By Edwin P. Morrow III, J.D., LL.M.(Tax), CFP®, RFC®
For many taxpayers, the traditional trust design for married couples is now obsolete. Traditional AB trust designs risk incurring higher income taxes after the first death, and reduced basis increase at the second death. New trust designs can not only mitigate against this risk, but create income tax advantages over outright bequests.
Some practitioners advocate using a marital deduction trust, even if there is no need for the federal marital deduction, to allow the family to achieve a second step-up in basis with the asset protection and control of a trust.
But we can do better. After all, marital trusts also receive a second step downin basis. Moreover, they cannot “spray” income to beneficiaries in lower tax brackets, 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 (aka “stretch IRAs”), especially for general power of appointment marital trusts. And, they won’t be as 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 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 are often 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 (“GPOAs” and “LPOAs”) 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.
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 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 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 Optimal Basis Increase Trust (OBIT) grants Jane a limited power of appointment (or no power at all) over all income in respect of a decedent (IRD) and assets with a basis higher than or equal to 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 $1,000,000 of additional basis). This may also be accomplished with a limited power of appointment (LPOA) that triggers the Delaware Tax Trap.
The result is that 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 very 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 depreciation to offset income, or 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.
This is only a brief introduction to the use of GPAs. They must be carefully crafted to not only maximize the basis benefit, but prevent exposure to estate tax or unintended distribution consequences.
Using the Delaware Tax Trap to Optimize Basis
There is also 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).
Under most state laws, 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 which grants 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. 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. However, this method would allow the surviving spouse to be more precise with inclusion (e.g. 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 all of the benefits of a traditional AB trust design, while largely avoiding the potential basis and income tax drawbacks.
RELATED EDUCATION ON THE “OBIT”
To find out more about the “OBIT”, join us for a special 90-minute teleconference on Tuesday, July 16, 2013 at 9am Pacific (12pm Eastern). For more information and to register, click here.
ABOUT THE AUTHOR
Edwin Morrow, J.D., LL.M., MBA, CFP®, RFC® is a manager of Wealth Strategies at Key Private Bank. Ed works with Key Private Bank financial advisory and trust teams, both local and nationwide, assisting with in-depth reviews of high net worth clients’ estate, trust, asset protection and tax planning in order to better preserve, protect and transfer their wealth in a tax efficient manner. Prior to joining Key Bank in 2005, Ed was in private law practice in Cincinnati, Ohio, concentrating in taxation, probate, estate and business planning.
Ed can be reached by phone (937) 285-5343 or by e-mail at Edwin_P_Morrow@KeyBank.com.