ACCOUNTANTS’ HANDBOOK VOLUM phần 9 pot

Fair market value of the principal of any irrevocable trust in which the decedent, as grantor or settlor, had retained any rights to income, or over the beneficiaries’ rights to the use,

heirs or devisees must be reimbursed if any assets are subsequently discovered from which the debtscould have been paid.

In many instances, if the decedent was an owner of a closely held business, he may have tered into some form of a buy sell agreement with his co-owners The agreement usually providesthat the executor shall sell the decedent’s interest in the business to one or more co-owners, or tothe business entity itself, at the price set forth therein in exchange for cash Depending on thearrangement, the buy-sell agreement will be referred to as either a cross purchase or entity re-demption (or corporate stock redemption) agreement The decedent’s agreement to be bound bythe terms of the agreement contractually binds the executor to sell the decedent’s interest in thebusiness pursuant to the terms of the agreement This sales price also works to establish the estatetax value of the business interest in the gross estate

en-The decedent, anticipating his need to provide liquidity for the estate, may have established andfunded an irrevocable life insurance trust In this arrangement, the trust applies for a life insurancepolicy on the decedent’s life The trustee is both the owner and beneficiary of the policy Upon thedecedent’s death, the trustee collects the insurance proceeds While neither the trustee nor the execu-tor is contractually bound to do so, the trustee usually purchases assets from the estate, hence pro-viding the needed liquidity This technique also eliminates the need for the executor to sell assets in

a rush at liquidation, or “estate sale,” prices

The executor should be sure to review the decedent’s personal papers thoroughly, and interviewthe surviving spouse and business associates or partners, to determine the existence of a buy-sellagreement or irrevocable life insurance trust

(xvi) Administration Expenses Reasonable and necessary outlays made by the representative in

collecting and distributing assets will be allowed by the court The representative is personally liablefor amounts disallowed The compensation of the representative, court costs, and an allowance forpreparing the accounting are allowed specifically when an accounting is made Attorney’s fees, ac-countant’s fees, fire insurance premiums, necessary repairs to property, collection costs, and other or-dinary expenses will be allowed The character and amount of the estate and the complications of theparticular situation will govern the decisions of the courts as to the reasonableness or necessity of aparticular expenditure

Most states statutorily regulate attorney’s fees by prescribing a set fee schedule based on the size

of the probate estate Should an attorney’s fee exceed the statutory maximum, he or she will need toseek the court’s approval In many instances, the estate’s attorney may also be one of the executors,

or the sole executor This may entitle the attorney/executor to both a fee and a commission; however,the attorney/executor will have to keep detailed records of time spent and duties performed in order

to sustain dual compensation

(xvii) Distribution of Estate Assets. After making appropriate provisions for the payment

of all claims against the estate, the personal representative proceeds to distribute the remainingassets according to the instructions in the will or in compliance with the laws of descent anddistribution

(xviii) Payment of Legacies Legacies are usually payable one year after the death of the testator.

General legacies ordinarily draw interest after that date and should be charged with interest for ments prior to the due date General legacies to the testator’s dependent children usually bear interestfrom the date of death If the estate appears to be solvent, the executor may pay or deliver legacies atany time but should, for his own protection, take a bond from the legatee providing for a refund to theestate in case the assets prove to be inadequate to meet the prior claims Otherwise a suit in equitymay be necessary to recover the improper payments

pay-(xix) Abatement of Legacies If there are insufficient assets to meet the debts and other prior

claims, the legacies are reduced or abated A complete revocation is referred to as an ademption Thefour rules governing priority in the abatement of legacies are as follows:

1 A specific legacy takes priority over a general legacy If the testator bequeaths specific shares

of stock to A and $5,000 in cash to B, B’s legacy will be diminished or, if necessary, entirelywiped out before the stock left to A is resorted to

2 A legacy for the support of the testator’s widow or children, who are not otherwise adequately

provided for, takes priority over legacies to strangers or more distant relatives

3 In most states, the personal assets of the estate will be used for the payment of debts before

re-sorting to the real estate As a result, the bequests of money or personal property may be ished or wiped out, although the devisees of the real property are not affected

dimin-4 Subject to the foregoing rules, all legacies are reduced pro rata in case of a deficiency.

If the will directs that real estate be sold to pay debts, the sale will take place before any legaciesare abated

(xx) Deductions from Legacies There may be certain required deductions from legacies, the

most common one being state inheritance taxes A debt due by a legatee to the testator should be ducted, but a debtor who becomes a legatee is not entitled to retain funds applicable to the payment

de-of all charges and legacies

(xxi) Lapsed Legacies A legacy is said to have “lapsed” if the legatee dies before the testator, and

the assets involved revert to the undistributed or residuary portion of the estate An exception issometimes made when the deceased legatee is a child or other near relative who has left survivingchildren; the children then receive the legacy

The children would receive the legacy on either a per stripes or per capita basis “Per stripes”means that the children of a deceased parent receive an equal share of the deceased parents’ share

“Per capita” means that the children of a deceased parent receive their own share For example: A’swill leaves everything to spouse or A’s children should spouse predecease A’s spouse and one adultchild predecease A A is survived by a second adult child (B) and the predeceased child’s two chil-dren (C and D) A per stripes distribution would leave 50% to B and 25% to each of C and D A percapita distribution would leave 331⁄3% to B, C, and D

(xxii) Advancement and Hotchpot An advancement is a transfer of property by a parent to a

child in anticipation of the share of the estate the child would receive if the parent died intestate If

a person indicates in his will that the advances are to be part of the child’s legacy, these advancesare considered as part of the corpus of the estate and must be taken into account in making the finaldistribution An allowance to a widow for the support of the family is not an advance, nor is it a di-rect charge against items devised or bequeathed to her

If there is no will and the advancement exceeds the child’s distributable shares of the estate, thelegatee is entitled to no further distribution but is not required to return the excess; if the advance-ment is less than the child’s share, he is entitled to the difference Hotchpot or collation is the bring-ing together of all the estate of an intestate with the advancements made to the children in order that

it may be divided in accordance with the statutes of distribution

(xxiii) Surviving Spouse’s Right of Election against the Will. Should a decedent’s will pletely disinherit a surviving spouse or provide less than a certain percentage of the estate to her,the spouse may petition the court to elect to receive a specified percentage of the estate, normallyranging between 30% to 50%, “against the will” (e.g., in lieu of the existing dispositive will pro-visions) The right to make this election will vary among the states depending on whether the pro-bated will was executed before the marriage or during the marriage between the decedent andsurviving spouse

com-(xxiv) Disclaimers It is often recommended that an intended legatee or beneficiary forfeit, give

up, or disclaim, an estate distribution In other words, the legatee or beneficiary waives his or herright to receive all or part of their interest in an estate asset or distribution of assets The effect of a

41.1 ESTATES—LEGAL BACKGROUND 41 11

proper disclaimer is that the intended legatee or beneficiary is presumed to have predeceased thedecedent, and the asset is distributed to the contingent legatee or beneficiary Disclaimers are gov-erned both by state statute and the Internal Revenue Code (IRC) in Sections 2046 and 2518 The re-quirements of both must be carefully observed in order to obtain the desired result In general, thefollowing four steps must be observed:

1 The disclaimer must be made in writing.

2 It must be received by the executor and filed with the surrogate or probate court that has

juris-diction of the estate within nine months of the date of death

3 The intended legatee or beneficiary must renounce all right, title, and interest in the item(s)

and must not have received, or be deemed to have received, any economic benefit of the assetsbeing disclaimed

4 The disclaimed interest must pass to someone other than the disclaiming legatee or

benefi-ciary, and he may not direct to whom the asset will pass in lieu of himself

(xxv) Decree of Distribution and Postdecree Procedure. The principal distribution of tate properties is made after the issuance by the court of a decree of distribution Upon the filing

es-of an acceptable final accounting (see below) and the expiration es-of the time for objections by interested parties, the court approves the accounting, allows the expenses of preparing the ac-counting and the representative’s commission, and issues a decree that disposes of the balance

of the estate according to the will or according to the statutes of descent and distribution in thatjurisdiction

The representative distributes the estate assets according to the decree, pays his commission, settlesany other expenses allowed in the decree, closes his books, presents his vouchers to the court, and asksfor a discharge from his responsibilities and for the cancellation of his bond

(xxvi) Funding of Trusts It is not uncommon for part of the estate to be distributed to a

testamen-tary trust or to a preexisting intervivos trust The distribution to the trust may make up part of a tal, residuary, or charitable bequest A testamentary trust may also be funded to hold assets for a minorbeneficiary The appointment and approval of the trustee(s), and the distribution of the estate assets tothe trust would be included in the courts’ decree described above

mari-(j) POWERS OF ESTATE REPRESENTATIVE

(i) Executor versus Administrator. The personal representative’s powers, as distinguishedfrom duties, are those acts that he is authorized, rather than required, to perform As previouslymentioned, the powers of an executor or administrator CTA are outlined in the will and areoften broader than those allowed to an administrator of an intestate, who must look solely tostatutory authority

The most common statutory and will clause powers of the personal representative are to investand reinvest estate assets, to collect income and manage the estate property, to sell estate property as

he sees fit, to mortgage property (in some states), and to deliver and execute agreements, contracts,deeds, and other instruments necessary to administer the estate Most properly drawn wills reproducethe statutory powers and add additional desired powers not granted by statute

(ii) Will Powers Not Conferred by Statute Using New York State law as outlined by Harris as an

example, the powers listed below, when included in a will of a New York decedent, would grant tional powers not conferred by statute.2These 10 powers would not be available to an executor unlessenumerated in the will (and are never available to an administrator of an intestate):

addi-2Homer I Harris, Estates Practice Guide, 4th ed (Lawyer’s Co-Operative Publishing, Rochester, NY, 1984),

Nov 1994 Suppl

1 To distribute the estate immediately after death Many states require the executor to delay

any distribution for as much as one year after letters testamentary are issued

2 To hold property without regard to the limitations imposed by law on the proper investment

of estate assets

3 To make “extraordinary repairs” to estate assets New York allows the representative to

make only “ordinary repairs”; he has to secure the permission of all beneficiaries and bly of the court to make “extraordinary repairs” such as replacing a heating system on realestate administered by the estate

possi-4 To charge the cost of agents such as attorneys, accountants, and investment advisors as estate

expenses

5 To continue a business of decedent.

6 To keep funds uninvested or invested in nonincome-producing assets.

7 To abandon, alter, or demolish real estate.

8 To borrow on behalf of the estate and give notes or bonds for the sums borrowed, and to

pledge or mortgage any property as security for the borrowing

9 To pay all necessary or proper expenses and charges from income or principal, or partly from

each as the fiduciary deems advisable (This important power will be expanded on in the cussion of income and principal of trusts.)

dis-10 To do all acts not specifically mentioned as if the fiduciary were the absolute owner of the

property

(iii) Will Powers versus Statutory Powers It is important to remember that state law is looked

to only where the will is silent Any will provision will be adhered to, even if it is broader or more strictive than statutory powers, unless such provision is contrary to law or public policy

re-(k) COMMISSIONS OF REPRESENTATIVES Many states make executors’ and administrators’

commissions statutory However, with an executor, the first step is to look to the will Testators mayspecifically provide the amount of commission or prohibit commissions for fiduciaries These willprovisions will be adhered to, although several states allow an executor to renounce the will provi-sions and receive statutory commissions Other states force the executor to renounce the appointmentand petition to be appointed administrator, thereby becoming eligible for the statutory commissions

of an administrator Some states do not have statutory commission rates, leaving the awarding ofcommissions to the court’s discretion

It is important to bear in mind that commissions are allowed only on the probate assets, that is, sets that come under the administration of the personal representative As previously mentioned, realproperty does not generally come under the control of the representative and thus is not usually aprobate asset When real property is a probate asset, the representative is entitled to commissions Inseveral states, specific bequests and the income thereon are treated as nonprobate and thus noncom-missionable assets In addition, if an asset is secured by a liability, only the net equity should enterinto the commission base

as-Sometimes a will provides for more than one executor State law must then be examined todetermine whether each is entitled to statutory commission or whether one such commissionmust be shared

(l) TAXATION OF ESTATES

(i) Final Individual Income Taxes. One of the responsibilities of the personal representative

is to file any unfiled federal and state income tax returns, as well as final income tax returns forthe short taxable year that ends on the date of death of the decedent If the deceased left a sur-viving spouse, the personal representative can elect to file a joint federal tax return for the year of death A joint return will normally be prepared on the cash basis for the calendar year,

41.1 ESTATES—LEGAL BACKGROUND 41 13

including the decedent’s income only through the date of death, and the income of the ing spouse for the full calendar year An election in the final return to accrue medical expensesunpaid at death that are paid within one year of death may be made Accrued interest on U.S.Government Series E Bonds owned by the decedent may be included as income in the final fed-eral income tax return Expert tax advice should be secured by the representative before mak-ing these or various other available elections.

surviv-Unused capital loss carryforwards and unused charitable contribution carryforwards of decedentare no longer deductible after the final year Unused passive activity losses are allowed on the final re-turn to the extent they exceed the estate tax value over the decedent’s adjusted basis

If a joint return is being filed, the tax shown on the return must be allocated between the decedentand the surviving spouse The allocation will take into account the decedent’s withholding tax and hisactual payments of estimated tax, leaving the estate of the decedent with either an asset (representingoverpayment of taxes) or a liability (representing underpayment of taxes) If the surviving spouse hadincome or paid some portion of the tax, she would owe the estate or be entitled to reimbursement from

it, depending on the relationship of her tax payments to the separate tax liability on her income

(ii) Federal Estate Tax Decedents with gross estates valued at over $1 million3are required to file

a Federal Estate Tax Return, Form 706, regardless of the fact that there may be no federal estate taxliability The federal estate tax is a tax on the value of the decedent’s gross estate less certain deduc-tions Generally, the tax is paid from the estate property and reduces the amount otherwise available

to the beneficiaries Therefore, in the absence of specific directions in a will or trust, taxes are ally apportioned to the property that causes a tax If property passes without tax because of a marital

gener-or charitable deduction, no taxes are chargeable to the property

The gross estate for tax purposes includes all of the decedent’s property as defined in the IRC, notmerely probate property The following are seven examples of property that is part of the gross estatefor estate tax purposes, though not part of the probate estate and thus not accounted for in the repre-sentative’s accounting:

1 Specifically devised real property

2 Jointly owned property passing to the survivor by operation of law

3 Life insurance not payable to the estate when the decedent possessed “incidents of ownership”

such as the right to borrow or change the beneficiary of the policy, and policies transferredwithin three years of death

4 Lump-sum distributions from retirement plans paid to someone as a result of surviving

the decedent

5 Gift taxes paid by the decedent within three years of death

6 Fair market value of the principal of any revocable “living” trust of which the decedent was

the grantor or settlor

7 Fair market value of the principal of any irrevocable trust in which the decedent, as grantor or

settlor, had retained any rights to income, or over the beneficiaries’ rights to the use, ment, or possession of the trust principal

enjoy-In putting a value on the gross estate for estate tax purposes, the representative has an election tovalue the estate as of the date of death or an alternative date The alternative date is either six months

3This is the filling threshold effective for decedents dying on or after January 1, 2002 This threshold isscheduled to increase as follows: in 2004, increases to $1.5 million; in 2006, increases to $2 million; in

2009, increases to $3,500,000; in 2010 the estate tax is repealed, hence no filing requirement; in 2011, theestate repeal “sunsets” and the pre-2002 rules become effective once again, hence the filing threshold is re-duced to $675,000 [see Internal Revenue Service Publication 950 (Rev March 2002), “ Introduction to Es-tate and Gift Taxes”] See discussion of these changes made by EGTRRA later

after the date of death or at disposition of an asset if sooner If the election to use the alternative date

is not made, all property must be valued as of the date of death; if the alternative date is elected, allproperty must be valued at the alternative valuation date or dates Alternate valuation is availableonly if there is a reduction in estate taxes

Deductions from the gross estate to arrive at the taxable estate include administration expenses (if

an election has not been made to deduct them on estate income tax returns), funeral expenses, debts

of the decedent, bequests to charitable organizations, and a marital deduction for property passing to

a surviving spouse

The 1976 Tax Reform Act unified estate and gift tax rates by provisions for a unified table

to be applied both to taxable gifts made after 1976 and to taxable estates for persons dyingafter 1976 In computing estate taxes on the taxable estate, gifts made after 1976 are added tothe taxable estate and the unified tax is recomputed with credit given for the gift tax previouslypaid on such gifts This computation has the effect of treating gift taxes paid as only payments

on account of future estate and gift tax brackets A marital deduction is now available for 100%

of property passing to the surviving spouse The property may be left in trust with income tothe spouse for life, together with either a general power of appointment, or limited power ofappointment The latter may qualify for the marital deduction if the representative makes aQualified Terminable Interest Property (QTIP) election with the return Eventually, the prop-erty would be taxable in the surviving spouse’s estate and the tax thereon would be payablefrom the property

Estates are also allowed an unlimited charitable deduction for bequests left directly to charities Aprorated charitable deduction is allowed for a split-interest bequest to charity either in the form of aremainder interest or an income interest

The Tax Reform Act of 1997 added a new exclusion or deduction Effective for decedentsdying after December 31, 1997, decedents who owned a “qualified family owned business in-terest” or family farm may be eligible for this new estate tax exclusion The amount of the ex-clusion is correlated with the unified credit, so that in any one year the combination of thetaxable estate equivalent of the unified credit and the family owned business exclusion total

$1,300,000 The eligibility rules to qualify for this new exclusion are complex and extensive;therefore, they must be closely reviewed before assuming that an estate will be able to avail it-self of this exclusion

A unified credit is allowed against the computed estate tax The unified credit is subtracted fromthe taxpayer’s estate or gift tax liability However, the amount of the credit available at death will bereduced to the extent that any portion of the credit is used to offset gift taxes on lifetime transfers.The amount of the credit is equivalent to a taxable estate of $600,000 Therefore, a decedent can have

a taxable estate of up to $600,000 before any estate tax is due

The Tax Reform Act of 1997 increased the unified credit over a period of years Beginning in

1998, the taxable estate equivalent to the credit was increased to $625,000; and will increase as lows through 2006: 1999, $650,000; 2000 and 2001, $675,000; 2002 and 2003, $700,000; 2004,

fol-$850,000; 2005, $950,000; and 2006, $1,000,000

The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), signed intolaw June 7, 2001, made broad, sweeping changes to several areas of the tax law including theestate, generation-skipping transfer, and gift taxes In short, the estate and generation-skip-ping transfer taxes are phased out from 2002 to 2009 and eventually repealed in 2010 Thecurrent law, however, “sunsets” on December 31, 2010, and becomes effective again as it didback in 2001 The gift tax is not repealed; however, the rates decrease to 35% by 2010 Thefollowing is a brief description of the changes made by EGTRRA while they last

The highest tax rate for all three transfer taxes will reduce as follows from 2002 through2009: 2002—50%, 2003—49%, 2004—48%, 2005—47%, 2006—46%, and 2007–2009—45% In 2010, the gift tax is cut to 35% while the other two transfer taxes are 0% (i.e., re-pealed) In 2011, the rates return to the 2001 level of 55% when the law sunsets The unifiedtax credit, or applicable exclusion amount, for the estate tax increases from 2002 through 2009

as follows: 2002–2003—$1 million, 2004–2005—$1.5 million, 2006–2008—$2 million,

41.1 ESTATES—LEGAL BACKGROUND 41 15

2009—$3.5 million The unified credit, or applicable exclusion amount, returns to the 2001level of $675,000 in 2011 The unified credit, or applicable exclusion amount, is increased toand remains at $1 million in 2002 This remains constant through 2010, until it returns to the

2001 level of $675,000

The qualified family-owned business deduction that was added to the law by the Tax ReformAct of 1997 (discussed above) is repealed in its entirety in 2004 It reappears, however, in 2011when the law sunsets.4

Several other credits may be allowed against the computed estate tax Most common is a creditfor state estate and inheritance taxes (described next) Depending upon the nature, situs, and other as-pects of certain assets included in the gross estate, the following other credits may be allowed againstthe computed estate tax: prior transfers, foreign death taxes, death taxes on remainders, and recovery

of taxes claimed as credits

Filing of the Form 706 is due nine months after the decedents’ date of death The executor or ministrator may request a six-month extension of time to file the return If any tax is due with the re-turn, an estimated payment of said tax is due six months from the date of death, with any balance duewith the filing of the return

ad-While payment of the estate tax cannot normally be extended, IRC Section 6166 provides relieffor certain estates Should the estate assets include an interest in a closely held business that exceeds35% of the adjusted gross estate, an election by the executor or administrator would permit the de-ferral and payment of the estate tax, that is attributable to the inclusion of the closely held businessinterest in the estate, in installments over several years The requirements of this code section arestrict; therefore, the executor or administrator should carefully consider all available options, advan-tages, and consequences of making this election

One of these options, available to closely held corporations, is an IRC Section 303 stock tion If funds are available, the corporation may redeem stock held by the executor or administratorequal to an amount that may not exceed the sum of the estate taxes, outstanding debts, and adminis-tration expenses While this option does not serve to defer the payment of estate taxes, it is an optionthat may be used in conjunction with or in lieu of the deferred payments under Section 6166 de-scribed above

redemp-(iii) State Estate and Inheritance Taxes The estate tax in some states, such as New York, take

the form of a tax on the right to transmit wealth that is similar to the federal estate tax In otherstates, like New Jersey, an inheritance tax is applied to one’s right to receive a portion of a dece-dent’s estate The state inheritance taxes are paid from estate funds by the representative, who willtherefore withhold an appropriate amount from each legacy or establish a claim against those bene-ficiaries responsible for the tax by the terms of the will or by state law Kinship of the beneficiary tothe decedent is usually the controlling factor in determining exemptions and tax rates, with closerelatives being favored

Other states, such as Florida, assess an estate tax based on the amount of credit for state deathtaxes claimed on the federal estate tax return

Almost all states provide for the tax to be at least equal to the federal credit for state death taxes

if total inheritance taxes are less

EGTRRA reduces the state death tax credit by 25% in 2002, 50% in 2003, and 75% in 2004

In 2005, the credit is repealed and replaced with a deduction for state death taxes actually paid.This will require almost every state to enact some form of conforming legislation to coordinateits statute with the federal changes

The timing of the state’s estate or inheritance tax return and payment of any taxes may differ fromthe federal rules An executor or administrator should be acquainted with these rules to avoid penalty

4For a more detailed discussion of EGTRRA, see Alan D Kahn, Mark H Levin, and Robert H

Col-son, “The 2001 Tax Act, Estate Tax Repeal?” The CPA Journal, September 2001, p 26.

and interest assessments A state return may be required to be filed even though no federal return isrequired if the gross estate is less than $1,000,000, and even if no state tax is due.

(iv) Generation Skipping Transfer Tax The Tax Reform Act of 1986 revised and imposes a new

generation skipping transfer tax on most transfers made to individuals two generations (i.e., children) down from the donor or decedent Most transfers prior to 1987 are exempt Direct transfers

grand-or distributions from trusts to individuals two generations down will be subject to the tax if the fer exceeds the allowable exemption

trans-A donor/decedent has a lifetime exemption of $1,000,000 Effective for decedents dying after cember 31, 1998, the Taxpayer Relief Act of 1997 provides that the $1,000,000 exemption amountwill be indexed for cost-of-living adjustments in $10,000 increments Transfers in excess of thisamount to grandchildren are subject to a flat tax in addition to the estate and gift tax This flat tax isimposed at the highest marginal estate and gift tax rate, which is currently 55% Consequently, it isconceivable that transferring $100 could cost $110 in estate/gift and generation skipping taxes Thelaw is relatively new and complex Therefore, knowledge of the law and planning is important inorder to minimize the impact of the tax

De-In 2001, the lifetime exemption was indexed up to $1,060,000 It will continue to be indexedfor inflation in 2002 (it is currently $1,100,000) and 2003 For 2004 through 2009, the lifetimeexemption is equal to the unified credit or applicable exclusion amount The tax is repealed for

2010 and then returns to the 2001 levels The tax rate is changed in the same manner as the tate tax rates discussed above In addition, some of the substantive rules were liberalized effec-tive for transfers made after December 31, 2000

es-(v) Estate Income Taxes The representative may be responsible for filing annual federal income

tax returns for the estate for the period beginning the day after the date of death and ending when theestate assets are fully distributed The returns are generally prepared on a cash basis and can be pre-pared on a fiscal year, rather than a calendar year, basis Such an election is made with the filing ofthe initial return and is often done to cut off taxable income in the first year of the estate Mainte-nance of books on a fiscal year basis and filing the request for an extension of time to file the returnwill also establish the fiscal year If returns are not timely filed, the estate will then be required to file

on a calendar year basis

A federal income tax return is due if the estate earns gross income of $600 or more per year A $600exemption is allowed in computing the income subject to federal income taxes Administration ex-penses, such as executor’s commission and legal and accounting fees may be deducted if the represen-tative does not elect to take these expenses on the federal estate tax return If the estate distributes netincome (gross income less expenses), such distributable net income is taxed to the recipient and theestate is allowed a corresponding deduction in computing its taxable income Any remaining taxableincome after deductions for exemption, expenses, and distributions is taxed at a rate specified in atable to be used exclusively for estates and trusts

The income tax basis of estate assets are stepped up to their estate tax value Therefore,should the executor or administrator sell any assets to raise cash, the assets’ estate tax value isused to determine whether any gain or loss is realized upon the sale There are, however, cer-tain assets includable in the estate whose income tax basis carries over from the decedent.These assets are called income in respect of a decedent, or IRD, and are described in IRC Sec-tion 691 The following are examples of IRD: proceeds of U.S savings bonds in excess ofdecedent’s purchase price, IRAs, tax sheltered annuities and regular annuities, deferred compen-sation, and final paychecks and other remittances of compensation Certain IRD give rise to in-come taxation upon receipt, while others do not cause taxation until they are redeemed orotherwise liquidated Should an item of IRD be paid directly to an estate beneficiary or be dis-tributed to the beneficiary from the estate, the same rules regarding income tax basis apply Anoffsetting deduction is available to the executor or beneficiary who must recognize IRD in hisgross income The deduction is equal to that item’s attributable share of the estate tax its inclu-sion in the estate has caused

41.1 ESTATES—LEGAL BACKGROUND 41 17

EGTRRA has modified the income tax rules relating to the step-up in basis discussed above ginning in 2010 To make up for the loss of revenue from the estate tax repeal, a new “carryoverbasis” regime will become effective Under this regime, property acquired from a decedent will have

be-a bbe-asis eqube-al to the lesser of the decedent’s bbe-asis or the fbe-air mbe-arket vbe-alue of the property on the dbe-ate

of the decedent’s death A total $4.3 million of property may, however, still qualify to use the currentstep-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 betterrecords 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, 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

ex-Some states also tax the income of estates, and the representative must see to it that such statestatutes 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 derlying equation expressing the accounting relationship is assets⫽ accountability However, the

un-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 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 bythe representative Every difference should be explainable

col-(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 beclosed 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 bursements to principal and income Such distinctions, although not called for under the will, arefrequently mandated by requirements of estate, inheritance, and income tax laws and regulations

dis-(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, arepaid by the representative and are recorded as “debts paid.” The payment of such debts reduces inproportion 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 thecontrol of the representative (e.g., real estate) Such information must be assembled in appropriateform 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 keeptrack of the distinction between principal and income

(ii) Operation of a Going Business. If the decedent was the individual proprietor of a goingbusiness 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 ofthe business may be continued as distinct from the general estate books, or the transactions ofthe 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 aseparate 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 andthe books closed, normally as of the date of death The liabilities should be transferred to the list ofdebts to be paid by the representative, leaving the assets, the operating expenses and income, and thesubsequently incurred liabilities to be recorded in the books of the company An account should beopened 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 tion of the remainder of the assets of the estate and a computation of the commission due therepresentative for his services If the court approves the report, it issues a decree putting the propos-als into effect

distribu-(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 fordebts paid, expenses paid, legacies distributed, and realization losses Each major item in the chargeand discharge statement should be supported by a schedule showing detailed information At anytime 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 ofproperty 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 incomeschedule, 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 tion have been explicitly indicated An implied trust may be created whether language of an instrumentindicates 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

administra-A testamentary trust is one created by a will administra-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 aguardianship

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

41.3 TRUSTS AND TRUSTEES—LEGAL BACKGROUND 41 19

A simple trust directs the trustee to distribute the entire net income of the trust to the named ciary A complex trust gives the trustee the discretionary authority to distribute or accumulate the trustnet 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’sattainment of age 21 or 25.

benefi-A grantor trust exists when both the grantor and beneficiary are the same individual benefi-A grantortrust 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 taxpurposes 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 propertyfor income tax purposes only The grantor will be taxed on the income of the trust instead of thetrust 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

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,

$xxxThe Executor credits himself as follows:

With amount paid for funeral and administrative expenses,

xxx

Second, as to Income:

The Executor charges himself as follows:

The Executor credits himself as follows:

With amount of administrative expenses chargeable to income,

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 trust may include a spendthrift clause that prohibits the beneficiary from assigning his interestbefore 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 functionsunder a bond issue, or when assets are assigned to a trustee for the benefit of creditors Bankruptcyand 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 commonlaw rule, otherwise known as the Rule against Perpetuities, limits the duration of a private trust to 21years 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 ample, is that in the case of a trust created for the benefit of a minor, the income can be accumulatedonly during the minority of the beneficiary Even the income of a charitable trust cannot be accumu-lated for an “unreasonable” period

ex-(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 thereforesometimes classified as “revocable” or “irrevocable.”

(b) APPOINTMENT AND REMOVAL OF TRUSTEES. In general, anyone competent tomake 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 toact 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 prosand 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 othermeans 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 situationestablishing a vacancy, the persons who may be appointed, and the manner of makingthe appointment

41.3 TRUSTS AND TRUSTEES—LEGAL BACKGROUND 41 21

(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 toaccept 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 TrustsA.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, ifthey 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 havebeen 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

6 Refusal to obey orders of the court5

(c) POWERS AND DUTIES OF TRUSTEES. The powers of trustees are obtained both from theprovisions 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 givenlength 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

5A W Scott, The Law of Trusts, 4th ed (Little Brown, 1987), 1995 Supplement.

The trustee secures possession of the trust property and holds title in his own name All debtorsshould be notified of the change in ownership of claims against them in order to hold them directlyliable to the trustee All debts due the trust estate should be collected promptly Trust property must bekept 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 isacting 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 usereasonable care to prevent the others from committing a breach of trust6

(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 toinvestment 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 viewthe preservation of the estate and the amount and regularity of the income to be derived In somestates (“legal-list” states), the legislatures tell trustees in what they must or may invest funds unlessthe 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

41.3 TRUSTS AND TRUSTEES—LEGAL BACKGROUND 41 23

6Id

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 corporations7

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 ilar to, or somewhat comparable to, the scope of these new rules The Restatement embodies threemain themes:

sim-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 investmentauthority to skilled professionals should they lack the required expertise or experience toproperly 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 ascurrent 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 uity, or the provisions of the trust indenture

eq-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 statesotherwise, 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 cautions that a careful businessman takes in guarding his own property, and if he is strictly following hisline of duty as a trustee If a trustee is not insolvent and mixes trust property with his own, the beneficiarymay take the whole, leaving the trustee to prove his own part If the trustee is insolvent, the beneficiaryshares with the other creditors unless definite property can be identified as belonging to the trust Interestwill be charged against a trustee who has mingled trust funds with his own If bank deposits are made inthe individual name of the trustee, he will be treated as a guarantor of the solvency of the bank, eventhough he uses care in his choice of the bank and has not in any way misused the funds

pre-In general, a trustee is not liable for losses caused by the default or negligence of a co-trustee less he has cooperated with the trustee who is at fault, or has known of the trustee’s misconduct andhas not taken any steps to prevent it If, however, each trustee should have interested himself in thematter in question, such as the proper investment of funds, each would be responsible even though hetook no part in or knew nothing of the misconduct All trustees should act together in handling thetrust property and should apply to the court for instructions in case they cannot agree Unanimity is

un-7Id

usually required for all important decisions in the case of private trusts, but a majority of a board oftrustees 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 ortrust is ultimately liable for any unpaid estate or gift taxes due on the transfer The liability isequal to the value of the property received by the recipient as of the date of transfer A review ofIRC Sections 6324 and 6901, primarily, is in order For example, the trustee of an inter vivostrust that is included in the gross estate for estate tax purposes could result in the trustee beingpersonally 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 reserveuntil he is satisfied that all such taxes are satisfied Upon making distributions, the trusteeshould also consider requesting that the beneficiaries indemnify him for any taxes that may beassessed 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 priate court The court must approve the appointment of a guardian by will A guardian is a trustee inthe strictest sense of the term He is directly under the supervision of the court If possible, only theincome 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 ofreal estate must be authorized by the court A guardian should have the authorization of the court orthe direction of a will before paying money to a minor or to anyone for the minor; otherwise he may

appro-be compelled to pay the amount again when the minor appro-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 exex-ecutor andtrustee under a will

The testamentary trustee has slightly more freedom in handling the funds than does theexecutor, 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 Atrustee 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, buttrustees 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 agraduated percentage of the funds handled

A trustee is entitled to be repaid expenditures reasonably and properly incurred in the care of trustproperty 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 thetrustee Unless the instrument by which the trust is created provides otherwise, the beneficiary, if ofage, 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 onthe 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 toallow 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 anyunauthorized action, if such action will result in irremediable damage The beneficiary may present a

41.3 TRUSTS AND TRUSTEES—LEGAL BACKGROUND 41 25

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 tothe trust, even if a substitution has been made for the original property, unless it comes into thehands of an innocent holder for value If the trust property cannot be traced or is in the hands of aninnocent holder for value, the beneficiary may bring action against the trustee in a court of equityfor breach of trust

If the beneficiary is of age and mentally competent, he may approve or ratify acts of the trusteethat 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 thegeneral legal rules must be followed

The life tenant (the present beneficiary) is entitled to the net income and the remainderman (the 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 theinvestment 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 alwaysthe 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

fu-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 tocomply with the modern portfolio theory contained in the Uniform Prudent Investor Act describedearlier As one commentator noted,8the incompatibility of the UPIA and UPAIA were reconciled

in 1997 by the National Conference of Commissioners on Uniform State Laws The revisedUPAIA accomplishes:

this result by way of an adjustment power conferred upon trustees, pursuant to which the trustee isempowered 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 optionalunitrust provision Instead of being limited to the annual accounting income actually realized bythe trust in any year, the current beneficiary of a unitrust is entitled to an amount equal to a fixedpercentage of the value of the trust’s assets determined annually As a result, the trustee is free toinvest 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 determineeach 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 yearinstead 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 bydefining 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 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)

Depart-8The 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 ment Memorandum, Vol 42, No 23 (November 5, 2001) The updated version of the article appeared

Manage-in a NYS Bar Association CLE publication entitled, “New York’s New PrManage-incipal and Income Act, thePower of Adjustment Between Principal and Income and the New 4% Unitrust Option.”

The following describes the principal and income rules under the UPAIA of 1962 Trusteesare advised to seek to professional counseling to determine whether the 1962 or 1997 revisedrules 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 tothe 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 ofspecial assessments made during the administration of the trust, the remainderman maypay the assessment and the life tenant may be charged interest thereon annually during thelife 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 arenecessary 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 erated on the property

op-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 pal; however, the expenses of litigation in an action to protest only the income are payableout of income

princi-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

41.3 TRUSTS AND TRUSTEES—LEGAL BACKGROUND 41 27

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 includesthe 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 withthe 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, dends, bond premium and discount, and depreciation and depletion

divi-(i) Unproductive Property. When the trustee is required to sell unproductive property andthe sale is delayed, the net proceeds of the sale should be apportioned between principal andincome The net proceeds are allocated by determining the sum that, with interest thereon atthe 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 erty is sold at a gain or a loss

prop-(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 ofthe 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

Larsen and Mosich provide a summarization of the general rule of accrual as applied to certainitems, 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 terest is paid only if the deposit remains until the end of the interest period, and (b) couponbonds when the payment is contingent upon the owner presenting the coupon, in which case thedate of receipt is controlling Similar rules apply to the accrual of interest expense

in-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 trustand the termination of the tenancy belongs to the income beneficiary Rent expense is handledsimilarly

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 isconsidered income to the trust A stock dividend is treated in the same manner in manystates [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 thebenefit of the income beneficiary are chargeable against income Special assessments made duringthe administration of the trust are usually paid by the remainderman, although in some caseswhere 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 onthe 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 manycases a partnership is dissolved upon the death of a partner, and there may be no income earnedafter the trust is established In the event that the business continues by specific direction of thegrantor or provision of the partnership agreement, any income earned after the trust is created isincome 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 whichcase the increase must be divided between principal and income in a manner which honors thisintention If the principal includes land, any crops harvested during this tenancy are consideredincome 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 operation with the remainderman are income to the trust.9

co-(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 trustbelong to the income beneficiary An ordinary stock dividend is usually regarded as income except instates that follow the Massachusetts rule This rule holds that all cash dividends are treated as incomeand that stock dividends are entirely principal

Some states follow the Pennsylvania rule, which holds that, in regard to extraordinary dends, it is not the form of the dividend but its source that determines whether and to what extent it

divi-41.3 TRUSTS AND TRUSTEES—LEGAL BACKGROUND 41 29

9E J Larsen and A N Mosich, Modern Advanced Accounting, 6th ed (Shephards McGraw-Hill, New York,

1994)

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 clared out of earnings accruing prior to the creation of the trust Thus, if such dividends cause thebook value of the corporation’s stock to be reduced below the book value that existed at the creation

de-of the trust, that portion de-of the dividend equivalent to the impairment de-of book value is principal andonly the remainder is income The present Pennsylvania law provides that stock dividends of 6% orless “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 ofcorporate distributions, Scott points out that the recent trend has been in favor of the Massachusettsrule.10The Uniform Principal and Income Act (Uniform Laws Annotated, Vol 7B, § 5) follows theessence of the Massachusetts rule in treating cash and other property dividends as income and stockdividends 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 theamortization of premium on bonds purchased by the trustee, but there has been little or no support ofthe accumulation of discount Any difference between the inventory value and the face value of thebonds 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 tize the premium to the date of redemption; the unamortized balance is a loss borne by principal If abonus is received, it should be credited to principal

(v) Depreciation and Depletion In determining whether provision must be made for

deprecia-tion and depledeprecia-tion, it is essential to consider carefully the intendeprecia-tions and wishes of the trustor If thetrustor intended to give the full, undiminished income to the life tenant even though the principalwould 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 principalintact, the trustee is required to withhold from income an amount sufficient to maintain the originalproperty of the trust

When the trustor’s intentions regarding the receipts from wasting property cannot be determinedfrom the trust instrument, then, according to Scott, the inference is that the trustor did not intend thatthe life beneficiary should receive the whole income at the expense of the principal.12Thus, when thetrustee holds wasting property, including royalties, patents, mines, timberlands, machinery, andequipment, he is under a duty to make a provision for amortization of such property The general rulehas been applied to new buildings erected and improvements made by the trustee; however, thecourts have generally held that buildings that were part of the trust estate at the beginning of the trustneed 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:

10Scott, The Law of Trusts.

11Id

12Id

a reasonable allowance for depreciation under generally accepted accounting principles, but no lowance shall be made for depreciation of that portion of any real property used by a beneficiary as aresidence or for depreciation of any property held by the trustee on the effective date of this Act forwhich the trustee is not then making an allowance for depreciation.

al-(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 tains substantial dominion and control), the income of the trust is subject to the federal income tax in

re-a mre-anner similre-ar to the cre-ase of re-an individure-al In generre-al, the trust is trere-ated re-as re-a conduit for tre-ax poses and is allowed a deduction for its income that is distributed or distributable currently to thebeneficiaries The trust may also be subject to state income taxes, personal property taxes, and so on

pur-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 ferences Trusts must be operated on a calendar year basis, whereas estates may operate on a fiscalyear, usually tied to the decedent’s date of death Secondly, trusts must pay estimated taxes in thesame fashion as individuals Estates, on the other hand, are exempt from this requirement, but onlyfor their first two tax years

dif-The impact of RRA ’93 (the Revenue Reconciliation Act of 1993) substantially compressed theincome tax rates applicable to trusts and estates Indexed from its original level effective for taxyears 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 marginalbracket 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 establishedwith a different rate structure in mind, and where state law permits, a trustee may want to considerbringing 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 inNew 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 apower reserved by the grantor or by the consent of all beneficiaries unless continuance of the trust isnecessary 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 tothose entitled to it according to the terms of the trust instrument The trustee, to protect himself, maysecure a formal release of all claims from all who receive any of the property and are competent toconsent, 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 properlydistinguished Two interests, that is, current or life versus future or remainder, usually serve differentparties 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 atSection 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 mitted to other interested parties at various intervals during the life of the trust

sub-41.4 ACCOUNTING FOR TRUSTS 41 31

(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 vestments is difficult because of such factors as accrued interest and amortization of bond premiumand 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

in-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 andregulations and the law relating to principal and income There are apt to be conflicts at variouspoints in the determination of taxable income and of income belonging to the life tenant The onlysolution 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 arecord of the differences between the income tax calculation of net income and the application oftrust 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 counts so as to be able to prepare a report of the administration of the estate as a whole and also aseparate report of each trust

ac-(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 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, isusually sufficient

han-(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 plete record of all transactions relating to the trust in order to protect himself, to make reports to thecourt, to prepare income tax returns, and to give the beneficiaries of the trust an adequate accounting

com-No special type of bookkeeping system is prescribed by law, but a complete record of all transactionsmust 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 TrustIncome account record the net worth or capital of the trust It will usually be necessary to analyzethose accounts for income tax purposes, just as equity is analyzed in corporation accounts to obtainall 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 bythe 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 ventory was filed, the trustee should have one prepared that will serve as the basis of his propertyaccounting Whenever possible, the inventory should contain the same values as those required forincome tax purposes in determining the gain or loss from the sale of property In any case, a record

in-of such values must be available

(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 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 bereceived at maturity should be treated as an adjustment of the interest earned and should be writtenoff during the remaining life of the bond If the amount is not large, the “straight-line” method may

re-be used, that is, the total premium or discount is divided by the numre-ber of remaining interest 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 thebond to obtain the income due to the life tenant

pay-(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, includingbuildings 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 entireperiodic deduction for depreciation is taken for income tax purposes by the beneficiaries, and thetrustee has no occasion to record depreciation in his records In all instances, the trustee should beguided 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 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, andthe 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

at-(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 beused must always be the same as those appearing on the inventory unless specific permission hasbeen 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 tributed income would be represented by an equal amount of cash in the bank If specific investmentshave 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, astatement 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 anddisbursements is also often prepared

undis-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

41.5 SOURCES AND SUGGESTED REFERENCES 41 33

———, 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 eficiaries, 2nd ed Little, Brown, Boston, 1993.

Ben-Gillett, Mark R., and Stafford, Joel D., “Steps to Prepare and File Estate Tax Returns Effectively,” Estate ning, May/June 1995 Warren Gorham & Lamont.

Plan-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 tion, 6th ed Warren, Gorham & Lamont, New York, 1991, 1995 Cum Suppl No 3.

Taxa-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.

CHAPTER 42

VALUATION OF

NONPUBLIC COMPANIES

Allyn A Joyce

Allyn A Joyce & Co., Inc.

Jacob P Roosma, CPA

Williamette Management Associates

(a) Definition of Nonpublic 2

(b) Purposes for Valuations 2

42.2 GENERAL PROCEDURE FOR

(a) Compile Background

Information about the Company 2

(b) Compile Financial Information

(c) Select Guideline Companies 3

(i) Compile Data on

(j) Employee Stock Ownership

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 ordinarilyrepresent fair market value In contrast, the common stock of a nonpublic company generally hasconcentrated 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 orclosely held company arises on many occasions Among the more important situations requiringthe valuation of nonpublic stock are filing estate and gift tax returns, transactions involving estateplanning, financial planning, employee stock ownership plan transactions and reports, grantingstock 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 anarm’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 onthat date The existence of a willing buyer and a willing seller is assumed in the very definition of fairmarket 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-informedbuyer and seller assumed in the definition of value

The appraiser should review the history of the corporation, including date and state of tion, the products originally made, evolutionary developments to the present, and changes in controlover the years A list of stockholders, directors, and a listing of officers’ names, salaries, ages, and ex-perience should be obtained

incorpora-The appraiser must understand the nature of the company’s products and/or services, raw materialsused, 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, andbackground 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 ofexisting competitors, barriers to entry and exit, and the bargaining position of customers andsuppliers

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

42.6 SOURCES AND SUGGESTED

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 Theeconomic 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 thecompetitive structure of the industry should be examined, and if these are important, the possibleeffects of patent expirations should be reviewed Research and development projects under wayshould be reviewed with management.

Changes in the industry, particularly those of a technological or marketing nature, must be 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 thegrowth 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 intrends between the company and its industry

ana-(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 thebooks 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 tionships that should be discussed with management Margins by product lines should be reviewedfor 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 sameperiod of the previous year

rela-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 balancesheet may indicate the existence of nonoperating assets, which, if material, should be segregated andvalued 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 theterms of any stock purchase agreements or stock options

The appraiser should get sales, income, and dividend data to review both the growth and cyclicalcharacteristics of the company, as well as its long-term dividend policy It is important to review thelong-term outlook with management and to obtain financial projections if available

(c) SELECT GUIDELINE COMPANIES. Having reviewed the quantitative and qualitativefactors discussed above, the appraiser must translate this complex array of facts into value Thisrequires an analysis of the most relevant facts from the actual marketplace This is ordinarilydone through the selection and analysis of guideline companies that can be used to formulateobjective 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 nopublic companies in the same industry, so it is necessary to select companies with an underlyingsimilarity of investment characteristics based on markets, products, growth, cyclical variability,and other factors

Such companies were traditionally called “comparative companies,” a term that seems toconnote companies “just like” the company being valued It is seldom, if ever, possible to findpublicly held companies “just like” the company under consideration Appraisers have come togenerally use the term “guideline companies” as a more appropriate term than “comparativecompanies.”

42.2 GENERAL PROCEDURE FOR VALUATION 42 3

The importance of a thorough, objective selection of guideline companies cannot be mated The credibility of any valuation analysis is dependent on the demonstrated objectivity of theselection of guideline companies.

overesti-There are numerous sources for identifying public companies by industry In recent years,many appraisers have switched from printed sources of information on possible guideline com-panies to computerized databases It must be recognized that the breadth and depth of coverageand the accuracy of the information contained in such services will affect the results Althoughthey are far more efficient than the traditional printed sources, if such databases are not com-prehensive in the number of companies they cover or in the way they classify businesses, someactively traded companies that meet the criteria established for the selection of guideline com-panies may be missed

The appraiser must clearly state the criteria used in selecting guideline companies A description

of each guideline company finally selected should be part of the report

(i) Compile Data on Guideline Companies It is necessary to compile financial and operating

data on the guideline companies Annual reports should be obtained on the guideline companies, and10-K reports often are helpful As much information as possible must be gleaned from official re-ports, trade sources, prospectuses, and so on, regarding products, markets, and customer depen-dence, for each of the guideline companies Balance sheet and income account comparisons arerecommended Where possible, adjustments should be made to the income and balance sheets of theguideline companies and/or the subject company to minimize differences in accounting when suchdifferences are material

Generally, public companies compute depreciation on the straight-line basis for financial ing purposes If the company being valued uses accelerated depreciation, its income and net worthshould be adjusted to a straight-line basis when the difference is substantial (10% or more of averageincome over the past five years)

report-Adjustments should be considered when there is a difference in inventory accounting method tween the subject company and the guideline companies The most common difference is that most orall of the guideline companies are on last-in, first out (LIFO) and the subject company is on first-in,first-out (FIFO)

be-The income accounts of the subject company should be carefully reviewed and the managementinterviewed with regard to extraordinary factors affecting income, such as inventory write-downs,uninsured losses, plant moving expenses, or anything of a substantial and nonrecurring nature Ad-justments should be made to eliminate the effects of these extraordinary, nonrecurring items

(ii) Calculate Market Value Ratios. Next, the appraiser should calculate the market values

of the guideline companies by multiplying the number of shares outstanding by the price pershare on the valuation date If the company has preferred stock outstanding, include it in thiscomputation

It is necessary to compute the price-earnings ratio The period selected must be the one thatbest measures the earning power of the subject company relative to the earning power of theguideline group Generally, median ratios are used to avoid the distorting effect of extremes onthe arithmetic average

Compute the average cash flow (net income plus noncash charges) for each of the guideline panies using the same period Compute the median price-cash flow ratio of the guideline group.Compute the price-dividend ratio of each of the guideline companies Generally, the dividend ofthe latest year is suitable for this purpose However, if there has been an abrupt change in the divi-dend rate in a recent quarter, the new rate may be more indicative of dividend expectations Computethe median price-dividend ratio of the guideline group

com-Compute market-value-to-book-value ratios and the median of these ratios

(d) ESTIMATE DIVIDEND-PAYING CAPACITY. The use of the price-dividend ratio raisesthe question of the significance of the actual dividend payments of a nonpublic corporation In

many cases, even though the company has the capacity to pay dividends, it pays small ones

or none at all This inevitably raises the question of whether actual dividend payments ordividend-paying capacity should be capitalized That dividend-paying capacity must be consid-ered is quite clearly the position of the IRS (Rev Rul 59-60, ¶ 3e), but the courts have not al-ways been as clear

In estimating dividend-paying capacity, the guideline companies are useful Compute the payoutratio (dividends as a percentage of net income) of the guideline companies and derive the medianpayout ratio of the group Then examine the financial position of the company being valued relative

to that of the guideline companies Consider also that the company being valued, as a closely heldcompany, does not have the same access to capital markets for equity capital as the guideline com-panies and must, therefore, rely on the retention of earnings to a greater extent than publicly heldcompanies When the financial position of the company being valued is weaker than that of theguideline companies, the dividend-paying capacity is correspondingly less If the financial position

of the company being valued is significantly stronger than that of the guideline companies, it mayhave a dividend-paying capacity equal to or greater than that of the guideline companies, despite itsinferior access to capital markets

A second part to this question is: If dividend-paying capacity should be capitalized, how?Does a dollar of dividend that could be paid, but is not paid, have a value to the minority inter-est investor equal to a dollar of dividend that is actually paid? One reasonable procedure is tocapitalize actual dividend payments at the same rate as the guideline companies and capitalizeunpaid dividend-paying capacity (the excess of the capacity to pay dividends over the actualdividends paid) at half the multiplier derived from the guideline companies This procedure rec-ognizes that the minority interest investor does benefit from that unpaid dividend-paying capac-ity because the company builds its equity base faster than it would if such dividends were paid.However, it also recognizes that the benefit is not as direct nor as immediate as the actual pay-ment of dividends

(e) JUDGMENTAL MODIFICATION OF THE VALUATION RATIOS. These market valueratios provide useful valuation guidelines However, they are nothing more than guidelines andmust inevitably be combined with the appraiser’s judgment in arriving at a sound valuation con-clusion The appraiser must, after careful consideration of all relevant factors, come to one of threepossible conclusions:

1 Investors would find the subject company to be more attractive than the group of guideline

companies (In this case, a premium must be added to the median valuation ratios.)

2 Investors would find the subject company to be less attractive than the guideline companies.

(In this case, a discount from the median valuation ratios is required.)

3 Investors would regard the subject as being neither more nor less attractive than the group of

guideline companies (In this case, the use of the median ratios would be appropriate.)This decision requires a careful comparative analysis of the subject company and the guideline com-panies in terms of both qualitative and quantitative differences

In addition to the basic nature of the product, qualitative considerations may include such factors

as market position, geographic, product, and market diversification, patent protection, depth of agement, research and development capabilities, and many others Often, but by no means always,public companies are larger and more diversified, and have more professional management Whenthey are used as guideline companies for the valuation of a smaller, weaker, less diversified company,

man-a judgmentman-al man-adjustment to the vman-aluman-ation rman-atios mman-ay be necessman-ary However, in mman-aking these mental adjustments, care must be taken to avoid “counting the same trick twice.” For instance, invaluing a company with low earnings, one should not take a discount for poor management, if it isthe poor management that causes the low earnings That would obviously be “doubling up.”

judg-In terms of quantitative differences, the appraiser should first look to long-term trends and look for sales and income Place the sales and income of each of the guideline companies on an index

out-42.2 GENERAL PROCEDURE FOR VALUATION 42 5

basis, selecting a base period that is not affected by abnormal factors Determine the median salesindex of the group of guideline companies and compare it to the company being valued Charts ofthese comparisons are particularly helpful.

Differences in trends may be properly reflected in the valuation procedure through the use of aweighted average However, a pronounced long-term inferiority of sales trend, and particularly of in-come trend, may require a further discount to the valuation ratios derived from the guideline compa-nies Conversely, a decided long-term superiority of trends may require an upward adjustment tothose valuation ratios

The appraiser should also look to the factor of variability A company with high variable earnings

is less attractive to investors than a company with a stable earnings trend However, be careful incomparing the trend of earnings of a single company to that of the group average or median The av-eraging process tends to have a stabilizing influence, and it may therefore be desirable to make acomparison on an individual company basis

A comparison of financial ratios is also recommended This should include the current ratio(current assets divided by current liabilities), liquidity ratio (current assets as a percentage oftotal assets), and leverage ratios (total liabilities as a percentage of total assets and net worth

as a percentage of total assets) Differences in financial position can be appropriately reflected

in the estimation of dividend-paying capacity In most cases, the use of dividend-paying pacity as a valuation factor makes a reasonable allowance for differences in financial position.When there are extreme differences, some further adjustment may be necessary The financialposition of the company being valued may be so weak that the nonpayment of dividends doesnot adequately reflect its poor financial position In this case, an appraiser must make a judg-mental negative adjustment to the valuation ratios On the other hand, a strong financial posi-tion is normally adequately reflected through either liberal dividend payments or a strongdividend-paying capacity A company with an extremely strong financial position relative tothe guideline companies represents an unusual situation, which is covered in Subsection42.3(h)

ca-Operating ratios, including sales times net worth, net income as a percentage of sales, and income

as a percentage of net worth, should be computed and charted These ratios should be reviewed withparticular attention to the profit margin A profit margin that is well below average may indicate ahigh-cost operation and, when accompanied by highly variable earnings, may require some discount

to the valuation ratios However, frequently a low profit margin is accompanied by a high ratio ofsales to net worth, and together these characteristics are symptomatic of integration lesser than that

of the guideline companies

Finally, examine the fundamental assumption in the valuation procedure that the earnings look of the subject company is roughly similar to that of the guideline companies If there are strongindications that such an assumption is not reasonable, make an appropriate adjustment to the valu-ation ratios

out-(f) APPLICATION OF THE MARKET VALUE RATIOS. At this point, the appraiser has rived four valuation ratios that have been derived from the guideline companies: price-net worthratio, price-earnings ratio, price-cash flow ratio, and price-dividend ratio The application of thefour ratios provides four indicators of value, and there may be considerable variation amongthem This inevitably raises the question of their relative importance There is close to universalacceptance of the notion that, except under unusual circumstances, earnings are the most impor-tant valuation factor

de-Some appraisers and some courts completely ignore the concept of cash flow The use of cashflow in valuation analysis is most appropriate when the company has large assets that do not neces-sarily decline in value with time and are not “used up” in production An obvious example is a realestate holding company The use of cash flow in the valuation of companies with very little invest-ment in depreciable assets (service companies, for instance) is somewhat redundant in that cashflow may be almost identical to earnings, and its use is simply a repetition of the price-earningsratio analysis

If the subject company is significantly more or less capital intensive than the guideline nies, the cash flow approach should be modified or eliminated.

compa-Some appraisers completely ignore dividends and dividend-paying capacity compa-Some give noweight to the book value factor

The necessity of translating these indicators into a value presents a dilemma to the appraiser

If he uses specific weights, he must defend these as reasonable and not constituting a formula Onthe other hand, deriving a value from only one of these factors also constitutes a weighting pro-cedure because it assigns a weight of 100% to that one factor and zero to the others Some ap-praisers cope with this problem by simply stating that “all things considered, I think the value isX,” but they must face the obvious question: What factors did you consider and how muchweight did you give to them?

For the most part, courts do not specify the weight they accord to these various valuation factors Inthe few cases where the courts have been specific, they have tended to ascribe primary importance toearnings rather than do dividends, and they have demonstrated a tendency to give more weight to earn-ings than to dividends The factor of book value has generally received relatively little weight in courtdecisions involving industrial companies However, it is not totally ignored

Whatever weights are used, the appraiser must thoughtfully analyze the resulting value for sonableness If this stock were publicly traded at this price, would it be more attractive than theshares of the guideline companies? Would it be significantly less attractive than shares of the guide-line companies? If the appraiser can answer both of these questions in the negative, he has probablyarrived at a reasonable result

rea-(i) Discount for Lack of Marketability The value derived from the guideline analysis is the

freely traded price, that is, the price at which the common stock of the subject company would trade

if it had an active public market

Clearly, lack of ready marketability makes a stock considerably less attractive than it would be if

it were readily marketable This was recognized by the IRS in its Rev Rul 77-287 when, in cussing the value of unregistered shares of public companies, it stated: “The discount from the mar-ket price provides the main incentive for a potential buyer to acquire restricted securities.”

dis-In recent years, appraisers have generally used transactions in the restricted shares of public panies as the best guideline for determining the appropriate discount for lack of marketability Anumber of studies have been made of this market, and they indicate a rather wide dispersion of dis-counts but most indicate a median discount of about 35% The two seminal studies, those of Maherand Moroney, indicated median discounts of 34.73% and 33% respectively.1More recent studieshave been made by Willamette Management Associates (median 31.2%) and Standard ResearchConsultants (45%) The change in the required holding period of restricted stock has limited theusefulness of this evidence in the valuation of nonpublic companies

com-Willamette Associates has also analyzed the relationship of original public offering prices toarm’s-length trades during the three years preceding the public offering, which suggests discounts inthe 40% to 60% range

(ii) Discount for Minority Interest The discount for lack of marketability should not be confused

with a discount for minority interest This chapter has explained the use of publicly held guidelinecompanies in making a judgment as to the value of stock in a nonpublic company The prices at whichthe common stocks of those guideline companies sell reflect minority interest values; therefore, thecomparative analysis enables the appraiser to express an opinion about the price at which the stock ofthe subject closely held company would trade if it had an active public market (the freely traded value)

It is therefore a minority interest value to begin with, and a minority interest discount is inappropriate

42.2 GENERAL PROCEDURE FOR VALUATION 42 7

1J Michael Maher, “Discounts for Lack of Marketability for Closely-Held Business Interests,” Taxes—The Tax Magazine, September 1976, pp 562–571 Robert E Moroney, “Most Courts Overvalue Closely Held Stocks,” Taxes—The Tax Magazine, March 1973, pp 144–154.

However, the stock of a closely held company is lacking in marketability, and a discount for lack ofmarketability is appropriate.

(g) DISCOUNTED FUTURE BENEFITS APPROACHES A discounted future benefits valuation

involves two fundamental, difficult, and very imprecise steps:

1 The long-term projection of the benefit

2 The determination of an appropriate discount rate, by which the future benefits may be

re-duced to present value

It is essential that the discount rate and the benefit be matched That is, a dividend or net-free cashflow discount rate must be applied to projected dividends or net-free cash flow An earnings discountrate must be applied to projected earnings The use of a net cash flow discount rate to discount earn-ings, for instance, is erroneous

Data on past rates of return on publicly traded common stocks are readily available and can beused as a reference point in estimating the appropriate rate of return (dividend or net-free cashflow discount rate) of a subject company As a result, discounted future benefits valuations are al-most always done on the basis of cash flow The term “net cash flow” is often used, usually in thecontext of an enterprise valuation Because net cash flow is the total cash flow of the businessminus its capital (fixed assets and working capital) needs, it is essentially the same as dividends ordividend-paying capacity

The projection of net-free cash flow or dividends is a three-step procedure:

1 Project total cash flow (total revenues less cash expenses)

2 Project the capital needs of the business

a Project required capital expenditures

b Project required net working capital changes

3 Compute dividend-paying capacity (total cash flow minus total capital needs)

The general theory used in estimating the expected rate of return is that investors’ return tions are based on past returns In establishing the required rate of return for a nonpublic company,practitioners almost invariably use long-term stock return data compiled by Ibbotson Associates,

expecta-whose Annual Yearbook includes series of stock return data.

In deriving the required rate of return for a subject company, it is first necessary to estimate therate of return investors expect on the small companies themselves on the valuation date Then, if theappraiser believes that an investment in the subject company is riskier than in the small companies,

he must add an increment to their rate of return to reflect that greater risk Conversely, if the appraiserbelieves the risk is less, the rate of return must be reduced

The value of stock is the present value of future returns in perpetuity This axiom requires, at leasttheoretically, that future dividends or net-free cash flows be projected and their present value be de-termined in perpetuity or, as a practical matter, so far into the future that present value increments be-come insignificant There are three ways of doing this:

1 The arithmetic method

2 The algebraic method

3 The semialgebraic method

Under the arithmetic method, each year’s dividend is projected and its present value determinedusing the expected rate of return This is done for all future years until the annual present value in-crements become insignificant Then the present values are totaled to give value

In the algebraic method, the appraiser used the Gordon Model, which is:

where D⫽ dividends for the first year after the valuation date, ROR ⫽ the expected rate of return,

and g⫽ expected rate of growth in perpetuity

The algebraic method produces the same value as the arithmetic method It is simply a tional shortcut It can be used only if the assumed growth rate of dividends is constant

computa-In the semialgebraic method, dividends or net-free cash flows are projected for a few years, ally five, and then present value is determined Then the Gordon Model is used to determine thevalue at the end of the projection period, and the present value of that “terminal value” is added to thepresent value of the cash flows during the projection period

usu-Appraisers rarely use the arithmetic method because it tends to highlight the fact that theirvaluation depends on a projection of dividends decades into the future Also, appraisers do notcommonly use the algebraic method, possibly because it seems embarrassingly simple By far themost common method used is the semialgebraic, probably because it give the appearance of suit-able complexity and tends to obscure the inherently infinite nature of the projection However,unlike the algebraic method, it can accommodate changes in the growth rates and capital needsduring the projection period

The discounted future net-free cash flow or dividends approach, as a valuation model, is nently sound However, the problems inherent in its application to a specific fact situation, primarilythe inexactitude of the two major inputs, return and benefits, render the results obtained only as good

emi-as the emi-assumption incorporated in its application

If the guideline company approach and the discounted future benefits approach produce tially different values, the appraiser should carefully analyze the reasons for the difference Such dif-ferences usually indicate that the investing public is using a different discount rate and/or growth ratefrom those used by the appraiser in his discounted benefits approach

substan-(h) USE OF FORMULAS Rev Rul 59-60, the courts, and the Employees Stock Ownership Plan

(ESOP) Association have discredited the use of valuation formulas The ESOP Association made thepoint very clearly: “Formula appraisals are totally unacceptable, because they will virtually alwaysresult in an unfair, if not absurd, appraisal at some time in the future.”

Valuation formulas can be as simple as “Value⫽ net book value,” “Value ⫽ net asset value,” or

“Value⫽ 10 ⫻ earnings.” On the other hand, they can be so complex as to defy comprehension.Doctors and engineers seem particularly enamored of complex valuation formulas

The most widely employed type of formula still in use by some business appraisers is the “excessearnings formula.” The original formula of this type was ARM-34, which was used for many years

by IRS in the valuation of closely held companies

ARM-34 was as follows:

Value⫽ book value ⫹ capitalized excess earningsGenerally, excess earnings were defined as earnings in excess of 10% of net worth, and a 20%capitalization rate was generally used in capitalizing excess earnings so that, in practice, the for-mula was:

Value⫽ book value ⫹ 5冢earnings⫺ 冣The formula has long since been discredited and abandoned by the IRS as well as the courts because it

is arbitrary and not market oriented and can therefore produce very unrealistic values

book value

DᎏROR⫺ g

42.2 GENERAL PROCEDURE FOR VALUATION 42 9

However, a variation of ARM-34 is still in use by some appraisers The basic formula isthe same:

Value⫽ book value ⫹ capitalized excess earningsExcess earnings are defined as the earnings in excess of the industry’s average rate of earnings onstockholders’ equity Typically, these excess earnings are capitalized at 20% (or multiplied by 5) Theshortcomings of this approach are fundamentally the same as ARM-34 The underlying assumptionthat a company is worth its book value if it has an average rate of earnings on net worth for its in-dustry is arbitrary, unsupported, and often absurd In fact, companies in industries marked by lowrates of earnings on book value will tend, on average, to have values in excess of book value, some-times by a factor of 4 or 5

(i) NET ASSET VALUE APPROACH Net asset value is simply computed by adjusting all assets to

a market value basis and deducting all liabilities Fundamentally, this is yet another formula approach,the formula being “Value⫽ net asset value.” There is ample evidence in the marketplace that the com-mon stocks of industrial companies can sell appreciably above or below net asset value This is not sur-prising because the normal expectation of investors is that the benefits of ownership will be received

by them by way of dividends and a rising market price However, if the liquidation of a company ispending, net asset value is of paramount importance

Net asset value has greater relevance to the appraisal of holding companies, notably investmentcompanies and real estate holding companies Even here, however, the evidence of the marketplace

is that the stocks of such companies almost always trade below net asset value

42.3 SPECIAL SITUATIONS

(a) WHOLESALE AND RETAIL COMPANIES The valuation of wholesale and retail companies

is essentially similar to that of an industrial company as described above Attention should be given

to costs of store openings as well as to credit and inventory management Particular attention should

be paid to the factor of geographic diversification in valuing distribution companies For example, asupermarket chain whose stores are concentrated in a single city involves greater investment riskthan a regional supermarket company operating in a number of cities, and special allowance should

be made for such differences

(b) VALUATION OF SERVICE COMPANIES The U.S economy is increasingly dominated by

companies engaged in the performance of services for their customers as opposed to manufacturing.Service companies range in the size and scope of activities from small businesses having a consider-able dependence on one or a few specialized employees to large businesses such as the major pay-roll/computer service businesses The size and scope of activities will determine the valuationmethod employed Since the value of a business engaged in the provision of services typically at-taches to human resources as opposed to capital assets, the factor of size of capital generally is ac-corded less weight than size of the financial benefits of ownership in the valuation of an industrial ormanufacturing company Moreover, the factor of cash flow may in many instances simply be du-plicative of earnings in service businesses having modest capital needs

Smaller businesses having a particular dependence on relatively few employees and a special ket niche may not lend themselves to the publicly traded guideline company approach Services pro-viding limited information on small company transactions exist and can be helpful in delineatingvaluation parameters provided the business in question is reasonably similar to the businesses re-ported on in these services The appraiser ordinarily will use a capitalization of earnings approach em-ploying an appropriate risk-adjusted capitalization factor giving consideration to the special risksassociated with their small size Such capitalization factors inevitably involve a considerable injection

mar-of prmar-ofessional judgment on the part mar-of the appraiser

(c) COMPANIES WITH LOW EARNINGS. The valuation of a company with a very low rate of earnings on stockholders’ equity can present a particular problem The extremeform of this is a company that over a period of years has had no earnings and no capacity

to pay dividends The use of the valuation procedure described earlier can be misleading inthis instance, since primary weight is given to evidence of earning power Obviously, the company with no earnings has no value based solely on the factor of earning power.These cases must be carefully judged on their own merits If liquidation is certain, or evenprobable, liquidating value is governing If not, a going-concern valuation is called for, rec-ognizing that companies that are “worth more dead than alive” because of chronically lowearnings may go on for years without liquidating, and the minority interest investor cannotforce a liquidation

In estimating going-concern value, it is helpful to examine the range of the ratios of marketvalue to book value of the guideline companies Frequently there are, among the guideline compa-nies, two or three companies with low rates of earnings on stockholders’ equity (5% or less), andthese tend to have low price-book value ratios In a group where the median price-book value ra-tios might be 80% or 90%, there may very well be two or three companies earning less than 5% oncapital, which may have price-book value ratios of 40% or 50% Under such circumstances, thesedata would lead to the conclusion that the company with no earnings at all should be valued belowthat 40% or 50%

The influence of judgment in this situation can be reduced through the use of a statistical gression technique Examine the relationship between the market value-book value ratio andthe rate of earnings on book value of the guideline companies Generally there is a definite re-lationship that can be described precisely through the use of a simple linear correlation Thistechnique makes it quite clear that the companies with high rates of earnings on stockholders’equity tend to have high price-book value ratios, and the companies with low rates of earnings

re-on stockholders’ equity tend to have low market price-book value ratios The statistical tion of this relationship can constitute a satisfactory basis for the valuation of a company withlittle or no earnings

defini-(d) HOLDING COMPANIES. The guideline company technique is also used in valuingholding companies, that is, companies whose assets consist largely of securities Guidelinecompanies must be selected that parallel, to the extent possible, the nature of the assets of thecompany being valued If the holding company being valued has a diversified portfolio of com-mon stocks, it is desirable to select closed-end diversified investment companies The analystcan then examine the relationship between the market value of the stocks of such companies andunderlying net asset values The relationships of market value to earnings and of market value todividends should also be reviewed However, the ratio of market value to net asset value is gen-erally conceded to be the primary determinant of value, and, as a practical matter, this ratio gen-erally shows far greater consistency than the price-earnings or price-dividends ratios ofclosed-end investment companies In determining the net asset value of the holding company,the capital gains tax on unrealized capital gains may be deducted as a way to reflect the tax dis-advantage of the holding company vis-à-vis regulated investment companies However, somesimply modify the median price to net asset value derived from comparatives on the theory thatthe subject company, unlike the guideline companies, may be “locked in” to some investments

by virtue of the capital gains tax

The procedure involving a nondiversified investment company is essentially similar to that justdescribed for diversified companies, except that nondiversified investment companies are selectedfor comparison The other difference is that some of the nondiversified investment companies may

be taxed as ordinary corporations; therefore, the holding company may not be at a tax disadvantagerelative to such guideline companies

If the portfolio of the subject company is concentrated in just a few investments, it may be cult to find public companies so lacking in diversification Under these circumstances, it will be nec-essary to apply a discount to the ratios derived from the guideline companies

diffi-42.3 SPECIAL SITUATIONS 42 11

If the investment portfolio is largely debt securities of good quality, the appraiser should amine the relationship between market value and underlying net asset value of closed-end bondfunds As a general rule, the market value-net asset value ratio among these companies is quiteclose to net asset value.

ex-(e) REAL ESTATE COMPANIES The valuation of a minority interest in a real estate holding

com-pany requires an appraisal of the underlying assets by a qualified real estate appraiser

The net asset value of the real estate holding company can then be computed by adjustingstockholders’ equity for the difference between the appraisal value of the real estate and netbook value

The appraiser should select publicly held real estate companies owning similar types of real tate, which disclose the estimated appraised value of their assets This can be used in calculatingnet asset value This, in turn, can be used to calculate the price-net asset value relationship It isalso recommended that the relationship among market value and earnings, cash flow, and divi-dends be examined

es-In applying such ratios to the company being valued, primary weight should be given to the ket price-net asset value ratio However, the factors of earnings, cash flow, and dividends certainlyshould not be ignored

mar-In applying these ratios, judgment must be brought to bear on qualitative differencesbetween the guideline companies and the subject company Diversification by property andneighborhood must be considered A comparison of financial position and the operating record

is important

(f) COMPANIES WITH NONOPERATING ASSETS. Industrial companies with large operating assets present a particular valuation problem The company whose cash clearly ex-ceeds its operating needs by a substantial margin is a case in point Another is a companyowning a large portfolio of securities Still another example is a company owning valuable realestate unrelated to its basic business In these instances, it is best to remove such assets from thebalance sheet and deduct the related earnings, with an appropriate tax adjustment, from reportedearnings Dividends must also be adjusted Value the company as though it did not own the non-operating assets It is then necessary to determine the appropriate increment to the value of thestock determined on an operating basis If the nonoperating assets are securities, the best proce-dure is that recommended for an investment company [see Subsection 42.3(d)] Similarly, ifsuch assets are real estate, the procedure used in valuing a minority interest in a real estate com-pany is appropriate

non-(g) LIFE INSURANCE PROCEEDS. In valuing common stock for estate tax purposes, it isnecessary to reflect any windfall to the company arising from any life insurance on the de-ceased This may be done by considering the company’s improved financial position and itshigher earning power related to the proceeds If the proceeds result in a level of cash beyondthe needs of the business, then the excess should be treated as a nonoperating asset, as re-viewed above

If the deceased was a key man, it may be necessary to apply a special discount to reflect thehigher risk related to his loss

(h) COMPANIES WITH AN EXTREMELY STRONG FINANCIAL POSITION. A companywith an extremely strong financial position can present a particular valuation problem An ex-ample is a real estate company with no long-term debt The publicly held companies that might

be used for comparative purposes, without exception, have large amounts of long-term debtoutstanding Thus any price-earnings ratio or price-net asset value ratio that can be derivedfrom them reflects the way in which the investing public values a real estate company with sig-nificant leverage

An appraiser might approach this problem in the usual way and then adjust the valuation tios derived from publicly held real estate companies to reflect the superior financial position ofthe subject company However, the influence of the appraiser’s judgment can be minimized bychanging to the “total invested capital technique,” to quantify better the effect of extreme superi-ority in financial position.

ra-In employing the total invested capital technique, the total market value of all preferred and mon stock is combined with the total market value of all the outstanding long-term debt of each ofthe guideline companies That represents the total market value of the total invested capital Thatamount is then related to the book value of that total invested capital (net worth plus long-term debt),adjusted for underlying asset values in the case of real estate companies

com-Similarly, the total market value of the total invested capital is related to the earningsavailable for that total invested capital (net income plus interest on long-term debt), to thecash flow available for that invested capital (net income plus noncash charges, plus interest

on long-term debt), and finally to the earnings paid out on that total invested capital dends plus interest on long-term debt) The application of these ratios to a company with adecidedly stronger financial position is recommended when the company being valued isstronger than the guideline companies by a very wide margin, a circumstance that tends tooccur in the valuation of real estate companies but may be encountered in the valuation of anindustrial company

(divi-One important drawback of this technique should be noted It is necessary to ascertain the marketvalue of the long-term debt of the guideline companies and, when the debt is not publicly traded, it isnecessary to estimate its market value This introduces an element of judgment that the basic proce-dure does not entail

(i) PREFERRED STOCK A standard preferred stock is a security which has the following seven

features:

1 The right to receive a stated cumulative cash dividend before any cash dividends are paid to

the company’s common stock

2 The right to receive a stated amount upon liquidation of the company before any proceeds are

distributed to the company’s common stock

3 No voting rights in normal circumstances

4 No participation rights in dividends or liquidation proceeds beyond its stated preferences

5 No conversion rights

6 No redemption rights at the option of the holder; may be callable by the company

7 No sinking fund or other feature that provides a definite maturity

There are two key elements in the valuation of a standard preferred stock:

1 The probability that the company will meet the obligations of the preferred stock This entails

consideration of:

a The earnings coverage for the dividend preference

b The asset coverage for the liquidation preference

c The characteristics of the corporation, which could affect these coverages, particularly its

prospective growth, financial position, and stability

2 The yields available from comparable fixed income investments

The valuation of preferred stock requires the selection and analysis of publicly traded preferredstocks that can be used to formulate the best possible valuation guidelines There are surprisinglyfew actively traded standard preferred stocks of industrial companies, and it is not possible to confine

42.3 SPECIAL SITUATIONS 42 13

comparatives to a single industry It is necessary to compute the earnings coverage of each of thesesecurities Earnings coverage is computed as follows:

Earnings before interest and taxes

Asset coverage is measured relative to both current assets and total assets and is computed as lows:

fol-Current assets coverage:⫽

Total assets coverage:⫽

Compute the yield (dividend divided by market price) on each of these securities, looking for arelationship between the yield and the earnings and asset coverages of the comparative preferreds.Qualitative factors should also be considered Precise relationships are seldom ascertainable How-ever, a careful review of the data should provide a good base for the exercise of informed judgment

in determining the freely traded value

A discount to the freely traded value is required General practice among appraisers is to apply adiscount of 15% to 20% for lack of marketability of standard preferred stocks

It is sometimes necessary to appraise a preferred stock that deviates in significant ways from astandard preferred stock An exhaustive list of such preferred stocks is not practical However, five ofthe more common variations are as follows:

1 Noncumulative preferred stock Some increase in the yield is warranted for the risk that the

dividend may be skipped and “gone forever.”

2 Preferred stock with share convertibility This is preferred stock that is convertible into

a specified number of shares of common stock It is necessary to determine the fair ket value of the common stock into which the preferred is convertible If the conversionvalue (the value of the common stock into which the preferred is convertible) is substan-tially less than the value as a standard preferred, the premium for convertibility is small

mar-or even nonexistent On the other hand, if the conversion value exceeds the value as astandard preferred stock, the market value is equal to the conversion value plus a smallpremium

3 Preferred stock with dollar convertibility This type of preferred is typically convertible

into an amount of common stock having a specified dollar value, usually $100, on theconversion date Even though its dividend may not warrant a value of $100, the conver-sion feature may give it a value close to or at the conversion price, depending on the as-surance that the owner of the preferred can convert and receive $100 worth of commonstock at any time

4 Preferred stock with participation rights This type of preferred is entitled to the standard

fixed dividend and liquidation preferences plus a share of the residual dividends or asset ues, or both, which would otherwise pass to the common stock Such rights give the pre-ferred some of the attributes of a common stock and these attributes should be valued in asimilar manner

val-5 Preferred stock with an adjustable dividend rate The dividend rate on such preferreds is

typi-cally adjusted quarterly to reflect prevailing market yields This adjustment feature, depending

on its specific structure, generally maintains the value of these preferreds at or near par Many

Total assetsᎏᎏᎏᎏᎏTotal liabilities⫹ par value of preferred

Current assetsᎏᎏᎏᎏᎏTotal liabilities⫹ par value of preferredpreferred dividend requirement

public companies have issued adjustable rate preferred stocks, but they are uncommon amongnonpublic companies.

(j) EMPLOYEE STOCK OWNERSHIP PLANS There has been an enormous growth in the

num-ber of companies with employee stock ownership plans The trust established under an ESOP quires a determination of fair market value for a variety of reasons, including these five:

re-1 Contributions of stock by the company or sales by its stockholders to the ESOP

2 Sales of stock by the ESOP to third parties

3 Transfer of shares from the ESOP to a beneficiary

4 Repurchase of shares from a beneficiary exercising his or her put

5 Reports required by the Employee Retirement Income Security Act (ERISA)

The appraiser of ESOP shares should be familiar with the Department of Labor (DOL) proposedregulations regarding ESOP appraisals These regulations stress the requirement that the appraiser beindependent of all parties to the transaction other than the plan They also stress the requirement of afully documented appraisal The proposed regulation affirms Rev Rul 59-60 as a reasonable state-ment of general valuation principles, but the DOL seems to go out of its way to mandate the use ofguideline companies

The valuation of ESOP shares is fundamentally the same as valuation for other purposes exceptthat the put obligation, providing it is enforceable, constitutes a kind of marketability that may re-duce or even eliminate the lack of marketability discount that would otherwise be required The ap-praiser, in deriving the freely traded value of the shares, will have used publicly held guidelinecompanies as valuation guidelines If the appraiser concludes that the put gives the beneficiary aboutthe same assurance of marketability that he would enjoy if the trust held stock of the guideline com-panies, then little discount is necessary However, if the business risks of the subject company aresuch that the assurance of marketability is less, then some discount for lack of marketability is re-quired The size of such discount depends on the appraiser’s assessment of the probability that thecompany will be financially able to honor put obligations This requires an analysis of the company’sgrowth, stability, financial position, and cash flow—all factors that the appraiser will have consid-ered in the basic process Consideration should also be given to the timing and size of stock distrib-utions to terminating employees since these factors could affect the company’s ability to honor itsput obligations

Some appraisers believe that an additional discount is required for the lack of marketability of thestock in the hands of the trust, because the put does not affect the marketability of shares until theyare distributed out of the trust Others, viewing the trust as a device by which stock is held for ulti-mate distribution to terminating employees, conclude that the degree of marketability to the trustneed not be reflected in valuing the stock

There has been considerable discussion within the appraisal profession as to the effect that thestock repurchase liability may have on the fair market value of the stock (“Stock repurchase liabil-ity” is not a liability in the normal sense of the word because it is an obligation to purchase an asset

at its market value.) To date, no consensus has developed, and most appraisers seem to ignore theissue or list it as “a factor that has been considered.”

Leveraged ESOPs present additional problems to the appraiser beyond the scope of thisbook

(k) VALUATIONS FOR MARITAL DISSOLUTIONS The classic definition of fair market value

is not always appropriate for a business valuation to be used in a divorce proceeding This is larly true in the case of professional practices that cannot be sold The standard of value may not beclear from the statutes or the case law It is imperative that the appraiser get guidance from the attor-ney with regard to the standard of value and the ways in which that standard can be applied to thecase at hand

particu-42.3 SPECIAL SITUATIONS 42 15