Second Thoughts: Decanting an Irrevocable Trust
A popular saying on the television program Once Upon A Time was “all magic comes with its price”. This is also true for irrevocable trusts. The magic of an irrevocable trust is its ability to remove all the assets held in the trust from the estate of the grantor as well as to carry out the grantor’s wishes for how those assets will be distributed.
But the price for such magic is the irrevocable nature of the trust and the notoriously difficult process to make any changes. Most jurisdictions require either the grantor and beneficiaries to agree on modifications to the trust or, at the very least, some sort of judicial modification which may not be entirely successful.
When a trust is funded, the provisions of the trust, including the powers of the trustee, are established to represent the needs of the grantor at that point in time. What if the grantor wants to change the terms of the trust? The process of decanting may be the most efficient course of action.
Trust decanting is the distribution of assets from one existing trust to another trust with more favorable terms. Common reasons for decanting include:
Changing where a trust is domiciled.
Adding or eliminating a beneficiary.
Changing the trustee.
Adding language to address a special needs beneficiary.
Protecting the trust’s assets from the creditors of a beneficiary.
Splitting up a trust.
Converting from a grantor to a non-grantor trust.
Adjusting distribution terms.
Changing withdrawal rights.
The first step in the decanting process is to make sure the existing trust is set up in a state which has favorable decanting legislation. If the state the trust is in does not have decanting laws permitting the sought-after modifications, steps should be taken to move the trust. This requires looking at the existing trust to see if it can be moved.
The two most favorable jurisdictions for decanting are South Dakota and Nevada. Both states have decanting statutes, (SD §55-2-15 & NV §163.556) which permit the decanting of a trust into a discretionary trust, do not require notifying beneficiaries, and permit the removal of mandatory income interest. The two states are also advantageous dynasty trust jurisdictions and have strong domestic asset protection.
Once the trust has been moved, if necessary, to a more favorable jurisdiction, the actual decanting can begin. Requisite documents pertaining to the desired trust changes are drafted and, like pouring a bottle of wine into a decanter, the assets of the existing trust are transferred into a new or existing trust with those different terms.
What about taxes? Experts generally believe that decanting an irrevocable trust is not a taxable event for income, gift or estate tax purposes. Many of these experts warn that some aspects of decanting are unsettled so care should be taken to consider a state’s specific statutes.
The IRS, for income tax purposes, does not perceive decanting as triggering capital gains. However, if a trust with liabilities in excess of a trust’s assets basis is decanted from a grantor to a non-grantor trust, this could trigger a gain.
The price for the magic of an irrevocable trust can be dramatically lowered by planning for the potential future use of decanting. Including such provisions in an agreement for an irrevocable trust or for a revocable trust which will become irrevocable will help ensure the flexibility for decanting exists, if needed. This will help avoid costly, lengthy and, possibly, unsuccessful jurisdiction proceedings.
Since its inception, Life Insurance Strategies Group has solely focused on the individual high net worth life insurance market. We do not sell products. This allows us to offer unbiased, pragmatic advice. Visit us at www.lifeinsurancestrategiesgroup.com.
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