Court reformation preserved limited powers and GST allocation

Plain-English summary

A grantor created three irrevocable trusts for grandchildren, but drafting errors gave beneficiaries powers broad enough to risk estate inclusion and gift tax on lapsing withdrawal rights. A state court reformed the trusts to limit appointments to family descendants, exclude appointments to a beneficiary, the beneficiary’s estate, or creditors, and cap withdrawal rights under the five-and-five and annual-exclusion limits. The IRS accepted the reformation as consistent with state law and the grantor’s original intent. It ruled that the changes would not pull the trust property into the deceased spouse’s estate or create general powers of appointment for the beneficiaries. The reformation also would not be treated as an exercise or release causing a gift, and the assets would not enter a beneficiary’s estate under section 2041. Finally, the trusts were skip persons, the transfers were direct skips, and the automatic allocation rules applied to the grantor’s and spouse’s unused GST exemptions for their gifts and bequests.

Ruling snapshot

• Question: What estate, gift, and GST consequences followed from the court-ordered correction of the trusts’ appointment and withdrawal provisions?
• Outcome: approved on all four requested rulings
• Key authorities: IRC §§ 2041, 2514, 2513, 2612, 2613, 2632; Commissioner v. Estate of Bosch

Full text (IRS public release)

Internal Revenue Service                                     Department of the Treasury
                                                             Washington, DC 20224

Number: 201920003                                            Third Party Communication: None
Release Date: 5/17/2019                                      Date of Communication: Not Applicable
Index Number: 2041.12-00, 2514.00-00,
              2632.00-00                                     Person To Contact:
                                                             ------------------, ID No. -----------------
------------------------------------                         Telephone Number:
------------------------------------------                   --------------------
-----------------------------                                Refer Reply To:
                                                             CC:PSI:B04
                                                             PLR-118629-18
                                                             Date:
                                                             November 26, 2018


Re: -------------------------------------------------------------

Legend

Grantor           = -------------------
Spouse            = ----------------------------------------------
Date 1            = -------------------------
Trust A           = ---------------------------------------------------------------------
--------------------------------------------------------------------
Trust B           = ------------------------------------------------------------------------
--------------------------------------------------------------
Trust C           = --------------------------------------------------------------------
--------------------------------------------------------------------
Grandchild A = ------------------------------------------------------
Grandchild B = -------------------------------------------------------
Grandchild C = ----------------------------------------------------------
Grandchild D = ----------------------------------------------------
Grandchild E = ----------------------------------------------------------
Grandchild F = ------------------------------------------------
Grandchild G = ------------------------------------------------------
Date 2            = ----------------
Accountant = --------------------
Law Firm          = ----------------------------
Son 1             = ---------------------
Son 2             = ------------------------
Daughter          = --------------------
State             = ---------
State Statute = ------------------------------------------------------
Court             = ----------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------------------------
-----------------------------------------------------------------------------------------------------------

PLR-118629-18                                     2

----------------------------------------
Date 3            = ---------------------
Date 4            = ---------------------
Date 5            = ---------------------------
Date 6            = --------------------------
Date 7            = -------------------------
Year 1            = ------
Year 7            = ------
Year 9            = ------
Year 11           = ------
Year 12           = ------
Year 19           = ------

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

This letter responds to your letter dated November 6, 2018, and prior correspondence,
submitted by your authorized representative, requesting rulings on the gift, estate, and
generation-skipping transfer tax consequences of court orders to reform three trusts to
correct scrivener’s errors and to modify the trusts to clarify a provision in the trusts.

The facts and representations submitted are as follows.

On Date 1, in Year 1, Grantor created three irrevocable trusts, Trusts A, B, and C, for
the benefit of his grandchildren. Son 1, Son 2, and Daughter are Grantor’s children.
Trust A is to be held for the benefit of Son 1’s children, Grandchild A, B, and C. Trust B
is to be held for the benefit of Son 2’s children, Grandchild D and E. Trust C is to be
held for the benefit of Daughter’s children, Grandchild F and G. Grandchild A through G
are referred to collectively as the “Beneficiaries” and individually as “Beneficiary.” Year
1 is after September 25, 1985. The trustee of Trust A and C is Son 1. The trustee of
Trust B is Son 2.

The terms of each trust are almost identical. Under Article III(b) of each trust, the
trustee shall immediately divide the trust property into equal parts, setting aside one
such part for the benefit of each Beneficiary. Article III(b)(1) provides that the trustee
may distribute so much of the income and principal of the trust to or for the benefit of the
Beneficiary for whom it has been set aside in such amounts, at such times and in such
manner as the trustee in its sole discretion deems advisable for the Beneficiary’s health,
education (including college and professional education), welfare, and support in
reasonable comfort and to permit the Beneficiary to enter into or engage in a business
or profession in which the trustee believes the Beneficiary has reasonable prospects of
success.

Article III(b)(2) provides that the separate trust held for a Beneficiary shall terminate
upon the death of such Beneficiary. Upon termination, the remaining principal and any

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undistributed income of such separate trust shall be distributed as the deceased
Beneficiary may appoint by a provision of the Beneficiary’s will which expressly refers to
the power of appointment given by the trust agreement. Any portion of the remaining
principal and any undistributed income of such separate trust that is not validly
appointed in such manner shall be distributed to the then living lineal descendants of
the Beneficiary, per stirpes; and, if there is none, then to the living lineal descendants of
Son 1, Son 2, or Daughter, depending upon the Beneficiary’s trust, per stirpes.

Article III(c) provides that notwithstanding the provisions of paragraph (b) of Article III, at
the time any property is initially placed in or later added to the trust, each living
Beneficiary shall have the unrestricted right to demand and receive from the trust that
share of such property which is allocated to that Beneficiary’s trust. The trustee shall
notify each Beneficiary of the existence of this right within fourteen days from its receipt
of such property. Beneficiaries must exercise such right by a written instrument
delivered to the trustee within thirty days from the date such notice is given, or such
right shall lapse.

Grantor and Spouse each made gifts to Trusts A, B, and C in Years 1 through 7 and
Years 9 through 11. Grantor and Spouse elected to treat the gifts each made to each
trust in Years 1 through 7 and Years 9 through 11 as made by both under § 2513.
Grantor died on Date 2, in Year 11, and bequeathed a portion of his estate to each of
the trusts. Following Grantor’s death, in Years 12 through 19, Spouse continued to
make gifts to each trust. Spouse died on Date 6, in Year 19.

Several years after Grantor’s death, the trustees became aware that Article III(b)(2)
lacked the language necessary to prevent an appointment of trust property to non-family
members and that the broad language could be construed as granting a general power
of appointment to the Beneficiaries. This would result in inclusion of trust property in
each Beneficiary’s gross estate. It is represented that such a result was contrary to
Grantor’s intent. On Date 3, Son 1, in his capacity as the trustee of Trust A and Trust C,
and as representative by joinder of Trust B, petitioned Court to reform Trusts A, B, and
C to include the necessary limiting language to qualify each Beneficiary’s power of
appointment as a limited power of appointment, expressly prohibiting the appointment of
trust assets to a Beneficiary, such Beneficiary’s estate, the creditors of such Beneficiary,
and the creditors of such Beneficiary’s estate.

The petition was supported by three affidavits, one each from Grantor’s Accountant,
Law Firm, and Son 1, in his capacity as the trustee of Trusts A and C and as
representative by joinder of Trust B. Accountant swore that Grantor intended the trusts
to be GST exempt. Law Firm swore that Grantor did not recognize that including the
power of appointment language would result in including the trust assets in each
Beneficiary’s gross estate.

PLR-118629-18                                 4

On Date 4, Court issued an order, effective Date 1, that limited the power of
appointment language in Article III(b)(2) to exclude the Beneficiary, the Beneficiary’s
estate, the creditors of the Beneficiary, and the creditors of the Beneficiary estate.
On Date 5, Court issued an amended order clarifying that the trusts terminate at the
death of the named grandchild and that per stirpes distributions are to be outright and in
fee. The amended order clarifies that each separate trust held for a Beneficiary shall
terminate upon the death of such Beneficiary. This is consistent with the provisions of
each trust, as originally executed. Further, the amended order clarifies that each trust
shall provide that upon such termination, the remaining principal and any undistributed
income of such separate trust shall be distributed as such deceased Beneficiary may
appoint to or for the benefit of one or more of the lineal descendants of the child of the
Grantor (Son 1, Son 2, or Daughter, depending upon the trust) who is a lineal
ascendant of such beneficiary, but excluding such Beneficiary, such Beneficiary’s
estate, the creditors of such Beneficiary, and the creditors of such Beneficiary’s estate.
The default provisions of each trust remain unchanged. Both orders were issued
contingent upon a ruling from the Internal Revenue Service.

On Date 7, Court issued a second amended order that reforms Article III(c) to limit the
Beneficiary’s withdrawal right to the lesser of (1) that amount equal to the greater of that
amount which under § 2514(e) will not be considered a release of a power of
appointment as the result of a lapse of the power (currently the greater of $5,000 or five
percent of the aggregate value of the assets out of which, or the proceeds of which, the
exercise of the lapsed power could be satisfied), or that amount that, under § 2503(b)
may be excluded in computing the total amount of gifts made during such calendar
year, or (2) the fair market value of any property, determined as of the date of the gift,
added to this trust by gift during such calendar year. This order is also contingent upon
a ruling from the Internal Revenue Service.

You have requested the following rulings:

    1. The judicial reformation and modification of Trusts A, B, and C will not cause the
      corpus of such trusts to be included in the gross estate of Spouse for federal
      estate tax purposes.

    2. Trusts A, B, and C, as reformed and modified, do not provide the Beneficiaries
      with general powers of appointment over the assets of such Beneficiary’s trust
      under § 2514 or 2041, and upon the death of the Beneficiary, the assets of the
      deceased Beneficiary’s trust will not be includible in such Beneficiary’s gross
      estate under § 2041.

    3. The judicial reformation and modification of Trusts A, B, and C do not constitute
      the exercise or release of any general powers of appointment by a Beneficiary
      resulting in a gift under § 2514.

PLR-118629-18                                 5

    4. Trust A, B, and C are “skip persons” as defined under § 2613(a)(2) and,
      accordingly, the deemed allocation rules of § 2632(b)(1) apply to allocate
      Grantor’s and Spouse’s GST exemption to the Year 1 through Year 7 and Year 9
      through Year 19 gifts and bequests to Trust A, B, and C.

Ruling Request 1

Section 2001(a) imposes a tax on the transfer of the taxable estate of every decedent
who is a citizen or resident of the United States.

Section 2033 provides that the value of the gross estate shall include the value of all
property to the extent of the interest therein of the decedent at the time of the
decedent’s death.

Section 2036(a) provides that the value of the decedent’s gross estate includes the
value of all property to the extent of any interest transferred by the decedent with
respect to which the decedent has retained for life either an income interest in the
property or the right to designate the persons who will possess or enjoy the property or
have an interest in the income of the property.

Section 2038(a)(1) provides that, in the case of transfers after June 22, 1936, 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 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 when any such power is relinquished during the 3-year period ending on
the date of the decedent’s death.

In the present case, Trusts A, B, and C are irrevocable trusts. During Year 1 through
Year 7 and Year 9 through Year 11, Spouse and Grantor consented to treat their gifts
as having been made one-half by each donor. Accordingly, Spouse and Grantor are
each treated as the transferor of one-half of the total transfers to the trusts during those
years. During Years 12 through 19, Spouse made gifts to each trust. Accordingly,
Spouse is the transferor of those gifts to the trusts during those years. However,
Spouse did not retain any right or interest in the trusts. Spouse did not retain a
beneficial interest in the trusts and did not retain the right to alter, amend, revoke, or
terminate any of the trusts. Further, Spouse did not retain the right to designate who
would possess or enjoy the property or income derived from the trusts. The reformation
and modification of Trusts A, B, and C were made pursuant to Court orders and not as a
result of rights retained by Spouse. Accordingly, based upon the facts submitted and
representations made, we conclude that the judicial reformation and modification of

PLR-118629-18                                 6

Trusts A, B, and C will not cause the corpus of Trust A, B, and C to be included in the
gross estate of Spouse for federal estate tax purposes.
Ruling Requests 2 and 3

Section 2001(a) provides that a tax is imposed on the transfer of the taxable estate of
every decedent who is a citizen or resident of the United States.

Section 2031(a) provides, generally, that the value of the gross estate of the decedent
shall be determined by including to the extent provided for in §§ 2031 through 2046, the
value at the time of his death of all property, real or personal, tangible or intangible,
wherever situated.

Section 2041(a)(2) provides that the value of the gross estate includes the value of all
property to the extent of any property with respect to which the decedent has at the time
of his death a general power of appointment created after October 21, 1942, or with
respect to which the decedent has at any time exercised or released such a power of
appointment by a disposition which is of such nature that if it were a transfer of property
owned by the decedent, such property would be includible in the decedent's gross
estate under §§ 2035 to 2038, inclusive. For purposes of § 2041(a)(2), the power of
appointment shall be considered to exist on the date of the decedent's death even
though the exercise of the power is subject to a precedent giving of notice or even
though the exercise of the power takes effect only on the expiration of a stated period
after its exercise, whether or not on or before the date of the decedent's death notice
has been given or the power has been exercised.

Section 2041(b)(1) provides that for purposes of § 2041(a), the term “general power of
appointment” means a power which is exercisable in favor of the decedent, his estate,
his creditors, or the creditors of his estate.

Section 2041(b)(2) provides that the lapse of a power of appointment created after
October 21, 1942, during the life of the individual possessing the power shall be
considered a release of such power.

Section 2501(a) imposes a gift tax for each calendar year on the transfer of property by
gift during the year by an individual.

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.

For gift tax purposes, § 2514(b) provides that the exercise or release of a general power
of appointment created after October 21, 1942, shall be deemed a transfer of property
by the individual possessing such power.

PLR-118629-18                                 7

Section 2514(c) provides that the term “general power of appointment” means a power
which is exercisable in favor of the individual possessing the power, his estate, his
creditors, or the creditors of his estate. Section 2514(e) provides that the lapse of a
power of appointment created after October 21, 1942, during the life of the person
possessing the power is considered a release of the power.

Section 25.2514-3(b)(4) of the Gift Tax Regulations provides, in part, that in any case
where the possessor of a general power of appointment is incapable of validly
exercising or releasing a power, by reason of minority, or otherwise, and the power may
not be validly exercised or released on his behalf, the failure to exercise or release of
his power is not a lapse of the power. However, section 2514(e) provides that a lapse
during any calendar year is considered as a release so as to be subject to the gift tax
only to the extent that the property which could have been appointed by exercise of the
lapsed power of appointment exceeds the greater of (i) $5,000, or (ii) 5 percent of the
aggregate value, at the time of the lapse, of the assets out of which, or the proceeds of
which, the exercise of the lapsed power could be satisfied.

State Statute provides that upon application of a settlor or any interested person, the
court may reform the terms of a trust, even if unambiguous, to conform the terms to the
settlor's intent if it is proved by clear and convincing evidence that both the
accomplishment of the settlor’s intent and the terms of the trust were affected by a
mistake of fact or law, whether in expression or inducement. In determining the settlor’s
original intent, the court may consider evidence relevant to the settlor’s intent even
though the evidence contradicts an apparent plain meaning of the trust instrument.

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 the present case, an examination of the relevant trust instruments, affidavits, and
representations of the parties strongly indicates that Grantor and Spouse did not intend
for the Beneficiaries of Trusts A, B, and C to have inter vivos or testamentary general
powers of appointment. In reforming the trusts, Court found that there was clear and
convincing evidence that the language in Article III(b)(2) and Article III(c) were
scrivener's errors and that the reformation and modification of the trusts was necessary
and appropriate to achieve Grantor’s and Spouse’s objectives, and that the reformation
was not contrary to Grantor's and Spouse’s intentions.

PLR-118629-18                                8


Consequently, based on the facts submitted and representations made, we conclude
that the Court's Orders of Date 4, Date 5, and Date 7, reforming and modifying the trust
instruments based on scrivener's errors, are consistent with applicable State law that
would be applied by the highest court of that state. Trusts A, B, and C, as reformed and
modified pursuant to the Court's Orders, do not provide the Beneficiaries with either
inter vivos or testamentary general powers of appointment over the assets of each
respective Beneficiary’s trust under §§ 2041(b) and 2514(c). Accordingly, based on the
facts submitted and the representations made, we conclude that the judicial reformation
and modification of Trusts A, B, and C do not constitute the exercise or release of a
general power of appointment by a Beneficiary resulting in a gift under § 2514 and that
the assets of the deceased Beneficiary’s trust will not be includible in such Beneficiary’s
gross estate under § 2041.

Ruling Request 4

Section 2601 imposes a tax on every generation-skipping transfer (GST) made by a
“transferor” to a “skip person.” A GST 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 GST tax imposed by § 2601 is the taxable
amount multiplied by the applicable rate. Section 2641(a) defines the applicable rate as
the product of the maximum federal estate tax rate and the inclusion ratio with respect
to the transfer.

Section 2652(a)(1) provides, that except as provided in § 2652 or 2653(a), the term
“transferor” means in the case of any property subject to the tax imposed by chapter 11,
the decedent, and in the case of any property subject to the tax imposed by chapter 12,
the donor. An individual shall be treated as transferring any property with respect to
which such individual is the transferor.

Section 2652(a)(2) provides that if, under § 2513, one-half of a gift is treated as made
by an individual and one-half of such gift is treated as made by the spouse of such
individual, such gift shall be so treated for purposes of chapter 13.

Section 2652(c)(1)(A) provides that a person has an interest in property held in trust if
(at the time the determination is made) such person has a right (other than a future
right) to receive income or corpus from the trust.

Section 2631(a) provides that, for Years 1 through 5, for purposes of determining the
inclusion ratio, every individual shall be allowed a GST exemption of $1,000,000
(adjusted for inflation) which may be allocated by such individual (or his executor) to any
property with respect to which such individual is the transferor.

PLR-118629-18                                  9


Section 2631(a) provides that, for Years 6 through 19, for purposes of determining the
inclusion ratio, every individual shall be allowed a GST exemption amount which may
be allocated by such individual (or his executor) to any property with respect to which
such individual is the transferor.

Section 2631(b) provides that any allocation under § 2631(a), once made, shall be
irrevocable.

Section 2631(c) provides that, for Years 6 through 19, for purposes of § 2631(a), the
GST exemption amount for any calendar year shall be equal to the basic exclusion
amount under § 2010(c) for such calendar year.

Section 2632(b)(1) provides that if any individual makes a direct skip during his lifetime,
any unused portion of such individual’s GST exemption shall be allocated to the
property transferred to the extent necessary to make the inclusion ratio for such
property zero. If the amount of the direct skip exceeds such unused portion, the entire
unused portion shall be allocated to the property transferred.

Section 26.2632-1(b)(1)(i) of the Generation-Skipping Transfer Tax Regulations
provides that if a direct skip occurs during the transferor’s lifetime, the transferor’s GST
exemption not previously allocated (unused GST exemption) is automatically allocated
to the transferred property (but not in excess of the fair market value of the property on
the date of the transfer).

Section 26.2632-1(b)(1)(ii) provides that the automatic allocation of GST exemption is
irrevocable after the due date and is effective as of the date of the transfer to which it
relates.

Section 2632(e)(1)(A) provides that any portion of an individual’s GST exemption which
has not been allocated within the time prescribed by § 2632(a) shall be deemed to be
allocated first, to property which is the subject of a direct skip occurring at such
individual’s death.

Section 26.2632-1(e)(2) provides that a decedent’s unused GST exemption is
automatically allocated on the due date for filing Form 706 to the extent not otherwise
allocated by the decedent’s executor on or before that date.

Section 2612(c)(1) provides that the term “direct skip” means a transfer subject to a tax
imposed by chapter 11 or 12 of an interest in property to a skip person.

Section 2613(a) provides that for purposes of chapter 13, the term “skip person” means
(1) a natural person assigned to a generation which is two or more generations below
the generation assignment of the transferor, or (2) a trust if all interests in such trust are

PLR-118629-18                                 10

held by skip persons, or if there is no person holding an interest in such trust, and at no
time after such transfer may a distribution (including distributions in termination) be
made from such trust to a non-skip person.

In the present case, Grantor and Spouse made gifts to Trusts A, B, and C. The primary
beneficiaries of Trusts A, B, and C are the grandchildren of Grantor and Spouse.
Pursuant to the reformation of Trusts A, B, and C, the Beneficiaries possess
testamentary limited powers of appointment to appoint to one or more of the lineal
descendants of Son 1, Son 2, or Daughter, depending upon which trust. In default of
the exercise, the trust property passes to lineal descendants of that Grandchild, or if
there are none, to the living descendants of Son 1, Son 2, or Daughter, depending upon
which trust. The Beneficiaries, lineal descendants of the Beneficiaries of Son 1, Son 2,
and Daughter are persons assigned to a generation which is two or more generations
below the generation assignment of the Grantor and, accordingly, the Beneficiaries are
skip persons as defined under § 2613(a)(1). Accordingly, we conclude Trust A, B, and
C are “skip persons” as defined under § 2613(a)(2) and the gifts to Trusts A, B, and C
are direct skips as defined in § 2612(c)(1).

Because Grantor and Spouse consented to split gifts under § 2513 for Year 1 through
Year 7 and Year 9 through Year 11, Grantor and Spouse are treated as the transferor of
one-half of the Year 1 through 7 and Year 9 through Year 11 gifts to the trusts under
§ 2652(a)(2). Therefore, based on the facts submitted and representations made, we
conclude that, the deemed allocation rules under § 2632(b) apply to allocate Grantor’s
and Spouse’s unused GST exemption to one-half each of the Year 1 through Year 7
and Year 9 through Year 11 gifts to the trusts and to allocate Grantor’s unused GST
exemption to the bequests to the trusts in Year 11, and to allocate Spouse’s unused
GST exemption to the Year 12 through Year 19 gifts to Trusts A, B, and C.

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.

The rulings contained in this letter are based upon information and representations
submitted by the taxpayers 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.

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.

PLR-118629-18                                  11


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

                                       Sincerely,


                                       Lorraine E. Gardner
                                       Lorraine E. Gardner
                                       Senior Counsel, Branch 4
                                       Office of Associate Chief Counsel
                                       (Passthroughs & Special Industries)


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