Sunday, September 18, 2022
Trusts are a popular part of an estate plan for many people. Trusts also come in different forms. Some take effect during life and can be changed whenever the trust grantor (creator or settlor) desires. These are revocable trusts. Other trusts, known as irrevocable trusts, also take effect during life but can’t be changed when desired. Or, at least not as easily. That’s an issue that comes up often. People often change their minds and circumstances also can change. In addition, the tax laws surrounding estates and trust are frequently modified by the Congress as well as the courts. Also, sometimes drafting errors occur and aren’t caught until after the irrevocable trust has been executed.
So how can a grantor of an irrevocable accomplish a “do over” when circumstances change? It involves the concept of “decanting” and it’s the topic of today’s post.
Why decant? Attempting to change the terms of an irrevocable trust is not a new concept. “Decanting” involves pouring one trust into another trust with more favorable terms. To state it a different way, decanting involves distributing the assets of one trust to another trust that has the terms that the grantor desires, with the terms that the grantor no longer wants remaining in the old trust. The reasons to decant a trust can be numerous. For instance, decanting can be done to change a trust’s situs or trustee powers. It can also be used to change the number of trustees or to consolidate different trusts. Decanting can also be used to change the distributional scheme to provide greater asset protection and to better address the needs of a special needs beneficiary.
Authority to decant. The ability to “decant” comes from either an express provision in the trust, or a state statute or judicial opinions (common law). Presently, 12 states have adopted the Uniform Trust Decanting Act (UTDA). Those states are AL, CO, IL, ME, MA, MT, NE, NM, NC, VA, WA and WV. 24 other states have not adopted the UTDA but have their own specific decanting statutes. These states are AL, AZ, CA, DE, FL, GA, IN, IA, KY, MI, MN, MO, NV, NH, NY, ND, OH, RI, SC, SD, TN, TX, WI and WY. In these states, a key question is whether the statute allow the trustee to make the changes that the grantor desires. If not, a determination must be made as to what the state courts have said on the matter, if anything. But that could mean that litigation involving the changes is a more likely possibility with a less than certain outcome.
Other states, such as Kansas, allow trust modification under common law. In some of these states, courts have determined that decanting is allowed based upon the notion that the trustee’s authority to distribute trust corpus means that the trustee has a special power of appointment which allows the trustee to transfer all (or part) of the trust assets to another irrevocable trust for the same beneficiaries. Thus, a trustee attempting to decant a trust must do so consistent with the fiduciary obligations that govern a trustee – reasonableness and good faith.
Note: With respect to fiduciary duties, because some beneficiaries might be disaffected by decanting, it may be wise for the trustee to obtain consents or releases from trust beneficiaries. But, if such consent is deemed to be a right to control property in the hands of the beneficiary, gift tax could be triggered. This is a particular likelihood if the beneficiary causes or permits the beneficiary’s interest in the trust to pass to a different beneficiary, or if the beneficiary releases a general power of appointment.
Ascertainable standard. Many trusts have “ascertainable standard” provisions that direct the trustee to make distributions to a beneficiary in an accordance with certain standards typically tied to the beneficiary’s living conditions and needs. If the trustee is also a beneficiary, any ascertainable standards established in the trust should not be changed by decanting. Indeed, state law might require the ascertainable standards in the new trust to be either more restrictive or at least as restrictive as the prior trust if the trustee having the power to appoint trust property is also a beneficiary.
Grantor’s rights. Care should be taken to not change the grantor’s rights and interests in trust principal. Likewise, the ability of the trustee to decant should not involve the grantor or be contingent upon the grantor’s consent so as to avoid the decanting process being deemed as a right to control property under I.R.C. §§2036 or 2038 that would cause inclusion of the trust corpus in the grantor’s gross estate upon death. Similar issues can arise with respect to beneficiaries. Decanting can create an estate tax issue for a beneficiary if the decanted trust (new trust) provides a beneficiary with a general power of appointment that wasn’t present in the original trust, or the property included in the beneficiary’s gross estate is treated as a gift by the beneficiary due to decanting, or the power to decant is deemed a general power of appointment, or decanting makes an incomplete gift a complete gift when the beneficiary dies.
Note: The decanting process cannot add beneficiaries without express authority in the original trust instrument. Even then, only a non-beneficiary trustee may engage in the decanting process.
GSTT. Also, if assets are added (even indirectly) to a grandfathered generation-skipping transfer trust (GSTT), the grandfathered status is lost, and the trust is exposed to the GSTT. In 2011, the IRS announced that it was studying the implications of decanting that result in a change in the beneficial interest in the trust. IRS requested comments regarding when (and under what circumstances) such transfers are not subject to the GSTT. Notice 2011-101, 2011-52 IRB 932.
Trust protector. If conditions are not favorable for decanting in a particular jurisdiction, it may be possible under the trust’s terms, or a “trust protector” provision, to shift the trust to a different jurisdiction where the desired changes will be allowed. Absent favorable trust terms, it might be possible to petition a local court for authority to modify the trust to allow the governing jurisdiction of the trust to be changed.
Document preparation. If decanting can be done, the process of changing the trust terms requires document preparation that will result in the pouring of the assets of the trust into another trust with different terms. Throughout the process, it is important to follow all applicable statutory rules. Care must be taken when preparing deeds, beneficiary forms, establishing new accounts and conducting any other related business to complete the change.
IRS Private Ruling – Judicial Reformation
In the fall of 2015, the IRS released a Private Letter Ruling that dealt with the need to change an error in the drafting of an irrevocable trust in order to repair tax issues with the trust. Priv. Ltr. Rul. 201544005 (Jun. 19, 2015). The private ruling involved an irrevocable trust that had a couple of flaws. The settlors (a married couple) created the trust for their children, naming themselves as trustees. One problem was that the trust terms gave the settlors a retained power to change the beneficial interests of the trust. That resulted in an incomplete gift of the transfer of the property to the trust. In addition, the retained power meant that I.R.C. §2036 came into play and would cause inclusion of the property subject to the power in the settlors’ estates. The couple intended that their transfers to the trust be completed gifts that would not be included in their gross estates, so they filed a state court petition for reformation of the trust to correct the drafting errors. The drafting attorney submitted an affidavit that the couple’s intent was that their transfers of property to the trust be treated as completed gifts and that the trust was intended to optimize their applicable exclusion amount. The couple also sought to resign as trustees. The court allowed reformation of the trust. That fixed the tax problems. The IRS determined that the court reformation would be respected because the reformation carried out the settlors’ intent.
When to Decant
So, it is possible that an irrevocable trust can be changed to fix a drafting error and for other reasons if the law and facts allow.
What are common reasons decant an irrevocable trust? Some of the most common ones include the following:
- To achieve greater creditor protection by changing, for example, a support trust to a discretionary trust (this can be a big issue, for example, with respect to long-term health care planning);
- To change the situs (jurisdiction where the trust is administered) to a location with greater pro-trust laws;
- To adjust the terms of the trust to take into account the relatively larger federal estate exemption applicable exclusion and include power of appointment language that causes inclusion of the trust property in the settlor’s estate to achieve an income tax basis “step-up” at death (this has become a bigger issue as the federal estate tax exemption has risen substantially in recent years);
- To provide for a successor trustee and modify the trustee powers;
- To either combine multiple trusts or separate one trust into a trust for each beneficiary;
- To create a special needs trust for a beneficiary with a disability;
- To permit the trust to be qualified to hold stock in an S corporation and, of course;
- To correct drafting errors that create tax problems and, perhaps, in the process of doing so create a fundamentally different trust.
The ability to modify an irrevocable trust is critical. This is particularly true with the dramatic change in the federal estate and gift tax systems in recent years. Modification may also be necessary when desires and goals change or to correct an error in drafting. Fortunately, in many instances, it is possible to make changes even though the trust is “irrevocable.”