The Unified Credit is Not a Tax that Must Be Paid

Take-Away: Using the federal unified credit to pay the federal gift tax due on a transfer is not the same thing as paying the gift tax, according to a recent Michigan Court of Appeals decision.

Background: Probate courts are often asked to interpret or construe the terms of a trust instrument. However, asking a court to construe the terms of a trust is not as easy as it sounds. When a judge construes a trust, the judge’s sole objective is to ascertain and give effect to the settlor’s intent. That intent is gauged from the trust instrument itself, unless there is an ambiguity. Restated, a judge cannot construe a clear and unambiguous trust in such a way as to rewrite it. Where possible, each word used in the trust will be given its meaning. These principles were on full display in a recent Michigan Court of Appeals decision where the lifetime beneficiaries asked a probate judge to, in effect, rewrite the terms of their trusts by overlooking the word payable.

Unpublished Decision: In re Davidson Magnifying Glass Non-Exempt Trust,  Michigan Court of Appeals No. 351357 (January 14, 2021)

Facts: Two cases were consolidated for the appeal to the Michigan Court of Appeals. Two separate irrevocable trusts were created by the late William M. Davidson (former owner of the Detroit Pistons, whose estate in recent years ‘went to war’ with the IRS over self-cancelling installment notes where hundreds of millions of dollars in estate taxes were in dispute.) Here, Mr. Davidson created trusts for each of his two adult children, Marla and Ethan. Apparently each trust agreement gave to the child-beneficiary a power of appointment, to appoint assets to their own ‘after-born’ children. The Court went so far as to suggest that probably Mr. Davidson encouraged his children, through the trust agreements, to exercise these powers of appointment. In fact the children did exercise the powers of appointment given to them for the benefit of after-born children.

Each of the trust agreements contained a Transfer Tax reimbursement provision. Paraphrasing, the trust agreements provided that if the exercise of the power of appointment “results in Transfer Taxes to the beneficiary, the trustees are required to pay from the remaining property held in a trust for the beneficiary the amount by which the Transfer Taxes payable… are increased.” The trust agreements defined Transfer Taxes as “any gift taxes… payable.”

Apparently each of Mr. Davidson’s children exercised their power of appointment (no amounts were reported, but they must have been large amounts) and their spouses joined in those lifetime taxable gifts through the exercised powers of appointment. Their lifetime unified credits were applied to those lifetime gifts, and in addition gift taxes were actually paid (above the applicable exemption/unified credit amounts used to reduce the gift tax liability.)

Each child-beneficiary then asked the trustees of their trust to reimburse him/her for both (i) the federal gift taxes they actually paid; and (ii) amounts that represented the value of the unified credits that they used to reduce the amount of federal gift tax actually paid.

The trustees reimbursed the children for the federal gift taxes that they actually paid, but the trustees declined to transfer to the children-beneficiaries any amount that represented the value of the unified credit that each child, and their spouse, used to shelter the transferred assets from federal gift taxes. The children expressed their displeasure to the trustees.

The trustees then filed petitions with the probate court seeking instructions from the probate judge, which in turn sought an interpretation of the trust agreements.

Probate Judge: The probate judge held that the trustees were not required to reimburse Marla and Ethan (or their spouses) for the value of the unified credits that were used to reduce the federal gift taxes that were owed when the powers of appointment were exercised. The trusts’ Transfer Tax reimbursement clause was clear on its face what was intended. Marla and Ethan appealed.

Appellate Court: The appeals court panel affirmed the decision of the probate judge to not reimburse Marla and Ethan for the value of their ‘used’ unified credit amounts.

“Under the plain meaning of the trust agreements, Marla and Ethan are only entitled to be reimbursed for the amount that there were required to pay in taxes, i.e. the amount of money that they were required to expend to discharge their tax obligation.”

“A unified credit is not a tax that must be paid to the IRS. [26 U.S.C. 2505] Rather, as evidenced by the facts of this case, a unified credit is used to calculate the gift taxes that must be paid to the IRS, and the credits function to decrease the amount of money owed to the IRS. Accordingly, under the terms of the trust agreements, the amount of gift taxes payable means the amount of gift taxes calculated after application of the unified credits. Consequently, because the use of the unified credit does not constitute payment of a gift tax, the trustees were not required to reimburse Marla and Ethan for the value of the unified credits.

Because the trusts’ tax reimbursement provisions were silent as to the use of tax credits to reduce the amount of the Transfer Tax incurred, the Court did not feel comfortable ‘re-writing’ the trust agreements to address how the settlor would have wanted the missing tax credit offset treated’

Marla and Ethan also pointed out that the trustees also possesses discretion to make distributions from the trusts for their general welfare, which would give the trustees the required authority to reimburse them for the value of their unified credits in reducing the federal gift tax owed. The Court only responded that while the trustees did possess such discretion, the Court would not interfere with the trustee’s exercise (or non-exercise) of that discretion unless the trustee has abused that discretion. [In re Estate of Sykes, 131 Mich App 49 (1983).]

Conclusion: This is not a big-time case that carries an important message (although it is no doubt a big–time decision for Marla, Ethan, and their spouses.) It is important only in that it is a helpful reminder that judges are loathe to re-write trusts and wills unless there is a genuine ambiguity in the words used.