Beneficiary’s acquiesence in investments not a bar to later objection

The Iowa Court of Appeals released an opinion in In re the Thompson Trust (No. 10-0458/1-078, May 25, 2011), which is interesting for a variety of reasons, and one of them even relates to the law. Both procedurally and as relates to fees and costs, the case is hauntingly similar to Jarndyce v Jarndyce.

One thing interesting about Thompson Trust is that the trust has been in existence for 99 years. Another interesting thing about the trust is that it reportedly has $60,000,000 in assets.

Apart from these somewhat voyeuristic details, the trustee had annually sought approval of the investments of the trust. The trust investments involve a large concentration of stock in one banking company. The trustee apparently had provided reports “for decades” to both current and contingent beneficiaries. In 2007, Arabella Decker’s status changed from contingent to current beneficiary. In 2008, she objected to the trustee’s annual report.

The case is a surprising procedural tangle. The beneficiary, seemingly, took a shotgun approach with her objection. The appellate opinion is a bit vague on all of the details, but she included an objection relating to the concentration of stock. The Probate Court found in favor of the trustee and sustained a motion for summary judgment. The trustee had “asserted the Objector’s claims were barred by the doctrines of res judicata, consent and affirmation, estoppel by acquiescence, and laches.”

Judge Vogel, writing for the Court of Appeals, agreed that there was not much to argue about on the trustee’s past-year performance. However, the Court agreed with the Objector that: “These legal doctrines could not apply as each year’s activities could present an actionable cause, such as a newly found breach of fiduciary duty, wholly independent from the prior year’s activities. Therefore no beneficiary is precluded from year to year, raising an objection to the annual report, absent a showing that the same claim had been raised and litigated, or an activity had been consented to or acquiescenced [sic] in or a claim fell by the wayside for failure to timely object.”

On the other hand, knowing in 2007 the trustee’s intentions for investment in 2008, the beneficiary was barred from objecting in 2008 to those investments. Of course, the beneficiary could, and the Court determined that she did, object in 2008 to the investments going forward. On this issue, the Court remanded for further hearing.

Still more fascinating is that the district court docket shows that, while the case has been on appeal, the Probate Court already approved a petition to convert the trust from an income trust to a “total return trust,” a trustee policy, and a plan to reduce the concentration of stock. There is no appeal of that order. According to the Court of Appeals decision, the trust is scheduled to terminate in 2018 — I wonder if we will see on the appellate docket again?

Iowa has in place the Uniform Prudent Investor Act. Iowa Code §§ 633A.4301 et seq. Aside from basic investor prudence, the law dictates: “A trustee shall diversify the investments of the trust unless the trustee reasonably determines that the purposes of the trust are better served without diversifying.” Clearly, having the Probate Court approve the proposed investment plan in a report distributed to contingent and current beneficiaries alike each year was itself a prudent act.

Credit shelter trust trap

The federal estate tax is gone for 2010. I think it is safe to say that it will be back in 2011. It is not clear how it will be back. Whether Congress will change the estate tax is a question that is on the minds of many. Congress has many proposals, but that is a topic for another time. One reason for concern is that many estate plans (both revocable trusts and wills) may have a potential issue lurking in the federal estate tax planning.

Many estate plans use a planning technique that creates a trust to minimize the effect of the federal estate tax. This is commonly called a “credit shelter” trust or sometimes a “family bypass” trust or even “A-B” trusts.

To understand this estate planning technique, one needs to understand that the federal government levies a wealth transfer excise tax called the estate tax. The tax does not reach most people because every person receives a credit to be applied against the tax. The credit amount roughly translates to what is commonly called the “estate tax exclusion” amount. The credit (and the exclusion) may be affected by certain lifetime gifts as well. The exclusion amount is approximately the value that can be passed along to the decedent’s beneficiaries before the estate excise tax kicks in. The exclusion amount has been a moving target for the last ten years.

In 2001, the exclusion amount was $675,000. In 2002 and 2003, the exclusion amount was $1,000,000. In 2004 and 2005, the exclusion amount was $1,500,000. From 2006 to 2008, the exclusion amount was $2,000,000. In 2009, the exclusion amount was $3,500,000. Unless Congress changes the law, the exclusion amount will return to $1,000,000 in 2011. Generally speaking, this means that an individual with assets of $1,000,000 or more who dies after 2010 may have exposure to the federal estate tax.

The credit shelter trust technique relies upon knowing the amount of a credit each person receives against the estate tax. The credit shelter works by setting aside the exemption equivalent amount from the estate of the first spouse to die. The trust assets are, in fact, taxed in the estate of the first spouse. The tax on these assets is reduced to zero by the application of the credit. The trust assets are kept out of the surviving spouse’s estate, thus no possible federal estate tax on the death of the second spouse, and are distributed to the children. The trust is commonly funded with appreciating assets, if possible, but not without a view to providing income to the surviving spouse. The credit shelter trust must prevent the surviving spouse from taking the trust principal (the assets that the trust starts with) – this keeps those asset out of the survivor’s estate. Any remaining assets usually pass to the surviving spouse. Any assets that pass directly to a spouse, can be deducted from the estate tax. Thus, between the credit shelter trust and the gift to the spouse, there is no federal estate tax to pay, at least in the estate of the first spouse to die.

If a decedent’s credit shelter trust is funded with an amount which is “the largest taxable estate on which no federal estate tax is payable,” what happens when the exemption is very high or nonexistent?

Much depends on the wording of the gift. The usual gift is in an amount “equal to the largest amount that can pass free of federal estate tax.” If there is no estate tax, literally everything can pass free of the federal estate tax. Thus, everything in the decedent’s name goes into trust. There is nothing to pass outright to the surviving spouse.

Now this everything-to-trust result might be good, but it might be bad. Whether this result is good or bad, it seems to me, depends in large measure on whether the result is intended. It might ultimately be a good result if the couple’s estates are equally balanced and very high net worth – in other words, the surviving spouse is not dependent on the deceased spouse’s assets. It might not be so good if the couple’s estate are not so balanced or their wealth is not so high.

It might be really bad if the credit shelter trust winds up with too much of the couple’s assets. In that case, the income may not be sufficient for certain big needs and the principal is likely to be restricted. So, for example, the survivor may find that having enough ready assets to buy a new car or put a roof on the house might be more difficult because of this estate plan.

The estate plan can be updated to limit these potential problems. One might write several options into the estate plan accounting for the several tax scenarios. One might leave the surviving spouse an opportunity to survey the landscape and direct provide that disclaimed assets will go to the family bypass trust. One might give the trustee authority to waive some or all trust assets.

In short, it is a good idea to look over those estate planning documents to make sure that any estate tax planning gives the predicted and intended results.