FEDERAL TRANSFER TAXES AND THE PROTEAN IRREVOCABLE TRUST.

• Author: Schenkel, Kent D.

1. INTRODUCTION

   Freedom of disposition (1) is the most familiar and universally recognized principle of the law of intergenerational wealth transfer, (2) held out to be its organizing principle. (3) An individual property owner exercises freedom of disposition by implementing one or more donative legal mechanisms of the owner's choice--a will, trust or nonprobate device. (4) The law upholds freedom of disposition by enforcing its corollary, the donor's intent. (5) Even where a donor's intent infringes on parties outside the trust deal, it often prevails. (6) In cases where the donor fails to express a dispositive intent, the law fills in a presumptive intent; a guess, based on what lawmakers determine the typical decedent would want. (7)

   In short, American property owners are said to be empowered to dispose of their property as they please. (8) Donor's intent not only guides judicial decisions, it is generally the standard against which legal outcomes in the trusts and estates field are tested. (9) A good result is measured by its allegiance to the freedom of disposition principle, while a failure to carry out the donor's intent represents a failure of the law to live up to its central purpose. (10)

   But what does it mean to dispose of an asset? The regulatory environment of United States trust law has long invoked freedom of disposition to justify not only a particular disposition, but also a trust settlor's post-disposition control of transferred assets, and even alterations in the property rights of outsiders to the trust. (11) The freedom to dispose, so construed, permits a trust settlor to not only dispose of, but also to control the beneficial enjoyment of transferred property long after its actual disposition, often extending well after the settlor's death, and in many cases, indefinitely. (12) Trust law empowers the settlor (or the settlor's proxy, channeling the settlor's presumptive intent) to make adjustments to the trust relationship in response to unanticipated post-transfer events, even if such events occur many years, or in some cases many generations, after the creation of the trust. (13) In this way, trusts and estates law affirms the American legal system's strong commitment to a donor's property rights by first inventing and then venerating one stick in the ownership bundle--perpetual control over others' use and benefit of property no longer owned by the donor.

   Even so, in a statement reflecting an anachronistic view of the law, a comment in the Restatement (Third) of Property, Donative Transfers, referring to the enforcement of donor intent, states that "[t]he main function of the law in [the donative transfers] field is to facilitate rather than regulate." (14) This statement reflects classical legal thinking, which categorized legal rules as either "intention-facilitating" or "transaction regulating." (15) As used in the Restatement comment, the term "facilitate" refers to the enforcement of the donor's wishes, or her "freedom of disposition." (16) But in this comment, the Restatement ignores an important insight made by legal realists--legal "facilitation," by giving the force of law to certain priorities, is necessarily regulation. (17) As pointed out by Gregory Alexander, "the model of judicial neutrality, or state nonintervention, in private transactions is theoretically incoherent and practically false." (18) Trust law, in its elevation of the deontological value of freedom of disposition, ignores important consequentialist perspectives. When law prioritizes and protects the property rights of donors (former owners), it is necessarily choosing not to protect the rights of current owners and, perhaps more importantly, anyone else who might be affected by the enforcement of the donor's wishes. (19) Under one particular change to the traditional trust law doctrine of equitable deviation examined here, (20) trusts are now governed not only by the settlor's intent at the time of transfer, but also by asking what the settlor would do in light of newly apparent circumstances that the settlor did not anticipate at the time of the transfer in trust. (21) Even the settlor's death in the interim is no obstacle to the application of this imperative. (22) The reason for the settlor's failure to appreciate the newly arisen circumstance is also of no moment. (23) Perhaps the settlor was short-sighted and did not anticipate post-transfer developments that were quite likely to occur. (24) Or perhaps the settlor simply received shoddy estate planning advice. (25) Perhaps no mortal could have anticipated the event now faced. No matter. A trust can forever be modified in the face of unanticipated circumstances. (26) All that matters is that the event has arisen, and the trustee, or perhaps the beneficiaries, have discovered that the trust terms are no longer optimal, if ever they were. (27) Courts, upon request, are legislatively directed to spring into action to help these settlors, whether still living or long dead, to renew and improve their estate plans at taxpayer expense. (28) Coupled with the erosion and repeal of rules against perpetuities enabling perpetual trusts, irrevocable trusts can now be renewed and amended repeatedly and indefinitely if necessary. (29) Such is the power and scope of post-transfer freedom of disposition in the age of the protean trust.

   Expansion and enforcement of freedom of disposition, so construed, has consequences. These ever-amendable "irrevocable" trusts are empowered against a backdrop of highly unequal ownership of assets, especially in the United States. (30) Trust settlors privileged to take advantage of the chronic post-disposition control offered by trusts and estates laws own a vastly disproportionate share of the nation's wealth. (31) Post-transfer control of wealth by a trust settlor or his proxy, if that control is permanent, necessarily entrenches inequality of ownership. And inequality of wealth ownership erodes democratic institutions. (32) Permanent post-disposition control of wealth, by embedding it disproportionately in the hands of the few, gives them outsized influence in political affairs and enables an American aristocracy. (33) It can also create new spillover effects that produce negative impacts on outsiders to the trust relationship. (34)

   This Article questions the wisdom of repeatedly asking the question "what would the settlor do?" It calls for a regulation of irrevocable trusts that goes beyond expansive enforcement of donors' ever-expanding rights of control, taking into account a broader view of the consequences to trust beneficiaries and nonparticipants to the trust arrangement. While the author takes the position that all post-transfer amendments and refreshments of trust arrangements should be reconsidered, including those facilitated by decanting, (35) trust direction, (36) and trust protection, (37) this Article focuses for illustrative purposes only on modifications made to the traditional equitable deviation doctrine.

   Part II of the Article looks first at how the concept of freedom of disposition has been expanded under American law to include the right to dictate post-disposition limits to property's benefits. The equitable deviation doctrine is then explored, first in its original form, and then as modified by the Uniform Trust Code and Restatement (Third) of Property. Turning to the federal estate tax consequences of the modified equitable deviation doctrine, Part III addresses the question whether, if the settlor makes the transfer in trust at death, the property transferred to the trust will be included in the settlor's gross estate for federal estate tax purposes. Next it considers, in cases where a transfer to an irrevocable trust is made during the lifetime of the settlor, (38) whether a modified equitable deviation provision would render the gift "incomplete" for federal gift tax purposes. Finally, it looks at whether, in cases of a lifetime transfer, sections 2036 and 2038 of the federal estate tax code would include the trust property in the decedent's gross estate at death. Part IV calls for modifications to the transfer taxes to create disincentives to post-transfer amendment of irrevocable trusts. Part V concludes.

2. IRREVOCABLE TRUSTS AND THE FREEDOM OF MODIFICATION

   For trust settlors, designating a trust as irrevocable brings important transfer tax and other benefits. (39) Any irrevocable trust can be revoked so long as a living settlor and all the beneficiaries agree. (40) But sometimes a settlor's explicit complicity is not forthcoming, or is impossible due to the settlor's death, for example. In such cases, under evolving trust law, an irrevocable trust can still quite often be modified, refreshed, or even completely restructured. (41) Methods for modifying an irrevocable trust vary, but all are purported to be justified by the settlor's freedom to dispose of property. (42)

   The more formal methods of modification of irrevocable trusts typically occur in one of three ways. (43) Some trusts are modified through the application of legal guidelines following what has come to be known as the Claflin doctrine, (44) although this doctrine is perhaps more often applied in response to requests by trust beneficiaries to terminate irrevocable trusts before their slated termination events or dates. (45) Equitable deviation, on the other hand, represents perhaps the most common formal approach to modification, and that doctrine has evolved significantly in recent years from its common law version. (46) A third method for modification of irrevocable trusts, and one that is highly flexible and increasingly popular, is the process known as trust decanting. (47) Each of these modification methods arose in the common law context, but each has now been codified in the Uniform Trust Code. (48) Importantly, each is also primarily driven by the concept of freedom of disposition.

   Even these techniques do not exhaust...