A Guide to Wills, Estate, Trust and Guardianship Litigation

Irrevocable trusts, despite their label, are not always rigid arrangements incapable of change.  To the contrary, a variety of methods exist to address desired changes to the actual terms or function of an irrevocable trust. Many irrevocable trusts have provisions which their function to be substantially altered by the addition or removal of trustees, the exercise of a power of appointment or power of withdrawal, or through the amendment of the trust’s administrative terms. Such changes can often be made without any technical alteration to the terms of the trust, generally by the exercise of certain powers by persons enumerated in the trust. In other cases, however, a trust term is no longer favorable or the term would defeat the material purpose of the trust and no power holder exists that could affect a change to the trust term. In those cases, a trust may be modified or decanted under certain circumstances even over the objection of the settlor or beneficiaries.

In many cases the function of a trust may be significantly altered without an actual modification or decanting action. This is possible when the terms of the trust provide a method for altering the trust. For example, a settlor that has no right to distributions from a trust may have retained substantial rights and powers that permit the settlor to greatly change the operation of the trust. A settlor may have retained a power of appointment, a power to remove and replace trustees, or even the power to veto distributions or investment decisions. Many of these powers are adverse to favorable wealth transfer tax treatment if retained by the settlor. Accordingly, a trust will generally provide for a third party “power holder” and grant that individual one or more powers over the trust in a capacity other than as trustee. In some situation a power holder may be able to effect a change to the terms of the trust without resort to other methods for modification of the trust discussed below.

Many trusts lack the incorporation of a comprehensive power holder capable of addressing substantive concerns regarding the terms of a trust or the power holder may simply refuse to exercise the power. In such cases, a trustee may believe that the amendment of a trust provision is appropriate and furthers the interests of the beneficiaries. For example, a trustee may seek to prohibit a required distribution to a spendthrift beneficiary or a beneficiary suffering from substance abuse. Alternatively, a trustee may wish to amend an administrative term of a trust to create tax savings.

At common law, it was argued that a trustee’s discretionary power to distribute trust property to or for the benefit of a beneficiary necessarily included the power to appoint the trust property to a second trust for the benefit of a beneficiary subject to different terms. The uncertainty surrounding the ability of a trustee to exercise this special power of appointment – more commonly called “decanting” – caused many states to adopt laws expressly granting a trustee broad decanting powers under certain conditions.

In North Carolina, G.S. §36C-8-816.1 provides a trustee with the express power to appoint trust property to a second trust. A trustee may, without authorization by a court, exercise the trustee’s discretionary power to distribute principal or income to or for the benefit of one or more current beneficiaries of the original trust by appointing all or part of the principal or income of the original trust subject to the power in favor of a trustee of a second trust. G.S. §36C-8-816.1. The trustee can exercise the power whether or not there is a current need to distribute principal or income under any standard provided in the terms of the original trust. Importantly, this power also includes the power to create the second trust. Id.

The second trust must comply with a series of mandatory rules unless the original trust instrument expressly alters those rules. These include the following:

Despite a prohibition against adding new beneficiaries to the second trust, North Carolina’s decanting statute provides a method to at least indirectly do so. G.S. §36C-8-816.1(8) provides that a “second trust may confer a power of appointment upon a beneficiary of the original trust to whom or for the benefit of whom the trustee has the power to distribute principal or income of the original trust.” Significantly, the “permissible appointees of the power of appointment conferred upon a beneficiary may include persons who are not beneficiaries of the original or second trust.”

The procedure for decanting trust assets is expressly set forth in the statute. G.S. §36C-8-816.1(f). A trustee who is a beneficiary of the original trust cannot exercise the decanting power. A disinterested trustee may exercise the decanting power by appointing the property by an instrument in writing that is signed and acknowledged by the trustee, setting forth the manner of the exercise of the power, including the terms of the second trust and the effective date of the exercise of the power. The trustee must give written notice, which includes the written instrument exercising the power, to all qualified beneficiaries of the original trust at least 60 days prior to the effective date of the exercise of the power to appoint of the trustee’s intention to exercise the power. All qualified beneficiaries can waive the notice period by a signed written instrument delivered to the trustee, which entitles the trustee to exercise the power earlier than the end of the 60 day period. The trustee’s notice cannot limit the right of a beneficiary to object to the exercise of the trustee’s power to appoint and bring an action for breach of trust. A trustee or beneficiary may commence a proceeding to approve or disapprove a proposed exercise of the trustee’s special power to appoint to a second trust.

Decanting can be a useful tool to, in effect, modify an irrevocable trust in appropriate circumstances, particularly if all beneficiaries consent to the change. There are, however, significant pitfalls that should be considered. First, a trustee exercises the power in a fiduciary capacity. Changing beneficial interests in the trust should not be considered lightly as a trustee could be held liable to a disgruntled beneficiary. Second, the tax implications of decanting a trust are not clear. While many have argued that the second trust should be treated as a modification of the original trust, the Internal Revenue Service has not issued official guidance to date. Consequently, practitioners are concerned that the exercise of the decanting power could result in negative income or wealth transfer tax results in certain circumstances.

If a trust lacks a designated power holder willing and able to effect a necessary change and decanting is not available or advisable, a trustee or beneficiary is not without options. The terms of a trust may still be modified for any one of several statutory reasons.

Any action to modify, terminate or decant a trust is properly brought as a civil action in superior court. A trustee or beneficiary may bring an action to modify or terminate a trust under G.S. §36C-4-411 through §36C-4-416. A settlor may bring an action to modify or terminate a trust under G.S. §36C-4-411 or §36C-4-413. A trustee is a necessary party to the action. The North Carolina Rules of Civil Procedure govern the procedural aspects of such proceedings subject to notable exceptions with respect to venue and the virtual representation of certain trust beneficiaries. See G.S. §36C-2-201, et. seq. Significantly, Article 3 of the NCUTC governs the representation of incompetent, minor, unascertainable, unborn or non-locatable beneficiaries. A guardian ad litem is not required except in circumstances where a qualified party seeking to represent another party using virtual representation has a conflict of interest.