An irrevocable trust can be a powerful estate planning tool, but in some cases irrevocability could be a disadvantage. For example, you might discover a drafting error that makes the trust inconsistent with your original purposes. Or perhaps changing tax laws or family circumstances render the trust ineffective or obsolete. The risk that a trust will cease to serve its purpose is greater if it’s designed to operate over several generations.
One strategy that may allow you to fix a broken trust is decanting. The ability to decant a trust depends on several factors, including the trust’s terms and the law of the state in which it resides.
Decanting is pouring wine or another liquid from one vessel into another. In the estate planning world, it means “pouring” assets from one trust into another with modified terms. The rationale underlying decanting is that, if a trustee has discretionary power to distribute trust assets among the beneficiaries, it follows that he or she has the power to distribute those assets to another trust.
Depending on a trust’s language and the provisions of applicable state law, decanting may allow the trustee to:
In light of the recent doubling of the gift and estate tax exemption and generation-skipping transfer tax exemption, many irrevocable trusts formed to shield assets from these taxes no longer serve that purpose.
In fact, unlike assets transferred at death, assets that are transferred to a trust don’t receive a stepped-up basis, so they can subject the beneficiaries to capital gains tax on any appreciation in value. One potential solution is to use decanting. Decanting can authorize the trustee to confer a general power of appointment over the assets to the trust’s grantor, or to name the grantor as successor trustee. Such actions cause the assets to be included in the grantor’s estate and, therefore, to enjoy a stepped-up basis.
Many states have decanting statutes and in some states decanting is authorized by common law. Either way, it’s critical to understand your state’s requirements, such as, in some states, the trustee being required to notify the beneficiaries or even obtain their consent to decanting; others require neither. And some states prohibit decanting if the trustee has discretion over distributions of income but not principal, or if distributions are limited by an “ascertainable standard,” such as a beneficiary’s health, education, maintenance or support.
Even if decanting is permitted, there may be limitations on its uses. Some states, for example, prohibit the use of decanting to eliminate beneficiaries or add a power of appointment, and most states will not allow the addition of a new beneficiary. If your state doesn’t authorize decanting, or if its decanting laws don’t allow you to accomplish your objectives, it may be possible to move the trust to a state whose laws meet your needs.
If the trust instrument includes decanting provisions, it may be possible for the trustee to decant the trust without the need to rely on state law.
Typically, state laws permit decanting without court approval, although some states require court approval for modifications that, for example, have an adverse impact on a beneficiary or on the tax treatment of the trust. Even if court approval isn’t required, trustees often seek such approval voluntarily if they anticipate objections from the trust’s beneficiaries.
One of the risks associated with decanting is uncertainty over its tax implications. Let’s say a beneficiary’s interest is reduced. Has he or she made a taxable gift? Does it depend on whether the beneficiary has consented to the decanting? If the trust language authorizes decanting, must the trust be treated as a grantor trust? Does such language jeopardize the trust’s eligibility for the marital deduction? Does distribution of assets from one trust to another trigger capital gains or other income tax consequences to the trust or its beneficiaries?
Several years ago, the IRS issued a notice raising some of these questions, but has yet to provide any answers.
If you have a trust in need of repair, consider decanting or other tools for modifying it. These techniques can be complicated, however, so consult with us to review the benefits and potential risks.
In addition to decanting, there are several other potential options for amending an irrevocable trust, including:
Reformation. Many states permit you to seek a court order rewriting a trust’s terms to conform to the grantor’s intent if its original terms were based on a legal or factual mistake.
Modification. Court-ordered modification may be available if required by changing circumstances to fulfill the trust’s purposes.
Division or combination. Some states permit a trustee to combine multiple trusts into one or to divide a trust into several trusts, under certain circumstances.
Relocation. State law may allow a trustee to move a trust to a jurisdiction with more favorable tax or asset protection laws.