Judicial Reformation Saves Estate Taxes

In planning to save estate taxes, many married couples may provide in their documents that the applicable exclusion amount (currently 5.490 million) is to be paid to a “credit shelter trust” and the balance to a marital trust. In such an estate plan, no estate tax is generally incurred until the surviving spouse’s (“SS”) death. The credit shelter trust can grow estate tax free until distributions to the ultimate beneficiaries.

To avoid estate tax inclusion in the SS’s estate, the credit shelter trust must be carefully drafted. The SS can have rights in the credit shelter trust, such as income and principal distributions limited to a health, education, maintenance, and support (“HEMS”) standard. However, the SS can not have certain powers of appointment over the credit shelter trust.

In Private Letter Ruling (“PLR”) 201737001, a grantor had created an irrevocable trust to benefit the grantor’s spouse and the grantor’s intent was that the assets held in the trust would not be included in the SS’s estate at the S’s death. The trust language gave the SS a “special power of appointment” (“SPOA”) to appoint the assets to “such persons, or charities” as the SS wanted. Under the Internal Revenue Code (the “Code”), if a SS holds a SPOA over assets, then the assets are NOT included in the SS’s estate. However, because this SPOA was unlimited as to whom the spouse could appoint, the power is a GENERAL power of appointment (“GPOA”) and the trust assets WOULD be included in the SS’s estate. To avoid the tax consequences of a GPOA, the takers under the power of appointment would have to EXCLUDE the spouse, the estate of the spouse, creditors of the spouse or creditors of the spouse’s estate.

The law in the state which governed this trust had a statute that permitted reformation to conform to the grantor’s intent and a statute that permitted a modification to achieve the tax objectives. Under these statutes, the grantor of the trust filed a petition in county court to reform the trust language to provide that the SS’s power of appointment would be to persons or charities OTHER than the SS, the creditors of SS, the estate of SS, and the creditors of the estate of SS. The court entered an order retroactively reforming and modifying the trust to conform to the grantor’s intent.

In this PLR, the grantor asked whether the reformation would be effective to exclude the assets from the SS’s estate at the SS’s death and whether the reformation would not create a gift (the release of a GPOA is a taxable gift under the Code).

In considering the request, the Internal Revenue Service (“IRS”) addressed the Bosch decision (discussed in a prior blog) which provides that the IRS is not bound by a lower court’s decision. This reformation occurred in a county court. The IRS, in effect, sits as the highest state court.

The IRS concluded that the error was a scrivener error and concluded that the power of appointment, as reformed, did NOT constitute a GPOA and the assets would not be included in SS’s gross estate at the SS’s death and that the reformation did not constitute the release of a GPOA and would not create a gift tax.

ADVICE: Many private letter rulings have approved judicial reformation or modification to “fix” scrivener’s errors. This PLR points out the importance of catching the error prior to the death of the parties involved as the grantor could confirm the grantor’s intent.  Florida has comparable statutes as to the reformation to conform to the grantor’s intent and to achieve tax objectives. Be sure and review those statutes before determining a document can not be fixed.

WORD OF THE WEEK: HEMS is the abbreviation for “health, education, maintenance and support”. Why is this “magic language” important?  The IRS allows a beneficiary to receive distributions for HEMS without the assets being included in the beneficiary’s estate when the beneficiary dies. Add the word “comfort” or other terms such as “well-being” “best interests” and others and you have a problem. How you define HEMS, however, is often determined under state law or in your document. For example, what does education include? Private elementary school? graduate school? books? tuition? room and board? The document should clarify the meaning of these terms.

GENEROSITY IS A KEY TO HAPPINESS …REACH OUT AND HELP SOMEONE TODAY!  😎

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