November 10, 2023
Surprise! Your Irrevocable Trust May Still Be Revocable
When an individual creates an irrevocable trust, often the drafting attorney will remind the trust’s creator, “You understand, this is an irrevocable trust that cannot be changed, right?” That is often the impression left with the trust’s creator — once their trust is signed and assets are transferred to it, it’s “locked in place.” Right or wrong, that conclusion may not entirely be accurate.
For a few decades now, the laws that govern trusts have evolved to permit the modification, and sometimes even the early termination, of an irrevocable trust. This evolution is reflected in Michigan’s Trust Code, which contains several different sections that authorize the modification or termination of an irrevocable trust, either through probate court proceedings or, in a couple of situations, without the probate court’s involvement. In recent years, Michigan also enacted another statute that permits the trustee to modify the terms of an irrevocable trust by decanting (i.e., transferring) the trust’s assets to a new trust that is created by the trustee. A decanting requires only a simple notice to the existing trust beneficiaries of the trustee’s intention to exercise its decanting authority.
This trend that authorizes the modification, or possibly early termination, of an irrevocable trust is a reflection that more trusts these days are of long duration intended to circumvent the federal transfer tax laws by “wrapping” inheritable assets in a long-term trust that beneficiaries may use and enjoy but never actually own, thus avoiding the imposition of federal estate taxes when a child or grandchild dies. However, with long-term trusts come the reality that tax laws and the circumstances of individual beneficiaries frequently do change, leading to the need to make the trust instrument flexible in order to adapt to those changes long into the future.
Michigan’s laws that can be used to alter the terms of an irrevocable trust include:
Trust Reformation — Mistakes: The terms of a trust can be reformed, even if those terms are unambiguous, in order to make those terms consistent with the trust creator’s intent, but only if there is clear and convincing evidence that both the creator’s intent and the trust’s terms were affected by a mistake of fact or law. If the evidentiary burden is met, a trust reformation has retroactive effect to the date when the trust was first created. A trust reformation is often used when the goal is to achieve certain tax consequences with the trust, since a trust reformation will normally be binding on the IRS. In contrast, a trust modification normally does not have retroactive effect.
Inefficient Trust: If a trust consists of property that has a total value of less than $91,000 (in 2023, which is indexed annually for inflation), the trustee can terminate the trust if the trustee concludes that the value of the trust property is insufficient to justify the cost to continue to administer the trust. Alternatively, the probate court can modify or terminate the trust if the probate judge reaches the same conclusion.
Achieve Tax Objectives — Probable Intention: In order to achieve the trust creator’s tax objectives, the probate court can also modify the terms of the trust in a manner that is not contrary to the creator’s probable intention. The court may order that the trust’s modification has retroactive effect, but that retroactive effect will not necessarily be binding on the IRS for tax purposes.
Unexpected Circumstance — Stated Purpose: The probate court can modify the trust’s administrative provisions if the continuation of the trust on its existing term is impracticable, wasteful, or impairs the trust’s administration. The court can also modify either the trust’s administrative or dispositive provisions because of circumstances that were not anticipated by the trust’s creator, so long as that modification or termination will further the creator’s stated purpose, or if there is no stated purpose, the creator’s probable intention. If the trust is terminated under this provision, the trustee must distribute the trust property in a manner as ordered by the probate court.
Trust Modification by Consent — Material Purposes: An irrevocable trust can also be modified or terminated by the probate court on the consent of the trustee and the qualified trust beneficiaries (current and remainder trust beneficiaries) if the court concludes that the proposed trust modification or termination is consistent with the trust’s material purposes or that continuance of the trust is not necessary to achieve any trust material purpose. This option does not apply, however, to a trust that was irrevocable prior to April 1, 2010. To pursue a modification or termination requires notice to be given to the trust’s creator, or to the creator’s representative if the creator is incapacitated. However, a receipt of this required notice of an intent to modify or terminate the trust does not mean that the creator must also consent to the proposed trust modification or termination, just an opportunity to be heard. If the trust is terminated under this provision, the trustee must distribute the trust property as agreed to by the qualified trust beneficiaries, not how the probate judge directs.
Modification by Decanting — New Trust: If the trustee possesses discretion to make distributions to the trust’s beneficiaries, within certain limits, the trustee can exercise its discretion to distribute assets to a trust that the trustee creates, i.e., decant the trust property, to another trust with new distribution provisions. While certain vested rights of existing trust beneficiaries cannot be altered with the trustee’s decanting of the trust’s assets, the interests of more remote trust beneficiaries can be altered or eliminated with the decanting. As noted earlier, the trust beneficiaries need not consent to the proposed decanting; rather, they must be given 63 days advance notice by the trustee and an opportunity to object in the probate court.
Nonjudicial Settlement Agreements — No Modifications: As the name implies, interested persons can enter a binding nonjudicial settlement agreement change the trust and without the approval of the probate judge, so long as that agreement does not violate the trust’s material purposes and so long the agreement includes terms and conditions that could have been granted by the probate court. However, the nonjudicial settlement agreement cannot be used to modify or terminate the trust. Often such an agreement is used to resolve disputes about the interpretation or construction of the trust’s terms.
All these opportunities to modify, or even terminate, an irrevocable trust might leave trust creators uncomfortable. Most individuals who create and fund an irrevocable trust give considerable thought to when, how, and to whom their assets will be distributed. That intent is then reflected in the trust’s terms that the creator ultimately signs. If that discomfort is too great, or they are alarmed that their trust beneficiaries might be able to change their trust or terminate their trust early, there are some steps that the trust creator can take.
- State in the body of the trust instrument that they do not want the trust modified or terminated in any way, despite the modification provisions of Michigan’s Trust Code, but that step might be too limiting.
- State their intent that the trustee does not hold the power to decant trust property to a new trust created by the trustee. This then would force a future modification to go before a probate judge who may find that the proposed modification is inconsistent with the creator’s stated or material purposes or probable intention.
- State clearly in the terms of the trust instrument the creator’s material purposes, since those material purposes will restrict the way the trust can be modified. This provision will preserve those purposes or prevent an early termination of the trust. Otherwise, without a clear statement of purpose, a probate judge will be left to search for what those intended purposes might otherwise be, in effect read between the line, or guess. The presence of a material purpose trust provision provides some flexibility to adapt to future changes in the law or a beneficiary’s circumstances, but it maintains the creator’s overarching purpose for the trust and its beneficiaries.