In five recent Private Letter Rulings, PLRs 201442042 01442046, the taxpayers asked the IRS to respect a trust reformation done by a State court to effectuate the intent of the trustor by correcting a scriveners error. Failure to respect the State court ruling would have resulted in additional estate taxes being paid due to the inclusion of the value of the trust assets in the estate of the trustor. The IRS ruled that it would respect the State court reformation proceeding because there was clear and convincing evidence of the trustors intent.
Here, the trustor created two Grantor Retained Annuity Trusts (GRATs) for estate tax savings purposes. The remainders of the two GRATs were to pass to a Childrens Trust at the expiration of the trusts. The Childrens Trust was by its express terms a revocable trust, which defeated the purpose of the planning strategy. The accountant who prepared the gift tax returns pointed this out to the drafting lawyer and the lawyer told him the Childrens Trust has been drafted correctly and that, not being an attorney, [the accountant] did not understand the State law governing the trust. The accountant made a note of the conversation and filed the gift tax returns showing the transfers to be completed gifts thereby removing them from the trustors estate.
A few years later a financial planner was reviewing the estate plan and discovered the same issue. The financial planner consulted with a second lawyer who confirmed the estate plan was flawed. The second attorney petitioned the State court to reform the trust. The petition included various affidavits, including an affidavit from the drafting attorney that he had made a scriveners error and that the Childrens Trust, as drafted, was contrary to the trustors intent. The State court approved the reformation.
In this case the IRS accepted the State court ruling, but the IRS is not bound by such rulings in applying federal tax law. There are several court rulings and PLRs holding that a retroactive reformation of a trust is not binding on the IRS for federal tax law purposes.
In PLR 201021038, husband and wife created a revocable trust, which they subsequently restated. The restated trust provided for the division of the trust, upon the death of the first spouse to die, into a Survivors Trust, a Bypass Trust, and a Marital Deduction Trust. The trust was intended to be the beneficiary of a large retirement plan. After the death of the surviving spouse, the Trustee was to make certain specific devises, make gifts to grandchildren intended to qualify for the generation skipping transfer tax exclusion by use of formula allocation, and distribute the residual to two Protective Trusts for children. Each child was designated as the trustee of his or her Protective Trust. The child had the power to make discretionary payments of income and principal to himself or herself for health, education, maintenance, and support. Upon the appointment of an independent trustee, discretionary payments of income and principal could also be made to the descendants of the child for health, education, maintenance, and support.
Upon attaining a designated age, each child could exercise a limited lifetime power to appoint the Protective Trust assets to designated beneficiaries, including charities. Each child beneficiary was given a similar testamentary power of appointment.
After the death of the first spouse, it was realized that the inclusion of the power of appointment to charities and other provisions of the trust would impede the ability to defer the distributions from the retirement plan for the longest time possible. A petition was brought in State court to reform the trust to provide for outright distribution of any retirement assets to the children. The State court approved the trust reformation.
The PLR held the trust reformation was not effective for federal tax purposes. It reasoned that the trust reformation was not correcting a scriveners error, but effectively changing the beneficiaries of the trust. As part of its analysis, it cited Estate of La Meres v. Commr., 98 T.C. 294 (1992). In La Meres, the trustees reformed a trust solely for the purpose of qualifying the bequest for the estate tax charitable deduction. The Tax Court held the retroactive reformation, undertaken solely for tax purposes, was not effective for federal tax purposes.
Using this logic, the IRS ruled that the terms of the reformed trust not be given effect for federal tax purposes and that the determination of minimum required distributions from the retirement plan must be based on the provisions of the restated trust as it existed at the date of death.
Many other courts have held in the IRS favor in denying the enforcement of State court reformations of trusts for federal tax purposes, including Commissioner v. Bosch, 387 U.S. 456 (1967), Estate of Hill v. Commr, 64 T.C. 867 (1975), Van Den Wymelenberg v. U.S., 397 F.2d 443 (7th Cir. 1968), M.T. Straight Trust v. Commr, 245 F.2d 648 (8th Cir. 1957), and
Sinopoulo v. Jones, 154 F.2d 648 (10th Cir. 1946).
Although reformations of trusts after the fact to correct scriveners errors and effectuate the intent of the creator of the trust serve many useful and valuable purposes, they cannot be relied upon to achieve a desired federal tax result. The IRS may not respect the reformation of the estate plan if the reformation is being done solely for tax purposes or where the beneficial interests created under the reformed trusts vary significantly from the terms of the original trust. As such it is always best to consult with a knowledgeable estate planning attorney and get it done right the first time.
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