ESTATE AND TAX PLANNING JULY 1995 REPORT Current Developments This report highlights several recent developments affecting estate and trust planning and administration. Relief to Canadian Citizens in New U.S.-Canada Tax Treaty A revised protocol to the U.S.-Canada Income Tax Convention, signed on March 17, 1995, will provide relief for Canadian citizens who own U.S. property at their death. Under the previous protocol, the U.S.-situs property of a Canadian was subject to both U.S estate tax and Canadian capital gains tax on the value of the U.S. property. Although U.S.-situs property would be taxed at rates applicable to U.S. citizens and residents, Canadians were entitled to merely a $60,000 Unified Credit (compared to the $600,000 Unified Credit available to U.S. citizens and residents); outright transfers to a non-U.S. spouse were not exempt from estate tax. Under U.S. and Canadian law, the U.S. estate tax could not be credited against the Canadian capital gains tax, so Canadian residents owning U.S. situs property could be subjected to a high combined tax rate. The protocol grants Canadian citizens a credit against U.S. estate tax equal to that fractional portion of the Unified Credit which the value of the Canadian's U.S.-situs assets bears to the value of his worldwide assets. The protocol also provides an additional exemption from Canadian capital gains tax on a bequest of U.S.-situs property to a surviving spouse. Further, if the Canadian's entire gross estate does not exceed US$1.2 million, the U.S. will levy an estate tax on only the Canadian's U.S. real estate (not any other U.S. property, such as shares of U.S. corporations). The protocol should reduce the impact of the U.S. estate tax on most Canadian owners of U.S.-situs property. Proposals to Increase Costs to Expatriates Gaining Ground in Congress Separate bills introduced in the Senate and the House would significantly alter the treatment of expatriates. The House bill, which passed the Ways and Means Committee last month, proposes to raise revenue by revising the tax treatment of U.S. persons (both U.S. citizens and long-term resident aliens) who renounce their citizenship or relinquish their "green cards". Currently, U.S. persons are subject to U.S. tax on their worldwide gains. However, the Treasury has found that certain wealthy U.S persons who expatriate or abandon the U.S. have been able to leave the U.S. without significant exposure to the U.S. tax laws. Under the House bill, a U.S. person who loses his citizenship would be treated as having expatriated with a principal purpose of avoiding taxes if (a) his average annual U.S. Federal income tax liability for each of the previous five years was greater than $100,000, or (b) his net worth was $500,000 or more on the date of his expatriation. Certain categories of citizens could request a ruling from the Treasury Department as to whether the loss of citizenship had a principal purpose of tax avoidance. The bill would apply to U.S. citizens who lost their citizenship on or after February 6, 1995, and long-term residents of the U.S. whose residency was terminated on or after June 13, 1995. U.S. citizens who had expatriated within one year prior to February 6, 1995 but who had not filed for a certificate of loss of nationality with the State Department prior to that date would be covered by a special transition rule. An individual covered by the new rules under the House Bill would be deemed to have sold his assets at fair market value immediately prior to expatriation. Any gain on such "sale" would be subject to U.S income tax. The rule would not subject to tax most U.S. real property interests and qualified retirement plans. However, interests in trusts in which the expatriate may not have a power of withdrawal, would be subject to the tax. Taxpayers subject to the new rules would receive a credit that would offset $600,000 of gain (in essence, a credit equal to the amount of the Unified Credit). In addition, the bill would permit an expatriate to enter into an agreement with the Secretary of the Treasury whereby any income or gains derived from foreign property received in an exchange of U.S. property would be treated as U.S.-source income for a period of ten years after expatriation. An alternate bill introduced by Senator Moynihan would impose a similar expatriation tax but would permit an expatriate to elect to have certain assets treated as if the expatriate had not renounced his citizenship, so that the expatriate would not be subject to an immediate tax on imputed gains. The various proposals taxing expatriates are a convenient way for Congress to separate itself from wealthy taxpayers. It remains to be seen, however, if the House or Senate proposals will achieve the necessary support. Proposed Restrictions on Foreign Trusts The Administration has proposed new rules concerning foreign trusts, which would impose new reporting requirements for such trusts. Under the Treasury Department's proposals, a U.S. grantor would be required to notify the IRS of any transfer to a foreign trust, specifying the trustee, the property transferred to the trust and the beneficiaries. Although there are reporting requirements for transfers to foreign trusts under current law, the proposed rules would tighten the rules and would impose larger penalties on improper reporting or failure to report, including a 35 percent penalty on the gross value of the transferred property. In addition, the Trustee of any foreign trust with a U.S. grantor or a U.S. beneficiary would have to file an annual income information statement with the IRS and appoint a U.S. person who would be the IRS's contact for the trust. Failure to file would subject the trustee to a $10,000 penalty and possible additional tax consequences. The Administration also proposes to treat the U.S. beneficiaries of a foreign trust established by Will upon the death of a U.S. person as the grantors of the foreign trust, thereby subjecting any gains received thereon to U.S. income tax. A foreign trust with U.S. beneficiaries created by a nonresident alien prior to emigrating to the U.S. would become a grantor trust if the grantor became a U.S. person within five years of the transfer. The new rules would limit the use of foreign grantor trusts created by foreign persons for the benefit of U.S. persons by restricting the application of the grantor trust rules to trusts created by U.S. persons. Thus, a non-U.S. person who created such a trust would not be treated as owning the trust assets. Finally, the rules would attempt to more clearly define a "foreign estate or trust." An estate or trust would be considered domestic if a U.S. court could exercise primary supervision over the entity's administration and if the entity's U.S. fiduciaries had the authority to control the major decisions of the entity. Foreign estates and trusts would be those entities that are not domestic. The proposed rules would be effective for tax years beginning after December 31, 1995 or after the date of their enactment, in the discretion of taxpayers. The proposed rules would restrict the benefits of utilizing foreign trusts as tax planning devices. The likelihood of the rules passing both houses of Congress is uncertain. Update on Estate and Gift Tax Activity in Congress Congress has begun studying the effects of increasing the Unified Credit. The Credit currently exempts total lifetime gifts and estates of up to $600,000. Proposals have been made to increase the Credit over the course of the next three years to exempt up to $750,000, with the credit being indexed for inflation after 1998. Any increase in the credit would presumably permit an individual who had already exhausted his Unified Credit to make additional gifts to utilize the additional credit. Among other changes would be an annual indexing for inflation of the $10,000 annual gift tax exclusion and the $1,000,000 Generation-Skipping Transfer Tax exemption. Critics of the proposal to increase the Unified Credit would prefer to see the increase apply only to small family-owned businesses. Other interesting items currently before the House Ways and Means Committee include (i) a proposal for the portability of the Unified Credit and GST exemption, thereby permitting a surviving spouse to inherit and use any unused Unified Credit and GST exemption amount of his or her deceased spouse; (ii) a simplification of the complex rules surrounding the use of qualified domestic trusts for non-citizen spouses of deceased U.S. citizens; and (iii) a prohibition upon adoption of certain proposed regulations concerning the application of the GST tax to nonresident aliens. The above proposals are in the early stages of consideration by Congress and may be significantly changed prior to any enactment. We will be watching their progress through Congress with interest. Nixon and Kennedy Legacies The deaths of former President Richard M. Nixon and Jacqueline Kennedy Onassis last year brought increased public awareness to certain estate planning opportunities. Mr. Nixon, who died of a stoke last year, had previously dictated the conditions under which he would continue to receive medical treatment through the use of a Health Care Proxy and Living Will. Several years ago, the New York Legislature authorized a statutory form of Health Care Proxy. The law permits an adult who is suffering from no mental incapacity to appoint another adult to act as his health care agent, to communicate health care decisions for the principal in the event the principal is unable to make decisions for himself as determined by the principal's physician. In addition to the statutory authority granted for Health Care Proxies, the effectuation of Living Wills has been established through case law in many jurisdictions. A Living Will states the directives to be followed in the event the signatory becomes unable to participate in decisions regarding his medical care. The instructions in the Living Will are normally designed to reflect the signatory's commitment to decline medical treatment under certain circumstances. When used in tandem with the Health Care Proxy, the Living Will provides the health care agent with a written expression of the principal's wishes as they relate to his ultimate medical care. Under the terms of her Will, Jacqueline Kennedy Onassis created a charitable trust, the C&J Foundation, and ensured that a substantial portion of her estate will escape estate tax. The trust, a charitable lead annuity trust, will pay an annual annuity amount to charities selected by the Trustees for 24 years. Upon the termination of the trust, the principal will be distributed to the descendants of her children, Caroline and John. The portion of the trust to be includible in her estate is determined by the value of the charitable bequest, the applicable IRS rates in effect at her death, and the term of the trust. Depending upon such variables, a large percentage of an estate may escape estate tax. Provided the trust principal is invested for growth, the remaindermen may inherit a significant portion of the original value of the trust, notwithstanding the imposition of a generation-skipping tax of 55 percent payable on a portion of the trust principal upon termination of the trust. Creating a health care proxy and a living will is a simple matter and can greatly ease the concern of loved ones at times of personal turmoil. Mrs. Onassis's trust provides a way to satisfy a charitable objective while ensuring that family members are also provided for. Prudent Investor Act January 1, 1995 marked the effective date of New York's new Prudent Investor Rule which, unless preempted by the express terms of a governing instrument, regulates the investments of fiduciaries of existing or future trusts and estates. The new Rule replaces the former Prudent Man Rule, which had been seen by fiduciaries as obsolete in light of current investment practices. Under the old Prudent Man Rule, the focus was on a fiduciary's individual investment decisions rather than on the overall management of the fiduciary's portfolio. Thus, a fiduciary could technically be surcharged for one poorly-performing investment even if the value of the total portfolio had increased in value. The Prudent Investor Rule prescribes no prudent or imprudent investments, nor does it require a standard of performance, but instead requires a "standard of conduct." Provided fiduciaries act in substantial compliance with the standards, they should be protected. Professional investment advisors, including banks, trust companies and persons with special investment skills, continue to be subject to the special duty to exercise such diligence as would customarily be exercised by prudent investors of discretion and intelligence having special investment skills. The new Rule departs from the former Prudent Man Rule in requiring fiduciaries to diversify investments unless they reasonably determine that diversification is not in the best interests of the beneficiaries. Mutual funds are specifically recognized by the Act as a method of maintaining diversity. The new Rule also requires fiduciaries to consider nine factors in making investment decisions: (i) the size of the portfolio; (ii) the nature and estimated duration of the fiduciary relationship; (iii) applicable distribution requirements under the governing instrument and the liquidity requirements; (iv) general economic conditions during the fiduciary's tenure; (v) potential effects of inflation or deflation; (vi) expected tax implications of investment decisions and distributions; (vii) the role of each investment or action undertaken by the fiduciary within the entire portfolio; (viii) the expected total return of the portfolio, including income and appreciation of principal; and (ix) the beneficiaries' needs for present and future distributions under the governing instrument. The new Rule also expressly permits a fiduciary to delegate investment and management functions to professional advisors. The fiduciary must exercise the same skill, care and caution in choosing his delegee as he exercises in his investments, must establish the scope and terms of the delegation, must review periodically the delegee's exercise of the delegated functions and must control the costs incurred as a result of the delegation. An investment manager who accepts a delegation of investment and management functions will be subject to the jurisdiction of New York courts and will have a duty to exercise his functions with reasonable care and caution. The Prudent Investment Rule is markedly different from the former Prudent Man Rule; it broadens the scope of a fiduciary's power over investment and management decisions, and grants the fiduciary a powerful right to delegate the fiduciary's authority. This report is distributed for general information purposes only. No action should be taken solely on the basis of its contents. This report is distributed for general information purposes only. No action should be taken solely on the basis of its contents. ©1998 Dunnington, Bartholow & Miller LLP. All Rights Reserved.