From the Archives: Valuing Discretionary and Remainder Interests in Trusts

Is there a good answer?

Video

Background

Recently, I have had the pleasure of hearing from several thought leaders - Paul Hood, Ed Morrow, and Bob Keebler, among others - about some of the broader issues relating to commutations of trusts. What is a commutation? It is a termination of a trust, whereby the actuarial values of the trust are split between the income beneficiaries and remainder beneficiaries.

I previously theorized that we are seeing a cottage industry of trust commutations pop up, which will continue to gain steam as wealth gets transferred into irrevocable trusts in a world where individuals are accustomed to (and expect) outright ownership of inherited property. The problem with these types of transactions is the lack of guidance on who should receive property, and in what amount.

While states vary, in most cases income interests and remainder interests are treated as being vested for property law purposes - especially when the only contingency is survivorship. And, in many cases, the power to disinherit a remainder beneficiary through a power of appointment is not treated as a contingency preventing vesting for property law purposes. Even worse, the harm from such un-vesting may accrue from the time of a revocable exercise of a power of appointment.

On the other hand, treatment of income interests can vary. If one has a mandatory right to receive trust (accounting) income and/or principal through periodic distributions, or an annuity or unitrust distribution, this is often treated as a vested property right having some positive value. But, when a trustee’s discretion is imposed - even where the income beneficiary is the trustee themselves - their trust interest may be treated as an expectancy, and not a property interest. This creates an odd tension between vested remainder holders and current expectancy holders. which can be difficult for trustee’s to navigate.

But, under a dynasty trust, that same “vested” remainder often vests into another discretionary trust for the remainder interest holder. The outcome is a conversion of a vested interest into an expectancy as well.

Likewise, there is a tension unique to a beneficiary’s circumstances when it comes to an expectancy. If a trustee’s discretion is limited by an ascertainable standard, state law may recognize some non-zero guarantee in distributions - even where the magic word “may” is used or implied with respect to a trustee’s discretion, or where a sprinkle/spray power among multiple income beneficiaries exists. Contrast this with a trustee’s fully discretionary distribution power, which often cannot be compelled to guarantee any distribution.

The Issue

Given these conflicting property rights, a commutation of a trust can be difficult to value for actuarial purposes. If all property is given to income beneficiaries, then this could be treated as a transfer from the holders of vested remainder interests. On the other hand, transfers to remainder interest holders beyond the actuarial (present) value of their remainder interest(s) could lead to a transfer from the income beneficiaries.

Recently, the IRS has begun to confront these issues in cases involving QTIP-elected trusts such as Anenberg and McDougall (which I will write about soon). In these cases, tax law applicable to QTIP trusts overrides state property law to treat a transfer of a spouse’s income interest as a transfer of underlying trust principal under IRC Section 2519. But, McDougall recently addressed a broader issue of valuing a remainder interest in a trust that is “transferred” to an income beneficiary (in this case, the spouse) during a commutation of a QTIP trust. I say “addressed” loosely, because the Tax Court merely said this could be a gift of a positive value for gift tax purposes without stepping into the facts and circumstances of valuation.

This issue will likely be magnified in the near future. And, the IRS has a long history of punting the issue of valuation as discussed in the video above. We do have one interesting piece of guidance, however, in the form of Rev. Rul. 75-550. In that Ruling, the IRS addressed whether and to what extend the discretionary income beneficiary’s actual anticipated support needs drive valuation under a HEMS standard. It is important to note, however, that while this Ruling is still good law it does predate our current gift tax laws (which kicked in in 1977).

No Solutions - Yet

For now, facts and circumstances rule the day. And, both courts and administrative agencies are not always the best arbiters of facts and circumstances. Perhaps a case on initial hearing or remand will lead to some guidelines, but for now tax planners have little into which to sink their teeth.

If nothing else, however, I hope this gives you pause when considering any decanting, modification, or termination of a trust. This issue seems to be on the radar of the IRS, so it is not an issue we can ignore anymore - especially where significant wealth is involved. Stay tuned, because I will have more to come on this complex topic.