Irrevocable Trusts May Not be as Permanent as Intended
Irrevocable trusts serve an
important role in estate planning, particularly reducing taxable estates and
protecting the held assets from creditors. One of the central characteristics
of an irrevocable trust is that it cannot be changed without the permission of
all named beneficiaries or the jurisdictional court. The permanency of
irrevocable trusts sometimes leads to challenging circumstances because the
trust may not meet the needs of the beneficiaries or the original intent of the
grantor as time passes. Decades ago, changing an irrevocable trust to reflect
the terms that would align with the purpose and intent was difficult to
impossible. In recent decades, a more modern solution has been made possible in
some states—decanting the trust.
Decanting a trust is a tool a
trustee can use to move assets from an irrevocable trust into another trust,
but this is only allowed by 27 states[1] and some of those states
have significantly restricted a trustee’s ability to decant a trust. One of the
most critical considerations that must be taken into account when decanting a
trust is that the decantation must be in the best interest of the trust’s
beneficiaries without violating the intent of the grantor. Statutory
restrictions prevent the trustee from being able to restrict or expand
distributions from the trust beyond the scope of those included by the grantor
in the original trust. Adding new beneficiaries is also forbidden through
restrictive statutes in some states that allow for legal trust decanting.
Some benefits that come with an
irrevocable trust are possible because the grantor does not have control over
the assets once the trust is funded. These include a reduction in the estate
value and a protection against claims made by the grantor’s creditors. It is
possible for those protections to remain in effect into the new trust, as long
as specific processes are followed and proper reasoning is used to determine
the need to decant the trust.
The United States Internal Revenue
Service issued a key ruling[2] that concludes decanting
certain grandfathered trusts would not subject those trusts to
generation-skipping transfer liabilities as long as the changes comply with all
perpetuities limitations and preserve the original tax status of the trust. The
ruling clarifies that transferring assets via decanting does not equate to a
construction addition to a trust as long as the trustee adheres to existing
restrictions. The need for careful compliance with all applicable fiduciary
standards and statutory requirements are both highlighted in this ruling by the
IRS.
The rationale used to determine if
decanting a trust must be specific, such as reducing administrative costs by
consolidating multiple trusts into one central trust that still allows for the
terms of the original trust to remain in a manner that maintains the same
spirit of that trust. Decanting a trust is also useful if there is a drafting
error that is noted after the irrevocable trust is established and funded. The
trustee must carefully review the comprehensive circumstances that surround the
need to decant the trust because legal challenges may arise if there are any
that border on fraud on behalf of the trustee or breach of fiduciary duty to
the beneficiaries of the trust.
Decanting a trust provides a level
of flexibility that is not originally intended for irrevocable trusts, but the
possibility can help to protect the original intent of the grantor and
inheritance of the beneficiaries when situations arise that make the original
trust terms become a liability. This flexibility comes at a significant risk of
legal, financial, and ethical challenges, so trustees must ensure they are
acting in the best interests of the beneficiaries without any regard to their
own personal gain. When used appropriately, trust decanting can preserve the
utility of the irrevocable trust and keep it in line with modern estate
planning needs.
[1]
James D. Harriss & Peter Sherman, Is an Irrevocable Trust Really
Irrevocable? Not Any More—Decanting, 1 J. Applied Fin. Rsch. 7 (2018).
[2]
Notice 2011-101, 2011-52 I.R.B. 932, available at
https://www.irs.gov/pub/irs-drop/n-11-101.pdf.