Posts Tagged ‘QTIP trusts’

Trust for Surviving Spouse Leads to Dispute With Stepchildren


When Albert Findlay (not his real name) died in 2002, he left a trust for the benefit of his wife Sharon. Sharon was named as trustee, and the trust document directed that she was to receive “the entire net income” from the trust for the rest of her life. Albert specifically directed that, as trustee, Sharon would not have any right to take principal out of the trust, but he left at least a half million dollars of investable assets in the trust, so it could be expected to produce some income for Sharon. In addition, the trust included several pieces of investment property — Albert appears to have been a moderately wealthy and successful man.

Albert also had three daughters from his first marriage (that is, they were not Sharon’s children). One of the significant assets in the trust was a 20.28% interest in an apartment building in downtown Prescott, Arizona. Albert’s daughters owned the remaining interest and managed the building.

Already the description of Albert’s estate plan should give some clues about what ended up going wrong. In our experience, clients have a hard time imagining what the family dynamics will actually look like after their deaths. We can guess that Albert might have had such a failure of vision. Would Sharon handle the trust properly? Would she get along with her step-daughters? Would any of them, financially enmeshed as they were, seek to take advantage of the others? Would all of them understand their obligations to one another, providing information and responding reasonably when asked?

It is not clear from the court record (you predicted that there would be a court proceeding, didn’t you?) who acted first, but in the few years after Albert’s death several things happened:

  1. Two of his daughters, as managers of the apartment complex, took out a loan against the building. They did not put the proceeds into the limited liability company running the rental building. The building did not generate sufficient income to make the loan payments, and the property was ultimately lost to a foreclosure.
  2. Sharon began automatically transferring $3,000 per month from the trust to her personal checking account, regardless of how much income the trust produced. The value of the stocks held in the trust began to decline.
  3. Albert’s daughters requested accounting information for the trust, but Sharon did not comply for months. In fact, she did not provide any detailed account information until court proceedings had been filed.
  4. The daughters attempted to sell one of the other assets held jointly among them and Sharon’s trust; Sharon objected to some of the terms of the proposed sale and it did not go through. The daughters then formed a new limited liability company and transferred their share of that asset to the new LLC. Meanwhile, they received an offer on the struggling apartment building (before the foreclosure) but rejected it without consulting Sharon.
  5. Once litigation began, Sharon hired an attorney and paid about $70,000 in legal fees from the trust. She actually initiated the lawsuit, seeking damages for her stepdaughters’ handling of the apartment building. They countersued, asking that she be removed as trustee, ordered to account and ordered to return money she should not have taken from the trust.
  6. Meanwhile, Sharon was receiving trust checks for rental payments on another trust asset, a commercial rental building. She deposited those checks into her personal account directly, and reported the income on her own income tax return rather than showing it as trust income. In fact, Sharon didn’t even have a trust checking account set up for most of the time she acted as trustee.

The trial court heard testimony from the warring parties, and ended up removing Sharon as trustee (a non-family member took over after her removal), ordering her to return trust money she should not have received, and directing her attorney to return $70,000 in legal fees paid by the trust. Sharon appealed.

The Arizona Court of Appeals affirmed most of the trial judge’s findings, but disagreed about how much Sharon should have been entitled to receive from the trust. The trial judge had ordered Sharon to return everything she had received above the “distributable net income” (DNI) of the trust — that calculation was wrong, said the appellate court. DNI is a tax-related calculation — it is the maximum amount of the income tax deduction available to a trust for distributions to an income beneficiary — and “income” for trust accounting purposes is a different (and often somewhat larger) number, according to the Court of Appeals.

The appellate court sent the dispute back to the trial judge for further hearings to calculate the amount that Sharon owes back to the trust. It also directed the trial judge to conduct proceedings to determine whether Albert would have wanted his trust used to pay for administrative items like legal fees. In the first hearing, the judge had refused to allow Albert’s lawyer to testify about what he might have intended in that regard.

Two other holdings by the Court of Appeals are worth mentioning. First, the appellate judges noted that Sharon’s decision to sell the stocks held in the trust when she took over is not, by itself, evidence of any wrongdoing. Even though the value of the stock holdings had apparently gone down during her administration, that is not necessarily actionable. A trustee is not an insurer, but has a duty to manage trust assets prudently. The trial judge will need to inquire further into the kinds of changes made before deciding to order Sharon to return funds.

Finally, the appellate court noted that there is not necessarily any problem with naming a trustee who has an interest in the trust’s administration. In fact, it is common to name beneficiaries as trustees — they then have a duty to the other beneficiaries, but that does not mean that someone in Sharon’s position is precluded from seeking to assert her own interests in the trust. The trial court will need to review the earlier ruling to make sure that the “conflict of interest” analysis was not too sweeping in its application. Favour v. Favour, February 11, 2014.

It is a challenge to describe a court opinion like the Favour holding without dropping into technical jargon. But perhaps it is more useful and interesting to think about how the litigation — and the outcome — might have been avoided in the first instance. We have a few ideas to suggest — though we are quick to note that we never discussed Albert’s wishes with him, and he might have rejected any or all of these:

  1. Naming a beneficiary as trustee is not at all objectionable, and (as the appellate court notes) it is commonly done. But if the trust’s author intends that everyone be treated scrupulously fairly, it might make more sense to name a disinterested person (or organization) — even a professional — as trustee.
  2. It is uncommon to see modern trusts that require distribution of all income but preclude distribution of any principal. That is an invitation to this kind of dispute, since the characterization of income and principal can be subject to interpretation. It also puts the income and remainder beneficiaries at odds — income beneficiaries are not interested in growth of investment value, and remainder beneficiaries would rather skip current income in favor of that growth.
  3. Putting fractional shares of investment assets into the trust is another way to encourage disagreement — particularly when other trust beneficiaries have management authority over the fractional interests.
  4. Once any level of conflict arose, it might have been appropriate for Sharon to consider application of Arizona’s “total return unitrust” statutory authority. Using that approach, she might have set a presumptive rate of distribution from the trust regardless of the actual income — and reduced the possibilities of disagreement between herself and her stepdaughters.
  5. Including some sort of dispute resolution mechanism in a trust — especially a trust like this one, involving a surviving spouse and stepchildren from an earlier marriage — might make sense as a way of minimizing conflict, avoiding court proceedings and reducing legal expenses.
  6. A trustee has a duty to report to remainder beneficiaries. Someone should have explained that to Sharon early, and pushed her toward satisfying that obligation. Delaying or avoiding her duty did not work to her benefit in the long run.

With remand to the trial court, it may not be too late for Sharon and her stepdaughters to work out some less-costly resolution of their dispute. But some part of the cost (and the breakdown in the interpersonal dynamics) has to be laid at Albert’s door — he could have reduced the conflicts and helped his family avoid disputes by a little more careful thought about the drafting, funding and future of his trust plans.


More on Types of Trusts — Some of the Less Common Varieties

Last week we wrote about different types of trusts you might have encountered, and tried to explain some of the generic terms, differences among and between types, and likely settings where a given type of trust might be appropriate. We wrote about spendthrift trusts, bypass trusts, special needs trusts and the difference between revocable and irrevocable trusts. Let’s see if we can clear up some of the confusion over less-common trust names.

Crummey trusts. In 1962 Californian Dr. Clifford Crummey created a trust for the benefit of his four children, who then ranged in age from 11 to 22. He was trying to address a problem with estate tax law: he could give the money to his children outright (and then worry about how they spent it) or put it in trust for them to protect it (but then not get it out of his own estate for estate tax purposes). His clever idea: put the money in a trust for each kid’s benefit, but give that child the right to withdraw his “gift” from the trust until the end of the year. When they didn’t exercise that right (hey — the youngest was only 11, and even the oldest would understand that withdrawing his money might affect future gifts) it would lapse, and the gift would be completed but stay in trust.

The Internal Revenue Service thought it was a trick, and they argued that Dr. Crummey and his wife had not made gifts at all. The IRS lost that argument, and the “Crummey” trust was born, in a 1968 decision by the U.S. Ninth Circuit Court of Appeals. If you’d like to read the actual decision in Crummey v. Commissioner you may — but we warn you that it will be interesting to only a few diehards, most of them lawyers or accountants.

For nearly a half-century, then, the Crummey trust has been a primary tool in the estate planner’s toolbox. The trusts have morphed over time — now they are often used to purchase life insurance (and may be called Irrevocable Life Insurance Trusts, or ILITs). The length of time for a beneficiary to withdraw the funds has been shortened in most cases — often to a month and sometimes even less. Some practitioners even give the withdrawal right to people other than the primary trust beneficiary. The Crummey trust in each case is an irrevocable trust intended to get a gift out of the donor’s estate for tax purposes but into a trust to control the use of the money after the gift is completed. With the present high gift tax exemption in federal law ($5 million for 2011 and 2012) the use of Crummey trusts will probably diminish appreciably.

Generation-Skipping trusts. In the simplest sense, a GST (practitioners love acronyms) is any trust that continues for more than one generation of beneficiaries. The “current” generation, if you will, might or might not have the right to receive income, or access to principal, of the trust — but it will continue until at least the death of that current generation representative.

GSTs are often constructed to skip multiple generations. The model for the maintenance of accumulated family wealth is usually the Rockefeller family — some of the trusts established by John D. Rockefeller before his 1937 death and valued collectively at over $1.4 billion at the time — are still chugging along for the benefit of his descendants.

Because of concerns about the accumulation of family wealth, and the avoidance of estate taxes in multiple generations by the use of such trusts, the federal government in 1976 introduced a new GST taxation scheme. More recent changes in the GST tax have driven the types, terms and use of GSTs. The GST tax is very high, but only applies (as of 2011 — the rules may change in two years or thereafter) to “skips” of over $5 million. Very elaborate GSTs are sometimes marketed as Dynasty trusts. One common problem in addition to tax issues: the common-law “Rule Against Perpetuities” may make it difficult to extend trusts for multiple generations. In Arizona it is now at least theoretically possible to extend a trust over more than 500 years without facing problems with the Rule. That is a sobering thought when you consider that 500 years ago the land that was to become Arizona was all but unknown to ancestors of the Europeans, Asians, Africans and even many Native Americans who live here now.

QTIP trusts. QTIP stands for “Qualified Terminable Interest Property.” Does that explain the trust type? Well, not quite.

In very general terms, a QTIP trust is probably designed for one narrow purpose. It permits a wealthy spouse to leave property for the benefit of a less-well-off surviving spouse without consuming the deceased spouse’s full estate tax exemption amount. In other words: if you were worth, say, $10 million dollars in 2009, when the estate tax exemption was at $3.5 million, you might have left $3.5 million to your adult children from your first marriage and most of the rest of your property in a QTIP trust for your second husband (or wife). That way your estate would pay no estate tax, and the tax would be due on the death of the surviving spouse. Since he (or she) had no property in our example, that means that his (or her) $3.5 million exemption would get used on your property first, and only the excess would be subject to taxation as it passed to your children from the first marriage.

As you can see, it is getting harder and harder to make a QTIP trust a good planning opportunity, except for extremely large estates with very high disparity in net worth between the spouses. But the QTIP trust isn’t dead yet — uncertainty about the federal estate tax, continued state estate taxes in some states (but not Arizona) and inertia preventing modification of older estate plans will all contribute to keeping the QTIP alive for a few more years, at least.

We don’t know about you, but we’re exhausted. Maybe we’ll tackle some more trust types on another day. Suggestions? Do you want to know about QDoTs (sometimes called QDTs or QDOTs)? QDisTs (Qualified Disability Trusts)? Cristofani Trusts? Just ask, and we’ll take a run at them.

©2017 Fleming & Curti, PLC