Income Tax Reporting for Decanting

by BakerHostetler
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Decanting refers to the distribution of trust property of one trust (the “first trust”) to another trust (the “second trust”). Over the past several years, the number of states specifically authorizing decanting by statute has grown rapidly. As of March 2014, at least twenty-two states have passed or proposed a state decanting statute.

Notwithstanding this proliferation of decanting statutes at the state level, the Internal Revenue Service (the “IRS”) has not provided authoritative guidance regarding the proper tax treatment of decanted trusts. In Notice 2011-101, the IRS invited comments from the public regarding the income, gift, estate and generation-skipping transfer tax issues arising from decanting. In response, the IRS received comments from many well-respected national groups but still has not issued guidance. In fact, to the contrary, the IRS continues to list certain decanting transactions on its “no ruling list” pursuant to Rev. Proc. 2014-3, and has not added decanting to its Priority Guidance Plan, all of which suggests that guidance will not be forthcoming in the near future. Meanwhile, trustees decanting trusts today must determine with their legal and other tax advisors how to report the distribution of trust assets from the first trust to the second trust without such guidance.

With respect to income tax reporting, one issue all trustees decanting a trust will face is whether the second trust should be treated as a new trust or a continuation of the first trust for income tax purposes.

If the second trust is treated as a new trust, the decanting will be treated as a distribution from the first trust to the second trust. Section 661 of the Internal Revenue Code would permit the first trust to deduct the value of the distribution from its taxable income, and Section 662 of the Internal Revenue Code would cause the second trust to realize that income. In practice, the trustee of the first trust would: (i) distribute all of its assets to the trustee of the second trust; (ii) file a final return; and (iii) complete a Schedule K-1. And, the trustee of the second trust would: (i) receive all the assets of the first trust; (ii) apply for a new tax identification number; and (iii) file its first return. An advantage of this approach is that the filing of the first trust’s final return puts the IRS on notice of the decanting and termination of the first trust, which, in turn, begins tolling the statute of limitations on any arguments the IRS might raise about whether the decanting is a non-taxable event for income tax purposes.

If the second trust is treated as a continuation of the first trust, fewer administrative steps are required. The assets of the first trust are retitled into the name of the second trust, the second trust continues to file returns under the tax identification number of the first trust, and the second trust reports the change of name on its next return. The advantage of this approach is its administrative simplicity. Moreover, this approach is consistent with non-binding rulings from the IRS.  For example, under the facts of Private Letter Ruling 2007326002, all the assets of one trust were to be divided and distributed into three successor trusts with substantially the same terms as the original trust. The IRS ruled, among other things, that for federal income tax purposes: (i) the successor trusts would be treated as a continuation of the original trusts; (ii) the transfer of assets would not be a distribution or termination under Section 661; and (iii) the transfer would not result in the realization of any income, gain or loss by the first trust, the successor trusts or any beneficiary of either of them.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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