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Should You and Can You Terminate an Irrevocable Trust?

November 30, 2023

Irrevocable trusts are created with the intent that they cannot be altered, amended, or revoked. The benefit is that such trusts can be used to minimize estate taxes or protect assets for numerous purposes such as Medicaid planning or to provide creditor protection. However, the downside is that the grantor (the creator of the trust) generally loses control over the assets in the trust and cannot make changes to the trust. A revocable trust is more flexible while the grantor is alive, but the trust becomes irrevocable when the grantor dies so beneficiaries are stuck with the terms of the trust instrument. In both situations, the grantor or beneficiaries may want to find a way to terminate an irrevocable trust. While that may be possible, there are important consequences to consider before doing so.

Reasons for Terminating an Irrevocable Trust

For various reasons, beneficiaries might want to terminate the trust and have access to the assets outright. The trust may not meet their needs because they have expenses to pay or they may be paying high taxes on the income they are receiving from the trust.

There may also be strategic reasons for the grantor or beneficiaries to terminate or at least substitute trust property held in irrevocable trusts. For example, it might be better for tax purposes to remove certain assets from an irrevocable trust because they have highly appreciated in value and if they remain in the trust, they will not get a step up in basis upon the passing of the grantor.

Process for Dissolving an Irrevocable Trust

Terminating an irrevocable trust is an involved, formal process. Usually, all beneficiaries must consent to termination. In some cases, it may also require court approval depending on the type of trust, whether there are minor beneficiaries and the legal jurisdiction of the trust.

Tax Consequences

Whenever assets held within the trust are liquidated, those transactions may trigger a combination of income and capital gains taxes, which would happen without regard to any subsequent trust termination.

However, when the assets of the terminating trust are distributed out to beneficiaries and/or yet another trust (such as when the original trust is being “decanted”), such distribution may carry out trust income to the distributee (which would then be included in the beneficiary’s income) and may also trigger the imposition of capital gains taxes on a deemed sale of trust assets, gift, generation-skipping transfer and estate taxes, depending on the particular facts and circumstances of the termination. 

Alternatives to Termination of a Trust

There are alternatives to termination, including substituting assets in the trust. Decanting is also an option. It involves moving assets from the existing trust to a new trust drafted with more favorable terms. This does not necessarily require the consent of the beneficiaries. Further, the situs of the trust (the state where it is created) can be moved when decanting to seek a more favorable tax environment. 

While there may be good reasons for terminating a trust, it is critical to analyze all the advantages and disadvantages before making a decision. If you are considering executing an irrevocable trust or want to discuss how to alter an existing trust to better meet your needs, contact us for a consultation.

 

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