DRAFTING WILLS AND TRUSTS FROM AN INCOME TAX PERSPECTIVE
A Panoply of Forms

By Noel C. Ice

The following is not a typical outline of income tax issues in the administration of trusts and estates. Rather, it is a series of forms, beginning in Article I with some typical will and trust clauses dealing with income tax issues. There follow a couple of letters and memos, used to fully apprise the poor fiduciary of the nuts and bolts issues that cannot be avoided, such as— “Do I need to get one or more taxpayer identification numbers, and, if so, how do I do it? Where do I deduct administrative expenses? What is the §645 election, and why is it so complicated? What is DNI and how is it affected by the separate share rule? Will there be gain when I fund a trust?”

For a more typical outline on the ins and outs of the post-mortem income tax rules, try to find the latest of Prof. Mickey Davis’s always excellent papers, presented on the subject at various Advanced Estate Planning/Drafting Courses sponsored by the SBT-PDP. Likewise, see Steve Akers Post-Mortem outline, a version of which resides at http://www.trustsandestates.net/Guest_Folder/Akers_Post-Mortem_Est_Admin_2003.htm.

If you do not tell the fiduciary about these rules who will? If you do not do it in writing, do you really expect the fiduciary to recall your oral explanation? Perhaps you could just say, “Don’t do anything at all without consulting me first,” but this simply may not be practical; moreover, all the lawyer can do is to advise; it is the fiduciary who has the responsibility of making ultimate decisions. These decisions must be made on a fully informed basis, and cannot always be done meaningfully merely on the basis of a prior oral conversation with counsel. Even if all of the technical issues are explained, in detail, orally, it is not reasonable to expect the fiduciary to absorb and be able to recall all that was said; unless, perhaps, the fiduciary is a professional fiduciary. I maintain that the lawyer should strive to give the fiduciary written instructions about what the fiduciary may need to know to execute the office. Unfortunately, it is impossible to give all the information that might be needed without bombarding the fiduciary with more data that the fiduciary can possibly absorb. Thus, a reasonable approximation is the most that can ever be achieved. Even then, the fiduciary would probably wish you had been less informative. You can’t win. All you can do is try.

The sample letters below cover a lot more than just income tax issues, but I thought I would throw the whole of them in for your benefit without editing, since I believe you will find them useful. I will confine my oral remarks to the income tax issues found in the letters.

ARTICLE 1
TRust Administrative provisions

The following provisions in this Article are will and trust clauses, which treat income tax issues, which I commonly use, and which I excised for your consideration.

1.1 Valuation For Funding and Distribution Purposes-In Kind Distribution.

1.1(a) In General.

Unfortunately, when property, including cash, is distributed in satisfaction of a gift that is not a specific gift, it will often be necessary to value the entire estate available for distribution as of the date of distribution, depending on the valuation method required by the governing instrument (e.g., minimum worth, FMV or fairly representative). Revaluation can be necessary, for example, if the distribution is in satisfaction of a fractional share gift (e.g., a gift of a fraction of the residuary estate), if some beneficiaries of the gift receive different assets than others (i.e., a nonprorata distribution), as is generally permitted but not required under this instrument; or if prorata distributions are not made at the same time. Revaluation is presumably also necessary in the case of a pecuniary distribution made under a Rev. Proc. 64-19 approach, in order to be able to demonstrate that such a distribution is “fairly representative of appreciation and depreciation” of all assets available for distribution. If a pecuniary gift is to be satisfied with property other than cash at its “fair market value on the date of distribution,” it will usually be necessary to recognize capital gain if the value of the property at the time of distribution exceeds its basis for federal income tax purposes; or, at least that is the probable IRS’ position. Interestingly, these are rules that will often be overlooked by all but a good probate tax lawyer, often to the advantage of the taxpayer, who otherwise pays a “competence tax.”

1.1(b) Method For Valuing Property Distributed as a Part of a Nonprorata Distribution of the Residuary Estate.

Except as otherwise specifically provided to the contrary herein, fractional share gifts that are not specific gifts, including gifts of the residuary estate, may be funded on a nonprorata basis (pick-and-choose) provided funding is based on either (1) the fair market value of all of the assets available for funding on the date or dates of funding or (2) in a manner that fairly reflects the net appreciation or depreciation in the value of all of the assets measured from the date of death to the date(s) of funding. Unless otherwise specified herein, the fiduciary will have the reasonable discretion to determine which of the two funding methods to use.[1]

[Note that a true pick-and-choose fractional share, as described in (1), apparently allows the fiduciary to play around with the basis. E.g., as long as each beneficiary receives assets equal in value to the beneficiary’s proportionate share of the fair market value of the entire fund subject to division, the fact that one beneficiary may receive low basis and the other high basis assets, is irrelevant for tax purposes. Arguably, method (2), Rev. Proc. 64-19,[2] requires that the assets themselves fairly reflect the appreciation and depreciation.[3] The GST regulations are even more explicit than Rev. Proc. 64-19 on this subject.[4]]

1.1(c) Method For Valuing Property Distributed in Satisfaction of a Pecuniary Bequest is Fair Market Value on Date or Dates of Distribution Except for Pecuniary Gifts Exceeding $100,000.

Except as otherwise specifically provided to the contrary, a pecuniary gift of $100,000 or less will be satisfied using assets having a fair market value at the date or dates of distribution equal to the pecuniary amount of the gift. However, in the case of distributions in satisfaction of pecuniary gifts of over $100,000, the cash and other property distributed will have an aggregate fair market value fairly representative of the pecuniary beneficiary’s proportionate share of the appreciation or depreciation of all property then available for distribution in satisfaction of the pecuniary gift.

1.1(d) Meaning of “Fairly Representative of Appreciation or Depreciation.”

The phrase “fairly representative of the pecuniary beneficiary’s proportionate share of the appreciation or depreciation” or “fairly reflects net appreciation or depreciation” or “fairly representative of appreciation or depreciation,” when used in connection with the valuation or funding of a pecuniary gift under this instrument, will all generally have the same meaning as the latter phrase has when it is used in Rev. Proc. 64-19; or, in the case of GSTT property, as the second phrase has in the final treasury regulations governing Chapter 13 of the IRC[5]. Maker believes that this means that the value of the property subject to this valuation method will generally be deemed to equal the fair market value of the property on the date used for determining basis for federal income tax purposes, but that the property used to satisfy the gift subject to the standard will fairly reflect net appreciation and depreciation (occurring between the basis determination date and the date of distribution) in all of the assets from which the distribution could have been made. Maker believes that in the case of property included in the Maker’s gross estate, the value of property for this purpose is its value for purposes of chapter 11 of the IRC, but that if the property was not included in the gross estate (e.g., the property is the sales proceeds of property included in the estate), the value of the property will, presumably, be its federal income tax value (adjusted basis). Notwithstanding the foregoing, this valuation funding provision will be implemented, interpreted, or modified by the Decedent’s fiduciary as and if necessary in order to be consistent with the usage of the terminology in Rev. Proc. 64-19, and, in the case of GSTT property, to comply with any final treasury regulations governing Chapter 13 of the IRC at the date of distribution, in order that the denominator of the “applicable fraction” (for GSTT purposes with respect to an Exempt Share or Trust) will equal in value the available GSTT exemption, consistent with Maker’s manifest intent elsewhere expressed. In this regard “[i]f the pecuniary amount is payable in kind on the basis of value other than the date of distribution value of the assets, the trustee is required to allocate assets to the pecuniary payment in a manner that fairly reflects net appreciation or depreciation in the value of the assets in the fund available to pay the pecuniary amount measured from the date of death to the date of payment.”[6]

1.1(e) Trustee Prohibited From Operating Trust As a Device To Carry On a Business.

Although the fiduciaries have been given broad powers, including the power to carry on a business under appropriate circumstances, the trusts created under this instrument are created for the primary purpose of protecting or conserving the trust property for beneficiaries, and, following the death of Maker, the trustee is prohibited from operating the trust simply as a device to carry on a profit-making business to the exclusion of the primary purpose.

* * * *

1.2 Tax Elections.

(1) The IRC permits or requires a fiduciary to make certain tax elections as an incidental consequence of the discharge of its fiduciary duties, including at various times and in various contexts:

(A) whether to elect to file a joint return with a spouse under the provisions of §6013(a) of the IRC,

(A-1) whether an estate tax deduction will be taken for estate transmission[7] and estate management expenses[8], or whether such expenses will be deducted on the probate estate's federal income tax return, or deducted in part on each,

(A-2) whether and to what extent to make an election pursuant to §2056(b)(7)(B)(v) to qualify certain terminable interest property, if any, for the estate tax marital deduction,

(B) whether and to what extent to make an election under §643(e)(3) of the IRC,

(C) whether and where and to what extent to make an allocation of the Generation Skipping Transfer Tax (GSTT) exemption under §2631(a) of the IRC for purposes of determining the “inclusion ratio” described in Chapter 13 of Subtitle B of the IRC,

(D) to elect a taxable year, which may be a fiscal or a calendar year, under the provisions of §441 of the IRC,

(E) the date that should be selected for the valuation of property in a gross estate for federal and state death tax purposes,

(F) whether any portion of an estate should be valued under any of the applicable provisions of §2032A of the IRC,

(G) whether any portion of the federal estate tax liability for an estate will be paid under any deferred payment option available to Maker's estate under the IRC,

(H) whether a deduction will be taken as an income tax deduction or as an estate tax deduction,

(I) whether and to what extent to elect to report on Maker's final income tax return unrecognized income from United States Series E and EE savings bonds,

(J) whether to make, terminate or revoke an S-Corporation election under §1362 of the IRC.

(K) whether to make an election to qualify a trust as an “electing small business trust” under IRC §1361(e).

(2) The fiduciaries are specifically given the discretion to make all tax elections, including those enumerated above. In the case of a tax election affecting Maker’s probate estate, such election will be made by Maker’s executor or as otherwise required by law in order to make the election. Such elections will be made in a fiduciary capacity, after considering the income and estate tax consequences and the intent expressed in this instrument. However, a fiduciary will not be liable to anyone for any adverse tax consequence occasioned by the exercise or nonexercise of such election, if made in good faith.

(3) An allocation of receipts and expenditures between income and corpus for fiduciary accounting purposes need not follow the allocation for tax reporting purposes. However, a fiduciary may, but need not, make compensating adjustments between income or principal or in the amount of any gift under this instrument as a result of a tax election.

(4) In addition, no liability will be incurred by the mere fact that the exercise or nonexercise of a tax election benefits Maker's spouse, it being intended to provide for Maker's spouse during such spouse's lifetime. If (as is hereby expressly authorized) Maker's executor joins with Maker's spouse (or the estate of Maker's spouse if Maker's spouse is deceased) on Maker's behalf in filing income tax returns, or consents for gift tax purposes to having gifts made by either of them during Maker's life considered as made one-half (1/2) by each of them, any resulting liability will be borne as prescribed by law.

1.3 Income in Respect of a Decedent.

Unless this instrument specifically provides otherwise elsewhere (e.g., only to the extent consistent with my manifest and paramount intent explicitly set forth in the above Subsections that deal with the MRD Rules), if a pecuniary or a residuary gift to Charity is made under this instrument, the principal amount of the gift will be satisfied, as a matter of right, first out of any income in respect of a decedent (691 items) otherwise available for that purpose, before any other properties are allocated, and second, if need be, out of other net income of the residuary estate. If there is more than one such gift, the 691 items and other income will be pro rated between them (691 items first, other income, if need be, second). If the 691 items exceed the value of the charitable gift, the charity(ies) will be entitled to a fractional share of the 691 items and no other income. Notwithstanding anything else herein to the contrary, the fractional share will be a true fraction, with no “pick and choose” power in the fiduciary. The allocation of income under this Section (if needed to satisfy the principal amount of a gift to Charity) will not, however, have the effect of reducing the value of any other gift or right to income in a beneficiary. Thus, if the allocation of income under this Section would have that effect (but for this sentence), then Maker’s fiduciary will make whatever equitable adjustment out of corpus is necessary to make the beneficiary (including the charity itself) whole.

ARTICLE 2
A Letter to the Personal Representative Talking About Income Tax Issues, Among Other Things [9]

[TOWHOM]
[HOME_STREET]
[HOME_CITY], [HOME_STATE] [HOME_ZIP]
[PhoneBusMain] (Business)
[PhoneHomeMain] (Home)
[PhonesImptOther]
[FAX] (FAX)
[EMail]
[WESITE]

RE: Estate of [DecedentFullName], Deceased
[DecedentFullName], Deceased
Probate Cause No.: [ProbateCauseNo]
Date of Death: [DateOfDeath]

[Dear [SALUTATION]:

I realize that this is a lengthy letter, so please bear with me. I have worked long and hard on this letter, with the intent to reduce to writing in one place most of what you will need to know to fulfill your duties as [TitleOfExecutor]. The letter covers a lot of ground, bu

ARTICLE 1 TRust Administrative provisions