October 19, 2012
Authored by: Luke Lantta
There aren’t a lot of cases out there dealing with reformation of trusts. Many jurisdictions allow for reformation to conform with the settlor’s intent. But settlors are usually understood to have meant what they said in the text of the trust instrument. So what qualifies as an event worthy of trust reformation?
In Rockland Trust Company v. Attorney General, the Appeals Court of Massachusetts showed us one circumstance under Massachusetts law that would allow reformation of a trust: avoiding adverse tax consequences, but with a caveat . . . .
Carol Vollmer established a trust that, upon her death, would pay from the income one or two $10,000 scholarships to Scituate High School students and, if the income was less than $10,000, the trust provided that the whole amount of the net income be paid as a scholarship. The trust didn’t identify any other beneficiaries.
The trust applied to the IRS to be treated as an income tax exempt private charitable foundation. The IRS declined to grant the status unless the trust was amended to demonstrate a general intent to benefit charity and not merely a specific intent to benefit a particular institution. Although the trust set forth a specific charitable purpose, it didn’t contain language evidencing a general charitable intent. The consequence of failing to qualify for the charitable exemption is payment of income taxes at a high marginal rate, thus reducing the income available for scholarships.
The trustee filed an action to reform the trust and alleged that, due to a scrivener’s error, the trust language didn’t reflect the settlor’s general charitable intent. The attorney who drafted the trust gave an affidavit that confirmed this. Also, two friends of Vollmer gave affidavits attesting to her charitable donations and volunteer work.
In addition to adding the “general charitable intent” language, the trustee also asked that the trust be reformed to avoid certain taxes on the undistributed income of the trust. The trustee was finding it difficult to comply with Section 4942 of the Internal Revenue Code (which imposes a hefty tax on any undistributed income retained by a private foundation at the end of any taxable period in which the initial tax is imposed) because the scholarship amounts cannot exceed $10,000 (or multiples thereof). Therefore, the trustee asked that the trust be reformed to allow the scholarship committee to distribute all the distributable funds in one or more scholarships.
The appellate court allowed the trust to be reformed as requested because the record was clear that the settlor intended to provide scholarships annually and that she intended that as much of the trust income as possible be used for that purpose. As it was written, the trust instrument resulted in tax consequences that reduced the amount of income used for scholarships and frustrated the settlor’s intent.
Here’s the caveat to trust reformation to gain more favorable tax treatment: The court further found that the proposed reformation would not be adverse to any person’s or entity’s interests under the trust instrument as there were no other beneficiaries. Therefore, the reformation was allowed.
Even though the trust was modified, it’s important to remember the burden that had to be satisfied. Before reforming a trust under Massachusetts law, a court needs “clear and decisive proof” that the trust instrument as drafted failed to embody the settlor’s intent. So, just because alternate wording could lead to better tax treatment doesn’t mean a trust automatically gets reformed to take advantage of better tax treatment.
Likewise, it’s important to draw attention to the court’s recognition that there were no other beneficiaries of the trust, so no one was going to be adversely impacted by the reformation. If a reformation affects the interests of a beneficiary or class of beneficiaries, a court will likely be less enthusiastic about reforming a trust.