by Edwin P. Morrow III, J.D., LL.M. (tax), CFP®, RFC®
Acknowledgement: The author would like to acknowledge Rosa M. Kohler, CRPC®, CFP®, for her valuable assistance with this article.
For many taxpayers, the traditional trust design for married couples is obsolete. Portability, coupled with the new $5.25 million (adjusted by inflation) exemption levels, negates one of the most easily quantifiable reasons to do trust planning-saving estate tax-for the majority of taxpayers.
Some financial planning practitioners advocate using a marital deduction trust, even if there is no need for the federal marital deduction, to allow the family to have the best of both worlds-a second step-up in basis with the asset protection and control of a trust.
But we might do better. After all, marital trusts also receive a second step down in basis. Moreover, they cannot "spray" income to beneficiaries in lower tax brackets as a bypass trust can, and they are "leaky" for both asset protection and tax reasons because of the mandatory income requirement. They provide greater complications for see-through trust status ("stretch IRAs"), especially for general powers of appointment (GPOA) marital trusts. And, they won't be efficient in saving state or federal estate taxes, especially if the surviving spouse lives long and assets appreciate significantly.
Achieving a Second Step-Up in Basis
It is possible to obtain a step-up in basis on assets in bypass trusts at the second death by building flexibility to trigger the inclusion of assets in the surviving spouse's estate, as follows:
- Give an independent trustee discretion to distribute up to the entire amount in the bypass trust to the surviving spouse.
- Give an independent trustee the power to add or create general testamentary powers of appointment or effecting the same via decanting or other reformation under state law.
- Give other parties (a child, friend of spouse, or non-beneficiary) a non-fiduciary limited lifetime power to appoint to the surviving spouse (this is known as a collateral power).
- Give the surviving spouse a general power to appoint appreciated assets up to his or her remaining applicable exclusion amount.
- Give the surviving spouse a limited power to appoint assets, but cause both the appointment and the appointive trust to trigger the Delaware Tax Trap over the appreciated assets (IRC §2041(a)(3)).
The first three techniques often are impractical and require an extraordinary amount of proactivity and omniscience, not to mention potential fiduciary concerns applicable to the first two. The last two methods use formula powers of appointment to allow for more certain and more precise tax planning. The creative use of general and limited powers of appointment (GPOA and LPOA) and the Delaware Tax Trap (DTT) can achieve better tax basis adjustments than either outright bequests or typical marital or bypass trust planning; they can assure that assets in the trust receive a step up and not a step down in basis. I refer to any trust using these techniques as an Optimal Basis Increase Trust (OBIT).
Example: John Doe dies in 2013 with $2 million in assets left in trust for his wife Jane. She files a Form 706 and "ports" $3.25 million of the deceased spousal unused exclusion (DSUE) amount. After eight years, when she dies, assets have grown to $4 million. Due to rebalancing, depreciation, and depending on the composition of assets, approximately $2.5 million might comprise assets with FMV of $1 million greater than basis; $500,000 might be "loss" property with basis of $750,000, and the remaining $1 million might be cash equivalents or income in respect of a decedent (such as retirement plans).
Had John used an outright bequest, or a marital trust, all the assets (except retirement plans) would get a new cost basis, including any loss properties. Had John used an ordinary bypass trust, none of the assets would get a new cost basis, including those with $1 million of unrealized gains.
Instead, John's OBIT grants Jane a limited power of appointment (or no power at all) over all income in respect of a decedent (IRD) assets, cash, and assets with a basis higher than the fair market value at the time of her death (which would salvage $250,000 of basis from disappearing). It grants Jane a general power of appointment (GPOA) over any assets that have a fair market value greater than tax basis (which would add $1 million of additional basis). This may also be accomplished with a limited power of appointment (LPOA) that triggers the Delaware Tax Trap.
Figure 1: Optimal Basis Increase Trust
Result: John and Jane's beneficiaries get a step-up on the trust assets, but, more uniquely, they do not get a step down in basis for any loss property-a crucial point if Jane were to die just after a market slump. The beneficiaries (through a continuing trust or outright) get a carryover basis on any assets received via limited power of appointment, or received by default if such assets were not subject to a general power of appointment at death. This allows them to use the higher basis for depreciable assets to offset income, or to sell assets to take the capital loss to offset other capital gains plus $3,000 per year against ordinary income, or hold for future tax-free appreciation up to basis.
Curtailing POAs to Maximize Benefit and Prevent Exposure to Estate Tax
The GPOA only would be applicable to those assets to the extent it does not cause increased federal or state estate tax. Powers of appointment can be limited in scope as to appointees or assets. Many existing trusts already have GPOAs over a portion of the trust (typically, the GST non-exempt share). There is no reason one cannot grant a general power of appointment over less than 100 percent of trust assets or by formula.1
Furthermore, the appointment could be applicable to the assets with the greatest embedded gain to satisfy this amount. Most families would prefer any additional basis go to depreciable property to offset current income before allocating to stocks, bonds, raw land, family vacation homes, etc. Ultimately, a weighting may be optimal, but at the most basic level, practitioners usually would want the GPOA to apply to the most appreciated assets first.
So, the trust might provide that the GPOA applies to the most appreciated asset first, cascading to each next individual asset until the unused exemption amount is reached. Assume that Jane inherited a large sum of money and had just $500,000 remaining applicable exclusion amount. If the trust's asset with the greatest embedded gain was a mutual fund with basis of $200,000 and FMV of $600,000, the GPOA would apply to only 5/6 of the shares of that fund.
In this example, the GPOA could never apply to the less-appreciated assets, and the IRS would have no statutory basis to include them in Jane's estate or accord them an adjusted basis.
Crafting GPOAs to Keep Fidelity to the Estate Plan
If no marital deduction was claimed, as we aim to do in an OBIT, two limitations on a GPOA may be included:
- A GPOA may limit the scope of eligible beneficiaries so long as creditors of the power holder are included. For example: "I grant my beneficiary the testamentary power to appoint to any of my descendants or to any trust primarily therefore. My beneficiary also may appoint to creditors of his or her estate."2
- A power is still a GPOA if it may only be exercised with the consent of a non-adverse party.3 Surprisingly, even a trustee with fiduciary duties to other beneficiaries is not considered adverse. For example, the following might be added to the above: "However, my beneficiary may only exercise said appointment with the consent of [name of non-adverse party]."
Using the Delaware Tax Trap to Optimize Basis
In the previous example, it is presumed that John's OBIT used a formula GPOA to cause estate inclusion and increased basis. There also is a technique that accomplishes the same result with a limited power of appointment. It involves IRC §2041(a)(3), colloquially known as the Delaware Tax Trap (DTT).
Generally, if Jane had a limited power of appointment that permitted appointment in further trust, and Jane appointed those assets at her death to a separate trust, granting a beneficiary a presently exercisable general power of appointment, this would trigger §2041(a)(3), cause estate inclusion, and therefore an increased basis under IRC §1014, just as a standard GPOA would.
Thus, Jane's will (or trust, or other document, if permitted by John's trust) could appoint any appreciated assets up to her available applicable exclusion amount to such a "Delaware Tax Trapping" trust. In drafting mode, this is probably not an optimal strategy to employ for John's trust, because it will necessarily require Jane to draft a new will or trust, invoking the LPOA and a new appointive trust with terms that ordinarily would be avoided. Giving a beneficiary a presently exercisable GPOA impairs asset protection much more than a testamentary power, and it destroys any chance of spraying income or making tax-free gifts. Also, it does not allow avoidance of state or federal estate taxation or avoidance of a step down in basis at the child's death.
With all of these downsides, using the DTT to harvest the basis coupon probably has more realistic application in the context of preexisting irrevocable trusts that already contain an LPOA. It probably should not be used in planning mode to accomplish optimal basis adjustments, especially because many practitioners and clients rely on disclaimer funding, which negates the LPOA necessary for a DTT. However, this method would allow the surviving spouse to be more precise with inclusion (for example, Jane could appoint only the family business stock to the DTT trust even though it is not the most appreciated, because she knows that the children will sell the business soon after her death).
In summary, the Optimal Basis Increase Trust design offers the benefits of a traditional AB trust design, while largely avoiding the potential basis drawbacks inherent to both.
Edwin P. Morrow III, J.D., LL.M. (tax), CFP®, RFC®, is one of Key Private Bank's national wealth specialists who works with wealth management teams nationwide, advising high net worth clients on how to preserve and transfer their wealth. For more information on this topic, including additional charts, footnotes, and sample clauses, contact the author at firstname.lastname@example.org. Also, see the article "The Optimal Basis Increase Trust" by Morrow in the March 20, 2013 edition of the LISI Estate Planning Newsletter (#2080).
1. Treasury Reg. §20.2041-1(b)(3) states that (3) Powers over a portion of property. If a power of appointment exists as to part of an entire group of assets or only over a limited interest in property, section 2041 applies only to such part or interest." Many cases and rulings about limiting powers and funding trusts with "caps" exist. A few in the GPOA context are PLR 2001-23045, 2000-101021, 2002-10051, 2004-03094, and 2006-04028.
2. IRC §2041(b)(1) is in the disjunctive "or". See also Estate of Edelman v. Commissioner, 38 T.C. 972 (1962), Jenkins v. U.S., 428 F.2d 538, 544 (5th Cir. 1970).
3. IRC §2041(b)(1)(C)(ii), Treas. Reg. §20.2041-3(c)(2).