Question: When my husband died, some of his assets went into a credit-shelter trust under the terms of his Last Will and Testament. I am the beneficiary of the trust during my life and when I pass away everything will be distributed to our son outright. I am concerned that by receiving the inheritance outright, my son’s creditors will be able to access the funds. In addition, my accountant advises me that I do not have a taxable estate and so the credit shelter trust is not going to help me and may in fact incur unnecessary capital gains taxes. Can I do anything to change this?
Answer: Yes! While trusts created under Wills are irrevocable and cannot be easily modified since the grantor (your husband) is deceased, there is a way to move the assets in your current credit shelter trust to a new trust which will protect the assets for your son. This process is informally known as “decanting.”
Just as you would decant wine from one vessel to another, decanting under EPTL § 10-6.6(b) permits the trustee of one trust to move the assets to a new trust with more favorable terms. In your case, your trustee would move the assets from your credit shelter trust to a new trust which added descendant’s trust provisions for your son. This would ensure that assets passing to your son would be protected from his creditors and would not be taxable in his estate.
With regard to the tax implications of keeping the credit shelter trust, your accountant is correct that keeping a credit shelter trust in effect when estate taxes are no longer an issue may lead to increased capital gains taxes. This is because when your husband died, any assets distributed to the credit shelter trust have a cost basis equal to the value at his death. Accordingly, if the assets are later sold capital gains could be imposed. If the new trust made the assets includible in your estate, there would be a step-up in cost basis at your death. This step-up would mean that if your son sold the assets after your death, no capital gains tax would be imposed because the value of the asset sold was equivalent to its cost basis.
Decanting a trust can be a great resource for fixing an irrevocable trust. However, it does not work in every case. You will need a trustee who is not a beneficiary or potential beneficiary of the trust. If you or your son is serving as Trustee, you will need to resign and appoint someone who is disinterested. The terms of the trust that can be changed will depend on several factors, including whether the beneficiary is entitled to principal and whether a power of appointment exists. Speak to an Estate Planning attorney to learn more.