The Wrong Way to Challenge a Will

While there may be several good ways to go about challenging a decedent’s last will and testament, in In the Matter of the Estate of Annie Rost, Superior Court of New Jersey, Appellate Division (Docket No. A-1807-19) decided April 8, 2021, the challenge brought by the decedent’s daughter failed with the result being that she lost her inheritance.

“Annie Rost died in September 2018, leaving behind a sizeable estate. Her will, executed in 2002, devised the estate among her four children and to various charities. It also contained an in terrorem provision that excluded any beneficiary from the estate if they contested the will. One of the beneficiaries […] filed a caveat with the Mercer County Surrogate’s Court six days after her mother’s death, protesting the grant of letters of administration or admitting the will to probate.”

An in terrorem provision, also known as a no contest provision, is a statement in the will that seeks to disinherit any beneficiary who challenges the validity of the will.

One example of such a provision may be: “Any beneficiary named in my will who contests the probate or validity of my Will or any of its provisions shall receive no benefit under my will and shall be treated as if that beneficiary predeceased me”.

While the pros and cons of including such a provision are debatable and should be specifically considered by the testator and not simply included as boilerplate, the effect of a valid in terrorem clause is severe — the total loss of one’s inheritance.

While New Jersey law recognizes the validity and importance of in terrorem provisions, the New Jersey Supreme Court has ruled that such provisions are unenforceable when the challenger has probable cause to contest the will. Haynes v. First Nat. State Bank of New Jersey, 432 A.2d 890, 904 (N.J. 1981). This ruling has been codified in N.J.S.A. 3B:3-47, which provides that “[a] provision in a will purporting to penalize any interested person for contesting the will or instituting other proceedings relating to the estate is unenforceable if probable cause exists for instituting proceedings”.

This makes sense. If the testator lacked capacity to make a will, or was acting under duress at the behest of a dangerous family member, then we would want an aggrieved party to be able to challenge that will and bring those facts to light. And if the aggrieved party turns out to be wrong, we don’t want them to lose an inheritance if there was good reason to bring the challenge in the first place. Remember that challenges must be brought quickly before all facts are known.

But just because all facts may not be known at the outset does not mean that a challenger can defeat the teeth of an in terrorem provision with mere speculation. In short, that was the problem the decedent’s daughter faced in Rost. She acted without any supporting evidence, and she continued to press several claims after she was informed that the will contained an in terrorem provision. The court found the decedent’s daughter did not present any evidence to support her challenge to the will at the March 27 hearing on the order to show cause.

Litigating in New Jersey Chancery Courts must be done with care and careful planning. And any litigant must pay close attention to language in a governing document that seeks to disinherit them just for bringing the challenge.

Are Promises to Make a Will Enforceable?

Can a person give up his or her right to make a will? Or can a person be forced to include (or not include) certain beneficiaries and certain provisions in a will? In New Jersey, the answer to both questions is YES. Under New Jersey law, a person can enter into a legally binding contract controlling the dispositive provisions of that person’s will.

Legal Authority

“A contract to make a will or devise, or not to revoke a will or devise, or to die intestate, if executed after September 1, 1978, can be established only by (1) provisions of a will stating a material provision of the contract; (2) an express reference in a will to a contract and extrinsic evidence proving the terms of the contract; or (3) a writing signed by the decedent evidencing the contract. The execution of a joint will or mutual wills does not create a presumption of a contract not to revoke the will or wills.” N.J.S.A. 3B:1-4.

Dad promised to leave me the house — Is that promise enforceable?

Oral agreements to make a will are generally not enforceable.

In Matter of Estate of Cosman, 193 N.J. Super. 664 (App. Div. 1984), the court ruled that an oral agreement to make reciprocal wills was not enforceable where the wills were each silent as to the existence of the agreement. The court held the statute was clear on its face and refused to find the existence of an implicit agreement to create unrevocable reciprocal wills.

However, in accordance with traditional contract principles, it may be possible to enforce an oral agreement in a court of equity where there has been part performance. For example, in a situation where testator promises to leave caretaker $50,000 in exchange for services, and where those services are rendered, caretaker would have a claim against testator’s estate. Obviously, the better practice would have been for caretaker to reduce the agreement to writing.

Marriage Separation Agreements

Marriage Separation Agreements (MSAs) commonly include provisions relating to a party’s will and overall estate plan. As part of a divorce, it is common for one party to agree to leave $X to the other at that party’s death if death occurs within a certain timeframe. This agreement is often backed by life insurance or a retirement account naming the ex-spouse as beneficiary. If that party either fails to make a will which includes the required bequest, or if that party fails to maintain the life insurance or IRA, the aggrieved party can bring a claim against the estate for breach of contract.

Enforcement

If the testator breaches the contract and fails to include you as a beneficiary, you can bring a claim against the testator’s estate and either seek damages or specific performance. Generally, you would not be able to invalidate the testator’s will, but you could seek a judgment from the court entitling you to what is owed. Timing is crucial and if you wait too long to bring a claim, that claim may be lost.

Qualified Small Business Stock (IRC 1202)

Not all stock sales are treated equally for tax purposes. If you bought stock after September 27, 2010 and that stock is “Qualified Small Business Stock” (QSBS) as determined by Internal Revenue Code section 1202, you may be able to exclude 100% of the gain!

Example: Individual taxpayer invests $10,000 in a startup company and receives shares in exchange. The startup company is taxed as a C corporation. After 5 years the startup, which was very successful, is sold and the shares taxpayer owns are now worth $7,500,000. Without section 1202, taxpayer would generally recognize $7,490,000 of gain. Taxed at 15%, taxpayer would owe $1,123,500 in federal income tax. If the stock is QSBS purchased after September 27, 2010, taxpayer would owe no federal tax!

If given the chance, would you rather pay $1,123,500 in taxes or ZERO?

The rules of IRC 1202 provide a complex roadmap, which can lead to incredible tax savings.

Some key requirements of QSBS are:

  • The stock must be issued by a domestic C corporation (corporate stock with an S election won’t qualify)
  • The stock must be owned by a taxpayer other than a corporation (think individuals, LLCs, and trusts)
  • The stock must have been held for more than five years
  • The company issuing the stock must be valued at no more than $50 million at the time of issue
  • The stock must be acquired from the company directly (original issue) in exchange for cash, property, or services

What about contributions of property or real estate in exchange for stock?

Example: Individual taxpayer contributes property worth $500,000 to a startup company. Assume taxpayer’s adjusted basis in the property is $200,000. Assume also the initial contribution qualified as a tax-free contribution for purposes of IRC 351. If the stock is QSBS and sells for $4,200,000 (a gain of 740%!) only $3,700,000 ($4,200,000 less $500,000) will qualify as 1202 gain. That means taxpayer will still recognize gain of $300,000 on the initial investment ($500,000 less $200,000).

What if the stock appreciates to $50,000,000? How much gain can I exclude?

Section 1202(b)(1) provides that the gain excluded cannot exceed the greater of:

(A) $10,000,000 reduced by the aggregate amount of eligible gain taken into account under for prior taxable years and attributable to dispositions of stock issued by such corporation, or

(B) 10 times the aggregate adjusted bases of qualified small business stock issued by such corporation and disposed of by the taxpayer during the taxable year.

Generally, this equates to a lifetime exclusion of $10,000,000 per taxpayer. Married taxpayers are treated as a single taxpayer for this purpose.

What if I received stock in exchange for services?

Unheard of that a startup would need your time and energy more than your cash! But seriously, if you received restricted stock in exchange for your services, you are treated as having acquired the stock when that stock is included in your income. So if you made an IRC 83(b) election to include the stock in your income, you are treated as if you purchased the stock on the date you made the election.

Do all corporate activities qualify?

No. The corporation must be actively engaged in a “qualified trade or business” during the holding period. And the corporation must use at least 80% of its assets in running its business.

Generally, any trade or business involving the performance of services in the fields of health, law (boo), engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees won’t qualify.

Similarly, banking, insurance, financing, leasing, investing, or similar business also won’t qualify.

Any farming business (including the business of raising or harvesting trees), any business involving the production or extraction of certain natural resources, and any business operating a hotel, motel, restaurant, or similar business also won’t qualify.

Note: startup activities count as if the corporation was actively engaged in the business during the startup phase.

What if I inherited the stock?

IRC 1202(h) provides that in a few situations, stock that was QSBS in the hands of the original owner will retain its character in the hands of another.

Stock acquired by gift, by inheritance, and in certain distributions from a partnership to a partner will be treated as if owned by the original owner.

BIG PLANNING OPPORTUNITY — This statutory exception can create planning opportunities that can result in significant tax savings.

Other considerations

There are other technical requirements built in to the fabric of 1202. Given the potentially huge tax benefits, a thorough understanding of these requirements is essential before investing in a startup company, while that company is operating, and prior to ( and preferably long in advance of) an exit event.

Private Letter Ruling 202017018, 04/24/2020, IRC Sec(s). 2511, 671

In the only private letter ruling addressing incomplete gift, non-grantor trusts (“INGs”) in 2020, the IRS ruled that the subject trust was a non-grantor trust under section 671 of the internal revenue code, and that transfers to the trust would be incomplete gifts for federal gift tax purposes under section 2511.

The subject trust has the following characteristics:

  1. Grantor created a domestic trust in a state that presumably does not impose an income tax on transactions within the trust.
  2. The trust is irrevocable for the benefit of Grantor, Grantor’s Spouse, Grantor’s issue, Grantor’s Parents, and the other issue of Grantor’s Parents (collectively, the “Beneficiaries”). Grantor had no power to alter or amend the trust.
  3. A corporate trustee (Trustee) is the sole trustee of the Trust.
  4. While Grantor is alive, the Distribution Committee is to be in existence. The Distribution Committee is initially composed of Grantor, Grantor’s parents and Grantor’s sister. Until the death of Grantor, the Distribution Committee must have at least two members, other than Grantor or Grantor’s Spouse. If there are less than two remaining members, other than Grantor or Grantor’s Spouse, the Trust Protector will appoint any one or more of the Beneficiaries other than Grantor’s Spouse to the Distribution Committee, provided that the number of members does not exceed four and that any member of the Distribution Committee is an adult, competent person.
  5. While Grantor is alive, Trustee must distribute income and principal of the trust estate as directed in writing by the Distribution Committee, Grantor, or both, as follows: (A) Income or principal to any Beneficiary (other than Grantor’s Spouse) as determined by a majority of the Distribution Committee, other than Grantor or Grantor’s Spouse, acting in a non-fiduciary capacity, with the written consent of Grantor (“Grantor’s Consent Power”); (B) Income or principal to any Beneficiary as determined by unanimous decision of the Distribution Committee, other than Grantor or Grantor’s Spouse, acting in a non-fiduciary capacity (“Unanimous Committee Power”); and, (C) Principal to any Beneficiary (other than Grantor or Grantor’s Spouse) as determined by Grantor, acting in a non-fiduciary capacity, for any one or more of such Beneficiary’s support, health, or education (“Grantor’s Sole Power“).
  6. Grantor may appoint all or any part of the principal of Trust, outright or in trust, at his death in favor of the issue of Grantor’s parents (other than Grantor, his estate, his creditors, or the creditors of his estate), Grantor’s Spouse, or any one or more charitable organizations as Grantor designates (“Grantor’s Testamentary Power”). Any part of the principal of Trust not effectively appointed by Grantor upon his death will be distributed to a designated trust.

INCOME TAX RULING

The IRS held that during the period the Distribution Committee is serving, no portion of the items of income, deductions, and credits against tax of Trust will be included in computing the Grantor’s taxable income, deductions, and credits under § 671.

Based solely on the facts and representations submitted, the IRS concluded an examination of Trust reveals none of the circumstances that would cause Grantor or any member of the Distribution Committee to be treated as the owner of any portion of Trust under sections 673, 674, 676, 677, 678, or 679 as long as the Distribution Committee remains in existence and serving and Trust remains a domestic trust. Furthermore, the IRS concluded that an examination of Trust reveals none of the circumstances that would cause administrative controls to be considered exercisable primarily for the benefit of Grantor under section 675.

This means that Trust would be considered its own Taxpayer and be required to report and pay its own federal and state income taxes.

GIFT TAX RULING

Section 25.2511-2(c) provides that a gift is incomplete in every instance in which a donor reserves the power to revest the beneficial title in himself or herself. A gift is also incomplete if and to the extent that a reserved power gives the donor the power to name new beneficiaries or to change the interests of the beneficiaries as between themselves unless the power is a fiduciary power limited by a fixed or ascertainable standard.

Under § 25.2511-2(c), a gift is incomplete if and to the extent that a reserved power gives the donor the power to name new beneficiaries or to change the interests of the beneficiaries as between themselves unless the power is a fiduciary power limited by a fixed or ascertainable standard. In this case, Grantor’s Sole Power gives Grantor the power to change the interests of the beneficiaries. Grantor’s Sole Power is a non-fiduciary power. Accordingly, the retention of Grantor’s Sole Power causes the transfer of property to Trust to be wholly incomplete for federal gift tax purposes.

This means that transfers to Trust by Grantor would not be taxable gifts and would not reduce Grantor’s lifetime gift tax exemption (which in 2020 was $11.58 million).

ESTATE TAX RULING

A Distribution Committee member’s gross estate for federal estate tax purposes won’t include the value of any trust property.

The IRS concluded that the powers held by the Distribution Committee are not general powers of appointment for purposes of section 2041(a)(2) and, accordingly, no member of the Distribution Committee upon his or her death will include in his or her estate any property held in Trust because such member is deemed to have a general power within the meaning of section 2041 over property held in Trust.

WHAT’S THE POINT? — Tax Savings!

The Grantor spent a lot of time, effort, and money setting up this trust, modifying it to run a gauntlet of sophisticated income, estate, and gift tax requirements, and then obtaining a favorable ruling from the IRS.

While the underlying transaction is unknown, let’s say the Grantor owned an asset worth $10,000,000 but with an adjusted tax basis of $1,000,000. If the Grantor were to sell the asset, the Grantor would realize $9,000,000 of gain and that gain would be subject to both state and federal taxes.

Let’s assume the plan was to transfer the asset to the trust and to have the trust sell the asset. Since the trust is a non-grantor trust, the trust then, and not the Grantor would be taxed on the gain. In many states, this structure would avoid state income taxes on the gain. The Distribution Committee could then direct any number of distributions to either return the proceeds to the Grantor, or to make gifts to the other Beneficiaries, or to continue holding the proceeds in trust. These decisions could further reduce income taxes, offer increased creditor protection, and otherwise provide for continued long-term management of the trust. The flexibility this structure provided, coupled with the tax savings, was the advantage sought by the Grantor.

SECURE Act Changes to IRA Distributions

The SECURE Act made sweeping changes on estate plans for decedents dying on or after January 1, 2020.

The new law changed the required minimum distribution rules for IRAs. Under the old rules, a beneficiary could elect to treat the IRA as an inherited IRA and stretch distributions over that beneficiary’s lifetime. Under the new law, that stretch IRA is no longer an option for most beneficiaries.

In most circumstances, an adult child, for example, will be required to take all distributions from the IRA within 10 years of the death of the account owner. This means that long-term income tax deferral is no longer available. The assets will be taxed in the year they are withdrawn and again, all assets must be withdrawn within 10 years. However, required minimum distributions are not required during this period, and the beneficiary can choose when to take the distributions.

“Qualified Designated Beneficiaries” are exempt from the 10 year rule. These include a surviving spouse, the account owner’s minor children, an individual that is chronically ill or disabled, or any individual who is not more than 10 years younger than the account owner.

The SECURE Act also changed the age when an account owner must begin taking required minimum distributions. The age was changed from 70 1/2 to 72.

These changes are important because many estate plans are based on the assumption that the IRA can be inherited over the beneficiary’s lifetime. Certain trusts such as conduit trusts may no longer be a good idea. For example, if you created a trust designed to pass all IRA distributions to the beneficiary, this trust will now be required to pay out the full amount to the beneficiary within 10 years. This can defeat the advantages for using a trust in the first place. If you name a non-spouse as beneficiary, you should take another look at your estate plan and see if it still accomplishes your objectives.