Editor: Mindy Tyson Weber, CPA, M.Tax.
Estates, Trusts & Gifts
By analogy to decanting a bottle of wine or spirits, decanting a trust involves a metaphorical pouring of trust assets from one trust into another. The receiving trust is an updated and improved trust that continues to express the grantor’s intent. Applying the analogy, this item addresses the mechanics of decanting and provides guidance on how not to spill or otherwise compromise the trust assets.
Estate planning advisers have spent considerable time elevating decanting from a potential strategy for clients seeking to fix a broken trust to a routine solution for trusts that have grown problematic due to changed circumstances. Through these efforts, much has been gleaned regarding the boundaries and requirements of state decanting statutes, as well as the protocols required for best practices.
Even after seeking and receiving comments on decanting from national legal and tax groups, the IRS omitted decanting from its 2013–2014 Priority Guidance Plan, thus indicating that it would not issue a revenue ruling on the tax aspects of decanting this year. Advisers are left to sift through private letter rulings and regulations on trust mergers, modifications, and severances to gauge the likely tax impacts of decanting. The most popular uses of decanting appear to be postponing or eliminating withdrawal rights; modifying or inserting powers of appointment; altering successor trustee provisions; creating a special needs trust; resolving drafting ambiguities; and changing trust situs to avoid state income taxes.
Decanting statutes have proliferated over the past three years. Largely as a result of the efforts of state bar groups, who sought options for updating trusts short of clogging courts with amicable petitions to fix broken trusts, 21 states now have decanting statutes. These states codified and expanded upon what many believed already existed at common law. The right to decant was first outlined by the Florida Supreme Court in Phipps v. Palm Beach Trust Co., 142 Fla. 782 (1940). The court ruled it was within the trustee’s discretion to invade trust principal and pay it over to another trust established for the benefit of the original trust beneficiary.
While the details vary greatly among the states with decanting statutes, the basic premise is the same. A trustee’s discretion to make distributions includes the lesser power to move the trust assets to a second trust. Some states, such as Florida and Indiana, require that the trustee have full discretion in order to decant. Other states, such as South Dakota, Nevada, and Delaware, allow decanting where the trustee has the discretion to make distributions based on a reasonably definitive standard. Still other state statutes, especially a few of the 2013 statutes, in effect combine these approaches and require absolute discretion for certain trust changes, but not for others. Illinois, Michigan, Ohio, Texas, and Virginia fall into this latter category. In some statutes, such as those in place in New York and Delaware, the power to invade the first trust and decant to a second trust is described as the exercise of a limited power of appointment.
Most statutes expressly prohibit the modification or elimination of an income interest. Though most statutes preclude a trustee from using decanting to add new beneficiaries, many statutes indirectly permit the addition of beneficiaries by allowing the second trust to include a limited power of appointment that theoretically could be used by the power holder to expand the class of beneficiaries. For example, Illinois (760 Ill. Comp. Stat. 5/16.4), North Carolina (N.C. Gen. Stat. §36C-8-816.1), Nevada (Nev. Rev. Stat. §163.556), and New York (N.Y. Est. Powers & Trusts Law §10-6.6) have such statutes. Extending the trust beyond the original trust term is often prohibited, and advisers should be wary of triggering Sec. 2514(d) (“the Delaware tax trap”) by unintentionally lengthening the trust term. In addition, most statutes direct the trustee to consider the intent of the settlor when deciding whether to decant or state positively that the new trust must carry forth the grantor’s purpose. As practitioners decant more and more trusts, consensus is building on the basic concepts.
Providing Notice and Memorializing the Changes
Practitioners have developed forms intended to provide notice to beneficiaries and accomplish several goals:
- The notice acts as the “written instrument” that memorializes the decanting. It should be signed and acknowledged by the trustee and placed with trust records. It is important to remember that the decanting is undertaken by the trustee and is the exercise of a fiduciary power. In Massachusetts, a state without a decanting statute, the Supreme Judicial Court considered a proposed decanting in Morse v. Kraft, 466 Mass. 92 (2013), and ruled that where the trustees were directed to act for the benefit of the trust beneficiaries, the trustees had the authority to distribute in further trust, without the need for beneficiary consent or court approval.
- The optimal notice ties the altered trust provisions into the boundaries created by the applicable decanting statute. For example, where a contingent withdrawal right is eliminated and replaced by distributions by a beneficiary-trustee subject to a support standard, the notice should invoke the sections of the statutes explicating the permissible changes to a beneficial interest.
- The ideal written instrument demonstrates that the new trust is consistent with the goals set forth by the grantor. The Morse case, as well as decanting lore, instructs advisers that the changes wrought by decanting must be consistent with the terms and purposes of the original trust. Grantors usually want to benefit their descendants but at the lowest possible tax cost. For instance, consider a typical family trust that has a “spray” provision (one that requires the trustee to distribute the property among a group of beneficiaries, but with discretion as to how much and to whom to distribute it), with preference given to the surviving spouse during her lifetime. The children are given general powers of appointment over their pro rata trust shares, but only upon the death of their mother. The property subject to the complete withdrawal right would be included in the estate of each of the children under Sec. 2041 when triggered. As initially drafted, that may not have been problematic, but perhaps one power holder is now age 60 and already has a taxable estate, or the beneficiary’s current circumstances have made a special needs trust desirable. Cutting back the general power of appointment to a limited power of appointment continues to satisfy the grantor’s desire to benefit his descendants but does not subject the child’s share to estate tax upon his or her subsequent death. It should be noted that the release of a general power of appointment would have tax consequences, but since the general power of appointment is contingent upon the power holder’s surviving his or her mother and the trustee’s not distributing the assets to another beneficiary, it arguably would not be the release of a general power of appointment under Sec. 2514(e) (this issue is addressed more fully below). Of course, the trustee may decide to make a late allocation of the exemption from generation-skipping transfer tax (GSTT).
- The notice should provide the beneficiaries with an outline of the provisions of the second trust. This is recommended even if the statute does not require it. As reinforced by the Morse case, decanting is the exercise of a fiduciary power. As such, decanting a trust must be undertaken in good faith and must comply with the trustee’s duties of loyalty and impartiality. The impact of the decanting on all beneficiaries must be fully considered and explained.
- The notice is important for establishing the time frame for the decanting, as several statutes require a notice period. If the decanting is tied to a specific tax election that must be made in a calendar year, the delivery of the notice will start the timer running on the effective date of the decanting. Beneficiary consent is not required by any of the statutes, although, under the Illinois statute, a beneficiary can ask a court to review a decanting. Some statutes that require notice allow for a waiver of the notice period.
Income Tax Planning
Legal and accounting experts have provided extensive public comments in response to Notice 2011-101, which requested comments on the estate, gift, income, and GST tax consequences of decanting. These comments and the rulings and Code sections underpinning them have built a foundation for advisers and attorneys to use to structure decantments.
Sec. 661 allows a trust in calculating its taxable income to deduct the value of distributions made to beneficiaries. The beneficiaries then pick up the income on their individual returns under Sec. 662. Given the notion that a decantment is essentially an exercise of the trustee’s distributive authority, where Trust A distributes less than all of its assets to Trust B, it seems appropriate to treat the distribution under the principles of Secs. 661 and 662.
However, where Trust A distributes all of its assets to Trust B, it is preferable to treat the second trust as an entirely new trust. This requires filing a final return for Trust A and obtaining a new tax identification number for Trust B. This has several advantages. Upon the filing of the final returns, the IRS and state revenue department are on notice regarding the decantment and the termination of Trust A. In this respect, silence would be golden, and the passing of three years would be evidence that the decantment was a nonevent for income tax purposes. This closure is vital for beneficiaries as well as fiduciaries.
The remaining issues surrounding the income tax consequences of decantment of all of a trust’s assets fall into three categories: (1) whether the termination of Trust A and distribution of appreciated assets from Trust A to Trust B cause gain to be recognized on the value of appreciated assets under Secs. 643 and 1001; (2) whether other tax attributes, such as net operating loss carryovers, are transferred with the trust assets upon a decantment; and (3) whether migrating trusts can avoid state income taxes by changing the situs of a trust.
Sec. 643(e) generally protects the distributing trust from gain recognition unless the trustee of the distributing trust elects to recognize gain under Sec. 643(e)(3). Several private letter rulings buttress this approach, including Letter Rulings 200607015 and 200736002.
In Letter Ruling 200607015, the IRS found that where state law permitted a trustee to exercise a limited power of appointment and distribute trust principal to separate trusts, the new trusts should be treated as a continuation of the original trust. One exception to this general rule is where the trustee distributes a negative-basis asset from Trust A to Trust B. In Crane, 331 U.S. 1 (1947), the U.S. Supreme Court ruled that the amount realized includes recourse and nonrecourse debt that is discharged. Thus, if the IRS takes the position that Trust A and Trust B are different taxpayers for income tax purposes, the Crane doctrine could cause Trust A to recognize gain. There are no clear answers as to whether Sec. 643(e) would override the result in Crane or whether a trust realizes gain by distributing a negative-basis asset to a beneficiary. A similar question is raised where Trust A holds a partnership interest with a negative capital account under Sec. 752(d), which requires a partner to recognize gain in the amount of a reduction in partnership liabilities.
The next question is whether the receiving trust or another beneficiary recognizes gain under Sec. 1001. Rulings such as Letter Ruling 200736002 and, especially, Letter Ruling 200231011 give advisers pause when answering this question. Letter Ruling 200231011 relied on the U.S. Supreme Court’s ruling in Cottage Savings Ass’n, 499 U.S. 554 (1991), and ruled that where an annuitant received a unitrust interest, as opposed to the annuity stream specified in the trust, taxable income was generated, since the two interests were “materially different.” Letter Ruling 200736002 also discussed the idea that a shift in the beneficial interest held by a trust beneficiary could trigger the Cottage Savings doctrine.
Where a beneficiary is given a limited power of appointment in Trust B that did not exist in Trust A or where a beneficiary implicitly consents to the release of a future general power of appointment, Cottage Savings could be implicated. Two counterpoints could be deployed against this reasoning. First, ample authority exists for the premise that decanting is merely a continuation of the original trust and, therefore, Trust B should succeed to the tax attributes of Trust A. The IRS reached this conclusion in Letter Ruling 200607015, and this position is also sanctioned by Regs. Sec. 1.671-2(c).
Sec. 642(h) provides additional insight into the resolution of this issue. In Letter Ruling 200607015, which addressed a situation where all of the trust assets were decanted to a series of second trusts that had the same dispositive provisions as the first trust, the IRS ruled the second trusts should succeed to the first trust’s tax attributes. Specifically, the letter ruling provides for tacking on the holding periods of the trust assets.
No case law explicitly provides that decanting can be used to successfully change the situs of a trust, although several of the state statutes invite such a move by allowing the statutes to be used by trustees seeking to move their trusts into a particular jurisdiction. The Delaware Supreme Court ruled recently in Peierls Family Inter Vivos Trusts, 77 A.3d 249 (Del. 2013), that trusts impliedly allowed for a change of situs by providing for a change in trustees. The court’s reasoning equally applies to a trustee’s using the Delaware decanting statute to move the situs of a trust. In addition, Letter Ruling 200607015 ruled favorably on a trust decanting undertaken in part to move trusts from one state to another.
As discussed above, where a decanting moves all of the trust assets from Trust A to Trust B, the trustee should file a final fiduciary income tax return for Trust A and obtain a new taxpayer identification number for Trust B. This way, Trust B will be treated as a separate taxpayer. In case a state taxing authority contests the migration of a trust, it may be beneficial to postpone any significant sales or exchanges during the year of decantment to minimize the amount of accumulated gains allocable to that final year in the state. An Illinois trustee used a similar strategy prior to the effective date of the Illinois decanting statute in Linn v. Department of Revenue, No. 4-12-1055 (Ill. App. Ct. 12/18/13).
Gift Tax Issues: Reporting a Nongift
As a general proposition under Internal Revenue Code Chapter 12 (gift tax), the decanting of a trust by a nonbeneficiary trustee exercising his or her discretion is not a gift. The exception to this rule centers on the release of a general power of appointment that is currently exercisable by the beneficiary. This exception is in Sec. 2514(b). It is important to remember that a presently exercisable withdrawal right is equivalent to a general power of appointment. For example, assume a beneficiary has a right to withdraw from his trust share, which is contingent upon his surviving his mother and reaching age 40. If he has met both conditions and then the trustee decants to a new trust that replaces his withdrawal right with a limited power of appointment exercisable in favor of his descendants, Sec. 2514(b) is triggered.
The more nuanced question is raised where the beneficiary is age 34 and his mother is still living when the trustee decants the trust. Is this an indirect gift by the beneficiary to his descendants? If it is a gift, how should the “gift” be valued? The taxpayer could contend that he holds a mere expectancy; his possessory interest is contingent upon living to age 40 and surviving his mother. The regulations offer contradictory conclusions. Regs. Sec. 25.2511-1(h)(6) provides that if A holds “a vested remainder interest in property, subject to being divested only in the event he should fail to survive one or more individuals or the happening of some other event, an irrevocable assignment of all or any part of his interest would result in a transfer includible for Federal gift tax purposes.”
While the sentiment applies to this item’s example, there are two important distinctions. First, the trustee—not the holder of the vested remainder interest subject to divestiture—is effectuating the alleged transfer. Furthermore, there is no irrevocable assignment, in the sense that the beneficiary will presumably still have the right to receive income or principal from his trust share during his lifetime, and the ultimate beneficiary of the property is unknown at the time of the decanting. The incomplete nature of the transfer arguably removes the transfer from the realm of a gift and places it within the exception in Regs. Sec. 25.2514-3(c). That regulation carves out an exception for a lapse or a release of a general power of appointment where the power holder may still appoint among a limited class of persons, not including himself or herself.
Technical Advice Memorandum 9419007 provides a cautionary tale on how the IRS may rule where a trustee uses decanting essentially to permit a beneficiary to sit on a contingent remainder interest throughout her life (pending her mother’s death) and then, as part of her estate planning, convince the trustee to limit her rights to her trust share to a limited power of appointment once she feels that she no longer needs the trust share to provide her with support during her lifetime. It is this type of wait-and-see planning that doomed the taxpayer in the U.S. Supreme Court case Jewett, 455 U.S. 305 (1982). In Jewett, a divided Court held that the taxpayer’s 33-year delay in exercising a disclaimer, which was valid under state law, was a gift for federal tax purposes.
For the above-outlined reasons, to the extent a decantment limits powers of appointment or withdrawal rights, the trustee should tether the decantment to the applicable state law and file a Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return, reporting the nongift. Even if the IRS ultimately adopts the position that such a decantment is a gift, the valuation of the gift under Sec. 2512 is complicated. In the example above, there would be two mortality calculations: (1) the value of the life estate held by the beneficiary’s mother and (2) the risk that the beneficiary would die before his withdrawal power became possessory. One possible further resolution of these issues involves deploying ascertainable standards and using the exception in Regs. Sec. 20.2041-1(b)(2).
To the extent a decantment involves a straightforward release of a presently exercisable power of appointment, the trustee should file a Form 709 and make a late allocation of GSTT exemption. Without that general power of appointment causing the beneficiary’s trust share to be included in her estate, the trust is now a GST trust. To exclude further appreciation from requiring additional GSTT exemption, it usually makes sense for the trustee to make a late allocation. The guidance on safeguarding GST-exempt status is well-established under Regs. Secs. 26.2601-1(a) and (b) and Regs. Sec. 26.2642-6.
More and more estate planning advisers are using decanting to deal with changes in circumstances and tax laws not anticipated by the drafters of the original trust agreements. Despite the case law, private letter rulings, and regulations offering guidance on the income, gift, and GST tax consequences of the most common uses of decanting, unanswered questions persist. Without formal rulings from the IRS, it remains unclear how the IRS will evaluate decantings that alter the beneficial interests created under the original trust.
Mindy Tyson Weber is a senior director, Washington National Tax, for McGladrey LLP.
For additional information about these items, contact Ms. Weber at 404-373-9605 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with McGladrey LLP.