Modifying Irrevocable Trusts: Proceed, But With Caution
Editors' Note: The version of this article that appeared in the print edition on Sept. 16 was inadvertently truncated during the editorial process. It appears in its entirety below, or on Page 7 of the Sept. 17 Law Journal.
Hindsight may reveal that an irrevocable trust is "defective" in some key aspect. This "error" may have been caused by negligence or inadvertence or may be attributable to an intervening change in circumstances or in the governing legal and tax principles, any of which may result in adverse economic and tax consequences to the beneficiaries under the trust, which is now irrevocable.
The common law, in relatively exceptional circumstances, provides only limited relief to cure these problems in the form of a bill in equity for reformation. The New York legislature has seen fit to provide broader statutory avenues of relief. In 2011, the legislature greatly expanded the reach of EPTL §10-6.6. This legislative action has provided fresh and significant impetus to utilize this statutory enactment and engage in a process commonly referred to as "decanting."
While this legislation has undoubtedly beneficial remedial aspects, estate planners, in "decanting" an irrevocable trust, must carefully weigh and evaluate the dangers and risks incident to "decanting." It is the purpose of this article to provide some cautionary notes relating to this mode of modifying an irrevocable trust.
Unlimited vs. Limited Discretion
The statute authorizes the trustees of an irrevocable trust to amend an irrevocable inter-vivos trust (by appointing some or all of the assets to another trust) without the consent of the creator of the trust or of any interested persons and without prior court approval.1 To achieve this objective, the trustees must have the discretion to invade principal for the benefit of one or more persons. If this discretion is unlimited, the trustees can change the trust so as to exclude all but one of the current or remainder beneficiaries.2 If the trustees do not have unlimited discretion, the trust may be changed by the trustees but they cannot change the beneficial takers.3
The statute, despite its recent amendment in 2011, still offers relatively little guidance in differentiating between "limited" and "unlimited" discretion. It merely provides that "unlimited" discretion means "the unlimited right to distribute principal that is not modified in any manner." It then proceeds to state that words such as "best interests, welfare, comfort, or happiness" are not considered limitations or modifications of the right to distribute principal.4
Prior to its amendment in 2011, the statute conferred the power to amend upon a trustee who had the "absolute discretion" to invade principal. In Estate of Mayer,5 decided under the pre-2011 version of the statute, the court held that even though the trustee had "sole and absolute" discretion to distribute principal for the health, support, maintenance and education of certain persons, this was not an "absolute power." In reaching this conclusion, the court rejected an argument, by analogy, to tax law.6 To this writer, it is unclear whether the term "unlimited discretion" was intended to differ from "absolute discretion." In any event, in drafting a trust intended to be eligible for decanting, the draftsperson should avoid sending mixed and inconsistent signals with respect to the scope of the trustee's discretion.
Selection of Trustee
In view of the significant power conferred upon the trustees to modify a trust, greater care must now be taken in the selection of trustees. While traditionally a settlor chose a trustee upon the basis of the candidate for trusteeship having intelligence, loyalty, good judgment (especially in instances where the trustees have the power to invade principal), and possibly having investment acumen (or at least the ability to engage and monitor competent investment advisors), this legislation creates a new, important trustee characteristic—the capacity of the trustee to prudently change the trust. Under the statute, the trustee does have a fiduciary duty to exercise the power in the best interest of "one or more proper objects of the exercise of the power" and must act prudently.7 Will the candidates for trusteeship exercise their power to amend prudently, if at all, and will they respond to a "suggestion" by the settlor as to the kind of change to be effectuated? Under the statute, the trustee apparently has no duty to modify even if modification is needed to avoid substantial harm.8 This position should be contrasted with Restatement of Trusts, 3rd, §66 which states that a trustee, who knows or should know of substantial harm that may otherwise ensue, has the duty to seek judicial approval for modification of at least an administrative provision of the trust.
Another factor to be weighted in evaluating a candidate for a trusteeship is the ability of the candidate to engage in intelligent estate planning. The statute provides that an "authorized trustee shall consider the tax implications of the exercise of the power."9 Assume that O creates an irrevocable trust pursuant to the terms of which the income is to be paid to O's son, S, for life, and upon S's death, the trust is to continue for S's descendants. The trustee has the unlimited power to distribute principal to S. Since S only has a life interest, the trust corpus would ordinarily not be includible in S's estate for federal estate tax purposes.10 On the other hand, the transfer of the economic benefits of the trust at S's death to S's descendants may trigger a generation-skipping tax.11 If S does not have significant assets of his own, it may be in the overall best interests of the S family for the trustee to exercise the decanting power and grant a general testamentary power of appointment to S, which the trustee may do under the statute.12 While the corpus may now be includible in S's estate for estate tax purposes,13 there may be a savings in generation-skipping taxes. The existence of a general power of appointment in S at S's death results in S being treated as the transferor for generation-skipping purposes and thus there is no generation-skipping event when beneficial enjoyment passes, for example, from S to S's son (who is only one generation below S, the transferor).14 The savings in generation-skipping tax may outweigh any cost incident to the includibility of the corpus in S's estate for estate tax purposes. Indeed, the Surrogate's Court Advisory Committee has noted that in such circumstances, this would be an appropriate exercise of the decanting power.15
On a more basic level, the selection of the trustee is relevant to the applicability of the statute. The statute applies to a trust which has a trustee who is an individual domiciled in New York or a corporate trustee having an office in New York, provided that a majority of the trustees select New York as the situs of the primary administration of the trust. The statute is also applicable to a trust which is governed by the laws of New York.16
Protection of Trustee
From the perspective of the trustee, the trustee should not be lulled into a false sense of security because of the ease and simplicity with which the power can be exercised. It can be exercised without the consent of the settlor or of the beneficiaries and without court approval17 and becomes effective 30 days after the amendment is served upon the settlor and the beneficiaries.18 The failure of a beneficiary to object to the exercise of the power does not constitute consent and does not foreclose the beneficiary from objecting to an account or compelling a trustee to account.19 If a trustee is concerned about whether the exercise of the power is consistent with the trustee's fiduciary obligations, the trustee is authorized to seek court approval of the exercise.20
Protecting the Settlor's Wishes
In planning a trust which might otherwise qualify for "decanting," the attorney should discuss with the client whether there are some aspects of the trust which should be beyond the reach of the trustee's power to amend. For example, a settlor may not want a particular beneficiary to be excluded by an amendment or a successor trustee to be changed. By clear and explicit language in the instrument, the trustee's power to modify can be circumscribed. A trustee cannot amend the trust if there is "substantial evidence" of a contrary intent of the settlor of the trust consisting of an express provision in the trust expressly prohibiting the exercise of the power in the manner intended by the trustee.21
Care must be taken in relationship to the tax consequences of a modification of the trust. A modification that "jeopardizes" a tax benefit otherwise available is ineffective.22 For example, estate planners must proceed with caution in modifying pre-Sept. 25, 1985 trusts that are exempt from generation-skipping taxation23 and would want to make sure that the modifications comply with the Safe Harbor Provisions of Reg. §26.2601-1(b)(4). While the statute provides that the exercise of a power to amend which jeopardizes a tax benefit is ineffective, and thus, in essence, is arguably a savings clause which prevents the loss of this tax benefit, the trustees and beneficiaries are left with the uncertainty of not knowing whether the tax benefit will be "jeopardized" until this matter is resolved. The need for a determination of the tax consequences by an appropriate authority may possibly result in a disruption of the administration of the trust and significant costs. Furthermore, the statute does not set forth the quantum of proof needed to show that a tax benefit is in jeopardy. Is it to be equated with a reasonable risk of a loss of the tax benefit or an appreciable risk of a loss of the tax benefit? Does it require proof, by a fair preponderance of the evidence, that the tax benefit will be lost? In addition, a resolution of the issue in a state court proceeding may not be dispositive of the ultimate federal tax issue. What happens if the trustee implements an amendment that is later determined to result in a loss of a tax benefit? This may open the door to a challenge of the validity of the amendment and a possible unwinding of transactions of the trust that were made after the amendment, which may necessitate the filing of amended tax returns. In light of these circumstances, a prudent trustee who has concerns about the tax consequences would be well advised to seek a tax ruling prior to implementing any amendment of the trust.
From an income tax perspective, the 2011 Report of the Surrogate's Court Advisory Committee does contain a puzzling comment.24 It states that even though grantor trust status may, in some instances, be a tax benefit, "an authorized trustee may exercise the power and change the trust from a grantor trust to a non-grantor trust." Grantor trust status may, indeed, be a tax benefit. For example, grantor trust status may have been sought by the settlor in order to facilitate a corporation in which the trust is a shareholder qualifying for Subchapter S's favorable tax treatment.25 I see no reason for distinguishing between this tax benefit and other tax benefits such as the annual exclusion, marital deduction and charitable deduction which the statute specifically treats as tax benefits which may not be jeopardized.26
Consider Other Alternatives
The glamor and allure of the "decanting" process should not blind the planner to the possibility of utilizing other techniques for amending an irrevocable trust, including (while the settlor is alive), EPTL §7-1.9, which authorizes even broader changes than the decanting statute and without the need for trustee action or for giving the trustee the power to invade principal. EPTL §7-1.9 authorizes modification of the trust if the settlor and all beneficiaries consent. The New York courts have interpreted this statute in a liberal fashion and have, in some instances, ameliorated the problem of obtaining the consent of all of the beneficiaries. For example, assume that O creates an irrevocable trust in favor of his child, C-1, for life, and then upon C-1's death, the property is to be held in trust for C-1's descendants. When O seeks to modify the trust, no children have been born to C-1. In these circumstances, the Court of Appeals has sanctioned O's modification of the trust with C-1's consent even though the unborn and unascertained class of issue or descendants did not consent.27 On the other hand, the situation would be more problematic if C-1 had given birth to some children since their consent would be required. It should be noted that while EPTL §10-6.6 contains liberal virtual representation provisions,28 no such language appears in EPTL §7-1.9. The hurdle of obtaining the consent of all of the beneficiaries may also be overcome to the extent that the alternative holding of Matter of Cord29 may be relied upon. Under this alternative holding, beneficiaries are presumed to consent to changes which benefit them.30 The estate planner should give careful consideration to the possible use of EPTL §7-1.9 as an alternative to decanting if the settlor is still living and the consent of the settlor and all of the beneficiaries can be obtained.
William Schwartz is counsel to Cadwalader, Wickersham & Taft; University Professor of Law, Cardozo Law School; and former Dean, Boston University School of Law.
1. EPTL §10-6.6(j)(1).
2. EPTL §10-6.6(b). Assembly Bill 7061, which has passed both Houses of the Legislature but not sent to the Governor as of the date of the writing of this article, authorizes the elimination of all remainder beneficiaries.