What Is Decanting a Trust and How Does It Work?

Decanting a trust is a process for modifying an irrevocable trust, which normally cannot be altered once created. The term is borrowed from winemaking, where wine is poured into a new container to separate it from sediment. Similarly, decanting a trust involves a trustee moving assets from an existing trust into a new one with more favorable terms, leaving behind undesirable provisions.

The function of decanting is to adapt an inflexible document to new circumstances without needing court approval. This allows a trustee to address issues or opportunities not anticipated when the trust was established. By creating a new trust, the trustee can introduce modern administrative clauses, correct errors, or respond to changes in laws or beneficiary situations.

Common Reasons for Decanting a Trust

A trustee may decant a trust for several reasons, including:

• To correct drafting errors or resolve ambiguities in the original trust document that make it unclear or impractical to administer, which might otherwise require court proceedings.
• To update administrative provisions by incorporating modern terms for appointing or removing trustees, changing the trust’s governing law, or granting specific investment powers not included in an older document.
• To adapt to a beneficiary’s changing circumstances, such as the development of special needs, by creating a special needs trust, adding spendthrift clauses for protection, or adjusting distributions due to a divorce.
• To respond to changes in tax laws by taking advantage of new savings opportunities or mitigating negative tax consequences. This can include changing the trust’s location, or situs, to a jurisdiction with more favorable tax treatment.

Requirements and Limitations for Decanting

A trustee must have legal authority to decant a trust, which comes from either the trust document itself or state law. While some modern trust instruments explicitly grant this power, in many cases the authority is granted by state statutes.

Many state laws are based on the Uniform Trust Decanting Act (UTDA), which provides a standardized framework. It is important to know if the state governing the trust has a decanting statute and its specific requirements. In states without specific decanting laws, modifying a trust is more complex and often requires court approval and the consent of all beneficiaries.

Even with authority, a trustee is bound by fiduciary duties, primarily loyalty and impartiality. The duty of loyalty requires the trustee to act solely in the interests of the beneficiaries, while the duty of impartiality prevents favoring one beneficiary over another. Any decanting action must align with these duties and further the original trust’s purposes.

There are also limitations on what can be changed. A trustee cannot add new beneficiaries who were not part of the original trust. Furthermore, decanting cannot impair a beneficiary’s vested rights, such as a fixed right to receive income. State laws often impose specific restrictions, for example, on modifying provisions related to marital deductions or annual gift tax exclusions.

The Decanting Process

The process begins with a review of the original trust instrument by the trustee, often with legal counsel. This step is to understand the existing terms, the trustee’s distribution authority, and the creator’s original intent. The review identifies problematic provisions and confirms that decanting is an appropriate solution.

Once the need for decanting is established, the next step is to draft the new trust document. This new instrument will incorporate the desired changes, such as administrative updates or modified distribution standards. The new trust must not fundamentally alter the original’s core purpose or violate any legal limitations on decanting.

After the new trust is drafted, the trustee must provide formal written notice to all qualified beneficiaries. The governing state statute dictates the specific notice requirements, including who must be notified and the timeframe. This notice informs beneficiaries of the trustee’s intention and gives them an opportunity to object.

The final step is the transfer and retitling of assets from the original trust to the new one. This involves legally moving all property, including bank accounts, real estate, and investment portfolios, to the new trust. Once the assets are transferred, the new trust becomes the operative vehicle for managing them.

Tax Considerations of Decanting

While many decanting transactions are structured to be non-taxable, certain modifications can trigger tax consequences. A primary concern is income tax. A decanting that significantly alters beneficial interests in a trust could be viewed as a taxable sale or exchange of property, leading to capital gains tax.

Federal gift tax is another risk. If the decanting process shifts beneficial interests in a way that is considered a gift from one beneficiary to another, it could trigger gift tax liability. The IRS has clarified that if a beneficiary consents to a decanting that diminishes their interest, they may be considered to have made a taxable gift.

The Generation-Skipping Transfer (GST) tax is another consideration. This tax applies to transfers to beneficiaries who are two or more generations younger than the donor. If a trust was exempt from the GST tax, a decanting could cause the trust to lose its exempt status if it extends the trust’s duration or improperly shifts interests.

Changing a trust’s situs, or legal location, through decanting can have state-level tax implications. Moving a trust to a state with no state income tax is a common reason for decanting, which can result in tax savings. However, the rules for establishing a new tax home for a trust are complex and must be followed carefully.