Step Up to Basis Planning

With the One Big Beautiful Bill Act now the law, the focus of most Americans will shift from planning to avoid estate taxes to positioning assets for an income tax basis adjustment at the owner’s death. The Act gives every American a $15 million exemption from gift, or estate, and generation skipping transfer tax. Since most Americans have estates less than $15 million federal transfer taxes will not be much of a worry. Accordingly, the shift in focus of many estate plans will now be to saving income and capital gains taxes for the owners and for their heirs.

If an asset is given away during lifetime, the gifted asset’s income tax basis is ‘carried over’ to the recipient. If the recipient then sells the asset, he or she will incur a capital gain. That is not the same if the asset is inherited after its owner’s death. As a generalization the Tax Code adjusts an asset’s income tax basis on its owner’s death to its date-of-death fair market value. [IRC 1014(a).] This is often referred to as an income tax basis step-up since many assets held by the decedent have appreciated in value since the asset was originally acquired.

Consequently, while past estate planning advice was to give away appreciating assets so that appreciation will not be subject to federal estate taxes on the owner’s death, now that advice might shift to hold onto the appreciating asset until its owner’s death, so that the individuals who inherit the decedent’s property will have a new, higher, income tax basis equal to the asset’s fair market value. If those individuals decide to sell the inherited asset, they will not pay much, if any, capital gain tax due to the step-up in basis on the decedent’s death.

Many of the wealth shifting strategies that were used in the past in estate plans, like qualified personal residence trusts (QPRTs), or grantor retained annuity trusts (GRATs), or spousal lifetime access trusts (SLATs) may no longer be as attractive as they once were, since with those strategies, the asset was removed from the trust creator’s estate, but with a carryover income tax basis, which meant that the assets never receive a basis adjustment at the time of the trust creator’s death. Similarly, other sophisticated estate planning strategies used in the past, like the gift of a limited family liability company (LLC) units to children or trusts for children might no longer be attractive, since those entities were used to intentionally ‘create’ valuation discounts for lack of control and lack of marketability of the units that were both gifted and retained by the parent. Now, ‘creating’ a valuation discount may no longer be a smart move if the goal is to gain a full fair market value income tax basis adjustment of assets that are retained by the parent until his or her death.

This income tax basis step-up basis can be exploited with some creative planning strategies, one of which was covered in a previous Perspectives article.

Free-Basing with Grandma

A previous article written years ago focused on ‘free-basing with grandma’ (a tongue-in-cheek title). With this strategy, a parent creates a trust for his or her children. In that trust the parent gives his or her parent, i.e., their children’s grandparent (grandma), a testamentary general power of appointment to appoint trust assets on the grandparent’s death to pay the creditors of the grandparent’s estate (if any). The grandparent does not even have to know that they possess this power of appointment for it to be effective; the mere fact that the grandma holds the power is sufficient to cause the value of the trust assets subject to the power to be adjusted to their fair market value on grandma’s death. This power results in a ‘free’ basis adjustment simply by grandma holding the power to use trust assets to pay any creditors when she dies, whether the power is exercised or not! The mere presence of the power enables the trustee to sell trust assets after the grandparent’s death without incurring any capital gain. When assets are later distributed from the trust to the trust creator’s children, the distributed assets will come to them with a much higher income tax basis.

More to the point, this power of appointment given to grandma can be written as a formula to limit the presence of the power of appointment that might otherwise cause grandma’s estate to pay federal estate taxes. Alternatively, grandma’s testamentary general power of appointment could be limited to only those trust assets with the lowest income tax basis, so that the basis step-up caused by the mere presence of grandma’s power would have the most impact. Or the formula of the power could apply only to those trust assets that would benefit from a basis step-up, but not to trust assets that would have their income tax basis reduced to fair market value when grandma dies.

Trust Director Power to Grant:

With this ability to increase a trust asset’s income tax basis simply by someone merely holding a testamentary general power of appointment over trust assets, some trusts might be drafted in a way where a trust director (formerly called a trust protector) is given the authority to amend the irrevocable trust to give to an elderly person, or a terminally ill trust beneficiary, a testamentary general power of appointment to pay creditors of the powerholder’s estate using trust assets, the presence of which will cause trust assets to have their income tax basis adjusted.

Springing the ‘Trap:’

Yet another way to cause trust assets to have their income tax basis adjusted is what is technically called by intentionally ‘springing the Delaware Tax Trap.’ The best way to explain this strategy under the Tax Code is that a trust beneficiary of a trust holds a limited power of appointment over trust assets. A limited power of appointment will not cause the value of trust assets to be included in the beneficiary’s taxable estate, so it does not cause a basis adjustment on the powerholder’s death. A limited power of appointment restricts the people to whom, or for whom, the power of appointment can be exercised, e.g., ‘the beneficiary may exercise this power of appointment to or for the use of the beneficiary’s descendants.’ However, if the trust beneficiary who holds this limited power of appointment exercises the limited power of appointment by appointing the trust assets into another trust, and that trust extends the period during which the trust assets are tied-up inside a trust longer than the state’s rule against perpetuities, then the value of the trust assets will nonetheless be included in the powerholder’s estate, which again causes the income tax basis of trust assets to adjust to their fair market value on the powerholder’s death. Think of this as ‘stacking’ one trust on top of an existing trust, which delays the distribution of trust assets for an extended period. Under the Tax Code this is called springing the Delaware Tax Trap, (why Delaware is a long story that will be skipped) to intentionally cause assets to have their income tax basis adjusted upward on the powerholder’s death. Unlike the free-basing strategy, with this ‘springing the trap’ strategy, the limited power of appointment must be exercised in a manner that keeps the trust assets tied up in trust for a much longer period of time, but has the effect of causing the value of trust assets to be included in the powerholder’s estate. Again, too, this power could be exercised using a formula to limit the powerholder’s estate to the exposure to pay a federal estate tax.

The world of estate planning changed for many with the Act, shifting the tax-savings focus to avoiding capital gains taxes. Parents and grandparents need to think twice before they make lifetime gifts, since the low tax basis of the gift asset passes to the recipient of the gift. Other lifetime wealth shifting strategies like QPRTs and GRATs may lose their luster when the low basis carried over to the trust beneficiaries is considered. And trust, while still important for creditor and predator protection purposes are still effective, it might be wise to use some testamentary powers of appointment with the trust to cause trust assets to benefit from a basis adjustment on the powerholder’s death.