United States

Decanting and the potential gift tax trap


Decanting has become a great opportunity to amend trust provisions that no longer fit the needs of the grantor or the family. Decanting is being used more frequently to transfer trust assets from an obsolete trust in favor of a new trust with updated terms and conditions. This strategy has been implemented to meet mundane goals, such as a change in trustee. It has also been used to adapt trusts to account for key family events such as a change in beneficiaries as a result of marriage, divorce, childbirth and death. Finally, decanting has been employed as an important tool for dealing with asset protection issues, particularly in situations where beneficiaries potentially need special care.

Currently, the following states provide some level of trust decanting by statute: Alaska, Arizona, Delaware, Florida, Illinois, Indiana, Kentucky, Michigan, Missouri, New Hampshire, New York, Nevada, North Carolina, Ohio, Rhode Island, South Carolina, South Dakota, Tennessee, Texas, Virginia, Wisconsin and Wyoming. In other states, such as Massachusetts, courts have found a common law right to decant.

A thorough analysis of the decanting repercussions and local rules should be undertaken before making the decision to decant. Otherwise, decanting could result in unintended gift and generation-skipping transfer tax consequences. Simply stated, trust decanting that alters the interests of the trust beneficiaries may result in a taxable gift. The IRS has declined to provide any guidance on decanting and could ultimately adopt expansive interpretations of existing gift and generation-skipping transfer tax regulations.

Trust decanting utilizes the trustee's discretionary distribution powers over the trust assets. Generally speaking, a trustee's exercise of a discretionary power to distribute trust assets in a manner that favors one beneficiary over another does not give rise to a taxable gift (Reg. section 25.2511-1(g)(1)) unless the trustee is also the beneficiary. However, if the state's decanting statute or an existing trust instrument requires the beneficiary's consent to a decanting, and the beneficiary in fact provides a consent to the decanting that results in a reduction of his or her beneficial interest, directly or indirectly, then the beneficiary may be deemed to have made a taxable gift tax to the other beneficiary(ies) (Reg. section 25.2514-3(b)).

In addition, a decanting that postpones the ultimate disposition of the trust principal can trigger the "Delaware tax trap," as section 2514(d) is colloquially known. This section pulls assets into the gift tax base (or gross estate base under section 2041) when a power of appointment is exercised to postpone the vesting of a beneficiary's interest or suspend ownership of a beneficiary's interest. Where a beneficiary/trustee decants and postpones in perpetuity the ultimate distribution of assets, section 2514(d) is in play.  

Due to the lack of guidance on decanting, it is advisable that a gift tax return documenting the decanting and statutory authority be filed by the trustee or the party releasing or exercising a power of appointment. Bear in mind that since decanting requires sophisticated analysis and planning, individuals should work with an advisor with the requisite planning experience.


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