Chapter 10: Mending a Broken Trust

I.   Overview

§10.1   A revocable grantor trust becomes irrevocable (i.e., the trust may not be amended or revoked) on the settlor’s death. Occasionally, the terms of a trust provide that a grantor trust is irrevocable on the settlor’s incapacity; however, during the administration of a noncharitable irrevocable trust, issues can arise that were not anticipated when the grantor trust was established. For the purposes of this chapter, a broken trust is a noncharitable irrevocable trust with terms that do not work given the existing facts and circumstances facing the trustee or beneficiaries.

A broken trust may involve one or more of the following issues:

• trust purposes that cannot be accomplished
• trust terms needing interpretation or construction
• a vacancy in the trusteeship
• discord among one or more trustees
• discord between a trustee and one or more beneficiaries
• unanticipated circumstances
• an inability to administer effectively
• an uneconomic trust
• drafting mistakes in facts or law, resulting in trust terms that do not reflect the settlor’s intent
• trust terms that do not achieve the settlor’s tax objectives

Changes that the trustees or beneficiaries may wish to make include the following examples:

• Change the trustee. The trustee may have a conflict of interest or powers that could result in adverse income, gift, or estate tax results. Other possible reasons for changing the trustee are that the trustee has a poor investment record or is not responsive to the legitimate needs of the beneficiaries.
• Change the situs. Change the situs of the trust for the convenience of a trustee or beneficiary or to take advantage of more favorable (or avoid unfavorable) state trust or tax laws.
• Divide the trust. Split a trust into two or more trusts to make more effective use of generation-skipping transfer tax exemptions, to enable a trust holding stock in an S corporation to qualify as an S corporation shareholder, or to permit different investment objectives (e.g., growth or income) for different co–income beneficiaries when the division of trust rules in MCL 700.7417 do not apply.
• Combine trusts. Combine two or more trusts into one trust to save administration costs when the consolidation rules in MCL 700.7417 do not apply.
• Reform for tax purposes. Reform a trust to qualify as a marital deduction trust, a charitable remainder trust under IRC 2055(e)(3), or a qualified subchapter S trust (QSST).
• Revise trustee powers. Change certain administrative or investment trust provisions.
• Modify distribution provisions relating to principal or income. Change trust terms related to the distribution of trust assets. For example, the trustee may desire to purchase a commercial annuity for a beneficiary instead of following trust terms requiring holding assets in trust for a term of years.
• Correct a drafting error. Correct a drafting error that defeats the settlor’s intent, or resolve ambiguous language in the trust instrument.
• Terminate a trust sooner than allowed by its terms. Permit early termination of a trust.

This is not an all-inclusive list.

Fortunately, various techniques and procedures are available to address these problems. A broken trust can be fixed in one or more of the following ways:

• pursuant to the terms of the trust (see §10.2)
• pursuant to terms of the Michigan Trust Code (MTC), without court intervention (see §§10.4–10.7, 10.8, 10.12, and 10.17)
• by a nonjudicial settlement agreement (NJSA) (see §§10.4–10.7)
• by a court order
  • approving an NJSA (see §10.7);
  • ruling on a petition to modify, terminate, or reform a trust or another contested matter (see §§10.9, 10.13, and 10.18); or
  • approving a settlement agreement resolving a contested matter (see §10.21)
• by dividing or consolidating trusts (see §10.22)
• by removing a trustee and appointing a different trustee (see §10.23)
• by decanting to another irrevocable trust (see §10.24 and chapter 5)

Before settling on a method to fix a broken trust, remember that not every section of the Estates and Protected Individuals Code (EPIC) will apply to all trusts. MCL 700.8101, .8206. Certain parts of EPIC, including certain parts of the MTC, are prospective only. EPIC took effect on April 1, 2000; and the MTC took effect on April 1, 2010.

To know what tools are available in fixing broken trusts, determine when an irrevocable trust was created and when a previously revocable trust became irrevocable. The provisions in MCL 700.7411(1), dealing with modification or termination of a noncharitable irrevocable trust, do not apply to irrevocable trusts created before April 1, 2010, or to revocable trusts that became irrevocable before April 1, 2010. MCL 700.7411(2).

The commentary to MCL 700.7411 makes clear that the drafters of the MTC did not intend to change the common law that applies to the agreement of a settlor and trust beneficiaries agreeing to terminate an irrevocable trust as provided in Hein v Hein, 214 Mich App 356, 543 NW2d 19 (1995).

II.   Nonjudicial Remedies

A. In General

§10.2   Court authorization is not always required to change the terms of an irrevocable grantor trust. First, determine if the trust is revocable and may still be amended. If so, amending the trust should resolve any broken trust issues.

Second, carefully review the terms of the trust to see if there are terms that allow the fixing of the trust. Some trusts contain language that allows the trustee, trust director, or another person to change the language in the trust to correct defects and drafting errors, to amend administrative or other terms, and to adapt to changed circumstances and comply with tax or other laws.

When undertaking to fix a defect in a trust pursuant to the terms of the trust, be sure to follow the express language in the trust instrument and prepare appropriate documentation. For example, if the trust instrument indicates that the surviving spouse has the power to remove and replace a trustee and the surviving spouse wishes to invoke the provision, prepare a document, signed and dated by the surviving spouse, removing and replacing the trustee. See form 10.1. This document becomes part of the trust instrument, just like an amendment. Likewise, a termination of the trust instrument should be prepared if the trustee terminates the trust pursuant to a trustee power in the instrument. See form 10.2.

B. Trust Law Default Provisions

§10.3   In considering whether the terms of the trust allow fixing a broken trust without court intervention, remember that the MTC includes a series of default terms that can be modified, subject to the mandatory provisions in MCL 700.7105(2). Thus, while a settlor can draft to make modification, termination, or reformation easier to accomplish than the default provisions in the MTC, the terms of a trust may not restrict the court’s jurisdiction.

The mandatory provisions relevant to fixing broken trusts include the following:

• MCL 700.7105(2)(c): A trust must have a purpose that is lawful, not contrary to public policy, and possible to achieve.
• MCL 700.7105(2)(e): A trust may not override the court’s power to modify or terminate a trust under MCL 700.7410, .7412(1)–(3), .7414(2), .7415, or .7416.

As can be seen in several sections of Part 4 of Article VII, when a court needs to modify or reform a trust due to conflicts with MCL 700.7105(2) or otherwise, the court must still consider and implement the settlor’s intent and stated purpose or, if not stated, the settlor’s probable intention and the purposes of the trust, as applicable. See MCL 700.7411, .7412, .7415, .7416.

C. Nonjudicial Settlement Agreements

1. In General

§10.4   Many broken trusts, or trusts with problematic terms, can be resolved using an NJSA. The MTC allows interested persons to enter into a binding agreement on certain matters without court involvement. MCL 700.7111(3). NJSAs are helpful to trustees, beneficiaries, and the courts, saving time, money, and court resources. Many issues that previously would have required a court proceeding may now be handled without court involvement. Use of the representation rules in Part 3 of Article VII will greatly expand the flexibility of NJSAs, by allowing their use with fewer people involved. See forms 10.3, 10.4, and 10.5 for sample NJSAs.

“Interested persons” for the purposes of NJSAs are those whose consent would be required to achieve a binding settlement were the settlement to be approved by the court. MCL 700.7111(5). Depending on the purpose of an NJSA, interested persons may vary.

2. Requirements of an NJSA

§10.5   For an NJSA to be valid, it

• may not violate a material purpose of the trust,
• may include only terms and conditions that could be properly approved by the court under the MTC or other applicable law, and
• must not be used to accomplish the termination or modification of the trust.

MCL 700.7111(2).

3. Application of an NJSA

§10.6   NJSAs are very flexible. MCL 700.7111 provides an illustrative but nonexhaustive list of matters that may be resolved by an NJSA:

• interpretation or construction of the terms of the trust (see form 10.3)
• approval of a trustee’s report or accounting
• direction to a trustee to perform or to refrain from performing a particular act or to grant to or to withhold from a trustee any power
• resignation or appointment of a trustee
• determination of a trustee’s compensation (see form 10.4)
• transfer of a trust’s principal place of administration
• liability of a trustee for an action relating to the trust

MCL 700.7111(3). NJSAs can address these and other matters as long as the other requirements are met. While an NJSA may not terminate or modify a trust, a trust may be reformed using an NJSA, provided the requirements of MCL 700.7111(2) are met. Reformation of an obvious mistake in the terms of a trust can easily be fixed by an NJSA. Other common uses for NJSAs are the interpretation of ambiguous terms of the trust, the appointment of a trustee, and the approval of a trustee’s report. For use in combination with an agreement to alter shares to simplify probate and trust administration, see form 10.5.

An NJSA does not include an agreement entered into by parties to a lawsuit that settles numerous pending actions, is entered into the record, and involves the retention of jurisdiction by the probate court to administer disputes regarding the performance or compliance of a party under the settlement agreement; in such a case MCL 700.7111 does not apply. In re Draves Tr, 298 Mich App 745, 828 NW2d 83 (2012).

4. Court Involvement

§10.7   Any interested person or trustee may request the court to approve or disapprove an NJSA. MCL 700.7111(4) provides that the court must enter an order approving the agreement if

• it determines that the representation as provided in Part 3 of Article VII was adequate,
• the agreement does not violate a material purpose of the trust, and
• the agreement contains terms and conditions the court could have properly approved.