Accountants’ Handbook Special Industries and Special Topics 10th Edition_17

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41 18 ESTATES AND TRUSTS • EGTRRA has modiﬁed the income tax rules relating to the step-up in basis discussed above be- ginning in 2010. To make up for the loss of revenue from the estate tax repeal, a new “carryover basis” regime will become effective. Under this regime, property acquired from a decedent will have a basis equal to the lesser of the decedent’s basis or the fair market value of the property on the date of the decedent’s death. A total $4.3 million of property may, however, still qualify to use the current step-up in basis rules. Up to $3 million of property passing to a surviving spouse, plus up to an ag- gregate of $1,300,000 of property passing to any beneﬁciaries will qualify for a step-up in basis. These new rules sunset after 2010, resulting in the modiﬁed carryover basis rules ending and the cur- rent step-up in basis rules being reinstated in 2011. So just in case, we should all start keeping better records in order to accurately reﬂect our tax basis in the assets we hold currently. Estates must now make quarterly estimated tax payments in the same manner as individuals, ex- cept that an estate is exempt from making such payments during its ﬁrst two taxable years. Accord- ingly, the penalties for underpayment of income tax are applicable to ﬁduciaries. Some states also tax the income of estates, and the representative must see to it that such state statutes are complied with. 41.2 ACCOUNTING FOR ESTATES (a) GOVERNING CONCEPTS. The general concepts governing the accounting for decedent’s es- tates are for the most part similar to those applicable to trusts, but there are some differences. The un- derlying equation expressing the accounting relationship is assets accountability. However, the representative is concerned not with the long-term management of property for beneﬁciaries, but rather with the payment of debts and the orderly realization and distribution of the estate properties. The col- lection and the distribution of income are incidental to the main function of the estate’s ﬁduciary. Whenever an estate accounting is prepared, a reconciliation of the gross estate as ﬁnally deter- mined for estate tax purposes should be made with the schedule of principal received at the date by the representative. Every difference should be explainable. (i) Accounting Period. The accounting period of the estate is determined by the dates set by the ﬁduciary or by the court for intermediate and ﬁnal accountings; nevertheless, the books must be closed at least once a year for income tax purposes. (ii) Principal and Income. Unless otherwise provided for, the rules outlined below for the trustee should generally be followed by the representative in the allocation of receipts and dis- bursements to principal and income. Such distinctions, although not called for under the will, are frequently mandated by requirements of estate, inheritance, and income tax laws and regulations. (iii) Treatment of Liabilities. The representative picks up only the inventory of assets of the decedent at the inception of the estate. Claims against the estate, after presentation and review, are paid by the representative and are recorded as “debts paid.” The payment of such debts reduces in proportion the accountability of the representative. (b) RECORD-KEEPING SYSTEM. No special type of bookkeeping system is prescribed by law, but a complete record of all transactions must be kept with sufﬁcient detail to meet the requirements of the courts and of the estate, inheritance, and income tax returns. Much of the information may be in memorandum form outside of the formal accounting system. The federal estate tax law requires information regarding assets beyond those ordinarily under the control of the representative (e.g., real estate). Such information must be assembled in appropriate form by the representative, who has responsibility for the estate tax return. (i) Journals. A single multicolumn journal is usually sufﬁcient. It should incorporate cash re- ceipts, cash disbursements, and asset inventory adjustments. Further, it is important to note and keep track of the distinction between principal and income.
41.3 TRUSTS AND TRUSTEES—LEGAL BACKGROUND 41 19 • (ii) Operation of a Going Business. If the decedent was the individual proprietor of a going business and if the court or the will instructs the administrator or executor to continue the oper- ation of the business, the bookkeeping procedure becomes somewhat complicated. The books of the business may be continued as distinct from the general estate books, or the transactions of the business may be combined with other estate transactions in one set of records. The best pro- cedure, if the business is of at least moderate size, is to keep the operations of the business in a separate set of books and to set up a controlling accounting in the general books of the executor or administrator. As soon as the representative takes charge of the business, the assets should be inventoried and the books closed, normally as of the date of death. The liabilities should be transferred to the list of debts to be paid by the representative, leaving the assets, the operating expenses and income, and the subsequently incurred liabilities to be recorded in the books of the company. An account should be opened in the books of the business for the representative that will show the same amount as the con- trolling account for the business in the books of the representative. (iii) Final Accounting. The “ﬁnal” accounting is the report to the court of the handling of the es- tate affairs by the representative, if required. It presents, among other things, a plan for the distribu- tion of the remainder of the assets of the estate and a computation of the commission due the representative for his services. If the court approves the report, it issues a decree putting the propos- als into effect. (c) REPORTS OF EXECUTOR OR ADMINISTRATOR. The form of the reports of the ﬁduciary will vary according to the requirements of the court and to the character of the estate. In general, however, the representative “charges” himself with all of the property received and subsequently dis- covered plus gains on realizations, and “credits” (or discharges) himself with all disbursements for debts paid, expenses paid, legacies distributed, and realization losses. Each major item in the charge and discharge statement should be supported by a schedule showing detailed information. At any time during the administration of the estate, the excess of “charges” over “credits” should be repre- sented by property in the custody of the ﬁduciary. It may be necessary to show the market value of property delivered to a legatee or trustee at the date of delivery, in which case the investment sched- ule will show the increase or decrease on distribution of assets, as well as from sales. The income schedule, when needed, should be organized to show the total income from each investment, the ex- penses chargeable against income, and the distribution of the remainder. Exhibit 41.2 is typical of the charge-and-discharge statement, each item being supported by a schedule. 41.3 TRUSTS AND TRUSTEES—LEGAL BACKGROUND (a) NATURE AND TYPES OF TRUSTS. The trust relationship exists whenever one person holds property for the beneﬁt of another. The trustee holds legal title to the property for the beneﬁt of the beneﬁciary, or cestui que trust. The person from whom trust property is received is known as the grantor, donor, settler, creator, or trustor. An express trust is one in which the trustee, beneﬁciary, subject matter, and method of administra- tion have been explicitly indicated. An implied trust may be created whether language of an instrument indicates the desirability of a trust but does not specify the details or when the trust relationship is as- sumed in order to prevent the results of fraud, breach of trust, or undue inﬂuence. The terms “con- structive,” “resulting,” and “involuntary” trust are sometimes applied to such situations. A testamentary trust is one created by a will. A living trust, or trust inter vivos, is created to take effect during the grantor’s lifetime. Trusts are sometimes created by court order, as in the case of a guardianship. A private trust is created for the beneﬁt of particular individuals, while a public or charitable trust is for the beneﬁt of an indeﬁnite class of persons. Charitable trusts are discussed in Chapter 33.
41 20 ESTATES AND TRUSTS • ESTATE OF JOHN SMITH Charge and Discharge Statement A. L. White, Executor From April 7, 20XX, to December 15, 20XX First, as to Principal: The Executor charges himself as follows: With amount of inventory at the date of death, April 7, Schedule A $xxx With amount of assets discovered subsequent to date of death, Schedule B xxx With gain on realization of assets, Schedule C xxx $xxx The Executor credits himself as follows: With loss on realization of assets, Schedule C $xxx With amount paid for funeral and administrative expenses, Schedule D xxx With amount paid on debts of the estate, Schedule F xxx With distributions to legatees, Schedule G xxx xxx Leaving a balance of principal, Schedule C, of $xxx Second, as to Income: The Executor charges himself as follows: With amount of income received, Schedule H $xxx The Executor credits himself as follows: With amount of administrative expenses chargeable to income, Schedule D $xxx With distribution of income to legatees, Schedule I xxx xxx Leaving a balance of income, Schedule J xxx Leaving a balance of principal and income of $xxx Balance of principal and income to be distributed to those entitled thereto, subject to the deduction of the Executor’s commissions, legal fees, and the expenses of this accounting, Schedule K. Exhibit 41.2 Sample charge and discharge statement. A simple trust directs the trustee to distribute the entire net income of the trust to the named beneﬁ- ciary. A complex trust gives the trustee the discretionary authority to distribute or accumulate the trust net income to or on behalf of the named beneﬁciary. In some instances, the trust may start off as com- plex and then convert to a simple trust upon the happening of a speciﬁed event, that is, the beneﬁciary’s attainment of age 21 or 25. A grantor trust exists when both the grantor and beneﬁciary are the same individual. A grantor trust may be implied if the grantor retains sufﬁcient rights or controls over disposition of trust in- come and/or principal. When a grantor establishes an irrevocable trust inter vivos and transfers assets to it, the grantor has made a completed gift of the property transferred for income, gift, and estate tax purposes. Should the grantor retain any of the rights enumerated in IRC Sections 671 to 679, however, the grantor will be continue to be treated as the grantor or owner of the trust property for income tax purposes only. The grantor will be taxed on the income of the trust instead of the trust or trust beneﬁciaries (even if they receive a distribution of this trust income). This is re- ferred to as an intentionally defective grantor trust (IDGT) and can be used as an effective estate and ﬁnancial planning tool.
41.3 TRUSTS AND TRUSTEES—LEGAL BACKGROUND 41 21 • A trust may include a spendthrift clause that prohibits the beneﬁciary from assigning his interest before receiving it or prevents creditors from enforcing their claims against the income or principal of a trust fund, or both. Trusts are often used for business purposes, as when property is transferred by a deed of trust instead of a mortgage, when trustees are appointed to hold title and perform other functions under a bond issue, or when assets are assigned to a trustee for the beneﬁt of creditors. Bankruptcy and insolvency are discussed in Chapter 43. (i) Limitations on Private Trusts. A public trust may be established for an indeﬁnite period, but a trust may not suspend indeﬁnitely the power of anyone to transfer the trust property. The common law rule, otherwise known as the Rule against Perpetuities, limits the duration of a private trust to 21 years after the death of some person who is living when the trust is created. Another common limita- tion in certain states is “two lives in being” at the origin of the trust. Accumulation of the income of a trust is also restricted by state law. A common provision, for ex- ample, is that in the case of a trust created for the beneﬁt of a minor, the income can be accumulated only during the minority of the beneﬁciary. Even the income of a charitable trust cannot be accumu- lated for an “unreasonable” period. (ii) Revocation of Trusts. A completed trust cannot be revoked without the consent of all the ben- eﬁciaries unless the right to revoke has been expressly reserved by the grantor. Trusts are therefore sometimes classiﬁed as “revocable” or “irrevocable.” (b) APPOINTMENT AND REMOVAL OF TRUSTEES. In general, anyone competent to make a will or a contract is competent to create a trust. The trustee must be one who is capable of taking and holding property and who has the legal capacity and natural ability to execute the trust. (i) Choice of Trustee. The decedent’s will usually names the trustee for a testamentary trust. A grantor who is establishing an inter vivos trust will usually appoint one or more of the following to act as trustee: a relative; his professional adviser, that is, attorney, accountant, broker; a business as- sociate; or an institutional entity, such as a bank or trust company. Each type of trustee has its pros and cons; however, the most important concern is not to choose a trustee that will cause adverse in- come tax consequences. (ii) Methods of Appointment. Seven of the means by which trustees are appointed are: 1. By deed or declaring of trust. The creator of the trust names the trustees in the instrument. 2. By will. The same person may be both executor and trustee under a will, but this dual capacity should be clearly indicated. 3. By agreement. 4. By the court. The court will appoint a trustee when a trust may fail for lack of a trustee, when a trustee refuses to serve or has died, or when a vacancy from any cause exists and no other means have been provided for ﬁling the vacancy. 5. By implication of law. 6. By self-perpetuating boards. When vacancies occur, they are ﬁled by the remaining members of the board. 7. By the exercise of a power of appointment. The instrument creating the trust may give the remaining trustees, beneﬁciaries, or any other person the power to appoint a trustee to ﬁll a vacancy. Speciﬁc instructions should be included in the instrument as to the situation establishing a vacancy, the persons who may be appointed, and the manner of making the appointment.
41 22 ESTATES AND TRUSTS • (iii) Acceptance or Disclaimer. Acceptance of an appointment as trustee may be made by posi- tive statement, by qualifying as executor if the appointment is by will, by the acceptance of property of the trust, or by other acts from which acceptance may be presumed. An individual may refuse to accept an appointment as a trustee and should execute and deliver a disclaimer expressing rejection of the appointment. (iv) Resignation of Trustee. According to the Restatement of the Law of Trusts 2d (1 Trusts A.L.I. 234): A trustee who has accepted the trust cannot resign except (a) with the permission of a proper court; or (b) in accordance with the terms of the trust; or (c) with the consent of all the beneﬁciaries, if they have capacity to give such consent. (v) Removal of Trustee. The court has power to remove a trustee and appoint a successor under certain circumstances. Scott cites, among others, the following six grounds upon which trustees have been removed: 1. Failure to exercise discretion 2. Self-dealing 3. Failure to keep proper accounts, and mingling with trustee’s own funds 4. Incompetency and neglect of duty 5. Conversion of trust property Refusal to obey orders of the court 5 6. (c) POWERS AND DUTIES OF TRUSTEES. The powers of trustees are obtained both from the provisions and implications of the instrument creating the trust and from the general laws pertain- ing to the trust relationship. The instrument may either expand or restrict the general powers, ex- cept that it may not relieve the trustee from liability for gross negligence, bad faith, or dishonesty. The powers of a trustee may be either (1) imperative or mandatory or (2) permissive or discre- tionary. In other words, they must either be exercised deﬁnitely and positively within a given length of time or upon the occurrence of some contingency, or they may be exercised at the dis- cretion of the trustee. (i) General Powers. The nine general powers of a trustee, which include all necessary incidental powers, are: 1. To take and retain possession of the trust property 2. To invest trust funds so as to yield a fair income 3. To sell and reinvest when necessary 4. To sell and convey real estate when necessary to carry out the provisions of the trust 5. To release real estate so that it may earn income 6. To pay for repairs, taxes, and other such expenses in connection with trust property 7. To sue or defend suits when necessary 8. To make contracts that are necessary to carry out the purposes of the trust 9. To pay over and distribute the trust property to those entitled to it 5 A. W. Scott, The Law of Trusts, 4th ed. (Little Brown, 1987), 1995 Supplement.
41.3 TRUSTS AND TRUSTEES—LEGAL BACKGROUND 41 23 • The trustee secures possession of the trust property and holds title in his own name. All debtors should be notiﬁed of the change in ownership of claims against them in order to hold them directly liable to the trustee. All debts due the trust estate should be collected promptly. Trust property must be kept separate from the property of anyone else. The trustee will be liable for any loss occurring as a re- sult of their mingling of funds or other property. An exception is usually made when a trust company is acting as trustee; it may deposit cash in trust funds with itself or may mingle various trust funds and de- posit same with designated depositories. (ii) Duties. The 14 duties of the trustee are outlined by Scott as follows: 1. To administer the trust as long as he continues as trustee 2. To administer the trust solely in the interest of the beneﬁciary (the duty of loyalty as a ﬁduciary) 3. Not to delegate to others the performance of acts which the trustee sought personally to perform 4. To keep clear and accurate accounts 5. To give to beneﬁciaries upon their request complete and accurate information as to the admin- istration of the trust 6. To exercise such care and skill as a man of ordinary prudence would exercise in dealing with his own property; and if the trustee possesses greater skill than that of an ordinary prudent man, he must exercise the skill he has 7. To take reasonable steps to secure control of trust property and to keep control of it 8. To use care and skill to preserve the trust property. The standard of care and skill is that of a man of ordinary prudence 9. To take reasonable steps to realize on claims which he holds in trust and to defend claims of third persons against the trust estate 10. To keep the trust property separate from his own property and separate from property held upon other trusts; and to designate trust property as property of the trust 11. To refrain in ordinary circumstances from lending trust money without security 12. To invest trust funds so that they will be productive of income 13. To pay the net income of the trust to the beneﬁciary at reasonable intervals; and if there are two or more beneﬁciaries he must deal with them impartially 14. Where there are several trustees, it is the duty of each of them, unless otherwise provided by the trust instrument, to participate in the administration of the trust, and each trustee must use reasonable care to prevent the others from committing a breach of trust 6 (d) PROPER TRUST INVESTMENTS. The trustee is under a duty to invest funds in such a way as to receive an income without improperly risking the loss of the principal. The only general rule as to investment is that the trustee is under a duty to make such investments as a prudent man (the “pru- dent man” rule or “Massachusetts” rule) would make of his own property, having primarily in view the preservation of the estate and the amount and regularity of the income to be derived. In some states (“legal-list” states), the legislatures tell trustees in what they must or may invest funds unless the terms of the trust otherwise provide. Eight kinds of investments that are almost universally condemned are summarized by Scott as follows: 1. Purchase of securities on margin 2. Purchase of speculative shares of stock 3. Purchase of bonds selling at large discount because of uncertainty of repayment at maturity 4. Purchase of securities in new and untried enterprises 6 Id.
41 24 ESTATES AND TRUSTS • 5. Use of trust property in the carrying on of a trade or business, even though it is not an untried enterprise 6. Purchase of land or other things for the purpose of resale, unless authorized by the terms of the trust 7. Purchase of second and other junior mortgages 8. Making unsecured loans to individuals or ﬁrms or corporations 7 Three types of investments that are almost universally permitted include: 1. Bonds of the United States or of the state or of a municipality thereof 2. First mortgages on land 3. Corporate bonds of a high investment grade In 1990, the American Law Institute adopted the Uniform Prudent Investor Act (the UPIA) and published it in the Restatement of the Law of Trusts, 3rd ed. The UPIA incorporates a new Prudent Investor Rule that has since been adopted by a signiﬁcant majority of the states in a form that is sim- ilar to, or somewhat comparable to, the scope of these new rules. The Restatement embodies three main themes: 1. Although it is thought that a trustee may not delegate any of his duties, other than certain minis- terial duties, this position is relaxed in that a trustee should, or even must, delegate investment authority to skilled professionals should they lack the required expertise or experience to properly manage the assets within the trust. 2. The costs incurred by the trustee in performing his duties must be reasonable. 3. A trustee is now charged with the responsibility for maintaining the trust portfolio so as to keep pace with inﬂation. In other words, trustees should invest for the maximum total return on investment without regard for distinctions between principal and income. This is referred to as modern portfolio theory, permitting trustees to invest for capital appreciation as well as current income in the form of interest, dividends, rents, and so forth. (e) TRUSTEE’S PERSONAL LIABILITIES AND LIABILITY FOR ACTS OF CO-TRUSTEE. A trustee is liable to the beneﬁciary for failure to fulﬁll his duties under the statutes, general rules of eq- uity, or the provisions of the trust indenture. A trustee must be particularly circumspect in all matters affecting his own property or beneﬁt. He is personally liable for torts committed by himself or his agents and, unless his agreement states otherwise, is personally liable on all contracts made on behalf of the trust. A trustee is not responsible for loss by theft, embezzlement, or accident if he has taken all the pre- cautions that a careful businessman takes in guarding his own property, and if he is strictly following his line of duty as a trustee. If a trustee is not insolvent and mixes trust property with his own, the beneﬁciary may take the whole, leaving the trustee to prove his own part. If the trustee is insolvent, the beneﬁciary shares with the other creditors unless deﬁnite property can be identiﬁed as belonging to the trust. Interest will be charged against a trustee who has mingled trust funds with his own. If bank deposits are made in the individual name of the trustee, he will be treated as a guarantor of the solvency of the bank, even though he uses care in his choice of the bank and has not in any way misused the funds. In general, a trustee is not liable for losses caused by the default or negligence of a co-trustee un- less he has cooperated with the trustee who is at fault, or has known of the trustee’s misconduct and has not taken any steps to prevent it. If, however, each trustee should have interested himself in the matter in question, such as the proper investment of funds, each would be responsible even though he took no part in or knew nothing of the misconduct. All trustees should act together in handling the trust property and should apply to the court for instructions in case they cannot agree. Unanimity is 7 Id.
41.3 TRUSTS AND TRUSTEES—LEGAL BACKGROUND 41 25 • usually required for all important decisions in the case of private trusts, but a majority of a board of trustees may act for a charitable trust. In certain circumstances, a trustee may become personally liable for the unpaid estate taxes of a decedent under the theory of transferee liability. Ordinarily, the beneﬁciary of an estate or trust is ultimately liable for any unpaid estate or gift taxes due on the transfer. The liability is equal to the value of the property received by the recipient as of the date of transfer. A review of IRC Sections 6324 and 6901, primarily, is in order. For example, the trustee of an inter vivos trust that is included in the gross estate for estate tax purposes could result in the trustee being personally liable, as opposed to the beneﬁciaries, for payment of any attributable estate taxes. Certain trust distributions trigger the GSTT, discussed in Subsection 41.1(l), requiring the trustee to pay this tax. As a result of this possibility, a trustee should consider maintaining a reserve until he is satisﬁed that all such taxes are satisﬁed. Upon making distributions, the trustee should also consider requesting that the beneﬁciaries indemnify him for any taxes that may be assessed against him. (f) GUARDIANS. If a person is incompetent to manage his own property because of a disability such as infancy or mental incompetency, a guardian will be appointed by the probate or other appro- priate court. The court must approve the appointment of a guardian by will. A guardian is a trustee in the strictest sense of the term. He is directly under the supervision of the court. If possible, only the income from the property should be used for the maintenance and education of the beneﬁciary; per- mission must be granted by the court before the principal can be used for this purpose. Any sale of real estate must be authorized by the court. A guardian should have the authorization of the court or the direction of a will before paying money to a minor or to anyone for the minor; otherwise he may be compelled to pay the amount again when the minor becomes of age. (g) TESTAMENTARY TRUSTEE. The work of the trustee appointed by a will begins when the ex- ecutor sets aside the trust fund out of the estate assets. One person may serve as both executor and trustee under a will. The testamentary trustee has slightly more freedom in handling the funds than does the executor, and his responsibility may be made less rigorous by provisions of the will. He holds, invests, and cares for the property, and disposes of it or its income as directed by the will. A trustee should have speciﬁc authority of a will or the court, or the consent of everyone inter- ested, before carrying on a business. If there are several executors, one can act alone, but trustees must act jointly. (h) COMPENSATION OF TRUSTEES. Trustees are usually allowed compensation for their work, either by provision of the trust instrument or by statute. The statutory provision is usually a graduated percentage of the funds handled. A trustee is entitled to be repaid expenditures reasonably and properly incurred in the care of trust property. The compensation is usually allocated to principal and income in accordance with the spe- ciﬁc provision of the indenture or as provided by statute or rules of law. (i) RIGHTS OF BENEFICIARY. The beneﬁciary has an equitable title to the trust property, that is, he can bring suit in a court of equity to enforce his rights and to prevent misuse of the property by the trustee. Unless the instrument by which the trust is created provides otherwise, the beneﬁciary, if of age, can sell or otherwise dispose of his equitable estate in the property. The beneﬁciary has the right to inspect and take copies of all papers, records, and data bearing on the administration of the trust property and income that are in the hands of the trustee. The beneﬁ- ciary may have an accounting ordered whenever there is any reason for suspicion, or any failure to allow inspection or to make satisfactory reports and statements. Whenever it seems advisable, a court of equity will order an accounting. The beneﬁciary may have an injunction issued to restrain the trustee from proceeding with any unauthorized action, if such action will result in irremediable damage. The beneﬁciary may present a
41 26 ESTATES AND TRUSTS • petition to the court for the removal of a trustee but must be able to prove bad faith, negligence, lack of ability, or other such cause for the removal. The trustee is entitled to a formal trial. The beneﬁciary can, if it is possible to do so, follow the trust property and have it subjected to the trust, even if a substitution has been made for the original property, unless it comes into the hands of an innocent holder for value. If the trust property cannot be traced or is in the hands of an innocent holder for value, the beneﬁciary may bring action against the trustee in a court of equity for breach of trust. If the beneﬁciary is of age and mentally competent, he may approve or ratify acts of the trustee that would otherwise be a violation of the trustee’s duties or responsibilities. (j) DISTINCTION BETWEEN PRINCIPAL AND INCOME. Probably the most difﬁcult problem of the trustee is to differentiate between principal (corpus) and income. The intention of the creator of the trust is binding if it can be ascertained, but in the absence of instructions to the contrary the general legal rules must be followed. The life tenant (the present beneﬁciary) is entitled to the net income and the remainderman (the fu- ture beneﬁciary) to the principal, as legally determined. The principal is the property itself that consti- tutes the trust fund, and the income is the accumulation of funds and other property arising from the investment or other use of the trust principal. Increases or decreases in the value of the assets that con- stitute the trust fund affect only the principal. The income determined under these rules is not always the same as taxable income or income as determined by generally accepted accounting principles (GAAP). The life tenant is entitled to receive only the net income from all sources for the entire term of his tenancy. He is not allowed to select the income from only those investments that are lucrative. The existing rules regarding principal and income are based on the Uniform Principal and In- come Act of 1962 (UPAIA). These rules are, to a great extent, at odds with a trustee’s ability to comply with the modern portfolio theory contained in the Uniform Prudent Investor Act described earlier. As one commentator noted,8 the incompatibility of the UPIA and UPAIA were reconciled in 1997 by the National Conference of Commissioners on Uniform State Laws. The revised UPAIA accomplishes: this result by way of an adjustment power conferred upon trustees, pursuant to which the trustee is empowered to allocate traditional trust accounting income (e.g., interest, dividends, rents) to prin- cipal and perhaps more importantly, to allocate to income what is typically considered principal. Thus, a trustee can increase the amount currently distributable to a beneﬁciary, for example, by al- locating capital appreciation to income. Some states (New York, New Jersey, Delaware, and Mis- souri) added an alternative approach to their respective adoptions of the new UPAIA: an optional unitrust provision. Instead of being limited to the annual accounting income actually realized by the trust in any year, the current beneﬁciary of a unitrust is entitled to an amount equal to a ﬁxed percentage of the value of the trust’s assets determined annually. As a result, the trustee is free to invest for total return absent the need to produce sufﬁcient income to satisfy the current beneﬁ- ciary. By adopting the unitrust alternative, the trustee is relieved of the obligation to determine each year whether an equitable adjustment is warranted. In addition, the unitrust approach pro- vides the current beneﬁciary with the certainty of knowing what he or she is entitled to each year instead of having to await the trustee’s possible exercise of its discretionary adjustment power. All of the statutes give testators and grantors the ability to opt out of the statutory language by deﬁning how they want principal and income to be recognized and charged. The UPAIA in effect in a given state is operative only if the trust document or will is silent. The U.S. Treasury Depart- ment and Internal Revenue Service have recognized this new trend in trust accounting and have is- sued Proposed Treasury Regulation Section 1.643(a) through (d). 8 The commentator is Linda B. Hirschon, Esq., of Greenberg Tauig LLP, New York, in an updated ver- sion of her article “The Unitrust Alternative, A Framework for Total Return Investing,” Tax Manage- ment Memorandum, Vol. 42, No. 23 (November 5, 2001). The updated version of the article appeared in a NYS Bar Association CLE publication entitled, “New York’s New Principal and Income Act, the Power of Adjustment Between Principal and Income and the New 4% Unitrust Option.”
41.3 TRUSTS AND TRUSTEES—LEGAL BACKGROUND 41 27 • The following describes the principal and income rules under the UPAIA of 1962. Trustees are advised to seek to professional counseling to determine whether the 1962 or 1997 revised rules are in effect in their respective state. (i) Receipts of Principal. The following ten receipts of cash or other property have been held to be part of the corpus of the trust and therefore to belong to the remainderman or persons entitled to the corpus: 1. Interest accrued to the beginning of the trust. Bond coupons are not apportioned in the ab- sence of a statute providing for such a division. 2. Rent accrued to the beginning of the trust. Under the common law, rent was not apportioned according to the time expired. 3. Excess of selling price of trust assets over their value in the original inventory or over its pur- chase price. Appreciation, in general, belongs to the trust corpus. 4. The value of assets existing at the time the original inventory was taken but not included in the inventory. 5. Dividends (see discussion below). 6. Proceeds of the sale of stock rights. 7. Proﬁt from the completion of executory contracts of a decedent. 8. Proﬁts earned prior to the beginning of the trust on the operations of a partnership or sole proprietorship. 9. Insurance money received for a ﬁre that occurred prior to the date of the beginning of the trust, or after that date if the property is in the hands of the trustee for the beneﬁt of the trust in general. 10. If trust property is mortgaged, the proceeds may be said to be principal assets, although there is no increase in the equity of the remainderman. (ii) Disbursements of Principal. The following 12 payments, distribution, and exhaustion of as- sets have been held to be chargeable to the corpus: 1. Excess of the inventory value or purchase price of an asset over the amount realized from its sale. 2. Payment of debts owed, including accruals, at the date of the beginning of the trust. 3. Real estate taxes assessed on or before the date of the beginning of the trust. In the case of special assessments made during the administration of the trust, the remainderman may pay the assessment and the life tenant may be charged interest thereon annually during the life of the trust, or else some other equitable adjustment will be made between them. 4. Any expenditures that result in improvements of the property, except those made voluntarily by a life tenant for his own beneﬁt, and all expenditures on newly acquired property that are necessary to put it into condition to rent or use. 5. Wood on the property that the life tenant uses for fuel, fences, and other similar purposes. The life tenant may operate mines, wells, quarries, and so on, that have been opened and op- erated on the property. 6. Losses due to casualty and theft of general trust assets. 7. Expenses of administration except those directly pertaining to the administration of income. For example, legal expenses incurred in defending the trust estate are chargeable to princi- pal; however, the expenses of litigation in an action to protest only the income are payable out of income. 8. Trustee’s commissions in respect to the receipts or disbursements out of principal. Commis- sions computed on income are ordinarily payable out of income. 9. Brokerage fees and other expenses for changing investments should generally be chargeable to principal, since they are a part of the cost of purchase or sale.
41 28 ESTATES AND TRUSTS • 10. Income taxes on gains made from disposition of principal assets. 11. Carrying charges on unproductive real estate, unless the terms of the trust direct the trustee to retain the property even though it is unproductive. 12. Cost of improvements to property held as part of the principal. (iii) Receipts of Income. The following six receipts have been held to be income and to belong to the life tenants or persons entitled to the income: 1. Interest, rent, and so on, accruing after the date of the beginning of the trust. The proceeds of a foreclosed mortgage may be apportionable between principal and income. Interest includes the increment in securities issued at a discount. 2. Increase in value of investments made by the trustee from accumulated undistributed income. 3. Dividends (see discussion below). 4. Crops harvested during the trust. 5. Royalties or other income from operation of mines, quarries, or wells that were made pro- ductive prior to the beginning of the trust, or were developed or leased in cooperating with the remainderman. 6. Net proﬁt from the operation of a business. (iv) Disbursements of or Charges to Income. The following eight items have been held to be chargeable against the income of the trust: 1. Interest payable, accruing during the life of the trust 2. Any expenses incurred in earning or collecting income, caring for trust property, or preserving its value, and an appropriate share of administration fees and expenses 3. Income tax except those levied on gains from sale of principal assets 4. Premiums on trustee’s bond 5. Provision for amortization of wasting property, including leasehold interests, royalties, oil and gas wells, machinery, and farm implements (see discussion of depreciation below) 6. Provision for amortization of improvements to trust property when such improvements will not outlive the duration of the trust 7. Losses of property due to the negligence of the life tenant 8. Losses due to casualty and theft of income assets (k) PRINCIPAL AND INCOME—SPECIAL PROBLEMS. The distinction between principal and income also involves a consideration of such problems as unproductive property, accruals, divi- dends, bond premium and discount, and depreciation and depletion. (i) Unproductive Property. When the trustee is required to sell unproductive property and the sale is delayed, the net proceeds of the sale should be apportioned between principal and income. The net proceeds are allocated by determining the sum that, with interest thereon at the current rate of return on trust investments, would equal the net proceeds, and the sum so de- termined is treated as principal and the balance as income (Restatement of Trusts 2d, § 241). Apportionment between principal and income is generally applicable to real estate, but it has been applied in the case of personal property also. It does not matter whether the prop- erty is sold at a gain or a loss. (ii) Accruals. There are two dates at which the matter of accruals becomes signiﬁcant. The ﬁrst is the date at which the trust begins. Income and expenses accrued at that date belong to the corpus of the estate. The second date is the one when the life interest terminates. Income and expenses accrued at that date belong to the life tenant or his estate.
41.3 TRUSTS AND TRUSTEES—LEGAL BACKGROUND 41 29 • Larsen and Mosich provide a summarization of the general rule of accrual as applied to certain items, from which the following is taken: 1. Interest. Interest accrued on receivables and investments at the date the trust is established is considered part of the trust corpus. Exceptions are interest on (a) savings accounts when the in- terest is paid only if the deposit remains until the end of the interest period, and (b) coupon bonds when the payment is contingent upon the owner presenting the coupon, in which case the date of receipt is controlling. Similar rules apply to the accrual of interest expense. 2. Rent. The accrual of rent prior to the beginning of the trust is considered by many states as a portion of a trust corpus. Any rent accruing between the date of the establishment of the trust and the termination of the tenancy belongs to the income beneﬁciary. Rent expense is handled similarly. 3. Dividends. Ordinary cash dividends are not divisible. If the dividend is declared and the date of record has passed before the trust is created, the dividend is a part of the corpus. Otherwise it is considered income to the trust. A stock dividend is treated in the same manner in many states. . . . [For a discussion of special treatment of cash and stock dividends under the Massa- chusetts and Pennsylvania rules, see below.] 4. Property taxes. Taxes which have been levied on trust property prior to the beginning of the trust are charges against the principal. Any taxes assessed on the basis of trust property held for the beneﬁt of the income beneﬁciary are chargeable against income. Special assessments made during the administration of the trust are usually paid by the remainderman, although in some cases where the assessment is for improvements which beneﬁt the life tenant, a part or all of the assess- ment may be charged against income. When the assessment is paid from the corpus, interest on the funds advance may be charged against income. 5. Proﬁts. Income earned by a partnership or proprietorship does not accrue. The income which is earned prior to the creation of the trust is considered a part of the principal of the trust. In many cases a partnership is dissolved upon the death of a partner, and there may be no income earned after the trust is established. In the event that the business continues by speciﬁc direction of the grantor or provision of the partnership agreement, any income earned after the trust is created is income of the trust. 6. Executory contracts. Any proﬁts earned on the completion of an executory contract by the trustee is an addition to the principal of the trust. 7. Livestock and crops. Any livestock born during the tenancy under the trust is considered in- come, except to the extent that the herd must be maintained as directed by the grantor, in which case the increase must be divided between principal and income in a manner which honors this intention. If the principal includes land, any crops harvested during this tenancy are considered income of the trust. 8. Premium returns. Any return of premium or dividend on insurance policies which was paid prior to the creation of the trust is a part of the principal. This is considered realization of assets. 9. Royalties. Royalties or other income from the operation of mines or other natural resource de- posits which were made operative before the trust was created or which were developed in co- operation with the remainderman are income to the trust.9 (iii) Dividends. The determination of whether a dividend is principal or income involves a con- sideration of applicable state laws. Ordinary cash dividends declared during the period of the trust belong to the income beneﬁciary. An ordinary stock dividend is usually regarded as income except in states that follow the Massachusetts rule. This rule holds that all cash dividends are treated as income and that stock dividends are entirely principal. Some states follow the Pennsylvania rule, which holds that, in regard to extraordinary divi- dends, it is not the form of the dividend but its source that determines whether and to what extent it 9 E. J. Larsen and A. N. Mosich, Modern Advanced Accounting, 6th ed. (Shephards McGraw-Hill, New York, 1994).
41 30 ESTATES AND TRUSTS • is income or principal. Generally, under this rule extraordinary dividends are income if declared out of earnings accruing to the corporation during the period of the trust, but they are principal if de- clared out of earnings accruing prior to the creation of the trust. Thus, if such dividends cause the book value of the corporation’s stock to be reduced below the book value that existed at the creation of the trust, that portion of the dividend equivalent to the impairment of book value is principal and only the remainder is income. The present Pennsylvania law provides that stock dividends of 6% or less “shall be deemed income” unless the instrument provides to the contrary. Although there is still wide diversity among the courts and state statutes in the apportionment of corporate distributions, Scott points out that the recent trend has been in favor of the Massachusetts rule.10 The Uniform Principal and Income Act (Uniform Laws Annotated, Vol. 7B, § 5) follows the essence of the Massachusetts rule in treating cash and other property dividends as income and stock dividends as principal. (iv) Premium and Discount on Bonds. The necessity of accumulating bond discount or amor- tizing bond premium in order to determine the correct interest income still gives rise to a great deal of confusion in trust and estate administration. In general, it appears that most courts support the amortization of premium on bonds purchased by the trustee, but there has been little or no support of the accumulation of discount. Any difference between the inventory value and the face value of the bonds taken over by the trustee is usually treated as an adjustment of principal. In the event of redemption before maturity, it has been held that the proper procedure is to amor- tize the premium to the date of redemption; the unamortized balance is a loss borne by principal. If a bonus is received, it should be credited to principal. Scott suggests: It might well be held that the whole matter [of amortizing premium and discount] should be left to the discretion of the trustee, and if he is not guilty of an abuse of discretion in unduly favoring some of the beneﬁciaries at the expense of the others, the court should not interpose its authority. This, of course, is the result reached where such discretion is expressly conferred upon the trustee by the terms of the trust.11 (v) Depreciation and Depletion. In determining whether provision must be made for deprecia- tion and depletion, it is essential to consider carefully the intentions and wishes of the trustor. If the trustor intended to give the full, undiminished income to the life tenant even though the principal would thereby be partially or completely exhausted, no deduction from income for depletion or de- preciation is allowed. If, however, there is an expressed or implied intention to preserve the principal intact, the trustee is required to withhold from income an amount sufﬁcient to maintain the original property of the trust. When the trustor’s intentions regarding the receipts from wasting property cannot be determined from the trust instrument, then, according to Scott, the inference is that the trustor did not intend that the life beneﬁciary should receive the whole income at the expense of the principal.12 Thus, when the trustee holds wasting property, including royalties, patents, mines, timberlands, machinery, and equipment, he is under a duty to make a provision for amortization of such property. The general rule has been applied to new buildings erected and improvements made by the trustee; however, the courts have generally held that buildings that were part of the trust estate at the beginning of the trust need not be depreciated. The courts have, in effect, refused to treat the buildings as wasting property. The trend appears to be in the direction of adopting principles of depreciation followed in account- ing practice. For example, the position taken in Section13 of the Revised Uniform Principal and In- come Act is that, with respect to charges against income and principal, there shall be: 10 Scott, The Law of Trusts. 11 Id. 12 Id.
41.4 ACCOUNTING FOR TRUSTS 41 31 • . . . a reasonable allowance for depreciation under generally accepted accounting principles, but no al- lowance shall be made for depreciation of that portion of any real property used by a beneﬁciary as a residence or for depreciation of any property held by the trustee on the effective date of this Act for which the trustee is not then making an allowance for depreciation. (l) TAX STATUS OF TRUST. Unless the trust qualiﬁes as an exempt organization (charitable, ed- ucational, etc.), or unless the income of the trust is taxable to the grantor (revocable, or grantor re- tains substantial dominion and control), the income of the trust is subject to the federal income tax in a manner similar to the case of an individual. In general, the trust is treated as a conduit for tax pur- poses and is allowed a deduction for its income that is distributed or distributable currently to the beneﬁciaries. The trust may also be subject to state income taxes, personal property taxes, and so on. A tax service should be consulted for the latest provisions and rulings as to deductions, credits, rates, and ﬁling requirements. It is important to note that although trusts and estates are taxed similarly, there are two major dif- ferences. Trusts must be operated on a calendar year basis, whereas estates may operate on a ﬁscal year, usually tied to the decedent’s date of death. Secondly, trusts must pay estimated taxes in the same fashion as individuals. Estates, on the other hand, are exempt from this requirement, but only for their ﬁrst two tax years. The impact of RRA ’93 (the Revenue Reconciliation Act of 1993) substantially compressed the income tax rates applicable to trusts and estates. Indexed from its original level effective for tax years beginning in 1993, trusts reach the top 38.6% marginal bracket at $9,200 of taxable income in 2002. Compare this to married individuals ﬁling jointly, for example, where the 38.6% top marginal bracket is not reached until taxable income exceeds $307,050 in 2002. That is quite a disparity. Trustees of existing trusts need to consider their responsibility to take this disparity into considera- tion when reviewing the mix of assets in the current trust portfolio and when exercising their discretion to make discretionary distributions of income. In certain cases, where older trusts were established with a different rate structure in mind, and where state law permits, a trustee may want to consider bringing a court proceeding to reform the terms of the trust accordingly. If the settlor is still alive, all of the beneﬁciaries are adults, and trust is irrevocable, it may be possible under state law, as it is in New York, to revoke the trust and create a new one if the gift tax cost is not excessive. (m) TERMINATION OF TRUST. A trust may be terminated by the fulﬁllment of its purpose or by the expiration of the period for which the trust was created. A trust may also be terminated under a power reserved by the grantor or by the consent of all beneﬁciaries unless continuance of the trust is necessary to carry out a material purpose for which it was created. When the trust is terminated, the trustee is discharged when he has transferred the property to those entitled to it according to the terms of the trust instrument. The trustee, to protect himself, may secure a formal release of all claims from all who receive any of the property and are competent to consent, may require a bond of indemnity from the beneﬁciaries, or may refuse to act without a de- cree of court. 41.4 ACCOUNTING FOR TRUSTS (a) GENERAL FEATURES. Generally, accounting for a trust is the same as accounting for an es- tate. The emphasis for a trust, however, is that principal or corpus versus income should be properly distinguished. Two interests, that is, current or life versus future or remainder, usually serve different parties. One party may have a current or income interest whereas another party holds a future or re- mainder interest. Therefore, allocation between principal and income is important. See discussion at Section 41.3(j) for an update on these issues. (i) Accounting Period. The accounting period for a trust depends somewhat on the nature of the trust and the provisions of the trust instrument. Reports may be required by the court or may be sub- mitted to other interested parties at various intervals during the life of the trust.
41 32 ESTATES AND TRUSTS • (ii) Recording Principal and Income. A careful distinction must be made between principal (corpus) and income in recording the transactions. The legal theory seems to be that the principal of a trust is not a certain amount of monetary value but is a certain group of assets that must be capable of isolation from the assets that compose the undistributed income. Actual separation of cash and in- vestments is difﬁcult because of such factors as accrued interest and amortization of bond premium and discount. Ordinarily it is sufﬁcient to keep one account for cash and one for each type of invest- ment, and to indicate the claims of the principal and income in the total. Accounts should be kept with the beneﬁciaries to show the amounts due and paid to each. The trustee should keep records that will meet both the requirements of the income tax law and regulations and the law relating to principal and income. There are apt to be conﬂicts at various points in the determination of taxable income and of income belonging to the life tenant. The only solution is to keep sufﬁciently detailed records so that all of the information is available for both pur- poses. In some cases, it may be necessary to prepare reconciliation schedules in order to keep a record of the differences between the income tax calculation of net income and the application of trust accounting principles of accounting income. See discussion at Section 41.3(j) for an update on these issues. (iii) Accounting for Multiple Trusts. Several trusts may be created by a single instrument, such as trusts originating through the provisions of a will, and a single trustee may have to keep his ac- counts so as to be able to prepare a report of the administration of the estate as a whole and also a separate report of each trust. (iv) Treatment of Liabilities. In some cases, trust property will be encumbered with an unpaid mortgage or other obligation of which the trustee must keep a record. It is also possible that in han- dling the business of the trust some liabilities will be incurred. These are usually current in character, and the entry made at the time of payment, charging the amount to an asset or expense account, is usually sufﬁcient. (b) RECORD-KEEPING SYSTEM. The bookkeeping system requirements for the trust, like those for any other enterprise, vary with the complexity of the situation. The trustee should keep a com- plete record of all transactions relating to the trust in order to protect himself, to make reports to the court, to prepare income tax returns, and to give the beneﬁciaries of the trust an adequate accounting. No special type of bookkeeping system is prescribed by law, but a complete record of all transactions must be kept in such a way that the reports required by the courts can be prepared. All records should be kept in permanent form and should be carefully preserved and ﬁled for possible future reference. (i) Journals. In a comparatively simple situation, one multicolumn journal may be satisfactory, but in most cases a set of various journals should be kept. (ii) Principal and Income Accounts. It is necessary to distinguish carefully between principal and income in the administration of trusts. The Trust Principal account and the Undistributed Trust Income account record the net worth or capital of the trust. It will usually be necessary to analyze those accounts for income tax purposes, just as equity is analyzed in corporation accounts to obtain all of the information required for the income tax return. There may be some conﬂicts between in- come as deﬁned by the law relating to the administration of trusts and taxable income as deﬁned by the income tax law and regulations. (iii) Opening Books of Account. If an inventory has been ﬁled with the court, such as an execu- tor’s or guardian’s inventory, the trustee must record the same values in his accounts. If no such in- ventory was ﬁled, the trustee should have one prepared that will serve as the basis of his property accounting. Whenever possible, the inventory should contain the same values as those required for income tax purposes in determining the gain or loss from the sale of property. In any case, a record of such values must be available.
41.5 SOURCES AND SUGGESTED REFERENCES 41 33 • (iv) Amortization of Bond Premium or Discount. When bonds are taken over in the inventory at more or less than their face value, the difference between the inventory value and the amount re- ceived at maturity is ordinarily treated as a loss or gain on realization; but when bonds are pur- chased at a premium or discount, the difference between the amount paid and the amount to be received at maturity should be treated as an adjustment of the interest earned and should be written off during the remaining life of the bond. If the amount is not large, the “straight-line” method may be used, that is, the total premium or discount is divided by the number of remaining interest pay- ments to obtain the amount to be written off at each interest date. If the amount is large, amortiza- tion tables may be used in which the effective rate of interest is applied to the present value of the bond to obtain the income due to the life tenant. (v) Depreciation. Except for buildings forming part of the inventory at the date of origin of the trust, or in trusts where contrary provisions were intended by the grantor, wasting assets, including buildings and equipment, should be preserved by reﬂecting depreciation as a charge to income, if al- lowed by the trust instrument or state law. Many states have no provision for depreciation. If all of the trust income is distributed to beneﬁciaries without regard for depreciation, the entire periodic deduction for depreciation is taken for income tax purposes by the beneﬁciaries, and the trustee has no occasion to record depreciation in his records. In all instances, the trustee should be guided by the provisions of the trust instrument or state law in his handling of depreciation. (vi) Payments of Expenses. A distinction must be made between expenses chargeable to princi- pal and income. In the absence of direction in the instrument, the ﬁduciary should rely on state law as to allocation of trust expenses. Generally if an expense is recurring each year, it is usually charged to income. It could also be allocable one-half to principal and one-half to income. If an expense is at- tributable to corpus, it should be charged to principal. If the expense was to maintain and collect in- come, then it should be charged to income. For example, capital gains are allocated to principal, and the income tax paid by the trustee on capital gains should also be charged to principal; however, when a bank assesses an annual fee for a custody account, the custody fee could be charged to in- come or split 50/50 between income and principal. (c) TRUSTEE’S REPORTS. Trustee’s reports vary in form and in frequency according to the na- ture and provisions of the trust, and whether it is being administered under the jurisdiction of a court. Moreover, the form of the report varies among jurisdictions. Before preparing the report, the ac- countant should ascertain from the court whether a particular form is required. The valuations to be used must always be the same as those appearing on the inventory unless speciﬁc permission has been granted to change them. If assets have been written off as worthless, they must nevertheless ap- pear in the new inventory without value. If income and principal cash accounts have been properly maintained, the balance of the undis- tributed income would be represented by an equal amount of cash in the bank. If speciﬁc investments have been made with the intention that the funds used were still to be considered as undistributed in- come, the assets acquired should be shown as assets belonging to the trust income account. The reports consist primarily of an analysis of the principal and income accounts. In addition, a statement showing the changes in the investments, an inventory of the property at the date of the re- port, and supporting schedules of various items will be required. A reconciliation of cash receipts and disbursements is also often prepared. 41.5 SOURCES AND SUGGESTED REFERENCES Denhardt, J.G., Jr., and Denhardt, J.W., Complete Guide to Trust Accounting and Trust Income Taxation. Pren- tice-Hall, Englewood Cliffs, NJ, 1977. Denhardt, J.G., Jr., and Grider, John D., Complete Guide to Estate Accounting and Taxes, 4th ed. Prentice-Hall, Englewood Cliffs, NJ, 1988.
41 34 ESTATES AND TRUSTS • ———, Complete Guide to Fiduciary Accounting. Prentice-Hall, Englewood Cliffs, NJ, 1981. Executors and Administrators, 31 Am Jur 2d (rev.), Lawyer’s Cooperative Publishing. Rochester, NY, 1989, April 1995 Cum. Suppl. Federal Taxes Weekly Alert, Effect of Death on an Individual’s Income Tax Attributes, November 16, 1995 Prac- tice Alert, Research Institute of America. Ferguson, M. Carr, Freeland, James J., and Ascher, Mark L., Federal Income Taxation of Estates, Trusts and Ben- eﬁciaries, 2nd ed. Little, Brown, Boston, 1993. Gillett, Mark R., and Stafford, Joel D., “Steps to Prepare and File Estate Tax Returns Effectively,” Estate Plan- ning, May/June 1995. Warren Gorham & Lamont. Harris, Ann C., “Proper Disposition if IRD Items Can Produce Tax Savings,” Estate Planning, September/ October 1994. Warren Gorham & Lamont. Harris, Homer I., Estates Practice Guide, 4th ed. Lawyer’s Cooperative Publishing, Rochester, NY, 1984, No- vember 1994 Suppl. Harrison, Louis S., “Coordinating Buy-Outs and Installment Payment of Estate Tax,” Estate Planning, May/June 1995. Warren Gorham & Lamont. Herr, Philip M., and Etkind, Steven M., “When and How an Interest in a Tax Shelter Should Be Disposed of Be- fore Death,” Estate Planning, September/October 1990. Warren Gorham & Lamont. Larsen, E. J., and Mosich, A. N., Modern Advanced Accounting, 6th ed. Shephards McGraw-Hill, New York, 1994. Nossman, Walter L., Wyatt, Joseph L., Jr. and McDaniel, James R., Trust Administration and Taxation, rev. 2nd ed. Matthew Bender, New York, 1988, August 1995 Cum. Suppl. Peschel, John L. and Spurgeon, Edward D., Federal Taxation of Trusts, Grantors and Beneﬁciaries, 2nd ed. War- ren, Gorham & Lamont, New York, 1989, 1995 Cum. Suppl. Restatement 3rd Trusts (Prudent Investor Rule) §§ 227-229. American Law Institute, 1990. Restatement, Second, Trusts. American Law Institute, 1959. Sages, Ronald A., “The Prudent Investor Rule and the Duty Not to Delegate,” Trust & Estates, May 1995. Schlesinger, Sanford J., and Weingast, Fran Tolins, “Income Taxation of Estates and Trust: New Planning Ideas,” Estate Planning, May/June 1995. Warren Gorham & Lamont. Scott, Austin Wakeman, The Law of Trusts, 4th ed. Little, Brown, Boston, 1987, 1995 Suppl. Share, Leslie A., “Domicile Is Key in Determining Transfer Tax of Non-Citizens,” Estate Planning, January/ February 1995. Warren Gorham & Lamont. Stephens, Richard B., Maxﬁeld, Guy B., Lind, Stephen A., and Calfee, Dennis A., Federal Estate and Gift Taxa- tion, 6th ed. Warren, Gorham & Lamont, New York, 1991, 1995 Cum. Suppl. No. 3. Stephenson, G. T., and Wiggins, Norman, Estates and Trusts, 5th ed. Appleton-Century-Crofts, New York, 1973. Tractenberg, Beth D., “Transferee Liability Can Reach Trustee as Well as a Beneﬁciary,” Estate Planning, Sep- tember/October 1994. Warren Gorham & Lamont. Trusts & Estates Staff, “Uniform Laws Provide a Road Map for Estate Planners,” Trust & Estates, May 1994. Trusts, 76 Am Jur 2d (rev.). Lawyer’s Cooperative Publishing, Rochester, NY, 1992, April 1995 Cum. Suppl. Turner, George M., Trust Administration and Fiduciary Responsibility, Shephards McGraw-Hill, New York, 1994. Uniform Principal and Income Act. American Laws Annotated, Vol. 7. Uniform Probate Code. American Laws Annotated, Vol. 8, 8A and 8B. Waggoner, Lawrence W., “The Revised Uniform Probate Code,” Trust & Estates, May 1994.
42 CHAPTER VALUATION OF NONPUBLIC COMPANIES Allyn A. Joyce Allyn A. Joyce & Co., Inc. Jacob P. Roosma, CPA Williamette Management Associates 42.1 DEFINITION OF VALUE 42.3 SPECIAL SITUATIONS 2 10 (a) Deﬁnition of Nonpublic 2 (a) Wholesale and Retail (b) Purposes for Valuations 2 Companies 10 (c) Fair Market Value 2 (b) Valuation of Service Companies 10 (c) Companies with Low 42.2 GENERAL PROCEDURE FOR Earnings 11 VALUATION 2 (d) Holding Companies 11 (a) Compile Background (e) Real Estate Companies 12 Information about the Company 2 (f) Companies with Nonoperating (b) Compile Financial Information Assets 12 Regarding the Company 3 (g) Life Insurance Proceeds 12 (c) Select Guideline Companies 3 (h) Companies with an (i) Compile Data on Extremely Strong Financial Guideline Companies 4 Position 12 (ii) Calculate Market Value (i) Preferred Stock 13 Ratios 4 (j) Employee Stock Ownership (d) Estimate Dividend-Paying Plans 15 Capacity 4 (k) Valuations for Marital (e) Judgmental Modiﬁcation of the Dissolutions 15 Valuation Ratios 5 (l) Restrictive Agreements 16 (f) Application of the Market (m) S Corporations 16 Value Ratios 6 (n) Start-Up Companies 16 (i) Discount for Lack of (o) Nonvoting Stock 16 Marketability 7 (p) Valuation of a Controlling (ii) Discount for Minority Interest 16 Interest 7 (q) Fifty Percent Interest 18 (g) Discounted Future Beneﬁts 42.4 COURT DECISIONS Approaches 8 ON VALUATION (h) Use of Formulas 9 ISSUES (i) Net Asset Value Approach 10 18 42 1 •
42 2 VALUATION OF NONPUBLIC COMPANIES • (d) Quantitative Considerations 22 42.5 SAMPLE CONDENSED (e) Application of the Valuation VALUATION ANALYSIS 18 Ratios 23 (a) Company Background 18 (b) Selection of Guideline Companies 19 42.6 SOURCES AND SUGGESTED (c) Qualitative Considerations 21 REFERENCES 27 42.1 DEFINITION OF VALUE (a) DEFINITION OF NONPUBLIC. A public company is one whose common stock has wide- spread ownership and investment interest and such active trading that market quotations ordinarily represent fair market value. In contrast, the common stock of a nonpublic company generally has concentrated ownership and such few trades that the transactions do not provide reliable indications of fair market value. (b) PURPOSES FOR VALUATIONS. The need for valuing the common stock of a nonpublic or closely held company arises on many occasions. Among the more important situations requiring the valuation of nonpublic stock are ﬁling estate and gift tax returns, transactions involving estate planning, ﬁnancial planning, employee stock ownership plan transactions and reports, granting stock options, drawing stock purchase agreements, marital dissolutions, structuring recapitaliza- tions, sales, mergers, and divestitures, and litigation. (c) FAIR MARKET VALUE. Brieﬂy stated, fair market value is that value at which a willing buyer and a willing seller, both well informed and neither under any compulsion to act, would arrive in an arm’s-length sale of the asset in question. Such value is always determined as of a speciﬁc date and is based on all pertinent facts and conditions that are known or reasonably might be anticipated on that date. The existence of a willing buyer and a willing seller is assumed in the very deﬁnition of fair market value. 42.2 GENERAL PROCEDURE FOR VALUATION (a) COMPILE BACKGROUND INFORMATION ABOUT THE COMPANY. In valuing the common stock of a nonpublic company, it is necessary to become as informed as the well-informed buyer and seller assumed in the deﬁnition of value. The appraiser should review the history of the corporation, including date and state of incorpora- tion, the products originally made, evolutionary developments to the present, and changes in control over the years. A list of stockholders, directors, and a listing of ofﬁcers’ names, salaries, ages, and ex- perience should be obtained. The appraiser must understand the nature of the company’s products and/or services, raw materials used, and the methods of manufacture. A facilities tour is helpful. He should inquire as to how techno- logically advanced (or backward) the company is and review anticipated capital expenditures. Information on the size of the labor force, the existence of collective bargaining agreements, and background information on employee relations as well as the corporation’s strike experience should be obtained. The risk of customer loss during a strike must be evaluated. The analyst should carefully analyze the structure of the industry, including the identity of existing competitors, barriers to entry and exit, and the bargaining position of customers and suppliers. Obtain information on the sales force, including its size, structure, methods of compensation, and radius of distribution. Information on markets, including principal industries served and
42.2 GENERAL PROCEDURE FOR VALUATION 42 3• principal customers served, is also important. Any material dependence on a single industry (25% or more of sales) or on a single customer (10% or more of sales) should be carefully re- viewed and the risk of a sudden loss evaluated. The nature of the markets served (e.g., replace- ment versus original equipment market or job shop versus proprietary) should be examined. The economic forces that give rise to demand for the company’s products or services should be un- derstood. Market share data, when available, can be helpful. Price, quality, and service as com- petitive factors should be assessed. The role of patents and proprietary or secret technology in the competitive structure of the industry should be examined, and if these are important, the possible effects of patent expirations should be reviewed. Research and development projects under way should be reviewed with management. Changes in the industry, particularly those of a technological or marketing nature, must be ana- lyzed in terms of the company’s outlook. The analyst should obtain a “feel” for the industry. Back- ground information can usually be obtained from trade sources. The analyst should understand the growth and cyclical characteristics of the industry. He should review the performance of the com- pany relative to its industry, and he should understand the reasons for any pronounced differences in trends between the company and its industry. (b) COMPILE FINANCIAL INFORMATION REGARDING THE COMPANY. The appraiser should obtain audit reports for the past ﬁve years. Some situations may require a complete audit of the books or even the services of a forensic accountant. The appraiser should disclose the source of the ﬁ- nancial information upon which he has relied. The appraiser should review the historical income accounts, including such areas as ofﬁcers’ compensation, the company’s relationship with afﬁliated entities, and travel and entertainment. It is helpful to restate the income account in ratios, as this may disclose trends in cost-price rela- tionships that should be discussed with management. Margins by product lines should be reviewed for a multiline company. The appraiser should obtain the latest interim statement and interview man- agement with regard to the company’s outlook. It is useful to get the interim statement for the same period of the previous year. It is helpful to review a ﬁve-year comparison of the balance sheets, to analyze changes that may be occurring in ﬁnancial position, and to evaluate its capacity to ﬁnance future growth. The balance sheet may indicate the existence of nonoperating assets, which, if material, should be segregated and valued separately. The potential existence of hidden assets or hidden liabilities should be discussed in interviews with management. The capital structure must be carefully reviewed, as well as the terms of any stock purchase agreements or stock options. The appraiser should get sales, income, and dividend data to review both the growth and cyclical characteristics of the company, as well as its long-term dividend policy. It is important to review the long-term outlook with management and to obtain ﬁnancial projections if available. (c) SELECT GUIDELINE COMPANIES. Having reviewed the quantitative and qualitative factors discussed above, the appraiser must translate this complex array of facts into value. This requires an analysis of the most relevant facts from the actual marketplace. This is ordinarily done through the selection and analysis of guideline companies that can be used to formulate objective guidelines for the evaluation of the subject company. Guideline companies are pub- licly held companies that come as close as possible to the investment characteristics of the com- pany being valued. Ideally, they are in the same industry. Frequently, however, there are no public companies in the same industry, so it is necessary to select companies with an underlying similarity of investment characteristics based on markets, products, growth, cyclical variability, and other factors. Such companies were traditionally called “comparative companies,” a term that seems to connote companies “just like” the company being valued. It is seldom, if ever, possible to ﬁnd publicly held companies “just like” the company under consideration. Appraisers have come to generally use the term “guideline companies” as a more appropriate term than “comparative companies.”