State Judicial Reformation of Trust Sufficient to Prevent Asset Inclusion for Federal Tax Purposes

A state law provision that enables a court to reform errors in a trust document was sufficient for IRS purposes under I.R.C. § 2041 to prevent the inclusion of the trust assets in the estate.  While letter rulings are, of course, limited to their facts, this is generally good news for the correction of errors and the implementation of tax-planning in Tennessee.

In this case, a Grantor created an irrevocable trust to benefit Grantor’s spouse and descendants.  A section of the trust was titled “Special Power of Appointment,” but the section’s language  failed to carve out the spouse, the estate of spouse, the creditors of spouse, and the creditors of spouse’s estate.  Therefore, the effect was that a general power of appointment was created.

The Grantor petitioned the state court for reformation of the trust document under  a state law that which allows for court modification to achieve the settlor’s tax objectives.  Since the Grantor represented to the state court that the power was intended to be special, and that, as written, the trust contained a scrivener’s error, the state court reformed the irrevocable trust so that the language no longer provided the spouse with a general power of appointment under I.R.C. § 2041.

Under the IRS letter ruling, the IRS considered this action sufficient under state law to constitute a special power of appointment and prevent the Trust assets from being included in the estate.  This is good news for Tennessee practitioners, since Tennessee has similar state laws that could be invoked. Tenn. Code Ann. § 35-15-416 allows for court modification of at rust to achieve tax objectives, and Tenn. Code Ann. § 35-15-411 even allows such changes during the grantor’s lifetime without the necessity of court approval.

Post by: Jillian Mastroianni

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