New decanting statutes offer road map for escaping fiduciary tax and updating trust terms.
island, 15 mi (24 km) long and 5 mi (8 km) wide, S R.I., at the entrance to Narragansett Bay. It is the largest island in the state, with steep cliffs and excellent beaches.
, Kentucky, Michigan, and Illinois enacted
decanting statutes last year to offer enhanced flexibility for trust
administration in their jurisdictions. These states joined at least 14
other states that explicitly by statute or under case law authorize
decanting. As these types of statutes proliferate, federal and state
taxing authorities must wrestle with the income, estate, and gift tax
issues raised by decanting.
Decanting statutes allow trustees to “pour” assets from
an existing trust into a new (or existing) trust with different terms
and conditions. The ability to modify an
decanting is a profoundly useful and coveted tool, not only for dealing
with problematic, antiquated trust agreements, but also for changing the
situs of trusts. As with other legislation in the estates and trusts
area, the statutes vary considerably from state to state. Some statutes,
such as those in Indiana and Florida, permit decanting only where the
trustee has unfettered discretion to make distributions of principal to
beneficiaries (Ind. Code [section]304-3-36; Fla. Stat.
[section]736.04117). Other, more liberal, statutes permit trustees to
make substantive changes even if they have more limited powers.
Virtually all of the statutes require notice to beneficiaries and,
at a minimum, their tacit approval. Decanting does not take place in a
vacuum and is usually undertaken at the beneficiaries’ behest.
Fiduciary duties of impartiality and loyalty overlay the decanting
process and constrain the trustee’s conduct. To protect against
estate tax inclusion, several statutes prohibit decanting when the
trustee is also a beneficiary.
Background and Basics of Decanting
To appreciate the potential benefits and consequences of decanting,
it is important to understand the background of the concept. Several
states recognize a common law right to
tr.v. de·cant·ed, de·cant·ing, de·cants
1. To pour off (wine, for example) without disturbing the sediment.
2. To pour (a liquid) from one container into another.
. Some commentators have
analogized decanting to the trustee’s exercise of a special power
of appointment (see, e.g., Blattmachr, Horn, and Zeydel, “An
Analysis of the Tax Effects of Decanting,” 47 Real Prop., Trust and
Est. Lau, J. 141 (Spring 2012)). In effect, the power to make
distributions in further trust is subsumed by the power to distribute
Trust provisions frequently targeted for modernization through
decanting include adding or changing beneficiaries, granting limited
powers of appointment, accelerating or postponing distributions,
changing trust situs, and extending the terms of trusts or terminating
old trusts. Some attorneys decant trusts to add or change investment
advisers, alter a successor trustee sequence, or remove or appoint a
corporate trustee. Very few decanting statutes deal explicitly with
taxation. The new Illinois statute, however, permits using the decanting
statute to turn a nongrantor trust into a
(760 III. Comp. Stat 5/16.4).
To avoid any unintended consequences, the implications of decanting
a trust must be thoroughly analyzed before any changes are made. The
general rule of thumb should be “first, do no harm.” Old
trusts can have advantageous tax treatment that should not be disturbed,
such as trusts established before Oct. 22, 1986, that are grandfathered
from generation-skipping transfer (
Greenwich sidereal time
(in Australia, New Zealand, and Canada) Goods and Services Tax
) tax or otherwise GST-tax exempt
(Regs. Sec. 26.2601-1). Other trusts that were created using marital or
charitable deductions should be examined, since the tax
Delaying of an obligation. See Default, Medical student debt. Cf Forbearance.
favorable treatment could be lost if the terms of the trust agreements
are altered without due consideration. In addition, care must be taken
to ensure the decanting does not trigger an unintended gift through a
lapse or release of a general power of appointment or diminishment of a
Significant Planning Opportunity
One issue that arises when trusts are decanted to new trusts is how
to characterize the transfer of trust assets. Does the old trust merely
, or does the old trust terminate upon the
creation and funding of the new trust? What are the federal and state
tax implications of the decanting? Does the distribution of appreciated
property to the new trust represent a realization event? Though this
last question is pivotal for trustees seeking to move their trusts to
states without an income tax, no
Relating to or having an effect on disposition or settlement, especially of a legal case or will.
case law exists on this
issue. The U.S. Constitution’s guarantee of due process limits a
state’s ability to tax a trust. Simply stated, if the new trust has
no nexus in the old state, it cannot be taxed by that state. Severing
all ties to the old state is more straightforward if the old trust is
deemed to be terminated upon decanting to a new trust administered in a
Recognizing a tide moving in the direction of decanting a few years
issued Notice 2011-101 and asked for comments on the
income, estate, and gift tax implications of decanting, especially on
whether such a transfer is an income tax gain-or-loss realization event.
In 2012, several professional associations responded with comments on
the ramifications of decanting. The
See American Institute of Certified Public Accountants (AICPA).
, for example, issued a letter
on June 26, 2012 (available at tinyurl.com/baedqjrn), stating that for
federal tax purposes the new trust is best viewed as a continuation of
the old trust. The AICPA cited Regs. Sec. 1.671-2(e)(5) as support for
the proposition that a
who transfers property to a new trust is
generally treated as the grantor of the transferee trust. In Letter
Ruling 200736002, the IRS reached a similar conclusion.
The letter ruling and AICPA statements concerned only federal law
and did not address how state courts and taxing authorities should
evaluate decanting under their trust and trustee statutes and tax
doctrines. State trust law characterizes how decanting alters the
property rights inherent in a trust agreement, and taxes are assessed
based on these interpretations. It will be up to the courts in the
jurisdictions permitting decanting to determine whether the old trust is
deemed to be terminated when a trustee decants all trust assets to a new
Nonetheless, looking at decanting statutes and trust law, there is
ample support for the proposition that the old trust terminates where a
trustee decants the entire res of a trust to a new trust. As a basic
tenet of trust law, a trust must have res (that is, an ascertainable
interest in property) to exist. If the res is removed to a new trust or
a beneficiary exercises a limited power of appointment to create a new
trust, the original trust no longer exists. Decanting statutes are often
analogized to the exercise of a limited power of appointment.
The decanting statutes themselves are sources for further guidance.
Several statutes provide, explicitly or implicitly, that a trustee is
permitted to change the federal tax treatment of a trust by decanting an
existing trust to a new trust and opting for either grantor or
nongrantor trust status, regardless of the status of the initial trust.
This suggests that decanting can be used to turn a grantor trust into a
complex trust for federal tax purposes without the grantor explicitly
relinquishing the powers that made the trust an intentionally defective
grantor trust for federal income tax purposes. Several statutes permit
the trustee of the initial trust to create the new trust.
In addition, virtually all of the statutes contain certain
prohibitions on the use of decanting. For example, some of the decanting
statutes bar a trustee from using decanting to lengthen the term of the
trust if there is a provision in the trust limiting the term of the
trust or to eliminate a vested beneficiary’s right to income, but
the statutes remain silent as to whether the situs of a trust can be
changed. Since seeking a change of situs is one of the principal reasons
for decanting, this omission arguably can be considered a legislative
affirmation of a trustee’s ability to change the situs of a trust
through decanting. The Delaware and Virginia decanting statutes
specifically provide that the trustee’s decanting power should be
considered the exercise of a limited power of appointment (Del. Code
tit. 12, S3528; Va. Code S55-548.16:1). Therefore, in those two states,
decanting should be viewed as an extension of the senior’s intent
and within the scope of the authority originally conferred by that
. By contrast, if the assets of an old trust are poured into a
trust created by someone other than the original senior or trustee, the
new trust is legally not the same as the old trust.
Brief Overview of State Fiduciary Tax Rules
An understanding of state fiduciary taxing regimes is necessary to
appreciate the ability to decant a trust to a better state. Many
advisers to residents of states that tax trusts created by a
long-deceased relative believe the most important aspect of decanting
statutes may be to escape state income tax in instances where the only
connection to the state is the death, years ago, of the trust’s
grantor. Seven states do not tax trust income, while others have
fiduciary income tax rates in excess of 12%. Therein lies the planning
opportunity. Some of the states, such as
, state in the N central United States. It is bordered by North Dakota (N), Minnesota and Iowa (E), Nebraska (S), and Wyoming and Montana (W).
, that permit
self-settled trusts with their various creditor protections also have no
state income tax, making those states even more attractive.
Settled U.S. Supreme Court doctrine limits the ability of a state
to tax the income of a nongrantor trust. In Safe Deposit and Trust Co.
v. Virginia, 280 U.S. 83 (1929), the Court held that a Virginia tax on
the value of an
inter vivos trust
n. a trust created by a writing (declaration of trust) which commences at that time, while the creator (called a trustor or settlor) is alive, sometimes called a “living trust.
, which had Virginia beneficiaries but
a Maryland trustee, violated the Due Process Clause of the U.S.
Constitution. The court noted that the residence of the holder of legal
title to the intangibles (stocks and bonds) determined the state where
the intangibles should be taxed. Thus, the intangibles were taxable in
the state where the trustee resided, not the state in which the
of the irrevocable trust resided. In general, states tax
a nongrantor trust based on one or more of the following criteria:
1. If the trust was created by the will of a
who lived in
the state at death;
2. If the grantor of an inter vivos trust lived in the state;
3. If the trust is administered in the state;
4. If one or more trustees live or do business in the state;
5. If one or more beneficiaries reside in the state; or
6. The location of trust property.
More than 15 states, including Illinois and Pennsylvania, tax a
trust created by a resident testator or resident settlor (in the case of
a living trust). In case law and regulatory decisions, this basis for
taxation has been justified by the involvement of the
A court limited to the jurisdiction of probating wills and administering estates.
Noun 1. probate court – a court having jurisdiction over the probate of wills and the administration of estates
administering the decedent’s estate. This is often referred to as
the continuing jurisdiction theory. However, if the trust created
pursuant to the probate case is terminated based on the trustee’s
decanting of the trust assets to another trust, this nexus with the
original taxing state is eliminated.
Middle Atlantic state of the United States. It is bordered by Vermont, Massachusetts, Connecticut, and the Atlantic Ocean (E), New Jersey and Pennsylvania (S), Lakes Erie and Ontario and the Canadian province of
and New Jersey tax based on the residence of the grantor,
but only if there is an additional connection to the jurisdiction, such
as a resident trustee, trust assets within the state, or source income
tied to the state. Similarly, more than 10 states, including
Connecticut, Delaware, Michigan, Missouri, Ohio, and Rhode Island, tax
an irrevocable trust created by a resident if the trust also has one
resident beneficiary. In addition, some states tax a trust if it has one
or more resident beneficiaries, some tax a trust if it is administered
in the state, and others tax a trust if one or more trustees reside in
the state. Since changing trustees or the situs of administration is
relatively simple, the states that tax on these bases afford the
simplest opportunity for planning through decanting. Consequently, many
corporate trustees in no-tax states are actively seeking this business.
The states impose top tax rates in excess of 12%, and the tax
typically applies to accumulated income and capital gains on intangible
assets of nongrantor trusts. Distributed income and capital gains are
typically taxable to the beneficiary upon receipt of the distribution.
Over the years, several state supreme courts have weighed in on the
constitutionality of taxing state fiduciary income. In one of the
leading cases, Swift v. Director of Revenue, 727 S.W.2d 880 (Mo. 1987),
the Missouri Supreme Court ruled that the fact that the testator of a
testamentary trust died in Missouri was insufficient to create a basis
for taxation where the trustee, the trust assets, and the trust
beneficiaries all were in Illinois. In rejecting the “continuing
jurisdiction theory,” the court said, “An income tax is
justified only when contemporary benefits and protections are provided
the subject property or entity during the relevant taxing period”
(Swift, 727 S.W.2d at 882). The Missouri Supreme Court followed the New
York appellate court decision reached in Taylor v. State Tax Commission,
85 A.D.2d 821 (N.Y. App. Div. 1981). The Taylor court concluded that a
trust created upon the death of a former New York resident, where the
trustee and trust property were located in Florida, could not be taxed
by New York.
In 1990, a Michigan appellate court faced a similar issue when a
Michigan resident died, causing her living trust to become irrevocable.
The beneficiaries of the trust lived in Florida, and the trust was
administered there by a local trustee. In Blue v. Department of
Treasury, 462 N.W.2d 762 (1990), the court said that Michigan’s
legal protections were “illusory” where the trust was
registered and administered in Florida. The court attacked the Michigan
Treasury’s argument that the state provided legal protection to the
trust and said, -The state cannot create hypothetical legal protections
through a classification scheme whose validity is constitutionally
suspect and attempt to support the constitutionality of the statute by
these hypothetical legal protections” (Blue, 462 N.W.2d at 764).
reached a contrary result in
v. Gavin, 733 A.2d 782 (Conn. 1999). Commentators have
attacked that decision, which is clearly a minority opinion. In fact, on
Jan. 3, 2013, the New Jersey Tax Court held that the accumulated income
of a resident trust administered outside of New Jersey by a New York
trustee was not subject to tax in New Jersey (
Trust A v.
Director, Division of Taxation, No. 0003642010 (N.J. Tax Ct. 1/3/13)).
The New Jersey Tax Director cited Gavin, the Connecticut case, and
encouraged the N.J. Tax Court to follow that decision, but the court
ruled that Gavin was contrary to settled New Jersey case law and cited
and reaffirmed Pennoyer v. Taxation Division. Director, 5 N.J. Tax 386
Possible Constitutional Challenge
Trusts historically taxed in states such as Illinois and
Pennsylvania, where the only connection to the taxing situs is the
continuing jurisdiction theory, are ripe for decanting and a
constitutional challenge to continued taxation. Though Illinois has
tried to head off such a challenge by providing in its decanting statute
that the settlor of the original trust is the settlor of the new trust,
that provision is subject to the same argument that defeated the
Michigan Treasury Department in Blue and the New jersey tax director in
Residuary Trust A, namely, that classifications do not create a taxing
nexus. In the decanting case ideal for a court challenge, a new trust
should be prepared with new trustees located in the jurisdiction of
choice. The written agreement setting forth the decanting should
specifically state that the old trust has been terminated. Pouring the
trust assets into a trust created in the new jurisdiction would
strengthen the termination argument.
For example, a trust originally created by a grandparent in
Illinois could be poured into a trust (I) created by a child who lives
in Florida, and (2) where the trust beneficiaries are all
descendants of the grandparent. Nongrantor status could be chosen and
final tax returns filed. Under this fact pattern, case law and trust law
would create a formidable barrier for the local taxing authority to
tr.v. sur·mount·ed, sur·mount·ing, sur·mounts
1. To overcome (an obstacle, for example); conquer.
2. To ascend to the top of; climb.
a. To place something above; top.
. However, the transfer of situs will not be effective if there
are beneficiaries residing in the old state or significant income from
the old state. In Residuary Trust A, the tax director contended that the
trust in issue effectively owned assets located in New Jersey of four S
corporations that it owned stock in and that the assets created the
requisite nexus to subject the trust to tax on its
non-New Jersey income, but the N.J. Tax Court flatly rejected this
Advisers should review all old trusts where the clients have left
the trust jurisdiction. Offshore trusts with U.S. beneficiaries may also
be candidates for decanting. In some cases, appointing a co-trustee
located in a state with a decanting statute may be sufficient to use
that state’s decanting statute. Most of the decanting statutes
include savings clauses to prevent potential latent tax complications.
When dealing with a GST-exempt trust, Regs. Sec. 26.2601-1(b)(4)(i)(A)
provides guidance on the framework for compliance where discretionary
powers are exercised.
The year 2013 should be significant in the evolution of decanting
statutes. The IRS will likely issue guidance on decanting this year. As
state statutes proliferate, more trusts will be decanted, and cases
testing the actions of trustees will be litigated by beneficiaries and
taxing authorities. Through these avenues, the contours of decanting
will continue to be clarified and refined.
From Audrey Young, J.D.,