Retroactive trust reformation preserves completed gifts and estate exclusion

Plain-English summary

A grantor created an irrevocable life-insurance trust intending completed gifts and exclusion of the trust property from her gross estate, but a drafting error tied the division of trust assets to her will and revocable trust. A state court retroactively reformed the provision after receiving evidence of the original plan, the grantor's intent, and the drafting attorney's error. The IRS concluded that the reformation was consistent with state law and effective from the trust's creation, so the transfers were completed gifts and the corrected provision did not retain powers or interests causing estate inclusion under IRC §§ 2035, 2036, 2038, or 2042. The generation-skipping transfer inclusion ratio for each gift is therefore based on the property's gift-tax value on its original transfer date.

Ruling snapshot

• Question: What gift, estate, and GST tax treatment follows from the retroactive correction of the trust drafting error?
• Outcome: Approved. The gifts are complete, the corrected provision does not cause estate inclusion, and original transfer-date values govern GST allocations.
• Key authorities: IRC §§ 2035, 2036, 2038, 2042, 2501, 2642; Commissioner v. Estate of Bosch

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201723002 Third Party Communication: None
Release Date: 6/9/2017 Date of Communication: Not Applicable
Index Number: 2036.00-00, 2038.00-00,
2501.00-00, 2601.00-00 Person To Contact:
-----------------------, ID No. -------------
----------------------------- Telephone Number:
--------------------------- ---------------------
----------------------------------- Refer Reply To:
CC:PSI:B04
In Re: ----------------------- PLR-123333-16
Date:
January 23, 2017

LEGEND:
Grantor = -----------------------

Representative = --------------------
Attorney = ------------------------------
A = -----------------------------
Plan = -------------------------------------------------------------------------------------

------------------------------------------------------------------------------------------------------

Trust = --------------------------------------------------------------------------------------
Revocable Trust = ----------------------------------------
State Court = ------------------------------------------------
Citation 1 = -------------------------------------------------------------------------------------

Citation 2 = -------------------------------------------------------------
Citation 3 = ----------------------------------------------------------------------------
Citation 4 = -------------------------------------------------------------
Citation 5 = ------------------------------------------------------------------------------------------------
State Statute = -------------------------------------------------------------------
Date 1 = ---------------------
Date 2 = -----------------
Date 3 = ---------------------------
Date 4 = -------------------------
Date 5 = ----------------

PLR-123333-16 2

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

This letter responds to your personal representative’s letter of July 22, 2016, and
subsequent correspondence, regarding the federal gift, estate, and generation-skipping
transfer tax consequences of a judicial reformation of a trust.

The facts submitted and representations made are as follows. Grantor, with her
representative (Representative), worked with Attorney to structure her life insurance
plan. On Date 1, Representative and Attorney discussed the possibility of creating a
trust to hold life insurance policies insuring Grantor’s life, the proceeds of which would
be payable on Grantor’s death to separate trusts for her children.

On Date 2, Attorney presented a detailed analysis taking into account premium
payments, income tax consequences and potential estate and gift tax consequences.
The analysis concluded that: (i) under this plan (the Plan), the greatest amount of net
insurance proceeds would be available for distribution at Grantor’s death; (ii) Grantor
would pay gift tax during life for her gifts of the annual insurance premiums; and (iii)
there would not be any estate tax payable at Grantor’s death. The detailed analysis
specifically concludes that the net insurance proceeds would not be includible in
Grantor’s gross estate.

Grantor and Representative agreed that this Plan represented Grantor’s intent and that
such plan would be implemented. With these specifications, Attorney drafted the trust
agreement. On Date 3, Grantor executed the irrevocable trust (Trust). A currently
serves as the trustee.

Paragraph B of Article I of Trust states that Grantor intends that the value of the Trust
shall not be included in her gross estate at death for federal estate tax purposes.
Under Paragraph B of Article V, at Grantor’s death, the trustee is to divide the trust
estate into as many separate shares as are then required to provide one share for each
then living child of Grantor and one share for the then living descendants, collectively, of
any child who died. The amounts of the shares are to be determined by multiplying the
total value of Trust by a fraction of which: (i) the numerator is the value of property
distributable to the child or the child’s descendants under Grantor’s Last Will and
Testament (Will) and Grantor’s revocable trust (Revocable Trust), and (ii) the
denominator is the total value of property distributable to all of Grantor’s children and
their descendants under the Will and Revocable Trust.

Grantor made an initial transfer to Trust, and the trustees used this to purchase policies
insuring her life. She periodically made additional transfers to Trust, and these were
applied to the life insurance premiums. Grantor reported each transfer on a timely filed

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Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return. She
allocated a portion of her generation-skipping transfer tax exemption amount to each
transfer.

Grantor recently discovered that, notwithstanding her expressed intention and decision
to create Trust in accordance with the Plan so that the trust property would not be
includible in her gross estate, it is possible that the trust property might be included in her
gross estate, due to a drafting error made by Attorney. In conflict with Grantor’s intent (as
set forth in Paragraph B of Article I), Paragraph B of Article V erroneously provides that a
child’s (or a child’s descendants’) share of Trust assets (at Grantor’s death) is to be
determined in accordance with Grantor’s Will and Revocable Trust.

On Date 4, Grantor filed a petition in State Court to retroactively reform (to Date 3)
Paragraph B of Article V. In her declaration to the court, Grantor represented that: (i) she
directed Attorney to draft a trust instrument consistent with the Plan, (ii) she believed each
of her gifts was a completed gift for federal gift tax purposes, and (iii) the proposed
reformation reflects her true intentions in establishing Trust. In his declaration to the court,
Attorney represented that the language of Paragraph B of Article V is the result of his
scrivener’s error. He further represented that the reformation was necessary to correct the
error to reflect Grantor’s true intentions in establishing a trust that would not be includible
in her estate.

State Court granted the petition on Date 5. As reformed, Paragraph B of Article V
provides that, following Grantor’s death, the trustee shall divide the trust estate into as
many separate and equal shares as are required to provide one share for each then living
child of Grantor and one share for the then living descendants, collectively, of any child
who has died.

You have asked us to rule that:

(1) As a result of the retroactive reformation of Paragraph B of Article V, Grantor’s
transfers to Trust will be completed gifts for gift tax purposes.

(2) As a result of the reformation, the assets of Trust will not be includible in Grantor’s
gross estate at her death.

(3) For generation-skipping transfer tax purposes, in determining the inclusion ratio
under § 2642 with respect to transfers of property made by Grantor to Trust, the
value of the property will be determined under § 2642(b) as of the date of each gift
to Trust.

PLR-123333-16 4

Law and Analysis

Ruling 1 and Ruling 2

Section 2501 of the Internal Revenue Code imposes a tax on the transfer of property by
gift by an individual.

Section 2511 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 a gift is made in property, the value of the property at
the date of the gift is considered the amount of the gift. Where property is transferred
for less than an adequate and full consideration in money or money’s worth, the gift is
the amount by which the value of the property transferred exceeded the value of the
consideration.

Section 2035(a) provides that if the decedent made a transfer (by trust or otherwise) of
an interest in any property, or relinquished a power with respect to any property, during
the three-year period ending on the date of the decedent’s death, and the value of such
property (or an interest therein) would have been included in the decedent’s gross
estate under § 2036, 3037, 2038, or 2042 if such transferred interest or relinquished
power had been retained by the decedent on the date of his death, the value of the
gross estate shall include the value of any property (or interest therein) which would
have been so included.

Section 2036(a) provides that the value of the gross estate shall include the value of all
property to the extent of any interest therein of which the decedent has at any time
made a transfer (except in case of a bona fide sale for an adequate and full
consideration in money or money’s worth), by trust or otherwise, under which he has
retained for his life or for any period not ascertainable without reference to his death or
for any period which does not in fact end before his death — (1) the possession or
enjoyment of, or the right to the income from, the property, or (2) the right, either alone
or in conjunction with any person, to designate the persons who shall possess or enjoy
the property or the income there from.

Section 2038(a)(1) provides that the value of the gross estate shall include the value of
all property, to the extent of any interest therein of which the decedent has at any time
made a transfer (except in case of a bona fide sale for an adequate and full
consideration in money or money’s worth), by trust or otherwise, where the enjoyment
thereof was subject at the date of his death to any change through the exercise of a
power (in whatever capacity exercisable) by the decedent alone or by the decedent in
conjunction with any other person (without regard to when or from what source the
decedent acquired such power), to alter, amend, revoke, or terminate, or where any

PLR-123333-16 5

such power is relinquished during the three-year period ending on the date of the
decedent’s death.

Section 2042 provides, in part, that the value of the gross estate shall include the value
of all property to the extent of the amount receivable by all other beneficiaries as
insurance under policies on the life of the decedent with respect to which the decedent
possessed at his death any of the incidents of ownership, exercisable either alone or in
conjunction with any other person.

It is well settled under State law that if by mistake, an instrument as written fails to
express the true intention or agreement of the parties, a court of equity will grant
reformation of the instrument to make it correctly express the agreement actually made.
This rule applies to inter vivos trusts. Citation 1. It is immaterial whether the mistake is
one of fact or law. Any mistake of the scrivener which could defeat the true intention
may be corrected in equity by reformation. Citation 2; Citation 3. Reformation does not
change the agreement. Rather, it enforces the agreement. It orders a change in the
drafted instrument so that it will correctly express what has been the real agreement
from its inception. Citation 4.

Under State Statute, a court may order that the terms of a trust be modified if it is
necessary to achieve the settlor’s tax objectives and is not contrary to the settlor’s
intentions. The court shall exercise its discretion to order a modification in the manner
that conforms as nearly as possible to the probable intention of the settlor. See also
Citation 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.

In this case, the declarations made by Grantor and Attorney to State Court, together
with contemporaneous correspondence and exhibits, provide clear and convincing
evidence that Grantor intended Trust to conform to the details of the Plan, as presented
to her by Attorney, most importantly, that the Trust property would not be included in her
gross estate. The language of Paragraph B of Article V, providing for a reserved power,
directly controverts Grantor’s clearly expressed intention that her gifts to Trust be
completed gifts, such that there would be no inclusion of the Trust property in her gross
estate. In further expressing her intent, Grantor filed timely gift tax returns reporting
each of her transfers to Trust as a completed gift for which she paid gift tax and to which

PLR-123333-16 6

she allocated GST exemption. Attorney has explained that the inclusion of the reserved
power in Paragraph B of Article V is the result of his scrivener’s error in drafting.

In reforming Trust, State Court found that the reformation was necessary to correct the
scrivener’s error and to reflect Grantor’s true intentions. Based on the information and
documentation submitted, we conclude that State Court’s order retroactively reforming
Trust is consistent with applicable State law, as applied by the highest court of State.
Accordingly, Paragraph B of Article V, as reformed, is effective as of Date 3, for estate
and gift tax purposes.

Consequently, we conclude that as a result of the reformation, Grantor’s transfers to
Trust are completed gifts, for gift tax purposes. Moreover, Paragraph B of Article V, as
reformed, does not reserve to Grantor any powers or interests for purposes of § 2035,
§ 2036 or § 2038, such that would result in inclusion of the Trust property in Grantor’s
gross estate. Likewise, Paragraph B of Article V, as reformed, does not give Grantor
any incidents of ownership in insurance policies held by Trust for purposes of § 2042.

Ruling 3

Section 2601 imposes a tax on every generation-skipping transfer. A generation-
skipping transfer is defined under § 2611(a) as, (1) a taxable distribution, (2) a taxable
termination, and (3) a direct skip.

Section 2602 provides that the amount of the tax imposed by § 2601 is the taxable
amount multiplied by the applicable rate. Section 2641(a) defines applicable rate as the
product of the maximum federal estate tax rate and the inclusion ratio with respect to
the transfer.
Section 2632(a)(1) provides that an individual’s GST exemption may be allocated at any
time on or before the date prescribed for filing the estate tax return for such individual’s
estate (determined with regard to extensions), regardless of whether such return is
required to be filed.

Under § 2642(a)(1), the inclusion ratio with respect to any property transferred in a
generation-skipping transfer is the excess (if any) of 1 over the applicable fraction. The
applicable fraction, as defined in § 2642(a)(2), is a fraction, the numerator of which is
the amount of the GST exemption under § 2631 allocated to the trust (or to property
transferred in a direct skip), and the denominator of which is the value of the property
transferred to the trust or involved in the direct skip, reduced by the sum of any federal
estate tax or state death tax actually recovered from the trust attributable to such
property, and any charitable deduction allowed under § 2055 or 2522 with respect to
such property.

Section 2642(b)(1) provides that, except as provided in § 2642(f), if the allocation of the
GST exemption to any transfers of property is made on a gift tax return filed on or

PLR-123333-16 7

before the date prescribed by § 6075(b) for such transfer or is deemed to be made
under § 2632(b)(1) or (c)(1), the value of such property for purposes of § 2642(a) shall
be its value as finally determined for purposes of chapter 12 (within the meaning of
§ 2001(f)(2), or, in the case of an allocation deemed to have been made at the close of
an estate tax inclusion period, its value at the time of the close of the estate tax
inclusion period.

In this case, the reformation is effective as of Date 3, and Grantor’s transfers to Trust
were completed gifts on the dates of such gifts. Consequently, the inclusion ratio with
respect to each transfer of property to Trust is determined under § 2642(b) based upon
the gift tax value of the property on the date of the respective transfer.

Except as expressly provided herein, no opinion is expressed or implied concerning the
tax consequences of any aspect of any transaction or item discussed or referenced in
this letter.

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 your authorized representative.

The rulings contained in this letter are 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
                                       Melissa C. Liquerman
                                       Chief, Branch 4
                                       Office of Associate Chief Counsel
                                       (Passthroughs & Special Industries)

Enclosure:
Copy of letter for § 6110 purposes

cc: