Tax Planning Using California's Decanting Statute

• Publication year: 2019
• Author: By Andrew M. Katzenstein*

TAX PLANNING USING CALIFORNIA'S DECANTING STATUTE

By Andrew M. Katzenstein*

MCLE Article

I. INTRODUCTION

California's decanting statute took effect on January 1, 2019. The decanting rules are found in Probate Code section 19501 et seq.

Many practitioners are uncertain how the decanting rules can be used to benefit clients with California trusts. One way that decanting can be of benefit is to help save taxes. The focus of this article is to identify a number of situations in which a decanting exercise under the new law can be used to save income, estate, gift, and/or generation-skipping transfer tax.

Decanting rules in other states have been used successfully to accomplish some of these tax saving strategies. The use of California's decanting rules to accomplish these strategies is untested because the rules are new. Nevertheless, as described below, it seems likely that California's decanting rules can be effectively used to accomplish tax savings.

This article is not intended to review in its entirety how the decanting statute works.¹ Rather, this article will discuss how the decanting statute can be used to maximize tax savings. However, set forth below is a short summary of some of the key provisions of the decanting statute that the practitioner must be aware of when considering how to use decanting to achieve those savings.

II. RULES TO BE AWARE OF WHEN USING CALIFORNIA'S DECANTING STATUTE TO MAXIMIZE TAX SAVINGS

The decanting rules allow trusts that have California as their principal place of administration—including trusts whose principal place of administration has been changed to California,² or where the trust instrument³ provides that it is governed by the laws of California, or which are actually governed by California law for purposes of administration, construction, or determining the meaning or effect of the terms of the trust⁴—to be decanted under California law.

The person with the power to decant is the "authorized fiduciary"—generally a trustee or fiduciary with discretion to distribute or direct a trustee to distribute part or all of the principal of the first trust⁵ to one or more current beneficiaries.⁶

California requires that the authorized fiduciary send notice to the beneficiaries 60 days prior to the exercise of the power to decant. Notice is required to be given to the following: (i) each settlor of the first trust then living,⁷ (ii) each qualified beneficiary⁸ of the first trust,⁹ (iii) each holder of a presently exercisable power of appointment¹⁰ over any part or all of the first trust,¹¹ (iv) each person who currently has the right to remove or replace the authorized fiduciary,¹² (v) each other fiduciary of the first trust,¹³ (vi) each fiduciary of the second trust,¹⁴ and (vii) the Attorney General if the provisions of Probate Code section 19514, subdivision (b) apply.¹⁵ Unless the "trust instrument" provides otherwise, minors and unascertained or unborn persons in these categories must receive notice from the authorized fiduciary.¹⁶ If the beneficiary otherwise has no representative (e.g., if there is a minor for whom a general guardian has not been appointed), the notice must be given to a guardian ad litem and the authorized fiduciary is directed to seek appointment of a guardian ad litem.¹⁷

No consent to the action is required. If no interested party objects to the exercise of the decanting power, it can then be exercised in a writing signed by the authorized fiduciary.¹⁸ The writing must: (i) identify by reference the notice required by Probate Code section 19507, (ii) identify the first trust and the second trust, and (iii) state the property of the first trust being distributed to the second trust and the property, if any, that remains in the first trust.¹⁹

A. Limited Distributive Discretion

The decanting powers have different restrictions depending upon the trustee's power to make distributions to the beneficiaries of the first trust. For example, when the trust allows the trustee to make distributions subject to an "ascertainable standard"²⁰ or a "reasonably definite standard,"²¹ the authorized fiduciary is said to have "limited distributive discretion" over the first trust.²² The authorized fiduciary may exercise the decanting power over the principal of the first trust,²³ however, each beneficiary of the first trust must be granted beneficial interests in the second trust which are "substantially similar" to the beneficial interests of the beneficiary in the first trust.²⁴

"Substantially similar" means that there is no material change in the beneficiary's interests, except as provided in Probate Code section 19512, subdivision (d).²⁵ The term "material change" is not defined. However, the comments to the Uniform Trust Decanting Act indicate that "[c]hanges to a fiduciary's administrative powers or investment powers, changes in a fiduciary, or changes in jurisdiction or the state law governing the administration of the trust are not material changes...."²⁶

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Probate Code section 19512, subdivision (d) states that the power to make a distribution under a second trust for the benefit of a beneficiary who is an individual is substantially similar to a power under the first trust to make a distribution directly to the beneficiary if it satisfies any of the following conditions: (i) the distribution is applied for the benefit of the beneficiary, (ii) the beneficiary is under legal disability or the trustee reasonably believes the beneficiary is incapacitated and the distribution is made as permitted under the Probate Code, and (iii) the distribution is made as permitted under the terms of the first trust instrument and the second trust instrument for the benefit of the beneficiary.

Therefore, the interests of a beneficiary of a trust in which the trustee has limited distributive discretion must remain unchanged, and decanting for these types of trusts is limited to modifying administrative—and not dispositive—provisions.

B. Expanded Distributive Discretion

Different rules apply when the trustee of the first trust has a discretionary power of distribution that is not limited to an ascertainable standard or a reasonably definite standard. That trustee is said to have "expanded distributive discretion."²⁷

An authorized fiduciary with expanded distributive discretion may exercise the decanting power over the principal of the first trust.²⁸ However, the second trust may not have any of the following provisions: (i) include as current beneficiary a person who is not a beneficiary of the first trust, except as provided in Probate Code section 19511, subdivision (d) (discussed below),²⁹ (ii) include as a presumptive "remainder beneficiary"³⁰ or "successor beneficiary"³¹ a person who is not a current beneficiary, presumptive remainder beneficiary, or successor beneficiary of the first trust, except as provided in Probate Code section 195111, subdivision (d) (discussed below),³² or (iii) reduce or eliminate a "vested interest."³³

Probate Code section 19511, subdivision (d) does permit: (i) the retention of a power of appointment granted in the first trust,³⁴ (ii) the omission of a power of appointment granted in the first trust, other than a presently exercisable general power of appointment,³⁵ (iii) the creation or modification of a power of appointment if the powerholder is a current beneficiary of the first trust and the authorized fiduciary has expanded distributive discretion to distribute principal to that beneficiary,³⁶ and (iv) the creation or modification of a power of appointment if the powerholder is a presumptive remainder beneficiary or successor beneficiary of the first trust, and provided that the exercise of the power may take effect only after the powerholder becomes, or would have become, if then living, a current beneficiary.³⁷

III. WAYS TO MAXIMIZE TAX SAVINGS USING THE DECANTING STATUTE

In essence, the decanting statute allows an authorized fiduciary to modify a trust that would otherwise be non-modifiable except by court order. The decanting power can be exercised to enhance the ability of trusts to maximize tax savings. As discussed below, there are seven specific ways that a decanting exercise can accomplish the goal of tax savings:

(i) convert a non-grantor trust into a grantor trust to either permit the settlor to diminish his or her estate without transfer tax consequence and/or permit the settlor to reacquire low basis trust assets so a basis step-up can be accomplished at death;
(ii) add a general power of appointment to a credit shelter trust to accomplish a tax-free basis step-up at the death of a surviving spouse;
(iii)add a general power of appointment to a trust that is exempt from the generation-skipping transfer tax to accomplish a tax-free basis step-up at the death of a non-skip person when assets pass to a skip person;
(iv) redefine what receipts are allocated to trust income and/or what expenses are allocated to trust principal to allow for more accumulation in transfer tax exempt trusts that require "all the income" to be distributed currently;
(v) modify a trust that is generation-skipping transfer tax exempt to keep assets that would otherwise be distributed outright to non-skip persons at certain ages to remain in trust for future generations;
(vi) eliminate a power of a current trustee-beneficiary that might otherwise cause inclusion of the trust in the trustee-beneficiary's estate; and
(vii) decant the trust so that accumulated income and capital gains are subject to state income tax at rates lower than in California.

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A. Convert a Non-Grantor Trust to a Grantor Trust

When a trust is a grantor trust for income tax purposes, all items of income, deduction, and credit of the trust are reported on the grantor's return. The grantor and the grantor trust are treated as the "same person" for income tax purposes.³⁸ This provides a distinct transfer tax advantage.

Example 1-A.

Assume that a grantor created a non-grantor trust for his or her child...