What If Perpetual Trusts Are Unconstitutional?

Transcription

1 What If Perpetual Trusts Are Unconstitutional? Steve Leimberg's Estate Planning Newsletter Subject:Jonathan Blattmachr, Mitchell Gans & William Lipkind: What If Perpetual Trusts Are Unconstitutional? An article just published in the Vanderbilt Law Review by Harvard Law School Professor Robert Sitkoff and Illinois Attorney Steven J. Horowitz, who is also a former student of Professor Sitkoff, takes the position that long term trusts created under the laws of Arizona, Nevada, North Carolina, Tennessee and Wyoming may be invalid by reason of a prohibition on perpetuities under the State Constitutions of those states. Practitioners whose clients have created long trusts in those jurisdictions may wish to consider whether they have an obligation to advise them of the potential effects of the invalidity of the trusts duration. If the trust contains an effective duration limitation clause, the concerns are probably small as the only significant effect may simply be to reduce the time the property will remain in trust and not raise issues of whether there was any transfer at all and whether gift and GST exemptions used in creating the trust have been wasted. The Vanderbilt article, even if unsettling to some, is very scholarly and thoughtful as well as thought provoking. Practitioners who have clients who might be affected by its conclusions should read it. They should then decide what action, if any, is appropriate to take. Certainly, all lawyers should consider using a perpetuities limitation provision in each trust they draft including those under Wills. We now turn to an important issue raised in a recently published article by Robert Sitkoff and Steve Horowitz reviewing how state constitutions in some jurisdictions may prohibit long term trusts, and the consequences if a trust has been created in one of those jurisdictions. Frequent LISI contributors Jonathan Blattmachr, Mitchell Gans and Bill Lipkind provide a summary of the key points of the article and make suggestions that practitioners involved with trusts in those states may wish to consider. Jonathan G. Blattmachr is the Director of Estate Planning for the Alaska Trust Company, a principal of Pioneer Wealth Partners, LLC, and co developer, with Michael L. Graham, Esq., of Dallas, Texas, of Wealth Transfer Planning, a computer system produced by Interactive Legal that provides artificial intelligence advice and automated document assembly systems for practitioners. Mitchell M. Gans is the Rivkin Radler Distinguished Professor of Law at the Hofstra University School of Law and an Adjunct Professor of Law at the New York University School of Law in its Masters in Tax program. William D. Lipkind is a graduate of the Harvard Law School, a founding member of Lampf, Lipkind, Prupis & Petigrow in West Orange, New Jersey, and an author of legal articles. Here is their commentary: EXECUTIVE SUMMARY: An article just published in the Vanderbilt Law Review by Harvard Law School Professor Robert Sitkoff and Illinois Attorney Steven J. Horowitz, who is also a former student of Professor Sitkoff, takes the position that long term trusts created under the laws of Arizona, Nevada, North Carolina, Tennessee and Wyoming may be invalid by reason of a prohibition on perpetuities under the State Constitutions of those states. Practitioners whose clients have created long term trusts in those jurisdictions may wish

2 to consider whether they have an obligation to advise them of the potential effects of the invalidity of the trusts duration. If the trust contains an effective duration limitation clause, the concerns are probably small as the only significant effect may simply be to reduce the time the property will remain in trust and not raise issues of whether there was any transfer at all, and whether gift and GST exemptions used in creating the trust have been wasted. Also, lawyers who are asked to advise a client about an appropriate jurisdiction in which to create a long term trust (well beyond the normal lives in being plus 21 years timeframe) may wish to consider states other than the foregoing five. In addition, it may be appropriate to consider whether a long term trust created in a jurisdiction other than those five which permits such trusts to be created (e.g., Alaska, Ohio, Utah) by an individual who resides in any one of the nine states (the five stated above plus Arkansas, Montana, Oklahoma, Texas), the constitutions of which prohibit perpetuities, might be declared invalid by a court in one of those nine states if the court has jurisdiction over the trust. COMMENT: Background Before the enactment of the original generation skipping transfer (GST) tax, probably the vast majority of even large inheritances were received outright or through trusts of short duration such as ones that would terminate when the beneficiary was relatively young (e.g., age 30 or 40 years), and despite the fact that estate and gift tax could be entirely avoided for about a century by keeping the property in trust under the common law rule against perpetuities of lives in being plus 21 years. However, the enactment of the GST tax, which prevented all property transferred by gift or bequest from being transferred from or for one younger generation (such as that of the transferor s children) to an even younger one (such as that of the transferor s grandchildren) without a wealth transfer tax but permitted only a limited amount to be so transferred (originally $1 million as of 1986), seemed to have caused property owners to try to take advantage of the limited exemption. Although it may seem counterintuitive for taxpayers to create long term trusts to take advantage of a limited exemption when they did not do so when the exemption essentially was unlimited (because there was no GST tax), it appears to reflect that scarcity of the exemption made it seem more valuable. In any case, Delaware, in 1995, essentially repealed its rule against perpetuities in order to draw trust business to the state. Alaska followed suit soon thereafter and now over half of the states, including Arizona, Nevada, North Carolina, Tennessee and Wyoming, have repealed their traditional rules against perpetuities to allow perpetual or extremely long terms trusts (e.g., 360 years). And many long term trusts have been created under the laws of these states, especially those that would not impose a state (or local) income tax on undistributed trust income. And now with the gift and GST exemptions being over $5 million, even more such trusts have been created. Probably, the states of Alaska, Delaware, Nevada and South Dakota have received most of the perpetual trust business in part because none (except Delaware if it has a Delaware beneficiary) imposes an income tax, and each has other favorable trust laws (such as so called decanting statutes which essentially permit amendment of irrevocable trusts).[i] State Law Limitations on Long Term Trusts

3 However, an article titled Unconstitutional Perpetual Trusts, 67 Vanderbilt Law 1769 (2014), by Robert H. Sitkoff, the John L. Gray Professor of Law at the Harvard Law School, and Steven J. Horowitz, Esq., a practicing lawyer, concludes that it is probable that the long term trust statutes (each of which allows property to remain in trust for much longer than the traditional common law rule against perpetuities) adopted by Arizona, Nevada, North Carolina, Tennessee and Wyoming are invalid because they violate a prohibition against perpetuities contained in the constitutions of those states. Although it has just been published, a detailed story about it appeared in the December 5 issue of The New York Times. More Detail about the Article The authors of the article present a thoughtful and detailed discussion of the history of the development of the common law rule against perpetuities which is based, at least in part, on concerns on restrictions on alienability of property and on the concentration of wealth. The article s essay is compelling, in part, because it explains, in detail, why the prohibition in the constitutions of the five states listed above against perpetuities means: (i) these constitutional provisions ban entails in form or in function; (ii) a perpetual trust is an entail in form and function, so it violates the provision; (iii) the common law rule, or a reasonable approximation of it, satisfies the constitutional bans, because the common law rule or a reasonable approximation prohibits entails in form or function; and (iv) possibly other implementing rules could satisfy the bans, so long as they stop entails in form or function. Their conclusion seems even more compelling in Nevada because of a failed attempt in the early 2000s to have the state constitution changed to eliminate its perpetuities prohibition. Without question, lawyers, bankers and other advisors in Arizona, Nevada, North Carolina, Tennessee and Wyoming will contend the Sitkoff/Horowitz conclusion is wrong or overstated. However, it seems it would not be prudent to ignore the issue either with respect to long term trusts created in one of those five jurisdictions or in considering the creation of a new long term trust under the laws of one of those states. In fact, it would seem prudent to consider creating the trust under the law of states whose constitutions do not contain the perpetuities prohibition in Arizona, Nevada, North Carolina, Tennessee and Wyoming. Practitioner Action What should practitioners whose clients have created a trust under the statute of one of the five states do? First, it seems appropriate to determine what the effect would be if the statute under which the trust is created is invalid under the state constitution. That in turn raises other issues, such as: (1) whether the effect of declaring the state statute allowing long term trusts unconstitutional which might be a reversion to the common law rule, and (2) whether the trust is entirely invalid ( Any hypothetical violation of the Rule, no matter how improbable, extinguishes otherwise legitimate interests. It is also an all or nothing kind of Rule. If one member of a class of possible takers of a future interest potentially takes a vested interest beyond the prescribed time, the interests of all members of the class fail. Uniform Law Commission, Statutory Rule Against Perpetuities, available at the following link: Statutory Rule Against Perpetuities.)

4 The hit movie Body Heat, starring Kathleen Turner and William Hurt, revolves around the indication that rule against perpetuities voided a disposition, causing the murdered decedent s entire estate to pass into intestacy to his young widow.[ii] However, it may be that the law and the remedy (declaring the trust entirely void) portrayed in the movie is wrong or at least an exaggeration. It seems that invalidity of all interests in the trust was not the correct legal remedy, since Florida had adopted a wait and see rule and that dependent relative revocation might also have been applicable. If the trust is invalid it could mean the property is still held by the trust s settlor, keeping it in his or her gross estate for Federal state tax purposes, causing all income and gain to be included in the settlor s gross income, exposing it to claims of creditors of the settlor, and the potential wasting of gift and GST exemption used in creating the trust. It may be that, if the property is deemed never to have been transferred, the exemptions probably should be treated as never having been used, although, if the statute of limitations to file an amended return has expired, that result is not certain. Compare for example, that any adjusted taxable gift is expunged for purposes of computing the estate tax under Section 2001 of the Internal Revenue Code if the gift is included in the gross estate which has the effect of restoring the exemption (technically, the applicable or unified credit) but here, with the voiding of the transfer, there never was an adjusted taxable gift. Invalidity of the statute and, therefore, the duration of the trust, might also mean that the property is deemed vested in the current beneficiary, which could mean, at least, wasting the GST exemption.[iii] Potential Remedies Although the Vanderbilt article does not directly suggest potential remedies, at least two routes may be available. The first could be a reformation under which a court may, for example, reduce the term to one that does not violate the application rule on trust duration. The second could be for the court to adopt the wait and see rule to see if the duration, in fact, violates the rule. If the trustee has the power to terminate the trust by, for example, paying the assets to someone before the allowable duration passes and does so, that might salvage the trust. It seems appropriate for practitioners to explore which of these routes may be available under law of the state where the trust was created and, perhaps, commence a proceeding to confirm the availability of one of those, or another, remedy. In fact, practitioners may wish to look at the prior law of those states, such as whether it permitted reformation or allowed a wait and see approach. Moreover, practitioners may wish to consider whether the invalidity of a state s long term trust law essentially means the reinstatement of its prior rule against perpetuities law. Domiciliaries of Limited Duration States Create Trusts Where There Is No Such Duration The Sitkoff/Horowitz article also raises the provocative question of whether a court in a state (e.g., Texas), whose constitution prohibits perpetuities and has jurisdiction over a long term trust created in a state that permits such a long term trust (e.g., Delaware), would declare it invalid if the trust were created by a domiciliary of the state where the court sits (e.g., Texas).[iv] Unfortunately, the result is not clear that the trust would be found to be valid. Note, for example, that the United States Bankruptcy Courts in In re Portnoy, 201 B.R. 685, 701 (Bankr. S.D.N.Y. 1996), and In re Brooks, 217 B.R. 98, 32 Bankr. Ct. Dec. (CRR) 23 (Bankr. D. Conn. 1998), both involving non US self settled trust, unraveled the trusts and exposed their assets to the claims of creditor by finding the trusts to be invalid under the law of the settlors domiciles. Strangely, the laws of neither state involved in those cases (New York and Connecticut) provide that a spendthrift self settled trust is invalid.

5 Rather, they essentially say such trusts are void with respect to the settlor s creditors. Perhaps, in the view of the courts, it amounts to the same thing, but that is not discussed in the opinions. In fact, as discussed in G. Rothschild, D. Rubin & J. Blattmachr, Self Settled Spendthrift Trusts: Should a Few Bad Apples Spoil the Bunch?, 9 Journal of Bankruptcy Law & Practice (Nov./Dec. 1999), there is a statute in New York that makes a settlor s express declaration of controlling law conclusive.[v] The New York courts have acknowledged that the statute is intended to encourage residents of other states to create New York trusts.[vi] And it should be noted that this issue is not limited to individuals domiciled in one of the five states mentioned above, but also those domiciled in Montana, Arkansas, Oklahoma and Texas, whose constitutions prohibit perpetuities. Nonetheless, it seems that it is more likely the court, in which appears to be consistent with the statement quoted above from the Uniform Law Commission, would merely reduce the trust s term. In any case, it may behoove a practitioner, who represents a client domiciled in any one of those nine states and who has created a long term trust in another state (even where the state constitution does not prohibit perpetuities), to seek to have a court in the domicile state declare that the trust is valid and not void as violating strong public policy of the domicile jurisdiction. Whether such a court ruling would be binding upon those not a party to the proceeding (e.g., a creditor) seems questionable. Safety of a Perpetuities Limitation Provision In any case, if the trust has a perpetuities limitation (or savings) provision, it appears there is no adverse result except that the trust may not last for as long as the settlor initially hoped. If a long term duration would not be valid, then under the savings provision a traditional trust duration period (e.g., the standard lives in being plus 21 years term) should apply. Here is a sample of such a duration clause which practitioners may wish to consider: Maximum Duration for Trusts Defined The Maximum Duration for Trusts is the longest period that property may be held in trust under this Agreement under the applicable rules governing perpetuities, vesting, accumulations, the suspension of alienation and the like (including any applicable period in gross such as twenty one (21) years or ninety (90) years). If under those rules the Maximum Duration for Trusts shall be determined (or alternatively determined) with reference to the death of the last survivor of a group of individuals alive upon the date of this Agreement, or at such other time that the application of such rules limiting the maximum duration of trusts is deemed to begin, those individuals shall consist of those measuring lives described in the paragraph below entitled Measuring Lives. [OBJ:STD MDT 1002]The measuring lives under this paragraph shall consist of those of the following individuals who are living at the time that the application of such rules limiting the maximum duration of trusts is deemed to begin: the Grantor's Wife, all of the Grantor's descendants and any surviving spouse of a descendant of the Grantor. [vii][obj:std MDT 1004] Certainly, it will behoove practitioners to place such a limitation in any trust that is to last a long time to ensure it will not be declared invalid because it violates some perpetuities limitation under applicable state law. Conclusion

6 The Vanderbilt article, even if unsettling to some, is very scholarly and thoughtful as well as thought provoking. Practitioners who have clients who might be affected by its conclusions should read it. They should then decide what action, if any, is appropriate to take. Certainly, all lawyers should consider using a perpetuities limitation provision in each trust they draft, including those under Wills. HOPE THIS HELPS YOU HELP OTHERS MAKE A POSITIVE DIFFERENCE! Jonathan Blattmachr Mitchell Gans William Lipkind CITE AS: LISI Estate Planning Newsletter #2263, (December 18, 2014) at Copyright 2014 Leimberg Information Services, Inc. (LISI). Reproduction in Any Form or Forwarding to Any Person Prohibited Without Express Written Permission. CITES: Perpetuities or Taxes? Explaining the Rise of the Perpetual Trust, 27 Cardozo L. Rev (2006); Jurisdictional Competition for Trust Funds: An Empirical Analysis of Perpetuities and Taxes, 115 Yale L.J. 356 (2005); Unconstitutional Perpetual Trusts, 67 Vanderbilt Law 1769 (2014); The New York Times; Uniform Law Commission, Statutory Rule Against Perpetuities; If God Wanted Lawyers to Fly, She Would have Given Them Wings: Life, Lust & Legal Ethics in Body Heat, 22 Okla. City U. L. Rev. 187 (1997); In re Portnoy, 201 B.R. 685, 701 (Bankr. S.D.N.Y. 1996); In re Brooks, 217 B.R. 98, 32 Bankr. Ct. Dec. (CRR) 23 (Bankr. D. Conn. 1998); Self Settled Spendthrift Trusts: Should a Few Bad Apples Spoil the Bunch?, 9 Journal of Bankruptcy Law & Practice (Nov./Dec. 1999); Searching for Better State Law Goodies, 2014 Annual ACTEC meeting; Hutchinson v. Ross, 187 N.E. 65, 71 (N.Y. 1933); In re Accounting of New York Trust Co., 87 N.Y.S.2d 787, 792 (N.Y. Sup. Ct. 1949); R.I. GEN. LAWS to (1997); Convention on the Law Applicable to Trusts and on their Recognition, Oct. 8, 1984, art.6 reprinted in 23 I.L.M. 1389, 1389 (1984); Jesse Dukeminier & Robert H. Sitkoff, Wills, Trusts, and Estates (9th ed. 2013); W. Barton Leach, Perpetuities in Perspective: Ending the Rule's Reign of Terror, 65 Harv. L. Rev. 721 (1952). CITATIONS: [i] For a discussion of the stimulus for the perpetual trust movement, see M. Schanzenbach & R. Sitkoff, Perpetuities or Taxes? Explaining the Rise of the Perpetual Trust, 27 Cardozo L. Rev (2006) (finding that "prior to the GST tax, states that abolished the Rule did not garner more trust business than those that retained the Rule"). Also, see R. Sitkoff & M. Schanzenbach, Jurisdictional Competition for Trust Funds: An Empirical Analysis of Perpetuities and Taxes, 115 Yale L.J.356 (2005). However, there does not seem to be readily available data that indicates that the increased in the GST exemption has triggered the creation of more long term trusts. [ii] See J. Burkoff, If God Wanted Lawyers to Fly, She Would have Given Them Wings: Life, Lust & Legal Ethics in Body Heat, 22 Okla. City U. L. Rev. 187

7 (1997). [iii] For a discussion (with citations) of the famous harshness of the what might happen test of the common law Rule, which invalidates ab initio any trust that violates the rule, giving rise the infamous cases of the fertile octogenarian, unborn widow, magic gravel pit and the like" see Jesse Dukeminier & Robert H. Sitkoff, Wills, Trusts, and Estates (9th ed. 2013) and W. Barton Leach, Perpetuities in Perspective: Ending the Rule's Reign of Terror, 65 Harv. L. Rev. 721 (1952). [iv] This was also raised in a paper by J. Blattmachr and M. Gans entitled Searching for Better State Law Goodies presented at the 2014 Annual ACTEC meeting. [v] Hutchinson v. Ross, 187 N.E. 65, 71 (N.Y. 1933). [vi]in re Accounting of New York Trust Co., 87 N.Y.S.2d 787, 792 (N.Y. Sup. Ct. 1949). For other laws supporting a settlor s right to determine the law applicable to a trust see R.I. GEN. LAWS to (1997); Convention on the Law Applicable to Trusts and on their Recognition, Oct. 8, 1984, art.6 reprinted in 23 I.L.M. 1389, 1389 (1984). ( A trust shall be governed by the law chosen by the settlor. ). [vii] This provision is derived from Wealth Transfer Planning, a computerized drafting and artificial intelligence system for lawyers, written by Jonathan G. Blattmachr and Michael L. Graham, which is published by Interactive Legal Systems, LLC, and is reproduced here with its permission. To comment on this newsletter Go Here: HELP US HELP OTHERS! TELL A FRIEND ABOUT OUR NEWSLETTERS. JUST GO TO: