Decanting and other trust modifications: potential tax consequences of transfers in trust

by Abby C. Boyd

With the recent passage of the Uniform Trust Decanting Act in Colorado, estate planners and their clients are reviewing whether irrevocable trusts should be modified or their assets transferred (“decanted”) into new trusts, in order to make changes to administrative provisions or to change beneficial interests.

The recent release of IRS Private Letter Rulings 201702005 and 201702006 serves as an important reminder that modification, decanting, or court-approved changes to a trust may have adverse income, estate, generation-skipping transfer or gift tax consequences.

Both of the above referenced private letter rulings involve similar facts. A pot trust, with beneficiaries including several family groups, was divided into several subtrusts with each family group given a stand-alone trust. The families involved in the splits sought IRS rulings on the tax consequences of the change. Splitting a pot trust into several stand-alone trusts is just one reason to modify a trust, there are numerous changes to trusts that may lead to the same tax consequences, e.g., changes to beneficial interests, decanting into new trusts for administrative purposes, etc.  The discussion below sets forth possible tax consequences of modifying a trust.

Estate Tax

Modification or transfer into a new trust may cause estate tax inclusion to a settlor or beneficiary. Inclusion may be caused by transfers within three years of the transferor’s death, or transfers in which the transferor retains any interest (reversionary or otherwise) in the possession or enjoyment of the trust or the right to designate beneficiaries. (I.R.C. §§ 2036, 2037, 2038). Transfers in trust in which the “distribution, management and termination provisions” of the old and new trusts are “substantially similar” will not likely lead to inclusion for beneficiaries. (PLR 201702005 at 12). Changes to beneficial interests, however, should be treated with caution for estate tax inclusion purposes.

Generation Skipping Transfer Tax

When modifying a trust that is exempt from generation-skipping transfer (GST) tax, one should consider whether that modification will cause the trust to lose its exempt status, thus causing the modified trust to be potentially subject to GST tax. I.R.C. 26.2601-1(b)(4)(i) provides the rules to determine whether a trust will lose its exempt status due to modification, judicial construction, settlement agreement, or trustee action. Very generally speaking, if the modification does not affect a beneficial interest (i.e., a modification is administrative in nature), it will not cause an exempt trust to lose its exempt status for GST purposes.

Gift Tax

Transfers between trusts may be subject to the federal gift tax under I.R.C. § 2501. Transfers (in trust or otherwise) for less than full or adequate consideration are subject to the federal gift tax. If the transfer will result in the beneficiaries having “substantially the same interests” in the modified trust, “no transfer of property will be deemed to occur” and thus the transfer to the modified trust will not be subject to the gift tax. (PLR 201702005 at 13). Changes to beneficial interests are more likely to be subject to the federal gift tax than administrative changes.

Income Tax

A modification may result in the creation of subtrusts, as in the private letter rulings named above. The creation of subtrusts may lead to the trusts being treated as separate trusts for federal income tax purposes and thus the modification may lead to additional filing requirements. I.R.C. § 643(f) states that if trusts have substantially the same grantor(s) and substantially the same beneficiaries, they will be treated as one trust for federal income tax purposes. In the case of a pot trust splitting into stand-alone trusts for each family group, each new subtrust will be considered a separate trust for income tax purposes.

In addition, asset transfers from one trust to another may result in the realization of gain or loss under I.R.C. §§ 661 or 662. Generally, divisions of trusts are not subject to these rules, if each asset is divided pro rata among the new trusts (Rev. Rul. 69-486). Capital gain may be recognized in transfers where assetsare not divided pro rata among the new trusts.

Transfers into a new trust or trusts may also affect the cost basis of the assets involved in the transfer. Generally, if the transfer does not cause capital gain or loss recognition, the cost basis of the assets will not be affected. However, if the transfer involves a gift, bequest, or devise, carryover basis may be impacted. See § 1.1015-2(a)(1).

While a general rule of thumb may be that sticking to administrative changes when modifying a trust is likely to keep one safe from tax consequences, it is important to have a tax professional evaluate any possible modifications or transfers in trust for adverse tax consequences.