On Aug. 17, 2011, Gov. Andrew M. Cuomo signed a bill liberalizing New York's decanting statute (EPTL §10-6.6(b)). New York was the first state to enact decanting legislation in 1992. The new law, which is effective immediately and applies to all trusts created before or after the effective date, broadens the scope and application of EPTL §10-6.6(b), bringing New York's statute more in line with other states' more liberal decanting statutes.
The ability to decant means the trustee of an irrevocable trust may appoint the assets of an existing trust to a new trust with greater flexibility or more favorable terms. The decanting statute has been a highly effective tool for trustees faced with changed circumstances, administrative inflexibility and tax inefficiencies, but until now has had limited application.
Prior to the new legislation, a trustee needed "absolute discretion" in order to decant. This meant that any limitations on a trustee's power to invade principal (i.e., a power limited by an ascertainable standard) precluded decanting. The new law, by contrast, permits decanting in the absence of absolute discretion to invade principal. Rather, the determinative factor is the trustee's power to invade principal for any purpose.
New Provisions
The new law establishes a bright line test. Central to this is the concept of unlimited discretion. Unlimited discretion, as defined in the statute, means the unmodified right to distribute principal. Words such as best interests, comfort, welfare or happiness are not to be construed as limitations or modifications of a trustee's right to distribute principal.
The statute is more permissive if a trustee has unlimited discretion. For example, if an authorized trustee1 has unlimited discretion to invade principal of an existing trust (the invaded trust), and exercises the power to appoint principal to a new trust (the appointed trust), then the current and remainder beneficiaries of the appointed trust need not be identical to the invaded trust. Rather, the current and remainder beneficiaries of the appointed trust may be any one or more of the beneficiaries of the invaded trust, to the exclusion of others.
Further, the trustee may grant a discretionary power of appointment (including a presently exercisable power of appointment) to any one or more beneficiaries of the appointed trust, provided that any beneficiary granted a power to appoint could receive distributions of principal outright under the terms of the invaded trust. If the trustee grants a power of appointment to a beneficiary that could receive outright distributions of principal under the invaded trust, the power may exclude as potential appointees only the beneficiary, the creator, the creator's spouse, or any of the estates, creditors or creditors of the estates of the beneficiary, the creator or the creator's spouse.
A trustee whose discretion is not unlimited has less flexibility. An authorized trustee with the power to invade principal but without unlimited discretion may appoint principal to a new trust only if the current and remainder beneficiaries of the appointed trust are the same as in the invaded trust. In addition, the distribution standard and any powers of appointment granted to beneficiaries in the appointed trust (including the class of permissible appointees) must mirror what is in the invaded trust. Significantly, however, the appointed trust may have a longer term than the invaded trust (including a term measured by the lifetime of a current beneficiary), and the distribution standard may be liberalized during the extended term. In either case, the appointed trust may be an existing trust, a new trust established by the invaded trust's creator, if alive, or a new trust established by the decanting trustee.
The new law specifically directs an authorized trustee to consider the tax implications of the exercise, and specifically precludes any exercise of the power to appoint that would jeopardize any deduction or exclusion claimed with respect to a contribution to the invaded trust that qualified for the marital or charitable deduction, the annual exclusion under IRC §2503(b), or any other transfer tax benefit.
The statute enumerates further restrictions on the exercise of the power. A trustee's power to appoint to a new trust may not be used to limit, reduce or modify any beneficiary's current right to receive mandatory distributions of income or principal, including a mandatory annuity or unitrust interest or right of withdrawal, provided that right has vested.
However, an authorized trustee may exercise the power to affect mandatory rights if the exercise is in favor of a supplemental needs trust that conforms to EPTL §7-1.12. The power may not be exercised to indemnify or exonerate a trustee from liability or to remove a right to remove or replace the trustee. Further, decanting may not be used to change the trustee's compensation unless a court directs otherwise, and a trustee is not entitled to paying commissions for exercising the power. Lastly, the power may not be exercised in a manner that violates the Rule Against Perpetuities.
The new law codifies both a fiduciary duty and a standard of care. An authorized trustee has a fiduciary duty to exercise the power in the best interests of one or more of the beneficiaries of the invaded trust, and must exercise the power as a prudent person would under the prevailing circumstances. The power may not be exercised if there is substantial evidence of a contrary intent on the part of the creator and it cannot be established that the creator's intent would have been different under the circumstances existing at the time of the exercise. The fact that the invaded trust contains a spendthrift clause or generally prohibits amendment or revocation does not, by itself, constitute "substantial evidence of a contrary intent."
The new statute addresses the procedural requirements for decanting. The trustee must execute a notarized written instrument, specifying what percentage of the invaded trust is being decanted. The exercise of the power becomes effective 30 days from the date the decanting instrument is served on all interested parties by personal delivery, certified mail with return receipt requested, or any other method prescribed by the court, unless all interested parties consent in writing earlier.
A copy of the invaded trust agreement and the appointed trust agreement must accompany the decanting instrument. Interested parties include the trust creator, if living, any person having the right in the invaded trust to remove or replace the authorized trustee, and any person "interested" in the invaded trust and the appointed trust. An interested person is anyone who would be entitled to service of process in a judicial settlement proceeding of the trustee's account under §315 of the Surrogate's Court Procedure Act. The consent of the creator, if living, is not necessary. Similarly, court approval is not necessary, although the trustee may seek approval if desired. Unlike the prior statute, for an inter vivos trust, there is no requirement to file the decanting instrument with the Surrogate's Court, unless there have already been proceedings in the Surrogate's Court regarding the invaded trust. The filing requirement for a testamentary trust remains.
Any person interested in the invaded trust may object to the trustee's exercise of the power by serving a written notice of objection on the trustee prior to the effective date of the exercise. Failure to object does not, however, constitute consent to the exercise.
Statute in Action
The following examples illustrate some possible applications of the broader decanting power:
Example 1. Father establishes a trust for the benefit of his 10-year-old son, with his brother as trustee, and funds it with interests in the closely-held family business. Son may receive distributions for health, support, maintenance or education until age 25, when the remaining balance of son's trust is to be distributed to him. Ten years later, the family business is sold for a large gain, and son's trust receives significant assets. The trustee determines that it is no longer appropriate for son to receive the entire trust at age 25. Using EPTL §10-6.6(b), the trustee decants the original trust assets into a new trust established by father. The appointed trust provides that son may receive distributions for health, support, maintenance or education until age 25, and thereafter, for any reason, and the trust assets may not be distributed entirely to son until age 40.
Example 2. Grandfather establishes an insurance trust that creates separate shares that pay out to his children at age 50. If any child dies before age 50, the assets of the child's trust are paid to the child's children. Unbeknownst to the grantor, generation-skipping transfer tax (GST) exemption is automatically allocated to all contributions made to the trust, including the payment of insurance policy premiums. After grandfather's death, the trustee uses the decanting power under EPTL §10-6.6(b) to transfer the assets to a new trust, created by trustee, that continues for the lifetime of each child and pays out at specified ages to grandchildren, therefore taking full advantage of the GST exempt status of the trust.
Example 3. Grandfather creates a pot trust for the benefit of his grandchildren, and provides that the trustee may make distributions to any one or more grandchildren for any reason, with the request that the trustee make distributions for his grandchildren's education, until his youngest grandchild attains the age of 30, at which time the remaining trust assets will be distributed in equal shares to his then surviving grandchildren. After grandfather's death, two of his six grandchildren develop significant substance abuse problems. The trustee uses the decanting power under EPTL §10-6.6(b) to appoint the trust assets to a new trust, created by trustee, of which only the other four grandchildren are the current and remainder beneficiaries.
Example 4. Father's Will creates a trust for the benefit of his daughter and her children, but father has no remaining GST exemption to allocate to this trust. The trust lasts for daughter's lifetime and is payable to her children on death, at which time there will be a taxable termination. The trustee may distribute income and principal to daughter during her lifetime for any reason. The trustee determines that it would be advantageous to postpone the imposition of GST tax on daughter's death and decants to a new trust, created by the trustee, for the benefit of daughter and her descendants. The trustee gives daughter a broad limited power of appointment, which she exercises to add a non-skip beneficiary, interposing a new beneficiary between her and her children, thereby effectively postponing the imposition of GST tax until the death of the appointee.
Factors to Consider
While the decanting power provides increased flexibility to accommodate unforeseen future events, there are several factors that should be considered before using the decanting power.
First, while a trustee may naturally be inclined to obtain the beneficiaries' consent before exercising the power to decant, it may be more advantageous for the beneficiaries not to do so. A beneficiary who consents to the postponement, or perhaps elimination, of his or her right to receive trust assets could be deemed to have made a gift to the remainder beneficiaries of the trust.
Second, special care should be taken to preserve any GST benefits of the invaded trust. The new statute directs the trustee to consider the tax implications of the exercise of the power, which would include both gift and GST tax, but goes into no further detail.
Third, while the statute gives trust beneficiaries the right to object to the decanting of a trust, it does not specify how beneficiary objections will be addressed. Quite possibly, a trustee will have to seek the guidance of the court if any objections are received.
The expanded decanting statute is an important tool in a trustee's arsenal. With its broader scope, the potential applications are varied and numerous. However, trustees should be mindful of any limitations on their own discretion and wary of potential tax traps prior to exercising the power.
Katherine E. Cauley is a partner and Britta L. McKenna is a senior associate in the estates and trusts practice group at Hodgson Russ.
Endnotes:
1. An authorized trustee is any trustee of an invaded trust other than the creator or a beneficiary with a current or future right to receive income or principal.
