Why You Should be Interested in Trusts and Estates Law

Suppose that S, scion of a prominent wealthy family but a bit of a ne’er do well, drunkenly and negligently wrecks his car, causing severe injury to innocent victim, V. V sues and wins a judgment against S, who is the beneficiary of a trust worth millions of dollars. Is V likely to collect on this judgment?

Not against the trust. Although S continues to benefit from the trust, the document that created it contains a “spendthrift clause.” Under the widely adopted Uniform Trust Code (UTC), a few simple words in the trust document numinously protect its corpus from claims of almost all third parties, including tort victims.

Should you be interested in trusts and estates law? Recently, two prominent economists weighed in on a similar query with regard to economics. Ha-Joon Chang’s 2014 book, Economics: The User’s Guide,  encouraged his readers to develop some facility with economic questions, the answers to most of which depend on the application of moral values and political views. His point was that when non-economists fail to engage economic questions, we get solutions skewed to the political biases of a handful of economists.

Likewise, French economist Thomas Piketty warned  that “the distribution of wealth is too important an issue to be left to economists, sociologists, historians, and philosophers.” Instead, he urged, everyone should be interested and involved. Piketty reported that inherited wealth accounted for at least 50–60% of total private capital in the United States in the late twentieth century and accounts for a much larger share today.

As in economics, moral and political values decide many questions about our laws governing inheritance. And if inheritance stands to play an increasing role in who gets what, as Piketty claims it will, questions of inheritance are crucial in determining how our resources are allocated.

Upton Sinclair wrote that it’s “difficult to get a man to understand something, when his salary depends on his not understanding it.”  Contemporary psychological studies confirm that what is now called “motivated reasoning” pervades our decision-making process. Rare is the person who adopts a political perspective or moral view that runs counter to his or her own livelihood. Trusts and estates lawyers make their living helping families hold onto their wealth across generations, meaning they are likely to be biased on questions regarding inheritance. Their vested interest runs towards ensuring entrenchment, rather than disbursement, of wealth. And they have outsized influence on the substance of inheritance law because they are motivated to give it their attention.

Let’s revisit S, the wealthy young man who negligently injured V. After V wins her judgment, Lawyer L defends S’s trust interest against V’s attempt to levy against it, but remains unpaid after billing S many times for his legal work. Fed up, L goes to court and gets a judgment against S for his fees. Is L likely to collect against the assets of the trust? Yes, because while the UTC shields the assets of the trust from almost all creditors’ claims, making it impenetrable by V, it opens the door to “a judgment creditor who has provided services for the protection of a beneficiary’s interest in the trust.”  Meanwhile, V remains uncompensated for her injuries.

Kent Schenkel

Should We Abolish the Estate Tax?

Here’s a simple yes or no question: Do you personally favor or oppose completely eliminating the estate tax—that is the tax on property left by people who die?

After you have answered that question consider this. Suppose you receive an unexpected call from a lawyer who tells you that she represents the estate of your great Aunt Leona, who recently died. She goes on to tell you that, in her will, Aunt Leona left you a bequest of $100,000 in cash. Do you think you would you be required to pay federal income taxes on that amount?

When I ask my new tax students this question most assume that federal income taxes would be owed. But most students' assumptions are wrong, because under federal income tax law property received by bequest or inheritance (and even that received by gift) is excluded from the definition of income. So you would get the whole $100,000, free and clear of federal income taxes.

What about federal “death” taxes? Federal law does include what is known as an “estate tax,” which is a tax on the aggregate value of everything a person owned at death. Would that tax reduce the amount you received from Aunt Leona’s estate? No, because that tax is paid by the decedent’s estate after her death. You would receive your bequest in full after the payment of any federal estate tax that was due. But chances are overwhelmingly good that Aunt Leona’s estate would owe no federal estate tax anyway. The tax has for many years applied to only a very small fraction of estates. And that fraction keeps getting smaller.

In keeping with this trend, late last year, Congress passed, and the President signed, a law under which no federal estate tax is owed unless the estate exceeds $5 million in total value, less any substantial gifts made during lifetime. Decedents can also leave an unlimited amount to their surviving spouses without any estate tax becoming due. Those spouses can then generally leave up to $10 million in assets to the next generation without their estates being liable for any federal estate tax.

To put this in perspective, in 2007 there were probably no more than 600,000 total households in the U.S. with a net worth in excess of $10 million. Based on today’s total U.S. population of about 308 million people, this means that far less than 1% of the U.S. population will be exposed to this tax. Although the 2010 law is more generous than most prior laws in exempting wealth from the estate tax, the federal estate tax has for many years affected only 2% or less of estates.

Consider again the question posed at the beginning of this post—do you favor or oppose the complete elimination of the estate tax? In annual polls commissioned by the Tax Foundation and conducted by Harris Interactive in 2006-2007, 66%-68% of people favored completely eliminating the estate tax altogether when that question was posed exactly as stated in the first sentence of this post. Note how this poll question, given by an organization that describes itself as “a nonpartisan tax research group,” was phrased as all-or-nothing: the “complete elimination” of the estate tax.

Consider some more data. In 2010, Michael Norton of Duke University and Dan Ariely of Harvard Business School devised a survey wherein they asked a “nationally representative online panel to estimate the current distribution of wealth in the United States and to ‘build a better America’ by constructing distributions with their ideal level of inequality.” The results: most of those surveyed vastly underestimated the actual percentage of wealth owned by the top 20% of Americans—those surveyed guessed it was 60% when in reality it’s 85%. The survey takers estimated that the poorest 40% of the population owned about 10% of the country’s total wealth. The real number is three-tenths of 1%. Perhaps even more striking, over 90% of those surveyed (including Republicans) preferred wealth distribution like that of Sweden (35% of wealth owned by the top 20%) over the U.S. when asked which type of wealth distribution they would deem most just.

A common argument in favor of estate tax elimination is that it amounts to a “double-tax.” In other words, income is taxed to the recipient, and then when the recipient dies that income, now in the form of wealth, is taxed again by the estate tax. But there are at least three counterarguments here.

First, the person who “earned” the property (and presumably paid tax on it) is now dead, and the heir (the new owner) paid no tax. The money you received from Aunt Leona’s estate is no longer Aunt Leona’s, it’s now yours, and this is why so many people automatically assume that it is subject to the income tax. In fact, under the tax law’s general definition of income as all “accessions to wealth” it would be taxed if it were not for a specific exclusion written into the Internal Revenue Code for gifts and bequests.

Second, studies have shown that some 56% of estates of over $10 million consist of unrealized capital gains. This means that even the dead person paid no income tax ever on over one-half of what he is passing on. To give this some context let’s assume, for example, that Aunt Leona had left you a painting she bought for $100 that was now worth $100,000. She may have paid tax on the $100 she earned to buy the painting but would never have paid tax on the $99,900 in appreciation.

Finally, other income tax rules provide that the recipient can sell almost any property inherited at the value it was when inherited and pay no tax on the proceeds. In other words, when you sell Aunt Leona’s painting for $100,000, you can pocket the sales price free of tax.

So rules governing taxation at death are complex, but generally pretty favorable to the taxpayer. This brings us back to the question that we started with. Do you favor the complete elimination of the estate tax? Or does the question need context and the answer call for nuance?

Kent Schenkel

Postmortem Publicity Rights: Coming Soon to a Court Near You?

Most of us are aware that famous persons can control and profit from the use of their identities during their lifetimes. Indeed, many celebrities are said to make much more from the selling of their endorsements and likenesses than from the activities that made them famous in the first place. Essential to securing this type of revenue stream is legal recognition of one’s “identity” as a property right. Granting individual identity the status of property means that the non-owner must have permission to use it. This permits individuals such as Michael Jordan, Oprah Winfrey and Madonna to package and sell publicity rights while imposing any restrictions on the use of their names, likenesses or images they choose.

But what happens when the celebrity dies? Do the heirs and beneficiaries of dead celebrities succeed to their publicity rights, allowing them to market and profit from them? That turns out to be a complicated question. And it’s a question that has heated up considerably in recent years.

Some states, such as California, recognize postmortem publicity rights, and some, such as New York, do not. One issue that presents considerable difficulty is which state’s law controls. Descendible publicity rights also raise sticky federal estate tax issues. Valuation is sure to be complicated and contested (a “herculean task” according to some experts), and discharging the tax obligation virtually requires that the property rights be exploited.

Perhaps most interesting are the policy questions. In a recent op-ed piece in the New York Times, Boston College law professor Ray Madoff argues that postmortem rights of publicity are “getting out of control.” She points out that the identities of important historical figures, such as Rosa Parks and Albert Einstein, are now being used to sell products, and raises concerns about whether literary endeavors involving these figures will infringe on property rights held by their heirs and the companies to whom those rights were sold.

Madoff also contends that while the preservation of proprietary rights in the identities of the dead makes money for heirs and companies, it is unlikely that a famous person would be able to take action during life to prevent a postmortem sale of those rights. She cites a longstanding principle of wills law that a person cannot effectively decree that their property be destroyed at their death. Further, those rights may have to be sold to raise money to pay the bloated estate tax bill accruing as a result of this property interest. Professor Madoff concludes that Congress should enact a preemptive federal statute that provides for a property right that is limited in time and that allows an individual to prevent the endurance of publicity rights after death.

Although Madoff’s proposed solution has precedent in federal trademark and copyright law, don’t look for federal legislation in this area anytime soon. In the meantime, with so much money to be made off of the famous dead, and with the laws in this area being so unsettled, litigation is sure to proliferate.

Kent Schenkel

Is There a Policy Behind the Grantor Trust?

We were all taught in school that statutory laws start with intentional legislative action. This means that federal laws favoring a particular economic faction, for example, were enacted by Congress with the intent to assist that group. We can determine Congressional policy then, by looking at the effect of laws enacted by Congress. The law reflects the intent of Congressional action. Likewise, administrative regulations reflect intent on the part of the responsible agency.
But in their 2010 book Winner-Take-All Politics, the political scientists Jacob Hacker and Paul Pierson ask us to focus, in part, on another aspect of governmental legal activity. Just as important as governmental action is government’s failure to act. Hacker and Pierson identify a form of inaction they call “drift.” Drift results from “systematic, prolonged failures of government to respond to the shifting realities of a dynamic economy.” They give the example of federal minimum wage laws. As inflation reduces the purchasing power of the dollar, minimum wage laws, if they are to keep pace, must be adjusted upward. Failure to make this adjustment in the face of continuing inflation will eventually drain these laws of all of their original effect. This is drift, and the Congressional policy reflected by this drift is that wage floors should not be set by the government.
In a paper prepared for the 2010 meeting of the American Political Science Association, Hacker and Pierson point out that drift often benefits legislators by allowing them to effect (for the benefit of a particular group) what might be broadly unpopular policy without bearing responsibility for that policy. And this form of legislative inaction, just like legislative action, is often mediated by powerful political groups.
Which leads me to the real topic of this post. University of Texas law professor Mark Ascher has written an important paper that shows how Congress, by failing to act, is furthering policies favoring only the high-end estate planning industry and those it serves. Ascher, who is the author of a well-known and regarded treatise on the income taxation of trusts, concerns himself in this article with a device known as the “grantor trust.” A grantor trust is a trust all of the income of which is taxed to the creator and funder of the trust, also known as the “grantor,” or “settlor” of the trust. This is a different taxation regime than exists for those trusts that are not grantor trusts. As a general rule, the typical “non-grantor” trust is liable for tax on income retained by the trust. This means that the trustee must pay the federal income tax out of the trust assets. In contrast, the grantor trust is not seen as separate from the trust’s settlor. All trust income and corresponding deductions are reported on the settlor’s tax return and the settlor is liable for the tax.
The grantor trust rules arose to prevent high-bracket taxpayers from shifting income from themselves to low-bracket trusts, while retaining the benefit of that income. At first, those rules covered only those situations where a settlor retained the right to revoke a trust or retained beneficial enjoyment of the trust’s income. But in a notable Supreme Court case from 1940 called Helvering v. Clifford, the taxpayer created a trust for his wife that was to terminate after five years. He retained the power to determine the amount of any income distributions to his wife. Presumably, the settlor’s goal was to have his wife taxed on income distributed to her from the trust and to have the trust taxed on any income retained by the trust. In this way, he could take advantage of the lower marginal rates to which his wife and the trust was subject.
The Supreme Court held that the settlor was liable for tax on all the trust’s income, which left the law regarding grantor trusts in a state of confusion. A few years later, the Treasury promulgated comprehensive regulations setting out the circumstances under which a trust would be treated as a grantor trust. So these regulations, like the extant grantor trust rules dealing with revocable trusts and trusts that make distributions benefitting the settlor, were enacted to prevent abuses of the income rules by shifting income to trusts. The regulations were later statutorily codified by Congress into the current grantor trust rules.
Between the date of enactment of the grantor trust rules and today, however, Congress also enacted a number of other laws whose combined effect was to virtually eliminate the advantages of using trusts for income-shifting:
• It allowed married to taxpayers to file a joint tax return, essentially treating their combined income as though one-half was earned by each.
• It enacted the “kiddie tax” which generally taxes a child’s unearned income at the parents’ rate.
• It reduced the highest individual tax rate (to which trusts are also potentially subject) from a high of 91% to its current 35% rate.
• It reduced the rate on dividends and capital gains to a maximum of 15%.
• It compressed the trust tax brackets so that trusts are now subject to a tax at the highest marginal rate on all income in excess of $11,350.
• It mandated the treatment of multiple trusts with substantially the same settlors and beneficiaries as one trust.
As a result, Ascher convincingly argues that taxpayers now have little or no incentive to create trusts for the purposes of income-shifting. Congress could therefore repeal the grantor trust rules. Yet it has not done so. As a result, rules enacted to prevent abuse of the income tax rules are now being employed in a number of strategies to avoid transfer (estate and gift) taxes.
Here’s a simplified overview of one of the simplest these strategies. Suppose that TP is a taxpayer whose estate is potentially subject to the federal estate tax. This means that TP’s total wealth exceeds that of well over 99% of all Americans. In order to reduce estate taxes, TP creates a trust for the benefit of his offspring and transfers some of his appreciating assets to the trust. Normally, this trust would be liable for income tax on all income generated by trust investments that is not distributed to trust beneficiaries. But TP makes the trust a grantor trust by inserting a provision in the trust instrument that provides that TP can, if he wants to, replace the trust property by substituting other property of equivalent value. (There is no need to ever actually replace the trust property, this is just language inserted in the trust instrument that allows TP to do this.) The result is that all trust income is now taxable to TP and not to the trust.
Why is this advantageous? The advantage comes when one considers that by paying the tax on trust income from his own assets, TP is essentially making an additional gift to the trust beneficiaries. Moreover, this transfer is not a gift subject to the gift tax because TP is legally liable for the payment of the tax—the tax payment is not a voluntary transfer. The effect, however, is the same as a gift.
Ascher goes into some detail describing a number of other strategies involving grantor trusts being employed by estate planners for the benefit of their wealthy clients. He concludes that these strategies pervert the original purpose of the grantor trust rules and that almost all of those rules should therefore now be repealed. He would preserve the rule that makes a revocable trust a grantor trust.
Ascher’s article is important because it sheds light on policies furthered by Congressional inaction. The integrity of our system of taxation depends on a fair and equitable application of laws. And as Ascher states, ploys like those available to the few under the grantor trust rules exacerbate “the already widely held impression that the [Internal Revenue Code] is a venal collection of provisions designed to allow those whose advisors are ‘in the know’ immense latitude in minimizing their tax liabilities.” Any Congress that fails to reform or repeal the grantor trust rules is by its inaction implementing policies that help bring reality in line with this impression.
Kent Schenkel

Our Perception of Corruption

Why are we outraged to hear about a bully picking on an innocent child yet learning about multinational corporations bribing corrupt government officials elicits only a yawning “business as usual” reaction? An article by a trio of South American scholars published in the International Journal of Psychology Research offers some insight.

The authors, Eduardo Salcedo-Albarán, Isaac de León-Beltrán, and Muricio Rubio, work from neurological research that examines activity in the brain while it is performing certain tasks. One of the findings of neurological researchers is that many of our behaviors— many more than previously thought—spring from our instincts rather than from what we think of as our reasoning processes. These findings are changing the foundational constructs of some of our social sciences; for example, the “rational person” assumption of economics is coming under increasing scrutiny. But the authors here are interested in our perception of corruption. What they conclude is that our inability to perceive corruption as “reprehensible behavior” stems from the lack of certain factual conditions necessary to trigger such an emotional response. The authors point out that campaigns aimed at preventing corruption often try to teach people how to connect corruption with its deleterious effect on society as a whole. The problem with this strategy, they say, is that it requires people to make “complex causal links” for which they may not have the training. Only when corruption can be shown to harm goods and services close to them do people tend to make the connection. Looking into research involving neurological mechanisms referred to as “mirror neurons,” along with psychological mechanisms called “Theory of the Minds,” they explain the basis for this disconnect. Mirror neurons allow us to experience a sort of vicarious distress when we become aware of the pain or discomfort of others. So violent crimes that hurt other human beings trigger negative feelings, such as regret or aversion. Likewise, Theory of the Minds allows us to infer the mental states of others; we assume that something that would hurt us would hurt another person.

But in order for these processes to work, there must be another person who is being harmed by the act in question. This is where the difficulty of causal links comes in. Learning about an act that harms society as a whole does not trigger in the observer an acute emotional response because, without engaging in extensive analysis, no discrete victim is identified. As the authors put it, “acts of public corruption are similar [to] hitting a tree” rather than a person. And, unfortunately for those pointing out the connection between the act of corruption and the suffering of individuals, careful argument is no match for the emotional impact triggered through these physiological processes. Marketers have understood this for years—this is why marketing strategies are designed to appeal to our emotions rather than to convince us by argument or logic that we need things they are selling. The authors conclude that in the case of the crime of corruption, it is important to show the victims and the causal links between the crime and those victims.

Elizabeth Spahn is a law professor at New England Law | Boston who studies international corruption. Spahn recently spoke about her area of expertise at a symposium entitled “Combating Global Corruption” at Georgetown Law School. In her talk, based on an article that will appear in the Georgetown Journal of International Law, she focused on the human consequences of bribery. Because bribery is used to circumvent regulations and bypass normal vetting processes for the production of goods and services, Professor Spahn points out that it has a prominent role in a number of international incidents implicating human suffering. It provides an entree into markets for transnational criminal organizations and sets the stage for organized crimes such as human trafficking and trade in wildlife and animal parts. Breaking down regulatory barriers leads to low quality-control products such as contaminated toothpaste, fake baby milk formula, toxic toys and poisoned pet food. Because not all regulations circumvented by bribes are merely bureaucratic; some are related to quality control. One study concluded that corruption reduces pollution control. It also had a role in the Yanacocha Mine mercury spill. Spahn’s non-exhaustive list goes on.

Although it may not be obvious without some observation and analysis, corruption has devastating human costs. The fight against corruption is made more difficult by limitations in our perception of the crime brought on by our physiological make-up. But if marketers can employ strategies to appeal to this aspect of our humanness to sell us products, surely those battling corruption can learn to make the same connections to invoke the outrage to fit the crime. In her presentation at Georgetown, Professor Spahn drew specific links between corruption and individual suffering. In the battle against international corruption, Elizabeth Spahn gets it. And she’s working to ensure that the rest of the world will soon get it too.