Fixing a Twenty-Year-Old Tax Mistake

• V.L. HARTMANN for the Wall St. Journal writes:  
A man in his thirties had just inherited his grandfather's large estate, which included a bypass trust and a marital trust. But the legacy came with a big tax bill.  The heir and his lawyer had sought help sorting out the implications of the trusts from estate planning and trust expert Steve Kunkel. The trusts were created by the grandfather's wife, who had died 20 years before him, and when Mr. Kunkel checked the details of her estate plan he discovered a problem: The assets in those trusts weren't only subject to estate tax, but to a large amount of generation-skipping transfer, or GST, tax as well.

"They weren't set up right originally," recalls Mr. Kunkel, a managing director at CBIZ MHM in Los Angeles, Calif., where he advises hundreds of clients on specialized estate and financial planning issues.

At the time of the grandmother's death, the GST tax exemption was $1 million. However, the grandmother's adviser only considered gift taxes, not GST tax, when creating those trusts. As a result, they put only $600,000-the maximum gift exemption at the time-in a bypass trust that was exempt from both estate and GST tax.

The remaining estate assets, worth several million dollars, were placed in a marital trust. But if the GST tax exemption had been considered at the time, the grandmother could have put an additional $400,000 in a separate marital trust that was exempt from GST tax, Mr. Kunkel says.

The assets had grown considerably over the two decades, and were now worth well more than the grandfather's $5.12 million estate tax and GST tax exemption. As a result, overlooking that additional $400,000 exemption would cost the family six figures in taxes.

"In my business, it's a sin to pay taxes that you didn't have to owe," Mr. Kunkel says. "My first thought was: There's got to be away to fix this."

Mr. Kunkel wanted to do a reverse Qualified Terminable Interest Property election, a common ruling used to avoid GST tax. The strategy would break the original marital trust into two trusts. One would hold $400,000, plus twenty years of average appreciation, to retroactively take advantage of the missed GST-tax exemption. The remaining assets would be placed in a separate, non-exempt trust.

To enact the strategy, Mr. Kunkel needed a private-letter ruling from the IRS sanctioning his request to split the marital trust and do the reverse QTIP election. He had researched similar rulings and felt confident that the IRS would grant the ruling.

However, the court has jurisdiction over changing irrevocable trusts. So the IRS ruling was contingent on filing a petition with the state's probate court. Mr. Kunkel filed a petition that explained why they were seeking the split and how it would benefit the trust's beneficiaries.

"The key argument for the probate court was that the partitioned trusts would have the same provisions as the original trusts and the beneficiaries would receive the economic interest that the trustor intended," Mr. Kunkel says.

The probate court reviewed the petition, approved it, and the IRS subsequently granted the private-letter ruling. The process took approximately nine months because of delays in the court system and at the IRS national office, but the tax savings made the wait worthwhile.

"The good news is that even though it was a mistake of 20 years duration, it was still possible to fix," Mr. Kunkel says.