Executive Summary: In this New York Surrogate’s Court opinion, the surrogate denied a petition to reform an income tax inefficient estate plan to leave an IRA to charity instead of to the surviving spouse, as the plan provided, with an offsetting legacy of other assets left to charity to the surviving spouse.
Facts: Charles died on August 17, 2013. Under his will, executed on November 4, 2004, Charlest left his tangible personal property and cooperative apartment to his surviving spouse, Vivian, and left his residuary estate to The Charles and Vivian Sukenik Philanthropic Fund, Inc. (the “Foundation”). Under Charles’ revocable trust, established on August 21, 1996, and amended and restated the same day as the will’s execution, he provided that, upon his death, Vivian would receive certain real property in Columbia County, New York, with the balance of the trust remainder to be distributed to the Foundation.
Charles left Vivian an IRA, apparently valued at approximately $3,200,000. Charles signed the IRA beneficiary designation form on July 29, 2009, almost five years after the will and trust, and it named Vivian as the recipient of his IRA.
The Problem: Vivian quickly realized that Charles’ estate plan was inefficient from an income tax standpoint in that Charles should have left his IRA, which was pregnant with income tax liability, to the Foundation, while transferring other assets from the estate to her.
Vivian asked the Surrogate’s Court for New York County to reform the trust to add a pecuniary bequest to her in a sum equal to the value of the IRA and to reform the IRA beneficiary designation form to name the Foundation the beneficiary instead of her. Vivian asserted that if such relief were granted, she would avoid receipt of an asset (the IRA) on which approximately $1,600,000 of income tax would be due. According to Vivian, while Charles intended to benefit the Foundation and herself, his estate plan “could have been structured in a more tax efficient manner, By “swap[ping]” assets, i.e., giving the taxable IRA to the Foundation while leaving after-tax assets to her. Vivian further noted that Charles’ intent to benefit her and the Foundation, would be carried out in a reformation of the trust and beneficiary designation “more tax efficiently.” Neither the Foundation nor the Attorney General of the State of New York opposed the application, apparently because the Foundation would be receiving equivalent value in the swap.
The Surrogate didn’t buy Vivian’s arguments, noting:
the reformation requested here is prompted by neither a drafting error nor a subsequent change in law. Several years after executing his will and trust, decedent himself thwarted the tax efficiency of his own estate plan by making [Vivian] the beneficiary of the IRA. There is nothing in the record indicating why, after executing these estate planning instruments, [Charles] chose to leave additional assets to his wife in this manner or why, in the four years before his death, he did not take steps to cure the unfavorable tax consequences of his choice of IRA beneficiary.

The Surrogate went on:

[Vivian] has offered no authority to support the reformation of a clear and unambiguous instrument in order to remedy the adverse tax consequences of poor estate planning. Although the court is sympathetic to [Vivian’s] regret that [Charles’] decision to leave her additional assets left her with an additional tax burden as well, nothing in the trust or the will indicates that [Charles] intended to minimize the income tax consequences of distributions to any beneficiary. Indeed, in both instruments, decedent indicated that he was neutral as to the tax consequences of distributions by giving his fiduciaries the power to distribute assets without regard to “income tax basis.” The IRA beneficiary designation is, of course, silent on this issue.

The Surrogate then denied the petition.
Comment: I guess that this was a good try to rescue a tax-inefficient estate plan from the bowels of the tax collector, but it seemed to have been a bridge too far. The Surrogate even acknowledged as such, noting:
[Granting the petition] would expand the reformation doctrine beyond recognition and would open the flood gates to reformation proceedings aimed at curing any and all kinds of inefficient tax planning.

Estate planners who aren’t abreast of basic income tax aspects of estate planning will no doubt lament this decision because it could have given erring practitioners an out on the malpractice exposure of poor income tax planning advice via reformations.

However, is the income tax on an IRA equal to the face value of the projected income tax liability, as Vivian claimed? The opinion does not set forth the terms of the IRA. However, if that IRA is like most, Vivian does not have to take the income tax hit all at once, but, rather, only as distributions are received, which could greatly reduce the present value of the alleged $1,600,000 income tax liability. And there also is the possibility that little income tax will ever be paid on the IRA, especially if Vivian does what Charles did not do and leaves it to charity at her death and only takes out the annual minimum required distributions.

Of course, Charles could have better planned for income taxes, since there is a significant difference between leaving an IRA to a charity, which is income tax-exempt, and to a surviving spouse. This is the lesson of this case. Why did Charles not do so? He clearly should have had plenty of time. There is a footnote in the opinion that seems to say that while his lawyer suggested leaving the IRA to the Foundation (and, thereby sidestepping a potential malpractice claim), Charles was too sick to make any changes.

It would not have surprised me one iota if the Surrogate had gone along with the proposed reformation. After all, there was no apparent opposition (although we don’t know whether the IRS was noticed in the matter). In uncontested matters such as these, it was my experience that the courts will bless just about any reformation, particularly one that saves the estate and its beneficiaries (who often are constituents of the judge) taxes!
The bottom line is that there are limits to what a court can be expected to do after the fact as a rescuer. It is incumbent upon estate planners to properly advise as to the income tax ramifications of an estate plan.
Cites: Matter of Sukenik, 2016 N.Y. Slip Op. 31217U (New York County Surrogate’s Court June 28, 2016).