QUARTERLY INSIGHTS FOR CLIENTS: Irrevocable Trusts That Don’t End Up As PlannedSeptember 2012
Irrevocable trusts (different than family revocable trusts) can be ideal for saving tax and controlling how beneficiaries use gifts. Less than ideal are problems that can crop up later because the trust terms are fixed, but the lives of beneficiaries, the nature of the trust assets, and economic conditions are not. As time goes by, an irrevocable trust may no longer be well-suited for its beneficiaries. For example:
A beneficiary’s life takes an unexpected turn. Parents providing for children and future grandchildren may have set distributions at certain ages, for stated purposes, and in specified amounts. What happens if, when it is time for a distribution, the children’s or grandchildren’s needs are greater (or less) than expected? What if a child is in the middle of a divorce, or bankruptcy? What if one grandchild is disabled and others are not? How about a child who did not mature when expected, has proved to be improvident, or has an addiction problem?
Beneficiaries or trustees move away. Beneficiaries and trustees named in a trust might move to another state or country. When it comes time for a distribution to a beneficiary, might it be subject to an unexpected punitive tax? If the beneficiary is living in certain foreign countries, this can happen. How about a trustee who moves into a state (like California) that imposes state income tax on a trust if the trustee resides there? Or what about a married beneficiary who moves into California and worries that separate property coming out of a trust could be changed into community property in the future?
Divorce. Divorce can make an irrevocable trust outdated. For example, irrevocable life insurance trusts created by married couples often hold joint life insurance on both spouses, payable when the second spouse dies. Other insurance trusts may hold a policy on one spouse that pays benefits to the other spouse. These may become inappropriate after divorce. Similarly, a divorced couple who created an irrevocable charitable remainder trust may want a change if it provides income to them for their joint lifetimes, and lets the survivor direct which charities receive the trust when the survivor dies.
Trust investments did not grow as expected. Trust investments can underperform or outperform expectations. A trust might become too small to make it worth continuing. At the other extreme, with outsized investment growth, a distribution for a beneficiary might be too large for the beneficiary’s own good. (This also can happen with custodial accounts that end at age 18.)
Named trustees no longer suitable. Those who were sound choices as initial and successor trustees may become unsuitable. Individuals named in the trust will age and may die, could encounter conflicts of interest with beneficiaries or trust investments, or become unable or unwilling to act. A merger or acquisition may change how a corporate trustee does business.
While no one has a crystal ball, it pays to anticipate change when planning and drafting irrevocable trusts. The more flexible the trust provisions and the more contingencies anticipated, the less likely the trust will become a bad fit. Here are a few approaches:
- A trust can better adapt to unforeseen circumstances if trustees are given latitude when making or withholding distributions to beneficiaries, guided by statements of what the trust creator was trying to accomplish. For example, instead of making a distribution to a beneficiary in the midst of divorce, possibly exposing the distribution to a claim from the other spouse, the trustee could be permitted to defer the distribution to a safer time.
- Trusted individuals with sound judgment can be named as trust “protectors” to make important decisions about how to provide for beneficiaries in the future. The judgment and expertise of trustees and protectors named in the trust must always be weighed.
- To avoid a trust growing too large for beneficiaries, the amount distributed to them might be capped, with any excess earmarked for alternative beneficiaries, including charities. In the case of small trusts, early termination can be allowed.
- To ensure compliance with unforeseen changes in tax and trust laws, the trust can provide for future specific amendments. Likewise, the trust can permit movement to a state with better tax and trust laws, if the state where it is being administered becomes less friendly.
However, even the best laid plans for flexibility can go awry in unexpected ways. What can be done then? Fortunately, California trust law helps. It provides several ways to modify, amend, or terminate an irrevocable trust, providing a way to handle all sorts of unexpected events.
- If the trust creator and all beneficiaries agree, they can simply modify the trust to handle the unforeseen circumstance.
- Trustees and beneficiaries can ask the probate court to make changes. The law allows the probate court to modify, amend or terminate a trust if circumstances have changed in unexpected ways. It also allows the court to do so if all the beneficiaries agree, as long as the trust does not need to remain unchanged to carry out a “material purpose” and the change requested does not violate a “spendthrift clause” in the trust.
- The law allows termination of trusts with uneconomically low principal: $40,000 or less, and gives the probate court latitude to make additional corrective changes in other small trusts.
- An irrevocable trust may be divided into one or more trusts by the court, which can help with some trusts in the case of divorce.
In addition to solutions under the trust law, other creative approaches can work. One could stop paying premiums on a life insurance policy held in a trust if the trust becomes outdated. If a large unfettered distribution made directly to a beneficiary may be harmful, the beneficiary might agree to put the distribution into a new irrevocable trust to be managed for him or her into the future. As an alternative, the trustee might consider investing the trust in sound investments that will remain illiquid until a time when the beneficiary is suited to handle them. Finally, if a distribution from an irrevocable trust cannot be changed, an individual might make offsetting provisions in a will or revocable trust to compensate for that which cannot be changed.
This publication is for informational purposes only and is not intended to provide legal or tax advice, or to create an attorney-client relationship.
Pursuant to IRS Circular 230, unless expressly stated to the contrary, any tax advice is not intended and cannot be used to (i) avoid penalties under the Internal Revenue Code or (ii) promote, market or recommend any transaction or matter to another party.