Fix irrevocable trusts that no longer benefit their beneficiaries
Neal, Gerber & Eisenberg LLP
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January 31, 2022 – Developments in property and trust law currently allow irrevocable trusts to operate in perpetuity for multiple generations, which can improve creditor protection and minimize exposure to transfer taxes. Modern perpetual trusts are supported by a wide range of flexible features to address planning “blind spots” that cannot be predicted when an individual initially creates and funds these trusts. Planning blind spots include unforeseen changes in the law, ambiguities in trustee authority, or, most commonly, beneficiaries who might best be characterized as irresponsible and misguided.
Unfortunately, many trusts drafted over the past 50 years could only change the terms of the trust by seeking court approval, which is costly and time-consuming. In some cases, trustees and beneficiaries can modify certain provisions by relying on non-judicial settlement agreements, which are helpful in solving administration problems, but have done little to remedy the problems of beneficiaries.
Today, more than half of the states have enacted settling laws that give trustees the power to alter or modify the terms of an irrevocable trust without obtaining court approval and, in many cases, without the beneficiary’s consent. Settlement is a process that allows a trustee who has the discretionary power to distribute the principal of the trust to exercise that power and distribute the assets of the trust to a new trust with amended and modernized provisions for the benefit of a or more of the current beneficiaries. Settlement proves to be a wonderful new tool for updating trust provisions in a way that best meets a beneficiary’s financial and emotional needs.
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What provisions can be updated?
Generally, a trust can be settled for:
• modifying the terms of the trust to achieve favorable tax status, which may include reducing or eliminating withdrawal rights or mandatory income interest to avoid the inclusion of estate tax;
•correct drafting errors or clarify ambiguous terms;
•updating the provisions relating to trusts to incorporate changes in the law, such as the new powers of trustees;
•convert the trust to an additional needs trust to ensure that a beneficiary with special needs retains eligibility for government benefits;
• merge several trusts into a single trust or divide a trust with several beneficiaries to provide maximum administrative efficiency to the beneficiaries;
• add or remove expenditure provisions;
• change applicable law for administrative or tax-saving purposes, such as reducing notice requirements;
•creating or modifying powers of appointment, which allow beneficiaries to direct the assets of the trust to or for the benefit of a class of persons and to determine how those assets are received, whether in trust or in whole;
•and amend or update the successor trustee provisions.
While in some circumstances a trustee can remove a beneficiary from an existing trust held for multiple beneficiaries (for example, by moving the assets of the trust to a new trust that excludes the unwanted beneficiary), the trustee cannot exercise the settling power to add new beneficiaries. In addition, most states prohibit a trustee from exercising the power of settling to reduce or eliminate vested beneficial interests, such as rights to mandatory distributions, current rights to withdraw trust property, and general powers of appointment currently exercisable.
Not all settling statuses are created equal
Each state has its own set of requirements for trust settling, and some are easier to implement than others. For example, some settling laws limit a trustee’s settling power based on the extent of the trustee’s distribution power. These statutes distinguish between trusts that give their trustees “limited distributive power”, or the discretionary power to distribute the principal of the trust that is limited by an ascertainable standard, and trusts that give their trustees a “limited distributive power”. wide distributive”, or the discretionary power to distribute the principal to a beneficiary in his best interest.
Settlement statutes in California, Florida, Illinois, and New York each provide that trustees with expanded power of distribution may exercise the power of settling to make both administrative changes and amendments to beneficial interests. Cal. Probationary Code §§ 19502, 19511; Fl. Statistics 736.04117; 760 ILCS 3/1202, 1211; McKinney’s EPTL § 10-6.6. However, trustees of trusts located in these states that have only limited distributive power may settle a trust, provided that no trust beneficiary can be removed and that the beneficial interest of each beneficiary remains substantially the same. after decantation. Cal. Probationary Code §§ 19502, 19512; Fl. Statistics 736.04117; 760 ILCS 3/1202, 1212; McKinney’s EPTL § 10-6.6.
In practice, a trustee with limited distributive power can only exercise the power of settling to update administrative trust provisions, such as the powers of the trustee or the correction of errors and ambiguities, and the trust cannot be settled to reduce or eliminate unearned beneficial interests, such as as future rights to mandatory income distributions, or to create or alter powers of appointment.
Other states, such as Delaware, Nevada, South Dakota and Tennessee, are less restrictive and simply provide that a trustee who has the discretion to distribute the principal of the trust, whether or not he has broad or limited power of distribution, may decant a trust to alter administrative arrangements and alter beneficial interests. 12 Del. C. § 3528; NRS 163.556; SDCL 55-2-15; TCA § 35-15-816.
In addition, trustees of trusts located in these states may exercise the settling power to reduce or eliminate mandatory income distributions (other than trusts for which a spousal deduction has been taken for estate tax purposes, charitable remainder trusts or annuity trusts retained by the grantor).
Although the exercise of the settling power does not necessarily require the consent of the beneficiaries, most states require a trustee to provide notice of the proposed exercise of the settling power and copies of the existing trust agreement and the new trust agreement (or amended trust agreement) to both the current and the remaining beneficiaries.
In states such as California and Illinois, the trustee must provide 60 days written notice prior to the decision to disburse the trust to all of the following: the settlor, each current and purported residual beneficiary, each holder of a power of appointment currently exercisable, each person who has the power to remove or replace any trustee, each trustee (including trustee advisors) and, for trusts that contain a charitable interest, the Attorney General. Cal. Probationary Code § 19507; 760 ILCS 3/1207. Legal notification requirements can be problematic for trusts whose disputed beneficiaries may object to a proposed settling, or for clients who wish to keep trust assets confidential.
A handful of trust-friendly jurisdictions, such as Delaware, Nevada, South Dakota, and Tennessee, do not require a trustee to notify current or remaining beneficiaries or any other interested parties of the proposed settling. 12 Del. C. § 3528; NRS 163.556; SDCL 55-2-15; TCA § 35-15-816. In some cases, it may make sense to move the administration of a trust to a jurisdiction with more favorable trust settling laws by simply migrating the administration of the trust to that jurisdiction. This would require a trustee located in said state.
Historically, modifying irrevocable trusts has been a lengthy and costly process, particularly when the changes were intended to accommodate a distressed beneficiary. Fortunately, with the evolution of trust settling laws in the United States, trustees now have a tool to update and, in some cases, repair the operation of a trust for the benefit of beneficiaries.
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