See-Through Trusts – Flexibility Regulations (Sort of)

Take-Away: The SECURE Act’s Proposed Regulations contemplate the flexibility to make changes to an irrevocable trust instrument after an IRA owner’s death in order to optimize required minimum distribution planning (RMDs) to the trust. How that flexibility is implement is the challenge.

Background: The SECURE Act Proposed Regulations provide new guidance on how an irrevocable trust, after the retirement account owner’s death, can be modified to accommodate the Tax Code’s see-through trust requirements and thus maximize the distributions from a retirement account that names the trust as the account’s designated beneficiary. This guidance contemplates the ability to appoint a trust director (or trust protector) who possesses the authority to make changes to the trust instrument in order to facility qualifying the trust for the optimal RMD payouts. That may, or may not, work in Michigan.

Manner of Implementing Changes to the Trust: The Proposed Regulations address the IRS’ favorable treatment of the modification of an irrevocable trust after the retirement account owner’s death, whether by court reformation, a nonjudicial settlement agreement among the trust beneficiaries, a more formal trust modification agreed to by the trustee, trust beneficiaries and the probate court, or through a trust decanting process. Obviously many of these trust instrument alteration options vary from state-to-state, so that not all of these options will be available to alter an irrevocable trust in Michigan. For example,  a nonjudicial settlement agreement in Michigan is generally only available to alter the administrative provisions of an irrevocable trust. [“ A nonjudicial settlement agreement shall not be used to accomplish the termination or modification of the trust. [MCL 700.7111(2).]

Time Limit: The only condition if pursuing one of these trust modification options is that the changes must be implemented by September 30 of the year following the year of the account owner’s death,  the so-called Determination Date.

Scope of Changes: The Proposed Regulations contemplate the removal or the addition of a trust beneficiary pursuant to a trust modification [MCL 700.7411(1) or 700.7412(2)], a court authorized trust reformation [MCL 700.7415], or a permitted trust decanting [MCL 556.115a].

Example: Joe dies in 2022 with his IRA payable to his revocable trust. Joe’s wife Jill is the lifetime beneficiary of Joe’s trust, with discretionary distributions of trust income or principal to Jill for her health, education, support and maintenance. On Jill’s subsequent death, the trust assets are then to be distributed to Joe’s son, Hunter. While Jill is a eligible designated beneficiary, since she is Joe’s surviving spouse, Joe’s son Hunter is only a designated beneficiary. Consequently, Joe’s IRA that is payable to his trust must be distributed within 10 years of Joe’s death. If, however, Joe’s trust is modified by September 30 of the year following Joe’s death, to remove Hunter as a remainder beneficiary though a trust modification proceeding, perhaps adding Joe’s siblings in place of Hunter as remainder beneficiaries, siblings who are less than 10 years younger than Joe (i.e. the siblings are eligible designated beneficiaries) then the distributions from Joe’s IRA to his trust for Jill can be stretched over Jill’s lifetime, which is much longer than 10 years.

Note: If Joe’s trust also gave Jill a testamentary general power of appointment, Jill could then disclaim or release the scope of the testamentary general power of appointment, restricting the potential appointees to individuals who are less than ten years younger than Joe, which would have the effect of ‘ignoring’ Hunter as a potential trust beneficiary, even if Jill never executes the ‘narrowed’ testamentary power of appointment, and Hunter ultimately receives the remaining trust’s assets on Jill’s subsequent death.

The ‘removal’ of Hunter as a trust beneficiary by the following September 30 (the Determination Date), either through the trust modification, or with a ‘narrowed’ testamentary power of appointment via Jill’s disclaimer or release, will be accepted by the IRS and will not affect the RMDs to the trust. Hunter is ‘ignored’ for purposes of determining the trust’s beneficiaries.

Fiduciary Duty Limitations: While it is good news that the Proposed Regulations provide some welcome flexibility to change the terms of an irrevocable trust prior to the Determination Date in order for the trust instrument to navigate the see-through trust and RMD stretch distribution rules, there is still the issue of how to deal with fiduciary duties, especially if a trust beneficiary who is an individual, who is classified as an ordinary designated beneficiary, needs to be ‘removed’ in order to enable stretch RMD distributions to the trust.

• Best Interests: A fiduciary must consider and ultimately act in light of the best interests of another, and in the case of a trust, in the best interests of all of the trust beneficiaries. [MCL 700.7801- “…the trustee shall administer the trust in good faith, expeditiously, in accordance with its terms and purposes, for the benefit of the trust beneficiaries…”] As such, if a fiduciary is in a position to want to change the terms of the trust instrument in order to minimize RMD distributions to the trust in order to rely on the stretch distribution rules by adding or deleting trust beneficiaries, that effort could easily trigger a violation of the fiduciary’s duties to all trust beneficiaries. The same of the trustee seeks to decant the terms of the trust in order to add or remove a trust beneficiary.

Trustee: Obviously the trustee of the trust is a fiduciary that is constrained by its fiduciary duties, and would be unlikely to initiate steps to remove a designated beneficiary from the trust instrument in anticipation of modifying the trust by the Determination Date through a decanting. [MCL 440.3307(a).] although a trustee could probably participate in a trust modification proceeding if all qualified trust beneficiaries consent to the modification, and even better if the trust beneficiaries initiated the trust modification process. [MCL 700.7411(1)];

Trust Director: Similarly, a trust director (formerly a ‘trust protector’ in Michigan) is subject to minimum non-modifiable fiduciary duties which will also constrain its ability to unilaterally take the required steps to modify the terms of the trust instrument prior to the Determination Date to ‘remove’ a problematic trust beneficiary, or to add a trust beneficiary. [MCL 700.7703a(4)(5) and (8.)]

Powerholder: Less clear in Michigan is with regard to a nonfiduciary powerholder as identified in the Michigan Trust Code. Apparently an individual who merely possesses the “power to modify, reform, or terminate” the trust is considered to hold only a nonfiduciary power, which would seem to enable that nonfiduciary powerholder to modify or reform the terms of the trust as contemplated by the Proposed Regulations. Still, this provision has yet to be interpreted by the courts as to scope and role under the Michigan Trust Code.

Comment: I guess I wish I understood (better) the difference between a designated ‘trust director’ and a ‘nonfiduciary powerholder’ if either one of them can ‘modify’ the terms of the trust, while one is a fiduciary and the other is not.

Conclusion: The ability to adapt the terms of an irrevocable trust prior to the Determination Date is a welcome feature of the SECURE Act’s Proposed Regulations. However, it is probable that a trust director in Michigan may not be in a position, due to his/her fiduciary duties, to initiate some of the changes contemplated by the Proposed Regulations. If an individual is named in a trust instrument, and expressly designated as a nonfiduciary powerholder with the authority to modify the terms of the trust to add or remove a trust beneficiary, then that might pass muster and not run afoul of any fiduciary duties. However, the trust director provisions of the Michigan Trust Code are still relatively new, so that this may be an optimistic solution to modify the terms of the trust to gain stretch RMD distributions. Perhaps an easier way to avoid the entire fiduciary vs. nonfiduciary question is to give the lifetime trust beneficiary a testamentary power of appointment, which can then be narrowed through a disclaimer/release prior to the Determination Date limited to appointees who are only eligible designated beneficiaries.