Author’s Synopsis: The proliferation of long-term generation-skipping trusts in recent years has been fueled by three converging trends. First, the ever-expanding GST exemption provides a powerful federal tax incentive to create such trusts. Second, the demise of the common-law rule against perpetuities invites the creation of trusts designed to last for 1,000 years or longer. Third, the enactment of trust decanting laws at the state level allows trustees to extend the duration of irrevocable generation-skipping trusts within the limits set forth in the federal GST tax regulations. This article examines the interaction of permissive state perpetuities and decanting laws. While the existing GST tax regulations are reasonably effective in curbing extensions of pre-1986 grand-fathered trusts, the article argues that amendments will be needed to impose meaningful restrictions on the duration of newly created exempt trusts.
For many years estate planners have advised their clients to create trusts that confer broad powers of administration and distribution on the trustee for the benefit of two or more generations of family members. Even before the advent of the federal generation-skipping transfer (GST) tax, such trusts were routinely designed to shelter property from gift and estate taxes throughout the trust term. Although the settlor incurred an initial gift or estate tax upon creation of the trust, the beneficiaries’ interests and powers were tailored to ensure that no further taxable transfers occurred while the property was held in trust or upon distribution to the beneficiaries. Thus, it was widely recognized that extending the duration of a generation-skipping trust increased the resulting gift and estate tax savings. The major barrier to perpetual tax avoidance was the rule against perpetuities, which generally required that the beneficiaries’ interests become vested or fail within an ascertainable period—lives in being plus twenty-one years—from the creation of the trust.
The enactment of the GST tax in 1986 marked a watershed in the taxation of family trusts. As its name implies, the GST tax reaches generation-skipping transfers that would otherwise escape gift and estate taxation, including distributions to younger-generation beneficiaries and terminations of the interests of intermediate-generation beneficiaries. At the same time, however, Congress provided a GST exemption, originally set at $1 million per transferor, which can be freely allocated to property transferred during life or at death. As a result, a generation-skipping trust initially funded with property equal to the amount of the GST exemption can escape GST tax for the maximum trust term allowed under applicable state law. Unsurprisingly, this highly visible tax incentive has sparked keen interest in long-term trusts among estate planners and their clients, trust companies, investment advisers, and state legislatures seeking to attract private trust capital.
Three trends have emerged since 1986 to transform both the federal taxation of generation-skipping trusts and the state law governing trust creation and administration. The first important development is the dramatic increase in the amount of the GST exemption, from $1 million in 2002 to nearly $13 million in 2023, which has amplified the incentive to create long-term trusts that are fully exempt from GST tax. Because the GST exemption is set equal to the “basic exclusion amount” allowed as an estate tax exemption, the GST tax may be viewed as an incidental target of a broader campaign aimed primarily at repealing the federal estate tax. The second major development is the decline of the rule against perpetuities as a significant limitation on the duration of private trusts. State legislatures have rushed to enact legislation allowing settlors to tie up property in trusts far longer than the traditional period of lives in being plus twenty-one years. Interestingly, only a few states have simply abolished the rule against perpetuities; most states have retained some version of the rule in a form that is designed to avoid unwanted tax consequences without imposing any meaningful limitation on dead hand control. The third recent development is the enactment of trust decanting statutes that authorize trustees to modify irrevocable trusts without court approval or beneficiary consent. Many of these statutes expressly allow the original term of an existing trust to be extended to take advantage of a longer perpetuities period under applicable state law.
This Article examines the interplay of permissive state perpetuities and decanting laws with the increased federal GST tax exemption in encouraging well-advised settlors to extend the duration of family trusts and maximize the resulting tax savings. Part II introduces the relevant federal transfer tax provisions, including the GST tax, and Part III provides a brief overview of state perpetuities law, including the Uniform Statutory Rule Against Perpetuities (USRAP). Part IV explores the impact of recent changes in perpetuities statutes on the taxation of generation-skipping trusts, and Part V discusses the use of trust decanting to extend the duration of trusts. Part VI provides a summary and conclusion.
At least since the enactment of the modern estate tax in 1916, well-to-do settlors have created trusts to shelter property from the estate tax, which reaches deathtime transfers of property (as well as lifetime transfers that are deemed to occur at death for estate tax purposes). Moreover, lifetime transfers that remove property from the gross estate are generally subject to gift tax, with the result that a settlor’s cumulative taxable transfers, whether made during life or at death, are subject to tax under a unified rate schedule. Gift and estate taxes are offset by a unified credit, which functions as an exemption for taxable transfers up to a specified dollar amount. The exemption has increased more than tenfold in recent years, from $1 million in 2002 to nearly $13 million in 2023, relieving all but the richest 0.1% of decedents from estate tax liability.
The creation of an irrevocable trust is subject to gift or estate tax in much the same way as an outright gift or bequest. After the initial taxable event, however, the property held in trust generally will not be exposed to another round of gift or estate taxes throughout the trust term, even as successive generations of beneficiaries receive distributions of income and corpus. Trusts routinely grant broad discretionary powers to the trustee and limited invasion powers and special powers of appointment to the beneficiaries, thereby preserving sufficient flexibility to adjust to individual needs and changing circumstances while avoiding transmissible interests or general powers that might trigger a gift or estate tax on the underlying trust property. In this way, trusts facilitate avoidance of the gift and estate taxes that would otherwise be imposed on outright transfers of property directly from one generation to the next. Prior to the advent of the GST tax, the major constraint on this type of tax avoidance arose from the rule against perpetuities under state law. By prohibiting the remote vesting of future interests, the rule generally ensured that all of the beneficial owners of trust property would be ascertained no later than twenty-one years after lives in being at the creation of the trust. Because those owners would be able to terminate the trust by unanimous consent, the rule indirectly limited the duration of private trusts.
The GST tax is imposed on transfers to beneficiaries who are more than one generation removed from the transferor. The GST tax functions as a backstop to the gift and estate taxes in the sense that it is aimed primarily at transfers that fall outside the reach of those taxes. As applied to trusts, the GST tax reaches distributions of income or corpus to younger-generation beneficiaries as well as terminations that shift beneficial enjoyment of trust property from intermediate-generation beneficiaries to younger-generation beneficiaries. Thus, the GST tax goes a long way toward closing the gap that allowed generation-skipping trusts to avoid gift and estate taxes under prior law. In enacting the GST tax, however, Congress included two provisions that have materially limited the scope of the tax. The first limitation involves the effective date of the 1986 Act. The GST tax generally applies to generation-skipping transfers made after October 22, 1986, the date of enactment, as well as to inter vivos transfers made after September 25, 1985, but a special grandfather rule provides immunity from the GST tax for preexisting trusts that were irrevocable on September 25, 1985. Such grandfathered trusts may remain exempt from GST tax (and any further gift or estate taxes) for as long as they remain in existence under applicable state law.
The second major limitation on the scope of the GST tax is the GST exemption allowed to each transferor. The GST exemption, originally capped at $1 million, has been set equal to the estate tax exemption since 2002, and since then both exemptions have increased in tandem to reach their current level of nearly $13 million. Unlike the estate tax exemption, which applies automatically to taxable transfers in chronological order, the GST exemption can be freely allocated to property transferred during life or at death, including property held in trust. An allocation of GST exemption to a trust directly affects the inclusion ratio—and hence the applicable rate of GST tax—for generation-skipping transfers occurring with respect to the trust throughout its existence. For example, if a transferor allocates $1 million of GST exemption to a newly created trust funded with $1 million of property, any taxable distributions or taxable terminations during the trust term will be subject to a zero rate of GST tax. In effect, the trust will be completely exempt from GST tax throughout its existence, even if the trust property appreciates to many times its original value. Thus, the GST exemption creates a powerful tax incentive to create trusts that will last as long as possible under applicable state law, to fund those trusts with property that is likely to appreciate substantially over time, and to allocate sufficient GST exemption to produce a zero rate of GST tax for the trust. In enacting the GST tax in 1986, Congress was undoubtedly aware that taxpayers would strategically exploit the GST exemption, but no one predicted the tenfold increase in the amount of the GST exemption or the rapid decline of the rule against perpetuities.
The common law rule against perpetuities evolved over several centuries as English judges struggled to define acceptable limits on the alienability of real and personal property. Early judicial decisions often framed the issue as whether a particular disposition unduly suspended the power of alienation, without addressing the technically distinct question of remote vesting, prompting several states to enact statutes limiting the permissible period for suspending the power of alienation of land (or the absolute ownership of personal property). Toward the end of the nineteenth century, however, the judges finally settled on the common law rule as a prohibition on the remote vesting of future interests. Professor Gray famously distilled the rule in a single sentence: “No interest is good unless it must vest, if at all, not later than twenty-one years after some life in being at the creation of the interest.” By the middle of the twentieth century, this formulation of the rule gained wide acceptance as the prevailing doctrine in all but a handful of American jurisdictions.
The common law rule prohibits the remote vesting of future interests; it does not directly limit the duration of trusts or the interests of bene-ficiaries, which may last well beyond the specified period of lives in being plus twenty-one years. In operation, the rule invalidates a future interest that might vest remotely under any imaginable sequence of events, no matter how unlikely; validity depends on what might happen rather than on events that actually occur. Moreover, a future interest is either valid or void based on facts existing at its creation. If an interest violates the rule, it is void from inception and cannot be salvaged by reformation or modification.
Because of its potentially harsh and seemingly arbitrary consequences, the rule has provoked scathing criticism as well as calls for reform. Prior to 1986, reformers proposed two basic changes to mitigate the rigors of the common law rule. First, they attacked the premise that a future interest was void if at the time of its creation there was any possibility that it might vest remotely. Instead, they argued that courts should “wait and see” whether the interest would actually vest within the perpetuities period based on events occurring up to the time of decision. The reformers’ second proposal focused on the consequences of a perpetuities violation. They argued that courts should not automatically invalidate a future interest on the ground of remote vesting but instead should have equitable discretion, analogous to “cy pres” in the charitable trust context, to reform the terms of the disposition to bring them into compliance with the rule. Both the wait-and-see approach and the cy pres approach, separately or in combination, were adopted in several states either by legislation or by judicial decision. Other states enacted more narrowly targeted statutory rules of construction to deal with recurring cases of potentially remote vesting. Significantly, while the reform proposals fundamentally modified the common law rule, none of the proposals questioned lives in being plus twenty-one years as the outer limit for timely vesting of future interests.
Promulgation of the USRAP in 1986 marked a new phase of perpetuities reform by introducing a fixed ninety-year wait-and-see period as an alternative to the common law rule. Under the USRAP’s two-pronged test, a future interest is valid either if it must vest or fail within twenty-one years after lives in being (the common law rule) or if it actually vests or fails within ninety-years (the wait-and-see rule). If neither test is satisfied, the future interest is subject to judicial reformation. In specifying the wait-and-see period as a fixed term of ninety years rather than lives in being plus twenty-one years, the USRAP drafters apparently sought to avoid the potential problems of identifying and tracing the relevant measuring lives. Noting that the ninety-year period reflected a “reasonable approximation” of the average duration of lives in being plus twenty-one years, the drafters insisted that the ninety-year term would not extend dead-hand control beyond the period routinely achieved by “competent drafting” under the common law rule. Nevertheless, by untethering the wait-and-see period from lives in being, the USRAP allowed settlors to create ninety-year trusts and, more importantly, provided a template for extending the wait-and-see period far beyond ninety years.
The USRAP’s combination of the common law rule against perpetuities with a ninety-year wait-and-see period initially appeared to be conspicuously successful as a law reform measure. Several states retained some version of the common law rule, at least as a default rule, but after 1986 the USRAP rapidly displaced the common law rule as the prevailing approach in a majority of American jurisdictions. However, even at the height of its popularity, the USRAP began to show signs of stress as enacting states amended their statutes to extend the wait-and-see period from 90 years to 500 years or even 1,000 years. A casual observer, reflecting that a 1,000-year wait-and-see period is tantamount to perpetuity, might ask whether it might not be simpler to abolish the rule against perpetuities altogether. Indeed, several states have drastically limited the scope of the rule or have made the rule optional, but complete, unequivocal repeal remains rare. Most of the states that have adopted a wait-and-see period far longer than lives in being or ninety years have retained specific statutory limitations on the use of successive powers of appointment, apparently to protect generation-skipping trusts from adverse federal gift, estate and GST tax consequences.
A typical generation-skipping trust provides for successive beneficial interests and nongeneral powers of appointment that are carefully tailored to avoid federal gift and estate taxes during the existence of the trust after its creation. Moreover, to comply with the common law rule against perpetuities, a nongeneral power of appointment must be certain to be exercised (if at all) no later than twenty-one years after lives in being at its creation, and the interests and powers created by the exercise of such a power must be certain to vest (or fail) within the same period measured from the creation of the power. Similarly, under the wait-and-see statutes and the USRAP, a nongeneral power must actually be exercised (if at all) and the resulting interests and powers must actually vest (or fail) within the applicable perpetuities period measured from the creation of the power. The “relation back” principle reflects the traditional notion that the holder of a nongeneral power does not own or transfer the underlying property but merely completes a transfer initiated by the settlor who created the power. Thus, the rule against perpetuities ensures that successive nongeneral powers cannot be used to postpone the vesting of beneficial interests indefinitely. Indirectly, therefore, the rule also places an outer limit on the use of generation-skipping trusts to avoid gift, estate, and GST taxes.
For gift and estate tax purposes, a general power is usually treated as tantamount to ownership of the underlying property; conversely, a nongeneral power is usually inconsequential. However, there is one major exception. The exercise of a nongeneral power to create a second power of appointment is treated as a taxable transfer if the second power can be validly exercised under applicable state law “to postpone the vesting of any estate or interest in [the underlying property], or suspend the absolute ownership or power of alienation of such property, for a period ascertainable without regard to the date of the creation of the first power.” This provision, known as the “Delaware tax trap,” was enacted in 1951 to forestall the use of successive nongeneral powers to avoid gift and estate taxes. The technique in question arises from a peculiar provision of Delaware law that allows the holder of a power of appointment to reset the perpetuities period for interests created by the exercise of the power and postpone vesting for an indefinite period of time. This technique for extending generation-skipping trusts indefinitely without incurring gift or estate taxes is unavailable in states that follow the common law rule against perpetuities or the USRAP because the perpetuities period for interests created by exercise of a nongeneral power always runs from the creation of the power. By contrast, the exercise of a general power is treated as a transfer of property by the holder.
Nevertheless, the Delaware tax trap has turned out to be a double-edged sword that can be used strategically to trigger a gift or estate tax. The trap may be sprung, even in states that follow the common law rule against perpetuities or the USRAP, if a nongeneral power of appointment is exercised to create a second, presently exercisable general power. The ownership of the underlying property is deemed to vest immediately in the holder of the second power, and the perpetuities period for interests created by an exercise of that power will run from the time it is exercised, not from the creation of the first power. The creation of the second power thus falls squarely within the terms of the Delaware tax trap and is treated as a transfer of the underlying property by the holder of the first power for gift and estate tax purposes. While springing the trap might seem counterintuitive as a tax strategy, it allows the holder of the first power to choose to subject property held in a generation-skipping trust to a gift or estate tax instead of an otherwise applicable GST tax. Such flexibility may be attractive, especially if the power holder has an available gift or estate tax exemption that would otherwise be wasted.
Exercising a nongeneral power to spring the Delaware tax trap may be a useful technique for a generation-skipping trust that would otherwise be exposed to GST tax, but the result could be disastrous if the trust is already exempt from GST tax. For example, if a trust has a zero inclusion ratio (reflecting an allocation of an earlier transferor’s GST exemption), an exercise of a nongeneral power to create a second power might inadvert-ently terminate the trust’s exempt status and cause the power holder to become a new transferor for GST tax purposes. Similarly, in the case of a pre-effective-date grandfathered trust, springing the trap would presumably cause the trust to lose its grandfathered status and become subject to GST tax. In states that retain the common law rule against perpetuities or the USRAP, even with an extended wait-and-see period, the exercise of a nongeneral power to create a second nongeneral power does not reset the perpetuities period and therefore does not spring the Delaware tax trap. In those states, therefore, the risk of springing the trap and forfeiting a trust’s exempt status is largely confined to situations involving the exercise of a nongeneral power to create a presently exercisable general power. By contrast, in a state that has simply abolished the rule against perpetuities, the exercise of a nongeneral power to create any second power, general or nongeneral, may spring the trap because the creation and exercise of successive powers are no longer constrained by any ascertainable perpetuities period, much less by a period running from the time the first power was created. The same problem arises in a state that makes the rule against perpetuities optional rather than mandatory.
It is therefore not surprising that several states which have repealed the rule against perpetuities for most other purposes have nevertheless retained a vestigial statutory rule that provides an extended wait-and-see period for successive powers of appointment and treats the interests created by the exercise of a second power (other than a presently exercisable general power) as relating back to the creation of the first power. The evident purpose of this type of statutory saving clause is to prevent the Delaware tax trap from applying broadly whenever a non-general power is exercised to create a testamentary or nongeneral power while allowing the first power holder to spring the trap—presumably deliberately—by creating a presently exercisable general power. Furthermore, the saving clause facilitates the creation of generation-skipping trusts with a zero inclusion ratio which can remain exempt from federal gift, estate, and GST taxes for a very long time, constrained only by the extended wait-and-see period under state law and by the amount of the GST exemption allocated to the trust at its inception.
Interestingly, the Delaware statute, the original target of the tax trap, has been amended to allow the holder of the first power to disable the trap by electing in the instrument exercising that power to treat the resulting interests and powers as relating back to the creation of the first power. Moreover, the Delaware statute provides a separate, overriding relation-back rule for successive powers over trusts that are exempt from the GST tax (i.e., pre-effective-date grandfathered trusts and trusts with a zero inclusion ratio). This rule was expressly designed “to prevent donees of powers of appointment over property held in trusts exempt from the federal generation-skipping tax [sic] from inadvertently incurring federal gift or estate taxes when exercising their powers.” It is a mirror image of the longstanding rule that gave rise to the tax trap, and treats the interests arising from the exercise of a nongeneral power as relating back to the creation of that power unless the power holder makes a contrary election in the instrument exercising the power. Arguably, however, the Delaware statutory provisions fail to achieve their intended purpose. Because Delaware has abolished the rule against perpetuities for trusts of personal property, there is no limit on remote vesting that can be invoked by either of these relation-back rules.
A separate but analogous problem arises in states that follow Wisconsin’s permissive approach to perpetual trusts. Wisconsin is one of several states that copied portions of an early New York statute regulating suspension of the power of alienation of real property. In a pair of early decisions, the Wisconsin Supreme Court held that the original Wisconsin suspension statute, enacted in 1849 and applicable only to real property, impliedly abrogated the common law rule of perpetuities for personal property. The court held that the suspension statute did not apply even to a trust of real property if the trustee had an express or implied power of sale, no matter how long the sale proceeds might remain tied up in trust. In effect, the court declared the suspension statute to be elective in its application to real property. Thus, by a tortuous line of reasoning, the court found an implied absence of statutory or common law restrictions on perpetual trusts of personal property and used the power-of-sale exception to eviscerate the suspension statute and clear a path for perpetual trusts of real property. The court reaffirmed its decision after the suspension statute was amended to apply to personal property in 1925, and in 1969 the Wisconsin legislature finally enacted an express power-of-sale exception to the suspension statute.
In recent years, several states have emulated Wisconsin’s suspension statute, including the power-of-sale exception. Presumably the renewed enthusiasm for suspension statutes is attributable at least in part to the tax benefits they offer for generation-skipping trusts, based on the widespread understanding that the Wisconsin statute allows the creation of perpetual trusts while circumventing the Delaware tax trap. This understanding is based on the Tax Court’s decision in Estate of Murphy v. Commissioner. In Estate of Murphy, a deceased trust beneficiary exercised her testamen-tary nongeneral power of appointment over a portion of the trust property and created a second testamentary nongeneral power in her husband. The court framed the issue as whether the decedent’s exercise of her non-general power came within the purview of the Delaware tax trap. The tax trap would apply only if under applicable local law the second power could be exercised to suspend the power of alienation “for a period ascertainable without regard to the date of the creation of the first power”; the Wisconsin suspension statute expressly provided that the permissible period ran from the creation of the first power; therefore, the court concluded, the tax trap provision was inapplicable.
On its face, the Tax Court’s decision in Estate of Murphy seems reasonable enough. But on closer examination, the court’s analysis is not completely satisfying. The court was clearly aware that in exercising her power of appointment the decedent had conferred a power of sale on the trustee, with the result that there was “no suspension of the power of alienation” within the meaning of the Wisconsin statute. Because the suspension statute was inapplicable to the trust from its inception, the relation-back rule would not have constrained the decedent’s husband from exercising the second power of appointment to suspend the power of alienation (for example, by making the beneficiaries’ interests inalienable and curbing the trustee’s power of sale). Accordingly, the permissible suspension period would have run from the exercise of the second power, not from its creation. Of course no suspension actually occurred—in fact, the husband renounced the second power—but the Delaware tax trap would have applied if the husband could have exercised the power to suspend the power of alienation “for a period ascertainable without regard to the date of the creation of the first power.” In this respect, the situation in Estate of Murphy was much the same as if Wisconsin had expressly made its suspension statute optional or repealed it altogether. Because the suspension statute was inapplicable to the trust, it imposed no restriction on suspension of the power of alienation. In other words, the relation-back rule under the Wisconsin statute did not operate to limit the husband’s power to suspend the power of alienation to any ascertainable period. Arguably, therefore, the power-of-sale exception in the Wisconsin statute is no more foolproof in circumventing the Delaware tax trap than the outright abolition of the rule against perpetuities in other states. States that have enacted suspension statutes with a power-of-sale exception should consider carefully whether Estate of Murphy provides guaranteed immunity from the Delaware tax trap for generation-skipping trusts.
The unraveling of the common law rule against perpetuities, accelerated by flexible choice-of-law rules governing trust validity, facilitates the creation of generation-skipping trusts to shelter property from gift, estate, and GST taxes far beyond the traditional period of lives in being plus twenty-one years. The resulting tax benefits are limited primarily by the amount of available GST exemption allocated to the trust rather than by any perpetuities restrictions under state law.
Trusts that were irrevocable on September 25, 1985, enjoy unlimited grandfather protection from the GST tax under the effective date provisions of the 1986 Act. Such trusts may lose their protected status, however, if they receive any actual or constructive additions. For example, if any person holds a general power of appointment over trust property, any exercise, release, or lapse of the power that is treated as a taxable transfer for gift or estate tax purposes will subject the trust to the GST tax. The same result should occur if the holder of a nongeneral power exercises it in a manner that springs the Delaware tax trap. It may be possible, however, to maximize the tax benefits of a grandfathered trust without jeopardizing its exempt status by exercising a nongeneral power to extend the duration of the trust. The GST tax regulations provide a safe harbor that prevents the exercise of a nongeneral power from being treated as a constructive addition as long as the power is not exercised in a manner that might “postpone or suspend the vesting, absolute ownership or power of alienation of any interest in property” beyond a “perpetuities period” running from the creation of the trust. For this purpose, the perpetuities period is defined as lives in being at the creation of the trust plus twenty-one years (plus, if necessary, a reasonable gestation period) or an alternative ninety-year period, consistent with the USRAP. Thus, while the specified perpetuities period is consistent with the common law rule and the USRAP, the safe harbor does not allow the exercise of a non-general power of appointment to extend a grandfathered trust for longer wait-and-see periods currently allowed under many state statutes. Similarly, the safe harbor does not allow the use of successive nongeneral powers to extend a grandfathered trust indefinitely, even if such powers are tolerated under applicable state law.
When the GST tax was enacted in 1986, the concept of trust decanting was relatively undeveloped. New York was the first state to enact a trust decanting statute in 1992, with the aim of facilitating the extension of grandfathered GST trusts, and other states soon followed. The Uniform Trust Decanting Act (UTDA), promulgated in 2015, has been enacted in more than a dozen additional states. At a very basic level, the decanting statutes authorize the trustee of an irrevocable trust to modify the terms of the trust if the trustee has a discretionary power of invasion over the trust property. Conceptually, decanting may be viewed as an exercise by the trustee of a fiduciary distributive power or a nongeneral power of appointment in favor of a new trust with modified terms. The UTDA contemplates that a decanting may be accomplished either by distributing trust property to a new trust or by directly modifying the terms of the trust, reflecting a more nuanced view of the decanting power as distinct from, but predicated on, the discretionary invasion power conferred by the terms of the trust. Under either view, the decanting power is inherently a fiduciary power, and in exercising it the trustee is subject to general fiduciary duties of loyalty, impartiality, prudence, good faith, and fidelity to the terms and purposes of the trust. Moreover, the decanting statutes provide specific safeguards and restrictions to protect the beneficiaries and prevent abuse of the decanting power.
A major attraction of decanting, compared to more traditional methods of judicial and nonjudicial modification, is that the trustee can exercise the decanting power without seeking approval from a court or consent from the beneficiaries. Although the decanting statutes generally require advance written notice to beneficiaries and other interested persons, who may seek instructions from a court regarding the propriety of a proposed decanting, framing decanting as a discretionary fiduciary power significantly expands the trustee’s traditional role in trust admin-istration while avoiding potentially unwelcome income, gift, and estate tax consequences for the beneficiaries.
Decanting can be used for many purposes, including extending the duration of a trust beyond its original termination date. The decanting statutes apply to preexisting trusts as well as trusts created after the date of enactment, if the trust has its principal place of administration in the enacting state or if the trust instrument designates the enacting state’s law as the governing law. Thus, if the requisite nexus is established, it may be possible to decant a grandfathered trust and extend its protection from the GST tax, subject to any applicable restrictions under the terms of the trust, state law or the GST tax regulations. In this regard, the UTDA expressly requires that the decanting comply with “any rules governing maximum perpetuity, accumulation, or suspension of the power of alienation which apply to” the original trust. The relevant perpetuities restrictions are those provided by the governing law applicable to the original trust. Thus, for example, if the original trust is subject to the common law rule against perpetuities, the trustee may not exercise a decanting power to take advantage of the law of another state that has abolished the rule. However, the UTDA would not prevent the use of decanting to postpone the vesting of interests during the lives of additional persons who were living at the creation of the trust. The UTDA may also permit the use of decanting to take advantage of the ninety-year wait-and-see period in a state that enacted the USRAP to replace the common law rule as the governing law applicable to the original trust.
Not all decanting statutes strictly follow the UTDA. Some of these nonuniform statutes similarly prohibit the use of decanting to extend the perpetuities period applicable to the original trust, but others allow the exercise of a decanting power to extend the duration of a trust in accordance with perpetuities restrictions under applicable local law.
Regardless of how permissive the decanting statute may be, however, any decanting that extends the duration of a grandfathered trust must comply with a safe harbor in the GST tax regulations to preserve the trust’s grandfathered status. The regulations provide several safe harbors, and three of them are especially relevant for trust decanting. The first, as previously noted, allows the exercise of a nongeneral power of appointment to postpone vesting or suspend absolute ownership or the power of alienation for a maximum perpetuities period of lives in being plus twenty-one years or ninety years from the creation of the trust. This perpetuities period applies independently of state law and is of limited assistance in extending the duration of a grandfathered trust.
The second safe harbor relates to the exercise of a fiduciary discretionary power to distribute property from (or retain property in) a grandfathered trust—in other words, a decanting. This safe harbor is substantially similar to the one relating to nongeneral powers of appointment and specifies a maximum perpetuities period in virtually identical terms (i.e., lives in being plus twenty-one years plus, if necessary, a reasonable gestation period, or ninety years). The scope of the safe harbor is sharply limited, however, by the requirement that the decanting be authorized either by the terms of the trust or by “state law” at the time the trust became irrevocable. In effect, this means that the safe harbor is available only for a decanting expressly authorized by the trust instrument or perhaps by the common law, but not for a decanting authorized by statute because all of the decanting statutes were enacted after the effective date of the GST tax. It is therefore not surprising that commentators frequently emphasize the common law basis for decanting as the exercise of a nongeneral power of appointment, and the decanting statutes expressly refrain from impairing a trustee’s power “to distribute or appoint property in further trust or to modify a trust” at common law. Indeed, a few statutes purport to codify preexisting common law. Nevertheless, even if a decanting power is deemed to be authorized by common law, the second safe harbor appears to add little or nothing to the safe harbor for nongeneral powers of appointment.
The third safe harbor relates to the “modification” of the terms of a trust, including a distribution by a trustee that falls outside the second safe harbor but is valid under state law. This safe harbor, unlike the other two, allows the decanting of a grandfathered trust pursuant to a state statute enacted after 1986, as long as the decanting “does not shift a beneficial interest in the trust” from any beneficiary to another beneficiary assigned to a younger generation for GST tax purposes and “does not extend the time for vesting of any beneficial interest in the trust beyond the period provided for in the original trust.” Thus, for example, a decanting may modify the “administrative” terms of a trust or convert an income interest to a unitrust interest (or vice versa) without causing a prohibited shift in beneficial interests. This safe harbor, however, does not allow any modification that would postpone the vesting of any interest for longer than the original trust, and in this respect it is more restrictive than the other safe harbors.
Many of the issues raised by decanting in connection with grand-fathered trusts also arise in connection with trusts that are sheltered from GST tax by an allocation of GST exemption. Under current law, a trust that has an inclusion ratio of zero may remain exempt from GST tax throughout existence unless an intervening event changes the inclusion ratio. Decanting might jeopardize a trust’s exempt status in two ways. One risk involves the possibility that the trustee’s exercise of the decanting power to create a second power could spring the Delaware tax trap, causing the trustee to become the new transferor of the trust for GST tax purposes and terminating the zero inclusion ratio established by the original transferor’s allocation of GST exemption. Some commentators argue that a decanting should not be subject to the tax trap unless the trustee has a beneficial interest in the underlying property. This argument appears to assume, contrary to the express terms of the Delaware tax trap, that a trustee’s exercise of a discretionary power can never give rise to a taxable transfer unless the trustee is also a beneficiary of the trust. By its terms, however, the tax trap treats the exercise of one power to create another power as a “transfer of property” in specified circum-stances, without drawing any distinction based on whether the power is held in a fiduciary or nonfiduciary capacity or whether the power holder has a beneficial interest in the underlying property, and nothing in the legislative history supports such a strained reading.
A second risk involves the possibility that a decanting might modify the terms of a trust in a manner inconsistent with maintaining its zero inclusion ratio. In the absence of regulations or other formal guidance concerning the effects of decanting on trusts with a zero inclusion ratio, the Internal Revenue Service has taken the position in numerous private letter rulings that “[a]t a minimum, a modification that would not affect the GST status of a grandfathered trust should similarly not affect the exempt status of such a trust.” The Service has also requested comments regarding when a decanting that changes the beneficial interests in a trust should not be subject to income, gift, estate, or GST tax, eliciting responses from several professional organizations. The Service’s ruling position implies that a decanting that falls outside the safe harbors for grandfathered trusts would not necessarily terminate the exempt status of a trust with a zero inclusion ratio, but it provides no further guidance concerning the types of modifications that would be permissible or the consequences of terminating a trust’s exempt status.
At one time, the regulations treated the holder of a nongeneral power of appointment as a transferor for GST tax purposes if the power was exercised in a manner that might “postpone or suspend the vesting, absolute ownership, or power of alienation of an interest in property” for longer than a perpetuities period of “any specified life in being” plus twenty-one years (or alternatively ninety years) running from the creation of the trust. The effect of this special rule was to terminate the exempt status of a trust by identifying the power holder as a new transferor, even though the exercise of the power was not treated as a taxable transfer for gift or estate tax purposes. The rule was repealed, however, when it became clear that it might be used to avoid GST tax by designating a new transferor of a non-exempt trust without incurring any gift or estate tax. The repeal of the special rule, coupled with the failure to replace it with a more precisely targeted rule, arguably implies that the duration of a trust with a zero inclusion ratio may be extended—subject to any applicable perpetuities restrictions under state law and the Delaware tax trap—without terminating the trust’s exempt status.
Indeed, several commentators argue that the decanting of a trust with a zero inclusion ratio should have no effect on the trust’s exempt status, even if the decanting extends the duration of the trust or gives rise to a shift in beneficial interests, as long as it does not result in a change of transferor. Although this standard is far more generous than the Service’s ruling position, in the absence of more specific regulatory guidance there appear to be few constraints under current law on the use of decanting to prolong the existence of exempt trusts and avoid GST tax far beyond the traditional perpetuities period set forth in the safe harbors for grandfathered trusts. By a strategic choice of trust situs and governing state law, and with some rudimentary planning to avoid springing the Delaware tax trap, a trustee may be able to exercise a decanting power to extend an exempt trust for up to 1,000 years.
When Congress enacted the GST tax in 1986, the duration of trusts under applicable state law was constrained in almost all states by some version of the rule against perpetuities or a suspension statute. And, despite myriad local variations in technical detail, it probably seemed reasonable to assume that the rule would remain in place to ensure that generation-skipping trusts would last for no more than two or three generations, or around 100 years. It may even have seemed reasonable to take the USRAP drafters at their word and assume that the USRAP would ameliorate the harshness of the common law rule without increasing dead-hand control. Given those assumptions, the $1 million GST exemption might have seemed like a modest concession to secure enactment of a new and improved GST tax.
Even in 1986, however, some skeptics warned that perpetuities reform had become a “slippery slope,” that the USRAP might undermine the common law rule in unintended but foreseeable ways, and that the GST exemption was an open invitation to tax avoidance. Their warnings were prescient. Within a few years, the initial wave of USRAP enactments crested and states began to dismantle their perpetuities statutes (as well as other longstanding regulatory constraints) in a fevered competition for private trust capital. In short order, the GST exemption jumped from $1 million to more than $10 million in tandem with the gift and estate tax exemption, opening a gaping hole in the federal wealth transfer taxes and amplifying the advantages of generation-skipping trusts. These changes, combined with the rapid spread of trust decanting statutes, have increased the availability and attractiveness of long-term generation-skipping trusts.
The unraveling of regulatory and tax constraints on the accumulation and transfer of wealth is neither inevitable nor accidental. On closer examination, the interaction of perpetuities restrictions and trust decanting statutes at the state level with the federal gift, estate, and GST taxes reveals a pattern of strategic behavior. The common law rule against perpetuities has not completely disappeared, but it has been superseded by statute in nearly all the states. The statutes preserve the traditional rule, fossil-like, as a safe harbor alongside far more permissive provisions, resulting in a dual-track system. In many states, a combination of protracted wait-and-see periods, power-of-sale exceptions, or opt-out provisions for trusts has made the common law rule essentially optional or illusory. Moreover, the permissive alternatives are designed to allow trusts to exploit the ever-expanding federal tax exemptions and shelter accumulated wealth from gift, estate, and GST taxes to an extent unimaginable in 1986.
Whether the rule against perpetuities is a paper tiger or a dinosaur, figuratively speaking, remains to be seen. What is clear, however, is that the GST tax can no longer rely on state law to constrain the duration of trusts in any meaningful way. If the GST tax is to function as an effective backstop to the gift and estate taxes, it will be necessary to limit both the amount and the duration of the GST exemption. Mechanically, both limita-tions would be fairly straightforward. Because the amount of the GST exemption is tied directly to the estate tax exemption, a reduction in the latter amount would automatically limit the amount of GST exemption that could be allocated to a newly created generation-skipping trust. The duration of the GST exemption could be limited by terminating any allocation of the original transferor’s GST exemption at the end of a perpetuities period, defined either as a fixed term of years or by reference to beneficiaries no more than two generations younger than the transferor. Resetting the trust’s inclusion ratio from zero to 100% would effectively terminate the trust’s exempt status and subject subsequent generation-skipping transfers to GST tax at a 40% rate. The most serious obstacle to reform is not technical but political. The GST tax is inextricably linked to the gift and estate taxes, and the conflict over curtailing exemptions is only a preliminary skirmish in a much larger battle over the taxation of inherited wealth.
