Retroactive trust reformation counts for foreign grantor-trust exception

Plain-English summary

A nonresident donor created an irrevocable U.S.-governed trust intending grantor-trust treatment, but the instrument allowed distributions to the donor's children during the donor's life. A 1996 statutory change meant that provision prevented the foreign donor from being treated as the owner under section 672(f), even though no distributions were made to the children. A state court later found clear and convincing evidence of a drafting mistake and reformed the trust from its creation date to remove the children as lifetime beneficiaries. The IRS found the court-ordered reformation consistent with the state law the state's highest court would apply. In these unique circumstances, it ruled that the reformation would be recognized from the original date when determining whether the trust qualified for the section 672(f)(2)(A)(ii) exception.

Ruling snapshot

• Question: Will the retroactive state-court reformation be recognized when testing the trust under the foreign grantor-trust exception?
• Outcome: Approved, the reformation is taken into account from the trust's original date for section 672(f)(2)(A)(ii).
• Key authorities: IRC §§ 671-679, particularly § 672(f)(2)(A)(ii); 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: 201807001 Third Party Communication: None
Release Date: 2/16/2018 Date of Communication: Not Applicable
Index Number: 672.05-00, 672.05-01
Person To Contact:
------------------------------------- -----------------------, ID No. --------------
--------------------------------- Telephone Number:
------------------------------------- ----------------------
---------------------------------- Refer Reply To:
CC:PSI:B01
PLR-115197-17
Date:
November 13, 2017

Trust = -----------------------------------------------
------------------------

Donor = -----------------

Attorney = -------------------------

Date 1 = --------------------------

Date 2 = ---------------------

Year 1 = -------

Year 2 = -------

State = -------------------

State = -----------------------------------------------
Statute -------------------------

Court = -----------------------------------------------
-----------------------------------------------
------------------------
PLR-115197-17 2

Dear ---------------------

This letter responds to your authorized representative’s letter dated April 18, 2017, and
subsequent information requesting a ruling regarding the consequences under
§ 672(f)(2)(A)(ii) of Trust’s reformation.

FACTS:

Attorney drafted Trust agreement to qualify as a grantor trust with respect to Donor
under subpart E of part I of subchapter J of the Code. On Date 1, Donor executed Trust
agreement and funded Trust. Although Donor is married and has issue now, Donor was
not married and had no issue when Trust was executed. Donor, Donor’s spouse, and
Donor’s issue are not and have never been citizens or residents of the United States
(within the meaning of § 7701(b)(1)(A) of the Internal Revenue Code (Code)).

Section 2.1(B) of Trust agreement, prior to amendment, provides that during the lifetime
of Donor, the Independent Trustees may at any time and from time to time distribute the
whole or any part of the income of the Trust to, or expend the same for the benefit of,
any one or more of Donor and the issue of Donor, in equal or unequal shares and with
or without making any distribution or expenditure to or for the benefit of any other or
others, or may accumulate the whole or any part of such income, all as the Independent
Trustees may determine.

Section 2.1(C) of Trust agreement, prior to amendment, provides that during the lifetime
of Donor, the Independent Trustees may at any time and from time to time distribute the
whole or any part of the principal of the Trust to, or expend the same for the benefit of,
any one or more of Donor and the issue of Donor, in equal or unequal shares and with
or without making any distribution or expenditure to or for the benefit of any other or
others, all as the Independent Trustees may determine, without considering other
resources available to such beneficiaries, to provide for their respective health,
education and comfortable support.

Section 2.1(D) of Trust agreement provides, in part, that upon the death of Donor, the
Trustees shall divide the trust estate of the Trust into shares for, and shall set apart one
of such shares with respect to each of, the issue then living of Donor, per stirpes.

Section 3.7 of Trust agreement provides that in the event any income of the Trust shall
be accumulated, such income may (but need not) be separately accounted for in an
accumulated income account. At any particular time, the power of the Trustees or the
Independent Trustees to dispose of income under the Trust agreement shall for all
purposes include the power to dispose of any accumulated income then on hand.

Section 3.8 of Trust agreement provides that an Independent Trustee is a trustee who
(i) has no interest, vested or contingent, direct or indirect, in the trust estate of the Trust,
PLR-115197-17 3

(ii) cannot be benefited by the exercise or nonexercise of any power, authority or
discretion given exclusively to or vested exclusively in the Independent Trustee by the
provisions of this Agreement or by law, and (iii) can alone possess and exercise such
power, authority and discretion without causing income, accumulated income or
principal of the trust estate of such Trust to be attributable to any beneficiary of the Trust
for income, gift or estate tax purposes.

Section 3.10 of Trust agreement provides, in part, that Trust shall be administered and
governed under the laws of State (within the United States).

Section 4.2(P) of Trust agreement provides that the Trustees of Trust shall have and
may exercise the power to determine income and principal of such Trust and to allocate
receipts and disbursements (including without limitation gains and losses) as between
income and principal, all as the Independent Trustees determine to be advisable in the
circumstances.

Section 4.4(B)(2)(a) of Trust agreement provides, in general, that in the event that the
Trustees exercise any power, authority or discretion given to or vested in them by the
provisions of the Trust agreement or by law in the administration and management of
the Trust estate, has the effect of making the whole or any part of the income of such
Trust taxable to any person who is a beneficiary of such Trust for the purpose of any
United States or state income tax law at such time in force and effect prior to the time
such person becomes entitled to the distribution of such income or prior to the time it is
used or expended for the benefit of such person, then such Trustees or Trustee shall
not have the right to exercise or participate in the exercise of such power, authority or
discretion and shall be deemed not to have exercised or participated in the exercise of
the same.

Section 4.5 of Trust agreement provides that the Independent Trustees are, at any
particular time, with the consent or approval of a court of competent jurisdiction,
authorized to reform, by a writing made and filed with the records of such Trust and
delivered to the other Trustees, any of the provisions of the Trust agreement relating to
such Trust to the end and purpose that burdensome tax consequences may, consistent
with the purposes of such Trust and this Trust agreement, be eliminated or minimized.

Section 6.2 of Trust agreement provides, in part, that Trust is irrevocable and Donor
renounces any rights to revoke, alter or amend the Trust agreement.

Although permitted under Trust’s agreement, no distributions have been made from
Trust to Donor’s issue. Trustees of Trust represent that Trust has consistently filed U.S.
tax returns consistent with the treatment of Trust as a grantor trust with respect to
Donor. To this end, all U.S.-source fixed and determinable periodic income received by
Trust has been subjected to 30% withholding by the payors.
PLR-115197-17 4

In Year 1, Donor sought the advice of separate counsel who informed Donor that Trust
did not qualify as a grantor trust.

LAW:

Section 671 provides, in part, that where it is specified in subpart E, part I, subchapter J
(Subpart E) that the grantor or another person shall be treated as the owner of any
portion of a trust, there shall then be included in computing the taxable income and
credits of the grantor or the other person those items of income, deductions, and credits
against tax of the trust which are attributable to that portion of the trust to the extent that
such items would be taken into account under this chapter in computing taxable income
or credits against the tax of an individual.

Sections 673 through 677 specify the circumstances under which the grantor is treated
as the owner of a portion of the trust.

Section 677(a)(1) provides that the grantor shall be treated as the owner of any portion
of a trust, whether or not he is treated as such owner under § 674, whose income
without the approval or consent of any adverse party is, or in the discretion of the
grantor or a nonadverse party, or both, may be distributed to the grantor or the grantor’s
spouse.

Section 1904 of the Small Business Job Protection Act of 1996 (the Act), Public Law
104-188, 110 Stat. 1755 (August 20, 1996), amended section 672(f) and certain other
sections of the Code. The amendments affect the application of §§ 671 through 679 of
the Code (the grantor trust rules) to certain trusts created by foreign persons.

Section 672(f)(1) , as amended, provides that subpart E (§§ 671 through 679) applies
only to the extent such application results in an amount (if any) being currently taken
into account (directly or through one or more entities) under this chapter in computing
the income of a citizen or resident of the United States or a domestic corporation.

Section 672(f)(2)(A)(ii), as amended, provides that the general rule does not apply to
any portion of a trust if the only amounts distributable from such portion (whether
income or corpus) during the lifetime of the grantor are amounts distributable to the
grantor or the spouse of the grantor.

Section 672(f)(1) was effective “on the date of enactment” (August 20, 1996). However,
section 1904 of the Act provided grandfather rules for certain trusts that were in
existence on September 19, 1995, to the extent any transfers to such trusts were made
on or before that date.

Trust was executed and partially funded on Date 1, which was after September 19,
1995, and before August 20, 1996. Therefore, Donor was treated as the owner of any
portion of the trust over which Donor retained the powers or interests described in
PLR-115197-17 5

sections 673 through 677 prior to August 20, 1996. However, as a result of the
enactment of section 1904 of the Act, Donor was prevented from being the owner of
Trust by the operation of § 672(f) as of August 20, 1996, and thereafter because Trust
did not qualify for the exception in § 672(f)(2)(A)(ii) because Donor’s issue were
beneficiaries of Trust during Donor’s life.

In Year 2, Donor filed a suit in Court to reform Trust in order to satisfy the terms of
Section 672(f)(2)(A)(ii). Both Donor and Attorney, who had drafted Trust agreement,
testified to the Court regarding their intent for Trust to qualify as a grantor trust since
Date 1 onwards.

As part of the State Court action an attorney was appointed guardian ad litem to
represent the interests of Donor’s issue, who are minors, and the interests of any future
issue. Following a trial, Court entered an order (the “Order”) on Date 2 modifying, as of
Date 1, Section 2.1(B) and 2.1(C) removing “the issue of Donor” as beneficiaries of
Trust during the lifetime of Donor. In its Order, Court found clear and convincing
evidence that Donor always intended Trust would be a grantor trust deemed owned by
Donor. The Court found that Section 1904 of the Act, which applied to certain
irrevocable trusts executed prior to the date of its enactment, including Trust, in effect
retroactively changed the grantor trust rules relied upon in creating the Trust. Thus, the
court concluded that the original Trust agreement was drafted based on what became a
mistake of fact and law. The Court determined that reforming Trust to delete the
inclusion of Donor’s issue as beneficiaries of Trust during Donor’s lifetime would correct
the mistake of fact and law underlying the creation of Trust and conform the Trust
agreement to Donor’s intent.

ANALYSIS AND CONCLUSION

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.

State Statute provides that a court may reform the terms of a trust, even if
unambiguous, to conform the terms to the settlor’s intention if it is proved by clear and
convincing evidence that both the settlor’s intent and the terms of the trust were affected
by a mistake of fact or law, whether in expression or inducement. Thus, courts in State
will reform a trust when it can be shown by clear and convincing evidence that
provisions were inserted or omitted because of a mutual or unilateral mistake and that,
PLR-115197-17 6

as written, the instrument does not truly reflect the settlor’s desires and intention at the
time of execution and delivery.

In this case, an examination of the relevant State Court trial transcripts and
representations of the parties indicate that Donor intended that Trust be a grantor trust
with respect to Donor. This intent was not carried out in the Trust agreement as a result
of a mistake of fact and law. As discussed above, the judicial action involves bona fide
issues and the reformation is consistent with applicable State law that would be applied
by the highest court of State. Accordingly, based on the facts presented and the
representations made, including the lack of any distributions by Trust to the issue of
Donor, we conclude that the reformation of Trust is consistent with applicable State law
that would be applied in the highest court of State. Thus, we rule, in these unique
circumstances, Trust’s reformation will be taken into account as of Date 1 for the
purpose of determining whether Trust falls within the § 672(f)(2)(A)(ii) exception to
§ 672(f)(1).

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

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 Trust’s authorized representatives.

                                    Sincerely,

                                    Faith P. Colson

                                    Faith P. Colson
                                    Senior Counsel, Branch 1
                                    Office of the Associate Chief Counsel
                                    (Passthroughs & Special Industries)

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

cc: