Trust Decanting: Flexibility and Danger Achieving Tax Benefits, Revising Fiduciary Powers, and Mitigating Trustee Liability

Transcription

1 Presenting a live 90-minute webinar with interactive Q&A Trust Decanting: Flexibility and Danger Achieving Tax Benefits, Revising Fiduciary Powers, and Mitigating Trustee Liability TUESDAY, OCTOBER 2, pm Eastern 12pm Central 11am Mountain 10am Pacific Today s faculty features: James P. Spica, Member, Dickinson Wright, Detroit Meryl G. Finkelstein, Sr. Counsel, Fulbright & Jaworski, New York Thomas R. Pulsifer, Partner, Morris Nichol Arsht & Tunnell, Wilmington, Del. Todd A. Flubacher, Partner, Morris Nichols Arsht & Tunnell, 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 PUBLICATIONS WEBINAR Trust Decanting: Flexibility and Danger Thursday, October 2, 1:00-2:30 PM (EDT) THE USES AND BENEFITS OF DECANTING AND DECANTING S CONCEPTUAL BASIS IN THE COMMON LAW James P. Spica Dickinson Wright PLLC Detroit jspica@dickinsonwright.com

6 THE USE OF DECANTING : A LOOSE METAPHOR FIDUCIARY AND NON-FIDUCIARY POWERS OF APPOINTMENT 6 By Trust Decanting, we generally mean the exercise of a fiduciary, special power of appointment to distribute assets from one trust to another This use of the term is under-determined by the metaphor on which it s based The analogy to pouring spirits from one vessel to another is apt enough, but there s no analogue in the decanting of spirits to our narrow reference to fiduciary powers: oenophiles know that one doesn t need a sommelier to decant wine; and similarly, in the right circumstances, a beneficial, special power of appointment may be as good as a fiduciary one for moving assets from one trust to another

7 THE USE OF DECANTING : A LOOSE METAPHOR POWERS OF APPOINTMENT BY ANY OTHER NAME 7 There are also powers of appointment we re not in the habit of calling powers of appointment that can be used to move assets from one trust to another, or to achieve practically equivalent effects. These include: powers of substitution (of the kind regularly used to attract grantor trust status), powers of amendment, powers of revocation or termination and disclaimers

8 THE USE OF DECANTING : A LOOSE METAPHOR POWERS TO DO THINGS OTHER THAN APPOINT 8 And there are means of effectively moving assets from one trust to another that have nothing to do with powers of appointment (nor, indeed, with the movement of assets), including: reformation or modification proceedings and trust mergers

9 THE USES OF DECANTING TO DECANT (ASSUMING ONE CAN) OR NOT TO DECANT 9 Whether decanting (in its narrow, if metaphorically under-determined sense) is a better means of moving trust assets than a beneficiary s, special power appointment, a power of substitution, a power of amendment, revocation or termination, a disclaimer a reformation or modification proceeding or a merger of trusts will often depend on one s particular motivations, on why exactly one wishes that the trust terms governing the assets in question were different

10 THE USES OF DECANTING COMMON MOTIVATIONS 10 Common motivations for decanting include wishes: to correct drafting errors or revise accurately rendered, but ill-advised provisions, e.g., a hobbling tax or perpetuities saving clause to enhance administration, e.g., by bifurcating fiduciary functions so as to protect a less sophisticated, but integral trustee from investment responsibility to address unanticipated circumstances concerning a beneficiary s creditors, marital status, wealth or health, e.g., by creating a supplemental needs trust so as to allow a beneficiary to qualify for public assistance to change a trust s vintage so as to put the beneficiaries interests in the way of prospective legislative innovations, e.g., perpetuities reform

11 THE USES OF DECANTING COMMON MOTIVATIONS (CONTINUED) 11 to change situs or governing law to supplement inadequate trustee provisions, e.g., by distinguishing the administrative powers of interested and disinterested trustees to engineer income tax consequences, e.g., by granting the settlor a power that ll trigger grantor trust status, or by spinning off capital loss assets for sale by a separate trust that can promptly be terminated in distributions to beneficiaries who have capital gains to increase the longevity of transfer tax advantages, e.g., by tying the termination of a trust grandfathered under Treasury s GST tax effective date regulations to the durations of extraneous measuring lives or by evading perpetuities constraints all together for trust assets to which GST exemption has been allocated

12 THE BENEFITS OF DECANTING COMPARING ALTERNATIVE MEANS 12 As the common motivations we ve described fairly suggest, one s reasons for wishing that particular trust terms governing particular assets were different will often implicate possible alternative means of achieving preferable results The point is that in many cases, decanting may be superior to other means at hand; and that, in any case, one has to compare the relevant alternatives

13 THE BENEFITS OF DECANTING ILLUSTRATION 1: DECANTING VS. EXERCISE OF A BENEFICIAL POWER WHEN THE NEW TRUST WILL GRANT POWERS OF APPOINTMENT 13 As between the use of a fiduciary, special power of appointment (i.e., decanting ) and a nonfiduciary one (i.e., a trust beneficiary s power), for example, one has always to reflect that the nonfiduciary power may implicate the so-called Delaware tax trap, IRC section 2041(a)(3) and its gift tax counterpart, IRC section 2514(d); whereas the legislative history of these sections indicates that the trap wasn t intended to apply to purely fiduciary powers of appointment, such as a trustee s discretionary power to invade principal See S. REP. No , at 1 (1951), as reprinted in 1951 U.S.C.C.A.N. 1535, 1535

14 THE BENEFITS OF DECANTING ILLUSTRATION 2: DECANTING VS. MERGER WHEN THE MERGER STATUTE REQUIRES SEGREGATION 14 Another example is the case of longevity planning for tax advantaged trust assets when the goal is to subject beneficial interests in the assets to a more favorable perpetuities regime In that case, use of a special power of appointment, whether a fiduciary power (i.e., decanting ) or a nonfiduciary one (i.e., a trust beneficiary s power), may be superior to merger of the existing trust or a part of the existing trust, following a strategic trust division with a new trust that qualifies for the desiderated perpetuities treatment if the applicable merger statute requires post-merger segregation of distinct perpetuities parcels Under the Michigan Trust Code s merger provision, for example, the merger of a trust that s subject to the Michigan USRAP with a trust to which the Personal Property Trust Perpetuities Act applies may well not subject the assets of the earlier trust to the reformed perpetuities regime See MICH. COMP. LAWS ANN (2) ( [i]f the rule against perpetuities speaks from different dates with reference to the trusts.... )

15 THE BENEFITS OF DECANTING ILLUSTRATION 3: DECANTING VS. CONSENSUAL MODIFICATION OF A TRUST GRANDFATHERED FROM GST TAX 15 Another example is the case of longevity planning for grandfathered status under the Treasury s GST tax effective date regulations In this case, perpetuity isn t in point, because the effective date regulations subject the tax advantage of grandfathered status to a RAP of their very own, one that s completely independent of state law See Treas. Reg (b)(1)(v)(B) (nonfiduciary, special powers of appointment); (b)(4)(i)(A) (fiduciary, special powers)

16 THE BENEFITS OF DECANTING ILLUSTRATION 3 (CONTINUED): DECANTING VS. CONSENSUAL MODIFICATION OF A TRUST GRANDFATHERED FROM GST TAX 16 But the regulations: contemplate that the exempt status of assets subject to a grandfathered trust may survive the assets being appointed to a new trust, provided the appointment may not postpone or suspend the vesting (or absolute ownership or power of alienation) of an interest in the assets beyond the Regulatory RAP period (see Treas. Reg (b)(1)(v)(D)(ex. 4) (especially the last sentence)) and permit the use of extraneous measuring lives with respect to the exercise of a nonfiduciary, special power of appointment (see id (b)(1)(v)(B)(2)) and a fiduciary, special power (i.e., decanting ) provided the terms of the grandfathered trust or state law at the time the grandfathered trust became irrevocable authorized the distribution to a new trust without the consent or approval of any beneficiary or court (see id (b)(4)(i)(A))

17 THE BENEFITS OF DECANTING ILLUSTRATION 3 (CONTINUED): DECANTING VS. CONSENSUAL MODIFICATION OF A TRUST GRANDFATHERED FROM GST TAX 17 The regulations also contemplate that the exempt status of assets subject to a grandfathered trust may survive the assets being distributed to a new trust, or retained in a trust that is modified, pursuant to a non-contested court order or non-judicial settlement But in that case, the distribution or modification must neither: shift a beneficial interest in the trust to any beneficiary who occupies a lower generation (as defined in IRC section 2651) than the person or persons who held that beneficial interest beforehand nor extend the time for vesting of any beneficial interest in the trust beyond the period provided for in the original trust See Treas. Reg (b)(4)(i)(D)

18 THE BENEFITS OF DECANTING ILLUSTRATION 3 (CONTINUED): DECANTING VS. CONSENSUAL MODIFICATION OF A TRUST GRANDFATHERED FROM GST TAX 18 The upshot is that: whereas a special power of appointment, whether a fiduciary power (i.e., decanting ) or a nonfiduciary one (i.e., a trust beneficiary s power), may afford scope for longevity planning for a grandfathered trust because the Treasury regulations allow an appointment to suspend vesting for a period determined by extraneous measuring lives; there s no scope for such planning with respect to modifications or distributions pursuant to non-contested court orders or non-judicial settlements, for in these cases, the modification or distribution isn t allowed to extend the period for vesting of interests in the grandfathered trust s assets at all

19 DECANTING S CONCEPTUAL BASIS IN COMMON LAW THE VINTAGE OF POWER 19 This last illustration, the case of longevity planning for trusts grandfathered under the GST tax effective date regulations, emphasizes the potential, taxplanning importance in every common law jurisdiction, regardless of the enactment of a decanting statute, of common law authority for decanting For, as we ve seen, the scope for longevity planning for a grandfathered trust may depend on the use of extraneous measuring lives And the use of extraneous measuring lives may depend on the existence of a fiduciary, special power of appointment (if the trust in question doesn t provide nonfiduciary, special powers) And in that case, unless the trust instrument itself provides that the trustee may extend the life of the trust or make distributions in further trust, state law at the time the grandfathered trust became irrevocable must have authorized the distribution to a new trust without the consent or approval of any beneficiary or court See Treas. Reg (b)(4)(i)(A) (supra Slide 16)

20 DECANTING S CONCEPTUAL BASIS IN COMMON LAW THE VINTAGE OF POWER (CONTINUED) 20 Now, it won't be oversimplifying for our purposes to say that a grandfathered trust is one that was irrevocable on September 25, 1985 (see Treas. Reg (b)(1)(i)) And the oldest decanting statute in the country, New York s original version, was enacted in 1992 (see N.Y. EST. POWERS & TRUST LAW (McKinney 2002)) So, unless the trust instrument expressly authorizes decanting, the scope for the longevity planning we ve described (having to do with the use of extraneous lives) depends, in every common law jurisdiction, on the plausibility of the claim that given the terms of the grandfathered trust, the common law authorizes the trustee to make distributions in trust for the benefit of permissible distributees

21 DECANTING S CONCEPTUAL BASIS IN COMMON LAW THE RESTATEMENTS (SECOND) AND (THIRD) 21 A trustee's discretionary power of distribution is a special power of appointment within the meaning of most states powers of appointment laws (see, e.g., MICH. COMP. LAWS ANN (c);.112 (i)) This tracks the treatment of a trustee s power to make discretionary distributions in the Restatements (Second) and (Third), which provide that unless the trust instrument that created the discretionary power manifests a contrary intent, a trustee s power to make discretionary distributions entails the powers: to make distributions in trust for permissible distributees and to create powers of appointment over trust assets (see RESTATEMENT (SECOND) OF PROP.: DONATIVE TRANSFERS 19.3 cmt. a illus. 2 (1986); RESTATEMENT (THIRD) OF PROP.: WILLS & OTHER DONATIVE TRANSFERS 17.1 cmt. g (2011))

22 DECANTING S CONCEPTUAL BASIS IN COMMON LAW CASE LAW 22 There may or may not be any case authority in a given jurisdiction for the proposition thus supported by the Restatements (viz., that at common law, a discretionary power to distribute trust property presumptively implies the power to decant ) In Florida, the proposition is strongly supported by Phipps v. Palm Beach Trust Co., 196 So. 299 (Fla. 1940) And in New Jersey, Wiedenmayer v. Johnson, 254 A.2d 534 (N.J. Super Ct. App. Div. 1969) seems to imply the proposition But here is, for example, as far as the author knows, no decided case binding as precedent on Michigan or Ohio judges that clearly stands for that proposition

23 DECANTING S CONCEPTUAL BASIS IN COMMON LAW CASE LAW 23 On the other hand, the mere absence of binding case authority in a jurisdiction cannot establish the absence of a common law basis for decanting there, since the method of common law adjudication obviously cannot be deduced from the doctrine of precedent alone Thus, the absence of local precedent did not prevent the Ohio legislature from asserting that its decanting statute is partly declarative of common law applicable prior to enactment (see OHIO REV. CODE ANN (O)(1) (2012))

24 DECANTING S CONCEPTUAL BASIS IN COMMON LAW SEGUE TO STATE STATUTES 24 And, indeed, a legislative decanting regime for Michigan, which the author has drafted on behalf of Greenleaf Trust and which is currently embodied in 2012 Michigan Senate Bill Nos. 978, 979 and 980, purports to be partly declarative But the declaratory aspirations of these very recent statutes (a fledgling in Ohio and one still in the womb of the Michigan legislature) must serve as our segue from the common law to a survey of decanting legislation, for which Meryl Finkelstein will be our guide

25 Strafford Publications Webinar Tuesday, October 2, 2012 TRUST DECANTING: FLEXIBILITY AND DANGER Achieving Tax Benefits, Revising Fiduciary Powers, and Mitigating Trustee Liability The State Decanting Statutes Meryl G. Finkelstein Fulbright & Jaworski L.L.P. 666 Fifth Avenue New York, NY Telephone: (212) Facsimile: (212)

26 INTRODUCTION A decanting statute permits a trustee who has the discretionary authority to invade the principal of a trust (and in some cases trust income) for the benefit of one or more trust beneficiaries to exercise that authority by transferring some or all of the assets of the trust in further trust. The rationale underlying a trust decanting is that a trustee who has the discretion to make an outright distribution of trust property to or for the benefit of one or more current beneficiaries of the trust has a special power of appointment over the trust property that allows the trustee to distribute the property to another trust for the benefit of one or more beneficiaries of the trust. Seventeen states have enacted specific decanting legislation and at least 3 other states have proposed statutes. As a general rule, a state decanting statute should apply to a trust unless the terms of the instrument creating the first trust specifically state to the contrary. Only 2 state statutes (Indiana and Rhode Island) actually use the word decanting in their titles. Most statutes refer to the trustee s invasion or distribution power or the trustee s power to appoint to another trust

27 CURRENT AND PROPOSED STATUTES

28 THRESHOLD CONSIDERATIONS FOR THE TRUSTEE 1. The proposed decanting must be consistent with the trustee s fiduciary duties of loyalty and impartiality. 2. Before undertaking a decanting, the trustee must thoroughly review the trust instrument. All of the state decanting statutes should apply unless the trust agreement provides to the contrary or the relevant statute specifically excludes the type of trust that is the subject of the proposed decanting. a. If the trust instrument prohibits the trustee from decanting the trust, then the trustee should not act absent court authorization. b. If the trust instrument gives the trustee specific power to decant the trust, then the trustee should confirm that the proposed decanting is consistent with what the trust instrument allows. c. Alternatively, the decanting power under the trust instrument may make it clear that it is not intended to abridge the trustee s power under state law, in which case the state decanting statute should also apply. 3. If the trust instrument creating the first trust is silent, then the trustee must confirm whether he has the requisite power under the applicable state decanting statute. 4. In addition, issues may arise in determining which state s law applies to the first trust, particularly if the situs or governing law of the trust was changed prior to the proposed decanting. 5. If the decanting will be effectuated under the applicable state decanting statute, then the trustee must confirm that the exercise of the decanting power will comply with all statutory requirements

29 STATUTORY DIFFERENCES All of the state decanting statutes are intended to achieve the same result to allow the trustee to appoint the assets of an existing trust to a second trust but their substantive provisions differ in a variety of ways, including: 1. The level of discretion that the trustee must have with respect to the power to invade the first trust (i.e., trusts where the trustee has absolute discretion to make distributions versus trusts with distribution standards). 2. Whether a decanting may be based solely on a power to invade trust income. 3. The persons for whose benefit the power to invade the first trust may be exercised and the persons who are permissible beneficiaries under the second trust. 4. Whether powers of appointment not granted under the first trust may be granted to a beneficiary under the second trust. 5. Limitations on the trustee s exercise of the decanting power that are intended to preserve certain tax benefits of the first trust such as marital and charitable deductions, gift tax annual exclusions, sub-s elections and allocations of generation-skipping transfer tax ( GST ) exemption. 6. Restrictions on the ability of a beneficiary-trustee to decant a trust. 7. The procedural aspects of the trustee s exercise of the decanting power, including: a. Method of exercise b. Notice to beneficiaries, contents of the notice and waivers of notice or the notice period c. Beneficiary consent d. Court approval and/or court filing requirements

30 SCOPE OF THE TRUSTEE S INVASION POWER UNDER STATE LAW 1. Three state decanting statutes -- Florida, Indiana and Rhode Island require that the trustee have the absolute discretion or power to distribute trust principal in order to decant an existing trust. 2. What constitutes absolute discretion or power under the Florida, Indiana and Rhode Island statutes? Absolute discretion or power is one that is not limited to specific or ascertainable purposes such as HEMS. The Florida and Rhode Island statutes make it clear that a power to invade for the best interests, welfare, comfort or happiness of a beneficiary does not constitute a standard. 3. All of the other state decanting statutes permit a trustee to decant the existing trust where the trustee s distribution or invasion power is limited by a standard If the trustee s discretion under the first trust is limited by a standard, the decanting statute must be reviewed carefully to determine whether the same standard must be included in the second trust. The Alaska, Illinois, Missouri, New York and North Carolina statutes all require that the same standard be included in the second trust and most also require that it be exercisable in favor of the same beneficiaries as provided under the first trust. The New York statute also provides that if the term of the first trust is extended in the second trust, then during the entire extended term of the second trust, the second trust must retain the original standard set forth in the first trust, but the second trust may additionally provide for unlimited discretion once the initial term under the first trust has expired. The Arizona and Kentucky statutes require that the same or a more restrictive standard be included in the second trust where the trustee exercising the distribution power is a possible beneficiary under the standard. Under the Ohio statute, if the trustee s discretionary distribution power is limited by a standard, the trustee s exercise of its distribution power will only be valid if the second trust does not materially change the interests of the beneficiaries of the first trust (if the trustee s power is unlimited, then beneficial interests under the first trust can be materially changed under the second trust). Under the Virginia statute, where the first trust contains an ascertainable standard for distributions, the second trust must include the same standard unless a court approves a change in or elimination of the standard and the standard must be exercised in favor of the same current beneficiaries as set forth in the first trust. Under the Delaware statute, the trustee s exercise of the invasion power must comply with any standard that limits the trustee s authority to make distributions from the first trust (example if the first trust has a 5% annual distribution limit, then only 5% of the assets can be decanted). 30

31 SCOPE OF THE TRUSTEE S INVASION POWER UNDER STATE LAW (continued) 5. In a number of states, a decanting may be based on a trustee s discretionary power to distribute trust income, not just principal. The Kentucky, Missouri, Nevada, North Carolina, South Carolina, South Dakota, and Virginia statutes all specifically apply to a trustee s power to distribute trust income or principal. The Arizona and New Hampshire statutes refer only to the power to make distributions, which includes both principal and income. In Alaska, the trustee s power to invade principal of the first trust must be exercised for the benefit of a beneficiary who is also an actual or potential income beneficiary of the first trust

32 PERMISSIBLE BENEFICIARIES OF THE SECOND TRUST One of most difficult issues arising with respect to trust decantings is determining the identity of the permissible beneficiaries of the second trust and to what extent the beneficiary provisions of the first trust may be varied in the second trust. Questions that typically arise in this context are: 1. Whether current beneficiaries under the first trust can be eliminated in the second trust: Under all of the statutes, the answer appears to be yes where the trustee has an unlimited distribution power or absolute discretion. Note that in several states, including Illinois, New York, North Carolina, Ohio and Virginia, if the trustee does not have absolute discretion, then the interests of current beneficiaries of the first trust may not be eliminated in the second trust. 2. Whether remainder beneficiaries in the first trust can be eliminated in the second trust: This is not explicitly addressed under most of the statutes, but most commentators take the position that if the interest of a current beneficiary can be eliminated under the statute, the interest of a future or remainder beneficiary also can be eliminated. The Illinois, New York and Ohio statutes specifically provide that remainder interests can be eliminated only where the trustee of the first trust has absolute discretion. If the trustee of the first trust does not have absolute discretion, then the interests of remainder beneficiaries of the first trust may not be eliminated in the second trust. 3. Whether the interests of remainder beneficiaries of the first trust can be accelerated to present interests in the second trust: The Missouri and South Dakota statutes specifically permit the acceleration of remainder interests. Although most of the statutes are silent, if the power to invade the principal of the first trust must be exercised in favor of one or more current beneficiaries of first trust, it follows that the acceleration of remainder interests should not be permitted. The Kentucky, North Carolina and Virginia statutes all specifically prohibit the acceleration of remainder interests. This is also implied under other statutes (such as Delaware)

33 PERMISSIBLE BENEFICIARIES OF THE SECOND TRUST (continued) 4. Can the second trust add as beneficiaries persons who are not beneficiaries under the first trust. None of the statutes specifically permit the addition of beneficiaries in the second trust and most of the statutes specifically state that the beneficiaries of the second trust may include only beneficiaries of the first trust. The New Hampshire statute specifically provides that the second trust may not include a beneficiary who is not a beneficiary of the first trust. 5. Some statutes permit the second trust to grant a power of appointment not provided for under the first trust, effectively allowing the addition of beneficiaries through the exercise of the power of appointment. The Delaware, Illinois, Kentucky, Nevada, New York, North Carolina, Ohio, South Dakota and Virginia statutes all permit the second trust to grant a power of appointment (usually including a general power of appointment) not provided for in the first trust to a beneficiary of the second trust. Under these statutes, the potential appointees under the power of appointment do not have to be beneficiaries of either the first trust or the second trust. Under some statutes, limitations apply: Under the Illinois and Ohio statutes, the trustee must have absolute discretion to distribute trust principal in order to include a power of appointment in the second trust. The Illinois statute also requires that the beneficiary who is given the power of appointment be a beneficiary who could have received an outright distribution of the property. New York allows a beneficiary under the first trust to be granted a power of appointment in the second trust that is not in the first trust where the trustee has absolute discretion and the beneficiary could have received the entire principal of the first trust outright. In such a case, the potential donees of the power must be unlimited (i.e., the power must be exercisable in favor of anyone in the world except where the beneficiary, the grantor or grantor s spouse would have a general power of appointment)

34 STATUTORY LIMITATIONS ON EXERCISE OF TRUSTEE S INVASION POWER The statutes also preserve certain provisions contained in the first trust, particularly as they relate to maintaining tax benefits of the first trust and certain fixed or mandatory interests of the beneficiaries of the first trust such as income interests and rights of withdrawal. 1. All of the state decanting statutes prohibit the reduction (or elimination) of fixed or mandatory income interests under the first trust. In Delaware and South Dakota, this restriction applies only where the first trust is a marital trust. In Illinois, Nevada, New Hampshire, New York and Ohio, only current income interests, not future income interests are specifically protected. This is implied under the Missouri statute. The Kentucky statute protects both current and future fixed income interests. In addition, many statutes such as Arizona, Florida, Indiana, Illinois, Nevada, Kentucky, New Hampshire, New York, North Carolina, Ohio, Rhode Island and Virginia also prohibit the reduction or elimination of annuity and/or unitrust interests, but note: In Delaware, a unitrust interest cannot be reduced or eliminated only if the first trust is a marital trust. In Missouri income and unitrust/annuity interests cannot be reduced in marital trusts, CRTs, GRATs and trusts holding sub-s stock. In South Dakota this limitation applies to CRTs and GRATs. 2. Many statutes contain provisions preserving specific tax benefits of the first trust: Marital and charitable deductions are specifically protected under the Florida, Indiana, Illinois, Kentucky, Nevada, New Hampshire, New York, North Carolina, Ohio, Rhode Island and Virginia statutes. In these states, the second trust cannot include any provision which, if included in the first trust, would have prevented it from qualifying for such deduction. Under the Ohio statute, the second trust also cannot omit any such provision. Contributions qualifying for the gift tax annual exclusion are specifically protected under the Illinois, Nevada, New Hampshire and New York statutes. Under the Delaware, Illinois, Kentucky, Missouri, Nevada, North Carolina, Ohio, South Dakota and Virginia statutes, where contributions qualified for the gift tax annual exclusion under IRC 2503(b) based on the first trust s qualification as a 2503(c) trust, the second trust cannot extend the age for vesting and distribution of the beneficiary s interest beyond the age set forth in the first trust. Under the Arizona statute, the proposed decanting cannot adversely affect the tax treatment of the first trust, the trustee, the settlor or the beneficiaries. The Illinois and New York statutes similarly prohibit a decanting where it would jeopardize any tax benefit of the first trust. The Illinois, Kentucky, and Ohio statutes also specifically protect trusts for which sub-s elections have been made. The New York and Illinois statutes make it clear that grantor trust status is not a tax benefit and thus a decanting can be undertaken to change a trust from a grantor trust to a non-grantor trust and vice versa

35 STATUTORY LIMITATIONS ON EXERCISE OF TRUSTEE S INVASION POWER (continued) 3. Many statutes also protect property subject to a presently exercisable rights or powers of withdrawal. Under the New Hampshire statute, the decanting power does not apply to such property. Under the Missouri, Nevada and South Dakota statutes, the decanting power does not apply unless the beneficiary s power of withdrawal under the first trust is unchanged in the second trust. Under the Delaware statute, the decanting power does not apply to a presently exercisable right of withdrawal held by a person who is the only beneficiary to or for whose benefit distributions may be made under the first trust. Under the Kentucky, North Carolina and Virginia statutes, the second trust must provide an identical power of withdrawal or sufficient assets to satisfy the right of withdrawal must remain in the first trust. The Illinois, New York and Ohio statutes also prohibit the elimination of the current right to withdraw a specified amount or percentage of trust principal. The Illinois, New York and Ohio statutes also protect a beneficiary s right to receive mandatory principal distributions under the first trust. 4. Many of the statutes also contain provisions prohibiting the extension of the permissible period of the rule against perpetuities applicable to the first trust. Attempts to extend the duration of a trust can have varying consequences depending on whether the trust is grandfathered from the GST tax, exempt from the GST tax or non-exempt. Care should be taken when a trust is decanted from a state that has a rule against perpetuities to a state that has repealed the rule against perpetuities or has a longer rule than the rule applicable to the first trust. Note that in Delaware, a trustee may validly decant from a first trust of limited duration to a second trust of longer duration, including a perpetual trust

36 ADDITIONAL LIMITATIONS WHERE TRUSTEE IS A BENEFICIARY OR WHERE BENEFICIARIES POSSESS CERTAIN POWERS Some of the decanting statutes also limit the ability of a beneficiary-trustee to decant. Concerns here include the potential for a taxable gift being made by the beneficiary-trustee or the beneficiary-trustee being deemed to hold a general power of appointment. 1.In New York, North Carolina and Virginia, a beneficiary-trustee simply is not authorized to act. North Carolina and Virginia also specifically permit the court to appoint a special fiduciary to exercise the power if all trustees are beneficiaries of the first trust. 2.In Arizona, the beneficiary-trustee cannot act if it would have an adverse tax effect on the beneficiary-trustee. 3.Where absolute discretion is required and you have a beneficiary-trustee whose action would be tantamount to a general power of appointment, they arguably cannot act (i.e., Florida, Indiana. Rhode Is). 4.Under the Nevada and New Hampshire statutes, a beneficiary-trustee cannot act : (a) if under the trust instrument or applicable law, the beneficiary-trustee cannot make or participate in discretionary distributions to himself, or is limited by an ascertainable standard, or (b) the beneficiary-trustee s power to distribute to himself requires the consent of a co-trustee or person holding an adverse interest and the second trust does not limit distributions to the beneficiary-trustee to an ascertainable standard and is exercisable without consent. 5.Under the South Dakota statute, a restricted trustee cannot act if doing so could have the effect of (i) benefitting the restricted trustee as a beneficiary unless the exercise is limited to a HEMS standard, (ii) removing restrictions on distributions to a beneficiary of the first trust unless distributions under the second trust are limited to a HEMS standard, or (iii) increasing the distributions that can be made from the second trust to the restricted trustee or to beneficiaries who can remove and replace trustees with related or subordinate parties to the beneficiaries unless the exercise of such authority is limited by a HEMS standard. 6.In Missouri, unless the trustee s distribution power is limited by a HEMS standard, the trustee cannot decant the assets of the first trust if (a) the trustee is a beneficiary of the first trust, or (b) any beneficiary of the first trust can remove and replace the trustee of the first trust with a related or subordinate party to such beneficiary. 7.Practitioners should also be aware of restrictions on decanting where beneficiaries of the second trust have the right to remove and replace trustees. The Missouri, Nevada, New Hampshire and South Dakota statutes require that the second trust contain an ascertainable standard for distributions where the beneficiaries have the right to remove and replace trustees with a related or nonsubordinate party to the beneficiary. 8.In Nevada and New Hampshire, a beneficiary-trustee cannot decant if the first trust prohibits a trustee s use of trust assets to discharge his support obligation unless the second trust also contains such a prohibition

37 MECHANICS OF THE TRUSTEE S EXERCISE OF THE POWER 1. Manner of exercise: TO APPOINT IN FURTHER TRUST Most of the statutes, including Delaware, Florida, Illinois, Indiana, Kentucky, New York, North Carolina, Ohio, Rhode Island, South Dakota and Virginia, require a written instrument that is signed and acknowledged by the trustee and filed with the records of the first trust (and the second trust in Illinois). The Alaska, Arizona, Missouri and New Hampshire statutes are all silent on the manner of exercise. 2. Can the second trust be established under the first trust or is a new trust required? The Alaska and South Dakota statutes specifically require that a new governing instrument be created. The Arizona, Delaware, Florida, Indiana, Missouri, North Carolina, Ohio and Tennessee statutes specifically authorize the trustee to establish the second trust under the first trust. 3. Notice Requirements: The Florida, Indiana, North Carolina, Rhode Island and Virginia statutes all require 60 days advance notice to the beneficiaries of the first trust. The Ohio statute requires 30 days advance notice to all beneficiaries of the first trust. The South Dakota statute requires 20 days advance notice to all beneficiaries of the first trust. The Illinois statute requires that 60 days advance notice be given to all legally competent current beneficiaries and presumptive remainder beneficiaries of the first trust (all as determined on the date the notice is sent). If the trust has a current charitable beneficiary or presumptive remainder beneficiary, notice must also be sent to the Attorney General. The Kentucky statute requires 60 days advance notice to current beneficiaries of the first trust and to all beneficiaries in the oldest generation of remainder beneficiaries of the first trust. The Missouri statute requires 60 days advance notice to all permissible distributees and qualified beneficiaries of the second trust. In New York, notice must be served on the beneficiaries of the first trust (interested persons) and also the trust creator, if living, and all persons with a right to remove or replace the trustee exercising the decanting power. New Hampshire and Illinois require notice to the Director of Charitable Trusts/AG where the first trust has a current or future charitable beneficiary. The Nevada statute authorizes but does not require notice and the Delaware statute does not require any notice. What constitutes notice? In New York, serving a copy of the decanting instrument plus both trust instruments. In Florida, Indiana, Kentucky, North Carolina and Rhode Island, serving a copy of the proposed instrument exercising the decanting power is sufficient. In South Dakota, serving a copy of the decanting instrument and the second trust constitutes notice. 37

38 MECHANICS OF THE TRUSTEE S EXERCISE OF THE POWER TO APPOINT IN FURTHER TRUST (continued) 4. Waiver of Notice: The Florida, Indiana, Kentucky, Nevada, North Carolina, Ohio, Rhode Island and South Dakota statutes all allow a beneficiary to specifically waive the notice period, in which case the decanting will be effective prior to the expiration of the notice period. New York allows the beneficiaries to accelerate the effective date of the decanting, which is 30 days from the date that the serving of notice is complete. In Illinois, the decanting will be effective 60 days after notice is sent. Missouri and Virginia statutes allow the beneficiaries to waive notice itself. 5. Beneficiary Consent: Beneficiary consent generally is not required in any state and there are both gift and GST tax reasons for this. The exceptions are Nevada where property specifically allocated to a beneficiary of the first trust will no longer be allocated for the beneficiary under either the first or the second trust and Ohio, where consent of the beneficiaries of the second trust or court approval is required when the second trust increases or changes the method for computing compensation of the trustee. Also, some statutes, such as Florida, Indiana, North Carolina, Nevada, New York, Ohio, Rhode Island and Virginia, make it clear that a trustee s giving notice and/or a beneficiary s waiver of the notice period do not limit a beneficiary s right to object. 6. Court Approval and Court Filing Requirements: Only Ohio requires court approval and only in cases where the first trust is a testamentary trust created by an Ohio domiciliary. New York has a court filing requirement for testamentary trusts and inter vivos trusts that were the subject of prior court proceeding (but court approval is not required). Some statutes, such as those in Arizona, Illinois, Kentucky, Nevada, New York and North Carolina, make it clear that the trustee can petition for a court approval. The Alaska statute specifically provides that the trustee can act without court approval

39 ADDITIONAL STATUTORY PROVISIONS 1. In Alaska, Delaware, Nevada and Ohio, the second trust can provide that it will be administered on terms substantially identical to the terms of the first trust after the passage of time or the occurrence of an event specified in the second trust. 2. The New York and Illinois statutes specifically permit the term of the first trust to be extended in the second trust. The ability to extend the duration of the first trust under the second trust is implied under the Ohio statute. 3. Some decanting statutes, such as those in Illinois, New York and Ohio, also provide that the decanting cannot change the commissions of the trustee under the second trust and prohibit a trustee from decanting a trust in order to reduce the trustee s standard of care or to exonerate or indemnify the trustee from liability under the second trust. 4. Virtually all of the decanting statutes specifically provide that spendthrift clauses and provisions prohibiting amendment or revocation of the first trust do not bar a decanting (See Florida, Indiana, Illinois, Kentucky, Missouri, Nevada, New Hampshire, New York, North Carolina, Ohio, Rhode Island, South Dakota, and Virginia). 5. The more modern decanting statutes also provide that a trustee does not have a duty to decant and most also provide that the trustee s failure to decant does not give rise to an inference of impropriety (See Florida, Indiana, Illinois, Kentucky, Missouri, Nevada, New Hampshire, New York, North Carolina, Ohio, Rhode Island and Virginia). 6. Many decanting statutes also make it clear that the statute does not abridge other rights of the trustee to appoint trust assets, whether under the trust instrument itself, or under state law or common law (See Delaware, Florida, Illinois, Indiana, Kentucky, Nevada, New York, North Carolina, Ohio and Virginia). 7. Some decanting statutes, such as those in Delaware, Missouri, New Hampshire, New York, Ohio, South Dakota and Virginia, contain statements that a decanting is subject to all of the trustee s fiduciary duties and standards as they would apply in making a discretionary outright distribution, and some statutes set forth guidelines that the trustee must consider before exercising a decanting power (such as the purposes of the trust as intended by the grantor, whether the decanting is in the best interests of all trust beneficiaries, whether the distribution is being made in good faith and the potential tax consequences of the decanting)

40 ADDITIONAL STATUTORY PROVISIONS (Continued) 8. All of the statutes apply to both testamentary and irrevocable inter vivos trusts that are governed by the laws of that state, and most of the statutes also make it clear that the statute will apply to a trust whose jurisdiction has been transferred to that state. 9. Some of the statutes, such as Delaware and Ohio, specifically apply to trusts administered under the laws of that state, even if the trust is governed by the law of another state. Under the Alaska and New York statutes, if the trust has a resident trustee and the other trustees elect to have the primary administration of the trust located in that state, their decanting statutes will apply (even if the trust is not governed by that state s law). 10. The New York and Illinois statutes make it clear that a distribution of all of the assets of the first trust includes subsequently discovered assets of the first trust, whereas if only a part of the assets of the first trust are distributed, then subsequently discovered assets will continue to belong to the first trust. 11. The Illinois, New York and Virginia statutes specifically allow the trustee of the first trust to decant to a second trust that is a supplemental needs or special needs trust. 12. Some of the decanting statutes do not apply to specific types of trusts. Examples: The Rhode Island statute does not apply to supplemental needs or special needs trusts The Kentucky statute does not apply to charitable remainder trusts

41 Strafford Publications Webinar October 2, 2012 TRUST DECANTING: FLEXIBILITY AND DANGER COMMON PITFALLS Thomas R. Pulsifer Morris, Nichols, Arsht & Tunnell LLP 1201 N. Market Street P.O. Box 1347 Wilmington, DE Telephone: (302) Facsimile: (302)

42 Trust Decanting: Flexibility and Danger Common Pitfalls I. Introduction A. At least seventeen states permit decanting by statute (Alaska; Arizona; Delaware; Florida; Illinois; Indiana; Kentucky; Missouri; Nevada; New Hampshire; New York; North Carolina; Ohio; Rhode Island; South Dakota; Tennessee; and Virginia) B. Superficial similarities in the statutes disguise important and sometimes subtle differences C. Rules regarding availability; circumstances in which decanting is permitted; permissible terms of recipient trust; formal requisites of decanting; and many other aspects of the decanting transaction vary from State to State D. The statutes offer many valuable options and opportunities but inevitably entail significant risks E. Forewarned is forearmed 42

43 II. Conflicts of Law; Availability of the Statue A. The proper conflicts of law analysis applicable to statutory decanting transactions is sufficiently novel so as to be unclear in its detail B. Typical fact patterns create many superficial issues amenable to easy resolution 1. Trusts governed in part by the laws of multiple jurisdictions 2. Trusts have co-fiduciaries in multiple jurisdictions C. Some outlier cases may create true traps for the unwary 1. Administration governed by laws other than the laws of the trust s situs 2. Trusts having no clear situs D. Proper analysis probably follows Wilmington Trust Company v. Wilmington Trust Company, 26 Del. C. 397, 1942) but this is not necessarily so. See 12 Del. C. 3528(f); compare AS ; A.R.S (B) E. Could following a statute break the law? 43

44 III. Statutory Requisites; Conditions; Limitations A. Identifying the nature of the trustee s principal distribution power; absolute discretion v. ascertainable standard B. Statutory safeguards; express and implied limitations C. Compliance with ascertainable standard D. Adding beneficiaries; reordering or altering beneficial interests of non-current beneficiaries E. Reduction in fixed income interest and other anomalies F. Cures: Releases and virtual representation G. Perhaps incurable powers deficiency problem 44

45 IV. Trustee Liability and Participation A. Issues encountered in obtaining trustee acquiescence to a proposed decanting B. Protecting the trustee from liability C. Law governing releases and consents; virtual representation; fiduciary liability and standard of care 45

46 V. Mechanical Issues A. Filing requirements B. Notice requirements C. Other statutory formalities 46

47 VI. Generation-Skipping Transfer Tax Considerations A. Treasury Reg (b)(4)(i)(D) 1. Modification v. exercise of a power B. Grandfathered trusts v. other exempt trusts 47

48 Strafford Publications Webinar October 2, 2012 TRUST DECANTING: FLEXIBILITY AND DANGER STRATEGIES Todd A. Flubacher Morris, Nichols, Arsht & Tunnell LLP 1201 N. Market Street P.O. Box 1347 Wilmington, DE Telephone: (302) Facsimile: (302)

49 STRATEGY OVERVIEW 1. Evaluate the trustee s power to decant What state law governs? Does the trustee have the power to decant under the instrument or applicable law Must/can the trust be moved to a new jurisdiction that permits decanting? How do you move the trust? How do you change applicable law? 2. Evaluate trustee s duties in connection with decanting 3. Address trustee s risk Can you mitigate trustee risk with releases? Can you bind all of the beneficiaries with releases? Virtual representation 49

50 STRATEGY OVERVIEW (Continued) 4. Implementation Requirements under applicable statute Entirely new trust agreement Simple decanting instrument Releases 5. Plan ahead Facilitate decanting under new instruments with express provisions Expressly authorize decanting Limitations on decanting liability 6. Tax Issues 50