Tax Law Update: Trusts and Estates

Tax Law Update: Trusts and Estates

By Alison E. Lothes, co-written by David A. Handler
Originally written for WealthManagement.com

Tax Court denies estate’s income tax charitable deduction because the amount wasn’t “permanently set aside” due to pending litigation

—In Estate of Belmont v. Commissioner (144 T.C. No. 6 (Feb. 19, 2015)), the U.S. Tax Court held that an estate wasn’t entitled to a charitable income tax deduction under Internal Revenue Code Section 642(c) because the decedent’s brother’s litigation against the estate risked that the amounts set aside wouldn’t be used for charitable purposes.

Eileen Belmont died in 2007 owning a primary residence in Ohio, a condo in Santa Monica and a pension retirement account. Her will provided that a $50,000 bequest be paid to her brother and the remaining estate be paid to the Columbus Jewish Foundation (the Foundation), an IRC Section 501(c)(3) organization.

The condo was the sticking point. She bought it in 2003 after her mother died. In 2006, she permitted her brother David to move into the condo; he’d been living there for about nine months when she unexpectedly died in April 2007. David wanted to continue to reside there and asked the Foundation if he could exchange his bequest for a life tenancy in the condo. However, the Foundation wasn’t amenable to David’s request. He then filed a creditor’s claim with the Probate Court, which was denied in May 2008. He next filed a Petition to Confirm Interest in Real Property, again with the Probate Court, on which he ultimately prevailed in 2011.

The estate filed its fiduciary income tax return on July 17, 2008. An accountant who wasn’t informed of David’s claim against the condo prepared the return. It claimed a charitable deduction on the basis of leaving the residue of the estate to the Foundation. The funds then thought to be payable to the Foundation weren’t segregated or otherwise set apart from the general funds used by the estate to pay its expenses.

Under IRC Section 642(c), an estate may claim a charitable contribution deduction if the contribution is made from the estate’s gross income pursuant to the terms of a governing instrument, and the contribution is permanently set aside for charitable purposes. The deduction was from gross income because it was to be paid from a distribution received from the retirement plan (which is gross income) and was made pursuant to the will (a governing instrument). However, for funds to be considered “permanently set aside” under the Treasury regulations, the possibility that the amount set aside won’t ultimately be devoted to such charitable purpose must be “so remote as to be negligible.” The court held that there was more than a negligible risk that the costs of defending David’s claims could dissipate the estate. These claims were known at the time the income tax return was filed, as he’d already filed his creditors claim in Probate Court and refused to vacate at the estate’s request. And, the estate contained no other income-producing assets and had other various expenses that would deplete its residue.

Trustee held liable for breach of trust despite exculpatory provisions in trust instrument absolving him of responsibility relating to insurance policies

—In Rafert v. Meyer (290 Neb. 219 (Feb. 27, 2015)), the Nebraska Supreme Court held a trustee liable for breach of trust, despite a trust instrument that purported to relieve him of all responsibility relating to insurance policies held by the trust.

Jlee Rafert established an irrevocable insurance trust to own three insurance policies on her life, the total death benefits of which were over $8 million. Her attorney, Robert Meyer, drafted the trust and was the initial trustee. He completed the policy applications and used a false address for his contact information (no explanation is given as to the reason for the false address). The trust instrument provided that he had no obligation to pay (or ensure payment of) premiums on the policies held by the trust or notify anyone about nonpayment and that he wasn’t subject to liability in the event of nonpayment. He did have an obligation to furnish annual reports to trust beneficiaries.

Jlee made the initial premium payment of over $290,000. She made a second premium payment, but the insurance broker never forwarded the payment to the insurance companies. The notices of nonpayment were sent to the false address and never received by Robert; consequently, Jlee and the beneficiaries (her daughters) were unaware that the policies lapsed. They sued for breach of fiduciary duty, but Robert argued that he wasn’t liable due to the explicit provisions of the trust.

The Nebraska Supreme Court disagreed. It held that under the Nebraska statute, the terms of a trust don’t prevail over the duty of the trustee to act in good faith and in the interests of the beneficiaries and to keep qualified beneficiaries of a trust reasonably informed about facts necessary to protect their interests. Further, even if such terms were exculpatory and could prevail over the statute, the court held that they wouldn’t prevail in this case because Robert didn’t adequately explain these terms to Jlee. The court held that the trust instrument didn’t override Robert’s duty of good faith or his duty to keep the beneficiaries informed.

Rafert is of interest because its situation (other than the false address) isn’t uncommon: Many insurance trusts include terms reducing the trustee’s responsibility and liability relating to insurance policies held by the trust. This case is a good reminder that any exculpatory language needs to be communicated to the client. The client needs to decide who’s responsible for maintaining, evaluating and paying for the policies and make an informed decision if he’s going to let the trustee off the hook. And, the trustee still has fiduciary duties, even if the trust instrument says otherwise.