HOW NOT TO DESIGNATE A REVOCABLE TRUST AS AN INSURANCE POLICY BENEFICIARY

In a recent Florida case that likely has relevance to other states, a decedent established a revocable trust for the benefit of his heirs. The trust had typical language that directed that the after the death of the settlor, the trust should be used to pay death obligations of the decedent and his estate. After such payment, the remaining trust proceeds would be used to fund residuary trusts for the decedent’s children.

The decedent named the revocable trust as beneficiary of two life insurance policies on his life. Due to financial reversals during his lifetime, at the time of his death the insurance proceeds were needed by his estate to pay the decedent’s death obligations, and thus would not pass to the trusts for the children.

The decedent’s personal representative and the trustee of his revocable trust (who was the same individual) asserted that Fla.Stats. §222.13(1) exempted the insurance proceeds from the claims of the decedent’s creditors.  Fla.Stats. §222.13(1) reads:

Whenever any person residing in the state shall die leaving insurance on his or her life, the said insurance shall inure exclusively to the benefit of the person for whose use and benefit such insurance is designated in the policy, and the proceeds thereof shall be exempt from the claims of creditors of the insured unless the insurance policy or a valid assignment thereof provides otherwise.

The decedent’s creditors claimed that Fla.Stats. §222.13(1) didn’t apply to protect the insurance benefits because the proceeds were payable to the revocable trust, and the revocable trust expressly provided for the payment of the decedent’s death obligations. The trial court agreed with the creditors, and on appeal, the appellate court concurred.

The court noted that a payment of insurance proceeds to a trust does not void the statutory exemption under Fla.Stats. §222.13(1). However, Fla.Stats. §733808(1) makes it clear that life insurance payable to a trust “shall be held and disposed of by the trustee in accordance with the terms of the trust as they appear in writing on the date of the death of the insured.” Since the terms of the trust directed payment of the decedent’s death obligations, then those terms would be given effect. Pursuant to the court’s reference in footnote 4 to  Fla.Stats. §733.808(4) which addresses payments to a revocable trust and the statutory direction for the payment of death obligations from a revocable trust, the court did not appear to believe that provision changed the analysis.

The case is relevant since oftentimes insurance, annuities, and other plan assets designate a trust to be established under a will or trust at the death of a decedent as the beneficiary. This allows the proceeds to pass into trust for the beneficiary and not outright to him or her, without the establishment of a separate trust for that purpose. Clearly, as this case confirms, a designation directly to the revocable trust which bears death obligation payment provisions will open such payments up to estate creditors.

While not addressed by the court, the better course of action would have been beneficiary designations directly to the testamentary subtrusts established under the revocable trust agreement, and not the revocable trust itself. Such subtrusts will usually themselves not be subject to the reach of the reimbursement obligation to the decedent’s estate as to assets flowing into them from assets situated outside of the revocable trust. Nonetheless, an express provision to that effect in the trust agreement  (i.e., that testamentary funding of a subtrust from insurance proceeds or other beneficiary designations is not intended to subject the funding assets to the  death obligation payment provisions of the revocable trust) would be helpful to avoid the interpretative issue whether it is intended that such fundings are subject to the death obligation payment provisions. Presumably, the statutory death obligation payment provisions (which exist outside of the payment provisions which are in the trust) will likely not be operable against such proceeds either, per the provisions of Fla.Stats. §733.808(4) which reads that a beneficiary designation to a trust “shall not be subject to any obligation to pay the expenses of the administration and obligations of the decedent’s estate or for contribution required from a trust under s. 733.607(2) to any greater extent than if the proceeds were payable directly to the beneficiaries named in the trust.”

While the above analysis does turn in part on Florida statutory law, it was the combination of the payment of the insurance proceeds directly to the revocable trust (and not a testamentary subtrust) and the express payment language in that trust, that created the problem. Therefore, the concept of choosing the right trust as beneficiary likewise should also have application in other states where the proceeds of life insurance payable directly to a beneficiary are not subject to the claims of a decedent’s creditor.

As an aside, the trial court and appellate court also turned down an attempt to reform the the trust to not have the death obligation payment provisions apply to the insurance, citing a lack of proof of intent that this is what the settlor intended.

Morey v. Everbank, 2012 WL 3000608 (1st DCA July 24, 2012)

IRS VICTORY IN FBAR WILFULNESS PENALTY CASE

[This entry was prepared by Mitchell Goldberg of our office]

In an unpublished opinion, the Fourth Circuit Court of Appeals in U.S. v. Williams, reversed the district court’s holding that the taxpayer’s failure to file Form TD F 90-22.1 (“FBAR”) was not willful and in so holding, gave the IRS a boost in its efforts to combat offshore noncompliance.  A case out of the District Court of the Eastern District of Virginia, Williams had been one of the few sources of precedent for how willful FBAR penalties will be enforced.  The District Court held in favor of the taxpayer, finding, in part, that mere failure to check “yes” as to whether the filer held an interest in a foreign account on Schedule B of Form 1040 was insufficient, alone, to prove willfulness, and the facts and circumstances had to be examined to determine willfulness.  The Fourth Circuit reversed the lower court’s holding as being clearly erroneous.  Significantly, without examining the facts and circumstances, the Fourth Circuit found that the taxpayer’s signature on his return was “prima facie evidence that he knew the contents of the return.”  Moreover, the Second Circuit found that the instructions to line 7a of Form 1040, which cross referenced the FBAR requirement, put the taxpayer on “inquiry notice” of the FBAR filing requirement.  Such notice, combined with the taxpayer’s admission that he never read his tax return nor consulted the FBAR form, resulted in a “conscious effort to avoiding learning about reporting requirements... meant to conceal or mislead sources of income or other financial information... that constitutes willful blindness to the FBAR requirements.”  (emphasis added).  The Fourth Circuit therefore held that the taxpayer willfully failed to file FBARs and found him liable for willful penalties under 31 USC § 5314.

U.S. v. Williams (4th Circuit, unpublished)

APPLICABLE FEDERAL RATES–AUGUST 2012

CLAWBACK DISCUSSIONS WITH PROF. PENNELL

I have written on the unified credit clawback issue previously, both here and here. I have had some email discussions with Professor Pennell, and wanted to share with you some of the salient points since they will be of interest to those who are involved with this issue.

If you read my larger analysis here, you will note that the key issue in this area is whether the computations for estate tax purposes that involve prior gifts require the use of the unified credit amount as it existed in the year of the applicable gift or the year of death. While it is my belief that there ultimately will be no clawback asserted, and the unified credit amount will be used in the above computation based on the date of death credit to effect that, I cannot completely eliminate the possibility of clawback being applied under the existing statute and regulations.

One aspect that some use to support the possibility of clawback are the current Form 706 instructions which if applied in their current form could allow for it. Professor Pennell is vehemently against giving any consideration to the current instructions. He wrote to me:

The instructions . . . do not and could not say anything about the problem at hand . . . because we have never been in an environment in which the exclusion amount has declined. . . . And . . . an instruction to a form is not in any sense the law.

His points are valid and should be considered in handicapping the likelihood of clawback being applied by Treasury in the future.

He also places a lot of emphasis on the Code and regulation provisions that require the use of tax rates as they exist in the year of death to support year of death applicable credit amounts as well.

…the unified credit is defined in the Code by two factors, the exclusion amount and the tax rate. And the regulations DO address those two factors . . .  by telling us which tax rate and which exclusion amount to use.

There is merit to this, too, since the tax rates do inform the unified credit computation, but as of now at least, the provisions are still too ambiguous to me to unequivocally resolve the issue.

My thanks to Prof. Pennell for taking the time to discuss these issues with me, and to allow me to share the above excerpts with our readers.

FBAR SCAM

A recent article warns of a current email scam that attempts to trick recipients into sending bank account to the scammers. The email comes with “Report of Foreign Bank and Financial Accounts (FBAR)” in the heading, and advises the recipients that there is a problem with their tax return and that they need to provide bank account information to the IRS. Of course, it is not the IRS making the request but scammers seeking to obtain bank account information.

Read more about the scam here.

RECENT CHANGES IN PRINCIPAL AND INCOME ACT ACCOUNTING [FLORIDA]

The following are some highlights of recent legislative changes, effective in 2013:

Carrying Value Definition. In fiduciary accountings, “carrying value” is the value of an asset when acquired by the fiduciary. Beneficiaries will often use the value to determine how the fiduciary has performed over time by comparing the current value of an asset to its carrying value. Fla.Stats. §738.102 clarifies that for estates and revocable trusts, this value is set at the value on the date of death. It also allows that if there is a change of fiduciaries, the fiduciaries can adjust the carrying value to fair market value at the time of change if done on the next accounting. This avoids fiduciaries being judged on values that were attributable to the period prior to when they became fiduciaries.

Unitrusts. Fla.Stats. §738.104 now allows a conversion of a trust to a unitrust without required a release of the power to adjust by the trustee. Fla.Stats. §738.1041 now employs a three year averaging rule in computing unitrust payouts unless a trust explicitly provides otherwise – this will provide smoothing in payouts in years with high volatility in values of assets.

Distributions to Beneficiaries. In the past, distributable income that was allocable among multiple beneficiaries was allocated based on their fractional interest in estate or trust assets based on date of distribution values. Fla.Stats. § 738.202(1) simplifies these computations by now using carrying values for this computation. Fla.Stats. §738.202(2)(a) now says to exclude unpaid liabilities from the assets in these computations.

Large Distributions from Publicly Traded Entities. New Fla.Stats. §738.401(3)(e) directs that distributions from publicly traded entities that exceed 10% or more of the value of the ownership interest will not be fully allocated to income, but will be allocated in part to income and in part to principal based on a 3% rate of return computation.  Correspondingly, publicly traded interests are removed from the partial liquidation reallocation rules that apply under Fla.Stats. §738.401(3)(c) per revised (5)(b) of the statute.

Distributions from Pass-Through Entities. Fla.Stats. §738.401(7) has been substantially revised and somewhat simplified. The general rule for distributions from entities is that distributions are income, not principal. Fla.Stats. §738.401(7) will instead disregard the entity and look to the assets generating the income in making the income vs. principal characterization when there is an individual trustee, the distributing entity is a pass-through entity and an investment entity, and the  trustee has the power to adjust.

Distributions from Deferred Compensation Plans, Annuities, and Retirement Plans Fla.Stats. §738.602 is simplified in its approach to using unitrust computations to allocate between income and principal.

Life Estates (or term for years tenancies) and Remainders. Fla.Stats. § 738.801 has been added to provide statutory rules for allocating expenses between the holder of the current tenancy and the remaindermen for nontrust interests.

Florida Laws, Chapter 2012-49

WHAT HAPPENS IF YOU DON'T PAY THE PENALTY FOR NOT HAVING HEALTH INSURANCE?

Not much! A recent Washington Post article tells us:

The law...severely limits the ability of the IRS to collect the penalties. There are no civil or criminal penalties for refusing to pay it and the IRS cannot seize bank accounts or dock wages to collect it. No interest accumulates for unpaid penalties.

So how can the IRS enforce the mandate? Scary letters and threats to withhold tax refunds.

The law allows the IRS to withhold tax refunds to collect the penalty, and most filers get refunds. This year, 77 percent of the 135 million individual income tax returns processed by the IRS qualified for a refund. The average refund: $2,707.

For those who don’t qualify for a refund, a stern letter from the IRS can be effective, even if it doesn’t come with the threat of civil or criminal penalties, said Elizabeth Maresca, a former IRS trial attorney who supervises the Tax & Consumer Litigation Clinic at the Fordham University law school.

"Most people pay because they're scared, and I don't think that's going to change," Maresca said.

FIDUCIARIES TAGGED UNDER FEDERAL PRIORITY STATUTE

Fiduciaries (trustees, executors, personal representatives) normally are not personally liable for the obligations of the trusts and estates they administer. As mentioned here previously, a major exception to this is the federal priority statute (a/k/a the federal claims statute) under 31 USC §3713(b)/Code § 6901(a)(1)(B). This little gem can create personal liability for a fiduciary that pays out estate or trust assets (including by reason of a distribution to beneficiaries) with knowledge that there are existing federal liabilities (such as taxes) that are unpaid, if the estate or trust is unable to later satisfy those liabilities.

This is not an abstract risk, but a very real liability for fiduciaries, as two fiduciaries learned in a recent case in Texas. In that case, the IRS asserted that a decedent did not pay gift taxes during lifetime, attributable to gifts indirectly made to the decedent. That is, the original donor did not pay the gift taxes on gifts to the decedent, so the decedent was liable for the gift taxes as a transferee. Both the executor of the decedent’s estate, and the trustee of his revocable trust, were knowledgeable of the IRS’ claim but nonetheless paid out funds without making provision for the payment of the gift taxes.

The case is illustrative of various aspects of the statute.

   A. The executor was liable for personal property that was distributed to beneficiaries. This is a common problem since by the time the family gets to the lawyers, they have often already made these distributions. This can be a problem under the claim statute, and also state statutes regarding priority of expenses and distributions.

  B. The executor was liable for rent payments made by the estate. Such payments are subordinate in priority to the federal claim for taxes.

  C. The executor was NOT liable for funeral and last illness expenses. While the federal statute does not on its face allow an exception for these items and other administrative expenses, case law exceptions to these payments exist to the extent they have a priority for payment under state law.

  D. The trustee of a revocable trust got caught up in the statute because the trustee was deemed to be the equivalent of a representative of the estate due to the obligation of the trust to pay the decedents debts.

  E. The fiduciaries had taken income tax charitable deductions for over $1.1 million that had been set aside to fund charitable bequests.  Such bequests were subordinate to the federal claim, so the fiduciaries were held personally liable for those set-aside amounts because the court found that the funds were beyond the reach of the IRS. Presumably, since those set-aside amounts were still held in the trust, the fiduciaries will have direct access to those funds to pay the liability, but perhaps the charities can somehow block that in the same fashion that the IRS and the court found that the IRS did not have access to those funds. In the case, the amount of the other expenditures that created liability for the fiduciaries was minuscule compared to this potential $1.1 million exposure.

  F. The fiduciaries were liable for legal and other expenses they paid for the charities. The court noted that payment of legal fees of the estate and trust for administrative purposes are generally not subject to the claim statute, but since these were obligations of third parties then they were not exempt under the statute.

  G. The fiduciaries do not have to receive formal notice or a claim from the IRS, to be on notice for purpose of the statute. The court provided:

the knowledge requirement is not actual knowledge. Leigh, 72 T.C. at 1110. It is sufficient to show that the fiduciary had “notice of such facts as would put a reasonably prudent person on inquiry as to the existence of the unpaid claim.” Id. Neither Marshall nor Hilliard contend that they were never told that the IRS might try to make a claim against Stevens for the unpaid gift taxes on the Gift. In fact, they admit that they were both told that the IRS might try to assert a claim against Stevens's Estate for donee liability on the Gift.

H. The fact that the fiduciaries did not believe the IRS’ claim was valid, or that they relied on their professionals, did not relieve them of liability. The court noted:

[T]hey argue that they did not believe the IRS's claim against Stevens was valid for various reasons. But, as the government points out, Marshall and Hilliard's belief in the validity of the government's claim is not the test. Marshall and Hilliard had sufficient notice of the claim to put a reasonably prudent person on notice. It is regrettable that they received incorrect advice on that point, but poor legal advice is not a defense. Despite their belief that the government's claim was not valid, Marshall and Hilliard were required by § 3713 to preserve the funds to pay the government's claim—should it be proved valid.

U.S. v. MACINTYRE, 109 AFTR 2d 2012-XXXX, (DC TX), 06/25/2012

IRS DISAPPROVAL OF VALUATION METHOD DOES NOT PREVENT THERE BEING A QUALIFIED APPRAISAL

To obtain a charitable deduction for many contributions of property, the taxpayer is required to obtain a “qualified appraisal” and submit that appraisal with the income tax return. Treas. Regs. §1.170A-13(c)(ii) contains a laundry list of items that must be included in the appraisal for it to be  qualified appraisal. One of these items is a description of  the “method of valuation used to determine the fair market value, such as the income approach, the market-data approach, and the replacement-cost-less-depreciation approach.”

If the IRS can show that no qualified appraisal was submitted, then it will seek to disallow the charitable deduction in full. If, instead, the IRS contests the appraised value, then the parties will negotiate, or fight out in court, over what is the appropriate value for deduction purposes. Obviously, for a taxpayer, it is better to be in the latter scenario (some deduction) than the former (no deduction).

In a recent case, the Tax Court had ruled that the above descriptive requirement was not met when an appraisal for a donated conservation easement described the appraisal method as the before-and-after method, using a fixed percentage reduction in the after-contribution value to determine the before value, and thus the value of the contribution. The Second Circuit Court of Appeals has now reversed the Tax Court. In its opinion, the Court noted that the above qualified appraisal requirement did not require that the valuation method be one that the IRS accepted – the requirement only goes to whether the method was properly identified. More particularly, the Court said:

For the purpose of gauging compliance with the reporting requirement, it is irrelevant that the IRS believes the method employed was sloppy or inaccurate, or haphazardly applied—it remains a method, and Drazner described it. The regulation requires only that the appraiser identify the valuation method “used”; it does not require that the method adopted be reliable.

Scheidelman v. Commissioner of Internal Revenue, 2nd Circuit Court of Appeals (6/15/12)