Tax and Non-Tax Issues Involving Irrevocable Trusts

View Article in PDF in Tax News & Comment — October 2012


I.    Introduction

Prior to the Statute of Wills, enacted by Parliament in 1540, it was impossible for a landowner to devise title in land to heirs. Moreover, under the harsh common law rules of primogeniture, if a landowner died without living relatives, his land would escheat to the Crown. To illustrate other legal difficulties encountered prior to the Statute of Wills, landowners leaving to fight in the Crusades might convey title in land to another person, expecting that person to reconvey title when the Crusader returned.  However, English law did not recognize the claim of the returning Crusader forced to sue if the legal owner refused to revest title in the original owner. Turned away at courts of law, some Crusaders then petitioned the King, who referred cases to the Courts of Chancery. These equitable courts often compelled the legal owner (the “trustee”) to reconvey the land back to the Crusader, (the ““beneficiary” or cestui que trust) who was deemed to be the equitable owner. Equitable remedies first recognized by Chancery Courts exist today in the form of injunctions, temporary restraining orders, and declaratory judgments, which remedies may be sought where there is no remedy at law. Despite the formal merger of law and equity in New York in 1848, the Court of Appeals has observed that “[t]he inherent and fundamental difference between actions at law and suits in equity cannot be ignored.” Jackson v. Strong, 222 N.Y. 149, 118 N.E. 512 (1917).
The principles of recognition and enforcement of trusts enunciated by Courts of Chancery form the basis of modern trust law. A trust is thus a fiduciary relationship with respect to specific property, to which the trustee holds legal title for the benefit of one or more persons who hold equitable title as beneficiaries. Thus, two forms of ownership — legal and equitable — exist in the same property at the same time. [Restatement of Trusts, §2]. The essence of a trust then, is to separate legal title, which is given to someone to hold in a fiduciary capacity as trustee, from equitable title, which is retained by trust beneficiaries. Irrevocable trusts, if properly structured, permit the settlor (i.e., the person transferring the assets into the trust) to retain control over the eventual disposition of the trust property.  Trustees are responsible, inter alia, for ensuring that trust property is made productive for beneficiaries. The trust instrument defines the scope of discretionary powers conferred upon the trustee. With respect to discretion involving distributions, the trust may grant the trustee (i) no discretion; (ii) discretion subject to an ascertainable standard (often described in terms of the “health, education, maintenance and support” of the beneficiary, or the “HEMS” standard); or (iii) absolute discretion. The scope of discretion granted has profound tax and non-tax consequences; even more so if the trustee is the grantor.

II.       Scope of Trustee Discretion

No Discretion

The trust may provide that the trustee “distribute to Lisa annually the greater of $1,000 or all of the net income from the trust.” In this situation, the grantor (also known as the trustor, settlor, or creator) of the trust could name himself as trustee with no adverse estate tax consequences, since he has retained no powers which would result in the property being considered part of his gross estate. (However, if Lisa were given a limited power to appoint income to which she would otherwise be entitled, to another person, a gift tax could result.) Eliminating trustee discretion with respect to distributions provides certainty to beneficiaries, and reduces the chance of conflict. Nevertheless, the trustee will also be unable to increase or decrease the amount distributed in the event circumstances change.  If the trustee is given no discretion, the trust could also never be decanted, as a requirement of the New York decanting statute (as well as other states which have decanting statutes) is that the trustee have at least some discretion with respect to trust distributions.

Absolute Discretion

At the opposite end of the spectrum lie trusts which grant the trustee unlimited discretion with respect to distributions. If the grantor were the trustee of this trust, estate inclusion would result under IRC §2036 — even if the grantor could make no distributions to himself — because he would have retained the proscribed power in IRC §2036(a)(2) to “designate the persons who shall possess or enjoy the property or the income therefrom.” Disputes among beneficiaries (or between beneficiaries and the trustee) could occur if the trustee possesses absolute discretion with respect to trust distributions. However, by adding the term “unreviewable” to “absolute discretion,” the occasion for court intervention would appear to be limited to those extreme circumstances where the trustee has acted unreasonably or acted with misfeasance. The “decanting” statutes in all states which have enacted them, including New York, permit the creation of new irrevocable trusts where the trustee has been granted absolute discretion with respect to distributions. One significant advantage of utilizing a decanting statute is that no beneficiary consent is required and court supervision is generally unnecessary in order to create a new trust. Nor is there is a need to demonstrate a change in circumstances, only that the decanting Trustee exercise his power to decant in the best interests of a beneficiary.

Ascertainable Standard Discretion

In the middle of the spectrum lie trusts which grant the trustee distribution discretion limited to an ascertainable standard. If the trustee’s discretion is limited by an ascertainable standard, no adverse estate tax consequences should result if the grantor is named trustee. Since this degree of discretion affords the trustee some flexibility regarding distributions without adverse estate tax consequences, and now qualifies under the New York decanting statute, many grantors find this model attractive. As noted, a beneficiary’s power to make discretionary distributions to himself without an ascertainable standard limitation would constitute a general power of appointment under Code Sec. 2041 and would result in inclusion of trust assets in the beneficiary’s estate. However, if the standard is limited to distributions for the “health, education, maintenance, and support” of the beneficiary, estate tax inclusion in the estate of the beneficiary should not occur.
The beneficiary may also be given the right to demand the greater of 5 percent or $5,000 from the trust each year without causing adverse estate tax consequences. If the power is not exercised, it would lapse each year. The lapse of this power will not constitute the lapse of a general power of appointment under IRC § 2514. Despite the flexibility afforded by trusts whose distributions are determined by reference to an ascertainable standard, issues may arise as to what exactly is meant by the standard used. Is the trustee permitted to allow the beneficiary to continue to enjoy his or her accustomed standard of living? Should other resources of the beneficiary be taken into account?  The trust should address, for example, with some specificity, what the accustomed standard of living of the beneficiary is, when invasions of trust principal are appropriate, and what circumstances of the beneficiary should be taken into account in determining distributions pursuant to the ascertainable standard. If the trust fails to address these issues, the possibility of disputes among current beneficiaries, or between current and future beneficiaries, may increase.

Investment Discretion

Investment of trust assets is an important consideration of the grantor. While the grantor may be content with delegating discretion for distributions to the trustee, he may have an investment philosophy which he wishes to be employed during the trust term. Unless otherwise stated in the trust instrument, the trustee is granted broad discretion with respect to the investment of trust assets. New York has not enacted the Uniform Prudent Investor Act. However, New York has enacted its own rule, found in EPTL §11-2.3, entitled the “Prudent Investor Act.” Under the Act, the trustee has a duty “to invest and manage property held in a fiduciary capacity in accordance with the prudent investor standard.”  The prudent investor standard encompasses the philosophy that the trustee will exercise reasonable care in implementing management decisions for the portfolio, taking into account trust provisions. The trustee should pursue a strategy that benefits present and future beneficiaries in accordance with the “risk and return objectives reasonably suited to the entire portfolio.” If the grantor believes that the named trustee can make distribution decisions, but requires assistance in investing trust assets, the instrument may authorize the trustee to engage a financial advisor to provide professional guidance in making investment decisions.

III.      Trust Protectors

Some jurisdictions, including New York, permit the use of trust “protectors” to provide flexibility in the administration of trusts. The Uniform Trust Code recognizes the principle that an independent person may be vested with the authority to direct the trustee to perform certain actions. Powers granted to the protector could include the power to (i) remove or replace a trustee; (ii) direct, consent or veto trust distributions; (iii) alter, add or eliminate beneficiaries; or (iv) change trust situs and governing law. To avoid adverse tax consequences, a trust protector should not be a member of the grantor’s family. Attorneys, accountants, siblings or friends could be named as a trust protector. Corporate fiduciaries may not be a good choice, since their ability to exercise authority may in practical terms be constrained by the institution.

IV.   Disputes Among Beneficiaries

Various avenues exist for disgruntled beneficiaries to challenge the manner in which a trust is being administered. Problems may arise where a beneficiary is also serving as co-trustee with an independent trustee. The most drastic step is to remove the trustee. In fact, discretionary trusts often provide for removal of the trustee, and replacement by the grantor or trust beneficiaries. However, the retention by the grantor of the power to remove the trustee may imbue the trust with transfer tax problems. Rev. Rul. 79-355 stated that a retained power by the grantor to remove a corporate trustee and appoint another corporate trustee was in essence the retention by the grantor of the trustee’s powers. The retained power would constitute an “incident of ownership,” and would cause the entire life insurance trust to be included in the grantor’s estate.However, the IRS in TAM 9303018 opined that the removal of a trustee “for cause” would not result in the power being attributed to the grantor. Some of the removal “for cause” powers cited include (i) the legal incapacity of the trustee; (ii) the willful or negligent mismanagement of trust assets; (iii) the abuse or inattention to the trust by the trustee; (iv) an existing federal or state criminal charge against the trustee; or (v) a relocation of the trustee.

V.   Spendthrift Provisions & Trusts

A spendthrift provision prevents the beneficiary from voluntarily or involuntarily alienating his interest in the trust. The Supreme Court, in Nichols v. Eaton, 91 U.S. 716 (1875), recognized the validity of a spendthrift trust, holding that an individual should be able to transfer property subject to certain limiting conditions. Under New York law, trust assets can be placed beyond the effective reach of beneficiaries’ creditors by use of such a “spendthrift” provision. Most wills which contain testamentary trusts would incorporate a spendthrift provision. A spendthrift clause typically provides that the trust estate shall not be subject to any debt or judgment of the beneficiary. Therefore, even if the trustee’s discretion is absolute, the trust should also contain a valid spendthrift clause, since it is not enough for asset protection purposes that a creditor be unable to compel a distribution.   The creditor must also be unable to attach the beneficiary’s interest in the trust.
A spendthrift trust may protect a beneficiary from (i) his own profligacy or bankruptcy; (ii) his torts; and (iii) many of his creditors, (including his spouse). No specific language is necessary to create a spendthrift trust, and a spendthrift limitation may even be inferred from the intent of the settlor. Still, it is preferable as well as customary to include spendthrift language in a trust. A spendthrift provision may also provide that required trust distributions become discretionary upon the occurrence of an event or contingency specified in the trust. Thus, a trust providing for regular distributions to beneficiaries might also provide that such distributions would be suspended in the event a creditor threat appears.  If a beneficiary is also the sole trustee of a discretionary spendthrift trust, the trust will be ineffective as against creditors’ claims. Other exceptions are in the nature of public policy. Thus, in many states, spendthrift trust assets may be reached to enforce a child support claim against the beneficiary. Courts might also invalidate a spendthrift trust to satisfy a judgment arising from an intentional tort. Finally, a spendthrift trust would likely be ineffective against government claims relating to taxes, since public policy considerations in favor of the collection of tax may be deemed to outweigh the public policy of enforcing spendthrift trusts.

VI.  Self-Settled Spendthrift Trusts

A trust beneficiary possesses equitable but not legal ownership in trust property. Therefore, creditors of a trust beneficiary generally cannot assert legal claims against the beneficiary’s equitable interest in trust assets. A self-settled trust is one in which the settler is either one of the beneficiaries or the sole beneficiary of the trust.  Under common law, a settlor cannot establish a trust for his own benefit and thereby insulate trust assets from claims of the his own creditors.  The assets of such a “self-settled spendthrift trust” would be exposed to creditor claims to the extent of the maximum property interest available to the settlor under the trust. Prior to 1997, neither the common law nor the statutory law of any state permitted a self-settled trust to be endowed with spendthrift trust protection. Since 1997, five states, including Delaware and Alaska, have enacted legislation which expressly authorizes the use of self-settled spendthrift trusts. Statutes in these states mitigate the problem associated with self-settled spendthrift trusts by permitting the settlor to be a discretionary beneficiary of the trust. A self-settled spendthrift trust, if established in one of these jurisdictions, may effectively allow an individual to put assets beyond the reach of creditors while retaining some control over and access to trust assets. These states now compete with exotic locales such as the Cayman and Cook Islands, and less exotic places such as Bermuda and Lichtenstein, which for many years have been a haven for those seeking the protection of a self-settled spendthrift trust.
New York has never been, and is not now, a haven for those seeking to protect assets from claims of creditors. Most states, including New York, continue to abhor self-settled spendthrift trusts. This is true even if another person is named as trustee and even if the trust is not created with an intent to defraud existing creditors. New York’s strong public policy against self-settled spendthrift trusts is evident in EPTL §7-3.1, which succinctly states: “A disposition in trust for the use of the creator is void as against the existing or subsequent creditors of the creator.”  Still, there appears to be no reason why a New York resident could not transfer assets to the trustee of a self-settled spendthrift trust situated in Delaware or in another state which now permits such trusts. Even though a New York Surrogate or Supreme Court Judge might look askance at an asset protection trust created in Delaware, the Full Faith and Credit Clause of the Constitution should imbue significant asset protection to such a Delaware trust.  If a self-settled spendthrift trust is asset protected, creditor protection may also reduce the possibility of estate inclusion under IRC §2036. Assets placed beyond the reach of creditors may also be considered to have been effectively transferred for estate tax purposes. However, the initial transfer in trust may be a completed gift.

VII.   Decanting Trusts

Under the Uniform Trust Code and EPTL §10-6.6, a noncharitable irrevocable trust may be modified with court approval “upon the consent of all beneficiaries if the court concludes that modification is not inconsistent with a material purpose of the trust.” The settlor, a beneficiary, or a trustee may initiate an action to modify an irrevocable trust. However, the court may approve the modification only if all of the beneficiaries have consented and the interests of all beneficiaries who have not consented will be adequately protected. Where trust modification under the EPTL or under common law is either not possible — or even where it is possible, but unattractive — modification under New York’s “decanting” statute may be preferable. New York was the first state to enact a “decanting” statute, which effectively permits the trustee acting alone to amend the terms of an irrevocable trust. “Decanting” statutes in some jurisdictions, such as Delaware and Alaska, permit the appointment of irrevocable trust assets into a new trust where the trustee has significant — but not absolute — discretion with respect to distribution of trust assets. Former EPTL §10-6.6(b) had required that the trustee have unlimited discretion to invade principal in order to vest trust assets in a new irrevocable trust. Therefore, an “ascertainable standard” trust established in New York could not have availed itself of New York’s decanting statute. However, New York in 2011 joined states such as Delaware and Alaska, and now permits decanting even where the trustee has only limited discretion. The potential uses of decanting are manifest: Despite the best efforts of drafters to contemplate unforeseen circumstances, situations arise where dispositive trust provisions may not reflect the present circumstances of beneficiaries. If the trust is revocable, and the grantor is alive, the grantor may revoke or amend the trust. However, trusts are often made irrevocable for tax or asset protection purposes. In those cases, revoking the trust, while not impossible, may be extremely difficult, especially if minor beneficiaries are involved.

Where Trustee Has Unlimited Discretion to Invade Principal

Under amended EPTL §10-6.6(b), if the trustee has unlimited discretion to invade trust principal in favor of “current beneficiaries,” the decanting statute now allows the trust into which the assets are decanted, the “appointed trust,” to benefit one or more beneficiaries to the exclusion of other beneficiaries. The rationale for this regime appears to be that if the trustee has unlimited discretion to invade principal in favor of one beneficiary, appointing all of the trust assets into a new trust which benefits only that person accomplishes the same result.

Where Trustee Has Limited Discretion to Invade Principal

Under EPTL §10-6.6(c), where the trustee has only limited discretion to invade principal, the appointed trust must have identical current and remainder beneficiaries as the invaded trust. Furthermore, the standard which guides the trustee in the appointed trust must be identical to that in the invaded trust for the duration of the original trust term. For example, if the invaded trust provided for principal distributions for the beneficiaries’ “health, education, maintenance and support” (i.e., the “HEMS”” standard), then the appointed trust may not deviate from this standard. Similarly, if the invaded trust were set to terminate when the beneficiary reached the age of 50, and required that the HEMS standard be utilized during the entire duration of the trust, statutory compliance would require that the discretion given to the trustee of the appointed trust be limited to the HEMS standard until the beneficiary reached the age of 50. For any period that assets are held in the appointed trust after the beneficiary reaches the age of 50, the discretion of the trustee may be unlimited.

Fixed Statutory Directives

As a prelude to the discussion of formal statutory requirements, it should be noted that the amended statute has dispensed with the requirement of court filing except in specific circumstances. Court filing is now required only for trusts which have been subject to prior court proceedings. The procedure for invoking EPTL §10-6.6 is straightforward:  Under the revised statute, notice must be given to “all persons interested in the trust,” and no trust may be invaded until 30 days after notice has been given. During this 30-day period, any interested party may object to the decanting by written notice of objection to the trustee. The invaded trust may be decanted immediately if all interested parties waive the 30-day notice period. The class of persons “interested” has been expanded, and now includes — in addition to those persons who would be required to be served with a trust accounting — the settlor of the invaded trust and any person who could remove the trustee (e.g., a “trust protector”). The power of a trustee to decant is not dependent upon the consent of the beneficiaries. Therefore, even a timely objection by a beneficiary to a proposed decanting will not nullify the power of the trustee to decant. Conversely, the failure of a beneficiary to formally object within the 30-day notice period does not operate as a waiver of the beneficiary’s right to object at a later date. Presumably, at that point Court involvement would be necessary. Another limitation of EPTL §10-6.6 is that the fixed income right of any beneficiary cannot be reduced by reason of the decanting. This limitation has been construed as being applicable only to a named beneficiary identified in the trust instrument as having a right to income for a fixed period of time. One purpose of this requirement is to ensure that the marital deduction for estate and gift tax purposes is preserved, since the surviving spouse must have a right to all of the income during her life from the trust to ensure the availability of the deduction.

Fiduciary Considerations

Regardless of the degree of discretion given to the trustee with respect to distributions of principal, no trust may be invaded if there is evidence that the invasion would be contrary to the intent of the creator. A corollary of this rule is that any trust may explicitly state that the trust may not decant.  In deciding whether to exercise a power to decant, the statute cautions that decanting should only be undertaken if a prudent person would consider it to be in the best interests of one or more, but not necessarily all, of the beneficiaries. No trustee has an affirmative duty to decant, even if decanting would be in the best interest of the beneficiaries. A trustee who does exercise the power to decant is under an affirmative duty to consider possible tax implications.

Circumstances Favoring Decanting

A trustee might seek to utilize EPTL §10-6.6 to accomplish any of the following objectives: (i) to extend the termination date of the trust; (ii) to add or modify spendthrift provisions; (iii) to create a supplemental needs trust for a beneficiary who is or has become disabled; (iv) to consolidate multiple trusts; (v) to modify trustee provisions; (vi) to change trust situs; (vii) to correct drafting errors; (viii) to modify trust provisions to reflect new law; (ix) to reduce state income tax imposed on trust assets; (x) to vary investment strategies for beneficiaries; or (xi) to create marital and non-marital trusts. For example, an irrevocable trust might provide for a mandatory distribution of principal at age 25, with final principal distributions at age 30. However, such mandatory distributions might be inadvisable if the beneficiary has creditor problems, or is profligate or immature. In In re Rockefeller, NYLJ Aug. 24, 1999 (Sur. Ct. N.Y. Cty.), the Surrogate allowed trust assets to be decanted into a new trust which contained a spendthrift provision. The beneficiary may have become subject to a disability after the trust had been drafted. To become (or maintain) eligible for public assistance, it might be necessary for the trust assets to be distributed to a supplemental needs trust.
The Nassau Surrogate, in In Re Hazan, NYLJ Apr. 11, 2000 authorized the trustee of a discretionary trust to distribute assets to a supplemental needs trust whose term had been extended, to enable the beneficiary to continue to be eligible for public assistance. If more than one trust has been created for a beneficiary, overall liquidity may be enhanced by transferring the assets of one trust into another trust. So too, combining multiple trusts into a single trust may greatly reduce administrative expenses. In In Re Vetlesen, NYLJ June 29, 1999 (Surrogates Ct. N.Y. Cty.), the court authorized the trustee to appoint trust assets to a testamentary trust with identical provisions to reduce administrative expenses. EPTL §10-6.6 is particularly well suited to address problems where it may be desirable to appoint new trustees. In re Klingenstein, NYLJ, Apr. 20, 2000 (Surrogates Ct. Westchester Cty.) authorized the decanting of assets into multiple trusts which granted the beneficiary of each trust the power to remove the trustee. The creation of new trusts in Klingenstein also allowed the removal of the impractical limitation requiring any trustee acting as sole trustee to appoint a corporate co-Trustee, and allowed for the elimination of successor trustee appointments. The decanting statute could also be utilized to modify trustee compensation.
EPTL §10-6.6 may also be utilized to change the situs of a trust for privacy reasons. The grantor of a trust may not want beneficiaries who are minors to become aware of the trust. To preserve secrecy, the trustee might wish to change the situs of the trust to Delaware, which limits the trustee’s duty to disclose. If trust property is also located out of New York, changing the situs of the trust might also facilitate trust administration. Drafting errors or changes in the tax law may also be occasions for seeking to distribute trust assets into a new trust. The Surrogate in In re Ould Irrevocable Trust, NYLJ Nov. 28, 2002 (Surrogates Ct. N.Y. Cty.) authorized the transfer of trust assets into a new trust where the retention of certain powers by the insured in the original trust may have resulted in estate tax inclusion. If a single trust contains many beneficiaries, one investment strategy might not satisfy the differing objectives and needs of each beneficiary. Splitting the trust into individual trusts for each beneficiary might enable the trustees to manage each trust in accordance with the differing objectives of each beneficiary. The Surrogate in In Re Estate of Scheuer, NYLJ July 10, 2000 (Surr. Ct. N.Y. Cty.) authorized the trustees of the original trust to appoint trust assets into ten new trusts to accomplish this objective.

New York State Tax Considerations

Tax considerations may provide another compelling reason for decanting trust assets. Under NY Tax Law §603(b)(3)(D), even if the trust is sitused in New York, if there is (i) no trustee domiciled in New York, (ii) no New York source income, and (iii) no real or tangible property located in New York, then accumulated income and capital gains will not be subject to New York income tax. Accordingly, if a New York trust holds considerable assets outside of New York, decanting those assets into a trust in another jurisdiction might avoid New York income tax on capital gains and accumulated income sourced outside of New York.

Federal Estate Tax Considerations

Federal tax considerations may also warrant consideration of EPTL §10-6.6(b). For example, the statute could be used to create GST Exempt and GST Non-Exempt trusts. Investment strategy for the GST Exempt trust — which would not be subject to GST tax — could be aggressive, while investment strategy for the GST Non-Exempt trust could be used to make distributions to children who are exempt from the GST tax. For example, these distributions could be made for tuition or medical care. [PLR 200629021 ruled that dividing a GST exempt trust into three equal trusts to facilitate investment strategies for different beneficiaries would not taint GST exempt status.] Dividing a trust into marital deduction and nonmarital deduction trusts may also yield both tax and nontax benefits. Assets decanted into the marital deduction trust, which would ultimately be included in the estate of the spouse, could be invested in conservative securities and could be used for distributions of principal to the spouse. To the extent the marital trust is depleted, the amount of assets ultimately included in the spouse’s gross estate would be reduced. Assets in the nonmarital trust, which would not be subject to estate tax in the estate of the spouse, could be in invested in growth assets for future beneficiaries.
A GST Exempt Trust is not subject to Generation Skipping Transfer Tax. Treas. Reg. §26.2601-1(b)(v)(B) states that the extension of an Exempt Trust in favor of another trust will not trigger GST tax. However, actual additions or deemed additions to a GST Exempt Trust would cause it to lose its exempt status. Therefore, care must be taken when utilizing EPTL §10-6.6 not to make an actual or deemed addition to the trust which would cause a GST Exempt Trust to lose its exempt status. If GST implications resulting from distributions to a new trust under EPTL §10-6.6 are unclear, a private letter ruling from the IRS should be obtained in advance. The IRS could argue that decanting causes a taxable gift by the beneficiary to the trust. If the beneficiary is entitled to receive trust distributions at a certain age, and by reason of decanting, the assets are held in trust for a longer period, the IRS could make the argument that the right of the beneficiary to receive trust assets at a certain age is equivalent to a general power of appointment. Thus, if the beneficiary fails to object to the decanting, the beneficiary has, in effect, released a general power of appointment, which would result in a taxable gift. This argument is less cogent in states like New York, where the beneficiary does not have the power to prevent the decanting. However, if a beneficiary could forestall an attempt by the trustee to decant, then the gift argument gains credibility. To weaken the argument that a taxable gift has occurred, the beneficiary could be given a limited power over trust assets in the new trust. The retention of a limited power of appointment generally should prevent the release from being a taxable gift. Treas. Reg. §25.2511-2(b).

Federal Income Tax Considerations

Decanting should result in no adverse income tax consequences. For gain or loss to occur, there must be either a sale or exchange of property, or the property received must be materially different from the property surrendered. Treas. Reg. §1.1001-1(a). The Supreme Court in Cottage Savings Ass’n v. Com’r, 499 U.S. 554 (1991) seemed to read out the word “materially” from the term “materially different”” in holding that an exchange of similar mortgages triggered a taxable event. Nevertheless, the IRS has stated in recent rulings that a distribution in further trust will not trigger income tax provided the distribution is permitted either by the trust instrument or by local law. If encumbered property is distributed pursuant a decanting statute, a potential income tax problem could arise under Crane v. Com’r, 331 U.S. 1 (1947), since that case held that the amount realized includes relief from liability. However, IRC §643(e) provides that distributions from a trust generally do not produce taxable gain. Therefore, substantial authority would appear to exist for the reporting position that decanting produces no realized even if liabilities exceed basis. In view of the preparer penalties under IRC §6694, practitioners might consider disclosing the position on the return.

IRS Interest in Decanting Statutes

In December of 2011, the IRS announced that it was considering the tax implications of trust decanting.  Notice 2011-11. Among the tax implications the IRS is considering are (i) the addition of new beneficiaries; (ii) the conversion of a grantor trust to a non-grantor trust (and vice versa); (iii)  the effect of consent of beneficiaries; (iv) whether the consent of a beneficiary to decant carries with it gift tax consequences; and (v) whether trust decanting constitutes a recognition event for income tax purposes.

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