Court reformation does not end a grandfathered trust's GST exemption

Plain-English summary

A trust created before September 25, 1985 contained drafting omissions about what would happen if a primary beneficiary died without descendants and how certain descendant shares would be administered. The trustor later confirmed that the omitted provisions were intended to keep each daughter's share within the family lines before property could pass to more remote relatives. A state court reformed the trust to resolve those ambiguities, contingent on a favorable IRS ruling. The IRS found that the proceeding involved bona fide issues and that the court's construction was consistent with the state law the state's highest court would apply. Because the trust was already irrevocable before the grandfather date and had received no later additions, the modifications did not cause the affected trust to lose its exemption from generation-skipping transfer tax.

Ruling snapshot

• Question: Would a court-ordered correction of drafting omissions cause the pre-1985 trust to lose its GST tax exemption?
• Outcome: approved
• Key authorities: IRC §§ 2601 and 2611; Treas. Reg. § 26.2601-1(b)(1) and (b)(4); Commissioner v. Estate of Bosch

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201712004 Third Party Communication: None
Release Date: 3/24/2017 Date of Communication: Not Applicable
Index Number: 2601.00-00
Person To Contact:
------------------------------------ ----------------------------, ID No. --------------
--------------------------------------------- -----------------
-------------------------------- Telephone Number:
----------------------
Refer Reply To:
Re: ------------------------------------ CC:PSI:B04
PLR-120964-16
Date: November 29, 2016

Legend

Trustor = --------------------------
Date 1 = ------------------------
Trust = -------------------------------------------------
Trust 1 = ---------------------------------------------------------------
Trust 2 = ------------------------------------
Trust 3 = -------------------------------------------
Daughter 1 = -----------------------------------------------------
Daughter 2 = -----------------------
Daughter 3 = ------------------------------
Date 2 = -----------------------
Trustees = -------------------------------------------------------------------------
Date 3 = --------------------------
Court = -----------------------------------------------------------------------------------------------

State = -------------------
Statute = ---------------------------------------------------
Cite 1 = ----------------------------------------------------------------------------------------------

Cite 2 = -------------------------------------------------------
Cite 3 = ----------------------------------------------------------------------------------------------
-------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------------

Dear ---------------:
.
This letter responds to your letter dated June 27, 2016, requesting a ruling regarding the
generation-skipping transfer consequences to a court-ordered modification to a trust.

The facts and representations made are as follows.
PLR-120964-16 2

On Date 1, Trustor created an irrevocable trust, Trust, to benefit his three daughters,
Daughter 1, Daughter 2, and Daughter 3. Date 1 is a date prior to September 25, 1985.
Pursuant to the terms of Trust, three separate trusts (Trust 1, Trust 2, and Trust 3) were
established, one to benefit each daughter. Each daughter is the Primary Beneficiary of
her trust. The three trusts are sitused in State and are administered under the laws of
State. This private letter ruling pertains to Trust 2 benefitting Daughter 2.

Article III, paragraph A. of Trust provides that during the Primary Beneficiary’s lifetime,
the Trustees may, from time to time, distribute to or for the benefit of each Primary
Beneficiary so much of the corpus and income of her trust as the Trustees determine in
their discretion. The income of a trust not so distributed shall be accumulated and
added to the corpus of the trust.

Article III, paragraph B. provides that the Trustees may also, from time to time, distribute
to or for the benefit of the issue of such Primary Beneficiary at such times and in such
amounts as they in their sole discretion determine.

Article III, paragraph C. provides that upon the death of a Primary Beneficiary, the
Trustees shall divide such deceased Primary Beneficiary’s trust into as many equal
shares as there are children of such deceased Primary Beneficiary surviving and
deceased children thereof leaving issue surviving. Thereafter, one such share shall be
allocated for the benefit of each surviving child of such deceased Primary Beneficiary,
and one such share shall be allocated collectively for the benefit of the surviving issue
of a deceased child of such Primary Beneficiary who leaves issue then surviving.

Article III, paragraph C.1. provides that the separate shares to a surviving child
(Secondary Beneficiary) of a deceased Primary Beneficiary shall be held and managed
as a separate trust. The Trustees may, from time to time, distribute to or for the benefit
of each such Secondary Beneficiary so much of the corpus and income of his or her
trust as the Trustees determine in their discretion. Under paragraph C.1., the
Secondary Beneficiary may withdraw one-third of the principal of his or her trust at the
age of 25; one-half of the principal of his or her trust at the age of 30; and the remaining
balance of his or her trust at the age of 35.

Article III, paragraph C.2. provides that if a Secondary Beneficiary dies before receiving
final distribution of his or her trust, then the balance shall be paid over and distributed
equally to such Secondary Beneficiary’s surviving issue by right of representation. But if
such Secondary Beneficiary leaves no issue surviving, then all of his or her trust shall
be paid over and distributed equally to the other Secondary Beneficiaries or their issue,
such issue, however, taking by right of representation only the share which their parent
would have received if living.
PLR-120964-16 3

Paragraph C.4. provides that, if any amounts become distributable to persons who have
not then attained the age of 21, then such distributee’s share shall continue to be held in
trust for his or her benefit and the Trustees shall pay to or for the benefit of such
distributee so much of the net income and principal that the Trustees in their sole
discretion deem necessary or advisable to provide for the proper care, support, and
education of such distributee. When such distributee attains the age of 21, any balance
held for his or her benefit shall be paid over and distributed to him or her outright. If
such distributee dies before attaining age 21, then upon the death of such distributee,
any remaining portion of such trust for his or her benefit shall be paid over and
distributed to the surviving issue of the child of such deceased Secondary Beneficiary
who was his or her parent, by right of representation. If no issue of his or her parent
survives him, then to Trustor’s heirs-of-law as determined at that time.

Article III, paragraph C.5. provides that if at any time before final distribution of the trust
estate there shall not be in existence any one who is or might become entitled to
receive benefits therefrom, any portion of the trust estate then remaining shall be paid
over and distributed as follows: (a) one-half in equal shares to Trustor’s two sisters or
to their surviving issue by right of representation, and (b) one-half to Trustor’s wife’s
parents, or the survivor of them.

Two omissions were made by the attorney in drafting the dispositive provisions of Trust.
First, Trust fails to include a provision directing how assets are to be distributed if the
Primary Beneficiary dies without surviving issue. Second, Trust contains no dispositive
provisions for any share allocated to the issue of a deceased child of Trustor’s
daughters. When Trustor executed Trust, he was not aware that the terms of Trust did
not contain these distributive provisions.

On Date 2, Trustor executed an affidavit to confirm that he intended to create separate
trusts for each daughter. He assumed each daughter would die with surviving issue
and he intended that the assets of each separate trust would be administered and
distributed under Article III of Trust as follows:

   1. To or for the benefit of Trustor’s daughters for whom each
      separate trust was created for her lifetime.

   2. In the case of a deceased daughter leaving surviving issue, to or
      for the benefit of the surviving issue of said daughter for whom
      the separate trust was initially created.

   3. In the case of a deceased daughter leaving no surviving issue, to
      be divided equally between the separate trusts of Trustor’s then-
      living daughters and the then-living issue of any deceased
      daughter by right of representation.

PLR-120964-16 4

  4. If all of Trustor’s daughters and all of their issue are deceased,
     then, and only then, would the remaining trusts assets be
     distributed to Trustor’s more remote family members named in
     Trust.

Trustees petitioned Court to modify the terms of Article III of Trust to resolve the
ambiguities in conformance with Trustor’s intentions. On Date 3, Court issued an order
that modifies and restates Trust as follows:

  Article III, paragraphs A. and B. are not modified.

  Article III, paragraph C. is divided into two paragraphs, C. and D.
  Paragraph C. contains provisions for Trust 1 in the event a Primary
  Beneficiary dies leaving no surviving issue, and paragraph D. contains
  provisions for Trust 1 in the event a Primary Beneficiary dies leaving
  surviving issue.

  Paragraph C. provides that upon the death of a Primary Beneficiary who
  leaves no surviving issue, the assets of such deceased Primary
  Beneficiary’s trust will be divided into as many shares as there are: (i)
  Primary Beneficiaries who are then living and (ii) Primary Beneficiaries
  who are then deceased but are survived by issue. One share is to be
  allocated to each living Primary Beneficiary and one share is to be
  allocated to each deceased Primary Beneficiary with surviving issue.
  Thereafter, any share of a living Primary Beneficiary will be distributed to a
  separate trust of such Primary Beneficiary established under Trust. Any
  share of a deceased Primary Beneficiary with surviving issue will be
  distributed to the issue of such deceased Primary Beneficiary by right of
  representation; provided that if an issue of the deceased Primary
  Beneficiary is a beneficiary of a separate trust established under Trust, the
  property that is otherwise distributable to such person will not be
  distributed outright to such person, but is to be instead added to such
  separate trust to be held and distributed as provided therein.

  Paragraph D. provides that upon the death of a Primary Beneficiary
  leaving surviving issue, the Trustees shall divide such deceased Primary
  Beneficiary’s trust into as many equal shares as there are children of such
  deceased Primary Beneficiary surviving and deceased children thereof
  leaving issue surviving. Thereafter, one such share shall be allocated for
  the benefit of each surviving child of such deceased Primary Beneficiary,
  and one such share shall be allocated collectively for the benefit of the
  surviving issue of a deceased child of such Primary Beneficiary who
  leaves issue then surviving.

PLR-120964-16 5

   Subject to Article IV, after such allocation, such shares shall be held and
   distributed as follows, i.e., pursuant to sections 1. through 4 of Article III.
   Sections 1. through 4. are substantively unchanged, except to incorporate
   new paragraph D. Section 5 and section 6 are unchanged and renamed
   paragraph E and paragraph F, respectively.

The modifications are contingent upon the trustees receiving a favorable private letter
ruling from the Internal Revenue Service.

Trust was irrevocable prior to September 25, 1985. The Trustees represent that there
have been no additions to Trust after September 25, 1985.

Ruling Request

Trustees request a ruling that the Court-ordered modifications of Trust to correct the
scrivener’s errors and resolve ambiguities related to the administration and distribution
of Trust 2 upon the death of Daughter 2 will not cause Trust 2 to lose its GST exempt
status or cause the provisions of chapter 13 to apply to any generation-skipping
transfers made under Trust 2.

Law and Analysis

Section 2601 of the Internal Revenue Code imposes a tax on every generation-skipping
transfer (GST). Section 2611(a) provides that, for purposes of the GST tax, the term
“generation-skipping transfer” means (1) a taxable distribution, (2) a taxable termination,
and (3) a direct skip.

Under section 1433(a) of the Tax Reform Act of 1986 (the Act), the 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 § 26.2601-1(b)(1)(i) of the
Generation-Skipping Transfer Regulations, the tax does not apply to any
generation-skipping transfer from a trust, if the trust was irrevocable on September 25,
1985, and no addition (actual or constructive) was made to the trust after that date.
Under § 26.2601-1(b)(1)(ii), any trust in existence on September 25, 1985, will be
considered irrevocable unless the settlor had a power that would have caused inclusion
of the trust in his or her gross estate under § 2038 or 2042, if the settlor had died on
September 25, 1985.

Section 26.2601-1(b)(4) provides rules for determining when a modification, judicial
construction, settlement agreement, or trustee action with respect to a trust that is
exempt from the GST tax under § 26.2601-1(b) will not cause the trust to lose its
exempt status. In general, unless specifically provided otherwise, the rules contained in
this paragraph are applicable only for purposes of determining whether an exempt trust
retains its exempt status for GST tax purposes. Thus (unless specifically noted), the
PLR-120964-16 6

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 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 be subject to the provisions of chapter
13, if (1) The judicial action involves a bona fide issue; and (2) 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)(E), Example 3, considers a situation where, 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 GST tax.

State Statute provides that a court may reform the terms of a trust to conform to the
trustor’s intention if the failure to conform was due to a mistake of fact or law and the
trustor’s intent can be established. State Statute is a codification of the court’s common
law equitable power of courts to reform a trust upon a showing of factors, including
mistake. See Cite 1. See also Cite 2, which quotes the rule that

   [w]here an instrument is drawn or executed, which professes or is
   intended to carry into execution an agreement . . . previously entered into,
   but which, by mistake of the draftsman, either as to fact or law, does not
   fulfill that intention, or violates it, equity will correct that mistake so as to
   produce a conformity to the agreement.

If the language of the trust instrument is not clear, construction of an ambiguous trust
instrument is a question of law to be decided by the court. See Cite 3. In interpreting a
trust instrument, all words and provisions appearing in the trust are given effect as far
as possible and none are cast aside as meaningless, but where the trust instrument is
ambiguous, extrinsic evidence can be used to determine a trustor’s intent. See Id.
PLR-120964-16 7

In Commissioner v. Estate of Bosch, 387 U.S. 456 (1967), the Supreme 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 rules 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.

In this case, the two omissions, described above, created ambiguities in Trust.
Trustees petitioned Court to construe Trust in order to resolve the ambiguities. This
judicial action involved bona fide issues. An examination of the relevant trust
instruments and representations of the parties indicate that Trustor intended to create
separate trusts to provide for his three daughters and their respective surviving issue.
Further, Trustor assumed that each daughter would die with surviving issue and he
intended that the assets of each separate trust would be administered and distributed
under Article III of Trust to each daughter for that daughter’s lifetime, and then for a
deceased daughter’s surviving issue. Trustor intended that in the event a deceased
daughter left no surviving issue, then that daughter’s trust would be divided equally
between the separate trusts of the then-living daughters and the then-living issue of any
deceased daughter by right of representation. Further, Trustor intended that if all of his
daughters and all of their issue are deceased, then, and only then, would the remaining
trust assets be distributed to Trustor’s more remote family members. Accordingly, we
conclude that the Court-ordered modifications to Trust are consistent with applicable
State law that would be applied in the highest court of State.

Therefore, based upon the facts presented and the representations made, we conclude
that the Court-ordered modifications of Trust to correct the scrivener’s errors and
resolve ambiguities related to the administration and distribution of Trust 1 upon the
death of Daughter 2 will not cause Trust 2 to lose its GST exempt status or cause the
provisions of chapter 13 to apply to any GST made under Trust 2.
PLR-120964-16 8

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.

                                  Sincerely,


                                  Leslie H. Finlow
                                  Leslie H. Finlow
                                  Senior Technician Reviewer, Branch 4
                                  Office of Associate Chief Counsel
                                  (Passthroughs & Special Industries)

Enclosures (2)
Copy of this letter
Copy for section 6110 purposes