Wednesday, November 30, 2016
Patrick J. Duffey recently published an Article entitled, Dude, Where’s My Income? Examining Property Conversion Clauses in Marital Trusts, 51 Real Prop. Tr. & Est. L.J. 1 (2016). Provided below is an abstract of the Article:
The “Marital Deduction” matters. As an instrument of public policy, it is a powerful statement by Congress that spouses are a single taxable unit. As a planning tool it is a flexible technique, subject to no dollar limitation, with few technical restrictions, and with relatively simple practical application. For these reasons and others, it is widely used both during life and at death. In fact, there is no single deduction that is more significant. It is, simply, the foundation of an estate plan for the quintessential married couple.
But there is a peculiar, technical, and inflexible requirement of the Marital Deduction that, though extraordinarily important, is often overlooked by planners who largely rely on form documents to provide the necessary “boilerplate” provisions required for modern trusts: spousal conversion of unproductive property. This required power, often effectuated by a trust provision (a Property Conversion Clause), operates to fulfill the substance behind the command found in the Treasury Regulations (Regulations) that trustees must distribute all income from trust property in order to qualify for the Marital Deduction. When a trust holds a significant amount of unproductive property, that rule is rendered toothless without a power, exercisable by the spouse, to force the trustee to sell that property and purchase income-producing property in its place.
The questions raised by the spousal conversion power are numerous. When, if ever, does underproductive property become “unproductive” for purposes of the Regulations? What timing requirements are associated with the spouse's right of conversion? When will local law suffice to fulfill this requirement? What portion of trust assets must be unproductive in order to trigger application of the conversion requirement? What portion of trust assets must be unproductive in order to trigger application of a given Property Conversion Clause? May the trustee use alternate methods to make adequate distributions to the spouse while preserving otherwise desirable (or unmarketable) trust property?
The Regulations, case law, and Internal Revenue Service (Service) provide guidance in this area that implicate these issues and more. All are worthy of comment. Although this Article does address those discrete issues, its central focus is the inexorably interrelated dichotomy between the role of Property Conversion Clauses as check-the-box requirements for a tax deduction and as substantive provisions in millions of trusts that hold billions of dollars in endlessly varying assets. This duality is examined both from the perspective of a planner looking to draft such a clause and the perspective of an administrator struggling with a flawed or missing provision. Towards that end, this Article includes sample provisions and practical suggestions drawn from analysis of state and federal law, including statutes, regulations, published guidance, and case law.