Expert Q&A on Decanting a Trust

Practical Law Article w-017-9751 (Approx. 8 pages)

Expert Q&A on Decanting a Trust

by Loretta A. Ippolito of Paul, Weiss, Rifkind, Wharton & Garrison LLP with Practical Law Trusts & Estates

What is decanting and why is it used?

Decanting is the act by a trustee of distributing all or a portion of the assets from one irrevocable trust (Distributing Trust) to another newly created or existing irrevocable trust (Receiving Trust) pursuant to an express power in the Distributing Trust instrument, a state statute, or state common law. The rationale behind decanting is that if a trustee has discretion to distribute trust property outright, it follows that the trustee should be able to exercise this discretion in a less extensive manner by distributing the property in further trust.

As of November 2018, 28 states have enacted some form of decanting statute. In addition, some states permit decanting under common law (see, for example, Morse v. Kraft, 992 N.E.2d 1021 (2013)). If a Distributing Trust instrument includes an express decanting power, the power typically will trump any state law provisions. State law merely provides default rules.

Decanting is used to provide flexibility to address changed circumstances unanticipated by the grantor. As a result, depending on the scope of the decanting power in the instrument or under state law, the Receiving Trust may include administrative changes, dispositive changes, or changes to the trust’s tax attributes. While decanting often is used to alter the administrative provisions of a trust, decanting increasingly is being used to modify the substantive provisions of a trust.

Decanting may be used to make administrative changes, including:

Consolidating multiple trusts to improve administrative efficiency.
Dividing trusts that have several beneficiaries to better address each beneficiary’s financial needs or to separate certain tax-exempt assets (such as generation-skipping transfer (GST) tax-exempt assets) from non-exempt assets.
Adding trustee delegation powers or expanding a trustee’s investment powers.
Changing trustee succession provisions and adding or eliminating trustee removal powers.
Changing governing law or trust situs, for example, to take advantage of certain state laws allowing directed trusts or quiet trusts.
Addressing liquidity concerns among a group of trusts. For example, if an irrevocable trust does not have sufficient cash to make a capital call or to meet other obligations, another irrevocable trust may partially decant cash assets to the trust to provide required liquidity.
Changing trustee compensation provisions. However, certain state statutes limit the ability to decant to a Receiving Trust that would change provisions regarding the trustee’s liability or compensation (see, for example, N.Y. EPTL § 10-6.6(n)(2), (q)(1)).

Decanting may be used to change certain dispositive provisions of a trust, including:

Eliminating or postponing mandatory distributions. This may be particularly helpful when it is desirable to extend the term of the trust by eliminating or postponing mandatory distributions, for example, where a Distributing Trust is GST exempt or the Distributing Trust’s assets have appreciated significantly (see the discussion below for more on the decanting of a GST exempt trust). Also, it may be desirable to extend the term of the trust if the beneficiary has creditor issues (such as a divorcing spouse) or suffers from addiction, psychological issues, or other problems that could inhibit the beneficiary’s ability to manage the trust property. However, if a divorce action is pending against a trust beneficiary, a decanting to eliminate mandatory distributions to the beneficiary or the beneficiary’s current withdrawal right may raise fraudulent conveyance issues (but see Ferri v. Powell-Ferri, 476 Mass. 651 (2017)).
Modifying distribution standards. In some states, the ability to modify distribution standards through a decanting depends on the distribution standards included in the Distributing Trust. For example, in New York, the Receiving Trust must contain the same standard of distribution as the Distributing Trust if the trustee was not given unlimited discretion to make distributions in the Distributing Trust (N.Y. EPTL § 10-6.6(c)(1)).
Creating a special needs trust so that the beneficiary with special needs will qualify for public benefits. Decanting also may be used to divide a single discretionary trust for multiple current beneficiaries into separate trusts to qualify one of the resulting trusts as a special needs trust for a beneficiary with special needs.
Granting or modifying powers of appointment.
Adding or eliminating a spendthrift provision.
Eliminating one or more trust beneficiaries. However, even if eliminating trust beneficiaries through a decanting is permissible under state statute, a decanting that eliminates beneficiaries may be interpreted as a violation of the trustee’s duty of impartiality (see, for example, Hodges v. Johnson, 177 A.3d 86 (Dec. 12, 2017)).

Decanting may be used to change certain tax attributes of a trust, including:

Changing from a non-grantor trust to a grantor trust or vice versa.
Meeting qualifications for an S-corporation shareholder.
Moving the trust situs for income tax planning purposes.

For information on the rules relating to grantor trusts, including how to intentionally trigger grantor trust status and potential planning opportunities, see Practice Note, Understanding Grantor Trusts.

In what ways does the ability to decant change planning with irrevocable trusts and what are the tax consequences of decanting?

With respect to the administration of existing irrevocable trusts, the ability to decant has significantly changed planning. Practitioners no longer must rely on time consuming and costly mechanisms such as judicial or nonjudicial settlement agreements or other court action to modify an irrevocable trust. Instead, practitioners use decanting to accomplish desired modifications.

In considering whether to decant, practitioners should determine:

Whether a trustee has authority under a particular decanting power or state decanting law to effectuate the contemplated change.
How to effectuate the decanting in accordance with the decanting power or state decanting law (for example, meeting any notice requirements).
The potential tax consequences of the decanting.

It is important to analyze the tax consequences of decanting because many of the income, gift, estate, and GST tax consequences of decanting are unclear. Though the Internal Revenue Service (IRS) will issue private letter rulings on the tax consequences of a decanting that effectuates administrative changes, the IRS will not issue rulings where a decanting results in a change in beneficial interests (see Rev. Proc. 2018-3). Although the IRS requested comments in 2011 on the tax consequences of decanting, the IRS has not announced any further plans to provide guidance on decanting.

What are the estate and gift tax consequences of a decanting?

In general, with respect to the grantor, there should be no estate tax consequences of a decanting if a grantor’s powers in the Distributing Trust would not have caused inclusion in the grantor’s estate and the grantor’s powers in the Receiving Trust are the same. However, if the grantor’s particular involvement in the decanting demonstrates the grantor’s retained control over the trust property, this could create an issue under Section 2036 or 2038 of the Internal Revenue Code (Code). For example, if the grantor indemnifies the trustee from liability with respect to a decanting, this may demonstrate the grantor’s retained control over the trust and trigger inclusion of the trust assets in the grantor’s estate for estate tax purposes.

There generally should be no estate tax consequences of a decanting for a beneficiary unless the Receiving Trust adds a general power of appointment for the beneficiary under Section 2041 of the Code.

A trustee’s exercise of a power to decant is unlikely to give rise to gift tax consequences in most circumstances. However, gift tax consequences may arise in certain cases, including when a beneficiary has a right to consent to a decanting or can object to and prevent a decanting, or when the trustee exercising the right to decant has a beneficial interest in the trust (if the distribution power is not limited by an ascertainable standard). The safest approach when decanting a trust in a manner that shifts the beneficial interests is for a disinterested trustee to exercise the power to decant.

On the other hand, if the Distributing Trust and the Receiving Trust have identical beneficiaries and dispositive provisions (for example, only administrative changes are made), there is no shift in a beneficial interest, so there should be no gift tax issues (even if the trustee is a beneficiary) (see IRS Priv. Ltr. Rul. 200401009).

For more information on the federal estate tax, including estate planning strategies for eliminating, reducing, or deferring the federal estate tax, see Practice Note, Federal Estate Tax.

For more information on the federal gift tax and the rules for making tax-free gifts, see Practice Note, Federal Gift Tax.

What are the income tax consequences of a decanting?

For income tax purposes, the grantor of the Distributing Trust generally will be treated as the grantor of the Receiving Trust (see Treas. Reg. § 1.671-2(e)(5)). If both the Distributing Trust and Receiving Trust are grantor trusts as to the same person, then there should be no income tax consequences (see Rev. Rul. 85-13).

In general, a decanting will be a nonrecognition event unless the decanting either:

Results in the sale or exchange of property that is materially different for purposes of Section 1001 of the Code and the US Supreme Court’s decision in Cottage Savings Association v. Commissioner (499 U.S. 554 (1991)). A decanting may result in a taxable exchange under Cottage Savings if a beneficiary’s interest in the Receiving Trust is materially different than the beneficiary’s interest in the Distributing Trust.
Involves property with liabilities in excess of basis or partnership interests with negative capital accounts.

A decanting from a grantor trust to a non-grantor trust generally does not result in gain or loss recognition to the grantor. However, if the decanting involves property with liabilities in excess of basis or partnership interests with negative capital accounts, then the grantor may realize the amount of the liabilities of the trust that the grantor no longer is treated as owning and the grantor may recognize gain to the extent the partnership liabilities exceed the basis in the trust’s partnership interest (see Treas. Reg. § 1.1001-2(c) (ex. 5)).

What are the GST tax consequences of a decanting for a GST exempt trust?

Where a Distributing Trust is exempt from GST tax, practitioners should proceed with caution when decanting so as not to jeopardize its GST exempt status.

A trust may be exempt from the GST tax for three reasons:

The trust was created prior to September 25, 1985, the effective date of the GST tax (Category 1 Trust).
An allocation of GST exemption was made to the trust so that the trust has an inclusion ratio of zero (Category 2 Trust).
The trust is completely outside of the US transfer tax system because it was funded by a non-US grantor with non-US situs property (Category 3 Trust).

In 2000, the IRS published regulations (GST Regulations) containing guidance regarding certain modifications to a GST exempt trust, including a decanting, that will not cause a trust to lose its GST exemption (Treas. Reg. §§ 26.2600-1 to 26.7701-2). The GST Regulations expressly apply only to Category 1 Trusts. However, the GST Regulations provide an instructive framework for analyzing any GST exempt trust.

Additionally, the IRS has issued a number of private letter rulings in which it has applied the GST Regulations to Category 2 Trusts (see, for example, IRS Priv. Ltr. Rul. 201709020 (“No guidance has been issued concerning changes that may affect the status of trusts that are exempt from GST tax because sufficient GST exemption was allocated to the trust to result in an inclusion ratio of zero [a Category 2 Trust]. At a minimum, a change that would not affect the GST status of a grandfathered trust [a Category 1 Trust] should similarly not affect the exempt status of such a trust [a Category 2 Trust]”)).

The GST Regulations provide four safe harbors, two of which are relevant to decanting:

The discretionary distribution safe harbor.
The trust modification safe harbor.

The discretionary distribution safe harbor provides that a decanting of a GST exempt trust to a new trust will not taint GST exempt status if both:

First, either:
- the terms of the governing instrument of the GST exempt trust authorize distributions to the new trust without the consent or approval of any beneficiary or court; or
- at the time the exempt trust became irrevocable, state law authorized distributions to the new trust, without the consent or approval of any beneficiary or court.

This requirement is difficult to satisfy because most Category 1 GST exempt Distributing Trusts did not expressly authorize decanting and state decanting statutes were not enacted until the early 1990s (though state common law could provide a basis to satisfy this requirement).

Second, the terms of the new trust do not extend the time for vesting of any beneficial interest in the trust beyond:
- a life in being on creation of the original GST exempt trust plus 21 years; or
- 90 years from the date of the creation of the original GST exempt trust.

This allows the trustee to extend the term of a GST exempt trust (for example, by eliminating mandatory distributions) provided that the new term does not extend beyond this safe harbor.

(See Treas. Reg. § 26.2601-1(b)(4)(i)(A).)

Under the trust modification safe harbor, a decanting that is valid under state law will not taint GST exempt status if both:

The modification does not shift a beneficial interest in the trust to any beneficiary who occupies a lower generation than the person or persons who held the beneficial interest prior to the modification.
The modification does not extend the time for vesting of any beneficial interest in the trust beyond the period provided for in the original trust.

(See Treas. Reg. § 26.2601-1(b)(4)(i)(D)(1).)

With respect to the first requirement, a shift in a beneficial interest to a lower generation beneficiary will occur if “the modification can result in either an increase in the amount of a GST transfer or the creation of a new GST transfer. ... [T]he effect of the instrument on the date of the modification is measured against the effect of the instrument in existence immediately before the modification.” (Treas. Reg. § 26.2601-1(b)(4)(i)(D)(2).)

For example, where an irrevocable trust was modified by court order with the consent of two of the current income beneficiaries to increase the share of income passing to the third current income beneficiary (who had special needs) and all three current income beneficiaries were the grantor��s grandchildren, there was no modification that shifted a beneficiary interest to a lower generation beneficiary. This is because the modification did not increase the amount of the GST transfer under the original trust or create the possibility that new GST transfers not contemplated in the original trust may be made. (See Treas. Reg. § 26.2601-1(b)(4)(i)(E)(ex. 7).)

The GST Regulations further clarify that an administrative change that indirectly increases the amount transferred to a beneficiary (such as by lowering administrative costs) does not constitute a shift in beneficial interests (see Treas. Reg. § 26.2601-1(b)(4)(i)(D)(2)).

Practitioners should be careful when a decanting effectuates a change of situs from a state that has the traditional common law rule against perpetuities to a state that has abolished the rule against perpetuities so as not to inadvertently run afoul of these safe harbors by impermissibly extending the time for vesting (see Treas. Reg. § 26.2601-1(b)(4)(i)(E)(ex. 4)).

For more information on the GST tax, including a discussion of ways to make transfers free of the GST tax, see Practice Note, Federal Generation-Skipping Transfer Tax.

What are the advantages and disadvantages of including a decanting provision in a trust agreement?

In general, it is advisable to include a decanting provision in a trust agreement rather than relying on state law. Nevertheless, there is tension between providing enough flexibility in a decanting provision to deal with future changed circumstances and, at the same time, safeguarding the grantor’s intent.

It is important that a decanting provision reflect the grantor’s view regarding the scope and use of the decanting power. Including specific language regarding the grantor’s intent mitigates the risk that a broadly drafted decanting provision could be used to make changes that are inconsistent with the grantor’s intent. For example, a broad decanting provision may unintentionally allow a trustee to modify mandatory principal distributions or exclude a beneficiary from a trust in a manner inconsistent with the grantor’s wishes. On the other hand, a decanting provision that is too narrow may prohibit a trustee from effectuating the grantor’s intent. This can happen, for example, if there are changed circumstances after the trust is created, such as a beneficiary with a substance abuse problem, and the trustee is not permitted to decant to extend the term of the trust.

If an irrevocable trust does not contain a decanting power and the applicable state law does not otherwise provide for decanting, a trustee may consider changing the law governing trust administration to a jurisdiction with a statutory power to decant (rather than relying on the alternative modification mechanisms).

Although state decanting statutes often include limitations on decanting to ensure that the grantor’s intent is safeguarded (see, for example, N.Y. EPTL § 10-6.6(b)), decanting under state law can also present challenges. State law may restrict the types of permissible decantings in a way that is contrary to the intent of the grantor. Further, many state statutes require that notice be provided to the trust beneficiaries, which can be time consuming, costly, and cause friction among the beneficiaries (see N.Y. EPTL § 10-6.6(j)). Finally, the state decanting statute or common law may change over time, so it may not be advisable to rely on state law.

What are the primary liability concerns for a trustee that decides to decant and can this liability be limited?

When exercising a power to decant a trust, a trustee is subject to fiduciary duties. A trustee may be concerned that a beneficiary will assert that the trustee has breached his or her fiduciary duty by carrying out the decanting because the Receiving Trust may contain less favorable substantive or administrative provisions with respect to the beneficiary.

To protect a trustee from liability, a trustee may seek consent or a release and indemnification from the beneficiaries of the Distributing Trust. However, this may give rise to adverse gift tax consequences. Where the Distributing Trust instrument or state law authorizes a decanting without beneficiary consent, but permits a beneficiary to consent or release the trustee from liability, it is unlikely that this consent or release would constitute a taxable gift by the beneficiary. However, the more cautious approach from a gift tax perspective would be to have a beneficiary consent or release the trustee only where the decanting involves purely administrative changes.

It is not advisable to have a grantor release or indemnify the trustee. As noted above, this conduct raises concerns about implied control and inclusion in the grantor’s estate under Sections 2036 and 2038 of the Code. An acknowledgement by the grantor that the decanting is consistent with the grantor’s intent and the purposes of the trust should not trigger such adverse tax consequences and may give the trustee more comfort regarding its decanting decision.

Further, a trustee could require a receipt and refunding agreement with the trustees of the Receiving Trust to provide some protection in the event of future liability with respect to the decanting.

Seeking court approval at the trustee’s election is another option that would provide the trustee with protection against potential claims. This protection should be weighed against the financial costs and time delay associated with obtaining court approval.

The author would like to thank Beth Kerwin, an associate at Paul, Weiss, Rifkind, Wharton & Garrison LLP, for her assistance in preparing these responses.

Expert Q&A on Decanting a Trust | Practical Law