The estate and gift tax provisions under the Internal Revenue Code (the “Code”) are extremely complicated. Thus, you must have an experienced estate planner draft documents which use techniques that can save estate and gift taxes. Nevertheless, mistakes can happen and sometimes a court reformation can save the technique as is discussed in Private Letter Ruling (“PLR”) 201652002.
In this PLR, a popular estate planning technique, the grantor retained annuity trust (“GRAT”), was used. A GRAT can be explained as follows.
Bob, the grantor, transfers property to a GRAT for a term of years (the “term”) during which Bob must receive an annuity payment each year. If Bob dies during the term, then the property is included in Bob’s estate for estate tax purposes. If, however, Bob outlives the term, then any remaining property in the GRAT is NOT included in Bob’s estate and the property is typically then held in trust for Bob’s family.
When Bob initially transfers the property to the GRAT, he is making a gift to his family of the remainder in the GRAT. The value of the gift to Bob’s family is reduced by the annuity payable to Bob during the term and is determined under tables provided in the Code. IF the property appreciates during the term faster than the annuity payments, then any appreciation in excess of the annuity payments, is removed from Bob’s estate. As there is a risk that Bob will die during the term, many GRATs are for shorter periods, such as 2 years.
Congress created Section 2702 of the Code to ensure that that annuity payments are properly paid to Bob if the ultimate beneficiaries are Bob’s family. Section 2702 requires that, if the annuity payments are not properly paid and the specific requirements of Section 2702 are not met, then the value of the interest held by Bob is zero and the value of the gift to Bob’s beneficiaries is 100% of the value of the property. Thus, no reduction in the value of the gift is allowed for the annuity payments to be paid to Bob and a larger gift will occur.
Unfortunately, in the PLR, the attorney omitted such language in the GRATs. Fortunately, the state statute provided that an interested person could modify the terms of the trust “to achieve the settlor’s tax objective” and the court could provide that such a modification could have retroactive affect.
Note that this state statute specifically permits a court modification, while, in this PLR, the grantor actually obtained a court order for reformation . Apparently the Internal Revenue Service (the “IRS”) was not concerned with that issue. The state court order for reformation allowed the change in the trust document language and allowed the change to be retroactive.
However, even though the court ordered the reformation, did the IRS have to follow that state court decision? The court in the United States Supreme Court case, Commissioner v. Estate of Bosch, determined that a decision of a state trial court as to a state law issue should NOT be controlling when applied to a federal statute. Only the highest court of the state would be the best authority. Thus, the IRS is not necessarily bound by a lower state court reformation.
These GRATs included language that the grantor intended to create a GRAT qualified under Section 2702 of the Code AND that the trustee had to power to amend the trust in any manner that may be required for ensuring that the the retained interest in the trust qualified under Section 2702 of the Code.
The IRS concluded that the judicial reformation of the GRAT corrected a “scrivener’s error” and that the grantor’s interest in the GRAT was a qualified interest effective as of the date the GRAT was created. Thus, the provisions of Section 2702 were met and the GRAT was saved.
ADVICE: Obviously, hire a qualified estate planning attorney to draft such documents. Be sure that you have “intent” language in the document and provisions allowing for reformation or modification if, for whatever reason, the document is not drafted correctly. If you find yourself in a situation where the trust is drafted incorrectly, then review Section 736.0416 for the Florida statutes for modification to achieve a settlor’s tax objectives.
WORD OF THE WEEK: Annuity: An annuity is a series of equal payments at regular intervals. Thus, if you receive an amount of $5,000 each quarter that is an annuity amount.
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