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Love 'em, hate 'em, but if you want to amend them, you better know precisely what to look for

On the other hand, irrevocable trusts are hated because they are so . . . well, irrevocable. They have fixed provisions, while the personal circumstances of most clients and their loved ones, not to mention the tax and other laws which govern trusts, are in a constant state of flux.

Clients (or their successors) are often unhappy, frustrated, disappointed. This inability to deal with change is frequently true no matter how cleverly documents are drafted and no matter how flexible the terms are made.

Fortunately, California law allows for the amendment, modification or termination of an otherwise irrevocable trust--under the proper circumstances and using the proper procedures. This article will discuss those Probate Code sections that accommodate the seemingly contradictory goal of changing an irrevocable trust.

Tax-related questions

This article will not address the estate, gift or income tax consequences of such actions. However, two tax-related questions must be answered whenever a change to an irrevocable trust is contemplated.

First, for a tax-motivated change to the terms of a trust, consider whether the change will be given effect by the Internal Revenue Service. That is, amendments may be accomplished under California law, but nevertheless not be recognized for federal tax purposes.

The Internal Revenue Service honors some amendments because they are authorized by the Internal Reve-nue Code or the regulations thereunder; for example, amending the terms of a trust to qualify it as a "qualified domestic trust" (QDOT) under Treas-ury Regulation §20.2056A-4.

On the other hand, the Internal Revenue Service takes the position (upheld by reviewing courts) that it is not required to honor all trust modifications, even when the modification is authorized under California law and is made pursuant to an order of the Probate Court. See, Commissioner v. Estate of Bosch, 387 U.S. 456 (1967), and the recent Ninth Circuit decision in Estate of Bert B. Rapp v. Commissioner, 140 F.3d 1211 (1998).

Second, even if a change to the terms of a trust is not tax-motivated, consider whether there will be unintended tax consequences. For example, will a change in the rights of a beneficiary result in a gift by that beneficiary?

To understand the scope of the opportunity afforded by California's statutory scheme for modifying or terminating an otherwise irrevocable trust, consider the following situations, which should be familiar to almost every attorney who handles trust and estate matters, and which have the potential to be remedied under applicable Probate Code provisions.

Amendment situations

We want to make a distribution to a beneficiary which is not clearly within the "health, support, maintenance or education" standard otherwise required by the trust (e.g., to make a gift, help defray the college costs of the beneficiary's child, invest in life insurance on the beneficiary's life).

We want to hold S corporation stock in a trust, but the trust has multiple beneficiaries (and therefore will not qualify as a Qualified Subchapter S Trust).

We want to divide one trust in order to separate property which is exempt from the generation-skipping transfer tax from property which is not exempt from the generation-skipping transfer tax.

We want to authorize the trustees to engage in transactions not authorized by the trust agreement (e.g., to guarantee obligations of related entities, to have enhanced investment powers).

We want an individual trustee in a trust requiring a corporate trustee.

We want a beneficiary to serve as sole or co-trustee where the trust instrument does not allow it.

We want to divide one trust with multiple beneficiaries into two or more trusts because there are beneficiaries who wish to pursue separate investment policies.

We want to try to achieve an estate and/or gift tax goal: for example, to qualify a trust for the marital deduction or to try to obtain a charitable deduction by transforming defective charitable trusts into outright charitable bequests.

We want to make changes to restrictions on the disposition of property in light of the maturity of children beneficiaries.

We want to benefit new, unanticipated beneficiaries.

We want to change the dispositive terms so that a series of nearly identical trusts for the benefit of a beneficiary can be consolidated for ease of administration.

We want to terminate or not create a trust which will be uneconomical to administer because of a smaller-than-anticipated corpus.

We want a marital trust to be modified to meet the QDOT requirements where a surviving spouse is not a United States citizen.

We want a trust created to qualify as a particular tax-savings vehicle (GRAT, GRUT, QPRT, CRT, etc.) to continue to qualify where the applicable requirements have been changed by statute or regulation.

Finally, a word of caution: Always consider whether a no-contest clause might be triggered by seeking to amend an irrevocable trust.

When and how to amend

In general, various Probate Code sections (discussed in detail later in this article) allow for amendment, modification or termination of a trust, generally upon petition to the Probate Court by the appropriate parties. Before a petition is instituted or the amendment is done non-judicially, however, determine if other alternatives are available to accomplish the same goal.

Some illustrations:

DISCLAIMER. Can a timely disclaimer (within nine months of transfer) solve the problem? Thus, if a "QTIP" (qualified terminable interest property) election for a marital trust is desirable, but the terms of the trust provide for income distributions to the surviving spouse and a child, will the child disclaim his or her income interest? If so, that is much easier than amending the terms of the trust (and more likely to obtain the desired tax result).

INTERPRETATION. Can the document be read to allow what is desired? In particular, consider the impact of the "savings clauses" in the Probate Code:

Probate Code §16081 (general powers of appointment);

Probate Code §§16100 et seq (charitable deductions);

Probate Code §21503 (formula marital deduction clauses);

Probate Code §21522 (marital deduction);

Probate Code §21524 (marital deduction trusts); and

Probate Code §§21540 and 21541 (charitable gifts).

INTERNAL AMENDMENT PROVISIONS. Is there a mechanism for amending the terms of the trust contained in the document itself? It is becoming more common, particularly in tax-oriented trusts (GRATs, GRUTs, QPRTs, CRTs), to find provisions allowing certain amendments.

CONSENT, INDEMNIFICATION. Is there someone who will indemnify the trustee with respect to the proposed action? (Caveat: The tax consequences of an indemnification should be considered.)

California's statutory scheme

Probate Code §§15400-15414 describe several methods for amending trusts under various circumstances and Probate Code §§17200-17211 describe the procedure for petitioning the court in the event court approval is required. These sections are summarized below along with practical considerations for using them.

METHODS FOR AMENDING. Division 9, Part 2, Chapter 3 of the Probate Code, commencing with §15400, is entitled "Modification and Termination of Trusts" and sets forth the various methods of modifying, terminating, consolidating and dividing trusts.

CONSENT OF ALL BENEFICIARIES. Section 15403 provides that, if all beneficiaries of an irrevocable trust consent, they may compel modification or termination of the trust upon petition to the court. Some important considerations are:

A guardian ad litem is frequently necessary because of the "all beneficiaries" requirement and the existence of minor, unborn or unascertained beneficiaries. Note, however, that Probate Code §15405 permits the guardian ad litem to "rely on general family benefit accruing to living members of the beneficiary's family as a basis for approving a modification or termination of the trust."

Under this section, a trust with a spendthrift clause cannot be terminated (compare this with methods under other Probate Code sections discussed later where the existence of a spendthrift clause is irrelevant).

The court must consider whether the continuance of the trust as created is necessary to carry out a material purpose of the trust, and the court must further determine whether the reason for the change outweighs the interest in accomplishing that material purpose. If so, the court may allow the modification or termination of the trust as requested. The important point is that the petitioning beneficiaries must demonstrate good reason for the change.

Consent of settlor and all beneficiaries. Under Probate Code §15404, if the settlor and all beneficiaries of a trust consent, they may compel the modification or termination of a trust. Some considerations:

Note that, in contrast to Probate Code §15403 (consent of all beneficiaries, discussed above), no petition to the court is required.

Because of the "all beneficiaries" requirement, a guardian ad litem may be necessary (see discussion above with respect to Probate Code §15403). Note, however, that under Probate Code §15404(c), the court may limit the class of beneficiaries whose consent is needed under certain circumstances.

A spendthrift clause will not preclude modification or termination.

No reason is required for the requested modification or termination.

CONSENT OF SETTLOR AND SOME BENEFICIARIES. Probate Code §15404 also governs the situation where the settlor and only some beneficiaries consent. In that event, however, a petition to the Court for an order compelling modification or partial termination is required and it will be granted on a showing that the interests of the non-consenting beneficiaries are not substantially impaired.

Uneconomically low principal. Probate Code §15408 provides an "out" when a trust becomes too small to administer efficiently:

A trust is presumptively too small if trust principal is no greater than $20,000, in which case the trustee may terminate the trust without further direction from the court.

If a trust is larger than $20,000, a beneficiary or trustee may petition for a court determination that continued administration will "defeat or substantially impair the accomplishment" of the trust's purposes. If the court so finds, it may, in its discretion, order any of the following (attempting to conform as nearly as possible to the intention of the settlor): termination of the trust, modification of the trust or appointment of a new trustee.

The court may order termination even where the trust includes a spendthrift clause.

CHANGED CIRCUMSTANCES. Probate Code §15409 permits a trustee or beneficiary to petition to have the administrative or dispositive provisions of a trust modified, or to have the trust terminated. The court has discretion to make such orders on a showing that "circumstances not known to the settlor and not anticipated by the settlor" will defeat or substantially impair the accomplishment of the purposes of the trust. Some considerations:

The court has wide latitude and may even modify the trust terms so as to include provisions which are not authorized or are forbidden under the original trust instrument.

A spendthrift clause will be considered along with all other factors (i.e., its existence is not dispositive of whether or not the trust will be modified or terminated in the face of changed circumstances).

This provision may be a good alternative when the consent of the beneficiaries and/or settlor cannot be obtained, or when doing so is considered risky for tax purposes.

COMBINATION OF SIMILAR TRUSTS. Under Probate Code §15411, a Court may, on a showing of good cause, order the combination of trusts if administration as a single trust will not defeat or substantially impair the accomplishment of the trust purposes or the interests of the beneficiaries. Important considerations include:

A petition by a trustee or beneficiary is required. It is often helpful to the court, in making its determination, to have the consent of the beneficiaries.

Because Probate Code §15411 allows the consolidation of similar (not necessarily identical) trusts, it may be possible to obtain a variation in terms of a trust by combining it with a similar trust.

DIVISION OF TRUSTS. Under Probate Code §15412, a Court may, on a showing of good cause, order the division of a trust into two or more separate trusts if this will not defeat or substantially impair the accomplishment of the trust purposes or the interests of the beneficiaries. A petition by a trustee or beneficiary is required. While not required, it is often helpful to the Court, in making its determination, to have the consent of the beneficiaries.

PROCEDURE. Division 9, Part 5, Chapter 3 of the Probate Code, commencing with §17200, is entitled "Judicial Proceedings Concerning Trusts" and sets forth the various court procedures for petitioning the Court with respect to trust matters.

The principal authorizing statute is Probate Code §17200(b), which provides that proceedings concerning the internal affairs of a trust include, inter alia, proceedings for approving or directing the modification or termination of a trust (Probate Code §17200(b)(13)) and approving or directing the combination or division of trusts (Probate Code §17200(b)(14)).

Under Probate Code §17201, a proceeding is commenced with the filing of a petition which states: (1) the facts showing that the petition is authorized under the Probate Code; (2) the grounds of the petition; and (3) the names and addresses of each person entitled to notice.

There are no Judicial Council forms for these petitions at this time--each must be individually created, based on the particular facts and circumstances.

Notice of the hearing must be given for at least 30 days before the hearing date, and the Judicial Council Notice of Hearing form is sufficient for this purpose.

Notice of the hearing must be given to all trustees and all beneficiaries.

A copy of the petition need not be served on trustees or beneficiaries unless the trustee or beneficiary has served and filed either a notice of appearance or a written request for a copy of the petition, in which case a copy of the petition must be mailed within five days after service of the notice of appearance or receipt of the request.

The requirement of service on all beneficiaries is subject to the "virtual representation" limitations set forth in Probate Code §15804.

Notice and a copy of the petition must also be served on any other person whose right, title or interest is affected by the petition. Special provisions, included at Probate Code §17203(c), apply if a person otherwise entitled to notice is deceased. If the petition relates to a charitable trust, notice must also be given to the attorney general.

Conclusion

The proliferation of irrevocable trusts for both tax planning and "control" purposes, coupled with the fact that lives (and law) are not always predictable, suggest that the ability to amend, modify and terminate trusts is an important feature of California's Probate Code.

Estate planners should not "just say no" when confronted with a client's wish to change an irrevocable trust, but, rather, should consider what can be accomplished through use of the statutory scheme described above.

Sandra Price of Cooley Godward LLP's San Francisco office is certified as a specialist in estate planning, trust and probate law. She is a member of the executive committee of the State Bar's Estate Planning, Trust & Probate Law Section.