Court-approved Trust Modifications-binding Effect on Irs and Tax Consequences
| Publication year | 2012 |
| Pages | 55 |
| Citation | Vol. 41 No. 6 Pg. 55 |
2012, June, Pg. 55. Court-Approved Trust Modifications-Binding Effect on IRS and Tax Consequences
June 2012
Vol. 41, No. 6 [Page55]
Trust and Estate Law articles are sponsored by the CBA Trust and Estate Section. Topics include trust and estate planning and administration, probate litigation, guardianships and conservatorships, and tax planning.
Coordinating Editors
David W. Kirch, of David W. Kirch, P.C., Aurora-(303) 671-7726, dkirch@dwkpc.net; Constance D. Smith, of Fairfield and Woods P.C.-(303) 894-4474, csmith@fwlaw.com
About the Authors
Jane Caddell Paddison is a sole practitioner in Boulder, with Jane Caddell Paddison, P.C., and is a former shareholder of the Denver firm Gelt, Paddison and Grassgreen, P.C. She has been practicing for more than twenty-five years in the areas of federal and state taxation, with a special emphasis in the estate, gift, and generation-skipping transfer tax areas. Randi M. Grassgreen is the Director of Family Wealth Planning at Crestone Capital Advisors LLC, a multi-family office and wealth advisory firm located in downtown Boulder. She is responsible for client estate and income tax planning, as well as philanthropic planning. This article is adapted from an article that originally appeared in the December 2011 issue of Trusts and Estates, published by Penton Media, Inc. For more information, visit www.trustsandestates.com.
With the recent adoption in Colorado of liberalized trust modification statutes, there remains concern about whether any such modification will be respected by the Internal Revenue Service (IRS). Even if the IRS accepts the modification, a question still may exist as to whether such modification will have unanticipated and adverse tax consequences to the settlor, trustee, or beneficiary of the modified trust.
Over the past several years, a number of state law changes have caused the issue of trust modification/reformation(fn1) to gain more attention from the Internal Revenue Service (IRS). One such change is the adoption of the Uniform Trust Code (UTC) by many states.(fn2) The UTC contains a potpourri of provisions making it significantly easier for parties to gain court approval of trust modifications. This includes a modification:
1) due to circumstances not anticipated by the settlor;(fn3)
2) if the continuance of such trust on its existing terms would be impracticable or wasteful, or would impair the trust's administration;(fn4)
3) that the court concludes is not inconsistent with a material purpose of the trust;(fn5) or
4) to achieve the settlor's tax objectives.(fn6)
Section 411(a) of the UTC expands these modification rules even further by providing for the modification of an irrevocable trust, even if the modification is inconsistent with a material purpose of the trust, as long as the settlor and all beneficiaries consent to the modification. Even if all beneficiaries do not consent, the court still may approve a modification if the interests of the non-consenting beneficiaries are adequately protected.(fn7)
Although many states have not adopted the UTC, a large portion of such states have adopted similarly broad trust modification statutes. For example, Colorado, although not a state that has made a wholesale adoption of the UTC in this area, recently enacted CRS §§ 15-11-806 (modification of trust terms to conform with the transferor's intent) and -807 (modification to achieve the transferor's tax objectives), both of which are intended to simplify the reformation process from a state law standpoint.(fn8)
In addition to the wider reach of the state trust modification statutes, many jurisdictions also have authorized the decanting of trusts. Simply stated, a decanting statute allows a trustee to pour over assets from one trust to a new trust, sometimes with terms or beneficiaries of the trusts that are substantially different from one another.(fn9)
There are many reasons decanting would be considered, including, but not limited to: (1) changing situs or governing law of a trust; (2) taking advantage of another state's domestic asset protection trust provisions or other statutory provisions; (3) changing administration provisions; (4) changing trustee powers; (5) adding language for a trust protector; or (6) changing for tax planning purposes. As such, the new trust may contain considerably more favorable tax provisions than the original trust. Although there always has been the availability to decant under common law, and occasionally pursuant to the trust provisions itself, most modern decanting statutes define the trustee's liability to the trust beneficiaries, making the option of decanting more attractive to many trustees.
The statutory expansion to the trust modification rules, as well as the general trend of states adopting decanting statutes, have resulted in the changes to trust terms generally and have enabled inspired taxpayers (and their attorneys) to modify seemingly irrevocable trust terms to create very favorable consequences for the trustee and beneficiaries, including at times, tax consequences. The following questions remain: Will the IRS respect the modifications as approved by the courts? Will any of these modifications generate unintended negative estate or gift tax consequences?
State Court Modifications Respected by the IRS
One might assume that a state court modification of a trust will be controlling for all purposes. This is not necessarily the case, at least to the extent of the binding effect on the federal government. There is a long history of decisions concerning whether the IRS is bound by a decision of a state court, particularly for federal estate taxes.(fn10) Until the U.S. Supreme Court's decision in Commissioner v. Bosch,(fn11) there was disagreement among the lower federal courts regarding whether a state court decision would bind the federal government.(fn12)
These decisions resulted in three distinct approaches by the lower courts. One was that a state court decision was binding on the IRS if "the issue was fairly presented to the state court for its independent decision," and was binding on the parties.(fn13) The opposite view held that a "the federal court will consider itself bound by the state court decree only after independent examination of the state law as determined by the highest court of the state."(fn14)...
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