THOUGHT PAPER

When the
irrevocable
trust no
longer fits.
What to do when the irrevocable trust doesn’t fit anymore.
A WealthCounsel Institute Thought Paper
Matthew T. McClintock, J.D.
Vice President, Education
The WealthCounsel Companies

The uncertainty of the pre-ATRA transfer tax system motivated many clients
with higher net worth to implement sophisticated, multi-layered estate
planning strategies. Driven by a desire to remove the value of appreciated (or
appreciating) assets out of their gross estates, many strategies incorporated
different types of irrevocable trusts that were designed to be completed gifts
for gift and estate tax purposes.

With ATRA came the combination of permanent, $5 million inflation-indexing

estate tax exemptions and DSUE Amount portability for surviving spouses,
obviating estate tax-driven strategies for all but a miniscule percentage of the
U.S. population. But higher marginal income tax rates, a higher capital gains
tax rate, and the collection of surtaxes that washed in the Affordable Care Act
has put income tax-driven strategies closer to the top of the list for most
clients. Moreover, while the pain of transfer tax was on a distant horizon, the
pain of income tax is acute and immediate as clients see that their income
doesn’t stretch as far as it used to.

The shifted focus from transfer tax to income tax can be particularly vexing in
the context of a client’s irrevocable trust strategy. Whether the trusts were
initially designed as irrevocable, or whether the trust has become irrevocable
because of the settlor’s death, when circumstances change that impose new
adverse consequences – or when new opportunities emerge that can benefit
the client and her family – clients and their advisors need solutions to help
them restructure their irrevocable trusts for maximum benefit.

The purpose of this brief article is not to examine any particular approach at
great depth, but to familiarize the reader with various methods of modifying
irrevocable trusts when changed circumstances or more effective strategies
demand a revised strategy.

Procedural modification

Most states’ statutes provide a mechanism for procedural modification of an

irrevocable trust. While particulars vary somewhat among the states,
generally all parties to a trust must consent to a proposed modification. This
includes the settlor or trust maker, the trustee, and all present and remainder

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(and even remote contingent remainder) beneficiaries. When minor
beneficiaries are involved, state law will determine whether a guardian ad
litem must be appointed for the minors, or whether their parents can
represent them in the proposed modification action.

If all parties join in the proposed modification, then court action is generally
not required. This is also the case under the Uniform Trust Code.1

If the parties do not all consent, or if the trust maker is incapacitated or

deceased, then the parties who seek the modification must petition the court
for approval of the modification. Generally, a court will approve a modification
even if not all parties consent, if the interests of the parties who do not
consent to the modification are otherwise protected.

Importantly, unless the trust maker joins in the modification action, the
proposed modification cannot defeat a material purpose of the trust. This
means that, if one of the material purposes of the trust was to remove the
value of appreciated assets from the trust maker’s estate, or to provide GSTT
exempt transfer by keeping assets out of subsequent beneficiaries’ estates,
then a modification action in which the trust maker is unavailable will not
likely be able to trigger estate inclusion for basis management purposes.

Decanting

Another mechanism for changing terms governing an irrevocable trust

includes the concept of trust “decanting.” Much has been written on the
subject and an increasing number of states are looking at adding decanting
statutes. But few attorneys – let alone other professionals – understand what
decanting entails.

Trust decanting occurs when the trustee of an irrevocable trust exercises his
or her discretion in making distributions for the benefit of a beneficiary and,
rather than distribute the property from the trust outright, the trustee
distributes property in further trust. The origins of decanting stem from the
position that if the trustee may distribute property outright – in fee simple –
to a beneficiary, then the trustee may distribute property in less than fee
simple, by creating a new trust to manage the distributed property.

The trustee’s power to decant may arise from a state’s case law, from statute,
or within the governing trust instrument. Case law has generally followed a

                                                                                                                       
1
See Model U.T.C. §§410-418, available for review at
http://www.uniformlaws.org/shared/docs/trust_code/UTC_Final_rev2014.pdf

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Restatement Second2 approach, finding that the trustee’s power to decant is
analogous to a special power of appointment.3 More recent cases – and
statutes, including those modeled after the Uniform Trust Code – follow a
Restatement Third4 approach that tends to find the trustee’s power to decant
as rooted in the trustee’s discretionary distribution power.5

A growing number of states have enacted decanting statutes that give the
trustee clear authority where case law is silent. While there are nuances and
exceptions, decanting under state law generally requires:

• Decanting should be done by a trustee who has no financial or

beneficial interest in the trust. Otherwise the trustee’s decanting power
may constitute a taxable gift or trigger estate inclusion;
• Decanting cannot add new beneficiaries who were not contemplated by
the original trust maker;
• The trustee cannot accelerate a future interest to a present interest6;
• If the original trust has a fixed income, annuity, or unitrust amount the
trustee cannot defeat that right by decanting to a new trust that limits
those rights;
• Decanting cannot eliminate a beneficiary’s current vested right to
withdraw property;
• If the original trust qualified for a charitable or marital deduction, the
trustee may not decant in a manner that would not also qualify;
• The trustee cannot expand his or her discretionary powers over the
trust, and the trustee may not modify trustee compensation in a way
that would increase the decanting trustee’s compensation;
• Importantly, decanting may be used to modify or grant to beneficiaries
various powers of appointment.

This last note is of particular importance if it becomes advantageous to either

eliminate a power of appointment to keep an asset out of a beneficiary’s
gross estate, or to include it in the beneficiary’s gross estate for a basis
adjustment when the beneficiary dies.

                                                                                                                       
2
Restatement (Second) of Property: Donative Transfers §11.1
3
See Phipps v. Palm Beach Trust Co. (142 Fla. 782 (1940)); In re Estate of Spencer (232 N.W.
2d 491 (Iowa 1975)
4
Restatement (Third) of Property: Wills and Other Donative Transfers
5
See Wiedenmayer v. Johnson, 106 N.J. Super. 161 (1969) 254 A.2d 534; Morse v. Kraft, 466
Mass. 92 (2013)
6
South Dakota is the exception here.

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Of course, when a trust instrument or will gives the fiduciary the power to
decant as an express power, then the governing instrument will establish the
scope and limits of that power. One of the sophisticated options in
WealthCounsel’s WealthDocx® estate plan assembly system includes an
option to include a decanting power for the fiduciary.

The option shown above merges language drawn from a collection of case
law, statutes, and scholarly writings to provide a robust decanting power to
allow the trustee to establish a new trust for one or more beneficiaries, and
then to appoint property from the original trust into the newly-established
trust according to the new trust terms.

Decanting provides a better solution than procedural modification for a few

reasons. First, it doesn’t require the consent of anyone beyond the trustee. If
the trustee has considerable discretion in making distributions, then decanting
affords the trustee great flexibility in crafting effective terms of a new trust to
best manage the distribution for the benefit of the trust’s beneficiary. No
beneficiaries need consent to the decanting action.

Second, the scope of procedural modification is often more limited than

decanting. Unless the trust maker is living, has capacity, and joins in the
procedural modification action, then the modification cannot defeat a material
purpose of the trust. For trusts established with the clear purpose of keeping
assets out of beneficiaries’ estates for estate or GSTT purposes, a
modification action would not likely prevail to trigger estate inclusion for
basis planning purposes.

Third, procedural modification looks backwards as a reforming action for an

existing trust. By contrast, decanting looks ahead with proactive planning to

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better deal with changed circumstances or newly-emerged planning
opportunities. Modification seeks to reform a trust with unfavorable terms;
decanting establishes a new trust with more favorable terms and then
manages property distributed from the old trust to the new trust.

One last point on decanting – the Massachusetts court noted in Morse v. Kraft
that,

“…the principal draftsman of the…trust states in his affidavit that he

intended the broad distribution authority [of the trustee] to allow the
disinterested trustee to distribute the income and principal of the trust
to another trust for the benefit of the beneficiaries.”

This begs the question, “Why didn’t the drafting attorney just include an
explicit power?” Why leave enough ambiguity in the document to require the
matter to go to a court for determination? The attorney could have helped
the client avoid significant trouble and expense by including an explicit
decanting power.

An excerpt of the WealthDocx® decanting power follows:

Whenever an Independent Trustee may distribute assets to or for the benefit

of a beneficiary, our Trustee may appoint the property subject to our Trustee’s
power of distribution in trust for the benefit of one or more beneficiaries of any
trust created under this instrument under the terms established by the
Independent Trustee. Any trust established by the Independent Trustee and
funded by the exercise of the power granted under this Section must meet
these requirements…7

The IRS has not provided much guidance on the tax implications of decanting
beyond highlighting a series of decanting-related issues that may trigger tax
liability.8 A deep examination of those issues goes beyond the scope of this
article, but attorneys and advisors must consider potential income, gift,
estate, and GST tax implications of trust decanting.

Trust protectors

Trust protectors have increased dramatically in popularity over the past

decade or so. Originally found in offshore asset protection trusts, the concept

                                                                                                                       
7
In the interests of brevity this is a brief excerpt of the WealthDocx® decanting language. The
language continues with various instructions and savings language modeled after many
statutory models and scholarly writings on the subject of decanting.
8
See Internal Revenue Service Notice 2011-101

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of a “protector” – or a special power holder – has introduced a great deal of
flexibility in irrevocable trust planning.

The popularity of the use of trust protectors is reflected in the growing body
of statutory recognition, now extending to several states with trust protector
statutes on the books. Statutory recognition is sure to grow in the years to
come as states consider adopting provisions form the Uniform Trust Code.
Section 808(b) of the UTC contemplates the role of the trust protector or
trust advisor as authorized third parties who may be empowered by a trust
settlor to hold and exercise certain powers.9

Though statutory law is growing, there is little case law as yet to guide
practitioners through some of the more challenging issues concerning trust
protectors. Moreover, scholars disagree – sometimes stringently – on the
propriety of using trust protectors beyond the offshore asset protection trust
model.

WealthDocx® includes extensive trust protector drafting provisions to help

attorneys consider and appropriately draft protector provisions in various
estate planning documents.

The majority of disagreement among scholars arises in the context of the

trust protector’s capacity – whether the protector’s powers are held in a
                                                                                                                       
9
Specifically, a comment to UTC §808(b) states that subsections under that section “…ratify
the use of trust protectors and trust advisors.”

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fiduciary capacity, a nonfiduciary capacity, or a mix of some sort – and to
what extent the protector should be indemnified from consequences of
exercising or failing to exercise a power.

Significant questions indeed remain regarding the use and scope of trust
protectors, but there is little question that in the context of providing
flexibility in the administration of irrevocable trusts they are becoming a more
popular strategic tool, and one that attorneys must become increasingly
familiar with.

Attorneys and client advisors must be familiar with the various methods by
which a client’s now-irrevocable trust may be adapted to meet dynamic legal
and economic realities. Possibilities range from the quite limited (procedural
modification) to the robust and more complex (decanting) to the nearly
unlimited and leading edge (trust protectors). As attorneys and counselors
we must be prepared to help clients adapt their plans to maximize the
strategic and economic benefit they intend to pass to beneficiaries.
Opportunities arise in the context of trust and estate administration through
guiding fiduciaries and power holders through the exercise of their powers, as
well as in the context of proactive planning and drafting.

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