August 29, 2016
Irrevocable trusts have been a widely utilized estate planning tool for decades. There are dozens of types of irrevocable trusts that are created for different purposes; the two most common are to reduce one's taxable estate and to protect the assets from creditors.
There comes with the funding of an irrevocable trust certain constraints that are designed to protect the assets in the trust, as well as to control how its assets are dispersed. But what happens when a change in circumstance fundamentally alters the situation and the trust is no longer able to fulfill its intended purpose? Or, what if dispositive provisions are no longer adequate to address the present circumstances of beneficiaries? If the trust is revocable, no problem; the grantor simply revokes or amends the trust, changing its provisions to suit its original or newly intended purpose.
Because irrevocable trusts are "irrevocable" for tax or asset protection purposes, it could be difficult if not impossible, to change key provisions. An extremely effective, yet, in my opinion, underutilized strategy known as decanting, can provide a suitable solution. In this article, I'll outline the uses of decanting; its background and history; and the mechanics of the process.
Decanting is the process by which an authorized trustee, not the grantor, transfers assets from one trust into another trust which contains the necessary changes that will achieve the intended purpose. New York's Estates Powers and Trusts Law §10-6.6, otherwise known as the "decanting statute," was the first of its kind in 1992. The original statute allowed certain trusts to benefit from continued exemption from the federal generation-skipping transfer (GST) tax, but it required a trustee to obtain either court approval or the beneficiaries' consent in order to decant. In response to Treasury Department regulations indicating that the requirement for approval or consent would disallow continued exemption from the GST tax, this requirement was removed in 2001. As a result, the 2001 version of the statute allowed the trustee far greater flexibility.
The statute was further revised in 2011, essentially making decanting available in more circumstances, including situations where the trustee possesses only limited discretion with respect to distributions of trust principal. The new decanting statute —which was further amended in 2013 to make technical corrections and to clarify the 2011 changes—broadened the application of decanting and made an irrevocable trust not so irrevocable after all.
There are many reasons why a trustee might want to decant a trust, including, and certainly not limited to:
- Create a supplemental needs trust for a beneficiary who is or has become disabled;
- Add or modify spendthrift provisions;
- Correct drafting errors;
- Consolidate multiple trusts;
- Modify trustee provisions;
- Modify trust provisions to reflect new law;
- Extend the termination date of the trust;
- Change the trust's situs;
- Reduce state income tax imposed on trust assets;
- Vary investment strategies for beneficiaries;
- Create marital and non-marital trusts;
- Create GST Exempt on GST Non-Exempt trusts;
- Create a more favorable income tax status, perhaps by creating an "Intentionally Defective Grantor Trust"; or
- Create a special power of appointment exercisable by an existing beneficiary, essentially adding a new beneficiary to the trust (which is otherwise not permissible under the statute).
Here are some specific illustrations of the more common and practical reasons for decanting.
Modifying Trust Provisions: If administrative provisions, such as those governing the appointment of successor trustees, became impractical due to changed circumstances, a trustee could decant to a new trust ("appointed trust") containing provisions better suited to the new circumstances.
Supplemental Needs Trust Becomes Necessary: After a trust is created, a beneficiary becomes eligible for governmental assistance. The trustee could decant to an appointed trust which contains supplemental needs trust provisions, thereby allowing the beneficiary to qualify for governmental assistance; something which he would have otherwise not been able to receive because of the dispositive provisions of the original trust ("invaded trust").
Adding or Modifying Spendthrift Provisions: A trust provides for a mandatory distribution of principal starting when the beneficiary is 30 years old, with final principal distributions concluding at age 40. If the beneficiary has creditor problems, or is a spendthrift, or simply too immature to receive substantial distributions, or has a gambling, drug, or alcohol addiction, such mandatory distributions would be inadvisable.
The trustee could decant assets to an appointed trust containing a spendthrift provision that adds the appropriate protections.
Reduction of State Income Taxes on Trust Assets: If a New York resident trust no longer has a trustee domiciled in New York, has no real or personal property located in New York and has no New York source income, then capital gains and accumulated income will not be subject to New York income tax. N.Y. Tax Law 603(b)(3)(D). Therefore, if a New York-sitused trust includes assets in another state, the trustee should consider decanting those assets to an appointed trust under another tax jurisdiction. By doing so, the decanted assets might avoid New York capital gains tax and accumulated income tax.1
Change of Investment Strategies with GST Exempt and GST Non-Exempt Trusts: The GST exempt status of a GST Exempt trust will not be adversely affected by dividing the trust into several equal trusts for the purpose of varying investment strategies for different beneficiaries. PLR 200629021. A trustee could consider decanting into an appointed trust that contains a GST Exempt trust (which would allow for a more aggressive investment strategy) and a GST Non-Exempt trust (which could be used to address the more immediate needs of non-skip persons utilizing a more conservative investment strategy).2
Rules, Rules and More Rules
The analysis of whether a trustee could (or should) decant, starts with knowing the rules, and that depends on the type of discretion the trustee has to invade principal. A trustee has either limited or unlimited discretion to invade principal, and each type has its own applicable rules under the statute. There are also rules that apply regardless of the type of discretion.
Unlimited Discretion: In order to decant under EPTL 10-6.6(b), the authorized trustee is required to have absolute discretion to invade principal in favor of one or more "current beneficiaries." In fact, only one or more than one current beneficiary of the invaded trust need be provided for in the appointed trust. The logic is simple. Since the trustee has the absolute discretion to distribute principal in favor of any current beneficiary, then he may decant in favor of one current beneficiary even to the exclusion of all other current, successor and remainder beneficiaries of the invaded trust. To reach any other conclusion would create rights in the excluded beneficiaries that the grantor did not intend. Had he intended as such, the grantor would not have given the trustee absolute discretion.
Limited Discretion: The major change in 2011 was to allow decanting even when the trustee does not have unlimited discretion to invade principal. However, to decant under EPTL 10-6.6(c), the trustee must comply with more restrictive rules. Most significantly, the appointed trust's beneficiaries must be the same current, successor and remainder beneficiaries as in the invaded trust.
The distribution standard in the appointed trust must also remain the same as in the invaded trust. However, if the appointed trust has a longer term (which is a permitted use of decanting), then the same distribution standard need only be the same in the appointed trust during the invaded trust's original term. Thereafter, the distribution standard can be different, or the invasion of principal may become fully discretionary.
Limited or Unlimited Discretion: The balance of the decanting statute, EPTL 10-6.6(d)-(t), contains rules and definitions that apply regardless of the distribution standard, and is what guides the trustee's analysis and the process of decanting. It is clear that despite the terms of the invaded trust, the trustee has a lot of discretion in modifying those terms. But with broadened discretionary powers also comes the responsibility to safeguard the grantor's intent. For example:
- decanting is prohibited if there is substantial evidence that it would be contrary to the intent of the grantor;
- although a trustee is not under any obligation to decant, if he chooses to do so, he has a fiduciary duty to decant in the best interests of the beneficiary;
- trustee is required to consider the tax implications of the decanting; and
- trustee is prohibited from changing provisions regarding the determination of trustee commissions without a court order.
The Decanting Process
Once it is determined that decanting is applicable, you understand what is permissible based on the trustee's level of discretion, and that the GST exempt status will not be adversely impacted, the process is rather straight forward:
- The exercise of the power to decant—the decanting instrument—must be in a written instrument that is signed, dated and acknowledged by the trustee exercising the power. Although there is no requirement to do so, the trustee may seek court approval for the exercise of the power.
- For the purpose of creating the appointed trust, the trust will be deemed signed by the grantor upon being signed by the trustee. An appointed trust need not be a "new" trust created by the trustee and could be an existing trust.
- The decanting instrument must explicitly state whether the decanting comprises some or all of the invaded trust's assets and, if a partial decanting, the instrument must state the approximate percentage of the value of the principal of the invaded trust that is being decanted.
- Notice of the decanting must be given by the trustee exercising the power by providing a copy of (1) the decanting instrument, (2) the invaded trust, and (3) the appointed trust to (a) all persons interested in the invaded trust, (b) all persons interested in the appointed trust, (c) the grantor, if living, and (d) any person having a right in the invaded trust to remove or replace the trustee exercising the power.
- The original decanting instrument must be filed with the court having jurisdiction over any invaded trust. This requirement does not apply to a lifetime trust that has never been the subject of a proceeding in the Surrogate's Court. A copy of the decanting instrument is kept with the trust's records.
- The decanting is effective 30 days after service of the requisite notice, unless the parties entitled to notice consent to an earlier date. All persons interested in the invaded trust are granted automatic standing to object to the decanting and may serve the trustee with written notice of objection prior to the effective date. The failure to object does not constitute consent. This 30-day period also provides interested persons with the opportunity to seek a judicial stay of the decanting and/or to compel the trustee to account for their decision to decant. A notice of objection, however, does not appear to affect the effective date of the decanting. Barring any evident violation of the decanting statute, however, this author believes that challenging this statutorily granted power is an uphill battle.
- An interested person's receipt of notice does not affect the person's right (even after the expiration of the 30 days) to compel the trustee to account for the invaded trust or file objections to the trustee's accounting. Receipt of notice is not intended to toll the statute of limitations on any action compelling the trustee to account.3 Note also that not all persons entitled to receive notice of the decanting are necessarily persons with standing to file objections in an accounting proceeding. (See SCPA 2210)
There certainly are situations where unanticipated circumstances may make changing the provisions of an irrevocable trust a viable option to uphold the grantor's original intent in setting up the trust. There are a number of moving parts involved, and as with anything involving complicated statutes, having a firm grasp on the underlying laws and how they need to be applied, can inform the decision and make the process go smoothly.
1. Under New York's new law affecting trust income tax, effective April 1, 2014, the accumulated income of these trusts is subject to income tax when that income is distributed to a New York beneficiary. Note that "ING" trusts (designed to shift state income tax liability from the grantor's state of domicile (New York) to a trust located in a more favorable tax jurisdiction) are not addressed in this example. Nonetheless, ING trusts are no longer available as an estate planning tool in New York because their income is now chargeable to the grantor under the new law.
2. A discussion of the various transfer tax considerations pertinent to decanting a GST Exempt trust is beyond the scope of this article. Suffice it to say, however, that if the GST implications are unclear, it would be prudent to obtain a private letter ruling in advance.
3. The statute is silent as to whether notice triggers the statute of limitations. However, since each decanting is different, EPTL 10-6.6(j)(5) provides, in pertinent part: "Whether the exercise of a power under paragraph (b) or (c) begins the running of the statute of limitations on an action to compel a trustee to account shall be based on all the facts and circumstances of the situation." EPTL 10-6.6(j)(6), in pertinent part, further provides that the decanting instrument is required to state that the trustee's exercise of his power to decant "in certain circumstances … will begin the running of the statute of limitations that will preclude persons interested in the invaded trust from compelling an accounting by the trustees after the expiration of a given time."
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