Decanting a Trust: How to Aerate Your Assets
Trust decanting offers a way to alter the terms of an irrevocable trust to better suit the interests of the settlor or beneficiaries.
Much like your favorite aged Bordeaux, your trust, sealed up by its irrevocable terms, may contain unwanted or outdated terms, provisions or other impurities that prevent it from functioning as desired. By decanting, or pouring assets from one trust into another, a trustee may be able to cure these deficiencies.
Basis for Decanting
When looking to decant trust assets, it is generally because there is something that needs to be changed in the terms of the trust. Historically, changing an irrevocable trust typically required some form of judicial modification. Not surprisingly, judicial modification was usually undesirable due to the cost, time and other legal barriers associated with court involvement. As the law and the trust documents themselves evolved, to a limited extent, changing document provisions became less cumbersome. However, even with the easing of restrictions on modifying trusts, the determination of whether trust provisions could be changed often hinged on the level of trustee discretion to invade principal or income for beneficiaries. Unless a trustee had unlimited power to determine income and principal distributions, they were limited in what modifications could be made, if any.
To allow for flexibility, many states have enacted or modernized existing decanting statutes to allow for trust modification. To date, twenty-five states have some form of decanting statute. However, while these laws provide a means and guidance to making modifications, there are still several gray areas as to the impact of decanting, particular with respect to taxes.
Potential Uses for Decanting
The use of decanting is highly dependent on the laws under which a trust is governed. While it is beyond the scope of this article to review each state’s decanting statute and which powers they may or may not grant, the following is a list of potential changes that can typically be made through decanting:
- Administrative change
- Protecting tax treatment of a trust
- Granting or changing powers of appointment
- Changing of trusteeship
- Dividing or consolidating trusts
- Correcting any error or ambiguity within the trust terms
- Adjusting withdrawal rights
- Adjusting distribution standards
- Adjusting the trust term
- Adding or eliminating a beneficiary
- Converting a trust’s status to grantor or non-grantor
- Changing a trust’s situs
- Adding or removing a spendthrift provision
As this list indicates, the changes that can be made run the gamut of trust reform. In addition to the types of modifications that can be made, state statutes can also differ as to who must consent to such changes. For example, some states place the power to decant solely in the hands of the trustees, while others may require beneficiary consent depending on the changes being made. Along with these considerations, trustees must also be cognizant of possible tax implications of decanting, which unfortunately, may be difficult to anticipate.
In most instances, it is believed that decanting is not a taxable event either for income tax or estate, gift and generations skipping tax purposes. However, because many of the tax issues with respect to decanting are unsettled, care must be taken when looking to decant a trust even if operating under the provisions of state statutes.
For income tax purposes, IRS has ruled that in general a decanting is not a recognition event with respect to capital gains. However, in certain circumstance a decanting could trigger gain. For example, if a trust with liabilities in excess of trust asset basis is decanted to convert from a grantor to a non-grantor trust, that decanting would likely trigger a gain.
In addition to gain issues, it remains an open question as to whether a decanting would be considered a distribution for fiduciary income tax purposes. If it is a distribution, a decanting from one trust to another would carry net taxable income from the old trust to the new trust. As a practical matter, whether the old or new trust is taxed on trust income may not make a difference. However, a distribution from a trust can impact trust tax attributes (passive activity loss carryovers, capital loss carryovers, investment interest expense carryovers, etc.), which could cause adverse tax results. The argument as to whether a decanting is a distribution could also turn on whether a trust is fully or partially decanted, which can lead to inconsistent tax results.
From a transfer tax standpoint there are also many unanswered questions. For example, if a trust is decanted to reduce or eliminate a beneficiary’s interest in that trust and applicable state law requires that beneficiary’s consent, is that consent a gift to the other beneficiaries? For generation-skipping transfer tax (GST) purposes, if a trust is GST exempt and is then decanted to extend the trust term or make that trust perpetual, could a gift be triggered, or could that trust lose its GST exemption?
In 2011, IRS issued Notice 2011-101 asking for comments on the potential federal tax consequences of decanting. The specific areas IRS sought to review include: shifts in beneficiary interests, rights, powers, and their ability or inability to consent, the conversion of a trust to grantor or non-grantor status, the change in trust situs, GST issues and the various effects of state law. In short, IRS has been reviewing everything about decanting. To date, IRS has not released additional guidance with respect to this Notice and it is possible they will hold off making further rulings until legislation has been enacted by the majority of states. Although there does exist a uniform trust statute, it has yet to receive wide support among state legislatures. As a result, many of the tax ramifications of decanting remain up for debate, and may continue to be for some time.
In adding flexibility, decanting statutes are generally seen as a welcome development for trustees trying to implement a settlor’s intent in the face of legal, economic or family changes. A trust flawless in its design when created may end up outdated or even potentially harmful with the passage of time. In allowing for simplified and efficient trust modification, these statutes provide a tool to correct for these issues. However, when taking advantage of this tool, trustees and their advisors must consider the ramifications of decanting, including possible hidden tax traps, particularly when the tax law with respect to decanting remains very much unsettled.