It’s a Gift if You Do. It’s a Gift if You Don’t. What Lurks in the Shadows When an Interested Fiduciary Acts

• Publication year: 2020
• Author: By Michael Gerson,* Wendy M. Morodomi Esq.,** and Lucille Campbell, Esq.**

IT’S A GIFT IF YOU DO. IT’S A GIFT IF YOU DON’T. WHAT LURKS IN THE SHADOWS WHEN AN INTERESTED FIDUCIARY ACTS

By Michael Gerson,* Wendy M. Morodomi Esq.,** and Lucille Campbell, Esq.**

An estate plan will often name a spouse or child as sole trustee of a trust in which that spouse or child is also a beneficiary. To maximize gift and estate tax savings, as well as enjoy creditor protection afforded by trusts,¹ a beneficiary-trustee ("interested trustee" or "interested fiduciary") should not have unfettered control over the trust. Trust provisions commonly prohibit the interested trustee from using trust funds to discharge the trustee's legal obligations and limit distributions to ascertainable standards.² What practitioners may not realize is that tax elections and administrative actions may also trigger gift and estate taxes, and that additional limitations to an interested trustee's powers may be prudent to avoid those consequences.³

This article explores this issue in four parts. The first part addresses general principles and provides background in tax and other applicable law. The second part deals with administrative actions exercised at the beginning of an estate or trust administration or as a result of the initial establishment or funding of a trust or estate, referred to in this article as an "initial action." The third part deals with actions as part of an ongoing trust administration, such as a trust that has been in existence for a few years, referred to in this article as a "subsequent action." The last part analyzes possible approaches to address these fiduciary issues in a trust administration.

I. GENERAL PRINCIPLES

To understand how tax elections and administrative actions by an interested fiduciary could be a gift, a review of the basics of taxable gifts is necessary. A gift is a transfer of property by the donor for less than full and adequate consideration.⁴ A trustee holds legal title, not beneficial title, to trust assets.⁵ Bare legal title is not property for purposes of either the gift or estate tax.⁶ Thus, in general, trustees in a fiduciary capacity do not make gifts of trust property regardless of their actions because they are not equitable owners of the property. However, trustees are often not just trustees of a trust; they may also be trust beneficiaries.

The actions of a trustee who also has a beneficial interest in trust property could be a gift.⁷ Gift tax can be imposed on an indirect gift of property, including when a beneficiary transfers benefits indirectly to another.⁸ The terms such as "property," "transfer," and "indirectly" are used and interpreted in the broadest sense.⁹ Generally, the trustee, as an individual, receives no consideration for taking fiduciary actions. Therefore, if the trustee makes a transfer of property, it will be for less than full and adequate consideration and thus could be a gift.

A. Fiduciary Obligation Does Not Preclude a Gift

Trustees are subject to fiduciary duties in the exercise of trustee powers. Put differently, in many situations the trustee "really does not have a power, but rather a duty."¹⁰ However, duties do not prevent the exercise of power from being a gift. Applicable regulations require that the duty be constrained by a reasonably fixed or ascertainable standard, one that is clearly measurable.¹¹

If the trust instrument effectively waives review, for example by providing that the "determination of the trustee shall be conclusive with respect to the exercise or nonexercise of a power, the power is not limited by a reasonably definite standard."¹²

In California, all trustee actions are subject to a reasonableness standard notwithstanding any language in the trust instrument; accountability exists for every action.¹³ However, IRS rulings have required definite limits on the discretion.¹⁴ Thus, although California law imposes some level of accountability on a trustee in exercising powers, with the additional required limitations on discretionary distributions, the limitations imposed by a reasonableness standard may not meet the "fixed or ascertainable" or "clearly measurable" standard set forth in federal tax law.

B. Power of Appointment

An interested trustee can also make a gift by exercising a fiduciary power if that power constitutes a power of appointment. Relevant treasury regulations state:

The mere power of management, investment, custody of assets, or the power to allocate receipts and disbursements as between income and principal, exercisable in a fiduciary capacity, whereby the holder has no power to enlarge or shift any of the beneficial interests therein except as an incidental consequence of the discharge of such fiduciary duties is not a power of appointment.¹⁵

[Page 34]

Because this regulation exempts some administrative actions from being powers of appointment, it implies that other administrative powers may be powers of appointment.¹⁶ Two key questions arise as a result.

The first question is which fiduciary powers are deemed powers of appointment. Here, the regulation provides a "safe harbor"—an administrative action is not the exercise of a power of appointment if the power is "mere" and only enlarges or shifts any beneficial interest "as an incidental consequence." The regulation does not provide that the inverse is true, i.e., a trustee's administrative power is a power of appointment if the power is more than a "mere" power or more than "incidentally" enlarges or shifts any beneficial interest.¹⁷ Treasury and the IRS have not issued any guidance on what constitutes "mere" or "incidental" for these purposes.

The second question is whether the power of appointment is a general power of appointment or a limited or special power of appointment. A general power of appointment is a power exercisable "in favor of the decedent, his estate, his creditors, or the creditors of his estate" that is not limited by an ascertainable standard (relating to the health, education, support, or maintenance).¹⁸ Although the power must be exercisable "in favor of" the interested trustee, the power does not have to be exercised in such a manner—the power could be exercised to benefit someone else and still be a general power of appointment so long as it could be exercised in favor of the interested trustee.

If the power of appointment is not a general power of appointment, it is a limited power of appointment. The exercise or non-exercise of a limited power of appointment is generally not a taxable gift. An exception exists if the beneficiary has a mandatory income interest in the trust. In that case, the tax court has held, and the IRS has ruled, an exercise of the power of appointment over the trust corpus is a taxable gift.¹⁹ So, while the exercise or non-exercise of every general power of appointment has tax implications, the exercise or non-exercise of a limited power of appointment appears to be a gift only when the beneficiary-trustee has a non-discretionary income interest in the trust.

For example, assume that the trust instrument gives a beneficiary an annual right to withdraw the greater of $5,000 or 5% of the value of the trust property. A trustee action that reduces or eliminates the trust corpus on which that withdrawal right is calculated could constitute a taxable gift.²⁰ In other words, if the interested trustee exercises a fiduciary power that reduces or eliminates the income stream and the withdrawal right by reducing the value of the trust corpus, that action arguably constitutes a gift.

II. ADMINISTRATIVE ACTIONS

In analyzing the potential gift tax consequences of trustee administrative actions, this article divides the actions into two types: the "initial" action and the "subsequent" action. An initial action is an action made as part of the establishment or funding of a trust; a subsequent action is any action involving an ongoing, established trust.

A. Initial Actions

A common initial action is the election to qualify a transfer to a marital trust for the estate tax marital deduction.²¹ If the election does not change the economic realities, so that the lack of an election only has tax effects and does not enlarge or shift any beneficial interest, no basis appears to exist to characterize that election as a gift.²² That election could only be a gift if the non-election results in assets passing to a trust that would not qualify for the gift or estate tax marital deduction, i.e., a Clayton QTIP.

In the Clayton case, the governing instrument provided that if the executor²³ failed to make the QTIP election, the estate assets passed to a trust that would not qualify for the estate tax marital deduction. ²⁴ The IRS initially contended that this provision gave the executor a power to appoint assets away from the surviving spouse.²⁵ Three appellate courts rejected that argument.²⁶ Although their reasoning was somewhat dissimilar, the courts held that the election was a defining characteristic of a QTIP trust based on the language in the statute.²⁷ It is a condition precedent to the QTIP trust existing. It follows that if the Clayton QTIP election is not a power to appoint assets away from the surviving spouse under section 2056, it should not be a power of appointment for all gift and estate tax purposes.

That conclusion is reasonable, as there is no trust asset to make a gift until the trust exists.²⁸ The beneficiary has no right in QTIP trust property until the election is made which transfers property to that trust. Furthermore, the fiduciary is guaranteed to either make or not make the QTIP election. This initial election is a condition precedent to the fiduciary beneficiary having any interest in the QTIP trust.²⁹

[Page 35]

Another example of an initial action is the election to deduct administration expenses on the estate tax return or income tax return.³⁰ The executor can deduct those expenses on the estate tax return or the fiduciary income tax return, but not both.³¹ Where those deductions are taken can have significant economic...