Trust division and decanting

Decanting borrows its name from wine. A trustee who already holds discretionary authority to distribute principal to a beneficiary exercises that authority by pouring the assets into a second trust for that beneficiary instead of handing them over outright. The old container empties, the contents move, and the terms of the new container govern from that point forward. Authority comes either from the trust instrument itself or from a state statute, and a majority of states now have one, many of them modeled on the Uniform Trust Decanting Act. This is a fiduciary act performed under state law, which is the first thing to understand about it. The trustee owes duties to the beneficiaries throughout, most statutes require advance written notice to interested parties, and a common notice period runs sixty days. Statutes often separate a trustee holding broad discretion, who may reach the beneficial terms within limits, from a trustee holding limited discretion, who may adjust administrative provisions but not who receives what. That distinction usually decides how far a plan can go. Families use the tool to correct a drafting error, to add a supplemental needs provision for a beneficiary who became disabled, to change how a trustee is replaced, or to move the administrative home of the trust to another state.

On the federal tax side there is less certainty than families expect. The Internal Revenue Service asked for public comment on these transactions in Notice 2011-101 and has since declined to rule on several of the questions while it studies them, so a good deal of practice rests on general principles rather than on direct guidance. The general principle that matters most is section 1001. A transfer between trusts is not a realization event where the beneficial interests are not materially different, and the second trust is usually treated as a continuation of the first for income tax purposes. Where a decanting genuinely rearranges who gets what, and especially where a beneficiary gives up one interest in exchange for another, the analysis changes and an exchange can be found. Gift and estate tax questions ride alongside the income tax ones. A beneficiary who consents to a change that reduces an interest may be treated as making a gift, which is why consents are handled with care rather than collected casually.

Numbers show why the question matters. Suppose the first trust holds 2,000,000 dollars of marketable securities carrying 900,000 dollars of built-in gain. If the movement to a second trust were treated as a sale, the federal tax at a 20 percent capital gain rate plus the 3.8 percent net investment income tax reported on Form 8960 would be about 214,200 dollars. Because a properly structured decanting that leaves the beneficial interests substantially alone is not a realization event, that 214,200 dollars is not due, the securities keep their existing basis under the rules described in Publication 551, and nothing is reported on Form 8949. State income tax may follow a different rule from the federal one, so the analysis gets run twice.

The common mistake is reading no tax due as no tax work needed. A decanting still moves every tax attribute the trust owns, and some of them do not survive the trip. The Reed Corporation is a certified public accounting and tax firm. We do not practice law, and we do not draft decanting instruments or the notices that go to beneficiaries. Whether your state permits the exercise, and how the document should read, are questions for your attorney. Our role is to price the federal tax consequences and to coordinate with counsel while the plan is still on paper. Families who run the tax analysis before the trustee signs almost never meet a surprise afterward, and our tax strategy consulting group handles that review.

The three tools solve different problems, and trust decanting is only one of them. A division splits one trust into two or more separate trusts, usually along family lines so each child has a share with its own trustee and its own investment policy, or to separate property carrying generation-skipping exemption from property that does not. A merger, sometimes called a consolidation, does the reverse and combines two trusts with substantially identical terms so the family administers one set of books instead of two. A decanting changes the terms themselves. Division and merger generally keep the existing dispositive provisions and rearrange the containers, while a decanting is how a trustee reaches a provision the original document got wrong. Authority for each comes from the instrument or from state statute, and some states require court involvement for one and not the others. Timing differs as well. A division or merger is often a single instrument signed by the trustee, while a decanting in many states runs on a notice clock that has to expire before the transfer takes effect.

The income tax treatment of a division is usually mild. Splitting a trust into separate shares along existing beneficial lines is generally not a recognition event, and each resulting trust becomes its own taxpayer. That means a new employer identification number for each new trust, obtained on Form SS-4 or through the online process the Service describes at its employer identification number page, and its own annual fiduciary return. The first trust may need a final return for the period ending on the transfer date, and getting that period right matters because deductions and payments follow it. Investment income then gets reported by each trust separately, with interest and dividend items following the rules in Publication 550 and arriving on Form 1099-DIV and similar statements addressed to the new taxpayer.

The transfer tax side is where a division earns real money. A trust that received only a partial allocation of generation-skipping exemption has a mixed inclusion ratio, meaning part of every future distribution is exposed to the 40 percent generation-skipping transfer tax. A qualified severance divides that trust into one fully exempt trust and one fully taxable trust, so the exempt trust can hold the assets expected to grow the most. The severance has to meet stated requirements, including a division on a fractional basis and resulting trusts whose terms carry forward the original ones. Take a 5,000,000 dollar trust with an inclusion ratio of 0.4. A qualified severance produces a 3,000,000 dollar exempt trust and a 2,000,000 dollar nonexempt trust. If the exempt trust triples over thirty years to 9,000,000 dollars, the 6,000,000 dollars of growth avoids a tax that would otherwise have run about 2,400,000 dollars at the 40 percent rate.

The mistake runs in the other direction. Trustees merge trusts for administrative convenience, one of them fully exempt and one of them not, and the combined trust ends up with a blended inclusion ratio. Exemption that was carefully allocated a generation ago is diluted in a single afternoon, and there is no way to unblend it. A merger can also disturb a trust’s state tax residency, since some states tax a trust based on where it was created or on who administers it. We ask for the inclusion ratio of every trust before anyone signs a merger agreement, and if the number is not in the file we rebuild it from the original returns. Trustees who inventory the tax attributes before choosing among the tools usually find that a division reaches the same practical goal without the cost, and keeping those records current through steady bookkeeping makes the next decision much easier.

Grantor trust status is the attribute most often disturbed and least often checked. Under sections 671 through 679, a trust is treated as owned by the person who created it when the document holds any of a list of powers, and the settlor then reports the trust’s income on a personal return. Whether the second trust carries that status depends entirely on which powers the new document holds. Adding a power to reacquire trust assets by substituting property of equivalent value under section 675(4)(C) usually turns grantor status on. Removing the power that supported the status turns it off. The trustee is not free to pick the result from a menu, because the powers have to be permitted by the decanting authority in the first place, which is again a question for counsel. Whether the first trust filed as a grantor trust or as a complex trust also drives what the second trust’s opening return looks like. The settlor’s death changes the picture as well, since a grantor trust generally stops being one at that point and becomes a separate taxpayer with its own return and its own compressed bracket structure.

Both directions carry consequences. Turning status off during the settlor’s lifetime is generally treated as a transfer of the assets from the settlor to what has become a separate taxpayer. Where the trust holds property encumbered by debt greater than its basis, that deemed transfer can trigger gain, the same principle that applies when a grantor trust holding leveraged real estate loses its status. Turning status on is usually not a taxable event by itself, and it has a quiet benefit. The settlor then pays income tax on trust income out of personal funds, which shifts value to the beneficiaries without using any lifetime exemption. On 100,000 dollars of trust income taxed at 37 percent, that is 37,000 dollars a year moved to the next generation with no gift reported. A settlor who later tires of that annual cost cannot always shed it, because the power creating the status often sits with someone else to release.

Basis is the other attribute families misread. A decanting is a gratuitous transfer, so the assets keep the basis they already had under section 1015 rather than receiving a new one. There is no step-up. Only property included in a decedent’s gross estate receives a new basis under section 1014. A trust holding 2,000,000 dollars of real estate with a 300,000 dollar basis still has a 300,000 dollar basis in the second trust, and the 1,700,000 dollars of built-in gain travels with it. Holding period tacks along with basis, so a long term asset stays long term for the new trust. Rules for gain on the eventual sale are set out in Publication 544, with basis mechanics in Publication 551 and reporting on Schedule D.

The common mistake is a family that decants specifically hoping to reset basis on appreciated property. It does not work, and the effort can create a gift or a realization event that would not otherwise have existed if beneficiaries are asked to consent to changes in their interests. We map the basis and the grantor status before the trustee acts, and we flag any asset where a change in status would produce gain. We also confirm whether any asset carries depreciation recapture, because that character follows the property rather than the trust and changes the rate on a future sale. Where the goal really is a basis adjustment, the planning belongs in the estate inclusion analysis with your attorney rather than in the decanting document, and starting that conversation years before it is needed leaves far more room to work.

Both, and these are the two failures that cost the most. Start with the S corporation problem. Only certain trusts may hold shares of an S corporation, and when assets move to a second trust, the second trust is a different taxpayer that has to qualify in its own right. An electing small business trust election or a qualified subchapter S trust election generally has to be made for the new trust within two months and sixteen days of the transfer, signed by the trustee in the first case and by the income beneficiary in the second, and filed with the service center where the company files its Form 1120-S. Miss that window and the company’s S election terminates, which is a problem for every other shareholder as well. A trust holding a partnership interest raises its own questions, since a transfer can affect a section 754 election and the allocation of income for the year of the move. The eligible owner rules sit within the framework the Service outlines on its business structures page.

Relief exists but it is not free. Revenue Procedure 2013-30 offers a simplified path for a late election made within three years and seventy five days when there is reasonable cause and consistent reporting. Beyond that the trustee is requesting a private letter ruling for inadvertent termination relief under section 1362(f), which carries a user fee and a wait measured in months. Meanwhile the first sign of trouble often arrives by mail as a notice, and the Service explains those in its guide to understanding your IRS notice or letter. A company earning 1,000,000 dollars that is treated as a C corporation for two years while relief is pending faces roughly 210,000 dollars a year of entity level tax at the 21 percent rate, or 420,000 dollars across the two, plus tax again on any distributions. The corporation itself has no say in the matter and no way to stop it, which is why shareholder agreements often require a holder to give notice before moving shares into another trust.

The generation-skipping side is quieter and can be larger. A trust that was irrevocable before September 25, 1985 sits outside the generation-skipping transfer tax entirely, and a trust with a zero inclusion ratio is fully protected by allocated exemption. Regulations provide safe harbors for modifying either one. A modification that shifts a beneficial interest to a beneficiary in a lower generation, or that extends the time for vesting beyond the period allowed under the original terms, falls outside the safe harbor and can cost the protection. Regulations also treat a discretionary distribution authorized by the original terms differently from one depending on a later modification, so the source of the trustee’s authority matters. Consider a 4,000,000 dollar grandfathered trust decanted into a document that stretches the term for another two generations. If the protection is lost, distributions to grandchildren face the 40 percent tax, roughly 1,600,000 dollars on the current balance and more as the trust grows.

The common mistake is starting with the document instead of the balance sheet. A trustee reads the state statute, confirms the exercise is permitted, and never inventories what the trust actually holds. We ask for the asset schedule, the inclusion ratio, and a list of every closely held interest before anyone drafts anything, and we tell counsel which of them constrain the plan. We put the findings in writing so the trustee has a record of what was checked and when. Trustees who run that inventory first almost never lose an election or an exemption, and the review costs a fraction of what a single ruling request would.

The lines are firm. We are a certified public accounting and tax firm. We do not practice law. We do not draft the decanting instrument, we do not prepare the notices that go to beneficiaries, and we do not advise on whether your state’s statute permits what the trustee wants to do. Those belong to your attorney, and where a court petition is involved, entirely so. We also give no opinion on whether the finished document accomplishes the family purpose behind it. What we handle is the tax layer. We inventory the attributes riding on the assets, we model the federal consequences of the proposed move, and we say plainly when the tax result argues against a plan that otherwise looks attractive. Where a corporate trustee is involved, we work from its own tax reporting rather than asking it to change systems, and we reconcile the two sets of numbers ourselves. We never promise a particular estate tax or income tax outcome, because both the facts and the law keep moving.

In practice the work has a rhythm. Before the trustee acts, we build an attribute schedule covering basis in each asset, grantor status, the generation-skipping inclusion ratio, any closely held business interest, capital loss carryforwards, and suspended passive losses. Attributes are where value quietly disappears. Section 642(h) sends unused capital loss carryovers and excess deductions to the beneficiaries when a trust terminates, so whether the first trust is treated as terminating or as continuing changes who owns those figures. We also check whether the trust made elections that have to be repeated, since an election attaches to a taxpayer rather than to a family. Distributions made during the transition need to be characterized as coming from income or from principal, because that drives what each beneficiary reports. After the trustee acts, we obtain a new employer identification number where one is needed through the process the Service describes at its employer identification number page, prepare the closing and opening fiduciary returns, and reset the quarterly payments using the framework on the estimated taxes page. Records are kept along the lines of the Service’s recordkeeping guidance, because no return is beyond an audit and the file has to stand by itself years later.

Here is what a single overlooked attribute costs. A trust carries a 180,000 dollar capital loss carryforward from a bad year. Decanted without thought, that carryforward can be stranded in a trust that no longer holds assets to generate gain against it. At a combined 23.8 percent rate the carryforward was worth about 42,840 dollars of future tax savings, which is more than the entire planning engagement. Suspended passive losses raise the same question and are often worth as much. If your family is considering a trust decanting this year, you can Request Private Consultation and we will build the attribute schedule alongside your attorney before the trustee signs anything.

The mistake we correct most often is timing. A trustee signs in December and tells the accountant in April, by which point the first trust has filed nothing, the second trust has no identification number, and the beneficiaries have received distributions nobody has characterized. Sorting that out costs several times what a call in October would have. A short written timeline agreed with counsel before the signing date usually removes the problem, because everyone can see which filing depends on which act. Beneficiaries who receive distributions report them on their own returns, which our individual tax return group prepares so the fiduciary and personal filings agree. As more states adopt these statutes and more families use them, keeping your attorney and your accountant in one conversation is what separates a clean transition from a repair project.