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How To unlock irrevocable trusts for maximum benefit
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How to Unlock an Irrevocable Trust for Maximum Advantage
April 12, 2014
by Steven J. Oshins, Esq., AEP (Distinguished) and Neil Schoenblum
“The fear of the w ord ‘irrevocable’ often causes people to fail to act and therefore fail to take advantage of opportunities that are available.”
Many of our clients fail to set up irrevocable trusts either because they don’t understand how much flexibility can be drafted into the trust or because their advisor isn’t aw are of the available options. Likew ise, those of our clients w ho have already set up irrevocable trusts, but then changed their minds about some of the choices made, often don’t realize that many of the provisions can be fixed or improved. The fear of the w ord “irrevocable” often causes people to fail to act and therefore fail to take advantage of opportunities that are available.
Why Revoke or Amend an Irrevocable Trust?
One reason to revoke or amend an irrevocable trust is that circumstances have changed. For example, the settlor of the trust might have lost his job, gotten sued or divorced, had a health issue or simply misjudged economic conditions that may not have been contemplated at the time the trust w as established.
It is also very possible that the settlor w ill change his mind about how much to benefit each of his heirs, including the possibility that an heir may have a problem that w asn’t contemplated w hen the trust w as initially designed. What happens if the settlor no longer w ants to give anything to an heir? What happens if the heir is going through a divorce and the trust w as established in a jurisdiction that doesn’t protect the trust’s assets from the divorcing spouses of the beneficiaries? What happens if the settlor and the trustees no longer get along or if a trustee is found to be dishonest?
In addition, many trusts are drafted w ith little thought tow ards protection for the beneficiaries. For example, it is very common for a trust to make mandatory distributions of one-third of the assets to the beneficiary upon reaching age 25, one-half of the balance upon reaching age 30 and the balance upon reaching age 35. This type of staggered distribution scheme sounds good in theory, but in reality it fails to consider the asset protection, divorce protection, bankruptcy protection and estate tax savings that most of our clients w ould w ant if given the option to have their trust drafted accordingly. Many of our clients, after discovering that their trusts could have been better-drafted, w ant to make changes w hich typically are forbidden since the trusts are irrevocable.
Furthermore, many trusts are set up in a state that has a state income tax that could have been avoided. Although the trust is irrevocable, are there options available to move the trust to a jurisdiction w here state income taxes can be avoided?
New vs. Preexisting Trusts
Designing a new irrevocable trust so that modifications may be made in the future and w here common drafting errors are avoided from the outset is much simpler than modifying a preexisting trust since it is easier to start from scratch than to have to w ork through the various issues that exist w hen trying to modify a preexisting irrevocable trust. Making adjustments to a preexisting trust are much tougher because the ability to make changes is generally limited by the trust agreement itself and applicable state law .
Modifying a Preexisting Trust
The first step in modifying a preexisting irrevocable trust is to look at the trust agreement. This w ill help determine w hat options are available.
Trust Protector/Independent Trustee Power to Amend
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Does the trust agreement give a trust protector or independent trustee the pow er to amend thetrust agreement? Some trusts provide for this, w hile many others do not. And if a party does havethe pow er to amend the trust agreement, there are often restrictions w ithin the applicableprovisions that w ould preclude amending the trust agreement for certain purposes. This often is aresult of the trust draftsman trying to provide flexibility w ithin the document, but yet not give thetrust protector or independent trustee so much pow er that items that the settlor w ould not havew anted to be changed can be changed.
Beneficiary Power of Appointment
Does a beneficiary have a pow er of appointment? The advisor should check the document todetermine w hether a beneficiary has a pow er of appointment w hich gives that beneficiary thepow er to make changes going forw ard. That beneficiary cannot have a pow er of appointment thatw ould allow the beneficiary to make changes for himself, his estate, his creditors or the creditorsof his estate unless inclusion of the trust assets in the taxable estate of the pow erholder w asintended.
If the beneficiary has a pow er of appointment, then the beneficiary can exercise that pow er tochange the trust terms in just about any w ay for the more remote beneficiaries. For example, manyirrevocable trusts set up by one spouse for the benefit of the other spouse give the beneficiaryspouse a pow er of appointment to allow the beneficiary spouse to make changes among thebeneficiaries. The spouse can reduce a beneficiary’s share, remove that share altogether, changehow the beneficiary receives the share or do just about anything else, except as may be limited bythe terms of the pow er of appointment.
The settlor’s children generally also have a similar pow er of appointment. It gives each of them thepow er to change how their descendants receive their assets. Very often, the grandchildren areyoung or even unborn w hen the trust is established. Therefore, planning for the ability to adjusttheir shares is an important flexibility to build into the trust agreement.
Trust Protector/Independent Trustee Power to Add Beneficiaries
Does the trust agreement give the trust protector or independent trustee the pow er to addbeneficiaries? If so, then, depending upon the class of beneficiaries that may be added to the trust,there may be a w ay to make adjustments to the ultimate shares by simply adding beneficiaries andthen having the distribution trustee make a larger distribution to a beneficiary that w as added to thetrust after the trust w as established. Sometimes the settlor’s spouse can be added as adiscretionary beneficiary. Sometimes the spouse is already a discretionary beneficiary. In anemergency, if the settlor needs access to the trust but isn’t a beneficiary, distributions can be madeto the settlor’s spouse w ho can then “share” the distributions w ith the settlor. If the settlor w antsto benefit someone w ho w asn’t an initial beneficiary of the trust, then if the trust allow s for it, thetrust protector or independent trustee can add that beneficiary and then the trustee can makedistributions to that new beneficiary or modify the ultimate distributions so that the new beneficiarygets a share.
Choice of State Law – Decanting
“There may be opportunities to change the terms of the irrevocable trust by taking advantage of flexible law s that many states now have.”
Depending upon the choice of state law provision in the document, there may be opportunities to change the terms of the irrevocable trust by taking advantage of flexible law s that many states now have. The current trend is to modify an irrevocable trust through decanting. Decanting a trust involves setting up a new trust w ith different terms for those beneficiaries and then having the trustees distribute the trust assets from the original trust into the recipient trust.
A minority of states allow decanting. If the state w here the irrevocable trust is domiciled does not allow decanting or has limited decanting statutes, then the advisor should look at the choice of law provision in the trust agreement and determine w hether the trust allow s the trustee to move the
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trust to a different jurisdiction. If so, then it’s simple to find a more favorable jurisdiction, name a trustee or co-trustee in the new jurisdiction, and then move the trust. After moving the trust, the trustee can decant the trust and make modifications that may be desired.
Decanting a trust can solve most problems. This area of the law is still undeveloped and many advisors have not yet utilized it. How ever, there are significant opportunities for an advisor to become familiar w ith decanting in order to be able to explore more flexibility for their clients w ho could use decanting, but might not have been introduced to it.
If the original trust does not allow the trustee to move the trust to another jurisdiction, then the trustee w ill need to check local law to see w hat the default law is if the trust is silent. One option if local default law s do not help is to have a local attorney petition the court to obtain approval to move the trust to a different jurisdiction. After obtaining court approval, the trust can be moved to the new jurisdiction w here it can then be decanted.
Creating New Irrevocable Trusts – Flexibility
New ly-designed irrevocable trusts should be designed w ith as much flexibility for change as possible. The trust scrivener should be aw are of the possibility that changes w ill be desired in the future and should draft accordingly. Follow ing are some tips that should be considered in designing new irrevocable trusts.
1. Use a “floating spouse” as a beneficiary. The “floating spouse” is defined as the person the settlor is married to from time to time. This means that if the settlor and settlor’s spouse get divorced, then if the settlor gets remarried, the new spouse is a discretionary beneficiary in place of the former spouse. This can be extremely valuable if the settlor ever needs to access any of the trust assets since it is easy for the trustees to make a distribution to the settlor’s spouse w ho can then share it w ith the settlor. This provision is recommended even if the settlor isn’t currently married since it opens up an interesting potential option in the future.
2. Give a trust protector or independent trustee the pow er to amend the document for certain purposes. There are often potential modifications that couldn’t have been anticipated w hen the trust w as established. Many settlors w ill be glad to have added this flexibility to their trust agreements.
3. Give the primary beneficiary a pow er of appointment. This is a pow er to amend the document for purposes of future beneficiaries. If the particular fact pattern is such that this w ould be too much control for the primary beneficiary, then consider giving the pow er of appointment w ith the caveat that it may only be exercised w ith the w ritten permission of the settlor’s close friend. The friend can make sure the pow er is exercised in a manner w ith w hich the settlor w ould agree and serve as the w atchdog.
4. The settlor should retain the pow er to remove and replace trustees. Many trusts fail to provide this pow er even though the tax code and IRS Rulings certainly allow for it. Be careful to design it so that it conforms to the tax law s. An advanced estate planner w ill be able to draft accordingly. There are many existing irrevocable trusts w here the trust scrivener did not realize that the settlor could retain this much pow er and therefore the trust w as drafted in such a w ay that the settlor lost the indirect control over the transferred assets.
5. Carefully select the jurisdiction in w hich to domicile the irrevocable trust.
1. There are many jurisdictions w here trusts are not subject to state income taxes in certain circumstances. This should be considered w hen determining w here to domicile the trust.
2. There are many jurisdictions w here the settlor can be a discretionary beneficiary of the trust, thereby creating w hat is commonly know n as a Domestic Asset Protection Trust. Even better, since there is often a concern about w hich state law applies to a Domestic Asset Protection Trust, consider instead using a Hybrid Domestic Asset Protection Trust. This is a trust in w hich the settlor isn’t a discretionary beneficiary initially, but w here the settlor can be added into the trust as a discretionary beneficiary by the trust protector. This fixes the issues that often exist w ith respect to a regular Domestic Asset Protection Trust. The ability to potentially be added as a discretionary beneficiary at a later date is often the difference betw een a client moving forw ard
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w ith the planning versus doing no planning as a result of the “w hat if I need it back?” concern. The leading Domestic Asset Protection Trust jurisdictions seem to be Nevada, South Dakota, Ohio, Tennessee and Alaska as ranked by the most recent Domestic Asset Protection Trust State Rankings Chart at http://w w w .oshins.com/images /DAPT_Rankings.pdf.
3. Also consider domiciling the irrevocable trust in one of the leading Dynasty Trust jurisdictions. A Dynasty Trust is an irrevocable trust that continues for as long as applicable state law allow s. This provides for estate tax savings and creditor protection for multiple generations. The leading Dynasty Trust jurisdictions seem to be South Dakota, Alaska, Nevada, Tennessee and Ohio as ranked by the most recent Dynasty Trust State Rankings Chart at http://w w w .oshins.com/images /Dynasty_Trust_Rankings.pdf.
