Trust modifications are often necessary when the terms of a trust, established under previous estate planning assumptions, no longer serve the intended purpose due to changes in tax laws or the financial situation of the beneficiaries. This is rather theoretical. Examples follow.

A common scenario involves a bypass trust, which was mandated in the trust instrument to minimize estate taxes by utilizing the estate tax exemption at the first spouse’s death. However, with significant increases in the estate tax exemption, funding the bypass trust may now be counterproductive. It could lead to unnecessary administrative complexity, limit the surviving spouse’s access to assets, and have negative income tax consequences. 

Table 1: Federal Estate tax exemption amounts and top estate tax rates from 2000 to 2024 (1)

The following situations are unfortunately not at all uncommon: 

A revocable living trust between spouses was established in the early 2000s and had the typical bypass trust provision. You get retained to review the trust in 2024. There is no prior amendment. The estate is currently not large enough by a margin to be subject to estate taxes. One of the spouses passed away a few years ago. Now only the survivor’s trust can be amended. Further, the situation often bifurcates into two scenarios: 

a) the trustee, typically the settlor did nothing (they did not fund the bypass trust) 

b) the trustee funded the bypass trust.

What are the problems?

a) The Trustee Did Nothing – No Bypass Trust Was Funded:

When the surviving spouse (often the trustee) does nothing after the first spouse's death and fails to fund the bypass trust, several problems can arise:

1. Missed Tax Benefits: The primary purpose of the bypass trust is to utilize the estate tax exemption of the first spouse to die, effectively sheltering a portion of the estate from future estate taxes. By not funding the bypass trust, the surviving spouse may inadvertently increase the taxable estate, potentially leading to a larger tax burden upon their death. This is currently not an issue for federal estate taxes but may be a problem for state estate taxes.

Table 2: State Estate Tax Exemption Amounts (from lowest to highest) (2)

   2.Loss of Asset Protection: The bypass trust can provide creditor protection for the assets placed within it, as these assets are no longer considered part of the surviving spouse’s estate. Without funding the bypass trust, the surviving spouse’s creditors may have access to these assets, putting the estate at risk.

   3. Complications in Estate Distribution: The bypass trust often includes specific instructions for distributing assets to heirs, ensuring that the children or other beneficiaries from the first spouse’s estate receive their intended inheritance. Some advisors call this ‘bloodline protection’. Failing to fund the bypass trust can lead to disputes among beneficiaries and possibly litigation, as the trust's intended asset distribution plan may not be followed.

   4.Potential Violations of Fiduciary Duty: The trustee has a fiduciary duty to follow the terms of the trust, including the creation and funding of the bypass trust. By neglecting this duty, the trustee (often the surviving spouse) may be liable for breach of fiduciary duty, which could result in legal consequences and demands for restitution by the beneficiaries.

   b) The Trustee Funded the Bypass Trust:

When the trustee funds the bypass trust, especially if this was done without careful consideration of the current tax laws and the estate’s financial situation, other issues may arise:

1. Unnecessary Complexity: If the estate tax exemption is sufficiently high, funding the bypass trust may no longer be necessary and could create unnecessary administrative burdens. This complexity may lead to higher legal and accounting costs, as well as increased effort in managing multiple trusts.
2. Restricted Access to Assets: The assets placed in the bypass trust are no longer freely available to the surviving spouse, who may only receive income or limited principal distributions from the trust. This restriction can lead to financial difficulties for the surviving spouse, especially if their needs change over time.
3. Potential Overfunding: In cases where the bypass trust was funded to its maximum allowable amount, it may reduce the size of the marital trust or survivor’s trust, which could be detrimental to the surviving spouse’s financial security. 
4. Estate Tax Implications: If the bypass trust was funded without proper tax planning, it could result in unfavorable tax consequences, particularly if the assets in the bypass trust appreciate significantly. The appreciation in value may lead to higher capital gains taxes when the assets are eventually sold, as opposed to receiving a step-up in basis had they remained in the marital trust or survivor’s trust.

In either case (trust funded or not funded), beneficiaries may sue trustees for breach of fiduciary duty, negligence, and failure to manage trust assets properly, and they may sue attorneys for legal malpractice, breach of contract, and negligence. These claims can arise when the trust’s provisions are not properly executed, leading to financial harm to the estate or beneficiaries.

Sometimes drafters used clauses that account for the possibility that the estate tax exemption might be high enough that funding a bypass trust (Nonmarital Share) could be unnecessary. This flexibility is not typical in older, more rigid trust documents, which often mandate the creation of a bypass trust without considering whether it is actually beneficial given changing tax laws.

Need for Trust Reformation

The scenarios above are common reasons for trust reformation. We will start with the ‘book’ or the California Probate Code. While California has only partially adopted the Uniform Probate Code, the statutes about trust modification are either very close to or heavily influenced by the UPC. Nevertheless, practitioners are advised to check their respective state laws.

The California Probate Code includes several sections dealing with trust reformation and the newly enacted trust decanting provisions. Here are the relevant sections:

1. Trust Reformation (CA Probate Code §§ 15400–15414)

These sections deal with the modification and termination of irrevocable trusts, including reformation under specific circumstances:

• Probate Code § 15403: Allows for the modification or termination of an irrevocable trust by the court with the consent of all beneficiaries, as long as doing so does not interfere with a material purpose of the trust.  

   

• Probate Code § 15404 allows trust modification or termination with the written consent of the settlor and all beneficiaries without court approval.  

   

• Court intervention will be necessary if
• any beneficiary does not consent to the modification or termination of the trust. In this case, the court may modify or partially terminate the trust upon petition to the court by the other beneficiaries, with the consent of the settlor, if the interests of the beneficiaries who do not consent are not substantially impaired.
• the trust provides for the disposition of principal to a class of persons described only as “heirs” or “next of kin” of the settlor the court may limit the class of beneficiaries whose consent is necessary to modify or terminate a trust to the beneficiaries who are reasonably likely to take under the circumstances. 

   

• Probate Code § 15409: Permits modification or termination of a trust if changed circumstances make the current terms impractical or impossible on a petition by a beneficiary or a trustee, as long as it is necessary to accomplish the trust’s purposes. 
   

Who are “all the beneficiaries”?

“Issue” are beneficiaries whose consent is required for termination, unlike “heirs” (see above § 15404). However, consent to termination may be obtained through a guardian ad litem according to § 15405.  

PRACTICE TIP

“In general, because of conflicts between current and remainder beneficiaries and the difficulty of adequately representing the conflicting interests of various minor, unborn, and unascertained beneficiaries by appropriate guardians ad litem, it is often impractical to modify a trust by attempting to obtain the consent of “all beneficiaries.” A more efficient approach is to convince the court to modify the trust because of the existence of changed circumstances. See Prob C §§15408–15409” (3).

2. Trust Decanting (Probate Code §§ 19501–19533)

Changes to irrevocable trusts are generally constrained to fairly narrow statutory modification provisions discussed above. However, decanting statutes allow the trustee to make changes to an irrevocable trust upon notice to the Qualified Beneficiaries but without court approval.

Trust decanting statutes were first enacted in New York state in 1992 and currently exist in more than 30 states. The underlying legal theory is that the power to invade a principal confers the power to appoint principal to a new trust for some or all of the beneficiaries without court approval, but court approval can be obtained if desired.

This concept was modified by the 2015 Uniform Trust Decanting Act (UTDA) of the Uniform Law Commission. The Act separates the types of changes that can be made depending on the distribution standard in the original trust, specifically distinguishing between “limited distribution discretion” and “expanded distribution discretion.” If the distribution standard in the original trust is governed by an ascertainable standard, it falls under the “limited distribution discretion” category. In such cases, each beneficiary’s interest in the new trust must closely resemble their interest in the original trust.

The California Uniform Trust Decanting Act (UTDA) went into effect on January 1, 2019. It generally follows the California statute but imposes broader notice requirements for minors and other incapacitated individuals than the ACT. The California statute specifically requires that notice be given in all circumstances to the following (§ 19507).

(1) Each settlor of the first trust, if living or then in existence.

(2) Each qualified beneficiary of the first trust.

(3) Each holder of a presently exercisable power of appointment over any part or all of the first trust.

(4) Each person that currently has the right to remove or replace the authorized fiduciary.

(5) Each other fiduciary of the first trust.

(6) Each fiduciary of the second trust.

(7) The Attorney General, if subdivision (b) of Section 19514 applies.

The term “Qualified beneficiary” is quite expansive and includes a beneficiary who can presently be given trust income or principal, a beneficiary who could receive trust income or principal at the termination of the interests of one or more current beneficiaries if the trust continues, or a beneficiary who would be entitled to distribution if the trust terminated at the termination of the interests of the current beneficiaries (§ 19502 (t).).

In summary, the California decanting statute adds an option that allows the trustee herself to initiate a trust modification. However the limitations and requirements limit its usefulness. Some practitioners in California may move the situs of the trust to a different jurisdiction where the decanting statutes are less stringent.

3. Other Avenues for Trust Modification

In the preceding, we have covered the ‘book’ (probate code) approach to trust modification. Referring back to the attention-getting title, what are hook and crook? 

In Ike v. Doolittle, 61 Cal. App. 4th 51, 80, 70 Cal. Rptr. 2d 887 (1998) the court clarified the continued applicability of common law principles in the modification of trusts:

“Citing Adams v. Cook (1940) 15 Cal.2d 352 [101 P.2d 484], and section 167, subdivision (1), of the Restatement Second of Trusts, the Court of Appeal in Stewart v. Towse (1988) 203 Cal.App.3d 425, 428 [249 Cal.Rptr. 622], recognized that "California courts have long had the equity power to modify the terms of a trust where such modification is necessary to preserve the trust or serve the original intentions of the trustor. . . ." (Italics added.) The Adams and Stewart cases are instructive of how broad is the common law power of a trial court in equity to modify a trust.”

But will the IRS play ball?

While there is no overarching federal law governing reformation, certain provisions of the Internal Revenue Code (IRC) specifically authorize and recognize the process. The stance of the Internal Revenue Service (IRS) and the courts regarding reformation in tax cases depends on the specific tax issues involved.

For example, reformation is explicitly authorized by statutes in cases such as charitable trusts and qualified domestic trusts. In other instances, IRS regulations acknowledge the effectiveness of reformation, as seen with generation-skipping transfers governed by transitional rules. Additionally, the IRS has recognized reformation in private letter rulings (PLRs) and technical advice memorandums (TAMs), particularly in cases involving trusts qualified to hold stock of an S corporation.

However, the IRS has generally resisted attempts to reform trusts to qualify for the federal estate tax marital deduction, primarily on the basis that the surviving spouse’s interest must vest at the date of death. Similarly, the IRS has shown reluctance to recognize reformations that affect powers of appointment, although practitioners have experienced some success in these cases.

Conclusion

In an evolving tax landscape, trust modifications, particularly for outdated bypass trusts, are often necessary to adapt to current estate planning needs. While bypass trusts once played a critical role in minimizing estate taxes, changes in tax laws have rendered many of these provisions unnecessary or even counterproductive. Modifying such trusts can prevent complications like administrative burdens, restricted access to assets, and unfavorable tax consequences.

Through statutory reformation, as outlined in the California Probate Code, trustees can petition the court to modify a trust based on changed circumstances or evolving needs. Theoretically, certain modification provisions do not require court approval. Sometimes common law principles also provide an avenue for trust modification when necessary to serve the original intentions of the trustor.

However, while state laws provide mechanisms for trust reformation, navigating federal tax implications can be more complex. Although the IRS supports some reforms, such as those involving charitable trusts or qualified domestic trusts, others, like those attempting to qualify for the federal estate tax marital deduction, face more resistance. Practitioners must carefully consider both state law and IRS positions when seeking to modify a trust to ensure the changes align with the best interests of the beneficiaries and the goals of the original estate plan.

References 

1. Julie Garber, How the Federal Estate Tax Exemption Changed from 1997 to Today, The Balance (Nov. 15, 2022), https://www.thebalancemoney.com/exemption-from-federal-estate-taxes-3505630. 

    

2. Clifford Pendell, The Complete List of States with Estate Taxes (Updated for 2024), JRC Ins. Grp. (2024), https://www.jrcinsurancegroup.com/the-complete-list-of-states-with-estate-taxes/. 
    
3. California Trust Administration §16.12 (2d ed. Cal. CEB 2024)