Over the past several years, a number of state law changes have caused the issue of trust modification/reformation1 to garner more and more attention from the Internal Revenue Service.
First, many states and Washington, D.C. have adopted the Uniform Trust Code (UTC).2 The UTC contains a potpourri of provisions, making it significantly easier for parties to gain court approval of trust modifications. These provisions allow for a modification:
- due to circumstances not anticipated by the settlor;3
- made because the continuance of such trust on its existing terms would be impracticable, wasteful or impair the trust's administration;4
- that a court concludes isn't inconsistent with a material purpose of the trust;5 and
- made to achieve the settlor's tax objectives.6
Moreover, Section 411(a) of the UTC expands these modification rules by providing for the modification of an irrevocable trust, even if the modification is inconsistent with a material purpose of the trust, as long as the settlor and all the beneficiaries consent to the modification. And, even if all of the beneficiaries don't consent, the court may still approve a modification if the interests of the non-consenting beneficiaries are adequately protected.7
Although many states haven't adopted the UTC, many of those states have adopted similarly broad trust modification statutes.
In addition to the wider reach of the state trust modification statutes, many jurisdictions have also authorized the decanting of trusts. Simply stated, a decanting statute allows a trustee to pour over assets from one trust to a new trust. Occasionally, the terms or beneficiaries of the two trusts are substantially different from one another.8 As such, the new trust may contain considerably more favorable tax provisions than the original trust. Although decanting has always been available under common law, as well as occasionally pursuant to the trust provisions themselves, most modern decanting statutes minimize a trustee's liability to the trust beneficiaries, making the option of decanting more attractive.
The expanded trust modification rules, as well as the general trend of states adopting decanting statutes, have not only resulted in changes to trust terms generally, but also have enabled inspired taxpayers (and their attorneys) to modify seemingly irrevocable trust terms to create very favorable tax consequences. But the questions remain: (1) Will the IRS respect the modifications as approved by the courts; and (2) Will any of these modifications generate unintended negative estate or gift tax consequences?
Respect State Court Modification?
You might assume that a state court modification of a trust will be controlling for all purposes. This isn't necessarily the case, however, at least to the extent of the binding effect on the federal government. There's a long history of decisions concerning whether the IRS is bound by a state court's decision in the federal estate tax arena.9 Until the U.S. Supreme Court's decision in Commissioner v. Bosch,10 the lower federal courts disagreed about whether a state court decision would bind the federal government.11
The Bosch court determined that when a federal statute is involved, the decision of a state trial court is not controlling; however, the IRS must follow a decision of the state's highest court. If there's no decision by the state's highest court, then “federal authority must apply what it finds to be the state law after giving ‘proper regard’ to relevant rulings of other courts of the state.”12 In effect, the IRS is required to give “proper regard” to any relevant state statutes, court decisions and administrative determinations in reaching its conclusion as to the effectiveness of the lower court decision. The Bosch court explained that “[i]n this respect, it [federal authority — IRS] may be said to be, in effect, sitting as a state court.”13 In application, this has historically meant that many state lower court modifications haven't necessarily been determinative of the federal tax outcome due to the lack of definitive state law for which the IRS could apply “proper regard” when “sitting as a state court.”
With the adoption of the UTC in many states and the addition by non-UTC states of liberalized modification statutes, taxpayers are now encountering fewer roadblocks in terms of the IRS recognizing the binding effect of a lower state court ruling.
Recently, taxpayers have been successful in obtaining favorable private letter rulings14 from the IRS, even though the modification of the trust in question is a result of a lower court order or parties' agreement. These favorable rulings have consistently held that the lower court decision or parties' agreement is “consistent with the state law that would be applied by the state's highest court.”15
Of particular note is the success rate of PLR requests for modifications to alter a power of appointment. Even when a trust is irrevocable and the settlor of the trust is deceased, the IRS has demonstrated its willingness to allow retroactive modifications from a general power of appointment, resulting in estate taxation at the holder's death, to a limited power of appointment, resulting in no estate tax consequence to the holder.16
The IRS has also issued PLRs approving changes made by agreement of the beneficiaries and pursuant to a special trustee's authority under the trust agreement, to decant trust assets from the original trust to a receiving trust.17
No Retroactive Effect
Notwithstanding the taxpayers' success, the courts and the IRS have consistently held that the IRS won't recognize a modification of a trust if the tax consequence has already taken place.18 The Tax Court has stated that “we are not bound to give effect to a local court order which modifies that document after [the IRS] has acquired rights to tax revenues under its terms.”19 The government's response, therefore, isn't that it refuses to recognize the legal effect of the lower court modification, but that it refuses to allow the lower court ruling to have an effect on the already occurred tax consequence.
Note that in the favorable power of appointment PLRs discussed above, the tax consequence, if any, hadn't yet occurred. It was the proposed modification that would result in a possible tax consequence. For instance, in the power of appointment PLRs, the existence of the general power of appointment itself was of no immediate tax consequence, as the holder of the general power of appointment was still living. The modification, however, resulted in the creation of a possible taxable event — the potential for the taxable release of the appointment power. Contrast these rulings with PLR 201021038 (May 28, 2010), which involved a trust identified as an individual retirement account beneficiary, but not qualified as a “designated beneficiary” under Internal Revenue Code Section 401(a)(9). After the death of the trust settlor, who was the owner of the IRA, the state court reformed the trust so that it would qualify as a “designated beneficiary.” Citing Estate of La Meres, the IRS refused to acknowledge the state court ordered reformation stating, “the reformation of a trust instrument is not effective to change the tax consequences of a completed transaction.”20
Highest Court Decision
Under Bosch, there's still the alternative of seeking a decision from the “highest court” of the state, but this alternative may lead to unintended consequences.21 In a recent Kansas State Supreme Court decision, the taxpayer's attempt to obtain a decision of the “highest court” of the state to bind the IRS didn't go exactly as planned.
In a lower state district court case, In the Matter of Trust D Created Under the Last Will and Testament of Harry Darby,22 the taxpayer received a favorable ruling that allowed for a trust modification. The taxpayer appealed the favorable decision to the state's supreme court under a statutory provision allowing this type of appeal to obtain a decision that would be binding on the IRS. Part of the modification ordered by the lower court changed a power of appointment from a limited power to a general power to avoid the generation-skipping transfer (GST) tax and make the trust assets includible in the beneficiary's estate for federal estate tax purposes. The beneficiary's estate was expected to be nontaxable. On appeal, however, the state supreme court rejected the lower court modification, stating that a “modification of a trust provision to achieve tax benefits can't be validated when it would alter the dispositive provisions of the trust.”23 The taxpayer in Darby now has a decision from the “highest court” of the state that's binding on the IRS, just not the type of decision it desired.
Adverse Tax Consequences
Even if the IRS respects a court-approved change to a trust provision, there are still potential tax traps for the unwary.
For example, since a modification or termination under UTC Section 411(b) requires the settlor's approval, if the settlor merely supplies consent, the IRS could argue (at least in certain situations) that the settlor:
- retained the right to designate the persons to possess or enjoy the trust property under IRC Section 2036(a)(2);
- possessed the power at death to alter, amend, revoke or terminate the enjoyment of the trust property under IRC Section 2038(a)(1); or
- held the right to appoint the property in favor of himself, his estate, his creditors or creditors of his estate under IRC Section 2041.
If successful, any of these arguments will result in the trust property being includible in the settlor's taxable estate. Similarly, by the UTC requiring beneficiary consent for certain trust modifications, those modifications may give rise to a taxable gift, particularly if the beneficiary's share of the trust assets is diminished as a result. However, to date, there have been no IRS decisions or court cases specifically ruling on the estate, gift or GST tax consequences resulting from the settlor or beneficiaries' participation in a trust modification.
In fact, in a PLR involving a court modification of a qualified personal residence trust, the taxpayer maintained that IRC Section 2702(a) wouldn't apply to the modification in which the trust granted the settlor's issue the power to unanimously direct the trustee to amend and restate the trust to provide a term interest in the residence to the settlor.24 However, in its ruling, the IRS stated:
Except as expressly provided herein, no opinion is expressed or implied concerning the tax consequences of any aspect of the transaction or item discussed or referenced in this letter. Specifically, no opinion is expressed or implied concerning whether the transfer of the [r]esidence to Settlor, pursuant to the modification of the Trust, would result in the [r]esidence being included in the gross estate of Settlor under [Section] 2036.
In a similar fashion, the IRS has placed decanting on its “no ruling” list with respect to how certain acts of decanting will be treated in income, gift and GST tax matters.25 However, the IRS recently added to its Priority Guidance Plan26 “notice on decanting of trusts under section 2501 and 2601.” This addition suggests that the IRS is unclear on how to treat decanting under current law and, hopefully, guidance will be forthcoming now that the issue has been added to the Priority Guidance Plan.
The IRS has also issued several favorable rulings for taxpayers in terms of the tax impact of a trust modification. These positive rulings fall mostly in the area of whether a modification will: (1) be construed as a general power of appointment;27 (2) result in the loss of GST tax status; or (3) generate a taxable gift.
For example, the IRS has given its blessing to a court-approved modification of a trust containing a drafting error related to the allocation of an estate's debts and taxes among various trusts.28 Specifically, the IRS ruled that the evidence submitted by a surviving spouse strongly indicated that he and his settlor-wife didn't intend to have any control over the trust assets and that the provision contained in the trust charging the credit shelter trust with the surviving spouse's debts, expenses and death taxes was the result of a scrivener's error. As such, the IRS ruled that, despite the court modification, the surviving spouse wouldn't be considered to: (1) hold a general power of appointment of the trust assets upon his death; (2) have released a power during his life; or (3) have made a deemed gift of an interest in the trust under IRC Section 2501. Instead, the IRS accepted the decision of the state court that construed the language of the document as creating a limited power of appointment only.29 In another power of appointment ruling, the IRS favorably held that a state court modification of a trust to convert a general power of appointment into a limited one wouldn't be treated as a taxable release of the power, even when the power holder participates in the modification.30
In addition to the power of appointment area, there also have been favorable IRS rulings related to court modifications of grandfathered GST tax trusts.31
Similarly, the IRS has issued favorable rulings in which a court modification to a trust was found not to trigger negative gift tax consequences.32 It's important to note, however, that these rulings involved adversarial parties, causing the IRS to find that the parties weren't transferring value to each other without fair and adequate consideration in return. It's unclear whether a favorable ruling would result if non-adversarial beneficiaries transacted with each other via a court modification.
Liberalized state modification statutes have been a welcome relief for attorneys and individuals with trusts crying out for attention and change. The IRS' recent willingness to listen to and correctly apply state law when “sitting as a state court,” has likewise resulted in success for the taxpayer. Nonetheless, we recommend caution as there continues to be uncertainty concerning whether a modification will achieve the tax consequence the parties desire. Trust modification will continue to have the potential for adverse income, estate, gift and GST tax consequences. To minimize or eliminate tax uncertainty, taxpayers should consider requesting a PLR.
- References to trust modification or reformation are intended to include modification, reformation, amendment and similar changes to trusts (or similar estate-planning documents).
- Twenty-four jurisdictions have adopted the Uniform Trust Code (UTC): Alabama, Arizona, Arkansas, the District of Columbia, Florida, Kansas, Nebraska, New Hampshire, New Mexico, Maine, Michigan, Missouri, Ohio, Oregon, North Carolina, North Dakota, Pennsylvania, South Carolina, Tennessee, Utah, Vermont, Virginia, West Virginia and Wyoming.
- UTC Section 412(a). Although the settlor's consent isn't required, the modification must be made in accord with the settlor's probable intention.
- UTC Section 412(b). Again, the settlor's consent isn't required; however, the modification must be made in accord with the settlor's probable intention.
- UTC Section 411(b). All beneficiaries must provide consent.
- UTC Section 416.
- UTC Section 411(e).
- New York was the first state to adopt a decanting statute, effective July 24, 1992. Since that time, nine states have enacted similar statutes: Alaska, Arizona, Delaware, Florida, Nevada, New Hampshire, North Carolina, South Dakota and Tennessee.
- The U.S. Supreme Court in Commissioner v. Estate of Bosch, 387 U.S. 456 (1967) recognized the need to address the issue, stating, “the problem of what effect must be given a state trial court decree where the matter decided there is determinative of federal estate tax consequences has long burdened the Bar and the courts. This Court has not addressed itself to the problem for nearly a third of a century.”
- Gallagher v. Smith, 23 F. 2d 218 (3d Cir. 1955); Faulkerson's Estate v. United States, 301 F. 2d 231 (7th Cir. 1962); and Pierpont v. Comm'r, 336 F. 2d 277 (4th Cir. 1964), cert. denied, 380 U.S. 908 (1965).
- Bosch, supra note 9 at 465.
- A private letter ruling is a written statement issued to a taxpayer that interprets and applies tax laws to the taxpayer's specific set of facts. A PLR is issued to establish with certainty the federal tax consequences of a particular transaction before the transaction is consummated or before the taxpayer's return is filed. Other taxpayers or Internal Revenue Service personnel may not rely on a PLR as precedent. PLRs are generally made public after all information has been removed that could identify the taxpayer to whom it was issued. See generally www.irs.gov/irs/article/0,,id=101102,00.html. Due to the redaction of taxpayer-specific information, the subject state isn't identified in the PLRs.
- See PLRs cited in note 16, infra.
- See PLR 201132017 (Aug. 12, 2011), referring to a state statute that provides, “when through fraud or mutual mistake of the parties, or a mistake of one party, a written contract does not truly express the intention of the parties, it may be revised on the application of the party aggrieved.” The state statute also provides that “if all beneficiaries of an irrevocable trust consent, they may compel modification upon petition to the court;” PLR 201002013 (Jan. 15, 2010) (“under state law, a probate court has equitable power to modify a trust if the provisions of the trust are ambiguous or if adherence to the terms of the trust would defeat the primary purpose of the trust”); PLR 201006023 (Feb. 12, 2010) (“state law provides that the courts are vested with the authority to reform a trust instrument and that to the extent a word or phrase of importance is omitted by mistake, it may be added in through the judicial power of reformation”).
- See PLR 200918006 (May 1, 2009), in which the IRS followed the state court approval of correction deeds and trust modification to reflect the intent of the donor. The change to the trust was deemed necessary to qualify gifts made to the trust for the annual per donee exclusion. The IRS ruled that the original conveyance was a completed gift of a present interest, qualifying for the annual exclusion. Changes were made pursuant to a nonjudicial agreement of the various parties. The state statute provides for “nonjudicial resolution of a matter, if all necessary parties agree in a written agreement,” and the written agreement “may be filed in court and that, upon filing the agreement, the written agreement will be deemed approved by the court and is equivalent to a final court order binding on all persons interested in the trust.” PLR 201134017 (Aug. 26, 2011) involved the decanting of a trust by a special trustee; however, the terms of the new “receiving trust” were represented in the ruling as being “substantially similar” to the original trust. The IRS ruled that the receiving trust would continue to have a zero inclusion ratio for generation-skipping transfer (GST) tax purposes.
- Estate of Nicholson v. Comm'r, 94 T.C. 666 (April 30, 1990); Estate of La Meres v. Comm'r, 98 T.C. 294 (March 23, 1992).
- Nicholson, ibid. at 673.
- PLR 201021038 (May 28, 2010).
- See the Kansas Supreme Court decision in In the Matter of Trust D Created Under the Last Will and Testament of Harry Darby, 290 Kan. 785, (June 25, 2010). Note that Kansas has adopted the UTC, which makes this decision of the Kansas Supreme Court even more surprising.
- Darby, ibid.
- Darby, ibid. at 800.
- PLR 201024012 (June 18, 2010).
- Revenue Procedure 2011-3, 2011-13 Internal Revenue Bulletin (March 28, 2011).
- 2011-2012 Priority Guidance Plan released Sept. 2, 2011, Department of the Treasury, Item #13 under the category of “Gifts and Estates and Trusts.”
- Under Internal Revenue Code Sections 2041 or 2514.
- PLR 201132017 (Aug. 12, 2011).
- See PLR 201002013 (Jan. 15, 2010), which ruled similarly.
- PLR 201006023 (Feb. 12, 2010).
- See PLR 201128011 (July 15, 2011), in which the IRS ruled that no adverse income or transfer tax consequences will result from the reformation of a grandfathered GST tax trust that would allow for the adjustment of receipts between principal and income and allow the trustee to exercise its discretion to do the same.
- See PLR 201121002 (May 27, 2011), in which all the beneficiaries of a trust entered into a legally binding settlement agreement by which a child (born out of wedlock) of one of the trust beneficiaries would be deemed a legal issue of the trust settlor and therefore, receive a portion of the trust estate. The IRS ruled that there was no gift because the settlement agreement was the product of an arm's length negotiation and the result of a bona fide controversy. See also PLR 201119003 (March 4, 2011), in which trust beneficiaries petitioned a court to approve transactions between a marital trust and the decedent's children from his first marriage to resolve discord between the surviving spouse and her stepchildren. The IRS ruled that no gift resulted because, again, there was a bona fide dispute and arm's length negotiations. Further, the IRS found that the spouse's right to income wouldn't be diminished or relinquished as a result of the court-approved transaction.
Randi M. Grassgreen, far left, is director of family wealth planning at Crestone Capital Advisors in Boulder, Colo., and Jane Caddell Paddison is an attorney at Jane Caddell Paddison, P.C. in Boulder, Colo.