DECANTING AND OTHERWISE FIXING BROKEN TRUSTS

First Run Broadcast: June 23, 2017

2:30 p.m. E.T./1:30 p.m. C.T./12:30 a.m. M.T./11:30 a.m. P.T. (60 minutes)

Not every irrevocable trust ends up serving its intended purpose or is financially viable. Many

unforeseen events can occur – laws change, deep conflicts arise among beneficiaries, there’s

deep downturn in the general economy or markets, or in an specific industry in which the trust is

heavily invested. In these and many other circumstances trusts are broken and need to be “fixed”

– fiduciary powers adjusted, distributions balanced, trusts divided or merged, or even terminated

early. The process of accomplishing these fixes are necessarily limited and come with risks,

including tax liability and potentially liability to future beneficiaries. This program will provide

you with a practical guide to techniques for fixing broken irrevocable trusts.

Why trusts become broken – beneficiary conflicts, changing law, changing

economy/markets

Modifying irrevocable trusts – material v. non-material terms

Dealing with principal and income distribution issues and problems

Merger and division of irrevocable trusts

Early termination of trusts

Permissibility and practical uses of “decanting” broken trusts

Avoiding pitfalls – liability to future beneficiaries and tax concerns

Speakers:

Benjamin S. Candland is a partner in the Richmond, Virginia office of McGuireWoods, LLP,

where his practice focuses on estate planning, administration, estate and gift taxation, and

litigation. He provides individual clients with advice on various estate planning matters

involving estate, gift, and generation-skipping transfer taxes. He is a member of the ABA Real

Property and Probate Section and the Virginia Bar Association Trusts and Estate Section. Mr.

Candland received his B.A. from Brigham Young University and his J.D. from the College of

William and Mary School of Law.

Stephen W. Murphy is an attorney in the Charlottesville, Virginia office of McGuireWoods,

LLP, where his practice concentrates primarily on estate planning, trust and estate

administration, real estate, and business law. He is a lecturer-in-law at the University of Virginia

School of Law where he teaches trust and estate administration and professor of law at

Washington & Lee University School of Law where he teaches statutory interpretation. Mr.

Murphy received his B.A. from the University of Maryland, his M.Phil. from the University of

Cambridge, his PhD from University of Virginia, and his J.D. from the University of Virginia

School of Law.

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Decanting and Otherwise Fixing Broken Trusts Teleseminar

June 23, 2017 1:00PM – 2:00PM

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Please note: This form is for your records in the event you are audited Sponsor: Vermont Bar Association Date: June 23, 2017 Seminar Title: Decanting and Otherwise Fixing Broken Trusts Location: Teleseminar - LIVE Credits: 1.0 MCLE General Credit Program Minutes: 60 General Luncheon addresses, business meetings, receptions are not to be included in the computation of credit. This form denotes full attendance. If you arrive late or leave prior to the program ending time, it is your responsibility to adjust CLE hours accordingly.

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Repairing the Broken Trust:Decanting, Modifying, and Restructuring

Irrevocable Trusts

Friday, June 23, 20171:00 p.m. to 2:00 p.m. EDT

Benjamin S. Candland

McGuireWoods LLP

901 East Cary Street

Richmond, Virginia 23219

(804) 775-1047

bcandland@mcguirewoods.com

Stephen W. Murphy

McGuireWoods LLP

310 Fourth Street, NE, Suite 300

Charlottesville, Virginia 22902

(434) 977-2538

swmurphy@mcguirewoods.com

© 2017 McGuireWoods LLPAll rights reserved

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BENJAMIN S. CANDLAND is a partner in the Richmond, Virginia office of

McGuireWoods LLP. His practice involves estate planning, estate administration, estate and gift

taxation, and fiduciary litigation. Mr. Candland provides individual clients with advice on various

estate planning matters involving estate, gift, and generation-skipping transfer taxes. He also

advises fiduciaries concerning the administration of trusts and estates and related tax issues. Mr.

Candland regularly represents corporate fiduciaries, individual fiduciaries, and beneficiaries in

fiduciary litigation matters; will contests; and trust reformations. He is admitted to practice law in

Virginia, the U.S. Court of Appeals for the Fourth Circuit and the Supreme Court of Virginia. Mr.

Candland earned his B.A. degree from Brigham Young University and his J.D. degree from

William & Mary Law School. Mr. Candland is a Fellow in the American College of Trust and

Estate Counsel.

STEPHEN W. MURPHY is an attorney in the Charlottesville, Virginia office of

McGuireWoods LLP. His practice concentrates primarily on estate planning, trust and estate

administration, real estate, and business law. He advises individuals, institutions, executors, and

trustees on complex estate plans, wills, trusts, estates, and the transfer and management of real

estate and closely-held businesses. Mr. Murphy regularly lectures and publishes on a variety of

legal topics relating to estate planning, trust and estate administration, and business law, including

the use of arbitration clauses in wills and trusts, estate planning for owners of closely-held

businesses, estate planning for artists, the drafting of non-compete agreements and buy/sell

agreements, elder care and special needs trusts, and the formation and transfer of business entities.

He is a lecturer in law at the University of Virginia School of Law, where he teaches trust and

estate administration. Mr. Murphy is admitted to practice in Virginia and before the U.S. Court of

Appeals for the Fourth Circuit. He is also an adjunct professor of law at the Washington & Lee

University School of Law, where he teaches a seminar on the interpretation of statutes and

regulations. Mr. Murphy was named a Super Lawyers Rising Star in Estate Planning in 2012 and

2013. Mr. Murphy received his B.A. degree from the University of Maryland, and earned his J.D.

and Ph.D. degrees from the University of Virginia.

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Repairing the Broken Trust:Modifying, Restructuring and Terminating Irrevocable Trusts

Benjamin S. CandlandStephen W. Murphy

McGuireWoods, LLP

I. Introduction

A. Irrevocable trusts can have important benefits for asset management, asset protection, and planning for estate, gift, and generation-skipping transfer tax.

B. However, the irrevocable nature of a trust can also lead to complications. Over time, the terms of the trust may no longer serve their desired purposes. This can occur for any number of reasons, such as changes in the nature of the trust assets, developments in the relationships or circumstances of the beneficiaries, or amendments to tax laws.

C. In such a case, tools are available to “repair” the characteristics of the trust to bring it in line with the purposes of the trust and changed circumstances. The fiduciary, advisor, and practitioner would do well to understand the circumstances that could lead a trust to need fixing, and the mechanisms by which such a trust can be “repaired.”

II. Why Trusts Become Broken

A. As noted above, there are numerous reasons that might lead a trust to be “broken,” or to no longer serve its original purpose. This can arise in any number of scenarios, and the examples are too many to try to list here. Below are just a few examples of the types of changes that might lead a trust to be “broken”.

B. Changing Circumstances.

1. Long-Term Trusts. Trusts are often designed to span multiple generations. Such trusts, sometimes referred to as “dynasty trusts,” allow a settlor to make effective use of his or her generation-skipping transfer tax exemption. However, it is common for circumstances to arise that could not have been foreseen decades earlier when the trust document was drafted. Such circumstances could frustrate the purposes of the trust by producing results the settlor never intended.

2. Uneconomical Trusts. A long-term trust might be established with a relatively modest amount of money. As a result of a declining market, poor investments, or excessive invasions of principal, the corpus of a trust could be depleted. Sometimes the cost of administering such a trust may render

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the trust uneconomical, or may require the trust to be amended in ways to make the administration more efficient.

3. Trust Purpose No Longer Exists. It is possible that the underlying purpose for which the trust was created no longer exists or has already been accomplished. If the trust document does not provide a trustee with the ability to modify or terminate the trust, the trustee must look to applicablelaw for relief.

C. Beneficiaries with Conflicting Interests.

1. Step-Parent vs. Step-Children. Those who regularly administer trusts probably know that the relationship between a step-parent and step-children can be difficult—especially when money is involved. Because the interests of such parties may not align, the trustee is placed in a very difficult position.

2. Income Beneficiaries vs. Remainder Beneficiaries.

a. Tension can also arise between income and remainder beneficiaries. A common scenario is when a marital trust is set up for the surviving spouse with the remainder of the trust assets passing to the children at the death of the surviving spouse. In such cases, it is in the best interests of the surviving spouse for the investments to be heavily invested in income-producing assets. Conversely, it is in the best interests of the remainder beneficiaries for the assets to be invested in assets that will grow. As a result, the trustee is placed in the nearly impossible position of trying to balance such interests.

b. This tension frequently arises. “The interests of a life income beneficiary, for example, are almost inherently in competition with those of the remainder beneficiaries, especially in light of the risks of inflation; and the different tax circumstances of the various beneficiaries frequently create competing investment preferences.” Restatement (Third) of Trusts 227, cmt. (c).

3. Different Family Lines. A trust may be set-up as a “pot” trust for a settlor’s children and their descendants. Perhaps one child has a descendant that has a medical condition that requires a substantial portion of the trust principal. The result might be that the trust principal is depleted to the detriment of the other family lines.

D. Investment Powers.

1. One particular reason for a trust to become “broken” might relate to the trustee’s powers to invest trust assets. Changes in investments of the trust, or investment goals of the trust, can also lead a trust to no longer serve its purposes. A trust could be modified, either judicially or nonjudicially, in

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order to insert such a provision into the trust or to otherwise allow the trustee to take actions consistent with the changed circumstances.

2. Division or Realignment of Investment Authority.

a. A circumstance might arise in which the parties wish to divide the responsibility for investments among multiple trustees, or to allow the trustee to be excused from investments altogether.

b. From a client’s perspective, high net worth individuals have traditionally tried to obtain the best advisors in each field in which the individuals need advice. For example, a high net worth individual may use multiple tax advisors for advice in different areas, such as one expert in individual income taxation, anther expert in pass through entity taxation, and another expert in transfer taxation. Also, some clients will have special assets or a special family situation that need special attention from someone familiar with the assets or family situation.

c. From a trustee’s perspective, the trustee may not have the expertise to handle all of the trust investment needs. Given the emphasis in the investment community on international and alternative investments, it is difficult for a trustee to be an expert in all types of asset classes. Also, a wise trustee may not want to be responsible for making discretionary decisions if the client has special assets or a special family situation.

d. In response to clients’ desires for obtaining the best advice and trustee desires to offer more specialized services, client advisors have become more inclined to “slice and dice” trustee responsibilities.

e. There are two primary methods of shifting trustee responsibilities.

i. Delegation. The trustee may delegate the responsibility to a third party.

ii. Directed Trustee. Alternatively, the grantor may direct that a third party (called a “trust advisor” for purposes of this paper) have responsibility for certain specified fiduciary actions.

f. Each of these methods, a trustee delegation or a directed trustee, has different ramifications and presents different risks and liability to the trustee. In addition, it is important that the drafter of the governing instrument provide clarity as to the authority and scope

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of the delegation or direction. Otherwise, in either scenario there is a significant risk of problems and litigation.1

3. Closely-Held Entities.

a. One area in which such an action can be particularly helpful relates to closely-held interests. A delegation, a directed trusteeship, or another action regarding the investment provisions of a trust agreement can help the trust address issues related to closely-held interests.

b. Retain a Closely-Held Interest. A trust might not allow the trustee to retain closely-held assets, such as a family business. This might otherwise lead the trustee to sell the business, to diversify the assets and comply with applicable standards for investments, such as the Prudent Investor Rule. Beneficiaries, the settlor, or the trustee may wish to alter aspects of the trust to allow the trustee to retain those assets.

c. Sell a Closely-Held Interest.

i. Conversely, a trust might have been drafted to require a trustee to retain an asset, but changed circumstances might lead the parties to wish to sell the asset. Joseph Pulitzer, the newspaper published who published The World, died in 1911. His will created a trust for the benefit of his descendants, which included shares in the Press Publishing Company, publisher of The World. While the terms of his will allowed the trustees to sell stock in other companies, the will expressly prohibited the trustees from selling stock in the Press Publishing Company. Pulitzer’s will stated that his goal in requiring the trusts to hold this stock was to require his descendants to carry on the company

I particularly enjoin upon my sons and my descendants the duty of preserving, perfecting and perpetuating “The World”newspaper (to the maintenance and upbuilding of which I have sacrificed my health and strength) in the same spirit in which I have striven to create and conduct it as a public institution, from motives higher than mere gain, it having been my desire that it should be at all times conducted in a spirit

1 Al W. King, III and Pierce H. McDowell, III, “Delegated Vs. Directed Trusts,” Trusts and

Estates, July 2006, page 26.

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of independence and with a view to inculcating high standards and public spirit among the people and their official representatives, and it is my earnest wish that said newspaper shall hereafter be conducted upon the same principles.

ii. In 1931, when the shares of the corporation had declined significantly, the beneficiaries petitioned the court to amend the terms of the trust to allow a sale of the shares. The court held that such a sale was appropriate, despite the clear language in the trust. The court reasoned that without the sale, the entire trust might lose its value, and in construing Pulitzer’s intent, his intent of benefiting his descendants was to be construed as a priority over the “mere vanity” of holding the interest in the company.2

E. Issues regarding Trustee Powers and Duties. The terms of a trust might also contain provisions regarding the designation of a trustee or trustees, which are no longer effective or necessary based on applicable law. It may become desireable to update any number of provisions of a trust, including the following:

1. The ability of trustees to delegate abilities to another;

2. The compensation provisions of a trust;

3. Removing, or inserting, a requirement that a corporate trustee serve as trustee; or

4. Grant the trustee a power to take a certain action, such as to retain a closely-held interest, that might otherwise be prohibited by the terms of the trust or applicable law.

F. The Trustee’s Duty and Authority to “Repair” a Broken Trust.

1. As noted below, the trustee or other parties might have the ability to “repair” the trust, through nonjudicial or judicial means.

2. Moreover, in some cases, a trustee might have a duty to repair that trust.

a. One example relates to the duty of impartiality. If a trustee is in a position in which the trustee cannot treat the beneficiaries impartially, the trustee might have a duty to take actions to remedy the situation.

2 See In re Pulitzer’s Estate, 249 N.Y.S. 87, 92 (Sur. Ct. 1931).

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b. For example, if the trustee cannot treat income beneficiaries and remainder beneficiaries impartially because of some provision of applicable law or the terms of the trust, then the trustee might have a duty to take remedial action.

c. Similarly, if a trustee has identified an issue regarding trust investments, such as the declining value of the stock referenced in the Pulitzer case, above, then a trustee might consider whether it has a duty to petition the court or to explore options to address this issue.

III. Sources of Law to Repair a Broken Trust

A. The trustee’s authority to repair a broken trust might derive from numerous sources.

B. Statutory Law and the Uniform Trust Code

1. The Uniform Trust Code (“UTC”) was drafted by the National Conference of Commissioners on Uniform State Laws (“NCCUSL”) in 2000, and amended in 2001 and 2003. The UTC includes various provisions that provide parties with the flexibility to modify or terminate irrevocable trusts.

2. The purpose of the Uniform Trust Code is “to provide a comprehensive model for codifying the law on trusts,” and to “enable states which enact it to specify their rules on trusts with precision and will provide individuals with a readily available source for determining their state’s law on trusts.”

3. The UTC has been adopted in the following states3:

Alabama New MexicoArizona North CarolinaArkansas North DakotaDistrict of Columbia OhioFlorida OregonKansas PennsylvaniaMaine South CarolinaMassachusetts TennesseeMichigan UtahMissouri VermontMontana VirginiaNebraska West VirginiaNew Hampshire WyomingNew Jersey

3 Uniform Law Commission, Legislative Fact Sheet, Uniform Trust Code,

http://www.uniformlaws.org/.

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4. The act has been introduced but not passed in Connecticut, Indiana, Minnesota, Oklahoma, and Texas.

C. The Uniform Principal and Income Act. The Uniform Principal and Income Act (“UPAIA”) was also originally drafted by NCCUSL. The UPAIA addresses issues related to principal and income allocations. The UPAIA also provides trustees with the tools to deal with difficult situations regarding investments and the allocation of earnings and expenses among beneficiaries.

D. Decanting. Another method of addressing the terms of the trust is through a process called “decanting,” discussed below. Decanting can be authorized by the common law, statutory law, or the terms of the trust.

E. Powers Included in the Trust Document.

1. The UTC and the UPAIA provide default rules, many of which may be overridden by the terms of the trust document. Attorneys should consider including provisions in the document to provide flexibility to address changing circumstances, while still ensuring that the objectives of the settlor are met.

2. The trust document might also name a third party, sometimes called a “Trust Protector” or “Trust Advisor,” who might have powers under the terms of the trust or applicable law to take actions related to the trust.

IV. Methods Available to Repair a Trust

A. Actions with Court Involvement. Certain actions can be taken by the trustee or the beneficiaries, with the approval of the court. These methods might require the time and expense of a judicial proceeding, but they might allow the parties to have some certainty regarding the propriety of their actions.

1. With the Consent of All Beneficiaries. If the settlor and all beneficiaries agree to the modification or termination of a trust, the court “shall approve the modification or termination even if the modification or termination is inconsistent with a material purpose of the trust.” UTC § 411(a) (emphasis added).

2. With the Consent of All Beneficiaries. A court may modify a trust “upon the consent of all the beneficiaries if the court concludes that modification is not inconsistent with a material purpose of the trust.” UTC § 411(a) (emphasis added).

3. Without the Consent of All Beneficiaries. A court may modify a trust even if all beneficiaries do not consent if the court finds that it has the authority to do so (i.e., no material purpose will be violated) and if the “the interests

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of a beneficiary who does not consent will be adequately protected.” UTC§ 411(a) (emphasis added).

4. To Further the Purposes of the Trust. A court may modify a trust if “because of circumstances not anticipated by the settlor, modification … will further the purposes of the trust.” UTC § 412(a).

5. Correcting Mistakes. A court “may reform the terms of a trust, even if unambiguous, to conform the terms to the settlor’s intention if it is proved by clear and convincing evidence that both the settlor’s intent and the terms of the trust were affected by a mistake of law or fact.” UTC § 415.

6. Tax Objectives. “To achieve the settlor’s tax objectives, the court may modify the terms of a trust in a manner that is not contrary to the settlor’s probable intention.” UTC § 416.

7. Special Rules for Charitable Trusts. If the charitable purpose of a trust becomes “unlawful, impracticable, impossible to achieve, or wasteful,” a court may order that the trust be modified or terminated. UTC § 412(b) (emphasis added).

8. In addition to the court’s retained general jurisdiction to enter any orders related to the administration of a trust, the UTC enumerates the following specific areas of court authority.

a. A court may modify or terminate a trust or remove the trustee and appoint a different trustee if the court finds that the trust assets are insufficient to justify the costs of administration. UTC § 414.

b. The court may reform the terms of a trust (even if not ambiguous) to conform to terms to the settlor’s intention upon clear and convincing proof that the settlor’s intent and the trust terms were affected by a mistake of fact or law. UTC § 415.

c. The court may modify the trust terms, including retroactively, to achieve the settlor’s tax objectives in any manner not contrary to the settlor’s probable intention. UTC § 416.

B. Actions without Court Involvement: Nonjudicial Settlement Agreements.

1. Generally.

a. Interested parties “may enter into a binding nonjudicial settlement agreement with respect to any matter involving a trust.” Court approval is not necessary. UTC § 111.

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b. Interested persons are persons whose consent would be required in order to achieve a binding settlement were the settlement to be approved by the court.

c. The representation provisions apply, thereby making it possible to bind minor and unborn beneficiaries to a settlement agreement without a court proceeding.

2. A nonjudicial settlement is valid only to the extent:

a. It does not violate a material purpose of the trust; and

b. Includes terms that could be properly approved by the court.

3. Examples. There are a wide range of situations where a nonjudicial settlement agreement would be appropriate. UTC § 111 provides examples. Again, nonjudicial settlement agreements cannot be used to violate a material purpose of the trust.

a. The interpretation or construction of the terms of the trust.

b. The approval of a trustee’s report or accounting;

c. Direction to a trustee to refrain from performing a particular act or the grant to a trustee of any necessary or desirable power;

d. Granting trustees necessary or desirable powers;

e. The resignation or appointment of a trustee and the determination of a trustee’s compensation;

f. Transfer of a trust’s principal place of administration; and

g. Liability of a trustee for an action relating to the trust.

4. Any interested person may petition the court to approve a nonjudicial settlement agreement to determine:

a. Whether the representation of parties was adequate; and

b. Whether the agreement contains terms the court could have properly approved.

5. Material Purpose.

a. There is limited authority on whether a given modification would violate a “material purpose,” and this would depend on the facts and circumstances of a particular case. Available case law typically

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addresses the termination of a trust, and not whether a given modification would violate a “material purpose.”4

b. On the one hand, the comments to the Uniform Trust Code state that a material purpose must be “of some significance.”5 The Restatement adds, “Material purposes are not readily to be inferred. A finding of such a purpose generally requires some showing of a particular concern or objective on the part of the settlor, such as concern with regard to the beneficiary’s management skills, judgment, or level of maturity.”6

c. The Restatement continues that the “line” between a material purpose and other intentions “is not always easy to draw.” When such an expression of a material purpose is not contact in the document itself, “the identification and weighing of purposes under this Section frequently involve a relatively subjective process of interpretation and application of judgment to a particular situation, much as purposes or underlying objectives of settlors in other respects are often left to be inferred from specific terms of a trust, the nature of the various interests created, and the circumstances surrounding the creation of the trust.”7

d. The Restatement suggests that a revision regarding who might serve as trustee are to be particularly (although sympathetically) reviewed. The comment explains, “a proposed modification might change the trustee or create a simple, inexpensive procedure for appointing successor trustees, or it might create or change procedures for removing and replacing trustees. Modifications of these types may well improve the administration of a trust and be more efficient and more satisfactory to the beneficiaries without interfering with a material purpose of the trust.”8

e. The comment to the Restatement continues that “repeated modifications to change trustees or even a particular change of trustee, or an amendment of provisions relating to the trusteeship, might have the effect of materially undermining the contemplated qualities or independence of trustees. A given change might even have the effect of shifting effective control of the trust in such a way as to be inconsistent with a protective management purpose or other material purpose of the trust. Thus, changes of trustees or in trustee

4 See, e.g., In re Estate of Brown, 529 A. 2d 752 (Vt. 1987).5 Uniform Trust Code § 411, cmt.6 Restatement (Third) of Trusts §65 cmt. d.7 Id., cmt. b.8 Restatement (Third) of Trusts §65 cmt. f.

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provisions are to be particularly but sympathetically scrutinized for possible conflict with a material trust purpose.”9

f. The Restatement cites a “thoughtful and interestingly illustrative opinion” from a trial court in South Dakota from 1999. In that case, the judge approved a change of trustee from one bank to another, since “it is not necessary that [the initial corporate trustee] invest the trust assets and distribute the income. Another trustee can do this function and it is not a material purpose of the [trust] that [the initial corporate trustee] complete this function.” But the judge denied a change in the trustee provisions to allow the beneficiaries to substitute future trustees. The court explained, “[u]nlike the first petition to substitute trustees, it cannot be presently ascertained whether a future substitution will cause a material change to the Hogan Trust. If this petition is granted, the Beneficiaries can substitute trustees until they find a sympathetic trustee who complies with their demands.”10

g. In light of this concern of whether a given modification—even one that only addresses the changing of the procedures to identify a successor trustee—would violate a material purpose of a trust, a trustee might prefer to ask a court to validate a nonjudicial settlement agreement, or might prefer to use the decanting process, which is not keyed to a “material purpose” of the trust.

h. In addition, because a nonjudicial settlement agreement necessarily requires consent of the beneficiaries, it can have adverse consequences for gift, estate, and generation-skipping transfer tax.

C. Further Actions without Court Approval: Termination, Combination, Division, and Modification without Court Approval.

1. The UTC provides some useful statutes giving trustees authority to deal with certain trusts without involving the court.

2. Under UTC § 414, a trustee may terminate an uneconomic trust without court approval:

a. After notice to the qualified beneficiaries;

b. If the total value of the trust is less than $ 50,000 or other sum determined by a particular state (Virginia, for example, has picked $100,000);

9 Id.10 Id., cmt. f, Reporter’s Notes (2003).

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c. The trustee concludes that the value of the trust is insufficient to justify the administrative costs; and

d. The trustee distributes the trust assets in a manner consistent with the purposes of the trust.

3. Under UTC § 417, a trustee without court approval may combine two or more trusts into a single trust or divide a trust into two or more separate trusts:

a. After notice to the qualified beneficiaries; and

b. If the result does not materially impair rights of any beneficiary or adversely affect achievement of trust purposes.

D. Resignation and Removal of Trustees.

1. There are also circumstances where the trust no longer serves its purpose because the trustee is no longer the best option to serve. In some such cases, the best option might be for the trustee to resign, or for the beneficiaries to seek to remove the trustee, and for the trust to be amended to remove any outdated requirements for the trustee.

2. Resignation.

a. While many trust instruments provide for trustee resignation, some trust instruments do not or have awkward restrictions on resignation. The UTC provides for resignation without court approval

b. Under UTC § 705, a trustee may resign:

i. On 30 days’ notice to:

(a) the settlor (if living);

(b) all co-trustees; and

(c) the qualified beneficiaries (unless it is a revocable trust); or

ii. With court approval.

c. A resigning trustee’s liability (or the liability of the surety on his bond) is not automatically discharged or affected by the resignation. UTC § 705(c).

d. The court, however, has broad powers to enter orders related to the administration, and this should include the ability to settle the

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trustee’s accounts as a part of judicial proceedings to approve the resignation.

e. It is advisable, if the trustee is concerned about post-resignation surcharge claims, for a resigning trustee to ask the court to release him from liability as a part of the resignation so that the trust will not have to defend a claim after resignation when the trustee does not have the benefit of the trust assets to fund the costs of defense.

3. Removal.

a. The UTC has expanded beyond the common law the grounds upon which a court may remove a trustee. Under UTC § 706, the Court may remove a trustee:

i. On petition by the settlor, a co-trustee, or a beneficiary, or on it own initiative;

ii. Because of:

(a) A serious breach of trust;

(b) Lack of cooperation with co-trustees that substantially impairs the trust administration;

(c) It is in the best interests of the beneficiaries because of:

(i) Unfitness;

(ii) Unwillingness; or

(iii) Persistent failure to administer the trust effectively.

(d) A substantial change of circumstances if:

(i) It is in the best interests of the beneficiaries;

(ii) It is not inconsistent with a material purpose of the trust; and

(iii) A suitable co-trustee or successor trustee is available.

(e) If requested by all of the qualified beneficiaries and:

(i) It is in the best interests of the beneficiaries;

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(ii) It is not inconsistent with a material purpose of the trust; and

(iii) A suitable co-trustee or successor trustee is available.

iii. In a suit to remove a trustee, the court may enter any relief appropriate under UTC § 1001 as necessary to protect the trust or the beneficiaries.

iv. The relief available under UTC § 1001(b) includes compelling a trustee to perform his or her duties; enjoining a trustee from committing a breach of trust; compelling a trustee to redress a breach of trust by paying money or restoring property; ordering a trustee to account; suspending or removing the trustee; reducing or denying compensation to the trustee; and voiding an act of a trustee.

V. Dealing with Income/Principal Distribution Issues

A. Generally. Sometimes a trust document may provide the trustee with the ability to distribute income, and not principal, to a beneficiary. Situations may arise when the income generated by the assets of the trust are not sufficient to meet the needs of the income beneficiary. Conversely, the trust assets may produce a large amount of income but have very little growth potential. The UPAIA provides options for trustees to deal with such issues.

B. The Principal and Income Adjustment Power

1. Generally. If the assets of a trust produce “too much” or “too little” income for the income beneficiary, a trustee may opt to make an adjustment in the allocation of assets between income and principal.

2. Trustee’s Power to Adjust. “A fiduciary may adjust between principal and income to the extent the fiduciary considers necessary.” UPAIA § 104.

3. UTC Comment. “The purpose of [this section] is to enable a trustee to select investments using the standards of a prudent investor without having to realize a particular portion of the portfolio’s total return in the form of traditional trust accounting income such as interest, dividends, and rents.”

4. Prerequisites to Exercising the Adjustment Power. Before a trustee may exercise the power to adjust between income and principal, certain prerequisites must be met, under UPAIA § 104(a):

a. The trustee must invest and manage the trust assets as a prudent investor;

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b. The terms of the trust must describe the amount that may or must be distributed to a beneficiary by referring to the trust’s income; and

c. The trustee must be unable (without the adjustment power) to administer the trust in such a way that would be fair and reasonable to all beneficiaries.

5. Example: A trust provides for the income to be distributed to a class of beneficiaries, with the remaining assets being distributed to a different class of beneficiaries at the termination of the trust.

The trust owns a substantial interest in a closely-held business. The entity begins to sell assets and make large distributions to the owners of the entity. The UPAIA provides that, subject to certain exceptions, distributions received from an entity are to be allocated to income.

The UTC Comments recognize the potential unfairness of such a rule and provide the following: “In such a case the trustee, after considering the total return from the portfolio as a whole and the income component of that return, may decide to exercise the power under Section 104(a) to make an adjustment between income and principal, subject to the limitations in Section 104(c).”

Note: The problem comes in actually applying the adjustment power to a given situation. Although the UPAIA provides factors that a trustee should consider, it is left to the trustee to exercise his/her discretion in determining exactly how much income should be allocated to principal (or vice versa).

C. Total Return Unitrusts.

1. Generally. In many instances, applicable law also permits a trustee to convert a trust to a total return unitrust. See, e.g., Va. Code § 64.2-1003. A unitrust allows a trustee to distribute to the income beneficiary a fixed percentage of the total assets of the trust. Some of the advantages of converting a trust to a unitrust include:

a. The adjustment power can be difficult to apply. Determining how much principal to allocate to income (or vice versa) is somewhat subjective. A unitrust takes away the guesswork.

b. Because the trustee is able to invest for an overall return rather than having to realize a certain amount of income, unitrusts can settle the inherit conflict that exists between income beneficiaries and remainder beneficiaries. Ideally, this would allow the principal of the trust to grow more over time.

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c. Unitrusts are easy for beneficiaries to understand.

2. The Conversion Process. The steps to convert an income trust to a unitrust are set forth by statute. See, e.g., Va. Code § 64.2-1003. Generally, a trust can be converted to a unitrust without court approval.

VI. Restructuring Irrevocable Trusts

A. Several mechanisms also exist to restructure trusts, perhaps to group similarly-situated beneficiaries together, or to address particular issues regarding transfer taxes.

B. Merger and Division of Trusts.

1. Generally. A trustee, after notice to the qualified beneficiaries, “may combine two or more trusts into a single trust or divide a trust into two or more separate trusts, if the result does not impair the rights of any beneficiary or adversely affect achievement of the purposes of the trust.” UTC § 417.

2. UTC Comment. “Administrative economies promoted by combining trusts include a potential reduction in trustees’ fees, particularly if the trustee charges a minimum fee per trust, the ability to file one trust income tax return instead of multiple returns, and the ability to invest a larger pool of capital more effectively. Particularly if the terms of the trusts are identical, available administrative economies may suggest that the trustee has a responsibility to pursue a combination.”

C. Qualified Severance Under IRC § 2642.

1. Generally. Certain trusts may be subject to generation-skipping transfer (“GST”) tax. Sometimes the allocation of a person’s GST tax exemption could result in a trust having a mixed inclusion ratio. In other words, part of the assets of the trust will be exempt from GST tax and part of the assets will not. In order to promote the most effective use of the assets that are exempt from GST tax, it is generally advisable to sever the trust into two trusts, one that will be exempt from GST tax and one that is not.

2. Procedure. Section 2642 of the Internal Revenue Code allows a trustee to sever a trust into two separate trusts. A “qualified severance” that meets the statutory requirements will result in the recognition of the trusts as two separate trusts for tax purposes. The qualified severance may occur at any time and must be authorized by either the trust document or state law. Further requirements for making a qualified severance are set forth insection 26.2642-6 of the Federal Regulations.

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VII. Early Termination of Irrevocable Trusts

A. A trust might also be “repaired” simply by being terminated. This might be particularly appropriate if the trust no longer serves any purpose, or if the trust is no longer economical to administer, or if the trust cannot be “repaired” in some other way.

B. Specific Instances When Early Termination is Allowed.

1. Uneconomical Trust. After notice to the qualified beneficiaries, the trustee of a trust consisting of trust property having a total value of less than $50,000 may terminate the trust if the trustee concludes that the value of the trust property is insufficient to justify the cost of administration. No Court approval is required. The remaining assets must then be distributed in a manner consistent with the purposes of the trust. UTC § 414(a).

2. Consent of the Beneficiaries. A court may terminate a trust “upon consent of all of the beneficiaries if the court concludes that continuance of the trust is not necessary to achieve any material purpose of the trust.” UTC § 411(b).

3. Unanticipated Circumstances. A court may terminate a trust if “because of circumstances not anticipated by the settler … termination will further the purposes of the trust.” Upon the termination of the trust, “the trustee shall distribute the trust property in a manner consistent with the purposes of the trust.” UTC § 411(c).

C. Termination Not Permitted if it Violates Material Purpose of the Trust.

1. Limitations of Termination. The power of a trustee or a court to terminate a trust is limited by the rule that the material purpose of the trust should not be violated.

2. Case Law. In one recent case, the beneficiaries petition to terminate a trust; but the Court refused, stating that such a termination would violate a material purposes of the trust. In Ladysmith Rescue Squad, Inc. v. Newlin, et al., the Supreme Court of Virginia addressed the issue of early termination of trusts. The Court rejected the attempt by the Petitioners to terminate the trust based on an alleged change of circumstances. The Court reasoned that “the testator’s or settlor’s intent prevails over the desires of the beneficiaries, and that intent is to be ascertained by the language the testator or settlor used in creating the will or trust.”11

11 280 Va. 195, 201–02 (2010).

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VIII. Other Ways to Modify Irrevocable Trusts.

A. There are numerous other ways to change the provisions of a trust, including (1) changing the situs and governing law of the trust, and (2) decanting the trust assets to a new trust. While the methods listed below might not technically “modify” the terms of a trust, these actions might have the practical effect of changing the terms that apply to the trust assets.

B. Changing the Situs of the Trust.

1. Generally. Often trust documents provide a trustee with the power to change the situs of the trust. The intention behind such a provision is that future beneficiaries may or may not be residents of Virginia. In order to facilitate the administration of such trusts, it may be preferable for the trust administration to occur in the state where the beneficiary is domiciled.

2. Tax Considerations.

a. Changing the situs of a trust from one state to another state may result in the trust having to file income tax returns in both states.

b. For example, Virginia imposes income tax on certain trusts. Section 58.1-360 of the Code of Virginia imposes a tax on the “Virginia taxable income for each taxable year for every estate and trust.” What portion of the income of a trust is taxable in Virginia depends upon whether such trust is considered a “resident trust” or “nonresident trust”. See Va. Code §§ 58.1-361 and 58.1-362.

c. The Virginia Administrative Code expands on this by adding that a trust is considered to be a Virginia resident trust if “its assets are located in Virginia, its fiduciary is a resident of Virginia, or it is under the supervision of a Virginia Court.” 23 Va. Admin. Code § 10-115-10.

d. Changing the situs of a trust from one state to another might allow the trust to no longer pay income tax to the prior state. Recent cases have addressed the extent to which a prior state can constitutionally tax a trust after the trust has left the jurisdiction.

C. Decanting

1. Decanting is a process by which a trustee of one trust transfers the assets of a trust to a new trust, which is either already in existence or which was formed by the trustee. This transfer is referred to as “decanting,” after the example of pouring wine from one container to another.

2. Advantages of Decanting

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a. Decanting has certain advantages over other methods of updating the administrative provisions of a trust.

b. In particular, the advantages of decanting can be seen as opposed to a judicial modification of a trust.

i. Judicial modification requires court approval, which can take time and money.

ii. The court may not approve of the trust modification. In one recent Delaware case, the court refused to allow modification of a testamentary trust to a directed trust. The court found that the testator intended for the trustee to exercise investment authority, and that the modification was not permissible, even with the beneficiaries’ approval.12 While the court in that case focused on the particular language of the trust instrument, this case nevertheless might give a trustee pause of whether a court would necessarily agree to modify a trust to create a directed trustee relationship.

iii. Judicial modification by beneficiary consent requires consent of the beneficiaries, which can have adverse tax consequences for gift, estate, and generation-skipping transfer tax, discussed below. These adverse tax consequences may be rare, however, in the case of a modification of the administrative terms of a trust; but in light of the potentially large adverse tax consequences, the trustee might be wise to seek court approval. For example, the trustee in Morse was careful to use decanting to modify the provisions for successor trustee, presumably in part to avoid requiring the beneficiaries to consent and to jeopardize the trust’s exemption from generation-skipping transfer tax.13

c. However, as discussed below, the lack of case law and the various statutory requirements might lead to uncertainty regarding when a decanting is permissible, or when a decanting is consistent with a trustee’s fiduciary duties.

12 See In re Trust under Will of Wallace B. Flint for the Benefit of Katherine F. Shadek, C.A. No.

10593-VCL (Del. Ch. June 17, 2015).13 Morse v. Kraft, 992 N.E.2d 1021 (Mass. 2013).

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3. Common-Law Origins and Continued Relevance of Common-Law Authority.

a. As noted below, the power to decant is now granted to trustees by statute in numerous states. However, decanting originated under the common law, based on a trustee’s discretionary power to distribute income or principal.14

b. These common-law cases remain important.

i. While numerous states have enacted decanting statutes, the other states do not grant a trustee the power to decant by statute. A trustee in one of those states could only decant based on the trustee’s common-law authority (or, if possible, by first changing the governing law of the trust to a state whose statute does allow decanting).

ii. In addition, even if a trustee is acting under the laws of a state which has enacted a decanting statute, the trustee might also need to know whether he or she had the authority to decant when the trust was initially created.

iii. For example, a trustee seeking to decant a trust that is exempt from GST tax must act carefully to ensure that the decanting does not jeopardize the trust’s GST-exempt status. As discussed in more detail below, one of the two “safe harbors” granted by the Treasury Regulations for decanting a GST-exempt trust requires that the trustee have the authority to decant under applicable law at the time that the trust first became irrevocable.15 Because many trusts were established long before the development of state decanting statutes, the trustee’s common-law authority to decant remains important in this inquiry.

iv. Finally, the courts’ reasoning in these cases remains relevant in reviewing a trustee’s exercise of decanting power under a statute. These cases remain some of the only cases in which courts have reviewed a trustee’s exercise of its discretionary power to decant, to determine whether the trustee’s exercise was consistent with the trustee’s fiduciary duties. Thus, these few cases may serve as the only guideposts for a trustee

14 See Phipps v. Palm Beach Trust Co., 196 So. 299 (Fla. 1940); Wiedenmayer v. Johnson, 254

A.2d 534 (N.J. Super. Ct. App. Div. 1969); Morse v. Kraft, 992 N.E.2d 1021 (Mass. 2013); see also In re Estate of Spencer, 232 N.W. 2d 491 (Iowa 1975).

15 See Treas. Reg. § 26.2601-1(b)(4)(i)(A).

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seeking to determine how a court might review his or her exercise of the decanting power.16

v. Accordingly, these common-law origins of decanting remain important, and not only for historical reasons. See, e.g., Phipps v. Palm Beach Trust Co. (1940)17; Wiedenmayer v. Johnson (1969)18 (holding that the trustees permissibly removed remainder beneficiaries from the first trust, and holding that a trustee’s consideration of the “best interests” of a beneficiary could include factors beyond the beneficiary’s pure “financial gain”); Morse v. Kraft (2013)19

4. Trend Toward Enactment of Statutes.

a. While there is limited authority on the ability of a trustee to decant a trust under common-law authority, in recent years numerous states have enacted a specific statute to authorize a trustee to decant.

b. New York enacted the first decanting statute in 1992 allowing a trustee to appoint trust property in favor of another trust.20

c. Since then, 25 total states have enacted decanting statutes. The trend toward enacting decanting statutes, although widespread, is not universal.

D. Decanting Statutes21

1. Twenty-five states now have statutes under which a trustee, pursuant to a power to distribute trust assets outright, may appoint trust assets in favor of another trust.

16 See, e.g., Morse v. Kraft, 992 N.E.2d 1021 (Mass. 2013); Wiedenmayer v. Johnson, 254 A.2d

534 (N.J. Super. Ct. App. Div. 1969).17 Phipps, 196 So. at 299.18 Wiedenmayer v. Johnson, 254 A.2d 534 (N.J. Super. Ct. App. Div. 1969).19 Morse v. Kraft, 992 N.E.2d 1021 (Mass. 2013).20 See N.Y. Est. Powers & Trusts § 10-6.6(b).21 For more details, see Alan S. Haleperin. “You May Not Need to Whine About Problems with

Your Irrevocable Trust: State Law and Tax Considerations in Trust Decanting,” 42d University of Miami Heckerling Institute on Estate Planning (2008), pp. 11-10 et seq.

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2. These states are the following:

Alaska22

Arizona23

Colorado24

Delaware25

Florida26

Illinois27

Indiana28

Kentucky29

Michigan30

Minnesota31

Missouri32

Nevada33

New Hampshire34

New Mexico35

New York36

North Carolina37

Ohio38

Rhode Island39

South Carolina40

South Dakota41

Tennessee42

Texas43

Virginia44

Wisconsin45

Wyoming46

22 Alaska Stat. § 13.36.157.23 Ariz. Rev. Stat. §14-10819.24 Colo. Rev. Stat. § 15-16-901.25 Del. Code tit 12 § 3528.26 Fla. Stat. § 736.04117.27 760 ILCS 5/16.4.28 Ind. Code § 30-4-3-6.29 KRS § 286.175.30 MCL § 556.115a.31 Minn. Stat. 502.851.32 Mo. Rev. Stat. § 456.4-419.33 Nev. Stat. § 136.037.34 N.H. Rev. Stat. § 564-B:4-418.35 N.M.S.A. § 46-12-101.36 N.Y. EPTL § 10-6.6(b).37 N.C. Gen. Stat. § 36C-8-816.1.38 Ohio Rev. Code Ann. § 5808.18.39 R.I. Gen. Laws § 18-4-31.40 S. Car. Stat § 62-7-816A.41 S.D. Codified Laws §§ 55-2-15 to 55-2-21.42 Tenn. Code § 35-15-816(b)(27).43 Texas Property Code §§ 112.071-112.087.44 Va. Code § 64.2-778.1 (Uniform Trust Decanting Act effective July 1, 2017).45 Wis. Trust Code § 701.0418.46 W.S. 4-10-816(a)(xxviii).

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3. Below is a summary of selected provisions of the decanting statutes of certain states.

a. Delaware47

i. A trustee of a Delaware trust needs only the authority to invade trust principal. There is no requirement of absolute discretion.

ii. In 2015, Delaware revised its decanting statute in certain respects.48 In particular, the statute now allows a trustee to decant income to the same extent that it could have previously decanted principal, so that the trustee may now decant income of a trust without first accumulating that income to principal.

iii. The Delaware statute differs from the Alaska statute in that the invasion standard of the new trust need not be the same as original trust.

iv. Exercise of the decanting power in Delaware does not require court approval or notice of consent of the beneficiaries.

b. Nevada49

i. Nevada amended its decanting statute in 2015, to clarify certain provisions and to give the trustee additional flexibility in decanting.50

ii. As revised, the statute provides the following:

(a) The decanting may remove a mandatory income interest of a beneficiary, so long as the income interest did not qualify for a marital, charitable, or other tax benefit.

(b) The second trust may accelerate future or remainder beneficiaries to be current beneficiaries. However, as with other decanting statutes, the second trust may

47 Del. Code tit 12 § 3528.48 See Del. S.B. 42 (effective August 1, 2015).49 Nev. Stat. § 136.037.50 Nev. SB484 (2015).

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not add a beneficiary who was not a beneficiary of the first trust.

(c) The statute applies to any trust that is sitused in, administered in, or governed by the laws of Nevada, whether the trust was first established there or was moved to Nevada.

iii. The Nevada statute specifically allows the decanting to grant a special or general power of appointment to one or more beneficiaries.

4. Uniform Trust Decanting Act (enacted in Colorado and New Mexico, and also in Virginia (effective July 1, 2017)).

a. Introduction.

i. The National Conference of Commissioners on Uniform State Laws (NCCUSL) has promulgated the Uniform Trust Decanting Act.51

ii. It is not clear what effect, if any, the promulgation of this model act is likely to have.

iii. Nearly one half of states have already adopted decanting statutes.

iv. As noted above, the legislatures in Colorado and New Mexico, which previously had not adopted decanting statutes, have adopted this act.

v. The promulgation of the model act may lead other states to adopt such statutes, just as it led Colorado and New Mexico to take such action.

vi. Meanwhile, Virginia already had a decanting statute, but Virginia enacted the Uniform Act, effective July 1, 2017.

vii. This model act may also lead to further uniformity in the states that have adopted such statutes.

viii. Some commentators have suggested that the lack of uniformity among the decanting statutes is beneficial, because it provides settlors, trustees, and beneficiaries with

51 National Conference of Commissions on Uniform State Law, “Uniform Trust Decanting Act,”

available at http://www.uniformlaws.org/shared/docs/trustdecanting/UTDA_Final%20Act.pdf[hereinafter “Uniform Trust Decanting Act”].

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numerous options in setting up a trust or in pursuing a decanting. For example, trustees who are considering a decanting could also consider changing the governing law to a state that provides for a certain procedure related to the decanting, such as a state that requires—or does not require—notice to beneficiaries.

b. Governing Law

i. The Uniform Trust Decanting Act recognizes that there may be doubt concerning which state’s laws should govern a trustee’s proposed exercise of the power to decant.

ii. The Restatements and Uniform Trust Code note potential conflicts regarding which state’s laws would govern a trust’s construction, the powers of its trustee and its administration, and its effect on beneficial interests.52 The comments to the Uniform Trust Decanting Act cite these authorities and confirm that decanting could be considered dependent on the validity or construction of a trust, or it could be an administrative power, or it could be a power to affect beneficial interests of a trust. And each of these perspectives on decanting might lead a court to conclude that a different state’s decanting laws should govern.53

iii. For this reason, the Uniform Trust Decanting Act, if enacted by a given state, provides that it would apply in any of the following cases:

(a) If the trust is governed by the laws of that state for purposes of administration;

(b) If the trust is governed by the laws of that state for purposes of determining meaning or effect; or

(c) If the trust has a principal place of administration in that state.54

52 See Restatement (Second) of Conflict of Laws § 267–79; Uniform Trust Code § 107 & cmt., §

108 & cmt.53 See Uniform Trust Decanting Act § 103, cmt.54 Uniform Trust Decanting Act § 103, cmt.

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c. Notice

i. The Uniform Trust Decanting Act does not require a trustee to get beneficiary consent or court approval before decanting.

ii. But the Act does require the trustee to provide 60 days’ notice of a proposed decanting, which would include a copy of the first and second trust instruments, to each of the following:

(a) the settlor, if living,

(b) each qualified beneficiary of the first trust,

(c) each person with authority to remove or replace the trustee,

(d) all other trustees of the first trust,

(e) the trustees of the second trust, and

(f) a successor beneficiary, if the decanting “materially and adversely affects” the interests of that successor beneficiary.55

iii. Qualified and Successor Beneficiaries

(a) Notably, the Uniform Trust Decanting Act also requires notice to be given to a “successor beneficiary.”

(b) The Uniform Trust Decanting Act and the Uniform Trust Code give rights to a “qualified beneficiary,” which is defined as a beneficiary who is a permissible distributee of trust income or principal, who would be a permissible distributee of trust income or principal if the current beneficiaries’ interest terminated.56

(c) The Uniform Trust Decanting Act defines a “successor beneficiary” as a beneficiary who is not yet a qualified beneficiary, but who may become a qualified beneficiary in the future by reason of

55 Uniform Trust Decanting Act§ 104.56 See Uniform Trust Decanting Act § 102(19) & cmt.; Uniform Trust Code § 103(13).

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inclusion in a class.57 The comments clarify that this includes unborn beneficiaries and beneficiaries who might be “second line” or more remote.

(d) This inclusion of successor beneficiaries in the notice provisions recognizes that decanting can have a substantial impact on a future beneficiary’s interest, and that those beneficiaries should be included in any proposal to decant. And as noted below, successor beneficiaries have the right to petition a court to consider whether the decanting is permissible.

d. Court Approval and Direction

i. The Uniform Trust Decanting Act also provides more robust provisions regarding the judicial remedies and options available to a trustee. A typical decanting statute would authorize a trustee or beneficiary to “commence a proceeding to approve or disapprove a proposed exercise of the power under this section.”58

ii. But the Uniform Trust Decanting Act would allow a trustee or any person entitled to notice of the decanting (including successor beneficiaries) to petition the court for a range of direction, or would allow the court to reach a number of conclusions, including the following:

(a) Providing instructions to the trustee of whether the proposed decanting is permitted under the Act and consistent with the trustee’s fiduciary duties;

(b) Approving the decanting;

(c) Proceeding with provisions of the Act, discussed below, regarding a partially impermissible decanting; and

(d) Ordering other appropriate relief.59

e. Under Section 301 of the Uniform Trust Decanting Act, the trustee may only decant the assets of the trust if the trustee may distribute

57 Uniform Trust Decanting Act§ 102(28) & cmt.58 Va. Code § 64.2-778.1 (I) (“A trustee or beneficiary may commence a proceeding to approve or

disapprove a proposed exercise of the power under this section.”).59 Uniform Trust Decanting Act§ 203(a).

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principal. That is, a trustee may not decant based on the trustee’s ability to distribute income only.60

f. Beneficiaries and Powers of Appointment

i. The Uniform Trust Decanting Act contains provisions regarding beneficiaries and powers of appointment that in many ways help to clarify existing statutes’ treatment of these issues.61

ii. Of particular relevance are the following.

(a) The Uniform Trust Decanting Act provides that a decanting may not be used to include as a current beneficiary any individual who is not a current beneficiary of the first trust.62

(b) The Act also provides that a decanting may not include a remainder beneficiary (that is, a future beneficiary who is not a qualified beneficiary) who is not a current, remainder, or successor beneficiary of the first trust. This helps to clarify a potential ambiguity under some states’ decanting statutes, some of which had simply provided that “[t]he beneficiaries of the second trust shall include only beneficiaries of the original trust.”63 Such general reference to “beneficiaries” seemed to cover remainder beneficiaries as well as current beneficiaries, but the use of more specific terms in the Uniform Trust Decanting Act helps to remove potential uncertainty regarding the ability to add future beneficiaries in a decanting.

iii. The Uniform Trust Decanting Act goes further than most statutes, and also provides that a decanting may not modify or eliminate a presently exercisable general power of appointment.64

60 Uniform Trust Decanting Act§ 301(b), § 302(b).61 See generally Uniform Trust Decanting Act § 301(c)(1).62 See generally Uniform Trust Decanting Act § 301(c)(3).63 See, e.g., Va. Code § 64.2-778.1(C)(1).64 Uniform Trust Decanting Act§ 301(c)(3).

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iv. The Act also clarifies the ability of a trustee to decant depending on whether the trustee acts under an ascertainable standard.

(a) Under the Act, if the first trust only grants the trustee “limited discretion” to distribute principal, such as if the trustee may only distribute assets to a beneficiary under an ascertainable standard, then the trustee may only decant in such a way that the second trust “in the aggregate, grant[s] each beneficiary … beneficial interests in the second trusts that are substantially similar to the beneficial interests of the beneficiary in the first trust.”65

(b) This is a less mechanical approach than under many current statutes; for example, in Virginia’s prior statute, a trust that must distribute under an ascertainable standard may only decant to a second trust with “the same current beneficiaries … and … subject to the same ascertainable standard.”66

(c) The Uniform Trust Decanting Act provides the trustee with more flexibility in decanting under an ascertainable standard. In particular, the comments to the Act note that this approach allows severance of a trust; this would not be permissible under Virginia’s statute, which requires that the second trust be for the “same beneficiaries.”67

v. The Act also allows the second trust to grant a power of appointment to beneficiaries, which can include the power to appoint assets to an individual who is not a beneficiary of the first trust.68

g. Partially Impermissible Decanting

i. Section 310 of the Act provides that a decanting is effective to the greatest extent permissible, and provides some procedure for addressing a decanting which includes impermissible actions by the trustee.69

65 Uniform Trust Decanting Act § 302(c).66 Va. Code § 64.2-778.1(C)(2).67 Uniform Trust Decanting Act § 302(c), cmt.68 Uniform Trust Decanting Act § 301(e).69 Uniform Trust Decanting Act § 310.

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ii. Notably, Section 203(a) allows the court to instruct a trustee regarding the remedies under Section 310.70

IX. Special Considerations / Avoiding Pitfalls

A. Liability to Future Beneficiaries.

1. Generally. It is possible that a modification to a trust might be in the best interests of current beneficiaries, but not in the best interests of future beneficiaries.

2. Uniform Trust Code. The UTC permits trust modifications by nonjudicial settlement agreements and by court orders. To ensure that such agreements or orders will be binding on future beneficiaries, the UTC provides for the binding of minors and unborn descendants.

3. Court Order. To avoid potential liability to a future beneficiary, a trustee should consider petitioning the court to approve the proposed actions. Even if an action is authorized by the Uniform Trust Code, it still might be preferable to obtain the approval of the court.

B. Tax Considerations.

1. Recognition of Gain. Parties should be sure that any modification to a trust does not trigger a taxable event. However, most of the modifications discussed herein will not result in a taxable event. “The estate planning community is solidly of one mind that the Cottage Savings doctrine has no place in the tax treatment of trust reformations, in which there are no exchanges and in which the beneficiaries’ receipt of trust corpus is governed by section 102, not section 1001.”71

2. Marital Trusts. Often an election will be made to treat the assets held by a trust as qualified terminable interest property (QTIP). Such election allows the assets to qualify for the marital deduction under section 2056 of the IRC. In order for the Trust assets to qualify for the marital deduction, the income of the trust must be distributed to the surviving spouse.

Care should be taken to ensure that any modifications of the trust terms do not jeopardize the marital deduction. See Section 20.2056(b)-5(f)(1) of the Federal Regulations.

70 Uniform Trust Decanting Act§ 203(a).71 “Old But Not Cold, Restructuring, Refocusing, and Retiring Irrevocable Trusts,” Ronald D.

Aucutt, McGuireWoods LLP, McLean, Virginia.

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3. GST Tax Exempt Trusts. When dealing with a trust that is exempt from generation-skipping transfer taxes, it is important that no changes be made that could impact the trust’s exempt status.

For example, trusts that are exempt from generation-skipping transfer taxes because they pre-date Chapter 13 of the Internal Revenue Code are grandfathered exempt from GST taxes. However, certain modifications to such trusts could result in the loss of the grandfathered status.

Note: Certain modifications discussed herein such as divisions of trusts and conversions to total return unitrusts may be permitted under the federal regulations. Treas. Reg. Section 26.2601-1(b)(4)(i)(E).

4. Changing the Residency of a Trust as a Solution to State Income Taxation.

a. Changing the residency for income tax purposes requires that the trustee and counsel analyze the rules regarding the residency of a trust in the current state and any state to which the trustee is considering moving the trust. Depending upon the laws of this current state of residency and the possible future states of residency, one must look at the terms of the trust instrument as well as the location of the trustee, the trust assets and the beneficiaries. An analysis should also be made of the potential state income tax savings that will arise from moving the trust.

b. It is also helpful to have in the document provisions that will provide flexibility in possibly changing the situs of the trust or the ability to add such provisions.

X. Conclusion

A. Irrevocable trusts can serve important purposes for managing a family’s assets over time. However, circumstances might arise that related to the beneficiaries, the trust assets, the trustee, or applicable law, which threaten to break the trust.

B. Unfortunately, some trusts carry on for years in a “broken” state, without optimally serving the interests and purposes of the trust.

C. The fiduciary, advisor, and practitioner should be aware of the various ways in which a trust might be broken, and the mechanisms available to repair that trust.

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