IT S TIME TO TRUST VIRGINIA LAW: VBA WILLS, TRUSTS & ESTATES

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1 IT S TIME TO TRUST VIRGINIA LAW: VBA WILLS, TRUSTS & ESTATES Jeffrey D. Chadwick Williams Mullen Center 200 South 10 th Street - Suite 1600 Richmond, Virginia jchadwick@williamsmullen.com

2 PROPOSAL: THAT VIRGINIA MODIFY ITS LAW TO PERMIT CREATING SELF-SETTLED SPENDTHRIFT TRUSTS It has been suggested that Virginia join the growing list of states that statutorily permit the creation of self-settled spendthrift trusts trusts afford spendthrift protection to the interests of the trust s creator. Twelve states already afford such protection by statute: Alaska, Delaware, Hawaii, Missouri, Nevada, New Hampshire, Oklahoma, Rhode Island, South Dakota, Tennessee, Utah and Wyoming. Several other states appear to permit these trusts by case law. See, e.g., Uhl v. United States, 241 F.2d 867 (7th Cir. 1957) (Indiana law); Estate of German v. United States, 7 Cl. Ct. 641 (1985) (Maryland law); Herzog v. Comm'r, 116 F.2d 591 (2d Cir. 1941), aff'g 41 BTA 509 (1940) (New York law). The proposed statute would change the present rule in Virginia under which a spendthrift clause is ineffective to protect a trust assets against the claims of a settlor who is also a trust beneficiary. This prohibition on self-settled spendthrift trusts has been criticized by some commentators, including eminent authority Dean Erwin N. Griswold, who stated: [W]e may well question the soundness of a rule which allows a man to hold the bounty of others free from the claims of his creditors, but denies the same immunity to his interest in property which he has accumulated by his own effort. Erwin N. Griswold, Spendthrift Trusts, 474, at (2nd Ed. 1947). Self-Settled Spendthrift Trusts, page 1

3 There are several reasons for allowing the creation of such trusts in the Commonwealth. First, Virginia already allows the creation of trusts that are protected from the claims of the creditors of the beneficiaries. This proposal merely extends that policy to trusts of which the grantor is also a discretionary beneficiary. Second, the prohibition of self-settled spendthrift trusts has been eroded significantly over the past two decades. As noted above, there are already over a dozen states that permit such trusts. Third, the Virginia prohibition of self-settled spendthrift trusts already makes an exception for individual retirement accounts. Va. Code An individual retirement account is merely a self-settled revocable spendthrift trust the contributions to which are, to a limited extent, deductible for income tax purposes. Also, in 2011, Virginia enacted an exception for certain inter vivos marital trusts, where the donor spouse survives the donee spouse. Va. Code (b)(3). If Virginia makes exceptions to the prohibition against self-settled spendthrift trusts (including, in one situation, a revocable trust), the prohibition cannot be said to reflect a strong public policy. Fourth, the general prohibition of self-settled spendthrift trusts is built on a rather suspect foundation. The national rule was essentially the product of Professor Austin W. Scott who inserted it in his standard treatise on the law of trusts and in the Restatement (Second) of Trusts, of which he was the reporter and principal author. Neither source offers a solid, independent rationale or theoretical basis for the rule, and the cases cited by Professor Scott do not, in fact, support the rule as he lays it out. See Danforth, Rethinking the Law of Creditors' Rights in Trusts, 53 Hastings L. J. 287 (2002). Self-Settled Spendthrift Trusts, page 2

4 Fifth, the current prohibition of self-settled spendthrift trusts ignores the rights of nonsettlor beneficiaries; the creditor who defeats a self-settled spendthrift trust frustrates the interests of the other beneficiaries, as well as that of the settlor. Sixth, the current prohibition on self-settled spendthrift trusts applies to trusts in which the grantor has no power to reacquire the trust assets, but merely remains a discretionary beneficiary. This appears to presume a collusion between the settlor and the trustee in which the latter will blindly do the former s bidding, without regard to the latter s legal obligations as a fiduciary. Such a presumption is unwarranted, particularly in this age of litigious beneficiaries. Seventh, the current prohibition on self-settled spendthrift trusts essentially grants the settlor s creditors greater rights than those the settlor possesses, because the creditors can compel that the trustee make distributions which the settlor cannot compel. Eighth, the creation of self-settled spendthrift trusts does not encourage fraud or evasion of the claims of creditors, because it does not negate the fraudulent transfer rule. Va. Code et seq. One cannot avoid present creditor claims by creating such a trust. A transfer to such a trust that otherwise renders one insolvent or unable to meet current creditor claims is fraudulent and could be set aside. Ninth, a statute that permits the creation of self-settled spendthrift trusts permits clients who wish to make gifts to family members to retain the often-desired ability to be supported from the trust assets, if the client s other assets are somehow depleted. Absent a statute permitting the creation of such trusts, the existence of a trustee s power to make discretionary distributions to the settlor, even if never exercised, would cause the trust assets to be subject to estate taxes as a part of the settlor s estate. Rev. Rul , Self-Settled Spendthrift Trusts, page 3

5 CB 293; Outwin v. Comm'r, 76 TC 153 (1981), acq CB 2; Paolozzi v. Comm'r, 23 TC 182 (1954), acq CB 4. Tenth, permitting self-settled spendthrift trusts within the Commonwealth would allow the retention within the Commonwealth of trust business which currently passes to other states, such as Alaska, Delaware, Nevada and South Dakota. We propose that Virginia adopt a statute that will permit a settlor to transfer assets to an irrevocable trust, to be held for the joint benefit of the settlor and at least one other beneficiary. Certain interests of the settlor in such a trust would be afforded the same protection against creditor claims allowed to assets held for a third-party beneficiary s benefit. Our proposal would limit this protection to trusts that have at all times at least one Virginia trustee, that administer some or all of the trust assets within the Commonwealth, and that are governed by Virginia law. It would also limit the settlor s interest that is protected from the claims of creditors to a non-mandatory interest in trust income, principal, or both, exercisable only in the discretion of an independent Virginia trustee. The settlor s creditors existing on the date of the transfer to the trust would still be able to enforce their claims against the settlor, and they would have five years in which to bring such claims against the trust. Self-Settled Spendthrift Trusts, page 4

6 PROPOSED LEGISLATIVE CHANGES 1 It is proposed that the Virginia Code be changed as follows: Creditor's claim against settlor A. Whether or not the terms of a trust contain a spendthrift provision, the following rules apply: 1. During the lifetime of the settlor, the property of a revocable trust is subject to claims of the settlor's creditors. 2. With respect to an irrevocable trust, except to the extent otherwise provided in to , a creditor or assignee of the settlor may reach the maximum amount that can be distributed to or for the settlor's benefit. If a trust has more than one settlor, the amount the creditor or assignee of a particular settlor may reach may not exceed the settlor's interest in the portion of the trust attributable to that settlor's contribution. 3. After the death of a settlor, and subject to the settlor's right to direct the source from which liabilities will be paid, the property of a trust that was revocable at the settlor's death is subject to claims of the settlor's creditors, costs of administration of the settlor's estate, the expenses of the settlor's funeral and disposal of remains, and statutory allowances to a surviving spouse and children including the family allowance, the right to exempt property, and the homestead allowance to the extent the settlor's probate estate is inadequate to satisfy those claims, costs, expenses, and allowances. This section shall 1 Material highlighted is to be added. Self-Settled Spendthrift Trusts, page 5

7 not apply to life insurance proceeds under No proceeding to subject a trustee, trust assets or distributees of such assets to such claims, costs and expenses shall be commenced unless the personal representative of the settlor has received a written demand by a surviving spouse, a creditor or one acting for a minor or dependent child of the settlor and no proceeding shall be commenced later than two years following the death of the settlor. This section shall not affect the right of a trustee to make distributions required or permitted by the terms of the trust prior to being served with process in a proceeding brought by the personal representative. B. For purposes of this section: 1. During the period the power may be exercised, the holder of a power of withdrawal is treated in the same manner as the settlor of a revocable trust to the extent of the property subject to the power; and 2. Upon the lapse, release, or waiver of the power, the holder is treated as the settlor of the trust only to the extent the value of the property affected by the lapse, release, or waiver exceeds the greater of the amount specified in 2041 (b) (2) or 2514 (e) of the Internal Revenue Code of 1986, or 2503 (b) of the Internal Revenue Code of The assets in a trust that are attributable to a contribution to an inter vivos marital deduction trust described in either 2523(e) or (f) of the Internal Revenue Code of 1986, after the death of the spouse of the settlor of the inter vivos marital deduction trust shall be deemed to have been contributed by the settlor's spouse and not by the settlor. Self-Settled Spendthrift Trusts, page 6

8 Article 9. Qualified Self-Settled Spendthrift Trusts General Rule. A settlor may transfer assets to a qualified self-settled spendthrift trust, defined in , and retain in that trust a qualified interest, also defined in , and, except as otherwise provided in this article, shall not apply to such qualified interest. A. Section shall continue to apply with respect to any interest held by a settlor in a qualified self-settled spendthrift trust, other than a qualified interest. B. A settlor s transfer to a qualified self-settled spendthrift trust shall not, to the extent of the settlor s qualified interest, be deemed to have been made with intent to delay, hinder or defraud creditors, for purposes of 55-80, merely because it is made to a trust with respect to which the settlor retains a qualified interest and merely because it is made without consideration. A settlor s transfer to a qualified self-settled spendthrift trust may, however, be set aside under or on other bases, such as if the transfer renders the settlor insolvent. C. A settlor s creditor may bring an action under to avoid a transfer to a qualified self-settled spendthrift trust or otherwise to enforce a claim that existed on the date of the settlor s transfer to such trust, within five years after the date of the settlor s transfer to such trust to which such claim relates. Self-Settled Spendthrift Trusts, page 7

9 D. A creditor shall have only such rights with respect to a settlor s transfer to a qualified self-settled spendthrift trust as are provided in this section. No creditor and no other person shall have any claim or cause of action against any trustee, trust adviser, trust director, or any person involved in the counseling, drafting, preparation, or execution of, or of transfers to a qualified self-settled spendthrift trust. E. If a settlor makes more than one transfer to the same qualified self-settled spendthrift trust, the following rules shall apply: 1. The settlor s making of a subsequent transfer shall be disregarded in determining whether a creditor's claim with respect to a prior transfer is valid under this section; 2. With respect to each subsequent transfer by the settlor, the five-year limitations period provided in paragraph C of this section, with respect to actions brought under Title 55, Chapter 5 with respect to the subsequent transfer, commences on the date of such subsequent transfer; and 3. Any distribution to a beneficiary is deemed to have been made from the latest such transfer. F. The movement to this Commonwealth of the administration of an existing trust which, after such movement to the Commonwealth, meets for the first time all of the requirements of a qualified self-settled spendthrift trust, shall be treated, for purposes of this section, as a transfer to this trust by the settlor on the date of such movement to this Commonwealth, of all of the assets previously transferred to the trust by the settlor. Self-Settled Spendthrift Trusts, page 8

10 Definitions. A. As used in this article, the following terms shall have the following meanings: Qualified interest means a settlor s interest in a qualified self-settled spendthrift trust, to the extent that such interest entitles the settlor to receive distributions of income, principal, or both, in the sole discretion of a independent qualified trustee, as defined in this paragraph A. A settlor may have a qualified interest in a qualified self-settled spendthrift trust and also have an interest in the same trust that is not a qualified interest, and the rules of shall apply to each interest of the settlor in the same trust other than the settlor s qualified interest. Qualified self-settled spendthrift trust means a trust if: (i) The trust is irrevocable; (ii) The trust is created during the settlor s lifetime; (iii) There is at all times when distributions could be made to the settlor pursuant to the settlor s qualified interest, at least one beneficiary other than the settlor to whom income may be distributed, if the settlor s qualified interest relates to trust income, or to whom principal may be distributed, if the settlor s qualified interest relates to trust principal, or to whom both income and principal may be distributed, if the settlor s qualified interest relates to both trust income and principal; (iv) The trust has at all times at least one qualified trustee, as defined in this section, who may, but need not be, an independent qualified trustee; (v) The trust instrument expressly incorporates the law of this Commonwealth to govern the validity, construction, and administration of the trust; Self-Settled Spendthrift Trusts, page 9

11 (vi) The trust instrument includes a spendthrift provision, as defined in , that restrains both voluntary and involuntary transfer of the settlor s qualified interest; and (vii) The settlor does not have the right to disapprove distributions from the trust. Qualified trustee means any person who is a natural person resident within this Commonwealth or a legal entity authorized to engage in trust business within this Commonwealth, and who maintains or arranges for custody within this Commonwealth of some or all of the property that has been transferred to the trust by the settlor, maintains records within this Commonwealth for the trust on an exclusive or nonexclusive basis, prepares or arranges for the preparation within this Commonwealth of fiduciary income tax returns for the trust, or otherwise materially participates within this Commonwealth in the administration of the trust. A trustee is not a qualified trustee if such trustee s authority to make distributions of income or principal or both are subject to the direction of someone who, were that person a trustee of the trust, would not meet the requirements to be a qualified trustee. Independent qualified trustee means a qualified trustee who is not, and whose actions are not subject to direction by: (i) The settlor; (ii) Any natural person who is not a resident of this Commonwealth; (iii) Any entity that is not authorized under Title 6.2 to engage in trust business within this Commonwealth; (iv) The settlor s spouse; Self-Settled Spendthrift Trusts, page 10

12 (v) A parent of the settlor; (vi) Any issue of the settlor; (vii) A sibling of the settlor; (viii) An employee of the settlor; (ix) A business entity in which the settlor s holdings represent at least thirty percent (30%) of the total voting power of all interests entitled to vote; (x) A subordinate employee of the settlor; or (xi) A subordinate employee of a business entity in which the settlor is an executive. B. A vacancy in the position of qualified trustee that occurs for any reason, whether or not there is then-serving another trustee, shall be filled in the following order of priority: (i) By a person eligible to be a qualified trustee and who is designated pursuant to the terms of the trust to act as successor trustee; (ii) By a person eligible to be a qualified trustee and who is designated by unanimous agreement of the qualified beneficiaries; or (iii) By a person eligible to be a qualified trustee and who is appointed by the court pursuant to and 26-50, or pursuant to C. A vacancy in the position of independent qualified trustee that occurs for any reason, whether or not there is then-serving another trustee, shall be filled in the following order of priority: (i) By a person eligible to be an independent qualified trustee and who is designated pursuant to the terms of the trust to act as successor trustee; Self-Settled Spendthrift Trusts, page 11

13 (ii) By a person eligible to be an independent qualified trustee and who is designated by unanimous agreement of the qualified beneficiaries; or (iii) By a person eligible to be an independent qualified trustee and who is appointed by the court pursuant to and 26-50, or pursuant to D. A trust instrument shall not be deemed revocable on account of the inclusion of any one or more of the following rights, powers, and interests: (i) A power of appointment exercisable by the settlor by will or other written instrument effective only upon the settlor s death, other than a power to appoint to the settlor's estate or the creditors of the settlor's estate; (ii) The settlor's qualified interest in the trust; (iii) The settlor s right to receive income or principal pursuant to an ascertainable standard; (iv) The settlor's potential or actual receipt of income or principal from a charitable remainder unitrust or charitable remainder annuity trust (each within the meaning of section 664(d) of the Internal Revenue Code) and the settlor's right, at any time, and from time to time, to release, in writing delivered to the qualified trustee, all or any part of the settlor's retained interest in such trust; (v) The settlor's receipt each year of a percentage, not to exceed five percent (5%), specified in the trust instrument of the initial value of the trust assets or their value determined from time to time pursuant to the trust instrument; (vi) The settlor's right to remove a trustee and to appoint a new trustee; Self-Settled Spendthrift Trusts, page 12

14 (vii) The settlor's potential or actual use of real property held under a personal residence trust (within the meaning of section 2702(c) of the Internal Revenue Code); (viii) The settlor's potential or actual receipt or use of a qualified annuity interest (within the meaning of section 2702 of the Internal Revenue Code); (ix) The ability of a qualified trustee, whether pursuant to discretion or direction, to pay, after the settlor's death, all or any part of the settlor's debts outstanding at the time of the settlor's death, the expenses of administering the settlor's estate, or any estate inheritance tax imposed on or with respect to the settlor's estate; and (x) A settlor's potential or actual receipt of income or principal to pay, in whole or in part, income taxes due on trust income, or the direct payment of such taxes to the applicable tax authorities, pursuant to a provision in the trust instrument that expressly provides for the direct payment of such taxes or the reimbursement of the settlor for such tax payments. E. A beneficiary who has the right to withdraw his or her entire beneficial interest in a trust shall be treated as its settlor to the extent of such withdrawal right, when such right to withdraw has lapsed, been released, or otherwise expired, without regard to the limitations otherwise imposed by B. Self-Settled Spendthrift Trusts, page 13

15 PROPOSAL: THAT VIRGINIA ADOPT A STATUTE PROTECTING TRUSTEES WHO ACT AT THE DIRECTION OF PERSONS EXPRESSLY AUTHORIZED TO DIRECT THE TRUSTEE It is becoming a relatively common practice for the settlor of an irrevocable trust to authorize another person to direct the trustee to take or not to take certain actions. Often, these directions relate to investments, but they may also relate to distributions and other decisions made by the trustee. Virginia Code Section presently provides that, where someone is granted the power to direct certain actions of the trustee, the trustee is required to act in accordance with an exercise of this direction, unless the attempted exercise is manifestly contrary to the terms of the trust or the trustee knows the attempted exercise would constitute a serious breach of a fiduciary duty that the person holding the power owes to the beneficiaries of the trust. That Section also provides that a person who holds a power to direct the trustee s actions is presumed to be a fiduciary and to be required to act in good faith with regard to the purposes of the trust and the interests of the beneficiaries. It also states that [t]he holder of a power to direct is liable for any loss that results from breach of a fiduciary duty. It is suggested that these provisions, while sound and valuable, are insufficient to protect the trustees from liability in many common situations. It is, therefore, proposed that the Virginia law be expanded to more completely protect trustees from liability when they follow the actions of a trust director, or fail to act while awaiting directions from a trust protector. It is also proposed that this expanded protection be afforded the trustee only where the person authorized to direct the actions of the trustee is required to act subject to a fiduciary duty. PROPOSED LEGISLATIVE CHANGES It is proposed that the Virginia Code Section be amended as follows: Powers to direct A. While a trust is revocable, the trustee may follow a direction of the settlor that is contrary to the terms of the trust. B. If the terms of a trust [[(1)]] confer upon a person other than the settlor of a revocable trust power to direct certain actions of the trustee, [[and (2) subsection E of this section does not apply,]] the trustee shall act in accordance with an exercise of the power unless the attempted exercise is manifestly contrary to the terms of the trust or the trustee knows the attempted exercise would constitute a serious breach of a fiduciary duty that the person holding the power owes to the beneficiaries of the trust. C. The terms of a trust may confer upon a trustee or other person a power to direct the modification or termination of the trust. D. A person, other than a beneficiary, who holds a power to direct is presumptively a fiduciary who, as such, is required to act in good faith with regard to the purposes of the trust and the

16 interests of the beneficiaries. The holder of a power to direct is liable for any loss that results from a breach of a fiduciary duty. [[E. The provisions of this subsection E shall apply if the settlor incorporates the provisions of this subsection into the trust instrument by specific reference to this subsection. The provisions of this subsection shall also apply if this subsection is incorporated into the trust instrument by a nonjudicial settlement agreement under Va. Code that makes specific reference to this subsection. 1. For purposes of this subsection E, a trust director means any person who is not a trustee and who has, pursuant to the governing instrument, a power to direct the trustee on any matter. No person shall be a trust director for purposes of this subsection E merely by holding a general or limited power of appointment over the trust assets. 2. Notwithstanding anything in the trust instrument to the contrary, the trust director shall be deemed a fiduciary who, as such, is (a) required to act in good faith with regard to the purposes of the trust and the interests of the beneficiaries and (b) liable for any loss that results from a breach of a fiduciary duty. 3. A trustee who acts in accordance with a direction in the governing instrument that the trustee is to follow the trust director s direction or act only with the trust director s consent or direction, shall not, other than in cases of wilful misconduct or gross negligence on the part of the directed trustee, be liable for any loss resulting directly or indirectly from any act taken or not taken by the trustee: (a) pursuant to the trust director s direction, or (b) as a result of the trust director s failure to direct, consent, or act, after receiving a request by the trustee for such direction, consent, or action. 4. A trustee shall not, except as otherwise expressly provided in the trust instrument, have any duty to: (a) monitor the trust director s conduct; (b) provide the trust director with information, other than material facts related to the trust administration expressly requested in writing by the trust director; (c) inform or warn any beneficiary or third party that the trustee disagrees with any of the trust director s actions or directions; (d) notify the trust director that the trustee disagrees with any of the trust director s actions or directions; (e) do anything to prevent the trust director from giving any direction or taking any action; or (e) compel the trust director to redress its action or direction. 5. The actions of the trustee pertaining to matters within the scope of the authority of the trust director, including confirming that the trust director's directions have been carried out and recording and reporting actions taken pursuant to the trust director's direction, shall, absent clear and convincing evidence to the contrary, presumptively be considered administrative actions by the trustee and not be considered to constitute either monitoring the trust director s actions or participating in the actions of the trust director.]]

17 PROPOSAL: TO AMEND VIRGINIA LAW TO PERMIT TRUSTEE DECANTING OF ASSETS FROM ONE TRUST TO ANOTHER TRUST Decanting is the act of a trustee exercising its power to distribute trust income or principal to or for the benefit of a beneficiary by distributing the assets to a new trust. The common law rationale behind decanting is that if a trustee has the discretionary power to distribute property to or for the benefit of a beneficiary, then the trustee has the power to distribute property to a second trust for the benefit of such beneficiary. The Restatement characterizes this power in the nature of a special power of appointment exercisable in a fiduciary capacity. See generally RESTATEMENT (SECOND) OF PROPERTY: DONATIVE TRANSFERS 11.1 and RESTATEMENT (THIRD) OF PROPERTY: WILLS & OTHER DONATIVE TRANSFERS The earliest reported case authorizing trust decanting is Phipps v. Palm Beach Trust Co., 196 So. 229 (Fla. 1940). In Phipps, the Florida Supreme Court authorized a trustee with the power to distribute trust principal in his sole and absolute discretion to transfer the trust property to a second trust for the purpose of giving one of the settlor s children a special testamentary power of appointment to appoint trust income to that child s wife. The court determined that the trustee s power to distribute trust property to the limited class of persons designated as trust beneficiaries was a special power of appointment, and that the trustee s ability to appoint property in further trust for members of the class depended upon the extent of the power authorized under the terms of the trust agreement. The court stated that [t]he power vested in a trustee to create an estate in fee includes the power to create or appoint any estate less than a fee unless the donor clearly indicates a contrary intent. Consequently, if a trustee can 1

18 distribute trust principal to a beneficiary outright, then the trustee should be able to distribute that same trust principal to a separate trust for the benefit of that beneficiary. Decanting is an incredibly useful tool for trustees, particularly for older trusts with antiquated language. For instance, a trustee may consider decanting to accomplish the following objectives: To change the trust s administrative provisions, such as: o changing trust situs or governing law; o providing for the resignation, removal, and appointment of trustees without court approval; o expanding the powers of a trustee to engage in sophisticated financial transactions, make or guarantee loans, adjust between income and principal, or participate in an initial public offering; o providing for the division of trustee roles and responsibilities; o addressing issues related to trustee compensation or liability; or o consolidating trusts for administrative efficiency. To address a beneficiary-related change of circumstances, including: o limiting distributions to beneficiaries with substance abuse problems or those engaging in other unproductive behaviors; o transferring assets to a special needs trust for a disabled beneficiary; or o dividing a single pot trust into separate trusts for each branch of the family. To respond to changes in federal or state tax law; or To correct errors or ambiguities in the trust instrument. 2

19 Twelve states have adopted decanting statutes (Alaska, Arizona, Delaware, Florida, Indiana, Missouri, Nevada, New Hampshire, New York, North Carolina, South Dakota, and Tennessee), and several others are considering it. The proposed Virginia statute, which incorporates many of the same provisions enacted by other states, is designed to balance the utility decanting can provide with safeguards for trust beneficiaries and trustees. Virginia s proposed statute, for example, requires notice to the trust beneficiaries with an opportunity to object, and includes several tax savings provisions that protect trustees from negatively impacting the trust. Given the increased legislative activity by states in enacting decanting statutes and the need to provide definitive guidance, the Internal Revenue Service placed trust decanting on its priority guidance plan and intends to issue guidance regarding the tax consequences of decanting. Overall, adding a decanting statute will substantially improve Virginia s trust law and make it a more attractive jurisdiction for trust administration. As a growing number of states have recognized, decanting permits trustees to accomplish their objectives in a cost-effective and timely fashion, while still maintaining the same safeguards for trust beneficiaries and trustees as provided under current law. In many circumstances, decanting an irrevocable trust will help promote the settlor s original intent by increasing benefits and advantages not otherwise available to the trust s deserving beneficiaries. 3

20 Trustee s special power to appoint to a second trust. A. As used in this section: 1. Current beneficiary means a permissible distributee of trust income or principal. 2. Interested distributee means a current beneficiary who has the power to remove the existing trustee of the original trust and designate as successor trustee a person who may be a related or subordinate party as defined in I.R.C. 672 (c), 26 U.S.C. 672 (c), with respect to such current beneficiary. 3. Interested trustee means: (i) an individual trustee who is a current beneficiary of the original trust or to whom the net income or principal of the original trust would be distributed if the original trust were then to terminate and be distributed; (ii) any trustee of the original trust who may be removed and replaced by an interested distributee; or (iii) an individual trustee whose legal obligation to support a beneficiary may be satisfied by distributions of income and principal of the original trust. 4. Original trust means a trust created either by an irrevocable inter vivos instrument or a testamentary instrument pursuant to the terms of which the trustee has a discretionary power to distribute trust principal or income to or for the benefit of one or more current beneficiaries. 5. Second trust means a trust established under an irrevocable inter vivos or testamentary trust instrument, the current beneficiaries of which are one or more of the current beneficiaries of the original trust. B. The trustee of an original trust may, without court authorization and whether or not there is a current need to distribute principal or income under any standard provided in the original trust terms, exercise the discretionary power to distribute principal or income to or for the benefit of one or more of the current beneficiaries of the original trust by appointing all or part of the original trust principal or income subject to the power in favor of the trustee of a second trust. The trustee's power to appoint trust principal or income in further trust under this section includes the power to create the second trust. C. The terms of the second trust shall be subject to the following: 1. The beneficiaries of the second trust may include only beneficiaries of the original trust. 2. If the power to distribute principal or income in the original trust is subject to an ascertainable standard, the power to distribute income or principal in the second trust (a) must be exercisable in favor of the same current beneficiaries as in the original trust and (b) unless the court approves otherwise, must be subject to the same ascertainable standard as in the original trust. 3. 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. 4

21 4. The terms of the second trust may not reduce any fixed income, annuity, or unitrust interest of a beneficiary in the original trust. 5. 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, 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. 6. If any contribution to the original trust was excluded from the federal gift tax by the application of Internal Revenue Code sections 2503(b) and 2503(c), the second trust shall provide that the beneficiary's remainder interest in the contribution 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. 7. If any beneficiary of the original trust has a power of withdrawal over trust property, either: (a) the terms of the second trust must provide a power of withdrawal in the second trust identical to the power of withdrawal in the original trust or (b) assets must remain in the original trust sufficient to satisfy any outstanding power of withdrawal. 8. The terms of the second trust may confer a power of appointment upon a current beneficiary 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 trust or the second trust. The power of appointment conferred upon a beneficiary shall be subject to the provisions of , et seq. covering the time at which the permissible period of the rule against perpetuities begins and the law which determines the permissible period of the rule against perpetuities of the original trust. 9. Notwithstanding the foregoing subsections, but subject to the other limitations of this section, the power under this section may be exercised to appoint to a second trust that is a special needs trust. D. A trustee who is an interested trustee may not exercise the power under this section. The remaining cotrustee or a majority of the remaining cotrustees who are not interested trustees may exercise the power under this section. If all of the trustees are interested trustees, or at the request of one or more of the trustees, the court may appoint a special fiduciary to exercise the power under this section. E. The exercise of the power under this section shall be: (1) subject to the fiduciary duties of the trustee of the original trust; (2) treated for all purposes as the exercise of a power of appointment in a fiduciary capacity that is not a power exercisable in favor the trustee individually, the trustee s estate, the trustee s creditors, or the creditors of the trustee s estate; (3) subject to the provisions of , et seq. covering the time at which the permissible period of the rule against perpetuities begins and the law which determines the permissible period of the rule against perpetuities of the original trust; and (4) permitted regardless of whether the original trust has a spendthrift provision or prohibits amendment or revocation of the original trust. 5

22 F. The exercise of the power under this section shall be made by written instrument signed and acknowledged by the trustee setting forth the manner of the exercise of the power, 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. G. At least 60 days prior to the effective date of the exercise of the power under this section, the trustee of the original trust must give written notice of the trustee s intent to exercise the power, including a copy of the written instrument provided under subsection (F), to: (1) the grantor of the original trust, if living; (2) without regard to the exercise of any power of appointment, the qualified beneficiaries of the original trust then determined under and , other than the attorney general of the Commonwealth; and (3) all persons acting as advisor or protector of the original trust. The representation provisions of , , , and shall apply to notice under this subsection. If all qualified beneficiaries of the original trust waive the notice required by this paragraph by a written instrument delivered to the trustee, the trustee of the original trust may exercise the power under this section without providing the notice under this subsection. The receipt of notice under this subsection shall not abrogate any right or remedy of any beneficiary against any trustee under the laws of the Commonwealth other than this section. H. Nothing in this section shall be construed to (1) create or imply a duty of any trustee to exercise the power granted in this section, and no inference of impropriety shall be made as a result of any trustee not exercising the power granted in this section or (2) limit the right of any trustee holding a power to appoint property in further trust under the terms of the original trust or by law. I. A trustee or beneficiary may commence a proceeding to approve or disapprove a proposed exercise of the power under this section. J. If accounts for the original trust are filed with the commissioner of accounts, the accounts for the second trust shall be filed with the commissioner of accounts unless the court orders otherwise. K. Subject to the provisions of the governing instrument, this section shall be construed as pertaining to the administration of a trust and shall be available to any trust that is administered under Virginia law, regardless of the date the trust was created, unless the governing instrument expressly prohibits the exercise of the power under this section. A provision in the governing instrument that The provisions of , Code of Virginia, as amended, or any corresponding provision of future law, shall not be used in the administration of this trust, or My trustee shall not have the power to appoint the income or principal of this trust to a second trust, or similar words reflecting such intent, shall be sufficient to preclude the application of this section. 6

23 DECANTING COMES OF AGE Jeffrey D. Chadwick Williams Mullen Center 200 South 10 th Street - Suite 1600 Richmond, Virginia jchadwick@williamsmullen.com

24 DECANTING COMES OF AGE Farhad Aghdami Williams Mullen 200 South 10 th Street, Suite 1600 Richmond, Virginia Jeffrey D. Chadwick Williams Mullen 200 South 10 th Street, Suite 1600 Richmond, Virginia We will sell no wine before it s time -- Orson Welles, on behalf of Paul Masson Winery Gradually, then suddenly. -- Mike Campbell, in response to a question about how he lost his money in THE SUN ALSO RISES, by Ernest Hemingway. I. INTRODUCTION AND OVERVIEW. A. Modifying Irrevocable Trusts. 1. On its face, the idea of modifying or changing a trust that, by its terms, is irrevocable seems difficult, if not, impossible and potentially contrary to the settlor s intent. 2. Irrevocable trusts are often required to achieve the settlor s tax objectives. 3. In many cases, it may be necessary to modify or change the terms of the trust to more accurately reflect the settlor s intent, to respond to beneficiary needs and circumstances, to address changes in law, to optimize tax consequences, or to correct errors in the trust instrument. 4. There are a number of mechanisms to modify an irrevocable trust including judicial reformation and modification, trust combinations and divisions, removal and substitution of trustees, non-judicial settlement agreements, the use of trust protectors or trust advisors to modify the terms of a trust, and now, with increasing popularity, decanting. B. Decanting Defined. 1. WEBSTER S DICTIONARY defines the verb decant as follows: (a) to draw off (a liquid) without disturbing the sediment or the lower liquid layers, 2

25 (b) to pour from one vessel into another, and (c) to pour out, transfer, or unload as if by pouring. 2. The act of decanting, in the trust context, is not too different from the definitions offered by WEBSTER S in that the assets from an old trust are poured into a new trust, with the less useful provisions contained in the old trust ( the sediment ) left behind. 3. Decanting is the act of a trustee exercising its power to distribute trust principal to or for the benefit of a beneficiary by distributing the assets to a new trust. 4. A decanting power is often thought of as the exercise of a special power of appointment, held by the trustee, to distribute assets for the benefit of a beneficiary. C. State Statutes Authorizing Decanting. To date, 12 states have adopted statutes which authorize decanting. They are, in chronological order of enactment: 1. New York. New York enacted the first decanting statute, N.Y. EST. POWERS & TRUSTS (b), which became effective on July 24, In 2011, both houses of the New York legislature approved a bill substantially revising New York s decanting statute. The bill, which was delivered to the governor on August 5, 2011, has not yet been enacted into law. Consequently, this outline discusses New York s statute as enacted in Alaska. Alaska enacted ALASKA STAT , which became effective on September 15, Alaska significantly amended its decanting statute in Delaware. Delaware enacted 12 DEL. CODE ANN. tit. 12, 3528, which became effective on June 30, Tennessee. Tennessee enacted TENN. CODE ANN (b)(27), which became effective on July 1, Florida. Florida enacted FLA. STAT , which became effective on July 1, South Dakota. South Dakota enacted S.D. CODIFIED LAWS to , which became effective on March 5, New Hampshire. New Hampshire enacted N.H. REV. STAT. ANN B:4-418, which became effective on September 8,

26 8. Arizona. Arizona enacted ARIZ. REV. STAT , which became effective on September 30, North Carolina. North Carolina enacted N.C. GEN. STAT. 36C , which became effective on October 1, Nevada. Nevada enacted NEV. REV. STAT , which became effective on October 1, Indiana. Indiana enacted IND. CODE , which became effective on July 1, Missouri. Missouri enacted MO. REV. STAT , which became effective on August 28, D. Tax Considerations. 1. Income Tax Considerations. As discussed in Part IV.B., infra, in most cases, there should be no income tax consequences associated with the transfer of assets from one trust to another through the process of decanting. It is important, however, that practitioners consider the capital gain implications of Cottage Savings Ass n v. Comm r., 499 U.S. 554 (1991), and the negative basis implications of Crane v. Comm r., 331 U.S. 1 (1947). In addition, it is important to consider whether the tax attributes of the old trust are carried forward into the new trust under the distributable net income (DNI) rules. 2. Federal Wealth Transfer Tax Considerations. As discussed in Part IV.C., infra, it is important to consider whether a taxable gift occurs when assets are transferred from one trust to another, and whether there is estate inclusion with respect to the decanted assets. In addition, as discussed in Part IV.D., infra, it is important to consider the generation skipping transfer (GST) tax consequences of decanting a grandfathered GST exempt trust or decanting a non-grandfathered trust that is exempt by reason of the allocation of GST exemption. 3. IRS Places Decanting on No-Ruling List. Given the increased legislative activity by states in enacting decanting statutes and the need to provide definitive guidance, the Service, in Rev. Proc , placed decanting on its no-ruling list. Specifically, Section 5 of Rev. Proc provides that until the Service publishes a more definitive revenue ruling, revenue procedure, regulation, or other publication, the Service will not issue determination letters or rule on the following matters: a. whether decanting gives rise to a Code 661 deduction or results in inclusion in gross income under Code 662; 4

27 b. whether decanting results in a taxable gift being made under Code 2501; and c. whether decanting causes the loss of GST exempt status or constitutes a taxable termination or taxable distribution under Code IRS Places Decanting on Priority Guidance Plan. After placing decanting on its no-ruling list, the Service placed decanting on its Priority Guidance Plan. a. Specifically, the Service intends to issue a Notice on decanting of trusts under 2501 and b. Interestingly, while the Service has targeted the gift and GST tax consequences of decanting, the Service did not include the income or estate tax consequences of decanting in its Priority Guidance Plan. 5. IRS Requests Comments on Decanting. a. On December 27, 2011, the Service issued Notice , in which it requested comments regarding when decanting that results in a change in the beneficial interests are not subject to income, gift, estate, and/or GST taxes. b. According to Notice , the Service is studying the tax implications of decanting and considering approaches to addressing some or all of the relevant tax issues in published guidance. c. Comments are due to the Service by April 25, II. COMMON LAW AND THE UNIFORM TRUST CODE. A. Nature of Decanting. 1. Exercise of Special Power of Appointment. Trust decanting generally refers to the distribution of property from one trust to another trust pursuant to a trustee's discretionary power to distribute property to or for the benefit of the trust's beneficiaries. The rationale behind decanting is that if a trustee has the discretionary power to distribute property to or for the benefit of one or more beneficiaries, then the trustee has, in effect, a special power of appointment that should enable the trustee to distribute property to a second trust for the benefit of one or more of such beneficiaries. 5

28 B. Restatement. 1. RESTATEMENT (SECOND) OF PROPERTY: DONATIVE TRANSFERS. a. The RESTATEMENT (SECOND) OF PROPERTY: DONATIVE TRANSFERS 11.1 (Comment d) provides that the trustee s ability to transfer trust property is similar to a special power of appointment, under which a trustee can transfer an interest in property equal to or less than the title authorized under the trust instrument. If the trustee is able to transfer full legal title to trust property to a beneficiary, the trustee should be able to transfer less than full legal title by transferring the property further in trust. It provides that [a] power of appointment is authority, other than as an incident of the beneficial ownership of property, to designate recipients of beneficial interests in property. b. Comment b of Section 11.1 provides that a power of appointment permits persons to transfer a beneficial interest in property they do not otherwise possess, and the exercise of the power is considered the completion of a transfer originating with the creator of the power. Therefore, the power to determine the identity of persons entitled to receive beneficial interests in property that are owned by persons other than the powerholder characterizes a power of appointment. c. Comment d of Section 11.1 characterizes a trustee s discretion to pay trust property to a beneficiary or among a class of beneficiaries as a power of appointment because the trustee is authorized to determine the recipients of beneficial interests in property that the trustee does not otherwise possess. d. Section 19.4 of the SECOND RESTATEMENT also authorizes a powerholder to create a new special power of appointment in any other person, which is exercisable only in favor of permissible appointees of the original power. For example, a trustee with the discretionary power to distribute trust property outright to or for the benefit of one or more trust beneficiaries should be able to distribute property to a separate discretionary trust for the lifetime benefit of one beneficiary that gives the beneficiary a special power of appointment over the appointed trust assets. 6