BILL ANALYSIS Ó ----------------------------------------------------------------- |SENATE RULES COMMITTEE | SB 1265| |Office of Senate Floor Analyses | | |(916) 651-1520 Fax: (916) | | |327-4478 | | ----------------------------------------------------------------- CONSENT Bill No: SB 1265 Author: Moorlach (R) Introduced:2/18/16 Vote: 21 SENATE JUDICIARY COMMITTEE: 6-0, 5/3/16 AYES: Jackson, Moorlach, Anderson, Leno, Monning, Wieckowski NO VOTE RECORDED: Hertzberg SUBJECT: Marital deduction trusts SOURCE: Executive Committee of the Trusts and Estates Section of the State Bar California DIGEST: This bill updates 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. ANALYSIS: Existing law: 1)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, unless otherwise exempt as specified, for purposes of tax imposed on property transferrable from a decedent's estate. SB 1265 Page 2 2)Limits the application of the marital deduction in the case of a life estate or other terminable interests. 3)Requires the formula to be applied to eliminate or to reduce to the maximum extent possible the federal estate tax if an instrument includes a formula intended to eliminate the federal estate tax. 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. 4)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. Existing law also defines material deduction gift to mean a transfer of property that is intended to qualify for the material deduction. 5)Does not apply the marital deduction trust savings statute to a trust that otherwise qualifies for the marital deduction under federal law. 6)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. 1)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 SB 1265 Page 3 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 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.) 1)Requires a trust to be administered, as specified, with due regard to the respective interests of defined income beneficiaries and defined remainder beneficiaries. 2)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. This bill: 1)Requires 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 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. SB 1265 Page 4 2)Deletes provisions made inoperative pursuant to changes in the Internal Revenue Code. 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 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 SB 1265 Page 5 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 updates the marital deduction trust savings statute in accordance with federal tax laws and regulations. Comments 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. 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 SB 1265 Page 6 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 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. 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. This bill repeals 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 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 SB 1265 Page 7 of the children. Related/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. FISCAL EFFECT: Appropriation: No Fiscal Com.:NoLocal: No SUPPORT: (Verified5/5/16) Executive Committee of the Trusts and Estates Section of the State Bar of California (source) OPPOSITION: (Verified5/5/16) None received ARGUMENTS IN SUPPORT: 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 SB 1265 Page 8 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. Prepared by:Margie Estrada / JUD. / (916) 651-4113 5/6/16 14:26:31 **** END ****