From the taxation of trust income in California to landmark civil rights decisions by the U.S. Supreme Court, we have recently seen some significant developments in estate planning and business law. To ensure that you stay abreast of these legal changes, we’ve highlighted a few noteworthy developments and analyzed how they may impact your estate planning and business law practice.
All Trust Income Derived from California Sources Is Taxable, Regardless of Residence of Fiduciaries
Steuer v. Franchise Tax Board, ___ Cal. Rptr. 3d ___, 2020 WL 3496779 (Cal. Ct. App., June 29, 2020)
Raymond Syufy established the Paula Trust for the sole benefit of his daughter, Paula Syufy Medeiros. The trustees were authorized, but not required, to make distributions to her. Paula Trust had two co-trustees, one a resident of California and the other a Maryland resident. In 2007, Paula Trust, which held a limited partnership interest in Syufy Enterprises LP, sold stock to several companies. Some of the capital gain income from the sale was allocated to Paula Trust, which reported gross income of $2,965,099 on its 2007 tax return, with $2,831,336 of capital gain, including the sale of stock, all derived from California sources. The trust paid $223,425 in income tax to the state of California.
The trustees filed an amended 2007 fiduciary income tax return in 2012 requesting a refund of $150,655 for an overpayment of income taxes. Paula Trust asserted that the capital gain had been incorrectly reported as California source income. Paula Trust relied on Cal. Rev. & Tax Code section 17743, which states: “Where the taxability of income under this chapter depends on the residence of the fiduciary and there are two or more fiduciaries for the trust, the income taxable … shall be apportioned according to the number of fiduciaries resident in this state….” The trustees claimed that only one-half of the capital gain—the half apportioned to the California trustee—was taxable income, and that the amount apportioned to the Maryland trustee was not taxable.
After its administrative appeal was rejected, Paula Trust filed a tax refund suit in 2016. The trial court ruled in favor of Paula Trust, holding that Paula Trust’s California taxable income should be determined by apportioning its income based upon trust fiduciaries’ residence, regardless of whether the income was from a California source. According to the trial court’s judgment, Paula Trust was to receive a refund of the $150,655 it had claimed as an overpayment as well as $68,955.70 in interest.
The Court of Appeals reversed the trial court’s decision. The Court of Appeals held that pursuant to Cal. Rev. & Tax Code section 17041, personal income tax can be imposed on two bases: (1) residents are taxed on all income, regardless of whether it is from a California or non-California source; and (2) nonresidents are taxed on California-source income.
Under Cal. Rev. & Tax Code section 17742(a), 100 percent of a trust’s income is subject to California income tax if all trustees or all non-contingent beneficiaries are California residents. Rejecting Paula Trust’s argument that the statutory definition of “resident” is limited to “individuals” or “natural persons,” the court held that trusts are taxed on the same basis as individuals. Section 17041(e) states that the taxable income of trusts is subject to “taxes equal to the amount computed under subdivision (a) for an individual having the same amount of taxable income.” The court found that Section 17041(e), read together with section 17041(i), which states that the taxable income of any nonresident must include income from a California source, requires that trusts must be taxed on all California-source income, regardless of the residence of the trust fiduciaries. Moreover, the court held that the plain language of section 17743, the regulations expressly incorporated into that statute, and legislative history require the taxation of all of a trust’s California-source income—and only income derived outside of California should be apportioned according to the number of resident fiduciaries.
The court also upheld the trial court’s ruling that the sole beneficiary had only a contingent interest in the trust income, precluding the application of section 17742(a) to impose a tax on trust income based on residency, without regard to source, if there is a noncontingent beneficiary.
Takeaways: Tax is imposed on the entire amount of trust income derived from California sources, regardless of the residence of the trustees. The residence of a California trust’s fiduciaries is only relevant when a trust’s income is derived from sources outside of California, in which case it is apportioned according to the number of fiduciaries resident in California.
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Tax Court Finds that “Loan” Is Actually a Gift
Estate of Bolles v. Commissioner, T.C. Memo. 2020-71, 119 T.C.M. (CCH) 1502 (June 1, 2020)
Mary Bolles made numerous transfers of money to each of her children from the Bolles Trust, keeping a personal record of her advances and repayments from each child, treating the advances as loans, but forgiving up to the annual gift tax exclusion each year. Mary made numerous advances amounting to $1.06 million to her son Peter, an architect, between 1985 and 2007. Peter’s architecture career initially seemed promising, and during his early career, it seemed that Peter would be able to repay the amounts advanced to him by Mary. However, his architecture firm, which had begun to have financial difficulties by the early 1980s, eventually closed. Although Peter continued to be gainfully employed, he did not repay Mary after 1988. By 1989, it was clear that Peter would not be able to repay the advancements.
Although Mary was aware of Peter’s financial troubles, she continued to advance him money, recording the sums as loans and keeping track of the interest. However, she did not require Peter to repay the money and continued to provide financial help to him despite her awareness of his difficulties. Although Mary created a revocable trust in 1989 excluding Peter from any distribution of her estate upon her death, she later amended the trust, including a formula to account for the loans made to him rather than excluding him. Peter signed an acknowledgment in 1995 that he was unable to repay any of the amounts Mary had previously loaned to him. He further agreed that the loans and the interest thereon would be taken into account when distributions were made from the trust.
Upon Mary’s death in 2010, the IRS assessed the estate with a deficiency of $1.15 million on the basis that Mary’s advances to Peter were gifts. Mary’s estate asserted that the advances were loans. Both parties relied upon Miller v. Commissioner, T.C. Memo 1996-3, aff’d, 113 F.3d 1241 (9th Cir. 1997), which spells out the traditional factors that should be considered in determining whether an advance of money is a loan or gift. To establish that an advance is a loan, the court should consider whether:
(1) there was a promissory note or other evidence of indebtedness, (2) interest was charged, (3) there was security or collateral, (4) there was a fixed maturity date, (5) a demand for repayment was made, (6) actual repayment was made, (7) the transferee had the ability to repay, (8) records maintained by the transferor and/or the transferee reflect the transaction as a loan, and (9) the manner in which the transaction was reported for Federal tax purposes is consistent with a loan.
In addition, the court recognized that where a family loan is involved, an actual expectation of repayment and an intent to enforce the debt are crucial for a transaction to be considered a loan.
The court found that the evidence showed that although Mary recorded the advances to Peter as loans and kept records of the interest, there were no loan agreements, no attempts to force repayment, and no security. Because it was clear that Mary realized by 1989 that Peter would not be able to repay the advances, the court held that although the advances to Peter could be characterized as loans through 1989, beginning in 1990, the advances must be considered gifts. In addition, the court found that Mary did not forgive any of the loans in 1989, but merely accepted that they could not be repaid. Thus, whether an advance is a loan or a gift depends not only upon the documentation maintained by the parties, but also upon their intent or expectations.
Takeaways: Given the current low interest rate environment, intra-family loans are now an advantageous estate planning tool, and wealthier family members can make low-interest loans to younger, less affluent family members, providing them with liquidity and allowing them to benefit from appreciation on the borrowed amount that is greater than the interest rate. To avoid a loan being treated as a transfer subject to gift tax, it is crucial in those situations not only to consistently treat such advances as loans, for example, through the execution of a promissory note, charging interest, providing security, and complying with other factors set forth in the Miller decision, but also for lending parties to steadfastly demonstrate their intentions by documenting their expectation of repayment and by enforcing the terms of the loan.
Iowa Supreme Court Overrules Prior Decisions to Bar a Tortious Interference with Inheritance Claim Not Joined with a Timely Will Contest
Youngblut v. Youngblut, ___N.W.2d___, 2020 WL 3107690 (Iowa S. Ct. June 12, 2020)
Brothers Harold and Leonard Youngblut were the beneficiaries of their parents’ mirror wills. Upon their parents’ death in 2014, a dispute arose regarding their 2014 mirror wills. Those mirror wills provided that Harold would receive his parents’ share in Youngblut Farmland Ltd., their successful farming business. Another property owned by the parents in their own names, South Farm, was bequeathed to Leonard, provided that he tendered his stock in Youngblut Farmland to Harold for one dollar. However, under earlier 2011 mirror wills, the Youngblut Farmland shares and South Farm passed to Harold, with the rest and residue of the estate divided among Leonard and the other children.
Harold believed that Leonard and his other siblings had improperly influenced their parents, but decided not to contest the will because of a concern that he could be disinherited pursuant to a no-contest clause if the contest failed. Although Harold did not contest the will before the expiration of the statutory deadline, he soon filed suit against Leonard and several other siblings for tortious interference with an inheritance. The other siblings reached settlements with Harold and were dismissed from the suit. Although Leonard sought summary judgment in his favor on the basis that Harold had failed to file a timely will contest, the case against Leonard proceeded to a jury trial. The jury returned a verdict in favor of Harold, ordering Leonard to pay $396,086.88 plus $200,000 in punitive damages. Leonard appealed.
The Iowa Supreme Court reversed the lower court decision, providing a lengthy review of its contrary precedent and recent legal developments. Although it disagreed with courts and commentators seeing no role for the tort of intentional interference with an inheritance, it ruled that it must not be used as a de facto substitute for a will contest. Rather, overturning its prior contrary decisions, the court held that such a claim must be joined together with a timely will contest.
Takeaways: Although the Iowa Supreme Court will not preclude parties from bringing an action for tortious interference with an inheritance for inducing a decedent to execute a will through wrongful means, such a claim must be joined with a timely will contest brought pursuant to Iowa law.
Probate Court Orders Must Include Findings of Fact in Contested Trust Cases
In re Elaine Emma Short Revocable Living Trust Agreement, ___P.3d ___, 2020 WL 3288079 (Haw. Sup. Ct. July 18, 2020)
Elaine created the Elaine Emma Short Trust Agreement (the Trust). Although the Trust was amended several times, at the time of Elaine’s death in 2012, its terms provided that the successor trustee could only distribute trust income, not its principal, from David and William’s subtrusts as necessary to meet their needs for “health, education, support, and maintenance.” Further, because William had a drug-related disability, income distributions were required to be only for vital necessities until he had been drug-free for at least a year. The Trust did not provide for the distribution of principal to David and William after Elaine’s death or for the termination of their subtrusts. Further, it provided that if Elaine’s husband and descendants did not survive her, the Trust was to be distributed to her heirs-at-law upon her death. Elaine’s husband and William predeceased her, but David survived her.
The trustee, First Hawaiian Bank (FHB), filed a petition for instructions regarding distribution and termination and for modification of the Trust in August 2015. Among other things, FHB asked the probate court to instruct the trustee that discretionary distributions of principal may be made from David’s subtrust. FHB listed the Cooks, that is, Elaine’s brother Leroy and his family, as contingent beneficiaries under her Trust. The Cooks opposed FHB’s modification that would allow the distribution of principal to David.
The probate court granted FHB’s petition, modifying the Trust to allow the distribution of principal to David, but its order did not contain any findings of fact as to whether the Trust contained ambiguity regarding the distribution of principal. The probate court’s order was affirmed by the Intermediate Court of Appeal.
On appeal, the Hawaii Supreme Court reversed and remanded the case, holding that the probate court should include findings of fact in orders in contested trust cases to avoid abuses of discretion and to enable meaningful appellate review. The probate court is not specially excepted under the Hawaii Probate Rules from having to make findings of fact in contested matters and should do so except when its refusal to do may be justified as a sound exercise of its discretion or when the parties agree to a resolution without an articulation of its basis.
Takeaways: In a contested matter, orders of the probate court must include findings of fact in contested trust cases with limited exceptions. Failure to do so impedes appellate review and necessitates remand of the case so the probate court can make the necessary findings of fact.
U.S. Supreme Court Holds that Title VII of the Civil Rights Act of 1964 Prohibits Employers from Discriminating Against Homosexual and Transgender Employees
Bostock v. Clayton County, 560 U.S. ___ (June 15, 2020)
Title VII of the Civil Rights Act of 1964 makes it “unlawful . . . for an employer to fail or refuse to hire or to discharge any individual, or otherwise to discriminate against any individual . . . because of such individual’s race, color, religion, sex, or national origin.” 42 U.S.C. 2000e–2(a)(1). In Bostock, the Supreme Court considered whether the termination of three long-term employees for being homosexual or transgender was a violation of Title VII’s prohibition against sex discrimination.
The Court held that an employer violates Title VII when it intentionally fires an employee based in part on sex. It is irrelevant if other factors such as the plaintiff’s attraction to the same sex or presentation as a different sex from that at birth contributed to the decision. In addition, it makes no difference that the employer would treat women as a group the same as men as a group, that is, that the employer is willing to subject all male and female homosexual or transgender employees to the same rule.
The Court found that it is impossible to discriminate against a person for being homosexual or transgender without discriminating against that individual based on sex. For example, if an employer has two employees, both of whom are attracted to men and are, to the employer’s mind, materially identical in all respects, except that one is a man and the other is a woman, the employer discriminates against the male employee if it fires him for no reason other than the fact that he is attracted to men. In this situation, the employer is discriminating against him for traits or actions it tolerates in the female employee. That is, the employer is intentionally singling out an employee to fire based in part on the employee’s sex, and the employee’s sex is a “but-for” cause of his discharge.
Takeaways: Under Title VII, the term “employer” means “a person engaged in an industry affecting commerce who has fifteen or more employees for each working day in each of twenty or more calendar weeks in the current or preceding calendar year, and any agent of such a person,” although the law provides certain exceptions. Many employees in the United States are employed by employers that have fewer than 15 employees and are thus not covered by Title VII. Employers within the scope of Title VII should review their employee benefits packages, policies, and handbooks in light of Bostock to ensure they are in compliance with Title VII.
Paycheck Protection Program Loan Application Deadline Extended and New Legislation in the Works
On Saturday, July 4, President Trump signed a bill extending the deadline to apply for a Paycheck Protection Program (PPP) loan from June 30 until August 8. In addition, on June 18, 2020, Democrat Senators Ben Cardin, Chris Coons, and Jeanne Shaheen introduced the “Prioritized Paycheck Protection Program (P4) Act,” which would extend the June 30 deadline to December 30 or longer to apply for a forgivable PPP loan, while creating a new option for a second loan for borrowers with 100 employees or fewer that have lost at least half of their revenue due to the pandemic. A companion bill was introduced by House Democrat Representatives Angie Craig and Antonio Delgado. The bill, in its current form, includes the following provisions:
- P4 loans, a subset of the PPP, would be for borrowers that are self-employed or have 100 or fewer employees that have demonstrated a revenue loss of 50% or more due to the pandemic compared to a relevant period. To qualify, borrowers must have fully used an initial PPP loan or be on pace to use up their initial loan proceeds.
- P4 loans may be as large as 2.5 times monthly payroll costs, as was the case for the initial PPP loans, but may not be larger than $2 million.
- P4 loans would allow borrowers to apply for forgiveness as early as eight weeks after the loan is disbursed rather than waiting until the earlier of 24 week after disbursement or December 31, 2020, minimizing the cost of the loan by reducing the amount of interest that would accrue prior to loan forgiveness.
- P4 loans would not be available to publicly traded companies.
- The same terms, conditions, and forgiveness criteria as initial PPP loans are applicable unless otherwise mentioned.
- The lessor of $25 billion or 20% of PPP funds is reserved for employers with ten or fewer employees to increase P4 assistance to underserved and rural businesses, and priority processing would be provided for those borrowers.
Takeaways: Businesses that have not yet applied for a PPP loan now have until August 8 to apply—a deadline that could be further extended if the Prioritized Paycheck Protection Program (P4) Act or similar legislation is enacted.
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