Making Changes to
Irrevocable Trusts

In passing the landmark Tax Reform Act of 1986, Congress aimed to limit the ability of a handful of America's wealthiest families to pass money tax-free in trusts from generation to generation in perpetuity. Yet the generation-skipping transfer taxes included in the Act created potential tax inefficiencies for many people  hoping to leave money to their grandchildren. Anything above the estate tax exemption could be taxed twice: first, when passing to the children, and second, when passing from children to the grandchildren. At the current tax rate of 40%, that could mean an effective tax rate of 80% by the time an inheritance reached the grandchildren. 

Generation-skipping trusts (GSTs) have offered many families of wealth a way to give more efficiently. By bypassing estate tax in the child's estate entirely, GSTs enable individuals or couples to leave money directly to the next generation. 

As a result, these long-term irrevocable trusts have become increasingly popular. One tradeoff, for grantors, is that they give up the power to revoke or amend the trust once it is formed. Yet because lives and families are constantly in flux, the longer a trust survives, the greater chance that it may need to be revised to reflect changed circumstances. Fortunately, irrevocable and unamendable don't mean immutable. It is possible, when necessary to change an irrevocable trust. 

This, in turn, raises a vital question: How does one change provisions in an irrevocable trust without violating its terms and potentially losing the long-term tax protections it provides? Simply dissolving the trust and starting over could eliminate the tax and asset protection benefits that made the original trust so valuable. In some cases, an answer may line in decanting — so named because it involves pouring the assets from an existing trust into a new one with more favorable terms. While decanting has become an increasingly popular option in recent years, it must be done with care and is not the answer for every situation.

Why Change a Trust?

There are a number of potential reasons for changing a trust. The first and simplest category involves administrative changes, such as correcting a drafting error, modernizing certain provisions, or dividing or merging a trust to reduce administrative costs. 

Other changes are more complex, involving how the trust assets are distributed. These might involve eliminating a beneficiary or, as the needs of various beneficiaries evolve, switching from a pot trust to separate share trusts. A pot trust (in which all beneficiaries receive money from the same set of assets) might be appropriate when the beneficiaries are young. But as they grow older, meeting their separate needs may require different methods of investing the assets. 

In some cases, a family may want the trust to hold special assets, such as concentrated stock positions, significant real estate holdings, or a family business, and appoint a direction advisor — a separate fiduciary assigned to manage them. This involves switching to a directed trust, which relieves the trustee of fiduciary responsibility over those assets. A trust may also need changing if a beneficiary is having problems with creditors, going through a difficult divorce or struggling with substance abuse. Finally, there may be tax reasons for changing a trust — for example, changing its location to a state with more favorable laws. These changes, however necessary, may be difficult to make within the existing trust — thus decanting or another method may be called for.

Ways to Change a Trust

Depending on the changes needed, there are a variety of approaches to consider:

Exercise of general trust powers. Depending on the terms of the trust, a trustee may already have the authority to make important changes, such as changing the trustee or the situs of the trust, dividing a trust to suit the needs of different beneficiaries, delaying distributions, changing governing laws, selling trust assets, or making other important administrative changes. Because it involves relatively minimal time and expense, exercise of general trust powers is the preferred option where practicable. 

Nonjudicial modification. More complex changes may be enacted within an existing trust and without the involvement of a court, assuming that all interested parties — including trustee, grantors, and beneficiaries — agree to the changes. Assuming everyone agrees, it may even be possible to change a trust in ways that run counter to its original purpose. Yet gaining everyone's approval may be difficult, especially if the change eliminates a beneficiary or alters his or her benefits in case of substance abuse problem or other issue, or where there are minor or disabled beneficiaries for whom no other party can consent on their behalf. Nor is the Internal Revenue Service necessarily bound to accept such agreement. 

Judicial modification. Changing a trust when all parties do not agree or cannot be represented by others requires a court's approval. In addition to the time and expense involved, judicial modification involves the risk that a judge or those appointed by the court to represent minor or disabled beneficiaries may disagree with the changes. And going to court opens up aspects of the trust to public viewing, thus negating one of the key advantages of trusts — privacy. 

Decanting. This approach is often considered to be the ultimate amendment power because it enables a single party, usually the trustee, to fundamentally modify certain terms of a trust without the consent of other trust parties (as in nonjudicial modification) or of a court (judicial modification). As such, it may be possible to make changes in a way that maintains privacy and avoids adverse tax consequences. 

The Decanting Revolution

As the name implies, decanting essentially involves "pouring" the assets from an existing trust into a new one with more favorable terms. In the decanting analogy, unwanted or outdated trust provisions are often compared with sediment that accumulates over the years at the bottom of a bottle of fine wine. 

Trust "sediment" may mean terms that lock its managers into an investment style that no longer pertains to current markets, forces managers to invest the same way for all beneficiaries, even as their needs have diverged, or that generate unnecessary administrative costs by requiring the trustee to adhere to outmoded processes. As originally written, the trust terms may interfere with a necessary change for tax efficiency, such as switching from a grantor trust to a non-grantor trust (or vice versa), or moving to a state that doesn't subject the trust to state income taxes solely because the grantor or trustee is located there. 

A primary advantage of decanting is that it does not require the consent of beneficiaries — an important consideration for issues such as substance abuse, where the beneficiary might resist a change limiting his or her access to distributions. Even when beneficiaries do agree to the changes, there may be tax reasons to have the trustee act alone. For example, if an older beneficiary actively agrees to give up some benefits in favor of a younger beneficiary, the IRS might view that as a gift, potentially triggering gift taxes. 

Just as a bottle protects wine from being spoiled, a trust provides a "protective wrapper" around the assets. The central challenge is to decant carefully enough to maintain the original trust's advantages. Without careful steps to ensure those assets will remain protected, they could be exposed to adverse tax consequences, and if a beneficiary is going through a divorce, being sued, or facing other pressures, the assets could be in jeopardy. 

Location, Location

For all the advantages of decanting, the rules governing the process are not fully settled at a federal level and vary considerably from state to state. Therefore, choosing the right state in which to decant is a vital part of the process, not just for the potential tax advantages that certain states offer over others, but to help ensure that the decanting safely protects the assets.

As of this writing, 29 states have decanting statutes, and others are considering enacting them. While the language of these statutes varies, the general idea is that a trustee's discretionary power grants him or her the authority to create a new trust and to distribute trust assets from the original trust to the new one. In a landmark 1940 court case in Florida, the Phipps family — the founders of Bessemer Trust — first established decanting as a viable process (see, "The Phipps Case: A Common Law Precedent"). Other important cases have occurred in New York and Iowa.

The Uniform Trust Decanting Act, dating to 2013, offers guidance to states on standardizing decanting rules nationwide. Yet some states, such as Delaware, have more favorable trust codes, including those related to decanting. Decanting in Delaware from a state with high income taxes offers families the opportunity to protect trust assets from those taxes. Delaware irrevocable trusts with out-of-state beneficiaries pay no separate Delaware income tax on distributions. 

In certain cases, some states provide that if a trust has a distribution standard for health, education, maintenance, and support for beneficiaries, the new trust must maintain the same standard. Conversely, Delaware allows for the new trust to further restrict the purposes for distribution. 

By the same token, moving to some states could pose risks. For example, several states — including Delaware, Nevada, Wyoming, Alaska, and others — have strong "creditor protection" provisions, making it hard for outsiders to gain access to trust assets. Decanting to a new trust in a state without such protections could put the assets at risk to creditors and inclusion of the trust assets in the beneficiary's estate. 

Limitations of Decanting

The first order of business when considering decanting is to do no harm. Perhaps the greatest risk involves trusts formed before the Tax Reform Act of 1986. These historic trusts contain exemptions from modern generation-skipping transfer taxes, thanks to grandfathering — and trustees and lawyers must take special care to avoid running afoul of IRS rules and potentially destroying that protected status. 

As a rule, purely administrative changes and other modifications that don't alter the quality, value, or timing of any beneficial interest under the trust are unlikely to result in loss of exempt status. But special care must be taken with actual or constructive additions to a grandfathered trust through the beneficiary's release, exercise or lapse of a power of appointment — which could result in the trust assets being subject to generation-skipping transfer taxes. 

Even with newer trusts, it's vital to consider all of the federal and state tax and legal consequences before taking action. Expert advisors with deep experience in financial, legal, and tax implications of trusts and the rules in various states can help you decide wither decanting could help you meet your objectives, and help ensure that, like fine wine, your trust provisions get better with age.

Bessemer's tax and trust and estate professionals are here to help you and your advisors consider whether trust adjustments could help your family transfer wealth efficiently as life and circumstances change.