By Edwin P. Morrow, III, J.D., LL.M., MBA, CFP®, CM&AA®

In PLR 202206008, the IRS approved of a judicial modification (approval of settlement) of a GST grandfathered trust to add a formula testamentary general power of appointment that would enable the remainder beneficiaries to receive a step up in basis over such assets at the primary beneficiary (child of settlor) powerholder’s death. The IRS ruled that 1) this addition did not disturb the GST exempt nature of the trust or cause any adverse GST consequences and that 2) it would cause estate inclusion over only the desired amount (more on this point, however, as there was a slight misstatement of the law at the end of the ruling).

I have been advocating for the use of such formula testamentary general powers of appointment for well over a decade now (see white paper discussing the use of such powers, downloadable for free at www.ssrn.com). For trust beneficiaries who do not have a taxable estate (which, at $12.06 million per taxpayer, is about 99.99% of the population), it’s a no-brainer to consider causing estate inclusion for any appreciated trust assets that would benefit from a step up in basis, provided the inclusion does not rise to a level that would cause an estate tax. The PLR, of course, does not have any actual dollar amounts, but imagine a situation in which the settlor established a trust for a primary beneficiary (child of the original settlor) with $2 million, which has grown over the decades to $8 million with a basis of $3 million, and the primary beneficiary’s estate outside the trust is $3 million. Causing estate inclusion of the trust could increase the basis of the assets for the next generation (grandchildren of the original settlor), which, depending on the state and federal income tax rate and types of assets, may save approximately $5 million (basis increase), times 30% (estimated state and federal income and net investment income tax rates on eventual sale or depreciation savings) or about $1.5 million in savings gained through causing estate inclusion. Failure to consider this type of planning is a tremendous wasted opportunity.

Naysayers have argued that somehow limiting the scope of powers of appointment to certain assets or placing a cap on the amount will somehow be attacked by the IRS as fraudulent or suspect in some way – it can’t possibly be that easy! Formula powers are too complicated, they argue. This is hogwash, of course, and just an excuse by practitioners to avoid learning a new trick. All statutory, regulatory, case law authority and rulings, including this new PLR, indicates that appointive assets can be limited and need not comprise the entire trust. Formulas are used all of the time in planning, and are even included in many examples in the regulations.

That said, I have some further thoughts on the ruling: If I were inclined to get a ruling on such a trust modification, I would consider asking the IRS to rule on the income tax and gift tax consequences of the modification as well. It does not cost anything more to add that to the ruling request.

Income Tax: Many practitioners do not even consider that substantial trust modifications can potentially trigger income tax, but there are arguments and rulings to that effect that should be considered as a possibility that a PLR could effectively foreclose.

Gift/Estate Tax: Courts have ruled that beneficiary consent to modifications can be deemed a transfer for gift/estate tax purposes – a potential argument that the PLR did not address was whether the grandchildren’s consent to giving their parent a greater interest in the trust and allowed their interest to potentially be divested through the general power of appointment might be a gift. Maybe it should not be, since it probably does not appreciably increase the value of the powerholder’s (child of the settlor’s) interest (and more importantly, decrease the value of the consenting remainder beneficiaries’ interests), but it can’t hurt to confirm this.

There was some discussion in the ruling about how there was controversy and the modification was necessary due to change in tax law and family dynamics to carry out the Grantor’s intent. To be charitable, much of that discussion seems like window dressing, if not hollow and manufactured. Adding a general power of appointment makes the children of the beneficiary’s interest less rather than more secure, as their interest that was fully vested (locked in, near certain) is now fully subject to divestment – if creditors come a knocking on the powerholder’s estate, depending on what state they live in, the trust assets may be susceptible to creditors, not to mention their powerholding parent’s change of mind (anyone out there watch HBO’s Succession?). I am not saying that adding the power is a bad idea at all – the upside is worth the small risk and this risk can largely be mitigated through several techniques, but you don’t need to add a general power of appointment to protect the remainder beneficiaries – you only need a general power to step up the basis of the appreciated property subject to the power!

What should interest drafting attorneys the most in the ruling, which I think is “black letter” law that the IRS would have to agree with, is the formula nature of the power of appointment.  It was over:

the largest portion of Trust B that could be included in 

Child’s federal estate without increasing the total amount of the “Transfer Taxes” actually payable at Child’s death over and above the amount that would have been actually payable in the absence of this provision

Of course, the IRS had no problem with this formula general power, any more than it has historically had problems with A/B funding formulas dividing trusts between bypass and marital trusts, or between GST exempt and non-exempt trusts. It should not.

There was no indication that the Child/Powerholder had a testamentary limited power of appointment that could have been used to trigger the Delaware Tax Trap. If that were the case, the result could likely have been obtained without an expensive court and IRS ruling. If one is going to bother going to court and apply for a ruling, it’s probably better to go all the way and ask for a general power to be added than a limited one, because in some states it is more certain to trigger IRC 2041 and any appointive trust could be free of some undesirable trust clauses that some states require in order to trigger the Trap.

Which brings us to the last paragraph of the IRS ruling on estate inclusion and a misstatement readers should be wary of. The IRS stated that:

However, the exercise by Child of Child’s testamentary general power of appointment will result in the appointed property being includible in Child’s gross estate under § 2041(a)(2). 

This statement is extremely misleading of course. The Child’s testamentary power of appointment results in the appointive property being includible in the Child’s gross estate under IRC 2041(a)(2), but the exercise of the power is completely irrelevant. Estate inclusion results whether it is exercised or not, which is a key component of the power of these clauses in exploiting the step up in basis loophole. The IRS may not have to issue a correction of the ruling, however, because the next sentence fixes the mistake and is more accurate in its conclusion:

Accordingly, based on the facts submitted and the representations made, we conclude that the exercise by Trustee of its discretionary authority over Trust B principal upon the terms of the Settlement Agreement will result in only the trust property subject to Child’s testamentary general power of appointment to be included in Child’s gross estate under § 2041(a)(2). 

Fear not optimizing the basis of trusts! It is not paranoid, but prudent to assume that the applicable exclusion amount may be decreased – if not by the Build Back Better Act or some new bill, then by the sunsetting provisions in 2026 under the colloquially known as Tax Cuts and Jobs Act. That doesn’t mean we should turn our backs on the prospect of tax savings, but merely draft such powers with a cap and other prophylactic techniques to adapt to such prospects.

ABOUT THE AUTHOR

Edwin P. Morrow, III, J.D., LL.M., MBA, CFP®, CM&AA® is a Wealth Strategist for Huntington National Bank, where he concentrates on thought leadership and planning ideas for high net worth clientele in tax, asset protection and estate planning areas.  Ed was previously in private law practice working in taxation, probate, estate and business planning. Other experience includes research and writing of legal memoranda for the U.S. District Court of Portland, Oregon as a law clerk. He is a Fellow of the American College of Trust and Estate Counsel (ACTEC). He is a Board Certified Specialist (through the Ohio State Bar Assn) in Estate Planning, Trust and Probate Law, a Certified Financial Planner (CFP) professional and a Certified Merger & Acquisition Advisor (CM&AA). He is also a Non-Public Arbitrator for the Financial Industry Regulatory Authority (FINRA) and a member of the Editorial Advisory Board of the Probate Law Journal of Ohio.  Ed is a frequent speaker at CLE/CPE courses on asset protection, tax and financial and estate planning topics, and recently co-authored, with Stephan Leimberg, Paul Hood, Martin Shenkman and Jay Katz, the 18th Edition of The Tools and Techniques of Estate Planning, a 997-page practice-based resource on estate planning.