June 6, 2013
Authored by: Kathy Sherby and Stephanie Moll
When is a modification or reformation of an irrevocable trust given effect for Federal tax purposes? In each of two recent private letter rulings, the government addressed the impact of a reformation and of a modification on Federal taxation of the trusts in question. Here, we will look at a ruling favorable to the IRS. Come back next week when we discuss a ruling in favor of the taxpayer.
In PLR 201243001, on advice of his own attorney, the Decedent’s son requested that Decedent amend her trust to eliminate the outright distribution of his inheritance, and instead to have that portion of her trust fund a continuing trust for the benefit of the son and his descendants during his lifetime, and, upon his death, to be distributed outright to his descendants upon reaching age 45. The purpose of this trust amendment was to avoid having the property that would fund the continuing trust be includible in the son’s taxable estate at his death.
Instead of amending the trust as requested, Decedent’s attorney prepared the trust amendment to provide as follows: the son’s share would be distributed outright to him, unless he disclaimed the gift, in which case, it would pass into a continuing trust having the terms requested by Decedent’s son. Decedent signed this trust amendment. Decedent’s attorney did not realize, until after Decedent’s death, that a person who was not a spouse could not disclaim in this fashion without gift tax consequences.
Son did not disclaim, but instead petitioned the court to reform the trust to remove the outright gift and disclaimer provision. The evidence introduced in the reformation proceeding was an affidavit provided by Decedent’s attorney documenting his mistake, and his belief that reformation of the trust was necessary to carry out Decedent’s intent, and a copy of the letter provided by Son’s attorney setting out the requested trust amendment. Under applicable state law, the court has the general equitable power to modify an irrevocable trust in whole or in part, and the state court entered its order making the requested modification, contingent on a favorable ruling by the government.
Decedent’s son requested a ruling that the reformation of Decedent’s trust as of the date of Decedent’s death would be recognized for Federal transfer tax purposes. The Ruling stated that, generally, a state court reformation of an irrevocable trust is not given retroactive effect for Federal tax purposes. The Ruling stated that in order to be given retroactive application, state law required that the unilateral mistake must be due to an ambiguity and must have been established in the reformation proceeding by “clear and convincing evidence.”
The PLR then concluded that there was no ambiguity in the trust that would justify a reformation under state law, and Decedent’s intent was not established by “clear and convincing” evidence. At best this was a modification of the trust under the power granted to the state court by applicable state law. Since the modification made a significant change to the terms of the trust and deferred the time for outright distribution of the trust for the life of Decedent’s son, solely to achieve the elimination of estate tax for the son, it would not be given retroactive application for gift, estate or GST purposes. Since Decedent’s son did not receive a favorable ruling, the modification was not given effect, and the trust property was distributed outright to Decedent’s son.