As oenophiles know, red wine often produces sediment as it ages, introducing a bitter flavor and gritty texture to the wine. The process of removing these impurities by carefully pouring the wine from the original bottle into a new vessel before serving is known as “decanting.” An old trust agreement can similarly acquire “sediment” in the form of tax provisions that are no longer applicable or distribution requirements that are no longer appropriate. In the trust context, the term “decanting” refers to the process of carefully appointing assets from an old trust to a new trust with more favorable terms. The practical effect of the appointment is to revise the terms governing the original trust agreement. If a trust instrument’s provisions do not provide the trustee with an amendment power, decanting may be the best way to modify unfavorable provisions and can be accomplished in New York without consent from the person who created the trust, the beneficiaries, or any court.
Decanting may be useful, for example, when a trust agreement requires mandatory distributions at a time when the beneficiary is involved in a messy divorce or is struggling with substance abuse, a distribution in the next year might not be in that child’s best interest. In the case of a disabled beneficiary, decanting a trust into a third-party supplemental needs trust may be particularly advantageous because, although new trust (the “appointed trust”) will be created with assets set aside for the beneficiary, that beneficiary will not be considered the creator for purposes of the Medicaid payback provisions. See, e.g., Kroll v. New York State Dep’t of Health (N.Y. App. Div. 2016).
The first decanting statute was passed in New York in 1992. This statute, Estates Powers and Trusts Law §10-6.6 (EPTL 10-6.6), has been amended several times since, most recently in 2015. Although at least 25 states also have decanting statutes, New York’s EPTL 10-6.6 remains one of the best and is a powerful tool for practitioners.
Decanting Under EPTL 10-6.6
Although EPTL 10-6.6 allows the trust that receives the appointed property (the appointed trust) to have substantially different provisions from the trust from which property is appointed (the invaded trust), there are limits to the trustee’s powers. The most important restriction stems from the nature of the power. The power to decant is a fiduciary power and must be exercised in the best interests of one or more of the beneficiaries. A trustee planning to decant should carefully consider the reasons for decanting. This is especially true if the trustee plans to make changes which may be adverse to one or more beneficiaries.
The trustee exercising the decanting power must have unlimited discretion to invade trust principal in order to fully access the statute. Unlimited invasion discretion includes the power to distribute principal for a beneficiary’s best interest, welfare, comfort or happiness. The logic behind the decanting statute is that a trustee who has the power to pay the trust’s entire principal to the beneficiaries should be allowed to pay the principal to a new trust for the benefit of one or more of those beneficiaries. The class of current and remainder beneficiaries of the appointed trust can be reduced but cannot be increased, although the trustee may grant a beneficiary a new discretionary power of appointment. This power of appointment must be very broad and can exclude as permissible appointees only the beneficiary, the trust’s creator, the creator’s spouse and the creditors, estates or the creditors of the estates of the beneficiary, the creator, and the creator’s spouse.
If no trustee has unlimited discretion, the statute allows the trustee to effect a decanting in a more limited manner. The current and remainder beneficiaries must remain the same, the trustee must have the same authorization to invade principal and distribute income, and any powers of appointment must remain identical. However, the term of the appointed trust may be extended beyond the term of the invaded trust. During this extended period, after the invaded trust would have ended, the trustee may be granted unlimited discretion to invade principal, allowing the trustee to decant to a new trust and eliminate beneficiaries or grant powers of appointment.
Some restrictions apply regardless of the level of discretion a trustee has. For example, a beneficiary’s presently exercisable withdrawal rights may not be eliminated. Additionally, a trustee may not decant to increase her compensation, reduce her liability, or eliminate a provision allowing someone else to remove or replace her. An extension of the perpetuities period beyond the period that would be required in the invaded trust will render the decanting invalid, and the trustee may not make changes that would jeopardize the trust’s marital or charitable deductions or cause it to fail to qualify for the gift tax annual exclusion.
Approval is not required for decanting but notice must be provided to the trust’s creator (if living), anyone who may remove or replace the trustee exercising the decanting power, and anyone interested in the invaded trust or the appointed trust 30 days before the effective date of the decanting. An “interested person” is anyone who would be required to receive notice if the trustee were to judicially account. Failure to object to the notice does not constitute consent to the decanting, although a court will consider the facts and circumstances of the notice in determining if it starts the statute of limitations to compel a trustee to account.
Before decanting, a trustee is required by EPTL 10-6.6 to consider the tax consequences of the decanting. Unfortunately, there is some uncertainty about these consequences. Although the Internal Revenue Service (IRS) has long recognized that guidance is needed, none has been issued (Notice 2011-101 (Dec. 21, 2011)). In addition, the IRS has said that until guidance is released it will not issue private letter rulings in connection with decanting transactions that change beneficiaries’ interests in a trust.
Although the income, gift and estate tax consequences of decanting must also be considered carefully, the generation-skipping transfer (GST) tax can pose particularly complex problems for the trustees of trusts that are protected from the GST tax either because they were irrevocable on Sept. 25, 1985 or because their transferors have allocated sufficient GST exemption to them. The IRS has suggested in a substantial number of private letter rulings that a trust could lose its exempt status if its terms are amended to change the interests of its beneficiaries.
The Treasury Regulations provide two safe harbors that may be relied on to protect a trust from loss of GST exempt status when beneficial interests are changed through a decanting. The first will not protect a trust unless state law then applicable to the trust permitted the decanting at the time the trust became irrevocable. The second will not protect a trust if the terms of the appointed trust shift a beneficial interest to any beneficiary who occupies a lower generation than those who held the beneficial interests before the decanting.
Any New York trust that became irrevocable before New York’s decanting statute was enacted will not be protected by the first safe harbor unless the New York Court of Appeals recognizes that New York’s common law permitted decanting prior to the enactment of EPTL 10-6.6(b). The second safe harbor described in the preceding paragraph will not be available unless it can be shown that there is no possibility that younger generation beneficiaries will receive more than they would have received under the terms of the invaded trust.
In this respect, the provisions of EPTL 10-6.6(b)(2) that permit the appointed trust to give a beneficiary a power of appointment present a potential trap. Because, as discussed above, any new power of appointment may not exclude members of a lower generation, the grant of any new power of appointment will be treated as shifting beneficial interest to a lower generation and cause the decanting to fall outside of the safe harbor.
EPTL 10-6.6 requires many steps and practitioners advising trustees to implement a decanting under the statute should carefully document each step. A checklist is below:
(1) Set up the appointed trust (i.e., draft, execute, provide initial funding). Ensure the terms of the appointed trust do not violate any of the restrictions of EPTL 10-6.6.
(2) If the appointed trust is not a grantor trust, acquire an EIN. Open bank and brokerage accounts for the appointed trust.
(3) Determine which individuals interested in the invaded trust must receive notice.
(4) Execute and acknowledge an instrument exercising the decanting power to transfer all, or part, of the assets of the invaded trust to the appointed trust. Unless the individuals who must receive notice of the transfer consent, the effective date of the transfer must be at least thirty days after service.
(5) Send copies of (i) the invaded trust, (ii) the appointed trust, and (iii) the instrument exercising the power, by registered or certified mail, return receipt requested, to the individuals entitled to receive notice.
(6) Retitle the invaded trust’s assets in the name of the trustees of the appointed trust.
(7) If the invaded trust is subject to proceedings in Surrogate’s Court (e.g. a testamentary trust), a copy of the transfer instrument must be filed in the Court within twenty days of the effective date of the transfer.
Toni Ann Kruse is a partner and Chris Nason is an associate in the private client group of McDermott Will & Emery in New York. Carlyn McCaffrey provided helpful comments in the preparation of this article.