THE NEW KENTUCKY DECANTING STATUTE

Transcription

1 40th Annual Midwest Midsouth Estate Planning Institute University of Kentucky Office of Legal Education THE NEW KENTUCKY DECANTING STATUTE (HOW AND WHEN TO USE IT... AND TAX CONSEQUENCES) by Jeffrey S. Dible Frost Brown Todd LLC Lexington, Kentucky July 26, Frost Brown Todd LLC All rights reserved. DISCLAIMER AND ACKNOWLEDGEMENTS The writer gratefully acknowledges the assistance of Barton T. Rogers and M. Todd Lewis in the review and revision of these materials with specific emphasis on Kentucky law. The writer has used his best efforts to include accurate and up-to-date information in these materials. These materials primarily address Kentucky law and federal law on a topic where only 18 states have statutes, and where the law is still evolving. The author makes no warranties about the legal conclusions stated or implicit in these materials. These materials are not intended as legal advice to any specific individuals or fiduciaries. The sample form provisions are offered merely as illustrative guidance for drafting and issue-spotting.

2 Jeffrey S. Dible Mr. Dible is a member of the law firm of Frost Brown Todd LLC and practices in that firm's Indianapolis office. Mr. Dible is a Fellow of the American College of Trust and Estate Counsel (ACTEC) and has been certified as an Indiana Trust and Estate Lawyer by the Trust and Estate Specialty Board (TESB), on which he currently serves as the co-chair. He has lectured frequently throughout Indiana to other estate planning professionals, nonprofit organizations, and groups of retirees and business owners on estate planning and tax-related topics, including 2010 and 2012 federal estate and gift tax reform and the modification and early termination of trusts. In 2011 and 2012, Mr. Dible testified at several legislative committee hearings in support of the repeal of Indiana s inheritance tax and continues to testify regarding current bills of interest to estate planners. Mr. Dible served on the committee that drafted the current (2012) Marion County Local Probate Rules and Forms. In December 2011, the Estate Planning and Administration Section of the Indianapolis Bar Association gave Mr. Dible the Patricia Paxton Wagner Award for Excellence in Estate Planning and Administration. Mr. Dible is immediate past president ( ) of the Estate Planning Council of Indianapolis, and a past chairperson of the Taxation Section of the Indiana State Bar Association (ISBA. Mr. Dible is admitted to practice law in Indiana (1979) New York (1986), in the United States Tax Court (1986), and in the U. S. District Courts in Indiana and New York. Mr. Dible received his law degree from the Indiana University Maurer School of Law at Bloomington in 1979 (magna cum laude, Order of the Coif). His undergraduate degree was in economics at Purdue University, where he graduated with highest distinction, Phi Beta Kappa, in 1976.

3 TABLE OF CONTENTS I. What is a Decanting Power?...1 II. What is the Source of a Decanting Power?...2 (A) Non-Statutory Decanting Power Implied in Law from Trustee s Discretionary Power to Invade Principal....2 (B) State Statutes that Explicitly Permit Decanting....4 (C) Provisions in the Trust Instrument that Explicitly Permit Decanting....6 III. What Purposes Could Be Accomplished if a Trustee Decants?...7 IV. An Annotated Walk Through the Kentucky Decanting Statute...10 V. What are the Potential Tax Consequences if Decanting Occurs?...23 (A) For Now, Nobody Knows (Most Trust Decanting is a Non- Ruling Area) (A) Private Letter Ruling (B) (C) (D) (E) IRS Notice and General Questions About Tax Consequences Can the Tax Risk Be Minimized While We Wait for IRS Guidance?...27 Loss of Grandfathered GST Exempt Status or Loss of Zero Inclusion Ratio What is the Delaware Tax Trap, and Should We Worry About It?...31 VI. What Other Issues Should a Trustee Worry About, in Deciding Whether or Not to Decant?...33 (A) Excessive Involvement by the Settlor of the Original Trust (B) (C) (D) Frustrating the Settlor s Intent (Being Too Eager to Please Some Beneficiaries) An Attempted Change of Situs or Governing Law for the Second Trust May Not Work...34 The Risk of Beneficiary Objections to Decanting AND from Soliciting Releases or Consents from Beneficiaries (E) What If a Trustee is Also a Beneficiary of the Original Trust?...38 i

4 (F) Dealing With Later-Arising Liabilities or Problems of the First (Original) Trust VII. Final Comments...40 Appendix 1: Text of Kentucky Trust Decanting Statute (2012)...41 Appendix 2: IRS Notice Appendix 3: ACTEC s suggested answers to open tax issues...48 Appendix 4: Sample form provisions for decanting...51 ii

5 THE NEW KENTUCKY DECANTING STATUTE Decant. [transitive verb] Gradually pour (liquid, typically wine or a solution) from one container into another, esp. without disturbing the sediment. New Oxford American Dictionary, 2nd edition. Power of appointment. [noun] A power or authority conferred by one person by deed or will upon another (called the donee ) to appoint, that is, to select and nominate, the person or persons who are to receive and enjoy an estate or an income therefrom or from a fund, after the testator s death, or the donee s death, or after the termination of an existing right or interest.... A general power is in trust when any person or class of persons, other than the grantee of such power, is designated as entitled to the proceeds, or any portion of the proceeds, or other benefits to result from the alienation. Black s Law Dictionary, 4th edition. All panaceas become poison. Stewart Brand I. What is a Decanting Power? A decanting power is simply a power of appointment that is explicitly granted to or held by a trustee, who can exercise the power in favor of one or more beneficiaries of an existing trust, by distributing (decanting or pouring) assets out of the existing trust and into a new trust for the same beneficiary or beneficiaries. The new trust has favorable provisions or features that the existing trust lacks, or, conversely, the new trust lacks provisions that make the existing trust problematic, in light of the needs or changed circumstances of one or more beneficiaries. Decanting assets from old trust into new trust therefore fits the metaphor of pouring old wine into a new bottle (contra Mark 2:22), so that the unwanted provisions, the sediment, remain in the old bottle (the old trust). A decanting power is classifiable as a limited power of appointment, because the trustee, as the holder of the power, cannot exercise the power in favor of the trustee in his, her, or its individual capacity, unless the trustee also happens to be one of the beneficiaries of the old or existing trust. In this paper, original trust refers to the original or source trust from which a decanting distribution is or may be made, and second trust refers to the other trust (existing or newly created) that receives a decanting distribution. This terminology is consistent with the Kentucky statute, KRS , and with the terminology in many 1

6 other state decanting statutes (Some other state statutes use first trust to refer to the original trust). II. What is the Source of a Decanting Power? There are three potential sources of a trustee s decanting power. (A) Non-Statutory Decanting Power Implied in Law from Trustee s Discretionary Power to Invade Principal. The first source of decanting power is common law. Originally, a trustee s power to appoint trust assets from one existing trust to a different trust for the same beneficiary was implied from the breadth of the trustee s discretion to invade and distribute principal. This implied power to distribute from one trust to another trust was based on three common-sense notions: If a power of appointment can be exercised by appointing property directly and outright to some appointee (recipient), who could do whatever he wanted with the appointed property, then that appointee should be able to expand the class of persons who could benefit from the property by creating and granting a further power of appointment. 1 If a broad power of appointment allows property to be appointed for the benefit of an individual, the holder of that power should be able to appoint property to a new or existing trust under which that individual is a beneficiary. A trustee s broad power to invade principal and to distribute it to or for the benefit of a beneficiary is similar to or the equivalent of a power of appointment. And even if such a distribution power is not classified as a limited power of appointment, making a distribution from one trust to another trust with the same beneficiary is one of the ways to benefit that beneficiary. Most commentators agree that there is a difference between a limited power of appointment held and exercisable by a beneficiary in a non-fiduciary capacity and a limited power of appointment held and exercisable by a trustee in a fiduciary capacity, even if both the beneficiary and the trustee could exercise the power by appointing property to a new trust. The difference is that the trustee has a general rule to administer the subject trust (and to exercise the trustee s powers) only in ways that are consistent with the settlor s intent, the purposes of the trust, and the trustee s general fiduciary duties of loyalty and impartiality toward the beneficiaries. This distinction led 1 See Restatement (Second) of Property: Donative Transfers, 11.1, comment d and 19.3 ( ). 2

7 the drafters of the Third Restatement to take the strange position that a trustee s broad and flexible power to invade and distribute principal is not a power of appointment. 2 The following are summary of some of the early court decisions that applied common law principles to validate or to invalidate decanting: In re Kennedy s Will, 279 N.Y. 255, 18 N.E. 146 (1938). A testamentary trust gave an adult daughter a life income interest and a testamentary power to appoint the remaining assets among her children and descendants of deceased children. The daughter purported to exercise this power of appointment to create a pair of trusts for her only two children, where each child had a life income interest and a testamentary limited power of appointment regarding the corpus of his or her trust. The New York Court of Appeals reversed the Surrogate (probate court judge) and held that the daughter s power to appoint the remaining trust assets did not give her the power to create interests for her children that delayed the vesting of their respective shares, and to that extent, she did not have the power to create further trusts to receive her children s shares of the original trust assets after the daughter s death. Matter of Fiske, 195 Misc. 1017, 88 N.Y.S.2d 446 (N.Y. Sur. 1949). The testator gave his surviving spouse a legal life estate and a testamentary power to direct the manner in which his five children s shares of net income and principal from the remainder would be distributed or disposed of; this power explicitly included the power to create trusts for those children. The surviving spouse exercised this power to create a trust to receive each child s share, and she added that the remaining assets of a child who died without issue or who predeceased her should be distributed to that child s heirs. The Surrogate determined that this last provision exceeded the scope of the power of appointment that the surviving spouse received from her late husband. Phipps v. Palm Beach Trust Co., 142 Fla. 782, 196 So. 299 (1940). The irrevocable trust instrument gave an individual trustee (the settlor s spouse) the broad power to direct the co-trustees (the spouse and a corporate fiduciary) to make distributions in particular amounts, shares or proportions to any one or more of the settlor s children and their descendants, with the individual trustee controlling the timing of distributions and also having the power to give such written directions in his last will. The individual trustee (settlor s spouse) gave the trust company a written direction to distribute the entire trust property to a new but slightly different trust with the same descendants as the beneficiaries, except that the new trust, among other things, permitted one son to appoint income from his share to his wife. The Florida Supreme Court upheld a decision by a chancellor, holding that the individual trustee s broad and absolute power to direct and control distributions gave him the power to create a second trust estate for the benefit of the same beneficiaries, with distributions from the second trust to occur at times and in a manner determined by the individual trustee. 2 Restatement (Third) of Property: Donative Transfers, 17.1, comment g (Tentative Draft No. 5, 2006). 3

8 Wiedenmayer v. Johnson, 106 N.J. Super. 161, 254 A.2d 534 (1969). The founder of Johnson & Johnson established trusts in 1944 for each of his six children. The trust for one son (John Seward Johnson III) authorized the trustee to use for or distribute and pay over to that son any or all of the Trust Property... from time to time and whenever in their absolute and uncontrolled discretion [the trustees] deem it to be for his best interests, with the Trust assets so distributed to be the absolute property of the son. If the son died at a time when his trust still contained assets and had not exercised his limited testamentary power of appointment, the remaining trust assets would pass to the son s issue in equal shares per stirpes. The trustees proposed to distribute all of the trust assets (about $18 million) outright to son J. Seward Johnson III, but on the condition that he immediately transfer those assets to a new trust, with himself as the primary beneficiary and with a content proposed by the trustees. J. Seward Johnson III himself approved of the condition and the provisions of the new or second trust; two of his children objected. The New Jersey appellate court held that the distribution of the trust assets and the funding of the second trust were valid, and that the contingent remainder interests of the two objecting children were at risk of being lost under the original trust as well, if their father could receive only unconditional outright distributions. In re Estate of Spencer, 232 N.W.2d 491 (Iowa 1975). Fern Spencer died in 1944, and her Will gave her husband (L. J.) a power of appointment that he could exercise during his lifetime or by Will to grant life estates in certain real estate to their four named children, with the remainders to their respective children. L. J. Spencer died in 1972 without having exercised the lifetime power of appointment, but in his Will, he devised the subject farm real estate to the trustee of a trust for the benefit of L. J. s and Fern s four children and other descendants, with the trust to continue for the longest period permitted by the Iowa Rule Against Perpetuities. The trial court found that L. J. s purported devise of the real estate in trust was a violation of the scope of the power of appointment he received from Fern. The Iowa Supreme Court held that L. J. s devise of the real estate to a trust for the children and other descendants was consistent with Fern s intent and was a valid exercise of L. J. s power of appointment, but that L. J. s trust provisions were invalid to the extent that they postponed the vesting of each child s fractional interest in the trust assets as that child died. Some trustees especially banks and trust companies that have a more finelyhoned sense of rational paranoia have been reluctant to act without the protection of court approval or a state statute, i.e., to exercise a discretionary power to invade principal by distributing assets from one trust into another trust, unless it appeared extremely unlikely that any beneficiary would object to the distribution to the second trust. (B) State Statutes that Explicitly Permit Decanting. The second source of decanting power is statutory. New York was the first U. S. state to enact a decanting statute, effective July 24, The passage of Section (b) 4

9 of the Estates, Powers and Trusts Law (EPTL) was originally motivated largely by a desire to allow trustees of existing (pre-september 26, 1985) generation-skipping trusts to adapt to changing circumstances without losing the grandfathered exemption from the re-tooled and re-enacted GST tax provisions that were added to the Internal Revenue Code, effective for transfers on or after October 23, As of March 2013, the eighteen (18) state statutes 3 that currently permit decanting are as follows (Effective dates are stated in parentheses): Kentucky: KRS (July 12, 2012) Ohio: Ohio Rev. Code (March 22, 2012) Indiana: I.C (July 1, 2010) Illinois: 760 Ill. Comp. Stat. 5/ 16.4 (January 1, 2013) North Carolina: N.C. Gen. Stat. 36C (October 1, 2009; amendment effective July 20, 2010) Delaware: 12 Del. C (June 30, 2003; amendments effective June 24, 2004, June 27, 2006, July 5, 2007, July 6, 2009, and July 13, 2011) Florida: Fla. Stat (January 1, 2007) Michigan: Mich. Comp. Laws a, a, and (December 28, 2012) Rhode Island: R.I. Gen. Laws (June 23, 2012; 2013 amendments possible) Missouri: Mo. Rev. Stat (August 28, 2011) Nevada: 13 Nev. Rev. Stat (2009) Tennessee: Tenn. Code Ann (b)(27) (July 1, 2004) New York: EPTL (b) (January 24, 1992; amendment effective August 17, 2011) New Hampshire: N.H. Rev. Stat. Ann. 564-B: (September 9, 2008) Alaska: Alaska Stat (September 15, 1998; amendments in 2006; proposed amendments in most recent session failed) Virginia: Va. Code and (after recodification) (July 1, 2012) South Dakota: S.D. Codified Laws to (2007) Arizona: Ariz. Rev. Stat. Ann (2009) 3 In February 2013, a Texas state senator introduced SB 648, which would amend 112 of the Texas Property Code to add trust decanting provisions. As of mid-june 2013, that bill was either stalled in committee or dead. 5

10 (C) Provisions in the Trust Instrument that Explicitly Permit Decanting. The third source of a trustee s decanting power is a provision in the trust instrument for the original trust (first trust) that explicitly permits distribution from that trust to a second trust (new trust) for the same beneficiary or beneficiaries. In 2013, with the exception of standard facility of payment or flexible distribution clauses that typically apply to trust beneficiaries who are minors or incapacitated, 4 trust provisions that specifically allow decanting (either with or without using the word decant ) are relatively rare in trust instruments. A specific decanting provision in a Kentucky trust instrument could permit decanting in a wider range of situations than Indiana s statute would permit, because of the general ability of a settlor to create trust provisions that apply instead of or in addition to the gap-filling rules of law in the Kentucky Uniform Trustees Powers Act and UPIA (e.g., KRS and (1)(a) and (b)). This writer suggests that an explicit decanting provision in a trust instrument should be custom-tailored to the settlor s purposes and to the particular characteristics and foreseeable future needs and circumstances of the trusts beneficiaries. If a trust instrument contains a broad, general decanting provision that purportedly allows the trustee to decant for a wide variety of purposes and to second trusts with widely-varying potential structures, the trustee may become paralyzed or confused by having too many choices and too little guidance, and a particular decanting distribution may violate the principles in KRS with uncertain legal, practical, and tax consequences. However, purely as an illustration of the kinds of purposes that could be served by a specific decanting provision in a trust instrument, Appendix 4 contains a general sample provision. 4 For example, a provision in the trust instrument that authorizes the trustee to distribute the share of a minor beneficiary to a minor s trust that fits the requirements of Code 2503(c). Under KRS (3)(v), a trustee s general statutory powers include the power: (v) To pay any sum distributable to a beneficiary under legal disability, without liability to the trustee, by paying the sum to the beneficiary or by paying the sum for the use of the beneficiary either to a legal representative appointed by the court, or if none, to a relative. This statutory power is arguably not worded broadly enough to allow the trustee to make a distribution on behalf of a disabled or incapacitated beneficiary to the trustee of an existing or newly-created trust for that beneficiary. 6

11 III. What Purposes Could Be Accomplished if a Trustee Decants? Trust decanting is a tool with uses similar to statutory remedies (such as courtapproved modifications or deviations or extra-judicial settlements in Uniform Trust Code jurisdictions), severances and mergers of trusts (either statutory or with court approval), 5 disclaimers, instrument-based tools such as trust protector or trust advisor action or limited amendment powers, or common-law remedies of reformation. Like these other tools, a decanting power can be used to achieve roughly the same variety of end results to update administrative provisions, to modify the interests of one or more beneficiaries, or to change the pattern of permitted or required distributions, in order to circumvent inflexible provisions or to deal with changes in circumstances that the settlor of the original trust did not anticipate. 6 The objectives that can be achieved through decanting vary from state to state, and some of the end results listed below would not be permitted under some state decanting statutes. But all of the following objectives either are theoretically achievable through decanting in at least one state or have been accomplished in particular cases: Changing purely administrative provisions, or adding new ones, to make changes of situs easier or to keep abreast of changes in state law Creating more specific or up-to-date rules in the second trust for trustee compensation, trustee powers, accountings, beneficiary access to information, and more flexible procedures for trustee replacement Changing the trustee management structure e.g., to provide for a division of labor between multiple cotrustees or to create the position(s) of directed trustee, distribution committee, trust protector or supervisor, trust advisor, investment manager, etc. 5 For example, the IRS determined that a severance of trusts into separate trusts under state law, followed by a merger of some of those trusts into existing trusts achieving the same end result as decanting would not have adverse estate, gift or GST tax consequences. See PLR (July 30, 2004). 6 However, unlike those other remedies, which usually require either the approval of a court or notice to or the consent of interested beneficiaries, a decanting power is generally exercisable without court approval (In Kentucky, court approval is not required unless a beneficiary files a timely objection proceeding after receiving notice). 7

12 Delay or eliminate the time at which a beneficiary of the original trust acquires a vested right to receive the outright distribution of all (or a stated fraction of) the trust assets [not possible in Kentucky if that beneficiary s interest in the original trust was funded with non-taxable gifts under Code 2503(c) or (b)] Eliminate the mandatory income interest of a non-spouse beneficiary who is also entitled to receive or benefit from discretionary distributions of trust principal [not possible in Kentucky to eliminate or reduce a beneficiary s fixed income, annuity, or unitrust interest] Getting rid of a HEMS standard that constrains or applies to the trustee s discretionary distribution powers under the original trust [not possible in Kentucky to remove an ascertainable standard if the trustee is also a beneficiary; otherwise, a standard in the original trust can be removed or made more or less restrictive in the second trust] Give a current or future beneficiary of the original trust a testamentary limited power of appointment under the second trust Add (in the second trust) spendthrift restrictions to the interest(s) of one or more beneficiaries of the original trust, to react to problems of substance abuse, financial irresponsibility, or the objective of maintaining eligibility for government benefits Following the severance (division) of one multi-beneficiary ( pot ) trust into separate trusts, transfer the trust assets for one (or fewer than all) of the beneficiaries to a new trust(s) that contains appropriate special needs or spendthrift restrictions Eliminating the interests of some contingent remainder beneficiaries under the original trust [Kentucky s statute arguably permits the elimination of one or more beneficiaries in the second trust so long as they do not have fixed income, unitrust, or annuity interests in the original trust] Adding contingent remainder beneficiaries in the second trust [Kentucky s statute does not permit the second trust to add beneficiaries who are not beneficiaries of the original trust, but if beneficiaries of the second trust are given powers of appointment, nonbeneficiaries could be permissible appointees] 8

13 Postponing the date on which the original trust must terminate (under the trust instrument for the original trust or under the applicable state Rule Against Perpetuities) [In Kentucky, possible only so long as vesting or the right of alienation is not postponed beyond the statutory RAP period] Addressing long-term GST tax problems with a multi-generation trust by giving skip-person beneficiaries general testamentary powers of appointment under the second trust, to deliberately cause estate inclusion under Code 2041 Converting a grantor trust to a nongrantor trust, or accomplishing the reverse (see Chief Counsel Advice ) Eliminating the Crummey withdrawal power of one beneficiary when a second ILIT is created to receive a decanting distribution from the first ILIT 7 [not possible in Kentucky unless the withdrawal power being eliminated is a one-time power and unless sufficient assets are left inside the original trust] Many of the above objectives could be achieved through limited amendments, if the original trust instrument gives a special amendment power to a trustee or other person, or if a court could be convinced to approve or authorize an amendment. Frequently, however, no trustee has an explicit amendment power; or the factual basis for court approval of an amendment is weak; or it is not possible to obtain waivers of notice and consents from all (or a sufficient majority) of the interested beneficiaries of the trust. The use of decanting to achieve one of the above-listed results could, in a particular situation, (a) cause unfavorable tax consequences, or (b) be outside the scope of the relevant state statute, or (c) attract objections or claims of breach of trust from one or more beneficiaries, on the grounds that the decanting was contrary to the settlor s intent or the purposes of the original trust. A trustee has a general obligation to defend and carry out the settlor s known intent. Even if a proposed decanting would make only administrative changes to the original trust, it may be wise or even essential for the trustee to seek advance court approval for the proposed decanting, if the resulting changes would reduce or narrow the standard of care or tend to limit the trustee s future liability to the beneficiaries. 7 See Matter of Ould, New York Law Journal, , p. 21, col. 5 (Surr. Ct. N.Y. County). 9

14 IV. An Annotated Walk Through the Kentucky Decanting Statute Kentucky s statute, KRS (see Appendix 1 for the text without annotations), only applies to decanting by trustees. If a trust instrument gives a nonfiduciary, such as a beneficiary, a suitably broad limited power of appointment to appoint trust assets to another (second) trust, that non-fiduciary could exercise the power of appointment within its stated limits and conditions, but without regard for the conditions and restrictions in In the table below, the left column contains the verbatim text of the subsections and paragraphs in Kentucky s statute and the right column contains explanatory comments. Text of KRS Comments (1) For the purposes of this section, the following definitions apply: (a) Current beneficiary means a person who is a permissible distributee of trust income or principal; (b) Original trust means a trust established under an irrevocable trust instrument pursuant to the terms of which a trustee has discretionary power to distribute principal or income of the trust to or for the benefit of one (1) or more current beneficiaries of the trust; and A current beneficiary can have the right to receiver or benefit from either discretionary or mandatory distributions of either income or principal. The definition of current beneficiary is important in testing whether the second trust is a trust to which a decanting distribution can be made. Decanting distributions are permitted only if the trustee of the original trust has the discretion to distribute principal OR income to or for the benefit of at least one current beneficiary. No particular distribution standard is specified and the trustee need not have unlimited or absolute discretion (see subsection (4)(h) below). 10

15 Text of KRS Comments (c) Second trust means a trust established under an irrevocable trust instrument, the current beneficiaries of which are one (1) or more of the current beneficiaries of the original trust. The second trust may be a trust created under the same trust instrument as the original trust or under a different trust instrument. (2) A trustee of an original trust may, without authorization by the court, exercise the discretionary power to distribute principal or income to or for the benefit of one (1) or more current beneficiaries of the original trust by appointing all or part of the principal or income of the original trust subject to the power in favor of the trustee of a second trust. The trustee of the original trust may exercise this power whether or not there is a current need to distribute principal or income under any standard provided in the terms of the original trust. The trustee s special power to appoint trust principal or income in further trust under this section includes the power to create the second trust. (3) The second trust may be a trust created or administered under the laws of any jurisdiction, within or without the United States. The second trust s current beneficiaries must consist of one or more of the current beneficiaries of the original trust. This language and subsection (4)(a) allow the second trust to eliminate the interest of one or more beneficiaries of the current trust (so long as at least one beneficiary remains) but not to add any new beneficiaries. This prohibition on adding beneficiaries to the second trust may help to prevent a taxable gift from occurring as a result of decanting. The decanting distribution is made to the trustee of the second trust. Either income OR principal OR both can be decanted to the second trust. Even if the original trust instrument prescribes a distribution standard under which there is arguably no current need for a distribution, the trustee can still decant. The trustee s decanting power is classified or characterized as a special power of appointment. The trustee of the original trust can create the second trust to which the decanting distribution will be made. Multiple second trusts may receive different decanting distributions. The second trust may accomplish a change of situs or governing law (compared to the original trust). 11

16 Text of KRS Comments (4) The terms of the second trust shall be subject to all of the following: (a) The beneficiaries of the second trust may include only beneficiaries of the original trust; (b) A beneficiary who has only a future beneficial interest, vested or contingent, in the original trust cannot have the future beneficial interest accelerated to a present interest in the second trust; Subsection (4) places limits on what would otherwise be a broad power to decant. The second trust instrument cannot add beneficiaries who are not beneficiaries of the original trust, but current or future beneficial interests that are purely discretionary could be eliminated. A beneficiary s future interest in the first trust cannot be replaced with a present interest in the second trust (to prevent a taxable gift). (c) The terms of the second trust may not reduce any fixed income, annuity, or unitrust interest of a beneficiary in the assets of the original trust, including an interest which is to take effect in the future; (d) If any contribution to the original trust qualified for a marital or charitable deduction for federal income, gift, or estate tax purposes under the Internal Revenue Code, then the second trust shall not contain any provision that, if included in the original trust, would have prevented the original trust from qualifying for the deduction or that would have reduced the amount of the deduction; Similar to many other state decanting statutes: If a beneficiary of the original trust has a non-discretionary income interest, annuity interest, or unitrust interest, that interest must be preserved in the second trust. Subsection (4)(d) is intended to prevent the loss of a charitable or marital deduction as a result of a decanting distribution. 12

17 Text of KRS Comments (e) If contributions to the original trust have been excluded from the gift tax by the application of Sections 2503(b) and 2503(c) of the Internal Revenue Code, then the second trust shall provide that the beneficiary s remainder interest in the contributions shall vest and become distributable no later than the date upon which the interest would have vested and become distributable under the terms of the original trust; Subsection (4)(e) s reference to the beneficiary s remainder interest is slightly odd. Example 1: The original trust is a 2503(c) minor s trust under which the child beneficiary has a one-time withdrawal right for a 30-day period beginning at age 21 AND the right to receive mandatory distributions of trust principal at ages 30, 35, and 40. The second trust must provide that child beneficiary with the same withdrawal right at age 21 AND the right to receive mandatory distributions at those ages or at earlier ages. The times for vesting and for mandatory distributions can be accelerated but not postponed further in the second trust. (f) If any beneficiary of the original trust has a currently exercisable power of withdrawal over trust property, then either: a. The terms of the second trust shall provide a power of withdrawal in the second trust identical to the power of withdrawal in the original trust; or b. Sufficient trust property shall remain in the original trust to satisfy the currently exercisable power of withdrawal; A currently exercisable withdrawal power under the original trust must be protected using either of the two methods in a and b. Method a could be used if a decanting distribution is being made from an existing ILIT or from some other type of 2503(b) trust into a new trust, when future gifts will be made to the new trust and when it is important to preserve the exclusion from taxable gifts. Method b may be suitable if the currently exercisable withdrawal power in the original trust is a one-time power. Example 2: The original trust is an ILIT in which all 3 of the settlor s children 13

18 Text of KRS Comments have Crummey withdrawal powers with respect to all gift additions to the ILIT. Neither Method a nor Method b could be used to eliminate the withdrawal power of 1 or 2 of those children under the second trust s terms. Example 3: The original trust has Child C as its sole current beneficiary and has never received annual exclusion gifts. C is 20 years old and has the right to receive or benefit from discretionary income and principal distributions. Immediately after reaching ages 30 and 35, C has the right to demand and withdraw one- third and one-half of the remaining trust principal. These two withdrawal powers are not currently exercisable, and so trustee could make a decanting distribution to a new second trust for C, under which C s withdrawal rights are postponed or eliminated. (g) If the original trust holds stock of an S corporation, the terms of the second trust shall not prevent or eliminate an election to be a qualified subchapter S trust or an electing small business trust or result in the termination of the S election of such corporation; After decanting, the second trust probably can use a QSST election to replace the original trust s ESBT election, but the reverse probably cannot be done via decanting unless the second trust preserves the all net income interest of each income beneficiary under the original trust. See 26 C.F.R (j)(12) and (m)(7) for the preconditions for IRS approval of a QSST-to-ESBT or ESBT-to-QSST conversion. 14

19 Text of KRS Comments (h) If the power to distribute principal or income in the original trust is subject to an ascertainable standard, then the power to distribute income or principal in the second trust shall be subject to the same or a more restrictive ascertainable standard as in the original trust when the trustee exercising the power described in subsection (2) of this section is a possible beneficiary under the standard; and Subsection (4)(h) arguably applies only if the trustee is also a beneficiary, and seems intended to prevent the accidental creation of a general power of appointment in the hands of the trustee if he or she remains a trustee under the second trust. If (4)(h) applies and if the original trust contains an ascertainable standard such as HEMS language to limit or guide the trustee s discretion, that standard must be preserved or made more restrictive in the second trust (To prevent the occurrence or appearance of a taxable gift, the second trust cannot eliminate or delete the ascertainable standard). Conversely, the second trust can ADD an ascertainable standard and/or spendthrift restrictions to any beneficiary s discretionary interest, and if the trustee is not a beneficiary, an ascertainable standard can be removed. Example 4: The original trust gives daughter beneficiary D the right to benefit from wholly discretionary distributions from trust income and principal. D has a serious substance abuse problem and the trustee wishes to give D an incentive to get and stay clean. Because D does not have a mandatory income interest in the original trust, the trustee could decant assets into a second trust under which D s entitlement to receive distributions would be conditioned on passing periodic drug screenings. 15

20 Text of KRS Comments (i) The second trust may confer a power of appointment upon a beneficiary of the original trust to whom or for the benefit of whom the trustee has the power to distribute principal or income of the original trust. The permissible appointees of the power of appointment conferred upon a beneficiary may include persons who are not beneficiaries of the original or second trust. The power of appointment conferred upon a beneficiary shall be subject to KRS , , and covering the time at which the permissible period of the rule against perpetuities and suspension of power of alienation begins and the law that determines the permissible period of the rule against perpetuities and suspension of power of alienation of the original trust. Even if the original trust does not confer a power of appointment on a beneficiary, the second trust can give that beneficiary a power of appointment, and that power could allow appointment of trust assets to persons who are not beneficiaries of either trust. The cross-references are to the Kentucky statutory rule against perpetuities (RAP) as it applies to interests in trusts. See the discussion of the Delaware Tax Trap on Page 31 below. With respect to trusts from which decanting distributions can be made, KRS (1)(c) should prevent the Delaware Tax Trap by causing the permissible [RAP] period to start running when the original trust was created. Reformation or modification proceedings should be available under KRS (2) to cure a real or apparent RAP problem that is created by decanting from an original trust. (5) The court may appoint a special fiduciary with the authority to exercise the power to appoint principal or income under subsection (2) of this section. If the current trustee or co-trustees of the original trust is or are gun-shy and reluctant to exercise the statutory decanting power (e.g., the trustee is also a beneficiary and perceives a conflict of interest), the court can appoint a special trustee with one-time or (presumably) continuing authority to make decanting distributions. 16

21 Text of KRS Comments (6) The exercise of the power to appoint principal or income under subsection (2) of this section: (a) Shall be considered an exercise of a power of appointment, other than a power to appoint to the trustee, the trustee s creditors, the trustee s estate, or the creditors of the trustee s estate; (b) Shall be subject to KRS , , and covering the time at which the permissible period of the rule against perpetuities and suspension of power of alienation begins and the law that determines the permissible period of the rule against perpetuities and suspension of power of alienation of the original trust; and (c) Is not prohibited by a spendthrift provision or by a provision in the original trust instrument that prohibits amendment or revocation of the trust. Subsection (6) confirms how a decanting distribution should be characterized. Consistent with case law and the Second and Third Restatements, a decanting distribution is treated as the trustee s exercise of a special (non-general) power of appointment. Also relevant under the second half of KRS (1)(c). See the discussion of subsection (4)(i) above and the discussion of the Delaware Tax Trap below. A spendthrift restriction on a beneficiary s interest in the original trust does not prohibit decanting. This Kentucky statute does not explicitly prohibit the removal of a spendthrift restriction in the second trust. 17

22 Text of KRS Comments (7) To effect the exercise of the power to appoint principal or income under subsection (2) of this section, all of the following shall apply: (a) The exercise of the power to appoint shall be made by an instrument in writing, signed and acknowledged by the trustee, setting forth the manner of the exercise of the power, including the terms of the second trust and the effective date of the exercise of the power. The instrument shall be filed with the records of the original trust; Subsection (7) specifies the required documentation, notice, and procedure for making a valid decanting distribution. (a) requires that the terms of the second trust be stated in the signed record of the exercise of the decanting power. The trustee of the original trust (or the court-appointed special fiduciary) must sign the record of exercise before a notary or other officer authorized to take acknowledgements. Presumably, a copy of the entire trust instrument for the second trust could be attached to the signed record. The record of exercise arguably should cite the provision in the original trust instrument that gives the trustee the discretionary power to distribute income and/or principal, and that is being relied on as the source of the decanting power. The record of exercise arguably must specify the amount of money or describe the other assets being distributed out of the original trust (as part of the manner of exercise of the power ). Unless there is a later objection or dispute, the record of exercise need not be filed with any court, but a copy of the record of exercise must be provided to certain beneficiaries, under subsection (7)(b) [next page]. 18

23 Text of KRS (b) The trustee shall give written notice of the trustee s intention to exercise the power to all current beneficiaries of the original trust and all beneficiaries of the oldest generation of remainder beneficiaries of the first [sic] trust, by certified mail with restricted delivery and return receipt, at least sixty (60) days prior to the effective date of the exercise of the power to appoint. The notice shall include a copy of the instrument described in paragraph (a) of this subsection; Comments Under (7)(b), 60 days advance notice is mandatory. Any beneficiary currently eligible to receive mandatory or discretionary distributions of income OR principal from the original trust must be sent written notice. Remainder beneficiaries of the original trust in the first generation (e.g., the children of a life income beneficiary) must be sent notice, but a contingent remainder beneficiary (who would not be a qualified beneficiary under UTC 103(13)(B) or (C)) need not be sent notice. Can principles of virtual representation be used to send written notice to representatives on behalf of beneficiaries who are minors or who are otherwise under a legal disability? If mailing by certified mail with restricted delivery and return receipt is not effective to deliver the statutory notice to a beneficiary, subsection (7)(e) implies that the trustee may not seek the court s approval to use a different method of service; the only recourse is for the trustee to seek court approval of the proposed decanting under (e). 19

24 Text of KRS (c) If all beneficiaries entitled to notice have received the notice as evidenced by the certified mail return receipt and waive the notice period by a signed written instrument delivered to the trustee, the trustee s power to appoint principal or income shall be exercisable after notice is waived by all such beneficiaries, notwithstanding the effective date of the exercise of the power; (d) A current beneficiary or a beneficiary who is not a current beneficiary but is a member of the oldest generation of the remainder beneficiaries of the original trust may, no later than thirty (30) days from the date of receiving notice under paragraph (b) of this subsection, commence a judicial proceeding in District Court pursuant to KRS to object to the proposed exercise of the power under subsection (2) of this section. In such case the proposed exercise of the power shall require consent of the District Court as defined by KRS (3). Any determination of the District Court shall be subject to KRS (5); and Comments The 60-day lead time between the service of notice and the effective date for decanting can be shortened if ALL beneficiaries who are entitled to notice have received the certified mail notice and sign written waivers of the rest of the lead time. Read literally, (7)(c) would not allow the trustee of the first trust to solicit and receive written waivers by sending the proposed record of exercise and notice to each beneficiary by or by overnight courier delivery. Two classes of beneficiaries can block proposed decanting (unless a District Court approves it) by commencing a proceeding to object: Any current beneficiary of the original trust, as defined in subsection (1)(a) Any remainder beneficiary who is a member of the oldest generation of remainder beneficiaries named or defined in the original trust The objecting beneficiary must file the objection proceeding within 30 days after receipt of the statutory notice under (7)(b). If the trustee or a beneficiary party disagrees with the District Court s decision to approve or disapprove the decanting distribution after a timely objection, the aggrieved party can file an adversary proceeding in Circuit Court (cross-reference to KRS (5), which in turn refers to KRS 24A.120(2)). 20

25 Text of KRS (e) In the event that a beneficiary did not receive the notice as evidenced by the certified mail return receipt, and no other beneficiary has commenced a proceeding under paragraph (d) of this subsection, the trustee may seek the approval of the District Court to exercise the power. (8) Nothing in this section shall be construed to create or imply a duty of the trustee to exercise the power to distribute principal or income, and no inference of impropriety shall be made as a result of a trustee not exercising the power to appoint principal or income conferred under subsection (2) of this section. Nothing in this section shall be construed to abridge the right of any trustee who has the power to appoint property in further trust that arises under the terms of the original trust or under any provision of law or under common law. Comments Subsection (7)(b) and (e) make the notice process unwieldy if any beneficiary refuses to accept certified mail service or cannot be served by mail, even if there is no objection by any of the beneficiaries who have received sufficient service by certified mail. (8) is a broad statement of legislative intent. The first sentence protects the trustee of the original trust from a breach-of-trust claim if any beneficiary is displeased with the trustee s decision to refrain from exercising the decanting power. The second sentence in (8) means that explicit, customized decanting powers can be included in new irrevocable trust instruments. Trustees who rely on such explicit decanting provisions or on other applicable law (instead of relying on the Kentucky statute) may make decanting distributions that would not be permitted under the Kentucky statute. Whether such decanting distributions would cause adverse tax consequences or other problems is a separate issue. (9) This section shall not apply to any charitable remainder trust as defined in 26 U.S.C. sec. 664(d). For obvious reasons, decanting from a CRAT or CRUT is not permitted under this statute Early terminations and severances of CRATs and CRUTs are still possible with court approval. 21