Morrison & Foerster LLP: Planning and Administration in a Volatile Economy: Dealing with Abatement

Morrison & Foerster LLP: Planning and Administration in a Volatile Economy: Dealing with Abatement

By Sonja K. Johnson, Esq., Morrison & Foerster LLP

Fluctuations in today's economic climate necessitate that individuals and their estate planning professionals consider the possibility of abatement (i.e., reduction of gifts due to insufficient estate assets) when designing a testamentary plan.  Instability in the values of securities, real estate and other assets can cause the property in an individual's estate to be worth much less at death than at the time the estate plan was put into place.  Depending on the operation of the estate plan, this can in some cases lead to unintended consequences, drastically reducing or even eliminating the gifts to those individuals who were intended to be the estate's primary beneficiaries.

The obvious scenario in which this issue arises is that in which a testamentary instrument provides for extensive special gifts (i.e., general and/or specific) to various beneficiaries, followed by a disposition of the residue, which is expected to constitute the bulk of the estate, to one or more primary beneficiaries.  If the value of the decedent's property declines substantially between implementation of the decedent's estate plan and his or her death, such a plan can leave a much smaller amount (after satisfaction of all of the special gifts) for the residuary beneficiaries than the decedent had intended.

Matters become even more complicated, however, in the case of abatement: in other words, when the estate or trust estate has insufficient assets to satisfy even the special gifts set forth in the will or trust instrument.  When this occurs, such gifts are subject to abatement in accordance with the terms of the will or trust instrument.  If, as is often the case, the testamentary instrument does not provide instructions with respect to abatement, then gifts are reduced in accordance with the applicable state statute.  The following discussion examines the operation of abatement under the California Probate Code, in particular focusing on the complex analysis that arises in the context of significant gifts to non-relatives-an issue that can become especially relevant for couples who are not married or in a registered domestic partnership,1 or for individuals who wish to make significant provisions for other people to whom they are not related.

Abatement under California Law

California Probate Code (the "Code") section 21402, "Order of abatement," provides that after the residue, shares of beneficiaries abate according to both the type of gift and the relationship to the transferor, as follows (with gifts subject to abatement first listed first):

1.      general gifts to non-relatives

2.      general gifts to relatives

3.      specific gifts to non-relatives

4.      specific gifts to relatives

For these purposes, the term "relatives" refers to persons who would take under intestate succession (in other words, a person's nearest of kin who would inherit his or her assets if s/he died without a valid will or trust), as set forth in Code sections 6400-6414.  "Specific" gifts refer to particular, named property such as tangible goods or real estate.  "General" gifts are those that, even if specific in amount, are to be paid out of the general assets of the trust or estate (such as special monetary gifts set forth in a will or trust instrument).

Although the foregoing section appears to provide clear guidance, the issue can be complicated by the more general Code section 21400, "Effectuation of instrument, transferor's plan, or purpose of transfer," which provides:

Notwithstanding any other provision of this part [including section 21402] ... if the transferor's plan or if the purpose of the transfer would be defeated by abatement as provided in this part, the shares of beneficiaries abate as is necessary to effectuate the instrument, plan, or purpose.

Thus, section 21400 presents a factual question as to a decedent's testamentary plan in case of abatement.  If, for example, the decedent's intent was not to prioritize gifts to his or her relatives, then implementation of the abatement hierarchy established in section 21402 would not be appropriate.

Abatement and Substantial Gifts to Non-Relatives

Our firm recently encountered this issue firsthand when representing the trustee of an administrative trust with insufficient assets to cover the trust instrument's special gifts.  Because of these circumstances, it was necessary for the trustee to allocate the trust property in the most appropriate manner possible, based on the rules of abatement described above and a good faith estimation of the decedent's wishes.  In our case, the trust instrument (which did not directly address abatement) included two very substantial special gifts, one to a niece and one to the decedent's significant other ("Terry"), as well as a number of smaller special gifts to various relatives and friends.  The value of the trust estate had declined substantially enough that abatement in accordance with the order set forth in Code section 21400 essentially would have eliminated the entire monetary gift to Terry-a result that did not appear to reflect the decedent's wishes.

Although a decedent's intent may be impossible to prove conclusively in the absence of language directly pertaining to abatement, a logical examination of the dispositions in the applicable will or trust instrument may shed some light on this question.  In our case, the two trust beneficiaries with the largest dispositions were a niece (a relative) and Terry (the decedent's significant other, a non-relative).  The decedent's two other special gifts to non-relatives were equal to the special gifts made to most relatives.  Therefore, it appeared that the decedent did not tend to favor relatives as a class, at least as indicated by the amounts the decedent chose to leave to them.

The other fact in our case that pointed in this direction was that Terry was to receive the decedent's home under the trust instrument.  In and of itself, the act of leaving this substantial asset to a non-relative indicated that the decedent was not necessarily inclined to favor relatives.  In addition, Terry had relatively limited assets and therefore might not have been able to keep the home if not for the special monetary gift also provided for in the trust.  It may be reasonable to assume that the decedent wanted Terry to be able to live in this home and that the decedent's testamentary plan would thus have been defeated if the trust provisions were abated in a manner that drastically reduced the special monetary gift to Terry.

Although case law in this area is somewhat conflicting and fairly old, it does seem to weigh in favor of treating the trust or estate beneficiaries equally in such a case.  Perhaps the most relevant case is Estate of Greenwald, in which "the testator gave two and one-half times as much to his friends as to his relatives."2  The testator's will did not specifically address the possibility of abatement, but the court cited several other provisions of the will in its finding that the testator intended for all beneficiaries to be treated equally.  In addition to citing the more substantial bequests to friends, the court stated:

With respect to both relatives and friends [the testator] provided that the bequests should not fail but should go to the legatee's spouse in the event of the legatee's prior death.  In paragraph XX he states that he has intentionally omitted to make any provision for his heirs other than that specifically mentioned in the will.  This is some indication that he did not intend to give them any preference which might otherwise arise from law ... In paragraph XXII, relating to estate and inheritance taxes, he provided that both relatives and friends should be treated alike.3

Thus, despite the fact that the will did not discuss abatement, the court found that "it sufficiently appears from the language of the will that the testator intended that all these legatees, without regard to kinship, should share proportionately in any assets available for distribution."4

As in Greenwald, the trust in our case did not directly address potential abatement, but provided these peripheral clues as to the decedent's intent.  One gift to a friend was to go to the friend's child (rather than failing) in the event that the friend did not survive the decedent, and vice versa with respect to a gift for the friend's child.  Terry's gift was to be distributed to certain of the decedent's nieces and nephews if Terry did not survive the decedent.  Among the gifts to the decedent's nieces and nephews, most had one specific secondary beneficiary (though some had none) and were to lapse if none of the named beneficiaries survived the decedent.  Thus, the decedent did not seem to have discriminated among beneficiaries, at least with regard to whether they were the decedent's relatives, in this respect.  Also mirroring the factors in Greenwald, the trust in our case provided that the decedent had intentionally failed to provide for the decedent's heirs other than as specifically mentioned in the trust, and that the special distributions, to friends and relatives alike, were to be made free of estate taxes.  Coupled with the above discussion of the gift amounts, these factors appeared to point towards equal treatment of all beneficiaries of the trust, regardless of blood relationship to the decedent.

It is important to note that not all cases point in this direction.  In re Buck's Estate illustrates a different approach, with the court finding that a bequest of stock to the testator's friend should abate prior to equal bequests of stock to his six children.5  In so finding, the court stated that "[i]n order to defeat the preference accorded to the children under the statute, it must affirmatively and unequivocally appear that such was the testator's intent."6  The will itself had not provided any specific direction with respect to abatement, and the court found that the mere fact that the testator had given equal amounts of stock to his friend and his children (whom, the will stated, had been otherwise provided for in his mother's will) was insufficient to show "that the testator intended to deprive his children of the preference accorded them by statute."7  Moreover, the extrinsic evidence introduced (though its contents are unclear) apparently lacked any specific facts bearing on this issue.8  Thus, the courts have not always found it so easy to discern a testator's intent to defeat statutory preference for blood relatives.9

Although In re Buck took a position contrary to Greenwald and the trustee's proposed treatment of the beneficiaries in our case, it is distinguishable from the latter approach in certain respects.  First, the Buck bequest to a friend was equal to those made to relatives.  The trust in our case (like the Greenwald will), on the other hand, made gifts to friends that were substantially larger than many of those made to relatives.  Second, the relatives involved in Buck were the testator's children, whereas those in our case (as in Greenwald) were nieces and nephews.  Although there is no formal distinction here, courts may generally be more inclined to support favorable treatment of a testator's or settlor's children than his or her more extended relatives.  Finally, the apparently insufficient extrinsic evidence in Buck is unclear, whereas the decedent in our case evidenced a fairly clear intent to allow Terry to live in the decedent's home.  Thus, In re Buck demonstrates the contrary position that may be taken on this issue, but did not necessarily indicate that equal treatment of beneficiaries would have been inappropriate in our case.

Ultimately, the trustee in our case determined that treating Terry as a relative for purposes of abatement was the best possible implementation of the decedent's intent.  Because of the potentially controversial nature of this determination, however, the trustee elected to put the issue to the beneficiaries with a notice of proposed action.10  No beneficiaries objected to the proposed approach, so the trustee was able to calculate and distribute amounts to each beneficiary based on an abatement schedule that treated Terry as a relative, thereby reducing but not eliminating the decedent's gift to Terry.

Conclusion

Ideally, of course, a decedent is able to leave sufficient assets to cover all of the gifts contemplated by his or her estate plan.  However, because this is rarely a certainty, it is important for individuals and their estate planning professionals to consider the potential outcome of a significant decline in the value of the estate, whether this means a smaller residue than anticipated or the subjection of special gifts to abatement.  Providing instructions with respect to the operation of abatement within the testamentary instrument provides the most certainty, but at minimum an individual should understand the abatement rules under current law to ensure that its operation would not undermine his or her wishes if the value of the estate is lower than anticipated.

For those already administering estates or administrative trusts with insufficient assets to cover all of the special gifts provided for in the testamentary instrument, it is critical to thoroughly understand the operation of abatement under applicable laws.  As illustrated by our experience, abatement can raise significant questions and complexities even under the best of circumstances.  In order to properly carry out a decedent's testamentary wishes, it is well worth thoroughly examining the operation of abatement in light of the particular circumstances involved.  Given the potential for discord among beneficiaries, in some cases it is also prudent to seek beneficiary consent through tools such as a notice of proposed action or to obtain court approval when necessary to confirm the manner in which gifts should be abated.


[1]   The California Probate Code does not distinguish between spouses and registered domestic partners, which may be either same-sex couples or opposite-sex couples in which at least one partner is 62 or older.  See Cal. Prob. Code §§ 6400-6414.

[2]   Estate of Greenwald, 25 Cal.App.2d 657, 661 (1938) [enhanced version available to lexis.com subscribers].

[3]   Id. at 661.

[4]   Id. at 662.

[5]   In re Buck's Estate, 32 Cal.2d 372 (1948) [enhanced version].

[6]   Id. at 377.

[7]   Id. at 377.

[8]   Id. at 377.

[9]   Although it ultimately did not distinguish among beneficiaries based on relationship to the testator, another court apparently found it necessary to rely on a will's no‑contest clause to justify treating beneficiaries equally in the abatement process, stating at one point that the "very fact that appellant was a stranger in blood but was nevertheless placed on a parity with the nieces of the testatrix may have caused her to make assurance doubly sure by the reinforcement which [the no-contest clause] gave to paragraph fourth [providing equally for her friend and two nieces]."  Estate of Lynn, 109 Cal.App.2d 468, 470 (1952) [enhanced version].

[10]   Under California law, a notice of proposed action is a voluntary procedure by a trustee notifying beneficiaries of a proposed course of action.  If the trustee receives written objection from any beneficiary within the applicable time period (which must be a minimum of 45 days), the trustee and/or the beneficiary(ies) may petition the court to have the action taken, modified or precluded.  Sending the notice does not obligate the trustee to take such action; if the trustee chooses not to do so, it simply must notify the beneficiaries (who will have opportunity to petition the court) of this decision.  If the trustee does not receive any written objection to a validly executed notice of proposed action within the applicable time period, the trustee will not be liable to a beneficiary for taking the proposed action.  The relevant form for filing such a notice is Judicial Council of California Form DE-165, available at http://www.courtinfo.ca.gov/forms/documents/de165.pdf.

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Morrison & Foerster's Trusts and Estates group provides sophisticated planning and administration services to a broad variety of clients.  If you would like additional information or assistance, please contact Patrick McCabe at (415) 268-6926 or PMcCabe@mofo.com.

© Copyright 2011 Morrison & Foerster LLP.  This article is published with permission of Morrison & Foerster LLP.  Further duplication without the permission of Morrison & Foerster LLP is prohibited.  All rights reserved.  The views expressed in this article are those of the authors only, are intended to be general in nature, and are not attributable to Morrison & Foerster LLP or any of its clients.  The information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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