By: Judson M. Stein
With the passage of the ATRA providing certainty as to the future “permanency” of the federal $5MM estate tax exemption amount, many high net worth individuals will be less concerned with estate tax planning and will be more concerned with income tax planning. Whether traditional credit shelter trust planning is still proper for individual or married taxpayers will depend on various factors including asset protection, trust income tax rates, desire to shelter appreciation from estate tax, willingness to pay practitioners for trust planning, etc. However, for those clients that decide to utilize irrevocable trust planning during their lifetimes and not rely entirely on portability, practitioners should consider drafting trusts to provide flexibility to account for potential changes to the estate tax laws and to allow for an income tax step-up in basis, if advisable.
An option known as the “Delaware Tax Trap,” (DTT) which, prior under the historically lower estate tax exemptions typically was to be avoided, now can provide flexibility in bypass trust planning. Using this potential tool, it is possible for property subject to a limited power of appointment to be included in the power holder’s gross estate at death, resulting in an income tax step-up in basis, if preservation of the estate tax exemption is not necessary. The DTT allows the surviving spouse to wait until soon before their death to decide whether to trigger estate tax inclusion or not by providing for the exercise of the power of appointment in a Will or codicil.
The rule states that a limited power of appointment will cause the subjected property to be included in the power holder’s gross estate at death (by converting the power to a general power of appointment) if the power is exercised to create another power of appointment which, under the applicable local law, can be validly exercised so as to postpone the vesting of any estate or interest in such property, or suspend the absolute ownership or power of alienation of such property, for a period ascertainable without regard to the date of the creation of the first power. (§§2041(a)(3), 2514(d)).
These provisions, enacted under the local law of most states, were designed to prevent the holders of limited powers in trusts to avoid the limited time frame that a trust may be in existence under the rule against perpetuities. Now many states have either greatly extended the rule against perpetuities period or have abolished it entirely.
One can also draft a formula contingent general power of appointment to cause estate tax inclusion to the extent that such inclusion would not cause any estate tax to be imposed on survivor’s estate. A court could argue, however, that the creation of the power is within the control of the surviving spouse, who has the power to generate it by spending down his or her estate. A court will analyze the issue of act of independent significance to decide upon whether the power of appointment is in the control of the beneficiary to determine whether or not he or she will ultimately receive the power. If the surviving spouse beneficiary ultimately loses on this argument, then the surviving spouse will be treated as having a general power over the entire non-marital trust, regardless of the size of his or her estate. There is no bright line test as to what constitutes an act of truly independent significance that can be used to generate a power of appointment.
As an alternative, one may have an independent trustee or trust protector with authority to grant the surviving spouse a general power of appointment. The release of this power may have adverse tax consequences, however, because the release of a power is a taxable transfer itself.