Modifying Estate Planning Documents

MODIFYING ESTATE PLANNING DOCUMENTS

Once a client has their estate planning documents in place, especially wills and trusts, they often think they are done.  However, as the laws change and personal situations evolve, estate planning documents often need a bit of modification.  Modifications can even be used to correct errors in elections or drafting or to impact tax consequences.  There are three areas in which modification may be discussed:  (1) retroactive modification; (2) prospective modifications; and (3) special considerations with respect to litigation settlements.

Retroactive Modifications.  Changes to documents after formation may be accomplished in a few ways.  First, reformation proceedings are available for a court to construe or reform a will or a trust and are often involved with charitable gifts, GST gifts, qualified domestic trusts and QTIPs.  However, the court held in Bosch that a determination by the state’s highest court must be obtained first in order for a reformation to be respected by the IRS.  Construction proceedings are an alternative; that is, a court is merely construing the terms of the document instead of reforming it.  As a general rule, the IRS is more likely to respect a construction determination than a reformation determination, especially without Bosch’s highest state court ruling.

In addition, where a client fails to timely make an election in regard to their trust documents with the IRS, Treasury Regulation §301.9100-3 grants an extension of the time to make an election permitted by the regulations or the statutes as long as the client-taxpayer acted reasonably and in good faith and the relief will not prejudice the interests of the government.  Although this relief is generally available for botched elections, it has met with mixed success in the case of QTIP elections.

Qualified disclaimers are another type of retroactive modification.  These were originally designed to permit someone not to accept a gift without incurring gift tax consequences, but they have often been used to correct errors.  Non-qualified disclaimers may also be used to correct errors. 

Finally, retroactive modifications are often accomplished as a result of probate contests, elective share contests, or contests involving conflicting agreements (such as separation agreements, prenuptial agreements, shareholder/partnership agreements, and the like).  In terrorem clauses can also result in reformation, in that provisions in wills carry a risk of forfeiture.

Prospective Modification.  In order to plan for the future with a completed document, decanting is one of the most powerful tools available.  Decanting allows the trustee to distribute property form one trust to another trust.   The following is a short list of reasons for decanting:

 (a)                update or modify trust provisions;

(b)               improve trust administration or management;

(c)                correct drafting errors;

(d)               address changed circumstances;

(e)                remove unworkable restrictions;

(f)                change provisions relating to trusts powers and succession;

(g)               achieve tax savings;

(h)               change trust situs;

(i)                 combine or divide trusts; and

(j)                 GST planning.

 See the article entitled “The Powers of Decanting and Appointment” for further discussion of decanting assets to another trust. 

Litigation Settlements.  As an initial matter, note that a marital deduction under Section 2056 and a charitable deduction under Section 2055 require that an interest must “pass from” the decedent under state law.  This qualifies an inheritance, as well as gifts to pass income tax free to the recipient under Section 102(a) of the Code.  However, where compensation is received in the form of damages in a lawsuit or other amounts received for services, the funds are included in the recipient’s taxable income.  In addition, fiduciary fees are generally deductible by an estate or trust, but beneficiary fees are not deductible, except in probate contests or construction proceedings. 

In the event a client is to receive a large settlement payment or other payment for services, there are several strategies for modifying an estate plan’s governing instruments to achieve the most tax efficient result.  There are a number of tax advantaged trusts which may be used, such as Credit Shelter Trusts, Marital Trusts, and GST Exempt Trusts.  The Trusts protect the assets from creditors and also allow the settlement payment or other cash assets to pass outside of one’s estate – saving estate taxes. 

 *IRS regulations require that we inform you as follows:  Any U.S. federal tax advice contained in this communication is not intended to be used and cannot be used for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or tax-related matters.