IRS Guidance Anticipated for Tax Effects of Trust Decanting

 By Rose Drupiewski

The IRS announced that it would place the issue of trust “decanting” on its priority list of items to focus on in 2011 and 2012 for purposes of providing taxpayer guidance.   Decanting occurs when a trustee, pursuant to authority provided in the trust agreement or under state law, transfers property from one trust to another.  Decanting powers have recently become popular with trust drafters as a way to provide additional flexibility to trustees when managing trust assets on behalf of beneficiaries.

The reason for the popularity of decanting powers is that such powers can provide flexibility to otherwise inflexible irrevocable trust agreements.  For example, if a trust agreement provides for an outright distribution of assets to a trust beneficiary at age 25 and the trustee has determined that the beneficiary lacks enough maturity at that age to handle a large distribution, the trustee could (if permitted under the trust agreement or state law) transfer the assets to another trust for the benefit of such beneficiary that will not terminate at age 25 but at a later date.

Although decanting can be extremely useful from the standpoint of flexibility, such flexibility may come with undesirable tax consequences.  The gift, estate, GST and income tax consequences of decanting are less than clear.  For example, there has been some concern that the presence of a decanting power may transform an otherwise irrevocable trust into a revocable trust for estate tax purposes, thus causing the assets in the trust to be included in the grantor’s gross estate.  This is obviously an undesirable consequence because many irrevocable trusts are created for the purpose of enabling a grantor to make gifts to family members in trust without causing estate tax inclusion.  There is also some concern as to whether, if the trustee is a beneficiary of the trust, the trustee’s decanting power might be deemed a general power of appointment for estate tax purposes, which might cause unwanted estate tax consequences for the trustee.  These are just a few examples of multiple unresolved gift, estate, GST and income tax issues relating to trust decanting powers.  Because of the lack of clarity regarding the tax effects of decanting and the hope for favorable guidance, the IRS’s announcement is welcome news for many tax planners and their clients.

In connection with the IRS priority plan, the IRS has recently requested comments from the general public regarding the tax implications of decanting powers.  Comments should be submitted to the IRS by April 25, 2012.

Explore posts in the same categories: Estate Planning, Gift Taxes, Income Tax, Tax, Tax Returns

Tags: income tax, income tax consequences, IRS, trust beneficiary, Trust Decanting

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