Trust Decanting: Beware of the Hidden Gift Consequences

Take-Away: If a trustee exercises a decanting power to transfer assets to a new, or second, trust it is possible that the trustee’s transfer may inadvertently cause a taxable gift.

Background: As we have covered in the past, Michigan has two separate decanting statutes.

• Administrative Changes: One statute, found in the Michigan Trust Code, primarily deals with changes to the administration of a trust, e.g. adding new administrative provisions designed to more efficiently administer the trust through clarification or corrections. [MCL 700.7820a.] Generally, with only changes to the administrative provisions of a trust, and not the substantive rights of beneficiaries, seldom will there be an implied gift with regard to a trustee’s exercise of a decanting power under the Michigan Trust Code.
• Beneficial Changes: The second Michigan statute, the Michigan Powers of Appointment Act, is when an implied gift may result from a trust decanting. [MCL 556.115a.] Under the Powers of Appointment Act it is possible to reshape, remove, shift, or expand the interests of the beneficiaries through the trustee’s exercise of a decanting power. It is a decanting of trust assets in reliance on this second decanting statute where an implied taxable gift can occur.
• Common Law: It is also important to remember that both of these Michigan statutes expressly indicate that they are codifications of the common law in Michigan. This means that a trust instrument can contain its own decanting power where the trustee will not have to comply with either of these two technical decanting statutes.

Gift Tax Consequences: The IRS has expressed reservations with regard to the possible gift tax consequences of a trust decanting that results in a change of the trust’s beneficial interests. [Notice 2011-101 (December 27, 2011.)] In addition, in a Regulation that deals with the generation skipping transfer tax, the IRS clearly stated that a trust decanting that shifts a beneficial interest in the new trust can have transfer tax consequences. [Treas. Regulation, 26.2601-1(b)(4)(i)(D.)]

Situations Where Caution is Warranted: 

• Trustee is Beneficiary: If the trustee is also a beneficiary (an interested trustee), to the extent that the trustee decants trust assets in a manner that eliminates or reduces the value of the trustee-beneficiary’s interest in the trust, there could be a transfer of value that triggers the federal gift tax.  Treas. Regulation 25.2511(g)(2) notes that If a trustee has a beneficial interest in trust property, a transfer of the property by the trustee is not a taxable transfer if it is made pursuant to a fiduciary power the exercise or nonexercise of which is limited by a reasonably fixed or ascertainable standard which is set forth in the trust instrument. Therefore, in the absence of an ascertainable standard, the interested trustee could make a taxable gift by exercising a decanting power.

• Beneficiary Acquiesces: Assume that an independent trustee, who is not a beneficiary, exercises a decanting power. The effect of the decanting is to shift a beneficial interest. The independent trustee cannot make a gift of something that he/she/it does not own an interest in. [Treas. Regulation 25.2511(g)(1).] If, however, a trust beneficiary whose beneficial interest is diminished or eliminated by the decanting could have sued the trustee to cause the decanting to be reversed, and instead allowed it to stand unchallenged, that beneficiary may have made a gift when the expiration of the applicable statute of limitations forecloses the lawsuit against the trustee. [Revenue Ruling 81-264.] This exposure boils down to a facts and circumstances analysis of whether the beneficiary actually had a good case to set aside the  trustee’s decanting. Gift tax consequences should only arise if the acquiescing beneficiary had more than just the ability to object to the trustee’s actions, and in fact had a reasonable chance to successfully object to the  trustee’s decanting. [Restatement (Third) of Trusts, Section 50.] In light of this risk, it would be wise to obtain a court-approved settlement agreement, consented to by all parties, that authorizes, in advance, a proposed decanting transaction. A judicially sanctioned decanting transaction will normally be recognized for tax purposes as legitimate and not give rise to a cause of action by the acquiescing beneficiary, from which the exposure exists. [Revenue Ruling 73-142.]

• IRC 2702 ‘Trap:’ If there is a ‘gift’ by a trustee-beneficiary (the interested trustee) or an acquiescing beneficiary to a family member who is a trust beneficiary, and he/she (the transferor) retains an interest in the decanted trust that is not classified as a qualified interest, the value of the gift will be the fair market value of the interested trustee or acquiescing beneficiary’s entire beneficial interest in the trust. [IRC 2702.] In short, if IRC 2702 applies, the full value of the transferor’s interest is the value of the gift, without any reduction for the value of any retained beneficial interest in the trust.

Conclusion: Over 30 states have separate decanting statutes. In Michigan, we have two statutes, that also declare that there is a common law power to decant if the trustee possesses discretion to make distributions from the trust.  There is also the recently enacted Uniform Trust Decanting Act. Clearly there is a popular movement to facilitate changes to trust instrument through the trustee’s power to decant. However, before we get too eager to modify trust terms to add or remove trust beneficiaries through a trust decanting, we need to be mindful of the potential for a taxable gift that arises from the transfer of assets from the first trust to the second (new) trust by the trustee.