Irrevocable trusts can help accomplish many financial goals, such as creating a legacy for future generations or providing financial support for a disabled family member. 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 may fall out of alignment with the intentions of the grantor and/or the interests of the beneficiaries.
That doesn’t mean adjustments can’t be made, however. Here are some of the various options for changing your client’s irrevocable trust.
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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 this, 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 of the U.S. states have adopted decanting statutes, so qualified advice is necessary when exploring this option.
Option 2: Modification and Revocation
The 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 2012, many clients transferred substantial assets to irrevocable trusts in anticipation of the lifetime exemption reverting to $1 million. The passage of the American Taxpayer Relief Act in the 11th hour avoided this reversion, however, and set the exemption amount at $5.25 million indexed for inflation. The Tax Cuts and Jobs Act passed in December 2017 increased this exemption amount again to $11.18 million. Mindful of these historic increases, some clients are wondering whether they can get their assets back. After all, the trust no longer serves it’s intended purpose.
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 changing your client’ 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 AB Trust (Is It Relevant?)
The AB 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 AB 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, and then again with the Tax Cuts and Jobs Act:
- The lifetime exemption amount now sits at $11.4 million in 2019.
- One spouse’s unused exemption amount can pass to the other spouse at death, provided proper paperwork is filed with the IRS.
With these changes, is the AB 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 requires assets in the revocable trust to 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 end up dying with $22.8 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. Irrevocable trust assets 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 AB 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.
Weighing the Options
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.
In your experience, what is the most challenging aspect of changing your client’s irrevocable trust? How do you coordinate your efforts with other legal and estate planning professionals to ensure the best outcome for your client? Please share your thoughts with us below.
Editor’s Note: This post was originally published in April 2016, but we’ve updated it to bring you more relevant and timely information.
Commonwealth Financial Network® does not provide legal or tax advice. You should consult a legal or tax professional regarding your individual situation.