The Delaware Tax Trap

Quick-Take: With income tax basis planning taking center stage now that the Big Beautiful Bill Act is the law with its $15 million applicable exemption amount per person, there could be a renewed interest in intentionally springing the ‘Delaware Tax Trap’ to gain a new, higher, income tax basis in trust assets on a beneficiary’s death.

Background: Giving a trust beneficiary a general power of appointment over trust assets may not be something that the trust settlor is willing to do, for fear that the powerholder’s creditor could access the trust’s assets to satisfy their claims against the general powerholder-beneficiary. In those situations, the trust settlor may find that giving the trust beneficiary a limited power of appointment over the trust assets an acceptable solution to expose trust assets to an income tax basis adjustment, usually on the powerholder’s death. This is called ‘setting up the Delaware tax trap.’

Delaware Tax Trap: There are two separate ‘Delaware tax trap’ provisions in the Tax Code. Both deal with the exercise of a limited power of appointment. One provision is found in the gift tax rules. [IRC 2514(d).] The other provision is found when the power of appointment is exercised in a testamentary context. [IRC 2014(a)(3).] Each Tax Code section states that the exercise of a limited power of appointment in a way that creates a new power of appointment (stacking powers) that can be validly exercised to create a new perpetuities period that is different from the original perpetuities period results in a taxable transfer. These two Tax Code sections are briefly described below.

IRC 2514(d): The lifetime exercise of a limited power of appointment by ‘tacking’ on yet another power of appointment that extends the perpetuities period is treated as a taxable gift. If the exercise of the limited power of appointment is limited to trust corpus, it is a gift of the powerholder’s income interest in the trust property if he/she has an interest in the appointed property under IRC 2036 to 2038 and IRC 2042. Where allocating the powerholder’s GST tax exemption is the goal with this exercise of the limited power of appointment,  springing the gift tax Delaware tax trap relies on the powerholder’s death to trigger his/her GST tax allocation; in this situation,  the GST Delaware tax trap can be ‘sprung’ immediately. However, in the gift tax context, the trust property does not receive an income tax basis adjustment when the ‘trap’ is sprung, since it is a lifetime gift with carryover basis. Therefore, in the lifetime exercise context, the powerholder must weigh the balance of allocation their full GST tax exemption or use the estate tax Delaware tax trap for gross estate inclusion, with an income tax basis increase to the appointed assets.

IRC 2041(a)(3): As implied above, the more traditional use of the Delaware tax trap is in the estate tax context, since it provides that if an individual powerholder exercises a power of appointment in a way that creates a new power of appointment that can be validly exercised to create a new perpetuities period that is different from the original perpetuities period, and that exercise of the limited power of appointment will cause the value of the appointed property to be included in the powerholder’s gross estate for federal estate tax purposes, and an income tax basis adjustment.

[Aside: The mere existence of a general power of appointment is sufficient to cause gross estate inclusion under IRC 2041, and an income tax basis adjustment to trust assets under IRC 1014. Even if the powerholder lacks capacity to exercise their general power of appointment, the income tax basis adjustment rule on the powerholder’s death still applies to all assets subject to that general power of appointment. Revenue Ruling 75-350.]

For example, a trust could grant an older individual a limited power of appointment that the older individual exercises in favor of a family member in a way that either (i) grants that family member a limited power of appointment that can be exercised to create a new perpetuities period, or (ii) grants that family member a presently exercisable general of appointment. [In the past this has been, tongue-in-cheek, called ‘free-basing with grandma.]

The common law and the Uniform Rule Against Perpetuities Act both follow the ‘relation back’ doctrine, which treats the perpetuities period of a newly created power of appointment as that of the original perpetuities period, except in the case of a presently exercisable general power of appointment. Thus,  the Delaware tax trap can be used as a flexible option to allocate additional GST exemption to a non-grantor trust and possibly obtain a new income tax basis of that trust’s appreciated assets. Perhaps a trust director could be given the power to grant an existing trust beneficiary a testamentary limited power of appointment so that it could later be exercised in a manner that could increase the income tax basis of trust assets.

Enhancing the “Trap:” Since the exercise of either a lifetime or testamentary limited power of appointment is needed to impact the income tax basis of trust assets when ‘springing’ the Delaware tax trap, a formula or condition-based limited power of appointment is often used in the trust instrument to enhance the likelihood of gaining the largest basis increase to the trust’s assets.

GST Exemption Allocation: For GST exemption allocation purposes using the Delaware tax trap, the powerholder’s limited power of appointment formula might be restricted to the value of the trust property that will not exceed the powerholder’s then available GST exemption. If the powerholder lacks sufficient GST exemption to fully exempt all of the trust’s assets from GST tax, then a qualified severance by the trustee might be used for the trust to ensure that the trust has fully exempt and fully non-exempt portions, and the powerholder’s limited power of appointment extends only to the non-exempt portion. [Regulation 26.2642-6.]

Tax Basis Adjustment: If the goal is to maximize a new income tax basis for trust assets under IRC 1014(a), the limited power of appointment formula could use an ‘ordering’ rule that prioritizes including in the limited power of appointment, or its exercise, only the trust property that is eligible for an increased new income tax basis, or a proportionate amount of the trust property, while excluding trust assets that are not eligible for a new tax basis on the power’s exercise, such as income in respect of a decedent (IRD), or property that would sustain a decease in its new income tax basis. [IRC 1014(c).]

Conclusion: Anytime anyone mentions the ‘rule against perpetuities’ all eyes glaze over. Anytime anyone mentions ‘triggering the Delaware tax trap’ most people (if they think they understand it) break out in hives. Despite these inevitable negative reactions, considerable tax (basis) planning for trust assets can be achieved by intentionally ‘springing’ the Delaware ‘trap.’ Perhaps new trusts should be drafted with flexibility in mind, and in a manner that gives a trust director the power to grant to an existing trust beneficiary a formula-based testamentary limited power of appointment over trust assets to possibly gain a targeted income tax basis adjustment to select trust assets.

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