Free-Basing: Maybe It’s Not As Easy As We All Thought

Take-Away: Over the last couple of years, and especially after the 2017 Tax Cut and Jobs Act gave taxpayers a dramatic increase in their federal estate tax exemption, there has been a lot written about how to intentionally include the value of assets held in preexisting irrevocable trusts in the trust settlor’s taxable estate at death in order to expose those trust-held assets to an income tax basis adjustment, tax planning referred to (tongue-in-cheek obviously) as free-basing. While there are several different ways in which to alter an irrevocable trust through reformations, modifications, and trust decanting proceedings, all of which are intended to expose the trust assets to an income tax basis adjustment on the settlor’s death, obtaining an income tax basis adjustment on the settlor’s death may not be nearly as easy as we originally thought to be the case, as courts seem to look at when, and how, those ‘prohibited’ powers came about which invite the application of the Tax Code’s estate inclusion provisions.

Background: For decades wealthy individuals have been encouraged to transfer assets to trusts using their lifetime gift tax exemption in order to remove those transferred assets, and all future appreciation in those assets, from the transferor’s tax base at death, in order to avoid federal estate taxes. That advice was given with the knowledge that a tax ‘trade-off’ was also involved, saving federal estate taxes (by no longer owning the appreciating assets) in exchange for the a loss of income tax basis adjustment to the assets held in trust when the settlor died (again, because the transferor no longer owned the appreciated assets.) But with the dramatic increase in an individual’s federal estate tax exemption to $11.18 million, coupled with the opportunity to use a deceased spouse’s unused estate and gift tax exemption (known as portability), many of those individuals now realize that they have foregone an income tax basis adjustment on their death, with no actual federal estate tax savings as a fair trade-off. In short, there is no longer any ‘trade-off’ for many of those individuals.

Hence, the search for ways in which to deliberately include the value of those previously transferred assets, now held in trust, in the settlor’s taxable estate at death in order to expose those trust assets to an adjusted (hopefully upward) income tax basis that can be enjoyed by the trust beneficiaries.

Free-Basing: Free-basing has generally focused on intentionally triggering a couple of key Tax Code sections, commonly known as the string-provisions, to cause estate inclusion of the value of the trust assets on the trust settlor’s death. But simply reforming, modifying the existing trust, or the trustee decanting the trust assets to a new trust, to add a string provision, may not be all that simple.

String Provisions: Normally two different Tax Code sections are viewed as the best paths to expose the value of trust assets to estate inclusion on the trust settlor’s death: IRC 2036 and IRC 2038.

IRC 2036: This Code section includes in the settlor’s gross estate the value of transferred assets if the grantor retained a lifetime beneficial enjoyment in, or a lifetime power to control the beneficial enjoyment of, the transferred assets held in the trust. The problem is that for this provision to apply, the settlor must have retained the ‘prohibited’ power in order to include the value of the trust assets under IRC 2036 in the settlor’s taxable estate at death. The retained power by the settlor can be either by either an express or implied agreement. So one free-basing approach was for the settlor (or his/her estate representative) merely to assert that he/she retained a power over the trust assets by an agreement with the trustees of the trust, even if the retained power is not expressly mentioned in the trust instrument.
Example: The settlor creates a qualified personal residence trust (QPRT) and outlives the retained exclusive use term. The settlor then chooses to continue to live the in the residence, but does not pay any rent to the trustee or the remainder holders of the QPRT, and the QPRT trustee (or the new titleholder) does not demand rent from the settlor for that continued occupancy. That continued use of the residence by the QPRT settlor, but without paying any rent, would probably be treated a retained beneficial enjoyment by the settlor by an implied agreement, if his/her rent-free occupancy was anticipated when the settlor first created the QPRT.
Form Over Substance: However, courts have found that a settlor (or the settlor’s estate) cannot argue substance over form- if the settlor selects the form of the transaction. With an irrevocable trust with no retained power to enjoy the assets or to control the enjoyment of the trust assets by others, the settlor cannot later challenge that form that he/she initially selected. Back to the QPRT example- if the QPRT’s terms prohibited the settlor from occupying the residence ‘rent-free’ after the end of the settlor’s retained exclusive use term, which the Regulations actually require, the settlor cannot later conveniently claim that there was a pre-existing agreement inconsistent with the QPRT’s terms that the settlor initially selected.
Pre-existing Arrangement: As such, IRC 2036 may not be a viable means to intentionally cause the value of the trust assets to be included in the settlor’s taxable estate at death, unless that ‘prohibited’ power was initially planned well in advance. Restated, if the power to enjoy the transferred assets, or the power to control the enjoyment of those transferred assets by others with regard to the assets the settlor initially transferred to the trust, was not expressly retained in the trust instrument, any claimed agreement between the settlor and the trustee as to the settlor’s continued use or enjoyment or control over the trust’s assets will have to be initially planned when the trust was first funded, and not miraculously appear via a self-serving implied agreement long after the trust was funded. Thus, while the IRS can claim a preexisting agreement held by the settlor to impose IRC 2036, it is much harder for the settlor’s estate representative to make the same claim which would expose the trust assets to an income tax basis adjustment on the settlor’s death under IRC 2036.
IRC 2038: This Code section includes in the settlor’s gross estate the value of trust assets if: (i) the decedent transferred the property during life; (ii) the transfer was not a bond fide sale for full and adequate consideration; and (ii) the decedent retained an interest or right in the transferred property, either alone or in conjunction with anyone to alter, amend or terminate the transferee’s enjoyment of the property that the transferor did not give up before death, or that was not relinquished in three years prior to the transferor’s death. IRC 2038 also applies when the settlor obtains [at a later date] the power to alter, amend, revoke or terminate the beneficial enjoyment of the transferred assets. This Code section thus applies “without regard to when or from what source the decedent acquired such power.” This language compels the settlor’s gross estate to include the value of the trust assets if the trust is decanted or reformed to give to the settlor a power to control the beneficial enjoyment of all or specific trust assets- i.e. the prohibited power was obtained, but not retained.
Example: The trustee decants the existing trust assets to a new irrevocable trust created by the trustee, over which the settlor is given a power to terminate the trust at the time of the settlor’s death.
‘When Created:’ Courts have held that an IRC 2038(a)(1) power cannot exist unless its creation was reasonably anticipated by the settlor when the trust was created. In re Estate of Skifter, 468 F.2d 699, 20 AFTR 2d 72-5920 (CA-2, 1972.) This decision turned on whether the power to control the trust assets was retained by the decedent, or if the power to control was ‘given to him long after he had divested himself of all interest- that it was not reserved by him at the time of the transfer.’ Consequently, the courts to continue to apply the retain concept to qualify obtain to a degree, e.g. the prohibited powers were reasonably anticipated by the settlor. The Sixth Circuit, which covers Michigan, formally adopted this same reasoning used in Skifter in Estate of Fruehauf, 427 F.2d 80 (CA-6, 1970).
“Active Involvement:’ Revenue Ruling 84-179, 1984-2 C.B. 195 seems to also have adopted the Skifter approach to require some active involvement to obtain the ‘prohibited’ power by the settlor before IRC 2038 will be applied to an irrevocable trust’s assets. In yet another federal court decision that described the implications of IRC 2038, the court said IRC 2038 applies: “where the transferor-decedent himself sets the machinery in motion that purposefully allows fiduciary powers over the property interest to subsequently return to him.” Estate of Reed, 36 AFTR 2d 75-6413 (DC Fla., 1974).
Thus, it appears from Skifter and the Revenue Ruling cited, that IRC 2038 can apply only if the settlor through his/her own actions initiates his/her possession of a power to alter, amend, revoke, or terminate beneficial enjoyment of the trust if it was later obtained but not retained by the settlor.
Examples: A trust reformation initiated by trust beneficiaries, or a trust decanting initiated by the trustee will probably not be respected by the IRS if the purpose is to give to the settlor a ‘prohibited’ power under IRC 2038. A petition to reform an irrevocable trust would need to be filed by the settlor for the reformed trust which conferred these powers on the settlor, to be a viable approach to intentionally trigger estate inclusion under IRC 2038. But see MCL 700.7410(2) which provides: A proceeding to confirm the termination of a trust under subsection (1) or to approve or disapprove a proposed modification or termination of trust under sections 7411 to 7416 or a trust combination or division under section 7417 may be commenced by a trustee or beneficiary. This Michigan statute thus gives legal standing only to trust beneficiaries or the trustee, not to the trust settlor, to initiate a trust modification or reformation proceeding. [MCL 700.7415, just mentioned, gives the probate court the power to reform the terms of a trust, while MCL 700.7416, also mentioned, gives the probate court the power to modify a trust retroactively to achieve the settlor’s tax objectives, but again the reformation petition would have to be filed by trust beneficiaries or the trustee, not the settlor.]
Retain vs. Obtain: Note the subtle language differences between these two string Tax Code sections. IRC 2038 will apply when the settlor obtains the ‘prohibited’ powers. Yet the Skifter decision seems to require that the settlor take some affirmative action in how the settlor actually obtained the ‘prohibited’ power, and that the settlor cannot passively sit back while the prohibited powers are bestowed on him/her in actions that are initiated by others.
Examples: A decanting of the trust assets by the acting trustee to a new trust that grants the settlor a general power to appoint the trust assets would probably not satisfy the standard created in the Skifter decision because the action is instigated by the trustee, not the settlor, and all the trustee is required to do is provide notice of its intent to decant to the settlor- the settlor’s consent is not required for a trust decanting by the trustee. [MCL 700.7820a(7).] Yet if the settlor could initiate a probate court trust reformation action to reform the trust to give to the settlor the prohibited powers, then that legal proceeding in which the settlor himself sets the machinery in motion, would probably meet the standard imposed in But the settlor has no legal standing under the Michigan Trust Code to seek either a trust modification or a trust reformation of the trust that the settlor created, according to the restrictive language used in MCL 700.7410(2).

Possible Solution: IRC 2041: While both IRC 2036 and IRC 2038 appear to be available to cause the value of an irrevocable trust’s assets to be exposed to estate inclusion on the settlor’s death, both the Michigan Trust Code’s legal standing provision on filing petitions for trust modifications or reformations stands in the way, added to which is how federal courts have looked at when and how ‘prohibited’ string powers were acquired by the settlor under IRC 2038, seem to make free-basing more of an academic discussion in Michigan. Perhaps the best approach in the search for an income tax basis adjustment on death is to turn to IRC 2041 and its implementing Regulations.

IRC 2041: This Code section provides that if the settlor of the trust retains a general power of appointment over trust assets, exercisable either during the settlor’s life or on the settlor’s death, the mere presence of that general power of appointment, exercised or not, will cause the value of the trust assets that are subject to the settlor’s general power of appointment to be included in the deceased settlor’s taxable gross estate.
Regulations Permit Conferring Power: The implementing Regulations to IRC 2041 state that the settlor cannot retain to himself or herself a power of appointment. “For purposes of Sections 20.2041-1 to 20.2041-3 the term ‘power of appointment’ does not include powers reserved by the decedent to himself within the concept of sections 2036 through 2038.” [ 20,2041-1(a)(2).]
Granting a General Power of Appointment: The implication from this Regulations, therefore, is that the general power of appointment can thus be conferred by a third party on the trust settlor, which, in turn, will cause estate inclusion of the value of the assets that are subject to that general power of appointment held by the settlor.
How to Confer a General Power of Appointment: Where a power of appointment was not ‘reserved’ by the settlor in the trust, a general power of appointment that was subsequently created for the settlor over the trust would still be treated as a general power of appointment for estate tax inclusion purposes. Consequently, a trust reformation to add a general power of appointment held by the settlor, or a trust decanting that added a general power of appointment over an irrevocable trust held by the original trust settlor, or an action taken by a trust protector to amend an irrevocable trust to give the settlor a testamentary power of appointment to use trust assets to pay the settlor’s creditors on death, might all be effective steps to bring the value of the trust’s assets back into the settlor’s taxable estate for estate inclusion and thus an income tax basis adjustment under IRC 1014.

Conclusion: There has been plenty of discussion in recent years about implementing a planning strategy to achieve an income tax basis adjustment, providing a fresh income tax basis, on a trust settlor’s death. But free-basing is not quite as simple as we once thought it to be, considering the Michigan Trust Code’s legal standing restrictions on trust reformations and modifications, and how some of the case law under IRC 2036 and IRC 2038 seems to stand in the way of implementing those free-basing strategies by requiring that the settlor take an active part in obtaining that prohibited power. The most effective approach is to add a testamentary general power of appointment granted to the settlor either through a trust reformation or trust modification initiated by the trustee or trust beneficiaries, or a trust decanting by the trustee, or a trust amendment by a trust protector. The opportunities still exist to free-base, but a lot more thought needs to go into identifying the best approach to achieve that free-basing objective.