At the time, it was an appropriate estate planning strategy for your family to establish an irrevocable trust. You named your trusted friend, John, as trustee and purchased life insurance. At your death, the trust property would be distributed outright to your children at age 30. The strategy provided estate tax savings by keeping the insurance out of your taxable estate and also protected the trust property until your children were adults and mature enough to receive their inheritance.
Surprise, surprise, things have dramatically changed over the past 25 years and the trust is no longer the right fit for your family’s current circumstances. You haven’t had contact with John for 10 years and your children’s shenanigans during college and your son’s shaky marriage have proven to you that they should not receive anything outright, especially their inheritance. What, if anything, can you do?
Can I simply start over? Starting over makes sense - cancel the insurance policy, establish a new irrevocable trust, pick a new trustee, purchase new insurance. However, you’re 25 years older, surely resulting in more expensive premiums. What if something in your year medical history has made you uninsurable?
Can I move the assets from the existing trust to a new trust? This is referred to as “decanting” and is possible in some circumstances. The terms of the irrevocable trust must specifically permit the trustees to decant the assets to a new trust. If your trust instrument permits decanting, your trustees could move the assets into a new irrevocable trust that will not distribute outright to your children at age 30, but will hold the insurance proceeds in trust for your children’s lifetimes. If the trust instrument does not specifically permit decanting, then state law would govern. Not all states permit trust decanting. For example, New York, Delaware and Florida have laws that specifically permit trustees to decant trust assets to a new irrevocable trust.
Can I move the trust to one of the decanting states? If permitted by the trust instrument, you may be able to move the legal situs of the trust. This often requires the appointment of a trustee who is a resident of the desired state. Absent language in the trust instrument, you may need to have the court approve the move. The court may be reluctant to relinquish control. If the trust can change its legal situs, you must make sure your circumstances fit under the state’s decanting statute. For example, if your trust instrument limited the trustee’s discretion to the “health, education, maintenance and support” of the beneficiaries (i.e., a common “ascertainable standard” restricting distributions from the trust), the trust could not be decanted under Florida law because Florida requires the trustees to have unlimited discretion to make distribution to the beneficiaries.
Can I have a new trust purchase the insurance policy from the existing trust? The insurance policy is an asset, like any other, that the trustee can buy and sell. The sale price for the insurance policy would be its fair market value, which the company issuing the policy will provide. How will the new trust pay for the insurance? One option is to transfer cash to the new trust. The new trust’s trustee will then transfer the cash to the old trust in exchange for the insurance policy. The gift of cash to the new trust may be a taxable gift. The amount of the taxable gift may be mitigated by your annual exclusion. The annual exclusion allows you to gift $13,000 to an unlimited number of people each year, e.g., a gift of $13,000 to you son and a gift of $13,000 to your daughter will not be a taxable gift because of the annual exclusion. Under certain circumstances, the annual exclusion may be available for gifts made to beneficiaries of an irrevocable trust. If you gift more than your annual exclusion, a gift tax may still not be due if you have any remaining lifetime gift tax exemption (currently $1,000,000). If you would prefer to avoid any gift tax consequences upon the sale of the insurance policy, another option is to loan the money to the new trust. The loan would be evidenced by a written promissory note and would have a minimum statutorily prescribed interest rate. After avoiding the gift tax traps, there are several income tax traps awaiting the unwary client. The favorable income-tax treatment available for insurance proceeds may be jeopardized if the policy is purchased unless the new trust and the insured are considered the same taxpayer for income tax purposes.
Can I modify an “irrevocable” trust? If all else fails, an irrevocable trust may be modified (i.e., reformed) by the court. If there is some change of circumstances undermining the trust’s purpose, the court may reform the terms of the trust to protect that purpose and effectuate the intent of the settlor (i.e., the person who created the trust). For example, if you directed your irrevocable trust to give money to a certain charity that no longer exists, the court may modify the terms of the trust to distribute the money to a similar charity. Reformations may also be granted if there has been a change in the tax law resulting in a tax liability that the settlor intended to avoid. Unfortunately, asking the court to reform an irrevocable trust is time-consuming and may become expensive, especially if some of the beneficiaries of the trust are minors, in which case the court may require a representative (a “guardian ad litem”) be appointed on their behalf.
Needless to say, making changes to an irrevocable Trust isn’t easy. The advice of an estate planning attorney and an insurance advisor is highly recommended to navigate the waters when pursuing any of these options. The good news is you have options.
Jennifer Civitella Hilario is an associate with Tarlow, Breed, Hart & Rodgers, P.C., a Boston law firm, and concentrates her practice in the areas of estate and tax planning for family-owned businesses.