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Fixing That ‘Irrevocable’ Trust

By definition, when something is irrevocable, it cannot be altered — unless you are talking about trusts.

An irrevocable trust can be a very effective wealth-transfer vehicle. The assets used to fund the trust, as well as any appreciation they generate, escape estate tax upon the death of the settlor, or person establishing the trust. The savings can be substantial, since the top federal estate tax rate is currently 45 percent. Depending on where the settlor, or grantor, lives, those savings can be further magnified if the state also assesses death taxes. Thus, using an irrevocable trust usually confers more assets to the settlor’s heirs. However, in exchange for the Internal Revenue Service’s generosity, the settlor must be willing to relinquish complete ownership and control of the assets placed in trust.

An attorney drafting an irrevocable trust includes provisions that best capture the settlor’s intentions for how the trust assets should be governed. The grantor usually wants the trustee, the individual she appoints to carry out her wishes, to administer the assets as the settlor would if the assets were still under the settlor’s control. But unforeseen events sometimes render these provisions impractical or contrary to the settlor’s intentions. Fortunately, that supposedly irrevocable trust can be modified to address such issues — often to the surprise and delight of settlors, trustees and beneficiaries.

Suppose, for example, your sibling appoints you as trustee of her irrevocable trust, and that your nephew, the beneficiary, develops a substance abuse or gambling problem, or becomes entangled in creditor issues or a divorce. You might want to withhold distributions to your nephew until such issues have been resolved, even if the trust document does not grant you that authority. Or if your nephew were to become disabled, you might want to transfer the trust assets into a “supplemental needs trust” so that he could qualify for government health care benefits instead of prematurely depleting the trust assets for his care. There may be other reasons to alter an irrevocable trust:

  • To extend the date the trust terminates to defer triggering transfer taxes;
  • To consolidate similar trusts to reduce administrative expenses;
  • To change the trust’s situs, or governing law, to avoid being required to inform young beneficiaries of their interest in the trust before they are mature enough to handle such newfound wealth responsibly;
  • To correct drafting errors that would defeat the primary purpose of creating the trust.

Decanting Statutes

The authority to modify an irrevocable trust depends on the state law that governs it. Currently, seven states have adopted decanting statutes allowing a trustee who has authority to make discretionary distributions to move all or part of the trust property to another trust after meeting certain requirements. The new trust is created under a separate agreement containing provisions that were lacking or that needed to be altered in the original trust. The states that have such laws are Alaska, Delaware, Florida, New Hampshire, New York, South Dakota and Tennessee. Each has its own prerequisites for decanting a trust.

New York was the first to adopt the decanting statute, and its language is the most restrictive. Under EPTL Section 10-6.6(b):

  • The trustee must have unfettered discretion to invade trust principal;
  • The exercise of such power cannot reduce any fixed-income interest of any beneficiary required to receive income from the trust;
  • The new trust must be in favor of the “proper objects” (generally, the intended beneficiaries) of such power;
  • The new trust cannot contain provisions that violate public policy;
  • The exercise of the decanting statute cannot violate the rule against perpetuities, which is a longstanding legal principle, still observed in most states, that prohibits perpetual trusts.

Most irrevocable trusts allow a trustee to make discretionary distributions to its beneficiaries, but only for health, education, maintenance and support. The law defines this as an “ascertainable standard.” A trustee whose power to invade principal is limited to an ascertainable standard would not meet the decanting prerequisite established by New York or Florida, which require absolute power to distribute trust assets. However, in Alaska, Delaware and Tennessee, the mere authority to invade principal, even if only for ascertainable standards, is sufficient to meet the decanting prerequisite.

The process is not difficult. In New York, for example, the trustee must sign a document carrying out the decanting; file it in the court with jurisdiction over the trust; and provide a signed copy to all interested persons. The trustee does not need court approval. However, it is wise to obtain the court’s blessing if the trustee is unsure of whether all decanting prerequisites have been satisfied or is concerned about potential claims by beneficiaries for having exercised this power.

Uniform Trust Code

The Uniform Trust Code (UTC), which provides a model for codifying the laws of trusts, also contains provisions for modifying irrevocable trusts, although not a specific decanting provision. Twenty-one states have enacted some version of the UTC since the National Conference of Commissioners on Uniform State Laws first approved it in 2000.

Generally, the UTC looks to keep the settlor’s original intentions intact. Thus, it requires the consent of the settlor and all beneficiaries to modify the trust if the change is inconsistent with the material purpose of the trust. If the change is consistent with the material purpose of the trust, the modification can be made with consent of the beneficiaries and court approval, or court decision alone. Unlike with a decanting statute, the trustee cannot modify the trust on his own.

Florida and Tennessee are the only states that have adopted both the decanting statute and the UTC. Therefore, trustees in those states have the most flexibility in deciding how best to modify an irrevocable trust.

Common Law

In states that have not adopted a decanting statute or the UTC, trustees may be able to decant using common law. Common law is developed through court decisions, as opposed to law established by legislative or executive action. Most trusts not only permit the trustee to make outright distributions to a beneficiary, but also to make distributions for the benefit of the beneficiary. Courts in various states have ruled that such authority also allows the trustee to distribute the trust property in further trust for the same beneficiary, effectively decanting the trust.

Tax Considerations And Consequences

Before you make any changes to an irrevocable trust, be sure to consult with a knowledgeable estate-planning attorney or tax preparer about the potential tax ramifications. Trust decanting and trust modifications under the UTC may trigger unintended income tax, gift and estate tax, and generation-skipping tax (GST) consequences.

Of all the tax regimes, the GST can cause the most concern. Changes might cause a trust that was once GST-exempt to lose that status — often referred to as “tainting” the status — which could result in a large and unnecessary tax bill.

For many years, a popular tax-planning strategy for wealthy families was to make gifts or bequests that skipped a generation because doing so avoided federal gift and estate taxes. Typically, these wealth transfers went from a grandparent to a grandchild, and generally occurred when the grandchild’s parent had already been amply provided for. In 1986, Congress attempted to curb this strategy by enacting the generation-skipping transfer tax. This is an additional tax, imposed at a flat rate equal to the highest gift and estate tax rate, currently 45 percent. The final GST regulations contain safe harbors for certain modifications that will not cause a GST-exempt trust to lose its exempt status. You will want to be certain to take advantange of these safe harbors.

People who are considering establishing an irrevocable trust should consider incorporating decanting or modification provisions. These should be specific, however, so the trustee may not rewrite the entire trust. Trustees, in turn, should tread carefully when modifying irrevocable trusts and should try to adhere to the intentions of the grantors.

Executive Vice President and Chief Operating Officer Shomari D. Hearn, based in our Fort Lauderdale, Florida headquarters, is among the authors of Looking Ahead: Life, Family, Wealth and Business After 55. He contribued Chapter 2, “Relationships With Adult Children”; Chapter 9, "Life Insurance"; and Chapter 17, "Retiring Abroad." He also contributed a chapter to the firm’s book for young professionals, The High Achiever’s Guide To Wealth.