August 27, 2018
Author: Kathleen May
Organization: Huck Bouma PC
I. Transfer in Furtherance of Trust--“Decanting”
(a) Introduction
On January 1, 2013, Section 16.4 and 16.7 of the Illinois Trust and Trustees Act took effect. 760 ILCS 5/16.4., entitled, Distribution of Trust Principal in Further Trust, is referred to as Illinois’ “decanting” statute. Before codification of 16.4, judicial reformation was the only way to modify an irrevocable trust and it was available only in limited circumstances.
As a matter of fact, when you review Section 16.4 of the Illinois Trust and Trustees Act, you will not find the word “decanting” anywhere in the statute. It is a term of art used for its description of the process involved.
Wikipedia’s entry on decantation includes the following:
• “a process for the separation of mixtures, by removing a top layer of liquid from which a precipitate has settled.
• Usually a small amount of solution must be left in the container, and care must be taken to prevent a small amount of precipitate from flowing with the solution out of the container.
• It is frequently used to purify a liquid by separating it from a suspension of insoluble particles (e.g. in red wine, where the wine is decanted from the potassuim bitartrate crystals).”1
The decanting process in the context of trust and estate terms is, in essence, the creation of a second trust, Trust No. 2, to honor and carry out the purposes of the first trust, Trust No. 1, by purifying the terms for the benefit of the beneficiary. Like the decantation process as defined in Wikipedia, some terms of Trust No. 1 must remain and care should be taken to ensure the integrity of process as delineated in Section 16.4.
(b) Decanting Defined
Decanting occurs when an “authorized trustee” of an irrevocable trust “pours” assets of the Trust No. 12 into Trust No. 23. It is important to note that the decanting process can be initiated regardless as to whether there is a current need for principal to be distributed.4
The requirements under Section 16.4 are as follows:
• Trust No. 1 must be irrevocable and an Illinois Trust.
• The Trustee must be an “authorized trustee,” which the statute defines as any person, other than the settlor, who has the authority under the first trust to distribute the principal for the benefit of one or more current beneficiaries.5
• The transfers must be documented in a writing, signed and acknowledged by the trustee, and filed with the records of both Trust No. 1 and Trust No. 2.
• There must be at least one competent current income or principal beneficiary as well as one competent presumptive remainder beneficiary6.
• The transfer in furtherance of trust must further the purposes of Trust No. 1.
• The trust itself must not expressly opt out of Section 16.4.
(c) Authorized Trustee’s Discretion as a Determining Factor in Allowable Modifications to Trust No. 2 When determining which provisions of Trust No. 1 can be changed and to what extent, the discretion of the acting trustee of Trust No. 1 must be examined for each provision being modified.
Absolute discretion is defined in Section 16.4 as “the right to distribute principal that is not limited or modified in any manner…A power to distribute principal that includes purposes such as best interests, welfare or happiness shall constitute absolute discretion.”7 If the trustee has absolute discretion in some instances and less than absolute discretion in others, then the trustee is determined to have absolute discretion.8
(1) Designation of Beneficiaries
(i) Absolute Discretion
If the trustee of Trust No. 1 has absolute discretion, the trustee has the authority to distribute all or part of Trust No. 1 principal to the trustee of Trust No. 2 for the benefit of one, multiple, or all of the current beneficiaries of Trust No. 1, or, all of the successor and remainder beneficiaries of Trust No. 1.9 This means that while the trustee cannot add new beneficiaries to Trust No.2, all beneficiaries designated in Trust No. 1 need not remain as beneficiaries of Trust No. 2.
(ii) Discretion Other Than Absolute
If the trustee does not have absolute discretion to distribute principal, then in order to distribute Trust No. 1 principal to the trustee of Trust No. 2, the beneficiaries of both trusts must remain the same.10 However, there are two exceptions to this limitation:
(1) If the beneficiaries are a class of individuals, Trust No. 2 beneficiaries will include those class members includible in the class post distribution to Trust No. 2.11
(2) If the trustee feels it is in the “best interest” of a beneficiary of Trust No. 1 who is a special needs individual, the trustee, even without absolute discretion, has the authority to distribute principal to a supplemental needs trust (Trust No. 2).12
(2) Powers of Appointment
(i) Absolute Discretion
If the trustee of Trust No. 1 has absolute discretion, the trustee of Trust No. 1 may grant general or limited powers of appointment to any or all of the current beneficiaries as long as the beneficiary could receive principal outright per the terms of Trust No. 1.13 The power of appointment may be broader than previously provided for in Trust No. 114, thereby, allowing for appointment of the beneficiary’s interest to someone who is not a possible beneficiary of Trust No. 1.
(ii) Discretion Other Than Absolute
If the trustee lacks absolute discretion in Trust No. 1, then any power of appointment granted in Trust No. 2 must mirror that of Trust No. 1.15 In other words, the power of appointment in Trust No. 2 can be no broader than that in Trust No. 1.
(d) Constraints on the Decanting Process
Despite the trustee’s discretion, Section 16.4, nonetheless, does provide for multiple constraints or restrictions on the decanting process.
(1) Further Purposes of Trust No. 1
Decanting is proper only if Trust No. 2 furthers the purposes of Trust No.1.
(2) Reduction of Beneficiary’s Current Mandatory Interest
A trustee, despite the discretion granted, cannot “reduce, limit or modify any beneficiary’s current right to a mandatory distribution of income or principal, a mandatory annuity, or unitrust interest, a right to withdraw a percentage of the value of the trust or a right to withdraw a specified amount.”16
There is one major exception to modification of a current interest in Trust No. 1 and it is in the context of decanting into Trust No. 2 as a supplemental needs trust for a beneficiary (discussed more fully below).
(3) Express Prohibition of Decanting in Trust No. 1
If Trust No. 1 expressly prohibits decanting under Section 16.4, the trustee is unable to engage in the process. In fact, Section 16.4 provides exact language Trust No. 1 can recite to opt out.17
(4) Limitations in Regards to the Trustee of Trust No. 2
(i) Trustee Liability
A trustee cannot use the decanting process as a way to limit liability for his or her actions in the capacity of trustee for failure to use reasonable care and diligence.18 The exception to this rule is in the event decanting is used to provide for a directed trust discussed in Section 16.3 of the Trust and Trustees Act and in Article II below.
(ii) Trustee Removal
A trustee cannot, in Trust No. 2, eliminate the right in an individual to remove the trustee. However, it is acceptable for Trust No. 2 to vest that removal right in another individual. For example, a trust protector or some other individual in a non-subservient role can be given the right to remove the trustee.19
(iii) Trustee Compensation
Decanting is improper if the sole purpose is to allow for or enhance a trustee’s compensation.20 The rate of compensation in Trust No. 2 cannot go beyond that which is reasonable.
(5) Causation of Payback for Government Benefits Provided
A trustee is prohibited from decanting if doing so exposes trust assets to the claims of any private or governmental provider and interferes with, reduces the amount of or risks the beneficiary’s entitlement to government benefits.21
(6) Term of Trust
Trust No. 2 cannot reduce, limit or modify the perpetuities provision unless Trust No. 1 expressly allows for it.22
(7) Preservation of Tax Savings Clauses
It is necessary to ensure that Trust No. 2 preserves all minimum distribution treatment, tax exempt status and S-Corp status as Trust No. 1. This includes qualification for the annual exclusion, marital deduction, charitable deduction or qualified for any other specific income, gift, estate or generation skipping tax benefit.23 One exception to the above is a change in grantor trust status.
(e) Procedural Requirements of the Transfer in Furtherance of Trust
The trustee of a trust has no duty to engage in the decanting process for the benefit of a beneficiary. If the trustee does, in fact, decide to decant, it is not required of a trustee to obtain consent from each of the beneficiaries of Trust No. 1. However, the trustee must fulfill the following procedural requirements.
(1) Independent of Court Involvement
In order for a trustee to complete the decanting process without approval of the court, the notice requirement of Section 16.4 must be fulfilled. The authorized trustee is required to provide written notice specifying, with detail, the facts essential in the proposed decanting and the proposed date of transfer of assets from Trust No. 1 to Trust No. 2.24
If there is not one legally competent current beneficiary AND one competent presumptive remainder beneficiary to provide notice to, then court approval must be obtained.25
The beneficiary must receive the notice 60 days prior to the transfer date. This 60 day wait period allows the beneficiary to object, in writing, to the decanting.26 If a charitable beneficiary requires notice, the notice must be provided to the Attorney General’s Charitable Trust Bureau.27 If a beneficiary is under a legal disability without a Guardian of the Estate or Person that notice provided to the disabled beneficiary is ineffective.28
(2) With Court Approval
If a notified beneficiary objects or the trustee for some other reason is not confident, a trustee may petition the court to approve, modify or deny the proposed decanting.29 The trustee, then, bears the burden of evidencing that the proposed decanting furthers the purposes of Trust No. 1.
(3) Assets Decanted and Later Discovered
Assets discovered after the decanting process occurs will be determined to have been included in the decanting if all trust property in Trust No. 1 is transferred to Trust No. 2. If a partial decanting has occurred, or in other words on some of the trust property of Trust No. 1 is poured into Trust No. 2, then later discovered assets remain property of Trust No. 1.30
(f) Decanting Into Trust No. 2 as a Supplemental Needs Trusts
It is interesting to note that of the seventeen states31 with decanting statutes, Illinois’ statute is unique in its allowance of broadening the trustee’s discretion in a special needs situation as provided in 760 ILCS 5/16.4(d)(4).32
(1) Best Interests Standard
As previously discussed, the authority provided for in (d)(4) is not determined based upon the discretion in the trustee of Trust No. 1. Rather, if the trustee determines it is in the best interest of the “disabled beneficiary” he or she may decant to a SNT (Trust No. 2).
Section 16.4 defines disabled beneficiary as “a current beneficiary, presumptive remainder beneficiary, or a successor beneficiary of the first trust who the authorized trustee determines has a disability that substantially impairs the beneficiary’s ability to provide for his or her own care or custody and that constitutes a substantial handicap, whether or not the beneficiary has been adjudicated a ‘disabled person.’”33
Section 16.4(d)(4)(ii) further defines “best interests” to include the financial impact on the beneficiary and his or her family members.
(2) Elimination of Mandatory Distributions
The provisions of Trust No. 2 can eliminate mandatory distributions of income and principal to the disabled individual to preserve eligibility for or qualification of government benefits.34
(3) Self-Settled Trusts to be Decanted to Supplemental Needs Trust
If the Trust No. 1 is a self-settled trust created by the disabled beneficiary or if the trust assets are controlled by the disabled beneficiary, special rules apply to Trust No. 2.
In these cases, the trustee can decant into a pooled trust as defined by Illinois Medicaid law. Additionally, Trust No. 2 must include pay back provisions in compliance with Illinois and Federal Medicaid regulations.35
(g) Tax Ramifications of Decanting
Due to the lack of guidance on this issue from the Internal Revenue Service, many unanswered questions remain as to the full tax ramifications of decanting. Currently, the IRS has issued no private letter rulings nor published any instructive rules or regulations on the implications of decanting.
(1) Generation Skipping Taxes
The issue presented here is: Whether Trust No. 2, having received property from Trust No. 1, is grandfathered for GST tax purposes?
(2) Gift Taxes
The question under this category is: Whether a beneficiary whose interests are diminished as a result of the decanting process has made a taxable gift?
(3) Estate Taxes
For purposes of the marital deduction, does the existence of a decanting power given to the trustee in a trust that otherwise qualifies for the marital deduction remove that qualification for the deduction?
Additionally, if a beneficiary does not object to the decanting, and this is deemed to be an incomplete gift due to the beneficiary’s limited power of appointment in Trust No. 2, is the trust property includable in the gross estate of the beneficiary?
(4) Income Taxes
The main question in this arena is: Does the existence of a decanting power cause the trust to be considered a grantor trust?
II. Directed Trusts
Also effective January 1, 2013, the Directed Trust Statute, in partnership with the statutory decanting in Section 16.4, moves to modernize trust and estate principals in Illinois. Found in Section 16.3 of the Trust and Trustees Act, a directed trust instrument appoints an individual(s) to advise the trustee as to certain aspects of the trust administration, separating the authority of the trustee and the appointed individual.
(a) Applicability
All trusts in existence on January 1, 2013 and all future trusts that provide for the ability of the appointment of a directing party are included in the Section 16.3. Additionally, this includes any trust that is modified in accordance with applicable law.36
However, if a grantor does not wish to provide for the appointment of a directed party, he or she can, and must, specifically preclude the applicability of Section 16.3.37
(b) Categories of Directing Parties
(1) Investment Advisor
Unless expressly provided otherwise within the trust instrument, an Investment Advisor has the authority to:
(i) Direct the trustee with respect to the retention, purchase, transfer, assignment, sale, encumbrance of trust property and the investment and reinvestment of principal and income of the trust;
(ii) Direct the trustee with respect to all management, control and voting proxies for securities held in trust;
(iii) Select and determine reasonable compensation of one or more advisors, managers, consultants, or counselors, including the trustee, and to delegate to them any of the powers of investment trust advisor; and
(iv) Determine the frequency and method for valuing an asset for which there is no readily available market value.38
(2) Distribution Advisor
Unless the terms of the governing instrument provide otherwise, the distribution trust advisor has authority to direct the trustee with regard to all decisions relating directly or indirectly to discretionary distributions to or for one or more beneficiaries.39
(3) Trust Protector
Section 16.3(d) delineates the authorities that can be conferred upon the trust protector. Those authorities include:
(i) Modify or amend the trust instrument to achieve favorable tax status or respond to changes in the Internal Revenue Code, federal laws, State law, or the rulings and regulations under such laws;
(ii) Increase, decrease, or modify the interests of any beneficiary or beneficiaries of the trust;
(iii) Modify the terms of any power of appointment granted by the trust; provided, however, such modification or amendment may not grant a beneficial interest to any individual, class of individuals, or other parties not specifically provided for under the trust instrument;
(iv) Remove, appoint, or remove and appoint, a trustee, investment trust advisor, distribution trust advisor, another directing party, investment committee member, or distribution committee member, including designation of a plan of succession for future holders of any such office;
(v) Terminate the trust, including determination of how the trustee shall distribute the trust property to be consistent with the purposes of the trust;
(vi) Change the situs of the trust, the governing law of the trust, or both;
(vii) Appoint one or more successor trust protectors, including designation of a plan of succession for future trust protectors;
(viii) Interpret terms of the trust instrument at the request of the trustee;
(ix) Advise the trustee on matters concerning a beneficiary; or
(x) Amend or modify the trust instrument to take advantage of laws governing restraints on alienation, distribution of trust property, or to improve the administration of the trust.
If a charity is a named presumptive remainder beneficiary or current beneficiary, before a trust protector can engage in (ii), (iii), (iv), (v) or (vi), the Attorney General’s Charitable Trust Bureau must be given 60 days’ notice of the action if it has not been waived.40
(c) Duty and Liability of Directing Party
Each of the above listed directing parties is a fiduciary of the trust unless the document provides otherwise. However, the governing instrument may not relieve or exonerate a directing party from the duty to act or withhold acting as the directing party in good faith reasonably believes is in the best interests of the trust.41
Once a directed party accepts appointment, he or she submits to Illinois jurisdiction, despite agreements otherwise, and may be made a party to any action or proceeding relating to a decision made by the directing party or action taken by the directing party. 42
(d) Duty to Inform Excluded Fiduciary or Other Directing Party
A directing party has a statutory duty to keep an excluded fiduciary or other directing party reasonably informed as to the actions the directing party is taking as well as regarding the administration of the trust. However, neither the performance nor the failure to perform of a directing party's duty to inform affects the limitation on the liability of the excluded fiduciary.43
(e) Case Law
At this date, there are very few courts who have addressed the issues involved with directed trusts. Perhaps the most notable is the Delaware case of Duemler v. Wilmington Trust Co.44, which ruled that a corporate trustee was not liable for the failure of a sophisticated investment advisor to direct it on an investment decision when the trustee sent information regarding the decision to the advisor.
1http://en.wikipedia.org/wiki/Decanting
2 Defined as “the first trust” or “an existing irrevocable inter vivos or testamentary trust part or all of the
principal of which is distributed in further trust under subsection (c) or (d).” 760 ILCS5/16.4(a).
3 Defined as “the second trust” or any irrevocable trust to which principal is distributed in accordance
with subsection (c) or (d). Id.
4 760 ILCS5/16.4(k).
5 760 ILCS 5/16.4(a).
6 It is important to note that Section 16.4 does not define “legally competent” for the purposes of
providing notice as required in 760 ILCS 5/16.4(e).
7 760 ILCS 5/16.4(a).
8 760 ILCS 5/16.4(h).
9 760 ILCS 5/16.4(c).
10 760 ILCS 5/16.4(d).
11 760 ILCS 5/16.4(d)(2).
12 760 ILCS 5/16.4(d)(4)(i).
13 760 ILCS 5/16.4(c)(1).
14 760 ILCS 5/16.4(c)(2).
15 760 ILCS 5/16.4(d)(3).
16 760 ILCS 5/16.4(n)(1).
17 The opt out language is: “Neither the provisions of Section 16.4 of the Trust and Trustees Act nor any
corresponding provision of future law may be used in the administration of this trust.”760 ILCS
5/16.4(m).
18 760 ILCS 5/16.4(n)(2).
19 760 ILCS 5/16.4(n)(3).
20 760 ILCS 5/16.4(q)(1).
21 760 ILCS 5/16.4(o).
22 760 ILCS 5/16.4(n)(4).
23 760 ILCS 5/16.4(p).
24 760 ILCS 5/16.4€.
25 The author has found this to be the biggest practical complication to application of Section 16.4 in her
Elder and Special Needs Law practice. Further, again, Section 16.4 does not define “legally competent.”
26 760 ILCS 5/16.4(f)(2).
27 760 ILCS 5/16.4(e)(2).
28 760 ILCS 5/16.4(u).
29 760 ILCS 5/16.4(f).
30 760 ILCS 5/16.4(i)(2).
31 The seventeen states include: AZ, D.C., HI, IL, ME, MD, MI, MO, NE, NH, NJ, NC, ND, OH, OK, VA and WY.
32 Decanting and the Special Needs Trust. Lutrey, David. IICLE
33 760 ILCS 5/16.4(d)(4)(ii).
34 760 ILCS 5/16.4(n)(1).
35 760 ILCS 5/16.4(d)(4)(iii).
36 760 ILCS 5/16.3(j).
37 The statute provides the following form to preclude application, “the provisions of 16.3 of the Trust and
Trustees Act and any corresponding provision of future law may not be used in the administration of this
trust.” 760 ILCS 5/16.7.
38 760 ILCS 5/16.3(b).
39760 ILCS 5/16.3(c).
40 760 ILCS 5/16.3(d).
41 760 ILCS 5/16.3(f).
42 760 ILCS 5/16.3(g).
43 760 ILCS 5/16.3(h).
44 2004 Del.Ch. Lexis 206 (Del. Ch. 2004).