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George F. Bearup, J.D. Senior Legal Trust Advisor

18-Nov-20

A Second Look at Decanting a Trust

Take-Away: While Michigan has two separate statutes that enable a trustee to decant trust assets to a second trust created by the trustee, not to be lost is that a trust instrument can include its own decanting authorization given to the trustee, without having to contend with some of the hurdles imposed by Michigan’s two decanting statutes.

Background: As has been previously reported, Michigan has two decanting statutes. The decanting authorization in the Michigan Trust Code deals primarily with changes to the administrative provisions of an existing trust. [MCL 700.7820a.] The other decanting statute is part of the Michigan Power of Appointment Act, which can be used, albeit in limited circumstances, to modify a beneficiary’s interests in the trust, such as a trust decanting that extends the duration of the first trust, and consequently a beneficiary’s interest in the first trust. [MCL 556.115a.] However, both of these Michigan decanting  statutes, like all decanting statutes that have been adopted in 30 states, is based on common law principles that emanate from a trustee’s discretion to make distributions (when, to whom, how, and subject to what restrictions or limitations.)

  • Tax Consequences: The IRS has expressed reservations with regard to the possible gift tax consequences of a trust decanting, particularly if the decanting results in a change of the trust’s beneficial interests. [Notice 2011-1010, December 27, 2011.] Moreover, in its Regulations, the IRS has noted that if a trustee-beneficiary’s interest in the trust is altered, that could result in a transfer-for-value situation [Treasury Regulation 25.2511(g)(2)] or that a shift in beneficial interests due to a trust decanting can result in triggering the generation skipping transfer tax. [Treasury Regulation, 26.2601-1(b)(4)(i)(D.)] The IRS has even held, albeit long ago, that a trust beneficiary whose beneficial interest in a trust is diminished or eliminated in a trust decanting may result in a taxable gift, if that beneficiary could have sued the trustee to cause the decanting to be reversed, but instead allowed the decanting to stand unchallenged and the statute of limitations on that claim was permitted to run. [Revenue Ruling 81-264.] Finally, just to make sure that the cloud that it has placed on the tax consequences of a decanting remains unclear, the IRS has formally announced that it will not respond to private letter rulings when the request centers upon the tax consequences of a proposed decanting.
  • Breach of Fiduciary Duty?: A few court decisions around the country have sustained a trustee’s authority to decant the first trust assets to a second trust created by the trustee, usually to address an administrative problem or to rectify an ambiguity in the first trust instrument. However, there have also been a couple of noteworthy court decisions where a trustee’s decanting of trust assets was found to be a breach of the trustee’s fiduciary duty. For example, the New Hampshire Supreme Court found the trustee had breached a fiduciary duty to trust beneficiaries when the second trust to which the first trust’s assets were decanted omitted 4 of the 6 beneficiaries of the first trust. Hodge v. Johnson, 170 N.H. 470 (2017.) Thus, while the trustee may possess the authority to decant trust assets, that authority may not relieve the trustee of the trustee’s fiduciary duties to the beneficiaries of the first

Michigan Trust Code Decanting:  In order to exercise the statutory decanting power the trust instrument must first contain a discretionary trust provision along with the absence of a provision in the trust instrument that expressly prohibits a decanting by the trustee. Other conditions that must exist before the trustee can decant trust assets to the second trust include:

  • (i) the terms of the second trust to which the first trust assets will be transferred do not materially change the beneficial interests of the beneficiaries of the first trust;
  • (ii) if the terms of the governing instrument of the first trust expressly indicates an intention that the first trust is to qualify for a tax benefit or the terms of the first trust are clearly designed to qualify the first trust for a tax benefit, and if the first trust would qualify for the intended tax benefit, the terms of the second trust must not be inconsistent with the tax planning that the first trust intended to accomplish. [MCL 700.7820a(a)(1)(a)(b).]
  • (iii) The transfer of assets to the second trust cannot result in: (a) an increase or change in the method used to determine the trustee’s compensation; (b) a fee or charge to transfer the assets to the second trust unless all beneficiaries consent to the fee or charge in writing; (c) a reduction in the trustee’s standard of care; and (d) the reduction in authority of a person who possesses power, as a fiduciary, to direct or remove the trustee. [MCL 700.7820a(2)(a)-(d).]
  • (iv) An increase in the maximum period during which the vesting of a future interest may be suspended or postponed will not constitute a material change in the interest of a trust beneficiary. [MCL 700.7820a(3)(b).]
  • (v) The trustee may decant without the consent of trust beneficiaries, but the trustee must give the qualified trust beneficiaries a 63-day notice before the decanting power is exercised. [MCL 700.7820a(7).]

Michigan Power of Appointment Decanting: Many of the provisions of this decanting statute are the same as the Trust Code’s decanting authorization, but not all of them. However, this decanting statute is normally used in more narrow circumstances. This statute’s authority to decant trust assets is limited to a trustee with presently exercisable discretionary distributive powers to distribute trust income or trust principal to one or more trust beneficiaries. The trustee will be presumed to possess a special power of appointment that permits trust assets to be appointed to a different trust. Restated, the trustee’s discretion must not be limited by a definite ascertainable standard. [MCL 556.115a(3)(b).] However, the second trust does not have to include all permissible beneficiaries of the first trust, which is why a trust decanting under this statute is deemed to permit a change in the beneficial interests of the beneficiaries of the first trust. [MCL 556.115a(1)(a).]

Distinguishing the Two Decanting Statutes: Both Michigan decanting statutes are fairly long and kind of hard to decipher (translated: I still move my lips when I read them.) The two can be distinguished in three or four different ways:

  • Ascertainable Standard: The Power of Appointment Act decanting provision will apply in fewer circumstances because the decanting power applies only when the trustee possesses a discretionary distribution power that is not limited by any definite or ascertainable standard for health, education or support. The Trust Code decanting statute can apply to a trust where the trustee’s discretion to distribute income or principal is subject to an ascertainable standard.
  • Materially Change Beneficial Interests: The decanting power under the Power of Appointment Act, when applicable, can be more broadly exercised. For example, the Trust Code decanting power cannot be exercised in a manner that results in a material change to the interests of the first trust’s beneficiaries. This restriction or limitation does not apply to the exercise of a decanting power under the Power of Appointment Act. This leads to the prior generalization that the Trust Code decanting power is primarily restricted to changing the administrative provisions of the first trust e.g. turn ‘off’ grantor trust status; add a trust director; expand scope of permissible investments. With the Power of Appointment Act decanting power, the decanting to the second trust can eliminate certain beneficiaries of the first trust, change the beneficial interests of the first trust, or alter the tax planning contemplated when the first trust was initially established. [MCL 556.115a(1)(2).]
  • Notice to Trust Beneficiaries: Under the Trust Code decanting authorization, the trustee must give advance notice to the settlor and any qualified trust beneficiaries of the plan to decant trust assets. With the Power of ,Appointment Act’s decanting authorization, the trustee is not required to give prior notice, but that will not relieve the trustee of the on-going duties to report and account to the beneficiaries of the second [MCL 556.115a(5).]

Non-Statutory Decanting: As indicated above, the power to decant is one that exists at common law. The Michigan decanting statutes are, therefore, essentially default decanting powers that are available to be followed if a trust instrument is silent on the trustee’s power to decant. Consequently, it is possible that a trust instrument may contain its own express decanting power that may be followed by the trustee. If the settlor of the trust wishes to add his or her own decanting power to their trust, the two decanting statutes can provide some helpful guidelines in what to include, or what to avoid, if the trustee is given a unique decanting power to transfer the trust assets to a second trust. In creating a non-statutory decanting power, the settlor will need to address the following issues and concerns:

  • Who may exercise the non-statutory decanting power? Only the initial trustee or all successor trustees?
  • Can a trust director amend the trust instrument to give to the trustee a non-statutory decanting power?
  • What are the beneficiaries’ income rights, and how can those rights be modified by the trustee’s non-statutory decanting?
  • Who can be the beneficiaries of the second trust to which the trust assets are decanted?
  • What are the standards of discretionary distributions that can be used in the second trust?
  • Can the trustee give a power of appointment to one (or more) beneficiaries of the second trust?
  • Can the second trust be used to extend the permissible rule against perpetuities period?
  • Will existing or outstanding powers of withdrawal held by a trust beneficiary prevent a non-statutory decanting of trust assets by the trustee, e.g. a crummy withdrawal right; a 5+5 withdrawal right?
  • What limitations, if any, will exist on the trustee’s exercise of a non-statutory decanting power to preserve  tax savings or other tax characteristics, e.g. preserve the marital or charitable deductions?
  • Whether any notice of intent to decant must be given to the trust beneficiaries, and if so, the duration of that advance notice?

Conclusion: As individuals, (and their attorneys) seek more and more flexibility over the irrevocable trusts that they create, the decanting power is going to play an important role to achieve that goal to make a trust more responsive to changes in circumstances of both the law and the needs of the trust beneficiaries. It is possible that more trusts will include their own non-statutory decanting power, as opposed to relying upon what is available (or not) to the trustee under the two statutory decanting authorizations in Michigan.