Trust reformation preserves GST exemption and creates no gift

Plain-English summary

A trust created before September 25, 1985, had ambiguous provisions governing who would receive the remainder if its primary beneficiary had no descendants. A proposed judicial reformation clarified that the assets would pass equally to two existing trusts for the beneficiary's siblings. The IRS found that the proceeding addressed bona fide issues and that the construction was consistent with applicable state law. The reformation did not shift a beneficial interest to a lower-generation beneficiary or extend the time for vesting, so the trust retained its generation-skipping transfer tax exemption. Because the judicial action did not change the beneficiaries' beneficial interests, no beneficiary was treated as making a gift.

Ruling snapshot

• Question: Would the judicial clarification of the trust remainder preserve the trust's GST exemption and avoid a taxable gift?
• Outcome: Approved, the trust remains GST-exempt and the reformation creates no gift.
• Key authorities: IRC §§ 2501, 2511, 2601, 2611, and 2651; Treas. Reg. § 26.2601-1(b)(4)(i)(C) and (D); Commissioner v. Estate of Bosch, 387 U.S. 456 (1967)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201521002 Third Party Communication: None
Release Date: 5/22/2015 Date of Communication: Not Applicable
Index Number: 2501.01-00, 2601.00-00
Person To Contact:
------------------------------- -----------------------, ID No. ------------
----------------- Telephone Number:
------------------------ --------------------
Refer Reply To:
------------------------------------------- CC:PSI:B04
PLR-120230-14
Re: ------------------------------------------------------- Date: NOVEMBER 12, 2015

LEGEND:
Settlor = ---------------------------
Trust = -----------------------------------------------------------------------

---

Date 1 = --------------------------
Date 2 = ---------------------
Date 3 = ---------------------
Date 4 = ---------------------------
Corporate Trustee = -------------------------------------------------
Child = --------------------------------------------
Grandchild = ----------------------------
Grandchild A = -----------------------------------
Grandchild B = --------------------------------
Grandchild A Trust = ------------------------------------------------------------------------

Grandchild B Trust = -----------------------------------------------------------------------

State Court = ------------------------------------------------------------------------

Case 1 = ------------------------------------------------------------------------

PLR-120230-14 2

Case 2 = ------------------------------------------------------------------------

x = ------------------

Dear ---------------:

This is in response to a letter dated May 12, 2014, and subsequent correspondence
submitted by your authorized representative requesting rulings on the gift tax and
generation-skipping transfer tax consequences of a judicial construction of a trust.

The facts and representations submitted are summarized as follows. Settlor created
and funded Trust, an irrevocable trust, on Date 1 (a date before September 25, 1985)
for the primary benefit of Grandchild. Corporate Trustee is the current trustee.

Under Article II(A) of Trust, the trustee is authorized to purchase and maintain insurance
on the life of Child. The net income is to be accumulated. However, the trustee may, in
its sole discretion, pay for the benefit of Grandchild so much of the net income as the
trustee may deem necessary and proper to provide for the support, maintenance and
education of Grandchild.

Article II(D) and Article III provide that Trust is to terminate five years after Child’s death.
Upon termination, the trustee is to distribute all of the Trust assets in equal shares to
Grandchild’s then surviving descendants. If all of Grandchild’s descendants die before
they would otherwise be entitled to receive the Trust assets, then the Trust is to
terminate and the assets are to be distributed in equal shares to Grandchild’s siblings,
Grandchild A and Grandchild B, then surviving. However, if Grandchild A is then a
current beneficiary of Grandchild A Trust, then her share is to be added to Grandchild A
Trust. Likewise, if Grandchild B is then a current beneficiary of Grandchild B Trust, then
his share is to be added to Grandchild B Trust.

Child died on Date 2. Trust will terminate on the earlier of Grandchild’s death or Date 3,
the fifth anniversary of Child’s death. Grandchild, the income beneficiary of Trust, is
living, but she has no descendants. Grandchild A is living and currently the beneficiary
of Grandchild A Trust. Grandchild B is likewise living and currently the beneficiary of
Grandchild B Trust. Trust, Grandchild A Trust, and Grandchild B Trust were created at
the same time and have virtually identical provisions.

On Date 4, the parties petitioned State Court for an order construing and reforming
Article II(D) and Article III of the Trust instrument to identify the contingent remainder
PLR-120230-14 3

beneficiaries and to clarify the disposition of the Trust remainder upon its likely
termination on Date 3. Under the proposed reformation, the Trust assets will be divided
into two equal shares with one share being distributed to Grandchild A Trust and the
other share being distributed to Grandchild B Trust upon either: (i) Grandchild’s death
before Date 3, or (ii) Trust’s termination on Date 3. After such distribution, the one-half
share distributed to Grandchild A Trust will continue to be held in Grandchild A Trust
and administered pursuant to the terms of that trust. The one-half share distributed to
Grandchild B Trust will be continue to be held in Grandchild B Trust and administered
pursuant to the terms of that trust.

Requested rulings:

You have asked us to rule that:

   1. The proposed reformation of Articles II(D) and III of Trust will not cause Trust
      to be subject to the tax on generation-skipping transfers under § 2601 of the
      Internal Revenue Code, and

   2. The proposed reformation of Articles II(D) and III of Trust will not constitute a
      gift for purposes of § 2501.

Rulings 1 and 2:

Section 2501 imposes a tax on the transfer of property by gift.

Section 2511 provides that the gift tax shall apply 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 2601 imposes a tax on every generation-skipping transfer, which is defined
under § 2611 as a taxable distribution, a taxable termination, or a direct skip.

Under § 1433 of the Tax Reform Act of 1986 (the Act), GST tax is generally applicable
to generation-skipping transfers made after October 22, 1986. However, under section
1433(b)(2)(A) of the Act and section 26.2601-1(b)(1)(i) of the Generation-Skipping
Transfer Tax Regulations, the tax does not apply to a transfer under a trust that was
irrevocable on September 25, 1985, except to the extent the transfer is made out of
principal added to the trust by an actual or constructive addition after September 25,
1985.

Section 26.2601-1(b)(4)(i) provides rules for determining when a modification, judicial
construction, settlement agreement, or trustee action with respect to a trust that is
exempt from the generation-skipping transfer tax under § 26.2601-1(b) will not cause
PLR-120230-14 4

the trust to lose its exempt status. In general, unless specifically provided otherwise,
these rules are applicable only for purposes of determining whether an exempt trust
retains exempt status for generation-skipping transfer tax purposes. The rules do not
apply in determining, for example, whether the transaction results in a gift subject to gift
tax, or may cause the trust to be included in the gross estate of a beneficiary, or may
result in the realization of capital gain for purposes of § 1001.

Section 26.2601-1(b)(4)(i)(C) provides that a judicial construction of a governing
instrument to resolve an ambiguity in the terms of the instrument or to correct a
scrivener's error will not cause an exempt trust to lose its exempt status if the judicial
action involves a bona fide issue, and the construction is consistent with applicable
state law that would be applied by the highest court of the state.

Section 26.2601-1(b)(4)(i)(D) provides that a modification of the governing instrument of
an exempt trust (including a trustee distribution, settlement, or construction that does
not satisfy paragraph § 26.2601-1(b)(4)(i)(A),(B), or (C)) by judicial reformation, or
nonjudicial reformation that is valid under applicable state law, will not cause an exempt
trust to be subject to the provisions of chapter 13, if the modification does not shift a
beneficial interest in the trust to any beneficiary who occupies a lower generation (as
defined in § 2651) than the person or persons who held the beneficial interest prior to
the modification, and the modification does not extend the time for vesting of any
beneficial interest in the trust beyond the period provided for in the original trust.

Section 26.2601-1(b)(4)(E), Example 3, provides as follows. In 1980, Grantor
established an irrevocable trust for the benefit of Grantor's children, A and B, and their
issue. The trust is to terminate on the death of the last to die of A and B, at which time
the principal is to be distributed to their issue. However, the provision governing the
termination of the trust is ambiguous regarding whether the trust principal is to be
distributed per stirpes, only to the children of A and B, or per capita among the children,
grandchildren, and more remote issue of A and B. In 2002, the trustee files a
construction suit with the appropriate local court to resolve the ambiguity. The court
issues an order construing the instrument to provide for per capita distributions to the
children, grandchildren, and more remote issue of A and B living at the time the trust
terminates. The court's construction resolves a bona fide issue regarding the proper
interpretation of the instrument and is consistent with applicable state law as it would be
interpreted by the highest court of the state. Therefore, the trust will not be subject to
the provisions of chapter 13.

Under applicable State law, a trust instrument may be reformed to conform to the
settlor's intent. To ascertain the settlor's intent, the State courts look to the trust
instrument as a whole and the circumstances known to the settlor on the date of
execution. Cite 1; Cite 2.
PLR-120230-14 5

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 estate 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.

Based on the facts submitted and the representations made, we conclude that the
the judicial action involves bona fide issues, and the judicial reformation of Trust to
provide for the distribution of Trust assets to Grandchild Trust A and Grandchild Trust B,
as described above, is consistent with applicable State law, as applied by the highest
court of State.

Accordingly, we conclude that the judicial reformation of Trust, as described above, will
not result in a shift of any beneficial interest in Trust to any beneficiary who occupies a
generation lower than the persons holding the beneficial interest prior to the
modification. Further, the reformation of Trust will not extend the time for vesting of any
beneficial interest in Trust beyond the period provided for in the original trust.
Therefore, the reformation will not cause Trust to be subject to the tax on generation-
skipping transfers under § 2601. In addition, the judicial reformation of Trust will not
result in any change in the beneficial interests of the beneficiaries. Accordingly, no
beneficiary will be regarded as making a gift as a result of the judicial reformation and
distributions, described above.

Except as expressly provided herein, we express no opinion on the federal tax
consequences of the transaction under the cited provisions or under any other
provisions of the Code.

This ruling is directed only to the taxpayers 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 your authorized representatives.
PLR-120230-14 6

The ruling contained in this letter is based upon information and representations
submitted by the taxpayer and accompanied by a penalty of perjury statement
executed by an appropriate party. While this office has not verified any of the material
submitted in support of the request for rulings, it is subject to verification on
examination.

                                       Sincerely,



                                       Melissa C. Liquerman
                                       Chief, Branch 4
                                       Office of Associate Chief Counsel
                                       (Passthroughs & Special Industries)

Enclosure:
Copy of letter for section 6110 purposes