June 17, 2013

The Not-So-Irrevocable Trust: Unlocking Trust Assets

The “irrevocable” label might have some clients feeling like they are locked into previously established irrevocable trusts for life, which might not always be the case. There are many reasons why a client might remain interested in preserving an irrevocable trust, but after the fiscal cliff deal made the generous $5 million estate tax exemption and spousal portability permanent, there are equally strong reasons why a client might prefer to terminate. In some cases, a client who no longer wishes to incur the expense of maintaining an irrevocable trust may be able to terminate.

The choice to terminate will force clients to reevaluate insurance and other trust held assets and lead to what are often long overdue replacement or reallocation discussions.

When Can an Irrevocable Trust Be Terminated?

Because the distinguishing feature of an irrevocable trust is that it is supposedly not possible to terminate, it may not be intuitive to assume that an otherwise irrevocable trust may be terminated based on the terms of the trust itself, but this is often the case. Many trusts contain provisions that allow the trustee to distribute the trust assets to the beneficiaries of the trust or to accelerate distributions that were set to occur at a much later date.

Further, many irrevocable trusts allow a trustee to terminate and distribute the trust assets if the trust contains assets that are worth relatively little. Bypass trusts often contain a provision that allow the trustee to terminate the trust and distribute the assets to the surviving spouse after the death of the first spouse. With the cooperation of the trustee and beneficiaries (who are often the client’s children), an irrevocable trust may be terminated based on its own terms.

The key to these strategies is a cooperating trustee and, in some cases, beneficiaries that agree with the strategy. If the trustee is unwilling to allow termination, your clients may have to petition the courts in order to unwind an irrevocable trust.

Considerations Upon Termination: What the Client Needs to Know

Many clients established irrevocable trusts to protect against uncertainty in the estate tax arena—estate tax rates were set to rise and the exemption level was set to decrease. Of course, this did not happen, which in and of itself may eliminate the need for many middle-class clients to incur the expense of maintaining a trust to shelter their assets.

Further, an otherwise unnecessary irrevocable trust may be made undesirable because trust income is often taxed at a higher income tax rate than the client himself—a trust enters the 39.6% tax bracket when its undistributed income exceeds $11,950 in 2013. For some clients, therefore, it would be beneficial to terminate the trust and invest in another type of tax-preferred vehicle, such as life insurance or an annuity product.

Despite these federal tax issues, a client should be aware that many states have not matched the $5 million federal exemption, so assets removed from an irrevocable trust may become subject to state estate or inheritance taxes. Once the irrevocable trust is terminated, it also becomes subject to the claims of the client’s—or the beneficiary’s—creditors.

Importantly, unless the client petitions the courts, it is often the case that trust beneficiaries must cooperate in unwinding an irrevocable trust. If the beneficiaries are the client’s children, they may be willing to cooperate in order to release the trust assets back to their parents. If the beneficiaries are uncooperative, a client might prefer to keep the trust in place so that their access to the trust assets remains governed by the terms of the trust.

In today’s estate tax environment, there are many reasons why maintaining an irrevocable trust may not make sense. However, it is important that clients are advised on all sides of the issue before deciding whether to pursue termination.

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