Trust Decanting Tax Consequences Navigating Income, Estate, Gift, and GST Tax Implications and Potential Safe Harbor Rules

Transcription

1 Presenting a live 90-minute webinar with interactive Q&A Trust Decanting Tax Consequences Navigating Income, Estate, Gift, and GST Tax Implications and Potential Safe Harbor Rules TUESDAY, FEBRUARY 19, pm Eastern 12pm Central 11am Mountain 10am Pacific Today s faculty features: Meryl G. Finkelstein, Sr. Counsel, Fulbright & Jaworski, New York Todd A. Flubacher, Partner, Morris Nichols Arsht & Tunnell LLP, Wilmington, Del. The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions ed to registrants for additional information. If you have any questions, please contact Customer Service at ext. 10.

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5 STRAFFORD WEBINARS & TELECONFERENCES Tuesday, February 19, 2013 Meryl G. Finkelstein, Esq. Fulbright & Jaworski L.L.P. 666 Fifth Avenue New York, NY (212)

6 INTRODUCTION A trust decanting, whether effectuated by a state statute, pursuant to a decanting provision in the trust instrument or under common law, allows a trustee who has the discretion to invade trust principal (and under some state statutes, trust income) for the benefit of one or more trust beneficiaries to exercise that discretion by transferring some or all of the assets of an existing trust (the first trust ) to a new trust (the second trust ) for the beneficiaries of the first trust. The basic principal underlying a trust decanting is that if the property of the first trust could be distributed outright to a trust beneficiary, it can also be distributed in further trust for the beneficiary. Eighteen states have enacted specific decanting legislation and at least two other states have proposed statutes. Where applicable, a decanting statute should apply to a trust unless the trust instrument specifically states to the contrary _1 States with Decanting Statutes: New York (1992, but substantially amended in August 2011) Alaska (1998) Delaware (2003) Tennessee (2004) Florida (2007) South Dakota (2007) New Hampshire (2008) Nevada (2009) (amended 2011) Arizona (2009) North Carolina (2009) Indiana (2010) Missouri (2011) Ohio (2012) Kentucky (2012) Virginia (2012) Illinois (2012) Rhode Island (2012) Michigan (2012) States with Proposed Decanting Statutes: South Carolina (introduced in February 2012) Colorado (stalled within Colorado Bar Ass n) Alaska -- significant proposed amendments that were not approved prior to the end of the legislative session Only two state statutes use the word decanting in their title. Most statutes simply refer to a trustee s distribution power. 6

7 DECANTING UNDER COMMON LAW What if you practice in a state that does not have a decanting statute and the trust instrument does not contain a decanting provision? A decanting may still be possible under common law. A common law basis for decanting is recognized under court decisions in Florida, New Jersey and Iowa, and is also supported under both the Second and Third Restatements of Property _1 A. CASES 1. Phipps v. Palm Beach Trust Co. (Florida Supreme Court) (1940): Phipps is the first American case recognizing the ability of a trustee authorized to make discretionary trust distributions to exercise that power to distribute trust assets to a second trust for the benefit of the beneficiaries of the first trust. Facts Wife ( W ) created a discretionary trust for her children and descendants and named Husband ( H ) and Trust Co. as trustees, giving H the absolute discretion to distribute trust assets among the beneficiaries. H distributed the assets of the first trust to a second trust for the benefit of the same persons. However, the second trust granted one of W s children a testamentary power of appointment exercisable in favor of his wife, who was not a beneficiary under the first trust. Issue The corporate trustee brought a construction proceeding to determine whether H s actions were within the scope of his powers as trustee. Holding The Florida Supreme Court upheld H s actions. First, it determined that H s distribution power was a special power of appointment, which included not only the ability to appoint the trust property outright, but also to create a lesser interest, such as an interest in further trust. Second, the Court noted that the class of beneficiaries under the second trust was identical to those under the first trust. Commentary Phipps is routinely cited as common law authority for a trustee s ability to appoint trust property in further trust, However, H s distribution power was more similar to a beneficiary power of appointment and less like the type of discretionary distribution power that a trustee normally has. 7

8 DECANTING UNDER COMMON LAW (CONTINUED) 2. Wiedenmayer v. Johnson (N.J. Superior Court) (1969) Facts Wiedenmayer involved a trust held for the benefit of an heir to the Johnson & Johnson family fortune. The trust gave the trustees absolute discretion to distribute trust principal to the beneficiary at any time they deemed it to be for his best interests. The trustees distributed the trust assets to another trust for the benefit of the beneficiary. The beneficiary had been married and divorced, and the trustees determined that the distribution in further trust was for the financial benefit of the beneficiary in that it would protect the trust assets from the claims of another spouse. Issue The guardian ad litem for the beneficiary s minor children opposed the distribution, claiming that it would defeat the children s contingent remainder interest under the first trust. Holding The court held for the trustees. It found that the appointment in further trust was consistent with the settlor s intent since it was in the best interest of the beneficiary to protect the trust assets from future creditor claims. It also noted that an outright distribution of trust assets to the beneficiary, which was within the scope of the trustee s powers, would similarly defeat the interests of the trust s remainder beneficiaries _1 8

9 DECANTING UNDER COMMON LAW (CONTINUED) 3. In Re: Estate of Spencer (Iowa Supreme Court) (1975) Facts Wife ( W ) created a testamentary trust for her children and gave Husband ( H ), who was a trustee, a testamentary power to grant life estates to the children, with the remainder to pass to W s grandchildren. H exercised his power of appointment by creating a trust for his children, to last for the maximum period allowed by the Rule Against Perpetuities. Issue The court examined whether H had the right to appoint the trust property in further trust for his children, as opposed to granting them life estates. Holding The court determined that H s appointment in further trust for the children during their lives was consistent with W s intention that the trust assets remain within her family line and that they pass as a single unit. However, the Court also held that it was clear that W intended that the property be owned outright by her grandchildren after the death of her children, and that H s attempt to continue the trust following the death of his children was an invalid exercise of his power and thus void. Note The power held by H was exercisable in his individual capacity, not in his capacity as a trustee of the trust. Thus, the court did not analyze the exercise of the power from a fiduciary standpoint _1 9

10 DECANTING UNDER COMMON LAW (CONTINUED) B. RESTATEMENTS OF PROPERTY Under the majority of state decanting statutes, a trustee s exercise of the power to distribute trust property from a first trust to a second trust is expressly analogous to the exercise by the trustee of a special power of appointment. Second Restatement of Property 1.Under the Second Restatement, a trustee s discretionary power to distribute trust assets gives the trustee the power to designate beneficial interests in the trust property and is considered a power of appointment as defined in the Second Restatement. 2.The power to appoint the trust property allows the trustee to vest interests in the property in the appointees of the property, and to divest the interests of the persons who would otherwise receive the property in default of the exercise of the power. 3.Under the Second Restatement, unless the donor has manifested a contrary intention, the holder of a special power of appointment has the same rights to dispose of the property among the objects of the power that he would have had he owned the property directly i.e., by making either an outright disposition of the property or disposing of it in further trust. 4.Thus, unless a trust instrument specifically limits the trustee s distribution power to making outright distributions, the trustee s distribution power includes the power to appoint the trust property in further trust for the beneficiaries _1 10

11 DECANTING UNDER COMMON LAW (CONTINUED) Third Restatement of Property 1.The Third Restatement takes a different approach by distinguishing between beneficiary powers of appointment and fiduciary distributive powers. 2.Under the Third Restatement, fiduciary distributive powers include a trustee s power to distribute trust income and principal to one or more designated trust beneficiaries. 3.A fiduciary distributive power is not considered a discretionary power of appointment under the Third Restatement because the exercise of the power is subject to the trustee s fiduciary obligations. 4.The Third Restatement provides that subject to fiduciary standards and the terms of the power as set forth in the trust instrument, a trustee can exercise a fiduciary distributive power such as a power of invasion to create another trust. 5.In addition, under the Third Restatement, a trustee exercising a distribution power in further trust is expressly subject to the same rules that apply to the exercise of a beneficiary power of appointment, including the persons for whose benefit the power can be exercised, under the same rules that apply where a trust is created by a beneficiary s exercise of a special power of appointment _1 11

12 REASONS TO DECANT A TRUST A trust decanting can be used to achieve a number of objectives with respect to the first trust. Common uses include: 1. To modify and/or modernize the first trust s administrative provisions. 2. To change the first trust s dispositive provisions (to the extent permitted by state law or the trust instrument) in order to address unforeseen circumstances of the beneficiaries of the first trust. 3. To change the first trust s governing law and/or situs. 4. To change the first trust s provisions in order to achieve certain tax benefits, including changes in grantor trust status. 5. To correct ambiguities and drafting errors in the first trust. 6. To strip out or segregate problem assets held by the first trust. 7. To separate trust assets in order to employ different investment strategies or combine the assets of multiple trusts to take advantage of increased investment opportunities and/or reduce investment costs _1 12

13 IRS NOTICE In Notice (the Notice ) the IRS requested comments from practitioners regarding the income, gift, estate and GST tax issues and consequences of a decanting that changes beneficial interests of the first trust. 2. For purposes of the Notice, a change in beneficial interests occurs when the interests of beneficiaries of the first trust are changed or terminated under the second trust and/or when the second trust adds a new beneficiary. 3. The Notice identifies thirteen facts and circumstances as potentially having tax consequences. These include situations where: a. A beneficiary s right to or interest in trust property is changed; b. Trust beneficiaries are added; c. Beneficial interests are added, deleted, or changed; d. Assets are transferred from a grantor trust to a non-grantor trust or vice versa; e. Beneficiaries of the first trust are required to consent, are not required to consent or actually do consent even though consent is not required; f. The identity of the transferor for gift and/or GST tax purposes changes; and g. The first trust is a GST grandfathered trust or is exempt from GST tax _1 13

14 IRS NOTICE The Notice also seeks guidance (a) in how decanting should be defined, (b) whether there should be additional tax consequences if the decanting is from a U.S. trust to a foreign trust or vice versa and (c) whether a new employer identification number should be required where all of the principal of the first trust is distributed to another trust. 5. While this issue is under study, the IRS has advised that it will not issue any private letter rulings with respect to a decanting that involves a change in beneficial interests, but it will continue to issue rulings with respect to transfers that do not change any beneficial interests and do not result in a change in the applicable rule against perpetuities period _1 14

15 IRS NOTICE In response to the Notice, various state bar associations and other professional organizations including the New York State Bar Association ( NYSBA ) Tax and Trusts and Estates Law Sections, The American College of Trust and Estate Counsel ( ACTEC ), the American Bar Association ( ABA ) Section of Taxation, the ABA Section of Real Property, Trust and Estate Law, and the Delaware State Bar Association and Delaware Bankers Association submitted formal comments. A review of the comments indicate that many of the tax consequences of a trust decanting are not settled law. One reason for this is the fact that few of the existing Treasury Regulations and Code sections expressly deal with a trust decanting (rather, they deal with distributions from trusts). As a result, in a number of circumstances, the comments specifically request that the IRS issue guidance to practitioners to provide much needed clarity in this area. Submitted comments include the following: NYSBA Tax Section, NYSBA Trusts and Estates Law Section, Report on Notice : Request for Comments Regarding the Income, Gift, Estate and Generation-Skipping Transfer Tax Consequences of Trust Decanting (April 26, 2012). ACTEC Comments to Notice (April 2, 2012). ABA Section of Taxation, Comments to Notice (April 25, 2012). ABA Section of Real Property, Trust and Estate Law, Comments on Notice (September 11, 2012). Delaware State Bar Association and Delaware Bankers Association, Joint Response to IRS Notice (August 13, 2012) _1 15

16 IRS NOTICE Many comments to the Notice recommend that the IRS adopt certain safe harbors under which a trust decanting will not have any adverse tax consequences. Where a trust decanting falls outside the scope of the safe harbors, then whether any adverse tax consequences arise would require analysis on a case-by-case basis. Proposed safe harbors would include situations where: a. All of the assets of the first trust are decanted to a second trust that changes only the administrative provisions of the first trust. b. The decanting is effectuated by a disinterested trustee and does not shift beneficial interests in the first trust or delay the vesting of a beneficiary s property interest in the first trust. c. The decanting does not reduce or eliminate a beneficiary s vested and mandatory rights to a distribution under the first trust. d. Beneficiary consent to the decanting is obtained but is not required as a condition of the decanting (and in all events, a beneficiary s failure to object should not be considered tantamount to consent). e. The first trust and the second trust are both grantor trusts treated as owned by the same grantor. See New York City Bar Association, Response to Request for Comments to Notice and New York State Society of Certified Public Accountants, Comments on IRS Notice , both of which recommend a number of safe harbor guidelines for the IRS to adopt _1 16

17 INCOME TAX ISSUES As indicated by the Notice, a trust decanting raises a number of potential income tax issues including the following: 1. APPLICATION OF THE SUBCHAPTER J RULES: Under the Subchapter J rules, a distribution from a complex trust generally carries out a share of the trust s distributable net income ( DNI ) to the beneficiary who receives the distribution. The first trust receives a distribution deduction under IRC 661 and the beneficiary includes in gross income an amount equal to his share of the trust s DNI under IRC 662. It is not clear whether the Subchapter J rules apply to a trust decanting. However, the Treas. Regulations and case law indicate that a trust can be a beneficiary of another trust, with the Subchapter J rules applicable to a distribution to the second trust. See Treas. Reg (c)-1 (which provides that for purposes of Part I of Subchapter J, a trust can be a beneficiary of another trust). See also Duke v. Comm'r, 38 BTA 1264, 1269 (1938); Comm'r v. Bishop Trust Co., 136 F2d 390 (9th Cir. 1943), aff'g 42 BTA 1309 (1940); Harwood Estate v. Comm'r, 3 TC 1104 (1945); White Estate v. Comm'r, 41 BTA 525 (1939); Lynchburg Tr. & Sav. Bank v. Comm'r, 68 F2d 356 (4th Cir. 1934) _1 17

18 INCOME TAX ISSUES (Continued) 1. APPLICATION OF THE SUBCHAPTER J RULES (continued): Comments to the Notice suggest that the Subchapter J rules should not apply to a decanting distribution where the second trust is considered to be a continuation of the first trust. This would be the case where all of the assets of the first trust are distributed to a second trust having substantially similar terms. In such a case, the distribution from the first trust would be tax neutral and no DNI would be carried out. See PLRs , , This should be the case even if property encumbered with debt in excess of basis or negative capital account property is decanted. When do the first trust and the second trust have substantially similar terms? The comments suggest that the first and second trusts will have substantially similar terms if the trusts have the same beneficiaries, the same standards for distribution and the same timing for payments. Where the second trust is viewed as a continuation of the first trust, the second trust should be able to use the same EIN as the first trust, although there may be practical reasons why issuing a new EIN is preferred. However, if only a portion of the assets of the first trust are distributed to the second trust, comments to the Notice suggest that the Subchapter J rules should apply because the distribution is more equivalent to a discretionary trust distribution. In this case, the first trust would receive a distribution deduction for the DNI that is distributed to the second trust under IRC 661 and the second trust would include DNI in income under IRC _1 18

19 INCOME TAX ISSUES (Continued) 2. CAPITAL LOSS CARRYOVERS AND CREDITS: Another question that arises where all of the first trust s assets are decanted is how the first trust s net operating loss carryovers, capital loss carryovers and foreign tax credit carryovers are affected. Does the second trust succeed to these carryovers, or are they passed out to the first trust s beneficiaries as if the first trust had terminated? Under IRC 642(h) and Treas. Reg (h)-3(d), on termination of a trust (i.e., in the trust s final year), unused carryovers are passed out to the trust beneficiaries and allowed as a deduction by them. There isn t any specific authority on point in the case of a trust decanting, but if all of the assets of the first trust are distributed to a second trust with substantially similar terms, so that the second trust is viewed as a continuation of the first trust, the second trust should succeed to the first trust s tax attributes. According to the comments, this should be the result even if the terms of the trusts are not substantially similar and is consistent with other areas of the law: 1) Under the private foundation rules, where all of the assets held by a private foundation are transferred to one or more other private foundations effectively controlled by the same person, then the tax attributes of the distributing foundation will flow through to the receiving foundation(s); and 2) In the case of a corporate reorganization, the successor corporation generally succeeds to the tax attributes of the terminating corporation. If the decanting is to multiple receiving trusts, then the tax attributes of the first trust should be distributed proportionately among the receiving trusts _1 19

20 INCOME TAX ISSUES (Continued) _1 3. FOREIGN TRUSTS AND THROWBACK RULES UNDER IRC If a foreign trust is decanted to a domestic trust, the throwback rules should apply to the distribution unless all of the assets of the first trust are transferred to a substantially similar second trust. In such a case, the throwback rules should not apply until distributions are made from the second trust to a US beneficiary (i.e., the result should be the same as if the foreign trust were domesticated without any change in terms, such as where the trustee is changed to a U.S. person). 4. GAIN RECOGNITION: Another issue raised by a trust decanting is whether the transfer of assets from the first trust to the second trust is a recognition event for either the first trust s beneficiaries or the trust itself. a. Gain Recognition by Trust Beneficiaries The general rule under IRC 1001(a) and Treas. Reg (a) is that an exchange of property is a disposition of property and results in the recognition of gain or loss only if the exchanged properties are materially different in either kind or extent. In Cottage Savings v. Comm r, 499 U.S. 554 (1991), the Supreme Court adopted a test for determining when property received in an exchange is considered to be materially different from the property transferred. Under Cottage Savings, two properties are materially different if their respective possessors enjoy legal entitlements that are different in kind or extent. In Cottage Savings, the taxpayer, a financial institution, exchanged mortgages in single family homes for another lender s mortgages that had the same fair market value. At the time of the exchange, the taxpayer s mortgages were worth less than their original value. The Supreme Court held that the taxpayer could not claim a loss on the exchange because there was no disposition of the mortgages for tax purposes since the exchanged properties were considered "substantially identical." 20

21 INCOME TAX ISSUES (Continued) _1 a. Gain Recognition by Trust Beneficiaries (continued) Several PLRs issued after Cottage Savings suggest that a distribution of assets from one trust to another could result in gain to the beneficiary if the interests of the beneficiaries under the second trust differ materially from their interests under the first trust. See PLRs , , In such a case, there would be an exchange of property by the beneficiary that results in gain under IRC In the PLRs, the interests of the beneficiaries were not materially different, so no gain resulted, but the suggestion is that if the beneficiaries interests were materially different, gain could have resulted. Unlike the taxpayer in Cottage Savings, which voluntarily exchanged its assets, a trust beneficiary rarely participates in a decanting (and is specifically or impliedly prohibited from participating under most state decanting statutes). Since any changes in the beneficiary s interests under the first and second trusts result from the trustee s decision to decant, not the beneficiary s actions, the comments to the Notice suggest that even if the beneficiary s interests under the two trusts differ materially, no gain should result. Several IRS private letter rulings are consistent with this view. Under these rulings, a beneficiary does not recognize gain where the distribution to another trust is authorized by the trust instrument or local law. See PLRs , , These PLRs are also consistent with Treas. Reg (h), which provides that a non-pro rata severance of a trust does not constitute an exchange of property for other property differing materially in either kind or extent if applicable state law or the trust instrument authorize the severance and non-pro rata funding. However, under Rev. Rul , gain may be recognized by a beneficiary on a distribution between trusts where the distribution is not authorized by applicable law or the terms of the governing instrument and occurs by agreement of the beneficiaries. 21

22 INCOME TAX ISSUES (Continued) a. Gain Recognition by Trust Beneficiaries (continued) Thus, if beneficiary consent is an express condition of the decanting, gain might be recognized if the beneficiary s interests in the first trust and the second trust are materially different. But where a state decanting statute exists and the decanting meets all statutory requirements, or if the trust instrument contains a decanting provision, a trustee s exercise of the decanting power should not result in any gain being recognized by the beneficiary under Rev. Rul Moreover, where beneficiary consent is not required under the terms of the trust instrument, applicable state law or as a condition of the decanting, Rev. Rul should not apply. This should be the case even if the beneficial interests in the first trust and the second trust are materially different and/or the beneficiary actually does consent even though not required to do so. (Note that most state decanting statutes do not required beneficiary consent, and where consent is required by statute, it is only in very limited circumstances.) PLANNING POINTER: Where possible, beneficiary consent or court approval should not be made a requirement of the decanting (whether under the trust instrument, state law or otherwise) as this could result in unintended income tax (and potential gift tax) consequences to the beneficiary _1 22

23 INCOME TAX ISSUES (Continued) b. Gain Recognition by the First Trust. Does a decanting distribution of appreciated assets from the first trust to the second trust cause the first trust to recognize gain? If both the first trust and the second trust are grantor trusts deemed owned by the same person, then no gain should be recognized under Rev. Rul , which disregards transactions between two grantor trusts that are deemed to have the same owner. Even if the first and second trusts are not both grantor trusts deemed owned by the same person, in most cases gain should not be recognized. When a domestic non-grantor trust is funded with appreciated property, the grantor does not recognize any gain on the transfer to the trust (since the grantor does not receive anything in exchange for the contribution). Instead, the receiving trust takes the grantor s basis in the transferred property. In addition, a 2008 IRS Chief Counsel Memorandum concludes that the conversion of a nongrantor trust to a grantor trust is not a transfer of property that requires gain recognition. See CCA (December 31, 2008). One exception is where appreciated assets from a domestic trust are transferred to another trust that is a foreign non-grantor trust. In such a case, the transfer will be treated as a sale or exchange of the property for its then fair market value under IRC 684 and gain will be recognized _1 23

24 INCOME TAX ISSUES (Continued) b. Gain Recognition by the First Trust. (continued) Another possible exception arises where the transferred property includes negative basis assets, such as property with debt in excess of basis or is a partnership or LLC interest with a negative capital account. In such a case, gain may be triggered under Crane v. Comm r, 331 U.S. 1 (1947), which held that where a taxpayer sells or exchanges property and is discharged from liability, the taxpayer s amount realized includes any debt that is discharged. Based on Crane, the IRS has concluded that the termination of grantor trust status results in gain recognition if the trust holds properties having liabilities in excess of basis or partnership interests with negative capital accounts. See Treas. Reg (e), Example 5, TAM (March 13, 2000), Madorin v. Comm r, 84 T.C. 667 (1985). Note, however, that it is not clear if Crane applies to a distribution from a non-grantor trust. IRC 643(e) provides that gain generally is not recognized on a distribution of appreciated property from a non-grantor trust and is not clear whether Crane trumps IRC 643(e). As a result, practitioners have requested that the IRS issue guidance on this issue. However, even if Crane does trump IRC 643(e), if all of the assets of a first trust are distributed to a second trust that is viewed as a continuation of the first trust, or if both the first and second trusts are grantor trusts deemed owned by the same person, no gain should be recognized on a decanting distribution. PLANNING POINTER: Practitioners must be aware of the nature of the assets that are held by the first trust if it is a grantor trust and determine whether any assets have negative basis _1 24

25 INCOME TAX ISSUES (Continued) 5. IDENTITY OF THE GRANTOR OF THE SECOND TRUST Another issue arising in a decanting is determining who the grantor of the second trust is for income tax purposes. If the second trust is viewed as a continuation of the first trust, then the same person should be considered to be the grantor of both trusts. This result is consistent with Treas. Reg (e)(5), which generally provides that if a trust transfers assets to another trust, the grantor of the first trust will be treated as the grantor of the second trust. The Illinois decanting statute specifically addresses this issue by providing that the grantor of the first trust is considered for all purposes to be the grantor of any second trust established pursuant to the statute. If the second trust has other assets, then under the Illinois statute, the grantor of the first trust is considered the grantor of the second trust only with respect to the assets that are transferred from the first trust to the second trust. An exception arises where property is distributed from one trust to another pursuant to the exercise of a general power of appointment. In such a case, the person exercising the power of appointment is treated as the grantor of the second trust. Thus, where a beneficiary-trustee participates in a decanting that results in the beneficiary making a taxable gift, or where a beneficiary s consent to a decanting is deemed to result in a taxable gift, the beneficiary should be treated as the grantor of the second trust. Comments to the Notice have requested that the IRS clarify the limited circumstances under which the grantor of the first trust will not be deemed to be the grantor of the second trust _1 25

26 INCOME TAX ISSUES (Continued) 6. A DECANTING MAY ALSO RESULT IN INADVERTENT GRANTOR TRUST STATUS. If the grantor of the first trust is alive, and if the class of permissible beneficiaries under the second trust is broader than under the first trust, this could cause the first trust to be considered a grantor trust under IRC 674 (which provides that the power to add beneficiaries other than after-borns or adopteds will result in grantor trust status). At present, none of the decanting statutes allow the addition of beneficiaries under the second trust. The acceleration of a remainder interest under the first trust to a present interest under the second trust (which is expressly permitted under a few state decanting statutes) also should not be treated as the addition of a beneficiary. Even where a decanting statute permits the second trust to grant a beneficiary of the first trust a power of appointment under the second trust, the comments suggest that the permissible appointees under the power should not be considered beneficiaries of the second trust. This is another point that the IRS will need to clarify with official guidance _1 26

27 INCOME TAX ISSUES (Continued) 7. CHARITABLE DEDUCTION ISSUES If you have a trust such as a CRAT, CRUT or pooled income fund where the distributions qualified for a charitable deduction, does the existence of a decanting power under either state law or the trust instrument disqualify the deduction when the trust is funded.? Under the state decanting statutes, fixed annuity or unitrust interests generally cannot be eliminated so the charitable deduction cannot be defeated since the charitable interest cannot be altered. In addition, many decanting statutes expressly prohibit a decanting that would jeopardize a tax deduction that the first trust qualified for. Thus, unless the trust instrument (or state law) permits a decanting that could alter a charitable interest, a charitable deduction should be available when the trust is funded. Distribution to Charity if the second trust grants a power of appointment that is exercisable in favor of charity, the second trust should receive a charitable distribution deduction if a distribution to charity occurs as a result of the exercise of the power of appointment _1 27

28 Strafford Publications Webinar February 19, 2013 GIFT, ESTATE AND GST TAX CONSEQUENCES OF DECANTING Todd A. Flubacher Morris, Nichols, Arsht & Tunnell LLP 1201 N. Market Street P.O. Box 1347 Wilmington, DE Telephone: (302) Facsimile: (302)

29 GIFT TAX ISSUES 29

30 IS THERE A TAXABLE GIFT WHEN THE TRUSTEE EXERCISES ITS POWER TO DECANT? Section 2501 of the Code imposes a gift tax on the transfer of property by gift Any transfer, including an indirect gift, that results in the shift of an economic right or benefit to another are potentially within the scope of the gift tax. Generally, there should not be a taxable gift associated with a decanting unless there were existing gift tax concerns associated with the trust, because a decanting is merely the trustee exercising the power to make a distribution. The gift tax consequences of decanting should be analyzed with respect to: The changes made to the trust as a result of the decanting, The identity of the fiduciary exercising the power to distribute principal, and The individuals who may or may not consent to the decanting. 30

31 WHAT ARE THE DIFFERENCES BETWEEN THE ORIGINAL TRUST AND THE RESULTING TRUST? Do the changes made by the decanting shift beneficial interests or are they purely administrative? If the changes are purely administrative and do not shift any beneficial interest, then there should not be a taxable gift. Examples of purely administrative changes include: adding a direction adviser, adding trustee powers, or changing situs. Examples of changes in beneficial interests Elimination of a beneficiary s general power of appointment (does this constitute a lapse and a taxable gift?) Elimination of a beneficiary s withdrawal right at a certain age Removing a beneficiary Division of trust 31

32 IS THE TRUSTEE A BENEFICIARY? The trustee is not a beneficiary. If the trustee has no beneficial interest in the trust then decanting should not be treated as a taxable gift (see Treas. Reg (g)(1)). Decanting is simply the exercise of the trustee s power to distribute principal, and is subject to all of the duties, standards and limitations applicable to a distribution of principal. If the trustee s exercise of its power to distribute principal constitutes a taxable gift, then the transfer tax issue was already inherent in the document. The trustee is a beneficiary. If a beneficiary is the trustee with the power to participate in distribution decisions, then there could potentially be gift tax consequences. A distribution by the beneficiary/trustee should not be a taxable gift if it is made pursuant to a power the exercise or non-exercise of which is limited to an ascertainable standard (see Treas. Reg (g)(2)). If a beneficiary is the trustee with the power to distribute principal and there is no ascertainable standard (e.g. a purely discretionary trust), then an exercise of the decanting power may be a gift tax issue. Again, that gift tax issue already existed in the original document. Some state decanting statutes limit a beneficiary s ability to decant and others limit a beneficiary/trustee s distribution powers. 32

33 BENEFICIARY CONSENT, NOTICE OR ACQUIESCENCE Beneficiary consent If the terms of the trust instrument or applicable law require beneficiaries to consent to a decanting, and a beneficiary consents to a decanting that reduces his or her interest in the trust, then the beneficiary may be deemed to have made a taxable gift. Could the effective power to allow or block a decanting that shifts economic interests away from a beneficiary have gift tax consequences? Generally, if a decanting power is exercised by a trustee, acting in accordance with applicable law and the governing instrument, then there should not be a taxable gift. Statute: Only the Nevada statute requires beneficiary consent to a decanting, and that is only required in the case where property specifically allocated to that beneficiary under the terms of the trust instrument ceases to be allocated to that beneficiary (see Nev. Rev. Stat (2)(e). 33

34 BENEFICIARY CONSENT, NOTICE OR ACQUIESCENCE (CONTINUED) Beneficiary notice. The right to receive notice does not confer a legal right to block a decanting. The trustee s decanting power is still exercisable regardless of the notice, and is subject to review under the abuse of discretion standard. A beneficiary, having received notice, could potentially bring an action in court under the abuse of discretion standard, as he or she could with respect to any other discretionary action of the trustee. The failure to challenge the trustee s decision in court should not result in a taxable gift. Beneficiary releases. As a practical matter, a trustee will generally not decant unless it is able to obtain releases from all beneficiaries. Is this tantamount to a blocking power that could actually give rise to a taxable gift? It is not a legal right to block the decanting. Example: A has the right to withdraw the trust assets at age 35, and the trustee decants to a new trust that eliminates that withdrawal right, but it will only decant if A consents and releases the trustee of liability. Has A made a taxable gift to the remaindermen? 34

35 ESTATE TAX ISSUES 35

36 OVERVIEW OF ESTATE TAX IMPLICATIONS If the property of the original trust was includible in the estate of the transferor due to certain retained powers or interests, and the powers or interests that caused estate inclusion are present in the governing instrument of the resulting trust, then the property of the resulting trust will continue to be includible in the transferor s gross estate. If the property of the original trust was not includible in the estate of the transferor and the governing instrument of the resulting trust does not confer any additional powers or interests on the transferor, the property of the resulting trust also should be not be includible in his or her gross estate. 36

37 RESULTING TRUST INCLUDES POWERS OR INTERESTS THAT CAUSE ESTATE INCLUSION FOR BENEFICIARY A trustee could decant a trust into a new resulting trust that confers powers or interests upon a beneficiary that would cause the trust assets to be includible in the beneficiary s taxable estate. The resulting trust could grant a beneficiary a general power of appointment. Several state decanting statutes expressly permit the trustee to grant a power of appointment (e.g. Delaware, Nevada, New York and North Carolina). Grant a beneficiary the power to remove and appoint the trustee of a discretionary trust without a Code Section 672(c) limitation. The resulting trust could grant a beneficiary a power to control incidents of ownership over life insurance. 37

38 ORIGINAL TRANSFEROR GIVEN DISPOSITIVE POWERS OR INCIDENTS OF OWNERSHIP OVER LIFE INSURANCE The property of the resulting trust may be includible in the original transferor s gross estate even though the assets of a original trust were not includible in the transferor s estate. For example, if the transferor did not have any dispositive powers over the original trust but is given a dispositive power over the resulting trust, the trust fund of the resulting trust may be includible in the transferor s estate under Code If the assets of the resulting trust include a life insurance policy on the transferor s life, and the trust instrument of the resulting trust gives the transferor a power that is an incident of ownership with respect to the policy, the value of the policy may be includible in the transferor s estate under Code 2042(2). 38

39 IMPUTED CODE 2036 RIGHTS OR INTERESTS? If a power or interest described in Code 2036 is not granted to the transferor of the original trust, but is granted to the transferor under the trust instrument of the resulting trust, the assets of the resulting trust generally should not be includible in the transferor s gross estate under Code This is because Code 2036 generally is applicable only in the case of powers or interests retained by the transferor from the time of his or her initial transfer to a trust. However, if at the time of the transferor s initial transfer of property to the original trust, the transferor and the trustee had an agreement or understanding that the trustee would later exercise its decanting power to create the resulting trust under which the transferor would hold a Code 2036 power or interest, could the property of the resulting trust be includible in the estate of the transferor? See Treas. Reg (c)(1)(i) ( An interest or right is treated as having been retained or reserved if at the time of the transfer there was an understanding, express or implied, that the interest or right would later be conferred. ). 39

40 MARITAL TRUSTS Generally, a decanting from a QTIP trust to a resulting QTIP trust should retain the marital deduction status. Several State decanting statutes include limitations on the decanting of a marital trust so that it cannot lose it s tax status. 40

41 GST TAX ISSUES 41

42 THREE CATEGORIES OF GST EXEMPT TRUSTS Grandfathered GST Exemption Allocation Trust created by non-resident alien 42

43 TWO DECANTING SAFEHARBORS FOR GRANDFATHERED GST EXEMPT TRUSTS Discretionary Distribution Safe Harbor (Treas. Reg (b)(4)(i)(A)). When the trust became irrevocable, either the terms of the trust instrument or local law authorized distributions in further trust without the consent or approval of any beneficiary or court; and The resulting trust does not extend the time for vesting of any interest in the trust in a manner that may postpone or suspend the vesting, absolute ownership or power of alienation of an interest in property for a period, measured from the date the original trust became irrevocable, beyond the longer of (a) lives in being plus 21 years, or (b) 90 years. There were no statutes in existence at the time that trusts became grandfathered (Sept. 25, 1985). NY statute was the first and it came into effect in Thus, the only option under this safe harbor is a decanting pursuant to the terms of the governing instrument. You can change whatever you want, just don t extend the perpetuities period beyond the federal rule against perpetuities period. 43

44 TWO DECANTING SAFEHARBORS FOR GST EXEMPT TRUSTS (Continued) Trust Modification Safe Harbor (Treas. Reg (b)(4)(i)(D)). the distribution does not cause a beneficial interest to be shifted to a beneficiary in a lower generation, and the governing instrument of the resulting trust does not extend the time for the vesting of any beneficial interest beyond the period provided for in the original trust instrument. Trust Modification Safe Harbor is the more relevant safe harbor because the discretionary distribution safe harbor only applies when you have express decanting language in the instrument. 44

45 EXAMPLES OF SHIFTING INTERESTS TO A LOWER GENERATION Cutting out an entire generation as beneficiaries. Cutting out one of the children from a class of current beneficiaries? Eliminating a life income interest of a current beneficiary. What if the trustee only has power to invest in Treasuries and you have a life income interest beneficiary and you want to expand the investment powers to include growth stocks that do not produce income? Grant a limited power of appointment to a beneficiary? Postpone a withdrawal right (e.g. withdrawal at age 30) to extend the trust for life (but the beneficiary is granted a general power of appointment over the resulting trust). The resulting trust is a so-called silent trust. Change of situs governing law. There are potential pitfalls with Treas. Reg (b)(4)(i)(E) Example 4. 45

46 DO SAFEHARBORS APPLY TO TRUSTS TO WHICH EXEMPTION WAS ALOOCATED? There is no safe harbor that expressly applies to trusts that are GST exempt because exemption has been applied to them. The Internal Revenue Service has stated that the regulations dealing with grandfathered trusts are relevant by analogy. The IRS has stated: No guidance has been issued concerning the GST tax consequences of the modification of a trust created after September 25, At a minimum, it seems appropriate to conclude that a change that would not affect the exempt status of a trust that was irrevocable on September 25, 1985 would similarly not affect the exempt status of such a trust. See, Priv. Ltr. Rul , see also Priv. Ltr. Rul

47 TRUSTS CREATED BY A NON-RESIDENT ALIEN Trusts created by a non-resident alien are exempt from GST tax and should not be effected by decanting because they fall outside of the scope of Chapter 13. unless there is new transferor triggered by a gift tax or estate tax 47

48 GST NON-EXEMPT TRUSTS Decanting strategies for GST non-exempt trusts. You may want to remedy a planning mistake that created a GST nonexempt trust that lasts for multiple generations The trustee of the original trust could create a new resulting trust and grant a beneficiary a general power of appointment to trigger estate or gift tax. Triggers a new transferor for GST purposes. Intentionally trigger the Delaware Tax Trap. 48