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George F. Bearup, J.D. Senior Legal Trust Advisor

6-Aug-18

‘Fresh Basis’ Strategies Revisited

Take-Away: Several ways exist to obtain an income tax basis adjustment for assets held in a long-time irrevocable trust. The lifetime trust beneficiary can exercise a limited power of appointment in trust for another beneficiary [the Delaware ‘tax trap’]. The trust can be modified to give to the lifetime trust beneficiary a general power of appointment over the trust.  The trust can be terminated by ‘merging’ the life estate interest held by the beneficiary with the remainder beneficiaries interests in the same trust, so the lifetime beneficiary owns the assets at death. Or, the trust can be formally terminated in probate court proceedings if tax avoidance was the purpose of the trust and as such, the trust is no longer required to achieve that purpose.

Background: There are several irrevocable trusts where the assets have appreciated substantially in value over the years the trust has existed. As a generalization, those assets will not receive an income tax basis adjustment (a fresh basis) on the death of the lifetime beneficiary, as those assets are not taxed in the lifetime beneficiary’s estate at his/her death. [IRC 1014] With the dramatic change in the estate tax exemption and with portability, often those trust-held assets could be included in the lifetime beneficiary’s taxable estate without incurring any additional estate tax liability. If the trust remainder beneficiaries would like to receive assets upon the lifetime beneficiary’s death with a fresh basis, some planning steps can be taken to deliberately expose the trust assets to estate taxation on the lifetime beneficiary’s death without incurring any additional estate tax liability. Some techniques we have covered before, so I will only briefly mention them.

Example: For purposes of reviewing these strategies, assume pretty basic facts. Husband died in 2001. Part of his estate plan was to set up a credit shelter trust for Wife. The trustee in its discretion may pay trust income or principal to Wife or for her benefit, for her welfare and happiness,  taking into consideration any other financial resources then available to Wife. Two children are the remainder beneficiaries of the trust. Because of the large IRA that Husband left for Wife which she rolled over,  she has been supporting herself with large RMDs. Consequently,  the income from the credit shelter trust has either been accumulated, or due to the high rates of income taxation the irrevocable trust faces, the trust assets have been invested for high growth and little present yield. As such, 18 years later, the $750,000  in assets that initially were used to fund the credit shelter trust have grown to $5,000,000 in 2018. Upon Wife’s death, when the credit shelter trust terminates, the two children will each receive $2.5 million distributed in trust assets but with an income tax basis of $375,000.

Strategies: If the assets held in the credit shelter trust are taxed in Wife’s estate upon her death, there will still be no estate tax liability as she now has roughly $11.18 million in estate tax exemption available to her estate. If the trust assets are taxed in Wife’s estate, the two children will each receive $2.5 million in trust assets, and those assets will have a $2.5 million in income tax basis, meaning the children can sell the trust assets and not incur any capital gain tax, or begin to depreciated the ‘inherited’ assets with a much higher depreciation basis. Accordingly the goal is to intentionally expose the credit shelter trust assets to taxation on Wife’s death, so they will receive a fresh basis. [IRC 1.1014-2(b)(2).]

  • Trigger the Delaware Tax Trap: One strategy that has been previously suggested is that if the credit shelter trust conferred on wife a testamentary limited power of appointment over the trust assets upon her death,  would be for her to exercise that limited testamentary power of appointment, in a continuing trust, for the benefit of her two children, i.e. by appointing the trust assets in trust for the benefit of the remainder beneficiary who also holds a power of appointment, i.e. stacking powers of appointment on top of one another. By doing so, Wife has deliberately triggered the Delaware Tax Trap on her death, and that will cause the credit shelter trust assets to be taxed in her estate. [IRC 2041(a)(3).] As such, Wife will have to affirmatively exercise the testamentary limited power of appointment; its mere existence is insufficient to cause estate taxation of the credit shelter trust assets.
  • Decant the Trust to Add Powers of Appointment:
  • Tax Trap: If the trust instrument does not provide to Wife a testamentary limited power of appointment, the trustee could exercise its decanting power under the Michigan Powers of Appointment Act and in the ‘new’ trust instrument created by the trustee, to add the needed testamentary limited power of appointment so Wife can intentionally trigger the ‘Delaware Tax Trap. The ability to add this type of provision is limited to situations where the trustee has considerable discretion to distribute trust income or principal to Wife. [MCL 556.115a]
  • General Power to Pay Creditors: Alternatively, the trustee could decant the trust assets to a ‘new’ trust in which Wife is given a testamentary general power of appointment to use the credit shelter trust assets to pay any of the creditors of her estate on her death. [Treas. Reg. 2041-3(c)(2).] The mere presence of this testamentary general power of appointment to pay creditors in the credit shelter trust will cause all the trust’s assets to be taxed in Wife’s estate on her death, whether or not the power is exercised. No affirmative act will be required by Wife. [IRC  1014(a).]
  • Formula Power: It is possible to use a formula for this testamentary power of appointment to pay creditors, limiting the amount of assets subject to Wife’s power of appointment to the then applicable exclusion amount for federal estate taxes, reduced by Wife’s taxable estate as finally determined without regard to such power for federal estate tax purposes. Limiting this power of appointment on Wife’s death to only pay creditors will provide some comfort to the trust remainder beneficiaries who must be given notice of the proposed decanting of the credit shelter trust assets (with an opportunity to object in court). By adding a formula ‘cap’ to amount of assets subject to the power of appointment also will also give the remainder beneficiaries comfort that all of the credit shelter trust assets will be used to pay Wife’s creditors on her death, but such a ‘cap’ on the amount of assets that could be used to pay creditors would then not expose all the credit shelter trust assets to a fresh basis on Wife’s death- just the amount of the ‘cap;’ as a generalization, if not all assets held in the credit shelter trust receive a 100% step-up to a fresh basis, then the fresh basis adjustment will be spread pro rata over all of the assets held in the credit shelter trust. It is possible, however, to single out assets held in the credit shelter trust that will more likely be sold by the remainder beneficiaries, or which the beneficiaries will retain but want to depreciate, e.g. commercial real estate, where the formula identifies the assets held in the trust over which Wife holds a power of appointment to pay her estate creditors. An even more refined power of appointment formula could be added to the ‘cap’ language, specifying that the power of appointment is was available only if Wife dies before 2026; after 2025, the federal estate tax exemption is schedule to drop back to $5.6 million, so that after that date the formula power of appointment to pay creditors available to Wife would disappear, presuming that she might not have enough estate tax exemption available to her estate to cover the assets held in the credit shelter trust.
  • Merge the Trust Life and Remainder Interests: Assuming a strong family relationship, the children who are the remainder beneficiaries could consider making a gift of the remainder interests in the credit shelter trust to Wife. The result is that all credit shelter trust assets will be included in Wife’s estate at her death, as her life estate and the remainder interests would be merged into one, held by Wife. These gifts effectively merge the life interest and the remainder interests into one, owned fully by Wife, resulting in the assets included in Wife’s taxable estate upon her death. A federal gift tax return would have to be filed by the children, and part of their $11.2 million gift tax exemptions would be consumed to cover the gift tax due as their gifts would not be covered by the federal gift tax annual exclusion. Presumably the children may be in a position that they can afford to utilize some of their lifetime federal gift tax exemption if they understand that they will ultimately receive the (former credit shelter trust) assets upon their mother’s death with a fresh tax basis. Arguably the children could sell their remainder interests in the credit shelter trust with the goal to merge the two trust interests, but that sale would cause gain to be recognized on the sale of their remainder interests in the trust. Also, if the trust contains a spendthrift provision, that would have to be eliminated in order to permit the children to sell or gift their remainder interests to Wife, perhaps again with the trustee decanting the trust to remove the spendthrift provision.
  • Make 100% Principal Distribution: Since the trustee possesses the discretion to make principal distributions to Wife for her welfare and happiness, considered to be non-ascertainable standards, the trustee could exercise its discretion and distribute all assets to Wife, effectively terminating the credit shelter trust with that single distribution. Since this is an extraordinary exercise of fiduciary authority, and arguably inconsistent with Husband’s purpose to establish the credit shelter trust, probably the trustee would not take this step to place title to all the credit shelter trust assets in the name of Wife unless all trust remainder beneficiaries (present and contingent) agreed with this proposed distribution. The remainder beneficiaries might get nervous if all of the assets fell under the control of their mother who might be victimized by predators or decide to give away all of the former credit shelter trust assets to charity on her death. One way to minimize this threat would be for the trustee to form an LLC, ‘wrap’ the LLC around all the credit shelter trust assets, and then distribute the LLC units to Wife with the trustee continuing on in its role as manager of the LLC, now owned by Wife, for a definite period of time, e.g. 5 years, with the power to appoint the successor manager of the LLC, e.g. the children.
  • Terminate the Trust: If the sole purpose of the credit shelter trust that was created by Husband on his death was to avoid federal estate taxes on Wife’s subsequent death [long before portability became part of the federal estate and gift tax laws] it would be possible for Wife and the children to formally petition the probate court to terminate the credit shelter trust, since its tax objectives no longer require the use of the credit shelter trust. [MCL 700.7411(1)(a); 700.7412(2); 700.7416.] Again, the children might be reluctant to agree to the termination if they have concerns about Wife’s long term intention with the assets now under her complete control after the trust is terminated.

Conclusion: With the recent doubling of the federal estate tax exemption amount, new planning opportunities arise, which include revisiting ‘old’ irrevocable trusts with an eye toward causing estate inclusion on the death of the lifetime beneficiary in order to establish a fresh basis in the trust’s assets.