Irrevocable doesn't mean inflexible. (Trust Changes).

Not long ago, I met with a couple for what appeared to be routine estate planning. The husband, using a walker, hobbled slowly into my office and sank into a chair to catch his breath. His considerably younger wife radiated energy and lit up the room with her smile. I was shocked a few months later when he phoned me and told me that his wife had passed away!

The game of life has an unsettling habit of throwing us a curve. Whether it's the sudden death of a younger spouse or the promising child whose future turns sour, unexpected developments have a way of wreaking havoc with the best-laid estate plans.

Where the operative planning documents remain subject to modification, of course, appropriate adjustments usually can be made. But what happens when an irrevocable trust is part of the estate plan?

There are various options clients may explore to reform or terminate an irrevocable trust, as well as some practical "work-around" solutions.

SCOPE OF THE PROBLEM

Problems with an irrevocable trust typically arise from three situations:

* Poorly drafted documents. A trust that fails to include necessary tax provisions or simply does not reflect what the grantor intended;

* Changes in tax laws. The trust was set up to meet certain tax criteria, but the tax laws changed; or

* Changes in family dynamics. Unanticipated problems with heirs or their families after the trust's creation may make planned distributions imprudent.

But how can a client modify an irrevocable trust?

STEP ONE: READ CAREFULLY

Despite "irrevocable" language, the trust may have been drafted with sufficient flexibility to permit adaptive changes, either through the use of a "trust protector" or "powers of appointment" (IRC Sec. 1041).

The relatively new concept of a trust protector ensures oversight by a disinterested fiduciary. While trust protectors typically are granted somewhat limited powers, they may be able to lend flexibility in changing circumstances through such critical functions as removing a trustee, amending the trust agreement to react to tax law changes or modifying how assets are distributed and to whom.

While a discussion of powers of appointment is beyond the scope of this article, it's important to keep in mind that close reading of such powers may offer assistance even when the trust is irrevocable. However, if significant assets are involved, exercise of such powers may tend to foster litigation over whether or not the appointment was within the trustee's designated discretion.

CONSIDER COURT ASSISTANCE

It appears that California--through its case law and statutes--has adopted a remarkably friendly attitude toward changing trusts.

Civil Code Sec. 3399 permits the "reformation" of a written contract when the writing, through fraud or mistake, fails to express the intention of the parties. This section codifies the traditional equitable action to correct a written document. While a court will not create a new agreement for the parties [See Getty v. Getty, 1987 Cal. App. 3d 1159 (1986)], reformation of the document might be appropriate in cases where, for example, poor drafting failed to carry out the settlor's intentions.

Probate Code Sec. 15409 also provides a broad umbrella under which a court may modify the administrative or dispositive provisions of a trust, or may terminate the trust, if "owing to circumstances not known to the settlor and not anticipated by the settlor, the continuation of the trust under its terms would defeat or substantially limit the accomplishment of the purposes of the trust."

That same code section even allows the court to order a trustee "to do acts that are not authorized or are forbidden by the trust instrument." This provision might be helpful when changes in the tax law threaten to defeat the testator's tax-minimization intent.

Procedurally, a trustee or beneficiary seeks the assistance of the court under Sec. 15409 by filing a petition. While the court must be convinced that there are "circumstances not known and not anticipated by the settlor" that would defeat or impair the trust's purpose, the statute does not require consent by the remaining beneficiaries or trustees to the requested change.

Similarly, a court may order modification or termination of a trust under Probate Code secs. 15403 and 15404. While both offer potentially broad-reaching assistance, it is important to note that various levels of consent are required under each of these provisions.

In an action under Probate Code Sec. 15403, if all beneficiaries of an irrevocable trust consent, they may compel modification or termination of the trust unless the court finds that a material purpose remains for continuance of the trust and that purpose outweighs reasons advanced for termination or modification.

Probate Code Sec. 15404 offers an even broader avenue of relief: If the settlor and all beneficiaries consent, they may compel termination or modification of a trust without any need for court action. Section 15404(b) further allows a court to compel modification or partial termination of the trust over the objection of non-consenting beneficiaries, provided that the settlor consents and that the request does not "substantially impair" the rights of the non-consenting beneficiaries. Because this procedure requires the settlor's consent, a trust cannot be set aside under this provision after death.

One potential procedural complication under Sec. 15403 or 15404 for trusts with minor beneficiaries is that a guardian ad litem typically will need to be appointed to represent the minor's interests and to provide the necessary consents (see Probate Code Sec. 15405).

Last but not least, where trust restructuring is desired, Probate Code secs. 15411 and 15412 offer additional avenues for redress. These provisions permit a court to combine or divide a trust or trusts "for good cause shown."

As a practical matter, attorneys in the probate and estate fields report that probate courts routinely approve trust amendment petitions if the beneficiaries unanimously consent to the proposed changes. However, where a disgruntled beneficiary lodges an objection, counsel will be required to argue the merits of the case and to demonstrate that the appropriate statutory test has been met.

Beyond these statutory options, California case law underscores the inherent equitable power of the courts to reform or modify a trust--an additional source of relief for clients.

One of the earliest California cases in this field, Lissauer v. Union Bank & Trust Co. [45 Cal. App. 2d 468 (1941)], established that when a drafting error has rendered the trustor's intention ambiguous, the trial court may consider extrinsic evidence (that is, evidence outside the four corners of the document) to determine the trustor's actual intent.

More recently, the California Court of Appeal in Stewart v. Towse [203 Cal. App. 3d 425 (1988)] authorized the modification of two irrevocable trusts to change the named successor trustee, confirming that trial courts have the inherent equitable 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."

Based on these precedents, your clients may be able to introduce testimony or other evidence to prove their true intent in a case where a drafting error occurred, or to make other changes necessary to carry out the settlor's plan.

Even more recently, the Court of Appeal's lengthy opinion in Ike v. Doolittle [61 Cal. App. 4th 51(1998)] summarized the case law to date and concluded that even beyond the statutory powers authorized in Probate Code Sec. 15400, a trustee or beneficiary may petition the court "concerning the internal affairs of a trust" under Probate Code Sec. 17200.

This broad power enables a court to entertain a litany of potential requests for change, including "ascertaining beneficiaries and determining to whom the property shall pass" and "approving or directing the modification ... of the trust." This essentially offers trial courts a variety of platforms upon which to modify or reform a trust on equitable grounds.

WORK-AROUND OPTIONS

Work-around techniques also can add flexibility to an irrevocable trust, without the necessity for a court-authorized change.

One of my clients, for example, was concerned about the dispositive provisions of an irrevocable life insurance trust he established 10 years ago. While he loved his children and wanted to preserve the estate for them, he was concerned that an outright distribution of $8 million from the trust would be inappropriate, as they had yet to learn how to manage money. Fortunately, repositioning the trust assets allowed us to solve the problem.

Here's what we did. The client created a second irrevocable trust and funded it with real estate and a percentage of the client's business. Both trusts then contributed their assets to a newly formed limited liability company, in return for LLC interests.

The old irrevocable trust received a "non-managing member" interest in the LLC, while the new trust, with a family friend as trustee, was given "managing member" LLC interest. This put the family friend in a position to control future distributions of income from the LLC, an important layer of protection against the improvidence of spendthrift heirs. Similar trust asset reallocation strategies can be structured using limited partnership interests, although care must be taken in both entity structures to avoid the deemed-sale rules of IRS Sec. 737.

A trustee, of course, has a fiduciary responsibility to the core beneficiaries; he is not an agent of the grantor. To protect the trustee, my client asked each of the beneficiaries to approve the transaction and to release and hold harmless the trustee from any claim they might have against him as a fiduciary.

To encourage cooperation by the beneficiaries to such changes, parents and trustees will find it helpful to communicate the full financial picture.

In this case, the parent explained to the beneficiaries that he was under no obligation to continue to make gifts to fund future premiums for the trust-held insurance policy. Since the lack of additional premiums payments would cause the policy to lapse, the beneficiaries were more than happy to cooperate. Care should be taken not to violate standards that set present interest gift exclusions as reflected in the Kohlsaat case (TC Memo 1997-212).

IRREVOCABLE DOESN'T MEAN INFLEXIBLE.

California's flexibility-friendly statutory and common law and creative asset re-allocation strategies offer multiple options for dealing with poorly drafted trust documents, responding to unanticipated changes in tax laws and changing family dynamics.

Joel B. Goldhirsh, CPA is a principal with Goldhirsh and Goldhirsh, a wealth management and estate tax consulting firm with offices in Irvine and Palm Desert. Advisory services offered through Sagemark Consulting. He can be reached at [phone] or [e-mail].