Decanting Questions

Take-Away: Michigan has two separate statutes that deal with a trustee’s ability to decant a trust’s assets to a new trust created by the trustee. While that authority exists to transfer assets from an existing trust to a new trust, several tax questions remain unanswered with regard to the trustee’s exercise of a decanting power.

Background: Michigan has two statutes that permit a trustee to decant trust assets. The Michigan Trust Code provision is essentially used to change the administrative provisions of a trust instrument. [MCL 700.7820a.] The other statute is an amendment to the Michigan Powers of Appointment Act, which can be used by the trustee to modify, but only to a limited degree, the beneficial interests of an existing trust. [MCL 556.115a.] While these statutes can be used by the trustee to decant the assets from an existing trust to a new trust that is created by the trustee, just because the power to decant exists does not necessarily mean that the power should always be exercised by the trustee. Moreover, an exercise of a decanting power by a trustee could also raise the question of whether the trustee has violated its duty of impartiality to all trust beneficiaries if an existing trust beneficiary has his/her rights in the trust curtailed in the second trust to which the trust assets are decanted.

Powers of Appointment Act Provisions: This statute is horrifically ‘wordy’ and tough to fully grasp. Distilling it’s provisions is therefore a challenge. Essentially, a trustee of a presently exercisable discretionary power over an irrevocable trust may, unless the trust instrument prohibits the decanting, decant trust assets to a second trust, but only if several conditions exist.

Conditions to the Exercise of a Decanting Power: The statutory conditions to which the trustee’s decanting power are subject follow:
(i) the beneficiaries of the second trust include only permissible appointees, aka beneficiaries, of the first trust, but those appointees of the second trust can be fewer than the appointees of the original, or first, trust; (translated: a potential beneficiary in the first trust can be excluded in the second trust)
(ii) if annual exclusion gifts are made to the first trust, e.g. a crummey trust, the rights of the trust beneficiary needed to assure that the present interest exists must be in the second trust; (this is to assure that the present interest gift tax treatment is preserved, which prohibits the trustee from curtailing the beneficiary’s rights in the second trust, e.g if the beneficiary had a general testamentary power of appointment in the first trust, that same power needs to be in the second trust)
(iii) the exercise of the trustee’s discretionary power in the decanting must not reduce the income, annuity, or unitrust interest, or a general power of appointment, when the trust is intended to qualify for the martial or charitable deduction; (again, this limitation imposed on the trustee is to assure that the intended marital or charitable deduction tax consequences intended for the first trust cannot be frustrated by the trustee’s decanting power to the second trust)- and
(iv) the exercise of the trustee’s discretionary power does not reduce a presently exercisable general power to withdraw a specified percent or amount of trust property of a trust beneficiary who is the only trust beneficiary to or form the benefit of whom the trustee has the power to make discretionary distributions (vested rights to property held in trust cannot be overridden by the trustee’s decanting power.)

Second Trust: The terms of the second trust permit the trustee to create a special or general power of appointment held by a trust beneficiary which could include the appointment of trust property to persons who are not beneficiaries of the first trust, i.e. add new individuals as potential trust beneficiaries.

Discretionary Power: A discretionary power held by the trustee is the power to make distributions when the timeliness of a present distribution to or for the benefit of

Tax Consequences: Lots of Guesswork: Almost a decade ago the IRS was asked to comment upon the tax consequences of a trustee exercising a decanting power. The IRS responded that it will not issue any private letter rulings while the tax consequences [income, gift, estate, GST] are under study by it. [Notice 2011-101, 2011-52 I.R.B. 932.] Almost a decade later, there is still no guidance from the IRS on the tax implications, if any, of a trustee’s exercise of a decanting power, either a decanting power that is inferred under common law in a discretionary trust, or a state statute’s decanting authorization.

Questions: Some of the tax questions that arise when a trustee decides to decant a trust include the following:

Settlor’s Identity: If a trustee transfers property from one trust to another as part of the exercise of a decanting power, the settlor of the trust that receives the property remains the same as the trust that distributed the property. [Treas. Reg. 1.671-2(e)(5).] This is consistent with the treatment of an exercised limited power of appointment, where the creator of the power of appointment is treated as the transferor of the property interest. However, if the property is transferred to another trust pursuant to a general power of appointment, the power holder becomes the ‘grantor/settlor’ of the second trust that receives the property. Thus, if a trustee decants assets from the first trust to a second trust, in light of the Regulation the ‘grantor’ of the second trust would continue to be the same as the settlor of the first trust. This principle works reasonably well, unless there are already assets in the second trust (that were not the subject of the trustee’s decanting power); in that case the settlor of the first trust is considered the settlor of the second trust, but only with respect to the portion or assets of the second trust that were distributed from the first trust. Thus, it is possible for the decanted second trust to have two or more settlors, which obviously can confuse things, including tax reporting consequences.
Grantor Trust? A trust is a grantor trust for income tax reporting purposes if any person has the power to distribute income or principal to any person without the consent of an adverse party. [IRC 674.] While this rule seems to encompass most trusts, that Tax Code section does provide statutory exceptions to take many irrevocable trusts out of the grantor trust However, the statutory exceptions to the general rule do not apply if any person has the power to add a beneficiary to the trust. The question that a decanting begs is whether the second trust would be considered a new beneficiary of the first trust, which could cause the first trust to be classified as a grantor trust when there was no intention for the first trust to be taxed as a grantor trust. This may not be all that big a problem so long as the second trust does not include any new beneficiaries that were not a beneficiary of the first trust. Less clear is when the trustee decants assets to a second trust when a new beneficiary is not added, but a remainder beneficiary of the first trust is advanced from their remainder position to a current or present beneficiary status. It is conceivable that advancing a remainder beneficiary’s position in the second trust could be interpreted as adding a new trust beneficiary to the second trust, thus retroactively triggering grantor trust status for the first trust.
Gifts of Interests: A common question when the trustee decides to decant trust assets to a second trust is whether a beneficiary with an interest in the first trust makes a gift to the second trust. Because decanting might result in the reduction or elimination of a current beneficiary’s interest, and that beneficiary may give either direct or indirect consent the transfer, many commentators are worried about an implied gift by the current beneficiaries when a decanting occurs. This arises under three possible situations:
Diminished Interest: A gift is formally defined as a transfer of property for less than adequate and full consideration in money or money’s worth. [IRC 2512.] Part of the delay in the IRS providing guidance is because it is looking into whether the reduction or elimination of a beneficial interest in property is a transfer of that property for less than adequate or full consideration. If the trustee does not possess absolute discretion to make distributions, this probably will not be an issue because the beneficiaries of the second trust must be the same as the first trust and there can be no change to distribution standards or powers of appointment with that decanting. However, if the trustee does have absolute discretion, the authorizing statute must permit the trustee to formally eliminate a trust beneficiary. As a generalization, if the current trust beneficiary does not have a power to withdraw assets or a general power of appointment over the trust assets, that beneficiary will not be deemed to have made a gift when the trustee exercises its discretion to make a distribution of the trust assets to a second trust.
Consent: While is seems reasonable that the mere reduction or elimination of a beneficiary’s interest will not be deemed to be a gift when assets are distributed from the first trust to the second trust in a decanting event, less clear is what effect a beneficiary’s consent has on that reduction or elimination. If the beneficiary consents, or can act to block the decanting of trust assets from the first trust to the second trust, it would appear that the consent, or the failure to block a reduction or elimination of the beneficiary’s interest could result in the beneficiary making a taxable gift. Michigan’s decanting statutes do not require a consent from the beneficiaries, but the beneficiaries are required to receive 63-day notice in advance of the intent to decant. [MCL 700.7820a(7).] It is unclear if this ability of a trust beneficiary to object to the trustee’s proposed decanting results in a situation where the beneficiary is deemed to have made a taxable gift by failing to exercise that right to object. In addition, the same Michigan statute permits a trust beneficiary to waive the 63-day notice of intent to decant; does a waiver signed by the trustee act as an implied consent triggering gift tax consequences?
Beneficiary as Trustee: If a trust beneficiary is also a trustee and participates in a decanting transaction, it is possible that the transfer might trigger a taxable gift by the trustee-beneficiary. If that trustee’s power to distribute is limited to an ascertainable standard, which is likely the case to prevent estate inclusion for the trustee-beneficiary, any distribution to another beneficiary should not be considered a gift by the trustee-beneficiary. This reasoning should also apply to a trustee’s power to decant. In contrast, if the trustee-beneficiary has absolute discretion there will already gift and estate tax consequences to worry about, and decanting the trust’s assets to the second trust will not eliminate those tax problems