From the Internal Revenue Service’s Dirty Dozen tax schemes to the standard applicable to waiver in federal arbitration cases, we have recently seen significant developments in estate planning and business law. To ensure that you stay abreast of these legal changes, we have highlighted some noteworthy developments and analyzed how they may impact your estate planning and business law practice.

Internal Revenue Service Releases Annual List of Dirty Dozen Tax Schemes

On June 10, 2022, the Internal Revenue Service (IRS) completed its annual Dirty Dozen tax scams list, which included sophisticated arrangements sometimes used by high-net-worth taxpayers to reduce or avoid taxes. The IRS highlighted the following schemes to avoid:

• Abusive charitable remainder annuity trusts (CRATs). To properly use a CRAT, a taxpayer sets up an irrevocable trust that provides the grantor or another beneficiary with an income stream from fixed annuity payments for a specified term (commonly until the death of the grantor). Upon the termination of the trust, the remaining balance in the trust is transferred to one or more remainder beneficiaries that are charities. When the CRAT is created, the grantor can immediately take advantage of a charitable tax deduction. 

However, the IRS will crack down on misuses of CRATs, such as when they are used to eliminate taxable gain. In the tax avoidance scheme described by the IRS, appreciated property is transferred to the CRAT, and the taxpayer claims a step up in basis as if the asset had been sold to the CRAT. The CRAT then sells the property and, due to the claimed stepped-up basis, does not recognize gain. Using the proceeds of the sale, the CRAT purchases a single premium immediate annuity (SPIA). The beneficiary then receives payment from the SPIA, reporting only a small portion of it as taxable income and treating the rest as a return of investment for which no tax is due. The IRS states that doing so is a misapplication of I.R.C. §§ 72 and 664. 

• Misuse of conservation easements. A landowner can properly set up a conservation easement under I.R.C. § 170 by entering into an agreement with certain qualified organizations, such as a public charity, not-for-profit land trust, or federal government agency. Despite retaining ownership and use of the land, landowners can satisfy their charitable and environmentally-friendly goals while also receiving a charitable tax deduction for the amount of the decrease in the fair market value of the land due to the conservation easement (i.e., the value of the land if it had been developed minus the value of the land with the conservation easement, which precludes its development). 

However, the IRS will be vigilant in looking for two abusive schemes involving conservation easements:

• Fraudulent appraisals. If a taxpayer purchases real estate for a low price and creates a conservation easement limiting its development, and then an appraiser values it at a much higher price based on a type of development that was unlikely to occur, the resulting large charitable tax deduction will be considered an abusive misuse of the conservation easement.
• Syndication. Some promoters have syndicated conservation easement purchases for investors, who then seek charitable deductions that are much larger than the amount they actually invested. In Notice 2017-10, the IRS characterized these types of transactions as tax evasion.

Takeaways: The foregoing are only two of the tax avoidance schemes that the IRS has targeted. Some of the others are similarly complex, and others are as simple as the failure of high-income individuals to file their tax returns. Estate planners should remind clients that transactions that seem too good to be true often are, and that an IRS determination of failure to pay or underpayment could be accompanied by very steep penalties. The failure to file penalty is generally 5 percent of the unpaid taxes for each month or part of a month that a tax return is late, but the penalty generally will not exceed 25 percent of unpaid taxes. The failure to pay penalty is generally 0.5 percent of the unpaid taxes for each month or part of a month the tax remains unpaid. The penalty will not exceed 25 percent of unpaid taxes.

Doctrine of Ademption Is Not Applicable to a General Bequest of Cash

In re Barbara A. Young Living Trust, 2022 WL 1194027 (Mich. Ct. App. Apr. 21, 2022)

Barbara Young died in 2012, and her husband Clemens died in 2008. Barbara’s will included a pour-over provision specifying that all of her property would be transferred to a revocable living trust (RLT) upon her death. Under a section entitled “Specific Distributions of Trust Property,” the RLT provided: 

Upon the death of the survivor of me and my husband, CLEMENS H. YOUNG, my Trustee shall make a cash distribution of $50,000.00 to a trust for each of my Grandchildren who survive me (hereinafter referred to as my “GRANDCHILDREN”). The trust for each of my GRANDCHILDREN shall be held and administered by my Trustee pursuant to the terms set forth below.

In a separate section, the RLT stated that all property not previously distributed under its terms (i.e., the residuary) should be divided among her children. 

One of Barbara’s children, Cynthia, was also the trustee of the trust. In 2019, Barbara’s grandchildren filed a petition to compel the distribution of their $50,000 specific gifts and for the removal of Cynthia as the trustee. Cynthia argued that the $50,000 cash gift to each of the grandchildren failed under the doctrine of ademption because Barbara’s estate included only a parcel of real estate but no cash, relying on a section of the RLT that stated: “If the property is not part of my trust property at my death or does not subsequently become trust property, then the specific distribution shall be considered to be null and void, without any legal or binding effect.” The probate court rejected Cynthia’s argument, and she appealed.

The Michigan Court of Appeals affirmed the probate court’s ruling. In its de novo review, the court, in an unpublished decision, noted that its sole objective in resolving an issue regarding the meaning of a trust is to ascertain and effectuate the intent of the settlor. The court found that whether the $50,000 gifts would fail under the doctrine of ademption depended on whether they were specific gifts or general devises, and/or demonstrative bequests, which must be determined based on Barbara’s intention. It noted:

• A general legacy is payable out of the general assets of the testator.
• A specific legacy is intended if the testator wanted the legatee to have the very thing bequeathed rather than a corresponding amount in value: “the identical thing, and that thing only,” and not a gift payable out of the testator’s general assets.
• A demonstrative legacy is a gift of money payable out of a particular fund (e.g., a specific investment account), but if that fund no longer exists, the legacy should be paid in any event.

Ademption occurs when a specific devise expressed in a will is no longer in the estate when the testator dies, and it does not apply to general bequests. 

The court held that after considering the language of the RLT, Barbara’s instruction to the trustee to make the $50,000 cash distribution to each of her grandchildren was a bequest of a certain value rather than a bequest of a specifically identifiable property that could be distinguished from other articles of the same nature. In other words, it was a general rather than specific devise, and thus, the doctrine of ademption was not applicable. As a result, the bequest should be distributed out of the general assets of the estate, even if the assets did not include cash at the time of Barbara’s death.

Takeaways: Estate planners should ensure that they have a good understanding of state law applicable to ademption. Further, careful drafting of wills and trusts that clearly specifies the intentions of the testator/settlor and the nature of their bequests is essential to avoid unnecessary litigation.

Co-Trustee Does Not Have To Be Perfect, but Is Liable for Approving Distributions that Violate Trust Terms and Fiduciary Duties

Greenberg v. Greenberg, 185 N.E.3d 921 (Mass. Ct. App. Apr. 4, 2022)

Mimi Greenberg established a revocable living trust (RLT) in 1973 to enable her husband Nathan and other trust beneficiaries to maintain their standard of living after her death and provide for their healthcare needs. The trust was designed to have three trustees; the original trustees were Nathan, Mimi’s brother, and a family friend. Two of the trustees (the family friend and Mimi’s brother) resigned. Agnes Kull was appointed successor trustee to replace the friend, but no one was appointed to replace Mimi’s brother. Although the RLT prohibited Nathan from making distributions to himself, it gave the trustees broad discretion in their investment decisions and explicitly authorized them to make investments that “but for this express authority, would not be considered proper for trustees.” The RLT incurred heavy losses due to investment in the now-notorious Bernie Madoff “fund” as well as other risky investments; Nathan also made distributions to himself. 

Agnes and Nathan, as trustees, brought an action against the beneficiaries for a declaratory judgment that their actions complied with the terms of the RLT, but the beneficiaries counterclaimed for breach of fiduciary duties based on certain trust distributions, investment decisions, and the failure to maintain a third trustee. The court found in favor of the beneficiaries and awarded them $6 million in damages.

On appeal, the Massachusetts Court of Appeals found that the record supported the lower court’s determination that Agnes, as co-trustee, had acted with reckless indifference by rubber-stamping substantial distributions Nathan made to himself and the other beneficiaries without inquiring about whether they were necessary or if they were made in violation of the terms of the trust.

However, after reviewing the record regarding three risky investments Nathan made as trustee, all of which were later determined to be criminal enterprises including the Bernie Madoff scheme, the court found that the trial court had erred in finding Agnes liable for breach of fiduciary duty by disregarding her duty to exercise reasonable care, skill, and caution when she her approved two of the investments. Interestingly, the trial court found that she had acted in good faith in approving the Madoff investment in particular. The court noted that the trial court had determined that Agnes had always acted in good faith—or at least not in bad faith—and that she had followed the same course in approving all three investments. 

Takeaways: The appointment of a co-trustees is one method used to provide trust beneficiaries with a stronger degree of asset protection. However, while they need not have perfect judgment, co-trustees cannot merely rubber-stamp decisions of other co-trustees and must comply with the terms of the trust and their fiduciary duties in approving distributions—or risk liability for breach of those duties.

US Supreme Court Finds Waiver of Right to Compel Arbitration under Federal Arbitration Act Is Not Conditioned on Prejudice of Opposing Party

Morgan v. Sundance, 142 S. Ct. 1708 (May 23, 2022)

Robyn Morgan, an employee at a Taco Bell franchise owned by Sundance, signed an agreement to arbitrate any employment dispute when she had applied for the job. However, she eventually filed a nationwide collective action asserting that Sundance had violated federal overtime laws. Sundance defended the lawsuit for eight months despite the existence of the arbitration agreement. It then filed a motion to stay the lawsuit and compel arbitration under the Federal Arbitration Act (FAA). Robyn opposed the motion on the basis that Sundance had waived its right to arbitration. Applying its precedent that a party waives its contractual right to arbitration if (1) it knew of the right, (2) acted inconsistently with the right, and (3) prejudiced the other party by its inconsistent action, the Eighth Circuit Court of Appeals reversed the district court’s ruling, which had found that the prejudice requirement had been satisfied, and granted Sundance’s motion to compel arbitration.

Because there was a split among the circuits regarding whether a showing of prejudice is required under the FAA in arbitration cases, the US Supreme Court granted certiorari to determine whether the courts “may create arbitration-specific variants of federal procedural rules, like those concerning waiver, based on the FAA’s ‘policy favoring arbitration.’” In a unanimous opinion authored by Justice Kagan, the court stated that generally, in nonarbitration cases, the federal courts do not include prejudice in their assessment of whether a waiver has occurred. In addition, the court held that the FAA’s policy favoring arbitration merely reflects its commitment to “overrule the judiciary’s longstanding refusal to enforce” arbitration agreements, so that they will be “as enforceable as other contracts” rather than more enforceable than other contracts. Therefore, the policy reflected in the FAA “does not authorize federal courts to invent special, arbitration-preferring procedural rules.” The court noted that FAA section 6 provides that an application under the statute generally “shall be made and heard in the manner provided by law for the making and hearing of motions.” The court found that this language in section 6 was “simply a command to apply the usual federal rules, including any rules relating to a motion’s timeliness. Or put conversely, it is a bar on using custom-made rules, to tilt the playing field in favor of (or against) arbitration.” Accordingly, the court vacated and remanded the case to the Eighth Circuit Court of Appeals for a waiver inquiry that focused solely on Sundance’s conduct.

Takeaways: The Supreme Court’s decision settles a long-standing split between nine circuits that had adopted a prejudice requirement in determining whether waiver of arbitration had occurred and two circuits that had not. Pursuant to the Morgan v. Sundance ruling, when the FAA is applicable, whether a waiver of arbitration has occurred must be considered using the same standard applicable to cases involving other types of contractual covenants.

California Court of Appeals Finds Issues of Fact Sufficient to Show Alter Ego Liability of Sole Director, Shareholder, and Officer of Corporation

Lopez v. Escamilla, 79 Cal. App. 5th 646 (Cal. Ct. App. June 7, 2022)

Alice Lopez obtained a default judgment for fraud, negligent misrepresentation, and breach of fiduciary duty against Magnolia Home Loans, Inc. for $157,370 in May 2012. Because Magnolia Home Loans, Inc. had no funds or assets and had been suspended by the California Department of Corporations, in 2018, Alice sued Jose Escamilla to recover the amount she had been awarded in 2012 plus interest, alleging that Jose was the alter ego of Magnolia Home Loans, Inc. The trial court granted Jose’s motion for summary judgment on the grounds that a complaint in a separate cause of action was not the proper procedure to obtain a determination of his liability under the alter ego doctrine. The trial court reasoned that Jose’s due process rights would be violated if he were held liable for the prior judgment because he had not been a party to the prior case, and as a result, he had not asserted evidence-based defense in that case.

The California Court of Appeals disagreed, holding that Alice’s complaint alleged facts sufficient to show alter ego liability. She asserted that Magnolia Funding, Inc. had procured the loan at issue and that it was doing business as Magnolia Homes Loans, Inc. In response to requests for admissions, Jose admitted that he had incorporated Magnolia Funding, Inc. and had been its initial and sole director, shareholder, and officer, and that only he had signed the company’s checks. In addition, the evidence showed that when Magnolia Funding, Inc. dissolved, Magnolia Home Loans, Inc. received its remaining physical assets. There was evidence that neither Magnolia Funding, Inc. nor Magnolia Home Loans, Inc. were adequately capitalized, each having only $1,000 in capital reserves. At the end of fiscal year 2009, Magnolia Home Loans, Inc. held $53,102.92 in cash, which was paid to Jose. Based on this evidence, the court of appeals found that there was a triable issue of fact regarding whether Jose could be subject to alter ego liability.

Further, the court of appeals distinguished the California Supreme Court’s decision in Motores De Mexicali v. Superior Court, 51 Cal. 2d 172, 331 P.2d 1 (1958), the case that Jose claimed supported his contention that holding him liable as an alter ego would violate his right to due process. In Motores, the court held that a postjudgment summary procedure to add individuals to a previously entered default judgment against a corporation denied those individuals’ due process rights to be heard and present their defenses. The court of appeals distinguished the present case as a new civil action in which Jose will have the opportunity to respond to the complaint, engage in discovery, and file pre-trial motions, and Alice must meet her burden of proving the alter ego liability claims. The court further distinguished Motores from the present case because in that case, there had been three alter egos, none of whom individually controlled all corporate decisions. In contrast, Alice had made a sufficient showing that Jose made all corporate decisions, including litigation decisions of the corporation: thus, there was a triable issue of fact regarding whether Jose had been “fully aware of the progress of the legal proceedings” against the corporation. 

Takeaways: Regardless of whether a business entity is structured as a corporation or a limited liability company, this case provides a reminder that personal liability cannot be avoided when the individuals who own or control the entity are using it merely as a shell or conduit for their own personal interests. In Lopez, the court mentioned several behaviors that could subject business owners to alter ego liability: commingling of funds and assets, identical equitable ownership, use of the same office space and employees, disregard for corporate formalities, identical directors and officers, inadequate capitalization, and treating the corporate assets as their own. Attorneys who advise business owners should caution them against engaging in such behaviors.