Tax And Estate Planning Involving Pets: Tricks For The IRS And FIDO

Most people consider their pets to be important members of their family. In fact, the bond between pets and their owners appears to be as strong as ever:

• 20% of Americans have altered a romantic relationship over a pet-related issue
• 80% of pet owners brag about their pets to others
• 79% allow their pets to sleep in bed with them
• 37% carry photos of their pets in their wallets
• 31% take time off from work to stay home with a sick pet

However, while over two-thirds of pet owners report that they treat their animals as members of their family, the Internal Revenue Code and the laws of most states do not see it the same way after the owner's death. Upon his death, a pet owner can, by will or trust, provide for every member of his family except for one. In the eyes of the law, a non-human family member is not a family member at all, but merely an item of personal property to be counted among the decedent's estate. Because one piece of property cannot hold title to another, a pet animal cannot be a beneficiary of either a will or a trust. Thus, a concerned pet owner who wants to ensure that his animal companion will be well cared for after his death must rely on the cooperation of animal-loving family or friends.

Unfortunately, many pet owners don't have any family or friends that they can count on to care for their pets. Other owners are simply not satisfied to rely on the generosity of others to provide the treatment that they feel their pets deserve. They seek the security of an enforceable legal instrument that will guarantee the proper care of their pets. This is an understandable goal, but why is this worth discussing here?

The American pet population is already significant and continues to grow. The American Veterinary Medical Association estimates that over 58 million households own a "companion animal." The U.S. domestic animal population includes:

• 59 million cats
• 53 million dogs
• 55 million fish
• 12.6 million birds
• 4 million horses
• 4.8 million rodents
• 3.5 million reptiles

Chances are that your clients are, or will become, pet owners. This is because households with higher incomes and larger family sizes are more likely to include a pet animal. Those households that do own a pet are willing to spend large sums for their care. Average annual veterinary expenditure per household per year is $186 for dogs, $147 for cats, $11 for birds, and $226 for horses. This aggregates to impressive national totals: $5.8 billion each year in veterinary care for dogs, $3 billion for cats, $50 million for birds, and $339 million for horses. Of course, these figures do not even include the billions of dollars in sales generated annually by America's retail pet supply industry.

In addition to spending small fortunes on pet food and veterinary care, many pet owners are engaging in serious pet-related estate planning. Between 12% and 27% of American pet owners have included their animals in their wills. Harper's Index reported in 1991 that over one million dogs had been named as will beneficiaries. The popular media occasionally reports on the various estate-planning efforts made on behalf of celebrity pets. For example, singer Dusty Springfield provided in her will that her cat, Nicolas, was to listen to Dusty's recordings each night at bedtime and was to be fed only imported baby food. Tobacco heiress Doris Duke left $100,000 in trust for her dog, while Betty White left her $5 million estate for the benefit of her pets. Oprah Winfrey has apparently also made undisclosed arrangements to ensure that her dog will live out his life in luxury.

Even celebrity power cannot overcome the fact that current laws generally do not accommodate such attempts to provide for the care of a pet animal after its owner's death or incapacitation. Bequests for the benefit of specific animals traditionally have failed either for violating the rule against perpetuities because the measuring life was not human or for being an unenforceable honorary trust because there was no human or legal entity to enforce the trust. In addition, the Federal Tax Code does not currently recognize a trust whose beneficiary is a pet animal and which does not permit an income or estate tax deduction for gifts to a charitable remainder trust when the non-charitable trust distributions are solely for the benefit of a pet animal.

Courts have frustrated an owner's intent to provide for the long-term care of a pet after the owner's death or incapacity on several technical grounds. First, a direct gift of money or other property to a pet animal is a legal impossibility. A pet animal is property and one piece of property cannot hold title to another. As a result, an owner's attempt to make a direct inter vivos or testamentary gift to a pet must fail.

Similarly, a trust that names a pet animal as a beneficiary also must fail. A valid trust requires a beneficiary who has legal standing to enforce the trustee's duties. As property itself, an animal lacks the legal standing necessary to act as a repository for the equitable title to the trust's property and cannot enforce the duties of the trustee.

Finally, trusts for the benefit of pet animals are most often invalidated for violating the rule against perpetuities. While pet trusts are commonly measured in the lives of the pets that they are intended to benefit, the rule against perpetuities requires that a trust be measured in human lives.

When confronted with a pet trust, courts have employed a wide range of responses. Some simply have voided the gift that was intended to benefit the pet and passed the affected property directly to the remainder beneficiaries, if any. Other courts have searched for more creative ways to implement the wishes of the decedent. For example, several courts have simply looked the other way. That is, they refused to invalidate a pet trust despite adverse precedent when the other will beneficiaries did not challenge the pet-related provisions of the will. In the very first American case to address the validity of a bequest or trust for the benefit of a pet animal, the Kentucky Supreme Court held that a testamentary gift for the care of a specific animal was a "humane purpose" and therefore effective under a Kentucky statute that validated any gift that had a humane purpose.

More commonly, courts simply deem a pet trust to be an honorary trust, which is technically unenforceable but which may be voluntarily carried out by the transferee. In these cases, the court would skirt the rule against perpetuities issue by limiting the duration of the honorary trust to 21 years or by deducing that the lifespan of the animal beneficiary would not exceed 21 years.

Other courts have tried to carry out the decedent's wishes by deeming the language that creates the pet trust to be precatory and, thus, non-binding. While this renders the condition on the beneficiary's use of the gifted property unenforceable, it does prevent the gift from failing altogether. If the decedent chose the beneficiary wisely, the beneficiary remains free to voluntarily use the property to care for the decedent's pet.

Still other courts have chosen to interpret pet-trust provisions as conditional gifts in which a human beneficiary receives a gift with a condition subsequent that requires the use of that gift for the benefit of the decedent's pet. In such cases, the legacy would vest in the beneficiary immediately but would be divested if the beneficiary failed to care for the pet.

While most courts have never followed Kentucky's enlightened approach, several states have recently begun to address the validity of pet trusts legislatively.

California Probate Code Section 15212 permits trusts for the care of pet animals but stops short of making them enforceable. Instead, the California statute is intended to protect pet trusts from attack based on the lack of a human beneficiary or for violation of the rule against perpetuities.

In 1999, Alaska went even further than California by adopting a new code section, AS 13.12.907, that makes pet trusts valid and enforceable for the life of the pet, up to a maximum of 21 years. The Alaska statute expressly provides that the granting language shall be liberally construed to carry out the intent of the decedent and to presume against merely precatory or honorary intent. The statute solves the human beneficiary problem by providing that a pet trust may be enforced by any designated individual or, if necessary, by an individual appointed by the court.

With the passage of the Jensen Bill in 1999, codified at ORS Section 114.215, Oregon has taken a unique approach to providing for the care of a pet animal upon the death of its human owner. Recognizing that the death of an owner can place a pet in immediate jeopardy, the Jensen Bill effectively removes pet animals from the probate process so that they promptly may be placed under the care of a new guardian. ORS Section 114.215 permits, but does not require, any of the decedent's family members or friends, or any animal shelter, to immediately take custody of a pet on the death of the decedent. Anyone who does take custody of a pet under ORS Section 114.215 is expressly entitled to reimbursement from the decedent's estate for the cost of caring for the animal. Thus, a concerned friend, family member or shelter may intervene to protect a pet even when the decedent failed to make any relevant testamentary provisions.

Other states also have attempted to better facilitate the care of pet animals after the death of their owners. In 1996, New York enacted a statute that is similar to Alaska's and makes pet trusts fully enforceable. Missouri's statute is similar to California's but limits the duration of the trust to 21 years. Tennessee has a detailed statute governing honorary trusts for animals but, like California, fails to make pet trusts enforceable. Wisconsin has an honorary trust statute that does not specifically refer to pet animals but that permits a transferee to apply trust property to any purpose that is not capricious. It is unlikely that a court would find a reasonable gift for the care of a pet animal to be capricious. Finally, a growing number of states are repealing the rule against perpetuities, which removes a major stumbling block to the validity of pet trusts.

Despite the newly emerging recognition of pet trusts at the state level, the Internal Revenue Code still refuses to recognize the validity of pet trusts. Nor is an estate or income tax deduction allowed under I.R.C. Sections 170, 664, 2055(a) and 2055(e)(2) for the bequest of a remainder interest to charity where the present interest is reserved for the care of a pet during its lifetime.

The IRS' adverse position regarding trusts for the care of a decedent's pet animal was explained succinctly in Rev. Rul. 76-486, 1976-2 C.B. 192. Treas. Reg. Section 301.7701-4(a) provides that the term "trust" is used in the Code to refer to an inter vivos or testamentary transfer of property to a trustee on behalf of a beneficiary. I.R.C. Section 643(c) defines "beneficiary" to include "heirs, legatees, and devisees." Heirs, legatees, and devisees are persons. I.R.C. Section 7701(a)(1) defines the word "person" to "mean and include an individual, a trust, estate, partnership, association, company or corporation." Because an animal does not fit within the Code's definition of person, an animal cannot be a trust beneficiary. Thus, under the Code, a purported pet trust actually lacks a beneficiary and is therefore invalid.

Rev. Rul. 76-486 does allow that a pet trust "should nonetheless be classified as a trust for tax purposes under Section 641" whenever such a trust is not invalid under applicable state law. Pursuant to Section 641, the income of such a pet trust would be taxable under Section 1(e). To do otherwise, the ruling explains, would be to ignore the effect of local law and to allow the trust's income to escape taxation altogether.

Section 2001(a) imposes a tax on the transfer of the taxable estate of every decedent who is a resident or citizen of the United States. Section 2055(a) provides that the value of a decedent's taxable estate excludes the amount of all transfers to certain specified recipients for limited uses. For example, transfers to the following recipients are deductible from a decedent's taxable estate under Section 2055(a): 1) the federal or a state government when used exclusively for public purposes; 2) a qualified religious, charitable, scientific, literary, or educational corporation, trust, society, or association; 3) a qualified veteran's organization, and; 4) a qualified employee stock ownership plan. Similar restrictions apply to persons who establish an inter vivos charitable remainder trust seeking an income tax deduction under Section 170.

A bequest in trust for the benefit of a pet animal with the remainder passing to a qualified charity is not eligible for the estate tax deduction. Section 2055(e)(2)(A) disallows a charitable deduction when an interest in property passes or has passed from the decedent for a charitable purpose and an interest in the same property passes or has passed for a non-charitable purpose. In cases where the remainder interest passes to charity, the non-charitable interest must be in the form of a charitable remainder annuity trust or unitrust pursuant to Section 664(d)(1)-(2) or a pooled income fund pursuant to Section 642(c)(5). A pet trust with a charitable remainder interest must fit within the Section 664(d)(1)-(2) definition of a charitable remainder trust in order to qualify for an estate tax deduction under Section 2055(a).

Generally, a charitable remainder trust is a trust that provides for a specified distribution, at least annually, to at least one beneficiary who is not a charity, for life or for a term of years, with an irrevocable remainder interest to be held for the benefit of or paid to a charity. Treas. Reg. Section 1.664-1(a)(2) provides that a trust is a charitable remainder trust "only if it is either a charitable remainder annuity trust ...or ... unitrust in every respect." According to Treas. Reg. Section 1664-2(a)(3) and 1.664-3(a)(3), distributions in charitable remainder annuity trusts and unitrusts must be "payable to or for the use of a named person or persons." I.R.C. Section 7701(a)(1) defines the word "person" to "mean and include an individual, a trust, estate, partnership, association, company or corporation." The use of the term "person" in the Code and Treasury Regulations is "specific and unambiguous." "A pet animal does not fit within the meaning of the term "person" for the purposes of the Internal Revenue Code." Thus, a pet trust is not a charitable remainder annuity trust or unitrust " in every respect" and is disqualified under Section 2055(e)(2)(A). Therefore, no Section 2055(a) deduction is allowed for a charitable remainder interest where the present interest is reserved for the care of a pet animal. Likewise, the income tax deduction for an inter vivos pet charitable remainder trust is denied under Sections 170 and 664 because a pet animal is not a "person."

Ironically, under the current Code, a trust for the benefit of a pet qualifies for a Section 2055(a) estate tax deduction only when the trust is void from inception under applicable state law. When a decedent bequests an interest in property to charity, the nature of the charitable interest is determined at the time of the decedent's death. Thus, when a trust for a decedent's pet is void under state law, the remainder interest accelerates and a present interest vests. This present interest constitutes an interest inherited directly from the decedent for federal tax purposes and renders Section 2055(e)(2)(A), which addresses only remainder interests, inapplicable. As a result, the entire present interest passing to a qualified charity would be allowed as a deduction under Section 2055(a). Of course, despite the deduction, this outcome is contrary to the decedent's wishes and provides little comfort to the disenfranchised pet.

The Morgan Bill proposes amendments to the Internal Revenue Code that are designed to accomplish two goals:

• overcome IRS objections to Sections 170 and 2055(a) income and estate tax deductions for bequests in trust for the benefit of a pet animal when the remainder interest passes to a qualified charity
• tax the distributions paid on behalf of a pet at the trust level in order to discourage the possible abuse of the new amendments

Insert a new subsection within Section 664(d), definitions regarding Charitable Remainder Trusts.

1. For purposes of this section, the terms 'beneficiary, person(s), and individual(s)' shall include animals.
2. Notwithstanding any statute, regulation, or other rule of law (excluding this section), with respect to any charitable remainder trust under Section 664, no trust shall be denied status as a charitable remainder annuity trust under Section 664(d)(1(A) or as a charitable remainder unitrust under Section 664(d)(2)(A) solely because the beneficiary of the trust is an animal.

This amendment redefines "person" to include animals so that a pet trust with a remainder interest to a qualified charity will fit within the Code's definition of a charitable remainder trust and thus qualify for an income and estate tax deduction. This revised definition is intentionally limited and designed to apply only to charitable remainder trusts for the purpose of qualifying for these particular deductions.

Insert a new subparagraph within Section 664(b), which defines the character of distributions.

Section 664(b) defines the characteristics of trust distributions in the hands of the beneficiary to whom they are paid. Distributions are thus taxed to the beneficiary as gross income, capital gain, other income, or as a distribution of the trust corpus. However, because a pet animal is not a taxpaying entity, a pet animal cannot be taxed on the distributions paid out of the trust on its behalf. Therefore, this new subparagraph proposes to characterize these distributions as taxable income of the trust and to tax the trust itself on the amount of these distributions at the levels provided in Section 1(e). This treatment is consistent with the IRS position as stated in Rev. Rul. 76-486.

Rewrite subsection Section 664(c) as follows:

Section 664(c) provides an express exemption from taxation for charitable remainder annuity trusts and charitable remainder unitrusts. This proposed revision of Section 664(c) is designed to correct an otherwise direct contradiction between the original Section 664(c) and new, proposed version of Section 664(b)(5). This revision creates an additional exception to the exemption from taxation for charitable remainder trusts when the beneficiary is an animal.

Pursuant to I.R.C. Sections 664(d)(1)(A) and 664(d)(2)(A), as amended by the Taxpayer Relief Act of 1997, annual CRT distributions to the non-charitable beneficiary must be at least five percent and not more than 50% of the fair market value of the property contained in the trust. The Morgan Bill amendments permitting pet trusts should not interfere with these requirements, though it is conceivable that distributions from some pet trusts may fall below the five-percent floor (e.g. for pet fish, or for small birds, reptiles or rodents). However, pursuant to the Morgan Bill, the entire taxable income would be taxable to the trust, thus complying with the underlying policy of forcing the taxation of trust income.

Also as a result of the Taxpayer Relief Act of 1997, I.R.C. Sections 664(d)(1)(D) and 664(d)(2)(D) now require that the present value of the remainder interest ultimately passing to a qualified charitable remainderman equal to at least 10% of the net fair market value of the property transferred to the CRT as determined on the date of the contribution to the CRT. Assuming a decedent's genuine donative intent, it is unlikely that a pet-related CRT would fail this requirement except in highly unusual circumstances.

Rev. Rul. 77-374 provides that a charitable remainder annuity trust does not qualify for a charitable deduction, and accordingly is not a qualified trust, unless the possibility that the charitable transfer will not occur is so remote as to be negligible. If there is more than a 5% probability that the noncharitable income beneficiary will survive the exhaustion of the trust assets then the probability is not negligible and the CRAT is disqualified. Again, except in highly unusual circumstances, a pet-related CRAT would appear unlikely to fail this test.

Why not? It is common for an owner to have more than one pet. If only for administrative ease and to minimize expense, an owner should be able to provide for all of his pet animals in one instrument. The risk of abuse on this point seems remote.

While a pet trust is not intended to apply to livestock or other animals raised for production, there would appear to be little real risk of abuse necessitating a narrow definition of pet animal. The contribution of an inventory asset to the trust would not generate a significant additional deduction.