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    TRUSTS & ESTATES AND TAX LAW UPDATE: IRS Recognition of a Postmortem Modification or Reformation of a Decedent's Trust

    Posted by Gale Burns on Tue, Mar 19, 2013 @ 13:03 PM

    March 26, 2013

    Brad Pettit, Senior Attorney, National Legal Research Group

    The Uniform Trust Code ("U.T.C.") 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."  U.T.C. § 415 (Thomson Reuters, Westlaw current through 2011 annual meetings of the Nat'l Conf. of Comm'r on Unif. State Laws & A.L.I.) (emphasis added).  More specifically, the U.T.C. states that "[t]o achieve the settlor's tax objectives, [a] court may modify the terms of a trust in a manner that is not contrary to the settlor's probable intention[, and a] court may provide that the modification has retroactive effect."  Id. § 416 (emphasis added).  The comment to section 416 seeks to explain the subtle distinctions between a court's discretionary power (1) under section 415 to approve the reformation of an irrevocable trust to conform to the settlor's intention by correcting a mistake of fact or law, and (2) under section 416 to modify an irrevocable trust in order to achieve the settlor's tax objectives:

    "Modification" under this section is to be distinguished from the "reformation" authorized by Section 415. Reformation under Section 415 is available when the terms of a trust fail to reflect the donor's original, particularized intention. The mistaken terms are then reformed to conform to this specific intent. The modification authorized here allows the terms of the trust to be changed to meet the settlor's tax‑saving objective as long as the resulting terms, particularly the dispositive provisions, are not inconsistent with the settlor's probable intent. The modification allowed by this subsection is similar in concept to the cy pres doctrine for charitable trusts (see Section 413), and the deviation doctrine for unanticipated circumstances (see Section 412).

    Id. § 416 cmt.

    The Restatement (Third) of Property also provides that "[a] donative document may be modified, in a manner that does not violate the donor's probable intention, to achieve the donor's tax objectives."  Restatement (Third) of Property:  Donative Transfers § 12.2 (Tentative Draft No. 1 promulgated and adopted Mar. 28, 1995).

    A recent Private Letter Ruling ("P.L.R.") by the Internal Revenue Service ("IRS") illustrates difficulties that an executor or trustee might encounter in trying to get the IRS to recognize and give effect to a state court's approval of a postmortem reformation or modification of a decedent's trust.  In P.L.R. 2012-43-001 (July 10, 2012) (under 26 U.S.C. § 6110(k)(3), a P.L.R. may not be used or cited as precedent), the IRS considered a request for a ruling on the issue of whether a state court's postmortem reformation of a decedent's trust could be recognized for federal gift, estate, and generation‑skipping transfer ("GST") tax purposes.  In response to the request for a ruling, the IRS acknowledged that under state law a unilateral mistake by the settlor of a trust may be a sufficient ground to reform a trust.  But the IRS went on to point out that under the U.S. Supreme Court's landmark decision in Commissioner v. Estate of Bosch, 387 U.S. 456, on remand, 382 F.2d 295 (2d Cir. 1967), there are rules that apply in a case where a petitioner wants the federal government or an agency thereof to recognize and give effect to a state trial court's decision on a matter of state law:

    It follows here then, that when the application of a federal statute is involved, the decision of a state trial court as to an underlying issue of state law should a fortiori not be controlling. This is but an application of the rule of Erie R. Co. v. Tompkins, [304 U.S. 64 (1938)], where state law as announced by the highest court of the State is to be followed. This is not a diversity case but the same principle may be applied for the same reasons, viz., the underlying substantive rule involved is based on state law and the State's highest court is the best authority on its own law. If there be no decision by that court then federal authorities must apply what they find to be the state law after giving 'proper regard' to relevant rulings of other courts of the State. In this respect, it may be said to be, in effect, sitting as a state court. Bernhardt v. Polygraphic Co., 350 U.S. 198, 76 S. Ct. 273, 100 L. Ed. 199 (1956).

    Id. at 465.

    After applying the principles that were enunciated in Bosch, the IRS determined that since the highest court and the appellate courts in the state in question had not considered the issue presented by the petitioner, the IRS was free to give "proper regard" to the state court's order when deciding whether to recognize the retroactive reformation of one of the trusts that were at issue in the case.  P.L.R. 2012-43-001.  Accordingly, the IRS gave proper regard to the state court's order to reform the trust in question and also considered the facts alleged and the representations made by the petitioner.  The IRS then concluded that "the reformation of Trust 2 [was] not consistent with applicable State law, as applied by the highest court of State."  Id.  Accordingly, the IRS ruled that "the reformation of Trust 2 [could] not be recognized retroactively for gift, estate, or GST tax purposes."  Id.

    The difficulties in trying to get the IRS to recognize and give effect to a postmortem modification of a decedent's trust are further illustrated by a 1990 decision in which the U.S. Tax Court disregarded a postmortem modification of a decedent's intervivos trust that was intended to enable the trust to qualify for the federal estate tax marital deduction.  Estate of Nicholson v. Comm'r, 94 T.C. 666 (1990).  In Nicholson, the trust, as it was drafted, failed to qualify for the federal estate tax marital deduction under 26 U.S.C. § 2056(b)(7) (estate tax deduction for a qualified terminable life interest in property that is bequeathed to a surviving spouse), because the instrument did not grant the decedent's widow the right to receive all the trust income for life.  94 T.C. at 674-75.  A Texas probate court modified the trust to give the widow the right to receive all of the trust income for life.  Id. at 671.  In deciding not to recognize the state probate court's postmortem modification of the trust in question, the Nicholson court stated:

    As to the parties to the reformed instrument the reformation relates back to the date of the original instrument, but it does not affect the rights acquired by non‑parties, including the Government. Were the law otherwise there would exist considerable opportunity for 'collusive' state court actions having the sole purpose of reducing federal tax liabilities. Furthermore, federal tax liabilities would remain unsettled for years after their assessment if state courts and private persons were empowered to retroactively affect the tax consequences of completed transactions and completed tax years.

    Under the terms of the trust at issue, the decedent's wife is not 'entitled to all the income from the property, payable annually or at more frequent intervals' as is required by section 2056(b)(7). Instead, the unambiguous language of the trust only allows her 'so much of the net income * * * as * * * [she] may from time to time require to maintain * * * [her] usual and customary standard of living * * *.' See Ithaca Trust Co. v. United States, 279 U.S. 151, 154 (1929).

    *                     *                     *

    Accordingly, even a consideration of the extrinsic evidence fails to show that the decedent intended that his wife be 'entitled to all the income' from the trust.

    Id. at 674, 678.

    The Tax Court's decision in Nicholson imposes a heavy burden upon an executor or trustee who wants the IRS to recognize and give effect to a state court's decision to modify or reform a decedent's trust in order to achieve federal tax savings.  Under that decision, an executor or trustee must be able to point to evidence that a deceased settlor's intentions with respect to the disposition of the trust assets were consistent with the postmortem federal tax savings that are being sought.  For example, if the language of a deceased settlor's trust suggests that the decedent did not want his or her surviving spouse to have the right to receive all of the income of the trust, the Tax Court will not give effect to a postmortem modification or reformation of the trust that has given the survivor the right to all trust income.

    The IRS's decision in P.L.R. 2012-43-001 similarly presents a good news/bad news scenario for executors and trustees.  On the one hand, the IRS was willing to look at the facts and circumstances of the case in order to decide whether to recognize the state court's approval of a modification or reformation of an irrevocable trust.  But after examining the facts and circumstances of the case, the IRS rendered an unfavorable decision from the petitioner's standpoint.

    In sum, it appears that in an appropriate case, the IRS will recognize and give effect to a state court's decision to allow an executor or trustee to modify or reform a decedent's trust.  However, an executor or trustee faces a decidedly uphill battle when trying to get the IRS to go along with a state court's decision to approve a postmortem modification or reformation of a decedent's trust and allow the decedent's estate to obtain federal tax savings as a result of the judicial change in the language of the trust.

    Topics: legal research, trusts & estates, postmortem modification or reformation of decedent, evidence of testator's intent, Brad Pettit, tax

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