Take-Away: Decanting a trust that is generation skipping transfer (GST) tax exempt is a dangerous proposition since the IRS refuses to give any guidance on the tax implications of decanting the assets from the GST exempt trust to a new trust that is created by the trustee.

Background: In 2011, the IRs announced that it would not respond to questions with regard to the income, gift, and GST tax consequences that arise from a decanting that changes a beneficiary’s interest in the trust. [Notice 2011-2011, 2011-52 I.R. B. 932.] The IRS stated that while these issues were ‘under study’, it will not issue private letter rulings with regard to proposed decanting that results in a change of beneficial interests.  Nine years later, there is still no guidance from the IRS on the tax implications of a trust decanting initiated by a trustee.

  • Some of the main topics that the 2011 Notice requested comments on are the effect of  a decanting has on the identity of the settlor, grantor trust status, potential gift and estate tax implications, and the impact on GST exempt trusts.
  • In the absence of express guidance on these topics, a trustee’s decision regarding whether to decant the assets held in a trust should be weighed heavily.

Michigan Law: Michigan has two separate decanting statutes. One statute deals primarily with a change to a trust’s administrative provisions, as part of the Michigan Trust Code. [MCL 700.7820a] The second statute is a provision that was added to the Michigan Powers of Appointment Act, which authorizes some modifications of beneficial interest in the exercise of its power of appointment. A trustee is considered to hold a power of appointment, albeit in a fiduciary capacity.  [MCL 556.115a.]

  • One of the Reporter’s Comments to the Michigan Trust Code section notes: Subsection (3)(b) makes clear that extending the duration of the first trust via exercise of the decanting power does not materially change the beneficial interests of the beneficiaries of the first trust. This limit will curtail the utility of the Michigan Trust Code decanting provision and force persons interested in decanting a trust to seek to use the decanting powers under Section 5a of the Powers of Appointment Act,… or to otherwise provide for decanting in the instrument.

GST Exemption:  An example is the implications and complications of a decanting of a GST exempt trust. A trust can be GST tax-exempt in one of two ways:  (i) Grandfathered Status: If the trust became irrevocable on or before September 25, 1985; or (ii) Zero Inclusion Ratio Trust: if the settlor allocates his/her available GST exemption to the trust.

Key Point: A careful review and analysis of the GST consequences of a trust decanting needs to be conducted prior to the trustee’s decision to decant the trust’s assets to a new trust.

Grandfathered Status Trust: As a generalization, distributions of principal from a GST grandfathered trust to a second trust will not cause the loss of GST exemption if one of the two following ‘tests’ are met:

  • Test #1: The first test is that either the state law or trust instrument at the time the trust became irrevocable permitted the distribution to a second trust without the consent or approval of any beneficiary or court, and the second trust does not extend the time for vesting beyond any life in being at the date the grandfathered trust became irrevocable, plus 21 years, i.e. the historic rule against perpetuities. [Treas. Reg.26.2601-1(b) (4) (i) (A).] More than likely this ‘test’ cannot be met for older trusts, as Michigan’s decanting statutes are relatively new and it is probable that decanting was not expressly permitted at the time the trust first became irrevocable.
  • Test #2: The second test for GST grandfathered trusts is to ensure that the transfer of principal from the GST grandfathered trust to the second trust does not shift the beneficial interest of any beneficiary to a beneficiary in a lower generation and the time for vesting of any beneficial interest in the trust is not extended beyond the period provided in the GST grandfathered trust. [Treas. Reg. 26.2601-1(b) (4) (i) (D).] With regard to this second test, the date of the decanting statute does not matter: Accordingly, as long as the second trust does not shift beneficial interests to a lower generation and the perpetuities period with regard to the trust is not changed, the second trust should not cause a loss in the GST exemption.
  • Caution: The concern is, therefore, to not in directly cause a shift in beneficial interests to a lower generation individual, and whether changes to trust administrative or boilerplate language could do indirectly cause such a shift in beneficial interests. Restated, it may not be readily apparent that the new trust terms affect beneficial interests and, as such, the terms of the new trust need to be carefully studied.

Zero Inclusion Ratio Trust: There are no safe harbor rules for zero inclusion ratio trusts similar to the rules just covered for a GST grandfathered trust. From private letter rulings, however, [which cannot be cited as precedent] it appears that any change in the second trust would not affect the GST exempt status of a grandfathered trust should not affect the GST exempt status of an existing  zero inclusion ratio trust. [See PRL 200743028; PLR 200839025; PLR 200919009.]

Conclusion: Decanting a trust is becoming more and more of a popular tool to modify the terms of a trust without the inherent  cost, delay, and publicity of a probate court trust modification proceeding. If the trust to be decanted is GST exempt, more care will be required in order to preserve that GST exempt status if the decision is made by the trustee to exercise a statutory decanting power. It would be nice, after waiting 9 years, if the IRS provided some guidance on the GST implications of a trust decanting since at least 26 states now have some sort of decanting statute.