BILL ANALYSIS Ó SB 1265 Page 1 Date of Hearing: June 28, 2016 ASSEMBLY COMMITTEE ON JUDICIARY Mark Stone, Chair SB 1265 (Moorlach) - As Introduced February 18, 2016 PROPOSED CONSENT SENATE VOTE: 38-0 SUBJECT: MARITAL DEDUCTION TRUSTS KEY ISSUE: IN ORDER TO BETTER PROTECT DECEDENTS AND THEIR SURVIVING FAMILIES FROM POTENTIAL TAX LIABILITY ASSOCIATED WITH INARTFUL DRAFTING OF ESTATE PLANS, SHOULD THE MARITAL DEDUCTION TRUSTS SAVING STATUTE BE UPDATED to be CONSISTENT WITH FEDERAL LAW? SYNOPSIS This non-controversial and technical bill updates provisions relating to marital deduction trusts savings statute by updating its references to federal law and deleting outdated provisions limiting a qualified terminable interest property trust. This bill is sponsored by the Executive Committee of the Trust and Estates Section of the State Bar of California (TEXCOM) and has no opposition on file. SB 1265 Page 2 SUMMARY: Updates the marital deduction trusts savings statute to reflect definitions used under federal law. Specifically, this bill: 1)Provides that the term income shall be construed in a manner consistent with subdivision (b) of Section 2056 and subdivision (f) of Section 2523 of the Internal Revenue Code, and shall include a unitrust payment or other allocation of income determined pursuant to a reasonable apportionment of total investment return that meets the requirements of Section 643 of the Internal Revenue Code and the regulations adopted pursuant to that statute. 2)Deletes provisions relating to qualified terminable interest property that specify that 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. EXISTING LAW: 1)Defines a marital deduction to mean the federal estate tax deduction allowed for transfers under Section 2056 of the Internal Revenue Code or the federal gift deduction allowed for transfers under Section 2523 of the Internal Revenue Code. (Probate Code Section 21520. Unless otherwise stated, all further statutory references are to the Probate Code.) 2)Defines a marital deduction gift as a transfer of property that is intended to qualify for the unlimited federal estate tax deduction or the federal gift tax deduction, as provided. (Ibid.) SB 1265 Page 3 3)Provides that if a marital deduction is made in trust, the following must apply: a) The transferor's spouse is the only beneficiary of income or principal of the marital deduction property as long as the spouse is alive. Further provides that nothing in this requirement precludes 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. b) 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 except as otherwise provided. c) The transferor's spouse has the right to require that the trustee make unproductive marital deduction productive or to convert it into productive property within a reasonable time. (Section 21524.) 4)Requires a trustee to administer the trust according to the trust or as provided by law unless the trust provides otherwise. (Section 16000.) 5)Requires the trustee to administer the trust with reasonable care, skill, and caution under the circumstances then prevailing that a prudent person acting in a like capacity would use in the conduct of an enterprise as provided. (Section 16040.) 6)Provides that a trustee, in making and implementing investment decisions, has a duty to diversify the investments of the trust unless under the circumstances it is prudent not to do so. (Section 16048.) SB 1265 Page 4 FISCAL EFFECT: As currently in print this bill is keyed non-fiscal. COMMENTS: When it comes to estate planning, federal tax law has a significant impact in how a decedent may transfer his or her property. A decedent seeking to minimize estate taxes on his or her gross estate upon death might consult an estate planner to maximize appropriate exclusions, deductions, and other calculations. In the other words: the lower the taxable estate, the lower the estate tax. Although California does not have an estate tax, federal law imposes an estate tax if a decedent's gross estate is valued at more than the established filing threshold for the year of the decedent's death. The filing threshold for 2016 is $5,450,000. The federal marital deduction can be used to shield a decedent's estate from tax liability. Commonly, a decedent who is married can reduce his or her gross estate by relying upon the marital deduction under federal law. The marital deduction, which is currently unlimited, allows a decedent to transfer all of his or her property to a surviving spouse without being immediately subject to wealth transfer taxes; generally, the estate tax is deferred until the death of the surviving spouse if any tax is applied at all. The policy reason behind this deduction is "based on the idea that transfers between spouses should not be subject to tax because spouses are considered one economic unit." (See Dukeminier & Sitkoff, Wills, Trusts, and Estates Trust (9th ed. 2013) p. 959.) Depending on the intent of the decedent, different trusts may be created. Since California is a community property state, joint trusts are common. According the sponsor, it is also common for a joint trust to have various subtrusts to help manage the assets upon the death of one of the spouses. To maximize the federal marital deduction benefit described above, a joint trust SB 1265 Page 5 may include a marital deduction trust as a subtrust. Practically speaking, upon death of the decedent, the decedent's property in the joint trust is divided, and the marital deduction gift flows to a marital deduction trust, where-depending on the type of marital deduction trust-income and/or principal may be distributed to support the surviving spouse during his or her life. One of the most common marital deduction trusts is a qualified terminable interest property trust (QTIP). Under a QTIP trust, income is paid to the surviving spouse for life and any remainder is directed to the other beneficiaries. To protect decedents from problems arising out of inartful estate drafting, California has enacted a backstop to federal law for marital deduction trusts. Generally, the federal Internal Revenue Code establishes the tax rules on transferring property between spouses during life and at death. (See 26 U.S.C. Sections 2056, 2523.) Accordingly, estate planners will look to federal law to ensure that estate plans are correctly drafted to help their clients. However, since the risk of tax liability caused by potential inartful drafting is significant, California has enacted a statutory backstop that mirrors federal law aimed at guarding decedents, surviving spouses, and their families from significant tax liabilities. Consequently, Probate Code Section 21524 establishes default provisions for marital deduction gifts made in trust. However, this savings clause becomes ineffective if it is inconsistent with federal law. In support of the bill, the author writes: 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 SB 1265 Page 6 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. However, this backstop is only effective if the marital deduction trust savings statute mirrors the requirements under federal law. 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. However, 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. Summary of this bill: Essentially, this bill adopts the definition of income as it is defined under federal law, and also defines it to include income from a unitrust payment or other allocation of income determined to be a reasonable apportionment of total investment return under the Internal Revenue Code. This bill also deletes an unnecessary provision of law relating to qualified terminable interest property that has been recognized under common law. This bill adopts the definition of income to include income from a unitrust payment. A unitrust is a type of trust that distributes a fixed amount or percentage of the trust property to the income beneficiary. Because a unitrust does not distinguish between income and principle, it provides more flexibility to a trustee to diversify and invest for a total return. In addition to adopting the definition of income SB 1265 Page 7 adopted under the Internal Revenue Code, this bill reasonable includes a unitrust payment or other allocation of income determined to be a reasonable apportionment of total investment return that meets the requirements of Section 643 of the Internal Revenue Code as income. Given that this definition is already recognized under federal law, this adoption would improve the state's marital deduction savings clause. This bill seeks to conform the current marital deduction savings statute to existing law by deleting outdated provisions. Probate Code Section 21524 (d) provides that in the case of a QTIP trust, upon the termination of the interest of the surviving spouse, all remaining accrued or undistributed income shall pass to the estate of the surviving spouse unless the instrument provides a different disposition that qualifies for the marital deduction. According to TEXCOM, when the statute was enacted in 1990, federal tax law was unsettled as to whether undistributed income that had accrued prior to the surviving spouse's death had to flow to the surviving spouse's estate in order for a trust to qualify for the marital deduction. TEXCOM states that it is now well-settled that a trust qualifies for the marital deduction without mandating distribution of that income. (See Estate of Howard v. Commissioner (9th Cir. 1990) 910 F.2d 633.) Accordingly, this bill justifiably deletes the outdated reference and removes the unnecessary limitations on a QTIP trust. REGISTERED SUPPORT / OPPOSITION: Support Executive Committee of the Trusts and Estates Section of the State Bar of California (sponsor) SB 1265 Page 8 Opposition None on file Analysis Prepared by:Eric Dang / JUD. / (916) 319-2334