DRAFTING AGREEMENTS FOR FAILURE TO FUND A TRUST OR

DRAFTING AGREEMENTS FOR FAILURE TO FUND A TRUST

OR TO INTENTIONALLY NOT FUND A TRUST

MICKEY R. DAVIS, Houston

Davis & Willms, PLLC

State Bar of Texas

ANNUAL

ESTATE PLANNING & PROBATE DRAFTING

October 4-5, 2018

Dallas

CHAPTER 15

MICKEY R. DAVIS

Davis & Willms, PLLC

Board Certified - Estate Planning and Probate Law

Texas Board of Legal Specialization

3555 Timmons Lane, Suite 1250

Houston, Texas 77027

Phone (281) 786-4500

Fax (281) 742-2600

[email protected]

EDUCATION:

· University of Texas School of Law, J.D. with High Honors, 1982. Chancellors; Order of the Coif; Associate Editor, TEXAS LAW

REVIEW; Member, Board of Advocates

· University of Arizona, B.B.A. with High Distinction, 1979. Beta Alpha Psi; Beta Gamma Sigma

OTHER QUALIFICATIONS:

· Fellow, The American College of Trust and Estate Counsel (ACTEC), (Regent, 2017- ; Member: Business Planning, Estate &

Gift Tax, and Fiduciary Income Tax Committees; Chair: Estate & Gift Tax Committee, 2013-2016)

· Board Certified, Estate Planning and Probate Law, Texas Board of Legal Specialization

· Adjunct Professor, University of Houston Law Center, 1988–2017, teaching Income Taxation of Trusts and Estates and

Postmortem Estate Planning

· Best Lawyers in America, Trusts and Estates; Texas Super Lawyer, Texas Monthly and Super Lawyers Magazine

· Named Best Lawyers' 2013 Houston Trusts and Estates "Lawyer of the Year"

· Named by Texas Lawyer as a 2013 "Top Notch Lawyer" for Trusts and Estates

· Awarded 2017 Jim D. Bowman Award for Outstanding Contributions to the Profession by the Texas Bar College

· Awarded 2017 Standing Ovation Award by TexasBarCLE staff

· Admitted to Practice: State Bar of Texas; Federal District Court for the Southern District of Texas; United States Tax Court

· Certified Public Accountant, Texas, Certified 1983 (retired status, 2018)

PROFESSIONAL ACTIVITIES:

· Member, State Bar of Texas (Sections of Real Estate, Probate and Trust Law; Tax); Houston Bar Association (Probate, Trusts and

Estates Section); Texas Bar College

· Member, Texas Society of Certified Public Accountants, Houston Chapter

· Member of the Board of Directors, ACTEC Foundation (2013-2018) (Former Chair: Grants Committee)

· Editor, ACTEC

LAW JOURNAL (2012-2013)

· Estate Planning and Probate Law Exam Commission, Texas Board of Legal Specialization (Member 1993-2003, Chair 2000-

2003)

RECENT SPEECHES AND PUBLICATIONS:

· Author: DAVIS'S TEXAS ESTATE PLANNING FORMS (O'Connor's, 2017, updated annually)

· Co-Author: Streng & Davis, R

ETIREMENT PLANNING–TAX AND FINANCIAL STRATEGIES (2

ed., Warren, Gorham & Lamont,

2001, updated annually)

· Author/Speaker: Fiduciary Income Taxation and Subchapter J, American Bar Association Section of Real Property, Trust & Estate

Law, Skills Training for Estate Planners – Fundamentals Course, 2015-2018

· Co-Author/Speaker: All About that Basis: How Income Taxes Have Reshaped Estate Planning, Estate Planning Council of Saint

Louis, 2017; Philadelphia Estate Planning Council, 2016; 42

Annual Notre Dame Tax and Estate Planning Institute, 2016;

, 37

, and 38

Annual ALI CLE Planning Techniques for Large Estates, 2016-2018

· Co-Author/Speaker: Estate Planning for Married Couples in a World with Portability and the Marital Deduction, 44

Annual

Midwest/Midsouth Estate Planning Institute, 2017; 38

Annual ALI CLE Planning Techniques for Large Estates, 2018

· Panelist: Fiduciary Duties, State Bar of Texas 24

Annual Advanced Estate Planning Strategies Course, 2018

· Co-Author/Co-Presenter: Income Taxation of Trusts and Estates: Ten Things Estate Planners Should Know, National Association

of Estate Planning Councils, 54

Annual NAEPC Advanced Estate Planning Strategies Conference, 2017

· Co-Author/Speaker: What Estate Planners Absolutely Have to Know about Income Taxation of Trusts and Estates, 44

Annual

Midwest/Midsouth Estate Planning Institute, 2017

· Co-Author/Panelist: It's 1:45 p.m. in the Garden of Good and Evil: Now How Do We Deal with Value in Estate and Business

Planning and Estate and Trust Administration?, 23

Annual Advanced Estate Planning Strategies Course, 2017

· Co-Author/Panelist: Yes, I'll Order That Trust "Fully Loaded", State Bar of Texas 41

Annual Advanced Estate Planning and

Probate Course, 2017; University of Miami 51

Annual Heckerling Institute on Estate Planning, 2017

· Co-Author/Co-Presenter: Planning for Married Clients: Charting a Path with Portability and the Marital Deduction, 42

Annual

Notre Dame Tax and Estate Planning Institute, 2016; 36

and 37

Annual ALI CLE Planning Techniques for Large Estates,

2016, 2017

· Co-Author/Co-Presenter: Maneuvering Among the Mazes and Minefields of Modern Estate Planning: Helping Clients Plan in a

High Exemption World, Dallas Jewish Community Foundation 21

Annual Professional Advisors Seminar, 2016

Drafting Agreements for Failure to Fund a Trust or to Intentionally Not Fund a Trust Chapter 15

TABLE OF CONTENTS

INTRODUCTION ............................................................................................................................................. 1

ISSUES WHEN FUNDING TRUSTS .............................................................................................................. 1

Probate vs. Non-Probate Assets ................................................................................................................. 1

Payment of Debts and Expenses ................................................................................................................ 2

Apportionment of Taxes ............................................................................................................................ 2

Other Changes in Assets During Administration ....................................................................................... 2

Income Earned During Administration ............................................................................................. 2

Sales and Exchanges of Estate Assets ............................................................................................... 2

Appreciation and Depreciation .......................................................................................................... 3

ARE TRUSTS STILL USEFUL, OR, WHY FUND A TRUST? ...................................................................... 3

Disadvantages of Bypass Trusts ................................................................................................................. 3

No Basis Adjustment at Second Death .............................................................................................. 3

Higher Ongoing Income Tax Rates ................................................................................................... 4

Some Assets Cause Greater Tax Burdens ......................................................................................... 4

Disclaimer Bypass Trusts .................................................................................................................. 5

Advantages of Trusts over Outright Bequests ............................................................................................ 5

Control of Assets ............................................................................................................................... 5

Creditor Protection ............................................................................................................................ 6

Divorce Protection ............................................................................................................................. 6

Protection of Governmental Benefits ................................................................................................ 6

Protection from State Inheritance Taxes ........................................................................................... 6

Income Shifting ................................................................................................................................. 6

Shifting Wealth to Other Family Members ....................................................................................... 6

No Inflation Adjustment .................................................................................................................... 7

Risk of Loss of DSUE Amount ......................................................................................................... 7

No DSUE Amount for GST Tax Purposes ........................................................................................ 7

Must File Estate Tax Return for Portability ...................................................................................... 8

Impact on Life Insurance Planning.................................................................................................... 8

Using QTIPable Trusts ............................................................................................................................... 8

Control, Creditor, and Divorce Protections ....................................................................................... 8

Less Income Tax Exposure ............................................................................................................... 8

New Cost Basis at Second Spouse's Death........................................................................................ 8

Preservation of GST Tax Exemption ................................................................................................ 9

QTIPs and Portability ........................................................................................................................ 9

QTIPs and Using the DSUE Amount ................................................................................................ 9

QTIP Trust Disadvantages ....................................................................................................................... 10

No "Sprinkle" Power ....................................................................................................................... 10

Estate Tax Exposure ........................................................................................................................ 10

Income Tax Exposure ...................................................................................................................... 10

Clayton QTIP Trusts ....................................................................................................................... 10

The QTIP Tax Apportionment Trap ................................................................................................ 11

Is a "LEPA" Trust a Better Choice? ......................................................................................................... 11

Structure of LEPA Trusts ................................................................................................................ 11

Benefits of LEPA Trusts ................................................................................................................. 12

Disadvantages of LEPA Trusts ....................................................................................................... 12

HOW NOT TO FUND A TRUST ................................................................................................................... 12

Fiduciary Duties of Trustees .................................................................................................................... 12

Duty of Loyalty ............................................................................................................................... 13

Fiduciary Duty to Be Generally Prudent ......................................................................................... 13

Duty to Control and Protect Trust Property .................................................................................... 13

Duty to Inform and Report .............................................................................................................. 13

Implications of Fiduciary Duties ..................................................................................................... 13

Drafting Agreements for Failure to Fund a Trust or to Intentionally Not Fund a Trust Chapter 15

Complying with the Letter of the Will or Trust ....................................................................................... 14

Funding the Trust and Distributing Its Assets ................................................................................. 14

Distributing "Through" the Trust .................................................................................................... 15

Distributing in the Face of a Strict Standard ................................................................................... 15

Modifying and Terminating Trusts .......................................................................................................... 15

Trust Modifications Under Common Law ...................................................................................... 16

Trust Modifications Under the Texas Trust Code ........................................................................... 16

Will Modifications Under Common Law ........................................................................................ 19

Will Modifications Under The Texas Estates Code ........................................................................ 19

Trust Divisions, Combinations and "Mergers" Under the Texas Trust Code ................................. 20

Reformation and Rescission ............................................................................................................ 21

Modification or Termination by Agreement of Grantor and Beneficiaries ..................................... 22

Circumventing the Will or Trust .............................................................................................................. 22

Disclaimer by Trust Beneficiaries ................................................................................................... 22

Disclaimer by the Trustee ................................................................................................................ 23

Agreement Not to Probate the Will ................................................................................................. 24

Agreement Not to Fund the Trust .................................................................................................... 24

The Oath of the Executor ................................................................................................................ 24

Impact of Consent or Agreement .................................................................................................... 25

The Attorney's Role ......................................................................................................................... 25

CONSTRUCTION, REFORMATION, REVOCATION, RESCISSON, DECANTING, AND

MODIFICATION OF WILLS AND TRUSTS ................................................................................................ 26

Overview .................................................................................................................................................. 26

Construction ............................................................................................................................................. 26

Reformation and Judicial Revocation ...................................................................................................... 27

Tax Issues Associated with Decanting and Other Trust Modifications ................................................... 27

General Tax Issues .......................................................................................................................... 27

Income Tax Issues ........................................................................................................................... 28

Gift Tax Issues................................................................................................................................. 30

Estate Tax Issues ............................................................................................................................. 31

Generation-Skipping Transfer Tax Issues ....................................................................................... 32

Ruling Requests for GST Tax-Exempt Trusts ......................................................................................... 34

"FUNDING" AFTER THE SECOND DEATH ............................................................................................... 34

Theories of Recovery ............................................................................................................................... 35

Applicability of State Law .............................................................................................................. 35

Impact of State Law ........................................................................................................................ 35

The "Vested in the Bypass Trust" Approach ............................................................................................ 36

The "Constructive Trust" Approach ......................................................................................................... 36

What was Consumed? ..................................................................................................................... 37

What Can Be "Identified as the Original Trust Property"? ............................................................. 37

Tracing "Mutations" ........................................................................................................................ 37

Effects of Commingling .................................................................................................................. 38

Did the Surviving Spouse Effectively "Distribute" All of the Assets? ........................................... 38

What About Income Taxes? ............................................................................................................ 38

The "Claim Against the Estate" Approach ............................................................................................... 39

Is There a "Debt"?–Estate of Bailey ................................................................................................ 39

How Much is the Debt? ................................................................................................................... 40

Deducting the Claim ........................................................................................................................ 41

The "Resulting Trust" Approach .............................................................................................................. 41

The "By Their Fruits You Shall Know Them" Approach ........................................................................ 41

Has the Statute of Limitations Run? ........................................................................................................ 42

Drafting Agreements for Failure to Fund a Trust or to Intentionally Not Fund a Trust Chapter 15

iii

Other Hard Questions ............................................................................................................................... 42

What About Basis? .......................................................................................................................... 42

Is a Federal Estate Tax Return Required? ....................................................................................... 43

Is it Cost Effective? ......................................................................................................................... 43

What Gets Disclosed? ..................................................................................................................... 43

Making the Funding Binding on the IRS ................................................................................................. 43

Fundamental Tax Considerations .................................................................................................... 43

Bona Fide Disputes ......................................................................................................................... 44

Enforceable Rights Under State Law .............................................................................................. 44

Does a Lawsuit Need to Be Filed? .................................................................................................. 45

The Relationship of the Parties ....................................................................................................... 46

CONCLUSION ................................................................................................................................................ 46

EXHIBIT A: HISTORICAL ESTATE & GIFT TAX EXCLUSION AND GST TAX EXEMPTION

AMOUNTS & TOP TAX RATES (1916-2019) ........................................................................................................... 47

EXHIBIT B: SAMPLE CLAYTON QTIP TRUST LANGUAGE ................................................................................ 49

EXHIBIT C: SAMPLE DISCLAIMER BY TRUST BENEFICIARY ........................................................................ 51

EXHIBIT D: SAMPLE DISCLAIMER BY TRUSTEE ............................................................................................... 53

EXHIBIT E: SAMPLE NOTICE OF INTENT TO DISCLAIM BY TRUSTEE ......................................................... 55

EXHIBIT F: SAMPLE WAIVER OF NOTICE OF INTENT TO DISCLAIM BY TRUSTEE .................................. 57

EXHIBIT G: SAMPLE FAMILY SETTLEMENT AGREEMENT (NOT TO PROBATE WILL) ............................ 59

EXHIBIT H: SAMPLE FAMILY SETTLEMENT AGREEMENT (NO FUNDING OF TRUST) ............................ 65

EXHIBIT I: MOTION AND ORDER APPROVING FAMILY SETTLEMENT AGREEMENT ............................. 73

Drafting Agreements for Failure to Fund a Trust or to Intentionally Not Fund a Trust Chapter 15

DRAFTING AGREEMENTS FOR

FAILURE TO FUND A TRUST OR TO

INTENTIONALLY NOT FUND A

TRUST

INTRODUCTION

In a perfect world, our clients would come to see us

on a regular basis to ensure that their Wills and other

estate planning documents are ideally suited to their

current circumstances. In reality, however, the time that

passes between the date that a Will or revocable trust is

drafted, and the client dies, can be years or decades. In

the meantime, the decedent's family and financial

circumstances may have changed dramatically. In

addition, tax and state laws may have also undergone

substantial changes.

From a tax standpoint, two recent legislative

enactments have had the effect of dramatically changing

the math for traditional tax-planned estate planning

documents. These same legislative enactments have

also changed the priorities of many of our clients.

Specifically, the American Taxpayer Relief Act of 2012,

P.L. 112-240, 126 Stat. 2313 (2013) ("ATRA"),

returned us to unified estate, gift, and generation-

skipping transfer ("GST") tax laws. ATRA also made

permanent some other important features, like

portability, which allows a surviving spouse to use the

"deceased spousal unused exclusion amount" (the

"DSUE" amount) of his or her last deceased spouse if an

estate tax return making the election to do so was filed

by the deceased spouse's executor. High transfer tax

exclusions and a tick up in the transfer tax rate, which

closed much of the gap between income and transfer tax

rates, caused estate planners to step back and refocus

how they help clients plan their estates. More recently,

the Tax Cut and Jobs Act of 2017, P.L. 115-97, 131 Stat.

2054 (2018) ("TCJA 2017")0F0F

made additional

significant changes to the income and transfer tax laws.

Of course, these changes are far from unique in the

history of the federal estate tax. Exhibit A summarizes

the federal estate tax exemptions, top rates, gift tax

annual exclusions and GST tax exemptions from the

inception of the estate tax in 1916 through 2018.

The technical name of the Act is "An Act to Provide for

Reconciliation Pursuant to Titles II and V of the Concurrent

Resolution on the Budget for Fiscal Year 2018", but

"AAPRPTIIVCRBFY 2018" seems to be a remarkably

unhelpful acronym. Some have suggested "the Act Formerly

known as TCJA 2018," or perhaps its abbreviation,

"AFKATCJA."

See, e.g., Featherston, The Changing World of Will

Construction: The Legislature's Influence, State Bar of Texas

ANN. ADV. EST. PL. & PROB. COURSE (1994);

Featherston, The Interpretation, Construction and Drafting of

Wills and Trusts: The Legislature’s Influence, UTCLE 10

NN. EST. PL. GUARD. & ELD. LAW CONF. (2008).

From a state law standpoint, the founding fathers

of the State of Texas showed their wisdom by allowing

the Texas Legislature to meet only every other year, and

then for not more than 140 days. Nevertheless, the

cumulative effect of legislative changes over many

years can dramatically change how Wills and trusts are

administered and interpreted.1F1F

In addition, Texas

appellate courts are constantly called upon to interpret

Wills and trusts, administrative requirements, fiduciary

duties, and similar topics, all of which may alter how a

Will or trust, being implemented years after its

preparation, may be interpreted after the testator or

grantor's death.

Legislative changes and judicial decisions, when

combined with naturally occurring changes in a client's

family and financial circumstances, often mean that the

decedent, if given the chance, might well have chosen

to change his or her estate planning documents

immediately before death. However, probate laws

relating back to the English Statute of Wills enacted in

1540 generally preclude family members from using

parole or other evidence to alter a decedent's estate plan.

There are, however, mechanisms that permit a family,

in a cooperative setting, to accomplish some types of

changes. These mechanisms include tried and true tools

such as disclaimers and simple gifts, to more

sophisticated tools, including judicial trust

modifications (and now, in some limited circumstances,

Will reformations), trust modification without court

involvement, trust decanting, and family settlement

agreements.

ISSUES WHEN FUNDING TRUSTS

Probate vs. Non-Probate Assets

In order to fund bequests made by a Will, an

executor must first identify which assets are within his

or her control. Estate planning professionals know that

while a variety of assets may transfer wealth as a result

of a client's death, only some of those assets will be

controlled by the terms of the decedent's Will. This fact

often comes as a surprise, however, to many executors

(and beneficiaries). Life insurance, retirement accounts,

and accounts held as payable-on-death to a named

beneficiary or in survivorship form all pass outside the

There are numerous outlines that provide a thorough

discussion of issues that arise in funding testamentary

bequests. See, e.g., Davis, Funding Unfunded Testamentary

Trusts, 48

UNIV. OF MIAMI ANN. HECKERLING INST. ON EST.

PL., Ch. 8 (2014). For sample documents commonly used to

document funding these bequests, see Prangner, Don't Let the

Door Hit You on the Way Out: Funding Agreements, Receipts

and Releases, and All That Jazz, State Bar of Texas 26

ANN.

EST. PL. & PROB. DRAFTING COURSE (2015); Ben-Yaacov,

Are We Having Fun(ding) Yet?: Practical Funding Issues

Encountered in Estate Administrations, State Bar of Texas

ANN ADV. EST. PL. & PROB. COURSE (2011).

Drafting Agreements for Failure to Fund a Trust or to Intentionally Not Fund a Trust Chapter 15

Will, and are thus typically unavailable to fund

testamentary bequests unless paid to the executor or the

estate, to the trustee of a revocable trust, or to a

testamentary trustee. For clients that have accumulated

amounts in retirement plans while residing in

community property states, one must be mindful that,

although retirement accounts are non-probate assets as

to the participant or employee, to the extent of the non-

participant spouse's community property interest in

those assets, they are probate assets as to that spouse.

See Allard v. Frech, 754 S.W.2d 111 (Tex. 1988). In

addition, the U.S. Supreme Court has ruled that as to

retirement accounts governed by ERISA, federal law

preempts state community property laws, and the non-

participant spouse has no devisable interest in those

plans. Boggs v. Boggs, 520 U.S. 833, 138 L. Ed. 2d 45

(1997). Since IRAs are not governed by ERISA,

common law principles of ownership, which may

include community property rights of a non-participant

spouse, continue to apply to IRAs and other non-ERISA

retirement assets.

Payment of Debts and Expenses

One of an executor's primary responsibilities

during the administration process is payment of debts

and expenses of the decedent and the estate, including

applicable taxes. In fact, much of local probate law

deals with the procedure for filing claims against estates,

the procedure for executors to evaluate and pay those

claims, identification of assets used to pay claims, and

the order in which the bequests "abate" or are

diminished to the extent that estate assets are used to pay

debts and expenses. See, e.g., T

EX. ESTS. CODE Chpt.

355 ("Presentment and Payment of Claims"); UNIF.

PROB. CODE Art. III, Part 8 ("Creditors' Claims")

(2010). Thus, although executors do not owe a fiduciary

duty to estate creditors, a part of the process in

administering an estate is insuring that debts of the

decedent are paid or provided for to the extent that the

estate has the resources to do so. Obviously, to the

extent that assets are used to pay estate creditors, they

are unavailable to fund testamentary gifts.

Apportionment of Taxes

In those estates in which estate or inheritance taxes

are owed, some assets of the estate will necessarily be

utilized in paying those taxes. In the absence of specific

instructions contained in the Will to the contrary, local

law generally sets forth a specific mechanism to allocate

taxes, interest, and penalties among the various

beneficiaries of the Will. See, e.g, T

EX. ESTS. CODE

Chpt. 124, Subchpt A; UNIF. PROB CODE Art. III, Pt. 9A

("Uniform Estate Tax Apportionment Act") (2010).

Other Changes in Assets During Administration

In addition to the payment of debts, expenses, and

taxes, the assets of the decedent's estate are likely to

undergo a number of other changes during

administration. As a result of these changes, the assets

used to fund bequests are rarely identical to those on

hand at the date of the decedent's death. These changes

can take a variety of forms.

Income Earned During Administration

If the decedent owns income-producing assets, the

executor will earn income during the administration of

the estate. Local law will generally outline how the

income generated by estate assets is to be allocated

among beneficiaries. See T

EX. ESTS. CODE Chpt. 310

("Allocation of Estate Income and Expenses"), which

incorporates by reference in part TEX. PROP. CODE

Chpt. 116 ("Uniform Principal and Income Act").

Sales and Exchanges of Estate Assets

It is not unusual for the executor to dispose of

assets during the administration process. In fact, it is

frequently necessary for an executor to sell one or more

of the assets of the estate in order to acquire sufficient

cash to pay debts and expenses as they come due.

Moreover, the executor may dispose of assets in the

exercise of prudent discretion, to protect and preserve

the value of the estate. For example, an asset that is

declining rapidly in value may be converted into an asset

of more stable value. Although it is unusual for an

executor to actively acquire new assets with cash

(except safe, short-term investment assets), it is not

uncommon for assets in the estate to change form during

administration. Surprisingly, under historical common

law principles, the executor of an estate did not have an

inherent power to continue a decedent's business.

Instead, the executor was normally charged with a duty

to wind up the business. See, e.g., Willis v. Sharp, 113

N.Y. 586, 21 N.E. 705 (1889); In re Wolf's Estate, 87

N.Y.S.2d 327 (Surr. Ct. 1943). The rationale for this

holding is that the continuation of the decedent's

business often prolongs the administration of an estate

and delays the payment of creditors, contrary to public

policy that estates be promptly settled and distributed.

See Davis, Income Tax Consequences (and Fiduciary

Implications) of Trusts and Estates Holding Interests in

Pass-Through Entities, State Bar of Texas 25th A

NN.

ADV. EST. PL. & PROB. COURSE (2001). In the modern

setting, however, executors often act to preserve and

protect estate assets that might include business

interests. Thus, for example, an executor may determine

to incorporate a proprietorship or partnership operated

by the decedent. This incorporation may be undertaken

to minimize liability of the estate to the claims of the

business. As a result of this transaction, the business

assets formerly owned outright by the decedent are

converted into stock in the new enterprise. An executor

may also transfer assets to a partnership or limited

liability company ("LLC") in order to provide a

convenient mechanism to manage assets that might

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Hooked on CLE: June 2023

First appeared as part of the conference materials for the

Annual Estate Planning, Guardianship and Elder Law Conference session

"What the Surviving Spouse Needs to Do, and What to Do if They Don’t"