From the imposition of transferee liability for estate taxes to actions arising from the misclassification of workers, we have 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.

Executor and Recipients Subject to Transferee Liability for Estate Taxes

United States v. Estate of Kelley, 2020 WL 6194040, slip op. (D. N.J. Oct. 22, 2020)

In United States v. Estate of Kelley, Lorraine Kelley died in 2003 leaving an estate with coexecutors, one of whom was her brother, Richard Saloom. Richard was also the sole beneficiary of her estate. In 2004, the coexecutors filed Form 706 reporting a gross estate of more than $1.7 million and estate tax liability of $214,412. After the Internal Revenue Service (IRS) opened an examination of the estate tax return, Richard consented to the assessment of an additional $448,367 based on a corrected gross estate of $2.6 million, bringing the total tax to $662,780.

In 2004, Richard and his coexecutor sold Lorraine’s primary residence for $450,000, and Richard received more than $1 million from an annuity, giving $50,000 of the proceeds from the annuity to his daughter Rose Saloom. Richard used the rest of the proceeds to run his business and purchase and develop other property, leaving Lorraine’s estate with no property by January 2008, despite still owing more than $400,000 in estate tax.

Richard had entered into an installment agreement with the IRS in late 2007 and made several significant payments toward the tax liability. Upon Richard’s request, Rose also made several payments on his behalf before his death in March 2008. At Richard’s death, his gross estate was valued at more than $1.1 million. Rose, who was the executrix and sole beneficiary of Richard’s estate, filed an inheritance tax return listing Richard’s debts, which included $456,406 described as indebtedness for federal tax purposes. Rose distributed and received all the property from Richard’s estate. At the time the IRS filed suit against Rose and Richard’s estate, Richard’s estate no longer had any property, and Rose no longer had any property from his estate.

In an unpublished opinion, the United States District Court for the District of New Jersey granted summary judgment against Richard’s estate based on transferee liability under Internal Revenue Code (I.R.C.) Section 6324(a)(2), which “imposes liability on the transferees of the decedent’s estate when the estate itself fails to pay its federal taxes.” In addition, summary judgment was granted against Richard’s estate and Rose based on fiduciary liability pursuant to I.R.C. Section 3713(b). That section imposes personal liability on the executor of an estate who pays the debts of the estate or distributes the estate to himself before paying debts owed to the United States, which is entitled to priority. To establish the executor’s liability, the IRS must show (1) the fiduciary distributed the assets of the estate; (2) the estate was rendered insolvent as a result of the distribution; and (3) the distribution occurred after the fiduciary had actual or constructive knowledge of the tax liability.

Learn about current developments in estate planning by registering for Advanced Estate Planning Summit—WealthCounsel's virtual conference for experienced estate planners. 

The court found that both Richard and Rose had distributed the estates for which they were executors to themselves, rendering them insolvent, and both had at least constructive knowledge of the estate tax liability. Richard had indicated his knowledge of the estate tax debt by entering into an installment agreement to satisfy the liability and making payments. Rose also made payments on Richard’s behalf and had listed the indebtedness for federal tax on her New Jersey inheritance tax return. Thus, the court held that there was no genuine issue of material fact as to whether the IRS had satisfied the three elements necessary to establish liability based on I.R.C. Section 6324(a)(2).

Takeaways: Personal representatives should request (nine months after filing the estate tax return to allow time for processing) and wait to receive an estate tax closing letter before distributing the estate. If state-level tax returns were also filed, estate tax closing letters should also be requested from each state’s taxing authority. Failure to do so could result in personal liability for any estate taxes due. Because of restrictions due to COVID-19, the IRS will currently only accept a request for an estate tax closing letter by facsimile to 855-386-5127 or 855-386-5128. Alternatively, an account transcript available online to authorized tax professionals reflecting the acceptance of Form 706 and the completion of an examination may be an acceptable substitute for a closing letter. The probate laws in some states require filing estate tax closing letters with the probate court so an account transcript may not be an option for those states. If beneficiaries are demanding distributions before the personal representatives have received the estate tax closing letters, the personal representatives should consider utilizing a receipt, release, refunding, and indemnification agreement in which the beneficiaries agree to refund and indemnify the personal representatives for any overpayments or erroneous distributions in return for an early partial distribution of the beneficiaries’ shares. The amount of the partial distribution is ultimately the decision of the personal representatives and depends on how much personal risk they are willing to assume.

Second Circuit Rules that a Trust Cannot Assert Fifth Amendment Right Against Self-Incrimination

United States v. Fridman, 974 F.3d 163 (2nd Cir. 2020)

As part of an IRS investigation of Natalio Fridman for the 2008 tax year based on the use of offshore bank accounts to improperly conceal federally taxable income, the IRS issued two summonses to Fridman—one in his personal capacity, and the other in his capacity as trustee of the David Marcelo Trust (the Trust), of which he was also a beneficiary. The Trust was a domestic trust with a foreign financial account. Fridman did not file a tax return for the Trust, but the IRS learned of its existence when Fridman’s representative provided several bank statements and records related to the account in 2012 and 2013. The summonses requested, among other things, certain documents related to the Trust. Fridman refused to produce the requested documents, asserting his Fifth Amendment privilege against self-incrimination.

In affirming the judgment of the United States District Court for the Southern District of New York requiring Fridman to produce the documents sought by the IRS, the Second Circuit held that the narrow act-of-production privilege, whereby the act of producing documents may in some cases communicate incriminatory statements and thus fall under the Fifth Amendment’s protection against self-incrimination, did not apply. Rather, the court applied the foregone conclusion doctrine: When the taxpayer adds little or nothing to the government’s information by conceding that he has certain documents, the existence and location of the papers are a “foregone conclusion.” Thus, requiring their production did not violate Fridman’s Fifth Amendment rights.

In addition, in a case of first impression in the Second Circuit, the court agreed with every other circuit that has addressed the issue in finding that the collective entity doctrine, which recognizes that the Fifth Amendment privilege only protects natural persons—not collective entities such as corporations, partnerships, and individual custodians holding a collective entity’s records in a representative capacity—from being required to produce documents, also applies to trusts. The court based its decision on several factors:

• A trust, including a traditional common law trust, has a legal existence separate from the trustee
• A trust is a formal institutional arrangement that is well organized and structured
• A trust is freely made and generates benefits, such as limited liability, and burdens, such as the need to produce documents in response to a subpoena

As a result, the court held that Fridman could not rely on the Fifth Amendment right against self-incrimination to avoid producing the documents sought by the IRS because the trust is a collective entity.

Takeaways: The Second Circuit Court of Appeals joined the First Circuit, Fifth Circuit, Eighth Circuit, and Ninth Circuit in finding that a trust is a collective entity, not a natural person, and thus, is not entitled to protection against self-incrimination under the Fifth Amendment. Trustees should be mindful of the result in Fridman as they file tax returns for their trusts. Grantors should be aware that, while trusts allow for more privacy than wills, privacy is not absolute and the courts can force the release of asset information.

IRS Private Letter Ruling States that Transfers to Transferee IRAs Are Not Taxable Distributions and Distributions to Their Beneficiaries Are Not Includible in Gross Income of Decedent’s Estate

I.R.S. P.L.R. 202039002 (Sept. 25, 2020)

A decedent who had two individual retirement accounts (IRAs) died after his required beginning date. He was unmarried and survived by his son, partner, and grandson, who were the named beneficiaries of his will. The decedent’s estate was the sole beneficiary of the two IRAs. The assets of the two IRAs were transferred into a single IRA titled as the IRA of the decedent for the benefit of the estate. Pursuant to the decedent’s will, the assets of the two IRAs passed to the son, partner, and grandson in equal shares. The personal representatives of the decedent’s estate proposed to subdivide the assets held by the new IRA for the benefit of the estate into three separate IRAs via trustee-to-trustee transfers, each titled “Decedent (Deceased) IRA f/b/o Beneficiary as beneficiary of Decedent’s estate.”

Under I.R.C. Section 408(d)(1), except as otherwise provided in Section 408(d), “any amount paid or distributed out of an IRA shall be included in gross income by the payee or distributee, as the case may be, in the manner provided under section 72.” The IRS relied upon Revenue Ruling 78-406, 1978-2 C.B. 157, stating that because each of the three transferees’ IRAs had been set up and maintained in the name of the decedent IRA owner for the benefit of one of the estate beneficiaries, the transfer of each of the beneficiary’s one-third interest in the estate’s interest in the new IRA established for the benefit of the estate to each transferee IRA was not a taxable distribution under I.R.C. Section 408(d)(1), nor did it amount to a rollover under I.R.C. Section 408(d)(3). Further, after the transfer to each of the transferee IRAs had occurred, any amounts distributed to the son, partner, or grandson should not have been included in the estate’s gross income, and the custodian of the transferee IRAs should not have reported such distributions as income to the estate.

Takeaways: Estate planners should counsel clients against designating their estate as the beneficiary of their IRA because of the unfavorable income tax implications. Where an estate is the beneficiary of an IRA and the decedent dies prior to the beginning date for required minimum distributions, its assets are required to be distributed in full by the end of the calendar year containing the fifth anniversary of the IRA owner’s death—and most estates do not stay open for five years, further increasing the income tax to which the estate may be subject. In contrast, if individuals are the designated beneficiaries of an IRA, they can defer the distribution of the IRA for at least ten years—and eligible designated beneficiaries can stretch the distribution of the assets over their lifetime. Where an estate is the beneficiary of an IRA, setting up and maintaining transferee IRAs in the name of the decedent IRA owner for the benefit of one of the beneficiaries of the decedent’s estate is a method of mitigating the income tax impact. Even though there have been numerous Private Letter Rulings supporting this type of transfer, there are IRA providers that are against allowing the transfer of an estate’s IRA to the beneficiaries of the estate. In such a situation, it may be prudent to provide the IRA provider with Private Letter Rulings showing the IRS’s position on the matter.

Dissociating Member Is Not Liable for LLC Expenses Where Operating Agreement Did Not Require Contributions to Cover Them

Bismarck Fin. Grp. v. Caldwell, 2020 WL 6156907 (N.D. Sup. Ct. Oct. 21, 2020)

Bismarck Financial Group, LLC (Bismarck) was formed in 2009, and the defendant, James Caldwell, purchased an interest in Bismarck from a former member in 2015. After Caldwell acquired his interest in Bismarck, certain governing documents were executed, including an operating agreement. In addition, Bismarck entered into a ten-year office lease and had one salaried employee. Caldwell informed Bismarck’s other members that he was dissociating from the company in 2019. Bismarck brought an action against Caldwell for wrongful dissociation, seeking $137,879.55, which represented his pro rata share of Bismarck’s debt, employee salaries, office overhead, and other expenses.

The district court granted Caldwell’s motion to dismiss, in which he asserted that he could not be held personally liable for company expenses and obligations and that Bismarck had not incurred any damages as a result of his dissociation because the operating agreement did not impose any obligation on members to contribute capital to cover Bismarck’s expenditures. The court assumed that Caldwell had wrongfully dissociated from Bismarck but held that Bismarck had not pleaded a cognizable claim for damages.

On appeal, the North Dakota Supreme Court noted that members of limited liability companies (LLCs) have limited liability and are generally not exposed to personal liability for the entity’s debts in the absence of a personal guarantee. However, under North Dakota’s version of the Uniform Limited Liability Company Act, a member may be liable for damages caused by a member’s wrongful dissociation from an LLC. Under N.D. Cent. Code Section 10-32.1-47(3), “[a] person that wrongfully dissociates as a member is liable to the limited liability company and . . . to the other members for damages caused by the dissociation. The liability is in addition to other debt, obligations, or other liability of the member to the company or the other members.” In addition, under N.D. Cent. Code Section 10-32.1-49(2), a member’s dissociation does not discharge the member from “any debt, obligation, or other liability to the company or other members that the person incurred while a member.”

In seeking to hold Caldwell liable for his pro rata share of Bismarck’s debt, employee salaries, office overhead, and other expenses, Bismarck relied on section 3.03 of the operating agreement, which stated that “Net Income and Net Losses shall be allocated annually among the Members based on their Percentage Interests.” The operating agreement defined “Net Losses” and “Net Income” as “the profits and losses of the Company, as the case may be, as determined for federal income tax purposes as of the close of each of the fiscal years of the Company.”

The court held that because the expenses existed regardless of whether Bismarck experienced an annual loss or profit, the expenses were not net losses as defined by the operating agreement, and that section 3.03 did not create an obligation for members to cover Bismarck’s expenditures. Therefore, Bismarck’s claim against Caldwell based on that provision failed as a matter of law. In addition, because section 3.08 of the operating agreement clearly stated that members had no obligation to make additional capital contributions to the company to cover company deficits, the court found that Caldwell’s dissociation did not cause the remaining members any injury arising from increased contribution obligations, as the members had no obligation to contribute additional capital.

Bismarck asserted that it was entitled to any statutory relief under the Uniform Limited Liability Company Act, though it did not specify any damages other than those it asserted had arisen from the operating agreement. However, the North Dakota Supreme Court found that the district court had erred in dismissing Bismarck’s complaint as a matter of law in its entirety and reversed in part on the basis that Bismarck’s allegation that Caldwell’s withdrawal had caused “additional, currently-unidentifiable damages,” was sufficient to support recovery against Caldwell if proven. The court affirmed in all other respects and remanded the case for further proceedings.

Takeaways: Many LLC statutes have provisions addressing the circumstances under which a member may dissociate from an LLC, when it will be considered wrongful, and the consequences of the dissociation. Such statutory provisions generally apply by default and can be altered or replaced by the terms of an LLC operating agreement. LLC operating agreements must be carefully drafted to provide a clear process for a proper dissociation, which may include notice to the other members of the LLC, provisions addressing how the LLC’s assets will be handled, and adherence to withdrawal provisions.

Proposition 22 Passes in California: Uber and Lyft Can Continue to Classify Workers as Independent Contractors

California Proposition 22, Exempts App-based Transportation And Delivery Companies From Providing Employee Benefits To Certain Drivers. Initiative Statute. (2020)

Just days after the California Court of Appeals affirmed the lower court’s entry of a preliminary injunction restraining Uber and Lyft from classifying their drivers as independent contractors rather than employees (People v. Uber Technologies, Inc., 2020 WL 6193994 (Cal. Ct. App. Oct. 22, 2020)) as a violation of Labor Code Section 2775.3 (commonly known as AB 5), Californians passed Proposition 22. Under Proposition 22, app-based rideshare and delivery drivers will continue to be classified as independent contractors rather than employees. It also provides them new benefits including healthcare subsidies, a minimum earnings guarantee, compensation for vehicle expenses, occupational accident insurance, and protection against discrimination and harassment.

Under Proposition 22, app-based drivers for companies such as Uber, Lyft, DoorDash, Instacart, and Postmates will not be covered by state employment laws governing minimum wage, overtime, unemployment insurance, and worker’s compensation. However, drivers will continue to have flexibility regarding when, where, and how they work, and companies will continue to be able to offer consumers affordable transportation and delivery options.

Takeaways: This is a major victory for Uber and Lyft, which had indicated that they would have to suspend their services in California, at least temporarily, if they were required to classify their drivers as employees. With the rise of the gig economy, it is likely that similar ballot measures will be sought by other industries and in other states.

WealthCounsel is passionate about helping its members stay on top of legal changes that may affect their practices. Learn what other benefits our members enjoy, such as access to on-demand webinars, live CLE opportunities, premier legal drafting software for estate and business planning, and a nationwide professional community.