Editor: Mindy Tyson Weber, CPA, M.Tax.
Estates, Trusts & Gifts
Virginia, Rhode Island, 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 irrevocable trust through 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 § 30-4-3-36; Fla. Stat. §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 decant. 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. Law J . 141 (Spring 2012)). In effect, the power to make distributions in further trust is subsumed by the power to distribute trust principal.
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 grantor trust, and vice versa (760 Ill. 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 (GST) 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 deferment or 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 beneficial interest.
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 continue with new terms, 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 dispositive 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 new state.
Recognizing a tide moving in the direction of decanting a few years ago, the IRS 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 AICPA, for example, issued a letter on June 26, 2012, 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 grantor 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 trust.
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, §3528; Va. Code §55-548.16:1). Therefore, in those two states, decanting should be viewed as an extension of the settlor’s intent and within the scope of the authority originally conferred by that settlor. By contrast, if the assets of an old trust are poured into a trust created by someone other than the original settlor 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 South Dakota, 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, 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 equitable owner of the irrevocable trust resided. In general, states tax a nongrantor trust based on one or more of the following criteria:
- If the trust was created by the will of a testator who lived in the state at death;
- If the grantor of an inter vivos trust lived in the state;
- If the trust is administered in the state;
- If one or more trustees live or do business in the state;
- If one or more beneficiaries reside in the state; or
- 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 probate court in 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.
New York 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).
The Connecticut Supreme Court reached a contrary result in Chase Manhattan Bank 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 (Residuary Trust A v. Director, Division of Taxation, No. 000364-2010 (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 (1983).
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 (1) created by a child who lives in Florida, and (2) where the trust beneficiaries are all lineal 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 surmount. 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 undistributed, non-New Jersey income, but the N.J. Tax Court flatly rejected this assertion.
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.
Mindy Tyson Weber is a director, Washington National Tax in Atlanta for McGladrey LLP.
For additional information about these items, contact Ms. Weber at 404-373-9605 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with McGladrey LLP.