State Court Trust Reformation

State Court Trust Reformation

IRS rules that correction of scrivener’s errors caused transfers to be completed gifts

In Private Letter Ruling 201442046 (Oct. 17, 2014), the Internal Revenue Service ruled that a reformation of a trust to correct scrivener’s errors caused remainder interests to be completed gifts and as such, a trust’s assets wouldn’t be included in a grantor’s gross estate on his death.  Moreover, the reformation wouldn’t cause any current or future beneficiaries to make a gift to any other trust beneficiaries.

 

The GRATs

In Year 1, a grantor and his wife met with an attorney to discuss estate planning in connection with their four children.  The couple discussed the use of grantor retained annuity trusts (GRATs), including a 4-year term GRAT (GRAT 1) and a 15-year term GRAT (GRAT 2).  On a certain date, the grantor established both GRATs by making gifts of stock to each GRAT.  The stock was from a company in which the grantor was a co-owner.  The grantor intended to make completed gifts of the stock when he transferred the stock to both GRATs.

Under GRAT 1, the grantor would receive an annuity for four years, after which the remaining assets would pass to a Children’s Trust for the benefit of his four children.  GRAT 2 similarly provided for an annuity, but for a term of 15 years, after which the Children’s Trust would be the remainder beneficiary.  The grantor didn’t intend to retain any powers over the Children’s Trust that would cause the gifts to be incomplete or that would cause the assets of the Children’s Trust to be included in his estate.

 

The Children’s Trust

The Children’s Trust was drafted as a revocable trust, allowing the grantor to revoke, amend or modify it any time.  It provided that any assets it received would be separated into equal shares for each child (that is, into a separate trust for each child).  If any child wasn’t alive at that time, his share would be held in further trust for such child’s own children, or if none, to be divided equally among the surviving children.  The trustee was directed to distribute income and principal, as it deemed appropriate for the health, welfare, education and support of any child who was the beneficiary of each separate trust.  Income not distributed would be added to the principal.  The trustee was to make mandatory distributions to each child at age 28, 31 and 34.  If a child died before his separate trust terminated, his share was to be held in trust for his own children or if none, distributed to specified relatives pursuant to the Children’s Trust.

 

The Tax Returns

The grantor hired an accountant to prepare Form 709 and report the date of the transfers to GRAT 1 and GRAT 2.  The accountant notified the grantor that the Children’s Trust contained language that appeared to make the Children’s Trust revocable by the grantor.  This language seemed to defeat the grantor’s intent to create GRAT 1 and GRAT 2 and instead, cause the remainder interests in the GRATs to be included in the grantor’s estate for federal estate tax purposes.  The accountant also believed that the distributions from the Children’s Trust to the grantor’s children would be taxable gifts. 

The accountant contacted the attorney who drafted the Children’s Trust, but the attorney insisted that the Children’s Trust was proper.  In a contemporaneous written memorandum, the accountant noted his conversation with the attorney and prepared the Form 709 showing completed gifts to both GRATs.

A few years later, the grantor’s company hired a financial planner, who reviewed the grantor’s estate-planning documents.  The financial planner agreed with the accountant that the Children’s Trust contained provisions seemingly inconsistent with the grantor’s intent.  The planner retained a new attorney who likewise agreed that for the transfers to both GRATs to be completed gifts as the grantor intended, the grantor shouldn’t have had the power to revoke the Children’s Trust.  The original attorney continued to state that the drafting of the Children’s Trust was proper, and the transfers to the GRATs were completed gifts and out of the grantor’s estate. 

 

The Reformation

The grantor then retained the second attorney to reform the Children’s Trust under state law.  The grantor also filed a petition in state court to request reformation of the Children’s Trust to correct mistakes under scrivener’s errors.  The state court approved the petition and provided an order to correct the errors.  The court ordered that the reformation should be effective as if its terms were included in the original Children’s Trust.  Moreover, the court conditioned its order on the issuance by the IRS of a PLR stating that the IRS would respect the court’s retroactive reformation of the Children’s Trust for federal estate and gift tax purposes.

 

IRS Rulings

The grantor requested that the IRS rule that as a result of the reformation, his transfers of the remainder interests in both GRATs be completed gifts, and on completion of the GRAT terms, the distribution of the remainder interests to the Children’s Trust wouldn’t cause him to make an additional gift. 

The IRS noted the well-settled law that the mistake of a scrivener in preparing a deed or writing may be established by parol evidence.   Moreover, under Uniform Trust Code Section 415, a court may reform a trust to conform to a settlor’s probable intention if it’s proved by clear and convincing evidence that the settlor’s intent, as expressed in the trust, was affected by a mistake of fact or law. 

The IRS considered the affidavits submitted by the grantor, both attorneys, the accountant and the financial planner, along with contemporaneous correspondence and memoranda, which provided clear and convincing evidence that the provision in the Children’s Trust didn’t conform to the grantor’s intention.  As such, the state court’s order reforming the Children’s Trust based on scrivener’s errors was consistent with applicable state law.

The IRS thus concluded that as a result of the reformation: 1) the transfers of the remainder interests in both GRATs are completed gifts, and on the completion of each GRAT’s terms, the distribution of the remainder interests of the Children’s Trust wouldn’t cause the grantor to make an additional gift; 2) the assets of the Children’s Trust wouldn’t be included in the grantor’s gross estate when he dies; and 3), the court’s reformation of the Children’s Trust wouldn’t cause any current or future beneficiaries of the trust to make a gift to any other current or future beneficiary of the trust.

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