Reformed annuity trusts receive qualified-interest treatment

Plain-English summary

A grantor created several grantor retained annuity trusts intended to provide qualified interests under section 2702. The drafting attorney omitted a required prohibition against satisfying annuity obligations with notes or similar financial arrangements. A state court later reformed the trusts to add that language retroactively and correct the drafting error. The IRS ruled that, as a result of the judicial reformation, the grantor's interests qualified from the dates the trusts were created.

Ruling snapshot

• Question: Does a state court's retroactive correction of a drafting error cause the retained interests to qualify under section 2702?
• Outcome: approved
• Key authorities: IRC § 2702; Treas. Reg. §§ 25.2702-2, 25.2702-3; Commissioner v. Estate of Bosch, 387 U.S. 456 (1967)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201652002 Third Party Communication: None
Release Date: 12/23/2016 Date of Communication: Not Applicable
Index Number: 2702.01-01, 2702.03-00
Person To Contact:
----------------------- -------------------------------, ID No. -----------
--------------------------------- -----------------
----------------------------------------------- Telephone Number:
----------------------
In Re: ---------------------- Refer Reply To:
CC:PSI:B04
PLR-109699-16
Date:
September 15, 2016

Legend:

Grantor = -----------------------
Trusts = ----------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------
Court = ----------------------------------------------------------------------------------------------
-------------------------------------------------------
State = ----------------------------------------------------------------------
Statute
Year 1 = -------
Year 2 = -------
Year 3 = -------
Date 1 = ----------------------------------------------------------------------------------------------
PLR-109699-16 2

Date 2 = --------------------

Dear ------------------:

This responds to your authorized representative’s letter of March 22, 2016, and
subsequent correspondence, requesting a ruling regarding a state court reformation of
several trusts for federal gift tax purposes.

The facts submitted and the representations made are as follows. Beginning in Year 1
and through Year 2, Grantor retained an attorney to draft several irrevocable trusts
(collectively, “Trusts”; individually, “Trust”). Year 1 is a year after September 20, 1999.
The first page of each trust instrument provides as follows:

     WHEREAS, the Grantor wishes to establish an irrevocable Grantor
     Retained Annuity Trust, the retained interest of which is intended to
     constitute a qualified interest within the meaning of Section 2702(b)(1) of
     the Internal Revenue Code.

Article Ninth of each trust instrument provides as follows:

     The Grantor has been fully advised concerning the legal effects of the
     execution of this Indenture and has been fully informed regarding the
     character and amount of the property transferred and conveyed hereby.
     The Grantor affirms her personal decision that this Trust shall be
     irrevocable. The Trustees shall have the power to amend the Trust
     Indenture in any manner that may be required for the purpose of ensuring
     that the Grantor’s retained interest in the Trust qualifies and continues to
     qualify as a “qualified interest” within the meaning of Section 2702(b)(1) of
     the Code.

In drafting each trust instrument, Grantor’s attorney failed to include language
prohibiting the trustee from issuing a note, other debt instrument, option or other similar
financial arrangement in satisfaction of the annuity obligation as required by
§ 25.2702-3(d)(6) of the Gift Tax Regulations.

In Year 2, Grantor was made aware of this failure when her son retained a new attorney
to review Grantor’s estate plan. On Date 1, in Year 2, the trustees of Trusts filed an
action with Court seeking reformation of each Trust to correct the scrivener’s error.

On Date 2, in Year 3, Court issued an order reforming Trusts to include the language
required by § 25.2702-3(d)(6), retroactive to the date each Trust was established.
PLR-109699-16 3

Grantor requests a ruling that as a result of the judicial reformation of Trusts to correct
scrivener’s error, Grantor’s interest in each Trust is a qualified interest under
§§ 25.2702-2 and 25.2702-3, effective as of the date each Trust was established.

Law and Analysis:

Section 2702(a)(1) provides that solely for purposes of determining whether a transfer
of an interest in trust to (or for the benefit of) a member of the transferor's family is a gift
(and the value of such transfer), the value of any interest in such trust retained by the
transferor or any applicable family member (as defined in § 2701(e)(2)) shall be
determined as provided in § 2702(a)(2).

Section 2702(a)(2)(A) provides that the value of any retained interest which is not a
qualified interest shall be treated as being zero.

Section 2702(b) provides that the term “qualified interest” means: (1) any interest which
consists of the right to receive fixed amounts payable not less frequently than annually,
(2) any interest which consists of the right to receive amounts which are payable not
less frequently than annually and are a fixed percentage of the fair market value of the
property in the trust (determined annually), and (3) any noncontingent remainder
interest if all of the other interests in the trust consist of interests described in
paragraph (1) or (2).

Section 25.2702-2(a)(6) provides, in part, that a qualified interest means a qualified
annuity interest, a qualified unitrust interest, or a qualified remainder interest.

Section 25.2702-3(b)(1) provides that an interest is a qualified annuity interest only if it
meets the requirements of this paragraph and § 25.2702-3(d). A qualified annuity
interest is an irrevocable right to receive a fixed amount. The annuity amount must be
payable to (or for the benefit of) the holder of the annuity interest at least annually. A
right of withdrawal, whether or not cumulative, is not a qualified annuity interest.
Issuance of a note, other debt instrument, option, or other similar financial arrangement,
directly or indirectly, in satisfaction of the annuity amount does not constitute payment of
the annuity amount.

Section 25.2702-3(d)(6) provides that in the case of a trust created on or after
September 20, 1999, the trust instrument must prohibit the trustee from issuing a note,
other debt instrument, option, or other similar financial arrangement in satisfaction of the
annuity or unitrust payment obligation.

State Statute provides that:
PLR-109699-16 4

   Upon application of any interested person, to achieve the settlor’s tax
   objectives the court may modify the terms of a trust in a manner that is not
   contrary to the settlor’s probable intent. The court may provide that the
   modification has retroactive effect.

In Commissioner v. Estate of Bosch, 387 U.S. 456 (1967), the Supreme Court
considered whether a state trial court’s characterization of property rights conclusively
binds a federal court or agency in a federal estate tax controversy. The Court
concluded that 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. Rather, 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.

In this case, each trust instrument provides that Grantor’s retained interest is intended
to constitute a qualified interest within the meaning of § 2702(b)(1). However, the
attorney retained to draft each trust instrument failed to include in each instrument the
prohibition required by § 25.2702-3(d)(6) thus causing the interest Grantor retained in
each Trust to fail to constitute a qualified interest within the meaning of § 2702(b)(1).
The trust instruments and State Statute permit the amendment of each Trust.

Accordingly, based on the facts submitted and the representations made, we conclude
that as a result of the judicial reformation of Trusts to correct scrivener’s error, Grantor’s
interest in each Trust is a qualified interest under §§ 25.2702-2 and 25.2702-3, effective
as of the date each Trust was created.

Except as expressly provided herein, no opinion is expressed or implied concerning the
tax consequences of any aspect of any transaction or item discussed or referenced in
this letter.

This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) provides
that it may not be used or cited as precedent.

In accordance with the Power of Attorney on file with this office, a copy of this letter is
being sent to your authorized representative.
PLR-109699-16 5

The rulings contained in this letter are based upon information and representations
submitted by the taxpayer and accompanied by a penalty of perjury statement executed
by an appropriate party. While this office has not verified any of the material submitted
in support of the request for rulings, it is subject to verification on examination.

                                 Sincerely,

                                 Leslie H. Finlow

                                 Leslie H. Finlow
                                 Senior Technician Reviewer, Branch 4
                                 Office of the Associate Chief Counsel
                                 (Passthroughs & Special Industries)

Enclosure:
Copy of this letter for § 6110 purposes

cc: