PLR 200033015: trust reformation to include minor adoptees does not trigger income or gift tax

Plain-English summary

A settlor created separate trusts for five children, but the instrument excluded all adopted descendants. After one child adopted a minor, a court reformed the trust to reflect the settlor's stated intent to exclude only adult adoptees. The IRS concluded that the reformation did not change the beneficiaries' original interests and would not create income or gift tax liability for the parties. It also concluded that reasonable necessary attorneys' fees paid or advanced from trust funds to effect the reformation would not create income or gift tax liability. Fees paid for the trust or trustee were deductible under section 212(2), subject to allocation for tax exempt income under section 265.

Ruling snapshot

• Question: Does the court ordered trust reformation, or trust payment of related reasonable legal expenses, create income or gift tax liability?
• Outcome: Approved. The IRS found no income or gift tax from the reformation or the specified legal fee payments and allowed the stated deduction subject to section 265 allocation.
• Key authorities: IRC §§ 61, 102, 212(2), 265(a)(1), 641(b), 643(a), 662(a), 667(e), 1001, 2501, 2511, and 2512; Treas. Reg. §§ 1.212-1(i) and 1.265-1(c).

Full text (IRS public release)

Internal Revenue Service                 Department of the Treasury

Index Numbers:    61.00-00, 212.00-00    Washington, DC 20224
                 667.00-00, 2501.00-00
Number: 200033015                        Person to Contact:
Release Date: 8/18/2000                  Telephone Number:

                                         Refer Reply To:
                                         CC:DOM:P&SI:4-PLR-109476-99
                                         Date:
Re:
                                                 May 15, 2000




LEGEND:
Settlor                    =
Child A                    =
Child B                    =
Child C                    =
Child D                    =
Child E                    =
Trust 1                    =

Trust 1A                   =

Trust 1B                   =

Trust 1C                   =

Trust 1D                   =

Trust 1E                   =

Trustee                    =
Will                       =

Trust 2                    =

Agreement                  =
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Attorney                     =

Dear               :

      This is in response to the letter of January 31, 2000, and prior correspondence,
requesting rulings on the income and gift tax consequences of a reformation of Trust 1.

       On March 9, 1988, Settlor created Trust 1, an irrevocable trust. The trust
instrument provided that the trust assets were to be divided into five equal shares, one
of each of the five shares to be held as a separate trust for each of the Settlor’s five
children. Accordingly, Trust 1A was established for Child A, Trust 1B was established
for Child B, Trust 1C was established for Child C, Trust 1D was established for Child D,
and Trust 1E was established for Child E.

        Under Paragraph 1.2 of the trust instrument, all of the net income of a separate
trust is to be paid to the child of Settlor who is the beneficiary of that trust. If the trustee
deems the income to be insufficient, the trustee is to pay to or for the benefit of that
child such part or all of the trust principal as the trustee deems necessary for the child’s
health, support, maintenance, and education.

        Under Paragraph 1.1b, each trust will terminate on the death of the respective
child for whom it is held. The remaining assets of that trust will be distributed in equal
shares to Settlor’s then living grandchildren who are (1) that child’s children, or (2) the
children of another child of Settlor who has predeceased that child (with cumulative
limitations).

      Under Paragraph 2.8, the terms “child,” “children,” “grandchild,” and
“grandchildren,” as used in the trust instrument, shall not include descendants by
adoption, but shall only include descendants by birth.

       Under Paragraph 2.1, subparagraph (k), the trustee has the authority to employ
any attorney to assist the trustee in administering the Trust and to pay reasonable
compensation by charging the compensation to principal or income.

The Will and Trust 2

        Settlor executed her Will and Trust 2 on July 25, 1988. The Will provides that
Settlor’s estate residue is to pass to Trust 2. The Will further provides that “References
to a child, children or issue . . . shall include descendants by adoption as well as by
birth.”

        Under Paragraph 2.3 of Trust 2, at Settlor’s death, the estate residue is to be
distributed in equal shares to Settlor’s children who survive her. If a child does not
survive her, but leaves issue who do, those issue will take, by right of representation,
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the share that the deceased child would have taken.

       Paragraph 9.2, in defining references to the parent-child relationship, provides
that the existence of a parent-child relationship shall be determined by California law
applicable to wills.

        At the time, California law applicable to wills provided (and continues to provide)
that, in construing a testamentary transfer by someone who is not the adoptive parent
of a person, the person is not considered the child of the adoptive parent unless the
person lived while a minor (either before or after the adoption) as a regular member of
the household of the adoptive parent. Cal. Probate Code § 21115 (Deering 1999),
originally enacted in 1983 as § 6152

The Adoption

        Recently, Child A adopted a minor child who, under the current terms of Trust
1A, would not share in the distribution of that trust’s principal. In seeking the
reformation of Trust 1 to include adopted minors as children and grandchildren, Settlor
claims that, when she executed Trust 1, she intended to exclude from the definition of
“children” and “grandchildren” under that trust only persons who were adopted as
adults.

       A declaration by Attorney, who drafted Trust 1 and oversaw its execution, is
submitted to corroborate Settlor’s intent at the time of execution. Attorney’s declaration
states that Settlor had become aware of the possibility of manipulative adoptions
involving the adoption of an adult to confer upon a non-family member status as a trust
beneficiary. She wished to prohibit that, and she asked Attorney to draft language to
address that specific concern. Attorney further declares that Settlor never indicated to
him any intent to exclude minor adoptees from receiving benefits under Trust 1. In
addition, the will’s definition of “child,” “children,” and “issue” and the incorporation of
California law in Trust 2 to define the parent-child relationship corroborate Settlor’s
claimed intent in executing Trust 1.

The Agreement and Court Order

       On December 25, 1998, the parties to Trust 1 agreed to the reformation of Trust
1 (the “Agreement”). Under the Agreement, the trustee will advance Trust 1 funds to
pay the reasonable and necessary expenses of the trust and the parties relating to the
implementation of the Agreement and the resolution of the matter (including attorneys’
fees).

       On February 17, 1999, the trustee filed a petition in the local court to reform
Trust 1. On March 22, 1999, the court held that Trust 1 fails to state the Settlor’s
original intention and issued an order reforming Trust 1 to provide as follows:
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      2.8 Children and Grandchildren The terms “child,” “grandchild” and
      “grandchildren” . . . shall include descendants by birth and any adopted
      person who lived while a minor (either before or after the adoption) as a
      regular member of the household of the adopting descendant-by-birth.

Requested Rulings:

               (1) The reformation of Trust 1 to recognize minor adoptees as
      “children” and “grandchildren” under Trust 1 will not give rise to income tax
      or gift tax liability for any party.

             (2) The trustee’s use of Trust 1 funds to reimburse any party
      thereto for the payment of reasonable and necessary attorneys’ fees and
      related expenses incurred to effect the Agreement for the benefit of the
      trust will not give rise to any income or gift tax liability for any party.

            (3) The trustee’s use of Trust 1 funds to pay or advance reasonable
      and necessary attorneys’ fees and related expenses to effect the
      Agreement, for the benefit of the parties thereto, will not give rise to any
      income or gift tax liability for any party.

THE INCOME TAX

       Section 61 of the Internal Revenue Code provides that gross income means all
income from whatever source derived, including gains derived from dealings in property
and income from the discharge of indebtedness. See §§ 1.61-6 and 1.61-12 of the
Income Tax Regulations.

       Section 102 provides that gross income does not include the value of property
acquired by gift, bequest, devise, or inheritance.

        Section 212(2) provides that in the case of an individual, there shall be allowed
as a deduction all the ordinary and necessary expenses paid or incurred during the year
for the management, conservation, or maintenance of property held for the production
of income.

       Section 1.212-1(i) of the Income Tax Regulations provides, in part, that
reasonable amounts paid or incurred by the fiduciary of a trust on account of
administration expenses, including expenses of litigation, which are ordinary and
necessary in connection with the performance of duties of administration are deduction
under section 212, notwithstanding that the trust is not engaged in a trade or business,
except to the extent that the expenses are allocated to the production or collection of
tax-exempt income.
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     Section 265(a)(1) provides, in part, that no deduction shall be allowed for any
amount otherwise allowable under section 212 that is allocable to interest wholly
exempt from the taxes imposed by Subtitle A.

       Section 1.265-1(c) provides that expenses that are directly allocable to any class
or classes of tax-exempt income shall be allocated to the tax-exempt income. The
regulations further provide that if an expense otherwise allowable is indirectly allocable
to both nonexempt and exempt income, then a reasonable proportion is allocated to
each considering the particular facts and circumstances.

       Section 662(a) limits the amount of trust distributions included in the gross
income of a beneficiary to the distributable net income of the trust. Under section
643(a), distributable net income is calculated by making certain modifications to taxable
income. Section 641(b) provides, in part, that the taxable income of a trust shall be
computed in the same manner as in the case of an individual, except as otherwise
provided in Part I of Subchapter J.

        Section 667(e) provides for the determination of adjusted gross income for
trusts, allowing deductions for costs paid or incurred in connection with the administra-
tion of a trust, which would not have been incurred if the property were not held in trust.

       Section 1001 provides that, unless otherwise provided, the entire amount of gain
or loss on the sale or exchange of property shall be recognized. The gain or loss from
the sale or other disposition of property is the difference between the adjusted basis of
the property and the amount realized. Section 1001(a). The amount realized is the
sum of money received plus the fair market value of any property (other than money)
received. Section 1001(b).

       An exchange of property results in realization of gain or loss under section
1001(a) if the properties exchanged are materially different. Cottage Savings
Association v. Commissioner, 499 U.S. 554, 566 (1991). The material difference
requirement is met if the properties embody legal entitlements that are different in kind
or extent or if they confer different rights and powers. Cottage Savings, 499 U.S. at
565.

       We accept that it was Settlor’s original intent to exclude only adult adoptees as
beneficiaries of the trust. To effectuate the original intent of Settlor, the court has
ordered reformation of the trust instrument to correct a drafting error. Because the
reformed trust reflects the original intention of Settlor, the beneficiaries’ interests before
and after reformation do not embody different legal entitlements as a result of the
transaction. Thus, there will be no sale or exchange in connection with the Agreement,
and no gain or loss will be realized by the parties to the Agreement.

       Furthermore, reformation of the trust to recognize minor adoptees as children
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and grandchildren will not result in gross income for any minor adoptee beneficiaries.
The reformation merely recognizes the rights of the minor adoptees as beneficiaries
pursuant to Settlor’s original intention and, under section 102, gross income does not
include the value of property acquired by gift, bequest, devise, or inheritance.

         In addition, no party to the Agreement will realize income from a discharge of
indebtedness. Although a taxpayer may realize income from a discharge of indebted-
ness where settlement of a disputed claim results in the discharge of a determined
liability of the taxpayer, there is no disputed claim here. Instead, there is a realization
by all the parties that Settlor’s original intent was to recognize and treat minor adoptees
as children and grandchildren (and beneficiaries) with respect to Trust 1.

        Whether legal fees are deductible expenses under section 212, or are capital
expenses under section 263, requires an examination of the origin of the claim giving
rise to the legal fees. See United States v. Gilmore, 372 U.S. 39, 49 (1963).

       Legal expenses relating to the final distribution of trust funds are a function of the
management of the trust property and are deductible if they are ordinary and
necessary. Trust of Bingham v. Commissioner, 325 U.S. 365, 376 (1945). In Herman
A. Moore Trust v. Commissioner, 49 T.C. 430 (1968), acq., 1968-2 C.B. 21, the Service
challenged the trustee’s deduction of certain attorneys’ fees in computing the trust’s
income. These fees arose from an action brought by the testator’s children to
accelerate their beneficial interests in the trust. Pursuant to state law, the court ordered
that the attorneys’ fees for the trustee, the beneficiaries, and the guardian ad litem be
paid from trust income. The court decided that (i) the state court decision aided the
trustee in its management of the trust property, and (ii) the trust benefitted by the
involvement of the beneficiaries and the guardian ad litem in the litigation. Thus, the
court held that all of the litigants’ attorneys’ fees paid from trust income were deductible
under section 212(2).1

       Based on the information submitted, we conclude that the reformation of Trust 1
by court order to recognize and treat minor adoptees as children and grandchildren will
not give rise to any income tax for any party. We also conclude that the origin of the
claim from which the legal expenses arose was the uncertainty as to the proper
beneficiaries of Trust 1. Furthermore, the trust benefitted by the involvement of the
actual and potential beneficiaries in the proceedings. Thus, subject to allocations under
section 1.265-1(c), we conclude that the attorneys’ fees paid for the benefit of Trust 1 or


       1
         In Moore, the Tax Court used the primary purpose test, rather than the origin of
the claim test, to determine the deductibility issue. Since the Tax Court’s opinion in
Moore, it has adopted the origin of the claim test. However, as recently noted by the
Tax Court, the application of the origin of the claim test in Moore “would not have
materially changed our decision.” Stevens v. Commissioner, T.C. Memo. 1999-259.
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for the benefit of the trustee are deductible under section 212(2) and do not give rise to
income to any party to the Agreement.

THE GIFT TAX

       Section 2501 provides that a tax is imposed for each calendar year on the
transfer of property by gift during the calendar year.

       Section 2511(a) provides that the gift tax applies whether the transfer is in trust
or otherwise, whether the gift is direct or indirect, and whether the property is real or
personal, tangible or intangible.

       Section 2512(a) provides that if the gift is made in property, the value thereof at
the date of the gift is considered the amount of the gift.

       In Commissioner v. Estate of Bosch, 387 U.S. 456 (1967), the Court considered
whether a state trial court’s characterization of property rights conclusively binds a
federal court or agency in a federal tax controversy. The Court concluded that the
decision of a state trial court as to an underlying issue of state law should not be
controlling when applied to a federal statute. Rather, the highest court of the state is
the best authority on the underlying substantive rule of state law to be applied in the
federal matter. If there is no decision by that court, then the federal authority must
apply what it finds to be state law after giving “proper regard” to the state trial court’s
determination and to relevant rulings of other courts of the state. In this respect, the
federal agency may be said, in effect, to be sitting as a state court.

      Under California law, in interpreting a trust, it is proper for a court to consider the
circumstances under which the trust was executed so that the court may be placed in
the position of the trustor whose language it is interpreting, in order to determine
whether the terms of the trust are clear and definite, or ambiguous in some respect.
Wells Fargo Bank v. Marshall, 24 Cal. Rptr.2d 507 (1993). Extrinsic evidence as to the
circumstances under which a trust was made is admissible to interpret the trust,
although not to give it a meaning to which it is not reasonably susceptible. The court’s
proper function is to give effect to the intention of the maker of the trust. Ike v. Doolittle,
70 Cal. Rptr. 2d 887 (1998); Estate of Torregano v. Torregano, 5 Cal. Rptr. 137 (1960).

      In this case, the court determined that there was sufficient evidence that Settlor
intended to include minor adoptees in the terms “child,” “grandchild,” and
“grandchildren.” Based on the facts submitted and the representations made, we
conclude that the reformation of Trust 1 is consistent with applicable California law as it
would be applied by the highest court of California. Thus, the reformation based on a
mistake in drafting does not change any of the beneficial interests in Trust 1 and,
accordingly, the reformation will not give rise to gift tax liability for any party.
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        We do not consider the document characterized as the “Agreement” to be
a settlement agreement for gift tax purposes because there was no disputed claim
among the parties, and neither the basis for the reformation nor the basis for the
definitional change in the trust arose by reason of the Agreement. That is, in the
Agreement, the parties’ merely acknowledge Settlor’s original intent and state that they
will not object to the reformation so long as they do not personally incur any gift tax or
income tax liability therefrom or any liability for legal fees and expenses.

        Under the terms of the trust, attorney fees and expenditures incurred by the trust
to obtain the Agreement and reformation are permissible expenditures. In this regard,
the minimal attorney fees incurred for the parties’ legal representation relates to their
consent to the court proceeding and facilitated the reformation, thereby benefitting the
trust. Accordingly, the trustee’s use of funds to pay or advance reasonable and
necessary attorneys’ fees and related expenses to effect the Agreement for the benefit
of the trust will not give rise to any gift tax. Likewise, the trustee’s use of funds to pay
or reimburse a party for reasonable and necessary attorneys’ fees and related
expenses incurred to effect the Agreement does not give rise to any gift tax liability for
any party to the Agreement.

        Except as specifically set forth above, no opinion is expressed concerning the
federal tax consequences of the facts described above under the cited provisions or
any other provisions of the Code. This ruling is based on the facts and applicable law
in effect on the date of this letter. If there is a change in material fact or law (local or
Federal) before the transaction considered in the ruling takes effect, the ruling will have
no force or effect. If the taxpayer is in doubt whether there has been a change in
material fact or law, a request for reconsideration of this ruling should be submitted to
this office.

      This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of
the Code provides that it may not be used or cited as precedent.

         In accordance with the Power of Attorney on file with this office, a copy of this
letter is being sent to the trustee.

                                           Sincerely yours,
                                           Assistant Chief Counsel
                                           (Passthroughs and Special Industries)
                                     By    Robert Honigman
                                           Acting Assistant to the Branch Chief
                                           Branch 4

Enclosure (1)
 Copy for section 6110 purposes