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, MAY 12, 2015 1pm Eastern 12pm Central 11am Mountain 10am Pacific Today s faculty features: Meryl G. Finkelstein, Sr. Counsel, Norton Rose Fulbright US LLP, New York Todd A. Flubacher, Partner, Morris Nichols Arsht & Tunnell, Wilmington The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions emailed to registrants for additional information. If you have any questions, please contact Customer Service at 1-800-926-7926 ext. 10.
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TRUST DECANTING: Achieving Tax Benefits, Revising Fiduciary Powers, and Mitigating Trustee Liability Decanting Under Common Law and the State Decanting Statutes Meryl G. Finkelstein Senior Counsel Norton Rose Fulbright US LLP meryl.finkelstein@nortonrosefulbright.com May 12, 2015
INTRODUCTION A decanting statute permits a trustee who has the discretion or 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. 6
INTRODUCTION (Cont d) Twenty-two states have enacted specific decanting legislation. As a general rule, a state decanting statute should apply to a trust unless the terms of the instrument creating the trust specifically state to the contrary. Only two statutes (Indiana and New Hampshire) actually use the word decanting in their titles. Most refer to the trustee s invasion or distribution power or the trustee s power to appoint to another trust. 7
CURRENT STATUTES States with Existing Decanting Statutes: New York (1992, amended August 2011) Alaska (1998, reenacted 9/19/13) Delaware (2003) (various amendments) Tennessee (2004, amended 7/1/13) Florida (2007) South Dakota (2007, amended 2012) New Hampshire (2008) Nevada (2009, amended 2011) Arizona (2009, amended 2011) North Carolina (2009, amended 2011) Indiana (2010) Missouri (2011) Ohio (2012) Kentucky (2012) Virginia (2012) Illinois (2013) Rhode Island (2012, amended 2013) Michigan (2012) Texas (2013) Wisconsin (2014) Wyoming (2013) South Carolina (2014) 8
DECANTING UNDER COMMON LAW What if you practice in a state that does not have a decanting statute and the trust instrument does not contain a decanting provision? A decanting may be possible under common law. A common law basis for decanting is recognized under court decisions in Florida, New Jersey, Iowa and Massachusetts, and is also supported under both the Second and Third Restatements of Property. A. CASES 1. Phipps v. Palm Beach Trust Co. (Florida Supreme Court) (1940): Phipps is the first American case recognizing the ability of a trustee authorized to make discretionary trust distributions to exercise that power to distribute trust assets to a second trust for the benefit of the beneficiaries of the first trust. Facts Wife ( W ) created a discretionary trust for her children and descendants and named Husband ( H ) and Trust Co. as trustees, giving H the absolute discretion to distribute trust assets among the beneficiaries. H distributed the assets of the first trust to a second trust for the benefit of the same persons. However, the second trust granted one of W s children a testamentary power of appointment exercisable in favor of his wife, who was not a beneficiary under the first trust. Issue The corporate trustee brought a construction proceeding to determine whether H s actions were within the scope of his powers as trustee. Holding The Florida Supreme Court upheld H s actions. First, it determined that H s distribution power was a special power of appointment, which included not only the ability to appoint the trust property outright to a beneficiary, but also to create a lesser interest, such as an interest in further trust. Second, the Court noted that the class of beneficiaries under the second trust was identical to those under the first trust. Commentary Phipps is often cited as common law authority for a trustee s ability to appoint trust property in further trust, However, H s distribution power was more similar to a beneficiary power of appointment and less like the type of discretionary distribution power that a trustee normally has. 9
DECANTING UNDER COMMON LAW (Cont d) A. CASES 2. Wiedenmayer v. Johnson (N.J. Superior Court) (1969) Facts Wiedenmayer involved a trust held for the benefit of an heir to the Johnson & Johnson family fortune. The trust gave the trustees absolute discretion to distribute trust principal to the beneficiary at any time they deemed it to be for his best interests. The trustees distributed the trust assets to another trust for the benefit of the beneficiary. The beneficiary had been married and divorced and the trustees determined that the distribution in further trust was for the financial benefit of the beneficiary in that it would protect the trust assets from the claims of another spouse. Issue The guardian ad litem for the beneficiary s minor children opposed the distribution to the second trust, claiming that it would defeat the children s contingent remainder interest under the first trust. Holding The court held for the trustees, finding that the appointment in further trust was consistent with the settlor s intent since it was in the best interest of the beneficiary to protect the trust assets from future creditor claims. It also reasoned that an outright distribution of trust assets to the beneficiary, which was within the scope of the trustees powers, would similarly defeat the interests of the trust s remainder beneficiaries. Note -- The trustees willingness to make distributions from the trust to the grantor s son was expressly conditioned on the son s agreeing to establish a second trust to receive those distributions. 10
DECANTING UNDER COMMON LAW (Cont d) A. CASES 3. In Re: Estate of Spencer (Iowa Supreme Court) (1975) Facts Wife ( W ) created a testamentary trust for her children and gave Husband ( H ), who was a trustee, a testamentary power to grant life estates to the children, with the remainder to pass to W s grandchildren. H exercised his power of appointment by creating a trust for his children, to last for the maximum period allowed by the Rule Against Perpetuities. Issue The court examined whether H had the right to appoint the trust property in further trust for his children, as opposed to granting them life estates. Holding The court determined that H s appointment in further trust for the children during their lives was consistent with W s intention that the trust assets remain within her family line and that they pass as a single unit. However, the court also determined that the assets could not be held in further trust beyond the lives of W s children as it was clear that W intended that the assets pass outright to her grandchildren upon the death of her children. Note The power held by H was exercisable in his individual capacity, not in his capacity as a trustee of the trust. Thus, the court did not analyze the exercise of the power from a fiduciary standpoint. 11
DECANTING UNDER COMMON LAW (Cont d) A. CASES 4. Morse v. Kraft (Mass. Supreme Judicial Court ) (2013) Facts Morse involved an inter vivos trust created for the benefit of the grantor s sons and their issue. The trust consisted of four subtrusts, each of which gave the trustees full discretion to distribute trust income and principal for the benefit of the grantor s sons. When the trust was created, the sons were all minors, and under the terms of the trust instrument, were ineligible to serve as trustees of the sub-trusts after attaining the age of majority. Morse, the independent trustee, brought an action for declaratory relief to clarify that the terms of the trust authorized him to transfer all of the assets of the subtrusts to new subtrusts (created under a new master trust) for the benefit of the same beneficiaries without beneficiary consent or court approval. The new trust would have broader administrative powers that authorized the grantor s sons to serve as co-trustees of their subtrusts. Since the trust did not specifically allow an appointment of trust assets in further trust (and Massachusetts does not have a decanting statute), the ruling was necessary in order to avoid losing the GST grandfathered status of the trust. Issue Whether the distribution language of the trust, which authorized the trustee to distribute trust principal for the benefit of each child, authorized a distribution in further trust. Holding Relying primarily on Wiedenmayer and Phipps, the court held that the trustee could transfer the assets of the subtrusts to new subtrusts without beneficiary consent or court approval. In finding that the trustees held a decanting power, the court relied on the specific language of the trust instrument, which gave the trustees the power to distribute 12
DECANTING UNDER COMMON LAW (Cont d) Holding (Cont d) trust principal for the benefit of the beneficiary. According to the court, the language used in the trust created a broad grant of almost unlimited discretion which the court found was evidence of the settlor s intent that the disinterested trustee have the authority to distribute assets in further trust for the beneficiaries benefit. Note The language in the trust instrument that the Morse court relied on is important because the court did not recognize an inherent power of the trustees of all discretionary trusts to exercise their distribution authority to distribute assets in further trust. The Boston Bar Association, in its amicus brief, had requested that the court recognize a decanting power in any discretionary trust where the trustee has the power to distribute trust assets to the beneficiary. The court declined to adopt this request and limited its finding of an inherent decanting power only to trusts where the trustee has the power to distribute for the benefit of the beneficiaries. 13
DECANTING UNDER COMMON LAW (Cont d) B. RESTATEMENTS OF PROPERTY Under the majority of decanting statutes, a trustee s exercise of the power to distribute trust property from a first trust to a second trust is expressly analogous to the exercise of a special power of appointment. Second Restatement of Property ( Second Restatement ) 1. Under the Second Restatement, a trustee s discretionary power to distribute trust assets gives the trustee the power to designate beneficial interests in the trust property and is considered a power of appointment as defined in the Second Restatement. 2. The power to appoint the trust property allows the trustee to vest interests in the property in the appointees of the property and to divest the interests of the persons who would otherwise receive the property in default of the exercise of the power. 3. Under the Second Restatement, unless the donor has manifested a contrary intention, the holder of a special power of appointment has the same rights to dispose of the property among the objects of the power that he would have had he owned the property directly i.e., by making either an outright disposition of the property or disposing of it in further trust. 4. Thus, unless a trust instrument specifically limits the trustee s distribution power to making outright distributions, the trustee s distribution power includes the power to appoint the trust property in further trust for the beneficiaries. 14
DECANTING UNDER COMMON LAW (Cont d) Third Restatement of Property ( Third Restatement ) 1. The Third Restatement takes a different approach by distinguishing between beneficiary powers of appointment and fiduciary distributive powers. 2. Under the Third Restatement, fiduciary distributive powers include a trustee s power to distribute trust income and principal to one or more designated trust beneficiaries. 3. A fiduciary distributive power is not considered a discretionary power of appointment under the Third Restatement because the exercise of the power is subject to the trustee s fiduciary obligations. 4. The Third Restatement provides that subject to fiduciary standards and the terms of the power as set forth in the trust instrument, a trustee can exercise a fiduciary distributive power such as a power of invasion to create another trust. 5. In addition, under the Third Restatement, a trustee exercising a distribution power in further trust is expressly subject to the same rules that apply to the exercise of a beneficiary power of appointment, including the persons for whose benefit the power can be exercised, under the same rules that apply where a trust is created by a beneficiary s exercise of a special power of appointment. 15
TRUST DECANTINGS -- THRESHOLD CONSIDERATIONS FOR THE TRUSTEE Is the proposed decanting consistent with the trustee s fiduciary duties of loyalty and impartiality? Before decanting a trust, the trustee must thoroughly review the governing instrument. All of the decanting statutes should apply unless the trust agreement provides to the contrary or the relevant statute (if being used) excludes the type of trust that is the subject of the proposed decanting. If the trust instrument prohibits the trustee from decanting the trust, the trustee cannot act absent court authorization. If the trust instrument gives the trustee specific power to decant the trust, the trustee should confirm that the proposed decanting is consistent with what the trust instrument allows. Alternatively, the decanting power under the trust instrument may make it clear that it is not intended to preempt the trustee s power under state law, in which case the state decanting statute could also apply. 16
TRUST DECANTINGS -- THRESHOLD CONSIDERATIONS FOR THE TRUSTEE (Cont d) If the trust instrument creating the first trust is silent, the trustee must confirm whether he has the requisite power under the applicable state decanting statute. If the decanting will be effectuated under the applicable state decanting statute, the trustee must confirm that the exercise of the decanting power complies with all statutory requirements and does not violate any limitations under the statute. 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. 17
STATUTORY DIFFERENCES All of the state decanting statutes are intended to allow the trustee to appoint the assets of an existing trust to a second trust but the operative provisions of the statutes can differ in a variety of ways, including: 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 or unlimited discretion to make distributions versus trusts with distribution standards). Whether a decanting may be based solely on a power to invade trust income. 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. Whether powers of appointment not granted under the first trust may be granted to a beneficiary under the second trust. 18
STATUTORY DIFFERENCES (Cont d) Limitations on the trustee s exercise of the decanting power that are intended to preserve tax benefits of the first trust such as marital and charitable deductions, gift tax annual exclusions, sub- S elections and allocations of GST exemption. Restrictions on the ability of a beneficiary-trustee to participate in a decanting. The procedural aspects of the trustee s exercise of the decanting power, including: Method of exercise; Notice to beneficiaries, contents of the notice and waivers of notice itself or the notice period; Beneficiary consent; and Court approval and/or court filing requirements. 19
SCOPE OF THE TRUSTEE S INVASION POWER UNDER STATE LAW Two state decanting statutes Florida and Indiana require that the trustee have the absolute discretion or power to distribute trust principal in order to decant an existing trust. Effective 7/15/13, the Rhode Island statute was amended to permit a trust to be decanted where the trustee has any authority to invade the principal of the trust (prior to the amendment, absolute power was required). What constitutes absolute discretion or power under the Florida and Indiana statutes? Absolute discretion or power is one that is not limited to specific or ascertainable purposes such as HEMS. Under the Florida statute, a power to invade for the best interests, welfare, comfort or happiness of a beneficiary does not constitute a standard. All of the other state decanting statutes permit a decanting where the trustee s distribution or invasion power under the existing trust is limited by a standard, but a distribution standard often limits the scope of the changes that the decanting can effectuate (i.e., changes in beneficial interests versus administrative changes). 20
SCOPE OF THE TRUSTEE S INVASION POWER UNDER STATE LAW (Cont d) If the trustee s discretion under the first trust is limited by a standard, the decanting statute must be reviewed to determine if the same standard must be included in the second trust. 21 The Alaska, Illinois, Missouri, New York, North Carolina, South Carolina and Texas 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 Alaska and New York statutes also provide 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. Where the trustee does not have unlimited discretion, the Alaska statute permits the original standard set forth in the first trust to be changed where the assets are appointed to a supplemental or special needs trust. 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.
SCOPE OF THE TRUSTEE S INVASION POWER UNDER STATE LAW (Cont d) 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 (which means that a decanting can only be undertaken to make administrative changes to the first trust). But if the trustee s power is unlimited, then beneficial interests under the first trust can be materially changed under the second trust. Under the Michigan statute, unless the trustee has a presently exercisable discretionary power to make distributions under the first trust, the second trust cannot materially change the beneficial interests of the beneficiaries of the first trust (including persons who hold non-fiduciary powers of appointment). 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. 22
SCOPE OF THE TRUSTEE S INVASION POWER UNDER STATE LAW (Cont d) Under the Wisconsin statute, where the first trust contains a specific or ascertainable standard, the second trust does not need to have the exact same standard, but it may not have a broader standard (but this provision does not apply where the second trust is for an individual with a disability). 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 annually). 23
SCOPE OF THE TRUSTEE S INVASION POWER UNDER STATE LAW (Cont d) 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, Michigan, Missouri, Nevada, North Carolina, South Carolina, South Dakota, Virginia and Wyoming statutes all apply to a trustee s power to distribute trust income or principal. The Arizona and New Hampshire statutes refer to the power to make distributions, which includes both principal and income. Under the Texas and Wisconsin statutes, where the trustee has the discretion to distribute principal of the first trust, that power may be exercised in favor of beneficiaries of the first trust who are eligible to receive income or principal from the first trust (and in Wisconsin also annuity or unitrust payments). 24
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: Can current beneficiaries of the first trust 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 Alaska, Illinois, New York, North Carolina, Ohio and Virginia, if the trustee does not have absolute or unlimited discretion, then the interests of current beneficiaries of the first trust may not be eliminated in the second trust. In Michigan, the trustee of the first trust must have a presently exercisable discretionary distribution power in order to eliminate current beneficiaries of the first trust. Under the Texas and Wisconsin statutes, if the trustee does not have full discretion, then the current, successor and presumptive remainder beneficiaries of the second trust must be the same as the current, successor and presumptive remainder beneficiaries of the first trust. 25
PERMISSIBLE BENEFICIARIES OF THE SECOND TRUST (Cont d) Can remainder beneficiaries of the first trust be eliminated in the second trust: This is not explicitly addressed under most of the statutes, but many 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 Alaska, Illinois, New York, Ohio, Texas and Wisconsin statutes all specifically provide that remainder interests (and in some cases successor interests) can be eliminated only where the trustee of the first trust has absolute or unlimited discretion. If the trustee of the first trust does not have absolute or unlimited discretion, then the interests of remainder beneficiaries of the first trust may not be eliminated in the second trust. In Michigan, if the trustee of the first trust does not have a presently exercisable discretionary power to make distributions, interests of remainder beneficiaries of the first trust cannot be eliminated. In Delaware, the interests of remainder beneficiaries under the first cannot be eliminated in the second trust (regardless of the level of the trustee s discretion to make distributions). 26
PERMISSIBLE BENEFICIARIES OF THE SECOND TRUST (Cont d) Can the interests of remainder beneficiaries of the first trust 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, South Carolina and Virginia statutes all specifically prohibit the acceleration of remainder interests. This is also implied under other statutes (such as Delaware). 27
PERMISSIBLE BENEFICIARIES OF THE SECOND TRUST (Cont d) Can the second trust add as beneficiaries persons who are not beneficiaries under the first trust. None of the statutes permit the addition of beneficiaries in the second trust and the majority specifically state that the beneficiaries of the second trust may include only persons who are 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. Matter of Johnson (2015 NY Slip Op 30018(U) (Surrogate s Court, New York County, 1/13/15) In matter of Johnson, the New York County Surrogate s Court invalidated the July 25, 2011 decanting of 2 trusts created for the benefit of the beneficiary and directed the return of the decanted assets to the trustees of the invaded trust. The decanting was effectuated under EPTL 10-6.6 as it existed prior to the August 17, 2011 amendment of the statute. The appointed trust extended the term of the invaded trusts for the life of the beneficiary. However, the appointed trust also purported to change the ultimate remainder beneficiaries of the invaded trusts by adding persons who were not beneficiaries under the invaded trusts. The Court noted that as a universal rule none of the 22 existing decanting statutes permit the appointed trust to include any beneficiaries who aren t beneficiaries of the invaded trust. 28
PERMISSIBLE BENEFICIARIES OF THE SECOND TRUST (Cont d) Some statutes allow the second trust to grant a power of appointment not provided for under the first trust, effectively allowing the back-door addition of beneficiaries through the exercise of the power of appointment. The Alaska, Delaware, Illinois, Kentucky, Michigan, Nevada, New York, North Carolina, Ohio, South Carolina, South Dakota, Tennessee, Texas, Virginia and Wisconsin 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, thus providing a method for adding beneficiaries. Under some statutes limitations apply: 29 Under the Illinois, Ohio, Texas and Wisconsin statutes, the trustee must have absolute discretion to distribute trust principal in order to add a power of appointment under the second trust. The Alaska, Illinois and Texas statutes also require that the beneficiary who is given the power of appointment be a beneficiary who could have received an outright distribution of property of the first trust.
PERMISSIBLE BENEFICIARIES OF THE SECOND TRUST (Cont d) New York allows a current 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. Under the New York statute, however, 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). Under the Michigan statute, the trustee must have a presently exercisable discretionary power to make distributions in order to grant a general or special power of appointment to a beneficiary of the first trust under the second trust. The Alaska, New York and Texas statutes specifically provide that where the trustee s discretion is not absolute or unlimited and the first trust grants a power of appointment to a beneficiary, the second trust must also grant this power of appointment and the class of permissible appointees must be the same as in the first trust. This is implied under the Michigan statute where the first trust includes a discretionary trust provision. 30
STATUTORY LIMITATIONS ON EXERCISE OF TRUSTEE S INVASION POWER The decanting statutes generally preserve certain provisions contained in the first trust, particularly as they relate to maintaining the tax benefits of the first trust and/or protecting certain fixed or mandatory interests of the beneficiaries of the first trust such as income interests and rights of withdrawal. All of the state decanting statutes prohibit the reduction (or elimination) of fixed or mandatory income interests under the first trust, but in some cases the scope of the prohibition is limited: In Delaware and South Dakota, this restriction applies only where the first trust is a marital trust. In Michigan, where the trustee of the first trust has a presently exercisable discretionary power to make distributions, this restriction applies in the case of trusts that were intended to qualify for a marital or charitable deduction, regardless of whether any such deduction was actually taken. In Alaska, Illinois, Nevada, New Hampshire, New York, Ohio and Texas, only current income interests, not future income interests, are specifically protected. This is implied under the Missouri statute. 31
STATUTORY LIMITATIONS ON EXERCISE OF TRUSTEE S INVASION POWER (Cont d) The Kentucky statute protects both current and future fixed income interests. The Alaska, Arizona, Florida, Indiana, Illinois, Michigan, Nevada, Kentucky, New Hampshire, New York, North Carolina, Ohio, Rhode Island, South Carolina, Texas, Virginia and Wisconsin also prohibit the reduction or elimination of annuity and/or unitrust interests, but note: In Delaware, this limitation applies only if the first trust is a marital trust. In Michigan, this limitation apples to marital and charitable trusts where the trustee of the first trust has a presently exercisable discretionary power. 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. In Alaska, these interests can be reduced, limited or modified if the second trust is a supplemental or special needs trust. Many statutes contain provisions preserving specific tax benefits of the first trust: 32 Marital and charitable deductions are specifically protected under the Alaska, Florida, Indiana, Illinois, Kentucky, Nevada, New Hampshire, New York, North Carolina, Ohio, Rhode Island, Tennessee, Texas, Virginia and Wisconsin statutes. In most of 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 statutes, the second trust also cannot omit any such provision.
STATUTORY LIMITATIONS ON EXERCISE OF TRUSTEE S INVASION POWER (Cont d) Contributions qualifying for the gift tax annual exclusion are specifically protected under the Alaska, Illinois, Nevada, New Hampshire, Tennessee, New York, Texas and Wisconsin statutes. Under the Delaware, Illinois, Kentucky, Michigan (where the trustee of the first trust has a presently exercisable discretionary power), Missouri, Nevada, North Carolina, Ohio, South Carolina, South Dakota, Virginia and Wisconsin statutes, if 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 and South Carolina statutes, the proposed decanting cannot adversely affect the tax treatment of the first trust, the trustee, the settlor or the beneficiaries. The Alaska, Illinois, New York and Texas statutes similarly prohibit a decanting where it would jeopardize any tax benefit of the first trust. The Alaska, Illinois, Kentucky, Ohio, Tennessee and Texas statutes also specifically protect trusts for which sub-s elections have been made. Under the New York, Illinois, Michigan and Texas statutes, grantor trust status is not a tax benefit and a decanting can be undertaken to change a trust from a grantor trust to a non-grantor trust and vice versa. 33
STATUTORY LIMITATIONS ON EXERCISE OF TRUSTEE S INVASION POWER (Cont d) In Michigan, where the trustee of the first trust does not have a presently exercisable discretionary power to make distributions, the governing instrument for the second trust cannot include or eliminate provisions which would cause the second trust to fail to qualify for any tax benefit (i.e., deduction, exemption, exclusion or other tax attribute) the first trust was intended to qualify for (but grantor trust status is not considered a tax benefit). Many statutes also protect property subject to 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, South 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. 34
STATUTORY LIMITATIONS ON EXERCISE OF TRUSTEE S INVASION POWER (Cont d) The Alaska, Illinois, New York, Ohio and Texas statutes also prohibit the elimination of the current right to withdraw a specified dollar amount or percentage of trust principal. The Alaska, Illinois, New York, Ohio and Texas statutes also protect a beneficiary s right to receive mandatory principal distributions under the first trust. The Alaska statute permits current mandatory rights to be reduced, modified or limited during the extended term of a trust or where the second trust is a supplemental or special needs trust. Under the Michigan statutes (i) where the first trust contains a discretionary trust provision, any mandatory distribution right cannot be eliminated and (ii) where the trustee of the first trust has a presently exercisable discretionary power, the second trust cannot reduce a presently exercisable general power to withdraw a specified percentage or amount of trust property in a beneficiary who is the only trust beneficiary to or for the benefit of whom the trustee has the power to make discretionary distributions. 35
STATUTORY LIMITATIONS ON EXERCISE OF TRUSTEE S INVASION POWER (Cont d) 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 decant from a first trust of limited duration to a second trust of longer duration, including to a perpetual trust. In Michigan, where the trust has a discretionary trust provision, the statute provides that an increase in the maximum period during which the vesting of future interests may be suspended or postponed under applicable law is not a material change in beneficial interests. This may allow the Michigan statute to be used to increase the duration of a trust having a zero inclusion ratio for GST tax purposes (because of an allocation of GST exemption), without regard to the Rule Against Perpetuities provided in the GST effective date regulations. 36
ADDITIONAL LIMITATIONS WHERE TRUSTEE IS A BENEFICIARY OR WHERE BENEFICIARIES POSSESS CERTAIN POWERS Some of the decanting statutes also explicitly 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. In Alaska, New York, North Carolina, South Carolina and Virginia, a beneficiary-trustee simply is not authorized to act. North Carolina, South 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. In Arizona, the beneficiary-trustee cannot act if it would have an adverse tax impact on the beneficiary-trustee. Where absolute discretion is required and the action of a beneficiarytrustee would be tantamount to the exercise of a general power of appointment, the beneficiary-trustee arguably cannot act. 37
ADDITIONAL LIMITATIONS WHERE TRUSTEE IS A BENEFICIARY OR WHERE BENEFICIARIES POSSESS CERTAIN POWERS (Cont d) Under the Wisconsin statute, a trustee with a beneficial interest in the first trust cannot decant the first trust unless the second trust is for an individual with a disability, the trustee s only beneficial interest in the trust is as a reminder beneficiary and the second trust does not increase the trustee s beneficial interest. 38
ADDITIONAL LIMITATIONS WHERE TRUSTEE IS A BENEFICIARY OR WHERE BENEFICIARIES POSSESS CERTAIN POWERS (Cont'd) Under the Nevada and New Hampshire statutes, a beneficiarytrustee 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 other 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 of a co-trustee or other person holding an adverse interest. 39
ADDITIONAL LIMITATIONS WHERE TRUSTEE IS A BENEFICIARY OR WHERE BENEFICIARIES POSSESS CERTAIN POWERS (Cont'd) 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. 40
ADDITIONAL LIMITATIONS WHERE TRUSTEE IS A BENEFICIARY OR WHERE BENEFICIARIES POSSESS CERTAIN POWERS (Cont'd) 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. The provisions of the Michigan decanting statute are subject to the provisions 7815(3) of the MTC, which provides that unless the trust instrument expressly indicates that 7815(3) does not apply, (a) a trustee-beneficiary who has the power to make discretionary distributions to or for the trustee s benefit may only make distributions subject to an ascertainable standard and (b) a trustee may not make a discretionary trust distribution to discharge the trustee s legal support obligation. 41
ADDITIONAL LIMITATIONS WHERE TRUSTEE IS A BENEFICIARY OR WHERE BENEFICIARIES POSSESS CERTAIN POWERS (Cont'd) Also be aware of restrictions on decanting where beneficiaries of the second trust have the right to remove and replace trustees. For example, 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 non-subordinate party to the beneficiary. 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. 42
MECHANICS OF THE TRUSTEE S EXERCISE OF THE POWER TO APPOINT IN FURTHER TRUST Does the statute specify a manner of exercise: Most of the statutes, including Alaska, Delaware, Florida, Illinois, Indiana, Kentucky, New York, North Carolina, Ohio, Rhode Island, South Carolina, South Dakota, Texas, Virginia and Wisconsin 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, Texas and Wisconsin). Where the trustee of the first trust does not have a presently exercisable discretionary power, the Michigan statute requires a written instrument exercising the trustee s distribution power under the first trust. The Arizona, Missouri, New Hampshire and Wisconsin statutes are all silent. Can the second trust be established under the first trust or is a new trust required? The Alaska, South Dakota and Wisconsin statutes specifically require that a new governing instrument be created. The Arizona, Delaware, Florida, Indiana, Michigan, Missouri, North Carolina, Ohio, South Carolina and Tennessee statutes all specifically authorize the trustee to establish the second trust under the first trust (or a new governing instrument can be created). 43
MECHANICS OF THE TRUSTEE S EXERCISE OF THE POWER TO APPOINT IN FURTHER TRUST (Cont d) Is advance notice of the decanting required? 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 Texas statute requires at least 30 days advanced notice to all current beneficiaries and presumptive remainder beneficiaries of the first trust. 44
MECHANICS OF THE TRUSTEE S EXERCISE OF THE POWER TO APPOINT IN FURTHER TRUST (Cont d) The South Carolina statute requires at least 90 days advanced notice to all qualified 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 Alaska and 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 the right to remove or replace the trustee exercising the decanting power. Michigan requires at least 63 days advance notice to the settlor (if living) and all qualified trust beneficiaries if the trustee does not have a presently exercisable discretionary power. Wisconsin requires at least 30 days advance notice to all qualified beneficiaries of the first trust, each trust protector and directing party under the first trust and the settlor of the first trust. New Hampshire, Illinois and Texas 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. 45
MECHANICS OF THE TRUSTEE S EXERCISE OF THE POWER TO APPOINT IN FURTHER TRUST (Cont d) What constitutes notice? In Alaska, New York and Wisconsin, serving a copy of the decanting instrument plus both trust instruments. In Florida, Indiana, Kentucky, Michigan, 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. In Texas, the trustee must serve a written notice regarding the terms of the proposal decanting and copies of the first and second trusts. Can beneficiaries waive notice? The Florida, Indiana, Kentucky, Michigan, Nevada, North Carolina, Ohio, Rhode Island, South Carolina, South Dakota and Wisconsin 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. Alaska and New York allow 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. The Missouri, Texas and Virginia statutes allow trust beneficiaries to waive notice itself. 46
MECHANICS OF THE TRUSTEE S EXERCISE OF THE POWER TO APPOINT IN FURTHER TRUST (Cont d) Is beneficiary consent required? Beneficiary consent generally is not required in any state and there are both gift and GST tax reasons for this. The exceptions are (i) 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 (ii) Michigan 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, and also in Michigan where the trustee is to receive a fee for the decanting. Note that in Michigan, the consent requirements apply only where the decanting trustee does not have a presently exercisable discretionary power to make distributions. Also, some statutes, such as Alaska, Florida, Indiana, North Carolina, Nevada, New York, Ohio, Rhode Island, Texas, Virginia and Wisconsin 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. The South Carolina statute makes it clear that a trust instrument can waive the notice provision for a decanting effected thereunder. 47
MECHANICS OF THE TRUSTEE S EXERCISE OF THE POWER TO APPOINT IN FURTHER TRUST (Cont d) Is court approval required or are there 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 Alaska, Arizona, Illinois, Kentucky, Nevada, New York, North Carolina, Texas and Wisconsin, make it clear that the trustee can petition for a court approval. The Alaska and Michigan statutes specifically provide that the trustee can act without court approval and without the consent of the settlor or any person interested in the first trust. 48
ADDITIONAL STATUTORY PROVISIONS In 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. This also applies in Michigan where the trustee of the first trust has a presently exercisable discretionary power. Alaska, New York, Illinois and Wisconsin specifically permit the term of the first trust to be extended in the second trust. This is implied under the Michigan and Ohio statutes. In Alaska, Illinois, New York, Ohio and Texas, the decanting cannot change the commissions of the trustee under the second trust and the Illinois, New York and Ohio statutes also 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. The Texas statute prohibits a trustee from decanting in order to decrease or indemnify against a trustee's liability or exonerate a trustee from liability for failure to exercise reasonable care, diligence, and prudence. The Michigan statute permits the decanting to change the method or the rate of the trustee s compensation, but the beneficiaries must receive notice of such change if the decanting trustee has a presently exercisable power to make distributions. If the first trust includes a discretionary trust provision, then the beneficiaries must consent to a change in the trustee s compensation. The same rules hold true for provisions indemnifying the trustee. 49
ADDITIONAL STATUTORY PROVISIONS (Cont d) Virtually all of the statutes provide that spendthrift clauses and provisions prohibiting amendment or revocation of the first trust do not bar a decanting (See Alaska, Florida, Indiana, Illinois, Kentucky, Michigan, Missouri, Nevada, New Hampshire, New York, North Carolina, Ohio, Rhode Island, South Carolina, South Dakota, Texas, Virginia and Wisconsin). The more modern statutes also provide that a trustee does not have a duty to decant and many provide that the trustee s failure to decant does not give rise to an inference of impropriety (See Alaska, Delaware, Florida, Indiana, Illinois, Kentucky, Michigan, Missouri, Nevada, New Hampshire, New York, North Carolina, Ohio, Rhode Island, South Carolina, Texas, Virginia and Wisconsin). Many statutes also provide 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 Alaska, Delaware, Florida, Illinois, Indiana, Kentucky, Michigan, Nevada, New York, North Carolina, Ohio, Rhode Island, South Carolina, Texas and Virginia). 50
ADDITIONAL STATUTORY PROVISIONS (Cont d) Some statutes, such as 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). Under the Texas statute, the trustee must exercise a decanting power in good faith, in accordance with the terms and purposes of the trust and in the interests of the beneficiaries. The Wisconsin statute also imposes a good faith requirement if there is any loss related to the appointment. All of the statutes apply to both testamentary and irrevocable inter vivos trusts that are governed by the laws of that state and many also make it clear that the statute applies to a trust whose jurisdiction has been transferred to that state. 51
ADDITIONAL STATUTORY PROVISIONS (Cont d) Some of the statutes, such as Delaware, Ohio and Tennessee 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). The Alaska, New York, Illinois and Wisconsin 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. Under the Michigan and Texas statutes, the trustee of the second trust has the option of designating whether after-discovered assets of the first trust should remain as assets of the first trust if it continues. The Alaska, 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. 52
ADDITIONAL STATUTORY PROVISIONS (Cont d) Some of the 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. 53
Presenter Meryl G. Finkelstein Senior Counsel Norton Rose Fulbright US LLP meryl.finkelstein@nortonrosefulbright.com +1 212 318 3301 Meryl is senior counsel in the New York office, where she focuses on trusts and estates matters, with an emphasis on estate and wealth planning for individuals and their families. Her clients include a wide variety of business professionals, owners of closely-held businesses and private investors. She has over two decades of experience in the development and implementation of sophisticated estate and wealth transfer plans. Her expertise extends not only to advising U.S. citizens, but also includes advising resident and non-resident aliens. 54
Disclaimer Norton Rose Fulbright US LLP, Norton Rose Fulbright LLP, Norton Rose Fulbright Australia, Norton Rose Fulbright Canada LLP and Norton Rose Fulbright South Africa Inc are separate legal entities and all of them are members of Norton Rose Fulbright Verein, a Swiss verein. Norton Rose Fulbright Verein helps coordinate the activities of the members but does not itself provide legal services to clients. References to Norton Rose Fulbright, the law firm and legal practice are to one or more of the Norton Rose Fulbright members or to one of their respective affiliates (together Norton Rose Fulbright entity/entities ). No individual who is a member, partner, shareholder, director, employee or consultant of, in or to any Norton Rose Fulbright entity (whether or not such individual is described as a partner ) accepts or assumes responsibility, or has any liability, to any person in respect of this communication. Any reference to a partner or director is to a member, employee or consultant with equivalent standing and qualifications of the relevant Norton Rose Fulbright entity. The purpose of this communication is to provide general information of a legal nature. It does not contain a full analysis of the law nor does it constitute an opinion of any Norton Rose Fulbright entity on the points of law discussed. You must take specific legal advice on any particular matter which concerns you. If you require any advice or further information, please speak to your usual contact at Norton Rose Fulbright. 55
Decanting: Flexibility & Danger Strafford Publications Webinar on Trust Decanting Presented by Todd A. Flubacher, Partner Morris, Nichols, Arsht & Tunnell LLP May 12, 2015
Introduction to Decanting A decanting statute permits a trustee who has the 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 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. 22 states have enacted specific decanting legislation and at least two other states have proposed statutes. Morris, Nichols, Arsht & Tunnell LLP Trust Decanting: Flexibility & Danger May 12, 2015 57
How Is Decanting Used? Real Examples: Eliminate an income interest Make a directed trust Postpone a withdrawal or distribution right Divide a pot trust Eliminate a beneficiary from a class of discretionary beneficiaries Grant a beneficiary a power of appointment Eliminate a trustee duty to notify or report to beneficiaries Migrate the administrative and/or tax situs of a trust Alter administrative provisions Morris, Nichols, Arsht & Tunnell LLP Trust Decanting: Flexibility & Danger May 12, 2015 58
Overview of Steps 1. Evaluate the trustee s power to decant (Possibly change situs and governing law). 2. Evaluate trustee s duties in connection with decanting. 3. Evaluate trustee risk. 4. Assess virtual representation for consent/release. 5. Assess tax implications. 6. Draft the documents. 7. Obtain beneficiary consent or release with accounting. 8. Satisfy statutory procedures like notice or court filing. 9. Set up new trust accounts, get new EIN, etc. 10.Transfer assets. Morris, Nichols, Arsht & Tunnell LLP Trust Decanting: Flexibility & Danger May 12, 2015 59
Step 1: Evaluate the Trustee s Power to Decant What state law governs the trust? Does the trustee have the power to decant under the instrument? Does the trustee have the power to decant under a statute that does apply or could apply? What is the nature of the power to distribute principal? Does the power granted by the instrument or governing law allow you to make the changes you want? 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? Morris, Nichols, Arsht & Tunnell LLP Trust Decanting: Flexibility & Danger May 12, 2015 60
What Law Applies? Many statutes provide that the decanting shall be viewed as an exercise of a power of appointment. Under Delaware law, the validity of the exercise of a power of appointment is governed by the laws of the jurisdiction in which the trust is administered. The Delaware decanting statute provides that the statute shall apply to any trust administered in Delaware. However, other states may have a different conflicts of laws approach to the applicability of a decanting statute. The issues of situs, governing law and place of administration can become complicated, particularly if a trust is being moved to a jurisdiction in order to utilize a decanting statute. If these issues are not addressed, there can be risk that the decanting was not proper, or that the trustee cannot effectively obtain releases. It may be necessary to get legal counsel in one or more jurisdictions to address these multi-jurisdictional issues. Morris, Nichols, Arsht & Tunnell LLP Trust Decanting: Flexibility & Danger May 12, 2015 61
Changing Governing Law When does the state s decanting statute apply? Can you change the law governing administration to effectively use releases and virtual representation under applicable law? How do you move the trust to a new jurisdiction and change applicable law? Flexible change of situs/governing law provision Traditional conflicts of laws rules Delaware Supreme Court Peierls Decisions Morris, Nichols, Arsht & Tunnell LLP Trust Decanting: Flexibility & Danger May 12, 2015 62
Evaluating the Trustee s Power to Decant The trustee generally must have the power to distribute all of the principal (or in some cases income) to one or more beneficiaries (discretion or ascertainable standard). Are there any procedures to be satisfied when distributing principal (e.g. does the trustee make distributions with the direction or consent of another)? Compare the original instrument to the new instrument, identify the differences, and assess whether the proposed changes are permissible under the applicable statute. Does the decanting statute limit the ability to reduce the standard of liability of the trustee of the new trust? Administrative Changes: Typically, administrative provisions can be modified in almost any way that is desired. Changing Beneficial Interests: However, if the decanting alters the beneficiaries interests, then close scrutiny is necessary to ensure that the new instrument does not run afoul of the applicable statute. Generally, you cannot add beneficiaries or change or eliminate the interests of beneficiaries who are not currently proper objects of an exercise of the power to distribute principal. Different statutes may also have other specific limitations (such as the inability to change the income interest under a marital trust or change the vesting of an interest under a 2503(c) trust). Morris, Nichols, Arsht & Tunnell LLP Trust Decanting: Flexibility & Danger May 12, 2015 63
Step 2: Evaluate the Trustee s Fiduciary Duties The decanting must be consistent with the trustee s applicable fiduciary duties for making a distribution. When a trustee decants, it is making a distribution of the trust assets. In exercising its discretion, the trustee must uphold its duties of impartiality, care and loyalty to all of the trust beneficiaries. Are the changes to be made by the decanting consistent with those duties? Does this present risk to the trustee? If there is a standard for making principal distributions, such as an ascertainable standard, the decanting must comply with the standard. Where a trustee has the power to invade the principal of a trust for a beneficiary that is subject to a standard, the trustee owes the other beneficiaries of the trust the duty of care to make some investigation to learn whether the condition precedent to the right to the principal exists and justifies the distribution. A corporate trustee will typically run the decision through its Trust Committee responsible for discretionary distributions. Morris, Nichols, Arsht & Tunnell LLP Trust Decanting: Flexibility & Danger May 12, 2015 64
Step 3: Evaluate Trustee Risk A trustee will generally be concerned about the potential liability for breach of fiduciary duties associated with its exercise of discretion to appoint the trust assets to the new trust, unless the reasons for the decanting are so ministerial and innocuous that it poses little or no risk to the trustee. The risk could be limited, or eliminated, if all of the beneficiaries consent to the decanting and release the trustee for all liability in connection with it. Of course, it is not always the case that all of the beneficiaries are living adults and there are often contingent remainder beneficiaries who might potentially complain in the future. Fortunately, many jurisdictions, like Delaware, have virtual representation statutes that can effectively bind all present and future beneficiaries of the trust if all of the adult beneficiaries release the trustee, and there is no conflict of interest between those beneficiaries and the parties represented (this is more easily accomplished when the changes caused by the decanting are administrative in nature and are not changes to beneficial interests). HOWEVER What law governs the releases and virtual representation? Morris, Nichols, Arsht & Tunnell LLP Trust Decanting: Flexibility & Danger May 12, 2015 65
Trustee Liability Concerns Two Lines of Defense A trustee should have two lines of defense in connection with a decanting, if the trustee has the power to make principal distributions in its discretion. First, the trustee can get release and indemnification agreements from the beneficiaries with virtual representation binding the minors and unborns. Second, even if there is some issue with the release and indemnification, the trustee s actions will be judged under the abuse of discretion standard. This provides that the trustee s exercise of discretion will only be overturned if it s actions were arbitrary or capricious, not merely unreasonable. Morris, Nichols, Arsht & Tunnell LLP Trust Decanting: Flexibility & Danger May 12, 2015 66
Standard of Review for Trustee s Exercise of Discretion If the trustee has discretion to make distributions under the original instrument, then the decision to make the distribution would typically be reviewed by a court under an abuse of discretion standard. The trustee should process the decision through its usual procedures for making a discretionary distribution. The trustee should make the decision through its discretionary distribution committee. The trustee should investigate the facts and circumstances. It may be advisable to get advice from legal counsel. The process should be documented. Morris, Nichols, Arsht & Tunnell LLP Trust Decanting: Flexibility & Danger May 12, 2015 67
Step 4: Assess Virtual Representation Prepare a family tree and identify beneficiaries adults and minors. Apply the virtual representation statute to the facts. Do the changes resulting from the decanting result in a conflict of interest between the consenting adults and the minor, unborn and unascertainable beneficiaries being represented? Consider every implication of the decanting. Will any signors be exculpated or be given greater authority or control? Do the parties have different interests in the outcome, different investment objectives, different interests in income or growth, etc.? Morris, Nichols, Arsht & Tunnell LLP Trust Decanting: Flexibility & Danger May 12, 2015 68
Step 5: Assess Tax Implications In Notice 2011-101 (the Notice ) the IRS requested comments from practitioners regarding the income, gift, estate and GST tax issues and consequences of a decanting that changes beneficial interests of the first trust. The Notice identifies certain facts and circumstances as potentially having tax consequences. These include situations where: A beneficiary s right to or interest in trust property is changed; Trust beneficiaries are added; Beneficial interests are added, deleted, or changed; Assets are transferred from a grantor trust to a non-grantor trust or vice versa; Beneficiaries of the first trust are required to consent, are not required to consent or actually do consent even though consent is not required; The identity of the transferor for gift and/or GST tax purposes changes; and The first trust is a GST grandfathered trust or is exempt from GST tax. While this issue is under study, the IRS has advised that it will not issue any private letter rulings with respect to a decanting that involves a change in beneficial interests Morris, Nichols, Arsht & Tunnell LLP Trust Decanting: Flexibility & Danger May 12, 2015 69
Step 5: Assess Tax Implications (cont.) If the changes made by the decanting do not shift beneficial interests and are purely administrative then there should be little risk of adverse tax consequences. Evaluate income, gift, estate and generation skipping transfer tax issues. Morris, Nichols, Arsht & Tunnell LLP Trust Decanting: Flexibility & Danger May 12, 2015 70
Two Decanting Safeharbors for Grandfathered GST Exempt Trusts Discretionary Distribution Safe Harbor (Treas. Reg. 26.2601-1(b)(4)(i)(A)). When the trust became irrevocable, either the terms of the trust instrument or local law authorized distributions in further trust without the consent or approval of any beneficiary or court; and The resulting trust does not extend the time for vesting of any interest in the trust in a manner that may postpone or suspend the vesting, absolute ownership or power of alienation of an interest in property for a period, measured from the date the original trust became irrevocable, beyond the longer of (a) lives in being plus 21 years, or (b) 90 years. Trust Modification Safe Harbor (Treas. Reg. 26.2601-1(b)(4)(i)(D)). The distribution does not cause a beneficial interest to be shifted to a beneficiary in a lower generation, and The governing instrument of the resulting trust does not extend the time for the vesting of any beneficial interest beyond the period provided for in the original trust instrument. Morris, Nichols, Arsht & Tunnell LLP Trust Decanting: Flexibility & Danger May 12, 2015 71
Step 6: Draft the Documents Simple Decanting Instrument: Depending upon the number of changes, you might simply draft a simple decanting instrument that provides that the new trust shall be held in accordance with all of the terms and conditions of the original trust subject to some enumerated changes and additions. New Trust Agreement: Alternatively, you might draft an entirely new trust agreement with a separate decanting instrument that memorializes the trustee s exercise of its power to decant the assets of the original trust to the new trust. The new trust could be a declaration of trust, or have the trustee of the original trust as the grantor, or it could have some other person as the grantor. Make the dispositive provisions of the new trust instrument closely resemble the original instrument to avoid confusion about what was changed. Trustee Release, indemnification and approval of account. Morris, Nichols, Arsht & Tunnell LLP Trust Decanting: Flexibility & Danger May 12, 2015 72
Step 7: Obtain Consents and Releases with Accounts Decanting as a Termination of the Old Trust When a trust is decanted, the assets of the first trust flow over into the second trust, and the first trust is terminated. Not only will the trustee typically seek releases in connection with its exercise of discretion to decant, but it will likely seek releases and an accounting, and any other typical procedure that a trustee in its particular jurisdiction will seek when a trust is terminated and its service as trustee ends. Decanting as a Removal of the Trustee Since the assets have been transferred to a new trust, which may or may not have the same trustee as the original trust, a decanting can also be viewed from the trustee s perspective as a removal of the trustee of the first trust and an appointment of a successor trustee. Consequently, it is advisable to include an indemnification provision in the new, second trust instrument that runs to the trustee of the original trust, even if the individual or corporate identity of the trustee is the same for both trusts (such individual or entity will still be serving in two different capacities). Thus, the outgoing trustee knows that if claims, taxes, fees, liabilities, etc. from the original trust arise in the future, which would have been properly payable from the trust, the trustee of the original, now defunct trust can still have some recourse against the new trust to be reimbursed. Morris, Nichols, Arsht & Tunnell LLP Trust Decanting: Flexibility & Danger May 12, 2015 73
Step 7: Obtain Consents and Releases with Accounts (cont.) Attachments to the Release should include: Full accounting Original trust instrument New Trust instrument Decanting instrument Description of changes made by the decanting Morris, Nichols, Arsht & Tunnell LLP Trust Decanting: Flexibility & Danger May 12, 2015 74
Step 8: Satisfy Required Procedures Some statutes may permit or require the trustee to provide notice to beneficiaries or file a notice with the court. Generally, a decanting requires a written instrument, signed by the trustee and notarized. Morris, Nichols, Arsht & Tunnell LLP Trust Decanting: Flexibility & Danger May 12, 2015 75
Step 9: Set Up New Accounts The decanting results in a newly-created trust. The trustee of the new trust will typically go through the procedure to set up a new trust account. The account set-up process may take some time and may involve compliance with regulatory requirements for traditional trust account set-up. The new trust may or may not be treated as a new, separate taxpayer with a new Tax ID Number. Morris, Nichols, Arsht & Tunnell LLP Trust Decanting: Flexibility & Danger May 12, 2015 76
Step 10: Transfer Assets As a part of the decanting, the assets of the original trust will be distributed to a new trust. This may require: Retitling of assets and accounts; Transfers of limited liability company interests through assignment and assumption agreements; Retitling stock and stock certificates; and Retitling real estate. These steps must be completed properly to abide by the technical requirements of the transaction. Morris, Nichols, Arsht & Tunnell LLP Trust Decanting: Flexibility & Danger May 12, 2015 77
Planning Ahead for Decanting By far, the biggest hurdle in accomplishing a decanting is the trustee s reluctance to take on the risk associated with the exercise of discretion. There may be potential transfer tax issues associated with getting beneficiary consents or releases. When drafting new trust agreements, it is advisable to draft: express decanting provisions to facilitate broad decanting powers; and enabling provisions in the agreements which limit a trustee s liability and provides indemnification in connection with a decanting. This kind of advanced planning might provide the flexibility and protection for a trustee to enable the trustee to perform a decanting in the future, if it is desired by the beneficiaries, without the delay and expense of releases, accountings, indemnifications, etc. Morris, Nichols, Arsht & Tunnell LLP Trust Decanting: Flexibility & Danger May 12, 2015 78
Speaker Todd A. Flubacher PARTNER Trusts, Estates & Tax Group (302) 351-9374 T tflubacher@mnat.com Todd works with national and local clients on the creation, migration, modification and administration of Delaware trusts. He represents Delaware trustees, beneficiaries, law firms and individuals throughout the country on all matters involving Delaware trusts and estates. His practice emphasizes the unique advantages of Delaware trust law, including directed trusts, dynasty trusts, tax planning, asset protection trusts, and all aspects of trust validity, construction and administration. Todd has substantial experience with migrating trusts to Delaware and modifying trusts by decanting, merger, nonjudicial settlement agreements, Delaware Court of Chancery trust petitions, administrative amendments, and addressing issues pertaining to choice of Delaware governing law. He drafts, reviews and comments on Delaware trust documents and renders Delaware trust law opinions. Todd is a Fellow of the American College of Trust and Estate Counsel (ACTEC). He is included in The Best Lawyers in America (2014-2015) and AV-rated by his peers in Martindale-Hubbell. Todd is a past-chair of both the Estates & Trusts and Tax Sections of the Delaware State Bar Association. Todd is a nationally recognized author on Delaware trust law and his articles have appeared in notable publications such as Trusts & Estates magazine and Estate Planning magazine, among others. He is a frequent presenter and panelist, appearing before professional and business audiences across the country. May 12, 2015 79