21-Jul-21
What’s the Delaware Tax Trap
Take-Away: There is a Bill pending in Lansing that would allow a beneficiary of a Trust to intentionally ‘spring’ the Delaware Tax Trap, and thus cause an income tax basis adjustment to the trust’s assets.
Background: At a recent breakfast presentation, I mentioned the Bill that would enact legislation to allow a trust beneficiary to ‘spring the Delaware Tax Trap.’ After that presentation I was asked by a couple of attendees to describe the Delaware Tax Trap and why a trust beneficiary would want to intentionally ‘springn a trap.’
Tax Code: The so-called Delaware Tax Trap is found in two sections of the Tax Code, but for purposes of this summary, only the federal estate tax provision will be addressed. The key provisions are IRC IRC 2514(d) [the gift tax] and IRC 2041(a)(3) [the estate tax.] Both of those Code sections deal with powers of appointment.
– General Power of Appointment: A general power of appointment may be exercised by its holder for their own benefit, for the benefit of their estate, or for either of their creditors. As such, the holder of a general power of appointment is considered as possesss a power of withdrawal over the trust’s assets. As a result, when the holder of the general power of appointment dies, that results in the inclusion of the value of the trust assets, whether or not the general power of appointment is exercised, in the powerholder’s taxable estate. The upshot is that the trust assets will receive an income tax basis adjustment, a ‘step-up in basis,’on the powerholder’s death.
Example: “I give to the trust beneficiary, my daughter Daphne, a testmentary general power of appointment to appoint the assets of this Trust on her death to or for the benefit of her estate or the creditors of her estate.his estate.”
– Limited Power of Appointment: The Delaware Tax Trap deals with the exercise of a limited power of appointment. A limited power of appointment is distinguished from a general power of appointment in that the limited power of appointment cannot be exercised by the powerholder for his or her own benefit, the benefit of his or her estate, or their creditors. The value of the assets held in the trust over which the beneficiary holds a limited power of appointment are not included in the power holder’s estate for estate tax purposes. Consequently, the trust beneficiary can have substantial control over the trust assets using the limited power of appointment, yet not expose those trust assets to estate taxation on the power holder’s death.
Example: “I give to the trust beneficiary, my son Sam, a testamentary limited power of appointment to appoint the assets of this Trust on his death to any of my descendants, or to their spouses, outright or in trust, but not to his estate or to the creditors of his estate.”
Delaware Tax Trap: The Tax Code provides that the exercise of a limited power of appointment in further trust will cause the value of the trust assets to be included in the power holder’s taxable estate, which results in a federal estate tax, but also step-up in income tax basis to the trust’s assets.
– IRC 2041(a)(3): The Tax Code provision is not, however, an example of clarity when it is read: For trust created after October 21, 1942, the trust assets subject to a limited power of appointment will nonetheless be included in the powerholder’s estate-
“By creating another power of appointment which under 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.”
In short, if the holder of a limited power of appointment exercises the power to stack’ a second limited power of appointment onto the first limited power of appointment, thus extending the duration of assets held in trust, the Delaware Tax Trap is triggered. Thus, the elements of the Delaware Tax Trap can be summarized by the following:
– 1. the powerholder validly exercises a limited power of appointment (often called the first power; )
– 2. which creates another limited power of appointment (often called the second power;) and
– 3. the second power can be exercised in an manner that both restarts the rule against perpetuities and extends the duration of the trust.
– Relation Back Doctrine: The legal principle behind the Delaware Tax Trap is what is known as the relation back doctrine. At common law, if an individual exercises a limited power of appointment [or a general testamentary power of appointment over a trust] to create one or more additional trusts, the Rule Against Perpetutities period [i.e. all interests must vest within 21 years after a life in being at the time the trust is created] that applies to the additional trusts so created by the exercise of the limited power of appointment is measured from the date that the original trust, which created the limited power of appointment, became irrevocable, not from the date of the exercise of the limited power of appointment.
Example: In 1943 Fred created a trust for the lifetime benefit of his son, Lamont. Lamont is given a testamentary limited power of appointment over the trust’s assets on his death, exercisable by a Will. If Lamont does not exercise the limited power of appointment on his death, the trust assets will escape estate taxation by not being included in Lamont’s taxable estate. If Lamont exercises the testmentary limited power of appointment in his will, by appointing the trust assets into a continuing trust for the benefit of Lamont’s grandchild, thus extending the duration of assets held in trust beyond the Rule Against Perpetuities, then the trust assets will be taxed in Lamont’s estate. The trust that Lamont created through the exercise of the testamentary limited power of appointment for his grandchild will be be treated as having been created by Fred, meaning that the additional trust for the grandchild relates back to the time when Fred first created the trust back in 1943.
Historical Diversion: The ‘tax trap’ came about when Delaware in changed its laws in 1933 to permit, in effect, a perpetual trust, i.e. one that was not in violation of the common law rule against perpetuities by providing that a limited power of appointment was not subject to the relation back doctrine. Accordingly, with that change in its law, a Delaware trust could confer on a trust beneficiary a limited power of appointment, who in turn could exerise that limited power by granting a second limited power of appointment, i.e two limited powers of appointment stacked on each other, and thus create a perpetual trust that was not in violation of the rule against perpetuties, and without the trust assets ever being subject to future federal estate taxation. Thus, successive limited powers of appointment could extend trusts indefinitely, thereby escaping federal estate taxes indefinitely. It is no surprise that Congress viewed this Delaware law change as creating an estate tax ‘loophole.’ Consequently, in 1951 the Tax Code was amended to provide what is now IRC 2041(a)(3), aka the Delaware Tax Trap.
Intentionally Triggering the Delaware Tax Trap: For several decades IRC 2041(a)(3) was truly a tax trap, where the trust beneficiary’s exercise of the limited power of appointment inadvertently exercised would cause the value of the assets subject to the power to be included in the beneficiary’s taxable estate, yet the assets that were appointed could not be used to pay the unexpected federal estate tax liability. But times change, as does the tax law. With an individual’s applicable exemption amount not at $11.7 million, it is possible for the value of some trust assets to be included in the powerholder’s taxable estate, yet no estate tax is paid due to the high applicable exemption amount. The goal is to expose the trust assets to an income tax basis step-up, but without actually having to pay a federal estate tax.
Example: In 1960 Gretchen established $1.0 million irrevocable trust for her granddaughter Doris. Doris was the lifetime beneficiary, who was also given a testamentary limited power of appointment over the trust’s assets. The trust over the years has grown in value and is now worth $10 million. Doris’ own estate is only worth $1.0 million. In addition, Doris has never used any of her applicable federal exclusion amount of $11.7 million. Doris dies and she by her Will exercises her testamentary limited power of appointment over the trust that Gretchen created, in favor of Doris’ own granddaughter Silva, by imposing a trust on those appointed assets, while also giving Silvia a testamentary limited power of appointment over that newly created trust. Doris has thus ‘stacked’ a second limited power of appointment on to the testamentary limited power of appointment that Gretchen originally created. The estate tax ‘trap’ is thus triggered by Doris. But the inclusion of the $10 million of trust assets in Doris’ taxable estate will not cause a federal estate tax to be paid, since she has plenty of applicable exemption amount to shelter the transferred assets from federal estate taxation. And, all $10 million of those assets will receive a step-up in income tax basis to their fair market value as of the date of Doris’ death. All of the assets held in trust for Silvia can be sold by its trustee and $9.0 million in capital gain taxes can be avoided. In sum, Doris intentionally triggered the Delaware Tax Trap to gain an income tax basis adjustment, but without having to pay a federal estate tax.
Pending Michigan Bill: Michigan, like many states, has written its Power of Appointment statute in a manner that prevents a powerholder’s inadvertent exercise of a limited power of appointment that would cause an unexpected federal estate tax liability due to IRC 2041(a)(3). Yet the Michigan Powers of Appointment statute was written many decades before to today’s currently high federal applicable exclusion amounts became the law. Accordingly, the Bill under consideration would allow a limited power of appointment to be exercised to cause federal estate tax inclusion- along with an adjustment to the income tax basis of the trust assets.
Conclusion: The Bill is intended primarily to expose trust assets to an income tax basis adjustment on the powerholder’s death. It is much like another Bill before the Legislature in Lansing that would permit spouses to declare that all joint trust assets are their community property, again which would cause a full income tax basis adjustment to the joint trust assets on the death of one spouse. One wonders if these Bills at the state level will gain much traction if President Biden’s recent Greenbook proposal for deemed sales and gain recognition on gifts or transfers at death becomes part of the federal Tax Code.