The Delaware Tax Trap and Irrevocable Credit Shelter Trusts: Using An Old Pitfall To Create A New Windfall


by Tom Kelley and Austin Bradley


tkelley@mcgrathnorth.com


abradley@mcgrathnorth.com

(402) 341-3070

For years Nebraska estate planning lawyers have utilized credit shelter trusts established for the benefit of a decedent’s surviving spouse and/or a decedent’s children to help couples protect their combined wealth from the federal estate tax. Credit shelter trusts are also referred to as family trusts or bypass trusts by estate planning lawyers. One downside of such planning was that the assets in a credit shelter trust did not get a step up in income tax basis upon the death of the decedent’s surviving spouse. This lack of a step up in income tax basis created potential income tax exposure on sales of “low basis” assets from the credit shelter trust after the death of the surviving spouse.

This downside was acceptable given that this type of estate planning created significant federal estate tax savings by potentially avoiding application of the 40% (and higher) top federal estate tax rates to all or a significant portion of the couple’s combined wealth upon the death of the surviving spouse. However, recent changes in the law have eliminated or significantly reduced the federal estate taxes payable at death for the vast majority of Americans. The focus now for many couples is to ensure that low income tax basis assets receive a new “stepped up” income tax basis under Internal Revenue Code (IRC) Section 1014 upon the death of the surviving spouse. This article discusses one creative technique designed to accomplish this goal which is known as the “Delaware Tax Trap.”

Bob and Mary

Take Bob and Mary, both age 65 and Nebraska residents, who were married with three adult children. When Bob died in 2003, Bob and Mary had a combined net worth of $3 million, consisting primarily of real estate and marketable securities. Assume Bob and Mary did no estate planning and held all their assets jointly with the right of survivorship. Since all the assets were held jointly with Mary, no federal estate tax would have been due upon Bob’s death in 2003.

Fast forward to 2008, when Mary’s net worth was $3 million. Had Mary died with a simple Will in 2008, leaving her assets equally to her three children, a federal estate tax of 45% would have been imposed on the excess of Mary’s net worth over the 2008 federal estate tax exemption amount of $2 million. The federal estate tax exemption amount represents the amount each spouse may pass to heirs, or a trust for their benefit, free of the federal estate tax. This would have resulted in a 2008 federal state tax liability of $450,000 ($3 million in assets less $2 million federal estate tax exemption amount multiplied by the 45% federal estate tax rate in 2008). Accordingly, at Mary’s death in 2008, of Bob and Mary’s combined wealth of $3 million, $450,000 would have gone to the payment of federal estate taxes and $2.55 million would have been distributed outright to their three adult children.

Had Bob and Mary visited with an estate planning attorney prior to 2003 for advice on how to protect their combined wealth from the federal estate tax, it is likely that their estate plan would have retitled their assets so that in 2003: (a) roughly $1.5 million in assets would have been in Bob’s name; and, (b) roughly $1.5 million in assets would have been in Mary’s name. In addition, the estate plan would likely have provided that upon Bob’s death in 2003: (a) $1 million (the 2003 federal estate tax exemption amount) would have been placed in Bob’s credit shelter trust (CST) for the health, education, support and maintenance of Mary and/or their three children during Mary’s life, with the remainder distributed outright to their three adult children upon Mary’s death; and, (b) the remaining $500,000 would have been placed in Bob’s marital trust (BMT) for Mary’s lifetime benefit with the balance to the three adult children upon Mary’s death. As Bob’s surviving spouse, Mary’s plan likely would have provided that her own assets be distributed outright to the three adult children upon her death. For flexibility, it is also likely that Bob would have granted Mary a special power of appointment to appoint the assets of the CST outright or in further trust upon Mary’s death among any one or more of Bob’s children or grandchildren. This plan would have resulted in no federal estate tax due in 2003 at Bob’s death.

With the above estate plan in place, had Mary died in 2008, when the value of the CST had increased to $1.4 million, the value of the BMT was $400,000 and the value of the assets in Mary’s name was $1.2 million, no federal estate tax would have been due. The $1.4 million value of the CST would have been excluded from Mary’s taxable estate. The $1.6 million combined value of the BMT and Mary’s assets ($400,000 plus $1.2 million) would have been well under the $2 million federal estate tax exemption amount for 2008. Under this scenario, all $3 million of Bob’s and Mary’s combined wealth would have been distributed outright to the three adult children at Mary’s death.

Accordingly, the utilization of typical credit shelter trust estate planning would have saved Bob and Mary’s children $450,000 in federal estate taxes had Mary died in 2008. Note that under this plan, the assets in the CST would not have received a step up in income tax basis upon Mary’s death. This potential income tax exposure on the $400,000 increase in the value of the CST assets from 2003 to 2008 was acceptable to Bob and Mary given the potential $450,000 in federal estate tax savings.

2018 Planning

Fast forward again, this time to 2018. Mary is now 80 years old and in declining health. In addition, Congress has now increased the federal estate tax exemption amount from $5,490,000 in 2017 to $11.18 million for 2018, indexed each year for inflation until 2025, when the federal estate tax exemption amount reverts back to the pre-2018 levels. Note that from 2003 to 2018, the federal estate tax exemption amounts and accompanying top federal estate tax rates were as follows:

Year Federal Estate Tax Exemption Amount Top Federal Estate Tax Rate
2003 $1,000,000 49%
2004 $1,500,000 48%
2005 $1,500,000 47%
2006 $2,000,000 47%
2007 $2,000,000 45%
2008 $2,000,000 45%
2009 $3,500,000 45%
2010[1] $5,000,000 or $0 35% or 0%
2011 $5,000,000 35%
2012 $5,120,000 35%
2013 $5,250,000 40%
2014 $5,340,000 40%
2015 $5,430,000 40%
2016 $5,450,000 40%
2017 $5,490,000 40%
2018 $11,180,000 40%

The increase in the federal estate tax exemption amount to $11.18 million means that very few individuals will be subject to the federal estate tax upon their death in 2018 or beyond. Given this current lack of any meaningful federal estate tax exposure for most individuals, now may be a good time for a surviving spouse such as Mary to revisit the income exposure of an existing irrevocable credit shelter trust. Specifically, clients such as Mary may want to consider whether any strategies exist to achieve a new “stepped up” income tax basis for the irrevocable credit shelter trust assets by having such assets included in her estate upon her death.

In Mary’s case, the 2018 CST (which currently will not be included in Mary’s estate and therefore will not be subject to the federal estate tax upon her death) has grown in value to $2.4 million. This $1 million increase in the value of the CST assets since 2003 was primarily due to the increase in value of certain real estate held in the CST trust since 2003. The combined value of the 2018 BMT and Mary’s 2018 assets is now $2 million, which while subject to the federal estate tax upon her death, is well below Mary’s current $11.18 million federal estate tax exemption, so there would be no federal estate tax exposure for Mary’s estate if she died in 2018. In fact, if the CST assets were included in Mary’s estate upon her death, the $4.4 million combined value of the CST, BMT and Mary’s assets ($2.4 million plus $2 million) is well below Mary’s current $11.18 million federal estate tax exemption, resulting in no federal estate tax exposure for Mary’s estate if she died in 2018.

While Mary and her children are no longer concerned about Mary’s federal estate tax exposure, they are very concerned about the CST’s income tax exposure given that, unlike the assets in the BMT and Mary’s assets, the CST assets, including the real estate, will not receive any step up in income tax basis under IRC Section 1014 upon Mary’s death. If Mary’s children desire to sell the CST assets shortly after Mary’s death, the income tax basis in the CST assets would be based on the income tax basis from 2003 (when Bob died) creating potential income tax exposure on the $1 million increase in value of the CST assets from 2003 to 2018.

Given Mary’s minimal federal estate tax exposure, the family would now actually prefer the CST assets be included in Mary’s estate upon her death. This inclusion might allow the income tax basis of all or a portion of the CST assets, notably the real estate, to be “stepped up” to the value of such assets on the date of Mary’s death.

Delaware Tax Trap

One strategy for Mary and her children to consider is to trigger the so-called Delaware Tax Trap. This planning strategy is designed to cause inclusion of the CST assets in Mary’s estate for federal estate tax purposes upon 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. IRC Section 2041(a)(3) generally provides that property subject to a special power of appointment (which would generally not cause inclusion in the power holder’s estate) will cause estate inclusion if the power holder exercises the special power of appointment 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 assets for a period ascertainable without regard to the date of the creation of the first power.

In other words, the basic question is whether the second power of appointment (the one created through the exercise of the original special power of appointment) has 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 assets are included in the estate of the person exercising the original special power of appointment (in this case, Mary). 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.

In Mary’s case, the process to trigger the Delaware Tax Trap would generally include the following steps.[2] First, Mary would create and fund a new irrevocable trust during her lifetime. The new irrevocable trust would contain certain provisions that grant each of the intended beneficiaries of the CST assets (Mary’s three adult children) a presently exercisable general power of appointment over the assets in the new irrevocable trust. A “presently exercisable” power is one that can be exercised immediately by the power holder, that is, Mary’s adult children. Second, Mary would execute a new Will that would exercise the original special power of appointment granted to her by Bob under the CST and would appoint the assets of the CST, upon Mary’s death, to the new irrevocable trust created by her.

Note that Nebraska adopted the Uniform Statutory Rule Against Perpetuities in 1989. In Mary’s case, care in drafting both her new irrevocable trust and her new last Will would need to be taken so that Mary’s exercise of the original special power of appointment granted to her by Bob over the CST assets was exercised so as to trigger the Delaware Tax Trap under Nebraska’s Rule Against Perpetuities. By triggering the Delaware Tax Trap, the goal would be to cause inclusion of the CST assets in Mary’s estate for federal estate tax purposes upon her death. This inclusion would allow the income tax basis of all or a portion of the CST assets, notably the real estate, to be “stepped up” to the value of such assets on the date of Mary’s death. This would alleviate the potential income tax exposure discussed above.

Caveat To Use Of The Delaware Tax Trap

One potential disadvantage of using the Delaware Tax Trap strategy in Mary’s case is that the CST assets would be fully includible in the estates of Mary’s three adult children and would be reachable by their spouses and creditors, if any. However, in a case such as Bob and Mary’s, where Bob and Mary both intended to distribute their assets outright to their three adult children in any event upon Mary’s death, the Delaware Tax Trap approach should not put any of the adult children in a worse position than they would otherwise have been in.

Finally, it should also be noted that no cases or IRS rulings have directly addressed the issue of whether the Delaware Tax Trap can be used to affirmatively cause estate inclusion. While it is believed that this strategy should accomplish inclusion of a decedent’s credit shelter trust assets in the surviving spouse’s estate for federal estate tax purposes upon the death of the surviving spouse, there can be no guarantee. The IRS or a court may reach a different conclusion with respect to the tax issues discussed in this article. If you have any questions regarding existing irrevocable credit shelter trusts and the potential utilization of the Delaware Tax Trap, please do not hesitate to contact one of our estate planning attorneys for assistance.

[1] There were special rules for decedents dying in 2010.

[2] Note that the facts of each case are unique and may require other factual and technical issues to be addressed before implementation of this strategy.

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