Reflections on Trust Decanting in Michigan

Take-Away: Michigan has two separate statutes that permit a trustee to decant trust assets to a new trust created by the trustee to ‘fix’ or ‘update’ on older irrevocable trust. While those statutory powers, whether the trustee actually decides to exercise a statutory power to decant trust assets is another matter.

Background: Twenty-seven states have adopted trust decanting statutes. In 2015 the Uniform Trust Decanting Act came into existence for consideration by the states. All this legislative activity that promotes decanting is intended to enable trustees to modernize existing irrevocable trusts, to ‘fix’ problematic trusts without the need to hire lawyers to petition probate courts to modify the terms of an irrevocable trust, and to respond to the ever-changing needs of the trust’s beneficiaries.

Decanting Examples: Popular reasons why a trustee might exercise a trust decanting power include: (i) to add a directed trustee provision, especially if closely held business interests are held in the trust; (ii) to add a trust protector to the trust to enhance flexibility in administration; (iii) to alter powers of appointment with the goal to gain an income tax basis adjustment to the trust assets on the lifetime trust beneficiary’s death; (iv) to add grantor trust powers to enable/require the settlor to pay the income taxes on the trust’s income, resulting in an indirect tax-free gift to the trust beneficiaries; (v) to modify crummey withdrawal powers if the beneficiary has current creditor that might attach the assets subject to the withdrawal right; (vi) to add provisions so the trust can qualify as a QSST trust in order to hold Subchapter S corporate stock; (vii) to change trust provisions so that the trust is taxed as a conduit trust if an IRA is made payable to the trust; (viii) to sever a trust into two separate trusts to accommodate the different investment philosophies of its two trust beneficiaries; (ix) to ‘spin out’ high-risk assets into a separate trust to protect other trust assets from those inherent risks; or (x) to alter a beneficiary’s distribution rights to enhance that beneficiary’s eligibility to qualify for Medicaid benefits or to preserve a disabled beneficiary’s eligibility to receive public benefits by converting the trust to a ‘supplemental needs’ trust. Actually the list of reasons why a trustee might a decanting power is endless, thus making the trustee’s power to decant  extraordinarily flexible.

Michigan Decanting Statutes: A trustee that possesses a presently exercisable discretionary power to make distributions from the trust is considered to hold a power of appointment over the trust assets. The exercise of this power of appointment leads to the trustee’s power to decant the trust assets to a ‘new’ trust that the trustee creates. Michigan has two separate decanting statutes, one that deals primary with changes to the administrative powers over the trust and its assets, and the other with the trustee’s distribution powers over the trust.

• Administrative Decanting: This decanting power is found in the Michigan Trust Code. [MCL 700.7820a.] It primarily deals with changing successor trustees, trustee compensation, a change in trust situs, etc. But there are limits on what can be accomplished to change a trust’s administration through the exercise of a trustee’s decanting power. For example, a change in the trustee’s compensation must be agreed to by the trust beneficiaries. Nor can the trustee exercise its decanting power to reduce its standard of care, to expand its exoneration from liability, to curtail existing powers to remove the trustee, or to eliminate an existing power held by another to direct that trustee. In general, an administrative decanting can be achieved if the trustee’s discretion is limited by an ascertainable standard, e.g. distributions for the beneficiary’s health, education, support and maintenance. This type of administrative decanting power was on full display in the infamous Ferri v. Powell-Ferri divorce case in Connecticut, where the trustee decanted the husband’s trust to add a spendthrift provision (missing in the ‘old’ trust) which ultimately kept the divorce court from treating the husband’s beneficial interest in the trust as a marital asset.
• Dispositive Decanting: This decanting power is found in the Michigan Powers of Appointment Act. [MCL 556.115a.] It primarily is exercised by the trustee to make major changes in the trust instrument with regard to who or what the beneficiaries might receive from the trust. This decanting power might be used to remove a beneficiary, convert a mandatory distribution provision to a discretionary distribution provision, extend the term of a beneficiary’s trust entitlement (but not the trust’s ultimate duration which is restricted by the Rule Against Perpetuities) or to give to a trust beneficiary a power of appointment over the trust assets. As a rule of thumb, a dispositive decanting by the trustee can be made only if there is no ascertainable standard that limits the trustee’s discretion, e.g. the trustee may make distributions for a beneficiary’s welfare, comfort, or best interests. [MCL 556.115a(3)(b).]There are other limits on the trustee’s power to decant and change dispositive provisions of an irrevocable trust. Those limits include: (i) the dispositive decanting can only alter or modify the interests of the trust beneficiaries who are currently eligible to receive trust distributions (the future interests of trust beneficiaries cannot be changed); (ii) only current trust beneficiaries can be removed from the trust (but no ‘new’ trust beneficiaries can be added through the exercise of a decanting power;)(iii) the decanting dispositive power cannot be exercised to reduce or eliminate an existing exercisable power to withdraw assets from the trust (this limitation is in place to protect existing crummey withdrawal powers);  (iv) the decanting power cannot be exercised to remove provisions in the trust that are necessary to obtain the ‘tax benefits’ of a marital or charitable estate or gift tax deduction; and (v) the decanting power cannot be exercised to reduce a fixed income, annuity, or unitrust interest in the trust. While the decanting statute precludes adding ‘new’ beneficiaries to the trust, the same result can be accomplished by giving an existing trust beneficiary a power of appointment over the trust which power could be exercised in favor of ‘new’ proposed trust beneficiaries. Ferri is also an example of a dispositive decanting power;  the trustee’s decanting power also removed from the trust instrument, in the ‘new’ trust to which all trust assets were transferred, the husband’s right to withdraw 75% of the trust assets when he attained age 40 years, again a step that was clearly intended to foreclose an effort by the divorce court to control assets held in the trust. [That could not take place in Michigan since existing withdrawal rights cannot be eliminated in a Michigan  dispositive decanting.]

Common Law: There also exists common law to the effect that a trustee that holds broad discretion to make distributions from the trust by implication also holds a decanting power. Phipps v. Palm Beach Trust Company, 196 So. 299 (1940). Moreover, the Dispositive Decanting statute expressly states that it is a codification of the common law of Michigan with regard to a trustee’s power to decant trust assets. [MCL 556.115a(8).] As such, it is possible for a trust to also be drafted to give to the trustee an even broader power to decant trust assets, perhaps even broader than what decanting can be accomplished under Michigan’s two decanting statutes. But if a trust is drafted to provide an expansive decanting power on the trustee, the tax consequences to the trustee- that effectively holds a ‘general’ power of appointment over the trust assets needs to be carefully considered. Similarly, a trust instrument can be drafted that expressly directs to the trustee to never exercise the common law or the statutory decanting powers, in effect opting out of the Michigan’s two decanting statutes.

Notice of Intent Obligation: Both decanting statutes require the trustee that intends to exercise a decanting power to provide written notice of its intended exercise of the decanting power to the settlors (if living) and all qualified trust beneficiaries [a term broadly defined in the Michigan Trust Code to include all present and future, i.e. remainder, trust beneficiaries, see MCL 700.7103(g)] and provide to each of them a copy of the proposed ‘new’ trust no later than 63 days before the exercise of the decanting power. [MCL 700.7814(2)(d).] This notice obligation imposed on the trustee could be very cumbersome, if not financially burdensome, if there are multiple beneficiaries of the trust, e.g. the contingent remainder beneficiaries are ‘all descendants of my parents’,  and it could lead to unexpected challenges from those more remote trust beneficiaries who were not even aware that the trust existed. Other states, e.g. Delaware, do not have any notice requirements in their decanting statutes. The trust beneficiaries who receive notice  can waive the 63 day ‘waiting’ period if that is to their advantage, otherwise the decanting of trust assets occurs 63 days after the notice is given by the trustee, without any probate court involvement.

Beneficiary Trap #1: The two Michigan decanting statutes do not require that the group of beneficiaries who are required to receive notice of the trustee’s intent to decant the trust assets to consent to that transfer. A beneficiary who consents to the exercise of the trustee’s decanting power runs the risk of triggering negative gift tax consequences, so it is best for the beneficiary to remain silent and implicitly acquiesce to the transfer of the decanted assets as opposed for affirmatively consenting to the transfer. Treas. Reg. 25.2512-8 notes that when a beneficiary consents to a trust decanting that reduces that beneficiary’s interest in the trust, that beneficiary has made a taxable gift.

Beneficiary Trap #2: If the beneficiary of the trust is also the acting trustee of the trust, and the trustee holds a broad decanting power, and as beneficiary he/she also possesses the power to replace the trustee, that power might cause the value of trust corpus to be included of the beneficiary’s taxable estate. Thus, it would be best for the trustee-beneficiary to resign before the notice of intent to decant the trust assets is given.

Trustee Trap #3: As was indicated by a recent New Hampshire Supreme Court decision, a trustee’s decision to decant trust assets to a new trust where  beneficiaries of the ‘old’ trust were not included in the ‘new’ trust can lead to claims of breach of fiduciary duty. In that case, since the decanting trustee did not consider the financial or economic needs of all trust beneficiaries in its decision to decant the trust assets, effectively disinheriting a group of trust beneficiaries no longer favored by the trust’s settlor, the trustee was found to have breached its fiduciary duty of impartiality to those trust beneficiaries and was formally removed as trustee by the probate court.  Hodges v Johnson, 2017 WL 6347941 (N.H. 2017). The Court in its decision held with regard to the Trustee’s decanting decision:

The evidence at trial shows this last purpose [to make reasonable and appropriate distributions for the ‘welfare, enjoyment and education’ of the beneficiaries] is what the trustees ignored when they accomplished the decantings and destroyed the disfavored beneficiaries’ interests. Nor it is relevant that those interests were non-vested and contingent- the duty of impartiality is owed to all beneficiaries no matter the nature of their interests.

Consequently, before a trustee makes the decision to decant trust assets to a ‘new’ trust, it needs to document all of the various considerations that go into that decision, with the expectation that its decision to decant may nonetheless be challenged by unhappy beneficiaries at a later date, especially if the trust beneficiary’s interest is the trust is substantially reduced or altered.

Taxation: The trustee’s exercise of a  decanting power usually does not result in any negative income, gift or estate taxes. Decanting is a non-recognition event for income tax purposes, i.e. it is disregarded for income tax reporting. But that also means that existing tax consequences associated with, or inherent in, the assets held in the ‘old’ trust, e.g. unrecognized gain, will be carried over to the ‘new’ trust and cannot be avoided simply by decanting those assets. There is no rule of thumb if the ‘new’ trust needs to obtain a new employer identification number or it can retain the old employer identification number  that was assigned to the ‘old’ trust. Private Letter Ruling 200736002 suggests that if the entire trust corpus is decanted to a ‘new’ trust, then the ‘new’ trust is the same trust for income tax reporting purposes as the ‘old’ trust from which the distribution was made, which  means that the existing taxpayer identification number can be used for the ‘new’ trust.

Practical Questions: Despite the increase in decanting statutes and the ability of trustees to decant trust assets to a ‘new’ trust created by the trustee, several questions still remain unanswered, including:

• What are the generation skipping transfer tax consequences of a trust decanting? Could the decanted assets be viewed as a ‘constructive addition’ to a GST ‘grandfathered’ trust? The IRS has requested public comments in Notice 2011-101 on these questions, but no guidance has yet to be provided after 7 years.
• Can the trustee use trust assets and incur an expense to create a ‘new’ trust to decant the existing trust assets before obtaining the implied consent of the trust beneficiaries who are given notice of the trustee’s intent to decant? What if a beneficiary objects, and a court refuses to permit the proposed decanting? How are those expenses incurred by the trustee in preparing the ‘new’ trust going to be allocated? While the trustee may possess the power to decant, that does not mean that expenses incurred in the intended exercise of that power will always be paid from the trust’s assets.
• While neither Michigan statute requires that the trustee petition the probate court to obtain approval of the proposed decanting, a cautious trustee might want the protection of the probate court order that approves the trustee’s decanting decision. Should the trustee seek court approval of its proposed decanting decision when the statutes do not expressly require that additional step of going before the probate court? A trust beneficiary might object to the court fees and expenses incurred by the trustee, not to mention the publicity that goes along with filing the proposed decanted trust with the probate court, arguing that the court approval process is unnecessary, a waste of trust assets, and seeking judicial approval sought if it is solely for the trustee’s protection, and not for the benefit of the trust beneficiaries.
• Must a trustee first explore other options to modify the terms of a trust to facilitate its administration, or to ‘fix’ perceived problems, prior to pursuing the ‘decanting remedy’ such as asking a trust protector to amend the trust instrument, or entering into a non-judicial settlement agreement?  Can a court order to modify the terms of the trust accomplish the same objectives as would a trust decanting?

Conclusion: The power to decant is clearly here to stay in Michigan. But  just how often will a trustee take the plunge and exercise its decanting power when there are plenty of other options available under the Michigan Trust Code to ‘fix’ a problem or address a clerical error in a trust instrument? The fact that a trustee possesses a broad power to decant the trust does not necessarily mean that the trustee must always exercise that power.