Lower Court Decision Affirmed: Failure to Obtain Life Insurance to Replace CRT Gift Not Malpractice

Lower Court Decision Affirmed: Failure to Obtain Life Insurance to Replace CRT Gift Not Malpractice

Article posted in Insurance on 18 September 2007| 2 comments
audience: National Publication | last updated: 18 May 2011
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Summary

The Michigan Appeals Court has affirmed the decision of a lower court in Smallegan v. Kooistra in which it held that a donor's attorney did not commit malpractice because he did not ensure the donor had acquired wealth replacement life insurance prior to the funding of a charitable remainder trust.

by Marc D. Hoffman
Editor-in-Chief

Background

Charitable remainder trusts are used commonly to reposition highly appreciated assets free of immediate capital gains tax exposure, provide an income stream for the trustor or others, produce a current income tax charitable deduction, remove assets from the trustor's taxable estate, and provide a gift of the remainder interest to the charitable organization(s) of the trustor's choice. In the context of estate planning, CRTs are commonly created in conjunction with the purchase of life insurance on the life of the trustor(s) to replace for family members the value of assets passing to charity. Properly structured, such "wealth replacement" insurance is owned outside of the trustor's taxable estate with the resulting death benefit passing to heirs estate tax free. The result can be a triple win for trustor, heirs, and charity.

Common sense dictates that when an irrevocable CRT and wealth replacement insurance are being contemplated, the trustor should secure the life insurance prior to funding the CRT. However, this did not happen in Smallegan v. Kooistra.

Click here to download the Michigan Appeals Court decision in PDF format.

Facts According to the Published Appeals Court Opinion

In 1998, Florence Smallegan, with the assistance of her son Kenneth Smallegan, approached attorney Ronald Kooistra for estate planning advice. Mr. Kooistra referred the Smallegans to a national financial advisory firm for the preparation of a comprehensive estate plan. Central to the firm's recommendations was the creation of a charitable remainder unitrust (CRUT) and purchase of wealth replacement life insurance on Mrs. Smallegan for the benefit of her son. Mr. Kooistra reviewed the plan with the Smallegans and the CRUT was drafted. Kenneth Smallegan was named trustee.

Prior to the funding of the CRUT, the financial advisers attempted to secure insurance coverage for Mrs. Smallegan; however, she was declined. According to the published opinion, they reassured Mrs. Smallegan and her son that a subsequent attempt would be successful. Armed with this reassurance, Mrs. Smallegan executed and transferred $900,000 of appreciated securities to the CRUT. However, subsequent attempts to obtain insurance for the elderly Mrs. Smallegan failed and she died in August of 2002. Mr. Smallegan then filed suit against Mr. Kooistra and his firm to recover the value of his lost inheritance from the nonexistent insurance proceeds.

The defendants demurred claiming the CRUT operated as designed and did not contain any errors for which they could be held liable. The court agreed on the basis of the "four corners rule" which interprets the meaning and understanding of the individual provisions of a document by considering the overall meaning and intention of the entire document to the exclusion of external factors. In the context of this case, the appeals court stated the "rule precludes a beneficiary from introducing extrinsic evidence to undermine the viability or intent of a clear and unambiguous testamentary document." Further, "In short, if a testamentary document clearly performs a function as designed, a would-be beneficiary has no grounds to challenge whether its function was actually intended by the decedent."

Other Arguments

Insurance Clause within CRUT. On appeal, the plaintiff argued the trust included an insurance clause that raised an ambiguity regarding whether the CRUT actually intended to replace its assets with insurance proceeds. Although we were unable to review the trust instrument, many charitable remainder trusts permit the trustee to purchase life insurance; however, the death benefit must be paid to the trust and, therefore, for the ultimate benefit of the charitable remainderman rather than the trustor's heirs. Furthermore, the trust specifically prohibits the use of trust assets for the benefit of others. The court rejected the plaintiff's argument that any ambiguity existed.

PGDC Comment: The presence of this argument raises an interesting question regarding the Smallegans' understanding regarding how the insurance would be purchased and owned. Did they truly understand the CRUT would produce the cash flow that Mrs. Smallegan would give to her son (or to life insurance trust for his benefit) to purchase the insurance, or did they understand the CRUT and insurance to be integrated with the CRUT actually paying the premiums?

Insurance Application Evidence of Intent. The plaintiff next argued his mother's insurance application constituted a testamentary document that should be read with the CRUT to reveal its true, but failed, intent. However, the court rejected this claim again under the "four corners" rule stating that once the application was rejected, it lost all of its force and effect as a testamentary document.

The Dog Ate the File. At some point the law firm lost Mrs. Smallegan's file, including her will. The plaintiff argued this raised the legal presumption the file contained unfavorable evidence regarding the defendants' handling of the CRUT. Again, pointing to the "four corners" rule, the appellate court found the lower court properly limited its analysis to the unambiguous intent of the CRUT.

Advising to Fund CRUT without Insurance In Place. Finally, the plaintiff argued that even though the CRUT was without flaw, the defendants still committed malpractice by advising Mr. Smallegan to fund the trust without first securing life insurance coverage. The court pointed out, however, that it would have been up to Mrs. Smallegan to bring a malpractice suit rather than the beneficiary of her estate. During the final years of her life, she took no action to disavow the trust, rescind its creation, or seek recourse against those who created it.

The appellate court affirmed the lower court's decision granting the defendant's summary disposition on all counts.

Observations

We contacted Mr. Smallegan to help fill in some of the missing pieces; namely, was litigation brought against the financial advisory firm? Mr. Smallegan stated that he could not comment. Reading between those lines, we presume the matter may have been settled privately, most likely by arbitration with a nondisclosure agreement. Therefore, we are left with more questions than answers.

The most obvious question is, "What was the big hurry?" The CRUT was funded with publicly-traded securities. Were the financial advisers simply too anxious to move the assets under management and begin earning fees to wait until they had a binding offer from an insurer or did Mrs. Smallegan's philanthropic desires override her wish to assure the assets would be replaced for her son?

And where was the charitable remainderman in this mix? As it turned out, it was nowhere. The remainderman was the Florence J. Smallegan Family Foundation, which, according to Guidestar.org is a private nonoperating foundation. Perhaps if a planned giving specialist representing an independent charitable remainderman had been in the loop, they could have suggested that everyone take a deep breath and implement the plan in proper order. Although the job of a planned giving officer is to raise funds, those who practice "donor-centered philanthropy" understand that a donor's overall intent is of paramount important to the success of a planned gift.

Final Thoughts

Finally, although the attorneys were exonerated, it is clear that no one really prevailed. There's an old saying amongst pilots: "Don't fly through clouds lest the ground rise up to smite thee." In the same spirit, if wealth replacement is part of a plan, it may not be wise to fund an irrevocable charitable gift before insurance is secured "lest the underwriting department rise up to smite thee."

When we asked if there was any advice he could give to other donors, Mr. Smallegan said, "Research, research, and research; and don't take anyone's words for granted."

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Comments

9/19 Mark Hoffman article

Very well written and understandable, particularly the background paragraph. Thanks!

Failure to Advise to wait

The court had two bases for denying the son's claim the attorney was negligent for advising premature funding of the trust before the life insurance was in place. First, that the attorney had no duty to the son. That argument will succeed in some states, but in a number of states an attorney's duty also runs to the estate's beneficiaries. Second, the court used an implied statute of limitations argument; the mother did not sue in the four years between implementation of the plan and her death. That may be a good argument as against her estate, but in states recognizing the attorney's duty running to the beneficiaries of the estate plan, the right to sue doesn't accrue until the plan becomes irrevocable - at the testator's death or when it was finally determined she was absolutely uninsurable.

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