What to Do When a Bypass Trust Was Never Funded

“What to Do When a Bypass Trust Was Never Funded,” that is the subject of today’s ACTEC Trust and Estate Talk.

This is ACTEC Fellow Margaret Van Houten of West Des Moines, Iowa.

At a recent ACTEC meeting, Fellow Mickey Davis of Houston, Texas asked how many attendees have not encountered the situation where a bypass trust created when one’s spouse dies was never funded? Almost no one raised their hands. Is there a way to fix this common problem by reconstructing an unfunded bypass trust long after the death of the first spouse to die or even after the death of the surviving spouse?

Mickey will discuss a number of theories that can be used to put the pieces back together. There is no one-size-fits-all approach, and Mickey reminds us that the route you choose can have a dramatic difference on reporting requirements, cost basis, and other aspects of estate and trust administration. Welcome, Mickey.

Thanks, Margaret. I appreciate it.

Can an Unfunded Bypass Trust Be Reconstructed?

Mickey Davis:  Here’s the scenario we seem to encounter more frequently. Hugh dies, his kids come to your office, and they say, well, dad’s estate is $20 million. And you ask for a copy of Wilma’s will; Wilma was his spouse and she died several years ago. Well, her will created a bypass trust for dad. And you ask the kids about the bypass trust, and they give you a blank stare. They say, what bypass trust? Dad told us everything belonged to him, and he just took it all.

Well, gosh, you go do some math. You realize Wilma’s bypass trust should have gotten about $6 million. And if that had happened, we wouldn’t owe any estate tax in dad’s estate. Well, darn it, dad. He just didn’t get his act together and get things funded. Is there any way for us to fix this broken bypass trust? And the answer is, although there’s not a lot of great case authority out there, we think that there are several tools that can be brought to bear to fix this bad situation.

Remember that the federal estate tax rules are governed by the Internal Revenue Code, but the estate tax is imposed upon the rights of a decedent measured under state law. So, what we’re looking for here are some state law remedies that let us put the bypass trust back together again.

State Law Remedies for Reconstructing a Bypass Trust

Well, what are those state law remedies? There are a variety of them out there that might be utilized. There’s a case out there called Richard v. Commissioner (Est. of Richard v. Comm’r, TC Memo 2012-173 (2012), where the kids encountered this very situation. Dad died. Mom’s bypass trust was never funded. And the shares that were included in mom’s estate, which the kids valued at $140,000, the IRS said, well, actually we think they’re worth $27 million. Well, during the course of this administration, the kids found mom’s will, had it admitted to probate, and said, those shares belong to the bypass trust, not to dad’s estate. And the taxpayers were successful in prevailing on the theory that mom’s assets vested in the bypass trust at the moment of her death, they never belong to dad, and therefore they’re not included in dad’s estate.

There’s another great case out there called Stansberry (Stansbury v. United States, 543 F. Supp. 154, (N.D. Ill. 1982), aff’d 735 F.2d 1367 (7th Cir. 1984). It’s not a bypass trust case, but the husband talked his sister into giving him both halves of their inheritance. He had some creditor problems, and so he transferred all those assets to his wife, and then his wife died. Well, the sister sues the wife’s estate and says, my brother tricked me out of those assets. They don’t belong to him, they certainly don’t belong to you. And a court agreed with her. Now the executors of the wife’s estate say, wait a minute, we know we had all these assets titled in our decedent’s name, but they really didn’t belong to her. They were held in a constructive trust for sister-in-law and therefore should be excluded from the wife’s estate. And the tax court, actually the Northern District of Illinois, approved that finding and allowed the assets to be excluded.

Constructive Trusts, Tracing Assets, and Fiduciary Duty

If the husband in my hypothetical at the beginning, had taken all the assets and retitled them in his name, what are we to do? He spent some of those dollars, he added to it, they’re all mixed up. Well, if Hugh was the trustee of that trust, he’s probably breached a fiduciary duty. And in that case, the courts say that we can trace the assets. If Hugh was spending money, the presumption is he was spending his own money first. If it’s hopelessly commingled and we can’t sort it out, the presumption is that all of the assets belong to the bypass trust. So here we have these state law theories that allow us to reconstruct it.

One other case I’ll mention is the Bailey case (Estate of Bailey v. Commissioner, 741 F.2d 801). It’s a Texas case, again, not a bypass trust case. Mom retitled all of her son’s inheritance in her name, died many years later, the son found out what happened, and he filed a claim against mom’s estate. He said that my mom stole this money from me, and we’re going to include all the assets in her estate, but we’re going to take a deduction of what the current value of those assets would have been if I had received them back when I was little. And the court said, you’re exactly right. You’re entitled to deduct from mom’s estate the value of the money she effectively stole from you.

So, think about some interesting issues here. If the assets are excluded in our example, that means we don’t file an estate tax return because my client’s estate is below the filing threshold. It also means those assets don’t get a basis adjustment because they aren’t included in the second decedent’s estate. If instead we use the debt approach and we say, oh yeah, mom made off with all these dollars, but she owes us the debt. She owes us the money. Now all the assets in mom’s estate are going to get a basis adjustment. We may have to file an estate tax return, but we’re going to take a big deduction that makes the tax go away.

Now many of these cases were out there before the IRS came in and changed the rules on how you deduct claims under Code Section 2053. You know, you’ve got to establish the claim and pay it before that the estate tax return or at least you’ve got to file some sort of protective election and make sure that the claim is paid and due course and then deducted. If you’re going to use the debt approach, then you’re going to have to think about the 2053 regulations and how you document that.

Statute of Limitations Issues in Unfunded Bypass Trust Cases

One of the issues is, has the statute of limitations run? Is it too late for you to bring this claim? Well, there’s some pretty good case law out there. If dad took the money and he never really told the kids anything, there’s some old case law out there that says, beneficiaries get to presume that an executor is going to fulfill his duties until he affirmatively renounces them. So, if dad never came to the kids and said, hey, by the way, I’m keeping all these assets, the statute of limitations might not even have started to run until the kids learn that the bypass trust was never funded.

Watch out though. There’s an unreported case out of Ohio where the kids were administering dad’s estate. They sent it out of notice to creditors. They did all the things that executors did and then they decided to make a claim against dad’s estate for the unfunded bypass trust. Unfortunately, they never actually filed their claim with the probate court and the court said, well, you might have had a claim, but the period for you making the claim has run. So sad, too bad, we’re not going to let you take that deduction.

Practical Considerations When Fixing an Unfunded Bypass Trust

Well, as you can see, there are a lot of nuances and different theories that allow you to reconstruct the bypass trust. Curious now where clients are sort of not wanting to fund the bypass trust, will the IRS come back and turn some of these against us and say, oh, you don’t get a basis adjustment. We’re going to use these theories to deem the bypass trust as funded. Well, we’ll see how that all plays out. The citations to some of the cases I mentioned are going to be available to you in the transcript. I encourage you to take a look at that. And when I’m not going to say if, I’m going to say when this problem comes upon your desk. There are some good ideas for you to think about in ways to go back and reconstruct these trusts. Thanks a lot. 

Margaret Van Houten: Thank you, Mickey, for this very informative explanation.

Citations:

• Est. of Richard v. Comm’r, TC Memo 2012-173 (2012) (shares excluded from H’s estate as having vested in bypass trust)
• Stansbury v. United States, 543 F. Supp. 154, (N.D. Ill. 1982), aff’d735 F.2d 1367 (7th Cir. 1984) (state law finding that decedent held assets in constructive trust for sister-in-law warranted excluding the assets from decedent’s estate for estate tax purposes)
• Estate of Bailey v. Commissioner, 741 F.2d 801, (5th Cir. 1984) (claim against mother’s estate for current value of property she withheld from son’s inheritance was deductible by her estate for estate tax purposes)
• Estate of Hester(unreported case from Ohio) (failure of children to file timely claim against father’s estate in accordance with Ohio claims procedure precluded them from deducting the claim for federal estate tax purposes.

 

You may also be interested in:

• Deemed Realization of Gains on Gratuitous Transfers
• Confronting the Challenges of Tax Reform

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