I sometimes draft wills and trusts which call for the mandatory sale of assets following a client’s death. This seems like it should be a simple clause to add to the document, but there are many twists to take into account. While this is a shorter article, I hope it gives you something to think about from a drafting or review perspective.
Purchase Price
Anytime a buy-sell agreement is put in place, one of the sticking points is determining the purchase price for a business interest. While buy-sell agreements are not the subject of this discussion, the purchase price issue is prescient.
Typically, testamentary documents which call for the sale of an asset are silent as to the purchase price. Instead, it is left up to the executor or trustee to determine what is reasonable based on the market. This is where the problem arises.
Fair market value (FMV) is the price at which an asset would change hands between a willing buyer and willing seller at arms-length. FMV is also what is taken into account on the estate tax return. As will be discussed below, the purchase price can create tax issues, but for the time being it is important to consider that the FMV at date of death may be different than the FMV at time of sale. Similarly, the FMV at the time that the will or trust is executed will usually be different from the FMV at the time of sale.
Fiduciary duties typically will require an executor or trustee to make at least a commercially reasonable effort to market the property, so as to obtain the best market purchase price for the beneficiaries of a will or trust. This may not always be possible, depening on the cash needs of the estate/trust and the time given to sell the asset.
From a drafting perspective, a mandatory sale clause should consider whether the executor or trustee is required to obtain the best price possible. If not, softening language should be included, which waives this fiduciary duty and gives the executor or trustee the leeway to sell the asset for less than FMV. Otherwise, you run the risk of beneficiaries fighting with the executor or trustee over what the purchase price should have been in their mind.
The executor or trustee may also need to balance their own ability or capacity to conduct the sale with the availability and cost of a broker. Obtaining a broker can limit some of the fiduciary liability exposure of the executor or trustee, but selecting the wrong broker can increase this liability risk. Even if the broker does a great job, a beneficiary can always argue that the net sales proceeds (after commission) were less than what the executor or trustee could have fetched by not retaining a broker. Thus, drafting can also consider whether fiduciary duties around selecting a broker can be softened or waived.
Another issue is that buyers may seek representations and warranties. Most assets sold by an estate or trust must be sold “as-is,” especially because the beneficiaries and/or fiduciaries do not want the added tail liability for material issues which arose during the decedent’s life or which were in the knowledge of the decedent, only. This can force the estate or trust to take a haircut in the purchase price, or even lose a buyer, unless you find a willing beneficiary or fiduciary to take on the reps and warranties. So, depending on the type of asset, this is another potential drafting gap to fill. For example, beneficiaries working in a family business who have greater knowledge than the executor or trustee could be required to “take one for the team” and provide guaranties under the reps and warranties.
Time Frame
When a sale is mandatory, beneficiaries will often expect that it occurs immediately. As you readers know, this is not possible. Executors and trustees must accept their fiduciary office and seek official appointment before even considering a sale of the asset, and even then the mandatory sale becomes one of many tasks which must be balanced. Similarly, beneficiaries are not the only interested parties - estate creditors could be waiting in the wings to get paid.
When drafting a mandatory sale clause, consideration should be given to the time frame for sale. This is a fine art, because you don’t want to give the executor or trustee the opportunity to languish and never make the sale. On the other hand, too short of a runway will create issues as well. The time frame should also consider tax effects, as discussed below.
There is no hard and fast rule here, but perhaps a range would work to set expectations. For example, the clause could state that the executor or trustee is not required to sell any sooner than 6 months from date of death. But, the clause could also specify a deadline, such as two years (or, if needed, the due date for the estate tax return).
Tax Considerations
The step-up in basis will typically eliminate tax on capital gain that accrues during the decedent’s lifetime. However, IRC Section 1014 and the basis consistency rules require that the executor or trustee use the FMV as reported for federal estate tax purposes.
In many cases, it is possible to use the sale price to establish the stepped-up basis, so that no gain is recognized on the sale. However, if there is a taxable estate, discounts could be claimed for federal estate tax purposes which would lower the FMV (and, consequentially, would lower the basis). This creates a tug-of-war and audit risk if, for example, a discount is claimed but the asset later sells for a much higher value. It also generates income tax to the estate or trust equal to the positive difference between the purchase price, and the discounted basis.
Even where no estate tax is due, similar rules could apply in determining the value of the property for generation-skipping transfer tax purposes if, for example, a GST non-exempt trust is selling the asset.
Both the purchase price consideration, and the time for sale consideration, come into play here. For example, if an asset is to be sold after the estate tax return due date, does the executor or trustee then have a duty to seek a purchase price that is equal to or greater than the value reported for estate or GST tax purposes?
IRC Section 2703 also rears its ugly head, as the IRS can disregard any restrictions on the sale of the asset in the will or trust if, for example, a family member or related party ends up being the purchaser. This can allow the IRS to increase estate tax, or disallow a loss, on the ultimate sale as well.
There is no good answer here, but the drafter should consider the interplay between the purchase price, identity of the buyer, and the FMV finally determined for estate or GST tax purposes.
Conclusion
Clients love simple solutions, and attorneys are often plagued by what-if scenarios. Drafting strikes a balance between these two conflicting objectives, but this issue strikes deeper if an executor or trustee is reluctant to take on the sale of an asset based on the authority granted in the will or trust. Waivers and indemnification can always be sought during or after the sale process, but doing so creates a headache of collecting consents (which could be withheld) from beneficiaries and possibly creditors. This could kill a deal if it the fiduciary’s indemnification process takes too long, but adding a few sentences to a mandatory sales clause could grease the skids.