The Lawletter Vol 38 No 2
Brad Pettit, Senior Attorney, National Legal Research Group
The Internal Revenue Code ("I.R.C.") provides that
[e]xcept in the case of a rollover contribution described in [§ 408](d)(3) . . . , no contribution [to a qualified individual retirement account or a retirement plan] will be accepted unless it is in cash, and contributions will not be accepted for the taxable year on behalf of any individual in excess of the amount in effect for such taxable year under section 219(b)(1)(A).
26 U.S.C. § 408(a)(1) (emphasis added). A key requirement for a "rollover contribution" is that "the entire amount received" by an individual upon a payment or distribution from a retirement account or plan must be "paid into" an individual retirement account, an individual retirement annuity, or an eligible retirement plan for the benefit of the individual "not later than the 60th day after the day on which" the payment or distribution is received. Id. § 408(d)(3)(A).
Since we live in an imperfect world, mistakes can be made when an individual seeks to achieve a timely tax-free rollover of money or securities from one tax-favored retirement account or plan into another. Accordingly, the I.R.C. provides that "[t]he Secretary [of the Treasury] may waive the 60‑day [rollover] requirement under subparagraphs (A) and (D) where the failure to waive such requirement would be against equity or good conscience, including casualty, disaster, or other events beyond the reasonable control of the individual subject to such requirement." Id. § 408(d)(3)(I) (emphasis added). In an administrative ruling, the Internal Revenue Service ("IRS") stated that "a taxpayer must apply for a hardship exception to the 60‑day rollover requirement using the same procedure as that outlined in Rev. Proc. 2003‑4 for letter rulings, accompanied by the user fee set forth in Rev. Proc. 2003‑8." Rev. Proc. 2003‑16, § 3.01, 2003‑1 C.B. 359 [after clicking on this hyperlink, scroll down to page 359].
In determining whether to grant a waiver, the Service will consider all relevant facts and circumstances, including: (1) errors committed by a financial institution, other than as described in Section 3.03 below; (2) inability to complete a rollover due to death, disability, hospitalization, incarceration, restrictions imposed by a foreign country or postal error; (3) the use of the amount distributed (for example, in the case of payment by check, whether the check was cashed); and (4) the time elapsed since the distribution occurred.
Id. § 3.02. According to the IRS, there is an automatic waiver of a defect in an attempt to carry out a tax-free rollover into an IRA, and no formal application for a discretionary waiver is necessary
if a financial institution receives funds on behalf of a taxpayer prior to the expiration of the 60‑day rollover period, the taxpayer follows all procedures required by the financial institution for depositing the funds into an eligible retirement plan within the 60‑day period (including giving instructions to deposit the funds into an eligible retirement plan) and, solely due to an error on the part of the financial institution, the funds are not deposited into an eligible retirement plan within the 60‑day rollover period.
Id. § 3.03. But the IRS cautions that "[a]utomatic approval is granted only: (1) if the funds are deposited into an eligible retirement plan within 1 year from the beginning of the 60‑day rollover period; and (2) if the financial institution had deposited the funds as instructed, it would have been a valid rollover." Id.
In a very recent Private Letter Ruling, the IRS denied a taxpayer's petition for a waiver of a defect in his attempt to roll over a retirement account distribution in the form of a check into an IRA, on the ground that the taxpayer could not establish that any of the factors that are listed in Revenue Procedure 2003-16 were present in his case. P.L.R. 2012-50-031 (Sept. 19, 2012). Thus, an individual who seeks to overcome a defect in his or her attempt to achieve a tax-free rollover of funds or securities from one retirement account or plan to another must make sure that the petition to the IRS sets forth facts and circumstances that indicate that a waiver by the IRS of the defect in completing the rollover contribution is justified.
March 26, 2013
Brad Pettit, Senior Attorney, National Legal Research Group
The Uniform Trust Code ("U.T.C.") provides that a "court may reform the terms of a trust, even if unambiguous, to conform the terms to the settlor's intention if it is proved by clear and convincing evidence that both the settlor's intent and the terms of the trust were affected by a mistake of fact or law, whether in expression or inducement." U.T.C. § 415 (Thomson Reuters, Westlaw current through 2011 annual meetings of the Nat'l Conf. of Comm'r on Unif. State Laws & A.L.I.) (emphasis added). More specifically, the U.T.C. states that "[t]o achieve the settlor's tax objectives, [a] court may modify the terms of a trust in a manner that is not contrary to the settlor's probable intention[, and a] court may provide that the modification has retroactive effect." Id. § 416 (emphasis added). The comment to section 416 seeks to explain the subtle distinctions between a court's discretionary power (1) under section 415 to approve the reformation of an irrevocable trust to conform to the settlor's intention by correcting a mistake of fact or law, and (2) under section 416 to modify an irrevocable trust in order to achieve the settlor's tax objectives:
"Modification" under this section is to be distinguished from the "reformation" authorized by Section 415. Reformation under Section 415 is available when the terms of a trust fail to reflect the donor's original, particularized intention. The mistaken terms are then reformed to conform to this specific intent. The modification authorized here allows the terms of the trust to be changed to meet the settlor's tax‑saving objective as long as the resulting terms, particularly the dispositive provisions, are not inconsistent with the settlor's probable intent. The modification allowed by this subsection is similar in concept to the cy pres doctrine for charitable trusts (see Section 413), and the deviation doctrine for unanticipated circumstances (see Section 412).
Id. § 416 cmt.
The Restatement (Third) of Property also provides that "[a] donative document may be modified, in a manner that does not violate the donor's probable intention, to achieve the donor's tax objectives." Restatement (Third) of Property: Donative Transfers § 12.2 (Tentative Draft No. 1 promulgated and adopted Mar. 28, 1995).
A recent Private Letter Ruling ("P.L.R.") by the Internal Revenue Service ("IRS") illustrates difficulties that an executor or trustee might encounter in trying to get the IRS to recognize and give effect to a state court's approval of a postmortem reformation or modification of a decedent's trust. In P.L.R. 2012-43-001 (July 10, 2012) (under 26 U.S.C. § 6110(k)(3), a P.L.R. may not be used or cited as precedent), the IRS considered a request for a ruling on the issue of whether a state court's postmortem reformation of a decedent's trust could be recognized for federal gift, estate, and generation‑skipping transfer ("GST") tax purposes. In response to the request for a ruling, the IRS acknowledged that under state law a unilateral mistake by the settlor of a trust may be a sufficient ground to reform a trust. But the IRS went on to point out that under the U.S. Supreme Court's landmark decision in Commissioner v. Estate of Bosch, 387 U.S. 456, on remand, 382 F.2d 295 (2d Cir. 1967), there are rules that apply in a case where a petitioner wants the federal government or an agency thereof to recognize and give effect to a state trial court's decision on a matter of state law:
It follows here then, that when the application of a federal statute is involved, the decision of a state trial court as to an underlying issue of state law should a fortiori not be controlling. This is but an application of the rule of Erie R. Co. v. Tompkins, [304 U.S. 64 (1938)], where state law as announced by the highest court of the State is to be followed. This is not a diversity case but the same principle may be applied for the same reasons, viz., the underlying substantive rule involved is based on state law and the State's highest court is the best authority on its own law. If there be no decision by that court then federal authorities must apply what they find to be the state law after giving 'proper regard' to relevant rulings of other courts of the State. In this respect, it may be said to be, in effect, sitting as a state court. Bernhardt v. Polygraphic Co., 350 U.S. 198, 76 S. Ct. 273, 100 L. Ed. 199 (1956).
Id. at 465.
After applying the principles that were enunciated in Bosch, the IRS determined that since the highest court and the appellate courts in the state in question had not considered the issue presented by the petitioner, the IRS was free to give "proper regard" to the state court's order when deciding whether to recognize the retroactive reformation of one of the trusts that were at issue in the case. P.L.R. 2012-43-001. Accordingly, the IRS gave proper regard to the state court's order to reform the trust in question and also considered the facts alleged and the representations made by the petitioner. The IRS then concluded that "the reformation of Trust 2 [was] not consistent with applicable State law, as applied by the highest court of State." Id. Accordingly, the IRS ruled that "the reformation of Trust 2 [could] not be recognized retroactively for gift, estate, or GST tax purposes." Id.
The difficulties in trying to get the IRS to recognize and give effect to a postmortem modification of a decedent's trust are further illustrated by a 1990 decision in which the U.S. Tax Court disregarded a postmortem modification of a decedent's intervivos trust that was intended to enable the trust to qualify for the federal estate tax marital deduction. Estate of Nicholson v. Comm'r, 94 T.C. 666 (1990). In Nicholson, the trust, as it was drafted, failed to qualify for the federal estate tax marital deduction under 26 U.S.C. § 2056(b)(7) (estate tax deduction for a qualified terminable life interest in property that is bequeathed to a surviving spouse), because the instrument did not grant the decedent's widow the right to receive all the trust income for life. 94 T.C. at 674-75. A Texas probate court modified the trust to give the widow the right to receive all of the trust income for life. Id. at 671. In deciding not to recognize the state probate court's postmortem modification of the trust in question, the Nicholson court stated:
As to the parties to the reformed instrument the reformation relates back to the date of the original instrument, but it does not affect the rights acquired by non‑parties, including the Government. Were the law otherwise there would exist considerable opportunity for 'collusive' state court actions having the sole purpose of reducing federal tax liabilities. Furthermore, federal tax liabilities would remain unsettled for years after their assessment if state courts and private persons were empowered to retroactively affect the tax consequences of completed transactions and completed tax years.
Under the terms of the trust at issue, the decedent's wife is not 'entitled to all the income from the property, payable annually or at more frequent intervals' as is required by section 2056(b)(7). Instead, the unambiguous language of the trust only allows her 'so much of the net income * * * as * * * [she] may from time to time require to maintain * * * [her] usual and customary standard of living * * *.' See Ithaca Trust Co. v. United States, 279 U.S. 151, 154 (1929).
* * *
Accordingly, even a consideration of the extrinsic evidence fails to show that the decedent intended that his wife be 'entitled to all the income' from the trust.
Id. at 674, 678.
The Tax Court's decision in Nicholson imposes a heavy burden upon an executor or trustee who wants the IRS to recognize and give effect to a state court's decision to modify or reform a decedent's trust in order to achieve federal tax savings. Under that decision, an executor or trustee must be able to point to evidence that a deceased settlor's intentions with respect to the disposition of the trust assets were consoistent with the postmortem federal tax savings that are being sought. For example, if the language of a deceased settlor's trust suggests that the decedent did not want his or her surviving spouse to have the right to receive all of the income of the trust, the Tax Court will not give effect to a postmortem modification or reformation of the trust that has given the survivor the right to all trust income.
The IRS's decision in P.L.R. 2012-43-001 similarly presents a good news/bad news scenario for executors and trustees. On the one hand, the IRS was willing to look at the facts and circumstances of the case in order to decide whether to recognize the state court's approval of a modification or reformation of an irrevocable trust. But after examining the facts and circumstances of the case, the IRS rendered an unfavorable decision from the petitioner's standpoint.
In sum, it appears that in an appropriate case, the IRS will recognize and give effect to a state court's decision to allow an executor or trustee to modify or reform a decedent's trust. However, an executor or trustee faces a decidedly uphill battle when trying to get the IRS to go along with a state court's decision to approve a postmortem modification or reformation of a decedent's trust and allow the decedent's estate to obtain federal tax savings as a result of the judicial change in the language of the trust.
The Lawletter Vol 37 No 12
Jim Witt, Senior Attorney, National Legal Research Group
With the proliferation of will substitutes (vehicles such as revocable trusts, IRAs, and pensions, used to pass assets to beneficiaries at the owner's death but outside the will), a problem can arise with possible duplication between the will substitute and the will. Such a problem was litigated in the Court of Appeals of South Carolina case, Estate of Gill ex rel. Grant v. Clemson University Foundation, 725 S.E.2d 516 (S.C. Ct. App. 2012).
In Estate of Gill, the testatrix bequeathed $100,000 to Clemson University to establish the "Scholarship." The income earned by the fund (but none of the principal) was to be used to provide scholarships for "academically deserving football players." Almost one year after executing the will, the testatrix established an IRA with Morgan Stanley. She specifically designated the Scholarship as the beneficiary of $100,000 in the IRA. The Estate contended that her intent had been to provide a funding mechanism for the Scholarship under the will, not for Clemson to receive two separate $100,000 gifts. Clemson contended that it was entitled to both the $100,000 from the IRA and the $100,000 bequest under the will.
The Estate brought suit for a declaratory judgment, and a special referee found that because the will was unambiguous as to the $100,000 bequest to establish the Scholarship, the bequest was not ambiguous and extrinsic evidence could not be considered. The referee therefore ruled that Clemson was entitled to both the $100,000 Scholarship bequest and $100,000 from the IRA as a nontestamentary asset passing outside the will.
On appeal, the Estate alleged that the referee had erred in failing both to consider extrinsic evidence regarding the testatrix's intent as to the funding of the Scholarship, because the will was ambiguous in that respect, as well as to admit the extrinsic evidence, because such evidence was relevant and satisfied the "state of mind" exception to the hearsay rule.
The Estate further argued that the referee had erred in failing to recognize that a latent ambiguity arose under the will because of the circumstance that the IRA was not in existence when the will was executed, thereby requiring that the terms of the bequest for the Scholarship and the beneficiary designation under the IRA had to be construed together as part of an overall plan. The extrinsic evidence consisted of the IRA agreement and the testimony of witnesses to the effect that (1) the testatrix had designated Clemson as a beneficiary under the IRA in order to obtain the charitable deduction on her income tax for that year; and (2) according to Linda Fraser, a financial advisor at Morgan Stanley, the testatrix was not familiar with the terms of the will at the time she established the IRA and nothing in the will stated that the IRA account was to satisfy the bequest to Clemson. The court of appeals ruled that the referee's failure to consider extrinsic evidence could not be the basis for the Estate's appeal, because the Estate had failed to preserve the issue on appeal.
The court of appeals also rejected the Estate's hearsay exception argument because the proferred testimony did not satisfy the requirement of Rule 803(3) of the South Carolina Rules of Evidence. To be admissible under Rule 803(3), a statement as to the declarant's state of mind, emotion, sensation, or physical condition must relate to his or her state of mind at the time of the statement but cannot include "[a] statement of memory or belief to prove the fact remembered or believed unless it relates to the execution, revocation, identification, or terms of declarant's will." Id. at 521.
As the court of appeals found, the testimony of the financial planner related to a statement made by the testatrix almost a year after she had executed her will. Additionally, the court rejected the argument that the IRA qualified as a "contemporaneous writing" under section 62-2-610 of the South Carolina Code, manifesting the testatrix's intent that Clemson's status as a beneficiary under the IRA serve as satisfaction of the $100,000 bequest. The court found no evidence of such intent in that neither the will nor the IRA instrument mentioned the possibility of satisfaction of the bequest prior to the testatrix's death.
The court thus affirmed the referee's conclusion that Clemson was entitled to both the $100,000 bequest and the $100,000 under the IRA. The obvious lesson here is that where a lifetime transfer, such as the establishment of an IRA, is intended to satisfy a testamentary gift, the manifestation of that intent should be made clear in either the will or the instrument embodying the lifetime transfer, or in both.
The Lawletter Vol 37 No 11
Matt McDavitt, Senior Attorney, National Legal Research Group
The situation occasionally arises wherein one or more parties interested in a decedent's estate or trust challenge the right of certain other beneficiaries to take via the will or trust on the ground that these other beneficiaries were allegedly recently adopted through adult adoption for the express purpose of creating a beneficial interest in the estate or trust. Two recent opinions reveal the factors reviewing courts examine to resolve such claims, which, if proven true, would amount to fraudulent interference with a gift or inheritance.
In Otto v. Gore, 45 A.3d 120 (Del. Super. Ct. 2012), for instance, a woman with three children from her former marriage adopted her 65-year-old ex-husband as her fourth "child." This adult adoption potentially created an interest in the ex-husband in a family trust created by the woman's parents, a trust granting shares to the settlors' "grandchildren." The court observed, however, that an ambiguity existed in the trust instrument because, while the descriptor "children" was defined as including adopted children, no such definition was included regarding "grandchildren," so extrinsic evidence was properly examined to determine whether the settlors intended adult adoptees to take. To find this intent regarding the adoption of grandchildren, the court referenced a letter sent by the settlors to their drafting attorney, which the court interpreted as indicating settlor intent that the class of grandchildren was to include solely minors who had a parent-child relationship with their parents.
The Otto court concluded that the adult adoption at issue had been effectuated specifically to create an interest in the trust and that, as this intention would have thwarted the settlors' intent to benefit only minor grandchildren in a true parent-child relationship, equity would intervene to prevent the ex-husband's taking under the trust, despite the fact that the adoption complied with state law.
A contrary result was reached in In re Estate of Fenton, 901 A.2d 455 (N.J. Super. Ct. App. Div. 2006). Whereas the court in Otto examined the timing and impact of the adult adoption to determine whether an ulterior motive demanded that equity prevent that adoption from creating a beneficial interest in the subject trust, the court in Fenton refused to speculate regarding the motives of the adoptive child and/or parent, instead relying on the adoptive mother's own statements in court indicating that she had effectuated the adoption of her 37-year-old second cousin in order to create a close family.
The Fenton court noted that the adoption was valid under the applicable state law and that the adoption statutes do not demand inquiry as to the purpose of the adoption. The adult adoption in Fenton created $30,000 in annual income in the adoptee for life. The court noted that the plaintiffs had failed to offer evidence of an ulterior motive, aside from the circumstantial evidence that the adoption created a substantial interest in the trust, although evidence was developed indicating that the adoptive mother had, prior to the adoption, specifically written to the trustee to see if the adoption would create an interest in her new daughter.
In the end, the Fenton court concluded that the trust language creating the class of beneficiaries expressly included adopted children, so there was no conflict between settlor intent and the outcome at hand. The plaintiffs in Fenton asked the court to annul the adoption, not interpret the trust to exclude the adult adoptee, but given the court's stated rationale that the trust terms allowed adopted children to take, the result seemingly would not have been different had the plaintiffs requested more appropriate relief.
The Lawletter Vol 37 No 10
Brad Pettit, Senior Attorney, National Legal Research Group
In a recent advisory opinion, the Chief Counsel for the Internal Revenue Service ("IRS") issued a decision that no doubt will be toasted by the rapidly growing vineyard industry in the United States. In IRS Chief Counsel Advisory ("I.R.S. C.C.A.") 2012-34-024 (Aug. 24, 2012), the Chief Counsel opined that individual taxpayers who developed a vineyard were entitled to claim a deduction under 26 U.S.C. § 179 (election to expense certain depreciable business assets) on their 2009 income tax returns with respect to expenses that they had incurred in planting the vineyard in 2005 and then placing it into service in 2009.
I.R.C. § 179 provides generally that "[a] taxpayer may elect to treat the cost of any section 179 property as an expense which is not chargeable to capital account" and that "[a]ny cost so treated shall be allowed as a deduction for the taxable year in which the section 179 property is placed in service." 26 U.S.C. § 179(a). "Section 179 property" is statutorily defined as including qualified tangible property to which § 168 (accelerated cost-recovery system) applies, which is also § 1245 property ("property which is or has been property of a character subject to the allowance for depreciation provided in section 167," id. § 1245(a)(3)), and which has been acquired by purchase for use in the active conduct of a trade or business. Id. § 179(d)(1). According to the Chief Counsel, "[s]ection 179(a) allows a taxpayer to elect to expense the cost (or a portion of the cost) of § 179 property, up to a limit, in the taxable year the property is placed in service by the taxpayer, instead of recovering the property by taking depreciation deductions over the applicable recovery period." I.R.S. C.C.A. 2012-34-024.
A key issue in I.R.S. C.C.A. 2012-34-024 was whether the taxpayers' vineyard was "tangible property," given the fact that in a 1967 Revenue Ruling, Rev. Rul. 67‑51, 1967‑1 C.B. 68, the IRS had concluded that certain fruit-bearing trees were not § 179 property because they did not qualify as tangible personal property within the meaning of § 179 of the 1954 Code. The Chief Counsel tackled that problem by pointing out that "[s]ince the issuance of Rev. Rul. 67‑51, the definition of § 179 property has significantly changed." I.R.S. C.C.A. 2012-34-024. The Chief Counsel noted that "[f]or the year in issue  and currently, § 179 property includes depreciable property that is tangible personal property or other tangible property under § 1245(a)(3) [of the Code]." Id. Accordingly, the Chief Counsel declared that "[b]ecause of the change in the definition of § 179 property, Rev. Rul. 67‑51 no longer applies for purposes of § 179 of the 1986 Code." Id.
I.R.S. C.C.A. 2012-34-024 indicates that as long as the requirements of § 179 of the Code are met, a vintner (or other similar farmer) can elect to expense the cost or a portion of the cost of the vineyard on Schedule F (Profit or Loss from Farming) of his or her federal income tax return. For an excellent, detailed discussion of I.R.S. C.C.A. 2012-34-024, the reader is urged to consult Vineyard Costs Deductible Under § 179, 53 Tax Mgmt. Mem. (BNA) No. 20, at 381 (Sept. 24, 2012).
November 6, 2012
Brad Pettit, Senior Attorney, National Legal Research Group
The volatility of stock, bond, and real estate markets, as evidenced by the technology stock and real estate "bubbles" during the last two decades, makes it incumbent upon trust professionals to make sure that they comply with current legal standards for managing and investing trust assets. The Uniform Trust Code provides generally that a trustee must act "prudently" when administering a trust:
§ 804. Prudent Administration.
A trustee shall administer the trust as a prudent person would, by considering the purposes, terms, distributional requirements, and other circumstances of the trust. In satisfying this standard, the trustee shall exercise reasonable care, skill, and caution.
Unif. Trust Code § 804 (U.L.A. 2000 & Westlaw current through 2011 annual meetings of the Nat'l Conference of Comm'rs on Uniform State Laws and A.L.I.).
The Uniform Prudent Investor Act expressly states that "[a] trustee shall diversify the investments of the trust unless the trustee reasonably determines that, because of special circumstances, the purposes of the trust are better served without diversifying." Unif. Prudent Investor Act § 3 (U.L.A. 1994 & Westlaw current through 2011 annual meetings of the Nat'l Conference of Comm'rs on Uniform State Laws and A.L.I.) (emphasis added); see also P.G. Guthrie, Annotation, Duty of Trustee to Diversify Investments, and Liability for Failure to Do So, 24 A.L.R.3d 730 (1969 & Westlaw databases updated weekly). The Restatement of Trusts similarly provides that "[i]n making and implementing investment decisions, the trustee has a duty to diversify the investments of the trust unless, under the circumstances, it is prudent not to do so." Restatement (Third) of Trusts ["Restatement"] § 90(b) (2007 & Westlaw current through Apr. 2012).
The Comment to § 3 of the Uniform Prudent Investor Act provides two examples of situations in which a trustee's general duty to diversify investments may be less than absolute:
Circumstances can, however, overcome the duty to diversify. For example, if a tax‑sensitive trust owns an underdiversified block of low‑basis securities, the tax costs of recognizing the gain may outweigh the advantages of diversifying the holding. The wish to retain a family business is another situation in which the purposes of the trust sometimes override the conventional duty to diversify.
Unif. Prudent Investor Act § 3 cmt.
It should also be noted that under the prudent investor rule, a trustee's duty to diversify may be enlarged or restricted by the express terms of the trust regarding investments:
The prudent investor rule, a default rule, may be expanded, restricted, eliminated, or otherwise altered by the provisions of a trust. A trustee is not liable to a beneficiary to the extent that the trustee acted in reasonable reliance on the provisions of the trust.
Id. § 1(b).
The Prudent Investor Act also makes it clear that a trustee does not have to make investment decisions, such as diversification, in a vacuum and can take into account matters such as the economy as a whole and the purposes of the trust:
§ 2. Standard of Care; Portfolio Strategy; Risk and Return Objectives.
. . . .
(b) A trustee's investment and management decisions respecting individual assets must be evaluated not in isolation but in the context of the trust portfolio as a whole and as a part of an overall investment strategy having risk and return objectives reasonably suited to the trust.
(c) Among circumstances that a trustee shall consider in investing and managing trust assets are such of the following as are relevant to the trust or its beneficiaries:
(1) general economic conditions;
(2) the possible effect of inflation or deflation;
(3) the expected tax consequences of investment decisions or strategies;
(4) the role that each investment or course of action plays within the overall trust portfolio, which may include financial assets, interests in closely held enterprises, tangible and intangible personal property, and real property;
(5) the expected total return from income and the appreciation of capital;
(6) other resources of the beneficiaries;
(7) needs for liquidity, regularity of income, and preservation or appreciation of capital; and
(8) an asset's special relationship or special value, if any, to the purposes of the trust or to one or more of the beneficiaries.
Id. § 2(b)–(c).
The Comment to § 90 of the Restatement discusses the role of proper asset allocation when diversifying the investment portfolio of a trust:
Asset allocation decisions are a fundamental aspect of an investment strategy, and are a starting point in formulating a plan of diversification (as well as an expression of judgments concerning suitable risk‑return objectives). These decisions deal with the categories of investments to be included in a trust portfolio and the portions of the trust estate to be allocated to each. These decisions are subject to adjustment from time to time as changes occur in the portfolio, in economic conditions or expectations, or in the needs or investment objectives of the trust. Basic asset classifications might begin with cash equivalents, bonds, asset‑backed securities, real estate, and corporate stocks, with both debt and equity categories further divided by their general risk‑reward or income/growth characteristics, by the domestic, foreign, tax‑exempt, or other characteristics of the issuers, and the like.
There is no defined set of asset categories to be considered by fiduciary investors. Nor does a trustee's general duty to diversify investments assume that all basic categories are to be represented in a trust's portfolio. In fact, given the variety of defensible investment strategies and the wide variations in trust purposes, terms, obligations, and other circumstances, diversification concerns do not necessarily preclude an asset‑allocation plan that emphasizes a single category of investments as long as the requirements of both caution and impartiality are accommodated in a manner suitable to the objectives of the particular trust.
Restatement § 90(b) cmt. g.
Courts have weighed in on the general duty of a trustee to diversify the investment portfolio of a trust. For example, a New Jersey court said:
The exercise of such "care, skill, prudence and diligence" under the [New Jersey Prudent Investor] Act requires a fiduciary to diversify investments "so as to minimize the risk of large losses." Therefore a prudent fiduciary "should not invest a disproportionately large part of [a] trust estate in a particular security or type of security."
In re Will of Maxwell, 704 A.2d 49, 61 (N.J. Super. Ct. App. Div. 1997) (quoting Comm'l Trust Co. v. Barnard, 142 A.2d 865, 871 (1958)), cert. denied, 708 A.2d 65 (N.J. 1998).
But, as a New York court pointed out, in order to determine whether the prudent person standard has been violated,
[(1)] the court should engage in a balanced and perceptive analysis of the trustee's consideration and action in the light of the history of each individual investment, viewed at the time of its action or its omission to act[; and (2) a]ll of the facts and circumstances of the case must be examined to determine whether a concentration of a particular stock in an estate's portfolio violates the prudent person standard.
In re Rowe, 712 N.Y.S.2d 662, 665 (App. Div. 2000) (citations omitted) (internal quotation marks omitted), leave to appeal denied, 749 N.E.2d 206 (N.Y. 2001). More recently, a New York appellate court pointed out that decisions like the one in Rowe must be viewed in light of the current version of that state's prudent investor statute, which provides that "[a] trustee shall exercise reasonable care, skill and caution to make and implement investment and management decisions as a prudent investor would for the entire portfolio, taking into account the purposes and terms and provisions of the governing instrument." In re HSBC Bank USA, N.A., 947 N.Y.S.2d 292, 300 (App. Div. 2012) (quoting N.Y. Est. Powers & Trusts Law ' 1-2.3(b)(2). The HSBC Bank court went on to say that "the prudent investor rule puts diversification at the forefront of the fiduciary's obligations, but allows leeway for the fiduciary to opt out if the beneficiaries require otherwise or if the testator/settlor directed a different course of action[.]" Id. at 301. Thus, "[a]t times, holding an overweight concentration of a security may be in the best interests of the beneficiaries." Id. at 305.
A recent decision by an Illinois court provides another excellent example of the tension between the general rule that a trustee must diversify the trust's portfolio of investments and the rule that a trustee also may take into consideration other matters when deciding or seeking to diversify the investments of a trust. Carter v. Carter, 2012 IL App (1st) 110855, 965 N.E.2d 1146, appeal denied, 968 N.E.2d 1064 (Ill. 2012). In Carter, the remainder beneficiary of a marital trust brought suit against the trustee/life income beneficiary, alleging, inter alia, that the trustee/income beneficiary had breached her fiduciary duty to diversify the investments of the trust when she invested the portfolio solely in income-producing tax-free municipal bonds. It should be noted that in Carter, the marital trust in question contained language that excused the trustee from diversifying the trust's assets.
In Carter, the trust remainderman argued that the trustee/income beneficiary's investment elections, which eschewed diversification and favored income over appreciation, constituted a breach of her duty to act as a prudent investor and that the permissive nondiversification clause in the trust did not insulate the trustee from liability where she knew that a failure to diversify would harm the remainder beneficiary. The Carter court rejected the remainderman's argument and, in a very trustee-favorable decision, held that the plaintiff had failed to establish a cause of action under the prudent investor rule because there was no evidence that the trustee/income beneficiary's decision to invest in municipal bonds was "wholly" arbitrary or unreasonable. In reaching its decision, the Carter court also relied heavily on the trust language that excused the trustee from diversifying the trust's investments and ruled that such a trust provision "altered the requirements of the prudent investor rule." Id. ¶ 36.
As the discussion above illustrates, trustees have the general duty to diversify the investment portfolio of a trust. However, the general rule of diversification is subject to further analysis as to whether full or partial diversification of the trust is required by the objectives of the trust or would be prudent under the circumstances. As the Carter
decision suggests, courts still seem to be reluctant to interfere with a trustee's decisions regarding diversification of trust investments, especially if the trust instrument expressly states that the trustee is not required to diversify the investment portfolio.
The Lawletter Vol 37 No 8
Jim Witt, Senior Attorney, National Legal Research Group
Perhaps the most obvious legal question that arises when a couple break their engagement is whether the formerly prospective bride, assuming that she has received an engagement ring, is obligated to return it to the formerly prospective groom. A recent South Carolina appellate case, Campbell v. Robinson, 726 S.E.2d 221 (S.C. Ct. App. 2012), arose out of the broken engagement of Matthew Campbell and Ashley Robinson. Campbell shows that depending upon the couple's level of rancor, the broken engagement and the question as to ownership of the ring can lead to additional legal issues.
In the Campbell case, Campbell proposed and presented a ring to Robinson in December 2005. In a spring 2006 phone conversation, they agreed to postpone the wedding. The engagement was later canceled, and a dispute ensued over ownership of the ring. Campbell filed suit against Robinson, demanding a jury trial and seeking (1) declaratory judgment that he owned the ring and was entitled to the ring's return or its equivalent value; (2) damages for the ring's wrongful retention; and (3) monetary restitution for the benefit Robinson had received while possessing the ring. Robinson counterclaimed, based on Campbell's breach of promise to marry, arguing that she was entitled to damages for her prenuptial expenditures, mental anguish, and injury to health.
Robinson testified that the engagement had been terminated solely by Campbell's action and that after the engagement was canceled, she asked Campbell twice whether she should return the ring. She asserted that Campbell had told her that she could keep it. Campbell, in his testimony, denied ending the engagement by himself and contended that the cancellation had been mutual. He also denied telling Robinson that she could keep the ring. He further contended that Robinson had refused to give him the ring after he asked for its return.
The trial court held that (1) South Carolina has not abolished actions for breach of promise to marry, and (2) South Carolina courts hinge postengagement entitlement to the engagement ring upon who was "at fault" for the engagement's cancellation. Therefore, the trial court ruled that Campbell would be entitled to the return of the ring if Robinson was at fault in terminating the engagement. If Campbell was at fault, however, Robinson would be entitled to keep the ring, and if Campbell breached the promise to marry, Robinson could recover damages. The trial court rejected Campbell's argument that he could recover damages on his claims. The jury found that Campbell was responsible for the termination of the engagement and therefore could not regain possession of the ring. The jury also found that Robinson was not entitled to any damages for Campbell's breach of promise to marry.
The court of appeals first dealt with the question of whether South Carolina courts recognize a cause of action for breach of promise to marry. The court acknowledged that certain heart-balm actions had been abolished in South Carolina, Russo v. Sutton, 422 S.E.2d 750 (S.C. 1992) (the Supreme Court of South Carolina abolished the heart-balm action for alienation of affection), but observed that promise-to-marry actions have not been expressly abolished. Therefore, the court concluded that Robinson had set forth a valid cause of action for breach of contract to marry.
The court agreed with Campbell's contention that the trial court had erred in ruling that the ownership of the ring depended upon the assignment of fault in the termination of the engagement. Rather, the court held, the question of the right to the ring depended on the determination of whether there had been a completed gift of the ring. The court reasoned that the gift of an engagement ring is impliedly conditioned upon the marriage's taking place. Thus, until the condition of marriage is fulfilled, the attempted gift is unenforceable, and the ring must be returned to the donor upon the donor's request. The court held that the party challenging the conditional nature of the transfer of possession of the ring has the burden of presenting evidence to establish either that the ring had not been intended as an engagement ring, that it was an engagement ring but had not been transferred subject to the condition of marriage or any other condition, or that the condition attached to the transfer of the ring had been canceled.
Robinson's testimony that Campbell had told her that she could keep the ring was evidence that the conditional nature of the transfer of the ring to Robinson had been converted to an absolute gift. As the court concluded, Campbell's claims for declaratory judgment as to the ownership of the ring and his claim for the ring's return presented a jury question as to whether the transfer had become absolute, necessitating the remand of the case to the trial court.
The court further ruled that Campbell's claim for restitution, based on Robinson's benefit in possessing the ring following the termination of the engagement, was barred as a matter of law because (1) there was no evidence that Campbell had presented the ring to Robinson at her request, and (2) there was no evidence that Campbell had permitted Robinson to keep the ring at her request or that he had reasonably relied upon her to pay for the ring. Finally, the court ruled that Robinson had not preserved her right to appeal from the denial of her motions for directed verdict and judgment N.O.V. as to her action for Campbell's alleged breach of promise to marry.
It seems that the only safe conclusion is that in the absence of prospective spouses' expression of absolutely clear terms as to the ownership of the engagement ring, there is a good possibility that the termination of the engagement will lead to unfortunate legal complications.
The Lawletter Vol 37 No 7
Matt McDavitt, Senior Attorney, National Legal Research Group
In many areas of law, practitioners nowadays are increasingly forced to apply long-established legal frameworks to digital media and transactions never envisioned by the authors of those legal principles. As society moves more and more toward the digitization of business and personal transactions, it is inevitable that states will soon have to address the rise of the digital will. At present, Nevada is the only state to have codified requirements to create a valid digital will. Remarkably, this law has been in effect for 11 years (and has apparently not yet generated any reported case law). The Nevada "Electronic Will" statute is instructive regarding how will execution formalities might be modified to accommodate digital will execution. It also highlights areas of technological improvement necessary to put digital wills on a par with paper wills in protecting against fraud and undue influence. See Nev. Rev. Stat. § 133.085.
Note that the valid "Electronic Will" under the Nevada statute requires the testator's electronic signature (a common enough feature in modern point-of-sale and online transactions), as well as an "Authentication Characteristic." The statute defines this phrase as "a fingerprint, a retinal scan, voice recognition, facial recognition, a digitized signature or other authentication using a unique characteristic of the person." Id. § 133.085(6)(a). The Authentication Characteristic thus necessitates incorporating a separate biometric component into the digital will.
While the Nevada statute laudably anticipates the kind of protective features necessary to assure the authenticity of a digital will, in practice the technology to accomplish this goal is seemingly not widely available in the market. First, integration of biometric markers into digital documents for authentication purposes would presumably require oversight to assure that the marker was not merely an electronic copy (i.e., a digital image of a retinal scan) that was cut-and-pasted into the document by parties unknown. Second, the statute necessitates that a single, identifiable "authoritative copy" of the digital will exist, an electronic "original" that must be deposited with a custodian, must be clearly distinguishable from digital copies, and must clearly track any postexecution changes. Certainly, no software or hardware is currently in widespread use wherein parties to electronic documents designate authentic "original" versions, immutably distinguishable from subsequent digital copies. Nor is software in widespread use wherein electronic documents may be evaluated to assure that no unauthorized changes were made following execution. Furthermore, there is a danger with digital wills—documents that may not become effective until many decades following their execution—that significant changes in hardware and software may render digital wills incompatibly archaic and unopenable (imagine a will saved to a 3.5-inch floppy disk in the early 1980s, using the obsolete MacWrite program).
Until such issues are sorted out in the digital marketplace so that electronic execution of instruments generally is recognized as safe and secure from fraud, as well as amenable to long-term storage protected from hardware or software obsolescence, it is unlikely that digital wills will become a common feature in the American landscape.
The Lawletter Vol 37 No 6
Brad Pettit, Senior Attorney, National Legal Research Group
In recent years, recreational and social clubs have experienced declines in membership and the corresponding reductions in revenues that they derive from their members' dues and other payments. As a result, these clubs have begun allowing nonmembers to use their facilities. Currently, clubs receive significant revenues from the use of their facilities by nonmembers. The tax question that arises when a club decides to supplement its income by allowing nonmembers to use its facilities is how much revenue it can receive from nonmembers before it loses its tax-exempt status.
The Internal Revenue Code (the "Code") provides that "[c]lubs organized for pleasure, recreation, and other nonprofitable purposes, substantially all of the activities of which are for such purposes and no part of the net earnings of which inures to the benefit of any private shareholder," 26 U.S.C. § 501(c)(7) (Westlaw current through P.L. 112‑142 (excluding P.L. 112‑140 and 112‑141) approved 7‑9‑12) (emphasis added), are "exempt from taxation under this subtitle unless such exemption is denied under section 502 or 503," id. § 501(a). Notwithstanding the "substantially all" language of § 501(c)(7) of the Code, the Treasury Regulations currently state that "[t]he exemption provided by section 501(a) for organizations described in section 501(c)(7) applies only to clubs which are organized and operated exclusively for pleasure, recreation, and other nonprofitable purposes[.] " 26 C.F.R. § 1.501(c)(7)-1(a) (Westlaw current through Sept. 6, 2012; 77 FR 54838) (emphasis added). The current Regulations also say that "[a] club which engages in business, such as making its social and recreational facilities available to the general public or by selling real estate, timber, or other products, is not organized and operated exclusively for pleasure, recreation, and other nonprofitable purposes, and is not exempt under section 501(a)." Id. § 1.501(c)(7)-1(b) (emphasis added).
Even though the Regulations still say that a recreational or social club must be organized and operated exclusively for pleasure, recreation, and other nonprofitable purposes, the less stringent current language of the Code, which provides that such a club is tax-exempt if substantially all of the activities are for pleasure, recreation, and other nonprofitable purposes, must be given effect by the Internal Revenue Service ("IRS"). In 1976, Congress passed Pub. L. No. 94-568, 90 Stat. 2697 (Oct. 20, 1976) (effective for taxable years beginning after the date of enactment), for the express purpose of removing the term "exclusively" from § 501(c)(7) of the Code and adding the term "substantially" to the statute in its place. By changing the language of § 501(c)(7), Congress intended that recreational and social clubs "be permitted to receive up to 35 percent of their gross receipts, including investment income, from sources outside of their membership without losing their tax‑exempt status." S. Rep. No. 94‑1318 (1976), reprinted in 1976 U.S.C.C.A.N. 6051, 6054. Congress "also intended that within this 35‑percent amount not more than 15 percent of the gross receipts should be derived from the use of a social club's facilities or services by the general public." Id.
In a very recent Private Letter Ruling, the IRS applied the above-described 35%-15% test to what appears to be a country club that has a golf course, swimming pools, tennis courts, and dining and other social-use facilities. I.R.S. Priv. Ltr. Rul. ("P.L.R.") 2012-25-018 (June 22, 2012). Since the facts of the case suggested that the club in question was receiving approximately 71% of its income from nonmembers who paid to use the club's facilities, the IRS concluded that the club was no longer exempt from federal income tax under § 501(c)(7).
For a more detailed discussion of P.L.R. 2012-25-018, see Country Club Loses Tax‑Exempt Status Due to 71% of Gross Receipts Deriving from Nonmembers, 53 Tax Mgmt. Mem. (BNA) 287, 307-08 (July 30, 2012) (visit http://www.bna.com/www.bnatax.com). The reader is cautioned that under 26 U.S.C. § 6110(k)(3), "[u]nless the Secretary otherwise establishes by regulations, a written determination [such as a P.L.R.] may not be used or cited as precedent."
The decision in P.L.R. 2012-25-018 indicates that professionals who advise recreational and social clubs should emphasize to their clients (1) the importance of following the guidelines for determining the effect on the clubs' exemption under § 501(c)(7) of gross receipts derived from nonmember use of the clubs' facilities, and (2) the recordkeeping requirements for clubs set forth in Rev. Proc. 71‑17, 1971‑1 C.B. 683 (note that the post-1976 35%-15% test applies to Revenue Procedure 71‑17).
The Lawletter Vol 37 No 4
Jim Witt, Senior Attorney, National Legal Research Group
It generally recognized that whether an individual dies intestate, or especially if he or she dies testate, escheat of the decedent's assets to the State is viewed as an absolutely last resort for the distribution of an estate. See 27A Am. Jur. 2d Escheat § 12 "Generally; escheat disfavored." Yet, in the recent Nevada case, In re Estate of Melton, 272 P.3d 668 (Nev. 2012), the result was escheat despite the fact that the testator, William Melton ("Bill"), left two wills.
Bill executed a formal will in 1975 under which he devised most of his estate to his parents, with small portions of the estate going to his brother, Larry J. Melton, and to two of his cousins. He indicated in this will that his daughter, Vicki Palm ("Vicki"), was to receive nothing. Bill also left the following handwritten letter, which he had sent to his friend, Alberta Kelleher ("Susie"), in 1995:
I am on the way home from Mom's funeral. Mom died from an auto accident so I thought I had better leave something in writing so that you Alberta Kelleher will receive my entire estate. I do not want my brother Larry J. Melton or Vicki Palm or any of my other relatives to have one penny of my estate. I plan on making a revocable trust at a later date. I think it is the 15 of [M]ay, no calendar, I think it[']s 5:00 AM could be 7:AM in the City of Clinton Oklahoma.
Lots of Love
/s/ William E. Melton
AKA Bill Melton
[Social security number]
Id. at 671-72.
Susie died in 2002, thus predeceasing Bill, who died in 2008. During the administration of Bill's estate, the existence of his daughter (and only known child), Vicki, was discovered. Prior to the discovery of the 1975 will, Vicki had argued that the 1995 letter did not qualify as a holographic will and that the estate therefore passed to her by intestate succession. After the 1975 will was found, Vicki argued that the 1995 letter was a valid will (but that it was ineffective because Susie had predeceased Bill) and that it revoked the 1975 will, thereby giving Vicki the entire estate as Bill's sole heir at law.
Bill's half sisters, seeking to uphold the 1975 will, argued that the 1995 letter was not a valid will but that if it was valid, it did not revoke the 1975 will. They further argued that even assuming that the 1995 letter was a valid will that revoked the 1975 will, the revocation had to be disregarded under the doctrine of dependent relative revocation, by which a subsequent will, which has no testamentary effect, does not revoke a prior will if it is shown that the testator intended that such revocation be conditioned on the effectiveness of the later will.
The State of Nevada argued that the 1995 letter was a valid will that revoked the 1975 will. The State argued that it succeeded to the entire estate by escheat on the basis that under the Nevada Probate Code, disinheritance clauses were enforceable even when an estate passed by intestacy. Therefore, in the State's view, the estate escheated because Bill, by the 1995 letter, had disinherited all of his relatives.
The district court ruled that the 1995 letter was a valid will but that the disinheritance clause therein was unenforceable. The district court also held that the 1995 letter revoked the 1975 will, with the doctrine of dependent relative revocation having no application, because (1) Nevada courts had not dealt with the doctrine, and (2) even if the doctrine were recognized in Nevada, it would not apply under the facts of the case. Therefore, the district court concluded that the estate passed by intestate succession, with Vicki entitled to the entire estate.
The Supreme Court of Nevada dealt with the appeal as raising a series of issues, which the court resolved in turn:
(1) The court concluded that the 1995 letter was a valid will and that the disinheritance clause contained therein was enforceable. The writing, in the court's view, manifested Bill's testamentary intent in that he referenced his mother's death and stated that he "'had better leave something in writing.'" Id. at 674.
(2) The court held that because both the 1975 will and the 1995 letter attempted to affect the same property, the instruments were inconsistent and that, therefore, barring the application of the doctrine of dependent relative revocation, the 1975 will was revoked under the doctrine of revocation by implication.
(3) The court decided that the doctrine of dependent relative revocation reflected sound policy and therefore was properly recognized under Nevada law. However, the court held that the doctrine did not apply under the facts of the case. The court reasoned that the objective of the 1995 letter did not fail, in that the disinheritance clause contained therein was enforceable and applied to Bill's half sisters. Since there was no clear evidence that the disinheritance clause was conditioned upon Susie's receiving the estate, there was no basis for the contention that Bill would not have wanted the 1975 will to be revoked had he known that Susie would predecease him. Moreover, the court observed that even if it could be said that the objective of the 1995 letter failed, the provisions of the 1975 will and the 1995 letter were completely different, which rebutted any claim that Bill would have wished for the revocation of the 1975 will to be disregarded.
(4) The court rejected Vicki's contention that because she was a surviving blood relative of the testator's, the requirement under Nevada Revised Statutes section 134.120 that escheat can apply only if "the decedent leaves no surviving spouse or kindred" had not been satisfied. The court rejected Vicki's "cramped" interpretation of this provision, because it is commonly understood that when a disinheritance clause is enforceable as to intestate property, a disinherited heir is treated, as a matter of law, to have predeceased the testator.
Thus, after a rather entangled analysis, the unusual result of escheat carried the day.