When was the last time you reviewed your estate plan? If you answered, “Not in the past few years,” it could be out of date. What with changing life circumstances and new tax laws, not to mention potential mistakes made when the plan was first drafted, the trusts used in your estate plan may be “broken.” The good news is that there are tools to fix them.
Why trusts “break”
Changing life circumstances are the primary reason a trust may cease to achieve your estate planning objectives. A trust that worked just fine when it was established may no longer achieve its original goals if your family circumstances change. If you divorce, for example, a trust for the benefit of your spouse may no longer be desirable. If your children grow up to be financially independent, they may prefer that you leave your wealth to their children. Or perhaps you prefer not to share your wealth with a beneficiary who has developed a drug or alcohol problem or has proven to be financially reckless.
Changes in the estate tax laws may also be a cause. Many trusts were created when gift, estate and generation-skipping transfer (GST) tax exemption amounts were relatively low. Today, however, the exemptions have risen to $5.45 million (in 2016), so trusts designed to minimize gift, estate and GST taxes may no longer be necessary. And with transfer taxes out of the picture, the higher income taxes often associated with these trusts — previously overshadowed by transfer tax concerns — become a more important factor.
Potential errors in your estate plan can wreak havoc on your estate planning objectives. Typical mistakes include naming the wrong beneficiary, omitting a critical clause from the trust document and including a clause that’s inconsistent with your intent. These are just a few examples of how you might end up with a trust that fails to achieve your estate planning objectives.
Tools for the fix
If you have one or more trusts in need of repair, you may have several remedies at your disposal, depending on applicable law in the state where you live and, if different, in the state where the trust is located. Potential remedies include:
Reformation. The Uniform Trust Code (UTC), adopted in more than half the states, provides several remedies for broken trusts. Non-UTC states may provide similar remedies. Reformation allows you to ask a court to rewrite a trust’s terms to conform with the grantor’s intent. This remedy is available if the trust’s original terms were based on a legal or factual mistake.
Modification. This remedy may be available, also through court proceedings, if unanticipated circumstances require changes in order to achieve the trust’s purposes. Some states permit modification — even if it’s inconsistent with the trust’s purposes — with the consent of the grantor and all beneficiaries.
Division/consolidation. The UTC also permits a trustee to divide a trust into two or more trusts, or to consolidate two or more trusts, under certain circumstances. For example, if a trust is only partially exempt from GST taxes, it might be appropriate to divide it into two trusts — one fully exempt and one nonexempt — and use the exempt trust to benefit grandchildren or for other generation-skipping gifts.
Relocation. In some cases, it may be possible to fix a broken trust by changing its situs — that is, by moving it to a jurisdiction where the laws are more favorable. The UTC may allow a trustee to relocate a trust to an appropriate jurisdiction if doing so would be in the beneficiaries’ best interests.
Decanting. Many states have decanting laws, which allow a trustee, according to his or her distribution powers, to “pour” funds from one trust into another with different terms and even in a different location. Depending on your circumstances and applicable state law, decanting may allow a trustee to correct errors, take advantage of new tax laws or another state’s asset protection laws, add or eliminate beneficiaries, extend the trust term, and make other changes, often without court approval.
Federal tax consequences
One risk associated with making changes to a trust — particularly those designed to take advantage of tax benefits — is uncertainty over how the IRS will view these changes. For one thing, state court rulings aren’t necessarily binding on the IRS, so the agency may reach its own conclusions about whether a reformation or modification of a trust is effective for federal tax purposes and whether it should apply retroactively.
The importance of specifics
If after reviewing your estate plan you believe your trusts are no longer working as you intended, meet with your estate planning advisor to discuss the appropriate fix. The techniques to modify trusts are complex, and tax law varies depending on your state of residency, so getting the specifics right is important.