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 word ‘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 aware of the available options. Likewise, those of our clients who 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 word “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 was established.
It is also very possible that the settlor will change his mind about how much to benefit each of his heirs, including the possibility that an heir may have a problem that wasn’t contemplated when the trust was initially designed. What happens if the settlor no longer wants to give anything to an heir? What happens if the heir is going through a divorce and the trust was 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 with little thought towards 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 would want if given the option to have their trust drafted accordingly. Many of our clients, after discovering that their trusts could have been better-drafted, want to make changes which 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 where 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 where 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 work through the various issues that exist when 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 will help determine what options are available.
Trust Protector/Independent Trustee Power to Amend
Does the trust agreement give a trust protector or independent trustee the power to amend the trust agreement? Some trusts provide for this, while many others do not. And if a party does have the power to amend the trust agreement, there are often restrictions within the applicable provisions that would preclude amending the trust agreement for certain purposes. This often is a result of the trust draftsman trying to provide flexibility within the document, but yet not give the trust protector or independent trustee so much power that items that the settlor would not have wanted to be changed can be changed.
Beneficiary Power of Appointment
Does a beneficiary have a power of appointment? The advisor should check the document to determine whether a beneficiary has a power of appointment which gives that beneficiary the power to make changes going forward. That beneficiary cannot have a power of appointment that would allow the beneficiary to make changes for himself, his estate, his creditors or the creditors of his estate unless inclusion of the trust assets in the taxable estate of the powerholder was intended.
If the beneficiary has a power of appointment, then the beneficiary can exercise that power to change the trust terms in just about any way for the more remote beneficiaries. For example, many irrevocable trusts set up by one spouse for the benefit of the other spouse give the beneficiary spouse a power of appointment to allow the beneficiary spouse to make changes among the beneficiaries. The spouse can reduce a beneficiary’s share, remove that share altogether, change how the beneficiary receives the share or do just about anything else, except as may be limited by the terms of the power of appointment.
The settlor’s children generally also have a similar power of appointment. It gives each of them the power to change how their descendants receive their assets. Very often, the grandchildren are young or even unborn when the trust is established. Therefore, planning for the ability to adjust their 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 power to add beneficiaries? If so, then, depending upon the class of beneficiaries that may be added to the trust, there may be a way to make adjustments to the ultimate shares by simply adding beneficiaries and then having the distribution trustee make a larger distribution to a beneficiary that was added to the trust after the trust was established. Sometimes the settlor’s spouse can be added as a discretionary beneficiary. Sometimes the spouse is already a discretionary beneficiary. In an emergency, if the settlor needs access to the trust but isn’t a beneficiary, distributions can be made to the settlor’s spouse who can then “share” the distributions with the settlor. If the settlor wants to benefit someone who wasn’t an initial beneficiary of the trust, then if the trust allows for it, the trust protector or independent trustee can add that beneficiary and then the trustee can make distributions to that new beneficiary or modify the ultimate distributions so that the new beneficiary gets a share.
Choice of State Law – Decanting
“There may be opportunities to change the terms of the irrevocable trust by taking advantage of flexible laws 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 laws 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 with 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 where 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 whether the trust allows the trustee to move the 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. However, there are significant opportunities for an advisor to become familiar with decanting in order to be able to explore more flexibility for their clients who 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 will need to check local law to see what the default law is if the trust is silent. One option if local default laws 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 where it can then be decanted.
Creating New Irrevocable Trusts – Flexibility
Newly-designed irrevocable trusts should be designed with as much flexibility for change as possible. The trust scrivener should be aware of the possibility that changes will be desired in the future and should draft accordingly. Following are some tips that should be considered in designing new irrevocable trusts.
- 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 who can then share it with 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.
- Give a trust protector or independent trustee the power to amend the document for certain purposes. There are often potential modifications that couldn’t have been anticipated when the trust was established. Many settlors will be glad to have added this flexibility to their trust agreements.
- Give the primary beneficiary a power of appointment. This is a power to amend the document for purposes of future beneficiaries. If the particular fact pattern is such that this would be too much control for the primary beneficiary, then consider giving the power of appointment with the caveat that it may only be exercised with the written permission of the settlor’s close friend. The friend can make sure the power is exercised in a manner with which the settlor would agree and serve as the watchdog.
- The settlor should retain the power to remove and replace trustees. Many trusts fail to provide this power even though the tax code and IRS Rulings certainly allow for it. Be careful to design it so that it conforms to the tax laws. An advanced estate planner will be able to draft accordingly. There are many existing irrevocable trusts where the trust scrivener did not realize that the settlor could retain this much power and therefore the trust was drafted in such a way that the settlor lost the indirect control over the transferred assets.
- Carefully select the jurisdiction in which to domicile the irrevocable trust.
- There are many jurisdictions where trusts are not subject to state income taxes in certain circumstances. This should be considered when determining where to domicile the trust.
- There are many jurisdictions where the settlor can be a discretionary beneficiary of the trust, thereby creating what is commonly known as a Domestic Asset Protection Trust. Even better, since there is often a concern about which state law applies to a Domestic Asset Protection Trust, consider instead using a Hybrid Domestic Asset Protection Trust. This is a trust in which the settlor isn’t a discretionary beneficiary initially, but where the settlor can be added into the trust as a discretionary beneficiary by the trust protector. This fixes the issues that often exist with 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 between a client moving forward with the planning versus doing no planning as a result of the “what 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://www.oshins.com/images/DAPT_Rankings.pdf.
- 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 allows. 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://www.oshins.com/images/Dynasty_Trust_Rankings.pdf.
Steven J. Oshins, Esq., AEP (Distinguished) is an attorney at the Law Offices of Oshins & Associates, LLC in Las Vegas, Nevada, with clients throughout the United States. He is listed in The Best Lawyers in America®. He was inducted into the NAEPC Estate Planning Hall of Fame® in 2011 and was named one of the 24 Elite Estate Planning Attorneys in America by the Trust Advisor. He has authored many of the most valuable estate planning and asset protection laws that have been enacted in Nevada. He can be reached at 702-341-6000, ext. 2, at email@example.com or at his firm’s website, www.oshins.com.
Neil Schoenblum, JD, LLM, is a Senior Trust Officer at Provident Trust Group in Las Vegas, Nevada. At Provident, he is principally responsible for overseeing fiduciary administration, with a focus on personal trust relationships and client service. Neil is a graduate of Northwestern University, Cornell Law School, and the LL.M. in Estate Planning Program at the University of Miami. He can be reached at 702-788-9918, at firstname.lastname@example.org, or at Provident’s website, www.trustprovident.com.