By Michelle M. Kenyon, JD, CLU®
Many clients would like to modify or terminate irrevocable trusts that they have created or would like to establish irrevocable trusts that may be easily altered in the future. In other cases, beneficiaries may want to make changes to a testamentary trust created in a family member's will or revocable trust. Some of the changes that may be desired include:
- Change of trustees or trustee provisions;
- Change of distribution provisions;
- Division into separate trusts with different provisions;
- Exclusion of beneficiaries;
- Adjustment for changes in income and estate tax laws or other laws that affect trust administration;
- Modification of powers of appointment; and
- Modification of trust terms to provide for a special needs beneficiary.
Generally, in order to keep the trust assets outside of the trust creator's (settlor's) estate for estate tax purposes, to maintain creditor protection, and to avoid other potential adverse consequences, the settlor may not modify an irrevocable trust he or she established.1
If the trust was initially drafted to include provisions that allow for flexibility and "modification" by others, changes can be made without adverse consequences or without going to court to request a trust modification or termination (if allowed under state law).
Some of the provisions that clients may want to include in their trusts for flexibility are described below, including:
- Powers of appointment;
- Power to transfer property to another trust (or decant);
- Trust protector provisions;
- Independent trustee provisions;
- Power to turn off grantor trust provisions.
Powers of appointment
A trust document can give a beneficiary the power to appoint property held in trust for his or her benefit, exercisable during his or her lifetime or at death, or both. Property can be appointed outright or in further trust(s) for the benefit of the appointees. Powers of appointment are an effective way to address changes in family circumstances or other events, allowing the holder of the power to "rewrite" the trust with respect to the appointed property.
For example, dad creates separate trusts for his three children, Adam, Betty, and Carol. Each trust gives the child a limited power to appoint trust property remaining at the child's death to his or her descendants, and property that is not appointed by a child is distributed outright to the grandchildren at age 35 (after the child's death). Adam has three children, one with special needs (Dale). Adam can use his power of appointment to appoint property to trusts for his children for their lifetimes and design the trusts and select the trustees. The trust for Dale can be drafted in a way that will not disqualify him from receiving government benefits. (See Diagram 1.)
General powers of appointment are often used for tax purposes since property subject to a general power of appointment is included in the power holder’s estate for estate tax purposes.2 Estate inclusion results in a step-up in basis for income tax purposes. Inclusion and step-up in basis occur even if the power is not exercised. A general power of appointment is often given to avoid generation skipping transfer (GST) taxes.
For example, mom created a separate (GST nonexempt) lifetime trust for each of her children, Adam, Betty, and Carol. Each child has a general power of appointment exercisable at his or her death. With the general power of appointment, the property is not subject to GST tax and is subject to estate tax only if the child has a taxable estate.
If desired, Adam could appoint property in the same manner as described above, to provide a special needs trust for Dale and lifetime trusts for his other children. If assets in a trust are sold soon after Adams's death, there should be little or no gain for income tax purposes due to the step-up in basis.
Power to transfer to another trust (or decant)
If a trust is decanted, the assets of the trust are transferred to a new trust with more favorable terms. Many states authorize decanting with specific statutes or under state common law. The trust instrument itself may also provide that certain trustees have the power to distribute trust property in further trusts for one or more of the beneficiaries.
For example, mom creates a single trust for her children, Adam, Betty, and Carol, when they are minors. The trust is to continue as a single trust until the death of the last surviving child. Adam, Betty, and Carol are now adults, and it makes more sense to have separate trusts for each child. The trust includes decanting provisions. The trustee can create three new trusts, one for each child, and transfer one-third of the assets to each new trust. (See Diagram 2.)
A trust can provide for a trust protector. The trust protector will have the powers provided by applicable state law, if any, and those powers expressly provided for in the trust. Some trust protector provisions that may be desirable include the power to:
- Amend a trust;
- Remove and replace trustees;
- Give a beneficiary a general or limited power of appointment and revoke the power of appointment; or
- Terminate the trust.
The power to modify is generally limited but can include modifications that take into account changes in tax laws or other laws, correct drafting errors, or carry out the settlor's intent. Generally, if the trust protector is given tax sensitive powers, the trust protector should be a person who is not related or subordinate to the settlor or to any beneficiary.
For example, Adam creates a trust for his daughter, Felicia. Fifteen years later the federal tax rates and rules for trusts are modified in a manner that is unfavorable to the trust and to Felicia. The trust protector, who has the power to amend the trust in such event, can modify the trust to achieve more favorable tax treatment under the new law.
Independent trustee provisions
The trust can provide for an independent trustee with the authority to exercise certain powers that cannot be exercised by a non-independent trustee without adverse tax consequences. Generally, an independent trustee is not related or subordinate to the settlor or to any beneficiary and has no legal obligation to support a beneficiary.
Some of the powers that might be given to an independent trustee include the power to make distributions to the beneficiaries for any purpose, to grant or revoke powers of appointment, to terminate a trust, or to postpone or terminate distributions to a beneficiary.
For example, Betty creates a trust for her child, Pat. Pat is 25, and Pat's trust provides that Pat receives all income at least annually. Pat has a gambling addiction and may need to file for bankruptcy protection. If the independent trustee has the power to postpone distributions, mandatory distributions of income may be paused by the independent trustee until these issues are resolved.
Grantor trust provisions
A grantor trust is a trust in which the trust creator (grantor or settlor) retains one or more powers over the trust and as a result the grantor and the grantor trust are treated as the same person and trust income is taxable to the grantor (or settlor).3 Payment of taxes on trust income by the grantor is not treated as a gift to the trust for gift tax purposes. This allows the assets to grow within the trust without the economic burden of paying income taxes.
Some of the other advantages of a grantor trust include the power of the grantor to sell assets to the trust at fair market value without recognition of gain,4 and allowing the purchase or exchange of low basis assets for higher basis assets without imposition of income tax.
At some point in the future, the grantor may want to stop paying taxes on the trust's income or, due to changed circumstances or laws, the advantages derived from the grantor trust provisions may have vanished or diminished. If the grantor trust includes provisions allowing the grantor or some other person to release or terminate the grantor trust powers, the grantor trust provisions can be turned off, and trust income will no longer be taxable to the grantor.
When establishing an irrevocable trust, or wills and revocable trusts that create irrevocable trusts in the future, consider the many ways to create flexibility, if desired, and work with professional advisors to ensure documents can be drafted in a way to meet personal objectives and family dynamics.
Michelle M. Kenyon, JD, CLU®joined The Nautilus Group in 2009 to provide personalized consultative services for Nautilus Plus Members. Michelle's professional experience includes estate planning, mergers and acquisitions, taxation, and general corporate work. Michelle graduated magna cum laude with a BBA in accounting from Texas Christian University, and holds a JD from Pepperdine University School of Law. Michelle is a member of the State Bar of Georgia and the State Bar of Texas, and she is licensed as a Certified Public Accountant by the Texas State Board of Public Accountancy.
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Joel M. Field III founded Field Financial Strategies, LLC as a boutique financial practice out of an overarching desire to help empower friends and clients to live life to its fullest and confidently pursue their goals, without worry about finances.
As a CERTIFIED FINANCIAL PLANNER™, Joel works extensively with business owners, professionals, entrepreneurs, and executives around the country. Joel's trademarked Financial Empowerment Process℠ is a comprehensive approach to developing a financial strategy that enables clients to work towards their financial goals. Joel is highly qualified to address the needs of clients in the areas of comprehensive financial planning, investment management, retirement planning, estate planning, insurance planning, and business planning.
Joel M. Field III, CFP®, CLU®, LUTCF®
Founder and Financial Planner