From the Internal Revenue Service’s (IRS’s) reversal of its position on estate tax deductions for certain unitrust interests of charitable remainder unitrusts (CRUTs) to newly enacted pay transparency laws, 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.

IRS Reverses Position, Denies Charitable and Marital Estate Tax Deductions for Unitrust Interest of CRUT Where Trustee Had Discretion to Distribute to Charity or Surviving Spouse

I.R.S. Chief Couns. Mem. 2022-33-014 (Aug. 19, 2022)

In a memorandum released by the Office of Chief Counsel, the IRS addressed whether the decedent’s estate was entitled to take an estate tax charitable deduction or an estate tax marital deduction for the value of the part of a unitrust interest of a testamentary CRUT that the trustee had the complete discretion to distribute to either the charity or the decedent’s spouse.

The decedent had left a portion of his estate to the CRUT. According to its terms, his surviving spouse was to receive annual unitrust payments of 5 percent for life. In addition, the CRUT specified that the trustee must distribute 25 percent of the unitrust amount to the spouse. The trustee had the complete discretion to distribute the remaining 75 percent of the unitrust amount to either the charity or the surviving spouse. Upon the death of the surviving spouse, the trustee was to distribute the remainder of the CRUT to the charity.

Charitable Deduction

The IRS noted that the terms of the trust created two charitable interests: a discretionary interest in a percentage of the unitrust amount and a remainder interest. The IRS found that, pursuant to I.R.C. § 2055(a), the decedent’s estate could claim the estate tax charitable deduction for the value of the remainder interest. However, the estate could not claim an estate tax charitable deduction for the value of the portion of the unitrust interest that the trustee had the discretion to distribute to either the charity or the decedent’s spouse. The charity’s interest was not in the form of a fixed unitrust amount to be distributed annually as required by I.R.C. § 2055(e)(2)(B). In addition, no part of the charity’s unitrust interest was ascertainable and severable from the surviving spouse’s interest as required by Treas. Reg. § 20.2055-2(a), where a trust is created for both a charitable and private purpose.

Marital Deduction

Under I.R.C. § 2056(a), an amount equal to the value of any interest in property that passes or has passed from a decedent to the surviving spouse may be deducted from the value of the gross estate to the extent that the interest is included in determining the value of the gross estate. Treas. Reg. § 20.2056(c)-2(a) provides that a property interest is treated as passing to the surviving spouse only if it passes to the spouse as the beneficial owner, and where it passes from the decedent in trust, it passes from the decedent to the surviving spouse to the extent of the surviving spouse’s beneficial interest in the trust. Here, the IRS determined that the interest in the 25 percent of the unitrust amount must be distributed to the surviving spouse pursuant to the terms of the CRUT, so the interest will pass from the decedent to the surviving spouse as the beneficial owner. As a result, the estate could claim the marital deduction for that interest. However, because the extent of the surviving spouse’s interest in the remaining 75 percent of the unitrust amount (over which the trustee had complete discretion to distribute to either the spouse or the charity) could not be determined at the date of the decedent’s death, it would not be deemed to have passed from the decedent to the spouse as beneficial owner under I.R.C. § 2056(a). Therefore, no estate tax marital deduction could be claimed for the value of the 75 percent interest.

Takeaways: The memorandum does not have precedential value, but it is noteworthy that it included a footnote stating that the IRS’s prior position set forth in Private Letter Rulings  2008-13-006, 2008-32-017,  2011-17-005, and 2018-45-014 (that taxpayers were entitled to an estate tax marital deduction under I.R.C. § 2056 or a gift tax marital deduction under I.R.C. § 2535 for a unitrust interest in a CRUT that the trustee had the discretion to distribute between a charity and a surviving spouse) no longer reflects the position of the IRS Office of Chief Counsel. This represents a significant change. In addition, the footnote indicated that the analysis and conclusion in the present memorandum would be the same for a completed gift transfer to a CRUT with similar terms under I.R.C. § 2535.

Failure to Comply with Paperwork and Documentation Requirements May Be Costly for Taxpayers 

Keefer v. United States, No. 3:20-CV-0836-B, 2022 WL 2473369 (N.D. Tex. July 6, 2022)

Kevin and Patricia Keefer sought a refund for an overpayment of income they paid in 2015. The alleged overpayment was due to the IRS’s disallowance of a charitable deduction for a donation of a 4 percent interest in a limited partnership that owned and operated a hotel property. The IRS notice of deficiency indicated that the charitable deduction was disallowed because the Keefers had failed to provide the IRS with a contemporaneous written acknowledgment (CWA) from the donee organization—a donor-advised fund—showing that it had exclusive legal control over the assets contributed. In addition, the notice of deficiency stated that the Keefers’ appraisal did not include the appraiser’s identifying number. Although the Keefers disagreed with the notice, they paid the additional taxes specified in the notice. Shortly thereafter, they filed for a refund of those amounts, arguing that their 2015 tax return and its attachments satisfied the CWA and appraisal requirements, and that the deficiency and penalties had been incorrectly calculated. The IRS disallowed their claim on the basis that it was untimely filed, and the Keefers filed suit.

Although the US District Court for the Northern District of Texas did not agree with all of the IRS’s determinations, it ruled that the IRS was correct in disallowing the Keefers’ charitable deduction for the donation because they did not obtain a CWA satisfying the statutory requirements of I.R.C. § 170(f)(8) (charitable deductions for contributions of $250 or more are not allowed “unless the taxpayer substantiates the contribution by a [CWA] of the contribution by the donee organization that meets the requirements of subparagraph (B)”). In addition, I.R.C. § 170(f)(18) specifies that a donation to a donor-advised fund must be substantiated by a CWA that the organization sponsoring the fund has exclusive control over the assets contributed. The court also ruled that substantial compliance is inapplicable to excuse noncompliance with those statutory requirements. Consequently, the court granted the government’s motion for summary judgment. In its ruling, the court held that the Keefers did not obtain a CWA that complied with statutory requirements, and thus their claim for a refund of $507,954.80—the amount of the charitable donation deduction—and other alternative claims were properly denied by the IRS.

Malek v. Comm’r, No. 9082-21S, 2022 WL 2978171 (U.S. Tax Ct. June 16, 2022)

Joseph Malek was employed by the City of Chicago as a patrol officer for the Chicago Police Department. Some of the terms of his employment were subject to an agreement between the Fraternal Order of Police and the City of Chicago. That agreement provided that officers could be reimbursed for certain employment-related expenses. For 2017, the relevant year, Joseph did not provide any receipts to the police department as required to make a claim for expenses. However, in the 2017 joint tax return Joseph filed with his wife, he claimed itemized deductions including $16,507 in unreimbursed employee business expenses, noncash charitable contributions of $500, and cash charitable deductions of $5,150. The IRS Commissioner determined a $4,834 deficiency in federal income tax based on disallowed deductions and imposed an accuracy-related penalty.

In the proceeding for a redetermination of a deficiency, the Tax Court noted that deductions are “a matter of legislative grace” and that taxpayers bear the burden of proving their entitlement to claimed deductions. In addition, although taxpayers may deduct ordinary and necessary expenses paid in connection with operating a trade or business, for expenses to be deductible, the taxpayer must not have a right to reimbursement from their employer. Joseph, however, had failed to make claims for his business-related expenses despite being entitled to reimbursement for at least some of them. In addition, he had not provided evidence to support his claimed deductions for business expenses or charitable contribution deductions. As a result, the court sustained the Commissioner’s determination of the deficiency.

Takeaways: The Keefer and Malek cases remind attorneys of the importance of encouraging clients to properly complete and submit paperwork affecting their wealth, whether it is tax-related or not. Careful planning can be derailed if, for example, documentation required for tax deductions or paperwork for beneficiary designations is disregarded. If necessary, refer clients to a tax professional who can help them properly submit returns and accompanying paperwork to the IRS and state tax authorities.

Beneficiary Rights Forfeited and No Contest Provision Enforced because Trust Contest Was a Direct Contest Without Probable Cause Despite Filing Outside Limitation Period

Meiri v. Shamtoubi, 81 Cal. App. 5th 606 (Cal. Ct. App. July 25, 2022)

Tale and Iraj Shamtoubi created the Shamtoubi Trust in 1994. They served as joint trustees for their lifetimes, and the trust’s property was used for their benefit. They executed an amended and restated Shamtoubi Trust (Amended Trust) in 2014, which provided that upon either of their deaths, the trust would be divided into three subtrusts, with the surviving spouse as the trustee and sole lifetime beneficiary of all of the subtrusts. Their four children were named as the remainder beneficiaries of one of the subtrusts, and they were entitled to distributions at the death of the surviving spouse.

Before the trust was amended, the trust made substantial gifts and loans to two of the children, including their daughter Meiri, and owed money to a third child. To account for this, the Amended Trust redistributed the benefits to Tale and Iraj’s four children. The Amended Trust included the following no contest provision:

[If] any person . . . for any reason or in any manner, directly or indirectly . . . contests in any court the validity of (1) this trust . . . or any provision of the foregoing or any subsequently executed amendment or codicil to the foregoing or any provision of such amendment or codicil (hereinafter referred to as Document or Documents) [ ] seeks to obtain an adjudication in any Direct Contest that a Document is void, otherwise seeks to void, nullify or set aside a Document . . . then the right of such beneficiary to take any interest given to him or her under this trust or any trust created pursuant to this trust shall be determined as it would have been determined had such beneficiary predeceased the trustors without surviving issue.

The Amended Trust defined a Direct Contest as “a pleading filed in any court that alleges the invalidity of a Document, or one or more of the terms [o]f a Document, on one or more of the following grounds: (1) revocation, (2) lack of capacity, (3) fraud, (4) misrepresentation, (5) menace, (6) duress, (7) undue influence, (8) mistake, (9) lack of due execution, and (10) forgery.” Tale gave the children, including Meiri, a Notification by Trustee pursuant to Probate Code section 16061.7 that explained in bold text that they may not bring an action to contest the trust “more than 120 days from the date this notification by the trustee is served upon you.”

Nevertheless, approximately 230 days after the notice was sent, Meiri filed a petition seeking to invalidate the Amended Trust. In her petition, she asserted that Iraj was suffering from health issues, heavily medicated, and unable to think or act clearly when he executed the Amended Trust. Meiri sought to have the Amended Trust voided based upon her father’s alleged incapacity and alleged undue influence and fraud committed by her siblings. She later amended her petition to assert that she was not contesting the validity of the Amended Trust but sought $20 million in damages for elder abuse and a determination that her mother, Tale, and her siblings and their issue had forfeited any interest in Iraj’s estate.

The probate court ruled that Meiri had filed a direct contest without probable cause under Probate Code section 21311, and that because of her violation of the no contest clause, she had forfeited her right to take as a beneficiary of the Amended Trust. On appeal, the California Court of Appeal affirmed, rejecting Meiri’s argument that an untimely filing is not a direct contest under section 21311. Rather, the court found that the untimely filing established a lack of probable cause and that any legally sufficient bar to relief, whether it was procedural or substantive, appeared to satisfy the statutory test for lack of probable cause. According to the court, Meiri’s position, if adopted, would enable litigants to circumvent the legislature’s policy judgments by enabling them to avoid the application of a no contest clause

by filing a grievance, even if that grievance entirely lacked probable cause, after the 120-day window, because that late grievance could never be a direct contest in the first instance. This expansive argument effectively asks us to nullify the legislative scheme relating to no contest clauses, with wide effects on the administration of trusts within the State. We do not so interpret the Probate Code.

As a result, Meiri lost her right to benefit from the Amended Trust and was liable for costs on appeal.

Takeaways: State law varies regarding no contest clauses. Although most states enforce them in at least some circumstances, they are unenforceable in a few states. Some states, such as California, enforce them unless the party who is contesting a will or trust had probable cause to challenge its validity. These states attempt to balance the policy of discouraging individuals who are simply dissatisfied with their inheritance from contesting a will or trust with the competing policy of allowing legitimate contests in situations in which a vulnerable person has been manipulated by a bad actor into changing their will or trust. 

Employers Must Provide Evidence that Independent Contractors Are Engaged in an Independent Trade or Business Under ABC Test

East Bay Drywall v. Dep’t of Labor & Workforce Dev., No. 085770, 2022 WL 3031731 (N.J. Aug. 2, 2022)

In 2017, the New Jersey Department of Labor and Workforce Development (DLWD) conducted an audit of East Bay Drywall, LLC (East Bay) to determine if the company owed any unemployment compensation or disability benefit funds. The determination of whether any funds were owed depended upon whether some of East Bay’s workers were employees or independent contractors. According to the Commissioner of the DLWD, based on the “ABC test,” set forth in N.J.S.A. § 43:21-19(i)(6) (and discussed herein), sixteen of East Bay’s subcontractors should have been classified as employees. As a result, East Bay owed more than $42,000 in unpaid contributions, in part because East Bay had not supplied evidence that the workers existed independently of East Bay and that there was no evidence that they had properly maintained their corporate status while performing services and receiving payments from East Bay. On appeal, the Appellate Division determined that only five of the subcontractors should have been classified as employees because they were not viable independent business entities under the ABC test. The New Jersey Supreme Court affirmed the Appellate Division’s ruling regarding the five subcontractors found to be employees, but reversed its judgment as to the other eleven workers.

According to New Jersey’s statutory ABC test, services performed by an individual for remuneration are considered employment activities, and the individuals are therefore considered employees, unless

1. such individual has been and will continue to be free from control or direction over the performance of such service, both under his contract of service and in fact;
2. such service is either outside the usual course of the business for which such service is performed, or that such service is performed outside of all the places of business of the enterprise for which such service is performed; and
3. such individual is customarily engaged in an independently established trade, occupation, profession, or business.

The court noted that the default presumption under the ABC test is that a worker is an employee and that “ABC test is conjunctive; thus, all three prongs must be satisfied for a worker to be considered an independent contractor.” In addition, the determination of whether a worker is an employee or independent contractor is fact sensitive and requires an evaluation of the substance rather than the form of the relationship. 

The court found it unnecessary to address whether East Bay had complied with prongs A and B of the test because it agreed with the Commissioner that East Bay had failed to supply sufficient information to satisfy prong C, which provides the “closest connection between the obligation to pay taxes and the eligibility for benefits.” Prong C is satisfied when the worker has an independent business, trade, occupation, or profession that will “clearly continue despite the termination of the challenged relationship.” The following factors are among those that should be considered when evaluating whether the worker can maintain an independent business:

• the duration and strength of the worker’s business
• the number of the worker’s customers and volume of their business with the worker
• the extent of the worker’s tools, equipment, vehicles, and similar resources
• the amount of remuneration received from the presumptive employer compared to other employers

The court held that East Bay’s testimony that the subcontractors worked for other contractors, would leave jobs before they were complete, and were free to accept or decline work, and the certificates of insurance and business entity registration for the disputed workers was insufficient to prove that the subcontractors were independent. The probative value of the subcontractors’ ability to work for others and refuse to accept or complete work was limited according to the court. In addition, the court determined that the insurance certificates and business registrations supplied by East Bay as evidence were in place for only part of the audit period. As a result, the court deferred to the Commissioner’s decision that the subcontractors should have been classified by East Bay as employees.

Takeaways: In New Jersey and other states that have adopted the ABC test, attorneys should advise business clients to maintain records and documentation sufficient to establish all three prongs of the test for their independent contractors and to evaluate whether the burden of compiling the necessary information outweighs the costs of treating them as employees. 

Email Was a Written Instrument Effective to Amend Partnership Agreement

Mizel Roth IRA v. Unified Capital Partners 3 LLC and Unified Asset Mgmt., 19 Civ. 10712 (NRB), 2022 WL 3359759 (S.D.N.Y. Aug. 15, 2022)

Steven Mizel Roth IRA (Roth IRA), beneficially owned by Steven Mizel, was an investor and limited partner in a partnership that was scheduled to dissolve within three years pursuant to the terms of the partnership agreement unless it was extended by the general partner, Unified Capital Partners (UCP), which had the sole discretion to extend its term for up to two consecutive one-year periods. Any further extension of the partnership term was required to be made by amendment. In January 2019, Steven, on behalf of the Roth IRA, inquired about the winddown of the partnership, and in June 2019, the Roth IRA sent a formal demand letter demanding that the partnership and its assets be liquidated. UCP replied by letter in July 2019, expressing its intention to amend the partnership agreement to extend its term to maximize the value of the fund it held. In August 2019, one of the managing members of the general partnership instructed an assistant to send an email to the limited partners informing them of UCP’s intention to extend the term of the fund. In part, the email stated: 

We formally will be extending the life of the fund until 2021.

Thank You 

Ron & Walter

The Roth IRA filed suit arising from UCP’s failure to dissolve the partnership by the deadline set forth in the partnership agreement. UPC filed a motion for summary judgment on several grounds, including that the August 2019 email was sufficient to effectuate an amendment of the partnership agreement and to extend its term.

The partnership agreement stated that it could be amended “only by a written instrument signed by the General Partner,” but it did not define written instrument. However, it did state that “[a]ll notices, requests and other communications to any party hereunder shall be in writing (including electronic means or similar writing).”

The court rejected the Roth IRA’s position that the email was not a written instrument, ruling that it was clear that the parties contemplated that an electronic transmission could constitute a written document and that there was nothing in the partnership agreement specifying that amendments should be treated differently. As a result, the court concluded that an email can be a “written instrument” that can effectuate an amendment to the partnership agreement.

Further, the federal Electronic Signatures in Global and National Commerce Act (E-Sign Act) (15 U.S.C. §§ 7001–7031) and Delaware’s limited partnership act (see 6 Del. C. § 17-113) recognize the validity of an electronic signature, which is defined as an “electronic symbol or process, attached to or logically associated with a document, and executed or adopted by a person with the intent to sign the document.” The managing member who had arranged for the August 2019 email to be sent testified that he had composed the email message, which concluded “Thank you, Ron & Walter” and had instructed his assistant to send it on behalf of him and the other managing partner. The Roth IRA merely stated in rebuttal that the email was unsigned, which the court determined was an unsubstantiated assertion that was insufficient to create a genuine issue of fact regarding the managing member’s intent to sign the email.

The Roth IRA’s assertion that the email did not specify the duration of the extension of the partnership agreement was also without merit because it stated that the fund would be extended until 2021.

Takeaways: The court granted UCP’s motion for summary judgment on other grounds as well, but its ruling that UCP’s email was a “written instrument” sufficient to effectuate an amendment to the partnership agreement is a reminder for attorneys who advise partnership and LLC owners to include clear procedures for effectuating amendments in their partnership or operating agreements. In addition, attorneys should advise clients that informal communications through emails or text messages could be viewed as evidence of a contractual amendment, particularly if the agreement allows electronic writings.

California Passes Pay Transparency and Reporting Law

S.B. 1162, 2021-22 Reg. Sess. (Cal. 2022)

On August 30, 2022, the California Senate passed SB-1162. The bill, which awaits Governor Gavin Newsom’s signature, would require employers of fifteen or more employees to include the pay scale for positions in their job postings and require third parties that publish job postings to include pay scales.

California’s bill, if enacted, goes beyond other pay transparency laws in that it would require private employers of 100 or more employees to submit a pay data report to the Civil Rights Department within the Business, Consumer Services, and Housing Agency that includes the median and mean hourly rate for each combination of race, ethnicity, and sex within each job category. If the private employer has 100 or more employees hired through labor contractors, a separate pay data report would be required for those employees. The report must be provided no later than the second Wednesday of May 2023 and annually thereafter. The bill would authorize a penalty of up to $100 per employee for failure to submit the pay data report and up to $200 per employee for subsequent failures.

Takeaways: If Governor Newsom signs the bill, California will join Illinois in requiring pay reporting. Similar pay transparency laws have been passed in Colorado, New York City, and Washington state.