For years, practitioners have freely used irrevocable trust decantings as a means to make various changes to irrevocable trusts without concern of giving rise to gift tax consequences. However, the Internal Revenue Service’s (“IRS”) Chief Counsel Advice Memorandum (CCA 202352018) (the “CCA”) may be the death to irrevocable trust decantings as we know them.

The term “irrevocable trust” is somewhat of a misnomer—there are mechanisms by which irrevocable trusts can be modified in certain respects. Generally, irrevocable trusts can be modified in one of two ways depending on applicable state law: (i) some states, such as New Jersey, Pennsylvania, and Connecticut, permit an irrevocable trust to be modified with the consent of the beneficiaries and the trustee (some states also require the consent of the settlor if he or she is then living), which is typically referred to as a “non-judicial modification;” and (ii) some states, such as New York, Delaware, and Florida, permit an irrevocable trust to be modified by a decanting, which is a process by which an authorized trustee exercises his or her independent discretion to pay over the property of the trust to a new trust that has different terms.

For years, practitioners have been concerned that using a non-judicial modification to make certain changes with the consent of the beneficiaries (such as removing a beneficiary, shifting beneficial interests, or diluting a beneficiary’s interest), may be deemed to be a taxable gift by the beneficiaries. However, this concern was not present with respect to decantings since a decanting is effectuated by the independent act of an authorized trustee, who does not have a beneficial interest in the trust, without the consent of the beneficiaries. That was, until the CCA.

In the CCA, the facts were as follows: “[i]n Year 1, A establishes and funds Trust, an irrevocable inter vivos trust, for the benefit of A’s Child and Child’s descendants . . . Under the governing instrument of Trust, a trustee may distribute income and principal to or for the benefit of Child in the trustee’s absolute discretion. Upon Child’s death, Trust’s remainder is to be distributed to Child’s issue, per stirpes . . . In Year 2, when Child has no living grandchildren or more remote descendants, Trustee petitions State Court to modify the terms of Trust. Pursuant to State Statute, Child and Child’s issue consent to the modification. Later that year, State Court grants the petition and issues an Order modifying Trust to provide a trustee of Trust the discretionary power to reimburse A for any income taxes A pays as a result of the inclusion of Trust’s income in A’s taxable income.”^[1]

The Chief Counsel finds that “[u]nder the governing instrument of Trust, Child and Child’s issue each have an interest in the [T]rust property. As a result of the Year 2 modification of Trust, A acquires a beneficial interest in the [T]rust property in that A becomes entitled to discretionary distributions of income or principal from Trust in an amount sufficient to reimburse A for any taxes A pays as a result of inclusion of Trust’s income in A’s gross taxable income. In substance, the modification constitutes a transfer by Child and Child’s issue for the benefit of A . . . The gift from Child and Child’s issue of a portion of their interests in [T]rust should be valued in accordance with the general rule for valuing interests in property for gift tax purposes . . . .”

This finding is consistent with the concerns of many practitioners that a modification of an irrevocable trust with the consent of the beneficiaries, which dilutes or potentially dilutes the beneficiaries’ interest in the trust, may constitute a taxable gift from the beneficiaries. However, the Chief Counsel goes on to state, “[t]he result would be the same if the modification was pursuant to a state statute that provides beneficiaries with a right to notice and a right to object to the modification and a beneficiary fails to exercise their right to object.”

This additional comment from the Chief Counsel appears to foreshadow the IRS’ position with respect to decantings—even though a decanting is effectuated by an independent act of an authorized trustee, if a beneficiary has the right to notice of the decanting and fails to object to the decanting, for gift tax purposes, the beneficiary will be deemed to have consented to the changes that were made to the trust.

This additional comment from the Chief Counsel may prove to be problematic for the future of decantings. Most states that authorize trust decantings by statute require the authorized trustee to provide the beneficiaries with notice of the decanting and provide that, unless the beneficiaries consent to an earlier effective date, the decanting will only be effective after a period of time elapses following the beneficiaries’ receipt of notice. As such, a decanting of an irrevocable trust with notice to the beneficiaries may now be deemed to be the beneficiaries’ consent to the changes to the trust, which may give rise to gift tax implications.

However, this additional comment from the Chief Counsel likely will not foreclose all possible options with respect to decantings. Although decantings are permitted under the laws of various states, many practitioners include provisions in their irrevocable trusts authorizing the trustee to decant the trust under the terms of the trust (this is known as an “internal decanting provision”). If the internal decanting provision does not require notice to be provided to the beneficiaries and provide them with an opportunity to object, the future of internal decanting provisions appears to be outside of the purview of the Chief Counsel’s discussion in the CCA.

Nevertheless, it is yet to be seen whether the IRS will issue further guidance on the intersection between decantings and gift tax implications, including how to value the “gift” made by the beneficiaries. Be that as it may, to the extent that any individual would like to explore the possibility of modifying an irrevocable trust, it is always best to speak with your trust and estates counsel, who will be able to advise on the options and potential risks.

FOOTNOTES

[1] For income tax purposes, an irrevocable trust is classified as either a “grantor trust” or a “non-grantor trust” depending on the terms of the trust, the trustees of the trust, and the beneficiaries of the trust. When an irrevocable trust is classified as a grantor trust, the trust is treated as owned by the settlor or the donor for income tax purposes, requiring the settlor to report all matters of income and deduction with respect to the trust on his or her own individual income tax returns. When an irrevocable trust is classified as a non-grantor trust, the trust is deemed to be a separate taxpayer, requiring the trustees to file annual income tax returns for the trust (known as fiduciary income tax returns) reporting all matters of income and deduction with respect to the trust. With respect to grantor trusts, the IRS has previously found that applicable state law or a provision in a trust agreement that provides the trustee with the discretion to reimburse the settlor for the income tax liabilities attributable to the trust property does not cause an estate tax inclusion risk and mere reimbursement is not deemed to be a gift by the beneficiaries, provided that certain requirements are satisfied (see Rev. Rul 2004-64).