The Duffey Law Firm Blog

Tuesday, February 7, 2017

DLF Estate Tax Repeal Update #3

As discussed in our DLF Estate Tax Repeal Update #2, many estate plans utilize a Family or Bypass Trust along with a Marital or Spousal Trust.  Due to the use of “formula funding language” used by most if not almost all estate planners over the last sixteen years or so, the repeal of the estate tax could result in all the assets of the decedent being funded into the Family or Bypass Trust.  The problem is, unless that Bypass Trust allows for distributions to the surviving spouse, the widow or widower of the decedent could be left with little or no assets.  Of course, there are many other potential unintended consequences if the estate tax is repealed, or if rules on income and capital gains taxes are substantially changed, which will cause many taxpayers to look to amendment or in some extreme cases even termination of their trusts.

In the case of a will or revocable trust agreement, the solution is simple, amend the will by codicil prior to death or in the case of the trust resolve issues by a simple amendment. But what about the situation where the testamentary document is an irrevocable trust?  This would include trusts of deceased parents or others in which the beneficiaries are negatively impacted by changes in the tax laws.

Today’s update focuses on the issues and potential solutions for amending or terminating irrevocable trusts under Florida law. In some instances amending, modifying or terminating a trust can be done, under some circumstances these options may not be available.

Takeaways from Trump Tax Reform Update #3

  • Many estate planning trust agreements created over at least the last 15 years include formula funding language which assumes an estate tax – it is possible that this formula may disinherit surviving spouses if the estate tax is repealed
  • Many people with trusts are likely to find a number of other reasons why they need to amend or “fix” irrevocable trusts due to changes in our tax laws in order to maximize new options under the law – so these issues are not limited to married people, but possibly any Settlor of an irrevocable trust
  • Irrevocable trusts are not always irrevocable – sometimes they can be amended or revoked –  but action is required

Unintended Consequences of Tax Reform

As mentioned in our prior tax reform update, due to the fact that many if not most married couples have “formula funding language” in their estate planning documents, there may be a unintended difficulties for some surviving spouses – in some cases it could even result in the surviving spouse being virtually or even literally disinherited.

Although the issue of bypass trusts and spousal disinheritance is significant, it is not the only potential unintended consequence that can result from tax reform.  For example, if at the time of the creation of the irrevocable trust, there was no estate tax or generation skipping transfer tax, many clients may not have created the irrevocable trust in the first place.  In other words, in some cases, the only reason the taxpayers created those irrevocable trusts and put the assets “beyond their reach” was due to tax situations.  If there is significant changes to the tax laws, those reasons for creating the irrevocable trusts may no longer exist. 

Some taxpayers may want to simply terminate the irrevocable trust.  In other cases, there may have been limits imposed by the terms of the trust with respect to the Settlor or the Settlor’s spouse that were included only in order to avoid detrimental consequences of the estate or generation skipping transfer tax (GSTT).  In those instances the Settlor may want to amend or modify the terms of the trust in order to improve the benefits of the trust for the beneficiaries of the trust, or the Settlor or the Settlor’s family under the new tax laws.  The critical starting point is to review all trusts documents in light of the current rules and proposed tax law changes and determine if action is required for you or your family.

So the question becomes how may one be able to “fix” an irrevocable trust which was created at a time when the law imposed an estate tax or a GSTT tax?

First we should dispense with the preconceived notion that the term “irrevocable trust” means the same thing under the law as it does under the plain meaning of the words in common usage.  Under certain circumstances an irrevocable trust can be revoked, amended, modified, terminated or altered by various legal methods.

The various methods and options depend on certain facts and circumstances which cannot be discussed in detail in a brief article such as this.  The ultimate takeaway is that anyone who has an irrevocable trust that was created in the last sixteen years or so, should do a review with their estate planning attorney to consider the consequences of estate tax repeal.  Keep in mind that many trust documents are highly customized, and all we can discuss here are the general principals and typical facts which apply in many circumstances.  With that said, here is a brief discussion of some of the more commonly utilized options for modification or termination of irrevocable trusts under Florida law.

The Intent of the Settlor is the Polestar of Trust Law

Without delving too deeply into legal principals and technicalities, it may be helpful to understand that one of the cornerstone principals in trust law is that the creator of the trust (the Settlor) has a right to dispose of the Settlor’s property in whatever way the Settlor sees fit (assuming of course there is nothing in the trust terms that violate the law or public policy). 

Over the thousands of years with which the law has had experience with trusts (dating back to the time of the crusades and English Law which was the predecessor to much of our American laws), lawyers and clients have encountered changing circumstances.  Thus, although the law generally respects the term irrevocable, the law has provided special circumstances in which either Settlors, Trustees or beneficiaries of trusts may be able to modify or change the terms of the trust agreement or terminate a trust that was originally intended to be irrevocable.

One possible example of this would be where a Settlor created a trust for the express purpose of benefiting his family under the facts and circumstances of a tax regime that imposes a substantial penalty on the Settlor or the Settlor’s family when assets are passed from one family member to another by an imposition of a substantial tax.  If under circumstances not contemplated by the Settlor, under current law, there is no imposition of that tax on a distribution to a beneficiary, the current terms of the trust may in fact frustrate the intention of the Settlor to benefit his family members or other beneficiaries.

Examples of Options to Modify or Terminate Irrevocable Trusts

There are five statutes under Florida law which are designed to allow either the Settlor or the beneficiaries of irrevocable trusts to either modify or terminate an irrevocable trust.  All five statutes are in addition to such rights that exist under Common Law (cases that have decided law over the past many years).  In other words, the statutes merely clarify or add to the rights that already exist under the case law which has been followed by the courts in Florida prior to the passage of the statute.

Here is a brief description of the Florida statutes that allow for modification or termination of irrevocable trusts:

Florida Statute §736.04113 – essentially provides that where there are circumstances which were not anticipated by the Settlor at the time of the creation of the trust agreement, and where such circumstances now frustrate the intent of the Settlor or make the intent of the Settlor impossible to accomplish, modification or even termination may be accomplished by the court.

Florida Statute §736.04114 – essentially provides that the court may take such judicial construction of the terms of the trust (read “interpretation of the terms of the trust”) in such a manner as to allow for the proper administration and distribution of assets of the trust as would be in keeping with the intention of the Settlor where the terms of the trust utilize a “formula clause” or reference such terms as “estate tax exemption” and other such terms. Note – this statute seems to fit almost exactly the central point of discussion herein, however, for various reasons, under different circumstances with different trust agreements and factual circumstances of various clients, this may not always be the most optimal means for accomplishing modification or termination.

Florida Statute §736.04115 – essentially provides that where a trust allows the Trustee to make distributions of principal in the Trustee’s absolute discretion, the Trustee would be permitted to make such distributions of part or even all (100% of the principal of the trust) to a Trustee of a new or “second” trust.  This remedy is often referred to as a “Trust Decanting”.  So named because it is similar to “pouring” the contents of the first trust into a second trust, like decanting wine from a bottle to a carafe.  There are several very specific rules that need to be followed, but the details are beyond the scope of this article.  Suffice it to say, this does allow a great deal of flexibility when a trust qualifies for this option.

Florida Statute §736.0412 – permits non-judicial modification of irrevocable trusts, after the death of the Settlor as long as the Trustee and all the qualified beneficiaries agree unanimously. In order to use this statute, modification or termination may not be prohibited in the agreement by a spendthrift clause and other technical elements apply.

Florida Statute §736.0410 – provides the ability for beneficiaries to obtain disapproval of non-judicial acts proposed by modification or termination under Florida Statute §736.0412 or other statutes.  This statute is intended to give a beneficiary an opportunity to be heard by the court in order to prevent a proposed modification or termination undertaken without court approval.

The important takeaway from all this is simply the necessity for anyone with an irrevocable trust to: (a) review and consider the terms of their trust; (b) determine whether or not the terms of that trust continue to serve the intentions of the Settlor as they did at the time of the creation of the trust; (c) if not, consider the options of either modification or termination; (d) choose which theory under the law is most suitable for modification or termination (e.g. either which of the statutes work best, or if a legal theory under case law is more suitable than a particular statute, and generally, whether action can be taken without court involvement or if a court supervised transaction would be appropriate; (e) finally, consider the costs involved and determine if the benefits of action outweigh the results of inaction.

In some cases, clients will find that no action is simply not a viable option as the result of the changes in the law (at the time of this writing only proposed) require action in order to protect the interests of spouse and family members.

In our next update will focus on some positive news under proposed changes and how one may take advantage of the new tax reforms in order to benefit either themselves or their spouse or family members.





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