FAILURE TO DIVIDE ESTATE INTO MARITAL AND NONMARITAL TRUST–WHAT HAPPENS AT DEATH OF SURVIVING SPOUSE

Upon the death of wife, wife’s assets were supposed to be divided into two marital deduction trusts and a bypass family trust. An estate tax return was filed, and an estate tax deduction was taken for the transfer that was supposed to be made to the marital trusts.

No division was ever made during husband’s remaining lifetime after wife’s death. Instead, the combined assets were reported for income tax purposes as one trust. When husband died, the issue arose as to how much of the remaining assets should be included in husband’s gross estate per being held in marital trusts under §2044, and how much was not to be included as being held in the family trust.

Not surprisingly, the husband’s estate argued that none of the trust assets were includible. Its theory was that $393,978 that had been withdrawn and put in the account of the husband after the death of the wife had come from the marital trust assets, and that a similar depletion of the marital trust assets occurred for $1,080,802 that had been withdrawn and paid to charity. With those withdrawals, and working backwards from what should have been used to fund the marital trust, in their estimation there was nothing left in the marital trust.

The IRS took the opposite tack and asserted that ALL of the remaining assets were in the marital trusts.

The Tax Court took a facts and circumstances approach, and did its best to determine which trusts should be charged with the withdrawals that had occurred. It found that the $393,978 that was paid to the husband’s account must have come from the marital trusts under the HEMS provision of those trusts, since the family trust provisions did not allow for distributions to the husband of principal. It then charged the charitable contributions to the family trust, again seeking which trust should be deemed to have paid out its assets based on the authorized distributions in each. After accounting for those distributions, it then provided what portion of the total remaining assets were allocable to the marital trusts and thus includible in the husband’s gross estate.

The fact that the division of assets did not occur at the death of the first spouse should not come as a surprise. Oftentimes, the proper professionals are not involved at the time of the first death, or the family or trustees do not follow their instructions, and thus the proper division does not occur. The problem is often not uncovered until the death of the surviving spouse.

The case confirms that the parties will not be “punished” for failing to make the division. Instead, the proper course of action is to make a constructive division as if the proper division occurred, and then attempt to deal with intervening occurrences prior to the death of the second spouse in a reasonable manner (such as the substantial distributions made in the subject case).

Estate of Elwood H. Olsen, et al., TC Memo 2014-58

DURABLE POWER OF ATTORNEY HOLDERS AND FBAR LIABILITY – WHAT THE HECK!

U.S. persons with an interest in a non-U.S. account must annually file a FinCEN Form 114, Report of Foreign Bank and Financial Accounts (FBAR) if the aggregate maximum values of the foreign financial accounts exceed $10,000 at any time during the calendar year. FinCEN Form 114 superseded Treasury Form TD F 90-22.1 and must be filed electronically through the BSA E-Filing System. Having ‘signature authority’ over a foreign account is enough of an interest in the account to be required to report it on an FBAR. Penalties for nonfiling can be quite substantial, including 50% of the value of the account for willful violations (repeated for each year of violation). Criminal penalties can also apply.

The IRS recently issued a “Reference Guide on the Report of Foreign Bank and Financial Accounts (FBAR),” which summarizes and augments previously published information on the FBAR filing requirements. The Guide defines ‘signature authority’ as “the authority of an individual (alone or in conjunction with another individual) to control the disposition of assets held in a foreign financial account by direct communication (whether in writing or otherwise) to the bank or other financial institution that maintains the financial account.” It then goes on to provide this example of signature authority:

Example: Megan, a United States resident, has a power of attorney on her elderly parents’ accounts in Canada, but she has never exercised the power of attorney. Megan is required to file an FBAR if the power of attorney gives her signature authority over the financial accounts. Whether or not the authority is ever exercised is irrelevant to the FBAR filing requirement.

Powers of attorney, especially durable powers of attorney, are a staple of estate planning. Planners will suggest them at the time estate planning documents are done so as to allow a trusted family member or friend to handle financial and legal affairs in the event of incapacity. Many, if not most, of durable powers of attorney, include authority to sign on behalf the principal for bank accounts of the principal. Per the above Example and the Guide’s definition of signature authority, persons named in such powers of attorney appear to be at risk for FBAR filing obligations and penalties in regard to foreign accounts of the person issuing the power – holy cow! One can legitimately question how many of such power holders (or their tax preparers or other tax professionals) are aware of this responsibility. One can also question the appropriateness of this responsibility and liability.

Some thoughts, observations, and concerns:

• Durable powers are set up before there is incapacity, and thus there may be a long period of dormancy where the powers are not exercised because the principal is well and capable of managing his or her own financial affairs. In most such situations, the power holder is not doing anything and often has no knowledge of the assets or accounts of the principal. It is clearly not the norm for such power holders to ask, inquire, or gather information regarding the accounts of the principal. So how is the power holder to know about the accounts? Is the IRS now requiring that the entire dynamic of the durable power of attorney relationship be modified, such that the power holder must inquire and obtain details of the principal’s accounts?
• Often, the power holder does not even know they are appointed. The durable power is signed, but then may be kept with the testator’s estate planning documents and not delivered to the power holder until it is needed. Alternatively, the powers are often left in escrow or custody with the estate planning attorney, to be released only if the attorney learns of a need for their use. How will the IRS address this situation? See the discussion below regarding lack of knowledge.
• Some states allow for “springing” powers – powers that are not effective until the principal is incapacitated or has some other mental or physical condition. Thus, even if the power holder knows of its existence, he or she may not be advised once it becomes effective. One can also foresee disputes with the IRS over when or if such springing power took effect.
• How effective will a “lack of knowledge” defense be to penalties? Even if effective for removing the most egregious penalties that rely on willfulness, it may not remove all penalties, such as a non-willful violation (up to $10,000 per violation) and negligent violations (up to $500). Further, no one wants to rely on proving lack of knowledge – it is unknown how many levels of IRS audit, review and litigation may be needed to prevail on such a claim, if one is successful at all. It is not an easy thing to prove a negative. At a minimum, the IRS should clarify that lack of knowledge voids the penalty.
• What happens if the principal reports the account, but the account holder does not, or vice-versa? The guide, in discussing agents in general, indicates that both of them must file (if both are U.S. persons).
• If a power of attorney is signed in the U.S., there is always the question of its enforceability in foreign jurisdictions. This might be another area of dispute with the IRS. As to filers, it would not be a good idea to rely on this – as in most foreign filings where there is a question, the better advice is usually to file notwithstanding any uncertainty.
• Most durable powers of attorney do not specifically describe each account to which it applies with specificity, but instead have a general description by type – e.g., “bank accounts” and “brokerage accounts.” The general definition of ‘signature authority’ coupled with the Example lead to the conclusion that the IRS intends to apply this rule to such generally described accounts. The Example describes a power of attorney over an account. Perhaps the example can be read narrowly to apply only to a specifically named account in the power of attorney instrument. If so, that would remove most of the above concerns, and if that is intended the IRS should so clarify the example. It would be a logical and fair limitation on such liability.

Reference Guide on the Report of Foreign Bank and Financial Accounts (FBAR)

SHORT-FORM FORM 1023 OUT BY SUMMER

Most organizations seeking Code §501(c)(3) tax-exempt status must file a 25+ page Form 1023 application. In a major change to this time-consuming procedure, the IRS will soon be issuing a short form three page Form 1023-EZ for smaller applicants to use.

The short form can be used by organizations that do not expect to have annual gross receipts of more than $200,000 in the next 3 years or in the prior 2 years, and do not have total assets in excess of $500,000. Some organizations that meet this criteria will still not be allowed to use the form, including foreign organizations, limited liability companies, successors to for-profit entities, churches, schools seeking public charity status, and hospital and medical research organizations seeking public charity status.

The apparent idea is to relieve smaller organizations from submitting an application that is based mostly on future projections anyway.Rather than using IRS resources to examine these applications, the IRS will instead employ a robust compliance process later, either through compliance checks or full examinations.

The IRS draft of April 23, 2014 of the Form 1023-EZ can be viewed here.