Funding marital trusts: Mistakes and their consequences
Soled, Jay AEditors' Synopsis: This Article illustrates the various formulas and clauses used to properly fund testamentary trusts and their effects on estate taxes. The authors then discuss common mistakes made in funding marital trusts, interested party litigation, and potential tax consequences arising from underfunding marital trusts.
Jay A. Soled*
Dena L. Wolf**
Nathan E. Arnell***
I. INTRODUCTION
II. FUNDING THE MARITAL TRUST
III. FUNDING MISTAKES
A. Poorly Drafted Funding Clauses B. Incorrect Valuation of the Assets Used to Fund the Marital Trust
C. Misunderstandings of the Law
D. Delays in Estate Administration
IV. CAUSES OF ACTION AND STATUTES OF LIMITATION
A. State Court Proceedings
B. Federal Court Proceedings
V. INTERNAL REVENUE SERVICE'S RESPONSE
A. Time to Commence Action
B. Effects of Transfer
VI. RECOMMENDATIONS
VII. CONCLUSION
I. INTRODUCTION
"To err is human ...."
Alexander Pope, An Essay on Criticism
Mistakes occur in every profession, and attorneys practicing estate administration are not immune from this phenomenon. Funding marital trusts at the death of the first spouse engenders numerous opportunities for mistakes given the complex and technical nature of the tax law and the variety of funding clauses.1 Mistakes in funding marital trusts remain prevalent and cannot be overstated, as the result is often lengthy litigation and needless estate and gift taxes. Therefore, the practice of estate administration and funding of marital trusts demands an awareness of both the possibility of these errors and the various available remedial options.
To illustrate the origin of the problem, this Article explains how to properly fund testamentary trusts at the death of the first spouse and how to reflect this funding on an estate tax return. Next, this Article discusses common mistakes made in funding the marital trusts, interested party litigation, and potential tax consequences arising from underfunding the marital trust. Finally, this Article demonstrates that, while mistakes are certainly not unique to estate administration, mistakes involving the funding of marital trusts are commonplace and have the potential to be particularly nettlesome.
To help set the stage, a fact pattern that will be referred to throughout the text is set forth below: Husband (H), having made no taxable gifts during his lifetime, dies with a gross estate of $2 million. He is survived by his second wife (W), his son (S) from his prior marriage, and his daughter (D) from his current marriage. The terms of H's will establish two trusts. The first trust (Trust A), funded by a pecuniary bequest, creates an income interest for the benefit of W during her life and, upon her death, provides that the trust corpus passes to S. The second trust (Trust B), funded by a residuary bequest, permits discretionary distributions to W and, upon her death, provides that the trust corpus passes to D. H's executor indicates on the decedent's federal estate tax return (Form 706) that Trust A will be funded with $1.4 million and Trust B will be funded with $600,00. Furthermore, the executor elects to qualify all the property passing into Trust A for the marital deduction.2 As H made no taxable gifts during his lifetime, no federal estate tax is due at H's death.3
Using the above fact pattern, suppose that at the date of distribution, due to the improper valuation of H's assets, Trust A is funded with assets having a fair market value of $1 million, and Trust B is also funded with assets having a fair market value of $1 million. If this mistake goes undetected, the remainder beneficiaries under Trust B will enjoy a tremendous tax windfall. In addition to the $600,000 and appreciation thereon not included in the estate of W at the date of her death, the $400,000 overfunding and appreciation thereon likewise will escape estate taxation.4 Assuming the estate tax rate at the date of W's death is 50%, this mistake offers an immediate e-state tax savins of V200,000.5
Suppose that S or the Internal Revenue Service discovers this mistake prior to, simultaneously with, or sometime after W's death. What courses of action can be taken to correct the executor's or the trustee's error? What latitude do the trustees of Trust A and Trust B have to ameliorate the situation? What tax consequences are associated with each course of action? What role does the statute of limitations play? These and similar questions need to be answered. Until attorneys practicing estate administration live in a perfect world, funding mistakes will continue to occur. When such mistakes do occur, attorneys must know the consequences and the actions to be taken.
II. FUNDING THE MARITAL TRUST
Property that passes from a decedent into a specially drafted marital trust qualifies for the unlimited federal estate tax marital deduction.6 Such trusts may take essentially three forms. First, a general power of appointment (GPA) marital trust may be created for the sole benefit of the surviving spouse during his or her lifetime with terms that provide the surviving spouse with an income interest for life, coupled with either an inter vivos or testamentary general power of appointment in favor of the spouse or the spouse's estate.7 Second, a qualified terminable interest property (QTIP) trust may be used for the sole benefit of the surviving spouse during his or her lifetime, but its terms require that the surviving spouse have a qualifying income interest for life only.8 Third, an estate trust may be used to provide discretionary distributions to the surviving spouse during his or her lifetime, but it requires that the remainder of the trust pass to the surviving spouse's estate at death.9 All of the marital trusts described above share the following characteristic: the value of the assets held by each trust will be included in the gross estate of the surviving spouse.10 In other words, bequests to these trusts do not eliminate federal estate tax, but instead, merely defer it.
Various clauses in the decedent's will dictate both the amount and manner in which the marital and other testamentary trusts are to be funded. These clauses take one of two general forms-pecuniary formula clauses or fractional formula clauses. Both types of formula clauses can generally be subdivided on the basis of funding methodologies. Seemingly innocuous on their face, these clauses may seriously affect the value and the nature of the assets passing into the marital trust.
Using the earlier fact pattern, suppose H's will contains the following pecuniary formula:
I give to my trustees, hereinafter named, a pecuniary amount to hold for the benefit of my spouse, W, pursuant to the terms set forth, which would result in the least federal estate tax payable, taking into account all the credits available to my estate (except the state death tax credit to the extent that it would cause an increase in tax to be due at my death).
This formula would result in a pecuniary amount of $1.4 million passing to H's trustees because that is the amount necessary to reduce H's taxable estate to zero, taking into account H's unused unified credit.11
The application of a fractional formula would produce a similar outcome. Suppose that H's will contains the following fractional formula:
I give to my trustees to hold for the benefit of my spouse, W, a fractional share of my residuary estate with the numerator equal to the amount that would result in the least federal estate tax payable, taking into account all the credits available to my estate (except the state death tax credit to the extent that it would cause an increase in tax to be due at my death), and the denominator equal to the value as finally determined for federal estate tax purposes of my entire residuary estate.
In H's estate, the numerator of the fractional formula would be $1.4 million, and the denominator would be $2 million.12 When this fraction is applied to H's residuary estate of $2 million, a bequest to the marital trust of $1.4 million will result.13
Based upon the simplistic facts above, the value of the property passing to the trustees of the marital trust, as reflected on H's federal estate tax return (Form 706), is the same under either approach. Yet, the actual value of property passing to the trustees of the marital trust may vary tremendously, depending on when the estate funds the marital trust and the nature of the funding clause chosen by the decedent. If a marital trust is instantaneously funded at the time of a decedent's death and a mathematical or valuation error does not occur, the value of the property passing to the trustees of the marital trust will be the same under both of the formula clauses and under any funding clause. However, marital trusts are never funded this quickly. Funding usually happens months or, more typically, years after a decedent's death. In the interim, assets of the estate likely will have either appreciated or depreciated in value, giving formula and funding clauses a crucial role in the determination of the marital trust's ultimate size.
The drafter of a will exercises complete discretion in choosing a funding mechanism, assuming the testator agrees with the choice. However, once a funding mechanism is chosen, that choice binds an executor administering a decedent's estate.
Funding a pecuniary marital trust usually involves one of three methods: (1) a true worth pecuniary approach; (2) a fairly representative pecuniary approach; or (3) a minimum worth pecuniary approach.14 When properly drafted, a true worth pecuniary approach involves funding the marital trust with assets valued at the date of distribution. A fairly representative pecuniary approach involves funding the marital trust with assets that are fairly representative of all appreciation and depreciation in the assets available for funding.15 A minimum worth pecuniary approach involves funding the marital trust with assets at the lesser of the assets' date of distribution value or basis for federal income tax purposes (ie., the value as determined for federal estate tax purposes or cost basis, if acquired after the decedent's death).
In contrast, funding a fractional marital trust usually involves either (1) a proration of each asset or (2) a selection among the assets of an estate.16 The pro rata method involves dividing each asset between the marital trust and the balance of the estate, while the selection among assets method allows the executor to choose the assets which are to be used to fund the marital trust.
To illustrate the dynamic role these clauses play and the vastly different consequences that result from these choices, suppose in our fact pattern that H dies on January 1, 1996, and that the assets of H's estate are distributed on December 31, 1998. Suppose further that H's estate consists of four assets which have date of death and date of distribution values as follows:
If H's will included a pecuniary formula for the marital trust, the total value of assets passing into the marital trust would be $1.4 million, unless H had chosen the minimum worth funding clause. Using the true worth method, the executor could fund the marital trust by using the decedent's interests in his closely held S corporation and the decedent's interest in the general partnership ($800,000 + $600,000). If the fairly representative pecuniary method were used, in light of the fact that the estate had appreciated in value by 15%, the marital trust could be funded with the decedent's general partnership interest, his investment real estate, and four-fifths of his publicly traded stock in X corporation ($600,000 + $400,000 + $400,000). Finally, if the minimum worth method were employed, the marital trust could be funded with a combination of the decedent's investment real estate, his interest in the closely held S corporation, and five-sixths of decedent's publicly traded stock in X corporation ($400,000 + $800,000 + $416,667). Note that under the minimum worth method, $1,616,667 passes into the marital trust, but the sum of the lesser of the date of death value and the basis of the property equals $1,400,000 ($400,000 + $750,000 + $250,000).
In contrast, if H's will employed the fractional method of funding, the total value of assets passing into the marital trust would be $1,610,000. The fraction to fund the marital trust would be $1.4 million/$2 million (seven-tenths). At the date of distribution, this fraction would be applied to determine the amount passing into the marital trust (7/10 x $2.3 million). Under the pro rata method of funding, 70% of each of H's four assets would pass into the marital trust. Under the selection among assets method, the executor could fund the marital trust using a combination of 42% of the publicly traded X corporation stock, all of the closely held S corporation stock, and all of the general partnership interest ($210,000 + $800,000 + $600,000). Regardless of which funding formula is chosen, the executor will typically have some discretion in choosing the assets to use in funding the trusts in question.
Assuming the value of the assets passing into a marital trust fulfills the requirements under the chosen funding method, neither the beneficiaries of the decedent's testamentary trusts nor the Internal Revenue Service will be concerned with which specific assets are chosen to fund the marital trust. From the beneficiaries' perspective, as long as the trustee exercises sound investment strategy, the original assets of the trust may be retained if they are producing satisfactory returns or, alternatively, they may be sold and the proceeds reinvested into assets producing greater returns.17 Because a trust qualifying for the estate tax marital deduction only defers federal estate tax, the Internal Revenue Service is interested only in adequate funding of a marital trust at its inception.18 Once a marital trust is funded, the federal estate tax relating to the property passing into trust is unlikely to be less at the death of the surviving spouse than at the death of the first spouse, unless the assets comprising the marital trust decline in value or the estate of the surviving spouse is in a lower marginal estate tax bracket. Of course, the trustee may have the discretion to distribute assets to the surviving spouse. However, should the surviving spouse attempt to transfer the distributed property, the transfer is subject to the gift tax19 unless the value of the gift does not exceed the annual exclusion20 or it is used for an appropriate exempt or deductible purpose.21
The surviving spouse and remainder beneficiaries of the marital trust can monitor the initial funding of the trust by compelling an accounting.22 Although the Internal Revenue Service lacks standing to compel an accounting,23 it can audit the federal estate tax return prepared by the estate's executor which purports to list the specific assets that are to be used to fund the marital trust.24 If, for whatever reason, the Internal Revenue Service questions the methodology employed in implementing the funding process, it may demand evidence that title to the assets in question was transferred into trust.25 This power may, however, be of little practical importance to the Internal Revenue Service because the estate tax return of the first spouse to die, which typically shows no estate tax due, is rarely audited.
III. FUNDING MISTAKES
The numerous sources of funding mistakes include, but are not limited to, poorly drafted funding clauses, incorrect valuation of decedent's assets, misunderstandings of the law, and unreasonable delays in estate administration. Because each of these mistakes evolves from a unique set of circumstances, each warrants further elaboration.
A Poorly Drafted Funding Clauses
The clauses establishing the marital trust and its funding mechanisms may not always be clear, or a reader may not understand the clauses well enough to use them properly. Either deficiency may cause a marital trust to be either underfunded or overfunded.
Many funding errors are attributable to the drafter's use of ambiguous or faulty language in drafting the testator's formula clause. For example, many controversies arise in determining whether the testator intended a disposition to the marital trust to be a pecuniary or fractional bequest.26 Typically, the drafter uses terms such as "share," "part," or "portion," implying the use of a fractional bequest, but often places this language prior to the disposition of the residuary estate, implying the use of a pecuniary bequest.
Poor drafting can also make it difficult to determine correctly the denominator employed in the fractional method.27 In a properly drafted document, the denominator should refer only to the residuary estate in an accounting sense under state law-taking into account the charges against the principal of the decedent's estate28-and not to its meaning for federal estate tax purposes. This clarification is necessary because the Internal Revenue Code does not define the phrase "residuary estate." A mere reference to the "decedent's residuary estate" likewise leads to confusion. Such a reference is not likely to make clear whether the decedent's residuary estate is to be determined before or after payment of debts, expenses, and taxes.29
Should a decedent's will nevertheless define the denominator of the fraction as "the decedent's residuary estate as determined for federal estate tax purposes" or make reference to the decedent's "entire residuary estate," a troublesome outcome may result unless the language is clarified in a construction proceeding. In our fact pattern, suppose that in connection with H's estate there is a $100,000 debt, nondeductible for federal estate tax purposes.30
Suppose further that the drafter defines correctly the numerator of the fraction as the smallest amount that, if allowed as a federal estate tax marital deduction, would result in the least possible federal estate tax payable. Finally, suppose that the denominator of the fraction is equal to the "decedent's residuary estate as determined for federal estate tax purposes."
In determining the deductible marital share, what would be the appropriate fraction to apply against the residuary? A literal reading of this clause would make the fraction in question equal to $1.4 million over $2 million. However, applying this fraction to the residuary of H's estate would result in the underfunding of the marital trust by $67,000.31 Furthermore, this underfunding problem would be exacerbated if the decedent's estate had grown to $4 million prior to the funding of the marital trust.32
Estate of Pidgeon V. Commissioner33 illustrates the problem of ambiguity, but in the context of a pecuniary bequest. The decedent's husband died on July 30, 1989, leaving the decedent various assets outright, totaling $260,777 including tangible personal property, life insurance proceeds, and assets jointly owned or payable-at-death. In addition, the husband's will created a marital trust for the benefit of the decedent.34 The pertinent part of the clause funding the marital trust read as follows:
If my wife survives me, I give, devise and bequeath onehalf of my adjusted gross estate as finally determined for Federal estate tax purposes to the First Tennessee Bank, N.A, Memphis, as Trustee, after taking into account all items of property, real and personal, required to be included in the computation of Federal estate taxes (whether such property shall pass under this will or otherwise).35
The husband's estate tax return reported an adjusted gross estate of $1,610,770 and a taxable estate of $805,385. The husband's executors computed the amount passing into the marital trust "as $544,608, representing one-half of the adjusted gross estate ($805,385) minus the value of the . . . items received outright by [the decedent] totalling $260,777."36
The sole issue before the Tax Court was the proper interpretation of the clause funding the marital trust. The decedent's executor claimed that the language "after taking into account" required that the items passing outright to the decedent, valued at $260,777, first be incorporated into the funding equation before division of the adjusted gross estate. The Commissioner, in contrast, argued that the terms of the funding mechanism simply required that one-half of the adjusted gross estate pass into the marital trust.
Turning to various rules of construction, the court found in favor of the Commissioner and held that the language in question did not require the property passing outside probate to be subtracted from the amount equaling fifty percent of the adjusted gross estate.37 The court recognized that the drafter's error probably occurred because the funding language was similar to funding clauses in use before the passage of the Economic Recovery Tax Act of 1981.38 The court refused, however, to rewrite the decedent's will on the basis "of possible inadvertence on the part of the draftsman."39
Additionally, the Internal Revenue Service provided an example of how poor drafting of a credit shelter bequest can affect the amount of assets passing into the marital trust.40 The decedent's will made an outright bequest to the decedent's son equal to "the amount of the exemption equivalent of the maximum unified credit allowable in determining the federal estate tax" on the decedent's gross estate reduced by specified probate bequests.41 This simplistic formula failed to take into account either the decedent's nonprobate property or any prior lifetime transfers constituting adjusted taxable gifts under I.R.C.sec 2001(d). Because the unified credit reduced the tax starting at the highest rate applicable to the taxable estate on the progressive rate schedule of I.R.C. sec 2001(c), this oversight reduced the amount that could be "sheltered" by the decedent's unified credit to less than the equivalent exemption of $600,000.42 This drafting error caused the marital trust to be unnecessarily increased in size, because it was a residuary bequest.43 As an example, the memorandum posits that if a decedent's taxable estate were $1 million, the tax would be $345,800. If the credit under I.R.C. sec 2010 of $192,800 were deducted from this amount, the credit would "shelter" only $508,750.44
B. Incorrect Valuation of the Assets Used to Fund the Marital Trust
Aside from readily marketable securities and bonds, valuation of other assets in a decedent's gross estate is never an easy task and is typically fraught with uncertainty. The Internal Revenue Service itself has acknowledged that "valuation is not an exact science."45 The Treasury Regulations define "fair market value" as "the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts."46 This apparently simple definition of fair market value camouflages its true complexity.
Determining an asset's fair market value involves an evaluation of various factors such as sales of similar property, the condition, location, and income production of the property, and any potential appreciation of the property. The weight allotted each factor will vary based on whether the asset in question is tangible or intangible and whether the asset is personal or real property. However, the valuation process may not end here. A second step involving an adjustment to the value of the property may be necessary if there is no ready market for the property or if the property represents a controlling or minority interest in an ongoing concern. In the vernacular, these adjustments are known as control premiums and minority, marketability, and blockage discounts. Adjustments may significantly affect the ultimate determination of an asset's fair market value.47 A failure to account correctly for these adjustments may result in the inaccurate funding of the marital trust.
Mistakes may be made at either juncture of the valuation process. For example, an executor may receive an inaccurate appraisal that misrepresents the true fair market value of an item.48 Alternatively, the executor may receive an accurate appraisal, but one that makes too small or too large an adjustment for the nature of the ownership interest of the decedent.
Estate of Chenoweth v. Commissioner49 addresses some of the funding problems that may beset the marital trust when assets are valued inaccurately. In Chenoweth, the decedent died owning all the outstanding common voting stock of Chenoweth Distributing, Inc., which was valued at $2,834,033. The decedent's will divided the company stock 51% and 49%, respectively, between the decedent's spouse and his daughter from a prior marriage. On the decedent's federal estate tax return, the decedent's executor took a marital deduction exactly equal to 51% of the value of the company ($1,445,356). Shortly thereafter, the decedent's executor, recognizing the value of the stock passing into the marital trust might qualify for a "control premium," brought a claim for refund, which the Internal Revenue Service denied.
The issue for the court was whether, in computing the marital deduction, a decedent's estate could adjust the value of certain property to take into account the destination of such property.50 The Tax Court began its opinion by stating that, under normal circumstances, the destination of a decedent's assets has no effect on the valuation process for purposes of computing the decedent's gross estate.51 Notwithstanding this general principle, on the basis of two opinions issued by the Ninth and Third Circuit Courts of Appeal that discussed similar issues,52 the court arrived at a contrary conclusion regarding the marital deduction. The court drew a distinction between computing the value of a decedent's gross estate and computing the value of the property passing to a surviving spouse. To determine the appropriate deduction, the court held that unlike the former, the latter required an exact accounting of the value of the property.53
Thus, Chenoweth requires an executor to consider the nature of the interest passing into the marital trust. Specifically, the executor should determine whether the interest is a minority, majority, or controlling interest. In addition, the executor must decide if there is an available market for the property. An executor's failure to address these and other valuation issues may cause the marital trust to be incorrectly funded and thus wreak havoc on an estate.54 Finally, if the marital trust is funded incorrectly, as discussed in further detail below,55 controversy initiated by trust beneficiaries or the Internal Revenue Service may erupt.56
C. Misunderstandings of the Law
In addition to poor draftsmanship and valuation errors, an estate administrator's misunderstanding of the law may be another catalyst for a funding error. For example, most states require that a pecuniary devise bear interest beginning one year after the appointment of an executor unless the will specifies otherwise.57 Considering that the process of administering an estate may last well over a year, an executor unfamiliar with this provision in the law may underfund the marital trust.
Suppose in our fact pattern that H utilizes the pecuniary method to fund the marital trust and that, using date of death values, the funding should total $1.4 million. Assuming state law requires that the pecuniary bequest bear simple interest at 10% after the first year and that funding of the marital trust happens two years after the local probate court appoints the estate's executor, the marital trust should be funded with $1.54 million.58 Should, however, the marital trust be funded with only $1.4 million, the executor will have underfunded the trust by $140,000.59 Conversely, should the executor inadvertently overlook a valid waiver provision in the decedent's will regarding this interest requirement, the executor may overfund the marital trust by $140,000.
Funding errors also arise because an additional estate tax deduction upon the first spouse's death yields no immediate tax savings due to the unlimited marital deduction. Thus, to achieve a tax savings, an administrator can deduct the estate's administration expenses on the estate's income tax return (Form 1041). However, what the estate administrator may fail to realize is that the law precludes claiming those same deductions in a de facto fashion on the federal estate tax return (Form 706).60 The size of the marital bequest must be increased by the amount of the administration expenses taken on the estate's income tax return, and the amount that may pass tax-free by virtue of the decedent's unified credit must be correspondingly reduced.
Suppose in our fact pattern that H's estate incurs $100,000 of administration expenses during the first year of administration and that the estate also generates taxable income of $100,000. Assuming the effective income tax rate is 40%, if H's administrator elects to deduct the administration expenses on the estate's income tax return, the estate will save $40,000 of income tax. However, this immediate tax savings comes at the expense of a $100,000 decrease in the size of the by-pass trust and a $100,000 increase in the size of the marital trust established under H's will.61
The following chart highlights the implications of this election:
Nothing is wrong thus far. The estate administrator may have legitimate reasons for wishing to effectuate an immediate income tax savings at the cost of deferred estate tax savings at the death of the surviving spouse. Often, the estate administrator wants the best of both worlds: an immediate income tax savings on the estate's income tax return and a deduction for the estate on its estate tax return. The estate administrator may unwittingly achieve the latter goal by funding H's by-pass trust with $600,000 and funding the marital trust with only $1,300,000.62 D. Delays in Estate Administration
Prior to funding the marital trust, issues of valuation and controversies between and among beneficiaries may arise. These issues and controversies may cause the circumspect estate administrator to take many years to marshall the assets of a decedent's estate and to make proper payment to creditors before making any distributions from the estate. Perhaps unintentionally, these delays may generate tremendous tax savings because appreciation in the value of the estate's assets may accrue to the benefit of the nonmarital beneficiaries and escape subsequent estate tax at the death of the surviving spouse. Needless to say, the federal government's coffer bears the latter expense in terms of foregone tax revenue and, lest it be forgotten, the surviving spouse, too, bears part of the cost by having less income because of the smaller marital trust.
Turning again to our fact pattern, suppose the drafter of H's will has used a pecuniary formula and, during the course of administering H's estate, the value of the estate's assets grows from $2 million to $4 million. This growth all accrues to Trust B, the by-pass trust, which, had it been funded immediately after H's death, would have been entitled to only $600,000. Now, because of the appreciation of the estate's assets and because the value of property passing into the marital trust was fixed at the date of H's death, the by-pass trust will receive a total of $2.6 million, rather than the $1.2 million it would have been worth had it appreciated at the same rate.63 At the death of the surviving spouse (W), the assets then comprising Trust B will pass tax-free to the remainderperson (D).
The same beneficial outcome will result to a lesser extent in the case of a fractional formula provided the fraction funding the marital bequest is less than 50%. Suppose that H dies owning assets worth $1.1 million instead of $2 million. The fraction funding the marital bequest would be $500,000/$1,100,000 or 45.45%. During the course of administration, were H's estate to grow in value to $3.2 million, a majority of the appreciation would accrue to Trust B.64 Again, the main benefactors of the elongated administration would be the beneficiaries of Trust B.
Unfortunately, estate administrators may fail to realize that their dilatory funding approaches may generate problems. For instance, the Internal Revenue Service may interpret the estate administrator's delay as a Fabian tactic designed to circumvent the payment of taxes.65 Also, under most state laws, the surviving spouse has a right to demand that interest be paid on the pecuniary share at the statutorily set rate.66 To the extent the surviving spouse waives the right to such interest, a taxable gift may be deemed to have been made.67 Finally, the risk of delay may be particularly costly if the estate's assets decline in value, rather than appreciate, potentially impoverishing the surviving spouse.68
IV. CAUSES OF ACTION AND STATUTES OF LIMITATION
The mistakes described above often lead to controversy. Although the nature of each controversy is unique, one analyst has neatly grouped these disputes into five distinct categories:69
(1) The will may leave Trust A, the marital trust, to the surviving spouse, and Trust B, the non-marital trust, to the children, making the interests of the surviving spouse and the children in direct conflict with each other.70
(2) The surviving spouse may remarry subsequent to the decedent's death, inducing the surviving spouse, at the time the estate is distributed, to seek a construction to increase the marital share that may be appointed to the new spouse. Alternatively, the remarriage may induce the decedent's children to seek a construction to keep the marital share to a minimum and reduce the amount that may be appointed to the new spouse, thus augmenting their own interests.71
(3) The surviving spouse may die during the administration of the estate and appoint the fund to charity. The charity thereby acquires an interest adverse to the interests of the children who are entitled to the nonappointed part.72
(4) The surviving spouse may die prior to distribution. In the hope of minimizing estate taxes in the surviving, now deceased, spouse's estate, the children interested in the estates of both parents would likely wish the executors of the decedent's estate to distribute to the surviving, now deceased, spouse's estate the minimum amount to which that estate would be entitled under any construction of the will. The children's interest is in direct conflict with that of the Internal Revenue Service, which may assert that the surviving spouse was entitled to a larger share of her spouse's estate.73
(5) The executors may propose a distribution in which the surviving spouse shares, or does not share, in the appreciation of the estate during its administration. Depending on the executors' proposal, either the remainder beneficiaries or the surviving spouse may object.74
In each of the foregoing categories, an interested party claims that property will be, or has been, mistakenly transferred in a manner contrary to the testator's intent. At the time a decedent's executor offers an accounting and proposed distribution schedule, interested parties may object to the distribution plan and compel a construction proceeding.75 Alternatively, after completion of the funding process, an interested party may seek restitution.76 Unless an overpaid beneficiary has significantly changed his position, making it inequitable to compel repayment to the trust estate,77 the beneficiary will be personally liable for the amount of the overpayment, and the beneficiary's interest under the trust will be liable for repayment.78
Sometimes, a court proceeding to construe a decedent's intent transpires in a nonadversarial setting. In these instances, neither res judicata nor collateral estoppel restrict the Internal Revenue Service from bringing a deficiency action and ignoring the state court's ruling, because the Commissioner was not a party to the lower court proceedings.79 The Commissioner may contend that under Bosch, a state court decision is binding in a federal tax proceeding only if the following tests are met: (1) the state court decree determines property rights, and (2) the decree issues from the state's highest court.80 What regard a federal court will give to a state court's decision that does not meet either or both of these two conditions is not entirely clear.81 However, absent a decision of the state's highest court, a "federal court must apply what it finds to be the state law `after giving "proper regard" to relevant rulings of other courts of the State."'82
In contrast to litigation when the parties are potential beneficiaries under the decedent's will, the nature of the remedy sought is quite different when the Internal Revenue Service is the interested party.83 Depending on the terms of the marital trust, the Internal Revenue Service may attempt to have the surviving spouse's inter vivos transfers declared either void ab initio84 or complete for purposes of the federal gift tax.85 There are no reported decisions indicating that the Internal Revenue Service has attemped to disallow all or a portion of the value of a property deduction supposedly qualifying for the marital deduction vis-a-vis a marital trust that has not been adequately funded.
The issue of timing for commencing an action is critical. The statute of limitations for bringing an action will vary depending on whether the interested party is the Internal Revenue Service or a beneficiary under the decedent's will. While state law controls an action brought by a beneficiary, federal law controls an action initiated by the Internal Revenue Service.
A. State Court Proceedings
An executor has a duty to account to the beneficiaries under a decedent's will.86 While these accountings may occur throughout the administration process, the executor's final accounting is germane to this discussion. Often in this accounting, the executor offers a proposed schedule for distribution of assets along with their purported fair market values.87 If a final accounting is filed with a court and the interested parties believe an error has been made, they must object immediately to the accounting. If they fail to object at this time, they will be estopped from doing so after the issuance of a judicial decree.88 Likewise, if the interested parties are not satisfied with an informal accounting because they believe it contains errors, they should not sign the executor's release; otherwise, they may waive their rights with respect to the proposed distribution.89
Suppose a mistake regarding the estate's distribution comes to light sometime after a final accounting has been approved by the court or the interested parties have signed the executor's release or both. Undeniably, a mistake is a permissible ground upon which to attack an executor's settlement90 absent acquiescence, fraud, or negligence on the part of the applicant.91 When is the appropriate time in which the interested parties must bring a cause of action?
The answer depends, in large part, on jurisdiction. In some states, statutes prescribe the time period within which relief against settlement must be obtained.92 In states that have no specific limitations period in which relief must be sought, a decree of final settlement may be opened or vacated within any reasonable time after its rendition.93 Two additional factors may come into play. First, the doctrine of laches may foreclose an interested party from bringing suit, notwithstanding any statute of limitations.94 Second, a mistake may toll the statute of limitations until the mistake either is or should have been discovered.95
B. Federal Court Proceedings
Generally, under a statute of limitations, a deficiency must be assessed within three years following the filing of a return.96 In the context of marital trust funding, however, the general statute of limitations rule will rarely apply. This difference is based on how the Internal Revenue Service classifies an executor's underfunding of the marital trust. The transfer may be deemed either void ab initio or as a completed gift for purposes of the federal gift tax. Under the first classification, the statute of limitations would not run because the Internal Revenue Service treats the transaction as if no transfer occurred to which a tax would apply. With respect to the latter classification, often the statute of limitations will not run because the surviving spouse will not have filed a gift tax return for the tax year in question.97 If the surviving spouse has filed a gift tax return for the year in question and the underfunded amount was omitted from the return and exceeds 25% of the total amount reflected on the return, the statute of limitations is extended from three to six years.98
V. INTERNAL REVENUE SERVICE'S RESPONSE
The potential for lost revenue provides a tremendous incentive for the Internal Revenue Service to be vigilant in making sure that marital trusts are accurately funded. Assuming the federal estate tax rate is a flat 50%, at least one-half of the underfunded amount, plus any appreciation thereon, will escape federal estate tax at the death of the surviving spouse.99 When should the Service take action? And when it does, what weapons does it have in its tax compliance arsenal? The authorities enumerated below are instructive in resolving these issues. Their small number, however, suggests that either the Internal Revenue Service has been somewhat lax in its oversight or, alternatively, once these mistakes come to light during the audit process, they are resolved primarily at the Service's administrative level.
A. Time to Commence Action
Upon discovering that a marital trust has been underfunded, the Internal Revenue Service might be inclined to bring an immediate deficiency action against either the surviving spouse or his or her estate. The result of such attentiveness, however, would likely be frustration. A case which vividly illustrates this point is Bergeron v. Commissioner.100 In Bergeron, the husband's will provided that his wife was to receive 50% of his estate and that she was to have a life estate in the balance of the remaining property, which was to pass to their three children upon the wife's death.101
To facilitate the administration of her husband's estate, the wife advanced $88,829 to the estate. Because 50% of the husband's estate was $344,972, the total owed to the wife by the estate was $433,801.102 When the estate was distributed, however, the wife received property from the estate valued at only $345,168. The $88,633 difference between what the wife was to receive and the amount she did receive passed into the residuary trust of her husband's estate. In its notice of deficiency, the Internal Revenue Service determined that the wife had made a taxable gift of $27,820 to the remaindermen of the testamentary trust. The Service came tc this conclusion because it claimed the wife: (1) had made an indirect transfer of $88,633 to the testamentary trust; (2) had a lifetime income interest in the trust; and (3) was 56 years old on the date ol distribution.103
The Tax Court held against the Internal Revenue Service. The court ruled that the Service had acted prematurely and that the wife's gift to the residuary trust was incomplete.104 The court relied on the explicit language of the gift tax regulations that relate to timing.105 These regulations clarify that a gift is subject to tax only when "the donor has so parted with dominion and control as to leave in him no power to change its disposition."106 Furthermore, the regulations explain that any gift in which the donor intentionally or unintentionally "reserves the power to revest the beneficial title to the property in himself" is incomplete.107 The court interpreted these regulations as standing for the proposition that "for the purposes of the gift tax, 'a gift is not consummate until put beyond the [sic] recall."'108
Next, the court cited two cases in support of its position. In
Touche v. Commissioner,109 while trying to take advantage of the gift tax annual exclusion, the taxpayer mistakenly transferred too much land based on her attorney's error. The Tax Court held that no complete gift was made for the years in question because the taxpayer had the right under local law to reform the deeds of gift and revest title in herself. In Dodge v. United States,110 while trying to take advantage of the charitable income tax deduction and also stay within the bounds of the 30% deduction limit,111 the taxpayer intended to transfer certain property in one-fifth increments to a charitable organization. The taxpayer's attorney, however, prepared a deed that transferred title to the entire property. The Fifth Circuit Court of Appeals ruled that the purported gift was incomplete because local law permitted reformation of the deed for unilateral mistake.112
Relying on the treasury regulations and these cases, the Tax Court chastised the Internal Revenue Service for acting in haste. The court reminded the Service that Minnesota law provided the wife with recourse against her husband's estate to recoup the monies she had extended.ll3 The court further noted that the gift was incomplete until the relevant statute of limitations had lapsed and until the wife no longer had the right to obtain an amendment of the probate court's decree and revest beneficial title in herself.114
The Bergeron court offered the Internal Revenue Service instructive advice: Wait until the transfer is irrevocable before commencing a deficiency action. Prior to Bergeron, this same advice had been given by the Internal Revenue Service in a ruling stating that an irrevocable transfer occurred at "the expiration of [the surviving spouse's] right to appeal the final order of the local probate court.115 But this translucent advice unfortunately becomes opaque in practical application because the purported guideposts prove illusory. Many states have adopted independent administration proceedings that require no direct court intervention or oversight.116 Estate administrators may, but are not required to, file formal accountings with the court. In these jurisdictions, absent a formal filing, it is unclear when a beneficiary's right against the estate lapses. The fact that an estate administrator secures a release and refunding bond further suggests that a mistake may always be reversed. If true, the Internal Revenue Service's attempts to affix a transfer date almost always will be thwarted. Furthermore, no line will clearly mark when a gift becomes irrevocable under local probate law.117
Consider a final issue as to timing. In theory, the nature of a particular marital trust (ie., GPA or QTIP trust) may hinder the surviving spouse's ability to make taxable gifts.118 In practice, courts have applied this rule in a fairly liberal fashion. Specifically, if a court finds that transfers have been made from a marital trust in which (1) all interested parties have consented and (2) a state court would not have reversed the transfers, then the value of the transferred assets will not be includible in the estate of the surviving spouse, although the transfers themselves will be subject to gift tax.1l9 If both of these conditions are not satisfied, a transfer of assets cannot be ascribed to the surviving spouse because the terms of the trust permit no such alienation.120
In light of these timing constraints, the Service must probably choose one of two courses of action. First, the Service may patiently wait until the death of the surviving spouse and increase the value of the marital trust to include the value of the underfunded amount or the unauthorized transfers, thereby considering an overall rate of appreciation or depreciation.121 Alternatively, the Service may attack the validity of the marital deduction on the death of the first spouse by arguing that the surviving spouse and the remaindermen have joined together to effectuate a de facto change in the terms of the trust that preclude the making of a QTIP election by the estate's executor as to the portion not passing into trust.122
B. Effects of Transfer
If the transfer is deemed complete and the marital trust is underfunded, the tax implications depend on where the excess property passes. The decedent's will usually dictates this destination. In Bergeron v. Commissioner,123 the will of the decedent provided for the non-marital portion to pass into trust for the lifetime benefit of the surviving spouse, with remainder to the issue. Had the Service prevailed, the taxable gift would only have been the gift of the remainder interest.124 In contrast, as illustrated by a revenue ruling,125 if the non-marital portion passes outright to someone other than the surviving spouse, a gift is deemed of the entire excess, less any amount that may qualify for the annual exclusion.126 Note that in the situation of an underfunded QTIP trust, when, in theory, the surviving spouse may never be deemed to have made an inter vivos taxable gift, save of her income interest,127 no immediate tax consequences apply to the underfunding.128
VI. RECOMMENDATIONS
Many funding errors can be avoided if the drafter uses certain precautionary measures throughout the estate planning process. At the outset, the drafter of the decedent's will must select carefully the methodology for funding the marital trust. The drafter must not use ambiguous or opaque verbiage that may confuse the estate administrator and thereby lead to misinterpretation of a funding clause and ultimately to a funding error. In crafting a client's will, the drafter must articulate clear instructions for the estate administrator.
The estate administrator also bears the burden of properly funding a marital trust. The administrator must carefully construe the decedent's funding clauses consistently with the decedent's intent. Failure to do so may result in either the overfunding or underfunding of the marital trust.
When the decedent's will contains an ambiguity,129 the estate administrator should consider bringing a construction proceeding to clarify the provisions in question.130 In resolving the ambiguity, the Restatement (Third) of Property provides a constructional preference in favor of the interpretation that gives more favorable tax consequences than other plausible constructions.131
If, on the other hand, the decedent's will contains an overt error rather than an ambiguity, the Restatement provides alternative guidance. In this context, the will may be reformed to conform to the donor's intention if the following elements are established by clear and convincing evidence: "(1) that a mistake of fact or law, whether in expression or inducement, affected specific terms of the document; and (2) what the donor's intention was."132 The Restatement adds that "[a] donative document may be modified, in a manner that does not violate the donor's probable intention, to achieve the donor's tax objectives."133 In certain cases, such as those involving federally authorized division of trusts, the Restatement provides muchneeded authorization to state courts to make needed modifications.134 In cases where federal tax law is unclear regarding the tax consequences of a proposed modification, the Restatement urges caution. The party seeking the modification bears the burden of showing a reasonable prospect that the proposed modification will be effective for federal tax purposes.135 For example, a party seeking to modify an otherwise nonqualifying trust to qualify it for the marital deduction could not, under current law, carry that burden and would, therefore, not be entitled to the proposed modification.136
Likewise, the funding process itself requires vigilance on the part of the estate administrator. As previously discussed,137 the valuation of assets is not an exact science. The circumspect estate administrator may attempt to secure two or three appraisals of the same property to ensure that neither the Internal Revenue Service nor the beneficiaries of the decedent's estate try to second guess an asset's value. Similarly, an astute estate administrator may consider soliciting a legal opinion regarding unresolved issues of law that affect the estate's administration.
Finally, it is important to consider when to fund a marital trust.138 If funding is done either prematurely or too late in the estate administration process, the risk that the marital trust may not be properly funded increases. Because the exact time at which to fund a marital trust may be difficult to gauge, estate administrators should review all the information at their disposal, keeping in mind that certain aspects of the timing choice are beyond their control.
In sum, like most estate administration concerns, the funding of marital trust calls for scrupulous attention to detail. Handled in the proper manner, this attention may act as a buffer from subsequent challenges by interested parties. Conversely, if funding is handled inappropriately and mistakes are made, estate administrators may inadvertently subject themselves to unwelcome litigation and expense.
Assume, despite all precautions, that the estate administrator nevertheless makes a funding mistake. What actions may the estate administrator take to remedy the error? Under a favorable set of facts, if refunding bonds have been secured from all beneficiaries, the estate administrator would have recourse to recover funds from the persons who received a disproportionate share of the decedent's assets and redirect that excess to its intended beneficiary.139
Suppose, instead, that the estate administration process has long since passed and a mistake regarding the funding of the marital trust subsequently comes to light. If the interested parties are nonadversarial, a simple exchange could be made between or among the interested parties without any gift tax repercussions. However, the trustee, at the very least, should notify beneficiaries of the intended transfer if the situation involves a trust that has been overfunded. The more cautious trustee may, in addition, attempt to secure the beneficiaries' consent and even go so far as to institute an action for instructions.140
However, the situation is far different if the interested parties are adversarial. The beneficiary who believes that he or she has not received a fair entitlement under the decedent's will may bring a cause of action to recover the shortfall against the beneficiary who allegedly received more than his or her proportionate share.141 Of course, the opposing party may challenge the complaint on numerous bases, including attacking the substance of the allegation or invoking the doctrine of laches or both.142
Additionally, a beneficiary may wish to consider suing the attorney who drafted the decedent's will, the estate administrator whose negligence caused the funding mistake, and the executor or trustee who may have acceded to the error. Attorneys, estate administrators, executors, and trustees are accountable for their funding mistakes.143 The drafting and funding of marital trusts offers no sanctuary from the intense scrutiny of disgruntled beneficiaries.
VII. CONCLUSION
The opportunity to err is ever present during the administration of an estate. Often, funding problems spawn litigation and additional taxes. Precaution is the watchword: the lawyer drafting a client's will should strive for clarity; the estate administrator should study a testator's will carefully with special attention to funding clauses; and the trustees of a decedent's testamentary trusts should demand a full accounting, formal or informal, of the assets of the decedent's estate to ensure accurate funding. Certainly, all those involved in the estate administration process should be well-advised and have a strong knowledge of the intricacies of tax law. Even the best of those practicing in the estate planning and administration process can make a mistake. When such a mistake occurs, a complete analysis of both the repercussions and its possible remedies should be made.
' J.D., University of Michigan, 1988; lL.M., Taxation, New York University, 1989.
.. J.D., Yale University, 1978; LL.M., Taxation, New York University, 1982. ... J.D., Stanford University, 1984; LL.M., Taxation, New York University, 1991. The authors would like to express their sincere gratitude to Lawrence W. Waggoner, professor of law at the University of Michigan, for his helpful comments.
1 There is an obvious incentive to underfund a marital trust. The excess funding will not ordinarily pass to the surviving spouse or to a trust includible in the surviving spouse's gross estate. For purposes of this analysis, it is assumed that the mistakes in question are made inadvertently. However, the authors suspect that some practitioners purposely underfund marital trusts-with and without the acquiescence of the estate beneficiaries-to avoid the imposition of the federal estate tax.
2 ILR.C. 2056(b)(7) (1994).
3 H's gross estate would be $2 million. Because of the marital deduction of $1.4 million applicable to Trust A, H's taxable estate would be $600,000, and the federal estate tax on this amount would be $192,800. However, the tax will be completely offset by H's unified credit of the same dollar amount. Id 2010 (1994). 4 See id 2031 (1994).
5 Were W to survive another ten years and the value of this portion of the trust corpus to double to $800,000, under our same estate tax rate assumption, the federal estate tax would be $400,000 less than it would otherwise have been.
6 IR.C. 2056 (1994). 7 Id 2056(b)(5) (1994). 8 Id 2056(b)(7) (1994). 9 Rev. Rul. 68-554,1968-2 C.B. 412.
10 I.R.C. 2041, 2044 (1994). Because the assets of an estate trust must be distributed to the surviving spouse's estate when he or she dies, the value of the assets of the estate trust will be included in the surviving spouse's estate under I.R.C. 2031.
11 H's gross estate is $2 million. Assuming the value of property passing to H's trustees qualifies for the marital deduction, H's taxable estate would be $600,000 ($2 million less $1.4 million). H's $600,000 taxable estate, however, would be insulated from federal estate tax because of H's unused unified credit of $192,800. Id. 2010 (1994). A common practice in estate planning is for the testator to direct that property equal to this value ($600,000) pass into what is known in tax parlance as a "credit shelter" or "by-pass trust." The terms of this trust often permit trust property to be used for the benefit of the surviving spouse. However, because the surviving
spouse lacks the requisite ownership and control over this trust, the value of the trust assets is not includible in the surviving spouse's gross estate.
12 This example simplifies the ordinary estate situation insofar as it assumes that H's estate bears no administration expenses. Were there such expenses, the value of the residuary estate, and thus the denominator of the fraction, would have to be adjusted downwards to account for these expenses. 13 ($1.4 million/$2 million) x $2 million = $1.4 million.
14 There are other ways to fund a marital trust (e.g., under a reverse pecuniary approach where the trustees of the decedent's bypass trust receive a pecuniary amount, and the trustees of the marital trust receive the residuary), but testators seldom employ these other methodologies. See W. REED QUILLIAM, How LEADING PROBATE LAWYERS ARE HANDLING MARITAL DEDUCTION PROBLEMS (AN EMPIRICAL STUDY), Advanced Estate Planning & Probate Course (State Bar of Texas) 1987.
15 This approach originates from Rev. Proc. 64-19,1964-1 C.B. 682. 16 If the decedent's will or local law does not specifically permit this second alternative, but the executor uses it anyway, a significant detrimental income tax could result due to deemed exchanges among the beneficiaries. See Rev. Rul. 69486.1969-2 C.B. 159.
17 RESTATEMENT (THIRD) OF TRUSTS 181 (1992).
18 I.R.C. 2031, 2041, 2044 (1994). 19 Id * 2511 (1994). 20 Id 2503(b) (1994). 21 Id Id 2503(e), 2522 (1994).
22 RESTATEMENT (SECOND) OF TRUSTS 172 (1957).
23 See, e.g., In re Workman's Estate, 68 P.2d 479 (Or. 1937) (finding that a party having no financial interest in the trust estate cannot sue for a court accounting).
24 I.R.C. 7601 (1994). The instructions to Schedule M of Form 706 (U.S. Estate Tax Return) that relate to the marital deduction specify that all assets qualifying for the marital deduction be listed. However, the absence of a list of specific assets will not cause the estate to lose its marital deduction. See Tech. Adv. Mem. 91-16-003 (Dec. 27,1990) (stating that a decedent's estate need not specify the exact assets that will be used to fund a marital deduction bequest of a preresiduary optimum marital deduction amount).
25 I.R.C. 7602 (1994). If the parties have not executed a formal closing agreement, the Internal Revenue Service generally may reopen a case and determine a deficiency in tax notwithstanding the issuance of an estate tax closing letter earlier in the proceedings, subject to a three-year nonextendable statute of limitations. Estate of Bommer v. Commissioner, 69 T.C.M. (CCH) 2541 (1995).
26 See Harrison F. Durand, Planning Lessons From Marital Deduction Litigation, 104 TR. & EsT. 943 (1965). For a listing of cases concerning this issue, see RiCHARD B. COVEY, MARITAL DEDUCTION AND CREDIT SHELTER DISPOSITIONS AND THE USE OF FORMULA PROVISIONS, 58 n. 88 (3d ed. 1984).
27 See Sheldon F. Kurtz, Allocation of Increases and Decreases to Fractional Share Marital Deduction Bequest, 8 REAL PROP. PROB. & TR. J. 450 (1973) (discussing in detail how the denominator of the fraction employed in the fractional method should be described).
28 See UNIF. PRINCIPAL & INCOME ACT 5(a), 7B U.L.A. 160 (1962) ("Unless the will otherwise provides . . ., all expenses incurred in connection with the settlement of a decedent's estate, including debts, funeral expenses, estate taxes, interest and penalties concerning taxes, family allowances, fees of attorneys and personal representatives, and court costs shall be charged against the principal of the estate.").
29 When these expenses are not taken into account in determining the residuary, the fraction is commonly referred to as a preresiduary fractional share bequest. In contrast, when these expenses are taken into account in determining the residuary, the fraction is commonly referred to as a true residuary share bequest. See Estate Tax Marital Deduction, 239-4th Tax Mgmt. (BNA) A-79 to A-80 (1990).
30 See IR.C. 2053(c)(1)(A) (1994) (requiring that debts for promises be grounded with adequate consideration in order to be deductible).
31 ($1.4 million/$2 million) x $1.9 million = $1.33 million. If the denominator of the fraction were accurately defined, the optimal marital deduction should instead be $1.4 million (ie., ($1.4 million/$1.9 million) x $1.9 million = $1.4 million). 32 ($1.4 million/$1.9 million) x $3.9 million = $2,873,684 compared to ($1.4 million/$2 million) x $3.9 million = $2,730,000, leaving an overall deficit in the marital trust of $143,684 ($2,873,684 - $2,730,000). 33 69 T.C.M. (CCH) 2638 (1995).
34 Id. at 2638. The terms of the marital trust originally qualified as a general power of appointment trust under I.R.C. 2056(b)(5) (1994). For reasons not made clear in the decision, the executor of the decedent's estate disclaimed the power of appointment, rendering the trust ineligible for the marital deduction under I.R.C.
2056(b)(5) (1994). However, the trust remained eligible for the marital deduction under I.R.C. 2056(b)(7) (1994). Id. at 2639.
35 Id at 2638. 36 Id at 2639. 37 Id at 2641.
38 Id at 2639 (referring to Pub. L. No. 97-34, 403(e)(3), 95 Stat. 172, 305, reprinted in 26 U.S.C. 2056 note (1994)).
39 id
40 Tech. Adv. Mem. 94-34-004 (Aug. 26,1994).
41 Id 42 Id. 43 Id 44 Id.
45 Rev. Rul. 59-60, 1959-1 CB. 237, 238. See also ROBERT W. JOHNSON, FINANCIAL MANAGEMENT 502 (4th ed. 1971) ("Valuation is not an exact science; it is `sophisticated guess work.' Not only are there many different methods of valuation, but variations in the use of each method may lead to widely different results." (footnote omitted)); Messing v. Commissioner, 48 T.C. 502, 512 (1967), acq., 1968-1 C.B. 2 (stating that valuation "should frankly be recognized as inherently imprecise and capable of resolution only by a Solomon-like pronouncement"). 46 Treas. Reg. 20.2031-1(b) (as amended in 1965). See Rev. Rul. 59-60,1959-1 C.B. 237, 238.
47 For a discussion of minority discounts, see Harwood v. Commissioner, 82 T.C. 239 (1984) (allowing a 50% minority discount), aff'd, 786 F.2d 1174 (9th Cir.), and cert. denied, 479 U.S. 1007 (1986); Ward v. Commissioner, 87 T.C.M. (CCH) 78 (1986) (allowing a 33.3% minority discount); Carr v. Commissioner, 49 T.C.M. (CCH) 507 (1985) (allowing a 25% minority discount). For a discussion of control premiums, see Estate of Salsbury v. Commissioner, 34 T.C.M. (CCH) 1441 (1975) (allowing a 38.1% control premium); Estate of Anderson v. Commissioner, 31 T.C.M. (CCH) 502 (1972) (allowing a 20% control premium). For a discussion of marketability discounts, see Estate of Lauder v. Commissioner, 68 T.C.M. (CCH) 985
(1994) (allowing a 40% marketability discount); Estate of Ford v. Commissioner, 66 T.C.M. (CCH) 1507 (1993) (allowing a 10% marketability discount). For a discussion of blockage discounts, see Commissioner v. Shattuck, 97 F.2d 790 (7th Cir. 1938) (allowing an 18% blockage discount); Estate of O'Keefe v. Commissioner, 63 T.C.M. (CCH) 2699 (1992) (allowing a 50% blockage discount for half of the artwork and a 25% discount for the balance of the artwork); Kopperman v. Commissioner, 37 T.C.M. (CCH) 1849-24 (1978) (allowing an 8% blockage discount). 48 See, e.g., Maxcy v. Golow (In re Tuttle's Estate), 7 N.W.2d 575 (Wis. 1943). 49 88 T.C. 1577 (1987). 50 Id. at 1580.
51 Id. at 1582. See Estate of Proctor v. Commissioner, 67 T.C.M. (CCH) 2943 (1994) (holding that the value of property held by decedent in unencumbered fee simple was not altered by decedent's death or will, and so passed undiminished at his death).
52 Ahmanson Found. v. United States, 674 F.2d 761 (9th Cir. 1981) (holding that the value of stock passing to a charity from decedent's estate must reflect its lack of voting rights); Provident Nat'l Bank v. United States, 581 F.2d 1081 (3d Cir. 1978) (holding that because a control block of stock passed into the marital trust, it was worth more than the value of stock passing into the nonmarital trust). 53 Estate of Chenoweth, 88 T.C. at 1582-84.
54 For example, an estate may utilize special valuation under IR.C. 2032A for valuation purposes on the federal estate tax return, but may use the actual fair market value at the date of distribution for funding purposes. Tech. Adv. Mem. 8314-001 (Sept. 22, 1982); Tech. Adv. Mem. 83-14-005 (Sept. 14, 1982). 55 See infra parts IV., V.A.
56 See, e.g., Harris Trust & Sav. Bank v. Ellis, 810 F.2d 700 (7th Cir. 1987) (adjudicating a dispute between trustee and trust beneficiaries over the valuation of stock passing into marital and residuary trusts).
57 See, e.g., ALASKA STAT. 13.16.550 (1985); ARIZ REV. STAT. ANN. 14-3904 (1995); CAL PROB. CODE 12003 (West 1991); COLO. REV. STAT. ANN. 15-12-904 (West 1987); DEL CODE ANN. tit. 12, 3525 (1995); IDAHO CODE 15-3-904 (1979); MB. REV. STAT. ANN. tit. 18-A, 3-904 (West 1981); MICH. COMP. LAWS ANN. 700.167 (West 1995); MINN. STAT. ANN. 524.3-904 (West 1975); MONT. CODE ANN. 72-3-913 (1994); NEB. REV. STAT. 30-24,102 (1989); NJ. REV. STAT. ANN. 3B:23-11 (West Supp. 1995); UTAH CODE ANN. 75-3-904 (1993). 58 (.1 x $1.4 million) + $1.4 million = $1.54 million. 59 $1.54 million - $1.40 million = $140,000.
60 I.R.C. 642(g) (1994). See cases cited infra note 62. 61 H's administrator may face a related problem if the remainder beneficiary (D) demands an equitable adjustment to the value of the property passing into the by-pass trust to account for the income tax savings which inures to the beneficiary of the marital trust (W). See In re Estate of Warms, 140 N.Y.S.2d 169 (Sur. Ct. 1955) and its progeny.
62 A series of cases suggests that if, during the administration process, there is sufficient income generated by an estate to pay administration expenses and the will or local law authorizes the use of estate income to pay administration expenses, the amount passing into the marital trust need not be increased by an amount corresponding to such expenses. Estate of Hubert v. Commissioner, 101 T.C. 314 (1993), aff'd, 63 F.3d 1083 (llth Cir. 1995), cert. granted, 116 S. Ct. 1564 (1996); Estate of Young v. Commissioner, 64 T.C.M. (CCH) 770 (1992); Richardson v. Commissioner, 89 T.C. 1193 (1987); see Rev. Rul. 93-48, 1993-2 C.B. 270. But cf. Burke v. United States, 994 F.2d 1576 (Fed. Cir. 1993) (holding that administrative expenses must be deducted from the estate and not from post-mortem income); Estate of Street v. Commissioner, 974 F.2d 723, 729 (6th Cir. 1992) (holding that the marital deduction must be reduced to the extent that estate income was used to pay administrative expenses); Tech. Adv. Mem. 96-17-003 (Apr. 26, 1996) (stating that estate administration, funeral, and other expenses paid from a trust's postmortem income trust be deducted from the value of trust property passing to the trust's marital share).
63 There may also be less income tax upon the satisfaction of the pecuniary marital trust because the administrator of H's estate may have a greater selection of assets on hand, including those that did not appreciate in value. See, Treas. Reg.
1.1014-4(a)(3) (1960); e.g., Kenan v. Commissioner, 114 F.2d 217 (2d Cir. 1940), aff'g 40 B.T.A. 824 (1939) (deeming a bequest of appreciated stock to be a sale and allowing for a tax assessment of the appreciated portion). 64 100% - 45.45% = 54.55%.
65 TREAS. REG. 20.2056(b)-5(i)(9) (as amended in 1965); see Tech. Adv. Mem. 8746-003 (July 22,1987) (stating that the Internal Revenue Service reserves the right to deem that funding has occurred at a reasonable time and then allocate appreciation after that time to the marital and nonmarital trusts). 66 See supra note 57.
67 Rev. Rul. 84-105, 1984-2 C.B. 197.
68 See, e.g., Boston Safe Deposit & Trust v. Boone, 489 N.E.2d 209 (Mass. App. Ct. 1986); Fulton v. First Nat'l Bank, 290 So. 2d 498 (Fla. Dist. Ct. App. 1974).
69 Durand, supra note 26, at 943. Some of the controversies cited by this author are less probable in today's estate planning environment because of the introduction of the QTIP trust. A decedent spouse may now direct the disposition of the assets held by a QTIP trust at the death of his surviving spouse. See I.R.C. 2056(b)(7) (1994).
70 See, e.g., In re Estate of Gilmour, 238 N.Y.S.2d 624 (App. Div. 1963); In re Will of Bush, 156 N.Y.S.2d 897 (App. Div. 1956), aff'd, 3 N.Y.2d 908 (1957).
71 See, e.g., In re Estate of Althouse, 172 A.2d 146 (Pa. 1961). 72 See Durand, supra note 26, at 943 (citing Estate of Kircheimer, Ill. Probate Ct. Cook Co. File No. 5608017).
73 Id (citing Alice Hempstead, T.C. Docket 27083 (1960)). 74 See, e.g, In re Estate of Kanter, 143 A.2d 243 (NJ. Super. Ct. App. Div. 1958); In re Will of Penny, 251 N.Y.S.2d 490 (Sur. Ct. 1964); In re Estate of Ossman, 209 N.Y.S.2d 251 (Sur. Ct. 1960).
75 See, e.g., Estate of Kanter, 143 A.2d at 243. 76 RESTATEMENT (SECOND) OF TRUSTS 254 (1957). See also Kerper v. Kerper, 819 P.2d 407 (Wyo. 1991) (holding that when decedent, as a trustee, mistakenly transferred property to a second trust of which she was also trustee, the property should be held under a constructive trust for the benefit of the first trust's beneficiaries); Copenhaver v. Copenhaver, 317 P.2d 756 (Okla. 1957) (finding that a person receiving property by a drafting mistake in a distribution decree may be charged as a trustee for the rightful owners).
77 RESTATEMENT (SECOND) OF TRUSTS 254 cmt. d (1957). 78 Mitchell v. Mitchell, 298 S.W.2d 236 (Tex. Civ. App.), rev'd on other grounds, 303 S.W.2d 352 (Tex. 1957); In re Seller's Estate, 67 A.2d 860 (Del. Ch. 1949); In re Peter's Estate, 72 N.Y.S.2d 583 (Sur. Ct.1947); In re Schell's Estate, 82 N.Y.S.2d 240 (Sur. Ct. 1943).
79 Commissioner v. Estate of Bosch, 387 U.S. 456, 463 (1967). 80 Rev. Rul. 69-285, 1969-1 C.B. 222.
81 F. son Boyle, Letting the State Dog Wag the Tax Tail, PROB. PRAC. REP., Feb. 1990, at 1; Gilbert P. Verbit, State Court Decisions in Federal Transfer Tax Litigation: Bosch Revisited, 23 REAL PROP. PROB. & TR. J. 407 (1988); Bernard Wolfman, Bosch, Its Implications and Aftermath: The Effect of State Court Adjudications on Federal Tax Litigation, 3 INST. ON Esr. PLAN. 69,200 (1969).
82 Estate of Salter v. Commissioner, 545 F.2d 494, 497 (Sth Cir. 1977) (quoting Bosch, 387 U.S. at 467); see White v. United States, 680 F.2d 1156, 1159 (7th Cir. 1982) ("The district court therefore properly recognized its duty to decide what position the Indiana Supreme Court would take if confronted with this problem."). 83 See infra parts IV.B., V.A.
84 See Estate of Bommer v. Commissioner, 69 T.C.M. (CCH) 2541, 2545-46 (1995) (holding that the IR.S. did not abuse its discretion when the government reopened an examination of a decedent's estate tax return to avoid a "Serious Administrative Omission").
85 See Rev. Rul. 84-105,1984-2 C.B. 197.
86 See RESTATEMENT (SECOND) OF TRUSTS 172 (1957). 87 See id 173.
88 See Estate of Camarda, 425 N.Y.S.2d 1012 (Sur. Ct. 1980). 89 In re Estate of Swanson, 429 N.E.2d 892 (III. App. Ct. 1981).
90 Miller v. McNamara, 66 A.2d 359, 362 (Conn. 1949) ('[I]t is generally held that an equitable proceeding for relief [will be granted] on the ground that a judgment is invalid because of fraud, mistake, or the like. . . ") (citations omitted).
91 See In re Estate of Lange, 383 A.2d 1130 (NJ. 1978) (finding that interested parties were precluded from subsequently objecting to the trustee's breach of the fiduciary duty where they validated the trustee's conduct); Poulsen v. First Nat'l Bank & Trust (In re Estate of Poulsen), 194 N.W.2d 593, 596 (Wis. 1972) (holding that a typographical error in a receipt listing 1800 shares of stock did not form a basis for fraud when the dollar amount was noted correctly and the plaintiff "knew the sale had been for only 800 shares.").
92 See, e.g., ALA. CODE 12-1140(a) ("When any error of law or fact has occurred in the settlement of any estate of a decedent to the injury of any party, without any fault or neglect on his part, such party may correct such error by filing a complaint in the circuit court within two years after the final settlement thereof."). See Pengelly v. Thomas, 84 N.E.2d 265 (Ohio 1949) (refusing to apply ten-year statute of limitations, when statute prescribed six-year period to vacate or modify the orders of the probate court on the ground that the interested parties were induced by a mistake as to certain facts).
93 See, e.g., Williams v. Hankins, 258 P. 1114, 1116 (Colo. 1927) ("[A] court of probate, may at any time, in furtherance of justice, revoke its orders and reopen proceedings with respect to the settlement of estates of deceased persons. . ., which have been irregularly made and procured by fraud or mistake.").
94 GEORGE G. BOGERT & GEORGE T. BOGERT, THE LAW OF TRUSTS AND TRUSTES 948 (rev. 2d ed. 1995) ("Delay for a shorter period than the statutory limit, accompanied by other conditions, may be sufficient to destroy the beneficiary's remedy.") (footnote omitted). See Grant v. Hart, 14 S.E.2d 860 (Ga. 1941), affd, 30 S.E.2d 271 (Ga. 1944) (finding that laches may bar a cause of action before the statute of limitations has run, but only when a change of circumstances makes it inequitable to enforce the cause of action); In re Nelson's Estate, 85 N.Y.S.2d 29 (N.Y. App. Div. 1948) (finding a party guilty of laches in waiting seventeen years to make an application to change estate accounting while, during that time, the party was in full possession of the facts).
95 See Giebrach v. Rupp, 164 A. 465, 468 (N.J. 1933) ("[I]n equity, . . . the time limit[ ] within which the action must be brought will not commence to run until the discovery of the fraud, or until the complainant was in a situation where, by the exercise of reasonable diligence, he would have discovered the fraud [or mistake]."); John P. Dawson, Mistake and Statutes of Limitations, 20 MINN. L. REv. 481 (1936) ("The essence of mistake is ignorance, and ignorance, so long as it persists, is an effective obstacle to the prosecution of a claim .... [I]t would seem that the statute of limitations should not commence to operate until this obstacle is removed.").
96 I.R.C. 6501(a) (1994). 97 I.R.C. 6501(c)(3) (1994). 98 I.R.C. 6501(e)(2) (1994).
99 The value of assets contained in the marital trust would be includible in the surviving spouse's gross estate. I.R.C. 2031, 2041, 2044 (1994).
100 52 T.C.M. (CCH) 1177 (1986). See also Estate of Peters v. Commissioner, No. 2879-96 (T.C. filed Feb. 15,1996) (The estate contests the determination that a marital deduction trust established by the decedent's husband was underfunded, resulting in indirect transfers by the decedent to a credit shelter trust in which she had a lifetime interest.).
101The will was formulated prior to the introduction of the unlimited marital deduction and was designed to take advantage of the maximum marital deduction which, at the time of decedent's death, was limited to the greater of $250,000 or onehalf of the adjusted gross estate. See Tax Reform Act of 1976, Pub. L. No. 94-455, 2002(a), 90 Stat. 1520, 1854 (repealed 1981). 102 $344,972 + $88,829 = $433,801.
103 The Internal Revenue Service offered the following calculation:
Marital transfer $344,972 Amount Advanced Estate $ 88,829 Total Amount Due $433,801 Total Amount Accepted $345,168 Shortage $ 88,633
Life Expectancy Factor for Female,
Age 56 .68612
Value of Shortage Retained $ 60,813 Value of Shortage $ 88,633 Value Retained $ 60,813 Gift to Remaindermen $ 27,820
104 Bergeron, 52 T.C.M. at 1181.
105 Ids at 1180 (relying on Treas. Reg. 25.2511-2(b), (c) (as amended in 1983)). 106 Treas. Reg. 25.2511-2(b). 107 Id 25.2511-2(c).
108 Bergeron, 52 T.C.M. at 1180 (quoting Burnet v. Guggenheim, 288 U.S. 280,
286 (1933)).
109 58 T.C. 565 (1972). 110 413 F.2d 1239 (5th Cir. 1969). 111 I.R.C. 170(b) (1994). 112 Dodge, 413 F.2d at 1243-44.
113 Bergeron, 52 T.C.M. at 1181 (citing MINN. STAT. ANN. 524.3-413, 525.02 (West 1975)). 114 id.
115 Rev. Rul. 84-105,1984-2 C.B. 197,198. 116 UNIF. PROB. CODE 3-704, 8 U.L.A. 321 (1990).
117 In theory, even at the death of the surviving spouse, the estate administrator
may be able to seek recovery for distributions made by the marital trust. 118 See I.R.C. 2056(b)(5) (1994) (permitting the testator to grant a testamentary general power of appointment in the surviving spouse only); I.R.C.
2056(b)(7)(B)(ii)(II) (1994) (specifying that under a QTIP trust "no person has a power to appoint any part of the property to any person other than the surviving spouse").
119 Estate of Halpern v. Commissioner, 70 T.C.M. (CCH) 229 (1995); Estate of Council v. Commissioner, 65 T.C. 594 (1975); see Estate of Hartzell v. Commissioner, 68 T.C.M. (CCH) 1243, 1246 (1994) (dismissing the Service's argument that under the facts of the case a state court would set aside the transfer).
120 See Estate of Halpem, 70 T.C.M. at 242 (holding that because a Pennsylvania court would have returned to the marital trust the assets distributed after the determination of the surviving spouse's incompetency, such assets remained subject to the surviving spouse's testamentary general power of appointment).
121 See Estate of Pidgeon v. Commissioner, 69 T.C.M. (CCH) 2638 (1995). The trustees of the marital trust could have argued that they had informally loaned the surviving spouse the amount in question. Thus, application of a fair interest rate, rather than a rate of appreciation, is the better measure to adjust inclusion of the marital trust in the surviving spouse's taxable estate.
122 Although the Service has not espoused this position in any reported cases, precedent exists that the income beneficiary and the remaindermen of a trust can join together to amend the terms of a trust even though the amendment indirectly contravenes the intent of the settlor. In re Trust of Mintz, 282 A.2d 295 (Pa. 1971) (allowing a departure from terms of trust under a family agreement); RESTATEMENT (SECOND) OF TRUSTS s 337 (1957) (allowing termination of a trust if all parties consent).
123 52 T.C.M. (CCH) 1177 (1986).
124 With the introduction of I.R.C. 2702 in 1990, the Internal Revenue Service might argue that the surviving spouse made a gift of her entire interest because an income interest is not a qualifying interest. I.R.C. 2702(a), (b) (1994). 125 Rev. Rul. 84-105,1984-2 C.B. 197. 126 I.R.C. 2503(b) (1994). 7 Id 2519 (1994).
128 See Estate of Pidgeon v. Commissioner, 69 T.CM. (CCH) 2638 (1995).
129 RESTATEMENT (THIRD) OF PROPERTY (DONATIVE TRANSFERS) 11.1 (Tent. Draft No. 1,1995) (approved by the American Law Institute at its May 1995 annual meeting) defines "ambiguity" as follows: "An ambiguity in a donative document is an uncertainty in meaning that is revealed by the text or by extrinsic evidence other than direct evidence of intention contradicting the plain meaning of the text."
130 See Steve R. Akers, Reformation Proceedings in Post-Mortem Tax Planning, 17 ACTEC NoTEs 254 (1992); Carlyn S. McCaffrey & Alan H. Hirschfeld, Restructuring Wills and Trusts to Reduce Generation-Skipping Taxes, TR. & EsT., Mar. 1992, at 8.
131 RESTATEMENT (THIRD) OF PROPERTY, supra note 129, 11.3(c)(4). This constructional preference is based on the foundational constructional preference for the construction that is more in accord with common intention than other plausible constructions. Id 11.3(c). See, e.g., Putnam v. Putnam, 316 N.E.2d 729 (Mass. 1974). The Putnam court stated "It would be a rare case in which a conflict of terms or an ambiguity in a will should be resolved by attributing to the testator an intention which as a practical matter is likely to benefit the taxing authorities and no one else." Id at 737.
132 RESTATEMENT (THIRD) OF PROPERTY, supra note 129, 12.1. 133 Id 12.2.
134 Id statutory note 1.
135 Id cmt. d.
136 See, e.&, Estate of Nicholson v. Commissioner, 94 T.C. 666, 679-82 (1990) (disregarding a post-death modification of an inter vivos trust designed to qualify the trust for the federal estate tax marital deduction). But see Estate of Mittleman v. Commissioner, 522 F.2d 132, 133 (D.C. Cir. 1975) (qualifying the testamentary trust for the federal estate tax marital deduction, the court construed language providing "for the proper support, maintenance, welfare and comfort of [decedent's wife] for her entire lifetime" as conferring a right to all the income for life). 137 See supra part III.B. 138 See supra part III.D.
139 In re Campisi's Will, 202 N.Y.S.2d 395 (Sur. Ct. 1960) (holding that even in the absence of authority for securing a refunding bond, the estate administrator has recourse against a beneficiary who received an overpayment). See Will of Deneau, 529 N.Y.S.2d 971 (Sur. Ct. 1988) (holding that a trustee was entitled to recover distributions of principal mistakenly made to the remaindermen of the trust); RESTATEMENT (SECOND) OF TRUSTS rs 254 (1957). 140 See Robinson v. McWayne, 35 Haw. 689 (1940).
141 Welch v. Flory, 200 N.E. 900, 902 (Mass. 1936) (holding that a beneficiary is entitled to recover overpayments made by an estate administrator to an improper party).
142 In re Lindsey's Will, 109 N.Y.S.2d 600 (Sur. Ct. 1952) (holding that an income beneficiary who acquiesces in an allocation with knowledge of the facts has no basis for later complaint); In re Wilbur's Estate, 5 A.2d 325 (Pa. 1939) (holding that laches and acquiescence by a beneficiary will bar his later obtaining any relief from an incorrect allocation); RESTATEMENT (SECOND) OF TRUSTS s 219(1) (1957) ("The beneficiary cannot hold the trustee liable for a breach of trust if he fails to sue the trustee for the breach of trust for so long a time and under such circumstances that it would be inequitable to permit him to hold the trustee liable.").
143 See GEORGE G. BOGERT & GEORGE T. BOGERT, THE LAW OF TRUSTS AND TRUSTEEs 814, at 314 (rev. 2nd ed. 1981) ("It is generally held that a trustee is under an unqualified and absolute duty to make payments and distributions to the beneficiaries entitled thereto, rather than merely to use the care and judgment of a man of reasonable prudence in distributing trust property."); REsTATEMENT (SECOND) OF TRUSTS 226 (1957) (stating that if the trustee has a duty to "pay or convey the trust property or any part thereof to a beneficiary, he is liable if he pays or conveys to a person who is neither the beneficiary nor one to whom the beneficiary or the court has authorized him to make such payment or conveyance").
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