BILL ANALYSIS Ó
SENATE JUDICIARY COMMITTEE
Senator Hannah-Beth Jackson, Chair
2015-2016 Regular Session
SB 1265 (Moorlach)
Version: February 18, 2016
Hearing Date: May 3, 2016
Fiscal: No
Urgency: No
TMW
SUBJECT
Marital deduction trusts
DESCRIPTION
This bill would update provisions relating to marital deduction
trusts for cross-references to applicable federal laws relating
to qualified terminable interest property and provide for a
unitrust payment or other allocation of income determined
pursuant to a reasonable apportionment of total investment
return, as specified.
BACKGROUND
Although California does not currently have an estate tax,
current federal law imposes an estate tax on all the assets of
United States citizens and residents. An estate tax at the rate
of 40 percent is assessed on the value of assets above the
estate exclusion ($5,340,000 for year 2014, indexed annually for
inflation). Federal law allows a decedent's estate an unlimited
estate tax marital deduction for property that passes to a
surviving spouse. Qualifying for the estate tax marital
deduction is a primary goal of many estate plans because that
qualification may reduce or eliminate the estate tax due on the
death of the first spouse, and defers payment of that tax, if at
all, until the death of the surviving spouse. Gifts in trust
for the surviving spouse may qualify for the estate tax marital
deduction, subject to the requirements in federal tax
regulations.
Probate Code Section 21524 (marital deduction trust savings
statute) was enacted as a statutory backstop to marital
deduction trusts drafted under California law. That statute
grafts the federal regulatory requirements onto marital
deduction trusts that may not otherwise qualify due to unartful
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drafting. The purpose of the statute is to rescue possibly
defective marital deduction trusts and ensure their
qualification for the federal estate tax marital deduction, and,
thereby, reduce or eliminate the estate tax on a decedent's
estate. To accomplish this rescue mission, the marital
deduction trust savings statute should mirror the requirements
for marital deduction trusts in federal tax regulations.
Federal law regarding marital deduction gifts has changed in the
nearly 25 years since the enactment of the marital deduction
trust savings statute, without any substantive change to that
statute. Two important changes have been made to federal tax
regulations in the interim: (1) a revised definition of income
for a qualifying marital deduction trust that reflects modern
portfolio theory and investment approaches; and (2) evolving
case law and government announcements regarding income of a
marital deduction trust that is accrued, but undistributed,
prior to the death of the surviving spouse.
Federal regulations now allow a marital deduction trust to pay a
unitrust amount, which may be less than actual net income, but
still qualify for the estate tax marital deduction. This bill
would update the marital deduction trust savings statute in
accordance with federal tax laws and regulations.
CHANGES TO EXISTING LAW
Existing federal law , unless otherwise exempt as specified, for
purposes of tax imposed on property transferrable from a
decedent's estate, authorizes the value of the taxable estate to
be determined by deducting from the value of the gross estate an
amount equal to the value of any interest in property which
passes or has passed from the decedent to his surviving spouse,
but only to the extent that such interest is included in
determining the value of the gross estate. (26 U.S.C Sec.
2056(a).)
Existing federal law limits the application of the marital
deduction in the case of a life estate or other terminable
interests. (26 U.S.C. Sec. 2056(b).)
Existing law , if an instrument includes a formula intended to
eliminate the federal estate tax, requires the formula to be
applied to eliminate or to reduce to the maximum extent possible
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the federal estate tax. (Prob. Code Sec. 21503(a).) If an
instrument includes a formula that refers to a maximum fraction
or amount that will not result in a federal estate tax, the
formula is construed to refer to the maximum fraction or amount
that will not result in or increase the federal estate tax.
(Prob. Code Sec. 21503(b).)
Existing law defines "marital deduction" to mean the federal
estate tax deduction allowed for transfers, as specified, or the
federal gift tax deduction allowed for transfers, as specified.
(Prob. Code Sec. 21520(a).) Existing law also defines material
deduction gift to mean a transfer of property that is intended
to qualify for the material deduction. (Prob. Code Sec.
21520(b).)
Existing law does not apply the marital deduction trust savings
statute to a trust that otherwise qualifies for the marital
deduction under federal law. (Prob. Code Sec. 21521.)
Existing law provides that if an instrument contains a marital
deduction gift:
the provisions of the instrument, including any power, duty,
or discretionary authority given to a fiduciary, shall be
construed to comply with the marital deduction provisions of
the Internal Revenue Code;
the fiduciary shall not take any action or have any power that
impairs the deduction as applied to the marital deduction
gift; and
the marital deduction gift may be satisfied only with property
that qualifies for the marital deduction. (Prob. Code Sec.
21522.)
Existing law provides that if a marital deduction gift is made
in trust, and does not otherwise qualify as a marital deduction
trust under federal law, each of the following provisions
applies to the marital deduction trust:
the transferor's spouse is the only beneficiary of income or
principal of the marital deduction property as long as the
spouse is alive; however, this provision does not preclude
exercise by the transferor's spouse of a power of appointment
included in a trust that qualifies as a general power of
appointment marital deduction trust;
as specified, the transferor's spouse is entitled to all of
the income of the marital deduction property not less
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frequently than annually, as long as the spouse is alive;
the transferor's spouse has the right to require that the
trustee of the trust make unproductive marital deduction
property productive or to convert it into productive property
within a reasonable time; and
notwithstanding the limitations on undistributed income under
the Uniform Principal and Income Act (UPIA), in the case of
qualified terminable interest property, as defined under
federal law, on termination of the interest of the
transferor's spouse in the trust, all of the remaining accrued
or undistributed income shall pass to the estate of the
transferor's spouse, unless the instrument provides a
different disposition that qualifies for the marital
deduction. (Prob. Code Sec. 21524.)
Existing law , the UPIA, requires a trust to be administered, as
specified, with due regard to the respective interests of
defined income beneficiaries and defined remainder
beneficiaries. (Prob. Code Sec. 16320 et seq.)
Existing law defines "undistributed income" to mean net income
received before the date on which income interest ends; however,
the term does not include an item of income or expense that is
due or accrued or net income that has been added or is required
to be added to principal by the trust. (Prob. Code Sec. 16347.)
This bill would require the income from a marital deduction
trust to which the transferor's spouse is entitled to be
construed in a manner consistent with the federal limitations on
life estate or other terminable interest, as specified, and
would include a unitrust payment or other allocation of income
determined pursuant to a reasonable apportionment of total
investment return that meets the requirements of federal laws
and regulations, as specified.
This bill would delete provisions made inoperative pursuant to
changes in the Internal Revenue Code.
COMMENT
1. Stated need for the bill
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The author writes:
Probate Code [S]ection 21524 was originally enacted in 1990 as
a savings clause. If a marital trust in a document fails to
meet the federal requirements, perhaps due to outdated or
unartful drafting, [S]ection 21524 will import those
requirements and give the surviving spouse this important tax
benefit.
Since 1990 changes in federal law have made qualification for
the [marital] trust more flexible. This bill updates Probate
Code [S]ection 21524 for two changes in federal law since the
time of its enactment. The first change is to allow trusts
that give the surviving spouse a unitrust payment to qualify
for the marital deduction. The bill makes a second technical
change to conform [S]ection 21524 to existing federal law.
Subsection (d) regarding the payment of undistributed income
is deleted because it does not reflect current federal estate
tax law and the California Principal and Income Act. This
change will clarify the law and bring the statute up to date.
2. Providing for unitrust payments
A unitrust is a type of trust in which a fixed percentage of the
trust property is paid annually to the trust's income
beneficiary. The California Uniform Principal and Income Act
(UPIA) provides trust accounting rules regarding distributions
of principal and income to trust beneficiaries and, among other
things, provides limitations on unitrust conversions and
payouts. (Prob. Code Sec. 16320 et seq.) Under California's
marital deduction trust savings statute, the surviving spouse is
entitled to all of the income of the marital deduction property
transferred from the deceased spouse at least once a year.
(Prob. Code Sec. 21524(b).) This bill would define "income" to
include a unitrust payment or other allocation of income
determined pursuant to a reasonable apportionment of total
investment return, as specified, and require the income to be
construed in a manner consistent with federal law, as specified.
As noted by the author, Treasury Regulation Section
20.2056(b)-5(f) defines when the surviving spouse is deemed to
be entitled to the entire income of a trust, thereby qualifying
that trust or interest in a trust for the estate tax marital
deduction. The author further notes that regulation was
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modified on January 2, 2004, by Treasury Decision 9102 to
reflect changes in the definition of trust accounting income
under state laws, and the concurrent change in federal income
tax law under Internal Revenue Code Section 643 and applicable
federal regulations. That modified regulation allows the income
payment determined under the trustee's adjustment power or a
unitrust payment to qualify as a marital deduction gift.
The Executive Committee of the Trusts and Estates Section of the
State Bar (TEXCOM), sponsor, contends that since the original
intent of the marital deduction trust savings statute appears to
be to preserve the marital deduction, it should mirror the
definition of income in current federal tax regulations. The
marital deduction trust savings statute currently provides a
default rule that a trustee must distribute all of the income,
without reference to unitrust payments. TEXCOM asserts that
without specific reference to unitrust payments, "income" under
the existing statute may be construed in accordance with the
definition of income in Probate Code Section 16324, or
traditional notions of income. Accordingly, this bill, by
incorporating unitrust payments and other allocations of income
into the meaning of "income" under the marital deduction trust
savings statute, seeks to harmonize the savings statute with
current federal tax regulations and the UPIA.
3. Updating marital deduction trust provisions to reflect changes
in federal tax law
Existing law, with respect to qualified terminable interest
property and subject to limitations on undistributed income
under the UPIA, requires all of the remaining accrued or
undistributed income to pass to the surviving spouse's estate,
unless the transferring spouse's testamentary instrument
provided for a different disposition that qualifies for the
marital deduction. (Prob. Code Sec. 21524(d).) This bill would
repeal those provisions.
A qualified terminable interest property trust (QTIP trust) is
one established by the transferring spouse for the benefit of
beneficiaries (other than the surviving spouse) to receive
assets from a marital deduction trust after the surviving spouse
dies. An example of the use of a QTIP trust is where the
transferor spouse is married to a second spouse, who is the
surviving spouse. The transferor spouse had children from his
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or her first marriage. The transferor spouse wants to provide
for the surviving spouse, as well as the transferor's children
from the first marriage. The transferor spouse establishes a
marital deduction trust for the benefit of the surviving spouse
until his or her death, at which time the assets in the marital
deduction trust are transferred to a QTIP trust for the benefit
of the children.
According to TEXCOM, when the marital deduction trust savings
statute was enacted in 1990, federal tax law was unsettled as to
whether a surviving spouse's estate had to receive income that
was accrued or undistributed prior to the surviving spouse's
death to qualify a marital deduction trust for the estate tax
marital deduction. TEXCOM asserts that the savings statute took
the conservative approach to avoid inadvertent disqualification,
and mandated distribution of such "stub" income (income
accumulated between the last income payment and the surviving
spouse's death). TEXCOM notes that Section 21524(d) appears to
be a relic that attempted to address the decision in Estate of
Howard (1988) 91 T.C. No. 26, that a QTIP trust did not qualify
for the estate tax marital deduction because the trust
provisions did not provide for payment of accumulated income to
the surviving spouse's estate.
TEXCOM states that the Ninth Circuit Court of Appeals, in Estate
of Howard v. Commr. (1990) 910 F.2d 633, ruled that an income
interest does not fail to constitute a qualifying marital
interest solely because undistributed income is not paid to the
estate of the surviving spouse. TEXCOM argues that this case
and subsequent acquiescence by the government effectively
overrule Section 21524(d).
As such, TEXCOM contends that the law is now settled in the
Ninth Circuit that a trust qualifies for the marital deduction
without a mandatory distribution of that income. Additionally,
TEXCOM argues that the UPIA provides for a default distribution
of undistributed income to the beneficiary's estate.
Accordingly, this bill seeks to conform the marital deduction
trust savings statute to current federal law by removing
outdated limitations on qualified terminable interest property.
Staff notes that Probate Code Section 21521, which, in effect,
defines the types of marital deduction trusts that require the
application of the marital deduction trust savings statute, also
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appears to be outdated due to its cross-reference to a
subdivision that no longer exists in the code of federal
regulations. Accordingly, the author may wish to consider
amending this bill to update the cross-reference to current
federal law.
Support : None Known
Opposition : None Known
HISTORY
Source : Executive Committee of the Trusts and Estates Section
of the State Bar of California
Related Pending Legislation : None Known
Prior Legislation :
AB 846 (Ackerman, Chapter 145, Statutes of 1999) enacted the
Uniform Principal and Income Act, and, among other things,
revised the cross-reference to the new Act under the marital
deduction trust savings statute.
AB 759 (Friedman, Chapter 79, Statutes of 1990) revised and
recast the Probate Code and, among other things, continued the
marital deduction gifts and trust provisions under prior law.
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