FIXING TRUSTS: TECHNIQUES TO ALTER A TRUST WHEN CIRCUMSTANCES HAVE CHANGED

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1 FIXING TRUSTS: TECHNIQUES TO ALTER A TRUST WHEN CIRCUMSTANCES HAVE CHANGED First Run Broadcast: January 22, 2014 Live Replay: April 24, :00 p.m. E.T./12:00 p.m. C.T./11:00 a.m. M.T./10:00 a.m. P.T. (60 minutes) Trusts are meant to endure, but shifting circumstances can take a substantial toll on their assets, their tax and legal status, their ability to make distributions or even survive. The law may change in ways that adversely impact a trust. Beneficiaries may develop intractable conflicts that jeopardize the trust s stability. Assets may underperform and the cost of administering a trust may make it uneconomical. In certain instances, too, trusts may just no longer have a purpose. In these and other circumstances, trustees, beneficiaries and their advisers struggle to find ways to reform or recast trusts to make them viable again or to dissolve them and distribute their assets. This program will provide you with a practical guide to the circumstances giving rise to trust reformation and practical techniques for fixing broken trusts. Effective techniques for reforming or fixing trusts Circumstances giving rise to trust reformation asset underperformance, beneficiaries conflicts, changes in law, trusts that no longer have purpose Principal and income adjustment powers under the UPIA Conversions of trusts from one type to another Use of decanting to distribute trust assets of broken trusts Agreement of parties or court order Special tax considerations and pitfalls Speaker: Benjamin S. Candland is an attorney in the Richmond, Virginia office of McGuireWoods, LLP, where his practice focuses on estate planning, administration, estate and gift taxation, and litigation. He provides individual clients with advice on various estate planning matters involving estate, gift, and generation-skipping transfer taxes. He is a member of the ABA Real Property and Probate Section and the Virginia Bar Association Trusts and Estate Section. Mr. Candland received his B.A. from Brigham Young University and his J.D. from the College of William and Mary School of Law.

2 PROFESSIONAL EDUCATION BROADCAST NETWORK Speaker Contact Information FIXING TRUSTS: TECHNIQUES TO ALTER A TRUST WHEN CIRCUMSTANCES HAVE CHANGED Benjamin S. Candland McGuireWoods LLP Richmond, Virginia (o) (804) bcandland@mcguirewoods.com Justin Trent McGuireWoods, LLP Richmond (804) jtrent@mcguirewoods.com

3 VT Bar Association Continuing Legal Education Registration Form Please complete all of the requested information, print this application, and fax with credit info or mail it with payment to: Vermont Bar Association, PO Box 100, Montpelier, VT Fax: (802) PLEASE USE ONE REGISTRATION FORM PER PERSON. First Name Middle Initial Last Name Firm/Organization Address City State ZIP Code Phone # Fax # Address Fixing Trusts: Techniques to Alter a Trust When Circumstances Have Changed Teleseminar April 24, :00PM 2:00PM 1.0 MCLE GENERAL CREDITS VBA Members $75 Non-VBA Members $115 NO REFUNDS AFTER April 17, 2014 PAYMENT METHOD: Check enclosed (made payable to Vermont Bar Association) Amount: Credit Card (American Express, Discover, Visa or Mastercard) Credit Card # Exp. Date Cardholder:

4 Vermont Bar Association CERTIFICATE OF ATTENDANCE Please note: This form is for your records in the event you are audited Sponsor: Vermont Bar Association Date: April 24, 2014 Seminar Title: Location: Credits: Fixing Trusts: Techniques to Alter a Trust When Circumstances Have Changed Teleseminar 1.0 MCLE General Credit Luncheon addresses, business meetings, receptions are not to be included in the computation of credit. This form denotes full attendance. If you arrive late or leave prior to the program ending time, it is your responsibility to adjust CLE hours accordingly.

5 Repairing the Broken Trust: Modifying, Restructuring and Terminating Irrevocable Trusts Benjamin S. Candland McGuireWoods, LLP Richmond, Virginia I. Why Trusts Become Broken A. Changing Circumstances 1. Long-Term Trusts. Trusts are often designed to span multiple generations. Such trusts, sometimes referred to as dynasty trusts, allow a settlor to make effective use of his or her generationskipping transfer tax exemption. However, it is common for circumstances to arise that could not have been foreseen decades earlier when the trust document was drafted. Such circumstances could frustrate the purposes of the trust by producing results the settlor never intended. 2. Uneconomical Trusts. A long-term trust might be established with a relatively modest amount of money. As a result of a declining market, poor investments, or excessive invasions of principal, the corpus of a trust could be depleted. Sometimes the cost of administering such a trust may render the trust uneconomical. 3. Trust Purpose No Longer Exists. It is possible that the underlying purpose for which the trust was created no longer exists or has already been accomplished. If the trust document does not provide a trustee with the ability to modify or terminate the trust, the trustee must look to Virginia law for relief. B. Beneficiaries with Conflicting Interests 1. Step-Parent vs. Step-Children. Those who regularly administer trusts probably know that the relationship between a step-parent and step-children can be difficult especially when money is involved. Because the interests of such parties may not align, the trustee is placed in a very difficult position. 2. Income Beneficiaries vs. Remainder Beneficiaries. A common scenario is when a marital trust is set up for the surviving spouse with the remainder of the trust assets passing to the children at the death of the surviving spouse. In such cases, it is in the best 1

6 interests of the surviving spouse for the investments to be heavily invested in income-producing assets. Conversely, it is in the best interests of the remainder beneficiaries for the assets to be invested in assets that will grow. As a result, the trustee is placed in the nearly impossible position of trying to balance such interests. 3. Different Family Lines. A trust may be set-up as a pot trust for a settlor s children and their descendants. Perhaps one child has a descendant that has a medical condition that requires a substantial portion of the trust principal. The result might be that the trust principal is depleted to the detriment of the other family lines. C. The Trustee s Duty 1. The Duty of Impartiality. As stated above, balancing the interests of beneficiaries can be very difficult, if not impossible. Despite this difficulty, the trustee has a duty to be impartial and to treat all beneficiaries fairly. UTC The Restatement (Third) of Trusts. The interests of a life income beneficiary, for example, are almost inherently in competition with those of the remainder beneficiaries, especially in light of the risks of inflation; and the different tax circumstances of the various beneficiaries frequently create competing investment preferences. Restatement (Third) of Trusts 227, cmt. (c). D. Authority to Modify Trusts 1. The Uniform Trust Code. The Uniform Trust Code ( UTC ) was drafted by the National Conference of Commissioners on Uniform State Laws ( NCCUSL ). The UTC has been adopted by 26 states and the District of Columbia, and it was introduced in January 2014 in Kentucky. The UTC includes various provisions that provide parties with the flexibility to modify or terminate irrevocable trusts. See UTC 410 through The Uniform Principal and Income Act. The Uniform Principal and Income Act ( UPAIA ), originally drafted by NCCUSL, has been adopted in some form by every state except Illinois, Louisiana, Georgia, and Rhode Island (and some of those states contain statutes authorizing adjustments between principal and income). The UPAIA addresses issues related to principal and income allocations. The UPAIA also provides trustees with the tools to deal with difficult situations. 2

7 3. Powers Included in the Trust Document. The UTC and the UPAIA provide default rules, many of which may be overridden by the terms of the trust document. Attorneys should consider including provisions in the document to provide flexibility to address changing circumstances, while still ensuring that the objectives of the settlor are met. II. Modifying the Terms of an Irrevocable Trust A. Modification of Non-Material Terms 1. Generally. Interested parties may enter into a binding nonjudicial settlement agreement with respect to any matter involving a trust. Such agreements are valid so long as they do not violate a material purpose of the trust. Court approval is not necessary. UTC UTC Comment. This section facilitates the making of such agreements by giving them the same effect as if approved by the court. To achieve such certainty, however, subsection (c) requires that the nonjudicial settlement must contain terms and conditions that a court could properly approve. Under this section, a nonjudicial settlement cannot be used to produce a result not authorized by law, such as to terminate a trust in an impermissible manner. 3. Examples. There are a wide range of situations where a nonjudicial settlement agreement would be appropriate. Section 111 of the UTC provides six examples. Again, nonjudicial settlement agreements cannot be used to violate a material purpose of the trust. (a) (b) (c) (d) The interpretation or construction of the terms of the trust; The approval of a trustee s report or accounting; Direction to a trustee to refrain from performing a particular act or the grant to a trustee of any necessary or desirable power; The resignation or appointment of a trustee and the determination of a trustee s compensation; 3

8 (e) (f) Transfer of a trust s principal place of administration; and Liability of a trustee for an action relating to the trust. B. Modification of Material Terms 1. With the Consent of Settlor and All Beneficiaries. If the settlor and all beneficiaries agree to the modification or termination of a trust, the court shall approve the modification or termination even if the modification or termination is inconsistent with a material purpose of the trust. UTC 411(a). See also Cal Prob Code 15404(a); NY EPTL With the Consent of All Beneficiaries. A court may modify a trust upon the consent of all the beneficiaries if the court concludes that modification is not inconsistent with a material purpose of the trust. UTC 411(b). See also Cal Prob Code Without the Consent of All Beneficiaries. A court may modify a trust even if all beneficiaries do not consent if the court finds that it has the authority to do so (i.e., no material purpose will be violated) and if the the interests of a beneficiary who does not consent will be adequately protected. UTC 411(e). See also Cal Prob Code 15404(b). 4. To Further the Purposes of the Trust. A court may modify a trust if because of circumstances not anticipated by the settlor, modification will further the purposes of the trust. UTC 412. See also Cal Prob Code Correcting Mistakes. A court may reform the terms of a trust, even if unambiguous, to conform the terms 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 law or fact. UTC Tax Objectives. To achieve the settlor s tax objectives, the court may modify the terms of a trust in a manner that is not contrary to the settlor s probable intention. UTC Special Rules for Charitable Trusts Cy Pres. (a) If the charitable purpose of a trust becomes unlawful, impracticable, impossible to achieve, or 4

9 wasteful, a court may order that the trust be modified or terminated. UTC 413. See also NY EPTL 8-1.1(c). (b) In some states, it is possible for the trustee to amend a charitable trust to conform with the requirements for exemption from federal taxes. See, e.g., Va. Code (trustee can amend with the consent of the settlor, if living, and the Virginia Attorney General). III. Dealing with Income/Principal Distribution Issues A. Generally. Sometimes a trust document may provide the trustee with the ability to distribute income, and not principal, to a beneficiary. Situations may arise when the income generated by the assets of the trust are not sufficient to meet the needs of the income beneficiary. Conversely, the trust assets may produce a large amount of income but have very little growth potential. The UPAIA provides options for trustees to deal with such issues. B. The Principal and Income Adjustment Power 1. Generally. If the assets of a trust produce too much or too little income for the income beneficiary, a trustee may opt to make an adjustment in the allocation of assets between income and principal. 2. Trustee s Power to Adjust. A fiduciary may adjust between principal and income to the extent the fiduciary considers necessary. UPAIA NCCUSL Comment. The purpose of [this section] is to enable a trustee to select investments using the standards of a prudent investor without having to realize a particular portion of the portfolio s total return in the form of traditional trust accounting income such as interest, dividends, and rents. 4. Prerequisites to Exercising the Adjustment Power. Before a trustee may exercise the power to adjust between income and principal, certain prerequisites must be met (UPAIA 104(b)): (a) The trustee must invest and manage the trust assets as a prudent investor; 5

10 (b) (c) The terms of the trust must describe the amount that may or must be distributed to a beneficiary by referring to the trust s income; and The trustee must be unable (without the adjustment power) to administer the trust in such a way that would be fair and reasonable to all beneficiaries. 5. Factors to Consider. The UPAIA requires the trustee to consider a number of factors when deciding whether to exercise the trustee s power to adjust principal and income, including: (a) (b) (c) (d) (e) (f) (g) the nature, purpose and expected duration of the trust; the intent of the settlor; the identity and circumstances of the beneficiaries; the needs for liquidity, regularity of income, and preservation and appreciation of capital; the assets held in the trust; the extent to which they consist of financial assets, interests in closely held enterprises, tangible and intangible personal property, or real property; the extent to which an asset is used by a beneficiary; and whether an asset was purchased by the trustee or received from the settlor; the net amount allocated to income under the other sections of the UPAIA and the increase or decrease in the value of the principal assets, which the trustee may estimate as to assets for which market values are not readily available; whether and to what extent the terms of the trust give the trustee the power to invade principal or accumulate income or prohibit the trustee from invading principal or accumulating income, and the extent to which the trustee has exercised a power from time to time to invade principal or accumulate income; 6

11 (h) (i) the actual and anticipated effect of economic conditions on principal and income and effects of inflation and deflation; and the anticipated tax consequences of an adjustment. 6. Example: A trust provides for the income to be distributed to a class of beneficiaries, with the remaining assets being distributed to a different class of beneficiaries at the termination of the trust. C. Total Return Unitrusts The trust owns a substantial interest in a closely-held business. The entity begins to sell assets and make large distributions to the owners of the entity. The UPAIA provides that, subject to certain exceptions, distributions received from an entity are to be allocated to income. The UTC Comments recognize the potential unfairness of such a rule and provide the following: In such a case the trustee, after considering the total return from the portfolio as a whole and the income component of that return, may decide to exercise the power under Section 104(a) to make an adjustment between income and principal, subject to the limitations in Section 104(c). Note: The problem comes in actually applying the adjustment power to a given situation. Although the UPAIA provides factors that a trustee should consider, it is left to the trustee to exercise his/her discretion in determining exactly how much income should be allocated to principal (or vice versa). 1. Generally. In approximately 25 states, state law permits a trustee to convert a trust to a total return unitrust. A unitrust allows a trustee to distribute to the income beneficiary a fixed percentage of the total assets of the trust. Some of the advantages of converting a trust to a unitrust include: (a) (b) The adjustment power can be difficult to apply. Determining how much principal to allocate to income (or vice versa) is somewhat subjective. A unitrust takes away the guesswork. Because the trustee is able to invest for an overall return rather than having to realize a certain amount of income, unitrusts can settle the inherit conflict 7

12 that exists between income beneficiaries and remainder beneficiaries. Ideally, this would allow the principal of the trust to grow more over time. (c) Unitrusts are easy for beneficiaries to understand. 2. The Conversion Process. The steps to convert an income trust to a unitrust vary from state to state, but generally include one or more of the following steps: (a) Provide notice to beneficiaries and give beneficiaries a period to object to the conversion; (b) Adopt a written policy of conversion or make an election to convert; (c) Deliver the policy or election in writing. 3. Court Approval. Generally, a trust can be converted to a unitrust without court approval. In some states, such as Delaware and Pennsylvania, a trustee can petition the court for approval to convert if the usual process doesn t work or if the trustee is an interested party by virtue of being a beneficiary. Del. Code Ann. tit. 12, 3527; 20 Pa. Cons. Stat Unitrust Percentage. Generally, the unitrust percentage will be between 3% and 5%, although some states specify a particular percentage (e.g., 4% in New York. NY EPTL ). IV. Restructuring Irrevocable Trusts A. Merger and Division of Trusts 1. Generally. A trustee, after notice to the qualified beneficiaries, may combine two or more trusts into a single trust or divide a trust into two or more separate trusts, if the result does not impair the rights of any beneficiary or adversely affect achievement of the purposes of the trust. UTC UTC Comment. Administrative economies promoted by combining trusts include a potential reduction in trustees fees, particularly if the trustee charges a minimum fee per trust, the ability to file one trust income tax return instead of multiple returns, and the ability to invest a larger pool of capital more effectively. Particularly if the terms of the trusts are identical, available administrative economies may suggest that the trustee has a responsibility to pursue a combination. 8

13 B. Qualified Severance Under IRC Generally. Certain trusts may be subject to generation-skipping transfer ( GST ) tax. Sometimes the allocation of a person s GST tax exemption could result in a trust having a mixed inclusion ratio. In other words, part of the assets of the trust will be exempt from GST tax and part of the assets will not. In order to promote the most effective use of the assets that are exempt from GST tax, it is generally advisable to sever the trust into two trusts, one that will be exempt from GST tax and one that is not. 2. Procedure. Section 2642 of the Internal Revenue Code allows a trustee to sever a trust into two separate trusts. A qualified severance that meets the statutory requirements will result in the recognition of the trusts as two separate trusts for tax purposes. The qualified severance may occur at any time and must be authorized by either the trust document or state law. Further requirements for making a qualified severance are set forth in section of the Federal Regulations. V. Early Termination of Irrevocable Trusts A. Specific Instances When Early Termination is Allowed. 1. Uneconomical Trust. After notice to the qualified beneficiaries, the trustee of a trust consisting of trust property having a total value of less than $50,000 may terminate the trust if the trustee concludes that the value of the trust property is insufficient to justify the cost of administration. No Court approval is required. The remaining assets must then be distributed in a manner consistent with the purposes of the trust. UTC Consent of the Beneficiaries. A court may terminate a trust 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. UTC Unanticipated Circumstances. A court may terminate a trust if because of circumstances not anticipated by the settler termination will further the purposes of the trust. Upon the termination of the trust, the trustee shall distribute the trust property in a manner consistent with the purposes of the trust. UTC

14 VI. Other Ways to Modify Irrevocable Trusts A. Changing the Situs of the Trust B. Decanting 1. Generally. Often trust documents provide a trustee with the power to change the situs of the trust. The intention behind such a provision is that future beneficiaries may or may not be residents of the jurisdiction in which the trust was originally created. In order to facilitate the administration of such trusts, it may be preferable for the trust administration to occur in the state where the beneficiary is domiciled. 2. Tax Considerations. Changing the situs of a trust to another state may result in the trust having to file income tax returns in both states. For example, in Virginia, section of the Code of Virginia imposes a tax on the Virginia taxable income for each taxable year for every estate and trust. What portion of the income of a trust is taxable in Virginia depends upon whether such trust is considered a resident trust or nonresident trust. See, VA. CODE ANN and The Virginia Administrative Code expands on this by adding that a trust is considered to be a Virginia resident trust if its assets are located in Virginia, its fiduciary is a resident of Virginia, or it is under the supervision of a Virginia Court. 23 Va. Admin. Code Generally. Twenty-one states now have statutes under which a trustee, pursuant to a power to distribute trust assets outright, may appoint trust assets in favor of another trust. These states are: (a) (b) (c) (d) (e) (f) (g) (h) Alaska Arizona Delaware Florida Illinois Indiana Kentucky Michigan 10

15 (i) (j) (k) (l) (m) (n) (o) (p) (q) (r) Missouri Nevada New Hampshire New York North Carolina Ohio Rhode Island South Carolina South Dakota Tennessee (s) (t) (u) Texas Virginia Wyoming 2. Example. The Delaware statute provides that in order to decant, a trustee of a Delaware trust needs only the authority to invade trust principal. There is no requirement of absolute discretion. The invasion standard of the new trust need not be the same as original trust. Exercise of the decanting power in Delaware does not require court approval or notice or consent of the beneficiaries. 3. Other States. If a trust is governed by the laws of a state without a decanting statute, a question exists as to whether the trustee could consider using a change of situs provision in the current trust to move the trust to a jurisdiction with a decanting provision. 4. Variations Between States. The state decanting statutes may vary in their approach to a variety of issues, including: (a) (b) (c) the required level of discretionary distribution authority that the trustee must have in order to decant; whether trustee/beneficiaries can decant; changes to beneficiaries distribution or withdrawal rights; 11

16 (d) (e) (f) (g) (h) (i) additions or changes to the identity or interests of the beneficiaries; whether any old powers of appointment must be carried over or whether any new powers of appointment may be granted in the new trust; tax savings provisions related to trusts qualifying for the marital or charitable deductions; provisions for notice to and objections by the beneficiaries; whether court approval is required; and the interaction between the trustee s fiduciary duties and the decision whether to decant. VII. Special Considerations / Avoiding Pitfalls A. Liability to Future Beneficiaries. 1. Generally. It is possible that a modification to a trust might be in the best interests of current beneficiaries, but not in the best interests of future beneficiaries. 2. Uniform Trust Code. The UTC permits trust modifications by nonjudicial settlement agreements and by court orders. To ensure that such agreements or orders will be binding on future beneficiaries, the UTC provides for the binding of minors and unborn descendants. See e.g., sections , and of the Code of Virginia. 3. Court Order. To avoid potential liability to a future beneficiary, a trustee should consider petitioning the court to approve the proposed actions. Even if an action is authorized by the Uniform Trust Code, it still might be preferable to obtain the approval of the court. B. Tax Considerations 1. Recognition of Gain. Parties should be sure that any modification to a trust does not trigger a taxable event. However, most of the modifications discussed herein will not result in a taxable event. 12

17 The estate planning community is solidly of one mind that the Cottage Savings doctrine has no place in the tax treatment of trust reformations, in which there are no exchanges and in which the beneficiaries receipt of trust corpus is governed by section 102, not section Marital Trusts. Often an election will be made to treat the assets held by a trust as qualified terminable interest property (QTIP). Such election allows the assets to qualify for the marital deduction under section 2056 of the IRC. In order for the Trust assets to qualify for the marital deduction, the income of the trust must be distributed to the surviving spouse. Care should be taken to ensure that any modifications of the trust terms do not jeopardize the marital deduction. See Section (b)-5(f)(1) of the Federal Regulations. 3. GST Tax Exempt Trusts. When dealing with a trust that is exempt from generation-skipping transfer taxes, it is important that no changes be made that could impact the trust s exempt status. For example, trusts that are exempt from generation-skipping transfer taxes because they pre-date Chapter 13 of the Internal Revenue Code are grandfathered exempt from GST taxes. However, certain modifications to such trusts could result in the loss of the grandfathered status. Note: Certain modifications discussed herein such as divisions of trusts and conversions to total return unitrusts may be permitted under the federal regulations. Treas. Reg. Section (b)(4)(i)(E). 13