Are Your Clients (And Their Older Relatives) Wasting Their $5.45 Million Coupon To Increase Tax Basis?

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obit-and-upstream-obitBy Edwin P. Morrow III, J.D., LL.M. (Tax), CFP®, RFC®

For many taxpayers, the traditional trust design for married couples is now obsolete. The number of estates paying federal estate tax is minimal. 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. Practitioners must now consider the applicable exclusion amount not so much as a “coupon” to exempt estate tax, but a “coupon” to increase basis – and one that should not be wasted without considering the alternatives.

I will refer to bypass trusts which use these techniques as Optimal Basis Increase Trusts (OBIT) and irrevocable trusts that use these techniques to generate a basis increase at either spouse’s death or an older relative’s death as an Upstream Irrevocable Optimal Basis Increase Trust (or “Leveraged Upstream Irrevocable OBIT” if an installment sale or other leverage is used).

Are QTIPs Being Overused and Oversold as a Replacement to Bypass Trusts?

Some practitioners advocate exclusively 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 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, they cannot trap accounting income to avoid state income tax in the beneficiary’s state of residency, they may lead to lower basis results when assets are owned between a QTIP and the surviving spouse and they are leaky for both asset protection and tax reasons because of the mandatory income requirement. Decanting statutes are much, much stricter with marital trusts as well. Moreover, although this author does not worry about this argument so much, some distinguished attorneys worry that the IRS may use Rev. Proc. 2001-38 to deny a second step up in basis if the QTIP election was unnecessary. Marital trusts 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 if those might apply, 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 in several ways, notably by giving the surviving spouse a general power to appoint appreciated assets up to his or her remaining applicable exclusion amount or by giving 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 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 state or federal 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”). It is important even if the trust and beneficiaries are nowhere near Delaware!

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.   This method would allow the surviving spouse to be more precise with inclusion of the most desirable assets.

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.

Upstream Planning and the Use of Irrevocable Optimal Basis Increase Trusts

The planning potential for powers of appointment are hardly limited to spouses in traditional bypass or QTIP trusts! Testamentary general and limited powers such as noted above can be granted “upstream” to older beneficiaries or “downstream” to a younger generation. Special concerns arise when such powers are granted in trusts while they are still revocable, but such powers are a natural fit in irrevocable trusts. in the most common would be an irrevocable intervivos bypass trusts (commonly known as spousal lifetime access trusts or SLATs). However, there are additional concerns and issues that arise in such multigenerational planning. Although the number of trusts subject to the generation skipping transfer tax (GST) are even less than those subject to the estate tax, we must still consider the impact of this tax, but perhaps more important, we must also consider Medicaid qualification and payback for older beneficiaries, asset protection and the “one year rule” under 1014(e) that can sometimes prevent a step up in basis.


To find out more about the “OBIT”, join us for a special teleconference on Tuesday, March 22, 2016 and Thursday, March 24, 2016at 9am Pacific (12pm Eastern) entitled, “Everything You Need to Know About OBITs & Upstream OBITs”.


Edwin P. Morrow IIIEdwin Morrow, J.D., LL.M., MBA, CFP®, RFC® is a board certified specialist in estate planning and trust law through the Ohio State Bar Association. He is currently the Director of Wealth Transfer and Tax Strategies for the Family Wealth Advisory Group at Key Private Bank. Ed works with family wealth financial advisory and trust teams nationwide, assisting with in-depth reviews of high net worth clients’ estate, trust, asset protection and tax planning. 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 or


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