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. Estate/tax planning professionals colloquially refer to this ever-evolving list 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. A critical initial point is that just because a tax issue is added to the no-ruling list doesn’t mean that there has been or will be any change to the Tax Code, nor does it mean that the IRS will ever actually provide further guidance on the matter. However, faced with potential uncertainty regarding the tax consequences of these techniques, what, if anything, should trustees and other fiduciaries do to protect themselves?
Let’s focus on the history of the no-ruling list as it relates to two popular planning and trust administration techniques: (1) the use of incomplete gift, non-grantor trusts (commonly known as “ING” trusts); and (2) decanting pursuant to state law. We’ll also discuss what options, short of avoiding these techniques altogether, that trustees may have to protect themselves from the risk of potential future tax changes.
ING Trusts
In an ING trust, the grantor may retain a beneficial interest in the trust while having the trust treated as a non-grantor trust for income tax purposes. The ING trust must be created in a jurisdiction that allows for self-settled asset protection trusts, because if creditors of the grantor can reach the trust assets, the trust will be a grantor trust.1 If structured correctly, the ING trust may allow for deferring or avoiding state income tax that the grantor would otherwise be subject to if the grantor didn’t part with ownership of the assets that the grantor transferred to the ING trust. Additionally, because the trust is a separate entity from the grantor for income tax purposes, the trust may separately avail itself of certain federal income tax benefits, including the ability to take its own capital gain exclusion on the sale of qualified small business stock.2 Because the funding of an ING trust is intended to be an incomplete gift, it allows the grantor to: (1) avoid using any of the grantor’s lifetime gift tax exemption on transfer, and (2) exercise a certain level of control over aspects of the trust’s administration that wouldn’t be possible if the trust were a completed gift.
Properly balancing the role of the grantor in an ING trust is critical to ensure that the trust is both a non-grantor trust for income tax purposes and an incomplete gift for gift tax purposes and touches on several provisions of the Internal Revenue Code and relevant Treasury regulations. For example, IRC Section 677(a)(3) provides that the grantor shall be treated as the owner of a trust for income tax purposes if trust income, without the approval or consent of any adverse party, may be distributed to the grantor or the grantor’s spouse.3 Therefore, for the trust to be a non-grantor trust for income tax purposes, the consent of an adverse party must be obtained prior to distributing assets to the grantor or the grantor’s spouse. This is most commonly accomplished through the creation of a distribution committee for the trust that consists of parties who are considered to be “adverse” to the grantor for income tax purposes and who broadly control distribution decisions, including the power to decide whether to distribute trust income or principal to the grantor. An ING trust is structured as an incomplete gift for federal gift tax purposes through the grantor’s retention of a lifetime limited power of appointment (POA) pursuant to which the grantor can appoint trust corpus to or for beneficiaries of the trust provided the power is limited by a reasonably definitive standard (sometimes referred to as the “grantor’s sole power”), a testamentary limited POA over the trust and through the grantor’s retention of a power whereby a distribution directed by any one member of the distribution committee must be approved by the grantor (often referred to as the “grantor’s consent power”).4
The IRS has issued numerous PLRs over many years that directly touch on the tax aspects of ING trusts. For example, several PLRs issued between 2005 and 2007 ruled that a grantor can create a non-grantor trust, fund the trust with contributions that aren’t considered taxable gifts for federal gift tax purposes and still retain the right to receive discretionary distributions of trust income and principal from the trust.5 Additionally, these PLRs concluded that if a distribution committee consisting of two to four of the permissible beneficiaries of the trust has the power, by unanimous consent, to direct the trustee to distribute trust assets to or among the permissible beneficiaries, then the distribution committee members have a substantial adverse interest to each other for purposes of IRC Section 2514 and, therefore, don’t possess general POAs over the trust.6
Subsequent PLRs in the following years further supported the intended tax aspects of ING trusts. For example, a 2013 PLR concluded that the grantor’s retention of each of the grantor’s consent power and the grantor’s sole power caused the transfer of property into the trust to be wholly incomplete for federal gift tax purposes.7 A 2015 PLR provided that the distribution committee’s distribution authority in connection with the grantor’s consent power and the distribution committee’s power to unanimously direct the distribution of income or principal didn’t cause the distribution committee members to possess general POAs for purposes of IRC Sections 2514(b) and 2041(a)(2).8
Despite the long and relatively consistent history of PLRs relating to ING trusts, pursuant to Revenue Procedure 2020-3, certain income tax questions involving IRC Section 671 were added to the no-ruling list, centering primarily around the tax consequences associated with the powers and makeup of a distribution committee, which would directly impact whether a trust is a non-grantor trust for income tax purposes.9 In 2021, additional areas were added to the no-ruling list in the specific portion of the revenue procedure entitled “Areas Under Study In Which Rulings Will Not Be Issued,” including whether a transfer to a trust would constitute an incomplete gift if the trust is structured as a non-grantor trust, and vice versa.10 These additions to the no-ruling list, in connection with a decidedly anti-taxpayer article that questioned the analysis of the IRS in the various PLRs,11 and the fact that a PLR interprets and applies tax laws only to the taxpayer’s specific set of facts,12 have understandably created concern that ING trusts are targets squarely in the crosshairs of the IRS.
How should a trustee assess the potential risk associated with administering an ING trust given these recent developments? There are several reasons why simply refusing to take part in ING trust planning may, in our estimation, be an overreaction.
First, some historical perspective may be useful in analyzing the risk, because this isn’t the first time that the IRS has questioned or reviewed tax aspects of ING trusts. In 2007, the IRS issued a notice questioning whether the conclusion in prior PLRs that the exercise of the powers held by the distribution committee members don’t result in gift tax consequences to such members was inconsistent with revenue rulings from the 1970s.13 Despite this, future PLRs continued to reach the same conclusion as the prior PLRs—that there were no gift tax consequences to the distribution committee members of the trusts that were the subject of the PLRs. Second, as will be noted later in this article when discussing decanting, matters can remain on the no-ruling list for many years without any further guidance from the IRS. Finally, the actual tax risks associated with a failed ING trust, whether it’s the payment of gift tax or the loss of state or federal income tax benefits, fall primarily on the grantor and not the trust.
Perhaps a trustee’s best protection is to ensure that the grantor has an accurate understanding of the current position of the IRS on the tax aspects of ING trusts, or, if not, to ensure that the grantor retains counsel who can provide this insight. Ultimately, trustees will need to weigh the potential tax and reputational risks associated with ING trusts against the benefits that this type of planning affords their clients.
Decanting
To the layperson, a decanting is the pouring of a liquid from one vessel to another. Generally speaking, with an exception discussed later in this article, the same is true for those of us who reside in the world of trusts and estates, except for us, the “liquid” is trust corpus and the “vessels” are trusts.
The common law concept of trust decanting appears to date as far back as 1940, when the Florida Supreme Court in Phipps v. Palm Beach Trust Co.14 held that an individual trustee holding a principal invasion power over an existing trust was authorized to transfer the trust estate of the existing trust to a new trust for the benefit of the beneficiaries of the existing trust. The court’s analysis likened the trustee’s principal invasion power to that of a POA.15 However, it took over five decades before any states enacted statutes specifically authorizing trust decantings, with New York being the first in 1992.16 Since that time, 35 other states have enacted trust decanting legislation, with some enacting the Uniform Trust Decanting Act, but most enacting their own state statutes.17
Not surprisingly, shortly 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).18 But in 2011, the IRS added decantings that result in a change of beneficial interests to its no-ruling list.19 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.20
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 17.21 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.
For states like Delaware that treat decantings as an exercise of a limited POA by the trustee,22 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 1998,23 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.
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.24
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,25 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 statute26 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.27 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.
Ultimately, trustees will need to weigh the potential tax and reputational risks associated with decanting and administering ING trusts against the benefits that these planning techniques afford their clients.
Endnotes
1. See Treasury Regulations Section 1.677(a)-1(d).
2. See generally Internal Revenue Code Section 1202.
3. IRC Section 677(a)(3).
4. Treas. Regs. Section 25.2511-2(b).
5. See Private Letter Ruling 200715005 (April 13, 2007); PLR 200647001 (Nov. 24, 2006); PLR 200637025 (Sept. 15, 2006); PLR 200612002 (March 24, 2006); and PLR 200502014 (Jan. 14, 2005).
6. Ibid.; see IRC Section 2514(c)(3)(B).
7. See PLR 201310002 (March 8, 2013).
8. See PLR 201550005 (Dec. 11, 2015).
9. See Revenue Procedure 2020-3, Section 3.01(93).
10. See Rev. Proc. 2021-3, Sections 5.01(9) and 5.01(17).
11. See Grayson M.P. McCouch, “Adversity, Inconsistency, and the Incomplete Nongrantor Trust,” 39 Va. Tax Rev. 419 (2020).
12. See Understanding IRS Guidance—A Brief Primer, www.irs.gov/newsroom/understanding-irs-guidance-a-brief-primer.
13. See IR-2007-127; PLR 201310002 (March 8, 2013) and PLR 201550005 (Dec. 11, 2015).
14. Phipps v. Palm Beach Trust Co., 142 Fla. 782 (1940).
15. Ibid., at pp. 785-786.
16. See NY Est. Pow. & Trusts L. Section 10-6.6.
17. www.actec.org/assets/1/6/Bart-State-Decanting-Statutes.pdf?hssc=1.
18. See, e.g., PLR 9438023 (June 17, 1994), PLR 9737024 (June 17, 1997), PLR 200013015 (Dec. 22, 1999), PLR 200607015 (Nov. 4, 2005).
19. See Rev. Proc. 2011-3.
20. See, e.g., Rev. Proc. 2022-3.
22. See, e.g., 12 Del. C. Section 3528(c).
23. See PLR 9848043 (No. 27, 1998) and PLR 9849007 (Sept. 1, 1998).
24. See, e.g., PLR 200743028 (Oct. 26, 2007).
25. See generally 12 Del. C. Section 3258.
26. For Delaware, the date of enactment of the decanting statute was June 30, 2003.
27. See supra note 25.