Malpractice Coverage – VI

Malpractice Coverage – VI

Don’t Leave Home Without It

(sixth in a series on design and implementation issues)                   

One problem encountered in setting up long term charitable trusts is the impatience of income and remainder beneficiaries.  All too often, there is an adversarial relationship among the various beneficiaries of split interest trusts, each perceiving their needs as more important than the other, forcing the trustee to weigh competing requests and desires.  The nature of a charitable lead or remainder trust often pits trustees interested in growth against those beneficiaries attracted to secure or tax-free income.  Just as often, there are trustees who are more concerned about preserving capital while beneficiaries may be adamant about increasing income by investing in more diversified growth assets.

One of the solutions is to spend more time conveying the concept and responsibilities of the parties involved, especially in testamentary plans.  In a court case described below, it’s apparent that the decedent didn’t do a very good job briefing his heirs about what he expected to accomplish with his estate plan.  A little prior planning would have avoided a lot of discord and the expense of taking the estate’s trustees to court.  It never hurts to have everyone rowing in the same direction when these trusts are put to work.

Estate of Rowe, 712 NYS 2^nd 662 (App. Div. 3^rd Dept., 8/10/2000).  Mr. Rowe created an 8% CLAT in 1989 by transferring 30,000 shares of IBM stock worth nearly $3.5 million designed to pay a fixed dollar annuity to charity for 15 years, and then pass the remaining balance to his nieces.  Unfortunately, the IBM stock took a hit in the market shortly after the trust was funded and the trust declined in value, but was still required to pay out the same annual charitable distribution.  Mr. Rowe’s bank, acting as trustee, decided to hold the stock with the expectation that it would recover its value.  The trustees counted on “Big Blue”, its history of paying dividends and consistent growth.  The bank argued in court that a sale in a down market would recognize a loss in value of the trust’s portfolio, while waiting until the stock recovered before it was sold would protect the trust better.  The nieces argued that a prudent trustee should have immediately diversified the trust (usually an obligation in a prudent investor state, but remember that a CLT is a tax-paying trust, so this has to be done carefully).  As a side note, appreciated stock sold by a CLT would trigger potential capital gains taxes and with the compression of federal trust tax rates, any ordinary income in excess of $8,650 is taxed at 39.6%. 

The court ruled in favor of the nieces and ordered the bank trustees to refund its commissions and pay $630,249 in damages.  The bank appealed, arguing that the trust still had ten years to operate and any “loss of value” was only a hypothetical paper loss and no damages could possibly be assessed until the trust terminated and remaining assets passed to the beneficiaries.  The trustees lost; although in hindsight, the IBM stock did rebound and the trust would have done quite well if it had been left alone. 

The goal of a non-grantor CLT is to fund charitable gifts and pass assets efficiently to heirs, so selecting solid growth assets is critical to success.   However, great strategic planning would give full consideration to any assets transferred into an irrevocable charitable trust, and diversification is critical to surviving market volatility. 

Good estate planning should address the potential disputes, map the responsibilities for all the parties in the process and avoid costly conflicts.  The secret to success is often good communication.