From the Department of the Treasury’s issuance of a new “green book” to the Biden administration’s withdrawal of a proposed Trump-era independent contractor rule, 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 a few noteworthy developments and analyzed how they may impact your estate planning and business law practice.

Department of the Treasury Issues Green Book

Exec. Off. of the President, General Explanations of the Administration’s Fiscal Year 2022 Revenue Proposals (2021)

For the first time since 2016, the Department of the Treasury (Treasury) has issued a “green book” report addressing the tax and revenue proposals set forth by the presidential administration. The new report provides more details on the Biden administration’s Made in America Tax Plan and the American Families Plan. One clarification provided by the report is that the administration’s proposal to tax capital gains of high-income earners at ordinary rates would be effective for gains required to be recognized after the date of announcement (but it does not specify whether this refers to the date the American Families Plan was announced) and that transfers of appreciated property by gift or at death will be treated as realization events.

In addition, the green book states that gain on unrealized appreciation would be recognized by a trust, partnership, or other noncorporate entity that is the owner of property if the property has not been the subject of a recognition event within the prior ninety years, beginning on January 1, 1940, meaning that the first possible recognition event would be December 31, 2030.

The green book also provides that, for purposes of the imposition of the tax on appreciated assets, “transfers of property into, and distributions in kind from, a trust, partnership, or other non-corporate entity, other than a grantor trust that is deemed to be wholly owned and revocable by the donor, would be recognition events.” (Exec. Off. of the President, General Explanations of the Administration’s Fiscal Year 2022 Revenue Proposals, at 62 (2021). Contributions to and distributions by partnerships are generally tax-free at present, so it is possible that this proposal was intended only to address indirect donative transfers. Further clarification is needed, however, because no such limitation was explicitly stated.

Takeaways: The foregoing are only a few of the additional details provided by the green book regarding the Biden administration’s tax proposals. Although it answers some questions, it raises others. The green book states that it would be effective for taxable years beginning after December 31, 2021, but the fifty-fifty split in the Senate means that enactment into law of the proposals is still far from certain. Learn more about the Green Book by registering for our webinar, Current Events in Estate Planning: Green Book Signals Green Light to Grandfathered Estate Planning, on June 24, 2021.

Estate Cannot Rely on Unreasonable Valuation of Split-Dollar Rights

Estate of Morrissette v. Comm’r, T.C. Memo 2021-60 (May 13, 2021)

In Estate of Morrisette v. Commissioner, the Tax Court addressed estate tax questions surrounding intergenerational split-dollar life insurance agreements, which are agreements between two parties, an owner and a nonowner, to share (i.e., split) the costs of premiums and the death benefits of a permanent life insurance policy. Clara Morrissette (Clara), the mother of three adult sons whose relationships with each other were acrimonious, died on September 25, 2009. The sons, Buddy, Don, and Ken, were personal representatives of her estate and the successor co-trustees of her trust (the CMM trust). Her main asset was a business, Interstate Group Holding (Interstate), started by her husband and run by her frequently-squabbling sons. Despite the contentious relationships, the family agreed that it was important to retain family control and ownership of Interstate.

To ensure that Interstate remained in the family, and in an effort to avoid substantial estate tax liability and enable Clara to qualify for an estate tax deferral on her real estate holdings, the sons had created a new estate plan in 2006 on her behalf (through a conservatorship established after she was diagnosed with Alzheimer’s disease). The new estate plan involved cross-purchases of life insurance on the lives of each son aimed at funding buyouts under a buy-sell provision for each son’s Interstate stock. The CMM trust paid the premiums pursuant to split-dollar agreements and established three dynasty trusts to own each son’s policy. The flexible-premium adjustable life insurance policies owned by the dynasty trusts each had an initial death benefit of $1 million and a rider for an additional $8.73 million. The CMM trust paid all of the policy premiums in full, including the additional premiums for the riders, pursuant to two split-dollar agreements it entered into with each dynasty trust (for a total of six split-dollar agreements). In total, the CMM trust made $30 million in premium payments. According to the agreements, the CMM trust was to receive the greater of the premiums it paid or the cash surrender value of the policy on the death of the insured or the termination of the split-dollar agreement. The dynasty trusts would receive the net death benefit upon the death of each insured.

The premium payments made by the CMM trust were reported by Clara as gifts to her sons for gift tax purposes according to the economic benefits regime, i.e., the premium payments were treated as annual gifts equal to the annual cost of current protection, thus allowing the death benefit to be free of income tax. The dynasty trusts paid premiums totaling $806,869 from 2006 to 2008 to reduce Clara’s taxable gifts. The total economic benefit was $1,443,526, and Clara reported $636,657 as gifts.

In 2009, the CMM trust transferred each of the split-dollar agreements to the dynasty trust owning the corresponding life insurance policy in a gift-sale transaction. The gift was equal to Clara’s remaining generation-skipping transfer tax exemption and the rest was transferred via a sale. The dynasty trusts executed promissory notes in favor of the CMM trust of $4.65 million to effectuate the sale. Upon the transfer of the split-dollar agreements to the dynasty trusts, the split-dollar agreements terminated, but the life insurance policies remained in effect.

Clara’s estate reported the fair market value of the CMM trust’s split-dollar rights as of the date of the transfer of the split-dollar agreements to the dynasty trusts as $7,479,000 on Form 706, a substantial discount from the $30 million in premium payments made by the CMM trust.

The Tax Court held that the proceeds of a life insurance policy were not includible in Clara’s gross estate because amounts transferred from her revocable living trust pursuant to split-dollar life insurance agreements fell within a bona fide sale exception as set forth in Internal Revenue Code (I.R.C.) § 2036 or 2038. According to the court, the facts of the case established (1) a legitimate and significant tax purpose and (2) adequate and full consideration, satisfying both prongs of the bona fide sale exception test. Clara and the CMM trust received several intangible financial benefits from the split-dollar agreements, including continued family control over Interstate, smooth management succession, and protection of Interstate’s capital by ensuring that adequate funds were available to pay estate taxes upon each son’s death.

In addition, the court held that the special valuation rules set forth in I.R.C. § 2703 do not require the inclusion of the cash surrender value of the policies in Clara’s estate. Section 2703 provides that the value of any asset includible in the gross estate will be determined without regard to (1) any option, agreement, or other right to acquire or use the property at a price less than its fair market value or (2) any restriction on the right to sell or use the property. However, the statute provides an exception where the restriction is a bona fide business arrangement rather than a device to transfer property to family members for less than adequate and full consideration. The court held that the facts and circumstances of the case established that the split-dollar agreements were entered into for valid business purposes and that mutual termination provisions in the agreements were not a device to transfer funds at less than adequate and full consideration.

The court also held that the fair market values of Clara’s split-dollar rights should be calculated using the discounted cash flow methodology, but the discount rates applied by the Internal Revenue Service’s (IRS) expert and the estate’s experts varied substantially. The estate’s experts used a 15 percent discount rate for the split-dollar rights, but the IRS’s expert used a 9.35 percent discount rate for Don’s insurance policies and 6.9 percent for Buddy’s and Ken’s policies. The court believed that the estate’s discount rate, which relied upon life settlement data, was unreliable and directed the parties to apply discount rates of 8.85 percent and 6.4 percent to the policies. The court determined that a 40 percent penalty for gross valuation misstatement of the split-dollar rights under I.R.C. § 6662(h) was appropriate, as the IRS had satisfied the procedural requirements for supervisory approval, the estate’s expert’s appraisal was not reasonable, and the estate had not relied on the appraisal in good faith.

Takeaways: The court emphasized that although tax benefits are permissible for clients using split-dollar life insurance agreements, the transaction is not permitted to be solely driven by estate tax savings. Although Clara had significant nontax reasons for entering into the split-dollar agreements, estate tax savings was the only purpose for the substantially discounted values used by the estate. Further, the sons had been advised by their attorney that the IRS would likely contest the values reported on the estate tax return. 

Trustee of Spendthrift Trust May Be Liable for Attorney’s Fees in California Marital Dissolution Proceedings

In re Marriage of Wendt, 63 Cal. App. 5th 647 (2021)

Elizabeth Ann Wendt (Wendt) was the beneficiary and Windham Bremer (Bremer) was the trustee of an irrevocable spendthrift trust (Trust) created in 1989. Wendt married William Pullen (Pullen) in 1997 but sought dissolution of the marriage in 2013. The dissolution proceedings involved several issues to be decided, including child custody, division of property, child and spousal support, and attorney fees. In January 2015, Bremer denied Wendt’s request to disburse funds from the spendthrift trust to enable her to pay spousal and child support to Pullen. In February 2016, Pullen filed a motion with the family court to join the Trust and Bremer, as trustee, as third parties to the dissolution action and to compel Bremer to disburse funds from the Trust to Wendt as necessary to ensure the payment of spousal or child support orders and attorney fees. The court granted the motion to join but did not order Wendt to pay spousal support or attorney fees to Pullen. 

In 2016, Pullen filed a request for attorney fees based upon California Family Code section 2030, seeking $76,141 in attorney fees and costs from Bremer for expenses incurred in bringing the motion to join the Trust and trustee. The family court denied the request, citing Ventura County Department of Child Support Services v. Brown, 11 Cal. Rptr. 3d 489 (2004), and indicating that attorney fees could only be awarded from a spendthrift trust when there is a finding of bad faith by the trustee—and there had been no such finding regarding Bremer.

The California Court of Appeal reversed the family court’s decision on the basis that Ventura dealt with a probate code section allowing a court to compel the trustee of a spendthrift trust to pay a beneficiary’s child support obligations. In that case, the court had indicated that the trustee had acted with an improper motive that justified an order requiring the trustee to pay child support. In contrast, Pullen’s request pursuant to section 2030 was a request for attorney fees, not child support, making Ventura inapplicable. The purpose of section 2030 is to ensure a level playing field between the parties to a dissolution proceeding regarding their ability to obtain effective legal representation, and there is no requirement that a party must prevail or establish a prima facie case to obtain attorney fees from a third party joined in the case. Therefore, the court found that conditioning relief on the third party’s bad faith was inconsistent with the purpose of section 2030.

In addition, there is no case law holding that a spendthrift trust is not required to pay debts related to its administration, and the court saw no reason to create an exemption. The purpose of a spendthrift trust is to prevent the beneficiary or the beneficiary’s creditors from dissipating the trust’s assets, and that purpose is not damaged by allowing creditors to reach the trust’s assets for the payment of debts arising from the trust’s administration. The court found that Pullen’s claim against the Trust was a debt arising from its administration—specifically, Pullen’s successful efforts to join the Trust and the trustee in the dissolution proceeding. Therefore, the claim was exempt from the Trust’s spendthrift provision, and the family court erred in not awarding attorney fees to Pullen in the absence of a showing of bad faith by Bremer. As a result, the court of appeals reversed the family court’s order and remanded the case for the family court to consider factual issues not yet addressed to determine if attorney fees should be awarded pursuant to section 2030.

Takeaways: Creditors can reach a spendthrift trust’s assets if the trust is involved in litigation. Specifically, the trust may be liable for attorney fees related to divorce proceedings even when the trust’s beneficiary makes no claims against the trust but the trust and its trustee have been joined as parties to the litigation. In this case, the attorney fees become a debt related to the trust’s administration. Although this case is from California, the trust in question was administered in Indiana, and the court found that Indiana law supported the result. Holdings such as this may make it more difficult to protect spendthrift trust assets from dissipation in the event of a beneficiary’s divorce. 

Tax Court Tells IRS to Beat It, Ruling in Favor of the Estate of Michael Jackson

Estate of Michael J. Jackson, T.C. Memo 2021-48 (May 3, 2021)

The Tax Court rejected the IRS’s valuation of the Michael Jackson’s estate as “fantasy,” holding that not only had the IRS’s expert valued the wrong assets, including a Cirque du Soleil show, a film, and a Broadway musical, rather than Jackson’s name and likeness, but also had included revenue streams that were unforeseeable at the time of Jackson’s death. The court held that foreseeability cannot be subject to hindsight. Because of Jackson’s poor reputation at the time of his death due to accusations of child molestation and other offenses, the IRS’s projections of a “torrent of revenue” based on his image and likeness were not reasonable. Consequently, Jackson’s estate was worth about $111 million rather than the $481 million determined by the IRS.

Takeaways: Although the typical estate planning client will not need to address the unique issues faced by Michael Jackson’s estate, the case is a reminder of the importance of the proper valuation of assets and that revenue streams that are not foreseeable on the date of death should be excluded from calculations.

Department of Labor Withdraws Trump Administration’s Proposed Independent Contractor Rule

Independent Contractor Status Under the Fair Labor Standards Act (FLSA): Withdrawal, 86 Fed. Reg. 24303 (May 6, 2021) (to be codified at 29 C.F.R. pts.780, 788, 795)

On May 5, 2021, the Biden administration’s Department of Labor (DOL) issued a final rule withdrawing the Trump administration’s proposed independent contractor rule, effective May 6, 2021. Although the Trump-era rule originally had an effective date of March 8, 2021, the Biden administration delayed its effective date pending a review. The Trump-era rule sought to simplify compliance with the minimum wage and overtime requirements of the Fair Labor Standards Act (FLSA) by clarifying the distinction between employees and independent contractors. The withdrawn rule narrowed the “economic realities” test to two core factors: the nature and degree of control over the work and the worker’s opportunity for profit or loss. The amount of skill required for the work, the degree of permanence of the working relationship between the worker and the potential employer, and whether the work is part of an integrated unit of production were to serve as additional guideposts in the analysis. The newly issued final rule emphasizes that a true balancing test properly considers the “totality of circumstances” rather than elevating certain factors and that “no single factor is determinative in the analysis of whether a worker is an employee or independent contractor.” Further, the DOL asserted that the withdrawn rule conflicts with the FLSA, congressional intent, and longstanding judicial precedent.

Takeaways: During his campaign, Biden endorsed the “ABC” test recently adopted by California, which significantly broadens the number of workers classified as employees rather than as independent contractors. However, at present, the withdrawal of the Trump-era rule simply retains the status quo rather than imposing any new requirements, and thus employers must continue to apply the existing fact-specific economic realities test. In addition, employers should continue to comply with relevant state laws, which may impose different standards.