Atkinson Case Illustrates the Importance of Having the Trustees Follow the Provisions of the Trust Agreement
An estate plan that is designed to minimize transfer taxes often involves the establishment of one or more trusts. For example, an irrevocable life insurance trust may be created to own and be the beneficiary of life insurance so that the insurance can be excluded from the estate of the insured and the insured's spouse. A "bypass" or "credit shelter" trust may be created to utilize the estate tax exemption of the first spouse to die and exclude the trust assets from the estate of the surviving spouse. A grantor retained annuity trust (or "GRAT") may be created to transfer wealth during lifetime at a reduced gift tax cost. A charitable remainder annuity trust (or "CRAT") is often created where a client would like to use assets to benefit non-charitable beneficiaries, such as family members, for a period of years or for the lives of those beneficiaries, and would like the property to then benefit a charity or charities. These trusts, as well as others, are drafted to contain certain provisions designed to ensure that the trusts satisfy the requirements under the tax law necessary to achieve the intended tax results. What is sometimes overlooked, however, is that strict adherence to those provisions during the administration of the trust is also necessary. Failure to follow the terms of the trust may result in a complete loss of the tax benefits that the trust was established to achieve. This lesson was illustrated in the case of Atkinson v. Comm'r., 309 F.3d 1290 (11th Cir. 2002)
In Atkinson, the taxpayer transferred $4 million worth of stock to a trust intended to qualify as a CRAT. One of the requirements under the tax law for a trust to qualify as a CRAT and therefore entitle the transferor or her estate to a gift or estate tax deduction for the remainder interest passing to charity, is that not less than 5% of the initial fair market value of the trust assets must be paid at least annually to one or more persons. Accordingly, the trust terms provided that, during the taxpayer's life, she was to be paid an annuity from the trust equal to 5% of the initial fair market value of the trust assets, and the payments were to be made quarterly. On the taxpayer's death, the trust was to pay the annuity to four individuals for their lives, if they elected to pay their share of estate taxes due at the taxpayer's death. After the death of the last of these individuals, the amount remaining in the trust would be donated to certain charities. Despite the trust terms, no annuity payments were actually made to the taxpayer during her life. Upon her death, the amount of the undistributed annuity was included in her estate, and the estate took a charitable deduction for the value of the remainder interest. The IRS disallowed the deduction, arguing that the trust was not a valid CRAT because the trust failed to make the required annuity payments to the taxpayer. The Tax Court agreed with the IRS, explaining that it is not sufficient to establish a trust with provisions that satisfy the CRAT rules, and then ignore those provisions during the trust's administration. As a result, no deduction was allowed, despite the fact that the failure of the trustee to pay the annuity to the taxpayer in no way injured the charities receiving the remainder interest.
Although the Atkinson case involved a CRAT, it should be viewed as a stark reminder that the terms of any trust must be followed during administration in order for it to achieve its intended results. For example, life insurance trusts and "bypass" or "credit shelter" trusts usually contain provisions designed to exclude them from the surviving spouse's estate, such as providing that, if the spouse is not only a beneficiary but also the trustee, then discretionary distributions may be made to her for "health, education, maintenance and support," and providing that trust assets cannot be used to satisfy a legal obligation to a dependent. If, upon a challenge by the IRS, it is found by a court that the spouse treated the trust assets as her own and ignored the distribution standard and other restrictions in the document, the trust assets may be included in her estate when she dies and the tax objectives of that trust may therefore be completely defeated. Where a trust provides for annuity payments to be made, such as a GRAT or, as in the Atkinson case, a CRAT, the trustee should ensure that the payments are actually made (and that the checks are cashed by the recipient). In addition, this case can be viewed as a reminder that the provisions of any estate planning document, not just a trust, should be followed to avoid losing the intended tax benefits. Failure to do so can defeat the objectives of even the best planning and drafting.