Judicial Reformation of Trust Avoids Negative Treatment Under Section 2041 (or, Practicing T&E Law Gatsby’s Way)

He wanted nothing less of Daisy than that she should go to Tom and say: ‘I never loved you.”  After she had obliterated four years with that sentence they could decide upon the more practical measures to be taken.

One of them was that, after she was free, they were to go back to Louisville and be married from her house – just as if it were five years ago.

‘And she doesn’t understand,’ he said. ‘She used to be able to understand. We’d sit for hours -‘ . . . .

‘I wouldn’t ask too much of her,’ I ventured. ‘You can’t repeat the past.’

‘Can’t repeat the past?’ he cried incredulously. ‘Why of course you can!’

He looked around him wildly, as if the past were lurking here in the shadow of his house, just out of reach of his hand.

‘I’m going to fix everything just the way it was before,’ he said, nodding determinedly. ‘She’ll see.’

F. Scott Fitzgerald, The Great Gatsby. New York: Scribner’s (1925).

In PLR 201002013 (Jan. 15, 2010), the IRS at last settled the long running dispute between Carraway and Gatsby cited above.  If a T&E lawyer and his clients are lucky, and don’t mind spending $14,000 (the user fee for a Letter Ruling after February 1, 2010), then they, like Gatsby, can repeat the past, and can fix everything just the way it was before.

Here is what happened in the factual situation underlying this Letter Ruling:

The husband/decedent and the wife established a revocable trust, and later amended it.

The revocable trust was atypical (at least for Kentucky practice) in that it was a single trust document for two spouses with estate tax exposure.  The revocable trust apparently created three trusts at the death of the first spouse: a bypass trust, a marital trust, and a “survivor’s trust”.

The trust provided, in relevant part, that on the death of the surviving (second-to-die) spouse, the trustee was to pay debts, expenses, and death taxes due by reason of the surviving spouse’s death and charge them against the bypass trust (i.e., the credit-shelter protected B Fund).

The next paragraph of the trust gave the surviving spouse a general power of appointment over the survivor’s trust, but provided that any assets in the survivor’s trust that were not so appointed and not consumed to pay debts, expenses, and taxes, would be distributed as provided elsewhere in the trust agreement.

The decedent was survived by his spouse and four children.  The surviving spouse was executor and trustee of the survivor’s trust.  One of the children was trustee of the bypass trust and the marital trust.

The attorney administering the estate had written the revocable trust agreement.  The attorney realized a scrivener’s error had occurred, in that debts, expenses, and taxes had been allocated against the bypass trust/B Fund, a fund that would otherwise be (and should be) protected from estate taxes at the death of the surviving spouse.  The attorney was also concerned that the reference to the bypass trust (as the source of payment for the surviving spouse’s debts, taxes, and expenses) might provide the surviving spouse with a testamentary general power of appointment over the bypass trust under IRC Section 2041(b)(1).

The attorney set about to remediate the scrivener’s error.  The spouse and attorney gave affidavits to the effect that the clients’ intent had been to minimize estate taxes and maximize use of the unified credit while avoiding subsequent inclusion in the surviving spouse’s taxable estate.  The attorney then sought judicial reformation of the trust agreement nunc pro tunc.

The pleadings in the reformation outlined how the error had occurred.  Apparently, a previous section of the trust (relating to payment of the expenses, debts, and taxes of the first spouse to die) had allocated those expenses to the bypass trust.  The same language was then used, without modification, in the section relating to the surviving spouse’s death.  In other words, the language had been copied but improperly edited, and the earlier reference to the bypass trust was not changed to refer to the survivor’s trust.

The reformation pleadings also noted the inconsistency of the trust referring to survivor’s trust assets that had not been appointed or consumed for debts, expenses, and taxes, when the debts, taxes, and expenses had been allocated to the bypass trust by the preceding paragraph of the trust.

The local probate court granted the petition for modification, finding that the proposed modification of revocable trust would not defeat a material purpose of the trust, but rather would serve to carry out the intent of the clients in establishing the revocable trust, by allowing the assets in the bypass trust to avoid taxation at the death of the surviving spouse.

The taxpayer (i.e., the attorney) requested the following rulings:

1. The bypass trust, as modified, does not provide the surviving spouse with a testamentary general power of appointment over the assets of Trust under IRC Section 2041.

2. The surviving spouse is not deemed to have made a gift, under IRC Section 2501, of an interest in Trust as a result of the court order modifying the trust.

3. The modification of the trust pursuant to the court order is not an exercise or release of a general power of appointment under IRC Section 2514(b) that constitutes a gift for federal gift tax purposes.

With respect to the first ruling request, the Service noted that Treas. Reg. Section 20.2041-1(c) provides in part that a power of appointment exercisable to meet the estate tax, or any other taxes, debts, or charges which are enforceable against the estate is included within the meaning of a power of appointment exercisable in favor of the decedent’s estate, his creditors, or the creditors of his estate.  {And, therefore, is a general power of appointment causing the assets subject to such power to the includible in the power-holder’s taxable estate.)

The Service noted the rule from Comm’r v. Estate of Bosch, 387 U.S. 456 (1967).  Namely, 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, “but that 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.”

The Service noted that under applicable state law, a probate court has equitable power to modify a trust if the provisions of the trust are ambiguous or if adherence to the terms of the trust would defeat the primary purpose of the trust, and a mistake by the scrivener or draftsman in reducing the intent of the parties to writing is ground for reformation. Under applicable state law, however, “the power to amend nunc pro tunc is a limited one, and may be used only where necessary to correct a clear mistake and prevent injustice.”

The Service concluded that the court order modifying the trust instrument nunc pro tunc based on a scrivener’s error was consistent with applicable state law that would be applied by the highest court of that state.  Because the trust as modified pursuant to the court’s order does not provide the spouse with a general power of appointment under IRC Section 2041(b), the Service concluded that the value of the assets in the bypass trust will not be included in the spouse’s gross estate under IRC Section 2041(a)(2) upon her death.

With respect to the second and third ruling requests, the Service noted that for gift tax purposes, Treas. Reg. Section 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.  It also noted that for gift tax purposes, Treas. Reg. Section 25.2514-1(c) provides in part that a power of appointment exercisable to meet the estate tax, or any other taxes, debts, or charges which are enforceable against the possessor or his estate is included within the meaning of a power of appointment exercisable in favor of the possessor, his estate, his creditors, or the creditors of his estate.

Relying on its first ruling, however, the Service noted that the trust, as modified, does not provide the spouse with a testamentary general power of appointment. Accordingly, the modification of the trust would not constitute the exercise or release of a general power of appointment by the spouse, within the meaning of Section 2514(b). (In other words, sensibly, one can’t be deemed to release a power of appointment one is deemed, nunc pro tunc, to have never had.)  Further, the modification of Trust would not be treated as a deemed transfer of an interest in Trust by the spouse for gift tax purposes under Section 2501.

The pro-taxpayer outcome in this instance was dearly bought, and this Letter Ruling is a cautionary tale.  Gatsby ends lyrically: “So we beat on, boats against the current, borne ceaselessly back into the past.”  Recreating the past can make for a fine novel, but we see in this Letter Ruling that it’s not the preferred way to write trust agreements.