¶ 1801
Overview
Scope of the chapter. Chapter 17 examined the trust law of decanting: where the power comes from, the uniform act and the leading state statutes, and the fiduciary limits on its use (see supra ch. 17). This chapter examines what the federal tax system does with the result. A decanting moves property from one trust to another, or rewrites the terms of a trust, without a court and usually without the consent of the beneficiaries. Each of the federal taxes that touches a trust has its own question to ask about that event. The income tax asks whether the transfer is a distribution that carries out income, and whether anyone realizes gain. The gift tax asks whether any person with a beneficial interest has given part of it away. The estate tax asks whether the decanting gives anyone a power or interest that will draw the property into an estate. The generation-skipping transfer tax asks whether a trust that was exempt remains exempt. State income taxes and the rules that classify a trust as domestic or foreign ask whether the trust has moved. The chapter takes those questions in turn. It begins with the position of the Internal Revenue Service, which has studied decanting since 2011 and has not issued general guidance (¶ 1810). It then treats the income tax in two parts, distribution (¶ 1820) and realization (¶ 1830), followed by grantor-trust status (¶ 1840), the gift tax (¶ 1850), the estate tax (¶ 1860), the generation-skipping transfer tax (¶ 1870) and state and foreign status (¶ 1880). It closes with the tax protections built into the Uniform Trust Decanting Act, a table of the issues by tax, and the procedure a trustee should follow (¶ 1890).
Why tax decides most decantings. Trust law usually answers the question whether a trustee may decant. Tax law usually answers the question whether the trustee should. A trustee who has the power under the instrument or a statute must still exercise it in the interests of the beneficiaries (see supra ¶ 1770), and a decanting that produces an unexpected gift by a beneficiary, a loss of exemption from the generation-skipping transfer tax, or a recognition of gain on appreciated property will rarely be in their interests. The uniform act recognizes the point. Its tax-related limitations section forbids a second trust from losing a marital or charitable deduction, an annual exclusion, S corporation eligibility, a zero inclusion ratio and several other tax attributes that the first trust enjoyed (see infra ¶ 1890). New York's statute goes further and directs that "[a]n authorized trustee shall consider the tax implications of the exercise of the power." N.Y. Est. Powers & Trusts Law § 10-6.6(o). A trustee who has not worked through the analysis in this chapter has not met that duty.
The absence of guidance. No statute or regulation addresses decanting as such. The Treasury and the Service invited comments in 2011 on "when (and under what circumstances)" decantings that change beneficial interests escape income, gift, estate and generation-skipping transfer tax. Notice 2011-101, 2011-52 I.R.B. 932. They have not issued the guidance the notice anticipated. The only regulation that speaks directly to a trustee's distribution of principal to a new trust is the safe harbor for trusts that are grandfathered from the generation-skipping transfer tax, and the regulation itself warns that it does not decide the income, gift or estate tax consequences of the same transaction. Treas. Reg. § 26.2601-1(b)(4)(i). For the rest, the analysis proceeds by analogy: to distributions in further trust under subchapter J, to severances of trusts, to the exercise of powers of appointment, to the regulations on gratuitous transfers between trusts, and to the Service's private rulings and chief counsel advice on modifications of trusts. The analogies point in a consistent direction for the common decanting that changes administrative terms only. They diverge for a decanting that shifts beneficial interests, and that is where the risk lies.
The organizing distinction. The Service's own pronouncements draw one line, and this chapter follows it. A decanting that changes administrative terms, such as the identity or powers of the trustee, the governing law, the investment provisions, or the addition of a trust director, does not change who benefits from the trust or in what shares. A decanting that changes beneficial interests does. The notice confined its study to decantings "that result in a change in the beneficial interests in the trust," and stated that the Service would continue to rule on decantings "that do not result in a change to any beneficial interests and do not result in a change in the applicable rule against perpetuities period." Notice 2011-101, supra. The current no-rule list repeats the phrase "resulting in a change in beneficial interests" in each of its decanting items. Rev. Proc. 2026-3, § 4.01(37), (55), (61), 2026-1 I.R.B. 143. The first question in every tax analysis of a decanting is therefore a question of trust law: compared with the first trust, does the second trust change any person's beneficial interest, including a power of appointment, or extend the period during which the property may remain in trust? The answer determines which of the following paragraphs matter.
Parties to the analysis. A decanting can produce tax consequences for four different persons, and an analysis that considers only the trust will miss most of them. The first trust may realize gain or be treated as making a distribution. The second trust takes the property with a basis, a holding period, and possibly carried-out income. Each beneficiary may be treated as a donor if the beneficiary's interest is reduced and the beneficiary has consented or failed to object. The settlor may gain or lose status as the owner of the trust for income tax purposes and, if the settlor is alive and the trust becomes a grantor trust, may begin to pay tax on income the settlor does not receive. The trustee, if also a beneficiary, may hold a power that is a general power of appointment. The table in ¶ 1890 lists the issues by tax and by party.