Taxation & Estate Planning

SEPTEMBER 20 IS NOT A FREE PASS TO REFORMING DESIGNATED BENEFICIARY TRUSTS

By Charles Rubin

In a recent Private Letter Ruling, the IRS addressed a trust established by a decedent that was a beneficiary of the decedent's IRA. It was clear from the trust instrument that the decedent desired that the IRA payouts be based on the age of the designated beneficiary so as to defer distributions and income taxes, pursuant to applicable tax rules. However, the subject trust allowed for the appointment of a charitable beneficiary, which power prevented there from being a designated beneficiary that would allow for the "stretch" of the post-death IRA payouts. To address this situation, a state court action was filed and an order obtained that removed the problem power to appoint a charitable beneficiary. The question before the IRS was whether this state court reformation would be given retroactive effect so as to allow for a designated beneficiary.

Generally speaking, state court reformation of dispositive instruments will be respected by the IRS only if there is a specific tax statute authorizing such reformation. There is no such specific statutory authorization in regard to determining if there is a designated beneficiary of an IRA trust. However, the beneficiaries of an IRA are measured/determined on September 30 of the year following the death of the decedent. This would imply that if a reformation is undertaken prior to such September 30 date, such reformation should be given tax effect. Indeed, this reasoning was followed in Private Letter Rulings in the past that allowed qualification of a designated beneficiary through state court reformation actions.

In this most recent ruling, the IRS has changed its analysis, and it denied effective retroactive effect to the change to the trust. Thus, the state court reformation was not effective to allow the subject trust to have a designated beneficiary for IRA purposes.

It would appear that the IRS had legal wiggle room to provide a favorable result for the trust, as evidenced by its prior rulings. It will be interesting to see if the taxpayer under the subject ruling, or some similarly situated taxpayer, litigates this issue in the hopes that the court will adopt the IRS' earlier analysis of the issue.

PLR 201021038

Full post as published by Rubin on Tax on September 23, 2010 (boomark / email).