Before deciding to modify a trust, it is important to consider the tax implications of such action.
Modifying a trust could adversely affect income, gift, estate, and/or generation-skipping transfer taxes. Trusts generally are either revocable or irrevocable, and each type can be modified or terminated in different ways.
Revocable Trusts
Modifying a revocable trust is relatively straightforward. A revocable trust is designed to be flexible and can be modified at any time during the settlor’s lifetime. (The “settlor” is the person who created the trust.) Revocable trusts can be modified by amendment or restatement of the trust. Any amendment or restatement should be notarized but does not need to be publicly recorded. The settlor has the option to terminate the trust completely or modify any term of the trust.
Irrevocable Trusts
Many revocable trusts become irrevocable upon the death of the settlor. A settlor may also designate a trust as irrevocable from its very inception. Modifying or terminating an irrevocable trust is much more difficult. Some methods of modification and termination do not require court approval whereas others require court intervention.
No Court Approval Required
1) Substantial Compliance with Trust Terms
Occasionally, a trust, by its terms, will specify how it may be modified or terminated. The trustee and/or beneficiaries can therefore revise or terminate the trust by substantially complying with its terms. Common language that allows for trust modification include: (1) granting the trustee power to revise the trust’s terms, (2) decanting provisions (explained below), and (3) appointing a trust protector who is authorized to reform the trust. A trust protector is someone other than the trustee or a beneficiary who is appointed to oversee the trustee, fill trust vacancies, and revise trust terms.
2) Uneconomic Trusts
An uneconomic trust must have a total value of less than $100,000. The trustee of an uneconomic trust may terminate the trust if he or she concludes that the value of the trust property is insufficient to justify the cost of administration. The trustee may only terminate the trust after providing notice of the intended termination to the beneficiaries. This method only allows for termination of the trust, not modification. Upon termination, the trustee must distribute the trust property in a manner consistent with the trust’s purposes.
3) Combination and Division of Trusts
A trustee may combine two or more trusts into a single trust or divide a trust into two or more separate trusts so long as the combination or division does not (1) materially impair the rights of any beneficiary or (2) adversely affect achievement of the purpose of the trust. The purpose of the trust must be determined by the settlor’s plain language. It may be helpful to include a statement of intent or purpose in the trust document.
4) Nonjudicial Settlement Agreements
Virginia Code § 64.2-709 seemingly provides individuals with wide latitude to modify or terminate trusts. The statute allows beneficiaries and trustees to enter into an agreement with respect to “any matter involving a trust.” However, such an agreement is only valid if it does not violate a material purpose of the trust. The statute does not define what constitutes a material purpose of a trust, and Virginia courts have not provided much guidance as to what constitutes a material purpose either.
In Ladysmith Rescue Squad, Inc. v. Newlin, the Virginia Supreme Court held that a spendthrift clause reveals a material purpose of the trust, which is to protect the beneficiaries’ assets from creditors and alienation. (A spendthrift clause limits beneficiaries from voluntarily or involuntarily alienating their interest in the trust property. This generally prevents creditors from reaching trust assets.) Therefore, modification and termination by nonjudicial settlement agreement likely won’t be successful if the trust contains a spendthrift clause because such modification or termination would likely frustrate a material purpose of the trust.
The statute also provides examples of matters that may be settled by a nonjudicial settlement agreement. Such matters include (1) the interpretation or construction of trust terms, (2) approval of a trustee’s report or accounting, (3) direction to a trustee to refrain from performing a particular act, (4) resignation or appointment of a trustee, (5) transfer of a trust’s principal place of administration, and (6) liability of a trustee for an action relating to the trust. Substantial modification or termination of a trust is missing from this list. Although Virginia courts have not interpreted this statute yet, it is possible that they would interpret the exclusion of modification or termination from this list to mean that such action cannot be done by a nonjudicial settlement agreement.
5) Lost Purpose
A trust will automatically terminate if the purpose of the trust is achieved or if the purpose of the trust becomes unlawful, impossible to achieve, or contrary to public policy.
6) Decanting
Decanting a trust is the process of transferring all the assets of an old trust to a new trust that has new terms. The old trust must be eligible to be decanted. To be eligible, the old trust must be irrevocable, and the trustee must have discretionary power to make distributions to the beneficiaries. A trustee with discretionary power can make material changes to the trust terms by eliminating beneficiaries, adding a spendthrift clause, and changing the trustee’s powers. A trustee that does not have discretionary power could still decant the trust assets into a new trust, but the new trust cannot be materially different from the first. In that case, a trustee would only be able to modify administrative provisions. Neither type of trustee may add beneficiaries or remove a vested interest.
Court Approval Required
1) Modification or Termination by Consent
A court may order the modification or termination of an irrevocable trust if the settlor and all beneficiaries consent to the modification or termination, even if such modification or termination is inconsistent with a material purpose of the trust. However, if the settlor does not consent or cannot consent because of death or incapacity, a court may only modify or terminate a trust if all the beneficiaries consent and such modification or termination does not frustrate a material purpose of the trust. As mentioned above, no statute defines what constitutes a material purpose of a trust. The Ladysmith case, however, illustrates that a spendthrift clause reveals a material purpose of protecting trust assets from creditors and alienation.
2) Unanticipated Circumstances
A court may modify or terminate a trust if such modification or termination will further the purposes of the trust in light of circumstances not anticipated by the settlor. The court must modify the trust according to the settlor’s likely intent.
Alternatively, a court may modify the administrative terms of a trust if continuation of the trust according to its existing terms would be wasteful or impair its proper administration. A court cannot terminate a trust solely on the finding that the administrative terms waste trust resources.
3) Uneconomic Trust
As an alternative to termination of an uneconomic trust by the trustee, a court may modify or terminate an uneconomic trust or remove and replace a trustee if the value of the trust property does not justify the cost of administration. The main difference with court intervention is that modification is possible as well as replacement of the trustee. (As a reminder, a trust must have a value of less than $100,000 to qualify as an uneconomic trust.)
4) Reformation to Correct Mistakes
A court may also reform the terms of a trust if the person petitioning for reformation can show by clear and convincing evidence that the settlor’s intent and the trust terms were affected by a mistake of fact or law. Once again, very little Virginia caselaw is available to define what constitutes a mistake of fact or law. Nonetheless, courts are much more likely to reform the terms of a trust based on a mutual mistake (when both parties are mistaken) as opposed to a unilateral mistake (where only one party was mistaken).
5) Modification to Achieve Tax Objectives
So long as any modification is not contrary to the settlor’s likely intent, a court may modify the terms of a trust to achieve the settlor’s tax objectives.
6) Cy Pres
Cy pres only applies to charitable trusts. A charitable trust must have a charitable purpose, which generally is demonstrated by listing one or more charities as the beneficiaries. A court may employ cy pres to modify or terminate a charitable trust if such a trust becomes unlawful, impracticable, wasteful, or impossible to achieve. Court modifications must be consistent with the settlor’s charitable purposes. Essentially, the doctrine of cy pres allows a court to reform a charitable gift to carry out the settlor’s charitable goal.
Davis Law Group Can Help
If you have questions about creating, modifying, or terminating a trust, contact us today to set up an appointment with one of our expert estate planning and trust administration attorneys. We can help provide the peace of mind that comes with sound legal counsel.
Modifying or Terminating a Virginia Trust
Before deciding to modify a trust, it is important to consider the tax implications of such action.
Modifying a trust could adversely affect income, gift, estate, and/or generation-skipping transfer taxes. Trusts generally are either revocable or irrevocable, and each type can be modified or terminated in different ways.
Revocable Trusts
Modifying a revocable trust is relatively straightforward. A revocable trust is designed to be flexible and can be modified at any time during the settlor’s lifetime. (The “settlor” is the person who created the trust.) Revocable trusts can be modified by amendment or restatement of the trust. Any amendment or restatement should be notarized but does not need to be publicly recorded. The settlor has the option to terminate the trust completely or modify any term of the trust.
Irrevocable Trusts
Many revocable trusts become irrevocable upon the death of the settlor. A settlor may also designate a trust as irrevocable from its very inception. Modifying or terminating an irrevocable trust is much more difficult. Some methods of modification and termination do not require court approval whereas others require court intervention.
No Court Approval Required
1) Substantial Compliance with Trust Terms
Occasionally, a trust, by its terms, will specify how it may be modified or terminated. The trustee and/or beneficiaries can therefore revise or terminate the trust by substantially complying with its terms. Common language that allows for trust modification include: (1) granting the trustee power to revise the trust’s terms, (2) decanting provisions (explained below), and (3) appointing a trust protector who is authorized to reform the trust. A trust protector is someone other than the trustee or a beneficiary who is appointed to oversee the trustee, fill trust vacancies, and revise trust terms.
2) Uneconomic Trusts
An uneconomic trust must have a total value of less than $100,000. The trustee of an uneconomic trust may terminate the trust if he or she concludes that the value of the trust property is insufficient to justify the cost of administration. The trustee may only terminate the trust after providing notice of the intended termination to the beneficiaries. This method only allows for termination of the trust, not modification. Upon termination, the trustee must distribute the trust property in a manner consistent with the trust’s purposes.
3) Combination and Division of Trusts
A trustee may combine two or more trusts into a single trust or divide a trust into two or more separate trusts so long as the combination or division does not (1) materially impair the rights of any beneficiary or (2) adversely affect achievement of the purpose of the trust. The purpose of the trust must be determined by the settlor’s plain language. It may be helpful to include a statement of intent or purpose in the trust document.
4) Nonjudicial Settlement Agreements
Virginia Code § 64.2-709 seemingly provides individuals with wide latitude to modify or terminate trusts. The statute allows beneficiaries and trustees to enter into an agreement with respect to “any matter involving a trust.” However, such an agreement is only valid if it does not violate a material purpose of the trust. The statute does not define what constitutes a material purpose of a trust, and Virginia courts have not provided much guidance as to what constitutes a material purpose either.
In Ladysmith Rescue Squad, Inc. v. Newlin, the Virginia Supreme Court held that a spendthrift clause reveals a material purpose of the trust, which is to protect the beneficiaries’ assets from creditors and alienation. (A spendthrift clause limits beneficiaries from voluntarily or involuntarily alienating their interest in the trust property. This generally prevents creditors from reaching trust assets.) Therefore, modification and termination by nonjudicial settlement agreement likely won’t be successful if the trust contains a spendthrift clause because such modification or termination would likely frustrate a material purpose of the trust.
The statute also provides examples of matters that may be settled by a nonjudicial settlement agreement. Such matters include (1) the interpretation or construction of trust terms, (2) approval of a trustee’s report or accounting, (3) direction to a trustee to refrain from performing a particular act, (4) resignation or appointment of a trustee, (5) transfer of a trust’s principal place of administration, and (6) liability of a trustee for an action relating to the trust. Substantial modification or termination of a trust is missing from this list. Although Virginia courts have not interpreted this statute yet, it is possible that they would interpret the exclusion of modification or termination from this list to mean that such action cannot be done by a nonjudicial settlement agreement.
5) Lost Purpose
A trust will automatically terminate if the purpose of the trust is achieved or if the purpose of the trust becomes unlawful, impossible to achieve, or contrary to public policy.
6) Decanting
Decanting a trust is the process of transferring all the assets of an old trust to a new trust that has new terms. The old trust must be eligible to be decanted. To be eligible, the old trust must be irrevocable, and the trustee must have discretionary power to make distributions to the beneficiaries. A trustee with discretionary power can make material changes to the trust terms by eliminating beneficiaries, adding a spendthrift clause, and changing the trustee’s powers. A trustee that does not have discretionary power could still decant the trust assets into a new trust, but the new trust cannot be materially different from the first. In that case, a trustee would only be able to modify administrative provisions. Neither type of trustee may add beneficiaries or remove a vested interest.
Court Approval Required
1) Modification or Termination by Consent
A court may order the modification or termination of an irrevocable trust if the settlor and all beneficiaries consent to the modification or termination, even if such modification or termination is inconsistent with a material purpose of the trust. However, if the settlor does not consent or cannot consent because of death or incapacity, a court may only modify or terminate a trust if all the beneficiaries consent and such modification or termination does not frustrate a material purpose of the trust. As mentioned above, no statute defines what constitutes a material purpose of a trust. The Ladysmith case, however, illustrates that a spendthrift clause reveals a material purpose of protecting trust assets from creditors and alienation.
2) Unanticipated Circumstances
A court may modify or terminate a trust if such modification or termination will further the purposes of the trust in light of circumstances not anticipated by the settlor. The court must modify the trust according to the settlor’s likely intent.
Alternatively, a court may modify the administrative terms of a trust if continuation of the trust according to its existing terms would be wasteful or impair its proper administration. A court cannot terminate a trust solely on the finding that the administrative terms waste trust resources.
3) Uneconomic Trust
As an alternative to termination of an uneconomic trust by the trustee, a court may modify or terminate an uneconomic trust or remove and replace a trustee if the value of the trust property does not justify the cost of administration. The main difference with court intervention is that modification is possible as well as replacement of the trustee. (As a reminder, a trust must have a value of less than $100,000 to qualify as an uneconomic trust.)
4) Reformation to Correct Mistakes
A court may also reform the terms of a trust if the person petitioning for reformation can show by clear and convincing evidence that the settlor’s intent and the trust terms were affected by a mistake of fact or law. Once again, very little Virginia caselaw is available to define what constitutes a mistake of fact or law. Nonetheless, courts are much more likely to reform the terms of a trust based on a mutual mistake (when both parties are mistaken) as opposed to a unilateral mistake (where only one party was mistaken).
5) Modification to Achieve Tax Objectives
So long as any modification is not contrary to the settlor’s likely intent, a court may modify the terms of a trust to achieve the settlor’s tax objectives.
6) Cy Pres
Cy pres only applies to charitable trusts. A charitable trust must have a charitable purpose, which generally is demonstrated by listing one or more charities as the beneficiaries. A court may employ cy pres to modify or terminate a charitable trust if such a trust becomes unlawful, impracticable, wasteful, or impossible to achieve. Court modifications must be consistent with the settlor’s charitable purposes. Essentially, the doctrine of cy pres allows a court to reform a charitable gift to carry out the settlor’s charitable goal.
Davis Law Group Can Help
If you have questions about creating, modifying, or terminating a trust, contact us today to set up an appointment with one of our expert estate planning and trust administration attorneys. We can help provide the peace of mind that comes with sound legal counsel.
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