Financial Advisor

March 2009

No Do-overs?

In tough economic times, some clients are wondering if they could tap those untouchable trusts. Probably not a good idea.


Kimberly Leach Johnson, an es­tate planning attorney in Naples, Fla., recently received a call from a client who said he wanted to unwind a trust that held a house he’d put inside it for his children. Under the plan, the man had put his $750,000 home into an irrevocable trust, called a qualified personal residence trust, that expired after 15 years. The hope was that the house would appreciate and his children would receive that rise in value-tax free.

Indeed, the house is now worth $1.5 million, meaning he and his wife were able to get $750,000 out of their estate without their children having to pay estate taxes on it.

But the plan required that once the 15 years were up, the parents had to pay their children rent. And in the current economic climate, the man, now 78, feared he could not afford to do that. Moreover, he wanted to keep the house.

Johnson pleaded with him to keep the plan in place, saying nearly 15 years had gone by and the trust was set to expire this February or March. If he unwound it now, the house would fall back into his estate, rendering the plan pointless. Moreover, it would cost about $7,000 in legal fees to unwind it.

“I kept telling him, ‘You’re overreacting. It’s a great estate planning technique,’” says Johnson, a partner with Quarles & Brady.

She finally convinced him, over the course of several conversations, though he still spent $3,000 in legal fees talking to her about it.

Another client wanted to unwind a trust he’d set up in 1990, into which he’d put an insurance policy. A popular estate planning technique, this allows the insurance to pay off taxes when the estate is passed on to the client’s children. In this case, the client’s insurance was with AIG Group, and the client feared the company would no longer be solvent when it was time to cash in. He asked Johnson to dissolve the trust, saying he would rather have cash than the insurance at this point. He was so fearful, in fact, that he told her to unwind his second trust as well, even though that one didn’t have AIG insurance but instead used a policy with Lincoln National Life Insurance Co. “There were going to be adverse tax consequences that he was willing to suffer because he wanted the cash,” Johnson says.

Like children trying to break into their piggy banks because their allowance money has dried up, clients have been calling up their advisors in recent months trying to break into their estate plans, fearing they won’t have enough cash in the current economic climate. Whether they have lost their jobs or seen their asset values plummet, many now have less money than they had when the plans were created, and now they want part of the money back.

“People are taking a closer look at any irrevocable trust to see what they’ve set up, what are their rights to access it, and, if there isn’t a direct route, did they retain any interest in it,” says Michael Smith, an attorney with Larkin Hoffman Daly & Lindgren Ltd. in Minneapolis.

Smith says he receives about three or four calls a month from clients looking to see if they can tap into their trusts. It’s not yet a big percentage of his client base, but the frequency of the calls has definitely increased.

There’s a buyer’s remorse problem going on right now in spades, says Jonathan Rikoon, a partner with Debevoise & Plimpton LLP. Rikoon says he has been in the business for nearly 30 years, and he’s seen cycles come and go, and clients sometimes call up and say they fear they’ve made a mistake. Now is one of those times.

“In the up cycles, the mistakes are that the kids are going to be too rich,” Rikoon says. “In down times, the problem is that they gave away too much. That’s harder to fix.”

There are two basic types of trusts for estate planning purposes, and both are usually irrevocable. One holds an insurance policy—either life or term—so that when the parents die, the children can use the policy to pay their estate tax bill. The second holds other assets, like real estate or stock. By setting up a trust, the client creates a new column in their assets that is considered untouchable.

But now people are wondering if they can get the money back. The answer is yes and no, says Jeffrey Asher, partner at Pryor Cashman LLP in New York City. A trust is an entity that stands outside their estate, in a separate column on their tax return. Some trusts have their own tax identification number and may have filed their own income tax returns. As a result, they have a separate existence. To all of a sudden unwind that trust might draw scrutiny from the tax authorities, Asher says.

Says Asher: “Clients come to us and say, ‘Can’t we just cancel the trust?’ The client knows what they can and cannot do, but they sometimes forget, especially in a market like this. They’ll say, ‘Even though you said I couldn’t do it, does that really mean I can’t?’”

There are actually several ways to access the money, depending on how the trust was set up. Some allow income to be distributed for very restrictive purposes, such as a child’s education or an unexpected health issue. But clients want to push the envelope. Robert Lopardo, whose firm ATG Trust Co. in Chicago is a trustee for many of these irrevocable vehicles, says one of his clients had a farmhouse on a large tract of land, and she sought reimbursement for the construction of a fence all the way around the property, claiming it was for medical reasons. She furnished the firm with a physician’s letter stating she was suffering from several medical conditions that required her to avoid strenuous exercise, and the fence would prevent her from having to chase her children should they wander off.

Another family recently asked for a distribution from the trust because they said their child, who was the ultimate beneficiary of the trust, had been accepted to a prestigious institution and the tuition needed to be paid immediately. What they didn’t say was that the child had withdrawn from the school and they planned to pocket the tuition refund. The trustee found out only after asking for a copy of the child’s grades, and the family couldn’t provide it. “It’s bad, and it’s hard to stop, but it’s more a function of human nature than the economy,” Lopardo says.

Clients can also access their trust money by asking the trustee to make a distribution to their spouses.

Alternatively, they can ask the trust to lend them money—though it must be at a fair market rate. Lopardo says he’s been called six times this year by clients who wanted to borrow from their trusts. He declined three of those times because the loans were prohibited by the terms of the vehicles. He did make two of the loans, however, and the sixth is still pending.

But borrowing from the trust can be problematic, advisors say. Smith of Larkin Hoffman says he received a call recently from a client who said he’d convinced his trustee to give him a loan of $20,000 to $30,000, and he was now unable to repay it. Problems arise when the “independent trustee” is a friend or relative of the grantor—the person who created the trust—because the trustee can feel torn. He may feel pressure to make the loan, but legally his fiduciary responsibility is to the beneficiaries of the trust, usually the grantor’s children.

“If they let mom and dad take a loan and it doesn’t get repaid, then they have jeopardized the children’s inheritance,” Smith says.

Daniel Swick, a partner with Herrick, Feinstein LLP in New York, says trusts generally have terms that are flexible enough to allow the person who set it up—or his spouse—to get money out. Swick says he had a client who set up a $500,000 trust for each of his children, and that money was meant to grow and perhaps pay for their college. But that man worked on Wall Street, and his income has since plummeted, and he now wants to use that money for other things, which he can do, provided it is spent on his children. In this case, the trustee was the client’s wife, who had no objections.

Swick says he hasn’t seen many people trying to break into their trusts, since most of his clients are ultra-wealthy, but he has seen some decide they no longer want to fund the insurance policies inside those trusts. With premiums running anywhere from $30,000 to $150,000 a year, the cost can be hefty. Others are reluctant to set up trusts in the first place, he says.

“Younger guys with a lot of debt, they see their income dropping, their house is not worth what they thought, and their fixed costs are high,” Swick says. “People are panicking.”

But some wonder whether the ease with which clients can get access to an “irrevocable” trust—either by changing the terms of it or obtaining a loan from it—will set off alarms with the Internal Revenue Service. After all, funds set aside in trusts are supposed to be outside the clients’ estates, and outside their access. If the IRS believes a client has retained or exercised too much control over one, it may question whether he ever really parted with the assets.

Indeed, there have been times where the client and his planners took an overly aggressive view of what could be done. The IRS has seized on those cases and tried to set a precedent with them. And once the tax authorities have won a few, they can try to change the law, experts say.

“For years, the IRS and Treasury have been sending proposals to Congress to try to stop or reduce the use of certain family estate-planning techniques, and by and large, those proposals have not been adopted,” Rikoon says. “But that can change if people become too aggressive.”