In the past, trusts often were drafted with little flexibility. Now, more and more, trusts tend to be drafted with increased flexibility and there are even ways to change trusts which have become “irrevocable.”
There are several ways to modify a trust, including by a Trust Protector, by a procedure under the state’s version of the Uniform Trust Code, by decanting under state law, or by some other judicial modification or by agreement.
Whatever the method chosen, the threshold question is whether the modification will be respected as binding under state law. For many modifications, that may be the only important question. A three-part series earlier this year focused on such modifications.
This article focuses on another aspect of a modification/reformation: the tax consequences. A prospective modification by a trust protector with powers granted in the instrument is normally respected for federal tax purposes. However, a state court which is modifying the provisions of the instrument won’t necessarily be respected by federal tax authorities unless it’s the highest court in the state. This is consistent with prior precedent.
Under Commissioner v. Bosch, the U.S. Supreme Court looked at a case in which the federal tax consequences hinged on the determination of state property rights. The Court determined the IRS was not bound by a state trial court’s determination of the state law property rights. In Bosch, the U.S. Supreme Court held the IRS is only bound by the interpretation of state law property rights by the highest court in the state.
The tax impact of modifications is still somewhat unsettled law. But it is still possible to proceed. First, the parties could pursue a modification under state law and hope the IRS agrees with the position taken, such as if the modification impacts only estate and gift taxes and the parties have ample exclusion. However, if the stakes are high and the potential federal tax consequences are great, that may be an unwise strategy.
Second, if the parties can take the case to the highest court in the state, its decision would bind the IRS regarding the state property rights, per Bosch. Perhaps the best method to proceed when the stakes are high is for the parties to pursue a Private Letter Ruling or “PLR” from the Department of Treasury. A PLR may be obtained in advance of the transaction (in most cases) and, if an adverse ruling is obtained, the parties need not go down that path.
If a favorable ruling is obtained, it is binding on the Service in that particular case. However, the Service is not bound by a PLR with regard to other taxpayers, even in similar situations. In other words, a PLR is only binding on the Service for the particular taxpayers who obtained it.
For example, in PLR 201843007, the Service ruled on the tax consequences of a judicial modification. Prior to the modification, each beneficiary of a trust had a withdrawal right which created a “general power of appointment” which would cause inclusion of the assets subject to the power in the beneficiary’s taxable estate. The modification of the trust included language which curtailed the withdrawal right and, hence, the general power of appointment.
The Service ruled this modification wasn’t a taxable gift by the beneficiary and the revised withdrawal power would not cause inclusion in the taxable estate of the beneficiary.
Be sure to think through all the consequences of a modification, including the federal tax consequences. Remember, it’s always better to draft carefully and flexibly. If you’re considering a modification and you’re unsure of the federal tax consequences, consider applying for a PLR to gain certainty.
Stephen C. Hartnett, J.D., LL.M.
Director of Education
American Academy of Estate Planning Attorneys, Inc.
9444 Balboa Avenue, Suite 300
San Diego, California 92123
Phone: (858) 453-2128