In Private Letter Ruling 201837005 (released Sept. 14, 2018), the Internal Revenue Service ruled that: (1) the judicial reformation of a trust didn’t give the beneficiaries general powers of appointment; (2) the lapse of their withdrawal rights didn’t result in a gift; (3) the trust assets wouldn’t be subject to tax on the beneficiaries’ deaths; and (4) the settlor and his spouse allocated their available generation-skipping transfer tax exemption to gifts to the trust.
Background Facts
The settlor executed an irrevocable trust that created three separate trust shares, one for the benefit of each of the settlor’s three grandchildren and their descendants. The trust contained two fundamental errors. First, during each calendar year when gifts were made to each separate trust share, a grandchild had the power to withdraw all of the gifts made to the grandchild’s trust share; a grandchild’s withdrawal right wasn’t limited to the gift tax annual exclusion amount. Second, each grandchild’s withdrawal right over the contributed assets was non-cumulative and lapsed, in its entirety, on an annual basis.
The settlor and the settlor’s spouse timely filed U.S. Gift and GST tax returns to report the initial gift to the trust. They elected to gift-split the initial gift and allocated their GST exemption amounts to the gift to the trust. However, the settlor and the settlor’s spouse incorrectly reported the initial gift on their individual Form 709s as an indirect skip.
Procedural Posture
When the settlor’s son engaged a new attorney to advise him regarding his estate plan, the son’s attorney advised the son of the drafting errors that were made to the settlor’s trust. On learning of these errors, the trustee petitioned the state court to judicially reform the trust to correct the scrivener’s errors and for such reformation to be effective as of the date the trust was originally created. The settlor’s spouse and the settlor’s drafting attorney provided the court with affidavits that it was the settlor’s intent to reduce overall transfer taxes, to exclude the property from a grandchild’s gross estate and to minimize GST taxes.
The IRS commented that the state statute in the settlor’s state allowed for a state court to reform the terms of a trust to conform to the settlor’s intent, even if the language of the trust was unambiguous, as long as it was proven by clear and convincing evidence that the settlors’ intent or the terms of the trust were affected by a mistake of fact or law. The state court granted the trustee’s petition to eliminate the scrivener’s errors retroactive to the date of the trust’s creation. After the judicial reformation, the trust limited the beneficiaries’ withdrawal rights to the gift tax annual exclusion amount and limited the annual lapse of the withdrawal rights to the greater of $5,000 or 5 percent of the value of the trust assets.
Issues Raised
Based on the favorable state court action, the settlor presented the following five issues to the IRS:
- Whether, following the judicial reformation of the trust, the grandchildren possessed general POAs under Internal Revenue Code Sections 2514 and 2041 over their respective shares of the trust, other than to the extent of each grandchild’s withdrawal rights.
- Whether the judicial reformation of the trust would constitute the exercise or release by any grandchild of a general POA.
- Whether the lapse of any grandchild’s withdrawal right would result in a gift.
- Whether any part of the trust property would be included in the grandchildren’s gross estates, other than to the extent of each grandchild’s withdrawal rights under the reformed trust agreement.
- Whether the settlor and the settlor’s spouse substantially complied with the requirements to allocate their available GST tax exemption to the trust.
Possession of General POAs
Regarding the first issue raised, prior to the judicial reformation, the IRS found that each grandchild would have possessed a general POA over their respective share of the trust because their right to withdraw the entire amount of any addition to the principal of the trust would have constituted a general POA under IRC Sections 2514 and 2041. The IRS ruled that the scrivener’s errors were contrary to the intent of the settlor, and the purpose of the reformation was to correct those scrivener’s errors, rather than to alter or modify the trust instrument. Therefore, as a result of the judicial reformation, the grandchildren didn’t possess general POAs, except to the extent of each grandchild’s withdrawal rights.
Exercise or Release of General POA
With respect to the second issue, the IRS held that the judicial reformation of the trust didn’t constitute the exercise or release by any grandchild of a general POA under Section 2514 or 2041.
Lapse of Withdrawal Right
With respect to the lapse of each grandchild’s withdrawal right, although Section 2514(e) provides that the lapse of a general POA during the life of the person possessing the power is deemed to be a release of the power, the lapse of such power during a calendar year only applies to the extent that the property that could have been appointed by the exercise of the power exceeds the greater of $5,000 or 5 percent of the value of the assets out of which the withdrawal could be satisfied. Given the judicial reformation of the trust being retroactive to the trust’s inception, the IRS ruled that the lapse of any grandchild’s withdrawal right over the trust didn’t result in a gift.
Exclusion of Trust Property from Beneficiaries’ Gross Estates
The IRS also ruled that because the trust was properly reformed by judicial reformation, the assets of each grandchild’s portion of the trust wouldn’t be includible in that grandchild’s gross estate on that grandchild’s death, because the drafting issues that otherwise would have caused inclusion under Section 2514 or 2041 were no longer at issue.
Allocation of GST Tax Exemption
With respect to the final issue, the settlor and the settlor’s spouse were each considered to be the transferor of one-half of the assets gifted to the trust because the gift was split between the two of them. The IRS held that the settlor and the settlor’s spouse substantially complied with the requirements to validly allocate their GST tax exemption to the trust. Although the settlor and his spouse incorrectly reported their gift as an indirect skip, the attempted allocation of GST tax exemption was sufficient to indicate that the settlor and the settlor’s spouse intended to make the allocation. The ruling held, therefore, that they’d both substantially complied with the requirement to allocate their respective GST tax exemption to the trust and that such allocations would be deemed effective.
It’s noteworthy that the IRS favorably considered the taxpayer’s application for the ruling and recognized the scrivener’s error when the scrivener failed to achieve the taxpayer’s objectives. While the taxpayers received a favorable ruling on all of their requests, the ruling should serve as a warning to all practitioners to review their trust language carefully to save the practitioner’s client—or the practitioner—the time and expense necessary to seek a judicial reformation and a favorable PLR.
Scott A. Weinberg is a shareholder in the trusts and estates group at Lynch, Cox, Gilman & Goodman, P.S.C., in Louisville, Kentucky, and is admitted to practice in Florida, Illinois, Indiana and Kentucky.