Cases decided over the past several years have demonstrated that defective trust administration, whether negligent or intentional, can cause a tax disaster even if the underlying trust instrument is technically sound.
In Estate of Atkinson, 309 F.3d 1290 (11th Cir. 2002) Melvine Atkinson created a charitable remainder annuity trust (CRAT) funded with stock worth about $4 million. Under the CRAT's governing instrument, Melvine was to receive a lifetime annual annuity of $200,000. The trust instrument provided for annuity payments to be made to successor beneficiaries following Melvine's death, if they agreed to pay their share of any estate taxes due at her death. After the death of the last annuity beneficiary, all remaining trust property was to be distributed to charity. Melvine died, and her estate claimed a charitable estate tax deduction in an amount equal to the present value of the charitable remainder interest in the CRAT as of Melvine's date of death.
There was just one problem. It turned out that, although there was no ambiguity or defect whatsoever in the trust instrument, no annuity payments had ever actually been made to Melvine. Accordingly, the Internal Revenue Service, on audit of Melvine's estate tax return, disallowed the charitable deduction for the CRAT remainder because the CRAT had failed to operate in accordance with Internal Revenue Code Section 664, the applicable Treasury regulations and the requirements of the trust instrument. The estate argued that the IRS, by focusing stringently on the CRAT rules, would deny a substantial charitable deduction because of a "foot fault" or a minor mistake, ignoring the certainty that CRAT property worth millions of dollars would pass to charity as a result of Melvine's death.
The U.S. Court of Appeals for the Eleventh Circuit sided with the IRS. The Court concluded the CRAT didn't give rise to an estate tax charitable deduction under IRC Section 2055 because "the CRAT regulations were not scrupulously followed." Id. at 1296.
In Securities and Exchange Commission v. Wyly, 56 F.Supp. 3d 394 (S.D.N.Y. 2014), Sam and Charles Wyly created and funded 17 offshore trusts and designated professional asset managers in the Isle of Man as trustees. The beneficiaries, in a variety of combinations among the trusts, included Sam and Charles, their spouses, their children and charitable organizations. Each trust had three trust protectors: Sam and Charles' lawyer, the chief financial officer (CFO) of the Wylys' family office and the CFO of a Wyly-related offshore entity. Neither any of the trustees nor any of the trust protectors was a "related or subordinate party" within the meaning of IRC Section 672(c). Among the trust protectors' powers were to "add or substitute[e] a charitable organization as a beneficiary and to remove and replace the trustees."
In making investments (including in Wyly family businesses and a fund run by Sam's son-in-law) and in purchasing lavish personal use items accessed and enjoyed by the trust beneficiaries, the trustees always followed the directions of the trust protectors, who received their marching orders from Sam and Charles.
The trusts were designed to be non-grantor trusts for federal income tax purposes. The trusts' governing instruments were properly drafted to accomplish this purpose. Because these were foreign, non-grantor trusts, none of the income generated by and retained in the trusts would be subject to U.S. income tax. At least that's what Sam and Charles thought.
The Court first observed that the trustees had powers of disposition in respect to beneficial enjoyment potentially giving rise to grantor trust treatment under IRC Section 674(a), but then said the trustees were ostensibly independent within the meaning of Section 674(c). The Court concluded, however, that the Section 674(c) independent trustee exception (which, if it applied, would have rendered Section 674(a) inapplicable) didn't apply because the trustees' powers of disposition weren't solely exercisable by them. Taking note of the facts that: (1) the trustees invariably followed the directions of the trust protectors; (2) in giving directions to the trustees, the trust protectors invariably followed the instructions of Sam and Charles; (3) the trust protectors were explicitly empowered to remove and replace the trustees; and (4) Sam and Charles had close relationships with the trust protectors, the Court reached this conclusion, despite the fact that Sam and Charles had no legal right to control the trust protectors.
In the end, the Court had no difficulty concluding that economic realities, rather than the literal terms of the underlying trust instruments, should control the income tax status of the trusts. The Court was convinced Sam and Charles, as trust seniors, effectively controlled the actions of the trustees. The result was that, since the Section 674(c) independent trustee exception didn't apply, the trusts were treated as grantor trusts, a disastrous result that ultimately forced the Wyly brothers into bankruptcy. The foregoing decisions demonstrate the ability of the Courts to reach similar results in circumstances involving unassailable trust instruments coupled with maladministration. The assessment of any trust must include a careful consideration of the realities of its administration.