Everything You Need to Know About Irrevocable Trusts

speaker-0: There are certain provisions like silent trust provisions where the beneficiaries actually don't even have the right to know that they're beneficiaries. speaker-1: All right, what is up and welcome back everyone to another episode of the practical planner podcast. I'm your host Thomas Koppelman. Here with me is Ann Rhodes.

And it's really all about how to modify irrevocable trust. And I think this is a really important episode because I think a lot of people assume that you can't, right? We think, okay, there's revocable that can be changed. It can be revoked.

We can do whatever we want. We can take things out. We can put things in. Great.

Easy to change. And then most people think on the irrevocable side, you set it up, you start it. There's no changes that can happen. And I think as Ann's gonna allude to today, that is not true at all.

So Ann, super excited to be back with you and kind of chatting on this, but where do you start this conversation? Obviously you worked in practice with this. I'm sure people came in and had reasons that they wanted to make changes to their trust. I know there's kind of a hierarchy of options, best to worst.

Where do you start? What is the best option here? speaker-0: Yeah, think, you know, ⁓ irrevocable trust, as you hinted, Thomas, you know, are actually changeable. You just have to know how and ⁓ the how is actually usually baked into either the state law or more often into the trust agreement.

Because in many ways, the trust agreement, you know, what differentiates and this is hard to kind of appreciate either as a non lawyer or as the client is just the boilerplate of your trust, what differentiates a really great quality trust versus not so great quality trust is actually when push comes to shove and you want to come and change something about that trust, right? And how much flexibility, how many tools you have in your toolkit to be able to change that trust is super, super important.

Now, the first place to start is just what is it that you're trying to change about this trust? There are certain things that honestly is just table stakes for trust agreements to have and that the lawyer should have thought to put into the agreement. So for example, changing your trustee or appointing a new trustee or some sort of new fiduciary, new role, like a trust protector. All of those things should just be like de facto, like there should be a procedure in your trust agreement to be able to achieve something like that.

You can imagine that over the course of a trust that has a very long life, know, trustees come and go. We also have things that are smaller, like And Thomas, I think that you have clients who are interested in doing this, but just trust, changing what's inside the trust, right? What assets it holds, the asset composition, usually irrevocable trusts are trying to achieve some sort of financial, know, numerical result or tax result. And so is your trust, you know, equipped?

Does it have the assets inside of it to be able to achieve those goals? ⁓ you end up needing to change what's inside the trust as well. So those are kind of smaller changes that you might make to a speaker-1: One, with somebody looking through their trust, where do they go look to see if that exists? Is that just the power of substitution or kind of where would you see, what would be the terminology there?

And then I do want to talk about why that's important. speaker-0: Yeah, every trust is drafted differently. And so generally speaking, if you're trying to change something within the trust, you're looking at its investment powers, because with investment usually also comes reinvestment. So if it's as simple as, currently hold real estate within this trust, and now I want to convert it to something with higher growth.

I want to sell the real estate, go and invest in some crypto or something like that. That's just a reinvestment of the proceeds within the trust. And that's still considered to be the principle of the trust, like it's seed fund. You're just changing the way that it looks.

That's just like a very typical power of the trustee. So you'd look within the trustee powers. When you're talking about the power of substitution, and the reason why it becomes so important, Thomas, is that usually it's not the trustee that holds the power of substitution for the assets, but the grantor himself. speaker-1: Would you walk there?

⁓ speaker-0: Exactly. So you're actually swapping back with the grantor. You're saying, hey, grantor, you first put real estate into this thing. For whatever reason, the trustee, because they have duties to the beneficiaries, duties of loyalty and prudent investment or whatever, they don't feel like they can just go out there and purchase the asset that you think would be better.

And in fact, maybe that asset, at that level of concentration, is only the grantor who has that. Think of a startup founder. They're super, super, you know, they have a closely held investment. They're super concentrated in that.

So actually what you want to do is swap assets with the grantor. That's where that substitution power comes in. speaker-1: Yeah, and that's where the value comes in. Like I think for me and my clients, you know, there's not many opportunities quite yet to do that, but it's kind of more of end of life planning, right?

So let's say you were a founder, you had early shares, you got QSBS eligibility inside of this trust, but the growth is huge since then. Maybe you got 10 million, it's now worth 100 million. I guess that's a bad example because I don't know where you're to come up with a new 100 million. But the thought is, okay, great.

We'd much rather get a step up in basis on these shares. then have those pass away with those in shares. You maybe would rather move cash into the trust and move this kind high growth asset out of the trust so they can get a step up in basis here and have less to worry about from that cash. Like that's where I really see it becoming valuable, but you also need a lot of planning to make sure that actually happens.

speaker-0: For sure. So deathbed planning, it's very important to have that substitution power. But also actually with things like GRATs. GRATs usually have substitution powers because you're trying to beat a certain hurdle rate, the 75-20 rate, ⁓ with the assets that are inside of it.

So you really only put hot assets, like things that you expect to have some growth potential, ⁓ to be able to make up for the annuity that comes back to the grantor. As the grant is going on, let's say it's a five-year grant, you're two years in, and you're like, ⁓ shoot, those initial two asset classes that I put in there are not performing the way that I thought. Should I just call this a loss or do I want to try to rescue that grant? You might actually use a power substitution to do the same thing.

Powers of substitution are not just kind of willy-nilly put into trust, by the way. So it's not, if your trust, the irrevocable trust you're working on, doesn't have a power of substitution. It's not necessarily because you had a bad attorney who forgot to put one in. There are certain powers that are called, quote unquote, administrative powers between the grantor and their trust that cause that trust to become a grantor trust under income tax rules.

And so these actually also include the power to borrow with adequate interest or security against the trust fund. There are certain of these kind of buzzwords and powers that are baked into section 675 of the code. And so the power of substitution is one of them. And so it may be that your trust should not be a grantor trust, which is why it should be paying its own income taxes.

And so that's why the attorney or whoever decided not to put a substitution power into your trust. speaker-1: Well, so now I think that's a really good intro part of some of the easier sides. Now if we actually want to modify it, you know, where does that look like? speaker-0: This is where you want to modify something significant about the trust.

And it may actually be even taking away beneficiaries, changing beneficiaries, things like that, or changing the shares that the beneficiaries get. Under sort of trust law, speaker-1: Question that so are they what are the most common reasons people do I think that's actually I didn't even think about that question of before we modify it why and I know you listed like maybe percentages hey we want to change you where this goes to maybe we want to get rid of certain beneficiaries maybe want to add new beneficiaries grandkids etc what are other reasons that you saw speaker-0: Yes, changing the state of the trust, right, into a state with better income tax profile.

So let's say you have a trust, a very old trust that was formed in California, and now the beneficiaries have moved out of state, you want, you know, a better tax profile. It's still paying federal taxes, but you want it to go and pay, you know, New Hampshire taxes. This happened to one of my clients. ⁓ Honestly, trust companies are trying to get your business too, right?

So there are a lot of other incentives that the trust company might offer you to change trustees. And one of those, of course, is state income tax. And so you need to be able to take this old clunky California trust and move it to the new state. And it doesn't have the language that allows like a trust protector to make that decision, for example.

But honestly, it can be changing the charities, know, changing. because you're no longer involved, your grantor, your client is no longer as involved with the specific. speaker-1: distribution rules you could you could change your mind know what you thought I mean think about maybe you started this forever ago and you didn't want your kids to get it till 40 and now you see the state of the world and say they actually probably need this earlier to help on houses and other things speaker-0: Yes, and I think also families are starting to get savvier and understanding that maybe back in the day it seemed like a good idea to have forced distributions of either net income, right?

Because you're saying, ⁓ well, the income can be skimmed off and given to my kids as like, you know, annual income to them. So that seems like a good idea. I'm going to force the trustee to pay, you know, the net income out to the beneficiaries or these principal distributions that are like every five years, my kid gets X amount. There are also issues with GST trusts where they're not properly structured to take advantage of the fact that they're exempt from GST tax forevermore.

And all of a sudden you realize, ⁓ crap, this trust actually has this really nice tax profile that we're going to waste if we don't change the trust. And so that's where you might seek to modify an irrevocable trust as well. speaker-1: Okay, thank you for going down that tangent for me. was just trying to think of situations where it actually warrant changing.

I think sometimes you have these topics, right? And as an advisor, if you haven't thought through them, you're just like, great, it's good to know this, but that doesn't really come up until you actually think about how likely you could or would want to change them. speaker-0: Yes. And so there are different ways.

Some are provided, again, by state law. And so the first one that I want to talk about is the nonjudicial settlement agreement. ⁓ Some are provided by your trust agreement. usually, the state law kind of provides default rules.

But your trust agreement can actually also just give additional powers, even if state law doesn't provide for it. But the bottom line for all of these sort of options is that the last resort for you is to go to court. So in the name is non-judicial settlement agreement. Well, it's because you could also go the judicial route and ask the court whose laws govern your trust to go ahead and be sympathetic to your cause and make the change and accept the change.

So there is a gamut there of options that you have. All of these do need an attorney to be involved. This is not kind of like a do-it-yourself thing. ⁓ because you need to have a really deep understanding not only of the trust agreement, but all the implications of doing that thing so that you're not opening up either the trustee or anybody else to more liability because you've made a significant change to that trust.

speaker-1: me since never want to go there. I hope it sometimes do what you got to do, I guess. speaker-0: Yep, exactly. So to my mind, if you have kind of a smaller family or set of beneficiaries, your grantor is still alive and this was like a, you know, actually this is a good thing for the beneficiaries that I'm changing this and all of them would agree.

You know, I had one of these circumstances with a client where actually they were just reshuffling, I think the shares among beneficiaries and making some changes for tax reasons, like, you know, moving the trust. they actually just went straight to the beneficiaries. The client said to probably called up each kid beforehand. All of them were adults and being like, hey, I'm going to go ahead and make this change.

I'm hoping that you can sign off on this. ⁓ And so this is where you think of like the Murdoch family, I think. This was probably the most ⁓ recent example of a failed nontraditional agreement. the idea there was patriarch.

wants to make a change, thinks it's in the best interest of all the family members, ⁓ thinks, you know, this is a pretty tight-knit group. I don't need to have, like, everybody on the planet, like, signing off on this. So I'm just going to go to every single child and ask that they sign off. The risk that you run, of course, is that the child won't sign off.

But generally speaking, the client you're working with should have a pretty good sense of how that conversation will go. Yeah. So that you avoid that. Yeah.

speaker-1: That makes sense. else to add on that one? speaker-0: Yes, a couple of things. So the first is unexpected pitfalls.

Is that technically all of the remainder beneficiaries may have to sign off too, which involves grandchildren, et cetera. So who gets to represent that grandchild? Whether their parents stand in their shoes to also bind their own minors and other beneficiaries. That's a big question.

So all of a sudden, what seems to be an intimate family starts to not look like an intimate family because you're also considering G3. and having a conversation with them, just so you know. So a lawyer kind of needs to make that determination, kind of give your client an assessment of the risk that one of these younger beneficiaries might someday come back and be like, no, my dad could not have signed off for me. I wouldn't have agreed, that kind of risk.

But there's a little bit of the like, are you going to bite the hand that feeds you? Generally speaking, think beneficiaries are just happy to be beneficiaries. speaker-1: You'd hope so. speaker-0: Yes.

And then the second thing that you need to be aware of is some practitioners, most practitioners think that if there is actually some beneficiaries shares are being reduced and some other beneficiaries shares are being increased, it is actually a taxable gift from those that like first bucket to the second bucket, meaning you're saying effectively by signing off, I agree that my share is going to be less. And so I'm actually making effectively a gift. to the other beneficiaries, and that complicates tax returns and things like that.

speaker-1: Yeah, yeah, you may be using some of your own gifting, et cetera. speaker-0: Yeah, exactly. And then each of the beneficiaries should technically be represented or can be represented by council of their own to be able to sign off on something like that. speaker-1: You can just imagine with a really wealthy family, there's like nine attorneys in a room, each seeing it.

Sounds like it'd be a terrible room to be in. Yeah. There's just so much litigation in this area. You know, like I have a few clients who are from very wealthy families and it's like, you know, they all they've just talked about how many different lawsuits and issues that they've had by managing family trusts.

And it's just like, man, you can see how these money definitely creates a lot of issues in families. speaker-0: ⁓ for sure. And I mean, the reason why we know so much about the Murdoch family's failed non-judicial settlement agreement is because, yes, they ended up going to court. It turned out three out of the four kids didn't agree with the non-judicial settlement agreement and fought it.

But there's risk. speaker-1: Dang, not fun stuff. For sure. For sure.

speaker-0: So if your patriarch wants to minimize that risk, you pick a different strategy. speaker-1: Makes sense. Okay, so that's the first one really, right? speaker-0: Mm-hmm.

Yep. And so the second one is to have somebody closer to the trust who is going to sign off ⁓ on the change. And this is either a trust protector or actually a trustee doing what's called a decanting of the trust. And these are slightly different mechanisms.

So a trust protector or actually for the states where there's no trust protector statute or for whatever reason, the attorney wanted to draft it a little differently. it can be just effectively an independent trustee, like an independent fiduciary. So by the way, this is the approach that Wealth.com takes because we think that underlying the trust protector statutes is actually just piggybacking off of power that like any trustee should be able to have.

⁓ And so that's just calling somebody who's independent from estate tax purposes. So there's no like estate tax inclusion problem and just have that person make a change. And so usually in the trust agreement, there will be a power for that trust protector to be appointed, number one. And number two, that spells out what kind of modifications that person can have and can make.

And so these can't be too broad because then all of a sudden it implicates the best interests of the beneficiaries. And that's a fiduciary duty concern. There's a tension between a trust protector taking an action that actually reduces the share or somehow like. works against the beneficiaries.

Sometimes the grantors want something different for their beneficiaries. And so I have an example of that from private practice. But ⁓ you can have a trust protector who steps in and let's say, for example, there's a change in law. And all of a sudden, the tax implications to that trust and the beneficiaries is not great anymore.

This happens a lot actually in the cross-border context where like beneficiaries move across borders and all of a sudden you see like they're going to be subject to like a huge amount of US income tax or something like that. So you want to restructure the trust a little bit to make sure that that beneficiary is not going to get hit with those taxes. So you might ask a trust protector to come in and like make some changes there. An example of this was we had a client who, know, company is about to IPO, forming a irrevocable grantor trust in really nice jurisdictions, like a dynasty trust.

And based on the calculations and the roadshow, you know, the numbers from the IPO, I was like, okay, my kids are each going to end up with 40 million. Like, great, that's a good amount of money. And the stock just went bonanza. And each kid ended up with almost like a billion dollars or something like that.

And that's when the client was like, holy cows, what do I do with something like that? And so you can start using some of those decanting powers and things like that to try to further limit the child's access to their bank accounts, basically, to their trust accounts. speaker-1: Did they try to take shares away or value away from them or just control? speaker-0: So it's just control in that case.

It's really, really difficult to truly take things away from a beneficiary. speaker-1: wanted like girls out of their estate anyways, right? So no matter what ended up. speaker-0: form different kinds of trusts.

You try to fully utilize exemption. Actually, that's a pretty typical power is just to sever trusts and combine and merge trusts as well that are similarly drafted. So anyway, so this client basically had to go through this whole exercise of like further segmenting their trust. speaker-1: Everybody in their own individual on different roles.

speaker-0: Exactly. Yep. And so a lot of paperwork through that. And we actually also had a client who wanted to move states.

And their old trusts were not well drafted for that. And so they were able to appoint a trust protector who made a series of different changes to be able to move those trusts to a different state. And so that's another way in which trust protectors come into play. speaker-1: Why would moving be an issue?

speaker-0: So if your trust agreement is very poorly drafted, ⁓ there are ways in which it may not have the provision that allows your trustee to actually even contemplate moving. And so in that case, to make sure that the trustee has a basis to do it, you want to insert that language. speaker-1: I don't think you want to be shackled from a trust of moving states. fuck.

speaker-0: Well, I will tell you on these, some of these conversations that I have, not just with trust companies, but actually just advisors, people have gotten really savvy. And the number one question that I ask is, does the wealth.com form have the ability for a trustee to change the state? It's like one of the top questions that comes up.

So people are getting savvier about this for sure. speaker-1: Okay, cool. So that's the decanting side of things. What else we have to go into?

speaker-0: So the decanting, I just want to add one more thing that's a little different from trust protector. Oftentimes, like the way that a trust protector takes action is basically creating an amendment to your trust. It's just like, here's two, three more pages where I've made changes to like rescue these provisions of the trust. And decanting is actually slightly different.

And I just want to mention it. You need to find a trustee who ⁓ is going to be able to take the trust agreement or state law. and say, have enough here to be able to distribute all the trust principle, not just the income, but all of the entire trust to a completely new trust. So you effectively have the trustee create a trust, which is kind of a weird thing to wrap your head around so that the grantor is kind of not the grantor anymore.

So it's like the trustee created that trust out of nothing, out of whole cloth, by pouring it into a new instrument. speaker-1: And what would be the benefit of that? Just so if I'm the person with my trust, the benefits for me, I can distribute it. I can go put it into a new trust.

Would I want to go irrevocable again? Or would this be like, I actually don't want to go irrevocable. speaker-0: It has to stay irrevocable. It has to stay irrevocable.

it basically piggybacks off of the trustees own distribution powers to be like, if your trustee has the ability to distribute all of the principal to certain beneficiaries, it can actually cut out certain of the beneficiaries by distributing only to certain people within that class. so it's a very... And it's very popular these days, decantings, because you can actually completely restate the trust effectively. So you're not just doing like a one-off like change.

You're actually completely making a new trust. And so that becomes popular to kind of, ⁓ especially for these old clunky trusts to kind of modernize them. But the other thing that's kind of nice is that the beneficiaries don't see the old document. You just forevermore present.

to them the new trust document. And that's just effectively the new constitution for that trust. speaker-1: I'm thinking that that helps the problems because if they made real changes they don't even know about them. speaker-0: Yeah, effectively.

Yeah. So it's a very, powerful tool. And then, of course, the last thing is just for whatever reason, if there's a lot of risk, you can't find a trustee who's willing to take whatever action you're asking them, you can just always go to court. But the court is going to, of course, have a whole process behind it.

You have to have a reason to change that trust that the court agrees is a good enough reason for them to kind of stick out their necks and sign off on the change that you're asking for. ⁓ And so involving the judiciary is always an option. speaker-1: which probably a longer, slower, more painful one, especially in California. speaker-0: Yes.

That being said, I will tell you that for certain planning, and this happened to one of my clients, if it's important enough to have kind of the formal like sign off from a court, like that imprimatur we call it, like this feeling of like, this is super, super official. And so no one, you know, can really go against it. You might still seek a judicial ⁓ settlement actually. That might actually be a desirable thing.

So we had a client, for example, who wasn't quite sure if his trust was a non-grantor trust, and so was doing QSBS planning with his trust. And all of a sudden, in the coming year, the IRS is going to be looking at the trust agreement to determine whether or not he gets his ⁓ capital gains ⁓ treatment that he wanted. And so there, we actually sought a judicial change to the trust so that the because a judge has signed off. The IRS is more likely to see this as more formal, as more reliable.

Now, the federal government doesn't always respect all decisions at the state court level, so that is a little bit of a risk. But by and large, it's so much better than maybe having a trustee who's made the decision and decanted. So you make that decision strategically, too. speaker-1: Okay, that makes sense.

What else have we not talked about as it relates to this topic? speaker-0: I think we've covered a lot of ground. speaker-1: ⁓ for sure. just you're the expert here I wanted to make sure there wasn't another one that we are missing but I think kind of opened my eyes to one I don't know if I'd say how easily they can be changed but how many more options I think there are to change and I think the average advisor knows and to That there's a lot more reasons to change and I think people realize I think there's a lot of fear in irrevocable trust planning from advisors to be like I don't want to kind of help push my client into something that can never be changed that they're stuck with because You know, like for me, I'm working with clients that are 30, 40, 50, who knows what could happen the next 30, 40, 50 years from them and they're probably gonna wanna make changes.

And so I think as advisors that we can open the conversation of saying, hey, you're very wealthy. You know, there's a lot of value here into QSBS stacking, you know, just different planning on taxes, control, et cetera. Here's just so you know that there are ways to be able to change these in the future. Let's make sure your documents are set up in a way that you're able to do that.

speaker-0: Exactly, and if your client is nervous because they think it's going to be so rigid and inflexible, you can talk to the attorney when that trust is being drafted about how to bake in the maximum amount of flexibility for your client. There are certain provisions like silent trust provisions where the beneficiaries actually don't even have the right to know that they're beneficiaries, that the trust even exists. So think about that as like for a while where your client is still alive, they actually don't even need to tell their beneficiaries that there is a trust and they can keep working on it.

They can keep, you know, changing things about it and the beneficiaries would have no clue, right? And so there are actually ways in which ⁓ I think you can make a great deal of flexibility even about the beneficiaries into your trust. And so don't let that fear, you know, kind of stop your client from even having a conversation with an attorney about their goals because the attorney might actually have quite a big bag of tricks to be able to bring comfort to your client that there are ways to continue working with that irrevocable trust.

speaker-1: Yep, that makes sense. Okay, sweet and super valuable episode. ⁓ Everybody appreciate you listening. Please don't forget to rate and subscribe and tune back in for another episode here in a couple weeks.