Can Decanting Change the Vintage of Irrevocable Trusts?
Written by Partner David I. Faust, Gallet Dreyer & Berkey, LLP. Featured in New York Law Journal.
Irrevocable trusts can be valuable tools for estate and tax planning purposes; however, the assumptions on which an irrevocable trust is based can change. Beneficiaries can fall out of favor; their needs may change. New people or entities may emerge who were not named in the trust but whom the settlor would like to favor or may reasonably be expected to have wanted to favor. The settlor may or may not be alive when such changes occur.
When are Irrevocable Trusts Revocable?
If the settlor is alive and so desires, an ostensibly irrevocable trust can be revoked or amended under New York law if all beneficiaries consent. EPTL 7-1.9. However, all means all. There is no statutory basis for limiting consent to only the adult, legally competent beneficiaries. Living grandchildren, even if minors, are contingent beneficiaries who cannot legally consent. Adult beneficiaries, current or contingent, who lack the requisite mental capacity to consent must also be considered.
While there is case law to the effect that changes that benefit the minor beneficiaries (one example being an amendment to provide for reduced trustee commissions) need not have their consent, the revocation of a trust to eliminate or modify the rights of one or more beneficiaries might not fit that criterion.
Since minors lack the legal capacity to consent, consent is commonly given by their parents as guardians. If a parent objects—perhaps a parent who is not a beneficiary but wants to protect a child or a child’s status—this would be a problem. There is also no exception to the requirement of consent by a cognitively disabled beneficiary. Here, as well, the consent of a guardian would be required.
Before considering revocation of, or changes to, an irrevocable trust, a settlor must consider tax consequences.
Irrevocable trusts are often used to remove assets from an estate for estate tax purposes. While a full description of the tax consequences of a trust revocation is beyond the scope of this article, tax considerations must not be ignored. A properly structured trust for that purpose would be a non-grantor trust or an intentionally defective grantor trust. In either case, if the contributed assets exceed the annual exception, a gift tax return should have been filed.
Depending on the amount involved, a federal gift tax may have been due and/or the settlor’s lifetime exception may be used up in whole or in part. If the trust is properly revoked, “the estate of the trustees ceases” with respect to the trust assets. If this results in the trust assets being returned to the settlor, those assets are restored to his or her estate with no provision to recover any gift tax which may have been paid, or to restore any portion of the lifetime exception which may have been used to calculate gift taxes when the trust was created.
Moreover, the beneficiaries who consented to the revocation may have made a taxable gift to the settlor. This is particularly a risk if the beneficiaries are vested or, if discretionary, there is a consistent pattern of distributions. The foregoing is a very brief summary and incomplete outline of some tax issues to be considered and should not be relied on as tax advice.
These complications can limit the ability a settlor has to revoke a trust through EPTL 7-1.9 and have them looking for other options.
An alternative to revoking or amending a trust could be decanting.
Decanting a Trust
Decanting in the world of wine means pouring wine from one container to another without disturbing the sediment. In the trust world, decanting means pouring the assets of one trust into a new trust, commonly to change jurisdiction. With care, it can also be a way to amend an irrevocable trust, which is prima facie unamendable. The route may be found in EPTL 10-6.6(b).
Assuming that the trustee has “unlimited discretion to invade trust principal,” he or she can decant all or a portion of the trust to a new trust for the benefit of one or more, but not necessarily all, of the beneficiaries. If the beneficiaries of the old trust include a defined class, this class may be included in the new trust and, if carefully worded, can be a way to add individual beneficiaries. No consent of the settlor or any of the beneficiaries is required, although the trust instrument may dictate requiring consent of a protector. Requiring the consent of the settlor could impair the irrevocability and tax characterization of the trust.
The key here is whether the trustee has “unlimited discretion to invade principal.” If that discretion is limited, the trustees can decant, but the beneficiaries must be the same in the new trust as in the old and the provisions on distribution of income and invasion of principal must be unchanged. EPTL 10-6.6(c).
Thus, the new trust in this case cannot exclude beneficiaries of the old trust, but if the beneficiaries of the old trust are described by a class, beneficiaries of that class can be added to the new trust.
If a settlor wanted to provide the trustee with the ability to add members of “a class” as beneficiaries of the new trust, then not only must the trustee have unlimited power to invade the principal, but the “class” should be described with some precision. “Citizens of the United States of America” or “people born in the Western hemisphere” won’t do…although such terms are not unusual with certain foreign foundations. Something like “issue of the settlor’s parents and/or the parents of the settlor’s spouse, by birth, marriage or adoption” or “charities whose principal objective is…” should work.
Discretion is not “limited” by words such as “best interests” and “welfare, comfort, or happiness.” [EPTL 6.6(s)8]. This section was added in 2011, overriding Matter of Estate of Mayer, 672 N.Y.S. 2d 998 (1998), which held the trustee to an “ascertainable standard” and meant that his or her discretion is not unlimited.
There is an interesting difference in a single word between the rights of a trustee with unlimited discretion and one without it. In the former case, the trustee may include present and future members of a defined class of beneficiaries in the new trust. In the latter case, the trustee shall do so. Compare EPTL 10-6.6(b)(4) and EPTL 10-6.6(c)(3). Does this mean that the trustee of a decanted trust, who does not have unlimited discretion, must name class members or beneficiaries? That could be a literal interpretation but not a sensible or reasonable one.
The better interpretation is that just as the trustee, without unlimited discretion, cannot exclude named beneficiaries in a newly decanted trust, he or she cannot exclude a class. The terms of the trust should dictate if the members of the class are vested or discretionary beneficiaries. This anomaly awaits legislative or judicial clarification.
The power to decant is subject to defined fiduciary duties, including those to the settlor, and is also subject to a “prudent person’s” standard. [EPTL 10-6.6(h)]. It is commonly understood that a trustee has fiduciary duties to the trust’s beneficiaries.
In decanting a trust, the trustee has explicit fiduciary obligations to the settlor as well and must be comfortable that any changes from the old vessel to the new one are not inconsistent with the settlor’s wishes or objectives which he or she “would be likely to have had” under the circumstances when the power is exercised.
How can a trustee determine, much less prove, what a settlor’s wishes or objectives might be in circumstances not envisioned by the settlor, who may be deceased or incapacitated? A “wish letter,” common in common law trusts but not with domestic trusts, would be helpful if not essential.
Decanting is subject to challenge by an affected beneficiary, all of whom are entitled to notice. EPTL 10-6.6(j)(2) and (4).
If the settlor wants to preserve the ability of the trustee to decant the trust, add or eliminate beneficiaries, or effect their rights, there are at least four things that must be done through a knowledgeable advisor.
- Be sure that the trustee has unlimited discretion to invade principal.
- Be sure to provide that the list of beneficiaries includes a properly defined class.
- Provide a wish letter that would give the trustee some precatory, if not binding, guidance about both deleting and adding beneficiaries.
- Consider tax consequences.
Decanting a trust, like decanting fine wine, must be done with great care, by someone who knows what they are doing…and, if done properly, can result in a new trust without unwanted sediment.
David I. Faust is a partner at Gallet Dreyer & Berkey.