Take-Away: When a trust is created with specific tax objectives in mind, it is critical that the trust instrument be administered according to its express terms, especially when tax objectives motivated the trust’s creation. Unlike a game of horseshoes, getting ‘close’ is not enough when it comes to administering a trust with tax objectives.

Background: Our lives are filled with trusts. We often find ourselves administering irrevocable life insurance trusts (ILITs,) grantor retained annuity trusts (GRATs), credit shelter trusts, and charitable remainder trusts (CRTs) all of which have specific tax consequences that are intended by the settlor. These tax-oriented trusts contain certain provisions required by the Tax Code that ensure that the trust satisfies the requirements under the tax laws that are necessary to achieve the intended tax results. Often overlooked is the need for strict adherence to those provisions during the trust’s administration for the tax results to actually be obtained. Failure to follow the terms of the trust instrument by the trustee can result in the complete loss of the tax benefits that the trust was established to achieve. Such was the result in the (infamous?) Atkinson case which frequently is cited as the ‘poster-child’ that playing ‘fast and loose’ with the requirements imposed by the Tax Code can produce disastrous results. Atkinson v Commissioner, 309 F.3rd 1290 (CA-11, 2002).

Atkinson: In Atkinson, the taxpayer transferred $4.0 million worth of stock to a trust that was intended to qualify as a charitable remainder annuity trust (CRAT.) One of the requirements under the Tax Code to establish a qualified CRAT, and thus entitle the donor to an estate or gift tax charitable deduction of the transfer of the remainder interest in the CRAT to a charity, is that not less than 5% of the initial fair market value of the CRAT’s assets must be paid annually to one or more non-charitable persons- i.e. the lifetime beneficiary of the CRAT. Thus, the CRT’s terms provided that during the donor’s life, she was to be paid an annuity from the CRAT equal to 5% of the initial fair market value of the CRAT’s assets, with the payments to be made to the donor quarter-annually. On the donor’s death, the annuity was to then be paid to four individuals for their lives so long as those individuals elected to pay their share of the federal estate taxes that were due on the donor’s death due to the continued annuity payments to them. Upon the death of the last of these named individuals, the amount remaining in the CRAT was to then be distributed by the CRAT trustee to charities. Despite the express terms of the CRAT, no annuity payments were ever paid to the donor during her lifetime. Upon the donor’s death, the amount of the undistributed annuity was included in the donor’s taxable estate; the donor’s estate then claimed a charitable estate tax deduction for the value of the charitable remainder interest in the CRAT. The IRS denied the charitable estate tax deduction claiming the trust was not a valid CRAT from its creation because the trust had failed to make the required annuity payments to the donor.

The Tax Court agreed with the IRS, finding that it is not sufficient to establish a trust with express provisions that satisfy the CRAT rules, and then ignore those trust provisions during the trust’s administration. As a result, no charitable deduction was allowed to the donor’s estate, despite the fact that the failure of the CRAT trustee to pay the annuity to the donor in no way injured the charities that were to receive the remainder interest in the trust (and in effect left even more to the charities on the CRAT’s termination.) On appeal the federal Circuit Court concurred that since the trust was not properly operated as a CRAT from its creation, it failed to be treated (and taxed) as a CRAT, despite the fact that the donor took no distributions from the CRAT during her lifetime  while leaving more for the charity remainder interest holder. The Court in Atkinson made the following observation that applies to any trust that must comply with specific provisions of the Tax Code to achieve the intended tax objectives:

The estate complains that this stringent focus on the CRAT rules amount to a denial of a substantial charitable deduction because of what amounts to a ‘foot fault’ or minor mistake. However, the scheme established by Congress is specifically designed to combat the problems associated with the donation of charitable remainders. In exchange for the significant benefits of allowing a present charitable deduction, even when the actual charitable donation is not to occur until the remainder interest in the property becomes possessory, and in allowing the assets of the trust to grow tax-free, the Code requires adherence to the CRAT rules. It is not sufficient to establish a trust under the CRAT rules, then completely ignore the rules during the trust’s administration, thereby defeating the policy interests advanced by Congress in enacting the rules. Despite the certain charitable donation in this case, the countervailing Congressional concerns surrounding the deductibility of charitable remainders in general counsel strict adherence to the Code and, barring such adherence, mandate a complete denial of the charitable deduction.

While Treasury has provided to taxpayers suggested form instruments for CRATs, CRUTs, CLATs, CLUTs,  merely using those recommended form trust instruments, or including their mandatory provisions in the trust instrument, is not enough. The trust needs to actually be administered consistent with those required provisions.

Free-Basing Silver-Lining?: While Atkinson admonishes fiduciaries to administer a trust consistent with the terms of the trust instrument in order to obtain the intended tax benefits, maybe there is a silver-lining in its message. Consider a credit shelter or bypass trust that contains provisions that are designed to exclude the credit shelter trust’s assets from inclusion in the surviving spouse’s taxable estate. The classic example is where the surviving spouse is not only the lifetime beneficiary of the credit shelter trust, but also the trustee, whose discretionary distributions may be made solely for his/her ‘health, education, maintenance and support.’ If, upon a challenge by the IRS, it is found by a court that the surviving spouse treated the trust assets as his/her own and the survivor completely ignored the distribution limitations and restrictions contained in the credit shelter trust instrument, the credit shelter trust assets must be included in the survivor’s taxable estate. A few years ago this would be viewed as a horrific result- having credit shelter trust assets included in the surviving spouse’s taxable estate, causing additional federal estate taxes to be paid. But these days with a $11 million dollar estate and gift tax exemption amount available to the surviving spouse, and the opportunity to increase the income tax basis in all of the credit shelter trust’s assets if their values are included in the surviving spouse’s taxable estate, maybe failing to administer the credit shelter trust consistent with its terms might produce a favorable income tax result for the survivor’s heirs (the remainder beneficiaries of the credit shelter trust.) In short, failing to administer the credit shelter trust in accordance with its terms might actually provide an income tax benefit to the settlor’s family. This observation is not to suggest that a credit shelter trust be intentionally mismanaged by the surviving spouse, just to obtain an income tax basis step-up on the survivor’s death. But it is something to keep in mind in light of the new, enlarged, federal estate tax exemption and the opportunity to obtain a basis increase for the assets held in the credit shelter trust.

Conclusion: A professional trustee would not mismanage or ignore its administrative obligations under a credit shelter trust just to expose the trust’s assets to an income tax basis adjustment on the survivor’s death,  but non-professional fiduciaries of a credit shelter trust are far more apt to not comply with the trust’s limiting provisions which, in turn, might cause the inclusion of the credit shelter trust assets in the surviving spouse’s taxable estate.