By Jeremy P. Gerch, Attorney, Bingham Greenebaum Doll LLP
As first appeared in the Louisville Bar Association Bar Briefs
There are many reasons why a client may choose to utilize an irrevocable trust as part of the client’s estate plan. These include avoiding or minimizing transfer tax and asset protection planning. However, individuals are often reluctant to proceed with prudent planning because of their concerns about transfers to irrevocable trusts. These concerns are generally centered around relinquishing control over the assets, and the inability to make changes to the irrevocable trust strategy if changes in tax laws or personal circumstances dictate.
Transfers to Irrevocable Trusts
The current federal estate tax law sets the basic exclusion amount, which is the amount individuals can transfer during their lifetimes and at their deaths to individuals other than spouses free of gift, estate and generation-skipping transfer tax, at $5,120,000 per person in 2012. This law expires after December 31, 2012, and unless Congress acts prior to that time, the federal transfer tax structure will revert to a $1,000,000 exclusion amount in 2013.
Unfortunately, we cannot know what future transfer tax law Congress will enact, if any. As a result, many individuals are choosing to make large gifts in 2012 in order to take advantage of the current estate planning opportunities. Individuals can make gifts outright to individuals; however, outright gifts may present asset management, transfer tax and asset protection issues for the recipient. A gift in trust for a recipient's benefit is generally a more advisable strategy.
In addition to making gifts, clients may also be interested in asset protection planning around their asset base during their lifetimes. The combination of litigation risk, along with the market volatility associated with investment portfolios, make asset protection planning a concern for many individuals. Asset protection planning may take many forms, including the appropriate funding of an irrevocable domestic asset protection trust.
The Use of Advisory Committees
Advisory committees can play an important role in the administration of discretionary trusts for the benefit of a person’s desired beneficiaries. Therefore, specific responsibilities, as well as replacement mechanisms, should be considered in the drafting process. While certain fiduciary duties of a trustee are non-delegable, advisory committees are often used to perpetuate a grantor’s wishes as to specific investments within, or distributions from, a trust. Advisory committees also permit settlors to determine who will make important decisions on the disposition of assets, and these individuals often have a better understanding of the beneficiaries and their particular circumstances.
When drafting a trust that includes an advisory committee, the draftsman should consider the level of participation the advisory committee should have in decisions about the trust’s administration. The trust language can require the trustee to merely consult with the advisory committee, or the language can give the advisory committee the authority to direct the trustee to act in certain situations. Language in trust instruments creating advisory committees should clearly define the role and responsibilities of advisory committee members, and how the duties of the advisory committee members otherwise affect a trustee’s duties.
An advisory committee can provide for a more efficient trust administration and also help limit the trustee’s liability. The level of limited liability provided to trustees is based on the situs of the trust and the applicable limitation provided by state law. The Kentucky Revised Statutes limit the liability of institutional fiduciaries acting at the direction of an advisory or investment committee. See KRS 286.3-275. It is important to recognize the limitations associated with using a direction advisor under Kentucky law. Further, clients may consider creating a fully directed trust in a jurisdiction recognizing the bifurcation of fiduciary duties that incorporates language segregating discretionary authority over special holdings, investments or distributions from other administrative trustee functions. If there will not be a corporate trustee, the trust instrument should describe whether the individual trustee’s liability is limited when acting at the direction of an advisory committee.
The Potential Role of a Trust Protector
Trust protectors are also used as a way to create client comfort with irrevocable trust strategies. Trust protectors are different from advisory committees in that trust protectors often have more substantial powers and take a role in making decisions that can influence the overall operation of a trust, while advisory committees participate mostly in recurring investment, distribution and other administrative functions. The duties and powers of trust protectors are defined by state law, either in statutes or by judicial decisions. While there are no Kentucky statutes defining the role of a trust protector, and no Kentucky case law directly addressing the duties and powers of a trust protector, many attorneys choose to incorporate a trust protector in the terms of an irrevocable trust instrument.
A trust instrument may vest a trust protector with a variety of powers, and these powers are ever evolving. However, in states where the role and authority of a trust protector is not well defined, there is no certainty as to their effectiveness and how a state court would ultimately treat the powers given to a trust protector, although it is possible that an interpreting court may look to the trust instrument itself to define the trust protector’s powers and liabilities. Given the number of jurisdictions that do recognize trust protectors, and given the flexibility that trust protectors may provide to address necessary future changes in a trust, estate planners may still consider incorporating a trust protector into a plan involving an irrevocable trust.
A trust protector can serve a vital role in ensuring flexibility with an irrevocable trust. However, the attorney and client must choose the individual who will serve as trust protector judiciously since choosing the wrong person to serve as trust protector has the potential to result in negative tax consequences. The trust protector should not be a person who is a family member or someone who is an employee or otherwise under the control of the individual establishing the trust.
Decanting as a Mechanism to Address Change
On July 12, 2012, KRS 386.175 became effective. This new statute, commonly known as Kentucky’s “decanting” statute, provides another procedure for future flexibility with irrevocable trusts, including trusts that were created prior to the enactment of this statute and are still in existence.
This statute gives the trustee the power to distribute income and principal of one trust to a second trust, which will often result in the second trust receiving all of the assets of the original trust. In order for the trustee to be able to utilize this statute: (1) both trusts must be established under irrevocable trust instruments; (2) the original trust must give the trustee discretionary power to distribute principal or income to or for the benefit of one or more current beneficiaries; and (3) the current beneficiaries of the second trust, which will receive the assets, are one or more of the current beneficiaries of the original trust. The trustee has the statutory authority to make this transfer regardless of the presence of a spendthrift provision in the original trust or a provision prohibiting revocation or amendment of the original trust.
The trustee of the original trust can actually create the second trust to which assets are to be distributed, and the second trust can be created under a different state law than that of the original trust. To make this process more efficient, court approval is not required to decant to a second trust. However, many trustees may feel more comfortable in obtaining court approval in connection with decanting to a second trust. There are several other restrictions and rules contained in KRS 386.175, such as, any fixed annuity interest in the original trust must be preserved in the second trust and that if a marital deduction was allowed for the original trust, the second trust must not contain any provision that would have prevented the allowance of the marital deduction. A full review of the entire statute should be made prior to any decanting to ensure compliance with the various restrictions and requirements of the statute.
While decanting may solve certain administrative issues or help with flexibility, the attorney should first consider all potential tax implications of the decanting, including income, gift, estate and generation-skipping transfer (GST) taxes, especially if there are going to be substantive changes or the original trust is already exempt from GST tax. While a discussion of these various tax implications is beyond the scope of this article, they should be fully reviewed in each decanting situation based on those particular facts. To make matters even more difficult, there is little guidance from the IRS on the tax effects of decanting. The IRS has requested comments from practitioners on the tax effects of decanting in IRS Notice 2011-101, but has also stated in Rev. Proc. 2012-3 that it is studying the GST tax implications of decanting, and will no longer issue rulings concerning the GST tax effects of decanting.
Estate planners and their clients may use irrevocable trusts for a variety of reasons. The use of advisory committees, potential incorporation of a trust protector, and the opportunity to decant as a mechanism to address change, may help clients feel more comfortable with the use of irrevocable trusts.