Decanting can be a great way to add flexibility to irrevocable trusts. Beyond correcting scrivener’s errors, resolving ambiguities, or clarifying trust language, decanting allows trustees to change some provisions of an irrevocable trust by pouring the assets into a new trust with modified terms.
Decanting can be used to make administrative changes like a change of trust situs, changes to the number and powers of trustees, or to consolidate trusts, to list a few. Decanting also can be used to make certain changes to how the trust assets are distributed, like enhanced spendthrift provisions, enhanced asset protection, or to qualify a special needs beneficiary for needs-based benefits, among other dispositive changes.
As long as the trustee proceeds with care, trust decanting can be a powerful tool. Consider these do’s and don’ts when deciding whether to decant an irrevocable trust.
Consider the trustee’s authority to decant
Before decanting, first determine the source of the trustee’s decanting authority. Decanting may be authorized by the express terms of the trust instrument, by common law, or by state statute.
As of October 2019, 29 states have enacted decanting statutes, with differing attributes. For example, some state statutes authorize decanting in a restatement of the original trust, eliminating the tedious task of re-titling assets to the new trust. Decanting by restatement is a preferred method for most practitioners. If the original trust is sitused in a state that does not allow decanting via a restatement, then the practitioner could consider changing situs to a friendlier state.
Protect the trustee
Trust decanting must comply with fiduciary principles. Because a trustee is subject to the fiduciary obligations of reasonableness and good faith when exercising a special power to appoint assets from the “old” to the “new” trust, the power should not be exercised arbitrarily. The trustee could be exposed to, or may be concerned about, liability to beneficiaries due to the decanting action. To protect the trustee, some practitioners obtain consents or releases from the trust beneficiaries. Others believe that beneficiary consent could give rise to a gift tax consequence if consent is deemed as a beneficiary right to control the property.
Avoid tax pitfalls
The IRS has issued little guidance for tax issues arising from trust decanting, but there are tax pitfalls to avoid, including the following:
- Take care not to create a gift. There are generally no gift tax issues to a trust beneficiary when the trust decanting does not change the beneficiary’s original trust interest. But, if a beneficiary causes, or permits, their interest in the trust to pass to a different beneficiary, or if a beneficiary releases a general power of appointment, a gift tax consequence will likely arise.
- Caution when the trustee is also a beneficiary. If the decanting trustee is also a beneficiary, do not change the ascertainable standards or restrict distributions. Some state statutes qualify the trustee’s special power of appointment in this respect, requiring the ascertainable standards to be the same or more restrictive if the trustee exercising the power to appoint trust property is a possible beneficiary under the standard.
- Steer clear of getting the trustmaker involved in the decanting. There are no estate tax issues for the trustmaker if the trustmaker’s rights and interests in the trust principal are not changed by decanting. Problems arise, however, when the trustmaker’s involvement, or even consent, in the decanting is deemed as a right to control property under IRC §2036 or §2038, causing inclusion of the property in the trustmaker’s estate. The risk of inclusion also exists if the new trust grants the trustmaker a power not present under the original trust.
To learn more about trust decanting, including planning opportunities by attending WealthCounsel's next Thought Leader Series webinar, “2022 Trust Decanting Update” on May 26, 2022.
Don’t grant new general powers of appointment
There are no estate tax issues for the settlor of an irrevocable trust where the settlor’s rights and interests in the trust principal are not changed via the decanting. However, estate tax issues can arise when the decanted trust grants the settlor a power not present under the original trust. As to trust beneficiaries, estate tax inclusion can arise where:
- the decanted trust grants a beneficiary a general power of appointment not provided in the original trust, causing inclusion in the beneficiary’s estate under IRC §2041;
- the property included in the beneficiary’s estate is treated as a gift by the beneficiary as a result of the decanting;
- the power to decant is itself deemed a general power of appointment under IRC §2041; or
- the decanting causes an incomplete gift to become complete on the beneficiary’s death.
Don’t add new beneficiaries
Trustees do not have the discretion to distribute trust property to non-beneficiaries. So, decanting should not attempt to add beneficiaries who were not contemplated in the original trust instrument. If decanting intends and has the authority to add new beneficiaries, only a non-beneficiary trustee may exercise its decanting powers. If the trustee is also a beneficiary, consider whether the trust protector can remove the beneficiary as trustee or appoint a special trustee to perform the decanting. To avoid creating a taxable gift event, consider granting a special power of appointment over trust property in the decanted trust to the beneficiary of the original trust.
Don’t modify a grandfathered trust
GST tax applies to transfers made after October 22, 1986, and thus some trusts enjoy a “grandfather” status. If a grandfathered trust is decanted and assets are directly or indirectly added, then the grandfathered status is lost, exposing the trust to GST tax. While exercising a special power of appointment is not considered adding assets to the trust, different rules apply when there is a distribution from, or a modification to, a grandfathered trust. In these situations, the IRS does not treat decanting as exercising a special power of appointment for GST tax purposes. Therefore, where there is a change in beneficial interest, decanting arising from the trustee’s powers to distribute trust property or to modify the original trust could be considered “adding assets to the trust”—even if done under the special power of appointment.
As long as the trustee is careful to follow proper mechanics, avoid tax pitfalls, and observe the trustee’s fiduciary duties, decanting offers a bevy of planning opportunities by modernizing trust provisions and furthering the settlor’s original intent. To learn more about trust decanting, including planning opportunities, and how to decant a trust in order to save federal and/or state income taxes by attending WealthCounsel's free webinar, “2022 Trust Decanting Update” on May 26th.