IRS Allows Court-Approved Trust Modification to Prevent Drafting Error

The IRS has approved a court’s modification to a trust containing a drafting error that could have triggered significant transfer tax to the surviving spouse. As a result of the modification, the surviving spouse will not be considered to (1) possess a general power of appointment over the trust at his death, (2) have released a power during his life, or (3) have made a deemed gift of an interest in the trust.

PLR 201132017.

Facts.  Husband and Wife created an inter vivos revocable trust (Trust), drafted by Attorney A, and served as the original trustees of the Trust.  The terms of the Trust provided that, upon the death of the first spouse to die, the Trust assets would be divided among the Marital Trust, the By-Pass Trust and the Survivor’s Trust.  The Trustee was directed to pay the debts of the surviving spouse, expenses, and death taxes due by reason of the surviving spouse’s death from the assets allocated to the By-Pass Trust.  Wife died, survived by her Husband and their three children.  Husband was appointed to serve as the Executor of Wife’s estate, and continued to serve as the sole Trustee of the Survivor’s Trust, the By-Pass Trust, and the Marital Trust.

Husband consulted Attorney B (who had not drafted the Trust), who discovered an error in the article directing the Trustee to charge debts, expenses and death taxes against the By-Pass Trust, as the provision should have referred to the Survivor’s Trust.  In sworn affidavits, Husband and Attorney A represented that it was the Husband and Wife’s intent in the establishment of the Trust to minimize their estate taxes, including maximizing the use of the unified credit. Accordingly, the By-Pass Trust should have been drafted by Attorney A to ensure that the assets in the By-Pass Trust would not be included in the surviving spouse’s gross estate, and that the surviving spouse would not have any property or other rights to the Trust property that would cause the assets to be included in the surviving spouse’s gross estate upon her death.

In order to correct the error in the Trust and to accurately reflect the intent of Husband and Wife, Husband, as Trustee, filed a petition with a state court seeking authorization to modify Trust. Husband stated in the petition that it was at all times his intent and desire that the assets of the By-Pass Trust be administered so as to avoid taxation at the surviving spouse’s death. He argued that the reference to the By-Pass Trust was a scrivener’s error, and the state court agreed and modified the trust in the manner sought.

IRS’ Ruling.  The IRS determined that the documentation submitted by Husband strongly indicated that he and Wife did not intend to have any control over the assets held in the By-Pass Trust, and that the provision of the Trust directing the Trustee to charge surviving spouse’s debts, expenses and death taxes from the By-Pass Trust was the result of a scrivener’s error.  In reforming the By-Pass Trust, the state court found that the modification of Trust was an equitable reformation of Trust under common law and a state statute providing that when through fraud or mutual mistake of the parties, or a mistake of one party, a written contract does not truly express the intention of the parties, it may be revised on the application of the party aggrieved.

Therefore, the IRS concluded that the state court order modifying the trust instrument based on a scrivener’s error was consistent with applicable state law that would be applied by the highest court of that state.  The court-modified version of the Trust did not provide surviving spouse with a general power of appointment, under Section 2041(b) of the Internal Revenue Code, over the assets of the By-Pass Trust.  Consequently, the IRS concluded that the value of the assets in the By-Pass Trust will not be included in surviving spouse’s gross estate upon his death.

The IRS also determined that the modification will not (1) constitute the exercise or release of a general power of appointment by surviving spouse within the meaning of Code Sec. 2514(b) , or (2) be treated as a deemed transfer of an interest in Trust by surviving spouse for gift tax purposes under Code Sec. 2501.