Trust Decanting: What Are the Tax Consequences?

Trust decanting is the process of transferring assets from an existing irrevocable trust to a new one with more favorable terms. This action is often compared to decanting wine, where the contents are poured into a new vessel to improve them. Trustees use this strategy to update old trusts, adapt to changing family needs, or respond to new laws. While many states have statutes permitting a trustee to decant a trust, the federal tax landscape is more complex. The Internal Revenue Service (IRS) has not provided comprehensive guidance, leaving trustees and beneficiaries to navigate potential tax issues.

Income Tax Implications of Decanting

A primary concern when decanting a trust is whether the transfer of assets triggers an immediate capital gains tax. The IRS has indicated that if the new trust is a continuation of the old one, and the decanting is authorized by the trust document or state law, it is not a taxable event. However, a taxable gain could be triggered if a trust with liabilities greater than the tax basis of its assets is decanted.

The decanting process can be used to alter a trust’s income tax status, for instance, by changing it from a grantor trust to a non-grantor trust. A decanting that converts a grantor trust to a non-grantor trust during the grantor’s life is treated as a disposition of the assets. This can trigger gain recognition if the trust’s liabilities exceed the basis of its assets.

In a decanting that is not treated as a taxable sale or exchange, the assets moved to the new trust maintain their original cost basis and holding period. For the purpose of calculating capital gains on a future sale, the new trust steps into the shoes of the old trust. The purchase price and date of the assets do not change, preserving existing unrealized gains or losses.

Decanting can also be used for state income tax planning. A trustee might decant a trust to move its legal location, or situs, to a state with more favorable tax laws, such as one with no state income tax. This can eliminate the annual state tax burden on the trust’s earnings and capital gains.

Gift and Estate Tax Consequences

Decanting can lead to unintended gift tax consequences if a beneficiary’s interest is reduced. If a beneficiary must consent to a decanting that diminishes their share, the IRS may view that consent as a taxable gift to the other beneficiaries. The decanting should ideally be executed by a trustee with discretionary authority, without requiring beneficiary approval.

When a trustee acts within their fiduciary duties and the decanting is authorized, the action itself is not considered a gift by the trustee. The trustee is exercising a power granted to them to manage the trust assets for the beneficiaries.

A risk in the estate tax context is causing trust assets to be included in a beneficiary’s taxable estate. This can happen if the decanted trust grants a beneficiary a “general power of appointment” they did not possess under the original trust. A general power of appointment gives the holder the ability to direct trust assets to themselves, their estate, or their creditors, which causes those assets to be included in their estate for tax purposes.

For example, if a decanting modifies a trust to give a child the unrestricted right to withdraw principal, that power could be classified as a general power of appointment. Upon that child’s death, the value of the assets subject to that power could be subject to estate tax. This is an important consideration, as a primary goal of many irrevocable trusts is to keep assets outside of a beneficiary’s taxable estate.

Generation-Skipping Transfer (GST) Tax Considerations

A significant tax risk with decanting involves the Generation-Skipping Transfer (GST) tax, a 40% tax on transfers to “skip persons” like grandchildren. Many older trusts are “GST-exempt” or “grandfathered” because they were irrevocable on September 25, 1985. A primary concern is that modifying such a trust through decanting could cause it to lose its protected status.

The loss of GST-exempt status can occur if a modification is seen as an “addition” to the trust or fundamentally changes beneficial interests. While the IRS has not provided definitive regulations, certain changes are considered safer than others. Modifications that are purely administrative, such as altering trustee succession provisions or changing the trust’s governing law, are less likely to jeopardize the exemption.

The modifications most likely to cause the loss of GST-exempt status are those that extend the trust’s duration. A decanting that extends the life of the new trust beyond the period permitted by the rule against perpetuities that governed the original trust is highly likely to cause the loss of the exemption. The rule against perpetuities sets a time limit on how long a trust can exist, and extending this period is viewed by the IRS as creating a new trust.

Any change that shifts value between beneficiaries can also be problematic. For example, removing a child as a beneficiary to increase the amount passing to grandchildren could be viewed as a modification with GST tax implications. Even if the decanting does not trigger an immediate gift tax, it could change the transferor for GST tax purposes, leading to complex outcomes.

Tax Reporting and Identification Numbers

After decanting, the new trust may need a new Employer Identification Number (EIN). If the decanting results in only minor administrative changes and the new trust is substantially similar to the old one, the IRS permits the new trust to continue using the original EIN. The trustee would report a name change on the next tax filing.

Conversely, if the decanting creates a trust with materially different terms or beneficiaries, it may be treated as a new trust requiring a new EIN. In this case, the decanting is reported as a distribution from the first trust to the second. This involves filing a final tax return for the original trust and an initial return for the new one.

The trustee must continue to meet annual tax filing obligations, such as filing the trust’s income tax return, Form 1041. If the decanting resulted in a taxable gift, a Form 709, the United States Gift Tax Return, must also be filed.

The trustee should maintain detailed records of the decanting process. This documentation should include the state law or trust provision authorizing the action, the rationale for the changes, and copies of both trust documents. These records are necessary to support the tax positions taken in the event of an IRS audit.