April 20, 2023
Building flexibility into your estate plan using various strategies is generally advised. The reason is that life circumstances change over time, specifically evolving tax laws and family situations. One technique that provides flexibility is to provide your trustee with the ability to decant a trust.
One definition of decanting is to pour wine or another liquid from one vessel into another. In the estate planning world, it means “pouring” assets from one trust into another with modified terms. The rationale underlying decanting is that, if a trustee has discretionary power to distribute trust assets among the beneficiaries, it follows that he or she has the power to distribute those assets to another trust.
Depending on the trust’s language and the provisions of applicable state law, decanting may allow the trustee to:
- Correct errors or clarify trust language,
- Move the trust to a state with more favorable tax or asset protection laws,
- Take advantage of new tax laws,
- Remove beneficiaries,
- Change the number of trustees or alter their powers,
- Add or enhance spendthrift language to protect the trust assets from creditors’ claims, or
- Move funds to a special needs trust for a disabled beneficiary.
Unlike assets transferred at death, assets that are transferred to a trust don’t receive a stepped-up basis, so they can subject the beneficiaries to capital gains tax on any appreciation in value. One potential solution is to use decanting.
Decanting can authorize the trustee to confer a general power of appointment over the assets to the trust’s grantor. This would cause the assets to be included in the grantor’s estate and, therefore, to be eligible for a stepped-up basis.
Follow your state’s laws
Many states have decanting statutes, and in some states, decanting is authorized by common law. Either way, it’s critical to understand your state’s requirements. For example, in some states, the trustee must notify the beneficiaries or even obtain their consent to decanting.
Even if decanting is permitted, there may be limitations on its uses. Some states, for example, prohibit the use of decanting to eliminate beneficiaries or add a power of appointment, and most states won’t allow the addition of a new beneficiary. If your state doesn’t authorize decanting, or if its decanting laws don’t allow you to accomplish your objectives, it may be possible to move the trust to a state whose laws meet your needs.
Beware of tax implications
One of the risks associated with decanting is uncertainty over its tax implications. Let’s say a beneficiary’s interest is reduced. Has he or she made a taxable gift? Does it depend on whether the beneficiary has consented to the decanting? If the trust language authorizes decanting, must the trust be treated as a grantor trust? Does such language jeopardize the trust’s eligibility for the marital deduction? Does distribution of assets from one trust to another trigger capital gains or other income tax consequences to the trust or its beneficiaries?
Decanting can breathe new life into an irrevocable trust. We’d be pleased to help you better understand the pros and cons of decanting a trust.