On the surface, the difference between revocable and irrevocable trusts couldn’t be any more straightforward. You can change your revocable trust whenever and however you choose. You can’t change your irrevocable trust at all.But beneath the surface, the waters are a bit more murky, especially with respect to making changes. Also, revocable trusts often become irrevocable when the grantor becomes disabled or passes away. So, let’s jump into these waters and clear up some of the murk.
The ability to amend It is true that the grantor of a revocable trust (sometimes called a “living” trust) can change it as she chooses, as long as she’s competent. If she becomes incompetent she can’t change it, though her agent under a durable power of attorney or a court-appointed conservator may be able to do so. Irrevocable trusts are a different story, but they’re not completely barred from being changed. Let’s start by distinguishing between trusts that are irrevocable upon their creation, such as those created for asset protection, tax planning or Medicaid planning purposes, and trusts that become irrevocable upon the grantor’s death. Grantors when creating immediately irrevocable trusts often still retain certain powers such as the right to change trustees and the right to redirect who will receive the trust property when they die or when the trust terminates at another time. The latter is known as a “testamentary power of appointment.” It can be broad or “general”, permitting the “appointment” of property to anyone, or more limited, for instance only allowing trust property to be redirected to family members and charities. Whenever the trust becomes irrevocable, the grantor may give these rights — the power to change trustees or to change ultimate beneficiaries — to other parties, often to the beneficiaries themselves. For instance, a trust may say that a majority of the grantor’s children can hire and fire trustees and that each child can say where his share will go in the event he dies before receiving it. Asset protection and special needs trusts also often appoint “trust protectors” who have the power not only to change trustees but sometimes to amend the trust completely. In such cases, the trust is irrevocable from the point of the grantor — she can’t revoke or amend it — but it’s actually completely amendable by the trust protector. Or the trust might limit this power, for instance in the case of a special needs trust only permitting amendments as necessary for the beneficiary to maintain eligibility for public benefits. This power is often granted to either the trustee or trust protector because public benefits programs often change their rules with respect to the treatment of trusts. In recent years, irrevocable trusts have become less irrevocable as states, whether by court decision or new statutes, have permitted decanting, reformation and nonjudicial settlements of trusts. Decanting is similar to the practice of pouring fine old wines into new carafes in order to let them breathe. With trusts, the concept is to transfer trust assets into new trusts that better accomplish the purpose of the initial trust. This practice gained steam when the Massachusetts Supreme Judicial Court permitted the Kraft family of Patriots football fame to decant one trust into a new one that would better achieve their original goals. Depending on state law, in order to decant, a change in law or circumstance must being impeding the original trust from achieving its intent and all beneficiaries must agree with the change to the new trust, which should not change anyone’s interest in the trust. Trust reformation, unlike decanting, requires court approval of a change to an irrevocable trust. Like decanting, those seeking such a change must show that the reformation is necessary for the trust to achieve its original purpose. All current and future beneficiaries must be given notice, but they don’t all have to agree. Thirty-four states and the District of Columbia have adopted the Uniform Trust Code which permits trust reformation without the involvement of a court, known as nonjudicial settlement agreements, where all interested parties are in agreement. The statute permits any change that does not violate a so-called material purpose of the trust. So, in effect, as long as all interested parties are in agreement, any irrevocable trust can in fact be modified. While the parties can avoid going to court if all can agree to decanting or a nonjudicial settlement agreement, if they’re not on the same page or some parties are noncooperative, which is not unusual, the proponents of a change will have to seek court approval of trust reformation.
Tax treatment When it comes to taxation of trusts, again, revocable trusts are quite simple and the waters can get deep and treacherous with respect to irrevocable trusts. Revocable trusts use the grantor’s Social Security number and all income is taxed to the grantor. Irrevocable trusts must obtain their own taxpayer identification numbers and file an annual tax return each year using Form 1041. If they do pay income taxes, the schedule is much more accelerated than that for individuals, reaching the top rate of 37% after just $13,050 of income (for the 2021 tax year). However, few irrevocable trusts actually pay any income tax because they only have to do so to the extent they retain the income earned and don’t distribute it and only if they are not “grantor” trusts, which are irrevocable trusts in which the grantor has retained certain powers that make the trust income taxable to him. To the extent the income of a non-grantor trust is distributed to beneficiaries it is taxed to the recipients and the trust acts as a pass-through for tax purposes. In that event, the trust issues the beneficiaries K-1s, which are similar to 1099s issued by financial institutions. Other tax issues are also straightforward with respect to revocable trusts and can depend on the form of the trust with respect to irrevocable trusts. For instance, a house held by a revocable trust that is sold will qualify for the $250,000 exclusion for capital gains. Capital gain on the sale of a house held by an irrevocable trust may or may not qualify for the $250,000 exclusion depending on whether or not it is a grantor trust for tax purposes. Upon the death of the grantor of a revocable trust, the trust property receives a step-up in basis, meaning that any capital gains disappear. Again, upon the death of the grantor of an irrevocable trust, the trust property may or may not receive a step-up in basis depending on whether the trust property is includable in the grantor’s taxable estate. The rules are somewhat different for income and estate taxation, so a trust may receive a step-up in basis upon the grantor’s trust but not be considered a grantor trust for income tax purposes. Irrevocable trusts never receive a step-up upon the death of a beneficiary. So a trust that provides for a surviving spouse will receive a step-up in basis upon the grantor’s death but not a second step-up upon the surviving spouse’s death. Or a trust that was created for the benefit of a child will not receive a step-up when the child dies and the trust is distributed to the grandchildren. As you can see, trust taxation can be very complicated (and we’re only scratching the surface here), but these principles apply throughout. Any questions should be directed to an accountant or tax attorney. Interests of beneficiaries All trusts have both current beneficiaries who have certain rights to trust income and principal distributions and future beneficiaries who will receive income or principal in the future after the occurrence of a triggering event, often the death of the current or “lifetime” beneficiary. While the interests of current beneficiaries of revocable and irrevocable trusts are identical, the interests of future beneficiaries can be very different. Future beneficiaries of revocable trusts essentially have no rights because the grantor can always change the trust and thus eliminate them as beneficiaries. So, they have no right to a copy of the trust, to see trust accounts, or even to know that the trust exists. The rights of beneficiaries of irrevocable trusts depend on whether their interest or role as beneficiary is “vested,” in other words on whether it can be changed. As we discussed in our prior article about trusts, they can contain a power of appointment permitting either the grantor or someone else, often an interim future beneficiary, to change who will receive property. If such a power of appointment exists, then the interest of the future beneficiary can be eliminated and has not vested. A nonvested future beneficiary has no rights concerning the trust. However, a vested future beneficiary has significant rights. The trustee must take her interests into account in making trust distributions to current beneficiaries and the future beneficiary has the right to view the trust instrument, to know the identity of the trustees, and in some instances to view trust accounts. An example can explain how this might work. Grandpa creates a trust for the benefit of Grandma, giving her a power of appointment. Assuming Grandma doesn’t exercise her power of appointment, the trust will continue after her death for the benefit of their children, Child A, Child B, and Child C. They each have a power of appointment over their share, but if they don’t use it, their shares will pass to their children (the grandchildren) after all the children have died. After Grandpa’s death, Grandma becomes the lifetime beneficiary. The children’s interests have not vested because Grandma can still remove them as beneficiaries through her power of appointment. They have only a limited interest in the trust. After Grandma dies, the three children become the primary beneficiaries and, again, the interests of their children are quite limited since the middle generation also has powers of appointment over their shares. Let’s assume that Child B dies leaving his own children and not exercising his power of appointment. At that point, even though they may have to wait until the deaths of Child A and Child C to receive anything, the interests of the children of Child B will have vested, giving them rights to the trust document, trust accounts and information about the trustees. As you can see, while they are both “trusts,” the differences between revocable and irrevocable trusts and the interests of the beneficiaries can be quite significant. Next time: What You Need to Know if You’ve Been Appointed Trustee Harry S. Margolis is a Massachusetts estate and elder law planning attorney. He answers consumer questions about estate planning at AskHarry.info and most recently published The Baby Boomers Guide to Trusts: Your All-Purpose Estate Planning Tools.