Estate Attorney Summary: Irrevocable Trust Reformations and Terminations

By: Elliott Stapleton

There are a variety of ways an Estate Attorney can assist in terminating an Irrevocable Trust. The path will depend on the terms of the Trust and the beneficiaries in the Trust.

In Ohio, generally, a Settlor’s intent (meaning the person who created a Trust which is now irrevocable) is not set in stone. There can be a change in the law, mistakes, or unanticipated changes in circumstances.

The options to terminate or modify an Irrevocable Trust include a Private Settlement Agreement, Non-Statutory Agreements, Judicial Reformation, and Decanting.

Private Settlement Agreement and Non-Statutory Agreement

A Private Settlement Agreement (or Non-Statutory Agreements) can be completed between the parties but may require the approval of the Probate Court. The benefit of the Private Settlement Agreement is to modify administrative terms or the Trustee of the Trust. Non-Statutory Agreements, ORC 5801.10 (N), allows parties to effect modifications not provided for in a Private Settlement Agreement.

Judicial Reformation and Modification

Judicial Reformation requires counsel to file a request for approval in Probate. The beneficiaries or trustees may bring this action. ORC 5804.11.

The Probate Court can modify an irrevocable trust. This applies even if the change is contrary to the intent of the Settlor, if the Trustee and beneficiaries all agree so long as it is not inconsistent with a material purpose or continuation is not necessary to achieve any material purpose of the Trust.

To determine the material purpose, we look to the Trust document. In some cases, the intent of a Settlor is defined if specific; but in most cases, the intent of the Settlor is not explicitly defined.

There can also be a modification based on a mistake. If, for example, the terms say I give my 1969 Corvette, but the actual year is 1968 Corvette, the Trust can be reformed to comply with the Settlor’s intent.

Changes related to tax mistakes would need to be completed before the death of the Settlor. More information on tax implications is provided below.

Decanting

Decanting of a Trust is the transfer of all trust assets into a newly created trust. For this to work, the Trustee must have an absolute power to distribute income and principal of the Trust. There cannot be a material change of the dispositive terms when decanting a trust. ORC 5808.18

Statutory Trust Modification Options

There are also potential changes permitted by statute. For example, there is a provision, ORC 2109.62, which permits the termination of a Trust if the management of the Trust is no longer economically feasible.

Income Tax Issues with Reformations and Terminations

There are potential tax considerations that must be considered with modifying any Irrevocable Trust.

In PLR 2019-32001 to 2019-32010, the IRS has held that the termination of a Generation-Skipping Trust to the individual beneficiaries was a sale between the beneficiaries. In at least one case, some of the beneficiaries are given a zero-tax basis, which makes portions all taxable. This results in an unfortunate outcome for the income taxes of certain beneficiaries.

The rationale in not awarding basis to certain beneficiaries is that the life interest beneficiary is “selling” their life interest in exchange for the termination. This is not to say the IRS is correct, but it is a risk since there is no clear authority on this issue.

There is another private letter ruling which held a commutation (ending the Trust early) is not a disposition and thus not a sale. PLR 2007-23014 citing IRC Section 1001.

In this situation, it seems we are only amending a Trust distribution. Why is a termination any different if it occurs earlier than the terms of the Trust? This is a distribution pursuant to state law, which is not a taxable event. Thus, the position of the IRS seems to create a windfall for the government since there is no tax that is being avoided by a termination.

If you are applying a tax to the appreciation, that would be sensible. The income effects seem to remove the basis from certain beneficiaries where they would have otherwise had a tax basis. It is possible this could apply if you have an Irrevocable Grantor Trust.

If there is a reformation of the Trust, for example, removing a beneficiary by paying them out early, IRC Section 1001 could be triggered. This might create capital gains tax to the income interest beneficiary. This means the income beneficiary owes tax but doesn’t yet have all of the funds. In this case, there was a similarly not tax basis. PLR 2002-31011

Administrative changes will not generally trigger IRC 1001. The risk comes when you are making material changes to the interests of beneficiaries. If a party is increasing its rights, that seems to be when the IRS has an issue and might impose additional income tax for the Trust interest.

There is a risk that a Trustee who Decants a Trust will have the same treatment as the Trust reformation or termination; since disposition does not need to be an affirmative event.

Before modifying an Irrevocable Trust, it is best to secure counsel from an Estate Attorney. Our firm offers legal services including Private Settlement Agreements, Judicial Reformation, and Decanting – as well as representation in Probate Court if necessary.

Is the IRS required to honor amendments?

In general, yes, but you cannot change federal tax consequences for a completed transaction. The change cannot make a retroactive modification, meaning you cannot undo a tax mistake after it has already been made.

What is the effect of reformations and terminations?

If the property is conveyed and they are not otherwise entitled to such an asset, then it is a gift unless there is consideration provided. This could also be the case if you fail to preserve or defend your right could also be a transfer as a gift.

On Decanting, the IRS has not yet issued regulations on how they will interpret the change of beneficial interest. It is not yet known at what point the change would be a taxable gift.

There is a chance the modification could cause an issue with Estate Tax inclusion if the beneficiary is complicit in the modification of the Trust under IRC Section 2036.

It is possible that the modification of a Trust could result in an argument that the Trust is now self-settled and thus accessible by a bankruptcy trustee or other creditors. There is also a chance that if a creditor could reach the asset that the asset is also included in the individual’s taxable estate.

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