Chapter 28 - § 28.5 • TAX CONSEQUENCES OF DECANTING

• Jurisdiction: Colorado

§ 28.5 • TAX CONSEQUENCES OF DECANTING

Any practitioner who is considering decanting a trust should have at least a working familiarity with some of the more significant tax considerations associated with such a strategy. This section discusses some of those considerations. Because Colorado does not have any effective gift, estate,¹⁴ inheritance, or any other transfer tax regime, the discussion focuses exclusively on the federal tax consequences of distributions from one trust to another trust for the benefit of one or more of the same beneficiaries. Unless otherwise indicated, all references are to federal tax authorities, including sections of the federal Internal Revenue Code and the accompanying Treasury Regulations.

In general, despite the increased acceptance of decanting as evidenced by various state statutes and recent jurisprudence, few authorities directly address the tax consequences of decanting. This uncertainty is partially deliberate, as the Service continues to include several decanting-related issues on its no-ruling list. As of this printing, the IRS refuses to rule on:

• Whether the distribution of property by a trustee from an irrevocable trust to another irrevocable trust resulting in a change in beneficial interests is a distribution for which a deduction is allowable under Code § 661 or which requires an amount to be included in the gross income of any person under § 662;
• Whether such a distribution constitutes a gift under Code § 2501; and
• Whether such a distribution may result in the loss of the first trust's generation-skipping transfer tax (GST) exempt status or constitutes a taxable termination or taxable distribution under Code § 2612.

See Rev. Proc. 2022-3, 2022-1 I.R.B. 144.

Given this refusal by the IRS to rule on these issues and the general lack of authorities that are directly on point, planners should exercise caution when considering whether to decant and should seek additional tax advice if necessary.

§ 28.5.1—Income Tax Consequences

There are several potential income tax considerations that a trustee should take into account in making a distribution from one trust to another trust. The specific income tax consequences associated with a decanting transaction depend in significant part upon the characterization of the two trusts for income tax purposes, and specifically whether either trust constitutes a "grantor" trust pursuant to Code §§ 672 through 678. Under these sections, one or more individuals are treated as owning the underlying assets held by a trust and must recognize all items of income associated with such assets on their own return (or returns). A complete discussion of the rules governing grantor trusts is beyond the scope of this summary, but planners should familiarize themselves with such rules before decanting, particularly given the popularity of so-called "intentionally defective" grantor trusts, which are trusts that are purposefully structured such that the settlor (or sometimes a beneficiary) is treated as a deemed owner for income tax purposes. Likewise, planners also should familiarize themselves with the rules governing distributions from trusts that are treated as separate entities under Subchapter J, Chapter 1 of the Internal Revenue Code (Subchapter J), many of which are classified as "complex" trusts.

Transfers Between Two Grantor Trusts with the Same Owner

When it comes to the potential income tax consequences associated with decanting, the most straightforward case involves a transfer between two trusts where the same individual is treated as a deemed owner under the "grantor trust" rules referred to above. While most of the authorities in this area do not involve transfers between trusts, there is support for the view that such a transfer constitutes a "non-event" for income tax purposes and should not give rise to any adverse income tax consequences.

The cornerstone for this view is the famous Revenue Ruling 85-13, 1985-1 C.B. 184,¹⁵ which held that the grantor of a wholly owned grantor trust would be treated as the same taxpayer as the trust — that is, as opposed to simply receiving all items of income, deduction, and credit generated by the assets held in the trust. As a result, transactions between the grantor and a wholly owned grantor trust are disregarded for income tax purposes. By this logic, a distribution from a wholly owned grantor trust to another wholly owned grantor trust with the same deemed owner also should be disregarded insofar as the same individual is deemed to own the underlying assets both before and after the distribution.

A related scenario involves a situation in which the second trust is created by someone other than the individual who created the first trust. In some cases, for example, the trustee of the first trust may serve as the settlor of the second trust (although the Act deems the settlor of the first trust to be the settlor of the second trust; see C.R.S. § 15-16-925). In such cases, there is a question as to the identity of the grantor of the second trust for purposes of the grantor trust rules. Treasury Regulation § 1.671-2(e)(5) provides:

If a trust makes a gratuitous transfer of property to another trust, the grantor of the transferor trust generally will be treated as the grantor of the transferee trust. However, if a person with a general power of appointment over the transferor trust exercises that power in favor of another trust, then such person will be treated as the grantor of the transferee trust, even if the grantor of the transferor trust is treated as the owner of the transferor trust under subpart E of part I, subchapter J, chapter 1 of the Internal Revenue Code.

Stated differently, unless the act of decanting is equivalent to the exercise of a general power of appointment (which is unlikely if an independent trustee makes the decanting decision or if distributions from the first trust are limited to an ascertainable standard¹⁶ ), the same individual should continue to be treated as the grantor of the second trust, regardless of whether another person creates the second trust.¹⁷ If the original grantor has one or more powers or interests under the second trust that would cause such individual to be treated as a deemed owner under the first trust, such individual also should be treated as a deemed owner of the assets held in the second trust going forward. All items of income, losses, and other income tax attributes associated with such assets should continue to pass through to such individual's income tax return as long as such individual is alive and continues to enjoy such powers and/or interests.¹⁸ For this reason, if one is considering decanting from a wholly owned grantor trust, there is a significant advantage to ensuring that the second trust also is a grantor trust that is deemed to be owned by the same individual for income tax purposes.

Transfers Between Trusts Treated as Separate Taxpayers

A more complicated (and uncertain) case involves transfers between two trusts that are treated as separate entities or trusts that are deemed to be owned by different individuals. Such distributions give rise to various additional issues, and there is only limited authority when it comes to the likely income tax consequences.

Under one theory, if all of the assets of the first trust are transferred to the second trust and the provisions of both trusts are substantially similar, it is possible that the IRS may treat the second trust as a "continuation" of the first trust.¹⁹ This is advantageous insofar as the transfer would be disregarded rather than being characterized as a distribution or termination under the rules of Subchapter J. Unfortunately, there is no binding authority in support of such an interpretation and, even if there were, many transfers likely would not qualify, as one of the common goals of decanting is to modify a dispositive provision of the first trust. Consequently, when decanting from one complex trust to another complex trust or when decanting between a complex trust and a grantor trust (or two grantor trusts with different owners), a trustee must consider various additional issues more commonly associated with distributions from trusts and/or terminations.

Distributable Net Income

Under the distributable net income (DNI) rules of Subchapter J, a distribution from a trust may "carry out" income to one or more of the beneficiaries that otherwise would have been recognized by the trust in the absence of such distribution. See I.R.C. § 662. Because decanting may constitute a distribution under state law, there is a question as to whether a distribution from one trust to another trust carries out DNI with the result that the second trust — or the beneficiaries of the second trust — becomes liable for the tax associated with such income. This could be especially relevant if such treatment changes the timing associated with income recognition or precludes the availability of one or more deductions, credits, or other offsets.

Unfortunately, there does not appear to be any clear answer as to whether a distribution from one trust to another trust carries out DNI. While the regulations and case law indicate that a trust can be a beneficiary of another trust for purposes of Subchapter J (see, e.g., Treas. Reg. § 1.643(c)-1), it is presently unclear whether or to what extent such distributions carry out DNI. For this reason, practitioners are well advised to consider a possible scenario in which the second trust or the beneficiaries of the second trust are forced to recognize income that otherwise would have remained with the first trust in the absence of the distribution.

Succession of Tax Attributes

A related issue is whether the second trust "inherits" or "succeeds to" the tax attributes of the first trust. This can be relevant where, for example, the first trust has significant carryovers such as a net operating loss (NOL) from a previous activity. At least in cases...