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

9-Oct-17

Michigan Trust Decanting- Limitations and the Common Law

Take-Away: Michigan’s two decanting statutes do not impose an affirmative duty on a trustee to decant the assets of an existing irrevocable trust to a new trust that is created by the trustee. But what if a trust is administered under the common law. Is there an implied duty to decant and what are the repercussions of a common law ability to decant a trust?

Background: Michigan has two statutes that permit a trustee to decant the assets of an existing trust into a ‘new’ trust created by the trustee.

  • Administrative: One statute generally deals with a change to a trust’s administrative provisions. MCL 700.7820a [part of Michigan’s Trust Code.] An administrative decanting can be achieved only if the trustee’s discretion is limited to an ascertainable standard, e.g. health, education, maintenance and support. Under this statute, the beneficial interests cannot be changed from the original trust to the decanted trust.
  • Dispositive: The second statute generally deals with changes to a trust’s dispositive provisions if the trustee possesses presently exercisable discretion to make distributions. That second statute is the Michigan Power of Appointment Act, MCL 556.111 et seq., specifically MCL 556.115a. Under this statute, the beneficiaries of the decanted trust can only include permissible appointees, even if fewer than all permissible appointees of the trustee’s discretionary distribution power at the time the power is exercised by the trustee. In ‘plain English’ that means that with a decanting, the trustee cannot add ‘new’ individuals as beneficiaries to the decanted trust, but the trustee can narrow the group of existing trust beneficiaries to a smaller number, or with different rights, than what existed in the original trust.
  • Common Law: Both statutes clearly state that the existence of the statute does not abridge the right of a trustee who possesses the power to distribute trust property in further trust under any other statute or the common law. MCL 700.7820a(9); MCL 556.115a(7). By inference, a trustee possesses the right to decant under historic [judge made]common law.
  • No Decanting Power: Both statutes also clearly state that a trustee can be denied a decanting power ‘if the provisions of the first trust expressly provide otherwise.’ MCL 556.115a(1); MCL 700.7820a(1). Restated, a trustee of an irrevocable trust in Michigan will hold these decanting powers unless the trust settlor expressly denies the trustee the use of the decanting power. While we are in an era where trusts are intentionally drafted to provide flexibility to adjust the terms of the trust to adapt to the needs of the trust beneficiaries and the trustee, some trust settlors may vehemently oppose any future changes to the terms of the trust that they create; if that is the case, those settlors must prohibit any decanting of the trust in the trust instrument.

Prohibition on Decanting: The Michigan Power of Appointment decanting statute also provides that a trustee will not possess a statutory authority to decant a trust to reduce a presently exercisable power to withdraw a specified percentage or amount of trust property in a trust beneficiary who is the only trust beneficiary to or for the benefit of whom the trustee has the power to make discretionary distributions. This provision curtails the ability of the trustee to decant a trust to frustrate the exercise of a crummey withdrawal right or a the right of a surviving spouse who is the sole beneficiary of credit shelter-type trust from exercising an annual right to withdraw 5% or $5,000 of trust assets, whichever is larger, (often referred to as the ‘5-and-5 limitation’). MCL 556.115a(1)(d).

Reasons for Prohibition: This prohibition on decanting is included in the one Michigan statute to avoid gift and income tax problems for the trust beneficiary. For gift and estate tax purposes, a presently exercisable  withdrawal power is treated as a general power of appointment held by the trust beneficiary. See IRC 2041(b) [estate tax] and MRC 2514(c) [gift tax.] If a trust is decanted to eliminate this withdrawal power held by the trust beneficiary, there is a concern that the beneficiary has made a taxable gift to the trust by reason of the lapse or release of their general power of appointment (subject to the ‘5-and-5’ limitation.) IRC 2514(b) and (e). Yet another tax complication if the disappearance of the withdrawal power in the decanted trust  is whether  that the beneficiary will be treated as a grantor of assets to the irrevocable trust after the release upon decanting. IRC 678(a)(2). This is admittedly a confusing area of the tax law where there are few answers. There is no guidance on whether this provision of the tax law only applies to a complete release of the power of withdrawal. Nor is it clear that the release, with all of its tax implications, requires some affirmative action by the trust beneficiary who holds the power of withdrawal to be treated as a release by that beneficiary. Rather than invite these possible gift and income tax problems for the trust beneficiary, it was best to simply prohibit by statute a decanting by the trustee when a beneficiary holds a presently exercisable right of withdrawal over the trust assets.

Common Law: As noted earlier, both Michigan decanting statutes reference that the existence of the decanting statutes does not ‘abridge the ability of a trustee that possesses a discretionary distribution power’ any other [decanting] power at common law. A reasonable interpretation of these provisions is that a trustee with discretionary distribution authority may already possesses the power to decant a trust’s assets at common law in Michigan. If that is the situation, it raises an interesting question.

Assume that I create an irrevocable trust which is intended to hold a life insurance policy on my life to provide liquidity available to my estate at the time of my death, in short a classic irrevocable life insurance trust,  or ILIT. In order to enable the ILIT trustee  to pay the life insurance premiums, I make annual gifts to the ILIT to cover the policy premium. I want my gifts to the ILIT to be covered by my federal gift tax annual exclusion gifting opportunity. IRC 2503(b) In order for my gifts to the ILIT to qualify for the federal gift tax annual exclusion those gifts must be a present interest. Thus comes into play the now famous crummey withdrawal right, where the trust beneficiaries of the ILIT are given the right to withdraw the gifts I made to the ILIT in a window period of 30 to 45 days, in order to satisfy the present interest rule of IRC 2503(b). The beneficiaries refuse to exercise their annual withdrawal right, and the ILIT trustee then uses the gifted funds to pay the policy premium. But if there is a common law right held by the trustee to decant the asset held in the lLIT, not limited by any prohibition that is otherwise found in the Michigan statute, could the IRS argue that the mere existence of the trustee’s common law decanting power, whether or not it is actually exercised, defeat the ILIT trust beneficiaries’ crummey withdrawal rights? If that was asserted by the IRS, then my gifts to the ILIT would not qualify for the federal gift tax annual exclusion.

You may recall that a few months back I reported on an interesting Massachusetts Supreme Court decision which concluded that a trustee that held and exercised a common law decanting power to eliminate a trust beneficiary’s right to withdraw 75% of the trust’s assets, which the beneficiary held as a matter or right (but not yet exercised) to prevent the trust’s assets from being available in the trust beneficiary’s pending divorce, was permissible. Ferri v. Powell-Ferri,  476 Mass 651 (2017). In its decision the Massachusetts Court found that the trustee’s common law power to decant took priority over the trust beneficiary’s existing right to withdraw trust assets. Of interest was that Court’s additional reference to the trustee’s ‘duty to decant if the trustee deemed decanting to be in the trust beneficiary’s best interests.’ The Massachusetts Court did not address the equally interesting question of whether that common law decanting power exercised by the trustee violated the state’s public policy, since the trust was clearly decanted to remove the trust assets (that had been subject to a right of withdrawal) from the trust beneficiary’s divorce proceedings.

Conclusion:  In practice, arguably the ability of a trustee to decant outside the parameters of Michigan’s two decanting statutes if that authority exists at common law can provide much-needed additional flexibility. Yet at the same time a common law decanting power could also present serious tax  problems to trust beneficiaries who may have their powers of withdrawal curtailed/released upon a common law decanting. And there will always be the lingering question if a decanting power was exercised by the trustee in a manner that violates the state’s public policy in some manner. The final unanswered question is whether there exists an affirmative duty at common law imposed on the trustee to exercise an implied decanting power if it is in the beneficiary’s best interest to do so. Lots of questions associated with a decanting power at common law that hopefully will be resolved some day in the near future.