How Estate Planning for a Family May Trap the Unwary Practitioner

Estate Planning attorneys often represent multiple members of a family. It’s a natural evolution of the attorney’s relationship with their clients. Consider a married couple who undertakes basic Estate Planning when they have young children or are beginning to build wealth. As their estate grows, their attorney recommends more sophisticated Estate Planning techniques designed for the tax efficient transfer and protection of that wealth. Upon the death of the first spouse, it’s not unusual for the attorney to have advised the couple’s children either because the surviving spouse solicited their involvement, or because the children have become clients of the attorney themselves. It’s easy to see how an Estate Planning attorney starts with a couple and ends up advising most of the family. This collaborative approach to Estate Planning usually produces better results, yet many Estate Planning attorneys and clients fail to comprehend the potential quagmire it creates. Let’s review an example based upon a recent case in which the attorney recommended a sophisticated Estate Planning technique that was successful yet still resulted in a malpractice lawsuit.

Assume that David and Iman are married and undertook estate planning in 2003. David had three children from a prior relationship. Upon the advice of counsel, David and those three children formed Bowie, Ltd., a limited partnership. David funded the partnership with his stock in Bowie Bonds, Inc. (“BB”), worth approximately $90 million. David maintained 98.9% ownership interest in Bowie, Ltd. and Children, LLC, a limited liability company owned by David’s children held the other 1.1% interest. In 2006, David’s attorney recommended that David sell his interest in Bowie, Ltd., to an intentionally defective grantor trust (“IDGT”) created by David. Because the trust would be a grantor trust as to David, there would be no income tax consequences on the sale. David implemented the sale in 2009 and sold his 98.9% Bowie, Ltd. interest to the IDGT in exchange for a promissory note for $50 million. When David later expressed confusion regarding the estate tax impact of the sale transaction, his attorney sent him letters explaining the transaction and reiterating that if the children sold BB, they would receive an additional $30 million after income tax liabilities. The letters also indicated that any appreciation in the value of BB would pass to the children estate and gift tax free.

Concurrently with David’s confusion and the attorney’s explanatory letters, Iman contacted the attorney’s assistant regarding concern over the attorney’s loyalty to David. Iman indicated that the attorney gave priority to the children’s interests, rather than David’s interest. Shortly thereafter, David fired that attorney and sued his children to set aside the 2009 transaction alleging that he did not know or understand that he had relinquished control of Bowie, Ltd., to his children, but kept the resulting income tax liabilities, including any arising from the sale of the interest. The case was settled and shortly thereafter, the children sold BB for $150 million causing a gain recognition event. David died the next year. Although the sale was a gain recognition event, through a loophole, neither David nor his estate paid the tax and the Internal Revenue Service failed to collect prior to the expiration of the statute of limitations.

David’s estate sued the attorney who recommended the transaction for malpractice alleging that said attorney failed to fully communicate to David the risks and implications of the transaction, including David’s substantial income tax exposure, while grossly misleading David regarding the transfer of wealth and the estate and gift tax savings. Even though the plan was successful from an estate tax perspective and even though neither David nor his estate paid any income tax on the sale of BB, the estate was permitted to continue the malpractice suit against the attorney who recommended the plan. Ultimately, the court found that the attorney failed to fully inform David of the consequences of the transaction. Thus, even when things go right for the client, they can go wrong for an attorney.

In addition to serving as a cautionary tale, this example highlights the tension that exists between income tax planning and estate tax planning. Section 671 of the Internal Revenue Code attributes the income, deductions, and credits of a grantor trust to the grantor of that trust. The Internal Revenue Service disregards a grantor trust for income tax purposes, allowing creative attorneys to leverage grantor trusts for their clients’ benefit. For example, a sale to IDGT, as described above, allows the assets sold to the trust to grow on an income tax free basis while remaining out of the grantor’s estate for estate tax purposes. Appreciation on the assets passes to the trust beneficiaries without additional tax consequences. The trust is termed “defective” because it’s not included in the grantor’s estate for estate tax purposes. The technique, however, is anything but defective. If done properly, it’s working exactly as intended by counting as the grantor’s asset for income tax purposes, but not for estate tax purposes. The sale technique provides that added benefit that any income tax paid by the grantor further reduces the grantor’s estate.

Using our example above, it’s easy to see how David benefits from exploiting the inherent tension between the income tax and estate tax. He remains responsible for the income taxes, but he would be responsible if he kept the asset anyway, so it’s a wash. Paying the income taxes reduces his overall estate thereby lowering any estate tax liability at death. Transferring the asset out of his estate allows the appreciation to escape estate taxation. In addition, he passes that appreciation to his beneficiaries without any reduction in his applicable exclusion amount over and above that which he used to seed the trust. All in all, remaining liable for the income taxes saves David significantly on potential estate taxes.

This example and the case it’s based upon provide many great lessons. First, ask questions or for clarification about the recommendations for your estate plan. Second, include non-attorney advisors as part of your team if possible. Everyone views the transaction through a different lens which results in a more comprehensive plan. Third, if the plan was implemented several years ago, consult with a qualified Estate Planning attorney to ensure that it’s working as designed and intended. Fourth, if you use the same attorney as other members of your family, remember that provides certain benefits, but may also have drawbacks. Finally, remember that this is your legacy and it’s vital that you have comfort with how the plan will function both during your lifetime and at your death. Reaching out to a qualified Estate Planning attorney can help you do just that.

Tereina Stidd
Associate Director of Education
American Academy of Estate Planning Attorneys, Inc.
9444 Balboa Avenue, Suite 300
San Diego, California 92123
Phone: (858) 453-2128
www.aaepa.com