Irrevocable trusts can save physician families millions of dollars in estate taxes. But many avoid them because these trusts can be very inflexible. Now, new "decanting" laws in some states allow modifications to trusts when family circumstances change.
An irrevocable trust can potentially save physicians’ families millions of dollars in estate and gift taxes. Because an irrevocable trust is not considered part of the estate, the trust assets will be exempt from federal and state estate taxes.
Under current law, the person who established the trust, or the “settlor,” would pay federal gift tax on any amount contributed to an irrevocable trust above $1 million, says Shomari Hearn, CFP, EA, and client service manager for Palisades Hudson Financial Group, a financial-planning firm in Scarsdale, N.Y. So a physician, and his or her spouse, each can give $1 million to the trust tax-free.
But the trust is called “irrevocable” for a reason: Once it’s set up, the settlor relinquishes ownership and control of the assets, and the trust documents can’t be changed.
What if your family circumstances change, either before or after the settlor dies, and you want to modify the terms of the trust? Fortunately, there are ways to fix an irrevocable trust that’s “broken,” says Hearn.
Suppose, for example, your late sister names you the trustee of her irrevocable trust and names your nephew Bob as beneficiary. What if Bob becomes addicted to drugs or gambling -- or gets entangled in a bitter divorce?
“You’d probably want to withhold distributions to Bob until the problem has been resolved, even though the trust document doesn’t grant you the authority,” Hearn says. Ditto if Bob becomes permanently disabled, since you might want to transfer the trust assets into a “supplemental needs trust” so that he could qualify for government health-care benefits.
Decanting Allowed in Ten States
If the irrevocable trust was established in one of the seven states that have “decanting” laws -- Alaska, Arizona, Delaware, Florida, New Hampshire, Nevada, New York, North Carolina, South Dakota and Tennessee -- you’re in a strong position to correct the problem.
Decanting statutes allow a trustee who has authority to make discretionary distributions to move all or part of the trust property to another trust after meeting certain requirements.
“It’s like pouring wine from an old bottle into a new one,” Hearn says. The new trust has provisions that respond to current needs.
State laws vary, but the process isn’t difficult. In New York, for example, the trustee must sign a document carrying out the decanting, file it in the court with jurisdiction over the trust and provide a signed copy to all interested persons. The trustee does not need court approval.
It’s wise to obtain the court’s blessing if the trustee is unsure of whether all decanting prerequisites have been satisfied, or is concerned about potential claims by beneficiaries for having exercised this power.
Uniform Trust Code Can Help
Twenty-three states have enacted some version of the Uniform Trust Code (UTC), which contains provisions for modifying irrevocable trusts. Under the UTC, if the change is consistent with the purpose of the trust, the modification can be made with consent of the beneficiaries and court approval, or by court decision alone. Trustees cannot modify trusts on their own.
In the remaining states, trustees may be able to decant using common law. Most trusts not only permit the trustee to make distributions to a beneficiary, but also to make distributions for the benefit of the beneficiary. Courts in various states have ruled that such authority also allows the trustee to transfer the trust assets to a new trust set up for the same beneficiary, effectively decanting the trust.
Before you make any changes to an irrevocable trust, consult with a knowledgeable estate-planning attorney or tax advisor about the potential tax ramifications, Hearn says. Trust decanting and trust modifications under the UTC may trigger unintended income, gift, estate and generation-skipping taxes.
People who are considering establishing an irrevocable trust should consider incorporating decanting or modification provisions -- and perhaps establishing the trust in one of the seven states with decanting laws. Make the trust provisions specific, however, so the trustee cannot rewrite the terms, Hearn advises.