One planning issue ultra-high-net-worth families face is handling irrevocable trusts put in place years ago that no longer serve their needs. Irrevocable trusts have historically been difficult to modify. However, families with these trusts can go through a process known as decanting to affect these types of changes. We are increasingly guiding trustees and clients through that process to ensure, with certain limitations, that their trusts are up to date and are delivering the intended outcomes and benefits.
Just like with wine, decanting a trust pours principal from the original trust into a new trust with updated terms that govern the trust property. It can be a valuable tool for trustees to modify many, but not all, irrevocable trusts and avoid the need for a judicial modification. It also gives families more flexibility in their planning and enables them to correct issues that in some cases were created decades earlier.
Modify and modernize
There are many reasons that a trust no longer serves its purpose and should be modified or modernized.
For example, depending on the trust terms and state law, trustees may need to address changes in governing law, correct drafting errors or issues, clarify trust terms or include administrative provisions that allow the trust to operate more efficiently, change the number of trustees or their powers under the terms of the trust, or take advantage of new laws or more advantageous jurisdictions
Shifts in family dynamics or financial circumstances could also impact the effectiveness of the trust. Restrictive distribution provisions put in place for minors at the time of drafting may no longer apply to those now-adult beneficiaries who are productive members of society. Those beneficiaries may also need broader access to trust assets if they are now married adults with their own children.
Further, it may be necessary, depending on family and financial circumstances, to amend the ages that were set for discretionary or mandatory distributions when the trust was originally drafted. Trusts may also need to be modified to address concerns about beneficiaries who have substance addictions or are unable to make financial decisions.
Avoiding potential pitfalls
In theory, decanting sounds simple. However, there are several issues to consider to ensure you emerge with a stronger trust and avoid potential tax pitfalls. Trustees and beneficiaries should consult with financial, legal and tax advisors to ensure they are complying with the applicable state laws for decanting. Here are some things to consider:
Find the right state
The statutory power to decant a trust typically rests with an authorized trustee — someone who is not the grantor or a beneficiary and has the power to invade the corpus (body) of the trust. However, the process and rules differ from state to state. State decanting statutes outline which powers are granted to trustees, the changes that can be made through decanting, and who must consent to such changes.
Even if your client doesn’t live in a state with favorable decanting laws, it may be possible to change the jurisdiction during decanting to achieve more favorable terms.
Understand the tax implications
The tax implications for decanting are still evolving, with very little direct guidance offered by the IRS. The biggest potential pitfalls here are income and capital gains taxes, along with gift and generation skipping taxes. Because of the uncertainty around these issues, trustees must be careful with the changes and provisions in the new trust to ensure they don’t trigger any unintended tax consequences.
For example, if a beneficiary allows their interest in the trust to move to a different beneficiary, or, in some cases, if a beneficiary releases a general power of appointment, the new beneficiary could be exposed to gift tax.
If the trustee is also a beneficiary and changes the ascertainable standard or restricts distributions in the new trust, this could trigger a tax event.
Know your limits
While there are a number of important changes you can make through decanting, it’s important to understand what you can’t do. Generally, trustees do not have the authority to distribute trust property to non-beneficiaries, and new beneficiaries should not be added to a trust through decanting. In the event you can add new beneficiaries, only a non-beneficiary trustee can manage the decanting process.
As time passes, it is not unusual for older irrevocable trusts to become outdated and fail to meet the current needs of beneficiaries. In many states, decanting now offers a safer more efficient statutory way to modernize and update certain provisions of a trust to adapt to changing circumstances.
The right legal, tax and financial advisors can guide trustees and beneficiaries through this process.
Todd Neal, J.D., is a client management partner at Callan Family Office, a $4 billion multifamily office in Palm Beach, Fla.
