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Financial Planning > Trusts and Estates > Trust Planning

Fixing an incorrectly drafted estate plan: A case study

By Tom Nawrocki

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An IRS ruling released last month presented some encouraging news for estate planners and their clients, regarding drafting errors made by attorneys. Despite the IRS’ reputation as a ruthless, unforgiving agency, it actually allowed someone a bit of leeway for a trust that was constructed incorrectly but in good faith. The case serves as a useful guide to how mistakes in an estate plan can be lawfully corrected.

The case involved a business owner with four adult children, who wanted a way to transfer property to his children with minimal gift taxes and avoiding estate tax. An attorney persuaded the businessman to establish two grantor retained annuity trusts, funded with stock from the company he owned.

The first GRAT was set up so that the businessman would retain the right to receive an annuity for four years, after which the remaining trust assets, if any, would pass to the children’s trust. The second GRAT was similar to the first one, but with a fifteen-year term.

The problem, though, was that the children’s trust was structured as revocable. The businessman’s accountant, preparing the gift tax returns, noticed that the nature of the children’s trust meant that the remainder interest being transferred to it from the GRATs would be both included in the businessman’s estate as well as be susceptible to gift taxes – exactly what the original estate plan was hoping to avoid.

The accountant mentioned this to the estate attorney, only to be told that – according to the IRS ruling – “Accountant, not being an attorney, did not understand the State law governing the trust.” Nevertheless, the accountant made a note of the exchange and filed it away.

In year three of the GRAT, the businessman brought in a financial planner to deal with estate issues related to the business’ shareholders. That financial planner also thought the original GRATs were constructed improperly, that the revocability of the children’s trust negated its tax advantages. He brought in another attorney, who agreed with him on the flaws.

This time, they confronted the businessman directly, who brought the concerns to the original drafting estate attorney. Once again, that attorney insisted that everything was constructed properly.

But the businessman wasn’t convinced. He hired the second estate attorney to redraft the trusts in order to ensure that the estate tax and gift tax advantages would remain. That attorney filed a petition in State Court to refile the trust, correcting the errors and establishing the children’s trust as irrevocable. The State Court approved the petition pending IRS approval. When the IRS sent a letter signaling its approval, the reformed trust was filed, and the businessman got what he had wanted all along.

It’s worth noting why the IRS agreed to approve the refiled trust. The agency ruled that the documents made by the taxpayer, attorneys, accountant and financial advisors “showed clear and convincing evidence that the reformation conformed to the taxpayer’s original intent.” The lesson here is that careful recordkeeping is important. The notes that the accountant kept, indicating that the original estate attorney expected the remainder from the trust to be free of both gift tax and estate tax, may well have been crucial.

The documents also made it clear that the businessman was not trying to get away with any added benefits from the way the original trust was set up. “Grantor did not intend to retain any powers over the Children’s Trust… that would cause the assets of Children’s Trust to be included in his estate (unless he did not survive the GRAT term),” according to the IRS ruling.

The state involved had a clear law on the books allowing changes to a trust in case of a mistake. The relevant statute allowed a court to “reform a trust instrument, even if unambiguous, to conform to the settlor’s probable intention if it is proved by clear and convincing evidence that the settlor’s intent as expressed in the trust instrument was affected by a mistake of fact or law, whether in expression or inducement.”

The whole story is an important reminder that mistakes do happen in complicated transactions, even when experienced estate planning attorneys are doing the drafting. As long as there is careful documentation of the client’s intent and the determination to correct the problem, there can generally be a satisfactory ending – even from the IRS.

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