By: Edward Brown, Esq
In this current 2021 tax landscape, each individual person is now able to own up to $11,700,000 in assets (or more if discounting vehicles are used) without ever being subject to (i) the 40% federal estate tax; (ii) the 40% federal generation-skipping transfer tax; and (iii) in a number of states, an additional state level estate tax. Many existing estate plans are outdated with the entire individual’s estate assets being directed to be held in a “bypass trust,” “credit shelter trust,” or in what is sometimes referred to as a “Trust B” or “exemption trust.” While it is true these types of plans also avoid the estate tax hit, they do so at the cost of disallowing any “step-up” in the income tax basis of trust assets upon the death of any family member. As such, without this step-up in basis, assets retain their historic low income-tax basis, which results in larger capital gains taxes or other taxes upon the eventual sale of those assets.
An update may therefore be in order for these outdated estate plans. Highly respected estate planning professionals have been suggesting the insertion of a clause in estate plans that allows a “special trustee” to grant a limited “general power of appointment” to any of the beneficiaries, which can include elder family members and other persons with much shorter expected life spans. These persons however need to truly be beneficiaries as opposed to a special trustee just granting “naked” powers to older individuals.
If there is a concern that once the special trustee grants a power of appointment to someone, such power could be abused or used in a way that would be against family values (as this power does give that someone a huge power to direct trust assets to be possibly paid to that person’s estate’s creditors, if any), then certain added drafting measures can be taken. For example, the exercise of any granted general power of appointment can be conditioned upon the joinder of consent by a non-fiduciary non-beneficiary person that you have selected. This consenting party serves as a check-and-balance so that such general powerholder cannot be coerced or influenced by opportunity-seeking adverse parties, such as a creditor.
What, however, if the trustee grants a beneficiary such a general power of appointment, but later decides that was a bad idea? Perhaps the trustee later develops a concern that the powerholder is about to be swindled into exercising the power, or the powerholder’s own estate has itself become subject to estate taxes due to a legislative reduction to the estate tax exemptions.
The IRS (in Private Letter Ruling 201845006 ) has stated that if such a power is in fact later revoked or restricted, no taxable gift occurs. Instead, this is viewed as simply an exercise of the administrative authority of a special trustee.
The above set-up can provide an incidental asset protection strategy as well. If a person creates a trust for his/her own benefit, it is what is known as a “self-settled” trust. Most state laws do not protect such trusts from the trust-creator’s creditors. In the scenario first described above, the trust is being created only for other family members, charities or possibly other persons very close to the trust-creator (who is called the “Settlor”). The only way the Settlor is able to become a recipient of the trust assets is by way of a couple of intervening events that are beyond the Settlor’s control (e.g., the appointment of a special trustee, or if already appointed, the special trustee granting a power of appointment, and such powerholder exercising that power of appointment to direct assets to the Settlor). Nonetheless, for those who think that this is a distinction without a difference, and therefore fear a court might consider such a trust to be in substance a self-settled trust, then consider as a belt-and-suspender approach having the trust incorporate the trust laws of (i) one of the nineteen states that protects self-settled trusts, or (ii) the laws of one of the numerous offshore jurisdictions (e.g., Cook Islands, Nevis, Isle of Man, Belize, Jersey, Guernsey) that protect self-settled trusts.
Nevertheless, the above set-up is positioned to better withstand any allegation that the Settlor has created a trust that includes the Settlor as a beneficiary. Also, if financial circumstances change some day (a rainy day trust concept) in which a need for access to the trust occurs, at least preferred independently-thinking parties are in control of the assets as opposed to the assets falling under the control of a creditor. The creditor who can otherwise seize trust assets, would likely act, in contrast to the preferred parties, in a manner that such creditor believes can do the most harm to the Settlor. Having the trust assets remain under the control of preferred parties allows such parties to take actions, if they so choose, to do what would not be motivated as a way to be hurtful to the Settlor. In other words, a Settlor’s situation may be vastly better than the alternatives.
Although beyond the scope of coverage of this blog, the trust can also be designed to have the trust assets, in the event the general power holder dies without ever having exercised the power, circle back to an enhanced trust design that also gives the Settlor better options, as well as achieving a newly “stepped-up” income tax basis that avoids capital gains taxes that the trust would not have otherwise been able to achieve. This can be even more significant especially if higher tax rates exist under the Biden administration, assuming any new tax laws do not run counter to the existing laws.
The icing on the cake is that such a trust is mostly a tax strategy, notwithstanding that is has some incidental asset protection qualities.
The trust assets, as intimated above, are eligible for a step-up in income tax basis (mark-to- market) at the time of the powerholder’s death because of the powerholder’s appointment powers. The tax code treats assets subject to such powers as includible in the powerholder’s estate (which has no estate tax ramifications if the powerholder owns or has such powers over less than $11,700,000 under current law, or more with what is known as “portability”) and therefore generally achieves a whole new “cost basis” in all of the trust assets. Such a tax goal/motive can take the wind out of the sails of a Settlor’s creditors who might otherwise try to argue that the Settlor had created the trust as a fraudulent transfer device, primarily motived (as such argument goes) to achieve nothing more than a scheme to hinder or delay creditors.
