Changing Your Client's Irrevocable Trust: What Are the Options?

Posted by Justin C. Duft, JD, CFP, MSFS, CLU, ChFC, CLTC

Find me on:

April 13, 2016 at 1:30 PM

meeting client goals with the irrevocable trustIrrevocable trusts have a variety of uses and benefits—to help avoid estate taxes, create a legacy for future generations, or provide financial support for a disabled family. Whatever the purpose, grantors enjoy tremendous flexibility when designing an irrevocable trust. But once that trust is in place, the ability to adjust its direction is often limited by rigid rules. As a result, over time, a trust’s initial purpose may no longer align with the intentions of the grantor and/or the interests of the beneficiaries.

That doesn’t mean that adjustments can’t be made, however. From decanting to asset swaps, there are various options for changing your client's irrevocable trust.

Option 1: Decanting

Decanting is the process by which one trust’s assets are distributed to a new trust using different language. There are many reasons for doing so, so let’s review some common scenarios.

Change of situs. One reason is that a trustee wants to change the situs of the trust to a state with more favorable trust or tax laws. If the language of the trust doesn’t allow this, decanting may be an alternative. For example, if income is not being distributed from the trust, and the trust situs is in a state with high income taxes, decanting would be a valuable option.

Imprecise language. Although trained professionals charge high fees to draft trust documents, mistakes are made, and imprecise language can cloud the grantor’s intent. If the trustee determines that a trust’s provisions are unclear or errors have been made, decanting into a new trust may be explored.

Trust as beneficiary. Finally, decanting is often considered when a trust is named as a beneficiary of an IRA. There are many reasons for naming a trust as an IRA beneficiary, and if drafted correctly, the ability to stretch the required minimum distributions (RMDs) on a trust beneficiary’s life can be preserved. That being said, it’s not uncommon for trusts to be drafted without the stretch provision in mind. If so, it may be possible for the trustee to decant into a new trust, allowing for the favorable stretch of RMDs.

Keep in mind that although decanting is a powerful tool, it’s not always possible. Only about half the states have adopted decanting statutes, so qualified advice is necessary when exploring this option.

Option 2: Modification and Revocation

Permanency of an irrevocable trust is implied in its name, but there are circumstances in which it can be modified or revoked in its entirety.

Example: In anticipation of the lifetime exemption reverting back to $1 million, your clients created an irrevocable trust and transferred substantial assets to the trust to avoid estate taxes. Now that the exemption amount has been adjusted to $5 million, the trust no longer serves its intended purpose. Can your clients get their assets back?

Some state laws do allow for the amendment or revocation of an irrevocable trust if the trust’s original intent is impeded by circumstance unforeseeable at the time of creation. Here, a few points should be noted: 

  • A typical state law requires several burdens to be met before any amendment or revocation can take place.
  • State trust law controls the ability to revoke or modify.
  • There is substantial variation among state trust codes.

Option 3: Asset Swap

Another strategy for meeting client goals with the irrevocable trust is the asset swap. Many grantors are not aware that an irrevocable grantor trust may allow them to swap assets from the trust without having the assets revert back to the grantor’s estate at death. This strategy may save beneficiaries significant money at the end of the grantor’s life.

Example: Many years ago, Mary transferred land into an irrevocable grantor trust. The land was originally valued at $500,000 but has appreciated to $2 million. At Mary’s death, the trust is to sell the land and distribute the proceeds to her son, Tom. When the land is sold, the imbedded $1.5 million gain will be subject to capital gains taxes. Mary, now nearing the end of her life, decides to exercise her swap power and transfer $2 million of cash into the trust in exchange for the land. She now owns the land with $500,000 basis, and the trust has $2 million of cash. When she dies, the land will receive a full step-up and pass via her will to Tom. The $2 million in the trust will also pass to Tom tax-free.

Of course, there are nuances to this strategy, and a qualified attorney can provide direction as to whether it is possible under the terms of the trust.

Option 4: The A/B Trust (Is It Relevant?)

The A/B trust was created to protect the lifetime exclusion amount of the deceased spouse. Prior to 2013, the lifetime exclusion amount had to be used at death for assets to pass free of estate tax. If this amount was not used, it was permanently lost. With an A/B trust, however, a revocable trust splits at the first spouse’s death: The deceased spouse’s lifetime exclusion amount passes to an irrevocable trust free of estate tax, and the remaining assets pass under the unlimited marital deduction to a revocable survivor trust (with some variation in strategy).

Circumstances changed with the American Taxpayer Relief Act (enacted in 2013), which permanently set the lifetime exemption amount at $5 million, indexing it for inflation (currently $5.45 million). It permits one spouse’s unused exemption amount to pass to the other spouse at death, provided proper paperwork is filed with the IRS.

With these changes, is the A/B trust still relevant, as the surviving spouse loses much of the control over the assets in the irrevocable trust?

Cons. The main argument against maintaining this design is control. The surviving spouse does not have unfettered access to the trust’s principal and income. The trustee has some discretion as to what is available to the surviving spouse, and typical trust language directs assets in the revocable trust be expended before tapping into the irrevocable trust.

Another downside is the loss in step-up in basis on irrevocable trust assets. With portability of the deceased spouse’s unused lifetime exemption, the surviving spouse may die with $10.9 million in assets and not owe any estate tax to the federal government. If an estate is unlikely to grow to this amount, it may be better to have the assets included in the surviving spouse’s estate and receive a step-up in basis at death.

Pros. Assets held in the irrevocable trust have stronger creditor protection, as the surviving spouse does not have indiscriminate access to the property held in trust. Furthermore, many states have lower exemption amounts from state-level inheritance and death taxes, and keeping assets in the irrevocable trust prevents them from exposure to these taxes.

Clients who have an A/B trust in place before the death of one spouse should seek professional advice to determine whether it makes sense given current tax law. For those clients whose trust has already split, some of the other strategies discussed here should be considered.

Tricky but Beneficial

There’s no doubt that reforming, decanting, and modifying irrevocable trusts can be tricky. Plus, state trust code variations make these waters particularly choppy. But if undertaken with the counsel of a qualified attorney, the results for all parties can be tremendously beneficial.

Do you think the A/B trust is still a viable option? Have you had success in using any of these strategies to meet your client's financial goals? Please share your thoughts with us below.

An Estate Planning Blueprint for Financial Advisors

  Subscribe to the Commonwealth Independent Advisor

Topics: Estate Planning

    
Commonwealth Business Review
5 Ways to Affiliate
The Independent Market Observer, Brad McMillan

Follow Us