Stepping Up To The Plate: Taking A Final Swing At Stepped-Up Income Tax Basis For Veteran Irrevocable Trusts
At times in an estate planning practice, advisors are faced with long-term irrevocable trusts which own appreciated assets with a fair market value (“FMV”) far in excess of the income tax basis of such assets. In situations where such trusts are scheduled to terminate in the near term, and the appreciated assets are subject to likely sale by the trust remainder beneficiaries receiving the appreciated assets as a result of the trust termination, the resulting potential taxable gain is a significant concern. Discussed below are the following potential strategies to seek a “step-up” in the income tax basis of such appreciated trust assets to address this concern: (1) springing the Delaware Tax Trap; (2) decanting; (3) filing a late qualified terminable interest property (“QTIP”) election; and (4) trust reformation under state law. [1]
But first, some background.
Oftentimes a long-term irrevocable trust is established by the estate plan of a now long deceased spouse (the “Settlor”) for the benefit of the then surviving spouse and the children of the Settlor. Such irrevocable trusts often provide: (1) mandatory payments of income to the surviving spouse on an annual basis and payments of principal for the health, education, support, and maintenance of the surviving spouse for the lifetime of the surviving spouse; and (2) upon the death of the surviving spouse, termination of the trust with distribution of the trust assets outright to the children of the Settlor. These trusts are set up for many good reasons, such as asset protection and / or avoiding inclusion of the trust assets in the estate of the surviving spouse. As noted above, however, an unfortunate reality of such long-term trusts is the potential taxable gain when trust assets are later sold.
Take the following example. Frank and Jenny set up a standard A-B trust arrangement in 2002 when the federal estate tax exemption was $1 million per individual. In 2002, Frank owned a farm with a current FMV of $800,000 and an income tax basis of $300,000, and Jenny owned assets with a current FMV of $800,000. Frank died in 2006, at which time the farm owned by Frank had an FMV of $1.5 million.
In 2006, the federal estate tax exemption was $2 million. Accordingly, the farm was placed in Frank’s Bypass Trust (a/k/a the Credit Shelter Trust or the Decedent’s Trust) which provided for (1) annual payments of income to Jenny and principal payments for the health, education, support, and maintenance of Jenny for Jenny’s lifetime; (2) termination of the Bypass Trust upon Jenny’s death; (3) a special power of appointment exercisable at her death (“SPOA”) for Jenny to appoint the assets of the Bypass Trust to Frank’s issue and under no circumstances to Jenny, Jenny’s estate and / or the creditors of Jenny or her estate; and (4) outright distribution of the Bypass Trust assets to Frank’s four children upon Jenny’s death. Note that the income tax basis of the farm owned by the Bypass Trust was “stepped up” to $1.5 million in 2006 when Frank died, and no federal estate tax return was required to be filed in connection with Frank’s estate.
It is now 2021 and Jenny is in poor health. The 2021 current FMV of the farm owned by the Bypass Trust is now estimated at $3,000,000. Apart from the Bypass Trust, Jenny has assets in the Survivor’s Trust with a 2021 current FMV of $1,200,000. Accordingly, even if Jenny owned all the assets in the Bypass Trust and Survivor’s Trust individually, there would be no federal estate tax due upon Jenny’s death in 2021 since her total estate would be approximately $4,200,000, and the federal estate tax exemption is well over that, at $11,700,000 in 2021.
Jenny and the four children are concerned that if Jenny dies in 2021, the Bypass Trust terminates with outright distribution of the farm to the four children, and the children sell the farm in 2021 for its current estimated FMV of $3,000,000, the children will be faced with a taxable gain of approximately $1.5 million ($3 million selling price less the income tax basis in the farm of $1.5 million, established in 2006 when Frank died). If, however, Jenny and the children could take action that resulted in the Bypass Trust assets being included in Jenny’s estate upon her death, the federal income tax basis of the farm would be “stepped up” to the FMV of the farm on the date of Jenny’s death. This would significantly reduce (or possibly even eliminate) the taxable gain on the sale of the farm by the four children if sold at or above FMV of the farm established on Jenny’s date of death.
DELAWARE TAX TRAP
Because Jenny was granted a SPOA over the Bypass Trust assets, one strategy Jenny and the four children might consider is to trigger the so-called Delaware Tax Trap. This planning strategy is designed to cause inclusion of the Bypass Trust assets in Jenny’s estate for federal estate tax purposes at her death. The term “Delaware Tax Trap” refers to a technique that causes inclusion of trust assets in the estate of a decedent under Section 2041(a)(3) of the Internal Revenue Code. Section 2041(a)(3) generally provides that property subject to Jenny’s SPOA under the Bypass Trust (which would generally not cause inclusion of the Bypass Trust assets in Jenny’s estate) will cause estate inclusion if Jenny exercises her SPOA by creating another power of appointment which under the applicable local law can be validly exercised so as to postpone the vesting of interests in the Bypass Trust assets for a period ascertainable without regard to the date of the creation of the first power.
In other words, the basic question would be whether a grant by Jenny of the second power of appointment (one created through Jenny’s exercise of her original SPOA under the Bypass Trust) would have the effect of restarting the testing period under the applicable state’s Rule Against Perpetuities? If it does restart the perpetuities period, then the Delaware Tax Trap is sprung, and the Bypass Trust assets would be included in Jenny’s estate. This strategy is called the Delaware Tax Trap, because Delaware appears to be the first state whose law (since changed) deemed the exercise of a limited power of appointment that created another limited power, as starting a new perpetuities period. For a more detailed description of the Delaware Tax Trap strategy, please see a prior article I co-authored with Austin Bradley, “The Delaware Tax Trap and Irrevocable Credit Shelter Trusts: Using An Old Pitfall To Create A New Windfall” - https://www.mcgrathnorth.com/publications/the-delaware-tax-trap-and-irrevocable-credit-shelter-trusts-using-an-old-pitfall-to-create-a-new-windfall/.
DECANTING
In the event the Bypass Trust did not grant Jenny a SPOA (or springing the Delaware Tax Trap is not feasible) another strategy Jenny and the four children might consider is decanting the Bypass Trust. Decanting is a process by which the trustee of the Bypass Trust might be able to exercise a broad discretionary distribution power under the Bypass Trust to transfer or “decant” assets of the Bypass Trust into an entirely new trust. The second “new” trust would contain many of the same provisions of the Bypass Trust, but would also contain modifications, such as granting Jenny a general power of appointment (“GPOA”) exercisable at her death, to appoint the Bypass Trust assets in a way that would cause the Bypass Trust assets to be included in Jenny’s estate upon her death.
Unfortunately, the decanting requirement of a “broad” trustee discretionary power to distribute the Bypass Trust assets to beneficiaries would likely rule out decanting in this case, given the more limited trustee discretion to distribute Bypass Trust principal for the health, education, support, and maintenance of Jenny for Jenny’s lifetime. For a more detailed description of decanting, see Jon Grob’s article, “What’s Old Becomes New: Nebraska Adopts The Uniform Trust Decanting Act” - https://www.mcgrathnorth.com/publications/whats-old-becomes-new-nebraska-adopts-the-uniform-trust-decanting-act/.”
LATE QTIP ELECTION
In the event the Bypass Trust did not grant Jenny a SPOA (or springing the Delaware Tax Trap is not feasible) and the decanting strategy is not feasible, another strategy Jenny and the four children might consider is a late QTIP election.
Many planners are unaware that Treasury Regulation § 20.2056(b)-7(b)(4)(i) provides that a QTIP election for a trust on a decedent’s federal estate tax return is valid if it is made on the last federal estate tax return filed by the decedent’s executor on or before the due date of the return, including extensions or, if a timely return is not filed, the first estate tax return filed by the executor after the due date. A QTIP election for the Bypass Trust in this case would be beneficial because if properly made, the assets in the Bypass Trust would be included in Jenny’s estate upon her death, subject to a “step-up” in income tax basis upon Jenny’s death.
The Bypass Trust in its present form would not qualify for the late QTIP election because Jenny does not have the power to compel the trustee of the Bypass trust to convert unproductive property in the Bypass Trust. Accordingly, the strategy would be to seek reformation of the Bypass Trust under state law to grant Jenny the power to compel the trustee of the Bypass Trust to convert unproductive property in the Bypass Trust, and then file a late federal estate tax return for Frank’s estate including a late QTIP election for the Bypass Trust.
Note that a risk with this strategy is that because the Internal Revenue Service (“IRS”) is not required to respect the orders of state law courts lower than the highest court in the state, the IRS might choose to ignore the state law reformation of the Bypass Trust. The IRS might then take the position that the QTIP election for the Bypass Trust on Frank’s late filed federal estate tax return was invalid due to Jenny’s lack of power to compel the trustee to convert unproductive property in the Bypass Trust.
TRUST REFORMATION UNDER STATE LAW
If all the above strategies are not feasible, the last recourse might be for Jenny and the four children to seek reformation of the Bypass Trust under state law to grant Jenny a GPOA exercisable at her death, to appoint the assets in a way that would cause the Trust assets to be included in Jenny’s estate upon her death. Under Nebraska state law, the basis for such a reformation request might be to achieve Frank’s tax objectives and / or unanticipated circumstances. Even if granted by the court, however, as noted above, there is a risk the IRS might choose to ignore the Bypass Trust reformation and deny the step-up in income tax basis for the Bypass Trust assets.
If you have any questions regarding the strategies discussed in this article, please do not hesitate to contact one of our estate planning attorneys for assistance. Our estate planning attorneys stand ready to assist you in evaluating what basis adjustment strategies might apply in your situation.
1 Note that the facts of each case are unique and may require other factual and technical issues to be addressed before implementation of any of the strategies discussed in this article. In addition, the IRS or a court may reach a different conclusion with respect to the strategies discussed in this article. Finally, practitioners should be aware that the tax changes being considered by the Biden administration include possible changes to the step-up in basis tax benefit. Any such changes may affect the strategies discussed in this article.
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