The Internal Revenue Service, on a periodic basis, issues revenue procedures that provide a list of issues on which the IRS won’t issue private letter rulings or determination letters, often referred to as the “no-ruling list.” Perhaps unsurprisingly, when new tax issues are added to the no-ruling list, especially for popular estate planning and trust administration techniques, it can sometimes cause a significant amount of consternation among practitioners and trust fiduciaries. They may be concerned that the addition of a new tax issue to the no-ruling list could be a precursor to future guidance from the IRS that ultimately curtails or even eliminates planning techniques they’ve consistently used.
One popular technique on this list is decanting. What, if anything, should trustees and other fiduciaries do to protect themselves when faced with potential uncertainty regarding the tax consequences of this technique?
Not long after states began enacting decanting statutes, practitioners began using them and seeking guidance from the IRS in the form of PLRs as to the tax effects of decantings (income tax, estate and gift tax and/or generation-skipping transfer (GST) tax). But in 2011, the IRS added decantings that result in a change of beneficial interests to its no-ruling list. Specifically, IRC Sections 661, 662, 2501, 2601 and 2663 were added to “Areas Under Study in Which Rulings or Determination Letters Will Not Be Issued Until the Service Resolves the Issue Through Publication of a Revenue Ruling, Revenue Procedure, Regulations or Otherwise.”
Also in 2011, the IRS released Notice 2011-101, requesting comments regarding when, and under what circumstances, decantings that result in a change in beneficial interests aren’t subject to income, gift, estate and/or GST taxes. Despite receiving substantial comments from the American Bar Association (Section of Real Property, Trust & Estate Law), the American College of Trust and Estate Counsel, the American Institute of CPAs and various state bar associations, the IRS has yet to issue permanent guidance or remove decantings that result in a change in beneficial interests from its no-ruling list.
Decanting Remains Popular
Although decantings that result in a change of beneficial interests remain on the no-ruling list, it doesn’t appear that practitioners have abandoned this method of modifying trusts. Rather, the use of decanting seems only to have grown. For example, as of 2011, when the IRS released Notice 2011-101, the number of states that had enacted decanting statutes was only 17. This number has more than doubled, as there are now 36 states with some form of decanting statutes.
So, what then, are practitioners relying on to provide some level of comfort before moving forward with a trust decanting? For starters, the IRS didn’t include decantings that result only in administrative changes to its no-ruling list, meaning that practitioners should still be able to obtain PLRs for these types of decantings. In addition, relevant guidance can be found in the form of safe harbors contained in the Treasury regulations.
Treasury Regs Guidance
For states like Delaware that treat decantings as an exercise of a limited POA by the trustee, practitioners could look to Treas. Regs. Section 26.2601-1(b)(1)(v)(B). This safe harbor provides that the exercise of a limited POA over a grandfathered trust won’t result in a loss of GST tax-exempt status unless the exercise of the POA postpones or suspends the vesting, absolute ownership or power of alienation of an interest in property beyond the federal perpetuities period, defined as a life in being when the trust was created plus 21 years, or 90 years from the date of the creation of the trust. However, pursuant to PLRs issued in 1998, the IRS determined that Treas. Regs. Section 26.2601-1(b)(1)(v)(B) wasn’t directly relevant in situations in which participation or concurrence by the court and/or trust beneficiaries was required, which is necessary under a number of states’ decanting statutes.
Additional Safe Harbors
If Treas. Regs. Section 26.2601-1(b)(1)(v)(B) isn’t applicable, there are two other safe harbors that practitioners should consider, specifically, Treas. Regs. Section 26.2601-1(b)(4)(i)(A) (the discretionary distribution safe harbor) and Treas. Regs. Section 26-2601-1(b)(4)(i)(D) (the trust modification safe harbor). Under the discretionary distribution safe harbor, a decanting shouldn’t result in the loss of GST tax-exempt status if the following requirements are satisfied: (1) when the trust became irrevocable, either the terms of the trust instrument or local law, that is, a statute or common law, authorized distributions of trust property to a new trust
(or retention of trust principal in a continuing trust); (2) neither beneficiary consent nor court approval is required for such distribution or retention; and (3) the terms of the new trust (or continuing trust) won’t delay the vesting of an interest in the trust beyond the federal perpetuities period.
In the event that beneficiary consent or court approval is required by state law, then practitioners can look to the trust modification safe harbor. Under this safe harbor, decanting shouldn’t result in the loss of GST tax-exempt status if the following requirements are satisfied: (1) the modification won’t shift a beneficial interest in the trust to a beneficiary occupying a lower generation than the persons holding the beneficial interests in the original trust; and (2) the modification won’t extend the time for vesting of any beneficial interest in the trust beyond the period provided for in the original trust. With respect to the first requirement, the Treasury regulations note that if a trust modification results in either an increase in the amount of a GST or creates a new GST, there’s a deemed shift in beneficial interests. In addition, if the effect of a modification can’t be determined immediately after it’s made, there’s deemed to be a shift in a beneficial interest to a lower generation.
It’s worth noting that the safe harbors apply specifically to grandfathered trusts. However, the IRS has suggested that the safe harbors should also apply to non-grandfathered trusts.
Pursuant to the foregoing, practitioners should take time to understand the specific requirements of their state’s decanting statutes to determine which safe harbor they can rely on before engaging in a decanting transaction that will result in a change of beneficial interests. If you’re in a state like Delaware, which doesn’t require court approval or beneficiary consent to decant, you should be able to rely on the discretionary distribution safe harbor, provided the trust becomes irrevocable after the enactment of your state’s decanting statute and the trust wasn’t initially governed by another jurisdiction that didn’t permit decantings or required court approval and/or beneficiary consent at the time the trust became irrevocable. For example, the discretionary distribution safe harbor isn’t available for an irrevocable trust established in Pennsylvania on July 1, 2003 and later moved to Delaware.
In some states, there’s also a potential workaround to obtain a PLR for a decanting that will result in a change of beneficial interests, which is to seek a PLR as a trust modification. Under Delaware’s decanting statute, for instance, a trustee can exercise its authority to invade the principal of the trust and appoint all or a part of such principal into the existing trust, as modified. The result is that the decanting is a de facto modification of the existing trust. Because trust modifications aren’t on the IRS’ no-ruling list, a cautious practitioner should still be able to obtain a PLR but probably should take caution not to use the term “decanting” in the request.
*This article is an abbreviated version of “No Ruling, No Problem?” which appears in full in the June 2022 issue of Trusts & Estates.