Defective wills and estate plans can cost a bundle

Poor counsel and errors of omission can give advisors with otherwise sterling reputations a bad name. Such mistakes, as a recent panel discussion made clear, also can be enormously costly for clients on the receiving end.

Titled “Rules of the game: Developments in the areas of estate and gift taxes,” the panel explored noteworthy court cases and Internal Revenue Service rulings in 2005 during the annual gathering of the Society of Financial Services Professionals, Forum ’05, held in Phoenix last month.

One of these cases, decided by the U.S. 7th Circuit Court of Appeals in October 2005, involved the estate of a wealthy businessman who bequeathed $40 million in trust for the benefit of surviving adult children and other beneficiaries; and $90 million in a marital trust for his wife.

The IRS ruled the $40 million was subject to estate tax because the businessman, while still alive, retained sufficient control of the trust to warrant its inclusion in the estate. The court interpreted his will as indicating that taxes should be paid out of “the residue of the estate” (i.e., the $90 million outside of trust).

Upshot: The businessman’s widow was forced to pay $47 million in taxes–approximately $27 million more than would otherwise have been paid. That, noted Charles “Skip” Fox, an attorney with McGuireWoods LLP, Charlottesville, Va., is because the will’s provision reduced the marital deduction and, thereby, increased the size of the marital estate.

“This case shows the problems you can run into when you have an attorney who fails to carefully consider how to draft a tax clause of an individual’s will,” said Fox. “The attorney probably used a boiler-plate provision that is not so common now and says, ‘pay all taxes out of the residue of my estate.’”

A defective will was the focus of another case that pitted the estate of a deceased widow, Rose Posner, against two daughters. The U.S. tax court adjudicating the facts had to determine whether Posner, while still alive, possessed a general power of appointment over a marital trust created by her deceased husband’s will. The latter was defective because it failed to include “substantive dispositions”–income beneficiaries, remaindermen and powers of appointment–normally found in a document establishing a testamentary trust.

Of greater interest to the panelist describing the case, Ellen Harrison, an attorney with Washington, D.C.-based Pillsbury Winthrop Shaw Pittman, was the other key issue: whether Posner’s estate was bound by the “duty of consistency” (or “quasi estoppel”). If applicable, the legal concept would have prevented the estate from securing a $2.9 million estate tax refund. The estate premised the refund request on a subsequent claim–one that contradicted its initial position–that Posner had no general power of appointment.

The tax court judge, Harrison noted, ruled that the legal principle did not apply to “mutual mistakes on the part of the taxpayer and the [Internal Revenue] Service concerning a pure question of law.” The IRS erred, said Harrison, in granting Posner the power of appointment and marital deduction, despite the fact the IRS had a copy of the will and had audited the estate.

Harrison viewed the court’s ruling approvingly, as she did an IRS private letter ruling, released in April 2005, which expanded on IRS Rev. Proc. 2001-38. The revenue procedure provides relief for surviving spouses and their estates in situations where a predeceased spouse’s estate makes an unnecessary qualified terminable interest property (QTIP) election under IRC section 2056(b)(7) that does not reduce the estate’s estate tax liability. The revenue procedure describes the circumstances in which QTIP elections are void for federal estate, gift and generation-skipping transfer tax purposes so that property will not be subject to transfer tax with respect to the surviving spouse.

The private letter ruling addressed the case of an estate that was divided between a bypass trust, for which a QTIP election was mistakenly made, and a family trust. Each of the trusts provided a surviving spouse with an income stream. Rather than applying a partial QTIP rule, the IRS letter ruling permitted the voiding of the QTIP election.

“I think this [letter ruling] is very useful because now in many states the applicable estate exclusion amount is different for federal and estate tax purposes,” said Harrison. “But the question remains as to whether or not you can rely on this [2001-38] revenue procedure to make an election for federal purposes that you can then claim as void.”

Harrison took issue with a tax court ruling that set forth a two-pronged test for satisfying IRC section 2036(a), which governs the sale of business interests to a family limited partnership. Fulfilling the test provisions–there must be a legitimate and significant non-tax reason for creating the FLP; and persons transferring property to the FLP must receive partnership interests proportionate to the value of the property transferred–is necessary for reducing one’s taxable estate.

The tax court rejected a wealthy businessman’s attempt to seek a tax discount using the FLP. The court held that he “retained the right to use the partnership assets,” in part because his 91% limited partnership interest in the FLP constituted an “implied agreement” that gave him effective control.

“I absolutely, strongly disagree with this opinion,” says Harrison. “While there was no tax purpose for creating the FLP, there’s no evidence that Bongard [the businessman] retained any enjoyment or control of the property. He never received a dime from it.

“I don’t think the FLP technique is dead,” she added. “But it’s severely wounded.”

In another instance involving negligence, Fox described the case of a trust officer of Norwest Bank Wisconsin (since renamed Wells Fargo Bank) who advised a widow to continue making annual exclusion gifts to a trust the officer knew to be defective. The attorney who drafted the trust, Fox noted, used a boiler-plate form that failed to include the Crummey powers needed to qualify the gifts.

Result: The widow’s estate, including some $40,000 placed in trust through the annual exclusion gifts, got hit with an additional $176,000 in estate tax upon her death. The estate’s executor sued the trust officer and attorney, who acknowledged the drafting error. But the attorney countered that the trust officer was the negligent party because he was providing estate planning advice (as opposed to only administering the trust) in counseling the widow to continue making the gifts. The Wisconsin Supreme Court agreed.

“What this case shows is the extraordinary need to pay attention to the advice that clients are getting,” said Fox. “Without checking to see whether the attorney could have reformed the trust to add Crummey powers, the trust officer advised the client to continue making gifts. Bad advice is where we all get into trouble.”