DECANTING (or when an Irrevocable Trust is not irrevocable)
The Problem: What if you created an Irrevocable Trust years ago that does not work today?
1. Bad Tax Consequences
A husband died years ago and created an Irrevocable Family Trust with discretionary income and principal distributions to his wife for life and, at her death, the remainder to his children. The Trust was funded with $1,000,000 in assets that have now appreciated in value to $2,500,000. The Trust is excluded from Federal Estate Tax (FET) at the wife’s death. She is the Trustee.
Wife has assets of her own totaling about $1,500,000. Therefore, the combined trust’s and wife’s assets equal $4,000,000, well below both (i) the current FET Exemption (amount you can pass estate tax free) of $11,180,000 per person and (ii) the FET Exemption when it reverts on January 1, 2026 to $5,600,000 (plus indexing for inflation).
So, with or without the Trust, no Federal Estate Tax will be assessed.
But what about Federal Income Tax (FIT)?
Under a concept called “stepped-up basis,” assets that are included in a decedent’s estate for FET purposes receive a new FIT basis equal to the asset’s fair market value on the date of death. For example, if I bought a stock for $50 and sold it for $100 dollars on the day before I died, I would pay capital gains tax on the $50 of appreciation ($100 value - $50 basis = $50 gain). However, if my estate sold that same stock for $100 on the day after I died, my estate would pay no capital gains tax ($100 value - $100 stepped-up basis = $0 gain).
That is the problem with this Trust for tax purposes. If the Trust’s assets were not exempt from FET at the wife’s death, her estate would still pay no FET, because $4,000,000 is below the $11,180,000 FET Exemption. However, when the children sell the Trust’s assets, they will incur capital gains tax on $1,500,000 of gain that was realized between the time the assets were deeded to the Trust and their value when sold ($2,500,000 sale price less the $1,000,000 basis). If the Trust could be changed so that the assets are included in the wife’s estate for FET purposes, the children could enjoy a stepped-up basis of $2,500,000 and avoid that looming capital gains tax liability.
Can this “Irrevocable” Family Trust be amended to avoid that capital gains tax?
2. Changed Family Circumstances
At his death years ago, a husband created an Irrevocable Trust with discretionary income and principal distributions to his wife (also the Trustee) for life, then income to his children for their lives, remainder to his grandchildren at 35. His purpose was to avoid both FET and Generation Skipping Tax (GST), a tax like FET that taxes transfers to grandchildren, at not only his wife’s death but also his children’s deaths.
Today, neither his wife nor children have estates exceeding $3,000,000, so no FET nor GST is anticipated. All the children are solid and financially astute, and his wife wants to terminate the Trust and give and bequeath the assets to her children.
Can the Trust be terminated?
3. Other Examples
Some other situations that can cause problems:
- The successor Trustee is no longer a good candidate.
- A descendant has creditor or substance abuse issues.
- The Trust has an error.
- A descendant is otherwise eligible for Medicaid, e.g. special needs grandchild.
The Solution – Part 1 (Decanting)
Wikipedia defines “wine decanting” as when wine that contains sediment is poured from one jar into a decanter to separate the sediment from the wine itself. In the process, the sediment remains in the first jar, and the sediment-free wine is transferred to the decanter.
Indiana Code § 30-4-3-36 allows one to accomplish the same result with eligible trusts. The assets of an existing Trust with “sediment” are transferred to a new Trust without that sediment.
To be eligible:
(i) The existing Trust must currently allow principal distributions;
(ii) The beneficiaries of both the existing Trust and the new Trust must be the same;
(iii) The new Trust must not reduce any income, annuity, or unitrust interest in the existing Trust;
(iv) The Trustee must be willing to decant; and
(v) The beneficiaries must be notified that the Trustee intends to decant the assets of the existing Trust to a new Trust.
If no objection is anticipated from any beneficiary, decanting can convert a “bad” trust into a “good” trust.
The Solution – Part 2 (Court Reformation)
What if decanting is not available, e.g., where a corporate Trustee will not decant due to liability concerns?
Indiana Code § 30-4-3-24.5 provides an alternative to decanting. If a beneficiary can show the Court that, due to changed circumstances since the Trust was created, the Trust needs to be amended, the Court has the power to reform the Trust.
The bottom line: an Irrevocable Trust is not always irrevocable. Decanting and Court reformation are possible alternatives to fix a “bad” trust. If you have an Irrevocable Trust that needs to be changed, please contact us to learn more about your alternatives.
James Koday concentrates his practice in the area of estate tax planning, succession planning, estate administration, and mediation. He can be reached at (260) 423-8844 or via email at firstname.lastname@example.org.