With the proliferation of family trusts over the last two decades, and the misinformation provided by some promoters of these trusts, tax practitioners now have to deal with more cases of unfunded—or stale—trusts. 

Most of these involve the typical family trust, which has not funded any of the sub-trusts called for in the trust document after the first spouse has died. Many times the problem comes to light after several years of ignoring the trust or when the surviving spouse dies. 

This situation can put tax practitioners in a very difficult position, especially if they have been the adviser for a long time and the issues were never addressed.

Whatever the circumstances leading up to this point, the tax practitioner is faced with several dilemmas, such as the filing of fiduciary tax returns; allocation of trust assets between sub-trust or beneficiaries; and the necessity to deal with all the trust beneficiaries.

The CalCPA Committee on Taxation put the question of unfunded sub-trusts to the IRS at its annual liaison meeting in November 2002. The IRS indicated that its position would depend on the particular facts and circumstances.

Still, the IRS did provide some insight into its thinking on these issues. 

First, the IRS indicated that in funding these trusts, the allocation of assets to each trust should be fairly representative, so that each side gets a representative share of appreciating and non-appreciating assets.

The IRS also weighed in on filing delinquent fiduciary income tax returns. If the surviving spouse has included all of the income on their returns and there would be no change in the overall tax, then the IRS would not require these returns to be filed. 

The IRS did not indicate at what level of materiality it would require administrative trust tax returns to be filed. With regard to returns for the sub-trusts, such as the survivor’s, by-pass and marital trusts, the IRS wanted these returns filed based on facts and not on a “deemed” funding date. Therefore, in most cases, until the sub-trusts are actually funded, fiduciary tax returns should not be filed. 

The last question put to the IRS had to do with the surviving spouse dying before the funding of the by-pass trust. The Committee on Taxation’s concern was that the failure to fund the by-pass trust could cause the inclusion of all family trust assets in the estate of the second-to-die.

The IRS response again was that it depends on the particular facts and circumstance. 

However, the IRS did indicate that if there were no transfers prior to the death of the second spouse—and a fair representation of the appreciable versus non-appreciable property still can be obtained—then it may be possible to still fund the by-pass trust.

In funding these sub-trusts, the tax practitioner needs to understand the formula being used.

The use of a true-worth, pecuniary funding formula has tax implications when funding the pecuniary trust with appreciated or Income in Respect of the Decedent assets.

Care needs to be taken in selecting which assets to place into these various trusts. Funding a pecuniary bequest with appreciated or IRD assets will cause capital gain or ordinary income to be recognized by the family trust at the date of funding. 

By the time these trusts are funded, several years could have passed since the first spouse’s death, and the appraisals and values used at date-of-death, or the alternative valuation date, are no longer current.

The trustee should get new appraisals for the trust’s assets prior to the funding of the sub-trusts. This is critical because if the by-pass trust is over-funded due to inaccurate values, it could cause a tax to be paid on the Form 706 of the first spouse to die.

What’s more, the over-funded portion could be brought back into the estate of the surviving spouse.

In addition to these tax considerations, there are several other serious problems caused by the lack of timely funding. 

For the trustee—normally the surviving spouse—there is a breach of fiduciary responsibilities to the trust beneficiaries. It is advisable at this point to discuss the problem with the beneficiaries and attempt to get an agreement on a funding solution. 

Further, the trustee and their professional advisers should be careful in selecting the assets for funding the various trusts. Their decisions could affect the income allocated to the income beneficiary and the assets ultimately going to the remainder beneficiaries. This could be important if each trust has different remainder beneficiaries.

Involving the beneficiaries in the process could protect the surviving spouse, trustee and professional advisers from future lawsuits, should the family dynamics change after funding the sub-trusts.

If faced with an unfunded trust situation, it’s essential to educate your clients about the problems they face and insist that funding be done as soon as possible.

The longer the problem continues, the greater the chance that the problems can grow.

John Woodford, CPAis a partner at Grass Valley-based Robertson, Woodford & Summers, LLP and a member of CalCPA’s Estate Planning Committee. He can be reached at john@abacus7.com. For more on the Estate Planning Committee, visit www.calcpaweb.org/estate.