Grantors create irrevocable trusts for various tax and non-tax objectives. Irrevocable trusts are trusts that cannot be revoked or significantly amended by the grantor, and they are often viewed as not capable of being modified or terminated after the grantor’s death in light of their “irrevocability.” When an irrevocable trust has become outdated, lacks flexibility, or is otherwise deficient, a question arises as to whether it can be changed or modified while maintaining the intent of the grantor and the purpose of the trust. Contrary to common belief, irrevocable trusts can be changed or terminated under certain circumstances if authorized by the trust instrument or applicable state law. In many jurisdictions, however, modification of a trust can be accomplished only through consent of the grantor and all the beneficiaries or, in the absence of consent or upon the grantor’s death, lengthy and costly court proceedings. Moreover, a judicial modification may not always meet with success, because the proponent of the change may not be able to establish that the modification comports with the settlor’s intent or otherwise does not frustrate a material purpose of the trust. One powerful tool for modifying a trust, however, is the concept of decanting, a process by which the trustee of the obsolete or deficient trust distributes the assets of that trust to a second trust in accordance with a decanting agreement that operates to modernize or cure the deficiencies of the first trust. A potential advantage of decanting, where authorized by state law, is that it may permit a trustee to modify a trust without the consent of the grantor and the beneficiaries or the time, expense, uncertainty, and publicity associated with obtaining court approval of the modification. As such, decanting can be a useful alternative to the modification of an existing trust.
This article will define decanting and discuss its purposes. It also will address the authority for the power (the trust instrument, state statute, and common law), the scope of the power under the various forms of authorization, and the fiduciary duty and tax implications of utilizing the power.
What Is Decanting?
As noted above, decanting involves a trustee distributing trust assets from one trust to another pursuant to the trustee’s fiduciary and discretionary authority to make distributions directly to, or for the benefit of, the original trust’s beneficiaries. Trust decanting has been analogized to the process of pouring wine from one bottle to another bottle (a decanter), which is intended to improve the quality of the wine. Similarly, with respect to trust decanting, a trustee distributes, or decants, trust assets from the original trust to a second trust for the purpose of making improvements on certain deficiencies identified in the original trust that interfere with, or otherwise impede, the grantor’s objectives or the purpose of the trust. The theory underlying decanting is that if a trustee possesses a discretionary power to invade principal and distribute the property from a trust to, or for the benefit of, one or more beneficiaries, then the trustee has, in essence, a special power of appointment, which should allow the trustee to distribute the trust assets to a new trust for the benefit of those beneficiaries.
Purposes of Trust Decanting
Decanting can serve a variety of purposes. Among other reasons, a trustee may want to decant in order to extend the terms of a trust, reflect changes or clarifications in the law that affect the trust instrument, protect the trust assets from a beneficiary’s creditors, correct drafting errors and clarify ambiguous terms, address a beneficiary’s change in circumstances, move the trust to a state with more favorable laws, grant powers of appointment, change trustee provisions, combine multiple trusts, separate trusts, avoid a beneficiary’s disqualification from receiving public benefits, and create or terminate grantor trust status. These reasons for decanting will be discussed further below.
Extend the Terms of a Trust
A trust that provides for mandatory distributions of principal to beneficiaries at various ages during their lifetimes may expose the beneficiaries to estate tax or the claims of creditors once distributed. By decanting the trust assets to a new trust with an extended term, such as a dynasty trust, the tax and creditor concerns can be avoided, and the new trust can now benefit multiple generations of beneficiaries, subject to any state rule against perpetuities. By way of further example, a trustee also may believe that it is inappropriate for a primary beneficiary to receive an outright distribution of trust principal at age 30 because of immaturity or other reasons. The trustee may choose to decant the assets of the original trust to a new trust that extends distributions to the beneficiary for his lifetime.
Reflect Changes or Clarifications in the Law That Affect the Trust Instrument
Decanting allows a trustee to update trust provisions to reflect changes or clarifications in the law governing the trust instrument. Thus, if federal or state law should change or be clarified, or new law should develop, after a trust instrument becomes operative, the trustee may decant some or all of the assets of an original trust to a second trust in order to reflect the change in law or the enactment of new law.
Protect the Trust Assets from the Beneficiary’s Creditors
A support trust distributes assets to a beneficiary based on a trustee’s limited discretion, such as for the beneficiary’s health, education, maintenance, or support (an ascertainable standard). Under applicable state law, such distributions may be subject to the claims of creditors. A trustee may elect to decant the trust assets from the original support trust to a new discretionary trust, empowering the trustee with absolute discretion in making distributions to the beneficiary, in an effort to protect the trust assets (and the beneficiary) from creditors. Decanting also can be used to add a spendthrift provision, missing from the original trust, to the new trust.
Correct Drafting Errors and Clarify Ambiguous Terms
Drafting errors and ambiguities often are identified after (sometimes many years after) a trust has become effective. Decanting can be used to correct errors and clarify ambiguities in the original trust.
Address a Beneficiary’s Change in Circumstances
A trustee may decide to decant to address a beneficiary’s changed circumstances. Changed circumstances may include a beneficiary’s financial distress, alcohol or substance abuse, and creditor or marital problems. For example, a parent funds an irrevocable trust that is intended to benefit his two children equally. After the parent’s death, one child becomes addicted to alcohol and the other is diagnosed with a chronic disease, which will be financially burdensome to the child. In light of this unforeseen change in circumstances, the trustee may elect to decant the existing trust into a new trust, so that the child afflicted with addiction receives smaller distributions and the child experiencing financial distress receives larger distributions.
Move the Trust to a State with More Favorable Laws or Amend the Governing Law Provision
The grantor may have established an irrevocable trust in a state with unfavorable tax laws or creditor protection laws. As long as the trust permits, or does not prohibit, a change in situs, this problem can be addressed by decanting the trust assets into a new trust established in a state with more favorable laws. For example, if income is being retained by an irrevocable trust, and the trust situs is in a state with high income tax rates (such as California), decanting would allow the trust assets to be transferred to a new trust with a situs in a state having a more favorable income tax rate or no income tax (such as Florida or Nevada). The trustee also might change the governing law provision in the original trust, by way of the second trust, to reflect the state with the more favorable law. In order to establish the necessary nexus with the desired state, however, a trustee would need to be appointed in that state.
Grant Powers of Appointment
An irrevocable trust may not contain a power of appointment, which would empower the powerholder to alter the succeeding interests of the beneficiaries and how they get the property. Decanting can grant those powers to a beneficiary in the new trust, which will be particularly useful if the trust will benefit several generations. Upon creating a trust, the grantor likely will not know the circumstances that may confront future generations of beneficiaries. By giving a beneficiary a power of appointment, that beneficiary will be able to assess the situation at any given point in time in the future and decide whether to alter the distribution of trust assets in order to satisfy the existing needs of the beneficiaries. In addition, with the estate tax exemption at such a high level and income tax savings becoming more significant, a general power of appointment possessed by a beneficiary at death will cause the trust assets to receive a stepped-up basis for income tax purposes.
Change Trustee Provisions
Decanting can be used to amend or update trustee provisions, so as to allow a trustee to delegate certain tasks or decisions to a co-trustee or to appoint a successor trustee or co-trustee. For example, the new trust could permit the appointment of a professional trustee to make decisions regarding the investment of trust assets, so as to relieve the existing, less sophisticated, individual trustee from having to be concerned with those decisions.
Combine Multiple Trusts
Trust decanting may be useful to combine multiple trusts in order to ease or simplify trust administration, lessen the oversight of the trusts and the cost of administering them, or merely to consolidate the investment assets, or other property, in the separate trusts.
Decanting also may be used to divide or segregate the trust assets in the original trust into separate trusts. A single pot trust can cause problems when there are multiple beneficiaries with differing needs and views on how to administer the trust. By decanting the original trust into separate trusts for each beneficiary, the trustee will ensure that each trust is tailored to the needs of each beneficiary, those needs are satisfied, and each trust is efficiently administered.
Avoid a Beneficiary’s Disqualification from Receiving Public Benefits
If an irrevocable trust requires distributions to a beneficiary receiving public benefits, pursuant to an ascertainable standard or some other limited manner, so as to be an available resource to the beneficiary, the beneficiary’s eligibility for those benefits may be jeopardized. In an effort to avoid the beneficiary’s disqualification from receiving public benefits, the original trust can be decanted to a special needs trust. For example, a parent creates an irrevocable trust for her then-living three children, with each of the children to receive an outright distribution of his or her equal share of the trust assets at age 30. Any distributions from the trust, prior to the children reaching the age of 30, are within the absolute discretion of the trustee. After the establishment of the trust, and prior to his 30th birthday, one of the grantor’s sons is involved in an accident, leaving him totally disabled. As a result of the disability, the son receives SSI and Medicaid benefits. The distribution of the trust assets allocated to the disabled son at age 30 will cause him to exceed the asset limit for public benefits and disqualify him from receiving those benefits. In advance of the son’s 30th birthday, the trustee of the original trust may utilize a decanting power by appointing the son’s share of the trust assets to a second trust, which will be established as a special needs trust, so as to allow the son to continue receiving public benefits.
To Create or Terminate Grantor Trust Status
A trustee also may be able to utilize the decanting power to convert a grantor trust to a non-grantor trust, or vice versa, for income tax purposes. This strategy may be implemented to achieve income tax savings. For example, certain states do not impose a tax on income and capital gains accumulated in a trust that ultimately will be distributed to beneficiaries residing out of state. A trustee may decant trust assets from a grantor trust to a non-grantor trust, so as to reduce or eliminate any state income tax on the income and capital gains accumulated in the original grantor trust. Decanting also may be utilized to convert a grantor trust to a non-grantor trust when the grantor is no longer able to pay the income tax resulting from the grantor trust.
Authority for, and Scope of, the Power
If the need should arise, where does a trustee obtain the authority or power to decant trust assets from the original trust to a new trust? The first place to look for decanting authority is the trust instrument itself to ensure that the grantor has not expressly prohibited the use of the power. If the trust instrument itself does not explicitly prohibit or authorize decanting, or does not afford the trustee the absolute, unfettered, or sole discretion to invade principal for a beneficiary, many states have enacted decanting statutes to address those situations in which an irrevocable trust needs to be modified. If the state governing the trust at issue does not have a statute addressing decanting, the common law of the state may authorize the power. In those states where there is no case law recognizing the power, the non-statutory basis for the power might be subject to challenge. This section will examine these forms of decanting authority and their scope.
The Trust Instrument
An irrevocable trust may expressly authorize the power to decant. To invoke the power, the trustee of the original trust must satisfy the requirements of the decanting provision set forth in the trust. Even if the original trust lacks a specific decanting provision, the trustee may be able to justify a decision to decant if the appropriate distribution standard is authorized under the trust, for example, unlimited or absolute discretion. In general, if the trustee has the absolute, unfettered, or sole discretion to invade principal of the original trust for the benefit of a beneficiary, the trustee should be able to appoint the trust property to a new trust, with different terms from the original trust, for one or more beneficiaries for whom the trustee of the original trust was empowered to invade principal. If decanting is not expressly prohibited, and explicit authority for the appropriate distribution standard for decanting is not found in the trust instrument, then state law needs to be reviewed.
Decanting under the authority and parameters of a state statute may be the safest and surest method of decanting, so long as the original trust instrument does not expressly prohibit decanting. As of 2018, 26 states have enacted statutes authorizing the trustee of an irrevocable trust to distribute trust assets from an existing trust to a new trust, each with its own limitations, structure, and procedure, which may, or may not, be similar to those in other states. The states with trust decanting statutes are Alaska, Arizona, Colorado, Delaware, Florida, Georgia, Illinois, Indiana, Kentucky, Michigan, Minnesota, Missouri, Nevada, New Hampshire, New Mexico, New York, North Carolina, Ohio, Rhode Island, South Carolina, South Dakota, Tennessee, Texas, Virginia, Wisconsin, and Wyoming. This section will examine, and compare and contrast, some of the more significant aspects of the New Hampshire and New York decanting statutes.
New Hampshire. N.H. Rev. Stat. Ann. § 564-B:4-418. New Hampshire’s decanting statute became effective in 2008. It provides that, subject to the limitations set forth in the statute, a trustee has the power to decant a trust, which is the power to appoint some or all of the trust property of a first trust to a second trust. The trustee’s power in this regard is deemed to be an administrative matter of the trust. The required distribution standard and power to decant, the permissible beneficiaries of the second trust and beneficiary rights, the duty to decant and trustee provisions, the special needs trust exception, the tax savings provisions, and procedural requirements will be discussed below.
The Required Distribution Standard and Power to Decant. Under New Hampshire’s decanting statute, there is no requirement, as there is in some states, that the trustee have absolute discretion to distribute trust principal to one or more beneficiaries for reasons other than administrative changes. As such, a trustee is allowed to decant, even if the distribution power in the first trust is limited by an ascertainable standard such as health, education, maintenance, and support. Moreover, there is no requirement that the trustee have any discretionary distribution authority with regard to the distribution of principal or income. There is also no requirement that the distribution standard in the second trust be the same as the first trust, with the exception of charitable trusts.
The trustee is not prevented from decanting solely because the first trust is irrevocable, the terms of the first trust state that it cannot be modified or amended, or the first trust contains a spendthrift provision. As noted above, decanting is not prohibited merely because, under the terms of the first trust, the trustee has no discretion in distributing income or principal to the beneficiaries, or the trustee’s discretion to distribute principal and income is subject to a standard.
A trustee’s power to decant under the statute can be expanded, restricted, terminated, or otherwise altered by the terms of the trust instrument. Except as otherwise stated in the trust, a trustee’s power to decant is in addition to any powers granted by the terms of the trust, the New Hampshire Trust Code, and New Hampshire law. However, the trustee is not permitted to decant to the extent that the terms of the second trust are inconsistent with a material purpose of the first trust.
Permissible Beneficiaries of the Second Trust and Beneficiary Rights. There is no requirement under the statute that the beneficiaries of the second trust be the same as those of the first trust. The beneficiaries of the second trust may include only one or more of the beneficiaries of the first trust. Correspondingly, the second trust may exclude one or more beneficiaries of the first trust. Furthermore, the current distributees and current permissible distributees of the second trust may include one or more persons who, under the terms of the first trust, are not current distributees or current permissible distributees, but would be distributees or permissible distributees upon the happening of a future date or event.
The second trust may not reduce or eliminate a beneficiary’s current right to a mandatory distribution of income or principal, a mandatory annuity or unitrust interest, a currently exercisable withdrawal power, or a non-contingent, unconditional right to receive an ascertainable portion of the trust principal upon the first trust’s termination. The statute is silent, however, as to whether a remainder beneficiary’s interests may be accelerated.
The Duty to Decant and Trustee Provisions. The trustee does not have a duty to decant or an ongoing duty to consider whether to decant. In utilizing the power to decant, however, the trustee must exercise the power in a fashion that is in accord with the grantor’s intent as expressed in the terms of the trust and act in accordance with the trustee’s duties under the New Hampshire Trust Code and the provisions of the first trust.
An interested trustee is prohibited from decanting, unless the second trust imposes the same limitation on the trustee’s discretion to make distributions to himself or herself under the first trust. In addition, a trustee cannot decant if she can be removed and replaced by a beneficiary with a related or subordinate party, who will have discretion to make distributions to the trustee not subject to an ascertainable standard.
Special Needs Trust Exception. If a beneficiary or the grantor is receiving public benefits, the trustee can decant only to the extent the decanting will not jeopardize the beneficiary or grantor’s qualification for those benefits.
Tax Savings Provisions. If the grantor’s transfer to the first trust qualified for a deduction, credit, exclusion, or exemption for purposes of any income, gift, estate, or generation-skipping transfer tax, then the trustee may decant only to the extent that the decanting will not jeopardize that deduction, credit, exclusion, or exemption.
Procedural Requirements. The New Hampshire statute has minimal procedural requirements for decanting. The trustee has no duty to notify a beneficiary of a non-charitable trust before decanting. Furthermore, the trustee has the power to decant without court approval, the consent of the grantor, or the consent of any of the beneficiaries of the first trust. The trustee or any other interested person, however, may seek court approval of the trustee’s exercise of the power to decant.
New York. N.Y. Estate Powers & Trusts § 10-6.6. New York enacted the nation’s first decanting statute in 1992. The statute is essentially divided into three categories: (1) the rules that apply when the authorized trustee (“trustee”) has unlimited discretion; (2) the rules that apply when the trustee does not have unlimited discretion; and (3) the rules that apply to both (1) and (2). A trustee’s exercise of the power to decant under the statute is considered to be the exercise of a special power of appointment.
As with the New Hampshire statute, the required distribution standard and power to decant, the permissible beneficiaries of the second trust and beneficiary rights, the duty to decant and trustee provisions, the special needs trust exception, the tax savings provisions, and procedural requirements will be examined below.
The Required Distribution Standard and Power to Decant. Unlike the New Hampshire statute, the New York statute makes a distinction between a trustee with unlimited discretion and one with limited discretion. In New York, a trustee with unlimited discretion to invade principal may appoint some or all of that principal to a second trust for the benefit of one, more than one, or all of the current beneficiaries of the first trust. The successor and remainder beneficiaries of the second trust may be one, more than one, or all of the successor and remainder beneficiaries of the first trust. In contrast, a trustee with the power to invade trust principal with limited discretion may appoint some or all of the principal of the first trust to a second trust, but only if the current beneficiaries of the second trust are the same as the current beneficiaries of the first trust, and the successor and remainder beneficiaries of the second trust are the same as the successor and remainder beneficiaries of the first trust. Thus, for example, if the trustee is required to distribute principal to the grantor’s son and daughter for their health, education, maintenance, and support for their lives with the remainder to their issue, the second trust must designate the son and daughter as current beneficiaries and their issue as remainder beneficiaries.
Like the New Hampshire decanting statute, the trustee has the power to decant under the New York statute, unless expressly prohibited by the first trust. A general prohibition against amendment or revocation of the first trust, however, or a spendthrift provision in the first trust, will not preclude the trustee from exercising the power to decant.
Permissible Beneficiaries of the Second Trust and Beneficiary Rights. Where the trustee has unlimited discretion, the statute expressly permits the trustee to decant in favor of one, more than one, or all of the current beneficiaries. As a result of having the discretion to decant in favor of fewer than all beneficiaries, the trustee has the power to exclude some current beneficiaries from distributions under the second trust. In addition, the second trust may benefit one, more than one, or all of the successor and remainder beneficiaries. As such, remainder beneficiaries’ interests cannot be accelerated. As with current beneficiaries, since the trustee can benefit fewer than all of the successor and remainder beneficiaries, the trustee has the power to exclude some successor and remainder beneficiaries from distributions under the second trust.
As noted above, when the trustee does not have unlimited discretion, the second trust must have the same current, successor, and remainder beneficiaries as the first trust. The second trust also must contain the same language, authorizing the trustee to distribute the income or invade the principal, as in the first trust. If, however, the trustee exercises the power under the statute to extend the term of the second trust beyond the term of the first trust, the second trust may include language providing the trustee with unlimited discretion to invade the principal of the second trust during the extended period.
As is the case in New Hampshire, a trustee is prohibited under the New York statute from decanting if it has the effect of reducing, modifying, or limiting any beneficiary’s right to a mandatory distribution of income or principal, a mandatory annuity or unitrust interest, a right to withdraw a percentage of the value of the trust, or a right to withdraw a specified dollar amount, but only if the mandatory right is effective with respect to the beneficiary.
Irrespective of whether the trustee has unlimited or limited discretion, if the beneficiary or beneficiaries of the first trust are described as a class, the beneficiary or beneficiaries of the second trust may include present or future members of that class.
The Duty to Decant and Trustee Provisions. As in New Hampshire, nothing in the New York statute imposes a duty on the trustee to decant. In exercising the power, however, the trustee must act in the best interests of the beneficiaries and as a prudent person would under the existing circumstances. The trustee cannot exercise the power if there is substantial evidence that the grantor would have a contrary intent and it cannot be demonstrated that the grantor would have changed such intention under the existing circumstances at the time of the trustee’s exercise of the power. The provisions of the first trust alone will not constitute substantial evidence of the grantor’s intent, unless the first trust expressly prohibits the exercise of the power in the manner contemplated by the trustee.
Trustee, as defined under the New York statute, excludes the grantor of the trust and a beneficiary to whom income or principal must be paid or who is, or will become, eligible to receive such a distribution. A trustee may not decant in order to decrease or indemnify against the trustee’s liability or to exonerate a trustee from liability for failure to exercise reasonable care, diligence, and prudence. Unless a court orders to the contrary, the trustee also may not decant to eliminate a provision granting another person the right to remove or replace the trustee. A trustee cannot receive a commission or other compensation for decanting trust property from the first trust to the second trust. The trustee also cannot decant to change the trust provisions relating to the trustee’s compensation.
Special Needs Trust Exception. The New York decanting statute, like the New Hampshire statute, allows a trustee, subject to compliance with the other provisions of the statute, to decant to a second trust that is a supplemental needs trust, so as to not jeopardize a beneficiary’s eligibility for public benefits.
Tax Savings Provisions. The trustee is required to consider the tax implications of decanting under the statute. Like New Hampshire, a trustee is not allowed to decant if it has the effect of jeopardizing any deduction, including the marital and charitable deductions, or exclusion, including the annual gift tax exclusion, under the Internal Revenue Code, or any other specific tax benefit for which a contribution to the first trust originally qualified under the Code, for purposes of income, gift, estate, or generation-skipping transfer tax.
Procedural Requirements. The procedural requirements of the New York decanting statute are much more rigorous than the New Hampshire statute. Under the New York statute, irrespective of whether the trustee is operating under unlimited or limited discretion, the trustee’s exercise of the power to decant must be evidenced by a written instrument, signed, dated, and acknowledged by the trustee. The trustee can exercise the power without the consent of the grantor or the persons interested in the first trust and without court approval. However, if trustee elects to seek court approval for the exercise of the power, notice must be provided to all persons interested in the first trust. The trustee also is required to deliver a copy of the instrument exercising the power, along with copies of the first and second trusts, to the grantor of the first trust, if living, any person having the right, pursuant to the terms of the first trust, to remove or replace the trustee exercising the power under the statute, and to any persons interested in the first trust and the second trust, by certified mail-return receipt, by personal delivery, or as by directed by a court having jurisdiction over the first trust. The instrument exercising the power is required to state whether the decanting involves all, or part, of the principal of the first trust, and, if part, the approximate percentage of the value of principal that is the subject of the decanting.
A person interested in the first trust has the right to object to the trustee’s exercise of the decanting power by serving a written notice of objection on the trustee before the effective date of the exercise of the power. The failure to object, however, does not constitute consent. An interested person’s receipt of a copy of the instrument exercising the power does not affect her right to compel the trustee to account for the use of the power and does not foreclose him or her from objecting to an account or compelling a trustee to account. A copy of the instrument exercising the decanting power is required to be kept with the records of the first trust, and, within 20 days of the effective date, the original instrument must be filed with court having jurisdiction over the first trust. Before the effective date, the trustee may revoke the exercise of the power. In revoking the power, the trustee must furnish notice of the revocation to the interested persons in the same manner by which the trustee furnished notice of the exercise of the power. If the notice of exercise of the power was filed with the court, the trustee must file the notice of revocation with that court.
With half of the states not having decanting statutes, the question arises as to whether there is a common law right for a trustee to exercise the power of decanting in those states. The Restatement (Second) of Property: Donative Transfers (the “Second Restatement”) and the Restatement (Third) of Property: Wills & Other Donative Transfers (the “Third Restatement”) lend support for the concept of decanting. There is also case law in certain states specifically recognizing the power, including Florida and Massachusetts. The Florida and Massachusetts decisions viewed the power of a trustee to appoint in trust as a special power of appointment, which, by extension, absent a contrary intent by the grantor, translates into a power to decant within the original trust instrument. While decanting may be allowed under common law in some states, like Massachusetts, unless the state has enacted a detailed statute, like the state of New York discussed above, the trustee will lack clear guidance as to the scope of the power, including any procedure for exercising the power, which may cause the trustee to seek guidance from the court (as was the case in the Florida and Massachusetts decisions). This section of the article will examine the Second and Third Restatements and case law decided in Florida and Massachusetts.
Restatement of Property
Although not referred to as the power of decanting, the concept for the power can be found in both the Second and Third Restatements, which provide that, unless the trust instrument creating the power provides otherwise, a trustee’s power to make discretionary distributions constitutes a special power of appointment, which enables the trustee to make distributions in trust for permissible distributees and create powers of appointment in these distributees over the trust property. Thus, if a trustee is able to transfer full legal title to trust property to a beneficiary, it follows, by extension, that the trustee should be empowered to transfer less than full legal title by distributing the property further in trust, which translates to the power to decant.
Florida Case Law. The power to decant existed under Florida common law long before its decanting statute was enacted in 2007. One of the first cases to consider decanting and one of the most often cited is Phipps v. Palm Beach Trust Co., 196 So. 299 (Fla. 1940). In Phipps, the grantor created a trust for the benefit of her children and their descendants. The grantor named her husband and a trust company as co-trustees. The trust provided that the husband, “in his sole and absolute discretion,” could distribute the trust corpus to any and all of the beneficiaries. Subsequently, the grantor’s husband directed the corporate trustee to transfer the trust property to a second trust, which had slightly different terms. The corporate trustee petitioned the court for a determination as to whether the grantor’s husband possessed the power to appoint the trust property in further trust. The court ruled in favor of the husband, and the corporate trustee appealed. The Florida Supreme Court determined that, because the husband could only distribute the trust corpus to the grantor’s descendants, he possessed a special power of appointment not a general power. The corporate trustee asserted that the husband could not appoint the trust property to a second trust because the trust did not expressly authorize him to do so. The court found that the grantor had “clothed him [her husband] with the absolute power to administer and dispose of the trust estate to any one of the named beneficiaries to the exclusion of others.” Consequently, the court held that the trust granted the husband with the power to distribute the trust property to a second trust, so long as one or more of the grantor’s descendants were named as beneficiaries.
Massachusetts Case Law. In Morse v. Kraft, 992 N.E.2d 1021 (Mass. 2013), the Massachusetts Supreme Judicial Court (SJC) validated the power of decanting. In Morse, the grantors created a trust with four sub-trusts for each of their four minor sons. The trust authorized a disinterested trustee to make distributions to each of the sons from their respective trusts, and the sons were not permitted to participate in any distribution decisions. The trustee, who was advancing in age and preparing to retire, sought to transfer all of the property in the original sub-trusts to new sub-trusts, so that the sons, who were now in their forties, could serve as trustees and manage the assets within their respective trusts. Given that the trust did not expressly authorize the trustee to decant, and Massachusetts had not (and has not) enacted a decanting statute, and concerns over whether the transfer of the trust property from the original sub-trusts (established in 1982) to the new sub-trusts (established in 2012) or distributions from the new sub-trusts, would trigger the generation-skipping transfer tax, the trustee petitioned the SJC, seeking a declaration that the trust language permitted him to decant without court approval or the consent of the sons. The SJC agreed. Relying on similar trust language in Phipps and decisions in other jurisdictions, because the trust gave the trustee broad discretionary powers to make an outright distribution to, or for the benefit of, the sons, the SJC held that such discretion included the power to distribute to a new trust, so long it was in the sons’ best interests. In reaching its decision, the SJC considered not only the terms of the trust, but also the affidavits of the grantor, the drafter, and the trustee, who all supported an intent to decant. The SJC, however, refused to recognize an inherent power to decant and also cautioned that, in the absence of legislation expressly authorizing the power, if a grantor wants a trustee to have the power to decant, the power should be clearly stated in the trust instrument.
Subsequently, the SJC, in Ferri v. Powell-Ferri, 72 N.E.3d 541 (Mass. 2017), once again addressed the propriety of decanting. This time, unlike in Morse, the issue was addressed after the trustees already had decanted the trust assets from the original trust to the new trust. In Ferri, the grantor established an irrevocable trust in Massachusetts in 1981for the sole benefit of his son. Under the terms of the trust, upon reaching various ages, the son had the power to withdraw certain percentages of the trust corpus. In 1995, the son married his wife. Fifteen years later, in 2010, the son’s wife initiated a divorce action against the son in Connecticut. After the divorce action was filed, the trustees of the trust decanted the trust assets to a new trust without advising, or obtaining the consent of, the son. At the time of the decanting, the son had the right to withdraw 75 percent of the trust assets. It was clear that the decanting occurred as a result of the trustees’ concern that the wife could access the assets in the original trust through the divorce action, so the new trust eliminated the son’s withdrawal rights by affording the trustee complete authority over whether, and when, to make payments to the son, if at all, with the son having no power to demand payment from the trust. In 2011, the trustees of the original trust filed a declaratory judgment action against the wife in Connecticut state court, seeking a declaration that the trustees validly decanted the trust assets from the original trust to the new trust and that the wife had no interest in the new trust. Ultimately, the Connecticut Supreme Court certified questions to the SJC, including whether, under the governing Massachusetts law, the original trust instrument authorized decanting. The SJC concluded that it did, noting that the original trust instrument, which did not explicitly authorize decanting, had more expansive trustee discretion than the broad discretion the court previously recognized in Morse. Accordingly, the grantor’s intention to permit decanting would seemingly follow. As Chief Justice Ralph Gants made clear in his concurring opinion, however, the SJC did not address whether Massachusetts law would allow trustees, from a public policy standpoint, to decant from a non-spendthrift trust to a new spendthrift trust for the sole purpose of removing trust assets from the marital property of a beneficiary and his or her spouse in a divorce proceeding.
Fiduciary Duty and Tax Implications
Fiduciary Duty Implications
A trustee owes fiduciary duties to beneficiaries of a trust, including: (1) the duty to be generally prudent; (2) the duty to carry out the terms of the trust; (3) the duty to be loyal to the trust and its beneficiaries; (4) the duty to give personal attention to trust affairs; and (5) the duty to account to trust beneficiaries. The trustee, in considering decanting, needs to be concerned with the effect that the exercise of the power will have on the trustee’s fiduciary duties. One duty that can have particular significance when a trustee elects to decant is the duty of loyalty. Pursuant to this duty, the trustee must act solely in the best interests of the beneficiaries and remain fair and impartial with respect to their collective interests. Decanting to make purely administrative modifications to the original trust should not adversely affect the trustee’s duty of loyalty. A trustee may breach the duty of loyalty by decanting to permit self-dealing, for example, to obtain increased compensation. The New Hampshire and New York decanting statutes discussed above contain specific provisions that prevent the trustee from decanting to benefit the trustee.
In addition, if the decanting will result in a preference of one beneficiary over another or a shift in the interests of one or more beneficiaries, the trustee could be accused of breaching the duty of loyalty and acting arbitrarily. Because of the exposure to liability, a trustee may be reluctant to decant if there is concern that the trust beneficiaries later will question the exercise of the power. In an effort to avoid liability, the trustee may attempt to obtain a release and indemnification from the beneficiaries, an indemnification from the grantor, or court approval. As discussed further below, implementing one or more of these options to protect against liability could have adverse tax ramifications. Notwithstanding the liability concerns, however, a trustee may be able to derive some degree of comfort in the fact that courts will generally defer to a trustee’s discretion, absent an abuse of discretion or bad faith, when acting pursuant to a discretionary authority (a higher standard) granted under a trust instrument.
Before exercising the power to decant, a trustee should carefully consider the resulting tax consequences, if any. Below is a brief survey of some of the basic income, gift, estate, and generation-skipping transfer (GST) tax issues that can arise in connection with decanting.
Income Tax. Decanting should result in income tax consequences only if there is a sale or exchange of property, and the exchange or sale results in the receipt of property significantly different from the property exchanged. The decanting from one domestic trust to another should not result in a sale or exchange of property for income tax purposes. If the entire trust corpus is transferred to another trust, the new trust seemingly would be the same trust as the original trust, which should result in the transfer being disregarded for income tax purposes. A transfer of trust assets from one grantor trust to another, which is taxed to the same grantor, should not create any income tax issues. Also, the conversion from a non-grantor trust to a grantor trust should not result in any income tax consequences. If a trust has assets with liabilities that exceed the basis, a decanting that converts a grantor trust to a non-grantor trust may result in the grantor recognizing gain to the extent the liabilities exceed the basis. It is possible that gain will be recognized when negative basis assets (where trust property is subjected to a liability that exceeds its basis) are decanted. Gain may also be recognized by a beneficiary if decanting changes the nature of the beneficiary’s interest in the trust and the beneficiary must consent to (or a court approve) the exercise of the power.
Gift Tax. When the trustee is a beneficiary, the trustee-beneficiary’s exercise of the decanting power can result in gift tax consequences. As such, a trustee who is a beneficiary should not exercise the power. In addition, a taxable gift could result from a decanting if a beneficiary’s consent is required or the beneficiary, in fact, consents to a decanting that results in a dilution or forfeiture of the beneficiary’s interest in the trust. If a beneficiary’s consent is not required in order to decant, and the beneficiary does not have a present right to receive property from the trust, there should be no gift tax issues resulting from the trustee’s exercise of the power. In addition, if a beneficiary has the same interest in the original trust and the new trust, there should no gift tax consequences, even if the beneficiary does not consent.
Estate Tax. From an estate tax perspective, a concern arises as to whether the mere utilization of a state-authorized decanting power might form the basis for a determination that the grantor retained a power to change or revoke when he or she created the “irrevocable trust,” thereby causing the trust assets to be included in his or her estate under IRC § 2038. Beneficiaries also will be subject to the risk of estate inclusion to the extent they had sufficient control over trust assets, so as to fall within IRC § 2036 or § 2038.
GST Tax. Trusts that became irrevocable on or before September 25, 1985 are exempt from GST tax (grandfathered status). A trustee needs to be concerned that decanting might be viewed as an addition or modification to such a trust, which causes it to lose its exempt status. The status will not be lost so long as the trust is not modified in a way that the vesting of the beneficiaries’ interests in the trust is extended beyond any life in being at the creation of the trust plus 21 years. The trustee’s exercise of a discretionary power to distribute trust property to a second trust will not result in a loss of grandfathered status if (1) the power is authorized under the terms of the trust instrument or (2) the power is authorized by state law that was in effect when the trust instrument became irrevocable. With respect to non-grandfathered trusts, where the grantor allocated GST exemption to the trust, the same safe harbors for exempt trusts referenced above should apply. In addition, if decanting does not alter a beneficial interest in the trust to a beneficiary at a lower generational level or extend the time for vesting, then the decanting should not result in a change to the inclusion ratio of the trust.
The power to decant, with its many purposes, can be a valuable tool for a trustee of an irrevocable trust. A trustee considering the use of the power needs to determine whether there is authority for the power and, if so, its scope. If the authority exists, the trustee must consider the fiduciary duty and tax implications before exercising the power.