Wills and Trusts

Wyatt, Tarrant & Combs, LLP

MAXIMIZING AND MULTIPLYING THE “STEP-UP” IN BASIS – Part IV

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MAXIMIZING AND MULTIPLYING THE “STEP-UP” IN BASIS – Part IV

General Powers of Appointment

Generally

A general power of appointment, as defined in the Code,[1] is a power exercisable in favor of: (i) the power holder, (ii) his or her estate, (iii) his or her creditors, or (iv) creditors of his or her estate.  From a transfer tax standpoint, the mere existence of an exercisable general power of appointment at the death (a testamentary general power) of the power holder will cause assets subject to the power to be includible in the power holder’s estate.[2]  Moreover, the lack of knowledge of the existence of a general power of appointment will not exclude the property subject to the power form being included in the estate of the deceased power holder.[3]

Whether or not the holder of the power exercises a testamentary general power, the property passing under the power is deemed to have passed from the deceased power holder without full and adequate consideration, and the property will get a “step-up” in basis.[4]

Given the potential income tax savings from the “step-up” in basis and growing Applicable Exclusion Amounts in the future, estate planners will need to consider how, under what circumstances and to what extent a testamentary general power of appointment should be granted to future trust beneficiaries, even if the assets have been correctly transferred into a vehicle (like a dynasty trust) that is structured to avoid estate tax inclusion at every generation.  So-called limited general powers may be helpful in this respect.  For example, a power to appoint only to the creditors of the powerholder’s estate may be less susceptible to undesirable appointment than a power to appoint more broadly.  Further, the exercise of a power may be subject to the consent of another person so long as the person does not have a substantial interest adverse to the exercise of the power in favor of the decedent, her estate, her creditors, or the creditors of her estate. [5]

Formula

A testamentary general power of appointment may be created by a formula that absorbs any unused portion of a beneficiary’s unused Applicable Exclusion Amount (including any DSUEA).  This would provide a “step-up” in basis to those assets subject to the power without causing any Federal estate tax liability.  In theory, this formula can be drafted with great precision.  Such a formula is very difficult to draft and may, even if properly drafted, be subject to IRS challenge.

A testamentary general power of appointment that attempted to achieve the maximum favorable tax results would seem to require the following features:

(1)  A formula that determines the size or amount of the general power of appointment.  As mentioned above, in theory, the starting amount of the formula is the Applicable Exclusion Amount as defined in section 2010(c)(2) of the Code, which would include the Basic Exclusion Amount under section 2010(c)(3)(A) of the Code, including any increases due to the cost-of-living increase, and any DSUEA.

(2)  The starting amount would then need to be reduced by any reductions due to taxable gifts that reduced the Applicable Exclusion Amount prior to death and any testamentary transfers that would not otherwise be deductible for Federal estate tax purposes (marital transfers under section 2056 of the Code and charitable transfers under section 2055 of the Code).

(3)  Once the size of the power of appointment has been so determined, the formula would need to provide that the power is not simply exercisable against all of the assets in trust, but  rather only against those assets in the trust that would benefit the most from a “step-up” in basis, given the tax nature of the asset (as discussed above).   For example,  if the trust only held publicly-traded assets, the formula would want to ensure that the power is exercisable against the lowest basis lots of securities, not against the securities that have unrealized losses or the cash.  The formula would likely need to determine the total income tax cost (including state income taxes) to the trust in a constructive liquidation of the assets in a taxable transaction for fair market value and then segregate those assets or portion of assets (like a separate lot of stock) that have the highest relative income tax cost compared to fair market value (the highest “effective” income tax cost).  Without this refinement, the basis adjustment under section 1014(a) of the Code will be applied across all of the assets whether they benefit from the “step-up” in basis or not, and if the total value of the assets exceed the size of the general power of appointment, no asset will get a full “step-up” in basis.[6]

(4)  The formula would likely also distinguish between assets that are and are not likely to be sold or redeemed in a taxable transfer (for example, closely-held C corporation shares in a family-owned business) and those assets that are not likely to be sold but provide some ongoing income tax benefits by virtue of the “step-up” in basis (for example, depreciable and depletable assets).

(5)  In determining the “effective” income tax cost in a constructive liquidation of the trust assets, the formula may need to reduce the original size of the power of appointment to take into account any state death tax costs (if the beneficiary dies in a state with a state death tax) that would result from the existence of the general power of appointment.  Most states with a death tax have an exemption that is smaller than the Federal Applicable Exclusion Amount, and no state provides for “portability” of a deceased spouse’s unused state death tax exemption.  As such, formula would need to take into account the “effective” state death tax cost (in comparison to the fair market value of the asset) and compare that to the income tax savings from the “step-up” in basis for the assets with the highest “effective” income tax cost on the date of death.  The formula might then reduce the size of the general power of appointment to so that at the very least the “effective” state death tax cost equals (but likely is less than) the “effective” income tax cost of those assets that would be subject to the power of appointment.  Note, some states provide that a general power of appointment is not subject to state death tax.[7]  Because of the foregoing, drafters may choose to limit the size of the general power of appointment to the lesser of the Applicable Exemption Amount and any applicable state death tax exemption.

(6)  To further complicate things, in determining the size of the general power of appointment, the formula will need to consider differences between the Applicable Exclusion Amount and the any remaining GST exemption the beneficiary may have at the time of death.  If, for example, Applicable Exclusion Amount is greater than the beneficiary’s GST exemption, should the general power of appointment be reduced to the lesser of the two amounts thereby foregoing some portion of the available “free” step-up in basis?  Or should the general power of appointment be the greater of the two amounts but provide a different disposition of those assets depending on whether GST exemption is applied to such “transfer” (even if the failure to exercise the power of appointment)?  In other words, assets receiving both a “step-up” in basis and application of the beneficiary’s GST exemption would continue to stay in the dynasty trust, for example, and assets that only receive “step-up” in basis would be held in a separate “non-exempt” GST trust.

Even if the formula could be so written with such precision, there is a chance that the IRS would challenge the general power of appointment (especially if the beneficiary has a surviving spouse) as indeterminable at the time of death of beneficiary or subject to a contingency or condition precedent.

As noted above, the size of the general power of appointment should be reduced by any transfers that would not otherwise be deductible for Federal estate tax purposes (marital transfers under section 2056 of the Code and charitable transfers under section 2055 of the Code).  Whether a transfer will qualify for the marital deduction or a charitable deduction may be dependent on a QTIP election under section 2056(b)(7)(B)(v) of the Code or a qualified disclaimer under section 2518 of the Code, both of which occur after the date of death.  A QTIP election is made on a timely filed estate tax return,[8] and a qualified disclaimer is made 9 months after date of death.[9]

The IRS’s argument might be that despite the crux of the  Fifth Circuit’s ruling in Clayton v. Commissioner[10] that a QTIP election relates back to the date of death and the same could be said about qualified disclaimers,[11] these actions do not relate to a general power of appointment under section 2041 of the Code.  The election and disclaimer do, however, affect the size of the general power of appointment.  As such, they are similar to a contingency that has not yet occurred on the date of death.  In private letter ruling 8516011, the IRS ruled that a marital bequest that was conditioned upon the surviving spouse’s survival of the decedent’s admission to probate would not be included in the surviving spouse’s estate because the spouse died prior to the will being admitted to probate.  In the ruling, the IRS stated that even though the spouse had the power to admit the will to probate and thus had a power of appointment, this power of appointment was subject to the formal admission to probate, which in turn requires a substantive determination by the court regarding the validity of the will.  As such, the general power of appointment was deemed not to exist for estate tax purposes.[12]  Because of the complexities of the formula and the risk of IRS challenge, a preferable approach may be to rely upon an independent person – – trustee, advisory committee, or trust protector, for example, to grant a new general power or to expand a special power so that it becomes a general power. [13]

Turney P. Berry

Louisville, Kentucky


[1] §§ 2041(b)(1) and 2514(c).

[2] § 2041(a)(2) and Treas. Reg. § 20.2041-3(b).

[3] Freeman Estate v. Commissioner, 67 T.C. 202 (1976).  Section 2207 apportions the Federal estate tax attributable to the property subject to the power to such property.

[4] Treas. Reg. § 1.1014-2(a)(4). Treas. Reg. § 1.1014-2(b)(2).

[5] Treas. Reg. § 20.2041 – 3(c)(2).

[6] Similar to the basis adjustment under section 743 of the Code upon the death of a partner when the partnership makes or has a section 754 election.  See also Rev. Proc. 64-19, 1964-1 C.B. 682 , in the marital funding area, which requires that the assets selected for distribution be fairly representative of the appreciation and deprecation between the decedent’s death and the funding.

[7] Pennsylvania provides that mere existence of a general power of appointment does not cause inclusion of the assets subject to the power for inheritance tax purposes.

[8] § 2056(b)(7)(B)(v).

[9] § 2518(b)(2).

[10] 976 F.2d 1486 (5th Cir. 1992), rev’g 97 T.C. 327 (1991).

[11] See § 2518(a) and Treas. Reg. § 25.2518-1(b).

[12] See TAM 8551001 and Kurz Estate v. Commissioner, 101 T.C. 44 (1993), aff’d, 68 F.3d 1027 (7th Cir. 1995).

[13] See, e.g., Alaska Stat. § 13.36.370(b)(4) (“modify the terms of a power of appointment granted by the trust”); Idaho Code §15-7-501(6)(c) (“To modify the terms of any power of appointment granted by the trust. However, a modification or amendment may not grant a beneficial interest to any individual or class of individuals not specifically provided for under the trust instrument.”); S.D. Codified Law § 55-1B-6(3) (“Modify the terms of any power of appointment granted by the trust. However, a modification or amendment may not grant a beneficial interest to any individual or class of individuals not specifically provided for under the trust instrument.”); Wyo. Stat. § 4-10-710(a)(xi) (“to grant a power of appointment to one (1) or more trust beneficiaries or to terminate or amend any power of appointment granted by the trust; however… of a power of appointment may not grant a beneficial interest to any person or class of persons not specifically provided for under the trust instrument or to the trust protector, the trust protector’s estate or for the benefit of the creditors of the trust protector.”).

Leave a reply. Please note that although this blog may be helpful in informing clients and others who have an interest in information privacy and security, it is not intended to be legal advice. The information on this blog also should not be relied upon to form an attorney-client relationship.

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