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

17-Apr-18

Trust Modifications – Tricks, Traps and Taxes

Take-Away: Frequently we are faced with an irrevocable trust that the settlor, or the trust beneficiaries, want to modify for some reason. Ignoring a trustees’ power to decant the trust assets to a new trust, can the trust’s provisions be modified by agreement? Michigan’s Trust Code permits an irrevocable trust to be modified, but ultimately a probate judge must approve of that modification. A few states, like Delaware, have more ‘user-friendly’ trust modification statutes. However,  any time a trust modification results in a change in beneficial interests among its beneficiaries, there lurks the risk of  gift, GST  or income tax consequences.

Background: Several provisions of the Michigan Trust Code contemplate that the terms of an irrevocable trust can be modified. Some of those provisions, however, are pretty narrow in their scope. For example, a probate court can modify the administrative terms of a trust if continuation of that trust under its existing terms would be ‘impracticable or wasteful’, as determined by the judge. [MCL 700.7412(1).] Or, a probate judge can modify the administrative or the dispositive terms of the trust because of ‘circumstances not anticipated by the settlor’, and the modification will ‘further the settlor’s stated purpose or probable intention’ as determined by the judge. [MCL 700.7412(2).] Similarly, a probate judge can modify the terms of a trust if the judge finds that the value of the trust property is ‘insufficient to justify the cost of the trust’s administration.’ [MCL 700.7414(2).] Then there is the Michigan Trust Code provision that permits a non-charitable trust to be modified by a probate judge upon the consent of the trustee and the qualified trust beneficiaries, but only if the proposed modification is ‘consistent with the trust’s material purposes, or the continuance of the trust is not necessary to achieve any material purpose of the trust’ as determined by the judge. [MCL 700.7411(1)(a).] Note, all of these trust modification provisions in the Michigan Trust Code require the involvement of a probate judge, which translates into court filings, court hearings, legal fees, and a loss of privacy to the extent that the trust instrument becomes a matter of public record in the probate court.

A Michigan trust created after April 1, 2010 can give the qualified trust beneficiaries and a trust protector the ability to modify the terms of a trust by agreement without a probate court’s involvement. [MCL 700.7411 (1)(b).] Or, if the terms of the trust permit, a trustee and/or trust protector can be given the power alone to modify the terms of the trust without any involvement of the probate court. [MCL 700.711(1)(c).] But in the absence of that express grant of authority to the trust protector or the trustee in the trust instrument to modify its terms, any other trust modification will ultimately require a trip to the probate court.

This rule on trust modifications [MCL 700.411] reflects Michigan’s adoption of Section 411 of the Uniform Trust Code in 2010.

Delaware Comparison: For comparison purposes, consider Delaware’s Modification of Trusts by Consent Statute. [12 Del. C. Section 3342.] That statute, adopted in 2016, permits an irrevocable trust to be modified on written consent, or a written non-objection, of all members of three groups: (i) the trust settlors (if living;); (ii) the fiduciaries then serving the trust at the time of the modification; and (iii) the trust beneficiaries. Note that this statute does not require: (a) the approval of a probate or chancery court; or (b) the preservation of the trust’s material purposes. Rather, the Delaware statute permits a modification to the trust, even if the modification violates a material purpose of the trust. This Delaware statute could be used to either adopt an entire restatement of the existing trust, it could be used to make beneficial changes to the trust, or, it could be used to permit directed trusts or silent trusts,  both of which are permissible under Delaware’s trust laws. Obviously, to take advantage of this statute, the trust must be administered under Delaware’s laws, which would require a change in situs of an existing irrevocable trust where a Delaware trustee then administers the trust. Of interest, too, is that Delaware’s statute applies to all irrevocable trusts, even those trusts that were created several years earlier, i.e. the procedure is not limited to new trusts adopted after the statute was passed in 2016.

  • Fiduciaries: One drawback to the Delaware statute is that it uses an expansive definition of Under that statute the fiduciaries who must consent to the trust modification include not only the trustee of the trust, but also trust protectors, investment or distribution trustees, or any other formal named ‘advisor’ to the trustee. Thus, if there are several ‘role players’ under the trust instrument who act in a fiduciary capacity, each will have to provide their consent to the trust modification.
  • Beneficiaries: Another drawback to the Delaware statute is that each trust beneficiaries of the trust must either directly consent or file a non-objection to the modification; a trust beneficiary includes remainder beneficiaries like minors and contingent successor beneficiaries who may be unknown. Fortunately Delaware, like Michigan, has a helpful virtual representation statute that permits the consent of some trust beneficiaries to bind other trust beneficiaries who are either minors, unborn, or are unidentified successor beneficiaries.

Transfer Tax Risks: Whether by agreement (Delaware) or with probate court approval (Michigan) it is always important to keep in mind the tax risks when the beneficial interests in the trust are altered through a trust modification.

  • Gift Tax: If the relevant trust modification decreases a beneficiary’s interest in the trust in favor of another trust beneficiary, because the enforceability of the modification requires the beneficiary’s written consent, that modification might create a gift tax obligation on the part of the beneficiary who possesses the decreased beneficial interest. On the other hand, if the beneficiary has substantially the same interests after the trust modification as he/she did before the trust’s modification, that modification will not trigger any gift or GST taxes. [PLR 201722007 (Feb. 16, 2017).]
  • Income Tax: The U.S Supreme Court has held that a trust beneficiary can realize gain or loss for income tax reporting purposes when a beneficiary exchanges interests in a trust that are ‘materially different.’ Cottage Savings Association v United States, 499 US 554, 566 (1991).
  • Estate Tax: In the case of the Delaware statute, where the settlor’s consent is required to a trust modification, there appears to be some protection that the settlor will not be treated as retaining a power to control who ultimately benefits from the trust,  a power which would otherwise cause inclusion of the trust’s assets in the settlor’s taxable estate under IRC 2038, through his/her ‘retained’ power to consent to the trust’s modification. Treas. Reg. 20.2038-1(a)(2) provides:

“a settlor’s gross estate will not include the value of property transferred into trust, even if the settlor enjoys the power to alter, amend, revoke or terminate the relevant trust, if such power could be exercised only with the consent of all parties having an interest (vested or contingent) in the transferred property and if the power adds nothing to the rights of the parties under local law.”

  • Because the Delaware statute requires the written consent or written non-objection of all interested parties, and all interested parties were never prohibited under Delaware law from effecting a modification to the trust, the Regulation should apply to this trust modification by consent statute so as to assure the settlor that he/she will not face adverse estate tax consequences merely by holding a power to consent to trust modification under the Delaware statute with the fiduciaries and all other trust beneficiaries.
  • IRS: Two weeks ago Treasury published a private letter ruling with regard to the gift, GST and income tax consequences of a trust modification. In the PLR Treasury confirmed the tax implication rules with regard to a trust modification. The trust modification deleted a mandatory income distribution right held by a beneficiary, and replaced it with the authority given to the trustee to withhold income distributions from the beneficiary. The modified trust required the trustee to accumulate the undistributed trust income, keep it segregated from the trust’s principal,  and ultimately pay that accumulated income to the trust beneficiary’s estate on his death. Treasury found that these modifications neither transferred interests in the trust to another individual, nor did the modifications confer any new rights to the trust beneficiaries. Moreover, because the trust modification increased the trustee’s discretion but did not confer new rights to the beneficiaries or result in any relative shifting of interests between beneficiaries, there was no realization of gain or loss that would be taxable. PLR 201814005 (April 6, 2018)

Conclusion:  It is time consuming and expensive to modify the terms of a trust in Michigan. Other states, recognizing those facts, have adopted statutes designed to facilitate and expedite trust modifications. Whether Michigan some day in the future moves in Delaware’s direction remains to be seen. But regardless of where the trust modification takes place, it is important to keep in mind the hidden tax traps that can result if a beneficial interest is altered. Just because a probate court issues an order that implements that change in the beneficial interests of a trust will provide no protection for the beneficiary from transfer or income tax consequences.