Getting the Best of Both Worlds from an Irrevocable Trust
Irrevocable trusts open the door to important tax strategies, but they mean the loss of control of the assets held in the trust … or do they? Today’s irrevocable trusts can be designed with some flexibility in mind.
The seeming finality of an irrevocable trust can sound scary to a lot of people. The whole idea that you are tying up large pools of your assets in a trust, and then giving control of that trust to someone else just doesn’t sit well with them. However, irrevocable trusts have a little more leeway to retain some control than you might realize.
Before we get into the details, we should talk about the two different types of trusts: revocable and irrevocable. The revocable trust, or living trust, is an agreement between the client (commonly called the settlor, grantor or trustor in the document) and the trustee (usually also the client), until his or her death. The living trust is designed to hold assets that remain fully available to the settlor but are excluded from the public probate process at death. These trusts can be fairly simple or very complex. A simple version may only organize the estate for outright distribution at the settlor’s death. A complex version may include several trusts to shelter the settlor’s assets from estate and generation-skipping taxes using available lifetime exemptions. The trust may hold concentrations in family businesses and real property or administer a family office that will provide essential investment and financial services for future generations.
All domestic trusts, whether for a small estate (under $500,000) or a massive one (worth billions), are governed by the same trust laws, under one state or another. And the Trustee’s adherence to the formalities of those trust statutes is essential to the success of the estate plan. But the settlor’s power to modify the trust is equally essential, because tax and trust laws change, as do the family’s circumstances, and that flexibility ensures that the trust will provide the benefits intended.
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Why Have an Irrevocable Trust?
However, for most tax-related trust strategies to go into effect, a trust must be irrevocable when funded, and an independent trustee must be appointed. Many people are apprehensive about using an irrevocable trust in their estate plan. They fear having an unrelated trustee control the legacy for their children under a document filled with legal terms that defy plain English definition.
So, what does it mean today for a trust — any trust — to be “irrevocable,” and why might that be both good and bad?
The first thing to understand is that a trust must have a trustee: one or more institutions with trust powers or qualified individuals who act as fiduciaries. A fiduciary, as it pertains to trusts, must at a minimum act in good faith, within the scope of the authority granted, and solely in the interests of the trust’s beneficiaries.
In recent years, the trend has been to employ family members in trust committees to manage specific assets, make certain tax elections and/or approve or direct distributions for the beneficiaries. In these cases, the trustee is not the sole fiduciary. In fact, for many complex trusts, the trustee is selected mostly to ensure that the laws of a certain state will control the trust’s taxation and administration while the family exercises trust discretion over investments and distributions.
State Codes Define Many Trust Provisions
The courts in the state where the Trust is created determine just how flexible an “irrevocable trust” can be. Most states have adopted a version of the Uniform Trust Code (UTC), a model legislative act to manage trusts in the state. The adopted version of the trust code in any state includes definitions and default and mandatory terms for trust instruments.
For our purposes, the UTC provides a definition for the term “revocable”: “As applied to a trust, [revocable] means revocable by the settlor without the consent of the trustee or a person holding an adverse interest” and “unless the terms of a trust expressly provide that the trust is irrevocable, the settlor may revoke or amend the trust.” Therefore, irrevocable means that the settlor may not retain an exclusive power to “revoke or amend the trust.”
But many state trust codes explicitly allow for the modification of a trust by the trustee and beneficiaries, subject to the settlor’s consent, if living, without court approval. Some state laws also allow a person to be appointed who may amend the trust, completely restate the trust, add or remove beneficiaries, and even pour the trust assets over into a completely new trust without the approval of any court, the consent of the settlor, or the agreement of the beneficiaries.
Make a Trust Easy to Change or Not?
There are good reasons that a settlor may want a trust to be easy to amend while he or she is living. As children grow into adulthood, many of the assumptions and expectations that may have determined the original trust’s terms and purposes can change in light of actual life events. But why would the settlor want the trust to be so easily modified by the beneficiaries after his or her death?
Simply put, the settlor might not. Clearly, there are many tax and financial reasons why a power to modify a trust that may last several generations is beneficial. But state trust laws have always included a process for a beneficiary to petition the court with jurisdiction to approve a modification, if necessary, to achieve or preserve an important trust purpose.
The courts have great experience and legal precedent to follow when balancing the preservation of the grantor’s intent — sometimes described as a material purpose of the trust — and elevating the interests of the beneficiaries, which may be contradictory or incongruent. And the court’s power to modify or revoke the trust and distribute the assets outright among the beneficiaries is subject to review by courts of appeal. This system is designed to protect the rights of all parties to the trust, including the deceased settlor, who speaks primarily through the trust instrument itself.
The trend toward ceding greater control to the trust beneficiaries and avoiding the use of state courts may be based on several factors. One is likely rooted in a distrust of the formal judicial system. This distrust may be based on anecdotes describing incompetence, unjustified delay, high legal costs, and unfair or insufficient court orders. This distrust does not stop at the courts but includes institutional trustees, too — primarily because they diligently follow the terms and limitations of the trust instrument, much to the chagrin of beneficiaries who resent the controls authorized by the settlor.
The second factor is that settlors and beneficiaries today are more likely to view the trust relationship as a purely financial strategy to reduce taxes and provide a means for family governance. This perspective does not value fiduciary expertise and services as much as it values family control and discretion.
Getting the Best of Both Worlds with Your Trust
For most settlors, the modern trust laws are a vast improvement, which is why states are trending toward adoption of a uniform trust code that supports almost unlimited beneficiary control, when the settlor consents to such control.
But what if the settlor wants the best of both worlds: the flexibility and control inherent in the use of family members as fiduciaries who can modify the trust and the protection of the settlor’s intent, evidenced by explicit and enumerated limitations that cannot be modified?
Well, that is the newest discussion point in the trust profession: How to draft an irrevocable trust that includes certain specific, unalterable instructions while giving authority to family members, as beneficiaries, to modify the rest of the trust as needed when laws and circumstances change.
Most of the rules in the modern UTC are simply default rules that may be excluded or modified by the settlor in the trust instrument. The UTC provides definitions and enumerated powers, duties and standards that allow the trust instrument to incorporate well-understood conventions and context, so the settlor need not execute a hundred-page trust document. But the settlor can pick and choose among the UTC provisions, not including certain mandatory rules essential to public policy and the purpose of trusts under state law.
Likewise, the settlor may provide that certain terms and limitations cannot be modified, even if the trust is poured over, decanted to a new trust instrument. The settlor could require court approval for certain trust modifications or trust termination to ensure that the settlor’s intent is not frustrated. These provisions would essentially opt out of the parts of the UTC that allow the beneficiaries to modify those trust terms and even include a penalty for any attempt.
An Example of How It Could Work
For instance, a settlor may want the trust to never develop a family farm transferred to the trust, now a family retreat. The trust may include a provision that the farm must be subject to a conservation easement with dedicated funding and supervision. But it may allow the beneficiaries to approve the partition of certain acreage for a limited number of homes for their use, or to sell off some or all the land, subject to that easement, after a specified term of years has passed.
A settlor would be advised not to limit an appointed trust protector from modifying the trust to, for instance, preserve assets from increased taxation or waste, to add new protections from creditors, or to shelter trust assets for supplemental needs so a beneficiary may qualify for useful public entitlement programs, among other circumstances that may arise.
In fact, no settlor in 1970 would have imagined the economy we have today with the marked decrease in full-time employment with benefits, historically low income tax rates, consistently low inflation, almost zero depository and federal bond yields, the elimination of defined-benefit pension plans, online investment brokerage, and the creation of cryptocurrency, among many other developments.
But a settlor today is making gifts to a trust for their grandchildren, intending to meet the financial needs of a group of preteens to last through their retirement. He or she may want to limit their ability to modify some terms of the trust but should take care not to hobble the trust for lack of flexibility.
This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.
Timothy Barrett is a senior vice president and trust counsel with Argent Trust Company. Timothy is a graduate of the Louis D. Brandeis School of Law, 2016 Bingham Fellow, a board member of the Metro Louisville Estate Planning Council, and is a member of the Louisville, Kentucky and Indiana Bar Associations, and the University of Kentucky Estate Planning Institute Program Planning Committee.
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