Balancing Basis Benefits in a Bypass

In my last article I discussed why the traditional bypass-type trust remains relevant, even after the federal estate tax has been repealed. Despite the fact that nearly no one pays federal estate tax any more (and if President-elect Trump and the GOP-controlled Congress gets their way, ABSOLUTELY no one will), bypass trusts provide some powerful benefits that marital deduction trusts simply cannot.

A Major Problem with Bypass Trusts: Captured Capital Gains

Bypass trusts are designed to prevent the assets held in trust from being included in the surviving spouse’s estate when he or she later dies. When the property in a bypass trust later passes to other beneficiaries, the basis received by those beneficiaries equals the value of the assets when the bypass trust was initially created and funded. For trusts funded at death, this will be the value of the assets on the date of the first settlor to die. Because basis is adjusted on the death of the first settlor to die, and because the assets are not included in the surviving spouse’s estate, there is no additional basis adjustment when that surviving spouse later dies.

This may not matter if the surviving spouse dies fairly soon after the founding settlor spouse or if the assets don’t appreciate before the surviving spouse dies. Absent significant capital appreciation, there is little tax to pay. But the more appreciation that occurs in the assets held by the bypass trust, the greater the total future capital gains tax liability will be. With the federal long term capital gains rate at 20% and state capital gains rates up to 13.3%,[i] beneficiaries will likely face steep taxes on the sale of appreciated assets when the bypass trust terminates.

Bailing Out the Bypass: Options for Basis Adjustment in a Bypass Trust

Creative planning and administration can dramatically reduce or eliminate the impact of unrecognized capital gains in a bypass trust. In an era when estate tax is irrelevant, it can be desirable to give the surviving spouse enough control over the bypass trust to cause appreciated property to ultimately pass through the surviving spouse’s estate to other beneficiaries. If the surviving spouse is treated as the transferor for capital gains tax purposes, §1014 will apply to cause appreciated assets from the trust to receive a step-up in basis at the surviving spouse’s death.

As a side note, it’s important to remember that assets don’t always get a step-up in basis; they receive a “basis adjustment” to the fair market value of the property in the hands of the decedent at the date of the decedent’s death. This means that if assets have decreased in value, they will actually get a step-down in basis, potentially losing the deductibility of the capital loss. So the trick is causing estate inclusion only for capitally-appreciated assets, and not for assets that have decreased in value. This means that we must be careful and strategic with the methods we use to cause estate inclusion for assets in a bypass trust. Fortunately, there are several techniques worth considering, which can be drafted into bypass trusts to provide flexibility:

Strategically distribute corpus before death. This is certainly a “low-tech” option, but it can cause highly-appreciated assets to get a step-up in basis when the surviving spouse dies. If the trustee of the trust has authority to distribute principal to the spouse, the trustee may simply make the distribution and cause the property to be included in the surviving spouse’s estate. When the spouse dies, the property receives a basis adjustment, wiping out the unrealized capital gains.

Although this can be an effective way to trigger a basis adjustment, it is not without risk. The property distributed outright to the spouse will ultimately pass according to his or her own estate plan. This may or may not be consistent with the original settlor’s intent. If the spouse has remarried, revised his or her will or trust, has disinherited a child, dies intestate, or has significant creditor concerns, the capital gains savings achieved by the outright distribution from the trust may come at a very high personal cost to the original settlor’s family.

Procedurally modify or terminate the trust. Most states have a procedural mechanism by which the beneficiaries can agree – often with the consent of the court – to modify or terminate a trust that no longer meets the settlor’s express intent. Surely one of the settlor’s primary objectives in originally forming a bypass trust was to minimize the impact of estate tax. When the estate tax-saving objectives of the settlor are obsolete, modifying or terminating a trust to minimize future capital gains tax liability for beneficiaries becomes an attractive tax-saving alternative for the bypass trust.

States vary on the requirements for procedural modification. Generally, every beneficiary – including minors – must be represented in the modification action. This may require appointment of a guardian or conservator for minor or incapacitated beneficiaries, likely requiring judicial approval and potentially limiting the scope of modifications that can be made. It can be an effective, if cumbersome, option to distributing property outright.

Decanting to an estate defective trust. Many states allow trust decanting either by statute or by case law. As with procedural modification, the range of flexibility that a trustee enjoys when designing a trust decanting varies widely. Under the comments attending Section 19(b)(8) of the model Uniform Trust Decanting Act,[ii] a trust that was originally intended to bypass the surviving spouse’s estate to avoid estate tax may be modified so as to cause estate inclusion because the “benefit” intended by the original settlor has not yet occurred; it will only do so, if at all, when the spouse dies.

Trusts sitused in states that have no decanting statute, or which have fairly restrictive statutes, can be moved to another jurisdiction with a more favorable statute.[iii] Once situs is adequately established, the trustee will design a new trust with a defect such as a testamentary power of appointment held by the surviving spouse beneficiary, causing the value of the trust to be included in the spouse’s estate at death. That general power may be given over the entire trust, over specific assets in the trust, or over a portion of the trust calculated as a percentage, fraction, or share. It may also be possible for the power to be drafted as formula-based general power of appointment, prioritizing the power to be granted over assets with the greatest amount of built-in gain.[iv]

Trigger the Delaware Tax Trap. In jurisdictions that have not repealed the Rule Against Perpetuities, it is possible for a beneficiary with a limited power of appointment to exercise the power in a way that causes the assets that are subject to the power to be included in the beneficiary’s estate. Specifically, if a limited power of appointment is exercised in a way that restarts the Rule Against Perpetuities, the property subject to the exercise of the power is included in the power-exerciser’s estate. By exercising a power in a way that grants someone else a presently-exercisable general power of appointment, or a “PEG” power, the property subject to the exercise of that limited power is included in the limited power exerciser’s gross estate, triggering a basis adjustment at death.[v]

Include tailored trust protector powers. Estate planning attorneys have significantly expanded the use of trust protectors in domestic planning, including extensive protector powers in revocable living trusts and in wills with testamentary trust provisions. The role of trust protectors has evolved through case law and statute in popular offshore trust jurisdictions and in many states with progressive trust laws.

A trust protector could be given the power to amend a trust instrument in a way that triggers estate inclusion, or the protector may simply expand a limited power to a general power for one or more beneficiaries. In doing so, the protector can strategically trigger inclusion over specific assets, shares, or percentages of a bypass trust to cause the assets subject to the general power to be included in the beneficiary’s estate at death, generating a basis step-up for appreciated assets.

In the context of a bypass trust this might certainly happen with a surviving spouse, but the power to expand or grant a general power of appointment could be used at any time to allow appreciated assets to be stepped-up at any beneficiary’s death. For example, if a bypass trust beneficiary who is younger than the surviving spouse has a terminal condition, the protector might grant that beneficiary the testamentary general power to appoint property in favor of the creditors of the beneficiary’s estate[vi] in order to trigger inclusion under §2041 and generate the basis adjustment under §1014.

By narrowly-tailoring the beneficiary’s general power of appointment the trust protector can tweak the trust to ensure that low-basis assets get stepped up at a beneficiary’s death, while maintaining a high likelihood that the assets will actually remain in trust subject to the original settlor’s intent.[vii]

Tax-driven decisions, however sound they may be, should not be made in an information vacuum. Trustees, protectors, and their counsel must carefully consider other nontax issues that may vitiate the distribution of property or the granting a power of appointment to a beneficiary under a bypass or other estate-excluded trust.[viii] Aside from historical transfer tax objectives, bypass-type trusts still offer benefits worth considering. With forward-thinking planning and creative administration, they can merge the protective benefits with modern tax opportunities.

I hope that by considering this article and its predecessor, attorneys and advisors have a renewed appreciation for the power of bypass trust planning in a post-estate tax world, and get some creative ideas for having the best of both worlds: bypass trust protection with basis adjustment flexibility.

Matt

Notes:

[i] Thank you, California.

[ii] As of this writing the model Uniform Trust Decanting Act has been enacted in Colorado and New Mexico, and is pending in California and Illinois.

[iii] For an excellent resource comparing state decanting statutes please see Steven J. Oshins’s excellent guide at https://oshins.com/images/Decanting_Rankings.pdf

[iv] This strategy was first designed and explained by Edwin P. Morrow, III. A full description of the formula-based general power of appointment strategy may be accessed at https://ssrn.com/abstract=2436964

[v] IRC §1014(b)(9)

[vi] In order to qualify as a general power of appointment the power must be exercisable in favor of any of the following: 1) the power holder, 2) the power holder’s estate, 3) the power holder’s creditors, or 4) the creditors of the power holder’s estate. (See Treas. Reg. §20.2041-1). Of course, it’s nearly inconceivable that a beneficiary would ever exercise a power to appoint in favor of the creditors of his estate. But merely holding the power–even if never exercised–causes the property subject to that power to be included in the power holder’s estate. This makes it possible to grant a narrowly tailored power of appointment that is not likely to be exercised, but in a way that nonetheless causes a basis adjustment for capital gains tax purposes.

[vii] If a trust protector expands a beneficiary’s limited power to a general power the beneficiary will become the transferor of that property for GSTT purposes. If the original settlor had allocated GSTT exemption to the transfer into trust for the beneficiary, this will effectively mean that the settlor has wasted the GSTT allocation. The decision to expand a LPOA to a GPOA must therefore be done on a case-by-case basis to balance the GST exemption allocation issues against the basis adjustment issues for the beneficiaries.

[viii] Quick examples include a beneficiary who is on needs-based assistance due to a disability, where a distribution of income would cause suspension of benefits, or a beneficiary embroiled in litigation, where a distribution may get swallowed up by a creditor.