A Guide to Wills, Estate, Trust and Guardianship Litigation
VII. Modifying Irrevocable Trusts
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:
- The beneficiaries of the second trust may include only beneficiaries of the original trust. However, the second trust does not necessarily need to include all beneficiaries of the original trust.
- A beneficiary who has only a future beneficial interest cannot have that interest accelerated in the second trust.
- If a beneficiary has any fixed income, annuity, or unitrust interest, the second trust must retain and not reduce those interests.
- If contributions to the original trust qualified for certain deductions or treatment for federal tax purposes, then the contributions must continue to qualify under the terms of the second trust for that same treatment.
- If any beneficiary has a power of withdrawal over trust property, then the second trust must either give the beneficiary the same right or the original trust must hold sufficient trust property to satisfy the withdrawal right.
- If a beneficiary is entitled to discretionary distributions subject to an ascertainable standard (i.e, health, education, maintenance or support) then the second trust must continue to provide discretionary distributions for this purpose to the same current beneficiary. G.S. §36C-8-816.1(c).
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.
Modification or Termination by Consent or Judicial Action
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.
A noncharitable irrevocable trust may be modified or terminated without court approval if the settlor and all beneficiaries consent. G.S. §36C-4-411(a). If consent is obtained, the modification may be compelled over the objection of the trustee and even if the action is inconsistent with a material purpose of the trust. A settlor’s power to consent to a trust’s modification or termination may be exercised under certain circumstances by the settlor’s attorney-in-fact or court appointed guardian. This is the only available method to modify or terminate an irrevocable trust without court approval.
In many cases, a settlor will not wish to participate in the modification or termination of a trust because of potentially negative wealth transfer tax consequences. See Example 7, Treas. Reg. §26.2601-1(b)(4)(i)(E); PLR 200917004. In such cases, G.S. §36C-4-411(b) provides that a noncharitable irrevocable trust may be modified upon consent of all of the beneficiaries if the court concludes that modification is consistent with a material purpose of the trust. Likewise, a noncharitable irrevocable trust can be terminated upon consent of all of the beneficiaries if the court concludes that continuance of the trust is not necessary to achieve any material purpose of the trust. Id. Accordingly, the beneficiaries have the right to compel a modification over the objection of a trustee if the court concludes that the action will not impede a material purpose of the trust.
Pursuant to G.S. §36C-4-411(c), a court may still authorize the modification or termination of a trust even if the court finds that the trust is necessary to carry out the purpose of the trust or where the modification is inconsistent with a material purpose of the trust if the court determines that the reason for modifying or terminating the trust under the circumstances substantially outweighs the interest in accomplishing a material purpose of the trust. Accordingly, if all beneficiaries consent, a court may engage in a balancing test to determine if the modification or termination is appropriate under the circumstances.
If all of the beneficiaries do not consent to the modification or termination, G.S. §36C-4-411(d) provides that the court may approve the modification or termination if (i) all of the beneficiaries had consented, the trust could have been modified or terminated under G.S. §36C-4-411 and (ii) the interests of a beneficiary who does not consent will be “adequately protected.” A court, therefore, has substantial leeway in determining whether a modification or termination is appropriate, particularly given the subjective determination of whether a beneficiary’s interest is adequately protected.
S. §36C-4-412(a) provides a court may modify the administrative or dispositive terms of a trust or terminate the trust if, because of circumstances not anticipated by the settlor, modification or termination will further the purposes of the trust. In such cases, to the extent practicable, the modification must be made in accordance with the settlor’s probable intention.
S. §36C-4-412(b) provides a court may modify the administrative or dispositive terms of a trust if continuation of the trust on its existing terms would be impracticable or wasteful or impair the trust’s administration. Notably, this provision only permits a modification of the trust.
S. §36C-4-414 permits a trustee to terminate a trust without court approval if the trust has a total value of less than $50,000 and the trustee concludes that the value of the trust property is insufficient to justify the costs of administration. No consent of the beneficiaries is required. A trustee may seek judicial approval of a termination of an uneconomic trust. Upon termination, the trust assets are required to be distributed in a manner consistent with the purposes of the trust.
G.S. §36C-4-415 permits a court to reform the terms of a trust, even if unambiguous, to conform the terms of the trust to the settlor’s intention if it is proved by clear and convincing evidence that both the settlor’s intent and the terms of the trust were affected by a mistake of fact or law, whether in expression or inducement.
G.S. §36C-4-416 provides that a court may modify the terms of a trust in a manner that is not contrary to the settlor’s probable intention to achieve the settlor’s tax objectives. In doing so, the court may provide that the modification has retroactive effect.
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.