ABA Section of Real Property, Trust & Estate Law 23 rd Annual Spring Symposia New York, NY

Transcription

1 ABA Section of Real Property, Trust & Estate Law 23 rd Annual Spring Symposia New York, NY Powers of Appointment: Exercising Powers over Perpetual Trusts & Other Tips for Drafting May 3, :30 9:30 a.m. Adam K. Sherman McDermott Will & Emery LLP 227 West Monroe Street Chicago, Illinois (312) IRS Circular 230 Disclosure: To comply with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained herein (including any attachments), unless specifically stated otherwise, is not intended or written to be used, and cannot be used, for the purposes of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter herein. -1-

2 Exercising Powers over Perpetual Trusts & Other Tips for Drafting Introduction The longer a trust will last, the more important flexibility becomes. Powers of appointment are one mechanism for addressing changed circumstances, both tax and non-tax. Due to the availability in a number of jurisdictions of perpetual trusts (or trusts with lengths tantamount to perpetual trusts), creating powers has taken on added importance. This outline reviews selected tax issues related to the exercise of powers over perpetual trusts and also considers a number of ways in which the flexibility of such powers can be enhanced. Section I: Exercising Powers over Perpetual Trusts 1. The Demise of the Rule Against Perpetuities and the Rise of Perpetual Trusts a. For most of U.S. history, the traditional common law rule against perpetuities ( RAP ) applied to invalidate (ab initio) contingent future interests in property that would fail to vest with a specified time period, eventually stated as the lives in being at the creation of the interest, plus 21 years. b. Beginning in the late 1940s, states began reacting to the harshness of the common law rule by enacting wait-and-see perpetuities rules. c. In the 1980s, NCCUSL adopted the wait-and-see approach in drafting a Uniform Statutory Rule Against Perpetuities ( USRAP ), replacing measuring lives with a fixed 90-year perpetuties period. d. USRAP was immediately criticized by commentators as representing a de facto repeal of the RAP. e. In 1986, only three states (Idaho, South Dakota and Wisconsin) had abolished a vesting RAP and adopted a rule stately solely in terms of prohibiting the suspension of alienation of property. f. Prior to the enactment of the current GST tax, perpetual trust jurisdictions attracted little outside business. After the introduction of the current GST tax, South Dakota and Wisconsin banks both ramped up their efforts to market themselves as perpetual trust jurisdictions. The former, due to the absence of a state income tax, was particularly successful in attracting trust business. g. In 1995, concerned that it was losing trust business to South Dakota and Wisconsin, 2012 by Adam K. Sherman. All rights reserved. -1-

3 Delaware repealed its rule against perpetuities (with respect to interests to personal property). h. Concerned that they would in turn lose trust business to Delaware, a large number of states followed suit and repealed or modified their perpetuities law: (including Alaska, Florida, Illinois, Colorado, Wyoming, New Jersey, New Hampshire, Missouri, Ohio, Rhode Island, Utah, Tennessee). 2. The History of the DE Tax Trap a. In 1942, the estate tax base was expanded to include certain powers of appointment. At that time, the common law rule in most states provided that the exercise of a nongeneral power of appointment or testamentary general power of appointment would not change the perpetuities period applicable to the property subject to the power, which period related back to the instrument creating the original power. b. Delaware, however, had a unique rule that departed from the common law rule and a provided that a new perpetuities period would start on the exercise of a nongeneral power of appointment. c. In 1951, Congress enacted the predecessor to the current Delaware tax trap to target this Delaware rule because: In the absence of some special provision in the statute, property could be handed down from generation to generation without ever being subject to estate tax. H.R. Rep. No. 327, 82d Cong., 1st Sess d. Although not targeted by Congress, the common law rule in most states also provided that the creation of a presently exercisable general power of appointment ( PEG ) would begin a new perpetuities period, on the view that the ability of the power holder to appoint property to himself/herself at any time is equivalent to ownership. Because tax law also treats a PEG as equivalent to ownership, one might conclude that the creation of a PEG would not trigger the Delaware tax trap. 3. The Trap: Code Sections 2041(a)(2) and 2514(d) a. IRC Sec. 2041(a)(3) provides that the value of a taxpayer s gross estate includes the value of all property: To the extent of any property with respect to which the decedent (A) by will, or (B) by a disposition which is of such nature that if it were a transfer of property owned by the decedent such property would be includible in the decedent's gross estate under section 2035, 2036, or 2037, exercises a power of appointment created after October 21, 1942, by creating another -2-

4 power of appointment which under the applicable local law can be validly exercised so as to postpone the vesting of any estate or interest in such property, or suspend the absolute ownership or power of alienation of such property, for a period ascertainable without regard to the date of the creation of the first power. b. The gift tax companion provision for the Trap is found in IRC Sec. 2514(d). c. Treas. Reg (e)(1)(ii) provides addition guidance on the application of the Trap: (e) Successive powers. (1) Property subject to a power of appointment created after October 21, 1942, which is not a general power, is includible in the gross estate of the holder of the power under section 2041(a)(3) if the power is exercised, and if both of the following conditions are met: (ii) If the power is exercised by creating another power of appointment which, under the terms of the instruments creating and exercising the first power and under applicable local law, can be validly exercised so as to (a) postpone the vesting of any estate or interest in the property for a period ascertainable without regard to the date of the creation of the first power, or (b) (if the applicable rule against perpetuities is stated in terms of suspension of ownership or of the power of alienation, rather than of vesting) suspend the absolute ownership or the power of alienation of the property for a period ascertainable without regard to the date of the creation of the first power. 4. How the Trap is Sprung a. A power is exercised to create a new power of appointment; and b. Under applicable local law, the new power of appointment can be validly exercised to do one of the following for a period ascertainable without regard to the date of the creation of the first power: i. Postpone the vesting of any estate or interest in property; or Suspend the absolute ownership or power of alienation of property. OR c. (Although the legislative history is clear that that the trap was not targeting such powers, arguably if) a power is exercised to create a new, presently exercisable general power of appointment ( PEG ). d. NOTE: Many commentators have suggested that the creation of a PEG by a power holder presents an option for deliberately springing the trap and triggering estate tax in lieu of GST tax (and a practical alternative to a shifting GPA or trustee power to -3-

5 grant a GPA), although given the history and purpose of the Delaware tax trap, one should exercise caution before relying on this application of the law. 5. Power of Appointment Defined a. Treasury Regulations (b) provides that the term power of appointment : includes all powers which are in substance and effect powers of appointment regardless of the nomenclature used in creating the power and regardless of local property law connotations. b. Are fiduciary powers covered (decanting, trust modifications, etc.)? i. In determining whether a power is a power of appointment, the gift estate tax regulations do not distinguish between fiduciary and non-fiduciary held powers. i Treasury Regulations (g)(1) does provide that a transfer by a trustee of trust property in which the trustee has no beneficial interest does not constitute a gift by the trustee, although this provision would not preclude a taxable gift under Section The legislative history suggests that Congress may have intended to exclude fiduciary powers from triggering the trap, but no such limitation appears in the Code or regulations. 6. Interpreting the Trap: Murphy v. Commissioner a. The only reported case that has addressed the DE Tax Trap is the Tax Court s 1979 opinion in Murphy Est. v. Comm r, 71 T.C. 671 (1979). b. Facts: i. Wisconsin law has no perpetuities vesting rule, but provides that (a) the power of alienation may not be suspended for a period longer than lives in being plus 30 years and (b) the power of alienation is not suspended for any period if a trustee has a power of sale. Taxpayer exercised a limited testamentary power of appointment over a trust established by her father in favor of her surviving husband, by creating a trust that gave her husband a limited testamentary power of appointment over the trust corpus. c. The IRS s position in the case was that trap sprung if any of the three conditions of title were violated: (1) postponement of vesting, (2) suspension of power of alienation or (3) suspension of absolute ownership. Because Wisconsin had no vesting perpetuities rule, the IRS argued that taxpayer s exercise should subject the -4-

6 property to estate tax. d. Tax Court holding: i. DE tax trap not sprung where second power cannot be exercised to suspend the vesting or alienation of property under the applicable state perpetuities rule i.e., it is the local rule that is relevant and Congress did not intend to impose a federal perpetuities rule. Because Wisconsin law provided that the power of alienation (the applicable, local perpetuities rule) is not suspended for any period if a trustee has a power of sale over trust assets, the DE tax trap was inapplicable to the power exercise at issue. e. In AOD , the Service acquiesced to the holding in Murphy. f. Tax Court s fuzzy crystal ball: Respondent [the IRS] asserts that acceptance of petitioner s position would leave open to individual States the ability to circumvent section 2041(a)(3) by enacting law similar to those in Wisconsin. Aside from the fact the we think it unlikely that States would take such steps to upset established local property law, any potential for abuse in this area would better be curbed by Congress. g. Key conclusion drawn from Murphy: trap not sprung as long as state law imposes some perpetuities rule (vesting or suspension of alienation) measured for a fixed period beginning on the creation of the first power. h. Linguistic Queries in Applying the DE Tax Trap to Non-Wisconsin Perpetual Trusts: i. By definition, a period can include an indefinite length of time. By extension, one should be able to define a period by reference to its starting point even if the end of the period is unclear. If the DE tax trap requires that a second power can be exercised to postpone the vesting of an interest in property subject to the first power, one can argue that it should not apply to perpetual trusts, since if no interest in a perpetual trust will vest it is not possible to postpone vesting. 7. Murphy & Repeal of the RAP a. When states began repealing the rule against perpetuities, most sought to comply with the Murphy holding in some fashion: i. Category One: Elongated (but fixed) vesting period (1) 1,000 Years (Alaska, Colorado) -5-

7 (2) 500 Years (Arizona) (3) 365 Years (Nevada) (4) 360 Years (Florida) Category Two: Introduce prohibition on the suspension of alienation of property (à la Wisconsin) (1) Illinois (but state did not repeal RAP) (2) South Dakota i iv. Category Three: Combination of the above Notable Holdouts: California ( wait-and-see ) and New York (common law rule), although perpetual trust legislation may be introduced in CA. b. Illinois Perpetual Trusts (765 ILCS 305/3) a Wisconsin-esque approach to eliminate a vesting rule and introduce a suspension of alienation rule: Sec. 3. Definitions and Terms. (a-5) "Qualified perpetual trust" means any trust created by any written instrument executed on or after January 1, 1998, including an amendment to an instrument in existence prior to that date and the exercise of a power of appointment granted by an instrument executed or amended on or after that date: (i) to which, by the specific terms governing the trust, the rule against perpetuities does not apply; and (ii) the power of the trustee (or other person to whom the power is properly granted or delegated) to sell property of which is not limited by the governing trust instrument or any provision of law for any period of time beyond the period of the rule against perpetuities. c. The Delaware Fix i. When Delaware repealed its rule against perpetuities in 1995, it eliminated the vesting rule but, unlike Illinois, did not introduce a rule against the suspension of alienation rule, meaning there was arguably no fixed period to measure for purposes of the Trap. Some commentators have suggested that The (belated) DE fix: 25 Del C. 504: Notwithstanding any other provision of this chapter, in the case of a power of appointment over property held in trust (the "first power"), if the trust is not subject to, or has an -6-

8 inclusion ratio of zero for purposes of, the tax on generation-skipping transfers imposed pursuant to Chapter 13 of the Internal Revenue Code [26 U.S.C. Ch. 13] or any successor provision thereto and the first power may not be exercised in favor of the donee, the donee's creditors, the donee's estate or the creditors of the donee's estate, then every estate or interest in property, real or personal, created through the exercise, by will, deed or other instrument, of the first power, irrespective of: (1) The manner in which the first power was created or may be exercised, or (2) Whether the first power was created before or after the passage of this section, shall, for the purpose of any rule of law against perpetuities, remoteness in vesting, restraint upon the power of alienation or accumulations now in effect or hereafter enacted, be deemed to have been created at the time of the creation of, and not at the time of the exercise of, the first power. For purposes of applying the foregoing rule, if any part of an estate or interest in property created through the exercise of the first power includes another power of appointment (the "second power"), then the second power of appointment and any estate or interest in property (including additional powers of appointment) created through the exercise of the second power shall be deemed to have been created at the time of the creation of the first power. i In essence, Delaware s fix is to provide that the second power is deemed to have been created at the time of the creation of the first power aping the language of IRC Sec. 2041(a)(3) without applying an actual fixed, measurable period. Some commentators have concluded that, absent the presence of any fixed vesting period, the Delaware fix has no substantive effect. See James P. Spica, A Trap for the Weary: Delaware's Anti-Delaware-Tax-Trap Statute is Too Clever by Half (of Infinity), 43 Real Prop. Tr. & Est. L.J. 673 (2009). 8. If A Fixed Period Is Required, Will Any Fixed Period Do? a. Given the lack of historical precedent, and practical equivalent to perpetuity, there is no way to predict how a court would interpret an elongated vesting period to be phony. It is possible that the IRS could argue that the only fixed period that would be respected would be the 90-year period used in the safe harbor regulations concerning the exercise of powers of appointment over GSTgrandfathered trusts, notwithstanding the Tax Court s view in Murphy that the DE Tax Trap does not amount to a federal perpetuities rule. b. Extended vesting periods may raise constitutional issues in the 8 states whose constitutions disallow perpetuities (e.g. Nevada, Arizona) given that perpetuities was historically understood to be anything longer than the common law rule (lives in being plus 21 years). c. The few states that also have a rule against accumulations of income may have failed to deal with such a rule in repealing the RAP (or in enacting a version of -7-

9 USRAP). 9. Addressing the Trap a. Given the magnitude of potential tax liability (and fact that it would subject property to transfer tax that would otherwise be deferred or avoided), and fact that it could be triggered in situations where power exercised in a manner that results in little change to the dispositive provisions of a trust, it is worth considering how to address the trap when exercising a power of appointment over a perpetual trust.. b. If a client is in Wisconsin, or a state that has adopted a Wisconsin-esque approach in which there is rule against the suspension of alienation that applies for a traditional RAP period, then Murphy, combined with a plain language reading of the Code and regulations, provide comfort that the exercise of a power over a perpetual trust to create a second power that similarly permits the preservation of perpetual trust status should not trigger the trap. c. For states with elongated vesting periods, there is a persuasive argument based on Murphy, the Code and regulations, that as long as there is any fixed vesting period, and vesting clock starts for all purposes from the creation of the first power. It is not clear that, absent a change to the statute, the legislative history of the trap would provide sufficient basis to ignore the presence of a fixed period. d. For states, like Delaware, that have no fixed term, it is advisable to consider a conservative structure, although there remains a theoretical concern if a traditional RAP is imposed via trust instrument when applicable state law no longer has such a rule: i. Use a lives in being plus 21 years RAP for all purposes. Provide a limitation on the exercise of a nongeneral power to avoid triggering the trap (i.e., prevent the creation of a second power of appointment that could be exercised to postpone vesting beyond the traditional RAP): No power of appointment granted under this instrument may be exercised by creating another power of appointment that could be exercised to postpone the vesting of any interest in the trust property, or to suspend the absolute ownership or power of alienation of the trust property for a period beyond twenty-one (21) years after the death of the last of [the measuring lives living on the date of this instrument] to die. 10. Conflict of Laws Issue: Cross-Border Creation of Perpetual Trusts a. If a resident of a non-perpetual trust state wishes to establish a perpetual trust, the ability to invoke a perpetual trust statute of another state generally depends on (1) whether an inter vivos or testamentary transfer is made and (2) whether real or -8-

10 personal property is transferred. b. General rules on law governing validity, including applicable perpetuities period (from Bogart, Restatement 2d of Conflict of Laws): i. Testamentary Transfers of Personal Property Less Freedom a) Testator cannot designate law of another jurisdiction if doing so would be contrary to a strong public policy of the testator's state of domicile at death. b) Designated state must have substantial relation to the trust (e.g., situs of trust administration, domicile of trustee/beneficiaries). Inter Vivos Transfers of Personal Property More Freedom c) Settlor cannot designate law of another jurisdiction if application of that law would violate a strong public policy of the jurisdiction designated by the settlor. d) Designated state must have substantial relation to the trust (e.g., situs of trust administration, domicile of trustee/beneficiaries). i Real Property law of situs governs validity. c. Is the RAP a strong public policy? Although case law, and the Restatement (2d Conflict of Laws), suggests otherwise, the case law pre-dates the rise of perpetual trusts. Furthermore, the fact that there was a clear public policy behind the common law RAP means extreme caution should be exercised in: i. Having an individual s revocable trust create perpetual trusts when that individual is domiciled in a non-perpetual trust jurisdiction; or i Having the assets of a resident of a non-perpetual trust jurisdiction pour into a perpetual trust in another jurisdiction at death. Note that the general prevalence of wait and see provisions in states that have retained a traditional vesting period may not invalidate (ab initio) interests created pursuant to the above, but could lead to future administrative uncertainty (or litigation). 11. Will Perpetual Trusts Become Targets? a. A separate question from whether the DE Tax Trap applies to perpetual trusts is whether such trusts will become the target for future legislation. b. Perpetual dynasty trusts are inconsistent with the uniform structure of the estate -9-

11 and gift taxes to impose a transfer tax once every generation. In addition, perpetual dynasty trusts deny equal treatment of all taxpayers because such trusts can only be established in the States that have repealed the mandatory rule against perpetuities. Staff Report of Joint Committee on Taxation, Options to Improve Tax Compliance and Reform Tax Expenditures 393, available at (accessed on March 21, 2012). c. President Obama s FY 2012 budget proposed requiring that the GST exemption allocated to a trust expire on the 90th anniversary of the trust s creation. The proposal would enforce a 90-year maximum term on any new trusts established after the legislation is passed or on new money/assets added to established trusts. d. Although this outline has not focused on decanting powers, the IRS is currently seeking tax consequences on the tax consequences of decanting (which may take the form of the exercise of a fiduciary-held power of appointment). -10-

12 Section Two: Other Tips for Drafting 1. Flexibility in Defining Class of Appointees (& Avoiding Impermissible Exercises) a. Issue: A common wish expressed by clients is to keep assets in the family. This wish often translates into a client granting powers of appointment to descendants but limiting the class of permissible appointees of those powers to only descendants. Doing so, however, limits flexibility in a number of situations which may or may not be important the client: i. Failure to name persons (whether extended family members or charity) as members of the class of permissible appointees will prevent the donee of a non-general power of appointment from naming those persons as default takers of trust property. (See Article 3 of Draft Uniform Powers of Appointment Act). i For GST non-exempt trusts, it may be beneficial to permit include a larger number of potential non-skip persons as permissible appointees, to avoid a GST taxable termination. For inter vivos trusts, failure to include the settlor in the class of permissible appointees would prevent the donee of a power (such as the settlor s spouse), from exercising a power in favor of the settlor if doing so would be desirable due to unforeseen circumstances. b. Drafting Solutions: i. Create second-tier appointees and allow a broader class to receive as takersin-default or in the event no descendants are living at the time of the power exercise: except that the beneficiary may appoint to or for the benefit of a [charitable organization/descendant of my father] no more than a contingent remainder interest that would vest only in the event that no descendant of mine is living. OR the trustee shall distribute so much or all of the remaining trust property (1) to or for the benefit of such one or more of my descendants as the beneficiary appoints by will, or (2) if no descendant of mine is then living, to or for the benefit of such one or more persons or organizations other than the beneficiary, his or her estate, or the creditors of either, as the beneficiary appoints by will. Permit the creation of income-only interests: except that the beneficiary may appoint to or for the benefit of a spouse of a -11-

13 descendant of mine no more than the income for that spouse s life i Grant spouse a power exercisable in favor of descendants of the settlor s mother (if a broad special power of appointment is unpalatable). Note however, that to avoid potential inclusion in the settlor s estate, there should be no prearranged exercise of the power by the surviving spouse in favor of the settlor. 2. Allowing Trustee/Protector Modification of Powers a. Limitations of a Shifting GPA Approach i. For non-gst exempt trust, a common technique to avoid the imposition of a GST taxable termination on the death of a non-skip person is to provide for a shifting general power of appointment, a limited power of appointment that becomes a general power of appointment to the extent a GST tax would be imposed at the non-skip person. i iv. Because GST tax rates and estate tax rates are flat or, in the case of states that impose separate estate or inheritance taxes, the GST tax may be cheaper. This is particularly true because, even if the estate tax would be cheaper, it would be more advantageous to trigger a GST tax: In addition, the GST tax allows multiple skips, whereas property subject to a general power would incur both estate and GST tax to transfer to the same class of persons (grandchildren of the donee of the power). If the beneficiary intends to exercise the general power, that exercise may subject the trust property to the claims of creditors (see Article 6 of Draft Uniform Act). v. Alternatively, it may be more advantageous in certain situations to trigger an estate tax, particularly if a beneficiary has estate/gst exemption that would otherwise be unused (note the creditor exposure point, however). b. Given the difficulty of predicting which power will be most tax advantageous at the time of exercise, it may be preferable to permit an independent trustee or protector to make a limited power a general power of appointment rather than hard-wiring the decision on what transfer tax will be incurred. c. Similarly, for non-gst exempt trusts, it may be beneficial to permit an independent trustee or protector to expand the class of permissible appointees to include additional non-skip persons. d. Note that because a nongeneral power of appointment (non-peg) is not regarded as an interest in property, a beneficiary exercising a power of appointment may create a -12-

14 such a non-fiduciary power via the exercise 3. Remember to Include Perpetuities Provisions in GRATs/QPRTs/CLATs (for Opt Out States) a. For states (like Illinois and Ohio) were a settlor must opt out of the common law perpetuities rule to create a perpetual trust, the failure to include an express opt out in a trust where property will pass in further trust (whether outright or pursuant to a power exercise) will mean the default perpetuities rule will apply. b. This is particularly important for clients who, given their asset base, may wish to allocate GST exemption to property passing via a successful GRAT (at the expiration of the ETIP), since the use of a perpetual trust arguably amplifies the benefit of GST-exempt dynasty trusts. 4. Structuring Trusts for Non-Qualified Disclaimers of General Powers of Appointment a. In a number of states (e.g., California), an individual can make a valid disclaimer of a power of appointment for state law purposes, even if that disclaimer is not respected for federal tax purposes under Section b. Some differences between the Section 2518 requirements and state law may include timing (a state may permit a disclaimer within a reasonable timeframe that exceeds 9 months) or the ability to direct the benefits (state law may permit a disclaimant to serve as trustee over disclaimed property, although the retention of certain powers may cause the property to be included in the disclaimant s estate under Section 2036 or 2038). c. Property passing pursuant to a valid state law disclaimer that does not satisfy the requirements of Section 2518 will be treated as a taxable gift (and a taxable transfer for GST tax purposes, if applicable) by the disclaimant. Because of the tax exclusive nature of the gift tax, property passing via a transfer subject to gift tax is cheaper than property passing subject to estate tax, so it may be more tax-efficient to trigger a gift tax than an estate tax. d. A valid state law disclaimer will not be treated as a transfer from the disclaimant, meaning that the disclaimant s gift and GST tax exemption may be utilized with a non-qualified disclaimer without subjecting the property to the disclaimant s creditors, which would not be the case if assets were first transferred directly to the disclaimant. Note, however, that although a surviving spouse may benefit from disclaimed property without violating the requirements for a qualified disclaimer under Section 2518, property passing pursuant to a non-qualified disclaimer by the surviving spouse could be included in the surviving spouse s estate if he or she retains a beneficial interest in or certain powers over the disclaimed property. -13-

15 5. Counterpoint: Drafting to Limit the Use of Powers Letting the Dead Hand Reign a. Settlors who have strongly-held beliefs about the dispositive provisions of a trust may not wish for fiduciary or non-fiduciary-held powers to be exercised in a manner that would radically alter the provisions of the trust, may wish to prohibit the use of decanting, or specify the circumstances in which decanting can be used (e.g. to address changes in tax law) and not used (e.g., to eliminate beneficiaries, change distribution standards, etc.). b. Similarly, settlors may wish to limit the ability of trust beneficiaries to modify powers of appointment or other terms of the trust under the more liberal trust modification statutes that have been introduced in a number of states. c. If possible, such anti-decanting or anti-modification provisions should reference the application statutory provisions in the initial trust jurisdiction and provide that any modification to the anti-decanting provision would defeat or impair a material purpose of the trust (since many state decanting statutes limit the ability to decant in such circumstances). -14-