New decanting statutes offer road map for escaping fiduciary tax and updating trust terms.

AuthorWeber, Mindy Tyson

Virginia, Rhode Island, Kentucky, Michigan, and Illinois enacted decanting statutes last year to offer enhanced flexibility for trust administration in their jurisdictions. These states joined at least 14 other states that explicitly by statute or under case law authorize decanting. As these types of statutes proliferate, federal and state taxing authorities must wrestle with the income, estate, and gift tax issues raised by decanting.

Decanting statutes allow trustees to "pour" assets from an existing trust into a new (or existing) trust with different terms and conditions. The ability to modify an irrevocable trust through decanting is a profoundly useful and coveted tool, not only for dealing with problematic, antiquated trust agreements, but also for changing the situs of trusts. As with other legislation in the estates and trusts area, the statutes vary considerably from state to state. Some statutes, such as those in Indiana and Florida, permit decanting only where the trustee has unfettered discretion to make distributions of principal to beneficiaries (Ind. Code [section]304-3-36; Fla. Stat. [section]736.04117). Other, more liberal, statutes permit trustees to make substantive changes even if they have more limited powers.

Virtually all of the statutes require notice to beneficiaries and, at a minimum, their tacit approval. Decanting does not take place in a vacuum and is usually undertaken at the beneficiaries' behest. Fiduciary duties of impartiality and loyalty overlay the decanting process and constrain the trustee's conduct. To protect against estate tax inclusion, several statutes prohibit decanting when the trustee is also a beneficiary.

Background and Basics of Decanting

To appreciate the potential benefits and consequences of decanting, it is important to understand the background of the concept. Several states recognize a common law right to decant. Some commentators have analogized decanting to the trustee's exercise of a special power of appointment (see, e.g., Blattmachr, Horn, and Zeydel, "An Analysis of the Tax Effects of Decanting," 47 Real Prop., Trust and Est. Lau, J. 141 (Spring 2012)). In effect, the power to make distributions in further trust is subsumed by the power to distribute trust principal.

Trust provisions frequently targeted for modernization through decanting include adding or changing beneficiaries, granting limited powers of appointment, accelerating or postponing distributions, changing trust situs, and extending the terms of trusts or terminating old trusts. Some attorneys decant trusts to add or change investment advisers, alter a successor trustee sequence, or remove or appoint a corporate trustee. Very few decanting statutes deal explicitly with taxation. The new Illinois statute, however, permits using the decanting statute to turn a nongrantor trust into a grantor trust, and vice versa (760 III. Comp. Stat 5/16.4).

To avoid any unintended consequences, the implications of decanting a trust must be thoroughly analyzed before any changes are made. The general rule of thumb should be "first, do no harm." Old trusts can have advantageous tax treatment that should not be disturbed, such as trusts established before Oct. 22, 1986, that are grandfathered from generation-skipping transfer (GST) tax or otherwise GST-tax exempt (Regs. Sec. 26.2601-1). Other trusts that were created using marital or charitable deductions should be examined, since the tax deferment or favorable treatment could be lost if the terms of the trust agreements are altered without due consideration. In addition, care must be taken to ensure the decanting does not trigger an unintended gift through a lapse or release of a general power of appointment or diminishment of a beneficial interest.

Significant Planning Opportunity

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