Irrevocable trusts are powerful tools. In addition to their estate planning benefits, they can help meet other family goals, such as providing for those left behind and reducing tax liabilities. One potential drawback to irrevocable trusts, however, is that they can be difficult to change.
While some trusts are irrevocable from the moment they are drafted, others become irrevocable at some later point in time. For example, even a trust that is revocable by the grantor becomes its terms becomes irrevocable when the grantor or his or her surviving spouse dies.
Characteristics of Irrevocable Trusts
The idea behind an irrevocable trust is that the grantor of the trust gives up the right to control the assets placed in the trust. While it may seem odd to want to give up control of your money or property, there can be several advantages to doing so, like these:
- Reducing potential tax liability: Giving up control over assets using an irrevocable trust can reduce the size of your taxable income or estate. For this reason, irrevocable trusts are sometimes used to reduce income (for state tax purposes) or to reduce the remaining estate (for federal estate tax purposes).
- Preserving spousal wishes: One estate planning tool that can be used to honor spousal wishes is known as an A-B trust. In this type of trust, when one spouse dies, the trust is divided into two parts. Although the living spouse's portion (known as the “survivor's trust”) remains revocable, the deceased spouse's portion (known as the “bypass trust”) becomes irrevocable. The living spouse's control over the assets in the bypass trust is limited, and the living spouse cannot cancel the trust and oftentimes cannot make changes to the beneficiaries or the provisions of the trust.
- Transferring wealth during life: Properly structured irrevocable trusts can effectively transfer wealth without triggering the payment of gift tax.
The central characteristic of an irrevocable trust is that it cannot be easily changed or terminated. In other words, the grantor cannot decide to take the assets back into his or her control or change the way that the assets are distributed to the trust beneficiaries.
Knowing this basic principle, many people believe that there is no way to modify or terminate an irrevocable trust. This, however, is often not the case.
Ways to Modify or Terminate an Irrevocable Trust
There are many reasons a grantor, beneficiary, or trustee may want to change or end an irrevocable trust. Circumstances change. Families grow or mature differently than expected. Tax laws are amended.
As a result of changes like these, people who have an interest in an irrevocable trust may seek to modify or change it in accordance with California law. Here are a few examples of typical goals:
- Reducing tax liability;
- Helping a trust beneficiary qualify for some type of government benefit;
- Changing how the assets from the trust are distributed;
- Dividing one trust with more than one beneficiary into separate trusts for each beneficiary;
- Changing the beneficiaries of the trust altogether; and
- Naming a different trustee or changing the trustee's powers.
The methods available to change or terminate an irrevocable trust depend on state law. In California, the potential avenues are set forth in the Probate Code. Here are a few of the most common ways that irrevocable trusts are changed or terminated in our state:
Grantor and All Beneficiaries Consent to Change an Irrevocable Trust
The most straightforward way of modifying an irrevocable trust occurs when the grantor and all of the trust's beneficiaries consent to the change. In this situation, the safest course of action is to request court approval of the change even if it may not appear to be required under the letter of the law. Why? California courts are very sensitive to the rights of potential beneficiaries. It is best to be protected by a court-approved change than to later be engaged in a legal battle over the rights of those who may be in a position to benefit from the trust. And when everyone agrees to the change, court approval is relatively easy to obtain.
Even when all parties consent, however, court approval may not be forthcoming. For example, a court will not allow the parties to agree to terminate an irrevocable trust if the trust contains what is called a “spendthrift” provision. This is a common clause in an irrevocable trust that is designed to prevent trust beneficiaries from spending money before they receive it. Also, special requirements apply if the change will frustrate a “material purpose of the trust.”
Not All Beneficiaries Consent to Change an Irrevocable Trust
If all of the beneficiaries do not consent to a change to an irrevocable trust, a court must approve any requested changes. This can happen in one of two circumstances. In the first situation, the grantor consents to the change and the court finds that any nonconsenting beneficiaries will not be “substantially impaired” by the modification. The second situation exists when modification is appropriate due to changed circumstances. In either case, a petition must be filed with the court.
Principal of the Irrevocable Trust Is Relatively Low When Compared to the Cost of Administering the Trust
California law also allows an irrevocable trust to be changed or terminated when the principal balance of the trust becomes “low in relation to the cost of administration,” enough so that the trust's ability to meet a stated purpose is “substantially impair[ed].” In California, it is assumed that if the fair market value of the trust principal is less than $40,000, the trustee can terminate an irrevocable trust. If the principal's value is $40,000 or more, the trustee can petition the court to end or modify the irrevocable trust.
Deciding to modify or terminate an irrevocable trust is a complicated decision that can have unintended tax and other consequences. If you have questions about a trust, enlist the help of a qualified estate planning attorney.