4 Trends in Commercial Office Leasing

Jun 22, 2022

Daniel Myers, partner and chair of the firm’s real estate practice group, speaks to leasing trends during the pandemic.

While the ongoing pandemic is still creating uncertainty, facility managers should understand four key leasing trends. New office leases have been signed during the pandemic and trends are starting to emerge from those deals.

To read the full article, visit www.facilitiesnet.com.


East Bay Developer Forum

Jun 03, 2022

Daniel Myers, partner and chair of the firm’s real estate practice group, joined industry leaders to share their viewpoints on the commercial real estate market and economic drivers throughout the East Bay.

From the tech world to the suburbs, the pandemic has shifted the workforce and pushed developers, healthcare, and more industries to revisit their real estate plans for the future.

Visit The Registry to watch the full webinar.


City of Oakland Set to Release More Zoning Details and Host Meetings Regarding the Downtown Oakland Specific Plan

Apr 27, 2022

On April 22, 2022, the City of Oakland posted an update to its website about soon-to-be-released proposed zoning amendments and upcoming virtual meetings regarding the much-anticipated Downtown Oakland Specific Plan (DOSP). The post provides that the City expects to release the draft zoning amendments for the DOSP before the end of April (except the details of the Zoning Incentive Program, which will be released in mid-May), and then will host at least five virtual informational/committee meetings between May 11th and June 8th to discuss the draft amendments. The meetings are organized by theme and are currently titled as follows: May 11thLand Use Activities; May 16thSpecial Districts; May 25thDevelopment Standards & Zoning Incentive Program; June 2ndCommunity Advisory Group (CAG) Discussion; and June 8thZoning Advisory Committee (ZUC) Hearing. The first four meetings will begin at 6 pm and the June 8th meeting is set to start at 3 pm. More information can be found at this link. Community members are encouraged to provide feedback about the draft DOSP and zoning amendments by participating at the meetings, emailing City staff, or filling out a survey that the City will prepare. The City expects that, following these meetings, the DOSP will be brought before the City Council for adoption later this year. 

For more information, please feel free to reach out to the Land Use Team at Wendel Rosen LLP. We will continue to monitor Oakland’s development of the DOSP and provide further updates as they become available. 


California’s Largest SB 35 Project Moves Ahead in Cupertino

Mar 30, 2022

An urban development with 2,400 housing units, 2 million square feet of office space, and what is slated to become the world’s largest green roof is set to break ground in Cupertino in 2022. 

Wendel Rosen land use attorneys played a significant role in the project approval, serving as special land use counsel to the City during administrative processing. With more than half of its housing units designated for low- or very-low-income residents, the project qualified for streamlined procedures under Senate Bill 35, a legislative effort to address chronic housing shortages in the state. 

California statute SB 35, in effect since 2018 and now set forth at Government Code Section 65913.4, provides for ministerial, streamlined approval of affordable housing projects that meet qualifying standards. The Cupertino project was challenged by opponents in a lawsuit and eventually prevailed in a 2020 Santa Clara County superior court decision.

Project developer Sand Hill Property Company envisions The Rise as a car-optional, walkable city with residential, retail and business space, as well as green space, trails, and bike paths. Located on the site of the former Vallco mall, a mile from Apple Inc. headquarters, the project plan includes 429,000 square feet of retail, dining, and entertainment space and a 29-acre green roof that will be open to the public.

Wendel Rosen land use attorneys advise private and public sector clients in development and permitting issues related to SB 35 and other land use matters in cities, counties, and special districts throughout California. The firm recently represented the developer in helping secure the approval of the first SB 35 project in Santa Cruz in December 2021. 

A series of recent decisions, including an upheld CEQA exemption in Newark, show continued court support for the legislature’s desire to provide much-needed housing in California. 

For more information about the processing of projects under SB 35, contact the Wendel Rosen land use group.


Ninth Circuit Offers Food Producers Relief from Prop 65 Acrylamide Lawsuits

Mar 25, 2022

The Ninth Circuit has reinstated an injunction on Proposition 65 claims against food products containing acrylamide, bringing a large number of food producers at least temporary relief from costly litigation. Proposition 65 (“Prop 65”) requires warnings to consumers regarding exposure to any of over 900 chemicals listed by the state as causing cancer, birth defects, or reproductive toxicity.

The Ninth Circuit in California Chamber of Commerce v. Council for Education and Research on Toxics (“CalChamber v. CERT“) upheld the District Court’s preliminary injunction against new lawsuits alleging Prop 65 violations involving acrylamide. The appellate court agreed with the lower court, finding that the required Prop 65 warning – that acrylamide is known to the state of California to cause cancer — is controversial and not purely factual. In essence, the State cannot know since the science is inconclusive and authoritative agencies disagree (the National Cancer Institute and American Cancer Society say dietary acrylamide is not likely to cause cancer, while the US Environmental Protection Agency, the US National Toxicology Program and the International Agency for Research on Cancer say it is.) 

CalChamber originally brought suit against the Attorney General, and CERT intervened in an effort to prevent an injunction from curtailing its enforcement actions. CalChamber argued that requiring businesses to make a statement that is controversial and not factual misleads the public and runs afoul of First Amendment free speech protections as “compelled speech.” As a result of the constitutional question, the likelihood that CalChamber would prevail on the merits, and other considerations, the District Court enjoined further Prop 65 acrylamide lawsuits, pending a decision on the merits. The 9th Circuit agreed.

Acrylamide was listed as a carcinogen by the State of California over 30 years ago, but it didn’t attract much attention until publication of its discovery in food in 2002. Most had never heard of it before – it was not an ingredient or even a contaminant of ingredients, but is generated in the process of cooking certain foods. As a result, Prop 65 enforcement involving acrylamide in food has become commonplace in the last several years, with over 1,200 claims since 2016, targeting all manner of baked goods (breads, biscuits, crackers, cookies), roasted nuts and nut butters, chips (potato, tortilla and vegetable), cereals, caramel corn, coffee, and other products. Businesses have paid well over $8 million in penalties and over $20 million in plaintiffs’ attorney fees to resolve these claims.

With the ultimate outcome of CalChamber v. CERT uncertain, food companies may want to continue researching methods to reduce acrylamide in their products while awaiting the decision.


New COVID-19 Paid Sick Leave: What It Means For Employers 

Feb 15, 2022

California Governor Gavin Newson and the State Legislature have renewed COVID-19 related paid sick leave, which expired September 30, 2021. On February 9, 2022, the Governor signed Senate Bill 114 (SB 114) into law and added as Labor Code sections 248.7 and 248.7.  

SB 114 provides COVID–19 supplemental paid sick leave (CPSL) for employees covered under its provisions who are unable to work or telecommute from January 1, 2022 through September 30, 2022, for enumerated COVID-19 reasons. The law takes effect on February 19, 2022 and applies retroactively back to January 1, 2022.  

This article summarizes how the new law affects employers generally, as provided under Section 248.6 (it excludes discussion about provisions relating to firefighters, and providers of in-home personal care services under Labor Code Section 248.7).  

The Basics 

  • CPSL applies to private employers with 26 or more employees and public entities in California 
  • Employees may seek CPSL retroactively from January 1, 2022, beginning on February 19, 2022 
  • Employers cannot require employees to use other available paid sick leave or other paid time off.  Employees determine how many CPSL hours they need, subject to some limitations described below
  • Similar to earlier COVID-19 paid sick leave, the maximum CPSL is $511 per day and $5,110 in total.  However, employees can elect to use other available paid leave to make up any difference from this maximum and their regular pay 
  • Establishes two separate banks of CPSL of up to 40 hours each for full-time covered employees (a collective maximum of up to 80 hours), and a proportionate amount for other employees. The first bank of time applies to a covered employee who is unable to work or telecommute for the following reasons: 
    • The employee is subject to a quarantine or isolation order related to  COVID-19 required by an order or guidance of state, federal or local health authorities with jurisdiction over the workplace  
    • The employee has been advised by a healthcare provider to isolate or quarantine due to COVID-19  
    • The employee is attending an appointment for him or her, or a family member, to receive a COVID-19 vaccine or vaccine booster  
    • The employee is experiencing symptoms, or caring for a family member experiencing symptoms, related to a COVID-19 vaccine or booster that prevents the employee from being able to work or telecommute
    • The employee is experiencing symptoms of COVID-19 and seeking a medical diagnosis 
    • The employee is caring for a family member subject to a quarantine or isolation order or guidance, or who has been advised to self-quarantine or isolate by a health care provider due to COVID-19 concerns
    • The employee is caring for a child whose school or place of care is closed or otherwise unavailable for COVID-19 related reasons
  • A second bank of time of CPSL of up to 40 hours of time exists and applies to employees who test positive, or are caring for a family member who tests positive, for COVID-19 
  • Family Member means a child, parent, spouse, domestic partner, grandparents, grandchild or sibling.  

Permissible Requests for Diagnostic Test Results 

When an employee, or a family member for whom the covered employee is providing care, tests positive for COVID-19 and requests CPSL, the employer may require the employee to take another diagnostic test on or after the 5th day after the first test was taken and provide the employer with the test result.  

This second test must be made available to the employee at no cost to the employee. Likewise, if the employee applies for CPSL to care for a family member who tests positive, the employer may require documentation of that family member’s test results before paying the additional leave. If the employee refuses to provide such test results, the employer can deny the CPSL leave for the additional second bank of CPSL leave. 

Further, for each leave taken for symptoms caused by a COVID-19 vaccine or booster, the employer may limit CPSL to 3 days or 24 hours. However, this time may be extended if the employee provides the employer with a verification from a health care provider that the employee or family member continues to have symptoms related to a COVID-19 vaccine or booster.  

How to Calculate Amount of Leave

Full-Time Employees:  An employee is full-time when: 

(i) The employer considers the employee to be working full time, or 

(ii) the employee was scheduled to work, or worked, on average at least forty (40) hours per week in the two weeks preceding the date the employee took CPSL.

  • Part Time Employees:  If an employee does not satisfy the above criteria, then they are entitled to CPSL as follows: Employees with a normal weekly schedule will be entitled to the total number of hours normally scheduled to work for the employer over one week for each bank of CPSL.
  • If an employee works a variable number of hours, the amount of CPSL will equal seven (7) times the average number of hours the employee worked each day in the preceding 6 months before the leave date.
  • If the employee worked for less than six (6) months, but more than seven (7) days for the employer, the calculation of CPSL will instead be made over the entire period the employee worked for the employer. 
  • If the employee works a variable number of hours and worked for the employer for seven (7) days or less, the number of hours of CPSL will be the number of hours that the employee worked for the employer.

CPSL Leaves Taken Must Be Reported as CPSL Hours Used On Each Pay Stub

  • Beginning the next full pay period following February 19, 2022, CPSL and other sick leave used must be displayed separately on employee pay stubs, and retroactive payments must be displayed on pay stubs for the period during which payments are made.  If no CPSL was used during the payroll period, then the pay stubs should display zero hours. 
  • Employers should verify with their payroll departments, or with outside payroll vendors, that these new pay stub requirements are known and will be followed.

Notice Requirements

  • Employers must post in a conspicuous location in the workplace, and disseminate by electronic means to employees who do not frequent the workplace, the new CPSL requirements and rights. The Department of Industrial Relations (Labor Commissioner) is required to make a model poster publicly available by February 16, 2022.  

Miscellaneous Rules

  • Employers cannot require employees to first exhaust their CPSL before satisfying any requirement to provide paid sick leave related to COVID-19 under any CAL-OSHA COVID-19 Emergency Temporary Standard.
  • If an employee has already received paid time off for a COVID-19-qualified reason, since January 1, 2022 and before February 19, the employee is entitled to be credited back any paid time off, vacation time or other paid sick leave that the employee received.  Similarly, if the employee did not receive paid sick leave for work time missed because of a qualified reason between January 1 and February 19, the employee will be entitled to receive such CPSL now.
  • Unlike last year’s legislation, no provision allows for employers to apply for tax credits for CPSL payments made to employees.

We expect employees will be seeking to utilize COVID-19 supplemental sick pay leave now, and employers need to become acquainted with its provisions and seek appropriate counsel to ensure compliance with the upcoming exercise of these new employee rights.


Court Upholds City’s Use of CEQA Exemption for 469-Unit Project Consistent with Specific Plan

Feb 08, 2022

Specific plans are a useful tool local agencies use to implement a general plan in smaller geographical areas. If an agency adopts a specific plan for which an environmental impact report is certified, certain residential projects that are consistent with the plan are exempt from further review under the California Environmental Quality Act. (Gov’t Code § 65457.)

In Citizens’ Committee to Complete the Refuge v. City of Newark (Cal.Ct.App. No. A162045, ordered published 1/25/22), the First District Court of Appeal upheld the City of Newark’s use of this CEQA exemption despite project changes, changes to circumstances, and the addition of a new mitigation measure.  The Court determined that these changes did not require major revisions to the previous specific plan programmatic EIR to address a new or more severe significant environmental impact.

In 2015, the City approved a program EIR and adopted a specific plan allowing mixed uses for Areas 3 and 4 located next to San Francisco Bay.  Area 3 was developed and subsequently in 2019, the City approved a 469-lot residential subdivision in Area 4.  The City prepared a checklist comparing the previously-certified specific plan EIR’s analysis of impacts with the impacts of the subdivision map.  In using the specific plan exemption for residential projects under Government Code section 65457, the City found the Area 4 project was consistent with the specific plan, and that project changes, changes to circumstances and addition of a new mitigation measure were not significant enough to require additional environmental review.

The changes included the placement of housing (as opposed to the planned golf course) in an upland area containing salt marsh harvest mouse habitat, filling and raising portions of the site adjacent to wetlands, and supporting the raised areas with riprap.  Challengers claimed these changes, and the insertion of a new mitigation measure (use of riprap), required additional environmental review.  The Court disagreed.

Reviewing whether an event specified in Public Resources Code section 21166 had occurred, the Court determined that the changes did not constitute “substantial changes” that would require “major revisions” to the previous programmatic EIR to address an additional or more severe environmental effect.  In addition, while the Court agreed the use of riprap was not mentioned in the EIR, the challengers failed to provide adequate evidence to show the new mitigation measure would result new impacts or a substantial increase in the severity of previously identified impacts that would require major revisions to the EIR.  The challenges argued the use of riprap would increase the rat population that would be detrimental to the salt marsh harvest mouse, an endangered species.

The Court recognized that by rejecting the challengers’ arguments regarding the riprap, it was “allowing the [] development to proceed despite a potential increase in the impact on the harvest mouse to some degree.”  The Court explained that the Section 65457 exemption compels this result by setting a “higher threshold for review of a residential development project consistent with a previously analyzed specific plan….” The Court continued by stating that the exemption “reflects the Legislature’s determination that the interest promoted is ‘important enough to justify forgoing the benefits of environment review.’” The interest of Section 65457 “is to increase the supply of housing.” The Court concluded by stating that Section 65457 exemption “is intended to permit housing developments like the one at issue here that are consistent with a specific plan that has already undergone environmental review, ‘regardless of possible environmental of the project.’”

The Citizens’ Committee decision is another in a series of recent, strongly-worded court opinions supporting the Legislature’s desire to provide much needed housing in California.


Wendel Rosen Client Obtains Approval for Contentious SB 35 Project in Santa Cruz

Dec 16, 2021

After a protracted process, the Santa Cruz City Council approved the City’s first SB 35 application, a 140-unit (55 of which are affordable) mixed-use infill project, proposed by Novin Development Corporation, an experienced affordable housing developer. In spite of considerable opposition, and an initial vote by the Council to deny the project, the Council reconsidered its previous denial and ultimately found the project to be consistent with objective zoning standards, and thus in compliance with SB 35, by a 4 to 3 vote at its meeting on December 14, 2021. Staff issued its ministerial determination of consistency on December 16, 2021.

SB 35, contained at Government Code section 65913.4, provides for an expedited approval process for qualifying affordable housing projects without having to undergo California Environmental Quality Act (CEQA) review. SB 35 sets forth specific timeframes by which a local agency must determine a project’s consistency with “objective” zoning, subdivision and design standards. Such determination must be “ministerial,” i.e., non-discretionary. While a local agency is authorized to conduct a public oversight meeting to determine consistency with objective standards, it must do so in a way that does not chill or inhibit the ministerial determination of consistency. These ministerial determinations are normally made by local agency staff.

After Novin’s application was filed, the Council voted to appoint itself, rather than staff, as the arbiter of requests for density bonus concessions and waivers made in connection with an SB 35 application. Such post-application amendments modifying the manner in which SB 35 projects are processed are strictly prohibited by SB 35.

The Council, acting as the public oversight body, initially denied the project in October, clearly inserting itself into a discretionary and decision-making role. While such discretion is routinely exercised in traditional land use applications, the legislature enacted SB 35 in 2017 to ensure that such discretion on the part of local agencies was limited regarding projects processed under the statute. A month later, and following a flurry of objections from Wendel Rosen on behalf of Novin, as well as from pro-housing groups and the California Department of Housing and Community Development (HCD), the Council rescinded its earlier denial. Novin also submitted additional materials to address minor inconsistencies in the application, thereby garnering a staff recommendation that the Council find the application consistent with SB 35, leading to the project’s approval.

Wendel Rosen Land Use attorneys Patricia Curtin, Amara Morrison and Todd Williams represented the applicant.


Real Estate Law: Lessons Learned from the Pandemic and Predictions for the Future

Dec 02, 2021

In a recent webinar, Wendel Rosen LLP partners Daniel Myers, Gregg Ankenman, and Albert Flor, Jr. shared important legal lessons they’ve learned from the COVID-19 pandemic and provided several predictions as to how the pandemic will impact real estate law in the future, with a particular focus on issues facing commercial landlords and tenants.

Lesson One: The language of the lease is key and common law concepts are still important.

During the pandemic, both landlords and tenants pulled out old leases to see how they addressed closures due to the pandemic. In particular, did the force majeure provision in the lease cover the pandemic and excuse the payment of rent? While shutdowns due to the pandemic were covered by most force majeure provisions in leases, they often stated that payment of rent was not excused by force majeure. As a result, many tenants looked to common law concepts, like frustration of purpose, impossibility and impracticability, for relief. These doctrines, that used to be mainly discussed in law school, have now become familiar to all commercial real estate lawyers. While in limited circumstances, some out-of-state courts have held that the doctrines apply, the panelists were not aware of any published opinion to date from a California appellate court specifically excusing the payment of rent during the pandemic under these common law doctrines. We note, however, that a recent California Court of Appeal case, The Inns by the Sea v. California Mutual Ins. Co. (2021 DJDAR 11813, November 15, 2021), held that an insured could not recover under its business interruption insurance policy because governmental COVID-19 closure orders did not constitute a physical loss or damage to property triggering coverage. Of course, practitioners should continue to monitor published opinions to see if there are new caselaw developments.

Lesson Two: In extreme situations, state and local governments will try to protect commercial tenants – which will significantly impact commercial landlords.

Because existing lease language often did not provide relief for commercial tenants due to pandemic-related closures, state and local governments stepped in to do so. The State of California allowed cities and counties to adopt eviction moratoriums protecting commercial tenants. The typical commercial eviction moratorium prohibited landlords from evicting tenants for the non-payment of rent. The last of the state-authorized commercial eviction moratoriums expired on September 30, 2021. However, many ordinances have repayment periods (for past due rent accrued during the pandemic) lasting well past September 30. As a result, landlords looking to enforce non-payment of rent actions should carefully review the language of the applicable ordinance. In many cases, the inability to enforce tenant defaults caused landlords to seek negotiated settlements with tenants.

Lesson Three: Courts will not always be accessible.

For the first time in recent memory, courts were closed on a statewide basis and parties could not obtain standard judicial relief. Even though courts have now reopened, there continues to be significant backlogs and delays. Parties must keep this in mind as the inability to gain access to court directly impacts both strategies and the ability to redress rights. Parties should consider including alternative dispute procedures, such as binding arbitration or judicial reference, in lease agreements. While courts became largely inaccessible, private judging continued unabated during the pandemic.

Lesson Four: Parties can negotiate many different alternative payment structures to keep leases in place.

Despite everything, many commercial landlords and tenants were able to reach negotiated agreements to address rent relief and payments going forward. These agreements included rent abatement for certain periods of time, deferral and repayment obligations and changes in rent structures – such as percentage rent tied to sales or rent tied to certain occupancy percentages, sometimes combined with lease term extensions. These agreements often relaxed operating covenants for tenants and in some cases changed co-tenancy requirements for landlords. These agreements were negotiated on a case-by-case basis so no one-size fits all standards were adopted. The parties should note that except in obvious circumstances, to grant rent relief, landlords typically required tenants to provide specific evidence as to how the pandemic impacted the tenants’ financial condition.

Lesson Five: Landlords have found alternatives to unlawful detainer proceedings to enforce rights under leases.

Because of the ban on unlawful detainer proceedings, commercial landlords were forced to find other ways to protect their rights. To the extent lawsuits were filed, they were typically based on breach of contract/lease claims. Although in a breach of contract/lease action the landlord cannot recover possession for the failure to pay rent, the landlord can recover past due rent and related damages. To further increase leverage, a landlord in such a case can also seek a temporary protective order or writ of attachment. A writ of attachment enables a creditor to put a lien on the debtor’s property prior to a judgment. For undisputed commercial contract claims with damages in liquidated amounts, a party can file a motion to obtain a writ of attachment in the amount of the claim that the party is likely to recover, plus anticipated attorneys’ fees and costs. In such a case, a sheriff may levy on bank accounts, real property, or other available assets. The assets will then be held by the sheriff until judgment. Although it takes some time for the court to move to an ultimate judgment, a breach of contact/lease case coupled with attachment provides a way for a landlord to exert leverage. Once an attachment is issued, most cases move toward settlement or bankruptcy.

* * * * *

First Prediction for the Future: Certain lease provisions will change because of the pandemic.

Because of the pandemic, commercial landlords and tenants are re-examining a wide range of standard lease provisions. Both landlords and tenants are more carefully drafting force majeure provisions to address future pandemics and other unexpected events. Some parties are specifically addressing rent abatement and other rights in the event of government mandated closures. Tenants are asking for more flexibility in operating covenants, which require tenants to continuously operate their store for a set number of hours and days per week. Similarly, landlords in shopping center leases are seeking to change or are refusing to grant co-tenancy rights. A co-tenancy clause allows a tenant to reduce rent and, in some cases, terminate the lease, if core tenants leave or a certain percentage of square footage the retail center becomes vacant. The idea is that the co-tenancy provision provides the tenant with some form of protection to compensate for the loss of traffic. However, landlords are re-examining the entire purpose of these co-tenancy provisions and they will undoubtable change in the future. Landlords are also reviewing how “gross sales” are calculated to determine a tenant’s obligation to pay percentage rent. As e-commerce strategically integrates with brick-and-mortar locations (e.g., order on-line and pick up or return at stores, order at store at on-line kiosk for home delivery, etc.), these definitions will continue to evolve.

Second Prediction: As courts remain backlogged, parties will need to plan for alternative ways to adjudicate and enforce rights.

Prior to the pandemic, obtaining a court date was often a frustrating process due to many delays. With our new normal, courts are even less accessible. As a result, binding alternative dispute resolution options will become even more important to address the unavailability of traditional courtrooms.  Examples of these include:

  • Binding Arbitration – Arbitration is the most common form of alternative dispute resolution as it allows for a neutral arbitrator to render a binding decision at the end of a hearing. Arbitration is faster than a court proceeding and most remedies in a lease setting are available. While the parties will have to pay an arbitrator, which can be costly, the time savings and less formal environment usually translates into lower attorneys’ fees.
  • Judicial Reference – This is similar to an arbitration except that the judicial referee is required to follow the law and the award may be appealed. This option eliminates the courts and juries and proceeds with a court-appointed judicial referee presiding over a trial. The referee prepares a statement of decision that stands as the decision of the court. Judicial reference can save time as referees have a shorter deadline to provide a decision than judges.
  • Mediation – With the assistance of a neutral third party, mediation allows for negotiation between the parties. Mediation is not always recommended as it can become unproductive if both parties are not adequately motivated. Successful mediation occurs when both parties have equal incentives to reach a solution. Because motivation is a key factor in any mediation, we do not recommend mandatory mediation clauses in leases as a mandatory mediation can often be a waste of time and money.

Third Prediction: Landlord/Tenant flexibility and negotiated exit strategies will be important.

As society emerges from the pandemic, parties continue to look for flexibility in leasing. Landlords and tenants both fear being locked into leases in uncertain and unpredictable times. Tenants will require shorter leases with various exit rights. Tenants may also ask for smaller spaces with more autonomy to utilize the space how they see fit. Landlords will want to continue to have some control and may ask for termination rights for underperforming tenants. No matter what, parties must continue to find creative solutions as the future is unpredictable.


Intentionally Defective Grantor Trust: Income Tax Issues

Oct 15, 2021

An intentionally defective grantor trust (“IDGT”) can be beneficial for transferring wealth and reducing estate taxes. With a transfer of assets to an IDGT, the settlor effectively removes those assets from the settlor’s estate while retaining the income tax liability for the income generated by those assets. By including certain powers in the trust (known as “grantor powers”) the settlor is treated as the owner of the trust assets for income tax purposes and the trust’s income is taxed to the grantor as if he or she received the trust income directly (IRC Section 671). The trust is called “intentionally defective” because the settlor relinquishes ownership of the assets for estate tax purposes but remains the owner of the trust for income tax purposes. The primary benefit of the grantor trust status is that the trust assets can continue to appreciate without being depleted by income tax payments, which amounts to an additional transfer of wealth to the trust beneficiaries that is not subject to transfer tax (Rev. Ruling 2004-64).

The following is a discussion of various income tax issues related to transfers of assets to an IDGT:

Will the transfer of encumbered assets result in taxable gain?
The grantor trust status provides an additional benefit when transferors intend to transfer assets to the trust that are encumbered by debt. A transfer of encumbered property could cause realization of a taxable gain if the amount of debt exceeds the transferor’s basis in the asset (IRC 1001). This raises a concern that the transfer of encumbered assets could be a tax event for the settlor. However, due to the grantor status of an IDGT, the settlor remains the owner of the trust assets for income tax purposes, and there will be no realization of gain upon the transfer of encumbered assets.

Can income tax liability be shifted to the trust?
IDGTs can also be drafted to retain the flexibility for the trust to pay its own income tax in the future. To provide such flexibility, and to allow for any future occasion in which the burden to the settlor of paying the income tax outweighs the above benefits, the trust may include terms which allow the grantor trust status to be turned, or “toggled” off. Exercising this “toggle power” shifts the income tax liability from the settlor to the trust itself. Depending on the nature of the grantor powers either the settlor or a trust protector can exercise the toggle power under the trust to relieve the settlor of the grantor powers, and the trust changes status to a non-grantor trust immediately. However, termination of the grantor trust status could be a tax realization event with respect to the original transfer of encumbered assets mentioned above. If the encumbrance is recourse, i.e. the holder of the debt retains the right to pursue the settlor directly, there would be no taxable event to the settlor upon transfer of the assets to the trust or upon the subsequent change in grantor trust status to a non-grantor trust.

Can the settlor be reimbursed for income taxes paid?
Although the settlor cannot shift the income tax liability to the trust without losing grantor trust status, the settlor may be reimbursed by the trust for the income tax paid. Trust terms may be included to allow the trustee to reimburse the settlor for income taxes paid at the trustee’s discretion.

Note the IRS has ruled that if reimbursements are mandatory, or if evidence of agreement or collusion exists between the settlor and the trustee, the settlor has effectively retained the right to use the trust property to discharge the settlor’s own obligation to pay income tax, meaning the full value of the trust assets must be included in the settlor’s estate (IRC 2036). Conversely, when the reimbursement is discretionary rather than mandatory, and there is no discussion of reimbursement between the settlor and the trustee, the assets of the trust are not included in the settlor’s estate as a result of the discretionary tax reimbursement clause.

IDGTs are complex, and must be drafted and implemented carefully. Wendel Rosen trust and estate attorneys can help establish an IDGT that works in tandem with your estate planning goals.