No Estate Inclusion Due to Court Reformations to a Trust

In Private Letter Ruling 201544005 (released Oct. 30, 2015), the Internal Revenue Service ruled that as a result of a state court’s reformations to a trust, the original transfers to the trust and future transfers to its subtrusts are completed gifts for federal gift tax purposes.  Accordingly, a grantor’s estate wouldn’t include the value of the transfers, and no tax would be due on the grantor’s death.

The Trust Provisions

A husband and wife (the grantors) created an irrevocable trust (Article 5 of the trust) for the benefit of their children.  The grantors were also the trustees, with the power to distribute income and principal for the well being of each child, prior to the child reaching age 25 (Article 6, par. 6.1).  When the eldest child turned 25, the trust was to be divided into two subtrusts—one for each child.  If a child died before receiving his full distribution, the remaining balance would go to the surviving child.  If both children died before reaching 25, the balance would go to the grantors. 

The grantors retained the power to amend the trust to increase the trust benefits going to their children, but not to decrease the benefits going to their children (Article 9).  The grantors could also name additional trustees (Article 9). 

In subsequent years, the grantors transferred real property and other property to the trust.  They filed Forms 706, reporting the gifts to the trust.  They never made any distributions to their children.

Court Reformation

The grantors believed that Articles 6 and 9 didn’t reflect their intent to have the transfers to the trust be treated as completed gifts so that they’d be excluded from the grantors’ gross estates.  As such, they filed a petition in state court seeking reformation to correct the scrivener’s errors.  The state court amended the trust to include language in Article 6 that if a child died before receiving his full distribution, the balance would go to the surviving child; if no child survived, the trustee would distribute the remaining balance to the deceased child’s estate.  

The grantors also submitted declarations to the state court that they each intended that the trust be drafted in a way so as to ensure that the transfers were completed gifts and that they never directed the attorney to include such language in trust.  The original drafting attorney submitted an affidavit that the grantors always intended the transfers to the trust to be completed gifts and the trust provisions, prior to reformation, were scrivener’s errors inconsistent with the grantors’ intent.  The attorney also swore that the purpose of the trust was to leverage the grantors’ unified credit and irrevocably set aside the maximum amount of property for the grantors’ children.  The grantors also resigned as trustees.

The grantors asked the IRS to rule on two issues.  First, they asked whether, as a result of the reformations, the original transfers to the trust and future transfers to the subtrusts were completed gifts for federal gift tax purposes.  Second, they asked whether the assets of the trust and subtrusts would be included in the wife’s gross estate. 

Completed Gifts

The IRS looked to Treasury Regulations Section 25.2511-2(b) that provides that a gift is complete when a donor parts with dominion and control as to leave him with no power to change its disposition, whether for his own benefit or another individual’s benefit.  Treas. Regs. Section 25.2511-2(c) provides that a gift is incomplete when a donor reserves the power to revest the beneficial title to the property in himself.  Moreover, a gift is incomplete to the extent that a reserved power gives a donor power to name new beneficiaries or to change the interest of the beneficiaries as between themselves unless the power is a fiduciary power limited by a fixed or ascertainable standard.

Turning to Commissioner v. Estate of Bosch, 387 U.S. 456 (1967), the IRS first addressed the weight of the state court reformation in the instant case.  In Bosch, the U.S. Supreme Court held that when the issue involved a determination of property interests for federal estate tax purposes, and that determination is based on state law, the highest state court is the ruling authority.  The IRS isn’t bound by a lower court decision, if one exists, but it should give “proper regard” to a state trial court's determination and other relevant state court rulings. 

In this instance, Article 9 gives the grantors the power to amend the trust, yet Article 5 provides that the trust is irrevocable.  Because these provisions are inconsistent, state law would permit extrinsic evidence to clarify the grantors’ intent.  The drafting attorney’s affidavits before the state court, in addition to the grantors’ representations, indicated that the grantors’ intent was to leverage their unified credit, transfer the maximum amount to their children, and make completed gifts.  The grantors didn’t intend to retain a reversionary interest or a distribution power not limited by an ascertainable.  Moreover, the grantors filed Forms 709 indicating that the transfers were completed gifts.  The IRS thus concluded that the state court’s reformations based on scrivener’s errors were consistent with state law as would be applied by the highest court of the state.  Thus, the reformations of the trust were effective; accordingly, the original transfers to trust and future transfers to subtrusts are completed gifts for federal gift tax purposes.

Not Includible in Gross Estate

Under Internal Revenue Code Section 2033, a gross estate includes the value of all

property to the extent of a decedent’s interest in such property at the time of her death.  IRC Section 2036(a) includes the value of property that a decedent transferred (except in a bona fide sale) if she kept: (1) the possession or enjoyment of, or the right to the income from, the property, or (2) the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income therefrom.  IRC Section 2038(a) includes transfers made in trust.

In the instant case, the reformation didn’t give either grantor an income interest in the trust or the subtrusts or a right to designate who will possess or enjoy the property or have an income interest under Section 2036.  The reformation also didn’t give the grantors the power to amend, alter, revoke or terminate the trust or subtrusts under Section 2038.  The IRS therefore ruled that the assets of the trust and subtrusts wouldn’t be includible in the wife’s gross estate on her death.