Internal Revenue Service would treat the exercise of such a power as a taxable transfer. It remains to be seen whether the statute will accomplish its purpose.

Supreme Court Review of Disclaimers in Pre-1932 Trusts

In 1917, fifteen years before the Federal gift tax was enacted, Minnesota businessman Lucius Pond Ordway created a trust for his five children and any eventual grandchildren. When the last of his children died in 1979, some of the living grandchildren disclaimed their remainder interests in an effort to pass portions of their shares in the family trust to their descendants free of gift tax. The Eleventh Circuit Court of Appeals determined that one child's disclaimer was a taxable gift. The Eighth Circuit decided that the disclaimer of another child, Mrs. Irvine, was not subject to Federal gift tax because the original transfer creating the interest was made prior to the existence of the gift tax. The IRS position was that a disclaimer of a pre-1977 interest had to have been made within a reasonable time after the disclaiming party knew of the existence of his or her trust interest -- which would in effect have called for action by Mrs. Irvine prior to the enactment of the Federal gift tax in 1932. In United States v. Irvine, the U.S. Supreme Court will settle the split between the two Circuit Courts and decide whether the Federal gift tax applies to a disclaimer of an interest in a trust created before there was a Federal gift tax.

The Irvine case has enormous gift tax implications for beneficiaries of still-extant pre-1932 trusts. If the taxpayer is successful, beneficiaries of such trusts may have an estate planning opportunity to pass assets down to a lower generation without transfer tax liability by disclaiming their interests in such trusts. The Supreme Court's decision is expected in 1994. We will be watching this issue closely.

Low IRS Interest Rate Serves a Higher Purpose

The IRS discount rate, which affects the valuation of gifts under certain estate planning techniques, was lower at the end of 1993 than at any time during the last several years. A low IRS rate favors the creation of:

A trust such as a "zero-out" Grantor Retained Annuity Trust, because a more modest retained annuity interest may be sufficient to reduce a taxpayer's gift to a minimal amount while increasing the likelihood of asset values passing to junior family members at the termination of the trust free of transfer tax.
A Charitable Remainder Annuity Trust with a relatively high payback rate, because the grantor will be less likely to run afoul of the rule which limits a current tax deduction for the charitable remainder if there is a greater than five percent likelihood of the charity ultimately receiving nothing.