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George F. Bearup, J.D. Senior Legal Trust Advisor

5-Sep-18

Settlor Incapacity: When Does a Revocable Trust Become Irrevocable

Take-Away:  When the settlor of the a revocable trust becomes mentally incapacitated,  the settlor’s lack of mental capacity alone will not cause the trust to automatically become irrevocable. Illogical as that sounds, it is the law in Michigan.

Background: Other individuals beside the settlor may directly or indirectly hold the power to terminate a trust, such that in the event of the settlor’s incapacity (and thus the settlor’s inability to exercise a power of trust revocation) the trust instrument may still be treated as a revocable trust if those others hold a power of revocation over the trust, or the settlor himself or herself holds other powers over the trust. For example,  MCL 700.7411(1)(b)(c) contemplates that the trustee or the trust protector expressly being given the power to revoke a revocable trust at any time.

Question: What if the settlor becomes incapacitated, and the settlor alone holds the power to revoke his/her trust? The settlor’s mental incapacity does not automatically result in their trust becoming irrevocable under the Michigan Trust Code.

General Statutory Definitions:

  • Incapacity: EPIC provides a definition of an incapacitated individual: an individual who is impaired by mental illness, mental deficient, physical illness or disability.. to the extent of lacking sufficient understanding or capacity to make or communicate informed decisions. [MCL 700.1105(a).]This definition is distinguished from a legally incapacitated individual who is either adjudged by a court to be an incapacitated individual or who has a guardian appointed for them. [MCL 700.1105(i).]
  • Trust: This term defined in EPIC includes, but is not limited to, an express trust, private or charitable, whenever and however the trust is created. [MCL 700.1107(n).]
  • Trust Instrument: This term means the governing instrument that contains the terms of the trust. [MCL 700.7103(m).]
  • Revocable Trust: The Michigan Trust Code’s definition of a revocable trust provides the answer to the technical question. [MCL 700.7103(h).]
  • “Revocable”, as applied to a trust, means revocable by the settlor without the consent of the trustee or a person holding an adverse interest. A trust’s characterization as revocable is not affected by the settlor’s lack of capacity to exercise the power of revocation, regardless of whether an agent of the settlor under a durable power of attorney, a conservator of the settlor, or a plenary guardian of the settlor is serving.

Impact of Settlor’s Incapacity: The Reporter Comments to the Trust Code’s definition of revocable  provide some additional insight into the Reporter’s reference to the characterization of a revocable trust. The Reporter notes in his comments:

“Because there is sometimes a question whether a trust remains revocable during the period of the settlor’s incapacity, the MTC includes language clarifying this point. This language was drawn from the Ohio Trust Code. Ohio RC 5801.01(r).

Although not found in the UTC definition of revocable, the additional, clarifying language is consistent with the understanding of the law described in comment to UTC 103(14) regarding this definition.”

Digging a bit deeper at the invitation of the Trust Code’s Reporter, the comments to Uniform Trust Code Section 103(14) that defines revocable provide:

“The definition of ‘revocable’ (paragraph 14) clarifies that revocable trusts include only trusts whose revocation is substantially within the settlor’s control. The fact that the settlor becomes incapacitated does not convert a revocable trust into an irrevocable trust. The trust remains revocable until the settlor’s death or the power of revocation is released. The consequences of classifying the trust as revocable are many. (liability of the trust to pay the settlor’s debts-505; the standard of capacity to create a revocable trust-601; subjecting the beneficiaries’ rights to the settlor’s control-603; the period of contesting the revocable trust-604; the power of the settlor to direct actions of the trustee-808(a); notice to qualified beneficiaries on the settlor’s death-813(b); and the liability of the trustee of the revocable trust for the obligations of a partnership of which the trustee is a general partner-1011(d).” [All these UTC code references are equally applicable to the Michigan Trust Code’s provisions that deal with the legal consequences of a revocable trust.]

While less ‘official,’ one of the estate planning textbooks used by Michigan estate planning attorneys has also commented on how a revocable trust does not automatically become irrevocable merely because the trust’s settlor becomes incapacitated. In Michigan Revocable Grantor Trusts, (2016) the author Charles Janssen states at Section 4.12, page 76 :

“Even though the grantor may be legally incapacitated and unable to manage assets, unless it is specifically provided for in the trust, he or she does not automatically lose the right to amend or revoke the trust and thereby change the testamentary disposition of assets. Rather, it is presumed that a grantor intends to retain the right to revoke or amend the trust as long as she has the capacity to make a testamentary disposition…. If the grantor lost the right to amend or revoke a trust upon ‘incapacity,’ the grantor would permanently lose control of and revocation powers over the trust. This could cause the inadvertent imposition of gift taxes. See IRC 2511-2512; see also Estate of Alperstein v. Commissioner, 613 F.2d 1213 (2d Cir 1978, cert. denied, 446 US 918 (1980).”

Common law: These trust code provisions are admittedly a departure from the common law as described in several trust treatises,  and how the common law describes the impact of the settlor’s incapacity on the retained right to amend or modify his or her trust.

  • Generally, the common law of trusts provides that the right of trust revocation is considered a personal right held by the settlor. Restatement (Third) of Trusts, Section 74, Reporters Notes (comments a(2) and (e).
  • “It is the presumed intention of the settlor that during periods of his or her incapacity, the trust will be irrevocable and that the revocation provision will be suspended so that there is no basis or authority on which the conservator or guardian for the settlor can act. Where the settlor reserves a power to revoke the power to revoke the trust under certain circumstances, he can revoke it only under those circumstances.” 4 Scott on Trusts Section 330.8.
  • “A legally incapacitated settlor cannot exercise a reserved right of revocation.” 5 Scott & Ascher Section 35.1; 4 Scott on Trusts, Section 330, note 7.

Agents: Despite the settlor’s incapacity, the settlor’s agent acting under a durable power of attorney can exercise the settlor’s retained power of trust revocation, subject to three conditions: (i) the applicable durable power of attorney statute authorizes such an agency; (ii) the applicable durable power of attorney under which the agent purports to act is sufficiently broad or sufficiently precise to cover the purported act of trust revocation; and (iii) the governing instrument, i.e. the trust,  itself contains a provision that authorizes a revocation by proxy. [Uniform Trust Code Section 411(a).] But the Restatement (Third) of Trusts, Section 63, comment 1, says that only conditions (i) and (ii) or  (i) and (iii) need to exist for the agent to possess the power to revoke the settlor’s trust. A guardian or conservator of the settlor of a revocable trust may not exercise the settlor’s right of revocation unless they are expressly granted such authority in a statute and in the governing trust instrument. Bogert, Trusts and Trustees, Section 1000.

These law summaries and trust treatises all either state, or imply,  that once the settlor becomes incapacitated, by default the trust becomes irrevocable because the settlor can no longer exercise his/her power of revocation.

Drafting Observation: In light of how the Michigan Trust Code treats a trust as continuing to be revocable despite the settlor’s mental incapacity and inherent inability to exercise the retained power to revoke his/her trust due to that incapacity, you can understand why I cringe whenever I read a trust instrument that says “upon the settlor’s incapacity this trust shall become irrevocable.” The trust instrument does not need to say that. Moreover, if the trust instrument is viewed, correctly so, as a clear manifestation of the settlor’s intent, then by announcing to the world that the trust automatically became  ‘irrevocable’ upon the settlor’s mental incapacity results in a completed taxable gift by the settlor, when it is pretty obvious that the settlor did not intend to make a lifetime taxable gift just because he/she became incapacitated. [Just one of my many pet-peeves when I read trust documents these days.]

Conclusion: Just because a settlor who retained the power to amend, modify or revoke his/her trust becomes incapacitated, does not mean that the trust automatically becomes irrevocable. If those retained powers are released by the settlor, then the trust will become irrevocable due to the formal release of those retained powers. Declaring a trust becomes irrevocable in the instrument when legally it does not under the Michigan Trust Code, based solely on the fact of the settlor’s legal incapacity, creates a taxable lifetime gift  probably when one was not contemplated which could ultimately result in the loss of an income tax basis adjustment of the trust’s assets on the subsequent death of the settlor.