When a trust is irrevocable, you might think it can't be changed — even if it contains drafting errors or becomes ineffective or obsolete due to changing tax laws or family circumstances. Or can it? Actually, through a process known as decanting, many irrevocable trusts may be “fixed,” when trustees deem it necessary.
Power to Pour
In common parlance, decanting is pouring wine or another liquid from one vessel into another. In estate planning, it means “pouring” assets from one trust into another with modified terms. The rationale underlying decanting is that if trustees have discretionary power to distribute trust assets among beneficiaries, then they have the power to distribute those assets to another trust.
Depending on a trust's language and the provisions of applicable state law, decanting may allow the trustee to clarify trust language, take advantage of new tax laws, move the trust to a state with more favorable tax or asset protections, or enhance spendthrift language to protect the trust assets from creditors' claims. Potentially more controversial, the trustee may be able to remove beneficiaries or alter the powers of trustees.
Decanting can be helpful, for example, when a trust might subject beneficiaries to capital gains tax. Unlike assets transferred at death, assets that are transferred to a trust don't receive a stepped-up basis, so its beneficiaries may owe capital gains tax on any appreciation in value. Decanting can authorize the trustee to confer a general power of appointment over the assets to the trust's grantor, or to name the grantor as successor trustee. Such actions cause the assets to be included in the grantor's estate and, therefore, to enjoy a stepped-up basis.
Most states have decanting statutes and in some of them, decanting is authorized by common law. Either way, it's critical to understand your state's requirements. In some states, the trustee is required to notify the beneficiaries or even obtain their consent to decanting. Others require neither. And some states prohibit decanting if the trustee has discretion over distributions of income but not principal, or if distributions are limited by an “ascertainable standard,” such as a beneficiary's health, education, maintenance or support.
Even if decanting is permitted, there may be limitations on its uses. Some states, for example, prohibit the use of decanting to eliminate beneficiaries or add a power of appointment, and most states don't allow the addition of a new beneficiary. If your state doesn't authorize decanting, or if its decanting laws don't allow you to accomplish your objectives, it may be possible to move the trust to a state with laws that meet your needs. And, if the trust instrument includes decanting provisions, it may be possible to decant the trust without the need to rely on state law.
Typically, state laws permit decanting without court approval, although some states require court approval for modifications that, for example, have an adverse impact on a beneficiary or on the tax treatment of the trust. Even if court approval isn't required, trustees often seek such approval voluntarily if they anticipate objections from the trust's beneficiaries.
Decanting isn't the only way to amend an irrevocable trust. There are several other potential options, including:
Reformation. Many states permit you to seek a court order to rewrite a trust's terms to conform to the grantor's intent if its original terms were based on a legal or factual mistake.
Modification. Court-ordered modification may be available if required by changing circumstances to fulfill the trust's purposes.
Division or combination. Some states permit a trustee to combine multiple trusts into one or to divide a trust into several trusts, under certain circumstances.
Relocation. State law may allow a trustee to move a trust to a jurisdiction with more favorable tax or asset protection laws.
Talk with your estate planning advisor about the pros and cons of each option and whether one or more may make sense given your situation
Tax Risks One of the risks associated with decanting is uncertainty over its tax implications — and the IRS has released little guidance on the issue thus far. So if you're a grantor establishing an irrevocable trust or a trustee seeking to decant a trust, work with advisors knowledgeable about both state law and federal tax law.