What do you mean irrevocable? I want to amend that trust
Clients have an option if circumstances or estate planning changes.
February 19, 2013
If I had a dollar for every time a client came to me asking to change a signed irrevocable trust document, I would have stockpiled enough money for a nice European vacation. I am also quite sure that many of my estate-planning colleagues have had similar experiences.
While rushing to make significant gifts at the end of 2012, many clients chose to establish irrevocable trusts at the same time. And now that the American Taxpayer Relief Act of 2012, P.L. 112-240, has been signed into law, and the federal gift tax exclusion of $5 million (adjusted for inflation) is now permanent, that perennial question is right around the corner—how do I change my irrevocable trust?
For many clients, the changes have nothing to do with taxation; there have been changes in the family (death, divorce, remarriage, substance abuse, or mental illness of the beneficiary), changes with the choice of fiduciary, or changes in circumstances.
Because of the gifting rush at the end of last year and because the unprecedented opportunity to make significant tax-free gifts will continue, clients should understand that not only will gifted assets bypass the transfer tax system at the time of the gift, any appreciation in the value of the assets will not be subject to the estate tax until distributed.
For assets that are discounted, leveraged, and/or have significant ability to appreciate, the real wealth win will come during the client’s lifetime. As significant assets continue to appreciate outside the transfer tax system, and the sheltered family wealth continues to appreciate, the family will face other changes. For gift, estate, and generation-skipping tax reasons, clients have always made irrevocable choices in a snapshot of time that will reverberate through life.
Of course, it is possible that the trust’s drafter contemplated that question and has already put safety mechanisms in place. However, if that is not the case, there may still be other options for the client. This column will address an increasingly common option: decanting the assets of one irrevocable trust to a new irrevocable trust.
Decanting a trust is a mechanism by which the trustee of an irrevocable trust, known as the “distributing trust,” transfers assets to another irrevocable trust, known as the “receiving trust.” The ability of a trustee to make this distribution exists, depending on the jurisdiction, by a statutory power, a common law power or a power in the trust instrument to make such a distribution, or by the exercise of a power of appointment to make the distribution. These powers are commonly known as “decanting powers.”
The use of decanting powers has become increasingly popular as a means of ensuring that a method exists for dealing with changed circumstances that were not contemplated when the trust was drafted. Beneficiary consent or court approval is not typically required or sought when decanting. In addition, decanting generally does not include any interim or final distribution from a trust that is required by the terms of the trust document.
The first case dealing with decanting, Phipps v. Palm Beach Trust Co., 196 So. 229 (Fla. 1940), was a Florida Supreme Court case that held that a trustee with absolute power to distribute trust property could invade the trust principal and pay it over to another trust for the benefit of the original trust’s beneficiary. This case was based on common law, not on any specific Florida statute. The American College of Trust and Estate Counsel (ACTEC) argues, based on the holding in Phipps, that “there is reason to believe that the common law of every other jurisdiction in the United States confers a decanting power on all the trustees who have the authority to invade trusts for the benefit of their beneficiaries” (ACTEC, Comments on Notice 2011-101 (April 2, 2012)). They also note that there are no contrary court decisions in this country.
Subsequent to the Phipps case, various states enacted legislation to authorize decanting. There are 13 states (Alaska, Arizona, Delaware, Florida, Indiana, Missouri, Nevada, New Hampshire, New York, North Carolina, Ohio, South Dakota, and Tennessee) that have adopted decanting statutes permitting trustees with distribution powers under the trust that can be exercised in favor of the trust’s beneficiaries to distribute property to another trust for the benefit of one or more of such beneficiaries—even if that other trust has different terms from those of the original trust.
Decanting an irrevocable trust can be a powerful estate-planning tool. ACTEC identifies many reasons to consider decanting, including protecting the tax treatment of the trust, granting a beneficiary a power of appointment, reducing administrative costs, altering trusteeship provisions, extending the termination date of a trust, converting a grantor trust to a nongrantor trust (or vice versa), changing a trust’s governing law, dividing the trust property to create separate trusts, reducing personal liability, converting a trust into a supplemental needs trust to permit a beneficiary to qualify for certain governmental benefits, making trust instruments spendthrift trusts, addressing changed circumstances in the family or trusteeship, modifying administrative powers, creating a dynasty trust, and correcting drafting errors without court involvement.
When considering decanting a trust, it is important to be aware of the income, gift, estate, and generation-skipping transfer tax consequences. As ACTEC points out, the income tax issues include whether the existence of the decanting power causes the trust to be a grantor trust; whether decanting a trust that is treated as a grantor trust to one that is not a grantor trust results in income tax liability; whether there is a recognition of gain (to the trust or to the beneficiary of the receiving trust) on the transfer; whether the receiving trust, upon receiving the assets of the decanted trust, also carries the tax attributes of those assets; whether the grantor of the distributing trust continues to be a grantor after decanting; and whether the existence of a decanting power results in the loss of qualified subchapter S trust status.
Gift and estate tax issues include whether a beneficiary whose interests are diminished as a result of the decanting has made a taxable gift, whether the decanting provision jeopardizes the marital deduction, and whether the donor of the distributing trust continues to be the donor of the receiving trust. There are also generation-skipping considerations that should also be carefully considered.
The IRS is currently studying the tax implications of decanting and says that it is “considering approaches to addressing some or all of the relevant tax issues in published guidance” (Notice 2011-101). In the notice, the IRS invited comments on tax consequences of decanting and identified various circumstances that might affect the tax consequences. Practitioners should watch for future IRS guidance.
Many tax issues surround decanting a trust that no longer serves its intended purpose. Notwithstanding the tax complexities, for those significantly funded and appreciating irrevocable trusts that face issues not contemplated at the outset, decanting is a tremendous opportunity that should be fully considered and explored.
Additional resources: AICPA Comments on Notice 2011-101 (June 26, 2012).
Patricia M. Annino, J.D., LL.M., a nationally recognized authority on estate planning and taxation, received the Boston Estate Planning Council’s “Estate Planner of the Year” Award in 2007, and chairs the Estate Planning practice at Prince Lobel Tye LLP. She has been voted by her peers as one of the Best Lawyers in America (trust and estates), a Super Lawyer, and a Top 50 Massachusetts Super Lawyer. She is a Fellow of the American College of Trust and Estates Counsel (ACTEC).