Bessemer Trust a Closer Look Making Changes to Irrevocable Trusts

A Closer Look Making Changes to Irrevocable Trusts

In Brief

• For decades, long-term irrevocable trusts have been an important means for families to transfer wealth to multiple generations in a tax-efficient way.

• Despite the benefits of long-term trusts, over time, key provisions on everything from administration to investments to beneficiary distributions may need to be adjusted to serve the trust creator’s goals or address circumstances that could not have been foreseen at the trust’s creation. Laura K. Zeigler, Fiduciary Counsel. • In some cases, trust decanting — “pouring” the assets from an older trust into a newer one — may be an effective way to update those provisions.

• It’s important to decant carefully so as not to jeopardize the tax efficiencies, asset protection, and other benefits of the original trust. And with rules varying from state to state, trust situs is another important consideration.

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 the 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 lie 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.

January 2021 Making Changes to Irrevocable Trusts

Why Change a Trust? GSTs and the Estate Tax Exemption There are a number of potential reasons for changing a trust. The first The current gift and estate tax and simplest category involves administrative changes, such as correcting exemption ($11.7 million for a drafting error, modernizing certain provisions, or dividing or merging individuals and $23.4 million a trust to reduce administrative costs. for couples in 2021 if the law isn’t changed under the Biden Other changes are more complex, involving how the trust assets are distributed. administration) has effectively These might involve eliminating a beneficiary or, as the needs of various eliminated estate taxes for most American families. Yet the beneficiaries evolve, switching from a pot trust to separate share trusts. A pot trust exemption is set to revert at the (in which all beneficiaries receive money from the same set of assets) might be end of 2025 to pre-2018 levels of appropriate when the beneficiaries are young. But as they grow older, meeting $5 million for an individual and their separate needs may require different methods of investing the assets. $10 million for a couple (indexed for inflation), and Congress could In some cases, a family may want the trust to hold special assets, such as potentially lower the exemption concentrated stock positions, significant real estate holdings, or a family before then. business, and appoint a direction advisor — a separate fiduciary assigned to And even at the current level, GSTs manage them. This involves switching to a directed trust, which relieves the may help families pass along more trustee of fiduciary responsibility over those assets. A trust may also need wealth and create greater asset changing if a beneficiary is having problems with creditors, going through a protection. Say, for example, a difficult divorce or struggling with substance abuse. Finally, there may be tax grandmother wants to leave money reasons for changing a trust — for example, changing its location to a state with to a grandchild. If she passes the money outright to her child, the more favorable laws. These changes, however necessary, may be difficult to make gift will count against her child’s within the existing trust — thus decanting or another method may be called for. exemption when the gift passes to the grandchild at the child’s death. By using the protective wrapper of a GST, the grandmother ensures Ways to Change a Trust. that money can ultimately be passed to subsequent generations Depending on the changes needed, there are a variety of approaches without diminishing her own to consider: child’s exemption. 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 a 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.

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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.

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Location, Location. more favorable trust codes, including those related to decanting. Decanting to Delaware from a state with high For all of the advantages of decanting, the rules income taxes offers families the opportunity to protect governing the process are not fully settled at a federal trust assets from those taxes. Delaware irrevocable level and vary considerably from state to state. trusts with out-of-state beneficiaries are generally Therefore, choosing the right state in which to decant is exempt from state taxes on earnings and capital gains, a vital part of the process, not just for the potential tax and nonresident beneficiaries pay no separate Delaware advantages that certain states offer over others, income tax on distributions. but to the help ensure that the decanting safely protects the assets. In certain cases, some states provide that if a trust has a distribution standard for health, education, As of this writing, 29 states have decanting statutes, and maintenance, and support for beneficiaries, the others are considering enacting them. While the language new trust must maintain the same standard. of these statutes varies, the general idea is that a trustee’s Conversely, Delaware allows for the new trust to discretionary power grants him or her the authority to further restrict the purposes for distribution. create a new trust and to distribute trust assets from the original trust to the new one. In a landmark 1940 court By the same token, moving to some states could case in Florida, the Phipps family — the founders of pose risks. For example, several states — including Bessemer Trust — first established decanting as a viable Delaware, Nevada, Wyoming, Alaska, and others — have process (See sidebar, “The Phipps Case: A Common Law strong “creditor protection” provisions, making it hard Precedent”). Other important cases have occurred in for outsiders to gain access to trust assets. Decanting New York and Iowa. to a new trust in a state without such protections could put the assets at risk to creditors and inclusion The Uniform Trust Decanting Act, dating to 2013, offers of the trust assets in the beneficiary’s estate. guidance to states on standardizing decanting rules nationwide. Yet some states, such as Delaware, have

The Phipps Case: A Common Law Precedent While the language of the original trust gave John S. Phipps 1 Though decanting has become increasingly popular in “sole and absolute discretion” over the trust assets, he and recent years, the practice was first established in a 1940 the corporate trustee believed that court decisions in their Florida court case involving the Phipps Family, the favor would encourage federal tax authorities to recognize founders of Bessemer Trust. the validity of the new trust in maintaining the same asset protection offered by the previous one. Margarita Phipps, a resident of Palm Beach County, had started a trust several years earlier for the benefit of her To gain that approval, the trust essentially sued itself (Hence, children and grandchildren. As the family grew, her husband, Phipps v. Palm Beach Trust Company) in a series of cases. John S. Phipps, serving as individual trustee, and the Palm In 1940, The Florida Supreme Court ruled that, given his Beach Trust Company, serving as corporate trustee, wanted absolute discretion in administering and disposing the trust, to include the spouse of one of the grown children as a “there can be no question of the power of the individual beneficiary. In order to accomplish this, they decided to trustee to create the second trust estate for the benefit of the 1 place the assets from the original trust into a new one. class named in the original trust indenture.” The case set an important precedent for other states and is a key reason that Florida remains one of the friendliest states for decanting.

1 Phipps v. Palm Beach Trust Co., 196 So. 299 (Fla. 1940).

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Limitations of Decanting Case Study: Creating Two Trusts Out of One The first order of business when considering decanting A family in California sought to change several provisions is to do no harm. Perhaps the greatest risk involves in a longstanding generation-skipping trust (GST). trusts formed before the Tax Reform Act of 1986. They wanted to protect family assets from unnecessary These historic trusts contain exemptions from dissipation and create investment flexibility for future generations. By moving the trust from California to modern generation-skipping transfer taxes, thanks to Delaware, the family was able to provide greater asset grandfathering — and trustees and lawyers must take protection under Delaware’s more favorable laws, minimize special care to avoid running afoul of IRS rules and exposure to California fiduciary income tax, create potentially destroying that protected status. flexibility in the investment portfolio, and retain control over investment decisions through a direction adviser. As a rule, purely administrative changes and other modifications that don’t alter the quality, value, or In order the attain their objectives, the administrative law of the trust needed to change from California to timing of any beneficial interest under the trust Delaware. But there was a hurdle: The original trust are unlikely to result in loss of exempt status. But terms contained no provision for changing the trust’s special care must be taken with actual or constructive administrative law. Bessemer helped the family gain additions to a grandfathered trust through the approval from a California court for a change of the beneficiary’s release, exercise or lapse of a power of trust’s administrative law. Delaware, with its trust appointment — which could result in the trust assets flexibility and favorable tax laws, was a natural choice. This change allowed the trust assets not otherwise being subject to generation-skipping transfer taxes. generating California source income to minimize Even with newer trusts, it’s vital to consider all of the exposure of the trust to California fiduciary income tax, thereby creating greater tax efficiency. The trust federal and state tax and legal consequences before became a directed trust, which allowed for more taking action. Expert advisors with deep experience in flexibility in the types of investments that the trust the financial, legal, and tax implications of trusts and could hold. The trust was divided into separate trusts the rules in various states can help you decide whether so that the trust could tailor the investments to each decanting could help you meet your objectives, and help beneficiary’s needs. By moving the trust to Delaware, ensure that, like fine wine, your trust provisions get the trust also gained greater asset protection from creditors and divorce through the application of better with age. Delaware’s more favorable asset protection laws. 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.

2 When forming a trust, it’s very helpful to include a provision enabling the trustee to change situs. When trusts (often, older ones, as in this case) do not include such language, a court must grant permission. This detracts from the key advantage of privacy that trusts offer.

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About Bessemer Trust Privately owned and independent, Bessemer Trust is a multifamily office that has served individuals and families of substantial wealth for more than 110 years. Through comprehensive investment management, wealth planning, and family office services, we help clients achieve peace of mind for generations.

This summary is for your general information. The discussion of any tax, charitable giving, or estate planning alternatives and other observations herein are not intended as legal or tax advice and do not take into account the particular estate planning objectives, financial situation, or needs of individual clients. This summary is based upon information obtained from various sources that Bessemer believes to be reliable, but Bessemer makes no representation or warranty with respect to the accuracy or completeness of such information. Views expressed herein are current only as of the date indicated and are subject to change without notice. Forecasts may not be realized due to a variety of factors, including changes in law, regulation, interest rates, and inflation.

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