Decanting is not just for fine Cabernet.??Decanting has grown in popularity as a method to revise an otherwise unrevisable, irrevocable trust.??In this context, “decanting” means transferring some or all of the assets from one trust into another. At last count, 18 states have adopted decanting statutes, with considerable variations from state to state.??Almost all of the states, however, require at least notice to the beneficiaries, and some require the beneficiaries’ written consent.
The IRS recognized this growing tide of decanting, and issued Notice 2011-101, asking for comments on the income, estate and gift tax implications of decanting.??Comments were due by April 25, 2012. In addition, the IRS included a decanting issue — specifically, whether a change in beneficial interest is a distribution for which a deduction is allowable under §661 of the Internal Revenue Code, or which requires an amount to be included in a person’s gross income under §662 — in Rev. Proc. 2013-3, 2013-1 I.R.B. 113, as an area under study, in which private letter rulings or determination letters will not be issued until a revenue ruling, revenue procedure or regulation is issued by the IRS.??Presumably, letter rulings may still be issued on other questions involving decanting.
Although New Jersey does not currently have a decanting statute, New Jersey case law has permitted the doneeof a power of appointment to exercise the power to create a trust for the permitted appointees.??Additionally, in the matter of Wiedenmayer v. Johnson, 106 N.J. Super 161 (1969), aff’d by Wiedenmayer v. Villanueva, 55 N.J. 81 (1969) (per curiam), the Appellate Division considered the circumstances under which a trustee, rather than the donee of a power of appointment, could decant an existing trust to another trust.
The trustees in Wiedenmayer were authorized, in their discretion and when “they deem it to be for [the beneficiary's] best interests,” to distribute all or any portion of the trust property to the beneficiary.??The trustee proposed to distribute all of the trust property to the beneficiary, which was clearly within the trustee’s authority.??The trustee also determined that it would be in the beneficiary’s “best interests” to make the distribution contingent upon the beneficiary’s transfer of the distributed property to a new trust.??The new trust, created by the beneficiary of the old trust, was identical to the original trust, except for the exclusion of two remainder beneficiaries.?? The two beneficiaries initiated the litigation to preserve their remainder interests.
The court reasoned that the trustee’s distribution to the primary beneficiary, permitted under the terms of the trust agreement, would also have extinguished the remainder beneficiaries’ interest, whether or not the trustee imposed the condition that the beneficiary create a new trust. Therefore, the imposition of the condition of a new trust was irrelevant.??The court also refused to substitute its definition of the beneficiary’s best interests in place of the trustees’ determination.
Wiedenmayer would appear to, at minimum, allow a trustee to transfer trust property to a new trust, particularly if the trustee was authorized to distribute all of the trust property to a beneficiary. It should also allow a trust-to-trust transfer that eliminates a present beneficiary, if the original trust gave a sprinkle power to the trustee, with the ability to exclude one or more of the permissible beneficiaries.
Once a trustee has determined that decanting is permitted as a distribution within the trustee’s discretion, there are other issues to be considered.??First and foremost, a trustee’s decision must still be considered within the context of the trustee’s fiduciary duty to the beneficiaries.??As mentioned above, there are no specific Treasury Regulations regarding decanting to guide a practitioner.??If one is proceeding with a decanting, there are tax issues to be considered when drafting a new trust to receive decanted property, or when drafting a decanting instrument.??The trustee should consider the following:
• Estate Tax: If a grantor’s interests in the old trust and new trust are the same, whether or not the trust’s assets are included in the grantor’s taxable estate will not change. If the grantor has a power or interest that causes estate tax inclusion under the old trust, and has the same power or interest over the new trust, then the assets of the new trust will be included in the grantor’s taxable estate.??If there was no estate tax inclusion under the old trust, decanting will only result in estate tax inclusion if: (1) the grantor is so involved in the decanting process that it implies a right to control the trust property under §§2036 or 2038; or (2) the new trust gives the grantor a new power that causes estate tax inclusion under §§2038 or 2041 of the Internal Revenue Code.
Decanting should not result in estate tax inclusion for a beneficiary unless: (1) the new trust grants the beneficiary a general power of appointment; or (2) the decanting is treated as a gift by a beneficiary of the old trust, who is also a beneficiary of the new trust.??In that event, §§2035-2039 or §2042 of the IRC will require the decanted property to be included in the beneficiary’s taxable estate.
• Gift Tax: A trustee’s exercise of a decanting power should not create gift tax issues unless: (1) the trustee exercising the power to decant has a beneficial interest in the old trust; (2) a beneficiary can object to the decanting and fails to do so; or (3) the decanting affects a beneficiary’s presently exercisable power of withdrawal or general power of appointment.
• Income Tax: The decanting of trust property from the old trust to a new trust generally will not be a taxable event unless: (1) the decanting results in a sale or exchange of property that is materially different than the property transferred; or (2) the decanting constitutes a sale or exchange under §1001 of the Internal Revenue Code.??”Materially different” was defined in Cottage Savings Association v. Commissioner, 494 U.S. 554, 560-61 (1991), as the fact that the properties held by the parties after the transaction had legal entitlements that differed in kind or extent.??This standard could result in a taxable exchange after decanting, if the beneficiary’s interest in the new trust is materially different than the beneficiary’s interest in the old trust.
• Generation Skipping Transfer Tax (GST): Decanting property from an irrevocable trust that is GST exempt because it was irrevocable on Sept. 25, 1985, (“grandfathered”) could result in a loss of the exempt status.??Also, if decanted property is considered an addition to a grandfathered trust, this could also cause a loss of exempt status.??The regulations do provide four safe harbors that apply to changes to grandfathered trusts.??Two of the safe harbors (Treas. Reg. §26.2601-1(b)(4)(i)(A), relating to discretionary distributions, and Treas. Reg. §26-2601-1(b)(4)(i)(B), relating to trust modifications) particularly apply to the decanting situation.
The regulations do not provide any guidance as to trusts that are exempt from GST tax because of the allocation of the individual’s exemption.??Some idea of the IRS’s thinking may be found in several private letter rulings which include language similar to this quote from PLR 200839025 (Sept. 26, 2008):??
No guidance has been issued concerning changes that may affect the status of trusts that are exempt from GST tax because sufficient GST exemption was allocated to the trust to result in an inclusion ratio of zero.??At a minimum, a change that would not affect the GST status of a trust that was irrevocable on September 25, 1985, should similarly not affect the exempt status of such a trust.
Until there is more guidance from the New Jersey legislature and the Internal Revenue Service, trustees and their counsel should fully consider the constraints of the trustee’s fiduciary duties and the potential tax consequences to a trust’s beneficiaries, prior to making a decision to use decanting to revise an irrevocable trust. •