An irrevocable trust has long been a key component of many estate plans. But what if it no longer serves its original purpose? Is it too late to change it? Depending on applicable state law, the trust’s owner may have several options for fixing a “broken” trust. This article explains how a trust can become broken and possible solutions to fixing it. But a sidebar warns of the federal tax consequences that may be associated with making changes to a trust.
An irrevocable trust has long been a key component of many estate plans. But what if it no longer serves your purposes? Is it too late to change it? Depending on applicable state law, you may have several options for fixing a “broken” trust.
There are several reasons a trust can break, including:
Changing circumstances. A trust that works just fine when it’s established may no longer achieve its original goals if your family circumstances change. If you divorce, for example, a trust for the benefit of your spouse may no longer be desirable. If your children grow up to be financially independent, they may prefer that you leave your wealth to their children. Or perhaps you prefer not to share your wealth with a beneficiary who has developed a drug or alcohol problem or has proven to be profligate.
New tax laws. Many trusts were created when gift, estate and generation-skipping transfer (GST) tax exemption amounts were relatively low. Today, however, the exemptions have risen to $5.45 million, so trusts designed to minimize gift, estate and GST taxes may no longer be necessary. And with transfer taxes out of the picture, the higher income taxes often associated with these trusts — previously overshadowed by transfer tax concerns — become a more important factor.
Mistakes. Potential errors include naming the wrong beneficiary, omitting a critical clause from the trust document, including a clause that’s inconsistent with your intent, and failing to allocate your GST tax exemption properly.
These are just a few examples of the many ways you might end up with a trust that fails to achieve your estate planning objectives.
If you have one or more trusts in need of repair, you may have several remedies at your disposal, depending on applicable law in the state where you live and, if different, in the state where the trust is located. Potential remedies include:
Reformation. The Uniform Trust Code (UTC), adopted in more than half the states, provides several remedies for broken trusts. Non-UTC states may provide similar remedies. Reformation allows you to ask a court to rewrite a trust’s terms to conform with the grantor’s intent. This remedy is available if the trust’s original terms were based on a legal or factual mistake.
Modification. This remedy may be available, also through court proceedings, if unanticipated circumstances require changes in order to achieve the trust’s purposes. Some states permit modification — even if it’s inconsistent with the trust’s purposes — with the consent of the grantor and all the beneficiaries.
Division/consolidation. The UTC also permits a trustee to divide a trust into two or more trusts, or to consolidate two or more trusts, under certain circumstances. For example, if a trust is only partially exempt from GST taxes, it might be appropriate to divide it into two trusts — one fully exempt and one nonexempt — and use the exempt trust to benefit grandchildren or for other generation-skipping gifts.
Relocation. In some cases, it may be possible to fix a broken trust by changing its situs — that is, by moving it to a jurisdiction whose laws are more favorable. The UTC may allow a trustee to relocate a trust to an appropriate jurisdiction if doing so would be in the beneficiaries’ best interests.
Decanting. Many states have decanting laws, which allow a trustee, according to his or her distribution powers, to “pour” funds from one trust into another with different terms and even in a different location. Depending on your circumstances and applicable state law, decanting may allow a trustee to correct errors, take advantage of new tax laws or another state’s asset protection laws, add or eliminate beneficiaries, extend the trust term, and make other changes, often without court approval.
The rules regarding modification of irrevocable trusts are complex and vary dramatically from state to state. And there are risks associated with revising or moving a trust, including uncertainty over how the IRS will view the changes. Before you make any changes, it’s critical to consult us to discuss the potential benefits and risks.
For more information on fixing a broken trust contact the experts at Schwartz, Fang & Keating, providing unparalleled law services.