IRS Recognizes State Court Trust Reformation in Federal Gift and Estate Tax Matter

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Author:  Matthew Conroy, J.D., CFP®, Argent Wealth Management, LLC

Private Letter Ruling 2014-36036 – IRS Recognizes State Court Trust Reformation in Federal Gift and Estate Tax Matter

 In PLR 2014-36036, the IRS was asked to rule on the impact of federal estate and gift taxation on a state judicially-reformed irrevocable trust. Original language in the trust conferred a general power of appointment on a trust beneficiary, which upon reformation was changed to a special power of appointment. The IRS recognized the state’s authority to reform trusts and stated it would apply federal tax law based on the amended provisions of the trust.

Background

Five settlors created and funded an irrevocable trust. The trust beneficiary was given a testamentary power of appointment, with no limitation on the exercise of such appointment in favor of the beneficiary’s estate, beneficiary’s creditors, or creditors of beneficiary’s estate. The settlors subsequently learned that this trust provision was contrary to their original intent.  They petitioned their state’s court to reform the trust, requesting that the beneficiary’s general testamentary power be replaced with a special limited testamentary power.  The state court agreed that a scrivener’s error had occurred and reformed the trust retroactive to the creation date.

As there are material estate and gift tax consequences in the exercise and release of powers of appointment, the settlors requested a PLR to determine the extent of the IRS’ recognition of the reformed trust language.

Issues

1.  Will the IRS recognize the reformed trust, and not include assets subject to the reformed testamentary power of appointment in the beneficiary’s estate?

2.  Will the reformation be considered a deemed release of the general power, thereby subjecting the beneficiary to gift taxation on the assets?

Discussion

Section 2041(a)(2) of the Internal Revenue Code includes in the value of the gross estate any property over which the decedent had a general power of appointment. Section 2514(b) provides that the exercise or release of a general power of appointment is deemed a transfer of property by the individual possessing the power.

In this Private Letter Ruling, the IRS cited U.S. Supreme Court case Commissioner v. Estate of Bosch, 387 U.S. 456 (1967).  This case considered whether a state trial court’s ruling would be conclusively binding on a federal agency in matters of estate taxation. The Court concluded that only those rulings from the highest court of the state would be binding when applied to a federal matter. However, in the absence of such a ruling, the federal authority may give “proper regard” to lower state court rulings. The federal authority would in effect “sit as a state court” when making its decision.

Ruling

Because the current case was not heard in the highest court of the state, the IRS instead gave “proper regard” to the lower court’s reformation of the trust. The IRS found that the court’s correction of a scrivener’s error was consistent with state law as would be applied by the highest court of the state.

The IRS concluded that the reformed testamentary power of appointment would not be considered a general power of appointment so as to include trust assets in the beneficiary’s estate. Further, the reformation was not considered a deemed exercise or release of the beneficiary’s general power, which would subject the beneficiary to gift tax.

Conclusion

This taxpayer-friendly ruling should give practitioners some peace of mind that state judicial reformations will be respected by the IRS. It should be noted that absent a ruling from a state’s highest court, the IRS keeps open the possibility of making rulings inconsistent with lower courts, even after giving them their proper regard.

Please note that a Private Letter Ruling is only directed to the taxpayer requesting it, and cannot be used or cited as precedent.